 | | |  | How Hot Money Inflames Oil Prices
Hedge
funds and other investors may have helped push oil prices up. Now, they're helping push them down—and fast
By
Christopher Palmeri
BusinessWeek Online
There's
been an ongoing debate since energy prices began their steep rise four years ago: Was the money pouring into the oil patch from mutual funds, traders, hedge funds, and other financial players pushing up the prices that consumers pay to heat their homes and fill their gas tanks? In other words, was hot money behind the sharp rise in energy prices?
Well,
now the hot money is moving out of energy, and it seems clear that it's adding just as much volatility to prices as they move down as when they were moving up. Without any major changes in supply or demand, the price of oil has been tumbling, dropping below $59 on Oct. 3. That's 25% off the peak of $78 in July. Natural gas prices have fallen even more sharply, to $5.80 per million Btus from $15 last December, a drop that likely precipitated the $6 billion blowup at hedge fund Amaranth Advisors.
DOWNWARD
TUMBLE. Behind the price declines is a sharp contraction in the amount of money being invested in energy assets. The amount of new money flowing into the 48 natural resources mutual funds followed by Morningstar slowed to just $12 million in August, down from $1.6 billion in the same month in 2005. The PIMCO Commodity Real Asset fund, which saw its assets swell to $12 billion since its startup in 2002, has taken in just $100 million this year. "There's been a big money exodus," says Peter Fusaro, founder of the Energy Hedge Fund Center, an energy trading information site that tracks hedge funds. "Many investors took profits and are sitting on their powder." (Figures for September money flows are not yet available.)
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Energy
prices have fallen so fast that they've prompted OPEC member countries into action. In September, Nigeria and Venezuela said they would make voluntary reductions in production in hopes of propping up prices. Edmund Daukoru, OPEC president and Nigerian Minister of State for Petroleum, called on other OPEC countries to follow suit.
This
is all a sharp reversal from the money pouring into energy investments in recent years. Chicago-based fund tracker Hedge Fund Research now counts 68 hedge funds devoted purely to energy, up from 14 in 2000. That number doesn't count the many funds—such as Amaranth—that invest only part of their money in oil and gas. Nor does it include the $100 billion that poured into funds that passively track commodity indexes. "Out of every dollar that gets put in the Goldman Sachs Commodity Index, 70 cents goes into energy," notes Sol Waxman, who follows hedge funds for the Barclay Group financial advisory firm. "Does that have an impact on price? I would suspect so."
TASTY
DEALS. Wall Street research backs that up. In a Sept. 20 report from Citigroup, analyst Doug Leggate noted that investors, funds, and other financial players recently accounted for more than half of energy futures contracts traded at the New York Mercantile Exchange (Nymex), up from 25% from 2000. In just the past three years the average number of crude oil futures and options contracts open on the exchange has shot from 600,000 to 2 million. Leggate's research found that the rising price of oil correlated 94% with the increase in trading volume. "We found a mathematical way of explaining the movement in energy prices," Leggate says. "The funds and open interest has been a very large driver. The question is—'Is it permanent or is something that reverses?'"
Brian
Dell, an energy analyst at the brokerage firm Sanford C. Bernstein, figures that the money flowing into energy futures may have very well helped spur the recent price decline. Dell predicted in a July report that the influence of funds was creating a commodity bubble. Dell concluded that by investing so much in futures contracts, the funds were driving up the anticipated prices of the commodities.
That
in turn was prompting utilities, refiners, and other industry players to stockpile more crude oil, natural gas, and gasoline in storage. When last winter turned out to be milder than expected and no major hurricanes knocked out supplies, the industry was left with more supplies than needed, prompting the current downturn in price.
WIDE
SWINGS. The fall in prices will likely slow what's been a hot market for oil company mergers and acquisitions. More than $350 billion in mergers and acquisitions have been announced so far this year, according to Thomson Financial, up from more than 50% over last year. They range from the $22 billion buyout of Kinder Morgan to the merger of Western Refining and Giant Industries to Andarko Petroleum's twin bids for Kerr-McGee and Western Gas Resources. In addition, San Antonio refiner Valero Energy and Russia's LUKOIL have been trolling for deals.
Ultimately,
oil and gas producers may cut back on drilling expenditures, affecting many companies that provide drilling rigs and oilfield services. "Our projects are conceived and executed over a three-year period," says Brian Jennings, chief financial officer of Devon Energy, a large oil and gas producer. "When you see these wide swings in natural gas prices, from a budgeting process it's really tough."
How
low could oil prices go? Despite the recent fall in prices, the consensus among Wall Street analysts is that oil will still average $65 a barrel in this year's fourth quarter before falling to $62 next year. Those estimates could be quickly adjusted downward if prices continue to slide. "If you see a lot of money getting out, it could get pretty ugly," says Dell. "You could see crude drop past $40." Good news for motorists, bad news for energy investors.
Palmeri is a senior correspondent in BusinessWeek's
Los Angeles bureau
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