Fluctuations in oil prices have caused oil-producing countries to design policies to control the global oil production and increase oil prices. The Organization of the Petroleum Exporting Countries (OPEC) regularly takes actions to coordinate its members’ oil production decisions and influence oil prices. The impact of OPEC decisions about the production level (increase, cut or maintain) on oil prices is a controversial issue among policymakers, regulators, and academics in particular (Loutia et al. 2016). To be able to affect oil prices, the OPEC and non-OPEC should have high levels of oil production coordination.
Specifically, the impact of changes in oil-production of all OPEC members on global oil production declines, whereas the impact of non-OPEC on global oil production increases. Changes in OPEC oil production have significant effects on non-OPEC oil production. Influence of Russian and US oil production on both OPEC and non-OPEC increases over time and dramatic increases in US shale oil and Russian oil productions have significantly affected the strength of Saudi Arabia in the oil production network.
Cut decisions do not have any effect on OPEC and non-OPEC coordination. Therefore, oil-producing countries do not act in line with the cut decisions. Increase decisions have a significant and positive impact on OPEC and non-OPEC coordination. OPEC and non-OPEC countries increase their oil production coordination level and act in line with increase decisions (Al Rousan et al. 2018).
Determinants of Oil Market Connectedness
- Non-OPEC producers are price-takers who respond to market conditions and thus produce at full capacity. On the other hand, OPEC has a market balancing role. The “call on OPEC” reflects the amount of production needed from OPEC to balance global demand and supply of crude oil. The lower the non-OPEC production and the greater the demand on OPEC, the higher the likelihood that OPEC influences prices (McKinsey Energy Insights 2018). Accordingly, non-OPEC production is ordered before OPEC production.
It can take less than a year to ramp up production on U.S. shale oil projects, unlike conventional and other unconventional development projects (e.g., the Canadian oil sands) where 3–10 years typically elapse between the final investment decision and actual production. Although shale oil projects move to production faster than conventional production projects, the volume is insufficient to balance the market, whereas the volume of the rest of non-OPEC production is large but has a slower response time (Buyukşahin et al. 2016a; Webster 2016). Hence, the U.S. and the rest of non-OPEC production are often modelled separately.
- Oil producers like Saudi Arabia do not react within a month to changes in oil prices by changing production levels (Kilian 2009). Hence, OPEC production is ordered such that it is affected by changes in prices and consumption with a lag.
- Precautionary demand for oil and uncertainty about future oil supply and market conditions have immediate impacts on oil prices before oil production actually changes. Hence, consumption is modelled such that it affects oil prices within a month.
Increase in total global petroleum consumption is driven by non-OECD (Organisation for Economic Co-operation and Development) demand. The non-OECD demand is driven not only by China, but also by other Asian and non-OECD countries (i.e., India, Pakistan, Saudi Arabia, Iraq, Russia, and Brazil). The International Energy Agency (IEA) has noted that the main risk to its oil demand forecast is the retaliation risk associated with ongoing international trade tensions. The IEA stated that a slowdown in G7 trade would negatively affect demand for bunker fuel, for example. It would also negatively affect trade for petrochemical products and feedstock. Consequently, global economic growth and oil demand would be adversely affected. Hence, aggregate global petroleum demand must be accounted to capture the impact of global demand for crude oil on oil prices.
The increase in China’s oil imports is also due to the increase in oil and liquid fuel consumption coupled with a decrease in domestic production, (although the growth in demand is relatively slow, it outpaces production) the accumulation of strategic reserves, reforms in the refinery sector, and the expansion of refinery utilization and capacity. China’s refined product exports have been rising; arguably, China is becoming an exporter of refined petroleum, which could explain the rise in China’s crude petroleum imports and its likely impact on the rest of the world’s demand. Also, some have argued that China has decreased its dependence on OPEC and increased its imports from Russia, Brazil, and the United States (Fickling 2018; Paraskova 2018).
