The need for a new OPEC strategy

by: Hans van Cleef

OPEC used to have the best and most reliable ‘information’ about supply and demand and the trade flows of oil. But today, entirely different players have the knowledge that matters. While OPEC basically still pursues a traditional static strategy, these new players are constantly adapting their approach. As a result, OPEC sees itself being overtaken by events all the time. So, according to Hans van Cleef, OPEC needs to keep up with the times.

Data-driven oil pricing and speculation

Market speculators and oil producers need real-time information to make an accurate estimate of future supply and demand for oil. Nowadays, the direction of financial markets, including the oil markets, is mostly determined by market speculation. Real-time information based on big data and trade per millisecond also put pressure on the margins of oil producers. Their margins depend on whether or not they have the right knowledge. The information they need comes from various sources, such as data tracking, analysis of flow-top (floating roof on oil tanks) data by satellites, algorithms, machine learning (nearly all trade in oil contracts is now conducted without human intervention) and of course the Weekly Petroleum Status Report of the US Department of Energy (DOE).

The Organisation of Petroleum Exporting Countries (OPEC) uses a strategy that is based on agreeing production levels twice a year. OPEC communicates a production level for the next six months and then ‘freezes’ this level until the next meeting assuming that this will balance out the market for months.

Trump uses different policy management tools

US President Donald Trump is currently seen by the markets as one of the most decisive factors in the price of oil. This has reduced OPEC’s power as the driving force of the oil market. While OPEC’s sole purpose is to bring stability to the oil market for producers, consumers and investors, President Trump’s policies focus on two other goals: geopolitics and economics.

In geopolitics, there are different events that have a direct influence on the supply of oil. These include the sanctions the US has imposed on Venezuela, Russia and Iran. President Trump pursues a different policy when it comes to economic factors. Within the US, he mainly focuses on the price of gasoline.

OPEC needs to keep up with the times

Where President Trump pursues a price-based policy, OPEC still balances the market by adjusting its production levels. To remain in control, OPEC might also have to adopt a strategy based on a price range. In my opinion, the most ideal bandwidth would be USD 50-70/barrel for Brent oil. This corresponds to the gasoline bandwidth in the US of USD 2-3/gallon. Below USD 50/barrel, shale oil production will be loss-making and the level will not be feasible for long. OPEC will not have to reduce its production because production in other regions will drop due to the price being too low. Above USD 70/barrel, OPEC must have sufficient capacity to increase production so as to depress the price.

By introducing a price bandwidth, OPEC may regain its grip on the market. But this requires knowledge and up-to-date data. That is why, in how it operates, OPEC will have to rely on its own up-to-date data to keep the upper hand on the financial markets, non-OPEC competitors and President Trump.

Need for new communication strategy

It is crucial for OPEC to develop a new communication strategy. In these modern times, it can no longer get away with agreeing on production capacity twice a year and measuring later on whether the agreed price proved sufficient to balance the market. I believe that there are two communication strategies that could serve as an alternative to the current OPEC meeting structure:

  • OPEC reports its up-to-date production and export data on a weekly basis, much like the DOE’s weekly Petroleum Status Report in the US. This would limit uncertainties regarding possible shortages and surpluses in the market. The market would benefit from more clarity to prevent unrest and – hence – speculation.
  • The second option is absolute silence. Knowledge is power. OPEC could communicate the bandwidth they will be using just once and ask the market to trust that it will supply the market such that the price will hover between roughly USD 50-70/barrel (for Brent). It then has to make sure, without issuing any further communications, that the top of the bandwidth is not exceeded.

Regardless of which alternative OPEC were to choose, the fact of the matter is that its current strategy is outdated. If OPEC does not adjust its strategy, it will only be reactive in its actions rather than being able to exercise control. In my view, changing its communication and production strategy is the only way for OPEC to stay relevant in the years to come.

 

This column was published earlier in Dutch on Beleggers Belangen