In Praise of Oil Speculation

BusinessWeek Economics Editor Peter Coy responds to columnist Ed Wallace and his attack on oil traders

The energy options pit on the floor of the New York Mercantile Exchange in New York City. Spencer Platt/Getty Images

by Peter Coy

Dear Ed,

You've written some great columns for BusinessWeek.com about oil prices and speculation (BusinessWeek.com, 6/27/08), and you've gotten barrels of positive reaction from readers—one recent example: "Ed Wallace is my hero." I buy gasoline, too, so I sympathize with your impulse to get to the bottom of why we're suddenly paying over $4 a gallon. I even agree with you that speculation is probably playing a role in driving up prices, and we need smart regulation of the energy markets.

But I can't work up much passion for blaming speculators and manipulators for the predicament we're in. My faith in human nature, especially when it comes to energy traders, is shallow. However, my faith in the power of financial gravity is bottomless. If speculators and manipulators have somehow managed to get prices too high, then those prices will come back to earth as surely as apples fall from trees and meteors land in Arizona. The price decline will inflict billions of dollars of losses on those speculators and manipulators—just deserts.
On the other hand, if by some chance the speculators and manipulators are correct—that oil prices could go even higher, based on supply and demand—then they will have done all of us a favor by ringing the alarm bell. High prices today are inciting suppliers to produce more oil and consumers to use less, which will ease the transition to a future of costly energy.

On July 1, the International Energy Agency in Paris predicted that by 2015, the developing countries will equal the mature economies in their oil consumption. Nobuo Tanaka, the IEA's executive director, dismissed speculation talk as a distraction: "OPEC production is at record highs, and non-OPEC producers are working at full throttle, but stocks show no unusual build," he said, according to a press release. "These factors demonstrate that it is mainly fundamentals pushing up the price."

Either way, then, it's hard to see what the big problem is. Either the traders are wrong and they are setting themselves up to lose a lot of money, or they're right, they'll make money, and they're sending the proper market signals to the economy.

Financial Gravity and Smart Regulation

Here's why I believe in financial gravity: If the price is too high, you might not know it right away because supply and demand don't react quickly in the short run. But they surely do react in the long run. Oil fields that were once too costly to explore suddenly become economical. Drivers switch from Tahoes to Civics. The natural supply of oil starts to exceed the demand. At that point, the only way to keep the price from falling is to buy oil on the open market and put it in storage. But that gets expensive, and there are only so many places you can store oil. After you've filled up every last tanker, teacup, and cowboy boot, the price must fall. Absolutely must.

Granted, the cleverest speculators and manipulators just might manage to sell before the crash and get away with a fortune, inflicting the loss on others who are just as greedy but not as bright. There's also a risk that a big, underregulated trader could go bust on bad bets and cause collateral damage, as the hedge fund Amaranth Advisors did when it blew up in 2006.

That's why I agree with you that we need smart regulation of energy markets. But unlike you, I'm optimistic about the changes in the works. You've been highly critical of Atlanta's IntercontinentalExchange (ICE), whose London unit trades an oil futures contract that's linked to the settlement price of the West Texas Intermediate contract of the New York Mercantile Exchange. You've quoted congressmen who described ICE as "dark" and "unregulated."

First, I don't rely on members of Congress to tell me who's underregulated. Second, U.S. regulators have (belatedly) put some heat on ICE. On June 17, ICE announced it would comply with Commodity Futures Trading Commission rules for reporting on large traders and capping the size of trades. I spoke with ICE's biggest competitor, Nymex (NMX), about this on July 2. Tom LaSala, Nymex's chief regulatory officer, said he was satisfied with what ICE agreed to.

The Diesel Factor and Murky Oil Data

Here's my nominee for least-appreciated factor in the runup in oil prices: diesel. You've also noticed in your columns that diesel prices have risen even more than gasoline prices. I draw a different conclusion from that. I take it as strong evidence that diesel is pulling the entire market upward. I even wrote an article (BusinessWeek.com, 5/29/08) about it. The idea in a nutshell is that diesel is scarce because of tighter sulfur standards, strong demand from China, and a steady move to diesel vehicles in Europe. Refineries can make so much money on diesel at these prices that they're competing for oil to refine into it, driving up the crude. The gasoline they get from the crude is just incidental. (By the way, that also explains why there's plenty of gasoline around.)

