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Derivatives Markets Raise Questions about CFTC's Oversight' which was
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Report to Congressional Addressees:
United States Government Accountability Office:
GAO:
October 2007:
Commodity Futures Trading Commission:
Trends in Energy Derivatives Markets Raise Questions about CFTC's
Oversight:
Commodity Futures Trading Commission:
GAO-08-25:
GAO Highlights:
Highlights of GAO-08-25, a report to congressional addressees
Why GAO Did This Study:
Prices for four energy commodities—crude oil, heating oil, unleaded
gasoline, and natural gas—have risen substantially since 2002. Some
observers believe that higher energy prices are the result of changes
in supply and demand. Others believe that increased futures trading
activity has also contributed to higher prices. This report, conducted
under the Comptroller General of the United States’ authority, examines
(1) trends and patterns in the physical and energy derivatives markets,
(2) the scope of the Commodity Futures Trading Commission’s (CFTC)
regulatory authority over these markets, and (3) the effectiveness of
CFTC’s monitoring and detection of market abuses and enforcement. For
this work, GAO analyzed futures and large trader data and interviewed
market participants, experts, and officials at six federal agencies.
What GAO Found:
Rising energy prices have been attributed to a variety of factors,
among them recent trends (2002-2006) in the physical and futures
markets. These trends include (1) factors in the physical markets, such
as tight supply, rising demand, and a lack of spare production
capacity; (2) higher than average, but declining, volatility (a measure
of the degree to which prices fluctuate over time) in energy futures
prices for crude oil, heating oil, and unleaded gasoline; and (3)
growth in several key areas, including the number of noncommercial
participants in the futures markets (including hedge funds), the volume
of energy futures contracts traded, and the volume of energy
derivatives traded outside of traditional futures exchanges. Because
these changes took place concurrently, the effect of any individual
trend or factor is unclear.
On the basis of its authority under the Commodity Exchange Act (CEA),
CFTC focuses its oversight primarily on the operations of traditional
futures exchanges, such as the New York Mercantile Exchange, Inc.
(NYMEX), where energy futures are traded. Energy derivatives are also
traded on other markets, namely, exempt commercial and over-the-counter
(OTC) markets, that are exempt from CFTC oversight. Both types of
markets have seen their volumes climb in recent years. Exempt
commercial markets are electronic trading facilities where certain
commodities, such as energy, are traded between large, sophisticated
participants. OTC markets allow eligible parties to enter into
contracts directly, without using an exchange. While the exempt
commercial and OTC markets are subject to the CEA’s antimanipulation
and antifraud provisions and CFTC enforcement of those provisions, some
market observers question whether CFTC needs broader authority to
oversee these markets. CFTC is currently examining the effects of
trading in the regulated and exempt energy markets on price discovery
and the scope of its authority over these markets—an issue that will
warrant further examination as part of the CFTC reauthorization
process. Moreover, because of changes and innovations in the market,
the methods used to categorize these data can distort the information
reported to the public, which may not be completely accurate or
relevant.
CFTC conducts daily surveillance of trading on NYMEX that is designed
to detect and deter fraudulent or abusive trading practices involving
energy futures contracts. To detect abusive practices, such as
potential manipulation, CFTC uses various information sources and
relies heavily on trading activity data for large market participants.
Using this information, CFTC staff may pursue alleged abuse or
manipulation. However, because the agency does not maintain complete
records of all such allegations, this lack of information makes it
difficult to determine the usefulness and extent of these activities.
In addition, CFTC’s performance measures for enforcement do not fully
reflect the program’s goals and purposes, which could be addressed by
developing additional outcome-based performance measures that more
fully reflect progress in meeting the program’s overall goals.
What GAO Recommends:
As part of CFTC’s reauthorization process, Congress should consider
further exploring the scope of the agency’s authority over energy
derivatives trading, in particular for trading in exempt commercial
markets. In addition, GAO recommends that CFTC improve the usefulness
of the information provided to the public, better document its
monitoring activities, and develop more outcome-oriented performance
measures for its enforcement program. In written comments, CFTC
generally agreed with GAO’s recommendations.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.GAO-08-25]. For more information, contact Orice
Williams at (202) 512-8678 or williamso@gao.gov.
[End of section]
Contents:
Letter1:
Results in Brief:
Background:
Several Factors Have Caused Changes in the Energy Markets, Potentially
Affecting Prices:
CFTC Oversees Exchanges and Has Limited Authority over Other
Derivatives Markets:
CFTC Engages in Surveillance Activities and Enforcement Activities, but
the Effectiveness of these Activities Is Largely Uncertain:
Conclusions:
Matter for Congressional Consideration:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Types of Contracts and Transactions for Energy Commodities
in the Physical and Financial Markets:
Appendix III: New York Mercantile Exchange Surveillance and Enforcement
Activities:
Appendix IV: Commodity Futures Trading Commission's Energy-Related
Enforcement Actions, August 2001-September 2006:
Appendix V: Comments from the Commodity Futures Trading Commission:
Appendix VI: GAO Contract and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: Exempt Commercial Markets, Dates They Filed Notice with CFTC
to Operate as an Exempt Commercial Market, and Commodities Traded on
Each Market, 2001-2006:
Table 2: Number of NYMEX Enforcement Cases Opened, Complaints Issued,
Settlement, and Hearings, January 2000-May 2006:
Table 3: Energy-Related Enforcement Actions Filed by CFTC, August 2001-
September 2006:
Figures:
Figure 1: Monthly Average Spot Prices and Front Month Futures
Settlement Prices, in Constant 2006 Dollars, 1987-2006:
Figure 2: Convergence of the April 2006 Crude Oil Futures Contract
Price and the Crude Oil Spot Price, March 22, 2004-March 21, 2006:
Figure 3: Futures and Options Trading Volume for All Commodities and
CFTC Staffing Levels (Actual and Estimated), Fiscal Years 1995-2008:
Figure 4: Increase in World Demand for Crude Oil (Actual and
Estimated), 1980-2006:
Figure 5: Estimates of World Oil Spare Production Capacity, 1991-2008:
Figure 6: Comparison of Annual Volatility with the Long-term Average
Volatility for Four Energy Futures (Measured in Relative Terms Using
Front Month Contracts), 1987-2006:
Figure 7: Average Daily Number of Large Commercial and Noncommercial
Traders per Month, July 2003-December 2006:
Figure 8: Average Daily Trading Volume for Crude Oil, Heating Oil,
Unleaded Gasoline, and Natural Gas Futures Contracts, 1982-2006:
Figure 9: Percentage of Long and Short Open Interest in Futures and
Options for Managed Money Traders, July 2003-December 2006:
Abbreviations:
BCC: business conduct committee:
CEA: Commodity Exchange Act:
CFMA: Commodity Futures Modernization Act of 2000:
CFTC: Commodity Futures Trading Commission:
COMEX: New York Commodity Exchange:
COT: Commitment of Traders:
CPO: commodity pool operator:
CTA: commodity trading advisor:
DOJ: Department of Justice:
EIA: Energy Information Administration:
FERC: Federal Energy Regulatory Commission:
FTC: Federal Trade Commission:
FTE: full-time- equivalent:
HU: NYMEX gasoline contract:
ICE: IntercontinentalExchange:
ISS: integrated surveillance system:
LTRS: large trader reporting system:
NYMEX: New York Mercantile Exchange, Inc.:
OMB: Office of Management and Budget:
OPEC: Organization of the Petroleum Exporting Countries:
OT: Cover- the-counter:
PART: Program Assessment Rating Tool:
RBNYMEX: reformulated gasoline blendstock contract:
SEC: Securities and Exchange Commission:
SRO: self-regulatory organization:
United States Government Accountability Office:
Washington, DC 20548:
October 19, 2007:
Congressional Addressees:
The price of energy commodities--crude oil, unleaded gasoline, heating
oil, and natural gas--increased significantly from 2002 to 2006,
negatively affecting consumers and the U.S. economy. While increased
energy prices generally are attributed to normal market forces of
supply and demand, some observers have questioned whether trading
activity in energy futures contracts and other types of energy
derivatives placed upward pressure on prices during this
period.[Footnote 1] A futures contract is an agreement to purchase or
sell a commodity for delivery in the future.[Footnote 2] Like other
types of derivatives, its price is based on the value of an underlying
commodity, such as natural gas or oil. While futures prices are
determined on the basis of prices in the market where physical goods
and commodities are sold (physical market), buyers and sellers of
natural gas, crude oil, gasoline, and other energy products are
influenced by the futures prices of these commodities when determining
their prices. Trading in futures contracts has grown significantly
since 2001, in part because of trading by new market participants, such
as hedge funds, and increased investment in commodity index
funds.[Footnote 3]
The surge in energy prices and the growth in the volume of futures
contracts and other derivatives have renewed questions about the
adequacy of the Commodity Futures Trading Commission's (CFTC) authority
and ability to oversee derivatives that are traded off exchange, or
over the counter (OTC). CFTC's primary mission includes preserving the
integrity of the futures markets and protecting market users and the
public from fraud, manipulation, and abusive trading
practices.[Footnote 4] In 2000, CFTC's authority regarding futures
contracts and other types of derivatives was clarified by the Commodity
Futures Modernization Act of 2000 (CFMA). Among other things, the CFMA
specifically authorizes off-exchange derivatives trading by
establishing a framework that tailors the level of regulation of a
market to the products being traded and the market's participants.
Under the act, some exchanges (e.g., the New York Mercantile Exchange,
Inc. (NYMEX)), that allow all types of traders, including retail
customers, to access their facilities are regulated, while other venues
that are off exchange can be accessed only by large, sophisticated
traders and are either largely unregulated or exempt from regulation.
Like futures markets, these unregulated, off-exchange markets also have
grown significantly, raising questions about the amount of regulatory
scrutiny that CFTC should provide.
This report, conducted under the Comptroller General of the United
States' authority, addresses concerns raised by Congress, consumer
groups, states' attorneys general, and others about rising prices in
energy markets and the relationship, if any, of futures trading to
rising energy prices. We addressed this report to you because of your
expressed interest or your committee's jurisdiction. This report
focuses on four energy commodities--crude oil, unleaded gasoline,
natural gas, and heating oil--and CFTC's oversight of these
commodities. Specifically, this report examines (1) trends and patterns
of trading activity in the physical and energy derivatives markets and
the effects of those trends on prices; (2) the scope of CFTC's
authority for protecting market users from fraudulent, manipulative,
and abusive practices in the trading of energy futures contracts; and
(3) the effectiveness of CFTC's monitoring and detection of market
abuses in energy futures markets and in connection with energy-related
enforcement actions.
To address these objectives, we obtained and analyzed end-of-the-day
trading data for energy futures contracts from NYMEX and data from
CFTC's large trader reporting system (LTRS) database, which we tested
and found reliable for our purposes.[Footnote 5] We obtained and
analyzed other CFTC records and reports relevant to the commission's
surveillance and other activities. We also reviewed applicable laws,
regulations, and policy statements. We obtained information from a
broad range of participants in the energy futures markets and officials
knowledgeable about the futures markets. These individuals included
officials from large oil companies, refiners, trade associations
representing end users of natural gas, investment banks, and hedge
funds as well as energy consultants and academic experts. We
interviewed officials in CFTC's Division of Market Oversight, Division
of Enforcement, Office of the Chief Economist, Office of the General
Counsel, and Office of the Inspector General. Moreover, because CFTC
oversight is also provided through officials located in the
commission's field offices, we obtained information from officials at
the CFTC New York Regional Office, which conducts surveillance of
futures trading on NYMEX. In addition, we gathered and analyzed
information on oversight of the energy markets provided by other
federal agencies, including the U.S. Department of Energy's Energy
Information Administration (EIA), the Federal Energy Regulatory
Commission (FERC), the Federal Trade Commission (FTC), the Department
of Justice (DOJ), and the Securities and Exchange Commission (SEC). We
conducted our work in Chicago, Houston, New York City, and Washington,
D.C., between July 2005 and September 2007 in accordance with generally
accepted government auditing standards. Appendix I contains a more
detailed description of our scope and methodology.
