What really caused the 2008 oil price spike?

I was gratified to read in this morning's Wall Street Journal that the folks in Washington are finally starting to wake up to the power of financial speculators in commodity markets. The behavior of oil prices last year makes it the poster child for what I call chronic speculitis--a painful condition that occurs when speculative buyers come to dominate a narrow, specialized market.

It all seems like a bad dream now, but at the time it was painfully real. Remember how oil prices spiked above $140 per barrel? The upward move was incessant. Pundits were spinning doomsday scenarios. We didn't believe it.

On May 1, 2008 I published an article  blaming the price spike on financial buyers. At the time, policy makers in Washington preferred to turn a blind eye to the reality of what was going on. They put out a hastily prepared report purporting to find no evidence that financial investors were having an impact on prices. Anyone with any real-world market experience knew the report's conclusion was bogus. Of course they were having an impact. Most of the financial investors were piling into oil and other commodities as buyers. The natural sellers of oil futures (hedgers, producers, etc.) were swamped. Of course the sellers would let the price rise. And the more they rose, the more financial buyers were pulled into the market.

Well finally a newly invigorated Commodity Futures Trading Commission (CFTC) is taking a fresh look at this situation.  According to the Wall Street Journal, a new review by the CFTC will be released next month and will likely put much of the blame for the run up in energy prices on financial players.

Here's and excerpt from the WSJ article:

The CFTC's new review, due to be released in August, adds fuel to a growing debate over financial investors who bet on the direction of commodities prices by buying contracts tied to indexes. These speculators have invested hundreds of billions of dollars in contracts that were once dominated by producers and consumers who sought to hedge against oil-market volatility....

The debate over speculators underscores the shifting nature of commodities trading in recent years. Before the mid-1990s, these markets were dominated by entities that had physical dealings with the underlying commodity, and "speculators" who often took the opposite position, providing liquidity to markets.

But a new group of investors has emerged in recent years. Those who want to bet on commodities prices have increasingly put their money in indexes that track the value of futures contracts, in which investors promise to pay a certain amount in the future for oil and other commodities. As of July 2008, financial investors had about $300 billion riding on these indexes, roughly four times the level in January 2006, according to the International Energy Agency, a Paris-based watchdog.

As those who know me will attest, I am an ardent advocate of free market economics. However, I also recognize that markets are human institutions and consequently are imperfect. They work best when power is distributed evenly among market players. When power becomes concentrated whether by monopoly or other means, the markets are no longer reliable mechanisms. Hedge funds and commodity index funds have become huge centers of power in the commodity markets in recent years. We owe it to ourselves to take a very careful look at their power.