Monday, 31 October 2016

OPEC’s Coordination Problem Is That Faced By All Cartels And It Might Not Be Worth Bothering

In Oil & Companies News 31/10/2016

opec new logo.jpg
That a cartel, when properly exercising its economic power, will benefit all the members of that cartel is entirely true. But it’s also true that it’s difficult to balance the individual interests when setting up the cartel. And then even more difficult to ensure that individual members don’t cheat. For that’s what the incentive is–to use the cartel to gain the generally higher prices, then to cheat the cartel through over production at those higher prices. Thus, of course, undermining the whole process itself.
This is the basic problem that Ope is facing now. At present it’s in trying to construct an agreement to exercise that monopoly (or oligopoly) power constructed through a cartel. But once they’ve done it they will be back to the problem Opec has long faced, people cheating on their quotas. The basic problem is that those whose oil industry has been reduced to rubble by war or sanctions aren’t willing to accept constraints until they get back to “more normal” levels of production:
OPEC’s internal disagreements over how to implement supply cuts remained an obstacle to securing the cooperation of other major suppliers at a second day of talks in Vienna.
Nations including Russia and Kazakhstan entered talks at the headquarters of the Organization of Petroleum Exporting Countries on Saturday. While non-member Oman was willing to cooperate, it said it couldn’t commit to a specific supply cut until OPEC had its own agreement. Discussions between members of the group on Friday reached an impasse over the role of Iran and Iraq, both of whom want to be exempt from any cuts.

Opec’s production needs to be lower than it is today if they’re going to drive the oil price higher. But if Iraq and Iran (and we can assume that Libya, once they get their internal war sorted out, will be making the same points) want to increase their production to older levels then that means that other producers will have to cut even more.
Iran wants to keep pumping until it reaches 4.2 million barrels a day, an increase of 400,000 barrels a day from current levels, according to an Iranian oil official. Iraq says it needs to keep pumping to generate revenue for an intensifying war against Islamic State. Iraqi officials didn’t respond to requests for comment Saturday.
Just that Iranian increase is more than the total planned cuts being discussed. The total planned cuts which are proving so very difficult to agree even without accommodating Iran.
OPEC Secretary General Mohammad Sanusi Barkindo alluded to the problem, saying “it is only together … that we can move forward.”
And that’s true but they also face a far larger problem–fracking from the US. A cartel only works if the actions really do produce oligopolistic, if not monopoly, powers over the supply of whatever it is. And in the past, in the medium term, Opec did have such power. A decent sized oil field, one large enough to make a difference to global supply, took at least a decade to bring online. So Opec could force up prices (assuming no cheating by Opec members) for that sort of period of time. And they did, quite successfully.
However, now there’s another competitor in the market, that fracking for tight oil. It depends upon who you talk to but the break even point for new wells being drilled is somewhere between $50 and $70 a barrel. It also takes, at most, a few months to get new wells online and their production shipping to market. Thus there’s not, ever again, going to be some sustained peak of oil prices above $70, maybe not even above $50. For in a commodity market for a fungible like oil the price is driven by the marginal barrel. If frackers are willing to sell at $55 then that, plus transport costs, is going to be the price for all oil.
At which point it could well be that Opec is meeting a problem that economists usually divine elsewhere. It’s a bit of folk economics that certain dastardly people will keep dropping their prices, taking vast losses, until everyone else goes bust. When that happens they twirl their handlebar moustaches and gouge everyone as a result of the monopoly they have created. The problem with this is that we’re all aware of the allegations. It’s just not obvious that anyone has ever done it. The reason being that the losses from the price cutting could be greater than the profits to be made later. And we’re also pretty sure that new companies would arise to challenge the monopoly as soon as prices rise.
As I’ve detailed in these pages this is what happened with China and rare earths. They restricted supply, prices rose, new mines opened and now prices are below where they where when China started.
With Opec it’s a little different but we might now get to the same result. They’re willing to take pain now, by limiting output, in order to drive the price up. They don’t need to bankrupt everyone else, they’ve already got market power if only they can agree. But as soon as they do agree and prices rise then they will be calling into existence that competition which will negate their profits. And prices really don’t have to rise far from today in order to get people drilling those tight oil fields again.
We might actually have reached the point where fracking is a large enough influence on upside oil prices that it’s not even worth Opec limiting production in order to drive up prices. And this of course is how all cartels eventually end anyway. Technological change sidesteps around their supply restrictions and they lose their market power. So far it’s only true that fracking limits their ability to push the price much higher. But my suspicion is that the technology is advancing quickly enough, falling in price fast enough, that Opec will soon enough have to keep cutting production in order to maintain prices. At which point it would probably be true that they might as well not bother. The time of the oil cartel may not be over yet but I suspect it is fast approaching.

Source: Forbes