energy & environmental economics

Energy & Environmental EconomicsV Models of the oil industry

Università degli Studi di Bergamo

a.a. 2015-2016

(Institute) Energy & Environmental Economics a.a. 2015-2016 1 / 28

The numberless problems of the oil industry

A highly concentrated industry, both from the geographical and�rm-level points of view.

An industry based on an exhaustible resource

A homogeneous product industry, where transportation costs makethe real di¤erence among oil produced in di¤erent countries

An industry which provides an essential input, without which oureconomic system (lifestyle?) is hard to imagine in the short/mediumrun (consider transportation)

For the above reason, an industry whose political/diplomatic/strategicimplications are almost as important as those purely economical

The products of the oil industry and their use play a key role in anumber of environment-related issues (greenhouse e¤ect, pollution,catastrophic accidents)


Which market model for the oil industry?

Concentrating on the upstream market (crude production and trade)rather than on re�ning, this is clearly an imperfectly competitive market.Which kind of imperfectly competitive market ?

1 Clearly not a monopoly. Data on reserves and even more onproduction tell another story.

2 In highly concentrated, homogeneous product markets the typicalmodels are Cournot and Bertrand. Is this enough?I

3 The oligopoly is clearly a non-symmetric one (to the extent thatcompetitors can be made to coincide with countries, data say thatthey are not all the same size.

4 The role of collusion5 Foreign Policy ?


Leadership Models

In leadership models, one �rm (or group of �rm) makes the relevantdecision (price-quantity, etc.) before the remaining competitors, whichthen must take such a choice as given.The "leader-competitive fringe" modelSuppose that the demand for oil is given by the function

Q = Q (p)

with Q 0 (p) < 0..Suppose that one �rm is price-maker ("leader") and theremaining �rms ("followers") are perfectly competitive. qL is the quantityof the leader, while QF is the total quantity of followers. Obviously

Q = QF + qL

Followers take the price set by the follower as given and their supplyfunction is QF = S (P)


.Then the leader maximizes

max (p � cL) (Q (p)� S (p))Q (p)� S (p) is the "residual" demand which remanins after we subtractfrom total demand the quantity supplied by the fringe.


First order conditions are

Q (p)� S (p) + (p � cL)�Q 0 (p)� S 0 (p)

�= 0

or

cL = p�1+

1pQ (p)� S (p)Q 0 (p)� S 0 (p)

�1pQ (p)�S (p)Q 0(p)�S 0(p) is the inverse of the elasticity to price of the residual

demand. Notice that the larger is S 0 (p), other things being equal, thesmaller is the markup with respect to the the leader�s cost


The "leader-follower" model (Stackelberg)The logical structure of the model is similar to the previous one, with thedi¤erence that there exists only one follower, which takes the quantity setby the leader as given (the followers acts as a Cournot competitor in asecond stage) The leader takes into account this reaction from the followerwhen setting his quantity, exactly as in the fringe model it takes intoaccount S (p).


Competitive-Collusive oligopoly models

The leader-follower model does not tell the whole story about the oilindustry (one big player versus other small, passive players; e.g. SaudiArabia versus all others). The oil industry can be described also as theinteraction among a number of non-identical, but comparable players (forinstance, Saudi Arabia, Iran, the Emirates), etc. The leader, if any, mightbe a collective leader (the OPEC?).When we have more than one strategic players, we fall in the �eld ofoligopoly models. In oligopoly models competition and collusion are partof the same game, rather than two mutually exclusive "worlds". This isparticularly important in the oil market.


The competitive game: Cournot model

The best �rst-approximation oligopoly model for the oil industry is after allthe Cournot model. Again p (Q) is the inverse demand curve for oil at theworld level. There are N competitors, each producing quantitiesq1, q2, ...qN . Notice Q = q1 + q2 + ...+ qN . The competitors need not beidentical: they migh have di¤erent marginal extraction costs c1 , c2,..., cNand also di¤erent capacities K1,K2, ...,KN , such that

q1 � K1, q2 � K2, qN � KNIn Cournot model, the i-th producer has an expectation concerning theother production levels and chooses its own, so as to maximize pro�ts


max p (Q) qi � ciqis.t.

