Oil, Cartels, And The ECB

OPEC is a cartel but it is a strange species in the sense that it only accounts for about 40% of oil production. In the past exerted its influence by cutting production, as in 2008, and driving up prices. Now it faces a different challenge. New supply has come on the market, which threatens the cartel’s position. 

There is only one way to address this challenge. Drive the price down. Squeeze rival sources. This is not just the US, but also Canada, Russia, and alternative energy like solar and wind. To squeeze rival sources, it must allow the price to fall.  

This will inflict some pain on the high cost producers in OPEC, like Iran and Iraq. The market has tended to focus on the budget assumptions of oil prices, not the cost of OPEC production itself. The drop in oil prices in the short-run can be absorbed by cutting some social spending and/or tapping savings (reserves and sovereign wealth funds). This is the short-term pain. The promise of long-term gain is that higher cost producers and alternatives are driven out of the market. 

Initially, many observers argued that the Saudi’s decision not to cut output was doing the US some sort of favor. We never accepted this assertion and are even less inclined following the OPEC meeting and comments from the Saudi and UAE oil ministers. It seems clear that the main impetus is the US shale producers. OPEC’s low cost producers (Saudi Arabia, Kuwait, Qatar, and UAE) are being strategic and seek a larger market share. 

Now some pundits are going in the other extreme.  OPEC is declaring war on US shale producers.  Isn’t it the other way around?  More more than 40 years, US President after US President has advocated energy independence. Through cheap credits in the high yield bond market and environmentally questionable practice (fracking), the US has succeeded in cutting its reliance on foreign energy by the most in a generation.  

The US fracking, and to a lesser extended the tar sands in Canada, have threatened the oil cartel. It responded in a market-rational way. It so happens that the high cost producers in the cartel itself, like Venezuela, Iran, and Algeria, will also be squeezed. Nigeria has been hurt. Russia, which is not an OPEC member, is also hurt by the drop in oil prices.