Fill ‘er Up

Although the image of giant cartels carving up the markets for sugar and oil and steel dominates the popular conception of American economic life at the turn of the 20th century, it’s an image without much foundation in reality. The Gilded Age did see an explosive growth in the size of U.S. corporations, and a few successful attempts by robber barons like John D. Rockefeller and J.P. Morgan to seize near-monopolistic control of entire industries. But the creations of Standard Oil and U.S. Steel were not the ultimate expression of broader anti-competitive tendencies in the U.S. economy. Instead, they were the result of the complete failure of cartel-like arrangements to curb competition. Standard Oil was necessary (in Rockefeller’s mind, at least) precisely because every previous attempt by independent oil producers to limit production and keep prices high had fallen apart. The pursuit of self-interest of each individual producer sabotaged the self-interest of the group as a whole.

This lesson has been driven home again in recent weeks by the failure of OPEC’s member nations to abide by the production cuts the cartel announced, to great public fanfare, in March and then again in June. As I wrote in these cyber-pages at the time of the first announcement (click here for that earlier column), OPEC’s control over world oil prices has been seriously weakened by radical improvements in oil-exploration technology and by the advent of the oil futures market. But that control was always tenuous to begin with, for the very same reasons that all of those would-be turn-of-the-century cartels fell apart: No one trusts anyone else.

U.S. cartels actually had a schedule of penalties that over-producers would have to pay. But in many cases the cartels set prices so high–at a time when production costs were dropping rapidly–that producers were able to undercut the market, pay the penalties, and still take home a tidy profit. OPEC, for its part, lacks any meaningful enforcement mechanism, and in June actually went outside the organization to bring in Mexico as a way of demonstrating the seriousness of its commitment. Needless to say, if nations that aren’t even part of your cartel are crucial to the success of your cartel, it isn’t much of a cartel.

In any case, OPEC has performed exactly as the skeptics expected it would. According to the International Energy Association, OPEC member nations cut oil production in July by just half of the 2.6 million barrels they were supposed to stop producing. And if you add in new production from Iraq and Indonesia, the cuts amount to just one-fourth of the target. Not surprisingly, oil prices fell again today, by almost 50 cents, which brings the futures contract near its 52-week low.

Certain OPEC nations, most notably Venezuela, are notorious cheaters, but the magnitude of this new failure suggests that noncompliance is now rife within the organization. There is something paradoxical about this, of course. Oil prices are at historic lows, and demand has shrunk dramatically as a result of the Asian crisis. Cutting back on supply when prices are low would seem to be the economically rational thing to do. But this is precisely why overproduction is a perennial problem in market economies: it’s rational for everyone to cut back production–but only if everyone cuts back production. If only some producers cut back, sending prices higher, then those who continue to produce as much as ever will reap the benefits. (The same dynamic has been evident in the semiconductor industry in recent years.)

Eventually the cycle will change, demand will revive, and prices will rise. But while the typical response to overproduction is consolidation, that’s not really an option for OPEC. Saudi Arabia and Nigeria aren’t going to merge, after all. It’s cheap gas at the pump for the foreseeable future.