Managing Oil Prices within a Band
Oil prices fell to very low levels during the January 1998 – March 1999 crisis. The oil-exporting countries sought to redress the situation by repeated attempts to impress the market with production cuts. The first attempt, made in March 1998, did not produce the desired price effect. The second attempt, in June 1998, was equally unsuccessful. The much delayed third attempt in March 1999 caused prices to rise to unexpectedly high levels.
This long and disturbing episode has undoubtedly taught oil-exporting countries many lessons. The first and most important one is that revenues, so vital to those developing countries which have few other resources than oil, depend far more on prices than production volumes. As Mr Nader Sultan, the chief executive of the Kuwaiti Oil Corporation, recently said: ‘A production cut of seven per cent brought about a 100 per cent increase in revenues’. This is a lesson that ministers in oil-exporting countries will not immediately forget.
The oil price movements of 1998- 9 carry another message. The message is simple, almost trite yet of considerable significance. It says that in commodity markets prices often under- or over-shoot equilibrium levels. In oil, the relevant price concept is not the competition market equilibrium but the producers’ preferred objective given that exporting countries exercise market power from time to time, however infrequently and clumsily.
In a market that naturally causes prices to collapse or to explode in response to either ill-informed expectations or small physical imbalances between supply and demand, production policies are unlikely to yield the desired price effect. Exporting countries, unhappy about a particular price situation, may change production volumes by too little or too much. The price target will therefore be missed. Furthermore, market’s views about what production policy ought to be rather than what the policy actually is have a significant bearing on the price outcome.
The exporting countries found themselves badly hit by an oil price crisis which they could not manage during fifteen months. And once out of the crisis they soon became confronted by a dilemma: should we now increase production to moderate the price rise or should we do nothing lest any production increase send prices tumbling down?
Production policy is failing to yield the desired price effect for the simple reason that it is not instrumentally related to the desired price target. Production cuts (as in 1998 and 1999) or production increases (as decreed by OPEC in their Jakarta meeting in November 1997) are shots in the dark. They cause oil exporters much trouble whenever they miss the price objective as we observed throughout 1998 and as we are seeing now. The dilemma which OPEC and its allies face today is whether they should keep unchanged the production quotas agreed in March 1999 at the risk of having prices running ahead out of control, or increase the quotas at the risk of having the price fall below desired levels.
It is worth recalling in this context that the oil market usually bids prices down whenever the producing countries are engaged in protracted and very public negotiations seeking an agreement on production. So far OPEC’s approach to policy making is to respond to a crisis in an ad hoc manner whenever one may emerge, and to stay put, sometimes for several years, when member countries believe that a change in the status quo will not be easily agreed upon. This is an inefficient approach.
To sum up, OPEC’s policy making suffers therefore from two defects. The first is the lack of a link between the production policy and a price objective, and the second is the ad hoc nature of responses to price shocks.
Some five years ago I proposed a policy scheme which is free from these two defects. The idea is simple and consists of the following elements:
(A) Producers would first define an oil price range as their objective for the average price of a reference crude that obtains over a certain period of time.
The reference crude could be either WTI or Brent. The period of time over which the average price is computed should not be shorter than a month, and not as long as three months. The range which defines the acceptability of the average price should not be very wide. A reasonable range is $2 per barrel.
It is important to stress that the proposed range does not set limits to price fluctuations in the market. They can move as they wish outside the limits of the range. What matters is that the average price of the relevant period (computed as an arithmetic average of closing prices) would be deemed acceptable if it falls within the range.
(B) If the average oil price in a relevant period falls outside the range, the exporting countries will automatically implement in the next period a pre-agreed adjustment to their exports. Exports will be cut if the average price is below the lower end of the range, and increased if it is above the higher limit of the range. A one per cent change in quotas (or a change close to one per cent) for a $1.0 barrel divergence of the average price from the relevant limits appears to be an appropriate adjustment.
(C) The variable subject to adjustments should be exports not production. This may require a translation of current production into export quotas.
(D) No policy – be it a single production policy or one which links production to a price objective – can perform efficiently when the decision makers have no access to the relevant information. One of the reasons why the production cuts of March and June 1998 and those of March 1999 were less than optimum is because they were based on wrong assumptions about production and /or stock levels. There is not much that OPEC can do about statistics in inventories other than apply a healthy and sharp critical sense to available information. But exporting countries have it within their power to publish export data every month.
In the context of our suggested policy scheme, export volumes can be reported at the end of every month to an ombudsman by submitting copies of the bills of lading of tankers which lifted oil in the month. When cuts are required no party will have an incentive to understate its exports. It may try to overstate them but this would imply faking bills of lading which is easily spotted. Similarly when export increases are required a party has no incentive to underestimate exports. As before, overstatement may be a problem but can easily be spotted.
This procedure does not require the expensive use of a firm of accountants visiting countries and checking their books. Since the relevant variable is exports, all that is needed is a pocket calculator to add up the bills of lading and a subscription to the Lloyds services to check on the existence of dubious tankers.
This idea of a policy scheme involving a price range and production adjustment is being promoted by some OPEC member countries. It is eliciting a number of objections some of which reflect a misunderstanding of the proposal outlined above (although perhaps not of proposals made by others which I have not seen).
It is wrong to liken this scheme to Central Bank intervention on foreign exchange markets. These sometimes fail because the market has larger foreign exchange holdings than the Central Bank. The oil situation is of a completely different nature.
It is also wrong to assume that the scheme is about an intervention that will keep price fluctuations tightly bound between limits. The objective is the average price not day-to-day or intra-day volatility. More importantly the purpose of the scheme is to signal to the market that the exporting countries are serious in their resolve to have average prices sticking to a preferred range. It would be naïve to think that the periodic quantitative changes will at every round bring the average price within the band. The adjustment is likely to be progressive involving a sequence of moves. The benefit of the scheme is that it reduces significantly the risk of prices moving consistently, for a fairly long period, below or above the range.
Three problems remain. First to define the range. Negotiations on the issue will revive the rift between doves and hawks. Second to cope with asymmetrical responses to price falls and price rises. Producers are more likely to adopt a policy that stops and reverses a price decline than to take the steam out of a price rise. Third, there is the more serious issue of the impact of price certainty on investments outside OPEC. For this reason the price range should be changed from time to time. This may appear to be the most difficult aspect of the scheme. Yet, on reflection, one wonders whether the industry investment plans are not predicated on what they think is a likely average price that remains stable for a long period of time. This price is perhaps $15 for Brent. To give them some certainty at $17 or $18 for Brent may not be such a very big deal after all.