Squaring off in the Senate over speculators

Full disclosure: I believe the most complete assessment of the situation has been done by the Commodity Futures Trading Commission, which has concluded that oil prices over time are not impacted by the actions of financial investors, but that in the short run those financial players can introduce tremendous volatility into markets. That explanation can defend simultaneously both the increase from just under $100 to almost $150 in just the first month of the year, and the steady increase from levels near $50 and $60 18 months ago.

Short-term volatility might also be one of the reasons why oil has fallen so far, so fast. There clearly was a belief on the part of some of the panelists that we're back down to the "real" price, and it's not possible for volatility to overdo it on the down side.

So a few impressions from the meeting:

--Michael Masters is a hedge fund manager who has become the leading voice advocating that speculators are driving the price unnecessarily high. As a result, he's also become a target of some fairly nasty criticism and innuendo, since his background is not as an energy expert. He also has significant hedge fund holdings in transportation, so in essence, he wakes up every morning "short" oil. The Republican senators on the panel piled on him, citing the sneering dismissal that energy economist Phil Verleger has aimed at Masters multiple times. (Verleger's latest weekly commentary called Masters' most recent report "awful.")

One notable place where Masters stumbled the worst was in his written testimony, where he noted that during the first six months of 2008, "inventories for crude oil were essentially flat -- they barely changed." He goes on to say that is a signal that since supply and demand were in balance, it can not explain the sharp first-half rise in prices.

But Masters is overlooking a key point: inventories aren't supposed to be flat in the first half. They generally draw somewhat during the first quarter, but are usually close to flat, and then they are supposed to build significantly in the second quarter. That has been the historical pattern for years. The fact that they barely built in the second quarter of 2007 set the market up for the fourth quarter rise in that same year, as the traditional 4Q pull on inventories came from a smaller base. It looked as if we were headed that way this year, but with OPEC output now above its fourth quarter call, it may not be quite as severe. But the failure to build inventories significantly in the second quarter is evidence of a very tight supply/demand balance.

--Senator Maria Cantwell of Washington showed a chart reflecting a tight balance between supply and demand, which at the end of the chart reflected demand outstripping supply by just a small margin. This apparently was to show us that things weren't that out of whack. I thought it was a fairly worthless chart -- it was overlaid with the rising price of oil -- but I guess we were supposed to think that the rising price should have shown demand
significantly outstripping supply.

But what the senator did not note is that prices are set on the margin, and if the battle to buy that last barrel of crude is fierce, the price is going up. The fact is that most supply/demand charts show rough balance; they must. Yes, the demand for beachfront property in Palm Beach would show demand far outstripping supply; that's why the houses cost a few million bucks. But for commodities, it's usually tight. But the level of difference, though
small, is significant, because it spells out who has the upper hand in the battle for that last barrel. By showing a chart where demand outstripped supply, Cantwell's chart actually undercut her case.

--Fadel Gheit, the oil analyst at Oppenheimer & Co., stands out as probably the most informed industry observer who believes financial players drove the price higher. I wanted to ask him this question: He said the companies he follows did not expect prices to be above $100. They even scoffed at $60 oil. So as an analyst, if he believed the price at $140 was unsustainable, did he suggest to the companies that they sell forward a large chunk of their forward production to guarantee a price that they believed was going away? There has always been that disconnect in the oil industry, and it's hard to understand.

--Finally, three cheers to Lawrence Eagles, the global head of commodity research at JP Morgan Chase. He read parts of testimony prepared for another JP Morgan Chase executive, but didn't leave out the most significant part.

Eagles was the only panelist who cited the diesel market in his comments. (More full disclosure: I did need to leave before the hearing was over, so it may have come up later). Diesel prices worldwide soared far more than crude in the first half of the year. Diesel doesn't get "hot money." This was all a true physical squeeze, and a strong argument that can be made that the crude price everyone was focusing on the first half of this year was
simply going along for a diesel-fueled ride.

Diesel and other distillates have fallen hard since their peak in July. Spreads against gasoline, which blew out to unheard-of levels, have narrowed, and with the enormous runup in gasoline following Gustav and Ike may be heading toward returning to more historic norms. Crack spreads between crude and diesel also are returning to earth. It didn't happen by magic. Refinery engineers tweaked and twisted and turned and squeezed and found new ways to get more diesel out of refineries. By extension, they got less gasoline out as a result. The supply lines shifted, and diesel prices fell sharply. (European gasoil, which really led the market more than the US, fell by an even bigger amount when measured in Euro terms, since the Euro fell against the dollar). The result was that the diesel-led surge lost a lot of steam, and the price of crude came back with it. That's the big story of the first
half of the year, and only one of six panelists mentioned it in their prepared remarks.