Energy Derivatives: Preliminary Views on Energy Derivatives
Trading and CFTC Oversight (12-JUL-07, GAO-07-1095T).
Energy prices for crude oil, heating oil, unleaded gasoline, and
natural gas have risen substantially since 2002, generating
questions about the reasons for the increase. Some observers
believe that the higher energy prices were solely due to supply
and demand fundamentals while others believe that increased
futures trading activity may also have contributed to higher
prices. This testimony highlights GAO's preliminary findings
related to (1) trends and patterns in the futures and physical
energy markets and the effect of these trends on energy prices
and (2) the Commodity Futures Trading Commission's (CFTC)
regulatory and enforcement authority over derivatives markets.
GAO analyzed futures and large trader reporting data; trading
data obtained from the New York Mercantile Exchange (NYMEX) for
crude oil, heating oil, unleaded gasoline, and natural gas; and
various other sources of energy-related data. GAO also analyzed
relevant academic and other studies on the subject and
interviewed market participants, experts, and officials at
relevant federal agencies.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-07-1095T
ACCNO: A72506
TITLE: Energy Derivatives: Preliminary Views on Energy
Derivatives Trading and CFTC Oversight
DATE: 07/12/2007
SUBJECT: Commodity futures
Commodity marketing
Commodity sales
Crude oil
Derivative securities
Energy marketing
Financial analysis
Financial futures
Gasoline
Natural gas
Petroleum prices
Prices and pricing
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GAO-07-1095T
* [1]Background
* [2]Multiple Factors in the Derivatives and Physical Markets Hav
* [3]The Energy Futures Markets Experienced Rising Prices, High V
* [4]Various Patterns in the Physical Markets Also Explain Rising
* [5]CFTC Oversees Exchanges and Has Some Authority over Other De
* [6]GAO Contacts
* [7]Staff Acknowledgments
* [8]GAO's Mission
* [9]Obtaining Copies of GAO Reports and Testimony
* [10]Order by Mail or Phone
* [11]To Report Fraud, Waste, and Abuse in Federal Programs
* [12]Congressional Relations
* [13]Public Affairs
Testimony
Before the Subcommittee on General Farm Commodities and Risk Management,
Committee on Agriculture, House of Representatives
United States Government Accountability Office
GAO
For Release on Delivery
Expected at 10:00 a.m. EDT
Thursday, July 12, 2007
ENERGY DERIVATIVES
Preliminary Views on Energy Derivatives Trading and CFTC Oversight
Statement of Orice M. Williams, Director
Financial Markets and Community Investment
GAO-07-1095T
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss our preliminary views on the
trading of derivatives for energy commodities such as natural gas and
crude oil. As energy prices have increased in recent years, the trading
volume of exchange-traded futures, off-exchange traded swaps, and other
types of derivatives have also experienced significant growth.1 Increased
energy prices generally have been attributed to normal market forces of
supply and demand, but these trends in energy derivatives markets have
raised questions about whether this trading activity has placed additional
upward pressure on the prices of physical energy commodities. The prices
of futures contracts, like those of all derivatives, are in large part
based on prices in the physical spot (cash) market where commodities are
sold. At the same time, buyers and sellers of natural gas, crude oil,
gasoline, and other energy products use exchange-traded futures prices,
which are published daily, when determining prices in the physical
markets. The extent to which off-exchange prices are used for determining
prices of the underlying commodity, however, is unclear. The growth in
energy futures trading since 2001 has in part been fueled by new market
participants such as hedge funds and by increased investment in commodity
index funds, which are funds whose prices are tied to the price of a
basket of various commodity futures.
My testimony today is based on an ongoing engagement on trading activity
in energy derivatives markets--primarily the futures market--and the
oversight role of the Commodity Futures Trading Commission (CFTC). Because
of the broad interest in this subject, our ongoing work has been initiated
under the authority of the Comptroller General. My remarks today present
our preliminary views on (1) trends in the energy derivatives and physical
markets and the effect of those trends on energy prices, and (2) the
regulatory structure of the various markets where energy commodities and
derivatives are traded.
In conducting this work, we obtained and analyzed energy futures prices
and trading volumes from the New York Mercantile Exchange, Inc. (NYMEX).
