Study: Role for Strategic Reserves To Limit Speculators

NEW YORK (Dow Jones)

Governments should consider their strategic petroleum reserves a part of their arsenal to limit speculation in the oil market, according to a report issued Thursday by Rice University's James A. Baker Institute for Public Policy.

The Commodity Futures Trading Commission, which regulates the oil market, is expected to issue a draft rule this fall limiting the size of positions held by those making speculative bets in energy, and is already gathering more information about the activities of large traders. U.S. regulators are also working to convince their foreign counterparts to adopt stricter limits.

The Baker Institute study argues that governments could go further, particularly by using strategic reserves if tightening supplies begin to drive up prices again. Oil prices peaked at a record price above $145 a barrel in July 2008, amid concerns that increasing global demand was starting to brush up against easily accessible production. Yet the U.S. government only stopped refilling its Strategic Petroleum Reserve when prices were well over $100 a barrel, too late to cool the rally, the study said.

The U.S. and other major oil consumers made a mistake last year when they decided against releasing oil from reserves as prices were skyrocketing, the study said. That inaction gave speculators the green light to hold positions in the oil futures market betting that prices would keep moving higher.

"When you're pulling oil off the market and putting it into strategic inventories, it sends a signal to all players in the market that governments are hoarding...without the intent to bring prices down," said Kenneth Medlock, an energy fellow who co-authored the study. "That actually can send a signal to players in the market that the market is tight, and it's going to stay tight."

Futures crashed to just over $30 a barrel by December as a global economic downturn created a surplus of crude. Prices have since climbed back to around $70 a barrel.

The CFTC said in a report last September that there was not enough evidence to link speculative traders, such as index funds, to that summer's record prices. The Baker Institute found no smoking gun either, but noted that speculative traders make up half of open interest in oil futures today, compared with 20% before 2002, when a less-volatile market was dominated by companies using futures to protect against fluctuating prices.

Many of the new class of investors are using dollar-denominated oil to protect against the effects of a weaker U.S. currency, rather than betting that supply and demand will move crude prices, the study said. Those funds can create a self-perpetuating loop, where higher oil prices drive up the U.S. trade deficit, causing the dollar to weaken further, the study said.

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