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The Myth of OPEC

Gaurav Sodhi | The Australian Financial Review | 24 June 2008

OPEC has long been considered an economic boogey man terrorizing 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 they get away with holding back supply?

OPEC is famously secretive about output and its reserve positions for good reason; it doest want the truth to slip that it has no 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. There 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 12 diverse oil producing countries that tries to influence prices by controlling output.

It does this by allocating each member country a quota for production. This means that all 12 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 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 so 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 1990’s oil prices fell close to $10 a barrel and the flaws of the cartel were open for all to see. Those same flaws still exist, but they are better disguised today. Strong demand for energy from the developing world and a faltering US dollar have both contributed to a secular 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.

The massive reserves of Saudi Arabia have also historically been a tool to encourage quota compliance. 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 there is a lack of confidence in the sustainability of its largest fields. The long standing threat to flood the market with cheap oil has now become a bluff, and the other members of OPEC know it.

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 honestly, 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 its 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 $140 a barrel.

There are two reasons for this. Member countries of course 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, its revenue.

But there is a more important reason. OPECs members aren’t stable democratic countries in which petroleum is just another industry. They are mostly authoritarian states that use oil as a means of sustaining political power. Oil money is a way of buying support from key parts of society and financing a security apparatus to deal with enemies. Oil creates the revenues that enable many OPEC regimes to continue to stay in power. By allowing countries to both buy authority and enforce it, oil strengthens regimes that would otherwise be very wobbly.

Nothing would be more destabilizing 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 off allies? Governments in Libya, Nigeria and Angola would similarly all be in perilous political positions without the benefit of oil money.

Far from being an economic boogey man, the truth about OPEC is that it is a largely powerless organisation that sustains its own existence with a myth, 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.

Gaurav Sodhi is an Economist at the Centre for Independent Studies