Transparency in Oil Markets and Other Myths
Two of the most persistent myths of oil markets are that: 1) the prices set for oil are efficient, which is to say, reflect the state of best knowledge about the market; and 2) oil production data published by the reporting services and consultancies accurately reflect the supply situation.
In both cases, analysts are the victims of their own naïveté. Pricing of oil is anything but the product of ‘efficient markets’, at least in the sense that we understand that term as applied to securities markets in a highly regulated environment such as the United States. Nor is the quantity of oil produced as readily ascertainable a sum as many would think. Faith is placed all too readily in the numbers reported by the services, with little or no critical analysis of the basis or implications of those numbers.
The tale of the missing barrels
At the centre of the debate over transparency in oil markets is the issue of production estimates. While exporting nations are quick to publicise new production targets and estimates, it is almost unheard of for these same nations to announce with equal fanfare the fact that they have either chosen or failed to reach these numbers. Thus the putative level of oil stocks in the world increases on the back of such estimates, which soon obtain the character of facts, and the search begins for the ‘missing barrels’. Reporters and analysts display a singular reluctance to examine the numbers with a critical eye, for if they did, they would discover that the amounts of oil in question are of such a fantastic scale as to call into question the initial estimates in the first instance.
A specific example that can be cited is the market in early 1998. OPEC, at its meetings in Jakarta in November 1997, reached a consensus that production quotas should rise by 10%. The decision was implemented in January of 1998. When asked by reporters how much crude they had produced for January, producers such as Saudi Aramco, the Abu Dhabi National Oil Company, and Kuwait Petroleum Corporation all would have replied that they had increased production by 10%. Such numbers became invested with authority when the IEA took these numbers on board. The end result was that, notwithstanding flat or declining imports in Asia, that production overall had ‘increased’. The result was the commencement of a hunt for barrels of crude that the IEA stated as being ‘missing’. Rather than go back to the source and critically examine the rationale behind the production reports, the press and many analysts instead engaged in a conspiracy theory worthy of Oliver Stone. Speculation about tankers at sea with millions of barrels of crude ran rampant, along with darker theories about oil stockpiling in China.
In the end, a much simpler explanation resolves the mystery without recourse to James Bond theories. In simple truth, the numbers were inflated. Producers could not be seen to not be implementing the new OPEC quotas, and yet demand was down. It would have been madness to produce at increased levels while imports held steady or fell, and yet many gullible observers, and even industry insiders, believed precisely this to be the case.
One of the central assumptions about oil markets is that the basis upon which prices are formed is known. In reality, much of the information that plays a key role in price formation is hidden from the view of all but the intimate participants in the particular oil transactions in which they happen to be engaged. Their knowledge is itself restricted to those transactions, and not all transactions occurring globally. First and foremost, a significant percentage, if not a majority, of physical oil transactions occurs beyond the view of analysts and outside the sphere of regulated markets. Futures markets such as the IPE and Nymex, which are more visible deal with contracts, not dirty oil.
To summarise, we must first acknowledge that there is an upward bias in production estimates. Second, demand, in the form of consumption data, is not known until a very long time after the period for which it is reported. Lastly, very little publicly reported, accurate information exists for oil stocks outside of the United States. And yet the US oil stocks may not be an accurate reflection of the world situation. Faced with assessing price movements in the market, analysts can choose between focussing on the upstream sector – broadly speaking OPEC and in some cases non-OPEC oil production – or turning their attention to the altogether thornier question of the downstream. It is far easier to turn to OPEC, where in the glare of publicity, pronouncements on production quotas and pricing formulae allow analysts to construct a simpler, and thus more readily comprehended, story. Yet the price spikes in 2000 had more to do with the refiners’ behaviour and the oil product markets in the US than with production of crude oil.
Finally, the reference prices (WTI and Brent) used in the formulae at which oil is sold by exporting countries are generally futures prices. Prices in the futures market do not move exclusively in response to physical oil supply and demand conditions. They are determined by many factors, not least of which are the totality of positions taken by traders in many non-oil markets (for example, bonds, equities, foreign exchange and other commodities). The reference prices are those of paper assets held in diversified portfolios. It is the price of an asset which is a composite and not that of the oil supplied by exporting countries and demanded by refiners. The present system of pricing oil is effectively based on prices determined by portfolio decisions, not entirely by physical markets conditions. Oil is being priced by a set of factors in which non-oil elements sometimes dominate.
What is needed now is first for analysts to develop a critical mindset when assessing the information available to them. With such a critical approach, analysts can then recognise information which is obviously wrong. Even if truth cannot be reached, it helps to know and expunge immediately all that is non-truth. More importantly, the time may have come for the current oil pricing regime to be reviewed with the aim of finding an alternative that is less imperfect.