Ayoub - Oil, Economics and Political

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Energy Studies Review

| Issue 1Volume 6 Article 2

5-9-1994

Oil: Economics and PoliticalAntoine Ayoub

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Recommended CitationAyoub, Antoine (1994) "Oil: Economics and Political," Energy Studies Review: Vol. 6: Iss. 1, Article 2.Available at: http://digitalcommons.mcmaster.ca/esr/vol6/iss1/2
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Oil: Economics and Political

Abstract

This article deals with the evolution of the international petroleum sector since 1973 with a special view to

interdependence between the economic and political factors that influence it. Two issues are focused upon:(1) the effects of the nationalization of oil companies on the sharing of oil rents and on changes in thestructure of the oil market; and (2) the determination of oil prices. The latter involves a discussion of, on theone hand, the political and economic behaviour of the United States and Saudi Arabia and, on the other, thecombination of cooperation and conflict that has tended to characterize relations among OPEC countries.

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This article deals with the evolution of the internationalpetroleum sector since 1973 with a special view tointerdependence between the economic and political factorsthat influence it. Two issues arefocused upon: (1) the effectsof the nationalization ofoil companies on the sharing ofoilrents and on changes in the structureof the oil market; and(2) the determination of oil prices. The latter involves adiscussion of, on the one hand, the political and economicbehaviour of the United States and Saudi Arabia and, on theothr:r, the combination ofcooperation and conflict that hilStended to characterize relations among OPEC countries.Carhele presente une synthese et une tentative d'explicationde l'evolution du secteurpetrolier international depuis 1973en tenant compte du phenomene de l'interdependance entrelesfacteurs economiqueset lesfactwrs politiques. Deux pointssont priviIegies. Le premier est l'examen des effets desnationalisations (facteur institutionnel) sur la partage de larente pitroliereet les modificationsdes structures du marche.Le deuxieme point met l'accent, d'une part, sur lescomportements economiques et politiques des Etats-Unis etde l'Arabie-Saoudite, et d'autre part, sur Ie "conflit-cooperation" entre les pays et l'OPEP, pour expliquer ladetermination et revolution des prix.

AntoineAyoub 'is Professor of Economics at UniversiteLaval in Quebec and Visiting Professor at UniversitePantheon-Assas, Paris II. This paper is based on notesfrom a seminar given by him when he was awardedthe College de France Medat June 4,1991.

Oil: Economics andPoliticsANTOINE AYOUB

1. IntroductionUntil the Gulf crisis of 1990-91, many werearguing that oil had lost i ts strategic role, thatit had become an ordinary commoditygovernedby the standard laws of the market, and that themarket would peacefully solve any conflictwithin OPEC or between OPEC and the oilbuying countries. "Desert Storm" blew downthose convictions by demonstrating, if itwas stillnecessary, the strategic and vital role of oil.Furthermore, it indicated again the interdependence between economics and politics in everything concerning oil.Such interdependencemay appear as evidentto anyone involved in oil management in eitherthe public or private sectors. It is not the case,however, for economists at universities who havestudied the market structures and price mechanisms involved. For them, the oilmarket has beenanother area in which to apply standard formaleconomic analYSis, without taking into accountthe role of politics. The results of these exerciseshave often appeared to bein a vacuum, far fromthe real world.

Indeed, 20 years after the oil shock of 1973,the academic literature is abundant but inconclusive.1 Despi te the great sophist ication of themodels describing the behaviour of OPEC and1/ See, among others, the surveys by Griffin and Teece(1982), Gately (1984 and 1986), Barbet (1983), andAyoub and Percebois (1987).

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oil prices, the question remains an "open" one(Gately, 1984, p.l113) and econometric testing ofall themodels does not seem conclusive (Griffin,1985; and Fischer, 1987). In short, an assessmentof those many years of work is apparentlydisappointing. The past does not seem to beexplained in a way thatwould satisfy a majorityof economists, and the predictions regardingfuture prices do not tend to be confirmed bywhat is subsequently observed on the market.This lack of consensus is, sadly, neither newnor unique in economics. In the context of thisdiscussion, however, it offers an advantage: amargin of freedom in our search for new ap-proaches to the problem. The approach I havechosen is deliberately institutional, in the sensethat it tries to tackle and understand economicphenomena (and change in them) by accounting,asmuch as possible, for institutional changes andgeopolitical factors. It is true that such an ap-proach is difficult to formalize, but that may bethe price to pay to be closer to the complexreality of the oil sector.

In my view, neither the thesis of oil as an"ordinarycommodity" (allowing explanation byeconomics alone), nor the thesis of a "plot"(allowing explanation by politics alone andattributing any changes to the occult actions ofsome country), appear satisfactory as ways ofunderstanding the problems and the evolutionof the oil sector. Consequently, I have tried sincethe beginning of the 1970s to analyze thisevolution by taking into account, as much aspossible, the convergence and the divergence ofboth economic and political interests, which hassometimes led the actors to a compromise andsometimes to a rupture. This article gives me anoccasion to bring earlier papers up to date andto clarify, develop, and correct some propositionsalready formulated (Ayoub, 1975, 1976a, 1976b,1986,1988,1990,1991).Without fully sharing alltheir conclusions, I note thatmany authors haveadopted the same institutional approach usedhere. It is possible to mention, among others,Moran (1982), Mohnfeld (1984), and Verleger(1988).By adopting such an approach, I admittedlybear the risk of setting out on a difficult pathwithout a safety belt. For, despite the important

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and recognized role of political factors in economic activity, there is not to my knowledge atheory that has succeeded in integrating, withina consistent and formal framework, the effectsof political power within an economic analysis.It is precisely for this reason that what followsdoes not claim to defend a thesis but rather proposes for discussion a frameworkwhichwill perhaps allow one to understand better the complexreality of the oil sector.

