05/09/2010 05:12 am ET | Updated May 25, 2011

When Oil Traders Make a Mistake, We All Pay the Price

Periodically, news articles from various sources attempt to explain the maddeningly confusing logic (or lack thereof) behind the movements of crude oil prices.

Perhaps the most important lesson to be learned from such reports is that in the oil markets, perception is everything. Just last week, a marginally positive US employment report caused a spike in crude oil prices that drove up gasoline and heating oil prices. If the business media is to be believed, oil traders perceived the jobs data as a sign that the US economy is on its way to recovery, which means US demand for oil will pick up sometime soon, which means prices will pick up also, which makes traders want to buy up oil futures contracts to cash in on the coming price increases. As more traders bought up contracts, the demand for contracts increased, sending crude oil prices upward on the New York Mercantile Exchange on Friday. As a direct result of the buying trend on Friday, heating oil and gasoline consumers are paying a few cents more per gallon today.

So here we have a clear-cut example of how oil traders' perceptions can have direct bearing on the retail prices of heating oil and other refined petroleum products. It seems a little arbitrary, but after all these traders are the experts, right? If they think the jobs report is reason to expect an uptick in oil demand, they're probably right. Even if the jobs report was not good news, it was not as bad as it could have been. As reported on Friday, "Though the report was modest in reflecting a flat month for hiring, the subtle loss is buoying positive sentiment among investors." On Friday, traders simply did their job: their perception, as experts, led them to buy more oil contracts and drive up the price.

But what happens when traders' perceptions are just plain wrong?

For an example, we need only to look back to last month. In a turn of events grossly underreported by the business media but deftly brought to light on Saturday by the Record Searchlight of Redding, California, traders made a boneheaded error that ended up costing consumers extra pennies per gallon.

On February 18, the West African nation of Niger experienced a military coup that deposed the nation's president, Mamadou Tandja. On February 19, the retail price of heating oil increased by an average of 4 cents per gallon as a result of the previous day's rise in crude prices. Although we didn't know it at the time, it appears that the coup in Niger had a lot to do with those rising prices. The day after the coup, Reuters reported that oil traders mistaking Niger for its oil-rich neighbor Nigeria had sparked a buying frenzy that helped send the price of crude to its February high of $79.29 a barrel.

Political turmoil in oil-rich nations and regions can have a major effect on oil prices, and with good reason: if a major oil exporter is gripped by a crisis that interferes with its oil industry, world oil supplies drop and prices go up. Nigeria is the eighth-largest exporter of crude in the world, supplying about 3 million barrels per day, so a coup or other major upheaval in that nation would certainly drive up prices. Niger, on the other hand, does not produce oil -- the CIA World Factbook lists the nation's 2007 oil experts as 0 barrels per day (157th in the world), so political events in Niger should have no bearing on oil prices whatsoever. Even the business news source MarketWatch (operated by the illustrious Wall Street Journal), seems to have hastily reported the coup had taken place in Nigeria, as this correction indicates. With that report, MarketWatch managed to take a false rumor off the trading floor and into world commodities and financial markets.

And so it seems that oil traders' misperception of Niger as Nigeria gave oil prices a significant boost. To be fair, Nigeria has more than its share of political problems, as rebel groups sporadically attack its oil infrastructure in protest of what they see as unfair distribution of oil wealth on the part of the national government. A coup in Nigeria would make sense, which made the false belief that one had taken place there that much more believable. And of course the names of the two nations are quite similar, not to mention the fact the bulk of Nigeria's oil comes from the Niger Delta region of the country. So perhaps the misunderstanding stemmed from an honest mistake. But honest or not, the point is that one piece of misinformation led to a trend that had billions of dollars worth of ramifications throughout the world economy, not least of which was American consumers paying more for their heating oil and gasoline.

Faced with their stupid and costly mistake, errant oil traders would likely claim that it was actually other factors that drive up oil prices on February 18, as Reuters explained, "oil prices continued rising afterwards to within cents of $80 a barrel on Thursday, spurred by other factors such as tension over Iran's nuclear programme and a weaker dollar."

While that may be true, would prices have increased that much on that day without the Niger/Nigeria factor? It is literally impossible to say with any certainty, but reasonable analysis would say no. Perhaps if traders had double-checked their information before reacting, heating oil would have risen by just two cents instead of four on the following day. Those two extra cents, multiplied by millions of gallons delivered around the country, amount to heating oil users paying millions if not tens or hundreds of millions of dollars for oil traders' careless error.

Theoretically, oil markets only respond to two forces: supply and demand. However, as last month's events show, the reality is that the whimsical perceptions of oil traders can have just as much influence on oil prices as supply and demand. Keep that in mind next time you notice the price of gas go up a few cents.

Oil traders: for crying out loud, check your facts! Put up a map of Africa in your cubicle, if necessary. Your mistakes can be expensive for the rest of us, so please do us the favor of making sure your perceptions are based on truth before you start the next buying frenzy.