He'll cheat without scruple, who can without fear
    —Benjamin Franklin

Charles Dingell (U.S. House of Representatives, D, Mich), Michael Masters (Masters Capital Management), and Abdullah bin Abdul Aziz Al Saud (the King of Saudi Arabia) all agree on one thing: greedy speculators playing a rigged game are behind the steeply rising oil price. This rare, exquisite consensus is described in Gas could fall to $2 if Congress acts, analysts say.

Testifying to the House Energy and Commerce Committee, Michael Masters of Masters Capital Management said that the price of oil would quickly drop closer to its marginal cost of around $65 to $75 a barrel, about half the current $135.

Fadel Gheit of Oppenheimer & Co., Edward Krapels of Energy Security Analysis and Roger Diwan of PFC Energy Consultants agreed with Masters' assessment at a hearing on proposed legislation to limit speculation in futures markets.

Krapels said that it wouldn't even take 30 days to drive prices lower, as fund managers quickly liquidated their positions in futures markets.

"Record oil prices are inflated by speculation and not justified by market fundamentals," according to Gheit. "Based on supply and demand fundamentals, crude-oil prices should not be above $60 per barrel." [emphasis added]

I've refrained up to now on commenting on the "speculators" theory in so far as I mainly believe that it merely represents another form of denial about the alarming oil market fundamentals. But with Congress ready to act to further regulate futures trading on the NYMEX, it's time to look at the situation more closely.

It's Mostly About the Fundamentals

Let's get the obvious out of the way. First, I am a "peak oil" writer. There is ample data to support the proposition that no or slow growth in the oil supply has caused production to fall behind burgeoning subsidized demand growth outside the OECD (in China, Russia, India, the Middle East). The supply & demand imbalance has caused the oil price to rise steadily (with one exceptional period) since the beginning of 2003. This is my "bias" in this discussion—it's mostly about the fundamentals.

Much of the exponential price rise we've seen in 2008 is not due to the market fundamentals, however. While it's true that the supply & demand imbalance is has become decidedly worse in 2008 due to stagnant oil supply growth outside of OPEC, there are substantial feedbacks between the weak dollar and the price of a commodity that is traded in dollars (Black Friday, ASPO-USA, June 11, 2008). Moreover, a bullish herd mentality now influences oil traders. Paul Roberts, author of The End of Oil, called it the oil speculator premium (Los Angeles Times, December 10, 2007).

Oil is, in other words, an inherently volatile commodity, and thus highly attractive to traders, who profit by betting on the daily and even hourly fluctuations in price. And while there's nothing criminal about betting on price, it is a problem when the bets themselves influence the price. If enough traders gamble that oil prices will rise over, say, the next 30 days, then the price of 30-day oil futures contracts will rise, which will eventually pull up the current, or spot, price of oil -- the classic self-fulfilling prophecy. And because traders are always looking for anything that might warrant a price increase (and thus, the placing of a bet), the smallest events -- unrest in Nigeria, for example, or even upbeat economic news (which implies greater oil demand), become potential catalysts for a price rise.

None of this would be happening if the oil market weren't as tight as a drum. There's hardly any surplus supply capacity. High oil prices since 2003 have failed to stimulate supply. Few believe that new oil coming on-stream will alleviate the situation. So the oil market is mostly working the way markets are supposed to work—lots of investors are betting the price will continue to rise because that's what the fundamentals tell them.

Yes, some of this is a "self-fulfilling prophecy" because higher futures prices do push up spot prices. But how much of the oil price rise is due to the influx of speculative money betting on higher oil prices? This is where things get hairy.

What's Going On at the CFTC and the NYMEX?

The image in the public mind depicts hordes of evil speculators driving up oil prices by throwing scads of money into the buy side of the equation. Ronald Ripple, an economist Macquarie University in Sydney, recently made some comments on futures trading in the Oil & Gas Journal concerning the role of speculators myth (June 9, 2008, subscription required).

The open interest on [oil] futures contracts represents the number of contracts, and therefore the volumes of the underlying commodity, that are active and still constitute obligations on the part of buyers and sellers.

According to NYMEX, “The exchange’s core energy contracts ... stipulate physical delivery, although deliveries usually represent only a minuscule share of trading volume—less than 1% for energy—overall.” That a very small share of the traded volumes goes to delivery is not indicative of speculation. The majority of contracts (i.e., open interest) are held by commercial traders who are likely hedging the price risk they face on the physical units bought or sold in separate transactions... [graph left]

Commercial traders are those deemed to have an interest in actually acquiring the physical commodity, while noncommercial traders do not have such an interest. Historically, commercials have been associated with hedgers, while noncommercials have been associated with speculators.

