Gasoline Prices, OPEC, and
Biofuel
Gal Hochman, Deepak Rajagopal, and
David Zilberman
ARE UC Berkeley
ICABR meeting Ravello 2009
Outline
• Modeling gasoline prices
▫ Competition-cartel-cartel of nations
• Opec with Biofuel
• Simulations▫ How much does biofuels affect fuel prices and
produciton
▫ How inaccurate are estimates based on model
▫ What will happen to oil price and production with
and without biofuels
Biofuel models ignore OPEC
• The literature on the economics of biofuel, and
its impact on fuel prices, assume competitive
energy market. This literature ignores the
“elephant in the room” – OPEC
▫ We need to understand how OPEC operates, so we
can explain
How OPEC responds to biofuels
How biofuels impact fuel markets
And the welfare implications of biofuels
Traditional models of OPEC are flawed
• Some explain OPEC’s price response assuming
Competitive profit maximization
▫ Griffin and Teece, 1982; Alhajii and Huettner,
2000a and 2000b (Saudi Arabia acts as the
dominant producer).
• Other assume OPEC is a cartel of firms (COF)
▫ Adelman 1982; Dahl and Yucel, 1991; Gately,
1984; Green, 1985; Griffin 1985; Griffin and Xiong
1997; Gulen, 1996; Horn, 2004; Loderer, 1985.
• But OPEC is a Cartel of Nations (CON)
Crude Oil Markets and empirical
analysis
• Energy markets are not competitive
• Empirical analysis we performed supports the
hypothesis that the major oil supplier (OPEC)
behaves like a cartel of nations (CON) and
subsidizes domestic consumption
• Cheap oil policies guide pricing behavior in oil
markets
Comparing the alternative models
• A competitive model
• A cartel-of-firms
• A cartel-of-nations
Competitive model
P
All consumers
pay the same
price- which
equals to
marginal costs
Supply
OPEC
Demand opec
Pc
Aggregate
Supply
Global demand
Quantity of fuel
Cartel of firms
P
All consumers pay the same price, albeit
Larger than the marginal costs
Supply
OPEC
Pm
Marginal
Revenue
Demand for opec
Global minus non
opec supply
Quantity of fuel
The Cartel of nations (CON) model:
Oil rich countries
• Politicians in the exporting country design the
export tax to maximize the sum of its consumers’
and producers’ net welfare plus the export tax
revenue
• The optimal export tax equals one over the
import demand elasticity.
Cartel of nation (CON)
• OPEC decides on export oil price paid by foreign
consumers and domestic oil
• Domestic oil price= export oil price -export tax (
wedge)
• Decision maximizes sum
▫ Domestic consumer surplus +
▫ Exporter revenues –
▫ Cost of production
Decision rule
•
•
•
•
Set quantities where
Marginal Revenue of export=
Domestic (inverse) demand=
Marginal cost
• Export price = Based on export demand greater
than
• Domestic price = marginal cost=marginal revenue
of export
• There is a wedge between foreign and domestic
price
Cartel of nation
All consumers pay the same price, albeit
Larger than the marginal costs
P
PE
Demand for (Glo
Global minus non
opec supply)
PD
Marginal
cost OPEC
Opec countries
domestic demand
Demand for OPEC
net domestic demand
Marginal
Revenue
Quantity of fuel
Cartel of Nations
There is a wedge between domestic price
in OPEC nations, and the international
crude oil price p*>p
P
S
P*
DX
P
MX
DD
X
C
Q
Implications from the cartel of
nations model
• International oil prices are highest under cartel
of nations, and lowest under competition.
• The oil rich countries pursue domestic cheap oil
policies, which in turn reduce the supply of oil to
the rest of the world
Basic facts about OPEC:
Gasoline prices and crude oil
• OPEC Countries are price makers- facing a
downward sloping demand curve for crude oil
• From the 1970s, oil is extracted by firms that are
controlled by political decision
• Gasoline and diesel prices in OPEC countries
are much lower than elsewhere.
▫ The price of super gasoline in Venezuela was 12
cents a liter in 2006.
Anecdotal evidence
• Gasoline and diesel prices in OPEC countries are
much lower, as compared to the rest of the
world.
• Although before 2000 the difference between
gasoline prices in OPEC countries and in the rest
of the world is stable, it grows at an increasing
rate after 2000.
