Think Moammar Khadafy's behind the rise in gas prices? The true answer may be a lot closer to home. Here's what really influences the price of oil, and how you can hedge against higher prices.
Many Americans seem mystified when it comes to what’s happening with oil. They wonder – quite reasonably – how American gas and oil can gush so far so fast based on political upheaval in a country from which we buy no oil. And rather than making it more clear, many news reports make it more confusing by laying the entire blame at the doorstep of some current news event. From a story at CNN Money…
Investors are keeping a close eye on commodities, after crude oil rose to more than $106 a barrel early Monday on continued tensions in Libya.
In short, the media would have you believe that Moammar Khadafy’s problem is your problem. And while that’s partly true, that’s not the full story. Because the only way problems in Libya should be able to influence the price of oil is if those problems resulted in a supply problem. And there’s no supply problem.
Youcef Yousfi, Algeria’s minister of energy and mines told CNBC that there is no supply panic, no shortage of oil and that part of the rise in oil prices is due to speculation.
So what the heck is going on here? To understand, let’s take a closer look at just how oil is priced.
Who’s not pushing up the price of oil
When you go to the store to buy a shirt, the wholesale price is established by the manufacturer, the retail price by the retailer. Simple. But when it comes to commodities like corn, wheat, soybeans, gold, copper, oil, gasoline and dozens of others, the story is entirely different.
The price of oil and gasoline aren’t set by Exxon, ConocoPhillips, or any other “manufacturer” – instead, they’re set in an auction market that takes place every weekday on a futures trading floor in New York, as well as other places around the world. As with an online auction like eBay or a live auction at Sotheby’s, buyers compete with one another, bidding up prices until the auction ends with a seller accepting the buyer’s offer – it’s called the “clearing price,” the price where supply and demand meet.
So the price you’re paying at the pump isn’t a reflection of what Exxon demands for the oil it has, nor is it related, at least directly, to the political stability of places like Libya. Instead, prices are tied to the number of buyers and sellers showing up at that day’s auction and the clearing price that results.
Who’s at the auction?
You would think that the auction for oil would have only two types of participants: companies that dig oil out of the ground and want to sell it, and companies that operate things like airlines and refineries and want to buy it. Since oil is auctioned in contracts of 1,000 barrels – 42,000 gallons – who else would go to an oil auction?
The answer is speculators. They have no oil to sell, and they certainly aren’t there to pick up 42,000 gallons of crude. They’re attending the auction simply to bet on the future price of oil. They’re hoping to buy (or sell) a bunch, wait for the price to rise (or fall), make money, and be out of their position long before the delivery date rolls around.
The problem is that if a bunch of well-heeled speculators hop on the buying bandwagon, they move prices – sometimes by a lot. That’s what’s been happening in recent weeks.
From another CNN Money story…
“It does not get any clearer which way Wall Street is trying to take oil,” says Stephen Schork, who writes the Schork Report energy markets newsletter in Villanova, Pa.
Schork notes that speculators now own nearly six times as many barrels of oil – 268,622 futures contracts representing nearly 269 million barrels – as can be stored at the West Texas Intermediate trading hub in Cushing, Okla. (Editor’s note: This is the nation’s largest storage site for this type of oil.)
In short, speculators are bidding up the price of oil by contracting to buy more oil than can possibly be put anywhere. What will they do when it’s time to actually take delivery? As I said above, they won’t hold the contracts that long – not their problem.
Is it fair?
Whether it’s fair for giant hedge funds and other speculators to influence the price of commodities is a complicated question, which is probably why it’s so rarely addressed in the media. It’s certainly not fair if one or more parties can exercise enough influence to manipulate the market. That’s why Congress tried to make this type of trading more transparent with last year’s Dodd-Frank Wall Street Reform and Consumer Protection Act. (I explained how that might help in an article I wrote back then called 5 Ways You’ll Profit From Financial Reform.)
But markets as big as the oil market aren’t easy to manipulate. And having free and open markets is the core of capitalism. I called the guy mentioned in the CNN Money article above – Stephen Schork – and talked to him about the fairness of the oil market. Schork explained that not only is having speculators in the market fair, it’s essential. Because by helping to establish clearing prices, speculators actually keep the supply of oil flowing.
Think of it this way. When speculators buy, they drive up the cost of oil. That, in turn, provides an incentive for companies like Exxon to go out and dig it out of the ground. When Exxon digs more than is needed, those same speculators sell oil, forcing prices down.
In short, speculators help keep markets in balance – as long as the trades they’re making are transparent and they don’t have the ability to manipulate prices, they’re a healthy addition.
So the next time you hear some talking head on the evening news tell you that oil prices are higher because of unrest in the middle east or elsewhere, remember: That’s not why oil prices went up. They went up because people on a trading floor decided that for whatever reason, they were willing to bet prices were heading higher, and they wanted a piece of the action.
Another thing to remember: You can do what they do. Back in December, I wrote a post called 28 Ways to Save on Gas You Already Know – and Maybe One You Don’t. The “One You Don’t” refers to my suggesting buying shares in oil company ConocoPhillips, a stock that would go up with oil prices, and one I own in my personal portfolio. At that time, the stock was $64. As I write this, it’s $80.
Of course, even if these markets are ultimately fair, and you have the means to hedge against higher prices by buying stocks or commodities, the vast majority of Americans don’t. What do we say to the people who are now cutting back on groceries so they can pay for the gas to get to work?
I asked Mr. Schork that exact question. His response? “Are you kidding me? Most Americans are way more interested in what Charlie Sheen is doing than oil prices.”