Should Congress investigate why oil is nearing $70 in a recession?

Is it time for the U.S. Congress to systematically investigate the oil futures market?

Market absolutists cry no, but an oil price pushing $70 per barrel amid the worst U.S. recession since 1982, the first global recession since World War II, and 10-year-high inventory levels argue otherwise.

After hitting a record high of $147.27 per barrel during the leverage-fed investment and trading frenzy of 2008, the price of oil collapsed with the onset of the U.S. recession and then the implosion of the financial crisis, the latter of which took numerous hedge fund and investment fund oil futures buyers out of the market. Prices plummeted to a low around $35 in December 2008.
Historically, $30 is a high price for oil

Further, it's significant to note that although crude's price collapsed, $35 is still, in historical terms, a strong price for oil, which has averaged $25-30 per barrel, in current dollars, over the past 150 years.

Moreover, many experts expected oil's price to recover only slowly in 2009. U.S. gasoline demand declined for much of the past 12 months, on a weekly basis. Emerging market demand growth -- a major factor in oil's price rise during 2003-2007 -- was low, and the world was set to record its second consecutive decline in global oil demand. But the incremental rise in oil's price did not occur: instead, the price of oil skyrocketed in the past six weeks, essentially doubling in a very short period of time, in macroeconomic terms.

Oil bulls say the oil futures market, like the stock market, is merely pricing in likely oil demand conditions six to nine months out: investors and traders sense a bottoming recession in the U.S. and better economic conditions internationally, and its implied rising global oil demand, and are pushing up oil's price accordingly. Under this thesis, a $70 (or higher) price is justified given likely, future economic conditions.

However, oil industry analysts, among others, are increasingly citing investment funds as the primary reason for the rise.

"It's the funds that are pushing the market higher," Jonathan Kornafel, director for Asia at options trader Hudson Capital Energy in Singapore, told Bloomberg News Friday. "When everyone reads the same report and comes to the same conclusion, then you're going to have the market moving in one direction. The general trend is for the dollar to get weaker and for crude to get stronger."

Or, in other words, some, if not many institutional investors are buying oil futures as an alternative asset – a perfectly normal deployment of capital in free markets, and one that's largely innocuous (except for the speculator or the hedger) if you're investing in oat futures or cotton, so says economist Peter Dawson. However, if the asset is the world's most important commodity - one on which the developed world's, and now much of the developing world's - economy hinges, depending on its price – the deployment of capital could become a concern, particularly if it is concentrated, Dawson told DailyFinance. At least in theory, a sector-wide concentration of institutional investors could 'artificially boost' the price of a commodity well above what supply and demand would typically dictate – in effect grossly distorting its price.

"No conspiracy or collusion need occur. Just concentration," Dawson said. "Concentration is enough to cause a price bubble, and the U.S. housing sector is an example of that. There was no 'conspiracy' to cause U.S. median home prices to rise to dizzying heights, but rise they did, and a bubble formed, due to the concentration of players, in housing's case, a lot of buyers due to the availability of subprime loans."

Tail wagging the dog?

Dawson said he wants price discovery to continue in markets, particularly in oil, "but what could be occurring now is not price discovery, but 'pack mentality.' " The U.S. Congress, Dawson said, should begin a formal, long-term study on the relationship between the rise in futures trading and oil's price, "and systematically research whether the ten of thousands of new oil futures players have led to higher prices than they would have been, under similar supply/demand conditions, with these players absent."

The oil market today - if prices don't moderate in the coming months - also "is capable of exhibiting characteristics that border on 'The Twilight Zone,' " Dawson added.

"The problem with the futures activity is that it's pushed prices up so high that, if a $60-70 price holds, it will further dampen consumer spending and crimp corporate budgets to the point that the economic recovery will be hurt," Dawson said. "And if that's the case, the futures activity will have the affect of eliminating the very economic recovery that prompted the oil futures buying in the first place. And when you think about it, that type of market behavior is just absurd and irrational, from an economic development standpoint."

Economic Analysis: Oil has quickly vaulted to levels few thought possible, given the inventory glut and tepid demand. The weaker dollar has played a role, but the dollar is down roughly 10-15 percent during oil's leap to near $70 – hardly enough to explain the price surge. Like economist Dawson, the view from here argues Congress should research the relationship between the number of oil futures players and oil's price.
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