Consider OPEC as a Central Banker

NEW YORK (Real Money) -- Oil is the global currency, and the Organization of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, has operated in essence as the world's central bank for oil since its founding in 1961.

OPEC has attempted to maintain a consistent supply and price of oil in balance with the demand for it, similar to the way that central banks attempt to manage the supply of monetary capital to the economies they serve.

The principal difference between OPEC and individual central banks is that OPEC is a global organization, so it is dedicated also to preventing competition among its members.

The Bank for International Settlements (BIS), essentially the central bank of central banks, does not have this mandate, so monetary policy among central banks is partially dedicated to competitive depreciation, although it is politically taboo to discuss it in those terms.

The process of competitive depreciations among the world's three dominant central banks -- the Bank of Japan, the European Central Bank and the U.S. Federal Reserve -- is, however, increasingly evident in the expansion of the balance sheets of all three, although it is discussed in terms of domestic economic need rather than as a reflection of competition with other central banks.

The zero-interest-rate policies in Japan and the U.S., and Europe's migration toward zero interest rates, and the failure of these policies to spur economic activity, provide insight into the pressures that are being exerted upon OPEC and its ability to maintain cohesion among its members.

On Monday, Glenn Williams noted that the price band within which oil prices may operate and be economically viable is shrinking. A few weeks ago, I made note of this same phenomenon from a different vantage point.

As the upper and lower economically viable price limits for oil shrink to a convergence point, the result is that OPEC's ability to affect the price of oil by managing supply shrinks as well, and at the point of convergence it becomes zero. At that point, the need to monetize oil to meet individual OPEC members' domestic financial needs becomes the sole driver of supply, irrespective of demand.

OPEC will no longer have the ability to manage supply, and oil prices could drop precipitously and even drop through the fixed cost of production, at which point oil production will stop by necessity and the process reverse.

This vicious spiral is not yet a foregone conclusion, but as global economic activity slows, driving down demand for oil, and the price as a result, simultaneously with increasing revenue requirements of cartel members, most importantly Saudi Arabia, the potential for such a spiral also grows.

Although this would be advantageous for consumers and for economic activity globally, it would wreak havoc on countries that rely on oil exports and on companies that are involved in high-cost oil production -- shale, tar sands, deep water and those that require fracking.

As the price of oil at current levels is very close to the price necessary for these new and alternative technologies to be viable and for Saudi Arabia to meet its financial commitments, any further reduction in oil prices increases the probability of a vicious spiral of oil production and reduced prices.

Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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