The battle between bulls and bears in the energy market is beginning to look like something of a rout. On Jan. 16, oil prices tumbled yet again, dropping 3% to settle at $51.21 on the New York Mercantile Exchange. Oil is down 35% from its high of $78 in July. It's already off 16% so far in 2007.

With every day's decline, analysts are scrambling to explain why. In recent weeks, they've cited the warm winter weather, which has dampened demand. Today, they pointed to comments from a top Saudi Arabian official who said that an emergency meeting by the Organization of Petroleum Exporting Countries (OPEC) to cut their oil production isn't necessary at this time. "Do not panic," said Ali Naimi, the Saudi oil minister.

Long-Term Driver
Yet these explanations around supply and demand aren't the whole story. That's because another class of player has been wielding more influence on prices of late: speculators. Hedge funds, investment banks, mutual funds, and other financial institutions are magnifying small movements in prices—first as prices moved up last year, and now as they move back down.

"There's been a huge jump in speculation in oil markets, and it's exacerbating price volatility," says Peter Fusaro, founder of the Energy Hedge Fund Center, an energy-trading information site that tracks hedge funds. "The plus side is that there's a lot more liquidity. The downside is that the swings are larger than ever before." (See BusinessWeek.com, 10/4/06, "How Hot Money Inflames Oil Prices.")

In a December report, analyst Doug Leggate of Citigroup (C) highlighted the growing influence of financial firms. He wrote that "rising fund interest" has emerged as the "dominant long-term driver of price."

"Already Bleeding"
The explosion in the number of financial players in the energy markets has occurred particularly in the past year or two. There are currently 530 energy hedge funds, according to Fusaro, up from just 180 in October, 2004. Of the total funds now, 177 are strictly energy commodity funds trading oil or oil futures and options, as opposed to the stocks of energy companies such as ExxonMobil (XOM) and Chevron (CVX). Larger financial institutions such as Goldman Sachs (GS) and Morgan Stanley (MS) have also stepped up their participation in the energy markets recently.

The increased speculation has some experts wondering whether some players could run into trouble because of the surprisingly sharp decline in oil prices in recent weeks. Last fall, Amaranth Advisors, of Greenwich, Conn., lost billions of dollars in the natural gas market after a steep drop in prices (see BusinessWeek.com, 9/19/06, "Behind Amaranth's Sudden Swoon").

Experts say there could be other firms that will suffer deep losses now. "Somebody's already bleeding profusely," says Peter Beutel, president of Cameron Hanover, an energy risk-management firm in New Canaan, Conn. "They've been hurt pretty badly in the past few weeks, and it could get worse."

Lower Prices Likely
Hedge funds and investment banks don't report their trading results in a timely fashion, if at all. But mutual funds, which tend to use more conservative trading strategies, usually do. It's clear from the mutual fund reports that have become public that this is shaping up to be a difficult year for energy traders. The average mutual fund that invests in natural resources is down about 5% so far this year, according to mutual fund researcher Morningstar (MORN). Oppenheimer Commodity Strategy has dropped about 8% in 2007, ProFunds Sector Oil & Gas, 9%, and BlackRock Real Investment is down nearly 10%.

Financial firms remain influential players in the energy markets. Stephen Schork, energy consultant and editor of The Schork Report, says that speculators have wielded significant influence on oil prices over the past five years—and have played a major role in both July's price spike and the current slide. "Speculators are definitely playing the market," he says. "They were bullish last summer, and now they're pulling back."

If the financial players have their way, oil prices are likely to keep heading south. Market data from the Commodity Futures Trading Commission shows that noncommercial traders were net short on oil prices as of Jan. 9. Though it's unclear whether the traders will be right in their wagers, that suggests that they're betting on oil price declines. "Now that the price has retraced back to a fair value," says Schork, "funds are gearing up to push it lower."