Is OPEC Killing Itself?

Includes: OIL, USO
by: Chandler Lutz

With oil prices sitting at more than 109 dollars a barrel, near the all-time high, you have to think that the title of this article makes me absolutely crazy. In fact, you're right. Billions of dollars are flowing from the West and Asia to the Organization of Petroleum Exporting Nations (OPEC). In 2008 the Energy Information Administration (NYSEMKT:EIA) predicts that OPEC revenue will hit $927 billion, up 37 percent from 2007. Also, in 2007 profits were also higher than 2006, with Saudi Arabia coming out as the biggest winner earning a cool $124 billion. (In case you're wondering, with about 7,000 member of the Saudi royal family, the House of Saud, they each could buy about 45,000 Ferraris.)

With this kind of success it's hard to argue that OPEC's future will be anything but bright, but that's exactly what I'm going to do.

Crisis Spurs Innovation

If one thing can be learned from history, it is that crisis spurs innovation: WWI brought us the United Nations, out of the Great Depression came the FDIC, SEC, Social Security and many other forms of government regulation, and the splitting of the atom was a result of the daunting threat of the German military in the Second World War. Those are just examples of government action and don't even touch on the countless other innovations created through our market-based economic system.

Markets facilitate creativity as competition grows and entire industries are affected by the delicate balance between supply and demand. In no part of our lives could this be truer today than with oil and gas. Consumers in the United States and all over the world are feeling the increasing pressure of rising fuel prices. It is this pressure that threatens the livelihood of the world's biggest oil exporters in the long run. Higher oil prices have created a modern crisis for the American economy. If history is a guide, our market system may facilitate a solution that leads us away from oil, rendering the OPEC cartel obsolete.

Why is this time different?

The United States has seen lofty oil prices in the past, but those higher prices have not translated to a decrease in America's dependence on oil. What makes this time different? To answer this question, we must first determine the cause of price increases today compared to the past.

High demand is blamed for the majority of the recent run-up in oil prices, while the previous oil spikes in the 1970s were politically motivated. These politically generated embargoes were not sustainable as the lure of higher profits broke the will of the cartel.

Today, future demand for oil is expected to increase as nations all over the world continue to develop. This increasing demand creates a long-term persistence in the price levels not seen in the past. Also, this persistence forces firms and other economic agents to further incorporate higher prices into their long-run expectations.

These expectations make this oil "crisis" different than anything we've seen in the past: Firms are anticipating long high oil prices.

Recall from your intro to macroeconomics class that in the short term some inputs are fixed, but in the long run all inputs are variable. Today, the majority of capital machinery depends on oil or gas as fuel. Over a long enough time horizon, that could all change. If oil prices continue to increase or remain at these elevated levels, it becomes economically viable for firms to pursue alternatives to oil and invest in other technologies. In a sense, as oil prices continue to rise, the black gold will face more and more competition and, as all investors know, competition destroys profits.

With OPEC reluctant to take action to alleviate current price pressures, it is making a big bet against the market system with their future on the line. The current oil crisis may cause consumers pain in the short run, but may be the catalyst the market needs to innovate in the long run.

Disclosure: Author has no positions.