I cannot help but be amused by articles, like one published today in Oilpro discussing OPEC’s dilemma, or comments by the likes of Ed Morse of Citibank, where price forecasts are presented with supporting “logic”. The fundamental problem with most, maybe all, forecasts of actual numbers is that this is an impossible challenge. You may appropriately ask “Why is that the case?” I shall explain.
First I will set the stage. Most analysts and forecasters feel the need to chose a scholarly-sounding basis for their pricing mechanism, and then proceed with their logic. For example, cost of production, however vague and undefined, is a popular choice, since it can be seen as economically sound. Once that starting point is chosen, it is rather straightforward to calculate a number to be used as the expected price. Everyone feels comfortable if the resulting number matches their wishes. But does anyone ever ask “How does that loosely-defined cost number get translated to the seller’s invoice?” The question just hangs. There is no mechanism. The basis is flawed. This same flaw applies to most chosen pricing bases.
What then is the real pricing mechanism? I submit that it is simply the action of the most desperate seller in a competitive world where every barrel of available productive capacity cannot be utilized. Some quantity of oil must be left un-produced in a supply system where it is physically impossible to set, beforehand, a production capacity that will exactly match demand at a future date.
How is the decision made a to who leaves their production capacity idle? In the “You Cut” scenario preferred by all the world, with the finger usually pointed at Saudi Arabia, the Saudis concede defeat and withdraw production wishes. But they are not always so accommodating. What happens then? I submit the following description as my answer.
At the interface where two competing suppliers meet where the customer will choose which supply to purchase, a bidding war arises. Remember, only one supplier will be successful while one supplier will shut in his production. The buyer will take the lowest priced offering. Which supplier will go the lowest? That answer will depend upon a number of factors including overdue notices, pre-set targets, personal performance objectives, job security, the boss’s instructions, etc. The price may be different at noon versus 3 PM. But at some point one supplier will be willing to take a number lower than the other supplier will tolerate. I think that this number is impossible to predict, but it will be well known once the transaction occurs.
The previous description describes a transaction of real oil. The same mechanism applies to the transactions between desperate futures traders, who most often set the actual price of oil. The reasoning is the same. The most desperate participant will cave in. The main difference between the real oil and the futures activity is that for real oil it is much more likely for desperation to occur from the selling side because there is always sufficient availability, except for rare timing circumstances. In the case of futures trading, the pressure to BUY a contract for close-out can be as great as that for a SELL, so futures desperation trades can easily be in either direction. The desperation of the buying side is the reason that we see many upward spikes in the price.
The super-urgent nature of these desperation decisions reveal the impossibility of knowing, beforehand, what the “cave-in” point is. Thus, what we call “free market pricing” is not an orderly process, but a series of desperation choices. The ultimate result is what I have accepted as oil pricing in today’s world – “random pricing on an instantaneous basis”. Price averages, over time, are more influenced by reality and feedback, and are therefore more rational and predictable.