Example Economics Essay

Example Economics Essay
OPEC’s impact has been controversial and debated due to its political nature and the complexity of commodity markets. Established in 1960 to serve the interests of national government oil producers, its twelve current members are Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Since this time its market share has declined, but it continues to wield market influence and as of November 2010 collectively held 79% of world crude oil reserves and 44% of the world’s crude oil production.
Much of the period from its inception to 1973 concerned the power balance between national sovereignty and the major Western oil companies and influences reflected the various experiences and contributions of countries including Libya, Algeria, Iraq and Iran (Skeet: 1988). From 1958 to 1970, the price of crude oil remained stable approximating $3 per barrel, but in constant 2008 dollars declined from above $19 to $14 per barrel (Williams: 2009). This decline when adjusted for inflation, and made more severe by the early 1970’s hyperinflation, was exacerbated by the additional effect in 1971 and 1972 of a weaker US dollar. In response to these pricing pressures, and having laid the groundwork to present a co-ordinated and effectual position, in 1973 OPEC went from negotiating the oil price to managing it.

As Skeet (1988) has observed, the problems OPEC faced in doing so were wholly different to those it was presented with before 1973. The true price of oil is affected by quality and changing demand for specific grades, distance to market, global economic conditions, non-OPEC competition, and competing national interests amongst members. This complexity has served to hinder OPEC’s effectiveness in delivering consistent and supportable higher prices as will be observed.

For five months from October 1973, OPEC’s Arab members withdrew supplies to countries supporting Israel during the Yom Kippur War, causing a fourfold price increase. Other countries were able to replace only a fifth of the 5 million barrels a day (mbd) in lost production, illustrating the powerful effect of (partial) co-ordinated action. As production resumed normality and prices fell in nominal and real terms, OPEC raised the oil price by 10% in January 1975. Its effect, seen in Figure 1, was to stabilise, at a level much higher than the pre-1973 norm, the decline that continued gently until the next energy crisis in 1979.

Figure 1 (source: Williams: 2009)

A major constraint on a co-ordinated approach to high oil prices and market stability has been the internal tensions existing within and amongst OPEC countries. The energy crisis of 1979 reflected a consistent pattern since OPEC’s foundation of price rises caused by Middle Eastern tensions that it has been unable to curtail – witnessed in 1973 (Yom Kippur War), 1979 and early 1980’s (Iran-Iraq), 1989-1990 and 2003-2005 (Gulf wars), and 2011 (Libya) – with consequences for its ability to present a united approach.

The 1979 Iranian Revolution precipitated market chaos and the spiralling of crude oil prices. Iraq’s subsequent invasion of Iran in September 1980 resulted in the combined production of both countries falling from 7.5mbd of a few months previously to just 1mbd by November of that year (Williams: 2009). By November 1980 global production had fallen 10%, sharply increasing the short-term oil price. However the longer-term consequence of the high cost and instability of oil sourcing was a drive to reduce consumption through improved energy efficiency, increased sourcing outside OPEC (see Figure 2), and a switch to alternatives such as coal and nuclear energy (Gülen: 1996). The warnings by the Saudi Oil Minister Ahmed Yamani to fellow OPEC members of the consequences of not raising production went unheeded, and once the short-term pressures on supply and prices had weakened, the result was lower demand and diminished revenues.

Figure 2 (source: Gülen: 1996)

From 1980 to 1986 supply from non-OPEC countries increased by 10mbd, threatening to erode OPEC’s market control, but from 1982 to 1988 it nevertheless sought to curtail production sufficiently in order to realise a higher oil price. It was the unwillingness of OPEC’s individual members to adhere to these quotas, which actually nullified its effect.

As a result Saudi Arabia, as largest producer and with the largest reserves, implemented the only measure existing within OPEC to maintain discipline. Weary of the consequences of attempting to maintain this policy, in August 1985 Saudi Arabia tied its price to the spot market and the following year increased production from 2MMBPD to 5MMBPD (Williams: 2009). The collapse in price to $10 per barrel, while preserving Saudi revenues through increased volumes, placed intolerable pressure on other OPEC members.

