Oil Prices: How Big is The Bubble?

Abstract: Growing speculation and new hedge funds may account for as much as $10 of the rise to $50 oil.

Analysis: Ever since crude oil prices began to rise last year, OPEC has been insisting that supplies are plentiful and distribution bottlenecks and speculators were the causes. At least in part that now appears to be true.

Demand has been up, apparently permanently, with China's growing economy the principal cause. Supplies are squeezed by events like the Iraq war, Nigerian unrest, Venezuelan shortfalls, Russian production slowdowns – even hurricanes in the Gulf of Mexico. Shortages in refining capacity and distribution bottlenecks such as lack of crude oil tankers further limit availability.

To compensate somewhat for all this, OPEC has allowed its members to open the taps and produce even more than the latest announced quotas. Still the price continues its relentless rise. And the questions come up: Why haven't the production increases caused prices to drop? Are supplies that tight? Are bottlenecks and market manipulations keeping prices high?

These are complicated questions with many influencing factors. There is no way to measure production and consumption and see if they are in balance. Nobody really knows how much oil is being produced. Official figures from many producing countries are widely disbelieved and second-guessed. Simple answers are out the window.

But perhaps a plausible approximate answers can be found by looking at the structure of the oil trading market and the way it is changing.

Looking for the Bubble
Oil is traded in two ways: directly from producer to consumer – oilfield to refinery, and in the futures markets of New York and London. The futures markets involve contracts to buy oil at some specific time in the future at a specific price. There are two players in this market: speculators and hedge funds.

Speculators buy, hold and sell oil contracts just to profit from price fluctuations. Hedging involves actual customers. An airline, for example might buy jet fuel for future delivery as a hedge against a later price increase.

Both players are involved with crude oil, of course. But speculators are most active during rising prices when further rises are anticipated. That seems to be the case with crude oil today.

Speculators can push prices up because the speculative purchase itself artificially increases demand. (Speculative selling can cause prices to fall in a similar fashion.) When price rises due to speculation cause more buying in the hope that the price will continue to rise, this forms the bubble. Once price levels off, however, speculative selling kicks in. This is usually even more pronounced than the period of rising prices. The bubble bursts.

Lately, in world oil markets, analysts are increasingly pointing at speculation as a major factor exaggerating current price rises and blowing up the bubble.

The Times on Line (UK) said in September "A secret analysis of the market carried out by a big European oil company recently found that speculators were adding between $7 and $8 — or between 15% and 20% — to the price of a barrel of oil." The way things are going, that number could easily round up to $10 by now.

But something more that short-term speculative profit now appears to be involved also: the transformation of traditional speculators into hedge funds – speculators metamorphosing into new middlemen in the sales chain from oilfield to refinery.

Hedge Funds
The Times on Line reported that investment banks such as Morgan Stanley are increasingly moving into the physical market to buy oil — even entire oilfields. These institutions are taking their knowledge of speculation into the physical marketplace and becoming suppliers – middlemen.

Over the past few years, a number of hedge funds have added the oil markets to their trading systems. The Times said several new and secretive hedge funds are now wagering hundreds of millions of dollars every day in the oil market and reaping the dividends.

The Times quoted an unnamed senior executive at one oil firm as saying: "This is the hottest oil market I have ever seen. There has been a massive increase in hedge-fund activity. And what we call non-commercial interests (those who do not use oil for their business) has doubled recently."

This activity growth in and of itself indicates that there is money to be made in oil markets. Supplies may be plentiful but bottlenecked, or they may be short. Either way the new hedgers apparently feel supplies are likely to remain scarce for some time.

Speculators can move rapidly in and out of markets, of course. But the extra step of establishing a hedge fund that might actually be involved in physical delivery to a final customer indicates a somewhat longer-term viewpoint. The potential profit in a period of rising prices makes for a very attractive bubble.