We call OPEC a cartel, but if it really had control over prices, how could it let them swing so wildly?
The answer is that even a cartel has to deal with market forces. With prices down about two-thirds from their July peak, OPEC has called an emergency meeting tomorrow to hash out a plan to stop the slide.
OPEC does pursue policies that raise the world price of oil - most notably by restricting access to the world's lowest-cost oil and gas fields. But over a period of time, even a cartel has to deal with the realities of supply and demand. If it jacks up prices too high, people cut their use or find alternatives. In the well-worn phrase of former Saudi oil minister Zaki Yamani, the Stone Age didn't end because the world ran out of stones. Then again, the Stone Age had a pretty good run.
It isn't easy for a cartel to figure out the price at which it's doing more harm to its interests than good. In his book "Genie Out of the Bottle; World Oil Since 1970," the famous Massachusetts Institute of Technology economics professor M.A. Adelman wrote that, "Like soldiers peering into the fog of war, sellers do their best with what information they have. Even before a situation has worked itself out, it is already changing."
He said that to describe OPEC around 1970. But it seems like a good description of the organization going into tomorrow's meeting. OPEC is trying to figure out how much production it needs to close off in order to bolster prices. But its information about world demand, world economic growth, and the response of non-OPEC countries to falling or rising prices is imperfect.
In October, OPEC cut its oil output by 1.5 million barrels a day. That seemed like enough to do the trick. But then the world economy continued to collapse, and so did oil prices. Tomorrow OPEC will try to take around 2 million barrels a day off the world market. Maybe that will work. Maybe it won't.
It's easy to imagine either outcome, successful or unsuccessful.
In the first scenario, OPEC's new production cut deal works. Gradually the size of world inventories, which have grown to 57 days' supply, return to a more normal level of 52 days and prices stabilize. This is basically what happened in the winter of 2006-2007, when oil prices that had been over $75 in mid-2006 tumbled down to around $50 a barrel. OPEC cut production, then cut production again; then prices stabilized and began to climb (and climb, and climb).
There's another scenario, though. In this one, the world economy stays weak. OPEC sticks to its lower production target, but prices stay low. How could this happen? One theory about international oil prices suggests that the price is more sensitive to the amount of excess production capacity rather than to the amount of oil in inventory. In this theory, the excess production capacity acts a bit like inventory in the ground (as opposed to in tank farms or floating tankers). Earlier this year, the world's capacity to produce oil fell to less than 2 million barrels a day, virtually all of it in Saudi Arabia. But new OPEC cuts could bring the world's idle oil production capacity to 4 million to 5 million barrels a day.
Recently Saudi King Abdullah, who is used to issuing edicts, said that the price of oil should be $75 a barrel. But this is an area where issuing an edict may not be enough.