Are big bets by speculators driving up oil?

From USATODAY.com

Speculation about whether speculators are to blame for the superspike in oil prices is in overdrive.

Now that it costs $100 to fill up big SUVs, an Agatha Christie-esque whodunnit featuring finger-pointing lawmakers and suspected speculators is gripping this oil-obsessed nation in search of someone to blame.

Anyone who drives a gas-powered vehicle or runs a business that uses oil — and is experiencing financial distress — can't help but wonder: What's causing prices to go up so much?

In the early 1970s, the Organization of Petroleum Exporting Countries was Public Enemy No. 1, thanks to its oil embargo, which caused gas shortages in the USA and long lines at the pumps.

But today's energy crisis is different. OPEC insists there's plenty of oil. There's no queuing up at gas stations. And Congress is pointing fingers at an altogether different villain: financial speculators.

"When I began to see wild swings in gas prices, I was suspicious of mischief in the markets," said Rep. Bart Stupak, D-Mich., who recently introduced an updated version of a bill dubbed the PUMP Act, or Prevent Unfair Manipulation of Prices Act.

The proposed legislation aims to close regulatory loopholes that enable speculators to manipulate and artificially inflate the price of energy.

Efficient market purists disagree. U.S. Treasury Secretary Henry Paulson, billionaire investor Warren Buffett and the oil-rich kingdom of Saudi Arabia all insist that free-market forces are at work. They cite the Economics 101 concept of supply and demand as the main reason a barrel of oil has surged above $140, up nearly 50% in 2008.

Phil Flynn, senior market analyst at Alaron Trading, sums up this thesis best: "You can argue that the economic fundamentals for oil are as strong as they have ever been in mankind's history." He cites robust demand from emerging economies around the world, a growing belief that future oil supplies will be tight, and the ability of foreigners to buy oil cheaply because of the steep drop in the value of the U.S. dollar.

Still, the search for a culprit is not surprising given how far and how fast oil prices have risen. Oil prices are now higher than the record set in the late '70s, adjusted for inflation. The oil rally is now bigger than the Nasdaq composite's run during the Internet stock bubble, Bespoke Investment Group says. And the energy sector is now the second biggest by market value in the Standard & Poor's 500 index, at 15.6%, three times larger than it was at the Nasdaq top in March 2000, says S&P.

The financial fallout is hard to ignore. Oil's rise has caused a sharp drop in stock prices, made it harder for average Americans to make ends meet, forced U.S. automakers to rethink their emphasis on gas-guzzling SUVs, and put domestic airlines on a death watch.

That's why Congress is on the offensive. Lawmakers are holding what seems like daily hearings to figure out what's going on in the futures markets where the price of oil is set. They have introduced a flurry of legislation designed to curb speculation. They are also working to boost the manpower and financial resources of the Commodity Futures Trading Commission, the USA's top commodities cop, to help it better monitor and detect questionable trading practices. The CFTC has 447 full-time employees, 50 fewer than at its inception in 1976.

Stupak has cited statistics showing that speculators account for roughly 70% of energy trading, up from 37% in January 2000, on regulated U.S. exchanges. However, the CFTC says that number is flawed because it includes trades by investors, not deemed as speculators, for the purpose of hedging and risk management.

"Speculation is not illegal, but that does not mean it isn't hurtful," said Sen. Joe Lieberman, I-Conn., at a Senate hearing last Tuesday addressing the role of speculation on energy prices. He plans to roll out an anti-speculation bill after July 4.

"Speculators," added Lieberman, "are moving enormous amounts of money into commodity markets for the obvious purpose of making more money. But in doing so, they are artificially inflating the price of fuel futures and causing real financial suffering for millions of people."

Some lawmakers contend that oil prices would tumble sharply, perhaps to $60 a barrel, if speculators were banned from commodities markets. They suspect — but have yet to prove — that illegal market manipulation is inflating a commodities "bubble." The CFTC acknowledges that it started a nationwide probe in December to investigate possible illegal activity in the oil futures market.

But without full knowledge of who all the players are and how big their positions are in the oil futures market, both regulators and politicians admit it's tough to prove their suspicions. "At this point, we simply don't know what role speculation or manipulation is playing in price increases," Sen. Dick Durbin, D-Ill., chairman of the Appropriations Subcommittee on Financial Services and General Government, said in a recent statement.

Some energy experts say singling out speculators as scapegoats is misguided.

Market forces are to blame for the bulk of the run-up in energy prices, says Jim Ritterbusch, president of energy consultant Ritterbusch and Associates. He points to a massive demand surge from China and India. The falling value of the U.S. dollar also deserves blame. Oil is priced in dollars, which makes it more affordable for foreigners paying with stronger currencies. He also cites a lack of investment in energy infrastructure and supply constraints.

