OPEC and the 1973 Oil Embargo - Term Paper Example

OPEC and the 1973 Oil Embargo The prices of crude oil in the world keep changing and being adjusted in a said move to ensure that there is a balance in production and sale. These trends are affected by the prevailing market conditions that depend on the supply and demand changes.1 The Organization of the Petroleum Exporting Countries (OPEC) is an international organization that is tasked with the responsibility of coordinating and unifying policies related to petroleum among the member countries. The organization was founded with a motive to not only regulate supply and demand for petroleum but also set safe and secure prices for the producers of petroleum while ensuring efficient and regular supply of the commodity to the consumers of petroleum in the world. This form of regulation has for a long time earned the organization the economic title ‘cartel’. This paper aims to explore the background and activities of OPEC. The thesis statement will guide the paper that activities of OPEC does not make it an international cartel of oil producing states. OPEC Background Organization of the Petroleum Exporting Countries is an international organization that was founded in 1960 by five of the then largest exporters of petroleum. The founding countries included Iran, Kuwait, Saudi Arabia, Iraq and Venezuela. The founding of the organization was based on the need to have a central policy maker on matters regarding the production, supply and pricing of petroleum. Currently, the organization includes other members such as Algeria, Libya, Nigeria, Qatar, UAE, Angola and Ecuador2. Since its founding, the organization has continued to exert its influence to the production and supply of petroleum. However, over the years the OPEC market share has progressively declined. Nevertheless, its influence on crude oil reserves remains at 79% while it also holds 44% of world’s crude oil production. Between the founding, 1960 and 1973, OPEC concentrated its efforts on the power balance between the sovereignty of individual nations and the influence from major Western companies. However, the price of crude oil remained stable at $3 per barrel. The weakening US dollar between 1970 n1nd 1972 resulted to strong pricing pressures. Hover, by this time the organization had already established a strong ground for control and in 1973, OPEC decided to undertake not just the regulation but also the management of the crude oil prices. Since by this time the member countries dominated the petroleum production and export industry, OPEC was given a mandate to dictate the production and revenue of oil among its member nations. The crude oil market prices were set for Saudi Arabia, the largest single exporter and all the other countries were supposed to standardize their prices with the set price3. With increasing demand as industrialization and motorization in the world increased, the policy was effective. Consistent increase in the prices resulted to increase in revenue for the member countries and the organization. However, the increase in prices as the organization sought to increase its member country revenue resulted to a tragic decline in the demand for oil in the years that followed. The recession of 1980s further intensified the reduced demands. This prompted OPEC to issue limits of outputs for its members as an effort to ensure that the established high prices were maintained. However, this did not solve the problem of reducing prices, and an eventual crash was witnessed in 1986, the oil glut, reduced demand and the rising environmental concerns for the use of hydrocarbons. This reduced the OPEC market share and its total revenue in the period that followed with constant fluctuations in prices and market conditions. The 1973 Oil Embargo In 1973, OPEC decided to increase its control of the global oil prices. This was a concerted effort of six of the major Persian Gulf oil producers, the Arab members who agreed on a move to raise their benchmark oil prices by 70%. This move resulted to the Arab members of OPEC cutting down the production of oil and reduced shipping of the commodity to major consumers such as the United States of America and other strong nations. This was not just an economic move but also a move to prove that OPEC was connecting the Arabic countries against Israel n the Yom Kippur War.2 The supply of crude oil was, therefore, stopped for the countries that supported Israel, the OPEC members’ common enemy. By 1974, the price of crude oil had risen to $12 per barrel more that 400% increase to the prices before the crises. This was a great triumph to the OPEC and their power was shown as the problem of oil shortage affected the whole world. The member states enjoyed enormous economic gains as other countries had to confer to the high oil prices. The crises created a long lasting reputation of control and management that benefitted a single organization and its members while negatively affecting the rest of the world. For five months since 1973, the Arab members of OPEC withdrew supplies of oil to the nations that were in support of Israel in the fierce Yom Kippur War. This caused what the economists call the worst and rapid rise of oil prices.4 A four-fold price increase in oil prices was witnessed. Al other producers of oil were only able to replace 20% of the 5 million barrels per day in normal production. This could not cover the demand of oil even in the United States and Europe alone. The resultant crisis illustrated the powerful effect of a coordinated action of the organization. It also demonstrated hos concerted efforts of major producers could monopolize the oil production and supply sector. The power of OPEC to control the oil prices and supply of the commodity internationally was first demonstrated in this crisis. When the crises ended and production returned to normal, the prices fell both in nominal and real terms. To monitor and control the prices to stability, OPEC raised the oil prices by 10% in 1975. This was meant to stabilize the prices at a level that is higher than the normal price of the pre-crises era.5 However, the coordination of the organization in regulation of oil prices has been observed to be in close relation with the political and social instability of the Middle East region. Crises have always resulted from tension in the region, and the organization uses oil