ALBUQUERQUE — With gasoline pushing $4 a gallon, many Americans are wondering when prices will come back down. But the outlook is pretty gloomy. And the idea that these prices are here to stay seems to be sinking in. A recent report by John Fleck for the Albuquerque Journal describes the increased use of public transit and purchases of fuel efficient cars in the Albuquerque area.



These are positive effects of rising fuel prices, in terms of shifting our economy away from fossil fuels. But Fleck also described the pain being felt by commuters who have no choice but to drive, as did the Independent’s Denise Tessier in a report describing efforts to mitigate hunger in relation to rural low-income families not being able to afford long round trip drives to and from the grocery store. In the short term, the rising prices are a serious problem for many.



The Wall Street Journal reported earlier this month that the Goldman Sachs Group is predicting the price of oil, which has climbed to a little over $130 a barrel, could range between $150 and $200 a barrel by October. At the rate its going, this reporter thinks $150 could happen a lot sooner.



“That would put oil at unprecedented price levels, even going back to just after the Civil War,” Stephen Brown, an energy economist at the Dallas Federal Reserve Bank, told the WSJ. The article goes on to say such prices could push gasoline to $4.50 a gallon.



Explanations for the rising cost of fuel are varied, and the solution, in the short term anyway, is elusive. Senator Jeff Bingaman, citing from testimony given before several Committee on Energy and Natural Resources hearings, spoke forcefully from the Senate floor on May 12 about one possible culprit: speculation in the oil markets. Here are excerpts from his remarks:
Here is what a Senior Vice President of a major oil company said at one of these hearings, on the House side.
 
When you look at the fundamentals of our business, Congressman, the supply/demand fundamentals, our assessment would be the price should be somewhere around ($)50, $55 a barrel. There is a disconnect. To me, there are three factors that contribute to that. One is the monetary issue, the weaker dollars we’ve already talked about. The other is geopolitical political risk. And the third, we believe, is speculation.
 
It would be fair to say that key energy analysts are in agreement that at least $30 of the current price of a barrel of oil is the result of market pressures unrelated to supply and demand for physical barrels of oil.
 
This general assessment of a significant cause of high oil and gas prices is broadly shared. One noted energy economist put it this way recently to the Wall Street Journal: “Crude futures prices have decoupled from the forces controlling the underlying physical flows of the commodity.” In plain English, that means that crude oil prices are not connected to supplies. If oil prices aren’t being driven by supply and demand, what are they being driven by?


Bingaman went on to call for increased regulation of futures markets, especially those outside the U.S.



In light of Bingaman’s remarks, I couldn’t help but notice that Carl Gutierrez of Forbes on May 16 cited the Goldman Sachs prediction itself (that oil would rise to $150-$200 per barrel by October) as partially responsible for the subsequent continued climb in oil prices. The prediction makes it so, according to Gutierrez, which seems to give credence to arguments that speculation is at least partially responsible. According to Gutierrez,

After it bet correctly on the subprime mortgage market, investors seem to be willing to listen carefully to Goldman Sachs, and the brokerage house’s bullish energy forecasts are lifting the price of crude to new heights, bringing it ever closer to the $150-$200 range the firm’s oil analyst recently predicted.

The Independent was curious about Senator Domenici’s position on regulation of the oil futures market. His spokesperson, Matt Letourneau, explained that its plausible that oil speculation is partially responsible but that they had not conclusively determined it was a factor so had not taken a position on it.
 

In a recent conversation on this topic, Trevor Hanger, head trader at Brookline Avenue Partners in Dallas, said this about the price of a barrel of oil:

Futures traders, like it or not, do set the commonly accepted price for a barrel of oil. That’s what a front month future is for, and it’s the same way with any commodity. For that matter, futures trading can sometimes dictate what happens in the equity markets too.

Trevor then obligingly agreed to break some of this lingo down in a Q&A on the matter, to share with Independent readers for whom, like me, the ins and outs of market speculation are not well understood:



Hi Trevor, thanks for taking the time to explain all this for me.



You’re most welcome, Marjorie. Any time.



First, what exactly is a future’s market?



