Why is Oil at a $100/barrel Speculation or Just the Fundamentals

Good discussion about the oil markets and whether or not the high prices are due to speculation or the fundamentals. It is probably both, but speculation has played a large part in the market since August. Text in bold is my emphasis. From CNNMoney:

Greed is driving oil prices to $100 a barrel. That's a common feeling among the general public, which sees record profits for investment banks that bet on oil prices - making wealthy oil companies even wealthier - while drivers shell out $3 and more for a gallon of gas.

It's also a common refrain from OPEC states. Having to defend themselves against charges their production quotas are responsible for the high prices, they point to near-average crude oil supplies and say speculation is what's behind the frenzy.

But industry experts offer mixed opinions on speculative investment's impact on oil prices. Some say it's marginal, that strong demand and limited supply are the real reasons oil prices have risen five-fold since 2002, and say additional investors actually benefit the market by adding more liquidity.

Others say the tight supply and demand situation has been known for a while, and nothing but speculation is behind the doubling of oil prices over the last year. They say there is a cost to the sheer number of oil contracts now traded on the oil exchanges, and this trading has just enriched Wall Streeters at the expense of average Americans.

The Energy Information Administration, the Energy Department's independent statistical and analysis arm, thinks strong demand and limited supply - otherwise knows as "the fundamentals" - is why oil is so pricey.

"Our view is that the market is tighter [than last year]," said Doug MacIntyre, senior oil market analyst at EIA. "We don't have the inventories now."

MacIntyre said inventories in developed countries - crude oil stored at refineries, or in tanks at ports, pipeline terminals and other locations - went from 150 million barrels above their five-year average at the start of the year to 10 million barrels below the five-year average now.

"That's a big difference," he said. "There's less slack in the system than there was a year ago."
EIA attributed the decline to OPEC production cuts of about 1.5 million barrels a day beginning at the start of 2007, when inventories were so high and oil prices briefly dipped below $50 a barrel.
The cuts came despite continued strong worldwide economic growth, which EIA said caused oil demand to rise by 1.3 million barrels a day over the last year. The agency projects an increase in demand of 1.5 million barrels a day in 2008.

"High oil prices are not rationing demand," Addison Armstrong, director of market research at the brokerage Tradition Energy Futures, said, adding that speculative money might be tacking on just $5 or $10 to the price of a barrel. "The fundamentals are much tighter than they were a year ago."

EIA said other factors contributing to a doubling in oil prices over the last year include moderate growth in new supplies from non-OPEC countries, the inability to immediately produce much more oil in OPEC countries, a lack of refining capacity and ongoing geopolitical threats.

But longtime Oppenheimer oil analyst Fadel Gheit doesn't buy it.

Gheit said inventories are declining because high oil prices give people an incentive to sell crude now and wait until later to restock supplies, when hopefully oil is cheaper.

Other than the decline in supplies, Gheit says all the other factors EIA lists have been with us since last year, when oil traded at under $50 a barrel.

"It's pure speculation," he said. "What's changed that we didn't know in January? Not a single thing."

It's hard to gauge the amount of money investment interests - as opposed to refiners or airlines or people who actually use oil - have in the oil markets. The government tracks contracts held by what it calls "commercial' and "non-commercial" users, but it lumps investment banks in with the commercial side.

Either way, the amount of investment money in oil is certainly large. It's been rumored Goldman Sachs has over $80 billion in the market, although the investment bank declined comment for this story.

Its influence is so big, traders refer to the day of the month when the bank sells the current month contract and buys the future month as the "Goldman roll" due to its effect on price. When Goldman last month told its clients to sell oil when it approached the mid-90's, crude lost over $3 in one day.

Goldman is of course not the only one. Morgan Stanley, which also declined comment, has reportedly bought facilities to store oil. Hedge funds, pension funds, commodity-centered mutual funds, insurance companies - all have gotten in on the act.

"Just the multiple [contract] turnovers in the futures markets has a cost of its own," said Judy Dugan, research director at the Center of Taxpayer and Consumer Rights.

Dugan, echoing recent sentiments by oil company executives themselves, said there's no fundamental reason why oil prices should be anywhere near $100 a barrel.

"There's no inability to buy oil, this is not 1981," she said.

The high prices and talk of speculation has attracted the attention of Congress, which is holding hearings on the matter beginning next month.

Among things lawmakers could do is increase the margin requirements - or require oil traders to put down a greater percentage of a contract's worth in-order to buy or sell it. Currently, traders can buy or sell oil with just 4 percent down, compared to 50 percent for stocks. (With no skin in the game, this will certainly encourage speculation.)

Another option could be to require traders to hold oil contracts for a certain amount of time before they sell them.

But one source familiar with the oil markets said that while the physical number of oil barrels available is limited, there is no limit on the number of contracts that can be written. So just because there's more money chasing oil contracts, that in and of itself doesn't necessarily guarantee higher prices.

He said speculators provide liquidity in the oil markets, and noted that they can lose money just as fast as they make it.