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Before the Subcommittee on General Farm Commodities and Risk 
Management, Committee on Agriculture, House of Representatives: 

United States Government Accountability Office: 


For Release on Delivery Expected at 10:00 a.m. EDT: 

Thursday, July 12, 2007: 

Energy Derivatives: 

Preliminary Views on Energy Derivatives Trading and CFTC Oversight: 

Statement of Orice M. Williams, Director: 
Financial Markets and Community Investment: 


GAO Highlights: 

Highlights of GAO-07-1095T, testimony before Subcommittee on General 
Farm Commodities and Risk Management, Committee on Agriculture, House 
of Representatives 

Why GAO Did This Study: 

Energy prices for crude oil, heating oil, unleaded gasoline, and 
natural gas have risen substantially since 2002, generating questions 
about the reasons for the increase. Some observers believe that the 
higher energy prices were solely due to supply and demand fundamentals 
while others believe that increased futures trading activity may also 
have contributed to higher prices. This testimony highlights GAO’s 
preliminary findings related to (1) trends and patterns in the futures 
and physical energy markets and the effect of these trends on energy 
prices and (2) the Commodity Futures Trading Commission’s (CFTC) 
regulatory and enforcement authority over derivatives markets. 

GAO analyzed futures and large trader reporting data; trading data 
obtained from the New York Mercantile Exchange (NYMEX) for crude oil, 
heating oil, unleaded gasoline, and natural gas; and various other 
sources of energy-related data. GAO also analyzed relevant academic and 
other studies on the subject and interviewed market participants, 
experts, and officials at relevant federal agencies. 

What GAO Found: 

Rising energy prices have been attributed to a variety of factors, and 
recent trends in the futures and physical markets highlight the changes 
that have occurred in both markets from 2002 through 2006. 

* Inflation-adjusted energy prices in both the futures and physical 
markets increased by over 200 percent during this period for three of 
the four commodities we reviewed. 

* Volatility (a measurement of the degree to which prices fluctuate 
over time) in energy futures prices generally remained above historic 
averages during the beginning of the time period but declined through 
2006 for three of the four commodities we reviewed. 

* The number of noncommercial participants in the futures markets 
including hedge funds, has grown; along with the volume of energy 
futures contracts traded; and the volume of energy derivatives traded 
outside traditional futures exchanges. 

At the same time these changes were occurring in the futures markets 
for energy commodities, tight supply and rising demand in the physical 
markets pushed prices higher. For example, while global demand for oil 
has risen at high rates, spare oil production capacity has fallen since 
2002, and increased political instability in some of the major oil-
producing countries has threatened the supply of oil. Refining capacity 
also has not expanded at the same pace as the demand for gasoline. The 
individual effect of these collective changes on energy prices is 
unclear, as many factors have combined to affect energy prices. 
Monitoring these changes will be important to protect the public and 
ensure market integrity. 

Based on its authority under the Commodity Exchange Act (CEA), CFTC 
primarily focuses its oversight on the operations of traditional 
futures exchanges, such as NYMEX, where energy futures are traded. 
However, energy derivatives are also traded on other markets, namely 
exempt commercial markets and over-the-counter (OTC) markets—both of 
which have experienced increased volumes in recent years. Exempt 
commercial markets are electronic trading facilities that trade exempt 
commodities between eligible participants, and OTC markets involve 
eligible parties that can enter into contracts directly off-exchange. 
Both of these markets are exempt from general CFTC oversight, but they 
are subject to the CEA’s antimanipulation and antifraud provisions and 
CFTC enforcement of those provisions. Because of these varying levels 
of CFTC oversight, some market observers question whether CFTC needs 
broader authority over all derivative markets. CFTC generally believes 
that the commission has sufficient authority over OTC derivatives and 
exempt energy markets. However, CFTC has recently taken additional 
actions to clarify its authority to obtain information about pertinent 
off-exchange transactions. 

What GAO Recommends: 

This testimony is based on an ongoing engagement, and therefore GAO is 
making no recommendations at this time. 


To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Orice M. Williams at 
(202) 512-8678 or 

[End of section] 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss our preliminary views on the 
trading of derivatives for energy commodities such as natural gas and 
crude oil. As energy prices have increased in recent years, the trading 
volume of exchange-traded futures, off-exchange traded swaps, and other 
types of derivatives have also experienced significant growth.[Footnote 
1] Increased energy prices generally have been attributed to normal 
market forces of supply and demand, but these trends in energy 
derivatives markets have raised questions about whether this trading 
activity has placed additional upward pressure on the prices of 
physical energy commodities. The prices of futures contracts, like 
those of all derivatives, are in large part based on prices in the 
physical spot (cash) market where commodities are sold. At the same 
time, buyers and sellers of natural gas, crude oil, gasoline, and other 
energy products use exchange-traded futures prices, which are published 
daily, when determining prices in the physical markets. The extent to 
which off-exchange prices are used for determining prices of the 
underlying commodity, however, is unclear. The growth in energy futures 
trading since 2001 has in part been fueled by new market participants 
such as hedge funds and by increased investment in commodity index 
funds, which are funds whose prices are tied to the price of a basket 
of various commodity futures. 

My testimony today is based on an ongoing engagement on trading 
activity in energy derivatives markets--primarily the futures market-- 
and the oversight role of the Commodity Futures Trading Commission 
(CFTC). Because of the broad interest in this subject, our ongoing work 
has been initiated under the authority of the Comptroller General. My 
remarks today present our preliminary views on (1) trends in the energy 
derivatives and physical markets and the effect of those trends on 
energy prices, and (2) the regulatory structure of the various markets 
where energy commodities and derivatives are traded. 

In conducting this work, we obtained and analyzed energy futures prices 
and trading volumes from the New York Mercantile Exchange, Inc. 
(NYMEX). Specifically, we collected data for crude oil, heating oil, 
natural gas, and unleaded gas for the period January 2002 through 
December 2006. We also obtained and analyzed data on market 
participants and the outstanding trading positions of different 
categories of traders from CFTC. In addition, we reviewed publicly 
available information, including academic studies and reports and 
market data. Finally, we interviewed a broad range of market 
participants and observers, representatives of energy trading markets, 
and government regulators and agencies involved with the energy 
markets. This work is being done in accordance with generally accepted 
government auditing standards. 

In summary, derivatives and physical markets for crude oil, unleaded 
gasoline, heating oil, and natural gas have experienced substantial 
changes in recent years. From January 2002 to July 2006, monthly 
average futures and spot prices for crude oil, gasoline, and heating 
oil registered increases of over 200 percent.[Footnote 2] The 
volatility of energy prices also generally remained above historic 
averages for most of the period but declined during 2006 to levels at 
or near the historical average. At the same time, trading volumes for 
futures increased, at least in part because a growing number of managed-
money traders (including hedge funds) began to see energy futures as 
attractive investment alternatives. While these changes were occurring, 
the physical market was experiencing tight supply and rising demand 
from increasing global demand, ongoing political instability in oil-
producing regions, limited refining capacity, and other ongoing supply 
disruptions. Some observers believe that higher energy prices were 
solely the result of supply and demand fundamentals while others 
believe that increased futures trading activity may also have 
contributed to higher prices. But the effect on energy prices of 
individual changes in these markets is unclear, as many factors have 
combined to affect energy prices. Monitoring these changes in the 
future will be important in protecting the public and ensuring market 

Energy derivatives are traded on futures exchanges, exempt commercial 
markets, and over the counter (OTC). Some of these markets are subject 
to CFTC oversight and some are largely unregulated. Under the Commodity 
Exchange Act (CEA), CFTC regulatory oversight is focused on the 
surveillance of futures exchanges, protecting the public, and ensuring 
market integrity. CFTC does not, however, have oversight authority over 
exempt commercial markets--electronic trading facilities that trade 
exempt commodities, including energy commodities, on a principal-to- 
principal basis solely between persons that are eligible commercial 
entities--and the volume of off-exchange transactions has increased 
significantly in recent years. Also, certain parties--those who qualify 
as eligible contract participants--can enter into contracts directly 
(over the counter). Both the exempt commercial market and the OTC 
market are exempt from general CFTC oversight. However, both markets 
are subject to CFTC's enforcement of the CEA's antimanipulation and, 
where applicable, antifraud provisions. Because of these varying levels 
of CFTC oversight, some market observers question whether CFTC needs 
broader authority over all derivative markets, particularly those 
involving exempt commodities. CFTC generally believes that the 
commission has sufficient authority over OTC derivatives and exempt 
energy markets. However, CFTC has recently taken additional actions to 
clarify its authority to obtain information about pertinent off- 
exchange transactions. 


Energy commodities are bought and sold on both the physical and 
financial markets. The physical market includes the spot market where 
products such as crude oil or gasoline are bought and sold for 
immediate or near-term delivery by producers, wholesalers, and 
retailers. Spot transactions take place between commercial participants 
for a particular energy product for immediate delivery at a specific 
location. For example, the U.S. spot market for West Texas Intermediate 
(WTI) crude oil is the pipeline hub near Cushing, Oklahoma, while a 
major spot market for natural gas operates at the Henry Hub near Erath, 
Louisiana. The prices set in the specific spot markets provide a 
reference point that buyers and sellers use to set the price for other 
types of the commodity traded at other locations. 

In addition to the cash markets, derivatives based on energy 
commodities are traded in financial markets. The value of the 
derivative contract depends on the performance of the underlying asset-
-for example, crude oil or natural gas. Derivatives include futures, 
options, and swaps. Energy futures include standardized exchange-traded 
contracts for future delivery of a specific crude oil, heating oil, 
natural gas, or gasoline product at a particular spot market location. 
An exchange designated by CFTC as a contract market standardizes the 
contracts, which participants cannot modify. The owner of an energy 
futures contract is obligated to buy or sell the commodity at a 
specified price and future date. However, the contractual obligation 
may be removed at any time before the contract expiration date if the 
owner sells or purchases other contracts with terms that offset the 
original contract. In practice, most futures contracts on NYMEX are 
liquidated via offset, so that physical delivery of the underlying 
commodity is relatively rare. 

Options give the purchaser the right, but not the obligation, to buy or 
sell a specific quantity of a commodity or financial asset at a 
designated price. Swaps are privately negotiated contracts that involve 
an ongoing exchange of one or more assets, liabilities, or payments for 
a specified time period. Like futures, options can be traded on an 
exchange designated by CFTC as a contract market. Both swaps and 
options can be traded off-exchange if the transactions involve 
qualifying commodities and the participants satisfy statutory 
requirements. Options and futures are used to buy and sell a wide range 
of energy, agricultural, financial, and other commodities for future 

Market participants use futures markets to offset the risk caused by 
changes in prices, to discover commodity prices, and to speculate on 
price changes. Some buyers and sellers of energy commodities in the 
physical markets trade in futures contracts to offset, or "hedge," the 
risks they face from price changes in the physical market. Exempt 
commercial markets and OTC derivatives can serve the same function. 
Price risk is an important concern for buyers and sellers of energy 
commodities, because wide fluctuations in cash market prices introduce 
uncertainty for producers, distributors, and consumers of commodities 
and make investment planning, budgeting, and forecasting more 
difficult. To manage price risk, market participants may shift it to 
others more willing to assume the risk or to those having different 
risk situations. For example, if a petroleum refiner wants to lower its 
risk of losing money because of price volatility, it could lock in a 
price by selling futures contracts to deliver the gasoline in 6 months 
at a guaranteed price. Without futures contracts to manage risk, 
producers, refiners, and others would likely face greater uncertainty. 

The futures market also helps buyers and sellers determine, or 
"discover," the price of commodities in the physical markets, thus 
linking the two markets together. Price discovery is facilitated when 
(1) participants have current information about the fundamental market 
forces of supply and demand, (2) large numbers of participants are 
active in the market, and (3) the market is transparent. Market 
participants monitor and analyze a myriad of information on the factors 
that currently affect and that they expect to affect the supply of and 
demand for energy commodities. With that information, participants buy 
or sell an energy commodity contract at the price they believe the 
commodity will sell for on the delivery date. The futures market, in 
effect, distills the diverse views of market participants into a single 
price. In turn, buyers and sellers of physical commodities may consider 
those predictions about future prices, among other factors, when 
setting prices on the spot and retail markets. 

Other participants, such as investment banks and hedge funds, which do 
not have a commercial interest in the underlying commodities, use the 
futures market strictly for profit. These speculators provide liquidity 
to the market but also take on risks that other participants, such as 
hedgers, seek to avoid. In addition, arbitrageurs attempt to make a 
profit by simultaneously entering into several transactions in multiple 
markets in an effort to benefit from price discrepancies across these 

Multiple Factors in the Derivatives and Physical Markets Have Impacted 
Energy Prices: 

Both derivatives and physical markets experienced a substantial amount 
of change from 2002 through 2006. These changes have been occurring 
simultaneously, and the specific effect of any one of these changes on 
energy prices is unclear. 

The Energy Futures Markets Experienced Rising Prices, High Volatility, 
Increased Trading Volume, and Growth in Some Types of Traders: 

Several recent trends in the futures markets have raised concerns among 
some market observers that these conditions may have contributed to 
higher physical energy prices. Specifically from January 2002 to July 
2006, the futures markets experienced higher prices, relatively higher 
volatility, increased trading volume, and growth in some types of 
traders. During this period, monthly average spot prices for crude oil, 
gasoline, and heating oil increased by over 200 percent, and natural 
gas spot prices increased by over 140 percent.[Footnote 3] At the same 
time that spot prices were increasing, the futures prices for these 
commodities showed a similar pattern, with a sharp and sustained 
increase. For example, the price of crude oil futures increased from an 
average of $22 per barrel in January 2002 to $74 in July 2006. At the 
same time, the annual historical volatilities--measured using the 
relative change in daily prices of energy futures--between 2000 and 
2006 generally were above or near their long-term averages, although 
crude oil and heating oil declined below the average and gasoline 
declined slightly at the end of that period. We also found that the 
annual volatility of natural gas fluctuated more widely than that of 
the other three commodities and increased in 2006 even though prices 
largely declined from the levels reached in 2005. Although higher 
volatility is often equated with higher prices, this pattern 
illustrates that an increase in volatility does not necessarily mean 
that price levels will increase. In other words, price volatility 
measures the variability of prices rather than the direction of the 
price changes. 

We also observed that at the same time that prices were rising and that 
volatility was generally above or near long-term averages, futures 
markets saw an increase in the number of noncommercial traders such as 
managed money traders, including[Footnote 4] hedge funds. The trends in 
prices and volatility made the energy derivatives markets attractive 
for the growing number of traders that were looking to either hedge 
against those changes or profit from them. Using CFTC's large trader 
data, we found that from July 2003 to December 2006 crude oil futures 
and options contracts experienced the most dramatic increase, with the 
average number of noncommercial traders more than doubling from about 
125 to about 286. As shown in figure 1, while the growth was less 
dramatic in the other commodities, the average number of noncommercial 
traders also showed an upward trend for unleaded gasoline, heating oil, 
and natural gas. 

Figure 1: Average Daily Number of Large Commercial and NonCommercial 
Traders per Month, July 2003 through December 2006: 

[See PDF for image] 

Source: GAO analysis of CFTC data. 

[End of figure] 

Not surprisingly, our preliminary work also revealed that as the number 
of traders increased, so did the trading volume on NYMEX for all energy 
futures contracts, particularly crude oil and natural gas. Average 
daily contract volume for crude oil increased by 90 percent from 2001 
through 2006, and natural gas increased by just over 90 percent. 
Unleaded gasoline and heating oil experienced less dramatic growth in 
their trading volumes over this period. 

Another notable trend, but one that is much more difficult to quantify, 
was the apparently significant increase in the amount of energy 
derivatives traded outside exchanges. Trading in these markets is much 
less transparent, and comprehensive data are not available because 
these energy markets are not regulated. While the Bank for 
International Settlements publishes data on worldwide OTC derivative 
trading volume for broad groupings of commodities, this format can be 
used only as a rough proxy for trends in the trading volume of OTC 
energy derivatives.[Footnote 5] According to these data, the notional 
amounts outstanding of OTC commodity derivatives excluding precious 
metals, such as gold, grew by over 850 percent from December 2001 to 
December 2005.[Footnote 6] In the year from December 2004 to December 
2005 alone, the notional amount outstanding increased by more than 200 
percent to over $3.2 trillion. Despite the lack of comprehensive energy-
specific data on OTC derivatives, the recent experience of individual 
trading facilities further reveals the growth of energy derivatives 
trading outside of futures exchanges. For example, according to its 
annual financial statements, the volume of non-futures energy contracts 
traded on the Intercontinental Exchange, also known as ICE, including 
financially settled derivatives and physical contracts, increased by 
over 400 percent to over 130 million contracts in 2006. 

Further, while some market observers believe that managed money traders 
were exerting upward pressure on prices by predominantly buying futures 
contracts, CFTC data we analyzed revealed that from the middle of 2003 
through the end of 2006, the trading activity of managed money 
participants became increasingly balanced between buying (those that 
expect prices to go up) and selling (those that expect prices to go 
down). That is, our preliminary view of these data suggests that 
managed money traders as a whole were more or less evenly divided in 
their expectations about future prices than they had been in the past. 

We found that views were mixed about whether these trends had any 
upward pressure on prices. Some market participants and observers have 
concluded that large purchases of oil futures contracts by speculators 
could have created an additional demand for oil that could lead to 
higher prices. Contrary to this viewpoint, some federal agencies and 
other market observers took the position that speculative trading 
activity did not have a significant impact on prices. For example, an 
April 2005 CFTC study of the markets concluded that increased trading 
by speculative traders, including hedge funds, did not lead to higher 
energy prices or volatility. This study also argued that hedge funds 
provided increased liquidity to the market and dampened volatility. 
Still others told us that while speculative trading in the futures 
market could contribute to short-term price movements in the physical 
markets, they did not believe it was possible to sustain a speculative 
"bubble" over time, because the two markets were linked and both 
responded to information about changes in supply and demand caused by 
such factors as the weather or geographical events. In the view of 
these observers and market participants, speculation could not lead to 
artificially high or low prices over a long period of time. 

Various Patterns in the Physical Markets Also Explain Rising Energy 

The developments in the derivatives markets in recent years have not 
occurred in isolation. Conditions in the physical markets were also 
undergoing changes that could help explain increases in both derivative 
and physical commodity prices. As we have reported, futures prices 
typically reflect the effects of world events on the price of the 
underlying commodity such as crude oil.[Footnote 7] For example, 
political instability and terrorist acts in countries that supply oil 
create uncertainties about future supplies that are reflected in 
futures prices in anticipation of an oil shortage and expected higher 
prices in the future. Conversely, news about a new oil discovery that 
would increase world oil supply could result in lower futures prices. 
In other words, futures traders' expectations of what may happen to 
world oil supply and demand influence their price bids. 

According to the Energy Information Administration (EIA), world oil 
demand has grown from about 59 million barrels per day in 1983 to more 
than 85 million barrels per day in 2006 (fig. 2). While the United 
States accounts for about a quarter of this demand, rapid economic 
growth in Asia has also stimulated a strong demand for energy 
commodities. For example, EIA data shows that from 1983 to 2004, 
China's average daily demand for crude oil increased almost fourfold. 

Figure 2: Increase in World Demand for Crude Oil, 1980-2006: 

[See PDF for image] 

Source: GAO analysis of EIA data. 

Note: The world oil demand data for 2006 represent a preliminary 

[End of figure] 

The growth in demand does not, by itself, lead to higher prices for 
crude oil or any other energy commodity. For example, if the growth in 
demand were exceeded by a growth in supply, prices would fall, other 
things remaining constant. However, according to EIA, the growth in 
demand outpaced the growth in supply, even with spare production 
capacity included in supply. Spare production capacity is surplus oil 
that can be produced and brought to the market relatively quickly to 
rebalance the market if there is a supply disruption anywhere in the 
world oil market. As shown in figure 3, EIA estimates that global spare 
production capacity in 2006 was about 1.3 million barrels per day, 
compared with spare capability of about 10 million barrels per day in 
the mid-1980s and 5.6 million barrels a day as recently as 2002. 

Figure 3: Estimates of World Oil Spare Production Capacity by the 
Energy Information Administration: 

[See PDF for image] 

Source: EIA. 

