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Causes of oil price volatility

Michael C.LynchSeptember 2002

Teacher: Dr Derakhshan

Student: Mohammad Noruzi

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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 uncertaintyVolatility of exogenous drivers The role of speculators.

2) What challenges this may impose on OPEC in managing the oil market?

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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

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The History Of VolatilityEarly in the history of the industry, oil

prices were very volatile.

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Oil price volatility in 1890s and 1900s

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The post- 1973 environmentAfter 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.

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The return to equilibriumThe 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.

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Reasons:

Two dimensions:

◦Physical◦Behavioral

changes in the physical market are also being compounded by some behavioral changes.

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Physical ConstraintsSurplus capacity:

OPECEnormous surplus of tankers

Product Regulations and Price Micro-bursts:◦The stringency of environmental standards.◦Transportation costs.◦Infrastructure: tankers, pipelines, … .

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OPEC surplus capacity

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Behavioral ChangesDesired inventories.Exogenous Effects.Speculators.Transparency.Data Timeliness and Quality

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Desired inventories:

◦Holding inventories instead of production capacity.

◦Shutting down of many small refineries in the U.S.

◦“Just-in-time” inventories.

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Exogenous EffectsSome 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

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SpeculatorsSpeculators 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.

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TransparencyAlthough 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.

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Missing barrels

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Data Timeliness and Quality

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

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IEA Inventory Revisions, in mb/d

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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 … .

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OPEC and Challenges to Setting the Price

1. Deciding on the price desired2. Estimating the necessary action

(quota change).3. Implementing the action.

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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.

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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.

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Third challengeThe 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.

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Conclusion - 1Oil 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.

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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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Thank YOU

THE END