**Testimony of**

**Dr. James Newsome, President and CEO**

**New York Mercantile Exchange, Inc.**

**Before the Subcommittee on General Farm Commodities and Risk
Management**

**United States House of Representatives**

**May 15, 2008**

Mr. Chairman and members of the Committee, my name is Jim Newsome and I
am the President and Chief Executive Officer of the New York Mercantile
Exchange, Inc. (NYMEX or Exchange). NYMEX is the world's largest forum
for trading and clearing physical-commodity based futures contracts,
including energy and metals products, and has been in the business for
more than 135 years. NYMEX is a federally chartered marketplace, fully
regulated by the Commodity Futures Trading Commission (CFTC) both as a
"derivatives clearing organization" (DCO) and as a "designated contract
market" (DCM). On behalf of the Exchange, its Board of Directors and
shareholders, I want to express our appreciation to the Committee for
holding today\'s hearing on recent trading activity in various commodity
futures markets. In particular, the Committee is seeking to review the
extent to which this activity is generated by market fundamentals or by
increased participation by index funds and other institutional
investors.

Over the last several years, NYMEX has worked closely with Congressional
leaders providing information and other assistance on legislative
initiatives that would add greater transparency to unregulated
derivatives venues. We believe that these measures reflect a consensus
regarding the need for greater transparency and oversight for certain
specified products now trading in unregulated over-the-counter
electronic trading markets. We look forward to this legislation becoming
law in the near future.

We also hope that Congress does not misinterpret the lessons of the
recent past by moving to impose new arbitrary and onerous burdens on
futures exchanges, which are the most highly regulated and transparent
segment of U.S. derivatives markets. Such steps would shift trading from
regulated and transparent markets to unregulated and nontransparent
markets and, thus, would constitute a significant step backward in
transparency and market integrity. .

**[OVERVIEW]{.underline}**

Prices in our markets are determined by fundamental market forces.
However, uncertainty about the availability of supply due to political
and security factors, uncertainty about the actual levels of continuing
growth of demand in developing parts of the world, and uncertainty about
currency fluctuations also materially weigh into the fundamental
analysis. NYMEX provides and vigorously monitors a highly regulated and
transparent marketplace. The available data indicate that commercials
continue to provide the majority of open interest in crude oil futures.
Moreover, the extent of non-commercial participation in crude oil has
actually declined over the last year. There is no evidence to date
either that the trading by non-commercials has impaired the price
discovery function of our markets or that raising margins would have an
impact on lowering prices.

**[MARKET ANALYSIS]{.underline}**

NYMEX staff monitors the supply and demand fundamentals in the
underlying cash market to ensure that NYMEX futures prices generally are
consistent with ongoing, cash market price movements and that there are
no price distortions. In a highly transparent, regulated and competitive
market, prices are affected primarily by fundamental market forces.
Currently, uncertainty in the global crude market regarding geopolitical
issues, refinery shutdowns and increasing global usage, as well as
devaluation of the U.S. dollar, are clearly having an impact on the
assessment of market fundamentals. One may view such factors as
contributing an uncertainty or risk premium to the usual analysis of
supply and demand data. Indeed, such factors now may fairly be viewed as
part of the new fundamentals of these commodities.

Before turning to analysis of specific market factors, we note an
article that appeared late last week in the Wall Street Journal (WSJ).
The WSJ conducted a survey from May 2-6, 2008 of 53 economists.
According to that survey, the majority of economists have concluded that
"the global surge in food and energy prices is being driven primarily by
fundamental market conditions, rather than an investment bubble."
"Bubble is not Big Factor in Inflation," May 9, 2008, page A-2.
.Fifty-one percent of those respondents said that demand from India and
China was the prime factor in soaring energy prices, and 41% said that
demand was the chief contributor to rising food costs. Constraint in
supply was cited second most often; 20% blamed supply problems for
higher food prices, and 15% for increasing energy prices. One economist
noted that it was a combination of demand and supply issues.

