OPEC and Shale Oil

Megan McArdle has on a single page most of what you need to know about cartel economics. Note: the explosion of shale oil and gas is not for purely technical reasons.

(…snip…) Here's the thing about cartels: without legal enforcement, they pretty much never work. The incentive to cheat, and take extra profits by producing a little more than your quota, is too high . . . so pretty soon everyone is cheating, and your cartel doesn't really exist any more.

OPEC has managed to flagrantly violate this general economic truism for a few decades now. Saudi Arabia is one of the main reasons that it's been able to hold together for so long, even after the price crash of the mid 1980s. Until the Chinese economic boom drove global oil demand right up against the limits of the industry's pumping capacity, causing prices to spike, Saudi Arabia's excess capacity kept prices roughly stable, in the neighborhood of $25-$35 a barrel. Which, probably not coincidentally, is well under the break-even price for shale oil projects.

(…snip…) Better for the cartel for prices to fall to the point where current fracking projects are just barely economic.

But this will not be better for Venezuela, et al. Venezuela is experiencing ongoing shortages of basic goods like toilet paper because of its economic mismanagement. Algeria reportedly needs an oil price of $121 a barrel to cover planned spending–and has already experienced riots over food and housing. Iran is experiencing runaway inflation thanks to sanctions; falling oil prices will only make this worse. That's why they so desperately want the cartel to keep prices over $100 a barrel.

For them, however, the strength of the cartel is also its weakness. In some sense Saudi Arabia is the cartel because they're the ones who can afford–and will stick to–production cuts. Venezuela can make all the demands they want. But unless they can afford to cut their production, they will ultimately have to accept whatever the gulf states decide.