A. F. Alhajji
Much of what you read and hear about world oil pricing is wrong. Here are a few things to keep in mind whenever you hear pundits talk about oil prices:
Lesson One: Prices in a competitive market are determined by supply and demand. If the world oil market is competitive, the price of oil on any given day is the result of the intersection between supply and oil demand. Through that process, we end up with “equilibrium” and the price is called “the equilibrium price.” There are no “shortages” in such a market. A shortage indicates that what people are willing and able to buy is more than what sellers are willing and able to sell. In the case of a shortage, prices will increase until we reach equilibrium: a balance between supply and demand. Economics 101 tells us that if the price for West Texas Intermediate is $75 per barrel, then the oil market is at equilibrium at that price and supply and demand are balanced.
We cannot have a market price of $75 and say that there’s a “clear imbalance between supply and demand,” as an OPEC document states; or “a fundamental imbalance between supply and demand growth,” as a senior official at a leading Canadian investment bank recently asserted; or a “misalignment between supply and demand,” as a well-known industry analyst has declared. Imbalance implies a shortage, and a shortage results in an increase in prices until we reach “balance.” Therefore, as long as there is a price – low or high – there is a “balance.”
Still not convinced? If an attack on a Nigerian oil facility reduces Nigeria’s oil output, world supplies decrease. If traders panic and speculators want to take advantage of the situation, demand will increase. The result is a higher price where the new supply curve, to the left of the original one, intersects the new demand, to the right of the original one. The higher price clears the market and supply and demand are balanced.
Lesson Two: Prices in a non-competitive market with no government price controls are determined by the producer who has market power. In this case, the price is determined by the marginal revenue and the marginal cost of the dominant producer, not by supply and demand. Therefore, if OPEC, the cartel, has market power, we cannot use the competitive supply-demand analysis to describe the oil market. In such case, there is no supply curve. OPEC operates at one point, but not on a curve.
Lesson Three: Statistical analyses are useless when they contradict economic principles. Having a data set and fancy software does not make a person an oil market expert. Several statistical studies have concluded that OPEC is a market-sharing cartel. Perhaps. But how do you end up with a powerful cartel when the market is competitive and oil prices have been as low as $10 – as they were in the late 1990s? In fact, when the same logic is applied to non-OPEC producers, non-OPEC ends up being a more powerful cartel than OPEC.
Lesson Four: The ability of a cartel to influence prices is limited. OPEC cannot effectively curb increasing oil prices unless it has lots of excess marketable capacity. Further, it may not be able to influence prices when they are falling. The latter is true because competition among OPEC members and the need for oil revenues prevent many OPEC members from cutting production.
Lesson Five: Predictions based on outdated assumptions are naturally wrong. The International Energy Agency (IEA) predictions that some OPEC members, such as Saudi Arabia, will increase their production over the next two decades by 60 to 80 percent are unfounded. These expectations are based on outdated assumptions from the early 1970s. The IEA assumes that OPEC production will be equal to total global oil demand minus all non-OPEC production. In other words, IEA has estimated world demand and non-OPEC production based on behavioral and historical variables and then assumes, in a very primitive way, that OPEC will supply the rest! So much for scientific analysis. That’s the end of today’s lesson.
Dr. A.F. Alhajji is an associate professor of economics at Ohio Northern University.