- Oil prices respond within a month to changes in demand, production and the financial market.
Changes in global demand and events in the financial markets are consistent with the conclusion that OPEC matters, and so do the U.S. and other non-OPEC producers, global demand, China’s demand, and the role of oil as an asset. It is in the best interests of all stakeholders to cooperate to achieve a stable, balanced oil market that provides oil at a reasonable price worldwide (Razek and Michieka 2019).
Although the total connectedness measure of all countries does not change significantly over time, the effect of OPEC and non-OPEC countries on all countries often shows significant time variation. The influence of OPEC measured as the total connectedness of OPEC on OPEC changes significantly over time.
The effect of Russian oil production on especially non-OPEC has increased substantially over time. The significant increase in the influence of Russian oil production is related to the average daily production of Russia. Ansari (2017) theoretically justifies the dramatic change in the impact of Russia. It was found that Russian oil production is above the equilibrium level and “Russia is voluntarily incurring losses for some of their sales”.
The rise in US shale production and exports may explain the recent rise in the country’s network strength. The surge in US shale production has become one of the major price determinants of oil prices. Some empirical findings indicate that the US has taken “the traditional role of Saudi Arabia as the swing producer in global oil markets” (Baumeister and Kilian 2016). Accordingly, the efficiency and production increases in shale oil weakened OPEC’s influence and OPEC members accepted the new oil market conditions.
Consequently, oil-producing countries do not act in line with the cut decisions. Increase decisions have a significant and positive impact on OPEC and non-OPEC coordination. OPEC and non-OPEC countries increase their oil production coordination level and act in line with increase decisions. Pierru et al. (2018) argued that spare production capacity holds a key role in determining oil prices. With valuable spare capacity, OPEC members seem to have the ability to mitigate the volatility of oil price.
The level of connectedness among OPEC members is significantly higher compared to non-OPEC oil-producing countries. This result extends the findings of Smith (2005) which states that a “core” group of producers including Kuwait, Saudi Arabia, and UAE have acted collectively and thus coordinate to mitigate production fluctuation arising from other OPEC members as well as non-OPEC members. Therefore, it can be concluded that countries with higher levels of production are able to affect the production of other countries. The network structure changes significantly over time. Specifically, the impact of OPEC on all oil-producing countries declines whereas that of non-OPEC on all countries increases.
Moreover, the fear of connectedness and the risk transfer between crude oil and selected currency pairs can show that the future market uncertainty captured by implied volatility acts as a proxy for the market risk of a security. The value of implied volatility drives the supply and demand of the underlying security, thus impacting its current price. Hence, exploring the relationship between future market uncertainties captured by implied volatility will help to establish a relationship between the crude and Forex market on a pairwise and systemwide basis. To determine the network connectedness, it would be better to identify and assess the direction of shocks at some specific events which can establish a bi-directional causality between crude oil and currencies. Such a directional relationship will determine whether crude affects Forex more or vice versa.
Forex market uncertainty translates into shocks to crude. However, during times of distress such as the oil crises of 2008–09 and 2014–16, the volatility spill over is from crude to currency pairs. Historically, crude has been blamed for bringing huge fluctuations to the forex market. However, for the full sample, the outcome is surprising where crude suffers more due to uncertainty prevailing in the Forex market. Thus, in the long run, volatility in the currency has more to do with macroeconomic parameters apart from crude. Therefore, it transfers the risk spill over to other currency pairs, though no uniformity has been found in which currency pairs are more vulnerable to shocks (Singh et al. 2018).
In global trade finance, the crude-currency dynamics is critical to a certain threshold. That is, whenever crude oil or dollar prices surpass a certain threshold, upper or lower, it buffers the co-movement of major currency pairs used heavily in world trade finance by oil-importing and -exporting nations for the balance of payment settlements. The cascading effect of the same can encourage central banks to take precautionary measures to align the prices of the dollar with the economic health of oil-importing and -exporting nations.