Results in Brief:
Significant changes occurred in both physical and energy derivatives
markets between 2002 and 2006 that were accompanied by rising energy
prices; however, it is difficult to precisely determine the extent or
effect of any single factor on energy prices. Specifically:
* There was a tight supply and rising demand in the physical markets
for crude oil, heating oil, unleaded gasoline, and natural gas,
stemming from various factors--such as increased political instability
in some of the major oil-producing countries, decreased spare oil
production capacity, refining capacity that did not expand at the same
pace as demand for gasoline, and rapidly rising global demand for
energy products.
* Volatility (a measure of the degree to which prices fluctuate over
time) in energy futures prices generally remained above historic
averages in 2002 and 2003, but declined through 2006 for crude oil,
heating oil, and unleaded gasoline.
* The number of noncommercial participants in the futures markets, the
volume of energy futures contracts traded, and the volume of energy
derivatives traded outside traditional futures exchange also have grown
steadily.
Reasonable arguments have been made that events in physical and futures
markets contributed in some degree to the increases in inflation-
adjusted energy prices in both markets during this period for crude
oil, unleaded gasoline, and heating oil. However, opinions vary on how
much the recent changes in the financial markets influenced energy
prices. For example, some market participants and observers have argued
that speculation alone could not have influenced prices artificially
over such a long period, while others have concluded that increased
trading activity put upward pressure on the prices of spot as well as
futures contracts.
Under the Commodity Exchange Act (CEA), CFTC's authority for protecting
market users from fraudulent, manipulative, and abusive practices in
energy derivatives trading is primarily focused on the operations of
traditional futures exchanges, such as NYMEX, where energy futures are
traded. To help provide transparency to the public, CFTC publishes
aggregate trading information for large commercial (such as oil
companies and refineries) and noncommercial (such as hedge funds)
traders for various commodities through its Commitment of Traders (COT)
reports. These reports include the number of traders, changes since the
last report, and open positions--an obligation to take or make delivery
of a commodity in the future without a matching obligation in the
opposite direction. However, because of changes and innovation in the
market, methods used to categorize these data can distort the accuracy
and relevance of the information reported to the public. The market for
energy derivatives also has changed in other ways. Specifically, trading
has grown on other markets, namely, exempt commercial markets--
electronic trading facilities that trade exempt commodities, more than
half of which trade in energy products--and OTC markets.[Footnote 6]
Currently, CFTC receives limited information on derivatives trading on
exempt commercial markets--for example, records of allegations or
complaints of suspected fraud or manipulation, and price, quantity, and
other data on contracts that average five or more trades a day. The
commission may receive limited information from OTC participants, such
as trading records, to help CFTC enforce the CEA's antifraud or
antimanipulation provisions. The scope of CFTC's oversight authority
with respect to these markets has raised concerns among some Members of
Congress and others that activities on these markets are largely
unregulated, and that additional CFTC oversight is needed. While many
regulators have resisted calls for more regulation in the past, recent
events in the physical and energy derivatives markets have resulted in
renewed focus on the sufficiency of CFTC's authority. As a result, CFTC
held a hearing in September 2007 to begin examining trading on
regulated exchanges and exempt commercial markets. The hearing included
assessments of the relationship between these markets and assessments
of whether markets other than NYMEX serve a price discovery function,
which is the process of determining a commodity's price on the basis of
supply and demand. These and future deliberations may provide insights
into whether changes are needed in the scope of CFTC's authority.
Depending on what CFTC finds in its assessments of the markets,
Congress might want to consider what actions, if any, are warranted.
To detect fraudulent or abusive trading practices involving exchange-
traded energy futures, CFTC daily monitors the trading on exchanges
such as NYMEX. CFTC examines daily electronic trading data on futures
contracts and other information sources, such as commercial sources on
energy commodities and tips from individuals on possible violations.
CFTC's surveillance program primarily relies on daily reports from
large traders to detect problems, such as the potential for
manipulation. When CFTC staff detect potential problems or violations,
they may gather additional information from NYMEX officials, traders,
or other sources to determine if further action is warranted. CFTC
staff said that they routinely investigated traders with large open
positions. However, the staff added that they did not routinely
maintain information about such inquiries; instead they documented
their actions only when further action was warranted. This lack of
information makes it difficult to determine the usefulness and extent
of these activities. Without sufficient data on these and other
inquiries, CFTC's records will understate the extent to which the
commission surveils trading activity. In addition, CFTC management also
might miss opportunities both to identify trends in activities or
markets and to better target its limited resources. According to
information provided by CFTC, the commission coordinates its
enforcement actions with NYMEX as well as FERC, DOJ, and others. It
also has taken enforcement actions in cases of attempted manipulation
and other abusive practices in energy derivatives trading that resulted
in fines of $305 million from 2001 through 2005. While these cases have
been successfully pursued, it is difficult to determine whether they
have helped deter market manipulation or the other abusive practices
these pursuits addressed because the effectiveness of enforcement
activities is not easily measured. The Office of Management and Budget
(OMB) has concluded that the enforcement program lacks performance
measures that illustrate whether it is meeting its overall objective.
This report includes a matter for congressional consideration and three
recommendations. In light of recent developments in derivatives markets
and as part of CFTC's reauthorization process, Congress should consider
further exploring whether the current regulatory structure for energy
derivatives, in particular for those traded in exempt commercial
markets, provides adequately for fair trading and accurate pricing of
energy commodities. Our three recommendations to the Acting CFTC
Chairman are aimed at improving the usefulness of information that CFTC
provides to the public as a result of its surveillance activities and
the efficiency of its enforcement program. First, we recommend that
CFTC reexamine the classifications in the COT reports to determine if
the commercial and noncommercial categories should be refined to
improve the transparency, accuracy, and relevance of public information
on trading activity in the energy futures markets. Second, we recommend
that CFTC explore ways to routinely maintain written records of
inquiries into possible improper trading activity and the results of
these inquiries to more fully determine the usefulness and extent of
its surveillance, antifraud, and antimanipulation authorities. Third,
we recommend that CFTC examine ways to more fully demonstrate the
effectiveness of its enforcement activities by developing additional
outcome-related performance measures that more fully reflect progress
on meeting the program's overall goals.
We provided a draft of this report to CFTC, and the commission provided
written comments that are reprinted in appendix V. In its comments,
CFTC generally agreed with our findings. CFTC said that the commission
will reexamine classifications in the COT reports. CFTC also said that
the commission will explore additional recordkeeping procedures for
staff, but that it must balance the time required for such additional
tasks against the need to undertake market surveillance by an already-
stretched surveillance staff. CFTC added that it has included the
development of measures to evaluate the effectiveness of its
enforcement program in its most recent strategic plan. CFTC also
provided technical comments, which we have incorporated in this report
as appropriate.
Background:
Energy commodities are bought and sold in several different physical
and financial markets. Physical markets include the spot, or cash,
markets where products such as crude oil or gasoline are bought and
sold for immediate or near-term delivery. The United States has several
spot markets. Examples are the pipeline hub near Cushing, Oklahoma for
West Texas Intermediate crude oil and the Henry Hub near Erath,
Louisiana, for natural gas. 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 in other locations.
The prices established for energy commodities in the physical markets
generally are determined by supply and demand. For example, when the
demand for the product rises relative to supply because economies are
growing, prices are likely to rise. Conversely, when demand falls
relative to supply, prices are likely to fall. For energy products,
demand and supply, and therefore price, can fluctuate on a seasonal
basis. For example, consumer demand for gasoline in the United States
is generally higher from May through early September--the summer
driving season--and tends to flatten after Labor Day. Similarly, demand
for natural gas and heating oil is highest during the heating season
between October and March.
The relative inelasticity of energy commodities means that small shifts
in demand and supply can result in relatively large price fluctuations.
In general, when the price of an energy commodity rises, the demand for
that product is likely to fall in the long term, and vice versa.
However, demand for energy commodities is price inelastic in the short
term--that is, the quantity demanded changes little in response to a
change in price. On the supply side, rising energy commodities prices
motivate producers to increase the amount of commodities they supply to
increase profits. However, because producers hold relatively low
inventories of energy commodities in reserve, and finding and producing
additional energy commodities takes a long time and is expensive,
supply also is relatively inelastic. For example, supplies of natural
gas from new production wells cannot be increased quickly to meet
higher demand because of the time required to get the newly produced
gas into the marketplace.
Energy commodities also are traded in the financial markets, especially
in the form of derivatives. Derivatives include futures, options, and
swaps, whose values are based on the performance of the underlying
asset. 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 traditionally are privately negotiated
contracts that involve an ongoing exchange of one or more assets,
liabilities, or payments for a specified period. Futures and options
contracts are traded on exchanges designated by CFTC as contract
markets (futures exchanges), where a wide range of energy,
agricultural, financial, and other commodities are bought and sold for
future delivery. Commodity futures and options can be traded on both
OTC and exempt commercial markets if the transactions involve
qualifying commodities and the participants satisfy statutory
requirements.
Energy futures include standardized contracts for future delivery of a
specific crude oil, heating oil, natural gas, or gasoline product at a
particular spot market location. The exchange standardizes the
contracts, and participants cannot modify them to their particular
needs. For example, a standard gasoline futures contract traded on
NYMEX is for 1,000 barrels (42,000 gallons), quoted in dollars and
cents per gallon, and for delivery of up to 36 months into the future
at New York Harbor.[Footnote 7] The owner of an energy futures contract
is obligated to buy or sell the commodity at a specified price and
future date. However, the owner may eliminate the contractual
obligation before the contract expires by selling or purchasing other
contracts with terms that offset the original contract. In practice,
relatively few futures contracts on NYMEX result in physical delivery
of the underlying commodity, but instead are liquidated with offsets.
Options on futures contracts also are traded on exchanges such as NYMEX
and foreign boards of trade that U.S. traders access directly.
In addition to exchange-traded futures and options, the financial
markets for energy commodities include derivatives traded among
multiple traders on exempt commercial markets and derivatives created
bilaterally in OTC transactions. As with futures, exempt commercial
markets and other OTC derivatives allow producers and users of energy
commodities to manage the risk of future changes in the price of a
particular commodity. These contracts include options and swaps at an
agreed-upon price. Appendix II shows some of the different types of
contracts and transactions for energy commodities in the physical and
financial markets.
Functions of Futures Markets:
Market participants use futures markets to offset the risk caused by
changes in prices, discover commodity prices, and 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 of
price changes in the physical markets. The futures markets help buyers
and sellers determine, or "discover," the price of commodities in the
physical markets, thus linking the two markets. Other participants--
generally, speculators--that do not have a commercial interest in the
underlying commodities but are looking to make a profit take varying
positions on the future value of commodities. In doing so, speculators
provide liquidity and assume risks that other participants, such as
hedgers, seek to avoid. Arbitrageurs are a third group of participants
that aim to benefit by identifying discrepancies in price
relationships, rather than by betting on future price movements.
Arbitrage is a strategy that involves simultaneously entering into
several transactions in multiple markets to benefit from price
discrepancies across markets. For example, traders can trade
simultaneously in exchanges and OTC.
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. A statistical measurement of the degree to which prices
fluctuate over time is known as "volatility" and can be applied to
prices in both the physical and financial markets. There are two basic
types of volatility measurements. Historical volatility measures are
calculated on the basis of price changes, using data from market
transactions. Implied volatility reflects market participants'
expectations of future volatility as derived from the prices of traded
options (see app. III). This report presents data on the relative
historical volatility of energy futures contracts, which we calculated
from relative changes in daily prices.
Futures and off-exchange derivatives markets provide participants with
a means to hedge or shift unwanted price risk to others more willing to
assume the risk or those having different risk situations. For example,
if a petroleum refiner wanted to shed its risk of losing money as a
result of falling gasoline prices, it could lock in a price by selling
futures contracts to deliver the gasoline in 6 months at a guaranteed
price. Likewise, a transportation company that knows it must refill its
gasoline tanks in 6 months might want to offset the price risk
associated with purchasing fuel by buying futures contracts to take
delivery of gasoline then at a set price. Without futures contracts
that help them manage risk, producers, refiners, and others likely
would face uncertainty related to investment planning, budgeting, and
forecasting--and potentially higher costs.
