Chocolate and Gold Coins

Friday, May 19, 2006

OPEC Loses Control Again

Last August I wrote:

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.

I went on to predict that the price of oil would soon be under $60 a barrel.

Well, at first, it seemed like I was right. The price of oil fell and gasoline prices came way down. It seemed like the spike in price was just an aberration and OPEC still controlled the price.

But the price of oil has headed steadily upwards lately. Today I read this.

I wonder if perhaps the assumption that OPEC still has 10 to 15 years of reserves is correct. Perhaps they have less. This might be like the slog overs of a cricket match: dwindling resources leads to a “go for broke” attitude. If you have only 5 years of oil left then why not get as much out of that as you can? By the time some exciting technology comes in and takes over, you made your money.

Another possibility is that it might be worthwhile to purposefully let the price spike and fall many times. During the spikes, you make large profits. During the falls, you put any competing technology out of business. Investors prefer to invest in venture with more certain returns. Creating uncertainty helps scare off investments in alternative energy.

I’m not convinced about this argument. I think that the longer the price stays above $60 a barrel the bigger the risk that oil will be replaced by something. But I cannot deny the possibility that the price of oil might spike at over $100 a barrel. But I still think that OPEC will bring the price back down under $60 soon. But it will be interesting to see what happens in the next two months.


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