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OPEC's Price-Making Power

The Organisation of Petroleum Exporting Countries is a dominant cartel consisting of producers with large reserves and it has always exercised its price-making power in the crude oil market. However, in the past few years, OPEC has been claiming that it has lost its power to alter crude oil prices. The article explores whether OPEC's claim is correct.

COMMENTARY

OPEC’s Price-Making Power

Kaushik Ranjan Bandyopadhyay

In the early 1980s, however, OPEC was often accused of behaving like a “clumsy cartel”3 with a clear presence of non- cooperative behaviour among some of its members with relatively lower crude

The Organisation of Petroleum Exporting Countries is a dominant cartel consisting of producers with large reserves and it has always exercised its price-making power in the crude oil market. However, in the past few years, OPEC has been claiming that it has lost its power to alter crude oil prices. The article explores whether OPEC’s claim is correct.

Kaushik Ranjan Bandyopadhyay (kaushik.banerjee@gmail.com) is at the Asian Institute of Transport Development, New Delhi.

M
ost of the developed, developing and less developed economies are largely dependent for their oil supply on the Organisation of Petroleum Exporting Countries (OPEC),1 a cartel consisting of 13-member countries mostly from west Asia. The cartel had played a significant role in the past in determining world crude oil prices and in countering the vulnerabilities and threats precipitated by oil price spikes or collapses. However, over the past few years, the OPEC producers, particularly Saudi Arabia (the largest producer holding a significant proportion of world crude reserves), have been reiterating that they have lost their control over price determination. The question of erosion of monopoly power of OPEC as a price-maker has become especially relevant in the face of the unprecedented and relentless rise in crude oil prices since 2004 (before they started declining sharply in the last couple of months), which rattled the poorer oil importing countries that were already grappling with dual bouts of rising global food prices and inflation.

The question is – should we buy the claim of OPEC that it has lost its power in oil price determination? In order to answer this question, one needs to explore the role that OPEC has been playing as a cartel and the factors that seem to have tinkered with its ability to control world crude oil prices and identify the true economic incentive for OPEC to adjust its output and hence, influence crude oil prices.

OPEC as a Cartel

During the 1970s, a clear line of demarcation could be observed between OPEC, the undisputed market leader sitting on the largest chunk of proven reserves,2 and non-OPEC, the follower in oil supply with considerably lower proven reserves. During that time, there was not an iota of doubt about the monopoly power of the cartel and its ability to control world crude oil prices through production cuts or increases.

reserves (like Qatar, Algeria, Indonesia and Venezuela). On account of lower reserves, these members, with the intention of amassing quick profits, often tried to cheat other members and produced in excess of the stipulated individual quota decided by OPEC, especially when oil prices were on the higher side. They were apprehensive that if they complied with the stipulated individual quota and postponed their production for the future, when oil prices could fall significantly, then they might just end up as major losers (Cremer and Isfahani 1991).

This tendency of non-compliance often threatened and raised questions about the cohesive capability of OPEC to exercise its market power through adjustment in its production. The lost confidence in the cohesiveness of the cartel and its pricing power was restored after OPEC successfully executed two successive production cuts when oil prices nosedived to an abysmally low level in 1998. However, the price hike in 2004 (when the crude oil prices rose above $50 a barrel) and the inability of OPEC, particularly its dominant producer Saudi Arabia, to counter that through production increases again shook confidence in OPEC.

Studies that explored the causal factors behind OPEC’s inability to counter spiralling prices through production increases evinced that this was primarily due to the erosion of their spare capacity for production of crude [Naimi 2005; Fattouh 2006; Mitchell 2006]. These studies underscored that the surge in non-OPEC production coupled with a rapid decline in world crude oil demand in the 1980s led to a drop in demand for OPEC crude far below expectation and eventually, generated its surplus production capacity. However, since the early 1990s, the spare capacity of OPEC has witnessed a considerable decline (Figure 1, p 19). This decline could be primarily attributed to accelerating global demand combined with low growth in non-OPEC oil supply, particularly over the period 19902004 (Figure 2, p 19) and thus, indicates a complete reversal of the trend in the 1980s.

