THE ROLE OF MARKET SPECULATION IN RISING OIL AND GAS PRICES: A NEED TO PUT THE COP BACK ON THE BEAT

[Senate Prints 109-65]
[From the U.S. Government Publishing Office]

109th Congress S. Prt.
SENATE
2nd Session 109-65
_______________________________________________________________________

THE ROLE OF MARKET SPECULATION IN RISING OIL AND GAS PRICES: A NEED TO
PUT THE COP BACK ON THE BEAT

__________

STAFF REPORT

prepared by the

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

of the

COMMITTEE ON

HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

[GRAPHIC] [TIFF OMITTED] TONGRESS.#13

JUNE 27, 2006

U.S. GOVERNMENT PRINTING OFFICE
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COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
NORM COLEMAN, Minnesota DANIEL K. AKAKA, Hawaii
TOM COBURN, Oklahoma THOMAS R. CARPER, Delaware
LINCOLN D. CHAFEE, Rhode Island MARK DAYTON, Minnesota
ROBERT F. BENNETT, Utah FRANK LAUTENBERG, New Jersey
PETE V. DOMENICI, New Mexico MARK PRYOR, Arkansas
JOHN W. WARNER, Virginia

Michael D. Bopp, Staff Director and Chief Counsel
Joyce A. Rechtschaffen, Minority Staff Director and Chief Counsel
Trina Driessnack Tyrer, Chief Clerk

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

NORM COLEMAN, Minnesota, Chairman
TED STEVENS, Alaska CARL LEVIN, Michigan
TOM COBURN, Oklahoma DANIEL K. AKAKA, Hawaii
LINCOLN D. CHAFEE, Rhode Island THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah MARK DAYTON, Minnesota
PETE V. DOMENICI, New Mexico FRANK LAUTENBERG, New Jersey
JOHN W. WARNER, Virginia MARK PRYOR, Arkansas

Raymond V. Shepherd, III, Staff Director and Chief Counsel
Leland B. Erickson, Counsel
Elise J. Bean, Minority Staff Director and Chief Counsel
Dan M. Berkovitz, Minority Counsel
Mary D. Robertson, Chief Clerk

C O N T E N T S

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Page

I. EXECUTIVE SUMMARY............................................. 1

II. FINDINGS AND RECOMMENDATIONS................................. 6

A. Findings.................................................. 6
1. GRise in Speculation................................... 6
2. GSpeculation Has Increased Prices...................... 6
3. GPrice-Inventory Relationship Altered.................. 7
4. GLarge Trader Reports Essential........................ 7
5. GICE Impact on Energy Prices........................... 7

B. Recommendations........................................... 7
1. GEliminate Enron Loophole.............................. 7
2. GRequire Large Trader Reports.......................... 7
3. GMonitor U.S. Energy Trades on Foreign Exchanges....... 7
4. GIncrease U.S.-U.K. Cooperation........................ 7
5. GMake ICE Determination................................ 7

III. RECENT TRENDS IN ENERGY MARKETS............................. 8

A. Increasing Prices......................................... 8

B. Increasing Amounts of Crude Oil in Storage................ 12

C. Increased Speculation in Energy Commodities............... 16
1. GIncreased Investments in Energy Commodities........... 16
2. GThe Effect of Speculation on Prices................... 17
3. GLarge Profits from Speculation in Energy Commodities.. 23

IV. NO COP ON THE BEAT FOR OVER-THE-COUNTER ENERGY MARKETS....... 28

A. Development of OTC Electronic Markets..................... 29

B. No Oversight of OTC Electronic Markets.................... 32

C. No Large Trader Reporting in OTC Electronic Markets....... 35

D. No Public Dissemination of Trading Data by OTC Electronic
Markets.................................................... 37

V. THE COP'S BLIND EYE: U.S. ENERGY TRADES ON FOREIGN EXCHANGES.. 40

A. U.S. Energy Commodities Traded on Foreign Exchanges....... 40

B. ICE Futures Trading of U.S. Energy Commodities............ 41

C. Implications for Oversight of U.S. Commodity Markets...... 42

APPENDIX: MEASURING THE INCREASE IN SPECULATIVE TRADING.......... 44

A. CFTC Commitment of Traders Report......................... 44

B. Increased Speculative Trading on the NYMEX................ 45

C. Increased Speculative Trading on ICE...................... 48

THE ROLE OF MARKET SPECULATION IN RISING OIL AND GAS PRICES: A NEED TO
PUT THE COP BACK ON THE BEAT

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I. EXECUTIVE SUMMARY

For the past 5 years, the U.S. Senate Permanent
Subcommittee on Investigations has conducted a number of
investigations into the pricing of energy commodities,
including gasoline, crude oil, and natural gas.¹
These investigations reflect a continuing concern over the
sustained increases in the price and price volatility of these
essential commodities, and, in light of these increases, the
adequacy of governmental oversight of the markets that set
these prices.
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\1\ See, e.g., Minority Staff, U.S. Senate Permanent Subcommittee
on Investigations, U.S. Strategic Petroleum Reserve: Recent Policy Has
Increased Costs to Consumers But Not Overall U.S. Energy Security, S.
Prt. 108-18 (March 5, 2003); Majority Staff, U.S. Senate Permanent
Subcommittee on Investigations, Gas Prices: How Are They Really Set?,
reprinted in Gas Prices: How Are They Really Set, Hearings before the
U.S. Senate Permanent Subcommittee on Investigations (S. Hrg. 107-509)
(April 30 and May 2, 2002), at p. 322; U.S. General Accounting Office,
Effects of Mergers and Market Concentration in the U.S. Petroleum
Industry, Report to the Ranking Minority Member, U.S. Senate Permanent
Subcommittee on Investigations, GAO-04-96 (May 2004); Volatility in the
Natural Gas Market: The Impact of High Natural Gas Prices on American
Consumers, Hearing before the U.S. Senate Permanent Subcommittee on
Investigations (S. Hrg. 109-398) (February 13, 2006).
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Over the past 6 years, crude oil, gasoline, and natural gas
prices have risen significantly. Crude oil has risen from a
range of $25-$30 per barrel in 2000, to a range of $60-$75 per
barrel in 2006. High crude oil prices are a major reason for
the record or near-record highs of the prices of a variety of
petroleum products, including gasoline, heating oil, diesel
fuel, and jet fuel. The average price for a gallon of regular
unleaded gasoline has jumped from $1.46 per gallon in 2000 to
$2.36 per gallon over the past 12 months, with peaks at $3.14
per gallon in September 2005, and $2.93 per gallon in May 2006.
Rising crude oil prices have helped push up natural gas prices
as well: the price of natural gas has risen from $2-$3 per
million BTU (British Thermal Unit) in 2000 to a typical range
of $6-$8 per million BTU during the past year.
The traditional forces of supply and demand cannot fully
account for these increases. While global demand for oil has
been increasing--led by the rapid industrialization of China,
growth in India, and a continued increase in appetite for
refined petroleum products, particularly gasoline, in the
United States--global oil supplies have increased by an even
greater amount. As a result, global inventories have increased
as well. Today, U.S. oil inventories are at an 8-year high, and
OECD oil inventories are at a 20-year high. Accordingly,
factors other than basic supply and demand must be examined.
For example, political instability and hostility to the United
States in key producer countries, such as Nigeria, Venezuela,
Iraq, and Iran, threaten the security and reliability of these
supplies. Furthermore, in each of the past 2 years hurricanes
have disrupted U.S. oil and gas production in the Gulf of
Mexico. As Saudi Arabia has increased its rate of production to
meet increasing demand, its ability to pump additional oil in
the event of a shortfall has declined, thereby providing less
of a cushion in the event of a supply disruption. It is often
asserted that these fears over the adequacy of supply have
built a ``risk premium'' into crude oil prices.²
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\2\ See, e.g., Statement of Daniel Yergin, World Crude Oil Pricing,
Hearing before the U.S. House of Representatives Committee on Energy
and Commerce, May 4, 2006.
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In addition, over the past few years, large financial
institutions, hedge funds, pension funds, and other investment
funds have been pouring billions of dollars into the energy
commodities markets--perhaps as much as $60 billion in the
regulated U.S. oil futures market alone--to try to take
advantage of price changes or to hedge against them. Because
much of this additional investment has come from financial
institutions and investment funds that do not use the commodity
as part of their business, it is defined as ``speculation'' by
the Commodity Futures Trading Commission (CFTC). According to
the CFTC, a speculator ``does not produce or use the commodity,
but risks his or her own capital trading futures in that
commodity in hopes of making a profit on price changes.''
Reports indicate that, in the past couple of years, some
speculators have made tens and perhaps hundreds of millions of
dollars in profits trading in energy commodities. This
speculative trading has occurred both on the regulated New York
Mercantile Exchange (NYMEX) and on the over-the-counter (OTC)
markets.
The large purchases of crude oil futures contracts by
speculators have, in effect, created an additional demand for
oil, driving up the price of oil to be delivered in the future
in the same manner that additional demand for the immediate
delivery of a physical barrel of oil drives up the price on the
spot market. As far as the market is concerned, the demand for
a barrel of oil that results from the purchase of a futures
contract by a speculator is just as real as the demand for a
barrel that results from the purchase of a futures contract by
a refiner or other user of petroleum.
Although it is difficult to quantify the effect of
speculation on prices, there is substantial evidence that the
large amount of speculation in the current market has
significantly increased prices. Several analysts have estimated
that speculative purchases of oil futures have added as much as
$20-$25 per barrel to the current price of crude oil, thereby
pushing up the price of oil from $50 to approximately $70 per
barrel. Additionally, by purchasing large numbers of futures
contracts, and thereby pushing up futures prices to even higher
levels than current prices, speculators have provided a
financial incentive for oil companies to buy even more oil and
place it in storage. A refiner will purchase extra oil today,
even if it costs $70 per barrel, if the futures price is even
higher.
As a result, over the past 2 years, crude oil inventories
have been steadily growing, resulting in U.S. crude oil
inventories that are now higher than at any time in the
previous 8 years. The last time crude oil inventories were this
high, in May 1998--at about 347 million barrels--the price of
crude oil was about $15 per barrel. By contrast, the price of
crude oil is now about $70 per barrel. The large influx of
speculative investment into oil futures has led to a situation
where we have high crude oil prices despite high levels of oil
in inventory.
As former Federal Reserve Chairman Alan Greenspan recently
explained in testimony before the Congress, over the past few
years ``there has been a major upsurge in over-the-counter
trading of oil futures and other commodity derivatives.''
³ Hedge funds and other institutional investors have
accumulated ``substantial net long positions in crude oil
futures, largely in the over-the-counter market.'' ⁴
According to Mr. Greenspan, these futures positions have
created an additional demand for oil for future delivery, and
``with the demand from the investment community, oil prices
have moved up sooner than they would have otherwise.'' Mr.
Greenspan states these price increases have stimulated
additional oil production, a large increase in oil inventories,
and a partial scale-back of consumption.⁵
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\3\ Statement of Alan Greenspan, Oil Depends on Economic Risks,
Hearing before the Committee on Foreign Relations, U.S. Senate, June 7,
2006.
\4\ Id.
\5\ Id.
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In general, speculative trading brings greater liquidity to
the futures market, so that companies seeking to hedge their
exposure to commodity prices can find counterparties willing to
take on those price risks. Speculative purchases of futures
contracts can also, in effect, finance the production and
storage of the underlying commodity to meet future demand. On
the other hand, large speculative buying or selling of futures
contracts can distort the market signals regarding supply and
demand in the physical market or lead to excessive price
volatility, either of which can cause a cascade of consequences
detrimental to the overall economy.
A key responsibility of the CFTC is to ensure that prices
on the futures market reflect the laws of supply and demand
rather than manipulative practices ⁶ or excessive
speculation.⁷ The Commodity Exchange Act (CEA)
states, ``Excessive speculation in any commodity under
contracts of sale of such commodity for future delivery . . .
causing sudden or unreasonable fluctuations or unwarranted
changes in the price of such commodity, is an undue and
unnecessary burden on interstate commerce in such commodity.''
⁸ The CEA directs the CFTC to establish such trading
limits ``as the Commission finds are necessary to diminish,
eliminate, or prevent such burden.'' ⁹
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\6\ 7 U.S.C. Sec. 5(b),
\7\ 7 U.S.C. Sec. 6a(a).
\8\ Id.
\9\ Id.
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At the same time that there has been a huge influx of
speculative dollars in energy commodities, the CFTC's ability
to monitor the nature, extent, and effect of this speculation
has been diminishing. Most significantly, there has been an
explosion of trading of U.S. energy commodities on exchanges
that are not regulated by the CFTC. Available data on the
nature and extent of this speculation is limited, so it is not
possible for anyone, including the CFTC, to make a final
determination about the current level of speculation.
In Irrational Exuberance, which forecasted the collapse of
stock market prices in 2000-2001, Professor Robert Shiller
wrote of the importance of understanding the role of
speculation in setting market prices. ``We need to know
confidently whether the increase that brought us here is indeed
a speculative bubble--an unsustainable increase in prices
brought on by investors'' buying behavior rather than by
genuine, fundamental information about value. In short, we need
to know if the value investors have imputed to the market is
not really there, so that we can readjust our planning and
thinking.'' ¹⁰
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\10\ Robert J. Shiller, Irrational Exuberance (Princeton University
Press, 2000), at p. 5.
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To a certain extent, whether any level of speculation is
``excessive'' lies within the eye of the beholder. In the
absence of data, however, it is impossible to begin the
analysis or engage in an informed debate over whether our
energy markets are functioning properly or are in the midst of
a speculative bubble. Again, Professor Shiller has warned, ``It
is a serious mistake for public figures to acquiesce in the
stock market valuations we have seen recently, to remain silent
about the implications of such high valuations, and to leave
all commentary to the market analysts. . . . The valuation of
the stock market is an important national--indeed international
issue.'' ¹¹ This advice would appear to be as
relevant to the energy markets as to the stock market.
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\11\ Id., at pp. 203-204.
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Until recently, U.S. energy futures were traded exclusively
on regulated exchanges within the United States, like the
NYMEX, which are subject to extensive oversight by the CFTC,
including ongoing monitoring to detect and prevent price
manipulation or fraud. In recent years, however, there has been
a tremendous growth in the trading of contracts that look and
are structured just like futures contracts, but which are
traded on unregulated OTC electronic markets. Because of their
similarity to futures contracts they are often called ``futures
look-alikes.'' The only practical difference between futures
look-alike contracts and futures contracts is that the look-
alikes are traded in unregulated markets whereas futures are
traded on regulated exchanges. The trading of energy
commodities by large firms on OTC electronic exchanges was
exempted from CFTC oversight by a provision inserted at the
behest of Enron and other large energy traders into the
Commodity Futures Modernization Act of 2000 in the waning hours
of the 106th Congress.
The impact on market oversight has been substantial. NYMEX
traders, for example, are required to keep records of all
trades and report large trades to the CFTC. These Large Trader
Reports (LTR), together with daily trading data providing price
and volume information, are the CFTC's primary tools to gauge
the extent of speculation in the markets and to detect,
prevent, and prosecute price manipulation. CFTC Chairman Reuben
Jeffery recently stated: ``The Commission's Large Trader
information system is one of the cornerstones of our
surveillance program and enables detection of concentrated and
coordinated positions that might be used by one or more traders
to attempt manipulation.'' ¹²
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\12\ Letter from Reuben Jeffery III, Chairman, Commodity Futures
Trading Commission, to Michigan Governor Jennifer Granholm, August 22,
2005.
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In contrast to trades conducted on the NYMEX, traders on
unregulated OTC electronic exchanges are not required to keep
records or file Large Trader Reports with the CFTC, and these
trades are exempt from routine CFTC oversight. In contrast to
trades conducted on regulated futures exchanges, there is no
limit on the number of contracts a speculator may hold on an
unregulated OTC electronic exchange, no monitoring of trading
by the exchange itself, and no reporting of the amount of
outstanding contracts (``open interest'') at the end of each
day.
The CFTC's ability to monitor the U.S. energy commodity
markets was further eroded when, in January of this year, the
CFTC permitted the Intercontinental Exchange (ICE), the leading
operator of electronic energy exchanges, to use its trading
terminals in the United States for the trading of U.S. crude
oil futures on the ICE futures exchange in London--called ``ICE
Futures.'' Previously, the ICE Futures exchange in London had
traded only in European energy commodities--Brent crude oil and
United Kingdom natural gas. As a United Kingdom futures market,
the ICE Futures exchange is regulated solely by the United
Kingdom Financial Services Authority. In 1999, the London
exchange obtained the CFTC's permission to install computer
terminals in the United States to permit traders here to trade
European energy commodities through that exchange.
Then, in January of this year, ICE Futures in London began
trading a futures contract for West Texas Intermediate (WTI)
crude oil, a type of crude oil that is produced and delivered
in the United States. ICE Futures also notified the CFTC that
it would be permitting traders in the United States to use ICE
terminals in the United States to trade its new WTI contract on
the ICE Futures London exchange. Beginning in April, ICE
Futures similarly allowed traders in the United States to trade
U.S. gasoline and heating oil futures on the ICE Futures
exchange in London.
Despite the use by U.S. traders of trading terminals within
the United States to trade U.S. oil, gasoline, and heating oil
futures contracts, the CFTC has not asserted any jurisdiction
over the trading of these contracts. Persons within the United
States seeking to trade key U.S. energy commodities--U.S. crude
oil, gasoline, and heating oil futures--now can avoid all U.S.
market oversight or reporting requirements by routing their
trades through the ICE Futures exchange in London instead of
the NYMEX in New York.
As an increasing number of U.S. energy trades occurs on
unregulated, OTC electronic exchanges or through foreign
exchanges, the CFTC's large trading reporting system becomes
less and less accurate, the trading data becomes less and less
useful, and its market oversight program becomes less
comprehensive. The absence of large trader information from the
electronic exchanges makes it more difficult for the CFTC to
monitor speculative activity and to detect and prevent price
manipulation.¹³ The absence of this information not
only obscures the CFTC's view of that portion of the energy
commodity markets, but it also degrades the quality of
information that is reported. A trader may take a position on
an unregulated electronic exchange or on a foreign exchange
that is either in addition to or opposite from the positions
the trader has taken on the NYMEX, and thereby avoid and
distort the large trader reporting system. Not only can the
CFTC be misled by these trading practices, but these trading
practices could render the CFTC weekly publication of energy
market trading data, intended to be used by the public, as
incomplete and misleading.
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\13\ Enron's manipulation of prices on its unregulated electronic
trading platform demonstrates the widespread economic harm that may
result from abuses in unregulated markets. In 2002, for example, the
Federal Energy Regulatory Commission (FERC) found that 174 trades
between Enron and one other party in the last hour of trading in
Enron's electronic market on January 31, 2001, resulted in a steep
increase in the price of natural gas on that date. The report
tentatively concluded that Enron OnLine price data was susceptible to
price manipulation and may have affected not only Enron trades, but
also increased natural gas prices industrywide. See, e.g., August 2002
report prepared by the FERC staff, Docket No. PA-02-000.
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It is critical for U.S. policymakers, analysts, regulators,
investors and the public to understand the true reasons for
skyrocketing energy prices. If price increases are due to
supply and demand imbalances, economic policies can be
developed to encourage investments in new energy sources and
conservation of existing supplies. If price increases are due
to geopolitical factors in producer countries, foreign policies
can be developed to mitigate those factors. If price increases
are due to hurricane damage, investments to protect producing
and refining facilities from natural disasters may become a
priority. To the extent that energy prices are the result of
market manipulation or excessive speculation, only a cop on the
beat with both oversight and enforcement authority will be
effective.
Extending the CFTC's Large Trader Reporting system to
require all U.S. traders of energy futures or futures-like
contracts to keep records and report large trades to the CFTC,
regardless of where the trade takes place--on the NYMEX, on an
unregulated OTC electronic exchange, or on a foreign exchange--
will eliminate the gaps in large trader reporting requirements.
This action is necessary to preserve the CFTC's ability to
oversee energy futures markets in order to detect and prevent
price manipulation and excessive speculation.

