The Concise Encyclopedia of Economics


by Benjamin Zycher
About the Author
Few people are aware of it today, but OPEC (the Organization of Petroleum Exporting Countries) was formed in response to the U.S. imposition of import quotas on oil. In 1959 the U.S. government established a Mandatory Oil Import Quota Program (MOIP) restricting the amount of crude oil (and refined products) that could be imported into the United States. The MOIP gave preferential treatment to oil imports from Mexico and Canada. This partial exclusion of the U.S. market to Persian Gulf producers depressed prices for their oil. As a result oil prices "posted" (paid to the selling nations) by the major oil companies were reduced in February 1959 and August 1960. In its early years the U.S. import quota program also discriminated against oil from Venezuela.

In September 1960 four Persian Gulf nations (Iran, Iraq, Kuwait, and Saudi Arabia) and Venezuela formed OPEC, the purpose of which was to obtain higher prices for crude oil. By 1973 eight other nations (Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon) had joined OPEC. Ecuador withdrew on the last day of 1992.

OPEC was unsuccessful in its first decade. Real (that is, inflation-adjusted) world prices for crude oil continued to fall until 1971. In 1958 the real price was $10.85 per barrel (in 1990 dollars). By 1971 it had fallen to $7.46 per barrel. However, real prices began to rise slowly beginning in 1971, and then jumped dramatically in late 1973 and 1974 from roughly $8 per barrel to over $27 per barrel in the wake of the Arab-Israeli ("Yom Kippur") War.

Contrary to what many noneconomists believe, the 1973 price increase was not caused by the oil "embargo" (refusal to sell) directed at the United States and the Netherlands that year by the Arab members of OPEC. Instead, OPEC reduced its production of crude oil, thus raising world oil prices substantially. The embargo against the United States and the Netherlands had no effect whatever: both nations were able to obtain oil at the same prices as all other nations. The failure of this selective embargo was predictable. Oil is a fungible commodity that can easily be resold among buyers. Therefore, sellers who try to deny oil to buyer A will find other buyers purchasing more oil, some of which will be resold by them to buyer A.

Nor, as is commonly believed, was OPEC the cause of oil shortages and gasoline lines in the United States. Instead, the shortages were caused by price and allocation controls on crude oil and refined products, originally imposed in 1971 by President Nixon as part of the Economic Stabilization Program. By preventing prices from rising sufficiently, the price controls stimulated desired consumption above the quantities available at the legal maximum prices. Shortages were the inevitable result. Countries that avoided price controls, such as West Germany and Switzerland, also avoided shortages, queues, and the other perverse effects of the controls.

OPEC is a cartel—a group of producers that attempts to restrict output in order to keep prices higher than the competitive level. The heart of OPEC is the Conference, which comprises national delegations, usually at the level of oil minister. The Conference meets twice each year to assign output quotas, which are upper limits on the amount of oil each member is allowed to produce. The Conference may also meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute.

OPEC faces the classic problem of all cartels: overproduction and cheating by members. At the higher cartel price, less oil is demanded. That is why OPEC assigns output quotas. Each member of the OPEC cartel has an incentive to produce more than its quota and "shave" (cut) this price because the cost of producing an additional barrel of crude is typically well below the cartel price. The methods available to shave official OPEC prices are numerous. Credit can be extended to buyers for periods longer than the standard thirty days. Higher grades (or blends) of oil can be sold for prices applicable to lower grades. Transportation credits can be given. Buyers can be offered side payments or rebates.

This tendency for individual producers to cheat on the cartel agreement is a long-standing feature of OPEC behavior. Individual producers usually have exceeded their production quotas, and so official prices have been unstable. But OPEC is an unusual cartel in that one producer—Saudi Arabia—is much larger than the others. That is why the Saudis are the "swing" producer. When prices start downward, they cut their production to keep prices up. One reason the Saudis have behaved that way is that departures from the official prices impose larger total losses on them than on other OPEC members in the short run. Because other producers have huge incentives to produce in excess of their quotas, the Saudis, in order to defend the official OPEC price, have had to reduce their sales dramatically at times. This erosion of Saudi production and sales has tended to reduce their revenues and profits substantially. In 1983 and 1984, for example, the Saudis found themselves producing only about 3.5 million barrels per day, despite their (then) production capacity almost three times that level.

How successful has OPEC been since the early seventies? Not as successful as many people perceive. Except in the wake of the 1979 Iranian revolution, and in anticipation of possible destruction of substantial reserves in the 1990-91 Persian Gulf conflict, real (inflation-adjusted) prices of crude oil have fallen since 1973. Prices began dropping very rapidly in the early eighties after the Saudis concluded that lower prices and higher production were in their best interests. Official prices fell from $34 (for the benchmark crude oil, Arabian light) to $29 in 1983, $24 in 1984, and about $18 in 1986 to 1988. Indeed, even prices unadjusted for inflation often have fallen. For example, prices fell from $35.10 per barrel ($49.10 in 1990 dollars) in 1981 to $16.69 ($18.69 in 1990 dollars) in 1987. (Price data are shown in table 1, and current reserves, production capacity, and production levels are shown in table 2.)

