CHAPTER 1

INTRODUCTIO
N

1
INTRODUCTION
OPEC is the Organization of Petroleum Exporting Countries and it was
founded at a meeting on September 14, 1960, in Baghdad, Iraq by five
founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela.

The purpose of choosing this institute is, OPEC is one of the largest
petroleum organizationsin the world, since the 1973 oil price shock, the
history behavior, and pricing power of the Organizationof Petroleum
Exporting Countries (OPEC) have all received considerable attention in the
academic. One view which prevails is that although OPEC has survived for
morethan 50 years, it has had little effect on either the oil price or oil
market dynamics. Rather, some of the oil price is seen as being
determined in a globally competitive market.

Another view is that OPEC has been successful in cartelizing the oil
market and in using itspower to raise the oil price above competitive
levels by restricting output. On the other hand,there is the view that OPEC
pricing power is not constant and tends to fluctuate dependingon the
interaction among OPEC members and on oil market conditions.The swing
in pricingpower became very apparent in the events that surrounded the
oil price collapse in 1998,which saw the Dubai price, the benchmark for
exports to Asia, decline from around $20 perbarrel, in early November
1997 to less than $12 per barrel, in March 1998 and averagingaround $10
per barrel in December 1998. At that time, OPEC seemed to have lost its
abilityto defend oil prices, and many analysts predicted its demise. This
view of an ineffectiveOPEC was, however, reversed only a few months
later, and many observers consequentlyregarded the events of 1998 to
have ushered in a new era of cooperation among its members.During
March 1998 and March 1999, OPEC embarked on two production cuts in
an attemptto put an end to the slide in the oil price. These production cuts
were implemented with ahigh level of cohesiveness among members,
contradicting the view that OPEC was not ableto collude. By the end of
1999, the Dubai price had risen to $23 per barrel.

The divergent views about OPEC pricing power have resulted in a wide
range of OPECmodels. These range from classic textbook cartel, to wealth-
maximizing monopolist(Pindyck, 1978a), to three-block cartel (Eckbo,
1976), to two-block cartel (Hnyilicza andPindyck, 1976), to clumsy cartel
(Adelman, 1980), to dominant firm (Salant, 1976; Mabro,1991), to loosely
co-operating oligopoly (Griffin, 1985), to residual firm
monopolist(Adelman, 1982), to bureaucratic cartel (Smith, 2005), to
competitive models (MacAvoy,1982; Crmer and Salehi-Esfahani, 1989,
1991). Many of these models were developed toexplain key historical
events, and in response to changes in key producers behaviour. TheOPEC

2
price war in 19856 resulted in many of the 1970s models those that
considered
OPEC as a rational wealth-maximizing monopolist or as a monolithic group
being revised.The models of the 1980s and 1990s had to incorporate
new elements such as the interactionbetween OPEC members, price wars,
output sharing, the issues of cheating and coordination,the conditions
under which OPEC members can collude, and the special role of Saudi
Arabiawithin OPEC.

In the 2000s, the entry of financial players in massive numbers, and

theincreasing role of futures markets in the price formation process,
prompted some studies toconsider the signaling role of OPEC.One of the
objectives of choosing this organization is the evolution of OPEC models
and to link thisevolution to some key events in the oil market. Main is that
OPECs pricingpower is not constant and tends to vary over time. There
are many instances in which OPECcan lose the power to influence oil
prices. Such changes in pricing power are brought aboutby market
conditions and can occur both in weak and tight market conditions.

Another thing is that because of OPECs varying conduct, there is no

single model that fits itsbehaviour and hence analysts have been forced to
choose from a wide range of models toexplain certain episodes. The
empirical literature has not been successful in narrowing thegap between
the various competing models (Smith, 2005). Griffins (1985) observation
in themid-1980s that empirical studies tend to reach onto the shelf of
economic models to selectone, to validate its choice by pointing to
selected events not inconsistent with modelsprediction still dominates
the empirical approach to studying OPECs behaviour.One of the
challenges faced by any collusive behaviour is the issue regarding entry of
newcompetitors. Although OPEC as an organization does not coordinate its
members investmentplans, many OPEC countries have been protected by
strong barriers to entry, which stemfrom ownership and control of the bulk
of low-cost oil reserves. By limiting investment intheir oil sector, OPEC
members can control the future flow of oil supplies into the market.They
also shift the burden of meeting the demand for the marginal barrel onto
high-costproducers.

Another reason is to analyses how OPEC members investmentdecisions

can affect the oil market structure and the behaviour of the oil price. The
decision has significant implications for the oil and gas (O&G) sector, as it
indicates that OPEC is changing its strategy from gaining market share to
one of stabilizing oil prices and creating a demand-supply balance in the
sector.

As the above reasons and objectives would be considered for the choosing
this institute and OPEC helps to understand more about crude oil network,
available reserve and pricing strategy of gulf countries.

3
METHODOLOGY

Methodology is the systematic, theoretical analysis of the methods

applied to a field of study. It comprises the theoretical analysis of the body
of methods and principles associated with a branch of knowledge.
Typically, it encompasses concepts such as paradigm, theoretical model,
phases and quantitative or qualitative techniques.

For this research data and information collected from secondary sources,
mostly from website of OPEC.

Objective of the study

To study various objectives functions and operations of OPEC.
To study the implications of OPEC in stabilizing oil demand and
supply balance.

To study OPECs role on deciding price of crude oil.

Importance and Significance

This report will provide insights to the management students about the wh
ole Organization of Petroleum Exporting
Countries. This will help them to understand the current oil supply and
demand by the OPEC and role of OPEC in stabilizing the oil prices world
over. They will come to know about various functions and objectives of
OPEC and its significance for oil demand and supply balance world over.

4
 CHAPTER
2
INTRODUCTION
OF OPEC

5
WHAT IS OPEC
Organization of the Petroleum Exporting Countries(OPEC) is
an intergovernmental organization of 13 nations, founded in 1960
in Baghdad by the first five members (Iran, Iraq, Kuwait, Saudi
Arabia, Venezuela), and headquartered since 1965 in Vienna. As of 2015,
the 13 countries accounted for an estimated 42 percent of global oil
production and 73 percent of the world's "proven" oil reserves, giving
OPEC a major influence on global oil prices that were previously
determined by American-dominated multinational oil companies.

OPEC's stated mission is "to coordinate and unify the petroleum policies of
its member countries and ensure the stabilization of oil markets, in order
to secure an efficient, economic and regular supply of petroleum to
consumers, a steady income to producers, and a fair return on capital for
those investing in the petroleum industry. The organization is also a
significant provider of information about the international oil market. As of
December 2016, OPEC's members
are Algeria, Angola, Ecuador, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qat
ar, Saudi Arabia (the de facto leader), United Arab Emirates,
and Venezuela. Two-thirds of OPEC's oil production and reserves are in its
six Middle Eastern countries that surround the oil-rich Persian Gulf.

The formation of OPEC marked a turning point toward national sovereignty

over natural resources, and OPEC decisions have come to play a
prominent role in the global oil market and international relations. The
effect can be particularly strong when wars or civil disorders lead to
extended interruptions in supply. In the 1970s, restrictions in oil
production led to a dramatic rise in oil prices and OPEC's revenue and
wealth, with long-lasting and far-reaching consequences for the global
economy. In the 1980s, OPEC started setting production targets for its
member nations; and generally when the production targets are reduced,

6
oil prices increase, most recently from the organization's 2008 and 2016
decisions to trim oversupply.

Economists often cite OPEC as a textbook example of a cartel that

cooperates to reduce market competition, but whose consultations are
protected by the doctrine of sovereign immunity under international law.
In December 2014, "OPEC and the oil men" ranked as on Lloyd's list of
"the top 100 most influential people in the shipping industry". However,
their influence on international trade is periodically challenged by the
expansion of non-OPEC energy sources, and by the recurring temptation
for individual OPEC countries to exceed production ceilings and pursue
conflicting self-interests.

BRIEF HISTORY OF OPEC

The Organization of the Petroleum Exporting Countries (OPEC) is a

permanent, intergovernmental Organization, created at the Baghdad
Conference on September 1014, 1960, by Iran, Iraq, Kuwait, Saudi Arabia
and Venezuela. The five Founding Members were later joined by nine
other Members: Qatar (1961); Indonesia (1962) suspended its
membership in January 2009, reactivated it in January 2016, but decided
to suspend it again in November 2016; Libya (1962); United Arab Emirates
(1967); Algeria (1969); Nigeria (1971); Ecuador (1973) suspended its
membership in December 1992, but reactivated it in October 2007;
Angola (2007); and Gabon (1975) - terminated its membership in January
1995 but rejoined in July 2016. OPEC had its headquarters in Geneva,
Switzerland, in the first five years of its existence. This was moved to
Vienna, Austria, on September 1, 1965.

OPEC's objective is to co-ordinate and unify petroleum policies among

Member Countries, in order to secure fair and stable prices for petroleum
producers; an efficient, economic and regular supply of petroleum to
consuming nations; and a fair return on capital to those investing in the
industry.

The 1960s

OPECs formation by five oil-producing developing countries in Baghdad in

September 1960 occurred at a time of transition in the international
economic and political landscape, with extensive decolonisation and the
birth of many new independent states in the developing world. The
international oil market was dominated by the Seven Sisters
multinational companies and was largely separate from that of the former
Soviet Union (FSU) and other centrally planned economies (CPEs). OPEC
developed its collective vision, set up its objectives and established its

7
Secretariat, first in Geneva and then, in 1965, in Vienna. It adopted a
Declaratory Statement of Petroleum Policy in Member Countries in 1968,
which emphasised the inalienable right of all countries to exercise
permanent sovereignty over their natural resources in the interest of their
national development. Membership grew to ten by 1969.

1st OPEC Conference, 10-14 SeptemberOPEC Board of Governors, 3 September

1960, Baghdad, Iraq 1962, Geneva, Switzerland

The 1970s

OPEC rose to international prominence during this decade, as its Member

Countries took control of their domestic petroleum industries and acquired
a major say in the pricing of crude oil on world markets. On two occasions,
oil prices rose steeply in a volatile market, triggered by the Arab oil
embargo in 1973 and the outbreak of the Iranian Revolution in 1979.
OPEC broadened its mandate with the first Summit of Heads of State and
Government in Algiers in 1975, which addressed the plight of the poorer
nations and called for a new era of cooperation in international relations,
in the interests of world economic development and stability. This led to
the establishment of the OPEC Fund for International Development in
1976. Member Countries embarked on ambitious socio-economic
development schemes. Membership grew to 13 by 1975.

