Wednesday, March 4, 2015

OPEC Is/Is Not the Central Bank of Oil: Taking Away the Punch Bowl

We have very mixed emotions about the writer's prognostication skills but other market participants seem to think he's swell.*
From RBN Energy:

The Era of Petro-Exuberance – The Real Reasons Underlying Today’s Crude Oil Prices 



Alan Greenspan coined the phrase "irrational exuberance" during his tenure as Federal Reserve chairman. He used it in a 1996 speech in reference to the excessively high prices of "dot-com" companies. He worried that assets were overvalued. Four years later, the dot-com bubble burst, confirming his concerns. Presently we are observing the last gasps of irrational exuberance in petroleum. Call it "petro-exuberance." This malady became apparent during a session on oil market issues at the World Economic Forum in Davos, Switzerland. Some panelists clearly had a case of irrational exuberance, an overenthusiasm no different from what we saw at the end of the dot-com and the housing crises.

Claudio Descalzi, chief executive of Eni, and the International Energy Agency's Fatih Birol showed the most distinct symptoms. Both seem under the illusion that oil price levels today are temporary rather than characteristic of a new ceiling that producers will welcome in a year or two. In his remarks, though, Descalzi unintentionally advanced an explanation for recent developments and the likely way forward for global oil markets: "What we need is stability. ... Opec is like the central bank for oil which must give stability to the oil prices to be able to invest in a regular way." His observation, if correct, promises a prolonged period of low prices and a harsh climate for those producing oil.
Figure 1 - Dated Brent Price
Panel moderator Daniel Yergin joined the dialogue and asked the participants whether the central bank of oil was making a mess of things. Their answers made one thing obvious: they had no concept of the role central banks play in economies. If they had, they might have said this: "Not at all. A major central bank of oil finally responded properly in November when a decision was made not to cut output. While the action came late, the bank took away the punch bowl, just as really good central bankers must do from time to time. Market participants had become irrationally exuberant, investing billions upon billions in high-cost projects."

In refusing to cut production, one central bank of oil (Saudi Arabia) followed a script written by Paul Volcker 36 years earlier. Volcker became head of the US central bank in August 1978 when inflation in the US was out of control. Oil today is in straits similar to those of the US economy in the late 1970s. The managers of the "central banks of oil," which include key producing countries and consuming nations that own large strategic stocks (especially the US and Japan), should be concentrating on oil prices and the rate of oil price increases or decreases, just as Descalzi suggests. However, all have ignored this responsibility for the last 10 years. This "dereliction of duty" on the part of oil producers and consuming nations allowed crude prices to rise to excessively high levels. As a result, an irrational exuberance grew in the oil industry, fueling larger and larger capital expenditures on gigantic projects to produce oil and, at the same time, prompting investment in expensive technology developments aimed at eliminating oil use. Investors in both camps received an additional boost from the quantitative easing advanced by central banks after the 2009 crisis.
Last year, the key Opec members recognized the danger in these circumstances regarding their market share and the future of oil in general. By refusing to decrease output to sustain high prices at their November 2014 meeting, they acted as a central bank should. In spite of his words, this is not what Descalzi and others in similar positions desire. That is, he does not want oil-exporting countries to act as prudent "central bankers" worried about the long-term viability of the world oil and gas business. What he and executives of other major oil companies really would like to see is Opec behaving like the imprudent banks of the early 2000s, the ones that kept layering credit default swaps upon mortgage loans upon other bad loans to keep their financial bonanza going.

Who Is the "Central Bank" of Oil?
The Davos presentations also exposed the flawed thinking of those in the energy business — pretty much everyone it seems who see Opec as the dominant "central bank of oil." The central bank idea originated more than 10 years ago at PFC Energy, a consulting firm since acquired by IHS. The firm popularized the view that Opec members, particularly Saudi Arabia, had taken on in petroleum the role accepted for economies by the US Federal Reserve, the Bank of England and the European Central Bank.

But neither Opec nor Saudi Arabia alone can act as the central banker of oil, just as no central bank, acting alone, can do much to affect global economic trends. Yes, in the event of an oil shortage, Saudi Arabia and other Middle Eastern producers can moderate prices by boosting production of certain types of oil (generally sour, medium to heavy grades). They can also reduce supply for short periods. Such actions do not always succeed, though. These countries, for example, could not stop prices from tripling or quadrupling from 2003 levels when demand for light, sweet crudes surged in 2007 and 2008....MORE
*From our June 2013 post "UPDATED--Izabella at Dizzynomics: "Fed, QE and commods"":
Update below.
Original post:
I have very mixed feeling about Mr. Verleger.
I am naturally suspicious of anyone who spends as much time on self-promotion as he does. On the other hand Craig Pirrong seems to respect him and, although I don't have much interest in Pirrong's snark, the Prof. probably knows as much about commodity storage as anyone.
Storage, being the nexus between physical and financial, is the aspect of the commodity biz that matters most so anyone who can instruct me is jake in my book....
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Update: A very sharp physical oil trader points out that the above timeframe is rather wide enough to drive a tanker through without touching either side of the bracket and sends along a couple of Mr. Verleger's public predictions:
From Bloomberg:

Verleger Sees $20 Oil This Year on ‘Devastating’ Glut (Update1) 
That's dated July 16, 2009 with the front futures at  $61.18. Oil had bottomed the previous December at  $32.40. and besides not going to $20 it never traded lower than the day of the prediction, closing the year at $79.36.

More recently, 2012 we have Foreign Policy mag via NPR:
Foreign Policy: The Coming Oil Crash
...Given this already-existing revenue gap, one might fairly wonder what would happen if, as Citigroup's Edward Morse says is possible, prices drop another $20 a barrel for an extended length of time. Oil economist Philip Verleger's forecast is even gloomier — a plunge to $40 a barrel by November. Or finally, what Venezuelan Oil Minister Rafael Ramirez — $35-a-barrel prices, near the lows last seen in 2008. In Russia, for instance, "$35 or $40, or even $60 a barrel, would be devastating fiscally," says Andrew Kuchins of the Center for Strategic and International Studies. That could damage the standing of President Vladimir Putin, since his "popularity and authority are closely correlated with economic growth," Kuchins told me in an email exchange....MORE
There's nothing wrong with making a mistake, I do it on the blog all the time and even more often in the higher risk-hopefully higher reward stuff that doesn't make the blog.

The thing is, I just looked for a retraction or an apology or even an acknowledgement of these major mistakes and found zip.

And that's where the suspicion that self promoters engender comes into play.
In a business where you are marked to market on an hourly basis you don't have the luxury of being anything less than straight-up about your mistakes.
In other fields you can fudge, hedge, pretend, whatev. And self-promoters tend to do it more than folks with nothing to prove, or those with nothing to sell. 
After the 2013 post we followed up with "The Set Up For a Collapse of Oil Prices": 

Twice in the last six weeks FT Alphaville has referred to Philip Verleger's call for lower oil prices.
The thesis is higher interest rates would cause currently financialized inventories to come out of storage.

I agree but I wish to heck it hadn't been Verleger making the argument....
So who knows? I like the Schroedinger's OPEC idea.