CHAPTER THREE

Why OPEC Had to Fail

WHEN THEY MEET IN DECEMBER 1982, the members of the Organization of Petroleum Exporting Countries will decide whether they can hold their cartel together for another year, or whether their attempt to keep both prices high and all production going has failed. The OPEC countries produced in 1982 only about 60 percent of the oil they pumped before the quadrupling of prices in 1973, and by 1982 even prices were beginning to be under pressure. Indeed, a strong case can be made that OPEC is declining just the way cartels have always declined.

To understand what is happening to OPEC, it is helpful to review the rules of cartel theory, first formulated in 1905 by a young German economist, Robert Liefmann, in his book Die Kartelle , and validated by all subsequent experience.

The first of these rules is that a cartel is always the product of weakness. Growing industries don’t form cartels: only declining ones do.

At first, it was assumed this rule did not apply to OPEC. It was assumed that OPEC could raise prices so astronomically because oil consumption had been growing exponentially and was slated to grow even faster.

But study after study since the price explosion of 1973 shows that the developed countries had previously been growing less dependent on petroleum. From 1950 to 1973, the energy required to produce an additional unit of manufacturing output in developed countries declined by 1.5 percent per year; since then the decline has been much more rapid.

The story is the same in transportation. Since 1960 the energy needed for each additional passenger mile or revenue freight mile has fallen as the result of the switch to jet airplanes, to compact and subcompact cars, and to diesel bus and truck engines. Even in heating and air-conditioning, the third major consumer of energy, there has been no increase in the incremental input unit of energy since 1960.

Perhaps most important, energy use in developed countries rose faster than GNP during the first half of the century, but since 1950 it has been growing slower than GNP. In the industrial countries, to produce one unit of GNP, it took 26 percent less oil in 1982 than it had taken nine years earlier.

The relative decline in oil consumption suggests that during economic downturns the industry will drop more sharply than the overall economy but will recover less than the economy in every upturn cycle.

According to the second basic rule of cartel theory, if a cartel succeeds in raising the price of a commodity, it will depress the prices for all other commodities of the same general class.

When OPEC raised oil prices in 1973, it was generally believed that the prices of all other primary commodities—agricultural products, metals, and minerals—would rise in parallel with the petroleum price. But a year later, the prices of all other primary products began to go down. They have been going down ever since.

Indeed, the share of disposable income that developed countries spend on all primary products, including oil, is lower today than in 1973. And the terms of trade are more adverse to primary producers than they were ten years ago. They are as unfavorable as they were in the great raw materials depression of the early 1930s.

One surprising consequence of this is that Japan, the country most panicked by OPEC and the “oil shock,” has actually been a beneficiary of OPEC, while the United States has been OPEC’s chief victim. Japan imports all its oil. But this amounts to less than 10 percent of its total imports, with the rest consisting mostly of other primary products such as foodstuffs, cotton, timber, metals, and minerals. Their prices have come down.

Conversely, the United States is the world’s largest exporter of nonpetroleum primary commodities, particularly agricultural products, whose prices are much lower than they would be were it not for OPEC.

A cartel, according to the third rule, will begin to unravel as soon as its strongest member, the largest and lowest-cost producer, must cut production by 40 percent to support the smaller and weaker members. Even a very strong producer will not and usually cannot cut further. The weaker members will then be forced to maintain their production by undercutting the cartel price. In the end, the cartel will collapse into a free-for-all. Or the strongest member will use its cost advantage to drive the weaker and smaller members out of the market. OPEC has been singularly lucky. Its second strongest member, Iran, has been forced to cut output by more than 50 percent as a result of revolution and war. Even so, the largest producer, Saudi Arabia, has had to cut its output by more than 40 percent to prevent a collapse of the cartel price. The other, weaker members, as predicted by the theory, have begun to bootleg petroleum at substantial discounts of as much as 15 percent below the posted price.

In the meantime, as the fourth of the cartel rules predicts, OPEC has lost its dominance of the oil market. “Any cartel undermines the market shares of its members within ten years or so,” Mr. Liefmann concluded in 1905. In 1973, the OPEC countries accounted for almost 60 percent of the oil supply of the industrialized countries. Their share nine years later had fallen to about 45 percent (and by 1985 to a third). As predicted by cartel theory, OPEC is losing market position to newcomers outside it, such as Mexico, the North Sea, and Gabon.

The fifth and final rule is that in the end a cartel permanently impairs the position of its product, unless it cuts prices steadily and systematically, as did the only long-lived monopolists on record, the explosives cartel before World War I and the Bell Telephone System from 1910 through 1970. However, the experience of most past cartels, for example, the European steel cartel between the wars, suggests that for a long time to come, petroleum will lose markets fast when it becomes more expensive but will not regain markets by becoming cheaper.

It would be foolish to dismiss the features that distinguish OPEC from other cartels. The most important is surely geopolitics: Much of the world’s petroleum, and particularly so much of the oil with low exploration and production costs, comes from areas of political instability. The developed countries might well decide to maintain costlier but politically safer sources of hydrocarbons; for example, Soviet natural gas for Western Europe or Mexican oil for the U.S. strategic petroleum reserve. But a decision to pay a premium price as political insurance could only speed the decline in consumption and in dependence on petroleum.

One cannot yet rule out what all the energy specialists predict: that the oil market is different, and OPEC will behave differently from other cartels. The test will come with the first sustained economic upturn in the developed countries. We will then know whether petroleum consumption will go up as fast as the economy, or whether, as cartel theory predicts, it will rise much more slowly or perhaps not at all.

(1982)

1986 Note: The test did indeed come with the 1983 upturn in the American economy. And as cartel theory predicted, consumption did not go up as fast as the economy, indeed hardly went up at all. What then delayed the cartel’s collapse for two years, until the fall of 1985, was Saudi Arabia’s willingness—possible only for a country that has very few mouths to feed—to cut production another 15 percent to below one-quarter of capacity output. But even this did not reverse the downward slide of both oil consumption and oil prices. And when the collapse came—in the fall of 1985—it went faster and further than any earlier major cartel had collapsed.