Reservoir Dogs: The Nature of OPEC in the Oil Market

Katrina Enoch

Dr. Ortigueira Silva

ECO 499: Energy and Commodity Markets

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1. Introduction

Cursing the name of Nixon, Ford, or Carter, the American consumer

in the 1970s, sheltered in an avocado or mustard colored Oldsmobile,

waited begrudgingly in line for the sweet taste of ethanol. Upon reaching

the coveted pump, sometimes after hours of anxious wait, the gas station

would be fresh out. In a moment of intense anger, a man would shout

“Where are we, the Soviet Union?” Thirty years later, while the gasoline

queues no longer posed a threat, the rising gas prices enraged a new

generation.

These price and supply shocks are unanimously attributed to the

“nefarious” deeds of OPEC (Organization of Petroleum Exporting

Countries), a cartel of countries rich in oil reserves that colludes to control

and influence oil production and prices in the world market. OPEC

epitomizes a paradox and is often the subject of scrutiny. “Is this the end of

OPEC?” graces an Energy Economic Journal every few years. Its duration is

puzzling: its penchant to cheat on the arranged production quotas

undermines the stability and the profitability of the cartel and its intra-

political tension threatens the cartel’s existence. Since its inception in 1960,

OPEC has defied the odds to the surprise of many. This paper seeks to

understand the nature and stability of OPEC in the oil market by analyzing

the cartel structure of OPEC, the market power of OPEC and non-OPEC

actors, and the inner politics of OPEC. Ultimately this paper will argue that

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the unique position of OPEC in the oil market, a dominant force among a

growing oligopolistic fringe of producers, combined with the expanding

nature of the oil market, allows OPEC to retain enough power to influence

oil price and supply. However, its power is not so strong that it would

classify as a cartel in strict definition and that its inner member tensions

and actions would be detrimental to its existence.

2. The Market Power of OPEC and Oil Price Determinants

Founded in September 1960 in Baghdad, the Five Founding

Members (Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela) represented

the empowerment of newly decolonized countries constrained by an

international bipolar power structure between the United States and the

Soviet Union. The mission of OPEC remains “to co-ordinate and unify

petroleum policies” in order to “secure fair and stable prices for

petroleum producers” as well as ensure “an efficient, economic and

regular supply of petroleum.”1 Throughout the 1960s and early 1970s,

the mission statement of OPEC and its increased power in the global

market allowed OPEC to grow to its present 12 members. However, it

was not until the oil embargo in 1973, in which the nascent organization

nearly paralyzed the United States and other pro-Israel countries, that

the world realized extent of its market power in the global oil market.

Historically, the market power of OPEC, as well as its plentiful

reserves, have coincided with the trend of increased inelasticity of oil

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due to the increasing prevalence of oil in economic development of

emerging economies, such as China and India.2 While this pattern

appears to place OPEC in an undoubtedly advantageous position, the

increasing global dependence of oil has opened the oil market to a

greater number of producers, such as Russia and Canada, which seek to

profit from its reserves but also attempt to diminish the market

dominance of OPEC. Furthermore, as global warming and energy

security flash across agendas of international summits, investments into

alternative energy resources are becoming major policy initiatives. These

factors combined to diminish the market power of OPEC to an estimated

35% of global production.3

2.1 Global Oil Production

The diagram below demonstrates the shares of varied oil producers

by geographic location between 1965 -2015 and shows a recent upward

trend in production of other actors aside from the Middle East:4

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The graphic shows that the oil production is not completely

dominated by OPEC and the Middle East, a viewpoint typically followed

by popular opinion. Furthermore, according to BP, in 2005, Middle

Eastern oil production, not just OPEC, constituted 25.1% of total oil

production, Europe and Eurasia constituted 17.1%, North America

13.6%, and Africa, Asia and Pacific Islands, and Central/South America

constituting nearly 10%.5 While one can argue that Venezuela heavily

accounts for the Central and South American portion, Venezuela

consistently produces under quota given its limited capacity and internal

political structure.6

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As new oil producers appear in the market, so do new production

techniques, most notably in the form of fracking and off-shore drilling.

