October 10, 2008

Commodity prices are a key component driving the American economy. But have such prices lately been the result of supply and demand or of excessive speculation?

Juxtaposing the positions provides an enlightening look at some of the factors that are controlling energy prices. Today's economy is fragile and concerns abound over whether recession is looming, creating weaker demand for most products and services that include oil and natural gas. With fewer buyers, prices fall. This scenario, in fact, has been occurring as commodity prices have been dropping.

But an interesting analysis by Energy Solutions proffers up the notion that the current financial crisis is also playing a critical part in the price volatility. According to Valerie Wood, president of the Madison, Wis.-based consulting group, the run-up in oil and gas prices has been facilitated by investors fleeing stocks and placing their money into commodity index funds comprised of many underlying assets that include oil and gas.

Such funds are inextricably tied to the investment banks, which are either heavily invested in them or are pushing these funds to others. Take S&P Goldman Sachs, which was involved with a fund that had 40 percent of its assets in oil and 6 percent in natural gas: Its projections that oil would rise to $200 a barrel were partly self-serving, says Wood.

"Speculators have always been in the market and we do need them there," says Wood. "They create the liquidity necessary to make a market function. But we think that there has been lots of buying -- promoted by the brokerage houses -- that have pushed up prices. When financial institutions such as Bear Stearns got out, there was a huge price decline even though there was no fundamental change in supply and demand."

She concludes that the rally was driven by speculation and the recent decline was precipitated by firms exiting the market. Speculators, historically, have been the large institutional investors that control pension funds. But this year such risk taking has evolved and now involves average citizens. They have been persuaded to invest en masse in commodities' index funds in an effort to earn bigger returns and to avoid instability in the stock market.

To bring some semblance to markets, Wood says the amount of "new" money flooding commodities funds must slow. Until this happens, it will exacerbate any supply and demand distortions or it will offset such fundamentals if they happen to be aligned.

Is this current phenomenon a form of market manipulation or is this the workings of a capitalistic economy shifting its resources? Markets are efficient and as such, reflect all public information. The logical result of free markets, says Wood, is that it would have been smart to invest in commodities in the first quarter. But, now, that strategy may prove to be a risky one. "This year has been an anomaly. It's too hard to explain the day-to-day price moves and much more so than in the past."

Global Demand

By her own admission, Wood says that the position she takes is in the minority. Most economists -- and certainly oil and gas producers -- say that increasing demand, from such emerging economies as China and India, is pushing up prices.

To put the matter in perspective, this country comprises about 5 percent of the world population but uses about 30 percent of the energy. Clearly, China and India will be bidding on the same resources as the United States. Prices will invariably rise. In fact, the U.S. Energy Information Administration projects oil consumption to increase by a third through 2030 while electricity demand will rise by 50 percent over the next decade.

Pragmatics then suggest that global and domestic enterprises need to increase oil and gas supplies if prices are to be tempered. But the school of thought that places blame for price spikes on excessive speculation says the issue is more complicated, that stricter government oversight of commodities markets would help mitigate potential distortions.

While it is true that the federal government is actively involved in trying to shore up financial markets, it only has so many resources. To date, though, it has assisted with the bailing out of Bear Stearns while literally propping up Fannie Mae and Freddie Mac. Congress, meanwhile, has passed legislation to shift banks' bad loans off their balance sheets and onto the books of the federal government.

At the same time, lawmakers are also discussing a complicated bill that would put numerous restrictions on commodities' index funds. The bills, which are floating in both the House and Senate, would among many other things set position limits across exchanges and over-the-counter markets. Introduced in August, the House seems prepared to pass a moderate version before sending it along to the Senate.

"If Congress returns for a 'lame duck session' in November, we think that the Senate may find time to return to the speculation theme and this bill may have a decent chance of finding its way into law," says Christine Tezak, regulatory analyst with Stanford Group, noting that the measure could just as easily be delayed until next January.

In any event, the overriding point is that oil and gas markets are getting pressure from multiple angles. With business and consumer confidence falling, the demand for goods and services will decline as well. That dynamic in combination with rising storage levels should put downward pressure on prices, but investors are leaving equity markets for commodities' funds, which work to offset those basic fundamentals.

The market will eventually reallocate capital. Until then, though, the threat of further oil and gas price spikes will hover and potentially jeopardize any economic recovery.

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Ken Silverstein EnergyBiz Insider Editor-in-Chief
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