Specifically, we collected data for crude oil, heating oil, natural gas,
and unleaded gas for the period January 2002 through December 2006. We
also obtained and analyzed data on market participants and the outstanding
trading positions of different categories of traders from CFTC. In
addition, we reviewed publicly available information, including academic
studies and reports and market data. Finally, we interviewed a broad range
of market participants and observers, representatives of energy trading
markets, and government regulators and agencies involved with the energy
markets. This work is being done in accordance with generally accepted
government auditing standards.
1Our analysis of energy prices and energy financial markets is generally
limited to the time period fromf January 2002 to December 2006.
In summary, derivatives and physical markets for crude oil, unleaded
gasoline, heating oil, and natural gas have experienced substantial
changes in recent years. From January 2002 to July 2006, monthly average
futures and spot prices for crude oil, gasoline, and heating oil
registered increases of over 200 percent.2 The volatility of energy prices
also generally remained above historic averages for most of the period but
declined during 2006 to levels at or near the historical average. At the
same time, trading volumes for futures increased, at least in part because
a growing number of managed-money traders (including hedge funds) began to
see energy futures as attractive investment alternatives. While these
changes were occurring, the physical market was experiencing tight supply
and rising demand from increasing global demand, ongoing political
instability in oil-producing regions, limited refining capacity, and other
ongoing supply disruptions. Some observers believe that higher energy
prices were solely the result of supply and demand fundamentals while
others believe that increased futures trading activity may also have
contributed to higher prices. But the effect on energy prices of
individual changes in these markets is unclear, as many factors have
combined to affect energy prices. Monitoring these changes in the future
will be important in protecting the public and ensuring market integrity.
Energy derivatives are traded on futures exchanges, exempt commercial
markets, and over the counter (OTC). Some of these markets are subject to
CFTC oversight and some are largely unregulated. Under the Commodity
Exchange Act (CEA), CFTC regulatory oversight is focused on the
surveillance of futures exchanges, protecting the public, and ensuring
market integrity. CFTC does not, however, have oversight authority over
exempt commercial markets--electronic trading facilities that trade exempt
commodities, including energy commodities, on a principal-to-principal
basis solely between persons that are eligible commercial entities--and
the volume of off-exchange transactions has increased significantly in
recent years. Also, certain parties--those who qualify as eligible
contract participants--can enter into contracts directly (over the
counter). Both the exempt commercial market and the OTC market are exempt
from general CFTC oversight. However, both markets are subject to CFTC's
enforcement of the CEA's antimanipulation and, where applicable, antifraud
provisions. Because of these varying levels of CFTC oversight, some market
observers question whether CFTC needs broader authority over all
derivative markets, particularly those involving exempt commodities. CFTC
generally believes that the commission has sufficient authority over OTC
derivatives and exempt energy markets. However, CFTC has recently taken
additional actions to clarify its authority to obtain information about
pertinent off-exchange transactions.
2To account for the effects of inflation on prices, prices are adjusted to
reflect prices in the base year of 2006.
Background
Energy commodities are bought and sold on both the physical and financial
markets. The physical market includes the spot market where products such
as crude oil or gasoline are bought and sold for immediate or near-term
delivery by producers, wholesalers, and retailers. Spot transactions take
place between commercial participants for a particular energy product for
immediate delivery at a specific location. For example, the U.S. spot
market for West Texas Intermediate (WTI) crude oil is the pipeline hub
near Cushing, Oklahoma, while a major spot market for natural gas operates
at the Henry Hub near Erath, Louisiana. The prices set in the specific
spot markets provide a reference point that buyers and sellers use to set
the price for other types of the commodity traded at other locations.
In addition to the cash markets, derivatives based on energy commodities
are traded in financial markets. The value of the derivative contract
depends on the performance of the underlying asset--for example, crude oil
or natural gas. Derivatives include futures, options, and swaps. Energy
futures include standardized exchange-traded contracts for future delivery
of a specific crude oil, heating oil, natural gas, or gasoline product at
a particular spot market location. An exchange designated by CFTC as a
contract market standardizes the contracts, which participants cannot
modify. The owner of an energy futures contract is obligated to buy or
sell the commodity at a specified price and future date. However, the
contractual obligation may be removed at any time before the contract
expiration date if the owner sells or purchases other contracts with terms
that offset the original contract. In practice, most futures contracts on
NYMEX are liquidated via offset, so that physical delivery of the
underlying commodity is relatively rare.