7th OPEC Conference, 23-28 Nov. 1964, 32nd (Extraordinary) OPEC Conference,

8
Jakarta, Indonesia 1617 March 1973, Vienna, Austria

The 1980s

After reaching record levels early in the decade, prices began to weaken,
before crashing in 1986, responding to a big oil glut and consumer shift
away from this hydrocarbon. OPECs share of the smaller oil market fell
heavily and its total petroleum revenue dropped below a third of earlier
peaks, causing severe economic hardship for many Member Countries.
Prices rallied in the final part of the decade, but to around half the levels
of the early part, and OPECs share of newly growing world output began
to recover. This was supported by OPEC introducing a group production
ceiling divided among Member Countries and a Reference Basket for
pricing, as well as significant progress with OPEC/non-OPEC dialogue and
cooperation, seen as essential for market stability and reasonable prices.
Environmental issues emerged on the international energy agenda.

73rd
(Extraordinary) OPEC Conference, Third OPEC Summit, 17-18 November
2830 January 1985, Geneva, Switzerland 2007, Riyadh, Saudi Arabia

The 1990s

Prices moved less dramatically than in the 1970s and 1980s, and timely
OPEC action reduced the market impact of Middle East hostilities in 1990
91. But excessive volatility and general price weakness dominated the
decade, and the South-East Asian economic downturn and mild Northern
Hemisphere winter of 199899 saw prices back at 1986 levels. However, a
solid recovery followed in a more integrated oil market, which was
adjusting to the post-Soviet world, greater regionalism, globalisation, the
communications revolution and other high-tech trends. Breakthroughs in
producer-consumer dialogue matched continued advances in OPEC/non-
OPEC relations. As the United Nations-sponsored climate change
negotiations gathered momentum, after the Earth Summit of 1992, OPEC
sought fairness, balance and realism in the treatment of oil supply. One
country left OPEC, while another suspended its Membership.

9
The 2000s

An innovative OPEC oil price band mechanism helped strengthen and

stabilise crude prices in the early years of the decade. But a combination
of market forces, speculation and other factors transformed the situation
in 2004, pushing up prices and increasing volatility in a well-supplied
crude market. Oil was used increasingly as an asset class. Prices soared to
record levels in mid-2008, before collapsing in the emerging global
financial turmoil and economic recession. OPEC became prominent in
supporting the oil sector, as part of global efforts to address the economic
crisis. OPECs second and third summits in Caracas and Riyadh in 2000
and 2007 established stable energy markets, sustainable development
and the environment as three guiding themes, and it adopted a
comprehensive long-term strategy in 2005. One country joined OPEC,
another reactivated its Membership and a third suspended it.

2010th

The global economy represented the main risk to the oil market early in the decade, as global
macroeconomic uncertainties and heightened risks surrounding the international financial
system weighed on economies. Escalating social unrest in many parts of the world affected
both supply and demand throughout the first half of the decade, although the market
remained relatively balanced. Prices were stable between 2011 and mid-2014, before a
combination of speculation and oversupply caused them to fall in 2014. Trade patterns
continued to shift, with demand growing further in Asian countries and generally shrinking in
the OECD. The worlds focus on multilateral environmental matters began to sharpen, with
expectations for a new UN-led climate change agreement. OPEC continued to seek stability
in the market, and looked to further enhance its dialogue and cooperation with consumers,
and non-OPEC producers.

Delegates and guests at OPEC's new 6th OPEC International Seminar, 3-4 June 2015,
Headquarters, 17 March 2010, Vienna, AustriaHofburg Palace, Vienna, Austria

10
OBJECTIVE OF OPEC

OPEC's objective is to co-ordinate and unify petroleum

policies among Member Countries, in order tosecure fair and stable
prices for petroleum producers an efficient, economic and regular supply
of petroleum to consuming nations and a fair return on capital to those
investing in the industry.

MISSION OF OPEC
In accordance with its Statute, the mission of the Organization of the
Petroleum Exporting Countries (OPEC) is to coordinate and unify the
petroleum policies of its Member Countries and ensure the stabilization of
oil markets in order to secure an efficient, economic and regular supply of
petroleum to consumers, a steady income to producers and a fair return
on capital for those investing in the petroleum industry.

VALUES OF OPEC

We believe in transparent, honest, and auditable governance procedures.

We are responsive to our Members, stakeholders in trade, and society.

SECRETARIAT

The OPEC Secretariat is the executive organ of the Organization of the

Petroleum Exporting Countries (OPEC). Located in Vienna, it also functions
as the Headquarters of the Organization, in accordance with the
provisions of the OPEC Statute.

It is responsible for the implementation of all resolutions passed by the

Conference and carries out all decisions made by the Board of Governors.

11
It also conducts research, the findings of which constitute key inputs in
decision-making.

The Secretariat consists of the Secretary General, who is the

Organizations Chief Executive Officer, as well as such staff as may be
required for the Organizations operations. It further consists of the Office
of the Secretary General, the Legal Office, the Research Division and the
Support Services Division.

The Research Division comprises Data Services, Petroleum Studies

and Energy Studies departments. The Support Services Division includes
Public Relations & Information, Finance & Human Resources and
Administration & IT Services departments.

The Secretariat was originally established in 1961 in Geneva, Switzerland.

In April 1965, the 8th (Extraordinary) OPEC Conference approved a Host
Agreement with the Government of Austria, effectively moving the
Organizations headquarters to the city of Vienna on September 1, 1965.

SECRETARY GENERAL

The Secretary General is the legally authorized representative of the

Organization and Chief Executive of the Secretariat. In this capacity, he
administers the affairs of the Organization in accordance with the
directions of the Board of Governors.

The Conference appoints the Secretary General for a period of three

years, which may be renewed once for the same period. This appointment
takes place upon nomination by Member Countries.

The Secretary General is assisted in the discharge of his duties by a team

of officers and staff including two Directors responsible for the Research
Division and Support Services Division, six Heads of Department, the
General Legal Counsel, Head of the Office of the Secretary General and
the Internal Auditor who independently ascertains whether the ongoing
processes for controlling financial and administrative operations at the
Secretariat are adequately designed and functioning in an effective
manner.

12
The first secretary general of OPEC 28thsecretary
general
FuadRouhani (23 October 190730 January 2004)
MohammadSanusiBarkindo

Literature Review

This literature review is divided into two parts (1) oil market modeling and
(2) OPECs behavior within the oil market. In the first part, describes
various oil market simulation and optimization models conducted to date
with more emphasis on the optimization ones as we attempt building an
oil market model of a similar nature. The second part of the review covers
the literature on the efforts conducted to date on modeling, testing and
analyzing OPECs behavior within the oil market as such a market
behavior is pivotal to the proposed models mathematical formulation and
solution.

1. Oil Market Simulation and Optimization Modeling

The interest in oil market modeling grew rapidly right after the Arab
embargo and the quadrupling of the oil price in 1973. Stephen Powel
(1990) mentions that by the late seventies there were more than thirty
publicly available oil market models. Since then the oil market modeling
efforts have slowed down significantly. In this part of the review, we briefly
present the more popular oil market models that were mentioned in
surveys and studies conducted to date and then elaborate more on the
optimization models as they are more related to our proposed model.

The survey by Fischer et al (1975) is one of the early surveys conducted

on oil market modeling. In their survey, they listed and criticized seven
world oil models including Blitzer-Meeraus-Stoutjestdijk, Kalymon-I & II,
Bohi-Russel, US-Federal Energy Administration, Kennedy, Levy and
Nordhaus models. The models of Kalymon-I & II (1975), Bohi-Russel (1975)
and Nordhaus (1973) were the only optimization models in their review. All
these optimization models are discussed in greater details later in this

13
part of the review. In a similar effort, NazliChoukri (1979) compared the
structures of twelve world oil market models. Four of these models were
static simulation, four were dynamic simulation and four were
optimization models including Kalymon I & II (1975), Nordhaus (1973),
Bohi-Russell (1975) and Hnyilicza and Pindyck (1976).

In 1990, Stephen Powel noted that most existing oil market models are
either inter-temporal optimization or behavioral simulation and listed
three models as inter-temporal optimization models including ETAMACRO
(Manne, 1981), Salant (1981) known as Salant-ICF, and Marshalla and
Nesbitt (1981) known as DFI-CEC. Eight years later, Baldwin and Prosser
(1998) conducted a similar survey and followed the same classification as
that of Powel (1990) and believed that most of the oil market models
belong to either recursive simulation models or inter-temporal
optimization models.

A more comprehensive and critical survey was conducted by Cremer and

Salehi-Asfahani (1991) where they surveyed fifteen years worth of
economic literature on oil market modeling. In the survey, they divided
modeling efforts into informal (with no or minimal mathematical
symbolism), simulation and theoretical models. They further subdivided
the informal models into two basic types according to behavior emphasis:
monopolistic (cartel or dominant firm) and competitive modeling
(backward bending supply curve, property rights or supply shocks).
Simulation models were further subdivided into three groups including
reduced form, optimization and energy balance models. Under the
simulation models and without classifying they included Kennedy (1974),
Nordhaus (1973), Blitzer-Meeraus-Stautjesdijk (1975), Kalymon (1975),
Ben-Shahar (1976), Cremer and Weitzman (1976), Hnyilicza and Pindyck
(1976), Gately-Kyle-Fischer (1977), Pindyck (1978), Ezzati (1978),
Houthakker and Kennedy (1978), Daly-Griffen-Steel (1982), MacAvoy
(1982), and Salant (1982). At the end of their survey, they covered
econometric studies conducted on the oil market with hypotheses related
to market structure and functioning.

The survey was later updated by Salehi-Asfahani (1995) to include new

studies on resource exhaustibility in an attempt to explain two issues:
price staying above cost and new informal models (cartel, dominant firm
and competitive). He also included some new empirical studies of
alternative theories of the oil market. In the update, he noted that
economists were still divided on the importance of the exhaustibility
concept and on explaining high oil prices staying above costs.

In 1981, the Economic Modeling Forum (EMF) which is a group of energy

experts, analysts, and policy makers conducted a study named EMF-6 on
oil market modeling. In the study, they used ten oil market models to
evaluate twelve scenarios on the future evolution of the oil market. The
models list included Gately-Kyle-Fischer (New York University), IEES/OMS
(U. S. Department of Energy), IPE (Massachusetts Institute of Technology),

14
Salant-ICF (U.S. Federal Trade Commission/ICF Inc.), ETAMACRO (Stanford
University), WOIL (U. S. Department of Energy), Kennedy and Nehring
(University of Texas/RAND corporation), OILTANK (Christian Michelson
Institute), Opeconomics (British Petroleum Corp.), and OILMAR (Energy
and Power Subcommittee, House of representative). 1,2 Out of these ten
models studied, only three models including ETA-MACRO, Kennedy and
Nehring, and SalantICF were optimization models.

