OPEC

In September 1960, four Persian Gulf nations (Iran, Iraq, Kuwait, and Saudi Arabia) and Venezuela formed OPEC in order to obtain higher prices for crude oil. By 1973, eight other nations (Algeria, Ecuador, Gabon, Indonesia, Libya, Nigeria, Qatar, and the United Arab Emirates) had joined OPEC; Ecuador withdrew at the end of 1992, and Gabon withdrew in 1994.

The collective effort to raise oil prices was unsuccessful during the 1960s; real (i.e., inflation-adjusted) world market prices for crude oil fell from $9.78 (in 2004 dollars) in 1960 to $7.08 in 1970. However, real prices began to rise slowly in 1971 and then increased sharply in late 1973 and 1974, from roughly $10.00 per barrel to more than $36.00 per barrel in the wake of the 1973 Arab-Israeli (“Yom Kippur”) War.

Despite what many noneconomists believe, the 1973–1974 price increase was not caused by the oil “embargo” (refusal to sell) that the Arab members of OPEC directed at the United States and the Netherlands. Instead, OPEC reduced its production of crude oil, raising world market prices sharply. The embargo against the United States and the Netherlands had no effect whatsoever: people in both nations were able to obtain oil at the same prices as people in all other nations. This failure of the embargo was predictable, in that oil is a “fungible” commodity that can be resold among buyers. An embargo by sellers is an attempt to raise prices for some buyers but not others. Only one price can prevail in the world market, however, because differences in prices will lead to arbitrage: that is, a higher price in a given market will induce other buyers to resell oil into the high-price market, thus equalizing prices worldwide.

Nor, as is commonly believed, did OPEC cause oil shortages and gasoline lines in the United States. Instead, the shortages were caused by price and allocation controls on crude oil and refined products, imposed originally by President Richard Nixon in 1971 as part of the Economic Stabilization Program. Although the price controls allowed the price of crude oil to rise, it was not allowed to rise to free-market levels. Thus, the price controls caused the amount people wanted to consume to exceed the amount available at the legal maximum prices. Shortages were the inevitable result. Moreover, the allocation controls distorted the distribution of supplies; the government based allocations on consumption patterns observed before the sharp increase in prices. The higher prices, for example, reduced long-distance driving and agricultural fuel consumption, but the use of historical consumption patterns resulted in a relative oversupply of gasoline in rural areas and a relative undersupply in urban ones, thus exacerbating the effects of the price controls themselves. Countries whose governments did not impose price controls, such as (then West) Germany and Switzerland, did not experience shortages and queues.

OPEC is in many ways a cartel—a group of producers that attempts to restrict output in order to raise prices above the competitive level. The decision-making center of OPEC is the Conference, comprising national delegations at the level of oil minister, which meets twice each year to decide overall oil output—and thus prices—and to assign output quotas for the individual members. Those quotas are upper limits on the amount of oil each member is allowed to produce. The Conference also may meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute.

OPEC faces the classic cartel enforcement problem: overproduction and price cheating by members. At the higher cartel price, less oil is demanded; output quotas are necessary in that each member of OPEC has an incentive to sell more than its quota by “shaving” (cutting) its price because the cost of producing an additional barrel of oil usually is well below the cartel price. The methods available to engage in such cheating are numerous: sellers can extend credit to buyers for periods longer than the standard thirty days, sell higher grades (or blends) of oil for prices applicable to lower grades, give transportation credits, offer buyers side payments or rebates, and so on.

This tendency of individual producers to cheat on a cartel agreement is a long-standing feature of OPEC behavior. Individual producers usually have exceeded their production quotas, and so official OPEC prices have been somewhat unstable. But unlike the classic “textbook” cartel, OPEC is unusual in that one producer—Saudi Arabia—is much larger than the others. This condition has caused Saudi Arabia to serve, from time to time, as the OPEC “swing” producer—that is, the producer that adjusts its output in order to preserve the official price in the world market. One reason the Saudis have so acted is that downward pressure on the official price imposes larger total losses on them than on the other OPEC producers in the short run. The Saudis, in their efforts to defend the official OPEC price, have periodically reduced their sales, at times dramatically, thus reducing their revenues substantially. In 1983, 1984, and 1986, for example, the Saudis produced only about 3.5 million barrels per day, despite their (then) production capacity of about 10 million barrels per day.

