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. For price discovery, markets need current  information about supply and demand, a large number of participants, and  transparency. 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.” 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. 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. 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. Moreover, these parties have observed that the lack of  spare capacity in certain areas, such as production, transportation, and  storage, can affect prices. The effects of these changes  on energy prices are not clear. 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. However, unleaded gasoline and heating oil  experienced less dramatic growth in their trading volumes during this  period. 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. 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. Also,  exempt commercial market participants are subject to CFTC’s  enforcement authority for the antimanipulation and antifraud provisions  of the CEA. CFTC staff also analyze trading using data from other sources. OMB further stated  that the outcome-related measures established for enforcement do not  fully reflect progress on meeting the program’s overall goals. Conclusions

The rise in energy prices can be and has been attributed to a variety of  factors. Other markets  are largely unregulated. Unless resolved, questions will continue about the  scope of CFTC’s authority. However, CFTC does not maintain complete  records of its surveillance activities. 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. Appendix I: Scope and Methodology

To examine trends and patterns of trading activity in the energy  derivatives markets and physical markets, we analyzed data on futures,  spot, and over-the-counter (OTC) derivative markets. To examine how CFTC monitors and detects market abuses in the trading  of energy futures, and enforcement actions taken in response to identified  abuses, we gathered information from officials at CFTC headquarters and  the New York Regional Office. NYMEX officials stated  that trade practice surveillance information may be used as part of market  surveillance, but this surveillance is not as focused on price movements  and involves different types of monitoring, such as physically observing  floor trading by people entering orders, and, in effect, is similar to “police  on the beat.” The officials added that with their recent use of the Chicago  Mercantile Exchange’s Globex electronic trading system to trade energy  futures, their trade practice surveillance system is changing, with more  emphasis on monitoring access to, and activity on, the Globex system in  NYMEX contracts. The Commodity Exchange Act: Issues Related to the Commodity Futures  Trading Commission’s Reauthorization.
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.