Earlier this week in a Reuters reported that OPEC Secretary-General Rilwanu Lukman said on Monday that prices were still far from the $21 price target for OPEC's basket of crudes. He said an OPEC basket of seven crudes for the year to date was valued at just over $15. Does this mean that the goal of OPEC is to average $21 for 1999. If so the may come closer  than many expect but there may also be repercussions.

The focus recently, excluding the statement by Lukman, has apparently changed from prices to inventories in the stated belief that a lower or normal level of crude oil stocks is the solution to OPEC's pricing problems. The first part of this analysis focuses on the problems of making decisions based upon the world stock of crude oil.  The second part focuses on the wisdom of targeting a worldwide stock reduction at this time. It is a Y2K problem even if the Y2K problems are minimal.

Stock / Inventory Management

Management Problems

In one sense inventory management can work. Controlling the inventory of crude oil relative to demand is an effective tool for price control. However, it has some problems: 

1. Which inventory level do you attempt to manage: crude oil or crude oil and petroleum products?
2. How can you manage oil inventory? 
3. How do you measure inventory level?

What is the impact of this policy? A sustained period of high prices leads to slower economic growth rates and lower demand for crude. High prices also lead to increases in exploration and development of fields in the non-OPEC countries. 

The United States faced with declining reserves
and high finding and lifting (production) costs is an excellent example. Crude oil prices increased rapidly in 1996. The U.S. industry which has experienced declining production for years responded with an increase in exploration activity. The prices where high enough to justify more drilling for crude oil even though U.S. finding and lifting costs are relatively high. The response to the price increase was delayed and mostly realized in 1997. By the end of 1997 the number of rotary rigs drilling for had increased from 700 at the beginning of 1996 to over 1,000 rigs in the last half of 1997. 

In addition to the discovery and completion of more oil wells the industry enhanced the production of existing wells through improved maintenance and enhanced recovery techniques.

A quick look at  U.S. crude oil production shows the results of these efforts.  After years of declining production U.S. production flattened out and actually showed a small increase in 1997 over 1996. The U.S. experience was not unique. Over 20 non-OPEC countries registered increased production in 1997.

We all know the rest of the story. Near the end of 1997 OPEC increased its quotas at the same time that Asia was entering a strong recession. Prices collapsed and did not recover until spring of 1999 when OPEC implemented significant production cuts. The price collapse illustrates the point that OPEC cannot control demand and is an example of its failure to react fast enough on the supply side. It may be that OPEC's discussion about inventories is an attempt to react faster to external market changes.  If so it is not likely to work or at best is not optimal. This brings us to stock measurement.

Measurement Problems

Even if an effective stock management program can be implemented where quotas adjust to the inventory level according to some formula, the purpose of which has to be to control prices, it is almost impossible for it to be effective. Let's look at inventory data.  Currently for the U.S. from the EIA reasonably good crude stock figures at most two weeks old are available  For the the OECD countries the most recent data from the same source is 3-1/2 months old. OECD Country detail data is older by months. In short, if OPEC used inventory data for production decisions it is likely that OPEC would have made mistakes that were similar to those that lead to the all too recent price collapse. Outside of the OECD countries much of the data will not be available for over a year and even then it is subject to significant error.

Stock Reduction and Y2K

It is not unreasonable to expect OPEC countries to want to make up some of the revenue lost in the price collapse. However, it may not be wise to do so at this time. We have outlined the problems in the longer term to OPEC of high prices. A period of sustained high prices essentially lowers OPEC's influence on and control of the market. The problems of low prices for the OPEC countries are obvious. 

What events are likely to happen for the remainder of 1999?  A significant part of demand depends on the severity or lack thereof of the winter in the Northern Hemisphere. Some depends upon the extent of the Asian recovery. Winters and economies are hard enough to predict, but the real wild card is Y2K. We are not predicting massive failure of the infrastructure of the economies of the developed countries.  However, whether or not there are any significant Y2K problems there will be a Y2K impact before the end of the year.

First, consider your own response. Even if you think it will be at most a blip on a few computer screens, it is probable that you will have a few days of extra food on hand and you are likely to top off your gas tank.  That will move demand for gasoline up for a few days before the end of the year. Some people will purchase and store large quantities. 

Second, consider the response of the companies that supply our gasoline. First they will attempt to anticipate your purchases prior to year end. That means oil companies need additional product inventory to satisfy the demand created by our uncertainty.

Third, even if the oil companies are confident of no problems in their production, refining or distribution system they are still subject to uncertainty. Will electricity be available in West Texas to power the pumping units? Will pipelines not in the company's control be able to deliver crude to the refinery or refined products to the distributor? .

What is the likely reaction of an integrated oil company facing these uncertainties? Since they don't want to lose customers the goal is to be certain they can supply them. How? Move the product downstream closer to the consumer. Fill the tanks at the local gas station. Fill the tanks at the local distributor. In short, the first line of defense is to move product closer to the consumer. Next is crude for refineries and finally filling the crude supply stream.

The summary is that demand will increase even if there are no Y2K problems. That will lead to even higher prices, increased production outside of OPEC and the potential for downward price pressure in the first half of 2000.  Of course if there are no Y2K problems everyone will have excess inventory and prices will drop.