How successful has OPEC been since the early 1970s? Not as successful as many observers believe. Except in the wake of the 1979 Iranian upheaval, and in market anticipation of a possible destruction of substantial reserves in the 1990–1991 and 2003 Gulf wars, real prices of crude oil fell from 1974 through 2003. Prices increased in 2004 and (thus far) 2005, but this has little to do with the effectiveness of OPEC as a cartel. The causes of the 2004 and 2005 price increases were increased demand in Asia; production problems in Venezuela, Nigeria, and other producing regions; a weakening dollar; and an increased terrorist threat to oil production and transport facilities. Over the longer time frame, prices began declining rapidly in the early 1980s, after the Reagan administration ended the price and allocation regulations, which, because of their specific design, increased the U.S. demand for foreign oil. The Saudis then concluded that lower prices and higher production would further their interests; world market prices (in 2004 dollars) fell from $62.76 per barrel in 1981 to $44.89 in 1984, $21.84 in 1986, and $21.39 in 1988. Indeed, prices even unadjusted for inflation often have declined, from $34.28 in 1981 to $14.96 in 1988. Table 1 shows price data; Table 2 contains current estimated reserves, official production capacity, reported production levels, and OPEC production quotas.

This longer-term downward trend in prices has yielded increased tensions between two rival groups within OPEC. The price “hawks”—for the most part nations with smaller reserves relative to population—have pressed for lower output and higher prices; the principal hawks within OPEC have been Iran and Iraq before the overthrow of the Baathist regime of Saddam Hussein. The price “doves”—for the most part nations with larger reserves relative to population—have argued for higher output and lower prices, so as to preserve over the longer term their oil markets, and thus the economic value of their oil resources. The principal doves within OPEC are Saudi Arabia, Kuwait, and the United Arab Emirates.

Relatively lower prices serve the interests of the OPEC doves because oil consumers have responded to prior price increases by finding ways to reduce oil consumption below levels that otherwise would have prevailed. For example, U.S. energy use per dollar of gross domestic product (2004 dollars) in 1970 was about 17,000 Btu. By 1988, after the price increases of 1973 and 1979, it had declined to about 11,600 Btu, and by 2003 it had declined further to about 8,900 Btu. Thus, the price doves, led by Saudi Arabia, generally resisted pressures for relatively higher prices.

Over the long run, the real prices of natural resources and commodities usually fall, largely because of technological advances. Crude oil is no exception. From about $47 per barrel (2004 dollars) in the late 1860s, prices fell to about $28 in 1920, about $13 in 1950, about $12 in 1960, and about $7 in 1970. The price increases of the 1970s and the first half of the 2000s are relatively recent phenomena, and historical patterns suggest that they will not be long-lived. Technological advances in seismic exploration have dramatically reduced the cost of finding new reserves, thus greatly increasing oil reserves; proven world crude oil reserves have doubled since 1980. Horizontal drilling and other new techniques have reduced the cost of producing known reserves, while other technological improvements yield both substitutes for oil and ways to use less oil to achieve given ends.

Moreover, advances in technology over time similarly will reduce prices for such substitute fuels as natural gas, thus exerting continuing downward pressure on crude oil prices. Also, an increasing willingness to devote resources toward environmental improvement suggests that the market for crude oil may decline relative to those for such “cleaner” energy sources as natural gas and nuclear power, unless other technological advances yield substantial improvement in the ability to use oil cleanly. Accordingly, the demand for crude oil over the long term may decline relative to the demand for competing fuels, just as wood gradually gave way to coal—which in turn gave way to oil. These long-term market forces suggest that the economic power of OPEC inexorably will erode.