TODAY’S STUDY: HOW OIL MARKETS ARE MANIPULATED

Competition in Global Oil Markets: A Meta-Analysis and Review

Andrew P. Morriss & Roger E. Meiners, April 2013 (Securing America’s Future Energy)

Abstract

The OPEC cartel has affected the oil market for four decades. An unstable cartel representing the interests of the major oil exporting nations, OPEC has at times been effective in forcing up the price of oil and, thereby, allowing the export nations to obtain a significant premium captured by national oil companies on behalf of their sovereigns. At times, this means a transfer of wealth from oilconsuming nations to oil-producing nations totalling hundreds of billions of dollars more than what the competitive-market price of oil would suggest. When the cartel has failed in its objective, the price of oil has collapsed, possibly lower than would have been the case were the market not subject to cartelization. The instability of the cartel means the price of oil has been highly variable over time, making it difficult to predict the future direction of oil prices. A review of the literature indicates that there is a general consensus that the oil market is greatly affected by the cartel. That is, the international market for oil is not a free market.

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Introduction

In the earliest days of the international oil trade, a small number of oil companies, including Standard Oil, vigorously competed for market share. Those firms dominated both international trade in petroleum and access to reserves. Public policy debates centered on the dangers of private monopolies controlling the market. Today, traditional for profit companies no longer control the vast majority of the world’s oil reserves. Instead, an international cartel (the Organization of Petroleum Exporting Countries or OPEC) has the ability to influence the supply of oil. State-owned national oil companies (of both OPEC members and non-members) hold the vast majority of proven reserves.

The problem of monopoly remains, although the economic concerns about pricing are now mingled with concerns over the motivations of companies responsive to governments rather than investors.

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Due to the importance of oil to the world economy, international oil markets have attracted considerable attention from economists and policy analysts. Numerous studies (we summarize more than 200 scholarly articles, reports, and government investigations in this document’s appendix) have been devoted to attempting to describe the economic structure of the petroleum market. This report examines this literature in search of a consensus on the key features of the oil market’s structure. We conclude that there is a consensus that the global oil market deviates in important ways from the competitive model and that these market anomalies have significant economic impacts and so are relevant for policy makers.

Since the early 1970s the oil market has frequently been significantly affected on the supply side by strategic market intervention by oil-producing countries. In particular, the oil market has periodically experienced the consequences of cartelization as a result of OPEC’s strategy over the past 40 years. As any cartel would, OPEC members have attempted to restrict output. It is generally recognized that Saudi Arabia, the largest oil exporter, is the lynchpin of OPEC. For example, in January 2013 the Saudis announced that they had cut production five percent in December. Immediately after, “Light, sweet crude oil for February delivery on the New York Mercantile Exchange rose 72 cents, or 0.8%, its highest settlement since Sept. 18.” Since the details of the deliberations of the organization are known indirectly through commentary, leaks, and after-the-fact disclosures, the exact role of the Saudis is not known. What is clear is that OPEC has had periods of spectacular success in restricting supply sufficiently to force prices up significantly. Of course, it has also had periods during which it has been much less successful.

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Whatever the particulars ofits operations, when OPEC is successful in imposing artificial scarcity, it forces demanders to move up the demand curve and, more importantly from the suppliers’ perspective increases profit margins for the oil producing countries. Because OPEC’s success at this strategy varies with political conditions within and among OPEC member states, factors such as the amount of non-OPEC supply, policies in consuming countries, and the costs of competing forms of energy, OPEC is not able to behave as a stable, textbook monopolist would. Thus an important part of understanding OPEC’s influence on world oil markets is to recognize that its influence varies considerably across time in ways that are difficult to predict.

Basic economic theory has long explained that monopolists seek to reduce output below the competitive equilibrium to force the price above the competitive market price. Monopolies have other ill effects, including reduced innovation and internal inefficiencies. (In this regard, economist J.R. Hicks noted in 1935 that “the best of all monopoly profits is a quiet life.”

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When a cartel is successful in acting as a monopolist, prices are less variable. Price gyrations reduce demand for the product, injuring the monopoly’s long-term profits and harming customer relations. Particularly where a cartel faces competition from substitute goods, it must pay attention to the impact of price on long-term demand. Not surprisingly, such demand considerations are a constant worry for OPEC, which fears demanders will diversify out of oil products if prices rise too high or become unpredictable. OPEC’s long term interest is therefore in a price that is high enough to provide its members with substantial economic rents, but not so high as to reduce the total economic rents it is able to collect over time by encouraging diversification out of oil by demanders.

