Macroeconomics 107
The answer involves two of the most authoritarian and controversial world leaders of this century, and Donald Trump.
Vladimir Putin, the President of Russia, and Saudi Arabia’s Crown Prince, Mohammed bin Salman, are meeting today to move towards an agreement that would end the 2020 Russia-Saudi Arabia Oil Price War.
You’ve probably heard of Putin, who is closer to a dictator than a president, as he is in the process of changing Russia’s constitution to allow him to stay in power indefinitely. MbS has made headlines in the past few years for *allegedly* ordering the torture, murder and dismemberment of journalist Jamal Khashoggi, and that time he held hundreds of the richest men in Saudi Arabia hostage in a Ritz-Carlton.
Here’s the background you need to know to understand the current price of crude oil. [Crude oil is used for all sorts of things related to energy—gasoline is just one of them, just so we’re clear on that]
With most of the world at least partially shut down, the global demand for oil has decreased enormously (imagine the demand curve shifting way to the left). What is that going to do to equilibrium price? [ceteris paribus] Right, market price has dropped. In the middle of this, Russia and Saudi Arabia (two of the top three producers of oil, along with the U.S.) have drastically increased their production of oil! So now imagine the supply curve shifting way to the right. Equilibrium price drops even lower.
The result may seem great for those of you who filled up your tank recently, as the average price per gallon in the U.S. was below $2.00 last week. The primary benchmark for measuring U.S. price is “West Texas Intermediate”, and the price of WTI dropped as low as $20.08 per barrel in the middle of March. It started 2020 at $63.05! A barrel is 42 gallons, if you were curious.
The problem is, the cost of production for U.S. oil companies is well above $20 per barrel. So they are losing money for every barrel they produce, and they produce 13,000,000 (13M) barrels per day. In other words, they are going bankrupt, fast.
We aren’t the only country who is getting shelled. Nigeria, Africa’s largest producer of crude oil, based their 2020 national budget on the projection that oil would stay above $57 per gallon. Ouch.
Talking about Africa and Saudi Arabia reminds me of deserts which reminds me of my book recommendation for the week!
“What makes the desert beautiful,’ said the little prince, ‘is that somewhere it hides a well…”
An oil well, perhaps? The Little Prince is one of my favorite books, and it’s also quite short and unintimidating. April 6 was the 77th anniversary of its release, so it’s young, as books go, but undoubtedly great.
Here is my goodreads.com profile again, you should make an account so we can be book buds (ha). And once again, I’m offering to send copies to any current students of mine who request it within the next week (capped at 5!)
So, back to the post, why is this whole oil fiasco happening?
Basically, Russia is using the global decrease in demand as an opportunity for greater leverage over prices, with the *suspected* goal of intentionally damaging U.S. oil companies. Why would Putin want to do that? Well, maybe because the U.S. recently put sanctions on a Russian oil company that is supporting the *corrupt* leader of Venezuela. International diplomacy and macroeconomics are often closely related…
How is it possible for one country to have so much control over the global price of oil?
Because world oil production is regulated through a cartel! When you hear “cartel“, you probably think of drug cartels, but it’s just another word for “oligopoly”: a group of producers who work with each other to manipulate prices for their product. Individually, they realize they only hurt their profits to compete with each other by lowering prices, so they team up against consumers and agree to maintain prices at a certain level. This sort of collusion is illegal for companies to do in the U.S., but that’s the system we’re stuck with for international oil supply.
Cartels can only exist in markets with high natural barriers to entry, otherwise new competitors could easily enter the market and steal market share by offering lower prices. When I say “barriers to entry“, think of natural things that would prevent you from entering the market. In the case of oil, only so many countries have the natural resources required to produce it.
Can you think of other industries who have high barriers to entry? Think about goods or services where you only have a few options to choose between. If that’s not enough, try to think about companies who are notorious for poor customer service…
In economic theory, there is a spectrum of competition that ranges from “perfect competition” (homogenous products, price-takers, free entry and exit) to “monopoly” (single seller, price maker, no competitors). Oligopolies are firms towards the monopoly side of the spectrum, and their goal is to cooperate with each other to act as a monopoly.
That’s why I said to think about poor customer service; if you aren’t concerned about losing customers, then you don’t need to worry about making them happy! The single biggest stereotype is the DMV, right? The government is a monopoly. You don’t have a choice about where you get your driver’s license, so the DMV has little to no incentive to make the process a pleasant experience. Coming in close behind are oligopolies: cable/internet providers, cell phone service, airlines. Ooh, what about the big three credit rating agencies—where else could you let 150 million people’s data get hacked and not lose a customer!
Some of those examples have made progress in recent years. You probably have better options for cell phone providers than you used to, and cord-cutting is slowly throttling cable companies. Airlines give normal people two basic options: pay a lot and get treated poorly, or pay a little less and get treated really poorly.
Perfect competition is the opposite. Remember learning about price elasticity of demand? Well, firms in perfect competition sell highly elastic goods, i.e., small changes in price can lead to disproportionate changes in quantity demanded. You probably think of Chick-fil-a when you think of good customer service, and fast food is fairly close to perfect competition. Coming full circle (K), imagine an intersection with a gas station on each corner (a phenomenon known as Hotelling’s Law). If one station sets its price at $2.00, and the other three set their price at $1.99, the one station is going to get wayyy less than 25% of customers. If all four agree to set their price at $3.00, most customers would fill up at a different corner, if they have the option.
Interesting how barrels of crude oil are the textbook definition of cartels, but gallons of gasoline are close to perfect competition.
The international oil cartel is known as the Organization of Petroleum Exporting Countries, or OPEC. These 14 countries produce about half the world’s supply of crude oil, led by Saudi Arabia. Russia and the United States are not in OPEC, but, historically, they coordinate with them. With the global decrease in demand, OPEC had a meeting at the beginning of March and decided production needed to decrease by 1.5 million barrels per day, i.e. reducing supply to keep prices and profits high. When they asked Russia to cut back and bear their share of reduced output, Russia went rogue and said they were actually going to increase production. Saudi Arabia responded by scrapping the whole plan and increasing their output as well. Prices fell nearly 40% over the next few days.
Who knew macroeconomics would be so interesting, right? To quickly sum it up, it looks likely Trump makes some concessions and Putin ends the staring contest and they all agree to some sort of deal soon, because although Russia can produce oil at lower costs than the U.S., Saudi Arabia’s costs of production can be as low as $3 per barrel. In other words, oil prices being this low are seriously harming the United States oil producers, while Russia’s are about breaking even. Saudi Arabia is still cashing in, but their economy is based almost entirely on oil and they obviously prefer to profit more rather than less, which is the whole point of forming a cartel. [The cost of production gap is mainly due to differences between conventional drilling and hydraulic fracturing, or “fracking”, by the way]
One last thing before I wrap up, and this may be the most interesting part of the post for those if you who care more about fashion than oil… While we are on the subject of purposefully reducing supply to keep prices high, let’s take a look at luxury goods, specifically clothes. Whereas many companies send their leftover clothes each season to outlet stores, luxury brands do not. They shred their leftover items, or burn them, or throw them in a landfill. That article has some insane facts in it, like, the average American purchases 68 garments per year! Or, there is a town in India whose economic specialization is shredding unworn clothes. Quotes like “The retail price of a luxury product has nothing to do with its actual value.” Fascinating stuff.
Oh, and for those of you who gets all your news from my posts, Bernie Sanders suspended his presidential campaign yesterday. Anddd, new unemployment numbers this morning were another 6.6 million, so nearly 17 million in the last three weeks, which moved the estimated current rate of unemployment to 14.7%.
