Rational Advisor

Speculating on the future

Last year, two U.S. senators published a report on the energy futures markets called “The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat.”

As the title implies, the senators wanted to make hay by looking at what those shady hedge funds were doing to oil prices. It turns out that the report was pretty much ignored until recently, but its findings were interesting and it could lead to changes that would make it harder to
speculate. If speculators are a big factor in crude prices, and if the report’s recommendations gain traction, we’ll soon find out how big.

At the time, the benchmark oil price was about $70 (U.S.) a barrel, even though U.S. inventories were the highest they’d been since 1998 - not too far from the situation today. Although the report said it’s difficult to quantify the extent to which speculators affect the market, it found, not surprisingly, that speculation did move prices.

Who would disagree with that today? Last month, the Organization of Petroleum Exporting Countries announced an increase in production and the price of oil rose instead of fell. US Fund company Pimco’s commodity fund has grown from nothing to $12-billion in five years. Enbridge estimates that 25% to 35% of its crude oil storage is leased by financial firms playing the difference between spot and future prices. Big global banks have big energy-trading operations.

There are other signs of speculation in energy markets, too. Open interest - the volume of contracts agreed to - on the New York Mercantile Exchange has tripled in the past three years. While it’s true that higher prices can bring on more contracts, it’s hard to say speculative money isn’t a big thrust under oil prices, given the rash of new commodity funds and the cash they’ve raised. The Pimco fund is just one example; most pension funds around the world have some cash devoted to oil futures.

Nymex used to be pretty much the only place for trading energy futures in the United States. Not any more. The over-the-counter market, according to the Bank for International Settlements, now does 20 times the volume. During the oil price crashes of the eighties and the nineties, the OTC market was negligible.

The natural state of affairs in the futures market is for a producer of oil to agree to sell a barrel of oil in, say, three months for an agreed-upon price. The buyer will be a refiner, which uses oil, or an airline, which wouldn’t use the oil directly but rather as a hedge.

Now there are legions of other buyers - we don’t know exactly how much buying they do - who are simply gambling on a thesis: that oil is headed higher. It’s not a bad thesis - oil is finite, producers have underinvested for a long time and are in no huge hurry to crank it up, and Third World demand seems strong. But does it justify $80+ oil?

Probably not. Oil analysts vary widely on this subject, but a sample of respected ones says the speculative premium in crude adds between $20 and $35 a barrel.

What if these investment funds - and they’re not all hedge funds – decide they want to short the market? Since they tend to move in a herd fashion, that would mean a big drop in oil prices.

As things stand, it doesn’t look as if there are many reasons for the fund to go short, given the rise in oil prices. But the statistics aren’t that reassuring. High prices always lead to a drop in demand. The U.S. consumes about a quarter of the world’s oil, and demand there is starting to fall.

And there might be an even better reason. The Senate report says that changes to the U.S. Commodity Exchange Act, which Enron lobbied for and got in 2000, make it difficult to track speculative positions in the future market. Basically, big traders can use the OTC and London based markets to anonymously trade and, perhaps, manipulate prices as Enron did in energy. The senators want to put a stop to that, and the Commodity Futures Trading Commission does too: This summer, it said it wanted to tighten its oversight of the OTC market, which comprises 75% of U.S. energy trading. Lawmakers are in favour, so new rules are likely on the way.

Observers figure these proposals would curb a lot of speculation in the energy markets, which might just trigger a change in the herd mentality. In the words of an energy trade quoted in the report, “When those entities decide to start liquidating their futures positions, look out below.”

Rational

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