Oil and Gas Prices in World Economy

The Organization of Petroleum Exporting Countries (OPEC) is an intergovernmental organization established at Baghdad, Iraq in September 1960 that coordinates the petroleum policies of eleven oil-producing member nations. Its founding members are Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Between 1960 and 1975 the organization expanded to include Qatar (1961), Indonesia (1962), Libya (1962), the United Arab Emirates (1967), Algeria (1969), and Nigeria (1971). (Wright, 2008) Iraq remains a member of OPEC but Iraqi production has not been part of OPEC quota agreements since March 1998. The organization is headquartered in Vienna, Austria, and decides matters related to oil production, quotas, and pricing among its members.

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Oil is at the heart of the international economy, with daily demand in 2004 exceeding 80 million barrels. Oil is today the world’s most actively traded commodity, and it changes hands in dollars (“petrodollars”) exclusively. Although OPEC’s influence has fallen somewhat from its peak in 1973 to 1983, the combined OPEC nations still supplied roughly 40 percent of the oil traded around the world at the end of 2004, and accounted for almost 70 percent of proven reserves. (Lowe, 2008).

OPEC was created as a reaction prompted by the unorganized condition of the oil market after World War II and from political pressures in the Middle East involving Israel. OPEC was not taken seriously as an organization during the 1960s because oil reserves, except Iran’s, belonged to Western oil companies. Additionally, there was a worldwide oil surplus, particularly with the reentry of the Soviet Union into the oil market in the late 1950s. (Matthew, 2006).

Between 1949 and 1972 surpluses persisted despite a tripling of energy consumption throughout the industrialized world. New oil discoveries more than kept pace with oil demand, and cheap oil became even cheaper because supply outpaced demand as oil-producing countries particularly as those in the Middle East competed with each other to increase exports. With increased volumes, the number of foreign oil companies and refineries increased as well, with the number operating in the Middle East alone growing from nine in 1946 to eighty-one in 1970.

The Arab-Israeli War of 1967 prompted calls from Arab states for OPEC to wield the “oil weapon” in the form of an embargo, and it did in the summer of 1967, against countries friendly to Israel. The embargo itself threatened to derail economic growth worldwide. Western Europe, after all, imported 75 percent of its oil from OPEC nations. (Wright, 2008) Not only volumes of oil, but also trade patterns of normal oil flow were affected, because embargo meant the closure of the Suez Canal and Mediterranean pipelines. Within a month, however, cooperation between oil companies, embargoed nations, and non-Arab oil producers including Indonesia and Venezuela blunted the embargo, which ended in September 1968 with large revenue and market-share losses for OPEC. (Matthew, 2006).

In the years after 1967 energy demand continued to increase and, by the early 1970s, had soaked up the two-decades-old oil-supply glut. In the fall of 1973 OPEC capitalized on the tightening market by calling for a restructuring of its relationship with oil companies such as Exxon, Shell, and British Petroleum, which held the concessions (rights to operate) in OPEC countries. Between 1970 and 1974 crude oil had tripled in real terms to over $10 per barrel. The exporting countries’ revenues were going up, but the companies’ part of revenues was also increasing in the buoyant market.

On the eve of the Vienna OPEC meeting with oil companies in October 1973, war broke out again between several Arab states and Israel. OPEC implemented another embargo and cut deals with the oil companies, stopping just short of nationalizing the oil industry. Until this time, the companies had set oil prices and production rates, but in 1973 this became the prerogative of OPEC, which immediately raised the price of crude by 70 percent a barrel in November, while reducing the companies’ revenue percentages and production authority. (Lowe, 2008).

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The embargo amounted to an average loss of 4.4 million barrels per day, or a 14 percent reduction in internationally traded oil. With supply constraints and demand surging, there were abrupt price increases by the end of 1973. This embargo was much more disruptive than that of 1967. (Kalyuzhnova, 2008) Besides introducing a redistribution problem for the oil companies, the embargo and price hikes threatened the international monetary system, stifled demand, slowed growth in industrialized nations, and strangled growth in poorer countries. Increases in the oil price reduced the purchasing power of the entire oil-importing world, with concomitant GDP growth declines, unemployment, and inflation. For its ability to effect such change, OPEC became the center of worldwide attention, and even after it lifted the embargo on March 18, 1974, the threat of another embargo lingered. (Matthew, 2006).

OPEC’s 1973 embargo had long-term effects. Seizure of the oil company concessions, abrupt withholding of oil and sharp price increases were new and bold actions that signaled OPEC’s seeming dominance in the oil marketplace. After all, OPEC still accounted for more that 60 percent of total “free-world” production (excluding the Soviet Union). For all its disruptive results, however, the embargo actually loosened OPEC’s grip by providing incentive for oil importers to become less dependent on Middle East oil. It also raised the oil price to a level that would support exploration for new energy sources.