II. FINDINGS AND RECOMMENDATIONS

Based upon its investigation into the role of market
speculation in rising oil and gas prices, the Subcommittee
staff makes the following findings and recommendations.

A. Findings

1. Rise in Speculation. Over the past few years speculators
have expended tens of billions of dollars in U.S. energy
commodity markets.

2. Speculation Has Increased Prices. Speculation has
contributed to rising U.S. energy prices, but gaps in available
market data currently impede analysis of the specific amount of
speculation, the commodity trades involved, the markets
affected, and the extent of price impacts.

3. Price-Inventory Relationship Altered. With respect to
crude oil, the influx of speculative dollars appears to have
altered the historical relationship between price and
inventory, leading the current oil market to be characterized
by both large inventories and high prices.

4. Large Trader Reports Essential. CFTC access to daily
reports of large trades of energy commodities is essential to
its ability to detect and deter price manipulation. The CFTC's
ability to detect and deter energy price manipulation is
suffering from critical information gaps, because traders on
OTC electronic exchanges and the London ICE Futures are
currently exempt from CFTC reporting requirements. Large trader
reporting is also essential to analyze the effect of
speculation on energy prices.

5. ICE Impact on Energy Prices. ICE's filings with the
Securities and Exchange Commission and other evidence indicate
that its over-the-counter electronic exchange performs a price
discovery function--and thereby affects U.S. energy prices--in
the cash market for the energy commodities traded on that
exchange.

B. Recommendations

1. Eliminate Enron Loophole. Congress should eliminate the
Enron loophole that currently limits CFTC oversight of key U.S.
energy commodity markets and put the CFTC back on the beat
policing these markets.

2. Require Large Trader Reports. Congress should enact
legislation to provide that persons trading energy futures
``look-alike'' contracts on over-the-counter electronic
exchanges are subject to the CFTC's large trader reporting
requirements.

3. Monitor U.S. Energy Trades on Foreign Exchanges.
Congress should enact legislation to ensure that U.S. persons
trading U.S. energy commodities on foreign exchanges are
subject to the CFTC's large trader reporting requirements.

4. Increase U.S.-U.K. Cooperation. The CFTC should work
with the United Kingdom Financial Services Authority to ensure
it has information about all large trades in U.S. energy
commodities on the ICE Futures exchange in London.

5. Make ICE Determination. The CFTC should immediately
conduct the hearing required by its regulations to examine the
price discovery function of the ICE OTC electronic exchange and
the need for ICE to publish daily trading data as required by
the Commodity Exchange Act.

III. RECENT TRENDS IN ENERGY MARKETS

``There has been no shortage and inventories of crude oil
and products have continued to rise. The increase in prices has
not been driven by supply and demand.''
--Lord Browne, Group Chief Executive of BP
¹⁴
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\14\ Melanie Feisst, ``Joseph was a speculator too,'' Hedge funds
draw on the Bible to defend themselves against accusations that they
have destablised the markets, The Daily Telegraph, U.K., May 6, 2006.

``Senator, the facts are--and I've said this publicly for a
long time--the oil prices have been moving steadily up for the
last 2 years. And I think I have been very clear in saying that
I don't think that the fundamentals of supply and demand--at
least as we have traditionally looked at it--have supported the
price structure that's there.''
--Lee Raymond, Chairman and CEO, ExxonMobil
¹⁵
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\15\ Engergy Pricing and Profits, Joint Hearing before the Senate
Committee on Commerce, Science and Transportation and the Senate
Committee and Energy and Natural Resources, November 9, 2005.
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A. Increasing Prices

In what has become an all-too-familiar refrain over the
past several years, energy prices have recently reached record
highs. Oil prices in the spring of 2006 surpassed the record
highs reached last summer in the days after Hurricane Katrina
rampaged through the Gulf of Mexico and shut down over a
million barrels per day of U.S. oil production. Figure 1 shows
the steep climb and recent record highs in crude oil prices.
[GRAPHIC] [TIFF OMITTED] T8640.001

Figure 1. Since January 2002, crude oil prices have steadily risen;
oil prices reached record high levels in spring of 2006. Prices reflect
spot month NYMEX futures contract prices. Data source: U.S. Department
of Energy, Energy Information Administration (EIA), NYMEX data.

Because gasoline and other petroleum-based energy
commodities are produced by refining crude oil, the rising
price of crude oil has been a major cause of rising gasoline
and petroleum product prices. Figure 2 illustrates how U.S.
gasoline prices have increased in recent years.
[GRAPHIC] [TIFF OMITTED] T8640.002

Figure 2. The average price of gasoline in the United States has
risen from an average of $1.10 cents per gallon in the late 1990s to an
average of over $2.20 per gallon over the past 12 months, and nearly $3
per gallon in the spring of 2006. Prices reflect the weekly average
retail price for all grades of gasoline. Data source: EIA.

Natural gas prices also have jumped higher over the past
several years. Because several industries, such as electric
power generation, can use natural gas as a substitute for crude
oil, and vice versa, natural gas prices are significantly
affected by crude oil prices. Natural gas prices also are
highly correlated with the prices of several petroleum
products, such as diesel fuel and heating oil. Figure 3
illustrates the recent rise in natural gas prices.

[GRAPHIC] [TIFF OMITTED] T8640.003

Figure 3. Natural gas prices have risen from an average of $2 per
million BTU in the late 1990s to a current range of $6-$8 per million
BTU in the spring of 2006. At times, price spikes have doubled the
price of natural gas. Prices reflect spot month NYMEX futures contract
prices. Data source: EIA, NYMEX data.

A number of factors are often cited as contributing to
these increasing prices.¹⁶ Generally, the rising
prices are attributed to an increasingly precarious balance
between supply and demand. Global demand for oil has been
increasing, led by the rapid industrialization of China, growth
in India, and a continued increase in appetite for refined
products, particularly gasoline, in the United
States.¹⁷ Although supplies have been increasing to
keep pace with this increased demand, ¹⁸ these
supplies are perceived to be increasingly vulnerable to
disruption. Political instability and hostility to U.S.
interests in the key producer countries of Iran, Iraq,
Venezuela, ¹⁹ and Nigeria ²⁰ are among
the most frequently cited threats to supplies. Additionally, in
each of the past 2 years hurricanes have disrupted U.S. oil and
gas production in the Gulf of Mexico.²¹ As Saudi
Arabia has increased its rate of production to meet increasing
demand, its ability to pump additional oil in the event of a
shortfall elsewhere has declined, thereby providing less of a
cushion in the event of such a supply disruption.²²
It is often asserted that these and other fears over the
adequacy of supply have built a ``risk premium'' into crude oil
prices.²³
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\16\ See, e.g., U.S. Department of Energy, Energy Information
Administration (EIA), Short-Term Energy Outlook and Summer Fuels
Outlook, April 2006 (2006 Summer Fuels Outlook), at pp. 2-3; Jeffrey H.
Birnbaum and Steven Mufson, Cost of Gas Puts Pressure on GOP, The
Washington Post, April 25, 2006; BBC News, What is driving oil prices
so high?, http://news.bbc.co.uk/go/pr/fr/-/1/hi/business/4922172.stm
(April 20, 2006); Peg Mackey and Janet McBride, Reuters, Oil's top
brass talk prices at summit, Saturday, April 22, 2006, 9:33 a.m.;
Steven Mufson, The Battle Over the Blame for Gas Prices, The Washington
Post, Friday, April 21, 2006, at p. A01.
\17\ See, e.g., Philip K. Verleger, Jr., A Primer on Oil Prices: I,
The Petroleum Economics Monthly, December 2005; International Energy
Agency (IEA), Oil Market Report, May 12, 2006, at p. 3.
\18\ For example, from 2002 through 2005 global demand increased
from 77.8 to 83.6 million barrels per day (bpd), while global supply
increased from 76.9 to 84 million bpd. This represents an increase in
demand of 5.8 million bpd, and an increase in supply of 7.1 million
bpd. As a result, OECD inventories grew by 300,000 bpd in 2003 and
200,000 bpd in 2004 and 2005. Id., at p. 43.
\19\ Monte Reel, Chavez Stokes Confrontation Over U.S. Role in
Venezuela, The Washington Post, July 19, 2005.
\20\ See, e.g., Matt Piotrowski, Nigerian Shut-Ins Fail to
Stimulate Oversupplied US Cash Crude Market, Oil Daily, March 6, 2006.
This spring, however, despite several well-publicized disruptions to
Nigerian supplies, no shortfalls resulted. `` `Physical traders have
taken the Nigerian outage totally in stride,' [one trader] said.
`Without the Nigerian troubles, there would be even more oversupply.'
'' Id.
\21\ Between August 26, 2005 and April 19, 2006, the cumulative
loss of production in the Gulf of Mexico due to Hurricane Katrina was
approximately 149 million barrels, or approximately 1 million barrels
per day (bpd). U.S. Department of Interior Materials and Management
Service (MMS), Hurricane Katrina/Hurricane Rita, Evacuation and
Production Shut-in Statistics Report, Wednesday, April 19, 2006, at
http://www.mms.gov/ooc/press0419.htm. Nearly 90 percent of total Gulf
of Mexico oil production, which normally is about 1.5 million bpd, was
shut down in the first few days after landfall on August 29; nearly 56
percent, or about 840,000 bpd, was still shut-in (i.e., unable to be
produced) on September 15, 2 weeks after landfall. U.S. Department of
Energy, Office of Electricity Delivery and Energy Reliability, Energy
Assurance Daily, September 15, 2005, at pp. 2-3.
In the 6-month period between September 11, 2004 and February 14,
2005, Hurricane Ivan caused a cumulative loss of nearly 44 million
barrels of crude oil production in the Gulf of Mexico, which was
equivalent to about 7.2 percent of the annual production of oil in the
Gulf. MMS, Hurricane Ivan Evacuation and Production Shut-in Statistics
as of Monday, February 14, 2005, Final Report, at http://www.mms.gov/
ooc/press/2005/press0214.htm.
The International Energy Agency (IEA) states that ``random
events,'' such as accidents, labor unrest, ``guerilla activity,''
unplanned maintenance, and weather-related events, including hurricanes
in North America, ``may cause supply losses of between 300 kb/d
[thousand barrels per day] and 400 kb/d for non-OPEC supply each
year.'' IEA, Oil Market Report, May 12, 2006, at p. 14.
\22\ 2006 Summer Fuels Outlook, at p. 3. On the other hand,
government-controlled strategic stocks, including the U.S. Strategic
Petroleum Reserve, are at historically high levels. 2006 Summer Fuels
Outlook, Summer Fuel Charts, at p.3 and at Summer Fuel Charts, p. 9;
IEA, Oil Market Report, March 14, 2006, at p. 59. In the event of a
disruption in supply, these strategic stocks can be just as effective
as using spare production capacity to make up for production
shortfalls. For example, in 2005, the United States released 30 million
barrels of oil from the U.S. Strategic Petroleum Reserve, and other IEA
members released another 30 million barrels to compensate for the loss
of production caused by Hurricanes Katrina and Rita. H. Josef Hebert,
Nations to Release 60M Barrels of Oil, Gas, Associated Press Financial
Wire, September 2, 2005, 10:51 p.m. GMT. In 2003, Saudi Arabia and
other OPEC members increased their production to compensate for the
temporary loss of about 1.7 million barrels per day of Iraq oil due to
the American invasion. David Ivanovich, OPEC strives to prevent world
oil-supply shortage, Houston Chronicle, March 10, 2003; Producers
Expect Minimal War Diruption, Oil Daily, March 19, 2003.
\23\ See, e.g., Daniel Yergin, Testimony Before the U.S. House of
Representatives Committee on Energy and Commerce, May 4, 2006, at
www.cera.com/news (last visited May 22, 2006).
---------------------------------------------------------------------------
These factors, however, do not tell the whole story.
Concurrent with the most recent sustained run-up in energy
prices, large financial institutions, hedge funds, pension
funds, and other investors have been pouring billions of
dollars into the energy commodities markets to try to take
advantage of price changes or hedge against them. Most of this
additional investment has not come from producers or consumers
of these commodities, but from speculators seeking to take
advantage of these price changes. The CFTC defines a speculator
as a person who ``does not produce or use the commodity, but
risks his or her own capital trading futures in that commodity
in hopes of making a profit on price changes.'' ²⁴
Reports indicate that in the past year a few speculators have
made tens and perhaps hundreds of millions of dollars trading
in oil and gas.²⁵
---------------------------------------------------------------------------
\24\ CFTC, The Economic Purpose of Futures Markets, at http://
www.cftc.gov/opa/brochures/opaeconpurp. htm.
\25\ See Section III.C.3 in this report, below.
---------------------------------------------------------------------------
The large purchases of crude oil futures contracts by
speculators have, in effect, created an additional demand for
oil, driving up the price of oil for future delivery in the
same manner that additional demand for contracts for the
delivery of a physical barrel today drives up the price for oil
on the spot market. As far as the market is concerned, the
demand for a barrel of oil that results from the purchase of a
futures contract by a speculator is just as real as the demand
for a barrel that results from the purchase of a futures
contract by a refiner or other user of petroleum.
Although it is difficult to quantify the effect of
speculation on prices, there is substantial evidence supporting
the conclusion that the large amount of speculation in the
current market has significantly increased prices; several
analysts have estimated that speculative purchases of oil
futures have added as much as $20-$25 per barrel to the current
price of crude oil. Additionally, by purchasing large numbers
of futures contracts, and thereby pushing up futures prices to
even higher levels than current prices, speculators have
provided a financial incentive for oil companies to buy even
more oil and place it in storage. A refiner will purchase extra
oil today, even if it costs $70 per barrel, if the futures
price is even higher.
As a result, over the past 2 years, crude oil inventories
have been steadily growing, resulting in U.S. crude oil
inventories that are now higher than at any time in the
previous 8 years. The last time crude oil inventories were this
high, in May 1998--at about 347 million barrels--the price of
crude oil was about $15 per barrel. By contrast, the price of
crude oil today is about $70 per barrel. The large influx of
speculative investment into oil futures has led to a situation
where we have both high supplies of crude oil and high crude
oil prices.
High crude oil prices are a major reason for the record or
near-record highs of the prices of a variety of petroleum
products, including gasoline, heating oil, diesel fuel, and jet
fuel.²⁶ There also is evidence that the skyrocketing
prices of metal commodities can partially be attributed to
these skyrocketing oil prices.²⁷
---------------------------------------------------------------------------
\26\ As explained in two previous reports issued by the
Subcommittee staff, U.S. gasoline prices are also influenced by the
overall gasoline supply and demand balance within the U.S. gasoline
market, which in turn depends on a variety of other factors, including
the profitability of refinery operations, domestic refinery capacity
and availability, the level of imports, competition within the industry
at the national and local level, and fuel specifications resulting from
environmental requirements that affect the fungibility of gasoline
supplies. This year, uncertainty within the market regarding whether
there would be an adequate supply of gasoline blended with ethanol to
replace the supply of gasoline blended with MTBE also contributed to
some of the increases in gasoline prices.
\27\ See, e.g., Falling oil prices would help stem rise in copper
prices: trader, Platts Metals Week, May 19, 2006, at http://
www.platts.com/Metals/highlights/2006/mp--mw--051906.xml (last visited
May 26, 2006).
---------------------------------------------------------------------------

B. Increasing Amounts of Crude Oil in Storage

``What's been happening since 2004 is very high prices
without record-low stocks. The relationship between U.S. [oil]
inventory levels and prices has been shredded, has become
irrelevant.''
--Jan Stuart, Global Oil Economist, UBS Securities
²⁸
---------------------------------------------------------------------------
\28\ Bhusan Bahree and Ann Davis, Oil Settles Above $70 a Barrel,
Despite Inventories at 8-Year High, The Wall Street Journal, April 18,
2006.

