OPEC, SAUDI ARABIA & OIL PRICES: ADEMOLA’S TAKE!

 By Ademola H. A. Siole-Balogun

The question of whether OPEC has contributed to the uncertainty in oil prices- which has now become a constant feature of international oil prices- will be given more than a passing comment in this article. OPEC is the sovereign body or cartel which was established in 1960 to promote the interest of its member oil-producers. The role of OPEC over time may not have been one  which is generally appreciated across academic discourse especially in the field of petroleum economics, but it is one that offers an insight as to the extent to which oil-producer nations can galvanize themselves into a formidable block which will hold its own  at all times.
I will also consider the role of the oil-rich Kingdom of Saudi Arabia will also be considered against the background of its traditional role as a swing producer, much until the last two decades when exigencies of the peculiar markets of oil have forced a change in its circumstances.

  

The creation of OPEC in the Bagdad Conference of September, 1960 by Saudi-Arabia, Iraq, Iran, Kuwait and Venezuela has remained one of the greatest phenomenons in the international oil industry. Several questions have been asked with regards to what the motive for establishing the body is; and like all cartels, the general belief appears to be that its interest is principally to limit production of oil in order to keep the prices high! In defense of OPEC however, it may appear that the body only appears to have adopted the strategy used by the IOCs (International Oil Company) to keep the oil prices within a particular threshold; i.e between the 1920s – 1960s when the oil producing countries had greater involvement in the exploration, exploitation and production of these finite resources.

The traditional problem of posted oil prices, which was incidentally different from the prevailing market prices made it equally compelling for OPEC members to take greater interest in the way and manner the IOCs operated. The issue at the time was about why the IOCs kept cutting posted prices of oil as a result of the increasing demand for a greater revenue sharing formula led by some oil producers like Venezuela. The dilemma of the IOCs was whether it did not amount to poor economics to sell oil at market prices, and share revenues with the Oil producing states on the basis of the posted prices which was often higher than the former[1].  The issue facing OPEC member countries was thus whether their oil was bought at the most commercially viable price and at a price which they derive the best available rent from the non-renewable resources which their oil deposits represented. The problems represented by the Cartel formation of OPEC may also seem to leave much to be desired. A problem with cartels is that they have a huge tendency to substitute cooperation for competition and it appears that OPEC is no exception in this regard. The gain for OPEC has principally been in increased revenue for the member countries when the prices are low but the disincentive for it is the risk of “cartel cheats.”  On the consumers’ side, it prevents the market from benefitting from the economic implications of healthy competition i.e low prices. The finite and depletable nature of oil deposits makes it a veritable product for cooperation as against competition!

Historical arguments exist to the extent that the era of US-controlled the international prices of crude did not benefit the oil-producing nations. The practice of oil price-fixing did not emerge today but by a regular collusion of oil prices by the IOCs who incidentally owned oil reserves in the ground in such oil producing countries. It is equally stated that there exists a volatility of oil prices[2] and economic pains associated with the high prices of oil.

     Fig 1.1      US Oil Price Controls-(1973-81)-Refiners Acquisition Costs

 From the above, analysts have argued that the pains of high oil prices between the period above would have had less significance but for the US’s domestic energy policy which made US oil price higher than the prevailing international market price.

TREND OF OIL PRICES VOLATILITY OVER THE YEARS (GRAPH) 

A consideration of the nature of Oil price volatility in the international market overtime will ultimately draw me into a peculiar argument as to the different periods in history when an oil player controlled the pricing of the commodity as against others. It is a consideration that will, in due course, lead to the necessary discourse of who or what that controlling force is, and the extent to which that force in question determined the prices and the period in which such control was operational. Since 1869, the history of oil prices has shown that while the price of oil may vary from one era to another; adjusted for inflationary rates, these prices vary from $22.52- $23.42  (2008 US Dollar terms) . The graph below explains to an extent, the nature of this price volatility overtime.

        Fig 2.0       Historical Graph of Crude Oil Prices- 1869-2009[3]

However, looking at half of the period in question, it would be seen that the average price of oil of both the US and World market is put at $16.71 per barrel, thus creating a history guide for companies to operate  within a threshold of a little over $17.60[4].

WHAT ROLE HAS OPEC PLAYED TOWARDS THIS TREND?

The next question in the situation explained from foregoing analysis is- what role the sovereign cartel- OPEC played towards the volatility or fluctuations of oil prices. A realistic way to analyze this issue is primarily to understand that OPEC was created as a reactionary body to deal with several anomalies that were in practice in the industry at the time. It may have arisen from seeming frustrations of member oil-producing countries, a situation complicated by the practice of the IOCs in maintaining two separate prices- the posted and market prices and the continued price-cutting of the posted prices to the detriment of the oil producers. One thing that may however be argued is that the establishment of OPEC in September, 1960 necessarily absolves OPEC or its member countries from any role in price fluctuations during the periods prior to 1960!

