Read it and weep:

August 13, 2006
Investing
Is a Futures Stampede Keeping Oil Prices High?
By NORM ALSTER
BY now, even a casual student of current affairs can reel off plenty of
reasons for high oil prices: soaring demand, dwindling supplies, conflict in
the Middle East and, most recently, the partial closing of an Alaskan oil
field.

Ben P. Dell, an analyst at Sanford C. Bernstein & Company, would place
another factor at the top of the list: the money that has been surging into
the commodities futures markets. Mr. Dell published a report last month
suggesting that a stampede of institutional investors, mainly pension funds,
into commodities is actually the chief cause of the rise in oil prices,
which he called "a bubble."

The report has generated more reaction than any other oil research published
by the firm in the last three years, Mr. Dell said. And not all of it has
been positive. Some oil experts say that while the flood of money has had
some effect on spot prices, it is by no means as important as Mr. Dell
maintains.

"I think the idea of speculation being the main driver of higher oil prices
ignores the fact that in the real world there are a whole host of things to
worry about," said Robert J. Weiner, professor of international business at
George Washington University.

Similarly, Jan Stuart, global oil economist at UBS, said factors like
geopolitics were more significant. Further, he said, "I'm not calling it a
bubble." For his part, Mr. Dell acknowledged that geopolitical concerns -
particularly fear of a possible disruption in supplies by Iran - were having
an impact on prices. But he said that such issues did not entirely explain
oil prices, which, in his view, should be trending downward based on
supply-and-demand fundamentals.

Despite some short-term fluctuations, inventory levels in the United States,
for example, are "well above the upper end of the average range," according
to a recent Energy Department report. Growth in global demand has cooled,
and new oil supplies have padded what had been a threadbare cushion of
supply over demand.

"You're growing supply," Mr. Dell said. "You're growing inventories. And
demand growth is slowing. But the price keeps going up."

The reason for this anomaly, he said, may be found in financial markets,
specifically in the billions of dollars that investors, mainly pension funds
and other typically conservative institutions, have poured into commodities
in recent years.

Commodities futures that track indexes like the Goldman Sachs Commodity
Index or Dow Jones AIG Commodity Index have become fashionable for many
investors. Their reasoning is that this asset class, though volatile,
affords portfolio protection because it has often performed well when stocks
and bonds have been weak.

Close to $100 billion will be invested by pension funds and other
institutions in futures contracts tied to the commodities indexes this year,
up from less than $20 billion three years ago, according to Goldman Sachs.

Pension funds, whose charters often prohibit short-selling, have been
exerting upward pressure on futures prices, several analysts said. "They
want to be long. They want to stay long and 'don't bother me with it.' "
said William H. Brown III, president of WHB Energy Research in Chappaqua,
N.Y. "It definitely adds a positive bias to the market."

This persistent upward pull on futures prices creates an arbitrage
opportunity that drags the price of spot oil higher as well, according to
Mr. Dell. With futures prices higher than the spot price, why not buy oil,
store it and then sell it forward in the futures market at a profit? Mr.
Dell and others argue that this is precisely what's happening.

"It's a typical commodities play currently being employed in oil markets,"
said Sal Gilbertie, a trader at Fimat USA in New York.

Similarly, Phillip Verlander, an independent energy economist, said that on
Aug. 4, for example, it was possible to "buy heating oil in New York Harbor
at $2 a gallon and store it and sell a future to deliver it in December for
$2.24," and that many traders were doing so.

Mr. Dell said that current oil prices were a bubble comparable to the tech
investment bubble of several years ago - and that the oil bubble was likely
to burst before very long.

Others on Wall Street agreed that the flood of institutional dollars had had
some effect, but they disagreed about just how much. Edward L. Morse, chief
energy economist at Lehman Brothers, said, "There is no doubt in my mind
that there's an impact from a new class of investors into commodity markets,
especially pension funds and also speculative investors including hedge
funds." That impact can at times be as much as $10 a barrel, but
"fundamentals play a much bigger role," he added.

In a similar vein, Mr. Stuart of UBS said: "Explosive growth in
commodity-related financial investments has translated into sharply higher
prices and higher trading volumes on long-term oil futures. In effect,
financial buyers have become consumers of oil, contributing to the
persistence of high prices."

But he said that tight supplies, China's growing appetite for oil and other
considerations were more important. "The arbitrage that's available is only
one of the factors supporting the price of oil," he said. Mr. Stuart expects
the average price of oil to hold around $69 a barrel next year; oil has been
trading around $75 recently.

ON the other hand, Mr. Brown of WHB Energy Research supports Mr. Dell's view
of current price levels. He has studied the historical correlation of oil
prices with inventory levels and, at current levels, oil should sell for
just $27 a barrel, he said. The impact of passive, long-term investors "is
in my view $33 a barrel," he said, with other factors, like flagging
production in the North Sea and in Nigeria accounting for much of the rest
of the gap. Still, he says he does not expect prices to tumble unless there
was "a major slowdown or even reversal of demand growth."

Mr. Dell said that prices could weaken once global storage capacity filled
up, limiting the possibility of arbitrage profits. He said that this could
happen within four to six months but emphasized that it would be hard to
predict precisely when oil prices might move down.

In Cushing, Okla, a giant oil storage hub, the tanks are indeed filling up.
"In today's environment, all the major tankage owners are being very well
utilized," said Rick Sandahl, senior vice president for market development
at Enbridge Inc. He said that 80 to 90 percent of his company's storage
capacity of 12.5 million barrels was in use. Asked if his customers seemed
to be hoarding oil to take advantage of a price arbitrage, Mr. Sandahl
replied: "I would think it's a factor in their decisions."

Investors who believe that oil prices are ready for a fall would want to
avoid mutual funds or exchange-traded funds that are linked to commodities
indexes. Mr. Dell said that stock investors should "underweight" oil,
recommending only such "defensive" plays as Exxon Mobil, Chevron, Total and
Apache, all of which, he said, have "considerable excess cash flow beyond
their capital spending needs." As such, he added, they could withstand a
drop in oil prices "and still deliver their growth plans."