Compelling evidence that the oft-cited geopolitical,
economic, and natural factors do not fully explain the recent
rise in energy prices can be seen in the actual data on crude
oil supply and demand. Although demand has significantly
increased over the past few years, so have supplies. As Figure
4 indicates, over the past couple of years global crude oil
production has increased along with the increases in demand; in
fact, during this period global supplies have exceeded
demand.²⁹
---------------------------------------------------------------------------
\29\ 2006 Summer Fuels Outlook, at p. 3.
[GRAPHIC] [TIFF OMITTED] T8640.004

Figure 4. In 2004 and 2005 the supply of crude oil exceeded demand.
---------------------------------------------------------------------------
Data source: EIA, International Petroleum Monthly, March 2006.

Projections for the future indicate that, for the near
term, supply will continue to keep pace with demand. In its
monthly report for March 2006, the International Energy Agency
(IEA), stated, ``Additions to OPEC and non-OPEC capacity are
forecast to keep global supply trends broadly in line with
global demand in 2007 and 2008.'' ³⁰ The U.S.
Department of Energy's Energy Information Administration (EIA)
recently forecast that in the next few years global surplus
production capacity will continue to grow to between 3 and 5
million barrels per day by 2010, thereby ``substantially
thickening the surplus capacity cushion.'' ³¹
---------------------------------------------------------------------------
\30\ IEA, Oil Market Report, March 14, 2006, at p. 3. See also,
2006 Summer Fuels Outlook, at p. 3.
\31\ EIA, Energy Assurance Daily, May 4, 2006. The EIA reported the
current spare capacity to be between 1 and 1.5 million barrels per day
(bpd). Id. The International Energy Agency reports the spare capacity
at 1.7 million bpd. IEA, Oil Market Report, May 12, 2006, at p. 14.
---------------------------------------------------------------------------
Because supplies have been rising along with demand,
commercial crude oil inventories have been rising as well. As
can be seen in Figure 5, the amount of crude oil in U.S.
commercial inventories is higher today than at any other time
in the current decade. The EIA forecasts that U.S. inventories
will increase again in 2006.³²
---------------------------------------------------------------------------
\32\ 2006 Summer Fuels Outlook, at Table 3. In Europe, crude oil in
inventories also were higher in 2005 than in either 2003 or 2004. IEA,
Oil Market Report, March 14, 2006, at p. 29. Not only are the absolute
levels of U.S. and European inventories above average, inventories are
also higher when measured by days-of-supply those inventories could
provide at current consumption levels. Id. In June, the IEA reported
that OECD crude stocks had risen to their highest level in 20 years.
IEA, Oil Market Report Highlights, June 13, 2006.

[GRAPHIC] [TIFF OMITTED] T8640.005

Figure 5. The amount of crude oil in storage in commercial
inventories has risen to higher-than-average levels over the past year.
---------------------------------------------------------------------------
Data source: EIA.

The amount of natural gas in storage also has been
increasing over the past couple of years. From mid-2004 to the
present, except for the period shortly following the landfall
of Hurricane Katrina, the amount of natural gas in storage has
exceeded the previous 5-year average.³³ Yet during
this entire period natural gas prices were higher than the
previous 5-year average. These trends are expected to continue.
Despite a projected increase in the amount of natural gas
available in storage for next winter, the EIA states that
``concerns about potential future supply tightness and
continuing pressure from high oil markets are keeping expected
spot natural gas prices for the next heating season at high
levels.'' ³⁴
---------------------------------------------------------------------------
\33\ EIA, Short-Term Energy Outlook and Summer Fuels Outlook, April
2006, Summer Fuel Charts, at p.11.
\34\ 2006 Summer Fuels Outlook, at Table 3. In mid-May of this
year, however, natural gas spot month futures fell below $6 per million
BTU.
---------------------------------------------------------------------------
Figure 6 shows the relationship between U.S. crude oil
inventories and prices over the past 8 years, and how the
relationship between physical supply and price has
fundamentally changed since 2004. For the period from 1998
through 2003, the chart shows that the price-inventory
relationship generally centered around a line sloping from the
middle-left of the chart down to the lower right, meaning that
low inventories were accompanied by high prices, and high
inventories were accompanied by low prices. For 2004, 2005, and
through May 2006, which is the most recently available data,
the inventory-price relationships fall nowhere near this
downward sloping line; if anything, the points seem to go in
the opposite direction, such that higher inventories seem to be
correlated with higher prices. Figure 6 clearly indicates that
there has been a fundamental change in the oil industry, such
that the previous relationship between price and inventory no
longer applies.

[GRAPHIC] [TIFF OMITTED] T8640.006

Figure 6. Since 2004, crude oil prices have risen as inventories
have risen. Data source: EIA.

As will be discussed in the next section, one reason
underlying this change is the influx of billions of dollars of
speculative investment in the crude oil and natural gas futures
markets. As energy prices have not only increased but become
more volatile, energy commodities have become an attractive
investment for financial institutions, hedge funds, pension
funds, commodity pools, and other large investors. One oil
economist has calculated that over the past few years more than
$60 billion has been spent on oil futures in the NYMEX market
alone.³⁵ As explained below, this frenzy of
speculative buying has created additional demand for oil
futures, thereby pushing up the price of those futures. The
increases in the price of oil futures have provided financial
incentives for companies to buy even more oil and put it into
storage for future use, resulting in high prices despite ample
inventories.³⁶
---------------------------------------------------------------------------
\35\ Philip Verleger, Commodity Investors: A Stabilizing Force?,
The Petroleum Economics Monthly, March 2006.
\36\ Some traders contend that the high inventories have lowered
spot prices. ``The physical market is pretty relaxed,'' one trader said
this spring, as prices rose over $60 per barrel. ``There's been
downward pressure on WTI [West Texas Intermediate] because of
inventories.'' Matt Piotrowski, Nigerian Shut-Ins Fail to Stimulate
Oversupplied US Cash Crude Market, Oil Daily, March 6, 2006. ``What the
high stock levels are doing, along with unsold spot cargoes and storage
capacity constraints, is driving down the spot and front month prices
relative to the outer months. In effect, a chunk of the fear premium is
being taken out of the market.'' Receding Fear Premium, Petroleum
Intelligence Weekly, March 13, 2006.
On the other hand, by creating a financial incentive to purchase
oil for storage, the steep rise in futures prices may also have
stimulated current demand, thereby pushing up current prices. Although
some of this increased demand for oil--for present consumption plus for
future consumption--has been met by increase in supply, any increase in
production necessary to meet this additional demand has come at a time
of low excess global excess production capacity. The recent decline in
global excess production capacity has been one of the major factors
supporting current price levels. See, e.g., Verleger, A Primer on Oil
Prices: I, at p. 22. (``This process of inventory building [due to
speculative purchases of futures contracts] reduces the supply of
certain crudes and products available to the current spot market when
current supply cannot be increased, as has been the case in 2005. This
promotion of inventory holding raises current spot prices.'').
Using the IEA estimate of 1.7 million bpd for OPEC's surplus
production capacity, an amount of oil equivalent to between 10 and 15
percent of OPEC's surplus capacity has been placed into commercial
inventories. It is not apparent why these increases in commercial
inventories, together with the high level of strategic reserves in OECD
countries, including the U.S. Strategic Petroleum Reserve, have not had
a greater effect in alleviating the ``fear premium'' regarding
potential supply disruptions.
---------------------------------------------------------------------------

C. Increased Speculation in Energy Commodities

``Ironically, hedge funds trading oil are not doing
anything very different than the large investment banks such as
Goldman Sachs, Bank of America, or Morgan Stanley already do.
The proprietary trading desks of these and other large
investment banks are actually ``hedge funds in drag,'' just as
Enron was.''
--Peter C. Fusaro and Gary M. Vasey, Hedge Funds Change
Energy Trading ³⁷
---------------------------------------------------------------------------
\37\ International Research Center for Energy and Economic
Development, 2005.
---------------------------------------------------------------------------

1. Increased Investments in Energy Commodities

At the same time energy commodity prices have been
increasing, there has been a large increase in the amount of
money expended on energy commodities futures and other
derivative instruments. ``Volatile energy markets and record-
high commodity prices are prompting renewed interest from
investors eager to play in the sector,'' The New York Times
reported earlier this year. ``That has pushed banks and a
growing number of hedge funds to hire more energy traders and
brainy quantitative minds to back their bets on energy
prices.'' ³⁸ Recent academic research indicating
that commodity futures have performed as well as stocks and
better than bonds, with less risk, also has boosted
expenditures on energy commodity futures.³⁹
---------------------------------------------------------------------------
\38\ Alexei Barrionuevo and Simon Romero, Energy Trading, Without a
Certain ``E'', The New York Times, January 15, 2006.
\39\ Michael R. Sesit, Commodities Enter Investment Mainstream,
Pension Funds, Universities Jump Into the Asset Class; High Returns,
Low Risk, Wall Street Journal, September 9, 2004; Philip Verleger,
Commodity Investors: A Stabilizing Force?, The Petroleum Economics
Monthly, March 2006. The most frequently cited research papers are
Thomas Schneeweis, Georgi Georgiev, The Benefits of Managed Futures,
June 10, 2002; and Gary Gorton and K. Geert Rouwenhorst, Facts and
Fantasies about Commodity Futures, Yale International Center for
Finance, Working Paper No. 04-20, June 14, 2004.
---------------------------------------------------------------------------
Because the over-the-counter energy markets are
unregulated, there are no precise or reliable figures as to the
total dollar value of recent spending on investments in energy
commodities, but the estimates are consistently in the range of
tens of billions of dollars. Last fall, the International
Monetary Fund reported, ``Industry estimates suggest that
approximately $100-$120 billion of new investment in the past 3
years has been in active and passive energy investment
vehicles.'' ⁴⁰ The New York Times cited an estimate
that there were ``at least 450 hedge funds with an estimated
$60 billion in assets focused on energy and the environment,
including 200 devoted exclusively to various energy
strategies.'' ⁴¹
---------------------------------------------------------------------------
\40\ Pelin Berkma, Sam Ouliaris, and Hossein Samiei, The Structure
of the Oil Market and Causes of High Prices, International Monetary
Fund, September 21, 2005.
\41\ Alexei Barrionuevo, Energy Trading, Without a Certain ``E'',
The New York Times, January 15, 2006 (citing Mr. Peter Fusaro of the
Energy Hedge Fund Center).
---------------------------------------------------------------------------
The increased speculative interest in commodities is also
seen in the increasing popularity of commodity index funds,
which are funds whose price is tied to the price of a basket of
various commodity futures. Goldman Sachs estimates that pension
funds and mutual funds have invested a total of approximately
$85 billion in commodity index funds, and that investments in
its own index, the Goldman Sachs Commodity Index (GSCI), has
tripled over the past few years to $55 billion.⁴² In
March of this year, petroleum economist Philip Verleger
calculated that the amount of money invested in commodity index
funds ``jumped from $15 billion in 2003 to $56 billion in 2004
and on to $80 billion today.'' ⁴³
---------------------------------------------------------------------------
\42\ Jad Mouawad and Heather Timmons, Trading Frenzy Adding to Rise
in Price of Oil, The New York Times, April 29, 2006.
\43\ Philip Verleger, Commodity Investors: A Stabilizing Force?,
The Petroleum Economics Monthly, March 2006.
---------------------------------------------------------------------------
With respect to crude oil in particular, Verleger estimates
that, during 2005, $25 billion was ``injected'' into the West
Texas Intermediate (WTI) crude oil futures contract traded on
the NYMEX, mostly coming from pension funds and other managed
money. Verleger states ``another $20 billion or so'' was
invested in NYMEX WTI contracts in the first few months of this
year.⁴⁴ Overall, Verleger estimates that between
July 2004 and mid-March 2006, a total of approximately $60
billion has been invested in the NYMEX WTI
contract.⁴⁵
---------------------------------------------------------------------------
\44\ Philip Verleger, A Primer on Oil Prices II: The Role of
Inventories, The Petroleum Economics Monthly, February 2006, at p. 20.
\45\ Verleger, March 2006.
---------------------------------------------------------------------------
The increase in speculative trading is directly observable
in the CFTC weekly reports on trading activity in the CFTC-
regulated futures markets. Over the past 2 years, the CFTC data
shows more than a doubling in the ``open interest'' in both
crude oil and natural gas contracts--essentially the number of
outstanding futures contracts at the end of a trading
day.⁴⁶ The CFTC data indicates that much of the
increase is due to ``non-commercial'' trading--namely, trading
by speculators.⁴⁷
---------------------------------------------------------------------------
\46\ See the Appendix to this Report for a more detailed discussion
of open interest.
\47\ See the Appendix to this Report for a more detailed discussion
of this CFTC data.
---------------------------------------------------------------------------

2. The Effect of Speculation on Prices

``There is little doubt that Katrina only exacerbated a
troubling trend in energy prices that already seemed to ignore
basic fundamental drivers to thrive instead on hype.''
--A futures trader, September 2005.⁴⁸
---------------------------------------------------------------------------
\48\ Behind Runaway Prices: Supply Issues are Real, But Hype Sets
Bar, Natural Gas Week, September 5, 2005.
---------------------------------------------------------------------------
One of the benefits of speculative trading is that it
brings needed liquidity to the futures market so that companies
seeking to hedge their exposure to commodity prices can find
counterparties willing to take on those price risks. Also, as
previously discussed, speculation can help finance the build-up
of inventories when prices are expected to increase. On the
other hand, large speculative buying or selling of futures
contracts can distort the price signals influencing supply and
demand in the physical market or lead to excessive price
volatility, either of which can cause a cascade of consequences
detrimental to the supply and price of the commodity and the
overall economy.
A key responsibility of the CFTC is to ensure that prices
on the futures market reflect the laws of supply and demand
rather than manipulative practices ⁴⁹ or excessive
speculation.⁵⁰ The Commodity Exchange Act (CEA)
states, ``Excessive speculation in any commodity under
contracts of sale of such commodity for future delivery . . .
causing sudden or unreasonable fluctuations or unwarranted
changes in the price of such commodity, is an undue and
unnecessary burden on interstate commerce in such commodity.''
⁵¹ The CEA directs the CFTC to establish such
trading limits ``as the Commission finds are necessary to
diminish, eliminate, or prevent such burden.'' ⁵²
---------------------------------------------------------------------------
\49\ 7 U.S.C. Sec. 5(b),
\50\ 7 U.S.C. Sec. 6a(a).
\51\ Id.
\52\ Id.
---------------------------------------------------------------------------
A number of energy industry participants and analysts have
noted the divergence between the ample supplies of crude oil
and natural gas, and record-high prices for those commodities,
and have attributed some of this disconnect to the presence of
speculators in the market. ``Gold prices don't go up just
because jewelers need more gold, they go up because gold is an
investment,'' one consultant said. ``The same has happened to
oil.'' ⁵³
---------------------------------------------------------------------------
\53\ Jad Mouawad and Heather Timmons, Trading Frenzy Adding to Rise
in Price of Oil, The New York Times, April 29, 2006 (quoting Roger
Diwan, partner, PFC Energy).
---------------------------------------------------------------------------
``The answer to the puzzle posed by rising prices and
inventories, industry analysts say, lies not only in supply
constraints such as the war in Iraq and civil unrest in Nigeria
and the broad upswing in demand caused by industrialization of
China and India. Increasingly, they say, prices also are being
guided by a continuing rush of investor funds in commodities
investments.'' ⁵⁴ Another gas trader said: ``It's
all about futures speculators shooting for irrational price
objectives, as well as trying to out-think other players--sort
of like a twisted game of chess.'' ``[T]he basic facts are
clear,'' he added, ``this market is purely and simply being
controlled by over-speculation.'' ⁵⁵ Tim Evans,
senior analyst at IFR Energy Services, stated, ``What you have
on the financial side is a bunch of money being thrown at the
energy futures market. It's just pulling in more and more cash.
That's the side of the market where we have runaway demand, not
on the physical side.'' ⁵⁶
---------------------------------------------------------------------------
\54\ Bhusan Bahree and Ann Davis, Oil Settles Above $70 a Barrel,
Despite Inventories at 8-Year High, The Wall Street Journal, April 18,
2006.
\55\ Behind Runaway Prices: Supply Issues are Real, But Hype Sets
Bar, Natural Gas Week, September 5, 2005.
\56\ Oil: A Bubble, not a Spike? BusinessWeek online, April 27,
2005.
---------------------------------------------------------------------------
Some traders charge that certain hedge fund managers have
purposefully contributed to a misperception that there is a
shortage of supply. ``There's a few hedge fund managers out
there who are masters at knowing how to exploit the peak
theories [that the world is running out of oil] and hot buttons
of supply and demand, (and) by making bold predictions of
shocking price advancements to come (they) only add more fuel
to the bullish fire in a sort of self-fulfilling prophecy.''
⁵⁷
---------------------------------------------------------------------------
\57\ Natural Gas Week, September 5, 2005.
---------------------------------------------------------------------------
Several analysts have estimated that the influx of
speculative money has tacked on anywhere from about $7 to about
$30 per barrel to the price of crude oil.⁵⁸ Even
OPEC officials are concerned that a shift in the market from
high futures prices relative to current prices, to lower
futures prices relative to current prices (i.e. from contango
to backwardation) could precipitate a ``quick drop of $20 a
barrel or more.'' ⁵⁹ Noting that ``fundamentals are
in balance and stock levels are comfortable,'' the president of
the OPEC cartel, Edmund Daukoru, recently attributed the
current price levels to ``refinery tightness, geopolitical
developments and speculative activity.'' ⁶⁰ Other
traders have pointed out the possibility of a sharp drop in
price. ``At some point, this oversupplied market has to begin
to break down this house of cards which is dominated by
speculative entities,'' one futures trader noted, ``and when
those entities decide to start liquidating their futures
positions in crude and gas, look out below.'' ⁶¹
---------------------------------------------------------------------------
\58\ See, e.g., Jad Mouawad and Heather Timmons, Trading Frenzy
Adding to Rise in Price of Oil, The New York Times, April 29, 2006
(``by some estimates 10 percent to 20 percent'' of current prices);
Goldman Sachs, Natural Gas Weekly, December 10, 2004 ($7 per barrel in
spring, 2004); John M. Berry, Speculation plays a role in high oil
prices, Alexander's Gas & Oil Connections, August 17, 2005 (`` `Current
US oil inventory levels suggest WTI crude prices should be around $25 a
barrel,' [oil analyst Mike Rothman of International Strategy and
Investment] calculated. `Given underlying issues and concerns about
OPEC capacity and demand growth, we certainly are not prepared to argue
that the price spread between the $25 model value and near $60 actual
is all speculation, but we do feel that a portion is.' ''); Oil
Pricing: Don't Underestimate the Fear Factor, BusinessWeek online,
March 13, 2006 (Sarah Emerson, director of petroleum market analysis
and research at Energy Security Analysis estimates an additional $15
per barrel is due to ``fear;'' Tim Evans, senior energy analyst for IFR
Markets, estimates $25-$30 per barrel.).
\59\ Bhusan Bahree and Ann Davis, Oil Settles Above $70 a Barrel,
Despite Inventories at 8-Year High, The Wall Street Journal, April 18,
2006.
\60\ Platts, OPEC has no option but to maintain output at current
prices: Libya, June 15, 2006. Similarly, Saudi Arabian Oil Minister Ali
Naimi has stated, ``World oil supply is currently exceeding demand, and
there is no lack of spare capacity.'' Kate Dourian, Naimi says
producers can't be assured robust demand will continue, Platts Oilgram
News, May 16, 2006. U.S. Energy Secretary Samuel Bodman agreed with
Minister Naimi's assessment: ``[Secretary] Bodman, meeting with
reporters after a speech at an electricity forum, suggested that there
seems to be plenty of oil available.'' H. Josef Hebert, Energy
secretary says U.S. can weather Iranian oil disruption, Associated
Press Worldstream, June 6, 2006.
\61\ Bears Predict Bullish Crude, Gas Bubble to Burst Sooner Than
Later, Natural Gas Week, June 27, 2005.
---------------------------------------------------------------------------
Generally, economists struggle to quantify the effect of
speculators on market prices. Part of the difficulty is due to
the absence of specific data about the strategies of particular
traders or classes of traders. The CFTC's weekly Commitment of
Trader Reports are not specific or precise enough to provide
the basis for rigorous quantitative analysis, ⁶² and
commodity traders are, as a rule, reluctant to distribute their
data for such purposes. Another difficulty is separating cause
from effect: are high prices caused by an increase in
speculation, or do more speculators enter the market when
prices become more volatile because that is when the profit
opportunities arise?
---------------------------------------------------------------------------
\62\ See the Appendix for an explanation of these reports.
---------------------------------------------------------------------------
Several recent analyses have concluded that speculation has
significantly increased energy prices; others have concluded
otherwise.

