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United States Government Accountability Office:


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

For Release on Delivery: 
Expected at 1:30 p.m. EDT: 
Wednesday, October 24, 2007:  

Commodity Futures Trading Commission: 

Trends in Energy Derivatives Markets Raise Questions about CFTC's 

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


Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss our recent report on the 
trading of derivatives for energy commodities, including crude oil and 
natural gas, and the Commodity Futures Trading Commission's (CFTC) 
oversight of these markets.[Footnote 1] The expansion of derivatives 
trading in energy markets, particularly by participants such as hedge 
funds, and rapid growth in trading off regulated exchanges have raised 
questions about the quality and quantity of reporting on and oversight 
of these trading activities.[Footnote 2] 

Specifically, I will discuss (1) trends in the physical and energy 
derivatives markets and their effect on energy prices, (2) the scope of 
CFTC's authority for protecting market users in the trading of energy 
derivatives, and (3) CFTC's monitoring and detection of market abuses 
in energy futures markets. I should point out that our review was 
intended to identify trends in both the physical and derivatives energy 
markets and to provide information on the current regulatory structure 
for energy derivatives trading, including analyzing the various 
perspectives of market participants on these issues. While our report 
frames issues that need to be addressed, we do not offer specific 
policy solutions. 

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


Physical and derivatives markets for crude oil, unleaded gasoline, 
heating oil, and natural gas have experienced substantial changes in 
recent years. Within the physical market, tight supply and rising 
global demand, ongoing political instability in oil-producing regions, 
limited refining capacity, and other supply disruptions all contributed 
to higher prices. While these changes were occurring in the physical 
markets, in the derivatives markets volatility of energy prices 
generally remained above historic averages for most of the period but 
declined during 2006 to levels at or near the historical average. 
Moreover, trading volumes for futures increased, at least in part 
because a growing number of managed-money traders (including hedge 
funds) began to see energy futures as attractive investment 
alternatives. Another change occurring during this time was the 
increased trading of energy derivatives outside the organized 
exchanges. Trading in these markets--specifically electronic 
commercial markets and over-the-counter (OTC) markets--is much less 
transparent than trading on futures exchanges, and comprehensive data 
are not available because these energy markets are not regulated. Given 
that the developments in the physical and derivatives markets were 
occurring simultaneously, determining their effect on energy prices is 
difficult. Continued monitoring of the various factors that affect 
market prices, and how those factors are changing, will be important in 
protecting the public and ensuring market integrity. 

Energy derivatives are traded on futures exchanges and off-exchange in 
exempt commercial and OTC markets.[Footnote 3] Exempt commercial 
markets are electronic trading facilities that trade exempt 
commodities, including energy commodities, on a principal-to-principal 
basis solely between commercial entities meeting certain eligibility 
requirements. In the OTC markets, parties meeting certain requirements 
can enter into bilateral energy derivatives transactions. Unlike the 
futures exchanges, which are subject to comprehensive oversight by 
CFTC, exempt commercial markets and OTC markets are not subject to 
general CFTC oversight, although CFTC can enforce the CEA's 
antimanipulation provisions and, where applicable, the antifraud 
provisions. To provide transparency about trading on the futures 
exchanges, CFTC routinely publicly reports aggregate information on 
trading by large commercial (such as oil companies, refineries, and 
other hedge traders) and noncommercial (such as hedge funds) 
participants that occurs on the exchanges. However, in the way the data 
are currently categorized, no distinction is made between commercial 
traders who use the exchanges to hedge their positions in the physical 
markets and those commercial traders, such as investment banks, who 
trade futures to hedge their trading in off-exchange derivatives. Given 
the developments and growth in the energy trading markets, questions 
have been raised over whether CFTC needs broader authority over the 
off-exchange derivative markets, particularly those involving exempt 
commodities and exempt commercial markets. 

At an operational level, we also reported that while CFTC conducts 
reporting, surveillance, and enforcement activities in the energy 
markets to help provide transparency to the public, detect fraudulent 
or manipulative trading practices, and deter abuses, the effectiveness 
of these efforts is unclear. For example: 

* Although CFTC monitors exchange trading activity through its 
surveillance program and gathers additional information from NYMEX 
officials, traders, or other sources to determine if further action is 
warranted, staff did not routinely document the results of these 
inquiries. Instead, they kept formal records of their findings only in 
cases in which improper trading was identified. As a result, CFTC may 
be limiting its opportunities to identify trends and its ability to 
measure the extent and usefulness of its monitoring activities. 

