Explaining Oil Price Fluctuations

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There is no doubt that financial investors play an increasingly large role in the market. At the New York Mercantile Exchange, one of the world’s biggest oil bourses, financial players account for up to 70 percent of trading; oil producers and companies account for most of the rest, mainly in the form of spot demands for crude that are part of the regular course of doing business.

Some investors are in for the long haul. Pension funds, university endowments, sovereign wealth funds, and other index investors buy and hold baskets of commodities futures, treating them much the same as any other investment. Before the contracts expire, these investors roll them over and, they hope, earn a profit. As long as prices keep going up, this is a moneymaking strategy.

Then there are the old-fashioned speculators—hedge funds, rich investors, and Wall Street banks—who invest based on their view of how prices will move. These investors tend to be in and out of the market fast, reacting to news and hoping to predict where prices will go. It is this latter group of quick-hit investors who dominate the market. According to a June research report from Goldman Sachs, speculators account for about 42 percent of all oil trading on Nymex; index investors, 11 percent; and oil producers and other companies make up the rest.

By some estimates, commodity index funds now have upwards of $250 billion in assets, compared with just $13 billion at the end of 2003. Nobody knows how much hedge funds and the proprietary trading desks of big banks have been betting on crude, but it is safe to assume that the figure is large. During the past year, so-called macro funds, which place bets on currencies and commodities, have been the best-performing types of funds, while on Wall Street, commodities trading has provided a substantial and much needed source of profit.

Soros and the other finger pointers are surely correct when they say that the weight of investment capital has contributed to the runup in the price of crude. But to assert that blind speculation alone is responsible for current prices is to misunderstand how the market works—and oversimplify trading that is unusually complex, influenced by global politics and economics. Expectations are what drive the futures market, particularly expectations about the long-term cost of crude. If prices rise much above that level, speculators will eventually bet against them, bringing them back down.

This year, however, the equilibrating mechanism has stopped working because, until recently, almost nobody was willing to bet that oil prices would drop. Paradoxically, it was the absence of speculators (bearish ones) that kept prices up. “What has happened is that the market’s anchor has disappeared,” says Christopher Allsopp, the director at the Oxford Institute for Energy Studies and a former member of the Bank of England’s ­monetary-policy committee. “The market doesn’t really know what the medium-term fundamentals are anymore.”

One reason for the confusion is the ongoing debate over whether global oil production is topping out, as a number of engineers and academics in the so-called peak-oil movement have claimed. I’m not convinced. While some big non-OPEC fields are declining faster than expected—particularly in Mexico, the North Sea, and Russia—production in Brazil, Canada, the Caspian region, and elsewhere in Asia is increasing, and some big OPEC producers, like Saudi Arabia, are expanding their capacity. Despite the ongoing production problems in Iraq, Nigeria, and Venezuela, most experts predict that crude stockpiles will rise considerably during the next couple of years.

Beyond that, who knows? Pessimists point to reports that the International Energy Agency, which has been carrying out a new survey of global production capacity, is expected to predict a crunch through 2030, as increases in crude supply fail to match rising demand in the developing world.

But many major producers, including Iran, China, and Venezuela, refused to cooperate with the agency’s researchers, and the situation in Saudi Arabia, the world’s biggest producer, remains extremely murky. In the ’90s, the Saudis, with a bit of prodding from the U.S., could be relied on to prevent big spikes in oil prices by flooding the market if necessary. Today, the Saudis and their Gulf allies appear unwilling or unable to open the spigots. Some analysts interpret this reluctance as evidence that the vast Middle Eastern fields will soon be tapped out. My view is that the House of Saud’s wish for stability in the oil markets has taken second place to its immediate need for money to pacify its restive and rapidly growing population. (One delicious, though unproven, conspiracy theory I came across recently: In order to keep the price of crude high, the Saudis have been quietly feeding misinformation about their giant fields to the peak-oil crowd.)

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