‘Hot money’ helps drive oil volatility

By Michael R. Sesit and David Reilly –
LONDON — For investors in the oil market, the ride keeps getting wilder.
When news of terror attacks in London broke last Thursday, “black gold” plunged about 7 percent, then rebounded 6 percent — all within a few hours. Such massive one-day swings are rare, even in typically volatile commodity markets. But oil investors might have to get used to them.

With the price of oil having doubled over the past two years to about $60 a barrel, the market is on a knife’s edge. Because of tight supply and gargantuan demand, $100-a-barrel oil may not be out of the question, some analysts say. Yet if, as some others believe, energy demand is peaking, particularly in China, the price could just as easily tumble to $30 a barrel. Into this fundamental disagreement steps more and more so-called hot money chasing a fast profit.
Of course, natural disasters or man-made shocks, such as severe storms or political revolutions, have always caused oil prices to fluctuate. On Tuesday, after news emerged that BP’s Gulf of Mexico Thunder Horse offshore platform — the biggest in the world — was found severely damaged after Hurricane Dennis — the price of oil in New York soared 4 percent to $61.25. It later gave back some of the gains to close at $60.62, a 3 percent rise from the previous day’s close. Wednesday on the New York Mercantile Exchange, crude oil for August delivery settled at $60.01 a barrel, down 61 cents.
What has changed is the market’s ability to deal with short-term crises. Until a few years ago, a sharp price shift would be tempered by the view that oil ultimately would have to move back into line with long-term price assumptions. These consensus views, which help people calculate the price they are willing to pay today for oil contracts coming due anywhere from five to 10 years down the line, were based more on oil-industry economics than short-term supply-and-demand factors.
Analysts generally agreed the long-term price of petroleum, largely derived from the likely cost to produce a barrel of oil, was $20 to $25 a barrel. In October 2000, when the USS Cole was attacked, the spot price for oil for immediate delivery rose to about $38 a barrel from about $35, but the price of oil for delivery in five or 10 years hovered around $20. The gap reflected the view that at some point, prices would fall closer to long-term production costs.
Now, longer-dated contracts have risen with spot prices. Wednesday, five-year contracts were trading at about $57 while the spot price was at about $60. This reflects uncertainty about the appropriate level for future prices based on production costs and on where future supply will come from, said Jeffrey Currie, head of commodities research at Goldman Sachs in London.
Analysts and investors are perplexed by new and unpredictable factors in the energy system: the thinnest margin of spare oil-pumping capacity in decades, the rapidly growing oil demand of China, rising taxes in developing countries that will boost the cost of producing oil and the growing role of speculators and other financial investors in the oil markets.
That is translating into more-extreme market moves. In the wake of the Sept. 11, 2001 attacks, oil fell about 25 percent on fears of a slump in travel, tourism, consumer confidence and global economic growth. That drop took nine days to play out.
On July 7, after the London bombings, the front-month August contract for crude oil on the New York Mercantile Exchange fell to $57.20 from $62.10 in about 90 minutes. The $4.90 price swing was the biggest move in dollar terms since Jan. 9, 1991, although it occurred during after-hours trading in the U.S., so volume was thin, and that potentially exacerbated the move.
After investors surmised the London attacks wouldn’t have a far-reaching economic impact, prices bounced back as quickly as they had fallen, closing at $60.73.
The oil market has gathered such speed thanks, in part, to the increasing number of pure speculators who, unlike airlines, utilities and oil companies, have no direct need to buy petroleum. Many in this so-called hot-money crowd are hedge funds that use computer programs to game trends in financial markets. When these trading programs spot a big price shift, they use futures markets to latch onto the momentum, often causing a move to gain an even greater pace.
Describing last Thursday’s trading as “really insane,” Don Casturo, a senior energy trader at Goldman Sachs, said, “There’s more hot money, and that definitely was what was behind (Thursday’s) move.” Oil, he added, “is certainly more of a toy than it was in the past.”
The growing clout of speculative players in the market exacerbates the uncertainty caused by potentially too-little future supply contrasted with the currently huge, but unpredictable, energy appetite of China and India. Noting oil-company forecasts that world demand for oil will rise 50 percent in the coming 20 to 25 years, Mark Mathias, chief executive at Dawnay Day Quantum, a specialist fund-management unit of Dawnay Day Group, said: “There is not enough oil from currently known reserves to meet this level of demand for any length of time.”
Production costs are rising, too, especially because many oil-producing countries in the developing world — where oil companies now must turn for new supply — are increasing taxes, said Goldman’s Mr. Currie. The unpredictability of these tax plans undermines investors’ ability to form a consensus on long-term prices, he added.
Such uncertainty hasn’t necessarily hurt investors willing to bet on oil’s rise. Through July 12, gasoline prices have soared 57 percent this year, heating oil has rallied 46 percent and U.S. light, sweet crude oil is up 44 percent, according to Deutsche Bank.
Increased volatility may bode well for investors who invest directly in oil rather than in, say, oil-company stocks. “I’d argue the one safe haven is going to be in the commodity itself,” Mr. Currie said. “Unlike equities, where volatility is bad, with commodities you’re more likely to be rewarded for it.”
Source: WSJ via Post-Gazette

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