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OPEC: Good is Bad – Bad is Good

Seeking Alpha

September 29, 2008

OPEC: Good is Bad – Bad is Good

By Praveen Jaiswal

“You should respect each other and refrain from disputes; you should not, like water and oil, repel each other, but should, like milk and water, mingle together.” (Gautam Buddha)

The history of the international petroleum industry is marked by attempts to restrict supply and maintain high prices. They include the Achnacarry (“As Is”) Agreement; the abortive Anglo-US treaties towards the end of the World War II; and the system of allowable practiced in the name of conservation, by various states in the United States, most notably in Texas, where the Texas Railroad Commission [TRC] was the lynchpin, setting monthly maximum allowable production levels.

OPEC therefore has a long and varied lineage, and indeed it was originally intended by two of its founders – Venezuela’s Juan Pablo Perez Alfonzo and Saudi Arabia’s Abdullah Tariki to play the same role as TRC, but on international stage. Perez Alfonzo provided the rationalization; Tariki the fire and they gave birth to this Vienna headquartered, formal institution known as OPEC (The Organization of Petroleum Exporting Countries) in September 1960.

In the oil industry, cartels have been common. The purpose of a cartel is to protect profits through uniform guidelines and actions. Members of the group can do this by expanding or contracting the supply of a commodity depending upon the demand conditions at any given time. The first famous cartel in the oil industry – the “Seven Sisters” – came in the 1920s and lasted until the early 1970s. This famous cartel dissolved only to be replaced by another. 

The organization came into existence as a result of a number of circumstances, some of which were not in fact closely related. Although the seeds were sown when the Arab League held its first meeting in 1945, however, few people are aware of it today, but the OPEC was formed in response to the U.S. imposition of import quotas on oil. In March 1959, the U.S. Government, led by President Eisenhower, established a Mandatory Oil Import Quota Program [MOIP], restricting the amount of oil that could be imported into the United States. The MOIP gave preferential treatment to oil imports from Mexico and Canada. The exclusion of the US market to Persian Gulf producers depressed prices for their oil.

As a fall out from this, in September 1960, representatives of the major Gulf exporting countries (Saudi Arabia, Venezuela, Kuwait, Iran and Iraq), “the founding members”, met in Baghdad on September 10 – 14, 1960 and reached an agreement paving way for formation of a new entity to confront this problem. It was called the Organization of Petroleum Exporting Countries [OPEC] and it made its intention clear: to defend the price of oil – more precisely, to restore it to its precut level. They also devised a system of “regulation of production” to control prices.

The original aims and objectives of OPEC were modest, as indicated by its first two “Resolutions”. The first resolution provided

… that members shall demand that oil companies maintain their prices steady and free from all uncessary fluctuations; that members shall endeavour, by all means availbale to them, to restore present prices…

The second Resolution stated OPEC’s overall objectives:

… The principal aim of the Organization shall be the unification of petroleum policies for the member countries and the determination of the best means for safeguarding the interests of member countries individually and collectively. 

Presently, OPEC is a group of twelve states made up of Iran, Iraq, Kuwait, Qatar, Saudi Arabia, United Arab Emirates, Libya, Algeria, Angola, Venezuela and Ecuador. Recently, Indonesia has decided to leave the organization.

The Economics of OPEC: The Prisoner’s Dilemma

Unlike competitive industries, oil production belongs to what is known as oligopoly,where only a few producers produce most of the output. Businesses or nations in an oligopoly produce almost the same thing and sell it at a price determined by demand and the overall supply of all the producers.

However, in order to maximize profit return on every unit of output businesses in an oligopoly, they need to collude and reduce output together so that prices rise and overall revenue rises. How does overall revenue rise when demand should naturally drop on higher prices? The problem is that demand for oil all over the world in fairly inelastic, which means that the drop in demand is lower than rise in prices. So, that is what OPEC does – the members have a clear understanding on the price elasticity of oil demand and that is how the supplies are regulated to ensure that the prices are reined to a level that demand is maintained without loss of revenue to the member nations.

