Middle East Economic Survey

VOL. XLVIII

No 13

28-March-2005

The Causes Of Crude Oil Price Volatility
By Bassam Fattouh

The following article was written for MEES by Dr Fattouh, Lecturer in Financial Studies, Centre for Financial and Management Studies, School of Oriental and African Studies (SOAS), University of London (Bf11@soas.ac.uk). Dr Fattouh wishes to thank Professor Robert Mabro and Dr Robert Skinner “for their useful suggestions. All remaining errors are mine.”

In the past few years, the world seems to have entered into an era of higher crude oil price volatility. It is enough to recall the rollercoaster event during the period December 1998 and March 2000 to gauge the increasing degree of volatility in oil markets. In December 1998, the WTI spot price (FOB at Cushing) stood at a historic low of barely $10/B. In March 2000 it increased to over $31/B. This rollercoaster episode has not been the only one in the last few years. After reaching a peak of about $37/B in September 2000, the WTI price declined to less than $18/B in November 2001 induced by fears of worldwide economic downturn as the result of the 11 September 2001 attacks. Since then there has been an upward trend in crude oil prices with WTI price reaching an unprecedented level (in nominal terms) of above $56 in October 2004.

Many factors have been put forward to explain these extreme movements in oil prices. However, there is a particular one that keeps popping up: OPEC behavior. In an interview in December last year the UK Chancellor of the Exchequer Gordon Brown argued that “if the oil price moves as it has in the period I've been finance minister, from $10/B at one stage to $50/B, then you’ve got a problem because you’ve got a degree of instability and volatility, but it makes it very difficult for countries to plan ahead. I think that OPEC, which has to be a force of stability in the oil market, has in the past few months not given us the stability we need.’’

Politicians are not alone in blaming OPEC for the current increase in the degree of volatility. Many established academics have taken a similar view. For instance, Professor M A Adelman notes that crude oil prices have been more volatile than other commodity prices, although in principle crude oil prices ought to be less volatile. On the demand side, oil consumption has been stable relative to GDP while on the supply side it is easier and faster to adjust output to demand conditions than in other industries. From these observations, he hypothesizes that oil prices must be more volatile for a special reason and that reason is OPEC output control. Thus, Professor Adelman argues that high oil price volatility is due to the fact that “the thermostat of a competitive market has been turned off” and then predicts that “price volatility will continue higher than in other markets so long as price is fixed high by collusion in the cartel."

OPEC To Blame?

For OPEC to receive all (or part) of the blame for the current episode of volatility is quite understandable given OPEC’s importance and its central position in the oil market. But explaining volatility in terms of OPEC’s ‘price fixing’ is not warranted. OPEC abandoned fixing the reference price in 1987, favoring a system in which OPEC sets production quotas based on its assessment of the market’s call on OPEC supply. Oil prices fluctuate depending in part on how well OPEC does this calculus. Through the process of adjusting its production quotas OPEC can only hope to influence price movements. This adjustment process can prove quite problematic, at times inducing undesired price volatility. Given the uncertainties of demand and supply, the lack of reliable and timely data about consumption, production and inventory levels, and the unreliability of short-term forecasts, it is difficult for OPEC to anticipate the direction of the market. Even if OPEC predicts the direction of the market adequately, implementing the agreed policy can prove very difficult because of OPEC’s structure. After all this is a coalition of a heterogeneous group of countries facing distinct economic, social and political challenges and with no incentive to share information. Furthermore, OPEC has no monitoring system to oversee production and shipments and more importantly no punishment mechanism to deter cheaters. This structure, in which agreements are reached at the last minute and concluded on the basis of compromise rather than optimizing decisions, generates considerable uncertainty about supply conditions, contributing to oil price volatility.

In this respect, it is interesting to note that implementing output adjustment is problematic both in the face of falling and growing global oil demand though for different reasons, i.e. OPEC’s response is asymmetric to global demand conditions. If global demand for oil falls, non-OPEC suppliers will continue to produce. They usually wait for OPEC to make the decision of how much to cut and which country must undertake these cuts. Because of OPEC’s structure, these are very difficult decisions to make and implement in face of a falling market. Furthermore, expectations of output cuts induce speculation about OPEC’s ability to adhere to them. These expectations can cause swings in net speculative positions and reversal of such positions if the cut is less than expected or does not materialize. In the case where global demand for oil rises, although agreements to increase quota are easier to reach and implement, OPEC may not respond quickly to this upward trend, especially in an environment of imperfect information. After all, the decision to wait and not increase output is much more profitable than to increase output if the trend turns out to be false. The slowness of the response to an upward trend can contribute further to volatility by undersupplying the market.

Speculation Around OPEC Meetings

This leads us to a related channel through which OPEC can induce volatility: the degree of speculation surrounding OPEC meetings. There is some evidence that suggests volatility drifts upwards as OPEC meetings approach. This does not necessarily mean that OPEC is causing volatility and may merely reflect market agents trying to be on the upside of a bet about what it might or might not do. However, OPEC, by getting it wrong sometimes, such as in 1997-78, can induce oil price volatility. As discussed above, this is in part related to lack of transparency in OPEC’s decisions and implementation, but also to the increase in the complexity of factors that enter into its decisions. The list of factors that OPEC has used to explain its decisions since 1999 expanded to include the level of oil and product stocks, market speculation, basket price range, geopolitical factors, supply demand situation and US$ exchange rate. The increase in the frequency of OPEC meetings and the increase in the frequency of quota adjustment in recent years have also contributed to an increase in speculative activity.