The study was later updated in 1991 by the EMF to compare international
oil supplies and demands alternatives and discuss how they affect the
worlds dependence on the oil imported from the Middle East. The study
used eleven economic models of the world oil market (EMF-11) to simulate
twelve scenarios including nine different predetermined price paths and
three market clearing price scenarios. The models list included EIA/OMS
(Energy Information Agency), IPE (Massachusetts Institute of Technology),
ETAMACRO (Stanford University), WOMS (Power Gen., UK), CERI (Canadian
Energy Research Institute), HOMS (Oak Ridge National Lab.), FRB-Dallas
(Federal Reserve Bank of Dallas), DFI-CEC (Decision Focus Inc.), BP
America (British Petroleum), Gately (New York University) and Penn-BU
(Boston University). Out of these eleven proprietary models, the ETA-
MACRO and DFI-CEC were the only optimization models while the rest
were simulation models. 3 The study found that dependence on the oil
from the Middle East will grow in the future and can not be halted or
reversed. It also found that oil demand would grow proportional to
economic growth assuming prices do not change and that at the price of
$19 OPEC members will be expected to increase their production
capacities.

In 1992, Margaret Walls surveyed the literature on empirical oil and gas
supply modeling and divided the supply modeling into three major groups
including geological-engineering, econometric, and hybrid models. She
further divided the geological-engineering models into play analysis
(simulation) and discovery (process) models. Also, she suggested that the
hybrid models containing features from econometric and discovery
process models are the best path for future research.

Although the above mentioned surveys were relatively comprehensive,

they missed a few oil market models that we believe are important. Again,
in this part of the review we attempt to briefly present the more popular
oil market models that some of which are optimization models and then
elaborate on these optimization ones as they are more related to our
proposed model. In the following few paragraphs, more oil market models
will be presented and their objectives and findings will be investigated.

In 1974, Michael Kennedy developed a regional multi-commodity

optimization model of the world oil market. The model was a static model
and had four sectors including crude production, transportation, refining
and consumption. It also had seven trading regions and assumed a
monopolist behavior for OPEC. The model studied the consequences of

15
OPECs behavior through simulating the effects of export taxes. The model
results showed that the high prices in 1973 are not likely to remain as
large producers will have problems allocating reduced production

Alsmiller and Horwedel (1985) developed a dynamic World Oil Market

(WOM) model for the period 1980-2040 to be a part of the framework of
another model, the Generalized Equilibrium Modeling System (GEMS)
which is available from Decision Focus Incorporated. The GEMS system is
basically a group of process sub-modules that are connected together and
their equations are solved simultaneously to determine prices and
quantities as functions of time. In the WOM, results were presented for
two cases, when OPEC is treated as a Stackelberg cartel and when OPEC is
treated as a competitive producer. Model results showed that full
cooperation among OPEC member can cause a 25% increase in the oil
price for 1990-2010.

In 1986, Lorentsen and Roland developed a traditional simultaneous

econometric model for the world oil market for the Norwegian Ministry for
Oil and Energy. Their model was used to trace crude oil price throughout
the year 2000. Several scenarios were developed for different economic
growth and conservation rates and for different alternative energy prices.
A year later, Geroski, Ulph, and Ulph (1987) developed an empirical model
for the world oil market where the pricing conduct is allowed to respond to
several factors and can vary over time. Changes and variation in players
behavior appears to be playing an important role in price movements and
tit-for-tat strategy (discipline and reward) was found consistent with the
data.

To analyze oil market conditions and oil prices, Amano (1987) developed a
small-scale econometric model for the oil market. The model simulation
results anticipated wide price fluctuation if OPECs core members (Saudi,
Kuwait, UAE, Qatar, Libya) attempt to defend the cartels market share. A
year later, Baldwin and Prosser (1988) developed a recursive simulation
model for the World Oil Market (WOM) and various strategies for OPEC
were tested assuming that OPEC can set either the price or the output.
Both oil consumers and non-OPEC producers were assumed to be price
takers where consumers maximize their benefits and non-OPEC countries
maximize their profits. OPEC on the other hand is assumed to set either
price or quantity. Results showed that supply and demand could balance
for a range of prices and OPEC output depending on what strategy OPEC
adopts.

Another econometric model for the oil market was developed by Robert
Kaufmann (1994) to integrate the effects of economics, geological,
political and environmental changes into the LINK model.4 The model by
Kaufmann forecasted oil prices based on market condition and OPEC
behavioral changes. In fact, the model results showed that OPEC can
influence medium and long run prices through the rate they add
capacities.

16
In 2004, Dermot Gately developed a simulation model for the oil market in
the form of an Excel spreadsheet to see whether OPECs members would
more than double their production capacity in two decades as the
Department of Energy (DOE) expected. The model simulated OPECs
payoffs for two scenarios, a fast growth at which OPEC meets the DOE
expectations, and a slower (the normal) capacity growth. The model
results showed that it would be unlikely for OPEC to expand their capacity
as there would not be so much difference in the payoff for OPEC between
the two scenarios.

A year later, Dees et al. (2005) described a structural econometric model

for the world oil market that can be used to forecast supply, demand and
prices. It simulates two behaviors for OPEC, competitive and cooperative.
In the model, oil prices are calculated using a price rule which takes into
account both OPECs behaviors and market conditions. The model
concluded that OPECs quota and capacity utilization effect oil prices
significantly.

Also, NoureddineKrichene (2005) estimated a simultaneous equation

model (SEM) for the world oil and natural gas markets for both short and
long runs. The model was constructed to study the influence of the United
States Nominal Effective Exchange Rate (NEER) and the US interest rate
on the crude oil price and to estimate short and long run price and income
elasticities. Results showed that demand for both crude oil and natural
gas is price inelastic in the short run. It also showed a significant reduction
in long run supply price elasticity, suggesting change from competitive to
market power. Also, results showed that falling interest rate and
depreciating NEER could result in a surge in the oil price.

As part of the DOEs National Energy Modeling System (NEMS) model, the
International Energy Model (IEM) is a recursive model of world petroleum
supply and demand by region. The IEM model calculates the average price
of the imported crude and the international trade patterns of crude oil and
refined products. It also consists of three components; World Oil Market
(WOM), Petroleum Product Supply (PPS), and Oxygenates Supply (OS)
models. The WOM is a new version of the Oil Market simulation model
(OMS) developed in earlier years by the EIA and uses a recursive
simulation approach. On the other hand, the PMM is a linear programming
(LP) model that chooses the mix of the refining operations to meet the US
domestic demand at the lowest cost (DOE, 2003).

Other known oil market models include the Oil Market Simulation Model
(OMS) that is used by the Energy Information Administration (EIA) to
forecast future world oil prices and OPEC oil production (Grillot, 1983) and
OPECs World Energy Model (OWEM) which is an econometric model
developed by OPEC in the 1980s for medium to long-term oil and energy
trends projections (OPEC Secretariat, 1994).

17
Out of the forty oil market models summarized above, only thirteen are
found to be optimization models. For the rest of this part of the literature
review, we will focus on these optimization models as they are of a similar
nature to the model we propose. The list includes Kalymon I & II (1975),
Cremer and Weitzman (1976), Hnyilicza and Pindyck (1978), Ben-Shahar
(1976), Ezzati (1976), Bohi and Russel (1975), Nordhaus (1973), ETA-
MACRO (Manne, 1981), Kennedy and Nehring, Salant-ICF (Salant, 1981),
and DFI-CEC (Marshalla and Nesbitt, 1981), Deam (1974), and Kennedy
(1974).

Seven of these optimization models were compared and contrasted for the
price behavior of OPEC by ShawkatHammoudeh (1979). They include
models of Kalymon I & II, Cremer-Weitzman, Hnyilicza and Pindyck, Ben-
Shahar, Ezzati and Bohi and Russel. Despite the fact that these models
differ in the way they group suppliers, they all consider OPEC as either a
residual supplier behaving like a monolith, a duopoly or a non-cohesive
cartel.

As Hammoudeh shows, both Kalymon-I & II dynamic models determine

optimal price trajectories that maximize the sum of producers surplus
(from sales to domestic and foreign consumers) and consumers surplus
(for domestic consumers) for a certain supplier or group of suppliers. The
difference between the two models is that Kalymon-I model treats OPEC
as a whole as a residual supplier (monolith) while Kalymon-II model has
three ways for grouping the residual suppliers: 1) Saudi Arabia alone, 2)
Saudi, Kuwait, Abu Dhabi and Neutral zone and 3) Saudi and Iran.

In fact, we find Kalymon-II to be the only oil market optimization model

treats Saudi Arabia individually as a separate supplier and therefore
maximizes the Saudi social welfare which is defined as the sum of
producers surplus (net revenues from oil sales to domestic and foreign
consumers) and consumers surplus (obtained by domestic buyers) is
maximized. Despite the fact that Kalymon-II is the closest model to our
proposed one, we find that our proposed model to be different than that of
Kalymon-II in many ways. Such differences between our proposed model
and Kalymon-II are covered in greater details, in our model paper, after
describing our model.

Cremer-Weitzman model is a little different than that of Kalymon. It

assumes that the Persian Gulf and North Africa producers act as a
monolith while the rest of the world acts competitively. In addition, the
model maximizes discounted profits for Persian Gulf and North Africa. The
fourth model in the study is the Hnyilicza and Pindyck model which
computes the optimal sum of discounted profits for OPEC under two
cases. In the first one, OPEC acts like a unified cartel, while in the second
OPEC acts as a two-part cartel: spenders (with high discount rate) and
savers (with low discount rate).

18
In a similar approach, the Ben-Shahar model assumes OPEC is the residual
producer (monolith) satisfying the difference between the worlds demand
and the non-OPEC supply and has three supplying groups including OPEC
and non-OPEC, non-oil energy. The model solves for the optimal price path
for OPEC for the years 1976 to 1990. The model maximizes the present
value of the oil revenues in addition to the present value of reserves at
the end of the mentioned time period.

