[Senate Prints 108-18]
[From the U.S. Government Printing Office]


108th Congress                                                  S. Prt. 
                            COMMITTEE PRINT                     
 1st Session                                                     108-18
_______________________________________________________________________

                                     




                   U.S. STRATEGIC PETROLEUM RESERVE:

                   RECENT POLICY HAS INCREASED COSTS

                      TO CONSUMERS BUT NOT OVERALL

                          U.S. ENERGY SECURITY

                               __________

                              R E P O R T

                            prepared by the

                             MINORITY STAFF

                                 of the

                       PERMANENT SUBCOMMITTEE ON

                             INVESTIGATIONS

                                 of the

         COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE



[GRAPHIC] [TIFF OMITTED] TONGRESS.#13


                             March 5, 2003



85-551              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003
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                   COMMITTEE ON 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
ARLEN SPECTER, Pennsylvania          RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois        MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

           Michael D. Bopp, Staff Director and Chief Counsel
        Joyce Rechtschaffen, Minority Staff Director and Counsel
                     Darla D. Cassell, Chief Clerk

                                 ------                                

                 PERMANENT COMMITTEE ON INVESTIGATIONS

                   NORM COLEMAN, Minnesota, Chairman
TED STEVENS, Alaska                  CARL LEVIN, Michigan
GEORGE V. VOINOVICH, Ohio            DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania          RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois        MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

        Elise J. Bean, Minority Staff Director and Chief Counsel
                   Dan M. Berkovitz, Minority Counsel
                     Laura Stuber, Minority Counsel
                     Mary D. Robertson, Chief Clerk


                            C O N T E N T S

                                 ------                                

                                                                   Page

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

     A. Findings.................................................     1

     B. Recommendations..........................................     4

     C. Overview.................................................     5

II. THE U.S. STRATEGIC PETROLEUM RESERVE.........................    11

     A. Introduction.............................................    11

     B. Withdrawals From the SPR.................................    12

        1. Emergency Drawdown....................................    12

        2. Exchanges.............................................    12

        3. Non-Emergency Sales...................................    13

        4. The 2000 Swap: Release of 30 Million Barrels..........    13

     C. Filling the SPR..........................................    15

        1. Initial Fill of the SPR...............................    15

        2. Recent and Current Programs to Fill the SPR...........    16

           a. 2000 Swap Refill...................................    16

           b. 1999 Royalty-In-Kind (RIK) Program.................    17

           c. 2001 RIK Program to Fill the SPR to 700 Million 
      Barrels....................................................    18

        3. Strategy for Filling the SPR..........................    21

           a. Different Types of Crude Oil May Be Placed in the 
      SPR........................................................    21

           b. Market-Based Acquisition Strategy and Fill 
      Schedules..................................................    22

           c. SPR Market-Based Procedures Abandoned..............    24

III. THE PRICING OF CRUDE OIL....................................    25

     A. Overview of Crude Oil Markets............................    27

        1. Term Contracts........................................    28

        2. Crude Oil Spot or Cash Market.........................    29

        3. Crude Oil Futures Markets.............................    30

        4. Over-the-Counter Markets..............................    39

        5. Convergence of Futures and OTC Markets................    44

        6. Disparity in Market Disclosure and Oversight..........    45

     B. Crude Oil Price Benchmarks...............................    48

        1. Brent Crude Oil.......................................    48

           a. 15- and 21-Day Brent...............................    51

           b. Brent Spot Market: ``Dated Brent''.................    53

           c. Brent Futures Markets..............................    53

           d. Brent Over-the-Counter Markets.....................    54

        2. West Texas Intermediate (WTI).........................    56

        3. Dubai.................................................    57

     C. The Vulnerability of the Brent Market to Squeezes........    58

IV. CASE STUDY: THE COSTS OF FILLING THE SPR IN SPRING 2002.....    69

     A. Introduction.............................................    69

     B. Analysis.................................................    70

        1. Large Amounts of Brent Crude Oil Were Put Into the 
      SPR in Late 2001 and Early 2002............................    70

        2. The Use of Brent to Fill the SPR Increased the Price 
      of Brent Relative to WTI...................................    73

        3. Higher Brent Prices Increased the Price of Crude Oil 
      Imported into the United States............................    77

        4. Higher Costs for Imported Crude Oils Led to Fewer 
      Imports....................................................    79

        5. High-Priced Imports Led Refiners to Use Crude Oil in 
      Existing Inventories.......................................    87

        6. Decreasing U.S. Inventories Spiked the Price of WTI...    88

        7. WTI Price Spike Led to Price Spikes for Home Heating 
      Oil, Jet Fuel, and Diesel Fuel.............................    95

        8. Higher Home Heating Oil, Jet Fuel, and Diesel Fuel 
      Prices Hurt U.S. Consumers and Businesses..................    97

        9. High Crude Oil Prices Increased Refiners Costs........   100

     C. Oil Company Decisions to Send So Much Brent to the SPR...   103

V. THE 2002 SPR FILL PROGRAM.....................................   107

     A. DOE Changed SPR Policy to Require SPR Fills Regardless 
      of Oil Prices..............................................   107

     B. SPR Career Officials Opposed Policy Change and Warned 
      DOE the New Policy Would Increase Oil Prices, Consumer and 
      Taxpayer Costs.............................................   111

     C. SPR Career Officials Warned DOE the New Policy Would 
      Reduce U.S. Crude Oil Commercial Inventories...............   114

     D. SPR Document States Filling the SPR Without Regard to 
      Oil Prices Was Not Justified Even If A Major Supply 
      Disruption Were Imminent...................................   121

     E. 2002 SPR Fills Increased Consumer Costs But Not U.S. Oil 
      Supplies...................................................   122

APPENDIX 1: PREVENTING MANIPULATION IN COMMODITY MARKETS.........   125

I. OVERVIEW......................................................   125

II. THE LAW OF MANIPULATION......................................   126

     A. Anti-Manipulation Prohibition in Commodity Exchange Act..   126

        1. Market Power..........................................   129

        2. Specific Intent to Create an Artificial Price.........   132

        3. Artificial Price......................................   135

        4. Causation.............................................   136

        5. Summary...............................................   137

     B. Market Oversight to Detect and Prevent Manipulation......   138

        1. CFTC Market Oversight.................................   138

        2. Market Oversight by Approved Futures Exchanges........   141

     C. Lessons Learned from the Sumitomo Manipulation of the 
      Copper Markets.............................................   143

        1. Sumitomo Manipulation of the Copper Markets...........   143

        2. International Agreement to Address Problems Raised by 
      Sumitomo...................................................   148

APPENDIX 2: HISTORY AND CURRENT STATUS OF COMMODITY MARKET 
  REGULATION.....................................................   153

I. LEGISLATIVE HISTORY OF THE COMMODITY EXCHANGE ACT.............   153

     A. Background on Commodities Exchanges and Need for 
      Regulation.................................................   153

     B. The Commodity Exchange Act...............................   155

        1. Grain Futures Act of 1922.............................   155

        2. Commodity Exchange Act................................   157

        3. 1968 Amendments.......................................   158

        4. 1974 Amendments: Creation of CFTC.....................   159

II. GOVER-THE-COUNTER ENERGY DERIVATIVES: EXCLUSIONS AND 
  EXEMPTIONS FROM COMMODITY EXCHANGE ACT.........................   163

     A. 1989 Swaps Policy Statement: Exemption for Certain OTC 
      Swap Transactions..........................................   163

     B. Exemptions for Certain Brent Crude Oil Contracts.........   164

        1. The Transnor Decision.................................   164

        2. Industry Response to Transnor.........................   167

        3. CFTC: 15-Day Brent Contracts are Forward Contracts....   168

     C. Exemptions for Energy Contracts..........................   173

        1. Futures Trading Practices Acts of 1992................   173

        2. CFTC Exemption for Energy Contracts...................   176

           a. CFTC Order Granting Exemption......................   176

           b. Congressional Hearings on CFTC Order...............   179

     D. The Commodity Futures Modernization Act of 2000..........   183

        1. Regulatory Uncertainty Following the FTPA.............   183

        2. Enactment of Commodity Futures Modernization Act......   185

           a. Summary of Relevant Provisions.....................   185

           b. Outstanding Issues.................................   192

APPENDIX 3: EXHIBITS.............................................   194

    EXHIBIT II-1.................................................   194

    EXHIBIT II-2.................................................   204

    EXHIBIT III-1................................................   217

    EXHIBIT V-1..................................................   219

    EXHIBIT V-2..................................................   220

    EXHIBIT V-3..................................................   221

    EXHIBIT V-4..................................................   222

    EXHIBIT V-5..................................................   227

    EXHIBIT V-6..................................................   228

    EXHIBIT V-7..................................................   229

    EXHIBIT V-8..................................................   233

    EXHIBIT V-9..................................................   234

    EXHIBIT V-10.................................................   240

    EXHIBIT V-11.................................................   243

    EXHIBIT V-12.................................................   244

APPENDIX 4: ADDITIONAL DOCUMENTS.................................   247
    1. Transcript of Interview of Dr. Philip Verleger on 
      National Public Radio on March 7, 2003, regarding impact of 
      no-deferral policy in 2002 on the price of crude oil, 
      gasoline, and heating oil..................................   247

    2. Analysis by Dr. Philip Verleger, ``Measuring the Economic 
      Impact of an Oil Release from the Strategic Petroleum 
      Reserve to Compensate for the Loss of Venezuelan Oil 
      Production,'' March 20, 2003...............................   249

    3. Department of Energy Statement in Response to Minority 
      Staff Report, March 5, 2003................................   260

    4. Excerpt from Subcommittee Minority Staff presentation on 
      the Minority Staff Report, regarding the significance of 
      the 2002 fill rate of 135,000 barrels/day on the level of 
      U.S. commercial crude oil inventories, March 14, 2003......   261

    5. Additional DOE document on SPR fill policy, dated June 
      11, 2002, prepared by DOE SPR Office and Subcommittee on 
      March 19, 2003.............................................   266

    6. Correspondence between Senators Levin and Collins and 
      Senator Levin and U.S. Department of Energy regarding 
      production of documents related to SPR fill rates and 
      policy.....................................................   279

 
                   U.S. STRATEGIC PETROLEUM RESERVE:
                      RECENT POLICY HAS INCREASED
                   COSTS TO CONSUMERS BUT NOT OVERALL
                          U.S. ENERGY SECURITY

                              ----------                              


                          I. EXECUTIVE SUMMARY

    In June 2001, the U.S. Senate Permanent Subcommittee on 
Investigations, then under the Chairmanship of Senator Carl 
Levin (now Ranking Minority Member), initiated an investigation 
into the increased volatility of U.S. retail gasoline prices in 
recent years. In April 2002, the Subcommittee released a staff 
report,\1\ Gas Prices: How Are They Really Set?, and held 
hearings on retail gasoline pricing and the operation of the 
gasoline refining and marketing industry. During the course of 
this investigation, in early 2002, the Subcommittee learned of 
allegations that the U.S. Department of Energy's program to 
fill the U.S. Strategic Petroleum Reserve (SPR) was causing 
crude oil prices to rise significantly. The Subcommittee also 
learned of allegations that certain companies were manipulating 
crude oil prices on the New York and London futures exchanges. 
The Subcommittee initiated an investigation into these crude 
oil pricing issues that affect not only retail gasoline prices, 
but also prices for other key petroleum products, such as home 
heating oil, jet fuel, and diesel fuel.
---------------------------------------------------------------------------
    \1\ Report printed in PSI hearings held Apr. 30 and May 2, 2002, S. 
Hrg. 107-509, Gas Prices: How Are They Really Set?'' on page 322.
---------------------------------------------------------------------------
    As part of its investigation, Subcommittee Minority staff 
met with the U.S. Department of Energy (DOE), including its SPR 
Office, the U.S. Commodity Futures Trading Commission (CFTC), 
and the United Kingdom Financial Services Authority; 
interviewed representatives from futures exchanges in Chicago, 
New York, and London, and the Intercontinental Exchange (ICE) 
based in Atlanta; interviewed crude oil traders and officials 
from a number of companies that purchase, sell, and trade crude 
oil; and spoke with oil industry economists, representatives 
from crude oil price reporting services, and other oil industry 
experts. The Subcommittee Minority staff also reviewed 
extensive price and trading data from the New York and London 
crude oil futures markets; case law and legal analyses related 
to commodity market regulation and manipulation; numerous 
academic, economic and industry publications related to crude 
oil; and documents provided by DOE in response to Subcommittee 
requests. The Subcommittee Minority staff then prepared this 
Report describing the findings of the investigation and 
offering recommendations for corrective action.

A. Findings

    Based upon the evidence obtained during its investigation 
into how recent measures to fill the SPR have affected crude 
oil markets, the U.S. Senate Permanent Subcommittee on 
Investigations Minority staff makes the following findings. The 
findings are organized according to the two major areas of 
inquiry of this investigation: (1) the filling of the SPR; and 
(2) the operation of the crude oil markets.

U.S. Strategic Petroleum Reserve

    1. IN 2002, DOE BEGAN TO FILL THE SPR WITHOUT REGARD TO 
THE PRICE OF OIL. The SPR Program was established to ``store 
petroleum to reduce the adverse economic impact of a major 
petroleum supply interruption.'' Following the tragic events of 
September 11, 2001, in November 2001, President Bush directed 
the Department of Energy to fill the SPR to its capacity of 700 
million barrels ``in a deliberate and cost effective manner.'' 
In early 2002, DOE decided to fill the SPR without regard to 
crude oil prices. Reversing a longstanding policy of filling 
the SPR when crude oil prices were relatively low and deferring 
oil deliveries when prices were relatively high, DOE stopped 
granting requests to defer SPR oil deliveries. In 2002, DOE 
deposited about 40 million barrels of oil in the SPR at prices 
ranging from under $20 to over $30 per barrel.

    2. FILLING THE SPR IN A TIGHT MARKET INCREASED U.S. OIL 
PRICES AND HURT U.S. CONSUMERS. DOE ignored warnings by career 
staff that filling the SPR when oil prices were high and oil 
supplies were tight could drive oil prices higher and hurt 
consumers, did not conduct a cost-benefit analysis of the new 
policy, and did not attempt to estimate or track consumer or 
taxpayer costs. A Subcommittee Minority staff case study 
illustrates the high costs of the new SPR fill policy. In late 
2001 and early 2002, about 25 million barrels of Brent crude 
oil were deposited into the SPR despite already tight supplies 
on world markets. In a 1-month period in mid-2002, crude oil 
price increases caused by SPR deposits spiked the U.S. spot 
price of home heating oil by 13 percent, jet fuel by 10 
percent, and diesel fuel by 8 percent, imposing on U.S. 
consumers additional crude oil costs of between $500 million 
and $1 billion. Since then, high crude oil prices have boosted 
the cost of gasoline, heating oil, jet fuel, and diesel fuel, 
generating the types of adverse economic impacts on U.S. 
consumers the SPR program was designed to prevent.

    3. FILLING THE SPR REGARDLESS OF OIL PRICES INCREASED 
TAXPAYER COSTS. Prior to 2002, DOE routinely granted oil 
company requests to defer scheduled oil deliveries to the SPR 
when near-term oil prices were high compared to longer-term 
prices (i.e. during market backwardation), in return for 
deposits of extra oil at a later date. In 2000 and 2001, DOE 
used these deferrals to save taxpayers over $175 million and 
add 7 million barrels to the SPR. By denying deferral requests 
for most of 2002, DOE missed opportunities for comparable 
taxpayer savings and extra SPR oil. Also, by using federally-
owned oil acquired from offshore oil leases for the SPR instead 
of selling the oil on the market when prices were high, DOE 
reduced revenues supporting taxpayer-funded programs. For 
example, at the 2002 SPR fill rate of 100,000 barrels per day, 
filling the SPR when crude oil is priced at $30 per barrel 
rather than $20 per barrel costs taxpayers an additional $1 
million per day. Over 3 months, the additional cost of filling 
the SPR approaches $100 million, a cost ultimately borne by 
U.S. taxpayers.

    4. DESPITE ITS HIGH COST, FILLING THE SPR DID NOT INCREASE 
OVERALL U.S. OIL SUPPLIES. In 2002, DOE put about 40 million 
barrels of crude oil into the SPR, increasing the total 7 
percent, from about 560 million to 600 million barrels. 
Removing 40 million barrels from the marketplace, however, 
increased oil prices, which caused U.S. oil refiners to take 
oil from inventory instead of buying expensive new oil. In 
2002, U.S. commercial crude oil inventories dropped 10 percent, 
from about 310 to 280 million barrels. In 2003, commercial 
inventories dropped again to less than 270 million barrels. 
Today, overall oil supplies in the United States, which 
consists of oil in the SPR and commercial inventories, total 
about 870 million barrels, about the same amount as at the end 
of 2001, before the recent SPR fills. Although the SPR program 
has placed more oil under government control, lower private 
sector oil inventories mean there has been no net increase in 
overall national oil supplies.

    5. 2003 SPR DELIVERIES WILL DRIVE OIL PRICES HIGHER. 
Today, crude oil prices are at a 12-year high, and U.S. 
commercial crude oil inventories are at record lows, 
threatening refinery disruptions due to inadequate oil 
supplies. In these market conditions, unless more oil enters 
the marketplace, new SPR contracts to remove another 40 million 
barrels from the U.S. market in 2003, if carried out, will 
further shrink commercial supplies, drive oil prices higher, 
and impose more costs on U.S. consumers and taxpayers.

U.S. Crude Oil Markets

    6. U.S. CRUDE OIL FUTURES MARKET NEEDS TO BE IMPROVED. In 
2002, after SPR deliveries removed oil from the marketplace, 
defects in the New York and London crude oil markets magnified 
local supply and demand imbalances into large increases in the 
price of crude oil. Although the London market made major 
improvements to correct defects in the Brent market, the New 
York Mercantile Exchange (NYMEX) has not made needed 
improvements to the West Texas Intermediate (WTI) futures 
contract that plays a key role in U.S. crude oil markets.

    7. THE UNAVAILABILITY OF KEY INFORMATION ON OVER-THE-
COUNTER TRADING ACTIVITY MAKES DETECTION AND PREVENTION OF 
PRICE MANIPULATION DIFFICULT, IF NOT IMPOSSIBLE. Crude oil 
prices are affected by trading not only on regulated exchanges 
like the NYMEX, but also on unregulated ``over-the-counter'' 
(OTC) markets that have become major trading centers for energy 
contracts and derivatives. The lack of information on prices 
and large positions in OTC markets makes it difficult in many 
instances, if not impossible in practice, to determine whether 
traders have manipulated crude oil prices.

B. Recommendations

    Based upon the evidence obtained during its investigation 
and the findings in this Report, the U.S. Senate Permanent 
Subcommittee on Investigations Minority staff makes the 
following recommendations.

U.S. Strategic Petroleum Reserve

    1. DEFER 2003 SPR DELIVERIES. DOE should defer all SPR 
deliveries scheduled for 2003, until near-term crude oil prices 
fall and U.S. commercial inventories increase. DOE should 
publicly announce this policy change to calm markets by making 
it clear the SPR will not further reduce commercial oil 
supplies under current market conditions.

    2. CONDUCT COST-BENEFIT ANALYSIS. DOE should analyze the 
costs and benefits of the current policy to fill the SPR 
without regard to oil prices and without deferrals, compared to 
its prior policy of filling the SPR when oil prices are 
relatively low and deferring deliveries when oil prices are 
relatively high or supplies are tight and the contractor agrees 
to deliver extra oil at a later time. When measuring the 
benefits, DOE should analyze whether U.S. energy security is 
better measured by considering only the amount of oil under 
government control or also the amount of oil in U.S. commercial 
inventories.

    3. RESTORE MARKET-BASED CRITERIA FOR GRANTING DEFERRALS. 
DOE should restore its SPR business procedures allowing 
deferrals of oil deliveries to the SPR when crude oil prices 
are high or commercial crude oil supplies are tight, and the 
contractor agrees to deliver extra oil to the SPR at a later 
time. DOE should ensure these procedures allow timing SPR 
deliveries to avoid increased U.S. oil prices, reduced U.S. 
commercial oil inventories, and added U.S. consumer and 
taxpayer costs.

U.S. Crude Oil Markets

    4. REVISE NYMEX WTI FUTURES CONTRACT. The Commodity 
Futures Trading Commission (CFTC) and NYMEX should work 
together to revise the NYMEX WTI futures contract to reduce 
price volatility caused by local supply and demand imbalances 
in the U.S. WTI market. One option to strengthen price 
stability is to allow crude oil deliveries under the WTI 
contract to take place at more locations than the one location 
now specified at Cushing, Oklahoma.

    5. INCREASE OTC DISCLOSURE. Congress should authorize the 
CFTC, which oversees commodity markets, to require traders in 
OTC markets to provide the CFTC with routine information on 
large positions in crude oil and energy contracts and 
derivatives, as well as other information that would aid the 
CFTC in detecting, preventing, and halting commodity market 
manipulation.

    6. STRENGTHEN INTERNATIONAL COOPERATION. The CFTC should 
strengthen efforts with its counterparts in other countries to 
implement the Tokyo Communique, including advancing mechanisms 
to increase reporting of over-the-counter trading positions and 
coordinating international efforts to detect, prevent, and halt 
commodity market manipulation.

C. Overview

U.S. Strategic Petroleum Reserve

    The United States, which consumes nearly 25 percent of the 
70-80 million barrels of crude oil produced daily worldwide, is 
by far the largest purchaser and importer of crude oil in the 
world today. The United States consumes about 18 million 
barrels each day and imports about 10 million barrels each day 
to meet approximately 60 percent of its daily needs. Most of 
this oil, about 90 percent, is refined into fuel products such 
as gasoline, home heating oil, jet fuel, and diesel fuel. The 
crude oil market is the largest commodity market in the world, 
and hundreds of millions of barrels are traded daily in the 
crude oil spot, futures, and over-the-counter markets. The 
world's leading exchanges for crude oil futures contracts are 
the New York Mercantile Exchange (NYMEX) and the International 
Petroleum Exchange (IPE) in London.
    In 2002, the price of crude oil in the United States nearly 
doubled, climbing from a low of around $18 per barrel in 
January to a high of $34 per barrel in December. Crude oil 
prices have continued to climb and recently reached a 12-year 
high of nearly $40 per barrel.
    Several global political events and economic forces were 
major factors pushing prices upward over this period: The 
steady erosion of large crude oil supplies that had built up 
immediately after the terrorist attacks on September 11, 2001; 
Saddam Hussein's 1-month suspension of Iraqi oil exports in 
April 2002; labor strikes in Venezuela in late 2002 that 
virtually shut down crude oil production and exports to the 
United States; U.S. industry's practice of keeping relatively 
limited crude oil inventories; and increasing speculation and 
concern over impending war with Iraq.
    In addition to these political and economic factors 
affecting global crude oil supply and demand, a large player 
entered the crude oil market in late 2001, and significantly 
affected global crude oil trading throughout 2002--the U.S. 
Department of Energy's (DOE) Strategic Petroleum Reserve (SPR) 
program.
    The purpose of the SPR is to ``store petroleum to reduce 
the adverse economic impact of a major petroleum supply 
interruption to the United States.'' Established in 1975, after 
the oil shortages of the early 1970's, the SPR has enjoyed 
strong and ongoing support in Congress and subsequent 
Administrations as a means to strengthen U.S. energy security 
and protect the U.S. economy from the negative economic 
consequences of a major oil shortage.
    In November 2001, following the tragic events of September 
11th, President Bush directed the Department of Energy to fill 
the SPR to its full capacity of 700 million barrels ``in a 
deliberate and cost effective manner.'' Very little oil had 
been added to the SPR since 1995, when the amount of oil in the 
Reserve totaled about 590 million barrels. Due to several 
withdrawals since then, by 2001 the total amount of oil stored 
in the SPR had declined to about 540 million barrels.
    In late 2001, when the new policy to fill the SPR to 
capacity was announced, crude oil prices were low and market 
supplies were plentiful--favorable market conditions for 
filling the SPR. As crude oil markets tightened in 2002, 
however, DOE's determination to direct millions of barrels out 
of the commercial marketplace and into the Federal Government's 
SPR regardless of market conditions became a major factor 
pushing prices upward and commercial oil inventories downward.
    The SPR Office had formerly used a market-based approach to 
filling the SPR, acquiring more oil when prices were relatively 
low and less oil when prices were relatively high. This 
approach took into account market conditions and allowed DOE to 
fill the SPR without significantly affecting crude oil market 
supplies or prices. Pursuant to this policy, using procedures 
most recently published in January 2002, DOE had routinely 
allowed oil companies to defer scheduled oil deliveries to the 
SPR when market prices were relatively high in return for 
providing additional barrels of crude oil at a later time. In 
February 2002, 1 month after the deferral procedures were 
published, however, DOE informed the SPR Office that requests 
to defer SPR deliveries would no longer be granted. Under this 
new no-deferral policy, which DOE publicly announced in April 
2002, oil was to be deposited into the SPR regardless of the 
price of oil on the markets.
    DOE documents show SPR career officials did not support 
discarding the market-based strategy they had been using to 
fill the SPR. SPR career officials accurately warned about the 
negative consequences of filling the SPR when oil prices were 
high and oil supplies were tight, predicting it could lead to 
``explosive price swings,'' higher trade deficits, and higher 
costs for taxpayers. SPR career officials also accurately 
warned that higher prices would cause U.S. refiners to take oil 
from inventory instead of buying expensive new oil, resulting 
in lower total U.S. commercial inventories of crude oil. 
Reducing U.S. commercial crude oil inventories undercuts the 
fundamental purpose of the SPR program--to ensure this nation 
has adequate supplies of crude oil in the event of a supply 
disruption.
    One senior SPR career official wrote that the new SPR fill 
policy ``appears irrational to the market place'' and ``was 
discredited years ago.'' He also warned: ``Insisting on [SPR] 
deliveries in a tight market would be heavily criticized as 
mismanagement and would be difficult to defend.''
    DOE ignored these warnings and initiated the new SPR fill 
policy in February 2002, without conducting a cost-benefit 
analysis or attempting to estimate or track consumer or 
taxpayer costs. Section IV of this Report provides a detailed 
case study illustrating the high costs of this new SPR fill 
policy, which was compounded by the type of crude oil deposited 
into the SPR. From November 2001 through May 2002, about 25 
million barrels of Brent crude oil were deposited into the SPR 
despite tightening Brent supplies on world markets. Brent crude 
oil provides a ``benchmark'' price for the price of two-thirds 
of the crude oil traded globally, and most of the Brent crude 
oil produced from March to May was sent to the SPR.
    The placement of so much Brent crude oil into the SPR 
created a shortage of Brent on world markets. This shortage 
drove up the price of not only Brent, but also other crude oils 
linked to the price of Brent. These price increases pushed up 
the cost of crude oil exports to the United States from Europe 
and Africa.
    Due to the increased price, resulting from both tighter 
market supplies in general and Brent in particular, U.S. 
refiners bought fewer barrels of expensive imported crude oil, 
choosing instead to draw down their inventories for refining 
crude oil into gasoline. As U.S. inventories declined, oil 
companies and traders began bidding up oil prices on the major 
U.S. crude oil exchange, the NYMEX, in the belief that there 
was a crude oil shortage in the United States. This trading led 
to a spike in the price of the principal crude oil traded on 
the NYMEX, West Texas Intermediate (WTI).
    The sudden, sharp increase in the WTI price, which rose 20 
percent, or $5 per barrel, from mid-April to mid-May 2002, 
resulted in the spiking of prices of U.S. fuel products, 
including the spot price of home heating oil, which jumped 13 
percent; jet fuel, which jumped 10 percent; and diesel fuel, 
which jumped 8 percent. In the span of 1 month, U.S. consumers 
and businesses paid additional costs of $500 million to $1 
billion. Since then, high crude oil prices have continued to 
boost the cost of gasoline, heating oil, jet fuel and diesel 
fuel, generating the types of adverse economic impacts on U.S. 
consumers the SPR program was designed to prevent. These added 
costs can be viewed, in part, as an ``SPR premium'' imposed on 
American consumers by the new SPR fill policy directing crude 
oil into the SPR regardless of the price of oil.
    Filling the SPR regardless of oil prices has not only 
increased U.S. consumer costs, it has also increased U.S. 
taxpayer costs. Prior to 2002, DOE routinely granted oil 
company requests to defer scheduled oil deliveries to the SPR 
when near-term oil prices are high, in return for deposits of 
extra oil at a later date. In 2000 and 2001, DOE used these 
deferrals to save taxpayers over $175 million and add 7 million 
barrels to the SPR. By denying deferral requests for most of 
2002, DOE missed opportunities for comparable taxpayer savings 
and extra SPR oil. Also, by using federally-owned oil acquired 
from offshore oil leases for the SPR instead of selling the oil 
on the market when prices were high, DOE reduced revenues 
supporting taxpayer-funded programs. For example, at the 2002 
SPR fill rate of 100,000 barrels per day, filling the SPR when 
the crude oil is priced at $30 per barrel rather than $20 per 
barrel costs taxpayers an additional $1 million per day. Over 3 
months, the additional cost of filling the SPR approaches $100 
million, a cost ultimately borne by U.S. taxpayers.
    Despite its high cost to U.S. consumers and taxpayers, the 
new SPR fill policy did not increase overall U.S. oil supplies. 
In 2002, the SPR program put about 40 million barrels of crude 
oil into the SPR, increasing the total 7 percent, from about 
560 million to 600 million barrels. Removing 40 million barrels 
from the marketplace, however, increased oil prices, which 
caused U.S. oil refiners to take oil from inventory instead of 
buying expensive new oil. In 2002, U.S. commercial inventories 
dropped 10 percent, from about 310 to 280 million barrels. In 
2003, commercial inventories dropped again to less than 270 
million barrels, which is the lowest level in the United States 
in 28 years and below the recognized level at which refinery 
operations risk disruptions due to inadequate oil supplies. 
Today, overall oil supplies in the United States, which consist 
of the oil in the SPR and commercial inventories, total about 
870 million barrels, the same amount as at the end of 2001, 
before the recent SPR fills. Although the SPR program has 
placed more oil under government control, lower private sector 
oil inventories mean there has been no net increase in overall 
national oil supplies.
    The benefit to U.S. energy security of shifting oil from 
private sector control to government control in the SPR, 
without a net increase in overall oil supplies, is unclear at 
best, since in the event of a major supply disruption, the SPR 
would act to release oil on the market, shifting supplies back 
to the private sector.
    Despite spiking U.S. oil prices, shrinking U.S. commercial 
inventories, and ongoing efforts by SPR career officials to 
restore the program's earlier market-based approach, DOE kept 
the SPR no-deferral policy in place throughout most of 2002. In 
mid-December, DOE granted three requests to defer approximately 
15 million barrels of crude oil scheduled for delivery to the 
SPR from December 2002 through March 2003. DOE stated at the 
time that the deferrals were granted to avoid ``negatively 
affect[ing] the oil market.'' In February 2003, however, with 
crude oil at $35 per barrel, DOE announced three new contracts 
to deliver another 24 million barrels to the SPR. When added to 
prior contracts, this announcement means DOE plans to deposit a 
total of 40 million more barrels to the SPR in 2003. DOE also 
published an accelerated schedule for these SPR oil deliveries 
to attain a rate of about 4 million barrels per month beginning 
in April 2003.
    Today, crude oil prices are at a 12-year high, and U.S. 
commercial inventories are at record lows, threatening refinery 
disruptions due to inadequate oil supplies. In these market 
conditions, unless more oil enters the marketplace, DOE plans 
to remove another 40 million barrels from the U.S. market in 
2003, if carried out, will further shrink commercial supplies, 
drive oil prices higher, and impose more costs on U.S. 
consumers and taxpayers, without any assurance that expanded 
overall U.S. oil supplies will result.
    Recent SPR fill policy has helped push up U.S. oil prices, 
reduce U.S. oil inventories, and hurt U.S. consumers and 
taxpayers. In light of the dubious benefits to national energy 
security provided by the current SPR fill policy and the high 
cost to U.S. consumers and taxpayers, this Report recommends: 
(1) a suspension of all 2003 SPR deliveries until near-term 
crude oil prices fall and U.S. commercial inventories increase; 
(2) an analysis of the relative costs and benefits of the new 
market-blind SPR fill policy compared to the prior market-based 
policy; and (3) a return to market-based procedures which allow 
DOE to time SPR deliveries to avoid increased oil prices, 
reduced U.S. commercial oil inventories, and added U.S. 
consumer and taxpayer costs.

U.S. Crude Oil Markets

    When analyzing the factors influencing crude oil prices in 
2002, this investigation also examined the operation of the 
crude oil markets and their vulnerability to manipulation. As 
described in Section III, crude oil markets today are far 
different from the market in the days when the ``Seven 
Sisters'' or OPEC ministers met behind closed doors and set 
crude oil prices worldwide. Although OPEC still plays a major 
role in determining crude oil prices through production quotas, 
crude oil prices also respond to the forces of supply and 
demand as determined by thousands of buyers and sellers in the 
inter-related spot, futures, and over-the-counter (OTC) 
commodity markets in which crude oil is traded.
    Currently, the U.S. futures markets, such as the NYMEX 
market for crude oil, are heavily regulated and are among the 
most transparent commodity markets in the world. Commodity 
trading on these markets is subject to a variety of reporting 
requirements and routine market oversight designed to detect 
and deter fraud and manipulation. This regulation and 
transparency has bolstered the confidence of traders in the 
integrity of these markets and helped propel the United States 
into the leading marketplace for many of the commodities traded 
on these exchanges.
    Increasingly, however, OTC crude oil markets, which are 
essentially unregulated, have become major trading centers and 
have become intertwined with crude oil trading on the regulated 
exchanges. Many of the instruments traded in the OTC markets 
and regulated exchanges are virtually identical, traders often 
operate in both settings, and both markets handle billions of 
dollars in commodity transactions daily, providing traders with 
price discovery and opportunities for hedging. Prices on one 
market necessarily affect the price of the same and related 
commodities on the other markets. Indeed, the NYMEX in New York 
and the IPE in London, two leading crude oil futures exchanges, 
have integrated their futures trading operations with OTC 
electronic trading of crude oil contracts, drawing the two 
types of markets closer together. The NYMEX now operates its 
own OTC electronic trading facility and even offers a futures 
contract for trading on its OTC facility, while the IPE was 
recently purchased by ICE, an OTC electronic trading facility 
based in Atlanta, Georgia.
    The lack of transparency in OTC markets stands in sharp 
contrast to the transparency of the regulated exchanges. Many 
OTC trades take place either directly between large traders or 
through brokers, and there is no reporting of prices or 
positions to any market oversight body. While some OTC 
electronic trading facilities, such as ICE and the electronic 
OTC facility at NYMEX, post bids, offers, and prices 
electronically, regulators do not have access to other 
information, such as large trader reports, routinely provided 
for trading on regulated exchanges. Under current law, OTC 
market information is available to the CFTC only upon special 
request, rather than on a routine basis for periodic analysis 
to detect and deter manipulation. The absence of OTC trading 
information means, for example, that suspect trading patterns 
cannot be detected in the OTC markets nor can OTC trading 
information be compared to information obtained from regulated 
exchanges. The absence of OTC information makes it nearly 
impossible for regulators and market participants to get a full 
understanding of market behavior in order to detect and deter 
manipulation.
    Because crude oil prices are affected by trading not only 
on the regulated exchanges, but also on the unregulated OTC 
markets, this Report recommends increasing OTC information 
disclosure and market oversight to detect and deter 
manipulation. This recommendation is consistent with the 
position taken by the United States in 1997, when the CFTC met 
with the market regulators from other nations to discuss 
strengthening the international regime for preventing commodity 
market manipulation. At the end of this meeting all 17 
participating countries, including the United States, issued 
the Tokyo Communique, which provides guidance and 
recommendations to improve commodity market surveillance and 
the sharing of information:

        [I]nformation should be collected on a routine and non-
        routine basis for on-exchange and related cash and 
        over-the-counter markets and should be designed to 
        assess whether the market is functioning properly. 
        Market authorities should have access to information 
        that permits them to identify concentrations of 
        positions and the composition of the market.

    This Report also finds that, in 2002, after SPR deliveries 
removed oil from the marketplace, defects in the New York and 
London crude oil futures markets magnified local imbalances 
between supply and demand into large price effects. Although 
the London market has made major improvements to correct 
defects in the Brent market to avoid a recurrence of these 
distortions, the NYMEX has not made needed improvements to the 
WTI futures contract which plays a key role in U.S. crude oil 
markets. To minimize U.S. crude oil price distortions, this 
Report recommends that the NYMEX and CFTC work together to 
revise the crude oil futures contract traded on the NYMEX to 
ensure the contract more accurately reflects national, rather 
than local, crude oil supply and demand, including allowing WTI 
contract deliveries to take place at more locations than the 
one location now specified in the WTI contract at Cushing, 
Oklahoma.
    The Report's recommendations for short-term improvements in 
the SPR fill program and long-term improvements in the crude 
oil markets are intended to strengthen U.S. energy security, 
curb the economic damage caused by increasing crude oil prices 
and tight supplies, and reduce the vulnerability of the U.S. 
crude oil markets to manipulation.

                II. THE U.S. STRATEGIC PETROLEUM RESERVE

          ``To maximize long-term protection against oil supply 
        disruptions, I am directing today the Secretary of 
        Energy to fill the SPR up to its 700 million barrel 
        capacity. The SPR will be filled in a deliberate and 
        cost-effective manner.''
            --President George W. Bush, November 13, 2001

A. Introduction

    The purpose of the U.S. Strategic Petroleum Reserve (SPR) 
is ``to store petroleum to reduce the adverse economic impact 
of a major petroleum supply interruption to the United 
States.'' \1\ In 1975, following the disruption to the U.S. 
economy resulting from the 1973 Arab oil embargo and the 
doubling of crude oil prices by the Organization of the 
Petroleum Exporting Countries (OPEC), Congress passed and 
President Ford signed the Energy Policy and Conservation Act 
(EPCA), which, among other energy-conserving measures, 
established a national policy to create a one-billion barrel 
reserve for the storage of crude oil that could be used in the 
event of a disruption in the supply of crude oil. The SPR 
program, which is operated by the U.S. Department of Energy 
(DOE), through its SPR program office, is designed to help 
stabilize domestic crude oil prices by allowing the withdrawal 
of oil from the reserve when either supplies are disrupted or 
prices are unusually high.
---------------------------------------------------------------------------
    \1\ U.S. Department of Energy Strategic Petroleum Reserve, 
Strategic Plan, October 2001, page 3.
---------------------------------------------------------------------------
    The SPR consists of four large underground caverns hollowed 
out from naturally occurring salt domes near the U.S. Gulf 
Coast in Texas and Louisiana.\2\ The Gulf Coast sites were 
chosen because of their proximity to the extensive port 
facilities, pipelines, and refineries in the region, and 
because using the natural salt caverns was less expensive than 
building new tanks for the storage of the crude oil.\3\ 
Currently, the SPR holds 600 million barrels and has a physical 
capacity of 700 million barrels.\4\ Two basic types of crude 
oil streams are deposited and stored in separate caverns in the 
SPR: sweet crude oil (with a sulfur content of not greater than 
0.5 percent) and sour crude oil (with a sulfur content greater 
than 0.5 percent). As of late 2002, approximately two-thirds of 
the current inventory is sour crude, and one-third is sweet 
crude oil.
---------------------------------------------------------------------------
    \2\ For security reasons, the DOE has removed additional 
information about these locations from its website.
    \3\ Storage costs in the SPR are approximately $1.50 per barrel, 
whereas storage in above-ground tanks costs a total of about $15 to $18 
per barrel, nearly 10 times the SPR cost. Additionally, the geologic 
pressure in the caverns at 2,000-4,000 feet below the surface should 
seal any cracks that may appear in the salt, and thereby prevent any 
leaks of oil out of the caverns. The temperature differential between 
the top and the bottom of the caverns keeps the crude oil circulating 
within the cavern, thereby maintaining a consistent quality of oil in 
each individual cavern. See DOE SPR website, at SPR-Quick Facts, at 
http://www.fe.doe.gov/spr/spr--facts.shtml.
    \4\ Id. Congress has authorized the SPR to hold a capacity of one 
billion barrels. If the SPR were to be filled to its one-billion barrel 
capacity, more physical storage capacity would have to be built or 
acquired.
---------------------------------------------------------------------------
    Crude oil has been withdrawn from the reserve on several 
occasions. Currently, the SPR is being filled in two ways: (1) 
adding oil through the Royalty-in-Kind (RIK) program; and (2) 
replacing oil that was previously swapped out in 2000.

B. Withdrawals From The SPR

    DOE is authorized to withdraw crude oil from the SPR for 
several purposes. Foremost among these is the authority to 
withdraw crude oil to alleviate disruptions and shortages in 
the supply of crude oil. Additionally, DOE may conduct 
operational ``exchanges,'' ``sales,'' and ``swaps'' for a 
variety of purposes, and has been authorized to withdraw crude 
oil from the SPR in order to establish a home heating oil 
reserve.

  1. Emergency Drawdown

    As the primary mission of the SPR is to provide a source of 
crude oil in the event of a severe disruption in the supply of 
crude oil, the EPCA authorizes what is called a ``drawdown'' 
upon a finding by the President that there is a ``severe energy 
supply interruption.'' Under the EPCA, a ``severe energy supply 
interruption'' occurs when: (a) an emergency situation exists 
and there is a significant reduction in supply which is of 
significant scope and duration; (b) a severe increase in the 
price of petroleum products has resulted from such emergency 
situation; and (c) such price increase is likely to cause a 
major adverse impact on the national economy.\5\
---------------------------------------------------------------------------
    \5\ 42 U.S.C.A. Sec. 6241 (d) (1995 & Supp. 2002).
---------------------------------------------------------------------------
    In 1990, after the Exxon Valdez oil spill interrupted the 
supply of Alaskan crude oil, leading to spot shortages and 
price increases, Congress provided DOE with additional drawdown 
authority. This authority allows more limited withdrawals from 
the SPR in the event of a ``domestic or international energy 
supply disruption of significant scope or duration,'' and where 
the drawdown would significantly reduce the impact of such a 
disruption. In these circumstances a Presidential declaration 
of a ``severe energy supply interruption'' is not required.
    The first and only emergency drawdown of the SPR occurred 
at the outset of the Gulf War in 1991, following Iraq's 
invasion of Kuwait. On January 16, 1991, immediately after 
launching air strikes against Iraq, President George H.W. Bush 
declared that an emergency situation existed regarding the 
supply of crude oil, and the DOE began to implement a plan to 
sell nearly 34 million barrels of crude oil from the SPR. 
Because world crude oil prices stabilized before the full 
amount of oil was released, only about half that volume--17.3 
million barrels--were sold. This is the only time a drawdown 
has been ordered by the President pursuant to a declaration of 
an emergency under the EPCA.\6\
---------------------------------------------------------------------------
    \6\ http://www.fe.doe.gov/spr/spr--facts.shtml, U.S. Dept. of 
Energy website.
---------------------------------------------------------------------------

  2. Exchanges

    The EPCA also authorizes DOE to exchange oil in the SPR for 
operational or other purposes. This general authority has been 
used three times. In 1996, DOE delivered approximately 900,000 
barrels of crude oil from the SPR to the ARCO Pipe Line Company 
after ARCO's Seaway Pipeline from the Gulf Coast to Cushing, 
Oklahoma was blocked by waxy crude oil. DOE took this action to 
provide a continuous flow of crude oil to Midwestern 
refineries. In return for the crude oil from the reserve, ARCO 
paid the government a fee and replaced the crude oil withdrawn 
within 6 months.
    In 1988, the Department exchanged 11 million barrels of 
heavy Mexican Maya crude oil for a lesser volume of lighter, 
higher quality Mexican Olmeca and Isthmus crudes. In June, 
2000, the Department agreed to withdraw 500,000 barrels from 
the SPR to supply crude oil to CITGO and Conoco refineries 
along the Gulf Coast when shipping lanes had been blocked by 
the collapse of a commercial dry dock into the shipping channel 
leading to the refineries. After the shipping lanes were 
restored, CITGO and Conoco replenished the Reserve for the 
amounts of crude oil withdrawn.
    In the FY 2001 Interior Appropriations Act,\7\ Congress 
formally authorized the creation of a home heating oil reserve 
for the northeastern region of the United States, with a 
capacity up to 2 million barrels. To establish the heating oil 
reserve, Congress authorized the DOE to obtain storage capacity 
and the refined product through purchase, contract, lease, or 
exchange with crude oil from the SPR. In 2000, DOE swapped 2.8 
million barrels of crude oil from the SPR in return for 2 
million barrels of heating oil for the home heating oil 
reserve.
---------------------------------------------------------------------------
    \7\ H. Rept. No 348-69, Pub. L. 106-291 (2000).
---------------------------------------------------------------------------

  3. Non-Emergency Sales

    On three separate occasions in 1996, Congress authorized 
the sale of oil from the SPR to raise revenues for the Federal 
Government.\8\ In February and March, 1996, the Defense Fuel 
Supply Center sold a total of 5.1 million barrels of oil, 
through competitive bids, to four oil companies for a total of 
$97.1 million, to pay for the unexpected decommissioning of the 
Weeks Island SPR site, which had fractured and was in imminent 
danger of collapse.
---------------------------------------------------------------------------
    \8\ DOE SPR website, at http://www.fe.doe.gov/spr/spr--rik.shtml.
---------------------------------------------------------------------------
    In late April 1996, the Congress authorized further sales 
of Weeks Island crude that had been transferred to other SPR 
storage sites, for the explicit purpose of reducing the Federal 
deficit. From May through August 1996, the Defense Fuel Supply 
Center sold 12.8 million barrels to nine oil companies, through 
competitive bids, at an average sale price of $17.81 per 
barrel, for a total of $227.6 million.
    The same year, Congress authorized the further sale of $220 
million worth of crude oil to offset fiscal year 1997 
appropriations. Between October and December the Defense Fuel 
Supply Center issued contracts for the sale of about 10.2 
million barrels, which provided $220 million in revenue for the 
U.S. Treasury.

  4. The 2000 Swap: Release of 30 Million Barrels

    In late September 2000, with crude oil prices nearing 
historical highs, stocks of home heating oil at historically 
low levels, and winter just around the corner, President 
Clinton issued an executive order, pursuant to the limited 
drawdown authority under the EPCA, authorizing a ``swap'' of 30 
million barrels from the SPR to alleviate a potential heating 
oil crisis.
    Under the swap, 30 million barrels of SPR oil were released 
for bid. Interested parties bid to borrow quantities of not 
less than 1 million barrels of oil, and contracts were awarded 
based on how much oil bidders offered to return to the SPR 
between August 1 and November 30, 2001. ``[B]idders based their 
offers on their best models of what it would cost them to 
acquire replacement crude, weighed against the benefit to them 
of having additional supply at the beginning of the winter.'' 
\9\
---------------------------------------------------------------------------
    \9\ Robert Bamberger, CRS Report, Strategic Petroleum Reserve, June 
26, 2002.
---------------------------------------------------------------------------
    After the release, according to the Congressional Research 
Service (CRS), ``it may have been that U.S. willingness to use 
the SPR temporarily took the wind out of the speculative 
element in the futures market,'' and spot prices fell from 
about $37 to $31 per barrel.\10\ It is unclear, however, 
whether other political and economic factors also contributed 
to the price decrease.
---------------------------------------------------------------------------
    \10\ Id.
---------------------------------------------------------------------------
    Figure II-1 shows the price of crude oil before and after 
the two major releases of oil from the SPR, the 2000 swap and 
the 1991 emergency drawdown.

[GRAPHIC] [TIFF OMITTED] T5551.011

C. Filling the SPR

  1. Initial Fill of the SPR

    From the mid-1970's until 1995, when the initial fill of 
the SPR was completed, 592 million barrels of crude oil were 
placed in the SPR. As of the end of FY 1997, the cumulative 
cost of the crude oil purchased to supply the SPR was nearly 
$16 billion. Table II-1 shows the sources of oil deposited into 
the SPR through 2001:

[GRAPHIC] [TIFF OMITTED] T5551.001


    From 1995 through 1998, the total inventory of crude oil in 
the SPR declined due to the sale of crude oil from the SPR and, 
with a ballooning Federal deficit and relatively stable crude 
oil supplies, new expenditures were postponed and alternative 
methods of adding crude oil to the SPR explored.

  2. Recent and Current Programs to Fill the SPR

    Recently, DOE has been depositing crude oil into the SPR 
under three programs: (1) contracts to replace the 30-million 
barrels released in the fall of 2000; (2) contracts under the 
1999 Royalty-in-Kind (RIK) program designed to replace the 28 
million barrels withdrawn in the 1996 sales; and (3) contracts 
to deliver additional crude oil under the RIK program pursuant 
to the President's November 2001 announcement to fill the SPR 
to 700 million barrels. These programs are listed in Table II-2 
and described below.

[GRAPHIC] [TIFF OMITTED] T5551.002


    a. 2000 Swap Refill

    Under the original schedule for returning the 30 million 
barrels of crude oil taken from the SPR in the September 2000 
swap, these barrels were to be returned between August 1 and 
November 30, 2001. In late March 2001, DOE renegotiated the 
schedule for the return of 24 million of these barrels. Under 
the new schedule, the return of these 24 million barrels would 
occur between December 2001 and January 2003, and the companies 
returning the oil would provide a total of 3.5 million 
additional barrels to compensate the SPR for the schedule 
extension. As of February 2003, about 28 million of these 
barrels have been returned. An additional 6 million barrels are 
scheduled to be returned in 2003.

    b. 1999 Royalty-In-Kind (RIK) Program

    In order to avoid additional Federal outlays for the 
purchase of crude oil to fill the SPR, in 1999, the Clinton 
Administration initiated the royalty-in-kind (RIK) program.\11\ 
Traditionally, the Federal Government, through a program 
managed by the Department of Interior's Minerals Management 
Service (MMS), has collected royalty fees, in cash, for crude 
oil produced from offshore crude oil and gas wells operating 
under leases on the federally-owned Outer Continental Shelf. 
Under the RIK program, the Federal Government obtains crude oil 
for the SPR as ``in-kind'' royalties--rather than financial 
payments--from these oil leases. This allows the Federal 
Government to fill the SPR without using appropriated funds to 
purchase the oil.
---------------------------------------------------------------------------
    \11\ The RIK program is described in the DOE's Office of Fossil 
Energy website at http://www.fe.doe.gov/spr/spr--rik.shtml.
---------------------------------------------------------------------------
    To begin the RIK process, the MMS announces a bidding 
competition for the transportation of royalty oil that will be 
due to the Federal Government from the crude oil produced on 
tracts leased by the Federal Government in the Gulf of 
Mexico.\12\ This competition is essentially a bidding contest 
for the transportation of the royalty oil from the company's 
wellhead in the Gulf to the ``market center'' designated by the 
MMS. Generally, the successful bidder will be the company 
offering the MMS the largest portion of the oil delivered to 
the market center, and taking the least amount of the oil 
itself as payment for the transportation of the oil to the 
center.
---------------------------------------------------------------------------
    \12\ The  sale  is  based  on  a  competitive  bidding  process.  
If  the  minimum  bid  price  is not met, MMS will have the option to 
negotiate prices with the highest bidder. http://www.mrm.mms.gov/
RIKweb/PDFDocs/51626.pdf.
---------------------------------------------------------------------------
    Because the royalty oil from the Gulf of Mexico leases is 
not of sufficient quality to be deposited in the SPR, DOE runs 
an additional, separate competition for contracts to exchange 
the royalty oil in the market centers for crude oil to be 
delivered to the SPR. The competition calls for bidders to take 
the royalty oil at the market center, swap it for oil suitable 
for the SPR, and then transport the SPR-suitable oil to the 
SPR. Generally, the successful bidder will be the company that 
promises to deliver the most barrels into the SPR in exchange 
for the royalty barrels taken from the market center.
    Because a variety of crude oils are acceptable to place in 
the SPR, the DOE may also consider the quality of the crude oil 
offered to be placed into the SPR as a factor in determining 
which bid to select.\13\ The quality of the oil to be deposited 
may be of particular significance when the leading bidders are 
offering approximately the same volumes to be deposited.
---------------------------------------------------------------------------
    \13\ Interview with DOE officials by Subcommittee staff on June 12, 
2002.
---------------------------------------------------------------------------
    In 1999, the RIK program was adopted as a means to refill 
the SPR for the 28.1 million barrels withdrawn during the 1996 
sales, without additional Federal outlays. The refills under 
this program began in the spring of 1999, and were to continue 
through January 2003, by which time the SPR was to have 
received a total of 30.7 million barrels.
    Although the RIK program enables the SPR to be filled 
without Federal outlays, using RIK oil for the SPR program 
nonetheless affects the Federal budget. The exchange of royalty 
oil for SPR oil deprives the Federal treasury of revenues that 
otherwise would have accrued had the MMS sold the royalty oil 
on the open market. Exchanging royalty oil for SPR oil when oil 
prices are high, therefore, results in a greater loss to the 
Treasury than exchanging royalty oil for SPR oil when oil 
prices are low. Hence, to the extent that the SPR program uses 
RIK oil when prices are high rather than low, taxpayers pay 
higher costs for the SPR, just as if the crude oil placed in 
the SPR had been bought on the open market at those high 
prices.

    c. L2001 RIK Program to Fill the SPR to 700 Million Barrels

    The increased national security concerns and falling crude 
oil prices that followed the terrorist attacks on the United 
States in September 2001, led both the Congress and the 
Administration to support filling the SPR to capacity. In 
October 2001, the House of Representatives passed a resolution 
supporting the filling of the SPR to its maximum authorized 
level of 1 billion barrels.\14\ In April 2002, the Senate 
passed an energy bill that included language to permanently 
authorize the SPR and require DOE to fill to its current 
capacity of approximately 700 million barrels.\15\
---------------------------------------------------------------------------
    \14\ H.Res. 250, 107th Cong., 1st Sess., A Resolution Urging the 
Secretary of Energy to Fill the Strategic Petroleum Reserve.
    \15\ The Senate passed the energy bill, H.R. 4, on April 25, 2002, 
but it was never enacted into law.
---------------------------------------------------------------------------
    In November 2001, President Bush announced the 
Administration's intent to fill the SPR to its current 700 
million barrel capacity.\16\ In the announcement, the President 
directed the Secretary of Energy to fill the SPR ``in a 
deliberate and cost-effective manner.'' \17\ In a 
contemporaneous DOE press release, DOE stated, ``The 
President's decision will expand an ongoing `royalty-in-kind' 
program, adding oil to the Reserve in a deliberate and cost-
effective manner at rates of up to 130,000 barrels per day 
beginning [in 2002].'' \18\
---------------------------------------------------------------------------
    \16\ http://www.fe.doe.gov/spr/spr--rik.shtml.
    \17\ President Orders Strategic Petroleum Reserve Filled, Statement 
by the President, at http://www.whitehouse.gov/news/releases/2001/11/
20011113.html.
    \18\ DOE Press Release, President Directs Energy Secretary to 
Increase Strategic Reserve, November 13, 2001.
---------------------------------------------------------------------------
    On January 22, 2002, DOE announced a solicitation for bids 
to exchange up to 22 million barrels of royalty oil for oil to 
fill the SPR.\19\ ``Because Strategic Reserve crude oil 
typically exceeds the quality of most offshore crudes,'' DOE 
stated, ``companies will likely deliver somewhat less than the 
22 million barrels of royalty oil to the Reserve after 
adjusting for the quality differences. The companies can also 
make adjustments to account for their costs to deliver oil to 
the Reserve sites. The Energy Department will negotiate 
contracts with the companies that offer the ratios most 
favorable for the U.S. Government.'' \20\
---------------------------------------------------------------------------
    \19\ DOE Press Release, Energy Department Opens Bid Process to 
Begin Filling Strategic Oil Reserve, January 22, 2002.
    \20\ Id.
---------------------------------------------------------------------------
    On February 6, 2002, DOE awarded this RIK contract to 
Equiva Trading Company, which has since become part of Shell. 
Under this contract, Equiva agreed to deliver 18.6 million 
barrels of sweet crude oil to the SPR through the RIK program 
between April 1, 2002, and May 1, 2003.\21\ This contract 
translates to a fill rate of approximately 60,000 barrels per 
day. Publicly announcing the award 5 days later, on February 
11, 2002, the Secretary of Energy stated, ``Today's 
announcement is another step forward in the President's efforts 
to strengthen the nation's energy security. . . . The Strategic 
Petroleum Reserve is one of our most important strategic 
assets, and today's action ensures that we will be prepared for 
potential supply disruptions in the future.'' \22\ Shell began 
delivery of oil to the SPR under this contract in April 2002.
---------------------------------------------------------------------------
    \21\ DOE anticipates that after this contract terminates in 2003, 
subsequent RIK contracts will specify that two-thirds of the oil 
deposited under the contract be sour crude and one-third be sweet 
crude. DOE interview with Subcommittee staff.
    \22\ http://www.fe.doe.gov/techline/tl--sprrik2002--equiva.shtml.
---------------------------------------------------------------------------
    In late July 2002, DOE announced a new RIK contract 
solicitation to increase the fill rate by about 40,000 barrels 
per day. ``More oil in the Reserve is more energy insurance for 
American consumers,'' the Secretary of Energy stated. ``And the 
faster we can add oil to the Reserve, the more energy security 
we can provide for all Americans.'' \23\ On August 11, 2002, 
DOE announced that Koch Supply and Trading had won the bidding 
for this contract. Under the contract, Koch agreed to supply 
approximately 8 million barrels of crude to the SPR, with 
deliveries beginning October 1, 2002, and running through April 
30, 2003.\24\
---------------------------------------------------------------------------
    \23\ Fossil.Energy.gov Techline, Administration to Increase Fill 
Rate of Strategic Petroleum Reserve, July 26, 2002, at http://
www.fe.doe.gov/techline/tl--spr--rik2002--phase2.shtml.
    \24\ Office of Fossil Energy website, at http://www.fe.doe.gov/spr/
spr--rik.shtml.
---------------------------------------------------------------------------
    On February 10, 2003, DOE announced the award of three new 
contracts to place, on average, another 116,000 barrels per day 
into the SPR over a 6-month period beginning in May 2003. On 
the same date DOE also announced that in April it would begin 
pumping about 15,000 barrels per day of crude from producers 
off the Texas coast into the SPR. According to DOE, ``The 
combined shipments will boost the Strategic Petroleum Reserve's 
fill rate to approximately 131,000 barrels per day--the fastest 
since President Bush announced plans in November 2001 to fill 
the Reserve to its full 700-million barrel capacity. . . . `` 
\25\ The contracts announced in February will add another 24 
million barrels to the SPR between April and October, 2003.
---------------------------------------------------------------------------
    \25\ DOE, New Contracts Awarded for Planned Spring Acceleration of 
Oil Fill for Strategic Petroleum Reserve, February 10, 2003, at http://
www.fe.doe.gov/techline/tl--spr--rik2003--sel.shtml.
---------------------------------------------------------------------------
    As of the writing of this Report in March 2003, the total 
volume of oil stored in the SPR is about 600 million barrels. 
As shown in Figure II-2, this total includes the steady 
addition of over 40 million barrels of oil from November 2001 
through September 2002.

[GRAPHIC] [TIFF OMITTED] T5551.012


Current SPR contracts call for depositing an additional 43 
million barrels in 2003, at a steady rate of over 130,000 
barrels per day. Table II-3 provides the current monthly 
schedule for future SPR deliveries.

[GRAPHIC] [TIFF OMITTED] T5551.003

  3. Strategy for Filling the SPR

    a. Different Types of Crude Oil May Be Placed in the SPR

    For each of the two basic types of crude oil stored in the 
SPR--sweet and sour crudes--DOE allows SPR contractors to 
deposit a variety of crude into the reserve, as long as they 
meet DOE's minimum standards for that specific type of crude 
oil. Providing contractors with flexibility in the types of 
crude oil that can be delivered to the SPR is one measure taken 
by the SPR program to minimize costs and market disruptions. 
Table II-4 shows the thirteen different types of oil that meet 
DOE's specifications for sweet crude oil:

[GRAPHIC] [TIFF OMITTED] T5551.154


    Although DOE provided its SPR contractors with the option 
to deposit a variety of sweet crudes into the SPR, from the 
fourth quarter of 2001 through the first half of 2002, oil 
companies chose to deposit into the SPR large amounts of Brent 
crude oil, a crude oil dwindling in supply and the price of 
which serves as a benchmark for the price of other crude oils.
    Figure II-3 shows the breakdown between Brent and other 
sweet crudes deposited into the SPR from April 1999, when the 
filling of the SPR recommenced under the 1999 RIK program, 
through September 2002. This investigation's findings regarding 
the significant consequences arising from these large deposits 
of Brent crude oil into the SPR, including the effect upon 
global crude oil markets and crude oil prices in the United 
States, are explained in Section IV.
[GRAPHIC] [TIFF OMITTED] T5551.013

    b. Market-Based Acquisition Strategy and Fill Schedules

    DOE solicitations for oil to be deposited into the SPR 
provide a general time period for the delivery of the oil to 
the SPR. After a solicitation is awarded, the contractor 
proposes a more specific schedule of deliveries. DOE and the 
contractor then establish a mutually acceptable schedule.\26\
---------------------------------------------------------------------------
    \26\ Typically, after a SPR fill contract is awarded, DOE will 
delay for several days the public announcement of the winning bidder in 
order to allow the winning bidder to prepare to implement the contract 
prior to the market learning of the general requirements of the 
contract. Even after publicly announcing the award of a contract, DOE 
withholds significant information from the market to ensure that 
persons other than the contract participants do not obtain advance 
knowledge of SPR purchase and shipping schedules. DOE also withholds 
details about the various bids received, why a certain bidder won, and 
the specific delivery schedule under the contract. DOE reveals only who 
the winning bidder is, and how much oil will be delivered into the SPR 
on a monthly basis. DOE withholds this contract, delivery, and bid 
information in part to prevent actions by crude oil market participants 
that could increase a contractor's transportation costs or ``squeeze'' 
the contractor by bidding up the price of oil suitable for the SPR.
---------------------------------------------------------------------------
    The SPR program's ``Business Procedures,'' Exhibit II-1, 
most recently issued in January 2002, provide DOE and SPR 
contractors flexibility to modify delivery schedules, either by 
deferring or accelerating deliveries, depending on market 
conditions.\27\ DOE has publicly stated that it used these 
business procedures to deposit more oil into the SPR when crude 
oil markets are ``weak,'' and delay deliveries when the markets 
are ``strong,'' both to minimize SPR program costs and to help 
stabilize crude oil markets.
---------------------------------------------------------------------------
    \27\ Strategic Petroleum Reserve, Business Procedures, Crude Oil 
Exchanges, January 2002; Exhibit II-1.
---------------------------------------------------------------------------
    If a contractor asks to defer or advance a shipment, DOE 
will require the contractor to compensate DOE for any loss in 
value from the change in schedule. The SPR Business Procedures 
state:

        During contract performance there may be situations 
        when due to programmatic requirements or through 
        contractor request the schedule for the delivery of 
        exchange oil to the SPR sites are proposed to be 
        deferred to a later date or accelerated to an earlier 
        date. An evaluation is performed incorporating a 
        formula that encompasses market conditions including 
        crude oil prices from contracted delivery period to the 
        revised delivery period, time value of money, and crude 
        type differentials. Based on this evaluation 
        negotiations are conducted with the contractor [and DOE 
        personnel]. Based on the negotiated agreement a 
        bilateral modification is executed [by DOE] and the 
        contractor incorporating the revised delivery schedule; 
        [and] any additional premium barrels owed by the 
        contractor as a result of the agreement. . . .\28\
---------------------------------------------------------------------------
    \28\ Id., at page 6.

    According to a September 2001 presentation, Exhibit II-2, 
prepared by the SPR Office for other countries considering 
establishing a crude oil reserve program, ``the key to a 
successful strategic reserve is cost control.'' \29\ Because 
``the number and extent of future disruptions is unknown,'' and 
``measuring the degree of damage from a disruption, and the 
consequent benefits of a petroleum reserve, to an individual 
economy is an uncertain science,'' DOE states that ``cost is 
the easiest aspect to control and has the highest probability 
of making the Reserve cost beneficial.'' According to the 
presentation, the major costs for the SPR program are the 
capital costs to construct the facility, the costs to operate 
and maintain the Reserve, and the costs of acquiring the oil 
for the Reserve.
---------------------------------------------------------------------------
    \29\ Presentation by John Shages, DOE Office of Strategic Petroleum 
Reserve, Asia-Pacific Economic Cooperation Energy Working Group, 
Workshop on Energy Security Policy, Sept. 14-15, 2001; Exhibit II-2.
---------------------------------------------------------------------------
    According to the same presentation, DOE follows four 
market-based principles when filling the SPR. In a chart 
entitled, ``Lessons Learned to Control Oil Acquisition Costs,'' 
DOE describes these principles as follows:

     Let the markets determine your buying pattern.
     Buy in weak markets.
     Delay deliveries during strong markets.
     Use your acquisition strategy to stabilize 
markets.\30\
---------------------------------------------------------------------------
    \30\ Id.

By calling them ``Lessons Learned,'' DOE indicates that these 
principles were developed as a result of previous program 
experience. Essentially, they direct DOE to buy more oil when 
current market prices are low, and less when oil prices are 
high.\31\
---------------------------------------------------------------------------
    \31\ More precisely, the terms ``weak'' and ``strong'' market 
appear to refer to when the market is in contango (near-term prices 
lower than longer-term prices) or in backwardation (near-term prices 
higher than longer-term prices), respectively. See also internal SPR 
memorandum, Exhibit V-4.
---------------------------------------------------------------------------
    In 2000 and 2001, DOE regularly followed these market-based 
principles. For example, in March 2001, DOE postponed the 
delivery of 24 million barrels of crude oil then scheduled to 
be delivered between August and November 2001, until sometime 
between December 2001 and January 2003. In return for the 
delay, DOE obtained an additional 3.5 million barrels. 
According to the Congressional Research Service, ``It is 
believed that the schedule was renegotiated to keep pressure 
off crude markets, and to keep this volume of oil in the 
private sector where it can be tallied in industry stocks going 
into the winter of 2001-2002.'' \32\ The available futures 
market data indicates that at the time of DOE's decision, crude 
oil futures markets were backwardated, meaning near-term prices 
were greater than longer-term prices.
---------------------------------------------------------------------------
    \32\ Robert Bamberger, CRS Report, Strategic Petroleum Reserve, 
June 26, 2002.
---------------------------------------------------------------------------
    Similarly, the original schedule for the 1999 royalty-in-
kind program called for delivery of just over 27 million 
barrels to the SPR throughout the year 2000. DOE obtained an 
additional 3.6 million barrels in return for extending the 
delivery schedule to run through 2002.
    In total, these two extensions resulted in an additional 7 
million barrels for the SPR, at no additional taxpayer cost. 
Based on the average spot price of crude oil in 2002 at $26 per 
barrel, these deferrals reduced SPR costs by over $175 
million.\33\
---------------------------------------------------------------------------
    \33\ See Exhibit V-4. DOE's calculation of savings are based upon 
an average price of $25 per barrel. This is a slight underestimation, 
since the average spot price for WTI in 2002 was just over $26 per 
barrel, which means taxpayer savings were actually closer to $180 
million.
---------------------------------------------------------------------------

    c. SPR Market-Based Procedures Abandoned

    In February 2002, DOE abandoned its market-based business 
procedures, and instituted a policy of denying all requests for 
deferrals of scheduled SPR deposits, regardless of market 
conditions. The decision to stop granting requests for 
deferrals, regardless of the price of oil, was announced by the 
Secretary of Energy after consulting with White House and other 
high-ranking Administration officials. SPR career officials 
warned that this change in strategy would lead to lower 
commercial crude oil inventories and higher prices, and 
unsuccessfully recommended a return to a market-based program.
    Sections IV and V of this Report detail the consequences of 
the no-deferral policy that was adopted in 2002. Section IV 
explains how the refusal to grant deferrals in early 2002 led 
to a squeeze in the market for Brent crude oil, which in turn 
led to price spikes in the U.S. crude oil market, costing 
American consumers and businesses between $500 million and $1 
billion in 1 month alone. Section V describes the concerns of 
the SPR career officials regarding the new no-deferral policy, 
and how the Administration's market-blind policy also led to 
higher crude prices and lower commercial inventories, resulting 
in no net increase in national oil supplies.

                     III. THE PRICING OF CRUDE OIL

          ``Leon Hess, whose oil company made more than $200 
        million by trading oil futures during the Persian Gulf 
        crisis . . . said he longs for the days when oil 
        company barons could get together and decide prices and 
        supply levels largely among themselves, rather than 
        depending on the violent price swings created by 
        traders who react to rumors and headlines.
          `` `I'm an old man, but I'd bet my life that if the 
        Merc [New York Mercantile Exchange] was not in 
        operation there would be ample oil and reasonable 
        prices all over the world, without this volatility,' 
        Hess said at a hearing the Senate Committee on 
        Governmental Affairs held on the role of futures 
        markets in oil pricing.''
            --``LOil Baron Longs for Past, Not Futures,'' 
        Newsday, November 2, 1990

    In 2002, the price of crude oil in the United States nearly 
doubled, climbing from $18 per barrel in January to over $34 
per barrel in December. Since then, crude oil prices continued 
to climb and recently reached a 12-year high of nearly $40 per 
barrel.\34\ Gasoline, home heating oil, jet fuel, and diesel 
fuel prices also have increased dramatically over this period.
---------------------------------------------------------------------------
    \34\ The price of West Texas Intermediate crude oil on the New York 
Mercantile Exchange reached $39.99 on February 27, 2003.
---------------------------------------------------------------------------
    To understand how filling the SPR became a major factor 
driving up oil prices, it is first necessary to understand how 
crude oil prices are determined in today's markets.
    The crude oil market is the largest commodity market in the 
world. The nations of the world consume approximately 70-80 
million barrels of crude oil each day. To meet that demand, 
each day, hundreds of millions of barrels are traded on the 
crude oil spot, futures, and over-the-counter markets, with 
several times the world's production of crude oil traded daily 
on the New York and London futures exchanges, and contracts 
worth hundreds of millions of dollars traded daily on the over-
the-counter markets. The United States is the single largest 
consumer of crude oil, consuming about one quarter of the 
world's production of crude oil, amounting to about 18 million 
barrels per day. The United States is also the largest crude 
oil purchaser and importer, importing about 60 percent of its 
oil needs, or about 10 million barrels per day. In the United 
States, most of this crude oil, approximately 90 percent, is 
refined into fuel products, such as gasoline, home heating oil, 
jet fuel, and diesel fuel.
    Crude oil prices today are heavily influenced by producers, 
consumers, and traders buying and selling oil contracts or 
related financial instruments in various markets for crude oil. 
The development of a market-based system for determining the 
price of crude oil is a relatively recent advance in the 
petroleum industry.\35\ Prior to the mid-1970's, crude oil 
prices were largely determined by fiat by a few large oil 
companies dubbed the ``Seven Sisters.'' Following the 
nationalization of many of the Middle Eastern oil fields owned 
by these companies and the rise in power of the Organization of 
the Petroleum Exporting Countries (OPEC) cartel, crude oil 
pricing shifted from private companies to OPEC, which 
effectively controlled global prices from the mid-1970's until 
the mid-1980's. A variety of political and economic factors, 
including falling demand for crude oil and rising production by 
non-OPEC members, precipitated a collapse of the OPEC 
administered pricing system in the mid-1980's and the 
development of a market-based pricing system.
---------------------------------------------------------------------------
    \35\ See, e.g., Robert Mabro, Oil Markets and Prices, Oxford 
Institute for Energy Studies, Monthly Comment, August 2000.
---------------------------------------------------------------------------
    Nearly all commodity and financial markets have changed 
significantly since the mid-1980's, largely as a result of the 
revolutions in computer, communications, and information 
technology. The crude oil markets are no exception. Over the 
past 20 years, trading volumes on the crude oil futures 
exchanges have greatly increased, and in the past few years 
electronic over-the-counter (OTC) markets have emerged to rival 
the traditional futures markets.
    This section of the Report provides an overview of the 
crude oil markets, including the spot, futures, and OTC 
markets. It describes the three ``benchmark crudes,'' which are 
used as a basis for the price of crude oils sold around the 
world, the major types of contracts by which crude oil is now 
sold and purchased, and the pricing mechanisms and related 
financial instruments that are now commonly used in futures and 
OTC markets. This section also outlines the varying degrees of 
regulation of the different crude oil markets in the United 
States, contrasting the extensive regulation of the futures 
exchanges with the near absence of regulation of trading in OTC 
markets.\36\
---------------------------------------------------------------------------
    \36\ More detailed information on the regulation of commodity 
markets, including the crude oil markets, is provided in Appendices 1 
and 2.
---------------------------------------------------------------------------
    This section also describes in greater detail the markets 
for the three crude oils that serve as price benchmarks for all 
other types of crude oil--Brent, West Texas Intermediate (WTI), 
and Dubai. Additional detail is provided about the Brent 
market, including how the Brent spot, futures, and OTC markets 
interact and affect each other's prices. The section also 
describes how the so-called ``Arcadia squeeze'' of the Brent 
market in 2000 dramatized the Brent market's susceptibility to 
manipulation. This vulnerability continued for the next 2 
years, until Brent market corrections were made in mid-2002.
    Understanding the Brent market, its vulnerability to 
squeezes, and its relationship to other crude oil markets, such 
as the U.S. market for WTI, is critical to understanding how 
depositing significant amounts of Brent into the SPR in late 
2001 and the first half of 2002 became a major factor driving 
up crude oil prices in the United States.

A. Overview of Crude Oil Markets

    Crude oil prices are largely determined by supply and 
demand conditions in the global oil market, reflecting numerous 
transactions between buyers and sellers taking place around the 
world.
    Most of the world's crude oil is located within the 
boundaries of the countries belonging to OPEC, and OPEC has 
nearly all of the world's estimated excess production capacity. 
OPEC attempts to set an average global price for crude oil by 
establishing production quotas for its members and meets 
regularly to adjust these quotas in consideration of the global 
balance between supply and demand. Because of its market power, 
OPEC decisions about the supply of oil significantly affect 
world oil prices. Nonetheless, its efforts have met with 
varying degrees of success, as OPEC members often have 
conflicting objectives and do not always adhere to the quotas, 
and production by non-member countries has increased in recent 
years. Economists disagree as to the effectiveness of OPEC as a 
cartel.
    Global price levels are also affected by the level of 
inventories of crude oil and petroleum products in oil-
consuming countries. When inventories are high, supplies are 
more plentiful, and prices tend to fall. Lower inventories mean 
tighter market supplies, which, in turn, push prices upward to 
bring more oil into the market.
    Oil prices also depend on the supply and demand for the 
various types of crude oil produced in different oil fields. 
Crude oil streams with a low sulfur content (``sweet'' crudes) 
or that are less dense (``light'' crudes) than heavier crude 
oils are easier to process into the more valuable refined 
products, such as gasoline. To efficiently process the heavier 
crudes into lighter products, refiners must install additional, 
expensive refining equipment. Generally, therefore, light, 
sweet crudes are more expensive than heavy, sour crudes. 
Different refiners have adopted different strategies as to 
whether to make significant capital investments for more 
processing equipment in order to refine the cheaper heavier, 
sour crudes, or whether to forego the capital expenditures and 
continue to pay a premium for light, sweet crude oil. The price 
differential between light, sweet crudes and heavy, sour crudes 
at any given time depends on the relative capacity within the 
refining industry for processing these two types of crudes, the 
supplies of these crude oils, as well as the relative demand 
for lighter and heavier refined products.
    The global crude oil market consists, therefore, of a 
number of sub-markets for crude oil, which are influenced by 
the characteristics of those crude oil streams, and the supply 
and demand balance for those particular types of crude oil. The 
price for any particular crude oil stream may deviate by as 
much as several dollars per barrel from the OPEC target or the 
global average, depending on the quality of the crude oil, the 
supply and demand situation in that particular sub-market, and 
local political and economic factors.
    Crude oils produced in the oil fields around the world are 
grouped into several hundred separate crude oil streams. Almost 
all of these crude oil streams are priced in relation to the 
prevailing market price of one of the three ``benchmark'' 
grades of crude oil--Brent crude oil produced in the North Sea 
territorial waters of the United Kingdom, West Texas 
Intermediate (WTI) produced near the U.S. Gulf Coast, and Dubai 
crude oil produced in the Middle East. Typically, other crude 
oil streams are priced at either a premium or a discount to the 
relevant benchmark price, depending on the quality of the oil 
relative to the benchmark.\37\ The benchmark used for a 
particular purchase will depend upon the type of crude oil 
being purchased and the location of the purchaser.
---------------------------------------------------------------------------
    \37\ Benchmark pricing is discussed in more detail infra.
---------------------------------------------------------------------------
    There are several different types of markets for crude oil 
and related financial products. Most of the crude oil that is 
purchased for delivery is done pursuant to either a fixed-term 
contract or on the ``cash'' or ``spot'' market. There are also 
two well-established futures markets for crude oil, the New 
York Mercantile Exchange (NYMEX) and London's International 
Petroleum Exchange (IPE), but futures contracts rarely result 
in actual delivery of crude oil. The futures markets serve 
mainly to spread the risks of price volatility and for price 
discovery.
    In addition, there is an extensive over-the-counter (OTC) 
market for various types of crude oil contracts and a host of 
related financial instruments. Many of these financial 
instruments, such as swaps, serve to spread financial risk and 
discover prices, in the same manner as futures contracts. OTC 
transactions either are negotiated directly between OTC market 
participants, over the telephone through brokers, or, 
increasingly, on electronic exchanges.

  1. Term Contracts

    Much of the world's crude oil is bought and sold using two-
party ``term contracts'' covering multiple transactions over a 
specified length of time. These contracts specify the volumes 
to be delivered for the duration of the contract and fix the 
method for calculating the price of the oil. Although these 
contracts can cover as few as one shipment of oil or last as 
long as several years, they typically cover a number of 
shipments over a 1-year period, and provide an option for 
renewal upon expiration. The contracts may also provide for 
different amounts of crude oil to be delivered at different 
times in the contract period.
    Term contract prices are usually tied to the price of one 
of the three benchmark crude oils, plus or minus a quality 
adjustment. Crude oil delivered into the U.S. Gulf Coast 
usually is priced in reference to the price of West Texas 
Intermediate (WTI) crude oil. Crude oil delivered into European 
markets or produced in West Africa usually is priced in 
reference to Brent crude oil. Crude oil delivered into Asia or 
the Middle East normally is priced in reference to the price of 
crude oil produced Dubai and Oman.

[GRAPHIC] [TIFF OMITTED] T5551.014

    Term contracts for the sale of crude oil priced in relation 
to a benchmark also typically contain a ``quality adjustment,'' 
which is a negotiated dollar amount reflecting the difference 
in quality between the oil being purchased and the quality of 
the benchmark oil. Most often, the value of the quality 
adjustment will be fixed for the duration of the contract. 
Crude oil purchased under a term contract is usually tied to 
the spot price of the specified benchmark at the time the 
seller loads the crude oil into a cargo ship for transport to 
the purchaser.
    Term contracts are negotiated through face-to-face 
meetings, or by telephone and fax, and are customized to the 
particular needs of the contract participants. These contracts 
are not traded on regulated exchanges or over-the-counter.

  2. Crude Oil Spot or Cash Market

    The crude oil spot market, also known as the ``cash'' 
market, is not a formal exchange like the NYMEX but rather an 
informal network of buyers and sellers. The spot market 
provides a market to dispose of or buy an incremental supply of 
crude oil not covered by contractual agreements, in response to 
the market's current supply and demand conditions. Rising 
prices on the spot market indicate that demand is high and more 
supply is needed, while falling prices indicate there is too 
much supply for the market's current demand level.
    A spot market transaction is an agreement to buy or sell 
one shipment of crude oil at a price negotiated at the time of 
the agreement. The crude oil may be delivered immediately, or 
it may be delivered at some specified time in the future, in 
which case the contract is also known as a ``forward'' 
contract. Typically, spot market transactions are priced at the 
time the crude oil is loaded at the terminal for shipment.
    The spot prices of the three major benchmark crudes--Brent, 
WTI, and Dubai--serve as indicators for all of the crude oils 
bought and sold on the spot market. The spot price is typically 
guided by the prices of other recent spot transactions, as 
reported in Platts and other trade publications, and by 
reference to the futures prices quoted on the NYMEX for WTI or 
on the IPE in London for Brent.
    Since the middle of the 1980's, increasing amounts of crude 
oil have been bought and sold on the worldwide spot market. 
Before 1979, less than 3 percent of all crude oil traded 
worldwide was traded on the spot market. By 1989, it was 
estimated that about one-third of all crude oil was traded on 
the spot market.\38\
---------------------------------------------------------------------------
    \38\ General Accounting Office, GAO/RCED-93-17, 37; Platts Oilgram 
Price Report, November 28, 2001; and DOE/EIA.
---------------------------------------------------------------------------
    Term contracts and spot market transactions are the leading 
mechanisms for arranging for the physical delivery of crude 
oil. In the United States, term contracts and spot market 
transactions for crude oil are commercial transactions subject 
to state and Federal law. Because neither type of transaction 
is considered a contract for future delivery, neither is 
subject to regulation under the Commodity Exchange Act (CEA), 
which regulates contracts for future delivery. Although the CEA 
makes it illegal to manipulate ``the market price for any 
commodity,'' in practice the Commodity Futures Trading 
Commission (CFTC) will scrutinize spot market transactions only 
in connection with an investigation of alleged misconduct 
involving the futures market. In short, crude oil term 
contracts and spot transactions are important mechanisms for 
the delivery of crude oil yet are not subject to commodity 
market regulation.\39\
---------------------------------------------------------------------------
    \39\ Subcommittee interview with CFTC staff.
---------------------------------------------------------------------------

  3. Crude Oil Futures Markets

    While term contracts and spot transactions involve the 
trade of physical barrels of oil for immediate or deferred 
delivery, the futures markets involve the purchase and sale of 
contracts for the future delivery of crude oil. A ``futures 
contract'' is a standardized contract by a buyer to accept and 
a seller to deliver a given quantity of a particular commodity 
at a specified place, price, and time in the future. For 
example, the standard crude oil futures contract traded on the 
NYMEX specifies 1,000 barrels of WTI crude oil to be delivered 
at Cushing, Oklahoma, at a specified date in a future 
month.\40\ By law, futures contracts generally must be traded 
on regulated commodity exchanges.\41\
---------------------------------------------------------------------------
    \40\ The contract actually provides for the delivery of several 
types of domestic and foreign crude oil streams, with either a discount 
or premium per barrel based on the specific crude the seller delivers. 
The standard NYMEX light sweet crude contract lists the specifications 
of the deliverable grades of crude oil with the specified discounts and 
premiums. This contract may be traded within a 30-month period prior to 
the date of delivery specified in the contract for the oil. NYMEX also 
offers standard light, sweet crude contracts for delivery of WTI crude 
oil 3, 4, 5, 6, and 7 years into the future.
    \41\ Exceptions to this general rule are discussed later in this 
Section and in Appendix 2.
---------------------------------------------------------------------------
    Rather than provide a mechanism for the actual delivery of 
physical volumes of crude oil, however, the primary purposes of 
futures contracts are to allow market participants to spread 
the risk of price volatility and to provide a mechanism for 
price discovery. Indeed, one of the major differences between a 
forward contract and a futures contract is that in the former 
delivery is intended whereas in the latter it is not.\42\
---------------------------------------------------------------------------
    \42\ See Commodity Futures Trading Comm. v. Co Petro Marketing 
Group, Inc., 680 F.2d 573 (9th Cir. 1982).
---------------------------------------------------------------------------
    The first function of a futures contract, risk spreading, 
occurs as producers and consumers buy or sell futures contracts 
that fix the price of future purchases or sales and thereby 
reduce the risk of price volatility and uncertainty prior to 
delivery. For example, a producer of crude oil may be concerned 
that the price of crude may fall in the future. At the same 
time, a refiner may be concerned that the price of crude may 
rise. By entering into a futures contract that fixes the price 
of crude oil to be delivered in the future, both the producer 
and the refiner can protect themselves against adverse price 
movements. Alternatively, a speculator may be willing to enter 
into a futures contract with either a producer or a refiner and 
be willing to bear the risk of a price movement in return for 
the possibility of speculative gains from those price changes.
    A broad range of participants in the oil industry use the 
futures markets. In addition to crude oil producers and 
refiners, oil trading firms, petroleum-product end users, 
financial institutions, and investment funds also account for 
significant trading volume. For example, a number of airlines 
use crude oil futures to hedge the cost of jet fuel. A number 
of investment banks use crude oil and other energy-related 
futures to hedge against changes in energy costs, which affect 
many of their other investments.

[GRAPHIC] [TIFF OMITTED] T5551.149

    The second function of the futures market, price discovery, 
occurs as market participants bring to the marketplace their 
knowledge of current supply and demand conditions and their 
expectations about the future. Prices change frequently as the 
participants revise or reevaluate their expectations on the 
basis of new information, and buy and sell futures contracts in 
accordance with those expectations. As a futures contract 
approaches the delivery date, the price of the first forward 
month should approach the spot price.

                  Basic Terms Used in Futures Markets:

          A purchaser of a futures contract that provides for 
        delivery of a commodity to the holder of the contract 
        at a future date is said to be long in the commodity. 
        The holder of a futures contract that requires the 
        contract holder to deliver the commodity at a future 
        date is said to be short in that commodity. At any 
        given time, the number of shorts must exactly balance 
        the number of longs. Because futures contracts are not 
        generally used to obtain or deliver actual commodities, 
        holders of futures contracts generally will square out 
        their positions (i.e., buy back from the market the 
        amount of the commodity that previously had been sold, 
        or sell back to the market that which previously had 
        been bought) before the expiry of the contract, meaning 
        the date on which the contract expires, at which time 
        the remaining holders of outstanding contracts will be 
        required to accept or make physical delivery of the 
        commodity. See, e.g., Chicago Board of Trade, 
        Agricultural Futures and Options (1998).

  Standardized Contracts

    The standardization of futures contracts facilitates the 
trading of these contracts, which is one of the major 
advantages of purchasing a contract that can be traded on an 
exchange. Typically, to execute a trade involving a 
standardized futures contract on an exchange, the only 
contractual term that must be negotiated for the sale or 
purchase of that contract is the price. On a commodities 
exchange, this takes place through either the open outcry 
system, which is the traditional system of traders and brokers 
signaling and shouting to each other bids and offers in trading 
pits located on the exchange floor, or through an electronic 
exchange, where the bids and offers are posted and matched 
electronically, without any face-to-face contact between the 
parties or their brokers. The NYMEX uses the open outcry system 
for trading crude oil and other commodity contracts, whereas 
the IPE plans to discontinue pit trading and switch to all-
electronic trading.
    Because the contracts are standardized, a single futures 
contract can be traded many times before the delivery date 
specified on the contract, each time at a new price as the 
market's supply and demand situation changes. Since futures 
contracts rarely are used to obtain or make physical delivery, 
the volume of crude oil traded under these contracts can far 
exceed the actual available volumes of the underlying 
commodity. In fact, in recent years the total volume of crude 
oil represented in open NYMEX light sweet crude oil contracts 
typically has been over 110 times the daily production of all 
crude grades deliverable under the contract.\43\ On average, 
less than one-tenth of 1 percent of these oil futures contract 
results in the actual delivery of crude oil. For example, over 
the 7 years that the December 2001 NYMEX light sweet crude oil 
contract was traded, 5 billion barrels were traded, but only 
31,000 barrels were actually delivered on those contracts.\44\
---------------------------------------------------------------------------
    \43\ Information provided to Subcommittee staff by NYMEX.
    \44\ Id.
---------------------------------------------------------------------------
    Futures trading of crude oil on NYMEX began in 1983, and 
today the volume of the WTI crude oil futures contract traded 
on the NYMEX is the largest of any physical commodity traded in 
any futures market. For example, in 2001, over 37.5 million 
crude oil futures contracts--each for 1,000 barrels of WTI 
crude oil--were traded on the NYMEX.\45\ Although the NYMEX 
also offers a futures contract for Brent crude oil, trading in 
this contract remains limited. The majority of futures 
contracts for Brent crude oil are traded at the IPE in London.
---------------------------------------------------------------------------
    \45\ Id. In addition to the trade in futures contracts, options to 
buy or sell futures contracts are also traded on the NYMEX. Options 
also are popular instruments used for hedging and speculating. For 
simplicity, the following discussion refers only to futures.
---------------------------------------------------------------------------

  Exchange Membership and Clearinghouse

    A commodity futures exchange like the NYMEX is similar to a 
stock exchange in that it is an association of members who own 
seats on the exchange and who can trade on the exchange. The 
members of an exchange generally fall into several categories: 
the commercial producers and purchasers of the commodities 
traded on the exchange, speculators, and brokers. Members may 
trade on the exchange for their own account or for others; 
nonmembers must trade through brokerage firms.
    A key feature of an exchange is a clearinghouse, which is 
operated by or on behalf of the exchange. Generally, a number 
of firms that are members of the exchange own and operate the 
clearinghouse. In addition to keeping track of all the trades 
that occur on the exchange each day, all trades must be cleared 
through the clearinghouse, and the clearinghouse guarantees 
performance on all the contracts traded on the exchange. When 
two customers buy and sell futures contracts on an exchange, 
each of their brokers actually conducts the transaction through 
the clearinghouse rather than by bringing the customers 
together. In effect, the clearinghouse acts as a party to every 
transaction. Thus, when customers want to sell back or buy back 
futures contracts, they do not need to find the original 
counterparty; rather they need only find another party 
interested in a new transaction, and the trade is again 
conducted through the clearinghouse.
    To guarantee contract performance, the members of the 
clearinghouse deposit funds into the clearinghouse. The rules 
of the exchange also require brokers trading through the 
clearinghouse and their customers to post deposits or 
``margins,'' related to the value of the positions taken in 
their trades, to cover any losses that may occur. At the end of 
each day of trading these margin accounts are ``marked-to-
market''--the exchange collects money from accounts that have 
lost value and credits those accounts that have gained value--
so that sufficient funds to guarantee performance are on 
deposit at all times. In this manner, ``counterparty risk''--
the risk that the other party to a trade will default on 
performance--is virtually eliminated.
    Traditionally, one of the major advantages of trading on an 
approved exchange rather than over-the-counter has been that 
the exchange guarantees financial performance and removes 
counterparty risk, whereas in the over-the-counter market each 
party to each contract assumes the risk that the other party 
may fail to perform.\46\ According to the Chicago Board of 
Trade, which uses a clearinghouse, ``the success of this system 
is obvious. Since its start in 1925, no customer within or 
outside of the [CBOT] exchange has lost money due to default on 
a futures position.'' \47\
---------------------------------------------------------------------------
    \46\ But see infra, which explains that OTC traders can now trade 
instruments backed by a clearinghouse.
    \47\ Chicago Board of Trade, Action in the Marketplace.
---------------------------------------------------------------------------

                   Regulation of IPE Brent Contracts

          In the United Kingdom, the futures and over-the-
        counter (OTC) markets are regulated by the Financial 
        Services Authority (FSA). Brent IPE contracts are 
        traded in a manner similar to the trading of NYMEX WTI 
        contracts, and many of the principles underlying the 
        U.K. system commodity market regulation are similar to 
        those of the U.S. system. There are also several 
        significant differences. The U.K. ``Code of Market 
        Conduct'' governing the U.K. futures exchanges and OTC 
        markets is less prescriptive than the regulatory system 
        under the CEA, emphasizing adherence to general 
        principles of conduct rather than detailed regulations.

          Additionally, the U.K. ``light touch'' regulatory 
        system provides for less stringent regulation of 
        ``professional'' markets, such as the IPE's crude oil 
        market, as opposed to markets in which retail investors 
        participate. The rationale for the light touch system 
        is that large institutions and market professionals are 
        sophisticated investors who have less need for 
        protective government oversight than small investors. 
        As explained in Appendix 2, U.S. law exempts certain 
        large market participants trading certain OTC 
        instruments from many CEA requirements, but applies the 
        full array of CEA requirements to the trading of crude 
        oil futures contracts on the NYMEX.

  Market Oversight

    The trading of futures contracts on the NYMEX and the other 
approved commodities exchanges in the United States is 
regulated by the Commodity Futures Trading Commission (CFTC) 
under the Commodity Exchange Act (CEA).\48\ The goal of Federal 
commodity market regulation is to ensure that the exchanges 
remain ``a means for managing and assuming price risks, 
discovering prices, or disseminating pricing information 
through trading in liquid, fair and financially secure trading 
facilities.'' \49\ The primary objectives of the CEA are ``to 
deter and prevent price manipulation or any other disruptions 
to market integrity; to ensure the financial integrity of all 
transactions subject to this Act and the avoidance of systemic 
risk; to protect all market participants from fraudulent or 
other abusive sales or practices and misuses of customer 
assets; and to promote responsible innovation and fair 
competition among boards of trade, other markets and market 
participants.'' \50\
---------------------------------------------------------------------------
    \48\ 7 U.S.C. Sec. 1 et seq.
    \49\ Id., at Sec. 3. For more information on the regulation of 
commodity markets, see Appendices 1 and 2.
    \50\ Id.
---------------------------------------------------------------------------
    A cornerstone of the CEA is the system of self-regulation 
by the exchanges. Although the CFTC is the Federal agency 
responsible for regulating the futures markets, and has 
authority to issue civil penalties for violations of its 
regulations, and to refer potential criminal violations to the 
Department of Justice for prosecution, \51\ the exchanges 
themselves have the front-line responsibility for ensuring that 
trading remains orderly, commodities brokers are properly 
qualified and registered, sufficient margins are posted to 
guarantee contract performance, and fraud or market 
manipulation is detected and stopped. To be permitted to trade 
futures, an exchange must establish rules and regulations for 
trading, as well as market oversight and surveillance programs, 
in accordance with the requirements of the CFTC under the CEA. 
An exchange whose self-regulatory programs and futures 
contracts have been approved by the CFTC is termed a 
``designated contract market.'' Generally, a futures contract 
for a commodity regulated under the CEA must be traded on a 
designated contract market.\52\ A list of currently active 
designated contract markets is provided in Table A.2-1 in 
Appendix 2.
---------------------------------------------------------------------------
    \51\ Less than a handful of criminal prosecutions have been brought 
for violation of the CEA. Markham, Manipulation of Commodity Futures 
Prices--The Unprosecutable Crime, 8 Yale J. on Reg. 281, n.604 (1991).
    \52\ The exceptions to this general rule are discussed infra.
---------------------------------------------------------------------------
    To ensure orderly trading, the exchanges have established 
daily price limits for most commodity futures contracts 
(limiting the amount the price can increase or decrease in 1 
day); position limits for the clearing members of the exchange 
(so that each clearing member has sufficient capital to cover 
its commitments); position limits for customers with contracts 
expiring in the current delivery month (to prevent squeezes of 
the commodity in the final month of the contract); and 
reporting requirements for customers with large positions in 
the futures and options markets. The market oversight and 
surveillance programs of each exchange monitor price movements, 
trading practices, and the accumulation of large positions in 
order to detect potential manipulations and squeezes and take 
corrective measures before the market is disrupted.

  Price Transparency

    Each time a transaction is completed on the floor of an 
approved exchange, the exchange records the pairing of buyers 
and sellers and reports the transaction price. These prices are 
available throughout the day from the exchanges via the 
Internet, \53\ are published in specialty trade publications 
and daily newspapers, and are reported on a weekly basis by the 
Department of Energy's Energy Information Administration. The 
timely availability of contract prices improves price 
transparency--the ability of any market participant to see the 
prevailing price level--and makes futures market contracts a 
price reference for negotiations in the spot and term contract 
markets.\54\
---------------------------------------------------------------------------
    \53\ See, for example, NYMEX website, at http://www.nymex.com.
    \54\ DOE/EIA-0545(99), Petroleum: An Energy Profile: 1999, July 
1999, 54-55; DOE, EIA, Oil Market Basics; GAO/FREC-93-17, 34-37; NYMEX 
website, at http://www.nymex.com; and February 11, 2002, meeting with 
NYMEX representative.
---------------------------------------------------------------------------

  Price Risk and Hedging

    The most straightforward use of the futures market by a 
crude oil producer or refiner is to ``hedge'' against adverse 
price movements by locking in the prevailing price for future 
deliveries. For example, an oil producer can establish a sales 
price for oil that will be produced later by selling a futures 
contract. Then, if a drop in market price causes the value of 
the oil to decline, the decline in the value of the oil sold in 
the physical market will be offset by the gain in the futures 
market made when the futures contract is bought back later at a 
lower price. Conversely, a refiner may want to fix the price 
that must be paid for crude oil that will be needed in the 
future. To do so, the refiner could purchase a futures contract 
for delivery of oil at a specified date in the future. If the 
price of crude oil increases in the cash market, the refiner's 
increased costs in the physical market when the crude oil is 
bought will be compensated for by its gain in the futures 
market when at the same time the refiner sells back the futures 
contract at a higher price. By limiting the uncertainty over 
future costs, hedging allows companies to offer fixed price 
arrangements to its customers for its products and to plan and 
budget for the future without having to bear all of the risk of 
price changes.\55\
---------------------------------------------------------------------------
    \55\ The term ``hedge'' means to take one position in one 
transaction, such as selling a commodity, and the opposite position in 
another transaction, such as purchasing the commodity, to minimize the 
possibility of losses from one of the transactions. The word hedge 
``evolved from the notion of the common garden hedge as a boundary or 
limit . . .'' Roger Lowenstein, When Genius Failed (Random House, 
1999), at 25.
---------------------------------------------------------------------------
    In general, crude oil refiners are more concerned with 
ensuring they receive adequate margins for their products 
rather than absolute price levels. It does not necessarily 
matter to a refiner whether crude oil is at $20 per barrel and 
gasoline is selling at $23 per barrel, or crude oil is at $25 
per barrel and gasoline is selling at $28 per barrel--the $3 
per barrel margin is the same in both cases. What matters to a 
refiner is the difference between the price of crude oil and 
the price of refined products, such as gasoline. To protect 
their margins, crude oil refiners will adopt trading strategies 
that protect against changes in relative price levels rather 
than lock in absolute price levels. These strategies typically 
involve the simultaneous buying and selling of futures 
contracts for different commodities, such as crude oil and 
gasoline futures, or the simultaneous buying and selling of 
futures contracts for the same commodity in different futures 
months. These strategies, termed ``spread trading,'' can be 
effective in locking in margins and protecting against 
unanticipated changes in price.
    Similarly, crude oil traders, like commodity traders in 
general, are not so much concerned with absolute prices as they 
are with relative prices. Whether crude oil is at $20 or $25 
per barrel is not nearly as important to a trader as whether 
crude oil was bought for less than it can be sold, or was sold 
for more than it can be bought. Crude oil traders frequently 
use spread trading to lock in the margin between buying and 
selling.
    Although exchange-traded futures contracts are standardized 
with respect to the type and quantity of deliverable commodity, 
standardized contracts can be used to hedge or speculate on 
price movements for a much broader range of commodities when 
there is a fairly predictable relationship between the 
commodity being hedged and the commodity in the standardized 
contract. Because the price of most crude oil is priced 
relative to WTI or Brent, the futures markets for WTI and Brent 
are used to hedge or speculate on price movements of many 
varieties of crude oil. Thus, for example, a purchaser of crude 
oil produced in Nigeria--which is priced at a differential to 
Brent--could use the IPE Brent futures market to hedge against 
movements in the price of Nigerian crude. Even with this hedge, 
however, a producer or consumer of Nigerian crude oil would 
continue to be exposed to the risk of a variance from the 
normal differential between Nigerian crude and Brent. Such 
variances could be caused by a variety of global or local 
conditions, such as political events in Nigeria or the United 
Kingdom, variations in commodity exchange rates, or changes in 
the local supply and demand conditions affecting Brent or 
Nigerian crude.
    This latter type of risk is part of a price risk that 
generally can never be completely hedged--namely, the variance 
between the spot or cash price and the futures price of a 
commodity. While the cash price of a commodity and the futures 
price of the commodity generally converge at expiry of the 
nearest-month contract, this convergence exists only for 
delivery of standardized quantities at a particular location on 
a particular date. Because most purchasers or sellers of 
commodities would like their purchases and sales to occur 
somewhere other than the specific location in the standardized 
futures contract and at a time other than the particular date 
on which a futures contract expires, the cash price for these 
particularized transactions will differ from the standardized 
futures price even at expiry. The risk that the cash price of a 
commodity will differ from the futures price of that or another 
commodity used for hedging purposes is known as ``basis risk,'' 
the ``basis'' being the difference between the cash price and 
the futures price at a given location and time.\56\
---------------------------------------------------------------------------
    \56\ Typically, the local basis of a commodity will be determined 
by transportation costs, storage costs, interest rates, and local 
supply and demand conditions. To minimize risk, or to attempt to obtain 
profits when cash and futures diverge from their historical 
relationships, commodity producers, purchasers, and traders closely 
follow the relationship between cash and futures prices and will 
structure their trades accordingly. These patterns and relationships 
are used to determine whether or not to accept cash bids for a 
particular commodity; which buyer or seller to use; when to purchase, 
store, or sell a particular commodity; when to terminate a hedge on the 
futures market; and which future month of a commodity to use for 
hedging or speculation. Chicago Board of Trade: Understanding Basis: 
Improving Margins Using Basis (1998).
---------------------------------------------------------------------------

  Arbitrage

    Although absolute price movements are impossible to 
forecast accurately, it is possible to make predictions about 
the relative prices of commodities in various markets, both 
cash and futures. Many commodities have seasonal supply and 
demand trends, and prices tend to follow corresponding seasonal 
patterns. For example, although the absolute levels of future 
gasoline prices are impossible to predict, gasoline prices in 
the United States tend to be higher in the summer, when demand 
is greatest. Traders use these patterns to minimize price risks 
and costs.
    In situations in which several different markets exist for 
the same commodity, or similar commodities, different prices 
may arise for the same or similar commodities, either in the 
cash market or in the futures markets. Local supply and demand 
conditions may influence one market more than another, traders 
in different markets may have different information upon which 
the market prices are based, or different traders may evaluate 
the same information differently.
    Different markets for the same or similar commodities are 
linked together by the principle of ``arbitrage.'' ``The 
general notion of cash arbitrage is that traders purchase goods 
where they are cheapest and simultaneously sell them where they 
are most expensive. In cash markets, arbitrage opportunities 
occur when prices in the two markets differ by more than 
transportation costs between the markets.'' \57\ In futures 
markets, opportunities for arbitrage arise when traders believe 
that futures prices for one commodity at a particular time in 
the future depart from their historical relationship either to 
the cash market, the futures prices for another commodity, or 
the price of the same commodity at another time in the 
future.\58\
---------------------------------------------------------------------------
    \57\ Steven Errera and Stewart L. Brown, Trading Energy Futures & 
Options, at 40 (1999).
    \58\ Warren Buffet reportedly once said, ``Give a man a fish and 
you feed him for a day. Teach him how to arbitrage and you feed him 
forever.'' Kirk Kinnear, The Brent/WTI Arb (NYMEX website).
---------------------------------------------------------------------------
    Hence, although there are three major benchmarks and a 
number of distinct, local markets for crude oil, these crude 
oil benchmarks and markets, both cash and futures, are linked 
together by the concept of arbitrage. Arbitrage trading between 
the Brent markets and the WTI markets, to a large extent 
determines the price and amount of oil imported into the United 
States from the Atlantic basin. On average, Brent is less 
expensive than WTI by about $1.50 per barrel, and it costs 
between $1.00 and $1.50 per barrel to ship Brent across the 
Atlantic in a large tanker. Because supply and demand 
conditions in the European markets and the U.S. markets may 
differ at any given time, the difference between the price of 
Brent and the price of WTI can vary from this average. When the 
price of Brent plus the cost of transporting Brent across the 
Atlantic is less than the price of WTI, refiners will import 
more Brent and Brent-priced crudes. When the price of Brent 
plus the cost of transporting Brent across the Atlantic is more 
than the price of WTI, refiners will import less Brent and 
Brent-priced crudes, and instead rely more upon crude oil 
produced in North and South America, as well as crude oil in 
domestic inventories. The Brent-WTI price difference, 
therefore, is one of the most significant factors determining 
the price and volume of the transatlantic crude oil trade.
    A significant amount of commodities and financial trading 
today consists of sophisticated and complex arbitrage trading 
designed to exploit differences between the various markets. 
This type of arbitrage trading brings additional liquidity to 
the market and helps bring the various markets into an overall 
equilibrium.\59\
---------------------------------------------------------------------------
    \59\ The Long-Term Capital Management (LTCM) debacle demonstrates 
how even sophisticated arbitrage trading carries risk. LTCM's strategy 
was to exploit differences in currency exchange rates, bond prices, 
interest rates, and other financial instruments, based on mathematical 
models of the historical prices and volatilities of those instruments. 
Although LTCM initially earned several billion dollars, with annual 
returns greater than 40 percent, after Russia devalued the ruble and 
defaulted on its bonds, an event not anticipated by the model, the fund 
``blew up'' and spiraled into near-bankruptcy, ultimately requiring a 
multi-billion dollar bail-out by the Wall Street firms and banks with 
which it had large amounts of outstanding trades. See Inventing Money, 
supra; When Genius Failed, supra.
---------------------------------------------------------------------------

  4. Over-the-Counter Markets

          ``Derivatives are financial instruments that have no 
        value of their own. That may sound weird, but it is the 
        secret of what they are all about.''
            --LPeter L. Bernstein, Against the Gods (Wiley, 
        1998)

    A derivative is any type of financial instrument that 
derives its value from an underlying commodity or market index. 
Strictly speaking, forward and futures contracts are types of 
derivatives, since their value derives from the value of an 
underlying commodity.
    OTC trading instruments also derive their value from an 
underlying commodity or market index but, unlike futures 
contracts, are not traded on a regulated commodities exchange 
and generally are not used by or offered to small businesses or 
retail customers. Initially, OTC derivatives were developed as 
customized devices to meet the particularized needs of parties 
to protect themselves against adverse price movements in 
financial and commodity markets, in situations in which such 
risks could not be adequately addressed by the use of 
standardized futures contracts on the regulated exchanges. 
Until recently, the terms of most OTC instruments were 
negotiated directly between the two parties to the transaction, 
either face-to-face or through brokers over the telephone.
    As OTC derivatives became more popular, parties to these 
instruments became interested in trading these instruments to 
help spread risks further. As a result, there has been a rapid 
growth in the use of standardized OTC derivatives and in the 
use of electronic exchanges to match parties seeking to trade 
OTC derivative instruments.
    Although the OTC market can provide the parties with more 
flexibility in crafting particularized instruments than the 
futures markets, the traditional OTC markets present a number 
of additional risks as well. In the typical OTC transaction, 
each party assumes the credit risk that the other party will 
not perform. There is no ``OTC clearinghouse'' to guarantee 
performance. In addition, unlike futures contracts, many 
individually negotiated OTC instruments are not transferable to 
third parties without the consent of both parties to the 
original transaction. Additionally, there is less price 
transparency in most of the OTC markets than on the designated 
exchanges. There is also less government oversight to detect 
and prevent market manipulation and fraud in the OTC markets 
than on the designated exchanges.
    Despite these drawbacks, the overall market for OTC 
derivatives is now estimated to be several times larger than 
the exchange-based futures markets. At the end of 1998, the 
estimated total notional amount of outstanding OTC derivative 
contracts was $80 trillion, whereas the estimated total value 
of outstanding exchange-traded futures and options contracts 
was $13.5 trillion.\60\ The vast majority of OTC derivatives 
contracts are interest rate and foreign currency exchange 
contracts; only a small fraction of the total relates to 
tangible commodities such as crude oil. The OTC commodities 
trade is nonetheless substantial; in 1999, the notional value 
of OTC commodities contracts was estimated at approximately 
$1.8 trillion.\61\
---------------------------------------------------------------------------
    \60\ Report of the President's Working Group on Financial Markets, 
Over-the-Counter Derivatives Markets and the Commodity Exchange Act, 
November 1999. The notional amount in a swap represents the value of 
the commodity or index underlying the swap, not the actual value 
swapped. Because there are no reporting requirements for OTC commodity 
transactions, more specific data with respect to commodity derivatives 
traded on the OTC markets is not available.
    \61\ Information on Intercontinental Exchange (ICE) website, as of 
October 2002.
---------------------------------------------------------------------------
    Normally, only large financial institutions, corporations, 
or commodities firms participate in OTC markets. Many of these 
traders, however, use both the OTC markets and the regulated 
exchanges. Traders who trade on the designated exchanges often 
prefer the advantages of a market with more participants and 
trades (``liquidity''), the greater price transparency provided 
by the exchanges, and the performance guarantees provided by 
the exchange clearinghouses. Traders who participate in the OTC 
markets may prefer the flexibility offered through 
individualized transactions, have a greater capacity to assume 
credit risks than other traders, and seek to avoid brokerage 
fees and margin payments required on the exchanges. Some 
traders may prefer the lesser degrees of transparency and 
regulatory oversight.

  OTC Swaps

    A key type of OTC instrument used by oil and other 
commodity traders is a derivative known as a ``swap.'' Swaps 
were originally developed in the financial markets to hedge 
against fluctuations in currency exchange rates, interest 
rates, bond rates, and mortgage rates. Increasingly, they are 
being used in commodity markets to hedge against fluctuations 
in commodity prices. Like a futures contract, a commodity swap 
locks in the value of a commodity at a particular price. For 
example, in a swap for crude oil to be delivered in the future, 
the seller will agree to pay the buyer for any increases in the 
price of crude oil above an agreed-upon value between the time 
the contract is entered and the time the crude oil is 
delivered, while the buyer will agree to pay the seller for any 
decreases below the agreed-upon value.
    In both the commodities and financial markets, there are an 
endless variety of swaps, individually tailored to address the 
particular risk and speculative strategies of market players. 
Definitive data regarding the magnitude of the swap market and 
the type of instruments used is impossible to obtain, however, 
since there is virtually no regulation of any swaps market.
    One of the major advantages of the swaps market is that 
swaps can be used to hedge against price changes for 
commodities for which there is not a market on the designated 
exchanges. To continue with a previous example, a crude oil 
refiner intending to purchase Nigerian oil could use a swap to 
hedge that part of the price risk that cannot be hedged by 
purchasing a Brent futures contract. The refiner could purchase 
a Brent futures contract to hedge that part of the price of the 
Nigerian crude that is linked to the price of Brent, and then 
enter into a swap with another party to hedge the risk that the 
price of Nigerian crude may vary from the price of Brent crude 
by a fixed differential. The ``price'' of this swap would be 
the price of Brent on the IPE plus the fixed differential 
between Brent and Nigerian crudes. Through this type of swap, 
basis risks remaining after futures contracts are bought or 
sold can be minimized.
    Because swaps allow more precise risk management for 
commodity traders they have become increasingly popular. Since 
these commodity swaps are often linked to the value of a 
commodity traded on a designated futures exchange, the growth 
in the use of such swaps has contributed to a corresponding 
growth in trading volume on the designated exchanges. In this 
manner, the price discovery and hedging functions of the 
designated exchanges and the OTC swaps market are now 
intertwined.
    Most swaps involving energy contracts, metals, and 
financial instruments are excluded from the extensive 
regulatory structure that the Commodity Exchange Act applies to 
the trading of futures contracts.\62\ These statutorily 
excluded swaps include any swap transaction involving a non-
agricultural commodity or financial instrument, between large 
market participants, \63\ provided the transaction is 
individually negotiated and not executed or traded on a 
``trading facility,'' meaning an exchange-like facility where 
multiple bids and offers are made and accepted. Under current 
law, then, bilaterally negotiated swap agreements involving 
crude oil are excluded from all regulation under the CEA.
---------------------------------------------------------------------------
    \62\ Appendix 2 provides more detailed information on the 
exclusions and exemptions for OTC energy contracts.
    \63\ These large market participants, termed ``eligible contract 
participants,'' include financial institutions, brokers and dealers, 
corporations with more than $5 million in assets, and individuals with 
more than $10 million in assets. 7 U.S.C. Sec. 2(g) (West Supp. 2002).
---------------------------------------------------------------------------

                      Example of a Crude Oil Swap

          In April a refiner is planning its crude oil 
        purchases for December. The NYMEX price for December 
        delivery of WTI is $25 per barrel, and December 
        gasoline futures are at $30 per barrel. The refiner 
        wants to lock in this $5 margin for 10,000 barrels. A 
        Wall Street investment firm believes that over the same 
        period the Euro will weaken relative to the dollar, 
        making European crudes cheaper for U.S. refiners to 
        import, and therefore WTI will fall in price. Neither 
        firm is concerned about non-performance by the other, 
        since they both have significant assets. In the swap, 
        they agree that in December, if the NYMEX price for 
        December delivery has increased above $25, the Wall 
        Street firm will pay the refiner the difference, and if 
        the price has decreased, the refiner will pay the Wall 
        Street firm the difference. Thus, if the December price 
        rises to $26, the Wall Street firm will pay the refiner 
        $10,000 (10,000 barrels at $1 per barrel). The 
        refiner's net cost for crude oil in December is still 
        $25 per barrel ($26 per barrel market price minus $1 
        per barrel payment from the Wall Street firm). If the 
        December price falls to $24, the refiner will pay the 
        Wall Street firm $10,000, yet its net cost for the 
        crude still will be $25 per barrel ($24 market price 
        plus $1 payment to the Wall Street firm).
          Although the swap is a hedge for the refiner, it is 
        speculation for the Wall Street firm, since the firm 
        will profit if the price of WTI falls as it projects, 
        but lose if the market moves in the other direction. 
        Should the Wall Street firm decide it no longer wishes 
        to speculate on the price of December crude oil, it 
        could buy a NYMEX December futures contract for WTI, in 
        which case it, too, would be hedging. Although the 
        notional value of this swap is $250,000 (10 barrels x 
        $25/barrel), the actual payments will be much less.

  OTC Electronic Exchanges

    Although OTC market participants desire flexibility to 
craft instruments to address their particular risk strategies, 
they also would like to be able to trade these instruments when 
market conditions change. Thus, although there is a large 
amount of innovation and customization in the types of 
instruments that are traded on the OTC markets, there also is a 
movement towards the standardization of features to facilitate 
the trading of these instruments.
    Recently, a number of companies have created organizations 
and facilities to take advantage of the growing desire to trade 
in OTC instruments. Generally, they have used strategies that 
fall into two broad categories. The first, typified by ``Enron 
Online,'' provides an OTC trading facility in which the company 
hosting the facility acts as the counterparty to all of the 
other parties seeking to buy or sell instruments. These are 
termed ``one-to-many'' facilities because one party acts as the 
counterparty to many other parties. The Enron scandal has 
exposed a number of weaknesses in this business model, as it 
provides the one counterparty with significant market power and 
knowledge that can be used to manipulate the market at the 
expense of all of the other traders.
    The second approach, which has become the most successful 
type of OTC trading facility, is the ``multilateral 
transactional facility,'' whereby an organization provides an 
electronic trading ``platform'' that facilitates OTC trading 
between the parties using the platform, but does not provide 
clearinghouse operations to guarantee performance or monitor 
trades.
    Using this second approach, in 2000, several investment 
banks and oil companies formed the Intercontinental Exchange 
(``ICE'') to trade in OTC energy and metals derivatives.\64\ 
Located in Atlanta, Georgia, the ICE is an electronic exchange 
open only to large commercial traders.\65\ Rather than provide 
a counterparty to all trades, as do the NYMEX and IPE 
clearinghouses, ICE acts only as a posting facility for bids 
and offers, which the traders can then choose to accept or 
reject.\66\ Any large commercial company can trade on ICE's 
facility without having to employ a broker or pay a fee to a 
member of the Exchange. All trades are bilateral deals between 
the buyers and sellers. There is no clearinghouse and, 
accordingly, no requirement to post margins. The ICE website 
advertises: ``There are no memberships. No artificial 
restrictions. No dues or fees beyond those incurred in the 
trading itself.''
---------------------------------------------------------------------------
    \64\ 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.
    \65\ Participation is restricted to parties that quality as an 
``eligible commercial entity'' under Sec. 1a(11) of the CEA. Generally, 
the entities that qualify 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.
    \66\ To the extent that all bids, offers, and contract prices of 
traders using ICE are posted on the ICE system, ICE provides a degree 
of price transparency that is wholly absent in other OTC transactions.
---------------------------------------------------------------------------
    Although ICE does not require exchange memberships or 
operate its own clearinghouse, it has established an 
alternative system for traders to protect against counterparty 
credit risk. ICE has arranged for traders using the ICE trading 
platform to apply to the London Clearing House or the Chicago 
Board of Trade Clearing Corporation for performance guarantees. 
The ICE software identifies traders who have obtained such 
performance guarantees, so that traders can choose to accept 
bids and offers from only those other traders who have obtained 
such guarantees. A party trading on the ICE platform can 
eliminate counterparty risk just as if he or she were trading 
on a futures exchange, thereby eliminating one of the major 
disadvantages of OTC trading.
    The ICE describes the benefits of using its OTC clearing 
system as follows: ``OTC Clearing on the Intercontinental 
Exchange provides traders and risk managers the best of both 
worlds: the safety and security offered by a central 
clearinghouse along with the flexibility and accessibility of 
the fully-electronic ICE platform.'' \67\
---------------------------------------------------------------------------
    \67\ ICE, Clearing and Credit, at http://www.theice.com/risk.html.
---------------------------------------------------------------------------
    A 2001 ICE press release describes the extent of the ICE 
system:

        [ICE's electronic trading system] is installed on over 
        6,500 desktops worldwide from which traders log on each 
        day of the business week to trade more than 600 listed 
        commodity and derivative contract types, approximately 
        200 more than when Intercontinental went live. Broadly, 
        these include crude oil and refined products, natural 
        gas, power, precious metals, and emissions allowances. 
        Contract forms include physical delivery as well as 
        financially settled swaps, spreads, differentials and 
        options based on a variety of fixed and floating price 
        indices.

According to this release, the total notional value of the 
contracts traded on IPE over the previous 12 months was in 
excess of $500 billion. As of 2001, the daily volume of oil 
traded on the ICE was approximately 19 million barrels.\68\
---------------------------------------------------------------------------
    \68\ Information obtained from ICE website, http://www.theice.com/
home.html.
---------------------------------------------------------------------------
    The NYMEX also operates an electronic trading platform for 
the trading of standardized OTC instruments. The NYMEX OTC 
platform opens for the trading for crude oil contracts at 3:15 
p.m., 45 minutes after the close of the open outcry trading in 
the NYMEX pits, and then closes at 9 a.m. the next morning, 1 
hour before exchange trading begins again.
    NYMEX also recently began to provide clearinghouse services 
for traders using the NYMEX electronic trading platform. NYMEX 
describes its system as follows:

          NYMEX ClearPortsm clearing services are 
        also available to market participants who wish to 
        conduct bilateral energy transactions in a slate of 23 
        standardized contracts for crude oil, natural gas 
        basis, refined products, and electricity and submit 
        them for clearing. Cleared bilateral transactions are 
        submitted, margin requirements are calculated, and the 
        transactions are processed by the clearinghouse in the 
        same manner as the NYMEX Division futures 
        contracts.\69\
---------------------------------------------------------------------------
    \69\ NYMEX ClearPortsm Services Overview, at http://
209.67.30.245/jsp/markets/cp--overvi.jsp.
---------------------------------------------------------------------------

  5. Convergence of Futures and OTC Markets

    As OTC instruments have become standardized, and 
organizations that operate the designated futures exchanges, 
like the NYMEX and the ICE/IPE, offer OTC instruments for large 
institutional traders and provide clearing services for OTC 
trades, the traditional distinctions between these OTC markets 
and the futures markets have vanished. Both the futures 
exchanges and the OTC electronic trading platforms offer 
standardized instruments; both offer ways to eliminate 
counterparty risk; and traders purchase, sell, and trade 
derivative instruments on both markets to hedge price risk. The 
NYMEX description of its clearing services for OTC trades 
states: ``Energy market participants no longer have to choose 
between the safety of the cleared, standardized markets of the 
Exchange, and the exposure to counterparty default that has 
traditionally been the drawback to customized deals in the 
over-the-counter markets.'' \70\
---------------------------------------------------------------------------
    \70\ NYMEX ClearPortsm Clearing Overview, About NYMEX at 
ClearPortsm Clearing http://209.67.30.245/jsp/markets/otc--
overvi.jsp.
---------------------------------------------------------------------------
    The OTC markets and the regulated exchanges now offer 
identical instruments for trading. The NYMEX, for example, now 
offers futures contracts for OTC trading. Specifically, as 
shown in Exhibit III-1, one can trade instruments NYMEX calls 
``Light Louisiana Sweet Crude Oil Futures'' and ``West Texas 
Sour Crude Oil Futures'' on the NYMEX OTC trading platform.\71\ 
These futures contracts traded electronically on the NYMEX OTC 
platform are identical in form and function to the futures 
contracts traded on the NYMEX pit. On the ICE, the instruments 
that are traded are so similar to futures contracts they are 
called ``futures look-alikes.'' Crude oil traders interviewed 
by the Subcommittee staff stated that, from their perspective, 
there was no functional difference between the types of crude 
oil derivatives they traded on the OTC electronic platforms and 
on the NYMEX or the IPE.
---------------------------------------------------------------------------
    \71\ See NYMEX website, at http://www.nymex.com/jsp/markets/lsco--
otc--llspe.jsp (LLS OTC futures); http://www.nymex.com/jsp/markets/
lsco--otc--wtsspe.jsp (West Texas Sour OTC futures). NYMEX also 
provides for OTC trading of WTI contracts with future delivery in 
Midland, Texas, and for trading of Mars Blend Crude Oil with delivery 
in the Gulf of Mexico. Although these contracts appear to be identical 
to futures contracts, they are not labeled as such on the NYMEX 
website.
---------------------------------------------------------------------------
    The OTC markets for crude oil were further intertwined with 
traditional futures markets for crude oil when, in 2001, ICE 
acquired the London IPE. Following the acquisition, ICE moved 
to integrate its OTC trading of Brent-related derivatives with 
the trading of Brent contracts on the London IPE. Recently, ICE 
began to offer a particular type of Brent contract, the ``BFO 
contract,'' for trading on ICE's platform.\72\ Previously, 
these Brent OTC instruments had been traded exclusively through 
OTC brokers. To further mesh the operations of ICE and the IPE, 
the London IPE plans to do away with open outcry trading of 
Brent futures and move towards an all-electronic trading 
system.
---------------------------------------------------------------------------
    \72\ The BFO contract is explained in the following subsection.
---------------------------------------------------------------------------

  6. Disparity in Market Disclosure and Oversight

    The U.S. futures markets, such as the NYMEX, are the most 
heavily regulated and transparent commodity markets in the 
world. Commodity trading on these markets is subject to a 
variety of reporting requirements and regulations designed to 
detect and deter fraud and manipulation. This regulation and 
transparency has bolstered the confidence of traders in the 
integrity of these markets and helped propel the United States 
into the leading marketplace for many of the commodities traded 
on these exchanges.
    Today, there are few, if any, differences between the 
commodity derivative instruments traded on the regulated 
futures markets and on OTC markets. Although many of the 
distinctions between the OTC and futures markets have 
disappeared in recent years, the trading of derivative 
instruments on OTC markets is subject to much less regulation 
than the trading of equivalent instruments on the regulated 
futures exchanges. For example, unlike the regulated exchanges, 
OTC trading facilities are not required to monitor trading to 
detect and deter fraud and manipulation. Commodity prices do 
not have to be disclosed to any oversight body. Although the 
new electronic trading facilities operated by NYMEX and ICE are 
improving the price transparency of the OTC market by making 
data on posted bids, offers, and completed trades available, 
other trading information routinely reported to the futures 
exchanges and the CFTC is not available. Large trader reports 
do not have to be provided on a routine basis to the CFTC, and, 
unlike trading on the NYMEX, there are no position limits or 
daily price limits.\73\
---------------------------------------------------------------------------
    \73\ See Appendix 2.
---------------------------------------------------------------------------
    A common justification for this disparity in treatment is 
that the large institutions using OTC markets are sophisticated 
traders with less need for governmental protection from 
misconduct. Largely for this reason, Congress determined it was 
not necessary to apply most of the regulatory safeguards of the 
CEA to OTC markets in which smaller investors and members of 
the public do not participate.
    With the convergence of the OTC and futures markets, 
however, this rationale is no longer convincing. Price 
manipulation in one market can harm other markets involving the 
same commodity, negatively affect related commodities, and 
ultimately harm a broad range of the American public. Federal 
regulation of the commodity markets is designed to protect not 
just small commodity traders, but also the purchasers of those 
commodities and the public at large. In the CEA, Congress 
clearly articulates the national interest in preventing market 
manipulation:

          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.\74\
---------------------------------------------------------------------------
    \74\ 7 U.S.C.A. Sec. 5 (West 1999).

