United States Government Accountability Office

GAO Testimony 

Before the Subcommittee on General 

Farm Commodities and Risk Management, 

Committee on Agriculture, House of 

Representatives

ENERGY DERIVATIVES

Preliminary Views on 

Energy Derivatives Trading 

and CFTC Oversight 

Statement of Orice M. Williams, Director 

Financial Markets and Community Investment 

For Release on Delivery

Expected at 10:00 a.m. EDT 

Thursday, July 12, 2007

 

GAO-07-1095T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

July 12, 2007

ENERGY DERIVATIVES

Preliminary Views on Energy Derivatives 

Highlights of GAO-07-1095T, testimony Trading and CFTC Oversight 

before Subcommittee on General Farm 

Commodities and Risk Management, 

Committee on Agriculture, House of 

Representatives 

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 energyrelated 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 Recommends

This testimony is based on an

ongoing engagement, and therefore 

GAO is making no

recommendations at this time. 

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: 

• 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. 

• 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.

• 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. 

www.gao.gov/cgi-bin/getrpt?GAO-07-1095T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Orice M. 

Williams at (202) 512-8678 or 

williamso@gao.gov.
Energy Derivatives

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss our preliminary views on the 

trading of derivatives for energy commodities such as natural gas and 

crude oil. As energy prices have increased in recent years, the trading 

volume of exchange-traded futures, off-exchange traded swaps, and other 

types of derivatives have also experienced significant growth.1

 Increased 

energy prices generally have been attributed to normal market forces of 

supply and demand, but these trends in energy derivatives markets have 

raised questions about whether this trading activity has placed additional 

upward pressure on the prices of physical energy commodities. The prices 

of futures contracts, like those of all derivatives, are in large part based on

prices in the physical spot (cash) market where commodities are sold. At 

the same time, buyers and sellers of natural gas, crude oil, gasoline, and 

other energy products use exchange-traded futures prices, which are 

published daily, when determining prices in the physical markets. The 

extent to which off-exchange prices are used for determining prices of the

underlying commodity, however, is unclear. The growth in energy futures 

trading since 2001 has in part been fueled by new market participants such 

as hedge funds and by increased investment in commodity index funds, 

which are funds whose prices are tied to the price of a basket of various 

commodity futures. 

My testimony today is based on an ongoing engagement on trading activity

in energy derivatives markets—primarily the futures market—and the 

oversight role of the Commodity Futures Trading Commission (CFTC). 

Because of the broad interest in this subject, our ongoing work has been 

initiated under the authority of the Comptroller General. My remarks 

today present our preliminary views on (1) trends in the energy derivatives 

and physical markets and the effect of those trends on energy prices, and 

(2) the regulatory structure of the various markets where energy 

commodities and derivatives are traded. 

In conducting this work, 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 for the period January 2002 through December 2006. 

We also obtained and analyzed data on market participants and the 

 1

Our analysis of energy prices and energy financial markets is generally limited to the time 

period fromf January 2002 to December 2006. 

Page 1 GAO-07-1095T 
Energy Derivatives

outstanding trading positions of different categories of traders from CFTC. 

In addition, 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 is being done in accordance with 

generally accepted government auditing standards. 

In summary, derivatives and physical markets for crude oil, unleaded 

gasoline, heating oil, and natural gas have experienced substantial changes 

in recent years. From January 2002 to July 2006, monthly average futures 

and spot prices for crude oil, gasoline, and heating oil registered increases 

of over 200 percent.2

 The volatility of energy prices also generally 

remained above historic averages for most of the period but declined 

during 2006 to levels at or near the historical average. At the same time, 

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. While these changes 

were occurring, the physical market was experiencing tight supply and 

rising demand from increasing global demand, ongoing political instability 

in oil-producing regions, limited refining capacity, and other ongoing 

supply disruptions. Some observers believe that higher energy prices were 

solely the result of supply and demand fundamentals while others believe 

that increased futures trading activity may also have contributed to higher 

prices. But the effect on energy prices of individual changes in these 

markets is unclear, as many factors have combined to affect energy prices. 