The sixth model, the Ezzati model, employs the interactive cartel
approach in which each country in OPEC optimizes to derive its production
requirements and the sum of the requirements meets the residual
demand. The optimization in the model determines various members
production requirements in order to maximize the present value of future
consumptions. In the model, suppliers are divided into three groups: UAE-
Qatar-Ecuador-Gabon, rest of OPEC and the non-OPEC. The model of Bohi
and Russel is the last model in the study. The model has two objectives: to
examine the stability of OPEC as a cartel and to determine the optimal
price path for OPEC. Also, the supply side in the model is divided into two
groups: USA and other producers whereby each member optimizes
individually.
Also, as mentioned earlier, Choukri (1979) compared the model structures
of twelve world oil market models out of which four were optimization
models. The optimization models included Kalymon I & II (1975), Bohi and
Russell (1975), Nordhaus (1973) and Hnyilicza and Pindyck (1978). Again,
the Kalymon model selects the price trajectory that maximizes the total
discounted benefits of oil production and export for OPEC while the model
of Bohi and Russell uses optimizing techniques for dual objectives: to
forecast the actual price for OPEC in the future and to evaluate the
stability of OPEC without assuming their collusion. The Nordhaus dynamic
model focuses on the whole energy market and minimizes discounted
costs to meet the demand and assumes competitive supplier operating in
a competitive market. The fourth model, the Hnyilicza and Pindyck model
which treats OPEC as a duopoly and divides it into two groups: spenders
and savers then solves for the optimal bargaining solution for the two-part
cartel.

Also, three more optimization models including Manns ETA-MACRO,

Kennedy and Nehring, Salant-ICF were mentioned previously in the
Economic Modeling Forum (EMF-6) study which was conducted in 1981. In
short, the ETA-MACRO model maximizes the discounted utility of
consumption for consumers. The Kennedy and Nehring model takes
OPECs production as exogenous and maximizes the discounted profits for
non-OPEC while the Salant-ICF maximizes the discounted profits for both
OPEC and NonOPEC. The study was later updated in 1991 and used eleven
economic models (EMF-11) out of which only 2 models were optimization
models including the ETA-MACRO (Global 2100) and DFI-CEC models. As
we mentioned, the ETA-MACRO model maximizes the discounted utility of
consumption for non-OPEC while the DFI-CEC model (proprietary model
from decision Focus Inc.) divides OPECs supply into core and non-core

19
(price takers) and maximizes both the discounted profits for all OPEC
producers and for non-OPEC.

Another global oil market optimization model is that of R. I. Deam (1974)

mentioned in the survey conducted by Hoffman and Wood (1976). In fact,
the model is the Queen Mary Colleges optimization model but was
published by Deam in 1974. The model defines the world patterns of
crude oil and gas production and supply, refining, product demand and
international oil and gas movements in a linear programming (LP) terms.
The model has 25 regions, 52 types of crude including Arabian light and
Arabian heavy, 22 refining centers, 6 types of tankers, 11 refining
processes, and eight refining products. The model minimizes costs and
solves for the optimal allocation and routing of crude oil and products
between different centers. Also, the model solves for the required refining
activities, tankers and production to meet projected demands for a certain
year.5 Although, this model is global in nature and looks at the same
activities we address in our model, we find our proposed model to be
much different than that of Deam in many ways. Such differences
between our proposed model and that of Deam are covered in greater
details after describing our model

Furthermore, Kennedys (1974) World Oil Model (WOM) is another global

oil market optimization model. The model is a multi-commodity, multi-
region single period economic equilibrium model with four sub-models
(crude production, transportation, refining, and consumption), four refined
products and seven regions. The international market equilibrium was
computed via solving a quadratic programming problem for maximum
gross net economic benefit. Once solved, the model determined products
consumptions, crude production, equilibrium prices, refining outputs, and
crude flow trades.

As can be seen from the number of oil market optimization models built in
the last few decades, the number has decreased significantly. Morrison
(1987) believes that these models have decreased in popularity for three
reasons. Firstly, they could not anticipate the 1979-80s price fall and that
is why only one of the EMF-6 (1982) models is an optimization model
(Salant-ICF model). Secondly, the complex decision-making process within
OPEC is described by a simple revenue maximizing objective. Thirdly, they
are built on a perfect foresight assumption. Morrison also suggests that
simulation models were not good either as seven out of ten in EMF-6
(1982) depend entirely on a price rule, which states that price increases
as OPEC exceeds its utilization target.

As can be seen from the number of oil market optimization models built in
the last few decades, the number has decreased significantly. Morrison
(1987) believes that these models have decreased in popularity for three
reasons. Firstly, they could not anticipate the 1979-80s price fall and that
is why only one of the EMF-6 (1982) models is an optimization model
(Salant-ICF model). Secondly, the complex decision-making process within

20
OPEC is described by a simple revenue maximizing objective. Thirdly, they
are built on a perfect foresight assumption. Morrison also suggests that
simulation models were not good either as seven out of ten in EMF-6
(1982) depend entirely on a price rule, which states that price increases
as OPEC exceeds its utilization target.

2. OPEC Behavior within the Oil Market

Since the crude oil price quadrupled in 1973-1974, numerous theoretical

and empirical studies were undertaken by economic theorists to examine
oil market structure and analyze the behavior of the OPEC. In this part of
the literature review, we briefly cover studies and approaches conducted
on modeling, testing and analyzing OPEC behavior in the last three
decades as we believe that understating such a behavior is pivotal to any
attempt to model the oil market for simulation and optimization purposes.

In fact, the economics literature on OPEC behavior has been surveyed and
criticized in many studies. Dermot Gatley (1984) conducted one of the
early such surveys and grouped OPEC behavior modeling approaches into
either a dominant theoretical approach based on the wealth maximizing
model or a simulation approach based on the target capacity utilization
model. 6 Both of these models are discussed in greater detail later in this
paper. In 1991, Cremer and Salehi-Isfahani conducted a more
comprehensive survey covering the economic literature on oil market
models for the years 1975-1990. In their survey, they divided OPEC
models into two basic types: monopolistic models including carteland
dominant firm models and competitive models including backward
bending supply curve, property rights, and supply shocks models. Later
the survey was updated by Salehi-Isfahani in 1995 to include some new
informal models.

In 1998, Mabro surveyed and criticized the literature on OPEC behavior for
the period 1960-1998 and grouped it into six categories including: history,
previous literature surveys, economic modeling, political economy, policy
proposals, and trade journals reporting. More surveys but rather shorter
ones are included as part of the literature reviews in studies conducted by
Moran (1982), Griffin (1985), Dahl and Yucel (1991), Al-Yousef (1998),
Alhajji and Huettner (2000 a, b and c), Ramcharran (2001 and 2002),
Smith (2005) and Kaufmann et al (2006).

Despite the large number of studies attempting to model OPEC behavior

in the last three decades, the literature review we present in this paper
reveals that the empirical literature as a whole remains inconclusive
regarding OPEC behavior and that experts still have different views and
opinions about what model represents the oil market structure and fits
OPEC behavior. This backs up observations made by Gately (1984), Griffin
and Teece (1982), Griffin (1985), Bockem (2004), and Smith (2005) where
Gatley noted it remains an open question how best to design a model of
the behavior of OPEC. Twenty years later, Bockem still noted, there

21
exists neither an accepted theoretical model, nor an econometric model of
this market. Moreover, there is a surprising dispute between economic
theorists and energy economists whether OPEC can be regarded as a
cartel or not. Similarly, Smith concluded that contributions remain
largely inconclusive regarding the behavior and impact of OPEC, despite
the best efforts of those authors.

On an extreme note, Griffin and Teece believed that OPEC behavior is not
well understood, either by politicians, professional analysts, or the OPEC
members themselves. Griffin tried explaining such a problem noting that
the standard practice to date has been to reach onto the shelf of
economics models, to select one, to validate its choice by pointing to
selected events not inconsistent with the models predictions, and to
proceed with some normative exercise. In fact, we believe that the study
by Griffin (1985) is what triggered most of the recent empirical research
on OPEC behavior. This study was later followed by a series of
contributions by Geroski, Ulph and Ulph (1987), Jones (1990), Dahl and
Yucel (1991), Polasky (1992), Gulen (1996), Alhajji and Huettner (2000),
Spilimbergo (2001), Ramcharran (2002), and Smith (2005) all of which will
be discussed in various sections of this review.

Even though the literature as a whole remains inconclusive about OPEC

behavior, our review reveals that the literature on OPEC behavior can be
divided into two main streams. The first one concludes that the oil market
has some power and that OPEC, or part of it (OPEC core or Saudi Arabia),
can be described by cartel behavior, dominant firm behavior, or target
behavior. This stream assumes that OPEC members objective is to
maximize their profits by controlling production, individually or collusively,
and thereby influencing market price. 11 We find that this stream
constitutes most of the literature on OPEC behavior. The second stream
considers the market to be more competitive and attempt to explain the
price fluctuations through factors other than the collusion among OPEC
members. A summary of our literature review on OPEC behavior within the
oil market is included in the appendix.

The first part of this review covers the first stream literature which
recognizes OPEC, OPEC core, or Saudi Arabia as a source of market power.
We divide this part into three sections covering cartel behavior, dominant
firm behavior, and target behavior models. The second part of the review
covers the second stream considering the oil market to be more
competitive and referring the price changes to reasons other than market
power. This stream includes political, and property rights models.

A. MARKET POWER MODELS

Several studies and models tried to explain OPEC behavior in the oil
market and concluded that there is some market power but did not
suggest a specific model for OPEC behavior within the oil market. As an
example, Griffin and Teece (1982) divided models to two categories:

22
wealth maximizing models and nonwealth maximizing models. They
further divided the wealth maximizing models into: monopoly models
(dominant producer models) and competition models (property rights
models) and divided the non-wealth maximizing models into: target
revenue models and political models (Figure 1). 12 In their conclusion,
they recognized the presence of economic rent and power over price and
implicitly rejected property rights model but did not suggest any specific
model for OPEC behavior believing that OPEC behavior still elicits
considerable puzzlement.

Similarly, Geroski, Ulph and Ulph (1987) did not suggest any specific
model for OPEC behavior either. In their study, they developed an
empirical model in which the pricing conduct varies over time responding
to endogenous and exogenous factors. They applied the model to the oil
market and specified different objective functions (weighted members
profit) for various OPEC members. Results rejected the constant
behavior hypothesis showing that OPEC members play a tit-for-tat
strategy, which is a combination of cooperative and competitive
behaviors.

