Speculators Make Their Mark on the Oil Market

Speculators in the oil markets are frequently labeled as the “bad guys” that caused extreme volatility on the crude market over the last year. Who are these speculators and what are they doing to affect the price of oil? Are they really to blame for the huge price swings seen in 2008?

Speculators are called as such because they speculate on, or estimate, the future price of crude oil and try to make money from their estimates. What separates them from other investors on the oil market is that speculators buy and sell contracts for crude oil but have no interest in accepting the physical oil. Most speculators in the oil market are “institutional investors” such as hedge funds, index funds, and investment banks. For example, Goldman Sachs can purchase a contract for crude oil to be delivered in April of 2009 today, then re-sell that contract as soon as its price goes up between now and April, making a profit. Increased buying of oil contracts by speculators can cause a sort of artificial demand and drive up prices independently of real-world supply and demand forces.

Does the profit-taking activity of these speculators cause volatility on the oil market? OPEC sure thinks so. Since receiving much criticism for making huge profits during the spike in oil prices last summer, the Organization of Petroleum Exporting Countries has repeatedly deflected the blame onto speculators. On Wednesday, OPEC Secretary General Abdalla el-Badri laid the blame for oil’s recent volatility squarely on speculators and called for the U.S. government to intervene and “limit the level of speculation” in the oil market, and also claimed that speculators are “delaying a recovery in prices,” according to Bloomberg.com. While OPEC may want to scapegoat speculators for volatile oil prices in a bid to protect its own public image, other analysts agree with OPEC’s assessment.

Earlier this month, 60 Minutes aired a report on speculation’s effects on the oil market, and concluded that increased buying and selling by speculators was clearly the cause of the extreme highs in oil prices seen last summer. The 60 Minutes story also concluded that the best way to prevent extreme volatility in the oil markets is to implement new government regulations on speculative activity—something President Obama promised to do on several occasions before taking office.

But the causality of last summer’s price spike and continuing volatility of oil prices has yet to be officially determined and universally agreed upon. The U.S. Commodities Futures Trading Commission found in a September 2008 report “no correlation between rising oil prices and the role of index fund investors and securities firms.” Proceeding on the assumption that speculation was at least partially responsible for surging oil prices in 2008, the U.S. House of Representatives passed a bill last September to limit speculation, but the bill was never voted on in the Senate and faded away from the congressional agenda.

Whoever is to blame for last summer’s oil price spike and subsequent price volatility, it cannot be disputed that the level of speculation in the oil markets has increased dramatically in the last few years. According to the Bloomberg report, 2008 saw a record-high trading volume on the crude oil market: the number of crude contracts exchanged on the market represented eight times the amount of oil produced worldwide. This was a marked increase over 2005, when the amount of oil traded was only three times more than the amount produced.

Only time will tell if the Obama Administration will make good on its promises to create a more transparent and more strictly regulated oil market. If the President or the Congress or both decide to undertake such a task, resistance from speculators and other financial interests that continue to make profits on buying and selling oil contracts will surely follow.

This article first appeared in the HEAT This Week newsletter on January 30, 2009