Abacus: An Economy of Oil
lupengyu
Oil, like most goods and services offered in a market-orientated economy, is priced based on the forces of supply and demand. However, oil has a formalized cartel that controls the supply ‘pipeline.’ The Organization of the Petroleum Exporting Countries (OPEC) was founded in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela, and since its inception has grown to include other states with large oil reserves (Qatar, the UAE, etc.). Oil reserves are naturally a requisite to join this club: as of 2018, OPEC member states held 79% of the world’s oil reserves.
OPEC’s cartel like power is derived from ‘production targets.’ This simple mechanism allows OPEC to control the amount of oil in global markets and adjust if prices become unfavorable. Anyone who has taken an introductory microeconomics course is surely familiar with an oligopoly; OPEC just happens to be an oligopoly of member states instead of firms.
The countries of OPEC are well aware of their collective ability to set prices. The operative word here is ‘collective.’ Without the bargaining power and market share of the entire group, the cartel loses sway in global markets and becomes more of a conglomerate. Ergo, there is an element of mutual trust involved, whereby one must trust other member states to follow production targets.
This sort of contract-breaking action is the study of many economists. One study suggests that since 1982 all OPEC members have at some point breached the mutually set production targets, in an effort to increase individual profit, risking the cartel’s effectiveness and validity.
Additional studies have examined the impact of statements given by OPEC and member states on the price of oil. One such study claiming that as the price of oil decreases the impact of these releases increases, whereas if oil producers are already ‘winning’ and prices are up announcements are less impactful. Naturally, the study also found that the sensitivity of oil prices is related to the type of information being released. It is specifically noted that announcements calling for a cut in production are often those with the greatest price implications. Though these studies prove intriguing, they neglect to address more pressing extraneous factors.
Russia often stands in the way of OPEC’s price setting agenda. Russia, much like Saudi Arabia (an OPEC member state), has the advantage of titanic scale on its side. Immense oil reserves allow the two countries to continue production when profit is marginal, while countries with smaller operations simply cannot bear the cost. One model predicts that Russian-based petroleum firms Lukoil and Rosneft would continue to earn a pre-tax profit even if prices dropped to $15 per barrel. This strength by scale provides a competitive edge in a pricing war.
In March, as shrinking demand and uncertainty related to Covid-19 decimated oil prices, Russia and Saudi Arabia took the gloves off to slug it out. In such a scenario, it is not unusual for a leading exporter to flood the market, driving prices down before others can offload the 'poisoned asset.’ Saudi Arabia’s market flooding caused a 30% price decrease in mere days. By the end of April oil prices became negative, a seemingly impossible eventuality. Depressed demand for oil among transportation and manufacturing companies, and limited capacity to store surplus oil, forced prices into negative territory in US markets.
While the market has since righted itself, the consequences of a global pricing war are likely not to be forgotten in the oil industry. The importance of OPEC has also naturally come into question, if non-member states, such as Russia, continue to have influence over the market the cartel has failed. Furthermore, as the pandemic has shown, ‘black swan’ events still have the ability to effect demand in ways unavoidable to oil producers. Adjusted production targets can only act to stem the bleeding. Finally, one ought to note where OPEC is going.
In 2019 Qatar left the organization, leaving many to predict domestic politics and production concerns will supersede the waning authority of OPEC. Most OPEC nations are ‘Rentierist’ states, relying on oil sales to fund all state programs and projects. In the wake of Arab Spring, popular uprising remains a primary concern and, in order to keep the people content, OPEC states require stability in the oil markets. Perhaps these states feel as though the cartel has outlived its purpose, and that the best path to revenue and regime stability lies outside OPEC.
