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OPEC and Venezuelan oil production: Evidence against a cartel hypothesis
Douglas B. Reynolds
, Michael K. Pippenger
Department of Economics, University of Alaska Fairbanks, Fairbanks, AK, USA
a r t i c l e i n f o
 Article history:
Received 9 December 2009Accepted 24 May 2010Available online 9 June 2010
RiskOil supplyOPEC
a b s t r a c t
This study revisits the OPEC cartel hypothesis using a case study. A test is conducted to see if Venezuelahas its production Granger cause its OPEC quota or whether the OPEC quota for Venezuela Grangercauses Venezuelan production. The results show both occur at different times. In the short run, OPEC’soil production quota for Venezuela Granger causes Venezuelan production. However, shortly after cuts,Venezuela cheats on agreements, suggesting a tit-for-tat oligopoly game, which is not anti-competitive.In the long run, we show that Venezuelan oil production Granger causes OPEC’s quota for Venezuela,but not vice versa. Having Venezuelan oil production Granger cause OPEC quotas for Venezuela in thelong run suggests OPEC does not coordinate outputs as much as it reacts to them. The evidence suggestsVenezuela is not a part of an OPEC anti-competitive syndicate even thoughwe show that Venezuelan oilproduction is low. An alternative explanation for why Venezuela and possibly other OPEC membershave low oil production outputs is that institutions and risk aversion, not cartel participation, is thecause. A vector error correction model shows that there is no tendency for Venezuelan oil production toconverge to OPEC’s quota for Venezuela.
2010 Elsevier Ltd. All rights reserved.
1. Introduction
Ever since the first oil price shocks of 1973, OPEC has beenaccused of operating as a cartel. However, with ten or moremembers making up OPEC’s producers, it is normally difficult forsuch an organization of independent players to maintain agree-ments.Van Huyck et al. (1990)and other game analyses suggestagents playing cooperative games have a difficult time trustingeach other especially if any uncertainty is involved, which is thecase for OPEC. Furthermore, asAdelman (1986b)implies, OPECmembers face the risk of losing oil value due to oil substitutiontechnology making oil’s value decline should OPEC attempt torefrain from production now and produce more oil later. There-fore, due to the potential competition, the future risk of technological substitutes for oil, and the difficulty of coordinatingin a game, there should be little if any supply reductions by OPECmembers. This suggests OPEC is not a cartel.However,Kaufmann et al. (2004)andLoderer (1985)do show that oil prices have been affected by OPEC actions, althoughLoderer shows that the amount the price of oil increases due toOPEC decisions and the length of the time oil prices stay high aresmall, and Kaufman et al. show that cheating by OPEC membershas nearly an exact counter neutralizing effect on quota inducedprice increases, suggesting a near competitive outcome notworthy of the term cartel. Nevertheless,Adelman (1986a)showsthat there is less investment in Saudi Arabia and Kuwait thanwhat would normally be the case in the United States, whichsuggests an effort to reduce output. What’s more, there was lessinvestmentin Saudi Arabia after1973than whatwas normal foritbefore 1973, although, if OPEC is affecting the market price, it isstill unclear what market manipulating model
cartel, priceleader or some form of oligopoly
best represents OPEC.However, changes in production by OPEC members can becaused by other factors than cartel agreements such as internal oilproducer institutions. SeeReynolds and Kolodziej (2007, 2009).Therefore, a necessary and sufficient condition for a cartel orsyndicate to be operating effectively is that it has a tool, and it isactivelyusing thattool and thatmembersare adhering tothe tool.The only tool OPEC has to raise price is its quota system, and asLoderer shows that tool was not in use in the 1970s, and sotherefore OPEC cannot have been a cartel or syndicate in the1970s. But what about after 1981? In order to determine if OPECworked coherently as a cartel or an anti-competitive syndicatethen Granger causality (Granger, 1969) should determine if members are adhering to the quota tool or not. If the OPEC quotadoes not Granger cause the member’s production and if amember’s production increases before its OPEC quota is increased,then OPEC’s quotas are not working. The only way to assume thata member is adhering to some form of price manipulation in thatcase is to assume internal or secret agreements are occurringoutside of the public view, which requires further proof.In this paper, Venezuelan oil production in comparison toOPEC’s stated quota for Venezuela is looked at. A test is conductedto see if Venezuelan production Granger causes the OPEC quota
Contents lists available atScienceDirectjournal homepage:www.elsevier.com/locate/enpol
Energy Policy
0301-4215/$-see front matter
2010 Elsevier Ltd. All rights reserved.doi:10.1016/j.enpol.2010.05.060
Corresponding author.
