Sunday, April 17, 2005

NOPEC is a bad idea

One of the fun conversations that occurs in any organization that is having cash flow problems is the "Who can we afford to piss off first... the bank(s) or our suppliers?" From my experience, the answer depends on what stage of crisis that the organization is in, and how much the suppliers have mission killing capacity on the organization. The less power each individual supplier has over the ability of an organization's ability to complete its mission, the more likely that the suppliers will be the first ones to get screwed. The converse is also true. However what happens when the suppliers are also your bankers?

Praktike at Politicla Animal is linking to a bill called NOPEC that has already been voted out of committee that would allow the following:

Dubbed "NOPEC", a bill passed by the US Senate Judiciary Committee would allow legal action to be taken against cartels such as OPEC, said Senator Patrick Leahy, one of the bill's co-sponsors.

"The bill would allow the US Department of Justice and the Federal Trade Commission to file antitrust lawsuits against foreign states, such as members of the Organisation of Petroleum Exporting Countries (OPEC), for price fixing and other anticompetitive activities," said the Democrat....

would make it illegal for foreign states and their agents "to act collectively or in combination with any other foreign state ...or agent" to limit the production of oil, natural gas, or any other petroleum product, or fix the prices of such products.

This bill will attempt to force an answer to that question as I would imagine that it would allow for asset seizure, forfeiture or court ordered changes in policy and pricing mechanisms so that the marginal price of oil would be equivilant to the marginal cost of production that we all learned to love in Frosh Econ. However, the costs of breaking (at best) a moderately effective cartel of the chokepoint commodity may be much higher than the potential consumer benefit.

OPEC is also the home to any remaining reserve capacity in a tight supply situation for oil. Even though the US is not the direct consumer of the majority of OPEC oil (we get a good chunk of our oil from Canada and Mexico) the prices that we pay are reliant upon high OPEC production to keep the Europeans, Chinese and Japanese from directly bidding for Canadian production. They may have problems controlling the low end of the price band due to production bottlenecks but OPEC has the ability to dominate the high bands of the price range.

Paul Krugman, in a look at oil pricing behavior of OPEC theorized that not pumping oil is a form of long term savings and a hedge against both economic and political shocks:

The fact that oil is an exhaustible resource means that not extracting it is a form of investment. And it is an investment that might look attractive to a national government when oil prices are high. If a country does not want to spend all of the massive flow of cash generated by a sudden price increase on consumption, it must do one of three things: engage in real investment at home, which is subject to diminishing returns; invest abroad; or "invest" by cutting oil extraction, and hence reducing supply.

Why not invest entirely abroad? There are a number of reasons, but one is surely political: as Iran and Iraq have found, assets abroad are vulnerable to seizure by the Great Satan.

OPEC and other oil exporters are currently significant capital exporters to the tune of roughly $250 billion last year. Given that the US is sucking up 70% to 80% of total global savings (ie current account surpluses/capital exports), that means OPEC is financing the US to a significant degree either through FDI/direct investments/direct purchases of US assets and debts, or by pass throughs and allowing the Chinese Central Bank to build more reserves. They are one of our major bankers.

The defensive moves in response to the NOPEC legislatution are fairly predictable. The first would be a brief note to the President to ask the Treasury to ascertain the effects of the US government losing annual inflows of ~$100 billion dollars at current interest rates. The second step would be to ask the President to talk to the FERC about the pattern of shutdowns, unscheduled and scheduled maitenance that happened to drive up prices of electricity in the California market even before Enron got too greedy and dishonest. The markets are relatively similiar in meta-structure --- short term supply shortages, few critical nodes, relatively inelastic demand curves, expensive surge capacity etc. Finally, OPEC could ask the President to talk to Treasury to ascertain what would happen to US domestic interest rates if oil was to be denominated in Euro and Yen.

These moves have significant costs to OPEC. Kash at Angry Bear outlines a similiar scenario but replaces OPEC with China to illustrate who bears what cost and what benefit. The US would be the net loser if oil was to spike to $70/barrel as say the Saudi fields which have been pumping at surge levels needed some prolonged maitenance for the next six months.

What are the US responses to these economic threats? Not many --- freeze OPEC assets in the US and thus cut off any future direct funding of the current account deficit and therefore accept a major recession? Only allow US companies to pay the marginal cost of oil instead of the current market clearing prices? Oil shortages would result as no one would want to sell the US oil, including domestic producers.

Invade and seize the Saudi or other OPEC fields? The Iraqi insurgents have shown how easy it is to keep fields working at best 50% capacity with only some basic intelligence, high explosives and willing inside collaboration. The Iraqi insurgents, operating as global guerillas have taken 1.5 mbd or 1.8% of world supply off the market, thus contributing seven or eight dollars directly to the cost of a barrel of oil. Imagine what would happen if the Saudi fields saw 5 million barrels per day taken off the market. This is roughly 6% of global daily consumption, and it would be a short term price increase of 60% (elasticity of demand .1) or more prosaically it would drive short term prices to ~$75-80/barrel until the entire world economy hits a massive recession.

NOPEC is a threat aimed at OPEC. However once we look into the costs of following through on the threat, it becomes an empty threat. Therefore it is a useless threat, and just loud noise that could increase the political risk premium on the interest rates that finance our deficits.

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