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Friday, December 15, 2006


The market for oil

OPEC said yesterday that "it planned to reduce its output by nearly 2 percent in February". This is the group’s "second production cut in two months." Opec is doing this in order to keep oil prices "above $60." The way this is going to work is each of the OPEC countries are going to cut their production down to "26.3 million barrels" in order to decrease the supply to raise prices. It is important to note that OPEC has already "agreed to a 4 percent production cut in October."

The Saudi oil minister reports they are doing this in order to aid the market for oil by keeping it 'in balance'. “I hope the market appreciates we are working so diligently to bring supply and demand in balance, to have inventories at a reasonable level so that we do not have gyrations.” This is not going to help the oil market, the only thing this will do is raise prices, and since the cartel holds a virtual monopoly on oil, consumers are forced to pay those prices or not drive- for most that is not a feasible alternative. The market on its own will set price and quantity and for the most part it should not be messed with unless there is a market failure. Oil producers are tying to make more money by supplying less product which they have the power to do because they are a cartel.

OPEC accounts for "40 percent of the world’s oil exports" and it has a new member to add to its 11 member group. Angola will be added next year which is the "first new member since 1975."
Angola is "Africa’s fastest-growing oil exporter" which pumps "1.4 million barrels a day, ranking it above Qatar and Indonesia within OPEC." This is a surprising addition considering OPEC is worried about current levels of output because of the subsequent decrease in price. The chief energy economist at Lehman Brothers, Edward Morse says "this makes an incredibly tight market even tighter... It’s a very aggressive, assertive move. Clearly, some OPEC members want to keep a $60 floor.”

“They are jawboning the market and trying to show they are being aggressive,” said Roger Diwan who is a managing director at PFC Energy. OPEC explains its reasoning as “market fundamentals clearly indicate that there is more than ample crude supply, high stock levels and increasing spare capacity.”

Another issue with the price floor created by this Cartel is the problems with enforcement. It is very difficult if not impossible to discern the difference in oil between countries in the middle east. Given the Nash equilibrium, there is incintive for these countries to cheat. If Saudi Arabia decided to ramp up production, it would be very difficult for the other members of OPEC to know who was doing it. If Saudi Arabia did cheat, their output would increase and they would sell more units for the same price as everyone else; therefore their profits would sky-rocket. It has been estimated that "OPEC countries have actually pared production by only 700,000 barrels a day, instead of 1.2 million barrels, since the October meeting." This is a result of the difficulties in enforcement, every country wants to make the highest amount of profit that they can. Not only is there incintive to cheat but it is almost counter-productive to a country's profit margins not to.

Since OPEC has a virtuall monopoly on oil, when they set a price floor, consumers have little choice but to pay the higher price. They only way they could avoid it would be if they didn't consume gasoline and for most this is an unrealistic assumption. Consumers will be forced to pay this price until the price reaches the point where it is more cost effective to turn to energy alternatives. "Analysts at the energy agency, which represents consumers, have warned OPEC not to cut its production further as higher energy prices could erode economic growth."

It is a cautionary tale, decreasing output will raise oil prices but if OPEC goes to far they can end up shooting themslves in the foot. The president of the Petroleum Industry Research Foundation in New York said "OPEC ministers should be careful how they manage the market in coming months." He also suggested that "high energy costs could reduce consumption." If consumers start turning to energy alternatives, there will be a sharp decline in demand and prices would plumit. OPec would be stuck wondering where did everybody go? “That’s a trend OPEC and the Saudis should not be ignoring because at the end of the day they want to sell, and if you want to sell, you need a vibrant economy particularly in the United States.”

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