The Riyadh connection

Why did OPEC's decision rattle futures markets? 

In the last six months, during which oil prices on the futures market declined, they plunged most steeply immediately after the November 27 decision of the Organization of Petroleum-Exporting Countries (OPEC) not to reduce its supply, perhaps because of a prisoner’s dilemma. Brent prices fell by $6 to $71.25 per barrel, reported Reuters.  Why did speculators respond to OPEC by dumping oil securities?

The most reasonable explanation would be that they believed that the decision would create an excess supply of oil.  Either supply would rise or demand would fall.  Let’s consider each possibility.

Could OPEC’s decision have increased supply?  It’s hard to see how.  Non-OPEC producers (like Russia and Kazakhstan) would not respond by increasing their own supply since, given demand, this would create an excess.  They might have stepped up production had OPEC voted to cut back, for this might have freed up some demand for themselves.  Indeed, this very possibility might have led OPEC to maintain its existing supply.

Surely, then, OPEC’s decision would lead to a fall in demand.  But this doesn’t make sense, either.  Why would buyers cut back in response to a confirmation of the usual supply?

Seeing is disbelieving

In short, it is not reasonable to think that OPEC’s policy could increase excess supply and thus cut oil prices.  So why did investors immediately respond by selling oil short?

Perhaps they considered not the actual effect of the decision but the perceived effect.  If the typical investor believes, correctly or otherwise, that the policy would increase supply, then it makes sense to get out of oil.  With apologies to Robert Shiller, one might call this an “irrational lack of exuberance.”

The weakness of this approach is that an investor who focuses on actual demand and supply will eventually profit at the expense of short sellers, if market conditions dominate prices over the course of a year or more.

For example, some analyses suggest that global oil prices are falling because of an (undocumented) excess supply of one million barrels per day in West Texas Intermediate oil.  Even if the excess supply does exist, it would be trivial in the context of a global market of more than 90 million barrels per day, according to data from the United States Energy Information Administration.  It is not reasonable to think that, given demand, a rise in supply of about 1% would lead to a fall in price of 30% or 40%.  But if investors think that such fallacies are commonly accepted, then they may sell oil short for profit, at least until a sense of reality prevails.  –Leon Taylor tayloralmaty@gmail.com   

Notes

1.  In the game called “prisoner’s dilemma,” each player chooses a strategy that most benefits him given whatever the other player would do – yet the overall outcome is worse for both players than a cooperative solution would be.  In OPEC’s decision, each country might prefer to maintain its own output regardless of whether other countries would maintain or reduce theirs.  But the general outcome might be worse for OPEC than a commitment by all its members to reduce output.

 References

Alex Lawler, David Sheppard and Rania El Gamal.  Saudis block OPEC output cut, sending oil price plunging.  Reuters.  November 27, 2014.

Robert Tuttle.  Brent, WTI slump to 4-year low as OPEC keeps quota steady.  Bloomberg.  November 28, 2014.

United States Energy Information Administration.  Copious oil statistics.  www.eia.gov