Chocolate and Gold Coins

Sunday, August 28, 2005

OPEC Loses Control

OPEC, the oil cartel, has temporarily lost control of world oil production. I say temporarily because I have no doubt that OPEC could quickly increase production by simply drilling more oil wells and sucking the oil out more rapidly.

But this raises a question: “If OPEC is making more money with the higher price, why would they want to increase production and reduce the price?” The answer is that letting the price of oil rise is like taking a submarine down to see how far it will go before the water pressure crushes it. It is a highly dangerous game. I think that OPEC must be very concerned that they might just spawn a monster of an alternative fuel technology.

If you control the world oil production and you want to maximize the present value of your total net revenue stream, then how do you set your price? The answer is that you would want to set the price just below the price where it becomes profitable for others to invest in alternative energy sources. If you set the price too high for too long, you run the risk that some exciting new energy alterative will come along and then you would be force to sell your oil at a discount later.

This really isn’t so unlikely as it might first seem. Markets don’t react instantaneously to changes in prices. It may take a few years for investments to come to market. But once they do, there may be learning by doing and the cost of new technologies may go down over time. This, in fact, typically happens with almost all markets. The more you produce a commodity, the better you are at producing it, and the cost falls.

My guess is that OPEC never intended the price of oil to get this high and is now a little worried. If they do not bring the price down in the next year or so, they will rapidly lose market share. They will lose it to coal, to alcohol, to synthetic oil, to compressed natural gas, and to many other products that are not even on the market yet.

Now you might think that OPEC really doesn’t care if they lose some market share since they will sell all of their oil anyway. But losing market share means selling their oil more slowly and that means a lower present value for the revenue stream. Also, they run the risk that this will accelerate the process of developing alternative energy sources, and learning by doing might cause the alternative fuel sources to really fall in price.

My prediction: oil will be below $60 a barrel by June of 2006.

Here is a curious thought: if the steam engine had received another 70 years of technological innovation, would steam power have been more economical than diesel electric power for locomotives and ships?

4 Comments:

  • Well, if you are right, you can make quite a bit of money by shorting some futures

    By Anonymous Ravikiran, at 3:25 AM  

  • Hi Ravikiran
    Thanks for the link.

    Well, not that much money unless I buy on the margin, and then it become a high stakes gamble. To tell the truth, I don't have enormous trust in the Saudis to act in their own best interest. After all, didn't they lose control of the price in the first place?

    By Blogger Michael Higgins, at 6:09 AM  

  • Michael - I agree that the oil prices have been out of control of the OPEC and that they will try to rein them in.... but I think that an alternative energy source should be round the corner (in a commercial sense) anyway.... what do you think?

    By Blogger @mit, at 5:26 PM  

  • Hi @mit
    I think so. Compressed natural gas is already beginning to take some market share. Coal is very inexpensive and electicity is relatively inexpensive. All that is necessary is a better car battery and a better way to charge up an electric car or a hybrid with a battery.

    By Blogger Michael Higgins, at 6:33 AM  

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