High oil prices affect nearly every household and business in the United States. Figure 1 illustrates that during the course of 2008, oil prices doubled to more than $145 per barrel and then rapidly fell by 80%. In early 2011, there was a run-up of about 20%, sending gasoline prices near 2008 highs. Few would rule out the possibility of similar price swings in the months to come. What explains oil price volatility? There are two possible kinds of explanations. The first looks to the fundamentals of oil production and energy consumption. Rapid global economic growth has led to rising demand for oil, and supply could not keep up at previous oil prices. But oil supply and demand are inelastic to price changes, at least in the near-term, which some would argue means that relatively small shifts in supply or demand can be expected to trigger significant price movements. Others consider price movements such as those of 2008 and early 2011 to be more extreme than warranted by the fundamentals of supply and demand. The second explanation for unstable commodity prices focuses on financial markets for derivatives contracts that are linked to the price of oil—futures, options, and swaps. Many market participants are pure financial speculators, who never deal in physical oil, but seek to profit from correctly forecasting price trends. Critics claim that speculators can drive oil prices above fundamental levels, resulting in a "speculative premium" that imposes unjustified costs on consumers. Although the relationship between speculation and commodity prices has been studied extensively, there is no consensus among academics and regulators as to whether speculative trading causes episodes of unusual price volatility. This report provides background on the oil derivatives markets and the different types of firms that trade in those markets. It reviews the concepts of manipulation and excessive speculation. It includes a brief section describing the fundamental factors that affect oil prices. Although the basic question of fundamentals versus speculation remains unsettled, this report provides a context for evaluating the opposing claims. The United States consumes about 19 million barrels of oil each day. Maintaining the supply of oil involves thousands of daily transactions, at prices varying by location, quality, quantity, and local supply and demand conditions. There is no single price at which spot (or physical) oil deals take place, but there are a number of benchmarks that buyers and sellers use as reference points. Private and government sources publish benchmark data about spot prices at various locations. Another important oil price benchmark is the futures price. A futures contract is a form of oil "derivative"—it is a financial instrument that gains and loses value as the price of oil rises and falls. In effect, futures traders buy the price of oil (and make or lose money as the price changes) without necessarily delivering or taking possession of a single barrel of the physical commodity. Thousands of traders buy and sell oil futures contracts. Their purposes, strategies, and investment horizons vary, but the sum of their transactions determines the futures market price, which is publicly available to all market participants. Many spot trades take place at the futures price, or at the futures price adjusted by some factor. Headlines reporting a dramatic jump or fall in oil prices are likely to quote the futures price. Both physical and derivative trades (futures, options, and swap contracts linked to the price of oil) contribute to setting the price. It is thus very difficult to disentangle the price impact of trades by producers and commercial users of oil from those of financial speculators who seek to profit by forecasting price trends. Does excessive speculation drive prices away from levels justified by supply and demand fundamentals, or do speculators provide liquidity and facilitate the price-setting mechanism? These questions remain controversial. The next sections of this report describe the mechanics of oil futures and the kinds of traders who participate in the market. Although oil swaps and options use different terminology, the economic substance is the same: they are bilateral contracts under which one party gains if the price moves in one direction, and the other party gains if the price moves in the opposite direction. An oil futures contract represents 1,000 barrels of oil, but neither party to the contract need ever possess the actual commodity. (Contracts may be settled by physical delivery, but in practice the vast majority are settled in cash.) When a futures contract is made today, one party (called the "long") agrees to buy oil at a future date from the other (the "short"). Contracts are available with different maturities, designated by various expiration months, but the size is always the same. (In crude oil, a contract expires every month and most trading is in the contract soonest to expire, called the "near" or "spot-month" contract.) The price at which the future purchase or sale is to take place is the current futures market price, which varies continuously during the trading day. Assuming the price of oil is $100 per barrel, the long trader is committed to buy at that price, and the short is obliged to sell. Now suppose that tomorrow the price of oil goes to $105/barrel. The long trader now has the advantage: he is entitled to buy for $100 oil that is now worth $105. His profit is $5,000 (the $5 per barrel increase times the 1,000 barrels specified in the contract). The short has lost the identical amount: she is obliged to sell oil for less than the going price. If, on the following day, the price goes to $110, the long gains another $5,000. The short, down a total of $10,000, may reconsider her investment strategy and decide to exit the market. She can do this at any time by entering into an offsetting, or opposite transaction. That is, she purchases a long contract with the same expiration date. Her obligation (on paper) is now to sell 1,000 barrels (according to the first contract) and to buy 1,000 barrels (the second contract) when both contracts expire simultaneously. Whatever price prevails at that time, the net effect of the two transactions will be zero. The short's position is said to be "evened out"—she is out of the market. The short's decision to exit does not affect the long, who may prefer to ride the trend. This is because all contracts are assumed by the exchange's clearing house, which becomes the opposite party on each trade, and guarantees payment. The ability to enter and exit the market by offset, without having to make or take delivery of the physical commodity, permits trading strategies based on short-term price expectations. While some traders may keep a long or short position open for weeks or months, others buy and sell in fractions of seconds. The exchange clearing house, which guarantees all trades, also controls traders' funds. Before entering into the trade described above, both long and short would have been required to deposit an initial margin payment of $6,750. (The figure, set by the exchange, was the CME Group's margin for speculators as of August 31, 2011.) All contracts are priced, or "marked-to-market," each day. The long trader above would have had his $10,000 gain credited to his margin account, whereas the short would have had to make additional "maintenance" margin payments to cover her losses. It is worth noting that her two-day $10,000 loss represents more than 100% of her original investment, that is, her initial margin deposit of $6,750: the risks of futures speculation are high. When traders exit the market, any funds remaining in their margin accounts are returned. (Other transaction costs, such as brokerage commissions and clearing fees, are not returnable.) Options on futures are also available for many futures contracts. The holder of an option has the right (but not the obligation) to enter into a long or short futures contract over the life of the option. The option will only be exercised if price movements are favorable to the option buyer, that is, if the underlying futures contract would be profitable. The seller of the option receives a payment (called a premium) for granting this right. The seller profits if the option is not exercised by the buyer. Swap contracts are traded in the over-the-counter market, rather than on organized exchanges (although the Dodd-Frank Act Reform and Consumer Protection Act, P.L. 111-203 , mandates that some swaps be traded on new "swap execution facilities," or SEFs). The terms of swap contracts are not uniform, as futures contracts are, but can be negotiated between the counterparties. Economically, however, swaps are equivalent to futures: one counterparty will gain if the price rises, the other if prices fall. Derivatives traders can be classed as either hedgers, who use the market to avoid price risk, or speculators, who assume risk in search of profits. In futures markets the distinction is formal, and is important because hedgers pay lower margin rates and are not subject to limits on the size of their positions. Hedgers and speculators may be further broken down into subcategories, as follows. Commercial hedgers are those involved in production, processing, transportation, or use of oil and petroleum products. Oil and gas exploration and production companies, refiners, industrial consumers, and retailers buy and sell oil and oil products to meet the physical needs of their businesses. In their physical trading, they buy and sell oil up and down the supply chain. For example, an upstream producer sells crude oil to a refinery, which sells jet fuel to an airline or gasoline to a retail station, which then sells it to motorists. Commercial participants can sign long-term sales agreements or may buy short-term contracts for near-term physical delivery of oil. Derivatives allow commercial participants to manage their risks related to the oil business, or hedge against oil price risk. This is a form of insurance against market fluctuations. For instance, an airline's profits may suffer when jet fuel prices increase.