The History of OPEC: Has it been a Success?
Vienna, Austria is home to some of the most picturesque buildings and monuments in Europe, but there is one very important building in the city center that you would be forgiven for missing. That's the OPEC headquarters. Although perhaps not the greatest tourist attraction in Vienna, the headquarters building gives off an aura of organization and unity. However, one could argue that the Organization of the Petroleum Exporting Countries is anything but.
OPEC's decision on 25 May to extend oil production cuts for a further 9 months in attempt to manipulate oil prices for the umpteenth time since its inception in 1960 has prompted us to take a look back at OPEC’s history of influencing global oil prices. But first, what exactly is OPEC?
What is OPEC?
The Organization of the Petroleum Exporting Countries, more commonly known simply as OPEC, is an intergovernmental organization that comprises 13 member countries that produce and export oil and other petroleum products. According to OPEC, as of 2015 the organization accounted for 81% of the world’s “proven” oil reserves. That’s 1213.4 billion barrels.
OPEC is often cited by economists as a classic example of a cartel. To some the word cartel has a negative connotation, as it is often associated with illegal drug cartels. But a cartel is simply a group of producers of some good or service that formally agree to regulate supply in an attempt to manipulate prices. Essentially, this group of otherwise independent actors, countries in the case of OPEC, acts together as if they were a single producer, cornering the market for their good or service to fix prices without the threat of competition.
Indeed, OPEC’s stated mission says it all, as they seek “to coordinate and unify the petroleum policies of its Member Countries and ensure the stabilization of oil markets in order 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 question is, has OPEC really been a successful organization? Based on their mission and the graph below, we will let you be the judge. But before jumping to any conclusions, let’s go through OPEC’s history to gain a little bit more insight.
Formation of OPEC – 1960s
In the 1950s and 1960s the world was going through a transitionary period of decolonization and new sovereign nations were coming into existence in the developing world. The global oil market was essentially controlled by seven private multinational companies known as the “Seven Sisters” that controlled over 85% of the world’s oil production. Many of the original Seven Sisters still exist today in one form or another:
- Anglo-Iranian Oil Company (modern-day BP)
- Gulf Oil (modern-day Chevron)
- Royal Dutch Shell
- Standard Oil of Southern California (now part of Chevron)
- Standard Oil Company of New Jersey (later known as Exxon, now part of ExxonMobil)
- Standard Oil Company of New York (later known as Mobil, now part of ExxonMobil)
- Texaco (now part of Chevron)
OPEC was born in September of 1960 at a conference in Baghdad with the five founding members being Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The organization's formation came about in response to a decision by the Seven Sisters to reduce the prices of the crude oil they supplied. As the Seven Sisters all originated from countries in the developed world, OPEC was ready to reclaim their oil resources from their former colonizers.
The Declaratory Statement of Petroleum Policy in Member Countries emphasized the “inalienable rights” of a country to “exercise permanent sovereignty over their natural resources in the interest of national development.” This marked a turning point in the national sovereignty of countries over their natural resources.
Headquarters were set up in Geneva, Switzerland, but were moved to Vienna, Austria in 1965. By the end of the decade, 5 more members joined: Qatar, Indonesia, United Arab Emirates and Algeria. It wasn't too long before OPEC began to play a prominent role in global oil markets and international relations.
OPEC's Rise to Power - 1970s
OPEC’s rise to power and prominence in global oil markets as well as international relations occured during the 1970s. With OPEC’s emphasis on exercising national sovereignty over natural resources, member countries took control of their domestic petroleum industries and together began to have a major say in the pricing of oil in global oil markets.
The first opportunity for OPEC to flex its collective muscle came with the outbreak of the Arab-Israeli war of 1973. When Egypt invaded Israel to start the war, OPEC took the decision to place an embargo on the United States and its allies that supported Israel. Known as the 1973 Arab Oil Embargo, it is often referred to as “the first oil shock.” Prices quadrupled from USD 3 per barrel to nearly USD 12 globally from September 1973 until March 1974 when the embargo was finally lifted.
