At the beginning of August traders speculating in oil futures had bet the price of a barrel of light sweet crude, delivered in September, up to almost $80, sparking a renewed outburst of worry that the fabled day of the $100 barrel of crude might soon arrive. Two weeks later, the price of that September barrel of crude has dropped to around $72. In the interim, stock markets around the world went on a wild ride.
The first explanation offered by analysts is that traders are worried that the credit crunch afflicting financial markets might spread into the general economy. Slower economic growth would mean less demand for oil, thus depressing prices. But on Monday, the Wall Street Journal's Matt Chambers suggested another explanation: Hedge fund operators are selling off their oil futures holdings, as part of a generalized effort to reduce their overall risk exposure. With so much going wrong elsewhere in their portfolios, it's time to sell risky assets and raise cash. It's the new, "risk averse" Wall Street, pledging, once again, to mend its carefree ways.
And maybe that's that. Crude oil prices did rebound a bit on Monday and an analyst at Goldman Sachs predicted that prices would resume their inexorable rise: "the recent price declines driven by speculative liquidation will prove to be short-lived."
But it's not clear to How the World Works that anyone has a good handle on just how much the price of oil is affected by speculation instead of purely physical laws of supply and demand. How many hedge funds are still sitting on big bets that the price of oil will continue to rise in future months? If they've been trading on the essentially unregulated ICE electronic platform, even government officials don't have much of a clue.
Doesn't that mean that if the financial position of hedge funds continues to deteriorate, there will continue to be downward pressure on oil?
Perhaps the most alarming nightmare scenario conjured up in the financial press in recent days as to how the credit crunch could go seriously awry goes like this: Over the past decade, the market for "credit derivatives" -- financial instruments that allow institutions to reduce risk by buying insurance for such negative events as a borrower defaulting on a loan -- has expanded enormously. Hedge funds have become major players in this market, buying and selling credit derivatives just as they buy and sell oil futures. But as we have been told repeatedly in recent weeks, hedge funds are "heavily leveraged" -- that is, they do a lot of their buying and selling with borrowed money.
Playing with borrowed money is lots of fun when your bets go right. You can pay back what you borrowed and pocket the profit. The more money you have to bet with, the more profit you get to take home. But when your bets go sour the same game can get ugly fast. No profit, and you still have to pay back the loan.
So who are the hedge funds borrowing their money from? The same banks that are insuring against the risk that their loans don't get paid back by purchasing credit derivatives -- from the hedge funds who are taking out the loans that need to be insured.
If it seems absurd that banks are lending money to the same institutions that they are buying insurance from, well, welcome to the wacky world of high finance. But if there's truth to this scenario, then it's very easy to see why there has been so much nervousness on Wall Street recently. If a few hedge funds can't live up to the fine print of their credit derivative obligations because they are scrambling for cash to pay back the money they borrowed to make bets in markets for credit derivatives or energy ... well, no wonder they're scrambling to get out of their oil positions. The might need a lot of cash, and they might need it soon.
So we'll see just how "short-lived" the selling pressure on oil futures turns out to be.