My arguments are organized around twopoints that I consider fundamental. The first isan at tempt to trace back the effects of thenationalization of oil companies (i.e., aninstitutional change) on the sharing of oil rentsand on market structure (a phenomenon ofdisintegration and of vertical reintegration). Thesecond pointwill dealmore particularlywith oilprice determination and the influenceof politicalfactors on that determination. In this regard, theemphasis will be pu t on the linkage of SaudiArabia and the United States and on the"conflict-cooperation game" within OPEC.II . Nationalization and Oil RentSharingDuring the 1960s and 1970s, national sovereigntyover natural r e s ~ ) U r c e s was one of the main demands of a majorityof newly independentThirdWorld countries. The dominant idea at the timewas that political independence would be anempty concept if it was not accompanied by atransfer of the ownership and control of theresources offoreign firms, mostly multinational,to the national public sector.The oil sector did not escape theconsequences of such an idea; indeed, it was afavoured ground for its application. Thus we canconsider the abolition of the concession systemand the nationalization of the oil companies inthe OPEC countries as perhaps the mostimportant turning point in oil history ( P ~ n r o s e ,1988). It is this major ins titut ional change much more important than the 1973 fourfoldprice increase, whichwas its consequence - thatis the starting point for an analysis of the evolution of the overall economic structure of the oilsector. The first issue to deal with is the sharing

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of oil rents.Oil Rent: DefinitionsRecall that oil production generates various sortsof rents an d quasi-rents: scarcity rent (A), monopoly (or, more generally, imperfect market) rent(rm ), an d Ricardian differential rents (rd)' Becausethe exploitation of a reserve of a non-renewableresource takes place through time, the determination of the path of its price is really a dynamicquestion. However, we can represent the priceat a given moment in time as

as the return received by certain units of aresource du e to some advantage they have inproduction relat ive to other units which arenevertheless essential for the achievement ofmarket equilibrium (Percebois, 1989). Thus,at a given time, even in a competitive market,some production units (or resource deposits)involve different (average an d marginal) costs.Consequently, a deposit t ha t c a n b e exploitedat lower cost than the marginal deposi textracts a rent from buyers.

Why Nationalize'

where p ' is the equilibriumprice in a competitivemarket, C is th e marginal cost of the resource (inthis case crude oil), an d Ais th e scarcity rent.The above assumes that a ll firms (wi th eachfirm defined by a single homogeneous deposit)are identical. No w relax this assumption, as wellas the competitive market assumption, allowingfirms to have some monopoly power.Considering the case in which monopoly poweris identical for all firms, (1) is replaced by

where P w o ul d b e the price in an imperfect marke t an d C an d rd c an v ar y across firms.

I t is useful to recall the defini tions an d theconditions that result in the above mentionednatural resource rents: Scarcity rent (user cost), A, is, despite the tenrunology, a cost an d no t a rent . I t pays for the

exhaustion (or th e n o n-ren e wa b ility ) o f theresource, assuming that the supply is fixed.Once the a ss um pt io n o f a fixed stock isaccepted, Ais greater than zero. A competitivemarket does no t eliminate A; only the relaxation of the fixed stock assumption could dothat. On the other hand, Acan rise or fall an dis affected by changes in the marginal cost ofa barrel of oil. Imperfect market rent, rm is a function ofmarketstructure. This form of rent vanishes completely in a perfectly competitive market an d is atits maximum in the presence of a pure mono-poly. Differential rent (Ricardian), rd' ca n be defined

p' = C + A, (1)

(2)

1n light of the above definitions, we can no w ask:wa s it necessary for OPEC members tonationalize the oil companies? Were the takeoversonly the resultof an exacerbated nationalism an dth e political independence recently acquired factors that certainly ha d their influence - orwere they also a response to a much more preciseeconomic constraint? In other words, were thesenationalizations no t the perfect example of theinterweaving of economics an d politics?If we admit that the "oil game" is in the en da matter of rent sharing, the nationalizations (orot her similar l ega l arrangements, such asassociation, participation, etc.) which the majorityof the OPEC countries declared at the beginningof the 1970s, an d sometimes long before, havea raison d'ffre an d a justification.From equations (1) an d (2), an d for the casewhere the two partners (the owner an d thefranchise holder) are involved in the productionprocess, i t is obvious that the sharing betweent he m o f all the rents (A, rm an d rd) is influencedby the knowledge that each has ofthe realvalueso f p ', P an d C. If this condition is no t satisfied,th e bargaining power ofthe uninformed partneris v e ry w e ak an d the informed partner is likelyto impose the sharing rules (Ayoub, 1975).Before 1973, the "informed" partners surelywere the foreign independent companies,particularly theMajors. The producing countrieswere considered as "sleeping partners," contentwith taxing the companies according to more orless complicated formulae, such as the "tax paidcost," or apparently more radical formulae suchas "fifty-fifty." Reality wa s a lot simpler: the

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rigorous enforcementof those formulae, or evennegotiations about their concrete use, were-directly and exclusively dependent on theinformation providedby the oil companies to theproducing countries about P; P and C.Regarding the productioncostC, the oil companies were the only ones to explore for andproduce crude oil in the host countries. Consequently, they were the only ones to know aboutthe reserves and the production costs involved.Concerning p" and P, the situation was evenmore complicated because the system of verticalintegration and internal transfer prices that hadbeen adopted by the Majors at the beginning ofthe 1920s so dominated the marke t that i t waspractically impossible to find your way from theprices of oil products to the price of crude oil.In such a situation, one way for theproducing countries to find out the true valuesof P; P and C was to nationalize the companiesand thereby gain direct control over theirnational reserves and production. In almost notime, the OPEC countries found themselves theowners of large and growing quantities of crudeoil that they had to market directly. After havingbeen collectors of taxes and fees from the oilcompanies operating on their territory, thosecountries became in a short time the holders ofthe world's most important oil reserves and theworld's principal producers and sellers of crudeoil. The OPEC market was born.The changes brought about by thenationalizations during the 1970s can beconsidered, justly, as the really historic breakingpoint in the process of oil policy-making in thesecountries. In them we find a perfect example ofan institutional change that induces a whole setof economic phenomena, either directly orindirectly.Regarding the particular question of rentsharing, the only possible conclusion - and infact, the one we observed in reality - is thatwith the eliminationof the concession system andthe recovery of direct control over their resources,the OPEC countries obtained the means not onlyto change rent sharing to their advantage, bu talso to extract the full rent at the productionlevel.But the nationalizations also had another

