Oil Market: Things Are Beyond OPEC’s Control

Thursday, March 20, 2008 | | |

What an exceptional week it has been!

With Bulls continuing to reign and crude for the first time in history crossing the $110 mark, this has been an unprecedented and turbulent week in many, many ways. Fears of a third oil shock are being expressed all around. Talks of stagflation, first heard in the 80s, are in currency once again. The worst economic recession since the Great Depression seems just round the corner.

Markets are setting new records. Having broken through the $100 psychological barrier, oil prices continue to soar and show little sign of slowing their upward march. Already at the beginning of the year, aggregate global oil inventories were at an all time low in terms of forward demand cover.

OPEC is rightly concerned, finding itself in a tight spot-under focus, yet feels it can’t do much. The London-based Center of Global Energy Studies in its March report underlines there are concerns within the producers’ group that any over-supply in a weakening market will undermine prices. However, there are others on the other side of the table who continue to argue that under-supply will continue to push prices to levels that will hasten the weakening of the market and erode demand.

OPEC thus has been arguing for some time that the supply side of the global crude balance cannot be blamed for the current woes of the market. Analysts agree that the size of oil supplies is just one factor, among others, that determine the crude market price. Other market driven factors seem to have overtaken and overpowered the fundamentals of the energy market. Definite question marks about the ability of the OPEC to control markets are thus being raised and debated all around. OPEC says the current Bull Run is much beyond its capacity and not every one disagrees.

Eminent London based scholar Dilip Hero underlining the issues the energy world is faced with today agrees with the OPEC and says, “an equally important factor (for the current market woes) is the capacity of refineries to transform crude oil into end-products.”

Mismatch between the available crude oil and the type of refinery leads to bottlenecks, not to mention the total capacity of refineries falling behind the aggregate amount of crude available worldwide. There is nothing that OPEC members can do about this, Hero said in a recent write up.

It is in this context that the issue of who controls the world energy markets comes into focus. There are no doubts that the OPEC definitely gained control of the oil markets in the aftermath of the 1973 Arab oil embargo. Indeed OPEC got into driving force then, as far as the global oil markets were concerned. However, the fact remains that the OPEC domination of the oil markets did not last long. And old newspaper files are enough to confirm that policy planners in major consuming nations maneuvered to ensure loss of OPEC control on the markets. And in fact forces much beyond the control and domination of OPEC today control crude markets.

Under the influence of Reaganomics, gradual deregulation of economies took place in the western economies. This resulted in the emergence of futures contracts for currencies and gold, with the New York Mercantile Exchange (Nymex) emerging as the leader. In 1981 it added petrol to its list of traded commodities. And this was a definite turning point in the world of energy as far as controlling the markets were concerned.

Enumerating the reasons of loss of OPEC’s control, Hero hence underlined that in March 1982, non-OPEC production for the first time outpaced the OPEC output. Interestingly much of the non-OPEC petroleum then came from the North Sea and was sold on Rotterdam’s spot market, where the price was determined by a variety of market factors — and indeed not OPEC.

And the impact of this was so deep that the oil cartel even failed to maintain its reference price of $34 a barrel it set earlier for its crude and in early March 1983, it had to yield to market forces to slash the price for the first time by 15 percent and reduce output.

However, the fatal blow to OPEC’s power to control and determine oil market prices was struck on March 30, 1983, when Nymex introduced petroleum futures. That meant the oil price being fixed daily, determined by the give-and-take of Nymex traders, with buyers and sellers monitoring their computer screens worldwide. OPEC was hunted out of the picture on this day. What an achievement in some senses, though the entire world is paying a price of this fallacy.

Given the current weakness in the equity markets, the falling value of the dollar, and the credit crunch caused by the subprime mortgage crisis in the US, speculators are putting their funds into such safe havens as gold and oil, spiking up their prices. Currency investors are plugging in more and more cash into commodities seeking refuge from tumbling world stock markets and US recession fears. Market participants are looking to US dollar denominated commodities to hedge against inflation and their forex exposure.

And it is in this perspective one could safely project that it is virtually impossible for the OPEC to tame the global crude markets. The current Bull Run now seems ready to continue for some time in future. A new fundamental needs to be added to the global energy equation — things are much beyond OPEC’s control today.