The value of the derivative contract  depends on the performance of the underlying asset—for example, crude  oil or natural gas. 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. Multiple Factors in the Derivatives and Physical Markets Have Impacted Energy Prices

Both derivatives and physical markets experienced a substantial amount  of change from 2002 through 2006. These changes have been occurring  simultaneously, and the specific effect of any one of these changes on  energy prices is unclear. The Energy Futures Markets Experienced Rising Prices, High Volatility, Increased Trading Volume, and Growth in Some Types of Traders

Several recent trends in the futures markets have raised concerns among  some market observers that these conditions may have contributed to  higher physical energy prices. During this  period, monthly average spot prices for crude oil, gasoline, and heating oil  increased by over 200 percent, and natural gas spot prices increased by  over 140 percent. At the same time, the annual historical volatilities—measured using  the relative change in daily prices of energy futures—between 2000 and  2006 generally were above or near their long-term averages, although  crude oil and heating oil declined below the average and gasoline declined  slightly at the end of that period. Despite the lack  of comprehensive energy-specific data on OTC derivatives, the recent  experience of individual trading facilities further reveals the growth of  energy derivatives trading outside of futures exchanges. 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. 2). As  we have reported, refining capacity in the United States has not expanded  at the same pace as the demand for gasoline. Some observers believe that higher energy prices were solely the  result of supply and demand fundamentals, while others believe that  increased futures trading activity contributed to higher prices. The relative effect of each of these changes remains  unclear, however, because all of the changes were occurring  simultaneously. Monitoring these trends and patterns in the future will be  important in order to better understand their effects, protect the public,  and ensure market integrity. CFTC Oversees Exchanges and Has Some Authority over Other Derivatives Markets

Energy products are traded on multiple markets, some of which are  subject to varying levels of CFTC oversight and some of which are not. This difference in oversight has caused some market observers to question  whether CFTC needs broader oversight authority. But in  recent years two additional venues for trading energy futures contracts  that are not subject to direct CFTC oversight have grown and become  increasingly important—exempt commercial markets and OTC markets. However, traders in these markets are subject to the CEA’s  antimanipulation and antifraud provisions, which CFTC has the authority  to enforce. Also, exempt commercial markets must provide CFTC with  data for certain contracts. CFTC conducts regular market surveillance and oversight of energy  trading on NYMEX and other futures exchanges. CFTC officials have said that while they  have reason to believe these off-exchange activities can affect prices  determined on a regulated exchange, they also generally believe that the  commission has sufficient authority over OTC derivatives and exempt  energy markets. However, CFTC has recently begun to take steps to clarify  its authority to obtain information about pertinent off-exchange  transactions. CFTC generally believes  that the commission has sufficient authority over OTC derivatives and  exempt energy markets.
Why GAO Did This Study

Energy prices for crude oil, heating oil, unleaded gasoline, and natural gas have risen substantially since 2002, generating questions about the reasons for the increase. Some observers believe that the higher energy prices were solely due to supply and demand fundamentals while others believe that increased futures trading activity may also have contributed to higher prices. This testimony highlights GAO's preliminary findings related to (1) trends and patterns in the futures and physical energy markets and the effect of these trends on energy prices and (2) the Commodity Futures Trading Commission's (CFTC) regulatory and enforcement authority over derivatives markets. GAO analyzed futures and large trader reporting data; trading data obtained from the New York Mercantile Exchange (NYMEX) for crude oil, heating oil, unleaded gasoline, and natural gas; and various other sources of energy-related data. GAO also analyzed relevant academic and other studies on the subject and interviewed market participants, experts, and officials at relevant federal agencies.

What GAO Found

Rising energy prices have been attributed to a variety of factors, and recent trends in the futures and physical markets highlight the changes that have occurred in both markets from 2002 through 2006. Specifically: (1) inflation-adjusted energy prices in both the futures and physical markets increased by over 200 percent during this period for three of the four commodities we reviewed; (2) volatility (a measurement of the degree to which prices fluctuate over time) in energy futures prices generally remained above historic averages during the beginning of the time period but declined through 2006 for three of the four commodities we reviewed; and (3) the number of noncommercial participants in the futures markets including hedge funds, has grown; along with the volume of energy futures contracts traded; and the volume of energy derivatives traded outside traditional futures exchanges. At the same time these changes were occurring in the futures markets for energy commodities, tight supply and rising demand in the physical markets pushed prices higher. For example, while global demand for oil has risen at high rates, spare oil production capacity has fallen since 2002, and increased political instability in some of the major oil-producing countries has threatened the supply of oil. Refining capacity also has not expanded at the same pace as the demand for gasoline. The individual effect of these collective changes on energy prices is unclear, as many factors have combined to affect energy prices. Monitoring these changes will be important to protect the public and ensure market integrity. Based on its authority under the Commodity Exchange Act (CEA), CFTC primarily focuses its oversight on the operations of traditional futures exchanges, such as NYMEX, where energy futures are traded. However, energy derivatives are also traded on other markets, namely exempt commercial markets and over-the-counter (OTC) markets--both of which have experienced increased volumes in recent years. Exempt commercial markets are electronic trading facilities that trade exempt commodities between eligible participants, and OTC markets involve eligible parties that can enter into contracts directly off-exchange. Both of these markets are exempt from general CFTC oversight, but they are subject to the CEA's antimanipulation and antifraud provisions and CFTC enforcement of those provisions. Because of these varying levels of CFTC oversight, some market observers question whether CFTC needs broader authority over all derivative markets. CFTC generally believes that the commission has sufficient authority over OTC derivatives and exempt energy markets. However, CFTC has recently taken additional actions to clarify its authority to obtain information about pertinent off-exchange transactions.