June 2014 OPEC: The Myth and the Reality William O’Keefe CEO, George C. Marshall Institute Since the first oil embargo in 1973, there has been an a widely held belief that OPEC is a powerful and effective cartel capable of keeping crude oil prices well above the competitive price by manipulating oil supplies. As a result, it is also believed that as a nation, the U.S. is poorer, held hostage to an organization (and its member states) that wishes us ill, and that our dependence on imported oil is a national security threat. There is little analytical evidence for these beliefs. OPEC, while organized as a cartel, does not operate as one and for most of its history has been a price taker and not a price maker. OPEC can influence crude oil prices but does not set them. This finding leads to the obvious question -­‐-­‐ why do so many groups and governments insist that OPEC is, in fact, a functioning cartel. The two most plausible answers are that the media has not done its job scrutinizing the claims and that advocates of certain policies find it convenient to have a scapegoat. OPEC is a catalyst that unites people and groups from both ends of the political spectrum—environmentalists and defense hawks—to lobby for actions to wean the nation off of oil. This strange political alliance is a manifestation of the ancient proverb that the enemy of my enemy is my friend. Since the 1973 embargo, politicians, starting with Richard Nixon and continuing to Barack Obama, have used OPEC to promote industrial policies to develop alternatives to oil. The opponents to oil imports and to the use of oil as a major energy source have disparate motives and objectives. In almost all instances, however, OPEC is a Trojan Horse, hiding their real agenda. OPEC: Myth and Reality June 2014 Some have an extreme dislike for Saudi Arabia because it is not a democratic country and they believe some money from oil sales finds its way to terrorists. Others use OPEC as a lever to promote an environmental agenda and to justify policy initiatives that enrich themselves through subsidies for developing alternative energy sources. And still others mistakenly believe that OPEC represents a national security risk by entangling the U.S. in Middle Eastern affairs. The most common critique is that OPEC’s inflation of oil prices is an economic drag on the U.S. economy. Is OPEC a Cartel? In the field of economics, a cartel is defined as an agreement between businesses in the same industry to control a market, to raise the market price of a commodity or good, and act like a monopoly. Over time, most cartels tend to become unstable because artificially high prices create incentives for members to cheat. If all or most members cheat, the cartel falls apart. While cartels damage economic efficiency, their power is often short-­‐lived because of this cheating and the inability to maintain strong barriers to entry. Although OPEC may be the most widely known “cartel,” the DeBeers Diamond Cartel is the most effective and, until recent years, the most enduring. In the 19th century, Cecil Rhodes, via the De Beers Consolidated Mines, Ltd., established an effective monopoly over the diamond industry. When OPEC is compared to the diamond cartel model, it fails the tests for an effective cartel. Analysts who have studied OPEC since its formation in 1960 and the oil market have described it as either a “clumsy cartel” or a syndicate -­‐-­‐ a group of organizations (countries) that combine or make a collective effort to carry out a specific activity. The DeBeers cartel’s objective is to maintain a high price for diamonds. The major diamond producers belong to or cooperate with De Beers and De Beers maintains this dominant position by using a network of global companies to buy up new sources of diamonds and control distribution of industrial diamonds and production of synthetic ones. But, even the DeBeers cartel is not immune to market competition. In the last decade, DeBeers control has been reduced from 90% of the diamond trade to about 50% as more diamonds have been found in more countries and more competitors have emerged. The characteristics of the diamond trade prior to this decade defined the characteristics of an effective cartel: 2 OPEC: Myth and Reality June 2014 §
