OPEC: The Equivalent of the Wizard of Oz

Since the first embargo in 1973, energy officials and many members of Congress have accepted the notion that since OPEC is called a cartel, it must be one. In reality it is like the Wizard of Oz behind the screen. Its power comes from being seen as powerful. The reality is nothing like the image.

In a George C. Marshall Institute paper that I wrote in June, OPEC: The Myth and the Reality, I made the following points. “In the field of economics, a cartel is defined as an agreement between businesses in the same industry to control an market, to raise the market price of a commodity or good, and act like a monopoly.” …”Although OPEC may be the most widely known “cartel”, the DeBeers Diamond Cartel is the most effective and, until recent years, the most enduring. …When OPEC is compared to the diamond cartel model, it fails the tests for an effective cartel.” A cartel is only possible when there are strong barriers to entry and in the case of oil the only barriers are money and access to technology and oil bearing lands. The reality is that OPEC is a price taker, not a price maker.

There are a number of reasons why OPEC did not reduce production at its most recent meeting, with most being political. First, the history of OPEC has been one of regular cheating by members. This is still going on with Iraq, Libya, Kuwait, and the United Arab Emirates exceeding their quotas. Under this condition, Saudi Arabia had no incentive to reduce its output. Refusing to do so sends a message to other members that they will pay a price for cheating. Second, a weak price does more damage to Iran than to Saudi Arabia and that serves the Saudi’s security interests. Third, letting prices drift lower because of the oil renaissance in North America will test the price point that begins to shut in US and Canadian investment and production.

Daniel Yergin in a November 30 Wall Street Journal opinion piece made a strong case for US production resilience. He stated, “It is now clear that the new U.S. production is more resilient than anticipated. There has been a widespread view that at around $85 or $90 a barrel extracting “tight” oil from shale would no longer be economical. However, a new IHS analysis based on individual well data finds that 80% of new tight-oil production in 2015 would be economic between $50 and $69 a barrel. And companies will continue to improve technology and drive down costs”. And, the CEO of ExxonMobil recently stated that the company makes its decisions on the basis of long term price expectations and could deal with oil at $40 a barrel.

The major drop in price from $100 a barrel to today’s price is the result of the substantial increase in US production and the drop in global demand caused by the EU and Japan slipping back into recession and slower growth in China. If the EU and Japan start adopting policies that will restore healthy economic growth, and those policies are not a mystery, demand will pick up and with it the price of crude oil. Oil prices are cyclical and always will be. They never keep increasing and the never keep falling.

What has taken place with the drop from $100 oil is a massive shift in wealth from companies to consumers that is measured in trillions of dollars. That is like a major tax reduction that will spur consumer demand and economic growth as we now are witnessing. Policy makers should give thanks for the market doing what they can’t do.

There are also unintended consequences. A significant one is the impact on the Russian ruble and economy that is now in a shambles. The effect of sanctions has been magnified. With a little good fortune, Putin may rethink his current tactics. Another big consequence is to make clear how dependent wind, solar, and EVs like Tesla are on high prices and expensive subsidies. If the market is allowed to work, consumers will continue to benefit and policy makers might rethink their misguided energy and anti-fossil energy policies.

 

This article appeared on the National Journal’s Energy Insiders weblog at http://www.nationaljournal.com/policy/insiders/energy/how-much-sway-does-opec-have-over-energy-markets-20141208

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