The use of financial derivatives by American industry began in agriculture in the 19 th century. Later, they were widely used in foreign exchange transactions, as well as in the bond markets. Their use in energy markets began in a modest way with the introduction of a heating oil futures contract in 1978 at the New York Mercantile Exchange (NYMEX). The NYMEX has since become the dominant market for traded energy derivatives in the United States. This initial contract expanded over the next fifteen years to include contracts on unleaded gasoline, sweet crude oil, propane, natural gas, and sour crude oil. In 1986, the first option contract, on crude oil futures contracts, appeared. This was followed by a host of other contracts on a variety of energy products as well as margins between products, and over time, which are called spreads. Use of these contracts expanded rapidly and they have become an important part of the financial and physical sides of the energy business. In 2004, the NYMEX traded and cleared approximately 169 million contracts on all commodities, a record, which was then surpassed in 2005, when over 204 million contracts were traded and cleared. Paralleling the growth of traded energy derivatives was the development of over-the-counter (OTC) derivative contracts. These contracts were originally arranged through an intermediary, generally a financial institution. The two parties to the agreement both had an interest in protecting themselves against future price movements as well as shifting risk, but needed more flexibility in the contract terms than standardized contracts on the NYMEX could provide. OTC contracts today are largely written on foreign exchange, interest rates, and equities, although commodity based contracts have also grown in importance. The Bank for International Settlements estimates that at the end of 2005 the notional value of outstanding OTC contracts worldwide was $284 trillion. Of this total, $3.6 trillion were commodity based. By 1993, problems related to the general use of financial derivatives began to surface. Derivatives were implicated in cases that resulted in huge financial losses. Orange County, California, lost $1.7 billion trading derivatives and went bankrupt. That same year, Metallgesellschaft lost over $1 billion in energy trading in the United States. The year 1998 brought the crisis at Long Term Capital Management, a leveraged hedge fund, that required intervention by the Federal Reserve Bank of New York, which arranged a rescue operation by major financial institutions. In 2001, Enron Corp., a company known for its promotion and use of derivatives through its trading arm, Enron Online, went bankrupt amidst major financial scandal. As a result of this association with bankruptcy and financial scandal over the past decade, questions have arisen as to whether derivative contracts are a legitimate requirement for functioning energy markets and companies, or are merely a dangerous financial game where the stakes are high and the potential for financial ruin very real. Are the potential effects on the physical energy supply, the financial condition of energy companies, the financial markets, and the economy as a whole significant enough to warrant a public policy response, and, if so, what factors might be important in developing appropriate policy? This report provides a systematic guide to understanding the use of financial derivative contracts in the energy industry, focusing specifically on the petroleum and natural gas sectors. There was little need for the use of derivatives in risk management in the energy industry before 1973. The domestic price of oil was stabilized through production restrictions and the international price of oil was managed by the large international oil companies. In this environment, price volatility, which could upset operational plans as well as profit forecasts, was not of major concern. Short run price volatility became a factor in the U.S. oil market following the first oil price shock of 1973/74. By 1981, when oil price regulation ended in the United States, the effects of oil price volatility were of major concern to producers as well as consumers of energy. Figure 1 demonstrates the volatile nature of oil prices as they reacted to OPEC actions as well as changing economic and political circumstances. As the figure shows, in relatively short periods of time the price of oil could rise more than two-fold, only to decline by almost two-thirds later on. This volatility in oil prices naturally spilled over into the product markets for gasoline, heating oil, jet fuel, and other refined products, directly affecting consumers and firms. Price volatility, on the scale represented in Figure 1 , gives rise to risk. Risk is defined as a situation in which a variable, in this case the price of oil, is likely to take on a value differing from that which was expected. Economists, and other analysts use a statistical tool, the standard deviation, to measure risk. The standard deviation measures the spread of possible outcomes around the average, or expected, value of the variable in question. Larger values of the standard deviation imply more risk. Risk management encompasses a range of activities designed to re-allocate risk to other parties more willing to bear it, and to mitigate the effects of remaining risk exposure. Although managing price risk has become a major consideration for energy companies, this doesn't necessarily require the use of financial derivatives. Several alternatives to derivative based strategies exist that might accomplish similar results. Vertical integration, the incorporation of the various stages of the production process, from exploration and production to final retail distribution, into one entity, allows the firm to control price risk. Vertically integrated firms are able to manage how a change in the price of a primary factor of production is incorporated into the cost structure of the firm. This strategy, to be fully implemented, requires the firm to own its oil or gas reserve base, an increasingly unlikely circumstance. Also, although the oil industry is characterized by integrated firms, it is also characterized by firms that operate in only one, or a limited number, of sectors of the industry. Even if the capital were available to form more vertically integrated firms, the most likely way this would be achieved in the oil industry would be through mergers and acquisitions, which have the potential of reducing competition. Price risk may also be managed through inventory control. If firms maintain substantial stocks of natural gas or oil in inventory, it is possible to use these stocks to effectively smooth out price movements. Draw down in periods of high market prices could be compensated by spot market purchases when the price is low. The problem here is cost. Storing oil and natural gas is expensive, making this strategy unattractive if cheaper alternatives are available. Long term contracting at fixed prices might also reduce the firm's exposure to price volatility. However, this strategy creates risks of its own. If the agreed upon contract price turns out to be higher than the actual market price in the future, the buyer of the product might find itself at a competitive disadvantage. For example, if a refinery agreed to purchase crude oil at $70 per barrel from an oil trader, and the price of crude oil then fell substantially, the refinery might not be able to produce competitively priced gasoline and might be forced to close or might possibly default on the contract. Similarly, if the price of oil turned out to be above $70 per barrel, the seller of the oil would have an incentive, at least in theory, to default on the contract and sell the oil on the higher value spot market leaving the refiner exposed to the higher price. The long term contract, which was designed to reduce price risk, accomplishes that goal by increasing default risk. To mitigate default risk, parties to the contract might diversify their purchases, buy insurance, require collateral, or only deal with well established firms. Managing price risk has become a necessity in the oil and natural gas industries to maintain profitability and to avoid being at a competitive disadvantage. A recent report by the Energy Information Administration (EIA) studied financial derivative use in the marketing, producing and refining sectors of the oil and natural gas industries. The study used company data and Securities and Exchange Commission filings and determined that virtually all of the largest energy firms use derivatives to hedge risk. However, the value of contracts held by companies varied widely. Since volatile energy prices may well continue in the future, firms are likely to undertake a strategy to protect themselves from 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. Derivatives are financial contracts whose value is based on another, underlying asset. For example, owning a futures contract on 1000 barrels of light, sweet, crude oil dated July 2007, at a price of $60, obligates the owner of that contract to purchase oil at that time, at those terms. In what sense does the futures contract have value? If, near the settlement date in July 2007, light, sweet crude is selling for $70 per barrel on the spot market, holding a legally enforceable right to buy the oil at $60 per barrel creates a value of $10 per barrel for the owner of the futures contract. Conversely, if oil is available on the spot market for $50 per barrel on the July 2007 settlement date, the futures contract is a liability for the contract holder in that it requires the oil buyer to pay $10 more for oil than the spot market price. In practice, very few futures contracts traded on markets like the NYMEX are ever settled through physical delivery of the product. The NYMEX contracts allow for cash settlement. Physical purchases can then be made on the spot market at then current market prices. 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. An important distinction between derivatives is whether they are traded on an organized exchange like the NYMEX or whether they are traded on the OTC market. Energy derivatives traded on the NYMEX are standardized contracts for a fixed amount of underlying product, delivered at a specified date, with a specified price, at a particular location.