The exclusive focus on OPEC to understand volatility, however, is one-sided and can lead to misleading policy remedies. After all, OPEC, in its current organizational structure and policies, was present in the late 1980s and mid-1990s when the current pricing system emerged. During this period, the market did not witness any major increase in price volatility except for few hikes in oil prices caused by political shocks beyond the control of OPEC. In fact, at time of such disruptions, the core OPEC producer, Saudi Arabia, played an important role as swing producer filling the oil gap and moderating oil prices. The Economist points out that Saudi Arabia has done this at various times: “during the Iran-Iraq war when output from both countries was disrupted; during and after the first Gulf war, when output from Iraq and Kuwait was lost and last year, when civil strife in Venezuela and Nigeria curbed output from both countries on the eve of last year’s invasion of Iraq, which itself disrupted Iraqi output”.

Additional Factors

It is clear that in order to understand the current episodes of higher volatility one must move beyond the exclusive focus on OPEC policies and broaden the analysis to include some features that have emerged in the oil market and the oil industry the past few years. Four such features are important: the gradual erosion of OPEC spare capacity; the shift in the strategy of inventory management by international oil companies; the increasing importance of the oil futures market in the current oil pricing system; and the deterioration (or no improvement) in the quality and timeliness of data on oil-related factors.

In the mid-1980s, OPEC countries were left with a huge surplus capacity estimated at around 11mn b/d (on an annual basis) when new discoveries in non-OPEC countries, responding to higher oil prices, and taking advantage of new technologies, increased their production capacity by a comparable amount . What is not well recognized by some observers is that during the mid-1980s, the oil market reached a turning point in which demand for OPEC oil slowly started to increase. At the same time, the 1986 price collapse saw a production collapse in some old non-OPEC basins. As a consequence, OPEC’s spare capacity was reduced to very low levels. Without this cushion of surplus capacity, OPEC’s ability to stabilize oil markets in a tight market has considerably weakened, contributing to price volatility. This problem has been compounded by lack of information and trust about OPEC’s spare capacity and its ability to act as a swing producer. Events last year highlight this fact. Saudi Arabia has gone to unusual length to provide assurances to markets and analysts that it can increase production to meet growing global demand. These assurances however were not able to calm oil markets. This has led The Economist to comment that, “Ali Naimi, the Saudi Oil Minister, usually moves markets when he speaks. Yet when he promised a few days ago that more oil is on the way, traders ignored him and the rally continued apace.”

Another important factor that contributed to heightened volatility is the change in practice of inventory management. Under pressures to maximize shareholder value, international oil companies have undergone major cost cutting exercise including cutting inventories to their lowest possible level and shifting to a “just-in-time inventories” policy. In this shift of policy, oil companies relied on OPEC large holdings and consuming countries’ SPR inventories and on a developed spot market for immediate deliveries. Backwardation, by discounting the value of crude oil in the future, also rationalized holding low inventories. The main consequence was a decline in level of inventories which meant any swing in demand could not be met immediately by changes in inventory levels but rather by fluctuations in crude oil prices.

The relationship between levels of inventory and volatility, however, is not straightforward and can run in the opposite direction, ie volatility of oil prices can affect inventory levels. First, oil price volatility causes increases in volatility in consumption and production and as a result market participants will want to hold greater inventories to buffer these fluctuations. Second, oil price volatility increases the opportunity cost of producing now such that producers will not be willing to extract oil unless the spot price is higher than the future price, ie except when the market is in strong backwardation. Pindyck provides evidence that market variables such as inventory levels can not explain crude oil price volatility whereas volatility can influence some market variables such as production although the effect is empirically very small.

Another important development in the past two decades has been the emergence and growing importance of futures market in setting oil prices. OPEC’s oil pricing regime since 1987 has been based on a price formula which uses crude markers such as WTI or Brent as a benchmark. Volatility in oil prices therefore not surprisingly reflects the volatility in the prices of these crude markers. Since the price of these markers are determined in the interrelated spot, future and derivative markets, daily oil price movements are affected not only by current fundamentals of the market but also by market participants’ expectations about future supply and demand of crude oil in the futures market. In principle, future markets should send signals about future investment needs and contribute to better allocation of resources. In the past few years, however, expectations were not driven only by the fundamentals of the oil industry, but also by political and psychological factors which in some instances seemed to carry considerable weight with some market participants. Speculation about the oil supply gap in the futures market has been central to understanding the wave of oil price volatility in the last two years.

Poor Data

Although oil prices have become more transparent over the years, information about crude oil consumption and production has not improved both in quality and timelessness. On the demand side, data on the consumption of oil, even those for OECD, are uncertain, subject to major revisions, and published with a considerable lag. This problem is becoming worse with the increasing importance of some developing countries such as India and China as major oil consumers with even less reliable data. On the supply side, the dominance of less transparent national oil companies and the uncertainty about OPEC production levels (OPEC must rely on ‘secondary sources’ to find out what its own members are producing) increases the uncertainty about oil production. Furthermore, the advent of many small oil producers on the oil scene increases further difficulty of collecting reliable and timely information. The quality of inventory data is also subject to uncertainties and revisions. Since in tight market every barrel matters, uncertainties about supply and demand contribute to the volatility of oil markets both through magnifying the oil gap and increasing speculation. Furthermore, unreliable data may induce OPEC to misinterpret the market’s direction and pursue policies that add to the uncertainty and compound volatility.

Quantifying the contribution of each of these factors to increased volatility is difficult. Furthermore, the type of volatility (persistent or temporary) induced by each of these factors can be different. It is important to realize that in order to understand volatility of oil prices, one has to take a broad approach that recognizes the major transformations in the oil industry and the oil market and the interaction of these developments with OPEC policies. To what extent improving our understanding of oil price volatility would actually lead to adequate remedies is another matter. But it is certainly a necessary step if not the first one.