qi � KiThe �rst order condition is

p0 (Q) qi + p (Q)� ci = 0

(remember that Q = q1 + q2 + ...+ qN ). This is fairly similar to whathappens in the oil market: competitors do not make the price in a strictsense: they decide how much to produce knowing that price will dependon their own (and the other producers�) production decisions. Forinstance, Saudi Arabia knows that if it doubles its production, the pricewill fall by a considerable amount, etc.An equilibrium in the market is asituation where the condition

p0 (Q) qi + p (Q)� ci = 0

is satis�ed for all i 0s.(Institute) Energy & Environmental Economics a.a. 2015-2016 10 / 28

Perfect collusion

Now suppose that instead of competing, �rms decide to collude. The�rst-best collusion (for producers!) consists in collectively behaving as ifthey where a single monopolist endowed with di¤erente "plants". Thenthe colluding producers will choose q1, q2, ...qN so as to maximize

maxP (Q)Q � (c1q1 + c2q2 + ...+ cNqN )

s.t.q1 � K1, q2 � K2, qN � KNi.e. the monopolist pro�t, later to be shared in proportion to theproduction of individual "plants". The �rst order condition is the followingone

P 0 (Q)Q + P (Q)� ci = 0which means that the groupactivates �rst the members with the lowest

marginal costs up to their capacity and produces the quantity of amonopolist with the same "plants".


The trouble with collusion is that, if under collusion q�i < Ki , then it mustbe true that

P 0 (Q)Q + P (Q) � ciwhile since P 0 (Q) q�i > P

0 (Q)Q, it is possible that

P (Q) + P 0 (Q) q�i > ci = 0

i.e., the i � th �rm has an incentive to increase its production (in spite ofthe collusive agreements).


The OPEC

OPEC (Organisation of Oil Exporting Countries) was founded in 1960 inBaghdad by �ve countries (Iran, Iraq, Kuwait, Saudi Arabia andVenezuela). Currently, there are 12 membersAlgeria,Angola,Libia,Nigeria,Iran,Iraq, Kuwait, Qatar, Saudi Arabia, UnitedArab Emirates, Ecuador, VenezuelaIt is an intergovernmental organization based in Vienna. It represents ahybrid between a political-diplomatic entity, an emanation of sovereignstates (like, say UNO or NATO) and a an international cartel. Countriesare admitted to OPEC conditional to the agreement of 75% of theparticipants, which have formally equal weight and roles within theorganization.


A short history

OPEC was founded with the objectives of:"coordination and uni�cation of petroleum policies ( ...)/safeguarding theinterests (of Member Countries) individually and collectively""Stabilization of oil prices, avoiding ... harmful and unnecessary�uctuations""Steady income to producing countries; e¤cient and regular supply toconsuming countries; fair retuns on capital invested in the oil industry"(Article 2 of the OPEC Statute)As a matter of fact, it was a reaction to the previous regime whereoil-owning countries were only passive licensors, while the oil market wascontrolled by British-American-Dutch companies (the "Seven Sisters").The foundation of OPEC must be placed within the more generalframework of de-colonisation, although the subsequent history of OPECcountries was obviously very di¤erent from the history of other ThirdWorld Countries.


The era of oil shocks (1973-1985)

Kippur War: The �rst great showdown of OPEC power came inOctober 1973, in the aftermath of the so-called Kippur War, whenOPEC countries decided an increase by 70% in the posted prices andshortly after decreed an embargo against the US, as the main allied ofIsrael and, to a di¤erent extent, against the other industrialisedcountries. The embargo fell upon a pre-existing situation ofgeneralised world in�ation and monetary turmoil, which made itse¤ects particularly dramatic (also remember that at the time,industrialised countries were much more oil-dependent than nowadays)


Iranian Revolution: In 1979, it was the Iranian revolution and theimmediately subsequent (1980) Iran-Iraq war to cause a sharp cut inoil production from these two prominent OPEC members, with therelated sharp increase in prices.

