Why OPEC is Playing a Dangerous Game With Oil Markets

By Markets Fool.com

OPEC appears to be standing firm to its commitment of keeping oil exports constant in an effort to squeeze marginal oil producers in the U.S., Russia, and elsewhere out of the market. The theory is, pain today for gain tomorrow.

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This general plan has been done before, as fellow Fool Tyler Crowe recently pointed out here. The oil glut of the early 1980s shocked the market and countries like the U.S., who were growing oil production, suddenly stopped drilling and became major OPEC oil importers. The flood of supply stoked increased consumption, lower production, and higher market share and revenue for OPEC. But will the strategy work again?

U.S. drilling may drop dramatically due to OPEC pressure. Image source: Meredithw at Wikimedia.

We've been here before
If OPEC can successfully squeeze marginal suppliers out of the market it could, in theory, allow oil to climb back to $80-$90 per barrel and increase market share from what it has today. As the theory goes, OPEC could then capture growing oil demand as the under-developed world grows and grow revenue dramatically long-term, as it did from the mid-80s to today.

But assuming history will repeat itself -- and buying oil stocks to play this trend -- assumes that conditions today are the same as they were in the early 1980s. There are some very fundamental reasons today's oil glut is very different from the one in the 80s.

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Efficiency is improving and that will continue
One of the things Tyler pointed out in the article above is that oil consumption was falling in the early 80s, as it is today. Between 1980 and 1985, U.S. oil consumption fell 7.8% as more fuel-efficient cars become popular in the U.S. Drivers traded in muscle cars for gas sipping compact cars, not too different from what we see today. OPEC had an incentive to lower prices and give consumers an incentive to buy less efficient vehicles, hooking them on higher demand, so they could grow revenue long-term.

Offshore drilling could stumble if OPEC maintains its supply plans. Image source: Seadrill.

You can see the long-term impact of the price decline in oil in efficiency of cars over the last 30 years. My first car was a 1982 Honda Civic that consistently got over 35 miles per gallon. Today, I drive a 2007 Honda Civic that gets just over 30 miles per gallon. Efficiency improved dramatically between the mid-70s and mid-80s, but the trend actually reversed course over the following 20 years-30 years.

If gasoline is cheap again, will the same movie play out over the next 30 years? I think there's a key difference between the 80s efficiency increase and consumption drop and the one happening today. In the 80s, a move by consumers to smaller vehicles drove a drop in oil demand. Once gasoline prices dropped, demand rose as vehicles got bigger.

Today, efficiency improvements are given a huge boost by increased efficiency across the auto fleet. And the gains will last long-term. U.S. CAFE standards require an average fleet efficiency of 54.5 miles per gallon by 2025. The government expects fuel efficiency for subcompact cars to increase from 34.6 mpg in 2012 to 58.4 in 2025 and for traditional SUVs to improve from 25.9 mpg to 41.2 mpg over the same timeframe.

Even if consumers trade up to larger vehicles, energy demand will likely fall in the developed world over the next decade. When combined with demographic changes pushing residents to city centers where vehicles aren't a necessity, you have a fundamental change in demand for oil in the future, versus the temporary change that happened in the early 1980s.

Alternatives are a very real option
Another option that wasn't a reality in the 1980s is a fundamental alternative to gasoline-powered vehicles. Electric vehicles now account for about 1% of all cars sold in the U.S. and the industry is growing quickly in both sales and viability.

Tesla's Motors' Model S has proven to be a headline grabbing vehicle that can get nearly 300 miles in range while still outperforming many sports cars. But it's actually the Chevy Volt and Nissan Leaf that are leading EV sales in the U.S. Add in new offerings from BMW, Ford, Toyota, and others and you have a serious alternative to gasoline powered vehicles.

If gasoline goes back to $1 per gallon I could see the EV revolution being halted, but at $2.25, where it is today, EVs are still an attractive alternative for some of the population. That'll put further pressure on oil prices and reduce upside potential if OPEC decides it wants higher oil prices in the future.

OPEC may not win this round
When oil prices got too high in the late 70s and early 80s, OPEC flooded the market to reduce the risk of losing consumers to more efficient vehicles or alternative fuels. The strategy worked and over the next 30 years OPEC grew oil export revenue dramatically.

But the oil glut on the market today is very different from the one in the 80s. Large SUV sales are only about a third of what they were a decade ago and I don't think there will be a wholesale shift to larger vehicles even if gasoline stays near $2 per gallon. Even if SUV sales do grow, vehicles are far more efficient than they were a decade ago. The upside that existed for OPEC in the 80s simply isn't there anymore.

When you factor all of these things together, OPEC is playing a dangerous game betting on future energy consumption. They may be able to squeeze out marginal players in the oil market today, increasing their market share in the future. But if the oil market begins to shrink long-term and it then owns a larger share of a smaller pie, it'll come out on the losing end of this battle. Next year alone, the EIA predicts that OPEC will lose out on $257 billion in revenue because of low oil prices and it'll need to make that up in the future for the strategy to be a success.

This may be a strategy OPEC feels it has to take, but betting on a bounce back in oil stocks as a result of OPEC's move is a strategy filled with risks extending far beyond how many barrels Saudi Arabia decides to export next year. It's a key energy debate to watch in 2015.

The article Why OPEC is Playing a Dangerous Game With Oil Markets originally appeared on Fool.com.

Travis Hoiummanages an account that owns shares of Ford and Seadrill. The Motley Fool recommends Ford, General Motors, Seadrill, and Tesla Motors. The Motley Fool owns shares of Ford, Seadrill, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.