Does the Market Need OPEC/OPEC+?

Does the global oil market need management? Why or why not? What will happen if OPEC/OPEC+ are dissolved?

This article was posted in late 2023 but remains relevant today. The above is form an old paper that proves that OPEC is not a cartel.

The oil industry, just like any other extractive industry, is capital intensive with its costs mostly being sunk cost, while the operating cost is relatively small.  During a period of an economic downturn and very low oil prices, producers focus on the operating cost. They continue to produce despite the hefty losses. As history shows us, the result is cut-throat competition and a waste of the world’s scarce resources.

Extreme Volatility Hurts Producers and Consumers

High oil price volatility hurts both oil producers and consumers. It reduces global economic growth— which is the source of oil demand growth— and job growth and increases unemployment rates in oil-consuming countries. With high price volatility, industries, and various service companies cannot efficiently plan their expansions. They cannot even achieve the optimal allocation of their budgets and resources.  Therefore, high oil price volatility leads to a waste of resources, higher costs, and a deterioration of efficiencies in oil production and consumption.   

Historical evidence since the commercialization of the oil industry in 1859 indicates that the cost of high price volatility is very high for both producers and consumers.  It also shows that the two always want to reduce volatility and achieve some sort of price stability in the oil market. 

The history of the oil industry reveals that oil prices experienced several periods of high volatility and relative stability.  Relative stability was achieved only when the oil market was managed in one way or another.  

Figure (1) below illustrates this fact by showing nominal and real prices stable during periods of market management, while volatile when markets were not managed. The increased volatility during the OPEC era is explained below and the main takeaway is that without some management from OPEC members, the market would have significantly been more volatile.  We disagree with claims that volatility increased during the OPEC era because of the role played by the group.

The Objective of Market Management: Historical Evidence

It was the discovery of a process to extract Kerosene from crude oil that made oil commercially valuable in 1859. It replaced whale oil that was widely used for illumination; an action that almost led to whale extinction. Oil prices were extremely volatile until John Rockefeller’s Standard Oil brought order to the industry, stabilized the market, reduced wastage and costs, and improved production efficiency. These benefits were the result of market management!

The irony is that policymakers’ ultimate goal was to achieve the above-mentioned benefits! While they shared the same objectives with Rockefeller, they thought his monopoly of the oil market was so powerful that they used federal antitrust laws to break up Standard Oil in 1911 into more than 30 companies. But this made Rockefeller richer: the value of the sum of the parts was significantly higher than the value of the whole!

Breaking Standard Oil into smaller companies meant competition among them (it took several years until these companies became truly independent of each other).  Meanwhile, large oil discoveries by various competitors of Standard Oil continued around the world. Extreme volatility returned, along with an increase in waste of resources, deterioration of efficiency, and higher costs. These developments forced policymakers in oil-producing US states such as Louisiana, Oklahoma, and Texas to intervene to ration oil production with the support of the Federal government.  When legal efforts failed, they used the National Guard to shut in production. Yes, they used force to ration the production of privately-held companies!

In Texas, policymakers gave the Texas Railroad Commission the authority to monitor and manage production. It was able to control production after the Texas National Guard occupied the oil fields in East Texas.

What did Rockefeller want from oil market management? He wanted to:

1. Reduce price volatility

2. Eliminate wastage of resources

3. Improve efficiency

4. Reduce costs

Rockefeller wanted to achieve all the above while generating massive profits from such actions. The Federal government and oil-producing states, such as Texas, wanted to do exactly the same, especially since higher production and lower prices lowered state tax revenues! Policymakers decided to do the job of Rockefeller and for the same exact goals. They were managing the market!

Private companies could not manage the oil market within the US because of antimonopoly regulations, so government entities assumed that position legally and managed the market. 

Since US antimonopoly laws, mainly the Sherman Act, do not apply outside US borders, international oil companies, some of which were descendants of Standard Oil, decided to collude and manage the market. It started with three companies, but ended up with the Seven Sisters! They expanded their market control and management horizontally and vertically.  With the Texas Railroad Commission and other commissions in Oklahoma and Louisiana within US borders, and the Seven Sisters outside the US, the entire global oil market was tightly managed. They reduced volatility, eliminated wastage, improved efficiency, and lowered costs!  All while generating massive revenues and profits!  

Wave of Nationalization

It is ironic that this tight control of the oil market led to its own demise.  On the one hand, the massive profits that the international oil companies raked in, lured smaller oil companies which offered better terms for the host governments or tribal Sheiks in the Arab Gulf region. On the other hand, the control of foreign companies created local opposition that included movements inspired by communism.  The Seven Sisters exploited the grievances of local populations to advance their own interests.

Oil-producing countries, such as Iraq for instance, associated the control of the Seven Sisters of their own national oil resources with colonialism and imperialism, especially amid the growing influence of socialist and nationalist ideas in developing countries. As international oil companies grew weaker, some oil-producing countries resorted to nationalization or the gradual purchase of the companies’ assets.

Nationalization started in Mexico in 1938 and was followed by Iran in 1951, and Iraq in 1961— but the country nationalized the rest of the sector in 1972. Libya’s first shot at nationalization started in 1971 and it continued to nationalize the rest of the sector in 1973 and 1974. Several other countries around the world also nationalized their oil sectors, including Bolivia, Venezuela, Peru, Egypt, and Indonesia. The Arab Gulf states resorted to a different type of control: sharing and buying until they got complete control instead of outright nationalization. 

Welcome to OPEC!

OPEC was established in September 1960, but most of its resources were under the control of international companies, and some countries were occupied by European powers. Therefore, the creation of OPEC did not change the market dynamics in the 1960s. OPEC was created by five members: Saudi Arabia, Kuwait, Iraq, Iran, and Venezuela to ELIMINATE their dependence on oil revenues. To do so, they needed revenues to transform their economies through sustainable development. This required “fair” prices for the oil resources.  To get “fair” prices, they needed to manage the markets by frequently adjusting supplies to match demand.  In other words, they did not want to see a surplus in the market— similar to the thinking of Rockefeller, the Railroad Commission of Texas, and the Seven Sisters. The problem was that most of them had no control over their resources which were held by the Seven Sisters. Hence, there were no production quotas, and no ability to match supply and demand at all times.  

The continuous increase in US oil demand accompanied by a slowing growth in US oil production resulted in companies producing at full capacity, therefore eliminating the need for the production control of the Railroad Commission of Texas.

As the US produced oil at maximum capacity, and the role of the Texas Railroad Commission ended, the Seven Sisters lost their power because of nationalization on the one hand, and competition from smaller companies on the other. The US government replaced the old system with a communist idea: full-price controls of energy sources!  Now the US Federal government became the oil market manager.

At that time, OPEC did not have a quota system, some countries had nationalized their oil resources, while others were still struggling with international oil companies.  But the US government made a move that energized the leaders of OPEC: it floated the US dollar, the currency used to price oil in global oil markets. As the dollar declined relative to gold (or the value of the old dollar), oil-producing countries saw their real revenues plummet before their eyes. They debated various measures including ditching the US dollar in favor of other currencies, raising posted prices, and cutting production. 

OPEC producers ended up raising posted prices (the price companies use to pay taxes to host countries)  by 70% to compensate for the loss of revenues from a declining dollar. Many Arab countries decided to impose an embargo on the US that involved cutting production for its military support to Israel during the 1973 October War (Arabs call it the Ramadan War while Israelis call it the Yom Kippur War. It started on October 6 and ended on October 25).

Several observers and media outlets have attributed the four-fold increase in prices to OPEC’s oil embargo.  That is not correct since OPEC, including Iran, adopted the proposal of Iran’s Shah to raise posted prices just before the embargo.  In addition, energy shortages were present in the US during the two years prior to the embargo. In fact, most of the photos that continue to be circulated nowadays about “gasoline shortages” and “gasoline lines” and which are associated in some media reports with the embargo, are in fact from the period that preceded the embargo.  The fact that prices were sustained at high levels after the embargo ended while production was restored, shows that the price increases were not influenced by the embargo.

OPEC remained powerless, without a clear direction or a quota system. But it received massive media coverage. 

After the embargo, the International Energy Agency (IEA) was established, followed by the US Department of Energy and its statistical arm, the Energy Information Administration (EIA), and the Strategic Petroleum Reserve (SPR).  New market managers and oil market management tools were introduced to the market, but now by consuming governments. Add to that the various energy and environmental regulations and taxes that were applied.

Strangely enough, the US abandoned the costly price controls, and liberalized energy markets in the early 1980s.  This meant that the US had relegated market management, by default, to OPEC which was not ready for the role!  OPEC had no quota system and no mechanism to manage the market at that time— not even political clout. The oil market collapsed in the mid-1980s, as a result. Extreme volatility returned with vengeance.  

OPEC's efforts to manage and stabilize the oil market started in the early 1980s with the establishment of the quota system— 20 years after the group’s establishment. OPEC’s efforts failed as it experimented with its new role in the market, while oil prices maintained a downward trend.  The group continued to experiment with the quota system until it perfected it on paper, but the problem was implementing it on the ground.  The failure of OPEC, along with other reasons, gave rise to the role of Saudi Arabia as the world’s swing producer and market manager, a role that required cooperation with some OPEC members, mostly in the Arab Gulf region, by keeping and utilizing spare capacity and reducing extreme volatility.  As time passed by, it was apparent that the role of some non-OPEC members was important, and this later led to the OPEC+ agreement in 2016. 

OPEC’s inability to stabilize the market in the same way Rockefeller, the Texas Railroad Commission, the Seven Sisters, and the US government did, can be easily explained by a few facts we list below:

1. The OPEC quota focused only on crude oil production, while Rockefeller and the Seven Sisters controlled the industry through vertical and horizontal integration.  They controlled everything to the pumps at gas stations, including the deployment of technology.

2. OPEC has no legal power over its members and no enforcement mechanism. The Texas Railroad Commission and the states that used the Armed National Guard to control privately owned oil fields used legal power and courts to enforce regulations.  US price controls were backed by US laws and the court system. 

3. The failure of OPEC in the 1980s was exacerbated by the fact that higher prices in the 1970s brought more than 5 million b/d online from Alaska and the North Sea—both areas outside OPEC.  In addition, industrial countries adopted policies that shifted the electricity sector from oil to coal and nuclear energy, while various other measures reduced energy consumption, especially in the transportation sector.

While no one can deny the fact that OPEC was NOT able to manage the market like others, evidence points out the role of Saudi Arabia, sometimes with allies, as a market power that can eliminate EXTREME volatility and which helped tame prices during periods of war and shortages, and supported prices during an economic downturn and recession.

By 2015, it was clear that OPEC was losing its clout, despite Saudi efforts, simply because of major production outside OPEC, specifically in Russia and the US.  The US shale revolution changed energy markets forever, while the increase in Russian production forced OPEC members to pivot to the East as economies in that region grew rapidly.  It was clear that OPEC needed an upgrade. In 2016, after tense negotiations, OPEC+ was formed, a coalition of OPEC 13 members in addition to 10 non-OPEC members led by Russia.  

Now, it was clear that reducing volatility was essential to reduce animosity to oil considering various environmental regulations, climate change policies, and the penetration of electric vehicles.  To maintain market share in the long run, stability was needed. Therefore, the cooperation between OPEC and non-OPEC oil producers, and the efforts to maintain production cuts despite the rise in US shale production, should not be viewed as actions aimed at only raising oil prices, but should also be viewed as part of the efforts to eliminate extreme market volatility to prevent a decline in future global oil demand.

Looking at the oil market since the late 1970s, and despite OPEC as a group failing to manage the market, Saudi Arabia, along with some Gulf allies at times, succeeded in reducing extreme volatility.  The fact that the oil market is more volatile since the early 1980s when OPEC attempted to manage the market can be explained by three factors: First, OPEC/Saudi share is small relative to the share once controlled by the Texas Railroad Commission and the Seven Sisters. Second, the Seven Sisters were wholly integrated from exploration to the gasoline pump, while OPEC is focused only on crude oil production without coordination in exploration. Third, the Texas Railroad Commission and the Seven Sisters used various measures to penalize violators and cheaters. OPEC, in its turn, has never had such a punishment mechanism. 

In conclusion, oil industry participants have realized the economic and financial benefits to companies, countries, and societies from managing the oil market, although the weight of these benefits may vary from one place to another and from time to time. Even if we ignore the monopoly of oligopoly profits, the gains from lowering volatility, preventing wastage, improving efficiencies, and reducing costs are huge.

While Saudis Arabia and its allies cannot bring stability to the market as Standard Oil did along with the Texas Railroad Commission and the Seven Sisters, they still play a pivotal role in reducing or even eliminating extreme volatility.  The inability to stabilize the market as others did in the past stems from the fact that their market share is relatively small.  In other words, without the efforts of some OPEC members to stabilize the market, we would have seen higher volatility.

Heavy taxation of petroleum products in consuming countries is a form of market management to reduce reliance on oil on the one hand and shield the public from large fluctuations in oil prices. However, they cannot eliminate extreme volatility. We have recently seen how some European governments started removing taxes on fuel and providing subsidies to the public as oil prices rose.

The use of the US Strategic Petroleum Reserve (SPR) is also a form of market management, but it is a policy that cannot be repeated often. OPEC’s policies are more consistent over time relative to the politically motivated US SPR releases.

So, yes, the market needs management, and it needs some measures to be taken by OPEC+ to manage extreme volatility.   If OPEC or OPEC+ is dissolved, another oil group will be created in one way or another.  In fact, if OPEC is suspended, this would give rise to more intervention from consuming countries in the oil market to shield their economies from extreme volatility. This would be translated through restrictions on oil imports and exports, taxation, heavy regulation of the oil industry, and nationalization. 

As a final note, and regarding questions raised by some readers about the possibility of the US nationalizing the oil industry, or the government creating its national oil company,  our view is that this is possible if OPEC is dissolved and Saudi Arabia decides to stop playing the swing producer role.  For now, the world needs Saudi Arabia to maintain this role. Even former US President Donald Trump, who is known for his decades-long disdain of OPEC, asked Saudi Arabia during his tenure to increase production in the fourth quarter of 2018 as Washington reimposed sanctions on Iran.  The same president also asked Riyadh to cut oil production in April 2020 to raise oil prices and prevent a total collapse of the US oil industry. 

The global oil market currently needs OPEC or any form of management. EOA