Organization of the Petroleum Exporting Countries (OPEC)

OPEC, an international cartel of oil-producing states, has affected the price of

nearly all crude oil traded in the world economy during the past thirty-five years.

Founded in 1960, OPEC initially consisted of five member states (Iran, Iraq,

Kuwait, Saudi Arabia, and Venezuela) who together accounted for 38% of total world

production of crude oil. The founders sought to coordinate national petroleum policies

and forge a more united front in dealings with the multinational oil companies that

operated within their borders. Although membership has grown to eleven, OPEC’s share

of global crude oil production still amounts to only about 42%. Coordinated restraints on

output (especially since 1973) have deliberately held OPEC’s market share in check.

During its first decade (1960-1970), OPEC’s principal objective was to secure for

its members a larger share of the profits derived from the production and sale of their

oil—the stated goal being to raise government take from 50% to 80% of total profit.

Beginning with the so-called Teheran-Tripoli Agreements of 1970-71, OPEC turned to

what has become its main purpose: manipulating the level of world oil prices by

restricting productive capacity and output. Initially, this was attempted without assigning

individual production quotas to the respective members. Only after the downturn in

world oil prices that began in 1982 did OPEC introduce a formal system of production

allocations—one that remains in force today. The members meet at regular intervals (and

sometimes on an emergency basis) to review market conditions and adjust individual

production ceilings as needed to maintain a target price. Adelman (1995) and Parra

(2004) describe the intriguing economic and political challenges faced by the members of

OPEC in dealing with the market and with each other.

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 There is no question that OPEC members have restricted production in ways that

are unrelated to the physical scarcity of oil. Even though OPEC’s proved oil reserves

have doubled since 1973, the cartel initiated sharp output cuts that by 1985 had removed

nearly half of their previous production from the market, as shown in Figure 1. Only

recently has OPEC production regained (barely) the level of 1973. Over that same

period, worldwide consumption of crude oil grew by 50% and production from non-

OPEC producers (who faced much higher marginal costs) managed to increase by 70%.

Economic Models of OPEC Behavior

Early economic analyses of OPEC behavior questioned whether the output

reductions might reflect competitive or other forms of non-cooperative conduct (e.g.,

oligopoly), as opposed to outright collusion. Mead (1979) and Johany (1980) proposed a

“property rights” explanation that linked the production cuts to the wave of

nationalizations that swept through the global oil industry in the early 1970s. Property

rights in oil reserves were transferred, via nationalizations, from the multinational

corporations (with higher presumed discount rates) to OPEC states (with lower presumed

discount rates and therefore greater patience in extracting the oil). However, this

explanation is belied by the fact that, throughout the 1960s, these same host governments

had repeatedly exhorted the multinational companies to increase, not decrease, their rates

of production (Adelman, 1982).

Teece (1982) and Crémer and Salehi-Isfahani (1980) advanced the idea that the

limited domestic revenue needs (“absorptive capacity”) of some OPEC members imposed

an indirect restriction on production. The higher the price, the lower the volume of oil

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exports required to achieve a requisite amount of revenue. The result would be a

backward-bending supply curve that links lower oil output to higher prices in a manner

that implies no coordination among OPEC members. One problem with this argument,

as Adelman (1982) pointed out, is that the absorptive capacities of OPEC members

seemed to increase faster than export revenues. Griffin’s (1985) subsequent empirical

tests found little statistical support for the target revenue hypothesis.

Distinguishing between the various models of OPEC behavior has been

complicated by the fact that cooperative and non-cooperative models share many similar

predictions. Thus, the same body of evidence has been interpreted in ways that are

consistent with a variety of competing models. By focusing on one aspect of producer

behavior (short-run reactions to cost shocks) that more clearly distinguishes between

models, Smith (2005) found a degree of parallelism among OPEC producers that can

only be accounted for as the result of cooperative behavior, not competition or mere

interdependence among producers, as in the Cournot oligopoly or Stackelberg dominant-

firm models.

Future Challenges Facing OPEC

Levenstein and Suslow (2006) identify three critical problems that any cartel must

solve if it is to endure: coordination, cheating, and entry. In the case of OPEC, the last

of these has been the easiest. OPEC is protected by barriers to entry that stem from

ownership and control of low-cost oil reserves. Roughly 75% of the world’s proved

reserves of crude oil are located in OPEC nations. Additional reserves are discovered

and developed each year, but this process has become increasingly difficult and

expensive—even more so outside OPEC than within. Thus, production of crude oil from

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non-OPEC sources does expand when the cartel cuts production and pushes prices up, but

the scope for this is limited and will remain so.

