Oil prices soar. But why?

McClatchy NewspapersOctober 18, 2007 

WASHINGTON — When investment bank Goldman Sachs & Co. said in March 2005 that oil prices could surpass $100 a barrel, it was accused of fear-mongering. Oil prices, after all, were around $57 a barrel.

This week, competitor Barclays Capital led a research report with this statement: "The issue seems no longer to be whether oil will reach $100 a barrel, but when." That statement barely raised an eyebrow.

Prices for contracts of future delivery of oil, called futures, closed up $2.07 on Thursday to $89.47 on the New York Mercantile Exchange. In after-hours electronic trading, prices hit $90.02. Prices are up almost $39 from a Jan. 18 low of $50.48 a barrel.

Yet, shockingly, high oil prices aren't translating into similar leaps in gasoline prices. The AAA motor club said the national average is $2.79 gallon, about the same as a month ago, but 52 cents higher than the January average.

That's good news for drivers, but it raises a troubling question about what's really behind today's high oil prices: How much is financial speculation, rather than economic fundamentals, driving today's energy markets?

"It's smoke and mirrors. It has nothing to do with consumers. The futures market in the near term is exceptionally bullish," said Fadel Gheit, an oil analyst for Oppenheimer & Co, a Wall Street advisory firm.

A 30-year veteran of oil markets, Gheit believes financial speculation is driving prices to unrealistic highs. Evidence of that, he says, is that oil prices are rising even as refiners can't pass along these rising costs to consumers because U.S. demand for gasoline is falling. The drop is due to both the end of summer vacations and a sluggish U.S. economy.

"Gasoline prices will likely pick up a little bit because oil prices have surged. But they are not likely to catch up with oil prices," said Gheit. "Demand for gasoline is coming down on a seasonal basis."

Oil industry critics say that refiner manipulation is to blame.

"These companies control the maintenance, the output, the expansions. There is a lot of limitation (in generating supplies) that is deliberate in refineries, and they were able to drive up profits to levels that were close to a dollar a gallon for finished gasoline" earlier this year, said Judy Dugan, research director for the Foundation for Taxpayer and Consumer Rights in Los Angeles, a consumer group that clashes frequently with Big Oil.

"Americans will pay $3 a gallon for gasoline, but if they were getting the margins they were getting this spring, gas would be over $4 a gallon, and you'd see people bring torches to the Capitol!"

Refiners angrily dismiss such charges.

"That's an ancient, unfounded allegation. Study after study, report after report, investigation after investigation, has concluded that price manipulation does not occur in our industry," said Bill Holbrook, spokesman for the National Refiners and Petrochemical Association.

The federal government asked refiners to defer maintenance after hurricanes Katrina and Rita in 2005, and upgrades and maintenance were finally done earlier this year, he said.

"Supplies dipped as units were taken offline for repairs, and mind you, there were never any shortages during that time, and that's what prompted the markets to react the way they did and drive prices higher," said Holbrook.

The Energy Information Administration, the research arm of the Department of Energy, maintains that the run-up in oil prices isn't due to speculation, but it doesn't discount the possibility.

"EIA's current analysis suggests that supply and demand fundamentals, including readily quantifiable factors such as the level of inventories and spare upstream capacity, and less quantifiable ones such as the effect of heightened geopolitical risks ... can provide an explanation of the recent increase in oil prices," the agency said Wednesday in its latest report, "This Week in Petroleum."

But EIA conceded that its models "do not 'prove' that the hypothesis that speculators have played a role in the run-up of crude oil prices is false."

Economic fundamentals clearly play a role. A hot global economy creates a surging demand for oil, even as the U.S. economy cools. The strong global economy drove up oil futures 46 percent since mid-October 2006. It's also why soybean futures prices rose 66 percent over the same period, tin 62 percent, platinum 30.8 percent and gold 26.4 percent.

But some important voices warn that economic fundamentals alone don't explain oil's surge.

"The commodity markets are the price discovery points for all energy commodities. Excessive speculation and questionable trading practices have an instant and tremendous impact on the consumer," said Craig Eerkes, chairman of the Petroleum Marketers Association, in July 12 testimony about commodities markets before the House Agriculture Committee. "American families and small businesses are at the financial whim of the energy trader and the hedge fund manager. It is time that Congress stepped in and said, 'Enough is enough.'"

Eerkes was referring to electronic trading of oil contracts on what are called Exempt Commercial Markets, or ECMs. These over-the-counter, unregulated exchanges were codified in law in 2000, thanks to intense lobbying by now-bankrupt energy giant Enron during a modernization of the Commodity Futures Trading Commission, the federal entity that regulates futures markets.

ECMs affect oil prices this way: Foreigners and lightly regulated hedge funds (investment pools for the ultra-wealthy) buy large oil positions on an ECM. Since these exchanges compete against the regulated New York Mercantile Exchange for investors, they affect demand for oil futures. This distorts the "price discovery" function that futures markets are supposed to provide in allowing users of oil to hedge against price changes.

Because ECMs are largely unregulated, it's difficult to tell whether, or to what degree, oil companies and wealthy oil-producing nations are driving up the price of oil by washing their profits back through futures markets to serve their own interests.

Some estimates are that 30 percent of oil futures contracts are traded on unregulated exchanges. Both Congress and federal regulators are looking at ways to bring them under greater scrutiny.

In any event, demand for oil is projected to outpace future supplies, which will push up prices. For reasons ranging from nationalism to price manipulation to ineptitude, oil-producing nations aren't investing enough in future production.

"A high price is certainly a message to invest in capacity," said Nobuo Tanaka, head of the Paris-based International Energy Administration, in an interview late last month. "In many countries, spare capacity is very limited, and limited to a small number of countries. We want to see more investment."

McClatchy Newspapers 2007

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