Price risk may also be managed through inventory control. Long term contracting at fixed prices might also reduce the firm's exposure to price volatility. The chosen strategy must be cost effective, flexible, and reliable. Financial derivative based strategies fit these requirements for many firms in the energy industries. While cash settlement expands the spectrum of participants in the market and is more efficient than physical delivery for most contract holders, it can create the perception that the motivation and focus of the contracts are a purely financial bet on the future price of oil rather than a business strategy designed to reduce risk. Through the use of OTC derivatives, the firm may be able to eliminate basis risk and more effectively hedge the effects of price risk. In many strategies, options are put together in combination to achieve the risk management goals of the company. Each of these transactions, as well as both taken together, could be legitimate hedging transactions. Also, the time frame can be important. This question has been answered for the traded derivative sector. As a result, the organized markets, including the NYMEX, self regulate with oversight by the Commission. However, the collapse of Enron's trading operations did put a chill on OTC energy trading and led to calls for a variety of specific reforms which are discussed later in this report. The use of derivatives might have the effect of reducing the cost of capital for firms, enhancing their real capital investment, and increasing their value. Although there is little direct evidence that the use of derivatives increases the value of the firm, the near universality of use by energy firms, as shown by the EIA, suggests that a wide spectrum of energy managers see value in using derivatives to manage risk. Derivatives and Commodity Prices

Since the value of a derivative contract is based on the value of the underlying commodity, when the price of the commodity varies the result is a variation in the price of the derivative. Specifically with respect to price volatility, the study found that changes in hedge fund positions, in both the crude oil and natural gas markets, tended to reduce price volatility, lending a stabilizing factor to the market. Senator Dianne Feinstein proposed derivatives legislation, ( S. 1951 ), in the Senate, while, independently, Representative Peter DeFazio introduced a bill, ( H.R. 4038 ), in the House of Representatives. Legislation introduced in the 109 th Congress focused on data reporting and the transparency of OTC trades. H.R. The proposals discussed above all touch on the issue of price transparency.
Risk management is important in the energy industries because of the volatility of oil and natural gas prices. Price volatility can reduce the profit of business strategies and hurt consumers. The use of financial derivatives, both traded and over-the-counter, has developed as a low cost method of hedging price risk. However, the use of derivatives has also been linked to major financial scandals and bankruptcies.
Risk management strategies can be undertaken without the use of derivatives. Vertical integration of the production process, inventory control, and long-term, fixed price contracts can all compensate for the effects of price volatility. Whether one of these choices, or a derivative strategy, is chosen depends on the cost and flexibility of each alternative. Derivative use has expanded rapidly both in value and volume.
Exchange traded and over-the-counter derivatives have different characteristics with respect to their liquidity, safety, transparency and flexibility. The benefits and costs of using either instrument depend on the circumstances and goals of the firm setting up the strategy. A wide variety of derivative contracts exists, including forwards, futures, options and swaps which can be put together to achieve a wide variety of objectives.
Although exchange traded derivatives are self regulated with oversight by the Commodity Futures Trading Commission, over-the-counter derivatives are largely unregulated. Whether these transactions should be regulated might depend on their effect on commodity price volatility, their effect on the stability and integrity of U.S. capital markets, their ability to reduce the cost of capital, enhancing domestic real investment and the value of more open disclosure and price transparency.
Congress considered proposed derivative legislation in the 107th Congress. Senator Dianne Feinstein introduced legislation in the Senate, while Representative Peter DeFazio independently introduced a bill in the House. In the 108th Congress, Representative DeFazio again introduced a derivative regulation bill (H.R. 1109) and the 109th Congress considered H.R. 1638 and S. 509. In the time since the collapse of Enron, many specific proposals to reform the derivative markets have appeared. These include tying derivative trading more closely to the underlying business interests of the market traders, establishing a clearinghouse to manage transactions, establishing structured derivative trading companies and enhancing reporting and documentation requirements. Each proposal has its strengths, but each could also reduce the effectiveness of the derivative industry in managing risk.
This report will be updated as events warrant.