The Effects Of Opec Pricing Policies Economics Essay

In the wake of the technological age we live in, most of our daily activities consist of the usage of oil as a form of energy. This means from an economic standpoint that the demand in the market for oil is highly inelastic. This gives oil producers high incentive to produce so they can achieve large profits. Unfortunately supply for this industry is also inelastic and due to the nature of oil as a natural resource there is a limit to how much producers can produce. Due to its worldwide need, the exporting and production of oil is done at a worldwide level. Hence suppliers in the oil industry are the countries themselves, which creates an oligopoly. Oligopoly’s are known for having kinked demand curves meaning that when left to the free market competitors will keep undercutting each other until neither are making the large revenue’s they projected when they entered. It is at this point that OPEC, the organization for petroleum exporting countries steps in. Using strategy following game theory they control supply so that they can maintain prices at a level where member countries of OPEC can increase their individual revenue as a group. In the short term, OPEC’s pricing policies increase revenue for its member countries, protect and maintain the price of oil, and reduce the rate of depletion of oil reserves. In the long term however OPEC’s pricing policies lead to a decrease in world market share as non-OPEC producers increase production of oil. This seems to lead to a point where OPEC’s policies will become less and less effective in controlling the market price of oil.

OPEC controls and maintains oil prices by changing supply. The reason they are successful in being able to control market prices is due to their large market share in the oil industry coming from the large oil reserves in the member countries demographic. Hence they are able to succeed according to the game theory model to maximize profit and revenue for all of their members. There is though a downside to these policies as noted by OPEC members since by decreasing supply over the long term, there is incentive for non-OPEC nations to increase supply. This increase leads to OPEC further decreasing supply to balance out the market price, which further ends up to a market share drop for OPEC in the long term.

Statistics show that since OPEC’s policies have started to affect the market, their production has steadily dropped. Shown above, from 1970 – 2001 OPEC’s production compared to the world oil industry has dropped off at a steady pace. The low point of this was the 1980’s Oil Glut, which was caused due to fear of OPEC member countries that they were reducing production to a point where they were losing the market share. As shown the market share dropped from nearly 50% in the 70’s to a third in the 80’s. This led to Saudi Arabia increasing production decreasing the price of oil and making most OPEC member oil facilities non profitable. It was after this that OPEC members realized the importance of the price policies since as developing countries most of their funds come from the exportation of oil. Though however OPEC’s policies can only be successful if their members follow them. Saudi Arabia holds the most power since they currently hold 13.5% of the world market share making them the swing producer. Hence as seen in the 1980’s any steps taken by Saudi Arabia affect all OPEC members immensely.

A clear representation of the effect of their production quotas policy on their overall world market share can be seen with their production change from 1978 – 2003. In 1978 OPEC produced an approximate 32 million barrels / day. This reduced to 27 million barrels / day by 2003. This decrease in production by OPEC over this span coincides with a 14 million barrel / day rise in world demand over the same period in time. This show that non-OPEC countries are filling the gap in world demand and OPEC supply resulting in a major loss in world market share for OPEC. In 2002 non-OPEC supplies accounted for approximately 59% of the world market share. Also Saudi Arabia’s share dropped from 22% in 1982 to 13% in 2002, a 9% decline. Saudi Arabia as explained is the swing producer in the OPEC organization so a 9% decline in their market share shows an overall loss for the organization as a whole. As explained earlier to combat the increase in non-OPEC supply OPEC will decrease supply again which will eventually lead to a point where they will not have control over the world market leading them to recapture market share by boosting production causing both OPEC and non-OPEC facilities to become non profitable.

These OPEC policies are highly criticized by western nations since they are the main losers from the world market restrictions on oil. Since OPEC owns the majority of the oil reserves now and going into the future, they are able to use this supply-controlling model to benefit their members. This is especially detrimental to western nations who are the major consumers of oil especially the United States. It is also to OPEC’s favour that due to their large oil reserves that costs are much lower than that of western countries that have to set up high cost offshore oil facilities. The below chart shows the dependency of countries such as the United States on OPEC oil as the produce much less then they consume. Hence the high price policy has a negative short-term impact on them.

