Bailing Out The Oil Market

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By William Pentland

Government Assistance

While everyone knows the U.S. government is looking to bail Wall Street banks, few people realize that it's also bailing out speculative oil and commodities traders in the process, fueling a sharp rise in energy prices. Lehman Brothers (nyse: LEH - news - people ) and AIG (nyse: AIG - news - people ) held enormous trading positions in commodities markets. If those positions had been liquidated suddenly, the price of everything from wheat to oil would have collapsed. The Commodity Futures Trading Commission, the main regulator of U.S. commodity markets, allowed Wall Street's investment banks and trading companies to take control of massive positions in commodities markets called swaps held by Lehman Brothers and AIG.

The result: Oil prices spiked by a whopping $16 per barrel on Monday, the largest single-day rise in oil prices ever.

"If speculators were forced to liquidate their positions, oil would easily be $65 to $75 per barrel by the time the liquidation was complete," said Michael Masters, the founder of Atlanta-based hedge fund Masters Capital Management. Tuesday, oil was trading at $108.74 in midday trading in New York.

For all the talk of OPEC, the biggest threat to high oil prices in the short term might be the implosion of Morgan Stanley (nyse: MS - news - people ) or Goldman Sachs (nyse: GS - news - people ), which would trigger a massive number of low-priced oil-futures contracts to flood the market all at once in search of buyers to liquidate those contracts.

"If either of these entities were to collapse, we believe the downside for commodities would be tremendous as these companies unwind positions," Valerie Wood, president and owner of Energy Solutions, told Platts on Monday. "In particular, we know Goldman Sachs has large investments in crude oil and natural gas commodities because its own Goldman Sachs Commodity Index fund [comprises] about 39% crude oil commodities and about 6% natural gas commodities. A liquidation of GSCI shares would directly result in the selling of these commodities, and selling pushes prices lower."

Ironically, the biggest losers turned out to be the traders who bet that at least one of the victims from this month's financial chaos would be forced to liquidate a major long position in oil prices. When they avoided that fate, the race to unwind those bets that oil prices would fall before the end of the trading month caused a massive rally in oil prices.

The market meltdown has revealed the full extent of Wall Street's influence on commodities prices and, especially, their role in energy markets. More than $40 billion in cash has poured into commodity markets since the start of 2008, according to a report by Standard & Poor's. The total amount of investments in commodity indexes is estimated at between $150 billion and $270 billion. In other words, new investments in the market have climbed by 15% to 25% in less than a year.

In 2006, the U.S. Senate's Subcommittee for Permanent Investigations had already reported "there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices." The trouble is that so much of the trading happens in so-called "dark markets," unregulated over-the-counter electronic exchanges where trading companies buy and sell energy derivatives, that this role is hard to document.

Investment banks make money off commodities speculation, but are just conduits for hedge funds and institutional investors that have taken large positions in commodities markets as a long-term investment.

"The market dynamics induced more and more financial players to move into commodities markets," said Fadel Gheit, a senior oil analyst at Oppenheimer & Co. "It was a perfect storm. The Federal Reserve was cutting interest rates and people were running away from the dollar as it lost value. Hedge funds, pension funds and mutual funds started pumping money into commodities because they were the safest place and the safest of them all was crude oil. There were too many dollars chasing too few physical assets. That's the bottom line."