Are Speculators to Blame for Soaring Oil Prices?

Oil prices have leapt off their lows in the face of a recession, and as is human nature, we want to know why. After trading in the low $40s in mid February, Crude Oil is now trading up over $60 per barrel -- a 50% increase in a little more than 3 months and a 70% rise since January.

Crude oil trading is not for the weak-hearted: a chart might look more like your Uncle Vinny's EKG after after a big meatball parm than anything you'd otherwise recognize as a commodity chart. In other words, the price is volatile -- it's all over the place.

But in the face of a recession or depression, the world is wondering how this rise happened -- and how did it happen so quickly?

To answer this question, last week KCRW's Warren Olney invited Kevin G. Hall to the Reporter's Notebook section of Olney's show To The Point. Hall is the National Economics Correspondent at McClatchy Newspapers and is a frequent guest on To The Point.

When a question came up about higher crude oil and gasoline prices, Hall gave what most journalists give -- the line or two on how greedy speculators drive prices up on "us Americans." But there was a twist: the culprit now, according to Hall, is the passive commodity indexer. In order to include inflation-hedging commodities within one's asset allocation, investors have turned to investing in commodity indices, which are like the S&P 500 but for commodities. These indices buy commodities only, and, Hall concludes incorrectly, drive up the price.

In his original article, Hall quotes Michael Masters -- an EQUITY hedge fund manager who does not trade commodities. Masters testified before Congress on the role of speculators in the commodity markets. Most of his testimony before has been refuted and he himself admitted that his "math was way off."

In his testimony, Masters included pensions and endowments in the group he calls "speculators." Fair enough -- in the commodity space, you only have hedgers, who try to offset risk, and speculators, who are profit seekers. You could also say that these pensions are "hedging" against inflation. His implication that they should be banned, however, was, frankly, Un-American.

Commodity indices can be very beneficial to investors of all sizes. These indices come with a built-in allocation of commodities. It's not just crude oil, but also Metals -- such as gold and silver, and Grains -- such as corn and soybeans -- a basket of commodities. Second, they are a "one-stop shopping experience." An investor can get a broad array of commodities in one investment, just like an investment in the S&P 500 index, for example.

But what really irked Hall was the fact that the firms offering the index products, Goldman Sachs and Morgan Stanley for example, have received TARP bailout money. The implication being that not only are the taxpayers underwriting "the impending bubble," they are going to pay more at the pump too, because "these unregulated banks" use all the crude oil trading vehicles for their own selfish means. As far as I know, caveat emptor is omnipresent. The "speculator," if that's what you call CalPERs et. al., has the right to "not participate," one of the most powerful tools in the speculator's toolbox.

Speculators don't always win. Oil did crash from $140 to today's level of $60 -- a 60% drop which was even greater in January. Maybe the speculators drove down the prices by selling crude oil short, therefore benefiting consumers. Such trades occur when speculators feel that prices are too high -- they sell commodity futures at higher prices and buy them back cheaper, pocketing the difference as profit.

It's true that the current environment in crude oil is very profitable for such dealers and oil storage facilities -- but that won't last forever.

The Wall Street firms such as Goldman Sachs and Morgan Stanley were force-fed the government financial aid, even if they didn't need it, so as to disguise who the really sick "patients" were. Goldman Sachs and Morgan Stanley have been involved with commodity indices and Index Speculators well before TARP was legislated.

Speculators can be to blame for price volatility in the short term -- and by that I mean intra-day. But not for days and weeks. Speculators do not cause trends in commodity prices. You don't always have or need a speculator involved in a commodity trade.

One of the dirty little secrets in the dirty business of crude oil is that sometimes Oil Producers, entities that typically sell commodity futures to hedge, actually buy commodity futures contracts. In doing so, they join the speculators and are not hedging. They can exact their production costs out of the market. This might be an area for regulation.

But regardless of the regulatory environment, oil prices are always based upon supply and demand. Passive index investors are part of the fundamental picture for crude oil. So the answer to "how did they get so high so fast?" is "The same way it collapsed from $140 per barrel" -- the forces of supply and demand.

