Rising Oil Prices Series: Part V

Posted by Patrick O'Connor on 6/18/08 8:58 am

This post contains Navellier top-ten energy stock holdings.

This article is the fifth installment of a multi-part series about rising oil prices. In this column, we’ll discuss how a weak U.S. dollar and speculation may be contributing to rising oil prices.  Read parts I, II, III, and IV.

Are speculators artificially manipulating oil prices?

Many industry experts believe the traditional forces of supply and demand cannot fully explain recent oil prices increases—and point the finger at a relatively new phenomenon, the impact of the speculator on the global commodities markets.

Global demand for oil has clearly been increasing, as we explained in Part III of this series. And the world’s crude oil supply is certainly limited, as we explained in Part IV.

That said, there are still considerable global inventories of crude oil. According to an April 2008 report from the Energy Information Agency (EIA), Organization for Economic Cooperation and Development (OECD) countries had 2.54 billion barrels at the end of the first quarter of 2008—22 million barrels more than the previous five-year average. And, the EIA projects that inventories likely will remain near average levels for the rest of the year.

Thus, say critics of the supply and demand theory of rising global oil prices, other factors must be examined—and one of those factors is speculation by institutional investors such as large financial institutions, pension funds, hedge funds, and sovereign wealth funds.

Speculation is investment in a commodity by an entity that does not “produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes,” according to the Commodity Futures Trading Commission (CFTC). In other words, speculators don’t buy oil; they buy futures contracts on oil, and as the delivery date approaches, they sell the contract to someone who actually uses the oil.

What’s driving speculation? First, many institutional investors are awash in cash due to lower interest rates and the virtual shutdown of the U.S. asset-backed commercial paper market, and they have to park that cash somewhere. In addition to letting speculators profit on rising prices and hedge against inflation, speculation on oil has a unique advantage over speculation on some other commodities: it hedges against the weak U.S. dollar. Crude oil is priced in dollars, meaning that the more the dollar slumps, the more attractive dollar-denominated oil contracts are to foreign investors. As a result, speculators have been pouring billions of dollars into futures contracts on crude oil.

How much? The Energy Hedge Fund Center says 600 hedge funds were trading oil in late 2007, up from just 180 in 2004. And oil futures contracts on London’s Intercontinental Exchange rose from $1.7 trillion in 2005 to $8 trillion in 2007, according to the U.S. Securities & Exchange Commission. (Data from the New York Mercantile Exchange, NYMEX, was not available).

So, how much is speculation driving up oil prices? It’s virtually impossible to say. But, in June 2006, when oil traded in futures markets at around $60 a barrel, a U.S. Senate investigation reportedly estimated that $25 of that $60 was the result of speculation—putting the “real” price of oil at around $35 a barrel, about 58% of the trading price. Extrapolating that to today’s market, where oil is trading at around $130 a barrel, it should be closer to $75.

So why not ban speculation? First, it serves a purpose: it reduces the risk to the producer. To understand how, it may be easier to consider an agricultural commodity, such as wheat. Without speculation, farmers might have a hard time finding someone to buy their crop in advance—what if there’s a drought or a flood? With speculation, they can transfer the risk to another party, the speculator. Sometimes the speculator makes money—but sometimes s/he doesn’t. The point is the risk is transferred to a party who is able to accept it, and that makes the markets more efficient.

Additionally, banning or limiting speculation would be difficult given that the oil market is global. If you ban trading on the NYMEX, speculators could still trade on the London exchange, or the newer Dubai exchange. If you shut down all exchanges, traders would create an ad hoc market. And that would make the situation even worse, because with a unified market like the one we have today, everyone can see what oil is trading for. On a closed market, there would be little transparency and major price swings would likely result.  Go to Part VI.

Navellier Top-Ten Energy Stock Holdings

Vantage Portfolio
Petroleo Brasileiro (PBR); 1-yr Chart; Profile
Sasol Ltd. (SSL); 1-yr Chart; Profile
Encana Corp. (ECA); 1-yr Chart; Profile
Cameron Intl (CAM); 1-yr Chart; Profile

Power Dividend Portfolio
Noble Energy Inc. (NBL); 1-yr Chart; Profile
Devon Energy Corp. (DVN); 1-yr Chart; Profile
XTO Energy Inc. (XTO); 1-yr Chart; Profile

All Cap Core Portfolio
Occidental Petroleum Corp. (OXY); 1-yr Chart; Profile

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Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any securities recommendations made by Navellier & Associates, Inc. in the future will be profitable or equal the performance of securities made in this report. For a list of recommendations made by Navellier & Associates, Inc., for the preceding twelve months, please contact Tim Hope at (775) 785-9416.

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