    The history of commodity markets demonstrates it is 
unrealistic to rely on the self-interest of a few large traders 
to protect the integrity of an entire market.\75\ The self-
interest of a limited group of large traders is not synonymous 
with the public interest, and it is not the responsibility of 
individual traders to look out for public rather than private 
interests. Most recently, the Enron scandal, which led to 
exposure of misconduct by traders at several large energy 
companies active in OTC trading, provides new evidence of how 
the conduct of a few sophisticated traders can harm not only 
other market participants, but also the public at large by 
artificially increasing prices.\76\ Consumers paying 
artificially elevated prices suffer the same harm regardless of 
whether the commodity price was manipulated through trades 
executed on regulated exchanges, on OTC electronic trading 
platforms, or through false information about prices and trades 
conveyed to price reporting services.
---------------------------------------------------------------------------
    \75\ See discussion of commodity market regulation in the 
Appendices to this Report.
    \76\ See, e.g., August 2002 report prepared by the Federal Energy 
Regulatory Commission (FERC) staff, Docket No. PA02-2-000, 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 utilizing ``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. See also, 
e.g., ``FERC Asks Gas Marketers for Data Given to Indexes,'' Wall 
Street Journal, October 29, 2002 (``A handful of companies have already 
disclosed in recent weeks that their traders provided inaccurate 
information to publishers of natural-gas indexes.--If traders provided 
false information--such as pricing and volumes--the possibility exists 
that they may have manipulated large swaths of the country's gas 
markets.''); Plea Agreement filed by former Enron trader Timothy 
Belden, United States v. Belden (USDC NDCA, Case No. CR 02-0313 MJJ), 
October 17, 2002, admitting to conspiracy to commit fraud ``to obtain 
increased revenue for Enron from wholesale electricity customers and 
other market participants in the State of California'' and to 
``manipulat[ing] prices'' in certain energy markets. Although these 
instances of fraud and manipulation did not occur through the use of 
many-to-many electronic trading facilities, they nonetheless illustrate 
the impact that misconduct by OTC market participants can have on the 
general public.
---------------------------------------------------------------------------
    The record also demonstrates that a legal prohibition 
against commodity market manipulation, without routine market 
disclosure and oversight, does not effectively deter or prevent 
manipulation.\77\ Routine market disclosure and oversight are 
essential to halt manipulation before economic damage is 
inflicted upon the market and the public. As one former CFTC 
Chairman stated: ``The job of preventing price distortion is 
performed today by regulatory and self-regulatory rules 
operating before the fact and by threats of private lawsuits 
and disciplinary proceedings after the fact. Both elements are 
essential.'' \78\
---------------------------------------------------------------------------
    \77\ See extensive analysis in Appendix 1.
    \78\ In re Indiana Farm Bureau Cooperative, 1982 CFTC LEXIS 25, 72 
(Stone, dissenting), Comm. Fut. L. Rep. (CCH) para. 21,796 ['82-'84 
Transfer Binder] (CFTC Dec. 17, 1982).
---------------------------------------------------------------------------
    The manipulation of the copper markets in the 1990's by 
Sumitomo Corporation demonstrated that, given a choice, some 
traders will operate on less-regulated, less-transparent 
markets in order to avoid the routine disclosure and oversight 
that takes place on the U.S. futures exchanges.\79\ Sumitomo 
traders admitted using less-regulated overseas and OTC markets 
to avoid detection by U.S. regulatory authorities. Hence, a 
disparity in the degree of oversight of different markets that 
provide traders with functionally equivalent instruments for 
trading undermines the oversight mechanisms of the more 
regulated market.
---------------------------------------------------------------------------
    \79\ See Appendix 1 for a discussion of the Sumitomo case.
---------------------------------------------------------------------------
    The Subcommittee Minority staff's findings indicate that 
the current disparity in market disclosure and oversight 
afforded OTC crude oil markets compared to the regulated 
exchanges is not justified. OTC markets today function as major 
trading centers for crude oil derivatives. OTC markets 
regularly affect crude oil prices on the regulated exchanges, 
and vice versa, since many of the same traders use both the OTC 
and futures markets for risk-spreading and price discovery, and 
trade virtually identical instruments in both markets. The 
price of many OTC derivatives are linked directly to futures 
prices on the regulated exchanges.
    The unavailability of OTC trading data was a major obstacle 
to the Subcommittee Minority staff's investigation of 
allegations of manipulation of crude oil markets in 2002. The 
absence of data regarding OTC prices and trades made it 
impossible to determine the extent to which traders may have 
sought to exploit or exacerbate squeezes through activity on 
OTC markets. The absence of OTC information made it impossible, 
in practice, to get a complete picture of crude oil market 
behavior to determine whether manipulation took place.
    Since many of the instruments traded on the regulated 
exchanges and OTC markets are virtually identical, traders 
often operate in both settings, and both markets handle 
billions of dollars in commodity transactions daily, it makes 
little sense to apply the full panoply of reporting 
requirements and market oversight to one market but none to the 
other. The absence of small traders in the OTC markets does not 
make the market less susceptible to price manipulation. Indeed, 
a market with fewer, larger participants may be even more 
susceptible to price manipulation. Moreover, due to the 
increasing interaction between the OTC and futures markets, 
price manipulation in one market necessarily affects prices in 
the other market.
    The following discussion of the Brent crude oil market 
illustrates these points. It explains the interconnections 
among the spot, futures, and OTC markets for Brent, and how the 
price of Brent in one type of crude oil market can affect the 
price of Brent in another. It also describes the relationship 
between the prices of Brent and WTI, which normally rise and 
fall together in response to global factors affecting crude oil 
supply and demand. Using the example of the 2000 Arcadia 
squeeze, the analysis shows how a market squeeze in Brent can 
disrupt the normal relationship between Brent and WTI, and 
increase the price of Brent relative to WTI. This explanation 
of the Brent market provides a broader context for 
understanding the following Section of this Report, Section IV, 
which shows how depositing large amounts of Brent into the SPR 
not only spiked the price of Brent in world markets, but led to 
a cascading set of price spikes in other crude oil and 
petroleum products in the United States.

B. Crude Oil Price Benchmarks

    This part of Section III provides more information about 
the three types of crude oil, Brent, WTI, and Dubai, that 
function as price benchmarks for crude oils traded around the 
world. Additional information is provided about the Brent 
market for the light it sheds on how crude oil spot, futures, 
and OTC markets interact, how Brent and WTI markets relate to 
each other, and how a market manipulation spikes crude oil 
prices and can shift the price curve for near-term and long-
term crude oil contracts.

  1. Brent Crude Oil

          ``A major feature of the Brent market is that it 
        works extremely well as long as one does not think 
        about it too hard.''
            --LPaul Horsnell, Oxford Institute for Energy 
        Studies Monthly Comment, May 2000

    Brent is a light, sweet crude oil produced in the North Sea 
within the territorial waters of the United Kingdom.\80\ 
Because Brent is slightly heavier and has slightly more sulfur 
than WTI, which is also a light, sweet crude oil, it normally 
costs less than WTI.
---------------------------------------------------------------------------
    \80\ Brent crude oil is a mixture of the oil produced in 19 
separate oil fields in the North Sea. The oil is collected through two 
distinct pipeline systems (the Brent and Ninian systems) to a loading 
terminal at Sullom Voe in the Shetland Islands. Paul Horsnell and 
Robert Mabro, Oil Markets and Prices 11 (Oxford University Press, 
2000). The Sullom Voe terminal is operated by the Royal Dutch/Shell 
Petroleum oil company.
---------------------------------------------------------------------------
    More crude oil is priced in relation to Brent than to any 
other type of crude oil. Brent serves as the benchmark for 
approximately 40-50 million barrels of crude oil produced 
daily. Most of the crude oil priced off Brent is purchased in 
Europe. About one-fifth of the 10 million barrels of crude oil 
imported daily into the United States are priced off Brent. As 
Figure III-3 shows, the Brent-based imports come from west 
Africa and northwest Europe.

[GRAPHIC] [TIFF OMITTED] T5551.150

    The U.K. oil fields, including the Brent fields, are among 
the most mature of the oil fields in the North Sea, and the 
production of Brent is in decline. In the early 1990's, the 
Brent fields produced approximately 700,000 barrels per day, 
which is the equivalent of about 60 cargoes per month. By 2002, 
production had fallen to around 350,000 barrels per day, or 
about 20-25 cargoes per month. Production is expected to 
decline by approximately 15 percent per year for the next 
several years. (Figure III-4).

[GRAPHIC] [TIFF OMITTED] T5551.017

    As is explained in more detail in Section III.C., the drop 
in the number of Brent cargoes leaving the Sullom Voe terminal 
to less than 1 per day made the Brent market much more prone to 
distortions and squeezes. To alleviate this problem, in July 
2002, Platts added two other grades of North Sea crude oil, 
Forties and Oseberg, to the pool of oil from which it computes 
the price of ``Brent.'' \81\ In September, the London IPE 
approved the inclusion of Forties and Oseberg within the Brent 
benchmark. The new benchmark is still often referred to as 
Brent, but also is called ``BFO.'' The inclusion of the Forties 
and Oseberg grades within the Brent benchmark has increased the 
number of cargoes to about 60 cargoes per month and reduced the 
vulnerability of the Brent benchmark price to manipulation.
---------------------------------------------------------------------------
    \81\ See footnote 55 for a description of how the price of Brent is 
calculated.
---------------------------------------------------------------------------
    The market for Brent is actually a complicated 
interrelation of four sub-markets: (1) an OTC market for ``15-
day Brent'' which, in 2002, changed to an OTC market for ``21-
day Brent''; \82\ (2) the spot market for ``dated Brent''; (3) 
the Brent futures market; and (4) an OTC market for Brent-based 
derivatives.\83\ Table III-1 summarizes the purpose and 
function of the four Brent sub-markets. Oil companies and 
traders use the 21-day Brent market to purchase standardized 
contracts for the delivery of 600,000 barrel Brent cargoes up 
to 21 days prior to the loading of those cargoes at the North 
Sea terminal. The dated Brent market is the spot market used to 
buy or sell Brent cargoes once they are about to be or after 
they already have been loaded on ship. The futures market and 
OTC swaps are used for hedging and speculation, but rarely to 
obtain actual delivery of oil.
---------------------------------------------------------------------------
    \82\ The 21-day BFO contract replaced the 15-day Brent contract 
when the Forties and Oseberg grades were added to the benchmark. The 
additional 6 days were provide to allow buyers more time to make 
arrangements for delivery if Forties or Oseberg were delivered rather 
than Brent.
    \83\ See Crude Oil Handbook, supra, at B9-B17.

    [GRAPHIC] [TIFF OMITTED] T5551.005
    
    Only part of one of these Brent markets--the futures 
market--is regulated in the United States. Although Brent 
contracts traded on the NYMEX are fully regulated under the 
CEA, the vast majority of Brent futures trading takes place on 
the London IPE, which is regulated by the U.K. Financial 
Services Authority.\84\ The Brent OTC markets, including the 
swaps and 15/21-day Brent contracts, have been exempted from 
most regulations by the CFTC and the Congress. The result is 
that the bulk of the Brent market is not regulated under U.S. 
law.
---------------------------------------------------------------------------
    \84\ See Section III.A.
---------------------------------------------------------------------------
    The complexity of the Brent market has evolved largely for 
historical reasons, as each type of contract or financial 
instrument was designed to fill a market need at a particular 
time. As one commenter has written: ``Physics may say that the 
bumblebee can not fly, but the bumble bee does not think about 
it. Financial theory would not produce a design like Brent, but 
Brent traders should also not think about it. The market has in 
general evolved more through chance than design.'' \85\ The 
following subsections provide additional detail about the Brent 
market.
---------------------------------------------------------------------------
    \85\ Paul Horsnell, Oil Pricing Systems, Oxford Institute for 
Energy Studies, Monthly Comment, May 2000 (a version of this article 
originally appeared in Pipeline, the magazine of the IPE). A thorough 
explanation of the Brent market is found in Horsnell and Mabro, Oil 
Markets and Prices, supra.
---------------------------------------------------------------------------

    a. 15- and 21-Day Brent

    The 15-day Brent market evolved to address the need of 
producers, traders, and purchasers of Brent crude oil to be 
able to trade in a contract that could accommodate the 
peculiarities of the Brent production schedule. The major 
owners of the crude oil in the Brent fields--Shell, BP, Exxon, 
and Philips/Conoco, which are called the ``equity producers''--
all use the terminal at Sullom Voe, in the Shetland Islands, 
off the coast of Scotland, to load the Brent crude oil onto 
crude oil tankers, some of which can hold up to 2 million 
barrels of oil. One company, Royal Dutch/Shell, the operator of 
the Sullom Voe terminal, controls the monthly production and 
delivery schedule. Shell requires each company that desires to 
load one or more cargoes at the terminal in any given month 
nominate the cargoes for loading by the 5th day of the 
preceding month. Shell finalizes the entire monthly loading 
schedule by the 15th day of the preceding month.
    Until Shell finalizes the loading schedule on the 15th of 
each month, the producers of Brent crude oil do not know when 
their crude oil will be available for delivery or sale on the 
spot market. Initially there can be as much as 30 days 
variability as to when a particular cargo will actually be 
delivered. Accordingly, contracts for 15-day Brent specified 
the month, anywhere from 1 to 4 months in the future, but not 
the particular date, in which the cargo of Brent will be 
loaded. Under the 15-day contract, the seller of a cargo to be 
delivered in a future month was required to provide at least 15 
days advance notice to the purchaser of when the cargo will be 
loaded at the Sullom Voe terminal. Now, under the 21-day 
contract, the seller is required to provide at least 21 days 
advance notice.
    Even though a producer may know anywhere up to 6 weeks in 
advance of when a particular cargo will be loaded, the 
purchaser of that cargo may not learn of the loading date until 
21 days in advance. Depending upon the market conditions at the 
time the notice is provided and the purchaser's commercial 
objectives, the purchaser may or may not want actual possession 
of the cargo. If the original purchaser has sold another 21-day 
contract to a second buyer, the first purchaser can require the 
second buyer to take the cargo if at least 21-days notice is 
given to the second buyer. The second buyer, in turn, may have 
sold a 21-day contract to a third buyer, and so on. In this 
manner, 21-day Brent can move through a ``daisy-chain'' of 
buyers and sellers until a purchaser desires physical 
possession of the oil or the 21-day notice period expires and 
timely notice cannot be provided to any more buyers.\86\
---------------------------------------------------------------------------
    \86\ Under the 15-day contract, the 15-day notice period expired at 
5 p.m., Greenwich Mean Time, 15 days before the 3-day loading period or 
``window.'' A holder of a contract who received notice at the last 
possible moment before the expiration of the notice period and was 
unable to require another purchaser to take delivery was said to have 
been ``five o'clocked'' or just plain ``clocked.''
---------------------------------------------------------------------------
    Purchasers of 21-day Brent can also opt out of the contract 
by identifying other contract holders with opposite positions 
and settling out their obligations with each other, along with 
any necessary adjustments for differences in transaction prices 
(called ``offset'' or ``bookout''). As with a typical futures 
contract, there may be many more 21-day contracts for the 
loadings of Brent in any particular month than there are actual 
cargoes of Brent in that month.
    The market for 15- and 21-day Brent always has been limited 
to major oil companies and traders. The large size of each 
contract--each 15-day contract represented a cargo of 500,000 
barrels, and each 21-day contract represents a cargo of 600,000 
barrels--the complicated mechanics of the daisy chain, and the 
informal nature of the market are major impediments to small 
traders. In the 1980's, about 100 companies traded in this 
market. As the formal futures markets became more established 
(the 15-day market existed prior to the futures market for 
Brent), and trading in over-the-counter derivatives increased, 
the market for 15-day Brent contracted. By the late 1990's, 
only about 30 traders remained. By 1998, the 10 most active 
traders accounted for over 80 percent of the deals with 
identified buyers and sellers.\87\
---------------------------------------------------------------------------
    \87\ Crude Oil Handbook, at B12. The 15-day market also developed 
to enable Brent producers to ``tax spin'' to reduce their tax liability 
to the British government. Under the British tax code in effect at the 
time this market developed, the tax paid by producers of North Sea 
crude oil was based on the market price of the crude oil, which was 
calculated on the basis of the prior transactions for that type of oil. 
Under tax spinning, ``an oil company would sell a contract to deliver 
oil into the market. This contract would pass through many hands and 
frequently end up back with the original company, completing what the 
market called a daisy chain. Positions would be cancelled out, losses 
and gains paid up, and the oil company was able to pay taxes based on 
the lowest price paid for an individual cargo while it shipped the oil 
off to its refinery.'' Steven Butler, Nervous Trading in a Market Held 
in Limbo, Financial Times (London), May 3, 1990; see also Transnor v. 
BP, 738 F.Supp. 1472 (S.D.N.Y. 1990).
---------------------------------------------------------------------------
    Traditionally, 15-day Brent contracts have been bought and 
sold through OTC brokers. In September 2002, ICE began to post 
bids and offers for 21-day BFO contracts on its electronic 
trading platform.
    As explained in Appendix 2, the nature and status of 15-day 
Brent contracts under U.S. commodities law was debated 
throughout the 1990's. The U.S. District Court for the Southern 
District of New York ignited this controversy in 1990 when, in 
the case Transnor v. BP, the court held that: the 15-day Brent 
market had a substantial effect on interstate commerce in the 
United States; the 15-day Brent market was subject to the 
jurisdiction of the U.S. courts and the CFTC; and 15-day Brent 
contracts were futures contracts within the meaning of the 
Commodities Exchange Act. The British government, Wall Street 
trading firms, and U.S. oil companies charged that the district 
court's decision was an unjustified extension of American 
jurisdiction into a British market, could undermine much of the 
Brent market, and cast doubt on the validity of a host of OTC 
contracts. In response, the CFTC issued a ``statutory 
interpretation'' that 15-day Brent contracts were not futures 
contracts subject to the CEA, but rather were forward contracts 
excluded from CEA regulation.
    In the Futures Trading Practices Act of 1992, Congress 
ratified the CFTC's authority to exempt 15-day Brent and other 
contracts that could be considered futures contracts from CEA 
requirements. In 1993, the CFTC issued implementing regulations 
exempting a host of energy derivatives traded between large 
institutions, including 15-day Brent contracts, from most of 
the CEA requirements. Under the Commodity Futures Modernization 
Act of 2000, a variety of energy derivatives, including 21-day 
Brent contracts bought and sold on the ICE, are exempted from 
many of the CEA's requirements. The end result is that the 21-
day Brent market is subject to very limited oversight by U.S. 
authorities.

    b. Brent Spot Market: ``Dated Brent''

    Brent crude oil bought and sold on the spot market is known 
as ``dated Brent.'' Once the notice period has expired under 
the 21-day Brent contracts, and the daisy chain has ended, the 
Brent oil that is to be loaded in the specified time period is 
traded on the spot market as dated Brent. Dated Brent is 
generally traded within 21 days of the loading date.
    The largest sellers of dated Brent are the Wall Street 
financial institutions and crude oil traders who have purchased 
Brent on the forward or futures market, and the largest buyers 
of dated Brent are the oil companies with refineries in 
Northwest Europe and in the northeastern United States.
    As dated Brent refers to crude oil that is to be loaded in 
the immediate future, it is the price of dated Brent that is 
used as the benchmark price for spot and contract transactions. 
The current price of dated Brent transactions is reported daily 
by reporting services such as Platts and Petroleum Argus.
    As a cash commodity market, the market for dated Brent has 
never been regulated, either in the United States or Britain. 
Although the CFTC may have the legal authority under a strict 
reading of the CEA to prevent fraud and manipulation in the 
spot or ``cash'' market for a commodity regulated under the 
CEA, the CFTC has never attempted to exercise authority over 
any spot market apart from its oversight of the corresponding 
futures market for that commodity. For all practical purposes, 
the dated Brent market is unregulated.

    c. Brent Futures Markets

    Although the NYMEX offers trading in a Brent futures 
contract, most Brent futures contracts are traded on London's 
IPE. Unlike the NYMEX WTI contract, which requires delivery of 
the physical commodity upon expiry, both the NYMEX and the IPE 
futures contracts for Brent are cash-settled. Upon expiry, the 
holders of outstanding contracts requiring delivery must pay 
the exchange the value of the Brent oil to be delivered, and 
the holders of the outstanding contracts requiring acceptance 
of delivery are paid the value of the crude oil to be 
delivered. No physical delivery of Brent oil is required.
    Because the 21-day Brent contract has many characteristics 
of a futures contract and the 21-day market performs many of 
the same functions as a futures market, the IPE Brent futures 
market is structured to converge to the 21-day market at 
expiry. The value of the Brent crude oil in the futures market 
on the date of expiry is therefore linked to the price of the 
next shipment of Brent crude oil in the 21-day market on that 
date.\88\ By providing a price discovery mechanism for traders 
in the 21-day market, the IPE Brent futures market makes the 
more limited 21-day market less susceptible to manipulation.
---------------------------------------------------------------------------
    \88\ This settlement price, termed the ``Brent index,'' is computed 
by taking the average of the following three elements: (1) the price of 
first month trades in the 21-day market; (2) the price of second-month 
trades in the 21-day market plus or minus a straight average of the 
spread trades between the first and second months; and (3) a straight 
average of all the price assessments published in media reports. These 
three elements are averaged to minimize the ability to manipulate the 
IPE price through the manipulation of the off-exchange prices used to 
calculate the Index. IPE, IPE Brent Crude Futures Contract, available 
at http://www.ipe.uk.com/include/downloads/contracts/bc--futures.pdf.
---------------------------------------------------------------------------
    The IPE Brent futures market attracts a much broader range 
of participants than the 21-day market, largely as a result of 
the smaller size of the standard contract--1,000 barrels for an 
IPE contract as opposed to 600,000 barrels for a 21-day 
contract. Approximately 75,000 contracts for Brent crude oil 
futures, representing about 75 million barrels, are traded 
daily on the IPE.\89\
---------------------------------------------------------------------------
    \89\ IPE, Introduction to the IPE, available on the IPE website, at 
http://www.ipe.uk.com/include/downloads/brochures/
introduction%20to%20the%20IPE(screen).pdf.
---------------------------------------------------------------------------

    d. Brent Over-the-Counter Markets

    The peculiarities of the Brent market have created a demand 
for several other types of financial instruments linked to the 
price of Brent crude oil. Because the price of Brent futures 
contracts on expiry are linked to prices on the 21-day market, 
the price of a cargo of Brent at expiry of a futures contract 
is fixed from 2 to 6 weeks in advance of the time when the oil 
underlying the contract is actually loaded for delivery. This 
time gap means there may be significant changes in the price of 
a barrel of Brent crude between the expiry of a future contract 
and when the barrel is loaded at the Sullom Voe terminal.
    Two types of instruments were developed as tools for 
hedgers and speculators to manage the risk of price changes in 
the price of oil in the 2 to 6 weeks between when a futures 
contract expires and the Brent is loaded. ``Contracts-for-
differences'' (CFDs) are contracts for the difference between 
the price of dated Brent and the price of Brent in the first 
forward month 15- or 21-day contract. By using a CFD, a buyer 
or seller can effectively lock-in the price of dated Brent in 
relation to the 21-day price, reducing exposure to changes in 
the price of the cargo of Brent from the time the 21-day 
contract expires and the time the cargo is loaded onto the 
ship.
    Because the price of dated Brent is the benchmark price, 
plus or minus a quality differential, for a variety of crude 
oils, a CFD is a useful tool, along with Brent futures 
contracts, for the purchasers and sellers of these other Brent-
linked crude oil streams to hedge against the risks of changes 
in the price of dated Brent. Brent futures contracts, by 
themselves, leave the purchasers or sellers of crude oil linked 
to dated Brent exposed to anywhere from 2 to 6 weeks of change 
in the price of dated Brent. CFDs provide a hedge against these 
changes in price. Hence, Brent CFDs have become a key risk-
management instrument in the crude oil trade.
    As with the formal futures markets for crude oil, the CFD 
market has grown rapidly since the early 1990's, and since the 
mid-1990's, trading volumes in CFDs have been larger than for 
both 15-day Brent and dated Brent. It is estimated that, by 
1998, over three-fourths of non-futures Brent transactions were 
in the form of CFDs, with the remainder in 15-day and dated 
Brent.\90\ Brent CFDs are purchased and sold through brokers, 
with daily quotes reported and published by Platts.
---------------------------------------------------------------------------
    \90\ Crude Oil Handbook, supra, at B16.
---------------------------------------------------------------------------
    In its description of CFDs, the Crude Oil Handbook reports 
on the strengths and weaknesses of the CFD market, including 
the incentives they may provide to manipulate underlying 
weaknesses in the dated Brent market:

          While CFDs would seem to be a perfect complement to 
        other Brent markets, these derivatives have come under 
        criticism since their inception as a vehicle for market 
        squeezes and as a source of price volatility. . . . The 
        main problem has been the large variation in price 
        between dated Brent and 15-day Brent. Ironically, the 
        possibility of hedging this exact risk with CFDs has 
        undoubtedly contributed to the growth of the market. 
        The emergence of CFDs did coincide with a period of 
        greater volatility in the spread between the dated and 
        15-day prices. While the CFD market is meant to hedge 
        that risk, it also may have prompted increased efforts 
        to manipulate price quotes for dated Brent. It also 
        seems to have contributed to squeezes in the forward 
        market, because it provides a way for the initiator of 
        a squeeze to make a profit unwinding the long position 
        that has been created in the forward market by taking 
        offsetting positions in CFDs before the squeeze gets 
        going.\91\
---------------------------------------------------------------------------
    \91\ Id. at B17.

    Another popular way to hedge the risk of divergence between 
the price of dated Brent and the price of Brent futures on the 
IPE is through the ``dated to front-line (DFL) swap.'' This OTC 
instrument is similar to the CFD, but is the difference between 
the price of dated Brent and the price of the next month's 
Brent on the IPE. As with the CFD, DFL swap prices are tracked 
and published on a daily basis by oil industry trade 
publications. DFL swaps are bought and sold either through 
brokers or directly between the parties.
    Generally, the Brent OTC markets are either totally 
excluded or substantially exempted from regulation under the 
CEA. CFDs and DFLs that are traded between oil companies, Wall 
Street firms, and crude oil traders could be considered swap 
transactions, which under the CFMA are totally excluded from 
regulation under the CEA. To the extent that OTC instruments, 
such as 21-day Brent contracts, are traded on an electronic 
exchange such as the ICE, such trades are exempt from all 
regulation other than some of the bare-bones anti-fraud and 
anti-manipulation provisions.
    Each of the different spot, forward, futures, and over-the-
counter markets for Brent crude oil has evolved to address the 
peculiar manner in which Brent crude oil is brought to the 
market and the risks of price changes during the process. 
Because of the importance of dated Brent as a benchmark for the 
price of so much crude oil worldwide, the highly liquid IPE 
futures market and OTC markets for CFDs and DFL swaps have 
become popular mechanisms to spread risk and discover prices 
for crude oil traded globally. However, in contrast to the 
highly transparent Brent futures market to which they are 
linked, at present there is little transparency in the market 
for Brent OTC instruments.

  2. West Texas Intermediate (WTI)

          ``It's not ideal, but it's what we've got.''
            --A crude oil trader, commenting on the NYMEX WTI 
        contract, December 2002

    WTI is the benchmark for approximately 12 to 15 million 
barrels of crude oil produced or sold each day in the Western 
Hemisphere. Except for crude oil produced in Alaska, nearly all 
of the crude oil produced in the United States is priced off 
WTI. About 80 percent of the crude oil imported into the United 
States is priced off WTI.\92\
---------------------------------------------------------------------------
    \92\ See Figure III-3. Because WTI is the benchmark for most of the 
crude oil consumed in the United States, exporters of North Atlantic 
basin crudes priced off Brent often will quote the prices in relation 
to WTI to facilitate price comparisons for U.S. importers.
---------------------------------------------------------------------------
    Although more crude oil worldwide is priced off Brent than 
WTI, the standard NYMEX WTI contract is the most widely traded 
commodity futures contract in the world. Approximately 150,000 
contracts for WTI are traded daily on the NYMEX, representing a 
volume of crude oil equal to nearly twice the world's daily 
production.
    WTI is actually a blend of crude oils produced in oil 
fields in Texas, New Mexico, Oklahoma, and Kansas. These crude 
oils all have relatively low sulfur levels and are relatively 
low in density. Like Brent, the production of WTI is dwindling. 
Ten years ago, around 750,000 barrels of WTI were produced 
daily; presently, around 400,000 barrels of WTI are produced 
daily. Future production is expected to decline.\93\
---------------------------------------------------------------------------
    \93\ Subcommittee interviews, 2002.
---------------------------------------------------------------------------
    As a result of the historical development of Cushing, 
Oklahoma, as a transportation and storage hub for crude oil 
produced in the region, the standard NYMEX futures contract for 
light sweet crude oil provides for the delivery of WTI or 
several comparable alternative grades at that location. 
Presently, there are about 20 million gallons of storage 
capacity at Cushing and an extensive network of crude oil 
pipelines leading into and out of these facilities. However, 
Cushing is landlocked, far from the ports handling oil imports 
and exports, and no longer the central distribution point it 
once was for crude oil produced in the United States.
    Numerous industry participants are concerned about the 
potential for distortion--either intentional or unintentional--
of WTI pricing due to the limited volume of WTI produced each 
month, the relative isolation of Cushing from global trade, and 
limits on Cushing's pipeline and storage capacity. Like Brent, 
the production of WTI is half of what it once was. Like Brent, 
the constrained logistics of WTI production, transport, and 
storage can make the availability of WTI subject to artificial 
bottlenecks or surges in supply.
    One of the most frequently raised issues regarding the WTI 
benchmark is that 80 percent of the tank storage capacity at 
Cushing, Oklahoma is controlled by two companies, BP and Shell. 
Figure III-5 shows one industry estimate of the division of 
ownership of the crude oil storage tanks at Cushing. Because 
crude oil inventories in the Midwest strongly affect WTI 
prices, the concern is that the actions of these two firms 
regarding their storage tanks at Cushing may have a 
disproportionate impact on Midwestern supplies and inventories 
and hence on the price of WTI.

[GRAPHIC] [TIFF OMITTED] T5551.151

    Many oil companies and traders do not consider the WTI 
price at Cushing, Oklahoma, to accurately reflect global supply 
and demand, and therefore do not rely solely on the price of 
WTI as a reference price to determine whether to import crude 
oil from Europe or west Africa. These companies and traders 
also use the price of Light Louisiana Sweet (LLS) crude oil, 
which is delivered on the Gulf Coast, to gauge whether it is 
profitable to import crudes from across the Atlantic (with 
attendant transportation costs) or instead purchase domestic 
crudes.\94\
---------------------------------------------------------------------------
    \94\ The addition of several new futures contracts for trading on 
the NYMEX OTC trading platform, including a LLS futures contract, 
indicates there may be sufficient market demand for futures contracts 
that can more precisely hedge crude oil costs than can be done with 
just a NYMEX WTI contract. As the Brent market shows, however, a 
proliferation of OTC instruments that complement an exchange-traded 
futures contract can obscure the price discovery function of the basic 
futures contract, expose the underlying exchange-traded contract to 
price distortions created in the OTC market, and introduce additional 
barriers to market transparency since OTC prices are not required to be 
published and may not always be widely available.
---------------------------------------------------------------------------

  3. Dubai

    Generally, crude oil purchased in Asia, most of which 
originates in the Middle East, is priced off the Dubai 
benchmark. This benchmark price is calculated from the price of 
crude oils produced in both Dubai and Oman. Approximately 10-15 
million barrels per day of crude oil are priced off the Dubai 
benchmark. Only a small fraction of U.S. crude oil imports are 
linked to the price of Dubai oil.
    Initially, the Dubai benchmark price was calculated solely 
on the basis of the price of crude oil produced in Dubai. 
However, as production declined from around 350,000 barrels per 
day 10 years ago to around 200,000 barrels per day in recent 
years, the Dubai market became volatile and susceptible to 
manipulation. In 2001, Platts added Omani crude oil to the 
benchmark formula, which effectively doubled the amount of 
crude oil underlying the calculation. The inclusion of Omani 
crude oil in the benchmark calculation immediately reduced the 
volatility of the price of Dubai.
    Just as crude oil purchasers located in the United States 
use the difference between the price of Brent and the price of 
WTI as a major factor in determining whether to import crudes 
from Europe and west Africa, purchasers in Asia use the 
difference between the price of Brent and the price of Dubai as 
a major factor in determining whether to export European and 
west African crudes to Asia. Hence, the price of Brent is a 
critical component of the entire global crude oil trade, and 
the relative price of the three benchmarks is a major factor 
determining the global flow of crude oil.

C. The Vulnerability of the Brent Market to Squeezes

          ``If you have to ask who the chump is, you're it.''
            --Alleged Remark of a Crude Oil Trader following 
        Brent Squeezes in 2002

    As production of Brent crude oil has dwindled, the number 
of Brent cargoes leaving the Sullom Voe terminal declined from 
about 60 cargoes per month a decade ago to only about 20 
cargoes per month, or less than 1 per day, by the first half of 
2002. This drop in the number of cargoes made the Brent market, 
prior to the addition of the Forties and Oseberg grades to the 
Brent pricing mechanism in mid-2002, prone to squeezes by 
making it possible for a single company to purchase most of the 
Brent production in a given month. As Horsnell and Mabro 
observed in their textbook on the Brent market, ``it is much 
easier and more tempting to squeeze a twenty cargo loading 
programme in a month than a sixty cargo programme.'' \95\
---------------------------------------------------------------------------
    \95\ Paul Horsnell and Robert Mabro, Oil Markets and Prices 138 
(Oxford University Press, 2000).
---------------------------------------------------------------------------
    One large-scale squeeze of the Brent market occurred in the 
summer of 2000, in an episode that is commonly referred to as 
the ``Arcadia squeeze.'' This squeeze disrupted the Brent 
market and led to spikes in the prices of crude oil priced off 
Brent, reportedly costing U.S. refiners tens of millions of 
dollars. The magnitude of the Arcadia squeeze surprised market 
observers and alerted the market to possible means and 
consequences of manipulating the price of Brent.
    Arcadia, a wholly owned subsidiary of the Japanese Mitsui 
Corporation, is a crude oil trading company, doing business 
principally in London and Geneva, and is active in the global 
and Brent crude oil markets. In September 2000, the Tosco 
Corporation, a refining company that has since been merged into 
what is now Philips-Conoco, sued Arcadia for $30 million in 
damages due to the higher costs for crude oil resulting from 
Arcadia's alleged manipulation of the Brent market.\96\ 
According to Tosco, Arcadia and other crude oil traders 
``pursued a complex scheme to monopolize the September Brent 
Crude sub-market, thereby manipulating the entire September 
[2000] Brent Indexed market.'' \97\ Tosco further alleged, 
``Arcadia knew at all times relevant that, by manipulating the 
Platts price for Brent crude, it would in turn manipulate 
prices for crude oil being purchased for delivery to the 
eastern United States.''
---------------------------------------------------------------------------
    \96\ Tosco Corp v. Arcadia Petroleum Ltd., (D.C. S.D.N.Y.) 
Complaint, Sept. 7, 2000.
    \97\ Tosco's complaint described the use and purpose of 15-day 
Brent contracts in a manner akin to futures contracts:
        ``15-day Brent'' transactions are paper transactions involving 
the sale or purchase of cargoes for delivery on an unspecified day of a 
given future month. The cargo becomes deliverable when the seller gives 
15 days notice to the buyer. Notice often travels down a chain of 
subsequent traders until one chooses to accept physical delivery of the 
cargo. Because 15-day Brent transactions do not initially require 
physical delivery, they are frequently traded for hedging and 
speculation purposes.
---------------------------------------------------------------------------
    Because Arcadia settled with Tosco several weeks after the 
lawsuit was filed in a confidential settlement, Tosco's 
complaint and contemporaneous press reports of the lawsuit are 
the main public sources of information about Arcadia's trading 
activities during this period.\98\ In addition, however, 
Arcadia's Brent trades left a trail of price spikes in the 
Brent spot, futures, and over-the-counter markets. These price 
spikes are consistent with the price spikes left by squeezes in 
other commodity markets.
---------------------------------------------------------------------------
    \98\ The Subcommittee staff requested an interview with Arcadia to 
provide it with an opportunity to clarify or supplement the record 
regarding Tosco's allegations of manipulation and antitrust violations. 
Arcadia declined to meet with the Subcommittee staff on any of the 
several dates proposed. Arcadia, which is organized outside the United 
States, is the only company trading crude oil that did not cooperate 
with Subcommittee requests for information in this investigation.
---------------------------------------------------------------------------
    In its complaint, Tosco outlined how Arcadia allegedly 
manipulated the limited Brent market:

          Arcadia effectuated its scheme by obtaining control 
        of the market for 15-day Brent contracts for September 
        2000 delivery. Arcadia did so by surreptitiously 
        purchasing more 15-day Brent contracts for September 
        delivery than it knew could be physically delivered in 
        September. Only a finite number of shipments of Brent 
        crude are available for delivery in any given month. In 
        conspiring to control the September Dated Brent market, 
        Arcadia and its coconspirators were undoubtedly aware 
        that, due to a market abnormality, only 22 deliveries 
        of Brent oil would be available in September, much 
        fewer than would be available in a typical month.

    Tosco asserted that Arcadia and its coconspirators used 
this ``monopoly power'' over the September deliveries of Brent 
oil to raise the price of Brent crude oil and all other crude 
oils indexed to the price of Brent ``higher than would result 
from the ordinary functioning of the market.'' According to 
Tosco, ``From August 21 to September 5, the price of Brent 
crude increased by $3.33 per barrel, including a 1-day leap of 
$2.38 per barrel between August 24 and 25.'' Moreover, said 
Tosco, ``In a conversation with a Tosco trader, an Arcadia 
trader stated that Arcadia controlled the September market for 
Brent crude, that Arcadia had raised the price of September 
Brent Crude by approximately $3.00 per barrel and that Arcadia 
could raise the September price further than it already had.'' 
``By causing September Brent Crude prices to spike,'' Tosco 
declared, ``Arcadia's squeeze on the market caused injury to 
every buyer in the September Brent Indexed market.''
    Arcadia has told the London IPE that all of its Brent 
trades during this period had valid commercial 
justifications.\99\ Similarly, Glencore International, one of 
Arcadia's alleged coconspirators, acknowledged that Arcadia 
bought large amounts of Brent crude in August and September 
2000, but asserted that these trades were undertaken for a 
valid commercial reason--to fulfill specific contracts for 
Brent crude oil. According to Glencore, ``the need to supply a 
crude contract to India'' was one of the reasons for the large 
purchases of September Brent.\100\
---------------------------------------------------------------------------
    \99\ Interview with IPE officials, November 2002.
    \100\ Ross McCracken, Esa Ramasamy, Beth Evans, Brent Row Escalates 
as Unipec Suspends Trading with Arcadia, Platt's Oilgram News, 
September 13, 2000.
---------------------------------------------------------------------------
    Although Arcadia and Glencore asserted there were valid 
commercial reasons for Arcadia's near-monopolization of the 
September 2000 Brent market, others were skeptical. According 
to Platt's, ``India's Ministry of Petroleum and Natural Gas 
asked its refiners at the end of August to reduce runs due to a 
drop in demand.'' \101\ ``Something is amiss,'' Philip Verleger 
wrote in late August 2000, ``On the one hand traders claim the 
oil is needed in India. On the other hand, India does not 
really need the oil.'' \102\
---------------------------------------------------------------------------
    \101\ Id.
    \102\ Id.
---------------------------------------------------------------------------
    The effects of Arcadia's purchase of large amounts of Brent 
cargoes in August and September 2000--whether a legal squeeze 
or an ``abusive'' one \103\--can be seen in a number of price 
charts. The data shows that the Arcadia squeeze raised, not 
only the spot price of Brent in August and September of 2000, 
but also the price of the futures contracts sold in August and 
September for the delivery of Brent crude oil in September and 
October. These price increases, in turn, raised the price of 
Brent OTC instruments whose value was linked to the spot and 
futures prices. The resulting price spikes are clearly 
observable in crude oil price data over this time period.
---------------------------------------------------------------------------
    \103\ Whether Arcadia and Glencore had a legitimate commercial need 
for the large amounts of Brent crude purchased in August and September 
2000 is critical to any determination, under U.S. law or U.K. law, on 
whether the Brent market was illegally manipulated. Under both U.S. and 
U.K. commodities law, manipulation will be found only if congestion in 
the market is not the natural result of supply and demand conditions in 
the market, but was intentionally created by a trader for the specific 
purpose of creating an artificial price. Accordingly, in this Report 
the use of the term ``squeeze'' does not connote illegal activity, 
unless there are additional elements present that amount to an 
``abusive squeeze'' or ``manipulation.'' See Appendix 1 for a more 
detailed discussion of the law of manipulation.
---------------------------------------------------------------------------
    Figure III-6 shows the increases in both the spot price of 
Brent and the price of the expiring Brent futures contracts 
resulting from the Arcadia squeeze of the Brent market in 
August and September 2000.
[GRAPHIC] [TIFF OMITTED] T5551.019


    A sharp increase in the price of the nearest futures 
contract as the current contract nears expiry is a classic sign 
of a squeeze.\104\ This spike in the price of the near-term 
contract occurs because towards the expiry of a futures 
contract the ``shorts''--those who must deliver the commodity 
to the ``longs'' when the next-month contract expires--must 
either purchase the physical commodity to make delivery or pay 
those expecting delivery--the ``longs''--to cancel out the 
obligation to deliver. In a squeeze, the supply of the physical 
commodity is in scarce supply, especially as compared to the 
outstanding contracts to deliver, so that the ``shorts'' have 
no alternative but to pay the ``longs'' for their expiring 
futures contracts to cancel their obligation to deliver the 
commodity.\105\ Because the shorts are legally obligated to 
either deliver the commodity--of which there is insufficient 
amount to supply all of the outstanding contracts--or purchase 
the contracts from the longs to cancel the obligation for 
delivery, the longs can ``squeeze'' the shorts for a high price 
for the purchase of the long contracts.
---------------------------------------------------------------------------
    \104\ Stephen Craig Pirrong, The Economics, Law, and Public Policy 
of Market Power Manipulation, 148 (Kluwer Academic Press 1996).
    \105\ ``He that sells what isn't hisn
          Must buy it back or go to prisn.''

      Attributed to Commodore Vanderbilt, in Edwin Lefevre, 
Reminiscences of a Stock Operator, 236 (Wiley, 1994).
---------------------------------------------------------------------------
    Because a squeeze creates a near-term shortage of the 
commodity, and not a fundamental change in the long-term supply 
or demand for the commodity, another tell-tale sign of a 
squeeze is an increase in the price of the commodity for near-
term delivery as compared to the price of the commodity for 
delivery farther out in the future.\106\ When a commodity price 
is higher for near-term delivery than for later delivery, the 
price curve of the commodity is said to be in 
``backwardation.'' When the commodity price for later delivery 
is higher than for delivery in the near future, the price curve 
for the commodity is said to be in ``contango.'' A sudden shift 
from contango to backwardation and a sharp increase in an 
already backwardated market are also classic signals of a 
squeeze.
---------------------------------------------------------------------------
    \106\ Pirrong, at 147; Jeffrey Williams, Manipulation on Trial, 83 
(Cambridge University Press, 1995); Horsnell and Mabro, at 132.
---------------------------------------------------------------------------
    As Figure III-7 illustrates, during the Arcadia squeeze the 
Brent futures market became sharply backwardated, with near-
term prices exceeding prices for later deliveries.

[GRAPHIC] [TIFF OMITTED] T5551.020


    In addition, price data shows that Brent prices rose 
sharply compared to WTI prices. This change in relative prices 
shows that the increased Brent price was not due to worldwide 
pressures on crude oil markets, but rather to events that 
affected only the Brent and not the WTI market. During a 
squeeze, the price of the squeezed commodity will increase in 
relation to the price of similar commodities that are not 
squeezed.\107\ Although the demand, and hence price, of 
related, substitutable commodities may also increase as the 
squeezed commodity becomes scarce and buyers seek alternative 
supplies, the primary effects of the squeeze are seen by 
comparing the price of the squeezed commodity to the price of 
similar but ``unsqueezed'' commodities.
---------------------------------------------------------------------------
    \107\ Pirrong, at 146; Williams, at 87.
---------------------------------------------------------------------------
    Figure III-8 shows that during the Arcadia squeeze the 
price of Brent crude oil rose sharply in comparison to the 
price of WTI. This is strong evidence that the price rise that 
occurred at the time was caused by a distortion in the market 
for Brent crude oil, rather than some other factor affecting 
the general global supply and demand for crude oil.

[GRAPHIC] [TIFF OMITTED] T5551.021


    The relationship between Brent and WTI is a major factor 
determining the volume and price of crude oil imported into the 
United States. Normally, Brent sells for about $1.50 per 
barrel, on average, less than WTI. Because it costs on average 
between $1.00 and $1.50 per barrel to transport a very large 
tanker of crude oil from the North Sea across the Atlantic 
Ocean to ports in the United States, Brent is generally price-
competitive with WTI only when it is priced at about $1.50 per 
barrel less than WTI. When the price of Brent plus the costs 
for shipping Brent to the United States is less than the price 
of WTI, the transatlantic ``arbitrage'' is said to be ``open,'' 
meaning that Brent and other crudes priced off Brent will be 
less expensive than WTI.\108\ Lower costs for importing Brent 
mean U.S. imports of these crude oils will be more attractive 
for U.S. refiners, who will then increase their purchases of 
Brent and other crudes priced off Brent. When the price of a 
barrel of Brent plus transportation costs is greater than the 
price of WTI, it is less economical to import Atlantic basin 
Brent-based crudes, and the transatlantic ``arbitrage'' is said 
to be ``closed.'' U.S. refiners then import less crude from the 
North Atlantic and rely more on their inventories and crude 
oils that are produced in North and South America and priced 
off WTI.
---------------------------------------------------------------------------
    \108\ Importers also consider the relationship between the price of 
WTI and the price of other domestic grades.
---------------------------------------------------------------------------
    An article by a crude oil trader for a major U.S. oil 
company posted on the NYMEX website describes the significance 
of the Brent-WTI price difference as follows:

          Several times during the year, the market provides 
        price incentives for the Atlantic Basin sweet 
        production to flow west. The Brent/WTI spread is the 
        ``roadmap'' the industry studies to determine if the 
        arbitrage is open or closed. The status of the 
        arbitrage is one of the driving factors determining the 
        structure of the forward WTI and refined product market 
        price curves in the United States and Europe. An open 
        export market for Brent implies tighter supplies for 
        the United States, and the reverse is true when the 
        barrels are priced to stay in Europe.\109\
---------------------------------------------------------------------------
    \109\ Kinnear, The Brent/WTI Arb: Linking the World's Key Marker 
Crudes (NYMEX website). This article further describes how the closing 
of the Brent/WTI arbitrage, which results in a reduction in the amount 
of Atlantic basin crude oil imported into the United States, can have a 
significant effect on U.S. crude oil prices:
      LDeliveries of Brent to the U.S. Gulf Coast and East Coast of 
Canada can reduce demand for domestic sweet barrels including WTI. When 
the trans-Atlantic sweet crude arbitrage to the United States is 
completely closed, there is typically a draw on sweet crude 
inventories; WTI volatility increases as does the probability of a 
market distortion.

    Figure III-9 shows, for a typical 12-month period during 
the 1990's, the relationship between the spot prices of Brent 
and WTI. During this period Brent and WTI spot prices closely 
tracked each other over a wide range of prices--from a low of 
$9 to a high of about $19 per barrel. On average, WTI was $1.86 
more expensive than Brent. At no time was Brent more expensive 
than WTI.\110\
---------------------------------------------------------------------------
    \110\ The standard deviation of the Brent-WTI price difference 
during this 12-month period was about 44 cents; hence about 68 percent 
of the time the price of Brent was between $1.42 and $2.32 less than 
WTI; and 95 percent of the time Brent was between 98 cents and $2.76 
less than WTI. The co-efficient of correlation between Brent and WTI 
prices during this period, ``R'', is 0.981, indicating a high 
correlation between the two markets (R=1 indicates a perfect 
correlation).

[GRAPHIC] [TIFF OMITTED] T5551.022

    As Figure III-8 shows, during the Arcadia squeeze the price 
of Brent rose to nearly $3.00 per barrel more than WTI. As 
Tosco's complaint states, such an increase in the price of 
Brent would make other Atlantic basin crude oils priced off 
Brent significantly more expensive for U.S. refiners. As the 
price of Brent rose to artificially high prices, U.S. refiners, 
such as Tosco, had to pay more for their imports that were 
indexed to the price of Brent.
    Figure III-10 shows the price difference between Brent and 
WTI from January 1992, through December 2000. The data shows 
that, on average over this 9-year period, Brent cost $1.46 less 
than WTI. The data also shows that, in 2000, the Arcadia 
squeeze raised the price of Brent compared to WTI to 
extraordinary levels when compared with the prior Brent-WTI 
relationship.

[GRAPHIC] [TIFF OMITTED] T5551.023


    Due to the peculiarities of the Brent market, a trader 
seeking to acquire a large number of Brent cargoes at some 
month in the future must acquire 21-day contracts to obtain the 
physical cargoes, as well as futures contracts and OTC 
instruments to hedge against the price increases that can be 
expected to follow from the increased market demand for Brent 
caused by the trader. As explained earlier, crude oil traders 
use Brent derivatives called contracts-for-differences (CFDs) 
and dated-to-frontline (DFL) swaps to hedge Brent price 
risks.\111\
---------------------------------------------------------------------------
    \111\ A CFD is the difference between the price of dated Brent 
(``spot price'') and the price of the 15- or 21-day contract needed to 
obtain a physical cargo of Brent. A DFL swap is the difference between 
the price of dated Brent and the price of the expiring IPE contract. 
See Section III.B.
---------------------------------------------------------------------------
    A squeeze in the Brent market will increase the price of 
CFDs and DFL swaps, since the values of these over-the-counter 
derivatives are linked to the spot and futures prices for 
Brent. As the price of the near-term futures contract increases 
in a squeeze, the price of the related OTC Brent derivatives 
will also increase. Figure III-11 shows that, during the 
Arcadia squeeze, the relative price of the Brent first month 
futures contract increased compared to the price of dated 
Brent, indicating a spike in the price of a DFL swap.

[GRAPHIC] [TIFF OMITTED] T5551.024


    In addition to sharp price increases, Figures III-6, 7, 8, 
10, and 11 also show classic price ``drop-offs'' after the 
squeeze is ended. A sudden drop in the spot price of a 
commodity or the price of a futures contract right after expiry 
of the contract is yet another indication of a short-term 
squeeze in the market for that commodity. Following the run-up 
at expiry in the price of the squeezed commodity and the 
expiring futures contract, the price of the commodity and the 
futures contracts rapidly fall to reflect the normal supply and 
demand in the market. Price spikes caused by factors other than 
squeezes do not normally cluster around the expiry of a futures 
contract.\112\
---------------------------------------------------------------------------
    \112\ Pirrong, at 147; Horsnell and Mabro, at 132.
---------------------------------------------------------------------------
    The magnitude of the Arcadia squeeze surprised market 
observers. ``In the 20 years that I've been following the oil 
market, this is probably the most extreme example of an 
artificial price being created that I've observed that has 
persisted for as long as this one persisted,'' said oil 
economist Philip Verleger at the time.\113\ Another petroleum 
economist, University of Houston Professor Michael Economides, 
stated at the time, ``The idea that one could corner, could 
encompass an entire benchmark market and, consequently, 
manipulate potentially other prices is absolutely fascinating 
and, in my view, astonishing. We certainly have not been 
confronted with a situation like this, to my knowledge, in the 
history of the petroleum industry.'' \114\
---------------------------------------------------------------------------
    \113\ National Public Radio, All Things Considered, October 3, 
2000.
    \114\ Id.
---------------------------------------------------------------------------
    Others, however, viewed Arcadia's squeeze and the use of 
derivatives to profit from the Brent squeeze as business-as-
usual in the petroleum markets. Commenting on Arcadia's effect 
on the market, the Oil Daily wrote, ``[T]he manipulation of 
dated Brent by trading houses, who skillfully engineer gains in 
derivatives markets, sometimes by sacrificing losses in 
physical markets, has evolved into a high art. And it is not 
only buyers of Brent that are affected. Buyers of Nigerian or 
other Brent price-linked crude grades exported to the US could 
argue that they too had been harmed by the manipulation of the 
Brent market.'' \115\
---------------------------------------------------------------------------
    \115\ Paul Merolli, Stephen MacSearraigh, Tosco Sues Arcadia for 
Brent Manipulation, Oil Daily, September 11, 2000.
---------------------------------------------------------------------------
    The price data during the period of the Arcadia squeeze 
demonstrates that a squeeze can spike prices not only in the 
crude oil spot and futures markets, but also in the OTC 
markets. The extent to which Arcadia profited from the squeeze 
caused by its activity in the Brent market is not known.
    Robert Mabro, Director of the Oxford Institute for Energy 
Studies, and one of the foremost authorities on the Brent 
market, contends the OTC Brent market facilitates squeezes, and 
enables traders to artificially create profits from the 
weaknesses in the market. According to an interview of Dr. 
Mabro reprinted by the Derivatives Study Center in 2000:

          ``A typical Brent squeeze involves a company quietly 
        building a strong position in short-term swaps called 
        contracts-for-differences, or CFD's, for a differential 
        not reflected in current prices. The company then buys 
        enough cargoes in the dated Brent market to drive the 
        physical crude price higher, which boosts the CFD 
        differential,'' Mabro said. ``The company may lose 
        money on the physical side, but it's more than 
        compensated from profits on its offsetting paper 
        position in the short-term swaps market,'' Mabro said. 
        ``The whole trick is to collect more money in CFD's 
        than you lose on the physical squeeze,'' Mabro said. 
        ``People seem to do it in turn. It depends on who's 
        smart enough to move in a way that nobody notices until 
        it happens.'' \116\
---------------------------------------------------------------------------
    \116\ Derivatives Study Center, Not Learning the Lessons of Long-
Term Capital's Failure, September 2000.

    In another article, Dr. Mabro concluded that the variety of 
financial instruments and the complexity of the Brent market 
magnifies the vulnerability of the Brent market to squeezes and 
---------------------------------------------------------------------------
price distortions:

          The array of instruments available to traders enable 
        a small number of powerful and sophisticated players to 
        operate squeezes or launch other operations which 
        causes prices to move in directions do not always 
        reflect the actual state of the supply/demand balance. 
        Whether these ``games'' whose frequency has been 
        increasing in recent years affect price trends over the 
        medium term is debatable. It is certain, however, that 
        they cause higher price volatility, and that they rob 
        prices from their most important function which is to 
        signal at every movement the state of the supply/demand 
        balance.\117\
---------------------------------------------------------------------------
    \117\ Robert Mabro, Oil Markets and Prices, OIES Monthly Comment, 
August 2000. Dr. Mabro's comments were written prior to the 
implementation of the BFO contract. In an interview with the 
Subcommittee staff in December 2002, Dr. Mabro stated that the new BFO 
contract could help prevent the particular types of squeezes in the 
Brent market to date, but that squeezes were ``endemic'' to all 
commodity markets. Dr. Mabro stated that the limited number of players 
in the crude oil markets, together with the lack of transparency in the 
OTC markets, continued to present risks to the efficiency and 
transparency of the market.

    Dr. Mabro and others point to profit-taking in OTC 
derivatives as a major source of gain for traders attempting to 
squeeze the crude oil markets. Price data tracing OTC price 
increases and documenting OTC trading gains is unavailable, 
however, due to the lack of price transparency and disclosure 
requirements in OTC markets.
    Dr. Mabro observes that large players in the crude oil 
markets have little incentive to improve the operation of the 
markets, and this situation harms U.S. interests and consumers:

          Traders like [the current situation] because they all 
        think that it provides them with opportunities to make 
        money. . . . Whether the system is good for the 
        exporting countries, the oil companies, the importing 
        countries, the US government and the final consumer is 
        very doubtful. Judging from recent experience it is 
        clear that nobody likes either very high or very low 
        oil prices. When they obtain, it is far too easy to 
        blame OPEC. The issue however is not OPEC on its own 
        but the system in its complex operation, in the links 
        between various markets, and the awkward relationship 
        between markets and OPEC. A fundamental reform is 
        required.\118\
---------------------------------------------------------------------------
    \118\ Id.
      IV. CASE STUDY: THE COSTS OF FILLING THE SPR IN SPRING 2002

          ``In the long run commodity prices are governed but 
        by one law--the economic law of demand and supply. The 
        business of the trader in commodities is simply to get 
        facts about the demand and the supply, present and 
        prospective.''
            --Edwin Lefevre, Reminiscences of a Stock 
        Operator, 1923

A. Introduction

    In February 2002, DOE reversed its policy of routinely 
granting requests to defer oil shipments to the SPR when crude 
oil prices were high and market supplies were tight.\119\ DOE 
made this policy change after receiving a request by an oil 
company in February to defer shipments due to be delivered to 
the SPR later in the spring. Senior DOE officials instructed 
the SPR Office to deny the oil company's request.
---------------------------------------------------------------------------
    \119\ See Section II of this Report.
---------------------------------------------------------------------------
    During DOE's consideration of this deferral request, SPR 
career officials warned senior DOE officials, including the 
Deputy Secretary of Energy, that filling the SPR when oil 
prices were high or oil supplies were tight could drive oil 
prices higher, reduce U.S. commercial inventories, and hurt 
U.S. consumers and taxpayers, and advocated returning to the 
prior market-based policy.\120\ Despite these warnings, DOE 
decided to keep the no-deferral policy in place for most of 
2002. DOE made this decision without conducting any cost-
benefit analysis of the new policy, without analyzing the 
relative costs of the new policy compared to the prior policy, 
and without preparing a detailed analysis of the new policy's 
potential impact on overall U.S. oil supplies.\121\ DOE has yet 
to track the actual costs associated with the new policy.
---------------------------------------------------------------------------
    \120\ See Section V of this Report.
    \121\ The Subcommittee asked DOE to produce all documents 
containing any cost-benefit analysis related to the new policy, and was 
informed by DOE that none exist. In fact, DOE was unable to produce a 
single document explaining or justifying the policy decision to stop 
granting requests to defer oil shipments to the SPR.
---------------------------------------------------------------------------
    This Section provides a case study illustrating how the new 
SPR policy became a major factor contributing to higher crude 
oil prices in the United States in the spring of 2002, which 
led to increases in the price of various petroleum products, 
such as heating oil, diesel fuel, and jet fuel. It focuses on 
the period from mid-November 2001, when DOE began to add 
substantial amounts of oil to the SPR, through mid-May 2002, 6 
months later. In particular, the case study traces how the 
large demands placed on the Brent market in late 2001 and early 
2002 due to purchases of Brent cargoes for shipment to China 
and the SPR increased Brent prices in early 2002. DOE's change 
in policy to not allow any deferrals of SPR shipments was a 
major factor contributing to the tightness of the Brent market 
in the spring of 2002, and helped boost the price of Brent and 
crude oils priced in relation to Brent.
    The case study details how these higher Brent prices 
translated into higher costs for imported crude oil, lower U.S. 
crude oil inventory levels, and a sudden, sharp increase in the 
futures and spot prices for WTI crude oil in April and May. The 
case study then shows how this spike in the price of WTI drove 
up the price of heating oil, jet fuel, and diesel fuel, and 
briefly explains how increases in the prices of these petroleum 
products hurt U.S. consumers and businesses. The case study 
also shows how the elevated crude oil prices decreased U.S. 
refining margins and increased economic pressures on U.S. 
refiners in the second quarter of 2002. The case study finds 
that, in just 1 month alone, the new SPR fill policy imposed 
additional crude oil costs on U.S. consumers and businesses of 
between $500 million and $1 billion. These 1-month costs were 
the most directly visible and quantifiable of the additional 
costs created by the SPR program during these months.
    DOE's actions to fill the SPR were not the only factor 
pushing up crude oil prices in the spring of 2002. Factors such 
as Saddam Hussein's 1-month suspension of Iraqi oil exports in 
April 2002, an 8-day oil strike in Venezuela, OPEC production 
cuts in the first quarter of 2001, and speculation and concern 
over impending war with Iraq also affected oil prices. 
Nonetheless, the evidence shows DOE's new policy to deposit oil 
into the SPR regardless of the price of oil was an additional 
major factor driving up U.S. oil prices and hurting U.S. 
consumers in the spring of 2002.

