By Rok Spruk, on September 21st, 2010
Recently, the Organization of Petroleum Exporting Countries (OPEC) celebrated its 50th anniversary (link). The organization was founded in 1960 with the purpose of regulating world’s oil prices and controlling the supplies of oil. Currently, OPEC controls 80 percent of world’s proven oil reserves and its 12 member states oil production capacity accounts for 40 percent of world’s total oil production.
OPEC’s oil production and the world economy
Source: The Economist ( link) As a profit-maximizing monopolist, OPEC is faced with a downward sloping demand curve and upward sloping marginal cost curve which represents the market supply curve of the orgaization’s 12 member states. As a profit-maximizing agent, OPEC countries equate marginal cost of production and marginal revenue from oil supplies and thus extract the entire consumer surplus from oil importing countries such as the United States, Japan and the European Union. There are several plausible explanation of OPEC’s monopoly power in the world oil market. First, oil is a good with no close substitutes. Thus, the price elasticity of oil demand curve is significantly price inelastic. The average empirical estimate of the world price elasticity of demand for oil is -0.4, suggesting that a 10 percent increase in the price of oil would, on average, reduce the market demand for oil by 4 percent, ceteris paribus.
The relationship between the total revenue of the monopolist and the elasticity of demand suggests that the unit elasticity of demand is the revenue-maximizing point elasticity of demand for the monopoly firm such as OPEC. As the graph shows, OPEC’s price spikes occured mostly during external shocks such as the 1973 oil shocks, Arab-Israeli war and the recent financial crisis. The spikes in the world price of oil reflected the pure logic of OPEC’s cartel. By pushing the price upward, OPEC countries realized that, in the short run, the price elasticity of demand for oil is even more inelastic, thus reducing the consumer surplus of oil importing countries while expanding the producer surplus of OPEC member states.
The strategic behavior of OPEC mostly depends on the nature of external shocks affecting the production capacity and reserves of world’s oil supplies. During political conflicts, the short-run demand for oil spiked and, therefore, the price elasticity of demand for oil decreased, increasing OPEC’s short run producer surplus. Thereupon, OPEC member states set oil production quotas which exactly reflected the organization’s intention to extract the entire consumer surplus from oil importing countries. Also, during the pre-2008 economic boom, the economic growth in emerging markets further inflated the world price of oil since the OPEC’s short run production capacity outpaced the quotas set by the organization. But during the recent financial crisis, the short-run response of OPEC has been the reduction of per barrel oil price as an strategic step towards maintain the stability of market demand for oil. During the recent crisis, personal consumption and incomes have fallen substantially and therefore, assuming the positive income elasticity of demand for oil, the world demand for oil decreased considerably. The change in the aggregate consumption of oil has led to relatively more price elastic demand for oil. Partly, the increase in the price elasticity of oil is explained by the technological innovation and market access to long-run substitutes of oil such as fuel-efficient and electric vehicles and electric cars.
The technological development of fuel-efficient vehicles has decreased the monopoly power of OPEC by increasing the price elasticity of demand for oil due to the availibility of closer substitutes. In the follow-up of the financial crisis, the OPEC set the per barrel price of oil at $75. Given the downward sloping market demand curve, the short-run oil consumption increased and OPEC thus raised the relative price of oil’s substitutes since it acknowledged the switching costs of changing the consumption of durable goods which complement the consumption of oil. What OPEC did is that it attempted to establish the short-run price elasticity of oil close to unity and, thereby, effectively increase the total revenue of the organization’s member states. However, if in the long run, the market demand for oil was elastic, the net effect of increasing the price of oil, would incidentally fall on the burden of OPEC producers. Therefore, relatively price inelastic demand and price elastic oil supply is the main source of OPEC’s monopoly power in the world oil market.
The rationale behind the cartelled market organization of oil supply is the stability of demand for oil across the world. Could OPEC’s monopoly power, in effect, be broken if one country would set asymmetric prices on the global oil market. The desire of OPEC member states to fully collude in the cartel is the well-known phenomena from industrial organization known as the trigger strategy. According to trigger strategy, a member of the cartel is likely to divert from the cartel’s strategy only if long-term gains outpace short-term losses of acting in accordance with the cartel’s strategic behavior. In purely theoretical terms, if Nash equlibrium exists in the long-term benefits of cooperation, the diversion from cartel’s strategic behavior, will not be feasible.
