The Oil-Hog Cycle

SYNOPSIS: Residual demand for OPEC oil rotates clockwise and moves outwards. OPEC makes more profit by decreasing production by a marginal amount to increase price by a large amount. High oil prices eventually make residual OPEC demand rotate counter-clockwise and move inwards since people conserve and non-OPEC nations produce more. As demand get less steep the amount by which a production cut increases price decreases. Demand eventually gets so unsteep that OPEC makes more profit by increasing production to the competitive level rather than witholding output to increase price. The world is awash in cheap oil, and people get into their dirty oil-hog habits again. The OPEC residual demand curve for oil rotates clockwise and moves outwards again. This is the oil-hog cycle

The price of crude oil, which was around $30 per barrel earlier this year, plunged last week to as little as $17, with warnings that it could go still lower. Alas, it's all too likely that today's oil price plunge will set the stage for tomorrow's oil price surge, in a repeat of a cycle that has been a major source of world instability these past three decades. Intelligent policies could break this cycle, but our actual policies seem, if anything, likely to make the cycle worse.

The good news is that cheaper oil provides a significant boost to our economy. The fall in oil prices transfers money at the rate of about $100 billion per year from Arab sheiks, Texas millionaires and other people who don't need the money to ordinary citizens. This will do far more for the economy than those giveaways to corporations and the wealthy that some politicians are trying to justify in the name of stimulus.

So what's not to like about cheap oil? For one thing, it may undermine some of our shakier allies. Everyone now realizes that Saudi Arabia, with its growing debt and soaring population, is an Afghanistan waiting to happen; a falling oil price brings the day of reckoning that much closer. It's less widely realized that Russia also depends crucially on sales of oil and natural gas; the relative stability and prosperity since Vladimir Putin came to power have arguably been the product more of high oil prices than of his leadership skills.

Beyond this, an oil glut now can all too easily produce an oil crisis later. Economists used to talk about something called the "corn-hog cycle"; since 1970 the world has suffered from something similar, but involving oil and S.U.V.'s rather than maize and porkers. Call it the oil-hog cycle.

Start with a world awash in cheap oil, as in the early 1970's or the early 1990's. This cheap oil encourages profligate consumption, including the purchase of gas-guzzling vehicles. As world demand for oil grows, the supply comes increasingly from the Persian Gulf, which has most of the world's oil reserves. At some point a handful of producing nations realize that they control the market's swing capacity that if they cut their production, they can drive prices far higher. And they do.

High prices, however, eventually undermine the oil cartel's power. They are a drag on world growth, they lead to increased production in non-cartel nations, and sustained high oil prices lead to a lot of conservation. Oil consumption in the United States peaked in 1979, then, thanks to higher prices, declined more or less steadily until the dawn of the S.U.V. era.

As demand shrinks and competing production rises, the cartel must follow its initial production cuts with further cuts, or watch the price of oil plunge again. Eventually it can cut no more, and the world is once again awash in cheap oil, ready to begin another cycle.

And that's the stage we have now reached. The oil cartel, faced with declining demand, is no longer willing to reduce production as other producers, Russia in particular, expand their exports. So the Organization of Petroleum Exporting Countries has made any further production cuts contingent on matching cuts elsewhere. In effect, the cartel is demanding that Russia become a de facto member, much as Mexico did in 1998. If this game of chicken succeeds, prices will go back up again soon; if the game fails, prices will fall even further. Either way, the oil- hog cycle will eventually repeat itself.

If we were wise, we would try to break out of the loop. What would this involve?

The most obvious thing is to prevent another dangerous surge in oil consumption. And it so happens that conservation policies would be politically easier to implement now than at any time in recent memory. We've just had a vivid reminder of the dangers of dependence on Middle East oil supplies. One major conservation step closing the loophole that exempts S.U.V.'s from mileage standards would be easy to justify. And new technologies that promise much higher fuel efficiency at minor expense, like hybrid gas-electric cars, are already available.

All we need is some leadership. Will the Bush administration drop its fixation on drilling in the Arctic which would produce too little oil, too late to make any difference and realize that conservation isn't just a "sign of personal virtue" but a way to make the world more stable?

Originally published in The New York Times, 10.14.01