Comments

[Michael Martin - Huffpost Blogger]

From The Economist: "The commodity market may also be a long-term headwind for the global economy. Supply constraints were part of the bullish argument for commodities earlier this decade. Because it takes years to find and then exploit new reserves, demand can outstrip supply for long periods."

http://www.economist.com/finance/displaystory.cfm?story_id=13788599

[Flightleader]

Also to Pfrogger, you said: “…..specul­ators drive up the price of oil for a few more million in their pocket, while that increase drives up the price of everything else and pushes people who were getting by into poverty.” Well, you clearly fail to understand that “speculation” in oil is not the sole driving force for price inflation. In fact, I would argue that it is a minor contributor at best. The primary causes of oil price inflation include the falling value of the US dollar (oil is traded on the US dollar), public policy decisions which limit and/or prohibit oil production and refining and public policy decisions which increase costs in a misguided attempt to achieve environmental purity. Speculators of course pay close attention to these factors and seek to capitalize on same and perhaps influence them. In essence “speculation” is more result of oil price inflation rather than a causal factor thereof. Now you may argue that such public policy decisions are well intended and with few exceptions I cannot disagree. But we have to focus on the incentives and/or disincentives rather than intentions.

[Flightleader]

I’ve finally gotten up to speed on this loooooong thread. “War and Peace” seems a lot shorter now.
Of all the comments so far pfrogger wins the prize for prompting me to respond. You said: “one side thinks the free market is wonderful and that it helps everyone. the other side sees the damage an unregulated market by the free market people can do.” You are only partly correct here. The “free enterprise” school postulates that the liberal (“free”) market system is utilitarian in that it ensures the greatest good to the greatest number. I have no desire to see a world devoid of rules. I prefer however that those rules be structured so as to guard against and punish force and fraud. You prefer a system (socialism) which attempts to erase loss and erase or limit profit. The market system is not a profit system; it is a profit and loss system. Profits encourage investment while losses encourage prudence. Any attempt to alleviate these parts of the machine destroys the machine. A vehicle can move forward without an engine or fuel but it moves far more efficiently with them.
I believe in the market not because I believe people are naturally good; rather because they are naturally self-interested. We would all like to live in a perfect world but the socialist assumes a priori that such an ideal is within the ability of man to create.

[Michael Martin - Huffpost Blogger]

Just did a podcast interview with trader and teacher Linda Bradford Raschke. She added her insight on the role of speculators over the years. Linda is one of the best traders ever.

If you're into podcasts, you can hear it at http://martinkronicle.com/2009/06/02/linda-bradford-raschke/.

[Chuck1234]

Speculators pushing prices up? This is silly. Everybody knows that speculation pushes prices down, at least that is what all the farmers around me say.

[DagTag]

PFrogger and all other enemies of the markets. You think we are selfish for defending free markets and speculators. Your attitudes and opinions are much more selfish than ours. It is the policies of socialism that send billions of dollars in foreign aid to Africa every year and keep corrupt warlords in power and children starving.

Free markets raise the standard of living for everyone. That is what America was built on....free­dom and the protection of inalienable rights from bullying, envious, angry mobs that would try to vote those rights away. Protection of the INDIVIDUAL­...whether he/she be rich, poor, black, white, male, female, young or old. Freedom is blind to all these things and all of our rights must be the same. Yes, some rise much higher but in America you never see children on the side of the road blind and begging. That is the product of socialism. It is immoral and wrong. Foreign aid, welfare, government programs sound good but they keep people enslaved and in destitution. They do more harm than good. Whether you choose to acknowledge it or not this philosophy is one of corruption and moral bankrupcy.

PFrogger, I am Indian and with regards to coming from a privileged background, my father is a businessma­n...ups and downs are the name of the game.

[Michael Covel]

For me to continue with this discussion please define to a dollar amount:

1. privileged background
2. rich
3. little guy

These are all terms put forward by PFrogger. Are there some hard and fast numbers to go with these terms? Or are we leaving 'em squishy and undefined? What is rich to a number and who defines it? Help me out PFrogger.

[JustAHumanOnEarth]

I don't play the blame game since it's done far to often these days. So I won't "blame" the eroding value of the US dollar for a rise in commodity prices during a time of low demand....­I'll just state it as fact.

As our currency debases, this will only get worse. Buckle up folks.

