Oil prices: Wall Street's game

Big fund money is flowing into oil markets sending prices to levels never seen before. Is it profiteering or an essential way to ensure supply?

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By Steve Hargreaves, CNNMoney.com staff writer

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NEW YORK (CNNMoney.com) -- There's no question about it: A new breed of speculator is pouring money into the oil market. What's less certain is whether this new money is responsible for driving up prices or essential to a healthy market.

Many blame record prices on Wall Street investors new to the oil market, saying they're bidding up gas prices to artificially high levels - and soaking drivers.

As oil nears $130 a barrel, some say $10 to $70 of that price is due to Wall Street speculation.

But that's not the whole story. Nearly everyone agrees that speculators have always been essential to a functioning market and that oil prices could be much higher without them.

What's harder to understand is the effect of new speculators flowing into commodities from big-money funds like university endowments, pensions and indexes.

Some say they're a good influence. In addition to limiting demand, they make it easier to sell oil contracts and create a larger market where prices are less susceptible to big swings following individual trades - known as liquidity in financial speak. This camp says $130 oil is justified since demand is rising faster than supply.

Others say big-fund money is making it harder for traditional oil speculators to do their job. This camp says big funds distort traditional models used to predict prices and think $130 oil is a bubble ready to pop.

What is a speculator?

Traditionally, a futures speculator bets on the direction of commodity prices and then guarantees that commodity at that price to a client. This removes some of the risk - and greases the wheels of commerce.

Speculators originated in the food market, and were intended to give farmers a set price in the spring to buy seed, according to Peter Beutel, an oil analyst at Cameron Hanover.

For example, a speculator would offer a farmer $3.50 in April for a bushel of corn to be delivered and paid for in October - these are called futures contracts. The speculator hopes that by October corn will sell for $4, and he'll make money. The farmer can plant his fields certain that he's making $3.50 a bushel.

Conversely, a speculator might bet the price of corn will fall.

He might offer to sell a bushel to a corn bread maker at $3.50 in April for corn to be delivered in October. If corn falls to $3 by October, the speculator comes out on top. The deal allows the bread maker to make long term business decisions, like how many employees to hire.

Without this transparent marketplace, uncertainty would be priced into the product, resulting in higher costs for everyone.

Although the lines between producer, consumer and speculator have been blurred in recent years, this same dynamic is at work in today's oil and gas markets.

"We're trying to get some type of cost certainty," said Brad Samples, a commodities analyst at Summit Energy in Louisville, Ky.

Summit buys energy for clients who use lots of it. One client, Samples says, goes through about $15 million a year in diesel fuel, and it's Samples' job to make sure it gets a good deal at a consistent price.

For Samples, more money in fuel markets means more people willing to sell him a contract. He doesn't think speculators push prices artificially high, arguing that supply and demand support prices.

"All the focus on speculators being the problem misses the point," he said. "The point is: supplies are not growing as fast as demand. You need sharp price growth to bring down demand."

Making the right bet

When Samples buys a contract, he needs someone to sell it to him, usually a bank. To manage the financial risk, the bank will go out and sell that contract to someone else - in other words, a speculator.

Sometimes that person might be someone like George Zivic, managing partner at Almanac Capital, a commodity investment firm.

For him, the influx of big-fund money betting oil prices will move in one direction - in this case up - into the commodities market is a challenge.

Before the new money, price movements were more predictable. For example, in the spring gasoline usually rises in tandem with crude, and Almanac and other related firms would look to make their money by betting on the difference between the two.

This year that hasn't happened - oil prices have greatly outpaced gasoline - and that's made making money in this market more difficult. He blames some of the schism on big-fund money betting oil prices will only go up.

"When you have directional money, it makes the historical relationships distorted," he said. "There's no short term shortage of oil. $127 a barrel doesn't make sense."

Placing blame

Beutel, from the consultancy Cameron Hanover and a former NYMEX floor trader, goes even further in blaming big-fund money.

"We want to see them out, they have no respect for our markets at all," he said.

But Beutel doesn't blame these funds for wanting to diversify their portfolio by investing in oil.

If anyone is to blame, he says, it's the Federal Reserve, which has been predictably cutting interest rates since September to shore up credit markets. When interest rates fall, investors flock to commodities as an inflation hedge.

"The Fed tipped their hand," he said. "[The big funds] were basically told by [Fed Chairman Ben] Bernanke that this is where the money is."

And if the money is there, why wouldn't the big funds take advantage of it?

"We are following for us what is a prudent strategy to maximize investment returns, said Clark McKinley, a spokesman for CalPERS, California's pension fund for workers in the public sector. "Obviously, there's some unintended consequences."

Not everyone agrees big-fund money is playing a role in driving up prices, starting with the Commodity Futures Trading Commission, the government's own regulatory agency.

Economists at the CFTC have testified that after studying all the numbers on who is trading what, there is no evidence speculators of any kind are significantly driving up the price of crude.

'You can't just point the finger at speculators," said Michael Haigh, head of U.S. commodities research at the investment bank Société Générale and a former economist at the CFTC. "Fundamentally, the markets are where they are supposed to be."

Haigh said that big-money funds are not just dumping their money onto the market - only betting prices will go up. He and others say these funds are sophisticated investors and take a variety of positions in the market.

Deutsche Bank took a somewhat novel approach in investigating the role of speculative money.

Analysts there looked at the price of commodities that do not trade in a futures market and came to basically the same conclusion.

"The rally in non-exchange traded commodity prices since the end of 2002 has been similar if not greater in magnitude," the bank's analysts wrote in a research note. "We believe this refutes the claim that speculators have been the primary drivers of rising commodity prices during this cycle."

So what's to be done?

Members of Congress, their ears bent by angry motorists paying nearly $4 a gallon for gas, are considering increasing the amount of money investors have to put up front in order to buy oil futures.

Some say this may work, as a lot of the investor interest in commodities is due to the fact that they can essentially gamble with a million dollars worth of oil by putting up $100,000 or less of their own money. In the stock market, they'd need to put up $500,000.

But others say increasing these requirements - known as margin requirements - would merely drive oil trading into less regulated markets where information would be even harder to track.

The motorist organization AAA doesn't have an opinion on what Congress should do. But like many American drivers, they've certainly noticed that oil prices have shot up $50 a barrel since August at the same time that the stock market tanked, while the supply and demand picture for oil remained little changed.

"After Israel invaded Lebanon, Hurricane Katrina, 9/11, all of these situations, we haven't seen prices rise to these levels," said AAA spokesman Geoff Sundstrom. "We have to wonder if the foundation behind these very high prices is nothing more than speculation."  To top of page

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