Economic Structure of OPEC

An oligopoly represents an intermediate market between a perfectly competitive market and a monopoly. Whereas perfectly competitive markets generally include a large number of producers and have small barriers to entry, oligopolies are competitive markets with a relatively small number of producers and large barriers to entry, and monopolies have a single producer and the largest entry barrier in that they produce a unique product. Competitive markets operate according to supply and demand curves and prices fluctuate accordingly, while monopolies operate only on a demand curves and can set their prices to maximize its profit.

Generally in competitive markets, such as oligopolies, producers need to concern themselves not only with supply and demand and pricing, but also with competition. An exception to this occurs when oligopolies engage in the generally illegal practice of forming cartels. Cartels are formed when the producers within an oligopoly cooperate by fixing their prices, limiting production or distribution in order to decrease supply, allocate markets geographically, or engage in any combination of these or other non-competitive market behaviors. Unless cartels or monopolies are specifically authorized by government intervention, sometimes in order to protect markets which may otherwise be destroyed, they are illegal in most capitalistic countries where competition is valued. Both cartels and monopolies were explicitly outlawed by the United States in 1890 when the U.S. Congress passed the Sherman Antitrust Act and again in 1914 when Congress passed the Federal Trade Commission Act, both of which “prohibit firms from explicitly agreeing to take actions that reduce competition”, (Perloff, 2007, p. 153). This federal legislation was passed notably due to mounting public furor concerning monopolies, most notably one conspicuously notorious monopoly that existed at the end of the 19th century, the Standard Oil Company, which was founded by John D. Rockefeller in 1870. Standard Oil was an extremely efficient company but had a history of alleged corrupt business practices throughout this 40 year period for using intimidation to control the majority of U.S. petroleum production and distribution. Generally Rockefeller either forced competitors out of business or acquired them through predatory pricing and by controlling the distribution network and formed a holding company called the Standard Oil Trust. The early legislation did little to deter Standard Oil Trust’s competitive practices and the company was eventually indicted by the U.S. Supreme Court and was dissolved into 23 different companies in 1911, (Witzel, 2008). By the time of the indictment Standard Oil’s control within the industry had already been steadily decreasing. Although at one point they controlled 88% of the petroleum products market, at the time of the Supreme Court decision they controlled only 64% of the market, (Armentano, p.70), leading one to speculate whether they truly were a monopoly.

Upon the dissolution of the Rockefeller oil companies, Shell, Gulf, and Texaco were already competitors in the industry. Many of the companies which became part of the U.S. petroleum industry oligopoly upon the dissolution of Standard Oil still exist today either as separate entities or as parts of other companies within the industry, including ExxonMobile, Marathon, and Chevron. It’s interesting to note that the although the petroleum production industry was essentially a free competitive market prior to the 1911 Supreme Court decision, following the decision we see increasing government regulation and intervention and we see the beginnings of cooperative, or cartel, behavior within the industry. Beginning with World War One and lasting through the 1960s, U.S. government intervention controlled not only domestic petroleum pricing and production through agencies that were specifically formed for this purpose, but also foreign pricing and production, (Armentano, p. 70).

The governments enforced cartel behavior during this period, through price fixing and limiting production in the guise of reducing waste, endowed the oligopoly with the market power of a monopoly. Cartels, whether they are legal or illegal, allow oligopolies to act as monopolies and destroy social welfare, the cumulation of consumer surplus and producer surplus. Illegal cartels and monopolies destroy social welfare by setting prices above marginal cost leading consumers to purchase less and therefore creating an overall, or deadweight, market loss. However, government intervention through a legal cartel differs from a traditional cartel oligopoly or a monopoly where sellers seek only to maximize profit. In the case of a government intervention, or interventionism, then either buyers or sellers are likely to gain, but at the expense of one another through the creation of an inefficient market. This differs from a traditional competitive oligopoly where buyers and sellers in an efficient market enter into exchange relationships where both gain advantage, and social welfare is gained at the intersection of pricing and output.

Firms in competition must adjust their output and pricing so that their potential economic gains are maximized. In a competitive market, firms in an oligopoly pay close attention to the behavior of one another in order to ensure continued or improved market share. In doing so, these firms are likely to make errors in judgment which generate losses for the firms, which are usually quickly corrected and can often lead to greater efficiency. The behaviors of oligopolistic firms that are involved in this competitive process are analyzed through game theory, a set of tools that economists use to “analyze conflicts and cooperation” (Perloff, p. 147). Firms strategize output and pricing through matrices in an attempt to predict what their options are and what the options of their competitors are, and then choose what appears to be the dominant strategy according to the matrix. In cartels, these same oligopolistic firms covertly share information on pricing and output so that they can act as monopolies, they then fix prices and minimize output so that they can maximize profits for all the members of the cartel. These same game theory matrices are used to predict behavior of firms within the cartel. Issues arise with trust in cartels according to game theory. Ultimately the firms that engaged in cartel behavior are competitors and are more interested in maximizing their own profits rather than the profits of the industry as a whole. Non-cooperative firms that increase output against a cartel agreement can realize even larger gains than they could even as members of the cartel, if they can keep this information secret from the other members of the cartel. The longer a cartel member can keep increased output and sales secret from the other members the larger the gains they are able to realize.

