The Effects of Decreasing Oil Prices on the OPEC Creator States - Essay Example

The Effects of Decreasing Oil Prices on OPEC Creator s I. Introduction Venezuela was the first country to move towards the establishment of OPEC by approaching Iran, Iraq, Kuwait and Saudi Arabia in 1949, suggesting that they exchange views and explore avenues for regular and closer communications between them (Yergin; Figueredo, 2007; Perkins, 2005). In September 1960, at the initiative of the Venezuelan Energy and Mines minister Juan Pablo Prez Alfonzo and the Saudi Arabian Energy and Mines minister Abdullah al-Tariki, the governments of Iraq, Iran, Kuwait, Saudi Arabia and Venezuela met in Baghdad to discuss ways to increase the price of the crude oil produced by their respective countries. OPEC was founded in Baghdad, triggered by a 1960 law instituted by American President Dwight Eisenhower that forced quotas on Venezuelan and Persian Gulf oil imports in favor of the Canadian and Mexican oil industries. Eisenhower cited national security, land access to energy supplies, at times of war. When this led to falling prices for oil in these regions, Venezuela's president Romulo Betancourt reacted seeking an alliance with oil producing Arab nations as a preemptive strategy to protect the continuous autonomy and profitability of Venezuela's natural resource: oil (Perkins, 2005). As a result, OPEC was founded to unify and coordinate members' petroleum policies. Original OPEC members include Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Between 1960 and 1975, the organization expanded to include Qatar (1961), Indonesia (1962), Libya (1962), the United Arab Emirates (1967), Algeria (1969), and Nigeria (1971). Ecuador and Gabon were members of OPEC, but Ecuador withdrew on December 31, 1992 because they were unwilling or unable to pay a $2 million membership fee and felt that they needed to produce more oil than they were allowed to under the OPEC quota. Similar concerns prompted Gabon to follow suit in January 1995. Angola joined on the first day of 2007. Indonesia reconsidered its membership having become a net importer and being unable to meet its production quota. The United States was a member during its formal occupation of Iraq via the Coalition Provisional Authority (Yergin; Perkins, 2005). Indicating that OPEC is not averse to further expansion, Mohammed Barkindo, OPEC's Secretary General, recently asked Sudan to join. Iraq remains a member of OPEC, though Iraqi production has not been a part of any OPEC quota agreements since March 1998. In May 2008, Indonesia left the OPEC group because of the soaring prices and the rising oil demand in East Asia. Economists think that the withdrawal of Indonesia will have little effect on OPEC and on the oil prices even though it has a high percentage in world oil production (Kohl, 2002; Perkins, 2005). The persistence of the Arab-Israeli conflict finally triggered a response that transformed OPEC into a formidable political force. After the Six Day War of 1967, the Arab members of OPEC formed a separate, overlapping group, the Organization of Arab Petroleum Exporting Countries, for the purpose of centering policy and exerting pressure on the West over its support of Israel. Egypt and Syria, though not major oil-exporting countries, joined the latter grouping to help articulate its objectives. Later, the Yom Kippur War of 1973 galvanized Arab opinion. Furious at the emergency re-supply effort that had enabled Israel to withstand Egyptian and Syrian forces, the Arab world imposed the 1973 oil embargo against the United States and Western Europe. In the 1970s, the great Western oil conglomerates suddenly faced a unified block of producers. This Arab-Israeli conflict triggered a crisis already in the making. The West could not continue to increase its energy use 5% annually, pay low oil prices, yet sell inflation-priced goods to the petroleum producers in the Third World. This was stressed by the Shah of Iran, whose nation was the world's second-largest exporter of oil, and one of the closest allies of the United States in the Middle East at the time. "Of course [the world price of oil] is going to rise," the Shah told the New York Times in 1973. "Certainly! And how...; You [Western nations] increased the price of wheat you sell us by 300%, and the same for sugar and cement...; You buy our crude oil and sell it back to us, refined as petrochemicals, at a hundred times the price you've paid to us...; It's only fair that, from now on, you should pay more for oil. Let's say 10 times more." The threat and use of embargo as a weapon, however, triggered a decline in OPEC's power. Western nations developed closer ties to the Soviet Union and rapidly built up their offshore drilling in the North Sea and the Gulf of Mexico, greatly lessening the potential impact of future price shocks induced by OPEC. The effect was not immediate, however. When the Shah of Iran fell in 1979, during the Iranian Revolution, another oil crisis (1979 oil crisis) ensued (Kohl 2002; Perkins, 2005). The Organization of the Petroleum Exporting Countries (OPEC) is a group of twelve countries made up of Iran, Iraq, Kuwait, Qatar, Saudi Arabia, the United Arab Emirates, Libya, Algeria, Nigeria, Angola, Venezuela and Ecuador. Recently, Indonesia has decided to leave the organization, a move which will be completed by the end of 2008. The organization has maintained its headquarters in Vienna since 1965, and hosts regular meetings among the oil ministers of its member states (Perkins, 2005). According to its statute, the principal goal is the determination of the best means for safeguarding their interests, individually and collectively; devising ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations; giving due regard at all times to the interests of the producing nations and to the necessity of securing a steady income to the producing