NEW YORK CITY -- What did it mean when oil prices today spiked by their largest amount in history, $16 in one day? It means something is seriously wrong with the oil price market. Analysts had no obvious explanation for the rise other than to say that it may have had something to do with the October contract expiring. But a price spike of this magnitude -- oil prices have now traveled from lows in the $90s last week to $130 today -- is alarming. And oil price volatility of this magnitude in the absence of any magic changes in supply or demand is frankly unacceptable over the long term for a commodity on which so much of our economy depends.
A hint into the source of this volatility was provided at the U.S. Senate's recent summit on energy. The fireworks commenced when Senators Bill Nelson of Florida and Maria Cantwell of Washington asked Goldman Sachs' COO, Gary Cohn, about the need to reign in speculation in the oil markets. The Senators cited a recent study by Michael Masters, manager of a hedge fund and a trader himself, blaming volatility on speculation on indices.
Northwestern CEO Doug Steeland echoed his belief that speculation was responsible for the bulk of volatility in the price of oil. Cohn answered that Goldman's position was that market prices were set by supply and demand and, in support, he cited a recent CFTC, trade by trade analysis, that showed no outright market manipulation.
However, Cohn also noted that in setting up the index market, Goldman and others' goal was to create a buy side among pension funds and other long term investors for oil futures to balance the supply side of oil producers seeking money for exploration. And, indeed, pension and others have become large players in the index market as energy futures have become another investment "class."
Today's volatility showed signs of institutions or traders shifting large blocks of money into an asset class to balance chaos in other markets. This is not outright market manipulation. But the emergence of oil futures indices as an asset play for huge non-energy investors, chasing yield, may be responsible for the unacceptable volatility in these markets.
Congress and the CFTC should be examining whether this is the case and, if so, devise measures to reduce the the exposure of this nation-critical market to large shifts in money and what hedge fund traders like to call, cross market correlation.
This was cross-posted at the NDN blog.