Now, unlike some doctrinaire believers in market efficiency, I'm perfectly happy to stipulate that speculation is responsible for big day-to-day movements in oil and gasoline prices. But who cares? That's how markets work. People bet whether oil prices should be higher or lower based on their best assessment of all the latest data, which is almost always incomplete and contradictory. (Here's a story I wrote about the murkiness of oil data (BusinessWeek.com, 5/13/08). For every piece of data you produce showing that supply seems to be exceeding demand, I could come up with a matching one for why people worry that demand will exceed supply. (I get scared just thinking about millions of Chinese and Indians buying econo-cars like the Chery QQ or Tata Nano for a few thousand bucks.)

Probably the only way to eliminate speculation from the oil market entirely would be to have the White House dictate prices. That didn't work well at all when Richard Nixon tried it.

Ed, over to you.

Coy is BusinessWeek's Economics editor.

--------------------------------------------------------------------------------------------------------

Points that stand out in this argument:


 - ....my faith in the power of financial gravity is bottomless. If speculators and manipulators have somehow managed to get prices too high, then those prices will come back to earth as surely as apples fall from trees....
 - Either the traders are wrong and they are setting themselves up to lose a lot of money, or they're right, they'll make money, and they're sending the proper market signals to the economy.
 - Granted, the cleverest speculators and manipulators just might manage to sell before the crash and get away with a fortune, inflicting the loss on others who are just as greedy but not as bright.

Rising prices? Blame it on China

WASHINGTON: Tired of high gasoline prices and rising foods costs? Well, here’s a solution. Let’s shoot the speculators.

A chorus of politicians, including John McCain and Barack Obama, blames these financial slimeballs for piling into commodities markets and pushing prices to artificial and unconscionable levels.

Gosh, if only it were that simple. Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don’t understand what’s happening or don’t want to acknowledge their own complicity.

Granted, raw material prices have exploded across the board. From 2002 to 2007, oil rose 177%, corn 70%, copper 360% and aluminum 95%. But that’s just the point. Did speculators really cause all those increases? If so, why did some prices go up more than others? And what about steel?

It rose 117%, and has increased further in 2008, even though it isn’t traded on commodities futures markets . A better explanation is basic supply and demand. Despite the US slowdown, the world economy has boomed. Since 2002, annual growth has averaged 4.6%, the highest sustained rate since the 1960s, says economist Michael Mussa of the Peterson Institute.

By their nature, raw materials (food, energy, minerals) sustain the broader economy. They’re not just frills. When unexpectedly high demand strains existing production, prices rise sharply as buyers scramble for scarce supplies. That’s what happened. “No one foresaw that China would grow at a 10% annual rate for over a decade. Commodity producers just didn’t invest enough,” says analyst Joel Crane of Deutsche Bank.

In industry after industry, global buying has bumped up against production limits. In 1999, surplus world oil capacity totalled 5 million barrels a day (mbd) on global consumption of 76 mbd, reckons the US Energy Information Administration.

Now, the surplus is about 2 mbd, and much of that is high-sulphur oil not prized by refiners, on consumption of 86 mbd. Or take non-ferrous metals, such as copper and aluminum. “You had a long period of underinvestment in these industries,” says economist John Mothersole of Global Insight.

For some metals, the collapse of the Soviet Union threw added production, previously destined for tanks, planes and ships, onto world markets. Prices plunged as surpluses grew. But Mothersole says “the accelerating growth in India and China eliminated the overhang.”

China now accounts for up to 80% of the world’s annual increased use of some metals. Commodity price increases vary, because markets vary. Rice isn’t zinc. No surprise. But speculators played little role in these price run-ups.

Who are these offensive souls? Well, they often don’t fit the stereotype of sleazy high rollers: Many manage pension funds or university and foundation endowments. Their trading might drive up prices if they were investing in stocks or real estate . But commodity investing is different.