Unfortunately for OPEC, it is regarded as an unstable cartel whose members are known to “cheat” on the legally unenforceable gentlemen’s agreements that have been made about production restrictions. Hence, it does not consistently restrict supply even from its member nations. Of course, non-member oil exporters have even less of an incentive to comply with cartel efforts to limit production. As the history of oil prices indicates, at times OPEC, perhaps often due to Saudi actions, is effective at keeping the price artificially high; at other times the price has dropped to levels not profitable for some producers over time. That is, oil markets frequently experience significant price swings not seen in similar markets for other commodities. For example, we can compare oil price gyrations with coal prices. Coal is a carbon-based energy source competitive with oil in several markets, but we do not see price swings in the coal market comparable to those we see in oil. An important reason is that there is no coal cartel.

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As competitiveness in international oil markets varies over time, prices rise and fall in response to sellers’ changing degree of market power. This source of supply intervention means oil markets are more volatile than they would be in either a competitive market, or a stable, monopolistic market. Ifinternational oil markets more closely resembled a textbook competitive market, prices would often have been lower than they were during periods of high prices in the past four decades. Ifinternational oil markets more closely resembled a stable monopoly, prices likely would have been higher than they were during periods of low prices. In short, oil markets switch back and forth from more competitive to less competitive market structures due to the politics of OPEC and other non-market factors. This adds to the overall price volatility of the market, a significant disadvantage for consumers and potential investors in both the development of new, higher cost oil supplies and substitutes for oil as it makes investment decisions less easy to predict.

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In addition to OPEC, there are other major differences between international oil markets and more competitive commodity markets. Beginning in the 1950s, an increasing amount of global oil reserves have been controlled by national oil companies (NOCs). These companies differ from private companies because the NOCs must respond to non-market considerations related to domestic and international politics, not just market forces. For example, the Venezuelan national oil company, Petroleos de Venezuela (PDVSA), only hired supporters of Hugo Chavez and the company serves as the primary revenue generator for the government. A market with major suppliers that are not primarily governed by market forces differs significantly from a competitive market made up of suppliers driven by the profit motive.Even before the rise of the NOCs, much of the world’s oil reserves were controlled under concessions negotiated between the major oil companies (often acting as cartels) and producer state governments. In many respects, there was no real international oil market under the concessions, since the buyer-side of the market had been effectively cartelized through the oil company consortia. With the addition of a major supplier cartel and the shift of reserves to non-profit-maximizing firms, the current international oil market bears almost no relation to the classic conception of a competitive market in which supply and demand determine prices.

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This report reviews the elements of the oil market, the economic consequences of these deviations from the competitive model, and examines the literature on oil markets to provide a non-statistical meta-analysis of scholarly publications. The papers, reports, and other materials collected and reviewed allow us to summarize the collective wisdom ofindependent researchers over many decades, rather than only report our own assessment of the competitive nature of the petroleum industry. Before getting to the review of the literature, we provide a brief overview of the economics of the oil industry…

A Short Primer on Energy and Petroleum...Are We Running Out of Oil?...Simple Model of the Cost of Oil Production…Who Owns and Makes What?...Monopoly Elements in a Market…The Costs of Monopoly…Elasticity of Demand…Cost of OPEC Action…Does Anti-Trust Law Matter?...

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Conclusion

This paper reviewed decades of research exploring the question: how competitive are global oil markets? Much of that work is summarized in the following appendix. We found that the issue has witnessed significant discussion over the past four decades, starting with the oil price hikes of the early 1970s. The collective conclusion of hundreds of studies is that the OPEC cartel has utilized its ability to force oil prices substantially above competitive levels. Conversely, oil companies operate under competitive conditions, as no one private firm has more than a trivial share of the oil market. Most oil is under the control of governments (par- ticularly the governments of OPEC member nations) through national oil companies. Such governments have strong incentives to attempt to restrict oil supply to force up prices and to maximize their revenues. Their ability to accomplish this varies over time with changes in political and economic factors. As a result, over the years we have seen oil prices rise and fall dramatically.

Oil suppliers do not like “low” oil prices set through a competitive market; despite this, com- petition breaks out at various times that are not easy to predict, just as the success of efforts to enforce price hikes are not always predictable. When they are high for sustained periods, it is evidence of the ability of OPEC to restrain supply sufficiently to force price up. These price gyrations impose transition costs on firms and consumers forced to respond to price changes. The costs of adjustment do not appear to have been quantified by researchers, but are undoubtedly significant. The cost of price spikes is primarily borne by oil buyers who pay high prices for fuel, thereby transferring substantial wealth to foreign sovereigns…

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