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Small number of significant producers Strong barriers to entry Lack of substitutes Durable commodity that is easy to store Short run price inelasticity Ability to easily increase/decrease supply to affect price Based on these criteria, OPEC fails 3 out of the 6. There are a large number of oil producing countries, there are not significant barriers to entry, and history has shown that OPEC cannot easily alter supply to affect price. Deborah Spar, in the Journal of Economic Perspectives—Markets, compares the prices of diamonds and other commodities from 1980 to 1998. The price of diamonds increased and the price of gold, copper, aluminum, and oil showed more volatility and were lower in 1998 than they were in 1980. Oil showed the largest price drop. Professor Jeffrey Colgan of American University examined OPEC’s influence on the global oil market. He concluded that “OPEC is dysfunctional as a cartel, as it has little or no causal impact on its members choices…” Although most politicians, the media, and some policy-­‐oriented groups contend that the dramatic impact on our economy was caused by the Arab oil embargo, Colgan points out that OPEC oil production hardly changed. Although, some OPEC members did embargo oil to the US and a few other countries, other members continued to sell oil to all buyers. The net effect of the embargo was simply to move embargoed oil to other consumers, freeing up their oil to go to embargoed countries. The economic impact of the embargo was not from a shortage but from a significant price increase on oil, which is one of the instances where OPEC did act as a cartel, and our nation’s price and allocation controls imposed in reaction to the embargo. Although the actual embargo lasted only a few months, our regulatory reaction lasted until those controls were ended in the early 1980s. However, in its 54-­‐year existence, OPEC actions generally followed price movements rather than trigger them. Colgan and other analysts confirm this conclusion with statistical and econometric analyses. Bina and Vo’s literature review article comes to the same conclusion, but make it even stronger: “OPEC is not a cartel nor does it possess any ‘market power’ which resembles the imagination of the orthodoxy.” Robert Bryce observes, “A cartel only has power if it can affect the movement of prices both directions: up and down. …OPEC effectively admitted that it has lost the ability to move prices downward. Algeria’s energy minister …said that OPEC ‘does not have the production capacity to increase its quotas.’” 3 OPEC: Myth and Reality June 2014 Similarly, James Smith, a Southern Methodist University economist, stated, “A large portion of OPEC’s apparent historical impact on the price of oil has come about not as the result of deliberate plans crafted by a purposeful cartel, but as a by-­‐product of clashing national agendas that encompass far more than the petroleum sector.” In a paper specifically intended to test the cartel hypothesis, Pedro Almoguera of the Federal Trade Commission and his co-­‐author find that, “although there were periods in which oil prices were measurably higher due to collusion among OPEC members, overall OPEC has not been effective in systematically raising prices….” These two articles and others that come to the same conclusion raise the question of why the myth of a powerful OPEC continues to persist. Colgan makes the point that reaction to the 1973 OPEC action—price and allocation controls that caused real shortages and long lines— “endowed OPEC with an almost mythical status as a manipulator of world oil markets.” OPEC has been powerful because it is perceived to be powerful in consuming countries and those countries, especially the United States, adopted energy policies that reinforce the perception. To be clear, OPEC was formed to be a cartel and for brief periods—the 1980s—acted as a cartel but its periodic success sowed the seeds for undermining its effectiveness. With the right energy policies in place, OPEC could have been made weaker sooner. OPEC’s Impact on Oil Prices As indicated previously, one of the characteristics of an effective cartel is the ability to quickly increase or decrease supply to affect price. But, Bina and Vo conclude that the “volatility impact of the OPEC output decisions is also transitory and confined strictly within event windows. As a result, we conclude that global oil market is the prime mover and OPEC indeed follows its trajectory accordingly and consistently.” Colgan demonstrates OPEC’s limited ability to affect price by the fact that cheating is of epidemic proportions. Drawing on EIA data, Colgan shows that OPEC’s nine core members have cheated on “their aggregate quota 96% of the time.” Some advocates of the OPEC price manipulation theory cite the relatively steady production levels over the past four decades as evidence of market control. For most of that period, according to EIA, production levels ranged from the high 20 million barrels a day level to the current 32 million in January. But, during those four decades, oil prices 4 OPEC: Myth and Reality June 2014 like all commodities were volatile which undermines the powerful cartel theory. The other explanation for more or less steady production levels is the fact that with few exceptions OPEC members since the early 2000s have been producing as much as they can. Since