RAY SUAREZ: Oil sells for over $135 a barrel, more than double what it was a year ago. Some on Capitol Hill are asking whether market speculators after a fast buck are partly to blame for record high prices.
Members in both houses and from both parties have introduced legislation. This morning, Democratic Senators Bill Nelson and Byron Dorgan brought forth a measure to curb speculation.
SEN. BYRON DORGAN (D), North Dakota: This is a run-up in prices on a commodity exchange that has been ballooned by excess speculation.
RAY SUAREZ: A House hearing took up the issue yesterday. This morning, it was the Senate Homeland Security Committee’s turn. Michael Masters runs a hedge fund which he says does not trade in commodities like oil.
MICHAEL MASTERS, Masters Capital Management: We’re not arguing that index speculators are the only reason that prices have gone up, but we are suggesting that they have greatly amplified a positive price trend.
I think, over the short term, if you did this, I think that it’s very likely that prices for food, energy commodities would come down hard.
RAY SUAREZ: But James Angel of Georgetown University Business School said speculation is nothing new and legislative remedies are of limited use.
JAMES ANGEL, Georgetown University: What will bring prices down is a credible action by the United States that signals to the rest of the world that we are serious about transitioning away from imported petroleum.
RAY SUAREZ: The United States imports 58 percent of the oil it consumes. Much of it comes from the world’s most volatile regions.
Beyond the Middle East, with its episodic instability, several other oil-producing nations face supply disruptions or production shortfalls, among them the West African country of Nigeria. It’s the world’s eighth-largest exporter, but its industry is under constant attack from a rebel group in the Niger River Delta, as it was again in the past few days.
This past weekend, Saudi Arabia, the world’s largest oil exporter, convened an emergency meeting on the issue of supply. Saudi King Abdullah addressed the assembled delegates.
KING ABDULLAH, Saudi Arabia (through translator): There are several factors behind the unjustified swift rise in oil prices. And they are: speculators who play the market out of selfish interests; increased consumption by several developing economies; and additional taxes on oil in several consuming countries.
RAY SUAREZ: The meeting ended with promises of modest production increases.
While American demand has been curbed slightly by high prices, China and India are fueling record economic growth with high demand for petroleum.
Why is the price of oil so high?
RAY SUAREZ: And we look at what drives higher oil prices with energy analysts who report on this field in their own newsletters. Peter Beutel is president of Cameron Hanover, an energy risk management firm in New Canaan, Connecticut.
And Stephen Schork is the president of The Schork Group. He also consults for major oil firms, OPEC member countries, and hedge funds.
So, gentlemen, if I ask you first, Peter Beutel, to give me a quick tour of petroleum economics, why is the price of oil now so high?
PETER BEUTEL, President, Cameron Hanover: Well, there are lots and lots of factors. I would have to say that, since August or September, probably the biggest single factor was the fact that the Fed tipped its hand and let everybody know that it was going to cut interest rates. That put selling pressure on the U.S. dollar.
And since commodities are denominated in dollars, that has made all commodities cheaper for Asians and Europeans. And it's meant that Americans have had to bid the price higher.
But there are a lot of factors here. Certainly, there is more demand than supply, although demand is now falling. China has been subsidizing energy prices, and that's created artificially high demand.
We have had lots of problems in Nigeria, ongoing now for about a year. We've had lower refinery runs, a curious little thing. Gasoline prices are not as strong against crude oil as they were, say, a year or two ago. And that's meant that independent refineries or people without oil in the ground have not been able to run as much.
So it's a combination of factors, but if you ask me, who is the biggest culprit in the last 12 months? Curiously enough, it's been the Federal Reserve.
RAY SUAREZ: Stephen Schork, first, do you agree with that analysis? And how would you explain a doubling over the last year?
STEPHEN SCHORK, Energy Analyst: Absolutely. I am on board with Peter with the Federal Reserve's decision in August.
We have to remember that, in January of 2007, crude oil was below $50. Now, we moved from $49.90 back in January to on the cusp of $80 by the end of July 2007.
Now, if you look at the net length held by large traders, quote, unquote, your "speculators," your large hedge funds, they were holding record length at the end of July.
Well, what happened last August? You had the credit meltdown. And, therefore, you had all these hedge funds that also had large positions in the commodity markets who also had large positions with exposure to the credit meltdown.
Therefore, when those markets began to get hit and the margins started racking up, these hedge funds had to sell. We know they sold because, at the end of July, like I've just said, they were holding record length, the net obligation to own 127 million barrels of oil at some point in the future.
Four weeks later, at the end of August, these funds were holding only 21 million barrel obligations. They sold the equivalent of 100 million barrels inside of four weeks. Therefore, that drove the price down of oil from about $80 to back below $70.
Now, in September, as Peter just said, the Fed tipped its hand. They were going to cut interest rates. That meant a cheaper dollar. So these hedge funds that liquidated all that selling back in August started piling back into the market back in September. And prices have doubled since then.