Monitoring these changes in the future will be important in protecting the 

public and ensuring market integrity.

Energy derivatives are traded on futures exchanges, exempt commercial 

markets, and over the counter (OTC). Some of these markets are subject

to CFTC oversight and some are largely unregulated. Under the 

Commodity Exchange Act (CEA), CFTC regulatory oversight is focused on 

the surveillance of futures exchanges, protecting the public, and ensuring 

market integrity. CFTC does not, however, have oversight authority over 

exempt commercial markets—electronic trading facilities that trade 

exempt commodities, including energy commodities, on a principal-toprincipal basis solely between persons that are eligible commercial 

 2

To account for the effects of inflation on prices, prices are adjusted to reflect prices in the 

base year of 2006. 

Page 2 GAO-07-1095T 
Energy Derivatives

entities—and the volume of off-exchange transactions has increased 

significantly in recent years. Also, certain parties—those who qualify as 

eligible contract participants—can enter into contracts directly (over the

counter). Both the exempt commercial market and the OTC market are 

exempt from general CFTC oversight. However, both markets are subject 

to CFTC’s enforcement of the CEA’s antimanipulation and, where 

applicable, antifraud provisions. Because of these varying levels of CFTC 

oversight, some market observers question whether CFTC needs broader 

authority over all derivative markets, particularly those involving exempt 

commodities. 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. 

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 (WTI) 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. 

Background 

In addition to the cash 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, which participants cannot 

modify. 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. 

Page 3 GAO-07-1095T 
Energy Derivatives

Options give the purchaser the right, but not the obligation, to buy or sell a 

specific quantity of a commodity or financial asset at a designated price.

Swaps are privately negotiated contracts that involve an ongoing exchange 

of one or more assets, liabilities, or payments for a specified time period. 

Like futures, options can be traded on an exchange designated by CFTC as

a contract market. Both swaps and options can be traded off-exchange if 

the transactions involve qualifying commodities and the participants 

satisfy statutory requirements. Options and futures are used to buy and 

sell a wide range of energy, agricultural, financial, and other commodities 

for future delivery. 

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 can serve the same function. 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. 

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. Price discovery is facilitated 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. 

Page 4 GAO-07-1095T 
Energy Derivatives

Other participants, such as investment banks and hedge funds, which do 

not have a commercial interest in the underlying commodities, use the 

futures market strictly 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 markets. 

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.

Multiple Factors in 

the Derivatives and 

Physical Markets 

Have Impacted 

Energy Prices 

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. Specifically from January 2002 to July 2006,

the futures markets experienced higher prices, relatively higher volatility, 

increased trading volume, and growth in some types of traders. 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.3

 At the same time that spot prices were increasing, the

futures prices for these commodities showed a similar pattern, with a 

sharp and sustained increase. For example, the price of crude oil futures 

increased from an average of $22 per barrel in January 2002 to $74 in July

2006. 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. 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 

 3

To account for the effects of inflation on prices, prices are adjusted to reflect prices in the 

base year of 2006. 

Page 5 GAO-07-1095T 
Energy Derivatives

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. 

We also observed that at the same time that prices were rising and that 

volatility was generally above or near long-term averages, futures markets 

saw an increase in the number of noncommercial traders such as managed

money traders, including hedge funds.4

 The trends in prices and volatility 

made the energy derivatives markets attractive for the growing number of 

traders that were looking to either 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 1, 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. 

 4

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. 

Page 6 GAO-07-1095T 
Energy Derivatives

Figure 1: Average Daily Number of Large Commercial and NonCommercial Traders per Month, July 2003 through December 

2006 

Traders

Crude oil

Commercial

Noncommercial

Source: GAO analysis of CFTC data.

Traders

Natural gas

Traders

Unleaded gas Heating oil

Traders

0

50

100

150

200

250

300

0

50

100

150

200

250

300

0

50

100

150

0

50

100

150

2003 2004 2005 2006

(July-Dec.)