Ritterbusch also says the Iraq war, rumblings of an Israeli-Iran dispute, and political upheaval in Nigeria have increased uncertainty about future oil supplies. The lack of good investment alternatives (stocks are down 13% this year, and long-term U.S. government bonds are yielding around 4%) has prompted big investors to divert more capital to better-performing assets, such as oil.

"Commodities such as oil, grains and metals have become the new kids on the block," says Ritterbusch of the influx of buy orders into the market.

So what exactly are lawmakers screaming about? And how are they proposing to fix it?

Congress has pinpointed two major areas of concern. One is the rise in energy prices they say is resulting from fresh cash being invested in commodities. The second issue involves regulatory loopholes that allow speculators to operate in relative secrecy, outside the purview of U.S. federal regulators. A closer look at the two:

Impact of index funds.

Much of the controversy surrounds massive investments in commodity-based index funds by pension funds and hedge funds in search of diversification, better returns and protection against rising inflation. Since 2004, assets in index funds that track a basket of commodities have jumped from $30 billion to $180 billion, says S&P. The popular S&P GSCI commodity index has a 70% weighting in energy-related commodities.

The emergence of commodities as an "asset class" — no different than stocks or bonds — is causing concerns. Big institutions have decided to boost their long-term, buy-and-hold portfolio weightings in commodities. In March, the California Public Employees' Retirement System (Calpers), the largest U.S. pension fund, said it may increase its commodities exposure to $7.2 billion from less than $1 billion by 2010. These funds are being branded as speculators because they have no intention of taking delivery of oil, unlike airlines or trucking firms.

In testimony before the Senate in late May, hedge fund manager Michael Masters said investments in all funds tied to oil futures have risen to $260 billion, from $13 billion in 2003. This massive cash infusion, he noted, has coincided with higher energy prices.

It is akin to investors' chasing returns as they did during the tech stock boom, says Jeffrey Kleintop, chief market strategist at LPL Financial. "Higher oil prices destroy demand for actual barrels of oil, but higher prices also encourage more investors to chase performance and put more cash into commodities."

But Merrill Lynch commodity analyst Francisco Blanch says there is "no evidence" that index money is responsible for rising prices. He says gains for commodities that are not linked to indexes, such as coal, rice and steel, have posted bigger returns than oil. And orange juice, tin and platinum have enjoyed big gains after dropping out of the biggest commodities index.

Many analysts say the only way speculators can artificially increase prices is by hoarding oil and taking supply off the market. But there is scant evidence that is occurring.

Still, lawmakers and regulators are proposing potential position limits on big investors. Lieberman's upcoming bill would restrict commodity investments by institutions that invest through index funds. CFTC Commissioner Bart Chilton says if his agency's study of commodity index trading, which will be sent to Congress on Sept. 15, shows that index players are creating a negative economic impact, new rules and controls might be required.

Impact of loopholes.

A major roadblock for U.S regulators is that they have not had oversight of all futures trades tied to U.S. crude oil. The CFTC has regulatory and data-gathering powers over trades placed on the New York Mercantile Exchange, or Nymex. But it has not had the power to regulate or investigate trades involving U.S. oil futures that originate in an electronic futures exchange based overseas.

An estimated 30% of U.S. oil futures trades are executed abroad, mainly in London on the ICE Futures Europe exchange. The problem: Those trades, which are not subject to the same position limits or reporting requirements as New York-based trades, fly under the CFTC's regulatory radar. It's called the London Loophole. This loophole raises the specter of, say, a hedge fund purposely driving up prices on a foreign exchange to influence the price of futures contracts traded in the USA.

That's about to change. A number of bills circulating on Capitol Hill, including the PUMP Act, would give the CFTC regulatory authority to police foreign trades involving U.S. futures contracts. The CFTC has also established new conditions that require traders using the London-based ICE exchange and other foreign exchanges to trade U.S. oil futures to abide by the same rules that apply at Nymex.

The CFTC "needs to have a complete picture," said CFTC's Chilton. It can't just "have an eye only on what goes on in New York."

To limit market access and make it more expensive for speculators to buy oil futures contracts, some Democrats in Congress propose to boost margin requirements to 50%, which is what stock investors pay. Currently, traders need to put down 5% to 7% in cash to buy a futures contract. That means a trader can control $10 million of future oil contracts by putting $500,000 to $700,000 down, says Daniel Clifton of Strategas Research Partners.

A report from TrimTabs Investment Research predicts oil prices would "collapse" if the margin requirement were raised to 25%. The CFTC and Nymex both are against raising margin requirements, saying it would cause business to move overseas.