Investors generally don’t buy the physical goods, whether oil or corn. Instead, they trade futures contracts, which are bets on future prices in, say, six months. For every trader betting on higher prices, another is betting on lower prices. These trades are matched.

In the stock market, all investors (buyers and sellers) can profit in a rising market, and all can lose in a falling market. In futures markets, one trader’s gain is another’s loss. Futures contracts enable commercial consumers and producers of commodities to hedge.

Airlines can lock in fuel prices by buying oil futures; farmers can lock in selling prices for their grain by selling grain futures. The markets work because numerous financial players, speculators in it for the money, can take the other side of hedgers’ trades. But the frantic trading doesn’t directly affect the physical supplies of raw materials.

In theory, high futures prices might reduce physical supplies by inspiring hoarding. But that’s not happening now. Inventories are modest. World wheat stocks, compared with consumption, are near historic lows. Recently, giant mining company Rio Tinto disclosed an average 85% price increase in iron ore for its Chinese customers.

That affirmed that physical supply and demand, not financial shenanigans, is setting prices: Iron ore isn’t traded on futures markets. The crucial question is whether these price increases will continue or ease as demand abates and investments in new capacity expand supply.

Prices for some commodities (lead, nickel) have receded. Could oil be next? Politicians promise to tighten regulation of futures markets, but futures markets aren’t the main problem. Scarcities are. Government subsidies for corn-based ethanol have increased food prices by diverting more grain into biofuels.

A third of this year’s US corn crop could go to ethanol. Restrictions on oil drilling in the United States have reduced global production and put upward pressure on prices. If politicians wish to point fingers of blame, they should start with themselves.

2 Jul, 2008, 0621 hrs IST,Robert J Samuelson
(c) 2008, The Washington Post Writers Group

Article Link

Oil Price: RECOIL

Painful though it is, this oil shock will eventually spur huge change. Beware the hunt for scapegoats

IN THE early 1970s a fourfold rise in the price of oil almost brought the world to a standstill. The shock of the Arab embargo left a deep mark in many countries: America subjected its cars to fuel-efficiency standards, France embraced nuclear power—though sadly shoene rukku, or “energy-conscious fashion”, the inspiration for Japan's fetching short-sleeved business suit, was ahead of its time.

Thirty-five years on, oil prices have quadrupled again, briefly soaring to a peak of just over $135 a barrel. But, so far, this has been a slow-motion oil shock. If the Arab oil-weapon felt like a hammer-blow, this time stagnant oil output and growing emerging-market demand have squeezed the oil market like a vice. For almost five years a growing world shrugged it off. Only now is it recoiling in pain.

This week French fishermen clogged up the port of Dunkirk and British lorry-drivers choked roads into London and Cardiff. Nicolas Sarkozy, France's president, suggested subsidising the worst affected and curbing taxes on petrol; Britain's beleaguered government is being pressed to forgo its tax increases on motorists. In America falling house prices have left consumers resentful—and short of money. Congress and presidential candidates have been drafting schemes and gas-tax holidays like so many campaign leaflets.

Gordon Brown, Britain's prime minister, thinks the big oil producers can be persuaded to come to the rescue. But only Saudi Arabia shows any enthusiasm for that. Elsewhere, output is growing agonisingly slowly. That is causing hardship and recrimination. But it could also come to represent an opportunity. The slow-motion shock seems irresistible today, but in time it will give rise to an equally unstoppable and more positive slow-motion reaction (see article).

Action replay

It is clear that high oil prices are hurting many economies—especially in the rich world. Goldman Sachs reckons consumers are handing over $1.8 trillion a year to oil producers. The wage-price spiral of the 1970s has been avoided, but the income shock is painful. Beset by scarce credit, falling asset prices and costly food, developed-country households are hardly well-equipped to foot the oil bill. America's emergency tax rebate, voted this year to help people cope with the credit crunch, has in effect been taken right away again.

Stuck for answers, politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people's hardship. Some $260 billion is invested in commodity funds, 20 times the level of 2003. Surely all that hot money has supercharged the demand for oil? But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.

