OPEC & Capacity (Part 3)

My last post quoted OPEC's stated objective. Let's look at the first sentence of the objective:

"...coordinate...oil production policies in order to stabilise the oil market and to help oil producers [i.e., countries exporting oil] achieve a reasonable rate of return on their investments."

This is basically the definition of a cartel, but let's look at a more formal definition. From Wikipedia, we read:

"A cartel is a formal (explicit) agreement among firms.... Cartel members may agree on such matters as price fixing, total industry output, [or] market shares...The aim of such collusion is to increase individual member's profits by reducing competition."

(Notice that the definition assumes the participants are firms or companies rather than countries. Monopolies and cartels are usually associated with large firms, but we will see that the same definition can include countries as well as firms.)

Within most countries, anti-trust laws forbid companies from forming cartels or colluding to fix prices. In the U.S., this is why most high profile mergers must be approved by the Federal Trade Commission. The FTC examines market conditions to ensure that the proposed entity would not control the U.S. market.

With OPEC, however, we are not talking about companies, but rather sovereign governments that can do whatever they want. The U.S. cannot pass a law to prevent one foreign country from forming an alliance with another country. Therefore, the U.S. has no direct power over OPEC.

So on the surface, it would appear that we have little hope of preventing OPEC from keeping prices high. It turns out, however, that it is much more likely for a cartel to do a poor job at cooperating than it is for it to effectively control prices. This is because each member of the cartel has an incentive to cheat.

In the case of OPEC, it must control its production output in order to keep supplies down and prices up. To do so, OPEC has traditionally assigned a quota to each member country. Since the OPEC countries are so dependent upon oil revenues, each wants to make sure its quota is as large as possible; so they haggle over why their own country should receive a higher quota than what the other countries want them to have. Once the quotas are assigned, each has an incentive to cheat and exceed their quota. The logic goes like this: "The OPEC quota is limiting total output and maintaining the price level. My government really needs additional revenues to meet its obligations, and at these prices, I could make a lot more money if I produced just a little in excess of my quota. An extra 100,000 barrels a day won't make a difference..." This, in essence, is the thought process of each country, so they all produce "just a little" too much, and as a result, there ends up being enough supply that prices don't rise to the level they are targeting.

The foregoing describes OPEC as it has existed for most of its history -- a dysfunctional cartel that tries, but largely fails, to control prices. As a result, the world has benefitted from cheap oil for many, many years. It has generally required something more ideological than price control to unify them to the point of efficacy. The first such uniting event came in October 1973 during the Arab Oil Embargo.

The Arab countries were incensed by the West's support of Israel in the Yom-Kippur war, and announced they they would no longer ship oil to the United States, the Netherlands, and later, most other western countries. For the rest of the 1970's, OPEC countries demanded, and received addtional revenues from the oil found within their borders.

In short, the balance of power in the oil market shifted from the "Seven Sisters" to sovereign governments. Eventually many of the OPEC countries negotiated settlements with the international oil companies, and paid them to go away, gaining control of the fields. ARAMCO is a perfect example:

The California-Arabian Oil Company (predecessor company of ARAMCO) was founded in the 1930's by the predecessor companies of Chevron and Texaco. The company was granted access to explore for oil by the Saudi governement. In 1938, the company made its first discovery. In the 1940's, the predecessor to Exxon bought in as an additional investor, and the name was changed to the Arabian American Oil Company (ARAMCO). In 1950, the king of Saudi Arabia threatened to nationalize the company if it did not agree to share its profits 50/50 with the government. (The king followed the example of Venezuela where same thing happened a few years earlier.) The companies were forced to concede, and thus the contract was changed. In 1973, the Saudi government acquired 25% of ARAMCO, increased this to 60% in 1974, and by 1980, had acquired 100% of the company, forcing the international oil companies out. Today, the company is now called "Saudi ARAMCO," which is a bit ironic, considering the underlying meaning of the acronym.

The volume of discoveries in OPEC countries dropped dramatically and immediately following the "buyouts" of the international oil companies, and has never recovered. Due to excess capacity, the national oil companies (NOCs) of OPEC nations had no incentive to explore. Why explore when they already had too much?

