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OPEC (Organisation of Petroleum Exporting Countries) is the largest oil-exporting cartel globally, supplying 38% of global oil demand (OPEC, 2024). However, as a group of countries, OPEC members intentionally restrict oil output to raise the price a barrel of oil sells for. Given the importance of maximising export revenues of a finite resource to them, it is important for us (importers of that oil) to understand how the cartel operates.
From Cournot to Collusive Oligopoly:
Before collusion, OPEC could have been classified by a specific type of oligopoly: the Cournot oligopoly. In this model, two firms (here oil-exporting nations) simultaneously set production depending on how much oil they think their competitor will produce. These beliefs about their competitor’s production are known as best response functions and show each country how much oil to produce, given the level of oil its competitors are producing, to maximise profits. Saudi Arabia produces the most oil individually and the other countries together produce smaller amounts individually. Together, they can be classed as Saudi Arabia’s oligopolistic ‘other half’.
Furthermore, the Cournot model assumes that competing firms (countries) produce identical goods at similar marginal costs. In our example this is true; the expense to OPEC members of adjusting production is minimal (allowing them to easily manipulate prices) and, as far as non-chemists are concerned, crude oil is crude oil. Therefore, the Cournot model fits seamlessly to OPEC.
However, under the Cournot model, price competition between countries for identical goods produced (oil) would reduce profits significantly, creating strong incentives to collude and dictate oil prices through production quotas. The reason they can do this is that the 12 members of OPEC own 81% of the world’s crude oil reserves (OPEC, 2024), meaning they have sufficient market share and insufficient competitors, to dictate global oil prices through production quotas. So instead of being in a Cournot equilibrium, OPEC members agree to cut production and raise prices above what they would be without collusion. Cartels are illegal, but due to the international lack of enforcement, OPEC is unimpeded.
Recently (as of March 2024), OPEC+ (which includes Russia) has agreed to extend cuts to oil production. As the Vice President of Rystad Energy (a firm within OPEC) said in 2024, “[these cuts] will keep the market in deficit [and] add price pressure”.
The Temptation to Cheat in a Cartel:
When in a cartel, OPEC members face the temptation to expand production and undercut competitors’ prices to capture the entire global market demand (consumers will want the cheapest oil because again, oil is oil) and earn huge profits. However, OPEC is largely effective in stopping this, through strong dialogue between members. Furthermore, there is an acceptance among members that if one breaks ranks, all others will follow with production expansions and the price will quickly collapse along with OPEC’s profits.
Therefore, the temptation to expand production only occurs if the member believes that the one-time profit they would capture from violating their production quotas would exceed the current value of future profits they would otherwise get by sticking to quotas. An example of this was the Russia-Saudi price war in 2020 with OPEC+. The breakdown of dialogue over voluntary production cuts (something Russia opposed because it faced lower production costs so wanted higher production) lead to a price war, as Saudi Arabia slashed prices by flooding the market with oil from its reserves and Russia responded in a similar fashion. By 20th April 2020, prices were negative and dialogue was reinstated. It is important to note the consequences of this price war were so acute because it coincided with the shutdown of the global economy and a collapse in global oil demand. This episode represents the reversion from collusion to the Cournot model of oligopoly.
You can find a great video on why Saudi launched the war below:
The Finite Fiasco:
Moving into the future, it is likely that OPEC will seek to continue production cuts for two or three interrelated reasons that essentially derive from the finite nature of oil as a fossil fuel. Firstly, given that oil is finite, OPEC members benefit from production cuts as it raises the total revenues they can generate from all the oil they have if they sell it at higher prices and it also extends the longevity of the revenues from oil sales. By restricting the output of oil, OPEC is extending the duration over which they can sell oil, generating a longer continuous flow of revenue. Finally, related to the two other reasons, OPEC nations know that oil is finite and are trying to re-engineer their economies to accommodate shifting global macroeconomic climates. This process is incredibly long and requires a vast upfront investment. These demands therefore rely on and incentivise OPEC nations to keep prices high and restrict output so they can maximise the profits from oil exports and reinvest them into the transformation of their economies.
OPEC operates as a cartel to raise prices through production quotas and their near dominance of global oil reserves means they face insufficient competition to force the cartel to end. As consumers, this means we face higher oil prices. However, the rising use of renewables may threaten the market power OPEC has in the global energy sector.
Links to Further Reading
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