Focusing on stability in challenging times

OPEC Bulletin Commentary March-April 2012

The big rise in oil prices since the end of January highlights once again the challenges producers face in their commitment to oil market stability.

After the monthly average price of OPEC's Reference Basket had stayed within a range of $106 and $112/barrel for nine months, it strengthened to $117.48/b in February and $122.97/b in March. This was in spite of the market being well supplied with crude at all times, with OPEC production reaching its highest level for more than three years and a comfortable level of OECD commercial inventories, especially in days of forward cover.

This is, of course, not to overlook the fact that, during much of that nine-month period, there was still excessive price volatility on a day-to-day basis.

Addressing the 13th Ministerial Meeting of the producer-consumer dialogue body, the International Energy Forum, in Kuwait City on March 13-14 on the recent price movements, OPEC Secretary General, Abdalla Salem El-Badri, said: "At OPEC, we believe that massive and rapid in- and out-flows of financial investments into oil markets can alter price dynamics away from fundamentals. This can exaggerate price swings, both up and down, in the short term, and, if persistent, in the medium-to-long term."

He stressed that volatility in energy markets remained "an obstacle for the world economy; for those producing countries whose economies are still highly dependent on oil export revenues; and for consumers whose energy needs continue to be primarily satisfied by fossil fuels. In truth, it matters for each and every one of us."

Price fluctuations were now amplified by the 'financialization' of commodity markets in general and oil markets in particular. The participation of financial players had grown significantly, with, for example, outstanding exchange-traded commodity contracts expanding from around 15 million contracts in 2004 to more than 60m contracts today. New players had entered the market, such as index funds and exchange trade fund sponsors. And strategies had become more varied and more complex, including hedging against inflation or currency fluctuations, portfolio return risk management, arbitrage opportunities, index-tracking, herd behaviour, speculation and, most recently, high frequency-trading.

On top of this, El-Badri continued, oil was being treated increasingly by financial investors as an individual asset class. Oil-related derivatives markets had expanded sharply, in terms of size, participants, types of contract and complexity - so much so that, in mid-2008, the total open interest of the NYMEX crude oil futures and options was 35 times the size of physical world oil demand.

Keeping all this in mind, what concerns us in the present volatile price environment is how little seems to have changed since 2008, despite efforts to enhance regulation in the financial markets. That troubled year saw the Basket price start out at $92/b, soar to $147/b in mid-July and then sink to the low-30s in December. As the dust settled in early 2009 and the true extent of the damage began to reveal itself, the words "never again" seemed to be etched on the tongues of many influential parties in the industry and the world at large.

Now, just a few years on, another unexpected strong surge in oil prices is recalling memories of 2008.

However, there should be no cause for concern. The market is in much better shape than it was in the first half of 2008, with a bigger gap between supply and demand, greater spare capacity, higher inventories and, looking further into the future, a better facility to bring on-stream new capacity in the medium term. On the demand side, there are continued doubts about the true state of the world economy, particularly in Europe; indeed, we have already revised down twice our global growth expectations for this year in our Monthly Oil Market Report.

There can be no denying that geopolitical concern, with fears of a supply shortage and amplified by excessive speculation, is driving up prices to well above fundamental levels; some people even speak in terms of around $20/b. An added danger here is that, once such concern has eased, oil prices could 'over-compensate', as they did in 2008, and fall below fundamental levels. This too would be detrimental to the longer-term interests of producer and consumer alike, as well as the world economy.

Therefore, it is up to all parties in the energy industry and related areas, notably the financial sector, to do their best to stabilize oil prices at reasonable, sustainable levels. This includes reducing that sector's influence on prices, which very often has its biggest impact at precisely the time when the market is at its most vulnerable. Balanced, rational dialogue has a key role to play here and is welcomed by OPEC.

OPEC Bulletin March-April 2012

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