Are Speculators Influencing the Price of Oil?

So, who are the Speculators and what do they Speculate?

Investopedia describes a Speculator as:

Paper Oil: Energy Index Speculators purchase oil futures but never take physical delivery of the commodity."A person who trades derivatives, commodities, bonds, equities, or currencies with a higher-than-average risk in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains."

So a Speculator is a risk-taker; but while he is taking the big risk for the big profit, he is also providing a benefit by creating marketability.

Let's look at commodities such as wheat, corn, gold, or oil. Most commodities are bought and sold with Commodities Futures. In commodities futures, contracts are made for a product to be purchased at a specific future price. This helps the producer assume less risk since their product's price is now set. Just imagine a farmer settling on price in May for his crop that he will deliver in September. This is known as Hedging. Think of it as insurance for the price of the commodity. [1] Finally, to fulfill a futures contract, the buyer actually takes delivery of the given commodity.

So, if Speculation provides a benefit to the market, why has there been so much negative debate about it recently?

One of the arguments is that the current degree of Speculation is excessive, thus unnaturally inflating prices.

But what and who defines excessive?

Let's go back to the basics. The original intent of futures markets was to benefit producers and consumers in getting the best price for their product while reducing risk. This is based on actual supply and demand fundamentals.

However, the Speculator (along with some Hedgers), does not take actual possession of a physical asset ("Wet Barrel") from their trade. When this happens with energy futures, a cargo of oil is referred to as a "Paper Barrel".[2]

This has resulted in a "financialization" of oil markets. During this "financialization", analysts have observed a very strong correlation between the growth of these futures and the rise in oil prices. Oil has become a hedging instrument against the weakening dollar and rising inflation for the last several months. It has now gone from a commodity, whose price can be "hedged" to reduce risk, to a new type of asset to be added to the portfolios of savvy investors. [3]

Michael Masters of Masters Capitol Management refers to these types of Speculators as Index Speculators.[4] They leverage this new type of asset in Index Funds. A Commodity Index uses computer models to gauge performance in particular commodity markets. Examples are the S&P Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index. Hence, Index Speculators invest in the actual index instead of a single commodity.

According to Masters, Index Speculators have been buying more commodities futures over the last five years than any other group. He calls them "the 800 pound gorilla" dominating the futures markets. Ten years ago, physical hedgers, those taking physical delivery of a commodity, ruled the commodities markets over Speculators, 4:1. The ratio is now 2:1 in favor of Traditional and Index Speculators.[5]

In his recent testimony before the House Energy and Commerce Oversight Subcommittee, Masters insisted, "Every single WTI Futures [crude oil] Contract that is traded for any reason other than the supply and demand of physical crude oil is a contract that weakens the Price Discover Function." Price Discovery is the process of deciding upon a commodity price based on Supply and Demand factors.

Even after hours of Congressional testimony by Masters and others pointing the finger directly at Speculation, other experts still insist the rise in crude oil prices is due to Supply and Demand.

In an article last month on Bloomberg.com, Boone Pickens, chairman of Dallas-based BP Capital LLC, was quoted as saying, "You have 85 million barrels a day of oil available in the global energy market and 86.4 million barrels a day of demand. So the price of oil is going to go up until you can kill demand.''[6]

In May, Jeffrey Harris, the chief economist for the Commodity Futures Trading Commission, told the Senate Homeland Security and Government Affairs Committee that prices are being driven by "fundamental market forces" along with supply and demand.[7]

The Commodity Futures Trading Commission (CFTC) is the government entity in charge of regulating Commodity Futures. Their mission is to protect the market and the public from fraudulent, manipulative, and abusive methods associated with commodity futures. However, Acting Chairman Walter Lukken told the House Energy and Commerce Oversight Subcommittee that the CFTC does not even have the term "excessive" defined.[8]

However, the agency is taking steps to figure the cause of soaring oil prices. They have organized an Interagency Task Force to look into the matter. The Task Force will bring together representatives from The Federal Reserve, Department of Treasury, Securities and Exchange Commission, Department of Energy, Department of Agriculture, Federal Energy Trade Commission, and The Federal Trade Commission. This super-bureaucratic team (referred by Lukken as the best and brightest minds in government) will evaluate the various factors involved in the Commodity Futures markets. Finally, after analyzing all the data, the CFTC will provide at report to Congress in September;[9] yes, in two months from now.

But Masters believes he has a better idea, suggesting Congress instead create a panel composed of commodity producers and consumers who should explicitly define excessive speculation. He also calls upon Congress to eliminate "Index Replication".

The most fascinating aspect of his solution is that he thinks that we could see gas prices cut by one third to one half in approximately 30 days. Other analysts think we could see results even more quickly.