Both events, however, generated the long run remedies:High prices made exploration and exploitation in previously neglected �eldsmore pro�table (North Sea Oil)Energy- and oil-saving investments where madeBy 1985 oil prices started a strong decrease


Hubbert�s oil peak

Marion K. Hubbert is a USA geo-physicists who in 1956 predicted, basedon empirical engineering studies of mining activity, that oil production wasto reach a peak (Hubbert Peak) after which production wouldcontinuously decrease.Such peak was expected to reached by the USAaround 1970).He modelled cumulate output Qt out of an oil �eld of sizeQ by the following function:

Qt =Q

(1+ aebt )

where b < 0.


As t goes to in�nity, Qt goes to Q. The �rst-order derivative (i.e. theproduction �ow) is :

dQtdt

= � baQebt

(1+ aebt )2

while the second-order derivative:

d2Qtdt2

= b2aQebtaebt � 1(1+ aebt )3

is �rst positive and then negative.


Q

time

Cumulate

Output


time

Output

Flow


Why the Hubbert curve ?

The argument behind the Hubbert curve is a variation on an old theme,namely the Ricardian theory of rent. When the exploitation of an oil �eldbegins, oil is close to surface, and it�s easy to extract. As the oil �eld isprogressively exploited, more investments are required, extraction is costlyand output peaks and then decreases. In the �nal stages, extraction is socostly and investments are so huge that the oil �eld is dismissed.This is true as regards the individual �eld, but it applies also to thediscovery of new �elds. First the "easiest" �elds are discovered andexploited, the research extends to �elds located in far away, geologicallydi¢ cult, costly locations (o¤shore, arctic regions, tar sands)


Details on behaviour of oil �elds are in the papers:Hook,M.- Soderbergh, B.-Jakobsson, K ., Aleklett, K. (2009) �TheEvolution of Giant Oil Field Production Behavior�Natural ResourcesResearch, Vol. 18, No. 1, March:39-56 , DOI: 10.1007/s11053-009-9087-zFantazzini, D.- Hook,M.- Angelantoni, A. (2011) �Global oil risks in theearly 21st century�Energy Policy 39: 7865�7873


Economic theory & the Hubbert curve

There is no con�ict between economic theory and the Hubbert curve,despite what some supporters of the latter say. Indeed, economic theorysays that Hubbert peak occurs at the beginning of the �led exploitation:production always decreases according to Hotelling. Moreover economicssays that parameters a and b depend on a range of more fundamentaleconomic variables (prices, demand, technology) especially at an aggregatelevel (at individual �eld level it is possible that purely geo-physical factorsprevail). Therefore, while the peak certainly exists, the really di¢ cultquestion is when it should appear.


Cycles in oil prices

Hotelling predicts a continuous rise in oil price.Actually, this trend coexistwith a marked cyclicity.There are more than an explanation

Aggregate demand global demand for oil depends on the generallvel of economic activity, which is cyclical per se. Such cycles aretherefore transmitted to the oil prices (and other raw materials)

Long/short run

Mining CycleSpeci�c characteristics of competition in the oil industry


Demand for energy in the short and long run

Suppose the oil industry is a perfect monopoly. Price will be given by theformula:

P�1+

1ε

�= c

where ε is price elasticity. In the oil market, elasticity is likely to be smallin the short run, and larger in the long run, since users can switch to otherenergy sources, or invest in energy-saving technologies, as a consequenceof the high oil price. An initial increase in extraction cost might increaseprice in the short run. In the long run, however elasticity might be larger,thus countering the e¤ect of the increase in price. Here the reasons for thecycle are again demand-side, but it is not aggregate demand cycle(macroeconomic), rather a market speci�c mechanism triggered by theincrease in cost.


The mining cycle

ISuppose demand increases. In the short run, price increase. However, theprice increase triggers in the long run exploration of new �elds or increasedexploitation of marginal �elds, which counters the initial increase in price.


Price wars

As we have seen, �rms face an incentive to break cartels. Price wars arethe other side of collusion: "You break the agreement, I�ll punish you witha price cut" "You cut the price, and I cut the price even more" ...until we�nd a new agreement.Such a mechanism may give rise to cycles


Lags in price adjustments

Suppose there is a quantity leader and a follower, who adjusts the quantityto a new desired level with some lag, say two periods . Then, at time t,the price is given by

pt = p�qLt + q

Ft

�But qFt is the reaction of the follower to the leader�s quantity two periodsbefore

qFt = RF�qLt�2

�


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