It’s Wednesday, so I have a couple of projects to discuss, and then some music. Many readers have emailed me asking about the OPEC+ cartel’s decision last week to cut crude oil production by 1.66 million barrels per day. Combined with the pre-October production cuts (2 million barrels per day), this pushed prices higher for a day or so, back above $80 a day. Many commentators immediately declared that this would drive inflation back up and force the central bank to step up interest rates. I disagree with these assessments. When analyzing cartel behavior (OPEC+ is one such organization), it is important to distinguish between price stabilization and price gouging activities. As I explain below, I believe OPEC+ will engage in price stabilization amid an expected decline in global crude oil demand. The risk is that demand will fall more than producers expect and they will have to cut output further. But even if the new price level remains unchanged, it will not actually trigger a new round of accelerated inflation.
OPEC+ Production Cuts – Questions?
On April 3, 2023, the OPEC cartel issued a press release following the so-called 48th meeting of the JMMC – 48th meeting of the Joint Ministerial Oversight Committee.
The committee is OPEC’s coordinating body.
One decision taken in liaison with Russia (making it OPEC+) was to make what they called a “voluntary production adjustment” – that is, supply reductions of around 1.66 million barrels per day, said to support “oil market stability” – aka maintaining a price floor to maximize profits.
Combined with the production cuts announced in October 2022, the cuts would reach 3.55 million barrels per day, or 3.7% of total world demand.
Why did they make that decision?
A cartel is an anticompetitive organization of suppliers (in any sector) that allows individual units to gain the benefits of output control and other techniques such as market share agreements, pricing, and rigging the bidding process.
The current OPEC+ decisions are the type of production controls that are typically used to push prices up or prevent them from falling below some expected threshold.
In the former case, as long as demand is relatively inelastic, organizations can in some cases drive up prices by restricting supply.
What does this mean in English?
Inelastic demand simply means that the demand for the good is not particularly sensitive to price, so when the price rises, there is little change in demand.
In this case, the cartel’s total revenue increases because they sell (say) the same quantity of product at a higher price, and as long as there is no corresponding increase in unit cost, the increase in revenue is pure profit.
I’ll come back to that as it pertains to the current situation.
Another motivation mentioned above is that supply constraints are used to prevent prices from falling below a certain level.
This is very important in the current situation.
The data used for the following figure comes from – US Energy Information Administration – and shows European Brent spot prices in USD/barrel from March 1987 to February 2023.
It reached a recent peak of $122.71 a barrel in June 2022 and is trading around $85 a barrel today.
Its most recent trough was on March 17, 2023, when the price was $72.77 a barrel.
On Friday (March 31, 2023), the spot price was $79.89 per barrel, and jumped to $85.23 per barrel within 2 days, and has since stabilized at that level.
The concern for OPEC+ is that irresponsible rate hikes by most central banks will depress global demand as the economy slips into recession, which will soon push prices below $80.
There are also concerns that raising interest rates will lead to bank failures (in the way we’ve already seen), which would lead to a GFC-like situation and dampen demand for OPEC+ oil.
Another point about production cuts is that they signal to financial markets that producers, not speculators, have the power.
Ahead of the OPEC+ decision, financial markets swooped in, trying to profit by shorting oil in the futures market.
They do so because they are betting that prices will fall further below $70 a barrel.
Speculators have plagued OPEC’s boss as they destabilize the oil market.
So by pushing for supply curbs, OPEC can prevent oil prices from falling, foiling short-seller bets.
This has to be applauded!
Another point — here we’re going back to the elasticity issue.
While OPEC+ wants to put a floor on oil prices in anticipation of lower demand, it also doesn’t want to exacerbate the negative impact of monetary policy shifts on demand.
That means the cuts are unlikely to be motivated by a desire to push prices to around $100 a barrel or higher.
Cartels know this has consequences they may not be able to manage.
1. Rising prices will further depress demand.
2. Higher prices will encourage non-OPEC countries to expand supply. OPEC currently supplies about 60% of the world’s crude oil trade.
Some non-OPEC countries (such as the United States, Canada, Norway) are large producers themselves, but they are also high consumers of oil, so their ability to export large quantities is limited.
U.S. shale oil still has huge potential, but further capital investment is required, and if OPEC+ engages in a massive price gouging campaign, shale oil will become more attractive.
3. Higher prices could lead to higher inflation and more interest rate hikes and lower overall demand for oil.
Is there a problem with production reduction?
I think it’s a price stabilization activity, not a price gouging activity.
The modest increase in prices since the decision is unlikely to have any significant impact on the oil-dependent nation’s inflation trajectory.
The only impact on that trajectory might be to delay the current decline in inflation for a longer period of time.
But that shouldn’t inspire the central bank to keep pushing rates higher.
It appears that central banks may finally be getting the message that they are overreacting.
Yesterday, for example, the RBA kept rates on hold while talking up future hikes.
They realize the damage from their decision is about to become severe (as more and more mortgage holders opt for historically low fixed-rate arrangements).
Given that the OPEC+ decision will likely only keep spot prices at a new level – a one-off effect – the flow into other prices will not accelerate.
Another point is – if the economy continues to slow down on the current trajectory – then OPEC+ may indeed find it difficult to stabilize spot oil prices above $80.
It is one thing to be able to manipulate prices through supply control, and quite another to maintain that manipulation when demand collapses.
This is the huge risk OPEC+ now faces.
On September 23, 2022, the Brent spot price was $84.87 per barrel.
OPEC then cut production by 2 million barrels per day, and the price will rise at $97.92 per barrel by October 7, 2022.
It held steady until early November, then spot prices fell as global demand fell.
This new production constraint is likely to happen again.
Uncertainty, however, has to do with China’s behavior as it boosts global oil demand after easing Covid restrictions.
We’ll see how it all plays out in the next few months.
My new podcast – Letters from Cape Town
Last week, I launched my new podcast – letter from the cape.
The background is our education—— MMTed – Now affiliated with 3CR Melbourne, a community radio station in Melbourne.
As part of this relationship, MMTed is assisting with a new radio program – radioMMT – Hosted by Anne Maxwell and Kevin Gaynor, every second Friday from 17:30 to 18:30.
What I’m contributing now is a fixed segment from their show.
The topics I cover are general but sometimes given specific local context, taking into account the location of the radio station.
Their topics focus on the application of Modern Monetary Theory (MMT) concepts to real-world contemporary problems.
While the segment airs regularly in Melbourne, I’ve decided to make it available as a podcast through my homepage so it can reach a wider audience.
A new podcast is released approximately every two weeks.
Music – YMO
Here’s what I’ve been listening to this morning at work.
I haven’t heard = yellow magic band – Been a while, but reloaded it on my iPhone the other day to remember the great music they made as an experimental band in the 1970s
The death of the keyboard player reminded me – Ryuichi Sakamoto – Turned 71 last week (March 28, 2023).
Unfortunately, two of the three YMO members are now gone – we’re all getting old.
drummer- Yukihiro Takahashi – Died earlier this year (January 11, 2023), Sakamoto passed away last week.
Sole Bassist – Hosono Haruomi – survived, he was several years older than the separated members.
They were pioneers of electronic music, creating very complex sounds using the famous ARP Odyssey, Prophet 5 and Yamaha C-80 synthesizers.
I first heard the band when they released their self-titled first album in 1978.
But the second album was the best, the famous song – Rydeen – on the second album released in 1979 – solid survivor.
I guess it’s a sign of the times that musicians who used to be a huge part of my life are now dying!
Enough for today!
(c) Copyright 2023 William Mitchell. all rights reserved.