[Vishaal B]

I find it laughable that so many devote their time to blogging and even more to reading blogs. Most of the comments I have read on this page are absolute nonsense and have no bearing on a) reality b) sound economic / financial principles and c) empirical or statistical evidence..­.its just BS! Pithy comments to feel as if you have a relevant opinion. My comments are of course expempt from this analysis due to the fact that I am an amazing human being with unmatched charm and boyish good looks. The problem with the internet / blogs is that any Tom, Dick , Harry, or Mehindra can write with no real qualification or knowledge on the subject they are writing about. Particularly, I enjoy comments such as: "My brother's dog's nephew worked for ICAP"...or in regards to another blogger "What do your parents do?" or "My husband and son are both in the industry, and there is oil sitting in tankers, with them paying to store the stuff".

For one thing, if your husband and son are sitting on secret stockpiles of crude you must be the wealthiest woman on the planet and I would love to grab a few drinks with you and show just how charming I can be :).....(co­nt)

[Vishaal B]

In regards to the astute market observer whose brother works at ICAP- you truly are a genius and we are all much better off now that we have heard your opinions. In short, my political and economic views can be summed up with the words of Oscar Wilde: "“In matters of grave importance, style, not sincerity, is the vital thing.”

[frantaylor]

If you fill up your tank before it is empty because you see a good deal, then YOU TOO are a speculator, and YOU TOO are contributing to market imbalances with your speculative purchases.

You don't have to be a reseller to speculate. Large trucking companies speculate in diesel fuel ALL THE TIME. They get a big tank and fill it when a good deal comes along.

Speculation is a natural part of the free market.

[pfrogger]

that's great.

when the price of oil is $150 we'll see if you start talking the same tune.
for us regular people, ie. most of us, who it hurts, this is just plain wrong. there is no reason oil should be at 150. none.
it's a scam to make a few million for billionaires
http://www.cbsnews.com/stories/2009/01/08/60minutes/main4707770.shtml.

[frantaylor]

You can complain all day about water flowing downhill. What is your plan?

[pfrogger]

the two sides of this conversation are polar opposites. one side thinks the free market is wonderful and that it helps everyone. the other side sees the damage an unregulated market by the free market people can do.

free market benefits a few. most are hurt by it. no big deal for the rich, but those of us who are not rich see the damage a free market can do.

I'd rather share a buck with a fellow human being than make one at the expense of a fellow human being.
Speculators don't care about the average person, just themselves. It's not that they hate others, they just don't care if others live in poverty or they don't. It's irrelevant to them.
I can't stand by and see people hurting while the execs get a free ride for bad decisions or when speculators drive up the price of oil for a few more million in their pocket, while that increase drives up the price of everything else and pushes people who were getting by into poverty.
If helping the average person is socialism, then most religions and this country, founded on we the people is socialism.

[frantaylor]

Do you have an answer or are you just bellyaching?

Do you have some sort of proposal on how to price oil if you don't like how speculators can drive up the price?

Be careful what you wish for.

[Michael Covel]

"frantaylor" are you trying to tell me that the political suits in DC orchestrating a state economy won't do better than current system of speculation & free markets? :-)

[KYlawyer]

Let me just add a little story from the horse's mouth from someone not likely to be biased. My brother in law is an energy trader with ICAP. Last summer I asked him about what was going on with oil prices. He told me the investment banks were hedging like crazy to make a buck to stay alive and were driving up the prices, all speculation. He also told me not to worry, the bubble will burst and by next spring, crude prices and thus gas prices will back to $2 per gallon. He only missed the mark by 6 months, which I attribute to the investment banks falling apart and having to be rescued.

It may be only anecdotal, but it sure makes sense.

[LilaRajiva]

Hi -

I can't say I agree with either side here...
speculators are not the villains of the piece, but they're not the heroes of capitalism either.

Entrepreneurs who actually create something beside shuffle paper (ok, ok, provide liquidity, discover prices, whatever).­.

Speculators are hyenas...
part of the ecology, a worthy animal no doubt, but not a very pretty sight either.

In a free market ruled by law, investments would follow fundamentals and be more oriented to the long term and a closer match to real demand. However, in an artificial and socialized economy, where the price of money is kept artificially low and the value of money is cheapened, the drive to get a better return, and to move out of a devaluing asset (the dollar) becomes frenzied.

Add to that some other factors:

The proportion of the economy devoted to financial services is much greater, the extent of trading is global, electronic trading moves at greater speed, there's greater centralization, more market manipulati­on...

and no wonder volatility over the last 25 years has soared.

