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The blame game: Hedge funds & oil
When oil prices spike, fingers point at 'speculators' like hedge funds. But does their trading really drive prices?
By Amanda Cantrell, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) - It's almost a given that when oil prices spike, so do rumors that hedge fund managers are causing the problem or making it worse.

The rumors gained steam again recently when oil surged past $75 a barrel. But are they actually true?

While market watchers say hedge funds have indeed ramped up their trading activity in the crude oil and natural gas futures markets, proving a direct link between this speculation and higher prices is a difficult task - and one that stirs up debate every time there's a pop in the price of oil.

Hedge funds are private investment pools limited to wealthy individuals and institutional investors. They can trade a variety of assets, including commodity futures.

Hedge funds have increased their trading of oil futures contracts, judging by data showing the trading volume of crude oil futures contracts and natural gas contracts traded on the New York Mercantile Exchange.

A futures contract is an agreement to buy or sell a particular commodity or financial instrument at a given time in the future. Sometimes these contracts call for the physical delivery of the asset, but most contracts expire before any oil changes hands.

Mary Ann Bartels, an equity trading strategist with Merrill Lynch, said the trading volume of commodities contracts has increased as the price of oil has climbed and as the assets invested in hedge funds and managed futures funds, which are often classified as hedge funds, have increased.

The majority of traders of these contracts can be described as "commercial," meaning they have some involvement in or risk tied to the assets, such as oil producers, manufacturers or dealers. The rest are non-commercial or "speculative," a group that includes hedge and managed futures funds.

Speculative trading can drive the price of an asset up beyond what the underlying market fundamentals justify and increase the volatility of an asset's prices, if enough traders pile into an asset and are making the same bet.

But Michael Haigh, Chief Economist of the Commodity Futures Exchange Commission, which regulates the futures markets, said speculative traders absorb the risk of the commercial participants and contribute to overall liquidity in the markets.

"To say speculators contributed to the run-up in prices is flat out wrong," said Haigh. "They are enabling those that need our markets to manage their risk. We don't see any undue influence by speculative activity in these markets that's causing a problem."

However, Mike Rothman, senior managing director of broker dealer and research firm International Strategy Institute and head of the firm's integrated oil research practice, authored a study last year that concluded that speculative trading may have added as much as $20 per barrel to the price of oil during a period in 2004, according to reports.

On Tuesday, executives at British Petroleum suggested that hedge funds and other speculators were partly to blame for current oil prices, according to UK newspaper The Guardian.

How do hedge funds affect prices?

So who's right?

Peter Beutel, president of energy risk management firm CameronHanover, acknowledged that while speculators can drive the price of an asset higher if they're all moving the same direction, that's not always what happens.

"On any given day, the speculatives can make the price move higher or lower than it probably ought to, and I'm sure you could say hedge fund buying has helped push the prices higher," he said. But he added that not all hedge funds are holding long positions, and in the natural gas futures markets, hedge funds are actually holding more short positions - when investments are sold before they are bought in a bet that prices will fall - than long.

Further, Beutel said that when oil prices are trending down, hedge funds contribute to those price movements too.

"It's very much a two-edged sword," he said.

"Are hedge funds playing a role? Of course," said Gary Vasey, co-principal of the Energy Hedge Fund Center, LLC. "But apart from having an impact on intra-day volatility I can't say they are having an impact on prices."

Vasey added that if hedge funds all go long on crude oil it'll certainly have an impact on the market, but he noted there have been times when hedge funds have gone short, been wrong and lost money.

For crude oil futures contracts, the most recent data available shows that speculative traders held 18.3 percent of available long positions and 11.6 percent of available short positions, according to the CFTC.

So who is to blame?

Beutel of Cameron Hanover said what is really driving oil prices higher is a combination of market factors. Tight supply and geopolitical events such as terrorism, the war in Iraq, violence in Nigeria and the nuclear threat from Iran may impact the price of oil and seasonal supply and demand issues.

"Everybody is upset about these prices and they are looking for a convenient target," said Beutel. "They are going to have a hard time making anything stick. What's driving up prices? Fear. People are afraid price is going to go higher, and there are a lot of things going on in the world. Almost everything impacts the price of oil."

Vasey agreed that those factors are driving the prices higher, but he believes the impact of unexpected demand from China and other Asian countries, under-investment in infrastructure and climbing gas consumption in America have all added to the problems.

"It's a lack of investment story and I blame the politicians," he said. "They are trying to blame oil companies and hedge funds; they should have put together an energy strategy years ago and not a bill with pork and nonsense."

Market watchers will undoubtedly scrutinize the CFTC's weekly traders report when it is released Friday. That report will contain futures contracts trading data through Tuesday this week and will illustrate how much trading by speculative traders spiked.

"It's hard to point the finger at any one class of trader and say they are responsible for a run-up or rundown," said the CFTC's Haigh. "It's more complicated than that, and there are lots of people with different objectives."

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Oil slips on inventory report: Click here.

Anatomy of a gas gouge: More hereTop of page

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