Middle East Economic Survey
VOL. LII
No 35
OPEC’s New Criterion
By Behrooz Baik Alizadeh
Mr Alizadeh is Senior Oil Market Analyst at Iran’s Ministry of Petroleum (Email: balizadeh@nioc.org). This analysis is based upon the personal opinion of the author and does not represent the official view of the ministry.
OPEC officials have recently stated that the organization, in order to regulate production, will also pay attention to the level of commercial oil stocks in the OECD member states and, in the event such stocks fail to drop to the required level, OPEC member states will avoid raising production.1 The same officials have in the meantime reiterated the point that, when making decision concerning production ceiling, what matters most is not the level of oil prices alone; rather it is the level of commercial oil stocks that counts.
The previous five-year average range of commercial oil stocks is usually referred to as a favorable range. It means that as long as the level of stocks in the OECD member states stands above 52-54 days of forward cover, OPEC will continue its regulatory policy and refuse to change production levels.2 According to a recent OPEC report, the level of commercial oil stocks in the OECD member states by the end of the first quarter of 2009 stood at 61 days. The International Energy Agency (IEA) has estimated this figure at 62 days. According to OPEC’s statistics, OECD’s commercial oil stocks’ average for the previous five years has been 54 days, and according to the statistics presented by IEA the average has been 52.7 days.
Some oil experts believe that oil stocks of 50 days of forward cover will raise prices to a great extent, 53 days only will strengthen prices, 57 days will bring about price bearishness and 60 days will cause dramatic price falls.3 Therefore, it is no surprise if OPEC officials are inclined to ensure that commercial oil stocks in the OECD states fall even below 52-54 days of forward cover. A drop in the level of oil stocks would mean that not only any surplus oil in the market would not reside, but also consumers would have to withdraw oil from their stocks in order to be able to meet demand, and for that reason oil prices would rise.
Days’ Storage Factor
Use of the criterion of the number of days of oil storage for deciding about OPEC’s oil production quota is useful since, in that case, OPEC will not be accused by the consumers of having violated the principles of the free market for determining the oil prices; thus, political pressures on OPEC producers will subside to some extent. Meantime, application of this new criterion within the context of production control is also associated with certain inefficiencies to which OPEC officials should pay due attention.
According to OPEC’s supply and demand balance table, there was only 100,000 b/d of oil surplus in the oil market in the first quarter of 2009. Meanwhile according to OPEC’s report, the overall oil stocks in the OECD states in the first quarter of 2009 compared with the last quarter of 2008 increased by 65mn barrels (an increase of 43mn barrels in commercial stocks and 21mn barrels in strategic stocks) and the volume of oil kept in vessels or storage tankers has recently decreased by 41mn barrels. In other words, commercial and strategic stocks in the OECD states have increased by more than the amount of surplus oil in the market. In fact, commercial oil stocks in the OECD region have gone up from 59 days of forward cover to 61 days. Of course, one may argue that oil stocks in the non-OECD countries which, by tradition, refuse to release their figures, may have decreased. However that is not convincing, for in the first quarter of 2009 the price of oil in the futures market for the farthest out future months was higher than the earlier month. At a time when prices were expected to increase in subsequent months, withdrawal from stocks has not been logical (see chart below). To understand oil stock movements in non-OECD countries, it is useful to look at China’s oil stocking policy. Recent news reports reveal that commercial oil stocks in China have been increased and stockbuilding completed. Chinese companies filled their commercial oil stocks under circumstances in which oil prices had slipped compared to those in the same period of time last year.
Nymex WTI Futures Prices 2009
Source: OPEC Monthly Oil Market Report, April 2009.
On the other hand like OPEC, which in its recent supply and demand outlook portrayed the market situation in the first quarter of 2009 with 100,000 b/d of oil surplus, the IEA’s supply and demand table also estimates 100,000 b/d of surplus oil. The agency believes at the same time that the total stocks in the OECD countries have increased by 58mn barrels (38mn barrels in commercial oil stocks and 20mn barrels in strategic stocks). Additionally, 500,000 b/d has been added to oil contained in vessels and storage tankers. On that basis, the IEA has had to admit that 1.1mn barrels of oil, which includes unreported stocks in the OECD countries and stocks in the non-OECD states, have been reduced per day. Of course, the agency’s statistics do not justify withdrawal from stocks at a time when prices are expected to increase. At any rate, according to OPEC’s report, although the OPEC member states have cut their crude oil production by 2mn b/d in the first quarter of 2009 compared with the fourth quarter of 2008, stocks in the OECD states have been increasing, a fact that is also admitted by the IEA. In other words, these statistics indicate that no longer does a link between stocks and OPEC’s production regulating program exist.
