Energy Trading: The Market's Response to Deregulation

The energy sector of the U.S. economy has changed in extraordinary ways. Today the prices we pay to heat and light our homes and offices, cook our food, and drive our cars are, when adjusted for inflation, about what they were in 1949. Widespread concerns about the security of energy supplies have diminished, also. Sooner or later Americans will buy all of their energy on the open market—probably from nationally known energy companies rather than local utilities—and get better service into the bargain. These benefits derive from an epochal shift in responsibility for setting energy prices—from the purview of governments and cartels acting in secrecy to free agents trading publicly in the marketplace.

Oil markets have been free of regulation for sixteen years. More recently, policymakers have been focusing on increasing competition in the natural gas sector and on liberating electric utilities from government's long-established control. The shift away from government regulation of energy has led to something perhaps even more important than implacable downward pressure on the price of a barrel of oil. It has instigated development of multiple trading centers—in New York, Rotterdam, Singapore, and else-where—that are dedicated to competition in free trade for crude oil and related products.

Does any of this trading activity really matter to ordinary people? Yes, but not obviously. Once goods and services enter the world of commodity markets, they become part of a trading system so vast, and now so global, as to make it difficult for any individual or group to manipulate supply and price as OPEC did during the notorious decade of energy crises. Identifying causes and effects of price changes also becomes difficult when markets take over. Consider something so common as toilet paper.

Paper mills, a great many of which burn residual fuel oil to power their plants, make products whose prices must necessarily reflect the energy cost of production. In the eastern half of the United States, the price that paper mills pay for fuel oil is set in the so-called New York Harbor (NYH) for fuel oil. The price of NYH oil is, in turn, shaped by the interplay between supply and demand on the U.S. East Coast, and by political and market developments in other regions of the world—as distant as Siberia.

Siberia? In recent years, one of the most influential factors shaping NYH prices has been Russian fuel oil export policy. During the last three winters, the Russian government has either banned fuel oil exports altogether, or has so heavily taxed the export barrels as to make them uneconomic on the world market. Russia has done so to guarantee availability of this same fuel to electric power plants in its own remote regions. Interestingly, barely a drop of Russian fuel oil ever actually makes it to the East Coast of the United States under any circumstances. But the imposition of Russian export controls dramatically elevates prices in NYH because it reduces the volume of fuel oil available to the highly integrated "Atlantic basin" market. Thus, because most paper mills buy fuel oil through long-term contracts tied to the spot price in New York, they are quite vulnerable to any price fluctuations anywhere in the system. Any increase in energy input costs ends up reflected in the price of toilet paper. (The spot price reflects a market where transactions take place immediately. Unlike futures markets, the commodity being traded is on hand and delivered to buyers "on the spot.")

The impact of Russian oil export policy can also be felt by electricity consumers in New England. In that region of the United States, plant capacity to generate electricity by using oil happens to be significant. The fuel oil that New England utilities purchase is typically priced off the same NYH market used by paper mills. To the degree that the electric utilities have supply contracts tied to spot prices, they are as vulnerable to changes in Russian export policy as are the paper mills.

As deregulation of electric utilities moves forward, events in places as remote as the frozen tundra of northern Russia will affect energy buyers in New England. And so if an increase in the price of toilet paper does not grab the attention of U.S. consumers, the rise and fall of electricity prices surely will.

The news about deregulation is of course not invariably positive. Along with vigorous competition, free markets also bring uncertainty and unpredictability—a kind of trading frenzy that results in price volatility. From time to time, and for reasons that are not entirely obvious to the average consumer, prices of commodities such as oil go up, sometimes sharply, recurrently and repeatedly, and always inconveniently. This was the case, for example, in the winter of 1996–97 when American consumers experienced unexpectedly high prices for the oil they use to heat homes and buildings. During the same winter, consumers were also subjected, albeit briefly, to extremely high prices for natural gas. Politicians reacted to these events by calling for government to intervene by, for example, releasing stocks held in the Strategic Petroleum Reserve.

That politicians feel pressure to step in and "fix" sudden price spikes is not surprising. Reliance on the market is hardly a policy carved in stone. And even when the commitment to competition is made, economic deregulation in a sense never really ends. Crude oil and markets for related products, for example, continue to require tinkering. The U.S. gasoline market was so fragmented by implementation of regulations related to the Clean Air Act amendments of 1990 that trading in gasoline futures remains unviable—an unintentional but nonetheless significant consequence. Similarly, the natural gas market, some aspects of which are still heavily regulated at both federal and state levels, has proven difficult to organize in a manner that protects the interests of all consumers (see "Deregulating Natural Gas"). The electric power market, meanwhile, is just getting organized. In terms of value and volume of trade, it will be larger than all other energy markets combined (see "Trading in Electrons").

For every problem created by deregulation, however, markets are proving capable of devising solutions. Some paper mills and electric companies, for example, have turned to investment bamls and trading houses to find protection from the price volatility of markets like those for fuel and oil. So-called hedging instruments for managing price risks, developed first in the oil markets, then in the natural gas markets, and now in the electric power markets, provide financial vehicles for large consumers to "lock in" energy prices over a specified period of time. These instruments free them from the price volatility that characterizes trade in spot markets. Moreover, they can use other financial tools, like price options, to capture a windfall if a price well below the guarantgeed price they locked in previously. So, in the imminent market for competitive electricity—and for other energy traded as commodities—the happiest consumer will be the one that chooses a clever hedger for a supplier.

The average home owner is, of course, unlikely to have the means or the opportunity to check on the financial management skills of the energy companies that offer service. Here the responsibility falls back on the regulators. They who previously devoted their greatest efforts to setting rates will, in the deregulated world, devote time and vigilance to ensuring that markets are competitive. A monopolist has no motivation to reduce price risk exposure because it can pass that risk (and the higher cost) on to the consumer. In a competitive market, however, where consumers can shop around for the energy they need, the vendor with the lowest price is likely to prevail. Other factors being equal, the vendor that sells at the lowest price is also the most likely to have protected itself against volatility.

Freedom Is Worth the Risk

The value of energy has preoccupied governments on all continents since economies first became dependent on commercial fuels. Energy has been priced too high or too low relative to its market value because governments have insisted on saddling its trade with myriad social and security burdens. Despite the fact that deregulation remains an unfinished business, what occurred thus far presents fairly clear evidence that free energy markets result in lower costs to consumers. If it remains for the political establishment to take this evidence and make it enduring policy at least a precedent exists for doing so. The impetus toward greater energy sector deregulation can be traced to the hotly debated Energy Policy Act of 1992 (EPAct). It took Congress nearly two years to forge a consensus in support of this legislation. But perhaps more than any other energy legislation in recent memory, this law sent a strong signal that the federal government was finally fully committed to free trade in energy.

Markets are risky, and their organization and management are sometimes flawed. But as Winston Churchill used to say of democracy they are better than all the other alternatives.