The problem of cheating has been more difficult for OPEC. Any system of output

restraints is vulnerable to the free-rider problem. Although OPEC as a whole may benefit

by restricting total output, individual members are tempted to produce beyond their

assigned quotas. Cartel membership is most beneficial to those members who do not cut

production. Without a system to detect and punish cheating, the cartel is hampered by a

prisoners’ dilemma in which the dominant strategy for most, if not all, members is to

ignore their assigned quotas.

It is common, as in Gately (2004), to distinguish between “core” (low cost, high

compliance) and “non-core” (high cost, low compliance) members of OPEC. In fact,

compliance with the quota by members of both groups has been sporadic, as shown in

Figure 2. Since the inception of the formal quota system in 1983, total OPEC production

of crude oil has exceeded the ceiling by 4% on average, but on numerous occasions the

excess has run to 15% or more. In general, full compliance has been achieved only

during episodes (like 2005-2006) when the production ceiling itself tested the limits of

each member’s available production capacity, such that cheating was not feasible.

The third problem, coordination among members, presents further difficulties.

Due to economic and demographic heterogeneity, the interests of individual OPEC

members do not naturally align behind a single “correct” price or production target. In

part, this is due to the fact that OPEC has limited means by which to redistribute earnings

among members. Therefore, any given set of quotas determines not only the overall

profit of OPEC, but also the individual revenues that accrue to each member. Moreover,

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coordination requires agreement not only about how aggregate output is parceled out to

individual members, but also about the amount of oil to be produced by OPEC in total.

Members with low-cost, long-lived reserves may be more reluctant to have OPEC pursue

severe output cuts since too-high prices would induce technological development and

new forms of energy (or energy conservation) that will eventually compete with OPEC.

Members who possess smaller reserves and shorter horizons are less affected by this and

may prefer deeper production cuts. Internal divisions between “price hawks” and “price

doves” have been observed previously and will likely surface within OPEC again.

In terms of longevity, OPEC is fast approaching the half-century mark, which

places it far beyond the mean lifetime (five years) of contemporary international cartels

(Levenstein and Suslow, 2006). In terms of economic impact, it is sufficient to note that

crude oil is among the most valuable commodities exchanged in international trade, with

total daily receipts in excess of $1 billion. Thus, by exerting even a small impact on the

market price, the cartel effects an enormous transfer of wealth between consumers and

producers of crude oil, and creates a substantial allocative inefficiency of the type that

arises whenever the price of a product deviates from its marginal cost. No one has yet

attempted to reckon the full magnitude of welfare losses that may be associated with

OPEC’s manipulation of the world oil market.

James L. Smith

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 Bibliography

Adelman, M. A. 1995. The Genie Out of the Bottle: World Oil Since 1970. Cambridge,
MA: MIT Press.

Adelman, M. A. 1982. “OPEC as a Cartel,” in OPEC Behavior and World Oil Prices,
James M. Griffen and David J. Teece, eds. London: George Allen and Unwin.

Crémer, Jacques, and Djavad Salehi-Isfahani. 1980. “A Theory of Competitive Pricing

in the Oil Market: What Does OPEC Really Do?” CARESS Working Paper #80-
4, University of Pennsylvania, Philadelphia.

Gately, Dermot. 2004. “OPEC’s Incentives for Faster Output Growth,” The Energy
Journal, 25(2), 75-96.

Griffin, James M. 1985. “OPEC Behavior: A Test of Alternative Hypotheses,”

American Economic Review, 75(5), 954-963.

Johany, A. D. 1980. The Myth of the OPEC Cartel. New York: John Wiley & Sons.

Levenstein, Margaret C. and Valerie Y. Suslow. 2006. “What Determines Cartel

Success?” Journal of Economic Literature, 44, 43-95.

Mead, Walter J. 1979. “The Performance of Government in Energy Regulation,”

American Economic Review, 69(2), 352-356.

Parra, Francisco. 2004. Oil Politics: A History of Modern Petroleum. London: I. B.

Taurus.

Smith, James L. 2005. “Inscrutable OPEC? Behavioral Tests of the Cartel Hypothesis,”
The Energy Journal, 26(1), 51-82.

Teece, David J. 1982. “OPEC Behavior: An Alternative View,” in OPEC Behavior and
World Oil Prices, James M. Griffen and David J. Teece, eds. London: George
Allen and Unwin.