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COMMENTARY

Except for 2000, 2001 and 2002, when the non-OPEC production surged due to an increase in production from Russia, global demand has consistently outpaced non-OPEC supply. This essentially implies that the shortfall in supply had to be met by OPEC. However, the consistent underestimation of the pace of growth of crude oil demand and overestimation of the growth in non-OPEC supply by the global

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year-to-year variation in global demand Year-to-year variation in non-OPEC supply

Figure 1: Spare Capacity of OPEC as Percentage of World Oil Demand For a large part of 17 17the 1980s and 1990s,

18

the regulation of OPEC

16 14 production based on

14

14

its spare capacity,

12

10

primarily that of its

9

10

9

lead producer Saudi

87

7 Arabia, helped in

6

6 countering demand

45

4

and supply shocks.

2

2

1 However, the decline

0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004in the spare capacity Source: Calculated by the author using data from IMF (2005) for spare capacity and BP (2008) of OPEC on account of for oil demand.

the aforesaid factors

Figure 2: Year-to-Year Variation in Global Oil Demand and Non-OPEC Supply

gradually weakened

(Thousands barrels per day) 3000

2500

2000

1500

1000

500

0

-500

-1000 Source: Calculated by the author using data from BP (2008).

energy agencies led to a number of miscalculated and inadequate responses on the part of OPEC, which relied entirely on those estimates. OPEC thus repeatedly failed to expand its production accordingly and well in advance by early investment in augmentation of their surplus production capacity. The consequence was an eventual erosion of OPEC’s spare capacity in order to cope with unprecedented rise in global demand. The process of erosion accelerated in the 1990s and early 2000 (Figure 1) largely due to the accelerating demand from emerging Asian economies. Furthermore, the decline in spare production capacity in the upstream (i e, crude exploration and production) sector was accompanied by bottlenecks in investment in downstream (i e, refining) assets such as pipelines,

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refineries and tankers, which also failed to cope with the rapid growth in global oil demand. Other crucial factors that exacerbated the problems of underinvestment in downstream capacity were: strikes of oil workers in Venezuela;4 sanctions on oil and gas industry of Iran by the US and that on Iraq and Libya by the United Nations in the 1990s; and Indonesia’s failure to arrest production decline especially since 2000.5

the global oil system’s ability to respond to oil shocks leading to increased volatility in oil prices and frequent spikes. In the process, the credibility of OPEC in exercising market power and restoring stability to the crude oil prices has invariably been threatened. Figure 3 (p 20) portrays how the decline in spare capacity of OPEC exacerbates the volatility in global crude oil prices. An important factor that has assumed significance particularly since the mid-1990s and has often been considered responsible for dwarfing OPEC’s market power is speculation. The Jeddah conference of 22 June especially brought this crucial issue to the fore. Abdullah bin Abdul Aziz, the monarch of Saudi Arabia, and the representatives of all other member countries of OPEC were extremely critical of oil speculators during the conference. Recent estimates based on the Commodity Futures Trading Commission data also indicate that as of April 2008, West Texas Intermediate (WTI) crude oil6 trading at New York Mercantile Exchange (NYMEX)7 comprises 71 per cent

speculators and just 29 per cent physical hedgers.8 Thus, undeniably, speculation has become a critical element in causing random fluctuations in crude oil prices.

In fact, the world oil pricing system has witnessed a sea change in the last 50 years or so which saw the oil market shifting from an administered oil pricing system (initially governed by the multinational oil companies and later by OPEC) to a market related system in which oil was initially priced off the spot market and later, on the basis of the futures market. However, the core of the problem that the world is facing now is because the price of oil is no more fixed on the spot market, where physical trading use to take place but on the futures market, where only paper barrels are traded. Thus, the peculiarity of the international oil market now is that the price of oil is being fixed on the market for a class of financial assets, oil futures.

Since only an insignificant proportion of the oil traded in the NYMEX is ever physically delivered, many different players (floor traders, fund managers, refiners, producers, financial institutions and speculators) [Fattouh 2007] can get involved in futures trading that are otherwise not involved in physical trading. This is equally true in all other commodity exchanges around the world. The presence of these diverse set of participants in the futures market has invariably complicated the process of decision-making within OPEC. In fact, OPEC’s ability to influence oil prices through output adjustment now is clearly contingent upon their ability to influence the expectation of the participants in the futures market. In order to execute that successfully, OPEC needs to consider a wide range of factors. These include, among others: the level of stocks or inventories of crude oil that the refiners are holding; size of the speculative positions of the traders in the futures market; traders bearish and bullish sentiments; and flow of hedge funds in and out of the market.