In 1991, Dahl and Yucel tested several hypotheses including: dynamic

optimization, target revenue, cartel, competitive, and swing producers to
model OPEC behavior. They assumed that in competitive dynamic
optimization, user costs (price minus marginal cost) are equal in different
periods while in the dynamic monopoly optimization the monopolist would
equate the marginal revenue minus the marginal cost in different periods.
Under the target revenue model, they examined both a strict and variant
target revenue models where production was assumed a function of
investment required by producers. For the swing producer hypotheses, the
swing producers were expected to have larger proportionate changes in
their productions than the total OPEC production. Results rejected both
variants of the target revenue model and found no evidence of dynamic
optimization or competitiveness for either the whole market or for the
fringe. Also, they found no evidence suggesting strict cartel behavior or
swing production. As a whole, the study suggested that loose coordination
or duopoly is the closest description to OPEC behavior.

Besides hypothesis testing, other concepts including scarcity and resource

exhaustibility were also used to demonstrate the existence market power
in the oil market. In 1992, Polasky extended an oligopolistic model that
was originally developed by Loury (1986) to predict production patterns

23
for several exhaustible resource producers. 13 The model predictions were
tested using oil industry data and found that empirical results were
consistent with the oilligopoly theory stating that producers with large
reserves always had lower production costs and extracted smaller share of
their reserves compared to producers with smaller reserves. Interestingly,
results showed that OPEC producers do not appear to restrain production
compared to non-OPEC and that the pattern of extraction in the oil market
is inconsistent with either patterns predicted by competitive theory or
dominant firm-competitive fringe theory.

A few more new concepts were used to test the existence of market power
in the oil market. In an econometric model, Danielsen and Kim (1988)
investigated the oil market power using reserve sacrifice ratio, capacity
sacrifice ratio, and production variability concepts. The objective was to
see if oil market behavior could be characterized as cooperative or
competitive market. The sacrifice concept implies that a country that is
producing at relatively slow rate is sacrificing relatively more than other
cartel members in their joint effort to maintain greater than competitive
prices. The model used double logarithmic functional forms for reserve
and capacity sacrifice ratios and annual cross-sectional data (1973-1985)
for all OPEC countries except Qatar. Although results showed that the
cooperation among OPEC countries is significant, Danielsen and Kim did
not suggest any model to fit OPEC behavior.

In 2005, Smith briefly surveyed and criticized the literature on OPEC

behavior and applied an econometric production-based approach to
examine alternative hypothesis regarding the world oil market. He
conducted two analyses: price analysis (assuming that market price
greater than marginal cost indicates market power) and production
decision analysis (testing responses to exogenous shocks for evidence of
interdependence among firms). In the former case, the null hypothesis of
perfect competition (price equals marginal cost) was tested against the
alternative of a perfect cartel. In the latter case, the study tested four null
hypotheses relating to OPEC and Saudi Arabia competitiveness. The
model results showed that there is a significant cooperative effort among
OPEC countries to restrict output and raise prices and that OPEC is much
more than a non-cooperative oligopoly, but less than a frictionless cartel.
Statistical evidence was mixed on the role of Saudi and other core
producers within OPEC including Saudi, Kuwait, and UAE.

The latest empirical attempt to explain OPEC behavior was conducted by

Kaufmann et al (2004 and 2006). They estimated a modified version of
Griffins (1985) econometric model to identify the economic and
organizational variables influencing production decisions of the nations of
OPEC. On one hand, the model results showed that quotas are significant
determinant of OPEC production implying that OPEC can change prices
and therefore has a market power. On the other hand, results showed that
real prices effect production and this effect depends on OPEC capacity
implying that OPEC acts competitively. Kaufmann et al concluded,

24
recognizing that OPEC does not fit neatly into a single behavioral model
is not an intellectual retreat.

So far, none of the studies covered in this review have actually recognized
a specific model for OPEC behavior within the oil market. In the next three
sections, the review will cover studies explicitly specifying a power model
for OPEC behavior and that will include cartel behavior, dominant firm
behavior, and target behavior models.

A.1. Cartel Behavior Models

A more explicit description of OPEC behavior is the market-sharing cartel.

The cartel behavior assumes that OPEC, as a whole or grouped into two or
three-parts, functions as a monolithic wealth-maximizing monopolist. In
fact, several studies and modeling efforts analyzed OPEC behavior and
concluded that OPEC countries constrain their coordinated production to
raise the price and therefore maximize their profits while non-OPEC
producers act as competitive producers. Other studies used the
assumption that OPEC behaves as a cartel to see this assumption effect
on the oil market. In this section, we will review the former group of
studies that concluded that OPEC is a cartel.

One-Part Cartel Models

As mentioned earlier, it is Griffin (1985) that triggered most of the recent

empirical research on OPEC behavior. In fact, Griffin was the first to
systematically test OPEC market behavior across the existing competing
hypothesis including cartel, competitive, target revenues, and property
right models. For the cartel model, he specified a log-log function for
individual OPEC members production as a function of oil price, and other
members production. The intuition was that any correlation between
individual members production and the overall OPEC production indicates
market-sharing behavior. We believe that even in competitive markets,
the firms outputs may move parallel as they respond to market shocks
and cost fluctuations that affect the whole market.

For the competitive case, a log-log function was specified for individual
members production as a function of price only. Any positive correlation
indicates a positively sloped supply schedule. For the target revenue
model, an investment parameter was added to the competitive case. For a
specific investment need, any price increase implies an output decrease
indicating target revenue behavior. Finally, to investigate the property
rights model, members production was regressed against the percentage
of the government-controlled production in a log-log relation. Results
showed that the partial market sharing cartel model could not be rejected
for OPEC members and that the partial market sharing dominates the
competitive market model. On the other hand, the competitive model
could not be rejected for eleven nonOPEC members. An extension by
Jones (1990) used the same formulation but covering period 1983-1988.

25
Similar to Griffins conclusion, Jones concluded that most OPEC members
continued to behave like a partial market sharing while non-OPEC
behaved more competitively.

Another attempt on testing OPEC behavior was conducted by Loderer in

1985 to see if the price changes for years 1974-1983 were caused by
OPEC collusion. The tested null hypothesis was that OPEC is unable to
affect the market price while the alternative was the otherwise. The
investigation found no evidence that decisions reached in OPEC meeting
had any effect on the oil market price between1974 and1980. Loderer
noted that for the period 1974-1980, OPEC was nothing more than a
trade association but the evidence on collusion was found in years
between 1980 to1983.

An update to Griffins (1985) study was carried Youhanna (1994) adding

lagged oil reserves and using quarterly data for 1983-1989. The study
failed to alter Griffins conclusion that a partial market sharing cartel
model dominates all other models (competitive, property right, and target
revenues) in explaining OPEC behavior. In 1995, Al-Sultan formulated none
possible profit maximizing behaviors models for OPEC out of which only
two were estimated: a competitive model and a Nash-Cournot non-
cooperative model. He found out that the Nash-Cournot non-cooperative
model (OPEC as a Nash-Cournot with nonOpec as a fringe) can potentially
explain the oil market better than the competitive.

Although most studies analyzing OPEC behavior used hypothesis testing,

some studies used other concepts such as scarcity and cointegration
analysis and causality testing to demonstrate the existence market power
in the oil market. Adelman (1982, 1986, 1990 and 1993) attempted to
study the relation between scarcity and oil market power. He argued that
the stability of oil development costs indicates that oil is not getting
scarce and that the existence of monopoly power, which is OPEC,
slowed down resource depletion. 16 He suggested that higher costs
producers (non-OPEC) sell all they can while low cost producers (OPEC)
restrict supplies to increase pieces. He demonstrated that the price
increases since 1970 have nothing to do with scarcity, and must therefore
be due to market power and that OPEC members have formed a loosely
cooperating oligopoly- or a cartel.

In 1996, Gulen used cointegration analysis and causality testing to

determine whether OPEC is a cartel with members coordinating their
output and cutting production to increase the oil prices. In fact, the study
repeated the first test conducted by Dahl and Yucel (1991) but with a
longer time period (1965-1993). The idea tested was that if OPEC was an
effective cartel, there would be a long-term relationship between its
members productions and the cartels total production. When this idea
was tested using cointegration analysis, only three members (none of
which was a major producer) were founded to be moving together with
the cartels production. Still, results still showed evidence of output

26
coordination and suggested that OPEC acted like a cartel in the 1980s
(1982-1993) to maintain prices. We believe that the same criticism that
was mentioned for Griffins model, that even in competitive markets the
firms outputs may move parallel, applies here too.

Using a relatively new technique, Bockem (2004) derived a market

description for the oil market using the ideas of New Empirical Industrial
Organization (NEIO). In the NEIO literature, both demand and supply
functions are jointly estimated without assuming any special case for the
market model. These joint estimates are used to derive a market power
parameter indicating a competitive market when such a market power
parameter value is zero. 17 He concluded that the crude oil market is best
described as a price leader model where OPEC appears to be the leader
and all non-OPEC countries are regarded as price takers.

Few other studies simply assumed that OPEC is a cartel. These include
Salant (1976), Cremer and Weitzman (1976), Pindyck (1979), Newbery
(1981), Morrison (1987), Greene (1991), Griffin (1992), Berg et al (1996),
Dahl and Celta (2000), and Byzalov (2002).

Two-Part and Three-Part Cartels Models

A smaller group of literature analyzed OPEC market behavior and

concluded that OPEC behaves as a twopart or three-part cartel
coordinating and restraining production to alter prices and therefore
achieve maximum profits. An early effort by Hnyilicza and Pindyck (1976)
examined pricing policies for OPEC assuming that the cartel is composed
of two blocks: spenders and savers. They described spenders as countries
with large cash needs and savers as countries with small need for cash.
Their results showed that the optimal path depends on whether the output
shares are fixed or subject to change. If output shares are fixed then the
optimal price path is the optimal monopoly price path, but if not, then the
optimal paths depend on the relative bargaining power of savers and
spenders. Using a similar approach and classification, Aperjis (1982)
reached the same conclusion as Hnyilicza and Pindyck.

In 1977, Tourk divided OPEC into two blocs, one with large reserves and
small population (Saudi, UAE, Kuwait and Qatar) and the other one with
large population but small reserves (the rest of OPEC). He assumed
different discount rates for both blocs whereby the former bloc with
limited absorption capacity has a lower discount rate than the latter bloc.
The main objective for blocs is to maximize the net present value of their
future profits. He concludes that his model seems to explain the ability of
OPEC to control supplies.

