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 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 spot 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. 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. 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 are also used to hedge this risk. The ability to reduce their 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. By establishing prices for future delivery, 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. Markets are best able to perform price discovery 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, generally use the futures market 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. The physical markets for energy commodities underwent change and turmoil from 2002 through 2006, which affected prices in the spot and futures markets. We reported that numerous changes in both the physical and futures markets may have affected energy prices. However, because these changes occurred simultaneously, identifying the specific effect of any one of these changes on energy prices is difficult. The physical energy markets have undergone substantial change and turmoil during this period, which can affect spot and futures markets. Like many others, we found that a number of fundamental supply and demand conditions can affect prices. According to the Energy Information Administration (EIA), world oil demand has grown since 1983 from a low of about 59 million barrels per day in 1983 to more than 85 million barrels per day in 2006 (fig. 1). While the United States accounts for about a quarter of this demand, rapid economic growth in Asia also has stimulated a strong demand for energy commodities. For example, EIA data show that during this time frame, China’s average daily demand for crude oil increased almost fourfold. 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 2, 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 about 5.6 million barrels a day as recently as 2002. Major weather and political events also can 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 Iran, 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 we have reported, refining capacity in the United States has not expanded at the same pace as the demand for gasoline. 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 also may 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. Another consideration is that the value of the U.S. dollar on open currency markets could 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 also are 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 weakening U.S. dollar to the extent they can. As you can see, conditions in the physical markets have undergone changes that can help explain at least some of the increases in both physical and derivatives commodity prices. As we have previously reported, futures prices typically reflect the effects of world events on the price of the underlying commodity such as crude oil. For example, political instability and terrorist acts in countries that supply oil create uncertainties about future supplies, which are reflected in futures prices. Conversely, news about a new oil discovery that would increase world oil supply could result in lower futures prices. In other words, changes in the physical markets influence futures prices. At the same time that physical markets were undergoing changes, we found that financial markets also were amidst change and evolution. For example, the annual historical volatilities between 2000 and 2006— measured using the relative change in daily prices of energy futures— 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. Elsewhere in the futures market, we found an increase in the number of noncommercial traders such as managed money traders. Attracted in part by the trends in prices and volatility, a growing number of traders sought opportunities to hedge against those changes or profit from them.