Case E.

10
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:
 The co-ordination and unification of the petroleum policies of member countries.
 The stabilisation of oil markets to secure an efficient, economic and regular supply of
petroleum to consumers, a steady income to producers and a fair return on capital for
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.

Sources: Nominal oil price data from Global Economic Monitor (GEM), Commodities (World Bank); Price Index
from Data Extracts (OECD).
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

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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 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.
OPEC responded to the falling price by announcing cuts in production, totalling some 14
per cent between August 2008 and January 2009. But with OPEC producing less than a third
of global oil output, this represented less than 5 per cent of global production. Nevertheless,
as global demand recovered, so oil prices rose again from 2009 peaking in March 2012 at
$118.
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, began to put
a brake on demand. The price of oil was to average close to $104 over 2013.

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 However, as we saw in Case Study B.6 prices were to fall steeply from summer 2014.
This was largely the result of the increased output in non-OPEC countries of non-
conventional deposits, such as in shale formations. Consequently, OPEC’s market share has
waned.
OPEC responded to the increased supply, not by cutting output, but by announcing that it
would retain output at current levels even if oil prices dropped as low as $40. What it was
relying on was the fact that production from shale oil wells, although often involving low
marginal costs, lasts only two or three years. Investment in new shale oil wells, by contrast, is
often relatively expensive. By OPEC maintaining production, it was hoping to use its
remaining market power to reduce supply of competitors over the medium to long term (see
the blog post A crude indicator of the economy (Part 2) on the Sloman Economics News
site).

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?