These facts also indicate that lack of access to precise and timely statistics is supporting the argument that the level of oil stocks cannot be used as an accurate criterion for regulating and controlling production. All these inefficiencies are the result of the fact that change in commercial oil stocks is not only due to the supply surplus or shortage of supply in the market; rather other factors are also responsible for changes in the level of stocks.
Incentives For Storage
When in the futures market far away futures prices are higher than nearer one (ie, contango dominates the market) oil consumers prefer to increase their stocks in order not to purchase more expensive oil for future use. And the longer such a gap, the more consumers are inclined to store oil. On the contrary, in the case of the nearer term prices exceed the far away futures prices (ie, a state of backwardation dominates the market) consumers prefer to withdraw oil from their stocks and provide for their future oil requirements at lower market prices.
Theoretically speaking, a cut in OPEC’s production quota could lead to a physical shortage of oil in the market, a rise in the spot and nearer term prices and a reduction of the contango strength, in which case there will remain less incentive for the storage of oil. The effect of measures taken by OPEC is supposed to be seen on the level of oil stocks and any change in the level of stocks should reveal whether OPEC has reduced or increased its production. Such a thing has in practice not taken place in the oil market, because the structure of prices in the futures market is not controlled by OPEC alone and depends on other factors as well. Political developments, global economic prospects, predicted changes in seasonal demand, predictions of likely disruptions of supply due to seasonal climatic fluctuations, perceptions of speculators about price developments and their reaction to market developments as well as many other factors can affect futures prices levels in the months ahead. Meanwhile, interest rates and the storage costs are factors influential in deciding whether or not storage of oil is economically feasible. Refinery gains and operations may also impact the level of oil stocks.
The interesting point is that prices and their structures for the few months ahead in the futures market impact the attitude to stocks, whereas these prices are not just under the influence of market fundamentals; rather speculators and financial institutions also play an essential role in the formation of prices. The expectations of speculators and financial institutions of future events affect their reactions, though these expectations may never materialize. Meantime, financial institutions benefit from the futures market by preserving the value of their assets. When the value of the US dollar drops against other hard currencies, or when the inflation rate jacks up, they pour into the commodity and oil exchange markets and affect prices, and such price movements may well influence storage behavior (see diagram below).
Factors affecting commercial oil stocks
There are also floating storage facilities, which in turn make more complicated the criterion of stock levels for the control of production. Oil companies and dealers such as Shell, Koch, Vitol, Glencore and BP store oil in giant tankers in the vicinity of consumption destinations, and at a point when oil prices are attractive enough they sell these stocks in the market. To follow such a process, these companies have to consider interest rates and tanker lease costs.
According to reports in late June, over 70mn barrels of oil were stored in vessels, which showed an increase of 20mn barrels compared with May. However, as oil spot prices increase, the storage of oil in vessels does not appear to be rewarding any more. The cost of storing each barrel of oil in vessels is almost $1/month. Therefore, these companies try to supply their oil stocks to the market, and such a measure may impede OPEC’s production regulating and control plan. It seems therefore that the ambiguities and complexities that are associated with the criterion of the number of oil cover days in the OECD countries will prevent OPEC to use this criterion for regulating or stabilizing market.
Evidently, in the current market situation, the spot prices are influenced by factors other than physical market fundamentals and are not just under the influence of OPEC behavior. So, the imperfections in using physical prices or the OPEC Basket price as an indicator to fine tune the production level are known as well. Therefore, the question is whether or not OPEC’s decisions should be linked to a criterion which is associated with numerous ambiguities and complexities, as long as a proper alternative has not been discovered for the target price or price band.
Notes:
1. Saudi Minister of Petroleum and Mineral Resources Ali Naimi has said that OPEC would wait until crude inventories fell to around 53 days of forward cover before considering raising output (Reuters, 30 May). He also has said that, if stocks are only going to fall to 57 days, the implication is that OPEC may do nothing, regardless of what happens to the price, adding that he wants to see world stocks at 52-54 days (Reuters, 8 June).
2. “At present, world stocks, in floating storage and onshore, amounted to the equivalent of 62-63 days of consumption. We need to stabilize the market. We’ve a lot of storage, floating storage, land storage and the level normally needed for market stability is 52-53 days of consumption,” said Jose Maria Botelho de Vasconcelos, Angola’s Minister of Petroleum (Dow Jones, 4 July).
3. “Historically, the general rule has been that 50 days of forward cover is mega-bullish for oil prices, 53 days is bullish, 57 days bearish and 60 days mega-bearish," said David Hufton, Managing Director of brokers PVM Oil Associates (Reuters, 30 April).