OPEC – The History of the Worlds Most Famous Cartel

OPEC – the Rise and Fall and Rise again of a Cartel
The history of the world’s most famous cartel 

OPEC is probably the best known of all cartels. It was set up in 1960 by the five major oil-exporting countries: Saudi Arabia, Iran, Iraq, Kuwait, and Venezuela. As of 2009, there were 12 members. OPEC’s stated objectives are: 

• Stabilisation of oil markets to secure an efficient, economic, and regular supply of petroleum. 
• Steady income for producers and a fair return to the capital to those investing in the petroleum industry 

The years leading up to 1960 had seen the oil-producing countries increasingly in conflict with the international oil companies, which extracted oil under ‘concessionary agreement’. Under this scheme, oil companies were given the right to extract oil in return for royalties. This meant that the oil-producing countries had little say over output and price levels. 

Oil prices

The early years 

Despite the formation of OPEC in 1960, it was not until 1973 that control of oil production was effectively transferred from the oil companies to the oil countries, with OPEC making the decisions on how much oil to produce and thereby determining its oil revenue. By this time OPEC consisted of thirteen members. 

OPEC’s pricing policy over the 1970s consisted of setting a market price for Saudi Arabian crude (the market leader), and leaving other OPEC members to set their prices in line with this: a form of dominant ‘firm’ price leadership. 

As long as demand remained buoyant, and was price inelastic, this policy allowed large price increases with consequent large revenue increases. In 1973/4, after the Arab–Israeli war, OPEC raised the price of oil from around $3 per barrel to over $12. The price was kept at roughly this level until 1979. And yet the sales of oil did not fall significantly. 

After 1979, however, following a further increase in the price of oil from around $15 to $40 per barrel, demand did fall. This was largely due to the recession of the early 1980s (although, as we shall see later on when we look at macroeconomics, this recession was in turn largely caused by governments’ responses to the oil price increases). 

The use of quotas 

Faced by declining demand, OPEC after 1982 agreed to limit output and allocate production quotas in an attempt to keep the price up. A production ceiling of 16 million barrels per day was agreed in 1984. 

The cartel was beginning to break down, however, due to the following: 

• The world recession and the resulting fall in the demand for oil.
• Growing output from non-OPEC members.
• ‘Cheating’ by some OPEC members who exceeded their quota limits. 

With a glut of oil, OPEC could no longer maintain the price. The ‘spot’ price of oil (the day-to-day trading price of oil on the open market) was falling, as the graph shows. 

The trend of lower oil prices was reversed in the late 1980s. With the world economy booming, the demand for oil rose and along with it the price. Then in 1990 Iraq invaded Kuwait and the Gulf War ensued. With the cutting-off of supplies from Kuwait and Iraq, the supply of oil fell and there was a sharp rise in its price. 

But with the ending of the war and the recession of the early 1990s, the price rapidly fell again and only recovered slowly as the world economy started expanding once more. 

On the demand side, the development of energy-saving technology plus increases in fuel taxes led to a relatively slow growth in consumption. On the supply side, the growing proportion of output supplied by non-OPEC members, plus the adoption in 1994 of a relatively high OPEC production ceiling of 241/2 million barrels per day, meant that supply more than kept pace with demand. 

The situation for OPEC deteriorated further in the late 1990s, following the recession in the Far East. Oil demand fell by some 2 million barrels per day. By early 1999, the price had fallen to around $10 per barrel – a mere $2.70 in 1973 prices! In response, OPEC members agreed to cut production by 4.3 million barrels per day. The objective was to push the price back up to around $18–20 per barrel. 

But, with the Asian economy recovering and the world generally experiencing more rapid economic growth, the price rose rapidly and soon overshot the $20 mark. By early 2000 it had reached $30: a tripling in price in just 12 months. With the world economy then slowing down, however, the price rapidly fell back, reaching $18 in November 2001. 

However, in late 2001 the relationship between OPEC and non-OPEC oil producers changed. The ten members of the OPEC cartel decided to cut production by 1.5 million barrels a day. This followed an agreement with five of the major oil producers outside of the cartel to reduce their output too, the aim being to push oil prices upwards and then stabilise them at around $25 per barrel. 

The alliance between OPEC and non-OPEC oil producers is the first such instance of its kind in the oil industry. As a result, it seemed that OPEC might now once again be able to control the market for oil. 

The price surge of 2003–8 … 

But how successfully could this alliance cope with crisis? With worries over an impending war with Iraq and a strike in Venezuela, the oil price rose again in late 2002, passing the $30 mark in early 2003. OPEC claimed that it could maintain supply and keep prices from surging even with an Iraq war, but with prices rising rapidly above $30, many doubted that it could. 

In 2004 the situation worsened with supply concerns related to the situation in Iraq, Saudi Arabia, Russia and Nigeria, and the oil price rose to over $50 in October 2004. OPEC tried to relax the quotas, but found it difficult to adjust supply sufficiently quickly to make any real difference to the price. 

From 2006, oil prices increased more sharply than they ever had before and, for the first time in years, the real price of oil exceeded that seen in the 1970s. The major cause of the increases was very substantial increases in demand, particularly from India and China, coupled with continuing concerns about supply. The implications of the sharp price increases were substantial: inflationary pressures built up across the world, while the income of OPEC nations doubled in the first half of 2008. 

By July 2008 the price had reached $147. Some analysts were predicting a price of over $200 per barrel by the end of the year. 

… then the fall … 

But then, with the growing banking turmoil and fears of a recession, the price began to fall – and rapidly so. When the price dropped below $100 in September 2008 the majority of the world breathed a sigh of relief. But as the economic outlook became gloomier and the demand for oil fell, so the price plummeted, reaching $34 by the end of the year – less than a quarter of the price just five months previously – and hovering around the $40 mark in the first quarter of 2009. Whilst this was good news for the consumer, it was potentially damaging for investment in oil exploration and development and also for investment in alternative energy supplies. 

… and then the rise 

OPEC responded to the falling price by announcing cuts in production, totalling some 14 per cent between August 2008 and January 2009, which represented a global cut of about 5 per cent. Nevertheless, as global demand recovered during 2009, so oil prices rose again.

In 2011, continued increases in demand, together with unrest in the Middle East, initially put upward pressure on prices, reaching $123 by mid-April. But, the fragility of economic growth, especially in Europe where many governments were ‘tightening their belts’ in the face of growing concerns over levels of borrowing, put a brake on demand. Consequently, prices were to range between $100 and $105 over the second half of 2011 and into 2012. 

The recent history of OPEC illustrates the difficulty of using supply quotas to achieve a particular price. With demand being price inelastic but income elastic (responsive to changes in world income, such as rising demand from China), and with considerable speculative movements in demand, the equilibrium price for a given supply quota can fluctuate wildly. 

Question 

1. What conditions facilitate the formation of a cartel? Which of these conditions were to be found in the oil market in (a) the early 1970s; (b) the mid-1980s; (c) the mid-2000s? 
2. Could OPEC have done anything to prevent the long-term decline in real oil prices after 1981? 
3. Many oil analysts are predicting a rapid decline in world oil output in 10 to 20 years as world reserves are depleted. What effect is this likely to have on OPEC’s behaviour?