The Oil-Price Rocket: What Factors Fuel It?

In his unprecedented press conference yesterday, Fed Chairman Ben Bernanke gave the classic economic explanation of the dramatic rise of oil prices so far this year -- supply-and-demand fundamentals. I have heard the same opinion from a contact in the oil industry, and read it elsewhere -- while U.S. oil demand has cooled, global demand is growing, and between Middle Eastern instability and a weak dollar it's not surprising prices are high.

No doubt this accounts for much of what lies under the price of oil (they're called "fundamentals" for a reason). And as we continue shelling out money for gasoline and review massive profit reports by big oil companies this week, and as the price of oil remains high, it's worth mulling over a thesis about another contributing factor.

Reading the wild history of oil trading The Asylum taught me that the market has gone through a complicated and massive shift in just the past few years. Hundreds of billions of dollars of money has flooded into the futures marketplace from "non-physical" oil traders, meaning investors who are hedging or betting or otherwise interested in this commodity. To be clear, this is not merely dreaded "speculators," although it includes them too. For example, it includes commodity indexes and if you have a 401(k) or a 403(b) seeking high returns, you may well be part of this phenomenon too. And it has been facilitated by the advent of electronic trading

The growing role of non-physical traders is just one part of a very complicated process of "price discovery" as described in painstaking detail by University of London Professor Bassam Fattouh in this recent paper.

It is also the main topic of another book on oil by Dan Dicker, a NYMEX trader for more than 20 years, who has been witnessing firsthand the influx of new buyers and money: Oil's Endless Bid (here's an excerpt and here's an interview with him yesterday).

It's important to understand conceptually what's happening as this money turbo-charges the futures market, ultimately affecting the price we pay at the pump, so pardon me while I quote from Dicker's book somewhat extensively about the actions of one specific index:

Tracking the prices of commodities through indexing had been around for years, but they had been created for academic purposes. That changed in 2000, with the passage of the Commodity Futures Modernization Act (CFMA) under President Bill Clinton and then-Fed Chairman Alan Greenspan. The CFMA opened the road for new commodity swap instruments to be created away from the regulated exchanges and over-the-counter trading...and also paved the way for the sale and marketing of commodity indexes as an insvestment. Many competitors began to devise instruments to capture the price of commodity indexes...

As money began to flow into them, it wasn't surprising to see one index product separate from the crowd to become the benchmark: The Goldman Sachs Commodity Index (GSCI). During the early years of my career on the floor in the 1980s and 1990s, the only well-known and reliable commodity index ever referenced was the Reuters-created Commodity Research Board index, far and away still the best recognized index in 2000 when the CFMA was passed. Yet when commodity indexes became investable and big money, the index from Goldman Sachs was quickly able to dominate and dwarf the older and better-established CRB.

...[T]he GSCI index is weighted overwhelmingly into energy commodities, comprising more than 70% of the index as of February 2010. In addition, the GSCI is nominally twice as big as all other commodity indexes combined. Their dominance allows this particular index game to work like an endless circle: overwhelming interest in oil fuels a deeper weighting into petroleum products, which subsequently adds more interest to and investment money into oil. It's a tidy trick. Goldman Sachs and its index managers can sell a sexier product and make a tidier profit by promoting their weightings more deeply into the most volatile commodities, and no commodity has been more volatile recently than oil.

Then comes the punchline further on in the chapter about indexes and exchange-traded funds: "Money seeks to buy, and only buy, oil through indexes. The other natural side of the futures trade is missing. The only way you can encourage people to sell something they really don't want to sell is to offer an outrageous sum for it." And this, according to Dicker, is how you get to "oil's endless bid." The problem, of course, is that oil isn't stocks; while many of us might benefit from higher returns to a 401(k) many more of us lose as the price pulls the price of gasoline at the pump up.

I think Dicker's is a pretty controversial idea. But, as I sit here looking at some media coverage of the explosive, comprehensive bi-partisan report on the financial industry's role in the economic collapse we're living through (Sen. Levin colorfully summed up: "Our investigation found a financial snake pit rife with greed, conflicts of interest, and wrongdoing."), and I read Dicker's latest column in HuffPost in which he claims the price of gasoline would drop if we addressed this particular factor in its rise, I can't help but think he's onto something.