Even though some OPEC member states face asymmetric market demand curves in the short run, the stability of world oil demand embodied in the relatively price inelastic oil demand decrease the feasibility of defection from the cartel’s strategic targets, discounted benefits from the collusion far outpace potential short-term losses.
By Stephan Zimmermann, on March 2nd, 2009
At OPEC’s most recent meeting held in December, the thirteen-member cartel agreed to reduce crude oil outputs by 2.46 million barrels per day, a record production cut for the group. As world crude prices dropped below $38/barrel, the cut is designed to stabilize prices to meet OPEC’s forecast of $75/barrel as “fair.”
Market analysts believe that the OPEC production cut is likely to fall short of the intended spur to $75/barrel. Among others, Morgan Stanley joined those whose world forecasts predict significantly lower prices in the $25 – $30 per barrel range.
Producers such as Saudi Arabia and the United Arab Emirates could maintain budget equilibrium or surpluses at the $25 price level. Less stable political bodies, such as Iran, however, could easily foresee increased borrowing requirements in light of continuous dropping world demand and a shortfall of oil revenues.
Russia, a non-OPEC member, hinted that it might support cuts of its significant domestic production if the worldwide economy does not recover to increase oil demand.
China cut prices on refined product, such as gasoline by 13.8% and diesel 18%, to stimulate its domestic economic demand.
India, with its large subsidized oil sector, nearly 70% import-dependent, cut its retail fuel prices. It continues with its political objectives of conservation, alternative energy, and strategic domestic reserves.
The recent economic roller-coast activity in the gyrating world-wide demand for oil points out one of the fundamental “truths” of economics.
When finite supplies of a product in world-wide high demand and only limited substitutability exist, cartels are a natural phenomenon. That is as true for sugar, coffee and many others as it is for oil … or drugs..
If cartel members agree on pricing policies and various political issues, cartels can remain effective for decades and longer.
That is certainly true on the supply side of the equation.
Less effective is potential manipulation of demand.
There is little OPEC can effectively do to stimulate economic demand that the market itself cannot.
Further, as actual substitutability for oil is demonstrated through the application of alternative energy sources, demand for oil is likely to decrease further.
The leadership of OPEC is economically savvy and understands the economics. It also understands the ills of short-term gratification at the expense of long-term satisfaction.
Whether the current financial worldwide crisis equally enlightens the American consumer remains to be seen.
The potential collapse of the automotive industry (as we know it) should give rise to a new, fossil-fuel-free base of employment.
It automatically generates expanded opportunities for research and development of existing and new technologies in every conceivable field of scientific and commercial application.
Will the average American consider the high levels of crude oil earlier this year and its subsequent fall as a xenophobic and conspiratorial plot?
Perhaps the public will finally understand the machinations of supply, demand and the effect of cartels?
Supply shocks and price increases occasioned by cartels are likely to recur in the near future if the world’s dependence on oil is not carefully checked. Most of that stems from the demand side of the formula!
OPEC’s next regular meeting is scheduled for March 15, 2009, in Vienna, Austria. It will precede the OPEC International Seminar on March 18-19.
By Stephan Zimmermann, on September 30th, 2008
Based on a September 18 Times (UK) report regarding the meeting of Middle Eastern finance ministers, the question was asked about the veracity of a plan for a single currency for the Middle East based on oil.
The answer is both true and false and maybe.
Yes, the immediate goal of the meeting last week was to establish a single currency for the Mideast. In that sense, the new currency would be similar to the euro, where various countries have joined under a common umbrella.
No, there were no (public or published) talks of an oil-based currency, which would effectively replace the U.S. dollar as the principal currency of oil trade.
Maybe? The idea of replacing the US dollar with an oil-based currency is not new. The late Saddam Hussein, various Iranian leaders and others have often broached the idea.
As early as 1987, financier George Soros in his book The Alchemy of Finance outlined just such a plan.
A single, oil-based currency would require the agreement of the various Middle Eastern heads of state as well as further agreement by OPEC.
Recent U.S. financial disasters do not rule out such an eventuality. However, the cumbersome and institutional process required should not add fuel to existing speculation.
The single currency issue addressed (without the use of oil) is planned for slightly more than two years hence. However, instability in world financial markets may prompt more rapid agreement to reach the goal.
