Why they were a single producer and thus

Why
did I choose this topic?

The primary reason I selected this topic is because it interests me
to know more and more about oil exporting countries in the world. Since this
topic interests me, I thought researching issues related to oil cartels would
be stimulating. Specifically, I wanted to learn about how oil cartels like OPEC
which is the largest oil cartel in the world is operating, and what steps are
being taken to control oil production.

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I thought it is quite easy to gather information about oil cartels
and there is many websites government and non-government websites which we can
find the related data to this topic.

 

 

Origin & nature

A cartel is an organization created from a formal agreement between
a group of producers of a good or service to regulate supply in an effort to
regulate or manipulate prices. In other words, a cartel is a collection of
otherwise independent businesses or countries that act together as if they were
a single producer and thus are able to fix prices for the goods they produce
and the services they render without competition.

The term cartel, can be defined as “a group of parties,
factions, or nations united in a common cause; a bloc” as well as “a
combination of independent business organizations formed to regulate
production, pricing, and marketing of goods by the members.” History shows
many examples of successful and not so successful cartels – they have been
around for hundreds of years. The steel industry and diamond industries are
some examples. However, one of the most powerful modern cartels is the
Organization of the Petroleum Exporting Countries more commonly referred to as
OPEC.

Oil and gas are considered among the world’s most important
resources. The oil and gas industry plays a critical role in driving the global
economy. Petroleum itself is used for numerous products, in addition to serving
as the world’s primary fuel source. The processes and systems involved in producing
and distributing oil and gas are highly complex, capital-intensive and require
state-of-the-art technology. This issue of the Business & Economics
Research Advisor provides a comprehensive overview and guide to resources on
this vast and important industry.

Prior to the rise of OPEC, the oil industry was dominated by the
large oil companies often known as the Seven Sisters that possessed the
technology and skills for exploration and production that the countries lacked.
OPEC was born, to some extent, to reduce the influence the oil multinationals.

As Skeet suggests in his book, “The governments of the oil
producing countries in varying degree, but in all cases with increasing fervor,
viewed the systems under which the companies operated as an outdated example of
imperialist domination.” In fact, one of the first things written in the
1st OPEC Conference Resolution in Baghdad states, “Members can no longer
remain indifferent to the attitude heretofore adopted by the Oil Companies in
effecting price modifications.”

 

 

Literature Review

1)     
The
interest in oil market modeling grew rapidly right after the Arab embargo and
the quadrupling of the oil price in 1973. Stephen Powel (1990) mentions that by
the late seventies there were more than thirty publicly available oil market
models. Since then the oil market modeling efforts have slowed down
significantly. In this part of the review, we briefly present the more popular
oil market models that were mentioned in surveys and studies conducted to date
and then elaborate more on the optimization models as they are more related to
our proposed model.

2)     
In
1990, Stephen Powel noted that most existing oil market models are either
inter-temporal optimization or behavioral simulation and listed three models as
inter-temporal optimization models including ETAMACRO (Manne, 1981), Salant
(1981) known as Salant-ICF, and Marshalla and Nesbitt (1981) known as DFI-CEC.
Eight years later, Baldwin and Prosser (1998) conducted a similar survey and
followed the same classification as that of Powel (1990) and believed that most
of the oil market models belong to either recursive simulation models or
inter-temporal optimization models.

3)     
In
1998, Mabro surveyed and criticized the literature on OPEC behavior for the
period 1960-1998 and grouped it into six categories including: history,
previous literature surveys, economic modeling, political economy, policy
proposals, and trade journals reporting. More surveys but rather shorter ones
are included as part of the literature reviews in studies conducted by Moran
(1982), Griffin (1985), Dahl and Yucel (1991), Al-Yousef (1998), Alhajji and
Huettner (2000 a, b and c), Ramcharran (2001 and 2002), Smith (2005) and
Kaufmann et al (2006).

4)     
Gately
(1984), Griffin and Teece (1982), Griffin (1985), Bockem (2004), and Smith
(2005) where Gatley noted “it remains an open question how best to design a
model of the behavior of OPEC”. Twenty years later, Bockem still noted, “there
exists neither an accepted theoretical model, nor an econometric model of this
market. Moreover, there is a surprising dispute between economic theorists and
energy economists whether OPEC can be regarded as a cartel or not.” Similarly,
Smith concluded that contributions “remain largely inconclusive regarding the
behavior and impact of OPEC, despite the best efforts of those authors.”

5)     
In
2005, Smith briefly surveyed and criticized the literature on OPEC behavior and
applied an econometric production-based approach to examine alternative
hypothesis regarding the world oil market. He conducted two analyses: price
analysis (assuming that market price greater than marginal cost indicates
market power) and production decision analysis (testing responses to exogenous
shocks for evidence of interdependence among firms). In the former case, the
null hypothesis of perfect competition (price equals marginal cost) was tested
against the alternative of a perfect cartel. In the latter case, the study
tested four null hypotheses relating to OPEC and Saudi Arabia competitiveness.

