How the Organization of Petroleum Exporting Countries perceives oil markets affects anyone who produces, processes, transports, or uses oil. Like the markets themselves, OPEC’s perceptions have evolved.
In the early 1990s, OPEC was wary of the markets that had developed over the prior decade for agreements to receive or deliver physical quantities of oil, or to buy or sell physical quantities, at some time other than the present.
These so-called paper markets emerged after spot trading began to grow at the expense of the long-term contracts that dominated oil markets until the price leaps of the 1970s. By allowing money and oil to change hands at different times, paper instruments such as futures contracts let buyers and sellers of oil hedge their risks of harmful future price movements. And they let investors assume those risks in the hope of profiting from future price movements-to speculate.
OPEC’s discomfort
OPEC’s discomfort related to speculation. Some of its members had a cultural aversion to anything other than direct sales between themselves and ultimate consumers of the oil they consider a divine blessing. In the early 1990s, too, some OPEC members no doubt resented the speculative profits that followed so soon their own failure to force up prices with production control.
In 1997, therefore, it was easy for OPEC to ignore financial signals, to dismiss forward price patterns of the paper market as evidence of speculative mischief, and to raise production just as demand was contracting because of an Asian financial crisis. By the next year, oil prices had collapsed.
Since then, OPEC has been more attentive to paper markets. If not always accurate-no one can predict oil markets-it has been much more anticipatory with its quota decisions than it was before.
Now the group has chimed in on a question that has rumbled around the oil industry for years: To what extent do financial markets influence the price of oil? The study that conveys the answer, from the OPEC Secretariat’s Petroleum Market Analysis Department, reveals much about market perceptions of the world’s most important collection of producers.
Especially interesting is the study’s view of how the oil market has changed.
In the 1990s, the study says, the market consisted mainly of producers, refiners, industrial oil users, and speculators. Spare production capacity among OPEC members provided a cushion against demand shocks, and downstream capacity was large enough to limit upward swings in crude and product prices. The dominant price pattern was backwardation-with immediate prices higher than prices in distant months. Trading was concentrated in near months.
“Use of oil and commodities as a distinct asset class in private and institutional funds was very limited,” the study says of this period. Investors made oil plays through equity in oil companies. “Investment banks, CTAs [commodity trade advisors], and trading companies had relatively small financial exposure to oil.”
Since 2000, that direct investment exposure to oil has grown, especially from the activity of investment banks, pension funds, and index and hedge funds. With more money being invested by more types of investors, futures markets gained influence over the price of crude. Paper markets became not just a hedge device but “both investment and hedge tools.”
In this new structure, the financial market “expresses its opinion of the future course of prices through position changes and higher volumes of futures and options trade,” the study says. So expectations and uncertainty about the future are “discounted into prompt prices more quickly and more forcefully than in the past.” It adds, “There is more transparency, but there is also more volatility.”
While these changes were in progress, global capacities to produce and refine crude oil were shrinking.
“This development reduced the cushion of supply security and the risk cover on sharp upside price movements, luring both paper hedge and speculative demand into the oil market,” the study says.
Physical factors
Some observers blame this movement largely for the increases in oil prices since 2002. The OPEC study notes-and voices agreement with-the alternative view emphasizing physical changes in supply and demand.
Its conclusions: physical factors rather than speculation are the main reasons for price increases since 2002. But speculation “has magnified price oscillations” and contributed to volatility.
Economists will debate validity of OPEC’s conclusions. What’s important to the oil industry is that the group no longer sees risk-absorbing speculators as wholly alien to petroleum markets.
