The World Oil Market—The Future Will Not Resemble The Past

The 1979-80 round of price increases—itself an unexpected event—led to a jump in the base price of oil from $12 to $34 per barrel. This was followed by an unforeseen sharp drop in worldwide oil consumption, growing excess supplies, and mounting pressure to reduce the price.

In response, OPEC reduced the base price by $5 in 1983 and allocated production quotas among member countries that limited total OPEC output to an average of 17.5 million barrels per day. By voluntarily reducing revenues to prevent even greater losses if no action were taken, OPEC passed the first true test of its resolve to act as a cartel; many observers had not thought it could or would act so decisively.

Even more surprising was that these actions proved insufficient: Demand continues to slump, and production from non-OPEC sources continued to grow beyond expectations. By 1984, OPEC's share of world oil production (outside Communist countries) had declined to 40 percent from 67 percent in 1973. Moreover, OPEC oil revenues had declined from a 1981 peak of $250 billion to $150 billion in 1984. Many member countries began to experience serious budget problems, and OPEC as a group fell from net surplus to net deficit status on international accounts. Saudi Arabia, with a government budget of $74 billion in 1984, is expected to liquidate previously accumulated assets by as much as $13 to $25 billion to cover the shortfall in receipts.

Compounding these economic pressures are the political tensions generated by the Iran-Iraq war. The war aids OPEC's cause in the oil market by reducing supplies from the two belligerents, but it also creates friction among member countries at a time when compromise and agreement on production and pricing policies are critical.

Present

In this environment, no one is astonished that member countries have been discounting prices and cheating on production quotas. On the contrary, it probably is more surprising that cheating has not been more widespread, given the difficulties of policing the market and of observed deviations from agreed base prices and production quotas. Still, in the first half of 1984, many member countries were attempting to alleviate their individual revenue problems, while softening market conditions called for more stringent collective restraints and OPEC failed to take collective action. This can be attributed to growing tensions imposed by economic and political conditions and, perhaps, to wishful thinking that demand would rebound enough to eliminate the problem.

This hope proved vain in October 1984 when Norway announced a reduction in posted prices (following an unsuccessful attempt to discount those prices secretly) in an effort to prevent customers from shifting to more competitive sources. Norway's lead soon was followed by the United Kingdom and OPEC-member Nigeria, two other major producers of similar grade crude oils that feel the force of competition immediately. With the apparent desertion of Nigeria from its shaky ranks, OPEC had to act.

At this stage, perceptions for OPEC of a united front became as important as reality. Member countries quickly agreed to temporarily reduce production quotas from 17.5 to 16 million barrels per day to persuade the market that posted prices would remain firm. But the market is not convinced. Inventories were not rebuilt for the peak winter-demand season as expected, nor has consumption increased as OPEC hoped. OPEC met again in December to consider more vigorous methods for policing members' production and pricing policies, but uncertainty prevails regarding what measures are necessary to stabilize the market and the extent to which OPEC can successfully implement them.

What the future holds for world oil prices is anybody's guess. OPEC's latest actions may not be sufficient to maintain current prices, in which case further adjustments in prices or production are likely. Some observers even are predicting the end of the cartel, but OPEC probably will make incremental responses to market call options rather than abandon completely the advantages of collective action. The cartel has served its members well, and they are aware of the risks of unrestrained competition.

Future

In assessing future prospects, it is important to recognize that the oil market evolved in two major ways that will strain OPEC decision making and otherwise affect the behavior of world oil prices: the price pattern of the 1970s is unlikely to recur in the next several years, even in a tighter oil market with less excess capacity to cushion disturbances. First, small interruptions in oil supplies in 1973-74 and again in 1979-80 led to overreactions by consumers and inventory holders that aggravated the increases in world prices. Increases in demand in past crises far outweigh the reductions in supply in driving up oil prices. For the future, panic and adverse speculative reactions are expected to be less important factors in the oil market.

Second, once each of the past oil crises ended, oil prices did not return to pre-crisis levels. OPEC took advantage of the disturbances to establish new, higher official posted prices, causing world prices to ratchet upward in two successive jumps. In contrast, for some time to come, OPEC's interests will be better served by acting to stabilize the market rather than to increase prices.

