Should Government Try to Reduce Energy Price Volatility?

Should Government Try to Reduce Energy Price Volatility?
October 1, 2009

James L. Johnston

Jim Johnston is The Heartland Institute's senior fellow for energy and regulatory policy and a... (read full bio)

The leaders of the world have declared war on speculation. The Obama administration’s Commodity Futures Trading Commission is considering position limits on the trading of energy contracts. U.K. Prime Minister Gordon Brown and France’s president, Nicolas Sarkozy, have urged “improving transparency and supervision of the oil futures markets” to reduce oil price volatility.

Even Pope Benedict has jumped into the issue, calling for global “regulation of the financial sector, so as to safeguard weaker parties and discourage scandalous speculation” in his recently issued encyclical, “Caritas in Veritate.”

Exchange-traded energy derivatives, including crude oil, refined products, and natural gas, are among the most liquid contracts and offer hedging opportunities extending several years into the future. For example, New York Mercantile Exchange (NYMEX) crude oil futures contracts extend 8.5 years, and natural gas futures contracts go out 12.5 years. Futures coupled with options contracts provide very useful hedging instruments, because they are substitutes for long-term contracts and vertically integrated corporate structures.

The hedging is done by those with long physical positions, including crude oil and natural gas producers, and those with short physical positions, including refined product refiners, marketers, and industrial consumers.

Speculators’ Add Liquidity

The hedging is facilitated by speculators who make the contracts liquid. Hedging is also helped by other financial institutions that tailor exotic derivatives to individual businesses “over the counter.”

These financial institutions then hedge their risk exposure using the exchange-traded derivatives. These operations are very complex mathematically and probably beyond the ability of regulators to intervene instantaneously with a positive benefit. Moreover, just the possibility of intervention serves to reduce liquidity and flexibility in developing new contracts. This, in turn, makes hedging substantially more difficult.

Some Prefer Intervention

Some institutions with physical positions to protect often choose not to hedge sufficiently. Instead, they rely on government intervention to relieve them from adverse prices.

Typically these are regulated utilities. The 2000-2001 energy crisis in California is a case in point. The electric utilities could have hedged the volatility of the government-imposed spot electricity market and the cap-and-trade emissions trading scheme by using natural gas contracts, but they did not. The utilities instead relied on the Federal Energy Regulatory Commission and the South Coast Air Quality Management District to overturn the contracts and order refunds.

Regs Favor Politically Connected

This raises the general question of how likely it is that government regulation will protect the poor and weak.

Whenever a political allocation of resources is substituted for a market allocation, it favors those with political power. Do the poor and weak have political power? I think not. If they did, they would not be poor and weak.

Moreover, it is important to understand that price volatility is a result of changes in demand and supply conditions. In the short run, accommodating changes in physical consumption and supply is very costly, hence prices move sharply to achieve equilibrium. In other words, markets do not create volatility in prices. It is the other way around. Volatility in prices creates the demand for markets for hedging.

Government-imposed limitations will not help the markets to function better, and the poor and weak will probably suffer most from the intervention.

Jim Johnston (jjohnston@heartland.org) is an economic advisor to The Heartland Institute.

James L. Johnston

Jim Johnston is The Heartland Institute's senior fellow for energy and regulatory policy and a... (read full bio)