OPINION
THE MYTH OF OPEC
OPEC has little to do with high oil prices, argues Gaurav Sodhi
O
PEC—the Organisation of
the Petroleum Exporting
Countries—has long been considered
an economic bogeyman, terrorising
economies all over the world. When
politicians fret that oil prices are
rising too high, too fast, it is OPEC
that they run to for relief. American,
European, and now Australian leaders
have all pleaded publicly for OPEC
to increase production. So why hasn’t
OPEC acted? How can it get away
with holding back supply?
OPEC is famously secretive about
output and its reserve positions for
good reason—it doesn’t want the
truth to slip that it has little sway in
oil markets. It’s a safe bet that OPEC
is pumping as much oil as it can.
OPEC is a cartel, not a monopoly.
This is an important difference.
If OPEC were a single country
with a dominant share of global oil
output, it would be an international
menace that could set the global
price of oil single-handedly. But it is
actually just a loose alliance of twelve
diverse oil-producing countries,
which tries to influence prices by
controlling output.
It does this by allocating each
member country a quota for production. This means that all twelve
members are told to produce at lower
levels than they otherwise would to
keep prices high. The problem with
this is that no one can check whether
individual countries are sticking to
their quotas. And since no individual
country has the reserves to influence
global prices—with the possible
exception of Saudi Arabia—every
member knows that it can quietly
produce more than its quota without
facing lower prices.
So every member faces the same
incentive to ‘cheat’ the cartel. Of
course, if all members pump out
more than the quota, the price starts
to fall and the cartel falls apart. This
has been the pattern of behaviour
not just of OPEC in the past, but of
all cartels. Because the incentive to
cheat by individual members is so
strong, and the ability of the cartel to
enforce compliance is so weak, cartels
have historically produced more than
they say they do. Consequently, they
don’t usually have a great deal of
influence in markets.
If cartels are inherently flawed,
why has OPEC managed to survive so long? OPEC hasn’t really
been successful as a cartel. In the
aftermath of the Asian financial
crisis in the late 1990s, oil prices
fell close to $10 a barrel, and its
flaws were revealed for all to see.
These flaws still exist, but they are
better disguised today. A faltering
US dollar and strong demand for
energy from the developing world
have both contributed to a bull
market in oil that has absorbed
the rampant cheating of OPEC
member countries. This is unlikely
to be the case during a period of
falling prices.
New oil supplies all over the world
are also proving to be stubbornly
expensive to discover, drill, and
extract. The ultra-deep waters off the
Brazilian coast have in recent months
yielded the largest oil shows in
decades, but each well costs US$250
million to drill and so requires a high
oil price to bring into production
economically. Shell has recently
estimated that its new offshore oil
extraction requires an oil price of
at least US$70 a barrel to become
viable. This is still a long way off
current prices, but does illustrate that
the industry is facing cost pressures.
OPEC certainly has little to do with
higher prices.
The massive reserves of Saudi
Arabia have historically been a tool to
encourage quota compliance among
OPEC members. The Saudis, with
their massive oil reserves and high
levels of spare production capacity,
have in the past threatened to flood
the market with oil to engineer a
collapse in price. With the world’s
cheapest production costs and lots
of spare capacity, it was a threat the
Saudis could theoretically carry out.
Not anymore.
Saudi Arabia no longer has the
buffer of excess production, and
Gaurav Sodhi is a Policy
Analyst at the Centre for
Independent Studies.
POLICY • Vol. 24 No. 3 • Spring 2008
5
OPINION
2008
there is a lack of confidence in the
sustainability of its largest fields.
Saudi Arabia has over 300 recognised
reservoirs, but over 95% of its oil
production comes from just five
super-giant fields discovered between
1940 and 1965. The largest of these
fields, and the mother of all onshore
oil fields, is the structure known as
Ghawar. It produces more than five
million barrels of oil per day—50%
of the Saudi total. There have been
whispers in the oil industry that
Ghawar, along with some of Saudi
Arabia’s other super-giant fields,
are in decline. There hasn’t been a
comparable super-giant discovery
since the 1970s.
The longstanding Saudi threat to
flood the market with cheap oil has
now become a bluff, and the other
members of OPEC know it.
Quotas for the cartel are calculated
according to stated, official reserves.
Each country is permitted to produce
a percentage of its reserves each
year. To maximise revenue, each
country has an incentive to overstate
its reserve position and exploit
higher quotas, higher production,
and greater revenue. True enough,
while the reser ve positions of
private, Western oil companies have
increased and decreased over the
years, the OPEC countries’ official
reserves have remained remarkably
stable. This suggests that either
OPEC is regularly adding new fields
to its reserve position, or that the
data are being fudged.
OPEC goes to great trouble to
pretend that it can influence prices.
It holds regular meetings where it
ordains a new production target with
much ceremony. But you would have
to be a mug to believe that OPEC
countries are purposefully limiting
production. When oil prices rise, so
does the opportunity cost of sticking
to the allocated quota. So while it’s
OPEC is a largely
powerless
organisation
that sustains its
own existence
with a myth that
governments in the
West are complicit
in spreading.
possible to maintain a cartel when
prices are low, you can bet your life
that each member is pumping out as
much crude as it possibly can at well
over US$100 a barrel.
Member countries have a financial
incentive to pump more at higher
prices: Saudi Arabia alone earns
more than a billion dollars a day
in oil revenue. For most OPEC
countries, oil is their main source
of revenue and if there is one thing
governments like, it is revenue.
In addition, OPEC’s members aren’t
stable democratic countries where
petroleum is just another industry.
They are mostly authoritarian states
that use oil as a means of sustaining
political power. Oil money is used
to buy support from key parts of
society and to finance a security
apparatus to deal with enemies. Oil
supplies the revenues that enable
many OPEC regimes to stay in
power. By allowing countries to
buy authority and enforce it, oil
strengthens regimes that would
otherwise be very wobbly.
Nothing would be more destabilising for the Saudi monarchy or the
Iranian theocracy than a fall in oil
revenues. Would Hugo Chavez
survive in Venezuela without using
cheap oil to buy allies? Governments
in Libya, Nigeria, and Angola would
similarly be in perilous political
positions without the benefit of
oil money.
The truth is that far from being
an economic bogeyman, OPEC is
a largely powerless organisation that
sustains its own existence with a
myth that governments in the West
are complicit in spreading. Like a
peacock that impresses with a great
show of colour and noise, OPEC is
really just a big bird that can’t fly.
ROSS PARISH
ESSAY COMPETITION
‘Does liberty lead to decadence?’
First prize $1,500 Second prize $1,000 Third prize $500
Go to www.libertyandsociety.org for further details.
The Ross Parish Essay Competition is part of the student program run by
The Centre for Independent Studies. www.cis.org.au
6
POLICY • Vol. 24 No. 3 • Spring 2008