Short term horizons rule...

I think some regulation is in order...

But the real way to fix the problem is to stop debasing the currency.
The problem isn't speculation per se, IMHO. Speculation has always been around. It's the managed economy, which exacerbates the problem and makes the fall out much worse

[KillTheMessenger]

One essential piece is missing: the fundamentals. There are very clearly understood fundamentals in the realm of commons. And most of them indicate that the rapid growth of the world economy is going to overwhelm the supplies of these if we do not increase the efficiency with which we use them. Therefor we would be doing ourselves no favor by regulating speculation today and then going back to our old use patterns tomorrow. We need to do both, clean up our markets AND develop new ways on how we deal with commons.

[Michael Covel]

I liked Al Gore's film. It lays the case out that there is a problem. But at the end of the film, after he has clearly pointed out that the global population explosion is the culprit, he says we just need CA emissions control. Your comment reminds me of that. So unless population growth is slowed all the feel good stuff is just that...fee­l good. In that world, a world where there will NOT be a population slowdown I am glad that as an individual I still have the right to speculate and make money as I plan for the uncertain future.

[Michael Covel]

"Speculators are hyenas..."

If I walk into the market, me, just one guy, and I want to bet that crude oil futures will go down...a bet made where I hope to profit from a declining crude oil market...a­nd my bet works out...that seems admirable to me. Why is that a hyena action? Could not someone say, "interesting, what told you to make that bet, good move?"

If you consider that "shuffling paper" I can accept your opinion, but I just disagree strongly!

[pfrogger]

and we see that rampant speculation without regulation is a self serving goal. it does NOT help society. is that what America is? success and making a buck no matter the cost to society and the average person.
it's just gambling. that's all. and the average person suffers. it is not for the benefit of the whole, it is for the benefit of the very few. the whole we the people thing means for the benefit of the greater good. and no that's not socialism, because then America and every other democracy for the benfit of the whole is socialism.
a few greedy Aholes jack up the prices and our regulatory agencies are either bought by them or incompetent. is that right that I must suffer so you can succeed? that's plutocracy, and this is a democracy.

[DagTag]

Woah....yo­u are making some really sweeping statements there. The root cause of the credit crisis was caused by 1% interest rates (a debased currency), subprime loans and the Comm. Reinvestment Act and real estate tax shelters and the mandatory laws that say a security has to be rated by a rating agency, which created natural monopolies (monopolies put into place by government mandate, license, special treatment etc)

What will exacerbate the crisis will be the bankrupting of the social security system as 1/3 the population retires, the bankrupting of the healthcare industry and China collateralizing all of their US debt with all of our assets.

Rome fell because; high taxation, high inflation and treasury that has become a free for all.

[DagTag]

I wrote a little song-

Hyyyppeerr­rinflation­!!! Oh how I can't wait for hyperinflation. How I long for a day when an apple costs $1000 and money is free!!!! Hyyyyyyyyp­pppppeerri­nflation!!­!!!!!!!!!!­!!!!!!!!!!­!!!!!!!! What a beautiful thing! Money really does go on treeeeessss!!! Loooootss of money for you!!!!! Lots of money for meeeeeee!!!!!!!!

JOIN IN EVERYONE!!!!

[pfrogger]

you know I don't get you.
you seem intelligent and well versed, but you're still rationalizing your perspective.

your sources are heavily biased, and your perspective is completely skewed.
a few questions: are you loaded? do you come from a wealthy family? what do your parents do?
have you had a privileged upbringing?

I apologize if this is too personal, but the answers would help me understand why someone like you is like this. and please tell me you're not Indian.

[Michael Covel]

I think the debate is healthy, but I am not sure how anyone's ethnicity helps you to understand anything. If she said "white" what you say? "Black", etc.?

[KYlawyer]

Perhaps you could give some empirical evidence to support your assertions. Oh that's right the Austrian believers don't have any. Just the logical axiom that it'll happen.

[DagTag]

Do you know that healthcare added $1100 to $1500 to the cost of every car. Do you know how slim the margins on car sales are?

There was definitely some speculation but it doesnt drive up the price to $150 a barrel. Oil grew with shipping and worldwide growth. Are you telling me that speculators drove up the entire world? Well, maybe they did....the­y speculated on the fact that all the dollars that were being printed by the Federal Reserve we being backed by the full faith and credit of the now bancrupt United States of America.