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effect, maybe more important than rent sharing:the determination of the amow1t ofrent availableto extract. Indeed, once the producing countriesbecame the sole owners of their resources, theyhad to face a serious question: how can this rentbe made as great as possible through time or, tobe more precise, how can the net present valueof their known stock of oil in the ground bemaximized? Such a question immediately leadsone to the quantity-price equation whichultimately determines the size of t he ren t at apoint in time and its trend through time. Thisquestion will be discussed again in section IV.III. Nationalization and MarketStructuresBreaking Vertical IntegrationAs a second effect, the nationalizations led to thebreaking up of themarket systembuilt and managed by the Majors since the 1920s. This systemwas based on: (a) vertical integration from the"well to the pump;" (b) horizontal (geographic)concentration allowing the management, undera common authority, of deposits dispersed indifferent countries;and (c) an agreement, implicitor explicit, between the companies regardingmarket sharing (Ayoub, 1986 and 1988).

Until the beginningof the 1970s and with thehelp of this system, the Majors had under theircontrol the exploration, production, transportation, refining, and distribution of between 70to 80% of all crude oil and oil productsconsumed in the "freeworld" outside the UnitedStates.The direct consequence of this system ofcontrolwas undoubtedly stability in oilmarkets,in contrast with the chaos and wastage ofresources that had prevailed before. Althoughfrom time to time there were tensions andassociated incidents - foreseeable consequencesof competition from independent firms outsidethe agreement - these had marginal i m p ~ c t s onprice levels, which were in a downward trenduntil the 1970s (see Figure 1).The nationalizations imposed a clear breakwith this system: an important link in the oilchain, the production andmarketing of crude oil,




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IP''''Ylvan,an IR,,,'an Io;,eo'O'Y 0' I""'" Pool-war I IL"'" OPEC Introd,,, N&tbock IOil Boom Oil Exports Spindletop, Shortage ReCllnstruction Iranian Pricing and, later,World Begin Taxas in US Supplies Production QuotasEvents !",matra Growlh 0' I I"..n,m S'''I yoml !,ran,anroduction Venezuelan Field Crisis KiPpur. RevolutionBegins Production Discovered W"80

60

50 mH+m.-j .m mm ....................... m m m m 'm........ . m' mmm.m. . . . . . . . . . . \ m .

40 +! f ' I30 !; ,! , ' ; . : ~ , .............................................

20

10 , . . . . .

1 9 2 0 ~ 2 9 1 9 3 0 ~ 3 9 1940-49 1 9 5 0 ~ 5 9 1980-69

Current $Figure 1: Price of Crude Oil since 1861Source: BP Statistical Review of World Energy, 1993.

was pu t under the direct control of the OPECcountries. This induced the disintegration ofthesystem run by the Majors and the implementation of a dual system, with the OPECcountries controll ing the upstream activities(production andmarketing of crude oil), and theoil companies controiling the downstreamactivities (transportation, refining, distribution,and sale of oil products).As a result of this dual structure, the integrated system of the Majors cou ld no longerwork as before, while the OPEC system, neithervertically nor horizontally integrated, revealeditself, after some years of trying, to be unable to

Constant (1992) $

take over control of the whole sector from theoil companies.This consequence of the new structure, al-though written in the facts as early as 1973, wastemporarily hidden by the fear of an oil shortage,justified or not, that was prevalent throughoutthe 70s, and by the particular relations betweenthe largest producing countries of the Gulf andthe previous concessionary companies. The na-ture of these relat ions ( long-term contracts,discount of official prices, phase-out clauses, etc.)induced a sort of artificial vertical integration(Verleger, 1988).When, from 1981 onwards, tradein oil switched from being a sellers' to a buyers'

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market, this transitory system did not hold upand the path was cleared for the expansion offree markets.

Many consequences have been observed following the nationalizations and the changes inmarket organization that they induced.Access of the Majors to oil: A direct observableeffect of the nationalizationswas a radical changein the competitive position of the Majors in themarket for crude oil (Mohnfeld, 1984). Between1973 and 1982, these companies lost around 50%of their share of the crude oil market , f rom 30million barrels per day (MMbbl/d) to around15.2 MMbbl/d, while "free world" demanddecreased by only 15% over the same timeperiod. Evenmore significant, in 1982 theMajorscould only rely on 6.7 MMbbl/d of productionfrom the reserves under their control, while thecorresponding number in 1973 was 255MMbbl/d - a decrease of 74% in less than 10years. In other words, the Majors werebecomingimportant net buyers of crude oil after havingfor a long time been vertically integrated sellersto their own refineries.Breakdown oflzorizontal concentration: The decrease in the share of the Majors in the crude oilmarket was accompanied by the entry of newcomers - the non-OPEC producers - attractedby the increase in oil prices of the 70s. Thisincrease stimulated them to explore and produceat home. (Examples are Norway, Mexico, GreatBritain, Egypt, and some African and Asiancountries.) The Herfindal index of horizontalconcentration in an industry went from 1600 in1965 to around 930 in 1986 for the crude oilproduction industry, and from 1250 to around600 for the exploration industry (Verleger, 1988).This indicates that the nationalizations not onlyindirectly favoured free ent ry into the market,bu t also, and by this very fact, created a furtherdestabi lizing factor for OPEC, as we will seebelow. Evenmore to the point, the large majorityof the new producing countries (especially thosefrom the Third World) followed the OPECexample by nationalizing oil at home andcreating public oil companies.Restructuring of the refining sector: Thedecrease in the direct access of the Majors andof other companies to the oil reserves of the

