The curious case of the supply-defying rally in oil

May 3, 2011: 5:00 AM ET

The current run-up in oil prices has little to do with oil fields in the Middle East and Texas, and everything to do with Wall Street's access to easy money, thanks to the Federal Reserve.

By Cyrus Sanati, contributor

FORTUNE -- When Federal Reserve Chairman Ben Bernanke fielded questions last week on rising commodity prices, especially that of oil and gasoline, he calmly noted that the Fed had little control over them and that this latest run-up in oil was more a supply and demand issue than a monetary one.

oilBernanke is only half-right. He is correct that the Fed has little to do with how much oil hits the market. As Bernanke said to reporters, "after all, the Fed can't create more oil." That would be all the explanation needed if demand for oil was very strong and supplies were tight.

But that isn't the case these days. Missing in his explanation was the role that Wall Street plays in the oil market and how it has been able to pour excessive amounts of money into the market, thanks in part to the Fed's easy monetary policy. So while the Fed isn't totally to blame for the high oil prices, it certainly bears some responsibility for it.

Trying to gauge where oil prices are going is a dangerous game. For years, prices moved pretty much on the basic economic fundamentals of supply and demand. Buyers would pay market prices to obtain oil based on the amount of supply available. But the oil trade has changed dramatically in the past decade as Wall Street decided to view oil more as an asset class, like equities, and a store of wealth, like gold, than just a commodity used to make gasoline and heating oil. Passive investment vehicles, like pension funds, which typically have a long-term investing thesis, have parked billions of dollars into the oil market, creating an upward spiral in prices. Speculators and momentum traders have joined the party too, driving prices up and down, irrespective of the fundamentals of supply and demand.

Debunking the 'supply and demand' defense

This latest run-up in oil prices is rooted more to the trading floors of New York, Chicago and London than to the oil fields of the Middle East and Texas. The fundamentals of the oil market today appear balanced with oil production covering consumption.

Let's look at two metrics: OPEC oil production and U.S. oil storage. Back when oil was last above the century mark in 2008, OPEC was producing at full tilt with a spare capacity of just 1 million barrels a day. As spare capacity dwindles, prices tend to rise. But today, even with Libya's production removed due to its civil war, OPEC has a spare capacity three times that of 2008 at 3.2 million barrels. Capacity upgrades across OPEC are only expected to increase in the next few years.

As for oil storage, the U.S. currently has around 54 days of oil supply in storage tanks across the nation, which is 7.7 more days than it had in storage when oil prices were at their zenith in 2008. It is also well within the five-year average for this time of year. Total crude stocks of 363 million barrels are at their highest level since November and 5.3% above their five-year average for this time of year.

So there doesn't seem to be a supply or demand issue. Sure, demand from China and the developing world is strong and growing. But the world is pumping enough oil to cover the extra demand and will continue to do so. Furthermore, the increase in oil consumption by the developing world has been partially offset by a drop in demand from the U.S. and other western economies.

If fundamentals aren't the major issue here, what is? Some blame the falling U.S. dollar for the recent spike in oil and other commodities. After all, oil is priced in dollars and the dollar has weakened in recent months against other competing currencies. A weakening dollar does come into play here and it does have something to do with the Fed's easy money policy, but it's hardly a major factor in the run-up in oil prices.

For example, in March of 2009, when the dollar index was at its highest point following the financial crisis at 89.49, oil was trading at around $47 a barrel. The dollar index is now at its lowest point since 2008, down around 18% to 73.5, while oil is up 140% to around $113 a barrel. If one readjusts the price of oil based on change in the dollar index, oil should be around just $55 a barrel.

So with fundamentals and currency adjustments taken out of the equation, what's left? There has certainly been a sizable geopolitical premium built into the price, thanks to the recent uprisings in Middle East and North Africa. But again, the headlines seem worse than the reality. The only major oil exporter that has seen its production severely disrupted due to the protests has been Libya and it supplied just 1% to 2% of the world's oil. Meanwhile, uprisings in the oil rich Persian Gulf states have either been crushed or failed to gain traction.

The recent capture and killing of Osama bin Laden is the latest geopolitical event to justify higher oil prices. Traders worry that his death might spark al Qaeda to attack oil installations. But there is no real causal link between the two events. Al Qaeda has focused its attacks mostly on military and social targets as opposed to economic ones. Besides, the terrorist network is strongest in failed states or states that really don't have much oil.

The long bet gets longer

That leaves Wall Street. Money managers have bid up oil prices and parked billions of dollars into the market, taking mostly bullish bets on crude. This has pushed prices up, some say artificially, to levels that defy the fundamental realities of the market.

The CFTC's latest Commitment of Traders report, which shows the various long (bullish) and short (bearish) bets Wall Street has made on various commodity markets, helps illustrate this. The report for the week ending April 19 shows money managers were long on oil 14 times more than they were short. The cumulative net long position they held in the oil market was near an all time high, indicating that a ton of people were not just betting on oil but were betting it was going to rise. This bullish momentum has a pull on prices, creating a tight upward spiral.

There is little the Fed can do to prevent speculators from betting on oil prices -- that's the jurisdiction of regulators and the exchanges. But the Fed does have the indirect ability to cut the money supply, thereby making it more expensive for everyone to borrow cash and bet on oil.

The Fed faces a difficult choice. If it raises interest rates, the economy will slow and unemployment will most likely increase. If it keeps rates low, asset bubbles will appear due to all the extra money sloshing around the economy. In the last decade, all the easy money flowed into the U.S. housing market and later showed up in commodities. With the housing market still in the dumps, all the easy money seems to be pouring straight into commodities.

Nevertheless, the laws of supply and demand will eventually kick in. Bernanke did call the current run-up in commodities "transitory." He is right there, but it could take a long time for this transit to move into retrograde. Nevertheless, while traders can ignore weeks of supply builds and lackluster demand, they can't turn a blind eye to the fundamentals forever.

With the oil market this overbought, it could take just one fiery conflict to cause traders to stampede out of the barn.

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