countries; an efficient, economic and regular supply of petroleum to consuming nations, and a fair return on their capital to those investing in the petroleum industry." OPEC's influence on the market has been negatively criticized. Several members of OPEC alarmed the world and triggered high inflation across both the developing and developed world when they used oil embargoes in the 1973 oil crisis. OPEC's ability to control the price of oil has diminished somewhat since then, due to the subsequent discovery and development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization (Yergin; Perkins, 2005). OPEC nations still account for two-thirds of the world's oil reserves, and, as of March 2008, 35.6% of the world's oil production, affording them considerable control over the global market. The next largest group of producers, members of the OECD and the Post-Soviet states produced only 23.8% and 14.8%, respectively, of the world's total oil production. As early as 2003, concerns that OPEC members had little excess pumping capacity sparked speculation that their influence on crude oil prices would begin to slip (Kohl, 2002; Perkins, 2005). II. Effects of Oil Price Fluctuations After 1980, oil prices began a six-year decline that culminated with a 46 percent price drop in 1986. This was due to reduced demand and over-production that produced a glut on the world market. This caused OPEC to lose its unity. OPEC net oil export revenues fell in the 1980s. Leading up to the 1990-91 Gulf War, Iraqi President Saddam Hussein advocated that OPEC push world oil prices up, thereby helping Iraq, and other member states, service debts. But the division of OPEC countries occasioned by the Iraq-Iran War and the Iraqi invasion of Kuwait marked a low point in the cohesion of OPEC. Once supply disruption fears that accompanied these conflicts dissipated, oil prices began to slide dramatically (Hammoudeh, 1997; Kohl, 2002). After oil prices slumped at around $10 a barrel in the late 1990s, concerted diplomacy, sometimes attributed to Venezuela's president Hugo Chvez, achieved a coordinated scaling back of oil production beginning in 1998. In 2000, Chvez hosted the first summit of heads of state of OPEC in 25 years (Rotemberg, 2005; Kohl, 2002; Kaufman, 2001). The next year, however, the September 11, 2001 attacks against the United States and the subsequent invasion of Afghanistan and 2003 invasion of Iraq and subsequent occupation prompted a surge in oil prices to levels far higher than those targeted by OPEC during the preceding period. Indonesia withdrew from OPEC to protect its oil supply interests. On November 19, 2007, global oil prices reacted strongly as OPEC members spoke openly about potentially converting their cash reserves to the euro and away from the US dollar (Rotemberg, 1996; Perkins, 2005; Kohl, 2002). III. Aims and Objectives of the Research The general aim of this proposed research is to find out how the decreasing oil prices are affecting the countries which are creators and/or members of the Organization of Petroleum Exporting Countries (OPEC). The specific objectives of this proposed research is to investigate the effects of decreasing oil prices on the political, economic and social institutions of OPEC member-countries such as Saudi Arabia, Kuwait and Venezuela. In particular, this proposed study seeks to look into the effects of decreasing oil prices on the political stability, economic performance, and social stability in the member-countries of OPEC. IV. Research Methodology The methodology of this proposed research is the use of survey questionnaire. Through the use of survery questionnaires, the proponent seeks to gather data on the perceptions regarding the effects of decreasing oil prices on the political stability, economic performance and social stability of member- and creator countries of OPEC. The survey methodology is important since it will provide primary data in this study. The proposed methodology will focus on gathering the views of a sample population. The contents of the survey questionnaire will be delimited to questions on how the respondents perceive the effects of decreasing world oil prices. V. Review of Related Literature The study of Rotemberg sought to modify the standard neoclassical growth model by assuming that competition is imperfect makes it easier to explain the size of the declines in output and real wages that follow increases in the price of oil. Plausibly parametrized models of this type are able to mimic the response of output and real wages in the United States. The responses are particularly consistent with a model of implicit collusion where markups depend positively on the ratio of the expected present value of future profits to the current level of output (Rotemberg, 1996). Optimization models are one way of analyzing the possible future oil pricing behaviour of oil producing countries. The paper by Hammoudeh compares and contrasts seven recently published optimization models of price behaviour. The specification, operation and results for each model are summarized, in turn, with particular emphasis on their treatment of Saudi Arabia as a price setting residual supplier (Hammoudeh, 1997 ). The shortcomings and advantages of each model are described and a comparison presented which provides a framework to enable the policy makers and model builders to assess the models. It is concluded that none of the models is entirely satisfactory and there is no agreement on optimal price trajectories. There is, however, consensus that present OPEC prices are higher than their long-term interests would prescribe (Hammoudeh, 1997; Perkins, 2005). This study by Kaufman, et al. estimate models that identify the economic and organizational determinants of crude oil production by individual OPEC nations. To clarify the interpretation of econometric results, the authors modeled production with