The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Organization of the Petroleum Exporting Countries (OPEC)

  • James L. Smith
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_2430

Abstract

Since the 1960s, the Organization of the Petroleum Exporting Countries (OPEC) has dominated the world oil market by exercising physical control over a large portion of the world’s oil reserves. Coordinated production restraint among OPEC members has artificially limited the supply of oil and succeeded in pushing oil prices far above the competitive level. Despite its past success, OPEC faces three basic problems that, in the long run, tend to undermine all cartels: coordination failures, opportunistic cheating, and the entry of competing producers who manage to find and bring alternative supplies to the market.

Keywords

Barriers to entry Cartels Cheating Coordination Cournot oligopoly Entry Free-rider problem Organization of Petroleum Exporting Countries (OPEC) Prisoner’s Dilemma Stackelberg dominant-firm models 

JEL Classification

F33 

The Organization of the Petroleum Exporting Countries (OPEC), an international cartel of oil-producing states, affects the price of nearly all crude oil traded in the world economy and has done so since the early 1970s.

Founded in 1960, OPEC initially consisted of five member states (Iran, Iraq, Kuwait, Saudi Arabia and Venezuela) which together accounted for 38% of total world production of crude oil. The founders sought to coordinate national petroleum policies and forge a more united front in dealings with the multinational oil companies that operated within their borders. Although membership has grown to 12, OPEC’s share of global crude oil production still amounts to only about 44%. Coordinated restraints on output (especially since 1973) have deliberately held OPEC’s market share in check.

During its first decade (1960–1970), OPEC’s principal objective was to secure for its members a larger share of the profits derived from the production and sale of their oil – the stated goal being to raise government take from 50% to 80% of total profit. Beginning with the so-called Teheran–Tripoli Agreements of 1970–1971, OPEC turned to what has become its main purpose: manipulating the level of world oil prices by restricting productive capacity and output. Initially, this was attempted without assigning individual production quotas to the respective members. Only after the downturn in world oil prices that began in 1982 did OPEC introduce a formal system of production allocations – which remained in force as of 2007. The members meet at regular intervals (and sometimes on an emergency basis) to review market conditions and adjust individual production ceilings as needed to maintain a target price. Adelman (1995) and Parra (2004) describe the intriguing economic and political challenges faced by the members of OPEC in dealing with the market and with each other.

There is no question that OPEC members have restricted production in ways that are unrelated to the physical scarcity of oil. Even though OPEC’s proved oil reserves in 2007 were double those of 1973, the cartel initiated sharp output cuts that by 1985 had removed nearly half of their previous production from the market, as shown in Fig. 1. Not until 2005 did OPEC production regain (barely) the level of 1973. Over that same period, worldwide consumption of crude oil grew by 50% and production from non-OPEC producers (who faced much higher marginal costs) managed to increase by 70%.
Organization of the Petroleum Exporting Countries (OPEC), Fig. 1

OPEC Production and reserves, 1973–2005 (Sources: Production, U.S. Energy Information Administration. Reserves, Oil & Gas Journal)

Economic Models of OPEC Behaviour

Early economic analyses of OPEC behaviour questioned whether the output reductions might reflect competitive or other forms of non-cooperative conduct (for example, oligopoly), as opposed to outright collusion. Mead (1979) and Johany (1980) proposed a ‘property rights’ explanation that linked the production cuts to the wave of nationalizations that swept through the global oil industry in the early 1970s. Property rights in oil reserves were transferred, via nationalizations, from the multinational corporations (with higher presumed discount rates) to OPEC states (with lower presumed discount rates and therefore greater patience in extracting the oil). However, this explanation is belied by the fact that, throughout the 1960s, these same host governments had repeatedly exhorted the multinational companies to increase, not decrease, their rates of production (Adelman 1982).

Teece (1982) and Crémer and Salehi-Isfahani (1980) advanced the idea that the limited domestic revenue needs (‘absorptive capacity’) of some OPEC members imposed an indirect restriction on production. The higher the price, the lower the volume of oil exports required to achieve a requisite amount of revenue. The result would be a backward-bending supply curve that links lower oil output to higher prices in a manner that implies no coordination among OPEC members. One problem with this argument, as Adelman (1982) pointed out, is that the absorptive capacities of OPEC members seemed to increase faster than export revenues. Griffin’s (1985) subsequent empirical tests found little statistical support for the target revenue hypothesis.

