LONDON (Reuters Breakingviews) – On a noisy train you have to shout to be heard. That acoustic fact helps explain the dramatic and rapid recent drop in the price of crude oil, and some big daily moves in stock markets.
As recently as 2014, the oil market looked remarkably stable. On December 23, 2010, the price of a barrel of West Texas Intermediate crude rose durably above $90 for the first time since the 2008 financial crisis. On October 7, 2014 WTI crossed the line again, on the way down. In the intervening 954 trading days the average daily closing price of the black stuff was $96 per barrel. On only one day was the price more than 20 percent above or below that average.
Suppliers have to be disciplined to keep the price so steady, loosening the spigots when prices start to rise and tightening them when inventories start to accumulate. Back in the early years of the decade, Saudi Arabia and its allies had enough clout to manage that, so mere whispers from the market kept everything in balance.
These days the oil market is speaking with a megaphone. The precipitate drop of 31 percent in just over two months is just the most extreme example. In the most recent 954 trading days, the average price for WTI has been $52, just about the current level. But the price has wandered a lot. The daily price has been 20 percent above or below that average almost a third of the time.
The first step to understanding what is going on is to forget the conventional economic theory of commodity prices. Neither the increased volatility nor the most recent sudden fall is a response to changes in the cost of supply. Those shifts come far too slowly to generate large daily or even monthly price moves.
Nor can the big ups and downs be anything like rational responses to changes in the quantity of either supply or demand. Both change relatively slowly. Annual moves on either side have averaged less than 2 percent for the last five years. Besides, oil inventories are flexible enough to absorb any surprises.
There has to be another reason for the 22 percent average annual price change over the same five-year period. Technical factors – speculators, financial costs, and so forth – play a role. However, the most helpful explanation is geopolitical. So much is going on, in the whole world and inside the biggest oil producing countries, that a big price drop is needed to spur a small reduction in output.
It is hard to list all the messes. Even with output from Iran and Venezuela constrained by political turmoil and sanctions, internal pressures are tempting the autocratic leaders of most oil-dependent big producers – Saudi Arabia, Russia, and Iraq – to pump more, not less. They do not want to listen to the market.
The United States is the least responsive big producing nation. As long as their cash flow remains positive, American producers basically cover their ears when the market starts to squeal. So output is 16 percent higher in the first eight months of 2018 than in the same period last year. The U.S. is now a big enough producer, at 14 of world output, to add meaningfully to the pressure on others to cut back.
The recent sharp price fall is the market equivalent of a three-year old screaming for attention. As many weary parents have learned, that is often a winning strategy. Russia’s Vladimir Putin and the Saudi leader, Crown Prince Mohammed bin Salman, have agreed to slice back production.
In effect, price volatility is disciplining the oil market in a way that the actual price is not doing. Oil would have to stay far below the current price of $53 a barrel for a very long time before negative cash flows cut global production significantly. It was the same before the financial crisis, in the other direction. When oil was at $140 a barrel, demand did not fall fast enough to restrain prices.
Then the financial crisis changed the dynamics of the oil market, and prices fell sharply, followed by modest production drops. This time, it is the price change itself that is doing to the work. The sharp shock to government budgets in producing countries is concentrating minds.
The oil market is not the only one where price changes can matter more than price levels. In equities, for example, actual prices have almost no economic effect, since the amounts that listed companies raise by selling new shares account for a tiny portion of capital investment. However, changes, especially fast and furious ones, are reasonably good indicators of investors’ mood swings.
Like oil producers desperate to keep pumping, central bankers, lenders and politicians do not necessary like to hear what the markets are saying. When politics are especially uncertain, as they are now in so many countries, leaders are particularly likely to try to whistle over the noise. The sharp share price falls in the last few weeks suggest the financial system could be working up to a great big yell.