At the end of 1997, with the Asian economic crisis unfolding and the Organization of Petroleum Exporting Countries raising production at its now infamous Dec. 1 meeting, some industry observers claimed that OPEC was out of touch, if not moribund.
The ensuing price decline of 1998 divided OPEC watchers into two camps: those who said the price decline was proof of OPEC's impotence and those who pointed to OPEC's high production and falling prices as evidence of OPEC's power, however mismanaged.
During the intervening 21/2 years, events in the oil market have validated, like no other period since the 1970s, OPEC's clear but largely unwieldy market power.
First, OPEC's overproduction brought crude oil prices to their knees, reaching close to $10/bbl for West Texas Intermediate. Then, its dramatic production cuts lifted prices over $30/bbl. A subsequent and comparatively small production increase has moderated prices only a little.
Now, with oil demand recovering and with limits on spare production capacity, OPEC's clumsy efforts to manage supply will continue. Indeed, the adoption of a $22-28/bbl (OPEC basket of crudes) price band is likely to keep oil prices on their rollercoaster ride, as it has put OPEC squarely in the sights of the noncommercial traders looking for a sure thing.
Traditionally, OPEC's production policies have been discussed in terms of the trade-off between maximizing price or maximizing market share. This dichotomy, however, provides only a simple framework, which is misleading in its characterization of OPEC's alternatives. The member states of OPEC are well aware of their dependence on steady oil consumption, thanks especially to the Asian economic crisis. Moreover, they know that high prices encourage investment in non-OPEC countries. So, at one extreme, deliberate supply curtailments designed to dramatically raise prices are a nonstarter because they encourage non-OPEC investment and discourage oil demand growth.
At the other extreme is the market share objective: Why not raise production, lower prices, and shut down non-OPEC output to seize market share? This has been the question since 1986, when Saudi Arabia's rejection of the role of swing producer precipitated the last price collapse and led to a quota-setting system that was ostensibly designed to "balance" the market.
OPEC does not have the stomach to wield its power in this way (or it would have by now). At the heart of it, OPEC's current spare capacity is concentrated in only a few countries. As a result, there are too many countries within OPEC that suffer from low prices but cannot necessarily increase production to gain market share. In the meantime, the core (spare-capacity) countries are unwilling to cut the others loose, and exercise this market power on their own. Perhaps they fear an energy security backlash by consuming countries or a diplomatic break with the US. Or, as happens in many multilateral organizations, the core countries get caught up with issues of membership and procedure rather than substance and outcome.
Pursuing stability
So, OPEC purports to follow a middle road in pursuit of "stable prices."
In this sense, OPEC wants to "manage" or "control" prices. OPEC's antagonist in the global drama of price formation, however, is not the consuming countries or the non-OPEC producers. It is the financial markets, which have vied with OPEC since the mid-1980s for influence over oil prices.
When OPEC makes big mistakes, such as overproducing in 1998, or takes strong action, such as cutting production in 1999, it determines the general price direction. The futures markets and their pure financial (noncommercial) players, however, can dramatically influence the pace and scope of that price move. A significant net short position by the noncommercials on the New York Mercantile Exchange certainly helped move prices down towards $10/bbl by the end of 1998. By the same token, we might not have surpassed $30 in early 2000 without a big net long position by the same players who shorted the market a year earlier. In sum, hedge funds help oil prices overshoot their fundamentally supportable levels.
The fact that the noncommercials, or hedge funds, can periodically influence a market where, by definition, they do not produce or consume wet barrels is, in part, OPEC's doing. The absence of credible data regarding supply and demand in OPEC countries is just one example of the general lack of transparency in the global market. Areas of limited or questionable public information and minimal market transparency preserve economic rent. But that rent does not necessarily go to OPEC the low-cost producer. It goes to the most clever, aggressive, or informed players. In many cases, that includes the major oil companies or the hedge funds. So, OPEC contributes to the opacity of the market but seldom receives all of the financial benefits of the market's inefficiencies.
Managing instability
While OPEC is trying to stabilize prices, oil companies and hedge funds actively take advantage of price fluctuations and pull economic rent away from the low-cost producers in OPEC.
Let's say that crude oil prices are $20/bbl (WTI) going into the winter months. The general market consensus is that prices will go up on the back of wintertime demand. Now, suppose an enterprising fund manager (or trading manager in a major oil company) studies the market very closely and perhaps has a better understanding of developments in some of the darker corners of the market. He or she believes that there are fundamental reasons why the price may actually go down rather than up. The offer curve in the futures market is relatively flat at $20 (or even in contango). He or she may decide to go short in the winter months of the futures market, because he is a speculator or because she is a hedger and wants to lock in the value of her crude production at $20 or more.