All cartels work to detect members that violate the cartel agreement, or cheat, through various methods up to and including the inspection of another members books, and if caught they also work to punish the offending member. Saudi Arabia, the leading producer of the Organization of Petroleum Exporting Countries, OPEC, acts in the capacity as punisher for this cartel. OPEC is a cartel that includes petroleum producing counties in the Middle East, Africa, and South America and acts to control price and production in the participating nations. In order to control the incentive to cheat and also to counter the problem of defection, which is greater for small producers in the cartel, OPEC enforces a small producer bias within their quotas, (Griffin & Xiong, p. 290). Additionally, OPEC relies upon Saudi Arabia to act in enforcement of the cartel agreement by engaging in modified tit-for-tat strategy where they routinely overlook small amounts of cheating, but punish those nations that drastically deviate from their quotas by allowing them to overproduce as well, (Griffin & Xiong, p. 306). This strategy generally works to curtail large scale cheating as those countries are that engaging in cheating behavior are punished through lower prices for their production, while the Saudis experience a gain in both production and pricing. One of the problems with oil production with the OPEC nations appears to be that they have figured out what level of cheating is allowable and to adjust their quotas accordingly. Invariably this has led to an overall overproduction by the Saudis and a substantial increase in pricing as OPEC nations account for approximately 40% of the world’s crude oil production according to the U.S. Energy Information Administration. A historical analysis of weekly prices dollars per barrel for world production reveals that annually prices have been rising steadily since 2005.

http://tonto.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=wtotworld&f=w

A detailed analysis of the data used to construct the above table indicates that the average for 2005 was $49.87, the average grew to $60.32 in 2006, $69.19 in 2007, spiked to $95.62 in 2008, and although the average came back down to $60.07 in 2009, it has since climbed back up to $75.59 for the first quarter of 2010.
The U.S. government recently announced that it will continue exploration for off-shore reserves in the Atlanta, the Gulf of Mexico, and the Arctic Ocean, (Keefe, 2010), as a result it is expected that OPECS overall contribution will remain at approximately 40% into the future. This is a dynamically efficient market move by the American government; by continuing to tap into previously unexplored reserves they will remain efficiently competitive in the industry. Through past discovery of oil reserves, the U.S. petroleum industry has consistently shown that they have been able to remain competitive despite the continued market manipulation from OPEC. It is expected that OPEC will continue to allow biased increased market share quotas in favor of small producers to prevent defection of these producers from the cartel over the next year. Additionally, OPEC will continue to exert forces on the market through overproduction as a result of Saudi Arabia’s successful tit-for-tat enforcement of the cartel agreement, and will therefore continue to drive up the price for barrels of crude oil, however, they may seek to punish those higher producers even further to try to contain prices to dissuade American exploration. This effort may mitigate rising crude oil prices somewhat by forcing Saudi Arabia to return in part to their role as a swing producer, allocated to making up the residual differences in total production, and then taking the tit-for-tat action only against the greatest increased production offenders within the cartel. Although this method has proved successful for OPEC in controlling cheating by cartel members, all in all it demonstrates an allocative inefficiency due to the fact that oil reserves are a limited natural resource.


References:

Armentano, D.T. (1981, Spring). The petroleum industry: a historical study in power. Cato Journal, 1 (1). 53-85. Retrieved from DOAJ Directory of Open Access Journals http://www.cato.org/pubs/journal/cj1n1/cj1n1-4.pdf

Griffin, J.T. & Xiong, W. (1997, October). The incentive to cheat: an empirical analysis of OPEC. The Journal of Law and Economics, 40(2). 289-316. Retrieved from Lexis/Nexis Academic

Keefe, B. (2010, March 31). Obama opens waters off Georgia, other states to oil exploration. The Atlanta Journal-Constitution. Retrieved from http://www.ajc.com/news/obama-opens-waters-off-423409.html

Perloff, J. M. (2007). Microeconomics (4th ed.). New York: Pearson Addison Wesley.

Witzel, M. (2008). The breaking of Standard Oil. European Business Forum, 2008(32). 50-53. Retrieved from EBSCOhost Business Source Premier.

U.S. Energy Information Administration, (2010, March 31). World Crude Oil Prices. Washington, DC: Author. Retrieved from http://tonto.eia.doe.gov/dnav/pet/PET_PRI_WCO_K_W.htm

U.S. Energy Information Administration, (2009, May 27). International Energy Outlook 2009 (Report #:DOE/EIA-0484). Washington, DC: Author. Retrieved from http://www.eia.doe.gov/oiaf/ieo/highlights.html