B. Analysis

  1. Large Amounts of Brent Crude Oil Were Put Into the SPR in Late 
                    2001 and Early 2002

    From November 2001, when DOE began its recent program to 
fill the SPR to 700 million barrels, through the second quarter 
of 2002, most of the oil deposited into the SPR was Brent crude 
oil. As can be seen in Figure IV-1, Brent crude oil accounted 
for about 25 of the 29 million barrels, or nearly 85 percent, 
of the sweet crude deposited into the SPR during this 
period.\122\ Although each company had the option of delivering 
a variety of light sweet crude oils to the SPR, each one 
deposited mostly Brent.
---------------------------------------------------------------------------
    \122\ See also Figure II-3.
---------------------------------------------------------------------------
    Crude oil traders interviewed by the Subcommittee stated 
that Brent was the most economical choice to place in the SPR 
for a number of reasons. These traders explained, first, that 
Brent is the most widely traded of the sweet crude oils that 
may be placed into the SPR, thus making it easiest to obtain. 
Secondly, some said that the variety of Brent instruments that 
are traded--21-day contracts, futures contracts, CFDs, and DFL 
swaps--makes it possible to hedge against changes in the price 
of Brent cargoes more precisely than for other types of crude 
oil. They stated that the use of other grades of crude oil 
presented basis risks (risks in the divergence between the 
price of the grade of crude oil and the price of dated Brent) 
that did not exist when Brent itself was used. Third, many of 
the companies depositing crude oil into the SPR during this 
period were major players in the Brent market, and their 
traders stated that acquiring physical Brent cargoes was, and 
is, a core part of their business. Fourth, according to some 
traders, it was physically easier to load large cargo ships at 
the Sullom Voe terminal than at other North Sea terminals. All 
of the traders interviewed by the Subcommittee staff denied 
their purchases of Brent were intended to increase oil prices 
by creating a shortage of Brent.
    As can be seen in Figure IV-1, however, beginning in July 
2002, much less Brent, relative to other sweet crudes, was 
placed into the SPR. It is not clear which additional factors 
made Brent so much more attractive for satisfying SPR 
obligations in the first half of 2002 than in the second half 
of the year. Section V.C. of this Report discusses whether oil 
companies and traders may have acquired large amounts of Brent 
crude oil in order to take advantage of the vulnerability of 
the Brent market to squeezes that existed through the first 
half of 2002.

[GRAPHIC] [TIFF OMITTED] T5551.025

    In addition to the demand for Brent created by the SPR 
program, in early 2002, two companies purchased large amounts 
of Brent for shipment to China. Sempra Energy Trading and 
Sinochem acquired all of the Brent cargoes loaded in February 
2002, and sent 20 of these cargoes to China. According to 
Sempra officials interviewed by the Subcommittee staff, a 
narrowing of the price differential between Brent and Dubai 
crude oils in late 2001 had made Brent relatively inexpensive 
compared to the sour Middle Eastern grades, which led Chinese 
refiners to purchase these large amounts of Brent. These 
shipments of Brent to China tightened market supplies just as 
DOE was announcing new contracts to fill the SPR. In the spring 
of 2002, with the Brent market unsettled by the large shipments 
to China, the market was further disturbed by reports that 
large amounts of Brent were being sent to the SPR.
    Figures IV-2 and IV-3 show the shippers and destinations 
for the Brent cargoes loaded from January through May 2002. 
Koch's Brent loadings in January, Shell's loadings in March and 
April, and BP's loadings in May went primarily to the SPR. 
Viewed together, Figures IV-1 through IV-3 demonstrate that an 
unusually large portion of the Brent crude oil produced from 
November 2001 through June 2002 was deposited in the Strategic 
Petroleum Reserve.

[GRAPHIC] [TIFF OMITTED] T5551.152


[GRAPHIC] [TIFF OMITTED] T5551.153

  2. The Use of Brent To Fill the SPR Increased the Price of Brent 
                    Relative to WTI

    The prices of the two major benchmarks, Brent and WTI, 
generally rise and fall together, reflecting changes in global 
supply and demand.\123\ Brent normally costs about $1.50 per 
barrel less than WTI.\124\ From November 2001 through May 2002, 
the price of Brent rose significantly relative to the price of 
WTI.
---------------------------------------------------------------------------
    \123\ See Figure III-9.
    \124\ See Section III.
---------------------------------------------------------------------------
    Figure IV-4 shows the price of Brent rose significantly 
relative to WTI at about the same time as Brent cargoes began 
to be sent to the SPR. From 1992 through September 2001, the 
average difference in price between WTI and Brent was $1.49; 
from November 2001 through May 2002, the average price 
difference was 75 cents. In other words, from November 2001 
through May 2002, the price of Brent rose 75 cents relative to 
the price of WTI, cutting in half the normal differential 
between the two benchmarks.

[GRAPHIC] [TIFF OMITTED] T5551.028


    Figure IV-4 also shows that on a number of dates in this 
period the price of Brent rose above the price of WTI. Several 
of these mini-spikes in the price of Brent appear to have been 
caused by announcements related to the SPR program: DOE's 
January 22, 2002 announcement opening the bidding for the RIK 
contract; DOE's February 11, 2002 announcement of the award the 
RIK contract for light sweet crude oil; and BP's announcement 
on April 18, 2002 that it was sending shipments of Brent to the 
SPR.

[GRAPHIC] [TIFF OMITTED] T5551.029


    Figure IV-5 places the relative Brent price increase in a 
historical context. As can be seen from Figure IV-5, for the 7 
months from November 2001 through May 2002, the price of Brent 
was higher in relation to WTI for a longer period than at any 
other time during the previous 10 years. For most of this 7-
month period, the price of Brent had risen between 60 cents and 
$1.20 in relation to WTI, which is between one and two standard 
deviations above the previous norm. For 2\1/2\ weeks in late 
January and early February 2002, the price of Brent rose to 
within 33 cents of WTI, which is a variation of more than two 
standard deviations from the norm. These are statistically 
significant price changes, and it is no mere coincidence that 
they took place at the same time as the demands placed on the 
Brent market from the SPR and China.
    Additional price data provides evidence that the large 
demands on the Brent market from China squeezed the Brent 
market in January, and the large demand for Brent for the SPR 
squeezed the Brent market from mid-March through early May. As 
Section III explains, in a squeeze the supply of the physical 
commodity is in scarce supply as compared to the outstanding 
contracts to deliver, so that the ``shorts'' must either bid up 
the price of the commodity to obtain it for delivery or pay a 
high premium to the ``longs'' to cancel their obligation to 
deliver the commodity.\125\ The fact that the Brent market was 
squeezed can be seen by examining the Brent-WTI relationship 
during this period, the price of near-term and longer-term 
Brent futures, and the price of Brent OTC DFL swaps. Viewed 
together, this evidence demonstrates the acquisition of large 
amounts of Brent in early 2002, due to shipments of Brent to 
China and the SPR, squeezed the Brent market, first in January, 
and then again from mid-March to early May, in the same manner 
as the Arcadia shipments of Brent to India had done in 2000.
---------------------------------------------------------------------------
    \125\ See also Appendix 1.
---------------------------------------------------------------------------
    One classic sign of a market squeeze is a sharp and sudden 
increase in the price of one commodity in relation to the price 
of similar commodities. Figures IV-4 and IV-5 demonstrate that 
the price of Brent increased significantly relative to the 
price of WTI shortly after Brent began to be used for SPR 
deposits, and this relative increase continued into May 2002.
    A second classic sign of a squeeze is a sudden increase in 
the near-term price of a commodity as compared to the price of 
the commodity farther in the future (backwardation), while the 
markets for other, similar commodities do not exhibit the same 
price behavior.\126\ Figure IV-6 shows the difference between 
the first and second-month contracts for IPE Brent and NYMEX 
WTI futures from July 2000 through August 2002. This chart 
shows the two instances in early 2002 in which the near-term 
prices for Brent increased sharply, particularly in relation to 
the prices for second-month contracts (backwardation), while 
the WTI market did not exhibit a similar pattern. The first 
instance was due to the large number of Brent cargoes purchased 
for shipment to China, and the second instance was due to BP's 
acquisition of a large number of Brent cargoes for shipment to 
the SPR.\127\ This contrast in the behavior of the Brent and 
WTI futures markets is evidence that squeezes in the Brent 
market occurred in January and from mid-March to early May 
2002.
---------------------------------------------------------------------------
    \126\ See Section III.C.
    \127\ Although Shell also bought large amounts of Brent in early 
2002, the Brent futures market did not show signs of a squeeze from 
these purchases, perhaps as a result of Shell's announcement on 
February 11, 2002, that it had ``potential demand for all the Brents 
[cargoes] in March.'' See The Oil Daily, Another Feared Brent Squeeze 
Sends Shock Across Energy, February 13, 2002. Although Shell's 
announcement helped spike the Brent spot price to a $1.00 premium over 
WTI on February 11, see Figure IV-4, the announcement also may have 
discouraged traders from selling futures contracts for delivering 
Brent, thereby avoiding a squeeze. See also Section IV.C.

[GRAPHIC] [TIFF OMITTED] T5551.030

    The increase in the price of various Brent derivatives in 
the OTC markets is additional evidence the Brent market was 
squeezed in January and from mid-March to early May.\128\ 
Figure IV-7 shows, for example, the difference between the 
price of the first month IPE Brent futures contract and the 
price of dated Brent. This price difference is equivalent to 
the price of a DFL swap, which is a Brent derivative traded on 
the OTC market. Figure IV-7 shows that in January and April the 
price of a Brent futures contract rose to nearly $1.50 more 
than the price of a dated Brent cargo, indicating the 
``shorts'' holding futures contracts requiring delivery of 
Brent were being forced to pay a premium to the ``longs.'' The 
monthly pricing patterns for DFL swaps from October 2001 
through May 2002, as seen in Figure IV-7, are similar to the 
pattern for DFL swaps during the Arcadia squeeze in August 
2000, as shown in Figure III-11. An increase in the price of a 
DFL swap, by itself, does not indicate a squeeze; however, a 
squeeze will result in an increase in the price of a DFL 
swap.\129\
---------------------------------------------------------------------------
    \128\ See Section III.B. for an explanation of these Brent 
derivatives.
    \129\ See Horsnell and Mabro, supra, at 130-132, for a discussion 
of the effect of a Brent squeeze on these derivatives.

[GRAPHIC] [TIFF OMITTED] T5551.031


    The price spikes in the futures and OTC contracts for Brent 
in January and throughout April 2002 cannot be explained by 
global oil supply and demand. The global economy was in a 
slump. The crude oil markets had yet to recover from the drop 
in demand following the September 11, 2001 terrorist attack on 
the United States. Indeed, the WTI futures market reflected 
these fundamentals--that current demand for crude oil was lower 
than anticipated future demand, and near-term prices were lower 
than prices further in the future (contango). The Brent market, 
however, was just the opposite (in backwardation), with higher 
near-term prices reflecting the immediate demands on Brent 
supplies from China and the SPR, rather than overall global 
supply and demand.
    In sum, the large number of shipments of Brent sent to the 
SPR and China, from November 2001 through May 2002, 
significantly increased the price of Brent relative to WTI, 
caused the near-term price for Brent to rise relative to the 
price of more distant Brent futures contracts (backwardation) 
for extended periods, and caused significant price increases in 
the OTC market. From mid-March through early May 2002, the 
demands placed on the Brent market by the SPR program squeezed 
the Brent market.\130\
---------------------------------------------------------------------------
    \130\ In interviews with the Subcommittee staff, officials from the 
London IPE and the U.K. FSA agreed with the characterization that the 
Brent market was squeezed in January and April 2002.
---------------------------------------------------------------------------

  3. Higher Brent Prices Increased the Price of Crude Oil Imported 
                    into the United States

    Increases in the price of Brent relative to WTI led to 
relative increases in the price of a variety of crude oils 
priced off Brent. Most of the crude oils priced off Brent are 
sold in term contracts that set the price of the oil at a fixed 
differential to the price of dated Brent. Generally, these 
differentials are fixed for the term of the contract, and are 
not renegotiated during the term of the contract. Squeezes and 
other disruptions in the Brent market that increase the price 
of dated Brent, therefore, generally increase the cost of crude 
oil priced off Brent under term contracts. Since term contracts 
are individually negotiated and not traded on any exchange, 
however, information on the terms of these contracts is 
unavailable, and the total impact of Brent price increases 
cannot be measured.\131\
---------------------------------------------------------------------------
    \131\ On April 24, 2002, the Petroleum Intelligence Weekly, in the 
article Beyond Hoarding, wrote, ``Buyers of less transparent or term 
contract barrels have been less able to protect themselves from the 
spiking benchmark.''
---------------------------------------------------------------------------
    Crude oil spot market data, however, provides evidence of 
how higher Brent prices increased the price of crude oils 
priced in relation to Brent. Although comprehensive and 
reliable spot price data is not available, the spot price of 
Nigerian Bonny Light, a major crude oil imported into the 
United States, is commonly reported by trade publications.
    Bonny Light is produced in Nigeria and is usually priced at 
a discount to Brent. The price of Bonny Light is generally 
reflective of the price of other Nigerian crudes. The United 
States imports large amounts of crude oil from Nigeria, which 
is the fifth largest exporter of crude oil to the United 
States, sending, on average in 2001, about 850,000 barrels 
daily to refiners in the United States.\132\ An increase in the 
cost of Nigerian imports, therefore, has significant effects 
for refiners and consumers in the United States.
---------------------------------------------------------------------------
    \132\ See Figure III-3.
---------------------------------------------------------------------------
    Data on spot market transactions shows the price of this 
Nigerian crude oil closely tracked the price of Brent during 
the period examined, from October 2001 through June 2002. 
Figure IV-8 shows how the price of Bonny Light moved in tandem 
with the price of Brent during this period.

[GRAPHIC] [TIFF OMITTED] T5551.032


    Figure IV-9 shows the difference between the price of dated 
Brent and the price of Bonny Light over the same time period. 
The data shows that the differential between the price of Bonny 
Light and the price of dated Brent varied by only a few cents 
per barrel from late 2001 through May 2002. This data 
demonstrates that as the price of dated Brent rose during this 
time period, the price of Bonny Light rose as well.\133\ Hence, 
as the price of Brent rose relative to WTI, the price of 
Nigerian crude oils rose too.
---------------------------------------------------------------------------
    \133\ Due to demand from Asia, Nigeria had little incentive to 
discount its crude oil for prospective purchasers in North America. The 
narrowing of the Brent/Dubai differential due to OPEC productions cuts 
in 2001 led Asian refiners to increase their purchases of Atlantic 
Basin sweet crudes, including Nigerian crudes. In light of the 
increased Asian demand for west African crudes, most west African 
exporters, such as Nigeria, did not provide discounts to refiners in 
the United States. According to one press report, ``Most West African 
crudes have managed to defend differentials to international benchmark 
dated Brent reasonably successfully in a tricky market.'' Energy 
Intelligence Briefing, Spring West African Barrels Pointed at US, Not 
Asia, April 23, 2002.
[GRAPHIC] [TIFF OMITTED] T5551.033

    In sum, the use of so much Brent to fill the SPR was a 
major factor increasing not only the price of Brent relative to 
WTI, but also the price of other sweet crude oils priced off 
Brent. Since both Brent and other crude oils priced off Brent, 
like Bonny Light, are regularly exported in large amounts to 
the United States, these increases significantly raised the 
costs of importing crude oil in the latter months of 2001 and 
the first part of 2002.

  4. Higher Costs for Imported Crude Oils Led to Fewer Imports

    The most immediate effect on the U.S. crude oil market of 
the Brent price increases just described was to increase the 
relative price of crude oil imports. From November 2001 to May 
2002, the price of Brent rose to within 50 cents of WTI on 48 
different days, and on 17 days was more expensive than WTI. As 
a rule of thumb, it is uneconomical to import Brent or other 
Atlantic basin sweet crudes when Brent is priced within about 
$1.50 of WTI. Although other factors mattered too, such as 
transatlantic shipping rates, grade differentials, and the 
price of other U.S. Gulf Coast crudes, like Louisiana Light 
Sweet (LLS), the unprecedented magnitude of the increases in 
the price of Brent relative to WTI beginning in late 2001 made 
Brent imports significantly more expensive when compared to 
domestic grades or to oil already purchased and stored in U.S. 
commercial inventories.
    A number of contemporaneous reports in oil industry trade 
publications explain how relatively higher prices for Brent 
affected U.S. crude oil imports. For example, several of these 
trade press reports state that on a number of occasions during 
this period the increases in the price of Brent relative to WTI 
``closed the arbitrage.'' On January 14, 2002, Weekly Petroleum 
Argus reported that Sempra's acquisition of a large number of 
Brent cargoes from BP ``pushed dated Brent to a premium over 
WTI, shutting off the arbitrage that allows crude cargoes to 
sail from Europe and west Africa to the US.'' \134\
---------------------------------------------------------------------------
    \134\ The transaction involved a swap of 60 cargoes, a volume of 
oil greater than the entire amount of Brent produced in February. 
Weekly Petroleum Argus, Brent Blip Squeezes Transatlantic Traffic, 
January 14, 2002.
---------------------------------------------------------------------------
    On February 4, Petroleum Argus reported that the January 
Brent squeeze, caused by Sempra's shipments of Brent cargoes to 
China, had distorted Brent-related trade and cut off shipments 
of Brent and other North Sea crudes to the United States. 
``Trade on Brent-related crudes, particularly other North Sea 
grades, became unhealthily opaque as buyers and sellers 
struggled to avoid the price spike. Brent's inflated strength 
forced some European refiners to cut runs. And dated Brent 
moved to an abnormally wide premium over WTI--from its 
customary discount--choking off the flow of cargoes to the 
U.S.'' \135\
---------------------------------------------------------------------------
    \135\ Petroleum Argus Global Markets, Ending Brent's Eternal Games, 
February 4, 2002.
---------------------------------------------------------------------------
    Following Shell's announcement that it had enough orders to 
purchase all of the Brent cargoes in March, most of which were 
deposited into the SPR, the transatlantic trade again was 
disrupted. ``North Sea trade came to a standstill as the market 
waited for Shell's intentions to become clear, pressuring 
unsold late February loading cargoes. . . . The prospect of 
another Brent trading play reduced the US appetite for Brent-
linked North Sea and west African crudes.'' \136\
---------------------------------------------------------------------------
    \136\ Petroleum Argus Global Markets, Prices Jump on Squeeze Talks, 
February 18, 2002.
---------------------------------------------------------------------------
    In mid-March, The Oil Daily reported the increase in the 
price of Brent relative to WTI had caused a decline in U.S. 
imports, putting upward pressure on domestic crude oil prices. 
``The narrow arbitrage between WTI and North Sea Brent, of 
about 25 [cents] on Friday, has been working against 
competition from foreign barrels, contributing to keeping 
values for most US grades steady last week.'' \137\
---------------------------------------------------------------------------
    \137\ The Oil Daily, US Sweet Grades Firm, Sours Lose Ground While 
WTI-Brent Arbitrage Remains Closed, March 18, 2002.
---------------------------------------------------------------------------
    In early April, the Financial Times Business Recorder 
reported that a brief drop in the price of dated Brent had 
opened up the trans-Atlantic trade:

          Crude oil traders are scrambling to exploit a brief 
        opening in the trans-Atlantic arbitrage for European 
        crude, taking advantage of a fall in benchmark dated 
        Brent despite steamy futures prices. As much as 10 
        million barrels of sweet North Sea grades have recently 
        been booked to sail west in April, fleeing the severely 
        depressed European market, but the opportunity could be 
        short-lived if wet Brent climbs again as many traders 
        expect. \138\
---------------------------------------------------------------------------
    \138\ Business Recorder, Never Mind Futures, Europe and US Crude 
Arb Opening, April 5, 2002. From mid- to late-March, the Brent-WTI 
differential averaged about 90 cents.

Crude oil traders quoted in this article attributed the higher 
dated Brent prices choking the transatlantic trade to the 
filling of the SPR: `` `The levels are all distorted because 
you don't have fundamentals, you have the SPR commitments that 
are affecting Dated,' said one trader with a US refiner.'' 
\139\
---------------------------------------------------------------------------
    \139\ Id.
---------------------------------------------------------------------------
    In late April, Petroleum Argus reported the April Brent 
squeeze was distorting the transatlantic trade.\140\ ``A 
squeeze on Atlantic basin benchmark Brent caused the grade's 
third price distortion this year, and pushed prices $2/bl 
higher last week. This left US benchmark WTI at a 35 cents/bl 
discount to Brent in May and confused transatlantic arbitrage 
economics. Sellers of Brent-linked North Sea grades were forced 
to slash their offers relative to dated Brent to keep cargoes 
moving to the US.'' \141\
---------------------------------------------------------------------------
    \140\ See Figures IV-6 and IV-7.
    \141\ Petroleum Argus Global Markets, Brent Squeeze Wreaks Havoc, 
April 22, 2002. The article also noted, ``Advance warning of the Brent 
squeeze had been provided by the short-term swaps market for dated 
Brent and Brent contracts for differences (CFDs). They indicated a late 
April and early May price spike.''
---------------------------------------------------------------------------
    Still another trade publication wrote about the decline in 
transatlantic Brent trade in late April due to higher prices. 
``The victim of a trading squeeze, liquidity in the physical 
Brent market had all but dried up and price transparency had 
effectively been limited to the often manipulated contract-for-
difference market. . . . A delay in the release of the May 
loading program and the lack of transparency as well as the 
steeply backwardated dated Brent pricing profile acted as a 
brake on trade.'' \142\
---------------------------------------------------------------------------
    \142\ Nefte Compass, Crude Oil: Brent Squeeze Hypes Benchmark, 
April 23, 2002.
---------------------------------------------------------------------------
    U.S. import data over this period shows a striking decline 
in imports of North Sea and west African crude oils priced off 
Brent. Figure IV-10 shows that this decline in imports began in 
December 2001 and continued through April 2002. This time 
period corresponds with the period during which the price of 
dated Brent rose, on average, 75 cents relative to WTI, and in 
which the transatlantic trade was totally disrupted several 
times due to the squeezes in the Brent market.
    Figure IV-10 also shows that Nigerian crude oil imports 
dropped the most of the Atlantic Basin crude oils imported into 
the United States during this period. From October 2001 through 
February 2002, imports of crude oil from Nigeria declined by 33 
percent. In April 2002, imports from Nigeria were 45 percent 
lower than in April 2000, and 56 percent lower than in April 
2001. This data is consistent with the data in Figures IV-8 and 
IV-9 showing the spot price of Nigerian Bonny Light moving in 
tandem with the price of dated Brent, thereby become relatively 
expensive compared to WTI. During this period the amount of 
crude oil from the United Kingdom also dropped significantly 
compared to previous U.K. import levels. Not including Brent 
crude oil sent to the SPR in April 2002, imports of crude oil 
from the United Kingdom were 20 percent lower than in April 
2001, and 65 percent lower than in April 2000.

[GRAPHIC] [TIFF OMITTED] T5551.034

    Crude oil imports into the United States declined more in 
the first half of 2002 than in any of the comparable time 
frames over the past several years. Figure IV-11 shows that 
from January through March 2002, average daily imports 
declined, whereas over a similar 3-month period in the years 
1999 through 2001 average daily imports were increasing. 
Additionally, average daily U.S. imports in April 2002 were 
substantially lower than in April 2001 and April 2000.
    The overall level of U.S. imports in early 2002 also was 
affected by a general economic slowdown following the September 
11 tragedy, so the reduction in imports seen in Figure IV-11 
was also caused by a decline in demand. Higher import prices 
were nonetheless another major factor contributing to this 
reduction.

[GRAPHIC] [TIFF OMITTED] T5551.035

    Additional evidence that the level of overall imports was 
reduced largely as a result of the reduction in imports priced 
off Brent is provided in Figure IV-12, which shows the level of 
U.S. imports priced off WTI. From January 2002 through April 
2002, at the same time the level of imports priced off Brent 
declined by 500,000 to 1 million barrels per day, \143\ no 
parallel decline took place in the amount of imports priced off 
WTI.
---------------------------------------------------------------------------
    \143\ See Figure IV-10.

    [GRAPHIC] [TIFF OMITTED] T5551.036
    
    The regional breakdown of U.S. crude oil imports provides 
further evidence that reduced imports of Brent-priced sweet 
crudes were responsible for the most of the decrease in U.S. 
crude oil imports during the first 5 months of 2002. Figures 
IV-13, IV-14, and IV-15 provide a month-by-month comparison of 
daily import levels into the East Coast (PADD 1), the Midwest 
(PADD 2), and the Gulf Coast (PADD 3). Of these three regions, 
refiners on the U.S. East Coast were the most sensitive to the 
price of Brent, as a number of East Coast refineries rely 
heavily on sweet crudes from the United Kingdom, Norway, and 
west Africa. Refiners in the Midwest (PADD 2) use both light, 
sweet crudes and heavy, sour crudes, and some Midwestern 
refiners are able to vary the types of crudes run through the 
refinery as the economics of the crude oil and refined product 
markets vary. Figures IV-13, IV-14, and IV-15 show that in the 
first several months of 2002 the East Coast, which is the 
refining region most sensitive to the price of Brent, 
experienced the most significant drop in imports, and that 
Midwestern refiners, who also rely heavily on light, sweet 
crudes, also cut back on imports significantly.

[GRAPHIC] [TIFF OMITTED] T5551.037


[GRAPHIC] [TIFF OMITTED] T5551.038

[GRAPHIC] [TIFF OMITTED] T5551.039

    Although a number of other factors also affected the price 
and supply of crude oil during the first part of 2002, these 
factors did not affect U.S. import levels nearly as much as the 
relative increase in the price of Brent during the first 5 
months of 2002. For example, although in early April Saddam 
Hussein announced a suspension of Iraqi oil exports for 30 
days, imports from Iraq did not decline below average levels 
until May 2002. As late as April 2002, the United States was 
importing over 750,000 barrels per day from Iraq, nearly at the 
2001 daily average of 795,000 barrels per day.
    Despite growing political unrest and an 8-day strike by oil 
workers in Venezuela, imports from Venezuela ranged from 1.1 to 
1.25 million barrels per day from January through May 2002, 
which is roughly equivalent to the Venezuelan imports over the 
same period in 2000, and only slightly less than the 1.29 
million barrels per imported daily, on average, in 2001. The 
strike spiked the market for several days, but the strike was 
short-lived and there were no long-term effects upon U.S. 
supplies from the temporary suspension of exports.\144\
---------------------------------------------------------------------------
    \144\ See, e.g., Bloomberg News, Oil Prices Fall as End Seen for 
Venezuelan Strike, National Post April 23, 2002. Additionally, OPEC 
representatives signaled to the market that OPEC would work to 
stabilize oil prices if the disruption in Venezuela continued. ``If the 
drama in Venezuela continues we could have a problem and we might have 
to put more oil on the market,'' one OPEC official stated. U.S. 
Secretary of Treasury O'Neill said ``it appeared that Saudi Arabia and 
other oil producers were `doing whatever production it takes' to stay 
within a price band.'' Matthew Jones and Andy Webb-Vidal, OPEC Moves to 
Limit Impact of Venezuela, Iraq, Financial Post, April 11, 2002. See 
also Nadim Kawach, UAE Saudi Arabia Assure Oil Supply, Gulf News, March 
21, 2002.
      Contemporaneous trade press reports also state that the 
Venezuelan strike had no effect upon U.S. crude oil producers operating 
in Venezuela. Petroleum Finance Week, As Chavez Returns, Venezuela's 
Oil Industry Tries to Get Back to Normal, April 22, 2002.
---------------------------------------------------------------------------
    Some observers attributed the reduction in U.S. imports in 
early 2002 to OPEC production cuts announced in January 2002. 
For example, in its weekly report released on April 24, the 
DOE's Energy Information Administration (EIA) linked the 
reduction in imports to lower OPEC production quotas:

          U.S. crude oil imports over the last 4 weeks have 
        averaged just 8.8 million barrels per day, or nearly 
        850,000 barrels per day less than over the same period 
        last year. With OPEC 10 (excluding Iraq) crude oil 
        production in the first quarter of 2002 averaging 22.6 
        million barrels per day, this is the lowest quarterly 
        average since the second quarter of 1992! With less 
        crude oil being produced by these countries after a 
        series of cuts in production quotas, they are exporting 
        less, and so it is no surprise to see the world's 
        largest importing country experiencing declining 
        imports.\145\
---------------------------------------------------------------------------
    \145\ EIA, This Week in Petroleum, April 24, 2002. In its report 
for the previous week, EIA had also stated, ``most of the reason for 
the crude oil import deficit rests with OPEC's decision to cut their 
quotas by another 1.5 million barrels per day (effective on January 1), 
which has clearly reduced imports into the United States.'' EIA, This 
Week in Petroleum, April 17, 2002.

    EIA monthly data indicates, however, that the OPEC 
production cuts were not nearly as significant a factor as 
initially reported. Of the 850,000 barrel-per-day reduction 
noted in the EIA's April 24 report, reduced imports of Atlantic 
Basin sweet crudes priced off Brent accounted for nearly all 
this amount--815,000 barrels. Reductions from Nigeria alone 
accounted for nearly 630,000 barrels, or about 70 percent, of 
this reduction. See Figure IV-10.
    Of the Atlantic Basin countries exporting crude oil, only 
Nigeria is a member of OPEC. The reason for the large reduction 
in Nigerian exports appears not to be the OPEC quotas, but the 
relatively high price of Nigerian crude oil priced off dated 
Brent. Even with Nigeria's initial adherence to the OPEC 
quotas, there was a surplus of Nigerian crude because of its 
inflated price and depressed demand. In early March, one 
publication reported, ``At this time of the month, most of 
Nigeria's crude oil cargoes designated to load in the Apr. 1-10 
time frame should have found permanent homes. They haven't. . . 
. To be fair, Nigerian barrels are not alone in having 
difficulties finding buyers. The physical market is well and 
truly in the dumps.'' \146\ Similarly, in early May it was 
reported:
---------------------------------------------------------------------------
    \146\ Energy Intelligence Briefing, Nigeria Ensures OPEC Compliance 
in March and April, March 7, 2002.

          The climate for selling Nigerian oil has taken a 
        severe turn for the worse in recent weeks, judging by 
        the May loading schedule for Nigeria's eight main crude 
        systems. The schedule indicates at least 6 May cargoes 
        still unsold, while appetite for early June remains 
        lackluster. Some tankers will soon be steaming toward 
        the U.S. Gulf Coast--port of last resort--in hopes that 
        conditions will have improved before they arrive. But 
        current prospects for placing cargoes at the right 
        price look slim, as crude supplies appear well in 
        excess of demand in the United States\147\
---------------------------------------------------------------------------
    \147\ Energy Intelligence Briefing, Nigerian Crudes Fail to Impress 
US Buyers--So Far, May 7, 2002.

    EIA's initial analysis did not reflect the extent to which 
global demand was sharply lower in early 2002 than in early 
2001. ``Even in a period when the Iraqi embargo and Venezuelan 
disruption took barrels off the market unexpectedly, demand 
fell even faster--by 1.4 percent and 1.5 percent on the year in 
March and April, respectively.'' \148\ In March, global 
production exceeded global demand by 400,000 barrels per day, 
and in April by 700,000 barrels per day.\149\ By contrast, in 
April 2001, global production had exceeded demand by only 
100,000 barrels per day. With relatively more crude oil 
available on the global market in 2002 than 2001, it does not 
appear that the OPEC cuts relative to 2001 production levels 
were responsible for the reduced levels of imports into the 
United States during this period.\150\
---------------------------------------------------------------------------
    \148\ The Oil Daily, Supply-Demand Fundamentals Far From Bullish, 
May 23, 2002.
    \149\ Petroleum Intelligence Weekly, Oil Prices Fly in Face of 
Fundamentals, May 22, 2002.
    \150\ As discussed in Appendix 3, the OPEC reductions did affect 
the price differential between heavy and light crude oils.
---------------------------------------------------------------------------
    In short, political events affecting the global crude oil 
markets in early 2002 did not create shortages of crude oil 
relative to demand during that period. Rather, in light of the 
reduced global demand for crude oil, there were ample supplies 
of crude oil available for U.S. refiners.
    Moreover, the global political factors just described 
affected the global supply and demand for crude oil, not just 
the North American market. Thus, although these factors 
contributed, to some extent, to the overall increase in the 
price of crude oil in the first 5 months of 2002, and the 
overall amount of oil supplied, none of these factors explains 
the dynamics of the crude oil trade between the United States 
and the rest of the world during this period. This trade is 
driven by the price differentials between the WTI and Brent 
benchmarks, rather than absolute price levels or absolute 
supply numbers. Global political events do not explain the 
divergences between the Brent and WTI markets beginning in late 
2001, when the price of Brent rose significantly relative to 
WTI. The most significant factor leading to the reduced U.S. 
crude oil imports in early 2002, other than the overall decline 
in demand, was the reduction in light sweet crude oil imports 
priced off Brent due to higher relative Brent prices resulting 
from the use of Brent to fill the SPR.

  5. High-Priced Imports Led U.S. Refiners to Use Crude Oil in 
                    Existing Inventories

    The relatively high cost of Brent-based imports had two 
major effects. First, U.S. refiners able to substitute less 
expensive WTI-based crudes did so, thereby increasing the 
imports of WTI-based crudes. Secondly, U.S. refiners 
increasingly relied upon crude oil already in their inventories 
to meet demand and build stocks of gasoline in anticipation of 
the upcoming seasonal surge in gasoline usage.
    In late March, the EIA noted that crude oil imports were 
decreasing at the same time U.S. refinery runs were increasing 
in anticipation of the late spring and early summer driving 
season. ``With crude oil imports last week at the lowest level 
in more than a year (partly due to significant fog-related 
closures in the Houston Ship Channel) and refinery runs 
increasing, last week saw a drop in crude oil stocks (4.5 
million barrels) not seen since the week ending October 12, 
2001. If crude oil imports continue to remain low, while inputs 
into refineries increase, crude oil stocks would continue to 
fall.'' \151\
---------------------------------------------------------------------------
    \151\ EIA, This Week in Petroleum, March 27, 2002.
---------------------------------------------------------------------------
    Even after the fog lifted from the Houston Ship Channel, 
U.S. crude oil imports continued to drop while use of crude oil 
in U.S. inventories increased. Total U.S. inventories declined 
from about 325 million barrels on April 5 to about 319 million 
barrels on April 12, and again declined from late April until 
mid-May. From April 5 to April 12 Gulf Coast (PADD 3) 
inventories also fell, from about 165 million barrels to about 
161 million barrels, and Midwest (PADD 2) inventories slipped 
from just over 70 million barrels to about 69 million barrels.

  6. Decreasing U.S. Inventories Spiked the Price of WTI

    In early April, EIA warned of increasing crude oil prices 
due to reduced imports and increasing refinery runs:

          The level of crude oil imports to supply increasingly 
        higher refinery output of petroleum products, 
        particularly gasoline, has become a major concern over 
        the past several weeks. In order to stave off a repeat 
        of last year's steep run up in motor gasoline prices, 
        crude oil supplies will need to be maintained at a rate 
        that keeps up with anticipated strong demand for 
        gasoline and other petroleum products as the U.S. 
        economy recovers from its recent downturn. . . . If the 
        discrepancy between crude imports and refinery runs 
        continues to widen as the summer driving season nears, 
        both crude and product stocks are expected to drop 
        sharply, pressuring up further gasoline and other 
        petroleum product prices.\152\
---------------------------------------------------------------------------
    \152\ Id., April 3, 2002.

    Two weeks later, EIA's weekly report warned: ``So, at a 
time when imports are usually increasing to supply increased 
refinery production as the gasoline season begins, this year, 
crude oil imports are declining. And while crude oil 
inventories started this period in much better position than in 
the previous 2 years, at this rate, it won't be long until 
crude oil inventories become tight once again, thus putting 
more pressure on crude oil prices.''
    Indeed, in mid-April the crude oil import data released by 
EIA and the American Petroleum Institute (API) affected the 
market in just the manner forecast. On April 16, 2002, API 
released its weekly industry data report showing a drop in U.S. 
crude oil inventories for the previous week. Immediately after 
the release of this inventory data, the price of the next-month 
WTI futures contract on the NYMEX rose about 20 cents per 
barrel. Over the next several days the next-month WTI futures 
contract continued to rise. A week later, on April 23, the WTI 
contract for delivery of crude oil in June (``the June 
contract'') became the next-month contract. At the same time, 
API and EIA data continued to show a decline in Midwest (PADD 
2) inventories. Traditionally, Midwest (PADD 2) aggregate crude 
oil inventories have strongly influenced the price of the NYMEX 
WTI contract, because they influence the supply and demand 
balance for crude oil at the WTI delivery location at Cushing, 
Oklahoma. Generally, the WTI market interprets a decline in 
PADD 2 inventories as a sign of a shortage of available crude 
oil in the region, and hence such a decline will lead to an 
increase in the price of WTI.
    The WTI market reacted in just this manner in late April. 
Just at the time the June WTI contract became the next-month 
contract, the price of this contract jumped above the price of 
the next month contract (shifting the market from contango to 
backwardation), indicating the market believed there was a 
near-term shortage in supply. The increase in the near-term WTI 
futures price took place at the same time as the April squeeze 
in the Brent market was dissipating, lowering the price of the 
near-term Brent futures contract (shifting the Brent market 
from backwardation to contango). See Figure IV-6.
    Many traders viewed the sudden upward shift in the WTI 
market in light of the Brent market's move in the opposite 
direction as evidence of a squeeze in the WTI market. For 
example, on May 8, 2002, Reuters reported:

          The premium for U.S. crude oil prices over other 
        international grades exploded higher on Wednesday as 
        dwindling supplies in the pivotal Midwest region made 
        the market more vulnerable to supply squeezes, traders 
        said. Oil traders said that a market play by oil major 
        BP was a driving force behind the sudden U.S. price 
        run-up--just the latest in a series of trading 
        maneouvers that has distorted prices on both U.S. and 
        European markets this year.\153\
---------------------------------------------------------------------------
    \153\ Reuters, U.S. Crude Rockets as BP Completes Brent Play, May 
8, 2002. Another publication stated: ``Market whispers last week 
focused on evidence of yet another wet-barrel crude squeeze, knocking 
the futures markets out of whack as they used physical trades as a 
guide. . . . The smoking gun: The forward price curve for Brent is in 
contango, or upward sloping, while the forward curve for West Texas 
Intermediate showed a 90 cents backwardation.'' Petroleum Intelligence 
Weekly, Marketview: Smoke and Mirrors, May 15, 2002.

    In reality, however, there were ample supplies of crude oil 
available to Midwestern refiners, indicating the sudden price 
increase in the WTI market was not caused by a squeeze. In 
interviews with the Subcommittee staff, traders and officials 
with a number of companies supplying and purchasing crude oil 
stated there were no shortages of crude oil at this time. 
According to these traders and officials, ample supplies of 
crude oil in the Gulf Coast were available for Gulf Coast and 
Midwest refiners, and the crude oil pipelines from the Gulf 
Coast to the Midwest were not filled to capacity.
    These traders and officials stated that Midwestern 
inventories declined not because of any physical shortages of 
crude oil, but rather because the imports that were reaching 
the Gulf Coast ports were too expensive for Midwestern 
refiners. According to traders interviewed by the Subcommittee, 
because crude oil priced off Brent arriving at the Gulf Coast 
already was expensive compared to WTI, it was uneconomic for 
Midwestern refiners to pay the additional costs to transport 
the crude oil by pipeline from the Gulf Coast to their 
refineries in the Midwest. These traders state they had plenty 
of crude oil in the Gulf Coast, and would have sent it to the 
Midwest if it were economical to do so.
    Instead of buying the relatively expensive imports, 
Midwestern refiners used crude oil from their existing 
inventories. As a result, Midwestern inventories declined. 
Figure IV-16 shows the decline in Midwestern (PADD 2) 
inventories during this period. Figure IV-17 shows that during 
this same period Gulf Coast supplies were increasing, 
indicating the decline in Midwestern inventories was not due to 
any shortage of crude oil, but rather because it was not 
economical to ship the relatively high-priced imports arriving 
on the Gulf Coast up to the Midwest.

[GRAPHIC] [TIFF OMITTED] T5551.040

[GRAPHIC] [TIFF OMITTED] T5551.041

    ``Refiners do not corroborate the widespread interpretation 
that the US Midwest is short of crude, and neither do the 
data,'' the Oil Market Intelligence wrote on May 21.\154\ The 
article blamed the relatively high near-term prices in the WTI 
market on the reluctance of Midwestern refiners to purchase 
crude oil: ``They are not keen on buying the incremental barrel 
because of the steep premium of prompt delivery to the second 
month, and are inclined to run down stocks and hold out for 
lower prices.'' \155\
---------------------------------------------------------------------------
    \154\ Oil Market Intelligence, Crude Oil Market Tightness: Squeezed 
or Perceived?, May 21, 2002.
    \155\ Id.
---------------------------------------------------------------------------
    Another article in the same publication observed it was 
``no surprise'' the ``sharp and sudden backwardation'' in the 
WTI market followed ``two weeks of sizable crude draws in the 
US. In particular, crude stocks in Padd 2--the Midwest region--
deflated by nearly 5 million barrels between mid-April and mid-
May.'' \156\ The article concluded crude oil traders had 
perceived the inventory drops in the Midwest (PADD 2) as an 
indication of a crude oil shortage:
---------------------------------------------------------------------------
    \156\ Oil Market Intelligence, Feature: Perception vs. Reality, May 
21, 2002.

          Traders bought the apparent Midwest tightness hook, 
        line, and sinker, bidding up the front-month price of 
        WTI by as much as $3 in the second and third week of 
        May. Crude inventories in Padd 2, some suggest, are 
        something of a barometer for the shape of the forward 
        price curve. Indeed, the relationship between the 
        first- and second-month New York Mercantile Exchange 
        contracts for light, sweet crude map very closely the 
        magnitude by which Padd 2 crude stocks rise or fall 
        above 65 million-67 million [barrels].\157\
---------------------------------------------------------------------------
    \157\ Id.

    But in fact, the article observes, there was no tightness 
---------------------------------------------------------------------------
in the supply of crude oil for the Midwest:

          But is the U.S. market really short of crude? At 
        second glance, the situation in the Midwest looks to be 
        not so much a story of refiners without crude, as it is 
        a story of crude without refiners. Refiners deny that 
        there is any outright lack of availability, the prices 
        just aren't right. . . . Meanwhile, since the run-up in 
        the front-month [WTI] crude price, it makes more sense 
        to rely on term-contracts and crude in storage for 
        throughputs, than it does to buy up prompt wet barrels.

    As evidence, they point to slowed crude supplies from 
Canada, and crude pipelines in the Midwest from the U.S. Gulf, 
which have ample spare capacity. In fact, crude stocks have 
piled up in the U.S. Gulf even faster than they drained from 
mid-continent tanks over the last month.\158\
---------------------------------------------------------------------------
    \158\ Id.
---------------------------------------------------------------------------
    The widely held but inaccurate perception of the actual 
supply and demand balance in the United States during the 
Midwest (PADD 2) inventory draw-down was re-enforced as 
refiners, in response to the sudden increase in near-term 
prices, drew even more heavily from their inventories of stored 
oil rather than make new purchases. This further drawdown in 
stocks further increased the near-term prices in the 
backwardated WTI market, creating a vicious cycle of inventory 
draws and near-term price increases that continued until the 
June NYMEX WTI contract reached expiry. As Oil Market 
Intelligence wrote: ``[E]nough market players have interpreted 
the stock draws as a shortage in the Midwest that they have 
successfully bid up prices. The result: a reinforcing cycle of 
backwardation.'' \159\
---------------------------------------------------------------------------
    \159\ Id.
---------------------------------------------------------------------------
    Figure IV-18 shows the difference between the first and 
second month WTI futures contracts for the period from February 
through June 2002. This Figure shows the price of the near-
month WTI futures contract jumped immediately after the release 
of the API and EIA inventory data. This spike in the near-term 
futures price for WTI lasted about 1 month, increasing the WTI 
June futures price nearly 20 percent, from $24.75 to $29.36 per 
barrel.
    From a variety of contemporaneous reports, as well as from 
the price data, it appears that the spike in the WTI June 
contract price, which lasted from late April through late May, 
was caused by traders bidding up the price of the contract in 
light of the declining Midwestern oil inventories. In the Gulf 
Coast, however, there was an excess of supply over demand, as 
indicated by rising inventories. Given this excess of supply 
relative to demand, Gulf Coast prices should have fallen and 
excess oil should have been shipped to the Midwest. But the 
near-month price for WTI continued to increase, discouraging 
refiners from buying oil, and causing WTI prices on the NYMEX 
to increase even more. Because the WTI contract delivery point 
is in the Midwest, it was the declining Midwestern inventories, 
rather than the plentiful Gulf Coast inventories, which drove 
up the price of WTI nationwide.
    This example illustrates how the supply and demand balance 
in the Midwest can present an isolated, disproportionate, and 
inaccurate reflection of national supply and demand, and yet 
still be the most significant factor affecting the NYMEX WTI 
price. If, indeed, as Dr. Mabro states, the ``most important 
function [of prices] is to signal at every moment the state of 
the supply/demand balance,'' over this time period the NYMEX 
WTI contract failed in its most important function.

[GRAPHIC] [TIFF OMITTED] T5551.042

    Figure IV-19 shows the sharp rise in the price of the near-
month WTI futures contract that began on April 16, when API and 
EIA data showing a decline in total U.S. and Midwestern 
inventories, and continued through late May, as Midwestern 
inventories declined from mid-April through late May (see 
Figure IV-16).

[GRAPHIC] [TIFF OMITTED] T5551.043

    Figure IV-19 shows that the price of the next-month WTI 
futures contract rose from $24.75 per barrel on April 16 to a 
peak of $29.36 on May 14, an increase of approximately $4.60, 
or 19 percent. Within days of expiry of the June contract, the 
WTI near-month futures contract price dropped back down to 
around $25, the WTI near-month futures price before the price 
spike. The sudden rise in the WTI next-month price as soon as 
the June contract began trading and the sudden fall in the 
next-month price after the June contract expired indicates the 
June contract price was artificially inflated and did not 
reflect the fundamentals of global supply and demand.\160\
---------------------------------------------------------------------------
    \160\ The price of the WTI nearest-month contract fell about $1 per 
barrel per day just before expiry--from $28.33 on May 20 to $27.33 on 
May 21 to $26.37 on May 22--and then down to $25.27 on May 28, 
following the Memorial Day holiday.
---------------------------------------------------------------------------
    Figure IV-20 shows that the WTI spot price closely tracked 
the nearest-month WTI futures price during this period. As seen 
in this figure, the price spike in the WTI futures market in 
April and May spiked the prices in the crude oil spot market as 
well.

[GRAPHIC] [TIFF OMITTED] T5551.044

    An upper-bound estimate of the additional crude oil costs 
imposed by the April-May WTI spike can be obtained by 
calculating how much the WTI spot price rose during the spike 
compared to the WTI spot price before and after the spike. The 
spot price of WTI before and after this spike was about $25 per 
barrel. The average price of WTI during the spike, from April 
16 to May 21, was $27.16. Hence, the spot price of WTI was, on 
average, $2.16 higher during the April-May spike than before or 
after. Under this methodology, in just the 1-month period from 
April 16 to May 21, U.S. consumers and businesses paid over $1 
billion in additional costs for crude oil as a result of the 
SPR fill.\161\
---------------------------------------------------------------------------
    \161\ The U.S. consumes approximately 18 million barrels of crude 
oil each day. $2.16/barrel/day x 30 days x 18 million barrels/day = 
$1.17 billion. A similar upper-bound estimate of over $1 billion in 
additional costs is reached if one takes the $2 drop in the price of 
the near-month WTI futures contract that occurred at the expiry of the 
June WTI contract as the added cost attributable to the backwardation 
the previous month.
      These estimates do not include the additional costs passed on 
through OTC instruments linked to the price of WTI. Nor do they include 
the additional costs to U.S. consumers and businesses from the increase 
in the cost of imports priced off Brent from November through May. This 
Report does not quantify these costs because of the unavailability of 
specific crude oil price and volume data for the affected imports.
---------------------------------------------------------------------------
    A more conservative, lower-bound estimate, of the added 
costs imposed on U.S. consumers is obtained by comparing the 
first and second month WTI contract prices to determine how 
much the first month contract rose above the baseline price 
during the 1-month price spike. Generally, the price of the 
second-month contract is viewed as a more accurate reflection 
of global supply and demand, since it is not subject to the 
type of distortions that can affect the price of a first-month 
contract near expiry. Thus, under this methodology, the second-
month contract price is considered the ``baseline'' WTI price. 
From April 23 to May 21, the price of the first month contract 
exceeded the price of the second-month contract by, on average, 
60 cents per barrel. Prior to and after these dates the second-
month contract was higher than the first month contract by 
about 20 cents. Hence, the first month contract rose, on 
average, 80 cents relative to the second month or ``baseline'' 
price during this period. Under this methodology, in the 1-
month period from April 23 to May 21, U.S. consumers and 
businesses paid over $450 million in additional costs for crude 
oil as a result of the SPR fill.\162\
---------------------------------------------------------------------------
    \162\ $0.80/barrel/day x 30 days x 18 million barrels/day = $432 
million. Again, this calculation does not take into account additional 
costs arising from inflated costs for OTC instruments or costs arising 
from the Brent price increases.
---------------------------------------------------------------------------
    It is reasonable to conclude, therefore, that the WTI price 
spike in April and May 2002 increased crude oil costs for U.S. 
consumers and businesses by between $500 million and $1 
billion. Most of these higher costs were passed on to consumers 
and businesses in the form of higher costs for home heating 
oil, diesel fuel, and jet fuel.\163\
---------------------------------------------------------------------------
    \163\ Spot prices are, in effect, wholesale prices. As a general 
matter, increases in petroleum product spot prices are eventually 
passed on in the form of higher retail prices for consumers. See, e.g., 
Michael Burdette and John Zyren, EIA, Diesel Fuel Price Pass-through, 
at EIA website at http://www.eia.doe.gov/pub/oil--gas/petroleum/
feature--articles/2002/diesel.htm1. Because of the decentralized nature 
of retail sales for petroleum products, which are sold through tens if 
not hundreds of thousands of retail outlets across the nation, retail 
sales data is much more difficult to obtain than data for the futures 
or spot markets. A host of additional factors affect product markets, 
apart from the crude oil markets, making an analysis of the specific 
short-term retail effects of increases in crude or wholesale prices 
beyond the scope of this Report.
---------------------------------------------------------------------------

  7. WTI Price Spike Led to Price Spikes for Home Heating Oil, Jet 
                    Fuel, and Diesel Fuel

    Figures IV-21, IV-22, and IV-23 show how the increases in 
the WTI spot price increased the price of home heating oil, jet 
fuel, and diesel fuel. From April 16 through May 14, the 19-
percent increase in the WTI spot price spiked the spot price 
for home heating oil by 13 percent, jet fuel by 10 percent, and 
diesel fuel by 8 percent.
[GRAPHIC] [TIFF OMITTED] T5551.045


[GRAPHIC] [TIFF OMITTED] T5551.046

[GRAPHIC] [TIFF OMITTED] T5551.047

  8. Higher Home Heating Oil, Jet Fuel, and Diesel Fuel Prices Hurt 
                    U.S. Consumers and Businesses

    Increases in the prices of these basic commodities affect 
nearly every American and every sector of the economy. Home 
heating fuel increases, for example, affect millions of 
families and businesses in the Northeast and Midwest. According 
to the Department of Energy, 70 percent of homes in the 
Northeast rely on home heating oil.\164\ In Michigan, for 
example, the percentage is 3.5 percent, in Minnesota, it is 8 
percent, and in Maine, 4 out 5 people, or 80 percent, heat 
their homes with oil.\165\
---------------------------------------------------------------------------
    \164\ http://www.eia.doe.gov/emeu/plugs/plheat.html.
    \165\ See, for example, Michigan Public Service Commission website, 
at http://cis.state.mi.us/mpsc/reports/energy/02--03winter/distill.htm; 
``More Minnesotans heating with natural gas,'' Minnesota Public Radio, 
December 4, 2002; ``Agency predicts surge in oil prices; A study finds 
Mainers could pay 45 percent more this winter, depending on the chill--
and the winds of war,'' Portland Press Herald, October 15, 2002.
---------------------------------------------------------------------------
    The hardships caused by expensive heating fuel have long 
been recognized. The Low Income Home Energy Assistance (LIHEAP) 
program assists more than 4.6 million low-income households 
each year. Recently, LIHEAP has provided about $1.5 billion 
each year to assist U.S. households with energy costs related 
to extreme heat and cold. At a 2002 event announcing the 
release of $200 million in LIHEAP funding for American families 
facing rising heating bills, U.S. Secretary of Health and Human 
Services Tommy Thompson noted, ``Higher fuel prices pose a real 
hardship for many Americans. This emergency aid will give 
states the opportunity to help more of their citizens stay warm 
this winter.'' \166\
---------------------------------------------------------------------------
    \166\ http://www.ncat.org/liheap/news/Jan03/emergen.htm.
---------------------------------------------------------------------------
    Congress also recently established the Northeast Heating 
Oil Reserve (NHOR) to stabilize home heating oil prices. This 
reserve was established to reduce the disruptive effects 
associated with home heating fuel shortages and sudden price 
hikes, such as occurred in December 1996 and early 2000. NHOR 
currently holds about 2 million barrels, all of which were 
acquired by exchanging crude oil from the SPR for heating oil 
delivered to NHOR storage facilities in New Jersey, 
Connecticut, and Rhode Island.
    Programs like LIHEAP and NHOR mean that the 13 percent jump 
in heating fuel futures caused by the 2002 crude oil price 
spikes imposed not only higher costs on U.S. consumers and 
businesses in the Northeast and Midwest, but also on taxpayers 
across the country, since these government programs are funded 
with taxpayer dollars.
    Jet fuel is another key petroleum product that was affected 
by the 2002 crude oil price increases. Jet fuel is the second 
largest airline cost after labor, and, each month, U.S. 
airlines consume approximately 1.6 billion gallons of jet 
fuel.\167\ In 2002, the airlines were estimated to have 
consumed about 18 billion gallons altogether.\168\
---------------------------------------------------------------------------
    \167\ ``Higher energy prices so far an irritant, but not a 
detriment, to U.S. economy,'' Associated Press, December 20, 2002.
    \168\ Information supplied by Air Transport Association.
---------------------------------------------------------------------------
    Jet fuel price increases have a major impact on the 
airlines' finances and ability to keep operating. David 
Swierenga, chief economist at the Air Transport Association, 
informed the Subcommittee staff that ``every penny increase per 
gallon translates into $180 million in added costs annually . . 
. which the beleaguered industry can ill afford.'' \169\ 
Another economist has estimated that when the price of crude 
oil increases by 1 percent, the price of jet fuel increases by 
0.74 percent.\170\ One low-cost operator, Southwest Airlines, 
indicated that, ``Jet fuel accounts for 15 percent of our cost 
structure. When we see energy prices move, it has a very 
dramatic effect on us.'' \171\ Another airliner, Northwest 
Airlines, has calculated that each penny increase in jet fuel 
costs it an additional $20 million annually.\172\
---------------------------------------------------------------------------
    \169\ Id. See also testimony of Susan Donofrio, Deutsche Bank 
Securities, before the Senate Committee on Commerce, Science, and 
Transportation, October 2, 2002.
    \170\ Subcommittee interview with Gene Huang, FedEx economist, 
February 5, 2003.
    \171\ ``Crude awakening,'' San Francisco Chronicle, April 10, 2002.
    \172\ ``Rising fuel prices hit NWA,'' Star Tribune, July 6, 2001.
---------------------------------------------------------------------------
    Media reports noted that, in 2000, high jet-fuel bills 
wreaked havoc on the airline industry, forcing bankruptcy 
filings of some start-up carriers, lowering earnings at major 
airlines, and widening losses at others.\173\ In 2002, jet fuel 
prices increased 10 percent, from about 56 centers per gallon 
in January to about 78 cents in December. This added expense 
came on top of higher airline safety costs, higher debt levels, 
and reduced travel demand after the 9-11 tragedy in 2001. This 
added expense contributed to the airlines' ongoing financial 
woes, which have persisted even after the industry received a 
$5 billion cash infusion authorized by Congress in 2001. 
Altogether in 2002, the major U.S. airlines suffered losses 
estimated between $5 and $7 billion; increased jet fuel costs 
over the same period contributed to these losses.
---------------------------------------------------------------------------
    \173\ See, for example, ``Southwest's Fuel Hedging Yields Lower 
Prices, Savings,'' Wall Street Journal, January 16, 2001.
---------------------------------------------------------------------------
    Diesel fuel, a third key petroleum product, is also 
sensitive to crude oil price increases. Due to their 
reliability, efficiency, and safety, diesel engines play a key 
role in the U.S. economy, powering engines used in agriculture, 
construction, mining, transportation, and the military.\174\ 
The Diesel Technology Forum has determined that locomotives, 
ships, trucks, and other forms of transportation utilizing 
diesel fuels move 94 percent of the nation's goods and 
materials, or more than 18 million tons of freight, each day. 
Farm equipment, which is essential to not only the 2 million 
operating farms in this country but also millions of consumers 
that buy U.S. food, generally relies on diesel fuel. Diesel 
fuel also powers most buses, including intercity, transit, and 
school buses, and a number of post office vehicles. Overall, 
the Diesel Technology Forum calculates that the gross output of 
the diesel industry in 1997, the last year for which figures 
are available, totaled more than $85 billion.
---------------------------------------------------------------------------
    \174\ See ``Diesel Technology and the American Economy,'' a report 
prepared for the Diesel Technology Forum, October 2000.
---------------------------------------------------------------------------
    The American Trucking Association estimates that for every 
dollar increase in crude oil prices, retail diesel fuel prices 
increase 2.8 cents.\175\ An economist at FedEx, Gene Huang, 
estimates that when the price of crude oil increases by 1 
percent, diesel prices increase by 43 percent.\176\ Figure IV-
23 demonstrates how closely diesel prices tracked crude oil 
prices in the first part of 2002.
---------------------------------------------------------------------------
    \175\ Subcommittee interview with Diego Saltes, economist at the 
American Trucking Association, February 3, 2003.
    \176\ Subcommittee interview with Gene Huang, FedEx economist, 
February 5, 2003.
---------------------------------------------------------------------------
    Higher diesel prices hike costs in each of the sectors that 
rely on diesel fuel, often with attendant, negative ripple 
effects across the U.S. economy. One example is the trucking 
industry. Nearly all large trucks that transport freight in the 
United States run on diesel fuel, with the trucking industry 
consuming roughly 32 billion gallons each year.\177\ According 
to the American Trucking Association, the trucking industry 
employs almost 10 million people, including over 3 million 
drivers, and accounts for nearly 5 percent of U.S. gross 
domestic product. Bob Costello, chief economist at the American 
Trucking Association, estimates that for every 10 cent increase 
in the price of diesel an average 1,000 motor carriers with 
five trucks or more in their fleet go bankrupt. According to a 
transportation analyst with A.G. Edwards, Donald Broughton, the 
large numbers of trucking company failures in 2000 and 2001 
generally coincided with the rise in diesel prices.
---------------------------------------------------------------------------
    \177\ Information provided to Subcommittee staff.
---------------------------------------------------------------------------
    In addition to trucking business failures, trucking 
disruptions can impose an immediate, widespread drag on the 
U.S. economy by delaying shipment of goods and materials. 
``There is more dependence on just-in-time deliveries,'' Mark 
Whitenton of the National Association of Manufacturers said. 
``Even a couple of days disruption could cause factories to 
close.'' \178\ In 2000, for example, a price spike in diesel 
fuel stalled truckers in parts of New England. ``Diesel fuel 
cost between $2.50 and $2.60 a gallon, and trucks would not 
even go into Maine because there was not enough freight to pick 
up on the return trip to offset the cost,'' said Todd Spencer 
of the Owner-Operator Independent Drivers Association.\179\ 
After Iraq invaded Kuwait in 1990, and crude oil prices nearly 
doubled to $41 per barrel, one long-haul trucker, Lee Klass, 
stopped driving.\180\ ``The price of diesel fuel jumped 40 
cents a gallon,'' Klass recounted. Rather than pay the price at 
the pump, he parked his truck. ``It reaches a point that unless 
rates are doubled it doesn't make sense to haul any freight.''
---------------------------------------------------------------------------
    \178\ ``Fuel price escalation already spills into cost of other 
goods,'' Chicago Tribune, January 26, 2003.
    \179\ Id.
    \180\ Id.
---------------------------------------------------------------------------
    Home heating oil, jet fuel, and diesel fuel prices spiked 
in the spring of 2002 as a result of the increase in the price 
of crude oil. Since that time, the prices of these petroleum 
products have continued to climb along with crude oil prices. 
They have been joined by increases in gasoline prices. Since 
these and other costs took place after the period examined in 
this case study, they are discussed in the next section of this 
Report. Their attendant negative effects on the U.S. economy 
have continued to hurt U.S. consumers and businesses.
    In light of the economic harm to U.S. consumers and 
business from higher prices for home heating fuel, jet fuel, 
and diesel fuel, as well as other costs associated with high-
priced crude oil, it is critical that DOE recognize these costs 
and take steps to minimize the costs associated with depositing 
oil into the SPR.