E-mail address:
for Venezuela or vice verse. The results show both occur but atdifferent lags. However, it is apparent based on the results that wecan reject the non-causality that Venezuela production does notGranger cause the OPEC quota in the long run which is a rejectionof the OPEC collusion hypothesis at least for Venezuela. However,by rejecting such collusion for Venezuela, then such collusivehypotheses have to be questioned for other OPEC members aswell, although that would require a more detailed analysis of eachmember’s institutions, which is research for the future.Nevertheless,the evidence suggests thatit is not OPEC’s quotasthat are affecting Venezuelan production in the long run, butrather Venezuela’s own internal decision making that is affectingits production. For example, during the 1970s when there was noOPEC quota for Venezuela, Venezuelan oil production declinedeven as prices compared to the 1960s were twice as high. Whenworld oil prices were low in the late 1980s and 1990s, Venezuelanproduction increased opposite what a competitive suppliernormally would do. Venezuela also kept pushing its productionwell above stated OPEC quotas in the 1990s making Venezuela apoor cartel or syndicate participant at best. This puts intoquestion the entire cartel or syndicate hypothesis. A moreplausible reason for the Venezuelan production decline duringthe 1970s was because Venezuela had nationalized its oilproduction, which created risk aversion to investment. Venezue-lan production increased during the 1990s because it putcompetitive institutions in place such as production sharingarrangements (PSAs), but oil production decreased again whenVenezuela nullified many of its competitive contracts around2000. A Cautious Shift Model is developed that may better explainVenezuelan and OPEC member oil production history.The paper is organized as follows. In the next section, we goover a literature review of various anti-competitive hypothesesfor OPEC. In Section 3, we develop the cautious shift model thatbetter explains OPEC behavior. In Section 2, we look at howexternal factors can enhance the cautious shift model, whichexplains the dichotomy between the 1970s and the 1980s forVenezuela and OPEC. We then explain the quadratic Hubbertmodel
an indexed Hubbert curve
as a method of comparingvarious oil production regions to the United States, a good freemarket example. In Section VI, Venezuela is compared to the USusing the Hubbert index to show how and why Venezuelan oilproduction changed. In Section VII, a test of Granger causality isconducted to see if OPEC Granger causes changes to Venezuelanproduction or vice versa. The results show that Venezuela iscausing OPEC’s long run quota to change contrary to a cartel orsyndicate hypothesis. In the short run, Venezuela does sometimesfollow OPEC directives indicative of a tit-for-tat game. The lastsection gives concluding remarks.
2. Literature review
A number of models explaining OPEC behavior have beenproposed, such as a low discount theory ( Johany, 1980), targetrevenue models (Ezzati, 1976; Cremer and Salehi-Isfahani, 1991;Teece, 1982), political models (Moran, 1982; Adelman, 1993), collusion models (Griffin, 1985; Al-Sultan, 1993), andHotelling (1931)models (Pindyck, 1978). Attempts to verify these models are shown inGriffin (1985),Green (1988),Jones (1990),Dahl and Yucel (1991),Griffin and Nielson (1994),Gulen (1996),Alhajji and Huettner (2000a, 2000b),Spolimbergo (2001), andRamcharran (2002).Smith (2005)shows evidence that none of these hypotheses are correct, although he does hypothesize an alter-native: that OPEC is a
bureaucratic production syndicate
thatallocates quotas but which faces high costs in deciding on thosequotas. However, as far as collusive quotas are concerned,Gaultet al. (1999)could not firmly establish a single statisticallysignificant model for how the assignment of quotas is done withinOPEC.If OPEC is a cartel or a syndicate, then it has to have a tool touse to carry out its market manipulation. Clearly OPEC has onlyone single tool to use: its production levels, i.e. quotas. Therefore,there has to be quotas for all periods when oil prices areconsidered to be abnormally high and OPEC members have tobe shown to be following those quotas or very quickly adhering tothe quotas in order for OPEC to be an effective cartel or syndicate.However, no quotas existed for OPEC members in the 1970s(OPEC, 2008). It may be true that OPEC members saw a reductionin their oil outputs right around the 1973 oil price shock making itlook as if OPEC was actively engaging in production cutbacks, butbecause there is no tool that OPEC used in the 1970s; then therecan have been no cartel or syndicate. Other than the Arabembargo months from October 1973 to January 1974, generalOPEC member reductions or plateaus in supplies were not OPECdirected. Indeed Loderer shows agreements in the 1970s had noeffect and that OPEC agreements in the 1970s were to lower oilprices not raise them, implying OPEC agreements to raise outputsnot lower them, which is completely counter to cartel orsyndicate theory.However, other reasons for a supply reduction are possible.From 1972 to 1974 the equity interest of oil producing operationsby governments in the Middle East increased by an average of 10–75% (Exxon, 1984). Since Middle Eastern governments suddenlybecame the owners of their own oil reserves, Johanny suggeststhat OPEC member governments had alternative social discountrates that induced lower production levels. Another