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OPEC cow1tr!es pushed them to rationalize theirworld refining and distribution network in orderto decrease their dependence on OPEC crude oiland preserve, as much as possible, their integrated structure as companies. Thus the worldrefining capacity of the Majors decreased from23.3 to 14 MJ\1bbl/d between 1973 and 1982. Thistrend toward rationalization was to be reinforcedby the increase in the refining capacity of son1eof the OPEC count ries , tha t wanted to sell notonly crude oil, bu t also refined products.Expansion of Free MarketsIn the wake of a declining OPEC the mostimportantmarket was witl10ut question the spotmarket (i.e., the Rotterdam free market). Thismarket had, of course, been operating since the1930s, but was fulfilling only a complementaryrole in the Majors' delivery system for refinedproducts (Abu Khadra, 1980). With thenationalizations and the emergence of the OPECmarket, the spot market changed in orientationan d in size. In orientation because it starteddealing in crude oil as wel l as ref ined products;in size because as the OPEC market was declining, the number of transactions on the spotmarket was increasing. From the beginning ofthe 80s, "the spot" became the reference marketin world crude oil trade.The consequences of the expansion of thespotmarket and the important role that it endedup taking on, to the disadvantage of the OPECmarket, can be summarized in the followingpoints.Increase in the number ofparticipants: The num-ber of active participants in the crude oil marketincreased substantially. While it was previouslyreserved for a few large companies , today's oilmarketis invadedby an increasingly largenum-ber of actors: the national oil companies of theOPEC and the non-OPEC countries; the privateand public companies of the consuming nations(from multinationals tomedium-size comparues);and finally, the traders and brokers.Multiplication ofcomplementary markets: As thespot market functions a lot like the stockexchange, its development made o il pricesvolatile and the risks to be borne fairly high. To




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decrease these r isks or to provide protectionagainst them, parallel markets developed, suchas the forward market, which in turn led to theoption market. Many saw in this evolution a"standardization" of oil and its transformationfrom a strategic product to an ordinarycommodity. Without going that far ( the eventsof 1990-91 in the Gulf reducing this conclusionto nothing), and without taking a position as towhether the free markets were stabilizing ordestabilizing (see Artus, 1989, on this point), wecan nevertheless assert that the development ofthese markets made price control more difficultfor OPEC than was foreseen.Market structure and prices: The combinationof the two above mentioned consequences didindeed result in an industrial structurefavouringcompetition or, at the very least, made i t moreclificult to reach oligopolistic agreements. Thisdevelopment of free markets, with i ts consequence of making i t less easy to control prices,gave rise to two opposing impacts on OPEC. Onthe one hand, it had a destabilizing effect, in thesense that the existence of a flourishing and accessible free market was an easy "way out" foran OPEC member who did not wish to respectits own quota. As one would expect, the patternwas widely imitated. On the other hand, it hada stabilizing effect, or rather provided an incentive for cooperation, in the sense that the freemarket, by bringing prices down, made i t moreprofi table for OPEC count ries to reestablishagreement rather than seeking individually toprofit from their own actions. Many examplescan be found in the recent history of OPEC andthe oil industry of these two effects, althoughthey also show that the second effect is moreimportant in a buyers market.Return to Vertical Integration?Many years ago, Frankel (1948) reached twoimportant conclusions in his masterly study ofthe international oil sector. The first is that"non-stop" competition, when i t reigns over theoil industry, either leads to a general failure, orto the survival of a monopoly. The second is that"there is no doubt that always and everywhere,there has been an irreversible tendency toward

concentration, integration, and collusion."About 40 years later, he again confirmed

these conclusions in a recently published paper(Frankel, 1989). The arguments used to make hispoint are simple bu t penetrating (or ratherpenetrating because they are simple). For him,oil is a high- ri sk indus try, no t only because ofthe random aspects of exploration, but alsobecause of the large inveshnents required in theother phases of production (transportation,refining, and distribution). To decrease this risk,or as protection against it, the producers havethe incentive to diversi fy their exploration inspace to be able to compensate for disappointments (dry wells) with other successes(marketable discoveries): this is the raison d'etreof horizontal concentration. "What is true forexploration is also true, according to hir'l, in theother phases of the industry. Hence, the goal ofvertically integrating two or more phases is todecrease risk and insure an acceptable averagerate of return on a consolidated investment. Wecan add two other incentives: the availability andcontrol of the supply of crude oil and thepotential for capturing the refined productsmarke t. For Frankel the conclusion is that"integration is the natural habitat of the oilindustry;" it leads, further-more, to a certain pricestability through time.Although this view is no t fully shared byAdelman (1972), who does no t see "natural"reasons for integration and concentration in theoil industry, Frankel's thesis and his conclusionsare nearly a credo for the professionals, and thebehaviour of decision makers in the oil industryconfirms the rendencies expressed therein.Regarding the relation between integration andprice "stability," Hubbard (quoted by Verleger,1988) thinks that vertical integration favoursshort -term price stability, whi le hor izonta lconcentration favours long-term stability.

