We Can't Even Tell Who's Speculating the Cost of Oil Through the Roof

By Nomi Prins, AlterNet. Posted July 8, 2008.

With oil prices going stratospheric -- give or take a few "down" days -- head-scratching and pump frustration, not to mention extreme profit-taking for a select few, keeps intensifying. But with the debate over whether speculators or fundamentals are driving prices echoing through the halls of Congress, the floors of Wall Street, and down Main Street, it's time to get to the root of how trading works.

Without pondering that, the blame debate is a waste of time. The starting question, then, shouldn't be who is driving prices, but how prices are being driven. From there, solutions become apparent. So, let's talk how.

First of all, an oil futures contract doesn't care who's buying or selling it, or why. A buyer can believe that fundamentals like Chinese demand outpacing supply, the dollar weakening, and Middle East unrest will boost prices. Or he or she can surmise that the sheer momentum of oil buyers buying will do the same trick. It doesn't matter.

If more people are willing to pay more to buy oil later, futures prices will rise. Period.

Second, futures prices are supposed to bear a clear relationship to the present, or "spot," prices of various commodities. That was the point of exchanges to begin with. Based in Chicago, at the epicenter of the mid-1800s U.S. agricultural belt, the Chicago Board of Trade (CBOT), the world's first modern futures exchange, was formed in 1848. The first contract that traded, called a "forward contract," was on corn in 1851. Futures contracts on agricultural products were standardized in 1865.

In 1882, the New York Mercantile Exchange (NYMEX) started trading poultry and canned goods in addition to butter, cheese and eggs. In 1933, it and the COMEX merged, encompassing metals, rubber and other commodities, under the umbrella of NYMEX. It was regulated by the independent government agency the Commodity Futures Trading Commission (CFTC) when that agency was created in 1974.

Crude oil futures were late to the party and did not start trading until 1983. Today, they are the most actively traded futures contract on the planet, and that's just counting the regulated exchanges. Monitoring them strictly for transparency should be mandatory.

Historically, roughly 70 percent of market participants used exchanges for specific commercial purposes directly related to supply and demand, meaning that grain merchants could "hedge," or protect against, a higher future cost of corn or wheat vs. the prevailing market price, while counting on futures prices to accurately reflect true value later, in case something went wrong with that year's crop. Speculators were invited to provide these hedgers liquidity. The key, though, was that they were outnumbered almost 3 to 1 on monitored exchanges. And even that wasn't perfect -- which is why farmers ultimately pushed Congress to pass the 1936 Commodity Futures Exchange Act to control excessive speculation.

But it's much better than what we've got now. Forget why someone is trading an oil contract -- today it's impossible to know who's trading how much. Fewer than 30 percent of market participants are clear hedgers with legitimate business purposes.

In the 1970s, it was clear who dictated oil price levels. Amid the Arab-Israeli war in 1973 and the Iranian Revolution in 1979, OPEC oil embargoes caused real supply disruption and painful price spikes. Gas station lines resulted from real people trying to tank up before there was nothing left.

Before the July 4 recess, with millions of angry, driving voters and an upcoming election, legislators focused on the current cause of exorbitant oil prices, holding separate commodity price speculation hearings in the House and the Senate.

Industry analysts, academics, money managers and heads of exchanges convened in front of Congress to discuss the issue. The most interesting participants, however, were the absent ones: the most influential speculators, like the Goldman Sachs commodity trading desk. After all, Goldman Sachs analysts were out there first, with a staggering but slowly actualizing crude oil futures price target of $150 to $200. Not, as Goldman has stated, that this forecast in any way relates to the firm's trading positions.

Having faced wrath from his peers for testifying on speculation's role last month, Mike Masters, head of Masters Capital Management, returned for round two in June, addressing the damage that index speculation (via institutional investors allocating to commodities) does to the price discovery function of commodity futures markets.

See more stories tagged with: oil prices, speculation, oil futures, trading

Nomi Prins is a senior fellow at the public policy center Demos and author of Other People's Money and Jacked: How "Conservatives" are Picking your Pocket (Whether You Voted for Them or Not).

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