OPEC President Chakib Khelil probably didn’t sound credible to many people Wednesday when he announced that the cartel is cutting production by more than a half-million barrels per day, but that consumers needn’t worry — the decision wouldn’t affect prices at all.
Most beginning econ students learn in the second week of class that demand is an inverse relationship between price and quantity. Reduce quantity and the price goes up. Centuries of history have proven this. Many people who never took an econ course also instinctively know this is true.
Indeed, if reducing output does not affect price, why in the heck should OPEC do it? Current oil prices may no longer be at record highs, but they still are far above OPEC’s average production costs and historic levels. So OPEC may be less focused on increasing the price of oil than on keeping prices from falling further. If the price stays the same, no matter what OPEC does, the cartel would make more money by continuing to pump at even higher levels than now.
Khelil, an economist, attributed the enormous run-up in crude oil and gasoline prices this year to the weakness of the U.S. dollar. With the dollar now increasing in price relative to other currencies, especially the Euro, oil prices will continue to trend downward, he predicted.
This argument is partially correct. There is an inverse relationship between the cost of the U.S. dollar in terms of other key currencies and the cost of oil, which is priced in dollars on international commodities markets. As the dollar becomes cheaper for foreigners to buy — which is another way of saying “as the dollar buys less abroad” — the price of oil tends to rise. The dollar’s slide indeed was one factor among several in the recent high prices for crude oil.
Another was the bubble effect created by investors piling into commodities as crude prices soared ever higher, inducing many to bet they would continue to rise inexorably. Many sought the rising asset of oil over the dropping asset of owning dollars. With crude now down by over a fourth from those highs, some of these investors are stanching gaping wounds.
So price in this case is not dependent on output alone — exchange rates and investor expectations also play large roles. But supply and demand continue to be the dominant forces.
Khelil would have been more credible if he had appealed to the classic economists’ fudge factor of “all other things being equal.” He should have said, “Well yes, by itself, an output cut would raise prices. But all other things are not equal. A strengthening dollar, speculators bailing out of their bets on higher prices — in other words, selling the oil they bought — and slowing economies in many parts of the world affecting demand will more than offset the cut we are making. After all, a cut of 520,000 barrels is less than 2 percent of our total daily production of 28.8 million barrels.”
Phrasing it that way would have been more accurate and more credible. Higher oil prices are reducing consumption, at least marginally, in many countries. Moreover, experience in the last half of the 20th century demonstrates that oil use can drop quite a bit when several major industrial economies slow, which seems to be the case right now.
So OPEC may be right in predicting oil prices will continue to drop. But this will occur because other factors are more than offsetting this week’s production cut, not because production levels have no effect on prices.
One issue OPEC did not address is whether the called-for cuts will actually occur. The 520,000-barrel reduction is not in OPEC’s official quota, which OPEC did not change. It is the estimated amount by which OPEC members have been pumping more than their country’s individual quotas.
Another early lesson for introductory econ students is that cartels like OPEC always face internal conflict. If a number of producers get together to form a cartel, an artificial monopoly rooted in collusion, they must agree collectively to reduce production below what it would be in a free market.
Deciding who must cut how much always is contentious. And the more successful the cartel is in raising prices, the greater the temptation is for any single member to cheat by selling more than its agreed-upon quota.
OPEC has struggled with this for years. Saddam Hussein’s Iraq and military-ruled Nigeria historically were the largest cheaters, but with oil in the $100 range, virtually all cartel members cheat at least a little. The question is whether this will stop.
So what oil prices will be in coming months is unclear. Production has exceeded consumption for some months. Stocks are high. Both these factors point to lower prices. But this is a difficult time to be very confident of any prediction.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.