A New Era for Oil Markets

Economies and markets periodically experience “sea changes” or disruptions. These inevitably shift how market participants relate to each other, transform the fortunes of many and alter fundamental relationships. Models and behavioral characteristics that accurately described relationships in the past no longer apply. The financial obligations assumed under the original system now lead to bankruptcy. Oil is undergoing such a conversion today.

There are historical precedents for such restructurings. Oil markets experienced this after the 1973 Arab Embargo, in which several countries assumed control of multinational oil company assets. At that time, the advantages of integration became a burden. The companies that recognized this first — Exxon Mobil, for one — survived, while those like BP, which did not, shrank.

Japan experienced a sea change of similar magnitude after the 1985 Plaza Accord, in which it was agreed to depreciate the dollar against the yen. The country suddenly had become rich. Ultimately, though, the depreciation of the dollar versus the yen contributed to a 20-year stagnation of the Japanese economy.

The current sea change for oil began when energy firms discovered that hedging could bring financial disaster, money was not free, banks preferred not to lend for commodities or energy and governments were willing to release strategic crude oil stocks to moderate price increases. Those developments have changed all the rules along with the customary standards regarding adequate stock levels.

Altered Reactions

In the past, disruptions or threats of disruptions would prompt companies to increase their crude oil purchases or cut back on third-party sales, which incentivized panic buying. Prices rose sharply. Many who follow oil might have expected similar responses to the latest escalation in Middle East tension and the risk of a larger conflict. They have been disappointed so far because crude oil buyers are being patient — with oil prices largely unmoved by the recent Iran/Israel missile-rattling.

Four significant events explain the industry’s seemingly blasé attitude toward market disruptions: the 2022 release of strategic stocks, tighter regulation of commodity financing by central banks, interest rate increases and the failure of hedging evidenced by the losses incurred during the 2022 European energy price crisis.

Strategic Reserves

When strategic petroleum reserves were released in 2022 after Russia invaded Ukraine, it fundamentally altered the profit opportunities available to the oil industry. Previously, strategic oil stock releases were a hypothetical concept for oil market participants. Then, in 2022, the International Energy Agency (IEA), led by the US, pushed more than 200 million barrels into the global market over 12 months.

These sales slowed and then reversed the war-related crude price rise. The releases also moderated the recessionary impact of the oil shock that economists had predicted, and the governments of consuming countries learned an important lesson.

The availability of large reserves (over 1.2 billion bbl according to the IEA) and the newly demonstrated willingness to release them should discourage traders and refiners from rushing to the market and bidding up prices in a crisis. Strategic reserves, once a theoretical tool, are now a disincentive for those tempted to buy oil based on expectations of large price increases.

New Regulations

Another disincentive for commercial oil buyers to add to stocks is the new regulations that threaten to raise the cost of holding inventories financed through banks.

International financial institutions began a wide-ranging review of bank regulations following the 2007-08 fiscal crisis. The analysis was led by the Basel Committee on Banking Supervision (BCBS), a group of banking supervisory authorities established by leading central banks in 1974. After the 2007-08 meltdown, BCBS issued a series of regulations known as Basel I, Basel II and Basel III that set standards for bank capital adequacy, stress testing and liquidity requirements.

The Basel III regulations became effective in January 2023. These and the other Basel rules must be implemented and enforced by the US Federal Reserve and other leading central banks. These regulations are now being applied, although the proposed standards have received substantial pushback from the largest financial institutions and banks in the United States and Europe.

Under Basel III banks making riskier loans must hold more capital than those with conservative portfolios. Tighter liquidity requirements also force banks to hold higher-quality liquid assets to cover short-term obligations. These rules could prompt banks to favor short-term lending over the longer-term lending that might be needed for acquiring opportunistic inventories. The impact of Basel III may already be appearing in oil markets.

Interest Rates

Higher interest rates also seem to be forcing a market change. Low interest rates prevailed from 2010-22 until a surge in inflation ended them. The high interest rates since have boosted the cost of holding oil inventories. Combined with tighter bank regulations, this discourages firms from buying oil.

This also reduces the likelihood of firms, with the possible exception of large state-owned companies, being able to rush into the market to buy oil when future supplies appear threatened. Even well-capitalized firms such as Exxon or Shell are unlikely to boost precautionary stocks at times of possible disruptions.

Market Changes

Commodity market instruments such as futures and options, introduced 40 years ago, also now fail to offer the protection they once provided to those in the physical industry, with the benefits of hedging having vanished of late. Indeed, using futures dragged numerous firms into financial collapse during the 2022 European energy crisis. More recently, futures have become “lottery tickets” for speculators looking to profit from a market disruption. For commercial firms, however, they now pose a great financial risk.

This risk was highlighted emphatically in September 2022 when Russia invaded Ukraine, natural gas prices in Europe rose to record levels and Europe’s power producers faced a potential €1 trillion of margin calls. As prices rose, traders and energy companies called for government intervention. Their pleas were rebuffed. Six months later, the Financial Stability Board reviewed the events associated with the 2022 liquidity crisis, noting a decline in hedging activity.

The Bottom Line

Recent events suggest that physical petroleum market participants have adjusted their behavior to compensate for the impact of governments releasing strategic stocks at times of crisis, recent developments in monetary policy, changes in financial regulation and the money managers’ speculative dominance of futures markets. Their response includes reducing inventories and accepting greater crude oil price volatility, which seems an optimal strategic decision for traders and refiners.

This strategy has three possible consequences: First, the decision to operate with lower stocks transfers the responsibility for stabilizing prices to consuming governments, which, in theory, can do so by intervening with strategic stock releases. Alternatively, the responsibility to stabilize prices is remanded to the Opec or Opec-plus producers. Second, greater price volatility will cut into petroleum’s long-term prospects. Increased price volatility for gasoline, diesel and jet fuel will make alternatives with lower volatility more attractive. Electric vehicle sales could see the largest impact. Third, crude oil and petroleum product prices will increasingly be governed by the comings and goings of speculators as refiners and traders operate on a just-in-time basis.

Policymakers in oil-exporting and oil-consuming countries can moderate these impacts. Oil exporters could be more proactive in production or sales decisions. Consuming nations could act to tame speculative commodity markets as they did during the 2022 European energy crisis. These steps could restore order to the market. Absent them, expect an increasingly volatile market.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is the editorial director of PKVerleger LLC. The views expressed in this article are those of the author.