If the speculators are not to blame, what about the oil companies, which have failed to increase output in spite of record profits? Profiteering, say some. However, that accusation doesn't stand up to much scrutiny either. The oil price is set in a market. For Shell, Exxon et al to hoard oil underground would be to leave billions of dollars of investment languishing unused. Others fear that oil is pricey because it is running out. But there is little evidence to support the doctrine of “peak oil” in its extreme form. The Middle East still seems to contain a sea of the stuff. Even if new finds elsewhere have been rarer and less accessible than in the past, vast quantities of oil could now be profitably stripped from tar sands and shale.

The truth is more prosaic. Finding and developing new oil fields is an expensive and time-consuming business. The giant new fields in the deep water off Brazil are unlikely to produce oil for a decade or more. Furthermore, oil is perverse. When prices are low, oil-rich countries welcome the low-cost, high-tech and well-capitalised oil firms. When prices are high, countries like Russia and Venezuela kick them out again. Likewise the engineers, survey ships and seismic rigs that oil firms need to find and produce new deposits are expensive right now. The costs of finding oil have, temporarily, doubled precisely because everybody wants to give them work.

Hope at the bottom of the barrel

So the oil shock will take time to abate. Some greens may welcome that, seeing three-figure oil as a way of limiting greenhouse emissions. Conservation will indeed increase. But everything high prices achieve could be done better by sensible carbon taxes. As well as curbing oil use, high prices have put tar sands in business which create far more carbon dioxide than conventional oil. Profits are going to ugly oil-fed regimes, not Western exchequers. And the wild unpredictability of prices will blunt the effect of dear oil on people's behaviour.

From this perspective, governments should speed up the adjustment—or at least stop delaying it. Half the world's people are sheltered from fuel prices by subsidies—which, perversely, have boosted demand and mostly benefited the better off. Now countries like Indonesia, Taiwan and Sri Lanka have begun to realise that they can ill afford this. Cutting fuel taxes in the rich world makes no sense either (see article). There are better ways to return cash to struggling voters.

The 1970s showed how demand and supply, inelastic in the short run, eventually give rise to conservation and new production. When all those new fields are on-stream, when the SUVs have been sold and the boilers replaced, the downcycle will take hold. By then the slow-motion oil shock could have catalysed momentous change. Right now motorists have no substitute for oil. But it is no coincidence that car companies are suddenly accelerating their plans to sell electric hybrids that are far cheaper to run than petrol or diesel cars at these prices. The first two oil shocks banished oil from power generation. How fitting if the third finished the job and began to free transport from oil's century-long monopoly.

Article Link

High oil prices should be passed on to consumers

The best argument for using market driven rates is the utter disrespect that Indian consumers have in splurging on oil in the past few years in spite of raising oil prices around the world. Car and bike sales have increased tremendously for the consumers are not feeling the pinch of the oil price. We hear news of US consumers switching to compact cars, dumping SUVs and hitching to public transport. If the rise in oil prices were passed onto the consumers in India, I'm sure there would have been more care taken in spending less. It could also have had some lessening effect on the auto pollution in our metros. So continuing with the current oil policy is not just a matter of fiscal issue but also physical!

--Vj

-----------------------------------------------------------

3 May, 2008, 0301 hrs IST,Cuckoo Paul, TNN

For a government which is preoccupied with tackling inflation, OPEC president Chakib Khelil’s observation couldn’t have come at a worse time. The OPEC president, in a recent statement, warned that crude oil could hit $200/bbl with the dollar losing its lustre. That too when oil prices have already climbed 100% to top the $120 a barrel mark over the last one year. With alternative sources of energy becoming a rage, land is being sacrificed for bio-fuels, pushing food prices to new highs.

For a country which is critically dependant on overseas sources for its energy needs and whose appetite for oil is insatiable, these developments are clearly worrisome — especially for emerging economies like India, China, Russia and Brazil.

“If we look at the BRIC countries, India looks like a sore thumb. We are the only country out there which is not in the pink of health when it comes to oil as all the other countries have their own resources or finances to manage the situation,” says Ajit Ranade, group chief economist with the Aditya Birla Group.

