Why OPEC Needs America Fat and Happy

Kevin's explanation of why oil prices are cause for severe concern is vintage Drum: informative, well-written, and containing a graph. Read it. But I think he gets something wrong in his evaluation of OPEC's incentives:

OPEC has the capacity to supply about 30 mbd. Question: what incentive do they have to continue pumping this amount? Economically, they have very little. If they cut production by 20% (6 mbp), that would reduce global supply to 78 mbd. Prices would immediately double to around $100/barrel, maybe even higher, since there would be no other source to make up the shortfall. As a result, OPEC's revenues would skyrocket — not all at once, since most oil is delivered under futures contracts, but soon enough. In addition, most Middle Eastern fields are being overproduced right now, so cutting production would have beneficial long-term effects as well.

Kevin goes on to argue that Saudi Arabia used to be a buffer against this because they could simply flood the market with cheap crude, but they don't have such powerful production capacity anymore and so aren't as able to regulate the industry*. In addition, Iran and Venezuela could care less about a recession in the West, so they might go for the short-term profits over our economic stability. The counter-argument is our capacity for a military response, but we can't really do that right now thanks to our deployment in Iraq, so what's to stop them?

Well, lots. Despite the skyrocketing costs of oil, the market hasn't priced oil commensurately with its finiteness. That'll change reasonably soon (as Kevin notes, the question is whether that happens gradually or suddenly), but it hasn't yet. That undervaluation of oil has allowed most economies to stroll along without really worrying about what comes after petrol or getting serious about reducing their reliance on it. An oil shock changes all that. Suddenly, life after cheap oil becomes a policy reality -- which is the worst possible scenario for OPEC, though probably one of the best for America.

There are a lot of ways to reduce our economy's reliance on oil. We can't yet end our dependance (at least, nobody but Amory Lovins seems to think we can), but we can reduce our usage in a hurry. There's precedent for that -- when OPEC tried to jack up prices in the 70's, they, not we, turned out the losers. Between 1977 and 1985, we cut our oil usage by 17% while growing our GDP by 27%. Not too shabby. During that period, oil imports fell by 50%, and imports from OPEC by 85%. It hurt, sure, but them more than us.