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Opec Needs to Fast-Forward

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February 2020 Philip Verleger

 

Just as the telegraph quickly ended the Pony Express in the American West, financial markets are now undercutting efforts by producers to stabilize commodity prices. The two, tightly related trading practices that are undercutting Opec and Opec-plus are hedging by other producers through forward sales, leading at the first sign of a dip in prices to automated selling in futures markets by the financial players who bought the forward contracts in the first place; and a lag in implementation of supply agreements that facilitates just the kind of price dip that triggers those automated sales. Attempts to sustain higher oil prices in the future are less and less likely to succeed, absent dramatic changes in Opec and Opec-plus strategy to counter these financialized oil market practices.

The Pony Express is an icon of American history. For 19 months, a system of riders and strategically placed depots transported mail from Nebraska to California in 10 days or less instead of the four weeks required for stagecoach transit or the months-long journey by sea. Then, a technological advance ended the business. The Pony Express died exactly two days after the completion of Western Union's transcontinental telegraph.

Efforts to stabilize commodity prices by producers, technically known as restrictive commodity agreements, have been ongoing for almost a century. They are the economic equivalent of the Pony Express. Near the end of World War II, British economist John Maynard Keynes proposed creating a monetary stabilization organization, the International Clearing Union (ICU), as the third leg of a globalized trade and monetary system. The first two legs were the precursors of the World Bank and the International Monetary Fund. The ICU was abandoned.

Stabilization programs emerged for many specific commodities, however, despite the lack of a broader world institution aimed at keeping trade in rough balance. Several of these commodity agreements succeeded for periods ranging from one to four or five years. Tin prices, for example, were sustained until the early 1980s. Opec, too, has had times of great success intertwined with failures.

In every case, the successful efforts have involved agreements among commodity producers to withhold supply from the market. In some cases, production volumes were stored. In other cases, production was curtailed. In a few instances, supplies were even destroyed. These reductions lifted prices.

Over the last 40 years, the members of Opec and Opec-plus have sought to raise prices by cutting production. In doing so, the members first relied on price differentials to divvy up the available market, but this system was fairly quickly abandoned in favor of negotiated agreements that stipulate a specific cutback for each. Over the years, the mere announcement of such agreements often resulted in price rises. Sometimes the price increases were modest and temporary. In other cases, as with the 1998 agreement, they were spectacular and long-lasting.

In their meetings, the ministers from oil-exporting countries often focus their anger on speculators, accusing them of selling futures to cause price declines, betting Opec's efforts will fail. Many statements coming out of these conclaves have concentrated on convincing market participants that producers would meet their commitments to cut production, which would cause prices to rise and thus punish those who wagered against Opec, in an evident effort to avoid such negative betting in the first place.

Those trying to stabilize prices by reducing output are fighting a losing battle with financial markets, just as the Pony Express lost to the telegraph, for two basic reasons. First, today it is the hedging done by other producers, not speculators, that is the problem. Second, the time lag between the announcement of a production decision and its implementation is too long.

Hedging by other producers creates a problem for Opec because the computers at banks and other financial institutions pay attention to only one thing: changes in prices. These machines are programmed to protect the financial integrity of the institutions writing price insurance contracts (puts) to oil producers. When prices fall, the computers sell futures, so they won't be stuck with covering a potentially large gap between prevailing market prices and the amount they have to pay out to producers that bought price insurance from them. Such so-called "short-covering" sales can be very large.

At the end of September 2019, contracts had been written to insure more than 2 billion barrels of oil be produced in 2020. The two largest parties buying insurance were Occidental Petroleum (130 million bbl) and the Mexican government (between 400 million and 500 million bbl).

The insurers' machines will buy if prices rise. Thus, decisions by investors to purchase oil will be magnified up to tenfold. The computers will also pile on if investors or speculators lose confidence and start to sell. The October to December 2018 price decline of $34 per barrel was caused by such selling, which followed a relatively modest loss of confidence in Opec.

No More Delay

The increase in producer hedging exposes a related weakness in Opec's current market management process. The problem is the delay between an announcement by Opec and the implementation of any action. In early February 2020, one observer explained that an agreement to cut production at the Opec Market Monitoring Committee meeting held in the first week of the month would not take effect until May, more than 90 days later. Such delays can make decisions irrelevant, especially if other bearish events occur in the interim.

One way to bridge the time delay would be to intervene in the futures or cash market immediately after announcing a decision. However, implementing such an approach would require creating a new institution with the funds needed to intercede in the market. This idea has significant risks. Tin producers tried it with the International Tin Council and then lost when speculators attacked the fund.

A better response to market conditions like those in February would be to employ a central bank technique. When confronted with a significant price decline, the Opec-plus members should swiftly remove a significant volume of oil from the market. For example, on Feb. 10, the Monday after their monitoring committee meeting, they should have exercised their contractual right to cut deliveries by 10%. Prices might have jumped back to $60/bbl had Opec announced such rapid supply reductions on Feb. 7. The announcement would have started a price increase, as those speculating on lower prices withdrew from the futures market by buying back their shorts, or forward contract sales. The short-covering price increase would then trigger and be amplified by a computer-driven rally.

Some will assert that a deliberative intergovernmental body such as Opec-plus cannot act so quickly. They may be correct. However, most agreements between sellers and buyers include 10% tolerance adjustments in the quantity shipped. Buyers can request that sellers increase or decrease the amount supplied by 10% from the contract amount. The key thing here, though, is that sellers have the same option.

At a minimum producers should be prepared to exercise this option promptly when markets are disrupted, as they have been by the Covid-19 coronavirus outbreak, and reduce supply by the maximum amount allowed under their contracts. They should also publicize their action to restrict supply. The cuts should be made by all members of Opec or Opec-plus that have the contractual flexibility to act. Further, this flexibility should be increased as contracts are renegotiated.

In sum, oil producers need to understand that they are at war with the computers at the financial institutions writing price insurance to Mexico, Oxy, and perhaps 100 other independent producers. These computers are programmed to protect the solvency of the financial institutions, not the Opec-plus members. Those producers need to respond rapidly to new circumstances. Markets now move at the speed of light, not the speed of horses.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980.

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