OPEC

In September 1960 four Persian Gulf nations (Iran, Iraq, Kuwait, and Saudi Arabia) and Venezuela formed OPEC, the purpose of which was to obtain higher prices for crude oil. By 1973 eight other nations (Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon) had joined OPEC. Ecuador withdrew on the last day of 1992.

OPEC was unsuccessful in its first decade. Real (that is, inflation-adjusted) world prices for crude oil continued to fall until 1971. In 1958 the real price was $10.85 per barrel (in 1990 dollars). By 1971 it had fallen to $7.46 per barrel. However, real prices began to rise slowly beginning in 1971, and then jumped dramatically in late 1973 and 1974 from roughly $8 per barrel to over $27 per barrel in the wake of the Arab-Israeli ("Yom Kippur") War.

Contrary to what many noneconomists believe, the 1973 price increase was not caused by the oil "embargo" (refusal to sell) directed at the United States and the Netherlands that year by the Arab members of OPEC. Instead, OPEC reduced its production of crude oil, thus raising world oil prices substantially. The embargo against the United States and the Netherlands had no effect whatever: both nations were able to obtain oil at the same prices as all other nations. The failure of this selective embargo was predictable. Oil is a fungible commodity that can easily be resold among buyers. Therefore, sellers who try to deny oil to buyer A will find other buyers purchasing more oil, some of which will be resold by them to buyer A.

Nor, as is commonly believed, was OPEC the cause of 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, originally imposed in 1971 by President Nixon as part of the Economic Stabilization Program. By preventing prices from rising sufficiently, the price controls stimulated desired consumption above the quantities available at the legal maximum prices. Shortages were the inevitable result. Countries that avoided price controls, such as West Germany and Switzerland, also avoided shortages, queues, and the other perverse effects of the controls.

OPEC is a cartel—a group of producers that attempts to restrict output in order to keep prices higher than the competitive level. The heart of OPEC is the Conference, which comprises national delegations, usually at the level of oil minister. The Conference meets twice each year to assign output quotas, which are upper limits on the amount of oil each member is allowed to produce. The Conference may also meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute.

OPEC faces the classic problem of all cartels: overproduction and cheating by members. At the higher cartel price, less oil is demanded. That is why OPEC assigns output quotas. Each member of the OPEC cartel has an incentive to produce more than its quota and "shave" (cut) this price because the cost of producing an additional barrel of crude is typically well below the cartel price. The methods available to shave official OPEC prices are numerous. Credit can be extended to buyers for periods longer than the standard thirty days. Higher grades (or blends) of oil can be sold for prices applicable to lower grades. Transportation credits can be given. Buyers can be offered side payments or rebates.

This tendency for individual producers to cheat on the cartel agreement is a long-standing feature of OPEC behavior. Individual producers usually have exceeded their production quotas, and so official prices have been unstable. But OPEC is an unusual cartel in that one producer—Saudi Arabia—is much larger than the others. That is why the Saudis are the "swing" producer. When prices start downward, they cut their production to keep prices up. One reason the Saudis have behaved that way is that departures from the official prices impose larger total losses on them than on other OPEC members in the short run. Because other producers have huge incentives to produce in excess of their quotas, the Saudis, in order to defend the official OPEC price, have had to reduce their sales dramatically at times. This erosion of Saudi production and sales has tended to reduce their revenues and profits substantially. In 1983 and 1984, for example, the Saudis found themselves producing only about 3.5 million barrels per day, despite their (then) production capacity almost three times that level.

How successful has OPEC been since the early seventies? Not as successful as many people perceive. Except in the wake of the 1979 Iranian revolution, and in anticipation of possible destruction of substantial reserves in the 1990-91 Persian Gulf conflict, real (inflation-adjusted) prices of crude oil have fallen since 1973. Prices began dropping very rapidly in the early eighties after the Saudis concluded that lower prices and higher production were in their best interests. Official prices fell from $34 (for the benchmark crude oil, Arabian light) to $29 in 1983, $24 in 1984, and about $18 in 1986 to 1988. Indeed, even prices unadjusted for inflation often have fallen. For example, prices fell from $35.10 per barrel ($49.10 in 1990 dollars) in 1981 to $16.69 ($18.69 in 1990 dollars) in 1987. (Price data are shown in table 1, and current reserves, production capacity, and production levels are shown in table 2.)