Former Federal Reserve Chairman Alan Greenspan. In
testimony before the Senate Committee on Foreign Relations,
former Chairman Greenspan stated that, in the last couple of
years, ``increasing numbers of hedge funds and other
institutional investors began bidding for oil [and] accumulated
it in substantial net long positions in crude oil futures,
largely in the over-the-counter market. These net long futures
contracts, in effect, constituted a bet that oil prices would
rise.'' ⁶³ The former Chairman observed that these
purchases of oil futures have had a cascade of effects on
prices, production, inventories, and consumption:
---------------------------------------------------------------------------
\63\ Statement of Alan Greenspan Oil Depends on Economic Risks,
Hearing before the Senate Committee on Foreign Relations, June 7, 2006.

With the demand from the investment community, oil
prices have moved up sooner than they would have
otherwise. In addition, there has been a large increase
in oil inventories. In response to higher prices,
producers have increased production dramatically and
some consumption has been scaled back. Even though
crude oil productive capacity is still inadequate, it,
too, has risen significantly over the past 2 years in
response to price.⁶⁴
---------------------------------------------------------------------------
\64\ Id.

Citgroup. In a May 5, 2006 report on prices of U.S.
commodities, Citigroup reported that the monthly average value
of speculative positions held in all U.S. commodity markets
rose to over $120 billion, just under the record of $128
billion set the previous October. Of the 36 agricultural,
energy, and metal commodities analyzed, Citigroup found the
largest speculative positions were in natural gas ($30.3
billion) and crude oil ($30.1 billion), followed by gold ($13.3
billion). The report stated, ``We believe the hike in
speculative positions has been a key driver for the latest
---------------------------------------------------------------------------
surge in commodity prices.''

Goldman Sachs. In a report on the natural gas markets
issued in late 2004, Goldman Sachs determined that the rising
natural gas prices--which were then near $7 per million BTU--
were ``rooted in tightening fundamentals.'' ⁶⁵
Goldman Sachs also stated, ``Our analysis indicates that
speculative money does have some impact on natural gas prices
and the shape of the forward curve.'' Goldman Sachs reported
that the net-speculative positions had depressed the next-month
natural gas futures contract price by $0.28 per million BTU in
early December 2004, but the previous spring it had increased
the ``prompt'' NYMEX natural gas futures contract (i.e., the
futures contract that is next to expire) by $0.60 per million
BTU--an increase of slightly greater than 10 percent.
---------------------------------------------------------------------------
\65\ Goldman Sachs, Natural Gas Weekly, December 10, 2004.
---------------------------------------------------------------------------
The Goldman Sachs report also noted that natural gas prices
were directly affected by crude oil prices, and ``we believe
that speculators also impact the price of crude oil and
petroleum products, with the impact of speculators peaking at
roughly $7 [per barrel] in the spring of 2004.'' At that time,
crude oil prices ranged from $35-$40 per barrel; hence,
according to the Goldman Sachs analysis, speculators at that
time were boosting the price of oil by about 20 percent.
``Unlike natural gas,'' Goldman Sachs wrote, ``we estimate that
the impact of speculators on oil prices is roughly equivalent
in magnitude to the impact of shifts in supply and demand
fundamentals (as reflected in stocks).'' In other words, shifts
in speculative positions could affect crude oil to the same
degree as actual changes in the supply of or demand for crude
oil.

Philip Verleger: A New Era for Energy. In a series of
analyses in his publication, The Petroleum Economics Monthly,
Philip Verleger contends that the recent increase in
speculative activity has altered the nature of the crude oil
markets and boosted futures prices. Verleger believes that the
recent infusion of tens of billions of dollars from pension
funds, speculators, and other investors into crude oil and
natural gas futures markets has ushered in a ``new era'' for
energy producers and refiners. ``The current new era is marked
by the entry of long-term investors, who have pushed forward
crude prices to record levels,'' Verleger writes. ``Consumers,
no doubt, will have another term for it.'' ⁶⁶ During
this era ``prices will likely be quite high for several
years,'' but ``will be followed by a period of very low
prices.'' ⁶⁷
---------------------------------------------------------------------------
\66\ Philip K. Verleger, Jr., The Petroleum Economics Monthly, July
2005, at p. 1.
\67\ Id., at p. 2.
---------------------------------------------------------------------------
A key indicator of this new era, according to Verleger, is
the emergence of a `` `disconnect' between the cash price
behavior and the fundamentals, as measured by supply-and-demand
balances or stocks.'' ⁶⁸ The reason for this
divergence, in Verleger's analysis, is that purchases of long-
term crude oil futures contracts have pushed up the longer-term
futures prices by so much that it is more profitable for oil
companies to store the oil and then sell it at a later date
than sell it today, even at record-high spot prices. Even if
oil is at $70 per barrel today, suppliers will hold their
inventories if they can sell it for $75 for delivery a year
from now.
---------------------------------------------------------------------------
\68\ Id., at p. 10.
---------------------------------------------------------------------------
Since 2001 there has been a dramatic growth in the open
interest in very long-term futures contracts (30 months or
longer). At the end of July 2001, there was an open interest of
19,624 in very long-term contracts, representing about 4.5
percent of all open interest; at the end of July 2005, there
was an open interest of 125,546 in very long-term contracts,
representing about 15 percent of all open interest. According
to Verleger, nearly all of the buying of these very long-term
crude oil futures contracts reflects speculative buying, since
commercial firms typically don't enter into contracts for
delivery so far into the future, and therefore have no need to
use such long-term futures contracts for hedging
purposes.⁶⁹
---------------------------------------------------------------------------
\69\ Id., at p. 12.
---------------------------------------------------------------------------
``In summary,'' Verleger writes, ``increased purchases of
long-dated crude lift the forward price curve. The rise in
prices is reflected back to contracts maturing in a few
months.'' ⁷⁰ Quantitatively, ``the impact of
increasing stocks has been overwhelmed by the strong demand for
forward crude, which has added as much as $24 per barrel to
prices.'' ⁷¹
---------------------------------------------------------------------------
\70\ Id., at p. 15.

\71\ Id., at p. 19.
---------------------------------------------------------------------------
CFTC staff study. In contrast to the studies that have
found a relationship between speculative activity and price, a
CFTC staff study released in April 2005 found, in general, ``no
evidence of a link between price changes and MMT [managed money
trader] positions'' in the natural gas markets and ``a
significantly negative relationship between MMT positions and
price changes (conditional on other participants trading) in
the crude oil market.'' ⁷² The CFTC staff found,
generally, that these managed money funds tended to follow what
the commercial participants in the market were doing, and
tended to trade less frequently than commercial traders.
---------------------------------------------------------------------------
\72\ Michael S. Haigh, Jana Hranaiova and James A. Overdahl, Office
of the Chief Economist, U.S. Commodity Futures Trading Commission,
Price Dynamics, Price Discovery and Large Futures Trader Interactions
in the Energy Complex, Working Paper, First Draft: April 28, 2005.

NYMEX study. A second study that found no relationship
between hedge fund activity and volatility was conducted by the
NYMEX. Overall, the NYMEX found that during 2004, ``hedge fund
trading activity comprised a modest share of trading volume in
both crude oil and natural gas futures markets,'' and comprised
``a relatively modest share of open interest.'' It also found
that hedge fund participation during this period tended to
decrease volatility. ``In short,'' the NYMEX stated, ``it
appears that Hedge Funds have been unfairly maligned by certain
quarters who are seeking simple answers to the problem of
substantial price volatility in energy markets, simple answers
that are not supported by the available evidence.''
⁷³
---------------------------------------------------------------------------
\73\ New York Mercantile Exchange, A Review of Recent Hedge Fund
Participation in NYMEX Natural Gas and Crude Oil Futures Markets, March
1, 2005.
---------------------------------------------------------------------------
A number of industry participants have expressed skepticism
about the accuracy of the NYMEX and CFTC analyses. Neither the
NYMEX study nor the CFTC study addressed the effects of hedge
fund and other speculative investments on the price of longer-
term futures contracts. Rather, both the CFTC study and the
NYMEX focused on the near-term effects of trading by hedge
funds, particularly with respect to volatility. ``[D]espite
those [NYMEX and CFTC] reports,'' one trade publication
reported, ``a majority of industry professionals still contend
that there are too many large speculative entities actively
engaged in the market--with fund accounts taking on massive
equity positions in the commodities.'' ⁷⁴ Another
article reported that many traders have ``scoffed'' at these
two studies, ``saying that they focused only on certain months,
missing price run-ups.'' ⁷⁵
---------------------------------------------------------------------------
\74\ Bears Predict Bullish Crude, Gas Bubble to Burst Sooner Than
Later, Natural Gas Week, June 27, 2005. See, e.g., Oil Market Control
Passes From OPEC to Speculators, Jet Fuel Intelligence, August 29, 2005
(`` `The amount of paper barrels being traded is extraordinary and this
has had an extraordinary effect on prices,' said one industry
veteran.''); Commodity Strategists: Oil to Fall, Toronto Bank Says,
Bloomberg.com, April 25, 2005 (the speculative rally has ``
`decoupled'' prices from the reality of supply and demand.'') .
\75\ Alexei Barrionuevo, Energy Trading, Without a Certain ``E'',
The New York Times, January 15, 2006.
---------------------------------------------------------------------------
In sum, while industry and regulatory economists and
analysts do not agree on the extent to which market speculation
has affected energy prices, it is beyond dispute that
speculation has increased. CFTC data as well as numerous
industry reports indicate that speculators have injected tens
of billions of dollars into the energy commodities markets.
Although the absence of data makes it impossible to precisely
quantify the effect of these speculative investments on prices,
it appears from the CFTC data, market data, and the comments of
a number of well-respected analysts that this increased
speculation has fundamentally altered the relationship between
crude oil inventories and prices. The purchase of long-term
futures by speculators has provided a financial incentive for
oil purchasers to build inventories and store oil for future
use; this has resulted in a market characterized both by large
amounts of oil in inventory and high prices.
Whether the current level of speculation has provided
needed liquidity, encouraged the building of inventories, or
created a speculative bubble in energy prices is impossible to
determine without additional data. It is clear that better
tools are needed to understand how much is being spent, by
whom, in which markets and instruments, and the effect of
increasing speculation on the price and affordability of energy
in the United States.
The importance of understanding the effect of speculation
on market prices cannot be understated. Professor Robert
Shiller, in his prescient book Irrational Exuberance, which
warned that the U.S. stock market was in the midst of a
speculative bubble just prior to the price collapse of 2000-
2001, wrote as follows:

The extraordinary recent levels of U.S. stock prices,
and associated expectations that these levels will be
sustained or surpassed in the near future, present some
important questions. We need to know whether the
current period of high stock market pricing is like the
other historical periods of high pricing, that is,
whether it will be followed by poor or negative
performance in coming years. We need to know
confidently whether the increase that brought us here
is indeed a speculative bubble--an unsustainable
increase in prices brought on by investors' buying
behavior rather than by genuine, fundamental
information about value. In short, we need to know if
the value investors have imputed to the market is not
really there, so that we can readjust our planning and
thinking.⁷⁶
---------------------------------------------------------------------------
\76\ Robert J. Shiller, Irrational Exuberance (Princeton University
Press, 2000), at p. 5.

In light of the vital importance of energy to our national
economy and security, the need to better understand the role of
speculation in price formation is just as important for the
energy market as for the stock market.

