Middle East Economic Survey

 

VOL. XLIX

No 6

5-Feb-2007

 

Crude Oil Prices: Can OPEC Keep Stemming The Tide?

 

By Ali Aissaoui

 

The following article by Ali Aissaoui, Head of Research at the Arab Petroleum Investments Corporation (APICORP), discusses oil market developments and OPEC policy. This article is published concomitantly in APICORP’s monthly Economic Commentary dated February 2007. Comments and feedback may be sent to aaissaoui@apicorp-arabia.com

 

Most industry analysts ended up agreeing with each other on what had caused the oil prices surge of recent years up to August 2006. They are, however, still debating what has driven their fall since. This analysts’ lag can probably be explained by a natural tendency to be first a devotee of a school of thought before zooming out again to gain a broader understanding of the market. Currently, three such schools predominate:

In line with the last bias, this commentary aims to provide insights into the main determinants of the oil market and the prime factors behind the recent fall in oil prices. Moreover, in a context where OPEC has adjusted its production to contain further price declines, the paper explores what additional actions are needed to credibly protect its members’ economic interests should the market deteriorate again.

 

Weakening Purchasing Power

Recent trends in oil and currency markets have raised serious concerns within the oil-producing community. The value of the OPEC reference basket (ORB),1 which reached an all time high of $72/B during the first week of August 2006, fell to $48/B during the third week of January 2007. It would have declined further if not for the combination of OPEC’s output cuts, the spread of colder weather and the planned expansion of the US Strategic Petroleum Reserve. However, although the ORB moved up robustly as a result, the continuing depreciation of the US dollar – the currency for pricing, invoicing and settlement of oil trades – has weakened the producers’ purchasing power. Oil prices expressed in euro for instance have settled at €40/B (Figure 1).

 

Figure 1

OPEC Reference Basket Value In US$ And Euro

 

As regards the oil market, several factors have combined to depress prices since last summer. They include slower global demand growth, OPEC acting benevolently, speculative downward pressures, a milder perception of geopolitical risks and the possible effect of US monetary policy.

 

Slowing Demand Growth

During the last five years, up to 2006, world oil demand rose by a remarkable 7mn b/d to 84.7mn b/d. More than 40% of this increment is attributable to China and the bulk of it has been for use in the transportation sector, making it hardly substitutable or elastic to prices. However, as a result of lower economic growth, oil demand growth has slowed.

 

The highest annual demand increment witnessed in recent years – some 2.8mn b/d in 2004 − occurred when oil prices were relatively moderate at below $40/B and world economic growth the strongest at 5.3%. Since then, despite the global economy’s resilience to higher oil prices, the annual incremental demand for oil has decreased gradually (Figure 2).

 

Assuming an average oil price of $55/B (the median value of current expert forecasts for light sweet crude oil), the above trend is very likely to continue in 2007. Indeed, with slower world economic growth of 4.4%, global oil demand is expected to increase by less than 1.3mn b/d to some 86mn b/d.

 

Figure 2

Annual Global Incremental Demand For Oil

 

A Benevolent OPEC

The analytical framework used to assess oil demand and supply and their effect on prices assumes that OPEC acts as a residual supplier. Accordingly, global oil demand is first met by supply from non-OPEC producers, eventually by a draw on commercial inventories, ultimately by OPEC producers (the call on OPEC oil). This role of residual supplier stems from the ability of OPEC to hold and use spare capacity, the bulk of which resides in Saudi Arabia, to balance the market.

 

As highlighted earlier, while global oil demand has increased by 7mn b/d during the period 2002-06, non-OPEC production has augmented by only 2.8mn b/d. Simple arithmetic dictates, therefore, that the incremental call on OPEC oil and inventories was 4.2mn b/d. In a context of rapidly increasing prices and fears of supply disruptions, OPEC acted benevolently using a significant portion of its spare capacity to raise output by 4.6mn b/d (including NGLs). This accommodative supply policy has had an inauspicious effect: allowing oil inventories to build up by 0.4mn b/d on average during the same period.

 

Aggravating Speculative Pressures

There is currently a highly polarized debate on whether commodity investors, whose involvement in oil futures markets has increased significantly in recent years, add more to the volatility of prices than to their levels. This has come out against suggestions that their activity has been a major contributor to the post-August 2006 downward trend in oil prices, in the same manner as they greatly contributed to their upsurge before.

 

Futures markets are intended to be used by commercial entities (producers, merchants and major consumers) for the purpose of hedging against price risks. However, future markets also provide refuge assets for a smaller portion of investors, including hedge funds, whose objective is to achieve high returns through the anticipation of price movements. This activity, which is in essence speculative, adds liquidity to the market and makes it easier for commercial players to hedge their exposure.

 

By betting on price changes, speculators tend to rush to buy the commodity (take positions) before the price trend ends, and an even greater rush to sell the commodity (unwind positions) when prices reverse. Obviously, this aggravates the movement of futures prices and, through time arbitrage transactions, that of spot prices. Therefore, spot prices end up much higher or much lower than are justified by the market fundamentals. This simple interpretation allows us to say that speculation may have exacerbated the ongoing episode of falling oil prices.

