Originally published on Platt's Barrel blog:

Guest blog: Scrap “The Call on OPEC”

Steven Kopits is the President of Princeton Energy Advisors, and has been a guest blogger on The Barrel numerous times in the past.

Seven years ago, when I first turned my attention full time to oil, one of the strangest concepts I encountered was the “call on OPEC”. The call on OPEC means different things in different contexts, but fundamentally, it is as non-economic and culturally imperialist a term as one could imagine.

The call of OPEC works like this. Non-OPEC countries are assumed to produce as much as they can, guided essentially by price signals.

Whatever demand is left over can be served by OPEC. OPEC is thus assumed to “balance the market” and the number of barrels necessary to do so is the “call on OPEC.”

Now, imagine this concept grafted onto, say, automobile production. Suppose an American policy-maker argued that GM and Ford should produce as many cars as they like, and then Toyota could supply any demand left over. From an economic viewpoint, this would be incomprehensible.

Why would Toyota’s motivation be any different than that of Ford? Why would Toyota’s economics dictate a deferral of production decisions until competitors had already claimed their own market share?

And moreover, were this to be the case, the political uproar would be deafening. Imagine the reaction if an American politician to suggest, for example, that the Japanese should really let the Americans lead in serving the market. If US car makers over-produce, the Japanese could cut production. The reaction would be one of complete outrage—and rightly so. And yet, when the call on OPEC has a similar effect, no one complains.

OPEC is expected to moderate its production around the activities of non-OPEC producers and consumers, because, well, we’re so important.

Now, the call on OPEC does exist for certain practical reasons. First, the cartel is assumed to act in concert. In theory, unified OPEC decisions can affect oil production and prices in ways that hundreds of profit-maximizing firms cannot. Therefore treating OPEC as a kind of entity makes some sense.

Further, OPEC production decisions are assumed to be geared to meeting national fiscal needs rather than maximizing profits. If Exxon ran, say, the Algerian oil fields, then production would be much higher than today, but the resource would be depleted much faster as well. Profit-maximizers will behave differently than revenue-satisfiers like the OPEC countries.

Finally, Saudi Arabia is the only country with material spare capacity which can be called, and the only OPEC country with the financial reserves to buffer any lost revenues due to curtailed production. Nor have the Saudis renounced this role.

Thus, OPEC dynamics are different than those of profit-maximizing oil companies. Analysts, therefore, treat OPEC as a separate analytical category, and divining OPEC intentions has become a skill unto itself.

Nevertheless, OPEC has left oil markets in the lurch not once, but twice, in recent times. The first was not the recent price collapse, but rather the price spike during the Arab Spring. This spike was, by historical standards, of sufficient magnitude to trigger a recession, and it did in both Europe and Japan. (The US barely escaped, although the data speak to a crypto-recession in America as well.) Saudi Arabia did respond, but too little and too late, and Saudi production additions were quickly withdrawn.

Those who thought Saudi Arabia might be willing to step up production to cover growing global demand were quickly disabused of the idea, and the analyst community came to accept that the Kingdom would probably never pump more than 10 million b/d on a sustained basis.

This assumption has proved true to date, and the belief remains intact. The call on OPEC no longer means “sustained Saudi production over 10 million b/d.”

The recent oil price collapse is simply the mirror image of Saudi response during 2011. If Saudi Arabia was not willing to permanently increase production at that time, there was no compelling reason to think it would permanently cut production now.

And that’s the key word: permanently. For those who know their history, the Lessons of ’79 dictate that Saudi Arabia would be poorly served to cut production in the face of a structural increase in supply or decline in demand.

Such action would lead to a death spiral of production cuts, in which Saudi production cuts are followed by increased non-OPEC supplies and falling demand, leading to further Saudi production cuts, and so on, with the Saudis facing both low prices and low production at the end of the day. This is exactly the narrative from 1980 – 1985, and the Saudis have not forgotten it.

Thus, the only surprising aspect of Saudi resistance to production cuts is that anyone thought the Kingdom would meekly cave to international pressure. They haven’t. But the pressure has been immense, and Saudi Arabia has taken the blame for low oil prices, completely without justification.

As can been seen on the graph below, Saudi oil production is only modestly higher than its level three years ago, and lower than in either 2012 or 2013. Indeed, Saudi production is lower than the same period last year. The Kingdom has actually cut production, even if not by much.

And that’s true of OPEC as well. OPEC output would be all but unchanged since 2011 for all but the recovery of Libyan output since the middle of 2014, and again, OPEC output is lower than its level in 2012 and much of 2013. If the Saudis are blameless, so is the rest of OPEC.