Discussion on “OPEC Production Cut Surprises the Market” by Stanley Reed (Business Week, September 2008)

Stanley Reed’s “OPEC Production Cut Surprises the Market” discusses OPEC and its decision to reduce production of oil in September 2008, eliminating 520,000 barrels a day from the oil market.  Regarded as one of the most prominent oligopolies, OPEC or the Organization of Petroleum Exporting Countries consists of 12 countries including Algeria, Angola, Ecuador, Iran Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.  It is referred to as a cartel, which means a “group of producers that attempts to restrict output in order to raise prices above the competitive level (par. 6).”  Within OPEC, Saudi Arabia is the largest producer of oil and the most influential country in the group, meaning that the have the greatest ability to effect output.  OPEC has all the key components of an oligopoly has we discussed in class—there are 12 different countries working together and all sell the same undifferentiated product.  In addition, the capital required to extract oil is extremely expensive, providing substantial barriers to entry into the oil market.  These countries work together to provide the optimal pricing strategy and maximize profit but must be aware of the demand for oil in setting output and prices.

The most glaring act of collusion from OPEC dates back to the oil embargo in the early 1970s and the resulting quadrupling of the price of oil. This embargo showed just how powerful a natural resource could be and that it could strategically be used as leverage in any political or economic situations that arose. Recently, however, OPEC has used that power to establish a cartel role primarily via its adoption of output rationing, which subsequently has profound effects on the price of crude oil by the barrel.

It is important to note that OPEC is not an exact price setter; rather, its decisions related to output influence price movements and keep the price within a range member countries are content with. OPEC is able to do this because of its tremendous supply of oil: member countries own 77% of proven world oil reserves and produce about 40% of the world’s oil supply, with their exports accounting for over 50% of the total oil export[1]. This ability to control price is the chief source of contention that OPEC fails to conduct its business in an ethical manner.

The purpose of forming a cartel is to utilize market power to drive prices higher than they would be under operating market conditions with the ultimate intent of gaining profits. OPEC achieves this through cutting production, as described in the article. The extent of the ethics lies in the degree to which OPEC abuses this power. Less production will result in higher prices, meaning greater gains and higher remaining oil supplies for members. This is what occurred in 2008-2009 as countries sought a return to high prices. Still, OPEC (and particularly Saudi Arabia, the most influential player of the group) has done the opposite in the past out of concern for long-run demand. This results in benefits for both firms and consumers, which isn’t completely expected from a colluding enterprise. Lower prices do a number of things: they shift profits from the short-run to the long-run for suppliers; the consumer base is more content with the value they receive per unit of spending; and in a forward-looking sense, they keep consumer nations away either conserving or from allocating large capital amounts to developing alternative energies that are not reliant on foreign trade. This is likely to be unpopular with citizens of member countries because the recognition of large profits is delayed into the future.

OPEC’s mission wishes to “ensure the stabilization 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 attempt to balance these factors appears to be the driving force behind production increases or decreases, not an abuse of market power. The current price of oil stands at under $103 per barrel, a rate nearly equal to that mentioned in the article and close to the minimum level OPEC nations would be willing to drop to. Additionally, OPEC average production from February to March, 2012 increased by over 100,000 barrels per day[2]. This current position gives the impression that OPEC is operating in a fair manner to date.

Another good example of a real world oligopoly is the soft drink industry.  The industry is dominated by a few large suppliers (Coke, Pepsi, and Cadbury-Schweppes). It is protected by high barriers to entry (i.e. the startup cost of what it would take to develop a company that can produce and distribute mass quantities of soft drinks).  Additionally, all of the companies charge essentially the same price for their products, as the products are all substitutes.  If you go into a store and buy a 20-ounce bottle of Coke and a 20-ounce bottle of Pepsi, for the most part they will cost the same.  The prices remain rather consistent as well.  You don’t see the prices of soft drinks fluctuating very much at all. Clearly, there are more than a few real-life applications of oligopoly, from the oil industry to the soft drink and beer industry, which can be analyzed by economists in terms of pricing strategies and market behavior.

Posted by Carlos, Peter and Tori (Section 2)

[1] IBISWorld Industry Report—Global Oil & Gas Exploration & Production; Feb 2012

[2] http://www.telegraphindia.com/1120408/jsp/business/story_15347411.jsp#.T4z-Ac1094U


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