London, 31 March 2010

How feasible is it for OPEC and the consumer countries to try to re-establish an implicit trading band for oil prices? The cartel and leading consumer countries seem to be converging on the idea that price instability is damaging because it hampers investment and encourages switching to cheaper and more stable alternatives. Both are nearing an agreement on $75 as a fair or sustainable price. There seems to be a concerted effort to stabilise market expectations around a price band of $70-$80, or more realistically $60-$90, in the hope this would encourage selfstabilizing speculation in the market and steady prices around this level. But how realistic is the stabilization effort?

Three Conditions for Success

In his paper on oil pricing, prepared for the ministers meeting at the International Energy Forum in Cancun, Bassam Fattouh of the Oxford Institute for Energy Studies (OIES) sets out three conditions for stabilization to work.

* The preferred price range must be in line with market fundamentals, which implies it must be dynamic and adjust in line with changing fundamentals (though presumably it should not be too dynamic, or the "band" would be indistinguishable from an uncontrolled market).

* To sustain the necessary convergence of views, key market participants may need to share information about costs, investment flows, and the demand-supply balance, and undertake other "confidence building" measures, to reduce uncertainty and information asymmetries.

* Feedback mechanisms linking prices to adjustments in supply and demand may need to be enhanced and accelerated. Where feedback is slow (for example because producers cannot or will not adjust output in response to a rise in price, or because it takes time for consumers to increase efficiency and switch to other fuels) prices can wander outside the band for considerable periods of time.

Fattouh argues "policy diplomacy" could play a role in preventing sharp price movements by increasing the visibility of these feedbacks and policy responses. He cites Saudi Arabia's pledge to raise production at the Jeddah summit in June 2008 as an example of how policy can help guide expectations.

More Questions Than Answers

The problem with any oil price stabilization programme is that it raises more questions than it provides answers:

(1) Is the oil market's natural state range-trading around a long-term equilibrium, or are wild swings in response to frequent supply and demand shocks the norm, so it makes no sense to try to define a long-run equilibrium?

Promoters of stabilization point to the market's tight range during much of the 1990s, and the low variability of prices, especially at the back end of the curve, as evidence that expectations about long-term supply and demand feedbacks can anchor forward prices.

Sceptics counter by pointing to oil demand's high response to income, and low response to price, to argue that large price swings are inevitable and inherent in the market's dynamics. Trying to manage swings away is futile.

(2) Can policymakers really make credible commitments to manage the market using a pricing band or will speculators simply treat the price floor/ceiling as a target to be breached?

Price stabilization schemes do not have a good track record. Buffer stock managers (tin, cocoa) have repeatedly failed to stabilise commodity prices. OPEC's own experiment with a $22-$28 price band in 2000-2005 was no more successful. From the start, the band existing more in rhetoric than reality, and was quickly abandoned.

The failure of the European Union's Exchange Rate Mechanism (ERM), which was simply another form of stabilization arrangement, this time for currencies, is the stuff of legend. Why should a new oil price band be any more successful than previous failed attempts?

In some contexts, however, policy commitments can become credible and do exert a strong, stabilizing influence on behaviour. No one seriously doubts the Federal Reserve's statements about the outlook for interest rates (for example the "extended period" language) powerfully shape market expectations about the interest rate trajectory.

The question is whether Saudi Arabia, or OPEC as a whole, has the capacity to act as a "central bank" to the global oil market? It is not clear that OPEC is sufficiently cohesive, or has enough control over the supply of a physical commodity, to enforce its decisions on the market.

(3) If the price band needs to be in line with fundamentals, and periodically adjusted as the fundamentals change, how will policymakers identify where the equilibrium is, and how often would the band need to be updated?

The market often struggles to identify an equilibrium value, and reach consensus; it is not obvious why policymakers would be any more successful. In terms of adjustments, how would policymakers differentiate between a small, temporary dislocation that should leave the bands unchanged and a large, permanent one that would necessitate changing them?

If adjustments were made frequently, in the limit continuously, it is not clear the "bands" would be much different from the current system of free floating oil prices. But if the market was managed more stringently, how would bandsetters ensure oil prices did not become misaligned?

(4) How would the market deal with positive feedback? Most of the discussion on price bands has been couched in terms of negative feedback mechanisms (in which price changes and expectations dampen price oscillations). But what if the band created a positive feedback loop (one that tended to amplify them instead)?

Imagine a price band that aimed to cap oil prices at no more than $85 per barrel. If a positive demand shock (say faster than expected growth in China) caused the market to tighten and prices to move above $85, OPEC would respond by adding more production to the market. But with prices capped at $85 there would be no reason for China to slow its demand growth. OPEC would have to keep adding more output until its spare capacity was used up, and its ability to enforce the ceiling was gone. At that point prices would surge higher and the band would be meaningless.

In the face of large and sustained supply or demand shocks, it is hard to see how OPEC could stabilise prices in anything other than the short term. Given the forward-looking nature of futures prices, its resolve would be tested almost immediately. Stabilization proponents argue that this is precisely the sort of large, sustained shock that should prompt an adjustment of the bands to reflect new fundamentals. In that case, however, price management within a band system is hard to distinguish from a free float.

(5) How to allay market suspicions about an asymmetric response to price changes? The market suspects OPEC is more worried, and certainly more cohesive, when it comes to preventing a price collapse than prices rising and breaching some notional ceiling.

The $22-28 band was quickly ditched when prices soared above $28. While OPEC and Saudi Arabia complained about the speculation-driven rise in prices during 2007 and the first six months of 2008, the cartel enjoyed the boost to its revenues.

It was only at the very end of the period that Saudi Arabia took action to cool the rally by increasing output. For most of the time, ministers were content to do nothing, merely noting the physical market was "well supplied". OPEC's asymmetric response to price changes is the oil market's equivalent of the famous "Greenspan put". It gives investors a natural reason to be long (hoping OPEC will cut supply enough to avert a price collapse, but prove less active restraining a bull market). It also gives them a natural reason to test the ceiling of any price band.

To make any price band sustainable, OPEC and the consumer countries would need to find a way to make their threat to flood if the ceiling was breached credible. A price band to anchor expectations could help dampen speculative price movements, but only as part of a wider policy to increase production and maintain spare capacity, as well as a willingness to take long-term measures to reduce demand and cut energy subsidies. It is at most a small part of the solution.

Ends --

By John Kem, Reuters columnist - for Commodities Now

The views expressed are his own