Middle East Economic Survey
VOL. XLVIII
No 17
Low Inventories Or Stable Prices? You Can’t Have Both
By William R Edwards
The following paper was first published in The Energy Journal, the quarterly publication of the International Association for Energy Economists (IAEE) and is republished with permission. William R Edwards is President of Edwards Energy Consultants, Katy, Texas (wre@texven.com).
OPEC has recently stated its intention to use US inventory levels as a guide in making its production/price decisions. The idea is that the way to keep prices high is to restrain production in such a way that inventories never rise to comfortable levels. If the consumer is always worrying about getting adequate and timely supply, then he will not worry about the price he pays for this supply.
On the surface this may look reasonable. But upon close examination it becomes apparent that this method of price control is patently unsound and does a huge disservice to both the consumer and the producer. The reason for this is that an environment of supply uncertainty is an environment of price uncertainty and volatility.
It is well known that oil futures prices as determined by the New York Mercantile Exchange (Nymex) is the major factor in current petroleum pricing. Correlations show that the Nymex now sets the price and the producing countries simply follow this price. History reveals that extreme volatility can occur on any commodity that is traded under a highly leveraged environment. When small moves in price create large demands on the financial assets of the participants, one can expect knee-jerk reactions on the price that these participants are willing to pay. Such is the case with oil futures prices on the Nymex.
The oil futures market has no restraints in pricing most of the time. When the supply situation is comfortable, futures prices can move up and down at will and are not influenced at all by real world fundamentals. Normally these fluctuations are modest in magnitude. However, when supply factors create a tight situation, the real oil world exerts a major influence on the futures market. It is a certainty that if inventories fall to minimum operating levels upward pressure on prices will be the result. Not only will prices rise, they will do so dramatically.
It is the nature of highly leveraged speculative markets to overemphasize any movement, either up or down. A tight supply situation is just what the skilled trader wishes for. In this environment trading becomes impulsive and erratic. Prices move rapidly in both directions with large fluctuations. This is exactly the situation that is created when OPEC production cuts achieve low inventory levels.
US Inventory
For purposes of illustration, let us look at the inventory situation in the United States. Commercial inventories of crude and product normally range between 1,000mn and 1,100mn barrels. The normal seasonal fluctuation is about 100mn barrels. This is shown in the following figure where commercial stocks are shown for the past 23 years.
The years 1996, 2000, 2003 and 2004 stand out in this chart because the inventory levels dropped in those years to the 900mn barrel level. Each of those years experienced a significant increase in price in the subsequent months. The erratic price jumps that we are now experiencing are confirming again that the 900mn barrel level for the US represents “empty tanks”. Thus it should come as no surprise that OPEC’s production cut in the 2003 winter created a surprisingly sharp run-up in prices. This was followed in 2004 by a refining capacity tightness that compounded OPEC’s production-cutting actions.
It is popular for oil producers to place the entire blame for the current extreme price volatility on psychological factors within the futures market. While it is true that the futures market contributes greatly to the magnitude of the price swings, it is inappropriate to place the entire blame for this situation on oil futures. Had not the inventory levels been reduced by the supply-restraint imposed by the producers, the role of the Nymex in this increase in volatility would never have been a factor. So ultimately the blame for price volatility lies at the feet of the OPEC producers.
If stability is to be returned to the oil markets, OPEC must return to a system that allows the free and adequate supply of petroleum markets without the imposition of supply restraints. In other words, it is impossible to have both low inventories and price stability. It is easily understood that if inventories are near tank bottoms, or at the operating minimum, any unexpected bobble will drastically affect prices. In order to avoid price instability, the customer must feel a sense of confidence that the oil will be there when he needs it. This confidence is impossible if inventories are skimpy.
OPEC should not be in the position of trying to manage customers’ inventory levels. It is entirely reasonable and appropriate for an individual refiner or consumer to decide what inventory level is comfortable for his business. The function of price management by OPEC should be an activity completely separate from supply management and must be conducted within the framework of a smoothly functioning supply system. Discovering and adopting such a system is OPEC’s challenge.
Commercial Stocks