The demand and supply fundamentals in the oil markets continue to be the
driving factors in high oil prices. In the latest Energy Information
Administration (EIA) *Short-Term Energy Outlook*, published on May 6,
2008, the demand and supply situation is summarized as follows:

> "The oil supply system continues to operate at near capacity and
> remains vulnerable to both actual and perceived supply disruptions.
>  The supply and demand balance for the remainder of the year is
> tighter than in last month's Outlook.  World oil markets are
> particularly tight during the first half of 2008, with year-over-year
> growth in world oil consumption outstripping growth in
> non-Organization of the Petroleum Exporting Countries (OPEC)
> production by over 1 million barrels per day.   The combination of
> rising global demand, fairly normal seasonal inventory patterns, slow
> gains in non-OPEC supply, and low levels of available surplus
> production capacity is providing firm support for prices."

I wish to highlight this finding: growth in consumption has outstripped
growth in non-OPEC production by over 1 million barrels per day. That is
substantially tighter than a snug fit. Indeed, that may be said to be
more akin to a choke hold. Conventional wisdom, borne out by substantial
experience from overeseas as well as here in North America, is that the
short-run worldwide demand for petroleum products such as gasoline\--
especially retail demand\-- is highly inelastic: consumption does not
decrease by much in the face of significant price rises. With projected
demand exceeding supply by 1 million barrels per day, the only way a
market with highly inelastic demand will equilibrate is through a
substantive rise in price. The upward pressure has been there and,
according to these projections, will continue to be there.

**[DEMAND]{.underline}**

At NYMEX, we understand the difficulty of assembling accurate and timely
information on non-OECD petroleum consumption and the corresponding
challenge in projecting non-OECD consumption. However, the latest EIA
*Short-Term Energy Outlook* projections provide important insight into
the current state of global demand.  EIA projects that world oil demand
will grow by 1.2 million barrels per day in 2008, up a healthy 1.4%,
with China accounting for 35% of this demand growth. The EIA predicts
China's oil consumption will rise by 0.4 million barrels per day in
2008, up 5.6% from its record-high levels achieved in 2007. Almost all
of the oil growth in 2008 is projected to come from the non-OECD
countries, led by China, India, Middle Eastern countries, and Russia.
U.S. oil demand is actually projected to decline slightly by 0.9% in
2008.

As a practical consideration, the most accurate data on energy
consumption applies to the U.S., followed by the OECD. However, the
strongest source of projected energy demand is from the far-less visible
reaches of developing countries such as China, India and the Middle
East. While we respect EIA's efforts to project these numbers, we would
caution anyone on oversimplifying the challenge of even accurately
assessing the demand in these countries, much less projecting it. The
only thing we can be certain of is the relentless increase in petroleum
demand pushed each year by the millions of people making the transition
from less-developed circumstances to the beginnings of middle-class
circumstances. Currently, China is putting more than eight million new
cars on the road each year. Does anyone doubt that the average driver is
increasing his/her amount of driving each year? India, the Middle East
and Russia are experiencing similar transitions. We believe the sheer
uncertainty around consumption in these economies, in combination with
the extremely tight world market conditions, is a strong influence on
price volatility in the world oil market. In concert with the tight
market conditions and inelastic demand for petroleum products we
highlighted above, that volatility is oscillating around ever increasing
prices.

It is key to realize that the market tightness and the market's struggle
to discern actual demand in growing and developing economies are both
fundamental influences in the world oil market. The most visible signs
of these conditions are the transparent market mechanisms that reside in
the world today, such as NYMEX's futures and options markets, where
prices are discovered and risk is managed. These mechanisms operate
immediately. Compare that to fundamental market information, such as the
consumption data referred to above. Consumption data, even for the most
advanced economies that have been collecting these data and refining the
process for collecting these data for decades (by the International
Energy Agency), are provided on a preliminary basis six weeks after the
fact. The data are then further refined four weeks later and again four
weeks after that; all of this for a monthly statistic, which at the time
of the final revision is 14 weeks after the month.

When you add onto that process the fact that the most dynamic component
of consumption emanates not from those economies but from others where
data collection is materially less advanced and the quality of the data
much less certain, then the importance of immediate price discovery and
transparency becomes even more evident. In a tightly supplied market
where demand is highly inelastic, the only check on rising prices is
competition and the price transparency and market liquidity that provide
the support for it. Anything that reduces price transparency and
liquidity under these market conditions will result in shifting price
discovery to the collection of uncoordinated, opaque and, at times,
esoteric mechanisms that comprise the cash market that provides limited
transparency; a market not informed by the immediate discovery of value
but by the relatively untimely release of fundamental information that
is of uncertain quality and that provides limited transparency.