Congress already has ideas of creating legislation to address this issue. Senators Lieberman and Collins, of the Senate Homeland Security and Governmental Affairs Committee, have started drafting documents to close some current loopholes and transparency issues in the commodity markets that discuss setting limits on commodity trading, and restricting large institutional investing in Index Funds. Lieberman believes that Speculators are motivated by the weakened dollar and rising demand for oil, and that they are putting incredible amounts of money into the commodities markets and artificially inflating prices.[10]

John Dingell, Chairman of the House Energy and Commerce Committee, has introduced H.R. 6238 to give power to the Department of Energy to create an Interagency Working Group to study the possible reasons for high energy prices. If passed, this legislation will cost taxpayers $25 million.

Michael Greenberger, a former director from the CFTC, says the solution could be addressed much more quickly with emergency powers the CFTC already has at their disposal.

"...section 8a (9) provides that ‘whenever [the CFTC] has reason to believe that an emergency exists,' it may take such actions ‘including, but not limited to ‘the setting of temporary emergency margin levels on any futures contract [and] the fixing of limits that may apply to a market position.'

An emergency is defined: to mean, in addition to threatened or actual market manipulations and corners, any act the United States or a foreign government affecting a commodity or any other major market disturbance which prevents the market from accurately reflecting the forces of supply demand for such commodity."

In other words, if the CFTC finds that Speculators are manipulating or abusing the Commodities Markets, they can take temporary emergency action to immediately address the issue.

When Chairman Bart Stupak asked Lukken his thoughts on using the CFTC's regulatory power for reducing energy prices, he simply responded that they needed more data.

One thing is certain, if we're unable to stop whatever is causing oil prices to soar, we're going to continue to feel the pain at the pump. In a recent interview with CNBC, Boone Pickens said he expects to the price of oil to keep going up, maybe to $150 a barrel. His solution? Switch to natural gas. He doesn't see gas prices going down at all unless we get hit with a global recession.[11]

For information on gas prices in your area, check out the National Gas Temperature.

[1] Commodity Futures Traders
Hedgers and Speculators Buy and Sell Futures in Commodities
© George Daleiden
http://futures-investing.suite101.com/article.cfm/commodity_futures_traders

[2] A Greek Speculator's Journal (June 09, 2006)
Oil to $386.57 per Barrel!
http://dhatz.blogspot.com/2006/06/oil-to-38657-per-barrel.html

[3] Testimony of Roger Diwan
Regarding Energy Speculation: Is Greater Regulation Necessary to Stop Price Manipulation? Part, II
House Energy and Commerce Subcommittee on Oversight and Investigations
(June 23, 2008)
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.Diwan-testimony.pdf
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.EnergySpec.shtml

[4] Testimony of Michael Masters
Regarding Energy Speculation: Is Greater Regulation Necessary to Stop Price Manipulation? Part, II
House Energy and Commerce Subcommittee on Oversight and Investigations
(June 23, 2008)
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.Masters-testimony.pdf
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.EnergySpec.shtml

[5] Written Testimony of Michael Masters
Regarding Energy Speculation: Is Greater Regulation Necessary to Stop Price Manipulation? Part, II
House Energy and Commerce Subcommittee on Oversight and Investigations
(June 23, 2008), Page 11
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.Masters-testimony.pdf
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.EnergySpec.shtml

[6] Bloomberg.com
Pickens Says CFTC Probe of Oil a `Waste of Time' (Update1)
(June 2, 2008)
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_v6FZgW1WAI

[7] Testimony of Jeffrey Harris
Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?
Senate Committee on Homeland Security and Governmental Affairs
(May 20, 2008)
http://hsgac.senate.gov/public/_files/052008Harris.pdf
http://hsgac.senate.gov/public/index.cfm?Fuseaction=​Hearings.Detail&HearingID=3fe95f08-0b7d-45d0-94ea-4c4346c353de

[8] Testimony of Walter Lukken
Regarding Energy Speculation: Is Greater Regulation Necessary to Stop Price Manipulation? Part, II
House Energy and Commerce Subcommittee on Oversight and Investigations
(June 23, 2008)
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.Lukken-testimony.pdf
http://energycommerce.house.gov/cmte_mtgs/110-oi-hrg.062308.EnergySpec.shtml

[9] Testimony of Walter Lukken
Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?
Senate Committee on Homeland Security and Governmental Affairs
(May 20, 2008)
http://hsgac.senate.gov/public/_files/062408Lukken.pdf
http://hsgac.senate.gov/public/index.cfm?Fuseaction=​Hearings.Detail&HearingID=3fe95f08-0b7d-45d0-94ea-4c4346c353de

[10] Opening remarks: Senator Joseph Lieberman
Ending Excessive Speculation in Commodity Markets: Legislative Options
Senate Committee on Homeland Security and Governmental Affairs
(June 24, 2008), Page 9
http://hsgac.senate.gov/public/_files/062408JILOpen.pdf
http://hsgac.senate.gov/public/index.cfm?Fuseaction=​Hearings.Detail&HearingID=b5b714c5-0b2e-4ab1-b1dc-2317a7d22e47

[11] CNBC.com
Pickens: Oil Going to $150, So Move to Gas
(May 29, 2008)
http://www.cnbc.com/id/24723260/