ECON6001 Economic Principles

Why did OPEC fail to keep the price of oil high Research on the trend for prices of oil from 1970 – 1990. Apply the
concept of demand, supply and elasticity to analyse the trend. Draw graphs and explain them. 

Global economy has experienced continuous energy crisis in the last few decades of twentieth century. Most of this crisis was actually intended by groups that had economic power during that time. One such powerful organisation was OPEC whose members include most of Middle East countries controlling a major share of world oil export.  In 1974 oil price made an almost 50 percent jump from its existing level. The price hop was the result of composite contraction of supply by OPEC countries. Next turning point was in 1990s. Pressure of declining world demand and increasing supply from members outside OPEC brought down the price and ensure stability.

World Oil Price Trend from 1970 to 1990

In this section empirical data on oil price is analyzed. Particular focus has given on the years that are considered as the turning points in history of world price.

In 1970 nominal price of oil was $3.39 and the inflation adjusted price was $21.04. World oil price was in line with its trend in the previous decade. There were no such economic tensions during this time that could influence the price. World was introduced with OPEC in 1960s with only 5 that has only five members then ("History and Analysis -Crude Oil Prices", 2017). It was not until 1973 when some additional members joined the organisation and strengthen its power. The phase from 1970-1973 had gone through fairly stable situations. Change in economic environment was realized thereafter due to several wars and its related consequences. Post war calamities and rise of OPEC as a power organization created massive instability in world price of oil.

Table 1: inflation adjusted crude oil price from 1970 to 1990 

Exporter countries under OPEC realized a significant increase in exported oil demand during this time. This encouraged them to push the prices up to raise their revenue. Their decision gathered additional support from the incidence of export prohibition to US in support of Arab during war against Israel (Dumoulin & America, 2016). To raise the price they took the composite decision to contract oil production and hence supply in this time. Because of supply inelasticity in the short run they could not reduce their supply much.  

In times of inelastic supply greater change in price is accompanied with a small change in quantity. This helped OPEC members to fulfil their goals of price rise. Inability of buyers to reduce their demand at a very short time span additionally benefitted OPEC’s exporters to increase their revenues (Hancock & Vivoda, 2014). This is precisely what is explained in figure 2. The downward sloping curve (dd) depicts oil demand curve and positively sloped curve (ss) explains oil supply. When supply Curve shifts to the left price increases from P₁ to P₂. It is clearly visible from the diagram that price rise is considerably higher than quantity reduction (p₁p₂ > q₁q₂).

                                                                      Market scenario in the short run

                                                                           (Source: as created by author)

Success of price rise in the first phase encouraged OPEC to make a second round increase in prices. During 1979-1980 price was as high as $109.51. However, this decision was not successful and it was the time when OPEC realized that it alone cannot control world price (Colgan, 2014). To remain in the world market they had to reduce their price. From 1973 to 1980 gave enough time to the consumers and producers outside OPEC to take some strategies to counteract price rise. Consumers started to purchase fuel efficient cars to conserve fuel. Non OPEC suppliers respond to higher price by exploring new sources and expanding production capacity. Actually demand and supply become elastic in the long run (Currie, Peel & Peters, 2016). This is explained in figure 3 by a relatively flatter demand and supply curve. The figure shows, in the long run a smaller increase on price required a larger reduction in quantity. This hurts revenue of OPEC suppliers.

                                                     Market condition with demand-supply elasticity

This declining trend started in 1980s and continued through the entire decade of 1990s ("OPEC: Brief History", 2017). Increased supply from sources outside OPEC and decreased demand put a downward pressure on prices. Viewing this OPEC decided to relax its quota to sustain their position in the world market. Per day quota is increased to 2.5 billion/day. Increased supply from both from OPEC and non OPEC members and restrained world demand highly affected price. Price lowered even more than that in 1970 (Ahrari, 2015).

Thus, OPEC failed to sustain a high price of oil in the world market for a very long period of time. Changing reaction of demand and supply with passes of time is the driving factor for OPEC failure. OPEC power as a cartel could not keep prices high for a long time. It usually takes time to set infrastructure of new production capacity to increase supply. Buyers also need time to change their consumption basket. The ability of the consumer to replace goods depends on the availability of close substitute available in the market. Fuel is a product having less close substitute. Increasing production or reducing consumption of fuel thus takes a long span than usual (Baumeister & Peersman, 2013). Alternate sources of energy like use of solar energy or energy efficient transport means are started to use. Revenue and hence profit prospect depends on supply and demand condition and their elasticity. This is the reason why the price hike in 1970s was a short run phenomenon.

Conclusion

The paper discussed the episode of oil price fluctuation from1970s to 1990s. In this fluctuation OPEC played a major role. After the formation of OPEC, the members thought to took the advantage of their cartel power and manipulate their supply to influence world price. Their gain was short lived. Soon, reactions came from members outside OPEC. Demand and supply that were inelastic at the initial phase reacted strongly when they get considerable time. High price produced interest among suppliers of oil. Consumers also cannot bear high price for a long time and soon curb their demand. With a declining world market share OPEC members exporting countries faced a decline in revenue. This broke up the cooperative environment in OPEC. The spirit of cartel eventually broke. Price fell back to its original stable level and even below that. OPEC experience can be viewed as an example of demand supply and elasticity consequences on price.

References

Ahrari, M. E. (2015). OPEC: The Failing Giant. University Press of Kentucky.

Baumeister, C., & Peersman, G. (2013). The role of time?varying price elasticities in accounting for volatility changes in the crude oil market. Journal of Applied Econometrics, 28(7), 1087-1109

Colgan, J. D. (2014). The emperor has no clothes: The limits of OPEC in the global oil market. International Organization, 68(3), 599-632.

Currie, D., Peel, D., & Peters, W. (Eds.). (2016). Microeconomic Analysis (Routledge Revivals): Essays in Microeconomics and Economic Development. Routledge.

Dumoulin, M., & America, N. (2016). How the 1973 oil embargo encouraged the bettering of diplomatic relations between Egypt and the United States in the 1970's (Bachelor's thesis).

Hancock, K. J., & Vivoda, V. (2014). International political economy: a field born of the OPEC crisis returns to its energy roots. Energy Research & Social Science, 1, 206-216.

History and Analysis -Crude Oil Prices. (2017). Wtrg.com. Retrieved 8 July 2017, from http://www.wtrg.com/prices.htm

McMahon, T. (2017). Historical Oil Prices: InflationData.com. Inflationdata.com. Retrieved 8 July 2017, from https://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp

OPEC: Brief History (2017). Opec.org. http://www.opec.org/opec_web/en/about_us/24.htm