specifications that resolve the statistical ordering of variables and estimate models with techniques that can cope with stochastic trends in the time series. The authors also analysed the short-run dynamics for asymmetries that may carry important insights about OPEC behaviour. Results indicate that quotas are an important determinant of production and their effects generally are symmetric, which implies that OPEC is an organization that influences production and ultimately prices. Real prices generally have a positive effect on production and the size of this effect may depend on share capacity, which implies that OPEC behaviours also embody competitive elements. The study concludes that all member-nations of OPEC other than Saudi Arabia show some form of production sharing behaviour, which may imply that OPEC shares mismatches between the call for OPEC production and OPEC quotas (Kaufman, 2001). In Kohl's study, the author asserts that price volatility has been a central feature of the world oil market over the past several years. Oil prices plunged to around $10/barrel in late 1998 and early 1999, then recovered and soared above $30/barrel in 2000. After seriously misjudging the oil market in 1997-98 and contributing to an oil price collapse, OPEC rallied in 1999-2000 and successfully pushed prices upward but overshot its target. In the first half of 2001 OPEC maintained high but more stable oil prices. Later in the year OPEC struggled to manage falling prices set off by a global recession made worse by the attacks of September 11 and the war on terrorism (Kohl, 2002). The oil price collapse caused serious damage to OPEC economies. Price recovery became a survival priority, and this was the prime motivation for a more successful effort to reduce production in 1999 in order to raise prices. Because of accumulated debts and expanded government services, and their failure to diversify their economies, most OPEC Gulf states have now become dependent on higher oil prices to fund their revenue needs. This explains OPEC's shift in strategy from market share to target price around $25/barrel and the adoption of a higher price band. But is the target price too high for the present world economy Will it encourage or discourage the long-term growth in oil demand upon which OPEC depends Political factors are also important in OPEC's improved discipline, including changes in government in Venezuela and other states, a Saudi-Iranian rapprochement, and increased professionalism on the part of OPEC itself in managing and reacting to the oil market (Kohl, 2002). Nevertheless, OPEC has difficulty in exercising its market power. It has only one instrument-adjusting supply-to meet seasonal demand changes for crude oil, changes in Iraqi exports, price movements, and shifting economic conditions. The oil market is a difficult market to manage, and OPEC still works with imperfect data and limited instruments. There are important aspects of the market over which it has little control. Price volatility is therefore likely to continue in the years ahead (Kohl, 2002). OPEC decisions have had considerable influence on international oil prices. For example, in the 1973 energy crisis OPEC refused to ship oil to western countries that had supported Israel in the Yom Kippur War or October War, which they fought against Egypt and Syria. This refusal caused a fourfold increase in the price of oil, which lasted five months, starting on October 17, 1973, and ending on March 18, 1974. OPEC nations then agreed, on January 7, 1975, to raise crude oil prices by 10%. At that time, OPEC nations - including many who had recently nationalized their oil industries - joined the call for a new international economic order to be initiated by coalitions of primary producers. Concluding the First OPEC Summit in Algiers they called for stable and just commodity prices, an international food and agriculture program, technology transfer from North to South, and the democratization of the economic system. Overall, the evidence suggests that OPEC did act as a cartel, when it adopted output rationing in order to maintain price. After the introduction of the euro, pre-invasion Iraq decided it wanted to be paid for its oil in euros instead of US dollars causing OPEC to consider changing its oil exchange currency to euros, although after Iraq's invasion, the interim government reversed this policy, and the subsequent Iraq governments stuck to the US dollar (Yergin; Perkins, 2005). Member states Iran and Venezuela have undergone similar shifts from the dollar to the Euro. Since currently worldwide oil sales are denominated in U.S. dollars, changes in the value of the dollar against other world currencies affect OPEC's decisions on how much oil to produce (Perkins, 2005). For example, when the dollar falls relative to the other currencies, OPEC-member states receive smaller revenues in other currencies for their oil, causing substantial cuts in their purchasing power. VI. References 1. Figueredo, Reinaldo. Energy Issues Redefining Latin American Policies, Society for International Development. (Amsterdam: December 2007); 2. Hammoudeh, Shawkat. The Future Oil Price Behaviour of OPEC and Saudi Arabia: A Survey of Optimization Models. (Energy Policy Journal: November 1997) 3. Kaufmann, Robert K., Bradford, Andrew, Belanger, Laura H. McLaughlin, John P., and Miki Yosuke. Determinants of OPEC Production: Implications for OPEC Behaviour, (2001) 4. Kohl, Wilfrid. OPEC Behaviour, 1998-2001. (Energy Policy Journal: July 2002) 5. Perkins, John. Confessions of an Economic Hit Man (2005); 6. Rotemberg, Julio J. and Woodford, Michael D. Imperfect Competition and the Effects of Energy Price Increases on Economic Activity. National Bureau of Economic Research (NBER) Working Paper No. W5634 (Harvard University: June 1996); 7. Yergin, Daniel. The Prize: The Epic Quest for Oil, Money, and Power. Read More