production as a tool to show the importance of the region on global stability and economic prosperity. In 1983, OPEC sought to adopt a quota system to manage oil production and supply and hence control the prices. Between 1980 and 1986, the supply of oil from the non-OPEC countries rose by 10 million barrels per day. This was a great threat to the OPEC oil market control. In 1982, OPEC decided that in order to realize high prices for its members oil, a quota system was necessary. This was in an effort to curtail production and hence create a demand that the non-OPEC countries production could not meet. However, the unwillingness of individual OPEC members to enter into the quota system nullified the effect of this attempt. The Effects of the 1973 Oil Embargo The oil crises in 1973 had effects on the world economy in short and long term basis. The non-oil producers first felt the effects. Countries that do not produce oil and those whose production did not meet their own demand suffered the blow. In the United States, the October 1973 crises coincided with a request by President Nixon for the Congress to increase the funding that the country made ti Israel in the Yom Kippur War. This was the main reason for the embargo that OPEC instituted on USA and its friends who were supporting Israel. The prices of oil rose from $3.0 per barrel to $12 per barrel in just three months.4 This negatively affected the economy of large consumers of oil such as USA, France and Germany. This increases the increased the prices of important commodities and affected the living standards of the people. The manipulation of oil prices and supplies by OPEC resulted to an increase in industrial commodities were rising at a rate of 10% per year, many commodities in the world were also in short supply. In response to the embargo, the US president instituted further control on oil prices in America. Rationing of oil to states was done in this effort. With increased shortage and a threat to the industrial sector, the Project independence was instituted in America to promote conservation of available oil reserves and use of alternative energy sources. This was an attempt to give the country independence from overreliance on oil imports in the future. Over the years, the United States has been pushing for this independence with various presidents strengthening the effort. The most recent of these efforts are President Obama’s promise to end the dependence of Middle East and Venezuelan oil imports within ten years upon his election as president in 2008.6 The $150 billion investment to increase the production of renewable energy is one of the current initiatives to enhance the independence. However, it is still not clear if this initiative will have a lasting impact. To the oil producing countries, the embargo did less than the expected. It was the expectation of OPEC that the crisis would increase its reputation and its control of the market. To achieve such a reputation would mean that the rest of the world would regard the organization highly, and the dependence increase their economic stability. However, the post-crisis lack of cooperation from individual members of the organization resulted to a failure in these efforts. Being different from a cartel system, the organization failed in this effort. The monopoly that the organization was only politically important. There were no initial intentions or strategies to increase profits or revenue. Over the years since the demonstration of the supremacy that was witnessed in 1973, political pressure has been increasing on OPEC from all sides. The politicians from the oil producing countries have used OPEC to exercise control on the market and indirectly on the importers economy. On the other hand, politicians from the oil-importing countries have been pushing for the international community to reduce the monopoly. Is OPEC a Cartel in Petroleum Industry? Many economists have used OPEC as a clear example of a cartel organization. This description has been based on the fact that the organization has used its monopoly in the petroleum industry to control and regulate oil prices for many years. One incident that is largely quoted to have demonstrated this qualification is the 1973 crisis that affected the petroleum industry which was planned and executed by OPEC for its profit maximization. However, what is true is that OPEC had never divided the oil market into quotas until 1983 nor has it ever defended the prices as an organization. These two are basic requirements for a cartel. According to the economic literature, a cartel is a company or an organization whose objective is to maximize its profit through making shifts of prices towards a monopoly side on the commodity demand curve2. A cartel combines several producers of a common commodity in an association based on trust. Scholars have related the shift of demand applied to the oil market by OPEC in 1973. The oil producers decided to reduce the supply of oil to the rest of the world. This resulted to an increase in demand and a subsequent increase in prices to the benefit of the organization and its members. However, the organization’s actions were not directly focused on increasing the profits for the member countries. The motive was to punish a common enemy and its allies through reducing their supply of oil to the nations. This unconsciously raised the demand of oil and hence the prices increased. In addition, contrary to the expectation of a cartel, OPEC has never exerted influence on its members’ oil production rate. The organization, beyond the crises, has had no impact on the prices. A cartel system demands elasticity and maximization of the profits or the members. The operations of a cartel are concentrated on the elastic portion of the demand curve in economics. This helps the cartel dominate the market thereby maximizing revenue and profits3. If this is not evident in the economy, then the organization does not qualify to be a cartel. OPEC, save for the few instances such as the crises, has exercised process that does not maximize the profits or the revenue for its members and has no such powers as a cartel to increase elasticity of the demand. The demand for OPEC oil is just a residual demand and does not in this capacity influence the prices, revenues and profits related to the oil market. When the political environment factors that provided the