I trade commodities - just finished up a one year engagement helping a firm trade their international feedstock and offtake contract in biodiesel. I was a guest speaker at a major natural gas industry function in 2005 - the title of my talk "Is Volatility Really Due to Hedge Funds" (the answer was yes).
So, when I hear people saying that hedge funds are the cause of energy prices going up in "the face of the supply/demand balance", I gnash my teeth. Why? Because hedge funds define the supply/demand balance.
Ok, you say: "But I see the oil storage numbers going up, I see demand dropping - that means there is more supply than demand." The answer is you are correct but only in part.
I used to trade but I also originated for the firm - that means I went out and sold structured transactions to other companies. The discussion I had with them has relevance to this discussion.
More below:
I would go to companies that had always avoided the financial markets and I would describe what futures markets did. The analogy had to do with buying a car.
In the old days, everyone just went in and bought a car. You haggled with the dealer and the price you two agreed to was the "value" of the car.
But imagine, instead, if I could sell you a "price tag" for that car - let's say a BMW. If you buy that tag you can walk into any BMW dealer and "put" your tag on the type of BMW you bought a price tag for - regardless what the dealer is asking, you get to pay the value of the "price tag" and drive away in the car. The dealer then brings the "price tag" to me and I pay him the difference between his sticker price and your "price tag" (or if prices are lower, he pays me. That is in essence what a futures contract is - a "price tag" that assures you the price you will pay at some future date (hence the name "futures").
Ok, but let's look at the impact of this market. The price of the futures contract is, therefore, the supply/demand balance for "price tags" in the future. In the oil market today, producers do have a lot of risk. If I am Shell Oil producing from Nigeria, how many "price tags" am I willing to sell regarding my Nigeria production in 2009. Please remember, if Shell doesn't have production, they have to go buy "price tags" to cover the production they don't have.
Therefore, the risk associated with the production of oil in the future is high. However, the "risk" associated with the demand for oil in China and India and the rest of the world isn't that high. Even if the demand drops 5%, that still means 95% of the existing demand for "price tags" will exist. And, if I feel there is a big risk for prices next year, I may be buying all the price tags for 2008 that I can buy now.
So, the real supply demand balance may look more like:
Users of oil for 2009 want to get "price tags" for 75% of their needs for 2009.
Producers of oil for 2009 only want to sell "price tags" for 30% of their production for 2009.
Let's assume that will be a 5% oversupply in 2009. One time .75 = .75; 1.05 times .3 = .315 - that means the demand is .75, the supply of price tags is .315.
That means there is two and a half times as much demand for 2009 "price tags" as there is supply.
What does the market price for "price tags" do in that environment? Yup. "to the moon, Alice"
The speculator impact has been that almost all hedge funds - and the pension funds investments especially - are "long" funds - meaning that the fund is required to only buy and hold "price tags", they can not "sell short" price tags as a fund position.
Therefore, the hedge funds take the market from three times under supplied to four or five. And the funds tend to act to buy in front of consumers when they are looking for price tags.
So the impact is, funds buy up the price tags. they then wait for the price to go up until consumer are forced to buy price tags from the fund at a value the fund is willing to sell at - usually about a 14-20% profit.
The fund then goes out an immediately buys a new inventory of "price tags" and waits for the next consumer to have to buy. Rinse and repeat.
But, you say, why buy "price tags" in this environment? Well, what happens if the "assumed" 2009 production is 20% less because of, oh, let's say a war in Iran. Now, the price tag is likely to really go up. So, do I overpay some now to avoid overpaying a lot later - many companies say yes. In many cases, the very risk management policies and procedures that consuming companies have put in place cause them to have to buy when prices go crazy.
Hope this helps in understanding what is happening.