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. 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. 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. 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. 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. 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 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. 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. Not surprisingly, our preliminary 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. 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. 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. 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 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.