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OPEC has never had as much power as people think

February 22, 2016

It is no surprise that OPEC has had extreme difficulty coordinating a response to the latest price drops in the oil market. OPEC as a political and economic organization has largely been unable to achieve its central goals since inception in 1960.

OPEC certainly never had the capability to prevent rapid price drops in crude when the market is flooded by alternate, non-OPEC sources, and over the past few decades, the organization has been degraded even further. Even now, supposed attempts to stabilize the market by maintaining January output levels ring quite hollow when compared to all the excess supply in the market.

OPEC has never effectively achieved its goals because of two main reasons: collective action issues relating to its members and the growth of non-OPEC oil.

Whenever people, organizations, or governments attempt to engage in collective action behavior, there always exists an inherent tension between group interest and individual interest. The interests of the individual person, organization, or country are extremely hard to resist, and we can see this time and again as attempts at cartelized behavior are more frequently undone by the individual interest over the group.

OPEC members have common ground on the oil price itself, and strive for higher pricing, but the level of output ultimately falls under the control of individual members, subject directly to the self-interest of each producer. This is a free-rider problem where each member hopes the others bear the costs of higher oil prices by reducing their output, allowing the individual producer to ship more oil at the higher price. And many of these are smaller producers, where their individual output doesn’t make much difference. The problem is, all the producers know this.

Collective action issues like this are a major concern anytime groups of people or organizations need to get together to accomplish a central goal. Who pays? Who reaps the benefits? Are benefits inclusive or exclusive? What is the size of the group? 5,000? 10? All these different components matter greatly to the group itself and whether or not it will be able to attain its goals and fulfill its purpose for existing. And purpose is important.

As with Mancur Olson’s landmark 1960s work on the topic of collective action, The Logic of Collective Action, we should look at the particular purpose of the organization. Organizations are meant to further the interests of their constituent members and in the case of OPEC, the organization began essentially with both economic and political goals, but after 1970s settled merely for furthering the economic goals of the members, that is, to keep the price of oil as high as sustainably possible while also maintaining the stability of oil markets.

In this particular case, the nuance of “sustainability” is incredibly important, because simply driving prices higher triggers negative demand reactions in consuming states, which may ultimately hurt producer revenues over the long-term. This is the reason Saudi Arabia has attempted to keep a price cap on the market, while at the same time maintaining a floor.

And again, OPEC has had to reduce its objectives largely because of the timely growth in non-OPEC sources of crude, triggered by the 1970s oil crises. OPEC reached the apex of its political and economic power in the 1970s, only to witness a large crash in the price of oil in the 1980s. Aside from the oil shocks in the 1970s, OPEC was largely unable to meet any of its political objectives.

Over the life of OPEC, the oil market has shifted to one of a heavily restricted and cartelized market, molded in that fashion primarily by the Seven Sisters in the earlier 20th century, to one more closely resembling perfect competition as new sources of oil have been made available for export, drastically increasing the geographic and political diversity of petroleum resources.

That means OPEC became a cartel operating within a competitive market beginning in the 1980s, when impressive volumes of oil began to make their way to global markets from the North Sea allowing countries like the United Kingdom and Norway to become larger players in the oil industry. In fact, the OPEC embargo spurred drilling in other countries to develop new fields, and in essence, had a hand in creating a vast new drilling industry outside its purview, not only in the North Sea, but also in Alaska, and eventually the Gulf of Mexico and Canada’s oil sands.

In a high supply environment, restricting output in the face of lower prices puts that country in an extremely disadvantageous position – something Saudi Arabia learned the last time it attempted this in the 1980s – and with little impact to the oil price. In a situation like this, the interests of each state are in direct opposition to all the others when you take not just price but individual output into account. Because of added supply and the weakness of OPEC to coordinate its actions resulting from collective action issues, the paralysis of the organization is plain to see.

And while a production freeze might seem like policy coordination, it simply won’t amount to much. Iran, a country now exiting the dormancy of sanctions on its oil industry is not going to freeze or reduce its exports. Its output is already low compared to its capacity, and it is not going assist other OPEC producers through cuts of its own.

Moreover, on the point of production capacity, OPEC producers are already pumping close to capacity in order to help with their respective budget shortfalls. They can propose a “price floor” through maintaining current production levels, but this is simply because they cannot pump anymore. This is not policy coordination.

Since the energy markets began to mature in the 1980s, perhaps the most useful function of OPEC, of which the disproportionate burden was placed primarily on Saudi Arabia, was the ability to ramp up spare capacity in order to calm oil markets and keep the price below certain levels. These contributions to oil market stability are notable, but not the result of OPEC coordination.

By Ryan Opsal


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