Futures Trading Pit Is Birthplace of Oil Prices

This article was originally published by Newhouse News Service on Thursday, May 4, 2006.

By Katherine Reynolds Lewis
c.2006 Newhouse News Service

Raymond Carbone blinked in wonder at the electronic display ringing the New York Mercantile Exchange's stadium-like trading floor.

Crude oil futures were closing at a record $75.17 per barrel, up a whopping $3 in just a matter of hours.

As a trader for Paramount Options, he is getting used to the feeling. It has become common for oil prices to climb on Friday afternoons before the markets close for the weekend.

On this day, April 21, traders on the Nymex floor were worried Nigerian rebels would attack an oil field or worse, the U.S. would bomb Iran. That would mean a jolt to the world's petroleum supply and mind-boggling run-ups in oil prices.

They know the key to trading is staying ahead of the curve, so they furiously bought futures that would mean big bucks if prices rose which had the self-fulfilling effect of driving up prices. Barring an international crisis over the weekend, they'd sell when they returned to work.

A fellow trader leaned over to Carbone. "If Iran is not a smoldering heap by Monday, we're going lower," he predicted.

Any economics student knows prices are determined by supply and demand. When more oil is extracted from the ground or refined into gasoline, prices fall. When millions of Chinese workers start trading in their bicycles for automobiles, prices rise.

But lately, the energy markets have become defined by something more powerful: fear.

With oil supply stretched drum-tight, any little disruption can make prices swell or collapse. Futures traders live in the heart of the beast, risking hundreds of thousands of dollars on a comment by a Saudi Arabian oil minister or a meteorologist's prediction about the path of a storm.

As a result, the impact of people like Carbone on the lives of average Americans has never been greater. More so than big oil companies, filling stations and world leaders, it's the guys making cryptic hand gestures in the trading pit who tell the world what oil should cost.

Traders consume information about politics, terrorism, weather and geology, and watch other traders buy and sell.

When a trader believes oil prices should be higher, he buys futures contracts, hoping to profit. When he thinks oil is overvalued, he sells. The net effect of all these actions is a constant tweaking of oil prices to reflect both the fundamental supply-demand situation and the ever-varying risk of a major crisis.

Commodities markets have recently attracted hedge funds, pension managers and even wealthy individuals seeking different assets to buy, as real estate and stocks have cooled.

They're swayed by research that shows commodities returns move in the opposite direction from stocks and bonds, said Philip Verleger, an energy economist and consultant based in Aspen, Colo. Their hope is if the stock market tanks or if inflation takes off, at least they'll make money in commodities.

These investors have the net effect of driving prices higher simply because they increase the demand for commodities, some experts argue.

"The amount of money invested in commodities has tripled in the last three years," said James Cordier, president of Liberty Trading Group, a futures broker in Tampa, Fla. "Are investment funds adding to the price of crude oil? Yes. People do not invest in commodities to bet on prices to go down."

It's easy to imagine that energy traders are raking in all the cash that disappears from your wallet when gasoline, natural gas and electricity prices soar. But for every winner in the futures market, there is an equal loser.

"It's a zero sum game," Carbone said. "If I made a dollar someone else had to lose a dollar."

Unlike a barrel of oil or bushel of corn, you can't see or touch a future. A futures contract is simply an agreement to buy or sell a fixed amount of a commodity, like oil, at a set date and location.

To buy futures, a trader on a futures exchange makes an offer. If there's a seller who likes his price, voila, a futures contract has just been created.

The exchange itself is merely the location for trading, and anyone in the world can participate, through a commodities broker.

Under Nymex terms, one crude oil futures contract is an agreement to buy 1,000 U.S. barrels (42,000 gallons) of a specified quality of light, sweet crude oil.

Most traders, though, don't actually want the oil. In practice, less than 1 percent of futures contracts result in the delivery of a commodity.

Instead, people holding a futures contract make sure to sell an equivalent contract before the delivery date, so the two transactions cancel out and result in a profit or loss.

Producers and consumers of goods from soybeans and rubber to electricity use futures to protect, or hedge, themselves against an unforeseen change in price. They can trade with each other, or they can buy from traders who are simply looking to make a profit.

Speculators are important to the market because they often step in when nobody else wants to buy or sell a certain contract. In fact, economists have found that the more traders in the market, the smaller the gap will be between the buying and selling price for commodities. This reduces costs for commodities companies, which eventually should lower price tags for grocery shoppers and utility customers.

On the trading floor, it helps to be tall and solidly built, with strong legs supporting you in the crush. The louder you yell, the more quickly you can execute trades. Your day lasts from the opening bell at 10 a.m. ET to the close of trading at 2:30 p.m.

"It's like if you spent four and a half hours on a football field or a basketball court," independent energy trader Eric Bolling said. "When you're done you're not only physically done, you're mentally done."

Bolling lost a shirtsleeve during the first war with Iraq. Carbone just had a double hernia operation that he blames on trading the larger of the two hernias was on the left side, where he's pushed most often.

Those in the fray of futures trading have a message for Americans concerned about high energy prices.

"Get ready. It's going to get worse before it gets better," Liberty Trading's Cordier said.

Commodities like coffee and cocoa typically are produced by poor countries, such as Honduras and Colombia, so producers also participate in the futures market to protect themselves against a drop in prices. But wealthy oil producers like Saudi Arabia don't need to hedge against lower prices, Cordier said. That creates an imbalance in the market where more people are buying, so supply-demand economics dictates that energy prices will rise.

"The only way to curtail high prices in energy is to reach a level where people stop using so much," he said.

Carbone, the New York trader, agrees.

Traders have lost a lot of money in the last three years betting that oil prices couldn't go higher than $50 a barrel, then $60 a barrel, and then $70, he said. There are so many events that could push oil prices up, and not a lot that could bring them down, that most people are protecting themselves from higher prices.

"There's the fear of waking up to $100 crude oil," Carbone said, remembering his shock at the buy orders flooding the market the week crude oil topped $75.

"That week was about defying gravity," he said. "It made me shake off fundamentals and look at any weakness as an opportunity to buy. Close your eyes and buy. If you think about it too much, it'll be $1 higher before you know it."

Across the country, policymakers and consumer advocates concerned about high gas prices have questioned whether speculation is driving energy prices artificially high, or exaggerating price swings.

"Speculators have the potential to reduce volatility because when prices go up they sell, and when prices fall they buy. Other times the speculators might add to the volatility, because if prices go up they jump on the bandwagon and drive prices up," said Randall Dodd, director of the Financial Policy Forum, a Washington, D.C., nonprofit research group that studies financial markets. "Speculators can play a positive role but they don't always."

Nymex President James Newsome told a House Agriculture Committee hearing on April 27 that speculators held 24 percent of gasoline futures positions in 2005, up from 22 percent the year before, whereas commercial companies held 76 percent.

In the end, oil prices are going to be determined predominantly by the supply the amount producers can pump from the ground and the ever-growing demand from China, India and the U.S., with our love of SUVs and suburban living.

"Blaming the futures markets for high commodity prices is like blaming a thermometer for it being hot outside," said Walter Lukken, a member of the U.S. Commodity Futures Trading Commission.