Elasticity

Why the big change? One reason is that the demand for OPEC oil is considerably more elastic than in the past; as a consequence, oil revenues are likely to decline with a price increase rather than grow. Because OPEC acts as the residual supplier in the oil market, adjusting production to fill the gap between non-OPEC supplies and total consumption, the demand for OPEC oil behaves differently from oil demand in general. Increases in non-OPEC supply, reductions in oil consumption, and measures taken to increase flexibility to shift among fuels when relative prices change, all directly affect the demand for OPEC oil and increase its price elasticity.

Similarly, OPEC oil revenues have become more volatile in response to fluctuations in market supply and demand, so that the price-administering role played by OPEC imposes an increasingly serious economic burden and is a source of tension among member countries. The reduction in market share, by itself, means that incremental adjustments in OPEC production to maintain the price structure are large in relation to total sales and that revenues will fluctuate more sharply as a result.

These remarks refer to OPEC as a group; some members could benefit from price increase if they bore proportionately less of the burden of supporting it. Conversely, in today's excess-capacity situation, OPEC as a whole could increase total revenue by permitting the price to fall, but some members would lose because output could not increase enough to compensate for the price cut. That some members would suffer creates a reluctance to alter the status quo. Added to this is the desire to maintain the perception of OPEC market power.

Incentives to lower prices exist in today's market, but eliminating excess supplies alone will not reverse them. As long as the demand for OPEC oil remains highly responsive to its price, the incentive for OPEC is to avoid higher prices. This condition may be expected to hold even after excess capacity is absorbed and the market tightens.

Spot and futures markets

Like OPEC, the private sector also is less likely to convert minor supply disruptions into major price shocks. The last few years have witnessed two key changes in the way oil transactions are conducted that promise to enhance price stability during periods of supply uncertainty—the development of an active spot market in crude oil and products and the related creation of viable futures markets.

Until very recently, nearly all oil was traded in international markets through long-term contracts or within integrated oil companies, and the spot market served the limited function of balancing refiners' input and output mixes. The marked increase in the relative importance of spot transactions in all phases of the industry has sharpened the degree of competition in the international market and increased the efficiency of oil distribution around the world. A measure of the importance of this development is the corresponding creation of futures markets for petroleum where none could survive before.

All segments of the industry have been forced to adjust to these changes. Refiners and distributors no longer can rely on segmented distribution channels and must compete with the spot market to maintain their customers. OPEC producers—who once shunned the spot market—now sell there about half of their total crude oil and product exports. The effect has been to enhance competition among sources of supply and to reinforce the competitive link between spot and official posted prices. The result in the current soft market is that posted prices are discounted to effective selling prices that do not deviate widely from spot prices. Also, unlike the situation during past market disturbances, spot prices are not likely to stray far from posted prices in periods of uncertainty, thus removing this factor as a source of instability.

Appearance versus reality

These institutional developments paradoxically introduce the appearance of price instability at the same time they create market forces that enhance stability. On the one hand, spot and futures prices now fluctuate daily in response to changes in supply and demand; in earlier periods, spot prices were firmly anchored to posted prices. On the other, the forces working to stabilize the market generally moderate fluctuations in inventory demand and counter panic buying in a crisis.

The spot market affects inventory demand because it replaces a traditional need for carrying inventories. Working inventories at refineries and distributors can be smaller because needed supplies may be obtained from—and excess supplies sold to—the spot market. Hence, inventory carrying costs can be reduced. Similarly, the spot market is less likely to dry up during a supply crisis than it once was. Rather, it will continue to provide an option to affected parties when normal channels are disrupted and thus reduce the need (and the cost) to store oil as insurance against disruptions.

Access to a futures market reinforces these influences. Futures contracts enable those who can least afford to be caught short in a crisis, and those most averse to risk, to cover themselves more cheaply and easily than by holding inventories of oil. In addition, a futures market permits speculators to gamble on changes in future oil prices without actually dealing in physical stocks of oil. Whether the motive is to hedge or to speculate, transactions involving pieces of paper are easier and cheaper to exchange than barrels of oil.

Lessons of the 1970s?

These developments suggest that, compared to the past, inventory demand will be less influenced by speculation and panic and prices will be less sensitive to uncertainties caused by interruptions in supply. Combined with the hypothesis that OPEC no longer is in a position to exploit supply crises to raise official prices to a new plateau, it may be argued that future price shocks will be more transitory and less dramatic than would be expected on the basis of experience.

Perhaps private and public policy-makers would do well to ignore Santayana's dictum that "those who cannot remember the past are condemned to repeat it." Too great a devotion to the "lessons of the 1970s" as far as oil is concerned will prepare us for a skirmish on a battlefield that no longer exists.