What’s Driving Up Oil Prices? Or The Yadda Yadda Yadda Theory of Oil Speculation

So, oil prices are above $100 per barrel, the price at the gasoline pump is well past $3 per gallon, and people are looking for reasons. Your possible explanations are:

• Unrest in the Middle East
• Rising worldwide demand, driven by growth in China and India
• Speculation by oil traders

You can find people pitching all of those answers, and there’s evidence for all three of them.  People are always looking for someone or something to blame when it comes to oil prices, especially when rounding up the bad guys means that the rest of us are off the hook.  Maybe that’s why we resurrect that perennial energy bad guy—the speculator—every time oil prices start to soar.

But just who are these nefarious speculators , and are they really to blame for the pain at the pump?

If you’re like most people outside the financial world, your impression of the commodities market is a big trading floor full of people shouting about pork bellies. That’s a good start, because the idea of commodities futures started out with farm products. The New York Mercantile Exchange, the first and still one of the biggest places for oil trading, started out as the Butter and Cheese Exchange.  Oil, in particular, is one of the truly global commodities. Lots of people are selling, and nearly everyone is buying, and everybody’s trying to get an angle.

Basically, the system works like this:

Let’s say you know you are going to want 100,000 barrels of crude oil next January (We won’t ask what you want it for). On the commodities exchange, you can buy those barrels from a producer in advance (That’s why it’s called a “future”) at a fixed price, say $100 a barrel. The advantage is that you and the oil producer have a deal you can count on at a fixed price. You don’t have to worry about not having the oil, and the producer doesn’t have to worry about not being able to unload it.

But it’s also a gamble. You, the buyer, are gambling that the price won’t drop between now and January. If it falls to $90 a barrel, you just lost out on cheaper oil and took a $1 million bath. But the producer is gambling that the price won’t go up to $110 a barrel—if it does, the producer is the one who takes the $1 million bath.

So it’s not exactly a rational, orderly process that determines the price of a barrel of oil. Oil prices go up based on what traders think will happen in the future. It can be the result of hope, fear, bravado, and panic.

Sometimes they get anxious. That’s why traders started bidding up the price of oil after the unrest in the Arab world spread to Libya. Yes, as many people have pointed out, Libya isn’t the even in the top 15 countries when it comes to world oil production. But it’s easy enough to envision the “Arab spring” destabilizing other oil producing nations.

Sometimes they look at the long run. It’s almost universally accepted in the energy world that global demand will skyrocket over the new two decades, as China, India and other parts of the developing world become middle-class consumer societies. Since oil is the scarcest of the fossil fuels and the only one (right now) that makes sense for transportation, prices are bound to rise over time.

And despite the chants of “drill, baby, drill,” very few oil experts think the United States, or anyone else for that matter, is going to be able to pump enough oil to keep up. The International Energy Agency has bluntly declared that “the era of cheap oil is over.” The International Monetary Fund is expected to release a report this week saying the world should brace for “increased scarcity” in oil markets. If that’s not a signal to buy up futures – and drive up prices – we don’t know what is.

So the situation is ripe for speculators, and regulators are playing catch trying to insure that traders follow the rules and don’t manipulate the market.  One member of the U.S. Commodities Futures Trading Commission – the panel that regulates energy markets, among others – says hedge funds and other traders are speculating in energy at the highest rate on record. The commission has been given additional powers to regulate energy markets and limit how many futures any one trader can hold, but it’s behind schedule on actually implementing them.

People get edgy and weird when something they really need is in scarce supply—and some of them try to get an advantage. Think about the famous “sponge” episode of Seinfeld, when Elaine’s favorite birth control method is taken off the market. She grabs up every box on the Upper West Side, and then institutes rigorous new standards to decide if a man is “spongeworthy.” And she has other people beating down her door to try and get some of her sponges.

There is little doubt that some speculators flout the rules, and regulators should go after them. But with the global trends they way they are, we are going to have to assume that everyone is going to  try to buy low, sell high and drive up prices every chance they have. That’s what scarcity does.   When all is said and done, maybe the best way to reduce speculation in the oil markets is to reduce the power of oil in our lives.