* We also found that CFTC has successfully pursued energy-related 
cases, but we were not able to determine how effectively CFTC's 
enforcement activities were in identifying violations and deterring 
misconduct because the agency lacked meaningful outcome-based measures. 

Our report includes a matter for congressional consideration and three 
recommendations to CFTC. In light of recent developments and the 
uncertainty over the adequacy of CFTC's oversight, we recommend that 
Congress, as part of the CFTC reauthorization process, further explore 
whether the current regulatory structure for energy derivatives, in 
particular for those traded in exempt commercial markets, adequately 
provides for fair trading and accurate pricing of energy commodities. 
To improve the transparency of market activities and the functioning of 
CFTC's oversight, we recommend that CFTC reconsider how information it 
publishes in trading reports for energy products could be improved and 
CFTC has agreed to reexamine the classifications used in these reports. 
CFTC also agreed with our recommendations aimed at better documenting 
its surveillance activities and developing more outcome-based 
performance measures and has taken steps to implement them. 


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

In addition to the spot markets, derivatives based on energy 
commodities are traded in financial markets. The value of the 
derivative contract depends on the performance of the underlying asset-
-for example, crude oil or natural gas. Derivatives include futures, 
options, and swaps. Energy futures include standardized exchange-traded 
contracts for future delivery of a specific crude oil, heating oil, 
natural gas, or gasoline product at a particular spot market location. 
An exchange designated by CFTC as a contract market standardizes the 
contracts. The owner of an energy futures contract is obligated to buy 
or sell the commodity at a specified price and future date. However, 
the contractual obligation may be removed at any time before the 
contract expiration date if the owner sells or purchases other 
contracts with terms that offset the original contract. In practice, 
most futures contracts on NYMEX are liquidated via offset, so that 
physical delivery of the underlying commodity is relatively rare. 

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

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

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

Several Factors Have Caused Changes in the Energy Markets, Potentially 
Affecting Energy Prices: 

The physical markets for energy commodities underwent change and 
turmoil from 2002 through 2006, which affected prices in the spot and 
futures markets. We reported that numerous changes in both the physical 
and futures markets may have affected energy prices. However, because 
these changes occurred simultaneously, identifying the specific effect 
of any one of these changes on energy prices is difficult. 

Various Changes in the Physical Market Contributed to Rising Prices: 

The physical energy markets have undergone substantial change and 
turmoil during this period, which can affect spot and futures markets. 
Like many others, we found that a number of fundamental supply and 
demand conditions can affect prices. According to the Energy 
Information Administration (EIA), world oil demand has grown since 1983 
from a low of about 59 million barrels per day in 1983 to more than 85 
million barrels per day in 2006 (fig. 1). While the United States 
accounts for about a quarter of this demand, rapid economic growth in 
Asia also has stimulated a strong demand for energy commodities. For 
example, EIA data show that during this time frame, China's average 
daily demand for crude oil increased almost fourfold. 

Figure 1: Increase in World Demand for Crude Oil (Actual and 
Estimated), 1980-2006: 

[See PDF for image] 

This figure is a line graph with a single line that depicts the 
increase in world demand for crude oil (actual and 
estimated), 1980-2006. The vertical axis of the graph represents 
barrels per day (in millions) from 0 to 90. The horizontal axis of the 
graph represents year from 1980 to 2006.  

Source: GAO analysis of EIA data.  

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

[End of figure] 

The growth in demand does not, by itself, lead to higher prices for 
crude oil or any other energy commodity. For example, if the growth in 
demand were exceeded by a growth in supply, prices would fall, other 
things remaining constant. However, according to EIA, the growth in 
demand outpaced the growth in supply, even with spare production 
capacity included in supply. Spare production capacity is surplus oil 
that can be produced and brought to the market relatively quickly to 
rebalance the market if there is a supply disruption anywhere in the 
world oil market. As shown in figure 2, EIA estimates that global spare 
production capacity in 2006 was about 1.3 million barrels per day, 
compared with spare capability of about 10 million barrels per day in 
the mid-1980s and about 5.6 million barrels a day as recently as 2002. 

