Middle East Economic Survey
VOL. LI
No 51-52
22/29
OIL PRICES
Review Of The ITF Interim Report On Crude Oil
By Mohammad Sadegh Memarian
This article is based on the keynote address ‘Brent/WTI Price Structures’, presented at the Energy Risk Trading and Derivatives Conference, held on in London on 29 October 2008 by Energy Risk magazine and Incisive Media. Mr Memarian is Head of the Petroleum Market Analysis Department, OPEC and Energy Affairs, at the Iranian Ministry of Petroleum. This analysis is based upon the personal opinion of the author and does not represent the official view of the ministry. The author can be contacted at msmemarian@yahoo.com.
The unprecedented price hikes of crude oil (WTI reached $ 147/B in July 2008) and other commodities, and the intensive role played by the non‐commercial funds, have become a key concern for market players and specifically for the US policymakers. The Commodity Futures Trading Commission (CFTC) invited staff from several federal agencies to participate in an Interagency Task Force on Commodity Markets (ITF), to examine conditions in the commodity markets. The task force issued an interim report limited to the crude oil market, which is preliminary in nature. The analytical importance of the report became clearer after the recent price trend reversals sent the crude oil prices below $60/B for some time. However, the current review is an attempt to shed some light on the diagnostics of the ITF interim report, which is mainly based on classical views of energy economics.
Introduction
Oil market functioning, and consequently the futures price structure, differs substantially in normal times from unusual conditions, especially when the market is tense and operates under abnormal political circumstances. Key oil market conditions and elements such as backwardation, contango, the sustainability of equilibrium prices, excess capacities and price structures will be affected significantly in a tense market.
In the past, political factors have been viewed solely as a one-off phenomenon, but recently analysts have increasingly recognized their significance and have begun taking them into account in their analyses. The ITF interim report’s chronological approach to oil market events represents an initial step in this adjustment. It is worthwhile to note that the impact of these political factors on the oil market would usually be temporary, in which case they would affect only the price structure, thereby potentially creating a so-called ‘price crisis’. However, on some occasions they can influence the oil market structures permanently, and can thus potentially create an ‘oil crisis’.
Generally speaking, ignorance of the role played by geopolitical factors in the oil market will have penalties for market players and policy makers as well. To be clear, it is necessary to consider a few of them.
Price Elasticity Of Demand
One of the key issues in the oil market is the nature of the price elasticity of demand (PED). Traditionally, it has been assumed that the relationship between oil demand and prices in the short run is inelastic, and only in long run will it become elastic. This would mean that, whatever level the prices are pushed up to, demand would absorb it easily in the short run. In this way, producer groups would have the upper hand and would naturally be responsible for any price hike.
The critical point here is that the ITF has presumably assumed that the PED was not affected by the ‘ultra oil crisis’. It was shown that, when the oil market operates under uncertainty caused by the geopolitical factors, the PED will start to increase and become close to unity with the escalation of the crisis. In the case of political deterioration, it could even temporarily exceed unity. The immediate implication is that, when the oil market is tense, the influence of producers will be relatively diminished, and the market will respond to price changes more quickly than otherwise. That is, it becomes more a consumer-led market rather than producer-led. If oil demand during crises did not become sensitive to pricing, then the demand response to an economic slowdown or political relaxation would be delayed significantly.
The market has shown evidence of a demand fall in response to price levels in excess of $100/B in the western industrialized countries such as the US and Europe, a level indicating their economic strength. For the expanding economies of Asia, with China at the center, demand fell in response to a price level of $140/B, supporting this theory. These were the price ranges where producers found it difficult to market their crude oils easily in the different markets. The recent oil price slump, with crude prices now well below $60/B, is good evidence of how quickly the oil market will respond to a global economic downturn and relaxation of political tensions.
Precautionary Inventories
There is a new moderator in the oil market, which has come to play a role explicitly for the first time in the post Cold War period. In line with the Keynesian demand theory, precautionary inventories have been created to cope with the various force majeures in the oil market. These secret inventories differ in nature and role in comparison with those of the US Strategic Petroleum Reserve (SPR). OPEC in the late 1990s, after a series of investigations, could only estimate the number of barrels which appeared to be inexplicably absent from the oil market place, and referred to them as ‘missing barrels’. These barrels have been mistakenly classified by OPEC within the category of non‐OECD inventories in the calculation of market balances.
Needless to say, since a significant part of oil demand in earlier similar crises has been used to fill up the required precautionary inventories, these volumes should not be treated as normal demand in the market balances. Interestingly enough, the difference between the ITF estimates for OPEC production growth of 2.4mn b/d and the call on OPEC supply of 4.4mn b/d since 2003, is exactly equal to the procurement rate for the precautionary inventories for the same period.