Let's say this particular trader is right, and prices fall by $3 to $17/bbl. He or she will earn $3 in the futures market. In the case of the speculator, it is a pure gain. For a hedger, it offsets the loss in the physical market. The OPEC producers, because by and large they do not hedge, earn $3 less than the $20/bbl or more that they were anticipating. For them, it is a pure loss. Now let's say the trader and hedger were wrong, and the price went to $23. The unhedged OPEC producer would enjoy the pure gain. Both the speculator and hedger would suffer a loss, but careful stop-loss management should minimize that loss. Moreover, both could use a careful combination of futures and options to further limit their losses.
Over the last 15 years, the futures market has allowed both commercial and noncommercial traders to periodically steal economic rent from OPEC. In the process, they can even move prices against OPEC's interests.
So, even though OPEC may be a passable crisis manager, the subtle maintenance of stable prices may be beyond its grasp, because the financial markets have made it possible for hedgers and speculators to exploit the market's inefficiencies. In doing so, they prey on and exacerbate the price fluctuations OPEC is trying to prevent.
Prices: band, pendulum, target
This leads us to the $22-28/bbl OPEC basket price range strategy.
Under this new arrangement, if the OPEC basket exceeds $28 for 20 days, OPEC will supposedly initiate a pro rata increase in output of 500,000 b/d. If the OPEC basket falls below $22 for 20 days, OPEC will supposedly initiate a pro rata decrease in output of 500,000 b/d. The effectiveness of this approach will depend on its implementation, but a few obvious flaws stand out:
- The price band is too high. A $22-28 OPEC basket is a $24-30 Brent or a $25-31 WTI. At this level of price, non-OPEC investment will accelerate, global oil demand growth will slow as alternate fuels become competitive with oil, and consuming country governments will continue to press for lower prices.
- Given the tendency of OPEC member countries to periodically overproduce, the margin of error in OPEC production estimates is close to 500,000 b/d. As a result, a trigger mechanism that adds 500,000 b/d may be hard to monitor, if not implement. If it is, the price band will gradually lose credibility.
- Traders will use this range essentially as points of support and resistance. As such, prices will tend towards one of the two ends of the price range rather than the middle.
The price of oil does not always reflect supply and demand. A technically driven rally in the futures markets in London or New York or temporary developments in the North Sea or Cushing, Okla., could lift the price of both Brent and WTI. For better or worse, these two crudes are the global benchmarks. Spot prices around the world would eventually follow them up.
If the OPEC basket price crossed the upper end of the price band, in theory, OPEC output would increase. At the same time, the noncommercials in the futures market would short the market. Not only would unnecessary oil flow into the market, but prices would feel the twin effect of more supply and a paper market sell-off.
Indeed, a version of this scenario appeared to be happening as this article went to press. In spite of the April 2000 production increase, something encouraged speculators to continue buying on the futures market. As crude prices rose, the OPEC basket moved closer and closer to the OPEC-imposed price ceiling of $28/bbl (OPEC basket). It is not inconceivable that the speculators will repeatedly call OPEC's bluff regarding the 20-day OPEC basket ceiling. If the fundamentals are supportive, as they have been, why not go long on crude oil until crude is bid up to a level that triggers the 20-day timer, then move up your stops and take profits-if not go short-when the market turns on OPEC's announcement that it will increase production? The same strategy would work on the downside. If the market turns, why not push it to the floor and wait for OPEC? In this case, OPEC has created a price pendulum rather than some stability around the midpoint of the price band.
If OPEC's definition of stability is a wide price range that is generally acceptable to consumers but keeps non-OPEC investment on a slow path, then OPEC will have to lower the price band and live with volatility. If distinct volatility is unacceptable, then OPEC will not only have to lower its price target, but scrap the price band, too.
In sum, OPEC will continue to eschew its true market power, opting to muddle through in search of stable prices. OPEC's success in "stabilizing" prices rather than maximizing the benefit to the core members will depend on OPEC's ability to embrace, respect, and understand the other components of the market, such as demand and non-OPEC supply but especially the financial markets.
Moreover, it will depend on patience and infrequent attempts to manage supply. The more OPEC tries to micromanage supply, the more vulnerable it will be to an overreaction in price.
The author-
Sarah Emerson joined Energy Security Analysis Inc. when the oil consulting practice was launched in 1986. Since then she has become a principal in the firm and currently oversees all day-to-day operations at ESAI and specifically directs the oil practice. Emerson has developed many of ESAI's unique analytical tools for analyzing the oil market and forecasting oil prices. She has conducted several industry studies on topics ranging from the transfer of pollution in energy trade to the future of gasoline markets to the future of the Russian oil industry. She regularly publishes articles in the energy trade press and co-authored the monograph, Storage in the International Oil System, published by the Economist Intelligence Unit. Emerson received her BA from Cornell University and her MA from the Johns Hopkins University Nitze School of Advanced International Studies.