Figure 2: Estimates of World Oil Spare Production Capacity, 1991-2008: 

[See PDF for image] 

This figure is a vertical bar graph depicting estimates of world oil 
spare production capacity, 1991-2008. The vertical axis of the graph 
represents barrels per day (in millions) from 0 to 6. The horizontal 
axis represents years from 1991 to 2008. The data for each year is 
depicted approximately as follows: 

1991-1997: 2.4; 
1998: 3.2; 
1999: 5.0; 
2000: 3.0; 
2001: 4.0; 
2002: 5.6; 
2003: 1.5; 
2004: 1.2; 
2005: 0.9; 
2006: 1.2; 
2007: 1.8;
2008: 1.9. 

Source: GAO analysis of EIA data. 

[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 

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

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

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

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

Another consideration is that the value of the U.S. dollar on open 
currency markets could affect crude oil prices. For example, because 
crude oil is typically denominated in U.S. dollars, the payments that 
oil-producing countries receive for their oil 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 in order to maintain the purchasing 
power in the face of a weakening U.S. dollar to the extent they can. 

The Effect on Prices of Relatively High but Falling Volatility and a 
Growing Volume of Trading in Derivatives Is Unclear: 

As you can see, conditions in the physical markets have undergone 
changes that can help explain at least some of the increases in both 
physical and derivatives commodity prices. As we have previously 
reported, futures prices typically reflect the effects of world events 
on the price of the underlying commodity such as crude oil.[Footnote 5] 
For example, political instability and terrorist acts in countries that 
supply oil create uncertainties about future supplies, which are 
reflected in futures prices. Conversely, news about a new oil discovery 
that would increase world oil supply could result in lower futures 
prices. In other words, changes in the physical markets influence 
futures prices. 

At the same time that physical markets were undergoing changes, we 
found that financial markets also were amidst change and evolution. For 
example, the annual historical volatilities between 2000 and 2006--
measured using the relative change in daily prices of energy futures--
generally were above or near their long-term averages, although crude 
oil and heating oil declined below the average and gasoline declined 
slightly at the end of that period. We also found that the annual 
volatility of natural gas fluctuated more widely than that of the other 
three commodities and increased in 2006 even though prices largely 
declined from the levels reached in 2005. Although higher volatility is 
often equated with higher prices, this pattern illustrates that an 
increase in volatility does not necessarily mean that price levels will 
increase. In other words, price volatility measures the variability of 
prices rather than the direction of the price changes. 

Elsewhere in the futures market, we found an increase in the number of 
noncommercial traders such as managed money traders.[Footnote 6] 
Attracted in part by the trends in prices and volatility, a growing 
number of traders sought opportunities to hedge against those changes 
or profit from them. Using CFTC's large trader data, we found that from 
July 2003 to December 2006, crude oil futures and options contracts 
experienced the most dramatic increase, with the average number of 
noncommercial traders more than doubling from about 125 to about 286. 
As shown in figure 3, while the growth was less dramatic in the other 
commodities, the average number of noncommercial traders also showed an 
upward trend for unleaded gasoline, heating oil, and natural gas. 

Figure 3: Average Daily Number of Large Commercial and Noncommercial 
Traders per Month, July 2003-December 2006: 

[See PDF for image]  

This figure is four separate line graphs, each with two lines, 
depicting noncommercial traders and commercial traders.  

The first graph is for Crude Oil. The vertical axis of the graph 
represents traders from 0 to 300. The horizontal axis represents years 
from 2003 (July through December) through 2006.  

The second graph is for Natural Gas. The vertical axis of the graph 
represents traders from 0 to 300. The horizontal axis represents years 
from 2003 (July through December) through 2006.  

The third graph is for Unleaded gasoline. The vertical axis of the 
graph represents traders from 0 to 150. The horizontal axis represents 
years from 2003 (July through December) through 2006.  

The fourth graph is for Heating Oil. The vertical axis of the graph 
represents traders from 0 to 150. The horizontal axis represents years 
from 2003 (July through December) through 2006.  

Source: GAO analysis of CFTC data.  