The Arab oil ministers meeting agreed in principle to establish a single currency. While there was no mention of oil or another commodity backing the potential currency, there is some speculation that the euro, rather than the U.S. dollar, could be designated for oil trades.
Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.
By J.D. Seagraves, on September 19th, 2008
On Monday, the Dow Jones Industrial Average – the bluest of Wall Street’s blue chips – lost 4.4% in a single day. Fannie Mae and Freddie Mac have been “seized” by the government. Oil continues to drop while gas prices rise. Inflation runs high while jobless claims continue to soar and gold falters. What a strange economic cocktail! Let’s look at the issues one by one:
First, “Black Monday.” It was prompted by the announcement that investment-banking giant Lehman Brothers would be filing for bankruptcy protection. This, after a weekend spent trying to negotiate a government bailout. For once, the government blinked. A week earlier, the markets soared on the news that the feds had “seized” control of the mortgage industry through Fannie Mae and Freddie Mac. Smart traders who hadn’t already taken the hint knew that those gains were illusory.
Now how is it that oil can continue to fall while gas prices have been on the rise? Two words: Hurricane Ike. It threatened refining capacity, which has nothing to do with the price of crude oil but everything to do with your pain at the pump. The real question is why does oil keep falling? That’s actually a troubling sign given the inflation being felt elsewhere in the economy. And the answer is: demand is softening…even in the face of monetary expansion. That does not bode well.
Is there really any question why consumer prices continue to rise? It can’t be blamed on OPEC (oil is dropping), or greedy corporations (profits are down), or labor unions (they hardly exist anymore), or the greatest scapegoat of them all, illegal immigrants (they’re moving back to Mexico!). No, instead, we’re finally confronted with the reality that the Federal Reserve creates “price inflation” (higher prices) through monetary inflation (creating new money). Just this past Tuesday, they unleashed another $70 billion into the economy. Think that won’t find its way into the price of your milk? Think again.
That jobless claims continue to rise shouldn’t confuse anyone unless they’ve had an economics class recently. Just three years ago, when I was taking introductory Micro- and Macroeconomics courses, my professors still taught the widely discredited Phillips Curve – the Keynesian idea that there’s a “trade-off” between inflation and unemployment (i.e., if you have high inflation you should have low unemployment and vice versa). Of course, this was objectively destroyed by the 70’s stagflation, and we’re headed there again.
But how is it that gold, presumably a measure of the dollar’s value, is falling even as dollar-denominated consumer prices rise? Well, as I stated earlier, it’s because gold was overbought – with Fed-created fiat money – and became its own bubble. As the Fed continues to inflate, though, look for gold to rise.
By James Ratcliff, on July 24th, 2008
As the price of fuel goes up, shiny new SUVs look shinier than ever; we’re not washing them more often, we’re just driving them less—especially in Alaska, where some drivers pay more than seven dollars a gallon for gasoline.
But this is not another anti-cartel, anti-big business, anti-government rant. If you’re looking for a reason to be miserable about the state of the economy, you won’t find it here. I was a university student living in Alexandria, Virginia, during the 1973 Arab Oil Embargo. High fuel prices were a frustrating fact of life then, as they are today, and the lines at the gas station were a lot longer.
Instead of complaining about the spike in fuel prices from Anchorage to Alexandria, we should be grateful.
Think about it. If the U.S. has made progress in energy and the environment over the past forty years, the 1973 OPEC Embargo was a major turning point. As someone who remembers asking his parents why Pittsburgh smelled so bad when we drove through it in the late 1950s, I can attest to the fact that real progress has been made.
Big problems create even bigger opportunities to find a better way to do things. Whether we face challenges as individuals or as a society, problems are a necessary goad. They’re painful, but they’re the only thing that gets us moving in the right direction.
In The Harried Leisure Class, Staffan Linder described a society that needed to be goaded into a change of direction. Forty years ago, Linder predicted that the tempo of life would become increasingly hectic. He showed why increases in productivity in rich countries would lead not to an increase in leisure but to less free time for average wage-earners.
Linder’s main point was that economic growth entails a general decline not only in the quantity but also in the quality of leisure. Linder realized that “consumption time” would replace “culture time” in prosperous economies. “Just as working time becomes more productive when combined with more capital, so consumption time can give a higher yield when combined with more consumer goods,” he explained.
