Monday, June 28, 2004

Oil Dependency

Regarding my post on the Volokh Conspiracy about oil dependency, a reader emailed me the following question:
I was confused by the following excerpt from your guest blog at

"Suppose that our goal is to deprive Saudi Arabia and other terrorist-breeding states of oil profits. The proposed policy would decrease the total profits of the oil industry (because of the lower price), but Middle Eastern countries would sell a larger share of it. Put simply, the Middle East would get a larger slice of a smaller pie, with an ambiguous overall effect on profits (at least based on theory alone - better information could possibly allow a more precise prediction). Remember that the next time someone tells you that driving an SUV helps fund the terrorists."

Ok, so I'm almost certainly wrong here given that you are an economist and I haven't taken an economics course in four years, but this doesn't make sense to me. I'm confused by your claim that the effects of decreased demand on Middle Eastern profits would be "ambiguous." If the price were to fall, wouldn't each individual producer be willing to produce less at that given price? Consequently wouldn't every individual producer in the Middle East be producing less at a lower price? Wouldn't this imply lower profits?
A good point, and I can see how my reader was confused. I believe I overstated my case. My essential point was this: that if the price of oil fell, the Middle Eastern producers would be responsible for a larger share of the remaining production, and they would get a larger share of the remaining profits. In that sense, we would be more “beholden” to them than we were before. That doesn’t mean, however, that their profits would actually be larger than before. It just means that the Middle Eastern producers’ profits would fall by less than would the profits of other oil producers.

The reader continues:
The first answer that pops into my mind is that your reasoning has something to do with the increased market power OPEC might have. I'm still a little confused about how this could work to increase profits given a lower oil price.
I was indeed thinking about the increased market power of OPEC. As other producers left the market, OPEC members would have a larger share of the market and thus a greater ability to affect prices. Now, if OPEC held prices too high, then the competing producers would re-enter the market, which means there would still be a natural limit to OPEC’s power. But it could take a long time for alternative producers to reemerge, and in the meantime OPEC could reap short-term profits. Also, knowing that OPEC could let the price drop back down to bankruptcy levels (for the higher-cost producers) as soon as enough of them returned to the market would be a disincentive for them to do so. Higher-cost producers are unlikely to incur the start-up costs unless they think high prices are likely to persist.

Thus, OPEC’s ability to manipulate prices would increase if demand fell, but that would not necessarily translate into reliably higher profits.

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