Oil Speculators: Manipulative Evil Masterminds or Just Savvy Investors?

As the price of oil climbed over the past few months, a growing army of commentators and pundits grimly hinted about "speculators" who were manipulating the oil market and profiting from the misery of the American people. In the darkest depictions, these speculators were alleged to be aligned in a vast, global cabal bent on squeezing money out of the U.S. middle class by driving up the price of crude.

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These rumblings about speculators are hardly surprising: They echo the groundswell that emerged three years ago, the last time that gas prices exploded. For that matter, there's no doubt that oil speculators exist: Oil futures are traded on the New York Mercantile Exchange (NYMEX), as well as on London's Intercontinental Exchange (ICE) and through direct sales. But do those speculators wield the diabolical, nearly omnipotent power over the market that some critics claim, or are they -- like the drivers who are now paying close to $4 a gallon for gasoline -- merely riding pre-existing trends?

Supply and Demand vs. Speculation

In all likelihood, the answer is a bit of both. The traditional explanation for gas prices is that they move based on supply and demand: Put simply, there is a limited supply of petroleum available on world markets at any given time, and as a rapidly growing number of people in emerging economies like China and India buy cars and become drivers, Americans must compete for fuel in an ever-more-crowded marketplace.

With more drivers clamoring for a share of that limited supply of gas, oil companies, refineries and gas stations can charge more, and the price goes up. But rising prices may lead drivers to cut back on their gas consumption, which increases the available supply and pushes the price back down.

According to speculation theorists, this supply-and-demand equation is being short-circuited by commodities traders, who push the price of gas up in order to reap a quick profit. These traders buy oil futures at low prices using mostly borrowed money, encourage the price to rise, then sell the futures at the new, higher price and collect the difference. Meanwhile, when oil producers see the market rising, they try to hold on to their crude so that they, too, can sell it at an inflated price -- which reduces supply further. Between the traders and the producers, oil prices shoot up, torturing drivers.

The Disappearance of Oversight

Up until a few years ago, oil speculation wasn't really a problem: Crude oil futures could only be bought and sold on the NYMEX, where they were regulated by the Commodity Futures and Trading Commission (CFTC), a government organization that was created in 1974 to -- you guessed it -- protect the market against speculators. For decades, the CFTC did its job well, watching over sales of oil futures and ensuring that investors didn't drive up prices to make a profit at the expense of consumers. But in 2000, everything changed.

That year, two events effectively crippled the CFTC. The first was the passage of a provision of the Commodity Futures Modernization Act -- sometimes called the Enron loophole -- that made it legal for companies to trade oil futures outside of the NYMEX in what are called over-the-counter (OTC) trades. The same year, the London-based Intercontinental Exchange made it possible for investors to buy and sell European oil futures, and offered a platform for OTC trading. In addition to driving up the global price of oil, futures trading on the ICE began to have a direct impact on U.S. gas prices in 2006, when the ICE gained the right to list U.S. oil futures. Since the CFTC could only regulate trades on the NYMEX, those events made it possible for speculators to escape oversight.

While it's difficult to prove whether or not speculators are directly responsible for high gas prices, most analysts agree that some portion of the current high cost of gas is attributable to the buying and selling of oil futures. After the sharp rise and steep fall oil prices took in 2007 and 2008, investigators found that 81% of gas contracts on the NYMEX had been held by speculators. In fact, 11% were held by a single company, Vitol. With that kind of pull, anti-speculation analysts argue, there's no question that oil traders can manipulate oil prices.

We Have Met the Enemy and He Is Us

But are gas speculators really the diabolical masterminds that some analysts have made them out to be? Fred Rozell, director of retail pricing for the Oil Price Information Service argues that these investors aren't malicious.

"Oil is a good bet for investors who are looking to reap a solid return on investment," he says. "This is especially true in the current economic climate, as a slowly improving economy points to increased consumption and tensions in the Middle East are fueling fears of a supply disruption." In fact, Rozell notes, many of these oil speculators are 401(k) plans that benefit middle-class consumers.

Beyond that, there's always a seasonal increase in the price of fuel. In the spring, gas companies switch over from their winter-grade fuel to their summer-grade. The summer mix contains different additives that, according to the EPA, cut down on pollution. To make the summer-grade fuel, refineries have to briefly shut down, a move that causes the price of gasoline to shoot up. Rozell calls this seasonal increase the "petronoia rally," as the brief gas shortage fuels paranoia among consumers and investors. He notes that gas prices usually peak in early May, then slowly decline.

What Can Be Done?

With high gas prices threatening America's fragile economic recovery, many people are asking what can be done to curb speculation. Last month, the Department of Justice launched the Financial Fraud Enforcement Task Force, which is tasked with fighting illegal oil speculation. While this might help somewhat, the sad fact is that most oil speculation occurs legally on the NYMEX, the ICE and in OTC trades. Ultimately, the solution is to increase the power of the CFTC.

Last year's Dodd-Frank Wall Street Reform and Consumer Protection Act was designed to do just that: Among other things, it gave the CFTC the power to regulate OTC trades. However, conservative opponents of the law have fought against its implementation: U.S. Reps. Darrell Issa (R-Calif.) and Michele Bachman (R-Minn.) introduced legislation to repeal the law, and Rep. Frank Lucas (R-Okla.) recently proposed H.R. 1573, which would delay its implementation until 2013.

If the Dodd-Frank Act's provisions go into effect, they could go a long way toward stabilizing gas prices, which would be a major boon for consumers. If not ... well, public transportation is looking more and more attractive.

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