Revolution in Iran, and the outbreak of war in September 1980 between two OPEC members, Iraq and Iran, again placed Persian Gulf oil in jeopardy, and threatened a third oil shock. The market price of oil (“spot prices”) spiked to a record $42 per barrel. But supply worldwide was as plentiful as demand was weak in the early 1980s, and prices slowly declined despite the loss of roughly 15 percent of OPEC production. Non-OPEC producers filled the gap. (Wright, 2008) Indeed, by 1982 they exceeded OPEC production by a million barrels a day. A free-for-all in the oil market emerged as OPEC and non-OPEC exporters competed, and as the largest oil market, the United States, deregulated its oil industry, freeing companies to compete and merge with reduced restriction.

Confronted with a competitive market, OPEC faced a choice: cut the price of oil or cut production. It officially chose to cut production, but OPEC members remained bitterly divided over price and output levels. Cheating by exceeding assigned output quotas became common among member nations, and there were barter arrangements such as oil for weapons, oil for technology, or oil or food. In 1983 the New York Mercantile Exchange began trading oil futures contracts, and soon London and Singapore followed suit. In the 1980s oil became an officially traded commodity like wheat, coffee, and equities, with OPEC just another albeit significant player in the daily setting of the oil price. (Kalyuzhnova, 2008) Reflecting a watershed in the decentralization of the oil market away from the Persian Gulf, the British sector of the North Sea produced more oil in 1983 than the three African members of OPEC Algeria, Libya, and Nigeria combined, and OPEC was cutting prices to keep market share and relevance in the world oil market. Producers large and small were coming on line from Australia to Canada, Angola to Mexico and diluting OPEC’s share. (Lowe, 2008) In addition to non-OPEC oil production, conservation was gaining traction worldwide, as was the use of coal, natural gas, and nuclear power in the most oil-dependent countries, such as India and Japan. Indeed, the oil share of the total energy market in industrial countries dropped from 53 percent in 1978 to 34 percent in 1985. (Matthew, 2006).

Oil prices collapsed in the mid 1980s after a buildup in production facilities left OPEC with 18 percent excess capacity and with the United States and Europe in recession. Member nations violated their share of OPEC’s output quotas, leaving markets oversupplied. In July 1986 crude had fallen to $11.58 a barrel – its lowest level since January 1976 – before recovering to its mean price for the decade of roughly $25 a barrel. (Wright, 2008).

When the Iran-Iraq War ended in 1988, Arab states invited companies back for exploration, reflecting a new flexibility in light of new competition in the oil market. By this time, however, the industrial world had settled into an economic equilibrium not fueled by oil demand. Except for a spike in 1990 after Iraq’s invasion of Kuwait, oil prices declined throughout the 1990s to a low of $10 a barrel in 1998. (Lowe, 2008).

In the early 2000s the OPEC cartel remained the single most important player in the oil market, although its position had changed since its dominance in the 1970s. With per-barrel oil prices touching $144 in September 2008, OPEC must balance between reaping windfall profits and triggering recession in oil-importing nations. It found that its ability to sway markets was reduced by its unusually thin margin of spare capacity.

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With other areas of the world on stream, OPEC vowed to act not as the central player it once was in the energy market, but as the “swing producer” of oil, beefing up or trimming supply to balance markets that could be rocked by seasonal changes in oil use and supply disruptions in the global production and transport chain. But with little spare capacity, the cartel has limited ability to tame markets. Moreover, as of October 2004 the world’s refining system, which converts crude oil into usable products such as gasoline, diesel fuel, and heating oil, is operating at close to capacity. The International Energy Agency expects non-OPEC nations to add 1.2 million barrels a day in production capacity by the end of 2004 including over 600,000 barrels a day from Russia, Azerbaijan, Kazakhstan, and Canada; and another 400,000 barrels from African nations such as Angola and Chad. The complexion of the oil market has changed radically since OPEC’s founding in 1960. Some believe the Middle East will regain its pre-1983 influence as other areas of production and supply run dry, and as global economic expansion drives demand.

The Organization of Petroleum Exporting Countries (OPEC) looks after 40% of the world’s supply of oil. With that much oil to control it gives them a governing position in directing the whole market including oil prices. NON-OPEC countries and Russia control the remaining oil. OPEC regulates how much oil they want to produce with the target of keeping the economy of the market stable. Although, recently all OPEC countries have exceeded their set targets by up to 10 million barrels a day. And even after this current oil prices are still rising!

