OPEC’s Economics Lesson

Last week OPEC members divided on whether to increase oil production, with the Saudis wanting to produce more and the Venezuelans wanting to limit supplies. Upon news of the stalemate, oil jumped to about $100 per barrel, but very soon the Saudis hinted they would not abide by OPEC’s guidance and oil fell to close to $98. Why a $2 swing in oil prices over mere words? The recent oil news confirms two essential truths: cartels like OPEC are powerless against the marketplace, and signals regarding future production affect today’s oil prices.

Since the 1970’s, pundits have vilified OPEC as causing high oil prices, but the OPEC embargo of 1973 only lasted five months. In the case of each oil crisis, the real culprit has been government interference in the market. In the late 1970’s, long after the OPEC embargo fell apart, Pres. Carter sought to ration gas and centrally direct its distribution. The result was price explosions, outages, and an economic disaster. As soon as this central planning regime ended, gas prices plummeted and supplies normalized. Today, the Fed is the main culprit in the current oil crisis. If the Fed had not devalued the dollar by about 20% over the past decade, oil would be closer to $80.

OPEC is not naturally a strong cartel. The Saudis want to increase production because they have the lowest cost to extract oil from their wells. Also, the Saudis need cash to bolster their monarchy given the current regional turmoil. The Venezuelans want to reduce production because their production capacity has fallen under their communist dictator, Hugo Chavez. Without the ability to raise capital to maintain production, Chavez can only increase his wealth by driving up prices at the expense of other members. The Saudis are hardly interested in doing favors for a communist revolutionary that supports FARK in his neighboring Columbia. Revolution is already too close to the Saudis for their comfort.

If OPEC were ever to set production quotas that were met by its members, it would be pure coincidence, and the same production would have happened without cartel guidance. Much like the UN, OPEC is a nice venue for wealthy dictators to rub shoulders and capture press; beyond that, OPEC is an empty shell.

Last week’s oil price fluctuation due to OPEC speculation also demonstrates the power of expectations on today’s prices. The $2 swing in daily trading was due to speculation over a 1.5 million barrel per day global production increase (less than a 2% increase). Coincidentally, ANWR production would eventually yield 1.5 million barrels per day. Mere rumors of a future change in oil production cause today’s price to change.

Pres. Obama and the Old Time Media justify his refusal to allow expanded oil production by stating that it would not lower oil prices until production actually starts. Obviously, had Congress approved ANWR drilling over eight years ago when Pres. Bush requested it, oil would be flowing today. Still, announcing future oil production has an immediate effect on today’s prices.

The complex and boring science of futures trading dictates that any commodity like oil that can be stored must have its present and future prices linked. If, due to expected increases in supply, future prices fall, present prices must also fall because people who own oil today will want to sell now to avoid a future loss. Alternately, if future prices increase, today’s holders of oil will want to wait (store their oil) until prices rise to sell, driving up today’s prices. Roughly, today’s price must equal tomorrow’s price plus the cost to store the oil, the result of futures trading. The Saudi’s have huge amounts of oil stored naturally underground, so their storage cost is nearly zero and their inventory practically limitless. If Obama were to seriously commit to increased future oil exploration, the Saudis would increase their production to capture profits before US oil production actually increased. If Obama seriously committed to allowing unrestricted shale oil production, whose supplies are practically limitless, today’s oil prices would quickly fall to nearly the price of shale oil extraction (less than $90 by some estimates).

Last weeks’ OPEC news demonstrates that there is no nefarious collusion driving up the price of oil. Oil producers are actually powerless to dictate pricing. In fact, the primary cause of oil crises has been the US Government’s attempts to manage oil supplies, be it through rationing or environmental restrictions. If the US were to allow expanded oil production, even if well regulated for safety and the environment, oil prices would quickly fall and remain stable. Since energy is a critical factor in any economic recovery, such a change in policy is perhaps the best hope for Obama’s political survival.