There are several others like him worried about the management of the oil economy. With polls round the corner, pump prices are unlikely to be hiked significantly to pass on the burden of the crude price rise. India is still among a handful of countries where kerosene is still being sold at $20/bbl levels, when international prices are ruling close to $125/bbl.

Over the years, when it comes to raising the prices of petrol, diesel and LPG, governments, irrespective of political hues, have uniformly chosen not to take any hard decision. This is because a decision on this issue can hurt them politically, never mind the fact that retail prices do not reflect international realities and that it can drill a hole into government finances.

The NDA government and its finance minister Yashwant Sinha started issuing oil bonds to skirt the issue. Since then these bonds which are IOUs guaranteed by the government of India and given to oil marketing companies (OMCs) to compensate them for their losses have proved to be a convenient tool to postpone solutions to the problem.

The OMC problem

Earlier these bonds compensated one third of the losses of the marketing companies. Over the years these bonds now offer up to 42% of the losses. When the bonds were originally issued, the plan envisaged was to gradually decontrol oil prices and make them market-related by the end of 10 years.

But as prices went up, the political cost became too high. Now with oil touching new highs every week, doubts are beginning to surface again whether the current mechanism of price-redress can be stretched beyond a point. Economists have already warned that postponing the problem would have long-term implications for the economy.

India’s fiscal deficit works out to 3.2% of the GDP and if the outstanding oil bonds are added to this number, the same fiscal deficit to GDP ratio escalates to 4.4%.

In general, under-recoveries are moving up faster than the jump in crude oil prices and this is again a cause of worry as it impacts all segments of the economy. In FY07, marketing companies had under-recoveries to the tune of Rs 50,000 crore which are expected to vault to Rs 1,00,000 crore in FY09, a rise of 100% in two years. During the same period average crude oil is expected to go up by 60%. For every $1 increase in price of crude, the under recoveries go up by Rs 3,000 crore.

Like American shoppers, the Indian government has followed a ‘consume now and pay later’ philosophy that is obviously unsustainable, feels an economist with a brokerage firm. The questions now being raised are: Does the government have any option? And how do other countries handle the same issue?

Options for the future

S Narasimhan, the finance director of India’s largest oil retailer Indian Oil, is one man who battles the fallout of high-oil prices on a daily basis. With the oil-major’s borrowings going up to Rs 36,000 crore, it is not surprising that his energy is focussed on finding ways to improve cash flow.

When oil prices increase, management of working capital also becomes a tricky issue as everything from inventory to cost of transportation needs to be reworked. One solution he can offer is to sell off the government issued oil bonds as soon as possible. Indian Oil holds bonds worth Rs 14,000 crore and is very keen to sell them, albeit at a loss. Narasimhan says, “Cash flows are severely constrained by the low retail prices of petroleum products.”

The marketing companies have no option but to sell these bonds at a loss as these bonds are not liquid. Again, since these bonds do not have statutory liquidity ratio (SLR) status, banks are lukewarm to the idea of picking up these bonds. To compensate for the lack of SLR status and liquidity these bonds offer a 25 basis extra coupon over the gilt rates.

One of the solutions to make these bonds attractive is to grant them SLR status. This way the marketing companies can obtain the right price for these bonds as banks would line up to buy them given the higher yields. If these bonds do get SLR status, then the extra 25 basis coupon will have to go and thus may not have the same attraction for banks. Since the government has a borrowing programme every year and banks are captive buyers of government paper, there is a scare that if oil bonds are given SLR status, the borrowing programme of the government will get impacted.

Banks will always find the oil bonds more attractive in terms of maturity as well as liquidity compared to other instruments floated by the government. Today the oil companies use the CBL route where the OMCs do the borrowings by using these bonds as collateral. This is turning out to be more efficient for the OMCs in many ways.

Gilt funds are allowed to invest in oil bonds, as these funds are mandated to invest in any security issued by the government of India. However, oil bonds are not included in the basket of securities, which banks invest in to meet the statutory requirements. According to IDBI Gilts’ head of fixed income S S Raghavan, “The main issue with gilt funds is that these securities lack trading interest and hence, are illiquid. First of all, banks do not prefer to invest in oil bonds because they do not carry an SLR status.