2003 2004 2005 2006

(July-Dec.)

2003 2004 2005 2006

(July-Dec.)

2003 2004 2005 2006

(July-Dec.)

Not surprisingly, our preliminary work also revealed that as the number of 

traders increased, so did the trading volume on NYMEX for all energy

Page 7 GAO-07-1095T 
Energy Derivatives

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. 

Another notable trend, but one that is much more difficult to quantify, was 

the apparently 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. While the Bank for International 

Settlements publishes data on worldwide OTC derivative trading volume 

for broad groupings of commodities, this format can be used only as a 

rough proxy for trends in the trading volume of OTC energy derivatives.5

According to these data, the notional amounts outstanding of OTC 

commodity derivatives excluding precious metals, such as gold, grew by 

over 850 percent from December 2001 to December 2005.6

 In the year from 

December 2004 to December 2005 alone, the notional amount outstanding 

increased by more than 200 percent to over $3.2 trillion. 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. For example, 

according to its annual financial statements, the volume of non-futures 

energy contracts traded on the Intercontinental Exchange, also known as 

ICE, including financially settled derivatives and physical contracts, 

increased by over 400 percent to over 130 million contracts in 2006. 

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). 

That is, our preliminary view of these data suggests that managed money

 5

The Bank for International Settlements (BIS) is an international organization that fosters 

international monetary and financial cooperation and serves as a bank for central banks. 

6

The notional amount is the amount upon which payments between parties to certain types

of derivatives contracts are based. The notional amount is not exchanged between the 

parties but instead represents a hypothetical underlying quantity upon which payment 

obligations are computed. The BIS data on OTC derivatives includes forwards, swaps, and 

options. 

Page 8 GAO-07-1095T 
Energy Derivatives

traders as a whole were more or less evenly divided in their expectations 

about future prices than they had been in the past. 

We found that views were mixed about whether these trends had 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. Contrary to this viewpoint, 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 of time. 

Various Patterns in the 

Physical Markets Also 

Explain Rising Energy 

Prices 

The developments in the derivatives markets in recent years have not

occurred in isolation. Conditions in the physical markets were also 

undergoing changes that could help explain increases in both derivative 

and physical commodity prices. As we have reported, futures prices 

typically reflect the effects of world events on the price of the underlying 

commodity such as crude oil.7

 For example, political instability and 

terrorist acts in countries that supply oil create uncertainties about future 

supplies that are reflected in futures prices in anticipation of an oil 

shortage and expected higher prices in the future. Conversely, news about 

a new oil discovery that would increase world oil supply could result in 

lower futures prices. In other words, futures traders’ expectations of what 

may happen to world oil supply and demand influence their price bids. 

According to the Energy Information Administration (EIA), world oil 

demand has grown from about 59 million barrels per day in 1983 to more 

 7

See GAO, Motor Fuels: Understanding the Factors that Influence the Retail Prices of

Gasoline, GAO-05-525SP (Washington, D.C.: May 2005). 

Page 9 GAO-07-1095T 
Energy Derivatives

than 85 million barrels per day in 2006 (fig. 2). While the United States 

accounts for about a quarter of this demand, rapid economic growth in 

Asia has also stimulated a strong demand for energy commodities. For 

example, EIA data shows that from 1983 to 2004, China’s average daily 

demand for crude oil increased almost fourfold. 

Figure 2: Increase in World Demand for Crude Oil, 1980-2006 

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Barrels per day (in millions)

Source: GAO analysis of EIA data.

0

55

60

65

70

75

80

85

90

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

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 3, 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 5.6 million barrels 

a day as recently as 2002. 

Page 10 GAO-07-1095T 
Energy Derivatives

Figure 3: Estimates of World Oil Spare Production Capacity by the Energy Information Administration 

0

1

2

3

4

5

6

1991- 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

 1997

Barrels per day (in millions)

Year

Projected

Source: EIA.

Note: The spare capacity data for 1991-1997 represent an average over those years. 

