A news article came out yesterday that received almost no attention. Yet its significance cannot be overstated to those still hoping for a large drop in energy prices.

Hedge-fund managers and speculators reduced bets on higher oil prices by 80 percent since July as crude futures rose to records and U.S. regulators started investigating trading, government data show.

So-called speculative net long positions fell to 25,867 contracts on the New York Mercantile Exchange in the week ended May 27 from a record 127,491 on July 31, according to a U.S. Commodity Futures Trading Commission report on May 30.

Quite simply, this destroys every single sound bite you've heard out of Washington and the mainstream news media over why energy prices are so high.

The Senate has placed the majority of the blame for high energy prices on speculators. The media has also portrayed the high energy prices as the fault of speculators, and the whole thing as a bubble waiting to burst.

A few weeks ago Senator Joe Lieberman floated an idea of how to bring down oil prices. His plan would be to prevent pension funds from investing in the commodities market.

There is one obvious problem with this plan - pension funds aren't speculators. They are passive, long-term investors. In other words, they are exactly the kind of investor that every industry wants. They are doing exactly what every investor should do - buy into a bull market and ride it until its over. To punish this kind of investor is to punish the most productive part of the financial system.
Pension funds normally invest in treasury bonds, but were forced into the commodity market when the Federal Reserve lowered interest rates below the level of inflation. If they don't want pension funds to invest in commodities then they should raise interest rates. Simple as that.

Hedge funds, on the other hand, are speculators. But as the article at the top shows, hedge funds have already bailed out of the energy market. In Wall Street parlance, hedge funds are "weak hands". They are the kind of investors that will throw huge amounts of money into a market while it is going up and bail out of that market the moment it starts to drop, thus causing high volatility in prices.
That's what happens in a bubble.

In contrast, pension funds are "strong hands". They will ride out the short-term volatility, thus smoothing out the markets and allowing corporations to make longer-term decisions (for instance, drilling in a high-risk region or developing other types of energy sources). That's what happens in a bull market.
What it also means is that the things they buy, in this case oil, won't be getting sold anytime soon.

The Oil Market Has a Crack Problem

There is another problem for people who hope for a quick drop in gasoline prices. It's something called "the crack spread".

The spread created by purchasing oil futures and offsetting the position by selling gasoline and heating oil futures.
The name of this strategy is derived from the fact that "cracking" oil produces gasoline and heating oil. Therefore, oil refiners are able to generate residual income by entering into these transactions.

If you listened to the major media you would think that oil refiners were making a killing with these high energy prices. In fact the truth is that oil refiners have actually absorbed a great deal of the rising price of oil instead of passing it along to the customer, and this has hurt their bottom line.

So if you are to look at the crack spread, i.e. how much the refineries make on a barrel of oil and turn it into a barrel of gasoline, they are making like $5.00 per barrel this coming summer and like $1.00 per barrel for this coming winter. Of course, this is all subject to change. But geez, if you’re a refiner you might as well go take a vacation and wait until it’s more profitable.

Therefore, something has to give. Either gasoline prices need to spike more than oil prices have in the coming months or oil prices need to fall much more than gasoline need to. OR else, we will face a gasoline shortage this summer as refiners all go on vacation and stop making gasoline.

Believe it or not, oil refiner stocks are trading near one-year lows because their profits have been squeezed so much.

For the last decade the average Oil/Gas ratio has been 35.7. In other words, a barrel of crude has cost 35.7 times as much as a gallon of regular gasoline. But in mid-March the ratio jumped to 45.8, the highest in over a decade. At that ratio oil refiners were actually operating at a loss.
That's a condition that cannot continue for obvious reasons.

At $120 oil, a long-overdue OGR support approach would mean $4.44 wholesale gasoline! This is 42.3% higher than this week’s price. This would translate into a $4.99 average retail gasoline price across the United States! If today’s gasoline prices bother consumers, imagine sentiment at $5+! Ouch.

Of course oil may very well correct too, Wall Street is sweating bullets praying for such an eventuality. But since gasoline prices are so far behind crude oil, even a correction doesn’t offer much relief. Bull to date, oil’s average major correction is 21.8% over 2 months. This would take us to $97 or so.

At $97 oil after a major correction if the OGR still contracts to 27 support as it ought to, a barrel of crude will cost 27x as much as a gallon of wholesale gasoline. This works out to $3.59, or 15.1% higher than today’s gas prices. This would translate into $4.12 or so at the retail pumps! So probabilities favor higher gasoline prices even if oil corrects hard. And if crude oil instead continues powering higher, then all these numbers are far too conservative!

Think about that for a moment. If the oil price just holds its own for the next few months then gasoline prices must rise to about $5 a gallon this year! The laws of supply and demand are absolute in this case. No refiner is going to operate at a loss for long even if they wanted to (and they obviously don't want to).

If oil prices correct down soon, which is likely, and the correction is about average for the energy bull market of the last seven years, then gasoline prices will probably still rise slightly this year.

The only scenario in which gasoline prices will fall this year is if the energy market is in a bubble. But if the energy market is in a bubble, then where are all the weak hands? They've already sold their holdings in the energy market.

The reason for the crack spread to get so low is because of abnormally high gasoline supplies. If the supply of gas is too high then refiners will stop making gasoline until the demand returns. This also applies to profitability. The refiners aren't going to operate at a loss for long. Eventually either the price of crude oil drops, or the price of gasoline rises. Otherwise they won't be making gasoline.
As expected, the crack spread has begun to widen in recent weeks.

So if the problem isn't oil refiners, and the problem isn't speculators, then why are energy prices so high? The answer is crystal clear. Despite the fact that oil prices have doubled in the last two years, worldwide oil production has fallen slightly (by 31,000 barrels a day).
You have to wonder if the rest of the world is even capable of producing more crude oil if a doubling of oil prices can't convince the producers to put more oil on the market.

And if Joe Lieberman has his way, the exact type of investor needed to convince the oil producers to create more product would be locked out of the market.