OPEC nations try to flex their old muscles

By David DeRosa

NEW YORK (Bloomberg): The Organization of Petroleum Exporting Countries (OPEC) and four non-member oil-producers ratified an agreement last week to remove about 2.1 million barrels of crude daily from the world market in hopes of boosting its sagging price.

Anticipation of such an accord has helped lift the price of oil about US$4 a barrel since mid-February. Longer term, it is hard to see how this ploy could have any enduring price impact as OPEC accounts for just 40 percent of world oil supply.

Here we go, right back to the classic economic theory of cartels. The first principle is that a cartel can raise the price of its commodity only if it can enforce production restrictions. But the incentive for cartel members themselves to cheat by exceeding their quotas is economically compelling. Who would be the wiser if a little extra oil just happened to be loaded onto a tanker now and then?

The cartel also has to worry about non-cartel members doing the same thing -- namely responding to the higher price by increasing production.

So the outlook isn't particularly good if the cartel, by its own device of restricting production, is the sole cause for the rising price of oil. On the other hand, if oil is rising because demand has increased, the cartel may appear to be effective even though other reasons are actually the causal factors.

A major loser when oil prices increase is Japan. The country, as is well known, is totally dependent on imported oil. If crude rises further, this has the makings of a serious kick in the teeth for Japan, which is trying to shake off very serious economic troubles. Higher prices won't do Korea or Southeast Asia any good either.

Some non-OPEC, non-cartel nations like Britain will benefit, and it should be noted that the pound has risen 2.5 percent so far this month. Sterling has always been in part an oil play because of Britain's North Sea oil resources.

The big beneficiaries are the major exporting nations -- Saudi Arabia and other Gulf countries as well as some African and Latin American oil producers. And brother, let me tell you those folks have been hurting, ever since the 1980s "oil glut."

Here are two numbers to contemplate in the economics of Saudi Arabia: $45 a barrel and 12 million barrels a day. That was the export price and volume Saudi Arabia enjoyed in 1980 when it was busy at work designing and building an infrastructure and grandiose development projects. That's also when the Saudis went "down-stream," investing in petrochemical plants and other assorted industries that use oil and natural gas as feed stocks.

Back then, the Saudis also decided to make a heavy investment in desert agriculture. They wanted to grow wheat in enormous quantities by pivot irrigation.

This was in part an overreaction to the Ayatollah Khomeini who had recently driven the Shah of Iran from power. Khomeini actively sought the overthrow of the Saudi royal family. It was also at this time that late Egyptian President Anwar Sadat made peace with Israel. The Saudis broke relations with Egypt over that treaty -- the Camp David Accord.

Feeling boxed in on the east and west, the Saudis began to think like survivalists and turned to agriculture. It was a financial disaster.

Too bad they didn't leave all that agriculture money in the U.S. Treasury market (their favorite investment back then). Or even better yet, too bad they didn't buy a large portfolio of U.S. common stocks. That money would have come in handy today.

I can tell you from personal experience that the only thing the Saudis worried about in 1980 was that some day, maybe in a few hundred years, they might run out of oil. To make things ultimately worse, Saudi proven reserves seemed to be growing without limit because even in years of peak production, new proven reserve finds exceeded the amount of oil coming out of the ground.

Of course what the Saudi planners never dreamt of was that both the price of oil and the quantity that they could sell would drop.

Now, the Kingdom is selling oil for about $15 a barrel and the total export market for Saudi crude is a little less than eight million barrels a day. It has been as low as four million. Now that is one hell of a drop in national income.

The writer is president of DeRosa Research and Trading and an Adjunct Finance Professor at Yale School of Management. The opinions expressed here are his own and don't necessarily represent the judgment of Bloomberg LP or Bloomberg News.