the 1973 oil embargo, there have been three major spikes in the price of oil. One occurred in 1979 as a result of the Iranian Revolution. The second happened at the start of Desert Storm in 1991. After those spikes, prices declined and in the late 1990s hit a low of about $10 a barrel. The most recent spike began in 2006 and was driven primarily by Asian demand, especially China and India. In addition to the increase in demand, other factors affecting price were a weak dollar, belief in the peak oil theory, higher exploration and production costs, higher costs of engineering and technology, and the risk premium associated with conflicts and tensions in the Persian Gulf region. Speculation may have exacerbated the recent increase in oil prices, but that hypothesis is controversial and beyond the scope of this paper. If OPEC actually functioned as a cartel, the high prices that have persisted in recent years would have sparked widespread cheating which would have caused prices to drop. EIA data show clearly that most OPEC members have been producing at maximum capacity since around 2004 and have limited ability to produce more. The exceptions are Saudi Arabia, Libya and Iran whose production dropped because of conflict and sanctions. Instead, the high prices have led to increased production by non-­‐OPEC members and have made non-­‐conventional oil –shale and oil sands—economical, especially in North America. Another way to look at powerful cartel theory is by looking at the price of oil in constant dollars or the price relative to the price of gold, which is a store of value and hedge against inflation. 5 OPEC: Myth and Reality June 2014 6 OPEC: Myth and Reality June 2014 These charts make clear that, measured in either constant dollars or in ounces of gold, crude oil has reflected the volatility of all commodities and, with one exception, has been below the peak in 1979 and since 1973 has mostly been cheap relative to gold. In real purchasing power—the constant dollar basis—crude oil prices have mainly declined except for the three spikes mentioned above. It has only been in recent years that the real price has climbed. Oil and National Security The final argument made by those who advocate the OPEC orthodoxy is that reliance on oil imports from the Middle East is a national security threat. For example, in 2013, Fred Smith, FedEx’s CEO, representing the non-­‐profit group Securing America’s Future Energy (SAFE), said, “The OPEC cartel … exercises monopolistic control on the price and supply of crude oil. In addition to the market price paid for oil by consumers … the cost taxpayer funded protection of Middle East oil resources must be included… .” It is surprising that such a successful and highly regarded CEO has become an advocate for an orthodoxy that is built primarily on perception. Clearly, he knows that our military presence in the Middle East predates our dependence on imported oil and would continue in one form or another if we imported no oil from the Persian Gulf. As the Marshall Institute has pointed out in other reports, even if the US imported no oil, we would have a military presence in the Middle East related to our commitment to the security of Israel and the fact that the global economy requires relative stability in the region because of the world’s dependence on oil. As the world’s major superpower, it falls to us to provide that stability by our presence. Conclusion The review demonstrates that OPEC no longer fits the model of an effective cartel and that it does not exert influence beyond the norm on oil prices. The belief that OPEC remains powerful is used by advocates to promote particular energy policies, making OPEC’s power more political than real. 7 OPEC: Myth and Reality June 2014 Bibliography Pedro Almoguera and Ana Maria Herrera (2007). Testing for the Cartel in OPEC: Noncooperative Collusion or Just Noncooperative. Federal Trade Commission. S Gurcan Gulen (1996). Is OPEC a Cartel? Evidence from Cointergration and Causality Tests. Dept of Economics, Boston College. Cyrus Bina and Minh Vo (2007). OPEC in the Epoch of Globalization: Event Study of Global Oil Prices. The Berkeley Electronic Press. Robert Bryce (2005). Is OPEC Irrelevant? World Energy Monthly Review. James Smith (2007). The Role of OPEC in the World Oil Market. Southern Methodist Univ. The Washington Free Beacon (2013). Study: OPEC is Engaging in Price Fixing. (April 26, 2013). Brieitbart.com (2013). FedEx CEO: Oil Has Become a Geopolitical Weapon. (April, 28 2013). Debora L. Spar (2006). Markets: Continuity and Change in the International Diamond Markets. Journal of Economic Perspectives. Jeff Colgan (2011). The Emperor Has No Clothes: The Limits of OPEC in the Global Market. American Univ. EIA Monthly Energy Review (2014). World Crude Oil Production: OPEC Members. (April 2014) 8