For the three-part cartel model, studies by Eckbo (1976), Houthakker

(1979), Noreenge (1978), and Griffin and Steele (1986) concluded that
OPEC behavior could be explained by a three-part cartel including core
members, price maximizing members and quantity maximizing

27
members.18 In addition, a dynamic simulation model by Daly et al. (1982)
used the assumption that OPEC behaves like a three-part cartel to
estimate non-communist world oil demand, non-OPEC supply, and OPEC
supply. For OPEC supply, they divided OPEC into: a cartel core including
Saudi Arabia, Kuwait, UAE, Qatar, and Libya; price maximizers including
Iran, Algeria, and Venezuela; and output maximizers including the rest of
OPEC-13 and then compared OPEC cartel behavior pre and post Iranian
revolution. 19 They concluded that a price above $32 is not sustainable
and will encourage conservation and induce synthetic fuels. They also
suggested that long run prices are more likely to be between $15 and $32.

A.2. Dominant Firm Behavior Models

Saudi Arabia as Dominant Firm Models

A large portion of the literature on OPEC behavior used the dominant firm
behavior to explain the role that OPEC plays in the oil market. Several
empirical models and studies suggested that OPEC ultimate monopoly
power is indeed invested in the largest producer with most of the access
capacity, Saudi Arabia, while other OPEC and non-OPEC producers act
more like a competitive fringe. Others suggested that OPEC power is more
likely to be concentrated in what is identified as OPEC core including Saudi
Arabia, Kuwait, UAE, and Qatar while the remaining OPEC and non-OPEC
producers act more like a fringe.

Mabro (1975) noting OPEC is Saudi Arabia and Erickson (1980) are some
of the early studies concluding that Saudi Arabia is a dominant producer
within OPEC and that remaining OPEC and nonOPEC members are a
competitive fringe. Similarly, Plaut (1981) notes OPEC does not follow the
cartel pattern of restricting supply and allocating output. It behaves more
like an oligopoly with Saudi Arabia as a price leader and largest producer.
Even Adelman (1982, 1986, 1990 and 1993), who is more of the opinion
that OPEC is best described as a cartel, noted in 1995 that Saudis have
acted as what they are: the leading firm in the world oil market.21 In
addition, Griffin and Teece (1982) described Saudi Arabia as the swing
producer or the balance wheel absorbing fluctuations to maintain a
monopoly price. They believed that Saudi chooses the price path that
maximizes its wealth taking the fringe reaction into account.

In 1994, Griffin and Nielson found evidence that after the price collapse in
1985-1986, Saudi Arabia played a significant role in disciplining and
rewarding the cartel members through its tit-for-tat strategy. Testing the
Saudi role was also conducted by Al-Yousef (1998) where she tested two
economics models for the Saudi behavior in the oil market for the period
1976-1996. The first model was a swing producer model covering the
period 1975-1986 while the second one was a market sharing model
covering 1987- 1996. The objective function for Saudi in the first model
was to minimize the difference between the oil spot price and OPEC
official price while the objective function for the second model was to

28
maximize Saudi revenues. Indeed, the modeling results were positive
showing that Saudi Arabia acted as a swing producer (adjusting output in
order to stabilize prices) in the period 1976-1986 and as a market-sharing
producer (concerned more about its share and revenues) for the period
1978-1996.

In an attempt to test OPEC behavior, Alhajji and Huettner (2000a)

investigated the existence of certain economic literature characteristics in
six different commodity cartels including OPEC. These characteristics
included quota system, monitoring system, punishment mechanism,
cartel authority, side payments, large market share, and additional
differences. They found that none of these economic literature
characteristics fit OPEC and concluded that neither statistical tests nor
economic theory supported modeling OPEC as a cartel or as a competitive
model and that OPEC is mainly Saudi Arabia, the dominant producer, and
some other sub-groups.

In another effort, Alhajji and Huettner (2000b) used a simultaneous

systems model to investigate the existence of a dominant producer in the
oil market from 1973 to 1994. Their study covered three possible market
behaviors including: dominant firm, Cournot, and competitive behavior.
The model results rejected all three models and showed that neither OPEC
nor the OPEC core (Saudi Arabia, Kuwait, UAE, Qatar) fits the dominant
firm model but Saudi Arabia when taken alone acts as a dominant
producer.

At the end of the study, Alhajji and Huettner gave seven reasons why
Saudi would fit this dominant firm model which includes: 1) most non-
OPEC produce at their capacity at all times, 2) none of OPEC producers
(except Saudi) reduces production unless forced to do so, 3) only Saudi
Arabia has history of mothballing production capacity, 4) only Saudi
production is negatively correlated with the rest of OPEC, 5) the model has
the highest R-square value even when corrected for autocorrelation, 6)
OPEC decided in 1983, when the quota was assigned, that Saudi will be
the swing producer, and 7) Saudi is the only OPEC country that operate in
the elastic part of the demand curve. The seventh reason is criticized by
Smith (2005) noting that it is quite easy to envision market conditions
under which a perfectly competitive industry comes to equilibrium at a
point on the upper half of the demand curve (i.e., where the demand is
elastic).

A year later, Spilimbergo (2001) reached the same results when he

investigated the dynamic competitive and collusive behavior among OPEC
members between 1983 and 1991. When the hypothesis of a cartel
sharing agreements was tested against the alternative competitive
behavior hypothesis, it was rejected at a very high confidence level except
for Saudi Arabia. Here, it is worth mentioning that Smith (2005) believed
that Spilimbergos results should be inconclusive as results are not strong
enough to distinguish between the null and its alternative.

29
The last study we include in the dominant firm literature is a computable
general equilibrium (CGE) study by De Santis (2003). He constructed a
CGE for Saudi Arabia to study the effect of oil supply and demand shocks
on oil price and outputs under two scenarios: production quota and
dominant firm model. The model results supported De Santis prior
believes that short run price fluctuations are due to OPEC quota
agreements while in the long run Saudi Arabia acts like a dominant firm.
The model results also indicated that Saudi Arabia does not have
incentives to intervene when the market is in equilibrium, has the
incentive in negative demand shocks, and has the disincentive in positive
demand shocks. In addition, results showed that to bring prices down, the
Organization for Economic Cooperation and Development (OECD) should
not apply taxes bur rather should apply policies that can increase price
elasticity of demand.

A Core Group as a Dominant Firm Model

The second part of the dominant firm behavior literature suggests that
OPEC core members including Saudi Arabia, Kuwait, UAE, and Qatar are
where OPEC power is concentrated while the remaining OPEC and non-
OPEC producers act as a competitive fringe. Such literature includes
studies by Singer (1983), Dahl and Yucel (1990), Mabro (1991), and
Hansen and Lindholt (2004).

The study by Singer (1983) concluded that a quasi-monopoly model,

which is a dominant firm model, is the best model to fit the oil price
between 1974 and 1978. In his study, Singer believed that Saudi Arabia
and smaller Arab producers dominate the residual demand and get to
determine the worlds oil price through adjusting their production levels.
Similarly, Dahl and Yucel recognized the power of OPEC core members and
concluded that OPEC, rather than being a weak cartel, consists of a non-
competitive core of swing producers including Kuwait, Nigeria, Saudi
Arabia, and Venezuela.

In addition, Mabro argued the core producers can set either a supply plan
or more straightforwardly a price. however, there exist some political
constraints on OPEC-core producers when setting the oil price. Here, it is
worth mentioning again that in 1975 Mabro was more of the opinion that,
OPEC is Saudi Arabia.

In a more recent effort to test OPEC core behavior, Hansen and Lindholt
applied a dynamic econometric model on the world market for the period
1973-2001 to test whether the behavior of OPEC as a whole or a sub-
group of OPEC would fit the behavior of a dominant producer. The model
results showed that producers outside OPEC are best described as
competitive producers (price takers), while OPEC members are not.
Results also showed that OPEC as a whole cannot be looked at as a
dominant producer and that neither Saudi Arabia nor OPEC core (Saudi,

30
Kuwait, Qatar, UAE) can be looked as a dominant producer before 1994.
However, the dominant producer behavior fits the OPEC core very well
between 1994 and 2001.

We believe that treating Saudi Arabia as a dominant firm and others oil
producers as a competitive fringe is the most compelling modeling
approach given the excess production capacity and the large reserves
Saudi possesses. Therefore, this market behavior describing the Saudi role
is the one we chose for our proposed model.

A.3. Target Behavior Models

The third part of the literature that recognizes OPEC market power covers
the target behavior modeling. It includes target revenue models, target
capacity models, and target price models. The target revenue models
assume that OPEC members seek certain revenue levels to meet
individual government internal budgetary obligations. The target capacity
models believe that OPEC production oscillates around a certain capacity
utilization level and that OPEC members adjust their production levels
accordingly. The third type of target behavior modeling, the target price
models, assumes that OPEC adjusts production to maintain the oil price at
a certain level or within a certain price band.

Target Revenue Models

The target revenues models are the most prominent among the target
behavior models. The literature on the target revenue models either
assumes or concludes that each country within OPEC faces a backward
bending supply curve meaning that cut backs occur if oil prices rise above
a specific level so countries satisfy certain, or fixed to be exact, target
revenues for their internal investment use (Figure-02). In the figure, any
increase in the price above P2 would result in a cutback in production, as
the producer desires a fixed level of revenues.

In 1982, Adelman argued that OPEC countries cutback production to raise

prices and get more money for their oil and that they have less pressure

31
to cheat as higher oil prices make them better financially. Despite the fact
that he noted, a loosely cooperating oligopoly-or cartel behavior for
OPEC, he concluded that the backward-bending supply curve could
explain OPEC behavior in the short run.

Similarly, but more explicitly, Teece (1982) described OPEC behavior as a

target revenue model. He indicated that it is inappropriate to model
OPEC as a wealth maximizing classical cartel and that some important
OPEC members set their oil production with reference to certain
budgetary requirements and internal and external political constraints.
He suggested that members of OPEC shut-in production capacity if their
export receipts and foreign earnings meet certain expenditure
requirements and increase production if otherwise and this relationship
between the price and output is best described by a backward bending
supply curve.

A modification to Griffins (1985) target revenue model, described earlier,

was conducted by SalehiIsfahani (1987) where he replaced the current oil
price in Griffins model by the long-term price, assumed individual OPEC
members production as a function of price and investment needs and re-
estimated the model. The conclusion supported the target revenue model
for OPEC.

In 2000, Alhajji and Huettner briefly reviewed the literature describing

OPEC behavior as a target revenue model and used four econometric
models (1 static and 3 dynamic) to examine the target revenue model for
individual OPEC members that dont coordinate production with Saudi
Arabia. In the static model, individual production was assumed to be a
function of oil price and individual countrys investment needs. For the
dynamic models, the first one assumed production as a function of price,
investment needs and lagged production. The second assumed that
current production depends on lagged prices, lagged investment needs
and lagged production while the third assumed current production to be a
function of lagged prices and lagged investment needs.