Prevalent in the United States, fracking involves drilling shale plays in

both rock and sand to extract oil. The grade of oil extracted by

conventional methods exceeds the quality extracted from fracking,

however according Kim J. Zietlow, the accessibility of oil reserves trumps

the geological grade of the oil.7 Currently, fracking costs exceed those of

conventional extraction, however the spike in oil prices in 2008 elicited

fervor for the practice and in off-shore drilling, despite the

environmental detriment.8 As a current policy issue in the United States,

the future of both practices are very much in conjecture as they are open

to both federal, state, and local policy considerations. In April, President

Obama has sanctioned off-shore drilling in the coastal waters of the

Southeast United States.9 The ability of fracking and of off-shore drilling

to create a more energy independent United States could spur increased

investment into these tactics for greater efficiency and technological

innovation. This efficiency would decrease the cost of fracking and

permit the United States to produce more competitively with OPEC on

the world market and institute environmentally sound measures of

regulation.

Oil production in other countries and regions has increased while

new practices of extraction are being developed and practiced to

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decrease the market power of OPEC for oil. Aside from attempted

competition in the oil sector, countries are developing alternate energy

sources to minimize the centrality of OPEC in that global energy

landscape.

2.2 Global Alternate Energy Source Investments

In its yearly Global Trends in Renewable Energy Investment report,

the United Nations Environment Program recorded a 17% increase in

global clean energy investment in 2014.10 On the international scene,

clean energy and climate change top the agendas of conferences and

summits. Recently, the United States and China, the largest producers of

carbon emissions, met to form a bilateral agreement to reduce their

respective carbon footprints. The increase stemmed mostly from China

and its solar power investment which grew its investment by 30% when

compared to 2013.11 In second place, the United States increased its

investment by 7% while Japan increased its investment in wind powered

energy by 10%, representing its greatest investment in clean energy in

its history. The number of renewable energy investments increased also

in developing nations such as India, Brazil, and South Africa.12

Given that emerging economies, especially China and India as the

fastest growing economies, and developed economies increased clean

energy investment could severely impact oil demand. The United States

constitutes 20% of global oil consumption with China pinned as the

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second largest oil importer according to U.S. Energy Information

Administration.13 Due to the monopsony power of these two economies

and joint efforts to promote cleaner energy consumption, this shift

energy dependence could decrease global demand for oil and negate the

power of OPEC to influence market prices in the long-term.

The growth of natural gas, especially its usage in Europe, contends

with the global dependence on oil. The current growth projection of

natural gas is 2.4% annually. Currently Asian-Pacific countries are

undergoing a gradual process of natural gas trading with the goal of

increased integration of natural gas in energy consumption.14 With

fracking, United States production of natural gas has increased by 56%

and could possibly develop into an export commodity. As Russia

dominates both natural gas consumption and reserves and trails OPEC

countries slightly by production, Russia’s role in the international energy

market could eclipse that of OPEC.

While oil will never be an irrelevant commodity, intended increases

in alternative energy resources, especially clean energy by developed

and emerging economies, threatens the dominance oil enjoys in the

energy market and thus threatens the market power of OPEC not only in

oil but also globally as prominent energy producers such as Russia may

continue to grow with the relevant resource sectors.

2.3 Oil Price Determinants

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In optimal extraction models, such as Hotelling’s Rule, oil prices

are tightly bound to the combined total of marginal extraction and

marginal user costs. If the price were any lower, producers would have

little to no incentive to produce. While the actions of OPEC are usually

pinned as the main reason for gas price spikes, they are not the sole

determinants. Energy economists detail new co-determinants that impact

price. These determinants connect to the political agendas of nations,

the internal political structure, and changes in the oil market.

In the Energy Policy Journal, researcher Marian Radetzki attributes

oil price transformation to, “capacity constraints caused by the

inefficiency of state owned enterprises that dominate the oil industry,”

which have effectively stripped private owners of the financial resources

necessary for investment in capacity expansion.15 Radetzki supports the

argument that state controlled industries do not brace the same

pressures as private businesses such as cost minimization, profit

maximization, and efficiency concerns. Government enterprises possess

alternate goals such as employment initiatives and economic

development while subsidies often efface efficient organization and

management. Radetzki’s diagram displays the state controlled oil

companies that control oil reserves (in billions of barrels):16

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The graph elucidates that the largest actors and producers in

OPEC primarily function through state-controlled reserves. The

determinant Radetzki underscores plays an influential role, especially

through Aramco, the Saudi government company, because Saudi Arabia

produces the most oil among its OPEC partners. Rising prices may not be

the result of production quotas solely, but structural inefficiency in

production.

