Colin Barr

Following the money in banking, economics, and Washington

Don't sweat the oil speculators

March 10, 2011: 6:41 AM ET

Rounding up the speculators sounds almost as appealing as killing all the lawyers. But neither will cool seething crude prices.

That is a point worth considering as oil markets run wild. Big traders are making a record bet that crude prices, up 26% over the past year, will rise further as unrest rattles the Middle East.

Notice the trend?

It's tempting to view that bet as irresponsibly driving up gas prices and endangering a tepid economic recovery. How can market fundamentals that justified $80 oil six months ago do the same for $105 oil now? Can't we blame some dark conspiracy?

Alas no. The reality is that bets on higher oil prices are little more than a rational response to steadily rising fuel demand in a world of increasingly uncertain oil supplies.

Governments in Tunisia and Egypt have fallen, and other oil-producing countries face threats of their own. Political problems aside, there are questions about whether the big oil exporters actually have it in them to fill in for further supply disruptions.

And if Saudi Arabia can't pump as much as we think or is running down its inventories faster than we expect, we could soon face a world in which $105 oil and $3.50 gasoline look like a bargain.

"When supply struggles to keep up with demand, the market becomes vulnerable to speculative demand shocks driven by concerns about events that have not happened yet," says Lutz Kilian, an economist at Michigan who has studied the oil shocks of the past four decades. "It is fashionable to argue that this phenomenon is distinct from supply and demand, but that is nonsense."

Kilian says that in a world of tight and uncertain supply and steadily growing demand, traders start to like the risk-reward profile of buying oil futures contracts in anticipation of future shortages.

In effect, it is this demand for oil inventories that has been driving prices up since Egypt and Libya came under pressure. Naturally, given the oil-importing world's dependence on crude from Saudi Arabia , the effect could be even greater if unrest breaks out there.

The Saudis have been saying they can pump up the volume if there is further disruption to other exporting countries. But talk of oil going to $140 or $150 a barrel starts to look distinctly reasonable if you consider what might happen if it turns out Saudi output isn't what we think – let alone where prices might go if things get ugly politically.

Analysts at Bank of America Merrill Lynch say oil could trade as high as $240 a barrel over the next year, were the dominoes to start falling.

That is not their base case, mind you. Most Wall Street economists are still expecting oil to average around $100 or so for 2011, which obviously assumes the Middle East simmers down and the global recovery creeps ahead.

But if something does come unglued, there is not a lot the United States can do about it. Though the gadflies may buzz about cracking down on futures trading or releasing fuel from the Strategic Petroleum Reserves, our failure to take things like conservation seriously mean that as usual we are struggling to fix a long-term problem with a short-term mindset.

"People talk about the market being broken, but what's really broken is that people going to work can't choose to stop using gasoline," said Lisa Margonelli of the New America Foundation, who grapples with this problem at her energytrap.org web site. "The yelling about speculators is beside the point."

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About This Author
Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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