Brace for oil-futures bubble to burst

Joe Napsha
| Thursday, July 7, 2011

The next global financial crisis could come from oil price volatility caused by speculative traders, a Duquesne University professor says in a new book.

"The real culprit is that you can't determine an adequate value for crude oil based on its market price. It is not a supply problem. Uncertainty is beginning to unravel the oil market," said Duquesne professor Kent Moors, who directs the university's Energy Policy Research Group.

Moors, who published "The Vega Factor: Oil Volatility and the Next Global Crisis," said it has already started. In an interview during a business trip to Morocco this week, he pointed to a 15 percent jump in oil prices in late April and early May as an example of the market being unable to respond to rapid volatility.

"The system cannot adapt," Moors said. "It (the price) goes up or down too quickly, the trading system is no longer adequate for that volatility. This could go on for the next 10 to 20 years."

Moors is referring to the world market where oil is sold through a system of "futures contracts," in which speculators offer to buy a barrel of oil at a certain price when delivered in future months.

On Wednesday, benchmark West Texas Intermediate crude for August delivery lost 24 cents to settle at $96.65 per barrel on the New York Mercantile Exchange.

If a speculator holds onto a futures contract and the market price at delivery is greater than their futures contract price, they earn a profit. Speculators often hedge their bets to avoid a loss by purchasing options that protect them when the market price comes in lower than their agreed-to futures price. But even hedges are missing their target because of the volatility in the market, Moors said.

He believes that increasing instability in oil markets -- with days of relative stability becoming shorter and shorter -- will create economic problems worldwide. If the price of oil spikes as it did in spring, that hurts the economy in the United States and other developed countries. If oil plummets, it creates political instability in producer nations that depend on oil revenue.

"If this bubble does burst, it will cause tremendous problems -- greater than when the housing bubble took a hit," because oil is more pervasive in the economy than the housing market, Moors said.

To prevent instability, Moors said government can limit the volume of oil and the number of contracts being purchased through the futures market.

Moors' view that speculative trading is causing problems is not shared by some oil industry analysts.

"It seems that the speculators keep getting brought up (as a cause) when the price goes too high, and someone does not like it," said Jeff Mower, editor of Platt's Oilgram Price Report.

The blame for volatility in the oil trading market should fall on the government's regulatory environment, said Philip K. Verleger, an economist and publisher of The Petroleum Economics Monthly.

"The problem is not caused by trading in futures, but by environmental regulations that are continually tightening the specifications for various (oil) products," Verleger said. That, combined with the refinery industry's failure to invest in facilities, is hurting the market, he said.

Moors said the federal government has been reluctant to rein in futures trading. In May, some senators called for a crackdown on speculative Wall Street trading in oil contracts on the grounds that betting on the future price of oil is driving up prices.

The senators want the Commodity Futures Trading Commission to adopt limits on speculation in oil contracts. The problem with that, Moors said, is that traders will go to unregulated markets.

"It is wrong to think that regulating the trading is going to cure the problem," said Verleger, who was director of the Office of Energy Policy during the Carter administration.

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