Related to state inefficiency, Kim Zietlow contends that political

implications amalgamated with opposing market conditions contribute

the rise in oil prices. According to Zietlow, “resource pragmatism and

nationalism,” merge to form a phenomenon in which governments falsely

report the amount of oil reserves to influence prices.17 When prices are

low, oil rich governments purposefully underestimate the supply of

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reserves so that when prices are too high they can claim the discovery of

new reserves in order to drive down the price. However, when these

tactics interact with market mechanisms, the outcome, such as in 2008,

may defy expectations. Zietlow proposes that the growing demand for oil

by emerging economies, notably China and India, in recent years poses a

problem for the above political tactic and identifies this problem as a

cause of the price spike in oil. The supply shortage, while a political

tactic, stemmed from an unprecedented increase in demand, which grew

so forcefully that OPEC producers could not satisfy it despite

concessions of reserve discoveries and despite its historically high

production levels.18

2.4 Conclusion

It is evident that the influence of OPEC decreased since the 1970s.

Such factors as renewable energy investments, coordinated international

green energy initiatives, insufficient capacity and inefficiency have

diminished the market power of OPEC. However, OPEC still retains

enough power that its presence and influence cannot be negated. Even

though there are new producers of oil, the reserves of OPEC countries

far exceed the reserves of other countries. As other countries will face

increased costs due to diminishing reserves, OPEC will be able to keep

its prices low. While the oil market is not completely at the mercy of the

whims and agenda of OPEC, it remains sensitive to its actions. Given its

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waned market power, the question of the nature of the oil market

construction and the classification of OPEC as a cartel arises.

3. OPEC as a Cartel in the Oil Market

The emergence of new oil producers diversified the oil market and

complicated the role OPEC producers possess. This development

sparked debates as to the composition and classification of the oil

market: is it a competitive market or controlled mainly by collusive

industries? Furthermore, due to its weakened role in the market and

widespread cheating among members, the classification of OPEC as a

cartel ignited newfound disagreement.

3.1 The Oil Market Classification

University of California, Davis economist Cynthia Lin connects the

Hotelling Rule of extraction to the oil market structure and argues

through decade-by-decade analysis that the oil market consists of a

dominant OPEC cartel among an oligopolistic fringe of producers. Lin

analyzes optimal extraction of OPEC but her main attempt is to classify

the fringe. Lin accepts OPEC collusion as a given monopoly and

questions whether the fringe producers behave as perfectly competitive

price takers or as a Cournot oligopoly. Through extensive mathematical

applications of Hotelling’s rule and microeconomic market behavioral

concepts, Lin developed a dynamic pricing model to determine market

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classification, that included shadow prices, and analyzed countries

throughout each decade to formulate her conclusions.19

Lin’s model of classification is impressive. However, Lin only

focused on past data and her Hotelling analysis, a precursor to the

development of her model, assumed collusion. Thus her model is

imperfect. It cannot adequately describe the current and future evolution

of the oil market and proves that which was inherently assumed in the

analysis. Furthermore, as discussed above, there are more price

determinants other than marginal extraction costs that are crucial to the

classification of the market.

Through advanced applications of the Hotelling Rule, the market

can be generally classified as having a collusive entity among other, less

prominent, producers that also attempt to control prices rather than

taking them from the market. While Lin pinpointed the existence of

collusion in the oil market, the extent of that collusion must be analyzed.

3.2 The Classification of OPEC as a Cartel

Compared to enduring cartels in other commodity markets, such as

the diamond cartel De Beers, OPEC exhibits peculiar behavior.

According to James Smith in The Energy Journal, the economic definition

of a cartel is, “A frictionless association of producers acting essentially

as a multi-plant monopoly; allocating output to equalize the marginal

cost of each producer with marginal revenue of the cartel.”20 Smith

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contends that cartels practice parallel action in which behavioral

decisions are discussed with all members and members act accordingly

in unison. OPEC, by comparison, practices compensatory behavioral

tactics.21 OPEC sets production quotas to which member countries

loosely adhere. In the case of Venezuela, other producers must

compensate for the inability of a member state to meet the defined

quota, a role that falls upon the shoulders of Saudi Arabia. To maintain a

control on the market, a cartel must cooperate, however OPEC

demonstrates sustained patterns of cheating and independent action.

When compared to a strong cartel, OPEC demonstrates that perhaps

collusive behavior does not inherently warrant a cartel.

De Beers, a diamond cartel in South Africa, epitomizes a cartel.

