OPEC Channels Adam Smith

Reports that OPEC and Russia are going to end their two-year agreement to limit oil production is an act of necessity and a simple manifestation of an Adam Smith economic truism. In Adam Smith’s 1776 Wealth of Nations, he wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”.  The decisions to terminate the agreement reflects the reality that OPEC is not really a cartel.  OPEC isn’t what it used to be and never was.  The media and policy makers called it a cartel but in reality it has mostly been a price taker; not a price maker.

The 2016 Agreement to limit production was an implicit admission that Saudi Arabia’s attempt to maintain market share in the face of growing US production was a flop that sowed the seeds of its own demise.  The fact that it appears to have worked for two years may be a reflection of technical constraints on cheating by other members as well as the collapse of Venezuela’s oil production.

OPEC leaders know that rising oil prices zre a strong incentive for US producers, especially shale producers to step up drilling to increase revenue by taking advantage of higher prices.  They also know that when prices get past $70 per barrel, there are incentives to invest in new technology if it appears that prices will not soon retreat.  In addition to Adam Smith’s economic principle is the economic reality that the cure for high prices is high prices. High prices bring about more supply and when supply exceeds demand, prices drop.

Perhaps more important, as prices recovered from the lows of $40 per barrel, the incentive for members to cheat grew stronger.  Cheating on quotas has been a characteristic of OPEC members for decades. Although today, the number of members who can cheat is fewer than when OPEC represented over 50% of world output, the incentive remains strong for those that can.

Cheating aside, the real reason was put into clear perspective by a recent piece by the Wall Street Journal.  “The fact that U.S. production call fill the gap left by OPEC’s sick men … means that continuing to curtain output will benefit American producers.

Oil Price Forecasting: It’s a Mug’s Game

To paraphrase Ralph Waldo Emerson, foolish precision in the face of uncertainty is the hobgoblin of energy forecasters.  Much has been made recently about how energy forecasters—private and government—seriously underestimated the large increase in crude oil prices that has taken place in recent months.

What is surprising is that so many have been surprised and that so many so-called analysts continue to make point estimates. Crude oil prices have never been easy to forecast very far in the future, except under very stable conditions. And, that difficulty in forecasting also applies to oil companies who have a very strong economic incentive for greater accuracy.  The problem is that there is a great deal of uncertainty in the political, economic, and technical factors that can drive price.

In spite of sophisticated models, forecasters too often assume that the near term will be like the present at that influences how they treat economic and political factors.  Most important, point estimates for uncertain variables guarantees that an estimate will only be correct by luck.  How much the dollar will strengthen or weaken, how companies will respond to rising oil prices, whether shale producers will start drilling or maintain fiscal discipline, how much global growth will occur, whether OPEC producers begin to cheat and how much, how much Iranian and Venezuelan production will fall, and the impact of political risk are all factors that work against point estimates.

Bill Gilmer, Director of the Institute for Regional Forecasting, in a recent Forbes article made the obvious point that the world is dynamic; forecasts are static in that they are based on information available at the time they are made.  It is one thing to use available data to look ahead; it is something else to pretend to divine the future with relative precision.  Gilmer points out that “it doesn’t take big headlines to upset the forecast. The global crude oil market depends on the politics of dozens of producing countries, economic cycles in consumer countries and a vast infrastructure of pipes, ships and refineries. Even if we account for the known issues correctly, we could list 1,000 or more low-probability events that could push our forecast off course. … if these events are independent of each other, the chance that at least one will significantly and unexpectedly affect the oil market within a year is 1-(.999)1000 or 63.2%.”

Oil price forecasts would be more credible if they provided ranges reflecting uncertainty.  Otherwise, forecasting is a “Mugs Game,” an exercise in futility.