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Oil was up today as word is that OPEC may do something about the production overrun. As I mentioned in an earlier post, this sounds very nice, but, much like a kid with a lemonade stand and no customers, the markers come out and prices keep dropping until they finally have to pour it all down the drain.

“Come on Phil!” you may say, “Surely the Organization of Petroleum Exporting Countries is more sophisticated than a couple of children selling lemonade at the side of the road.”

Sadly no. They are not. In fact, it could be argued that they are in a poorer business position than your average 8 year-old because:

A) The 8 year-old doesn’t keep making lemonade even when no one is buying.
B) The 8 year-old knows how to price to the market. When business is slow, they immediately drop prices to keep the consumers in the game.
C) The 8 year old isn’t funding a $60b dollar economy almost entirely on petro dollars!

According to Richard Bernner of Morgan Stanley: “Higher prices ultimately beget more supply and trigger conservation. And commodity demand tends to shrink as a share of output as economies mature and likely become more service-oriented.” In other words, while demand may be inelastic in the short run (say the past 2 years), over the longer term the supply and demand curves invert, and they are just as slow to move back the other way.

The greed of oil countries (who could have talked down prices before demand snapped) and oil traders literally drove prices to the breaking point: the point at which U.S. consumers actually stopped buying SUVs!

Now 30% less SUVs over 3 years means 9 million cars that will get at least 5 miles more per gallon, consuming 40m less barrels of oil per year. That’s assuming no one is car pooling or shortening trips in any other way. As we previously mentioned, just 1 degree on the thermostat drops another 1-2% off energy consumption, and you just know industrial users (including airlines) are cutting back, so we could be talking about knocking close to 1m barrels a day off U.S. consumption.

Will OPEC fold up their lemonade stand? Of course not! We still use 20m barrels of oil per day, and 9m barrels are produced at home. Rig count is up 20% in the continental U.S. and, if that leads to a 20% increase in domestic production, that’s another 1mbd that we won’t be buying from OPEC.

What’s an oil cartel to do?

A production cutback can work if demand is inelastic (it isn’t), but what happens when supply is inelastic? It isn’t the U.S. that’s addicted to oil, it’s OPEC that is addicted to cash, and we have them Jonesing big-time for a steady fix.

Oil is not a finished product. It is a raw material that has no value to the producer if it sits in the ground. Every barrel that goes unsold is an opportunity cost. Our cash is their principal source of OPEC income, and it will be a hard sell to get their members to turn off the spigots.

Iran, for example, exports 2m barrels of oil per day, taking in $47.5b a year in revenue at $65 a barrel.

When oil drops to $60 a barrel, Iran’s revenues drop down to $43.8b a year.

A production cutback of 10% of OPEC’s 30b output to maintain that $60, if it were spread evenly, would cost Iran an additional $4.4b (and idle production facilities, putting people out of work, not to mention infighting among groups as to who shuts down how much production).

This would drive their net revenues down to $39.4b, a 17% decrease!

Let’s not forget that there are production costs there as well. If we assume production accounts for $20 of every barrel, then we are talking about a much steeper decline in net revenues…

If instead, Iran were to continue producing a full 2b and let the price drop to $55 they would net $40.15b, more than if they cut back. Of course if they cheat and scale up supply, they could even come out ahead –- but that would be wrong!

Once oil gets down to $50 a barrel or less and Iran is out over $14b a year in revenues, cutbacks will be the furthest thing from their minds!

Another problem with production cutbacks is that OPEC simply isn’t the only game in town anymore. Aside from our (and the rest of the world’s) growing use of domestic fuel sources, non-OPEC countries now produce 65% more oil than OPEC does. Not many of those countries (we are one of the biggest) have much interest in maintaining OPEC’s price floors.

Oh no! Another lemonade stand opened across the street! We all know what happens when the customers are scarce and the kids have to compete for business...

Source: OPEC: Lemonade Cartel