OPECs Ability to Manage Oil Price - Essay Example

?OPEC’s ability to manage oil price Introduction This essay tries to asses the ability of the Organisation of the Petroleum Exporting Countries (OPEC) to manage the price of oil. This cartel is a significant component of the modern-day global production system. Oil reserves and OPEC The OPEC is a cartel composed of 12 member countries including Algeria, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, Venezuela, Angola and Ecuador. OPEC is said to hold about 70% of the world’s oil reserve in 2008 (Gorelick, 2009). These members supply around 40% of the world’s oil (USA Congressional Record, 2007). Law of Supply and Demand (Mankiw, 2008) OPEC’s economic goal is to control production in order to raise the price of oil and eventually increase the generation of its members’ substantial profit. In a free market, the supply and demand tend to push the price at the level in which quantity supplied and quantity demanded are equal (Baumol and Blinder, 2008). Based on this law, it can be pictured out that when the supply of a normal good is low but its demand is higher, it substantially results to price increase. Thus, OPEC is on the right track of controlling production in order to maximise the oil resources of its members. In fact, it has a significant power to control the entire market considering that 70% of world oil reserve belongs to the cartel. Furthermore, OPEC targets to supply only 40% of the world’s oil consumption. This means that it has created influence on the world’s oil supply provided that the demand is higher and even reaching to an upward spiral due to rising economies. Oil is the lifeblood of the modern economy (Navarro, 2008). This means that every economy, developing or even highly developed will tend to maximise resources and even operations, but this cannot be addressed efficiently without relying heavily on oil supply. For instance, oil has become the very reason for every business to operate. From production, down to transportation and inside every household, oil is gaining a wide range of importance, function and economic role. Thus, oil is considered as a normal good and becomes the basic commodity in the world. Oil therefore has created a specific level of demand depending on a certain economy’s requirements in order to sustain and enhance its development and growth. However, from 1972 to 2008, it is noted that OPEC has been ineffective at maintaining cooperation among its members due to issues concerning restriction of production (Mankiw, 2008). Mankiw explained that members were tempted to cheat their productions just to gain more profit advantage. As a result to this, the increase of oil price was never been successful on restricting production, but because of the increase in demand of worldwide consumption. As shown in Table 1, the price of oil per barrel increases over time. However, this increase was pointed out as barely influenced by OPEC’s success in restricting its production, but due to increase in market demand for the said commodity (Mankiw, 2008). In the mid-1980s OPEC members were having misunderstanding regarding on the regulatory issues of production. As a result, the production increased beyond the controllable limit as specified by OPEC. As the production of oil in the world market increased, there was more supply available leading to the decrease in price. Such decrease in price was clearly due to availability of supply, but what seems to be obvious was the desire of some OPEC members to gain productive output from their oil resource. In 2007 to 2008, the price of oil substantially was higher. However, it was due to the increase of demand in the world oil market as there was an increasing number of emerging economies such as China (Mankiw, 2008). Table 1. History of oil price as influenced by OPEC regulation of production (Mankiw, 2008) Year Price per barrel 1972 $3 1974 $11 1981 $35 1986 $13 Income and substitution effect The positive income effect states that when the price of normal good decreases it leads to increase consumption of that good because of affordability issue (Dwivedi, 2002; Alhadeff, 1982). However, the increase in price for a normal good leads to reduction of purchasing power or even will lead to substitution effects (McEachern, 2008; Baumol and Blinder, 2008). The substitution effect is a specific measure of a good’s consumption level based on some changes made in its price (Lindeman, 2001). It is therefore implied that in the case of a normal good, the relative changes in its price leads consumers to find for alternatives provided that income remains constant (Chakravarty, 2009; Schwartz, 2010; Hirschey and Pappas, 1996). This further implies reduction of revenue for a certain good that has been replaced with any available alternatives. This also points out the very nature of the demand of a certain good. It is therefore clear that the change in demand is equivalent to the combined impacts of substitution effect and income effect (McConnell and Brue, 1993). Considering that OPEC will be successful in its control of oil production in the world, its goal is then partially obtained. The cartel’s basic view is specifically to generate oil price increase in the world market by limiting its production. However, the theory of income and substitution effect may apply in this case. It is not easy to achieve what OPEC wanted to happen with their production