The oil market needs central bank-style guidance from Saudi Arabia

Crude oil prices are above $70, the highest since 2018. Nationally, gasoline prices are above $3.

The International Energy Agency’s widely watched monthly oil market report on Friday said “OPEC+ needs to open the taps to keep the world oil markets adequately supplied.”

Yet Saudi Arabia’s energy minister, Prince Abdulaziz bin Salman, speaking recently at the St. Petersburg economic forum, said “we’ll have to see demand before you see supply.”

That’s a recipe for losing control.

Faced with a collapse in global oil demand last year due to the COVID-19 pandemic, Abdulaziz led an unprecedented cooperative effort to regain control of the oil market. Saudi Arabia, Russia and a group of 18 other oil-producing countries (the so-called OPEC+ group because it comprises most OPEC members as well as nonmembers like Russia) agreed to — and delivered — the largest coordinated oil production cuts the world has ever seen.

But there was more to the story.

It wasn’t just the large cuts (and surprising avoidance of cheating that has traditionally sunk such cooperative efforts). The group also included a forward-looking perspective, much like the Federal Reserve’s famous “forward guidance.” Way back in April 2020, when OPEC+ first agreed on large production cuts, the group also laid out plans for a managed return of that production that extended all the way to April 2022.

It was a remarkably prescient plan. The original cuts of roughly 10 million barrels per day, which was more than 10 percent of pre-pandemic global oil production, were slated to moderate to about 8 million barrels per day after two months; then to roughly 6 million barrels per day at the beginning of this year, which would extend through April 2022. 

With so much uncertainty, the group has been meeting monthly to track market developments, and the original plan had been modified several times to keep up with changing market circumstances — just as central banks do. For example, earlier this year, as a new wave of COVID-19 infections led to renewed shutdowns in Europe, the group delayed plans to increase production.

But these adjustments have continued to be accompanied by forward-looking projections of how the group anticipated the continued evolution of its coordinated cuts. For example, this year’s April meeting published updated production targets through July for managed monthly production increases totaling 2 million barrels per day (including the reversal of 1 million barrels per day of voluntary additional cuts from Saudi Arabia). 

From the OPEC+ perspective, this combination of large production cuts and communication of forward-looking plans has succeeded in two ways: It has pushed prices higher, and done so in a relatively orderly fashion. 

The results have been striking: After famously falling below zero here in the U.S. last spring, oil prices have marched steadily higher. And yet, that increase has been relatively tidy, with the group’s communication strategy helping to avoid the large swings that have often been the oil market’s norm. Even with tremendous uncertainty about the recovery of global demand, including yet another tragic cycle of COVID-19 infections in places like India and Brazil, monthly crude oil prices over the past year have only been about as volatile as they were over the previous decade. 

But now, with oil prices above pre-pandemic levels, has OPEC+ gotten too comfortable? With the group’s current targets running through July, this month’s meeting failed to include forward targets. Rather, bin Salman now says “we’ll have to see demand before you see supply.”

Now is not the time for overconfidence. Waiting to “see” demand is a risky strategy. It takes time for the global oil system to digest changing supply-and-demand developments, because of the time it takes for oil tankers and pipelines to move crude, then to refine it and distribute it to consumers (not to mention the long lags in reporting oil market data — note that the most recent IEA oil report only had information on inventories from April). So waiting to “see” today’s demand risks an over tightening and sharply higher prices. 

Central banks like the Fed have a critical mission of avoiding excessive price volatility, and transparent forward guidance is an important element in their toolkits. Maintaining the confidence of investors and consumers is essential to the smooth functioning of any market — and oil is not just any market. Even with growing pressure to shift away from fossil fuels, oil remains by far the world’s largest source of energy — and as we saw after last month’s Colonial Pipeline closure, it remains (at least for now) essential to modern life.

Saudi officials like to think of themselves as the oil market’s central bank. With the next OPEC+ meeting just two weeks away, now is the time to show it by maintaining their approach of giving “forward guidance” on production.

Mark Finley is the fellow in energy and global oil at Rice University’s Baker Institute. He is a former senior U.S. economist at BP and CIA energy security analyst. Follow him on Twitter: @finley_mark

Read More:The oil market needs central bank-style guidance from Saudi Arabia

2021-06-17 12:31:03

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