 

History
of the Oil Industry

The use of oil and gas has a long and fascinating history spanning
thousands of years. The development of oil and gas has evolved over time and
its numerous uses have also expanded and become an integral part of today’s
global economy. The use of oil eventually replaced coal as the world’s primary
source of industrial power in the early twentieth century. Just as oil and gas
drives today’s world economy, the control and availability of oil and gas
played a major role in both World Wars and still remains the critical fuel
source that powers industry and transportation. This section provides an
overview of the history of the oil and gas industry, looking at the use of oil
and gas in ancient times, as well as the early days of the modern oil and gas industry.

Oil
and gas have played an important role throughout world history. Ancient
cultures used crude oil as a substance for binding materials and as a sealant
for waterproofing various surfaces. Five thousand years ago, the Sumerians used
asphalt to inlay mosaics in walls and floors. Mesopotamians used bitumen to
line water canals, seal joints in wooden boats and to build roads.

By 1500 B.C., techniques for lighting consisted of a censer or fire
pan filled with oil made of a certain volatility so that it would burn slowly
and not cause uncontrollable flames or explosions. Over time, the wick oil lamp
replaced the fire pan using a flammable oil similar to today’s kerosene
lanterns.

Current Situation

The current level of oil prices has made it even more challenging
for OPEC members to maintain their cartel output levels. All of the Middle
Eastern member countries—Saudi Arabia, Iran, Iraq, Kuwait, United Arab
Emirates, and Qatar—fund virtually all of their government spending from oil
sales. And they’ve each set their spending levels based on an assumed price of
oil that is significantly higher than the current price of $50 per barrel. At
current oil prices, these OPEC member countries maximize the contribution that
oil sales make to their government budgets by producing as much as possible.
Consequently, given the dire financial straits facing many of these
governments, it is unlikely any members of the cartel will agree to produce
less oil unless it is in their unilateral interest.

Even if OPEC produces 700,000 fewer barrels per day, this is
unlikely to move oil prices by a discernible amount, thanks to changes in the
global oil market over the past six years. The shale oil boom has almost
doubled U.S. oil production from slightly over 5 million barrels per day in
2010 to over 9.5 million barrels per day in 2016. Shale oil extraction
technology requires frequent drilling and fracturing of the shale oil deposit
to maintain oil production. While current oil prices have led to a significant
decline in the amount of drilling activity in the U.S. over the past year,
there are still many locations in the U.S.—North Dakota, Pennsylvania, and
Texas, to name a few—with significant shale oil deposits, which makes it easy
for North American producers to quickly ramp up their output in response to an
oil price increase.

 

The world’s major oil producers have extended production cuts
through to the end of 2018, in a bid to tackle a global glut of crude and keep
prices buoyant.

Members of OPEC, the oil cartel, and other major producers
including Russia agreed that the curbs, which started in January and have
lifted a barrel of Brent crude from $40 to $50 last year to more than $60 now,
will continue for a further nine-months.

 

Industry Cartels & Organizations

 

Organization of the Petroleum Exporting Countries (OPEC)

OPEC is a permanent, intergovernmental organization created at the
Baghdad Conference on September 10-14, 1960. It was an outgrowth of the 1st
Arab Petroleum Congress in 1959 when the Oil Consultation Commission, created
by a few of the oil producing countries, signed what was known as the Maadi
Pact at the end of their meetings.

While this pact was originally kept secret and there was no
official confirmation that such a group existed, a move by Esso and other oil companies
to reduce the posted price for Middle East crudes prompted Perez Alfonso of
Venezuela and Abdullah Tariki – both influential in the meetings of 1959 – to
convene meetings in Baghdad which resulted in the creation of OPEC. 3 Early
members were Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela with Qatar,
Indonesia, Socialist People’s Libyan Arab Jamahiriya, United Arab Emirates,
Algeria, Nigeria, Ecuador, and Gabon joining later (Gabon left in 1994/1995 and
Indonesia left in 2009). Its goal is to co-ordinate and unify petroleum
policies among Member Countries. However, there are large producers who are not
members of OPEC, notably Russia, Norway, Mexico, and the United States.

The early years of OPEC – as with many newly formed groups – were
difficult. The organization spent its early years consolidating its position
with the major oil companies. However, this caused OPEC to lose some control.
Starting in the early 1970’s, OPEC influence grew. The first few years of the
1970’s saw so much instability in the oil industry as a whole that no player
was left unaffected. Then came the oil crisis of 1973, which marked a turning
point for the oil industry and OPEC in particular.

