Oil's Crude Awakening Wonder why oil prices keep hitting crazy highs? One answer lies surprisingly close to home.

(FORTUNE Magazine) – Over the past few months, as oil prices raced toward $50 a barrel, most observers blamed a smorgasbord of international culprits, including the meltdown of Yukos, the gargantuan appetite of China, and chaos in Iraq and Venezuela, to explain the seemingly inexorable rise. Maybe they should have been checking out the action in a place not normally considered part of the oil patch--Wall Street.

It's not that oil demand isn't running way ahead of expectations or that the threat of terrorism and violence in the Middle East isn't straining a system already perched close to the edge of capacity. But what's largely been missed is how these negative fundamentals have triggered an explosion of pressure on the oil market by hedge funds, brokerage firms, and other financial players. They've played a major role in pushing prices so far so fast, especially in mid-August, when crude futures hit new records in 14 out of 15 trading days. Like the Nasdaq in early 2000, the oil market today is caught in a classic speculative fever, and events that might normally have been written off as inconsequential--Hurricane Charley, for example--are good for a buck or two increase.

Eventually this bubble, like all bubbles, will burst. "With the move from the low 40s to around $50 a barrel, the paper markets have become very divorced from the fundamentals," says Seth Kleinman, market analyst for Washington-based consulting firm PFC Energy. "There's no shortages anywhere, gasoline prices have come down slightly, but crude oil just keeps going up." Fred Leuffer, a veteran oil analyst at Bear Stearns, echoes Kleinman's appraisal. "We believe speculation pervades the oil market," Leuffer writes in a new report. "Fear worked its way into oil prices beginning with production outages in Iraq last year and is now incited by something as routine as the announcement of maintenance downtime at a small oil field."

Crunching the numbers from venues like the New York Mercantile Exchange illustrates this story. Between July 2003 and July 2004, the volume of trades on NYMEX crude oil contracts jumped 35%, while trading in heating oil and gasoline jumped more than 50%, as trading in other commodities like gold and silver declined. Part of that rise can be attributed to increased trading and hedging by oil producers, refiners, and other companies connected to the energy industry. But data compiled by the Commodity Futures Trading Commission shows just how active Wall Street has become. Since the end of 2002 the long positions of financial firms--essentially bets on higher prices--have doubled. Similar bets by energy firms have increased only 10% over the same period, according to the CFTC.

Indeed, while stocks and bonds have proved mediocre investments this year, commodities have been drawing much more interest from investors. Commodity index funds and hedge funds "are a new entry in the market that creates added upside momentum," says Larry Goldstein, president of the Petroleum Industry Research Foundation. "And the volatility has been a magnet for speculators, so good news is absorbed while bad news drives prices higher." In the past, says Goldstein, there were cushions in the market--spare crude oil and refining capacity and large inventories--that absorbed the impact of negative surprises. Today, he says, those shock absorbers are gone.

As Goldstein notes, it's a mistake to simply blame traders or hedge funds for high prices. Like everyone else on Wall Street they're just trying to make a buck. And there's no getting around the fundamental factors that are responsible for the long-term rise in energy costs. But there are steps that the government, as well as regulators, could take to siphon off some of the recent market froth. Goldstein suggests opening the taps of the Strategic Petroleum Reserve. Even a modest release from the federal oil stockpile would signal to traders that Washington is serious about getting oil prices under control (although politically it could be difficult to pull off, since that's not what the reserve is designed for). Another possibility would be to increase margin requirements on oil contracts. As market strategist Charles Biderman of TrimTabs says, a similar move during the silver bubble of the early 1980s sent silver prices down sharply.

For now, though, traders are betting on what they call "blue sky"--higher and higher prices. "We're in uncharted territory," says Rob Laughlin, an energy broker with GNI Man Financial in London. "It's been a classic domino effect, when one thing triggers the next. Any news just adds more fuel to the fire."

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