Options give the purchaser the right, but not the obligation, to buy or
sell a specific quantity of a commodity or financial asset at a designated
price. Swaps are privately negotiated contracts that involve an ongoing
exchange of one or more assets, liabilities, or payments for a specified
time period. Like futures, options can be traded on an exchange designated
by CFTC as a contract market. Both swaps and options can be traded
off-exchange if the transactions involve qualifying commodities and the
participants satisfy statutory requirements. Options and futures are used
to buy and sell a wide range of energy, agricultural, financial, and other
commodities for future delivery.
Market participants use futures markets to offset the risk caused by
changes in prices, to discover commodity prices, and to speculate on price
changes. Some buyers and sellers of energy commodities in the physical
markets trade in futures contracts to offset, or "hedge," the risks they
face from price changes in the physical market. Exempt commercial markets
and OTC derivatives can serve the same function. Price risk is an
important concern for buyers and sellers of energy commodities, because
wide fluctuations in cash market prices introduce uncertainty for
producers, distributors, and consumers of commodities and make investment
planning, budgeting, and forecasting more difficult. To manage price risk,
market participants may shift it to others more willing to assume the risk
or to those having different risk situations. For example, if a petroleum
refiner wants to lower its risk of losing money because of price
volatility, it could lock in a price by selling futures contracts to
deliver the gasoline in 6 months at a guaranteed price. Without futures
contracts to manage risk, producers, refiners, and others would likely
face greater uncertainty.
The futures market also helps buyers and sellers determine, or "discover,"
the price of commodities in the physical markets, thus linking the two
markets together. Price discovery is facilitated when (1) participants
have current information about the fundamental market forces of supply and
demand, (2) large numbers of participants are active in the market, and
(3) the market is transparent. Market participants monitor and analyze a
myriad of information on the factors that currently affect and that they
expect to affect the supply of and demand for energy commodities. With
that information, participants buy or sell an energy commodity contract at
the price they believe the commodity will sell for on the delivery date.
The futures market, in effect, distills the diverse views of market
participants into a single price. In turn, buyers and sellers of physical
commodities may consider those predictions about future prices, among
other factors, when setting prices on the spot and retail markets.
Other participants, such as investment banks and hedge funds, which do not
have a commercial interest in the underlying commodities, use the futures
market strictly for profit. These speculators provide liquidity to the
market but also take on risks that other participants, such as hedgers,
seek to avoid. In addition, arbitrageurs attempt to make a profit by
simultaneously entering into several transactions in multiple markets in
an effort to benefit from price discrepancies across these markets.
Multiple Factors in the Derivatives and Physical Markets Have Impacted Energy
Prices
Both derivatives and physical markets experienced a substantial amount of
change from 2002 through 2006. These changes have been occurring
simultaneously, and the specific effect of any one of these changes on
energy prices is unclear.
The Energy Futures Markets Experienced Rising Prices, High Volatility, Increased
Trading Volume, and Growth in Some Types of Traders
Several recent trends in the futures markets have raised concerns among
some market observers that these conditions may have contributed to higher
physical energy prices. Specifically from January 2002 to July 2006, the
futures markets experienced higher prices, relatively higher volatility,
increased trading volume, and growth in some types of traders. During this
period, monthly average spot prices for crude oil, gasoline, and heating
oil increased by over 200 percent, and natural gas spot prices increased
by over 140 percent.3 At the same time that spot prices were increasing,
the futures prices for these commodities showed a similar pattern, with a
sharp and sustained increase. For example, the price of crude oil futures
increased from an average of $22 per barrel in January 2002 to $74 in July
2006. At the same time, the annual historical volatilities--measured using
the relative change in daily prices of energy futures--between 2000 and
2006 generally were above or near their long-term averages, although crude
oil and heating oil declined below the average and gasoline declined
slightly at the end of that period. We also found that the annual
volatility of natural gas fluctuated more widely than that of the other
three commodities and increased in 2006 even though prices largely
declined from the levels reached in 2005. Although higher volatility is
often equated with higher prices, this pattern illustrates that an
increase in volatility does not necessarily mean that price levels will
increase. In other words, price volatility measures the variability of
prices rather than the direction of the price changes.
3To account for the effects of inflation on prices, prices are adjusted to
reflect prices in the base year of 2006.
