Article from New York Times business section this morning.
August 13, 2006
Investing
Is a Futures Stampede Keeping Oil Prices High?
By NORM ALSTER
BY now, even a casual student of current affairs can reel off plenty of reasons for high oil prices: soaring demand, dwindling supplies, conflict in the Middle East and, most recently, the partial closing of an Alaskan oil field.
Ben P. Dell, an analyst at Sanford C. Bernstein & Company, would place another factor at the top of the list: the money that has been surging into the commodities futures markets. Mr. Dell published a report last month suggesting that a stampede of institutional investors, mainly pension funds, into commodities is actually the chief cause of the rise in oil prices, which he called âa bubble.â
The report has generated more reaction than any other oil research published by the firm in the last three years, Mr. Dell said. And not all of it has been positive. Some oil experts say that while the flood of money has had some effect on spot prices, it is by no means as important as Mr. Dell maintains.
âI think the idea of speculation being the main driver of higher oil prices ignores the fact that in the real world there are a whole host of things to worry about,â said Robert J. Weiner, professor of international business at George Washington University.
Similarly, Jan Stuart, global oil economist at UBS, said factors like geopolitics were more significant. Further, he said, âIâm not calling it a bubble.â For his part, Mr. Dell acknowledged that geopolitical concerns â particularly fear of a possible disruption in supplies by Iran â were having an impact on prices. But he said that such issues did not entirely explain oil prices, which, in his view, should be trending downward based on supply-and-demand fundamentals.
Despite some short-term fluctuations, inventory levels in the United States, for example, are âwell above the upper end of the average range,â according to a recent Energy Department report. Growth in global demand has cooled, and new oil supplies have padded what had been a threadbare cushion of supply over demand.
âYouâre growing supply,â Mr. Dell said. âYouâre growing inventories. And demand growth is slowing. But the price keeps going up.â
The reason for this anomaly, he said, may be found in financial markets, specifically in the billions of dollars that investors, mainly pension funds and other typically conservative institutions, have poured into commodities in recent years.
Commodities futures that track indexes like the Goldman Sachs Commodity Index or Dow Jones AIG Commodity Index have become fashionable for many investors. Their reasoning is that this asset class, though volatile, affords portfolio protection because it has often performed well when stocks and bonds have been weak.
Close to $100 billion will be invested by pension funds and other institutions in futures contracts tied to the commodities indexes this year, up from less than $20 billion three years ago, according to Goldman Sachs.
Pension funds, whose charters often prohibit short-selling, have been exerting upward pressure on futures prices, several analysts said. âThey want to be long. They want to stay long and âdonât bother me with it.â â said William H. Brown III, president of WHB Energy Research in Chappaqua, N.Y. âIt definitely adds a positive bias to the market.â
This persistent upward pull on futures prices creates an arbitrage opportunity that drags the price of spot oil higher as well, according to Mr. Dell. With futures prices higher than the spot price, why not buy oil, store it and then sell it forward in the futures market at a profit? Mr. Dell and others argue that this is precisely whatâs happening.
âItâs a typical commodities play currently being employed in oil markets,â said Sal Gilbertie, a trader at Fimat USA in New York.
Similarly, Phillip Verlander, an independent energy economist, said that on Aug. 4, for example, it was possible to âbuy heating oil in New York Harbor at $2 a gallon and store it and sell a future to deliver it in December for $2.24,â and that many traders were doing so.
Mr. Dell said that current oil prices were a bubble comparable to the tech investment bubble of several years ago â and that the oil bubble was likely to burst before very long.
Others on Wall Street agreed that the flood of institutional dollars had had some effect, but they disagreed about just how much. Edward L. Morse, chief energy economist at Lehman Brothers, said, âThere is no doubt in my mind that thereâs an impact from a new class of investors into commodity markets, especially pension funds and also speculative investors including hedge funds.â That impact can at times be as much as $10 a barrel, but âfundamentals play a much bigger role,â he added.
In a similar vein, Mr. Stuart of UBS said: âExplosive growth in commodity-related financial investments has translated into sharply higher prices and higher trading volumes on long-term oil futures. In effect, financial buyers have become consumers of oil, contributing to the persistence of high prices.â
But he said that tight supplies, Chinaâs growing appetite for oil and other considerations were more important. âThe arbitrage thatâs available is only one of the factors supporting the price of oil,â he said. Mr. Stuart expects the average price of oil to hold around $69 a barrel next year; oil has been trading around $75 recently.
ON the other hand, Mr. Brown of WHB Energy Research supports Mr. Dellâs view of current price levels. He has studied the historical correlation of oil prices with inventory levels and, at current levels, oil should sell for just $27 a barrel, he said. The impact of passive, long-term investors âis in my view $33 a barrel,â he said, with other factors, like flagging production in the North Sea and in Nigeria accounting for much of the rest of the gap. Still, he says he does not expect prices to tumble unless there was âa major slowdown or even reversal of demand growth.â
Mr. Dell said that prices could weaken once global storage capacity filled up, limiting the possibility of arbitrage profits. He said that this could happen within four to six months but emphasized that it would be hard to predict precisely when oil prices might move down.
In Cushing, Okla, a giant oil storage hub, the tanks are indeed filling up. âIn todayâs environment, all the major tankage owners are being very well utilized,â said Rick Sandahl, senior vice president for market development at Enbridge Inc. He said that 80 to 90 percent of his companyâs storage capacity of 12.5 million barrels was in use. Asked if his customers seemed to be hoarding oil to take advantage of a price arbitrage, Mr. Sandahl replied: âI would think itâs a factor in their decisions.â
Investors who believe that oil prices are ready for a fall would want to avoid mutual funds or exchange-traded funds that are linked to commodities indexes. Mr. Dell said that stock investors should âunderweightâ oil, recommending only such âdefensiveâ plays as Exxon Mobil, Chevron, Total and Apache, all of which, he said, have âconsiderable excess cash flow beyond their capital spending needs.â As such, he added, they could withstand a drop in oil prices âand still deliver their growth plans.â