Through its institutions, De Beers claims considerable market power.

Firstly, De Beers mines in South Africa constitute the largest source of

diamonds. Secondly, to counteract the influence of fringe producers, De

Beers created the Central Selling Organization (CSO) in London. The

CSO, through its dominance, allows miners to market their diamonds

through De Beers. The four members of De Beers, Namibia, Botswana,

South Africa, and Canada decide the amount of diamonds to sell. The

CSO controls roughly 80% of diamond supply and handles the marketing

of the diamonds.22 Through its parallel action, small number of

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producers, and centralized market dominance, De Beers defines a

frictionless cartel.

OPEC by comparison, possesses 12 member countries (which

would be more if some countries previously tied to OPEC didn’t end their

affiliation) and functions in a market with multiple producers because of

whom, as discussed earlier, the market power of OPEC has waned. While

De Beers can directly control the price of its commodity and retain

power over other producers, OPEC can only be considered a possible

determinant in oil prices. Moreover, its lack of coordinated action

diminishes the effectiveness of the cartel as a threat to fringe producers.

Smith hypothesizes that OPEC represents a new classification of a

cartel, one in which the frictions within the cartel preclude perfectly

aligned action. The rampant disregard of production quotas stems from

the higher cost of parallel action. According to Smith, OPEC, “operates

under the weight of transaction costs” that could outweigh the benefits

of a production consensus, “unless the scope of the proposed

reallocation is substantial and expected to persist.”23 Such transaction

costs explain the infrequency of quota revision which could further

explain the lack of adherence to a quota system that is seen as a burden

to the cartel. Furthermore, inequalities exist within the cartel. Saudi

Arabia is often viewed as the core to the cartel. If Saudi Arabia were to

end its OPEC affiliation, the cartel would lose most of its market

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influence. Moreover, political frictions plague the cartel, especially

between Iran and Iraq, two countries often at political and religious

odds. The lack of homogeneity in OPEC in political, organizational, and

productive spheres, warrant a special, but loose, cartel classification.

3.3 Conclusion

Through the Hotelling Model, the oil market can be characterized

as dominated by a collusive core and supplemented by an oligopolistic

fringe of producers. The nature of the collusive core, due to its lack of

parallel action and centralized market organization, is that of a loose

cartel. The precarious position of OPEC is that of a strange balance of

power that allows its survival. OPEC has just enough of a share in

market power that it maintains an influence on price and supply, but its

power is not so strong that its internal frictions and organizational issues

threaten the profitability of the cartel and the member states nor the

stability of the cartel.

4. Conclusion

OPEC will remain a force in the oil market given its resource base

and its surprising duration. However, its position in the world market

has shifted as the oil market and energy markets have opened to more

complex factors and actors. Through renewable energy investments and

emerging oil producers, the grip of OPEC has loosened. Furthermore,

the emergence of numerous price determinants demonstrates the

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fallacious perception of OPEC as the sole determinant of oil prices. State

inefficiency, political agendas, or even unpredicted demand increases

contribute to price spikes. However, optimal extraction analysis through

the Hotelling Rule has contended that a collusive confederation

dominates the production and price determinant of the market while an

oligopoly of fringe producers contributes some influence. The nature of

the collusion is that of a loosely tied cartel in which the perception of a

united front is stronger than the union itself. As the market presence of

OPEC diminishes, it is not completely expunged. Its current position is

that of a peculiar balance, where member countries can cheat on the

quotas and still reap profits and a competitive edge while maintaining

cartel stability, nearly negating the prisoner’s dilemma.

The man who once lamented the gas lines back in the 1970s now

thanks Russia for the drop in gas prices as he puts back the pump. The

oil market has expanded over the past forty years, however OPEC

remains and will continue to ravenously cling to its still hefty market

power.

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Bibliography

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http://www.opec.org/opec_web/en/about_us/24.htm.“China Country Analysis Brief Overview,” U.S. Energy Information and

Administration, 4 February 2014. http://www.eia.gov.“Global Oil Production,” Energy Insights, 10 April 2015.

http://www.energyinsights.net.Lin, Cynthia. “Market Power in the World Oil Market,” (Working Paper, University of

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California, Davis, April 2014). 6.“Natural Gas,” International Energy Agency, 10 April 2015.

http://www.iea.org/topics/naturalgas/.“Oil and Gas Reserves, 2005,” BBC, 10 April 2015.

http://news.bbc.co.uk.Ortigueira, Salvador. “Lecture 6,” (University of Miami, 2015).Marian Radetzki, “Politics—not OPEC interventions—explain oil's extraordinary price

history,” Energy Policy, no. 46 (July 2012).Smith, James L. “Inscrutable OPEC? Behavioral Tests of the Cartel Hypothesis,” The

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released,” Elsevier Ltd, 8 April 2015. http://www.renewableenergyfocus.com.

