Hedge funds are being blamed for all kinds of things these days. Most recently, observers have charged that speculative and irrational activity by the funds has caused the soaring price of oil. Is it true? In part, yes.

The price of oil has almost unquestionably exceeded its “real” or long-term equilibrium price. No doubt that overrun has been exacerbated by the managed funds industry and especially by so-called momentum players.

Trading by so-called noncommercial entities (investors and speculators) on the New York Mercantile Exchange has risen with prices, and last week accounted for 28% of all long positions and 22% of all shorts – about double the level of two years ago.

Investors have crowded into the commodities markets this year for the very obvious reason that nothing else has been working. So far this year hedge funds have not starred; most are flat to slightly down.

Exceptions are emerging markets and fixed-income arbitrage funds, which the Tremont index shows to be up 3.7% and 5% respectively through July, and, not surprisingly, the short sellers, who were ahead 3.4% for the same period. Still, it’s a far cry from the results of recent years.

Oddly, the worst performing group through July was the managed futures funds, down almost 9%. Oops. One would expect this group to benefit from the general rise in commodities prices.

However, the group’s holdings are heavily weighted toward financial futures, which of course got nailed by the reversal in interest rates last spring.

But it should also be noted that fundamental supply and demand factors have also supported the recent strength in oil. Some notable investors have anticipated and benefited from those underlying trends.

Remember T. Boone Pickens? The former CEO of Mesa Petroleum now heads up BP Capital. His outfit manages two hedge funds; one is invested mainly in oil and gas equities and is up about 40% this year. The other holds energy futures and options, and is up “in the triple digits.”

Garrett Smith, who manages the equities fund, used to be the CFO of Mesa. He attributes the fund’s success to his group’s intimate knowledge of and correct analysis of the energy markets. They anticipated oil price increases, which Mr. Smith describes as the result of a demand squeeze in the marketplace. In the past, spikes in oil prices have resulted from supply disruptions – most notably the Arab embargo in the mid 1970s.

This time, surprisingly strong world demand growth has caused a gradual tightening of the market. This demand surge reflects two unusual variables, according to a leading (but publicity shy) Wall Street analyst.

First, growth in China is pushing consumption up – by an estimated 800,000 barrels a day this year and an expected 500,000 barrels a day in 2005. These additions represent about one third of world demand growth.

The increases reflect not only the growth in China’s economy, but also an undetermined amount of “start-up” demand, which comes from building supplies and distribution capabilities all through the infrastructure.

Second, the dampening effect of a rise in oil prices, which tends to lower the relationship between economic expansion and energy consumption, tends to diminish over time. In obvious ways, such as speed limits creeping up and consumers buying gas-hungry cars, past conservation efforts are put aside as the economy absorbs a higher price.

Oil prices have also risen because of fears of supply disruptions – from Iraq, from Russia because of the Yukos fracas, from Venezuela because of political mayhem, and from elsewhere in the Middle East. So far, however, supplies have been enough to absorb the rapid increase in demand.

The margin of safety is admittedly narrow, given that OPEC producers are expected to be at 89% of capacity next year, compared to a 10-year average of 87%. This assumes some restoration of Iraq’s output – conservatively figured at 2.1 million barrels a day. But it also assumes no production disruptions.

The Pickens group’s underlying assumption is that oil supplies are not being replaced. New fields do not compare in magnitude or quality with those being depleted, leading to a long-term upward bias to energy prices.

This is not a new thought. It is also not a reality, which will set the daily price of oil. Investors in crude markets must be agile and willing to bet against long-term convictions.

This is a lesson that many investors have had to learn, including, evidently, Barton Biggs. It has been reported that the well-known former Wall Street strategist got clobbered in his Traxis fund, which was down 7% through July, by holding to his conviction that oil prices had risen too far, too fast.

The question is, where do we go from here? Last week, oil prices dropped almost 15% from a high of $49 per barrel on August 20. Now that the immediacy of a major supply disruption seems to have diminished, investors may start to focus on discerning “real” or “normalized” oil prices as the new benchmark.

Most industry long-timers would put that in a $25-$30 per barrel range – considerably below the current price of about $43 a barrel. Since a supply disruption is still a possibility, oil will continue to sell at a premium, so perhaps the mid-30s is a reasonable projection over the next several months.

A drop in prices is suggested by a rising level of commercial inventories, and – barring the unforeseen – by the elements which make up next year’s supply and demand picture. The oil industry and speculators appear to be winding down positions in response to that expectation. Last week’s report form the NYME shows noncommercial long positions down more than 10%, and short positions up slightly.

No doubt the downward path in oil prices will not be smooth, and there will be winners and losers along the way. We wonder – will the hedge funds be blamed for a decline in oil prices?