  9. High Crude Oil Prices Increased Refinery Costs

    Higher crude oil prices in early 2002 also increased 
refinery costs. A refiner's income is determined by how much it 
can sell its product for on the wholesale market, and its 
expenses are determined by how much it has to pay for crude oil 
and how much it costs to operate the refinery. If it can sell 
its products for more than it costs to purchase the crude oil 
plus its expenses, then it will make a profit; if not, it will 
lose money. The difference between the price a refiner can 
obtain for a refined product, such as gasoline, and the price 
of crude oil is called the ``refining margin,'' and to a large 
extent determines the profitability of the refinery.
    In spring 2002, U.S. refiners saw their crude oil costs 
increase significantly, but were unable to raise gasoline 
prices due to the high level of gasoline supplies resulting 
from a flood of gasoline exports from Europe. Because the 
plentiful supplies of excess European gasoline capped potential 
increases in the retail price of gasoline, more direct consumer 
harm from the crude oil price increases was avoided. Instead, 
U.S. refiners absorbed these additional costs.
    Because U.S. refiners could not pass along the increased 
costs of crude oil to the gasoline market, refining margins 
fell significantly in April and May. The overall margin for a 
refinery (termed the ``crack spread'') is determined by taking 
into account the refining margins for several of the key 
products of a typical refinery. Figure IV-24 shows the negative 
effect the April-May WTI price spike had on the ``3-2-1 crack 
spread.'' The 3-2-1 crack spread is calculated by assuming that 
three barrels of crude oil are refined into two barrels of 
gasoline and one barrel of heating oil. As Figure IV-24 
demonstrates, refining margins, as measured by the 3-2-1 crack 
spread, fell from $6.38 per barrel on April 16, when the EIA 
and API inventory data was released, to $3.98 per barrel on May 
21, when the WTI June contract reached expiry.
    The near-40 percent fall in the crack spread resulting from 
the WTI price spike dropped this measure of refinery 
profitability to one of the lowest levels in the past several 
years.

[GRAPHIC] [TIFF OMITTED] T5551.048


    These lower refining margins were one of the major reasons 
for the dismal financial performance of oil companies in the 
second quarter of 2002.\181\ Table IV-1 presents the reported 
earnings of major oil companies for the second quarter of 2002, 
a very poor quarter for refiners, as compared to the second 
quarter of 2001, a very good quarter for refiners.
---------------------------------------------------------------------------
    \181\ The narrowing of the heavy-light and sweet-sour differentials 
led to major losses for U.S. refiners that rely on heavy and sour 
crudes. Although OPEC production cuts are often attributed to be the 
reason for the narrowing of this differential in the first half of 
2002, the decrease in Atlantic basin sweet crude imports due to high 
Brent prices led U.S. refiners to use relatively more heavy sour 
crudes. This shift in the relative percentages of heavy and light 
imports also contributed to the narrowing of the heavy-light 
differential in the second quarter of 2002.

[GRAPHIC] [TIFF OMITTED] T5551.006

    Different refiners were affected differently, based upon 
the slate of crude oils normally purchased for the different 
refineries. East Coast refiners relying on the transatlantic 
---------------------------------------------------------------------------
trade in sweet crudes priced off Brent were hit hardest:

          Average U.S. gross refining margins dropped more than 
        $1 barrel to $2.50 a barrel during the week ended May 
        11, marking the fourth consecutive weekly decline due 
        to high crude oil prices and relatively moderate prices 
        for gasoline and distillates, according to Salomon 
        Smith Barney's weekly margin report. . . . The weakest 
        margins are on the East Coast for Brent-based 
        production at $1.40 a barrel, while the highest are in 
        the Midwest at $4.40 a barrel.\182\
---------------------------------------------------------------------------
    \182\ Reuters, US Refining Margins in Red in Most Regions--Report, 
May 14, 2002.

The high costs of Brent were cited as reasons for production 
cuts at the Valero and Phillips refineries in New Jersey.\183\
---------------------------------------------------------------------------
    \183\ Id. In mid-May, Valero announced it would cut back on 
refinery production by 23 percent--or by 360,000 barrels per day--as a 
result of ``high product inventory levels and uneconomical operating 
conditions.'' The Oil Daily, Refiners Put Brakes On As Car Season 
Nears, May 17, 2002; Oil Market Intelligence, Americas: Where's the 
Upside?, May 21, 2002. ``The very low margin between the selling price 
of gasoline and the purchase price of crude oil is the reason for the 
run cuts,'' Valero officials stated Dow Jones, Valero Cuts Runs at Non-
West Coast Refineries by 20%, May 16, 2002.
---------------------------------------------------------------------------
    The negative effects of the SPR program on refinery 
performance is of concern because low refining margins 
threatening the financial viability of many U.S. refiners. Low 
and volatile refining margins have been one of the main factors 
underlying the large degree of consolidation in refinery 
ownership that has occurred in recent years. In a number of 
areas of the country the refining industry has become highly 
concentrated, exacerbating the volatility of gasoline prices, 
harming consumers and the national economy.\184\ To the extent 
that governmental action imposes additional costs upon this 
industrial sector with no attendant benefits, further 
investment in this sector is discouraged, energy security is 
diminished, and consumers are harmed.
---------------------------------------------------------------------------
    \184\ The Subcommitttee's Report, Gasoline Prices: How Are They 
Really Set? on page 322 of the PSI hearings held Apr. 30 and May 2, 
2002, S. Hrg. 107-509, addressed these issues.
---------------------------------------------------------------------------
    Perhaps most significantly, in recent years refiners have 
been reducing inventories as a way to reduce costs. 
Governmental actions and policies that increase the costs for 
refining crude oil, without any commensurate benefits, will 
lead refiners to reduce inventories even further.\185\ This 
will lead to more price volatility and higher consumer prices.
---------------------------------------------------------------------------
    \185\ For example, independent refiner Valero, which was one of the 
companies most affected by the increase in crude oil prices and the 
narrowing of the heavy/light differential in early 2002, and facing a 
downgrade by Moody's credit-rating agency, recently announced that it 
had cut its stocks from a high of 69 million barrels in 2002 to 54 
million barrels. Philip K. Verleger, Jr., Notes at the Margin, February 
3, 2003.
---------------------------------------------------------------------------

C. Oil Company Decisions to Send So Much Brent to the SPR

    Although DOE provides SPR contractors with the option to 
place a variety of sweet crude oils into the SPR, from the 
fourth quarter of 2001 through the second quarter of 2002, 
nearly 90 percent of the sweet crude oil deposited into the SPR 
was Brent crude oil. The placement of so much Brent crude oil 
into the SPR, as well as the shipment of so much Brent to 
China, halved the normal Brent-WTI differential for most of 
this period and squeezed the Brent market twice, once in 
January, and once around April. The Arcadia squeeze of 2000 had 
demonstrated the price increases that would follow of a squeeze 
in the Brent market, so traders acquiring large amounts of 
Brent in 2002 would have known that acquiring large amounts of 
Brent would significantly increase prices.
    One of the issues examined by this investigation is whether 
traders may have acquired large amounts of Brent in early 2002 
to create these foreseeable impacts and profit from them, or 
whether the decision to acquire large amounts of Brent was 
motivated by other commercial interests.\186\ Because of the 
complexity of the analysis required, and the unavailability of 
information about OTC trading activity, the Subcommittee 
Minority staff was unable to reach a conclusion on this matter.
---------------------------------------------------------------------------
    \186\ Even if trading activity is undertaken pursuant to a 
legitimate commercial purpose, however, a trader's activity still may 
amount to abuse under U.K. law or manipulation under U.S. law if the 
trader exacerbates a ``natural'' squeeze that has arisen. The CFTC has 
warned that traders who continue to purchase ``long'' contracts during 
a squeeze may be found to have violated the prohibition against 
manipulation. See Appendix 1.
---------------------------------------------------------------------------
    The following discussion presents the explanations provided 
by oil companies interviewed by the Minority Staff as to why 
they acquired large amounts of Brent in late 2001 and early 
2002. Because of the voluminous and complex records underlying 
these transactions, the Staff did not examine company 
documents.
    In essence, traders with companies that purchased large 
amounts of Brent in early 2002 told the Subcommittee staff that 
their purchases of futures contracts for Brent were undertaken 
solely for hedging purposes, were limited to the amount of 
contracts necessary to accomplish this purpose, and were not 
undertaken for the speculative purpose of profiting from rises 
in the price of Brent. Similarly, these officials stated that 
their use of the 15-day Brent OTC market was for the purposes 
of hedging and acquiring Brent cargoes.
    Sempra Energy Trading Company officials told the 
Subcommittee staff that in November 2001, Chinese refiners 
placed large orders for Atlantic Basin sweet crude oil because 
the Brent-Dubai differential had narrowed, making it more 
economic to purchase Brent and other Brent-based grades than 
sour Middle Eastern grades. Sempra officials stated they used 
the futures market to hedge the purchase price of the cargoes 
it was acquiring, and did not make trades to exacerbate the 
squeeze.
    Shell officials told the Subcommittee staff that in late 
January and early February it received a large number of 
inquiries and orders for light sweet crude oil. Shell believed 
these orders were placed by oil companies seeking light sweet 
crude oil to meet the DOE's SPR fill requirements, and from 
other traders who had postponed their purchases of North Sea 
crudes until the market had returned to contango following the 
backwardation arising from the purchase of Brent for buyers in 
Asia. Shell stated that its public statement on February 11 
that it had potential orders for all of the Brent crude loading 
in March evidences its intent to avoid an exacerbation of the 
market congestion, which, Shell admitted, was partially done 
for purposes of self-interest, as it was acquiring cargoes 
during this period. Shell claimed that its announcement, 
despite causing a 1-day price spike in the market, helped 
prevent the type of squeezes that occurred in January and April 
2002.
    BP stated that its schedule for delivering crude oil into 
the SPR was set by the DOE pursuant to the requirements of the 
exchange program under which BP had previously acquired crude 
oil from the SPR, and to meet this schedule it was necessary to 
acquire large amounts of Brent crude for loading in April and 
May 2002. BP pointed to the fact that in early April it 
requested the DOE to permit a deferral of its obligations in 
light of the high price of Brent that prevailed at the time as 
evidence that it sought to relieve rather than exacerbate the 
market congestion resulting from the large demands placed on 
the Brent market from the SPR program.
    All of the traders interviewed by the Subcommittee staff 
stated that Brent was the light sweet crude that was easiest 
and most economical to obtain. Some traders stated Brent was 
preferable even at a small premium in price to other acceptable 
sweet crudes because the price of Brent could be hedged more 
precisely and because of the ease of obtaining large amounts of 
Brent, both directly from the loading terminal at Sullom Voe 
and through trades with other companies.
    Officials from the London IPE stated in interviews with the 
Subcommittee staff that their review of IPE trading activity in 
early 2002, which included a review of trading positions and 
discussions with all of the parties involved in significant 
trades of Brent, did not detect any violations of exchange 
rules by any traders within its jurisdiction. Officials with 
the U.K. FSA attributed the unusual movements in the price of 
Brent to the dwindling supply of Brent, and did not conclude 
there was any market abuse under U.K. law. But IPE officials 
also noted that their review of the Brent market encompassed 
only trading activity within the IPE's market, and did not 
extend to other markets, such as trading on the OTC markets.
    The Subcommittee's review did not include a review of OTC 
activity, since data on OTC trading activity is not available. 
Without information about the OTC positions held by traders, 
such as the amount and types of contracts purchased or sold, 
the price paid, and the dates of the transactions, it is 
impossible to arrive at any conclusion regarding whether or not 
the OTC markets were used to exploit the squeezes in the 
physical and commodity markets, or whether positions were taken 
in the OTC markets that would constitute manipulation or abuse 
if undertaken on the futures markets.

                      V. THE 2002 SPR FILL PROGRAM

          ``If you decide to have a simple rule for acquiring 
        SPR oil, the worst one you could possibly pick would be 
        filling at a constant rate of speed.''
            --Internal DOE Analysis of SPR Program

          ``As to the questions that relate to the deferring of 
        the filling of the Reserve because of issues that 
        relate to price, we believe it's in our interest at 
        this point to continue moving ahead at the pace we're 
        moving to continue filling the Reserve, and not to 
        defer that because of price fluctuations.''
            --U.S. Secretary of Energy, April 9, 2002

    In November 2001, the President directed the Secretary of 
Energy to fill the SPR to its 700 million barrel capacity ``in 
a deliberate and cost-effective manner.'' Existing DOE market-
based practices were to acquire crude oil for the SPR while oil 
prices were relatively low and less oil when prices were 
relatively high. Pursuant to this market-based policy, DOE had 
routinely allowed oil companies to defer scheduled shipments to 
the SPR when prices were high in return for additional barrels 
of crude oil deposited into the SPR at a later time. This 
approach had allowed DOE to avoid disrupting the crude oil 
markets and the economy while filling the SPR.
    In February 2002, DOE decided to stop allowing SPR 
deferrals. Under the new policy, oil was to be put into the SPR 
at a constant rate, regardless of the price of oil. Documents 
provided to the Subcommittee by DOE indicate the decision to 
overturn the SPR program's market-based fill procedures was 
made by the Secretary of Energy after consulting with other 
high-ranking Administration and White House officials.
    DOE documents show SPR career officials opposed discarding 
the market-based procedures they had been using to fill the SPR 
and then pushed for a return to those procedures. SPR officials 
accurately warned about the negative consequences of the no-
deferral policy, including higher prices for crude oil, a 
dampening of economic growth, and foregone savings of hundreds 
of millions of taxpayer dollars. SPR career officials also 
accurately projected that filling the SPR without regard to 
global supplies or crude oil prices would reduce U.S. private 
sector inventories of crude oil, thereby undercutting the 
fundamental purpose of the SPR program--to ensure this nation 
has adequate supplies of crude oil in the event of a major 
disruption in oil supplies.

A. DOE Changed SPR Policy to Require SPR Fills Regardless of Oil Prices

    In February 2002, BP, an oil company, asked DOE for 
permission to defer delivery of 9 million barrels of Brent 
crude oil that BP was contractually required to deliver to the 
SPR in May, June, and July 2002. At the time of BP's request, 
SPR Business Procedures allowed deferrals of scheduled deposits 
into the SPR provided the company seeking the deferral 
compensated the government for the delay by depositing 
additional amounts of oil into the SPR at a later time.\187\ 
SPR policies allowed the SPR Office to ``let the markets 
determine [its] buying pattern'' and to use its crude oil 
acquisition strategy ``to stabilize markets.'' \188\
---------------------------------------------------------------------------
    \187\ See Section II and Appendix 3, Exhibit II-1, for a copy of 
the published procedures.
    \188\ See Section II and Appendix 3, Exhibit II-2.
---------------------------------------------------------------------------
    As explained in Section IV, in early 2002 Brent crude oil 
was in scarce supply due to large numbers of shipments of Brent 
to China and the SPR. As a result of the increased demand for 
Brent, Brent prices had increased in the spot and futures 
markets, and the difference in price between Brent and WTI had 
narrowed to about 75 cents, a level at which it generally is 
uneconomic to ship crude oil across the Atlantic. According to 
BP officials, BP was concerned that taking additional large 
quantities of Brent out of the marketplace at that time would 
further strain Brent supplies and increase prices, and so 
requested DOE to defer delivery of the 9 million barrels of 
Brent BP was required to deposit in the SPR. DOE denied the 
request.
    On March 18, 2002, as the near-month price of Brent climbed 
to $25 a barrel and near-term prices on the Brent futures 
market exceeded future prices (shifting the market into 
backwardation), BP renewed its request for a deferral. In an e-
mail to a DOE SPR official, Exhibit V-1, a BP official offered 
to deliver an additional 500,000 barrels if DOE would allow a 
1-year deferral. In the e-mail, the BP official stated the 
deferral would ``eas[e] logistical issues,'' and wondered 
``whether the politicians might be keen given the rise in 
prices that we are currently seeing.''
    In reviewing the BP offer, another SPR official wrote in an 
internal e-mail dated March 20, Exhibit V-1, ``See no change in 
the no deferral policy unless the price of oil increases. 
Recommend saying thank you, but not at the present time.'' On 
March 20, William C. (``Hoot'') Gibson, the DOE Project Manager 
at the SPR site in Louisiana, responded to BP by e-mail, 
stating that DOE wanted to proceed with filling the SPR, and 
that BP should deliver according to the terms of the 
contract.\189\
---------------------------------------------------------------------------
    \189\ This e-mail was described in a telephone conversation between 
DOE and Subcommittee staff on November 20, 2002, but DOE has not 
provided the Subcommittee with a copy.
---------------------------------------------------------------------------
    The next day, March 21, 2002, a DOE official, in an 
internal e-mail sent to other SPR officials, Exhibit V-2, wrote 
that John Shages, Director of the Finance and Policy Office in 
the SPR program, planned to discuss the no-deferral policy with 
the staff of the National Security Council, so the issue should 
not be considered ``totally closed.'' According to this e-mail:

          Deferrals in general were discussed in our PR 
        [Petroleum Reserves] staff meeting this morning, with 
        Hoot in attendance. John Shages said he wanted to 
        discuss with the National Security Council to make sure 
        he understood what the White House's reaction would be 
        if prices were to go up to the politically sensitive 
        level of $30/bbl or so. I think the issue is not 
        totally closed and will be discussed further by 
        management.

    On April 1, following an increase in the near-month Brent 
price to nearly $27 per barrel, BP again asked DOE to allow a 
deferral, and upped its offer by another 250,000 barrels. ``I 
know that you said last week that the government would have no 
interest in deferring the exchange barrels,'' the BP official 
wrote in Exhibit V-3, ``but the oil price does keep rising. As 
of this morning we calculate a years deferral would be worth an 
extra 750,000 [barrels] to you. I'm not trying to bug you on 
this, but just wanted to make sure you knew of the 
opportunity.''
    DOE officials told the Subcommittee staff that ``issue 
papers'' discussing BP's deferral request were provided to the 
Secretary of Energy as well as to National Security Council 
(NSC) and National Economic Council (NEC) officials at the 
White House. These DOE officials also told the Subcommittee 
staff it was their belief--although they did not have actual 
knowledge of the decision process--that the decision to adopt a 
no-deferral policy was then made by the Secretary of Energy in 
consultation with other high-ranking White House and 
Administration officials.\190\
---------------------------------------------------------------------------
    \190\ Telephone conversations with Subcommittee staff, November 7, 
15, and 20, 2002. In a letter dated December 9, 2002, the Subcommittee 
asked DOE to provide all documents generated after November 2001, 
related to deferrals of SPR deliveries. On January 10, 2003, DOE 
provided several hundred pages of responsive documents to the 
Subcommittee, but also stated, ``Certain additional documents still are 
under review.'' DOE staff subsequently told Subcommittee staff no 
responsive documents containing communications between DOE and the 
Executive Office of the President would be provided. DOE has yet to 
provide the Subcommittee with copies of documents indicating they were 
prepared for the Energy Secretary, NSC, or NEC officials related to the 
SPR deferral issue.
---------------------------------------------------------------------------
    The no-deferral policy was publicly announced by the 
Secretary of Energy at a press briefing on April 9, 2002. This 
press briefing took place a few hours after a meeting of 
several Cabinet members, including the Secretary of Energy, at 
the White House.\191\ A reporter asked the Secretary, ``In 
light of Venezuela and Iraq, how serious are you about using 
the Strategic Petroleum Reserve or, maybe to a lesser extent, 
deferring royalty oil?'' The Secretary responded:
---------------------------------------------------------------------------
    \191\ Telephone conversations with Subcommittee staff, November 7, 
15, and 20, 2002.

          Well, in terms of a decision to tap the Strategic 
        Petroleum Reserve, I think the President has made it 
        very clear that that happens if there's a belief that 
        it's in the national security interests of this 
        country. We're not at the point of making a--even 
        looking at those options at this point. It's obviously, 
        however, a tool available to the President should he 
        conclude national security interests are involved.
          As to the questions that relate to the deferring of 
        the filling of the Reserve because of issues that 
        relate to price, we believe it's in our interest at 
        this point to continue moving ahead at the pace we're 
        moving to continue filling the Reserve, and not to 
        defer that because of price fluctuations.\192\
---------------------------------------------------------------------------
    \192\ Federal News Service, April 9, 2002.

    After the Secretary's public statement on the deferral 
policy, a senior SPR career official prepared an internal SPR 
document entitled, ``Options for Filling the SPR,'' Exhibit V-
4, which describes the change in the SPR fill policy. This 
document notes that the no-deferral decision was made ``after 
conferring with the White House'' and that the ``reasoning'' 
was ``not made public.'' The author observes, however, that 
``the most plausible explanation'' is to fill the SPR as fast 
as possible ``for national security or energy security 
---------------------------------------------------------------------------
reasons.'' One passage states:

          Prior to the events of September 11, 2001, the SPR 
        Office routinely renegotiated delivery dates. The 
        business model of trading more delivery time for 
        increased volumes of oil was characterized by reduced 
        costs, conformance with normal private sector 
        practices, logistical flexibility to accommodate busy 
        terminals or maintenance requirements at the sites, and 
        acceptance by all of the companies with contracts. In 
        February 2002, the SPR Office received a request to 
        defer deliveries of 9 million barrels of oil for a 
        year. The initial offer of extra oil in consideration 
        of the deferral was valued at $18 million. In order to 
        stay in conformance with the President's highest 
        priorities, the SPR Office asked the Administration for 
        guidance prior to negotiating for this deferral, and 
        the Secretary after conferring with the White House 
        announced we were planning to take oil deliveries on 
        schedule without deferrals. The reasoning for turning 
        away from a successful business model was not made 
        public, however, the most plausible explanation is a 
        desire to have as much oil in the SPR as fast as 
        possible for national security or energy security 
        reasons.

    Two internal DOE e-mails, Exhibits V-5 and V-6, provide 
more evidence that SPR deferral issues were discussed by senior 
Administration officials to resolve conflicting views on 
whether to postpone SPR oil shipments when crude oil prices 
were high. These e-mails indicate that the Department of 
Interior (DOI), which oversees the exchange of royalty oil from 
federally-owned offshore leases for crude oil to be deposited 
into the SPR, wanted to stop transferring oil to the SPR 
program ``when a certain trigger price for oil is reached'' 
such as $30 per barrel.\193\ According to these e-mails, the 
DOI and DOE positions differed on whether transfers of oil to 
the SPR should stop when the trigger price was reached, and the 
issue was to be resolved by the Deputy Secretary of Interior 
and the Deputy Secretary of Energy, ``and then reviewed by the 
White House.''
---------------------------------------------------------------------------
    \193\ See Section II.C.2 for a description of the role of the DOI 
in filling the SPR program. As explained in this section, the higher 
the price at which royalty oil is used for the SPR program, the greater 
the loss to the Treasury from royalty revenues, and hence the greater 
the total program cost to the taxpayer.
---------------------------------------------------------------------------
    Exhibit V-5, an e-mail dated November 15, 2001, from John 
Shages, of the SPR Office, to Deputy Secretary of Energy 
Francis Blake, states:

          Frank: We held a meeting today with the Minerals 
        Management Service hierarchy today. They allowed 
        [Deputy Secretary of Interior] Steve Griles gave them 
        clear instructions that if oil prices spike, and it 
        becomes desirable to stop filling the SPR, the MMS 
        should stop the transfer of royalty oil to DOE. We made 
        the case for continuing the transfer and allowing DOE 
        to manage the delivery schedule to eliminate the 
        unwanted demand. They immediately said the issue would 
        have to be resolved by you and Steve Griles, and then 
        reviewed by the White House. They proposed writing an 
        issue paper for you and Steve Griles, and then reviewed 
        by the White House. They proposed writing an issue 
        paper for you and Steve Griles, and we have agreed to 
        do that jointly with them. While we believe the pros 
        and cons of this issue are obvious, MMS feels they need 
        some time to prepare their position and asked for 
        November 28 as a date to have the paper ready for 
        delivery to you, and we also agreed to that.

Although both e-mails indicate a joint DOI-DOE issue paper was 
being prepared to help resolve this interagency dispute, DOE 
informed the Subcommittee staff that the dispute was resolved 
in DOE's favor after oral discussions and no such document was 
ever prepared.
    Together, these internal DOE documents indicate that DOE's 
decision to deny BP deferral requests were made after the 
Secretary of Energy consulted with other senior Administration 
and White House officials. DOE has declined to provide the 
Subcommittee, however, any documents prepared by SPR or other 
DOE staff for the Secretary of Energy, other top DOE officials, 
DOI, NSC, NEC, or other officials in the White House related to 
the deferral decision. DOE officials have also provided limited 
and, at times, inconsistent information on the process by which 
the Energy Secretary made the decision to deny the BP deferral 
requests and, more generally, to overturn the SPR Office's 
market-based deferral policy in favor of an inflexible rule 
against deferrals.

B. SPR Career Officials Opposed Policy Change and Warned DOE the New 
                    Policy Would Increase Oil Prices, Consumer and 
                    Taxpayer Costs

    In response to the Subcommittee's request for documents 
related to the change in SPR deferral policy, several issue 
papers were provided from the files of SPR officials. These 
documents provide candid assessments by SPR career officials of 
the new no-deferral policy and record their repeated attempts 
to return to a market-based deferral policy.
    Exhibit V-7 is an internal SPR memorandum analyzing 
possible fill rates for the SPR. It notes that DOE has ``the 
option of entertaining offers to delay [SPR] deliveries in 
return for bonus barrels of oil which could relieve the 
speculative oil market,'' as well as options to further 
accelerate the fill rate. The undated memorandum appears to 
have been written for higher-ranking Administration officials 
evaluating BP's April 1 request for a deferral, since it 
states, ``DOE has received an offer to pay an additional 
750,000 barrels of oil in exchange for rescheduling 9 million 
barrels to one year later,'' and discusses the pros and cons of 
accepting the offer.
    The document summarizes the previous deferral policy of the 
SPR Office as follows: ``During 2000 and 2001, whenever these 
conditions arose, the SPR Office agreed to later delivery dates 
in exchange for more oil. Renegotiation of delivery dates, if 
proposed by contractors, in exchange for more oil is the 
standard business practice for SPR oil acquisition.'' The 
document notes that deferrals during these years enabled DOE to 
acquire 7 million barrels of additional SPR oil at no cost, 
thereby saving the Treasury $175 million.\194\
---------------------------------------------------------------------------
    \194\ See Section II.
---------------------------------------------------------------------------
    The document provides an overview of the economic, energy 
security, budgetary, foreign relations, and market consequences 
of accelerating or deferring shipments to the SPR. The document 
summarizes the pros and cons of deferrals as follows:

     Option 1: Do not entertain offers to renegotiate delivery dates

                                  Pros

     Sends no signals to producing countries or allies

     Fills the SPR at an even rate between now and 2005

     Does not raise any speculation that the Administration is 
willing to meddle in the market

                                  Cons

     Deviates from the normal SPR business practice

     SPR fill would continue even if markets become distressed 
or highly speculative

                  Option 2: Renegotiate delivery dates

                                  Pros

     Reduces the program cost to Treasury, with a potential in 
the hundreds of millions of dollars

     Acts automatically to counteract market volatility by 
increasing demand when prices are relatively low and reducing demand 
when prices are relatively high

     Acts to mitigate an unwelcome price rise while the 
world's economies are only beginning to recover from recession

     Could be viewed favorably by consumers

                                  Cons

     Delays the addition of oil to the SPR, with energy 
security implications

     May appear to be a market intervention or an attempt to 
challenge OPEC in controlling market inventories and prices

     Could be viewed as an accommodation to ``big oil''

The memorandum favors granting deferrals, identifying as 
potential benefits, among others, the saving of hundreds of 
millions of dollars for the Federal Government and lowering 
``unwelcome'' crude oil price increases to benefit consumers 
and national economies.
    A second document, Exhibit V-4, described earlier, was 
prepared after the Secretary of Energy's announcement on April 
9, 2002, of the new no-deferral policy. This document describes 
how the policy to allow deferrals was overturned by the 
Secretary after conferring with the White House, warns of the 
adverse consequences of a no-deferral policy, and proposes a 
return to the previous policy allowing market-based deferrals, 
which the paper calls ``a successful business model.''
    According to this document, one of the prime reasons 
provided to the SPR Office for not granting deferrals was ``the 
concern that the Government should not manipulate the market.'' 
Countering this assertion, the paper explains in detail how 
``its normal business practice does not manipulate the market, 
but instead conforms with the goal [that] the acquisition 
should minimize impact on market forces.'' Indeed, the paper 
notes, ``The simple rule of taking SPR oil as it is 
contractually due exaggerates [price swings caused by OPEC 
production], since the SPR takes the same volume regardless of 
price. It is a business model different from all private market 
participants, and if followed by a significant number of market 
participants would lead to explosive prices swings.''
    The paper advocates a return to acting in ``a rational 
business-like manner'':

          The SPR Office proposes a return to the SPR oil 
        acquisition business model, allowing deferrals which 
        will always be counter-cyclical to OPEC induced price 
        volatility. Since there would be consistency in our 
        behavior, markets would not be surprised, and 
        contractors would be comfortable knowing that the 
        Government was acting in a rational business-like 
        manner. Acquiring less oil in high price markets and 
        more oil in low price markets is . . . ordinary 
        behavior, [and] it would have much less impact on 
        market forces than does the practice of ignoring price 
        and acquiring just as much oil at high prices as at low 
        prices.

    The document also identifies a number of benefits from 
allowing deferrals when market prices are high. The document 
notes, ``it would be good public policy if oil acquisition were 
to take [place] during robust growth and deferred when the 
economy is in a cyclical downturn.'' Identified benefits 
include reduced costs of oil imports, an improved balance of 
trade, and reduced costs for the SPR program.\195\
---------------------------------------------------------------------------
    \195\ The final page of this document describing the benefits of 
the SPR's prior deferral policy ends in mid-sentence, one-third of the 
way down the page. Despite repeated requests, DOE has yet to explain 
the missing or redacted information.
---------------------------------------------------------------------------
    Another document, Exhibit V-8, is entitled ``Renegotiation 
of Delivery Dates for Strategic Petroleum Reserve Oil'' and 
contains a handwritten notation ``5/2/2002'' in the upper-right 
hand corner. It is a one-page document that, again, advocates 
``allow[ing] the [SPR] Office to resume negotiations of 
delivery dates for oil that is contracted for delivery on 
certain future dates.'' According to this document, the 
advantages to allowing renegotiation of delivery dates are that 
it is ``very business like''; it ``increases the inventory of 
the Reserve without fiscal expense''; the practice ``testifies 
to serious management by bringing down the average cost of oil 
in the Reserve''; and it is ``good public policy'' because 
deliveries ``can be successively renegotiated until [private 
sector] inventories are normal, near-term prices are low and 
the economy is growing strongly.'' The author observes, 
``Insisting on deliveries to the SPR during [a] tight market 
would be heavily criticized as mismanagement and would be 
difficult to defend.''
    Exhibit V-9 is a June 5, 2002, memorandum from John Shages, 
a senior SPR official, to Paul Leiby of the Oak Ridge National 
Laboratory (ORNL), \196\ in response to an earlier memorandum 
sent by Mr. Leiby in May 2002, Exhibit V-10, on designing a 
study of the economic impacts of filling the SPR. In his 
memorandum, Mr. Shages argues that a policy of allowing 
deferrals of deliveries into the SPR based on market conditions 
can provide a variety of significant benefits, including lower 
overall market prices for crude oil, an improvement in the 
balance of trade by $250 million per month, and greater amounts 
of crude oil available for private sector inventories.
---------------------------------------------------------------------------
    \196\ Mr. Leiby is the principal author of a report prepared for 
the SPR Office in November 2000, entitled ``The Value of Expanding the 
U.S. Strategic Petroleum Reserve,'' and has authored several other ORNL 
reports on the SPR.
---------------------------------------------------------------------------
    In one passage, the document states the new no-deferral 
policy ``appears irrational to the market place.'' The document 
observes that this new policy--which is termed the ``status 
quo''--may have facilitated the squeeze in the Brent market in 
April 2002:

          For 2 years, any contractor could look at the 
        backwardation in the futures market, and make us an 
        offer for deferral. We ran our own valuation of the 
        delay, set a negotiating target for ourselves for a 
        share of the money on the table, and if we hit our 
        target we agreed to the deferral. Every contractor 
        deferred deliveries; they understood the process, it 
        mimicked what they do in the private sector, and no 
        surprises. The status quo is what appears irrational to 
        the market place. It leaves the contractor vulnerable 
        to things such as a short squeeze in the Brent market, 
        and in fact there have been some attempts to blame a 
        recent squeeze in the dated Brent market on us for 
        demanding delivery regardless of market circumstances. 
        Also, remember Howard Borgstrom's thesis. It can be 
        boiled down to, ``If you decide to have a simple rule 
        for acquiring SPR oil, the worst one you could possibly 
        pick would be filling at a constant rate of speed.''

In another passage, the document describes the no-deferral 
policy as ``a fill model that was discredited years ago.''
    Together, these DOE documents demonstrate that SPR career 
officials were aware of and warned against the negative 
consequences of a strict no-deferral policy, from encouraging 
``explosive price swings,'' to increasing taxpayer and consumer 
costs, to increasing the market's vulnerability to squeezes. 
The documents also demonstrate SPR officials advocated 
returning to a flexible deferral policy based on market 
conditions and overall national energy security.

C. SPR Career Officials Warned DOE the New Policy Would Reduce U.S. 
                    Crude Oil Commercial Inventories

    Exhibit V-4, the internal SPR memorandum prepared by a 
career SPR official, also accurately warned DOE that filling 
the SPR during a tight market would reduce U.S. private sector 
crude oil inventories.
    This prediction is based on fundamental market principles 
of supply and demand. In a tight market--when immediate demand 
is high relative to supply--every barrel of oil that goes into 
the government's inventory is at least one less barrel for 
private sector inventories. When near-term prices are high 
relative to future prices (i.e., when the market is in 
backwardation), refiners are more likely to take oil from their 
existing stocks than pay for expensive spot market purchases of 
crude oil.\197\ When the U.S. Government increases its own 
crude oil inventories during a tight market, it further 
tightens the market--reducing supplies and raising prices--
making it even more uneconomic for the private sector to 
increase commercial inventories.\198\
---------------------------------------------------------------------------
    \197\ See, for example, Section IV of this Report, showing how 
refiners in the Midwest drew upon their crude oil inventories during 
the spike in near-term WTI prices in April and May 2002.
    \198\ It has been suggested that each barrel placed into the SPR 
during a tight market in preparation for an imminent interruption in 
supply may displace more than one barrel in private sector inventories. 
Not only is each barrel placed into the SPR one less barrel for use in 
the private sector, either in a refinery or in storage, but to the 
extent that producers and refiners know the SPR will be available, they 
may be less likely to stockpile themselves. For example, one analyst 
recently commented, ``Why were the oil companies holding such huge 
inventories prior to the Persian Gulf War? You saw a similar buildup 
prior to the Iran-Iraq war. And why aren't they building them now? . . 
. [I]t could be that they are relying on the U.S. Strategic Petroleum 
Reserve, and counting on the government to hold the extra supply for 
them.'' Melita Marie Garza, Fuel Price Escalation Already Spills Into 
Cost of Other Goods, Chicago Tribune, January 26, 2003, quoting Bill 
O'Grady, vice president, futures research, A.G. Edwards.
---------------------------------------------------------------------------
    Although the daily fill rate of the SPR is relatively small 
compared to daily global consumption and production rates for 
crude oil, it is sufficient to remove several millions of 
barrels of crude oil from the market over the course of a few 
weeks. In a tight market, this marginal reduction in market 
supplies can cause a corresponding reduction of several million 
barrels of crude oil from private sector inventories. SPR 
career officials were well aware of this causal relationship. 
Exhibit V-4 explains:

          Essentially, if the SPR inventory grows, and OPEC 
        does not accommodate that growth by exporting more oil, 
        the increase comes at the expense of commercial 
        inventories. Most analysts agree that oil prices are 
        directly correlated with inventories, and a drop of 20 
        million barrels over a 6-month period can substantially 
        increase prices. . . . A variation of 3 or 4 million 
        barrels from expected inventory can change prices more 
        than a dollar per barrel during a day. Clearly, a 
        change in private inventories equal to the SPR 
        inventory change could have a substantial price impact.

    In a June 5, 2002, memorandum, Exhibit V-9, John Shages 
predicted the SPR fills would significantly reduce private 
sector crude oil inventories:

          Given OPEC behavior over the last 18 months, I 
        believe OPEC is not accommodating economic growth, much 
        less an inventory drop caused by SPR fill. . . . If you 
        accept the assumption of an intransigent OPEC, then the 
        impact of SPR fill on inventories is not a seemingly 
        innocuous 100,000 barrels per day, but a powerful 30 
        million barrel reduction of private inventory over 10 
        months.

    Later in the June 5 memo, Mr. Shages discusses the SPR's 
impact on U.S. inventories as follows: ``Think of the deferrals 
not as a daily flow, but as a change to projected inventory in 
the private sector. If, come December 2002, U.S. private 
inventories are down 30 million barrels of crude oil, we will 
have higher prices, nervous traders, a more confident OPEC and 
an [Iraq] that can cause price gyrations by deciding not to 
renew its export agreements for a month.''
    Mr. Shages accurately forecast the decline in U.S. private 
sector inventories in the latter half of 2002. Figure V-1 shows 
that, from June to October 2002, U.S. commercial crude oil 
inventories fell by nearly 50 million barrels, including 1-
month drops of 20 million barrels in July and 30 million 
barrels in September. These large drops in inventories followed 
price spikes in the WTI market in which near-term crude oil 
prices exceeded longer-term futures prices (backwardation). By 
February 2003, U.S. private sector inventories had declined to 
their lowest levels since the EIA began keeping national 
inventory data records in 1979.
    Not only have U.S. private sector inventories declined to 
unprecedented low levels, but these levels have become 
dangerously low--dipping under 270 million barrels which is 
considered the ``Lower Operational Inventory'' for the U.S. 
refining industry. According to the EIA, ``While there is 
nothing to prevent inventories from falling below 270 million 
barrels, were that to occur, less flexibility would be 
expected, and according to the National Petroleum Council, 
localized disruptions in refinery operations could be 
expected.'' \199\ U.S. commercial inventories have hovered 
around the Lower Operational Inventory Level from the latter 
part of 2002 to the present, risking refinery disruptions due 
to inadequate supplies.
---------------------------------------------------------------------------
    \199\ EIA, This Week in Petroleum, January 15, 2003.

    [GRAPHIC] [TIFF OMITTED] T5551.049
    
    Over the same time period, DOE continued to fill the SPR at 
a steady rate of about 100,000 barrels per day, or about 3 
million barrels per month, regardless of the tightening market 
conditions. The total amount of oil deposited into the SPR from 
June through November exceeded 20 million barrels.
    Figure V-2 shows both the increasing deposits into the SPR 
and the decline in U.S. crude oil commercial inventories during 
2002. Figure V-2 also shows the periods in which the WTI market 
was in backwardation during 2002. When the market is 
backwardated, the near-term price of crude oil is higher than 
the price of oil farther in the future. Under these market 
conditions, refiners will use oil in their existing inventories 
rather than purchase expensive oil on the spot market. Placing 
oil into the SPR when near-term prices are relatively high 
therefore exacerbates the tightness of the market, pushing 
near-term prices even higher, and providing incentives for 
refiners to take oil out of inventory. Thus, as can be seen 
from Figure V-2, depositing oil into the SPR during a tight 
market has the direct effect of depleting private sector 
inventories.

[GRAPHIC] [TIFF OMITTED] T5551.050

    According to the fundamentals of supply and demand, 
reductions in crude oil inventories place upward pressure on 
crude oil prices. By comparing Figure V-1 and Figure V-3, it 
can be seen that at the same time total inventories dropped 
from over 320 million barrels at the end of May to just over 
270 million barrels by the beginning of October, the spot price 
of WTI rose from just under $25 to nearly $31 per barrel. This 
relationship between inventory and price is a typical pattern 
in commodity markets, and was also predicted by SPR career 
officials in the spring of 2002, in Exhibits V-4, V-7, and V-9. 
As demonstrated in the case study in Section IV, placing oil 
into the SPR in a tight market can trigger a vicious cycle of 
lower inventories and higher prices.

[GRAPHIC] [TIFF OMITTED] T5551.051

    Despite rising oil prices, tight markets, and shrinking 
commercial inventories throughout the latter half of 2002, DOE 
kept the SPR no-deferral policy in place. Figure V-4 shows how 
the SPR continued to fill at a constant rate from October 2001, 
through the first 9 months of 2002, the period for which the 
Subcommittee staff obtained detailed SPR program data.

[GRAPHIC] [TIFF OMITTED] T5551.052

    The inflexibility of the DOE's no-deferral policy was 
demonstrated in late September and early October 2002 when DOE 
insisted upon crude oil deliveries to the SPR even as Gulf 
Coast refineries were hit by supply disruptions and shut down 
due to tropical storms battering the Gulf Coast.
    In advance of Tropical Storm Isidore in late September, 
nearly 600 offshore oil and gas rigs in the Gulf of Mexico were 
evacuated, shutting down 95 percent of crude oil production in 
the Gulf. Most of the evacuated workers did not return or had 
to be re-evacuated the next week in advance of Hurricane 
Lili.\200\ In just over 1 week Isidore and Lili together halted 
the production of about 10 million barrels of crude oil from 
offshore platforms.\201\
---------------------------------------------------------------------------
    \200\ See John Sullivan, Double Hit for Oil Industry, Daily 
Advertiser (Lafayette, Louisiana), September 26, 2002; Marc Dupee, 
Market Eyes Wrath of Hurricane Lili, October 3, 2002.
    \201\ John Sullivan, Double Hit for Oil Industry, infra; Business 
Wire, Lili Hits Offshore Hard; Platforms Register 150 mph Winds, 30-
foot Swells, October 4, 2002. Lili was a Category 2 hurricane over 
Louisiana, but a Category 4 hurricane when it passed over much of the 
oil and gas production area of the Gulf of Mexico. One company measured 
150 mile per hour winds at its production platform; another company 
reported that its semisubmersible drilling unit had been ripped from 
its moorings and blown 45 miles away before grounding in 35-foot deep 
water off the Louisiana coast. Id.
---------------------------------------------------------------------------
    On October 2, 2002, with Hurricane Lili ``bearing down'' on 
its Louisiana refinery, its crude oil supplies depleted due to 
the disruption from Tropical Storm Isidore, its Ohio and 
Kentucky refineries running at reduced levels due depleted 
stocks and crude oil market shortages, and with near-term crude 
oil prices over $30 per barrel in the backwardated WTI futures 
market, Marathon Ashland Petroleum (MAP) requested DOE to defer 
its delivery of 250,000 barrels to the SPR scheduled for 
October ``in hopes that we can prolong or at least expedite the 
recommencement of refining operations.'' \202\
---------------------------------------------------------------------------
    \202\ See e-mails exchanged between MAP and the SPR Office in 
Exhibit V-11.
---------------------------------------------------------------------------
    DOE denied MAP's request. In an e-mail dated October 7, 
2002, Hoot Gibson, the DOE SPR site manager, wrote to other DOE 
SPR staff: ``The SPR policy per [the Deputy Assistant Secretary 
in the SPR Office at DOE headquarters] on deferrals of in bound 
crude oil is no deferrals at this time--deliveries should be 
made per current contract dates. Let me know by e-mail each 
deferral request received. Any media inquiries should be 
referred to Ms Rochon who will refer them to the proper contact 
in HQ. Thank you.'' On October 10, DOE informed MAP ``the SPR 
is not considering deferrals at the time.''
    This decision demonstrates DOE was so determined to 
increase the oil stored in the SRP that it was even willing to 
risk prolonging refinery slowdowns. Even after being warned by 
a major U.S. refiner that it lacked enough crude oil to keep 
its refineries running, DOE insisted that the refiner divert 
scarce crude oil to the SPR.
    The crude oil market deteriorated even further in the last 
2 months of the year. The prospect of war between the United 
States and Iraq, a major global supplier that provides 5-10 
percent of U.S. oil imports, increased market uncertainty 
regarding future crude oil supplies and prices. In early 
December, Venezuela, a major exporter of crude oil to the 
United States, began reducing exports to the United States due 
to labor strikes and political unrest. The coldest U.S. winter 
in recent years also increased demand for home heating oil, 
further tightening the crude oil markets.
    By mid-December 2002, several more refiners warned DOE that 
the shortage of crude oil imports from Venezuela would lead to 
refinery outages and requested a deferral of their upcoming 
shipments to the SPR. Initially, DOE denied these 
requests.\203\ Instead, DOE declared the Venezuela strike a 
``force majeur'' event under the SPR delivery contracts, which 
would allow a company to defer delivery if it could prove that 
the oil scheduled for delivery into the SPR had been Venezuelan 
crude and the company did not have adequate inventories to meet 
its SPR delivery requirements.\204\
---------------------------------------------------------------------------
    \203\ Cathy Landry, Sheela Ponnusamy, US DOE Rejects Requests to 
Defer SPR Deliveries on Venezuela Strike, Platt's Oilgram News, 
December 13, 2002.
    \204\ Id.
---------------------------------------------------------------------------
    Several days later, however, DOE agreed to allow any 
company to defer shipments scheduled for December 2002 or 
January 2003, even without such proof.\205\ These were the 
first SPR deferrals granted in more than a year. According to a 
public statement by the Secretary of Energy, this change in 
policy was made to ``help ensure that the deliveries will not 
negatively affect the oil market, while still providing for the 
energy security of the US.'' \206\ The result of this decision 
was that 7.8 million barrels scheduled for delivery in December 
and January became eligible for deferral.\207\ Nearly all of 
these scheduled deliveries were, in fact, deferred.
---------------------------------------------------------------------------
    \205\ Cathy Landry, US in Negotiations to Defer SPR Oil Deliveries, 
supra note.
    \206\ Id. This article quoted a DOE spokesman as saying the 
Secretary made the decision ``following consultation with advisors and 
oil company analysts.'' DOE has not provided the Subcommittee with any 
documentation related to this decision.
    \207\ Dow Jones Newswire, December 17, 2002.
---------------------------------------------------------------------------
    As the Venezuelan strike continued into 2003, and war 
tensions intensified, inventories remained near record lows, 
just above the ``Lower Operational Inventory'' level, and crude 
oil prices continued to mount. In early January 2003, DOE 
announced that deliveries then scheduled for February 2003--
approximately 3 million barrels--were also eligible for 
deferral.\208\
---------------------------------------------------------------------------
    \208\ Oil Daily, DOE Delays SPR Deliveries, January 6, 2003.
---------------------------------------------------------------------------
    On January 24, 2003, Senator Levin called on the 
Administration to suspend further SPR deposits ``until surging 
crude oil prices stabilize and consumers get relief from rising 
prices for gasoline, home heating oil, and other petroleum 
products.'' \209\ Specifically, Senator Levin requested 
deferral of 4.4 million barrels scheduled to be delivered in 
March 2003, and of 3.7 million barrels scheduled to be 
delivered in April 2003.
---------------------------------------------------------------------------
    \209\ See Sen. Levin Press Release, Exhibit V-12.
---------------------------------------------------------------------------
    On January 28, 2003, DOE approved requests from oil 
companies to delay the 4.4 million barrels scheduled for March 
delivery, but did not, at that time, delay the deliveries 
scheduled for April.\210\
---------------------------------------------------------------------------
    \210\ Oil Daily, DOE Defers SPR Deliveries, January 28, 2003.
---------------------------------------------------------------------------
    One week after granting the deferrals of the March 2003 
shipments--presumably to calm crude oil markets--DOE seemed to 
reverse course again, announcing a further acceleration of 
shipments into the SPR, beginning in April 2003. The new DOE 
schedule called for the deposit of an additional 24 million 
barrels over 6 months. In total, DOE now plans to deposit about 
40 million barrels of crude oil into the SPR in 2003.\211\ If 
carried out under current market conditions, these 2003 SPR 
deliveries will further reduce commercial supplies, further 
help drive up oil prices, and impose more costs upon U.S. 
consumers and businesses, again without ensuring any overall 
increase in U.S. oil supplies.
---------------------------------------------------------------------------
    \211\ The current schedule of SPR deliveries appears in Section 
II.C.2.
---------------------------------------------------------------------------
    Since abandoning its market-based strategy for deferring 
SPR deliveries when crude oil prices are high and supplies 
tight, the SPR program has failed to develop a consistent, 
coherent, or cost-effective deferral policy. The last-minute 
nature of the deferrals granted last December and January, the 
delay in making a decision on the April deliveries, and the 
further acceleration of shipments into the SPR in the face of 
record low inventories and high oil prices, demonstrate that 
DOE has yet to embrace a market-based policy.

D. SPR Documents State Filling the SPR Without Regard to Oil Prices 
                    Was Not Justified Even If A Major Supply Disruption 
                    Were Imminent

    The SPR career official who wrote Exhibit V-4, on options 
for filling the SPR, states that the SPR Office believes it 
should not matter to the United States government whether the 
crude oil then scheduled for delivery to the SPR in 2002 is 
actually delivered in 2002 or postponed to 2003, even if an 
``energy supply emergency'' were likely to occur within the 
next year. The reasoning underlying this advice is begun but 
interrupted in the version of this document provided to the 
Subcommittee. Exhibit V-4 states:

                      The Issue of Urgency to Fill

          As noted above the strongest argument against 
        renegotiating delivery schedules is that there is 
        urgency to fill the Reserve to its capacity. However, 
        given the current outlook for OPEC exports, and 
        commercial inventories, it appears to the SPR Office 
        the Government should be indifferent to deliveries of 
        the outstanding oil accounts receivable in 2002 or 
        2003. If in fact, a major event is likely to occur 
        within the next year that will cause an energy supply 
        emergency, it is arguably superior to have the

At this point the document ends in mid-sentence, leaving the 
rest of the page blank.\212\
---------------------------------------------------------------------------
    \212\ See footnote 195, infra.
---------------------------------------------------------------------------
    A clue as to the SPR Office's reasoning, however, is 
provided in Exhibit V-9, Mr. Shages's June 2002 memorandum to 
Mr. Leiby. In Exhibit V-9, Mr. Shages discusses the costs and 
benefits of postponing SPR deliveries scheduled for 2002 until 
2003. In this memo, Mr. Shages states there is almost no 
incremental benefit to the SPR from placing an additional 42 
million barrels, on top of the 570 million barrels already in 
the SPR, in 2002 rather than 2003, even if it were known there 
would be a massive supply disruption in January 2003. The 
document states:

          The volume subject to deferrals at this moment is 42 
        million barrels, and the period of deferral might be a 
        year. If you ran the [model] and postponed the 
        incremental fill by 1 year (made 2002 fill equal to 
        zero but increased 2003 fill by the same volume) how 
        would the value of the Reserve change? I venture to say 
        almost not at all, because the chances of drawing all 
        the oil in the Reserve during the year delay are 
        minute. Furthermore, if I knew we were going to have a 
        massive disruption starting in January 2003, given my 
        assumption that OPEC does not accommodate SPR fill with 
        more production, I would doubly insist on deferral 
        because I would rather see a build in private 
        inventories than in SPR inventories.

Thus, in the opinion of this SPR expert, if the United States 
were facing the prospect of a massive and imminent disruption 
of oil supplies, U.S. energy security would be better served by 
building up oil supplies in private sector inventories rather 
than shifting that oil from the private sector to the SPR.

E. 2002 SPR Fills Increased Consumer Costs But Not U.S. Oil Supplies

    As predicted by DOE SPR officials, filling the SPR without 
regard to oil prices and tight market supplies helped push up 
oil prices and deplete U.S. private sector inventories. The 
case study in Section IV traces how SPR deposits in the spring 
of 2002 raised the prices of crude oil and related petroleum 
products, in particular home heating oil, jet fuel, and diesel 
fuel. Since then, prices for crude oil have continued to climb, 
recently reaching a peak of nearly $40 per barrel. Home heating 
oil, jet fuel, and diesel fuel prices have also continued to 
climb, and gasoline has recently done so as well. Figure V-5 
shows that gasoline prices are now over $2 per gallon in many 
markets, record highs for late winter. The continuing record 
low levels of crude oil in U.S. commercial inventories may lead 
to additional gasoline price spikes as refiners begin to build 
gasoline supplies for the spring and early summer driving 
seasons. The SPR program's record in 2002 demonstrates that, 
under these market conditions, more deposits of crude oil into 
the SPR will only exacerbate supply shortfalls and high prices.

[GRAPHIC] [TIFF OMITTED] T5551.053

    Despite its high cost to U.S. consumers and taxpayers, 
inventory data indicates that the new SPR fill policy did not 
increase overall U.S. oil supplies. In 2002, the SPR program 
put about 40 million barrels of crude oil into the SPR, 
increasing the total reserves by about 7 percent, from about 
560 million to 600 million barrels.\213\ Most of this oil was 
removed from the marketplace, however, when crude oil markets 
were tight, which increased oil prices and caused U.S. oil 
refiners to take oil from inventory instead of buying expensive 
new oil. In 2002, U.S. commercial inventories dropped 10 
percent, from about 310 to 280 million barrels. In 2003, 
commercial inventories dropped again to less than 270 million 
barrels, dipping below the recognized level at which refinery 
operations risk disruptions due to inadequate oil 
supplies.\214\ Today, overall oil supplies in the United 
States, which consist of the oil in the SPR and commercial 
inventories, total about 870 million, the same amount as at the 
end of 2001, before the recent SPR fills. Although the SPR 
program has placed more oil under government control, lower 
private sector oil inventories mean there has been no net 
increase in overall national oil supplies.
---------------------------------------------------------------------------
    \213\ See Figure II-2.
    \214\ See Figure V-1.
---------------------------------------------------------------------------
    The benefit to U.S. energy security of shifting oil from 
private sector control to government control in the SPR, 
without a net increase in overall oil supplies, is unclear at 
best, since in the event of a major supply disruption, the SPR 
would act to release oil on the market, shifting supplies back 
to the private sector.
    Filling the SPR to capacity is intended to strengthen U.S. 
protections against the ``adverse economic impact'' of a major 
oil shortage. But the facts show that the abandonment of the 
SPR program's ``deliberate'' and ``cost-effective'' market-
based approach to filling the SPR, in favor of a market-blind 
policy of filling the SPR regardless of oil prices, resulted in 
the depletion of private sector crude oil inventories by at 
least as much as it has increased governmental reserves, 
costing U.S. consumers billions of dollars while contributing 
marginally, if at all, to overall U.S. energy security.
    With crude oil prices at a 12-year high, and U.S. 
commercial crude oil inventories at record lows, it is time for 
DOE to reassess and revise its policy regarding deferrals of 
crude oil shipments to the SPR.


                               APPENDIX 1

                              ----------                              


              PREVENTING MANIPULATION IN COMMODITY MARKETS

          ``The methods and techniques of manipulation are 
        limited only by the ingenuity of man.''
            --Cargill v. Hardin, 452 F.2d 1154, 1162 (8th Cir. 
        1971).

          ``Sophisticated economic justification for the 
        distinctions made in this area of law may at times seem 
        questionable. Sometimes the `know it when you see it' 
        test may appear most useful.''
            --Frey v. CFTC, 931 F.2d 1171, 1175 (7th Cir. 
        1991).

        Summary: Manipulation in commodity futures markets is 
        effectively prevented only by a comprehensive oversight 
        program to detect manipulation and an enforcement 
        program to punish manipulation. Because it is so 
        difficult to bring an after-the-fact prosecution for 
        manipulation, it is vitally important to have an 
        effective market oversight program to detect, deter, 
        and prevent manipulations before they occur.

I. OVERVIEW

    As Appendix 2 explains, a central purpose of the Commodity 
Exchange Act (CEA) is to prevent manipulation of the futures 
markets. To accomplish this objective, the CEA not only 
contains a provision that makes manipulation a felony, but it 
also requires approved contract markets to self-regulate to 
ensure orderly trading and prevent manipulation. It also 
directs a Federal agency--the Commodities Futures Trading 
Commission (CFTC)--to oversee operation of the approved markets 
and to itself perform market oversight and take necessary 
measures to ensure orderly trading and prevent manipulation. 
Former CFTC Chairman James Stone explained, ``The job of 
preventing price distortion is performed today by regulatory 
and self-regulatory rules operating before the fact and by 
threats of private lawsuits and disciplinary proceedings after 
the fact. Both elements are essential.'' \1\
---------------------------------------------------------------------------
    \1\ In the Matter of Indiana Farm Bureau Cooperative Ass'n, Inc., 
1982 CFTC LEXIS 25, 72 (Stone, dissenting), Comm. Fut. L. Rep. (CCH) 
para. 21,796 ['82-'84 Transfer Binder] (CFTC Dec. 17, 1982).
---------------------------------------------------------------------------
    Congress, the courts, the CFTC, commodity traders, and 
legal scholars have struggled with the meaning of the term 
``manipulation'' for as long as the law has prohibited it. 
Nowhere in the CEA as currently written or any of its 
predecessors is the term ``manipulation'' defined. The current 
body of judicial and administrative case law is confusing and 
contradictory. Not surprisingly, there is widespread 
dissatisfaction with the law of manipulation as it currently 
stands.\2\ A common theme of this criticism is that the CFTC 
and judicial precedents make it too difficult to determine just 
what activity constitutes a ``manipulation'' or to prove, after 
the fact, that a manipulation has occurred.
---------------------------------------------------------------------------
    \2\ See, e.g., Jeffrey Williams, Manipulation on Trial, at 8 (1995) 
(``Manipulation is a particularly vague offense.''); In re Soy Bean 
Futures Litig., 892 F. Supp. 1025, 1043 (N.D. Ill. 1995) (``[T]here is 
a `dearth of settled caselaw' on price manipulation; as a result the 
courts and the CFTC are still struggling to define the basic elements 
of the claim and to differentiate between fair means and foul in 
futures trading.''); Perdue, Manipulation of Futures Markets: 
Redefining the Offense, 56 Fordham L. Rev. 345, 401 (1987) (``Congress, 
courts, and commentators have condemned manipulation for over 65 years. 
Despite this long history, manipulation never has been adequately 
defined.''); Friedman, Stalking the Squeeze: Understanding Commodities 
Market Manipulation, 89 Mich. L. Rev. 30, 31 (1990) (``Congress has 
been intent on preventing manipulation since the beginning of Federal 
commodities regulation in the 1920's, yet courts, administrators, and 
academic commentators have failed to agree on a sensible approach to 
the basic question: What is manipulation?''); Markham, supra at 283 
(``[U]nder present law the crime of manipulation is virtually 
unprosecutable, and remedies for those injured by price manipulation 
are difficult to obtain. Moreover, even where a prosecution is 
successful, the investigation and effort necessary to bring a case will 
involve years of work, enormous expenditures, as well as an extended 
trial.''); Lower, Disruptions of the Futures Market: A Comment on 
Dealing with Market Manipulation, 8 Yale J. on Reg. 391, 392 (1991) 
(``The absence of a clear statutory definition, the elusiveness of the 
economic concepts involved and the ad hoc nature of the enforcement 
process has produced a regulatory approach which lacks the clarity and 
predictability which would allow effective monitoring, early detection 
and successful prosecution.''); Fischel and Ross, Should the Law 
Prohibit ``Manipulation'' in Financial Markets?, 105 Harv. L. Rev. 503, 
606 (1991) (``Notwithstanding the recent focus on manipulation, 
however, no satisfactory definition of the term exists. . . . As one 
commentator has noted, `the law governing manipulations has become an 
embarassment--confusing, contradictory, complex, and unsophisticated.' 
''), quoting McDermott, Defining Manipulation in Commodity Futures 
Trading: The Futures ``Squeeze,'' 74 NW. U. L. Rev. 202, 205 (1979); 
Pirrong, Commodity Market Manipulation Law: A (Very) Critical Analysis 
and a Proposed Alternative, 51 Wash & Lee L. Rev 945 (1994) (``Evidence 
abounds that commodity market manipulation law in the United States is 
extraordinarily confused.''); Kozinn, Note: The Great Copper Caper: Is 
Market Manipulation Really a Problem in the Wake of the Sumitomo 
Debacle, 69 Fordham L. Rev. 243, 248 (2000) (``[A]ny student of 
commodity manipulation law will discover a body of law that is `a murky 
miasma of questionable analysis and unclear effect.' ''), citing 
Timothy J. Snider, 2 Regulation of the Commodities Futures and Options 
Markets, 12.01, at 12-5 (2d ed. 1995).
---------------------------------------------------------------------------
    The difficulties in prosecuting manipulation after-the-
fact, outlined in this Appendix, highlight the importance of 
prospective safeguards in the regulatory system. Former CFTC 
Chairman James Stone wrote: ``The Act envisions a careful 
balance between preventative regulation and remedial judicial 
action. To weaken the latter . . . would strengthen the need 
for the former.'' \3\
---------------------------------------------------------------------------
    \3\ In the Matter of Indiana Farm Bureau Cooperative Ass'n, Inc., 
supra at 74-5 (Stone, dissenting).
---------------------------------------------------------------------------

II. THE LAW OF MANIPULATION

  A. Anti-Manipulation Prohibition in Commodity Exchange Act

    Section 9 of the CEA states makes it a felony punishable by 
a fine of up to $1 million or imprisonment for up to 5 years 
for ``Any person to manipulate or attempt to manipulate the 
price of any commodity in interstate commerce, or for future 
delivery on or subject to the rules of any registered entity, 
or to corner or attempt to corner any such commodity.'' \4\
---------------------------------------------------------------------------
    \4\ 7 U.S.C.A. Sec. 13(a)(2) (West Supp. 2002).
---------------------------------------------------------------------------
    Although this is one of the core provisions of the Act, 
nowhere in the statute or the CFTC's regulations is the term 
``manipulation'' defined. Moreover, the CFTC, its predecessor 
agencies, and the courts have not been able to arrive at a 
satisfactory or stable definition of the term. Current case law 
provides contradictory guidance on the types of market behavior 
that are considered manipulation.
    Much of the confusion is inherent in the concept of 
manipulation. It is extraordinarily difficult--some would say 
impossible--to formulate a test that will easily or 
consistently distinguish between legitimate self-interested 
market behavior and illegitimate and unfair tactics motivated 
by greed. As far back as the 1920's, during the consideration 
of the Future Trading Act, which eventually became the Grain 
Futures Act and later the CEA, Congress recognized the 
difficulty in drawing the line between legitimate and 
illegitimate trading. Senator Norris, Chairman of the Senate 
Committee on Agriculture and Forestry, stated: ``[T]hese things 
are various and perhaps impossible of direct definition. I do 
not know how we would draw a definition to bring it home to the 
individual.'' \5\ Shortly after the Grain Futures Act was 
passed, the Grain Futures Administration reported to Congress 
that ``it is practically impossible, merely because a man 
sells, to prove that he is doing it in order to manipulate the 
market.'' \6\ Tommy ``the Cork'' Corcoran, President Franklin 
Roosevelt's legendary lobbyist, once stated with respect to 
securities manipulation, ``you cannot tell at exactly what 
stage a kitten becomes a cat in determining whether a man 
bought or sold on the market for the purpose of raising or 
depressing the price.'' \7\ Another practical reason for 
failing to specify the elements of the offense of manipulation 
``arose from [Congress's] concern that clever manipulators 
would be able to evade any legislated list of proscribed 
actions or elements of such a claim.'' \8\ To date, no-one has 
been able to establish a `` `smoking-gun,' conduct-based test'' 
for manipulation.\9\
---------------------------------------------------------------------------
    \5\ Future Trading in Grain, Hearings on H.R. 5676, before the 
Senate Committee on Agriculture and Forestry, 67th Cong., 1st Sess. 335 
(1921); cited in Perdue, Manipulation of Futures Markets: Redefining 
the Offense, 56 Fordham L. Rev. 345, 353, n. 64.
    \6\ Commodity Short Selling, Hearings before the House Committee on 
Agriculture, 72nd Cong., 1st Sess. 181 (1932); cited in Markham, supra 
at 312.
    \7\ Stock Exchange Practices, Hearings before the Senate Committee 
on Banking and Currency on S. Res. 84, 56, and 97, pt. 15, 73rd Cong., 
1st Sess. 6509 (1934); cited in Markham, supra at 366, n. 548.
    \8\ In re Soy Bean Futures Litig., supra at 1044.
    \9\ Pirrong, supra at 992.
---------------------------------------------------------------------------
    Because of the sparse legislative history of the term 
``manipulation,'' the CFTC and the courts have often relied 
upon Arthur Marsh's testimony in 1928 before the Senate 
Agriculture Committee in interpreting what Congress meant by 
the term.\10\ Marsh, a former President of the New York Cotton 
Exchange, had accused another witness, William Clayton, of 
manipulating the cotton market in New York, and in so doing 
provided the following definition of manipulation:
---------------------------------------------------------------------------
    \10\ See, e.g., Volkart Brothers, Inc. v. Freeman, 311 F.2d 52, 58 
(5th Cir. 1962).

