Fracking is Pitting OPEC Members Against Each Other. It Couldn't Happen to a Nicer Bunch of Cartel Members.

Venezuela, Iran, and others, desperately need high oil prices. But the more powerful members of OPEC don't seem willing to go along.

OPEC meets in Vienna on Friday, a meeting that will, according to the Wall Street Journal, be a mite testy. The last few years have been flush for the cartel, with oil prices well above their historical average. Now fracking is changing all that--and hammering open fissures in the cartel that been temporarily plugged with huge wads of petrodollars.

On one side are members like Saudi Arabia, who you can think of as OPEC's central banker. Saudi Arabia sits on top of a vast reservoir of high quality oil that is cheap to pump and cheap to refine. It's not literally true that you can just stick a pipe down in the desert and have oil come-a-gushing, but it might as well be. Because they have such a huge quantity of cheap, good oil, Saudi Arabia is the low-cost producer. They also manage their production very intelligently--Aramco, the state-owned oil company, is very well run, and the Saudi government hasn't pumped every spare petrodollar into their economy. Which means that when the price falls, Saudi Arabia can afford to cut back production a bit.

Here's the thing about cartels: without legal enforcement, they pretty much never work. The incentive to cheat, and take extra profits by producing a little more than your quota, is too high . . . so pretty soon everyone is cheating, and your cartel doesn't really exist any more.

OPEC has managed to flagrantly violate this general economic truism for a few decades now. Saudi Arabia is one of the main reasons that it's been able to hold together for so long, even after the price crash of the mid 1980s. Until the Chinese economic boom drove global oil demand right up against the limits of the industry's pumping capacity, causing prices to spike, Saudi Arabia's excess capacity kept prices roughly stable, in the neighborhood of $25-$35 a barrel. Which, probably not coincidentally, is well under the break-even price for shale oil projects.

Saudi Arabia is one reason that the cartel has held together. The other is countries like Venezuela and Iran, which are pumping much less than they theoretically could. Thanks to Iranian sanctions, and Venezuela's terrible oil management policies, production in those countries is well under its theoretical maximum . . . which acts as a sort of implicit subsidy to the other members of OPEC.

As long as prices were high, all of this was fine; Saudi and everyone else were pumping a lot and taking in a lot of money. But fracking threatens to change that happy equilibrium. The supply of oil will once again start rising to meet demand. And that means that the price is likely to fall.

It probably isn't headed back to $20 a barrel any time soon; at that price, shale oil projects wouldn't be economic. But Venezuela and others cannot afford any sustained decrease in the price of oil. They have spent every petrodollar they got, neglecting investment in favor of other projects. With production declining they are absolutely dependent on the scarcity pricing that has prevailed over the last 5-8 years. They will be pressing for production cuts to maintain price.

But the Journal suggests that lower-cost producers with sounder finances, like Saudi Arabia, are unlikely to be accomodating. They face no threat from fracking--they will always have cheaper, more plentiful oil than North Dakota or Alberta. And from the perspective of the cartel as a whole, it is probably better if price comes down. The higher the price, the more investment there will be in fracking projects. And the more investment there is in a new technology, the greater the risk that some combination of practice and breakthroughs will bring down the production costs of fracked oil. Better for the cartel for prices to fall to the point where current fracking projects are just barely economic.

But this will not be better for Venezuela, et al. Venezuela is experiencing ongoing shortages of basic goods like toilet paper because of its economic mismanagement. Algeria reportedly needs an oil price of $121 a barrel to cover planned spending--and has already experienced riots over food and housing. Iran is experiencing runaway inflation thanks to sanctions; falling oil prices will only make this worse. That's why they so desperately want the cartel to keep prices over $100 a barrel.

For them, however, the strength of the cartel is also its weakness. In some sense Saudi Arabia is the cartel because they're the ones who can afford--and will stick to--production cuts. Venezuela can make all the demands they want. But unless they can afford to cut their production, they will ultimately have to accept whatever the gulf states decide.