The oil industry is one of the most profitable industries worldwide. There is a global market for oil, with nearly every country using oil for fuel and other purposes. The price of oil just hit a five year low ($66.19 per barrel) as OPEC raises the stakes in its price war with the United States. However, the U.S. is not the only country feeling the effects of OPEC’s pricing strategy. Russia’s economy is taking serious hits from the decision as oil is the top export (approximately 58% of total exports) for the country. Russia, which extracts a majority of its oil in Siberia, has significantly higher production costs than OPEC countries and the U.S. As a result, Russia is not able to price competitively in the market, which will result in a large decrease in its oil exports and consequently its profits. Firms in the U.S. have already made cuts on expenditures for next year, including Conoco, which cut spending by $3 billion. Following our Bertrand model, we can expect oil prices to continue to decline. In fact, Morgan Stanley has warned that the price of oil could drop to $43 a barrel in 2015. Nonetheless, the price war is a win for consumers, who benefit from lower prices. Additionally, the lower oil prices are restoring some semblance of confidence in the economy for many Americans.
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Being from Montana, I frequently here discussion about the Bakken oil region because it has energized the economies of North Dakota and Eastern Montana. However, the fall in oil prices will hurt this region because of higher fixed costs. Fortunately oil hasn’t fallen far enough to disrupt production yet, but if it falls to $43 a barrel shale production would fully stop.( http://www.cnbc.com/id/102094881)
The fall in oil prices seems to be due to a wide range of reasons (such as recent falling demand in China). But I find it interesting you point out that the falling prices are making Americans more confident because if they fall much more it could hurt the the industry and lead to increased imports of oil. How would this affect confidence in the economy?
So … to bring IO to bear: is this an issue of a cartel [OPEC] breaking down with rampant cheating on promises to cut quantity? Or is the petroleum market reasonably competitive, in that no single producer has all that much impact on prices?
This is consistent with our models of price wars. One assumption [partially offset by the use of linear demand] is that elasticities are the same in strong and weak markets, so that the ability to affect prices is symmetric. I don’t think that’s true, the ability to affect prices rises with demand. But I’m not sure how to carefully define the problem, much less test for it econometrically.
A friend recently told me that the price fall out has been caused not only by OPEC’s unrelenting supply, but also because the global economy has faltered, lowering demand as well. In tandem with IO assumptions, lessened demand diminishes a firm’s (OPEC’s) ability to affect prices. Accordingly, it appears that as price falls, each exporter is becoming increasingly unable to affect prices, leading to a more competitive global market.
It seems more likely that a break in promises within the OPEC cartel is causing the decline in price. Wouldn’t prices have been lower than they were previously if the oil market was reasonably competitive? I do agree that it is a difficult problem to define. OPEC only has 1/3 of the world’s known crude reserves now, so the cartel is not able to exert its power in the market like it was able to in 1973 (and it ultimately lost that battle too). Perhaps the price war is a last ditch effort to stop other firms from eating away at its market share?
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