With these issues looming over our minds, the United States is now in a position where it must allocate an exceptional amount of time and resources to curtail its dependency on foreign oil. Over the last several decades, it has been a focal point of discussion amongst the different administrations that have governed the United States. With the price of a barrel of oil surpassing the $140 mark, the need to put into action one of these plans is of utmost importance. (Kalyuzhnova, 2008) OPEC can be described as an oligopoly for several reasons. It fits with the condition of being dominated by more than two large firms; in this case it’s eleven. It also practices price rigidity as they agree on both level of output and therefore the price of oil is influenced by the agreement of a certain supply. The goods they provide are also homogenous. In oligopolies firms also don’t choose to maximize profits, and this can be clearly shown in the OPEC case as they aim was to secure fair and stable prices for producers, and ensure an efficient and regular supply of oil. There is also a barrier to entry which is described in the case study which states that the oil industry has high fixed costs and risk associated with it, this Is another characteristic of an oligopoly.

It can be argued however, that it is also a monopoly. This is due to the fact that OPEC has 60% of control over the oil that it traded internationally. Usually, a monopoly is classified as anything which has a market share of over 25%; OPEC has almost tripled that which suggests it may be a monopoly. (Lowe, 2008) However, due to the fact it doesn’t price discriminate and aims to secure fair and stable prices for producers, and ensure an efficient and regular supply of oil, suggests it can’t be a monopoly. Also, the fact that a cartel is made and decisions are made on the level of output clearly suggests that OPEC doesn’t have total price control.

Due to the price elasticity of demand being relatively low for oil, it means that OPEC has a product which is relatively inelastic. This is due to the fact that it has no close substitutes and if fairly necessary for many countries day to day running. This means by restricting the supply, they won’t affect demand too greatly due to the fact that the product is inelastic. OPEC can manipulate prices more now with lower risk due to the price elasticity of the product. In recent events, the price of oil has been on its lowest for years, this could be due to the fact that the war in Iraq has opened up new opportunities which would increase world supply and therefore reduce prices, and that’s what has happened to today’s oil prices. Due to recent changes and improvement in technology, it may be that the previous barriers to entry such as high fixed costs could be reduced and mean that the market would open up to new entrants into the market. (Wright, 2008).

There could also be an improvement in technology which would reduce overall energy consumption fuelled by oil. For example, more and more people especially in this part of the world could use solar energy more often. This would have an adverse affect on the demand for oil. In the near future more substitutes would be created for oil, with even oil companies such as Shell having specific research departments to deal with alternatives for oil. The introduction of the electronic car in the last ten years has meant that people do have alternative to using petroleum run cars, if these cars were made more widely available and more appealing to all customers in the near future, this would certainly reduce the demand for oil specifically in western countries as they are the ones which consume the most oil. (Kalyuzhnova, 2008). A reduction in the demand for oil could be due to an economic downturn; however this would only be in the short term due to the economic cycle. There could be an increase production of oil from a non-OPEC supplier, which could mean that OPECs demand would drop as a competitor drops their prices. As the products are homogenous and no such branding on consumers, people will simply chose the oil with the lower price. (Lowe, 2008).

They could increase their profit margin in the short run and this would boost profits temporarily, however this may be difficult as this has to be agreed with the other members of the cartel, and in the long run this would have a negative impact on the long run as they would be sanctions from OPEC and fines if the prices are increased simply for boosting profits. Companies could ensure they achieve a boost in profits by controlling retails outlet of fuel and petrol and offer a wide range of convenience goods, this would ensure a wider product range a new market for them which would boost profits due to the volume of goods sold rather than the profit margin itself. OPEC and other oil companies could announce future cuts in output which would reduce supply, and won’t affect demand as much due to the inelasticity of oil. Due, to the eleven members controlling 100% of the market prices, consumers would have no choice but to purchase the oil at that price. This would work in the short term, however in the long term their would be sanctions from one of the superpowers demanding lower prices, USA also have a new supply of potential oil which has been achieved through the overthrowing of Iraq and if required their Alaskan reserve could be drilled into for oil.

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Kalyuzhnova, Yelena. (2008) Economics of the Caspian Oil and Gas Wealth: Companies, Governments, Policies. London and New York: Palgrave MacMillan.

Lowe, Anderson, Smith & Pierce, (2008) Cases & Materials on Oil & Gas Law, 5th ed., Thomson-West Publishers.

Matthew R. Simmons. (2006) Twilight in the Desert The Coming Saudi Oil Shock and the World Economy. New York: Wiley Publishers.

Wright Charlotte J., Gallun Rebecca A. (2008) Fundamentals of Oil & Gas Accounting. Pennwell Books.

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