Banks' Involvement in Energy Markets

Unlike the more mature market for interest rate derivatives, recent deregulation of the energy markets has spawned tremendous growth of tradeable energy futures and other derivative products. The modern oil markets — spot, forwards, futures, and other derivatives — have evolved only over the past 20 years¹ and free markets for natural gas are less than 10 years old.

Commercial banks are relatively small players in the energy markets. Estimates are that they account for roughly 5-10% of trading activity in the domestic energy sector. However, the role they play as intermediaries between producers and users of oil and gas products serves as an important niche for them, and for market participants as well. Banks' role in applying tested risk management techniques and market-making skills has helped to increase liquid­ity in these markets. Additionally, their ability to transform risks as financial intermediaries has enabled entities to hedge attendant exposures, eg, credit risk, which are a component of energy transactions though not directly related to the price of energy.

Banks' participation, which is essentially limited to the larger, money center banks, stems primarily from meeting the needs of customers with oil-contingent revenue streams. A presence in the energy markets also provides banks with a "strategic diversification" away from more traditional banking exposures, ie, interest rates and foreign exchange.² Other factors which may influence a bank's decision to keep an active energy portfolio include: enhanc­ing their product line and strengthening the credit quality of a borrower, thereby providing the customer with greater access to funds.

The relative maturity of the interest rate derivative markets in relation to the energy derivative markets suggest that growth and innovation in this sector may have significant potential. In addition, more sophisticated banks' trading rooms — whose profits are reliant on volatility — may be more attracted to the higher volatility inherent in energy products during times of relative calm in financial markets. The growing focus on corporate risk management across industries may also serve to increase the risk management activities of end-users and producers, contributing to growth in this sector and a greater role for banks' intermediary activities.