The model results showed that investments and budgetary needs do not
affect oil production in free-market economies, but do in centrally
planned, isolated and oil dependant economies. Only the African OPEC
countries were found to be fitting the backward-bending supply curve. 25
The strict proportional version of the target revenue model fits only one
country (Libya), the non-proportional version fits Libya and Nigeria, while
the weak version fits Libya, Nigeria, Mexico, Egypt, USSR, China, and
Malaysia.

Another modification to Griffins (1985) target revenue model, described

earlier, was conducted by Ramcharran (2001) to test the target revenue
theory for OPEC and to estimate supply elasticities for OPEC and non-
OPEC countries using 1973-2000 data. Similar to Alhajji and Huettner
(2000), results were more supportive of the partial version of the

32
revenue target model more than of the strict version model. A year
later, Ramcharran (2002) repeated the same exercise using 1973-1997
data. Again, the results partially supported the target revenue hypothesis,
rejected the competitive hypothesis for all OPEC countries and supported
the competitive hypothesis for non-OPEC.

Target Capacity Models

The target capacity utilization assumption implies that OPEC sets and
attempts to maintain a certain capacity utilization target. If this limit or
target is exceeded then oil price will increase as OPEC reduces the
production to match their predetermine capacity utilization level. For
example, a target capacity utilization of 80% implies that if OPEC capacity
utilization rate exceeds 80%, then higher demand will stimulate OPEC
price increases. The higher price will then reduce demand and eventually
reduces OPEC capacity utilization, and vice versa.

In an attempt to see whether the target capacity utilization rule satisfies

OPEC economic objectives, Suranovic (1993) used the United States
Energy Information Administrations Oil Market Simulation model called
OMS92. The OMS92 model is an annual model projecting the global oil
market conditions to the year 2010. The model has seven regions
including USA, Canada, Japan, Europe, formerly Centrally Planned
Economies (CPEs), OPEC, and others.

In the OMS92, the demand by OPEC, CPEs, and the US government for
strategic petroleum reserves are considered exogenous while the demand
for the remaining five regions is determined using geometric Koyck-lag
demand function estimated using reduced form equations with
coefficients derived from largescale EIA and non-EIA macroeconomic
models. Similarly, the supply from the CPEs is considered exogenous while
supply from other regions is determined using geometric Koyck-lag supply
function estimated using reduced form equations with coefficients derived
from large-scale macroeconomic models. The model results showed that
the target capacity utilization rule comes closest to optimum either when
there are no lags in supply and demand or when OPEC optimizes subject
to a minimum revenues constraint. In fact, this study by Suranovic is the
only study we found on testing the target capacity model for OPEC. We
believe that the reason is that this model is not quite popular in modeling
OPEC behavior.

Target Price Models

A few more studies either assume or conclude that OPEC targets a certain
price level or a price band and then defends it through production
adjustments. The three studies reviewed in this part of the literature
involved ShawkatHammoudeh either as a standalone or as a joint author.
In 1995, Hammoudeh and Medan incorporated market expectations and
inventories shocks and expectations in examining OPEC oil pricing

33
mechanism and behavior. They applied the literature on target zone and
speculative attack to investigate oil price dynamics in two models: two-
sided target zone model and asymmetric tolerance zone model. Their
modeling results showed that OPEC credibility to intervene is directly
related to oil price sensitivity to changes in both the output and price
expectations.

Later on, Hammoudeh (1997) conducted a similar study and discussed the
price solutions for single and multi-target zone models. He concluded that
under normal conditions, market participants form expectations that
cause price fluctuation in anticipation of OPEC interventions while under
other circumstances OPEC shifts the target zone when it fails to hold the
line with previous targets. Furthermore, Tang and Hammoudeh (2002)
tested the same model and investigated the oil price behavior for the
period 1988-1999.29 They found that OPEC tried to maintain a weak
target zone regime for the oil price, that the oil price is affected by both
OPEC behavior and the markets expectation of OPEC behavior, and they
also suggested that OPEC became more explicit in adopting a target price
zone model.

B. OTHER MODELS

The second part of this literature review on OPEC behavior covers the
second and the smaller stream suggesting that the oil market to be more
competitive and referring the price changes to reasons other than market
power. This stream includes political and property rights models.

B.1. Political Models

Although empirical studies by Griffen (1985), Jones (1990), Dahl and Yucel
(1991), and Gulen (1996) rejected the hypothesis that OPEC behavior is
consistent with that of a competitive firm, several studies including Ezzati
(1976, 1978), Moran (1981), MacAvoy (1982), and Verleger (1987)
suggested that the oil market is competitive and that significant oil price
changes are due to factors not related to market power.

Early studies by Ezzati (1976) concluded that the price increases were due
to political factors and that the price was sustained at high levels due to
OPEC limited absorptive capacity. In 1981, Moran tried explaining the
behavior using a political model. He critically reviewed past attempts to
model OPEC behaviors models based on maximizing revenues and
suggested that a political decision rule was the driver of the Saudi energy
policy. He claimed that the data between 1973 and 1980 suggested that
not a single economic model is consistent with the Saudi behavior except
for that of the political decision rule. He argued that the Saudi behavior
can be better explained by an operational code of advancing Saudi
political priorities while minimizing hostile external and internal pressures
upon the kingdom rather than any other model.

34
Similarly, MacAvoy (1982) suggested that the oil price can be explained by
a model focusing on supply and demand, market fundamentals, rather
than cartel behavior and that the price increases in 1973-74 and 1979-80
were due to shortages and cut backs that were mainly due to political
conditions and accidents (e.g. Arab embargo and Iraq-Iran revolution and
war) rather than any cartel collective supply control. Also, Verleger
(1987) followed the same path and explained the oil market behavior
using a competitive model rather than a market power one.

B.2. Property Right Models

Another part of the literature suggesting the oil market to be more

competitive tries to explain the market power using property rights
models. These models conclude that the producing governments have
much lower discount rates than international oil companies and that the
lower the discount rate, the lower the preferred production. This implies
that producing governments value future productions more than the
international oil companies and therefore decide to produce reserves in
future rather than now.

Similar to Mead (1979) and Odel and Rosing (1983), Johany (1979 and
1980) argued that the price hike in 1974 was mainly a result of property
rights changes where individual oil producers, rather than international oil
companies, started determining their oil production rates at different
market prices. He argued that countries have lower discount rate than
companies because they have longer production horizon while companies
have limited concessionaries time. The idea is that different discount
rates, depending on property right, lead to different production rates and
hence different prices.

To summarize, this part of the review reveals that despite the large
number of studies attempting to model OPEC behavior (Table-1), the
empirical literature as a whole remains inconclusive regarding OPEC
behavior and that experts still have different views and opinions about
what model represents the oil market structure and fits OPEC behavior. In
general, the literature on OPEC behavior can be divided into two main
streams. The first and the more popular one concludes that the oil market
has some sort of market power and that OPEC or part of it, OPEC-core or
Saudi Arabia, can be described by cartel behavior, dominant firm
behavior, or target behavior. This stream assumes that OPEC members
seek to maximize their profits by controlling production, individually or
collusively, and thereby influencing market price. We believe that treating
Saudi as a dominant firm and others as competitive fringe is the most
compelling model. The second stream considers the market to be more
competitive and attempt to explain the price fluctuations through factors
other than the collusion among OPEC members.

35
MEMBER COUNTRIES

The Organization of the Petroleum Exporting Countries is a permanent,

intergovernmental Organization, created at the Baghdad Conference on
September 1014, 1960, by Iran, Iraq, Kuwait, Saudi Arabia and
Venezuela.

The five Founding Members were later joined by nine other Members:

Qatar (1961); Indonesia (1962) suspended its membership in January

2009, reactivated it in January 2016, but decided to suspend it again in
November 2016; Libya (1962)

United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador

(1973) suspended its membership in December 1992, but reactivated it
in October 2007

Angola (2007); and Gabon (1975) - terminated its membership in January

1995 but rejoined in July 2016.

OPEC had its headquarters in Geneva, Switzerland, in the first five years
of its existence. This was moved to Vienna, Austria, on September 1,
1965.

OPEC currently has twelve active members. Ecuador

suspended its membership in 1992, and reactivated it
in 2009.

OPEC Joined Located OilProduced Comments

Country (mbpd)2015

Algeria 1969 Africa 1.16

Angola 2007 Africa 1.77

Ecuador 1973 Central 0.54

America

36
 OPEC Joined Located OilProduced Comments
Country (mbpd)2015

Gabon 1975 Africa NA Terminated

Indonesia 1962 Asia 0.69 Willresignratherthancut.

Iran 1960 Middle 3.15 Willriseby0.5mbpddue

East tonucleartreaty.
Iraq 1960 Middle 3.5 NeedsfundsforIraqWar.
East
Kuwait 1960 Middle 2.86
East
Libya 1962 Middle 0.40
East
Nigeria 1971 Africa 1.75

Qatar 1961 Middle 0.66

East
SaudiArabia 1960 Middle 10.19 Producesonethirdoftotal.
East
UnitedArab 1967 Middle 2.99
Emirates East

Venezuela 1960 Central 2.65 Fundsfailinggovernment.

America
TOTALOPEC 32.32

Saudi Arabia is by far the largest producer, contributing nearly one-third of

total OPEC oil production. It is really the only member that produces
enough alone to materially impact the world's supply. For this reason, it
has more authority and influence than the other countries.

37
According to current estimates, more than 80% of the world's proven
crude oil reserves are located in OPEC Member Countries, with the bulk of
OPEC oil reserves in the Middle East, amounting to 65% of the OPEC total.

38
OPEC Member Countries have made significant additions to their oil
reserves in recent years, for example, by adopting best practices in the
industry, realizing intensive explorations and enhanced recoveries. As a
result, OPEC's proven oil reserves currently stand at 1,213.43 billion
barrels.

WHAT DOES OPEC DO?

OPEC's first goal is to keep prices stable. It wants to make sure its
members get what a good price for their oil. Since oil is a fairly
uniform commodity, most consumers base their buying decisions on
nothing other than price.

What's a good price? OPEC has traditionally said it was between $70-$80
per barrel. At those prices, OPEC countries have enough oil to last 113
years. If prices drop below that target, OPEC members normally agree to
restrict supply to send prices higher.

Without this agreement, individual oil-exporting countries would wind up

increasing the supply to make more national revenue. By competing with
each other, they would drive prices even lower. That would stimulate even
more global demand. OPEC countries would run out of their most precious
resource that much faster. Instead, OPEC members agree to produce only
enough to keep the price high for all members.