**[SUPPLY]{.underline}**

On the supply side, global production of crude oil was relatively flat
in 2007, despite rising demand and rising prices. It is important to
note that this rising demand did not provoke a significant supply
response. The EIA *Short-Term Energy Outlook* points to the slow growth
in non-OPEC oil supplies, along with the OPEC quota constraints, which
have given "firm support for prices."

Further, the geopolitical risks provide added uncertainty to the oil
supply outlook. Moreover, various state-owned oil companies have not
been investing adequately in oil production. Venezuela nationalized
assets owned by U.S. oil companies and has generally proved to be an
unreliable partner. Mexico's major oil field has been depleted, and
Mexico will not allow US companies to engage in deep water drilling.
Colombian rebels have been blowing up pipelines with some frequency, and
are being financially backed by the Venezuelan government. Nigerian
rebel forces routinely shut down oil fields - either through strikes,
terrorism or sabotage. Russia has suffered a decline in production.
Finally, U.S. production has declined dramatically in the past 20 years,
and promising new drilling areas are generally not being opened up in
this country due to environmental considerations.

In addition, the price for crude in Euros has risen but much more
modestly. For instance, the last time the Dollar and Euro were exchanged
at par was during December 2002 when the spot price of oil was about
\$27 per barrel. By the end of April 2008, the price of oil in Dollars
had risen 340% while the price in Euros had risen 180%, a substantial
difference. Attached is a chart showing the price of oil in Dollars and
Euros since 2000. So, while supply and demand fundamentals are the major
determinants of price, at the margin, as the value of the dollar goes
down, it may be providing some upward pressure on the price of oil in
dollars so that it stays constant in value with the value of crude in
Euros.

In the face of these market factors, NYMEX provides a level of economic
stability to the market by offering a reliable and well-regulated price
discovery and risk management mechanism. Our highly transparent, open
and competitive market continues to work according to design.

**[NYMEX'S ROLE]{.underline}**

Futures markets fulfill two primary functions that provide important
economic benefits to the public: (1) permitting hedging, giving market
participants the ability to shift price risk to others who have inverse
risk profiles or who are willing to assume that risk for profit; and (2)
facilitating price discovery and market transparency. Transparency
involves many factors, including: (1) continuous price reporting during
the trading session that is disseminated on a real-time basis worldwide
by various market data vendors; (2) daily reporting of trading volume
and open interest; and (3) monthly reporting of deliveries against the
futures contract.

NYMEX is the benchmark for energy prices around the world. Trading on
NYMEX is transparent, open and competitive and highly regulated. NYMEX
does not trade in the market or otherwise hold any market positions in
any of its listed contracts, and, being price neutral, does not
influence price movement or set prices for commodities trading on the
exchange. Instead, NYMEX provides trading forums that are structured as
pure auction markets for traders to come together and to execute trades
at competitively determined prices that best reflect what market
participants think prices will be in the future, given today's
information. Further, NYMEX operates in the most highly regulated
trading tier overseen by the CFTC. As such, NYMEX maintains rigorous
oversight and enforcement programs designed to promote the orderly
operation of its markets and to detect and to deter any ill activity
which would negatively effect the market and its users.

Futures markets provide a reference point for use in executing
off-exchange trades at competitively determined prices. In addition,
there is a strong beneficial and interdependent relationship between the
futures and the underlying physical commodity or "cash" markets. The
primary motivation for using the futures market is to hedge against
price risk in the cash market. Price volatility drives many into the
futures markets to offset the risk. Prudent business managers rely on
the futures market to protect their business against price swings in the
cash market.

> **ANALYSIS OF PARTICIPATION IN NYMEX CRUDE OIL CONTRACT**

Data analysis conducted by our Research Department indicates that the
percentage of open interest in NYMEX Crude Oil futures held by
non-commercial participants relative to commercial participants actually
decreased over the last year even at the same time that prices were
increasing. The attached chart indicates the percentage of open interest
in the NYMEX Crude Oil futures contract held by non-commercial longs and
shorts relative to that held by commercial longs and shorts. The review
period commenced at the beginning of 2006 and continues through to the
present. As can be seen, during the last year, commercial longs and
shorts consistently have comprised between 60 and 70% of all open
interest.