We also observed that at the same time that prices were rising and that
volatility was generally above or near long-term averages, futures markets
saw an increase in the number of noncommercial traders such as managed
money traders, including hedge funds.4 The trends in prices and volatility
made the energy derivatives markets attractive for the growing number of
traders that were looking to either hedge against those changes or profit
from them. Using CFTC's large trader data, we found that from July 2003 to
December 2006 crude oil futures and options contracts experienced the most
dramatic increase, with the average number of noncommercial traders more
than doubling from about 125 to about 286. As shown in figure 1, while the
growth was less dramatic in the other commodities, the average number of
noncommercial traders also showed an upward trend for unleaded gasoline,
heating oil, and natural gas.
4CFTC collects data on traders holding positions at or above specific
reporting levels set by the Commission. This information is collected as
part of CFTC's Large Trader Reporting System.
Figure 1: Average Daily Number of Large Commercial and NonCommercial
Traders per Month, July 2003 through December 2006
Not surprisingly, our preliminary work also revealed that as the number of
traders increased, so did the trading volume on NYMEX for all energy
futures contracts, particularly crude oil and natural gas. Average daily
contract volume for crude oil increased by 90 percent from 2001 through
2006, and natural gas increased by just over 90 percent. Unleaded gasoline
and heating oil experienced less dramatic growth in their trading volumes
over this period.
Another notable trend, but one that is much more difficult to quantify,
was the apparently significant increase in the amount of energy
derivatives traded outside exchanges. Trading in these markets is much
less transparent, and comprehensive data are not available because these
energy markets are not regulated. While the Bank for International
Settlements publishes data on worldwide OTC derivative trading volume for
broad groupings of commodities, this format can be used only as a rough
proxy for trends in the trading volume of OTC energy derivatives.5
According to these data, the notional amounts outstanding of OTC commodity
derivatives excluding precious metals, such as gold, grew by over 850
percent from December 2001 to December 2005.6 In the year from December
2004 to December 2005 alone, the notional amount outstanding increased by
more than 200 percent to over $3.2 trillion. Despite the lack of
comprehensive energy-specific data on OTC derivatives, the recent
experience of individual trading facilities further reveals the growth of
energy derivatives trading outside of futures exchanges. For example,
according to its annual financial statements, the volume of non-futures
energy contracts traded on the Intercontinental Exchange, also known as
ICE, including financially settled derivatives and physical contracts,
increased by over 400 percent to over 130 million contracts in 2006.
Further, while some market observers believe that managed money traders
were exerting upward pressure on prices by predominantly buying futures
contracts, CFTC data we analyzed revealed that from the middle of 2003
through the end of 2006, the trading activity of managed money
participants became increasingly balanced between buying (those that
expect prices to go up) and selling (those that expect prices to go down).
That is, our preliminary view of these data suggests that managed money
traders as a whole were more or less evenly divided in their expectations
about future prices than they had been in the past.
5The Bank for International Settlements (BIS) is an international
organization that fosters international monetary and financial cooperation
and serves as a bank for central banks.
6The notional amount is the amount upon which payments between parties to
certain types of derivatives contracts are based. The notional amount is
not exchanged between the parties but instead represents a hypothetical
underlying quantity upon which payment obligations are computed. The BIS
data on OTC derivatives includes forwards, swaps, and options.
We found that views were mixed about whether these trends had any upward
pressure on prices. Some market participants and observers have concluded
that large purchases of oil futures contracts by speculators could have
created an additional demand for oil that could lead to higher prices.
Contrary to this viewpoint, some federal agencies and other market
observers took the position that speculative trading activity did not have
a significant impact on prices. For example, an April 2005 CFTC study of
the markets concluded that increased trading by speculative traders,
including hedge funds, did not lead to higher energy prices or volatility.
This study also argued that hedge funds provided increased liquidity to
the market and dampened volatility. Still others told us that while
speculative trading in the futures market could contribute to short-term
price movements in the physical markets, they did not believe it was
possible to sustain a speculative "bubble" over time, because the two
markets were linked and both responded to information about changes in
supply and demand caused by such factors as the weather or geographical
events. In the view of these observers and market participants,
speculation could not lead to artificially high or low prices over a long
period of time.
