High volatility and specialness in energy markets result in more challenging trade execution, larger capital requirements and diminished effectiveness of benchmark hedging in contrast to other asset classes. Given these challenges, it is reasonable to ask why energy is traded as extensively as it is. Part of the answer is an inclination of some market participants to prop trade, with the higher volatility and peculiarities of the markets providing an interesting arena to do just that. The real driver, however, is risk transfer between producers and consumers.

The life cycle of energy commodities begins with the production or extraction of the raw commodity, which is then converted and transported as required and ultimately consumed. Energy commodities must be created, moved through space and time, and transformed into a usable form. This has been true from the inception of human control of energy sources, initially involving very simple processes such as harvesting wood, drying it, and hauling it to the fireplace. Over time, the level of sophistication has created a “virtuous” cycle in which greater energy availability has resulted in more efficient extraction and transport methods and ultimately greater demand. There are two immediate consequences of these technological advances.

The first is that major sources of energy are often found at considerable distances from the locations of ultimate consumption, resulting in large regional imbalances with consequences ranging from international capital flows to geopolitical risks to the reliability of energy supply.