OPEC needs to make fundamental changes to the way in which oil is sold if it wants to limit volatility and keep prices in a specified band. Despite its longer-term role as a price-fixing cartel, OPEC acts in the short term as a price taker, selling its oil at formula prices established by the market. As a result, crude supply and prices are determined independently of each other and the market lacks an essential safety valve through which supply could potentially adjust to changes in demand, making oil prices more volatile than they might otherwise be.
If OPEC really wants to control oil prices, it needs to restructure the crude oil market around the marginal source of supply - the Middle East Gulf - which could play a pivotal role. However, the restrictive terms under which oil is sold by the biggest Gulf producers have created a marketing system that is not only unresponsive to prices but also inhibits effective arbitrage. The use of formula pricing, destination restrictions and constraints on third-party trading have stifled the growth of a representative spot crude market in the Gulf, prolonging imbalances between East and West which have added to market volatility.
Direct spot sales at the point of production by major Gulf producers would have a number of advantages for the market. First, it would help to create a more representative price marker that could be used in term contract sales of Middle East Gulf crudes. Secondly, it would improve arbitrage between East and West by providing a universal fob marker price for all crudes irrespective of destination. Thirdly, it would bring Middle East Gulf producers into direct contact with the market, negotiating prices directly with buyers at the point of production instead of letting the market determine them via a formula after cargoes have been lifted.
It would also provide a much more effective method of controlling oil prices than the one proposed by OPEC. Instead of waiting for oil prices to move outside a pre-determined band, by which time the market has already acquired a momentum that can be difficult to halt, Gulf producers could set a price at which they are willing to sell (or buy) additional spot volumes. Like a central bank setting the interest rate, this would create a forward market around the preferred oil price that could be used by both buyers and sellers of Middle East Gulf oil.
Creating a truly representative market for Middle East crudes requires a radical shift in the attitudes of Gulf producers who have remained resolutely opposed to spot and futures trading. However, it is difficult to see how OPEC can achieve its objective of limiting oil prices to a less volatile band unless marginal supply does become more responsive to prices - and the right market structure is created to ensure that the right oil gets to the right place at the right time.