Causes of oil price volatility Michael C.Lynch September 2002 Teacher: Dr Derakhshan Student: Mohammad Noruzi

Questions:  Michel Lynch argues that "it is harder to predict next year's oil price than to predict the average price over ten years". 1) Explain the above argument using the following factors: Data uncertainty Volatility of exogenous drivers The role of speculators. 2) What challenges this may impose on OPEC in managing the oil market?

Introduction Volatility is a common condition of commodity markets. Volatility has been throughout history. Different attitudes to the volatility: ◦ Speculators ◦ Large consumers and producers ◦ governments

The History Of Volatility Early in the history of the industry, oil prices were very volatile.

Oil price volatility in 1890s and 1900s

The post environment After 1973, OPEC took over the task of stabilizing the market. After 1981, this burden was primarily carried by Saudi Arabia, which adopted the role of ‘swing producer’. After1985, OPEC shifted to a policy of setting formal production quotas and attempting to instead let price stabilize the market.

The return to equilibrium The market lately entered a new period, in two dimensions:  First, prices have become more volatile.  Second, they now show an upward volatility that was lacking earlier.

Reasons:  Two dimensions: ◦ Physical ◦ Behavioral  changes in the physical market are also being compounded by some behavioral changes.

Physical Constraints Surplus capacity:  OPEC  Enormous surplus of tankers Product Regulations and Price Micro-bursts: ◦ The stringency of environmental standards. ◦ Transportation costs. ◦ Infrastructure: tankers, pipelines, ….

OPEC surplus capacity

Behavioral Changes Desired inventories. Exogenous Effects. Speculators. Transparency. Data Timeliness and Quality

Desired inventories: ◦ Holding inventories instead of production capacity. ◦ Shutting down of many small refineries in the U.S. ◦ “Just-in-time” inventories.

Exogenous Effects Some factors have more influence in the short-term than the long-term: ◦ Consumption data Some factors are inherently unpredictable in the short-term: ◦ Weather ◦ Economic growth

Speculators Speculators are often accused of playing a role in price movements. Uncertainty encourage speculative behaviors. ◦ The 1985/86 Oil Price Collapse ◦ Gasoline in the US, 2001 Speculators do matter, and can be wrong, however their influence is relatively short- term.

Transparency Although prices have become much more transparent but they are unreliable: A difference of about 300 tb/d among the major sources is typical. Oil consumption data also remains unreliable. There is smuggling in some parts of the world.

Missing barrels

Data Timeliness and Quality World petroleum and poor quality data. Decreasing the quality in data. Poor quality data are not useful to planners.

IEA Inventory Revisions, in mb/d

OPEC and Market Management OPEC is not successful because of its organizational structure. Why has it been successful? Because the stakes are so large. Lack of enforcement powers in OPEC leaves the other cause of volatility, cheating and ….

OPEC and Challenges to Setting the Price 1. Deciding on the price desired 2. Estimating the necessary action (quota change). 3. Implementing the action.

First Challenge: How Many Barrels on the Margin?  How much oil is necessary to reach the price desired?  The size of previous changes in quotas.  Considering inventory levels, and the difference between a tight and weak market.  Historically viewing.

Second challenge: What does OPEC know ? When do they know it? When OPEC meets, typically midway through the last month of each quarter, there is OECD demand data for the first month of the quarter and supply data for the first two months. And for the coming quarter, where OPEC is attempting to project needed output to stabilize the market (or achieve a price goal), the uncertainty is somewhat higher.

Third challenge The presence of unusual political events, weather, economic performance and so on can also have a substantial effect as to whether the uncertainty is higher or lower than that.) For OPEC, price stabilization is going to be very difficult, especially if the organization relies on setting quarterly quotas to balance the market.

Conclusion - 1 Oil market volatility cannot be eliminated short of massive government intervention. Some reduction in the amount of volatility could be achieved by: 1. Improving the collection of data 2.Increasing the timeliness and reliability of the data 3.Enlarged effort at improving analysis of the near-term future market balance.

Conclusion - 2 Two other policies would clearly help. ◦ Faster OPEC response to market ◦ Maintenance of spare capacity (production, shipping and refining) but would be expensive.

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