By Alex Mills
Some members of Congress have been throwing verbal spears at energy “speculators.” They believe that “speculators” are a primary cause of rising crude oil and gasoline prices, and they are trying to pass legislation that would make it more difficult for speculators to influence crude oil markets.
Speculation is not new in futures markets. Crude oil has been traded on the New York Mercantile Exchange (NYMEX) since 1983. Theoretically, anyone can speculate or hedge in crude oil futures to lock in the price of a transaction that may occur in the future.
Many believe that such a market is the best mechanism to determine a true price of the commodity and ensure efficient allocation of resources. Detractors, however, say that such “paper trades” distort the true price of a barrel of crude oil, which should be set on actual sales of liquid barrels.
The price of crude oil at the wellhead – commonly known as the posted price – follows the NYMEX closing price on a daily basis. Usually these price spikes are reactions to events that may impact future supply or demand. It is illegal to intentionally manipulate prices, and the Commodity Futures Trading Commission (CFTC) monitors markets and recommend penalties for alleged violations.
One area of concern is the increased participation in commodity markets of institutional investors, such as pension funds, foundations, and endowments, according to a study conducted by the Congressional Research Service that was prepared for members of Congress on July 8. “Many institutions have chosen to allocate a small part of their portfolio risk,” the study said. “While these decisions may be rational from each individual institution’s perspective, the collective result is said to be an inflow of money out of proportion to the amounts traditionally traded in commodities, with the effect of driving prices artificially high.”
Speculators that trade frequently and in large volumes can have an impact of prices, either up or down. They usually are reacting to some sort of news that could impact either supply or demand of crude oil. For example, Nigerian rebels have been raiding offshore platforms and causing supplies to decrease temporarily. Another example would be hurricanes causing production in the Gulf of Mexico to halt. Because speculators believe that supplies will decline, they will bid up the price.
The same scenario happens on news that supplies will increase or demand will drop. If a major event were to occur in a major consuming part of the world that would cause consumption to decrease, speculators would bid down the price of oil because its demand has decreased.
On July 24, a company in Tulsa filed for Chapter 11 bankruptcy protection because it had speculated that crude oil prices were going to drop but they actually increased dramatically. The company, SemGroup, stated in court documents that it attributed its losses to volatility in the commodities markets and tighter margin requirements (the collateral a trader must post to support its positions).
The Wall Street Journal quoted a person familiar with SemGroup’s trading strategy and it involved moves that exposed the company to huge risks if the price of crude oil rose. On the other hand, if the price had declined as SemGroup anticipated, the strategy would have been brilliant.
Speculation in commodities markets is a volatile game even for seasoned veterans.
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