Market Power, Asset Allocation and Oil Price

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. Monopoly power explains the level of prices, i.e. why price is $8 rather than $5, but it doesn't explain the change in prices, i.e. why the price would change from $8 to $12. There are ways to tell this story, e.g. a war or some other event giving a cartel the cover it needs to raise prices and blame it on external factors, but I don't think that's what's going on in oil markets today, at least I don't think this is a significant factor behind the oil price increases.

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 of sure-fire cheaters and constrained suppliers 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,13. But that's especially true when cartel members have little incentive to cheat. Normally, we think of governments as spendthrifts, always eager to spend an extra dime unless constrained by tax revenues or debt markets. That's obviously a mischaracterization of today's most important oil producers, whose governments 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 one's 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. Real interest rates on "safe" dollar assets are currently negative, both in US and home country terms, and the outlook for safe euro assets is uncertain at best. 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.)

Brad Setser recently noted that...

[T]here are two clear paths that could end the current “oil up, dollar down” pattern.

Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil.

Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.

Ironically, a strong, healthy US economy might also push oil prices down, even while increasing US and world demand for oil! The price of oil to discretionary producers is not measured in dollars, but in the future purchasing power of the assets dollars can buy. If oil producers expected US financial assets to appreciate in value more quickly than oil (in terms of what they want to buy), President Bush wouldn't have to look anyone in they eye to get the producers to invest in new wells. However, if that's not the case, then the rate of production might be determined more by the political costs of failing to produce than by world demand or current-dollar prices.

 

But ... for US dollar assets to appreciate faster in oil-producer purchasing power than oil itself, those assets would have to represent claims (direct or indirect) on future goods that producers want to buy, that is investment in tradable goods and services. Unfortunately, Brad is probably right to suggest that a "rebound" in the US economy would drive oil prices up, since we've come to believe that more GDP is always better, sectoral composition doesn't matter, and producing tradables is for the little people. Federal stimulus checks might give a zetz to GDP, but in and of themselves they do nothing to make claims on American assets worth buying.

Comments

[iThinkBig]

Hi. How about U.S. energy independance declaration, $300 B gov subsidies in nuke, biodiesel and coal and create a new party for the U.S. and OPEC to invest in? Might help our crumbling dollar and keep OPEC around the U.S. a big vested interest. Just a thought about selling the global consumer what they want. Something that escapes the Democrat party, rational thought. Lawyers make horrible lawmakers. And don't give me that shit about Republicans had the majority in 2002 on the energy bill. You need a super majority of 60% to pass a bill. 91% Republicans voted yay, 89% Democrats voted nay. Sell the globe a great investment in American energy and you get the biggest and longest bull run of U.S. history. Until then, bumpy ride is an understatement but money can now be made shorting (I will in September for myriads of reasons)

[Navivest]

There used to be a time when OPEC. or more specifically Saudi Arabia, was highly concerned about perception. That is, while like any normal purveyor of a product or service they wanted the highest price they could command, they also worried about disturbing that delicate balance between maximum pricing and upsetting customers. Now they've seen that we'll basically pay anything so they're emboldened to the point where they can actually look our president in the eye and say no they won't increase production, even though they could.

It is imperative that we increase US output as well as get serious about alternative energy. Unfortunately as is so often the case in this country, wherever there are politicians there are lobbyist so that now we have a very powerful farm lobby that refuses to let us use alternate feedstock for ethanol besides corn. This has resulted in everyone knocking ethanol. Lest we forget, Brazil is efficiently producing ethanol and powering their vehicles with it.

Thankfully, there is a limit that Americans will reach. Ford actually announced they will delay releasing their new F150 truck. The delay is supposedly for just two months, but to the extent that this is their bread and butter, what does that mean for the company? As it is, Explorer sales have fallen from over 450k units at their peak, to just about 150k a year! Something needs to be done ASAP.

[Robert Sczech]

The production of crude oil in the US is declining since 1970. We produce today roughly 50% of the amount of oil we produced in 1970. That decline of production happened despite lots of drilling and the usage of the most sophisticated pumping technology in the world. It has little to do with politics but a lot with the geology of the oil fields. The remaining US oil to be pumped yet is less than 20% of the oil the US was originally equipped with before the oil bonanze started. In other words, we already used more than 80% of our own oil. What is left, could power our way of life for less than 5 years if imports were not allowed. Energy independence is a delusion.

It is a great tragedy that this simple truth, 30 years after the onset of the production decline, is still unknown to the educated people of this country.

[theinvestingspeculator]

All this talk about speculation. Speculation add liquidity, supply/demand and crowd behavior governs prices. There is a lot of big money that could short oil if it were over valued. Right now it is cheap, I will tell you why @ theinvestingspeculator...