Futures markets also provide a means of price discovery for commodities
such as energy products. For price discovery, markets need current
information about supply and demand, a large number of participants,
and transparency. Market participants monitor and analyze the factors
that currently affect, and that they expect to affect, the future
supply and demand for energy commodities. With that information, they
buy or sell energy commodity contracts on the basis of the price for
which they believe the commodity will sell at the delivery date. The
futures markets, in effect, distill the diverse views of market
participants into a single price. In turn, buyers and sellers of
physical commodities consider those predictions about future prices
with other factors when setting prices on the spot and retail markets.
A wide variety of participants hedge and speculate in energy
derivatives markets. For the exchange-traded futures markets, CFTC
categorizes traders in general terms as either commercial or
noncommercial participants. CFTC identifies several subcategories of
participants within the commercial category: producers, manufacturers,
dealers/merchants, and swaps/derivatives dealers. Dealers and merchants
include, among others, wholesalers, exporters and importers, shippers,
and crude oil marketers. Typical noncommercial traders are entities
such as those that manage money ("managed money traders").[Footnote 8]
These noncommercial traders include, among others, commodity pool
operators (CPO) and commodity trading advisors (CTA), many of which
advise or operate hedge funds.[Footnote 9] Other noncommercial traders
include floor brokers and unregistered traders.
Relationship between Futures and Spot Prices:
The prices for energy commodities in the futures and in the spot or
physical markets are closely linked because they are influenced by the
same market fundamentals in the long run. Prices in the physical spot
and futures markets for the four energy commodities we reviewed are
highly correlated and rose dramatically from 2002 to 2006. As shown in
figure 1, from January 2002 to July 2006, monthly average spot prices
for crude oil, gasoline, and heating oil increased by at least 220
percent.[Footnote 10] Natural gas spot prices increased by more than
140 percent. At the same time that spot prices increased, the futures
prices for these commodities showed a similar pattern of a sharp and
sustained increase from January 2002 into 2006. For example, the price
of crude oil futures increased from an average of $22 per barrel in
January 2002 to an average of $74 per barrel in July 2006. Natural gas
futures prices spiked rapidly in the fall of 2005 after several strong
hurricanes raised concerns about supply disruptions for the winter of
2005-2006, then prices fell sharply due in part to a mild winter.
Prices in the spot and futures markets show similar patterns because
traders in those markets tend to rely on the same types of information
when entering into transactions.
Figure 1: Monthly Average Spot Prices and Front Month Futures
Settlement Prices, in Constant 2006 Dollars, 1987-2006:
[See PDF for image]
Source: GAO analysis of Global Insight and NYMEX data.
Note: The front month futures contract is the actively traded contract
with the closest delivery date. NYMEX did not begin trading natural gas
futures until 1990.
[End of figure]
The differences between futures and spot market prices for energy
commodities narrow and the prices converge when futures contracts near
expiration and physical delivery is required. As the expiration date
nears, the physical delivery provision of the contract and the ability
of traders to arbitrage combine to bring the futures and physical
market prices together. Arbitrage plays a crucial role in moderating or
removing price differences between spot and futures markets and
contributes to the convergence of futures and spot prices at
expiration. For example, if the price for a crude oil futures contract
that would expire in 2 weeks were $62 per barrel and the spot market
price were $60 per barrel, a trader could choose to buy oil now at the
spot price and enter into a futures contract to deliver oil in 2 weeks
at the futures price, thereby making a $2 profit.[Footnote 11] This and
similar transactions by other traders would put upward pressure on the
spot price and downward pressure on the futures price and move them
toward convergence. Figure 2 provides an example of how the price of
the April 2006 crude oil futures contract and the spot price for that
commodity converged as the contract approached expiration.
Figure 2: Convergence of the April 2006 Crude Oil Futures Contract
Price and the Crude Oil Spot Price, March 22, 2004-March 21, 2006:
[See PDF for image]
Source: GAO analysis of EIA and NYMEX data.
[End of figure]
Changes in CFTC Oversight Authority and Resource Levels:
Between the creation of CFTC in 1974 and the year 2000, the CEA
generally restricted commodity derivatives trading to futures and
options entered into on exchanges and made all transactions in futures
contracts subject to CFTC's exclusive jurisdiction. However, in the
late 1980s and early 1990s, commercial entities began entering into
nonstandardized, off-exchange derivative contracts that had pricing
characteristics similar to futures (i.e., pricing of the transactions
derived from the prices of various commodities), and the instruments
were used for risk shifting. According to CFTC officials, under
exemptive authority provided in 1992 reauthorization legislation, CFTC
announced that it would not take enforcement action against qualified
commercial entities engaged in certain types of energy derivatives
transactions, but the legality of instruments not covered by the
exemption (i.e., their status as futures contracts subject to the CEA)
remained unresolved.[Footnote 12]
In 2000, the CFMA amended the CEA to provide for both regulated markets
and markets largely exempt from regulation and to permit off-exchange
trading of energy derivatives by qualified parties.[Footnote 13] The
regulated markets include futures exchanges that have self-regulatory
surveillance and monitoring responsibilities as self-regulatory
organizations (SRO) and by CFTC.[Footnote 14] CFTC's primary mission
includes preserving the integrity of these futures markets and
protecting market users and the public from fraud, manipulation, and
abusive practices related to the sale of commodity futures and options.
This mission is achieved through a regulatory scheme that is based on
federal oversight of industry self-regulation. The CEA also permits
derivatives trading in markets that are largely exempt from CFTC's
regulatory authority, including both OTC and exempt commercial markets,
subject to statutory requirements governing the types of commodity and
trader and the facility used for conducting the trades. The President's
Working Group's 1999 report on OTC derivatives focused on changes to
the CEA that in their view would "promote innovation, competition,
efficiency, and transparency in OTC derivatives markets, to reduce
systemic risk, and to allow the United States to maintain leadership in
these rapidly developing markets."[Footnote 15] Derivatives on energy
commodities, which are within the act's definition of "exempt
commodity," may be traded in exempt commercial markets by 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.
Violations of the CEA and CFTC regulations may be remedied by
imposition of civil monetary penalties, trading bans, restitution, and
other appropriate relief.
In addition to CFTC oversight, futures exchanges accept self-regulatory
obligations as a condition of designation. For example, NYMEX, as an
SRO, is responsible for establishing and enforcing rules governing
member conduct and trading; providing for the prevention of market
manipulation, including monitoring trading activity; ensuring that
futures industry professionals meet qualifications; and examining
exchange members for financial soundness and other regulatory purposes.
CFTC oversees SROs to ensure that each has an effective self-regulatory
program.[Footnote 16]
Within CFTC, three of the commission's six major operating units
actively oversee futures exchanges and their derivatives clearing
organizations.[Footnote 17]
* The Division of Market Oversight approves and oversees the futures
exchanges, conducts its own market surveillance, conducts trade
practice reviews and investigations, and reviews exchange rules.
* The Division of Clearing and Intermediary Oversight oversees, among
other things, derivatives clearing organizations and the registration
of intermediaries, which are persons such as futures commission
merchants, CPOs, or CTAs that act on the behalf of others in futures
trading.[Footnote 18]
* The Division of Enforcement investigates and prosecutes alleged
violations of the CEA and CFTC regulations.
At the beginning of fiscal year 2006, 167 (34 percent) of CFTC's 490
full-time-equivalent (FTE) positions were allocated to the first two
CFTC divisions; at the beginning of fiscal year 2007, that allocation
declined to 162 (35 percent) of CFTC's 458 FTE positions. These staff
monitor the markets and market participants from CFTC's headquarters in
Washington, D.C., as well as from field offices in New York; Chicago;
Kansas City; and, until recently, Minneapolis.[Footnote 19] About one-
third of CFTC's staff are located in the field offices. At the
beginning of fiscal year 2006, 132 (27 percent) of CFTC's 490 FTE
positions were allocated to the Division of Enforcement; at the
beginning of fiscal year 2007, that number declined to 120 of CFTC's
458 FTE positions. The 2007 data are estimated. While CFTC staffing
levels have declined, according to CFTC, futures and options trading
volume for all commodities has roughly doubled from fiscal years 2002
to 2006 and is expected to continue to rise, as indicated in figure 3.
Figure 3: Futures and Options Trading Volume for All Commodities and
CFTC Staffing Levels (Actual and Estimated), Fiscal Years 1995-2008:
[See PDF for image]
Source: GAO analysis of CFTC, the National Finance Center, and the
Future Industry Association data.
[End of figure]
Several Factors Have Caused Changes in the Energy Markets, Potentially
Affecting Prices:
Both physical and futures markets experienced a substantial amount of
change from 2002 through 2006. Reasonable arguments have been made that
events in both markets have contributed to rising energy prices, at
least in the short term, but opinions vary regarding the extent that
recent changes in the financial markets have influenced the prices of
energy products in the physical markets over the long term. Because of
these concurrent changes, identifying the causes of the increases in
energy prices in both the physical and futures markets for crude oil,
unleaded gasoline, heating oil, and natural gas is difficult. First,
during this period, the physical markets experienced tight supply and
rising demand from increasing global demand, ongoing political
instability in oil-producing regions, and other supply disruptions.
Second, annual volatility of energy prices remained above historic
averages during the beginning of the period (although during 2006,
volatility generally declined to levels at or near the historical
average). Third, the volume of trading in energy futures increased as
growing numbers of managed money traders viewed energy futures as
attractive investment alternatives.
Tight Supply and Rising Demand for Physical Energy Commodities
Contributed to the Increase in Futures and Spot Prices:
The energy physical markets have undergone substantial change and
turmoil from 2002 through 2006, which affected prices in the spot and
futures markets. First, like many market observers and participants, we
found a number of fundamental supply and demand conditions that could
influence prices. Moreover, these parties have observed that the lack
of spare capacity in certain areas, such as production, transportation,
and storage, can affect prices. Second, over the short term, weather
events also were a significant cause of rising energy prices because of
their effects on energy supply, according to several of the market
observers we interviewed. Third, many market observers also identified
geopolitical uncertainty arising from the instability and insecurity of
the world's major oil-producing regions as a major factor affecting
energy prices.[Footnote 20] Concerns about political events may
manifest in the form of higher futures prices if traders predict that
an event--such as a strike within the industry or pipeline sabotage by
terrorists--will have an effect on future supply. Finally, on the
demand side, a significant factor noted by observers was the increase
in global consumption of petroleum products, primarily among
industrializing Asian nations such as China and India.
Analysis of world oil prices by EIA and us indicates that increases in
crude oil prices occur if political instability, terrorist acts, or
natural disasters create uncertainties about, or actual disruptions in,
supply from countries that produce or refine oil. For example,
according to EIA, in the early 2000s, cutbacks in the Organization of
the Petroleum Exporting Countries (OPEC) production and rising demand
caused oil prices to increase to more than $30 per barrel, only to fall
precipitously when the global economy weakened following the September
11, 2001, crisis.[Footnote 21] Moreover, as we reported in 2005, rapid
growth in oil demand in Asia contributed to a rise in crude oil prices
to more than $50 per barrel during 2004.[Footnote 22]
According to EIA, world oil demand that was about 59 million barrels
per day in 1983 grew to more than 85 million barrels per day in 2006.
The United States consumes nearly one-quarter of this amount--or more
than 20 million barrels per day in 2006--and its demand has grown about
1.5 percent per year since 1983. The rapid economic growth in Asia also
has stimulated a strong demand for energy commodities. For example,
China has overtaken Japan as the second-largest consumer of crude oil,
after the United States. According to EIA data, from 1983 to 2004,
Chinese demand grew from about 1.7 million barrels consumed per day to
about 6.4 million barrels consumed per day. This increase in the global
demand for crude oil is shown in figure 4.
Figure 4: Increase in World Demand for Crude Oil (Actual and
Estimated), 1980-2006:
[See PDF for image]
Source: GAO analysis of EIA data.
Note: The world oil demand data for 2006 represent a preliminary
estimate.
[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, with
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 were a supply disruption anywhere in the
world oil market. EIA estimates that global spare production capacity
in 2006 was about 1.3 million barrels per day (see fig. 5). Most of
that capacity was concentrated in the 12 OPEC countries that supply
about 40 percent of the world's oil, primarily Saudi Arabia. This
compared with spare capacity of about 10 million barrels per day in the
mid-1980s, or of about 5.6 million barrels a day as recently as 2002.
