OPEC – the Rise and Fall and Rise Again of Cartel
The History of the World’s Most Famous Cartel
OPEC is probably the best known of all cartels. It was set up in 1960 by the five major oil-exporting countries: Saudi Arabia, Iran, Iraq, Kuwait and Venezuela. Today it has 12 members. OPEC’s stated objectives are:
- The co-ordination and unification of the petroleum policies of member countries.
- The stabilisation of oil markets to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.
The years leading up to 1960 had seen the oil-producing countries increasingly in conflict with the international oil companies, which extracted oil under ‘concessionary agreement’. Under this scheme, oil companies were given the right to extract oil in return for royalties. This meant that the oil-producing countries had little say over output and price levels.
The Early Years
Despite the formation of OPEC in 1960, it was not until 1973 that control of oil production was effectively transferred from the oil companies to the oil countries, with OPEC making the decisions on how much oil to produce and thereby determining its oil revenue. By this time OPEC consisted of 13 members.
OPEC’s pricing policy over the 1970s consisted of setting a market price for Saudi Arabian crude (the market leader), and leaving other OPEC members to set their prices in line with this: a form of dominant ‘firm’ price leadership.
As long as demand remained buoyant, and was price inelastic, this policy allowed large price increases with consequent large revenue increases. In 1973–4, after the Arab–Israeli War, OPEC raised the price of oil from around $3 per barrel to over $12. The price was kept at roughly this level until 1979. And yet the sales of oil did not fall significantly.
After 1979, however, following a further increase in the price of oil from around $15 to $40 per barrel, demand did fall. This was largely due to the recession of the early 1980s (although this recession was in turn largely caused by governments’ responses to the oil price increases).
The Use of Quotas
Faced by declining demand, OPEC after 1982 agreed to limit output and allocate production quotas in an attempt to keep the price up. A production ceiling of 16 million barrels per day was agreed in 1984.
The cartel was beginning to break down, however, due to the following:
- The world recession and the resulting fall in the demand for oil.
- Growing output from non-OPEC members.
- ‘Cheating’ by some OPEC members who exceeded their quota limits.
Source: Nominal oil price data from Global Economic Monitor (GEM), Commodities (World Bank); Price Index from Data Extracts (OECD)
With a glut of oil, OPEC could no longer maintain the price. The ‘spot’ price of oil (the day-to-day trading price of oil on the open market) was falling, as the graph shows.
The trend of lower oil prices was reversed in the late 1980s. With the world economy booming, the demand for oil rose and along with it the price. Then in 1990 Iraq invaded Kuwait and the Gulf War ensued. With the cutting-off of supplies from Kuwait and Iraq, the supply of oil fell and there was a sharp rise in its price.
But with the ending of the war and the recession of the early 1990s, the price rapidly fell again and only recovered slowly as the world economy started expanding once more.
On the demand side, the development of energy-saving technology plus increases in fuel taxes led to a relatively slow growth in consumption. On the supply side, the growing proportion of output supplied by non-OPEC members, plus the adoption in 1994 of a relatively high OPEC production ceiling of 241⁄2 million barrels per day, meant that supply more than kept pace with demand.
The situation for OPEC deteriorated further in the late 1990s, following the recession in the Far East. Oil demand fell by some 2 million barrels per day. By early 1999, the price had fallen to around $10 per barrel – a mere $1.40 in 1973 prices! In response, OPEC members agreed to cut production by 4.3 million barrels per day. The objective was to push the price back up to around $18–20 per barrel.
But with the Asian economy recovering and the world generally experiencing more rapid economic growth, the price rose rapidly and soon overshot the $20 mark. By early 2000 it had reached $30: a tripling in price in just 12 months. With the world economy then slowing down, however, the price rapidly fell back, reaching $18 in November 2001.
However, in late 2001 the relationship between OPEC and non-OPEC oil producers changed. The 10 members of the OPEC cartel decided to cut production by 1.5 million barrels a day. This followed an agreement with five of the major oil producers outside of the cartel to reduce their output too, the aim being to push oil prices upwards and then stabilise them at around $25 per barrel.