morepractical possibility is that the take-over and nationalization of oil and gas assets that took place around 1973 included putting inplace new, local and possibly inexperienced managers to run theworld’s great oil fields, which could have affected production,although risk aversion may have a roll. Nevertheless, the owneroperator governments would still be competitors with each other.Looking closely at all the anti-competitive hypotheses sur-rounding OPEC, if OPEC is a Bertrand Edgeworth Oligopoly, thenOPEC agreements have to specify increases in prices, notdecreases in prices, in order for OPEC to raise oil prices. However,in the 1970s OPEC agreements were to decrease prices not toincrease them. If OPEC exhibits Stackelburg or Cournot behavior,then quotas are not needed and no quotas would be established,but quotas have been established since 1982. In a tit-for-tat game,each OPEC agreement should affect spot prices immediately, butOPEC agreements did not affect spot prices immediately in the1970s (Loderer). If the Johanny hypothesis of the increase inproperty rights by a set of low social discount governments is thecorrect hypothesis for OPEC, then this is counter intuitive to OPECmember actions to invest in US Treasury-bills and internationalbond and equity markets in order to maximize their wealth. If youwant to maximize the present value of your savings, then it onlymakes sense that you will want to maximize the present value of your oil revenue. Therefore, no model of OPEC consistently works.Smith does show evidence that OPEC members are not merelyfree market competitors. Monthly and quarterly productionchanges for oil producers relative to other OPEC and non-OPECproducers do not exhibit compensating change. If OPEC were acartel, each member would change outputs to compensate forother OPEC and non-OPEC variations in output more than 50% of the time, but that does not happen. If OPEC members were notcomplyingwith anyorganizationaldirectives at allor were simplyparticipating in a Cournot Oligopoly or in a competitive market,then they would have at least a 50–50 chance of arbitrarilycompensating their own production levels vis-
a-vis otherOPEC and non-OPEC members. That does not happen either.
D.B. Reynolds, M.K. Pippenger / Energy Policy 38 (2010) 6045–6055
Surprisingly, positive compensating quantity changes happensignificantly less oftenthan a 50–50chance, which indicates someform of inefficiency. Something is constraining output. Onesuggestion is that OPEC is an inefficient syndicate that is delayingdecisions to raise quotas (doing nothing) while members areraising production due to world demand (cheating), which is tosuggest that OPEC is not a syndicate at all, but a set of competitiveproducers, who are inefficiently producing oil.The evidence of OPEC’s
nature also includes theworldwide Herfindahl–Herschman index (HHI). In 1982 afterOPEC stated its quota and assuming OPEC, the US and the SovietUnion were single individual producers in that year, and usingdata from the EIA for 1982, then the HHI for 1982 for OPEC wasless than 1700 indicating the world oil market was ‘‘moderatelyconcentrated,’’ i.e. moderately competitive, according toUSDepartment of Justice (2008)definitions of anti-competitivemarkets. This suggests that the high oil prices in the 1970s andthe early 1980s could not have been due to an OPEC cartel, butoccurred under a competitive market where many of theproducers could not increase their output. Furthermore, asCampbell (2005)andStaniford (2006)clarify, OPEC went through a series of ‘‘quota wars’’ or more to the point oil reserve justification wars where each OPEC member tried to top the nextin publishing outlandish proven reserve estimates in order to justify that each member’s own quota needed to be higher. Thisblatant oil reserve cheating in and of itself suggests the lack of anycoordination on the level that would signify anti-competitivebehavior on the part of OPEC. SeeBakhtiari (2006).It is possible that OPEC engages in a tit-for-tat game betweenits price leader Saudi Arabia and the rest of OPEC. For exampleGeroski et al. (1987),Dahl and Yucel (1991),Alhajji and Huettner (2000a, 2000b), andGriffin and Nielson (1994)andDibooglu and Algudhea (2007)do show a tit-for-tat game strategy within OPEC.However while a tit-for-tat game strategy to reduce outputs andpunish cheaters can work in the short term, there is still incentiveto cheat over the long term and expand production capacity.Frank (2008, p. 462)says a successful tit-for-tat strategy to cutoutput and raise profits when several producers are in the game isa ‘‘hopeless task,’’ and therefore such a strategy is competitive.Axelrod (1984)suggests an oligopoly that plays a game of tit-for-tat is not an anti-competitive institution. This is where propo-nents of a cartel or syndicate are quick to point out that OPEC ismade up of governments and not corporations. However, whileOPEC is made up of governments, it is not made up of a singlegovernment but a set of competing governments who are eachwealth maximizing entities and thus who are each in competitionwith the others. Even if a short run tit-for-tat strategy issuccessful for a few months, the incentive for each governmentover the long run is to expand each their own production to earnas much revenue as possible in that way each producer will havemore leverage for the next round of short run tit-for-tat games.This suggests an alternative explanation for OPEC is needed toexplain the Smith and Loderer data.