[End of figure] 

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

While much harder to quantify, another notable trend was the 
significant increase in the amount of energy derivatives traded outside 
exchanges. Trading in these markets is much less transparent, and 
comprehensive data are not available because these energy markets are 
not regulated. However, using the Bank for International Settlements 
data as a rough proxy for trends in the trading volume of OTC energy 
derivatives, the face value or notional amounts outstanding of OTC 
commodity derivatives excluding precious metals, such as gold, grew 
from December 2001 to December 2005 by more than 850 percent to over 
$3.2 trillion. [Footnote 7] 

Further, while some market observers believe that managed money traders 
were exerting upward pressure on prices by predominantly buying futures 
contracts, CFTC data we analyzed revealed that from the middle of 2003 
through the end of 2006, the trading activity of managed money 
participants became increasingly balanced between buying (those that 
expect prices to go up) and selling (those that expect prices to go 
down). Using CFTC large trader reporting data, we found that from July 
2003 through December 2006, managed money traders' ratio of buying 
(long) to selling (short) open interest positions was 2.5:1 indicating 
that on the whole, this category of participants was 2.5 times as 
likely to expect prices to rise as opposed to fall throughout that 
period, which they did. However, as figure 4 illustrates, 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. As 
you can see, managed money trading in unleaded gasoline, heating oil, 
and natural gas showed similar trends. 

Figure 4: Percentage of Long and Short Open Interest in Futures and 
Options for Managed Money Traders, July 2003-December 2006: 

[See PDF for image] 

This figure is a series of vertical bars graphs depicting the following 

Crude Oil: Year 2003: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 5.0%;
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 12.6%. 
Ratio: 2.5:1. 

Crude Oil: Year 2004: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 7.1%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 14.5%; 
Ratio: 2.0:1.  

Crude Oil: Year 2005: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 11.7%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 15.1%; 
Ratio: 1.3:1.  

Crude Oil: Year 2006: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 14.7%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 17.6%; 
Ratio: 1.2:1.  

Unleaded gasoline: Year 2003: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 4.2%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 27.6%; 
Ratio: 6.6:1.  

Unleaded gasoline: Year 2004: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 6.9%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 20.2%; 
Ratio: 2.9:1.  

Unleaded gasoline: Year 2005: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 8.7%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 20.2%; 
Ratio: 2.3:1. 

Unleaded gasoline: Year 2006: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: HU: 9.0%; 
Managed money traders: HU: Long-term interest - meaning positions to 
buy the underlying commodity: 15.3%; 
Ratio: 1.7:1.  

Unleaded gasoline: Year 2006: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: RB: 4.5%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: RB: 15.1%; 
Ratio: 3.4:1.  

Heating Oil: Year 2003: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 6.5%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 13.9%; 
Ratio: 2.1:1.  

Heating Oil: Year 2004: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 9.6%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 18.9%; 
Ratio: 2.0:1.  

Heating Oil: Year 2005: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 15.0%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 18.0%; 
Ratio: 1.2:1.  

Heating Oil: Year 2006: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 17.1%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 17.6%; 
Ratio: 1.0:1.  

Natural Gas: Year 2003: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 15.8%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 9.6%; 
Ratio: 0.6:1.  

Natural Gas: Year 2004: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 21.3%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 19.7%; 
Ratio: 0.9:1.  

Natural Gas: Year 2005: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 33.5%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 31.0%; 
Ratio: 0.9:1.  

Natural Gas: Year 2006: 
Managed money traders: Short-term interest - meaning positions to sell 
the underlying commodity: 41.2%; 
Managed money traders: Long-term interest - meaning positions to buy 
the underlying commodity: 41.1%; 
Ratio: 1.0:1.  

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 three 
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 NYMEX reformulated gasoline blendstock (RB) and for the NYMEX 
gasoline contract (HU) that began to replace RB. 

[End of figure] 

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

CFTC Oversees Exchanges and Has Limited Authority over Other 
Derivatives Markets: 

Under 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. Off exchange 
markets, which are available only to eligible traders of certain 
commodities under specified conditions, are not regulated, although 
CFTC may enforce antimanipulation and antifraud provisions of the CEA 
with respect to trading in those markets. The growth in trading off 
exchange has raised questions about the sufficiency of CFTC's limited 
authority over these markets. These changes and innovations also have 
brought into question the methods CFTC uses to categorize published 
data about futures trading by participants in the off exchange markets 
and whether information about their activities in off exchange markets 
would be useful to the public. CFTC is taking steps to better 
understand these issues. Most importantly, it is currently examining 
the relationship between trading in the regulated and exempt energy 
markets and the role this trading plays in the price discovery process. 
It is also examining the sufficiency of the scope of its authority over 
these markets--an issue that will warrant further examination as part 
of the CFTC reauthorization process. 

