Saudi Oil Price Redux

In an earlier article I corrected some common misconceptions on what is happening with oil prices and how it affects the economy. This generated some feedback and further questions that I will address in this article. In particular I will focus on understanding the role of a cartel, the long term incentives of an oil producer and why oil prices have risen.

Let’s start with the concept that OPEC is a cartel. It isn’t because it lacks a major feature of a successful cartel: legal enforceability of quotas. To understand OPEC’s actual role in the history of oil, you need to start with the Texas Railroad Commission (‘TRC’). The TRC is the original cartel that controlled global oil prices and was an agency of the State of Texas that controlled up to 40% of US production until the late 1950s. Their power was derived from an oil production boom that saw prices plummet and Texas oilmen demand a cartel system of enforced quotas. The TRC served as a model for OPEC. The irony is not lost upon this writer.

The popular belief that OPEC was formed in 1960 to manipulate oil prices is false. At that time the International Oil Companies (‘IOCs’), also called the Seven Sisters, controlled 85% of the world’s petroleum reserves! Reserves, not production! The Seven Sisters set oil prices, not the sovereign nations that owned the oil. OPEC started as an organisation to share information between member producing countries so that they could better manage their relationships with the Seven Sisters. It was only in 1973 that OPEC understood its ability to influence oil price. The trigger was the Yom Kippur war and the accompanying oil embargo.

This set a precedent for the rise of oil price for the next four decades. In 1973 the price of oil did not increase due to economic considerations but due to sanctions against the United States. Geo-political incidents continued to be the main driver of oil price increases. In the late ’70s it was the Iran revolution. In the early 80’s it was the Iran-Iraq war. Skipping the intervening 20 years (although there is a nice graph at the BBC) we come to 2001 when oil was USD 20 per barrel.

Then came 9/11 which signaled a 600% rise in price to USD 140 per bbl over the next 7 years driven by the Iraq invasion, Lebanon invasion, sectarian violence and tension over Iran’s nuclear plans. Everybody worldwide was producing at capacity. This simply did not stop the oil price increase. Even with a global recession post 2008, oil price still rebounded with the Arab Spring and other geo-political violence and tensions in the region. OPEC cannot control the price of oil. This is not only empirically clear it can be explained by game theory that shows cartel members are incentivised to cheat.

A brief note about the long term incentives of oil producers. In the late ’70s, after Arab-Israeli disengagement post the Yom Kippur war, Saudi, led by Oil Minister Yamani, tried to convince other OPEC members that oil prices needed to be reduced for long term sustainable global growth. The rest of OPEC was not receptive. In the other price direction, in the mid ’80s Saudi tried to enforce quotas verbally whilst decreasing production to maintain oil prices before giving up and reverting production to normal which caused a price collapse.

Does OPEC try to influence oil prices? Of course they do. The real question is, can they influence oil prices? The answer seems to be rarely. If an interview by The Guardian of Yamani is to be believed, OPEC are not the only ones to try to influence oil prices. I think that it is clear, though, that OPEC have become better at understanding that long term thinking and the health of the global economy are far more important than short term price bumps.

The one thing that continues to puzzle me is the reaction in the media to what is happening and the characterisation of lower oil prices as a bad thing. Although the media might sometimes get things wrong at the beginning they quickly correct it (I should know). I could be wrong but I fail to see how a 25% – 30% cut in oil prices, right before the northern hemisphere’s winter, could be a bad thing for the global economy. Quite frankly, I see no better way to help the economy get back on its feet. This is better than quantitative easing.

I think that the take away is clear here: Texas oilmen of the 1930s are responsible for all of this.

You may also two related articles on oil: Saudi Oil Price and Oil: Through the Looking Glass.