Whatever i s the outcome of this debate, it remains that in the last 10 years a clear willingnesshas been observed on the par t o f a few OPECcountries to invest in the refining anddistribution sectors in the United States andEurope. This trend took two fonns (Ayoub, 1988):direct control ( the Kuwaitian case), or sha redcontrol in joint ventures with the Majors (Saudi

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Arabia with Texaco in the US) or with privateoil companies of lesser importance (the cases ofVenezuela, Libya, Mexico, etc). Currently, OPECmembers' acquisitions in downstream activitiesoutside their borders represent 7.4% of totalrefining capacity in Europe and the US (about1.77 MMbbljd). (See Petroleum IntelligenceWeekly, 1990.) I f we add to these acquisitions thecontribution to exportsof refineries built in mostof the OPEC countries, we canreasonably talkof a new restructuring of the oil industry as areal, although hesitant, pOSSibility (Bourgeois etPerrin,1989). -

OU f conclusion at this stage is that a returnto a form ofvertical integration at the world levelwill never be achieved without taking into account the radical institutional change involvedin the nationalizations. The forms that such anintegrationwil l take wil l be closer to a partner-ship between each OPEC country and the oilcompanies than to exclusive control on the partof the oil companies, as was thecase before 1973.

On the other hand, paradoxical though itmayseem, it is precisely the nationalizations that haveled, by their effects on market structure an dprices, to a more pointed awareness of the inter-dependence between producing countries, con-suming countries, and the oil companies.IV. Oil Prices: An Economic Observationand Two Political ConstraintsIf we had to sununarize the overall oil pricingproblem, we could say that it is characterized bythe existence of a floor price that has not beenpierced since 1973, and by the absence of anagreed upon and stable ceiling price. Theexistence of the floor price is the consequence ofthe adoption by the United States of a preferencefor security rather than for narrowly defined pureeconomics. The absence of a ceiling price is ademonstration of the contradictions within OPECwhich divide members between those whoadvocate a "short plan" and those who prefer a"long plan."A Floor Price Ne-ver BreachedFigure 1 shows the evolution of the averageprice

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of crude oil f rom 1900 to the present . One notesthe sharp contrast between the period 1900-1970and the one that begins in 1973. While the firstlong period seems characterized by relativestability, the second is clearly dominated byabrupt and large fluctuations.Indeed, the average price (in current dollars)changed from US$1.90 jbbl in 1972, to $11 jbblin 1974, to $36jbbl in 1981, back to $14jbbl in1986, to $17 jbbl in 1989, and to $18-19 jbblcurrently. Over a 20-year interva l pr ices haveexploded twice (in 1973j74 and 79 j80), collapsed(in 1986),been almost stagnant (1975-1978), gonedown steadily (1981- 1985), and been highlyvolatile and uncertain (from 1987 to now).Despite this stormy history - Which tookmischievous delight in frustrating any attemptat rationalization, explanation, or prediction -it is nevertheless possible to find a constantrequiring an explana tion. From 1973 to now,annual average oil prices never went below thethreshold of $14-15jbbl in nominal terms and$18-20jbbl in real terms (1991 US$). Evenduringthe price war of 1986, prices went down to$7 jbbl for only a few days, while for the wholeof 1986 the average price was about $14jbbl.Looking closely, there seems to be some-sort offloor price that has not been pierced during theperiod under consideration.

This constant in oil price determination iseven more worrisome because over the periodnearly all of the likely configurations of marketand pricing structures were experienced. First,in regard to controlling prices, we saw insuccession the official OPEC price system(1973-80), the mixed system of official and spotprices (1981-85), domination by the spot price(since 1986), and its regionalization (Dubai, Brent,West Texas Intermediate). Second, in regard tomarket structure, we observed the passage froma vertically and horizontally integrated structureby the oil companies to a dual structure (theproducing countries controlling the upstreamactivities, the oil companies the downstreamones), the emergence and development of freemarkets at the expense of the OPEC-market, andthe beginning of new shapes of verticalintegration linking some producing countries andsome companies. Finally, in regard to the




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composit ion of aggrega te supply , since thebeginning of the 1980s we have recorded a continuous decrease in the market shares of theOPEC countrie s to the advantage of t he non-OPEC countries (from 60-65% in the 70s to 3035% in the 80s), along with many attempts byOPEC countries to regain their shares, even bywaging price wars, like the devastating one o f1986 (Ayoub, 1988).

I f we were to adopt a "happiness" criterionof the sort suggested in economics textbooks tocharacterize a market dominatedby a monopoly,such a rocky and unrelenting story might leadus to c la im that it was OPEC that introduceddisruptions and competition in a sector of theeconomy which unti11973 was obviously livingin a dreary tranquillity! But reality is even morecomplex. How can one explain the existence ofa floor price, and especially itspersistence lmderdiverse market structures?The Logic of CostThe first explanation of this phenomenon, theeasiest and certainly themost widespread, especially among English-speaking economists, can bebriefly summarized by referring to the work ofAdelman (1986), a representative of this school

. of thought.Adelman starts from the observation that thereplacement cost of a barrel of oil2 extracted in1978 in the US was nearly 69 times higher thanthe corresponding cost in Saudi Arabia.' In thislight, he argues that economic logic necessarilyleads to three conclusions.1) Scarcity does no t explain the price level(neither the current price, no r the floor price).2) In a competi tive market with such a cost

spread between Saudi Arabia and the US,demand would first be satisfied by theproducers with abundant reserves and lowcosts (Saudi Arabia and the Gulf countries),and only then by contr ibut ions f rom

2/ Its marginal cost, which is, according to Adelman,the sum of the marginal extraction cost and themarginal cost of the :"'lvested capital required tomaintain or increase production.3/ $O.13/bbl in SaudiArabia and $8.06/bbl in the US.

producers with low reserves and high costs(the US and the rest of the world). Thedifferential rent that the first group ofcountries now collects would then tend todecrease, and could in the long run evenvanish completely.

3) Closing the argument, if prices did no t fallto a level near t he lowest costs, it was,according to Adelman, because OPEC is acartel, the function of which was to establisha dam against a fall in prices. "I f the dambreaks, so will the price" (Adelman, 1986,p.394).