background of the 1973 crises are considered, the implication of OPEC as a cartel is voidable. This is because the stopping of the supply of oil to some countries by the Arab members of OPEC was in response to the war that was happening and involved Israel7. In an effort to ensure that the war was grounded, political systems in the Arab countries manipulated the decision to control the supply. This indicates that the actions were not determined to increase revenue and profits. International trade and economy identify various qualities or characteristics of a cartel system. These include a quota system, monitoring, punishment, presence of buffer stock, large market share and exercise of authority. On quota system, OPEC operated as a single entity until 1983. This means that by definition of a cartel as having quota systems in the effort to increase prices. The lack of a quota system in 1973 is an indication that the organization does not qualify to be a cartel. In 1985, OPEC established a ministerial monitoring committee. The monitoring committee was mandated with the task of monitoring the member country violation of the code of practice that the members agree upon. However, the monitoring that is done by the committee does not entail control of exports or production of oil by the member country. The monitoring expected of a cartel is round the clock and is strongly focused on the general requirement of the system, to increase profits and revenue for the group. The absence of such a monitoring system in the case of OPEC proves its weakness as a cartel. The other requirement of a conventional quota system is the prescription of instituted punishment. A conventional quota system recommends that the monitoring committee produce a list of those members of the cartel who are non-compliant to the regulations of the cartel. These members are punished according to the regulations and rules of the cartel, and this is instituted effectively. OPEC has never had such mechanisms, and every member is allowed to abide by the requirements of the organization not secondary to coercion but as a means of achieving what the organization has been formed upon 6. Further, the organization does not exercise any authority over member countries production of petroleum. The countries, although under OPEC retain the production autonomy. This is not the case in a typical cartel whose objective is to exercise control of the commodity production, marketing, supply and demand. In the production, market and supply of commodities, cartels exercise control through maintenance of a buffer stock. This allows control of prices to be done from a safe range. The commodity that is kept in stock is used to buffer the prices hence ensure control. OPEC has no oil reserves of its own. The fluctuation of prices around the world is not the making of OPEC. OPEC itself follows market prices but the prices do not originate from OPEC8. On matters of market share, a cartel aims at controlling the market by having a monopoly in the market that is dictated by the market share. For OPEC, the highest recorded market share was between 1970 and 1999 when was an average of 56%. This has over the recent ears decreased to 30%4. With the current market share of 33%, the organization cannot be regarded as a cartel by any means, typical cartels in the world control a minimum of 80% of the market share. With such control, it is possible to manipulate the market and maximize revenue and profits from the market. Conclusion The economic crisis that resulted from the 1973 embargo in the oil market has given the world an economic lesson. Many developed countries have adopted measures to ensure that such a crisis does not affect their economy. This has been effected by measures to reduce the dependence on OPEC for oil production and supply as well as seeking alternative sources of energy to run the economy. However, OPEC still remains a relevant organization in the oil industry9. The myth about OPEC being a cartel has been propagated by the political importance of the issue. The control of oil prices effected by the organization for many years has earned it a reputation that is similar to that of a cartel system. However, critical assessment of OPEC and comparison of its activities and motives with those of a conventional or ideal cartel system in the world market shows that OPEC is not a cartel in the oil market. The control of prices has been used by the organization, not for revenue and profits maximization as a primary motive but to enhance its relevance and reputation and to achieve political advantage. Further, the organization does not have any membership control system such as monitoring committees and punishment systems. This makes it possible for the member countries going against the common directive without risking penalties. In addition, the organization lacks a buffer stock system to control oil supply and demands. Currently, OPEC has no control of the prices of oil in the world, this is inherently controlled by large oil producers in the Middle East region and also regulated by the general world economic indices. Works cited 1Reich, Bernard. Securing the Covenant: United States-Israel Relations after the Cold War. Westport, CT: Greenwood Publishing Group, Inc, 1995. 2Alhajji, A.F. “The oil weapon: past, present, and future.” Oil and Gas Journal 103, no. 17 (May 2005). 3Merrill, Karen.  The Oil Crisis of 1973-1974: A Brief History with Documents. Boston: Bedford/St. Martin’s, 2007. 4Bernanke, Ben, “Oil and the Economy,"  Remarks at the Distinguished Lecture Series, Darton College, Albany, GA,  October 21, 2004. 5Hammes, David, and Douglas T. Wills. “Black Gold: The End of Bretton Woods and the Oil Price Shocks of the 1970s.” Independent Review 9, no. 4 (Spring 2005): 501-11. 6Merrill, Karen.  The Oil Crisis of 1973-1974: A Brief History with Documents. Boston: Bedford/St. Martin’s, 2007. 7Matsumoto, Ken’ichi et al. “Exploring Crude Oil Production and Export Capacity of the OPEC Middle East Countries.” Energy Policy 48 (2012): 820–828. 8Alhajji, A. F., and David Huettner. “OPEC and World Crude Oil Markets from 1973 to 1994: Cartel, Oligopoly, or Competitive?” Energy Journal 21 (2000): 31–60. 9Ramcharran, Harri. “Oil Production Responses to Price Changes: An Empirical Application of the Competitive Model to OPEC and Non-OPEC Countries.” Energy Economics 24 (2002): 97–106. Read More