3. Large Profits from Speculation in Energy Commodities

Accurate information about the profits and losses of market
participants is difficult to obtain. Nonetheless, reports
indicate that a number of firms, funds, and traders have reaped
enormous profits from the recent increases in energy prices,
energy price volatility, and trading volume. These large
profits provide an indication of one of the incentives for
speculation in today's energy commodity markets.
For example, it has been reported that in 2004, Goldman
Sachs and Morgan Stanley, the two leading energy trading firms
in the United States, earned a total of about $2.6 billion in
net revenues from commodities trading, mostly from energy
commodities.⁷⁷ For 2005, Goldman Sachs and Morgan
Stanley each reportedly earned about $1.5 billion in net
revenue from energy transactions.⁷⁸
---------------------------------------------------------------------------
\77\ Alexei Barrionuevo, Energy Trading, Without a Certain ``E'',
The New York Times, January 15, 2006.
\78\ Wall Street firms reshape power trading, add liquidity in
physical and paper markets, Platts Power Markets Week, January 16,
2006; See also, Ann Davis, Morgan Stanley trades energy in barrels,
Pittsburgh post-gazette.com, March 3, 2005.
---------------------------------------------------------------------------
A recent article in Trader Monthly magazine included short
profiles of the ``100 Highest Earning Traders'' for 2005, as
ranked by the magazine. Overall, Trader Monthly reported, ``On
Wall Street, some of the scores were gargantuan, as bulge-
bracket banks enjoyed one of the most profitable years in the
history of the markets, from asset-backed to credit and crude
to crack spreads.'' ⁷⁹ Although the rankings are
based on estimates and anecdotal information, and the article
does not explain how the profiled traders generated their
income, it nonetheless provides some information regarding the
magnitude of some of the earnings of leading energy commodity
traders in 2005.⁸⁰ The Trader Monthly rankings group
these traders into several categories: hedge fund managers,
Wall Street Traders, and ``the rest,'' which includes traders
working for brokerage firms that own seats on the NYMEX.
---------------------------------------------------------------------------
\79\ Rich Blake and Andrew Barber with Robert LaFranco, The Trader
Monthly 100; Earn, Baby, Earn, Trader Monthly, April/May 2006
(hereinafter cited as ``The Trader Monthly 100''), at p. 69.
\80\ The Subcommittee staff has not verified the information
contained in the Trader Monthly article.
---------------------------------------------------------------------------
At the top of the Trader Monthly list, T. Boone Pickens was
reported to have earned between $1 and $1.5 billion in energy
trading in 2005. The magazine reports that Mr. Pickens' main
commodities fund earned a return of approximately 700 percent
in 2005, which it ``believes is the largest one-year sum ever
earned.'' ⁸¹ Another hedge fund magazine, Alpha,
estimated that Mr. Pickens' trading strategies earned $1.4
billion in 2005, largely due to his bets on crude
oil.⁸²
---------------------------------------------------------------------------
\81\ The Trader Monthly 100,, at p. 71.
\82\ Stephen Taub, Really Big Bucks, Alpha, May 2006, at p. 19. Mr.
Pickens ranked second on the Alpha list. Mr. James Simons, who Trader
Monthly ranked third with an estimated $900 million-$1 billion in
earnings, was ranked first by Alpha, with an estimated $1.5 billion in
earnings. The two rankings identify many of the same individuals as the
top hedge fund traders, although the estimates of earnings vary by
significant amounts--hundreds of millions of dollars in some instances.
The Alpha rankings only list the top 25 traders; with the exception of
Mr. Pickens, the energy traders identified in the Trader Monthly
rankings did not earn enough to qualify for this list. See also
Alistair Barr, Hedge-fund giants Simon, Pickens made more than $1 bln
in 2005, MarketWatch, May 26, 2006, at http://www.marketwatch.com (last
visited May 26, 2006).
---------------------------------------------------------------------------
Following an interview with Mr. Pickens, the Associated
Press reported, ``Oil tycoon Boone Pickens' bet that energy
prices would rise made him more money in the past 5 years than
he earned in the preceding half century hunting for riches in
petroleum deposits and companies.'' ⁸³ During this
interview, which occurred in mid-2005, when the price of oil
was approaching a then-record $60 per barrel, Mr. Pickens
stated, ``I can't tell for sure where [prices are] going, other
than up.'' ⁸⁴ Mr. Pickens' success in predicting
price increases may have even created its own momentum for
further price increases--according to Natural Gas Week, ``[Mr.
Pickens] regularly talks up crude oil and natural gas prices on
financial market cable TV. Traders and futures brokers report
that each time this happens, more speculative interest is drawn
to energy futures markets.'' ⁸⁵
---------------------------------------------------------------------------
\83\ Brad Foss, AP Interview; Riding high on oil prices, Boone
Pickens sees prices going even higher, Associated Press, June 22, 2005.
\84\ Id. It was long before this 2005 interview, however, that Mr.
Pickens began betting that the price of oil would rise, based on a
belief that the rapid increase in demand had used up all of the global
spare production capacity. In May 2004, for example, when oil was
trading at about $40 per barrel, and most analysts were predicting
prices would fall, Mr. Pickens publicly predicted prices would keep
increasing: ``I think you'll see $50 before you see $30 again.''
Darrell Preston, Bloomberg News, T. Boone is Back; The Corporate Raider
Who Brought Down Gulf Oil is Cashing in on Oil Price Spike, Pittsburgh
Post-Gazette, October 10, 2004. Opinions vary as to the reason Mr.
Pickens has been so successful recently. ``He understands the industry
and business like no one else,'' commented billionaire Harold Simmons,
one of the original investors in Mr. Pickens' hedge funds. Id. On the
other hand, Peter Fusaro, chairman of Global Change Associates, a
consulting firm, commented, ``He just got lucky.'' Id.
\85\ Behind Runaway Prices: Supply Issues are Real, But Hype Sets
Bar, Natural Gas Week, September 5, 2005.
---------------------------------------------------------------------------
Also at the top of the list of energy traders is John
Arnold, a former Enron trader who left Enron in 2002 to start
his own hedge fund, Centaurus Energy, with three employees and
$8 million of his own money.⁸⁶ As of January of this
year, Centaurus employed 36 people and had about $1.5 billion
in assets.⁸⁷ At a recent energy conference, Mr.
Arnold said he ``looks to place bets on a market that he
determines is `biased,' '' meaning that the market is not
reflecting the fair value for a product.⁸⁸ ``We ask
ourselves can we identify what is forcing a market to price a
product at an unfair value, and then, what will push it back to
fair value.'' ⁸⁹ Mr. Arnold also stated how a
significant amount of speculative trading was taking place on
the unregulated over-the-counter Intercontinental Exchange
(ICE). `` `Trading never went away,' Arnold said, `What has
changed is the non-commercial type of interest.'
Intercontinental Exchange, he said, has provided huge new
opportunities, as has NYMEX's Clearport trading. `Because of
this, there has never been as much investor interest . . . as
there is today.' '' ⁹⁰
---------------------------------------------------------------------------
\86\ See Barrionuevo, Energy Trading, Without a Certain ``E'', The
New York Times, January 15 2006.
\87\ Id.; See also, Peter Elkind, Bethany McLean, The Luckiest
People in Houston, Fortune, April 17, 2006. Among those now working for
Mr. Arnold is Greg Whalley, who, as head of wholesale trading at Enron,
once was Mr. Arnold's boss. In August 2001, following the resignation
of Jeffrey Skilling, Mr. Whalley was appointed Enron's president. Id.
\88\ Two former Enron trading experts share dais and ideas on
energy market evolution, Platts Power Markets Week, February 13, 2006.
\89\ Id.
\90\ Id.
---------------------------------------------------------------------------
Table 1 lists the traders who Trader Monthly reported to
have obtained a significant portion of their profits from
trading energy commodities. Inclusion on this list is not meant
to imply that any of the traders derived their profits from any
improper trading activity.

Table 1
Selected Top Energy Traders in 2005
------------------------------------------------------------------------
Firm Type of 2005 Estimated
Trader Trader Earnings Trader Monthly Comments
------------------------------------------------------------------------
T. Boone BP Capital $1.5 billion + `` `Long Crude' doesn't
Pickens (hedge fund) even begin to describe
T. Boone Pickens'
position. With $5
billion and growing in
assets under management,
his fund company, BP
Capital, is throwing off
a small national economy
via an unshakable bet
that the world's oil
supply can't keep up
with demand. . . .
Returns on Pickens' main
commodities pool were
over 700 percent in
2005. . . . [This]
translates into what
Trader Monthly believes
is the largest one-year
sum ever earned. . . .''
------------------------------------------------------------------------
Brian Hunter Amaranth $75-$100 ``In 2005, Hunter was
Advisors million certainly among the top
(hedge fund) natural gas traders in
the world. . . . Rumor
is that Hunter made
Amaranth an estimated
$800 million off his
book, mainly [natural]
gas derivatives
positions but also some
other energy
dabblings.''
------------------------------------------------------------------------
John Arnold Centaurus $75-$100 ``Starting 4 years ago
Energy million with $8 million of his
(hedge fund) own dough, John D.
Arnold, former star
Enron energy trader, has
since amassed more than
$1 billion in assets.
Most of the 16 other
traders at his Centaurus
Energy fund operation
came from Enron.''
------------------------------------------------------------------------
Jim Pulaski Tudor $50-$75 ``[T]his Tudor energy
Investment million trader is commander in
(hedge fund) chief when it comes to
natural gas.''
------------------------------------------------------------------------
Steven Berkson Trader $25-$30 ``Readers of Trader
(NYMEX) million Monthly will remember
the legend of natural-
gas-futures stalwart
Steve Berkson and
Hurricane Katrina. One
of the tallest versions
of the tale has Berkson
making $40 million off
the opening bell the day
Katrina made landfall
(we heard he ended up
tallying around $20
million for the week).
Lesser known is how much
of that score Berky
ultimately slid to
relief efforts
(reportedly a sizable
portion).''
------------------------------------------------------------------------
Mark Fisher MBF Clearing $25-$30 ``Few people have more at
operator million stake in the future of
(NYMEX) the NYMEX than Fisher,
who runs MBF Clearing,
the primary market-
making operation for the
exchange's top-grossing
crude-oil futures
contract.''
------------------------------------------------------------------------
Simon Morgan $20-$25 ``Morgan Stanley's head
Greenshields Stanley million of gas and power,
Greenshields is part of
the bank's elite energy
crew. His specialties
are natural gas and
electricity. . . .''
------------------------------------------------------------------------
Olav Refvik Morgan $20-$25 ``Refvik is a key part of
Stanley million one of the most
profitable energy-
trading operations in
the world. He has helped
the bank dominate the
heating oil market by
locking up New Jersey
storage-tank farms
adjacent to New York
Harbor. . . .''
------------------------------------------------------------------------
John Shapiro Morgan $20-$25 ``Shapiro has been a
Stanley million vital part of Morgan's
energy effort, working
[to help] oversee the
200-plus-person profit
center.''
------------------------------------------------------------------------
John Bertuzzi Goldman Sachs $15-$20 ``A star trader on one of
million the most powerful energy
desks on earth. . . .''
------------------------------------------------------------------------
George J.P. Morgan $15-$20 ``[Taylor] . . . switched
``Beau'' million over to J.P. Morgan,
Taylor where he now helps
oversee the firm's 80-
person energy-trading
unit.''
------------------------------------------------------------------------
Jeffrey Trader $15-$20 ``Crude oil traders don't
Wolfson (NYMEX) million come much bigger than
the man whose badge
reads GEOF. A one-man
volume-generation
machine. . . .''
------------------------------------------------------------------------
Vincent Citigroup $10-$15 ``Kaminski is a revered
Kaminski million energy trader considered
among the foremost
authorities on measuring
and analyzing market
risk. . . .''
------------------------------------------------------------------------
Todd Applebaum Trader $10-$15 ``Applebaum is another
(NYMEX) million natural gas guy who lit
it up in 2005. `Great
trader, huge volume,'
says one NYMEX
insider.''
------------------------------------------------------------------------
Eric Bolling Trader $10-$15 ``Among the most famous
(NYMEX) million natural gas traders on
the floor today . . .
[Bolling] is said to
account for as much as 5
percent of total volume
in [natural gas]. . .
.''
------------------------------------------------------------------------
Sandy Goldfarb Trader $10-$15 ``. . . [Goldfarb]
(NYMEX) million knocked his [natural
gas] book out of the
ozone layer last year
amid one hurricane after
another and some of the
most treacherous
volatility ever recorded
in the decade and a half
since natural gas
futures were created. .
. .''
------------------------------------------------------------------------
Robert Halper Trader $10-$15 ``When it comes to
(NYMEX) million [arbitraging] crude oil
against gasoline, Bob
Halper wrote the book.
According to some, he
will go down as one of
the biggest crack-spread
traders the NYMEX has
ever seen.''
------------------------------------------------------------------------
Daniel Trader $10-$15 ``A natural gas
Lirtzman (NYMEX) million `natural.'. . .''
------------------------------------------------------------------------
Kevin Trader $10-$15 ``Chalk up yet another
McDonnell (NYMEX) million blowout year. . . .''
------------------------------------------------------------------------
Simon Posen Trader $10-$15 ``Last year's natural gas
(NYMEX) million swings produced a
significant surge in
Posen's trading
profits.''
------------------------------------------------------------------------
Mitchell Stern Trader $10-$15 ``Stern had a huge year,
(NYMEX) million sources say.''
------------------------------------------------------------------------

Table 1. Large trader profits are an indicator of increased
speculation in energy commodity markets. Data source: Trader Monthly,
April/May 2006.

Not only are the top traders for investment banks and funds
earning record incomes, but in-house corporate traders are
earning record amounts as well. According to a recent article
in Bloomberg news, at Sempra Energy, the owner of the biggest
U.S. natural gas utility, ``as many as 30 commodity traders
[make] more than the $2 million earned last year by Chief
Executive Officer Don Felsinger. `That's what it costs to be in
this business,' Felsinger [said] in a May 17 interview.''
⁹¹ Bloomberg also reported that division managers
for commodities trading were also the most highly paid
employees at Constellation Energy, earning approximately $5
million in bonuses, compared to a total compensation package of
about $4 million for the chief executive officer.⁹²
---------------------------------------------------------------------------
\91\ What's a Top Commodity Trader Worth? Quintuple 2000 Salaries,
Bloomberg.com, June 1, 2006.
\92\ Id.
---------------------------------------------------------------------------

IV. NO COP ON THE BEAT FOR OVER-THE-COUNTER ENERGY MARKETS

Until recently, the trading of U.S. energy futures was
conducted exclusively on regulated exchanges within the United
States, like the NYMEX, and subject to extensive oversight by
the CFTC and the exchanges themselves in order to detect and
prevent price manipulation. Under the Commodity Exchange Act,
the purpose of CFTC regulation is to deter and prevent price
manipulation, ensure the ``financial integrity'' of
transactions, maintain market integrity, prevent fraud, and
promote fair competition.⁹³ This regulation and the
resulting transparency has bolstered investor confidence in the
integrity of the regulated U.S. commodity markets and helped
propel U.S. exchanges into the leading marketplace for many
commodities.
---------------------------------------------------------------------------
\93\ 7 U.S.C. Sec. 5.
---------------------------------------------------------------------------
Pursuant to its statutory mandate to detect and prevent
price manipulation, the CFTC has imposed a variety of reporting
requirements and regulations on the trading of commodity
futures and options. NYMEX traders, for example, are required
to keep records of all trades and report large trades to the
CFTC. The CFTC uses these Large Trader Reports, together with
daily trading data providing price and volume information, to
monitor exchange activity and detect unusual price movements or
trading.
None of this oversight to prevent price manipulation,
however, applies to any of the energy trading conducted on OTC
electronic exchanges. As a result of a provision inserted by
House and Senate negotiators during the waning hours of the
106th Congress into legislation that became the Commodity
Futures Modernization Act of 2000 (CFMA), ⁹⁴ the
Commodity Exchange Act exempts from CFTC oversight all trading
of energy commodities by large firms on OTC electronic
exchanges.⁹⁵
---------------------------------------------------------------------------
\94\ The provisions of the CFMA that provide exclusions and
exemptions for energy and metal commodities were included in the
version of the legislation that passed the House on October 19, 2000
(H.R. 4541, 106th Cong., 2nd Sess.), but were omitted from the version
placed on the Senate calendar after passage by the Senate Committee on
Agriculture in late August (S. Rept. 106-390). Following negotiations
between members of the House and Senate Agriculture committees, the
legislation that became the Commodity Futures Modernization Act--with
the exclusions for energy and metal commodities--was introduced in the
House on December 14 and in the Senate on December 15, 2000. The CFMA
was passed by both the House and Senate on December 15, the last day of
the 106th Congress, as part of an omnibus legislative package involving
13 appropriations bills and several authorization bills. There was no
opportunity for debate on any of the specific provisions in the CFMA;
the Senate passed this entire omnibus package by unanimous consent. A
history of the regulation of the trading of energy commodities is
presented in Appendix 2 of the Report prepared by the Minority Staff of
the Permanent Subcommittee on Investigations, U.S. Strategic Petroleum
Reserve: Recent Policy Has Increased Costs to Consumers But Not Overall
U.S. Energy Security, S. Prt. 108-18, 108th Cong., 1st Sess. (March 5,
2003).
\95\ 7 U.S.C. Sec. 2(h)(3).
---------------------------------------------------------------------------
In recent years, there has been a tremendous growth in the
trading of energy commodity contracts that are virtually
identical to futures contracts, but which are traded on OTC
electronic exchanges rather than the regulated futures
exchanges. These contracts are so similar to futures contracts
that they are often called ``futures look-alike contracts.''
Although the trading of futures contracts on futures markets is
subject to extensive oversight, as a result of the CFMA
exemptions the trading of futures look-alikes on an OTC
electronic exchange is not subject to any CFTC oversight. The
growth of these OTC electronic markets, therefore, has been
creating an increasing ``blind spot'' in the CFTC's oversight
of the trading of energy commodity futures. This increasing
blind spot significantly impairs the CFTC's ability to carry
out its statutory mandate to detect and prevent price
manipulation.

A. Development of OTC Electronic Markets

``Enron did two things for us. It validated our model, and
in 2000, 13 big market makers agreed to support the ICE's
efforts.''
--Jeffrey Sprecher, Chairman and CEO, Intercontinental
Exchange ⁹⁶
---------------------------------------------------------------------------
\96\ Gerelyn Terzo, A Battle Royal; A sleek upstart and an
entrenched giant are waging all-out war for the soul of the energy
trading market, Investment Dealers Digest, May 1, 2006.