The Logic of SecurityInitially very attractive, the cost argument failsto take into account the equally meaningfulgeopoli ti ca l factors or, more precisely, thequestion of the security of oil supplies. The firstconsequence of strict economic logic is that, ina freemarket, low-cost petroleum would quicklydrive ou t high-cost petroleum. In the case of theUS, thi s would mean a radical decrease, andeventually a complete cessation, of oilproduction, with a parallel increase ofdependence on foreign suppliers. This wouldhave been conceivable in principle if the worldconsisted of a single political entity, rather thana group of sovereign entities, different from oneanother by their interests and objectives. And itis true that the US wants to avoid completedependence on a country or a group of countriesin a politically explosive region.All the more so because the nationalizing ofthe oilmultinationals by the producing countriesthrough the 1970s had launched a kind ofdialectic relation between resource control andthe security of supply. The more the producingcountries increased their control, the more theimporting industrialized countries tried todecrease their dependence on oil as an energysource and on OPEC as a supplier (Ayoub,1976a).

In fact, US policy tried to substitute nationaloil, to the extent it existed (in Alaska, forinstance), and more general ly non-OPEC oil(from the North Sea), for OPEC oil. Thus, thedifference in the production cost between these

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two types of oil can be considered as the cost ofsecurity. This c ost can e ve n be measured andquantified. Indeed, if the cost of OPEC-oil is Coand the cost of non-OPEC oil is Cn' we can writethe cost for security Cs as

(3)en can even be considered as the "floor price"of crude oil that the US tries to maintain on themarket. This cost is, furthermore, the major portion of the differential rent of the OPECcountries.

Even i f we hear from time to t ime that theUS lacks an energy policy, it is nevertheless clearthat it has for a long time had a precise strategyinvolving two objectives. The first has been toavoid a significant increase in its oildependence.This implied the acceptance of some increase inprice in support of that objective, though a t thesame time it did not want to jeopardize the rateof economic growth. The second strategic objective has been to assure the security of its necess-ary oil imports, especially in regard to thoseimports originating in the nervous Gulf region.Consequently, i f the current oil price wasa ro un d the a ve ra ge c ost of using: the Americandeposits, thefirst objectiveWaS to an extent real-ized. The spread in production costs between theUS and Saudi Arabia would be the price to bepaid by the US to preserve its national oil industry from closure and to provide somemargin ofprotectionfrom foreign imports. The second objective, to ensure the security of imports, ofcourse required other actions than maintaininga certain price level. These were: a policy onstrategic stocks; better cooperation, within theframework of the International EnergyAgency,for the allocation of stocks in case of emergency;the reinforcement of bilateral relations with theGulf countries (especiallywith SaudiArabia), etc.The US pursued these actions during the last 20years, while making it clear from t ime to t ime,that they were no t excluding the use of militarypower in the last resort to protect the securityof their oil supplies at a "reasonable price"(Hogan in Griffin and Teece, 1982).As early as 1974,HenryKissinger even specified the level of this price by saying that, for theUS, a price above a ceiling of $7/bbl (1974 US$)

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would, according to him, strangle the economy.However, the ceiling he suggested was a pricewhich, while no t discouraging the explorationand production of substitutes for oil, did no tendanger economic growth. Throughout the1974-1981 period, Saudi Arabia tried, withoutgreat success, to lead OPEC to adopt this price.Hence, the price suggested byMr. Kissingerwasin fact becoming the "floor price," whi le theofficial OPEC price could be seen as the "ceilingprice" which evo lved in response to theorganization's concerns that high oil priceswouldencourage substitution.

During the presidencies of Nixon, Ford andCarter, American policy consisted mostly o fputting pressure on the OPEC countr ies to letgo of their policy of increasing prices and moveas closely as possible toward the floor price, asconceived of here. The switch of the market in1981, which was mostly a consequence of thisshort-sighted policy of price increases, was toreduce themarket shares of the OPEC countriesmore and more, and to triggeroffmany conflictsamong its members, conflicts which have nowbecome 1-- ermanent.The culmination of this situation was withoutdoubt the price war of 1986, in which at onepoint the famous floor pricewas almost pierced.The reaction of the US was fast, since GeorgeBush, then Vice-President, was sent to SaudiArabia to ask it to stop the price war and tobring the prices back to the floor price level ofthe time, $15-16/bbl. In a few days, t he pricesindeed rose from $7-8/bbl, their lowest level, to$16-17/bbl. This clear and direct intervention,in the middle of the period of Reaganiteconservatism on economic matters, shows suffi-ciently the vital interest of the US in themaintenance of a floor pricewhich would satisfyto the greatest extent possible its objective ofrelative oil autonomy. This episode also showsthe convergence of the interests of Saudi Arabia(along with those of other smaller countries inthe Gulf, such as Kuwait and UAE) with theinterests of the USin maintaining a current pricelevel no t too far from this floor price, neither toohigh nor too low.But why do the count ri es of the Gul fwantto defend this price? The answer to this question




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(4)

sends us directly to the second contradiction ofthe oil system: the opposition between the "longterm plan" and the "short-term plan" withinOPEC. The considerable difficulties whichprevent the Organizat ion from finding andmaintaining a ceiling price agreeable to everyoneare the direct consequences of this opposition.Long Plan and Short PlanAs ear ly as 1975, I had the occasion, with otherobservers, to focus on a deep contradictionwithinOPEC which evidently constitutes one of themajor causes of its instability (Ayoub, 1975): theproblem of the determination of the optimal pricelevel ("ceiling price") for the member countriesas a group (Al-Chalabi, 1986).Two conceptionswere in opposition to eachother and have remained so since the first oilshock. Each possesses its own logicwhich in theend follows directly from a physical reality, no teasily subject to modification, and from an econornic reasoning that implies constraints.For the low-population Gulf countries,withlimited financial needs, large stocks, and extremely low extraction and development costs (nomore than $0.50jbbl on average), the oil priceshould be maintained at a competitive levelwithrespect to the costs of subst itutable forms ofenergy. Price increases, according to this logic,should be spread over a long time period toprotect the in-ground value of the stocks of thesecountr ies f rom the premature competition ofother energies. This position, the "long plan," isthe basis of the behaviour of cOlmtries likeKuwait, United Arab Emirates, and the mostimportant among them, Saudi Arabia.