Secondly, provident funds and pension funds, which comprise the large set of investors in these securities, hold these bonds till maturity. Hence, there is no trading interest from these superannuation funds. Due to these reasons, most gilt funds which are professionally managed, do maintain an internal cap on investments in oil bonds.”

Typically, on the shorter end, these bonds carry a 25-30 basis point spread over the government bond of a similar tenor. On the longer end, the spread extends to over 50-100 basis points over the government bond. Currently, oil bonds of a 15-year tenor carry a coupon of 9%, almost 100 bps over the corresponding g-sec.

Much of the trading is now concentrated on the shorter end, where yields have witnessed a sudden spike on account of monetary measures such as the recent hike in the cash reserve ratio. On the longer end, trading interest is restricted given the illiquid conditions.

Apart from the financial management part, there are other issues which needs to be addressed. One of the best options would be for state governments to lower the sales taxes on fuel,the Rs 50 or so that a consumer pays for a litre of petrol, about 60% is the tax component, for diesel it is roughly 40%.

Oil revenues form a major chunk of earnings for the governments, both at the centre and in the states, so the measure has not found favour yet. The centre has cut taxes to an extent on some petroleum products, but the states have not yielded ground at all. There is a lot of scope on sales tax reductions, the taxes are currently linked to retail prices and hence increase each time prices go up.

Oil analysts say China has tackled the high oil problem by capping levies to a single tax rate. Duties on transportation fuel are a uniform 13% all over China, much lower than the Indian rates. Of course, the additional advantage that countries like China, Brazil and Malaysia have is that they produce more oil domestically.

India now imports close to 70% of its oil needs and domestic production has been stagnant for over a decade. Narasimhan says the second option to deal with the situation is an oil cess. Oil companies have proposed that the government levy a 3% cess on income tax on the lines of the education cess. This could raise close to Rs 15,000 crore every year, which could be used to stabilise oil prices.

Targeted subsidies

The third option is to have targeted subsidies; which means passing on the subsidy only to economically weaker sections instead of all the consumers. The huge under-recoveries by the oil companies are on the sale of four petroleum products — petrol, diesel, LPG and kerosene. “Of these, LPG and petrol are products that are consumed by a vast swathe of urban population that can afford to pay much more,” says an oil company official.

Subsidised LPG and kerosene can be sold to families below the poverty line, but why should everyone enjoy this benefit? he asks. This can be done through the issue of pre-loaded oil-cards, on the lines of the Kisan cards. This would ensure that the under-recoveries come down by almost half, according to estimates. This is something some economists have also endorsed.

The new president of CII KV Kamath says, “While the situation on inflation does not make it possible at present to consider a greater pass through of oil prices, this is a measure which would have to be taken sometime in the near future, based on the situation on inflation.

The situation on oil prices also mandates that the country set a target for itself in terms of conservation. Demand management of energy consumption including greater efficiency in utilisation is a must for the country.”

The impact

The impact of the high prices is being felt by oil companies more than anyone else. Consumers of aviation fuel, naptha and furnace oil too are bearing the brunt. For the rest it is of little consequence. However, the slowdown in oil company spends may soon start impacting growth.

For 2007-8, the government expects to issue oil bonds worth about Rs 32,000 crore. The figure is not fixed yet and bonds for the fourth quarter of the year are yet to be issued. In 2008-9, the figure is likely to be higher, depending on actual prices through the year.

The under-recoveries of the oil marketing companies, are currently shared between the companies themselves, oil producers (ONGC) and the government (through the issue of bonds). As oil prices went up, the central government has taken a larger share of the losses which meant greater recourse to oil bonds.

Weighed against the backdrop of these developments, it is amply clear that the government may have to soon bite the bullet. The options are limited. Either the political managers would have to take some hard measures or the other option would be to settle for lower economic growth rate. Issuance of oil bonds was fine as long as the economic growth was robust.

However, exercising such a relatively easier option may be far more difficult when the economy slows down. That is the time when these bonds can be a heavy burden. There is no escaping the fact that oil prices will have to be passed on to consumers. Many countries have done it. India may not have much of a choice. The longer the government delays it the greater will be the collateral damage.