The crisis was sparked by the announcement in October, that the
Arab members of OPEC would not ship oil to countries that supported Israel in
the Yom Kippur War. Because OPEC countries have about 2/3 of the world’s oil
reserves and hold about 40% of the world’s oil production and half of the
exports, the announcement by the Arab OPEC members was an enormous blow to the
industry and the world economy as a whole.

 

OPEC technically doesn’t set oil prices, but because the OPEC
countries produce about 40% of the world’s oil supply and their exports account
for about 55% of the total export in oil, their decisions do play a part in
prices.

The purpose of OPEC is to agree on the quantity and price of the
oil their countries export. They state their primary objectives as:

To coordinate and unify the petroleum policies of its Member
Countries and ensure the stabilization of oil markets in order 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 members meet twice a year (usually March and September) at the
OPEC Conference to co-ordinate and unify their petroleum policies and consider
the current situation and forecasts of economic growth rates and petroleum
demand and supply scenarios. Delegates are normally the Ministers of Oil, Mines
and Energy of Member Countries.

The Conference is the supreme authority of the Organization.
However, there are three main organizational units which oversee the operations
of the organization:

 

1)     
OPEC
Secretariat – This group functions as the Headquarters of OPEC. It is
responsible for carrying out the executive functions of the Organization. It
consists of the Secretary General and the Research Division, headed by the
Director of Research, who oversees the Petroleum Market Analysis, Energy
Studies, and Data Services Departments.

2)     
Board
of Governors – The Board is composed of Governors nominated by Member Countries
and confirmed by the Conference for two years. The Board directs the management
of the Organization, implements Resolutions of the Conference; draws up the
Organization’s annual budget, and submits it to the Conference for approval.

3)     
Research
Division – is a specialized research oriented body operating within the
framework of the Secretariat. It consists of three Departments, namely, Data
Services, Energy Studies and Petroleum Studies.

Much about the actual operations and decision making process of
OPEC is unknown. The organization is quite secretive about itself so there is
not much written about its internal workings. This secrecy has often lead to
misunderstandings or conspiracy theories, which are prevalent in some books and
articles written on OPEC.

 

International Energy Agency (IEA)

The International Energy Agency (IEA) is one of the larger
organizations involved in the oil and gas industry. The IEA is the energy forum
for 26 industrialized countries. Formed by the Organization for Economic
Cooperation and Development (OECD) as an autonomous intergovernmental entity
within the OECD in 1974 in direct response to the oil crisis, its members
include:

Australia, Austria, Belgium, Canada, the Czech Republic, Denmark,
Finland, France, Germany, Greece, Hungary Ireland, Italy, Japan, Republic of
Korea, Luxembourg, The Netherlands New Zealand, Norway, (participates under a
special Agreement), Portugal, Spain, Sweden, Switzerland, Turkey, United
Kingdom, and the United States. One of the overall objectives of the IEA, which
reflects the original reason for the group’s establishment, is to seek ways to
reduce the members’ vulnerability to a supply disruption.

Objectives of the IEA:

v  To promote cooperation between member countries in reducing
dependence on oil through energy conservation and the development of
alternative energy sources

v  To set up an information system on the international oil market and
establish consultations with oil companies

v  To cooperate with oil producing and consuming countries in efforts
to stabilize world energy markets and to ensure fair and effective management
of world energy resources

v  To devise and implement plans to address potential major oil crisis
and the disruption of world oil supplies

The second oil shock occurred in 1979, again causing dramatic
increases in world oil prices. This oil shock was the result of the Iranian
crisis caused by political and social discontent in Iran, which led to strikes
in most sectors of the economy, in particular the oil industry.12 Iranian
production fell from 6 million barrels per day in September 1978 to 400,000
barrels per day in January 1979.13 Saudi Arabia initially increased production
to compensate for the Iranian supply shortage, but later placed a ceiling on
its production. These series of events led to escalating oil prices and a great
deal of uncertainty concerning the world oil market.

 

 

Organization of Arab Petroleum Exporting Countries (OAPEC)

The Organization of Arab Petroleum Exporting Countries (OAPEC) was
established in 1968 and is based in Kuwait. Membership is limited to petroleum
producing Arab countries. The three founding members were Kuwait, Libya, and
Saudi Arabia. The OAPEC is not a cartel in the same sense as OPEC. OAPEC is
devoted to developmental activities and increasing the cooperation among its
members.