Note: The spare capacity data for 1991-1997 represent an average over 
those years. 

[End of figure] 

Major weather and political events can also lead to supply disruptions 
and higher prices. In its analysis, EIA has cited the following 

* Hurricanes Katrina and Rita removed about 450,000 barrels per day 
from the world oil market from June 2005 to June 2006. 

* Instability in major oil-producing countries of the Organization of 
Petroleum Exporting Countries (OPEC), such as Iraq and Nigeria, have 
lowered production in some cases and increased the risk of future 
production shortfalls in others. 

* Oil production in Russia, a major driver of non-OPEC supply growth 
during the early 2000s, was adversely affected by a worsened investment 
climate as the government raised export and extraction taxes. 

The supply of crude oil affects the supply of gasoline and heating oil, 
and just as production capacity affects the supply of crude oil, 
refining capacity affects the supply of those products distilled from 
crude oil. As we have reported, refining capacity in the United States 
has not expanded at the same pace as the demand for gasoline.[Footnote 
8] Inventory, another factor affecting supplies and therefore prices, 
is particularly crucial to the supply and demand balance, because it 
can provide a cushion against price spikes if, for example, production 
is temporarily disrupted by a refinery outage or other event. Trends 
toward lower levels of inventory may reduce the costs of producing 
gasoline, but such trends may also cause prices to be more volatile. 
That is, when a supply disruption occurs or there is an increase in 
demand, there are fewer stocks of readily available gasoline to draw 
on, putting upward pressure on prices. However, others noted a 
different trend for crude oil inventories. That is, prices have 
remained high despite patterns of higher levels of oil in inventory. 

In addition to the supply and demand factors that generally apply to 
all energy commodities, specific developments can affect particular 
commodities. For instance, the growth of special gasoline blends--so- 
called "boutique fuels"--can affect the price of gasoline. As we have 
reported, it is generally agreed that the higher costs associated with 
supplying special gasoline blends contributed to higher gasoline 
prices, either because of more frequent or more severe supply 
disruptions or because the costs were likely passed on, at least in 
part, to consumers.[Footnote 9] 

Like the futures market, the physical market has undergone substantial 
changes that could affect prices. But market participants and other 
observers disagree about the impact of these changes on increasing 
energy prices. Some observers believe that higher energy prices were 
solely the result of supply and demand fundamentals, while others 
believe that increased futures trading activity contributed to higher 
prices. Another consideration is that the value of the U.S. dollar on 
open currency markets could also affect crude oil prices. For example, 
because crude oil is typically denominated in U.S. dollars, the 
payments that oil-producing countries receive for their oil are also 
denominated in U.S. dollars. As a result, a weak U.S. dollar decreases 
the value of the oil sold at a given price, and oil-producing countries 
may wish to increase prices for their crude oil in order to maintain 
the purchasing power in the face of a weakening U.S. dollar. The 
relative effect of each of these changes remains unclear, however, 
because all of the changes were occurring simultaneously. Monitoring 
these trends and patterns in the future will be important in order to 
better understand their effects, protect the public, and ensure market 

CFTC Oversees Exchanges and Has Some Authority over Other Derivatives 

Energy products are traded on multiple markets, some of which are 
subject to varying levels of CFTC oversight and some of which are not. 
This difference in oversight has caused some market observers to 
question whether CFTC needs broader oversight authority. As we have 
seen, under the CEA CFTC's regulatory authority is focused on 
overseeing futures exchanges, protecting the public, and ensuring 
market integrity. But in recent years two additional venues for trading 
energy futures contracts that are not subject to direct CFTC oversight 
have grown and become increasingly important--exempt commercial markets 
and OTC markets. However, traders in these markets are subject to the 
CEA's antimanipulation and antifraud provisions, which CFTC has the 
authority to enforce. Also, exempt commercial markets must provide CFTC 
with data for certain contracts.[Footnote 10] 

Futures exchanges such as NYMEX are subject to direct CFTC regulation 
and oversight. CFTC generally focuses on fulfilling three strategic 
goals related to these exchanges. First, to ensure the economic 
vitality of the commodity futures and options markets, CFTC conducts 
its own direct market surveillance and also reviews the surveillance 
efforts of the exchanges. Second, to protect market users and the 
public, CFTC promotes sales practice and other customer protection 
rules that apply to futures commission merchants and other registered 
intermediaries.[Footnote 11] Finally, to ensure the market's financial 
integrity, CFTC reviews the audit and financial surveillance activities 
of self-regulatory organizations. 