Various Patterns in the Physical Markets Also Explain Rising Energy Prices
The developments in the derivatives markets in recent years have not
occurred in isolation. Conditions in the physical markets were also
undergoing changes that could help explain increases in both derivative
and physical commodity prices. As we have reported, futures prices
typically reflect the effects of world events on the price of the
underlying commodity such as crude oil.7 For example, political
instability and terrorist acts in countries that supply oil create
uncertainties about future supplies that are reflected in futures prices
in anticipation of an oil shortage and expected higher prices in the
future. Conversely, news about a new oil discovery that would increase
world oil supply could result in lower futures prices. In other words,
futures traders' expectations of what may happen to world oil supply and
demand influence their price bids.
According to the Energy Information Administration (EIA), world oil demand
has grown from about 59 million barrels per day in 1983 to more than 85
million barrels per day in 2006 (fig. 2). While the United States accounts
for about a quarter of this demand, rapid economic growth in Asia has also
stimulated a strong demand for energy commodities. For example, EIA data
shows that from 1983 to 2004, China's average daily demand for crude oil
increased almost fourfold.
7See GAO, Motor Fuels: Understanding the Factors that Influence the Retail
Prices of Gasoline, [14]GAO-05-525SP (Washington, D.C.: May 2005).
Figure 2: Increase in World Demand for Crude Oil, 1980-2006
Note: The world oil demand data for 2006 represent a preliminary estimate.
The growth in demand does not, by itself, lead to higher prices for crude
oil or any other energy commodity. For example, if the growth in demand
were exceeded by a growth in supply, prices would fall, other things
remaining constant. However, according to EIA, the growth in demand
outpaced the growth in supply, even with spare production capacity
included in supply. Spare production capacity is surplus oil that can be
produced and brought to the market relatively quickly to rebalance the
market if there is a supply disruption anywhere in the world oil market.
As shown in figure 3, EIA estimates that global spare production capacity
in 2006 was about 1.3 million barrels per day, compared with spare
capability of about 10 million barrels per day in the mid-1980s and 5.6
million barrels a day as recently as 2002.
Figure 3: Estimates of World Oil Spare Production Capacity by the Energy
Information Administration
Note: The spare capacity data for 1991-1997 represent an average over
those years.
Major weather and political events can also lead to supply disruptions and
higher prices. In its analysis, EIA has cited the following examples:
o Hurricanes Katrina and Rita removed about 450,000 barrels per
day from the world oil market from June 2005 to June 2006.
o Instability in major oil-producing countries of the Organization
of Petroleum Exporting Countries (OPEC), such as Iraq and Nigeria,
have lowered production in some cases and increased the risk of
future production shortfalls in others.
o Oil production in Russia, a major driver of non-OPEC supply
growth during the early 2000s, was adversely affected by a
worsened investment climate as the government raised export and
extraction taxes.
The supply of crude oil affects the supply of gasoline and heating oil,
and just as production capacity affects the supply of crude oil, refining
capacity affects the supply of those products distilled from crude oil. As
we have reported, refining capacity in the United States has not expanded
at the same pace as the demand for gasoline.8 Inventory, another factor
affecting supplies and therefore prices, is particularly crucial to the
supply and demand balance, because it can provide a cushion against price
spikes if, for example, production is temporarily disrupted by a refinery
outage or other event. Trends toward lower levels of inventory may reduce
the costs of producing gasoline, but such trends may also cause prices to
be more volatile. That is, when a supply disruption occurs or there is an
increase in demand, there are fewer stocks of readily available gasoline
to draw on, putting upward pressure on prices. However, others noted a
different trend for crude oil inventories. That is, prices have remained
high despite patterns of higher levels of oil in inventory.
In addition to the supply and demand factors that generally apply to all
energy commodities, specific developments can affect particular
commodities. For instance, the growth of special gasoline
blends--so-called "boutique fuels"--can affect the price of gasoline. As
we have reported, it is generally agreed that the higher costs associated
with supplying special gasoline blends contributed to higher gasoline
prices, either because of more frequent or more severe supply disruptions
or because the costs were likely passed on, at least in part, to
consumers.9
Like the futures market, the physical market has undergone substantial
changes that could affect prices. But market participants and other
observers disagree about the impact of these changes on increasing energy
prices. Some observers believe that higher energy prices were solely the
result of supply and demand fundamentals, while others believe that
increased futures trading activity contributed to higher prices. Another
consideration is that the value of the U.S. dollar on open currency
markets could also affect crude oil prices. For example, because crude oil
is typically denominated in U.S. dollars, the payments that oil-producing
countries receive for their oil are also denominated in U.S. dollars. As a
result, a weak U.S. dollar decreases the value of the oil sold at a given
price, and oil-producing countries may wish to increase prices for their
crude oil in order to maintain the purchasing power in the face of a
weakening U.S. dollar. The relative effect of each of these changes
remains unclear, however, because all of the changes were occurring
simultaneously. Monitoring these trends and patterns in the future will be
important in order to better understand their effects, protect the public,
and ensure market integrity.
