Exempt commercial markets  and OTC derivatives are also used to hedge this risk. 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. 1). 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. For example,  political instability and terrorist acts in countries that supply oil create  uncertainties about future supplies, which are reflected in futures prices. 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. 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. 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. 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. 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. 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. 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. 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 Uncertain

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. 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. 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 implications;   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.
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 role derivatives markets have played and the scope of the Commodity Futures Trading Commission's (CFTC) authority. This testimony focuses on (1) trends and patterns in the futures and physical energy markets and their effects on energy prices, (2) the scope of CFTC's regulatory authority, and (3) the effectiveness of CFTC's monitoring and detection of abuses in energy markets. The testimony is based on the GAO report, Commodity Futures Trading Commission: Trends in Energy Derivatives Markets Raise Questions about CFTC's Oversight ( GAO-08-25 , October 19, 2007). For this work, GAO analyzed futures and large trader data and interviewed market participants, experts, and officials at six federal agencies.

What GAO Found

Various trends in both the physical and futures markets have affected energy prices. Specifically, tight supply and rising demand in the physical markets contributed to higher prices as global demand for oil has risen rapidly while spare production capacity has fallen since 2002. Moreover, increased political instability in some of the major oil-producing countries has threatened the supply of oil. During this period, increasing numbers of noncommercial participants became active in the futures markets (including hedge funds) and the volume of energy futures contracts traded also increased. Simultaneously, the volume of energy derivatives traded outside of traditional futures exchanges increased significantly. Because these developments took place concurrently, the effect of any individual trend or factor on energy prices is unclear. Under the authority granted by 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. Increasing amounts of energy derivatives trading also occur on markets that are largely exempt from CFTC oversight. For example, exempt commercial markets conduct trading on electronic facilities between large, sophisticated participants. In addition, considerable trading occurs in over-the-counter (OTC) markets in which eligible parties enter into contracts directly, without using an exchange. While CFTC can act to enforce the CEA's antimanipulation and antifraud provisions for activities that occur in exempt commercial and OTC markets, some market observers question whether CFTC needs broader authority to more routinely 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. 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, determining the usefulness and extent of these activities is difficult. In addition, CFTC's performance measures for its enforcement program 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. Because of changes and innovations in the market, the reports that CFTC receives on market activities may no longer be accurate because they use categories that do not adequately separate trading being done for different reasons by various market participants.