October 1, 2003

Some of the weakness in stock prices earlier this week was blamed upon the surprise move by the Organization of Petroleum Exporting Countries (OPEC) to reduce oil production quotas by 900,000 barrels a day.  Can OPEC impact oil production?  Does such a reduction in production pose a risk to economic activity? And why do we tolerate a production cartel such as OPEC anyway?

Economists cannot easily forget 1973, when the Arab nations in OPEC denied the U.S. two million barrels a day in oil imports.   Gasoline lines formed, petroleum prices jumped, and a recession developed.  That recession spread throughout the world, eventually causing oil demand to fall, but the economic damage from the embargo was done. 

Ever since that time, the world has closely followed OPEC pronouncements on production restraints.  In recent years, however, OPEC has lost much of its sting.  Indeed, less than 25 million of the nearly 80 million daily barrels of oil consumed worldwide now comes from OPEC. 

In the short run, the demand for oil is price inelastic.  This means that prices must rise a multiple of the percentage decline in output to restore balance to oil markets.  We already have bought our vehicles, located or schools and jobs, and occupied our work places.   

Indeed, most of the short term adjustment occurs through the impact that higher prices have upon reduced consumer purchases.  As sales fall, jobs are lost.  That reduction in work leads to less use of petroleum product.  This is precisely what investors feared when they sold equities after learning about the OPEC decision. 

However, if OPEC is successful in reducing production by its intended goal, that would be less than 1.5 percent of the world's supply.  Assuming no increased production by other oil producers, a price increase of about 7.5 percent would be more than sufficient to restore balance to demand and supply in the oil markets.  (At an initial price of $27 per barrel, that would equate to a $2 increase in the price of a barrel of oil.)

Only Saudi Arabia, Kuwait and the UAB tend to abide by the production quotas.  Most other OPEC countries sell whatever they can produce.  Therefore, the actual reduction in OPEC supply probably will be less than half the intended amount. 

Also, any price increase will encourage other producers, from Colombia, Vietnam, Russia, some of the republics of the former Soviet Union, and even China to raise their petroleum production.  Though initially small, this supply response will increase the longer oil prices are being propped up by production cutbacks in OPEC.

In fact, OPEC argued that production needs to be cut back to forestall a sharp decrease in prices resulting from increased supplies. 

In the past year, despite oil production disruptions in Venezuela, Nigeria, and Iraq, prices per barrel only temporarily soared above the $22-$28 per barrel range that OPEC hopes to maintain.  Now that the Iraqi oil minister in the new coalition government argues that exports from that country will rise to more than 2 million barrels per day by next spring, OPEC saw oil supplies growing about 2 million barrels per day faster than demand. 

Just as a production cutback raises oil prices by a multiple of the percentage reduction in supply, a surge in production causes prices to fall by a multiple of the percentage oversupply.   Oil prices had fallen by almost $3 per barrel during September alone. 

Whether Iraqi oil production rises by that 2 million daily barrels remains to be seen.  (The administration's request for $20 billion to aid the reconstruction of Iraq suggests that Washington is not anticipating that amount of oil revenue next spring.)

Other ifs are how severe the winter weather might be, how rapidly the world rebounds from its recession, and whether production disruptions reappear in the producing countries that suffered problems. 

Which brings us to the final question.  Does OPEC matter that much?  The financial markets reacted as if it does.  In fact, the cartel is becoming increasingly irrelevant as production rises outside its control.  Despite the drop in stock prices, I am not changing my forecast because of this announced reduction in OPEC supply of petroleum. 


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