The futures market has to be highly regulated.
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In the past, OPEC's production decisions have often failed to influence prices. Many have opined that OPEC's policies were aimed at price manipulation. My belief is that OPEC's decisions have had more to do with keeping production at levels where supply matched demand to protect against price declines through over-supply.
This time is different.
OPEC has a hard job - on the one hand, cutting production too deep will lead to price increases which will ultimately cause demand destruction. On the other hand, not cutting production allows prices to fall to levels which will cause under-investment and major price escalation and demand destruction in the future.
The president of OPEC has already indicated that cuts will be deep; deeper than the market expects. The aim is to remove supply to an extent that will surprise the market. Why then inform markets of a surprise ahead of the intent? I believe the intent is to gain an insight into market expectations; and then cut marginally ahead of those expectations! Or else, it is to prepare the market so the impact of the shock is spread over a week instead of a day.
My view is that OPEC will have learned from the last downturn when it failed to cut production and the result was oil priced cheaper than mineral water. This time OPEC will cut deep. It will force a sharp draw down of inventory. OPEC will not supply cheap oil to build and maintain inventory levels; instead production cuts will force a sharp draw down of inventory. Once inventory is down, prices will rise and at that stage enhancing production to allow inventory to return to normal levels will make sense.
In the immediate term, energy prices may decline as inventories are drawn down and non OPEC oil is used in an attempt to break OPEC. Short term, it is likely that oil prices will escalate once more. Oil trading needs strong regulatory over-sight, otherwise price levels will rise on rampant speculation once again; this can derail prospects for recovery from amongst the longest recessions in US history - it could be the straw which breaks the camel's back.
To price oil, there is demand which comes from users, and supply which comes from producers; there need be nothing more. Demand is created by users with a desire together with the willingness and ability to pay. Similarly, supply is created by producers willing and able to deliver at a price. A supplier will never increase supply if the price for that unit of supply falls below the cost of production of that additional unit; to do so would be an economically irrational decision. The equilibrium price is what the user is willing to and able pay the producer for that last additional unit of production; it is the point where marginal revenue equals marginal cost; this is where the price of oil must be and it is my belief that a reasonable estimate of the marginal cost of production is $60.
Oil needs to be priced rationally; in my view a price substantially below $60 means the needs of future generations will not be met. A price substantially above $60 is damaging to the present generation.
Why then are bubbles created? When oil prices were at $147, I wondered how speculation could occur without an inventory build by hoarders; everything produced was getting consumed at the price without an inventory build, so speculation seemed unlikely.
Here is how I think it works. This bubble was created because the relationship between users and producers became obscured. In the very short term, because demand destruction takes time, a user's "willingness & ability" to pay can exceed the producer's marginal cost of production. This spread between user willingness and ability to pay and the marginal cost of production creates an arbitrage opportunity. It is fairly easy to exploit the arbitrage opportunity through the futures market in a manner which allows today's production to continue at capacity with no inventory build up. The only problem is that real users end up paying tomorrow's potential prices today.
As long as demand continues to grow as expected by financial investors, everyone is happy. But once prices go above that user "willingness & ability" to pay, future demand falls as demand destruction occurs. The last financial investor owning the futures instrument holds "the can" as the cookie crumbles. And prices rapidly fall back towards marginal cost of production; then prices fall below the marginal cost of production as losses are limited by the can holder. Then the producer response occurs and we have come a full circle. All this occurs because the user and producer relationship has been obscured by intermediaries and arbitrageurs.
The futures market has an incredibly important role to play. It allows better pricing and provides producers and users information which will permit both better planning. However, when the market is distorted by a chain of financial investors with no underlying demand for the physical commodity, things start to go wrong. In truth, the futures market should reduce volatility; in fact, since it has obscured the relationship between users and producers, it has enhanced volatility and economic risks. This market should not be abandoned, but I believe it requires strict regulatory over-sight; it should be a market operational only for parties with real demand for the physical commodity.
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http://seekingalpha.com/article/1095...cut-production