The effect of the OPEC production decisions have on oil prices has been of significant interest since the 1973 oil crisis and the major economic and geopolitical events that caused. Since then a large body of academic research has built up and this post looks at the most recent material which found that the impact of OPEC’s announcements of oil prices evolves over time and among decisions, is more significant for production cuts and maintain and is different for WTI and Brent. Furthermore, OPEC’s decisions depend on the exploration and extraction cost of more expensive/unconventional oil resources
OPEC and oil prices
The decisions about the production level (increase, cut or maintain) on oil prices is a controversial issue among policy makers, regulators, and academics in particular. For some, this impact is weak or has been declining over time, especially lately as more and more non-OPEC producing countries increase their market share. For others, the impact is strong as prices deviate from their competitive level when members modify their oil production. Finally, there are some who support the viewpoint that OPEC’s impact changes over time as a result of prevailing market conditions.
The role of OPEC may also be scrutinised through the lens of the recent evolution of oil prices and the exploration of new oil resources. Indeed, we have seen oil prices not only breaking the $40 bbl long-run level but staying for a long time at $80 bbl, which is the level that makes the exploration and extraction of more expensive/unconventional oil resources economically viable (for instance, US shale oil, Canada’s tar sands, Brazil’s deep-sea off-shore oil, Venezuela’s heavy oil, and Arctic offshore oil, among others). Moreover, it is estimated that these resources represent about 50% of the global oil and gas proven reserves, thus increasing the importance of other non-OPEC producing countries still more on the global energy scene and reducing the influence on global oil prices of OPEC announcements.
Modelling the consequences of OPEC power on oil prices often consider OPEC as a cartel, whose members can collude, manipulating prices through production quotas, resulting in monopolistic profits. An alternative view is based on market competition, suggesting that the oil market is competitive and therefore OPEC has little influence on oil prices by operating as a cartel. Empirical evidence for these two explanations of OPEC behaviour has yielded conflicting results. Amongst other, work by Loderer in 1985, Huettner in 2000 and Bremond in 2012 argue that OPEC’s behaviour varies over time depending on economic, market, and geopolitical conditions and cannot be represented by a single model.
The 2000s, and the financialisation of commodity markets, brought the role of information in price formation to the fore. Thus, instead of directly modelling OPEC’s behaviour, another strand in the literature empirically studies the effect of OPEC’s announcements of production changes on oil prices. Deaves and Krinsky (1992) analysed crude oil as well as heating oil futures returns over a longer period, distinguishing favourable and unfavourable news for investors who take long positions. They found that traders earn economically and statistically significant abnormal returns after an OPEC conference conveying “good news.” They conclude that their results do not support the market efficiency hypothesis.
A paper by Lin and Tamvakis (2010) enriched the analysis over a long period, 1982–2008, by examining the impact of OPEC’s announcements on OPEC and non-OPEC crude oil, and for different oil qualities. Their empirical evidence suggests that the effect of OPEC’s decision depends on the production quotas (increase, cut, or status quo) and on the price trend. In contrast, they did not find a significant difference between OPEC and non-OPEC crudes or between oil qualities. The dramatic fluctuations in oil prices have led some authors to investigate the relation between OPEC’s announcements and the volatility of oil prices. Taking the period from 1989 through 2001 and employing an event study period, Horan in 2004 explored how and whether the implied volatility of crude oil option prices react to OPEC’s announcements. Their results suggest that implied volatility increases before announcements and decreases the first day following OPEC’s meetings.
Using intra-day returns of crude oil and natural gas futures contracts over a five year period (1995–1999), Wang found strong evidence of a positive impact of a production increase announcement on weekly volatility, but no evidence of impact on daily volatility. Schmidbauer and Rösch (2012), for the period 1986–2009 and for daily data, concluded that the impact of OPEC’s decisions on volatility is anticipated by investors, as there is a positive effect before the announcements and an asymmetric effect on expected returns after the announcements.
As we can see from the above, WTI and Brent prices steadily but slowly increased from 1991 to 2004, radically changing in their pace of growth and attaining very high values in July 2008. Then prices sharply decreased, before increasing again in mid-2009. Moreover, these two periods are characterised by different levels of volatility. A recent paper by Louitia, Mellios and Andriosopoulos – and the basis of this post – extended the earlier works mentioned above by examining daily spot prices for March 1991 to February 2015 for both WTI and Brent crude oil. Due to the different price regimes they split their examination into three regions; the whole period, March 1991 to December 2004, and January 2005 to February 2015. To investigate the effects of OPEC announcements on crude oil prices, they used an event study methodology. Event studies examine the behaviour of abnormal returns of a security around a relevant event. In their case, events were held to be announcements made by OPEC about its oil production output. The incorporation of the information, following an event, in asset prices may be immediate or may spread out over time. The choice of the event window is not based on formal rules and can differ among different studies. From there they then calculated the cumulative abnormal returns (CARs) and indexed these against the expected normal market returns by autoregressive and constant mean return models. The index’s they used were S&P, GSCI and BCI.
