Those Hedge Funds Are At It Again!
Along with the routinely enumerated causes for the sharp escalation of oil prices in the last year, the role played by hedge funds is coming under increasing scrutiny and criticism. According to the Financial Times, the Japanese government is calling for "international discussions" on this aspect of high oil prices, though it isn't clear exactly what that means or what it might accomplish. Despite this, and in the face of the obviously serious potential consequences for the economy of sustained high oil prices, I would suggest that the concerns about hedge fund activity are overblown, at least for now.

Many of my readers have access to better statistics of hedge fund open interest on the New York Mercantile Exchange and other international oil commodity markets than I do, so I'll confine my comments to the issues, not the numbers. It does appear that hedge funds have taken a strong interest in oil futures and options, particularly as other markets have slowed. It also appears that their analytical tools drive them to increase their open positions in oil as prices go higher, adding to both the overall level of the market and to volatility, the main measure of market variability. In the short run, this creates a sort of self-fulfilling prophesy: previous futures positions appreciate as prices rise, and the value of long options grows with increasing market volatility.

But there are several ways in which the market for physical oil is buffered from these gyrations. First, although the daily trading volumes for the NYMEX West Texas Intermediate Crude (WTI) contract and the London Brent Crude futures contract are enormous relative to the actual volumes of these two grades of oil, they are not as representative of the market as a whole as some might think. While many contracts for physical crude oil are pegged to WTI or Brent, a great deal of the world's oil is too dissimilar from these light, sweet grades to be traded solely based on the futures markets. Nor is all of the world's crude actually delivered to the physical settlement locations of these futures contracts, such as the US Gulf Coast.

As a result of these factors, oil of substantially different quality, or for delivery to other locations, usually trades on the basis of a "differential" to WTI or Brent, that is, with an agreed amount added to or subtracted from the quoted daily or monthly price for the "marker" grade. For example, a cargo of heavy, high-sulfur oil delivered to the US West Coast might trade at $5.00 per barrel below WTI.

When the price of the marker crude becomes distorted by local conditions, such as unusually high or low inventories of oil in the US Midcontinent, or by excessive speculation, the differentials for the physical delivery of other grades--always in flux, anyway--will widen or shrink to take this into account to some degree. Imagine, for instance, that speculators have driven WTI up by $2.00 per barrel at the same time that increasing physical invetories of oil would suggest a drop of $2.00 might be more appropriate. The discount for that notional West Coast heavy sour cargo would probably widen from $5.00 per barrel to $6.00 or more, reflecting lower demand for it elsewhere due to higher inventories.

In addition to such cargo-specific factors, a large quantity of oil is traded on long-term contracts at prices that are not directly influenced by the futures markets. The combination of these factors means that the cost of much of the oil that is delivered to refiners around the world is at least partially protected from speculative swings in the price of the futures markets.

There's a cautionary note here for hedge funds and their investors, too. As with other markets, oil markets that get too far out of line with the underlying realities of the commodity have a tendency to correct with a vengeance. The hedge funds would not be the first to try to "corner the market" in oil, though they might be the deepest pockets to try it. The history of the industry is littered with commodity traders who built up a fabulous position but got their heads handed to them when the market finally corrected. Perhaps the funds are too sophisticated to get caught this way, but I wouldn't bet on it, which is exactly what they seem to be doing.