OPEC’s decision Wednesday to cut its production targets by 4 percent has thrown some observers into a tizzy.
Ignoring inflation, world crude prices and U.S. domestic gasoline prices are at or near record levels. Fuel prices are becoming an issue in the U.S. presidential campaign. Some forecasters worry higher energy prices will stunt U.S. economic growth. Others fear it will fuel inflation, leading the Fed to constrict the money supply earlier than it might otherwise.
Such concerns are understandable, and, to some immediate extent, justified. But much dramatic hand-ringing is highly overdone.
OPEC has great pricing power in the short run, particularly when world demand or political uncertainty are high. In the longer run however, it is a paper tiger. Over any time horizon longer than a couple of years, OPEC needs oil customers more than oil consumers need OPEC. We need to be sure that short-term pinches, such as the current one, do not seduce us into longer-term policies that will prove to be self-destructive.
The key to understanding world oil markets is something economists call “elasticity of demand.” This is one of those concepts that makes 19-year-old eyes glaze over, but is crucial to understanding just what is going on as oil buyers and sellers make short- and long-run decisions. So hang on for a short explanation.
Elasticity of demand is a measure of how quantity bought responds to changes in prices. If a given price increase results in a large decrease in purchases, demand is elastic. If the same increase leads to a small decrease in consumption, demand is inelastic.
All the calculations are made using percentages to get away from inflation, different currencies or quantity units such as barrels, gallons or metric tons. The elasticity of demand is simply the percentage change in quantity divided by the associated change in price. If gasoline prices go up 10 percent and purchases go down 5 percent, the elasticity is 5/10 or 0.5. If crude oil prices go down 8 percent and purchases go up 12 percent, the elasticity is 12/8 or 1.5. If price goes up 10 percent and quantity falls 10 percent, the elasticity is 10/10 or 1.
The importance of all of this is that elasticity of demand determines a seller’s pricing power. You can be a monopolist, but if demand for your product is elastic, raising prices not only reduces the quantity you sell, but also your total revenue. For example, as steam locomotives became obsolete in the late 1950s, one European firm emerged as the only manufacturer outside of the communist bloc. That monopoly position didn’t mean much because if they raised prices, any remaining potential buyers would turn to diesel. Demand was very elastic.
Without going through the arithmetic, if demand is inelastic and you raise prices, you raise the total dollar value of your sales. If elastic, raising prices cuts such total revenue.
The demand for oil is very inelastic in the short run, but much more elastic in the long run. SUV owners don’t all sell their vehicles if gas prices go up for a month or two. But the longer they stay high, people who are buying a different car will give more weight to fuel economy.
Few commuters switch from driving to public transit in response to short-term price spikes, but at the margin, more and more choose to do so the longer prices stay high. Heating oil prices that are high through one winter won’t make every homeowner in the Northeastern U.S. get a gas furnace. But if prices stay high, more and more will shift. Gas companies will find it justified to increase pipeline capacity or build compressed natural gas terminals.
OPEC economists are well aware of consumer behavior. They also know that they control less than half of global crude output and that every time they act to hold short-term prices above the mid-$20-per-barrel range, they lose market share to non-OPEC members and to natural gas — and such losses often are permanent.
No one studies elasticities of demand for oil more than OPEC. Its leaders know that in the very short term — i.e., a few weeks or months — a 10 percent price hike may cut their sales only 1 percent or less. But in the long term, price hikes cut OPEC member nation revenues.
If OPEC had any real long-term pricing power, the value of member-nation oil reserves would grow. They have not. If Saudi Arabia, for example, has sold a billion barrels of its reserves to someone else in 1974 or 1981 and put that money into U.S. Treasury bonds, they would have much more money today than the value of the same billion barrels at 2004 prices.
Alarmists always retort, “Yes, but it is different now; this time they really have us over a barrel.” They are mistaken. As technology matures and alternative sources of energy come into play, the importance of oil will fade.
A century from now, there will still be billions of barrels of crude lying unpumped beneath the sands of the Middle East just as there still are large quantities of copper in Montana and Arizona. Like such copper, the oil simply won’t be worth pumping because no one will be willing to pay much for it.
Nor should we worry unduly about maintaining dutifully friendly regimes in the Middle East or even Venezuela.
Countries like Saudi Arabia, Iraq and Iran have little going for themselves beside oil. Cutting off shipments to punish the United States or other industrialized countries would damage their own interests much more than those of anyone else.
Oil is an extremely fungible product. What matters is global supply and global demand. Blocking flows between any two particular countries or sets of countries is meaningless except in the very short run. Don’t lose any sleep over this issue.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.