and income generating strategy considering that that there are other alternatives, which will substantially change the nature of demand for oil the moment price will increase. The existence of biofuels and other alternative energy sources are all potential alternatives in the event that oil prices from OPEC production increases to the level in which the income effect may substantially affect the nature of demand for oil consumption. For instance, one of the essential functions of fossil fuel such as oil is to conduct electricity and other industrial usage. In Europe alone, fossil-fuel based electricity generation is very common. However, the existence of wind energy source substantially contributed to the reduction of strong dependence on fossil fuel energy source as shown in Table 2. This is also in consideration with the strong campaign against excessive use of fuel source that will produce green house gases. Therefore, one of the alternative energy sources aside from fossil fuels like oil is wind energy. This is just a specific case that in an economic activity, people are likely to look for alternatives in order to consider savings and other important economic considerations. As shown in Table 2, it is very likely that fuel oil will be replaceable by other alternative energy source just for this reason. Again, the capacity of OPEC to control the price for world’s oil market may not be due to restricting its production due to income and substitution effect. On the other hand, the presence of other alternatives weakens the ability of the said cartel to be so ambitious to reach a specified world’s oil price. In fact, some countries are now trying to look for alternatives and one of them is Denmark. As shown in Table 3, Denmark is one of the highest producers of electricity from wind energy in the world. This means that it has substantially saved enough from using fuel oil at some point. This specific case alone contributed to the reduction of demand for oil. Table 2. Fossil fuel-based electricity generation replaceable/avoidable by wind (and other renewable electricity generation technologies) in the EU-27 Member States in 2007 (European Wind Energy Association, 2009) Table 3. Percent of Total Electricity Derived from Wind (2006) (Asplund, 2008) Setting a target range for the price of oil As an advisor to the secretary general of OPEC, it would be important to explain the fact that the goal of some members to increase production for the purpose of generating more profit would not be generally beneficial for the cartel, but generally for the consumers. In the case of highly developed countries, the decrease in price for world oil would be a great opportunity for them to acquire for more reserve. Thus, this specifically will reduce the chance of OPEC to supply oil at considerable revenue considering that the nature of demand has substantially changed. The oil reserve bought at a lower price would be a better substitute for a high priced one. Considering that oil is lifeblood of modern economy then it implies that it is indeed a necessity for economic growth. In order to set a target range for the price of oil, OPEC must prevent consumers to look for alternatives because this will reduce its revenue. As observed, increasing the price for oil may not necessarily increase profit among producers. What OPEC needs to do is to remain with its goal to control production at a level in which it would stimulate high level of demand just like in the year 2007 to 2008. In order to obtain this, OPEC must be able to come up with internal policies that will prevent its members from over production through gaining genuine cooperation from them. Furthermore, since oil price is based on the US dollar, there can be no assurance that the same price will prevail from time to time. To maintain its goal for a higher price plus a considerable profit, it is good if OPEC will supply less in times when the value for dollar is lower and vice versa. However, it must regulate distribution among highly developed nations that are capable of buying enormous volume for reserve. OPEC must target to control oil reserve of every nation especially those highly developed countries. Conclusion The idea of OPEC to control or regulate production to influence world’s oil price may not be sufficient. This is due to the fact that there are other economic considerations that need to be taken into account. What OPEC can substantially do is to focus on creating effective policy to entirely control its oil production and gain genuine cooperation among its members. References Alhadeff, D. A. (1982) Microeconomics and human behavior: toward a new synthesis of economics and psychology. Los Angeles: University of California Press. Asplund, Richard W. (2008) Profiting from clean energy: a complete guide to trading green in solar, wind, ethanol, fuel cell, power efficiency, carbon credit industries, and more. New Jersey: John Wiley and Sons. Baumol, W. 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(2008) The coming China wars: where they will be fought and how they can be won. New Jersey: FT Press. Schwartz, R. A., Carew, M. G., and Maksimenko, T. (2010) Micro Markets: A Market Structure Approach to Microeconomic Analysis. New Jersey: John Wiley and Sons. USA Congressional Record (2007) Proceedings and Debates of the 110th Congress: First Session. Washington DC: United States Government Printing Office. Read More