 

Milder Perceptions Of Geopolitical Risks

Perceived geopolitical risks in key producing areas generally translate into an implicit risk premium to reflect possible adverse supply effects. While this was apparently the case until August 2006, heightened uncertainties in the Middle East have had no such effect since. For instance, the market has ignored rejection by the US administration of the recommendations of the Iraq-Study Group (Baker-Hamilton) and subsequent embracing of a more confrontational “New Iraq Strategy”.

 

One possible explanation is that well-informed speculators may internalize such risks when taking positions on the futures market aggravating, as noted earlier, the upward movements of oil prices. Asymmetrically, their pull back from the market, as has recently been the case, removes any premium that would have otherwise offset their anticipated risks. 

 

A more plausible explanation, however, lies in the possibility of a milder market’s perception of geopolitical risks. This may stem from the fact that, as a result of both additional capacity from Saudi Arabia and the lower call on OPEC oil, OPEC enhanced spare capacity is now seen as a strong mitigating factor against potential supply disruptions.2

 

Detrimental Effect Of Monetary Policies

Prominent academics have recently argued that the oil market determinants reviewed previously are only part of the story. Other key factors affecting oil prices include US monetary policy. This phenomenon, which has been documented both theoretically (by analogy to Dornbusch’s overshooting model) and empirically (through correlation and causality tests), has focused the attention of Prof Jeffrey Frankel from Harvard University. His central claim is that “monetary policy, as reflected in real interest rates, is an important […] determinant of the real prices of oil and other mineral and agricultural products […]”.3

 

It apparently happened in the past each time interest rates rose sharply, first in the mid-1970s then most dramatically in the early 1980s (Figure 3). But to what extent the most recent increases of interest rates by the US Federal Reserve (up to 5.25% in June 2006), which paralleled those of oil prices, have contributed to their subsequent fall? In other words does it happen systematically or just occasionally?

 

Figure 3

Evolution Of  Real ORB Values And Real US Federal Fund Rates 

Frankel (ibid) contends that it occurs whenever interest rates are high. High enough to reduce demand for commodities or increase their supply, the latter by: a) acting as an incentive for an opportune increase of the extraction of the primary commodity resource; b) serving as a disincentive to carry commodity inventories whose costs rise with interest rates; and c) enticing speculators to shift out of commodity contracts into interest bearing instruments.

 

Whether or not the above intuitive arguments will appeal to commodity market practitioners and policy makers remain to be seen. In any case, should oil prices be affected significantly by the US Federal Reserve monetary policy (or for that matter by that of the European Central Bank) then the issue would be serious enough to warrant OPEC’s attention and vigilance.

 

Can OPEC Keep Stemming The Tide?

OPEC, which acted benevolently in times of high oil prices, should be expected to be self-interested in time of low prices. What is at stake is not only securing and stabilizing export revenues and fiscal receipts, so vital to its members’ macroeconomic balances, but also preserving the economic viability of their petroleum investment plans. These investments, which have already suffered from overly inflated project costs (see Economic Commentary Vol 1 No 9 and MEES 4 September 2006), will be further affected by lower project revenues should prices fall again.

 

Up to now the two rounds of OPEC production cut, which total 1.7mn b/d or 6% of its total output, have greatly contributed to shore up falling prices, despite the market tending to believe that such cuts hardly materialize entirely.  However, with anticipated slow demand growth (beyond the seasonally low second quarter), expected larger non-OPEC supply and an overhang of excess inventories, the call on OPEC oil is likely to continue to shrink. In such a case, further policy actions will likely prove necessary.

 

In a context of sharper geopolitical and ideological differences and uneven accumulation of net savings (see Economic Commentary Vol 1 No 7-8) between its members, OPEC has ended up with a specific approach that reflects a least-common denominator consensus: commit to a series of affordable output cuts. This may be sufficient to stem a rising tide. A more effective policy tool, which supports an explicit reference price - preferably in the form of a band - will better convey OPEC’s expectations to the market and make it easier to navigate through should the tide keep rising.4

 

 

Notes

 

1.    This is the new – exclusively OPEC crude-based – Reference Basket implemented in June 2005. Its price differential relative to light sweet crude benchmarks such as WTI has been minus $3.75/B on average in recent months.

 

2.    During the third week of January trade journals reported that Minister Ali Naimi stated that Saudi Arabia's spare capacity was set to rise to 3mn b/d in February after the second OPEC output cut, adding that the kingdom would, in any case, maintain a spare capacity of 1.5-2.0mn b/d.

 

3.    Jeffrey Frankel (December 2006), “The Effect of Monetary Policy on Real Commodity Prices”, in Asset Prices and Monetary Policy, John Y. Campbell, Editor, The University of Chicago Press (forthcoming).

 

4.    It is worth remembering that in the aftermath of the 1998 oil market crisis, OPEC found inspiration in a series of proposals by Robert Mabro to articulate a new comprehensive supply management policy. Despite changing circumstances and market dynamic, Mabro’s guidelines are generic enough to inspire again. For further details see: Robert Mabro (1998), The Oil Price Crisis of 1998. A monograph published by the Oxford Institute for Energy Studies.