 

It
should be said that cartels are difficult to hold together. The principal
reasons are as follows:

 

1)     
As
the number of member firms (or nations) increases, it is increasingly difficult
for collusion to be effective – members all have an incentive to
“cheat” on the cartel by producing “a little bit” more and
earning a little bit more money. But if everybody cheats a little bit, the
supply increases and prices get lowered, and we move closer towards a
competitive market. This has happened a lot in OPEC, and it is periodically
controlled by having Saudi Arabia open up the taps for a while to lower the price
in order to get the message to other OPEC nations that they can punish
cheating. This brings us to the second point:

2)     
When
it is difficult to detect cheating, it is hard for collusion in a cartel to
hold. OPEC nations do not allow other nations, even other OPEC nations to
independently verify what their production levels are. This is very different
from western nations like the US, Canada, and Britain, where the volume of
petroleum production is reported by private and public firms to the government,
and these figures are collected and reported by the government. Because nobody
is able to independently measure and police production quotas, there is a lot
of cheating.

3)     
The
third point is that low barriers to entry – we will talk more about barriers to
entry in the next lesson – make it difficult to control price. In the oil
business, the barrier to entry is the presence of oil in a country. If there is
oil in a country, that country can produce and sell the oil relatively easily,
and it turns out that many, many countries have at least some oil. The OPEC
nations have a big slice, but when OPEC drives up prices by successfully
restraining production, every other country has an incentive to look for oil,
and frequently find it. This increases production globally and tends to lower
prices. High oil prices also provide incentives for the development of other
forms of energy – the substitution effect – and the last thing that OPEC wants
is for oil to become obsolete because somebody figures out a better, cheaper way
to power our cars and planes. We used to burn a lot of oil to generate
electricity and heat homes, but we do very little of that now because there are
cheaper alternatives, and we are getting closer to the point where we have
alternatives for powering our vehicles. We will talk a lot more about this
topic in the last lesson or two of this course.

What
did I learn?

A cartel is a form of market power in which suppliers collude with
each other to manipulate supply. The most famous cartel in the world is OPEC,
the Organization of Petroleum Exporting Countries. It turns out that crude oil
is found in many countries in the world. In fact, there are probably oil wells
in pretty much every country in the world. But there are a few countries that
have large supplies of oil that is relatively cheap to produce.

The history of the international oil industry is convoluted and
full of lots of stories about power, colonialism, and nationalism. The oil in
many parts of the world was controlled for about half a century by a group of
American and European companies called the “Seven Sisters.” The
countries in which the oil was found resented this control, as they believed
that the price was being kept artificially low to benefit the consuming, and
not producing countries. Several of these countries banded together to take
control of their own resources and formed the organization we know as OPEC.

As I mentioned, there is a lot of fascinating history in the oil
industry and OPEC. If you have more interest, I suggest you look at the
Wikipedia page for OPEC for a quick overview, and if you are interested in
investing a little more time, I recommend reading the book “The
Prize” by Daniel Yergin. However, this is an economics course, and I want
to focus on the economics of cartels.

OPEC is able to act somewhat like a monopolist, even though the oil
industry is not a monopoly. OPEC countries produce about 30% of the world’s
oil. However, they produce a lot of low cost oil, so they are able to
effectively control the supply curve and where it intersects the demand curve
by restricting their output.

I should make it clear that OPEC is not trying to maximize the
price in the short run. Since the elasticity of demand for oil is quite steep
in the short run, OPEC could raise the price quite a bit more with slightly
lower production. However, such actions are likely to be damaging to the OPEC
nations in the longer run: it will cause recession, which hurts long-term
demand, but, more importantly, having a very high oil price will incentivize the
development of alternative energy sources, which means that oil would then have
substitutes, and its demand elasticity would not be as steep. OPEC would not,
then, be able to control the price as much.

 

 

 

 

 

 

Suggestions

First, by unlocking vast resources that had long been deemed
uneconomical, the fracking technology has dispelled ‘peak oil’ worries just as
rising climate concerns have begun to cast doubt on the long-term outlook for
oil demand growth. This has fueled speculation that a huge ‘carbon bubble’ is
in the making, that large amounts of oil would have to ‘stay in the ground’,
and that some of OPEC’s resources might end up being ‘stranded assets’. This
might change the revenue-maximizing strategy of low-cost producers like Saudi
Arabia and give them an incentive to speed up, rather than slow down, oil
extraction.

Second, the shale revolution accelerates the eastward migration of
the global oil market, whereby the center of gravity of oil consumption, and
hence oil trade flows, are decidedly shifting to the so-called ‘East of Suez’
region. That leaves oil exporters competing with each other for an increasingly
concentrated Asian market, which is itself dominated by supergiant Chinese oil
trading companies with considerable market power. This situation provides
another deterrent for OPEC to implement production cuts.

Last but not least, what stands at the center of the shale oil
revolution is that it has changed the cost curve and elasticity of oil supply.
The fracking industry operates on a much shorter investment cycle than the
conventional oil industry: upfront costs are relatively low, decline rates are
steep, lead times and payback times are short. There is no real exploration
process to speak of because the location and broad characteristics of the main
plays are well known. The time from an investment decision to actual production
is measured in months, rather than years, making the tight oil industry far
more nimble and responsive to price signals.

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