The Clumsy Cartel

Abstract

OPEC's Uncertain Future Since 1970 the world price of crude oil has been both high and unstable. The price-setter, the Organization of Petroleum Exporting Countries (OPEC), whose members include the United Arab Emirates, Algeria, Indonesia, Iran, Iraq, Kuwait; Libya, Nigeria, Saudi Arabia, and Venezuela, has since 1980 followed a bumpy downward path that is unlikely to reverse itself in the foreseeable future. An important factor in OPEC'S downward spiral is that it is not a single entity but a collection of independent developing sovereign states. Conferring regularly, these states must from time to time agree to restrict output and to maintain or raise prices. Without their collective restraint, prices would decline toward the competitive floor. When members begin to jostle each other with competitive offers and prices fall or threaten to do so, new actions must be taken. Ironically, the OPEC mission has been made more difficult by its own success. Consumers responded, however slowly, to 1970's higher prices, and OPEC exports have never regained their 197 3-74 peak. Since then, world oil consumption has grown by only one percent per year instead of the previous seven percent. In addition, when OPEC restricted its lower-cost output in the 1970s, non-OPEC output grew. Once around 65 percent, the OPEC share of the world market is down to a little over 35 percent. It is important, moreover, to keep in mind that OPEC exports are the only valid measure of their market share. Internal OPEC consumption, now nearly one-fifth of OPEC countries' output, is unrelated to the world market price and yields no foreign exchange. In Iran, 30 percent of the nation's crude oil is refined for the local market, at prices so low that products are smuggled out and replaced with higher-priced imports. In any market ruled by competition, low-cost suppliers gain market share from high-cost suppliers. But since 1970, just the opposite has occurred in the oil industry: low-cost areas (i.e. OPEC) have continually-lost ground to high-cost areas. By cutting their production, the OPEC nations have created all the oil shortages of the past three decades. Moreover, the OPEC nations have held back unused production capacity. The market has thus been turned upside down. This odd and ineffective arrangement must be perpetuated to keep prices high. Awkward Collaboration Group collective control is inherently awkward and slow. First, OPEC must forecast market demand by trial and error--especially error, because inventory data are poor and do not reveal forecasting errors as they should. This inexactitude is what leads to collective control's awkwardness. Next, OPEC estimates non-OPEC output and subtracts it from consumption. OPEC must then supply the remaining amount. The harder task is to allocate this share among members, who are each trying to maximize their individual output while leaving to others the burden of curtailment. The OPEC nations must reach a consensus on who produces how much; after that, they must oversee members' compliance to their commitments. Management by a group that cannot accurately predict market demand or production and that does not know how much obedience to expect from its own members is inevitably clumsy and inconclusive. Such inexactitude leads to price movements that are unpredictable and often sudden and jarring. When small incidents can have such big effects, the system is obviously unstable. Despite the East Asian recession between 1997 and 1999, world oil consumption kept growing. Non-OPEC output, which was not restrained, grew even faster. To make room and prevent excess supply, OPEC for its own sake had to cut output modestly. But for two years the member countries could not agree on which member should cut how much. As they argued, the price kept falling. The inability to track inventory and inventory changes was one of the worst gaps in OPEC knowledge and consequently kept the organization paralyzed. …