When tourists film family members climbing a Mayan pyramid, the “goods” added to the leisure activity—a camera, in this case—actually reduce the pleasure derived. Instead of imagining what it might have been like to scale the pyramid 1,000 years ago, we worry about the quality of the images we’re capturing.
“If total consumption time is constant,” Linder theorized, “there will thus be a decline in absolute figures in the time devoted to activities that are not particularly dependent on goods.”
Buying the most expensive digital camera on the market will hardly increase the pleasure derived from a candlelight dinner with your spouse. But a bigger and more expensive flat-panel television set will certainly heighten your enjoyment of the Super Bowl.
As productivity increases and goods become cheaper, people spend more time watching the Discovery Channel and less time trying to discover a vision for their lives. The bottom line: as the economy grows, we will have bigger and better Super Bowls and fewer candlelight dinners.
Chilling Questions
Social media websites attempt to increase the yield on consumption time by adding consumer goods to activities that aren’t dependent on them. Simulated experiences like Second Life, the online world where residents use real money to buy and sell virtual real estate, reveal deep confusion about wants and how to satisfy them.
The explosion of social media websites is a result of two things: our growing technological capability and our increasing scarcity of time. The Web, of course, is the perfect platform for speeding everything up; social media sites accelerate the process of meeting people and developing new relationships—and, presumably, of ending relationships when they go bad.
But are travelers on the Information Highway driving in the dark about the things that matter most? Does the Internet lead to decisions based more on impulse than on analysis? Does the accelerated pace at which all kinds of transactions take place on the Internet lead us to expect faster results in all areas of our lives?
Few economists today take the time to ponder the chilling questions that Linder asked 40 years ago:
“The requirement that the yield on time must increase as the level of income rises is a general one; it relates to time spent on all different purposes, including, as we have seen, in making decisions. And it must apply to the time spent in making all sorts of decisions, not just economic ones. Only half in jest, one can perhaps claim to find examples of a declining quality of decision-making in all possible fields. Is it possible that we devote less and less time to forming our opinions on a life after death? Is it that we spend less and less time thinking of the ultimate purpose of our economic growth?”
Economics is all about choices. In Linder’s view, a solution “presupposes that people desire to spend their time in a way that does not involve consumption centered on goods.”
Every time we hear someone complain about the high price of gasoline, we have a choice: we can go on worrying and complaining about it, or we can exchange a trip to Starbucks for quiet time at home. We can use the time to write a personal mission statement or to discover how to help a hungry child.
If you live in Alaska, you might even find a reason to be grateful for $7-a-gallon gasoline.
By Evelyn Black, on July 18th, 2008
In 2005, the U.S. Department of Energy published a report entitled Peaking of World Oil Production: Impacts, Mitigation, & Risk Management. Called “The Hirsch Report” after its lead author, Robert Hirsch, its purpose was to lay out a governmental strategy for softening the effects of peak oil and its aftermath: that is, the chaos and economic crises sure to follow the point at which the world’s oil reserves would begin to fall.
The Hirsch Report laid out three possible scenarios for mitigation and risk management. In the first scenario, alternative energy sources, redesign of U.S. infrastructure, and other extraordinary measures are taken 20 years in advance of peak oil, with significant negative impact on the economy but a good chance at a positive outcome after a period of adjustment.
In the second scenario, extraordinary coordinated emergency measures are taken at all levels of government 10 years in advance of peak oil, with a period of severe shortages and social stress in the immediate 5-10 years after peak oil.
In the final and scariest scenario, nothing is done until after worldwide peak oil production occurs. In this scenario, severe shortages, widespread social upheaval, the collapse of financial markets, and violence are predicted, with an uncertain and painful adjustment period that could take decades.
What is alarming is that the U.S. government and the oil industry have known since the mid-1950s that peak oil would occur sometime between the year 2000 and 2010 if not earlier. Shell Oil itself commissioned the original study, done in 1956 by geophysicist M. King Hubbert. Hubbert predicted that after the peak, reserves would drop off very sharply, creating an environment in which social upheaval, famine, violence, and general chaos could occur if other energy sources were not in place. The first chart at the top of this post shows M. King Hubbert’s original 1956 peak oil curve.
Ever since Hubbert’s peak oil curve became the touchstone for oil supplies and the mitigation of their depletion, very little has been done in terms of preparing for what both the U.S. government and big oil have known would happen all along. I think it is disturbing and revealing that, even though the Hirsch report was commissioned in 2005, the U.S. is still basically doing nothing to mitigate the effects of peak oil.
