Hedge Funds and The Third Oil Shock

Last week I wrote about two causes of what I am calling the Third Oil Shock: 1) increased demand from China and India combined with flat supply as the world approaches its peak oil production and 2) the impact of the falling dollar which is responsible for almost half the rise in the dollar price of oil compared to the Euro price. This week I want to discuss a third possible cause: hedge fund speculation. While the first two causes suggest high oil prices are likely to be here for some time, if high oil prices reflect speculation, then there is a chance prices may come down. The role of speculation in skyrocketing prices lies behind the belief of some that we are in the midst of a commodities bubble. However, there is a lot of debate about this point. Here are a few obervations.

First, my own informal poll of hedge fund managers, none of whom invest in oil futures themselves but who track the strategies of others, suggests there is something to the speculation theory of skyrocketing prices. The word among traders and analysts is that hedge funds are driving up prices--both by bidding up oil index futures or, when they do go short, having to cover positions if bets turn sour. Hedge funds, of course, have huge leverage at their disposal...a $5 billion hedge fund can command $50 billion in capital through borrowing. And by buying futures which are already highly leveraged, the leverage becomes enormous. This was the thrust of a much talked about Barrons article that appeared about a month ago. That article and others in Seekingalpha and other investor-focused publications have detailed the strategies Hedge Funds are using to play in oil.

Second, a number of influential Senators seem to think speculation is part of the problem. Senator Lieberman has been holding hearings on the subject this past week.

While one would not expect traders to come out and talk about how they are destroying the American way of life, one hedge fund manager, Michael Masters of Masters Capital did put the blame for prices on what he called "index speculators", hedge funds buying futures of indices. His testimony included a primer for Senators on commodity speculation and graphs showing how speculators are moving the market.

The Lieberman hearings prompted a rebuke from John Dizard in yesterday's Financial Times in which he cited studies by the Commodities Futures Trading Corporation in Chicago that speculation can not lead to sustained higher prices because the participation in the markets of users--like industrial companies and the airlines--is sufficiently great to outweigh speculation. Speculators who bet against the real world, the CFTC, argues will eventually lose their shirt. The operative word, however, is eventually. It is quite possible that speculation may exacerbate spikes and how long speculation-induced bubbles continue can be anyone's guess. After all every market, even the housing market for example, eventually must reckon with supply and demand--but the reckoning may be put off for years if capital is sufficienlty abundant. And capital is certainly abundant in the oil business today--especially with money having flowed out of other asset classes such as property and structured debt.

My own guess is that there is something to the speculation theory. The history of financial markets for many years has been a pursuit of what investors consider their God-given right to double digit returns. When any one market slows, this has led them to seek out a a series of alterantive investments--from tech stocks to real estate to now, perhaps, commodities-- that by virtue of the inflow of capital alone eventually turn into bubbles.

However, the other two causes of rising oil prices, skyrocketing demand from China, India and the developing world as well as a falling dollar are still with us. If a correction does ensue as a result of the real economy intervening, it is not likely to happen until after the summer driving season. And it will not address the long term force of increasing demand for a finite resource.