OPEC accommodates investor demand

September 10, 2009

By keeping production targets unchanged despite swelling inventories and uncertainty about the outlook for oil consumption, OPEC has decided to accommodate rather than fight investors’ demands for a high level of inventories.
Forward cover has crept up to 62 days, well above the long-run average of 52-53 days OPEC members have previously indicated is their target, consistent with stable prices. But further cuts were never seriously on the agenda at this meeting, and seem unlikely to be seriously considered at the next one in December unless there is a shift in sentiment and a price collapse in the meantime.

While spot prices are less than half last year’s peak, they have rebounded to a level that was unprecedented before 2007. Ministers must be amazed at their good fortune, with prices at historically high levels amid the deepest global downturn since World War Two.

More importantly, the cartel is keeping a wary eye on the Copenhagen climate conference in December. Key members, led by Saudi Arabia, are anxious to avert a repeat of last year’s vertiginous price spike and the bout of demand destruction that came with it.

Being seen as a responsible supplier of energy is especially important now, with consumer countries about to take decisions on conservation and substitution measures that will have profound impact on demand for OPEC’s output for decades to come.
Producers therefore had little choice. So long as investors demand a high level of stock to alleviate fears about a future supply crunch, OPEC’s task is to accommodate them. Cutting output to force inventory levels back down to long-run averages would risk triggering another sharp rally, reigniting consumer demands for tough climate measures to reduce dependence on “unreliable Arab oil”. 

OPEC is often portrayed as the oil market’s central bank, with the ministerial conference playing the role of the Fed’s Open Market Committee, reviewing current and projected demand before making periodic output adjustments in a bid to control inventory levels and achieve target prices, much as the Fed tweaks interest rates to control growth and inflation.

In practice, the Fed analogy overstates the cartel’s control over prices, as much as it misunderstands how central banks actually work.

The dramatic boom then bust in financial markets this decade should have proved beyond doubt that liquidity and credit are determined endogenously in the market by investors’ shifting appetite for risk (the “animal spirits” popularised by John Maynard Keynes) rather than central bank policy. Notwithstanding purists’ demand the Fed “lean against the wind”, in most cases policy has reacted to events rather than led them, accommodating rather than restricting demand for liquidity.

OPEC too has more often responded to shifts in investor sentiment and the market balance than led them. Cartel policy has been reactive rather than proactive. So long as investors’ remain comfortable with current inventory levels, OPEC is unlikely to make serious efforts to reduce them.

While many cartel members may fear privately that investors’ tolerance for inventories, and market prices, will fall in future if a robust recovery fails to materialise, that is a decision for another day. If they tried to anticipate a future shift and begin cutting inventory levels now, the cartel would risk adding fuel to the rally and prices overshooting. 

The bank analogy highlights another problem facing the organisation. Dutch economist Jan Tinbergen famously proved that to achieve n-independent objectives simultaneously policymakers need n-independent instruments. So two targets require two separate instruments; three targets require three instruments etc.

To achieve desired trade-offs between inflation-growth (“internal balance”) and the exchange rate-balance of payments (“external balance”) both monetary and fiscal policy have to be used in tandem. Otherwise policymakers can focus on one but accept the other as determined by the market.

In practice macroeconomic policy has been delegated to central banks in recent years, who have used their one instrument (interest rates) to target inflation. Exchanges rates, loan growth and asset prices have been left to the market.

As the shortcomings of this policy have become evident, fiscal policy is enjoying a revival and officials are considering creating a third instrument, some form of quantitative restriction on credit growth, to limit the extension of credit and manage asset prices.

OPEC faces the same problem. It has only one instrument (production targets) with which to achieve two objectives (inventories and prices). If there was a stable link between inventory levels and prices, the cartel could treat them as a single objective. But in practice the link is highly unstable. It depends on investors’ perceptions about both the amount of spare production capacity as well as macroeconomic influences such as growth, inflation and the exchange rate.

Over the past decade, OPEC policy has oscillated uncertainly between inventory control and direct price management. Between 1998 and 2003, the cartel focused mostly on inventories, adapting production to match demand forecasts in a bid to keep stocks low. When prices burst above the cartel’s declared “ceiling” of $28 per barrel, the organisation shifted to price targeting, raising output and allowing inventories to swell in 2004-2006 in a bid to cap the rally.

The past three years have seen another switchback. In 2006-2007 OPEC drained stocks, and resisted demands for output increases even as prices spiked, insisting it was powerless to prevent speculators driving prices higher in a market that was fundamentally well-supplied. But as prices have recovered following last year’s collapse, the cartel now appears to have reverted to price management. The cartel is prepared to “look through” ballooning stock levels while prices remain healthy in anticipation of future tightening.

The cartel’s current target appears to be around $75, the level articulated by Saudi Arabia’s King Abdullah earlier this year. As a result, it has no choice but to supply whatever level of inventories the market demands to keep prices at this level.

For the moment, investors want a high level of inventory cover to offset concerns about a strong recovery and the early absorption of the relatively limited amount of spare production capacity during 2010 and 2011. The cartel must accommodate this demand if it is to prevent prices rallying further.

If recovery expectations deteriorate, the volume of inventories which the market is ready to hold for any given price level will fall. At that point, the cartel will have to trim output and restrict inventories to the new, lower desired level. But that is a problem ministers could comfortably postpone to another day.

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