 

However strongly one may agree with the view that from post-OPEC formation oil volatilities have often to do with its (OPEC) member states, it may be observed that internal issues and problems in these countries have proved to be a significant contributory factor. By this, I imply that the causes of oil price volatilities may have been attributed to the body (OPEC) since creation in 1960; but prior to 1960 OPEC could not be seen to have contributed to an increase in the price of oil. Since this article seeks to consider the role played by OPEC in this regard, the Arab-Israeli war, popularly called the Yom Kippur war, would earn its place in history as the first time OPEC- member countries tested their new found control of the international oil market. The Arab league of OPEC, led by Saudi Arabia imposed an embargo on the US, Netherlands and a few other nations to protest their support for Israel and press home its points, consequently fixing an official price of $11.65 for crude oil prices (See the graph in Fig 2.0). This situation led to huge inflow of foreign exchange earnings, further leading to inflation and economic mismanagement in some developing country-members of the body. Nigeria, for instance instituted an award for its public service workers by the Government and led to an unprecedented inflation- never experienced in that West African country[5].  The second oil shock which can be linked to an OPEC member is the Iranian revolution; the consequent ban on its petroleum export to any American firm, as well as its war with Iraq led to OPEC (with exception of Saudi Arabia) setting the official price over $34 per barrel. The 2^nd oil shock as well as the global economic recession occasioned in the 1980s cannot be totally detached from OPEC and its cartel’s desire to control oil prices which were already spiraling downwards under the body.

 

The third instance of price volatility in which an OPEC-member set off was the Persian Gulf crisis in which Iraq attempted to annex Kuwait as part of its sovereign territory as historically claimed. Iraq had wanted to do this in order to pay off its war debts, and raise its declining revenues from oil. This was further prompted by Kuwaiti’s continued exploration of oil in a field close to Iraq. The impact of this crisis too, like the previous, was short-lived as Saudi Arabia again stepped in as a swing producer, thus pumping millions more of barrels of oil into the international market in order to keep the prices at a desired economic price.

The role of Saudi Arabia as a buffer for falling oil prices may not have been without some self-interests. This enlightened self –interest will now be considered.

SAUDI- ARABIA: A STABILIZING MAJOR OIL PRODUCER?

The kingdom of Saudi Arabia has consistently stated its energy policy objectives; maintaining a certain price level for oil so as to ensure a sustainable and lasting use of the product as an energy source, stabilize the oil market for in the short- term, present itself as a reliable supplier of oil to the west over a long term, minimize the price of oil in order to maintain its domestic political economy and prevent fundamental changes to its internal political system. The Saudi Arabian share of OPEC quota increased from Pre-Gulf War figure of 25% to a Post Gulf war figure of about 35%[6]. In fairness to Saudi Arabia, it may be mentioned that it maintained its quota as a swing producer even when other members cheated on theirs and sold at competitive prices.

By 1986, the Kingdom had discontinued the swing producer status as a result of internal economic concerns- with particular reference to the drop in oil production quota from 10 million to 3 million BPD and oil prices from $28.00 to $14 .00 in 1981 and 1986 respectively. In the immediate aftermath of the Persian Gulf crisis, Saudi Arabia ensured that the world did not have to bear the loss of production from the two major actors – Iraqi and Kuwait, by producing excess crude oil into the international market.  Some other reasons were also given for the reasons by the Kingdom to keep the prices of oil low in prior to the Gulf war; that included the need for Saddam Hussein-led Iraq to remain pre-occupied with rebuilding Iraq in the aftermath of its war with Iran and reduce its aggression towards its neighbours. In summary, it may be mentioned that Saudi Arabia consistently used its excess capacity and excess financial reserves (cushioning effects) to instill some level of discipline into OPEC and perhaps its contribution towards stability of oil prices may be supported in that light.

NUTSHELL:

Ademola has examined the phenomenon of oil prices with a view to clarifying some notions about the roles of OPEC and Saudi Arabia in contributing to the volatility of the prices. Interestingly we are pointed to the pre-OPEC era and find that the price movements were as unpredictable as now. We also find that there was a different kind of "bad guy" then- the International Oil Company which had powers to influence the oil prices to the detriment of producer nations. We find that in real prices and adjusted with inflation, the price movement is within a well defined range. OPEC may be blamed for increasing price uncertainty but one thing that is sure is that Saudi Arabia is the''poster boy'' for the stability in prices. This is obviously due to the relatively low marginal cost of lifting oil from a Saudi Oil field and the abundance of the oil reserves. Ademola will conclude this analysis on oil prices by examining the different global reactions in different markets to oil price fluctuations. Look out for his next article. For more information on this article and to view Ademola's professional profile, click here.-->