Volatility and instability

Oil industry managers once gave much thought to an ideal called stability. Now they spend less time trying to achieve stability and more time trying to survive an instability that seems destined to last. But is it?

By "stability," most people refer to price and mean the opposite of "volatility." With crude oil and key products now traded as commodities, prices are indeed volatile.

By itself, this is not a bad thing. In an active market, trade-by-trade lurches in price should balance one another into fairly smooth trends that reflect shifting relationships between supply and demand. The smoothing happens because supply, demand, and price gravitate toward a balance that economists call equilibrium.

Ability to forecast

Except in theory, markets never achieve equilibrium. Weather, human activity, and other imponderables constantly churn supply and demand, changes in which alter the price, which influences decisions that in turn affect supply and demand. But the inclination toward equilibrium makes it theoretically possible to forecast price on the basis of assumptions about future supply and demand.

So why can't anybody predict oil prices with reasonable accuracy? Why do slumps so frequently upset the oil business?

The problem is not so much that oil prices are volatile but that the oil market itself is unstable. It is unstable partly because oil demand is difficult to predict. More to the point, much oil supply doesn't follow economic logic. Because few valid assumptions can be made about future supply, price predictions often go wrong.

At a given moment, supply, net of inventory changes, should depend on the incentive to produce from available capacity. And that incentive should mainly reflect the difference between revenue from the sale of oil and the cost of producing it. When demand weakens and prices decline, the costliest production should cease first, the rest on a scale defined by cost.

The oil market doesn't work that way. The biggest producers, with capacity cheapest to operate, try to support price with coordinated cuts in output. When demand sags, the market develops an overhang of idle, state-owned production capacity cheaper to use than commercially owned capacity remaining on stream at maximum rates. That's backwards.

What's more, production management helps all producers, not just those sacrificing sales to support prices. Over a period of years, the world's capacity to produce oil grows more than it should, creating volume competition for producers with the lowest operating costs. Meanwhile, the cost advantage diminishes. Most production sacrificed to price management belongs to governments with national budgets dependent on oil revenues. With operating costs already low, they can respond to cost reductions by competitors only by cutting public services. And supply decisions gain a political dimension.

Demand camouflages supply-side imperfections when it grows and multiplies producer troubles when it stagnates, as it did last year. Political agreements that always leak now strain to restrict economically viable production.

Where is equilibrium in a market with such strong motivations to overdevelop supply and to overproduce during periods of surplus? There is no clear answer. There is instability-a problem of the whole market, not just prices.

Managing surprise

Dealing with instability isn't easy. As the past year reminded everyone, companies need to manage against surprise. They also should recognize how instability amplifies the influence of demand; indeed, not all market surprises are bad ones.

For the longer term, companies should stay alert for changes that would move the market toward stability, make oil prices more predictable, and make long term investments safer to plan. The signs will be easy to spot. Private oil companies will begin drilling wells under equity terms or reasonable likeness in places like Saudi Arabia and Kuwait.