What western critics though often overlook is that by controlling these prices and maintaining them at high levels OPEC is able to help develop their member countries. In the case of Algeria, which is a member of OPEC, oil exports as of 2004 accounted for 95% of the total revenue received from exports as well as 40% of the GDP. In that year alone their GDP grew 6%. Algeria is among a number of OPEC countries that rely heavily on its petroleum exports and similar to other members is a developing country with high unemployment rates (reaching 50% in 2004 for adults below the age of 30). Even Saudi Arabia, which achieved a surplus in 2004 and has the most power over OPEC quotas, has shown their bad economic position with increasing birth rates and high unemployment rates. These countries all rely heavily on their oil revenues and as seen in the 1986 oil glut where quotas were exceeded, a drop in the market price of oil can heavily damage OPEC member countries respective economies. Saudi Arabia for instance had a GDP of $103,897,800,000.00 in 1985 fell to a GDP of $86,961,920,000.00 in 1986 mainly due to the Oil glut created by increasing supply. This is calculated roughly to a 17% drop in GDP. Thus showing the damage caused by removing the quotas and letting prices fall on to the free market.

Though there are many critics of OPEC’s price policy, and there are many long-term costs, there are also many long-term benefits to the world market as opposed to just OPEC member countries. Due to the decrease in market share non-OPEC countries expand their facilities by re investing in the industry, thus increasing the amount of accessible oil reserves. Also since prices are held high and OPEC doesn’t produce to max capacity, oil is conserved so that when non OPEC facilities start to dry out and lower production, OPEC countries will be able to step up and produce more while keeping prices high taking back the market share and retaining huge profits (See Graph Below).

The graph shows that due to conservation of OPEC oil reserves OPEC will dominate the market share when high cost facilities will run out. This shows the maximum gap in the market share projected in the year 2027. Another benefit from this policy, which is also a cost to the oil industry, is that the maintained high price of oil causes the world to look into renewable and alternate energy sources, which might be cheaper alternatives. With funding of this research in place OPEC and the oil industry in general are at risk of having demand change by becoming more inelastic with more alternatives entering the market. This serves as a benefit to society but a cost to the Oil Industry. As you can see in the graph below the increase in consumption is steadily increasing and is greater than the discovery of new oil. Hence OPEC’s strategy to save their oil reserves will prove useful in the future as oil reserves dry out.

OPEC’s pricing policy at the moment is short sighted in the sense that it looks to increase revenue for oil producers in the short run, yet does not take into account the steady loss of market share and imminent oil glut to be caused in the future to regain the market share as noted in 1986. The solution to this situation though is not to remove OPEC’s policies completely, since doing so will cause economic turmoil to all OPEC countries resulting in a huge loss in revenue reducing GDP’s of these countries immensely. OPEC, I believe should adopt a strategy to slowly increase its production not to cause a giant surplus, but to slowly regain market share and decrease prices. The decrease in prices will firstly cut into the revenue of new high cost facilities off shore in the west, which will cause them to shut down since they will be unable to maintain prices high enough to make a profit. Such a tactic though at the moment is a risk since the world is coming out a recession so a drop in revenue for these OPEC countries is especially detrimental. OPEC though holds 77% of the world’s current oil reserves and can produce oil at low cost. Hence in the long term once they regain market share they will be able to control price once again at very high production levels so they will quickly be able to come out of economic turmoil more permanently compared to the false economic stability created by restricting oil supply. This false economic stability comes from this policy basically leading to OPEC nations to grab market share by increasing supply. These grabs basically cancel out benefits from years of increased revenues. It is however fantastical to believe that such a solution can be easily implemented due to external economic factors but it is in the interest of OPEC’s future to do such as at their current rate their market share will drop to a point where they will have little to no control over price and will have to abolish the organization and increase supply. This is especially deadly as the price change and more then likely rapid increase in Saudi Arabian oil production will destroy economies of OPEC’s lesser off members. Therefore, even though OPEC’s current price policy is effective in the short term by increasing revenue’s, protecting prices, and safeguarding future oil supply, it is self inflicting in the long term and cancels out its short term benefits by leading to a decrease in market share, and a foreseeable oil glut resulting from the market share loss. Hence it is beneficial for both upper and lower echelon OPEC members to change their price policies so that they look towards long-term benefit as opposed to short-term gain.

http://www.eia.doe.gov/cabs/orevcoun.html

http://www.mees.com/postedarticles/oped/a46n42d01.htm

http://seekingalpha.com/article/97800-opec-good-is-bad-bad-is-good

http://www.mees.com/postedarticles/oped/v48n11-5OD01.htm

http://www.nationmaster.com/time.php?stat=eco_gdp-economy-gdp&country=sa-saudi-arabia