By Christopher Palmeri
There is no doubt most of oil's huge price leap -- up 40% in the past year, to $45 a barrel -- is grounded in fundamental supply-and-demand issues. But how much of crude's big bounce is also because of speculation -- hedge funds and other financial players pushing up the price in futures markets? That's tougher to answer, but these traders are surely adding froth to an already superheated market.
New players are helping to push up the volume of crude-oil contracts traded on the New York Mercantile Exchange (Nymex). Such trades are on their way to an all-time record this year, up 13% through July. Data from the Commodity Futures Trading Commission (CFTC) show that the amount of money flowing into commodity funds -- many of which include a good chunk of oil investments -- has surged whenever the stock market has swooned over the past five years. Today, there are more than 3,200 funds registered with the cftc, almost twice the number in 1999.
Most of the speculators, moreover, are betting that prices are going even higher in the short term. So-called noncommercial traders -- hedge funds and other financial players that don't use or produce oil -- added 7,453 contracts of crude-oil futures and options on the Nymex as of Aug. 3. And their purchases of crude outnumbered their sales by about 79,000 contracts, the largest such position since the first week in June, according to Platts, which, like BusinessWeek Online, is a division of The McGraw-Hill Companies. This recent buying helped propel crude oil prices (see BW Online, 8/12/04, "Coping with Sky-High Oil Prices").
Certainly, financial investors serve an important role in oil markets, making it easier for producers and consumers to hedge risks. An oil company worried that the price of its crude will fall in coming months can sell a contract for December delivery on the Nymex at a certain price, say, $43 a barrel. On the other end of the trade, a commodity fund manager who thinks oil's price will go higher may agree to buy those barrels. If the price rises, the manager will have made money, and the oil company will at least get $43 a barrel.
But that seemingly simple transaction can also inflate the price of oil for consumers, if, say, the money manager wildly outbid others to buy the contract. And he could flip his contract at a higher price to another investor who thinks the recent trade will lead to even higher prices. That can help create momentum for more jumps. Oil users scrambling to hedge prices, such as airlines and trucking companies, are also adding to the frenzy. "Everybody believes there is still some upside," notes Scott Meyers, senior trading analyst at commodities broker Pioneer Futures Inc. "It's very hard to step in front of a freight train."
Thanks at least in part to such trading, today's oil prices might be exaggerating the market risks, some players believe. Consider that a barrel of oil has roughly the same energy as 6 million British thermal units of natural gas, a ratio that usually keeps the two commodities trading more or less in sync. With natural gas selling at about $5.70 per million Btus, crude ought to be at around $34 a barrel, not $45, notes Fadel Gheit, an oil company analyst at broker Oppenheimer & Co. Moreover, the current U.S. supply of crude -- not counting the Strategic Petroleum Reserve -- has risen 3.6% over the past year, to 294 million barrels.
Based on historical price-to-inventory ratios, crude should be $10 to $12 less per barrel, figures Howard Rennell, president of commodities broker Windham Group. Even the futures market suggests that these high prices won't last. Oil for delivery 12 months from now is trading at under $40.
To some that means that the markets -- and speculators-- are doing their jobs. "The increased activity at this point is providing much-needed liquidity," says James E. Newsome, the new president of Nymex. Adds cftc Acting Chairman Sharon Brown-Hruska: "If [speculators] do a bad job of predicting the markets, they will lose money. If they do a good job of predicting the markets, they make money."
At $1.6 million per seat, the price of membership at Nymex -- which trades a dozen other commodities besides oil -- has passed that of the New York Stock Exchange. Whatever impact speculators have on oil prices, one thing is clear: Lots of people want in on the action.
Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau.