The Strengths of OPEC

The major distinction of the Organization of Petroleum Exporting Countries is obvious even to the casual observer: the nations composing it constitute the greatest monopoly in history; its tribute now is over $100 billion a year.

As far as I can see, for the immediate future OPEC's elements of strength look more important than its elements of weakness. The cartel will not soon disappear.

The forces acting against the cartel are subsumed in the fact of excess capacity. This is the traditional nemesis of cartels, since it puts in motion the sequence of small price reductions by some sellers to gain additional sales volume, then competitive or matching reductions. To preserve the cartel, each member must avoid acting for his own independent good, and must do what is best for the group as a whole. The greater the burden of excess capacity, the greater the temptation to act independently, the greater the fear of others' independent action, and the higher the probability of severe erosion or breakdown. So the fate of the cartel depends essentially on the strength of exogenous factors, demand and uncontrolled supply, versus the strength of an endogenous factor, the cohesion of the group. All too often either one of these factors is treated in isolation as though the other were not there.

By mid-1975, production of the OPEC nations was around 26 million barrels daily, and unused capacity was 12, or nearly half. Clearly great strain was being exerted. Just as clearly there was great strength, for the price was actually raised at the end of September. Let us therefore look at the principal actors of strength.

One preliminary but important comment: political factors are not likely to damage the cartel any more than they have helped it. The notion that OPEC results from tension in the Middle East is a myth. Even assuming instant peace between Israel and the Arab states, it is exceedingly unlikely that anyone should want to lower oil prices as a consequence. But if political objectives of these sovereign nations have little to do with cartel objectives, their sovereignty itself is a great help. These nations are subject to no law that would limit or abridge their monopoly. It is free enterprise at its freest.

In addition to the advantage that its members are sovereign nations, a second great advantage enjoyed by this cartel is its use of the multinational oil companies to clear the market, insuring that the amount offered at the prevailing price does not exceed the amount demanded. The multinational oil companies, without any collusion, limit output and allocate it among the producing countries. The system is simple and has worked excellently so far. The exporting countries transfer the great bulk of their oil to the companies at the fixed price. Each company produces only what it can sell at that price. Since margins are very thin, around 2 percent of the price, companies cannot make significant price cuts. As nobody makes lower offers to get more outlet, the market clears.

The market share of each country depends on what its resident companies can sell. What matters is not "nationalization," but that the exporting nations accept those market shares and shun any large-scale independent selling efforts. This has imposed some strains. Since the companies now have a relatively small stake in operating in any particular country, they are more ready to buy crude elsewhere, and have done so, in small amounts. Hence governments have engaged in the novel experience of bargaining over prices, and even losing sales. Even when the amounts are tiny they react with surprising vehemence. Algeria has not hesitated to make harsh criticisms of Nigeria and Libya for having given small incentives to their resident companies, preventing them from buying Algerian crude oil. The outstanding nonconformist is Iraq, which has shaded prices just enough to keep output at over 90 percent of capacity, and has in consequence now upgraded its 1980 plans by 50 percent. Much of its gain has been at the expense of Kuwait, which has found its former resident companies, Gulf and BP, uninterested in taking all the oil made available. Kuwait shook a stick at the companies—no oil sales contract whatever—and offered a carrot—a 10¢ price reduction, promptly denounced by Iraq in an official diplomatic note: such reductions would "inspire competitive bidding among producers." Competitive bidding is the clear and present danger, and its avoidance is worth many times 10¢. I expect Kuwait to come to some kind of understanding with the companies. Yet the tie that binds companies to any given source of supply is weaker than ever before. Even with no cataclysmic change when the margin on crude oil becomes thin, even if a government scrupulously maintains it, the company has shifted its emphasis away from disposal of profitable crude oil toward the procurement of crude oil for its refining-marketing operations to run at a profit.

My own guess is that the situation will be contained for the immediate future because both parties know that the multinational companies are indispensable. Perhaps the governments could themselves limit output and divide markets. They don't want to find out. Haggling over market shares, surveillance, and compensation of losers, would be a constant divisive irritant. Confrontation in council, month after month, would strain and I think severely damage the cartel.

Another advantage of the cartel nations is the super-abundant liquidity of some of them. Many a price fixing agreement has been undermined by reluctant price cutters, who cannot help themselves because they must have additional cash and can only raise it by increasing sales even at lower prices. Most OPEC governments are in excellent financial shape, and have therefore tolerated the companies' sales reductions. Even those which have overspent revenues find their credit is very good. There is a backward bending supply function: the higher the price, the greater the cohesion of the cartel, the less put on to the market.

We touch here on a very important point: the rate of expansion of capacity of the fringe of the cartel, the nations which must choose between (a) acting price takers, and expanding output as fast as possible or (b) permitting the companies to operate the cutback scheme or understanding. The fringe nations—broadly the non-Arab members plus Iraq—have mostly refrained from pushing output to the maximum, and have chosen rather to bear as great a reduction as the core countries—broadly the Persian Gulf Arab states. If the fringe nations were to sell at capacity, and expand capacity, the cartel would be much weaker. Each fringe nation knows that what each does makes no difference. If they see others complying they will most likely do the same. Conversely, every flouting of the implied obligation makes it more likely that others will flout. It is a basic instability: a tendency in either direction becomes self-reinforcing. But today the self-reinforcing tendency strengthens the cartel.

Relations between core and fringe are complicated by the fact that no two governments have quite the same rate of time preference. Some of them want higher prices today even if it means lower prices tomorrow, while others would maximize the present value of their assets by a somewhat flatter gradient. A long-run equilibrium monopoly price for Saudi Arabia would be lower than for Algeria. But that is a conditional statement, not a reference to any actual prices. There is no truth in the U.S. government's romance that Saudi Arabia is trying to keep down the price. In fact that nation was the leader, raising prices throughout 1974. They not only acquiesced in the price increase of 1975: recent statements by Sheik Yamani clearly foreshadow further price increases when industrial recovery is farther advanced. But Saudi Arabia, like any prudent monopolist, advances the price step by step, pausing to test the market before raising it again. And just as with other cartels where costs vary greatly among the cartelists, it may be necessary for the lower-cost producers to make side payments to the higher-cost ones. In the oil nations' cartel, the side payment would take the form of agreeing to a higher price than would optimize the holdings of the lower-cost producer. But that problem has not yet become serious.

This brings us to an advantage for the cartel which is potential rather than actual—Saudi Arabia as the restrictor of last resort. In the United States, from the end of World War II to the end of the 1960s Texas absorbed most of the production cutbacks, and tolerated excess capacity that was often 75 percent of the total. Texas was about two-thirds of East-of-the-Rockies output, while Saudi Arabia accounts today for about one-fourth of OPEC production. It cannot yet serve as the backstop of the cartel, and let others produce as they wish. Suppose it had tried to do this in the middle of 1975, when OPEC excess capacity was equal to or a bit greater than Saudi capacity. Saudi output would then be zero, quite an intolerable result. But in the near future the Saudis will be able to occupy all the coastal states of the Persian Gulf. Then, in similar plight they would produce about 6 million barrels daily. With Iran producing more than 6 million barrels daily and with all fringe nations booming ahead to develop additional capacity, thereby promising attrition of even that 6 million barrels, would this be tolerable? I submit that even the Saudis do not know and rightly do not want to find out.

Let me turn now from the factors inside the cartel to those outside. The amount of excess capacity with which the cartel must cope depends on the speed with which noncartel production develops.

The noncartel reaction might at first be supposed very simple: these countries would act like simple price takers and expand output as fast and as far as possible, until its marginal cost is equal to the price.

This is the case in countries where the oil industry is nationalized. The Soviet Union, China, Mexico—these are expanding like rational if sometimes sluggish capitalists. But in most private enterprise countries, political forces have not permitted that simple response of output to higher prices. The economy as a whole would of course be benefited by any production whose total cost was less than the import price of equivalent energy. But the producing companies would get "too big a share" of that increased national income. Governments would rather prevent windfall gains then get the production response. Whether right or wrong, this policy prevails and its results must be allowed for. In the United States, oil prices are under control, thereby subsidizing consumption, inhibiting production, and promoting imports. Field price regulation of natural gas has done it for years. Expansion of low sulfur coal, particularly in the Rocky Mountain states, has been prevented largely by those states, both directly and through their congressional delegations. To some extent this is a matter of concern over the environment, to some extent a desire to share in the windfall gain; whatever the reason, the production response is prevented.

