Ecarnomics of OPEC: What Is It, and Why Should I Care?
At the beginning of 2014, the world price for a barrel of light sweet crude oil hovered around $100 USD/barrel. Within a year, the price of that same barrel of oil had collapsed to around $50 USD. In January of this year, the price oil hit a low of $28.50 USD, less than a fifth of what it was 9 years ago. Why did this happen? If you’ve been paying attention to the world markets, you’ve probably heard experts mention OPEC in the discussion of world oil prices; and for good reason.
OPEC stands for the Organization of Petroleum Exporting Countries. It is an intergovernmental organization comprised of 14 countries (as of 2016) which are responsible for three quarters of the world’s proven oil reserves. It was founded in 1960 and originally consisted of Venezuela, Iraq, Iran, Kuwait, and Saudi Arabia.
Because the OPEC nations have control over the majority of the world’s oil reserves, they have considerable power in the world market for oil. What do they do with this power? Depends on who you ask, of course. OPEC says that their mission is to provide stability to the oil market which, in turn, benefits consumers, producers and investors. If you were to ask a businessperson, however, they would probably tell you that OPEC is what’s known as a cartel.
In order to explain what a cartel does, here’s some basic economics. Let’s consider two parties: producers, and consumers. Consumers are willing to buy certain quantities of oil for certain prices. The higher the price, the less oil is purchased, and vice versa. We can show the consumer’s willingness to pay for a barrel of oil as a downward-sloping curve (the demand curve) on a plot of price against quantity. Likewise, producers are willing to supply certain quantities of oil at certain prices. The higher the price, the more oil producers are willing to supply. We can show this relationship as an upward sloping curve (the supply curve) on the same plot. In a market with many consumers and producers, the market price and quantity are determined where the supply curve crosses the demand curve. In other words, the consumers and producers both believe that the price and quantity are fair, and everyone is happy.
Here’s how the OPEC cartel upsets this equilibrium. Because the OPEC nations sit on around 75% of the world’s proven oil supply, they have what’s called market power if they co-operate with each other. This is exactly what a cartel is: a group of producers or consumers that engage in organized behaviour in order to influence market prices and quantities and maximize their profits. With only a few other major players in the oil industry, this leaves OPEC as a critical influence on oil prices. This allows OPEC nations to sell a lower quantity of oil at a higher price; and it also allows OPEC to temporarily sell large quantities of oil at a low price in order to eliminate competition in the marketplace.
The latter tactic is exactly what OPEC employed in 2014. Saudi Arabia, scared by the rapid growth of the U.S. shale oil industry, encouraged OPEC to raise their production ceilings. The theory was that this would cause the price of oil to sink so low that the shale oil “fracking” projects in the U.S. would no longer be profitable. In fact, that’s what happened. However, it also caused a massive oversupply of oil, which forced production operations in many non-OPEC nations to go offline, damaging the economies of those nations. Russia was hit particularly hard by this, causing the Russian Ruble to plummet and the Russian interest rate to skyrocket as high as 17%.
However, even OPEC member-states were feeling the pinch. The United Arab Emirates is one of the strongest economic powers in the Middle East, but low oil prices wrought havoc to the nation. Millionaires, even billionaires were losing tons of money as a result of these extremely low prices. Because the UAE has no bankruptcy laws (and defaulting on loan payments is considered a crime under Sharia law), many of the heavily indebted fled the country. In other words, low oil prices were partly to blame for the mass exodus of bankrupt oil tycoons from the area; resulting in the abandonment of thousands of the world’s most exotic supercars.
Of course, OPEC was happy to reclaim their market share from the U.S. and Russia, but it came at a considerable cost to other nations. Because of the 2014-2016 oil supply glut, many nations, especially the United States, believe that OPEC should not be allowed to exist. Their argument is that OPEC gives its nations an unfair competitive advantage in the marketplace, even if OPEC isn’t violating the rules of the World Trade Organization.
Even in the face of opposition from Americans and businesspeople, it is unlikely that OPEC is going away. And as long as they are around, they will have a direct impact on the price we pay for petroleum products. Obviously, this has an effect on us petrolheads. But the effects go far beyond influencing the price of petrol. A cartel this big has the power to influence the global demand for vehicles through oil prices. However, this influence is so large that OPEC can actually have an impact on your country’s economy. If you are from the United States, this means that your oil industry cannot compete with OPEC, causing billions of dollars to flow out of your country. In a general sense, because OPEC has the ability to charge a higher price for their oil, it stands to reason that petrolheads in countries outside of the 14 OPEC nations should come to despise this cartel, even if there is nothing we can do about it.