The graph below shows worldwide disoveries over time in millions of barrels, split into volumes found in OPEC nations (darker bars on top) and non-OPEC nations (light bars on bottom). There is a dotted vertical line indicating the year 1980, the year in which Saudi Arabia completed its takeover of ARAMCO. Visually, note the abrupt change in OPEC discoveries from pre-1980 to post-1980. It would be difficult to believe that this step change was a result of natural phenomena, rather than a result of the international oil companies' loss of access to the region.

OPEC & Capacity (Part 2)

My last post introduces the concept of spare capacity, which is the ability to produce more at a given time than is demanded. More detail is in order.

A certain amount of spare capacity is desirable, indeed, necessary for the orderly functioning of any production process. Take the U.S. job market, for instance. Although the exact figure is a matter of debate, economists consider a society to be fully employed when the unemployment is in fact greater than zero -- at some level between 3-5% or more (called frictional unemployment, where workers are temporarily between jobs in order to maximize benefit). There is actually a tradeoff between the rate of inflation and the level of unemployment. If an economy experiences a sustained unemployment rate of only 2%, inflation will increase as companies offer higher and higher wages to attract people. Rising wages lead to higher costs and higher prices until workers demand even higher wages, perpetuating the cycle. At some level or "ideal unemployment rate" wages and costs are for the most part balanced and inflation remains under control.

On the flip side, a slowing economy leads consumers and businesses to cut back on purcahses. Decreases in sales lead to cost cutting, which eventually means layoffs. When fewer people are employed, they consume less and the downward spiral continues. The job market and the economy go through this cycle over and over, vascillating between an expanding economy (low unemployment) and a slowing economy (higher unemployment).

Let's take this example to the extreme. Say the U.S. suddenly made a dramatic change to immigration or foreign worker policy, and overnight the workforce increased 10% due to the influx of foreign workers. These workers would accept jobs at a much lower wage than that currently received by incumbant workers. Immediately, wages would fall as workers were fired in favor of the newly available and cheaper labor, or as a result of incumbants accepting lower wages in order to avoid being laid off.

This is a situation analogous to what happened as the mega fields of the Middle East and Venezuela were brought online. If production was not controlled, oil prices would fall as a glut of supply was created. Of course, any single producer would continue to maximize profits by producing as much as they could, so the result was cheap oil. When oil was cheap, there was very little incentive to be efficient consumers. Americans drove large cars with big engines that delivered a lot of power, but not a lot of miles per gallon.

At first, a country experiencing the bonanza of newly obtained oil revenue would just be happy to see the additional money come in. Eventually, however, the mineral owners (in this case, sovereign goverments) become more sophisticated, and realize that this source of funds will not continue forever. The OPEC countries (before they were OPEC) understood that they were selling a diminishing resource for cheap, while paying a higher price for other finished goods--some of them the end products of oil--originating in the oil consuming nations.

The realization that they were selling low and buying high created a desire to take more control of their own destiny and their limited resource. Various political events created a convenient environment for cooperation between the OPEC countries, and eventually they formed an alliance.

The OPEC website (opec.org) states that the organization was created in Bagdad on September 10-14, 1960, by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. OPEC's stated objective is to "coordinate...oil production policies in order to stabilise the oil market and to help oil producers [i.e., countries exporting oil] achieve a reasonable rate of return on their investments." In simpler terms, OPEC's objective is to ensure its member countries' oil is not sold at a price tantamount to giving it away.

(Continued in Part 3)

OPEC & Capacity (Part 1)

I've been in Philly this week attending a course at Wharton. At the moment, I'm stuck in the Philadelphia airport with a long delay, so it appears I have some time to write.

I shared a cab from my hotel to the airport with a gentleman who happened to be going at the same time -- a professor emeritus in political science from the University of Arizona, who now lives in California. We got chatting about gas prices, so I told him that I had just started this blog and he said he'd check it out.

I'm going to start with a narrative, with few specifics, in order to simply set the stage. Over time (weeks, months?), I'll add more details, references, and data, but let's start with the basics. (There will certainly be oversimplifications in the following, but otherwise we'll include too much detail to make sense of it for now.)

