Oil Price Hysteria and How Incentives Sabotage Cartels

As you may have heard, the stock market has been a bit of a disaster this year. American stocks have lost about 6% of their value since the beginning of the new year based on the Dow Jones Index, and daily swings of 3 or even 4 percent have not been uncommon. Most stock markets in Asia and Europe have performed even worse with greater losses and volatility. And while no single factor can adequately explain all of the turmoil we've seen, many commentators placed the blame on low oil prices.

Why does oil matter?

At first blush, this doesn't make much sense. It's easy to see why low oil prices would be bad for oil companies. But for just about everyone else, this would seem like a good thing. Consumers benefit from lower gas prices and have more money left over to spend or save. Meanwhile, companies benefit from reduced transportation costs, and will presumably earn higher profits as a result.

The analysis above is perfectly sound economics, yet somehow low oil prices have sent the broader market into a tantrum. The reason for this is that many of the struggling oil companies were heavily financed by debt. As their losses begin to mount, there is a high possibility that some will go bankrupt and fail to repay their loans. If enough bankruptcies occur, they could potentially destabilize the banks that gave them money, leading to a ripple effect that cascades through the overall economy.

In this way, high levels of debt tend to make the economy much more fragile than it otherwise would be. Problems that should be confined to a single industry or group of companies can quickly become problems for everyone. Of course, this is not an argument for bailing such companies out--which can only postpone an eventual collapse. But it is another good reason to oppose the artificially low interest rates established by the Federal Reserve, which encourage consumers and companies to borrow more money. Ironically, in the name of promoting economic stability, such policies make the broader economy more unstable. The current hysteria over oil prices is a reflection of this.

What will happen to oil prices?

Because oil prices actually do matter in the present economy, the market has been desperate for any news that might point to higher oil prices. This has led to an emotional roller coaster of sorts as each optimistic report was widely hailed, but then quickly fell flat as new details emerged. The following headlines give you some sense of the anxiety over this issue:

• Monday, Feb. 15 - Oil stages late gains as Saudi, Russia, Venezuela to meet
• Tuesday, Feb. 16 - Oil prices crash after Saudis fail to broker global production cut
• Wednesday, Feb. 17 - Oil prices get boost as Iran praises Saudi plan to freeze output
• Thursday, Feb. 18 - Oil prices fall on oversupply concerns after U.S. crude stocks hit record

As you can see, the market has been basically bipolar, and most of the focus is on the possibility output cuts from the major oil producing countries - Saudi Arabia and the Gulf states, including Iran, Iraq, Venezuela, and Russia.* The major news outlets clearly seem to have no idea whether a deal will occur or not. The prevailing view at any given time seems to depend on whatever statement was issued last. In reality, the likely outcome of these talks is pretty certain to eventually end in failure. And a basic understanding of economics helps us understand why.

The major oil producing countries mentioned above are facing many of the same problems right now. In varying degrees, the domestic economy of each country is dependent on oil exports, and they also use oil proceeds to finance a substantial portion of the government. Thus, low oil prices have led to weaker economies at home and growing government deficits. All of them would love to see oil prices go higher to reduce these current problems. But all of them are also desperate to get as much money out of their oil supplies as possible right now, precisely because of these same problems.

Their interests create a kind of Catch-22. Collectively, they would like to see lower oil production so that prices will eventually go up in response to reduced supply. But individually, they need to maximize their production to get the most revenue possible. This tension in interests is what tends to make all production- or price-fixing agreements highly unstable in a competitive system.

The short-term result tends to be that the players involved will formally or informally agree to cut production. This has the immediate effect of sending oil prices higher on the expectation that supply will soon fall. But because each player has such a compelling incentive to cheat and produce more than agreed to, the arrangements typically break down. This is true for countries competing in a global oil market. And it's also true for private companies in any open competitive environment. Cartels and price-fixing arrangements are often seen as key examples where markets can fail and governments may need to step in to protect consumers. But the incentives at work in a free market all but ensure cartels will be unsustainable.

Bringing it back to oil prices, this is great news if you're a fan of low gas prices. If you lent money to an oil company, however, probably not so much. As long as no major new wars break out in the Middle East, look for oil prices to stay low in the near-term until the markets have time to adjust.

*The US has recently become a major oil and natural gas producer as well. But because the US oil industry is largely decentralized to private actors, the US doesn't typically get included in such discussions.