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.