The aforesaid causal factors, namely, the erosion of spare capacity and influx of speculation through commodity futures, have repeatedly been used by OPEC in the past to justify its inability to increase output and at the pace demanded by the rest of the world and hence, reduce the price. As mentioned before, OPEC has also

COMMENTARY

been constantly claiming that oil supply is available in plenty.

Leaving aside these causal factors that seem to have a significant bearing on the erosion of OPEC’s market power, one also needs to examine the true economic factor

would always expand output as per the “call” unless that increased output level serves the interest of OPEC and its key producers in the best possible manner. He estimated OPEC’s net present value (NPV) of expected profits for different choice of OPEC’s export share in non-

Figure 3: Relationship between Spare Capacity and Volatility in

OPEC consumption and for

Crude Oil Prices

Accelerating Accelerated certain paths of non-OPEC global demand OPEC spare Global oil rise in oil

supply and found that the

capacity system’s prices Low non-OPEC

reduced ability to

NPV of expected profits is rel

supply growth respond to Volatility in

shocks History of low Bottlenecks in weakened investment downstream

History of low Geopolitical investment Impact of shocks Weather shocks

magnified in Refinery fires

{

absence of spare Speculators capacity

Source: Fattouh (2006), Figure 2.

that lies behind the OPEC’s incentive to produce more or less, which is often missed out when the discussion is just focused on spikes in the short-run.

Most of the recent modelling structures, namely, the National Energy Modelling System of Department of Energy, US and International Energy Agency, Paris assume that OPEC is a residual supplier and the amount of oil to be supplied by OPEC could be expressed as: OPEC output = world oil demand + stock adjustment – non-OPEC output.

These agencies further assume the existence of an equilibrium price path. After calculating the world oil demand and non-OPEC output, the latter is subtracted from the former (as shown above) after allowing for stock adjustment. This gives the excess oil demand (often referred to as “call on OPEC”), which is expected to be met by OPEC. These models thus essentially assume that OPEC plays the balancing role of an equilibrator by producing exactly the amount that is being demanded from it.

History, however, provides us with a different picture altogether and indicates that the conduct of OPEC has never followed a deterministic trajectory. Thus, contrary to its claim, OPEC has neither always supplied as per the “call on OPEC” nor has it oversupplied or undersupplied in a persistent manner. In fact, it is rather unusual to expect a rigid behavioural conduct from OPEC consisting of members with divergent views and interests.

Gately (2004) clearly demonstrated that there is no guarantee that OPEC as a whole share. He further delineated that the increase in expected profit from higher output would be more than offset by lower prices as a result of rapid output expansion.

oil prices atively insensitive to higher
Occasional output growth. Thus, he under
spikes in oil prices scored that aggressive output
expansion plan as per the
“call on OPEC” would yield
lower payoff than if OPEC
decides to maintain its market

In the light of the above argument, which largely explains OPEC’s contractionary behaviour based on expected profit in the long-run and especially in the light of the prolonged short-term windfall gains9 from the unprecedented price hike (which crossed the psychological threshold of $ 100 per barrel this year), it appears rather unusual to expect that the members of OPEC would consistently fully comply with the demand from the importers and pump in more crude oil rather than allowing such price-spirals to stay on for some more time and enjoy the rent by postponing its plan of output expansion.

Furthermore, although Saudi Arabia, the dominant OPEC producer spearheading OPEC’s spare production capacity, had been playing the balancing role of swing producer especially in situation of crisis in the past and has agreed to produce more even now, it may not be rational to expect that it will continue to play that role in the future and compromise on its revenue gains just to counter such relentless spikes for the greater cause of stability in world crude oil prices. Such behaviour would be all the more unlikely especially when all other big producers within OPEC might be reluctant to follow suit. In this regard, it may be recalled that Saudi Arabia had actually displayed its tendency to defect in 1986, after persistently bearing the brunt as balancing swing producer for nearly a decade (Stevens 1995).