GH6
Fuel Pump Prices
Fig. 4: Average Prices at the Fuel Pump
120
100
80
60
40
20
0
Gasoline: OPEC member
Gasoline: not OPEC
member
Diesel: OPEC member
Diesel: not OPEC member
1993
1995
1998
2000
2002
2004
2006
11
62
23
65
18
60
20
65
17
64
22
88
28
104
5
47
11
47
11
41
Year
13
49
12
49
17
72
26
90
Diapositiva 18
GH6
The generic concept of subsidization relates to a benchmark whereby fuel pricing is commercially calculated with respect to world market prices.
In this sense, subsidization takes place when the actual pump price is below the benchmark price. Because these benchmark prices are difficult
to calculate with precision, on paper, fuel prices are considered to be subsidized if they are below the average U.S. price level, after deducting a
highway tax, which in the United States is equal, on average, to 10 US cents per liter.
We apply a similar logic to non-petroleum and petroleum producing countries. Although petroleum-producing countries have their own national
supplies, and therefore their low cost prices can be classified as non-subsidized prices, we reject this classification. If the volume of oil
consumed domestically was sold on the world market, it would have achieved higher prices.
G H; 02/10/2008
Taxes and Subsidies
Fig. 3: Super gasoline taxes and subsidies
50
40
30
20
10
0
-10
-20
-30
-40
year
1998
1993
1995
2000
2002
2004
2006
OPEC member states
-21
-11
-14
-27
-23
-32
-35
Non-OPEC
30
31
28
18
24
34
41
Diapositiva 19
GH7
G H; 02/10/2008
COUNTRY
Wedge
Venezuela
-0.83
Iran
-0.83
Saudi Arabia
-0.54
Algeria
-0.29
Indonesia
-0.29
Kuwait
-0.55
UAE
-0.38
Qatar
-0.6
Iraq
-0.95
Libya
-0.63
Nigeria
-0.51
Angola
-0.24
The wedge
The wedge between
domestic and
international prices
varies among OPEC
countries
Strategy of the analysis
• Actually we stated from a Helpman Grossman
estimating weight simultaneously elasticity
demand for OPEC and the weight given to
consumers and producer surplus in opec
countries
• We found that the the weight is equal
• So we can use the con model
The results: Demand elasticity
−1 / ε * (i.e., θ )
0
Consumption intensity
( i.e., θ1 )
Revenue/real GDP
-0.1941*
-0.2177**
(0.1111)
(0.0909)
0.0021***
0.0015***
(0.0005)
(0.0005)
-0.0272**
-0.0179&
(0.0120)
(0.0109)
Dummy equals 1 if year greater
-0.2288*
-0.1916*
equal 2000
(0.1199)
(0.0993)
-0.5323*
Core OPEC countries
System Weighted R^2
(0.2848)
0.7406
0.9896
• The elasticity of the
residual demand for oilimporting countries
decreased after 2000 by
more than 75 percent
(the elasticity decreased
from -5.15 to -2.36).
These numbers are
consistent with the
literature.
The results: Optimal Export Tax
−1/ ε *
(i.e., θ0
)
Consumption intensity
-0.1941*
-0.2177**
(0.1111)
(0.0909)
0.0021***
0.0015***
(0.0005)
(0.0005)
( i.e., θ1 )
Dummy variables equals 1 for
-0.0272**
-0.0179&
Venezuela
(0.0120)
(0.0109)
Dummy equals 1 if year greater
-0.2288*
-0.1916*
equal 2000
(0.1199)
(0.0993)
-0.5323*
Core OPEC countries
System Weighted R^2
(0.2848)
0.7406
0.9896
• OPEC countries, although
placing more weight on
consumers (the parameter
is significant at a 10
percent level), set their
wedge close to the wedge
set by politicians who
maximize aggregate
welfare (the sum of the
welfare of domestic
consumers plus industry’s
profits).
Policy implications:
“One industry source estimated Saudi Arabia
had reduced exports, as opposed to production,
by around 900,000 barrels per day (bpd)
compared with a peak in August” (CNBC.com,
November 4 2008).
• OPEC pricing behavior can be approximated
using the CON Model.
▫ Although consumption of crude oil in the Middle
East, Algeria and Venezuela together currently
amounts to 10 percent of total world consumption
of crude oil, consumption grew from 2005 to
2006 by 3.5%, 3.4%, and 4.3%, respectively -much faster than it did in the rest of the world,
where crude oil consumption grew by an
insignificant 0.7%.
Biofuel and crude oil
Biofuel models ignore OPEC
• The current literature on the economics of
biofuel, and its impact on fuel prices, assume
competitive energy market.
Competitive (or Cartel of Firms)
Models Yield Misleading Results
• How much do we error if, instead of modeling
Cartel-of-Nations, we assume a competitive oil
market? Cartel of firms?