Creation Of Real Demand
One of the most prominent features of precautionary inventories is that, during the process of acquisition, they create a real demand in the marketplace. This means that they directly influence the price of oil. Because of this, since the year 2001, the US has attempted to fill its required precautionary inventories from existing commercial petroleum stocks. The consequence was that, while the price effect was not pronounced within the oil market, the stockbuilding did send misleading messages. In this case the market was artificially faced with shortages, which were indicated by the resulting lower level of commercial stocks, and this in turn implied a need for further supply to the market when it was already over-supplied.
The nature and functioning of the oil market varies substantially when subject to different types of crises. Nevertheless, the performance of the physical market under different market conditions is usually treated in a uniform manner by the traditional analysts. This is a false approach, which has been repeated by the ITF economists.
Backwardation Is Normal?
There is a widespread consensus about the oil price structure that has been reiterated in the ITF interim report, which states that the ‘market in normal times is in backwardation’. However, theoretically this is not always the case. One of the key factors that is used as an indication for the persistence of any crisis, when the ongoing prices are higher than the assumed market equilibrium prices, is the continuous status of the oil price structures in backwardation. This is shown in the ITF finding in Figure 1, which shows an ascending price trend – indicating that the oil price has become divorced from the equilibrium – yet shows the oil prices still structured in backwardation.
Since the beginning of the 1990s, the oil market has been in turmoil off and on, with oil prices usually above the market equilibrium prices. Therefore, under these conditions, not only is the oil crisis still running, but also there exists a strong tendency in the oil market for prices to return to their initial equilibrium levels. These conditions are thoroughly different from normal geopolitical circumstances, where the status of backwardation indicates an encouragement to get rid of oil inventories.
Figure 1: Term Structure Of Crude Oil Futures Prices ($/B)
Source: Energy Information Administration and Commodity Futures Trading Commission.
Excess Oil Capacity
Excess oil capacity, whether in the oil production or refining sectors, is one the most complicated issues in understanding oil markets. This is because one of the critical factors that has been seriously damaged by geopolitical concerns is the investments strategies to be adapted in the oil market for the creation and maintenance of excess capacity in both sectors. The impact on oil market strategies is likely to be long-term, and the adaptation of ‘just‐in‐time management’ is only one of its by-products. This newly adapted strategy of the post Cold War era, has been aimed at the efficient use of existing capital that had been previously tied up in maintaining precautionary inventories, which were designed to cope with the earlier geopolitical uncertainty. The immediate consequence was that the conventional level of existing excess capacity was reduced firstly in the refinery sector, and secondly in the oil production sector, and specifically in the camp of the OPEC producing countries.
In the short run and in the case of a geopolitical relaxation of tensions, high excess capacities in production and refining can create stock overhangs, which result in downward price pressures for OPEC and other producers. This situation is similar to current oil market conditions. As stock overhangs have been experienced again recently, this suggests that the OPEC production adjustment policies in these circumstances are not effective any more.
Another factor relates to the perception of oil price levels when market balances are being estimated. Regularly the oil market analysts, and typically the EIA and IEA in their market balance reports, end up with either excess supplies that imply stock build-ups or with excess demand that implies stock draw-downs, irrespective of the prevailing price levels. Only at times of booming oil prices, like those experienced recently, do the analysts signal for intentional production policies. Otherwise, they keep the price level issue to one side, as if prices are determined exogenously. This happens because of the implicit assumption that any substantial shifts in oil equilibrium price levels could take place only exogenously. Yet, while the analysts overlook the role of geopolitical factors by treating them as transit components in their time series applications, they cannot deny the reality of the exogenous nature of their effects on price structures.
Finally, according to the political characteristics of the global economy, the occurrence of an oil crisis will not only raise oil prices, but also it will depreciate the currency values of the other party involved – that is the US dollar of late.
Dollar Value Linkage To Oil Prices
In the current crisis the functioning of one side of the equation is clear, namely that rises in the price of oil will result in the devaluation of the dollar, but the other side of the equation is rather less clear. The question is with respect to how the depreciation of the dollar could raise oil prices, when the oil market is in turmoil and is operating under the high price elasticity of demand values close to unity.
Historically, OPEC production adjustments have succeeded in compensating for dollar devaluations. However, in the current crisis this task of compensation was carried out by the investment funds. These funds, which held long positions that have been switched, from investments in dollar deposits with losing values into firm assets such as oil, have affected the oil market by creating real demand.
To sum up, the ITF interim report is quite preliminary and lags far behind the oil market realities, since the theoretical reasoning of the report for the oil price hikes does not seem to be applicable when the oil market is experiencing price dives below the $60/B level. This is particularly the case when only a marginal fraction of the price collapse has been attributed to the world economic downturn, while a major part of the recent OPEC production adjustment has been neutralized.