Concluding Observations

In the short-run, speculation might gear up the price to an unprecedented level belying all expectations based on the structural supply-demand framework but that should not lead to the conclusion that OPEC has lost its power in influencing world crude oil prices. The rent-seeking intention of OPEC was clearly implicit in its rejection of Chidambaram’s proposition at Jeddah of a regulated “price-band” for crude price stabilisation based on an agreed floor and ceiling on crude price between producers and consumers. Erosion of spare capacity may not adequately explain OPEC’s lukewarm response to the issue of regulated crude prices, which otherwise would clearly lead to a compromise on the revenue gains of OPEC, especially when there are ample windfall gains as has happened recently in the face of spiraling crude prices. The Centre for Global Energy Studies (CGES), in its monthly oil report for July (CGES 2008) has underscored that OPEC member countries, facing increased government spending and rising inflation, will not be happy to see prices fall far below $ 100 per barrel. The report further reaffirms that OPEC may actually decide to cut the cartel’s oil output

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quota in its September meeting in case the price of crude falls under $100 a barrel.

In a recent address at the 19th World Petroleum Congress, held at Madrid, Spain from 29 June to 3 July 2008 (El-Badri 2008), OPEC’s secretary general, however, underscored, “The outlook for the coming years is sound. Despite rising costs, there are more than 120 upstream development projects underway in OPEC countries, with over $160 billion in cumulative investment to 2012, to add net capacity of around 5 million barrels a day”.

This is indeed heartening for the oil importing countries that are already struggling with spiralling oil prices, food prices and inflation. However, if the promised increases in the production capacity of OPEC fail to translate into reality on time and as per expectation (due to geopolitical reasons or tensions in the middle east) and if the non-OPEC supply of crude (spearheaded by Russia) fails to grow adequately; then, without a major global recession and a phenomenal drop in demand from oil importers (hardly showing any sign of relenting in the near future), the situation will worsen. In the process, OPEC might just continue to exercise its non-compliance with the “call” more often in order to counter its own revenue loss leading to more spikes. As a consequence, problems for developing and less developed oil importing countries would get compounded with threatened resilience and severely constrained macroeconomic management.

Postscript

In keeping with the forecast of Centre for Global Energy Studies (CGES), London, mentioned earlier in this article, in an emergency meeting held in Vienna on 24 October OPEC decided to go for a cut in production quota when crude prices started falling below $80 a barrel due to the onset of the global economic recession triggered by the US crisis.

Understandably, after having earned windfall profits, thanks to the unprecedented surge in crude prices earlier in the year, the OPEC countries were not quite willing to let these profits dwindle. After OPEC’s decision to cut production, the crude oil price also seems to have stabilised at the time of writing (10 November) around $60-70 a barrel. Importantly, the OPEC’s

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decision bears testimony to the assertion that the cartel has indeed not lost all its power to influence world oil prices, the influence of speculation notwithstanding. Incidentally, the dominant role played by the fundamentals of supply and demand, rather than speculation, in determining crude price movements has been reinforced by the Interim Report on Crude Oil brought out in July this year by the Interagency Task Force in Commodity Markets, Washington. Based on the evidence available to date, the report has argued that although between January 2003 and June 2008, activity on the crude oil futures market (as measured by the number of contracts outstanding, trading activity, and the number of traders) increased significantly, changes in futures market participation by speculators did not systematically precede price changes. On the contrary, most speculative traders were typically observed to have had altered their positions following price changes, suggesting that they were responding to new information. Thus, if the findings of the report are to be believed, the causality has worked in the direction of prices to speculative tendencies rather than the other way round, as would have been the case if speculation was indeed the predominant factor determining crude prices in the recent past.

Notes

1 The OPEC is a permanent, intergovernmental organisation, created on 10-14 September 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The five founding members were later joined by nine other members: Qatar (1961); Indonesia (1962); Libya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973) – suspended its membership from December 1992-October 2007; Angola (2007) and Gabon (19751994). OPEC had its headquarters in Geneva, Switzerland, in the first five years of its existence. This moved to Vienna, Austria, on 1 September 1965.