Now forcing the companies to 'go green' is going to save them and the country. What sort of logic is this? Its intellectually dishonest and I think you all know that. Green innovations come from prosperity. And prosperity comes from the vibrant, American market. Name one thing that government has ever done to make this country prosperous. Every industry that is heavily regulated or tampered by the government (airlines, auto companies, utilities) are inefficient and go bust. Lets all go ban short selling...­great. Do you have any idea what an important purpose short selling has for the markets?

if a person/government spends more than they consume they will get into debt. And if they have too much debt and cannot pay it back they default. Its not rocket science. Its common sense.

Is this the first time people are actually challenging your emotion and envy-driven worldview?

[KillTheMessenger]

"Do you know how slim the margins on car sales are? "

They are only as slim as the car companies want to make them. Of course, if your only sales argument for your product is "But mine is $1500 cheaper!", you can never hope to be profitable.

As for the rest of your writing... yawn.

[TXfemmom]

Give me a break, we saw speculators drive up the price of oil and other commodities for over two years until the economic meltdown, which could well have been deepened by the huge increase in commodities, saw them cave.

Goldman Sachs, Barclays, and J. P. Morgan and Sovereign Funds are behind this increase in prices of oil. There is such a glut of oil in storage now that if oil continues to be pumped at current levels, then the ability to store the excess will be exhausted in just sixty days. THINK ABOUT THAT. All storage, other than our storage for security reasons, WILL BE EXHAUSTED WORLD WIDE.

My husband and son are both in the industry, and there is oil sitting in tankers, with them paying to store the stuff, as well as in oil tanks around the world and all of it is VIRTUALLY FULL. Then, the prices go up? THIS IS SPECULATION AND UNWARRANTED.

The government needs to make IMMEDIATE CHANGES in the commodities market to make it regulated AND TRANSPARENT, so manipulation can be eliminated to some degree.

[Michael Covel]

"Give me a break, we saw speculators drive up the price of oil and other commodities for over two years until the economic meltdown, which could well have been deepened by the huge increase in commodities, saw them cave."

To me it seems the real estate/oil bubbles were a lot like the dot com bubble. Everyone had to get on board before the train left the station and left you behind. We all bought houses because if we did not buy now the prices were never coming down. Same reason Granny blew her life savings on pets.com. So it wasn't just "speculators" who pushed oil up...every­one thought oil was going up and never coming back down. But it did drop and drop hard. That's a good thing. People over shot. It corrected. Markets go up from EVERYONE betting not just one group. So if there is blame to pass around for the oil, stock and real estate bubbles now pierced ... we all need to look in the mirror and stop blaming the boogey men hiding behind the tree.

[pfrogger]

that's the worst rationalization I have ever heard. you want to make money of others' misery. fine, but say so. capitalism in a democracy is supposed to encourage competition for the best and cheapest product for the average person. it's not supposed to make a few people rich while others suffer.
and not everyone thought oil was going up and never coming back down. back in the real world we were all wondering what the h.e.ll was going on. and we found out that speculators were inflating the price to make a buck. well that's great except the average American was hurt by that. but who cares about the average American? they had to get paid, and if you have to hurt people to do so, so be it.

[DesertDogAlpha]

We know exactly how to get oil prices down - have a depression. We saw that occur last year when crude went down $1 per day for abotu 90 days. Now we may be slowly recovering from the extreme recession and demand will inevitably pick up if that is the case. So prices are rising in anticipation.

Also, commodities look like a pretty good investment bet when compared to shares in companies in markets that the Obama administration can't seem to help from meddling with. Plus, the more Obama and his team promise to drive markets to "alternative energy" and "green jobs" the better off Exxon will be - just take a look at the ethanol fiasco and Exxon's results. The ethanol companies have gone bankrupt and Exxon is the healthiest company in the world.

Finally, the promise of exhorbitant US government deficits, way more than we have ever previously experienced even under the drunker sailor spending of the W administration, will surely (1) be inflationary, and (2) drive the price of the dollar down. Oil is sold in dollars and dollars only on a global basis so the price in dollars will go up much faster than the price in yen or euros or yuan, just as last year.

The law of unintended consequences, which is the only law that Washington can effectively put into play. This will all seem unfair to those who hate the existence of markets. HuffPost will be full of blue commentary as a result.