Analysis by EIA indicates that the growth of oil production in non-OPEC
nations, which produce most of the world's oil and include countries
such as Canada, China, Mexico, Norway, Russia, the United Kingdom, and
the United States, has slowed relative to the growth in demand, and
these nations have virtually no spare production capacity. As a
commodity that is produced and traded worldwide, crude oil prices could
be affected by the value of the U.S. dollar on open currency markets.
For example, because crude oil is typically denominated in U.S.
dollars, the payments that oil-producing countries receive for their
oil also are 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 to
maintain purchasing power in the face of a weakening U.S. dollar, to
the extent they can.
Figure 5: Estimates of World Oil Spare Production Capacity, 1991-2008:
[See PDF for image]
Source: GAO analysis of EIA data.
Note: The spare production capacity data for 1991-1997 represent an
average estimate over that period.
[End of figure]
Major weather and political events also can lead to supply disruptions
and higher prices. In its analysis, EIA has cited the following
examples:
* 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 OPEC oil-producing countries, such as Iran,
Iraq, Nigeria, and Venezuela, has lowered production and increased the
risk of future production shortfalls.
* 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 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 23]
Despite a growth in the capacity of existing gasoline refineries, the
growth in demand has meant that refineries have been running at an
average of more than 93 percent of production capacity since the mid-
1990s, compared with about 78 percent in the 1980s. Higher utilization
rates can increase operating costs and lead to prices being higher than
otherwise would be expected, as occurred in the second half of the
1990s.
Another factor affecting the supply, and therefore the price, of
petroleum products is the amount held in inventory. Inventory is
particularly crucial to the supply and demand balance because it can
provide a cushion against price spikes if, for example, a refinery
outage temporarily disrupts production. We have reported that, as in
other industries, the petroleum products industry has adopted "just-in-
time" delivery processes to reduce costs, leading to a downward trend
in the level of gasoline inventories in the United States. For example,
in the early 1980s, private companies held stocks of gasoline in excess
of 35 days of average U.S. consumption; while in 2004, those stocks
were equivalent to less than 25 days consumption.[Footnote 24] Lower
costs of holding inventories may reduce gasoline prices, but lower
levels of inventories also may cause prices to be more volatile because
when a supply disruption occurs or there is an increase in demand,
there are fewer stocks of readily available gasoline from which to
draw, thereby putting upward pressure on prices. Others have noted that
higher prices for future delivery of oil have induced oil companies to
buy more oil and place it in storage. They concluded that this practice
has created a situation where oil prices are high despite high levels
of oil in inventory.
In addition to the supply and demand factors that generally apply to
all energy commodities, there are specific conditions that apply to
particular commodities. For example, to meet national air quality
standards under the Clean Air Act, as amended, many states have
mandated the use of special gasoline blends--so-called "boutique
fuels." As we have recently reported, there is a general consensus that
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 higher costs are likely
passed on, at least in part, to consumers.[Footnote 25] As another
example, according to EIA, the recent phaseout of a chemical used to
improve gasoline performance--methyl tertiary butyl ether--increased
the price of U.S. gasoline, in part because the chemical was replaced
by ethanol, a more costly additive. As in the futures markets, the
physical markets have undergone substantial changes that can affect
prices. These specific factors affecting particular commodities, when
combined with the general supply and demand conditions, contribute to
increased energy prices and price volatility. However, market
participants and other observers disagree on whether high energy prices
were solely due to supply and demand fundamentals or whether increased
futures trading activity also was fueling higher prices.
The Effects of Relatively High but Falling Volatility and a Growing
Volume of Derivatives Trading on Energy Prices Are Unclear:
The changes occurring in the physical markets have not happened in
isolation; they have been accompanied by advances in technology,
relatively high but falling volatility in energy futures prices, and a
growing volume of trading in the derivatives markets. The effects of
these changes on energy prices are not clear.
Although energy futures prices increased from 2002 to 2006 (see fig.
1), the relative volatility of those prices for three of the four
commodities generally declined. As shown in figure 6, the annual
historical volatilities--measured using the relative change in daily
prices of energy futures--from 2000 through 2006 generally were above
or near their long-term averages, although crude oil and heating oil
declined below the average and gasoline declined slightly. As we have
reported, futures prices typically reflect the effects of such world
events on the price of crude oil.[Footnote 26] Political instability
and terrorist acts in countries that supply oil create uncertainties
about future supplies, which is 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 decisions.
Figure 6: Comparison of Annual Volatility with the Long-term Average
Volatility for Four Energy Futures (Measured in Relative Terms Using
Front Month Contracts), 1987-2006:
[See PDF for image]
Source: GAO analysis of NYMEX data.
Note: NYMEX did not begin trading natural gas futures until 1990.
[End of figure]
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. EIA has stated
that the volatility of natural gas prices is due to factors in the
physical marketplace, such as changing weather, producers' inability to
move natural gas quickly to areas in response to quickly rising demand,
and limited local storage. A research director for a consumer advocacy
organization who studied natural gas prices concluded that increased
trading by speculators had increased volatility and prices.[Footnote
27] CFTC also has studied this issue and found that natural gas prices
from August 2003 through August 2004 did not appear to be determined by
any single category of market participant, although joint demand and
supply of contracts by all participants clearly affected the change in
price. In other words, managed money traders' activity (including hedge
funds), by itself, did not have a significant effect on price
changes.[Footnote 28]
While some often equate higher prices with higher volatility, an
increase in futures contract prices does not necessarily mean that
volatility will increase in a similar manner, and an increase in
volatility does not necessarily mean that prices will rise. Price
volatility measures the variability rather than the direction of price
changes and is based on the standard deviation of those
changes.[Footnote 29] Therefore, if futures contract prices change at a
steady rate, the prices may have lower volatility than if large swings
in prices occurred.
At the same time that prices were rising and volatility was generally
above or near long-term averages, futures markets also experienced an
increase in the number of large noncommercial participants, such as
managed money traders.[Footnote 30] The trends in price and volatility
made the energy derivatives markets attractive for an increasing number
of traders looking to either hedge against those changes or profit from
them. According to CFTC large trader data, from July 2003 to December
2006, crude oil futures and options contracts experienced the most
dramatic increase as the average number of noncommercial traders grew
from about 125 to about 286. As shown in figure 7, over a similar
period, the average number of noncommercial traders also showed an
upward but less dramatic trend for unleaded gasoline, heating oil, and
natural gas.
Figure 7: Average Daily Number of Large Commercial and Noncommercial
Traders per Month, July 2003-December 2006:
[See PDF for image]
Source: GAO analysis of CFTC data.
[End of figure]
Some market participants and observers have concluded that large
purchases of oil futures contracts by speculators in effect have
created an additional demand for oil that has led to higher prices;
others disagree. The Senate's Permanent Subcommittee on Investigations,
Committee on Homeland Security and Governmental Affairs, issued a staff
report in June 2006 that concluded that the traditional forces of
supply and demand could not fully account for increases in the prices
of energy commodities.[Footnote 31] Also, according to an energy firm,
an investment bank, an academic, and hedge fund officials, increasing
numbers of speculative traders in the market and rising trading volume
placed upward pressure on futures prices. However, others, including
investment bank and CFTC officials, have argued that speculators did
not increase prices, but they provided liquidity and dampened
volatility. Moreover, other investment banks, energy firms, and FERC
officials told us that speculative trading in the futures markets can
contribute to short-term price movements in the physical markets.
However, they did not believe it was possible to sustain a speculative
"bubble" over time because the two markets are linked and both respond
to information regarding changes in supply and demand caused by such
factors as the weather or geopolitical events. Therefore, in their
view, speculation could not lead to artificially high or low prices
over a long period.
Within the noncommercial trader category, the largest increases came
from managed money traders--which generally trade for their own
accounts rather than for others. Specifically, for crude oil, the
average number of managed money traders that trade daily increased
significantly from about 62 in July 2003 to about 128 in December 2006.
At the same time, the number of smaller traders also grew significantly
from an average of about 26 per day in July 2003 to an average of about
111 per day in December 2006. The number of managed money traders and
smaller traders for unleaded gasoline, heating oil, and natural gas
also increased similarly during that period. The number of commercial
futures traders generally did not increase in a fashion similar to that
of noncommercial traders.
As the number of traders has increased, so has the trading volume on
NYMEX for all energy futures contracts, particularly crude oil and
natural gas, as shown in figure 8. From 2001 through 2006, the average
daily contract volume for crude oil increased by 90 percent and for
natural gas increased by 93 percent. However, unleaded gasoline and
heating oil experienced less dramatic growth in their trading volumes
during this period.
Figure 8: Average Daily Trading Volume for Crude Oil, Heating Oil,
Unleaded Gasoline, and Natural Gas Futures Contracts, 1982-2006:
[See PDF for image]
Source: GAO analysis of NYMEX data.
Note: The trading volume data for unleaded gasoline include the RB
contract introduced on NYMEX in October 2005. The start dates for these
commodities varied for these NYMEX contracts.
[End of figure]
Along with the strong growth of energy futures trading, the amount of
energy derivatives traded outside of exchanges also appears to have
increased significantly. However, comprehensive data on the trading
volume of energy-related OTC derivatives are not available because OTC
energy markets are not regulated. The Bank for International
Settlements publishes data on worldwide OTC derivative trading volume
for broader groupings of commodities that can be used as a rough proxy
for trends in the trading volume of OTC energy derivatives.[Footnote
32] According to these data, the notional amounts outstanding of OTC
commodity derivatives--excluding precious metals, such as gold--grew by
854 percent from December 2001 through December 2005.[Footnote 33] From
December 2004 through December 2005, the notional amount outstanding
increased by 214 percent to more than $3.2 trillion. Despite the lack
of comprehensive energy-specific data on OTC derivatives, the recent
experience of individual trading facilities revealed the growth of
energy derivatives trading outside of futures exchanges. For example,
according to an annual financial statement of the
IntercontinentalExchange (ICE), the volume of contracts traded on ICE-
-including financially settled derivatives and physical contracts--
increased by 438 percent, from more than 24 million contracts in 2003
to more than 130 million in 2006.
While some market observers believed that managed money traders were
exerting upward pressure on prices by predominantly buying futures
contracts, CFTC data reveal that, from the middle of 2003 through the
end of 2006, the trading activity of managed money participants became
increasingly balanced between buying and selling. According to basic
futures market theory, a trader speculating and holding an outstanding
position to buy the commodity--a long open interest position--expects
that the price of the commodity will rise, while a trader holding an
outstanding position to sell the commodity--a short open interest
position--expects that the price will decline. As shown in figure 9,
according to CFTC data, from July 2003 through December 2003 managed
money traders' ratio of long open interest in crude oil to short open
interest was about 2.5:1, suggesting a strong expectation that prices
would rise, on average, throughout that period, which they did. By
2006, this ratio fell to 1.2:1, suggesting that managed money traders
as a whole were more evenly divided in their expectations about future
prices. Managed money trading in unleaded gasoline, heating oil, and
natural gas showed similar trends. Although for natural gas, open
interest was more often short than long, suggesting a general
expectation that prices would decline, which largely did not occur
until 2006. Also, the relatively high percentage of open interest for
natural gas held by these traders in 2006--surging to just over 40
percent--was perhaps due to the increased volatility of natural gas
futures prices from 2005 to 2006, which provided traders with more
opportunities for profit (or loss).
Figure 9: Percentage of Long and Short Open Interest in Futures and
Options for Managed Money Traders, July 2003-December 2006:
[See PDF for image]
Source: GAO analysis of CFTC data.
Note: Data for 2003 were for July through December. The percentages
indicate what portion of long and short open interest was held by
managed money traders. For example, in 2004, managed money traders held
14.5 percent of the total long open interest for crude oil and 7.1
percent of the total short open interest. Because data are not included
for all categories of traders, the percentages for these categories
within a particular period do not total 100. These data should be
viewed as a general overview of managed money traders' positions. They
do not provide insights into how traders' individual positions changed
over time. Our data for 2006 include contract trading data for RB and
for the gasoline--HU--that began to be replaced by RB.