Major weather and political events can also lead to supply disruptions and 

higher prices. In its analysis, EIA has cited the following examples: 

• 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 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 

Page 11 GAO-07-1095T 
Energy Derivatives

we have reported, refining capacity in the United States has not expanded

at the same pace as the demand for gasoline.8

 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 may also 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. However, others noted a different 

trend for crude oil inventories. That is, prices have remained high despite 

patterns of higher levels of oil in inventory. 

In addition to the supply and demand factors that generally apply to all 

energy commodities, specific developments can affect particular 

commodities. For instance, the growth of special gasoline blends—socalled “boutique fuels”—can affect the price of gasoline. As we have 

reported, it is generally agreed that the higher costs associated with 

supplying special gasoline blends contributed to higher gasoline prices, 

either because of more frequent or more severe supply disruptions or 

because the costs were likely passed on, at least in part, to consumers.9

Like the futures market, the physical market has undergone substantial 

changes that could affect prices. But market participants and other 

observers disagree about the impact of these changes on increasing energy

prices. 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. Another 

consideration is that the value of the U.S. dollar on open currency markets 

could also 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 are also 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 

 8

See GAO, Energy Markets: Factors Contributing to Higher Gasoline Prices, GAO-06-412T 

(Washington, D.C.: Feb. 1, 2006) and GAO-05-525SP. 

9

GAO, Gasoline Markets: Special Gasoline Blends Reduce Emissions and Improve Air 

Quality, but Complicate Supply and Contribute to Higher Prices, GAO-05-421 

(Washington, D.C.: June 17, 2005). 

Page 12 GAO-07-1095T 
Energy Derivatives

weakening U.S. dollar. 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. 

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. As we have seen, under 

the CEA CFTC’s regulatory authority is focused on overseeing futures 

exchanges, protecting the public, and ensuring market integrity. 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.10

CFTC Oversees 

Exchanges and Has 

Some Authority over 

Other Derivatives 

Markets 

Futures exchanges such as NYMEX are subject to direct CFTC regulation

and oversight. CFTC generally focuses on fulfilling three strategic goals 

related to these exchanges. First, to ensure the economic vitality of the 

commodity futures and options markets, CFTC conducts its own direct 

market surveillance and also reviews the surveillance efforts of the 

exchanges. Second, to protect market users and the public, CFTC 

promotes sales practice and other customer protection rules that apply to

futures commission merchants and other registered intermediaries.11

Finally, to ensure the market’s financial integrity, CFTC reviews the audit 

and financial surveillance activities of self-regulatory organizations. 

CFTC conducts regular market surveillance and oversight of energy 

trading on NYMEX and other futures exchanges.12 Oversight activities 

include: 

 1017 C.F.R. § 36.3; see 7 U.S.C. § 2(h)(4)(D). 

11See 17 C.F.R. Parts 155, 166.

12NYMEX conducts its own surveillance activities and may bring enforcement actions when 

violations are found. 

Page 13 GAO-07-1095T 
Energy Derivatives

• detecting and preventing disruptive practices before they occur and 

keeping the CFTC commissioners informed of possible manipulation or 

abuse; 

• monitoring NYMEX’s compliance with CFTC reporting requirements 

and its enforcement of speculative position limits; 

• investigating traders with large open positions; and 

• documenting cases of improper trading. 

In contrast to the direct oversight it provides to futures exchanges, CFTC 

does not have general oversight authority over exempt commercial 

markets, where qualified entities may trade through an electronic trading 

facility. According to CFTC officials, these markets have grown in 

prominence in recent years. Some market observers have questioned their 

role in the energy markets and the lack of transparency about their trading 

activities. Trading energy derivatives on exempt commercial markets is 

permissible only for 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. These markets are not subject to CFTC’s general direct 

oversight but are required to maintain communication with CFTC. Among 

other things, an exempt commercial market must notify CFTC that it is 

operating as an exempt commercial market and must comply with certain

CFTC informational, record-keeping, and other requirements. 