On the otherhand, for otherOPEC countries,with relatively more modest stocks and largerpopulations and financial requirements, theoptimal valuationof their in-ground stocks leadsthem, with a logic just as meaningful as that ofthe first group of countries, to be inclined to anincrease in oil prices in a relatively short period.Their goal is to ensure that oil prices ge t as closeas possible, and faster would be better, to thecosts of subst itutes. This is because when thelatter become available on the market, the oilstocks of those countries will be either exhausted

or in decline. This is the "short plan" of countrieslike Algeria, Indonesia, Nigeria and Venezuela.lran and lraq are in this respect in a particularposition given the sizes of their reserves, theirpopulations, and their financial requirements. Thedeadly and devastatingwarin the 1980s betweenthese two countries considerablyincreased theirfinancial requirements and led them to adopt the"short plan" despite their large hydrocarbonreserves.

To summarize the posit ions of these twogroups,we can say that the first tries to optimizeits revenues a t the margin by adjusting quantities, while the second tries to do the same byadjusting prices. There is not, to my knowledge,a solut ion, either theoret ical or practical, thatcould completely and simultaneously satisfythese two groups of countries. In other words,there is no single optimal price that wouldprotect the interests of the OPEC countries takenas a whole and, a t the same time, the interest ofeach country taken individually. The onlypeaceful solution to this problem is compromise,and all the more so since the 13 members ofOPEC are sovereign states, each with its own(international, regional and national) politicalvision and its own alliances. By definition, suchcompromise is a function of bargaining powersat the time considered.Indeed, assume that each country determinesits price according to an objective function fidependent on many variables (Xi' ..., Xg, . .. , Xn).According towhat we have written above, thesevariables are no t only economic, bu t alsopolitical, s tra tegic, social, etc. For the OPECcountries taken as a whole; we then have a seriesof objective functions corresponding to thenumber of members. This series can be written:

1 IIi i i1,(X, ,...,Xgr"'Xn ), . .., jJX, ,...,Xg,...,Xn),N N N

..IN(X, ,. ..,Xg ""'Xn )with (i=l,. ..,N) and (g=l,. .., n).Because of the interdependence among them,it would be impOSSible to maximize all of thesefunctions simultaneously. I t is thus necessary tointroduce a composite function of the type:

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(5)in which the variables are the own functions ofeachcountry. The maximization of Q can be con-sidered if : (a) for each function, the variables areintroduced (Xl' X2, ..., Xg, ... , x,,) in a way suchthat Q becomes a function of these variables; and(b) ifwe can put weights on the relative import-ance of the different functions f1, f2, ... , fi, ... , fNby a system of given prices. Given the nature ofthese variables (economic1 but also strategic, pol-itical, social, etc.), it is clear that only a politicaltrade-off can determine, at a given moment intime, the relative weights of these variables foreach country, and the relative weights assignedto each country in the composite function (seeAyoub, 1975).The lack of a collective optimal solutiondoesnot, however, exclude the possibility of two strategies, both sub-optimal in other respects. The firstis the competitivemarket, with the risk of a pricewar, especiallywhen the market is overcrowded,as in the 1980s. The second possible strategy isa compromise within OPEC between the optimalpositions of each different country or group ofcountries. The latter strategy is relatively easierto put in place and more likely to succeed wheneach member produces at a level close to its pro-duction capacity, as was the case in the 1970s.When each country produces well below its capacity, as has been the case since 1981, the samestrategy is less likely to succeed and the associated compromise is fragile. Recent history givesus many examples of these strategies and of theirlimitations (Ayoub, 1988).

To illustrate the importance of the effect ofpoliticalfactors on both the stabilityof OPEC andits survival, we can again take the example ofSaudi Arabia. On purely economic grounds, thiscountry holds in its hands the key to the wholesituation because it controls around 40% of thetotal reserves of all th e OPEC countries. In prin-ciple, then, the economic and social damage thatthis country can cause the others to suffer i f itdecides to go its own way are without comparison to the damage it might itself suffer i f all theother countries were to collude against it. The1986 price war demonstrated this. But this sameexample also demonstrates that Saudi Arabia had

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to stop t ~ price war and to 10\-\7(:-[ its productionwhen the political reactions of the suffering countries began to be felt. The latter included not onlythe other OPEC coulltries, bu t also the US.Given these conditions, it is not reallynecessary to resort to a conspiracy theory toexplain the behaviour of the Gulf countries inregard to pricing policy, especially in the casesof Saudi Arabia and Kuwait. On the one hand,we have seen that this policy has coincided withthat of the US, which favours a current price thatis not too high, no r too far f rom the floor price.On the other hand, this convergence in economicinterests is strengthened by the needs of thesevulnerable countries for military protection,which they try to obtain from th e US.

The following conclusions can be w1derlined: There is a floor on the average price that hasnever been pierced since 1973, despite nwnerous changes in market structures.

o This floor price, currently in the range of $1820/bbl in nominal dollars, approximately corresponds to the average production costs ofAmerican (and Canadian) deposits.

The maintenance of this price since 1973 hasnot allowed the US to realize energy independence (a costly project and, in any case, achimera), bu t i t has preserved a certain energyautonomy. In the case of a completely free andcompetitive market, this floor pricewould nothave resisted, and the US would have beentotally dependent on foreign oil (mostly thatof the Gulf). That is no t the case today.o The fact that this floor price did holdthroughout this period is no t because OPECis a cartel, but rather because SaudiArabia hasagreed to defend it by adjusting its productionaccording to the state of supply and demand(except for the short gap o f the price war) .

o lfSaudi Arabia, Kuwait, and the UAl: adoptedthe policy of moderated increases in prices byincreasing production, it is on the one handbecause this policy corresponds to t h e ~ r owneconomic interests and on the other becauseit ensures them of political and military prok,-tion by the US.




