Sunday, November 18, 2007

OPEC: The Cartel that Refuses to Break

In the midst of the first oil shock following the 1973 Israeli-Arab war, the late great economist Milton Friedman predicted that OPEC, the oil cartel, would ultimately collapse. His forecast was based on the historical failure of most cartels to hold together.

Here is Friedman's pronouncement in 1974 on the skyrocketing oil prices brought on by OPEC oil production cutbacks that began in October 1973: "The world crisis is now past its peak. The initial quadrupling of the price of crude oil after the Arabs cut output was a temporary response that has been working its own cure. Higher prices induced consumers to economize and other producers to step up output . . . In order to keep prices up, the Arabs would have to curtail their output to zero; they would not for long keep the world price of crude at $10 a barrel. Well before that point the cartel would collapse" (Newsweek, March 4, 1974).

Not only has the cartel held together for 33 years, it has become more influential than ever. OPEC is producing a gradually rising share of global oil output. It can count on a steady increase in demand for oil due to the need for energy imports in India and China, the latter modeling its industrializing strategy, in part, on the American experience with motor vehicles.

Oil-importing nations—Japan, the United States, most of Western Europe—want OPEC members to invest in new capacity to keep pace with rising demand, lest the price continue to rise. For its part, as a condition of investing in new capacity, OPEC wants a guarantee of secure demand for oil. What this means, in practice, is that oil- importing nations must promise not to invest too heavily in alternative energies, or take extreme measures against climate change, that would substantially reduce their imports of OPEC oil and reduce its price. This is a classic Catch-22 situation. If OPEC detects significant progress in the development of alternative energies among the oil-importing nations, it will act to keep supply tight and prices high. If, on the other hand, alternative energies are not developed, OPEC will continue to exercise a stranglehold on oil-importing economies.

OPEC meetings draw bevies of analysts and reporters, hoping to learn what its decisions will be on the price and quantity of oil. OPEC is enjoying the current high price, earning its members some $650 billion in 2006, a fivefold increase in a few short years. Saudi Arabia alone earned almost $200 billion.

This represents the beginning of a new world order, rising demand for oil and the ability of OPEC to control the supply and influence the price. In so doing, OPEC members will earn trillions of dollars in the coming years which it can use to step up its purchases of public debt and other assets of oil-importing countries. The "Golden Rule" states that "he who has the gold rules." Over time, OPEC members, many unfriendly to the United States, will gain power and influence over U.S. domestic and foreign policy.

To give but one example, OPEC is beginning to weigh a currency shift from dollars to euros, thereby reducing its exposure to a weakening dollar. Some OPEC members complain that the falling dollar is driving up inflation in their countries and reducing the purchasing power of their non-dollar imports. Such a shift would further weaken the dollar, restrict the ability of the Federal Reserve Board to lower interest rates less inflation accelerate to unacceptable levels. India recently announced that it will no longer accept dollars at its tourist attractions. Entrance fees must now be paid in rupees.


Brian said...

In my view it doesn't matter if OPEC and India's tourist attractions do not accept dollars. If they're better off accepting some other currency then they were foolish to have accepted dollars in the past.

If you think that it matters which currency is accepted by OPEC and India's tourist attractions, you're suggesting they were fools. When it comes to a question as arithmetically trivial as maximizing income, I doubt either were fools or incapable of arithmetic.

4getmenot said...

In the end, the most significant thing to emerge from last week`s meeting here of OPEC oil ministers may not be the modest price cut the majority finally agreed on but just the fact they managed to make it through one more meeting without falling apart.

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