CFTC conducts regular market surveillance and oversight of energy 
trading on NYMEX and other futures exchanges.[Footnote 12] Oversight 
activities include: 

* detecting and preventing disruptive practices before they occur and 
keeping the CFTC commissioners informed of possible manipulation or 

* monitoring NYMEX's compliance with CFTC reporting requirements and 
its enforcement of speculative position limits; 

* investigating traders with large open positions; and: 

* documenting cases of improper trading. 

In contrast to the direct oversight it provides to futures exchanges, 
CFTC does not have general oversight authority over exempt commercial 
markets, where qualified entities may trade through an electronic 
trading facility. According to CFTC officials, these markets have grown 
in prominence in recent years. Some market observers have questioned 
their role in the energy markets and the lack of transparency about 
their trading activities. Trading energy derivatives on exempt 
commercial markets is permissible only for eligible commercial 
entities--a category of traders broadly defined in the CEA to include 
firms with a commercial interest in the underlying commodity--as well 
as other sophisticated investors such as hedge funds. These markets are 
not subject to CFTC's general direct oversight but are required to 
maintain communication with CFTC. Among other things, an exempt 
commercial market must notify CFTC that it is operating as an exempt 
commercial market and must comply with certain CFTC informational, 
record-keeping, and other requirements. 

Energy derivatives also may be traded OTC rather than via an electronic 
trading facility. OTC derivatives are private transactions between 
sophisticated counterparties, and there is no requirement for parties 
involved in these transactions to disclose information about their 
transactions. Derivatives transactions in both exempt commercial 
markets and OTC markets are bilateral contractual agreements in which 
each party is subject to and assumes the risk of nonperformance by its 
counterparty. These agreements differ from derivatives traded on an 
exchange where a central clearinghouse stands behind every trade. 

While some observers have called for more oversight of OTC derivatives, 
most notably for CFTC to be given greater oversight authority over this 
market, others consider such action unnecessary. Supporters of more 
CFTC oversight authority believe that more transparency and 
accountability would better protect the regulated markets and consumers 
from potential abuse and possible manipulation. Some question how CFTC 
can be assured that trading on the OTC market is not adversely 
affecting the regulated markets and ultimately consumers, given the 
lack of information about OTC trading. However, in 1999 the President's 
Working Group on Financial Markets concluded that OTC derivatives 
generally were not subject to manipulation because contracts were 
settled in cash based on a rate or price determined in a separate 
highly liquid market and did not serve a significant price discovery 
function.[Footnote 13] Moreover, the market is limited to professional 
counterparties that do not need the protections against manipulation 
that CEA provides to retail investors. Finally, the group has recently 
noted that if there are concerns about CFTC's authority, CFTC's 
enforcement actions against energy companies are evidence that the CFTC 
has adequate tools to combat fraud and manipulation when it is 
detected.[Footnote 14] 

The lack of reported data about off-exchange markets makes addressing 
concerns about the function and effect of these markets on regulated 
markets and entities challenging. CFTC officials have said that while 
they have reason to believe these off-exchange activities can affect 
prices determined on a regulated exchange, they also generally believe 
that the commission has sufficient authority over OTC derivatives and 
exempt energy markets. However, CFTC has recently begun to take steps 
to clarify its authority to obtain information about pertinent off- 
exchange transactions. In a June 2007 proposed rulemaking, CFTC noted 
that having data about the off-exchange positions of traders with large 
positions on regulated futures exchanges could enhance the commission's 
ability to deter and prevent price manipulation or any other 
disruptions to the integrity of the regulated futures markets.[Footnote 
15] According to CFTC officials, the commission has also proposed 
amendments to clarify its authority under the CEA to collect 
information and to bring fraud actions in principal-to-principal 
transactions in these markets, enhancing CFTC's ability to enforce 
antifraud provisions of CEA. 