8See GAO, Energy Markets: Factors Contributing to Higher Gasoline Prices,
[15]GAO-06-412T (Washington, D.C.: Feb. 1, 2006) and [16]GAO-05-525SP .
9GAO, Gasoline Markets: Special Gasoline Blends Reduce Emissions and
Improve Air Quality, but Complicate Supply and Contribute to Higher
Prices, [17]GAO-05-421 (Washington, D.C.: June 17, 2005).
CFTC Oversees Exchanges and Has Some Authority over Other Derivatives Markets
Energy products are traded on multiple markets, some of which are subject
to varying levels of CFTC oversight and some of which are not. This
difference in oversight has caused some market observers to question
whether CFTC needs broader oversight authority. As we have seen, under the
CEA CFTC's regulatory authority is focused on overseeing futures
exchanges, protecting the public, and ensuring market integrity. But in
recent years two additional venues for trading energy futures contracts
that are not subject to direct CFTC oversight have grown and become
increasingly important--exempt commercial markets and OTC markets.
However, traders in these markets are subject to the CEA's
antimanipulation and antifraud provisions, which CFTC has the authority to
enforce. Also, exempt commercial markets must provide CFTC with data for
certain contracts.10
Futures exchanges such as NYMEX are subject to direct CFTC regulation and
oversight. CFTC generally focuses on fulfilling three strategic goals
related to these exchanges. First, to ensure the economic vitality of the
commodity futures and options markets, CFTC conducts its own direct market
surveillance and also reviews the surveillance efforts of the exchanges.
Second, to protect market users and the public, CFTC promotes sales
practice and other customer protection rules that apply to futures
commission merchants and other registered intermediaries.11 Finally, to
ensure the market's financial integrity, CFTC reviews the audit and
financial surveillance activities of self-regulatory organizations.
CFTC conducts regular market surveillance and oversight of energy trading
on NYMEX and other futures exchanges.12 Oversight activities include:
1017 C.F.R. S 36.3; see 7 U.S.C. S 2(h)(4)(D).
11See 17 C.F.R. Parts 155, 166.
12NYMEX conducts its own surveillance activities and may bring enforcement
actions when violations are found.
o detecting and preventing disruptive practices before they occur
and keeping the CFTC commissioners informed of possible
manipulation or abuse;
o monitoring NYMEX's compliance with CFTC reporting requirements
and its enforcement of speculative position limits;
o investigating traders with large open positions; and
o documenting cases of improper trading.
In contrast to the direct oversight it provides to futures exchanges, CFTC
does not have general oversight authority over exempt commercial markets,
where qualified entities may trade through an electronic trading facility.
According to CFTC officials, these markets have grown in prominence in
recent years. Some market observers have questioned their role in the
energy markets and the lack of transparency about their trading
activities. Trading energy derivatives on exempt commercial markets is
permissible only for eligible commercial entities--a category of traders
broadly defined in the CEA to include firms with a commercial interest in
the underlying commodity--as well as other sophisticated investors such as
hedge funds. These markets are not subject to CFTC's general direct
oversight but are required to maintain communication with CFTC. Among
other things, an exempt commercial market must notify CFTC that it is
operating as an exempt commercial market and must comply with certain CFTC
informational, record-keeping, and other requirements.
Energy derivatives also may be traded OTC rather than via an electronic
trading facility. OTC derivatives are private transactions between
sophisticated counterparties, and there is no requirement for parties
involved in these transactions to disclose information about their
transactions. Derivatives transactions in both exempt commercial markets
and OTC markets are bilateral contractual agreements in which each party
is subject to and assumes the risk of nonperformance by its counterparty.