The following diagram clearly illustrates this point, with supply shifting to the left and the demand for oil being inelastic in the short term has a big effect on price.

OPEC coordinates oil production policies to help stabilize the oil market and help oil producers achieve a reasonable rate of return on their investments. This policy is also designed to ensure that oil consumers continue to receive stable supplies of oil. Hence, OPEC is at its weakest point when it does not have excess capacity. With excess marketable capacity, OPEC can influence oil prices when they are increasing, but might not be able to influence prices when they are decreasing. As an old adage says “adding fuel to fire”; however OPEC defies the old adage and are adding fire by withdrawing fuel.

Virtues are Accidents; Vices are Planned

The formation of OPEC was the first collective act of sovereignty on the part of the oil exporters and it turned out to the first turning point in the international economic relations towards the control over natural resources. OPEC now functions as a price-setting and output-limiting institution, and it has opted for a policy of high prices relative to those prior to 1970. The main function and intention of the group was, as publicly stated, to form a cartel in order to secure profits in the oil industry by controlling the supply of oil in the world through agreed-upon production quotas.

Everyone agrees that world oil markets have changed remarkably since 1960. The old order, based on military and technological superiority of Western powers, has given way to the new reality of OPEC. In 1960, six of the thirteen present member nations of OPEC were protectorates, or colonies of European countries. Oil flowed through the Suez Canal and the Strait of Hormuz was controlled by European and American interests.

The formation of OPEC should be viewed as a natural development evolving out of the geographical distribution of petroleum reserves OPEC derives its power from the fact that its members own two-third of known petroleum reserves and that their extraction costs are minimal. In total, the Middle East alone accounts for 65% or 685 thousand million barrels of proved oil reserves. Members of OPEC export 85% of all oil moving in international trade, primarily because their reserves are large and extraction costs are low. Due to this very fact, at times OPEC has also shown its ability to use oil as a weapon. The oil prices now reflect the desires of the Middle East, as one of the Saudi Oil Minister declared, “The moment has come, we are masters of our own commodity”.

Conventional wisdom holds that the OPEC oil control has the world in its grasp. It can manipulate prices by tinkering with supplies, but the conventional wisdom is mostly wrong OPEC is no wizard; its actions lap behind fundamental changes in oil supply and demand rather than leading them. OPEC’s ability to control price of oil has, over a period of time, diminished due to discovery and development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization. It is, however, hard to figure out exactly what goes behind OPEC closed doors, but glimpses are possible by following what the cartel members say about prices and how they set quotas.

Less is More – More is Less

As an old adage says “less is more”, meaning that less production will yield more revenue for all producers combined. OPEC members have adopted cooperative policies to hold prices well above costs and to reduce production while increasing their current and potential income.

OPEC is a basically a price fixing cartel with Saudi Arabia generally acting as the price leader. As oil is the principal energy resource at present because it is cheap relative to alternative fuels, and as the world demand is inelastic even at current prices, OPEC holds the key. OPEC is more concerned with the elasticity of demand for its own oil rather than with the elasticity of total world demand. In a very real sense, OPEC functions as a residual supplier, with an elasticity of demand much greater than for non OPEC suppliers.

On the supply side, the membership of resource owners is important because of the need to communicate and coordinate policies. The volume of reserves held by each country is all the more important because large resource owners exert a substantial influence on volume and prices. There are several instances when large volume owners like Saudi Arabia andKuwait have increased / decreased production when required to maintain prices. The status of OPEC, in its true sense, is said to be in violation of the WTO global rules and the alleged manipulation of oil prices is detrimental to consumers, especially developing countries.

The Price “Hawks” and “Doves”

The price “hawks”, usually OPEC nations with smaller crude oil reserves, argue for lower oil output and higher prices. The principal hawks within OPEC are Iran and Iraq. The price “doves”, usually with larger reserves, argue for higher output and lower prices to preserve, over the longer term, the oil markets and thus the economic value of their oil resources. The principal doves within OPEC are Saudi Arabia, Kuwait and the UAE. 