Initially, the OTC market was not an actual place or
facility where trading occurred, but rather a general term that
referred to instances in which two parties would come together
to reach agreement on a contract between them to protect
against or assume price risks that could not be adequately
addressed by the trading of standardized futures contracts on
the regulated futures exchanges. Until the advent of electronic
trading in the late 1990s, the terms of most OTC contracts were
customized through negotiations between the two parties, either
face-to-face or through brokers over the telephone. Because the
terms of these customized, bilateral deals were unique, and the
contracts generally could not be traded or assigned to third
parties, these OTC contracts were considered simply as
bilateral contracts, outside the CFTC's jurisdiction.
In the 1990s, as energy deregulation gained momentum, and
energy was increasingly being considered as another commodity
priced on an open market, energy producers and suppliers
desired additional protections against market price risks. OTC
contracts became more popular, and the increasing number of
energy providers, merchants and traders holding these contracts
desired to trade these OTC instruments to third parties to help
reduce, diversify or spread the risks they had assumed. In
response, the OTC market began to develop standardized OTC
contracts that could be traded to multiple parties. Following
rapid developments in computer and internet technology in the
1990s, a number of companies and groups developed electronic
exchanges to facilitate these OTC trades.⁹⁷
---------------------------------------------------------------------------
\97\ Initially, the most prominent of these electronic exchanges
was operated by Enron. On Enron's electronic trading platform, called
``Enron OnLine,'' Enron became the counterparty to all of the trades.
Enron's position as a party to all trades provided Enron with superior
market information and created a non-level playing field. Following
Enron's collapse and the subsequent revelations of how Enron abused its
superior knowledge and market position, see, e.g., note 117, the Enron
``one to many'' trading model was discredited. Today, all of the
electronic exchanges are ``many to many'' exchanges, meaning that the
parties trade with each other rather than the operator of the exchange.
---------------------------------------------------------------------------
In 2000, a half dozen investment banks and oil companies
formed the Intercontinental Exchange (ICE) for OTC electronic
trading in energy and metals commodities.⁹⁸ The
Atlanta-based ICE is an electronic exchange open only to large
commercial traders that meet the definition of an ``eligible
commercial entity'' under the Commodity Exchange
Act.⁹⁹ According to ICE, its market participants
``must satisfy certain asset-holding and other criteria and
include[] entities that, in connection with their business,
incur risks relating to a particular commodity or have a
demonstrable ability to make or take delivery of that
commodity, as well as financial institutions that provide risk-
management or hedging services to those entities.''
¹⁰⁰
---------------------------------------------------------------------------
\98\ The founding partners of ICE are BP Amoco, Deutsche Bank AG,
Goldman Sachs, Dean Witter, Royal Dutch/Shell Group, SG Investment
Bank, and Totalfina Elf Group. In November 2005, ICE became a publicly
traded corporation. Many of these original founders are major
shareholders: Morgan Stanley owns nearly 15 percent of ICE shares,
Goldman Sachs owns about 14 percent, Total owns about 9.5 percent, and
BP owns about 9 percent. Market Forces: Big Oil increases market reach,
Energy Compass, March 24, 2006.
\99\ Participation is restricted to parties that quality as an
``eligible commercial entity'' under Section 1a(11) of the CEA.
Generally, these entities are large financial institutions, insurance
companies, investment companies, corporations and individuals with
significant assets, employee benefit plans, government agencies, and
registered securities brokers and futures commission merchants.
\100\ Intercontinental Exchange Inc, Form 10-K, filed March 10,
2006 (``ICE 10-K''), at p. 14. There does not appear to be any
mechanism to ensure that only eligible commercial entities actually
trade on ICE. The CFTC does not monitor or oversee participation; ICE
declined to answer the Subcommittee staff's questions as to whether or
how it monitors trader qualifications.
---------------------------------------------------------------------------
Today, ICE operates the leading OTC electronic exchange for
energy commodities. ICE describes its participants as ``some of
the world's largest energy companies, financial institutions
and other active contributors to trading volume in global
commodity markets. They include oil and gas producers and
refiners, power stations and utilities, chemical companies,
transportation companies, banks, hedge funds and other energy
industry participants.'' ¹⁰¹ According to ICE, its
electronic markets now constitute ``a significant global
presence with over 9,300 active screens at over 1,000 OTC
participant firms and over 440 futures participant firms as of
December 31, 2005.'' ¹⁰²
---------------------------------------------------------------------------
\101\ ICE 10-K, at p. 14.
\102\ ICE 10-K, at p. 6. As explained in Section V, in 2001, ICE
purchased the International Petroleum Exchange, a London-based futures
exchange that traded North Sea Brent crude oil and natural gas
delivered in Europe. In 2005, ICE renamed the London exchange as ``ICE
Futures'' and converted its open-outcry pit trading system into an all-
electronic exchange. Hence, ICE now operates two major electronic
markets: ICE Futures and ICE OTC. ICE Futures is a futures market in
London, regulated by the U.K. Financial Services Authority, and ICE OTC
operates as an ``exempt commercial market'' under Section 2(h)(3) of
the U.S. Commodity Exchange Act. Both markets operate outside of the
CFTC's oversight.
---------------------------------------------------------------------------
Unlike NYMEX, ICE does not require its participants to
become formal members of its exchange or to join a
clearinghouse.¹⁰³ Any large commercial company
qualifying as an eligible commercial entity can trade through
ICE's OTC electronic exchange without having to employ a broker
or pay a fee to a member of the Exchange.
---------------------------------------------------------------------------
\103\ In contrast, on NYMEX and other regulated futures exchanges,
the exchange clearinghouse acts as the buyer for all sellers and the
seller for all buyers. Persons that are not members of the exchange
must trade through a clearing member. Clearing members accept all
financial responsibility for the trades they conduct on behalf of the
customer initiating the trade.
---------------------------------------------------------------------------
Although ICE's OTC exchange does not operate its own
clearinghouse, ICE has contracted with a third party, the
LCH.Clearnet, to offer clearing services for traders who desire
to trade only with other cleared traders. By trading only with
other cleared traders, a party trading on ICE can eliminate the
risk of default by the other party just as if he or she were
trading on a futures exchange, thereby avoiding one of the
traditional disadvantages of OTC trading.¹⁰⁴ ICE
describes the advantages of OTC trading through a
clearinghouse:
---------------------------------------------------------------------------
\104\ NYMEX also offers an electronic trading platform for the
trading of standardized OTC instruments, and provides clearinghouse
services, called ``NYMEX ClearPort,'' for traders using the NYMEX OTC
electronic trading platform. NYMEX states that its OTC clearing service
``lets market participants take advantage of the financial depth and
security of the Exchange clearinghouse along with round-the-clock
access to more than 60 energy futures contracts including natural gas
location differentials; electricity, crude oil spreads and outright
transactions; refined product crack and location spreads and outright
transactions; and coal.'' NYMEX, NYMEX ClearPort Services, on NYMEX
website, at http://www.nymex.com/cp--overview.aspx (last visited May
19, 2006).

The use of OTC clearing serves to reduce the credit
risk associated with bilateral OTC trading by
interposing an independent clearinghouse as a
counterparty to trades in these contracts. The use of a
central clearinghouse rather than the reliance on
bilateral trading agreements [has] resulted in more
participants becoming active in the OTC markets. In
addition, clearing through a central clearinghouse
typically offers market participants the ability to
reduce the amount of capital required to trade as well
as the ability to cross-margin positions in various
commodities.¹⁰⁵
---------------------------------------------------------------------------
\105\ Intercontinental Exchange Inc., Form 10-Q, filed May 2, 2006
(``ICE 10-Q''), at p. 16. In 2005, ICE also contracted with North
American Energy Credit and Clearing, LLC, to provide clearing for
trades in physically-settled OTC natural gas and power contracts. Id.

ICE claims that its OTC markets ``offer trading in hundreds
of natural gas, power and refined oil products on a bilateral
basis. At the end of first quarter 2006, we also offered over
50 cleared OTC contracts, which account for the majority of our
commission revenue. In March 2006, we began the introduction of
more than 50 planned additional cleared OTC contracts, with the
first 34 cleared contracts launched through the end of April
this year.'' ¹⁰⁶ According to ICE, its natural gas
contracts are its most heavily traded contracts. ICE states it
traded nearly 43 million cleared OTC Henry Hub natural gas
contracts in 2005, ``compared to 10.4 million cleared OTC Henry
Hub natural gas contracts traded by our nearest competitor
during the same period.'' ¹⁰⁷
---------------------------------------------------------------------------
\106\ ICE 10-Q, at p. 17.
\107\ ICE 10-K, at p. 5.
---------------------------------------------------------------------------
ICE claims that its ``introduction of cleared OTC products
has enabled us to attract significant liquidity in the OTC
markets we operate.'' ¹⁰⁸ Others agree. ``[C]learing
is paving the way for greater growth of the energy market as a
whole,'' one futures industry publication reported. ``Clearing
not only helped restore liquidity post-Enron, it opened the
door to an influx of hedge funds and other professional
traders, many of whom come from the financial world.''
Moreover, OTC clearing has ``created a new linkage'' between
the futures markets and the OTC markets. ``On one level this is
simple arbitrage between two sets of similar contracts. On
another level it is a cross-fertilization of people and ideas,
as each side seeks out better opportunities in newly accessible
markets.'' ¹⁰⁹ ``If you want to participate in all
the information of the market,'' said Bo Collins, former
President of NYMEX, and now the operator of his own hedge fund,
``you have to participate electronically and OTC.''
¹¹⁰
---------------------------------------------------------------------------
\108\ ICE 10-K, at p. 5. ICE states, ``both physically-delivered
and cash-settled gas products can be traded at a fixed price or
differential to recognized published indices.'' ICE website, at https:/
/www.theice.com/naturalgas.jhtml. See also, e.g., ICE, OTC Natural Gas
Clearing and Credit, Product Specifications, March 24, 2006; ICE, OTC
Natural Gas and Financial Power Clearing and Credit, Product
Specifications for products to be launched on April 7, 2006. ICE
further amplifies: ``A substantial portion of the trading volume in our
OTC markets relates to approximately 15-20 highly liquid contracts in
natural gas, power, and oil. For these contracts, the highest degree of
market liquidity resides in the prompt, or front month, whereas that
liquidity is reduced for contracts with settlement dates further out,
or in the back months.'' ICE 10-K, at p. 9.
\109\ Will Acworth, The Tipping Point: OTC Energy Clearing Takes
Off, Futures Industry Magazine, January/February 2005.
\110\ Id. Although NYMEX's ClearPort offers a similar OTC trading
opportunities, ICE currently has approximately 80 percent of the market
for cleared OTC Henry Hub natural gas contracts and 85 percent of the
cleared OTC PJM financial power contracts. ICE 10-Q, at p. 28.
---------------------------------------------------------------------------
Today, there are few, if any, practical differences between
the energy commodities traded on the regulated futures markets
and the standardized, cleared contracts traded on the
unregulated OTC electronic exchanges. From an economic
perspective, there is no distinction between trading a
standardized, cleared OTC contract for future delivery on ICE
and trading a standardized, cleared futures contract on
NYMEX.¹¹¹ Both types of contracts allow buyers and
sellers to hedge against price risks and to speculate on price
changes. In each market counterparty risk is eliminated by use
of a clearinghouse. In each market, contracts are put on the
market and bought and sold many times.
---------------------------------------------------------------------------
\111\ Generally, futures contracts for key energy commodities can
be settled through physical delivery of the commodity, whereas OTC
futures look-alikes are financially settled. Since only a small
percentage of futures contracts actually result in physical delivery of
the commodity, this distinction does not make a practical difference in
the economic function or utility of the two types of contracts.
Moreover, many of the financially-settled OTC contracts reference the
NYMEX price for settlement; in this respect the two markets are
intertwined.
---------------------------------------------------------------------------
From a practical perspective, the only real difference
between the two markets is the degree of regulation. ICE
distinguishes its OTC market from the regulated futures
exchanges primarily by the absence of regulation.¹¹²
Trading on the futures market is subject to CFTC oversight,
while trading on the unregulated OTC exchanges is not.
---------------------------------------------------------------------------
\112\ ICE 10-K, at p. 25.
---------------------------------------------------------------------------

B. No Oversight of OTC Electronic Markets

Section 2(h)(3) of the Commodity Exchange Act, which became
law as part of the CFMA, exempts from CFTC oversight all
agreements, contracts, and transactions in energy and metals
(``exempt commodities'') that are traded on electronic trading
facilities between ``eligible commercial entities.''
¹¹³ Generally, an eligible commercial entity must be
either a large financial institution, insurance company,
investment company, corporation or individuals with significant
assets, employee benefit plan, government agency, registered
securities broker, or futures commission merchant. Markets
operating under Section 2(h)(3) are referred to as ``exempt
commercial markets.'' ¹¹⁴
---------------------------------------------------------------------------
\113\ 7 U.S.C. Sec. 2(h)(3).
\114\ 7 U.S.C. Sec. 1a(11).
---------------------------------------------------------------------------
An exempt commercial market (ECM) is subject to the CEA's
statutory prohibitions on fraud and price manipulation and, if
the CFTC determines that the market performs a significant
price discovery function, the ECM must provide pricing
information to the public, but otherwise it is fully exempt
from the CFTC's regulatory oversight. The CFTC describes its
authority over these ECMs as follows:

In contrast to its authority over designated contract
markets and registered derivatives transaction
facilities, the CFTC does not have general oversight
authority over exempt commercial markets. Exempt
commercial markets are not registered with, or
designated, recognized, licensed or approved by the
CFTC.¹¹⁵
---------------------------------------------------------------------------
\115\ Cite to Section 2(h)(3). CFTC, Exempt Commercial Markets That
Have File Notice with the CFTC, at CFTC website at http://www.cftc.gov/
dea/dea--ecm--table.htm (last visited May 19, 2006).

Today, the CFTC does not apply to exempt commercial markets
like ICE any of the oversight and surveillance measures it
currently uses to oversee regulated futures markets like the
NYMEX. Table 2 provides a comparison of the oversight
mechanisms used to police trading on the two markets and
prevent price manipulation and fraud.

Table 2
Futures and Exempt Commercial Markets:
Differences in Oversight to Prevent Price Manipulation
----------------------------------------------------------------------------------------------------------------
Does the Measure Apply to the:
Measure to Prevent Price Manipulation ---------------------------------------------------
Futures Market Exempt Commercial Market
----------------------------------------------------------------------------------------------------------------
CFTC Market Surveillance Program
----------------------------------------------------------------------------------------------------------------
CFTC staff monitoring of daily trading reports Yes No
----------------------------------------------------------------------------------------------------------------
Weekly reports and reviews for expiring contracts Yes No
----------------------------------------------------------------------------------------------------------------
Option of special data call by CFTC Yes Yes
----------------------------------------------------------------------------------------------------------------
Large Trader Reporting
----------------------------------------------------------------------------------------------------------------
Large trader reporting by clearing members Yes No
----------------------------------------------------------------------------------------------------------------
Large trader reporting by exchanges Yes No
----------------------------------------------------------------------------------------------------------------
Filing of information about trading accounts by Yes No
traders
----------------------------------------------------------------------------------------------------------------
Core Principles for Exchange Operations
----------------------------------------------------------------------------------------------------------------
Exchange is responsible for monitoring compliance Yes No
with market rules
----------------------------------------------------------------------------------------------------------------
Exchange can only list contracts for trading that Yes No
are not readily susceptible to manipulation
----------------------------------------------------------------------------------------------------------------
Exchange must monitor trading to prevent Yes No
manipulation, price distortion, and disruption of the
delivery or cash-settlement process
----------------------------------------------------------------------------------------------------------------
Position limits for speculators to reduce the Yes No
potential threat of manipulation or congestion
----------------------------------------------------------------------------------------------------------------
Emergency authority, in consultation with the CFTC, Yes No
to liquidate positions, suspend trading, or impose special
margin requirements
----------------------------------------------------------------------------------------------------------------
Daily submission of trading information to CFTC Yes Limited
----------------------------------------------------------------------------------------------------------------
Daily publication of trading information Yes *
----------------------------------------------------------------------------------------------------------------
Exchange must keep records of trading Yes Yes
----------------------------------------------------------------------------------------------------------------
* Section 2(h)(4) of the Commodity Exchange Act requires daily publication of trading information if the market
performs a price discovery function. The CFTC has not made any determination as to whether any of the exempt
commercial markets performs a price discovery function. See Section IV.D. in this report.

These differences are substantial. For example, unlike the
regulated exchanges, on OTC electronic exchanges, neither the
CFTC nor the OTC trading facility itself monitors trading
activity to detect and deter fraud and price manipulation. Key
trading information is not disclosed to the CFTC or the public.
Although ICE discloses to the CFTC and subscribers of its data
services certain information about posted bids, offers, and
completed trades, other critical data routinely reported by the
regulated exchanges to the CFTC and the public, such as open
interest, is not reported by ICE. Large trader reports do not
have to be filed with the CFTC. Unlike trading on the NYMEX,
there are no position limits or price change limits.
The most frequently asserted justification for this
disparity in regulatory coverage is that only large
institutions that are sophisticated traders with less need for
governmental protection are permitted to trade on these
electronic trading facilities. But federal regulation of
commodity markets is not designed solely to protect commodity
traders; it is also intended to protect commodity purchasers
and the public at large, including consumers who ultimately
bear the costs of energy products such as gasoline, heating
oil, diesel fuel, and natural gas.
The Commodity Exchange Act articulates the national
interest in preventing price manipulation and excessive
speculation:

The transactions and prices of commodities on such
boards of trades are susceptible to excessive
speculation and can be manipulated, controlled,
cornered or squeezed to the detriment of the producer
or the consumer and the persons handling commodities
and the products and byproducts thereof in interstate
commerce, rendering regulation imperative for the
protection of such commerce and the national public
interest therein.¹¹⁶
---------------------------------------------------------------------------
\116\ 7 U.S.C. Sec. 5. This statement of purpose in the CEA was
revised to read in its current form as part of the CFMA of 2000.

