Oil Markets and Prices
In 1973/4 OPEC inherited from the Seven Sisters a pricing regime, which effectively administered by fiat the price of oil. There was a difference, however. The majors in the pre-1974 period used to fix a posted price, which was then used to compute royalties and the income tax paid to producing countries. When OPEC countries took over, the administered price (then called GSOP or OSOP) was in effect the price at which oil was sold and bought in arms’ length transactions from the exporting countries.
The fixed (or administered) price system collapsed in 1985. The problem arose from the difficulty encountered by OPEC of defending a given price in the face of strong competition from emerging, and rapidly growing, non-OPEC sources. Increasing non-OPEC supplies, at a time of stagnant world demand resulted in the emergence of considerable surplus capacity within the OPEC region. This induced intra-OPEC competition, which means price discounting by several countries to protect their export volume. In the end, the defence of the administered price resulted in such a production fall in Saudi Arabia as to become unsustainable.
For a relatively short, but dramatic period in 1986 netback pricing replaced administered prices. The effects were catastrophic. The experience of the first half of the 1980s combined with a resurgence of a liberal `the markets rule’ view backed by powerful western political interests, has led to the conviction that administered pricing is a dangerously flawed system which is fundamentally unviable. That the oil majors found it perfectly suitable during twenty-five or thirty years at least, and that the OPEC countries enjoyed a revenue bonanza thanks to this system has been totally forgotten. This does not mean that we are advocating a return to an administered price system. Our point is that a more balanced judgement on its merit and defects is needed in order to clarify the pricing debate. The administered price regime collapsed after several decades; the netback system in less than a full year!
Netback pricing was replaced in 1987/1988 by a market related price formulae system. The first country to introduce it was Mexico. This country’s officials disliked netback pricing and never wanted to use it because the negotiations with buyers on the various components of the netback calculations lacked transparency and involved opportunities for corruption.
The price formulae system links the price at which a producing country would sell its oil to that of the `market price’ of a reference crude. Initially the reference crudes were ANS Spot, dated Brent, Dubai and Oman. The idea is to ensure that the price at which a buyer will purchase an OPEC crude will be equivalent to that of competing non-OPEC crudes in the relevant importing region.
Like all pricing systems, this one is not without defects. The idea of trailing the market has a strong economic rationale if the market that is being followed is the locus where demand and supply forces meet on a world scene. In such a case the price that emerges brings into balance world supply and demand. The markets which generate the reference on marker prices which exporting countries use for selling their oil – being Brent, WTI or Dubai – have important limitations. The first is that they are regional markets. The WTI price is strongly influenced by the balance between oil demand in the Chicago region and crude supplies in the US Gulf region. The Brent price is similarly influenced by demand and supply conditions in NW Europe. Although there is arbitrage between different regions of the Atlantic Basin, this force operates much more weakly as we move further away from that basin.
The second is that the reference prices emerge through a complex interaction between very thin spot markets, a relatively more liquid physical forward market (in the case of Brent), two very liquid futures markets (the NYMEX and the IPE), and markets which trade a variety of instruments such as the CFDs. The more liquid markets, those which play therefore the greater role on oil price determination, are the ones that are farther removed from the fundamentals of physical supply and demand. This is not to say that the fundamentals play no role at all, but that they are only one element in a set of determinants which include traders’ responses to news, traders’ views on how other traders interpret information and news, and on many occasions switches by financial investors to and from the oil markets from and to other commodity, bond or foreign exchange markets.
There are other problems. Let us mention two which are particularly significant. (a) The array of instruments available to traders enable a small number of powerful and sophisticated players to operate squeezes or launch other operations which causes prices to move in directions do not always reflect the actual state of the supply/demand balance. Whether these `games’ whose frequency has been increasing in recent years affect price trends over the medium term is debatable. It is certain, however, that they cause higher price volatility, and that they rob prices from their most important function which is to signal at every movement the state of the supply/demand balance.
(b) The information available to economic agents – oil companies, traders, oil-exporting countries etc. – about the key parameters – production, exports, demand and stocks – is so poor that the responses to this information which are important determinants of price formation in futures exchanges and elsewhere do not always relate to actual economic conditions. Everybody is to blame for this information problem: particularly the exporting countries, the oil companies and the IEA. One is tempted to say that the failure to recognize this problem and to seek remedies must mean that all those involved believe that the lack of transparency serves their own interests. The truth, however, is that poor information corrupts the functions of markets and prices and must in the end cause more harm than good to all the parties.