          Manipulation, Mr. Chairman, is any and every 
        operation or transaction or practice, the purpose of 
        which is not primarily to facilitate the movement of 
        the commodity at prices freely responsive to the forces 
        of supply and demand; but, on the contrary, is 
        calculated to produce a price distortion of any kind in 
        any market either in itself or in its relation to other 
        markets. If a firm is engaged in manipulation it will 
        be found using devices by which the prices of contracts 
        for some one month in some one market may be higher 
        than they would be if only the forces of supply and 
        demand were operative; or using devices by means of 
        which the price or prices of some month or months in a 
        given market may be made lower than they would be if 
        they were freely responsive to the forces of supply and 
        demand. Any and every operation, transaction, device, 
        employed to produce those abnormalities of price 
        relationship in the futures markets, is 
        manipulation.\11\
---------------------------------------------------------------------------
    \11\ Cotton Prices, Hearings before a Subcommittee of the Senate 
Committee on Agriculture and Forestry, Pursuant to S. Res. 142, 70th 
Cong., 1st Sess. 201-202; cited in Perdue, supra at 362.

    Clayton denied all accusations of manipulation and 
complained about the vagueness of the charge. In response to a 
Senator's question, Clayton remarked, ``The word 
``manipulation'' . . . in its use is so broad as to include any 
operation of the cotton market that does not suit the gentleman 
who is speaking at the moment.'' \12\
---------------------------------------------------------------------------
    \12\ Id. at 154; cited in Perdue at 355, n. 67.
---------------------------------------------------------------------------
    Several of the elements of manipulation identified by Marsh 
have become part of the basic test used by Federal courts and 
the CFTC in determining whether manipulation has occurred. They 
include: (1) whether the market prices reflect actual 
conditions of supply and demand or whether the prevailing 
prices were artificially created by the suspected manipulator; 
(2) whether the suspected manipulator caused the artificial 
price; and (3) whether the suspected manipulator intended to 
cause the artificial price.
    In Cargill v. Hardin, the U.S. Court of Appeals for the 
Eighth Circuit provided the most recent Federal appellate 
exposition on the meaning of ``manipulation.'' \13\ Cargill had 
been charged with manipulating the wheat futures market by 
controlling nearly two-thirds of the long futures contracts 
just prior to the close of trading, as well as most of the 
physical deliverable supply of wheat. The court distinguished 
between what are perhaps the two most common types of 
manipulation, a ``corner'' and a ``squeeze.'' With respect to a 
corner, the court stated:
---------------------------------------------------------------------------
    \13\ Cargill v. Hardin, 452 F.2d 1154 (8th Cir. 1971).

          In its most extreme form, a corner amounts to nearly 
        a monopoly of a cash commodity, coupled with the 
        ownership of long futures contracts in excess of the 
        amount of that commodity, so that shorts--who because 
        of the monopoly cannot obtain the cash commodity to 
        deliver on their contracts--are forced to offset their 
        contract with the long at a price which he dictates, 
        which of course is as high as he can prudently make 
        it.\14\
---------------------------------------------------------------------------
    \14\ Id. at 1162.

    The court identified a ``squeeze'' as ``a less extreme 
---------------------------------------------------------------------------
situation than a corner,'' in which:

          There may not be an actual monopoly of the cash 
        commodity itself, but for one reason or another 
        deliverable supplies of the commodity in the delivery 
        month are low, while the open interest on the futures 
        market is considerably in excess of the deliverable 
        supplies. Hence, as a practical matter, most of the 
        shorts cannot satisfy their contracts by delivery of 
        the commodity, and therefore must bid against each 
        other and force the price of the future up in order to 
        offset their contracts.\15\
---------------------------------------------------------------------------
    \15\ Id. The Cargill court noted that not all squeezes are caused 
by intentional manipulations, but may also result from ``natural market 
forces,'' such as natural disasters that destroy the supplies of the 
commodity. The court cautioned that a person who finds himself with 
supplies in such circumstances does not have a license to extract as 
high a price as possible:
        [G]iven a shortage of deliverable supplies for whatever 
reason, the futures prices can be manipulated by an intentional squeeze 
where a long acquires contracts substantially in excess of the 
deliverable supply and so dominates the futures market--i.e., has 
substantial control of the major portion of the contract--that he can 
force the shorts to pay his dictated and artificially high prices in 
order to settle their contracts.

---------------------------------------------------------------------------
    In Cargill, the court adopted the following test:

          We think the test of manipulation must largely be a 
        practical one, if the purpose of the Commodity Exchange 
        Act is to be accomplished. The methods and techniques 
        of manipulation are limited only by the ingenuity of 
        man. The aim must be therefore to discover whether 
        conduct has been intentionally engaged in which has 
        resulted in a price which does not reflect basic forces 
        of supply and demand.\16\
---------------------------------------------------------------------------
    \16\ Cargill v. Hardin, 452 F.2d at 1163.

    Relying upon the various judicial precedents, the CFTC has 
established a four-part inquiry to determine whether 
manipulation has occurred. In a 1989 decision, In the Matter of 
Cox and Frey,\17\ the CFTC stated that in order to sustain a 
charge of manipulation, the CFTC must demonstrate, by a 
preponderance of the evidence, that:
---------------------------------------------------------------------------
    \17\ 1987 Westlaw 106879 (C.F.T.C.)

            (1) the accused had the ability to influence market 
        prices;
            (2) the accused specifically intended to do so;
            (3) artificial prices existed; and
            (4) the accused caused the artificial prices.\18\
---------------------------------------------------------------------------
    \18\ Id.

    A review of the judicial and CFTC caselaw indicates that 
establishing each of these elements is an extraordinarily 
difficult task.

  1. Market Power

    The first factor, the ability to influence market prices, 
requires a determination of whether the person accused of 
manipulation of the price of a commodity had sufficient market 
power to affect the market price of the commodity, and whether 
alternative supplies of the commodity were reasonably available 
to market participants. The two parts of this factor are inter-
related and often dissolve into disputes over the appropriate 
scope of the market to be analyzed.
    Federal courts have disagreed over which facts are 
sufficient to establish market power, the scope of available 
substitute commodities, and the obligation of commodity traders 
to purchase such substitutes. In Great Western Food 
Distributors v. Brannan,\19\ for example, Great Western Foods 
was accused of manipulating the price of refrigerated eggs by 
obtaining possession and control of the supply of deliverable, 
refrigerated eggs in the Chicago area as well as ownership of 
between 60 and 75 percent of the open long futures contracts in 
the week before the futures contract expired. Under these 
circumstances, the open short contracts were required to bid up 
the price of the scarce remaining supplies of eggs in the 
Chicago area in order to avoid default on their contracts for 
delivery. In addition to finding that Great Western Foods 
dominated the physical supply of refrigerated eggs in the 
Chicago area, the court found that fresh eggs ``customarily 
range higher in price than refrigerators,'' and therefore 
``were generally not contemplated as part of the supply for 
these futures transactions.'' \20\ The court found that ``out 
of town prices plus freight and differential charges render out 
of town eggs more costly for delivery on Chicago contracts than 
local eggs,'' and therefore there was ample justification for 
the conclusion that Great Western Foods ``held a controlling 
position in the available cash supply of eggs deliverable on 
December futures contracts.'' \21\
---------------------------------------------------------------------------
    \19\ Great Western Food Distributors, Inc. v. Brannan, 201 F.2d 476 
(7th Cir. 1953).
    \20\ Id. at 480.
    \21\ Id. at 481.
---------------------------------------------------------------------------
    In another case involving the availability of substitutable 
supplies, Volkart Brothers v. Freeman,\22\ the Fifth Circuit 
Court of Appeals reached a contradictory result. Under the 
futures contract at issue in this case, only certificated 
cotton could satisfy the contract delivery requirement. 
Nevertheless, the court held that the supply of cotton that had 
not yet been certificated prior to the last day of trading must 
be considered as part of the available supply of certificated 
cotton where a party stands accused of squeezing the contract 
for certificated cotton on the last day of trading. The court 
wrote, ``Unless the shorts are to be excused from the 
performance of their contracts and from the exercise in due 
diligence to that end, the ample supply of uncertificated 
cotton must be considered as available to them.'' \23\ In light 
of the availability of uncertificated cotton, the court 
overturned the agency's finding of manipulation of the price of 
certificated cotton.
---------------------------------------------------------------------------
    \22\ Volkart Brothers v. Freeman, 311 F.2d 52 (5th Cir 1962).
    \23\ Id. at 60.
---------------------------------------------------------------------------
    In Cargill v. Hardin,\24\ the Eighth Circuit rejected the 
Fifth Circuit's reasoning in Volkart that the shorts had an 
obligation to secure supplies of uncertificated cotton to 
reduce congestion in the delivery of certificated cotton. 
Cargill was charged with manipulating the futures market for 
soft red winter wheat after accumulating 62 percent of the open 
long interest in soft red winter wheat futures--nearly 2 
million bushels--just prior to the close of trading on the 
contract, as well as holding most of the cash market supply of 
soft red winter wheat in Chicago warehouses. In determining 
that Cargill had sufficient market power to find manipulation, 
the court of appeals found that due to differences in use, 
price, and quality, the supplies of hard wheat in the Chicago 
area were not ``reasonably interchangeable'' with the 
deliverable supplies of soft wheat. The court concluded, 
``Since there was no soft red winter wheat available in 
significant quantities from sources other than Cargill, the 
conclusion is inescapable that the shorts could not fulfill 
their contracts, at least to the extent of 2,000,000 bushels, 
without coming to Cargill.'' \25\
---------------------------------------------------------------------------
    \24\ Cargill v. Hardin, supra.
    \25\ Id. at 1167.
---------------------------------------------------------------------------
    With respect to Volkart, the Eighth Circuit stated:

          If in a squeeze situation, the shorts must be forced 
        either to pay manipulated prices to offset their 
        contracts or in the alternative to bring in higher 
        priced outside supplies which are neither wanted nor 
        needed in the local market, then both the cash and the 
        futures market will be dislocated. . . . [W]e have been 
        shown no good reason why the futures price should 
        reflect the cost of bringing in a higher price and 
        grade of wheat for which there is no demand in the 
        local area. . . .\26\
---------------------------------------------------------------------------
    \26\ Id. at 1173.

    Despite the more recent ruling in Cargill, the CFTC has 
followed the Volkart reasoning on several occasions. In In re 
Indiana Farm Bureau, for example, the CFTC majority found that 
it was ``irresponsible market behavior for shorts to enter the 
delivery month, especially where low cash supplies are evident, 
without making adequate delivery preparations.'' \27\ The CFTC 
seemingly sanctioned squeezes that were not ``intentionally 
created'' when it stated, ``[w]here a long has not 
intentionally created or exploited a congested situation, the 
long has a contractual right to stand for delivery or exact 
whatever price for its long position which a short is willing 
to pay in order to avoid having to make delivery.'' \28\
---------------------------------------------------------------------------
    \27\ In re Indiana Farm Bureau (1982), supra at 31.
    \28\ Id.
---------------------------------------------------------------------------
    In Indiana Farm Bureau, CFTC Chairman Johnson concurred 
with the result, but dissented from this reasoning. ``I cannot 
join in the majority's view,'' the Chairman wrote, ``that it is 
the `contractual right' of longs to demand as high an offset 
price as possible from the shorts during periods of natural 
market congestion.'' \29\ Commissioner Stone also dissented 
from the majority's holding regarding the ability of the longs 
to extract as high a price as possible, writing that this 
approach ``runs contrary to many years of marketplace and 
regulatory tradition. . . . The surveillance budgets of 
regulators and self-regulators alike are largely devoted to 
avoiding the extraction of premiums over cash prices in 
congested markets. It is a dramatic break from the past if the 
Commission majority now thinks it legal to extract a 
substantial premium so long as as this was not the original 
purpose of the dominant player at the time the congestion was 
initiated.'' \30\
---------------------------------------------------------------------------
    \29\ Id., at 59.
    \30\ Id., at 107-9.
---------------------------------------------------------------------------
    In 1987, in In re Cox and Frey, a majority of the CFTC 
commissioners again reasoned it was primarily the obligation of 
the shorts to avoid congestion by securing adequate supplies of 
a deliverable commodity prior to contract expiry, rather than 
the obligation of the longs to refrain from exploiting such 
congestion.\31\ In Cox, the CFTC stated ``[t]he fact that the 
local supply of a commodity is scarce does not release the 
shorts from their obligation to honor their contractual 
commitments to deliver. We do not believe that a valid analysis 
of deliverable supply can be made in the context of the last 
trading day.'' The CFTC rejected the position that ``premium 
grades of a commodity at out-of-town locations must routinely 
be excluded from deliverable supply calculations.'' \32\
---------------------------------------------------------------------------
    \31\ In re Cox and Frey, CFTC Docket No. 75-16, 1987 WL 106879 
(C.F.T.C), July 15, 1987.
    \32\ Id., at 5.
---------------------------------------------------------------------------
    Commissioner West dissented, stating, ``to simply define 
the market congestion out of existence because the Commission 
felt the shorts were negligent amounts to establishing a 
``contributory negligence'' standard which creates an absolute 
shield for the longs no matter how egregious their aberrant 
behavior.'' \33\ Commissioner West added, ``If a bank leaves 
its vault open overnight and a burglar takes the money, the 
burglar cannot escape guilt based on the bank's negligence. . . 
. Two wrongs do not make a right.'' \34\
---------------------------------------------------------------------------
    \33\ Id., at 16.
    \34\ Id., at 20.
---------------------------------------------------------------------------
    Commissioner West agreed with the CFTC staff's argument 
that under the Volkart standard, ``the more successful the 
upward price manipulation, the larger the deliverable supply 
will be, since at artificially high prices parties can profit 
by disrupting the normal flow of the cash commodity and making 
delivery to the manipulator on the futures market. At some 
point, the manipulated futures price will be high enough to 
warrant shipments of wheat into Chicago from around the 
country, or even around the world.'' \35\
---------------------------------------------------------------------------
    \35\ Id., at 17.
---------------------------------------------------------------------------
    The conflict over the appropriate scope of the relevant 
market is a key contributor to the confusion in the law of 
manipulation. One noted analyst summed up the problem:

          [T]he analysis of deliverable supplies resembles the 
        vacuous debates over market definition that occur in 
        antitrust cases. . . . [A]ccused manipulators attempt 
        to define the market as broadly as possible, and the 
        accusers attempt to define it as narrowly as possible. 
        . . . If manipulation cases turn on definitions of 
        deliverable supplies, they may simply decay into 
        struggles to draw firm boundaries where none naturally 
        exist. Establishing the quantity of a commodity 
        available at the competitive price requires information 
        on the value of alternative uses of the various stocks. 
        . . . [D]eliverable supply estimates provide little 
        information not already contained in prices, and making 
        a manipulation conviction turn on inevitably artificial 
        estimates of supplies invites confusion and 
        contradiction.\36\
---------------------------------------------------------------------------
    \36\ Pirrong, supra at 974. This article approved of the holdings 
in Cargill and Great Western, ``which imply that shorts are not 
obligated to purchase fancy grades, or to go outside the delivery 
market, in order to acquire deliverable supplies.'' Id. at 975. It was 
extremely critical of the CFTC's reasoning in Cox (``defies logic'') 
and similar arguments in Indiana Farm Bureau (``egregious errors''). 
The author contended that under these two decisions and Volkart, ``it 
is nearly impossible to find a long guilty of market power 
manipulation.'' Id. at 976. See also Markham, supra at 355 (``Following 
the decision in Cox, the CFTC's Division of Enforcement was left with 
an almost impossible burden of proof in proving manipulation.''); 
Perdue, supra at 377 n.192 (``But few courts agree on how broadly to 
construe this concept: should it include, for example, only those goods 
that were in fact deliverable at the expiration of the contract, or 
should it include goods that could have been made deliverable if the 
necessary steps had been taken? . . . The courts seem to lack any 
coherent theory in analyzing these questions, and the approaches vary 
considerably.'').
---------------------------------------------------------------------------

  2. Specific Intent to Create an Artificial Price

    In the recent Sumitomo case involving manipulation of the 
copper markets, the CFTC stated ``the intent to create an 
artificial or distorted price is the sine qua non of 
manipulation.'' \37\
---------------------------------------------------------------------------
    \37\ In re Sumitomo Corporation, 1998 CFTC LEXIS 96; Comm. Fut. L. 
Rep. (CCH) para. 27,327, at 16.
---------------------------------------------------------------------------
    Quoting Volkart, the CFTC said ``there must be a purpose to 
create prices not responsive to the forces of supply and 
demand; the conduct must be calculated to produce a price 
distortion.''\38\ ``At bottom,'' according to the CFTC and the 
courts, manipulation is ``the creation of an artificial price 
by planned action, whether by one man or a group of men.'' \39\
---------------------------------------------------------------------------
    \38\ Id., quoting Volkart Brothers, Inc. v. Freeman, 311 F.2d 52, 
58 (5th Cir. 1962).
    \39\ Id., quoting General Foods Corp. v. Brannan, 170 F.2d 220, 231 
(7th Cir. 1948).
---------------------------------------------------------------------------
    In several recent administrative cases the CFTC has 
emphasized that the degree of intent required to establish that 
a manipulation has occurred is not simply a general intent to 
undertake the conduct in question, but rather it is conduct 
undertaken with a manipulative intent akin to the mens rea 
requirement in the criminal law. In other words, the accused 
must actually have intended that an artificial price result 
from his or her conduct.
    Similar to proving intent to fix prices or restrain trade 
in violation of the antitrust laws, proving specific intent in 
commodity price manipulation cases necessarily relies on 
circumstantial evidence. The CFTC has explained, ``Since it is 
impossible to discover an attempted manipulator's state of 
mind, intent must of necessity be inferred from the objective 
facts and may, of course, be inferred by a person's actions and 
the totality of circumstances.'' \40\
---------------------------------------------------------------------------
    \40\ In re Indiana Farm Bureau Cooperative Ass'n, Inc., 1982 CFTC 
LEXIS 25, Comm. Fut. L. Rep. (CCH) para. 21,796 ['82-'84 Transfer 
Binder] (CFTC Dec. 17, 1982). See also In the Matter of Graystone Nash, 
Inc., et al., 1996 SEC LEXIS 3545 (SEC June 27, 1996) (proof of 
manipulation under the Securities Exchange Act ``almost always depends 
on inferences drawn from a mass of factual data. Findings must be 
gleaned from patterns of behavior, from apparent irregularities, and 
from trading data. When all of these are considered together, they can 
emerge as ingredients in a manipulative scheme designed to tamper with 
free market forces.''); citing Herman & MacLean v. Huddleston, 459 U.S. 
375, 390-91 n.30 (1983); Santa Fe Industries v. Green, 430 U.S. 462, 
475 (1977); Pagel Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986); Mawod 
& Co., 591 F.2d 588, 596 (10th Cir. 1979).
---------------------------------------------------------------------------
    The CFTC has found several fact patterns to be indications 
of manipulative intent. The purposeful reduction of supplies in 
a tight market is one such indication. In a case involving an 
alleged squeeze of the frozen concentrated orange juice market, 
the CFTC stated that ``manipulative intent may be inferred when 
the holder of a long position increases his position despite 
knowledge of a congested situation in the underlying 
contract.'' \41\ Put another way, ``a congested market is not 
an appropriate venue for unrestrained self-interest.'' \42\
---------------------------------------------------------------------------
    \41\ In re Louis Abrams and Theodore Butler, 1993 CFTC LEXIS 136, 
at *14 (CFTC, May 4, 1993).
    \42\ In re Louis Abrams, 1995 CFTC LEXIS 196, at *10, Comm. Fut. L. 
Rep. (CCH) para. 26,479 (CFTC, July 31, 1995).
---------------------------------------------------------------------------
    On the other hand, the CFTC will not find manipulation when 
a trader merely holds out for the best price in a congested 
market, for example where the futures contract is near 
expiration and the physical supply of the commodity is 
insufficient to cover the outstanding future contracts 
requiring delivery. ``Seeking the optimum price from the 
futures market (risking, of course, the possibility of 
delivery) is not unlawful. Manipulative intent may be inferred, 
however, where, once the congested situation becomes known to 
him, the long exacerbates the situation by, for example, 
intentionally decreasing the cash supply or increasing his long 
position in the futures market.'' \43\
---------------------------------------------------------------------------
    \43\ In re Indiana Farm Bureau Cooperative Ass'n, Inc., 1982 CFTC 
LEXIS 25, Comm. Fut. L. Rep. (CCH) para. 21,796 ['82-'84 Transfer 
Binder] (CFTC Dec. 17, 1982).
---------------------------------------------------------------------------
    The distinction between taking advantage of a ``natural'' 
squeeze or congestion by holding out for a higher price, versus 
intentionally creating or exacerbating such conditions by 
purposely reducing or withholding the supply of the deliverable 
commodity, has caused controversy and confusion. As one 
commentator put it:

          The doctrine of a ``natural'' squeeze provides a 
        large trader with a manipulation option; if the trader 
        creates a large long position for a legitimate hedging 
        or speculative purpose, the trader can exercise his 
        option to squeeze the market if conditions subsequently 
        change to make manipulation profitable. One can imagine 
        the havoc that would result if judges were to find only 
        those who meticulously planned a murder guilty of the 
        crime and to free those who merely killed impulsively 
        when the opportunity presented itself. The precedents 
        in manipulation law create the conditions for such 
        chaos in futures markets.\44\
---------------------------------------------------------------------------
    \44\ Pirrong, supra at 987.

    Another commenter has noted that persons seeking to 
manipulate the price of a commodity are not likely to be 
thinking about whether the affected price levels are 
``artificial'' or do not reflect the forces of supply and 
demand; the traders only intend ``to make as much money as 
possible.'' ``To frame an intent element in terms of something 
that most manipulators have either never thought of, or if they 
have thought of it, are totally indifferent to, simply invites 
unnecessary complication. . . . [C]ourts either must rely on 
convoluted notions of intent or attribute to people intentions 
and expectations bearing little relation to what they actually 
think about or even reasonably can be expected to think 
about.'' \45\
---------------------------------------------------------------------------
    \45\ Perdue, supra at 375-6.
---------------------------------------------------------------------------

          The Law of Manipulation Under British Commodity Law

          Like U.S. law, U.K. commodities law distinguishes 
        between a legal squeeze, which results from legitimate 
        commercial transactions, and an ``abusive'' squeeze, 
        which results from trading activity undertaken 
        partially for the purpose of ``positioning the price at 
        a distorted level.'' The U.K. Financial Services 
        Authority (FSA) Handbook, which incorporates the Code 
        of Market Conduct, the law governing the operation of 
        financial and commodity markets in the U.K., explains, 
        ``Squeezes occur relatively frequently when the proper 
        interaction of supply and demand leads to market 
        tightness, but this is not of itself abusive.'' \46\
---------------------------------------------------------------------------
    \46\ FSA Handbook, Release 002, at Sec. 1.6.15 (December 2001).

          British law does not prohibit conduct that results in 
        a squeeze if the trading activity is undertaken for a 
        legitimate commercial justification other than to 
        squeeze the market. According to the FSA Handbook, the 
        U.K. Code of Market Conduct ``does not restrict market 
        users trading significant volumes where there is a 
        legitimate purpose for the transaction . . . and where 
        the transaction is executed in a proper way, that is, a 
        way which takes into account the need for the market as 
        a whole to operate fairly and efficiently.'' \47\
---------------------------------------------------------------------------
    \47\ Id., Sec. 1.6.10.

          Under U.K. law, an abusive squeeze of a commodity 
        occurs when a person with (1) ``a significant influence 
        over the supply of, or demand for, or delivery 
        mechanisms for a . . . relevant product; and (2) a 
        position . . . in an investment under which quantities 
        of the . . . relevant product in question are 
        deliverable; engages in behaviour with the purpose of 
        positioning at a distorted level the price at which 
        others have to deliver, take delivery, or defer 
        delivery to satisfy their obligations.'' \48\ The Code 
        notes that price distortion ``need not be the sole 
        purpose of entering into the transaction or 
        transactions, but must be an actuating purpose.''
---------------------------------------------------------------------------
    \48\ Id., at Sec. 1.6.13E.
---------------------------------------------------------------------------

  3. Artificial Price

    As one CFTC Commissioner wrote, although ``[p]rice 
artificiality is an essential ingredient of a completed 
manipulation,'' establishing artificiality is not sufficient to 
establish that manipulation has occurred in violation of the 
Act. ``It is like a new cadaver at the morgue, a trigger for 
further inquiry but not in itself the proof of an offense.'' 
\49\
---------------------------------------------------------------------------
    \49\ Indiana Farm Bureau, supra at 75-6 (Stone, dissenting).
---------------------------------------------------------------------------
    Although the concept of an artificial price appears to be 
straightforward and intuitive, the means for determining 
whether the price of a commodity is ``artificial'' has proved 
to be remarkably difficult. ``Defining manipulation as the 
creation of an artificial price simply substitutes one 
unhelpful term for another.'' \50\ Part of the difficulty stems 
from the fact that the futures market itself is an 
``artificial'' creation and there is no fixed baseline against 
which to measure the performance of the market. Moreover, to 
the extent that buyers and sellers seek to bid the price of the 
commodity up or down in any given transaction, any resulting 
price from such transactions could be termed ``artificial.'' 
\51\
---------------------------------------------------------------------------
    \50\ Id. at 348. In Indiana Farm Bureau, supra at 9, the CFTC 
stated, ``When the aggregate forces of supply and demand bearing on a 
particular market are all legitimate, it follows that the price will 
not be artificial. On the other hand, when a price is effected [sic] by 
a factor which is not legitimate, the resulting price is necessarily 
artificial. Thus, the focus should not be as much on the ultimate 
price, as on the nature of the factors causing it.''
      Commissioner Stone took issue with the majority's statement. ``To 
make the identification of illegitimate market forces a prerequisite 
for a finding of artificial price is an insufficient improvement. 
Legitimacy with respect to supply and demand is undefined in law and 
economics.'' Id. at 80 (Stone, dissenting).
    \51\ ``[T]he determination of the `true' economic price will turn 
on an after-the-fact economic analysis of the price a willing buyer and 
a willing seller would have paid in the absence of the manipulation. 
But this economic analysis is so complicated and affected by so many 
factors that it is often impossible to determine what the `true' price 
was.'' Markham, supra at 284. See also Fischel and Ross, supra at 546 
(``None of these tests distinguishes artificial prices from non-
artificial prices because, whenever unusual conditions of supply and 
demand occur, such comparisons will demonstrate that prices are 
`unusual.' '').
---------------------------------------------------------------------------
    In examining an allegation of manipulation of the price of 
a commodity, both the courts and the CFTC have examined the 
``web of prices'' in the various cash and futures markets for 
that and related commodities. These inquiries have analyzed the 
relationship between the price of the affected commodity in the 
affected market with the contemporaneous spot and futures 
prices of the commodity in other markets; the price of related 
commodities; the relationship between the near-term and the 
long-term price for the commodity on the futures markets, and 
historical price data.\52\ This effort may entail a very 
complex factual and economic analysis. Indeed, the complexity 
of the analysis required to thoroughly analyze the requisite 
amount of market data ``may strain the competence of the 
regulatory agency and the budget of the respondent to the point 
that it is unlikely to be undertaken in particular cases.'' 
\53\
---------------------------------------------------------------------------
    \52\ See, e.g., Cargill v. Hardin, supra. An exposition of the 
obstacles one faces in proving that a prevailing price was 
``artificial'' is found in Stanford University Professor Jeffrey 
Williams's Manipulation on Trial, an account of one of the civil 
lawsuits resulting from the Hunt brothers' near-cornering of the silver 
market.
    \53\ Gray, Economic Evidence in Manipulation Cases, CBOT Seminar 
Report on Research on Speculation 108, 110 (Nov. 1980); quoted in 
Perdue, supra at 368 n.136.
---------------------------------------------------------------------------

  4. Causation

    The problems with proving that a trader ``caused'' an 
artificial price are closely related to the problems in 
defining the relevant market and in determining the alleged 
manipulator's intent. Since there are always two parties to any 
transaction in the futures market, it may be impossible to 
determine which party ``caused'' an increase in price. ``Asking 
whether the buyer or the seller `caused' the price, thus is 
useless--like trying to cut with only one blade of a scissor. . 
. . There simply exists no meaningful way to determine who, in 
the two-sided bargaining process, `caused' the price.'' \54\
---------------------------------------------------------------------------
    \54\ Perdue, supra at 376.
---------------------------------------------------------------------------
    In most instances the spot and futures prices of a 
commodity at any time are determined by a multitude of 
factors--aggregate supply and demand, political events, 
logistical disturbances, to name a few. Indeed, what makes a 
market a market is that the various participants have differing 
views as to the influence of each of those factors on prices. 
If there were no uncertainty or difference of opinion regarding 
how each of those factors affected the future price of a 
commodity, there would not be much of a futures market. 
Isolating and quantifying, in retrospect, the price impact of 
any single one of the many factors and how the various market 
participants reacted to that factor, would be an impossible 
task in many situations.\55\
---------------------------------------------------------------------------
    \55\ One of the expert witnesses in the litigation that followed 
the Hunt manipulation of the silver market concluded: ``Most 
frustrating to those concerned with commodity markets, the Hunt trial 
did not resolve the extent to which the Hunts caused the price spike. 
The trial itself was filled with the ambiguity, contradictions, and 
inconclusiveness found in the turmoil in the silver market during 1979 
and 1980.'' Williams, supra at 4.
---------------------------------------------------------------------------
    In Volkart, Indiana Farm Bureau, and Cox, responsibility 
for a price increase was placed upon the shorts, who were found 
culpable for failing to arrange for delivery of a substitute 
commodity. In situations like these, the longs will not be 
found to have caused the increase in price.
    The conflicts in existing case law has led one observer to 
conclude, ``major precedents concerning the evidence necessary 
to determine causation in a manipulation case may provide 
substantial legal shelter to a cornerer. Most importantly, the 
potential for the accused to refute causation by convincing a 
court or commissioners that the deliverable supply is large may 
allow him to escape unscathed.'' \56\
---------------------------------------------------------------------------
    \56\ Pirrong, supra at 984.
---------------------------------------------------------------------------

  5. Summary

    The CEA does not define the offense of ``manipulation'' and 
the case law is confusing and contradictory. Despite the 
extensive analysis and criticism of the current law of 
manipulation, no one has yet formulated an alternative standard 
that would satisfy all of the problems that have been 
identified with the current law or the proposed alternatives. 
And there is not much reason for optimism that additional 
analysis ever will find one. In the final analysis, the concept 
of manipulation may necessarily remain ambiguous. After 
struggling with the definition of manipulation during the Hunt 
brothers' trial for manipulating the silver market, one of the 
lawyers for the plaintiffs commented, ``[T]he flexible, open-
ended concept of manipulation should continue to prevail over 
any fixed formula rigidly defining manipulation. Otherwise, the 
creation of the next new form of manipulation will be 
encouraged rather than deterred.'' \57\
---------------------------------------------------------------------------
    \57\ Williams, supra at xviii (Foreword of Thomas O. Gorman).
---------------------------------------------------------------------------
    One Federal appellate court has likened the difficulty in 
defining manipulation to Supreme Court Justice Potter Stewart's 
legendary observation about the difficulty in defining 
obscenity: ``Sophisticated economic justification for the 
distinctions made in this area of law may at times seem 
questionable. Sometimes the `know it when you see it' test may 
appear most useful.'' \58\
---------------------------------------------------------------------------
    \58\ Frey v. CFTC, 931 F.2d 1171, 1175 (7th Cir. 1991). See also, 
Lower, Disruptions of the Futures Market: A Comment on Dealing with 
Market Manipulation, 8 Yale J. on Reg. 391 (1991).
---------------------------------------------------------------------------
    The difficulties in defining the offense of manipulation 
and in proving, after-the-fact, manipulation has occurred means 
that it is extraordinarily difficult to prosecute claims of 
manipulation. One former Chief Counsel of the CFTC Division of 
Enforcement has written, ``[U]nder present law the crime of 
manipulation is virtually unprosecutable, and remedies for 
those injured by price manipulation are difficult to obtain. 
Moreover, even where a prosecution is successful, the 
investigation and effort necessary to bring a case will involve 
years of work, enormous expenditures, as well as an extended 
trial.'' \59\ Other former senior CFTC officials interviewed by 
the Subcommittee staff agreed that retrospective manipulation 
cases were exceedingly difficult to prosecute. Current CFTC 
staff interviewed by the Subcommittee staff indicated that as a 
general matter manipulation cases entailed extensive market 
analysis, required heavy use of staff resources, were generally 
vigorously contested by the parties, and took years to 
prosecute.
---------------------------------------------------------------------------
    \59\ Markham, supra at 282.
---------------------------------------------------------------------------
    In light of the current state of the law, the following 
observation sensibly warns against heavily relying on after-
the-fact prosecutions to deter manipulation:

          [T]he current precedents make it extremely difficult 
        to find a trader guilty of manipulation even in cases 
        in which the economic analysis suggests that the trader 
        has indeed manipulated. Given this state of affairs, ex 
        post deterrence is currently a weak bulwark against 
        future manipulations.\60\
---------------------------------------------------------------------------
    \60\ Pirrong, supra at 959.
---------------------------------------------------------------------------

B. Market Oversight to Detect and Prevent Manipulation

  1. CFTC Market Oversight

    The goals of the CFTC's market oversight and surveillance 
program are to preserve the ``economic functions of the futures 
and option markets under its jurisdiction by monitoring trading 
activity to detect and prevent manipulation or abusive 
practices, to keep the Commission informed of significant 
market developments, to enforce Commission and exchange 
speculative position limits, and to ensure compliance with 
Commission reporting requirements.'' \61\ The CFTC's market 
surveillance program seeks to ``identify situations that could 
pose a threat of manipulation and to initiate appropriate 
preventive actions. Each day, for all active futures and option 
contract markets, the Commission's market surveillance staff 
monitors the daily activities of large traders, key price 
relationships, and relevant supply and demand factors in a 
continuous review for potential market problems.'' \62\
---------------------------------------------------------------------------
    \61\ CFTC, The CFTC Market Surveillance Program, at CFTC website: 
http://www.cftc.gov/opa/backgrounder/opasurveill.htm.
    \62\ Id.
---------------------------------------------------------------------------
    In physical commodity markets, the CFTC will most closely 
examine those situations in which the market is most 
susceptible to manipulation--when the deliverable supply of the 
commodity is small in relation to the outstanding positions 
held by traders. In these circumstances, the CFTC will examine 
the positions held by the largest long traders, the deliverable 
supplies not already owned by those traders, whether the long 
traders are likely to demand delivery, whether the short 
traders are capable of making delivery, and the price of the 
commodity on the futures market near contract expiration as 
compared to the price of the commodity on the cash market.
    The CFTC explains how it analyzes market information:

          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.\63\
---------------------------------------------------------------------------
    \63\ Id.

    A more colorful description of the weekly surveillance 
meetings is found in Stephen Fay's Beyond Greed, a tale of the 
---------------------------------------------------------------------------
Hunt brothers' attempt to corner the silver market:

          The significant business of the CFTC takes place on 
        Friday mornings, behind closed doors, in a gloomy, top-
        floor back room. The room is dominated by a large, 
        round, laminated table, cluttered with pencils, pads, 
        and microphones--which are there not to make the 
        conversation but to tape it for the record. The 
        commissioners listen to the weekly surveillance 
        briefings, in which the staff discuss price 
        fluctuations and reveal any substantial changes in the 
        positions of market traders and big speculators, which 
        must be reported confidentially to the CFTC each 
        day.\64\
---------------------------------------------------------------------------
    \64\ Beyond Greed, supra at 109-110.

    According to CFTC staff, no written record is kept of these 
meetings and ``what happens in the room stays in the room.'' 
\65\
---------------------------------------------------------------------------
    \65\ Interview with Subcommittee staff.
---------------------------------------------------------------------------
    If the CFTC believes that a market is unduly congested or 
there is a threat of manipulation, it may take any one or more 
of a variety of actions, either formal or informal, to ensure 
that trading remains orderly. Generally, the CFTC's oversight 
program obtains information from and shares information with 
the affected futures exchanges, and corrective actions are 
coordinated.
    The CFTC explains the types of informal action it may take 
with an exchange to maintain orderly trading:

          Potential problem situations are jointly monitored 
        and, if necessary, verbal contacts are made with the 
        brokers or traders who are significant participants in 
        the market in question. These contacts may be for the 
        purpose of asking questions, confirming reported 
        positions, alerting the brokers or traders as to the 
        regulatory concern for the situation, or warning them 
        to conduct their trading responsibly. This 
        ``jawboning'' activity by the Commission and the 
        exchanges has been quite effective in resolving most 
        potential problems at an early stage.\66\
---------------------------------------------------------------------------
    \66\ The CFTC Market Surveillance Program.

    Current and former CFTC officials interviewed by the 
Subcommittee staff believe that ``jawboning'' is an effective 
tool to prevent manipulations in commodity markets. One former 
CFTC official stated that the Chairman of the Commission would 
make perhaps five or six telephone calls per year to 
``jawbone'' with exchange officials, top company officers, and 
large traders. These officials believe that the CFTC's anti-
manipulation program is far more successful as a result of this 
behind-the-scenes action than indicated by information on the 
public record, including administrative and judicial decisions 
in after-the-fact CFTC prosecutions.
    If neither the exchanges nor jawboning by the CFTC 
alleviates the agency's concerns regarding the potential for 
manipulation, the CFTC has a wide range of ``emergency powers'' 
that it can exercise to maintain order in the markets. In an 
emergency the CFTC can require the liquidation of positions, 
establish limits on positions in the market, extend the period 
for delivery under futures contracts, or, in the extreme, close 
the market.\67\ The CFTC has used these emergency powers 
sparingly. ``The fact that the CFTC has had to take emergency 
actions only four times in its history demonstrates its 
commitment to not intervene in markets unless all other efforts 
have been unsuccessful.'' \68\
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    \67\ In Beyond Greed, Fay notes ``there is virtually nothing the 
CFTC cannot do'' in the face of ``threatened . . . or actual 
manipulations'' to ensure the orderly operation of the market. But, 
writes Fay, ``There is just one drawback to this panoply of regulatory 
power: the act omits any definition of `manipulation' or `squeeze' or 
`corner.' Moreover, the CFTC is committed to show intent to 
manipulate--a difficult thing to do even in so apparently 
straightforward a case as Bunker and Herbert's excursion into soybeans 
in 1977. This is the Catch-22 of commodities regulation: the law gives 
the CFTC immense power, and makes it almost impossible to deploy it.'' 
Id. at 112.
    \68\ The CFTC Market Surveillance Program.
---------------------------------------------------------------------------
    The CFTC obtains the information it uses to analyze the 
futures markets from publicly available sources, daily reports 
provided by the exchanges, and from its large-trader reporting 
system. Publicly available data includes information on supply 
and demand conditions, price information, trading volumes and 
open interest data on the number of outstanding long and short 
contracts. The exchanges report daily to the CFTC on the daily 
positions and trades of the members of their clearing houses. 
This information identifies the firms that hold the largest 
positions in the market, or that clear the largest trades, but 
it does not identify the firms or persons that actually hold 
the underlying positions. To determine this latter information, 
the CFTC relies upon the large-trader reporting system.\69\
---------------------------------------------------------------------------
    \69\ See, CFTC, The CFTC's Large-Trader Reporting System; available 
at CFTC website, at http://www.cftc.gov/opa/backgrounder/opa-ltrs.htm.
---------------------------------------------------------------------------
    The CFTC recently testified before the Congress on the 
importance of the large-trader reporting system:

          The heart of the Commission's direct market 
        surveillance is a large-trader reporting system, under 
        which clearing members of exchanges, commodity brokers 
        (called futures commission merchants, or FCMs), and 
        foreign brokers electronically file daily reports with 
        the Commission. These reports contain the futures and 
        option positions of traders that hold positions above 
        specific reporting levels set by CFTC regulations. 
        Because a trader may carry futures positions through 
        more than one FCM and because a customer may control 
        more than one account, the Commission routinely 
        collects information that enables its surveillance 
        staff to aggregate information across FCMs and for 
        related accounts.\70\
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    \70\ Statement of James E. Newsome, Chairman, CFTC, Hearing before 
the Senate Committee on Energy and Natural Resources, Enron 
Corporation's Collapse, 107th Cong., 2nd Sess., January 29, 2002, at 
27.

    The CFTC devotes a significant portion of its annual budget 
and its personnel to market oversight. For Fiscal Year 2003, 
the CFTC requested a budget of $10.6 million--about 13 percent 
of the agency's total budget--for its Market Surveillance, 
Analysis, and Research program within the Division of Economic 
Analysis. According to the CFTC's Budget Request for FY 2003, 
``The primary responsibility of the Market Surveillance, 
Analysis, and Research program is to foster markets that 
accurately reflect the forces of supply and demand for the 
underlying commodity and are free of disruptive activity. By 
detecting and protecting against price manipulation, this 
program assists the markets in performing the vital economic 
functions of price discovery and risk transfer (hedging).'' 
Under the request, ``57 FTE's will be employed to detect and 
prevent threats of price manipulation or other major market 
disruptions caused by abusive trading practices.'' \71\
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    \71\ For FY 2003, the CFTC requested $22.9 million for the Division 
of Enforcement. Only a fraction of the enforcement budget is devoted to 
manipulation cases. In FY 2001, for example, the CFTC filed 3 
administrative complaints in manipulation cases. During the same year, 
the CFTC filed 7 cases involving the sale of illegal foreign currency 
futures or options, 25 cases involving fraud, 4 cases involving 
management of customer funds, and various other administrative actions. 
The enforcement division also works with other law enforcement agencies 
on a variety of financial fraud, conspiracy, and money laundering 
actions. CFTC, FY 2001 Annual Report. A comparison of the CFTC's Budget 
Request with its Annual Report indicates that in the normal course of 
business the CFTC devotes far more resources to the before-the-fact 
prevention of manipulation than to the after-the-fact prosecution of 
manipulation.
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  2. Market Oversight by Approved Futures Exchanges

    In order for a commodity exchange to obtain CFTC approval 
to trade in futures contracts, the exchange must have its own 
market oversight and enforcement program to detect and prevent 
excessive speculation and market manipulation. Each of the 
``designated contract markets'' authorized by the CFTC has 
established such a program, and works closely with the CFTC to 
prevent manipulation and other trading abuses.\72\ The CFTC 
periodically reviews each of the approved exchanges' market 
surveillance and enforcement programs to ensure they remain in 
compliance with the standards established by the CFTC.
---------------------------------------------------------------------------
    \72\ See Table A.2-1 for a list of the designated contract markets 
currently in operation.
---------------------------------------------------------------------------
    The NYMEX, the largest exchange for energy contracts, 
describes its self-regulatory program as follows:

          The New York Mercantile Exchange enforces a rigorous 
        self-regulatory program closely monitoring and 
        regulating floor trading activity to prevent market 
        manipulation and other anti-competitive activity. The 
        Exchange has taken the lead in developing and 
        maintaining new trade surveillance enhancements 
        including the addition of public representatives to a 
        revamped disciplinary panel, increased penalties, and 
        tightened recording procedures. During numerous 
        hearings on the reauthorization of the CFTC, Exchange 
        officials stressed the Exchange's intolerance of 
        wrongdoing, and encouraged legislation aimed at further 
        preserving public confidence in the markets. The 
        Exchange's rules and procedures have been carefully 
        honed as a result of nearly 125 years of experience in 
        building one of the world's safest and most liquid 
        futures and options markets. The Exchange board of 
        directors and staff remain committed to providing the 
        vigilance and financial support necessary to preserve 
        the highest levels of customer confidence in the 
        integrity of our market.\73\
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    \73\ NYMEX, Safeguards and Standards.

    In 1998, the NYMEX Trade Practice Surveillance section, 
which investigates and prosecutes NYMEX rule violations, had a 
staff of 21 persons,\74\ and the Market Surveillance section 
had a staff of 15.\75\ The Chicago Mercantile Exchange (CME) 
had 10 full-time employees in its market surveillance division, 
which is responsible for monitoring and reviewing daily price 
movements, volumes and open interest in CME contracts, and 
other futures market activity.\76\ It appears that the approved 
exchanges, in aggregate, devote a level of resources to 
surveillance and enforcement that is comparable to the level of 
resources that the CFTC devotes to these activities.\77\ 
Altogether, then, on the order of a hundred individuals in the 
government and on the designated exchanges monitor billions of 
dollars in commodity transactions each day.
---------------------------------------------------------------------------
    \74\ CFTC, Rule Enforcement Review of the Commodity Exchange, Inc. 
Division of the New York Mercantile Exchange (1999).
    \75\ CFTC, Rule Enforcement Review of the Market Surveillance 
Program at the COMEX Division of the New York Mercantile Exchange 
(1998).
    \76\ CFTC, Rule Enforcement Review of the Chicago Mercantile 
Exchange (1999).
    \77\ The New York Board of Trade has a 21-person compliance 
division. CFTC, Rule Enforcement Review of the New York Cotton Exchange 
(2001).
---------------------------------------------------------------------------
    The designated exchanges have several types of regulations 
and programs to ensure orderly trading and prevent 
manipulation. First, the exchanges impose a variety of 
financial requirements on firms that are members of the 
exchange to ensure the creditworthiness of the parties trading 
on the exchange. One of the major advantages of purchasing 
exchange-traded futures contracts rather than OTC derivatives 
or swaps for hedging or speculation is the much greater 
assurance of creditworthiness that the exchange-traded 
instruments provide. In an OTC transaction, each party assumes 
the credit risk of the other party. In a transaction conducted 
on an approved exchange, with a clearinghouse that is 
capitalized by its members, the clearinghouse effectively acts 
as the counterparty to all transactions and so eliminates 
counterparty credit risk. To ensure the financial integrity of 
the market, the exchanges require the maintenance of sufficient 
margins to cover market fluctuations, and require clearing 
member firms to maintain sufficient capitalization to cover 
their operations, including the trades made on behalf of their 
customers.
    To ensure orderly trading, the exchanges have established 
daily price limits for most commodity futures contracts, which 
limit the amount the price of the contract can increase or 
decrease in 1 day; position limits for clearing members of the 
exchange to ensure each clearing member has sufficient capital 
to cover its commitments; position limits for customers on 
contracts for the current delivery month to prevent commodity 
squeezes in the final month of the contract; and reporting 
requirements for customers who acquire large positions in the 
futures or options markets.
    Like the CFTC, the exchanges have market oversight programs 
to ensure that trading is orderly and in compliance with 
financial and trading regulations. As the NYMEX explains, 
``daily surveillance is performed to ensure that Exchange 
prices reflect cash market price movements, that the futures 
market converges with the cash market at contract expiration, 
and that there are no price distortions and no market 
manipulations.'' \78\ Generally, the exchanges hold weekly 
meetings to review market conditions. Market oversight meetings 
may be held more frequently if unusual market conditions 
warrant.
---------------------------------------------------------------------------
    \78\ Safeguards and Standards.
---------------------------------------------------------------------------
    In sum, the day-to-day market oversight by the approved 
exchanges is one of the key elements in preventing manipulation 
in the commodity futures markets. The exchanges devote a level 
of resources to market oversight and enforcement that is 
comparable to the level of resources the CFTC devotes to these 
activities, and the exchanges work closely with the CFTC to 
monitor the markets and take action, when necessary, to ensure 
that trading remains orderly and in compliance with 
regulations. The CFTC and exchange anti-manipulation programs 
work together to detect, deter, and punish market manipulation.

C.  Lessons Learned from the Sumitomo Manipulation of the Copper 
                    Markets

        Summary: The Sumitomo manipulation of the global copper 
        market in the mid-1990's demonstrated the importance of 
        monitoring over-the-counter markets and of sharing of 
        information among regulators.

  1. Sumitomo Manipulation of the Copper Markets \79\
---------------------------------------------------------------------------

    \79\ The facts regarding Sumitomo's manipulation set forth herein 
are taken from the Offer of Settlement agreed to by the CFTC and 
Sumitomo Corporation in In re Sumitomo Corporation, 1998 CFTC LEXIS 96, 
Comm. Fut. L. Rep. (CCH) para. 27,327 (CFTC, May 11, 1998). The facts 
regarding the CFTC's response are taken from an article written by 
Brooksley Born, CFTC Chair at the time. Born, International Regulatory 
Responses to Derivatives Crises: The Role of the U.S. Commodity Futures 
Trading Commision, 21 NW. J. Intl. L. & Bus. 607 (2001).
---------------------------------------------------------------------------
    Sumitomo is a Japanese corporation that has marketed copper 
metal for hundreds of years. During the time period relevant 
here, Sumitomo's Copper Metals Section, also known as 
Sumitomo's ``Copper Team,'' was a major supplier of copper 
cathode to Asian manufacturers. Historically, Sumitomo 
extensively used the futures market to hedge against the risks 
presented by the volatility in copper prices.
    Yasuo Hamanaka began trading in copper for Sumitomo in 
1973, and was promoted to head the Copper Team in 1987. Just 
prior to Hamanaka's promotion, the Copper Team had begun to 
lose significant amounts of money from copper trades. These 
losses were compounded by losses incurred as a result of 
speculative trades made by Hamanaka and another trader in an 
attempt to compensate for the losses in the physical market. 
Hamanaka did not enter the losses from these trades on 
Sumitomo's normal bookkeeping system; rather he recorded the 
transactions in a personal notebook.
    Shortly after he was promoted to head the Copper Team, 
Hamanaka began plotting to manipulate the copper market to 
recover some of Sumitomo's losses. Beginning in late 1993, 
Hamanaka entered into a series of unusual copper purchasing 
agreements with a newly-formed U.S. copper merchant firm, 
whereby both Sumitomo and the U.S. firm had an incentive for 
the transactions to be conducted at higher prices. According to 
the CFTC, much of the copper purchased by Sumitomo under these 
contracts was immediately resold to the U.S. firm's supplier 
and was never actually delivered to Sumitomo.\80\
---------------------------------------------------------------------------
    \80\ The Sumitomo settlement agreement did not name ``the U.S. 
copper merchant'' with which Sumitomo traded.
---------------------------------------------------------------------------
    As part of their scheme to manipulate the copper market, 
Hamanaka and his co-conspirators attempted to acquire all of 
the stocks of physical copper in the warehouses owned by the 
London Metals Exchange (LME). By November 1995, Sumitomo owned 
and controlled 100 percent of the copper inventory in LME 
warehouses, including the inventory in the newly opened LME 
warehouse in Long Beach, California. ``As Sumitomo's copper 
trader knew, the concentration of ownership of all, or 
essentially all, of the LME warehouse stocks in the hands of 
cooperating market participants and the withholding of such 
stocks from the market would have the effect of increasing the 
price of copper and also creating a large backwardation. These 
developments allowed Sumitomo's copper trader to liquidate, 
lend or roll forward Sumitomo's large market holdings at the 
higher price or price differential and thereby earn significant 
profits for Sumitomo.'' \81\ At the same time, Sumitomo had 
acquired and maintained large and controlling futures positions 
on the LME, which ``bore little legitimate relationship to the 
marketing of physical copper to Sumitomo's customers, but 
rather were specifically designed to cause artificial prices 
and price relationships.'' \82\
---------------------------------------------------------------------------
    \81\ In re Sumitomo Corporation, supra, at *11-12. In the futures 
markets for commodities that can be stored easily, such as copper, the 
market is generally in contango rather than backwardation, as the 
producers or sellers of the commodity for future delivery will obtain a 
market premium to compensate them for the storage costs of the 
commodity to be delivered in the future. The crude oil markets are an 
exception to this general rule, as crude oil is more difficult to store 
than a metal such as copper or silver, and refiners are willing to pay 
a slight premium for the convenience of having an assured prompt supply 
of crude oil to keep their refineries in continuous operation. A large 
backwardation in the copper or silver market therefore indicates some 
type of immediate supply disruption or shortage.
    \82\ Id., at 12.
---------------------------------------------------------------------------
    In early 1995, the NYMEX and the CFTC became concerned 
about the price of copper on global markets, especially on the 
NYMEX and LME. Working with the NYMEX surveillance program, the 
CFTC surveillance staff recognized several unusual price 
relationships in the copper markets, such as increased 
volatility and the significant backwardation that had arisen 
due to Sumitomo's extraordinarily large physical holdings. For 
example, the cash price of copper on the LME had risen from 
about $1,900 per metric ton in June 1994, to about $2,500 per 
ton by the end of September 1994.
    In addition, the CFTC and NYMEX market oversight staffs 
``detected unusual activity in warehouse stocks.'' \83\ 
Although New York spot prices for copper were higher than the 
spot prices for copper on the LME in the summer and fall of 
1995, inventories of copper in the LME warehouses--including 
the new LME warehouse in Long Beach--continued to increase. As 
the NYMEX explains, ``Exchange officials and many members found 
this curious since exchange warehouses are intended to be the 
supplier or receiver of last resort. When demand for physical 
product is high, material should not continue to accumulate in 
an exchange warehouse; logically there should have been a 
reduction in LME stocks. . . .'' \84\ In late 1995, the NYMEX 
Vice-President called the LME warehouse inventories ``a sign of 
sickness, not well-being,'' and inconsistent with rational 
commercial activity.\85\
---------------------------------------------------------------------------
    \83\ Born, supra at 622.
    \84\ NYMEX, Collapse of Copper Prices Draws Attention to 
Differences in Oversight on the Exchange and Foreign Markets (1996).
    \85\ Id.
---------------------------------------------------------------------------
    Although both the NYMEX and CFTC had spotted ``unusual 
activity,'' they could not discover the cause of such activity, 
and, as a result, were unable to take any preventive action to 
stop the manipulation. The NYMEX and CFTC examined the 
positions of traders on the NYMEX, but no unusual positions 
were detected. No large-trader reports had been filed.
    Hamanaka and his co-conspirators had taken certain basic 
measures to evade NYMEX and CFTC oversight. They had acquired 
their futures and options positions on the LME and in the OTC 
markets rather than on the NYMEX in order to avoid the 
transparency and large-trader reporting requirements of the 
NYMEX and the CFTC. Indeed, Hamanaka ``shunned the Comex 
[division of NYMEX], not only because it lacked the liquidity 
for the volume of trading he was doing, but also, he said in 
past interviews, because its regulations were too stringent.'' 
\86\
---------------------------------------------------------------------------
    \86\ Stephanie Strom, A Market Ripe for Manipulation; Laxity in 
London Opened Door for a Sumitomo Trader, New York Times, July 12, 
1996.
---------------------------------------------------------------------------
    The LME did not have comparable reporting requirements, and 
trading was much less transparent than on the American 
exchanges. On the LME, traders were ``allowed to meet daily 
margin calls with credit, rather than cash, letting them amass 
large positions without attracting the attention of their 
corporate treasurers, who would otherwise have to cut them 
checks. The Comex requires cash.'' \87\
---------------------------------------------------------------------------
    \87\ Id.
---------------------------------------------------------------------------
    After the Sumitomo manipulation was discovered, one NYMEX 
official blamed the LME's lenient regulatory philosophy:

          Unlike the strict reporting and disclosure 
        requirements of the Exchange's COMEX and NYMEX 
        Divisions that give those markets their transparency, 
        the corresponding rules on the LME are considerably 
        more lax where they exist at all. The result is an 
        opaque market where problems like Sumitomo's have 
        occurred with distressing regularity, including the tin 
        market default in 1985 and a $175 million loss suffered 
        by the Chilean copper producer Codelco in 1993 because 
        of alleged unauthorized trading.\88\
---------------------------------------------------------------------------
    \88\ Id. In Chile, the losses at Codelco grew into a political 
scandal dubbed ``Coppergate,'' and contributed to the fall of the 
Chilean government. Garth Alexander and John Waples, Copper Meltdown, 
Sunday Times, June 16, 1996.