First, let's talk about the underlying reason that OPEC came to exist. An accurate history would include a lot of politics, but fundamentally, the creation of OPEC was all about economics.

Decades ago as the international oil companies (IOCs) scoured the globe for oil, they identified a lot of potential in the countries that today make up OPEC. The most important of the IOCs were often called the "Seven Sisters." Today these companies would be known as Exxon, Mobil, Shell, BP, Gulf, Texaco, Chevron, and Total, but most went by a different name at the time. The IOCs signed agreements with foreign governments which granted them access over a certain period of time to explore for oil. The agreements also provided a rough framework for subsequent development plans for any fields discovered.

Of course, the IOCs, were in competition with one another, so they each strove to find more and more oil, secure supplies, and beat the competition. Along the way, they found some of the largest oil fields ever discovered in places like Saudi Arabia, Kuwait, Iran, Iraq, and Venezuela, which were the eventual founding members of OPEC. As the IOCs began to develop these massive discoveries, it was soon apparent that the fields could not all be produced at maximum capacity without creating a glut of supply that could not be matched by the then current world demand. At any given time, carelessly opening up a few valves would flood the market with oil for which there was no market.

Saying this another way, the addition of these highly productive fields to world supply created excess capacity. Excess capacity is at the heart of oil price history and of OPEC itself. I'll continue with this discussion in part 2 of OPEC and Capacity in my next entry.

For a more detailed history of OPEC, see http://www.opec.org/aboutus/history/history.htm Reading this may distract you from my simplified narrative, but at least you know where you can go for more info. You can also consult Wikipedia.

A Thoughtful and Rational Journalist

This morning as I was getting ready for the day in my hotel room I heard some comments from a journalist that amazed me, and this time in a positive way.

John Stossel (of ABC's 20/20 fame) was asked what he thought about oil prices. He responded that energy policy is being dictated exactly as it should be -- from market signals. He answered several other questions that are normally not expressed as questions but rather as accusations hurled toward "big oil" that suggested a thoughtful view of what was behind rising oil prices. Over the years, I have been attracted to Mr. Stossel's practical and fair view of the world, his 20/20 series being typical. I'm sure I haven't always agreed with him, but I would say that he is a journalist that honestly tries to make sense of the world rather than finding extreme or rare cases which disprove that free people and free markets are generally rational.

To comment more on his appearance today, I would need to find a re-broadcast of the discussion online, which I may do sometime, but for now I can only tell you what my impressions were. In short, I believe he is a journalist that for the most part can be trusted to help us find at least some part of the truth among a cacaphony of misinformation.

Just one more quick comment: In my opinion economist and actor, Ben Stein (the "boring teacher" in Ferris Beuhler's Day Off), is another voice of reason on such issues.

Bill O'Reilly's Blame Misplaced

Just like almost every other media figure, Bill O'Reilly is blaming the "greed" of big oil for the nation's energy prices.

In my previous post, I mentioned that the principles behind our energy problems do not require an advanced degree. However, this does not mean that the problem is so simple that we can just jump to conclusions and blame oil companies. Economics, international and domestic politics, business and consumer incentives, the investment cycle, nature (geology), and current engineering and technology limitations all contribute to the energy issue.

It is far too simplistic to demonize the industry that provides the fuel upon which we all depend. I will not be able to address all the factors listed above in a single post, but I will try to discuss each aspect as I continue to write.

Bottom line, I'm disappointed at what little thought is put into media programs before the hosts share their uneducated opinions as fact.

Enough

Enough is enough. I have finally reached the point at which I feel the obligation speak up.

The media and politicians monopolize the energy discussion. I'll give them the benefit of the doubt that they are only unintentially spreading misinformation about energy. However, even if unintentional, the fact is that they speak out of ignorance and pass along bad information to the public. These are not the people that who should be leading the discussion.

Understanding the energy debate does not take an advanced degree. There are some simple principles involved, some scientific, some economic, some political, that explain most of the issues behind the situation we find ourselves in.

It is my intention to discuss energy topics in terms that I'm convinced anyone can understand. If I can help a few people who stumble across this blog make more sense of what's behind the energy debate, then I think it will have been worth it.