Distinguishing between the various models of OPEC behaviour has been complicated by the fact that cooperative and non-cooperative models share many similar predictions. Thus, the same body of evidence has been interpreted in ways that are consistent with a variety of competing models. By focusing on one aspect of producer behaviour (short-run reactions to cost shocks) that more clearly distinguishes between models, Smith (2005) found a degree of parallelism among OPEC producers that can be accounted for only as the result of cooperative behaviour, not competition or mere interdependence among producers, as in the Cournot oligopoly or Stackelberg dominant-firm models.

Future Challenges Facing OPEC

Levenstein and Suslow (2006) identify three critical problems that any cartel must solve if it is to endure: coordination, cheating and entry. In the case of OPEC, the last of these has been the easiest. OPEC is protected by barriers to entry that stem from ownership and control of low-cost oil reserves. Roughly 75% of the world’s proved reserves of crude oil are located in OPEC nations. Additional reserves are discovered and developed each year, but this process has become increasingly difficult and expensive – even more so outside OPEC than within. Thus, production of crude oil from non-OPEC sources does expand when the cartel cuts production and pushes prices up, but the scope for this is limited and will remain so.

The problem of cheating has been more difficult for OPEC. Any system of output restraints is vulnerable to the free-rider problem. Although OPEC as a whole may benefit by restricting total output, individual members are tempted to produce beyond their assigned quotas. Cartel membership is most beneficial to those members who do not cut production. Without a system to detect and punish cheating, the cartel is hampered by a Prisoner’s Dilemma in which the dominant strategy for most, if not all, members is to ignore their assigned quotas.

It is common, as in Gately (2004), to distinguish between ‘core’ (low cost, high compliance) and ‘non-core’ (high cost, low compliance) members of OPEC. In fact, compliance with the quota by members of both groups has been sporadic, as shown in Fig. 2. Since the inception of the formal quota system in 1983, total OPEC production of crude oil through 2005 has exceeded the ceiling by 4% on average, but on numerous occasions the excess has run to 15% or more. In general, full compliance has been achieved only during episodes (like 2005–2006) when the production ceiling itself tested the limits of each member’s available production capacity, such that cheating was not feasible.
Organization of the Petroleum Exporting Countries (OPEC), Fig. 2

OPEC compliance with the production ceiling, 1983–2005 (Sources: Ceilings, OPEC Annual Statistical Bulletin. Actual production, U.S. Energy Information Administration)

The third problem – coordination among members – presents further difficulties. Due to economic and demographic heterogeneity, the interests of individual OPEC members do not naturally align behind a single ‘correct’ price or production target. In part this is due to the fact that OPEC has limited means by which to redistribute earnings among members. Therefore, any given set of quotas determines not only the overall profit of OPEC but also the individual revenues that accrue to each member. Moreover, coordination requires agreement not only about how aggregate output is parcelled out to individual members, but also about the amount of oil to be produced by OPEC in total. Members with low-cost, long-lived reserves may be more reluctant to have OPEC pursue severe output cuts since too-high prices would induce technological development and new forms of energy (or energy conservation) that will eventually compete with OPEC. Members that possess smaller reserves and shorter horizons are less affected by this and may prefer deeper production cuts. Internal divisions between ‘price hawks’ and ‘price doves’ have been observed previously and will likely surface within OPEC again.

In terms of longevity, OPEC is already far beyond the mean lifetime (5 years) of contemporary international cartels (Levenstein and Suslow 2006). In terms of economic impact, it is sufficient to note that crude oil is among the most valuable commodities exchanged in international trade, with total daily receipts in 2007 in excess of $1 billion. Thus, by exerting even a small impact on the market price, the cartel effects an enormous transfer of wealth between consumers and producers of crude oil, and creates a substantial allocative inefficiency of the type that arises whenever the price of a product deviates from its marginal cost. As of 2007, no one has attempted to reckon the full magnitude of welfare losses that may be associated with OPEC’s manipulation of the world oil market.

See Also

Bibliography

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Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • James L. Smith
    • 1
  1. 1.