Is oil about to go sky high? I asked Jerry Taylor from CATO about the OPEC meeting this week and this preview. Should we be alarmed?
“There is no way to know” if it is bad news yet, he says. “OPEC declarations about agreed-upon production cuts do not necessarily translate into actual production cuts. Rampant cheating is the rule and production discipline is the exception. That’s because each OPEC member is in a multilateral prisoner’s dilemma game. A producer will maximize revenue if every other member of the cartel complies with the quotas save for the producer in question. A producer earns lesser amounts if everyone, including the producer, complies with the quotas. They earn the least revenue when everyone cheats. Decisions to cheat or not to cheat are made simultaneously, however, and cheating cannot be detected with confidence for several weeks at the very least. Hence, there is a major coordination problem that simply cannot be resolved in advance.”
Jerry continued: “The OPEC experience that is most instructive in this case is the 1981-86 experience. Then, too, a severe global economic recession hammered global crude oil demand at the very time that most parties were of the opinion that the record high prices observed in 1980 would only be a precursor of things to come. At first, OPEC as a whole successfully cut production enough to prop-up prices to offset to a large extent the collapse of global demand. But the production cuts were uneven. Most cartel members cheated on their quotas with only the Saudis making good on commitments (more evidence, by the way, that our ’special relationship’ with the Saudi government means nothing of practical consequence in oil markets at least). The more the non-Saudi cartel members cheated, the more Saudi Arabia cut back to keep the market tight. Eventually, Saudi Arabia got tired of sacrificing revenue for the free-riders and declared that, unless the cheating stopped, they would likewise abandon production restraint. Despite promises to the contrary, the cheating continued and, to everyone’s shock, Saudi Arabia actually made good on their threat. What followed was an epic price collapse of 1986. Most parties thought it was only a temporary phenomenon and that prices would soon recover once the cartel was properly chastised, but it took 17 years for prices to climb back to pre-1986 levels.”
Taylor’s Christmas optimism: “Given the cartel’s history, I am modestly skeptical that production cuts will be delivered as promised. It is, however, possible. But even if the advertised production cuts follow, it’s no guarantee that (i) the cuts will be large enough to offset falling global demand and thus keep prices in their current (or higher) price band, or (ii) that production restraint will be sustained throughout the recession. If it’s a long one and OPEC discipline is maintained throughout, it will be the first time we ever observed such a thing. “