Collusion, multiple equilibrium, and petrol prices

Conjecture is rife regarding why petrol prices have risen so strongly. There are a number of common explanations:

1. Rising demand for oil,
2. The weak US dollar, increasing the US$ price,
3. Peak Oil (Infometrics article requires a subscription),
4. Negative real interest rates in the US (as not mining the oil is the same as investing in inventories),
5. and speculation.

All these factors are playing a part in the saga of ever rising oil prices. However, Calculated Risk has suggested another, highly interesting way that fuel prices could have risen – a backward bending supply curve and multiple equilibrium.

This idea is pretty cool – so I thought I would spend a little bit of time explaining how it could work.

The idea posited by Calculated Risk originally stemmed from Professor Krugman in this article. Furthermore, he gives credit for the idea to Cremer and Salehi-Isfahani.

Fundamentally this idea is based on the fact that higher petrol prices increase the income of the Oil producing country (it is a positive terms of trade shock). An unanticipated increase in aggregate income will lead to a greater incentive to invest (consumption smoothing). One way of investing is to reduce oil production – as the stock of oil you leave in the ground is capital that you can consume (or trade for consumption) in the future! Fundamentally this argument is very similar to the negative interest rate argument.

Do you have anything to add?

Actually I do. Remember tacit collusion. There was a model by Green and Porter (1984) that said that in the face of unobservable demand shocks tacit collusion requires price wars during low demand periods in order to sustain co-operation in high demand periods.

If this is the case, the level of world demand for oil may have crossed over to a point where it now constitutes “high demand”. In this case the OPEC partners can feel free to limit their quantity and set prices higher as they can tell that no-one is defecting from this tacit collusive agreement.

However, demand growth has slowed. When world oil demand growth slows sufficiently enough we would expect this agreement to collapse – as the OPEC partners can’t tell if there is a fall in oil demand or if one of their partners is cheating.

Although it is widely documented that OPEC doesn’t seem to be very collusive at all, it may be possible that they can support collusion in states that currently seem like very high demand states – but when put in perspective with the outlook for future fuel consumption do not seem as extreme. If this is the case, the collusive ability of OPEC would be expected to rise over time.

(Note: My main criticism of this is that the equilibrium should really depend on demand growth vs expected demand growth, not the level of demand. If this is the case any unanticipated negative shock to oil demand could spark a large price fall – and as demand appears to be relatively inelastic this does not imply that there will be a huge increase in production).

It will be interesting to look back on this time period and work out which of these possible explanations were the main contributors to rising oil prices.