CFTC Has General Oversight Authority over Futures Exchanges, but 
Information on These Exchanges Reported to the Public Has Not Kept Pace 
With Changing Market Conditions: 

To help provide transparency in the markets, 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 Commitment of Traders (COT) reports.[Footnote 8] As we reported, 
CFTC observed that the exchange-traded derivatives markets, as well as 
trading patterns and practices, have evolved. In 2006, CFTC initiated 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 9] A disconnect between the 
classifications and evolving trading activity could distort the 
accuracy and relevance of reported information to users and the public, 
thereby limiting its usefulness for both. 

In December 2006, CFTC announced a 2-year pilot program for publishing 
a supplemental COT report that includes positions of commodity index 
traders in a separate category. However, the pilot does not include any 
energy commodities. Although commodity index traders are active in 
energy markets, according to CFTC officials, currently available data 
would not permit an accurate breakout of index trading in these 
markets. For example, some traders, such as commodity index pools, use 
the futures markets to hedge commodity index positions they hold in the 
OTC market. However, these traders also may have positions in the 
physical markets, which means the reports that CTFC receives on market 
activities, which do not include such off-exchange transactions, may 
not present an accurate picture of all positions in the market place 
for the commodity. In response to our recommendation to reexamine the 
COT classifications for energy markets, CFTC agreed to explore whether 
the classifications should be refined to improve their accuracy and 

CFTC Authority over Exempt Commercial Markets and OTC Markets Is 
Limited, and Views Vary about the Sufficiency of Its Regulatory 
Authority with Respect to Off-Exchange Energy Derivatives: 

Now let me address some of the larger policy issues associated with 
CFTC's oversight of these markets. Under 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. 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 agency may receive limited 
information, such as trading records, from OTC participants to help 
CFTC enforce the CEA's antifraud or antimanipulation provisions. The 
scope of CFTC's oversight authority 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 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. Supporters of more CFTC 
oversight authority believe that regulation of OTC derivatives markets 
is necessary to protect the regulated markets and consumers from 
potential abuse and possible manipulation. One of their concerns is 
that, due to the lack of complete information on 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. 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 that does not serve a significant price discovery 
function.[Footnote 10] 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, the lack of reported data about this market makes addressing 
concerns about its function and effect on regulated markets and 
entities challenging. 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 other disruptions to the 
integrity of the regulated futures markets.[Footnote 11] According to 
CFTC officials, the commission 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, enhancing 
CFTC's ability to enforce antifraud provisions of the CEA.[Footnote 12] 

Also, in September 2007, CFTC conducted a hearing to begin examining 
trading on regulated exchanges and exempt commercial markets more 
closely. The hearing focused on a number of issues, including: 

* the current tiered regulatory approach established by the Commodity 
Futures Modernization Act, which amended the CEA, 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. 

Given ongoing questions about the similarity of products traded on the 
markets and how and whether exempt markets play a role in the price 
discovery process and whether existing reporting requirements are 
sufficient, we recommend that Congress take up this issue during the 
CFTC reauthorization process to begin to answer some of these questions 
and the implications for the current regulatory structure in light of 
the changes that have occurred in this market. 

CFTC Engages in Large Trader Reporting, Surveillance, and Enforcement 
Activities, but the Effectiveness of the Activities Is Largely 

CFTC provides oversight for commodity futures markets by analyzing 
large trader reporting data, conducting routine surveillance, and 
investigating and taking enforcement actions against 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 large trader reporting 
system (LTRS) provides essential information on the majority of all 
trading activity on futures exchanges. CFTC staff said they routinely 
investigate traders with large open positions, but do not routinely 
maintain information about such inquiries, thereby making it difficult 
to determine the usefulness and extent of these activities. According 
to recent data provided by CFTC, about 10 percent of the enforcement 
actions 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 it lacks effective outcome-based 
performance measures. 

