The Oil Explanation and Marketing Companies: Oil-Producing Regions - Research Paper Example

Organisation of Oil Producing and Exporting Countries, formed in 1960, is widely known as OPEC is an organised association of 12 top oil producing countries (namely Saudi Arabia, Iran, Libya, Qatar, United Arab Emirates, Nigeria, Iraq, Algeria, Angola, Venezuela, Ecuador and Kuwait) with large crude oil reserves. These nations have now made an unwritten agreement (basically a Cartel or a type of Collusion) that they will control demand and supply mechanisms in international oil market by increasing or decreasing their mutual oil production after analysing the international oil demand from consuming nations. In other words, they control around 40% of world’s oil industry output with the coordination and agreement of member countries. In fact, these nations thus also have considerable control over prices as they are the top producers. Cheating is a term used for those OPEC members that exceed their assigned production limit or oil quota by head of the organisation headquartered in Vienna (Austria). Such countries that exceed assigned production quota are actually involved in cheating the other member countries which obey the so-called rules and regulations as developed by OPEC head. 2. What type of market structure is the oil industry? Oil Industry is an oligopolistic market, which has been dominated by top oil producing countries having large oil reserves and production facilities (oil refineries). This industry is ruled by 12 Opec members and other non-Opec members, which control overall industry output and supply chain. These businesses are actually price setters rather than price takers and they manipulate the market conditions by restricting or sometimes increasing the output. It is worthwhile to mention that Crude Oil produced by these countries is a homogeneous product (almost similar with no real differences) that has a highly inelastic demand, since it is used as for energy and power generation, production of petroleum products including gasoline, petrol, generator and machinery oil, for production of jet fuel used in aircrafts and various other uses etc. Therefore, there are a great number of buyers that purchase oil at prevalent market prices from the whole sellers, dealers and retailers. In addition, most of the oil explanation and marketing companies belong to developed western nations such as from USA, United Kingdom, Norway, France etc. as they have highly sophisticated technology and they are well equipped with modernized exploration equipments and machinery. These companies then invest in oil producing regions and enjoy a considerable power (forcing the host companies for high royalties, commissions, incentives, benefits) because of their glib expertise and proficiency in their respective field of interest. 3. Using appropriate economic theory, explain how OPEC set price and output. OPEC constantly tracks the changes and fluctuations in international oil demand by analysing the economic growth forecasts in highly developed nations, emerging economies and in less developed countries. In addition, it also reviews the economic forecasts developed by world’s top and highly authentic financial institutions such as World Bank, International Monetary Fund and Asian Development Bank. This provides the OPEC representatives an insight about existing market trends and expectations about future oil prices that is directly correlated with growth in international economy. In turn, OPEC calls the meetings of its member countries where they jointly discuss about the total oil production and its impact on prevalent market prices. OPEC countries then review the forecasts and based on their analysis, they decide to increase or decrease their production (barrel per day). The reduction in oil production and expectations about the tightening of global economy in coming future is aimed to catch the diminishing trend in oil prices. Similarly, the increase in oil demand followed by some increase in production by cartel (as OPEC work to maintain some demand / supply gap or never attempt to achieve 100% equilibrium) anticipates the surge in both oil prices and profit margins. If demand increases in short run, the cartel often does not increase production to let prices touch new peaks (like what happened 2 years back when prices jumped to $147 per barrel). 4. Why doesn’t OPEC simply fix the highest price possible in the short run? Why have many non-members of OPEC “shadowed” OPEC decisions, and followed their lead on price? OPEC simply does not fix the highest possible oil price in the short run because first, it has control on just over 40% of total industry output. Secondly, Non-Opec members, which are often pressurised by USA and its allies, opt out to increase production to catch the alarming increase in world oil prices, as this hampers the growth in developed nations. Also, fixing the price and consumer manipulation in short run may result in possible legal actions against the member countries and OPEC cartel by consuming nations, which are heavily dependent on oil imports. Many non-members of Opec did not become a part of this OPEC cartel mainly because of international pressure and their personal economic interests with consuming nations that are known as industrial giants. They, therefore, do not increase or reduce their production according to OPEC’s instructions rather follows their own policy to rationalise oil prices and to sometimes have short run economic gains from unprecedented higher prices from their oil export. In this way, they don’t sabotage their relationships with various leading economies while simultaneously maintains their reputation and goodwill through fair play in the international market and world community. 5. How and why do some oil producers cheat? How does OPEC deal with ‘cheats’? As mentioned above, Cheating is a term used for those OPEC members that exceed their assigned production limit or oil quota. Some countries that exceed assigned production quota are actually involved in cheating the other member countries which obey the so-called rules and regulations as developed by OPEC head. These nations are involved in ‘Cheating’ because they are pressurised by a large group of developed powerful countries and their allies as oil is a blood for economy of these nations. Secondly, the nations also cheat because there allies may threaten them for economic sanctions, trade restrictions and other pressure tactics as some oil producing nations are only rich in oil and have no industrial manufacturing base essential for real economic growth. Any sanctions by developed nations results in more costs than benefits they reap from oil export at higher prices. It is worthwhile to mention that these oil producers actually hurt the joint benefits of OPEC members, since their additional production disturbs the demand and supply equilibrium or gap and thus results in downward pressure on oil prices in international market. Therefore other members, like Saudi Arabia and Kuwait with mammoth oil reserves and low cost exploration and production capabilities, then punish their so-called black sheep or ‘cheats’ by increasing their own production so that cheats with high business production costs would incur colossal financial losses and higher inventory carrying costs. 