The history of commodity markets demonstrates it is
unrealistic to rely on the self-interest of a few large traders
as a substitute for dedicated, independent oversight to protect
the public interest. Commodity traders have no responsibility
or obligation to look out for public rather than private
interests. In some cases, it could be a breach of fiduciary
duty for officers of a private corporation to look out for
interests other than those of the corporation's shareholders.
Most recently, the Enron scandal, which involved misconduct by
a number of traders at large energy and trading companies
active in OTC trading, is clear evidence of how a few
sophisticated, unscrupulous traders can harm not only other
market participants, but also the public at large by
artificially increasing prices.¹¹⁷ Consumers paying
artificially high energy prices suffer the same harm regardless
of whether the price was manipulated on an OTC electronic
exchange or on a regulated futures market.
---------------------------------------------------------------------------
\117\ See, e.g., August 2002 report prepared by the Federal Energy
Regulatory Commission (FERC) staff, Docket No. PA-02-000, which found
significant evidence of price manipulation and deceptive practices by
Enron in connection with its OTC electronic trading platform, known as
Enron OnLine. The report includes a detailed analysis of natural gas
trades made on Enron OnLine for next-day delivery into California over
the course of a single day, January 31, 2001. The report found that of
a total of 227 trades on that day, 174 involved Enron and a single
unnamed party; these 174 trades took place primarily during the last
hour of trading, and by using ``higher prices,'' these trades resulted
in a steep price increase over the last hour of trading. The report
also noted that price information displayed electronically on Enron
OnLine was a ``significant, even dominant'' source of price information
used by reporting firms publishing natural gas pricing data. The report
tentatively concluded that Enron OnLine price data was susceptible to
price manipulation and may have affected not only Enron trades, but
also increased natural gas prices industrywide.
---------------------------------------------------------------------------

C. No Large Trader Reporting in OTC Electronic Markets

As indicated in Table 2, Large Trader Reports are not
required in OTC electronic markets. The absence of information
about large trades increases the vulnerability of these markets
to price manipulation and excessive speculation.
CFTC Chairman Reuben Jeffery III, recently stated, ``One of
the core themes of the Commodity Exchange Act . . . is that the
commodity markets operate free of manipulation and the
Commission's most basic responsibility is to detect and deter
such behavior so that markets operate in an open and
competitive manner, free of price distortions.'' ¹¹⁸
To fulfill this responsibility, the Commission has established
a market surveillance program, whose primary mission is ``to
identify situations that could pose a threat of manipulation
and to initiate appropriate preventive actions.''
¹¹⁹ ``[T]he Commission attempts to proactively
combat potential manipulation,'' Chairman Jeffery explains,
``rather than simply waiting until someone has attempted to
manipulate prices.'' ¹²⁰ The CFTC staff monitors the
daily trading on the regulated exchanges, with particular focus
on ``the daily activities of large traders, key price
relationships, and relevant supply and demand factors.''
¹²¹
---------------------------------------------------------------------------
\118\ Letter from Reuben Jeffery III, Chairman, Commodity Futures
Trading Commission, to Governor Jennifer Granholm, August 22, 2005.
\119\ CFTC Backgrounder, The CFTC Market Surveillance Program, June
2001, at CFTC website, at http://www.cftc.gov/opa/backgrounder/
opasurveill.htm?from=home&page=mktsurveil-content.
\120\ Letter from Reuben Jeffery III, Chairman, Commodity Futures
Trading Commission, to Governor Jennifer Granholm, August 22, 2005.
\121\ CFTC, The CFTC Market Surveillance Program.
---------------------------------------------------------------------------
The ``cornerstone'' of the surveillance program is the
Commission's Large Trader Reporting (LTR) system.¹²²
Chairman Jeffery states the LTR system ``enables detection of
concentrated and coordinated positions that might be used by
one or more traders to attempt manipulation. This transparency
is also well known to market participants, providing yet
another element of deterrence.'' ¹²³ The CFTC's
Chief Economist, Dr. James Overdahl, recently told Congress
that the LTR system ``is a powerful tool for detecting the
types of concentrated and coordinated positions required by a
trader or group of traders attempting to manipulate the
market.'' ¹²⁴
---------------------------------------------------------------------------
\122\ Letter from Reuben Jeffery III, Chairman, Commodity Futures
Trading Commission, to Governor Jennifer Granholm, August 22, 2005.
\123\ Id.
\124\ Statement of Dr. James Overdahl, Global Oil Demand/Gasoline
Prices, Hearing before the Senate Committee on Energy and Natural
Resources, September 6, 2005.
---------------------------------------------------------------------------
Under the LTR system, clearing members of futures exchanges
(the entities that actually do the trading on behalf of
customers) must file daily reports with the CFTC identifying
the futures and options positions held by its customers above
specific threshholds established by the Commission. To enable
the CFTC to aggregate trader positions that may have been
established through more than one clearing member, traders
themselves are required to inform the CFTC of each account that
acquires a reportable position. ``Only by properly identifying
and aggregating accounts can the surveillance staff make a
thorough assessment of a trader's potential market impact and a
trader's compliance with speculative position limits.''
¹²⁵ The exchanges themselves are required to report
similar data to the CFTC. According to the CFTC, ``The
aggregate of all large-traders'' positions reported to the
Commission usually represents 70 to 90 percent of the total
open interest in any given market.'' ¹²⁶
---------------------------------------------------------------------------
\125\ CFTC Backgrounder, The CFTC's Large-Trader Reporting System,
at CFTC website, at http://www.cftc.gov/opa/backgrounder/opa-ltrs.htm.
\126\ Id.
---------------------------------------------------------------------------
The Commission describes how it uses this data to take
appropriate action to detect and deter price manipulation:

Surveillance economists prepare weekly summary
reports for futures and options contracts that are
approaching their critical expiration periods. Regional
surveillance supervisors immediately review these
reports. Surveillance staff advise the Commission and
senior staff of potential problems and significant
market developments at weekly surveillance meetings so
that they will be prepared to take prompt action when
necessary.¹²⁷
---------------------------------------------------------------------------
\127\ CFTC, The CFTC Market Surveillance Program.

The LTR system also provides critical information for the
weekly Commitment of Traders Reports that the CFTC provides to
the public. The CFTC's Chief Economist stated, ``Data from the
CFTC's Large Trader Reporting System can help answer questions
about the role of non-commercial traders in U.S. energy futures
markets.'' This data can be used to help determine the relative
participation of commercial participants (firms that buy or
sell the traded commodity as part of their business and use the
futures markets for hedging) and of speculators (who are not
using the market for hedging physical commodities). Without a
Large Trader Reporting system, it is impossible to determine
the composition of the futures markets and analyze the
influence of speculation on market prices.¹²⁸
---------------------------------------------------------------------------
\128\ There are anecdotal reports that some traders prefer trading
on the OTC energy markets in the United States because of the lack of
regulation. Natural Gas Week recently quoted one trader:
When volumes all of a sudden begin to increase in one market and
begin to erode in another, you have to ask yourself where the real
market is? Since there's not the same sort of mandatory reporting
requirements in the OTC world, it's very likely the funds have had
their fill of being scrutinized and spot-lighted as the culprits, so
they are moving into another market area that is not so easily tracked
and doesn't have as much attention drawn to it.
Funds Increasing OTC Volumes, Sidestepping Nymex Oversight, Natural
Gas Week, April 25, 2005. Natural Gas Week also reported that hedge
funds ``benefit from the OTC traded futures market because they are not
as transparent as NYMEX traded futures, and the non-commercial
reporting requirements such as the CFTC mandated Commitment of Traders
Report is not as stringent.'' Id. The article explained how speculators
can influence the futures markets through their activity in the OTC
market, or vice versa, and capture a profit through the difference in
price between the two markets that may result from trading in one of
the markets.
``Last week, there was a lot of arbitrage going on between the
OTC gas futures markets and the NYMEX futures markets, because at times
the OTC markets were as much as 5 cents in back of the futures
screen,'' another gas futures trader said. ``The OTC futures markets
usually trade nearly in tandem with the NYMEX futures screen, but it's
not uncommon to be able to capture a spread between the two markets.
Still, it's amazing that the speculative entities in the OTC market can
move the NYMEX down by 5 cents or more in about 30 seconds. But they
could just as easily position themselves in the OTC market to influence
the NYMEX futures market to the upside as well,'' the trader added.
Id. The article also noted that funds can take large positions in
the OTC market without having to report those positions to any
regulatory agency, thereby circumventing any position limits that apply
to their trading on the futures market.
---------------------------------------------------------------------------

D. No Public Dissemination of Trading Data by OTC Electronic Markets

Under the Commodity Exchange Act, regulated markets are
required to publish daily information about settlement prices,
volume, open interest, and opening and closing price ranges for
all actively traded contracts.¹²⁹ Under the
Commodity Futures Modernization Act, OTC electronic markets
must publish similar information if the CFTC determines that
the market ``performs a significant price discovery function''
for the underlying cash market.¹³⁰ Although there is
substantial evidence that the ICE OTC electronic exchange
performs such a price discovery function, the CFTC has not
undertaken any effort to make this determination. The failure
to even attempt to make this determination ignores the
Congressional mandate expressed in the law that the OTC
electronic exchanges that perform a price discovery function be
as transparent to the public as the regulated futures
exchanges.
---------------------------------------------------------------------------
\129\ 7 U.S.C. Sec. 7(d).
\130\ Under the CEA, electronic trading facilities that trade
energy commodities are subject to ``such rules and regulations as the
Commission may prescribe if necessary to ensure timely dissemination by
the electronic trading facility of price, trading, volume, and other
trading data to the extent appropriate, if the Commission determines
that the electronic trading facility performs a significant price
discovery function for transactions in the cash market for the
commodity underlying any agreement, contract, or transaction executed
or traded on the electronic trading facility.'' 7 U.S.C. Sec.
2(h)(4)(D).
---------------------------------------------------------------------------
In 2004, the CFTC issued a rule setting forth the process
and criteria it would use to determine whether an electronic
exchange performed a price discovery function.¹³¹
However, the CFTC has not taken any action in the 2 years since
that rule was issued to actually determine whether ICE or any
other OTC electronic market meets these criteria. Under the
2004 rule, an ECM performs a price discovery function when it
meets one of two specified criteria:
---------------------------------------------------------------------------
\131\ 69 Fed. Reg. 43285 (July 20, 2004).

(A) LCash market bids, offers or transactions are
directly based on, or quoted at a differential to, the
prices generated on the market on a more than
occasional basis; or
(B) LThe market's prices are routinely disseminated in
a widely distributed industry publication and are
routinely consulted by industry participants in pricing
cash market transactions.¹³²
---------------------------------------------------------------------------
\132\ 17 C.F.R. Sec. 36.3(c)(2).

An ECM operating under the Section 2(h)(3) exemption must
notify the CFTC when ``it has reason to believe'' either of
these criteria are met, or if the ``market holds itself out to
the public as performing a price discovery function for the
cash market for the commodity.'' ¹³³
---------------------------------------------------------------------------
\133\ 17 C.F.R. Sec. 36.3(c)(2)(C).
---------------------------------------------------------------------------
If an ECM notifies the CFTC that it has reason to believe
that it meets any of these criteria for performing a price
discovery function, or the CFTC itself determines that an ECM
appears to meet one of these criterion, then the CFTC must
provide the ECM ``with an opportunity for a hearing through the
submission of written data, views and arguments.''
¹³⁴ After conducting such a hearing, and
``consideration of all relevant matters,'' the Commission
``shall issue an order containing its determination whether the
electronic trading facility performs a significant price
discovery function'' under this section.¹³⁵
---------------------------------------------------------------------------
\134\ 17 C.F.R. Sec. 36.3(c)(2)(C)(iii).
\135\ Id.
---------------------------------------------------------------------------
If the CFTC determines that an electronic trading facility
performs a significant price discovery function, then the
regulations require the facility to disseminate to the public,
on a daily basis, the following information:

(1) Contract terms and conditions, or a product
description, and trading conventions, mechanisms and
practices;
(2) Trading volume by commodity and, if available,
open interest; [and]
(3) The opening and closing prices or price ranges,
the daily high and low prices, a volume-weighted price
. . . or such other daily price information as proposed
by the facility and approved by the
Commission.¹³⁶
---------------------------------------------------------------------------
\136\ 17 C.F.R. Sec. 36.3(c)(2)(C)(iv)(A). The information must be
publicly disseminated no later than the business day following the day
to which the information applies. Id. at Section 36.3(c)(2)(C)(iv)(B).
The 2004 rule also requires an exempt commercial market to inform
the CFTC of those commodity contracts it is trading in reliance on the
exemption set forth in Section 2(h)(3). Id. at Sec. 36.3(b)(1)(ii). The
ECM must provide the CFTC with a description of the contract and weekly
reports on the price, quantity, and other information the CFTC
determines is appropriate for each trade in that commodity contract
during the previous week. The facility may either provide this
information in weekly reports or provide the CFTC with electronic
access to the same information. Id. at Section 36.3(b)(1)(ii)(A) and
(B). Additionally, the ECM must maintain records of complaints or
allegations of fraud or manipulation, and forward any such complaints
to the CFTC. Id. at Section 36.3(b)(1)(iii) and (iv). There is no
requirement that the CFTC or an ECM provide this data to the public.
In comments filed on the proposed rule, ICE contended that the
CFMA did not give the CFTC authority to conduct regulatory oversight of
trading on electronic trading facilities or to require electronic
trading facilities to submit reports. The CFTC rejected this argument,
noting that Congress expressly stated ECMs were still subject to the
anti-fraud and anti-manipulation provisions of the CEA. ``If the
Commission is to have the ability to enforce those provisions, it must
have access to meaningful information concerning transactions on
ECMs.'' 69 Fed. Reg. 43287. The CFTC also dismissed the contention that
allowing the CFTC staff to monitor trading through the installation of
a view-only trading screen at the CFTC was sufficient to enable the
CFTC to monitor those markets for fraud and manipulation. ``The
Commission has found that the information provided under the current
electronic access option is neither as relevant, nor as useful, as
anticipated.'' Id. 69 Fed. Reg. 43286. It stated that the view-only
access to computer screens provided to the CFTC by ICE ``is not, in
fact, equivalent to the large trader information received with respect
to designated contract markets.'' Id. The CFTC, however, has not used
this section to require information on open interest or large trades.
Hence, the information that is provided to the CFTC under this section
does not serve to provide the CFTC with the type of large trader
information necessary to detect and prevent manipulation.

Despite the 2004 regulations, to date, neither ICE--nor any
other ECM--has informed the CFTC that it has reason to believe
that its electronic exchange performs a price discovery
function. Yet at the same time, ICE appears to have made that
very claim to the Securities and Exchange Commission (SEC). In
the Form 10-K that ICE filed with the SEC on March 10, 2006,
ICE identified price discovery as a core function of its over-
the-counter markets: ``Our participants, representing many of
the world's largest energy companies, leading financial
institutions and proprietary trading firms, as well as natural
gas distribution companies and utilities, rely on our platform
for price discovery, hedging and risk management.''
¹³⁷
---------------------------------------------------------------------------
\137\ ICE 10-K, at p. 4.
---------------------------------------------------------------------------
ICE's 10-K filing also describes its sale of a daily report
containing price data about OTC transactions as a core business
activity. ICE described its ``OTC End of Day Report'' as
follows:

The OTC ICE Data end of day report is a comprehensive
electronic summary of trading activity in our OTC
markets. The report is published daily at 3:00 p.m.
Eastern time and features indicative price statistics,
such as last price, high price, low price, total
volume-weighted average price, best bid, best offer,
closing bid and closing offer, for all natural gas and
power contracts that are traded or quoted on our
platform. The end of day report also provides a summary
of every transaction, which includes the price [and]
the time stamp. . . .¹³⁸
---------------------------------------------------------------------------
\138\ ICE 10-K, at p. 13.

It is not apparent why traders and energy firms would pay
for ICE Data's End of Day Trader Reports if those reports did
not provide valuable information about the data that is most
useful to market participants--prices. Such price reports would
appear to be useless or not worth the cost if the ICE trades
did not perform a price discovery function. By generating
valuable daily price data to industry participants, trading on
ICE now performs a price discovery function.
It is difficult to reconcile ICE's daily trading reports
and its statements to the SEC with its failure to notify the
CFTC that its natural gas and electricity markets perform a
price discovery function. As ICE states, most of the natural
gas and power contracts traded in its OTC markets relate to
``the prompt, or front month,''--meaning the futures contract
that is closest to the spot or cash market. Hence, the prices
of these contracts as traded on ICE have a direct influence on
the prices of these commodities in the cash market.
Although the CFTC's 2004 rulemaking requires an ECM that
has reason to believe it is performing a price discovery
function to notify the CFTC, the CFTC has retained authority to
initiate a hearing to determine whether an ECM meets the
criteria for performing a price discovery function. Despite
numerous unqualified statements by ICE on its website,
¹³⁹ in press releases, ¹⁴⁰ and in filings
with the SEC that its OTC electronic trading facility performs
a price discovery function, the CFTC has failed to initiate any
type of inquiry to evaluate this issue. In light of the
substantial evidence that the ICE electronic exchange is
performing a price discovery function, the CFTC appears to have
failed to carry out its statutory mandate to require ICE to
publicly disseminate trading data.
---------------------------------------------------------------------------
\139\ See, e.g., ICE. The Energy Marketplace, at https://
www.theice.com/profile.jhtml (last visited June 9, 2006)
(``IntercontinentalExchange is the world's leading electronic
marketplace for energy trading and price discovery. . . . ICE's
electronic trading platform offers direct, centralized access to trade
execution and real-time price discovery through over 7,000 active
screens at more than 1000 OTC and futures participant firms.''); A
Global Community of Energy Market Participants, at https://
www.theice.com/customers.jhtml (last visited June 9, 2006) (``Through
ICE's markets, participants have direct access to trade execution,
real-time price information, market activity and unparallelled
transparency in both futures and OTC energy markets. From the world's
leading oil majors, to funds, utilities and financial institutions,
energy market participants rely on ICE.''); Clearing, at https://
www.theice.com/futures--clearing.jhtml (last visited June 9, 2006)
(``As the world's leading electronic energy exchange, ICE provides an
unsurpassed forum for price discovery and risk management.''); ICE
Platform, https://www.theice.com/ice--platform.jhtml (last visited June
9, 2006) (ICE's electronic platform is the gateway to an open
marketplace--one in which each participant has access to real-time
price discovery and trading functionality.'').
\140\ See, e.g., Statement of Jeffrey Sprecher, ICE Chairman and
Chief Executive Officer, Intercontinental Announces 2003 Results, March
4, 2004, (``ICE's investment in the development of cleared OTC products
was beneficial to a growing number of market participants who relied on
clearing to ease credit constraints while managing risk. As a result,
Intercontinental is well positioned to participate in the stabilizing
OTC energy markets, and to facilitate the migration to electronic price
discovery.''), at https://www.theice.com/showpr.jhtml?id=558; Statement
of Jeffrey Sprecher, Trading Technologies to Connect to ICE Energy
Markets, March 17, 2004 (``We look forward to together delivering
alternatives to the markeplace for electronic price discovery and
expanded market access to a diverse group of participants.''), at
https://www.theice.com/showpr.jhtml?id=557.
---------------------------------------------------------------------------

V. THE COP'S BLIND EYE: U.S. ENERGY TRADES ON FOREIGN EXCHANGES

``Growth in our industry is certainly exceeding the ability
of the regulators to get their heads around it.''
--Jeffrey Sprecher, ICE Chairman and CEO ¹⁴¹
---------------------------------------------------------------------------
\141\ Comments at a conference, May 9, 2006. An audio replay of Mr.
Sprecher's presentation can be downloaded from the ICE website, at
https://www.theice.com/showpr.jhtml?id=2321 (last visited June 9,
2006).