World Crude Oil Prices
(U.S. dollars per barrel)

Year Nominal Price In 1990 Dollars Year Nominal Price In 1990 Dollars
1955 2.25 10.88 1973 3.27 8.69
1956 2.36 11.04 1974 11.17 27.20
1957 2.73 12.34 1975 11.57 25.66
1958 2.45 10.85 1976 12.41 25.86
1959 2.27 9.82 1977 13.33 26.05
1960 2.23 9.49 1978 13.43 24.46
1961 2.27 9.57 1979 20.19 33.78
1962 2.26 9.32 1980 32.27 49.52
1963 2.25 9.13 1981 35.10 49.10
1964 2.23 8.91 1982 32.11 42.22
1965 2.22 8.64 1983 27.73 35.10
1966 2.24 8.42 1984 27.44 33.50
1967 2.27 8.31 1985 25.83 30.63
1968 2.24 7.81 1986 12.52 14.47
1969 2.27 7.50 1987 16.69 18.69
1970 2.35 7.36 1988 13.25 14.36
1971 2.52 7.46 1989 16.89 17.59
1972 2.64 7.47 1990 20.42 20.42
SOURCE: U.S. Departments of Energy, Commerce, and Labor.

OPEC Reserves, Production Capacity, and Production Levels
Nation Reservesa Capacityb Productionc
Algeria 9,200 800 750
Ecuador 1,514 330 280
Gabon 733 200 260
Indonesia 8,200 1,300 1,200
Iran 92,860 3,000 3,100
Iraq 100,000 3,500 3,100
Kuwait* 97,125 2,200 1,800
Libya 22,800 1,600 1,250
Neutral Zone n.a. 600 300
Nigeria 16,000 1,700 1,700
Qatar 4,500 600 365
Saudi Arabia* 257,559 7,000 5,300
Un. Arab Em. 94,105 2,210 2,060
Venezuela 58,504 2,400 2,000
OPEC Total 763,100 27,440d 23,465
World Total 1,001,572 63,740d 60,320
aMillions of barrels on January 1, 1990.
bMaximum sustainable as of August 1990, thousands of barrels per day.
cThousands of barrels per day as of May 1990, excluding natural gas liquids.
dNon-OPEC capacity for first quarter 1991, from internal Department of Energy/Energy Information Administration estimate.
* Includes one-half of the Neutral Zone.
n.a.—not available.
SOURCE: U.S. Department of Energy, Central Intelligence Agency.

This downward trend has increased tensions between two rival groups within OPEC. The price "hawks," usually nations with smaller crude oil reserves relative to population, argue for lower oil output and higher prices. The principal hawks within OPEC are Iran and Iraq. The price "doves," usually nations with larger reserves relative to population, argue for higher output and lower prices to preserve, over the longer term, their oil markets and thus the economic value of their oil resources. The principal doves within OPEC are Saudi Arabia, Kuwait, and the United Arab Emirates.

Such relatively lower prices serve the interests of the doves because oil consumers have used less oil in response to prior price increases. For example, U.S. energy use per dollar of GNP (adjusted for inflation) was 27.49 thousand BTUs in 1970. By 1988, after the price increases of 1973 and 1979, it had decreased to 19.93 thousand BTUs. Thus, the price "doves," led by Saudi Arabia, generally have resisted pressures for higher prices.

Over the long run, real prices of natural resources and commodities usually fall, largely because of technological advances. Crude oil is no exception. Technological advances in seismic exploration have dramatically reduced the cost of finding new reserves, thus increasing oil reserves greatly. Horizontal drilling and other new techniques have reduced the cost of recovering known reserves. Also, improvements in technology provide both substitutes for oil and ways to use less oil to achieve given ends.

Moreover, advances in technology will reduce prices for such substitute fuels as natural gas, thus exerting continuing downward pressure on crude oil prices. And increasing willingness to devote resources toward environmental improvement suggests that the market for crude oil will decline relative to those for such "cleaner" energy sources as natural gas and nuclear technology, unless other technical advances yield substantial improvement in the ability to use oil cleanly. Thus, the demand for crude oil is likely over the long term to decline relative to the demand for competing fuels. This has been the experience of mankind, as wood gradually gave way to coal, which in turn declined as the use of oil expanded. These facts suggest that the economic power of OPEC inexorably will erode.

About the Author

Benjamin Zycher is a senior economist at the Rand Corporation and a visiting professor of economics at the University of California at Los Angeles. He was formerly a senior staff economist with President Reagan's Council of Economic Advisers.

Further Reading

Bohi, Douglas R., and Milton Russell. Limiting Oil Imports: An Economic History and Analysis. 1978.

Bradley, Robert L., Jr. The Mirage of Oil Protection. 1989.

Horwich, George, and David Leo Weimer, eds. Responding to International Oil Crises. 1988.

Glasner, David. Politics, Prices, and Petroleum. 1985.

Zycher, Benjamin. "The Silly Season for Energy Policy." Regulation (Spring 1991): 6-9.

Zycher, Benjamin. "Emergency Management." In Free Market Energy, edited by S. Fred Singer. 1984.

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