CAUSES OF OPEC’S SUCCESS
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In 1999, the oil prices had fallen to about $10/barrel. This was largely due to the Asian financial crisis that led to a fall in demand, while supply was largely unregulated, due to OPEC’s inability to check the quotas of its members. Fearing collapse of oil revenues, Saudi Arabia negotiated with other major OPEC and non-OPEC members to cut production sharply and since then, compliance with output quotas has been considerably good.
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Since 1999, the world demand for oil has increased consistently. In 2007, it was 86 million barrels/day (mbd), up 13% from 1999. During this period, China’s (a rapidly growing economy) oil use has almost doubled to 7.5 mbd. Similarly, American oil use too has gone up 7% to 20.8 mbd.
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The world supply of oil has remained stagnant due to depressed production in Iraq, Nigeria, Iran, Venezuela, etc., due to wars, civil strife and nationalization.
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Even though crude prices started slipping in late 2006, OPEC stepped in and like a true cartel, cut production to prop up prices. By the end of 2007, excess inventories with the oil producing countries were wiped out. Thus, prices soared and have now crossed the $100/barrel mark, due to OPEC’s supply cuts.
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The combination of higher demand and stunted supply has pushed up prices.
MAXIMIZATION OF JOINT PROFITS IN A CARTEL
The decision regarding the level of total output to be produced, the price at which this output will be sold and the allocation of output among various countries by OPEC can be explained with the help of the following diagram:
In this diagram, an assumption of a Cartel with two member countries, Country A and B is taken.
In the diagram above, since the objective of the cartel is to maximise joint profits, its level of equilibrium, i.e. the level of output which gives maximum joint profits, will be at a point where MR for the industry as a whole is equal to MC of the industry as a whole. Thus, the total market demand for oil will first be estimated which the countries under this Cartel are to produce. Since Oligopoly is a case of market imperfections, the demand curve for the industry will be downward sloping as shown by D=AR in Fig.1(c). Fig.1(a) shows the AC and MC of Country A, while Fig.1(b) shows the AC and MC of Country B. Assuming that these are the only two countries in the cartel, then the Cartel’s MC curve is given by the horizontal summation of the marginal cost curves of the two countries. Thus, the MC curve of the Cartel, MCc = MCa + MCb; where MCa and MCb are the marginal cost curves of Country A and B respectively.
Point of Equilibrium
The point of equilibrium for a cartel is the point of maximum joint profits. Thus, for the Cartel (the industry as whole), D=AR is the demand curve facing it and therefore, MR is the Marginal Revenue curve. This curve intersects with MCc at a point G, which gives OQ level of equilibrium output and OP price per unit.
Now, the Cartel will allocate the output quota to be produced by Countries A and B in such a way that the marginal cost of producing the allocated output of each country is the same. Thus, if a line is drawn from G, parallel to the X axis, it will intersect MCb and MCa at H and J respectively. Thus, marginal cost of OQ1 output for Country A is equal to the marginal cost of OQ2 level of output for Country B, which is also the marginal cost of the total industry output-OQ. Hence, Country A will produce OQ1 and Country B will produce OQ2, making the total output equal to OQ. This allocation of output between Countries A and B will assure maximum joint profits, which are equal to the profits made by Country A-PABC and Country B-PDEF.
DIAGRAMMATIC DESCRIPTION OF OPEC’S SUCCESS STORY SINCE 1999
In the diagram, the supply curve of non-OPEC countries is represented by SN. Initially, the OPEC countries are willing to supply all crude oil that is demanded at the world price-OP and thus, the world supply curve for crude oil is the horizontal curve SW. The world supply curve cuts the world demand curve for oil DD at point E. Therefore, the world production of crude oil was OM of which, OM1 was supplied by non-OPEC countries and M1M by the OPEC countries. When OPEC enforced quotas for member countries and restricted the output, the world supply curve became SW’. The new world supply curve SW’ cut the world demand curve DD at point F. Therefore, after restrictions imposed by OPEC, the world price rose to OP’ and world output got reduced to OM2. At world price of OP’, the non-OPEC countries supplied OM3 quantity of crude oil and the quantity supplied by OPEC was M3M2. In this way, OPEC has been able to increase its overall oil revenues and the non-OPEC countries have also gained as a result of the price rise.
CAN OPEC’S SUCCESS STORY LAST?
As per the article, OPEC’s market power could be limited by curbing world demand and increasing world supply. As the gap between the supply and demand increases, it will become harder for OPEC to control the oil market. The member countries will be tempted to increase the production to raise revenues. This can happen with the world economy heading towards recession, which would lower world demand and cause a downturn in crude oil prices. However, on the flip side, this might not happen as the USA has done little to check its demand for imports of crude oil. It has steadfastly rejected higher gasoline taxes to curb demand for crude oil and strengthen demand for fuel efficient vehicles. As a result, the crude oil prices may continue to remain high, worsening the global recession. Hence, the situation is increasingly becoming uncertain to predict. Whatever may happen, the long term threat of OPEC’s power will remain and it will be hard to curb it, unless steps are taken to curb world demand.
Terminology:
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CARTEL: A cartel is a formal (explicit) agreement among firms. Cartels usually occur in an , where there are a small number of sellers and usually involve . Cartel members may agree on such matters as , total industry output, , allocation of customers, allocation of territories and the division of profits or combination of these.
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OLIGOPOLY: An oligopoly is a in which a or is dominated by a small number of sellers. There is a high degree of interdependence among the firms. Each firm has enough market power to prevent itself from being a price taker; however, each firm is subject to enough inter-firm rivalry to prevent it from considering the market demand curve as its own.
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PROFIT MAXIMIZING LEVEL OF OUTPUT: It is obtained where a firm’s Marginal Cost (MC) is equal to its Marginal Revenue (MR) and the MC curve intersects the MR curve from below.
Citation:
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Definitions with reference from:
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History of OPEC:
