Why the OPEC Put Matters

As of the time of writing, current month Brent is trading at about $47.70. This is a 60% fall on the year. Prices this low have not been observed since 2005, and back then prices were on the rise. What gives?

Demand side factors are certainly playing a role. James Hamilton from Econbrowser estimates that dollar strength, global macro weakness as proxied for by copper prices, and the decline in 10 year rates explains around 44% of the fall in crude prices since July.

That leaves around half of the decline unexplained. By definition, if it’s not coming from the demand side it must be from demand. Many analysts have talked about fracking and the growth in tight oil in the United States as a major factor. But there’s two reasons to be skeptical.

First, increasing tight oil production has been a long time coming. That should have easily been priced in.

Second, more sober analyses of the expansion in US oil production that suggest that much of the hype surrounding US oil production substantially changing global prices is overrated. There’s just not enough oil of the right blends to be making such a huge impact on global markets.

In my view, any plausible story for the recent decline in oil prices has to explain why recent small shocks about the future state of the world can translate into such dramatic price moves today.

One possibility comes from a story about the OPEC put. OPEC’s announcement in November wasn’t just about not cutting production, but rather it represented a regime change about how OPEC would respond to lower prices. One way to think about it is that OPEC’s previous policy of cutting production at low prices functioned as a put option on oil. No matter what, there would be a price floor.

But now that put option is out of the window. Without it, the left tail in oil prices exerts an effect on the current price. This can happen in at least two ways. As a first order effect, people with oil stocks sell at expected value, and when the low price events become possibilities, you sell at a lower price. But there’s also a risk premium effect as well. Now that the oil price is allowed to vary over a greater range, this increases its comovements with negative economic conditions. Since the price of risk is very expensive in these bad states of the world, these scenarios get overweighted and exert outsize effects on the current market price. This pushes the price of oil down even further in order to generate a higher return going forward.

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