To explain what a future’s market really is, it’s easiest to compare it to other, more conventional markets. For instance, when you go into a supermarket and buy a loaf of bread, you pay for it and take it with you immediately. In trading lingo, this is called a “spot” or cash market. Similarly, it’s possible to “trade” for “commodities” (oil, gold, wheat, etc) for immediate delivery as well. In that circumstance, the buyer is purchasing the actual barrel of oil, ounce of gold, etc, and will actually physically possess that item as soon as its purchased.



But on a futures market, the buyer and seller agree that the physical exchange of the item will take place in the future. This type of trading has been around in the U.S. for about 150 years, and originated to make agricultural trading more sensible. By allowing, for example, farmers and bread makers to agree to a wheat trade six months ahead of time, the farmer is better able to judge demand for his next crop, and the bread maker has a locked-in price for a primary ingredient going forward. In many ways, it’s that price certainty that keeps futures markets practical today.



So how does the “future price” on the future’s market set the price of a barrel of oil now?


Because few people actually want to take delivery of a physical barrel of oil. Because of this, the spot price and the “front month future price” almost always trade at the same price. The term “front month” simply refers to the next expiring futures contract, which roughly translates to the next month on the calendar. The front month future right now is July, and the July Crude Oil Future is what everyone is referring to when they talk about the price of oil.

 
Is speculation driving up the price?


The run up is probably based both on speculation and market fundamentals. Speculators buy oil because they think it’s going higher, but they don’t say “oh, I just have a feeling oil’s going higher.” Speculators making those decisions have been trading oil for years or even decades, and they recognize there are more forces at work than just supply and demand.


There are fundamental reasons why oil will stay high. But it’s my feeling (culled in large measure from talking to oil traders) that the move from $60 to $130 in the last 12 months is maybe 55% fundamentals and 45% speculation. So retracing the speculation move would bring oil back down around $100 give or take.



My understanding is that we’re dealing with a global market so would imposing regulations on speculators really have a significant impact on the price?



When it comes to oil and energy trading, there are two main places to trade. Here in the US, the Chicago Board of Trade (CBOT) was founded in 1848, and the Chicago Mercantile Exchange was founded in 1898. They merged last year, and the combined group is in the process of taking over the NY Mercantile Exchange. For the purposes of this discussion, it’s easiest to look at them all as one large entity.



However, the biggest and most active oil and energy futures market is the Intercontinental Exchange (ICE), which is an electronic market based in London. Some people estimate ICE handles up to 80% of all oil and energy trading around the world. Technology has become so seamless that commodities trading can essentially be done 24 hours a day from almost anywhere in the world.



As it currently stands, regulating that global market is difficult because the body that regulates the US exchanges “generally oversees, but does not substantively regulate” ICE. However, regulation across both the US markets and especially ICE would likely have a significant short term effect on oil prices.



So how would regulation happen?



Technically, the Commodities Futures Trading Commission (CFTC) and the National Futures Association (NFA) are the two organizations specifically charged with regulating futures trading in the US. The CFTC is federally regulated and has five commissioners who are appointed by and serve at the pleasure of the President, so they would likely act on any call from the White House for more regulation. The NFA is the industry self-regulatory body.



ICE falls under what’s commonly known as the “Enron Loophole”, which is a congressional exemption from regulatory oversight. Congress would first have to close that loophole, paving the way for the CFTC to regulate ICE the way it does the other US futures markets. One way the CFTC regulates the market is through limiting the number of futures contracts one trading firm can hold, which limits the ability of a single firm to corner large chucks of the market. Those limits exist on the NYMEX and CME, but not on ICE, which is one of the main reasons why so much more trading is on ICE.



Another example of regulation involves the margin required to trade futures. Because futures trades don’t result in any immediate exchange of goods, traders and their parent companies are required to prove they have a certain percentage of the pledged cash available. This is called the “margin.” By raising margin requirements, you limit the purchasing power of all traders, and force banks that can’t meet their margin requirements to stop buying and in some cases start to sell contracts. Oil prices would fall as a result, although it’s no more than a guess as to how much.



Thanks for explaining this for us, Trevor. It’s very complicated. But it sounds like regulating the market might help stabilize prices even if they don’t come down.



It’s very possible.

 

*The Enron Loophole has been closed through an amendment attached to the 2008 Farm Bill just last week.