On the other hand, non-commercial longs and shorts consistently have
been in the range of 25-30% of the open interest Thus, non-commercials
holding long or buy positions have not been participating in the market
to the extent that they could have a significant impact on market price.
Moreover, as noted, the extent of non-commercial participation in the
crude oil energy futures contract has actually declined since the levels
observed last summer. It should also be noted that the percentage of
non-commercials longs (as a percentage of all long or buy open
positions) is generally within just a few percentage points of the
percentage of non-commercials shorts (as a percentage of all short or
sell positions).  In other words, non-commercial participants are not
providing disproportionate pressure on the long or buy side of the crude
oil futures market.  Instead, non-commercials are relatively balanced
between buy and sell open positions for NYMEX crude oil futures. In
addition, \"hedge funds" identified in analysis conducted by NYMEX staff
only accounted for approximately 5% of the total volume in the NYMEX
Light Sweet Crude Oil contract in 2007.

According to the CFTC website, for purposes of their Commitment of
Traders Reports, commercials and non-commercials are categorized as
follows:

> **"Commercial and Non-commercial Traders**. When an individual
> reportable trader is identified to the Commission, the trader is
> classified either as \"commercial\" or \"non-commercial.\" All of a
> trader\'s reported futures positions in a commodity are classified as
> commercial if the trader uses futures contracts in that particular
> commodity for hedging as defined in [CFTC Regulation
> 1.3(z)](http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=5915c05d67e60a553c4434f3c646904f&rgn=div8&view=text&node=17:1.0.1.1.1.0.1.3&idno=17),
> 17 CFR 1.3(z). A trading entity generally gets classified as a
> \"commercial\" trader by filing a statement with the Commission, on
> [CFTC Form
> 40](http://cftc.gov/stellent/groups/public/@forms/documents/file/cftcform40.pdf):
> Statement of Reporting Trader, 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 may exercise judgment in re-classifying
> a trader if it has additional information about the trader's use of
> the markets.
>
> A trader may be classified as a commercial trader in some commodities
> and as a non-commercial trader in other commodities. A single trading
> entity cannot be classified as both a commercial and non-commercial
> trader in the same commodity. Nonetheless, a multi-functional
> 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
> non-commercial."

Currently, NYMEX's core energy futures contracts trade on the Exchange
floor and by electronic trade-matching on CME Globex®. For energy
contracts, trading terminates in the month preceding the month of actual
delivery of the underlying commodity (if positions are not offset and
held through the termination of trading for that contract month).
Consequently, the front or spot month listed for much of this month has
been the June 2008 contract month. The daily settlement price for each
contract month of a listed contract is calculated pursuant to Exchange
rules, which reflect the various business judgments exercised by
Exchange officials in the calculation of our settlement prices.

By listing contracts that are traded in contract months listed out into
the future, our prices at all times are reflective of the collective
consensus of the marketplace as to the future direction of commodity
prices. By contrast, many cash markets of the underlying commodities for
our products, such as for gasoline, are quoted and traded in the cash
market for near-term, prompt delivery (sometimes next-day).
Consequently, there can be at times significant differences between
prices in our markets and prices in the prompt-delivery cash market.

NYMEX energy futures markets are highly liquid and transparent,
representing the views and expectations of a wide variety of
participants from every sector of the energy marketplace. Customers from
jurisdictions around the globe can submit orders for execution on
Globex. The price agreed upon for sale of any futures contract trade is
immediately transmitted to the Exchange's electronic price reporting
system and to the news wires and information vendors who inform the
world of accurate futures prices.

Price signals are the most efficient transmitters of economic
information, telling us when supplies are short or in surplus, when
demand is robust or wanting, or when we should take notice of
longer-term trends. NYMEX futures markets are the messengers carrying
this information from the energy industry to the public. The wide
dissemination of futures prices generates competition in the
establishment of current cash values for commodities.

**[SURVEILLANCE]{.underline}**

NYMEX has numerous surveillance tools, which are used routinely to
ensure fair and orderly trading on our markets. The NYMEX Market
Surveillance staff routinely reviews price activity in both futures and
cash markets, focusing on whether the futures markets are converging
with the spot physical market as the NYMEX contract nears expiration.
Large trader data are reviewed daily to monitor reportable positions in
the market. On a daily basis NYMEX collects the identities of all
participants who maintain open positions that exceed set reporting
levels as of the close of business the prior day. Generally NYMEX
identifies in excess of 85% of all open positions through this process.
These data, among other things, are used to identify position
concentrations requiring further review and focus by Exchange staff. Any
questionable market activity results in an inquiry or formal
investigation. By rule, NYMEX also maintains and enforces limits on the
size of positions that any one market participant may hold in a listed
contract. These limits are set at a level that greatly restricts the
opportunity to engage in possible manipulative activity on our markets.

