Falling Oil Prices: Again, Blame Speculators

When oil prices soared to a peak of $147 a barrel last summer, oil speculators became the whipping boy from Main Street to Congress. Critics demanded that regulators rein in hedge funds, pension funds, college endowments, and other investors that had piled into oil futures in a quest for easy profits. But the protests have died away now that prices have plunged by $100. "You don't hold Senate hearings when oil prices are low," says Joel Fingerman, managing partner of Chicago-based Fundamental Analytics, a commodities analysis firm. "There's no political mileage to be gained."

But just as the stampede of nontraditional investors into the oil futures market helped to push prices up, their exit has had a hand in bringing them down. Many hedge funds and institutional investors have unwound losing positions or have been forced to sell to meet margin calls elsewhere in their portfolio, analysts say. Noncommercial traders—mainly investors who never take actual delivery of crude—reduced their long futures bets on the New York Mercantile Exchange by about a fifth over the seven-month period ending in December, from 266,733 in May to 215,665 as of Dec. 22, according to Nymex figures.

"The new speculators—those who were caught up in a herding mentality and helped to cause the bubble trouble—have exerted added momentum to the swift price declines," says Bart Chilton, a commissioner with the U.S. Commodities Futures Trading Commission, which regulates oil trading.

Speculators Went Long

True, it was the global recession that dramatically accelerated the slide in petroleum prices. And some of the speculators got out in time to cash in winnings.

The exodus began last spring, when crude prices soared past $110 a barrel. Unlike oil traders who can be long or short, or sometimes both, in a single day, the newcomers to the market had taken uniformly long positions—that is, they were betting oil prices would continue to go up. When the financial crisis began to worsen, many of these investors stopped rolling over their positions when contracts expired, thus removing a crucial underpinning to higher prices. Nymex data show that among noncommercial traders, the number of long positions still exceeds the shorts. But analysts don't know if this is intentional or whether some are simply having trouble unwinding their positions.

Speculators were not alone in causing the price bubble—commercial traders were behind the last leg in oil's rise, from about $110 a barrel to its July 11 peak of $147 a barrel, according to Fingerman. But could speculators now be now be causing prices to overshoot on the downside?

Some seasoned oil hands think at least part of the problem is financial liquidity—the sell-off has gone so far that there isn't enough bank lending to finance trading. Yet there are others, such as Peter Beutel, a New Canaan (Conn.) oil analyst, who believe prices are in sync with the market. "I don't think $50 oil is a bubble as much as a return swing of the pendulum," Beutel said.

Still-Active Speculators

What if oil prices begin creeping back up? Will the hedge funds, pension funds, and college endowments tiptoe back into the futures market? Dennis Gartman, a seasoned oil trader in Suffolk, Va., thinks not: "As Mark Twain said, the cat who has sat on a hot stove won't sit on a hot stove again—or even a cold one—because to him all stoves are hot."

But recent price swings indicate that speculators are still active. On Wednesday, Jan. 7, news of a fresh increase in U.S. oil and gasoline inventories reversed a spike in oil prices, to over $50 a barrel, just the day earlier. That had been provoked by the fighting in Gaza and the natural gas dispute between Russia and Ukraine. Oil plunged on Jan. 7, to $42.63 a barrel on the New York Mercantile Exchange, on news of a 6.6 million-barrel rise in oil stored in U.S. storage tanks. That was five times the 800,000-barrel increase expected by the market. Tanks now hold 325.4 million barrels of oil, the most since May.

Price Hikes Ahead?

The rising amount of oil in storage at least partly reflects the biggest gamble on the market now—that oil prices will somehow rise steadily over the next months and years, a position in the trade called "contango." When contango happens, speculators respond by storing all the oil they can at a price locked in with two futures contracts, with the idea of profiting down the road when they can sell it at that price.

Gartman, the Suffolk (Va.) trader, said that if he could get his hands on $10 million, he would pump every cent of it into crude oil futures. If he bought February 2009 oil futures (selling for $41.24), and a sell order for February 2010 (selling for $60.22), he would pocket more than 40% profit after covering fees and storage expenses, he says. Too bad banks aren't lending, Gartman says, though even if they were the world is so awash in crude that there is almost no place to store it.

Storage is so hard to come by that traders are storing it at sea in 2-million-barrel supertankers. About two dozen supertankers are already hired out for storage purposes, and Bloomberg reported on Jan. 7 that oil traders are seeking to let as many as 10 more.

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