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As Oil Speculators Lose Backing, Market Exodus Could Ripple

THE WALL STREET JOURNAL 

As Oil Speculators Lose Backing, Market Exodus Could Ripple

Evaporating access to credit and fears of an economic washout are taking a toll on oil prices, forcing speculators using borrowed money out of the market.

Lehman Brothers Holdings Inc.’s sudden bankruptcy filing and Merrill Lynch & Co.’s pending sale to Bank of America Corp. suggest big banks may be less willing or able to absorb debt to boost trading positions, with implications for the inherently leveraged oil-futures markets. Analysts believe that could have a ripple effect on other speculative investors in the market.

Widespread liquidation of futures contracts compounded fears of faltering oil demand in knocking oil down near $90 a barrel on Tuesday before rebounding to settle at $91.15 on the New York Mercantile Exchange. Some traders faced margin calls, or demands for more cash collateral, in other asset classes, market participants said. In a conference call with analysts,Goldman Sachs Group Inc.’s chief financial officer noted “deleveraging” among its clients, attributing it to “more fear than anything.”

The potential for less leverage — or borrowed money — at play in the oil-futures market has already helped spark a sharp fall in oil prices, which have lost about 20% of their value this month. The drop has come amid a slew of factors that should support prices, including a production cut by the Organization of Petroleum Exporting Countries, renewed attacks in key crude-oil producer Nigeria and a major knock to gasoline output in the U.S. Gulf Coast in the wake of Hurricane Ike.

The duress suggests investment banks’ own proprietary commodities trading could decline as banks think twice about how much debt they take on to fund risky positions. Banks’ risk aversion could also drive their clients out of the oil market, which could continue to weigh on prices, with some analysts identifying this year’s lows of $86 as a near-term floor. That would represent a 42% drop from a peak above $147 a barrel hit in July.

“Essentially, the big banks will be doing less prop trading,” said Craig Pirrong, director of energy markets at the University of Houston’s Global Energy Management Institute. “To the extent they have clients that want to do hedges and things of that nature, they’ll still be there, though probably not on as favorable terms as before. As a result, some of their clients might be less willing to hedge.” Mr. Pirrong sees banks raising collateral requirements for customers seeking to trade oil.

Oil and other commodities have offered a key profit alternative for large investment banks in the past year as the credit crunch spread to many other parts of their business. Besides handling large volumes of trades for clients via the opaque over-the-counter commodity-swaps markets, they are also large commodity traders in their own right. Goldman Sachs and Morgan Stanley, the two banks with the biggest commodity businesses, are obsessively watched by other traders.

Both Merrill and Lehman have significant energy-trading operations, too. Merrill re-entered the sector in 2004, when it bought the trading business of Entergy-Koch LP. Lehman established its energy trading business in 2005. Barclays PLC, whose investment bank is also a major force in energy markets, has reached an agreement to buy the Lehman’s U.S. capital-markets businesses, which include commodities.

Lehman declined to comment on its commodities business.

Whatever Lehman’s future, its collapse on the heels of the rapid takeover of Bear Stearns and now Merrill Lynch is already sparking questions about the implications for the oil-trading businesses of other major banks.

A big oil-market exodus wasn’t in evidence Monday, as the number of Nymex crude contracts outstanding rose by nearly 18,000. But given the prevalence of trading on the vast over-the-counter swaps markets, it is difficult to get a one-day fix on traders’ positions.

One executive involved in oil trading said brokerages have reduced or canceled lines of credit to traders, even telling customers they need to double the amount of margin required from last week.

“If they want to put a position on and their requirement was a million dollars Friday, now it’s $2 million,” the executive said. The Nymex margin requirement for crude is currently about $10,000 per 1,000-barrel contract, and brokerages typically tack additional margin onto that.

Philip Gotthelf, president of Equidex Brokerage Group Inc., said some brokerage houses “are at 150% of exchange margin. They’re essentially shutting the little guy out completely.” It is harder to buy or sell crude, because “there’s less credit around to do it,” he said.

Fewer investors in the market won’t necessarily spell lower oil prices, as speculators can take bets with equal ease on price declines or gains. It could also lead to greater price swings.

“If a certain amount of market-making capacity leaves the market, you might have more volatility because they’re not here to stabilize prices,” said James Angel, an associate professor of finance and expert on exchanges at Georgetown University.

“For everybody in every asset class, risk aversion has gone up,” said Michael Wittner, global head of oil research at Societe Generale. “When volumes get thinner, it always adds to volatility.”

Write to Gregory Meyer at [email protected]

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