Great attention in major media sources has been called to the recent dip in oil prices (CL1Q) which peaked at over $114 per 159 liters of light crude. It is hovering around $94 now, which is a decrease of over 16% from the peak. Traditional thinking claims that gas prices typically peak in the summer months due to more gas being used during holiday travel times such as the 4th of July and Memorial Day (and Earth Day: irony?). One of the recent developments is a claim by OPEC companies that the International Energy Association (IEA) released emergency oil stocks to alter the oil prices. In response, some observers believe that Saudi Arabia will not follow through on their promise to increase oil production by as much as originally claimed (some reading here and here). The confusion as to how each individual country will respond to this creates very different incentives for each of the countries in OPEC.
OPEC, which stands for Organization of Petroleum Exporting Countries, is one of the world’s largest cartels (along with maybe DeBeers). Algeria, Ecuador, Iran, Qatar, Libya, Angola, Iraq, Kuwait, Nigeria, Saudi Arabia, United Arab Emirates and Venezuela are the twelve countries that comprise the members of OPEC. These twelve countries produce about 40% of the world output in oil, with much of the rest being produced by Canada, Russia, China, Mexico, Brazil and the United States. Understanding how this cartel works and the specific incentives they face may help people understand global oil economics better.
One of the first things many economics students learn is that marginal revenue is a steeper curve than price curve for monopolists than regular competitors. Since the entire market is owned by one company, getting an additional customer also requires lowering the price on all the customers as well. This leads to a quantity much lower (restricting output) and a price much higher (inflating price) than a normal competitive environment would provide.
What is interesting, however, is that in most markets, if there were two competitors not only would it lower price and raise output (obvious results) but the sum of their profits should be less than the monopolist’s alone. The competition makes each profit less than half the monopolist’s. This is where cartels come in: if the two companies acted as if they were a single monopolist and then split the profits appropriately, then they would each make more money (by restricting output and inflating price). There are a lot of details about how to prevent others from defecting agreements in Game Theory (more reading in the book The Evolution of Cooperation by Robert Axelrod), but I won’t go into detail here.
The important problem with the above situation is that it is assuming that all the firms (or countries) have the same exact structures and costs. If, for example, Saudi Arabia produces oil at a much cheaper rate than Venezuela, then Saudi Arabia will want to produce at a higher rate and lower price to drive out competition and profits upwards. All of the decisions I have described are also politically neutral. If a country’s finances are in turmoil, the urgency to produce more will be much more important than establishing a long-term profit plan. Because of this, many have estimated that OPEC has less control than they actually do. Their “goal” is to stockpile inventory to be able to control prices, but with such a geo-politically diverse constituency and less than half of the world’s output in oil, their influence is overstated at times.
This is all written, however, in 2011. If OPEC continues to withhold or stockpile oil inventories, a peak oil crisis in the near future may cause their influence to increase even further.