OPEC may call itself an “organization”, but everyone knows that it is, pure and simple, a cartel that manipulates markets restricts output and fixes prices. The cartel’s economic effect on world oil markets has been devastating, dating from the oil embargo in the 1970s to today’s unstoppable escalation of pump prices. The impact of the Arab oil embargo was so devastating that in the US, cars with license plates ending in odd/even numbers were allowed to fuel on alternate days and the national speed limit was reduced to 55 mph. In the last three years alone, crude prices rose from $54 to nearly $147 a barrel – which means more spending by oil importing countries leading to fat pockets of OPEC member countries, in turn increasing their economic and political power. OPEC is clearly a “combination of conspiracy” that restrains trade.

OPEC’s agenda shifts with tides. Its central aims are said to consist of extracting maximal economic rent from the world’s consumers and dissuading corporate oil from investments in exploration elsewhere. The security premium built into oil prices is attributed to hysteria and fear, a psychological state manipulated by OPEC’s skillful propaganda, mediated by traders of the electronic barrel.

The Bad is Good

OPEC’s most important achievement is its contribution to the growing knowledge of the industry in member countries, and awareness of their crucial role in the industry that is so important to the economic growth of the world and especially of the industrialized countries. Members of OPEC earned US $642 billion in oil exports during the first seven months of 2008. Boosted by high oil prices and increased production, OPEC’s earnings could exceed 1 trillion dollars by the end of this year.

World over, oil producers need to pump $2.4 trillion into projects to expand crude output capacity to meet future world demand, and around $680 billion alone need to be invested by OPEC members. The OPEC oil cartel have recently announced plans to invest more than $150 billion by 2012 on more than 120 upstream projects targeting output expansion. These projects are expected to raise OPEC’s existing production capacity by over 500 million barrels a day, aimed at satisfying growing demand for uninterrupted secure oil supplies as well as offering an adequate level of spare capacity.

In place of the Robin Hood role it briefly assumed in the 1970s, OPEC has now taken on the burden of bringing “stability” to the wild and crazy oil market.

  • OPEC supports promotion of technologies that address climate change concerns;
  • OPEC’s aim is to make fossil fuel use more consistent with protection of environment;
  • Carbon capture and storage is a promising technology. OPEC is taking lead in its development and deployment; and
  • At the third OPEC summit in Riyadh in November 2007, OPEC pledged US $750 million towards research into energy and environment.

OPEC – 2: One is Not Enough

A number of important oil-exporting states have remained outside the OPEC. These include Russia, Mexico, Norway and Angola. Oil openings in Central Asia, West Africa and Russia to expand production would place OPEC states in conflict and pose a serious threat to OPEC’s survival.

Mr. Alexei Miller, CEO of Russia’s largest oil company, Gazprom, has already said,

OPEC-2, consisting of a core group of oil-producing states, may have a greater effect on oil prices than the existing 13-member cartel.

Mr. Miller further states,

The idea has been brought up of founding an OPEC-2, which will consist of fewer players, but the structure will be more flexible and capable of really influencing the market.

Russia which pumps 12% of the world’s crude, is the largest oil producer outside the OPEC, and founding a natural-gas OPEC might see the light of the day very soon. As pointed by Gazprom’s CEO,

the main task of the forum, in contrast to OPEC, isn’t the setting of daily production quotas, but questions of long-term strategy and investment plans in gas industry.

In many ways, OPEC is an institutional relic of the Cold War era and is one of the great survivors in the oil landscape. There could emerge longer-term threats to its survival, like inter-fuel competition from unconventional oils, gas/liquid natural gas, condensates, nuclear, bio-fuels and coal. Even with the global trend towards greater diversity in potential reserve dispositions and oil export supplies, as well as a worldwide decline in old fashioned geopolitical institutions, the odds still appear to be on the continuity of OPEC.

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