Energy derivatives also may be traded OTC rather than via an electronic

trading facility. OTC derivatives are private transactions between 

sophisticated counterparties, and there is no requirement for parties 

involved in these transactions to disclose information about their 

transactions. Derivatives transactions in both exempt commercial markets 

and OTC markets are bilateral contractual agreements in which each party 

is subject to and assumes the risk of nonperformance by its counterparty. 

These agreements differ from derivatives traded on an exchange where a 

central clearinghouse stands behind every trade. 

While some observers have called for more oversight of OTC derivatives, 

most notably for CFTC to be given greater oversight authority over this 

market, others consider such action unnecessary. Supporters of more 

CFTC oversight authority believe that more transparency and

accountability would better protect the regulated markets and consumers 

from potential abuse and possible manipulation. Some question how CFTC 

can be assured that trading on the OTC market is not adversely affecting

the regulated markets and ultimately consumers, given the lack of 

information about OTC trading. However, in 1999 the President’s Working 

Page 14 GAO-07-1095T 
Energy Derivatives

Group on Financial Markets concluded that OTC derivatives generally 

were not subject to manipulation because contracts were settled in cash

based on a rate or price determined in a separate highly liquid market and 

did not serve a significant price discovery function.13 Moreover, the market 

is limited to professional counterparties that do not need the protections 

against manipulation that CEA provides to retail investors. Finally, the 

group has recently noted that if there are concerns about CFTC’s 

authority, CFTC’s enforcement actions against energy companies are 

evidence that the CFTC has adequate tools to combat fraud and 

manipulation when it is detected.

14

The lack of reported data about off-exchange markets makes addressing 

concerns about the function and effect of these markets on regulated

markets and entities challenging. 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. In a June 2007 proposed rulemaking, 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 any other disruptions to the 

integrity of the regulated futures markets.15 According to CFTC officials, 

 13The President’s Working Group was established by executive order in 1988 following the 

1987 stock market crash. Its purpose was to enhance the continued integrity, 

competitiveness, and efficiency of U.S. financial markets and maintain the public’s 

confidence in those markets. See the Report of the President’s Working Group on Financial 

Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act 

(Washington, D.C.: 1999). 

14June 11, 2003, letter signed by the members of the President’s Working Group to the

Honorable Senator Michael D. Crapo and the Honorable Zell B. Miller.

15According to CFTC, the purpose of the proposed regulation is to make 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 and/or pursuant to Sections2(d), 2(g) or 2(h)(1)-(2) of the

Commodity Exchange Act (Act) or Part 35 of the Commission’s regulations, on exempt 

commercial markets operating pursuant to Sections 2(h)(3)-(5) of the Act, on exempt 

boards of trade operating pursuant to Section 5d of the Act, and on foreign boards of trade;

and to make the regulation clearer and more complete with respect to hedging activity. 72 

Fed. Reg. at 34413. 

Page 15 GAO-07-1095T 
Energy Derivatives

the commission has also proposed amendments to clarify its authority 

under the CEA to collect information and to bring fraud actions in 

principal-to-principal transactions in these markets, enhancing CFTC’s 

ability to enforce antifraud provisions of CEA. 

In closing, our work to date shows that the derivatives and physical 

markets have both undergone substantial change and evolution. Given the 

changes in both markets, causality is unclear, and the situation warrants 

ongoing review and analysis. We commend the Subcommittee’s efforts in

this area. Along with the overall concern about rising prices, questions 

have also been raised about CFTC’s authority to protect investors from 

fraudulent, manipulative, and abusive practices. CFTC generally believes

that the commission has sufficient authority over OTC derivatives and 

exempt energy markets. However, CFTC has taken an important step by 

clarifying its authority to obtain information about pertinent off-exchange 

transactions. 

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.

For further information about this testimony, please contact Orice M. 

Williams on (202) 512-8678 or at williamso@gao.gov. 

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 John Wanska (Assistant Director), Kevin Averyt, 

Ross Campbell, Emily Chalmers, John Forrester, and Paul Thompson. 

GAO Contacts 

Staff 

Acknowledgments 

Page 16 GAO-07-1095T 250355 
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