After the embargo, it was decided by OPEC that instead of driving prices up, which discourages consumption and encourages investment in alternative sources, it would be best to adopt a strategy that works to stabilize prices. This would guarantee a regular supply of oil to consumers, but also a steady stream of income to the producers. Ironically, this strategy seemed to go out the window starting in 1979 as oil prices skyrocketed and later collapsed like a house of cards in the mid-80s.
Although the 1979 Energy Crisis was not of OPEC’s doing, it certainly benefited most members of OPEC. Oil production in Iran halted during the Iranian Revolution in 1979 and the outbreak of the Iran-Iraq war that followed the next year. Sometimes referred to as the “second oil shock,” the 1979 Energy Crisis actually only decreased global oil supply by around 4%, as other OPEC members increased supply to benefit from the skyrocketing prices. However, widespread panic in markets seemed to be the real catalyst for the price increase. The price of oil doubled to about USD 40 per barrel during this time period, a level that was not to be exceeded for another 10 years.
Price Wars and Price Plunges - 1980s
After skyrocketing with the outbreak of the Iran-Iraq war, prices eroded gradually due to a combination of a global oil glut as oil exploration in non-OPEC countries increased, falling demand due to decreased economic activity in industrialized nations and energy conservation in response to astronomical gas prices.
As oil prices began to fall, OPEC kept oil production low in an attempt to keep prices up. However, with production so low, non-OPEC oil countries usurped OPEC and their market share dropped to below one-third of global production.
In 1983, in an attempt to regain their lost market share, OPEC introduced oil price cuts for the first time to bring prices for Saudi Light crude in line with the global market price. This was when OPEC really began to look like a price setting cartel.
At this time, OPEC also introduced production quotas as well as a production ceiling for all OPEC members. Saudi Arabia was the only exception as they decided to be the swing producer, varying output to match market conditions. The production quotas proved hard to enforce, as many OPEC members were unhappy with their quotas and cheated or decided to completely ignore the production quotas agreed upon.
By 1985, Saudi Arabia was fed up with their role as swing producer while other OPEC members continued to cheat on their production quotas. It was at this point that Saudi Arabia decided to punish other OPEC members and began producing at full capacity.
The result of Saudi Arabia’s increased production coupled with an increase in production from non-OPEC members elsewhere, such as the North Sea and Alaska, was a massive oil glut. Oil prices plunged to as low as USD 7 per barrel in 1986.
At this point the group finally abandoned its production quotas and price setting scheme. A new production quota system was developed after studies were done on how to create a formula for setting quotas equitable for all OPEC members. A Reference Basket for pricing was also set.
Stable and then Not-So-Stable - 1990s
The new production quota system seemed to succeed where the previous one had failed. Prices began to creep up during the rest of the decade to around USD 20 per barrel. The brief 1990 oil shock in response to the Iraq invasion of fellow OPEC member country Kuwait sent oil prices sky high once again to the USD 40 barrier not seen since the 1979 Energy Crisis. However, according to OPEC “timely OPEC action reduced the market impact of Middle East hostilities in 1990–91.” The price did indeed come back down to earth not too long later and stabilized at around the USD 20 per barrel level for the majority of the decade until the late 1990s.
In 1997, the Asian Financial Crisis, also known as the Asian Contagion, hit South-East Asian countries hard as a series of currency devaluations, starting in Thailand, snowballed into a full-blown crisis spreading into many other countries in in the region. This caused declines in stock markets, reduced import revenues and stirred government turmoil.
OPEC inexplicably decided to increase their production ceiling by 10%, which completely misjudged the market. They did not take into account the Asian Financial Crisis, which resulted in lower demand for oil. As a result oil prices plummeted to the single digits, with Brent Crude Oil prices falling below USD 10 per barrel toward the end of 1998 and into 1999.