    The CFTC requested information from the U.K. Securities 
Investment Board (SIB), but the SIB had neither the requested 
information nor the inclination to co-operate with the CFTC. 
Reflecting some of the attitudes in London, The Guardian 
reported, ``The CFTC's direct approach to investigating 
complaints lodged by its own members has been dubbed 
``colonialism'' by some market participants in London.'' \89\ 
NYMEX appealed to the LME for information on the copper 
markets, but it too was ``rebuffed.'' \90\ In response to the 
complaints that the LME was too weak as a regulator, the chief 
executive of the LME, David E. King, ``insisted that charges 
that it lacks regulatory zeal are merely sour grapes from the 
[New York Exchange], which has lost most of its market share in 
copper to London in recent years.'' \91\
---------------------------------------------------------------------------
    \89\ Paul Murphy, Complaints About American Regulators' London 
Activity, The Guardian (London), January 30, 1996.
    \90\ Strom, A Market Ripe for Manipulation; Laxity in London Opened 
Door for a Sumitomo Trader, supra.
    \91\ Id.
---------------------------------------------------------------------------
    According to Brooksley Born, CFTC Chair during this period, 
``the CFTC was frustrated in its ability to investigate the 
causes of the price abnormalities during 1995 because it was 
limited to information about the U.S. markets. At a time when 
Sumitomo's manipulative scheme might have been stopped before 
great harm was caused to copper market participants, the CFTC's 
hands were tied by lack of information.'' \92\
---------------------------------------------------------------------------
    \92\ Born, supra at 622.
---------------------------------------------------------------------------
    In the absence of specific information about trading in the 
copper markets, the CFTC was unable to detect or stop 
Hamanaka's manipulation. In April 1996, following a series of 
letters from the CFTC to the LME regarding the unusual activity 
in the copper markets, Sumitomo began its own 
investigation.\93\ When during this internal investigation a 
Sumitomo clerk discovered a variety of unauthorized accounts at 
Merrill Lynch and other small brokerages, Sumitomo reassigned 
Hamanaka, who confessed to the manipulation scheme shortly 
afterward. At this time, however, Hamanaka had yet to unwind 
his futures and cash positions at the high market prices he had 
created. Sumitomo also informed the CFTC of the losses Sumitomo 
had incurred over the years as a result of Hamanaka's trading--
at the time it estimated those losses at $1.8 billion. It later 
revised the estimate to $2.6 billion. Following Hamanaka's 
reassignment and subsequent dismissal, copper prices dropped 
nearly 30 percent--from $2,800 per metric ton to below $2,000 
per metric ton.
---------------------------------------------------------------------------
    \93\ Suzanne McGee and Stephen E. Frank, Metal Detection: Sumitomo 
Debacle is Tied to Lax Controls by Firm, Regulators, Wall St. J., June 
17, 1996. See also Kozinn, supra at 270-77.
---------------------------------------------------------------------------
    Once Hamanaka's activities were disclosed, the CFTC again 
requested information from the SIB regarding Sumitomo's 
positions on the LME and the positions of U.S. affiliates on 
the London exchange as well. According to former Chair Born, 
``The SIB now recognized the seriousness of the situation and 
became more responsive to the CFTC's information requests. 
Nonetheless, there still remained some confusion and 
disagreement about what information was relevant for regulatory 
purposes and what information might be competitively 
sensitive.'' \94\ The CFTC's subsequent investigation revealed 
that Hamanaka had not only used the cash market for copper and 
the LME to achieve his price manipulation, but had ``also used 
OTC transactions in furtherance of its manipulative scheme, 
both to obtain financing and to disguise the speculative nature 
of its transactions.'' \95\
---------------------------------------------------------------------------
    \94\ Born, supra at 623. In requesting information from the SIB, 
the CFTC invoked the ``Boca Declaration,'' which had just been signed 
in March 1996. The Boca Declaration, which was prompted by the collapse 
of the Barings Bank due to unauthorized trading in derivatives by one 
of its young employees, pledged the signatories to share information in 
the event of a significant financial reversal by a member of an 
exchange or clearing organization.
    \95\ Id.
---------------------------------------------------------------------------
    Because Sumitomo had sufficient assets to cover the entire 
$2.6 billion loss, Sumitomo did not default on its obligations 
and its losses did not trigger a chain-reaction of defaults or 
require a take-over or bail-out. Nonetheless, according to the 
former CFTC Chair, ``the impact of Sumitomo's activities on 
world copper prices did have a profound economic impact both 
within the United States and abroad. As the CFTC investigation 
revealed, Sumitomo manipulated the price of copper in what may 
well have been the most significant commodity price 
manipulation since the Hunt brothers' manipulation of the world 
market in silver in 1979 and 1980.'' \96\ One metals trader 
estimated that Hamanaka's manipulation artificially raised the 
price of copper an average of 5 cents per pound on the spot 
market for 5 years, during which time copper was trading 
between 73 cents and $1.46 per pound.\97\ This cost would have 
been passed on to copper processors and manufacturers of copper 
products, and ultimately, consumers.\98\
---------------------------------------------------------------------------
    \96\ Id.
    \97\ Strom, A Market Ripe for Manipulation; Laxity in London Opened 
Door for a Sumitomo Trader, supra.
    \98\ Some sophisticated market players, such as George Soros, 
detected that copper prices were unusually high during Hamanaka's 
manipulations and sold short large quantities of copper. Such 
speculative short selling drove even more buying by Hamanaka to prop 
prices up. Eventually, even Soros declined to continue to trade against 
Hamanaka. Paul Krugman, How Copper Came a Cropper, The Dismal Science, 
July 19, 1996.
---------------------------------------------------------------------------
    Sumitomo acknowledged the activities of Hamanaka, but 
claimed it had no knowledge of those activities at the time, 
and stated that such activities were unauthorized. Sumitomo 
settled with the CFTC by agreeing to cease and desist from 
further violations of the anti-manipulation provisions of the 
CEA, paying a $125 million civil penalty, and establishing a 
$25 million escrow fund to pay restitution to persons injured 
by Sumitomo's manipulative conduct. At the time, the civil 
penalty imposed upon Sumitomo was the largest civil penalty 
ever imposed by the U.S. Government. In Japan, Hamanaka was 
found guilty of forgery and fraud, and sentenced to 8 years in 
prison.
    Subsequently, the CFTC found that Merrill Lynch had ``aided 
and abetted'' Sumitomo by providing more than $500 million of 
credit to Sumitomo, which Sumitomo used to purchase copper on 
the cash market and LME futures contracts. The director of the 
CFTC's enforcement division stated the case was ``one of the 
most serious world-wide manipulations of a commodities market 
encountered in the 25-year history of the commission.'' \99\ 
The CFTC complaint charged ``Merrill Lynch participated in the 
manipulation as something it wished to bring about because 
Merrill Lynch earned money as copper prices rose.'' \100\ It 
further alleged that Merrill Lynch officials ``had correctly 
concluded that Global and Sumitomo's warrant-taking operation 
was motivated by their intention to manipulate prices and 
spread, not by genuine commercial need, and that Global and 
Sumitomo were attempting to manipulate, and were successfully 
manipulating the world's copper markets.'' Although Merrill 
Lynch initially denied any wrongdoing, it settled the CFTC's 
suit by agreeing to a cease and desist order and paying a civil 
monetary penalty of $15 million.
---------------------------------------------------------------------------
    \99\ Charles Gasparino, CFTC Charges Merrill Lynch in Sumitomo 
Copper Scandal, Wall Street Journal, May 21, 1999.
    \100\ Id.
---------------------------------------------------------------------------
    In 1999, Sumitomo filed suit against J.P. Morgan Chase for 
its role in facilitating Hamanaka's manipulative scheme. 
According to papers filed by Sumitomo in the lawsuit, J.P. 
Morgan and its Morgan Guaranty Trust subsidiary sold 
``esoteric'' derivatives to Sumitomo which, in reality, were no 
more than disguised loans. Sumitomo claimed that J.P. Morgan 
officials knew that Hamanaka was engaged in an illegal trading 
scheme, but nonetheless provided him with $735 million in 
credit so they could earn substantial fees and 
commissions.\101\ In 2002, J.P. Morgan Chase agreed to pay $125 
million to Sumitomo to settle the suit.\102\
---------------------------------------------------------------------------
    \101\ Bank & Lender Liability Litigation Reporter, J.P. Morgan 
Granted Relief in Sumitomo Case; Chase Not so Fortunate, November 30, 
2000.
    \102\ Bayan Rahman, J.P. Morgan Chase, Sumitomo Settle in Copper 
Scandal, National Post (f/k/a The Financial Post), April 2, 2002.
---------------------------------------------------------------------------
    A U.S. metals trading firm alleged to have conspired with 
Sumitomo to manipulate copper prices, Global Minerals & Metals 
Corp., has contested the CFTC's charge of manipulation. The 
CFTC's enforcement proceedings against this company and several 
of its employees are on-going, but have been delayed by 
acrimonious pre-hearing disputes. In a ruling earlier this 
year, a CFTC administrative law judge stated, ``From the 
outset, this matter has been mired in pleading, document 
production, and professional misconduct disputes. To date, this 
case has generated a total of 13 CCH-reported opinions and 
orders (this will be the 14th), without a hearing on the merits 
of the Commission's complaint in sight.'' \103\ With respect to 
the merits, the judge opined, ``[T]his proceeding raises a host 
of highly complex and interesting issues of law, economics and 
quantitative analysis for our consideration.'' \104\
---------------------------------------------------------------------------
    \103\ In re Global Minerals & Metals Corp. et. al., 2002 CFTC LEXIS 
12, at *5, Comm. Fut. L. Rep. (CCH) para. 28,916 (January 23, 2002).
    \104\ Id. at 2.
---------------------------------------------------------------------------
    The Sumitomo case demonstrates that even in a manipulation 
case in which the principal participant has admitted guilt and 
is serving an 8-year prison sentence for fraud and forgery, the 
responsible corporation in the manipulative scheme has admitted 
liability and paid $150 million in penalties, and two of the 
investment firms that financed the scheme have paid an 
equivalent amount, many obstacles impede proving, under current 
case law, that alleged conspirators in the scheme manipulated 
the market.

  2. International Agreement to Address Problems Raised by Sumitomo

    In the wake of the Sumitomo manipulation, regulators from 
the three nations whose markets were principally affected by 
the affair--the United States, United Kingdom, and Japan--
recognized the existing international understandings and 
framework for obtaining and sharing information on commodity 
trading were inadequate. Hamanaka had managed to evade 
detection for as long as he did by operating in the London and 
OTC markets, where there was much less transparency than on the 
regulated U.S. exchanges. In addition, by using a mix of 
international markets, he ensured that none of the various 
market authorities with jurisdiction over Hamanaka's trading 
activity was able to obtain a complete or accurate view of 
their own markets or his activities. Following the incident, 
CFTC Chair Born wrote, ``The Sumitomo incident had confirmed 
that information sharing may be important to market oversight 
and regulation even before any enforcement actions are 
envisioned and that the information needed may involve the 
state of the market as a whole as well as the situation of 
particular market participants.'' \105\
---------------------------------------------------------------------------
    \105\ Born, supra at 625.
---------------------------------------------------------------------------
    The U.S., U.K., and Japanese regulators convened a meeting 
of international commodity market regulators in London in 
November 1996, to begin to develop a new international 
agreement for the sharing of market information. ``The co-
sponsors believed that Sumitomo's manipulation of the copper 
markets demonstrated that derivatives markets in international 
commodities involving physical delivery, such as copper, posed 
special regulatory issues and concerns, especially relating to 
the availability of deliverable supplies and susceptibility to 
market manipulation.'' \106\
---------------------------------------------------------------------------
    \106\ Born, supra at 626.
---------------------------------------------------------------------------
    The London meeting resulted in the issuance of the London 
Communique on Supervision of Commodity Futures Markets, which 
sought to address the international regulatory issues raised by 
the Sumitomo manipulation. The London Communique ``recognized 
that futures contracts based on an underlying physical 
commodity--and particularly those requiring physical delivery--
pose particular concerns for market integrity and the 
supervision of such markets.'' \107\ In issuing the Communique, 
the regulators specifically agreed that better contract design, 
more effective market oversight, and regulatory measures 
designed to provide regulators with information on large 
positions in cash and OTC markets should be adopted.
---------------------------------------------------------------------------
    \107\ Id.
---------------------------------------------------------------------------
    Specifically, the London Communique stated the following 
with respect to physical commodity markets:

     Proper contract design is critical to reducing 
the susceptibility of such contracts to market abuses, 
including manipulation, and is an important complement to an 
appropriate market surveillance program.

     An effective market surveillance program by the 
market regulatory authorities is essential to ensure that 
commodity futures markets operate in a fair and orderly manner; 
and should be designed to detect, to prevent, to take 
corrective action with respect to, and to punish abusive 
conduct and should be supported by appropriate regulatory 
measures.

     Market authorities should have access to 
necessary information.

     Market authorities of related markets should 
share surveillance information in order to manage market 
disruption.

     Regulatory measures which facilitate the 
identification of large exposures should be developed. These 
measures may involve access to information relating to the 
persons holding or controlling large exposures and their 
related derivatives, over-the counter and cash market 
positions. These measures may also involve access to 
information on deliveries.

    Following the issuance of the London Communique, 
international regulators continued to work to develop 
appropriate standards of best practice and guidelines for the 
design of contracts and market oversight programs. In October 
1997, the regulators met again, this time in Tokyo, Japan. This 
international meeting resulted in the issuance of the Tokyo 
Communique on Supervision of Commodity Futures Markets, which 
contained Guidance on Standards of Best Practice for the Design 
and/or Review of Commodity Contracts; and Guidance on 
Components of Market Surveillance and Information Sharing 
(``Market Surveillance Guidance'').
    The Market Surveillance Guidance recommends that regulators 
routinely collect and analyze information regarding cash and 
OTC markets related to regulated futures markets. The Guidance 
states:

     Each commodity futures market and other market 
authorities should have a clear framework for conducting market 
surveillance, compliance and enforcement activities and there 
should be oversight of those activities.

     Information should be collected on a routine and 
non-routine basis for on-exchange and related cash and over-
the-counter (``OTC'') markets and should be designed to assess 
whether the market is functioning properly. Market authorities 
should have access to information that permits them to identify 
concentrations of positions and the composition of the market. 
It is acknowledged that data on related cash and OTC markets 
may be less immediately available than data for exchange 
markets. This may be an area which requires governmental 
powers.

    The Market Surveillance Guidance also stated that the 
collection and analysis of market information should occur 
``speedily''; effective emergency powers should be available to 
intervene in the market to prevent or to address abusive 
practices or disorderly conditions; effective power should be 
available to discipline market members; the relevant authority 
should have the power to address abusive actions by non-
members; and market authorities should cooperate to share 
information, particularly on large exposures.
    The 17 nations that participated in the Tokyo conference 
also recommended the removal of domestic legal barriers to the 
implementation of these recommendations:

          Furthermore, in view of the fact that information is 
        a critical tool for maintaining fair and orderly 
        markets and ensuring market integrity in non-financial 
        physical delivery markets with finite supply, that 
        market authorities should seek the removal of domestic 
        legal or other barriers to ensure, consistent with the 
        regulatory framework of each jurisdiction, access by 
        market authorities to information that permits them to 
        detect and to deter abusive practices and disorderly 
        conditions in the markets, including access to 
        information that permits them to identify 
        concentrations of positions and the overall composition 
        of the market.

    Former CFTC Chair Born summarized the significance of the 
Tokyo Communique as follows:

          The Guidances provide for the first time useful 
        international benchmarks for the supervision of 
        commodity derivatives markets and underscore the 
        importance of detecting and deterring manipulative 
        activities such as those engaged in by Sumitomo. The 
        consensus on the need for information concerning large 
        positions on exchange markets and related cash and OTC 
        markets was a significant step forward in enhancing the 
        international standards of regulation of these markets, 
        particularly in light of the participants' commitment 
        to work to alter their domestic laws in order to 
        implement the provision. Furthermore, the recognition 
        of the importance of sharing such information as part 
        of an international effort to detect broad-based 
        manipulation efforts in their incipiency represents 
        substantial progress toward protecting the integrity of 
        the global marketplace.\108\
---------------------------------------------------------------------------
    \108\ Born, supra at 630.

    Despite the commitments it made in the 1997 Tokyo 
Communique, the United States has failed to increase its 
oversight of or collection of information related to large 
positions on OTC markets. To the contrary, as explained in 
Appendix 2, in 2000, Congress enacted the Commodity Futures 
Modernization Act (CFMA), which extended the unregulated status 
of OTC markets for energy, metals, and financial derivatives. 
Economic damage to U.S. consumers, business, and the California 
and U.S. economies from fraud and possible price manipulation 
in U.S. energy markets have renewed calls for increased 
government oversight of energy contracts, swaps, and 
derivatives. Legislation has been introduced, but not yet 
enacted into law, to eliminate a number of the exclusions and 
exemptions for energy contracts from the CEA that now limit the 
Federal Government's ability to detect, deter, and punish 
manipulation in U.S. energy markets.


                               APPENDIX 2

                              ----------                              


       HISTORY AND CURRENT STATUS OF COMMODITY MARKET REGULATION

    In the United States, the Commodity Exchange Act (CEA) is 
the primary Federal statute governing the purchase and sale of 
contracts for the future delivery of crude oil. Section I of 
this Appendix describes the legislative history and major 
provisions of the CEA as it relates to the trading of contracts 
for future delivery of crude oil. Section II describes the 
recent exclusions and exemptions for energy and crude oil 
contracts that are traded ``over-the-counter.''

I. LEGISLATIVE HISTORY OF THE COMMODITY EXCHANGE ACT

          ``[The CFTC] chairman, William Bagley, was fond of 
        reminding people that the CFTC had fewer `policemen' 
        than the Rockville, Maryland, Police Department--and 
        this to monitor the commodity exchanges that are among 
        the world's most complex economic institutions.''
            --Dan Morgan, Merchants of Grain (1980)

        Summary: A fundamental purpose of the regulation of the 
        commodities futures markets is to prevent manipulation.

A. Background on Commodities Exchanges and Need for Regulation

    In 1848, as the industrial revolution was helping transform 
the American Midwest into productive farmland, 82 merchants 
founded the Chicago Board of Trade (CBOT) to be a central 
marketplace for producers, buyers, and sellers in the expanding 
grain trade. In 1865, the CBOT developed futures contracts for 
trading on the exchange. These standardized contracts, which 
provided for delivery of a standardized quantity of grain, at a 
specific location, on a fixed date in the future, at an agreed-
upon price, afforded farmers with the price certainty and 
stability that enabled them to commit resources to the planting 
of wheat without knowing the specific prices the wheat would 
eventually obtain on the spot market. Similarly, these futures 
contracts allowed grain traders, processors, and merchandisers 
to protect themselves or ``hedge'' against price volatility 
while transporting, storing, and processing the grains. The 
trading of futures contracts attracted speculators who were 
willing to absorb some of these price risks in exchange for 
speculative gains, bringing ``liquidity'' to the market. This 
market innovation enabled American farmers and merchants to 
join in the mushrooming international trade in grains in the 
latter part of the 19th Century.
    Hundreds of other agricultural exchanges soon sprouted 
across the country to participate in the domestic and 
international markets. In 1872 in New York, a group of dairy 
merchants organized the ``Butter and Cheese Exchange of New 
York,'' which also began trading in futures. The New York 
exchange soon grew to become the ``Butter, Cheese and Egg 
Exchange,'' and, in 1882, to reflect the inclusion trade of 
poultry, groceries, dried fruits, and other produce, became 
simply ``the New York Mercantile Exchange.''
    Over time, most of the smaller exchanges could not compete 
with the large exchanges in New York and Chicago, and have 
either folded or been consolidated into the major exchanges. 
The last major consolidation occurred in 1994, when the New 
York Mercantile Exchange merged with the Commodity Exchange 
(COMEX), which trades in items such as gold, copper, hides, 
rubber, silk, silver, and tin. A list of commodity exchanges in 
operation today is provided in Table A.2-1.\1\
---------------------------------------------------------------------------
    \1\ CFTC website, at http:/www.cftc.gov/dea/deadcms--table.htm.

    [GRAPHIC] [TIFF OMITTED] T5551.007
    
    In the late 19th Century, the commodities markets were 
self-regulated and rife with manipulation. To many, the 
commodities markets did not reflect natural forces of supply 
and demand or perform a valuable economic function, but rather 
were corrupt institutions that enabled unscrupulous speculators 
to control the price of basic commodities. ``[T]he frequent 
picture of commodity exchanges was one of unbridled 
speculation, recurrent market manipulations, and spectacular 
price fluctuations. Indeed, it was a serious question with many 
whether the economic services of the system in the 1870's and 
1880's were not outweighed by speculative excesses and abuses 
of the system.'' \2\ The ``shenanigans that took place year in 
and year out at the Chicago Board of Trade'' fed into the 
populist resentment against the trusts, banks, and other large 
corporate interests toward the end of the century:
---------------------------------------------------------------------------
    \2\ Report of the Senate Committee on Agriculture, Nutrition, and 
Forestry, to accompany S. 2019, Futures Trading Act of 1982, S. Rept. 
97-384, 97th Cong., 2nd Sess. 11 (1982).

          The Board of Trade, which was created in 1848 at the 
        instigation of Chicago's merchants, soon became a sort 
        of international symbol of the worst elements of 
        American free enterprise: greed; the cycle of riches 
        and ruin, boom and bust; corruption. There was an orgy 
        of speculation and market manipulation during the Civil 
        War. The Board printed rules governing trading in 1869, 
        but abuses of all kinds continued--fraud, bribery of 
        telegraph operators to obtain confidential information 
        (until coded messages were used), and the spreading of 
        false rumors to influence prices. Outside the trading 
        floor at Jackson and La Salle streets, bucket shops, 
        not much different from bookie joints or other gambling 
        establishments, flourished.\3\
---------------------------------------------------------------------------
    \3\ Dan Morgan, Merchants of Grain, at 95 (Penguin, 1980).

    Most attempts at cornering the market did not succeed, 
mainly because the markets were too large. ``Memoirs of the 
markets are full of stories about attempted corners, and they 
usually have two things in common: greed and failure.'' \4\ 
``Squeezes made some rich, and bankrupted others. The more 
severe episodes placed enormous strains on the nation's 
financial system. . . . Indeed, the gold corner shook the 
administration of Ulysses S. Grant (who was indirectly linked 
to the scheme) to its core and largely foreshadowed its litany 
of scandal.'' \5\ The rampant corruption and manipulations 
undermined confidence in the futures markets. ``The 
irresponsible trading and lack of effective market regulation 
in the early period stirred farm resentment and opposition to 
futures trading that still exist to a limited extent.'' \6\
---------------------------------------------------------------------------
    \4\ Stephen Fay, Beyond Greed, at 60 (1982).
    \5\ Steven Craig Pirrong, The Economics, Law, and Public Policy of 
Market Power Manipulation 2 (1996).
    \6\ S. Rept. 97-384, supra at 11.
---------------------------------------------------------------------------

B. The Commodity Exchange Act

  1. Grain Futures Act of 1922

    ``The abuses of futures trading in this early period 
resulted in repeated efforts of various State legislatures, 
from the late 1860's onward, to abolish futures trading.'' \7\ 
In 1892-93 both houses of Congress passed bills that would have 
imposed a prohibitive tax on futures trading; final legislation 
was narrowly defeated on a procedural motion.\8\ As farm prices 
rose and stabilized in the ensuing years, however, legislative 
efforts focused on regulation of the markets rather than their 
abolition.
---------------------------------------------------------------------------
    \7\ S. Rept. 97-384, supra at 11; Dan Morgan, Merchants of Grain, 
at 97 (Penguin, 1980).
    \8\ S. Rept. 97-384, supra at 11.
---------------------------------------------------------------------------
    It was not until grain prices collapsed after the First 
World War that Federal legislation was passed to regulate the 
futures markets. During the First World War, the disruption of 
European grain production and markets drove up prices for 
American grain, providing handsome profits for entrepreneurial 
merchants and speculators. After the War ended, the high levels 
of production in the United States and the resumption of grain 
production in Europe caused wheat prices to plummet. At the 
same time, the overall U.S. economy had fallen into a 
depression. American farmers blamed their post-war plight on 
the excesses of the speculators, particularly the short 
sellers, whose speculative selling, they believed, had driven 
down the price of grains.\9\ At Congressional hearings, farm 
witnesses ``attacked speculators as `predatory parasites,' 
thieves, gamblers, and wealthy individuals who `live like lords 
and ride in high-powered automobiles and live in great 
residences.' '' \10\ The farmers clamored for either outright 
abolition of the trading of futures or, at the very least, 
stringent linkages between contracts for futures and the 
physical market.\11\
---------------------------------------------------------------------------
    \9\ See Romano, The Political Dynamics of Derivative Securities 
Regulation, 14 Yale J. on Reg. 279, 287 (1997).
    \10\ Id. at 292.
    \11\ Id., at 291-294.
---------------------------------------------------------------------------
    Largely as a result of the agitation from the farmers, in 
1922, the Congress passed the Grain Futures Act to prevent 
excessive speculation and manipulation.\12\ Congress set forth 
in the statute itself the purpose of the futures markets--for 
hedging, price discovery, and price dissemination; the 
importance of these markets to the national and international 
commerce; and the public interest in preventing excessive 
speculation and manipulation:
---------------------------------------------------------------------------
    \12\ The Future Trading Act, 42 Stat. 187 (1921), imposed a tax on 
all grain futures contracts that were not traded on a designated 
contract market. In Hill v. Wallace, 269 U.S. 44, 42 S.Ct. 453, 66 
L.Ed. 822 (1922), the Supreme Court held this Act to be an 
unconstitutional violation of the taxing power. To remedy this 
constitutional defect, the next year the Congress passed the Grain 
Futures Act, 42 Stat. 998 (1922), with virtually the same provisions as 
the overturned law, but without the offending tax provision. The Grain 
Futures Act simply made it illegal to trade in futures contracts off a 
designated contract market. The Supreme Court upheld the Grain Futures 
Act as a constitutional exercise of the power to regulate interstate 
commerce in Board of Trade v. Olsen, 262 U.S. 1, 43 S.Ct. 479, 67 L.Ed. 
839 (1923).

          The prices involved in such transactions are 
        generally quoted and disseminated throughout the United 
        States and in foreign countries as a basis for 
        determining the prices to the producer and the consumer 
        of commodities and the products and byproducts thereof 
        and to facilitate the movements thereof in interstate 
        commerce. Such transactions are utilized by shippers, 
        dealers, millers, and others engaged in handling 
        commodities and the products and byproducts thereof in 
        interstate commerce as a means of hedging themselves 
        against possible loss through fluctuations in price. 
        The transactions and prices of commodities on such 
        boards of trade 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.\13\
---------------------------------------------------------------------------
    \13\ 7 U.S.C.A. Sec. 5 (1999).

    The 1922 Act established much of the framework for the 
regulation of the commodities exchanges in effect today. The 
Act required all grain futures contracts to be traded on a 
designated contract market,\14\ and authorized the Secretary of 
Agriculture to designate a board of trade as a ``contract 
market'' if the board satisfied a number of conditions set 
forth in the statute. Among these conditions were for the board 
of trade to require members of the exchange to keep records of 
their transactions, to prevent ``false or misleading or 
knowingly inaccurate reports concerning crop or market 
information,'' and to prevent the ``manipulation of prices and 
the cornering of any commodity.'' \15\ The Act provided the 
government--a commission made up of the Secretary of 
Agriculture, the Secretary of Commerce, and the Attorney 
General--with the authority to revoke the designation of any 
board that failed to comply with the conditions of its 
designation as a contract market.
---------------------------------------------------------------------------
    \14\ In making off-exchange transactions in futures illegal, 
Congress intended to stop the ``bucketing'' of orders in ``bucket 
shops.'' A ``bucket shop'' would take a customer order for a futures 
transaction but not place the order on the exchange; as the counter-
party to the customer's transaction the bucket shop would attempt to 
profit from price movements adverse to the customer. Bucket shops also 
would offset orders from customers with opposing positions against each 
other, thereby short-circuiting the open outcry price discovery 
mechanism of the exchange. Both practices exposed the customers to 
additional costs and risks of default. See, e.g., Markham, supra at 
n139 and accompanying text.
    \15\ 7 U.S.C.A. Sec. 7 (1999).
---------------------------------------------------------------------------

  2. Commodity Exchange Act

    In 1936, Congress enacted the Commodity Exchange Act (CEA) 
to rename and expand the scope of the original Grain Futures 
Act to include not only grain but various other commodities, 
including cotton, butter, and eggs.\16\ The exchanges that 
traded these commodities opposed the regulation of their 
markets as unnecessary, and, in what became a typical objection 
to the various proposed expansions of the markets regulated by 
the CEA, predicted dire consequences if these markets were 
regulated. Experience, however, proved such fears to be 
unfounded.
---------------------------------------------------------------------------
    \16\ 49 Stat. 1491 (1936).
---------------------------------------------------------------------------
    Congress also strengthened the anti-manipulation provisions 
of the Act. In response to the 1936 Supreme Court decision in 
Wallace v. Cutten \17\, in which the Court held the Grain 
Futures Act did not permit after-the-fact criminal prosecutions 
for violations of the anti-manipulation provisions, Congress 
made manipulation a misdemeanor punishable by a fine of $10,000 
and imprisonment of up to 1 year. \18\
---------------------------------------------------------------------------
    \17\ 298 U.S. 229 (1936).
    \18\ 49 Stat. 1498, 1499 (1936)
---------------------------------------------------------------------------

               Butter & Eggs and Cotton Exchanges Opposed

                        Regulation under the CEA

          Although farmers and dairy producers supported the 
        regulation of butter and egg futures, the butter and 
        egg exchanges opposed it. Romano, supra. The President 
        of the Chicago Mercantile Exchange testified the 
        legislation was not needed to ``insure the free flow of 
        butter and eggs from the farm to the table of the 
        consumer.'' The President of the New York Mercantile 
        Exchange predicted the bill would ``undoubtedly curtail 
        trading in futures to such an extent that future boards 
        on commodity exchanges handling butter and eggs will 
        practically become useless.'' The exchanges requested 
        further study before legislation was enacted. Hearings 
        before the Senate Committee on Agriculture and 
        Forestry, To Amend the Grain Futures Act, 74th Cong., 
        2nd Sess., April 21, 22, and 23 (1936).

          Phelan Beale, General Counsel for the Cotton 
        Exchange, testified ``it would be a grievous error to 
        include cotton in a bill that primarily was drawn to 
        apply to grain.'' He asked the Committee to further 
        study the issue so that ``through no inadvertence nor 
        sins of omission or commission may the greatest 
        commodity in the United States and the greatest export 
        of the United States be impaired.'' Hearings before the 
        House Committee on Agriculture, Regulation of Commodity 
        Exchanges, 74th Cong., 1st Sess., 45-46, February 5, 7, 
        and 8, 1935.

    The Congress also added an anti-fraud provision, which to 
this date has remained essentially unchanged. \19\
---------------------------------------------------------------------------
    \19\ 7 U.S.C.A. Sec. 6b (1999).
---------------------------------------------------------------------------

                      The CEA Anti-Fraud Provision

          Section 4b of the CEA makes it unlawful for any 
        person, in connection with the sale of or order for any 
        contract for future delivery that is used for hedging, 
        price discovery, or actual delivery of such commodity, 
        to: (i) cheat or defraud, or attempt to cheat or 
        defraud, another person; (ii) willfully make any false 
        statement to another person or create a false record; 
        (iii) willfully deceive or attempt to deceive another 
        person; or (iv) to bucket any such orders, offset such 
        orders against orders of other persons, or willfully 
        and knowingly become the buyer or seller of sell or buy 
        orders without the consent of the other party.

  3. 1968 Amendments

    In 1968, Congress again expanded the Act and strengthened 
the anti-manipulation and anti-fraud provisions.\20\ The 1968 
amendments brought several additional commodities, such as live 
cattle and pork bellies, within the scope of the Act. It 
empowered the Secretary of Agriculture to disapprove rules 
adopted by a contract market that would violate the Act or the 
regulations established thereunder, and also required the 
contract markets to enforce all of its rules that were not 
disapproved by the Secretary of Agriculture. The amendments 
made a violation of the anti-manipulation and anti-fraud 
provisions a felony rather than a misdemeanor, with a maximum 
prison term of 5 years.
---------------------------------------------------------------------------
    \20\ 82 Stat. 26 (1968).
---------------------------------------------------------------------------

  4. 1974 Amendments: Creation of CFTC

    Initially, jurisdiction over the commodities markets was 
provided to the Department of Agriculture because the 
commodities markets were centered around a limited number of 
agricultural products. By the 1970's, a number of futures 
markets in other products had developed, such as coffee, sugar, 
cocoa, lumber, and plywood, plus various metals, including the 
volatile silver market, and foreign currencies. In 1974, 
Congress concluded the need to regulate these commodity markets 
was no less than the need to regulate the agricultural markets 
already within the Act:

          A person trading in one of the then unregulated 
        futures markets needed the same protection afforded to 
        those trading in the regulated markets. Whether a 
        commodity was grown, mined, or created, or whether it 
        was produced in the United States or outside the United 
        States made little difference to those in this country 
        who bought, sold, processed, or used the commodity, or 
        to the United States consumers whose prices were 
        affected by the futures market in that commodity.\21\
---------------------------------------------------------------------------
    \21\ S. Rept. 97-384, supra at 13.

    Accordingly, Congress overhauled the CEA and expanded its 
coverage to include a broad range of futures contracts, not 
just the agricultural commodities already specified in the 
statute.\22\
---------------------------------------------------------------------------
    \22\ The commodities listed in the statute are wheat, cotton, rice, 
corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, 
eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and 
oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, 
and all other fats and oils), cottonseed meal, cottonseed, peanuts, 
soybeans, soybean meal, livestock, livestock products, and frozen 
concentrated orange juice. 7 U.S.C.A. Sec. 1a(4) (West Supp. 2002). In 
1958, as a result of the numerous manipulations of the onion market, 
the Congress prohibited all futures in onions. Pub. L. 85-839, Sec. 1, 
Aug. 28, 1958, 72 Stat. 1013; 7 U.S.C.A. Sec. 13-1 (West 1999). See 
Markham, supra at 318 (``Perhaps the most manipulated market of all was 
onions.'').
---------------------------------------------------------------------------

             Coffee & Sugar and Cocoa Exchanges and Silver

               Companies Opposed Regulation Under the CEA

          The New York Coffee and Sugar Exchange and the New 
        York Cocoa Exchange (both are now part of the New York 
        Board of Trade) opposed the regulation of their 
        markets. One representative testified these exchanges 
        were ``more than adequately regulated'' under their own 
        rules and the ``good sound judgment'' of their officers 
        and governing boards. He perceived ``no reason'' for 
        regulation under the CEA. The exchanges predicted that 
        regulation would drive these futures markets overseas, 
        causing the United States and the City of New York ``to 
        lose substantial employment opportunities and taxable 
        revenues,'' and ``would increase the volatility of 
        commodity prices passed on to consumers in the United 
        States.'' Commodity Futures Trading Commission Act, 
        Hearings before the Senate Committee on Agriculture and 
        Forestry, 93rd Cong., 2nd Sess, Pt. 2, 464, 465 (1974).
          Today, the New York Board of Trade states it is ``the 
        world's premier futures and options markets'' for 
        cocoa, coffee, cotton, frozen concentrated orange 
        juice, and sugar. New York Board of Trade, Agricultural 
        Futures & Options.
          Several companies trading in silver opposed the 
        regulation of futures contracts for silver. Even as the 
        Hunt brothers were active in the silver market, the 
        Chairman of Mocatta Metals, the largest U.S. silver 
        bullion dealer, testified there were ``no major 
        scandals or improprieties affecting trading on the 
        major international commodity exchanges necessitating 
        emergency amelioration,'' and urged more study of the 
        issue. Mocatta predicted full CFTC regulation ``could 
        upset the markets for international commodities and 
        materially reduce the vitality of U.S. participation in 
        those markets, thereby causing those commodities to 
        flow away from our shores and to be most costly to 
        acquire for consumption in the U.S.'' 1974 Senate 
        Hearings, supra, at Part. 3, 797 (Statement of Dr. 
        Henry G. Jarecki).

    The 1974 Amendments expanded the Act to include ``all other 
goods and articles . . . and all services, rights, and 
interests in which contracts for future delivery are presently 
or in the future dealt in.''
    In expanding the scope of the Act, Congress reiterated the 
purpose of the Act to prevent fraud, manipulation, and control 
speculation in the commodity markets:

          The fundamental purpose of the Commodity Exchange Act 
        is to ensure fair practice and honest dealing on the 
        commodity exchange and to provide a measure of control 
        over those forms of speculative activity which too 
        often demoralize markets to the injury of producers and 
        consumers and the exchanges themselves.\23\
---------------------------------------------------------------------------
    \23\ S. Rept. 93-1131, 93rd Cong., 2nd Sess. (1974).

    The legislation transferred the authority of the Secretary 
of Agriculture to the new Commodity Futures Trading Commission 
(CFTC), an independent five-member regulatory agency. The 1974 
Amendments increased the maximum fine for a violation of the 
anti-manipulation prohibition from $10,000 to $100,000.\24\
---------------------------------------------------------------------------
    \24\ Pub. L. 93-463, Sec. 212(d)(1) (1974). In 1978, Congress 
increased the maximum financial penalty for manipulation to $500,000, 
Pub. L. 95-405, Sec. 19(1). The maximum penalty was increased to 
$1,000,000 in 1992. Pub. L. 102-546 Sec. 212(a).
---------------------------------------------------------------------------
    Congress also clarified that this expansion of CEA coverage 
did not extend to certain financial transactions. During the 
debate over the 1974 amendments, the Treasury Department had 
expressed concern that the proposed language to broaden the Act 
could be read to encompass the existing trade in currency 
futures between large banks and other sophisticated 
institutions. Congress responded by enacting the ``Treasury 
Amendment,'' which exempted from the Act ``transactions in 
foreign currency, security warrants, security rights, resales 
of installment loan contracts, repurchase options, government 
securities, or mortgages and mortgage purchase commitments, 
unless such transactions involve the sale thereof for future 
delivery conducted on a board of trade.'' \25\
---------------------------------------------------------------------------
    \25\ 7 U.S.C.A. Sec. 2(i) (1999).
---------------------------------------------------------------------------
    The Senate report on the 1974 legislation explained the 
rationale underlying the Treasury Amendment:

          [T]he Committee included an amendment to clarify that 
        the provisions of the bill are not applicable to 
        trading in foreign currencies and certain enumerated 
        financial instruments unless such trading is conducted 
        on a formally organized futures exchange. A great deal 
        of the trading in foreign currency in the United States 
        is carried out through an informal network of banks and 
        tellers. The Committee believes that this market is 
        more properly supervised by the bank regulatory 
        agencies and that, therefore, regulation under this 
        legislation is unnecessary.\26\
---------------------------------------------------------------------------
    \26\ S. Rept. 93-1131 (1974).

    In the mid-1970's, following the extreme price volatility 
in the energy sector resulting from the Arab oil embargo, a new 
market for energy futures emerged. In 1978, NYMEX offered 
futures contracts in heating oil, and over the next several 
years NYMEX proposed a variety of futures contracts in other 
petroleum products. In 1983, NYMEX began trading in the WTI 
futures contract.\27\
---------------------------------------------------------------------------
    \27\ See John Elting Treat, ed., Energy Futures, Trading 
Opportunities for the 1990's, 20-23 (1990).
---------------------------------------------------------------------------
    Today, the vast majority of futures contracts traded on the 
exchange are unrelated to agriculture. Whereas as recently as 
the early 1970's, most of the approximately 13 million futures 
contracts traded annually on domestic boards of trade involved 
agricultural commodities, in 1999, nearly 600 million futures 
contracts were traded annually in the United States, but with 
only a small fraction--about 11 percent--related to 
agriculture.\28\
---------------------------------------------------------------------------
    \28\ Chicago Board of Trade, Action in the Marketplace, at 2.
---------------------------------------------------------------------------
    In 1980, in a case involving the question of whether the 
CEA provided a private right of action, the U.S. Court of 
Appeals for the Second Circuit traced the history of the CEA 
and observed how the Act had been strengthened over the years 
to match the needs of the evolving futures markets:

          The history of congressional concern with commodity 
        futures trading has thus been one of steady expansion 
        in coverage and strengthening of regulation. In 1936, 
        1968, and 1974 new commodities came under the CEA. In 
        each of these years the power of the regulatory 
        authority were augmented, and penalties were either 
        extended, increased, or both. The question of 
        Congressional intent with respect to private sanctions 
        under the Act must be considered against this 
        background of increasingly strong regulation designed 
        to insure the existence of fair and orderly 
        markets.\29\
---------------------------------------------------------------------------
    \29\ Leist v. Simplot, 638.F.2d 283, 296 (2d Cir. 1980), aff'd sub 
nom. Merrill Lynch, Pierce, Fenner & Smith v. Curran, 456 U.S. 353 
(1982).

    Although one of the main purposes of the CEA was to 
discourage and punish market manipulation, manipulations and 
attempts at manipulation of the commodity markets have 
continued. In 1982, following the Hunt brothers' attempts to 
---------------------------------------------------------------------------
corner the silver market, one observer commented:

          The 19th Century grain market in Chicago was littered 
        with examples of attempted squeezes and corners; to a 
        lesser extent it still is. Rings and corners in the 
        stock market ended with the Great Crash and the 
        establishment of the Securities and Exchange Commission 
        in 1934. But commodities remained a temptation to the 
        corner men. In the last generation corners were 
        attempted in eggs, onions, vegetable oil, soybeans, and 
        potatoes. The fact that market manipulation is now 
        illegal does not stop people trying.\30\
---------------------------------------------------------------------------
    \30\ Stephen Fay, Beyond Greed, at 60 (1982). For a list of Federal 
manipulation cases decided between 1940 and 1989, see Markham, 
Manipulation of Commodity Futures Prices--The Unprosecutable Crime, 8 
Yale J. on Reg. 281 (1991) (``The commodity futures market has been 
beset by large-scale manipulations since its beginning.'')

    More recent history demonstrates that manipulations are not 
``simply relics of the distant past.'' \31\ Allegedly, the Hunt 
brothers squeezed the soybean market in 1977, as well as the 
silver market a couple of years later. The Feruzzis allegedly 
squeezed the CBOT soybean market in the late 1980's. ``In 1991, 
the eminent investment bank and primary government securities 
dealer Salomon Brothers successfully cornered several issues of 
Treasury notes, thereby causing huge disruptions in the world's 
financial market and throwing a cloud of suspicion over it that 
has yet to dissipate completely.'' \32\ As discussed in 
Appendix 1, the Sumitomo Corporation manipulated the price of 
copper in the mid-1990's, causing as much as a 30 percent rise 
in copper prices. And as discussed in the main section of this 
report, in 2000, a U.S. refiner obtained a large financial 
settlement from Arcadia, a crude oil trading company, in a 
lawsuit over alleged manipulation of the crude oil market.
---------------------------------------------------------------------------
    \31\ Steven Craig Pirrong, The Economics, Law, and Public Policy of 
Market Power Manipulation (1996) at 3.
    \32\ Id. See also Nicholas Dunbar, Inventing Money 109-112 (2001).

II. OVER-THE-COUNTER ENERGY DERIVATIVES: EXCLUSIONS AND EXEMPTIONS 
                    FROM COMMODITY EXCHANGE ACT

          ``With the CFTC's withdrawal from regulating many of 
        the more popular derivatives in the late 1980's and 
        early 1990's, it appeared that dealers in those 
        financial products had found a virtually regulation-
        free promised land.''
            --Philip McBride Johnson, former Chairman, CFTC 
        (1999)

    The CEA provides the CFTC with jurisdiction over 
``agreements . . . and transactions involving contracts of sale 
of a commodity for future delivery traded or executed on a 
contract market . . . or any other board of trade, exchange, or 
market.'' Neither the original Grain Futures Act of 1922, nor 
any of the subsequent amendments, defined or set forth the 
elements of a ``futures contract'' or the term ``future 
delivery.'' Rather, the term ``future delivery'' is defined 
only in reference to that which it is not--a ``forward 
contract.'' The CEA's definition of ``future delivery'' merely 
states: ``The term `future delivery' does not include any sale 
of any cash commodity for deferred shipment or delivery.'' \33\
---------------------------------------------------------------------------
    \33\ 7 U.S.C.A. Sec. 1a(19) (Supp. 2002).
---------------------------------------------------------------------------
    The distinctions between ``future contracts,'' or 
``contracts for future delivery,'' and ``forward contracts'' 
have never been settled. A key issue that arose after the 1974 
expansion of the CEA and the enactment of the Treasury 
amendment was the extent to which the swaps and other over-the-
counter derivatives that were coming into widespread use in the 
1980's could be considered contracts for future delivery within 
the scope of the CEA. Many of the OTC derivatives, such as 
swaps, call for one or both parties to make a stream of 
payments to the other party over a specified period of time. If 
these OTC derivatives were to fall within the definition of a 
contract for future delivery, then they would have become 
legally suspect because they were not being traded on an 
approved exchange. In the 1980's, as large corporations and 
financial institutions increasingly used OTC derivatives to 
manage financial risks, the uncertainty of the legal status of 
these instruments became a significant concern. From then to 
the present, the CFTC, other Federal agencies with jurisdiction 
over financial instruments, the financial community, the oil 
industry, other commodity traders, and Congress have debated 
the extent to which these instruments should be regulated under 
the CEA.

A.  1989 Swaps Policy Statement: Exemption for Certain OTC Swap 
                    Transactions

    In 1989, in response to the call for more legal certainty, 
the CFTC issued a ``Swaps Policy Statement'' to clarify that it 
would not seek to regulate certain OTC swap transactions.\34\ A 
swap transaction is essentially ``an agreement between two 
parties to exchange a series of cash flows measured by 
different interest rates, exchange rates, or prices with 
payments calculated by reference to a principal base (notional 
amount).'' \35\ Financial swaps are used by corporations and 
financial institutions to hedge exposure to changing interest 
or currency exchange rates, or, on the other side of such a 
transaction, to speculate on interest or currency exchange 
rates. Commodity swaps are structured similarly to interest 
rate or currency swaps, except that payments are calculated in 
reference to the price of a specified commodity, such as crude 
oil.
---------------------------------------------------------------------------
    \34\ 54 Fed. Reg. 30,694 (1989).
    \35\ Id.
---------------------------------------------------------------------------
    In its 1989 Swaps Policy Statement, the CFTC held that 
although swap transactions had elements of futures contracts, 
most swap transactions were sufficiently distinguishable from 
futures contracts to conclude they were ``not appropriately 
regulated as such under the Act and its regulations.'' The CFTC 
set forth a number of criteria a swap transaction must meet to 
qualify for this exemption from regulation: (1) the swap 
agreement must not be fully standardized, meaning the terms 
must be negotiated by the parties and their terms must be 
``individually tailored;'' (2) the swap agreement may not be 
terminated through an exchange-style offset with other swap 
agreements of opposite positions, and may be terminated only 
with the consent of the counterparty; (3) the swap agreement 
cannot be supported by the credit of a clearing organization, 
as futures contracts are supported on an exchange, and each 
party to the agreement must assume the credit risk of the other 
party; (4) the transaction must be undertaken in conjunction 
with a line of business, such as that conducted by a large 
corporation, commercial or investment bank, insurance company, 
or governmental entity; and (5) the swap transactions sought to 
be exempted may not be marketed to the public.
    The 1989 Swaps Policy Statement, however, did not end the 
debate over the status of these types of contracts. The CFTC 
did not declare in its policy statement that swap transactions 
were excluded from regulation under the CEA; it only stated the 
CFTC had chosen not to regulate them ``at this time.'' The 
CFTC's action left open the possibility that swap transactions 
could be regulated at some time in the future. This concern was 
heightened the very next year, when controversy erupted over 
the applicability of the CEA to the Brent market.

B. Exemptions for Certain Brent Crude Oil Contracts

  1. The Transnor Decision

    In April 1990, Judge William Conner, U.S. District Judge 
for the Southern District of New York, ruling on a motion for 
summary judgment in the case of Transnor v. BP,\36\ held that 
15-day Brent contracts were future contracts within the meaning 
of the CEA. As explained in more detail in Section III of the 
main report, these contracts provide for the delivery of a 
cargo of Brent crude oil, fully loaded at the Sullom Voe 
terminal in the North Sea, at a specified month in the future. 
They are used for hedging, price discovery, and speculation, as 
well as for physical delivery of crude oil.
---------------------------------------------------------------------------
    \36\ 738 F. Supp. 1472 (S.D.N.Y. 1990).
---------------------------------------------------------------------------
    In Transnor, the plaintiff, a Bermuda-based oil trading 
company, alleged that several North Sea oil producers--BP, 
Shell, Conoco, and Exxon--had conspired to sell Brent crude oil 
at below-market prices in order to lower the tax imposed on 
their Brent production.\37\ In December 1985, Transnor 
purchased, at an average price of $24.50 per barrel, two 15-day 
Brent contracts for the delivery of two Brent cargoes (500,000 
barrels per cargo) in March 1986. In early 1986, an OPEC price 
war erupted, and the price of crude oil plummeted. By the end 
of March, the price of Brent had fallen to $13.80 per barrel. 
Transnor refused to take delivery of the crude oil and filed 
suit against the four producers of Brent crude for $230 million 
in damages, claiming that they were partially responsible for 
the fall in price. Transnor alleged the Brent producers 
conspired to fix prices, in violation of the Sherman Antitrust 
Act, and manipulated the price of 15-day Brent contracts, in 
violation of the CEA.
---------------------------------------------------------------------------
    \37\ Shell and BP settled with Transnor and were dismissed from the 
case. Shortly after filing suit, Transnor's oil trading operations went 
bankrupt.
---------------------------------------------------------------------------
    In his ruling, Judge Conner first addressed the question of 
whether principles of comity and international law compelled 
the court to decline to exercise jurisdiction. The judge found 
that although the British government had expressed an intention 
to promulgate some binding regulations applicable to the Brent 
market, it had not actually issued any. The court concluded 
``application of U.S. antitrust and commodity laws does not 
create either an actual or potential conflict with existing 
British government regulation of Brent market transactions. 
That a conflict may arise in the future should the British 
government act is too uncertain to weigh against the exercise 
of jurisdiction.'' \38\ The court went on to find that the 
parties' ties to the United States were ``stronger than those 
to the United Kingdom,'' the alleged conduct ``clearly impacted 
U.S. commerce,'' there were ``issues of fact as to whether 
defendants intended to affect U.S. commerce or should 
reasonably have foreseen such an impact,'' and ``the U.S. is an 
important locus, if not the hub, of defendants' alleged 
manipulation.'' \39\ In sum, the court held, ``with all factors 
considered, both a quantitative and a qualitative tally favor 
the exercise of jurisdiction by this Court--a result which 
should not affront British interests.'' \40\
---------------------------------------------------------------------------
    \38\ 738 F.Supp. at 1477.
    \39\ Id. at 1477-1478.
    \40\ Id.
---------------------------------------------------------------------------
    After rejecting the defendants' arguments to dismiss the 
plaintiff's antitrust claims, the court turned to the 
defendants' contention that 15-day Brent contracts were in 
reality ``contracts of sale of a commodity for future 
delivery''--i.e., forward contracts--and therefore not within 
the scope of the CEA. In analyzing this claim, the court first 
reviewed the administrative and case law on the differences 
between futures contracts and forward contracts, and then 
examined the nature of the 15-day Brent market.
    ``Once distinguished by unique features, futures and 
forwards contracts have begun to share certain characteristics 
due to increasingly complex and dynamic commercial realities,'' 
the court stated. ``The predominant distinction between the two 
remains the intention of the parties and the overall effect of 
the transaction.'' In forward contracts, delivery of a physical 
commodity occurs, but is delayed or deferred for convenience or 
necessity.\41\ ``By contrast, futures contracts are undertaken 
primarily to assume or shift price risk without transferring 
the underlying commodity. As a result, futures contracts 
providing for delivery may be satisfied either by delivery or 
offset.'' \42\ In determining whether physical delivery is, in 
fact, intended, the courts and the CFTC look both to the terms 
of the contract and to the practices of the parties.\43\
---------------------------------------------------------------------------
    \41\ The leading appellate case discussing these distinctions is 
Commodity Futures Trading Comm. v. Co Petro Marketing Group, Inc., 680 
F.2d 573(9th Cir. 1982).
    \42\ Transnor, 738 F.Supp. at 1489.
    \43\ Judge Conner also stated that language in an agreement 
requiring future delivery of the underlying commodity does not mandate 
the classification of the agreement as a forward contract, if the 
delivery requirement is not expected to be enforced. ``This Court 
concludes that even where there is no `right' of offset, the 
`opportunity' to offset and a tacit expectation and common practice of 
offsetting suffices to deem the transaction a futures contract.'' Id. 
at 1492.
---------------------------------------------------------------------------
    In examining the 15-day Brent contract, the Transnor court 
found it had elements of both a futures contract and a forward 
contract. The court concluded that although the 15-day Brent 
contract embodied a binding commitment to buy or sell crude 
oil, physical delivery was not generally contemplated by the 
parties, and occurred only in a minority of transactions in the 
15-day market. Thus, the court held the 15-day contracts were 
not forward contracts:

          Moreover, the high degree of standardization of terms 
        such as quantity, grade, delivery terms, currency of 
        payment and unit of measure, which facilitate offset, 
        bookout and other clearing techniques available on the 
        Brent market, further evidence the investment purpose 
        of Brent trading. The 15-day Brent market does not 
        remotely resemble the commercial trading originally 
        exempted from the Act. While this Court recognizes that 
        commercial transactions have increased in complexity 
        since the predecessor to the CEA was enacted, the 
        interests of Brent participants, which include 
        investment and brokerage houses, do not parallel those 
        of the farmer who sold grain or the elevator operator 
        who bought it for deferred delivery, so that each could 
        benefit from a guaranteed price.\44\
---------------------------------------------------------------------------
    \44\ Id. at 1491.

    The court then concluded the 15-day Brent contracts were 
---------------------------------------------------------------------------
futures contracts covered by the CEA:

          Most importantly, the Brent contracts were undertaken 
        mainly to assume or shift price risk without 
        transferring the underlying commodity. Defendants 
        acknowledge that the volume of Brent contract trading 
        greatly exceeded the amount of physical oil available 
        to satisfy such contracts. The volume of contracts 
        traded and the high standardization of the contracts 
        demonstrate the essential investment character of the 
        15-day Brent market. ``With an eye toward [their] 
        underlying purpose,'' the Court concludes that 
        Transnor's 15-day Brent transactions constitute futures 
        contracts.\45\
---------------------------------------------------------------------------
    \45\ Id. at 1492.

    With respect to Transnor's assertions, the court found 
there were issues of material fact, and denied the motion for 
summary judgment.\46\
---------------------------------------------------------------------------
    \46\ The remaining defendants, Conoco and Exxon, settled 
approximately 1 month later. The terms of the settlement were sealed. 
Platt's Oilgram News, Brent 15-Day Market Case Settled; Terms Expected 
to be Sealed, Say Lawyers, May 23, 1990. The New York Times, Suit on 
Price of Crude Oil is Settled, May 23, 1990.
---------------------------------------------------------------------------

  2. Industry Response to Transnor

    The Transnor decision opened up a can of worms for oil 
companies and traders in the Brent market--whether the CFTC 
would begin to regulate the hitherto unregulated 15-day Brent 
market, and whether the Brent contracts were legally invalid 
under the CEA because they had not been traded on an approved 
exchange. NYMEX President Patrick Thompson reflected the 
market's worry over the ruling, stating the Transnor decision 
``creates a concern that these are off-exchange futures 
contracts, which are illegal under Section 4(a) of the 
Commodity Exchange Act. If this holding stands, the 15-day 
Brent market would have to be discontinued in the U.S.'' \47\
---------------------------------------------------------------------------
    \47\ Platt's Oilgram News, NYMEX President Warns Forward Market 
Players of Risk From Transnor Ruling, May 15, 1990. Thompson stated 
NYMEX would support a clarification by the CFTC that provided an 
exclusion from regulation of the 15-day Brent market for ``true 
commercial interests.''
---------------------------------------------------------------------------
    At the time the Transnor decision was issued, the CEA did 
not provide the CFTC with any flexibility as to how futures 
contracts were to be regulated. Under the CEA as it then 
existed, once an instrument was determined to be a futures 
contract, it was required to be traded on an approved exchange 
in accordance with all of the rules and regulations regarding 
exchange-traded contracts, or else be considered illegal. As 
the Transnor decision highlighted, this ``all or nothing'' 
regulatory scheme, which had existed since the original Act was 
passed in 1922, may have been adequate to deal with 
conventional contracts for the sale or delivery of agricultural 
commodities, but it did not provide any flexibility as to how 
to best deal with the swaps, derivatives, hybrids, and other 
novel financial instruments that had developed since the early 
1980's.
    The participants in the Brent market reacted swiftly. 
Several major oil companies and traders, including Shell, 
stopped trading 15-day Brent contracts with American firms; 
others, such as Exxon, suspended all trading in 15-day Brent 
contracts.\48\ ``The Transnor case has scared Brent's 
traders,'' reported The Economist. ``Many have quit the Brent 
market altogether, hedging instead on America's NYMEX and 
London's International Petroleum Exchange, the two big official 
oil-futures exchanges.'' \49\
---------------------------------------------------------------------------
    \48\ Platts Oilgram Price Report, Basin Users Turn to ARCO Portion, 
May 2, 1990; Steven Butler, Nervous Trading in a Market Held in Limbo, 
Financial Times (London), May 3, 1990.
    \49\ The Economist, Oil Trading; Brent Blues, April 28, 1990. 
Because of the lack of transparency of the Brent physical market, it is 
not possible to determine with any degree of accuracy just how much the 
market was affected by the Transnor decision. One British publication 
reported that by the time the Transnor case was settled, about six 
weeks after the ruling, the 15-day Brent market had lost ``at least two 
thirds of its liquidity.'' Larry Black, The Independent (London), Firms 
in Brent Oil Trial Agree to Settle Out of Court, May 23, 1990. In his 
dissent from the CFTC's subsequent decision to exempt 15-day Brent 
contracts from regulation, Commissioner West quoted from several 
articles by Petroleum Argus, a leading price reporting service, that 
despite the Transnor decision Brent trading in April 1990 was higher 
than in April 1989 and not much lower than in April 1988, and that 
Brent trading had been steadily increasing since June 1990. CFTC, 
Statutory Interpretation Concerning Forward Transactions, Dissent of 
Commissioner West, Commodity Futures Law Reports, Commerce Clearing 
House para. 24,925 (October, 1990).
---------------------------------------------------------------------------
    Within days of Judge Conner's decision, lobbyists descended 
upon the CFTC, seeking to mitigate the ruling.\50\ ``What the 
CFTC will do next is uncertain,'' an article in Platts stated, 
``but the lobbyists reportedly were urging the CFTC to state 
that it will not regulate the 15-day Brent market. One source 
said the judge's ruling did not mandate that the CFTC regulate 
Brent trade. Instead, it stated only that Brent trade was not 
`forward' trading as defined by the Commodities Exchange Act, 
but instead is `futures' trading.'' \51\
---------------------------------------------------------------------------
    \50\ Platts Oilgram Price Report, Companies Still Sorting Transnor 
Impact; Brent Market Liquidity Impacted, April 24, 1990.
    \51\ Id.
---------------------------------------------------------------------------
    The British government promptly weighed in against the 
Transnor decision too. In a letter sent to the CFTC less than 2 
weeks after the decision, Britain's Department of Trade and 
Industry (DTI) stated that the decision could be interpreted to 
mean that all trading in 15-day Brent contracts, even such 
trading between British persons within British territory, was 
subject to the U.S. commodities laws. This interpretation, 
according to the DTI, was ``in the British government's view, 
contrary to international law and damaging to the British 
national interest.'' The DTI expressed particular concern that 
trades of 15-day Brent contracts within the United Kingdom 
could be declared illegal or void in the United States. The DTI 
proposed an urgent meeting with the CFTC to resolve the 
issue.\52\
---------------------------------------------------------------------------
    \52\ Platts Oilgram News, UK Agency Expresses Concern Over Conner 
Ruling on Brent Trading, May 2, 1990; The Financial Times (London), 
Britain Challenges US Jurisdiction Claim over Brent Crude Oil Market, 
May 2, 1990.
---------------------------------------------------------------------------
    In response to the concern over the Transnor decision, the 
CFTC immediately began ``an examination'' of the Brent 
issue.\53\ ``The probe appears to be triggered as much by 
pressure from Brent market participants as by Conner's 
ruling,'' Platts reported.
---------------------------------------------------------------------------
    \53\ Robert Di Nardo, Platts Oilgram Price Report, CFTC Begins 
Study of Brent Market Trading, April 25, 1990.
---------------------------------------------------------------------------
    Seven days after the Transnor decision, the CFTC announced 
it was ``considering actions appropriate to maintain United 
States commercial access'' to the Brent market and committed 
itself to act ``as expeditiously as possible.'' \54\ According 
to Platts, ``The CFTC issued its advisory in response to calls 
from Brent players who have been uncertain whether they can 
continue to trade paper Brent from the US after a ruling by a 
Federal district court last week . . . that the Brent 15-day 
contract is a futures contract.'' \55\
---------------------------------------------------------------------------
    \54\ CFTC Advisory No. 31-90, April 25, 1990; Platts Oilgram Price 
Report, CFTC Looking to Act Quickly on Brent Market, April 26, 1990.
    \55\ Id.
---------------------------------------------------------------------------

  3. LCFTC: 15-Day Brent Contracts are Forward Contracts

    In response to the concerns of oil companies and traders, 
financial institutions, and the British government, CFTC 
Chairwoman Wendy Gramm quickly concluded the CFTC should not 
assert authority over the Brent market. In a speech to the 
Futures Industry Institute on May 2, 1990, Chairwoman Gramm 
``indicated aversion to regulating the 15-day Brent market,'' 
stating it is ``not true that any instrument with a bit of 
futurity is a futures contract and therefore within the CFTC's 
jurisdiction.'' \56\
---------------------------------------------------------------------------
    \56\ Platt's Oilgram Price Report, Gramm Speaks Out on Brent 
Regulation, May 3, 1990.
---------------------------------------------------------------------------
    Shortly afterwards, in mid-May, the CFTC reaffirmed that 
position. The CFTC and the British Department of Trade and 
Industry issued a joint release stating, ``The Brent market is 
an international market and cannot be regarded as or regulated 
as if it were exclusively a U.S. market.'' \57\ Concurrently, 
the CFTC staff sent a letter to the companies that had 
contacted the CFTC on the Transnor decision, stating:
---------------------------------------------------------------------------
    \57\ CFTC New Release No. 3248-90, May 16, 1990; Hattie A. Wicks, 
The Oil Daily, U.S., British Agencies Reject Plans to Regulate Brent 
Forward Market, May 17, 1990.

          As represented to the staff, it is our understanding 
        that the market in 15-day Brent contracts among other 
        things involves negotiated transactions between 
        commercial parties, each of whom has the capacity to 
        make or take delivery of Brent crude oil. These 
        contracts are not offered or sold to the general 
        public. Based on these representations the Task Force 
        is of the view that these contracts fall within the 
        category of transactions encompassed by the so-called 
        forward contract exclusion.\58\
---------------------------------------------------------------------------
    \58\ The Oil Daily, CFTC Outlines its View of Brent Trade, May 17, 
1990.

