Use of financial derivatives lags in U.S. electricity market

Washington, D.C.

The daily average volume of energy-related futures contracts on the New York Mercantile Exchange (NYMEX) grew from approximately 7,340 in 1982 to 467,042 in the first half of 2002. Essentially all of these contracts involve natural gas and petroleum, the Energy Information Administration (EIA) reported recently.

Today, natural gas and petroleum products are the second most heavily traded category of futures contracts on organized exchanges, after financial products, according to an EIA report released last month, “Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries.”

The growth in derivatives reflects the volatility of energy markets.

Over the past decade, natural gas prices have been five times more volatile than the Standard and Poor’s 500 stock index (S&P 500).

Gasoline and heating oil have been about 2 1/2 times more volatile.

Wholesale electricity prices in the East and West have been 20 times more volatile than the S&P 500 over the past five years.

Domestic energy industries have turned to derivatives to manage these rapidly changing, volatile prices. Energy companies have increasingly purchased and sold futures contracts, options, swaps and other derivatives to lock in favorable prices. By transferring price risk to those more able and willing to bear it, firms smooth out their cash needs and can invest in worthwhile projects they otherwise would forgo.

Unlike the oil and gas markets, derivatives in electricity markets have not met with a great deal of success. NYMEX began offering electricity derivatives in March 1996, and the Chicago Board of Trade and the Minneapolis Grain Exchange have also offered electricity derivatives.

NYMEX had the most success, at one point listing six different futures contracts. Trading in electricity futures and options contracts peaked in the fall of 1998; however, by the fall of 2000 most activity had ceased. Today, no electricity contracts are listed on the regulated exchanges.

The prospects for the growth of an active electricity derivatives market are tied to the success of the Federal Energy Regulatory Commission’s (FERC) recent initiatives to build a competitive electricity market. A well-functioning electricity market might encourage the revival of electricity derivative markets and provide the industry with powerful tools to manage price risk.

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