The reliance on reference prices generated by markets which are (1) more strongly influenced by economic fundamentals in specific regions than on the global scene, (2) often subject to squeezes and manipulations, (3) moved by switches of funds from oil to non-oil trading, (4) dominated by responses to poor or wrongly interpreted information and (5) led by transactions such as futures, CFDs etc. which are at some remove from the supply/demand interface is a cause of serious problems.
To list the most important:
- Oil price volatility has become a very significant phenomenon. Consider the following price movements of the first month WTI contract on the NYMEX in year 2000:
7 January $24.64
7 March $34.13
10 April $23.85
20 June $33.05
1 August $27.60
21 August $32.47
- Over eight weeks (7 January/7 March) the price rose by $9.50 per barrel. Then in less than 5 weeks (7 March – 10 April) the price fell by more than $10 per barrel. We then had a movement of $9.50 per barrel over ten weeks (10 April – 20 June), and finally a $5 per barrel change in as short a period as 3 weeks (1 August – 21 August). To put this in perspective, recall that the fall in price from $19 to $11 per barrel during the famous 1998 crisis occurred over a period longer than a year.
- As mentioned before, because of the lack of good information on production, stocks and demand, what rules the market is the consensus view about these numbers rather than the actual situation. This has an important implication for OPEC. When OPEC has to decide on a production policy in order to reverse a price fall as in 1998 and March 1999, it is obliged to reduce production by the volume demanded by traders and not by the amount required to restore the supply/demand balance. And the market has a tendency to believe in myths, such as the myth of the `missing barrels’ in 1998. In that year OPEC, together with Mexico and Norway, reduced oil production twice (in March and June) to no avail. The oil price continued to fall. The market did not believe that the reductions were large enough. In March 1999 OPEC cut production by the large amount demanded by the market. This turned out to be too much as evidenced by the relentless price increase that followed throughout that year.
It is nice to say that markets should rule. The statement is however meaningless and indeed dangerous in its implications if one does not specify which market, and the conditions that qualify a market to rule. The oil futures markets as they exist today and for the reasons mentioned earlier on do not qualify. Yet, OPEC has to follow their whims to influence the course of oil prices and this seems to be an important cause of high volatility.
- The developments of recent years have now reached a point where the oil industry, in the USA and in many other places elsewhere, has become very attuned to the operations of trading instruments. Refiners have learnt to hedge. They look closely at the term structure of prices on futures markets (backwardation and contango), at arbitrage and hedging opportunities etc. They have learnt (and this has now become an almost universal feature of behaviour) that you do not add to stocks when the market is in backwardation and that you pile up onto stocks as much oil as you can get hold of if the market is in a contango. The trouble is that futures markets watch inventory levels and interpret a fall in stocks as a sign of supply/demand tightness and a rise in stocks as a sign of supply/demand slack. A vicious circle then sets in. As stocks fall, oil prices are bid up and this often results in a steeper backwardation which further discourages the building up of stocks. As stocks rise, oil prices are bid down and this often results in a steeper contango which encourages further build-up in stocks. The system is in very unstable equilibrium. Backwardation could lead to prices rising and rising, contango to prices falling and falling. Only big shocks can stop these movements. But big shocks do not only arrest the price movement. They can reverse it, recreating the problem of relentless rise or fall until the next shock. We have witnessed some of that in 1998-2000.
To conclude. The situation is very unsatisfactory. Traders like it because they all think that it provides them with opportunities to make money. That it is impossible for everybody to win at the same time does not concern them since everybody believes that one day a good opportunity will be encountered and fortune will smile.
Whether the system is good for the exporting countries, the oil companies, the importing countries, the US government and the final consumer is very doubtful. Judging from recent experience it is clear that nobody likes either very high or very low oil prices. When they obtain, it is far too easy to blame OPEC. The issue however is not OPEC on its own but the system in its complex operations, in the links between various markets, and the awkward relationship between markets and OPEC. A fundamental reform is required. We hope to be able to contribute ideas for changes in the coming months.