Article / 25 August 2016 at 14:45 GMT

Opec: Cartel of collusion or an ouroboros?

Managing Partner / Spotlight Group
United Kingdom
  • Opec is a cartel... it seeks to fix prices by Saudi dictat
  • It is ineffective as junior members chisel and cheat
  • Iran has no interest in curbing production
  • Market manipulation to higher prices will encourage new entrants

By Stephen Pope

I feel I ought to explain my headline by describing what is meant by Opec: cartels and collusion.
The website of the Organisation of Petroleum Exporting Countries says that it is an intergovernmental organisation of 14 oil-exporting nations that coordinate and unify the petroleum policies of its member countries. That is not really true now, is it? 

Opec is dominated by the will of its leading member and oil producer, i.e. The Kingdom of Saudi Arabia.
Opec Source:

Venezuela’s oil output, is currently at its lowest level since 2009 and is going to decline further this year. Oil contractors are rushing to scale back drilling programmes after the national government has fallen more than $1 billion behind in payments.

Oil production, which generates 97% of export revenue is set to fall by 12% in 2016 from 2.3 million barrels/day last year to just 2.0m b/d. This is all because oil-services companies aren’t being paid, according to the International Energy Agency.

Therefore, as far as Opec goes, KSA is supreme. No other producer can directly offer a challenge to the will of the Saudis within the Opec framework.

 Opec is dominated by the will of its leading member and oil producer,
the Kingdom of Saudi Arabia. Photo: iStock 

This fact may play into the oil producer’s hands as it is known that a further decline in Venezuelan output, combined with disruptions in Nigeria and Libya, could leave the global oil market short of supply by the end of Q2 2017. No – shale production will fill the gap.

Really, the only reason that the policies of Opec nations are unified is because when it comes down to it they all have to – superficially at least – fall in line with KSA and sign up to the direction the leader producer wishes to take. That sounds rather like a cartel, i.e. “ association of manufacturers or suppliers with the purpose of maintaining prices at a high level and restricting competition.”

I will not soft-soap the issue, Opec is a formal organisation of oil-producing nations that agree to fix production using a variety of tactics such as setting minimum or target prices (price fixing), adjusting total industry output and fixing market shares or a combination of these. The aim of this collusion (also called the cartel agreement) is to increase individual members' petroleum. This is known as “joint profit maximisation”.

Joint profits will be maximised when the industry’s marginal revenue (MR) equals the industry’s marginal cost (MC). The chart shows the situation where D is the market (or cartel) demand curve and MR is its corresponding marginal revenue curve. The aggregate marginal cost curve of the industry ΣMC is drawn by the summation of the MC curves of producer 1 and 2, so the ΣMC = MC 1 + MC 2.
Joint Profit Max
Source: Spotlight Education

The problem with joint profit maximisation is that the cartel members may eventually agree on the principle but in practice, the lowest cost producer, i.e. KSA in Opec’s case, will tend to always be the largest producer and so many members do not believe they receive a fair deal from the distribution of proceeds from joint profit maximisation.

The output of oil once fixed by Opec cannot be openly changed even if the market conditions require it to be. This is because it takes a long time for the members to arrive at a new agreement. The upshot of the mismatch between a dynamic market and stochastic production is “chiselling” where producers begin to violate the quota agreement.

Oil prices show slippery activity

Last week, the price of oil was slowly climbing back up to $50/barrel based on reports that Opec leaders were planning to meet to discuss a production freeze at the end of September. At the start of this week, however, the oil analyst community did not believe that Opec will agree to a production freeze. After all, KSA has been pumping as fast as possible so as to pursue a revenue maximisation policy given the threat of oil supplies from the US shale industry.

On Tuesday, August 23 at 1045 Eastern standard time, the price of oil shot up by 2.87%, (see orange oval in chart below), all based on a Reuters report based on an unnamed Opec source, that Iran might be interested in “joint action” to support oil prices, i.e. “joint profit maximisation”.

This was irrational behaviour by the oil market given the fact that the Iranian Oil Ministry had not even confirmed that Iran was attending the September meeting in Algeria.

Consider the facts. Iran has no incentive to curtail its oil production. The Islamic Republic is in urgent need of money and has just overcome a major political hurdle on the way to offering new types of petroleum development contracts (called Iran Petroleum Contracts or IPCs) to investors.

The entire premise is flawed as if Iran issued an agreement to freeze its oil production at current levels it would signal to investors that Iran is not open for petroleum development. That would severely fetter the country’s ability to increase its revenue and deploy the latest Western oil technology in the future. In short I am convinced Iran will not be party to such an arrangement.

What is more likely is that Iran is in cahoots with others in Opec in exploiting the speculative nature of a commodity market such as oil. Given that all oil-producing countries and companies (with exceptions, i.e. Libya, Nigeria and Venezuela) are producing at high rates, and given that global demand is not increasing at the same rates, the price of oil is stuck in a range.

Producing countries – both Opec and non-Opec – have found that they can easily manipulate oil traders with words, and oil ministers past and present, have criticised the market speculators for their knee-jerk reactions to their every word. So why not play the weakness of the market to one’s advantage?

 Getting ready ... higher oil prices will encourage shale producers to start
returning to their drilling rigs. Photo: iStock

The market has to be smart enough to see through the calculated statements that are not outright lies but are highly “truth-lite”. These statements are designed to create a period of rising prices even though there is an excess of supply. The worst form of industrial economic price manipulators are showing their true colours. They are breaking the laws of economics but doing it legally.

However, Opec will get its comeuppance as higher oil prices will encourage shale producers to start returning to their drilling rigs, threatening to slow further price gains. Until the global economy moves into overdrive, or there is a disaster (heaven forbid) in the oil-producing region then oil prices cannot defy gravity.

In the end the market will always triumph as the cartel might raise prices but it cannot create effective barriers to entry. If Opec members carry on in this manner then they will find their influence fading fast as Opec goes the way of an ouroboros.

– Edited by Gayle Bryant

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.


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