Federal regulators inched closer to reigning-in oil speculators as the Commodity Futures Trading Commission (CFTC) held the first of three hearings aimed at preventing Wall Street from causing wild swings in oil prices.

Senator Bernie Sanders (Ind.-VT) explains, ”We have got to make sure that Americans are no longer ripped off at the gas pump by some of the same Wall Street gamblers responsible for the worst economic crisis since the Great Depression.”

The issue at hand is whether or not the energy market is determining oil prices or if Wall Street is determining oil prices through massive Oil Futures trading.  In the oil futures market, contracts are traded, not physical barrels of oil.  The contracts allow companies to buy oil at a particular price in the future similar to how you can lock in a low price in the summer for your winter heating oil.  This convention allows companies to reduce their exposure to rising oil prices, while on the contrary the oil suppliers are hoping to insulate themselves from potential drops in price.  Ultimately, futures are intended to reducing risk, but many argue that it does exactly the opposite.

When you hear crude oil prices in the news you are actually hearing the price of oil in the futures market. Approximately 1 billion barrels of oil are traded every day on the New York Mercantile Exchange (NYMEX) compared to actual 80 million barrels that are consumed daily across the world.  By trading on margin, futures trader are able to trade ten times what they can afford.  This allows single companies or hedge funds to effectively set the price of oil.

Normally, supply and demand dictates the price of a product.  Since oil demand has been steadily dropping since last fall and supply is building up, traditional economic models would suggest that the price of oil should be going down. Yet since December of last year—despite declining demand—the price of oil has more than doubled.

Last year as the price of oil rose to a record high of $147 a barrel the CFTC, headed by the Bush appointed Walter Lukken, published a report that the rise in oil prices was a result of supply and demand.  Now under Obama appointee Gary Gensler, the CFTC appears to be taking a new position and plans to publish a new report next month based on the findings of the current hearings.

Proponents of oil speculation still maintain that the price of oil is a function of supply and demand.  They allege that the oil markets, like many other industries last year was over inflated when oil reached $147 a barrel which resulted in a crash dragging the price down to an artificially low $33 a barrel.  The doubling of the price over the last 7 months is a natural correction of the market, not a result of market manipulation.

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If you look at the price trends, oil steadily climbed to about $70 a barrel from 2003 to mid 2006.  It dipped at the end of the year to about $60 a barrel before a meteoric rise to last summers record high.  The index proponents argue that things are finally getting back to normal.

Whether or not speculators did manipulate the market, it’s clear that in the current system they are capable of it.  The CFTC could trust these captains of finance to be on their honor and trust that the free market will remain impervious to the interests of the self serving, but I don’t think that’s going to happen.  It’s probably time for the free wheeling oil speculators to start hedging their bets.

Photo Sources: Azrainman on Flickr & Trading Charts