These agreements differ from derivatives traded on an exchange where a
central clearinghouse stands behind every trade.
While some observers have called for more oversight of OTC derivatives,
most notably for CFTC to be given greater oversight authority over this
market, others consider such action unnecessary. Supporters of more CFTC
oversight authority believe that more transparency and accountability
would better protect the regulated markets and consumers from potential
abuse and possible manipulation. Some question how CFTC can be assured
that trading on the OTC market is not adversely affecting the regulated
markets and ultimately consumers, given the lack of information about OTC
trading. However, in 1999 the President's Working Group on Financial
Markets concluded that OTC derivatives generally were not subject to
manipulation because contracts were settled in cash based on a rate or
price determined in a separate highly liquid market and did not serve a
significant price discovery function.13 Moreover, the market is limited to
professional counterparties that do not need the protections against
manipulation that CEA provides to retail investors. Finally, the group has
recently noted that if there are concerns about CFTC's authority, CFTC's
enforcement actions against energy companies are evidence that the CFTC
has adequate tools to combat fraud and manipulation when it is detected.14
The lack of reported data about off-exchange markets makes addressing
concerns about the function and effect of these markets on regulated
markets and entities challenging. CFTC officials have said that while they
have reason to believe these off-exchange activities can affect prices
determined on a regulated exchange, they also generally believe that the
commission has sufficient authority over OTC derivatives and exempt energy
markets. However, CFTC has recently begun to take steps to clarify its
authority to obtain information about pertinent off-exchange transactions.
In a June 2007 proposed rulemaking, CFTC noted that having data about the
off-exchange positions of traders with large positions on regulated
futures exchanges could enhance the commission's ability to deter and
prevent price manipulation or any other disruptions to the integrity of
the regulated futures markets.15 According to CFTC officials, the
commission has also proposed amendments to clarify its authority under the
CEA to collect information and to bring fraud actions in
principal-to-principal transactions in these markets, enhancing CFTC's
ability to enforce antifraud provisions of CEA.
13The President's Working Group was established by executive order in 1988
following the 1987 stock market crash. Its purpose was to enhance the
continued integrity, competitiveness, and efficiency of U.S. financial
markets and maintain the public's confidence in those markets. See the
Report of the President's Working Group on Financial Markets,
Over-the-Counter Derivatives Markets and the Commodity Exchange Act
(Washington, D.C.: 1999).
14June 11, 2003, letter signed by the members of the President's Working
Group to the Honorable Senator Michael D. Crapo and the Honorable Zell B.
Miller.
15According to CFTC, the purpose of the proposed regulation is to make
explicit that persons holding or controlling reportable positions on a
reporting market must retain books and records and make available to the
Commission upon request any pertinent information with respect to all
other positions and transactions in the commodity in which the trader has
a reportable position, including positions held or controlled or
transactions executed over-the counter and/or pursuant to Sections2(d),
2(g) or 2(h)(1)-(2) of the Commodity Exchange Act (Act) or Part 35 of the
Commission's regulations, on exempt commercial markets operating pursuant
to Sections 2(h)(3)-(5) of the Act, on exempt boards of trade operating
pursuant to Section 5d of the Act, and on foreign boards of trade; and to
make the regulation clearer and more complete with respect to hedging
activity. 72 Fed. Reg. at 34413.
In closing, our work to date shows that the derivatives and physical
markets have both undergone substantial change and evolution. Given the
changes in both markets, causality is unclear, and the situation warrants
ongoing review and analysis. We commend the Subcommittee's efforts in this
area. Along with the overall concern about rising prices, questions have
also been raised about CFTC's authority to protect investors from
fraudulent, manipulative, and abusive practices. CFTC generally believes
that the commission has sufficient authority over OTC derivatives and
exempt energy markets. However, CFTC has taken an important step by
clarifying its authority to obtain information about pertinent
off-exchange transactions.
Mr. Chairman, this concludes my prepared statement. I would be happy to
respond to any questions that you or other Members of the Subcommittee
might have.
GAO Contacts
For further information about this testimony, please contact Orice M.
Williams on (202) 512-8678 or at [18][email protected] .
Staff Acknowledgments
Contact points for our Offices of Congressional Relations and Public
Affairs may be found on the last page of this statement. Individuals
making key contributions include John Wanska (Assistant Director), Kevin
Averyt, Ross Campbell, Emily Chalmers, John Forrester, and Paul Thompson.
