Have Oil Speculators Already Priced In War With Iran?

A tank of crude oil near an operating oil rig outside Fort Collins, Colo. Photograph by Patrick Andrade/The New York Times/Redux

The last time the price of Brent crude closed below $100 a barrel was Oct. 6, 2011. It’s since gone up nearly 30 percent, to a high of $126.20 on March 1. Tensions over Iran’s nuclear program have people spooked that a potential attack would disrupt the country’s 2.2 million barrels of daily oil exports. And so money has been pouring into oil futures contracts, driving up the price without any significant change in the underlying supply-and-demand fundamentals. Only the threat of one.

So who’s buying?

Talk to oil analysts these days and chances are they’ll tell you that more than half the spike in the oil price is due to speculators—specifically noncommercial users. That’s jargon for investors who are buying up futures contracts not because they intend to use the oil, but because they think it’s a good investment. These aren’t airlines or refining companies; these are money managers betting that the price will go up. And so far they’ve been right, thanks to themselves.

Since October, money managers have bought the equivalent of 372 million barrels of oil through a variety of futures contracts, essentially doubling their oil exposure. That includes contracts for West Texas Intermediate crude traded on the New York Mercantile Exchange and the Atlanta-based IntercontinentalExchange, known as ICE. It also includes contracts for Brent crude, gas and heating oil, and what’s known as RBOB gasoline: stocks of refined gasoline that are ready to be blended into the various grades of gasoline used in the U.S.

According to Tim Evans, an oil analyst with Citigroup, money managers now hold a record net long exposure to oil through 638,774 futures contracts, which at 1,000 barrels per contract equates to about 638.8 million barrels of oil. “That’s about 290 days’ worth of Iranian oil exports,” says Evans. “Which implies that we’ve already priced in a nine-month outage from Iran.”

And that’s without a single shot fired. In a way, oil speculators are betting on the likelihood of war with Iran. Because without a material disruption in supply, at some point the price will have to return to something more reflective of demand fundamentals, which aren’t terribly strong at the moment.

In the U.S., the world’s biggest oil consumer, demand is close to a 15-year low. China’s economy is set to expand at its slowest pace since 2004. This week the Energy Information Agency predicted that global consumption of liquid fuels will grow by an annual average of 1.1 million barrels a day in 2012; EIA forecasts that supply from non-OPEC countries will grow by just 700,000 barrels per day. While that suggests a bullish future for oil prices, it’s not robust enough to justify a 30 percent rise over the last five months.

“This is a huge risk position these money managers are putting on,” says Evans. Since futures contracts are purchased on margin, speculators typically put up something around 10 percent of the value of the total contract, depending on how leveraged they are. So while the notional dollar amount of outstanding contracts may not be incredibly large, the positions relative to the size of the crude oil market are. Evans worries that the price of oil now depends entirely on the situation in Iran. “There’s only one fundamental scenario we’re hinging on: We either lose Iranian supply or we don’t,” says Evans.

This isn’t the first time speculators have poured into oil futures and pushed the price up. But the scale of what’s happening now dwarfs previous run-ups. For example, back in July 2007, a year before the price of oil peaked at $144 a barrel, money managers held a net long position of 160,000 WTI futures contracts on the NYMEX, says Evans. Today, that number is 272,000 contracts.

Just as rising oil prices sparked angry congressional hearings about oil speculators in 2008, this week Democratic members of Congress lashed out at oil speculators, and the Commodity Futures Trading Commission for failing to limit them.

“This is so much bigger than what happened in ’07 and ’08,” says Tom Kloza, director of New Jersey-based research firm Oil Price Information Service. As long as the threat over Iran remains, the price will continue to rise. “Iran is dissuading the typical sellers out there who function as circuit breakers when markets get out of control to the upside,” says Kloza.

“The downside risk gets bigger every day,” says Evans. Not just for speculators, but for the global economy. High oil prices eventually destroy demand. Back in 2008, the huge run-up in oil helped push down economic growth before the financial crisis kicked in. Says Evans: “In 2008 we kept telling ourselves that demand was strong and ignored what the price increases were doing to the demand side of the market.”

Kloza believes we’re “in the middle innings” of a situation that would result in a similar destruction of demand. Tempting as it may be to read into this some nefarious collusion or market manipulation, Kloza believes it’s simply a matter of markets having short memories. “It’s simply a matter of crowd behavior,” says Kloza. “And the amazing propensity of increasingly bright people to do incredibly dumb things.”