"Market Power, Asset Allocation, and Oil Prices"

Steve Waldman:

Market power, asset allocation, and oil prices, by Steve Randy Waldman: In response to a (somewhat ridiculous) proposal that we "sue OPEC" over high oil prices, Mark Thoma writes:

[I]t's unlikely that [monopoly power] is the factor behind the run-up in prices. ...

I think there may have been a change over the last few years in the market power of oil producers, for structural reasons. Traditionally, OPEC has suffered from the usual problem that makes large cartels unwieldy: Under agreements to restrain production, members individually have an incentive to cheat and sell larger-than-agreed upon quantities at still artificially high prices. But that assumes that the production quotas are significantly beneath the capacity of most members to produce. More subtly, it also assumes that each country gains by producing more rather than less oil, if cartel prices are maintained. Both of those assumptions may no longer hold.

As the global oil market has grown, demand may have outpaced individual countries' capacity to supply, either because investment in new projects has not kept pace, or because nations have hit domestic "peak oil". (See Indonesia for an extreme example.) Other countries may desperately need money in order to fund current spending, so it is widely known they will produce as much as they can, regardless of quotas. Ironically, as long as the total capacity ... is well below global demand at the cartel's target price, the certainty of their output may enhance the ability of discretionary producers to control the quantity produced.

It'd always be easier for a cartel of five or six producers to exercise market power than a cartel of, say, thirteen. But that's especially true when cartel members have little incentive to cheat. ...[O]il producers ... spend far less than the oil revenue they receive. For Saudi Arabia, selling a barrel more of oil is a portfolio choice: revenue from the marginal barrel will be saved, not spent, so the question becomes whether it is wise to shift some of the Kingdom's current allocation out of oil and into some asset that can be purchased with currency. For countries that have very little non-oil savings, mere diversification would encourage oil sales. It is unwise to have all ones eggs in one basket, and oil producers remember all too well that world prices can go down as well as up. They'd want to store their national wealth in an "efficient portfolio", one that maximizes their return on risk by including a variety of investments.

But as oil producing nations have accumulated vast reserves of financial assets, switching from oil-in-the ground to stocks, bonds, or bank accounts is no longer so sure a bet. ... Central banks and sovereign wealth funds of oil-producing nations already hold hundreds of billions of dollars worth of Western financial assets. They might already have reached or exceeded what they view as an optimal allocation of their national wealth into these securities. Of course, producers are still not well diversified, and it's pretty clear that sovereign wealth funds are looking for alternative assets that might hedge their exposure both to oil and Western paper. But allocating into less liquid, unfamiliar categories of assets is slow work if you want to do it well. Perhaps current oil revenues outstrip oil producers' capacity to find good investment opportunities, and they view oil-in-the-ground as a better second-best asset than dollars in the bank.

Ten years ago, oil producers did not have vast hoards of dollars and euros, and required oil revenue to meet budgetary needs. World demand was low enough that cheating by OPEC members could corrode producer pricing. It was hard to exercise market power. Now, cheaters don't matter, and discretionary producers may be indifferent or worse to the prospect of selling a barrel more of oil at current prices.

(In a sense you might not call this market power at all, as price equals marginal cost, that is to oil producers, the assets they can buy for the dollar price of a barrel of oil are worth no more to them than a barrel of oil left in the ground.) ... [...more...]

Comments

[James Killus]

In The Control of Oil (1976) John Blair presented an interesting graph of oil (chart 5-1) production from the OPEC countries, 1950-1972, showing a regression line of 9.55% annual growth, with an r^2 of 99.9%. Blair notes that growth rates during the period were precisely in line with prior internal forecasts from Exxon and other majors.

That's quite a trick for an industry that hasn't got "monopoly power," wouldn't you say? And given that the Iraqi oil fields have just been handed back to the majors, it looks to me like this is one of those times when oligarchical control and historic profits go hand in hand.

I think it's time to stop looking for alternative explanations and time to start checking into how much the oil companies know about international terrorism in oil producing countries. It would be poor business practice for them not to be looking into the matter, or, for that matter, influencing events. And I'm thinking that some more severe questioning than what happens before a Senate Committee might be in order. You know, just for funsies.

[reason]

I think Randy Waldman has it 100% correct here. And isn't it interesting to see depletion counted as a cost of extraction? I keep saying leaving it in the ground is not speculation, it is asset management. Why is that so hard to understand?

[Oupoot]

IMHO, very true. I strongly feel many of these oil producing countries dont know what to do with all their monies. At the very least, you want to ensure that its inflation/depreciating proof - invest it so that 100bn $/€/Yen/Franc today is equal to 100bn $/€/Yen/Franc in 10 to 20 years time. And leaving the oil in the ground may be the 2nd best alternative given the lead times of investing in hard infrastructure: feasibility studies, business plans, skills training, marketing, etc.

Just now we have a Dubai based investor wanting to invest a few billion $ in a very new themepark type development in KZN province, South Africa. And its a 30 to 50 year investment horizon for them - It is significant on our scales, but relatively small on global scales.