3. The cautious shift model
Looking back at OPEC’s history, one wonders, why OPECproduction rose at 10% per year from 1960 to 1970, but only at1% per year from 1970 to 1980, most of which was a rise in SaudiArabia’s oil production from 1970 to 1973, if an OPEC cartel wasnot working during the 1970s? One reason is that during the1970s, scarcity may have limited supplies. Another reason is thatthere was a tremendous transition among all OPEC membersaway from competitive institutions and free market leasearrangements toward non-competitive institutions that includedhigh taxation and outright nationalization. These changes ininstitutions may have affected risk taking in the 1970s andtherefore affected the quantities of oil supplied, although the brief supply reduction in the aftermath of the 1973 Yom Kippur/TenthRamadan War also caused a reduction in quantities.In finance,Markowitz (1952a, 1952b)andFriedman and Savage (1948)explain the efficiency frontier, made up of a set of stocksexhibiting various past risk return combinations, which are used byforward looking investors to gauge the future. The curve is made upof combinations of the highest expected future return for each givenlevel of risk. This same idea can explain OPEC member actions.However, instead of looking at a set of firms with different risk andreturn combinations as in a stock market, consider one single firmfaced with a set of investment options, as in one oil companyexploring for or developing various oil prospects. Since the oil is notyet found or not yet fully developed, there is uncertainty about eachprospect.Newendorp and Schuyler (2000, p. 564)show exactly how thisriskinputworksforoilandgasexploration.Howeverwhatisneededto complete the Newendorp and Schyler analysis is the limitingconstraint on investment.Knight (1921)says in his famous analysisof risk and uncertainty that risk is an input into production. A firmneeds labor, real capital and the willingness of investors to pay forthose inputs in order to get an output. The willingness to invest isdependentonhowmuchriskis involvedandhowmuchappetiteforrisk, or uncertainty, that the investor will take.According toRicardo (1815)the law of diminishing returnsmeans that any increase in one input of production will have adeclining marginal output. If instead of looking only at labor andreal capital as inputs, we include risk as an input, measured asexpected future variance of return, then investments in oil andgas prospects will on average produce more oil (have a higherreturn) as more risk (appetite for high expected variance of returnoutcomes) is used, and on average investments in oil and gasprospects will produce less oil (have a lower expected return) asless risk is used, all other factors the same. According to the law of diminishing returns, high risk (high expected variance) projectswill not produce proportionately greater oil in comparison to lowrisk (low expected variance) projects but will instead exhibit adeclining marginal increase in oil for the same level of capital andlabor, similar to the Markowitz frontier. This physical return trendcan be called an iso-capital constraint curve, which would parallelthe Markowitz efficiency frontier. It is called an iso-capitalconstraint curve because, at a given point in time, an investor’savailable financial capital for new projects is constrained. Thelimited financial capital available to the firm means it can investinto one similar-cost, high risk project with a high expected oiloutput or one similar-cost, low risk project with a low expectedoil output but not both. Limited financial capital, and the financialresults of an investment, is the iso-capital constraint.If we combine an indifference curve, of the utility of theexpectation for risk versus return with a diminishing return-to-variance iso-capital constraint curve, we can determine utilitymaximization. SeeFig. 1. There are three curves. One curve is theiso-utility curve of a relatively more risk averse investmentproject manager, an agent. The second curve is the iso-utilitycurve of a relatively less risk averse agent. The third curve is theRicardian or Markowitz iso-capital constraint curve. The iso-capital constraint, like the Markowitz frontier, assumes, based onexpected outcomes (where high risk, low return projects arediscarded) that the curve encompasses all the physical outcomesof a given investment constraint. The investor maximizes utilitywhere the highest utility curve is just tangent to the investmentconstraint.An interesting hypothesis byStoner (1961, 1968)is the RiskyShift Phenomenon where the level of risk taking changes when
D.B. Reynolds, M.K. Pippenger / Energy Policy 38 (2010) 6045–6055

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