Sunday, November 11, 2007

Why Wall Street May Let Air Out of Oil Balloon

November 12, 2007

This is shaping up to be a hugely important week in energy markets. The hot oil balloon could rise to $100 a barrel. But don't be surprised if Wall Street -- driven by a mountain of expiring futures and options contracts -- steps up and pricks it.

The sheer speed with which oil has risen could intensify second-guessing as its price hovers near three digits. "Holding that number is going to require a lot more than just a belief in a momentum trade," says Ben Dell, energy analyst with Sanford C. Bernstein & Co. He says the market is hardly acknowledging that amid oil's climb, U.S. gasoline demand has slipped.

Some analysts believe derivatives markets could be making a "Great Unwind" in oil inevitable. Trading desks at big investment banks -- from Goldman Sachs Group and Morgan Stanley to Lehman Brothers Holdings -- have been active players this year in crude-oil options, which give buyers a right to buy or sell the commodity at a set price in the future. The banks' role, and the hedging they do to neutralize their exposure, can have a huge influence on crude prices.

In a recent report, Lehman analysts point to earlier this year as an example. Many oil producers wanted to hedge themselves against falling oil prices. The producers made bets with Wall Street market makers to protect themselves, Lehman says.

As part of the series of trades that ensued, Wall Street firms gained rights to buy oil at $70 and $80 a barrel. In their efforts to hedge their own positions, Lehman says, the investment banks became sellers of oil, acting as a weight on the market. When the options came into the money, Wall Street removed the hedges. Their selling pressure came off about two months ago and helped lift oil prices.

Another batch of options and futures expire this week. This time, rather than being a weight on the market as they had been earlier, many trading desks have been fueling it, says Lehman. That is because they have sold options to investors, including hedge funds, to buy oil at $100 a barrel. The closer it gets to that price, the more the investment banks buy oil to hedge.

Lehman warns a "free-fall" could follow when the investment banks stop their hedge-driven buying after options expire tomorrow. Futures contracts expire Friday. At the very least, says Lehman's chief energy economist Edward Morse, this week "could be one of the most volatile weeks for oil in years."

How big a deal are these machinations? As of Friday, says Lehman analyst Adam Robinson, 30% of all contracts to buy crude at $100 on the New York Mercantile Exchange were set to expire tomorrow.

Of course, other factors drive oil. The weak dollar supports oil, in part because investors buy it as an alternative to the cheapening currency. Strong demand in developing economies puts upward pressure on oil. And ministers of the Organization of Petroleum Exporting Countries gathering this weekend will shape the supply outlook for crude.

But when oil rises as far and fast as it has the past few weeks, one has to wonder about the role of Wall Street's financial engineers. By the end of the week, you will know a lot better.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.