Vogelsang, Ivona. “The International Diamond Cartel,” (University of California,

Berkeley, Spring 2005). http://are.berkeley.edu/~sberto/debers.pdf.Warrick, Joby. “Obama administration opens up southern Atlantic coast to offshore

drilling – but restricts it in Alaska,” The Washington Post, 27 January 2015. http://www.washingtonpost.com.

Worstall, Tim. “What Happens To OPEC And The Oil Price If Fracked Shale Isn't The

High Cost Producer?,” Forbes, 13 January 2015. http://www.forbes.com.Zietlow, Kim J. “The market power of OPEC – Implications for the world market price

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Endnotes

1“Brief History,” Organization of Petroleum Exporting Countries, 10 April 2015, http://www.opec.org/opec_web/en/about_us/24.htm. 2 Kim J. Zietlow, “The market power of OPEC – Implications for the world market price

of oil,” (SiAg Working Paper, Humboldt University of Berlin, 2015), 6. 3 Ibid. 1. 4 “Global Oil Production,” Energy Insights, 10 April 2015.

http://www.energyinsights.net/cgi-script/csArticles/articles/000000/000085.htm. 5 “Oil and Gas Reserves, 2005,” BBC, 10 April 2015.

http://news.bbc.co.uk/2/shared/spl/hi/guides/456900/456974/html/nn3page1.stm. 6 Salvador Ortigueira, “Lecture 6,” (University of Miami, 2015). 7 Kim J. Zietlow, “The market power of OPEC – Implications for the world market price

of oil,” (SiAg Working Paper, Humboldt University of Berlin, 2015), 3.8 Tim Worstall, “What Happens To OPEC And The Oil Price If Fracked Shale Isn't The

High Cost Producer?,” Forbes, 13 January 2015. http://www.forbes.com/sites/timworstall/2015/01/13/what-happens-to-opec-and-the-oil-price-if-fracked-shale-isnt-the-high-cost-producer/2/.

9 Joby Warrick, “Obama administration opens up southern Atlantic coast to offshore drilling – but restricts it in Alaska,” The Washington Post, 27 January 2015. http://www.washingtonpost.com/news/energy-environment/wp/2015/01/27/obama-administration-opens-up-southern-atlantic-coast-to-offshore-drilling-but-restricts-it-in-alaska/.

10 “UNEP’s 9th annual 'Global Trends in Renewable Energy Investment 2015' report released,” Elsevier Ltd, 8 April 2015. http://www.renewableenergyfocus.com/view/41961/unep-s-9th-annual-global-trends-in-renewable-energy-investment-2015-report-released/.

11 Ibid.12 Ibid. 13 “China Country Analysis Brief Overview,” U.S. Energy Information and

Administration, 4 February 2014. http://www.eia.gov/countries/country-data.cfm?fips=ch. 14 “Natural Gas,” International Energy Agency, 10 April 2015.

http://www.iea.org/topics/naturalgas/. 15 Marian Radetzki, “Politics—not OPEC interventions—explain oil's extraordinary price

history,” Energy Policy, no. 46 (July 2012). 16 Ibid. 17 Kim J. Zietlow, “The market power of OPEC – Implications for the world market price

of oil,” (SiAg Working Paper, Humboldt University of Berlin, 2015), 8.18 Ibid. 5. 19 Cynthia Lin, “Market Power in the World Oil Market,” (Working Paper, University of

California, Davis, April 2014). 6.20 James L. Smith, “Inscrutable OPEC? Behavioral Tests of the Cartel Hypothesis,” The

Energy Journal, no. 26 (2005): 66.21 Ibid. 22 Ivona Vogelsang, “The International Diamond Cartel,” (University of California,

Berkeley, Spring 2005). http://are.berkeley.edu/~sberto/debers.pdf. 23 James L. Smith, “Inscrutable OPEC? Behavioral Tests of the Cartel Hypothesis,” The

Energy Journal, no. 26 (2005): 67.