[End of figure]
CFTC Oversees Exchanges and Has Limited Authority over Other
Derivatives Markets:
Energy products are traded on multiple markets, which are subject to
varying levels of CFTC oversight and regulation. Under the CEA, CFTC
regulatory oversight is focused on conducting the surveillance of
futures exchanges, protecting the public, and ensuring market
integrity. CFTC collects and analyzes trading position information on
futures exchanges, which is central to this oversight. The information
is subsequently published at highly aggregated levels in the
commission's COT reports, and it helps to provide transparency to the
market. However, these public reports have been criticized because the
informational categories for traders do not accurately reflect energy
market activity. While CFTC's oversight is focused on futures
exchanges, the number of exempt commercial markets for trading energy
commodities, which are not subject to general CFTC oversight, have
grown. However, traders in these markets are subject to the CEA's
antimanipulation and, where applicable, antifraud provisions.[Footnote
34] Also, exempt commercial markets must provide CFTC with data for
certain contracts and notify CFTC if cash markets use exempt market
prices to price their transactions (although that has not
occurred).[Footnote 35] Energy products also are traded off exchange
(referred to as OTC) and are not subject to direct CFTC oversight and
regulation. However, as we have previously noted, certain types of off-
exchange transactions are subject to antifraud and the antimanipulation
provisions of the CEA, which CFTC has the authority to enforce. In
addition, contract participants may be subject to other regulatory
authority on the basis of their role in the physical market. To enhance
its ability to detect and deter price manipulations, CFTC has published
for comment a proposal to amend part 18 of its regulations to obtain
from traders that have large (reportable) positions in an exchange-
traded commodity information about their off-exchange positions in the
same commodity.[Footnote 36] CFTC also held a hearing in September 2007
to examine trading on regulated exchanges and exempt commercial
markets, which included an assessment of price discovery and the
implications for CFTC oversight.
CFTC Has General Oversight Authority over Futures Exchanges, but Its
Publicly Reported Information on These Exchanges Has Not Kept Pace with
Changing Market Conditions:
Under the CEA, CFTC has general oversight authority over futures
exchanges such as NYMEX. These exchanges receive CFTC approval to list
futures and options contracts for trading and are subject to direct
CFTC regulation and oversight. To be a regulated futures exchange, an
exchange must demonstrate to CFTC that the exchange complies with (1)
the criteria for designation under section 5(b) of the CEA for, among
other things, the prevention of market manipulation, fair and equitable
trading, the conduct of trading facilities, and the financial integrity
of transactions conducted on the board; (2) the set of core principles
under section 5(d) of the act establishing their regulatory
responsibilities; and (3) the provisions on application procedures of
part 38 of the CFTC rules.[Footnote 37] According to CFTC officials,
following procedures in the CEA, these exchanges may list new
contracts, after certifying that they are in compliance with certain
core principles, including ascertaining that the contracts are not
readily susceptible to manipulation and monitoring trading to prevent
price manipulation.[Footnote 38]
CFTC's oversight is focused on fulfilling three strategic goals
relating to futures exchanges. First, to ensure the economic vitality
of the commodity futures and options markets, CFTC conducts its own
direct market surveillance and also reviews on an oversight basis the
surveillance efforts of these exchanges. According to CFTC officials,
the commission monitors trading activity in futures markets and uses
these trading data to analyze large positions that might be used to
manipulate futures markets. In its oversight role, CFTC reviews new
futures contracts to assess susceptibility to manipulation. To list a
new futures contract, an exchange must file a written self-
certification with CFTC and, if requested, must provide additional
evidence, information, or data to CFTC on whether the contact satisfies
CEA requirements and the commission's regulations or policies. Second,
to protect market users and the public, CFTC has promoted sales
practices and other customer protection rules applicable to futures
commission merchants and other registered intermediaries.[Footnote 39]
In this connection, CFTC closely monitors the enforcement of
registration and other requirements by the National Futures
Association, which is an SRO responsible for regulating all firms and
individuals conducting futures business with public customers. Third,
to ensure the market's financial integrity, CFTC reviews the audit and
financial surveillance activities of SROs. It also periodically reviews
registered derivatives clearing organizations to ensure that they are
effectively monitoring risks and protecting customer funds.
CFTC provides the public information on open interest in exchange-
traded futures and options by commercial and noncommercial traders for
various commodities in its weekly COT reports, which are relied upon by
the public. Changing market conditions caused CFTC in 2006 to reassess
COT reporting and its value to the public.[Footnote 40] A trading
entity generally gets classified as commercial by filing a statement
with CFTC that it is commercially "engaged in business activities
hedged by the use of the futures or option markets." To ensure that
traders are classified with accuracy and consistency, commission staff
review this self-classification and may reclassify a trader if staff
have additional information about the trader's use of the markets. A
trader may be classified as commercial in some commodities and as
noncommercial in other commodities. A single trading entity cannot be
classified as both commercial and noncommercial in the same commodity.
Nonetheless, a multifunctional organization that has more than one
trading entity may have each trading entity classified separately in a
commodity. For example, a financial organization trading in financial
futures may have a banking entity whose positions are classified as
commercial and have a separate money-management entity whose positions
are classified as noncommercial.
Recently, CFTC observed that the exchange-traded derivatives markets,
as well as derivatives trading patterns and practices, have evolved,
leading CFTC to question whether the commercial and noncommercial
categories of today's COT reports appropriately classify trading
practices. In June 2006, CFTC issued a notice in the Federal Register
that it was undertaking a comprehensive review of the COT reporting
program out of concern that the reports in their present form might not
accurately reflect the commercial or noncommercial nature of positions
held by nontraditional hedgers, such as swaps dealers.[Footnote 41] On
the basis of the comments received in response to the notice, in
December 2006, CFTC announced the initiation of a 2-year pilot program
for publishing a supplemental COT report that would contain, in
addition to categories for noncommercial and commercial positions, a
category showing aggregate futures and options positions of index
traders in 12 selected agricultural commodities. In explaining the
program, CFTC observed that the "index traders" category would include
traders that also were included in the noncommercial and commercial
categories:
"In addition, the Commission will begin publishing a supplemental COT
report that includes, in a separate category, the positions of
commodity index traders in certain physical commodity futures markets.
These so-called 'Index Traders' will be drawn from both the current
Noncommercial and the Commercial categories. Coming from the
Noncommercial category will be managed funds, pension funds and other
institutional investors that generally seek exposure to commodity
prices as an asset class in an unleveraged and passively managed manner
using a standardized commodity index. Coming from the Commercial
category will be entities whose positions predominantly reflect hedging
of OTC transactions involving commodity indices--for example, swap
dealers holding long futures positions to hedge short OTC commodity
index exposure opposite institutional traders such as pension funds.
These latter position holders are those traders described in the
request for comments as 'non-traditional commercials.'"
CFTC stated that the pilot program for reporting of commodity index
trading did not include energy and metals markets because the large
trader data currently available to the commission would not permit an
accurate breakout of index trading in these markets. According to CFTC,
swap dealers, who use futures markets to hedge commodity index
transactions in the OTC market, conduct most trading of commodity index-
related futures. However, these swap dealers also may engage in OTC
derivative transactions on energy or metals prices directly and conduct
cash transactions in the underlying energy or metals markets. As a
result of these activities, the overall futures positions held by swap
dealers in energy and metal futures markets may not necessarily
correspond closely with the hedging of OTC commodity index
transactions. The commission stated that including these traders in the
new index trader category would not enhance market transparency.
Furthermore, it did not want to delay publication of the new COT report
while it continues to study whether it is feasible to publish
meaningful reports for other markets. The objective of the pilot
program is to improve the transparency of an evolving market by
separately reporting the positions of index traders. Similarly, the
increasing volume of off-exchange trading in energy derivatives and the
recent volatility of energy commodity prices justify considering
whether a COT category of futures positions held by participants in off-
exchange energy markets also could enhance transparency. CFTC said it
will assess the relevance and usefulness of the new reporting and study
whether it is possible and appropriate to expand the supplemental
report to include data for other physical commodity futures markets.
Significant changes in the energy markets also may lead CFTC to further
examine the usefulness, accuracy, and relevance of reported information
to users. According to CFTC officials, energy trading has seen the
entry of new market participants. For example, investment banks, hedge
funds, and swaps dealers have become significant market participants.
Moreover, according to industry analysts and representatives from
investment banks and large oil companies, some commercial participants
only hedge, some only speculate, and others both hedge and speculate in
the energy markets. While some commercial participants may hedge and
speculate in the same energy market, CFTC classifies these entities as
commercial participants. CFTC has not been able to identify new
categories for traders of energy commodities. Such reporting can
distort the accuracy and relevance of reported information to users and
the public, thereby limiting the usefulness of the information reported
to the public as well as information used by traders.
CFTC Authority over Exempt Commercial Markets Consists of Enforcing the
Antifraud and Antimanipulation Provisions of the CEA and Administering
Certain Reporting Requirements:
In contrast to the direct oversight provided to futures exchange,
exempt commercial markets are not subject to CFTC's general oversight
authority. According to CFTC officials, as these markets have grown in
prominence, some market observers have questioned their role in the
energy markets. Trading energy derivatives on exempt commercial markets
is permissible only for eligible commercial entities. While not subject
to general CFTC oversight, these markets are subject to CFTC rule 36.3,
which provides for the dissemination of exempt commercial market
trading data should exempt commercial market prices be used to price
cash markets and contains notification, recordkeeping, and reporting
requirements.[Footnote 42] Also, exempt commercial market participants
are subject to CFTC's enforcement authority for the antimanipulation
and antifraud provisions of the CEA.[Footnote 43] These markets are not
required to register with CFTC, but must notify CFTC that they are
operating as an exempt commercial market and comply with certain CFTC
informational, recordkeeping, and other requirements.[Footnote 44]
Specifically, CFTC promulgated rule 36.3 under two subsections of the
CEA. One subsection authorizes CFTC to prescribe rules if necessary to
ensure the timely dissemination of price, trading volume, and other
trading data for a derivative traded on an exempt commercial market if
the commission determines that the electronic trading facility used by
the market performs a significant price discovery function for
transactions in the cash market for the commodity underlying the
derivative.[Footnote 45] The other subsection establishes notification,
recordkeeping, and reporting requirements for exempt commercial
markets.[Footnote 46] The rule requires, among other things, that the
electronic trading facility in an exempt commercial market must notify
CFTC of its reliance on the exemption and provide CFTC with price,
quantity, and other data on contracts that average five or more trades
a day over the most recent quarter for which they are relying on the
CEA exemption. The facility also must maintain a record of allegations
or complaints they receive concerning instances of suspected fraud or
manipulation and provide CFTC with a copy of the record. CFTC officials
said that the reports include transaction-level data, such as quantity
and price, for all trades in products meeting the criteria, but not the
identities of counterparties to the trades. These officials said that
three exempt commercial markets--ICE, the Natural Gas Exchange, and
ICAP--currently provide the rule 36.3 trade information reports; in the
past, the Optionable and ChemConnect exempt commercial markets also
provided these reports. For example, ICE officials told us that for
their OTC activities they keep records for all of the products traded
on their platform, and report to CFTC on liquid markets (those
averaging five trades a day) and any complaints received from market
participants. ICE officials said that CFTC often asks ICE for detailed
information about participants that are putting up bids and offers and
about all of the trades executed in a day.
CFTC officials said that the other electronic exchanges have provided
notice that they are operating in reliance on the CEA exemption, but
they have not provided rule 36.3 trade information reports. CFTC
officials explained that an electronic exchange only has to provide
information reports if it meets the threshold for reporting, which
includes averaging five trades per day in the relevant contract. These
officials also said that they do not actively check to determine
whether the thresholds are being met.