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, focusing on detecting and 
preventing disruptive practices before they occur and keeping the CFTC 
commissioners informed of possible manipulation or abuse. According to 
CFTC staff, when a potential market problem has been identified, 
surveillance staff generally contact the exchange or traders for more 
information. To confirm positions and determine intent, staff may 
question exchange employees, brokers, or traders. 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. 

According to CFTC staff, they routinely make inquiries about traders 
with large open positions approaching expiration, but formal records of 
their findings are only kept in cases with evidence of improper 
trading. If LTRS data revealed that a trader had 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 ensure that the trader was able to take 
delivery. If the trader provided a reasonable explanation for the 
position and a reasonable delivery or liquidation strategy, staff said 
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. 
According to one CFTC official, no formal record would be made unless 
some signal indicated improper trading activity. However, without such 
data, CFTC's measures of the effectiveness of its actions to combat 
fraud and manipulation in the markets would not reflect all 
surveillance activity, and CFTC management might miss opportunities to 
identify trends in activities or markets and better target its limited 
resources. In response to our recommendation, CFTC agreed to improve 
its documentation of its surveillance activities. 

CFTC Energy-Related Enforcement Actions Generally Involved Allegations 
of False Reporting and Attempted Manipulation, but Its Program Received 
a Mixed Rating and Lacks Effective Outcome-Based Performance Measures: 

CFTC's Division of Enforcement is charged with enforcing the 
antimanipulation sections of the CEA.[Footnote 13] 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 
agency initiated 287 enforcement cases and more than 30 of these cases 
involved energy trading. In the past several months, CFTC has taken a 
series of actions involving energy commodities, including allegations 
of false reporting, attempted manipulation of NYMEX natural gas futures 
prices, and attempted manipulation of physical natural gas prices. 

Although CFTC has undertaken enforcement actions and levied fines, 
measuring the effectiveness of these activities is an ongoing 
challenge. For example, the Office of Management and Budget's most 
recent 2004 Program Assessment Rating Tool (PART) assessment of the 
CFTC enforcement program identified a number of limitations of CFTC's 
performance measures.[Footnote 14] As is the case with most enforcement 
programs, identifying outcome-oriented performance measures can be 
particularly challenging.[Footnote 15] However, as we point out in the 
report, 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 reflects differences in 
program structure and anticipated outcomes, and that the evaluations 
are designed around the programs and what they aim to achieve.[Footnote 
16] Without utilizing these or other methods to evaluate program 
effectiveness, CFTC is unable to demonstrate whether its enforcement 
program is meeting its overall objectives. CFTC has agreed that this is 
a matter that should be examined and has included development of 
measures to evaluate its effectiveness in its strategic plan and has 
requested funding to study the feasibility of developing more 
meaningful measures. 

In closing, I would like to reemphasize the difficulty in attributing 
increased energy prices to any one of the numerous changes in the 
physical or derivatives markets. As I have mentioned, our research 
shows that the physical and derivatives markets have both undergone 
substantial change and evolution, and market participant and regulatory 
views were mixed about the extent to which these developments exerted 
upward pressure on prices. Because of the importance of understanding 
the potential effects of such developments in these markets, ongoing 
review and analysis are warranted. As the scope of CFTC's authority is 
debated, additional information is needed to understand what may need 
to be done to best protect investors from fraudulent, manipulative, and 
abusive practices. Such information includes: 

* how different or similar are the characteristics and uses of exchange 
and off-exchange products being traded and do these continue to justify 
different regulatory treatment; 

* to what extent does trading in off-exchange financial derivatives 
affect price discovery and what are the regulatory and policy 

* how large of an effect are nontraditional market participants, such 
as commodity index funds, having in these markets; and: 

* are the changes in the energy markets unique or are such concerns 
also worth reviewing for other commodity markets. 

By answering questions such as these, CFTC and the Congress will be 
better positioned to determine what changes, if any, may be needed to 
oversee these markets. 

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

[End of section]  

GAO Contacts: 

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

Staff Acknowledgments: 

Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this statement. Individuals 
making key contributions include Cody Goebel (Assistant Director), John 
Forrester, Barbara Roesmann, and Paul Thompson. 