Clearly, however, commercial traders have dominated, even in the recent past associated with the run-up in prices. For 2000-08, as much as 53% of the increase in long positions is attributable to commercial traders. So, more than half of the growth on the long side—the side typically associated with pushing prices higher—has been from commercial traders rather than noncommercials. [emphasis added]

According to Ripple, the bulk of the growth of "open interest" in NYMEX contracts results from hedging by commercial traders who are interested in acquiring physical oil, not non-commercial speculators buying and selling paper. It makes sense that commercial traders would want to hedge their bets as far as possible to mitigate risk in a highly volatile market driven by important but imperfect information about the shaky world oil situation.

Michael Masters and Michael Greenberger dispute Ripple's view. Greenberger is a professor of law at the University of Maryland and served "as the Director of the Division of Trading and Markets (T&M) at the Commodity Futures Trading Commission (CFTC) from September 1997 to September 1999." Greenberger testified before the Senate on June 3, 2008. Here's what he had to say about the distinction between commercial and non-commercial traders on the NYMEX. Futures trading is regulated by the CFTC. It's necessary to quote some passages from pp. 17-18 at some length.

Senator Lieberman‘s and other legislative conclusions about the adverse impact of speculation were doubtless driven by the testimony of Michael  W. Masters, Managing Member of Masters Capital Management, LLC, at the May 20 hearing. Mr. Masters showed that investment banks and hedge funds, for example, who were "hedging" their off exchange bets on energy prices on regulated exchanges were quite remarkably and inexplicably being treated by NYMEX, for example, and the CFTC as "commercial interests," rather than as the speculators they self evidently are. By lumping these investment banks and hedge funds with traditional commercial oil dealers, even U.S. fully regulated exchanges were not applying traditional speculation limits to the transactions engaged in by these speculative interests. Mr. Masters demonstrated beyond all doubt that a huge percentage of the trades in WTI futures, for example, were controlled by non-commercial interests. It is now clear that the CFTC in its pre-May 29 assurances had never before examined the positions of these "swaps dealers", because in that release it required these banks and hedge funds to report their trades to the CFTC and the CFTC committed "to review whether classification of these types of traders can be improved for regulatory and reporting purposes"...

Indeed, Senator Bingaman, Chairman of the Senate Energy Committee and Natural Resources Committee in a May 27, 2008 letter to Acting Chairman Lukken [of the CFCT], stated: "[I] remain concerned that the Commission‘s assertions to date—discounting the potential role of speculation in driving up oil prices—have been based on a glaringly incomplete set of data." Senator Bingaman referenced not only the likelihood of the CFTC not having adequate data on foreign boards of trade who do business in the U.S. or the over-the-counter unregulated futures markets, but the CFTC‘s sanctioned practice of "classify[ing] so-called  'swaps dealers'—including large investment banks [--] as 'commercial' market participants, alongside physical hedgers such as oil companies and airlines, rather than as non-commercial participants," the latter of whom would be subject to speculation limits. In other words, Senator Bingaman realized that when Messrs. Lukken and Harris [of the CFCT] had been assuring the Senate Energy and Natural Resources Committee that speculators played no role is the oil prices run up, they were not counting certain investment banks and hedge funds, for example, as speculators! [emphasis added]

The CFTC thus counts investment banks and hedge funds as "commercial interests," not speculators, so Ripple's data (graph above) is misleading. This regulatory debacle is further complicated by unregulated trading on the NYMEX in foreign exchanges, e.g. the London-Dubai Loophole or other unregulated exchanges like The ICE. We can therefore conclude that huge amounts of speculative money has flooded into the NYMEX as the "big money boys" bet that the oil price will rise and help it along as they do so.

The Heart of the Speculators Question

The heart of the speculators question concerns whether this huge influx of non-commercial money (liquidity) in the oil market has distorted the price beyond all reasonable recognition, or whether the influx of capital is the signature of a healthy market predicting higher prices based on the fundamentals, and thus driving up those prices.

The answer can not be black or white, for as Greenberger notes, "even U.S. fully regulated exchanges [NYMEX] [are] not applying traditional speculation limits to the transactions engaged in by these speculative interests." I'm not sure what "traditional speculation limits" are, but if NYMEX futures transactions are not being regulated as they normally would be according to historical precedent, then we have a problem that has to be fixed.

On the other hand, the worsening market supply & demand fundamentals are crystal clear to anyone who has looked at the data. It is inconceivable that 50% of the oil price is due to speculation as Masters claims. Here's what Scott Nations of Fortress Trading had to say in the CNBC video below.

The [oil] price is what the price is... And it seems to me that the first part of a cure is to understand that you have a problem. If this is the discussion that we're having [about speculators], then the stock market is not even ready to admit that oil is a problem right now.

