Reckoning Oil’s Worth: The OPEC, Brent Index and How We Calculate Global Oil Prices

The price of oil, controlled by a select few, can exacerbate the shortcomings of a slowing global economy.

 

On 9 December, the organization of petroleum exporting countries (OPEC)[1] and Russia—collectively known as OPEC Plus—collectively agreed to cut global oil production levels by 5,00,000 barrels a day, causing the Brent index, on which the price of crude oil is pegged, to increase by 1.6%. 

In 2014, crude oil sold at $100 per barrel before falling to $30 per barrel in 2016—coinciding with a boom in shale production in the United States (US). In 2018, the price per barrel crossed $85. A decision to further cut oil production could see oil prices skyrocket. Sanctions imposed by the US on Iran and Venezuela, both of whom are major oil producers, has also driven up the price of crude oil. At present, oil trades on the Brent index at around $63 a barrel. Saudi Arabia’s state-run oil company, Saudi Aramco, is also looking to sell 1.5% of its stock in an upcoming initial public offering, but a steady supply of oil from the OPEC’s de facto leader is uncertain: an attack by Houthi rebels in September wiped out 58% of its production capacity. The International Energy Agency, a non-governmental organisation that looks towards ensuring affordable global oil prices, has cautioned against a potential oil glut, and has previously asked the OPEC to “make the right decision” regarding oil supply, in light of a fragile global economy. 

However, supply is but one factor that influences oil prices. Indices such as the Brent, which decide the rate at which oil barrels are traded, are largely influenced by the trading of virtual oil, known as paper barrels. This reading list looks at the role the OPEC plays in influencing oil prices, and how oil is traded on the market floor.       

1) OPEC’s Influence on Oil Prices

Bhamy V Shenoy writes that given the ever-changing geopolitical scenarios, it is almost impossible to forecast crude oil prices. Shenoy argues that global oil prices are firmly controlled by the OPEC countries, who produce oil according to a predefined quota—in 2014, Saudi Arabia decided to increase production as per its allotted market share, which resulted in oil prices falling from $90 per barrel to less than $30 in 2016. 

OPEC and non-OPEC members have been successful in enforcing quotas during this time. In February 2018, compliance by OPEC members was 147% while for non-OPEC members, it was 86% (IEA 2018). As a result of such high compliance, excess stocks built during the period of supplies exceeding demand have started to come down. As of mid-April 2018, oil stocks in the developed countries were just 43 million barrels above the five-year average level (Zhdannikov 2018). This indicates a reasonable balance between world oil supply and demand … Another important factor that is considered to have an influence on oil prices is the surplus or spare oil production capacity mostly with OPEC. Oil pundits explain the reason for crude oil price increase during 2003–08 by pointing at the spare capacity of OPEC, which was less than 1 to 2.0 million bbl/day (USEIA 2018b). When we look at the OPEC surplus during 2014–16, it was less than 2 million bbl/day. Still, oil prices were low. 

Shenoy further argues that it is the oil futures market that primarily influences price fluctuations, as it predicts whether or not the OPEC countries will change their production quotas. 

One of the purposes of the futures market is to “discover” prices for the commodity …  the oil futures market has not been good at such price discovery. On the other hand, though experts differ, there is a compelling argument to show that the futures market has increased price volatility. This has resulted in the futures market acting like huge gambling casinos generating billions of earnings for its owners and dealers. The gambling that is taking place may be a zero-sum game for those who play there. However, their gambling has unnecessarily resulted in greater uncertainty and sometimes even higher crude oil prices than warranted by supply/demand fundamentals.

2) Calculating the Brent Index

In May 2013, Shell, Statoil and British Petroleum, among other oil companies, were accused of conspiring to “intentionally manipulate” the Brent crude oil index and the Brent futures market. Akshay Mathur writes that an assessment of pricing practices, commissioned by the Group of 20, reveals that the methodology used by indices such as the Brent is at best, opaque. 

There are indications that their assessments could be subjective and that their methodology may be open to manipulation by the users of their system. In their lawsuit, NYMEX traders claimed that the price reporting agencies will not take action against the oil companies since they are their largest users, and thus a crucial source of revenue …  Even a 1% manipulation of the Brent price could cost India $480 million or Rs 3,000 crore annually based on purchases in the physical markets alone. 

Mathur also argues that even if some amount of wrongdoing exists, the global benchmarking process is highly complicated and incredibly difficult to understand, let alone penalise. Benchmark methodology is not based on demand and supply, but rather uses information sourced from oil producers, companies and traders.

The physical market—where the actual exchange of crude oil takes place—is itself quite opaque and has been so since the early 20th century when the “Seven Sisters” (the seven big oil companies) dominated the oil market. As the joint report of the energy amd regulatory groups explains, there is no obligation for the participants to report the transactions to the price reporting agencies like Platts and Argus, since the process is voluntary and unregulated. Even if they do, it is within a short 30-minute window and they can choose the volume and type of transactions to report. The agencies then analyse this based on the type of crude oil, location, volume, weighted averages, etc, to determine the pricing benchmark or the spot price. If the data is not representative, the agencies use their judgment.

3) Deciding on the Actual Market Price

Kaushik Ranjan Bandyopadhyay writes that OPEC's decisions on how much oil to produce is not based on global demand, as some international agencies believe, where an equilibrium price for oil exists and where attempts are made to achieve it, but rather on the grouping’s own personal interests. 

It appears rather unusual to expect that the members of OPEC would consistently fully comply with the demand from the importers and pump in more crude oil rather than allowing such price-spirals to stay on for some more time and enjoy the rent by postponing its plan of output expansion. Furthermore, although Saudi Arabia, the dominant OPEC producer spearheading OPEC’s spare production capacity, had been playing the balancing role of swing producer especially in situation of crisis in the past and has agreed to produce more even now, it may not be rational to expect that it will continue to play that role in the future and compromise on its revenue gains just to counter such relentless spikes for the greater cause of stability in world crude oil prices. 

Bandyopadhyay further contends that oil prices are largely decided by the futures market, where very little physical oil is sold and paper barrels are traded instead. The OPEC’s ability to control the price of oil does not depend on how much oil is produced, but rather on its ability to control the complex futures market, which includes players like floor traders, fund managers, and other speculators.

OPEC’s ability to influence oil prices through output adjustment now is clearly contingent upon their ability to influence the expectation of the participants in the futures market. In order to execute that successfully, OPEC needs to consider a wide range of factors. These include, among others: the level of stocks or inventories of crude oil that the refiners are holding; size of the speculative positions of the traders in the futures market; traders bearish and bullish sentiments; and flow of hedge funds in and out of the market.

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