April 29, 2013 12:53PM

What to Do about OPEC?

Cato hosted a policy forum last week (which you can watch in its entirety if you missed it the first time around) to discuss a new paper released by Security America’s Energy Future (SAFE).  The paper – written by long-time friends Andy Morriss and Roger Meiners – argues that there is a consensus among academics who have studied OPEC.  The consensus?  The cartel is responsible for less crude oil on the market than would otherwise be the case (which means higher prices than would otherwise be the case) and for the bulk of the price volatility we find in crude oil and, thus, gasoline markets.  “The international market for oil is not a free market” they conclude.  “The global oil market deviates in important ways from the competitive model and that these market anomalies have significant economic impacts and so are relevant for policy makers.”

While Morriss and Meiners would thus seem to invite politicians to act, they offered no agenda of their own.  That’s where SAFE comes in.  FedEx’s Fred Smith, who co-chairs SAFE’s Energy Security Leadership Council, argued at the forum that the federal government needs to respond to OPEC’s machinations by (1) achieving energy independence for North America (a goal I’ve been quite skeptical about in the past), (2) establishing tough energy efficiency standards for a whole host of goods, but most particularly, for U.S. automobiles via CAFÉ standards (an agenda that most economists would reject in favor of accurate price signals), and (3) subsidizing R&D in order to find alternatives to oil in transportation markets.  SAFE discusses this agenda more robustly in their “National Energy Strategy for Energy Security, 2013”.

SMU’s James Smith – one of the most prominent energy economists who works in this field – was on-hand to offer what I think was a compelling rebuttal to the central arguments forwarded by the Morriss and Meiners study.

Smith argued that, contrary to Morriss and Meiners, there is simply no consensus in the literature about what impact, if any, OPEC has on the world crude oil market.  One can find empirical analyses demonstrating that the cartel has zero impact on crude oil prices and production relative to what would be the case absent the cartel; that it’s not the cartel per se but Saudi Arabia that exercises the market power at issue; and that the cartel does indeed restrain production but not in the manner popularly thought.  That is, the production restraint is primarily in the form of underinvestment in upstream production capacity, not in cutting back production at opportune times to drive up prices.  Which of these narratives – if any – is closest to the truth is, according to Smith, unclear despite 40 years of serious study.  While most academic observers probably believe that OPEC does indeed restrain production below what a perfectly competitive free market might yield, they can’t conclusively prove it.

Smith further argued that oil price volatility has little to do with the cartel; it has to do with relatively inelastic supply and demand.  Small changes in supply or demand have a major impact on crude oil prices with or without the cartel, and those “small changes” happen all the time.  To illustrate his point, he noted that natural gas markets, which have similarly (relatively) inelastic supply and demand, yield gas prices that are even more volatile than oil prices … and there’s certainly no “gas cartel” that one can blame for that.

Smith concluded with a powerful point: if a cartel exists and successfully reduces supply, the cartel members will enjoy excess profits, or “rents” in the jargon of economists.  Should those rents go instead to consumers?  As consumers, of course, we think that it is unfair that the rents (the difference between the world crude oil price and the cost of production plus a normal profit margin) are denied us.  But beyond the fact that we benefit, is there any objective reason to believe that our claim to those rents are morally stronger than the producers’?

Cato adjunct scholar Richard Gordon offers the most powerful response to the Morriss & Meiners paper; “so what?” Whether we like or not, OPEC exists, it has market power, and it is in their rational self-interest to use it. Given that we cannot change those facts, how can we best respond?  By leaving the market alone.  OPEC-driven oil scarcity will produce higher prices which will, in turn, induce the necessary amount of non-OPEC exploration and production, energy conservation, and investment in alternative fuels.  Market actors – if they choose – can hedge against price volatility by signing fixed price, long-term contracts, by taking positions in the futures market, or by investing in energy efficiency.  The contention that government will act more efficiently in these pursuits than will the market only holds (maybe) if we can find significant market failures in non-OPEC oil and gas production, energy consumption, or alternative fuel markets … and we cannot.

Unfortunately, these issues are muddied by statements such as Morriss’ and Meiner’s contention that “The international market for oil is not a free market.”  This is the standard cry of those who wish to justify intervention.  After all, if it’s not a free market, leaving it alone does not yield efficiency; only intervention – ideally, to make it a free market, or less ideally, to dictate energy production and consumption patterns reflecting what we think would follow from an OPEC-free market – can hope to do that.  But think about it.  The international oil market is extremely competitive.  Price signals change minute by minute and quite accurately reflect variations in supply and demand.  At worst, the market simply has less oil to distribute because OPEC holds back production.  The market qua market, however, works fine.