The alliance between OPEC and non-OPEC oil producers is the first such instance of its kind in the oil industry. As a result, it seemed that OPEC might now once again be able to control the market for oil.
The Price Surge of 2003-8
But how successfully could this alliance cope with crisis? With worries over an impending war with Iraq and a strike in Venezuela, the oil price rose again in late 2002, passing the $30 mark in early 2003. OPEC claimed that it could maintain supply and keep prices from surging even with an Iraq war, but with prices rising rapidly above $30, many doubted that it could.
In 2004 the situation worsened with supply concerns related to the situation in Iraq, Saudi Arabia, Russia and Nigeria, and the oil price rose to over $50 in October 2004. OPEC tried to relax the quotas, but found it difficult to adjust supply sufficiently quickly to make any real difference to the price.
From 2006, oil prices increased more sharply than they ever had before and, for the first time in years, the real price of oil exceeded that seen in the 1970s. The major cause of the increases was very substantial increases in demand, particularly from India and China, coupled with continuing concerns about supply. The implications of the sharp price increases were substantial: inflationary pressures built up across the world, while the income of OPEC nations doubled in the first half of 2008.
By July 2008 the price had reached $147. Some analysts were predicting a price of over $200 per barrel by the end of the year.
And Then the Fall
But then, with the growing banking turmoil and fears of a recession, the price began to fall, and rapidly so, reaching $34 by the end of the year – less than a quarter of the price just five months previously. It then hovered around the $40 mark in the first quarter of 2009. While this was good news for the consumer, it was potentially damaging for investment in oil exploration and development and also for investment in alternative energy supplies.
OPEC responded to the falling price by announcing cuts in production, totalling some 14 per cent between August 2008 and January 2009. But with OPEC producing less than a third of global oil output, this represented less than 5 per cent of global production. Nevertheless, as global demand recovered, so oil prices rose again from 2009 peaking in March 2012 at $118.
The fragility of economic growth, especially in Europe where many governments were ‘tightening their belts’ in the face of growing concerns over levels of borrowing, began to put a brake on demand. The price of oil was to average close to $104 over 2013.
However prices were to fall steeply from summer 2014. This was largely a result of the increased output in non-OPEC countries of non-conventional deposits, such as in shale formations. Consequently, OPEC’s market share has waned.
OPEC responded to the increased supply, not by cutting output, but by announcing that it would retain output at current levels even if oil prices dropped as low as $40. What it was relying on was the fact that production from shale oil wells, although often involving low marginal costs, lasts only two or three years. Investment in new shale oil wells, by contrast, is often relatively expensive. By OPEC maintaining production, it was hoping to use its remaining market power to reduce supply of competitors over the medium to long term.
The recent history of OPEC illustrates the difficulty of using supply quotas to achieve a particular price. With demand being price inelastic but income elastic (responsive to changes in world income, such as rising demand from China), and with considerable speculative movements in demand, the equilibrium price for a given supply quota can fluctuate wildly.
Answer the questions in essay style not short answers. The answers should be related to the case study above. Around 500 words
Case study OPEC – The Rise and Fall and Rise Again of a Cartel.
1a) Who are likely to be the (i) demanders and the (ii) suppliers of oil?
1b) Suggest factors which are likely to affect the (i) demand for and (ii) supply of oil in world markets?
1c) Explain, using examples from the data, how changes in demand and supply have: (i) Raised the price of oil; (ii) Reduced the price of oil.
Part2 – answer the questions
Is not related to the case study, so you have to a research about it. Around 600 words. References needed in Harvard style
Analyse, the, concept of market orientation, E.g. monopolistic, oligopolistic, monopoly and perfect competition and explain their significance to business
3a) It is usual to divide markets into four categories under which firms operate. List and describe (In ascending order of firms’ market power) the four categories using examples where appropriate.
3b) Outline the differences, using examples, between the four categories using a table layout.
3c) Choose one of the following:
(i) Consider this highly contestable monopoly: A bus company operating a particular route. How well is the consumer’s interest served?
(ii) An example of monopolistic competition is provided by fast-food restaurants. What other businesses are in competition with fast-food restaurants and what determines the closeness of this competition?