Are Speculators Driving Energy Prices?

BusinessWeek’s Moria Herbst thinks so, and I have heard similar things from brokers:

The battle between bulls and bears in the energy market is beginning to look like something of a rout. On Jan. 16, oil prices tumbled yet again, dropping 3% to settle at $51.21 on the New York Mercantile Exchange. Oil is down 35% from its high of $78 in July. It’s already off 16% so far in 2007….

“There’s been a huge jump in speculation in oil markets, and it’s exacerbating price volatility,” says Peter Fusaro, founder of the Energy Hedge Fund Center, an energy-trading information site that tracks hedge funds…

In a December report, analyst Doug Leggate of Citigroup (C) highlighted the growing influence of financial firms. He wrote that “rising fund interest” has emerged as the “dominant long-term driver of price.”

The explosion in the number of financial players in the energy markets has occurred particularly in the past year or two. There are currently 530 energy hedge funds, according to Fusaro, up from just 180 in October, 2004. Of the total funds now, 177 are strictly energy commodity funds trading oil or oil futures and options, as opposed to the stocks of energy companies such as ExxonMobil (XOM) and Chevron (CVX). Larger financial institutions such as Goldman Sachs (GS) and Morgan Stanley (MS) have also stepped up their participation in the energy markets recently.

The increased speculation has some experts wondering whether some players could run into trouble because of the surprisingly sharp decline in oil prices in recent weeks. Last fall, Amaranth Advisors, of Greenwich, Conn., lost billions of dollars in the natural gas market after a steep drop in prices (see, 9/19/06, “Behind Amaranth’s Sudden Swoon”).

Experts say there could be other firms that will suffer deep losses now. “Somebody’s already bleeding profusely,” says Peter Beutel, president of Cameron Hanover, an energy risk-management firm in New Canaan, Conn. “They’ve been hurt pretty badly in the past few weeks, and it could get worse.”…

If the financial players have their way, oil prices are likely to keep heading south. Market data from the Commodity Futures Trading Commission shows that noncommercial traders were net short on oil prices as of Jan. 9. Though it’s unclear whether the traders will be right in their wagers, that suggests that they’re betting on oil price declines. “Now that the price has retraced back to a fair value,” says Schork, “funds are gearing up to push it lower.”

BusinessWeek cover stories are a famous counterindicator, but this theme hasn’t risen to that level yet, so it’s reasonable to accept their view that this trend has some way to run.

But how far could it possibly go? The fundamentals haven’t changed. Advanced economies continue to use more energy, particularly for computers, and advancing economies are energy sinks (look how China has been willing to ruin its air by running coal-fired electrical plants). We haven’t found any large new oil fields, and at below $50, much of Venezuela’s 76 billion barrels of proven reserves, which are mainly heavy crude, is no longer economical to refine. And of course, volatile (and artifically low) oil prices discourage the development of alterntive energy.

Short interest is usually seen as a bullish sign, since a meaningful upward price movement will produce buying to cover any naked shorts. Even though the Administration continues to dismiss stories that report on its belligerent intentions toward Iran as “conspiracy theories,” there seem to be a lot of well-plugged-people, starting with Seymour Hersh, who believe otherwise. One view is that Israel will launch air or worse, tactical nuclear strikes, which would mean that the Bushies’ denials are technical correct but fundamentally inaccurate. Any flare up in the Middle East would produce a big spike in oil independent of significant short interest, and this level of shorts (pardon me here) would be gas on the fire.

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