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Dealing with Price Volatility in Oil Markets: Considerations for Governmental Energy Policy

Dealing with price volatility for commodities of all types has been an occupational hazard of producers and consumers of commodities since the world began. For a nation which depends heavily on a single commodity or a few commodities for the economic well-being of its people, this fact of life can be particularly worrisome. When the commodity happens to be oil or natural gas, the issue becomes an even greater issue than with most other commodities because of the massive global side effects which volatilities in oil & gas prices create. These volatilities can be caused by either an excess of supply over demand or a scarcity of demand for available oil & gas supplies. In some cases, the problem is compounded when demand decreases dramatically over a short period of time and supplies increase dramatically over the same period. This appears to be the situation the world faces today.

In an ideal economic world, such a disequilibrium would be corrected by buyers increasing demand, producers reducing supply or a combination of the two.

Depending on circumstances, such a logical reaction by the players might not be a simple matter. Buyers might not have the financial or physical capacity to take more volumes. Low prices might always sound good to buyers but they might not be able to act on them if they have no need for the commodity or cannot afford or deal with adequate volumes to make a difference, regardless of unit price.

On the other side of the equation, decreasing supply may not be as easy a solution to achieve as theoretical economic models might presage. A producer might be concerned about losing market share; it may need the revenue or it may be contractually obligated to drill more wells in order to avoid losing its rights in the oil field. In such cases, the producer may continue to produce even at a loss. Well financed producers may be able to afford to take per unit losses for a period of time. Saudi Arabia is, of course, a classic example of producer who can afford to weather the storm – up to a point. Poorer producers will by floundering at an earlier point.

Under such circumstances, what is a buyer to do? What is a producer to do? In dire situations, the world's economy or a particular nation's economy cannot just wait it out until an equilibrium at acceptable levels is found once again. The social and economic costs of such a wait might be just too great. So, governments and multilateral organizations may need to step in with policies designed to return the situation to equilibrium at a level that both producers and buyers find acceptable as quickly as possible. Unfortunately, history resounds with examples of misplaced governmental efforts designed to fix the problem. Currently, conventional wisdom would indicate that $65 a barrel is a price for crude that will allow oil companies to operate efficiently and make a reasonable profit without breaking the backs of consumers.

In the long term, governmental tampering with markets is doomed to failure because negative side-effects are created which produce undesirable consequences. For example, government policies, such as oil taxes, import duties or import restrictions, designed to prop up domestic oil prices may accomplish the purpose in the short term but will increase the cost of manufactured goods that rely on oil as an energy source or as a raw material thereby raising prices for the end product. Thus, a nation's export markets for the end product could be adversely impacted.

Government regulated market stabilization policies such as production allocations implemented by the Texas Railroad Commission or OPEC can work, but only if the controls are mandatory and enforced over a large enough portion of the market place to allow a material segment of the market to be affected, so that the price of oil is stabilized. This succeeded fairly well in the United States domestic market in earlier periods of price instability - after the federal government and the oil producing states, working together over a period of time, developed a fair method for formulating, implementing and enforcing the program. The concept has worked less efficiently in the case of OPEC since there is no effective international means to enforce production quotas.

One possible solution to OPEC's inability to enforce production quotas might be for OPEC to join with oil consuming states to allocate acceptable production levels for each producing state. Then, if such allocations are exceeded, the oil consuming states would restrict the import of oil from the nation that is in violation of its production quotas. The consuming states would, in effect, become the enforcers. This might not be a very appealing position for a consuming nation to be in since it would prefer to buy oil at a discounted price available from the perpetrator. However, if the temporary imposition of such sanctions would bring about price stability, the consuming nation might see it as in its best interest to forego the temporary advantage of buying oil at a discounted price in favor of long-term price stability.

Of course, the first challenge will be for the producing states to reach agreement on production quotas, a challenge which may be impossible to achieve at the present time. Iran, which due to sanctions has been closed out of international oil markets until recently, wants to return to pre-sanction production levels and is not likely to agree to quotas at least until those levels are reached; other countries have no desire to reduce their own production if they feel another country will simply step in to fill the gap.

Unfortunately, finding the ideal policies and reaching fair agreements for their implementation are difficult processes. But policy makers should not despair or give up. To avoid the risks which could come about as a result of prolonged depressed oil prices, policy makers must find a solution, even if not perfect. This effort will require a bipartisan approach in the finest sense. In the United States this will require both major parties in Congress, the Executive Branch, the states, energy industry participants and consumers to respect each other's views and to be willing to compromise. All constituencies must be willing to share some of the pain in bringing oil markets to a new equilibrium but, if the dialogue is transparent and sincere, the goal should be attainable.

The goal must be to find policies that serve the purpose but do not simply redistribute the pain of the current situation or introduce new inefficiencies which might serve to exacerbate the problem in the next economic cycle. Such policies should also be structured so that they do not outlive their usefulness.