Is Wall Street Speculation to Blame for High Gas Prices?

For much of the year, high gasoline prices have been a major drain on consumers' wallets. Last month, a gallon of gas averaged a high of $3.94. While global demand and supply are the primary determinants of the price of oil, the biggest component of gasoline, there is a growing view that Wall Street speculators are pushing up oil prices far beyond fundamental levels.

One study concludes that speculation last year bid up the price of gas by as much as $0.80 per gallon, costing consumers billions of dollars. Other studies find that is has little to no impact. What's really going on?

The gas price blame game
Throughout history, oil prices have primarily been driven by global demand and supply. The logic is simple: As the global economy expands, it demands more oil, which raises the price. But in recent years, an increasing number of people have been blaming speculators.

They argue that an abnormally large flow of speculative money into oil futures drove the current price of oil above its fundamental level. Some commentators go even further, claiming that nefarious speculators "manipulated" the market. While these claims undoubtedly attract public attention by villainizing Wall Street traders as profit-hungry speculators -- the truth, as always, is a bit more complicated.

Don't hate, speculate
A speculator is basically anyone buying a crude oil contract in the hopes that its price will go up. They're essentially betting on the future price movement of oil without taking physical possession of the commodity. These bets are placed through futures contracts, where buyers and sellers agree to the future delivery of crude oil at a pre-determined price and date.

The biggest speculators are primarily hedge funds, big investment banks, and pension funds, which have become increasingly important players in the market for oil futures. Historically, end-users of oil, such as airline and oil companies, made up around 70% of the market. But in recent years, speculators have dominated. They account for a whopping 70%-80% of total contracts in any given week, more than twice their traditional share.

Because this influx of speculators over recent years has also coincided with tremendous volatility in oil prices, people are linking the two events and saying one caused the other. But did it really?

A mixed bag of findings
Several academics don't think so. A recent study by the Center for Economic and Policy Research concluded that speculation did not play a significant role in driving the spot -- or current -- price of oil after 2003. In fact, most academic studies have failed to find a link between futures prices and spot prices. Instead, they argue, these prices reflect economic fundamentals.

But others disagree. Goldman Sachs (NYSE: GS) , one of the biggest players in the oil futures market, suggested last year that speculation drove up the price of oil some 20%. Researchers at the St. Louis Fed put their estimate at 15%. And Rex Tillerson, the CEO of ExxonMobil (NYSE: XOM) , claimed that number is as high as 40%.

With such a diversity of credible opinions, it's hard to pick sides.

Weighing the options
On the one hand, speculators play a necessary role in the futures market by providing liquidity to other market participants such as hedgers. In an almost symbiotic relationship, they take the other side of the trade by accepting the price risk that hedgers seek to reduce.

Without speculators, airline companies like United (NYSE: UAL) , JetBlue (Nasdaq: JBLU) , and Southwest (NYSE: LUV) wouldn't be able to hedge fuel costs, their single highest operating expense. Fuel hedging saved Southwest some $3.5 billion in the decade since 1998.

But on the other hand, when a market becomes overrun with speculators, other investors who actually use the oil get crowded out. End-users like the airlines claim that the market has become hostage to speculators who are distorting prices and increasing volatility.

Who should we believe?
After weighing the options, I tend to agree with the Fed, Goldman Sachs, and big oil (shocking, I know) that during certain periods of time, speculation raised oil prices by some 15%-40%. Still, I think it's unfair to say that speculators "control" the price of oil, or that they deserve all the blame for high gas prices.

It's not like they sit in their offices, fingertips tented like Mr. Burns from The Simpsons, hatching a plan to screw over hard working people. Their primary goal is to make money. They move money into an asset class, hoping that its price will rise, but only after assessing the basic supply and demand fundamentals. In other words, they work with market forces, not against them. And with the dearth of other investment opportunities, oil has often proved a good bet.

Is there a solution?
Going forward, there are no easy remedies. An outright ban on speculation would prove disastrous for all parties involved, for reasons outlined earlier. And increased regulation, which President Obama recently proposed, may not work either. The proposed regulatory changes include higher margin requirements and stiffer penalties for market manipulators.

Raising margin requirements may simply drive hedgers and smaller speculators out of the market, thereby increasing the market share for larger players. This might actually lead to less liquidity and more volatility -- the exact opposite of what was intended. And raising market manipulation fines from $1 million to $10 million may ward off smaller speculators, but it's still pocket change to the big hedge funds and investment banks.  

Even if you're a speculator, oil prices are impossible to predict with accuracy. Many oil companies rise and fall with oil prices. But there is one oil and gas company that stands to profit regardless of price fluctuations. Read more about this energy stock ready to soar in our special free report: "The Only Energy Stock You'll Ever Need." Don't miss out on this limited-time opportunity to discover the name of this under-the-radar company. Click here to access your report -- it's totally free.  

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