A changing landscape
Between 1991 and 2004, two phenomena seem to be present. First, the consumption of crude oil constantly increased, as did the production by both OPEC and non-OPEC producers. Second, the level of OPEC’s spare capacity dramatically plummeted between 1981 (around 14 million barrels (mb) per day) and 1990 (less than 2mb per day), whereas it fluctuated during the first sub-period between about 2mb per day and 8mb per day. On the other hand, non-OPEC oil producers are generally considered as price takers, meaning that they do not adjust their production to influence oil prices. Consequently, non-OPEC producers operate at or near full capacity and so have little spare capacity. Taking all these considerations together, it can be argued that an increase in OPEC’s production may be interpreted by market participants as a sign of tensions in the oil market, signalling a greater intervention of OPEC and thus resulting in higher future oil prices. The greater is the OPEC intervention, the greater is its impact on oil prices. However, OPEC’s diminishing spare capacity limits its ability to manipulate oil prices.
When a reduction in oil production is announced, in general, WTI prices react more than Brent prices to OPEC’s cut announcements, whatever the index. Moreover, the results seem more sensitive to S&P GSCI than to BCI. This can be explained by the weights of the WTI crude oil and Brent crude oil in these indices. Indeed, the weight of WTI crude oil is higher than that of Brent crude oil in the two indices, even if, in recent years (notably since 2011), the proportion of WTI decreases in favour of Brent, though the latter has not overtaken the former yet.
However, for the whole period (Q1 1991 to Q1 2015) WTI re-turns responded significantly to those decisions before the announcement day (up to three days). It follows that when WTI prices fluctuate in a relatively narrow band, the market anticipates OPEC’s cut decisions.
Following a cut in production, oil prices should increase. Despite the OPEC cut announcement, oil prices have continued to decrease. OPEC’s cut decisions occurred in 2006, when oil prices fell significantly, and before the sharp increases in 2007 and 2008 (when prices peaked in July 2008). This apparently counter-intuitive result may reflect considerations of market participants with regard to world current and future supply and demand for oil and their scepticism concerning the cohesion of OPEC as a group, as well as the actual reduction in production. Indeed, from 2005 to 2008, economic growth and oil demand were strong, whereas the oil supply and the spare capacity were low, putting upward pressure on oil prices.
However, oil prices depend also on expectations of future supply and demand, which turn out to be very difficult to predict when market conditions are uncertain. For instance, a slight discrepancy between EIA’s oil demand forecasts and anticipations for 2007 impacted oil prices more heavily than OPEC’s announcement. In 2008, market participants attached more importance to the world economic recession and the resulting decrease in oil demand than to the insufficient OPEC production cut. Economic considerations may be amplified by OPEC members’ behaviour vis- à-vis quotas. OPEC is a group of countries with divergent political and economic interests. Its members may disagree on the decision and on the level of quota cuts, in particular during periods when prices are falling. In this case, it is difficult to achieve discipline on the part of OPEC members, who may not comply with the quotas assigned (as experienced in 2015 by the actions of a key member, Saudi Arabia
Status quo decisions may have a significant impact on the pre-announcement period, on the event day, and on the post-announcement window. Such announcements are often perceived as non-decisions for different reasons. Market fundamentals, economic conditions, or geopolitical events could lead OPEC to reduce its production. Nevertheless, disagreements among OPEC members result in a status quo. The market interprets such decisions as a signal that there is a sufficient level of supply. Thus oil prices fall and CARs are negative. Moreover, it recognizes a greater influence of these decisions and tries to anticipate them.
A maintain of production also has an influence on returns with a post-announcement delay of several days, notably in the second sub-period and for WTI prices. These results may be put in perspective by introducing non-conventional oil resources into the reasoning. The exploration of such resources is relatively costly and is economically efficient only under high oil price conditions. For instance, the US produced more than 3mb a day in 2014 from shale formations. If prices remain high, non-OPEC countries can raise their production and challenge OPEC’s role in oil price formation. However, OPEC members’ exports and revenues depend heavily on oil prices. Thus, OPEC faces a dilemma: maintain production quotas at levels that would keep prices elevated or at levels that would contribute to lower prices, forcing out some of the high-cost producers. The potential increase in non-conventional oil resources and natural gas production, which can significantly affect global energy markets, may arise as a key factor in OPEC’s decision-making.
A large body of evidence suggest that the announcements effect on oil prices varies across periods, production decisions, oil prices and benchmark indices. The data suggests that OPEC is less influential during periods when oil prices are high the more so as above a certain level price, unconventional oil resources are economically viable. However, although the effect of OPEC decisions is more pronounced when prices are low, OPEC members may face dilemma: keeping prices at low levels could prevent high cost oil producers from entering the market, but, at the same time, could reduce OPEC members’ revenues.
Oil prices respond differently to quotas changes: a reduction or a status quo in production results in significant cumulative abnormal returns in contrast to an in-crease in production. These decisions reflect disagreements or a lack of discipline among OPEC’s members and the necessity for OPEC to take into account previous unilateral quotas changes. More specifically, a cut decision has a stronger effect and is anticipated by the market when price fluctuations are lower.
The role of unconventional oil is increasing in energy markets. The technological improvements allow for a greater unconventional oil production and unconventional reserves are now estimated to be higher than conventional reserves. It would be interesting to conduct in the future a similar study on the impact of OPEC production decisions, given the role of unconventional oil.
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