OPEC then decided to cut oil production two times in 1998, however, the cuts failed to halt the slide in prices. A third round of cuts was needed in 1999, this time in collaboration with Norway and Mexico, to stabilize prices.
The Ascencion - 2000s
Prices eventually recovered and OPEC announced a new “price band mechanism” in March of 2000. This was designed to essentially keep oil within a range of USD 22 to USD 28. If the prices for a reference basket of crude oil fell below the lower-end of the range, OPEC would automatically increase production and if it passed the higher-end they would automatically decrease production. This seemed like a fairly prudent system to implement, but the price band mechanism was unceremoniously and quietly done away with in 2005. Since then OPEC is more tight-lipped on specifying prices.
From 2003 onwards, rising demand from Asia, especially China, led oil prices on a rapid upward trajectory breaking the USD 100 per barrel barrier in 2008 and finally topping out at almost USD 150 in July of the same year.
After prices passed USD 100 per barrel, Saudi Arabia called an emergency OPEC meeting to discuss the skyrocketing prices as it was concerned that the high prices could derail the world economy and bring demand crashing down with it. Saudi Arabia basically agreed to pump as much oil as consumers were demanding.
Ironically, the beginning of the Global Financial Crisis hit oil markets not too long later in 2008 and the price of oil plummeted down toward the USD 30 price level. In response OPEC announced a record output cut. After the output cut, prices traded between 2008 and 2011 somewhere in the USD 70 – USD 85 per barrel range.
Prices Plunge Before the OPEC Deal - 2010s
In 2011 discontent began to surface among the OPEC members. Prices began to rise, and a failed meeting to increase output was declared by Saudi Arabia Oil Minister, Ali Al-Naimi as “one of the worst meetings we have ever had.” In December of that year OPEC abandoned its production quota system.
Prices held at high levels through to mid-2014 when new supply coming from U.S. shale producers brought oil prices down. OPEC members again could not agree, this time on oil production cuts, and instead decided to fight for market share. Saudi Arabia especially began producing at record levels in an attempt to bring prices down to a level that would make higher-cost U.S. shale production unprofitable. U.S. shale production did indeed drop, however, the slowdown in China hit demand bringing prices down more than had been anticipated finally bottoming out at a 14-year low of USD 22.5 per barrel in January of 2016.
In February, Saudi Arabia Oil Minister Al-Naimi announced plans for a potential production freeze. After months of speculation, which brought prices up slightly, OPEC finally agreed on production cuts in late 2016 for the first time in nearly 8 years.
There was reluctance among some members to agree to cuts. Besides the ubiquitous mistrust between members of OPEC, one reason was that an increase in prices may bring U.S. shale producers back online and offset the cuts. Although the OPEC deal aided an increase in oil prices, as feared U.S. shale production ramped up and prices have come back down as the global oil glut has persisted.
With prices not increasing as hoped with the OPEC deal, OPEC ministers met on 25 May 2017 to extend output cuts a further nine months in the hopes that demand will eventually outstrip supply despite higher U.S. shale production. However, some have their doubts this strategy will work.
Has OPEC Been a Success?
Looking back at OPEC’s history, one would be hard pressed to say that OPEC has been an overwhelming success. Although they have many of the world’s largest oil producers on the books, they have failed to get ahold of the global oil market and stabilize prices, as is there stated mission. OPEC infighting has been part of the problem as well as their inability over the years to stay disciplined and adhere to agreements made.
OPEC as a cartel has therefore left much to be desired. Some have even gone so far as to say that the end of OPEC is near. According to studies by Margaret Levenstein and Valerie Suslow, the average life of a cartel since the 20th century has been 3.7 to 7.5 years. If this extension of the OPEC deal does not do the job, could it indeed be the end of OPEC? We’ll have to wait and see.
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Date: May 26, 2017
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