ICE now operates two types of electronic energy exchanges.
One is the ICE OTC exchange, which is registered in the United
States. The other is ICE Futures, which is a futures exchange
registered in London and regulated by the United Kingdom
Financial Services Authority (FSA). Until January of this year,
ICE Futures traded solely in European-based energy commodities.
Within the past few months, however, the CFTC has permitted ICE
Futures in London to use its trading terminals within the
United States for the trading of U.S. energy commodities,
including U.S. crude oil, U.S. gasoline, and U.S. home heating
oil. The result is that persons located in the United States
seeking to trade key U.S. energy commodities now can avoid all
U.S. market oversight and reporting requirements simply by
routing their trades through the ICE Futures exchange in London
instead of the NYMEX in New York.

A. U.S. Energy Commodities Traded on Foreign Exchanges

In May 1999, the London International Petroleum Exchange
(IPE) petitioned the CFTC to permit the IPE to make its
electronic trading system available to IPE members in the
United States. Specifically, the IPE desired that its members
who were registered with the CFTC be able to electronically
place orders from within the United States, or to
electronically submit the orders of customers within the United
States, to the IPE in London, without requiring the IPE to be
fully regulated as a U.S. futures market under the CEA. The
IPE's petition contained general information about the IPE's
operations, the contracts traded on the IPE, its floor and
trading procedures, a description of the United Kingdom
regulatory structure applicable to the IPE, the IPE's
procedures for compliance with the U.K. regulations, and
procedures for sharing information with the CFTC.¹⁴²
---------------------------------------------------------------------------
\142\ Letter from IPE to CFTC, May 14, 1999.
---------------------------------------------------------------------------
In November 1999, the CFTC granted the IPE's request by
releasing a ``no-action'' determination, permitting the IPE to
allow its members to electronically trade from within the
United States without having to designate the IPE as a U.S.
futures exchange under the CEA. The CFTC wrote that its
position was ``restricted to providing relief from the
requirement that IPE obtain contract market designation
pursuant to [the CEA] and regulatory requirements that flow
specifically from the contract market designation requirement
in the event that the above-reference contracts are made
available in the United States.'' The CFTC stated its ``no-
action position does not affect the Commission's ability to
bring appropriate action for fraud or manipulation.'' It also
stated that it retained the authority to ``condition further,
modify, suspend, terminate, or otherwise restrict the terms of
the no-action relief provided herein, in its discretion.'' The
initial no-action letter permitted the trading of IPE's natural
gas, fuel oil, gas oil, and Brent crude oil contracts through
IPE terminals in the United States. Subsequently, in 2002 and
2003, following the purchase of the IPE by ICE, the IPE
received permission from the CFTC, through several amendments
to the initial no-action letter, to trade U.K. natural gas, gas
oil, and Brent crude oil contracts through the ICE electronic
trading platform.

B. ICE Futures Trading of U.S. Energy Commodities

In mid-January 2006, ICE notified the CFTC that on February
3, 2006, it would begin trading a U.S. energy commodity--West
Texas Intermediate crude oil, a crude oil that is produced in
the United States--on its ICE Futures exchange in London, and
that it would offer this contract for trading on its electronic
trading devices that were operating in the United States under
the no-action letters the CFTC had previously issued. Under
CFTC policy in effect at the time, ICE Futures did not need an
additional no-action letter to make this new contract available
for trading in the United States; rather, ICE Futures needed
only to provide prior notice to the CFTC.¹⁴³ This
marked the first time that futures contracts for crude oil
produced in the United States was traded on an exchange outside
of the United States.
---------------------------------------------------------------------------
\143\ Notice of Statement of Commission Policy Regarding the
Listing of New Futures and Options Contracts by Foreign Boards of Trade
that Have Received Staff No-Action Relief to Place Electronic Trading
Devices in the United States, 65 Fed. Reg. 41641 (July 6, 2000). On
April 14, 2006, the CFTC revised its policy to require a foreign board
of trade to provide the CFTC with at least ten days' notice prior to
the commencement of trading from within the United States of any
product on such board of trade. 71 Fed. Reg. 19877 (April 18, 2006).
---------------------------------------------------------------------------
Since ICE began trading WTI crude oil futures on its London
exchange, it has steadily increased its share of the WTI crude
oil furtures market.¹⁴⁴ According to CFTC data, as
of the end of April 2006, nearly 30 percent of WTI crude oil
futures were traded on ICE Futures.¹⁴⁵ According to
one energy trade publication, several of the large ICE
stakeholders--BP, Total, and Morgan Stanley--were ``doing their
best to support the ICE WTI contract, with Goldman Sachs
directing its traders to use the ICE platform rather than
Nymex.'' ¹⁴⁶
---------------------------------------------------------------------------
\144\ Prior to the listing of a WTI contract on the ICE Futures
exchange, ICE offered a WTI contract for trading on its OTC electronic
exchange. In a recent interview, ICE Chairman and CEO Jeffrey Sprecher
described how ICE's development of a successful OTC contract for WTI
paved the way for the introduction of the WTI contract on ICE Futures:
To the outside world, we launched WTI and it came out with a very
high adoption rate. But the reality is ICE was working on that contract
for a year and a half prior to its launch. One unique thing about ICE
is that we can take a product and launch it as a bilateral OTC contract
allowing the energy trading community to trade it. While they trade it
we can work out many of the details, such as the size of the contract,
delivery aspects, tick size and those things. Then we can add clearing
to it and bring in more of the funds and speculators--if we get that
going, then we can make it a futures contract. That's the process we
went through with the WTI contract. It went from a bilateral swap to a
cleared OTC contract to a futures contract.
And we're bringing other contracts through that conveyor belt
process. In the first half of this year, we're bringing clearing to 50
bilateral contracts that we already offered.
ICE: ``The market has spoken,'' Futures & Options Week, April 24,
2006. As previously discussed, quantitative data on the WTI contract
traded on the ICE OTC electronic exchange is not readily available.
According to former Federal Reserve Chairman Greenspan's recent
testimony, during this period hedge funds and other institutional
investors conducted a substantial amount of trading in crude oil in
this market.
\145\ CFTC data provided to the Subcommittee.
\146\ Market Forces: Big Oil increases market reach, Energy
Compass, March 24, 2006.
---------------------------------------------------------------------------
ICE Futures has further expanded its reach into the U.S.
energy commodities market. In addition to trading WTI crude oil
futures on its London exchange, in April 2006, ICE Futures
began trading futures in U.S. gasoline and home heating oil.

C. Implications for Oversight of U.S. Commodity Markets

The trading of U.S. energy commodities on the ICE Futures
exchange in London from terminals within the United States
permits traders within the United States to trade U.S. energy
commodities without any U.S. oversight or regulation. This type
of unregulated trading of a U.S. commodity from within the
United States undermines the very purpose of the Commodity
Exchange Act and the central mission of the CFTC--to prevent
manipulation or excessive speculation of commodity prices ``to
the detriment of the producer or the consumer and the persons
handling commodities.'' Without information about the trading
of U.S. energy commodities, the CFTC cannot undertake, let
alone accomplish, its mission.
Furthermore, the trading of U.S. energy commodities on
foreign or unregulated OTC exchanges without any reporting to
the CFTC undermines the reporting system for commodities traded
on CFTC-regulated exchanges. With respect to traders that trade
on both exchanges, the CFTC will be provided only partial data
regarding the extent of their trades, thereby affecting the
accuracy of the data to the CFTC.
For example, a trader wishing to disguise its position on
the regulated market, or give the regulated market a false
impression of its trading, could buy and sell an identical
number of futures in different months; this would then be
reported to the CFTC as a spread position. That same trader
then could offset one of those positions, say, for example, the
short position, on the unregulated exchange. In this example,
the trader would have a net long position, but it would appear
to the CFTC and the public, through the Commitment of Traders
Report, as a spread position. Hence, both the CFTC and the
public would have an inaccurate view of the composition of the
market. Only the trader would know the correct position. It is
not difficult to imagine other schemes to distort the CFTC's
market data.
For the CFTC to be able to carry out its fundamental
mission to protect the integrity of the U.S. commodity futures
markets, all U.S. traders of U.S. energy futures or futures-
like contracts must keep records and report large trades to the
CFTC, regardless of where the trade takes place--on the NYMEX,
an electronic exchange, or a foreign exchange. To continue the
present situation, in which the CFTC does not police two of
three major markets trading U.S. energy futures, is to turn a
blind eye to an increasingly large segment of these markets,
thereby impairing the ability to detect, prevent, and prosecute
market manipulation and fraud. The United States needs to put
the cop back on the beat in all of these key energy markets.

APPENDIX

----------

MEASURING THE INCREASE IN SPECULATIVE TRADING

A. CFTC Commitment of Traders Report

One of the few direct, quantitative measures of the
increased trading activity by speculative money managers in
energy futures trading is provided by the Commodity Futures
Trading Commission (CFTC) weekly report on futures trading
activity. The CFTC publishes, on a weekly basis, a ``Commitment
of Traders'' (COT) Report, providing, for each commodity traded
on a U.S. futures exchange, statistical information regarding
the extent and nature of trading in that commodity in the
previous week. Oil industry consultant and analyst Matthew R.
Simmons characterizes the COT Report as, ``In the Land of the
Blind, it is the `One-Eyed King.' '' ¹⁴⁷ The report
``tells who the players are,'' provides a ``snapshot of Tuesday
market close,'' and can ``spot some long-term trends (after the
fact).'' ¹⁴⁸
---------------------------------------------------------------------------
\147\ Matthew R. Simmons, Oil Prices, Volatility and Speculation,
Presentation at the IEA/NYMEX Conference, New York, New York, November
23, 2004.
\148\ Id.
---------------------------------------------------------------------------
For trades conducted on the regulated futures markets, the
CFTC regulations require clearing houses and brokers to report,
on a daily basis, futures positions on their books for traders
that hold positions exceeding certain levels established by the
CFTC (``reportable positions''). Traders holding futures
positions are also required to file a report with the CFTC
describing the nature of their business; the CFTC uses this
data to classify each trader as ``commercial'' or ``non-
commercial.'' Commercial traders are those entities that use
the commodity as part of their business, and hence use the
futures markets for hedging; non-commercial traders are all
other traders. The non-commercial category includes commodity
pools, pension funds, hedge funds, and other types of managed
money funds. Generally, non-commercial traders do not use the
commodity in their normal course of business or purchase
futures to hedge their exposure to changes in the price of
those commodities; they are instead engaged in market
speculation to profit from price changes.¹⁴⁹
---------------------------------------------------------------------------
\149\ In some cases, a hedge fund or other type of managed money
fund may purchase futures for portfolio diversification to limit the
fund's financial exposure to energy prices fluctuations.
---------------------------------------------------------------------------
The COT Report provides, for each commodity: the total
amount of open interest in that commodity, meaning the total of
all futures and option contracts entered into and not yet
offset by another transaction or delivery of the
commodity.¹⁵⁰ The COT Report also provides the
number of outstanding short and long positions held by
commercial and non-commercial traders, respectively; and the
number of ``spreading'' positions held by non-commercial
traders. Spreading includes each trader's reported long and
short positions in the same commodity, to the extent they are
balanced.¹⁵¹ The report also identifies the number
of long and short non-reportable positions, which is derived
from the total open interest and the data on the reportable
positions. Generally, reportable positions represent from 70-90
percent of the particular market.¹⁵² The COT Report
also provides data on the percentage of open interest and
various other positions held by the largest four and largest
eight traders. This data provides a gauge on how much of the
market is dominated by the largest traders.
---------------------------------------------------------------------------
\150\ The CFTC defines ``open interest'' as ``the total of all
futures and/or option contracts entered into and not yet offset by a
transaction, by delivery, by exercise, etc.'' Open interest held or
controlled by a trader is referred to as that trader's position. For
the CFTC's Commitment of Traders Futures and Options Combined Report,
the open interest in options is calculated by mathematically computing
the futures-equivalent of the unexercised option contracts. CFTC
Backgrounder, The Commitment of Traders Report, at CFTC website, at
http://www.cftc.gov/opa/backgrouder/opacot596.htm.
\151\ For example, a trader might purchase a contract in the near-
future, and, at the same time, sell a longer-term futures contract.
This would be reported to the CFTC as a spread position. If the trader
purchased two long futures contracts, and sold one short contract, it
would be reported as one spread contract and one long contract.
\152\ Haigh, Hranaiova and Overdahl, at pp. 3-4.
---------------------------------------------------------------------------

B. Increased Speculative Trading on the NYMEX

The increase in trading in oil and natural gas futures and
options by money managers and speculators is seen clearly in
the trends in the CFTC trader data over the past several years.
Figure A-1 shows the increasing amount of open interest in
crude oil and natural gas contracts traded on the NYMEX since
1998.

[GRAPHIC] [TIFF OMITTED] T8640.007

Figure A-1. The open interest in both crude oil and natural gas
contracts has doubled since 2004. Data source: CFTC COT data.

A breakdown of the crude oil and natural gas open interest
by the various types of positions tracked by the CFTC shows how
there has been a shift in the composition of trading on the
NYMEX over the past couple of years. As Figure A-2 demonstrates
for crude oil contracts, and Figure A-3 demonstrates for
natural gas contracts, in the past few years there has been a
significant increase in the amount of open interest held by
non-commercial traders. In both markets, there has been a large
increase in the amount of spreading--i.e. holding of both long
and short positions that do not offset each other--by non-
commercial traders. In short, the amount of speculative trading
in crude oil and natural contracts has increased significantly
in the past 2 years.

[GRAPHIC] [TIFF OMITTED] T8640.008

Figure A-2. The amount of speculative trading in crude oil contracts
has increased significantly in the past 2 years, as evidenced by the
increase in the number of non-commercial spread positions. Data source:
CFTC.

[GRAPHIC] [TIFF OMITTED] T8640.009

Figure A-3. The amount of speculative trading in natural gas
contracts has increased significantly in the past 2 years, as evidenced
by the increase in the number of non-commercial spread positions. Data
source: CFTC.

Table A-1 presents similar information in tabular format.
Additionally, Table A-1 shows the increase in the number of
non-commercial traders over this same period. Although the
number of commercial traders holding short and long positions
has not varied by more than about 20 percent during this
period, the number of non-commercial traders holding spread
positions has quadrupled, so that there are now more non-
commercial traders than commercial traders.

[GRAPHIC] [TIFF OMITTED] T8640.011

Table A-1. CFTC data shows a significant increase in the number of
non-commercial traders and the percentage of open interest held by non-
commercial traders in the past few years. Data source: CFTC.

Figure A-4 shows how the influx of investment into longer-
term futures has raised the prices of futures contracts above
the price of the nearer-term futures contracts (``contango'').
The relative increase in the price of longer-term futures
contracts has provided a financial incentive for oil companies
and refiners to purchase additional oil and put it into
inventory.

[GRAPHIC] [TIFF OMITTED] T8640.010

Figure A-4. In recent years longer-term futures prices have
increased to levels higher than nearer-term futures contracts,
providing a financial incentive to purchase and store oil. For years
1999-2002, the dates reflect the forward curve as of December 1 of that
year. For other years, the dates reflect the foward curve as of
December 2, 2003, December 2, 2004, December 6, 2005, and April 1,
2006. Data source: NYMEX.

C. Increased Speculative Trading on ICE

Because there are no reporting requirements for OTC
trading, there are no publicly available quantitative measures
of the extent of speculative trading in the OTC markets.
Industry participants are not required to file large trader
reports and the CFTC does not have any data to compile
Commitment of Trader Reports. What little information has been
publicly disclosed, however, indicates there has been a
substantial growth in speculative activity on the ICE OTC
market.
ICE financial statistics show a tripling in the amount of
OTC commission fees it has received from a level of
approximately $8 million in the fourth quarter of 2004 to
approximately $24 million in the first quarter of
2006.¹⁵³ ICE reported an increase in the number of
cleared Henry Hub natural gas contracts from 4,512,000 in 2003
to 15,887,000 in 2004 and then to 42,760,000 in
2005.¹⁵⁴ In the first 3 months of 2006, ICE reported
a trading volume of 44,906 million North American natural gas
contracts as compared to a trading volume of 23,838 million gas
contracts for the first 3 months of 2003.¹⁵⁵
---------------------------------------------------------------------------
\153\ ICE Form 10-Q, at p. 22.
\154\ ICE Form 10-K, at p. 73.
\155\ ICE Form 10-Q, at p. 22 (each contract representing one
million BTUs).
---------------------------------------------------------------------------
The ICE financial statistics indicate that a large part of
this growth can be attributed to increased trading by hedge
funds, managed money, and individual speculators. Table A-2
provides the most recent breakdown provided by ICE of the
composition of ICE participants.

Table A-2
ICE OTC Participants
----------------------------------------------------------------------------------------------------------------
Year ended December 31,
OTC Participants Trading (as % of total commissions) -----------------------------------
2003 2004 2005
----------------------------------------------------------------------------------------------------------------
Commercial companies (including merchant energy) 64.1 56.5 48.8
----------------------------------------------------------------------------------------------------------------
Banks and financial institutions 31.3 22.4 20.5
----------------------------------------------------------------------------------------------------------------
Hedge funds, locals and proprietary trading shops \156\ 4.6 21.1 30.7
\156\ The term ``local'' refers to an individual who commits his or her own
capital for speculative trading on an electronic exchange. A ``proprietary
trader'' is a professional trader hired by a firm to trade that firm's
money. See, e.g., Jim Kharouf, Prop Shops and Trading Schools Raise the
Bar, Stocks, Futures & Options Magazine, January 2004.
----------------------------------------------------------------------------------------------------------------

Table A-2. Hedge funds and other speculators have
significantly increased their use of OTC electronic markets.
Data source: ICE Form 10-K, at p. 73.