To date, no exempt commercial market or CFTC has determined if cash
markets for energy commodities routinely use exempt market prices to
price their transactions. According to CFTC officials, an exempt
commercial market or CFTC may determine, using certain criteria, if the
market serves such a price discovery function. Exempt markets that
serve such a function become subject to certain public reporting
requirements. According to CFTC officials, the commission has not made
such a determination for two reasons. First, they said that the only
consequence of serving a price discovery function under current law is
that the exempt commercial market must publish its prices. They noted
that this is a circular argument because it is the public availability
of pricing information that enables the exempt commercial market to
serve a price discovery function. Second, they said that this is a low
priority. In their view, the current fiscal situation does not allow
CFTC to send its economists into the field on matters such as this that
would not go before the commission. Also in their view, even if the
markets served a price discovery function, no significant consequence
would entail because of the circularity argument. However, in light of
the growth of trading on ICE and the lessons learned from the Amaranth
crisis, CFTC held a hearing in September 2007 to examine trading on
regulated exchanges and exempt commercial markets.[Footnote 47] The
hearings included an assessment of price discovery in these markets and
the implications for CFTC oversight of these markets.
Since 2001, 17 facilities have notified CFTC that they had begun
operating as exempt commercial markets (see table 1). According to CFTC
officials, 11 of these markets currently offer, or had offered,
transactions in energy products, with 8 now operational. Some of these
markets have become important players in the trading of energy
products. ICE, in addition to the exempt swap contracts it trades in
its capacity as an exempt commercial market, is the trading platform
for physical commodities, including spot and forward contracts, which
routinely involve delivery. According to CFTC officials, some in the
industry assert that ICE is the trading platform for an estimated 70
percent of the spot trading for natural gas.[Footnote 48] Another
exempt commercial market, ChemConnect, advertises that data and news
providers, such as Bloomberg and Dow Jones Energy Services, rely on it
to provide accurate, timely information on energy products.
Furthermore, the Web site for the HoustonStreet Exchange indicates that
it serves as an electronic trading facility for crude oil and refined
products also traded on NYMEX. While there has been significant growth
in the number of electronic exchanges, CFTC officials said that they
receive trade information reports from only 2--ICE and the Natural Gas
Exchange. According to CFTC officials, they have no evidence that the
others meet the minimum threshold trading volume for reporting.
Table 1: Exempt Commercial Markets, Dates They Filed Notice with CFTC
to Operate as an Exempt Commercial Market, and Commodities Traded on
Each Market, 2001-2006:
Notification date: 2006;
Exempt commercial market: ChemConnect;
Commodity category: Energy products.
Notification date: 2003;
Exempt commercial market: Chicago Climate Exchange;
Commodity category: Emission allowances.
Notification date: 2002;
Exempt commercial market: Commodities Derivative Exchange;
Commodity category: Metals.
Notification date: 2002;
Exempt commercial market: HoustonStreet Exchange;
Commodity category: Energy products.
Notification date: 2006;
Exempt commercial market: ICAP Commodity and Commodity Derivatives
Trading System;
Commodity category: Energy products.
Notification date: 2006;
Exempt commercial market: ICAP Electronic Trading Community;
Commodity category: Natural gas and its derivatives.
Notification date: 2005;
Exempt commercial market: ICAP Hyde Limited Trading System;
Commodity category: Forward freight agreements.
Notification date: 2001;
Exempt commercial market: IntercontinentalExchange;
Commodity category: Precious metals, base metals, and energy products.
Notification date: 2001;
Exempt commercial market: International Maritime Exchange;
Commodity category: Freight rates.
Notification date: 2002;
Exempt commercial market: Natural Gas Exchange;
Commodity category: Energy products.
Notification date: 2006;
Exempt commercial market: NetThruPut;
Commodity category: Condensates and liquefied petroleum gas.
Notification date: 2001;
Exempt commercial market: Optionable;
Commodity category: Energy products.
Notification date: 2003;
Exempt commercial market: Spectron Live.com Limited;
Commodity category: Liquefied petroleum gas.
Notification date: 2003;
Exempt commercial market: TFS Energy;
Commodity category: Weather derivatives.
Notification date: 2005;
Exempt commercial market: Trade Capture;
Commodity category: Energy products.
Notification date: 2002;
Exempt commercial market: Tradespark;
Commodity category: Energy products, weather indexes, and emission
allowances.
Notification date: 2003;
Exempt commercial market: Tradition Financial Services Pulp and Paper
Division;
Commodity category: Pulp and paper products.
Source: GAO analysis of CFTC data.
[End of table]
Although CFTC Can Enforce Antimanipulation and Applicable Antifraud
Provisions of the CEA in OTC Energy Derivatives Markets and Exempt
Commercial Markets, Views Vary about the Sufficiency of Its Regulatory
Authority with Respect to Off-Exchange Energy Derivatives:
Energy derivatives also may be traded OTC, under the conditions and
restrictions in the CEA for exempt commodities. The act exempts from
most of its provisions transactions in exempt commodities into which
large market participants enter and that are not traded on a trading
facility. In addition, the act exempts from most of its provisions
transactions in exempt commodities traded on an electronic trading
facility, as long as large commercial traders (defined in the act as
"eligible commercial entities") enter into them on a principal-to-
principal basis.[Footnote 49] Bilateral OTC derivatives contacts are
viewed as private transactions between sophisticated counterparties,
and there is no requirement for parties involved in OTC transactions to
disclose details of their transactions. Because OTC derivatives are
contractual agreements, each party is subject to and assumes the risk
of nonperformance by its counterparty. This is different from exchange-
traded derivatives, where a central clearinghouse stands behind every
trade. Thus, according to officials of the International Swaps and
Derivatives Association, in the OTC context it is vitally important
that one has confidence in the creditworthiness and trustworthiness of
one's counterparty. While these markets generally are not subject to
direct CFTC oversight, CFTC has the authority to enforce antifraud and
antimanipulation provisions of the CEA in connection with transactions
in exempt commodities that take place through an electronic trading
facility, and that are entered bilaterally without being subject to
negotiation.[Footnote 50] Several of the enforcement actions filed by
CFTC since 2001 addressed the use of false reporting in an attempt to
manipulate energy prices on NYMEX.
In addition to being subject to certain provisions of the CEA, the
participants in these contracts may be subject to other regulatory
authorities on the basis of their activities in the physical market.
For example, certain actions--such as the buying and selling of a
physical energy commodity by traders, such as hedge funds--may fall
under the regulatory authority of FERC, which regulates the interstate
transmission of physical commodities, such as natural gas, oil, and
electricity, to protect energy consumers. Also, certain OTC derivative
activities conducted by commercial banks are subject to oversight by
the appropriate bank regulator. For example, commercial banks that
engage in OTC derivatives are overseen by their relevant regulator,
such as the Office of Comptroller of the Currency or the Board of
Governors of the Federal Reserve System with respect to how their
derivatives trading satisfies requirements of the banking laws.
Likewise, SEC also has oversight authority over investment banks'
activities that fall under its regulatory purview. These regulators do
not regulate the specific transactions or maintain oversight of OTC
derivatives as a class of instruments or markets; they regulate the
entities that enter into the contracts or that act as dealers,
counterparties, or both.
While some observers have called for more oversight of OTC derivatives,
most notably for CFTC to be given greater oversight authority of this
market, others oppose any such action as unnecessary. Supporters of
more CFTC oversight authority believe that regulating OTC derivatives
markets is needed to protect the regulated markets and protect
consumers from potential abuse and possible manipulation. One of their
concerns is that because there is little information available about
the size of this market or the terms of the contracts, CFTC may not be
assured that trading on the OTC market is not adversely affecting the
regulated markets and, ultimately, consumers. Specifically, some have
mentioned that, unlike trading on a regulated exchange, OTC derivatives
are not subject to any routine reporting requirements. Some have
suggested that a combination of quantitative and qualitative
information (such as whether derivatives are used mainly for trading or
hedging purposes, and notional amounts by derivatives category) be
collected.[Footnote 51]
However others, including the President's Working Group, have concluded
that OTC derivatives generally are not subject to manipulation because
contracts are settled in cash on the basis of a rate or price
determined in a separate, highly liquid market and these OTC
transactions do not serve a significant price discovery
function.[Footnote 52] The Working Group also noted that if electronic
markets were to develop and serve a price discovery function, then
consideration should be given to enacting a limited regulatory regime
aimed at enhancing market transparency and efficiency through CFTC, as
the regulator of exchange-traded derivatives.
However, because of the lack of reported data about this market,
addressing concerns about its function and effect on regulated markets
and entities would be a challenge. CFTC officials have said that they
have reason to believe these off-exchange activities affect prices
determined on a regulated exchange. In a June 2007 Federal Register
release clarifying its large trader reporting authority, 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
53] According to CFTC officials, the commission also has proposed
amendments to clarify its authority under the CEA to collect
information and bring fraud actions in principal-to-principal
transactions in these markets, thus enhancing CFTC's ability to enforce
antifraud provisions of the CEA.[Footnote 54]
Also, in August 2007, CFTC announced plans to conduct a hearing to
begin examining more closely the trading on regulated exchanges and
exempt commercial markets. The September 2007 hearing focused on a
number of issues, including:
* the current tiered regulatory approach established by the CFMA and
whether this model is beneficial;
* the similarities and differences between exempt commercial markets
and regulated exchanges, and the associated regulatory risks of each
market; and:
* the types of regulatory or legislative changes that might be
appropriate to address any identified risks.
CFTC Engages in Surveillance Activities and Enforcement Activities, but
the Effectiveness of these Activities Is Largely Uncertain:
CFTC provides oversight for commodity futures markets through routine
surveillance, analysis of market data, and inquiries of market
participants and others. The commission uses information gathered from
surveillance activities to identify unusual trading activity and
possible market abuse. In particular, CFTC's LTRS provides essential
information for surveillance, and LTRS provides information on the
majority of all trading activity on futures exchanges. CFTC staff also
rely on data from other sources and on their experience to identify
potential problems, reporting unresolved potential market problems to
the commission. NYMEX also conducts its own surveillance activities.
According to CFTC and industry officials, CFTC and NYMEX contact
traders to collect additional information about questionable trading
practices. CFTC staff also said that they routinely investigate traders
with large open positions, but the staff added that they do not
routinely maintain information about such inquiries, thereby making it
difficult to determine the usefulness and extent of these activities.
In addition, CFTC coordinates its surveillance activities with other
federal, state, and foreign authorities. While CFTC's surveillance
authority is limited to futures exchanges, the commission's enforcement
authority for manipulation and fraud extends to both exchange-based
trading and off-exchange trading in exempt commodities, such as energy
products. According to data provided by CFTC, in recent years, it has
used its enforcement authority to file enforcement actions for almost
300 cases, more than 30 of which involved energy-related commodities.
However, as with programs operating in regulatory environments where
performance is not easily measurable, evaluating the effectiveness of
CFTC's enforcement activities is challenging because of the lack of
effective outcome-based performance measures. CFTC's enforcement
program received mixed ratings in a recent OMB review because CFTC
could not fully demonstrate the effectiveness of its enforcement
activities.
CFTC Oversight Includes Surveillance of Energy Futures Trading, but the
Full Extent of Follow-up Activities Is Uncertain:
CFTC conducts regular market surveillance and oversight of energy
trading on NYMEX and other futures exchanges. These activities include
focusing on detecting and preventing disruptive practices before they
occur and keeping the CFTC commissioners informed of possible
manipulation or abuse. In addition to conducting direct surveillance of
trading in energy futures markets on NYMEX, CFTC focuses on NYMEX's
compliance with appropriate CEA core principles, including monitoring
of trading to prevent price manipulation and enforcing position limits
and position accountability rules. In conducting its own surveillance
activities, NYMEX may bring enforcement actions when violations are
found. CFTC staff also investigate traders with large open positions
and document cases of improper trading.
CFTC Oversees Trading on Futures Exchanges:
According to CFTC officials, CFTC staff at three regional offices
provide much of the market oversight and monitor daily trading
activity. For instance, CFTC's New York Regional Office employs seven
economists, who look for unusual trading and potential market
manipulations in all futures contracts traded on New York futures
exchanges. The New York regional staff obtain information from both
market participants and NYMEX to monitor energy trading activity. New
York CFTC staff stated that each morning, about 160 firms
electronically submit large trader position data from the previous day
to CFTC. CFTC headquarters receives these data and makes them available
on a network to its field offices. Staff review these data for
potential errors or omissions and then populate the LTRS, a database
that staff use in conducting their surveillance activities.