 Why would that be? Is it because the U.S. Department of Energy thinks peak oil is still 20 years off in the future or more? Or is it because it is already too late and the U.S. is being run by a pack of oil executives like George W. Bush, Dick Cheney, and Condoleezza Rice? I mean, it’s not like they personally are going to suffer when the worst consequences hit. On their way out, to very wealthy established lives, they have little to lose at this point.
Houston, I think we have a problem.
I think we had a problem back in the seventies, and we should have dealt with it then by instituting a sane longterm energy policy. We didn’t. By general agreement, we passed our own peak oil production point during that same time period and for the past 30 years have been relying heavily on imports (as shown by the chart at the bottom; the middle chart shows all the competing current theories on when peak oil will occur worldwide). By all the best estimates, globally, we are now at or just past peak oil, and we’ve done basically nothing to mitigate its effects. This has happened just as global demand for oil in developing industrial nations like China and India has spiked and continues to climb rapidly.
Yes, commodities speculators are driving up prices right now, including oil prices, but trading in oil commodities is tightly regulated. Speculation is a very small part of the total picture. What is happening right now with oil (and by default gas prices) is more consistent with increased demand in the face of limited or even decreasing supply.
If in fact we have passed peak oil production, we will know it very quickly because things will get very, very bad very, very fast.
 But let’s say the optimists are right and peak oil will not hit until 2020 or 2030. (I think they’re wrong, but for the sake of argument, let’s say they’re right.) Even then, by our own government’s study on mitigation, we know that right now we need to be taking extraordinary measures toward alternative energy and energy independence just to soften the blow. Where are these measures? Why are we not taking them?
Think about that for awhile, and while you’re thinking about it, think about planting some food in your backyard and getting to know your neighbors.
I think we’re in for quite a ride.
By Evelyn Black, on July 17th, 2008
As I write this, Treasury Secretary Henry M. Paulson’s announcement that the Bush administration will indeed shore up Fannie Mae and Freddie Mac is all over the news and still sinking in. After opening slightly higher Monday morning, Wall Street dipped back into negative territory as analysts attempted to digest the bail-out news.
What can it mean for the average person?
If you’ve been listening to the news, you’ve probably heard that it means that the American taxpayer can expect at some point to carry the brunt of the subprime lending debacle losses. That is, if the Bush Administration is able to ram their plan through Congress (and they almost certainly will be able to do this), at some point the money to back the bad loans currently bundled into Fannie Mae and Freddie Mac securities will literally come from our own individual pockets in the form of tax dollars.
That price tag could be as high as 5.5 trillion dollars. In fact, the price tag could end up being so high, that along with Congressional approval for the bail-out itself, the Bush administration will also need permission to bump up the ceiling on the federal debt by as much as 50%. The national debt is already so large that at the current rate of spending we will not be able to pay even the interest portion on it by 2050, and at that point it will actually exceed our gross national product.
So how can we possibly bump it up 50%? As the title of this website points out, I’m an amateur economist, so maybe I am missing something here, but didn’t we just borrow a load of money from China so we could send out economic stimulus checks that were refunds on the taxes most of us paid last year? We borrowed that money, the money for our tax refunds, so again, I have to ask, where is this money for these bail-outs coming from? Are we just going to print some more up?
I have looked all through my bank accounts and I confess, I can’t pick up even a few pennies of Fannie Mae and Freddie Mac’s problems, and it gets worse every day here in Michigan, where I live, where the unemployment rate is over 10% and growing and gas is currently about $4.30 a gallon.
I don’t even know how we are going to pay for fuel oil this winter. I ordered it early, hoping to head off whatever ungodly price will be charged come September or October, but so many people had the same idea that the oil company still hasn’t delivered it. They can’t keep up with the phone calls let alone the oil deliveries in the dead heat of summer, and now I hear all of us red-blooded, can-do types are going to bail out the fat cats at Fannie Mae and Freddie Mac too.
Wow, talk about piling on the pressure.
After 9/11, the President urged the American people to go shopping and go on vacation as if nothing had happened; to spend money and keep spending, or the terrorists win. So people did that. We spent money. We spent money we didn’t have. We spent money that didn’t exist in any universe, not even in the alternate Bizzaro Universe at Bear Stearns. Now, having spent up all the money, we are supposed to come up with some more money to help out giant lending institutions.
