What’s wrong with the global oil market?

Recent developments in domestic energy production have shifted the political debate about energy independence. Yet as the discussion focuses on finding a desirable mix of American energy sources, policy decisions must account for a global oil market distorted by the interventions of foreign governments.

Some may think this doesn’t matter because the domestic oil boom offers the United States a chance to reclaim the title of the world’s largest oil producer. Estimates suggest that there are more than seven billion barrels of oil in shale formations in the Dakotas and Montana alone. If more federal lands were opened to exploration, there is no doubt Americans could soon lose the need to import oil.

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Yet even under this welcome scenario, America would not be truly energy independent. Increased domestic production, however beneficial, cannot insulate the price Americans pay at the pump from the global price of oil. Whether extracted in North Dakota or Saudi Arabia, oil is a commodity priced in global markets. Increased domestic production will not diminish the role played by the OPEC (Organization of Petroleum Exporting Countries) cartel.
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Securing America’s Future Energy (SAFE), an organization that seeks to protect American national and economic security through reduced oil dependence, asked us to survey the literature on the global oil market. We reviewed hundreds of articles from the economics and policy literature, as well as dozens of experts’ congressional testimony. This review identified three important aspects of the oil market that policy makers should keep in mind.

First, the oil market is far from the free market of economics textbooks. OPEC, which came to prominence in the 1970s, is what MIT professor and oil expert Morris Adelman termed a “clumsy cartel.” When it is effective, it has an impact. OPEC works to restrict supply. Saudi Arabia’s announcement in January 2013 that it had cut production five percent in December 2012 led oil prices for February delivery to climb 72 cents per barrel. Monopolies drive up prices and lower productivity and misallocate resources. One study estimated the cost of OPEC to the U.S. economy was as much as $500 billion in 2008.

The price volatility caused by OPEC harms American interests no matter how the price moves. When OPEC forces the price of oil higher, Americans have transferred a premium to OPEC nations beyond what the competitive market price of oil would have been. When OPEC suffers a collapse, the price at times has fallen so low as to disincentivize alternatives to oil, as well as new, higher-cost oil supplies.

Second, the stability of OPEC itself depends heavily on non-market factors. OPEC functions poorly when its members are fighting wars with each other (as Iran and Iraq did between 1980 and 1988). It functions more effectively when it has support from the outside, as it did when the Nixon Administration used higher oil prices as a means of subsidizing allies like the Shah of Iran without asking Congress to authorize sending a check.

Third, most of the world’s oil reserves outside the United States are controlled by government-owned oil companies such as Venezuela’s PDVSA or the Saudi Arabian Oil Company (Saudi Aramco). They behave quite differently from profit-maximizing firms. Unlike in the United States, where mineral rights are often privately owned, in the rest of the world mineral rights belong to governments. Autocrats use control of their nations’ oil resources as a political tool.