A Strategy for Stabilizing Oil Prices: Look to the futures markets.

• Author: Verleger, Philip K., Jr.

Crude oil prices declined 40 percent between the beginning of October and Christmas Day in 2018. The decrease, from $86 to $50 per barrel, has been variously attributed to the United States' failure to follow through on its tough sanctions on Iran, unexpected increases in U.S. oil production, oil-exporting countries not cutting production sufficiently, and/or realizations that global economic growth was slowing.

These explanations are all relevant. However, none can explain a decline that matches in magnitude the decrease that occurred after OPEC's November 2014 meeting. At that time, the organization surprised the world by ending the self-imposed limits on its crude oil output. Nothing like that happened in the fourth quarter of 2018.

The analysis of petroleum markets has changed little since 1950. For almost three-quarters of a century, those seeking to understand and predict movements of prices have focused on "supply/demand balances." The balances comprise estimates of how much oil the forecaster believes will be consumed and produced and the difference, which represents the inventory increase or decrease.

To be blunt, the supply/demand balance approach to assessing oil markets--and many other physical commodities--is irrelevant today.

The reality is that the market has been transformed over the past three decades. Market analysts must seek new methods to explain and project oil market behavior. And oil producers must alter their approach to managing the market and stabilizing prices. Press conferences that produce bold pronouncements or complaints regarding price volatility will not be effective. Markets have changed.

For better or worse, prices going forward will be driven by the hedging process whenever West Texas Intermediate dips below $60 per barrel or Brent falls below $70. In this unstable price range, it is the computers--not oil ministers, pundits, or politicians--that determine day-to-day price movements.

Thirty-one years ago, on Black Monday--October 19, 1987--equity markets experienced a one-day decline in share prices of 22 percent. The falloff was later blamed on portfolio insurance, specifically the sales of stock futures to hedge contractual agreements written to protect portfolio values from share-price declines.

History may not always repeat itself, but sometimes it rhymes. In the oil market at the end of 2018, firms and agents had written insurance policies to oil producers, primarily U.S. independent firms, guaranteeing prices around $50 per barrel. As crude prices fell, the writers of the insurance policies had to sell additional futures contracts, creating a cascade effect.

Thus hedging, which was undertaken to help stabilize the prices producers receive, instead caused prices to fluctuate wildly.

These types of price decreases will occur again unless a new approach to market management is adopted. Furthermore, the declines will become more exaggerated if U.S. output keeps expanding, because more oil will be hedged. These widening swings will threaten the economic viability of financial firms and the economic health of many oil companies and key oil-exporting countries. Indeed, global economic and political stability may be at stake, particularly given the situation in some Middle Eastern nations.

The price stabilization problem can be addressed by changing how oil markets are managed. Today, OPEC members, Russia, and other countries meet and agree on production levels with a view toward balancing global supply with global demand and stabilizing prices. Almost...