Like I said, I’m still waiting on my fuel oil: I’m a little light in the wallet this week.
Talking heads universally agree that the federal government almost has to bail out these giant institutions or risk destabilizing not just U.S. markets but the markets of the entire world. And yet, as we lurch from one economic disaster to the next in this country, each one bigger and scarier than the last one, we are bleeding credibility. Does anyone seriously think that anybody is at the wheel anymore? I don’t think so. And as that sinks in, things will begin to fall apart in a very big way.
OPEC is about a hair away from changing over to euros instead of dollars because of our instability and waffling, and once that happens, the dollar will fall harder than a fruitcake on December 26th.
Here are a few other implications of the “solution” to the latest catastrophe on Wall Street:
More Bank Failures. The FDIC is out reassuring the world that just because it shut down IndyMac Bank Saturday and just because it expects up to 150 more bank failures in the coming year, this is really nothing to be concerned about since during the savings and loan fiasco in 1994 its list of troubled institutions topped 575. In 1994 I made quite a bit more money than I do now, and so did most of the people who work for a living in the U.S. Not a good way to make me feel better, FDIC, try again.
Loss of Confidence in the U.S. We are living on borrowed money, literally. We borrow from China and Japan and the Mideast just to pay the basic costs of running our government. So far, these countries continue to loan us money because we are a major market for their products. But as we continue to not manage our own finances in any kind of sane or coherent way, they will begin to rethink their lending. No law exists that says they have to keep lending us cash. In fact, as developing nations buy more and more of their own products (as in China, where a consumer middle class is now emerging), these nations will have less and less reason to lend to us.
Higher Mortgage Rates. It is going to get more expensive and more difficult now to get a mortgage anywhere in the U.S., and it will be nearly impossible in some places. This will only make the housing crisis worse, which will only terrify Wall Street even more.
More Assets Sold. On the other hand, our current situation makes commercial real estate in the U.S a fabulous bargain for overseas investors. As more U.S. corporations resort to selling off their assets to raise cash, this will result in more cash flowing out of the U.S. and into the already deep pockets of foreign bargain hunters.
Violence. Seriously, at some point it will get ugly here. Working people in the U.S. are already stretched to the limit, and more and more people are not working. In a city close to where I live, a bicyclist was recently stopped by a motorist who was frustrated with having to suddenly share the road with so many non-motorized vehicles. The motorist beat the bicyclist within an inch of his life. Biking accidents that involve bikes being struck by cars are up 80% in some parts of the state this year alone.
When my kids were little, they used to complain about having to clean up the kitchen when they didn’t make the mess. I’d point out to them that I spent the better part of most days cleaning up after them, and I was glad to do it; that part of being a family means you clean up after each other and you don’t gripe about it.
OK, but in this case, I guess I want to know, when are the big guys going to cut us little guys some slack? When do I get to borrow the family Mercedes?
When do I get my multi-million dollar golden parachute?
I’m not greedy. A single million would be plenty, that’s all I really want or need. Send it in care of www.amateureconomists.com. And Quatar? Stop calling me.
I don’t answer my phone anymore.
By G.L.C., on July 13th, 2008
The price of oil continues to hit record high. Many believe the main reason for this is speculation.
The price of oil has nearly tripled since 2004. The trading in oil on the New York Mercantile Exchange also tripled since 2004. A mere coincidence? OPEC no longer controls the price of oil. Majority of the trade in oil is done in London or New York. The price of oil is now determined by Wall Street.
According to the Commodity Futures Trading Commission (CFTC) a speculator does not produce or use the commodity but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.
Speculators on the other hand blame the increased demand from China as the reason for the rise in oil prices. According to the Department of Energy, annual Chinese demand for oil has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels. Over the same five-year period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China. With the impact of the subprime crisis on the real estate market and the downward slide of the U.S. stock markets, more money is being pumped into the futures market by investors. According to The Economist, about $260 billion has been invested into the commodity market – up nearly 20 times from what it was in 2003. It is estimated that in the commodities market, half of the bets are placed on oil. This increased investment along with a week dollar has resulted in the price of oil rising to record high. A majority of these investments are bets placed by hedge and pension funds looking out for risky but high-yielding investments. Unlike stocks where the margin requirements may be as high as 50%, for commodities, it is a 5–7%. So with $130 billion, the speculators can take positions of about $2.5 trillion.