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v. ConclusionsThe nationalizations of oil resources in theOPECcountries and the transfer of their managementfrom the foreign oil comparues to thegovITlffients of these countries set in motion aseries of events.

Regarding oil rents. this institutional changefirst induced an internalization of rents by theproducing countries and then led to the emergence of a differential (Ricardian) rent.which wasin effect supported by the policies of the industrialized countries (especially the US) designedto develop national substitutes for imported oilin order to increase their independence from theOPEC countries.Regarding the structure of oil markets. thenationalizations led to the breakup of the systemsof vertical and horizontal integration of theMajors and to its replacement by a new dualstructure with OPEC controlling the upstreamactivities of the oil sector and the oil companiescontrolling the downstream ones. This transformation also facilitated the growth of free marketsfor crude oil.Regarding price determination and OPEC behaviour, pricesmove betvveen a floor price deter-mined by the costs of substitute deposits in theUS, while the determination of ceiling levels byOPECappears to rest on successive compromiseswhich are necessarily fragile.Overall it appears obvious that oil is a s trategic product, despite the appearances createdby the existence of spotmarkets, forward trading,options, etc. The determination of prices andquantities depend not only on economic consider-ations, but also on political imperatives ininternational, regional, or national spheres.

I f we have to characterize the oil marketusing available models from economic theory,researchers should consider an adjustment to thebilateral oligopoly model,with the US and SaudiArabia as the principal actors. Detailed analysisof the economic and geopolitical factors that determine the behaviour of these tvvo countries isthen a necessity.

ReferencesAbu Khadra, R. (1980) 'The Spot Oil Market:

Genesis, Qualitative Configuration and Perspectives: OPEC Review, vol. IIII 4 & IV II.

Adelman, M.A. (1972) The World PetroleumMarket, (Baltimore: JOM Hopkins UniversityPress).-(1986) 'Scarcity and World Oil Prices: TheReview of Economics and Statistics, 387-97.AI-Chalabi, Fadhil (1987) 'What is the OptimalPrice of Oil from the Producer's Point of

View:Middle East Economic Survl?IJ (MEES) 28sept, 1-8.Artus, P. (1989) 'Quand la creation d'un marche

it terme peut-elle destabiliser Ie cours aucomptant?: Revue Economique, 71-93.Ayoub, A. & Percebois, J. (eds.) (1987) Petrole:marche et strategies, Economica, Paris.Ayoub, Antoine (1975) 'Le marche-OPEP dupetrole brut et ses consequences sur lesrelations entre pays producteurs: Re-uue d'Eeonomie Politique, 85:2:257-74.

-(1976a) 'Les prix petroliers: essai d'explication:Etudes Internationales, VII:1:3-24.-(1976b) 'Prix du petrole et degre de stabilite

de I'OPEP: L'Actualite Economique, juilletlseptembre, 311-23.-(1986) 'Evolution du marche petrolier: de I'integration verticale a la decentralisation/ Revuede l'Energie, no. 381, mars, 1-8.-(1988) 'Le marche pet rol ier international:instabilite et restructuration: Re-cnle de l'Energie,no. 407, decembre, 754-63.-(1990) 'Oil to 2000: Natural Resources Forum,May, 163-67.-(1991) 'Le petrole economie et politique,

fE?flexion preliminaires sur la crise du Golfe,'Revue de l'Energie, no. 432, juillet-aolit, 473-82.Barbet, Philippe (1983) 'La theorie des prix del'energie dans la pensee economique: unerecenSIon,' Economies & Societes,XVII:12:1809-34.

Bourgeois, B. & Perrin, F. (1989) 'Les compagniespetrolieres des pays producteurs endeveloppement s'internationalisent,' EnergieInternationale, 1989-90, Economica, 81-93.

British Petroleum Company (1992) BP StatisticalRe-uiew of World Energy, London, June.

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Fisher, Anthony, C. (1987) 'Whither Oil Prices:the Evidence from Theory,' Natural ResourceModeling, 2:1:5-22.

Frankel, Paul (1948) L'Economie petroliere, (trad.),ed. Lib. Medicis.-(1989) 'Principles of Petroleum - Then andNow,' The Energy Journal, 10:2:1-5.Gately, Dermot (1984) 'A Ten Year Perspective:OPEC and the World Oil Market, ' Journal ofEconomic Literature, 22:3:1100-14, September.-(1986) 'Lessons from the 1986 Oil PriceCollapse,' Brookings Papers on Economic Activity,no. 2, 237-84.Griffin, J. & Teece, D. (oos.) (1982) OPEC Behaviorand World Oil Prices (London: George Allen

& Unwin).Griffin, James M. (1985) 'OPEC Behavior: A Testof Alternative HypothesiS,'American EconomicReview, 75:5:954-63.

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Mohnfeld, J.H. (1984) 'The Trend of StructuralChange in the International Oil Industry in the1980s' Annual Review of Energrj, vol. 9, 155-78.Moran, T. (1982) 'Modeling OPEC Behavior:Economic and Political Alternatives' dansGriffin & Teece, OPEC Behavior and World OilPrices (London: George Allen & Unwin)94-130.Penrose, Edith (1988) 'Defending the Price ofOil,'The Energy Journal, 9:1:19-25.Percebois, Jacques (1989) Economie de l'Energie,

Economica, Paris.Petroleum Intelligence Weekly (PIW) (1990) 'What'sNext for OPEC Downstream Club,' SpecialSupplement Issue, January 15, 1-4.Verleger, Ph. K. Jr. (1988) 'The Role and ImpactofCommocityMarket Institutions in the Determination of Oil Prices ,' Annual Review ofEnergy, 13, 359-82.


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