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Oil's Puzzling Spring Surge Reignites Debate About Speculators

By Steven Mufson
Washington Post Staff Writer
Tuesday, July 14, 2009

The run-up in oil prices that began earlier this year was not as steep as last summer's record climb, but it was almost as mystifying.

Demand was low, the global economy was sagging, and the world's oil consumers and producers were brimming with excess supply. Those factors ought to keep prices down, but the monthly average price of crude oil jumped $10 a barrel from February to April, another $10 in May and again in June. Gasoline prices in the United States rose 54 days in a row, and AAA called the increases through May "the largest five-month retail advance this century."

Then over the past 10 days, oil prices tumbled back, falling to $59.69 a barrel, to the lowest level in eight years, summoning memories of last year, when prices hit a record $147 on July 11 before falling back down. Renewed pessimism about the economy was one reason for the 10-day swoon, but the abrupt shift has been dizzying. And not entirely reassuring. Many regulators, oil analysts and oil executives say that the lurches in price this year -- even more than last year's -- must be attributable primarily to one factor:

Speculators.

"Here we go again," Bart Chilton, a commissioner at the Commodity Futures Trading Commission, said late last month. "Crude oil prices are up 60 percent on the year. Supplies are at a 10-year high, and demand is at a 10-year low. You do the math. Why should prices be over $70?"

Last week, the CFTC said it would consider new measures to curb speculation and increase transparency in energy markets, where the agency's data suggest that a substantial amount of oil trading was concentrated in the hands of just a few investment banks and trading firms. Also last week, the leaders of Britain and France urged measures to counter "damaging speculation."

Regulators worry that even a small bubble in oil prices could stifle economic recovery by draining money from savings or other purchases, undercutting the government stimulus program and reigniting inflation.

"It's almost as if these current prices are in an alternative universe," hedge-fund manager Mike Masters, a fixture at congressional hearings on commodities oversight, said in an interview with the trade publication Mastering Derivatives. "You've got the speculative price of oil, and you've got what the actual price of oil would be."

Speculation, many analysts note, is a loaded term. It conjures images of unprincipled middlemen who manipulate and bet on prices. In reality, "speculators" are simply investors who have no commercial use for oil and never plan to take delivery. They can include state pension funds and college endowments, as well as investment banks and hedge funds seeking to use oil futures the same way they use other financial instruments.

" 'Speculation' isn't a dirty word," Chilton wrote in an e-mail. "Speculators are a necessary part of futures markets, and they play a critical and important role in the price discovery process. If, however, a group of entities is affecting the price of a critically important commodity in an uneconomic fashion, the CFTC has a responsibility to investigate and address it."

Some oil experts, economists and analysts said supply and demand have, in fact, been bigger factors than speculation in driving oil prices. And those experts expect costs to keep going up.

"We continue to gain confidence that the trough in the oil cycle has passed and a new up-turn is underway," Goldman Sachs oil analyst Arjun Murti wrote in a report last month. He cited stagnant world oil supplies -- and declining production outside the Organization of the Petroleum Exporting Countries -- along with a gradual revival of demand. Goldman Sachs boosted its price forecasts by $10 a barrel, saying the cost would surpass $100 over the next couple of years.

Adam Sieminski, chief energy economist for Deutsche Bank, asked, "How long can a commodity stay below its replacement cost?" He estimated that the cost of finding a new barrel of oil is "at least $60 and might be $80."

Chilton -- like others who see a bubble in oil prices -- points to the wave of money coming into oil markets from investors. Last year, the CFTC estimates, about $200 billion flowed into regulated oil markets. Chilton said billions of dollars more probably flowed into unregulated, or "dark," markets, where it is impossible to identify players or track trade volumes. Investment banks say money has been flowing into oil funds.

Many of these investors are seeking to diversify their holdings or protect themselves against inflation that governments and central banks might foment while jolting the global economy. "It's like a barbecue that is not catching fire," said Jan Loeys, J.P. Morgan Chase's London-based head of market strategy. "You put all kinds of lighter fluid on it, and it's not taking. Then at some point, it takes, and then you don't have a lot of time before it blows up in your face."

Loeys has been telling clients that oil has been a better inflation hedge than gold, a traditional haven in times of instability or inflation. While he accurately predicted in late June that oil prices could drop $10 with falling stock markets, he added, "I think there's a high chance that in the next six months, the oil price will be higher, and a large part of that will be fear of the upside risk of inflation."

James C. May, head of the Air Transport Association, said the opacity of oil markets distorts prices. "People are playing the same expectations game as a year ago," he said. "We've got an average consumption somewhere in the 80- to 84 million-barrel-a-day range in physical trades out there, and at the same time well over a billion barrels being traded on the speculative side."

Does all that trading change the price? Most economists say no. They say speculators are essentially placing side bets while supply and demand dictate prices. "They matter for a little while, but they can't fight gravity," said Kevin Book, an energy expert at ClearView Energy Partners, pointing to last week's price decline.

CFTC statistics show that physical and speculative traders have different views of the market. In May, for example, noncommercial traders increased their bets on rising prices, while commercial traders adjusted their positions in anticipation of falling prices. Therefore, some analysts say, noncommercial traders can skew markets. (In the week ended July 7, the CFTC reported that noncommercial traders sharply reduced their bets on rising prices, one reason prices dipped.)

Economists say that a sign of a speculative bubble is a buildup in inventories because people will hoard supplies in anticipation of ever higher prices.

Last year, there were few signs of that. This year, however, worldwide inventories have been at or near record levels. Additional oil has been floating offshore in tankers. Last week, the Energy Information Administration reported that U.S. commercial stocks are high enough to cover 60.6 days of demand, several more than usual.

Roger Diwan, an oil expert at the Washington consulting firm PFC Energy, argues that there can be a bubble even without excess physical stockpiles. He says paper contracts for oil futures on the New York Mercantile Exchange -- which requires physical delivery -- are an easier way for people to lay aside supplies without having to lease ships or storage tanks.

Wei Xiong, an economist at Princeton University, has studied financial bubbles and has been looking at last year's oil shock.

He said CFTC data show that when prices started soaring in 2007, the "long positions," or bets on rising prices by noncommercial traders -- those trading for investment and not for delivery -- were 4.5 times the average of the previous decade.

"This evidence does suggest that many investors are speculating on the appreciation of oil prices," he said.

Moreover, he said, OPEC members can curtail output instead of adding to inventories. "Since the cost of storing oil is much higher than many other commodities, the best way for producers to build up inventory is to keep the oil underground," he said.

"The latest surge in oil prices defies fundamental logic," Edward Morse, oil expert at Louis Capital Markets Research, wrote in late June. "But in a disturbing echo of the 2007-08 commodity bubble, markets are again shrugging off the fundamental picture in favor of financial positioning and return-chasing."

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