Why OPEC Needs America Fat and Happy

Kevin's explanation of why oil prices are cause for severe concern is vintage Drum: informative, well-written, and containing a graph. Read it. But I think he gets something wrong in his evaluation of OPEC's incentives:

OPEC has the capacity to supply about 30 mbd. Question: what incentive do they have to continue pumping this amount? Economically, they have very little. If they cut production by 20% (6 mbp), that would reduce global supply to 78 mbd. Prices would immediately double to around $100/barrel, maybe even higher, since there would be no other source to make up the shortfall. As a result, OPEC's revenues would skyrocket — not all at once, since most oil is delivered under futures contracts, but soon enough. In addition, most Middle Eastern fields are being overproduced right now, so cutting production would have beneficial long-term effects as well.

Kevin goes on to argue that Saudi Arabia used to be a buffer against this because they could simply flood the market with cheap crude, but they don't have such powerful production capacity anymore and so aren't as able to regulate the industry*. In addition, Iran and Venezuela could care less about a recession in the West, so they might go for the short-term profits over our economic stability. The counter-argument is our capacity for a military response, but we can't really do that right now thanks to our deployment in Iraq, so what's to stop them?

Well, lots. Despite the skyrocketing costs of oil, the market hasn't priced oil commensurately with its finiteness. That'll change reasonably soon (as Kevin notes, the question is whether that happens gradually or suddenly), but it hasn't yet. That undervaluation of oil has allowed most economies to stroll along without really worrying about what comes after petrol or getting serious about reducing their reliance on it. An oil shock changes all that. Suddenly, life after cheap oil becomes a policy reality -- which is the worst possible scenario for OPEC, though probably one of the best for America.

There are a lot of ways to reduce our economy's reliance on oil. We can't yet end our dependance (at least, nobody but Amory Lovins seems to think we can), but we can reduce our usage in a hurry. There's precedent for that -- when OPEC tried to jack up prices in the 70's, they, not we, turned out the losers. Between 1977 and 1985, we cut our oil usage by 17% while growing our GDP by 27%. Not too shabby. During that period, oil imports fell by 50%, and imports from OPEC by 85%. It hurt, sure, but them more than us.

So though it'd be painful, we could break OPEC. Arab economies are too reliant on oil to shut off the spigot entirely, and the American economy is too energy inefficient (meaning we've got room to decrease demand) for OPEC to believe they can take us. The truth, though counterintuitive, is that we have more flexibility in our demand than they have in their supply. A serious, multibillion dollar initiative to increase public transportation and strongly encourage the widespread adoption of hybrid cars could probably take care of what OPEC could throw. To be clear, it wouldn't be fun, but we'd win that confrontation -- Arab economies are simply too oil dependent**.

But there's a more serious reason OPEC doesn't want an oil shock. Peak oil, depending on who you listen to, is -1 to 30 years away. Somewhere in that time period, industrialized and industrializing countries are going to have to figure out how to create a post-petrol economy. There's some question as to whether this is possible (I think it is), but there's certainly a chance that a massive investment in finding new energy sources and a huge push to reduce demand will create a successful changeover. OPEC can't take that chance a day before it has to. The moment we get serious about energy independence, long-term demand plummets. It'll do that anyway, but OPEC wants that to happen when supply is plummeting too, not while a bunch of accessible and sellable crude remains in the ground. Essentially, they want us to move on only once their reserves runs out, they don't want a skittish world market to flee from oil and find other solutions thereby rendering OPEC's underground petroleum worthless.

So OPEC's long-term incentive is to keep oil prices stable and delay the reality-check for as long as possible. All things considered, that's a bad strategy for the rest of the world -- the more crude still in the ground when we decide to change our energy economy, the more time and breathing room we have to come up with solutions. That's why energy independence is a "the sooner the better" kinda thing. Not only do we want OPEC's buffer, but with non-OPEC oil either peaking or already peaked, the quicker this changeover happens the less it needs to happen on OPEC's terms.

Politicians don't want to make the hard, painful choices that will lead to energy independence, so they don't. But if OPEC created an oil shock, the pain would have already come, the public would be clamoring for solutions, and Washington would have a lot more room to craft tough policy. So an OPEC led oil crisis would only hasten their economic obsolescence -- it's the worst economic move they could make. And while Venezuela and Iran will never be mistaken for superbly-run economies, they're not suicidal, either. Ending cheap oil, for them, would be suicidal. Considering the benefits of moving from petrol sooner than later, some (though not too much) demonstration of OPEC's instability would actually be a boon for our economy because it'd force us to evolve while we can still do it on our terms. Nevertheless, I don't think it's going to happen.

* He also mentions terrorism which, unfortunately, I've got no optimistic counter-argument to. A single act could throw the world economy into recession -- it's really very scary. Head here for more on it.

** It's possible that OPEC could make up some of the slack in China and India, but neither can currently come close to our demand.