TABLE 1
World Crude Oil Prices (U.S. dollars per barrel)
Year	Nominal Price	In 1990 Dollars	Year	Nominal Price	In 1990 Dollars
1955	2.25	10.88	1973	3.27	8.69
1956	2.36	11.04	1974	11.17	27.20
1957	2.73	12.34	1975	11.57	25.66
1958	2.45	10.85	1976	12.41	25.86
1959	2.27	9.82	1977	13.33	26.05
1960	2.23	9.49	1978	13.43	24.46
1961	2.27	9.57	1979	20.19	33.78
1962	2.26	9.32	1980	32.27	49.52
1963	2.25	9.13	1981	35.10	49.10
1964	2.23	8.91	1982	32.11	42.22
1965	2.22	8.64	1983	27.73	35.10
1966	2.24	8.42	1984	27.44	33.50
1967	2.27	8.31	1985	25.83	30.63
1968	2.24	7.81	1986	12.52	14.47
1969	2.27	7.50	1987	16.69	18.69
1970	2.35	7.36	1988	13.25	14.36
1971	2.52	7.46	1989	16.89	17.59
1972	2.64	7.47	1990	20.42	20.42
SOURCE: U.S. Departments of Energy, Commerce, and Labor.

TABLE 2
OPEC Reserves, Production Capacity, and Production Levels
Nation	Reservesa	Capacityb	Productionc
Algeria	9,200	800	750
Ecuador	1,514	330	280
Gabon	733	200	260
Indonesia	8,200	1,300	1,200
Iran	92,860	3,000	3,100
Iraq	100,000	3,500	3,100
Kuwait*	97,125	2,200	1,800
Libya	22,800	1,600	1,250
Neutral Zone	n.a.	600	300
Nigeria	16,000	1,700	1,700
Qatar	4,500	600	365
Saudi Arabia*	257,559	7,000	5,300
Un. Arab Em.	94,105	2,210	2,060
Venezuela	58,504	2,400	2,000
OPEC Total	763,100	27,440d	23,465
World Total	1,001,572	63,740d	60,320
aMillions of barrels on January 1, 1990. bMaximum sustainable as of August 1990, thousands of barrels per day. cThousands of barrels per day as of May 1990, excluding natural gas liquids. dNon-OPEC capacity for first quarter 1991, from internal Department of Energy/Energy Information Administration estimate. * Includes one-half of the Neutral Zone. n.a.—not available. SOURCE: U.S. Department of Energy, Central Intelligence Agency.

This downward trend has increased tensions between two rival groups within OPEC. The price "hawks," usually nations with smaller crude oil reserves relative to population, argue for lower oil output and higher prices. The principal hawks within OPEC are Iran and Iraq. The price "doves," usually nations with larger reserves relative to population, argue for higher output and lower prices 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.

Such relatively lower prices serve the interests of the doves because oil consumers have used less oil in response to prior price increases. For example, U.S. energy use per dollar of GNP (adjusted for inflation) was 27.49 thousand BTUs in 1970. By 1988, after the price increases of 1973 and 1979, it had decreased to 19.93 thousand BTUs. Thus, the price "doves," led by Saudi Arabia, generally have resisted pressures for higher prices.

Over the long run, real prices of natural resources and commodities usually fall, largely because of technological advances. Crude oil is no exception. Technological advances in seismic exploration have dramatically reduced the cost of finding new reserves, thus increasing oil reserves greatly. Horizontal drilling and other new techniques have reduced the cost of recovering known reserves. Also, improvements in technology provide both substitutes for oil and ways to use less oil to achieve given ends.

Moreover, advances in technology will reduce prices for such substitute fuels as natural gas, thus exerting continuing downward pressure on crude oil prices. And increasing willingness to devote resources toward environmental improvement suggests that the market for crude oil will decline relative to those for such "cleaner" energy sources as natural gas and nuclear technology, unless other technical advances yield substantial improvement in the ability to use oil cleanly. Thus, the demand for crude oil is likely over the long term to decline relative to the demand for competing fuels. This has been the experience of mankind, as wood gradually gave way to coal, which in turn declined as the use of oil expanded. These facts suggest that the economic power of OPEC inexorably will erode.