How oil price speculation works

Why is gas now 4 times more expensive than it was 8 years ago? A lot of the price change may have to do with “speculators” - people who buy and sell oil strictly to take advantage of price changes. Here’s a brief description:

Who’s to blame for $4 gas

From the article:

Strong demand, tight supplies and a volatile marketplace have attracted the interest of investors - the last main contributor to high prices.

“The speculator has seized upon this opportunity,” said Schork. “They have recognized there is something fundamentally flawed in this market.”

Since 2003, the number of oil contracts exchanged on the NYMEX has more than doubled, said Schork.

Money flowing into oil - and commodities in general - has been especially sharp over the last 6 months as investors look for good returns amid falling stock prices and an inflation hedge against a falling dollar.

That’s helped push oil prices to nearly $130 a barrel and gasoline to an average of nearly $3.80 a gallon - smashing previous records even when adjusting for inflation.

This article defines speculators:

Perhaps 60% of Today’s Oil Price is Pure Speculation

From the article:

In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.”

The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.

There are many large firms now “speculating” in oil because of inflation fears:

Big fund money is flowing into oil markets sending prices to levels never seen before

From the article:

If anyone is to blame, he says, it’s the Federal Reserve, which has been predictably cutting interest rates since August to shore up credit markets. When interest rates fall, investors flock to commodities as an inflation hedge.

“The Fed tipped their hand,” he said. “[The big funds] were basically told by [Fed Chairman Ben] Bernanke that this is where the money is.”

And if the money is there, why wouldn’t the big funds not take advantage of it?

“We are following for us what is a prudent strategy to maximize investment returns, said Clark McKinley, a spokesman for CalPERS, California’s pension fund for workers in the public sector. “Obviously, there’s some unintended consequences.”

But it might not be a bad thing:

For Samples, more money in fuel markets means more people willing to sell him a contract. He doesn’t think speculators push prices artificially high, arguing that supply and demand support prices.

“All the focus on speculators being the problem misses the point,” he said. “The point is: supplies are not growing as fast as demand. You need sharp price growth to bring down demand.”

Even individual investors (like you and me) now have easy ways to speculate in oil. You can buy shares of an exchange traded fund (ETF) like OIL:

U.S. OIL FUND ETF

Here’s a description of the fund:

The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil. The fund is nondiversified.

When you buy shares of OIL, you increase the price of oil worldwide in some small way. When you sell shares, you push prices down. Right now, there is a lot of money looking to buy.

What might be done about speculation inflation?