A subdued suggestion that global oil production be managed on the basis of reported inventory levels deserves more attention than it probably will receive. It came from an unidentified official of Saudi Arabia speaking in the press run-up to this week's meeting of the Organization of Petroleum Exporting Countries. The source-someone representing the world's premier oil producer and therefore OPEC's most important member-makes the idea especially intriguing.
The suggestion acknowledges that OPEC's decision-makers, now basking in the success of last April's production cuts, need a beacon safer than price by which to navigate. Some OPEC members seem ready to follow rising prices overboard. Even before this week's meeting, OPEC ministers were trumpeting their determination not to raise production before next March. With crude futures prices now touching $23/bbl, they have little current motive to change course.
Effects on demand
Yet simple economics and a casual reading of history say that rising prices eventually will erode demand and stimulate development of supply. Under those conditions, the major suppliers will lose market share, as OPEC did the last time too many of its members became transfixed by price. And all producers will face the rigors of a shrinking market for crude oil.
It was amid the premeeting promises that OPEC wouldn't rain new production volumes on the summer price parade that the anonymous Saudi official offered this observation, as quoted by Reuters: "The name of the game is the level of stocks, not the prices. This is the most important market fundamental." Even before he spoke, attention to stocks had been high. OPEC's production restraint this year accommodates an essential and large inventory draw that has yet to reach needed proportions. But the Saudi official implied that OPEC should not just pay attention to stock numbers but rather make them, not price, the center of decision-making.
Why stocks? In strictly physical terms, stocks are the market's buffer. Their level rises when output of crude oil and petroleum products exceeds consumption. It falls when output comes up short. Stock movements thus show whether the market is inclined toward surplus or shortage-something with which OPEC, the market balancer, must concern itself.
Prices, integral to the dynamic, constitute a similar window on market. But they never tell the whole story. For its own good, OPEC should be paying close attention to the effects of its actions on demand or-better yet-the relationship between demand and now-deliberately limited supply.
Stock volumes and changes gauge that dimension of the market. The problem is that stock levels themselves are difficult to measure. They can be imputed from supply and consumption figures. Some can be measured in countries, mostly the developed ones, that bother to keep track. Yet no one knows exactly how much space exists in the world in which to store oil. So no one knows exactly how much of that space contains oil at any one time.
Suspicion lingers
This became a popular controversy last year when reporting agencies deduced stock levels they couldn't actually measure. The theory developed that traders had undervalued oil supposing that more of it was on hand than actually was the case. Now that oil prices have rebounded no one seems to care. Suspicion lingers about the validity of stock figures nevertheless.
For that reason, the Saudi suggestion for putting stocks at the center of OPEC decisions about production will go nowhere. Instead of heeding an imperfect but useful indicator of market dynamics, therefore, OPEC will stay riveted to price. It will base its decisions on the natural craving for revenue associated with one more dollar per barrel and worry about market contraction later. For everyone else in the oil industry, a little such worry now would make a prudent basis for planning.
