OPEC's Business Model: Sit Back and Let the Money Flow In

OPEC, producer of about 40% of the world's oil, is back in the catbird seat, once again. Now, you're probably thinking, "When hasn't OPEC been in the catbird seat?"

True, when you're sitting on a considerable portion of the modern world's most important commodity, it's hard to ever argue that the deck is stacked against you, but these are especially advantageous times for OPEC.

Consider this: For the next year or two, and perhaps for longer, OPEC's "business model," if you will, doesn't have to adjust at all, and revenue is still likely to rise. Most important, OPEC can keep production targets the same, and it probably will still record impressive year-over-year increases in revenue. During these times of tremendous change, tech-based and otherwise, how many businesses, large or small, can make that claim?

Two Costly U.S. Policy Errors

And the reason OPEC can relax and let the dough roll in? The actions and inactions of the U.S. that have, remarkably, helped keep the price of oil at historically high levels, despite the worst global recession since the end of World War II. True, oil prices did plunge to about $35 per barrel during the financial crisis's acute stage in December 2008, but they recovered roughly in sync with healing credit markets. Oil moved above $50 in the spring of 2009, then above $70 in the summer of 2009 and have basically remained in a $70-$80 range ever since.

And that $70-$80 price is well above oil's 150-year average of about $25-$30 per barrel.

The chief U.S. action that caused this ? Clearly, the weak dollar has artificially boosted the cost of oil. Since oil is priced in dollars, the price tends to rise when the dollar falls, and the dollar has fallen considerably in the past decade. In 2000, it took only 84 cents to buy 1 euro. Today, it takes $1.35.

What's the primary factor in the dollar's decline? The U.S. budget deficit. In 2000, the federal budget was in surplus. The 2001 Bush income tax cut, senior citizen drug program (unpaid for), spending for the Iraq and Afghanistan wars (unpaid for) and the recession ended the era of balanced budgets and started a new era of debt. Institutional investors have bid the price of dollars down, pushing oil's price up.

Inability to Cut Back

The chief nonaction? The inability of the U.S. in 2001-2008 to systematically reduce its consumption of oil used for transportation. The Bush administration opposed increasing CAFE (corporate average fuel economy) standards, and basically adhered to a free-market vehicle efficiency stance. Market demand would determine whether Americans would drive fuel-efficient vehicles or gas guzzlers.

The result? Americans increasingly opted for gas-guzzling SUVs and larger vehicles -- not a problem when gasoline is $1.50 or $1.85 a gallon, but a more serious issue for family budgets when gasoline is $3 or $4 a gallon. The decade's legacy? A larger U.S. trade deficit due to an increase in imported oil, and no appreciable reduction in the nation's oil consumption for transportation.

Further, when combined, that weaker dollar and still-high U.S. per capita oil consumption for transportation were more than enough to lead the nation to the really unusual circumstance of high oil prices -- $50, $60, then $70-a-barrel oil -- during a recession. That's even as gasoline demand remained sluggish in 2008 and 2009 after millions of drivers were taken off U.S. highways and roads due to layoffs and millions of others simply realized they needed to drive fewer miles.

OPEC Is Ready to Reap a Bigger Bounty

What's more, OPEC's bonanza and preferred circumstance stemming from the above policy errors are nothing short of extraordinary. Contrast the December 2008 $35 bottom in oil prices with the 1999 slump, during which prices fell to a low of $17 per barrel (about $22 in 2010 dollars) amid the Asian financial crisis. In 199, the price dropped so low it forced the closure of high-cost wells and drove other players out of the market.

Further, in the immediate years ahead, given the dollar's value and current U.S. oil use, OPEC stands to reap an even bigger bounty -- without increasing production -- as oil prices are likely to trend higher as the U.S. and global economic recoveries progress and global oil demand rises. The U.S. Energy Information Agency sees OPEC earning $767 billion in net export revenue in 2010, up 33% from $573 billion in 2009, and rising to $823 billion in 2011.

Sit tight and just let more revenue roll in for the same production. Talk about lucrative business models.

OPEC ministers, at their just-completed March meeting, had to practically intentionally frown to avoid appearing gleeful with the current state of the oil market. Saudi Arabian Oil Minister Ali al-Naimi called current prices "beautiful" and said there was no need to increase production. Angolan Oil Minister Jose Maria Botelho de Vasconcelos said prices between $80 and $90 a barrel are good and above $90 would be too high.

A beautiful $80 oil price? It's beautiful if you're a producer nation, not if you're a consumer nation. Moreover, for the U.S., $80 oil means reduced disposal consumer income, higher fixed costs for businesses, more oil-price-based inflation, lower GDP growth and, above all, a massive transfer of wealth from the U.S. to the oil-producing nations it buys boatloads of oil from. And as most investors know, oil shocks triggered two U.S. recessions, in 1973-74 and 1979-80, and were a factor in two other cyclical declines, in 1990-91 and the most recent recession.

Will OPEC Squeeze the World Again?

Of course, if global oil demand continues to rise, OPEC will have to think seriously about increasing production -- the group has about 4 million barrels per day of spare capacity. But investors, and especially U.S. motorists, should understand this: Historically OPEC has shown a tendency to push the price of oil to the maximum the market will bear, and then some.

What will OPEC do if/when oil rises to $100? To $120? To $140? Again, if history is any indicator, it won't preemptively increase production to drop prices, but it will see how the U.S. economy functions with gasoline at $3.50 per gallon, then at $4, and then at $5, and so on.

In other words, chances are good that OPEC will -- again -- naturally seek to maximize its revenue first, and respond to U.S. and global economic conditions second. And if such a scenario plays out, the U.S. -- the world's largest and strongest economy -- will have once again been tipped into a recession largely because of its dependence on and vulnerability to imported oil.

And as you might sense, "vulnerability to imported oil" and "world's largest and strongest economy" are characteristics that won't walk in tandem indefinitely. One of them has to give way.
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