Six Myths About Oil Speculators

By Rick Newman, U.S.News & World Report

So now we know who's really responsible for $4 gas. Finger-pointers from Washington, the International Monetary Fund, and even Saudi Arabia no longer seem to buy the idea that the demand for oil around the world is simply growing faster than the supply, driving prices to record highs close to $140 per barrel. There must be a more nefarious reason, it seems. So now entering this drama is a villain everybody can hate: The Evil Speculator.

At recent congressional hearings, politicians and energy experts argued that speculators have artificially added $30 or more to the cost of a barrel of oil, turned oil trading into a global poker game, and doubled the price of gasoline practically overnight.

But who are these party crashers? Where did they come from? How are they doing this? And who can stop them? We'd all like to see a superhero swoop in and smite the speculators, saving Gotham from the peril of $4 gas. The only problem is, speculators aren't quite the bogeymen that politicians want us to think--and they even play an important role in the oil markets and the global economy. Some major misconceptions:

Speculators are inherently bad for the economy. There's no doubt that speculators are out to make money, by buying a commodity like oil (or gold, or real estate) when they think the price is likely to rise and they'll be able to sell for a profit. But they also help sustain the market for buyers and sellers and provide ways for individuals and businesses to offset risks.

Many companies, for instance, want to lock in the price they're going to pay down the road for petroleum products and other supplies they need to run their businesses. So they make agreements with suppliers on a price they'll pay next year, or the year after, when they actually take possession of the oil. Buying and selling such "futures contracts" makes these companies speculators by definition, since they're placing a bet on the future price of oil.

Companies doing this kind of hedging include gasoline refiners, airlines, shipping companies, and others that spend a lot on fuel or petroleum. Often they use investment banks or other intermediaries to arrange the deals. They might be gambling, but this kind of speculation actually helps companies run their businesses more smoothly, and if they guess right on future prices, it may give them a competitive advantage against other companies that don't plan as prudently.

There's a Speculator Star Chamber somewhere. Global markets are so abstruse to ordinary folks that it's easy to imagine a cabal of evil geniuses pulling the levers from some fortified complex in London or Geneva. But that's the Hollywood version. "The market is so competitive that that's nonsense," says Bob Hodrick, a finance professor at Columbia Business School. "There's no way for everyone to communicate and get together and say, 'We're going to buy and drive the price up.' " There are thousands of investors around the world placing bets every day on whether oil prices will go up or down--and they have no way of knowing who their fellow speculators are. All they know is the current price, shown on a computer monitor, plus whatever their own research tells them.

Speculators are super-rich market manipulators. Certainly some are super-rich, including investors in sovereign wealth funds from Middle Eastern and Asian nations. But new data show that many oil speculators these days may be big pension and index funds that invest on behalf of ordinary working Americans. These huge investment funds have typically invested in equities, but in recent years they've been adding commodities--including oil--to their portfolios as a way to diversify.

Even if the commodity portion of these portfolios is just 3 or 4 percent, that can trigger big swings in the oil markets, where most investors up till now have been smaller players. "There's no malice or manipulation here," says Ed Krapels, an analyst with the research firm Energy Security Analysis. But the entry of such big institutional investors into the oil market could definitely contribute to rising prices, especially since they tend to buy and hold securities like futures contracts, instead of quickly selling--which contributes to scarcity and rising prices.

The government tracks speculators and knows who they are. Part of the reason nobody's really sure what effect speculators have on the oil markets is a lack of information. Exchanges like the New York Mercantile Exchange track the activities of their members, but even then, a trader could be a speculator one day, buying oil or futures contracts, and a seller the next day: Nobody checks a "speculator" box when making a trade.

A recent study by the federal Commodity Futures Trading Commission, which regulates commodities markets, found a big increase in the percentage of speculators buying oil contracts for investment purposes--"paper barrels"--instead of buying because they need the oil. But oil markets are less regulated than markets for stocks or bonds, and there's still a lot that's unknown. Congress has ordered more studies, with new regulation likely as well.

Speculators are creating a huge bubble in oil. We've just seen a bubble pop in the housing market, with home values now plummeting. And before that, the tech bubble inflated, then burst. But the run-up in oil prices is probably different. The housing boom was generated by cheap and, in some cases, fraudulent mortgages, not by a huge increase in the number of people who needed housing. The tech boom was similar to old-fashioned manias, where investors raced in hoping to cash in on a gold rush and bid the price of technology shares way above their inherent value.

But in the oil markets, there is in fact growing demand because of strong Asian economies. And supply is fairly fixed for now, since adding more oil to the market means finding new sources and spending billions to extract it, not just opening a spigot a little wider. "There are pretty strong fundamentals behind this run-up," says Sarah Emerson, another analyst at Energy Security Analysis. Speculators may be pushing oil prices somewhat higher than they would otherwise be--but a bust similar to housing or tech stocks seems unlikely.

Speculators should be banned. Few, if any, economists or energy analysts advocate this. In fact, some fairly modest regulatory changes could bring greater transparency to oil markets and force them to operate more like stock and bond markets. Buying a contract for oil futures, for instance, typically requires the buyer to put down less than 10 percent of the value of the contract; the rest can be borrowed. That allows buyers to roll up big stakes with relatively little cash. Raising the "margin requirement" to 50 percent, the usual threshold for stocks, would cool demand for oil futures, while still keeping the speculators in business. And maybe get the witch hunters off their case.