Impact of futures market
RAY SUAREZ: Well, Stephen Schork, you used the word "speculators." That was a word in great use on Capitol Hill this week. Who is it that we're talking about? Who is it that trades notions about what oil is going to cost three months, six months a year down the road?
STEPHEN SCHORK: Well, the speculator is a very broad term. They've been in the futures markets. Without the speculator, you would not have futures markets. You would not have someone telling you about the disconnect between supply and demand. And this is what the speculator is telling us.
So this speculator is, hey, it's Goldman Sachs, it's Morgan Stanley, it's the 97 hedge funds that have been created over the last year that focus specifically on hedge funds. It is also the doctor, the lawyer that has the disposable income that's plowing money into the index funds.
And this is because, first and foremost, great returns. The fundamental outlook, this is a fundamental issue that's been 30 years in the making. There's no silver bullet. We're certainly not going to have the answer by the time we go to the polls in November, regardless of what the Republicans or the Democrats tell us.
And, therefore, we know this. It continues to track investments, everywhere from the local guy on the street to the guy up in the penthouse.
RAY SUAREZ: Peter Beutel, help us a little bit more with the mechanism. Those markets that you heard Stephen Schork just describing, what do they do? Why do we have markets to make bets on the future price of oil?
PETER BEUTEL: Well, Stephen is absolutely correct, but I'll tell you the genesis of all commodities. It started with a farmer going to a banker and saying, "Look, I need money to buy seeds and to have somebody that will water my crops." The banker says, "Fine, how do I know what price you're going to have in September when you actually bring this corn to harvest?" The farmer says, "Well, I don't know."
So the farmer then went to a futures market. And the futures markets were created.
In March, the farmer goes and says, "I need to get a price for corn in September." The speculator was born. The speculator says, "I will give you $3 a bushel come September for your corn." The farmer sells it to that speculator. The speculator now takes the risk that the price will go lower, but also takes the potential reward that maybe it will go higher.
But the farmer is happy, because he can now go to the banker and say, "I will sell my corn for $3 a bushel in September. Please loan me the money." The banker gives him the money. He plants the corn.
This simple idea has been extended to a number, a plethora of different commodities, and it's the same concept, but without the speculator, this poor farmer could never get his bank loan.
What has happened now that is different than, say, what had been going on for 100 years is that now we have some traders that really don't know what they're doing. A lot of them are union pension funds, college foundations, people we normally think of as good guys.
They have been buying and holding commodities, unlike most speculators, who buy, then sell, then sell, then buy, who are equally as comfortable selling things they don't have as they are buying things they don't want.
These guys, the new investors, have been buying and holding. And this has created a different signal. The market interprets it as long-term end users. These people are really speculators, only I'd be willing to bet many of them don't even know it.
And I'd be willing to bet that, if you went and told some of these people, one, that they're helping to push the price higher and, two, what incredible risks that they're taking on that they'd be mortified that they were actually doing this.
RAY SUAREZ: Stephen Schork, you've both cited dollar weakness and supply and demand as factors, along with speculation. This week, both the House and Senate heard testimony that there was a sizable portion sitting on top of that $135 price of oil -- the estimates went anywhere from $30 to $65 a barrel -- that was pumped into there strictly by speculation.
Is it possible to separate out that part of the price that's being created by the way the market mechanism is working right now?
STEPHEN SCHORK: The only way you can really do it is look at the current price path. Now, oil prices have from moved from the start of this bull run in the fourth quarter of 2001 up until about the third quarter of 2007. Prices moved from $20 to $60 -- excuse me, $20 to $80, a $60 move. We have moved another $60 above and beyond that.
Now, a commodity is generally thought of to be priced at relative -- or the growth rate of a commodity should be discounted or grows at a discounted rate of growth, plus a small convenience yield for the right of holding that.
If you based on these formulas and the current price path that we have seen, given how the fundamentals have changed over the past six years, the estimates are that oil right now is essentially fairly valued at about $95 a barrel.
This is essentially why all the major Wall Street houses back in December, when they were given us their 2008 forecast, all their average ranges ranged between $85 and $95.
So anything above and beyond that, if you want to call it a balloon, you want to call it speculation, you certainly could lop that off and said what is above and beyond now what this, quote, "fair value" is essentially this speculative bubble.
RAY SUAREZ: So you're estimating about a third of the entire price, quickly, before we go?
STEPHEN SCHORK: Oh, absolutely. This market has been moving in a linear function, but in the last two months a parabola has been drawn into this price path and prices have gone virtually straight up.
There is no doubt what we are seeing now is long-term bullish prognostications; 2, 5, 10 years down the road are being compressed into the prompt market. This has created a panic. People are moving in this market.
And it's -- hey, this is nothing unlike what we saw in the dot-com market in the late 1990s. When this bubble bursts -- and it will burst -- we're going to go right back to where we started from, below fair market value, below $95, back towards $70, when this all began last August.
RAY SUAREZ: Stephen Schork and Peter Beutel, gentlemen, thank you both.
STEPHEN SCHORK: Thank you.
PETER BEUTEL: Thank you.