[End of section]  


[1] GAO, Commodity Futures Trading Commission: Trends in Energy 
Derivatives Markets Raise Questions about CFTC's Oversight, GAO-08-25 
(Washington, D.C.: Oct. 19, 2007). 

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

[3] Energy swap transactions also may be conducted off-exchange if they 
satisfy the requirements for excluded swap transactions contained in 
section 2(g) of the Commodity Exchange Act.  

[4] GAO, Motor Fuels: Understanding the Factors That Influence the 
Retail Price of Gasoline, GAO-05-525SP (Washington, D.C.: May 2005). 

[5] GAO-05-525SP. 

[6] CFTC collects data on traders holding positions at or above 
specific reporting levels set by the Commission. This information is 
collected as part of CFTC's large trader reporting system. 

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

[8] These reports include the number of traders, changes since the last 
report, and open positions. 

[9] 71 Fed. Reg. 35627, 35630-31 (June 21, 2006). 

[10] President's Working Group on Financial Markets, Over-the-Counter 
Derivatives Markets and the Commodity Exchange Act (Nov. 9, 1999). 
Members of group are the Chairman of CFTC, the Secretary of the 
Treasury, the Chairman of the Board of Governors of the Federal 
Reserve, and the Chairman of the Securities and Exchange Commission. 

[11] As stated by CFTC, the purpose of the proposed regulation is to 
make it explicit that persons holding or controlling reportable 
positions on a reporting market must retain books and records and make 
available to the commission upon request any pertinent information with 
respect to all other positions and transactions in the commodity in 
which the trader has a reportable position, including positions held or 
controlled or transactions executed over-the-counter or pursuant to 
sections 2(d), 2(g) or 2(h)(1)-(2) of the CEA or part 35 of the 
commission's regulations, on exempt commercial markets operating 
pursuant to sections 2(h)(3)-(5) of the CEA, on exempt boards of trade 
operating pursuant to Section 5d of the CEA, and on foreign boards of 
trade (hereinafter referred to collectively as non-reporting 
transactions); and to make the regulation clearer and more complete 
with respect to hedging activity. The purpose of the amendments is to 
clarify CFTC's regulatory reporting requirements for such traders. 72 
Fed. Reg. 34413. 

[12] Section 4b of the CEA is CFTC's main antifraud authority. In a 
November 2000 decision, the 7th Circuit Court of Appeals ruled that 
CFTC only could use section 4b in intermediated transactions--those 
involving a broker. Commodity Trend Service, Inc. v. CFTC, 233 F.3d 
981, 991-992 (7th Cir. 2000). As amended by the Commodity Futures 
Modernization Act of 2000, the CEA permits off-exchange futures and 
options transactions that are done on a principal-to-principal basis, 
such as energy transactions pursuant to CEA sections 2(h)(1) and 
2(h)(3). According to CFTC, House and Senate CFTC reauthorization bills 
introduced during the 109th Congress (H.R. 4473 and S. 1566) would have 
amended section 4b to clarify that Congress intends for CFTC to enforce 
section 4b in connection with off-exchange principal-to-principal 
futures transactions, including exempt commodity transactions in energy 
under section 2(h) as well as all transactions conducted on derivatives 
transaction execution facilities. 

[13] Section 9(a)(2) of the CEA prohibits "(a)ny person to manipulate 
or attempt to manipulate the price of any commodity in interstate 
commerce, or for future delivery on or subject to the rules of any 
registered entity, or to corner or attempt to corner any such commodity 
or knowingly to deliver or cause to be delivered for transmission 
through the mails or interstate commerce by telegraph, telephone, 
wireless, or other means of communication false or misleading or 
knowingly inaccurate reports concerning crop or market information or 
conditions that affect or tend to affect the price of any commodity 
interstate commerce..." 

[14] The assessment includes a 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. 

[15] GAO, Results Oriented Government: GPRA Has Established a Solid 
Foundation for Achieving Greater Results, GAO-04-594T (Washington, 
D.C.: Mar. 31, 2004). 

[16] GAO, Program Evaluation: OMB's PART Reviews Increased Agencies' 
Attention to Improving Evidence of Program Results, GAO-06-67 
(Washington, D.C.: Oct. 28, 2005).  

[End of section]  

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