Freedom's Fidelity

Sunday, February 15, 2004

OPEC vs The Market

In my Chaos is Progress post I briefly discussed why the cartels such as OPEC rarely reach their goals. This Reuters story supports that:

OPEC members so far show no sign of meeting their pledge to stop 1.5 million barrels per day of over-production, with March crude allocations to key customers unchanged from those for February, traders said on Friday.

Trade sources named Iran and Kuwait as the latest OPEC members to have kept supplies steady, despite the cartel's announcement in Algiers on Tuesday that it would eliminate production above OPEC's official output ceiling with immediate effect.

Earlier this week, customers of Saudi Arabia in Europe and Asia said they expected March supplies to be unchanged from February levels, while oil traders said it would be very difficult for Nigeria to reduce March oil availability because most of it had already been sold.

Sales from the United Arab Emirates to their main customers in Asia also were unchanged.

"I haven't had any communication which says production will be coming down," said one trading source at a Nigerian producer.

The downside of collusion is that it creates a tremendous incentive for members to cheat, especially if they are motivated by money. OPEC's strategy is to keep prices artificially high by limiting output, if prices start to trend downward they will respond by cutting supply, or at least announcing they will. As the Reuters article indicates though, OPEC's declarations often don't translate into reality. The real world responds to incentives, and an artificially high price provides profit potential for increased production. Regular cheating has been a hallmark since OPEC's inception because of the prisoner's dilemma it creates. Each member nation could assume that every other member will follow the rules and everyone will be better off. Some members though will operate under the more realistic assumption that at least one other will ignore protocol. In this case, the members will find it in their own best interest to increase production and take the profits before the other cheaters do. The net effect is downward pressure on prices of gasoline and other oil based commodities - prices that, in real terms, have been steadily falling since the 70's. In my neighborhood a 20 oz bottle of water goes for about $1.25 and 64 oz of gas for $1.99. You do the math. OPEC is no match for Adam Smith's invisible hand.

posted by Paul  permalink | |