    The letter went on to say that the CFTC likely would issue 
a formal interpretation of the CEA consistent with this view, 
and, in the meantime, ``the staff will not recommend to the 
Commission any enforcement action under the Commodity Exchange 
Act or regulations thereunder based solely upon the activity of 
engaging in transactions involving such contracts.'' \59\
---------------------------------------------------------------------------
    \59\ Id.
---------------------------------------------------------------------------
    In late September 1990, the CFTC issued, by a 3 to 1 vote, 
a formal ``statutory interpretation'' to make clear that 15-day 
Brent transactions ``are excluded from regulation under the 
[CEA] as sales of cash commodities for deferred shipment or 
delivery.'' \60\ In determining that the 15-day contracts were 
forward contracts, the CFTC stated ``it is significant that the 
transactions create specific delivery obligations. Moreover, 
the delivery obligations of these transactions create 
substantial economic risk of a commercial nature to the parties 
required to make or take delivery thereunder,'' such as theft, 
damage, or deterioration of the crude oil to be delivered. The 
CFTC majority noted that obligations for sale or delivery under 
the 15-day contracts were not discharged through ``exchange-
style offset,'' but rather could be cancelled only through 
individually negotiated agreements with the other parties in 
the distribution chain. ``Under these circumstances,'' the 
majority concluded, ``the Commission is of the view that 
transactions of this type which are entered into between 
commercial participants in connection with their business, 
which create specific delivery obligations that impose 
substantial economic risks of a commercial nature to these 
participants, but which may involve, in certain circumstances, 
string or chain deliveries of the type described above, are 
within the scope of the [forward contract] exclusion from the 
Commission's regulatory jurisdiction.'' \61\
---------------------------------------------------------------------------
    \60\ 55 Fed. Reg. 39188 (Sept. 25, 1990). On June 29, 1990, the 
CFTC had issued a draft statutory interpretation to the same effect. 
The draft statutory interpretation was not published in the Federal 
Register, the usual manner for public notice, but rather announced in a 
CFTC advisory, CFTC Advisory No. 49-90, June 29, 1990, which was sent 
only to several media outlets. The Advisory stated that a copy of the 
draft interpretation was available from the Commission's Office of 
Communication and Education Services, and that public comments were 
invited until July 13, 1990. About a dozen comments were received.
    \61\ Id.
---------------------------------------------------------------------------
    Commissioner Fowler C. West dissented, questioning whether 
the market had been so severely disrupted as to warrant such 
extraordinarily quick action on a complex issue. He questioned 
whether the majority's action, which he termed a significant 
change from existing law, was more properly classified as a 
rulemaking, which would require notice-and-comment, rather than 
a statutory interpretation accompanied by a media advisory.
    Commissioner West's dissent referenced the comments of the 
Chicago Board of Trade (CBT), which noted that the current 
methods for clearing and settlement in the 15-day Brent market 
were the same as the antiquated clearing and settlement methods 
previously used on the CBT more than 70 years ago, before the 
CBT created a clearing corporation for all trades on the 
exchange. ``The CBT stated that at the time Congress first 
restricted futures trading to designated exchanges, CBT used a 
`ring' method of clearing and settlement closely resembling 
today's Brent market. CBT argues that `rather than 
distinguishing 15-day Brent contracts from futures contracts, 
the daisy chains, book-outs and cancellation agreements of 
circles and loops confirm that the 15-day Brent market is 
composed of the very kind of transactions intended to be 
regulated as futures contracts.' '' \63\
---------------------------------------------------------------------------
    \63\ West Dissent, at 10.
---------------------------------------------------------------------------
    The dissent also noted that the 15-day contracts were 
highly standardized, and that many of the companies urging the 
CFTC not to regulate the 15-day Brent market as a futures 
market had stated that these contracts were used for hedging 
and price discovery, which is the primary purpose of the 
futures markets.\64\ He also observed that traders in the 15-
day Brent market included speculators and traders who had no 
intention of ever taking or making delivery. ``Those commenters 
seem to want the Commission to exclude from regulation even 
those hedging and pricing activities which Congress determined 
the Commission should regulate under the Commodity Exchange 
Act.'' \65\
---------------------------------------------------------------------------
    \64\ See, e.g., Comment Letter of Phibro Energy, Inc., May 2, 1990 
(``The participation by such entities in these markets provides price 
protection for the participants both in the Brent and related physical 
markets and adds significantly to the market's depth, liquidity, 
pricing efficiency and pricing transparency.''); Comment Letter of 
Mobil Oil Corp., May 2, 1990 (``Because of its relevance in the pricing 
of a wide variety of international crude oils equity producers, 
refiners and traders also enter into 15-day Brent contracts to manage 
their price exposure in the market); Comment Letter of Bear Stearns, 
April 30, 1990 (``The Brent crude oil market is used regularly by Bear 
Stearns for its commercial needs, including as a hedging mechanism for 
non-U.S. oil that, in Bear Stearns' view, cannot be as efficiently 
protected under the New York Mercantile Exchange's futures contract 
which is sensitive to domestic economic developments.''); see also 
Comment Letter of Mobil Oil Corp. on Regulation of Hybrid and Related 
Instruments, April 11, 1990 (``Mobil and other major participants in 
these markets often enter into transactions to manage price risk, 
rather than to transfer ownership of the underlying product.'').
    \65\ West Dissent, at 12.
---------------------------------------------------------------------------
    In conclusion, he wrote, ``Broadening the applicability of 
the forward contract exclusion to include transactions by 
traders who are speculators, who are not contemplating 
delivery, who are using generally standardized contracts, who 
routinely offset their positions and who do not use the 
underlying commodity itself is an erroneous interpretation of 
the Act.''
    Although he disagreed with the majority's conclusion that 
the 15-day Brent contracts were forward rather than futures 
contracts, Commissioner West did not believe the 15-day 
contracts needed to be traded on designated U.S. exchanges. He 
suggested several alternatives for the treatment of the 15-day 
Brent market that, in his opinion, would preserve the legal 
validity of these contracts without changing the meaning of the 
forward contract exclusion. His preferred alternative would be 
for Congress to provide the CFTC with the authority to exempt 
certain transactions from the exchange-trading requirement:

          The cleanest way for the Commission to permit such 
        markets to operate without contract market designation 
        would be for it to have the authority to exempt certain 
        transactions by rule, regulation or order from the 
        exchange trading limitation of Section 4(a) of the Act, 
        when in the public interest to do so. The Brent 
        situation may demonstrate the desirability of such 
        authority. Congress could provide the Commission such 
        exemptive authority, and the Commission could then 
        exercise that authority in a manner recognizing 
        historic concerns about fraud and manipulation.\66\
---------------------------------------------------------------------------
    \66\ West Dissent, at p.19. In an unusual move for a Federal 
regulatory agency, the CFTC majority--Chairwoman Gramm and 
Commissioners Kalo Hineman and William Albrecht--blocked the official 
publication of Commissioner West's views. As a result of the majority's 
action, in 1992, Congress amended the CEA to require the publication of 
all dissenting opinions. ``Whenever the Commission issues for official 
publication any opinion, release, rule, order, interpretation, or other 
determination on a matter, the Commission shall provide that any 
dissenting, concurring, or separate opinion by any Commissioner on the 
matter be published in full along with the Commission opinion, release, 
rule, order, interpretation, or determination.'' 7 U.S.C.A. 
Sec. 4a(h)(3) (West 1999 & Supp 2002).

    A couple of months later, ``still steamed'' about the 
majority's handling of the Brent issue, Commissioner West again 
took issue with the majority's actions.\67\ In a public speech, 
Commissioner West expanded his criticisms of the procedures 
used by the majority for its new interpretation of the forward 
contract exclusion:
---------------------------------------------------------------------------
    \67\ Securities Week, CFTC May Not Be Able to Live Down ``Mistake'' 
on Brent Oil Decision, December 3, 1990.

          While the standard notice and public comment 
        procedures of rulemaking were not followed in issuing 
        the statutory interpretation, some dozen comments were 
        received. Even though the Commission issued a press 
        release inviting comments on the draft statutory 
        interpretation, this severely limited opening in the 
        decision-making process occurred only after some 
        individual commissioners became concerned about the 
        scope of the interpretation's coverage and insisted 
        that some public participation was necessary. Those 
        instincts were correct and should have been followed 
        farther.
          At the very least the Commission, as an expert 
        agency, is obligated to take its own hard look at an 
        issue. This was not done. Instead, the majority of the 
        Commission seems to have relied on the representations 
        of parties with a substantial stake in the outcome of 
        our action. . . . The Commission has not made its own 
        independent study of [the Brent] market, nor has it 
        taken appropriate steps to seek out the views of those 
        parties who might oppose the proposition that Brent 
        transactions are forward contracts, as it likely would 
        have obtained in a rulemaking. These were the minimum 
        steps that we should have taken.\68\
---------------------------------------------------------------------------
    \68\ Remarks by Commissioner Fowler C. West, CFTC, The Brent Issue: 
More Than A Statutory Interpretation, before the Committee on 
Commodities and Futures Law, New York State Bar Association, November 
29, 1990.

    Commissioner West again stated that the Brent contracts 
were ``largely indistinguishable from futures contracts.'' 
Furthermore, he warned, ``The Commission may soon be paying a 
price for its politically expedient statutory interpretation. I 
doubt that its new forward contract exemption can be restricted 
to large international oil and trading firms represented by 
influential lawyers. The public, down the road, will suffer 
from this fit of de-regulation, no matter how well-intended. I 
believe Congress expects us to have more concern for the 
public.'' \69\
---------------------------------------------------------------------------
    \69\ Id.
---------------------------------------------------------------------------
    Later, the North American Administrators Association 
(NASAA), representing ``the 50 state securities agencies 
responsible for investor protection and the efficient 
functioning of the capital markets at the grassroots level,'' 
characterized the CFTC's response to the Transnor as ``quick, 
but beyond its authority and misguided. In its attempt to calm 
oil traders, producers, and purchasers, the CFTC went too 
far.'' \70\ The state regulators viewed the CFTC's statutory 
interpretation as incorrect and dangerous:
---------------------------------------------------------------------------
    \70\ Hearing before the House Subcommittee on Environment, Credit, 
and Rural Development, Committee on Agriculture, To Amend the Commodity 
Exchange Act to Ensure the Continued Application of The Act's Antifraud 
and Antimanipulation Protections, Statement of Wayne Klein, on behalf 
of NASAA, June 30, 1993.

          The CFTC's solution was a bad one. It decided to 
        ``overrule'' the Transnor court and, in effect, create 
        an exemption. Since it lacked exemptive authority, 
        however, it chose to alter the traditional definitional 
        elements of a futures contract. The Commission 
        arbitrarily announced, under the guise of merely 
        ``interpreting'' the law, that a new standard now 
        existed. As a result, the CFTC interpreted away its own 
        jurisdiction and disclaimed authority over a broad 
        category of products. The Commission seemed not to care 
        that by changing the definition of a futures contract, 
        the new criteria threatened to shield fraud in the 
        trading of other commodities--a hefty price to pay for 
        helping the oil companies.\71\
---------------------------------------------------------------------------
    \71\ Id.

    Shortly after he left the CFTC, Commissioner William 
Albrecht described the reasoning underlying the CFTC's Brent 
---------------------------------------------------------------------------
interpretation:

          [Hybrids, swaps and Brent contracts] had some, but 
        not all, of the characteristics of a futures contract. 
        The law, however, did not contemplate the existence of 
        a partial futures contract--it was a futures contract 
        or it was not. In each case, however, the Commission 
        found a way to rule that it would not regulate these 
        instruments, even though they did contain futures or 
        options-like components. The Commission believed there 
        was not need to extend its regulatory system to these 
        instruments, either because they were regulated 
        elsewhere (hybrids) or the participants did not need 
        the type of regulation provided by the CFTC (swaps and 
        Brent oil contracts).\72\
---------------------------------------------------------------------------
    \72\ William P. Albrecht, Regulation of Exchange-Traded and OTC 
Derivatives: The Need for a Comparative Institution Approach, 21 Iowa 
J. Corp. L. 111, 125 (1995).

    Philip McBride Johnson, Chairman of the CFTC in the early 
1980's, has since criticized the CFTC's Brent interpretation 
for muddying the test for when an instrument is a futures 
contract under the CEA: ``[T]he historical litmus test which 
was coldly objective (no delivery? not a forward contract) has 
been displaced by a devotion to form and process.'' \73\ The 
former Chairman also described the relief in the financial 
markets that followed the CFTC's 1989 swaps policy statement 
and 1990 Brent statutory interpretation: ``With the CFTC's 
withdrawal from regulating many of the more popular derivatives 
in the late 1980's and early 1990's, it appeared that dealers 
in those financial products had found a virtually regulation-
free promised land.'' \74\
---------------------------------------------------------------------------
    \73\ Philip McBride Johnson, Derivatives, at 40 (1999).
    \74\ Id.
---------------------------------------------------------------------------

C. Exemptions for Energy Contracts

  1. Futures Trading Practices Act of 1992

        Summary: Congress provided the CFTC with discretion to 
        exempt certain swaps and energy contracts that could be 
        considered to be futures contracts from CEA 
        requirements.

    Although the CFTC quickly countered the Transnor decision 
with its statutory interpretation relating to the Brent market, 
the CFTC's actions did not eliminate the concern that another 
court could declare certain derivatives, including swaps and 
energy contracts, illegal under the CEA because they were not 
traded on a designated futures exchange.\75\ Firms and traders 
pressed Congress for a statutory amendment to the CEA to ensure 
it would not be interpreted by courts in a manner that would 
invalidate existing contracts and markets.
---------------------------------------------------------------------------
    \75\ See, e.g., Securities Week, Legislation Needed to Resolve 
Ambiguities Left by Transnor Settlement, May 28, 1990; Business Law 
Brief, Brent Litigation Settled, June 1, 1990.
---------------------------------------------------------------------------
    In 1992, Congress enacted the Futures Trading Practices Act 
(FTPA) to amend the CEA to provide the CFTC with discretion to 
determine that future contracts--or other instruments that 
might be considered to be futures contracts--did not have to be 
traded on a designated futures exchange. The Conference Report 
accompanying the 1992 Act explains the rationale for the 
exemptive authority:

          [T]he conferees recognized the need to create legal 
        certainty for a number of existing categories of 
        instruments which trade today outside of the forum of a 
        designated contract market. These instruments may 
        contain some features similar to those of regulated 
        exchange-traded products but are sufficiently different 
        in their purpose, function, design, or other 
        characteristics that, as a matter of policy, 
        traditional futures regulation and the limitation of 
        trading to the floor of an exchange may be unnecessary 
        to protect the public interest and may create an 
        inappropriate burden on commerce.\76\
---------------------------------------------------------------------------
    \76\ H. Rept. No. 102-978, 102nd Cong., 2nd Sess. 81 (1992).

    The FTPA established the principle that although a contract 
may have some features of a futures contract, it does not 
necessarily have to be traded on a designated exchange. It 
provided the CFTC with the flexibility to determine the 
appropriate level of regulation for novel types of financial 
instruments, such as swaps and derivatives, that were becoming 
popular in the market.\77\
---------------------------------------------------------------------------
    \77\ Pub. L. 102-546, 106 Stat. 3590 (1992).
---------------------------------------------------------------------------
    The report of the Senate Committee on Agriculture, 
Nutrition, and Forestry accompanying the Senate bill explained 
that in order to foster the development of new financial 
instruments the CFTC needed to have the flexibility to 
determine whether such new instruments that had some elements 
of a futures contract need be traded on an approved exchange:

          Since 1974, when Congress created the CFTC, the 
        principle of ``functional'' regulation was intended to 
        govern the introduction of new financial instruments: 
        ``the CFTC would * * * regulate markets and instruments 
        that would serve a hedging and price discovery function 
        and the SEC would regulate markets and instruments with 
        an underlying investment purpose.'' S. Rept. 97-384, 
        97th Cong., 2nd Sess. 22 (1982).
          But increasingly, this principle has become blurred 
        as novel ``hybrid'' instruments are developed. Bonds--a 
        traditional security--can be transformed to offer a 
        return indexed to the price of a commodity like oil or 
        gold. The final product may have significant attributes 
        of a commodity option or future.
          This lack of clarity over the extent of CFTC 
        jurisdiction with respect to new ``hybrids'' and the 
        statutory requirement that all futures contracts must 
        trade on designated contract markets have combined to 
        create a legal cloud that may inhibit the emergence or 
        development of many such markets. Under current law, 
        the CFTC has the power to permit a commodity option to 
        trade off exchange in accordance with CFTC rules, but 
        the CFTC has no authority to exempt any futures product 
        from the exchange-trading requirement. This disparate 
        treatment could prevent the CFTC from permitting the 
        introduction of many economically useful new products 
        to the marketplace.\78\
---------------------------------------------------------------------------
    \78\ S. Rept. 102-22, 102nd Cong., 1st Sess. 6 (1991).

    Generally, the FTPA authorized the CFTC to exempt various 
swap and hybrid transactions from the exchange-trading 
requirements and other provisions of the CEA. Specifically, the 
FTPA authorized the CFTC, either on its own initiative or upon 
application of any person, to exempt from the exchange-trading 
requirement, or any other requirement of the CEA, ``any 
agreement, transaction, or class thereof--between ``appropriate 
persons.'' \79\ The types of agreements that Congress intended 
the CFTC to initially exempt under this authority included a 
variety of OTC derivatives, such as non-standardized swap 
agreements, ``hybrid instruments that are predominantly 
securities or depository instruments,'' forward contracts, and 
bank deposits and accounts. The ``appropriate persons'' who 
could be authorized to trade in these instruments off-exchange 
included large commercial institutions, such as banks, savings 
associations, insurance companies, investment companies, 
commodity pools, large corporations, employee benefit plans, 
governmental entities, securities brokers, and futures 
merchants and brokers.
---------------------------------------------------------------------------
    \79\ Section 4(c)(1) of the CEA, as amended by the FTPA, provides 
the CFTC with authority to exempt from the CEA, ``any agreement, 
contract, or transaction (or class thereof) that is otherwise subject 
to subsection (a) . . .'' (emphasis added). The contracts that are 
``otherwise subject to subsection (a)'' are futures contracts ``for the 
purchase or sale of a commodity for future delivery,'' which, under the 
CEA, ``does not include any sale of any cash commodity for deferred 
shipment or delivery,'' i.e., a forward contract. 7 U.S.C.A. 
Sec. Sec. 1a(11), 6(a), (c) (West 1999 & Supp. 2000).
---------------------------------------------------------------------------
    Congress qualified this broad exemptive authority in 
several respects. First, the Conference Report emphasized that 
the exemptive authority should be applied narrowly to the four 
specified categories of instruments--swaps, hybrids, forward 
contracts, and bank deposits and accounts. The conferees stated 
that any further exemptions should be granted only after 
further study and deliberation by Congress:

          The goal of providing the Commission with broad 
        exemptive powers is not to prompt a wide-scale 
        deregulation of markets falling within the ambit of the 
        Act. Rather, it is to give the Commission a means of 
        providing certainty and stability to existing and 
        emerging markets so that financial innovation and 
        market development can proceed in an effective and 
        competitive manner. Except as discussed below, the 
        Conferees do not intend for the Commission to use this 
        authority to grant broad exemptions from the Act for 
        instruments or markets before these studies are 
        completed and Congress has ultimately decided the 
        issues raised by them.\80\
---------------------------------------------------------------------------
    \80\ H. Rept. No. 102-978, at 81.

    The conferees specifically directed the CFTC to consider 
whether to grant the 15-day Brent market an exemption under 
---------------------------------------------------------------------------
this new authority:

          One court has found transactions in the Brent crude 
        oil market to be futures contracts. See Transnor 
        (Bermuda) Limited v. BP North America Petroleum, 738 
        F.Supp. 1472 (1990). In response, the Commission has 
        issued a statutory interpretation to the effect that 
        certain transactions in that market qualify as sales of 
        cash commodities for deferred shipment or delivery, 
        that is, forward contracts, and, as such, are not 
        subject to regulation under the Act.
          Many markets of this nature are international in 
        scope; foreign parties are already engaging in such 
        transactions free of restraints imposed by the Act that 
        may create competitive disadvantages for U.S. 
        participants.
          Without expressing a view regarding the applicability 
        of the Commission's statutory interpretation, the 
        Conferees encourage the Commission to review this 
        situation and these contracts to determine whether 
        exemptive or other actions should be taken.\81\
---------------------------------------------------------------------------
    \81\ Id. at 82.

    Second, in determining whether to grant any exemption, 
Congress intended that the CFTC nonetheless be able to 
effectively regulate the affected markets within its 
jurisdiction. Before granting any exemption, the CFTC was 
required to find that such exemption would be ``consistent with 
the public interest'' and the purposes of the Act, and ``will 
not have a material adverse affect on the ability of the 
Commission or any contract market to discharge its regulatory 
or self-regulatory duties under this Act.''
    The Conference Report emphasized that in granting exemptive 
authority for certain instruments it was not making any 
determination that such instruments were futures within the 
scope of the Act, and that in making any determination to 
exempt instruments from the exchange-trading requirement the 
CFTC need not make any such determination. ``Rather, this 
provision provides flexibility for the Commission to provide 
legal certainty to novel instruments where the determination as 
to jurisdiction is not straightforward.'' \82\
---------------------------------------------------------------------------
    \82\ Id.
---------------------------------------------------------------------------
    Passage of the FTPA reduced the importance of categorizing 
financial instruments as futures or forward contracts. Under 
the FTPA, even if an instrument is classified as a futures 
contract within the jurisdiction of the CFTC, as opposed to a 
forward contract outside of the scope of the CEA, the CFTC may 
determine that the exchange-trading requirement or other 
requirements of the CEA do not apply.

  2. CFTC Exemption for Energy Contracts

        Summary: The CFTC exempted energy contracts between 
        large companies from the exchange-trading requirement 
        and the anti-fraud provisions of the CEA.

    a. CFTC Order Granting Exemption

    The Futures Trading Practices Act was signed into law on 
October 28, 1992. Two and a half weeks later, on November 16, 
nine crude oil, natural gas, and other energy businesses filed 
with the CFTC an application for an exemption under the new Act 
from the exchange-trading requirement for certain transactions 
in energy contracts.\83\
---------------------------------------------------------------------------
    \83\ The nine firms were BP Oil Company, Coastal Corporation, 
Conoco Inc., Enron Gas Services Corp., J. Aron & Company, Koch 
Industries, Inc., Mobil Sales and Supply Corp., Phibro Energy Division 
of Solomon Inc., and Phillips Petroleum Company. Hearing before the 
House Subcommittee on Environment, Credit, and Rural Development, 
Committee on Agriculture, To Amend the Commodity Exchange Act to Ensure 
the Continued Application of the Act's Antifraud and Antimanipulation 
Protections, June 30, 1993, at 132.
---------------------------------------------------------------------------
    On January 21, 1993, on the final day of the Administration 
of President George H.W. Bush, the CFTC approved a final rule 
exempting certain non-standardized swap agreements from the 
requirement that all futures contracts be traded on a 
designated exchange.\84\ At the same time, it issued a proposed 
order granting a similar exemption to large commercial 
participants in various energy contracts.\85\
---------------------------------------------------------------------------
    \84\ 55 Fed. Reg. 5587 (1993). The CFTC's rule adopted the same 
definition of ``swap agreement'' that is used in the Bankruptcy Code, 
11 U.S.C. 101 (55), and limited the exemption's applicability to a 
subset of ``appropriate persons'' that were termed by the rule as 
``eligible swap participants.'' The swap agreements that were eligible 
for the exemption could not be ``part of a fungible class of agreements 
that are standardized as to their material economic terms.''
    \85\ 58 Fed. Reg. 6250 (1993).
---------------------------------------------------------------------------
    On April 20, 1993, the CFTC approved, by a 2 to 1 vote, a 
final order granting an exemption for energy contracts from the 
exchange-trading requirement of the CEA, ``thereby formalizing 
with an express order a previous interpretative order which 
stemmed from the Brent Oil-Transnor dispute.'' \86\ The CFTC's 
final order applied only to contracts among a limited class of 
large commercial participants who were ``appropriate persons'' 
under the FTPA, such as a bank, trust company, large 
corporation, securities broker-dealer, or a futures commission 
merchant. To qualify for the exemption, these commercial 
participants must, in connection with their business activities 
incur risks, in addition to price risks, related to the 
underlying physical commodities, such as the risks of damage in 
transit, and the participants in the transaction also must be 
able to make or take delivery of the commodity.
---------------------------------------------------------------------------
    \86\ Securities Week, CFTC Has Split Vote Over Regulatory Exemption 
for Forward Energy Contracts, April 19, 1993; 58 Fed. Reg. 21286 
(1993).
---------------------------------------------------------------------------
    The final order was not limited to Brent contracts, but 
applied to a broad class of energy contracts ``for the purchase 
and sale of crude oil, condensates, natural gas, natural gas 
liquids or their derivatives which are used primarily as an 
energy source.'' To qualify for the exemption, such contracts 
must be: (1) between covered commercial participants; (2) 
individually negotiated; and (3) impose binding obligations to 
make and receive delivery of the underlying commodity. With 
respect to the latter condition, the CFTC's order stated that 
there must be ``no right of either party to effect a cash 
settlement of their obligations without the consent of the 
other party . . . provided, however, that the parties may enter 
into a subsequent book out, book transfer, or other such 
contract which provides for the settlement of the obligation in 
a manner other than by physical delivery of the commodity 
specified in the contract.'' \87\
---------------------------------------------------------------------------
    \87\ In a reference to the daisy-chain method of settling 15-day 
Brent contracts, the CFTC explicitly clarified that the obligation to 
take delivery could be satisfied ``regardless of whether the buyer 
lifts or otherwise takes delivery of the cargo or receives pipeline 
delivery, or as part of a subsequent contract, passes title to another 
intermediate purchaser in a `chain,' `string' or `circle' within a 
`chain.' ''
---------------------------------------------------------------------------
    Although the final order exempted these energy contracts 
from the exchange-trading requirement, the CFTC stated it would 
continue to apply the basic statutory authorities under 
sections 6(c), 6c, 6(d), and 9(a)(2) of the CEA to prevent 
manipulation.\88\ The CFTC stated that these anti-manipulation 
provisions will continue to apply, ``to the extent that these 
provisions prohibit manipulation of the market price of any 
commodity in interstate commerce or for future delivery on or 
subject to the rules of any contract market. . . .''
---------------------------------------------------------------------------
    \88\ Section 6(c) provides the CFTC with authority to issue a show 
cause order and conduct a subsequent administrative hearing to prohibit 
any person from trading if there is reason to believe the person has 
manipulated, attempted to manipulate, or is manipulating or attempting 
to manipulate the market price of any commodity. 7 U.S.C.A. 
Sec. Sec. 9, 15 (West 1999 & Supp. 2002).
      Section 6c authorizes the CFTC to bring an action in Federal 
court to obtain a temporary or permanent injunction or restraining 
order whenever it appears that any person has violated or is about to 
violate any provision of the CEA or CFTC rule. 7 U.S.C.A. Sec. 13a-1 
(West Supp. 2002).
      Section 6(d) authorizes the CFTC to issue cease and desist orders 
in manipulation cases, and levy civil penalties for failure to obey 
such orders. Id. at Sec. 13b.
      Section 9(a)(2) makes manipulation of or attempts to manipulate 
the price of a commodity a felony punishable by a fine of up to 
$1,000,000 and imprisonment of up to 5 years. Id. at Sec. 13.
---------------------------------------------------------------------------
    In the most controversial aspect of its decision, the CFTC 
stated that the anti-fraud provisions of the CEA would not 
continue to apply to energy contracts. The CFTC majority stated 
that most comments agreed with the views expressed by one 
commenter, that `` `given the commercial characteristics of 
these transactions and the significant requirements to be 
`commercial participants' and `appropriate persons,' the 
[commenter] * * * does not believe that section 4[4b] of the 
Act (anti-fraud) should be applied to Energy Contracts.' '' The 
majority stated, ``In this particular instance, the Commission 
concurs with the commenters that it need not retain section 4b 
authority, to whatever extent that section of the Act would 
otherwise be applicable to these transactions.''
    In his concurring opinion, Acting Chairman William Albrecht 
explained the CFTC ``has never regulated this market, nor has 
sought to regulate it.'' Further, he stated, ``The Commission 
is not aware of fraudulent practices perpetrated against the 
general public by the participants in this market, nor indeed 
have any of the commercial participants in this market 
complained to the Commission of any fraudulent practices by 
other participants.'' Because this market ``is characterized by 
principal to principal transactions between large sophisticated 
commercial entities,'' the Acting Chairman wrote, ``there 
generally do not appear to be any concerns about the ability of 
these market participants to perform their obligations.'' 
Acting Chairman Albrecht wrote, ``There does not appear to be 
any reason sufficient to justify commission regulation, nor any 
necessity for the Commission to involve itself in this 
market.''
    Just before the CFTC's final vote granting this exemption, 
the Acting Chairman emphasized his view that the CFTC had no 
knowledge of the energy markets and therefore had no ability to 
monitor those markets. ``In fact,'' Albrect stated, ``the CFTC 
does not and cannot supervise this market.'' \89\
---------------------------------------------------------------------------
    \89\ Alan Kovski, CFTC Exempts Cash Market from Controls, The Oil 
Daily, April 14, 1993.
---------------------------------------------------------------------------
    Commissioner Sheila Bair dissented from the majority's 
``failure to retain the general anti-fraud provisions contained 
in section 4b and 4o of the Commodity Exchange Act.'' She 
criticized the majority's reasoning in several ways. First, she 
wrote, the Commission ``has never recognized an exemption to 
its jurisdiction based solely on the `commerciality' of the 
participants, nor can I see any policy reason why commercial 
firms engaging in futures transactions should not have the 
basic protection of our anti-fraud provisions.''
    Commissioner Bair also disagreed with the majority's 
position that sophisticated market participants do not need the 
anti-fraud protections of the CFTC, arguing that ``if we are to 
rationalize exemptions from anti-fraud and other components of 
our regulatory scheme on the basis of `sophistication' of 
market users, we might as well close our doors tomorrow, 
because approximately 98 percent of users of regulated, 
exchange-traded futures'' would meet the eligibility 
requirements of the exemption.
    Commissioner Bair stated that the exemption from the anti-
fraud provisions went far beyond what was necessary in the case 
at hand and set a ``dangerous precedent'':

          What is especially frustrating to me is that we do 
        not need to paint ourselves into this corner. The main 
        reason why the CFTC sought general exemptive authority 
        in last year's reauthorization was so that we would 
        have the flexibility to craft appropriately tailored 
        exemptive relief based on public policy considerations, 
        instead of having to deal with the ``all or nothing'' 
        jurisdictional decisions we had to make in the past. 
        Yet, we are still following this ``all or nothing'' 
        approach, when in my view, we should be carefully 
        weighing individual aspects of our regulatory structure 
        and making a reasoned determination as to which 
        requirements should and should not apply to a 
        particular class of transactions. And, for the reasons 
        I have stated, I do not believe the case has been made 
        for providing an exemption from basic anti-fraud 
        provisions.

    A Washington Post article also sounded this cautionary note 
as to the potential effect of this exemption for energy 
contracts:

          The CFTC's decision not to regulate energy contracts 
        means the Federal Government will have no way of 
        monitoring these growing markets in which huge sums of 
        dollars change hands every year. If a big player failed 
        to make good on a contract, the other participant might 
        suffer such huge losses that it, too, would default on 
        contracts, sending the ripples throughout the financial 
        system.\90\
---------------------------------------------------------------------------
    \90\ Jerry Knight, Energy Firm Finds Ally, Director in CFTC Ex-
Chief, The Washington Post, April 17, 1993.

    At the time of this CFTC decision in 1993, the collapse of 
Enron and the evidence of fraud and manipulation in energy 
markets in the late 1990's were still several years in the 
future.

    b. Congressional Hearings on CFTC Order

    Barely a week after the CFTC granted the exemptions for 
energy contracts, Representative Glenn English, Chairman of the 
House Agriculture Subcommittee with jurisdiction over the CFTC, 
held a hearing on the CFTC's decision to exempt these contracts 
from the CEA's anti-fraud provisions.\91\
---------------------------------------------------------------------------
    \91\ John M. Doyle, House Chairman Slams CFTC Exemption of Off 
Exchange Energy Contracts, The Associated Press, April 28, 1993.
---------------------------------------------------------------------------
    Acting Chairman Albrecht defended the Commission's 
position, contending that retention of anti-fraud authority 
over the energy markets would actually be worse for the public 
than granting the exemption. Retention of this authority, in 
his view, ``would inject the illusion of Commission supervision 
into a market where there is none. In that regard, some may 
take comfort from the coverage of 4b [anti-fraud authority], 
but it would be cold comfort indeed without the benefits of any 
ongoing regulation. After all, the Commission just does not 
have the resources necessary to adequately regulate these 
markets. In short, the benefits of extending the coverage of 4b 
to this market are not apparent.'' \92\
---------------------------------------------------------------------------
    \92\ Statement of Dr. William P. Albrecht, Acting Chairman, CFTC, 
Hearing before the House Subcommittee on Environment, Credit, and Rural 
Development, Committee on Agriculture, Review of the Commodity Futures 
Trading Commission's Discretion to Exempt Certain Transactions from 
Antifraud Provisions of the Commodity Exchange Act (hereinafter House 
April 1993 Hearing), April 28, 1993, at 53.
      Dr. Albrecht also voiced the concern that regulation would drive 
markets overseas: ``I am concerned that maintaining section 4b 
authority over this market would provide little, if any, benefit, and 
perhaps cause very real harm. If section 4b remains an issue, some 
international commercial participants will continue to refuse to do 
business with U.S. energy firms, and some U.S. firms will set up off-
shore branches. In short, retaining 4b authority will damage U.S. 
international competitiveness.'' Id.
---------------------------------------------------------------------------
    Acting Chairman Albrecht made it clear that, in his view, 
the CFTC should maintain minimal regulatory authority over the 
energy markets:

          The genius of [the FTPA] authority is that it frees 
        us from the increasingly meaningless debate over 
        whether something is a future or not. Instead, we can 
        concentrate on designing the appropriate regulatory 
        scheme for products that have futures-like 
        characteristics.
          We can consider how much regulation by the CFTC is 
        needed based upon the characteristics of the market, 
        such as the customer base, the market's purpose, the 
        potential for fraud, and the availability of other 
        governmental oversight.
          For some products, such as the energy contracts under 
        discussion today, this may mean almost no oversight by 
        the CFTC. For others, such as swaps, we've decided to 
        maintain more oversight.\93\
---------------------------------------------------------------------------
    \93\ House April 1993 Hearing, supra at 11.

    Albrect noted that the participants in the energy markets 
``are large commercial entities, well aware of their 
contractual rights and legal remedies,'' so that they neither 
needed nor wanted the protections afforded by the statute. 
``This market has been in operation for over a century, and has 
gotten along just fine without CFTC oversight,'' he 
testified.\94\
---------------------------------------------------------------------------
    \94\ Id.
---------------------------------------------------------------------------
    Commissioner Bair, who dissented from the CFTC's decision, 
told the House Subcommittee, ``To my knowledge, it is 
unprecedented for the Commission to provide relief from 
antifraud protections for transactions that are not subject to 
the jurisdiction of another regulator.'' \95\
---------------------------------------------------------------------------
    \95\ Prior to the decision, several senior CFTC officials had 
raised concerns with the proposed exemption from the anti-fraud 
requirements. The CFTC's Director of Enforcement commented there was no 
precedent in the securities laws for an exception to the anti-fraud 
protections, stating that ``we are not aware of any Securities and 
Exchange Commission exemption that excludes securities products from 
anti-fraud jurisdiction.'' Memorandum from Dennis Klejna, Director, 
Division of Enforcement, to Gerry Gay, Director, Division of Economic 
Analysis, April 8, 1993, reprinted in Hearing before the House 
Subcommittee on Environment, Credit, and Rural Development, Committee 
on Agriculture, Amend the Commodity Exchange Act to Ensure the 
Continued Application of The Act's Antifraud and Antimanipulation 
Protections (hereinafter House June 1993 Hearing), June 30, 1993, at 6-
7.
      Similarly, the Director of the Division of Trading and Markets 
wrote, ``To my knowledge, the Commission has never before exempted 
transactions in products subject to its jurisdiction from the anti-
fraud provisions of the Act unless another regulatory regime clearly 
applied to such transactions.'' Memo from Andrea M. Corcoran, Division 
of Trading and Markets, to Files, Exemption for Certain Contracts in 
Energy Products, April 9, 1993, reprinted in House April 1993 Hearing, 
supra at 85-87.
---------------------------------------------------------------------------
    NASAA, an organization representing the securities agencies 
of the 50 states, voiced its concerns regarding ``a more 
general (and disturbing) trend at the CFTC--that is, 
increasingly inadequate and lax oversight of the commodities 
markets.'' \96\ NASAA described the energy contract exemption 
as:
---------------------------------------------------------------------------
    \96\ Testimony of Wayne Klein, NASAA, House June 1993 Hearing, at 
144, 147.

          Just the latest example of what perhaps may be best 
        characterized as the agency's ``reluctance to 
        regulate,'' even in the face of blatant threats to 
        investors and the integrity of the markets. Worse yet, 
        the Commission has vigorously guarded what it believes 
        to be its ``turf,'' only to turn around and severely 
        limit its own regulatory role. This minimalist approach 
        seems to be one of ``we won't police the area but we 
        don't want anyone else to either.''

                                 * * *

          I am deeply concerned that during the past several 
        years, the CFTC has embarked on a course of abandoning 
        and repudiating its responsibilities to protect the 
        integrity of the categories of energy products from the 
        anti-fraud and anti-manipulation provisions of the CEA 
        is the most recent, and a most egregious, example of 
        this new course. Without active and vigorous oversight, 
        the markets under the CFTC's exclusive jurisdiction 
        invite fraud and abusive trading.\97\
---------------------------------------------------------------------------
    \97\ Id.

    Chairman English took issue with the rationale that large 
sophisticated players in the market did not need the CEA's 
---------------------------------------------------------------------------
protections against fraud:

          I've heard, ``Well, these are big boys. Let them take 
        care of themselves.'' I would suggest to you, before 
        this thing is done, as a consequence of your actions, 
        there are going to be some little people that are going 
        to get hurt, too. They may be big in our part of the 
        country, but they're little in this world, and it seems 
        like, that any time when the big people get hurt, they 
        have to fall someplace, and they fall on an awful lot 
        of little people. The little folks end up bearing a 
        good deal of this burden.\98\
---------------------------------------------------------------------------
    \98\ House April 1993 Hearing, supra at 22.

    Near the end of the hearing, Chairman English expressed 
---------------------------------------------------------------------------
frustration with the CFTC's position:

          It brings us down to the real question of ``What in 
        God's name is the CFTC all about?'' If it's not--if we 
        can't even count on the CFTC to protect the public from 
        fraud, if we can't depend on the CFTC not to give away 
        the store, from the standpoint of giving blanket--not 
        exemptions, exclusions--that's an outrage. . . . [w]hen 
        it comes down to opening the door to fraud, that's 
        simply going too far. That's not deregulation, that's 
        just blatant irresponsibility. . . . In the 18 years 
        I've been in Congress, this is the most irresponsible 
        decision I've come across.\99\
---------------------------------------------------------------------------
    \99\ Id., at 44-45. At this hearing Chairman English revealed that 
during the rulemaking process on the exemption for swap agreements the 
CFTC had intended to exempt those swap agreements from the anti-fraud 
provisions as well. Chairman English recounted that when this decision 
``was barreling down the track about 90 miles an hour,'' he telephoned 
Chairwoman Gramm to express his ``grave concerns'' about this aspect of 
the decision. Id. at 23. The CFTC decided not to include the removal of 
anti-fraud authority in the final swap agreement exemption.

    Immediately after the hearing, Chairman English ``told 
reporters the acting head of the agency `would do a real 
service to the country' if he resigned.'' \100\
---------------------------------------------------------------------------
    \100\ John M. Doyle, House Chairman Slams CFTC Exemption of Off 
Exchange Energy Contracts, The Associated Press, April 28, 1993.
---------------------------------------------------------------------------
    Two months later, Chairman English held another hearing, 
this time focusing on legislation he had introduced to overturn 
the CFTC's energy contract order insofar as it exempted such 
contracts from the CEA's anti-fraud provisions. His bill also 
would have prohibited the CFTC from granting any exemptions 
under the FTPA to the anti-fraud and anti-manipulation 
provisions of the CEA.
    In testimony opposing the legislation, the CFTC majority 
reiterated the rationale it had previously stated in its order 
and at the prior hearing. But the CFTC went even further, 
extending its exemptive reasoning to the CEA's anti-
manipulation provisions as well. Writing for himself and 
Commissioner Dial, Acting Chairman Albrecht stated there was no 
need to retain anti-manipulation authority over the energy 
markets:

          The concerns raised about eliminating Commission 
        flexibility with regard to anti-fraud jurisdiction also 
        apply to manipulation jurisdiction. There does not 
        appear to be a need for retaining this authority, there 
        will not be significant benefits gained by retaining it 
        generally and there are very real burdens to be placed 
        on the exempt markets.\101\
---------------------------------------------------------------------------
    \101\ House June 1993 Hearing, supra at 101.

    During this hearing, the CFTC made it clear that it 
intended to apply the 1990 Brent Statutory Interpretation to 
the Brent market, and therefore exclude the 15-day Brent 
contracts from all regulation under the CEA, rather than 
consider them merely exempt energy contracts under the new 1993 
energy contracts exemption. This distinction between excluded 
forwards contracts, which are not subject to the CEA at all, 
and exempt derivatives contracts, which are subject to a 
limited form of regulation, first appeared following the CFTC's 
creation of the 1993 energy contract exemption. This 
distinction has become increasingly significant following 
enactment of the Commodity Futures Modernization Act of 2000, 
which bases a number of provisions upon this distinction.
    Commissioner Bair, who opposed the CFTC's broad energy 
contract exemption, still supported the Brent exclusion. In her 
testimony in support of Chairman English's bill, she wrote that 
the bill ``will achieve the important goal of ensuring that the 
anti-fraud and anti-manipulation protections of the Act 
continue to apply to transactions exempted by the Commission 
from other regulatory requirements. Preserving such authority 
in no way implies that particular types of exempted off-
exchange transactions such as traditional swaps or 15-day Brent 
Oil contracts are in fact future contracts subject to CFTC 
jurisdiction.'' \102\
---------------------------------------------------------------------------
    \102\ Id. at 104-5.
---------------------------------------------------------------------------
    Kenneth Raisler, an attorney representing the Energy 
Group--the nine companies that had applied for the energy 
contracts exemption--testified that although the Energy Group 
was ``adamantly opposed to fraud in any market,'' repealing the 
exemption from the anti-fraud provision would not be effective. 
According to these companies, the CFTC did not have the ability 
to regulate energy markets. ``In our view, application of the 
CFTC's antifraud jurisdiction only confuses the picture. The 
CFTC has never overseen or been involved in policing these 
markets. I believe that is just a critically important point. 
Without the staff or the expertise, retaining antifraud 
jurisdiction could create a misleading impression about the 
CFTC's abilities.'' \103\
---------------------------------------------------------------------------
    \103\ House June 1993 Hearing, supra at 121. In an exchange with 
Rep. Jim Nussle (R-Iowa), Mr. Raisler confirmed that the Energy Group 
wanted no regulation at all of energy contracts under the Federal 
commodity laws, regardless of the CFTC's abilities:
        Mr. NUSSLE: OK, but the bottom line though is that the real 
remedy that you are prescribing in the alternative of this legislation 
is the civil courts. You are basically saying let the buyers beware, 
let the market beware, and you are on your own, you take care of it on 
your own. You have to investigate it, you have to uncover it, you have 
to be aware of it, and then you have to prosecute it.
        Mr. RAISLER: And let me point out, as a general matter in this 
country the buying and selling of goods, whether they be energy or any 
other kind of product, find themselves with that remedy, yes.

                        * * *
        Mr. NUSSLE: And the Government has no place regulating or 
monitoring that particular transaction, in your opinion?
        Mr. RAISLER: The Government never has, and so we see no reason 
for them to start now.
    Id. at 131.
---------------------------------------------------------------------------
    The Chairman of the Chicago Board of Trade, Patrick Arbor, 
testified as to the higher burden of proof the various CFTC 
exemptions imposed for claims of fraud and manipulation in the 
energy markets:

          Under the swaps exemption, anyone manipulating the 
        price of an exempt swap would not violate the CEA 
        unless that manipulation effected a ripple manipulation 
        on a futures exchange or in the cash market as a whole. 
        The swaps exemption also may be illusory or at least 
        cumbersome when it comes to fraud. Any fraud action 
        would require the complaining party to prove first that 
        the swap is a futures contract and second that fraud 
        occurred. Other than shielding wrongdoing, no reason 
        exists to make the complaining party make a double 
        showing. The energy contract exemption has the same 
        flaw in the manipulation area as the swaps exemption 
        and contains no antifraud provision.\104\
---------------------------------------------------------------------------
    \104\ Statement of Patrick H. Arbor, Chairman, CBOT, Hearing To 
Amend the Commodity Exchange Act to Ensure the Continued Application of 
the Act's Antifraud and Antimanipulation Protections, June 30, 1993, at 
134-5 (emphasis added).

    Chairman English's bill was reported out of his 
subcommittee, but made it no further in the legislative 
process.

  D. The Commodity Futures Modernization Act of 2000

  1. Regulatory Uncertainty Following the FTPA

    Although the Congress attempted to clarify the legal status 
of certain derivative and swap instruments with the passage of 
the FTPA in 1992, subsequent events led to continued 
uncertainty and renewed calls for Congressional clarification. 
Most of these issues concerned the regulation of financial 
swaps and derivatives. Calls for Congressional action 
intensified after a 1995 CFTC enforcement proceeding alleging 
market manipulation by MG Refining and Marketing, Inc. and MG 
Futures, Inc., in which the CFTC again sought to define ``all 
the essential elements of a futures contract.'' Although the 
CFTC indicated it did not intend to change the meaning of a 
futures contract under the CEA, and did not seek to impose new 
regulations upon the swaps and derivatives industry, the CFTC's 
action nonetheless raised anew the concerns that these 
instruments could someday be declared unenforceable as illegal 
futures contracts.\105\
---------------------------------------------------------------------------
    \105\ See, e.g., Statement Submitted on Behalf of The International 
Swaps and Derivatives Association, Inc., to the Senate Committee on 
Agriculture, Nutrition, and Forestry, 105th Cong., 2nd Sess., July 28, 
1998. (``The possibility that some or a substantial category of 
privately negotiated derivatives transactions may be interpreted, even 
inadvertently, to be futures contracts also raises serious concerns 
with respect to those transactions falling outside the scope of the 
current or a future revised Swaps Exemption, particularly equity swaps 
and other swaps based on the prices of securities.'').
---------------------------------------------------------------------------
    A ``concept release,'' issued by the CFTC in May 1998, to 
``reexamin[e] its approach to the over-the counter derivatives 
market'' also caused alarm in the financial community.\106\ 
Although the CFTC stated that the release ``in no way alters 
the current status of any instrument or transaction'' under the 
CEA, the industry viewed it as the beginning of an attempt to 
increase the CFTC's role in regulating aspects of the OTC 
derivatives markets. ``Until the Concept Release,'' the Swap 
Dealers told Congress, ``the CFTC appeared to have worked on 
the assumption that a contract is subject to their jurisdiction 
if they determine it to be a futures contract, and is not 
subject to the Act until then. But under the Concept Release, 
the CFTC moved to the other side and asserted that all 
derivatives are automatically subject to its jurisdiction, 
unless it affirmatively states otherwise.'' \107\ In response 
to objections of the financial industry, in the Agriculture 
Appropriations Act for fiscal year 1999, Congress imposed a 6-
month moratorium on the CFTC's rulemaking authority in this 
area.
---------------------------------------------------------------------------
    \106\ Id.
    \107\ Id.
---------------------------------------------------------------------------
    The rapid development of computerized trading systems for 
OTC derivatives complicated the regulatory picture as well. The 
CFTC's existing swap exemption only applied to swaps that were 
not entered into on an exchange. The question arose as to 
whether computerized OTC trading systems that automatically 
facilitated negotiations between multiple parties were more 
akin to the trading floor of an exchange or more like 
electronic communication systems, such as telephones and fax 
machines. To many, analysis based on such distinctions elevated 
form over substance. ``Market participants . . . have argued 
that the means to execute a swap agreement (computer systems 
rather than telephonic systems) should not alter the regulatory 
status of the agreement.'' \108\
---------------------------------------------------------------------------
    \108\ U.S. Department of the Treasury, the Board of Governors of 
the Federal Reserve System, Securities Exchange Commission, and 
Commodity Futures Trading Commission, Report of The President's Working 
Group on Financial Markets, Over-the-Counter Derivatives Markets and 
the Commodity Exchange Act (November 1999), at 14.
---------------------------------------------------------------------------
    This and other regulatory issues were addressed in the 
Report of The President's Working Group on Financial Markets, 
Over-the-Counter Derivatives Markets and the Commodity Exchange 
Act, which was prepared jointly by the Department of the 
Treasury, the Board of Governors of the Federal Reserve System, 
the SEC, and the CFTC, and issued in November 1999. ``A cloud 
of legal uncertainty has hung over the OTC derivatives markets 
in the United States in recent years,'' the Report stated, 
``which, if not addressed, could discourage innovation and 
growth of these important markets and damage U.S. leadership in 
these arenas by driving transactions off-shore.''
    The President's Working Group issued a number of 
recommendations for the treatment of financial instruments, 
including a CEA exclusion for bilateral swap agreements between 
certain participants (termed ``eligible swap 
participants''),\109\ and a CEA exclusion for certain types of 
electronic trading systems involving those same participants. 
The Working Group was clear, however, that any exclusions from 
the CEA should be limited to ``markets that are not readily 
susceptible to manipulation and that do not currently serve a 
significant price discovery function.'' To this extent, the 
Report stated that the recommended exclusions ``should not 
extend to any swap agreement that involves a non-financial 
commodity with a finite supply.'' The Working Group explained:
---------------------------------------------------------------------------
    \109\ The ``eligible swap participants'' who could qualify for this 
exclusion would be regulated financial institutions, large 
corporations, certain pension funds, state and local governments, and 
individuals with significant assets.

          Due to the characteristics of markets for non-
        financial commodities with finite supplies, however, 
        the Working Group is unanimously recommending that the 
        exclusion not be extended to agreements involving such 
        commodities. For example, in the case of agricultural 
        commodities, production is seasonal and volatile, and 
        the underlying commodity is perishable, factors that 
        make the markets for these products susceptible to 
        supply and pricing distortions and to manipulation. 
        There have also been several well-known efforts to 
        manipulate the prices of certain metals by attempting 
        to corner the cash or futures markets. Moreover, the 
        cash market for many non-financial commodities is 
        dependent on the futures market for price discovery. 
        The CFTC should, however, retain its current authority 
        to grant exemptions for derivatives involving non-
        financial commodities, as it did in 1993 for energy 
        products, where exemptions are in the public interest 
        and otherwise consistent with the CEA.\110\
---------------------------------------------------------------------------
    \110\ Id. at 16-17. In footnotes, the Working Group added that 
``nothing in this report should be construed to affect the scope of 
exemptions that are currently in effect,'' and recommended the CFTC 
``retain its current exemptive authority for these [non-financial 
commodity] derivatives.''
---------------------------------------------------------------------------

  2. Enactment of Commodity Futures Modernization Act

    a. Summary of Relevant Provisions

    In 2000, Congress enacted the Commodity Futures 
Modernization Act (CFMA). The CFMA overhauled the regulatory 
framework for financial and energy derivatives under the CEA. 
Consistent with the recommendations of the President's Working 
Group, the CFMA sought to clarify the exclusion of various 
financial derivatives from the scope of the CEA, and to 
establish a tiered regulatory system for the commodities and 
derivatives within the scope of the CEA, with the degree of 
regulation dependent upon the type of product (such as 
financial, agricultural, energy or metals), the type of market 
(such as designated exchanges, bilateral negotiation, 
multilateral negotiation, or electronic exchange), and the type 
of participant in the marketplace (such as retail customer, 
sophisticated player, or speculator). Generally, the CFMA 
subjects markets that restrict trading to professional traders 
or commercial participants and trade in products that are less 
susceptible to manipulation to less regulation than markets 
with a broader range of participants or with commodities in 
finite supply.
    The CFMA resolved the longstanding concern regarding the 
legal enforceability of OTC derivatives that were not traded on 
an approved exchange. The CEA now provides that no swap 
agreement between eligible contract participants shall be 
unenforceable under the CEA or any other law based on a failure 
to comply with any exclusion or exemption from any provision of 
the CEA.\111\
---------------------------------------------------------------------------
    \111\ 7 U.S.C.A. Sec. 25 (West Supp. 2002).
---------------------------------------------------------------------------
    A significant number of provisions in the CFMA address 
issues related to the regulatory treatment of a variety of 
financial instruments. Most of these complex provisions are not 
directly relevant to the issue of the regulation of energy 
contracts under the CEA. Accordingly, this report examines the 
provisions of the CFMA only insofar as they relate to or are 
entangled with issues regarding the regulation of energy 
contracts, such as those involving crude oil. Table A.2-2 
provides a summary of the regulation of energy derivatives 
under the CFMA. Table A.2-3 identifies the key dates in the 
regulation of the commodity markets up to and including the 
enactment of the CFMA.

[GRAPHIC] [TIFF OMITTED] T5551.008

[GRAPHIC] [TIFF OMITTED] T5551.009

[GRAPHIC] [TIFF OMITTED] T5551.010

    (i) Categories of Participants

    One of the criteria used by the CFMA for determining the 
level of regulation under the CEA is the nature of person 
involved in the transaction. Generally, the Act only provides 
exclusions and exemptions for transactions between large 
institutions or individuals with large personal assets, who are 
either (1) deemed to be sufficiently sophisticated to be able 
to protect their own interest, or (2) subject to another 
regulatory scheme, such as the banking or securities laws. For 
transactions and markets in which the general public or small 
businesses participate, the full regulatory apparatus of the 
CEA still applies.
    Most of the exclusions and exemptions provided by the CFMA 
apply to those large organizations that qualify as an 
``eligible contract participant'' (``ECP''), the definition of 
which includes financial institutions; insurance companies; 
corporations, trusts, and partnerships with total assets 
greater than $10 million; large pension benefit plans, 
governmental entities, natural persons with assets greater than 
$5 million who are entering the transaction for risk management 
purposes, and certain others.\112\
---------------------------------------------------------------------------
    \112\ The CFMA's definition of ECP is based upon the CFTC's 
definition of ``eligible swap participant'' used for the 1993 swap 
exemption, but is slightly broader. See 17 CFR Part 35.
---------------------------------------------------------------------------
    A subset of ``eligible contract participants'' qualify for 
further exemptions and exclusions. An ``eligible commercial 
entity'' is an eligible contract participant that (i) has the 
ability to make or take delivery of the commodity; (ii) incurs 
commodity risks in addition to price risks; or (iii) is a 
dealer in either the commodity or derivatives transactions 
involving that commodity.\113\ In essence, this category 
applies to large traders that make or take delivery of a 
physical commodity, such as, for example, energy trading 
companies like Enron, Williams Company, Duke Energy, and El 
Paso Corporation.
---------------------------------------------------------------------------
    \113\ 7 U.S.C.A. Sec. 1a(11) (West Supp. 2002).
---------------------------------------------------------------------------

    (ii) Categories of Commodities.

    The CFMA also created three categories of commodities.
    ``Excluded commodities'' are a variety of financial 
derivatives, including interest rate, currency, equity, debt, 
credit, weather, economic index, and other derivatives based on 
one or more commodities for which there is no cash market or 
whose price levels are not within the control of any party to 
the transaction.
    Under the CEA as amended by the CFMA, an ``exempt 
commodity'' is ``a commodity that is not an excluded commodity 
or an agricultural commodity.'' \114\ This category includes, 
for example, metals and energy products.
---------------------------------------------------------------------------
    \114\ 7 U.S.C.A. Sec. 1a(14) (West Supp. 2002).
---------------------------------------------------------------------------
    The third category of commodities is ``agricultural 
commodities.'' Although it is used in the definition of 
``exempt commodity,'' the term ``agricultural commodity'' is 
not defined. Logically, it refers to the list of agricultural 
commodities traditionally within the jurisdiction of the CEA 
under section 1a of the Act. It is unclear, however, whether or 
not the term encompasses any additional agricultural 
commodities. Generally, the regulatory framework for the 
futures markets for agricultural commodities was not altered by 
the CFMA.

    (iii) Excluded OTC Derivative Transactions

    Section 2(d) excludes from the CEA all agreements, 
contracts, and transactions in ``excluded commodities'' between 
``eligible contract participants'' that are not executed on a 
``trading facility.'' \115\ A ``trading facility'' is defined 
as a physical or electronic exchange.\116\ Roughly speaking, 
this section excludes from the CEA financial derivatives that 
are traded over-the-counter, not on an approved futures 
exchange, among large institutions or corporations.
---------------------------------------------------------------------------
    \115\ 7 U.S.C.A. Sec. 2(d)(1) (West Supp. 2002). Section 2(d)(2) 
provides a further exclusion for certain ``principal-to-principal'' 
transactions in excluded commodities on an electronic exchange. Id.
    \116\ ``The term `trading facility' means a person or group of 
persons that constitutes, maintains, or provides a physical or 
electronic facility or system in which multiple participants have the 
ability to execute or trade agreements, contracts, or transactions by 
accepting bids and offers made by other participants that are open to 
multiple participants in the facility or system.'' 7 U.S.C.A. 
Sec. 1a(33) (West Supp. 2002). An ``electronic trading facility'' is a 
trading facility that ``operates by means of an electronic or 
telecommunications network'' and maintains an audit trail of bids, 
offers, orders, and transactions on the facility. Id. at Sec. 1a(10).
---------------------------------------------------------------------------

    (iv) Excluded Swap Transactions

    Section 2(g) excludes from the CEA all agreements, 
contracts, and transactions ``in a commodity other than an 
agricultural commodity'' between ``eligible contract 
participants'' that are individually negotiated by the parties 
and that are ``not executed or traded on a trading facility.'' 
\117\ These are referred to as ``excluded swap transactions.'' 
Unlike the provision excluding certain OTC derivative 
transactions, which applies only to excluded commodities, which 
are basically financial in nature, this provision applies to 
all commodities other than agricultural commodities, which 
means that agreements, contracts, and transactions in energy 
and metals individually negotiated, not on an exchange, by 
large corporations and institutions can qualify for the 
exclusion for swap transactions.
---------------------------------------------------------------------------
    \117\ 7 U.S.C.A. Sec. 2(g) (West Supp. 2002).
---------------------------------------------------------------------------

    (v) Transactions in Exempt Commodities: Section 2(h)

    Section 2(h)(1) of the CEA was meant to exempt from 
regulation dealer markets and facilities, such as ``Enron 
Online,'' in which one organization acts as the counterparty to 
many or all of the other participants in the market. Section 
2(h)(1) provides that all agreements, contracts, and 
transactions in an ``exempt commodity''--which includes energy 
and metals--between ``eligible contract participants'' and 
``not entered into on a trading facility'' are generally 
exempted from the requirements of the CEA. Unlike the swap 
transaction exclusion, this exemption applies even if the 
agreement, contract, or transaction is not individually 
negotiated.
    Some of the CEA provisions, including anti-fraud and anti-
manipulation provisions, still apply to most of these 
transactions. However, the agreements, contracts, and 
transactions in these commodities between ``eligible commercial 
entities''--meaning those eligible contract participants that 
can make or take delivery, incur commodity risks, and are 
commodity dealers--are not subject to the CEA anti-fraud 
provisions. This special exemption from the CEA anti-fraud 
provisions essentially codifies the CFTC's 1993 energy contract 
exemption from the exchange-trading and anti-fraud provisions 
of the CEA.
    Section 2(h)(3) is designed to allow large market 
participants to trade amongst themselves on electronic trading 
facilities with little government oversight. This section 
provides an exemption for agreements, contracts, and 
transactions involving ``exempt commodities,'' such as energy 
or metals, that are executed or traded on an ``electronic 
trading facility,'' and entered into on a principal-to-
principal basis between ``eligible commercial entities.''
    A reduced number of CEA provisions apply to transactions on 
these facilities. For example, a number of the CEA's statutory 
proscriptions against manipulation apply to these transactions. 
The proscription against fraud in connection with commodity 
option transactions applies as well. These facilities must keep 
trading records for 5 years, make such records available for 
inspection by the CFTC, and provide other data upon ``special 
call'' by the CFTC. In addition, if the CFTC determines that 
the facility performs a significant price discovery function 
for the underlying commodity, the facility must disseminate 
price, volume, and other trading data in a timely manner as the 
CFTC determines is appropriate. The CFTC has not yet proposed a 
rule to implement this provision of the CFMA.
    One of the sources of confusion following the passage of 
the CFMA is the inconsistency between sections 2(g) and 
2(h)(1)--whereas Sec. 2(g) totally excludes energy and metals 
swaps that are individually negotiated from the CEA, 
Sec. 2(h)(1) exempts energy and metals transactions from the 
exchange-trading and other requirements but generally applies 
the anti-fraud and anti-manipulation provisions to over-the-
counter transactions in these commodities. It is not clear 
whether the exclusion provision takes precedence over the 
exemption provision, or vice versa.
    Moreover, to the extent that a negotiation over price can 
be considered ``an individual negotiation,'' it would appear 
that sections 2(g) and 2(h)(1) cover the same transactions and 
are in direct conflict regarding the applicability of the CEA's 
anti-fraud and anti-manipulation provisions. The CFTC staff has 
told the Subcommittee staff that the CFTC interprets the term 
``individual negotiation'' to include price negotiations; under 
this interpretation there is no difference between sections 
2(g) and 2(h)(1). Under this interpretation, all instruments 
traded under 2(h)(1) on ``one-to-many'' facilities or through 
dealer-brokers could be considered excluded swaps.

    b. Outstanding Issues

    The CFMA created a complex statutory and regulatory scheme 
that perpetuates different degrees of CFTC oversight for energy 
contracts, swaps, and other derivatives, depending on the size 
of the parties to the transaction and the type of market in 
which the contracts are traded. As other parts of this Report 
demonstrate, however, as the risk-transference and price 
discovery functions of the over-the-counter markets and 
approved futures exchanges have become increasingly 
intertwined, these distinctions make less and less sense. It 
hardly makes sense to allow participants to operate in one 
market in a manner that is not allowed in another.
    Moreover, as other parts of this Report demonstrate, the 
operation of both the OTC markets and the approved futures 
exchanges can have significant impacts upon consumers and 
businesses that may not trade at all on either market. Both 
markets perform a vital economic function for the American 
economy as a whole, and the behavior of the participants in 
these markets affects not only other market participants, but 
potentially millions of persons outside of those markets. 
Whether or not large institutions need or desire governmental 
oversight to protect themselves from each other, governmental 
oversight is necessary to ensure the markets are operating 
efficiently and effectively in the public interest. 
Accordingly, as the OTC energy markets now perform economically 
identical functions to the designated futures exchanges trading 
energy contracts, the distinctions created in the CFMA between 
large institutions and other types of traders, and between OTC 
markets and approved futures markets, no longer is sound public 
policy.


                          APPENDIX 3: EXHIBITS

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                    APPENDIX 4: ADDITIONAL DOCUMENTS

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