A few weeks ago, much space was devoted on this blog to the price of oil, the effect "speculators" are having on it, and the question of whether the involvement of those "speculators" might not be signaling the end of the oil bubble.

This last week saw herculean efforts from our legislators to convince voters that they are on the case and will soon be passing laws to address the problem. They have identified the problem as "speculators making the price of oil go higher," which is convenient because that is a group that does not enjoy very favorable poll numbers, making them ideal scapegoats.

Be afraid, investors, be very afraid! Whenever your elected officials start passing laws to alter the behavior of market participants in an election year, count on them getting it wrong and creating the dreaded Unintended Consequences (UCs). The Mother of All Unintended Consequences is about to be brought into existence by Congress, just in time to accomplish the exact opposite of what they want to accomplish.

In short, loyal readers, investors and voters, Congress is about to pass a law that will make it more difficult for oil to drop in price, just as the tide has turned and oil has begun to do just that. In the last two weeks, the price of light sweet crude has dropped from an all-time-high of over $145-a-barrel to a closing prices Friday of $123.26. That equates to a decline of 15%, a Nice Round Number, which readers of the Shady Side might recognize as being fraught with meaning.

To enable readers of the Shady Side to understand what is happening, let's first make them understand exactly who these evil speculators are that Congress is going after. The headlines that you are reading, and even the testimony before Congress from alleged experts, do not spend much time identifying the culprits. I know these folks, and I would be happy to introduce them to you.

Over here, say hello to the natural counterparties in the trading of oil (and all commodity) futures. These are the folks who have a legitimate business need for trading futures, apart from any speculation about whether the price of oil might rise or decline. Since I just wrote a ridiculous check to Con Edison for my electricity, I will make them one of those natural counterparties, intent on locking in the supply of oil that they need to generate my electricity. So Con Ed buys futures contracts on the CME or the NYMEX that guarantee them a supply of oil at a certain price, regardless of where the price of oil goes on the spot market.

Who sells it to them, under the terms of that futures contract? Might have been Exxon Mobil, which has been engaged in an ongoing program of hedging its production for years. In other words, Exxon is willing to engage in a futures contract with Con Ed to provide them with all of the oil they might need because the price of oil in the contract is high enough that Exxon will make a very nice profit margin.

These folks, again, are what we call "natural counterparties."

To their credit, Congress has at least excused them from the bill winding its way through the legislature. Recognizing that the futures exchanges were created to enable businesses to control their risks in the way described above, our legislators wrote language into the bill that exempts companies that use futures for "legitimate hedging purposes."

As discussed in previous entries of the Shady Side, those natural counterparties were responsible for over 70% of the volume traded in futures contracts in the 1980s, shortly after the futures exchanges opened. By the year 2000, financial buyers, or "speculators", accounted for 37% of the volume transacted on the exchanges.

Today, over 70% of the volume on the exchanges is transacted by financial buyers like banks, brokerages, and hedge funds. This space featured that number and others like it recently as evidence that the oil bubble was not far from bursting. Market tops are always preceded by periods of rampant speculation, whether the market in question is for technology stocks, tulips, or oil.

We can further break these speculators down into two groups. The first group, over here, are the ones we will call the "long-only speculators," who are all betting on crude oil continuing to increase in value. Included in this group are individual investors who have made their wagers on the price of oil by putting their money into commodity-linked mutual funds or by buying the oil Exchange Traded Funds (ETFs). These are shares of stock that trade on the New York Stock Exchange (and other exchanges) that each represent fractional ownership in a barrel of oil.

Also included in the "long-only" group are some of the largest investing institutions in the world, like the California Public Employees Retirement System (CalPERS). The country's largest pension and retirement fund, CalPERS is in charge of investing over $200 billion of retirement assets for employees of the state of California, most of them blue collar workers.

Also investing in "long-only" oil plays are the major university endowments, like the $25 billion Yale University Endowment Fund. According to the 2007 annual report of the Yale Endowment Fund, approximately 27% of those billions was invested in the "Real Assets" category, which includes Real Estate and commodities like oil and gold.

There are two very compelling reasons why CalPERS and Yale University should invest in oil and other commodities. First is performance. If you are running money for these big institutions, you have a mandate to deliver performance, to make sure that your portfolio is earning positiive returns year in and year out. With the US stock market down over 10% year-to-date, you have to get your performance from somewhere else. Those who have investments related to oil are getting those positive returns there, and are probably keeping their jobs even though the stock portion of their portfolios are down.

But the second reason for "long only" oil investing might be even more compelling. If you are trusted with the nest eggs of a large number of workers, you need to examine what that money will ultimately be spent on. When your constituents retire, it is safe to assume that some amount of their pensions will be spent on gas for their cars. If gas is generally more expensive in the future, you need to have some investments that will benefit from that situation. You buy oil because you are hedging that exposure for those who are trusting you to anticipate such things.

It is true that Congressional actions to limit the effect that "speculators" have on the price of oil might reduce the influence that these "long onlies" may have on the market. Nevertheless, neither the blue collar workers whose money is invested by CalPERS nor the students and faculty strolling the lawns of Yale University match the portrait of the evil speculator that Congress would like you to think they are going after.

More importantly, the amount of money invested in oil and other commodities by the "long onlies" is dwarfed by the amount that is playing in the space controlled by hedge funds, managed futures funds, and others in the final category to which you should be introduced. Over here, these folks are the "long-and-short" traders.

These investors have the ability to make money on the price of oil whether it is rising or falling. There is also money here from CalPERS and Yale University, perhaps even more than is committed by them to "long only" strategies. When oil is rising, these traders buy the long futures contracts, which promise to deliver them a quantity of oil at some date in the future. But when the price of oil is falling, as it has been recently, the "long-shorts" sell the futures short, with the idea of buying it back cheaper in the future.

By far the most prevalent strategy employed by the "long-shorts" is known as "trend following." In this strategy, one tries to buy oil (or any asset) as it is rising in price, and to sell it short when it is falling in price.

So a 15% drop in oil, like we have just experienced in the last few weeks, might be expected to cause a rush for the exits in the oil trade. The folks who have made so much this year on the long side are nervously watching their computer screens for evidence that the previous trend has reversed.

If they become convinced that the trend is now down in the price of oil, they not only sell out their long positions (ones that bet on oil rising), they then begin to build short positions (those that make them money when oil falls). The bet here is that the recent 15% drop in oil has triggered some of this activity recently.

Here's the best part: if these speculators affected the price of oil as it was rising, they most certainly will have the same effect as it is falling. It may be impossible to calculate precisely, but I would guess that at least half of the recent $20+ drop in the price of a barrel of oil is the result of the "long-shorts" getting out of their long positions and putting on short positions.

The funniest part is this: the current legislation designed to limit the effect of speculators on the price of oil will also limit this downside effect. At precisely the moment when our economy is poised to benefit from the falling price of oil, Congress is busy passing a law that will mute that effect. They allowed the long-shorts to profit handsomely by trading oil to the upside, but will now impose limits on their trading at the exact time that this trading will accentuate the move to the downside.

That is certainly not what the folks in Congress had in mind. If they could, our legislators would probably pass a law that outlaws oil (and the price of gas at the pumps) from going up.

But they can't, so instead we get the unintended consequences of an imperfect law.

We would probably all be better off if they just took longer vacations and left everything alone.