Speculators keep oil prices afloat

Investors still think oil is a hot commodity, which may explain why crude hasn't fallen far despite brimming supplies, warm weather and a cooling economy.

By Steve Hargreaves, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- Temperatures and inventories are high, while economic growth and global tensions, relatively speaking, are low. But although oil prices have fallen in the last few days, they still remain historically high at over $50 a barrel. Why haven't crude prices fallen further?

Many analysts agree this is due in large part to the amount of speculative investment money pouring into the market over the last two years.


"There is no fundamental reason for [the price of oil]," Stephen Schork, publisher of the industry newsletter the Schork Report said of oil prices in the $55-$65 range. "This is a market that is trading on speculation."

"In our view, with the current supply demand environment, the price ought to be $35 to $40 a barrel," said Mark Gilman, an oil and gas analyst with the Benchmark Co., a New York-based investment firm.

Gilman said geopolitical tensions may add another $5 to the cost of crude, but to "chalk up the rest to money flows."

It's difficult to say just how much investment interest is bidding up the price of crude oil, but some experts said it's substantial.

One measure of investor interest is the number of traders on the New York Mercantile Exchange each day. "The action [there] is just incredible," said Tom Kloza, chief oil analyst at Oil Price Information Service. "It's many multiples of what it used to be."

Speculators in the oil (or refined products) market can generally be defined as investors who would not take delivery of the product when the contract comes due, like an investment bank.

The other big players in the market are industrial users - like refiners or airlines.

Money from hedge funds and other large investment funds started flowing into oil and other commodities a few years ago to as their prices climbed due to surging global demand.

That runup only sparked more fund buying, further boosting prices, and the attractiveness of commodities as an inflation hedge added to the buying spree.

Schork said that the jump in so-called open interest contracts is one sign that more speculators are in the market. Open interest refers to the number of futures contracts that haven't been exercised, sold or delivered on a commodity exchange.

Last December, for example, Schork said that open interest accounted for 1.06 billion barrels of oil on the New York Mercantile Exchange - about double the average for 2004 - and a figure that is higher than the actual number of physical barrels of oil in the United States on any given day.

"Commodities today are what the dot.coms were in the late 90s," said Schork. "They are the hot market."

Analysts are quick to point out that the rise in commodity buying by big investors isn't necessarily a bad thing.

Sure, you may pay more for a gallon of gas, but it's not just big hedge funds that are walking away with those profits.

Pension funds are also in on the oil game. And individual investors can benefit if they're in a commodities mutual fund or if they buy mini contracts available on NYMEX specifically designed for the retail market.

Also, greater investor participation keeps the oil market more liquid, meaning industrial users can buy and sell oil more easily on short notice.

But speculators can sell the market just as fast as they can buy it, as evidenced by last week's plunge in U.S. crude prices of nearly 9 percent.

With oil prices now near 18-month lows, some say a price jump spurred by speculative cash is just around the corner.

"[Investor cash] is the steroid that's very, very patient," said Kloza. "[It's] comfortable with the premises that we are just a headline away from a $20 move in the price of crude."

Kevin Norrish, a commodities analyst at Barclays in London, has a price target for U.S. crude of $80 a barrel by the third quarter of 2007.

Norrish believes that rise will be fueled mostly by fundamentals. He pointed out that the U.S. Northeast, where warm weather has dominated for the last several weeks and has been cited as the main driver behind the recent selloff, only accounts for 6 percent of all U.S. oil use.

"People sold on the back of this warm weather and we think they are incorrect," he said.

Norrish also pointed to what he sees as flat production from non-OPEC countries and OPEC cuts as other supporting factors in a price jump.

And while inventories are high historically, for the last couple of weeks they have fallen in the U.S.

"Excess inventories have been whittled away," he said "They are not going up." As a result, prices might.


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