In Canada, higher prices led actually to large scale disinvestment: the provincial and national governments raised taxes enough to send scores of rigs migrating southward. The result was to decrease Canadian reserves, which in turn set off a further reaction, to restrict exports lest Canada run out of oil; this will diminish reserves still more. In the United Kingdom, the price explosion of 1973 led to a North Sea profits explosion which had two effects. One was a wild bidding up of factor prices. The other was a steep increase in taxation, which recently drew back short of taking all of the economic rents. The slippage in the North Sea has already been considerable, so that expected output in any given year of the near future will be considerably less than attainable, and there is also a considerable reluctance by private investors to explore and develop further.

It would be tedious to extend the list, but I draw the general conclusion, which is again that of a backward bending supply curve: past some point, higher price in the world market has led to less, not more, investment in the non-OPEC countries because other objectives have overborne the desire for increased national income.

I come now to the reaction of the consuming countries as such to the price increases of the cartel. There are several reasons why public opinion will tolerate and even defend actions which had they been done by private parties would have brought swift punishment. There is the Club of Rome syndrome, that we are quickly running out of everything, and hence the price increase is actually a good thing, enforcing a little more thrift upon us. There is also a feeling of guilt in the face of the poor nations of the world, a wish to make up to them. I do not see what good is done by making the poorest nations still more poor, but the guilt feeling persists in spite of the facts.

Moreover, the rapidly escalating imports of the OPEC nations—from $20 billion in 1972 to $100 billion estimated by Morgan Guaranty for 1976—are building up a powerful vested interest in the consuming countries. Thousands of people have jobs and some are getting rich selling OPEC goods and services.

The United States is the most important consuming nation. It is impossible to give any kind of statement of American policy. A mystery or void remains at its center. At its best, our policy is import reduction, with the aim, one supposes, of affecting the cartel by adding to excess capacity. But in 1974-75 the growth in excess capacity was greater and faster, hence with more shock effect, than anything the United States could accomplish. The cartel not only took the strain, but also kept raising prices. Also, "conservation" generally will not affect the world price unless used as a lever to disrupt the cartel, and no such act is now contemplated. We have deceived ourselves with only half-believed fantasies of self-sufficiency. The producing nations have taken the measure of the United States and fear us not.

The forthcoming conferences on energy and raw materials between consuming and producing nations will hear talk of interdependence. The oil exporting countries will be told they cannot prosper if their customers are in a depression—though the experience of the last two years shows this is false. If the industrial nations give investment guarantees to the OPEC nations with the largest foreign-exchange surpluses, that will be a disguised price increase. It will also strengthen the core at the expense of the fringe. A long-term deal to fix what Mr. Kissinger has called "a just price" seems less likely now, fortunately. A sovereign monopolist cannot be held to any agreement. A private firm or individual is constrained by competition, or law, or both. Anyone who welshes on a deal is either abandoned, as people go elsewhere to do business, or else a court orders him to keep his word or have his assets seized. But the cartel has suppressed competition and there is no law against the sovereign.

Summing up, I would say that the strong points are more impressive for the immediate future than the weaknesses, and that we must therefore expect to see a continued increase in prices. Admittedly, things may change, and swiftly. Even great success does not change the basically fragile nature of a cartel, which is the home of the self-fulfilling prophecy and the self-reinforcing trend. Saudi Arabia may be the restrictor of last resort, but they have swiftly built producing capacity which they cannot possibly use, even well into the 1980s. It is a hedge or more accurately a threat that, if anyone starts any price war, they will finish it. Cartel-watchers should pay attention to the role of the oil companies as the market-clearing instrument. Eventually some consuming nations may realize that the Iraq government, in the remark quoted earlier, states the cartel's greatest fear: "Competitive bidding among producers." But that is another story.