Who’s Driving the Price of Oil Up?

I have to admit it: I’m a speculator. I own shares in the United States Oil Fund (USO). I even own call options on USO. Needless to say, I have made a nice return so far.

You have probably heard that speculators are driving the price of oil up.  It’s all over the news. The recent run-ups have nothing to do with fundamentals, it’s all speculation, they say. And it’s not hard to believe. Oil is seen as a safe haven, a hedge against inflation and an ever sinking dollar. Crowds of investors are even buying oil merely a speculative play, in hopes of parabolic price-increases.

But those investors have little influence over the price of oil, because of the way oil is traded. Oil, unlike gold, is not a commodity which is traded directly. You buy contracts for delivery of oil at a specific place and time. The contracts settle at a specific date, at which time you have to take physical delivery of the oil. The current oil price quoted by most media is the June 2008 contract. It settles on May 20. If you’re a speculator, that means you have a few days left to sell your contract.

In order to drive the price up, you need to strangle supply or increase demand. There is no way the speculators can do this. They can get a free ride up along with the price, but they do not affect the settlement price, unless they refuse to sell by the expiry date. One contract is 1000 barrels, so unless you have an enormous basement, this is not a scenario you’d want. In fact, I’d be pretty desperate to sell at any price as expiry closes in.

The only real customers of the oil are the refiners. If they refuse to buy oil at the prices demanded by the speculators, the speculators will surely cave. The reason they don’t have to is that actual demand for oil is high enough that all contracts are bought by refiners.

To sum it all up: No speculator is taking oil out of the market and storing it up for later in some giant tank farm somewhere. It’s the drivers who are driving, literally, the price of oil up. I am biking the price of oil down.

Why am I doing this? The average American is using close to 25 barrels of oil per year (Wikipedia), either directly or indirectly through their lifestyle. That sums up to 1950 barrels over the average life expectancy of 78 years. The good news is that you only need two contracts to cover this. The bad news is that those two contracts are trading at more than $125 000 each. In practice you are shorting a huge amount of oil, and have taken 6 digit losses already. Oil was $60 last year. When I started monitoring it back in 2004, it was because it had broken up above $40, and this made me worried. I’m merely buying protection, and at the same time cutting my own oil costs, because I’m too wimpy to keep shorting my own lifestyle.

The question is: Do you feel lucky?