6. Suggest why high oil prices may lead to problems for businesses and the whole economy. It must be highlighted that oil industry is an oligopolistic industry, which is dominated by oil rich nations. A maximum number of economies are directly dependent on oil imports from producing and exporting nations to fulfil their domestic oil demand by residential, commercial and industrial consumers. The oil is then used for energy production, in automobiles, in industries, in transportation of goods through rail, road, air and sea and for other purposes. High oil prices results in an increase in energy costs that in turn increases entire manufacturing industry and supply chain because the costs of goods increase. In other words, this leads to inflation that then compels the employers to increase wages and salaries of employees who now demand high wages for their services. In addition, the costs of other inputs, transportation, related supporting industries also increase that further aggravates the situation and result in aggregate higher prices of final product to end user. In short, the real incomes and purchasing power of consumers reduces that in turn decrease the demand of final products and number of transactions. So, businesses are double affected from this vicious cycle that turns violent for emerging economies that depend on oil energy compared to developed nations that use alternative energy resources. Government then has to announce subsidies, tax incentives and rebates that add to its financial burden. Also, the overall shrinkage or contraction in economy reduces its tax revenue from businesses and consumers respectively. 7. What were the causes of the recession?  Using relevant economic theory, suggest what needs to be done to move the economy out of recession. Economic recession refers to meltdown of economy that in turn results in contraction, shrinkage or negative growth. The global economic meltdown started from United States when US property market crashed due to failure of sub-prime mortgage scheme. This then resulted in financial crises, credit crunch, bankruptcies and debacle of many US small and large financial institutions, especially the downfall of Lehman Brothers, which were dependent on interest income from property mortgage schemes. The banks then involved in retrenchments, lay offs and dismissals. In short, unemployment started increasing while consumption reduced simultaneously. The failure of commercial banks was then followed by failure of many manufacturing industries and service industries that further the business outlook and sent shock waves all across the world. The unemployment in USA adversely affected the consumption and demand patterns in US economy that in turn severely affected the economies directly dependent for exports to USA. In simple words, the debacle of US economy triggered global economic turmoil that later covered all the world. It not only affected developed nations but also the emerging economies like China, India, Indonesia and others that export heavily to USA and Europe. The international commodity prices such as those of minerals, oil and food products fell down after economic downturn. In order to get economy out of recession, the central bank has to pump money in market through open market purchase operations. The federal bank purchases securities from banks, brokerage houses, governments, insurance agencies, private investors etc. to improve their cash at hand position. Also, it reduces the discount rate to reduce the cost of acquiring monetary units. The banks then lend the loans to cash starved borrowers who invest in their business operations and continue their production cycles. Finally, government also intervenes in the market and announces bail-out packages so that leading industries could avoid bankruptcy and possible closures. Also, government and businesses run campaigns to improve buyers’ confidence and persuade consumers to make their routine purchases and transactions rather tightening their belts. This is done to increase aggregate demand of products that then improves revenue streams of businesses, creates new jobs and improve employment prospects. In short, the aggregate demand and supply increases and finally the economy growths. Also, the government can help those specific sectors for example property to help revive the struggling businesses. 8. Using supply and demand diagrams and the data above, explain (1) the oil price change from 2007 to mid-2008 and (2) the oil price change from mid-2008 to early 2009. (Use a discussion of relevant elasticities in your answer.) The oil prices started increasing in 2007 when international oil demand was picking due to high economic growth rates in emerging economies such as China and India (nations with population of 1.35 and 1.25 billions respectively). Economic pundits in both countries observed massive industrialisation and manufacturing sectors that improved employment prospects and buying power. In short, oil consumption skyrocketed after increase in economic activities that led to heavy domestic oil demand by automobile, transport and energy sectors. Furthermore, India also observed a boom in its Information Technology sector that further improved purchasing power and oil demand simultaneously. The graphs below provides us a clear overview that oil demand jumped from $50-60 per barrel in 2007 to their peak $147 in mid 2008 due to real economic growth of over 6% in emerging nations and around 2-3% in advanced economies where demand either remained stable or declined. Demand of oil was highly price inelastic as I have already pinpointed in above discussions. Supply, on the other hand, remained almost constant as the producing nations (expecting heavy financial gains) deliberately refused to increase their production in short run although some non-Opec members did increase their production on international pressure. Then, the debacle of property sector and subsequent financial and industry closures in 2008 triggered recession that later covered all major economies. Oil demand plummeted to just $35 nearly in December 2008 compared to $147 in July 2008 as then slightly recovered to $45 in February – March 2009 after some improvement in demand from advanced nations. However, the demand in emerging nations continued to rise because of increase in their population / buyers and their economic model. It is worthwhile to mention that developing countries have more genuine ‘needs-based’ economies compared to West’s more transactions-per-person based economy. (Lipsky, 2009) Source: http://www.imf.org/external/np/speeches/2009/031809.htm Sources / Bibliography: No author (2003) “Opec: The oil cartel” BBC News Available at http://news.bbc.co.uk/2/hi/689609.stm Horowitz, Andrew (2008) “Oil Prices: Blame Speculators” Business Week Available at http://www.businessweek.com/debateroom/archives/2008/08/oil_prices_blam.html Lipsky, John (2009) “Economic Shifts and Oil Price Volatility” International Monetary Fund Available at http://www.imf.org/external/np/speeches/2009/031809.htm Morton, Pete (2009) “The Role of Speculation in the 2007-2008 Spike in Oil Prices” Aspousa.org Available at http://www.aspousa.org/index.php/2009/03/the-role-of-speculation-in-the-2007-2008-spike-in-oil-prices/ “The OPEC Cartel” Tutor2u Available at thisismoney.co.uk Read More