Speculating About Oil’s Rise

06/12/2008 12:00 am EST

Focus: COMMODITIES

Howard Gold

Founder & President, GoldenEgg Investing

When the price of crude oil shot up $16 a barrel late last week to hit a record $139, investors once again wondered if this is all driven by economics or speculation. 

The answer is: Yes.

Tight supply and strong overseas demand for oil, fears of inflation, and a weaker dollar have combined with a big increase in trading volume to create a "perfect storm" that has caused crude prices to spike some 40% this year.

Meanwhile, hedge funds have been putting some of their $2.8 trillion in assets to work in the energy markets. And exchange traded funds (ETFs) that invest in crude and other commodities have exploded in popularity, giving individuals and institutions a piece of the action.

The interplay of all these forces was on display last week. Having briefly peaked at about $135 a barrel, crude began what looked like an orderly retreat, selling down to the low $120s.

But then, Jean-Claude Trichet, president of the European Central Bank, suggested that the ECB might raise interest rates in July to combat inflation in the Euro zone. That was bad news for the US dollar, which began falling after having firmed a bit lately.

That was about when a Morgan Stanley shipping analyst penned a brief research note that said inventories "at critically low levels" would drive crude prices to $150 a barrel by July 4th. Happy Independence Day!

This unusual call-Wall Street firms famously avoid giving near-term target dates for their predictions-was the equivalent of dropping a lit cigarette in a dry forest. Oil prices shot up, and the many traders who were short crude scrambled to unwind their positions.

It was all there in microcosm: a weak dollar, fears of inflation, concerns about tight supply. And lots of speculators providing the kindling wood.

So, how much of a role are they playing?

When you look at the markets' action, you'd think it was obvious: Speculators, probably hedge funds, are selling the dollar and buying oil, just as they piled in to the yen carry trade (borrow in low-interest yen, invest in high-return countries) while world markets soared in 2006 and 2007.

But the data are pretty mixed.

No doubt trading on the oil markets has exploded. Open interest in West Texas Intermediate crude oil futures has trebled since 2004, to about three million contracts a few weeks ago, according to Jeffrey Harris, chief economist of the Commodity Futures Trading Commission (CFTC), which regulates futures markets.

And daily trading volume is running eight to ten times the amount of crude oil actually produced each day. 

Yet the so-called "noncommercial" (i.e., speculative) share of that open interest has risen only two percentage points, to 36%, in the last three years, said Harris in Congressional testimony last month. ("Commercial" buyers-oil companies, airlines, utilities, the people who actually use the stuff-use the markets primarily to hedge, not speculate.)

And surprisingly, says Todd Salamone, senior vice president of research at Schaeffer's Investment Research, a lot of the speculators aren't buying contracts at all.

"Net long positions among speculators [have shown] a significant drop since its highest level," he says

In fact, says Salamone, "small traders had the largest net short position in decades."

And the most recent Commitments of Traders report released by the CFTC showed more traders of all kinds taking short positions in crude on the New York Mercantile Exchange.

Not all speculation takes place on the futures markets, however. In the past year or so, individuals and institutions have piled into the commodities markets. Whether they're protecting their portfolios or chasing the latest hot trend is hard to say. But they sure aren't buying barrels of crude to park in their backyards.

Institutions have invested $260 billion in commodities markets-20 times what they did five years ago. As of April, net assets in commodities ETFs topped $33 billion, nearly double last April's total, while net assets in natural resources ETFs totaled $18.7 billion, a TK% increase.  And two natural resource funds are among the ten most heavily traded ETFs, according to Morningstar.

So, how big a role is speculation playing in driving up oil prices?

I basically agree with Harris, the CFTC's general counsel, who testified that "overall commodity price levels including.energy futures prices, are being driven by fundamental economic forces of supply and demand."

And John Person, president of NationalFutures.com, asks: "Maybe it's 10% speculation. It's just an overall fear among market participants."

Here's what I think is going on: The airlines, utilities and oil companies that need oil to do business are hedging more actively than usual. These parties remain long, according to the data.

They have to. Southwest Airlines has locked in most of its fuel at the equivalent of $50 a barrel of crude. Many other airlines, um, didn't. And look at the mess they're in now.

So, although all the players hedge their positions all kinds of ways, when prices start moving up, the commercials have to pile in on the long side to protect their supply. Individual investors follow suit by gobbling up rising ETFs. And speculators, who are net short, have to cover like crazy.

How long will this game go on? Who knows? Person says that historically the seasonal high for energy prices is in September, three months from now. And Salamone adds that "we're just not seeing the euphoria that would suggest a peak."

I've written here that demand for oil should weaken as world economies slow-and a report from the International Energy Agency this week says that's beginning to happen. When it does, I'm confident oil prices will come down.

But until sanity returns, we'll just have to watch the tug of war between the hedgers and speculators in the futures pits, while we all pay more at the pump.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow or MoneyShow.com.

Related Articles on COMMODITIES