250355
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[25]www.gao.gov/cgi-bin/getrpt?GAO-07-1095T .
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Highlights of [26]GAO-07-1095T , testimony before Subcommittee on General
Farm Commodities and Risk Management, Committee on Agriculture, House of
Representatives
July 12, 2007
ENERGY DERIVATIVES
Preliminary Views on Energy Derivatives Trading and CFTC Oversight
Energy prices for crude oil, heating oil, unleaded gasoline, and natural
gas have risen substantially since 2002, generating questions about the
reasons for the increase. Some observers believe that the higher energy
prices were solely due to supply and demand fundamentals while others
believe that increased futures trading activity may also have contributed
to higher prices. This testimony highlights GAO's preliminary findings
related to (1) trends and patterns in the futures and physical energy
markets and the effect of these trends on energy prices and (2) the
Commodity Futures Trading Commission's (CFTC) regulatory and enforcement
authority over derivatives markets.
GAO analyzed futures and large trader reporting data; trading data
obtained from the New York Mercantile Exchange (NYMEX) for crude oil,
heating oil, unleaded gasoline, and natural gas; and various other sources
of energy-related data. GAO also analyzed relevant academic and other
studies on the subject and interviewed market participants, experts, and
officials at relevant federal agencies.
[27]What GAO Recommends
This testimony is based on an ongoing engagement, and therefore GAO is
making no recommendations at this time.
Rising energy prices have been attributed to a variety of factors, and
recent trends in the futures and physical markets highlight the changes
that have occurred in both markets from 2002 through 2006. Specifically:
o Inflation-adjusted energy prices in both the futures and physical
markets increased by over 200 percent during this period for three of the
four commodities we reviewed.
o Volatility (a measurement of the degree to which prices fluctuate over
time) in energy futures prices generally remained above historic averages
during the beginning of the time period but declined through 2006 for
three of the four commodities we reviewed.
o The number of noncommercial participants in the futures markets
including hedge funds, has grown; along with the volume of energy futures
contracts traded; and the volume of energy derivatives traded outside
traditional futures exchanges.
At the same time these changes were occurring in the futures markets for
energy commodities, tight supply and rising demand in the physical markets
pushed prices higher. For example, while global demand for oil has risen
at high rates, spare oil production capacity has fallen since 2002, and
increased political instability in some of the major oil-producing
countries has threatened the supply of oil. Refining capacity also has not
expanded at the same pace as the demand for gasoline. The individual
effect of these collective changes on energy prices is unclear, as many
factors have combined to affect energy prices. Monitoring these changes
will be important to protect the public and ensure market integrity.
Based on its authority under the Commodity Exchange Act (CEA), CFTC
primarily focuses its oversight on the operations of traditional futures
exchanges, such as NYMEX, where energy futures are traded. However, energy
derivatives are also traded on other markets, namely exempt commercial
markets and over-the-counter (OTC) markets--both of which have experienced
increased volumes in recent years. Exempt commercial markets are
electronic trading facilities that trade exempt commodities between
eligible participants, and OTC markets involve eligible parties that can
enter into contracts directly off-exchange. Both of these markets are
exempt from general CFTC oversight, but they are subject to the CEA's
antimanipulation and antifraud provisions and CFTC enforcement of those
provisions. Because of these varying levels of CFTC oversight, some market
observers question whether CFTC needs broader authority over all
derivative markets. CFTC generally believes that the commission has
sufficient authority over OTC derivatives and exempt energy markets.
However, CFTC has recently taken additional actions to clarify its
authority to obtain information about pertinent off-exchange transactions.
References
Visible links
14. http://www.gao.gov/cgi-bin/getrpt?GAO-05-525SP
15. http://www.gao.gov/cgi-bin/getrpt?GAO-06-412T
16. http://www.gao.gov/cgi-bin/getrpt?GAO-05-525SP
17. http://www.gao.gov/cgi-bin/getrpt?GAO-05-421
18. mailto:[email protected]
19. http://www.gao.gov/
20. http://www.gao.gov/
21. http://www.gao.gov/fraudnet/fraudnet.htm
22. mailto:[email protected]
23. mailto:[email protected]
24. mailto:[email protected]
25. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1095T
26. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1095T
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