[Click on the picture to watch the video. CNBC's Rick Santelli notes that when the "front month" contract expires, there is no large sell-off of speculative paper contracts. He regards this as strong evidence that speculation is not driving the oil price.]

I incline to Scott Nations' view. Analysts who say speculation alone is responsible for 50% of the oil price, implying that the oil market fundamentals are sound, are a bit like alcoholics who need to join a 12-Steps program. So, Michael Masters, repeat after me:

Step 1. We admitted we were powerless over oil; that our lives had become unmanageable.

Onions, Oil and Stable Markets

The House of Representatives has "directed the CFTC to use all its authority, including the agency's emergency powers, to 'curb immediately' the role of excessive speculation in energy futures markets." The legislation passed by a vote of 402 to 19. A number of new bills are in the works which would create barriers to entry in the U.S. oil exchanges.

Fixes in the works on Capitol Hill range from new constraints on speculators — including a 50 percent margin requirement on financial speculators, full disclosure of all trading by investment banks in all markets, and prohibiting investment banks from holding energy assets — to a bigger role for the Commodity Futures Trading Commission.

It is clear that more regulation is required, but care must be taken to insure that over-regulation does not distort markets in a different way.

What can onions teach us about oil prices? Fortune Magazine notes that "the bulbous root is the only commodity for which futures trading is banned." And what has been the result? Huge volatility, much greater than that seen in the daily oil price fluctuations. The wild price swings (graph above left, cwt abbreviates hundredweight) "have reinforced academics' belief that futures trading diminishes extreme price swings." See the Economics of Oil Futures Trading for a discussion of how a well-functioning futures market smoothes price changes and creates accurate price signals, at least in theory.

No proposal now on the table will actually abolish the oil futures market in the U.S, but Congress may do more damage than they know by severely curtailing futures transactions on the NYMEX. Tremendous price swings in a commodity like oil as seen for onions would make future planning impossible for all those with a vested interest in the commodity, which is everybody. The mixed signals would confuse the supply & demand further, thus making reasonable demand responses to high (low) prices impossible.

What Changed in 2008?

For what it's worth, here's what I think happened in the oil markets this year: the long-term expectations about the future oil supply affecting the market balance going forward became more pessimistic.

Look at the EIA's forecasts for their high price case over the last 5 years (graph left, courtesy of George Asebius). World oil production now goes down in the high price case due to decreased demand. As Asebius pointed out to me, the EIA now regards its high price scenario as the most likely outcome. "Given current market conditions, it appears that world oil prices are on a path that more closely resembles the projection in the high price case than in the reference case." The International Energy Agency (IEA) has put out similar views over the last few years.

As "official" forecasts come more into line with "peak oil" views, the expectations of oil traders have changed to reflect the new reality. Naturally, non-commercial speculators want a part of the action. The oil market is mostly healthy even if it requires more regulation to prevent overheating at the moment. On this view, changing market fundamentals drive the increase in speculative investments. They're not called fundamentals for nothing.

I believe¹ the effects of the weak dollar and the "speculator premium" account for about 20% of the current NYMEX price. A price "tumble" down to $110-$115/barrel would not surprise me at all. Oil prices have dropped almost $10/barrel in the last two days. I believe that prices in this range are nearer to what the fundamentals dictate at this time. The oil price could stay at this relatively "low" level for a short while before resuming its inevitable rise. But a price slide to $60-$75/barrel is impossible because continuing tightness in the market precludes it. The soaring demand for middle distillates combined with the relative scarcity of light sweet crude oil does not permit such a market "correction."

Finally, oil could never drop to $60-$75/barrel because OPEC would cut production sharply to defend a floor price well above this level at $100/barrel or more, especially in light of the weak dollar. This would happen so fast that it would make your head spin, Mr. Dingell. Tell that to your Michigan constituents.

If you think speculators are responsible for 50% of the oil price rise over the last 3 years, nothing I could say will persuade you otherwise. I believe future events will bear out the view that an irreversible historical shift has occurred in the oil markets. If the NYMEX and other exchanges require further regulation, these actions should be carried out immediately so the world has a clearer picture of what's actually going on. Once that has been done, the "speculators" craze of 2008 will wither away as all insignificant twists and turns eventually do. Much of this talk just distracts us from the important energy tasks at hand.

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Notes

1. Look at chart of the monthly average price for WTI crude.

I've added two rough curve fits. Do you believe the red line? Or do you believe the gray line? I believe the longer term trend is more reliable than the steep run up. So, I think the "fundamentals" price is about $110-$115/barrel, above where the gray line points due to changing expectations about the future oil supply. Do I know that I'm right? Not at all. Is anybody? No.