CFTC staff also said that they rely on the commission's integrated
surveillance system (ISS), which contains surveillance data that CFTC
has collected from the futures exchanges, clearing members, foreign
brokers, and large traders. According to CFTC's 2005 performance and
accountability report, ISS is a critical application to support futures
and options data market surveillance.[Footnote 55] This system provides
continuously updated trading data on holders of large futures and
option positions that CFTC staff uses daily to monitor futures and
option trading, detect potential problems, and identify trends in the
marketplace. According to CFTC officials, ISS also is used to
facilitate analysis of data received from exempt markets as a result of
special calls for information. For example, pursuant to separate
special calls issued in April, September, and December, 2006, ICE now
continuously provides the commission with large trader position data.
The commission also issued enforcement-related special calls seeking
data for two individual ICE market participants in September 2006 and
February 2007.
The LTRS, which is part of ISS, is a comprehensive system for
collecting information on market participants, a key information source
for CFTC's market surveillance program and essential for monitoring
markets and identifying and resolving potential problems involving
market congestion, manipulation, and speculative position
limits.[Footnote 56] Congestion may occur when traders holding short
positions are attempting to cover their positions but are unable to
find an adequate supply of contracts provided by traders with long
positions or by new sellers willing to enter the market, except at
sharply higher prices. In conducting their daily surveillance
activities, CFTC officials said they analyze the trading data for
indications that individual traders may be attempting to manipulate the
market. This activity involves (1) looking for traders having unusually
large market positions relative to open interest--the total number of
futures contracts that have been entered into and not yet liquidated by
an offsetting transaction or fulfilled by delivery--and deliverable
supply and (2) examining the potential for disruption at expiration and
sharp moves in the market. If certain positions pose concerns to CFTC
staff, they can request additional information from a reporting firm or
trader about trading and delivery activity.
CFTC staff also analyze trading using data from other sources. CFTC
officials said that the staff look at price movements and price
relationships--especially in the natural gas, crude oil, heating oil,
and unleaded gasoline markets--using commercial information sources,
such as Bloomberg, Gas Daily, Reuters, and other market sources. They
also obtain information about traders by monitoring their Web sites and
use NYMEX's and EIA's Web sites and Lexis-Nexis, as well as firms' Web
sites. CFTC staff said that they are in regular contact with exchange
officials, who have data on clearing members and trading activity. They
also obtain surveillance information from other units within the
commission and from tips by the public.
While CFTC data and other market collections are focused on identifying
potential market disruptions and manipulations, staff also rely on
their experience to identify potential problems. According to CFTC
staff, the New York Regional Office staff assigned to surveillance of
energy trading have many years of experience, either doing surveillance
work for CFTC or in the futures industry, in general. Experienced staff
are needed because, according to CFTC staff, analyzing market data is
an art as well as a science. CFTC staff referred to the traditional
test for manipulation set forth in the commission's Indiana Farm
decision as a commonly recognized statement of the elements that are
necessary to prove manipulation.[Footnote 57]
According to CFTC staff, when a potential market problem has been
identified, surveillance staff generally contact the exchange or
traders to gather additional information. They said that surveillance
staff may ask exchange employees, brokers, or traders questions to
confirm positions and determine the intent of traders. They added that
staff may express concern about the size of positions or possible
actions by traders and caution traders to act responsibly.[Footnote 58]
According to the staff, CFTC's Division of Market Oversight may issue a
warning letter or make a referral to the Division of Enforcement to
conduct a nonpublic investigation into the trading activity. Markets
where surveillance problems have not been resolved may be included in
reports presented to the commission at weekly surveillance meetings.
These reports provide information on traders with the four largest long
and short positions; other market information, including delivery
information; and background on the contact. According to CFTC staff,
CFTC commissioners review the reports; discuss the situations with
surveillance staff; and, if appropriate, consider other possible
remedial actions, such as suggesting that the exchange take emergency
action. If necessary, the commission itself may take emergency action.
If these actions do not resolve the issue or if an exchange fails to
resolve a problem by taking actions that the commission deems
appropriate, CFTC can order an exchange to take emergency actions.
These actions include limiting trading, imposing or reducing limits on
positions, requiring the liquidation of positions, extending a delivery
period, or suspending trading. The commission has taken such emergency
actions four times in its history, but never for energy markets.
In addition to CFTC's surveillance of NYMEX and trading on the
exchange, NYMEX conducts its own surveillance activities and, if
violations are found, brings its own enforcement actions. NYMEX is
responsible for enforcing its own standards and CFTC's standards
embodied in its rules governing the exchange, and its surveillance
program is designed to monitor for possible manipulation by market
participants. If NYMEX staff find potential violations, they will
gather information and, if needed, take enforcement actions. For
example, according to officials at a large refiner, NYMEX staff call
them nearly every month about a large trade to make sure that their
physical (or wet) barrels have moved and that their trade is not a
price-setting mechanism or market ploy. Refiner officials added that
even though NYMEX staff know they are a big refiner, they will examine
their trades to see the actual signed contract to make sure it is
valid. In their view, NYMEX staff are vigilant, as they should be.
Officials from a hedge fund also said that both NYMEX and CFTC staff
monitor their positions carefully and, as a speculator, would be
notified immediately by NYMEX and CFTC if they were over the trading
limits on any day. When asked about what weaknesses in the structure,
monitoring, or enforcement mechanisms of derivative markets might allow
for market manipulation, one market observer responded that he was not
aware of any such weaknesses. Appendix III contains detailed discussion
of NYMEX surveillance activities and enforcement actions.
Actions Taken by CFTC Staff to Inquire about Potential Problems May Not
Always Be Documented:
CFTC staff routinely make inquiries about traders with large open
positions approaching expiration, but formal records of their findings
are only kept in cases where there is evidence of improper trading. If
LTRS data reveal that a trader has a large open market position that
could disrupt markets if it were not closed before expiration, CFTC
staff would contact the trader to determine why the trader had the
position and what plans the trader had to close the position before
expiration or to ensure that the trader was able to take delivery. If
the traders provided a reasonable explanation for the position and a
reasonable delivery or liquidation strategy, staff said that no further
action would be required. CFTC staff said they would document such
contacts on the basis of their importance in either informal notes, e-
mails to supervisors, or informal memorandums. No formal record would
be made of the inquiry, according to one CFTC official, unless there
was a signal indicating improper trading activity. Without such data,
CFTC's measures of the effectiveness of its actions to combat fraud and
manipulation in the markets will not reflect this surveillance
activity, and CFTC management might miss opportunities to both identify
trends in activities or markets and better target its limited
resources.
CFTC staff added that all surveillance projects and activities that
require a minimum number of hours of work are tracked by quarterly
statistical reports, including those futures expirations with large
trader or deliverable supply problems. They said that expirations are
routinely monitored by economists and reviewed with their supervisors
through weekly surveillance reports. Economists are responsible for the
analytical review of cash and futures market developments, including
the assessment of supply and demand factors, basis and spread
relationships, the adequacy of deliverable supply, large trader
positions and position changes, large trader histories, and the
potential for group trader activity. CFTC staff said that their
economists keep their supervisors and the commission informed of
potential problems as they arise.
CFTC Coordinates Its Surveillance and Oversight Activities with Others:
In addition to keeping CFTC commissioners apprised of surveillance
activities and specific cases that may require action, CFTC coordinates
its surveillance and oversight activities with other federal agencies,
states' attorneys general, and foreign regulators. CFTC officials told
us that through the Division of Enforcement's Office of Cooperative
Enforcement, which was created in 2002, they conduct outreach efforts
to other financial regulators at the federal and state levels.
Specifically, CFTC and FERC coordinate oversight and enforcement
activities and have a memorandum of understanding that provides for the
exchange of data. FERC regulates the interstate transmission of natural
gas, oil, and electricity, and it audits natural gas sellers'
compliance with the protocols outlined by FERC for reporting sales to
index publishers like Platts, a company that compiles information on
oil, natural gas, and electricity and other energy commodities and
provides industry reports on commodity prices. If futures transactions
are thought to affect transactions within FERC's jurisdiction, then
FERC and CFTC may coordinate their oversight and enforcement work by
sharing data as provided in the memorandum. In pursuing potential
market abuse cases, such as individuals trying to manipulate energy
spot prices to benefit their futures market positions, FERC officials
said that FERC will tend to take the lead when abuses occur in the
physical markets. FERC officials also said that CFTC will tend to take
the lead when abuses occur in the futures markets. In July 2007, FERC
filed two market manipulation cases that, according to a commission
announcement, was the first time the agency used its enforcement
authority under the Energy Policy Act of 2005 and its former market
manipulation rule. According to CFTC officials, CFTC has filed 38 cases
over the past 6 years that have focused on conduct in both the cash and
futures markets (see app. IV). CFTC and FERC also may work with DOJ on
certain cases.
In addition, CFTC officials said that, on occasion and when warranted
by the circumstances, CFTC has shared large trader information with
certain agencies, such as the Department of the Treasury, the Board of
Governors of the Federal Reserve System, and the Federal Reserve Bank
of New York, to address issues of common concern to the agencies. For
example, in the aftermath of the financial difficulties in 1998 of Long
Term Capital Management, a large hedge fund, CFTC shared information on
the hedge fund's exchange trading activity with members of the
President's Working Group. Because coordinating requires judgments
about what information would need to be and could be shared and about
how best to share it, we concluded in a 1999 report that the regulators
are in the best position to determine the most effective ways to
enhance their coordination.[Footnote 59] CFTC also shares information
with other members of the President's Corporate Fraud Task Force at
their quarterly meetings on antifraud cases.
CFTC Energy-Related Enforcement Actions Generally Involved False
Reporting and Attempted Manipulation, and Enforcement Actions Often Are
Coordinated with Other Authorities:
CFTC's Division of Enforcement is charged with enforcing the
antimanipulation sections of the CEA, including sections 6(c), 6(d),
and 9(a)(2). In particular, section 9(a)(2) sets forth the commission's
antimanipulation and false reporting authority in cash and futures
markets.[Footnote 60] In determining whether violative conduct has
occurred, CFTC officials told us that the Division of Enforcement has
broad investigatory authority to obtain records and testimony,
including subpoena authority, under a commission order. They added that
upon conclusion of an investigation, which is routinely nonpublic, the
division may recommend enforcement action if warranted.
The enforcement actions CFTC has taken in its energy-related cases
generally have involved false public reporting as a method of
attempting to manipulate prices on both the NYMEX futures market and
the off-exchange markets. CFTC officials said that from October 2000 to
September 2005, the commission initiated 287 enforcement cases and more
than 30 of these cases involved energy trading, including actions
against Enron and others. For example, according to CFTC data, from
2001 through 2005, CFTC levied fines totaling $305 million in actions
alleging attempted manipulation of the price of natural gas (see app.
IV for more detailed information). Most of these cases charged
attempted manipulation by means of falsely reporting natural gas
trading information to energy index firms, such as Platts, that
calculate surveys or indexes of natural gas prices for various physical
delivery points (hubs) throughout the United States. Generally, these
cases involved allegations of various defendants knowingly
disseminating false information in an effort to skew the indexes for
their financial benefit or for other reasons. Participants in the
natural gas markets use the indexes for price discovery and assessing
price risk. Many of the actions were initiated on the basis of
information that came from sources other than CFTC surveillance
activities, or those of NYMEX, because they involved activities outside
of NYMEX. As one major oil company official told us, in his view, CFTC
and FERC vigorously pursued attempts by traders to manipulate the
market.
Most recently, on August 1, 2007, the commission entered an order
imposing a $1 million penalty against Marathon Petroleum Company, LLC,
for attempting to manipulate spot cash crude prices by attempting to
influence the Platts market assessment. On July 25, 2007, the
commission commenced an action against Amaranth and others for
attempted manipulation of NYMEX natural gas futures prices. Also on
July 26, 2007, the commission commenced an enforcement action on Energy
Transfer Partners, L.P., and others for attempted manipulation of
physical natural gas prices.