In exercising its ‘nuclear option’ members were forced to agree a new price of $18 per barrel in December 1986, yet by the following month even this agreement foundered and prices remained subdued as rival members sought to undercut each other. By 1988, with oil at $13 a barrel and having fallen by over a third in a year, Algeria's Oil Minister Belkacem Nabi reflected the concerns within OPEC, admitting “We have problems of discipline, of quotas, and we must absolutely address them in a fundamental way… We had designed a system of pricing and production in London in 1983 that has not worked and since then there has been no stability within OPEC”(Ibrahim: 1988).

The complexity in assessing OPEC’s success is highlighted by statistical analysis that contradicts even this near-universally agreed assessment from the participants involved. In Gülen’s (1996) study of OPEC’s cartel attributes, he argues that it had been able to strengthen its market influence after officially adopting an output-rationing framework in 1982. Contrary to conventional wisdom, Gülen’s evidence points to OPEC being less successful in the 1970’s than in the following decade of depressed prices and demand. From 1982-93, Gülen concludes OPEC prevented prices falling further and, by maintaining a less abrasive pricing and quota policy, helped protect its future market share and demand.

The main argument against OPEC’s success is its contribution to, and failure to avoid, fluctuations in production and price, jeopardising longer-term market prosperity. A leading factor in this is its own political fabric, with a membership composed predominantly of autocratic national governments. At times this has translated into policy determined by short-term whims and profits, exacerbated by corruption and lack of transparency, minimising incentives for long-term planning and co-operation.

Following the First Gulf War, partly stemming from Iraq’s accusation of Kuwaiti ‘economic warfare’ in oversupplying the market, crude oil prices resumed their downward trend, reaching a twenty-five year low in constant dollar prices by 1998. OPEC proved unable to halt this decline even at a time of rising demand, which from 1990 to 1997 increased by 6.2mbd (5.9mbd from Asia), and a contraction in Russian supply from 1990 to 1996 of 5mbd.

The difficulty any cartel faces in the imposition of quotas or price targets lies in predicting upcoming market conditions and in the timing of interventions. This inherent risk was highlighted in December 1997 when OPEC agreed a 10% increase of 2.5mbd in its supply quota, in view of the long-term rising demand from Asia. This occurred as the Asian financial crisis unfolded and the first fall in Asian demand since 1982. The result was a sharp downward drop in the price of crude oil and OPEC was forced to respond with a hasty reversal of its quota cuts. OPEC had implemented the wrong action at precisely the wrong moment and the consequences for weak crude prices were felt throughout 1998, hitting a low of $10.35 a barrel (DiPaola and Shenk: 2008).

This miscalculation was repeated in the following economic cycle, as aggressive optimism of buoyant market conditions in 2000 led OPEC to increase its production quota by 3.2mbd in three tranches from April to October. At the same time a revitalised Russian oil industry and declining US demand in 2001 meant OPEC had to retreat on its short-lived quota increases and more.

Skeet (1998) argues that OPEC’s success should be measured by whether it achieves its intended price bracket, which at its March 2000 meeting in Vienna was set at $22-28 (Kohl: 2006). Following the events of 9/11, OPEC reduced its quota by 1.5mbd in co-ordination with Russia in what proved a successful intervention. But although the oil price was raised into the target bracket by March 2002, for only half the time from 2000 to 2006 did it remain there (Kohl: 2006).

In the face of rising prices, on 31 March 2004 OPEC reduced production by 1mbd to 23.5mbd arguing the upward pressure on prices was due to market speculation and problems in the US supply market rather than production shortages. But this glossed over a division between members such as Saudi Arabia seeking to maintain goodwill and stability in the interests of both producers and consumers, and members such as Iran and Venezuela, antagonistic to Western interests and with pressing economic and political reasons to pursue a more self-interested policy. At the Beirut meeting in June 2004, OPEC production was increased to 25.5mbd as a compromise and continued upwards until the 2008 recession. The price of crude oil rose consistently and steeply without respite, peaking at $147 in July 2008, and despite a precipitous drop in the latter half of that year, oil prices have remained at historical highs.

One viewpoint is that from 2002 onwards OPEC has been able to achieve a price broadly sustainable in the medium-term. Figure 3 illustrates how during this period of steadily increasing prices, production increased at broadly similar levels. It suggests rising prices resulted from increased demand, met through a combination of increased supply and increased price, the natural reward for supplying an in-demand product. This graph appears to show the sensible route taken, profiting from this rise in demand, but not profiteering, and learning the lessons of previous oil price spikes.

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