• The impact on markets, distribution of resources
among groups and nations, and carbon emitted
from energy consumption is substantially
different among different market structures
Calibrating the Model
We start by making the following assumptions:
• The price of a barrel of crude oil is $72 (this
assumption implies an international price of
$1.71 per gallon of fuel)
• The biofuel mandate equals the global amount of
biofuel produced in 2007
• The quantities of crude oil produced and
consumed are equal to their level in 2007
• Biofuel is produced and consumed by countries
that import crude oil; countries that export
crude oil do not produce or consume biofuel
Numerical simulation
• We performed the following exercise:
▫ Building on price and quantity data for 2007 we
calibrated the following models, assuming import
demand elasticity -1.25 to -2.0 and crude oil
supply elasticity 0.25:
The competitive model
The cartel of firms model
The cartel of nations model
Derivation of the competitive
equilibrium
Derivation of equilibrium assuming
perfect competition:
In equilibrium MC=P
Where P=1.7143 (=72/42)
Derivation of the cartel of firms
equilibrium
The outcome assuming cartel of firms.
In equilibrium MR = MC and P = 1.7143
Derivation of cartel of nations
equilibrium
In equilibrium,
DEX + MRIM = MC
Price in the oil rich
country equals
MC, which is less
than the
international price
(which equals the
price in the
importing country)
Computing the impact of biofuel
▫ The calibrated model is used to compute the
surplus in the fuel markets- with biofuel
▫ Next, we assumed no biofuel, and recomputed the
equilibrium given the specific structure computed.
▫ Finally, we computed the change in producer and
consumer surplus in both the exporting and the
importing countries, as well as the change in
prices and quantities
Prices
• The Competitive and Cartel models overestimate price changes
• The price in OPEC countries declines more than the international
price; OPEC cuts exports not domestic consumption
Percentage change in fuel prices when biofuel is introduced
Demand elasticity
-1.25
-1.5
-1.75
-2
Competition
-2.52%
-2.15%
-1.87%
-1.65%
Cartel
-2.35%
-2.02%
-1.77%
-1.57%
CON: Exporting
-17.10%
-10.27%
-7.40%
-5.81%
CON: Importing
Wedge
-2.02%
2.65%
-1.87%
2.95%
-1.68%
3.09%
-1.52%
3.18%
Overestimating the price effect
The competition model overestimates the price effect
between 9% and 25%, whereas the cartel model
overestimate the price effect between 4% and 16%.
-1.25
-1.5
-1.75
-2
Competition
25.48%
14.91%
11.00%
8.86%
Cartel
16.45%
7.83%
5.02%
3.65%
Quantities
• The Con model predicts gasoline consumption goes down,
whereas total fuel consumption (gasoline plus biofuel) goes up.
Millions of gallons
Demand elasticity
-1.25
-1.5
-1.75
-2
Export country 1,715.30
951.96
664.80
512.98
Import country -3,065.40
Total -1,350.10
-2,200.80
-1,248.80
-1,786.10
-1,121.30
-1,522.40
-1,009.40
Underestimating the quantity effect
The competition model underestimates the oil
quantity effect between 37% and 46%, whereas the
cartel model overestimate the quantity effect
between 4% and 16%.
-1.25
-1.5
-1.75
-2
Competition
-37.26%
-42.55%
-44.50%
-45.57%
Cartel
16.45%
7.83%
5.02%
3.65%
The Inaccuracies Caused by the
Competitive Assumption
• The reduction of price due to biofuel is
overestimated by more than 10%
• The reduction in gasoline consumption is
underestimated by more than 37%
▫ Underestimating the reduction in gasoline
consumption, significantly underestimate
carbon savings
Increasing Global Demand for Fuel
by 20% (as Asians Drive More Cars)
• Assume demand for fuels increase by 20%,
welfare in importing countries increases by
more than 12% with the introduction of
biofuels.
• Prices now decline by more than 6%.
Indirect Biofuel Effects on
Carbon Emissions
Biofuel provides alternative fuel supply
Reduces demand for fossil fuel
Reduces fuel prices
Reduces incentives to increase supply of
dirty fuels (bitumen, oil sands, coal to
liquid)
• Reduces green gas emissions
• Work is being done on quantifying these
secondary effects
•
•
•
•
conclusion
• The Con model is a sound model to analyze
OPEC and oil markets
• OPEC reduces exports in response to biofuel
• Assuming competition tends to overestimate
▫ The price effect of biofuels
• A competition model, on the other hand,
underestimate
▫ The reduction in gasoline consumption
▫ Carbon savings
▫ The loss to OPEC countries from biofuel