Why Don't the Oil Countries Make a Cartel

[randomep]

One thing I can't understand about oil prices. I hope someone here can give me a simple answer. Thanks in advance.

 

The price of oil is determined by the price at the margins.  So the top half dozen oil producing countries produce half the oil in the world. Why won't some of them that aren't scrupulous get together and just reduce their production a bit. Choking off production by say 1M barrel a day would jack up the price significantly right?  I mean saudi arabia and I guess russia have very cheap production, so nearly all of their oil price per barrel is their profit. In the case of russia it either goes to the companies (which are in cohoots with the government) or it goes to government in the form of taxes.  So even if their volume is cut by half if they can triple the price of oil from $45 to $135 they still come out with higher revenue and profit right? So I am just puzzled why don't Russia cooperate with OPEC or join them.

 

Maybe there is something in the dynamics of market forces that I am not getting.......

 

 

[Cardboard]

Because their cartel would not be a real cartel or not having control over all sources of production. So it is doomed to fail as OPEC did fail. People found oil elsewhere, even if at higher cost, and developed new sources of energy. And on top of that, these guys have no discipline among themselves!

 

Some have said that Saudi Arabia is smart. IMO, they are the dumbest operator alive.

 

In a capitalist system, low cost producers expand rapidly during good times, then contract less than high cost producers in bad times. Saudi Arabia has done just about the opposite ensuring two things:

 

1- Less revenues over the life of their oil fields: sell fewer barrels during periods of high prices and more during periods of low prices.

2- Attract competition from all corners because of the supply crunches that it created.

 

If the Saudis had rapidly expanded their low cost production in 2005-2008 to prevent the large spike at over $140 U.S./barrel, it would have slowed down significantly the development of shale, solar and all other competing sources of energy. Their market share would have also grown significantly.

 

Instead they did let it happen, the world got scared and has and is developing a multitude of new sources of energy.

 

The same happened between 2010 and 2014.

 

Now, they have tried to crush their competitors by flooding the market at the bottom which will ensure another supply crunch down the road. And the lowest amount of revenues possible for themselves for about 2 or 3 years.

 

It does not take a genius to figure out that fusion is in our future. Solar production costs have been declining for years. And whenever oil prices went up too much, somebody found oil in non-OPEC countries.

 

So knowing that new sources of energy at lower costs will inevitably be developed in our future. Even a 6 year old kid would know about that! Would it not have been in their best interest to prevent scary energy price spikes, increase their production to say 15 or 20 million barrels/day and enjoy more stable revenues all along while slowing down the interest of new competition to form?

 

Maybe that they are getting it now but, they surely didn't and with the genie out of the bottle, competition from all sides will be back again.

 

Cardboard

 

 

[randomep]

 

 

 

Cardboard, so you are saying it is market forces.

 

Thinking down that path I think I have the answer that makes me less perplexed.

 

The futures market acts like a low-pass filter on prices. i.e. it has a dampening effect on sudden changes in prices that the consumer sees.  By consumers I mean the big buyers/wholesellers of oil not car drivers.  So if a cartel chokes off supply consumers don't feel it, people who trade oil futures will. Once the choking starts, the market has enough time to create more supply. Once the lower price futures contracts runs out for the consumer, the new supply has come online which naturally counterbalances the choking by the cartel.

 

 

[netnet]

Well, OPEC is a cartel.  The question is why is the cartel not working. Well history shows that cartels always collapse.  They tend to have relatively short term effective lives. 

 

I would suggest that you have to add in mental models from game theory as well as market forces.

 

There are political factors at work here as well.

 

• First of all it is pretty hard to cooperate with your fellow cartel members when you are in a proxy war with one of them in Yemen and you believe that they are fomenting a fifth column in your country (Saudi Arabia) or you believe that the other country is oppressing your co-religious (Iran). Whether true or not, that is what the ruling princes and mullahs believe.)
  
• Given that background the Saudis do not want a post sanctions Iran, their regional rival, benefiting from maximum oil revenues
  
• Saudi Arabia used to be the swing producer willing to throttle their own production but for the first two reasons and their own exploding population and budgetary needs do not want to be that producer
  
• Without a swing producer and no enforcement mechanism, the incentives are to produce the incremental barrel. Classic problem similar to the prisoner's dilemma.
  

[Ballinvarosig Investors]

You have to add in mental models from game theory.

 

There are political and economic factors at work here. 

 

• First of all it is pretty hard to cooperate with your fellow cartel members when you are in a proxy war with one of them in Yemen and you believe that they are fomenting a fifth column in your country (Saudi Arabia) or you believe that the other country is oppressing your co-religious (Iran). Whether true or not, that is what the ruling princes and mullahs believe.)
  
• Given that background the Saudis do not want a post sanctions Iran, their regional rival, benefiting from maximum oil revenues
  
• Saudi Arabia used to be the swing producer willing to throttle their own production but for the first two reasons and their own exploding population and budgetary needs do not want to be that producer
  
• Without a swing producer and no enforcement mechanism, the incentives are to produce the incremental barrel. Classic problem similar to the prisoner's dilemma.
  

I don't really buy that angle. No one is going to beggar themselves just to land a blow on a political rival.

 

I think the issue is that so many of the major oil producing nations are running deficits. When you're a dictator and you've bought the support of the nation through high public spending, then you have no choice but to keep that taps on, otherwise you are literally dog meat.

[netnet]

I don't really buy that angle. No one is going to beggar themselves just to land a blow on a political rival.

Really, you believe that we are all rational, well I have some Enron stock here to sell you.

 

But seriously, many a war has been fought that has beggared the combatants.

 

On a micro level, I have seen this myself. Look at family estate fights or divorce courts. I have personally seen two litigants spend over 90% of the value of the estate suing each other. Now imagine that cat fight spread over 1000 years with a 'religious' divorce, where you believe that your opponent might love to kill you and all of your kin. 

 

 

 

And then there is the ethnic component, whew.

[rukawa]

I think one of the huge difficulties with cartels is that its difficult to actually monitor how much cartel members are selling. Each member of the cartel agrees to certain limits. But its difficult to know whether they are making sales on the side that you don't know about. A real organized cartel would need enforcement mechanisms like fines and permanent inspectors in each country.

 

De Beers has an even better model which is that they forced all producers to go through the De Beer's distribution channel. This effectively allowed De Beer's to control how many diamonds got sold and to whom. This is a highly efficient sensible way to implement a cartel but it only worked for diamonds because De Beers had ways of disciplining producers who tried to operate outside their system by flooding the market with similar types of diamonds.

[UNF2007]

I think one of the huge difficulties with cartels is that its difficult to actually monitor how much cartel members are selling. Each member of the cartel agrees to certain limits. But its difficult to know whether they are making sales on the side that you don't know about. A real organized cartel would need enforcement mechanisms like fines and permanent inspectors in each country.

 

De Beers has an even better model which is that they forced all producers to go through the De Beer's distribution channel. This effectively allowed De Beer's to control how many diamonds got sold and to whom. This is a highly efficient sensible way to implement a cartel but it only worked for diamonds because De Beers had ways of disciplining producers who tried to operate outside their system by flooding the market with similar types of diamonds.

 

 

Agree with what other people have said, I think the answer is explained best with game theory. To illuminate further there is actually an example in the CFA course materials that covers this exact topic. The answer as to why the cartel doesn't work well is that based on game theory it winds up being in everyone's best interest to cheat, which winds up creating an overall non-optimal result.

 

Here is a link that explains it better

http://www.investopedia.com/exam-guide/cfa-level-1/microeconomics/oligopolies.asp