Regarding energy futures, CFTC coordinates its enforcement activities
with NYMEX officials and various other federal, state, and foreign
authorities. CFTC staff stated that they meet periodically with NYMEX
Compliance Department officials to discuss enforcement activities, as
appropriate, and have formal quarterly meetings to discuss mutual
involvement in specific cases, including energy products. In addition
to coordinating energy enforcement matters with NYMEX, as a regulator
of derivatives trading, CFTC often will work with the regulator of the
underlying commodity or affected market, whether the Department of
Agriculture, FERC, or Treasury. CFTC does not have criminal authority
but often works with DOJ on those cases involving violations of the CEA
that DOJ believes warrant criminal prosecution.[Footnote 61] DOJ
officials stated that their focus has been on natural gas cases, which
began with cases involving Enron. According to DOJ officials, their
role complemented the regulatory roles of FERC and CFTC, and they have
an effective working relationship with CFTC in terms of sharing case
information. For example, pursuant to a memorandum of understanding
with CFTC, in May 2006, FERC obtained information about trading in
natural gas futures contracts that FERC used in support of an
enforcement action against Amaranth that was initiated in July
2007.[Footnote 62] On July 25, 2007, CFTC filed an action in the United
States District Court for the Southern District of New York against
Amaranth Advisors, L.L.C., Amaranth Advisors (Calgary) ULC, and Brian
Hunter alleging, among other things, that the defendants intentionally
and unlawfully attempted to manipulate the price of natural gas futures
contracts on NYMEX on February 24, 2006, and April 26, 2006. In another
case, on June 28, 2006, CFTC brought an enforcement action against BP
Products North America, Inc., alleging, among other things, that BP
cornered the physical propane market and manipulated the price of
propane in February 2004.[Footnote 63] Also on June 28, 2006, DOJ
announced that a former BP trader had pled guilty to conspiracy to
manipulate and corner the physical propane market. FTC also has
exercised its authority in the energy arena. Since 1980, FTC's focus in
energy has been in reviewing mergers and acquisitions for
anticompetitive behavior and investigating instances of possible
collusion, price fixing, and other anticompetitive conduct. However,
FTC staff told us that they generally did not coordinate their work
with CFTC, but added that they would turn over any evidence of futures
manipulation to CFTC. CFTC staff said that, as appropriate, CFTC also
coordinates its antifraud enforcement activities with states' attorneys
general, who often will assist in a case by acting as a co-plaintiff
with CFTC. In turn, CFTC may detail an attorney to a state. CFTC staff
said that they also may work with international authorities, such as
the United Kingdom's Financial Services Authority, on cases involving
activities in more than one nation.
CFTC's Enforcement Program Received a Mixed OMB Rating but Lacks
Effective Outcome-Based Performance Measures:
Although CFTC has undertaken enforcement actions and levied fines,
OMB's most recent 2004 Program Assessment Rating Tool (PART) assessment
of the CFTC enforcement program was mixed. OMB designed PART to provide
a consistent approach to assessing federal programs in the executive
budget formulation process. PART is a standard series of questions
meant to serve as a diagnostic performance tool, drawing on available
program performance and evaluation information to form conclusions
about program benefits and recommend adjustments that may improve
results. In the assessment, OMB rated the enforcement program as
"Results Not Demonstrated" and said that the enforcement program lacked
performance measures that illustrate whether the program meets its
overall objective. However, CFTC's existing performance measures show
that it brings substantive cases in a timely manner and "is well
designed to meet its objectives [of protecting commodity futures and
options market users and the public from fraud, manipulation, and
abusive practices related to the sale of certain commodities through
the enforcement of laws against such practices] and to maximize the use
of its resources." According to the PART assessment, the enforcement
program has a clear purpose, addresses the public interest by ensuring
adherence to the CEA and CFTC's regulations, is not duplicative of
other government programs, is free of major design flaws, and is
effectively targeted so that the resources address the program's
purposes. OMB scored CFTC at 100 percent for the dimensions of both
program purpose and design and program management, 71 percent for
planning, and 67 percent for results and accountability. Compared with
the other 96 programs that OMB identified as similar to CFTC's program,
the comparable programs have much lower average scores for the
dimensions of purpose and design (82 percent), program management (84
percent), and results and accountability (50 percent) and have a
similar score for planning (73 percent).
CFTC's score of 71 percent for the planning dimension reflected OMB's
assessment that CFTC included performance measures in its annual
reports; used the actual results it achieved during the preceding
fiscal year as a baseline for all of its performance measures and
strove to set ambitious targets for its performance; was scrutinized on
a regular basis by CFTC's Office of the Inspector General; had budget
requests that were explicitly tied to accomplishment of the annual and
long-term performance goals, and resource needs that were presented
completely and transparently in the program's budget; and had taken
meaningful steps to correct its strategic planning deficiencies.
However, OMB also concluded that regarding the strategic planning
dimension, the program had a limited number of long-term performance
outcome measures that did not fully reflect the program's goals, and
that the long-term measures and targets did not fully reflect the
program's purposes. These measures included:
* the percentage growth in market volume,
* the increase in the numbers of exchanges and clearinghouses,
* the percentages of SROs and clearing organizations that complied with
the requirement to enforce their rules, and:
* the percentage decreases in both the number of customers who lost
funds because of alleged wrongdoing and the amount of funds that these
customers lost.
CFTC enforcement staff stated that they face challenges in establishing
measures to determine whether the enforcement program achieves its goal
of deterring people from engaging in market manipulation or other
abusive behavior.
According to OMB, CFTC's score of 67 percent on the program results and
accountability dimension reflected its assessment that CFTC's
enforcement program had demonstrated both (1) improved time
efficiencies and cost-effectiveness in achieving its program goals and
(2) our several evaluations of CFTC indicating that it was effective
and achieving results.[Footnote 64] OMB also reported that for fiscal
year 2004, the enforcement program met all of its outcome measures and
came close to meeting all of its output measures, with one exception.
OMB further stated that the outcome-related measures established for
enforcement do not fully reflect progress on meeting the program's
overall goals.
While CFTC satisfied most but not all of OMB's PART criteria, it has
fallen short in its ability to develop long-term performance outcome
measures that are reflective of its program's goals and purposes. As
OMB identified, CFTC has substituted proxy measures for outcome
measures: that is, using measures such as percentage growth in market
volume and increase in the number of exchanges and clearinghouses as
proxies for protecting market integrity, and percentage decreases in
both the number of customers who lost funds because of alleged
wrongdoing as proxies for both protecting market integrity and
consumers. We have found that managers in a regulatory environment
where programs and activities are not easily measurable, as is the case
with CFTC enforcement, have reported that it is particularly
challenging to measure outcome-oriented performance and collect useful
data.[Footnote 65] However, there are a number of other ways to
evaluate program effectiveness, such as using expert panel reviews,
customer service surveys, and process and outcome evaluations. We have
found with other programs that the form of the evaluations reflect
differences in program structure and anticipated outcomes, and that the
evaluations are designed around the programs and what they aim to
achieve.[Footnote 66] Without utilizing these or other methods to
evaluate program effectiveness, CFTC is unable to demonstrate whether
its enforcement program is meeting its overall objectives.
Conclusions:
The rise in energy prices can be and has been attributed to a variety
of factors. From January 2002 through June 2006, the physical and
derivatives markets both underwent substantial change and evolution.
The physical energy markets experienced tight supply and increasing
global demand, ongoing political instability in oil-producing regions,
and other supply disruptions, which affected the prices of energy
products. At the same time, increasing numbers of and different types
of market participants were trading futures in search of higher
returns, thereby increasing contract volume. Substantial growth in the
exempt commercial and OTC markets also occurred. Determining the impact
of any one factor is complicated because price changes in the physical
and futures markets are closely linked and in the long run are
influenced by the same market fundamentals. Generally, futures prices
reflect traders' views of the impact of changes in the physical markets
and spot prices are affected by these expressed views and vice versa.
Given this interrelationship, it is not surprising that some market
observers point to the changes in the energy futures and other
derivatives markets as a possible explanation for price increases,
while others, primarily the regulators, look to changes in the physical
markets to explain the increases. However, given the changes in both
markets, attributing causality to any one factor--much less a
particular type of trading activity--is difficult. Regardless of the
reason for the increases in prices, ongoing monitoring of both markets
is warranted to ensure that the public interest is being protected as
well as the integrity of the markets.
Related to concerns about rising prices, some market observers and
others have questioned whether CFTC's authority is broad enough to
protect investors from fraudulent, manipulative, and abusive practices.
The scope of CFTC's authority varies, depending on the market where the
commodity is traded. Some markets are available for retail trading and
receive direct CFTC oversight, while others are limited to professional
traders (such as OTC energy derivatives markets) and receive less
oversight. Other markets are largely unregulated. Given the changes in
these markets in general and the growth in off-exchange trading in
particular as well as ongoing questions about the relationship between
exchange-traded and off-exchange markets, a reexamination of the scope
of CFTC's authority is warranted. The results of CFTC's hearings on its
existing regulatory structure and the similarities and differences
between exchange-traded and exempt markets may be instructive for such
a reexamination. While participants on all sides of this issue have
perspectives that call for further consideration, these are public
policy decisions that ultimately will be made by Congress. Unless
resolved, questions will continue about the scope of CFTC's authority.
In the interim, we have identified a number of process issues that CFTC
can address to strengthen its enforcement and surveillance programs.
* First, CFTC has attempted to provide the public with more meaningful
information through the COT reports. While this effort has expanded the
reporting for some agricultural commodities, it has remained virtually
unchanged for energy commodities that have a high level of public and
industry interest. Not having complete information on trading in energy
commodities impairs the ability of traders to make fully informed
decisions.
* Second, CFTC's oversight of regulated exchanges involves a range of
surveillance activities that have resulted in a number of commission-
related enforcement actions. However, CFTC does not maintain complete
records of its surveillance activities. Currently, the commission does
not maintain written records on all surveillance follow-up activities,
particularly in instances where no potential violation was found.
Without such records, CFTC staff cannot fully demonstrate the actions
they are taking to combat fraud and manipulation in the markets.
* Third, as is the case with most enforcement agencies, CFTC has had
limited success in identifying meaningful outcome-based performance
measures. However, agencies can use a variety of methods to evaluate
program effectiveness, such as expert panel reviews, customer service
surveys, and process and outcome evaluations. Without meaningful
measures for program effectiveness, CFTC may be missing opportunities
to identify significant trends in certain activities or markets and to
better target its limited resources.
Matter for Congressional Consideration:
In light of recent developments in derivatives markets and as part of
CFTC's reauthorization process, Congress should consider further
exploring whether the current regulatory structure for energy
derivatives, in particular for those traded in exempt commercial
markets, provides adequately for fair trading and accurate pricing of
energy commodities.
Recommendations for Executive Action:
To improve the oversight and available information on energy futures
trading, we recommend that the Acting CFTC Chairman take the following
three actions:
* reexamine the classifications in the COT reports to determine if the
commercial and noncommercial trading categories should be refined to
improve the accuracy and relevance of public information provided to
the energy futures markets;
* explore ways to routinely maintain written records of inquiries into
possible improper trading activity and the results of these inquiries
to more fully determine the usefulness and extent of CFTC's
surveillance, antifraud, and antimanipulation authorities; and:
* examine ways to more fully demonstrate the effectiveness of CFTC
enforcement activities by developing additional outcome-related
performance measures that more fully reflect progress in meeting the
program's overall goals.
Agency Comments:
We provided a draft of this report to the Commodity Futures Trading
Commission for comment. In its written comments, CFTC said that the
commission will reexamine classifications in the COT reports. CFTC also
said that the commission will explore additional recordkeeping
procedures for its staff, but that it must balance the time required
for such additional tasks against the need to undertake market
surveillance by an already-stretched surveillance staff. CFTC added
that it has included the development of measures to evaluate the
effectiveness of its enforcement program in its most recent strategic
plan. The commission's comments are reprinted in appendix V. CFTC staff
provided technical comments and corrections that we have incorporated
in this report where appropriate.
We will provide copies of this report to interested congressional
committees. We are also sending a copy of this report to the Acting
Chairman of the Commodity Futures Trading Commission, the Secretary of
the Department of Energy, the Chairman of the Federal Energy Regulatory
Commission, the Chairman of the Federal Trade Commission, the Acting
U.S. Attorney General, and the Chairman of the Securities and Exchange
Commission. We will make copies