OPEC: The Writing on the Wall

The thirteen nations that form OPEC are in for some very hard times and they know it. In an attempt to keep a floor on oil prices, OPEC announced they would slash output by 1.5 million barrels per day - the largest production cut in nearly 8 years. Unfortunately for OPEC (but not for us) they have little chance of success. Unless things change dramatically, they are about to fall victim to the inherent weakness of all cartels: the near irresistible urge to cheat. Here's how likely plays out.

In normal economic times, the purpose of OPEC is to artificially restrict the supply of oil from the market. Because demand outstrips supply, the price oil rises. As long as supply is restricted, the price will stay higher than it otherwise would be. In bad economic times (like now), OPEC tries to restrict supply in order to keep members from oversupplying the market and driving prices dramatically lower.

However, the nations of OPEC are hugely dependent on oil revenue. According to calculations I made based on information i gleaned from the CIA Factbook website, oil accounts for more than 70 percent of the government revenues in OPEC countries, more than 80 percent of their foreign exchange earnings and more than 40 percent of their GDP. Furthermore, these countries engage in huge social spending to head off latent civil unrest stemming from the relatively poor living conditions of their rank and file citizens.

As demand falls, cartel members race to outproduce each other. They have no choice. They need the foreign exchange to pay for imported consumer goods and they need budget revenues to pay for social programs and all this while their GDP is collapsing. It takes a very strong regime to tell its complaining citizenry to take a hike while they have plenty of oil to exchange for the things they desperately need.

The bottom line for the oil consuming world is that oil and oil-products are likely to get a lot cheaper in coming months. This is a silver lining to the otherwise difficult economic environment we face and it provides us with a unique opportunity to move the economy to greater energy independence before the inevitable resurgence in oil takes place.