NYMEX maintains a comprehensive audit trail of all transactions executed
on the Exchange. The audit trail includes such data as trade time,
executing broker or trader, and the account number for the beneficial
owner of the trade and other data, which can be used to reconstruct
trading activity for investigative purposes.

**[SPECULATORS]{.underline}**

It is widely, yet inaccurately, theorized that speculators can drive
prices up. Placing blame on speculators may grab the attention of the
media, but does not accurately reflect the realities of how markets
work. With hundreds of commercial participants and instantaneous price
dissemination, any \"speculative\" price would be expected to be met
with an equally strong \"commercial\" reaction. If markets move in a
direction inconsistent with actual market factors, a vast number of
participants, including energy producers, wholesalers, retailers, and
government agencies, have comparable access to information. These
participants will respond to ensure that prices rapidly return to where
the industry consensus believes they should be.

Speculators do exist and, while it may not be politically popular to
acknowledge this reality, the simple truth is that they play a necessary
role in the market. They add liquidity to the market and enable
commercial traders to get in and out of the market when necessary. By
the nature of their role, speculative traders seek to participate in
price trends that are already underway, but because they lack the
capacity to make or take delivery, they will never be in a position to
hold a market position through to the delivery process. They create
virtually no impact on daily settlement prices, the primary benchmark
used by the marketplace.

**[MARGINS]{.underline}**

In futures markets, margins function as financial performance bonds and
are employed to manage financial risk and to ensure financial integrity.
A futures margin deposit has the economic function of ensuring the
smooth and efficient functioning of futures markets and the financial
integrity of transactions cleared by a futures clearinghouse. Margin
levels are routinely adjusted in response to market volatility. At
NYMEX, margin generally is collected to cover a 99 percent probability
of a likely one-day price move, based on an analysis of historical and
implied data.

Some have suggested that the answer to higher crude oil prices is to
impose substantially greater margins on energy futures markets regulated
by the CFTC. We believe that this approach is misguided. As previously
noted, in a highly transparent, regulated and competitive market, prices
are affected primarily by fundamental market forces and imposing more
onerous margin levels will not affect price levels. Currently,
uncertainty in the global crude market regarding geopolitical issues,
refinery shutdowns and increasing global usage, as well as devaluation
of the U.S. dollar, are now market fundamentals. Adjusting margin levels
significantly upward will not change the underlying market fundamentals.
Furthermore, given the reality of global competition in energy
derivatives, increasing crude oil margins on futures markets regulated
by the CFTC inevitably will force trading volume away from regulated and
transparent U.S. exchanges into the unlit corners of unregulated venues
and onto less regulated and more opaque overseas markets.

Finally, Exchange staff has examined trends in margin levels at the
Exchange going back to early 2000. The data clearly indicate that higher
margin levels lead rather than follow increases in the price of crude
oil futures products. In other words, when Exchange staff, in exercising
their independent and neutral business judgment, determined to increase
margin levels in response to changes in crude oil volatility levels, the
higher margin levels were followed not by lower prices but instead by
yet higher crude prices.

**[CONCLUSION]{.underline}**

At all times during periods of volatility in the market, NYMEX has been
the source for transparent prices in the energy markets as well as the
principal vehicle by which market participants achieve stability.
Remember, futures markets provide the means by which to achieve price
certainty and lock-in prices. Our price reporting systems, which provide
information to the world's vendors, have worked flawlessly and without
delay. The NYMEX marketplace continues to perform its responsibility to
provide regulated forums that ensure open, competitive and transparent
energy pricing. The market uncertainty and mayhem and further
devastation to consumers that would unfold is clear if NYMEX were unable
to perform its duty and prices were determined, subject to limited
competition, behind closed doors. Policies that would inevitably result
in reducing transparency and liquidity would only succeed in conferring
market power unto those who would benefit from price increases in the
crude oil market, a market that is so prominently characterized by the
inflexible demand of its end-users. Transparency and liquidity are the
foundation that supports competition in the oil market.

I thank you for the opportunity to share the viewpoint of the New York
Mercantile Exchange with you today. I will be happy to answer any
questions that any Members of the Committee may have.