It's All About the Price of Oil

Does Oil Price Speculation = Manipulation?

The US stock market could not have sent a clearer signal these past two days as to what it is obsessing on – the price of oil. For as important as the Fed’s actions are (with the same opinion being applied to the Financials and their prospective economically destructive write-downs and write-offs), the price of oil is numero uno in the mind of Mr. Market.

And in this regard, the debate rages over just what explains the high price of oil. For example, today Libya , in contemplating cutting production, joined Saudi Arabia in declaring that the physical demand for oil is being more than met by existing supply. Yet, free market ideologues continue to rant that it’s all about the physical supply/demand equation with references to the oil output crisis du jour be it Nigeria or questions re the true reserves in Saudi Arabia or impending hurricane season in the US or failure to build and update adequate refinery capacity or….well you get the picture.

The center of the oil price storm appears to rest with the battle between the US politicians and the free market ideologues. In this regard, it seems that both the politicians and the free market ideologues have got it partly right, but wrong in key aspects.

The politicians are right to focus on the speculators as they have tilted the supply/demand equation via speculative positions. Moreover, in a world where positions established cannot be determined (dark markets, OTC index and derivative related trading), it is anybody’s guess as to just how strong the demand is and to what end such demand is being established.

Where the US politicians have gotten wrong, however, is their implied (and often stated) conclusion that speculation = manipulation. In this regard, it is hard to support the view that speculation = manipulation if large asset managers (e.g. pension plans) move large sums of their investment capital into what they have come to accept as an attractive asset class – commodities. Moreover, it is hard to support the speculation = manipulation thesis when true speculators (versus large asset managers) piggyback on the speculative (not physical) supply/demand imbalance pushing prices higher. That is, of course, assuming that collusion is not occurring.

As for the free market ideologues, they are right to argue that markets tend to function best when regulation is minimized. Moreover, free market activities by speculators provide desirable liquidity, which reduces the cost of investing via smaller price spreads.

Where free market ideologues get wrong, however, is to argue that free markets are efficient markets. If anything behavioral finance has proven wrong is the unfettered markets = efficient markets thesis. In this regard, it is advisable to remember that not all speculators are price efficiency arbitrage operators. Many are momentum players joining the parade for the ride and tending to exacerbate an existing trend. Therefore, unfettered free markets influenced by large shifts of capital from major asset managers enhanced by momentum speculators allowed to establish undisclosed positions is rife for price exploitation.

Investment Strategy Implications

When it comes to today's stock market, it’s all about the price of oil. The economic havoc due to soaring energy costs has many parallels to the destruction of the credit creation process and broken business models of financial services firms and their effect on economic growth. If the US politicians and various experts are correct, the price of oil will decline once both regulatory (CFTC) and legislative action (closing the Enron and London Loopholes) take effect.

On the other hand, if the free market ideologues are correct, then demand destruction is the sole path to end of the current oil price crisis. However, that path will produce broad economic pain (how does a global recession sound?) and, therefore, significant and more onerous regulatory and legislative action, made more likely in a US election year.

On this last point: Investors operating under the assumption that the Democrats in charge of the US Congress will operate in manner similar to the way the Republicans have acted for a dozen years are sorely mistaken. Should the free market ideologues prove correct, investors will learn the real meaning of the slogan “change”.