In closing, our work to date shows that the derivatives and physical 
markets have both undergone substantial change and evolution. Given the 
changes in both markets, causality is unclear, and the situation 
warrants ongoing review and analysis. We commend the Subcommittee's 
efforts in this area. Along with the overall concern about rising 
prices, questions have also been raised about CFTC's authority to 
protect investors from fraudulent, manipulative, and abusive practices. 
CFTC generally believes that the commission has sufficient authority 
over OTC derivatives and exempt energy markets. However, CFTC has taken 
an important step by clarifying its authority to obtain information 
about pertinent off-exchange transactions. 

Mr. Chairman, this concludes my prepared statement. I would be happy to 
respond to any questions that you or other Members of the Subcommittee 
might have. 

GAO Contacts: 

For further information about this testimony, please contact Orice M. 
Williams on (202) 512-8678 or at 

Staff Acknowledgments: 

Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this statement. Individuals 
making key contributions include John Wanska (Assistant Director), 
Kevin Averyt, Ross Campbell, Emily Chalmers, John Forrester, and Paul 


[1] Our analysis of energy prices and energy financial markets is 
generally limited to the time period from January 2002 to December 

[2] To account for the effects of inflation on prices, prices are 
adjusted to reflect prices in the base year of 2006. 

[3] To account for the effects of inflation on prices, prices are 
adjusted to reflect prices in the base year of 2006. 

[4] CFTC collects data on traders holding positions at or above 
specific reporting levels set by the Commission. This information is 
collected as part of CFTC's Large Trader Reporting System. 

[5] The Bank for International Settlements (BIS) is an international 
organization that fosters international monetary and financial 
cooperation and serves as a bank for central banks. 

[6] The notional amount is the amount upon which payments between 
parties to certain types of derivatives contracts are based. The 
notional amount is not exchanged between the parties but instead 
represents a hypothetical underlying quantity upon which payment 
obligations are computed. The BIS data on OTC derivatives includes 
forwards, swaps, and options. 

[7] See GAO, Motor Fuels: Understanding the Factors that Influence the 
Retail Prices of Gasoline, GAO-05-525SP (Washington, D.C.: May 2005). 

[8] See GAO, Energy Markets: Factors Contributing to Higher Gasoline 
Prices, GAO-06-412T (Washington, D.C.: Feb. 1, 2006) and GAO-05-525SP. 

[9] GAO, Gasoline Markets: Special Gasoline Blends Reduce Emissions and 
Improve Air Quality, but Complicate Supply and Contribute to Higher 
Prices, GAO-05-421 (Washington, D.C.: June 17, 2005). 

[10] 17 C.F.R. § 36.3; see 7 U.S.C. § 2(h)(4)(D). 

[11] See 17 C.F.R. Parts 155, 166. 

[12] NYMEX conducts its own surveillance activities and may bring 
enforcement actions when violations are found. 

[13] The President's Working Group was established by executive order 
in 1988 following the 1987 stock market crash. Its purpose was to 
enhance the continued integrity, competitiveness, and efficiency of 
U.S. financial markets and maintain the public's confidence in those 
markets. See the Report of the President's Working Group on Financial 
Markets, Over-the-Counter Derivatives Markets and the Commodity 
Exchange Act (Washington, D.C.: 1999). 

[14] June 11, 2003, letter signed by the members of the President's 
Working Group to the Honorable Senator Michael D. Crapo and the 
Honorable Zell B. Miller. 

[15] According to CFTC, the purpose of the proposed regulation is to 
make explicit that persons holding or controlling reportable positions 
on a reporting market must retain books and records and make available 
to the Commission upon request any pertinent information with respect 
to all other positions and transactions in the commodity in which the 
trader has a reportable position, including positions held or 
controlled or transactions executed over-the counter and/or pursuant to 
Sections2(d), 2(g) or 2(h)(1)-(2) of the Commodity Exchange Act (Act) 
or Part 35 of the Commission's regulations, on exempt commercial 
markets operating pursuant to Sections 2(h)(3)-(5) of the Act, on 
exempt boards of trade operating pursuant to Section 5d of the Act, and 
on foreign boards of trade; and to make the regulation clearer and more 
complete with respect to hedging activity. 72 Fed. Reg. at 34413.

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