The CFTC is no longer able to properly regulate commodity trading to prevent speculation, manipulation, or fraud because much of the trading takes place on commodity exchanges in the U.S. and abroad that are not within the CFTC’s purview.
Traders on NYMEX (New York Mercantile Exchange) are required to keep records of all trades and report large trades to the CFTC, enabling it to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. But traders on unregulated over-the-counter electronic exchanges are not required to keep records or file any information with the CFTC as these trades are exempt from its oversight.
Merely introducing laws that would regulate the trading of future commodities in the U.S. will not help control speculation. It is possible for a person in the U.S. to trade in a key U.S. energy commodity such as oil and avoid all U.S. market regulators by routing his or her trade through an exchange located in London or any other place. The law should regulate all trading of key U.S. energy commodity – traded through an exchange in the U.S. or abroad.
By Bhagwad Jal Park, on July 10th, 2008
One of the neatest developments in economics is the formulation of game theory. Even though its strategies and recommendations have been known to people throughout history, game theory puts these strategies on a theoretical structure. One of the situations thrown up by game theory is a Nash equilibrium.
Assume that there are competing players in a situation (call it a game). Each player has to choose which strategy to adopt. The outcome of that strategy is going to depend on what other people choose. In such a situation, a Nash equilibrium is formed when each player knows what strategies the other player is going to adopt and will gain nothing by changing his/her choice.
Let us take an example of chess. If you watch a Grandmaster play chess against someone who is well beneath him or her in playing stature, you will probably be surprised that the Grandmaster will take longer to beat the novice than an expert would take, although the expert is still much superior to the novice but far inferior to the Grandmaster.
Grandmaster Chess. Photo by Kryten. Taken from Everystockphoto.com
The reason for this is that when you try and finish off an opponent quickly, you leave gaps in your own defenses. These gaps are not easy to spot, but Grandmasters are in a position to take advantage of them. Therefore, it is in the interests of anyone who is playing a Grandmaster to take their time and not rush. So if there are two Grandmasters playing each other, each knows that the other will adopt the strategy of non-rush and will therefore play non-rush themselves. Because of this, Grandmasters are in the habit of taking their time, securing their defenses, and playing slowly.
However, when the expert plays the novice, he has no problems about tearing the poor novice apart because he knows that the novice can’t take advantage of the weaknesses that he leaves behind while attacking. If the expert were to play the Grandmaster, however, he would be a fool to rush into the attack.
In the case of the two Grandmasters, the Nash equilibrium consists of both players choosing the strategy of non-rush because they know that their opponent will do the same. It would be foolish to attack a Grandmaster hastily because they would be building their own defenses, and if you don’t do the same, you will be left in an untenable position. Therefore, the strategies of two Grandmasters playing each other are stable. Each will not change their own strategy if the other continues to maintain theirs.
In a cartel, a group of players who control the supply of a certain product get together and agree to keep the price of that particular product high. There are two strategies here – high prices and not so high prices. It’s easy to see why all the cartel members benefit in the long run if each follows the strategy of high prices. However, it is unstable because it is not a Nash equilibrium.
This is because of the fact that if one of the cartel members changes their strategy to not so high prices, that person will get all the customers who will no longer buy from the other players since they are following the high prices strategy. This will lead to a dramatic gain of business for the player who changes his strategy to not so high prices. Naturally, this situation can’t last. The moment the other players find out that one of them has changed their strategy, it is no longer in their best interests to adhere to the strategy of high prices. Thus, they change their strategy to not so high prices as well, and the cartel breaks.
OPEC Headquarters in Vienna
Cartels are so unstable precisely because of the threat of betrayal. And the more people that make up the cartel, the more unstable it becomes since there are more chances of any one person changing their strategy.
Cartels like OPEC have stood the test of time because, firstly, there are not too many players. And secondly, they all recognize that they’re here for the long term and that if one of them breaks the cartel by adopting not so high prices, then all others will follow suit, and they will be back to square one with lower prices.
Indeed, the only real reason for any cartel to stay together is if they are in the long run together and realize that united they stand and divided they fall.
Editor’s note: Last year a German watch magazine did an interview with John Nash. Read more about it at Amateur Economist. Thanks to Chris Meisenzahl for the link!
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