A YouTube video covering this material is available at
Today's
article is precipitated by a segment on All Things Considered,
entitled “Major Producers Work On Agreement To Freeze Oil
Production”. The segment outlines how several members of OPEC are
working on agreements to limit their output in the hopes of
increasing the price of oil, and thereby increasing their profits.
There
are a few points to make here, some of which are made by the hosts
and John Ydstie, who has the byline. First, they note correctly that
Iran and Iraq are unlikely to follow along with any such agreement,
as they have strong motivations to maintain or increase their output.
In Iraq's case, their oil output is helping to fund their opposition
to ISIS. In Iran's case, the recent lifting of sanctions has given
them an excuse to greatly increase their oil exports.
Ultimately,
the efforts of OPEC are destined to fail. A basic understanding of
cartels suggests that they can only be effective when they encompass
the vast majority of the producers of some good, and when policing
the other members is relatively simple. In this case, it may have
been true ten years ago that most of the potential production of oil
was present in OPEC countries, but the advancement of technology has
increased greatly the oil reserves of countries outside of OPEC,
which will place a fairly strong upper bound on the price level oil
is allowed to rise to.
This
upper bound is largely determined by the marginal price of the new
oil in non-OPEC countries. If, for example, Saudi Arabia can produce
a barrel of oil for five dollars, but American shale fields can
produce a similar barrel for twenty, Saudi Arabia can safely sell its
oil for nineteen dollars a barrel (shipped) and there will be very
little incentive for American shale fields to be tapped.
Requirements for capital goods to start tapping shale fields is an
additional cost which will make holders of American shale oil
hesitant to invest in what is required to harvest the oil.
Iran's
difficulty in selling its relatively inexpensively produced oil
during sanctions means that they probably have a good deal of
relatively high-quality, low-cost oil which they would love to
introduce to the market. For example, while Iran was under sanction,
imagine that Saudi Arabia sold all of their oil that could be
produced for less than five dollars per barrel. Before the
sanctions, Iran and Saudi Arabia both were producing oil at a cost of
two dollars per barrel. The rate of consumption of the underground
oil reserves in Iran was reduced, so it is likely that Iranian oil
has a temporary price advantage over other sources in the market.
The
existence of a market for a good generally causes its price to
approach the marginal value that it produces. Different producers
must compete selling the same thing to consumers who place varying
values on the good. The price of the good determines which potential
producers actually allocate effort toward production. If there are
plenty of sellers at fifteen dollars per barrel, then it makes very
little sense for those who can only produce at a cost of twenty
dollars per barrel to actually bother producing.
However,
the advancement of technology permits the marginal costs of
production of certain goods, such as oil, to change over time.
Twenty years ago, the oil present in the shale fields of America
could not be brought to market for the low prices it can today--the
knowledge required to extract that oil cheaply did not exist. But
the genie cannot easily be put back into the bottle. Now that shale
oil can be extracted at a price which is competitive with oil prices
in the recent past, the producers have two broad directions they can
proceed: One, they can reduce their sale prices to prevent newcomers
from entering the market (encouraging them to put up the initial
capital required to produce the oil), or two, they can maintain
higher prices but gradually lose market share. In either case, they
lack the ability to bring oil back up much over the price of the new
oil available to non-OPEC members, no matter how they want to prop it
up.
