Energy commodities are bought and sold in several different physical and financial markets. Physical markets include the spot, or cash, markets where products such as crude oil or gasoline are bought and sold for immediate or near-term delivery. The United States has several spot markets. Examples are the pipeline hub near Cushing, Oklahoma for West Texas Intermediate crude oil and the Henry Hub near Erath, Louisiana, for natural gas. 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 in other locations. The prices established for energy commodities in the physical markets generally are determined by supply and demand. For example, when the demand for the product rises relative to supply because economies are growing, prices are likely to rise. Conversely, when demand falls relative to supply, prices are likely to fall. For energy products, demand and supply, and therefore price, can fluctuate on a seasonal basis. For example, consumer demand for gasoline in the United States is generally higher from May through early September—the summer driving season— and tends to flatten after Labor Day. Similarly, demand for natural gas and heating oil is highest during the heating season between October and March. The relative inelasticity of energy commodities means that small shifts in demand and supply can result in relatively large price fluctuations. In general, when the price of an energy commodity rises, the demand for that product is likely to fall in the long term, and vice versa. However, demand for energy commodities is price inelastic in the short term—that is, the quantity demanded changes little in response to a change in price. On the supply side, rising energy commodities prices motivate producers to increase the amount of commodities they supply to increase profits. However, because producers hold relatively low inventories of energy commodities in reserve, and finding and producing additional energy commodities takes a long time and is expensive, supply also is relatively inelastic. For example, supplies of natural gas from new production wells cannot be increased quickly to meet higher demand because of the time required to get the newly produced gas into the marketplace. Energy commodities also are traded in the financial markets, especially in the form of derivatives. Derivatives include futures, options, and swaps, whose values are based on the performance of the underlying asset. 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 traditionally are privately negotiated contracts that involve an ongoing exchange of one or more assets, liabilities, or payments for a specified period. Futures and options contracts are traded on exchanges designated by CFTC as contract markets (futures exchanges), where a wide range of energy, agricultural, financial, and other commodities are bought and sold for future delivery. Commodity futures and options can be traded on both OTC and exempt commercial markets if the transactions involve qualifying commodities and the participants satisfy statutory requirements. Energy futures include standardized contracts for future delivery of a specific crude oil, heating oil, natural gas, or gasoline product at a particular spot market location. The exchange standardizes the contracts, and participants cannot modify them to their particular needs. For example, a standard gasoline futures contract traded on NYMEX is for 1,000 barrels (42,000 gallons), quoted in dollars and cents per gallon, and for delivery of up to 36 months into the future at New York Harbor. The owner of an energy futures contract is obligated to buy or sell the commodity at a specified price and future date. However, the owner may eliminate the contractual obligation before the contract expires by selling or purchasing other contracts with terms that offset the original contract. In practice, relatively few futures contracts on NYMEX result in physical delivery of the underlying commodity, but instead are liquidated with offsets. Options on futures contracts also are traded on exchanges such as NYMEX and foreign boards of trade that U.S. traders access directly. In addition to exchange-traded futures and options, the financial markets for energy commodities include derivatives traded among multiple traders on exempt commercial markets and derivatives created bilaterally in OTC transactions. As with futures, exempt commercial markets and other OTC derivatives allow producers and users of energy commodities to manage the risk of future changes in the price of a particular commodity. These contracts include options and swaps at an agreed-upon price. Appendix II shows some of the different types of contracts and transactions for energy commodities in the physical and financial markets. Market participants use futures markets to offset the risk caused by changes in prices, discover commodity prices, and 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 of price changes in the physical markets. The futures markets help buyers and sellers determine, or “discover,” the price of commodities in the physical markets, thus linking the two markets. Other participants—generally, speculators—that do not have a commercial interest in the underlying commodities but are looking to make a profit take varying positions on the future value of commodities. In doing so, speculators provide liquidity and assume risks that other participants, such as hedgers, seek to avoid. Arbitrageurs are a third group of participants that aim to benefit by identifying discrepancies in price relationships, rather than by betting on future price movements. Arbitrage is a strategy that involves simultaneously entering into several transactions in multiple markets to benefit from price discrepancies across markets. For example, traders can trade simultaneously in exchanges and OTC. 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. 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. There are two basic types of volatility measurements. Historical volatility measures are calculated on the basis of price changes, using data from market transactions. Implied volatility reflects market participants’ expectations of future volatility as derived from the prices of traded options (see app. III). This report presents data on the relative historical volatility of energy futures contracts, which we calculated from relative changes in daily prices. Futures and off-exchange derivatives markets provide participants with a means to hedge or shift unwanted price risk to others more willing to assume the risk or those having different risk situations. For example, if a petroleum refiner wanted to shed its risk of losing money as a result of falling gasoline prices, it could lock in a price by selling futures contracts to deliver the gasoline in 6 months at a guaranteed price. Likewise, a transportation company that knows it must refill its gasoline tanks in 6 months might want to offset the price risk associated with purchasing fuel by buying futures contracts to take delivery of gasoline then at a set price. Without futures contracts that help them manage risk, producers, refiners, and others likely would face uncertainty related to investment planning, budgeting, and forecasting—and potentially higher costs. Futures markets also provide a means of price discovery for commodities such as energy products. For price discovery, markets need current information about supply and demand, a large number of participants, and transparency. Market participants monitor and analyze the factors that currently affect, and that they expect to affect, the future supply and demand for energy commodities. With that information, they buy or sell energy commodity contracts on the basis of the price for which they believe the commodity will sell at the delivery date. The futures markets, in effect, distill the diverse views of market participants into a single price. In turn, buyers and sellers of physical commodities consider those predictions about future prices with other factors when setting prices on the spot and retail markets. A wide variety of participants hedge and speculate in energy derivatives markets. For the exchange-traded futures markets, CFTC categorizes traders in general terms as either commercial or noncommercial participants. CFTC identifies several subcategories of participants within the commercial category: producers, manufacturers, dealers/merchants, and swaps/derivatives dealers. Dealers and merchants include, among others, wholesalers, exporters and importers, shippers, and crude oil marketers. Typical noncommercial traders are entities such as those that manage money (“managed money traders”). These noncommercial traders include, among others, commodity pool operators (CPO) and commodity trading advisors (CTA), many of which advise or operate hedge funds. Other noncommercial traders include floor brokers and unregistered traders. The prices for energy commodities in the futures and in the spot or physical markets are closely linked because they are influenced by the same market fundamentals in the long run. Prices in the physical spot and futures markets for the four energy commodities we reviewed are highly correlated and rose dramatically from 2002 to 2006. As shown in figure 1, from January 2002 to July 2006, monthly average spot prices for crude oil, gasoline, and heating oil increased by at least 220 percent. Natural gas spot prices increased by more than 140 percent. At the same time that spot prices increased, the futures prices for these commodities showed a similar pattern of a sharp and sustained increase from January 2002 into 2006. For example, the price of crude oil futures increased from an average of $22 per barrel in January 2002 to an average of $74 per barrel in July 2006. Natural gas futures prices spiked rapidly in the fall of 2005 after several strong hurricanes raised concerns about supply disruptions for the winter of 2005-2006, then prices fell sharply due in part to a mild winter. Prices in the spot and futures markets show similar patterns because traders in those markets tend to rely on the same types of information when entering into transactions. The differences between futures and spot market prices for energy commodities narrow and the prices converge when futures contracts near expiration and physical delivery is required.