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OPEC, the Phantom Menace

- June 16, 2014

Oil ministers of the Organization of the Petroleum Exporting Countries attend the 165th OPEC Conference in Vienna, Austria, June 11, 2014. (Herbert Pfarrhofer/EPA)
From the Keystone pipeline to Ukraine to fracking and American self-sufficiency, Washington is abuzz about energy politics these days, but top U.S. policymakers continue to make mistakes when thinking about world energy markets. For example, James Woolsey, a former director of the CIA and self-proclaimed energy hawk, argues that the Organization of the Petroleum Exporting Countries (OPEC) has a grip on global oil and gasoline prices so tight that the United States will never be free of its influence. Like most people, Woolsey wrongly believes that OPEC is a powerful cartel.
In reality, OPEC rarely if ever influences its members’ oil production rate. It has almost no impact on prices, except under rare conditions. OPEC has been coasting on a reputation gained in 1973, perpetuating – and benefiting from – a myth about its own importance. It is long past time that myth was dispelled.
Economists have been debating the role of OPEC for decades. Most economic studies cast doubt on the cartel hypothesis, but there are still some scholars who support the proposition. My research looked at OPEC’s behavior since 1982, the year that it first adopted formal production quotas for its members. That creates the appearance of a cartel, because by definition a cartel creates agreements about how much each member will produce, in order to restrict overall production and thereby increase prices. If OPEC is a cartel, one thing we should see is the oil production rates of new members decline or decelerate when they join the organization. But they don’t. Members should also generally produce quantities at or below their assigned quota. Instead, they over-produce a whopping 96 percent of the time. Third, changes in OPEC quotas typically should be followed by changes in production. They aren’t. Finally, members of the cartel should generally produce oil at a lower average rate, all else equal, than non-members of the cartel. Yet again, they don’t. Any of these findings would cast doubt on OPEC’s status as a cartel; collectively they are damning. The fourth point is perhaps the strongest, as it is difficult to imagine how an organization that does not restrict output compared to non-members could be called a cartel: How else could it increase prices? Yet that is exactly what the data suggest.
Even though OPEC is not a cartel, Saudi Arabia probably has some power to affect world oil prices by virtue of its spare production capacity, which it can turn on and off as it desires. One or two other OPEC members, like Kuwait and the United Arab Emirates, might also have some market power (though less than Saudi Arabia). The key thing, however, is that they have this power as individual countries: OPEC as an organization adds nothing, and there is no evidence that they actually collude. Moreover, most OPEC members – from Venezuela to Nigeria to Iraq – are pumping their oil as fast as they can, with no spare capacity at all.
If OPEC is not a cartel, why do people believe that it is? The 1973 oil crisis is a major contributing factor. That crisis was one occasion (perhaps the only one) on which OPEC had a significant impact on the market. Yet OPEC’s role in the crisis has been greatly misunderstood. For instance, it was not OPEC but rather a group of Arab producers that enacted the oil embargo against the United States. The embargo was both small in magnitude (restricting world oil supply by 2 to 4 percent) and temporary (only a few weeks). Still, the OPEC governments did prove that some of them were capable of cooperation and joint decision making. Many observers incorrectly concluded that OPEC would henceforth operate as a cartel. And that suited OPEC members just fine.
OPEC perpetuates a “rational myth” about its cartel power, in order to generate political benefits and prestige for its members, both at home and abroad. So long as OPEC is viewed as powerful, its leaders can claim political credit at home for “managing the economy.” For example, former Venezuelan president Hugo Chávez argued that he revitalized OPEC and thus almost single-handedly increased world oil prices after he was elected in 1998. This narrative gave Chávez a significant domestic political asset.
Internationally, the perceived power of OPEC allows its members to reap political rewards in terms of diplomatic influence and the attention paid to OPEC members. In practical terms, this means that OPEC members receive more diplomatic recognition from other countries than non-OPEC members, all else equal. On average OPEC membership is associated with a boost of nine additional ambassadors or other representatives, compared to an equivalent country that is not an OPEC member. Strikingly, OPEC membership has roughly the same impact on diplomatic representation as the possession of nuclear weapons, often thought to be the ultimate status booster.
Why does anyone outside of OPEC buy into this myth? It turns out that some people already know better, but others seem to be genuinely fooled. For instance, oil commodity traders and business executives want to know “does at least one of the members of OPEC have some market influence?” The answer to that question is probably yes (Saudi Arabia). But that is different from saying OPEC acts as a cartel in the sense of coordinating production to manipulate prices, which it doesn’t. So savvy market participants pay attention to OPEC only for signals about present and future behavior of its members, especially Saudi Arabia.
The real cost of the OPEC myth is political. Politicians in oil-importing countries blame OPEC for manipulating world oil markets, especially during times of high gasoline prices. For instance, NOPEC (No Oil Producing Exporting Cartels) bills have been introduced to the U.S. Congress over a dozen times since 1999, though none has passed. These bills distract Congress and the public, thereby imposing an opportunity cost on the political system and contributing to congressional paralysis. (Worse still, some politicians seem to know full well that OPEC doesn’t matter, but like a scapegoat for high prices.) The myth also causes U.S. diplomats to waste valuable political capital when they kowtow to various members of OPEC. Government officials are liable to defer to OPEC members and offer (modest) favors in exchange for changes in oil production.
All in all, the West would be better off if it stopped assuming that OPEC drives oil markets. It does not. Most of the credit or blame for rising oil prices in recent years rests with Asian customers, not diabolic moves by OPEC. With the price of oil set by market forces almost entirely outside of its control, OPEC is along for the ride like everyone else.
Jeff Colgan is currently an assistant professor at American University. On July 1, he becomes Richard Holbrooke Assistant Professor at the department of political science and Watson Institute for International Studies at Brown University. Much of his research focuses on the geopolitics of energy.