Some Interesting Oil Market Articles

Lynne Kiesling

On Friday Saudi Arabia signaled its desire to control world oil prices through OPEC’s decision to reduce production by 1.2 million barrels per day. Lots of observers have noticed that 5 years ago OPEC’s unstated trigger/target price was $30/barrel, but now it seems that they are targeting a price of $60-70/barrel. Clearly, political risk and rising demand contribute to that target price creep.

One interesting thing that the linked International Herald Tribune article notes is that the hurricane season in the Gulf of Mexico was calmer than expected, which means no supply shock and built up inventories as insurance that was unnecessary. This incorrect expectation has contributed substantially to the sub-$60 prices in the market today.

To see current oil prices, check out Bloomberg’s energy market data. Prices are down about $0.75-1.00 since this morning’s open, so some of Friday’s increase from the OPEC decision has retreated.

Another interesting thing that could contribute to OPEC’s target price creep is the factor discussed in an excellent Economist article from last week’s issue: OPEC countries have not invested sufficiently in oil production. Thus their techniques and their technology are probably inefficient, and their marginal cost thus higher than it would otherwise be. Here’s why: a cartel strategy, while increasing revenues, also reduces output, so a cartel member has little incentive to make investments that would increase output at lower marginal cost.

Their output today, of some 27.5m b/d, is much the same as it was in the 1970s. What is more, they are scarred by the memory of the 1980s, when slower-than-expected growth in demand and a glut of non-OPEC supply left them saddled with lots of expensive excess capacity. The high prices of recent years are partly a legacy of that glut, insofar as OPEC, still leery of over-investment, allowed its cushion of spare capacity to dwindle to almost nothing, heightening supply concerns.

Unfortunately for oil consumers, OPEC has little incentive to expand that cushion in the short term. It would, in effect, be spending money to reduce its revenue, since the price of oil would doubtless fall if traders had no fear of future shortages. Dermot Gately, a professor of economics at New York University, has modelled OPEC countries’ income at different levels of production. He concluded that any effort on OPEC’s part to expand capacity to maintain its market share would only begin to yield higher revenues after 2015, and even then, the increase would be marginal. Given all the uncertainties involved, a rational OPEC planner would probably resolve simply to maintain exports at today’s levels rather than add capacity.

Thus the pressures that arise from competitive dynamics for innovation to reduce costs are diluted to the extent that the cartel is effective. I like the Economist’s lede on this article: “If OPEC were a company, shareholders would be criticising its failure to invest”.