Why gas prices dropped

Trust us. It wasn't OPEC or Republicans trying to influence midterm elections.

(Fortune Magazine) -- If the recent plunge in gas prices is the result of a conspiracy by President George W. Bush to help the Republicans retain control of Congress, as 42 percent of Americans believe, according to one Gallup poll, a lot of Wall Streeters wish they'd been in on the plot.

So what really drove prices down - if not an Oliver Stone-worthy scenario involving the Commander-in-Chief, the House of Saud and Secretary of the Treasury Hank Paulson cajoling his cronies at Goldman Sachs to sink the crude market?

Hedge funds get ahead of themselves

By late summer, hedge funds and other investors had poured billions into long positions in oil, gasoline, natural gas and the rest of what traders call the "energy complex," all betting on a replay of the severe 2005 hurricane season that sent prices soaring in the wake of Katrina and Rita. But one day after oil reached a monthly high of $76.98 a barrel on Aug. 7, government meteorologists downgraded their hurricane forecast and cautioned that a repeat of 2005 was "unlikely."

That announcement, combined with the end of the summer driving season and a recalibration of the Goldman Sachs (Charts) commodity index that reduced the weighting of gasoline, prompted speculators to head for the exits even faster than they'd piled in.

The switch in Goldman's basket of commodities had been previously announced by the firm, but that didn't stop the conspiracy theorists. "Hmm, what a coincidence, luring Goldman's top dog to take a HUGE pay cut by becoming Treasury's top dog, and then Goldman Sachs makes this unexpected decision, serving to dramatically drive down gas prices," said the Grey Matter, a liberal blog. But the grassy-knoll crowd didn't bother to crunch the numbers.

According to Joel Fingerman of Chicago-based OilAnalytics.net, between the peak of $77 a barrel in August and the October low of just under $58, traders dumped nearly 40 million barrels (a 20 percent drop) from their long positions. The volatile gasoline market showed an even sharper decline - with traders cutting long positions from 32 million barrels in midsummer to just 1.7 million in October.

"Whatever you want to call it - speculators, fast money, hot money - a big part of the drop in crude that we've seen this year is because of selling by hedge funds," says Merrill Lynch technical analyst Mary Ann Bartels.

That avalanche of cash also explains what's got the paranoid types talking - not merely the timing of the plunge in prices but its rapid speed. "Speculators create more velocity around existing trends," says Bartels. "Things are happening a lot more quickly in these markets than they used to."

The losers

Some traders were lucky and got out in time; most weren't. Implosions like the collapse of the $9.2 billion Amaranth fund seem spectacular, but the fund was merely caught in a bigger and badder bet than others hoping for another Katrina. Amaranth trader Brian Hunter bet the farm that hurricanes and a cold winter would push up natural gas prices, but, says Bartels, "a lot of people were caught by surprise."

The average energy hedge fund dropped 4 percent last month, according to Joel Schwab, a managing director of Hedgefund.net, which tracks fund performance. "They were having a great year, then things fell apart in September when they were caught long," says Schwab.

Even broader index-type funds that invest in a wide range of commodities and are open to individual investors are down. Manager John Brynjolfsson's Pimco Commodity Real Return fund is now off 5.6 percent for the year, after being up 1.4 percent before the summer rout.

The winners

One trader who's been luckier is Julian Barrowcliffe, manager of the $500 million Anglian Commodities fund. He has managed to eke out an 8 percent gain for the year by avoiding bets on which way crude would go, instead playing off the spreads between different products, betting on how, say, heating oil would move if gasoline prices went down.

"Anytime you have a big reversal, the guys who follow the trends get killed trying to get out quickly," says Barrowcliffe. As for those conspiracy theories, Barrowcliffe insists he wasn't tipped off. "It's ludicrous," he says. "Maybe 42 percent of Americans think Elvis is alive too."

Ironically, the current price for crude - $59 a barrel - is roughly where oil insiders have been predicting it would be if it weren't for all that hot money flowing into commodities. Last spring, energy consultant and Deloitte advisor Joe Stanislaw told Fortune that fundamental supply and demand factors suggested a price of about $50 a barrel, with geopolitical factors adding $10 and speculators putting another $10 on top of that.

Unfortunately for drivers, Stanislaw doesn't expect the premium caused by worries about tensions in key oil-producing countries like Iran, Iraq, Venezuela and Nigeria to fade anywhere near as quickly as all that hot money did. And there's no reason that money won't move back into energy if sentiment turns and there's a new trend to play.

Right now, the latest bet by traders is for a normal winter - if there's a sudden cold snap before Thanksgiving, expect a bump in crude. So enjoy the low gas prices while they last. You can be sure the White House will, even if it didn't orchestrate them.

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