2 Proven reserves are estimated quantities that analysis of geologic and engineering data demonstrates with reasonable certainty are recoverable under existing economic and operating conditions. The proven reserves of OPEC, as of 2007, stand at 939,016 million barrels, which is around 78 per cent of the world proven crude oil reserves.

3 This term was coined by M Adelman, the father of energy economics in 1980. See Adelman (1980) for details.

4 The strike began on 2 December 2002 when workers at the state-owned oil company Petroleos de Venezuela refused to work, thus severely reducing oil production and crippling the Venezuelan economy. The strike was one of the longest in Latin American history and lasted for two and half months.

5 Indonesia’s production has been continually declining since 1995. Forced by years of declining oil production caused by deteriorating oil infrastructure that has converted it from an exporter to a net importer of petroleum, Indonesia has announced its decision this year to withdraw from the OPEC, even as crude oil prices have reached record levels.

6 WTI crude oil is a high quality crude oil. Its American Petroleum Institute gravity is 39.6 degrees (making it a “light” crude oil) and it contains only about 0.24 per cent of sulfur (making it a “sweet” crude oil). It is the major benchmark of crude oil in US.

7 The NYMEX is the world’s largest physical commodity futures exchange, located in New York City and handles billions of dollars worth of energy products, metals and other commodities being bought and sold on the trading floor and the overnight electronic trading computer systems. The prices quoted for transactions on the exchange are the basis for prices that people pay for various commodities throughout the world. The floor of the NYMEX is regulated by the Commodity Futures Trading Commission, an independent agency of the US government. The NYMEX is one of the few exchanges in the world to maintain the open outcry system, where traders employ shouting and complex hand gestures on the physical trading floor.

8 The hedger is a dealer in the actual “physical” commodity who desires “insurance” against the price-risk he faces. The commodity futures market is visualised as a convenient mechanism through which price-risk can be transferred from one group to another. The speculators role in commodity futures market is to assume the risks that hedgers desire to transfer from their own shoulder and to enjoy the premium for undertaking that risk. The speculators thus have an obvious role in pricemaking and manipulation in futures commodity markets (For more details see Johnson 1960).

9 The Energy Information Administration predicted recently that the OPEC’s earnings from oil exports will reach a record $1.251 trillion in 2008, about $73 billion more than previously estimated (Reuters 2008).

References

Adelman, M A (1980): “The Clumsy Cartel”, The Energy Journal, Vol 1, No 1, pp 43-53.

British Petroleum (2008): “Statistical Review of World Energy”, available at: www.bp.org.

Centre for Global Energy Studies (2008): “Monthly Oil Report”, Vol 17, Issue 7, London.

Cremer, J and D Salehi Isfahani (1991): Models of the Oil Market (New York: Harwood Academic Publishers).

El-Badri, HE Abdalla Salem (2008): “Meeting the Challenges in the International Oil Market”, An OPEC/IEA Luncheon Address to the 19th World Petroleum Congress, Madrid, Spain, 29 June- 3 July delivered by OPEC Secretary General.

Fattouh, B (2006): “Spare Capacity and Oil Price Dynamics”, Middle East Economic Survey, Vol 49, No 5, 30 January.

– (2007): “OPEC Pricing Power: The Need for a Newer Perspective”, WPM 31, Oxford Institute of Energy Studies, March, available at www.oxfordenergy.org.

Gately, Dermot (2004): “OPEC’s Incentive for Faster Output Growth”, The Energy Journal, Vol 25, No 2, pp 75-96.

IMF (2005): “World Economic Outlook”, available at: www.imf.org.

Johnson, Leland L (1960): “The Theory of Hedging and Speculation in Commodity Futures”, The Review of Economic Studies, Vol 27, No 3, June, pp 139-51.

Mitchell, J V (2006): “A New Era for Oil Prices”, 06-014 WP, Centre for Energy and Environmental Policy Research, MIT.

Naimi, A (2005): “Globalisation and the Future of the Oil Market”, Middle East Economic Survey, Vol 47, No 22, 30 May.

Reuters (2008): “OPEC to Earn $ 1,251 Trillion from Oil Exports”, 9 July. Stevens, Paul (1995): “The Determination of Oil Prices: 1945-95”, Energy Policy, Vol 23, No 10, pp 861-70.

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