(With inputs from Pravin Palande and Preeti Iyer)


http://economictimes.indiatimes.com/Features/Special_Pages/The_Big_Story/High_oil_prices_should_be_passed_on_to_consumers/rssarticleshow/msid-3006066,curpg-1.cms

As oil nears $100, look out below

A discussion on the most intriguing topic of today:



Oil prices are soaring. Having jumped 40% since August, crude prices hit another historic high on November 6, rising to $96.70 a barrel. The factors sparking the $2.72 rally this time: bad weather in the North Sea that could force production cuts, the dollar’s continued fall, more violence in the Middle East, and fears that US crude supplies are low. But is there a sharp fall just ahead? Analysts say that the oil market looks overheated, and a number of factors could puncture the price bubble.

Most important, speculators have played a key role in driving up crude prices this year, and if the trend reverses they’ll get out fast. Certainly, global demand remains strong for now. But a number of factors—technical indicators, an economic slowdown, lower demand— could prompt investors to exit en masse. “Oil prices are in uncharted territory,” says Peter Fusaro, co-founder of the Energy Hedge Fund Centre, which tracks commodities hedge funds. “My worry is that if the market tanks, everyone will want out at the same time.

The market would collapse, and who knows what the bottom is.” Much Trading Remains Opaque Speculators have played a growing role in the oil market in recent years. There are 595 hedge funds that are engaged in at least some energy trading now, more than triple the 180 funds involved just three years ago. Fusaro estimates the assets involved in such trading total more than $200 billion, up more than 60% from the beginning of the year. It’s tough to get a firm handle on the speculation.

A large portion of trading takes place in the unregulated, over-thecounter market. Still, some of the trading in crude oil takes place on the New York Mercantile Exchange (NYMEX), and there the market is approaching a record in terms of the number of crude oil contracts that predict a price rise. Traders have committed to 135,000 contracts— each representing 1,000 barrels of crude—betting that prices will continue to rise. That’s just shy of the record 155,000 contracts reached this summer. Some analysts say that if the number of contracts rises sharply, oil prices could fall. “The exit signal for investors could be breaking through the 150,000 or 160,000 contract barrier,” says Joel Fingerman, president of OilAnalytics.net, an energy consulting firm. “At that point investors could feel they’re using all their bullets.”

For Now, It’s Full Steam Ahead In the meantime, however, investment continues to flood the crude oil market, as well as commodities in general. “The mentality now is very bullish,” says Fingerman. “As long as money keeps flowing in, people will keep buying [oil] as though it’s going to go to the moon.” The optimism has helped the stocks of the oil majors. ConocoPhillips is up nearly 40% over the past year. ExxonMobil, Chevron, British Petroleum and Royal Dutch Shell have posted similar if somewhat smaller gains. Still, some analysts say the psychological impact of $100 oil could mark the beginning of a slip in prices. “The professionals will get out of the market at $98.50 or $98.99,” says Peter Beutel, president of the energy risk management firm Cameron Hanover in New Canaan, Conn. “They’re not going to wait for $100 to materialise.” But is there anything special about the $100 mark? Some experts think not. “The barrier was supposedly $70, $80, then $90, and we’re past that. Why would $100 suddenly cause a reversal?” says Stephen Schork, an energy consultant in Villanova, Pa., and editor of the Schork Report, a daily energy newsletter. “$100 is not the death knell to the bull market.”

A Correction Is Inevitable Beutel says that regardless of the exit signal for investors, the oil market is due for a correction. “Historically speaking, we see that every time there is a sustained vertical [price] rise, there is a 20% correction,” says Beutel, adding that the serious threat of a recession could take 40% off oil prices. “It’s a beautiful thing that people forget: The market moves more quickly on the downside than it does on the upside.” It’s also possible that ballooning oil prices will begin to fall when demand responds to price signals, as it happened in the 1980s. “The uptick in crude hasn’t caused the same drag on the economy as it did 28 years ago,” says Ray Carbone, owner of the trading firm Paramount Options. “But once we’re past all-time highs in oil prices, things could change.”

Courtesy: BusinessWeek