When prices are higher than $80 a barrel, other countries have the
incentive to drill more expensive oil fields. Sure enough, once oil prices
got closer to $100 a barrel, it became cost effective for Canada to explore
its shale oil fields. U.S. companies used franking to open up the Bakker oil
fields for production. As a result, non-OPEC supply increased.

OPEC's second goal is to reduce oil price volatility. For maximum

efficiency, oil extraction must run 24 hours a day, seven days a week.
Closing facilities could physically damage oil installations and even the
fields themselves. Ocean drilling is especially difficult and expensive to
shut down. Therefore, it's in OPEC's best interests to keep world prices
stable. A slight modification in production is usually enough to restore
price stability.

For example, in June 2008, oil prices hit an all-time high of $143/barrel.
OPEC responded by agreeing to produce a little more oil, which brought
prices down. But the global financial crisis sent oil prices plummeting to
$33.73/barrel in December. OPEC responded by reducing the supply,
helping prices to again stabilize.

39
OPEC third goal is to adjust the world's oil supply in response to shortages.
For example, it replaced the oil lost during the Gulf Crisis in 1990. Several
million barrels of oil per day were cut off when Saddam Hussein's armies
destroyed refineries in Kuwait. OPEC also increased production in 2011
during the crisis in Libya.

The Oil and Energy Ministers from the OPEC members meet at least twice
a year to coordinate their oil production policies. Each member country
abides by an honour system, agreeing to produce a certain amount. If a
country winds up producing more, there really is no sanction or penalty.
Furthermore, each country is responsible for reporting its own production.
Therefore, there is room for "cheating." On the other hand, a country
won't go too far over its quota, since it doesn't want to risk being kicked
out of OPEC.

Despite its power, OPEC cannot completely control the price of oil. In
some countries, additional taxes are imposed on gasoline and other oil-
based end products to promote conservation. More importantly, oil prices
are set by the oil futures market. Much of the oil price is determined by
these commodities traders

Objectives of OPEC

OPEC seeks to ensure the stabilization of oil prices in international

oil markets, with a view to eliminating harmful and unnecessary
fluctuations

OPECs role in overseeing an efficient, economic and regular supply

of petroleum to consuming nations.

To ensure a fair return on capital to those investing in the petroleum

industry.

To deliver steady supply of oil to deliver steady supply of oil to

consumers.

To get oil to people at reasonable and fair prices.

40
CHEPTER 3

41
 STRETAGY AND
IMPACT OF
OPEC

OPEC INVESTMENT STRATEGY

In addition to coordination and cheating, one of the issues facing any

collusive behavior isthe issue of entry of new competitors. OPEC has been
protected by strong barriers to entry,which stem from ownership and
control of low-cost oil reserves. Although production ofcrude oil from non-
OPEC sources expands when OPEC cuts production and prices are high,the
scope of expansion remains limited. After all, OPEC still controls the bulk
of the worldsproven oil reserves.One standard way of modeling OPEC
supply in long-term projections has been to treat it as aresidual, often
referred to as the call on OPEC. This is the hypothetical amount that
OPECneeds to produce to close the gap between anticipated oil demand
and non-OPEC supply. Inother words, projections of OPEC supply are not
based on any behavioral analysis but arederived from a simple accounting
formula that balances world demand after taking intoaccount various
factors. This approach clearly suffers from major limitations as it is based
ontwo simplistic assumptions: the first is that OPEC always has the
incentive to expand outputto increase its market share; the second is that

42
OPEC producers can and will undertake thenecessary investment to
increase capacity.

These assumptions, however, are highlyquestionable. Regarding the first,

aggressive plans to expand OPEC output can yield lowerpay-offs (Gamely,
2004). This result is quite intuitive. Lower prices resulting from a
rapidoutput expansion would lead to decreased revenues, cancelling out
the higher output. As tothe second assumption, even if OPEC has the
incentive to increase market share, theinvestment needed to attain such a
share is substantial, and the investment decision may beaffected by a
number of other factors. These include: uncertainty about long-term oil
demandgrowth, which increases the option to wait (Dixit and Pindyck,
1994); unfavorablegeopolitical factors; sanctions; and the relationship
between the government and the nationaloil company that may lead to
low investment in the oil sector.

The decision to restrict investment by holders of low-cost reserves creates

a market structurein which both low-cost and high-cost producers co-exist,
with implications on oil pricebehavior. The oil price can clear within a wide
range, depending on oil market conditions:the lower boundary of the
range is set by the cost of production in key OPEC members whilethe
upper boundary is set by the potential entry of substitutes. When the
market ischaracterized by predictions of excess demand, potential
substitutes and adjustments indemand cannot place a cap on the short-
term price. Instead in the absence of spare capacity,most of the
adjustment is likely to occur through sharp increases in oil prices. Thus,
when themajority of OPEC members are producing at or close to their
maximum capacity, OPEC haslittle ability to act to lower the price. This
problem can be compounded by market skepticism about OPECs spare
capacity and its ability to raise production. In other words, at times
whenprices are rising and when OPEC is perceived to be in the control
seat, OPECs power toinfluence price is weakest.When the market is
characterized by excess capacity, the oil price tends to move towards
thelower boundary. As we have argued, in times of declining demand
(such as periods ofrecession), tacit collusion is fragile. This means that
prices can fall somewhat below thecollusive outcome. Yet experience has
shown that collusion may reassert itself powerfullybefore the competitive
price floor is reached.

OPEC, RENTS, AND OIL SUBSTITUTION POLICIES:

A core feature of oil is that it creates large economic rents, which are often
contested betweenproducers and consumers and among the various
players in the supply chain.

The sizable economic rents have been a prize deemed worth fighting for,
far beyond thenormal competition among market players. They have
guaranteed persistent involvement bygovernments everywhere, either as
producers or tax collectors.

43
OPEC producers would like to claim higher rents by maintaining
increasingly stringentconstraints on investment and supply. Consumer
governments would like to capture the rentsinvolved via domestic
taxation or equivalently by cap-and-trade systems. Driven by
energysecurity and climate change concerns, many OECD and non-OECD
countries have beenstimulating the use of renewable energies often
through a combination of regulations,incentives, subsidies, taxation, moral
persuasion, and/or a combination of these instruments to change the
composition of their energy mix to one with a lower carbon content.
Oilsubstitution policies can have a large impact on long-term oil demand
since their impact iscumulative and irreversible. Thus, from OPECs
perspective, taxes on petroleum productsand oil substitution policies are
seen as discriminatory, tending to dampen oil demandgrowth, and
reducing OPECs export share in the energy mix in the long term.

There are few recent studies examining the potential responses of OPEC
to oil substitution
policies. OPEC can divert a larger part of the rent through raising its
prices. Since the easiest
oil demand is substituted first, the oil demand remaining is highly
inelastic. Analternative policy would be for OPEC to anticipate the extent
of demand destruction and increase its quota, inducing a decrease in the
oil price to generate a rebound in global oildemand and drive out non-
OPEC supply. Using simulation analysis,however, show that OPEC would
derive no advantage from flooding the oil market even if allannounced
climate change policies were fully implemented, since its own net
revenues woulddecrease in such an event. Simulation results also show
that OPECs profits would be lowerin a world of effective climate change
policies and that there is only limited scope for OPECto defend its oil
revenue by adopting a firm price strategy consistent with significant
production restraint. OPEC countries feeling threatened by a decline in
future prices willrespond by increasing production in the short run,
reducing prices and increasing oil consumption and thus accelerating
global warming

HOW DOES OPEC PRODUCTION IMPACT OIL PRICES?

The market share of OPEC-produced oil in the global oil market keeps
hovering around 40%. For instance, the International Energy Agency
(IEA) provides the following representation of OPEC oil share in the global
market between 2013 and 2015:

44
OPEC-exported oil accounts for around 60% of the global oil trade,
which indicates its dominant position in the global oil market. IEA
also reports that 81% of the worlds proven crude oil reserves lie
within the boundaries of the OPEC nations. Of that, around two-
thirds lie within the Middle Eastern region. Additionally, all OPEC
member nations have been continuously improving on technology
and enhancing explorations leading to further enhancements to
their oil production capacities at reduced operational costs.

OPEC remains influential due to three primary factors: an absence of

alternative sources equivalent to its dominant position, a lack of
economically feasible alternatives to crude oil in the energy sector,
and the comparatively low-cost price advantage against the
relatively high-cost non-OPEC production.

OPEC has the economic capability to disrupt or enhance the supply

of oil to substantial levels at any time, severely affecting the oil
prices. The 1973 Arab oil embargo saw prices quadrupling from $3
to $12 per barrel, while the recent ongoing oversupply has brought
down prices from $100 a year before to present-day $28 per barrel.

Within the OPEC group, Saudi Arabia is the largest crude oil producer
in the world, and remains the most dominant member of OPEC.

45
A representation from EIA indicates that each instance of a cut in oil
production by Saudi Arabia has resulted in a sharp rise in oil prices,
and vice versa.

Prior to 2000, all historical instances since the 1973 Arab oil embargo indicate that
Saudi Arabia has managed to maintain its upper hand in the oil market. It calls the shots
in determining crude oil prices by controlling the supply. All major oil price fluctuations
can be clearly attributed to production levels from Saudi Arabia, along with other OPEC
nations.

ASSESSMENT OF OPEC IN MANAGING OIL PRICES

According to economics literature, market power exists when a group of

producers collude to maximize profit by reducing output while charging
high prices. The behaviour of OPEC as a wealth maximizing cartel is an
example of an imperfect market condition where some degree of market
power is exercised by producers with a reasonable degree of market
share. Although the market share of OPEC is still below 40%, its influence
on oil prices over the years is significant. More so, the marginal cost of

46
producing oil in the core OPEC regions is relatively low and as a result of
its position as a key oil supplier, the elasticity of demand for OPECs oil is
relatively low in the short run.

In controlling the price of oil, OPEC needs to stay consistent and totally
cooperative in its policies (Horn 2004), this has however not been the
case as literature and data have shown that OPEC have struggled to get
its members to commit13 to a output policy agreements without cheating
on their respective quotas. Dibooglu and AlGudhea (2007) concluded in
their assessment of cheating within OPEC that members have reacted in
response to rising oil prices than falling prices and they occasionally have
to be cautioned by Saudi Arabia when cheating starts reducing its market
share. More so, the divided interests14 amongst OPEC members have led
to a series of fluctuations and inconsistency in its behaviour and they
have been mostly been reactive rather than proactive in assessing the oil
market conditions in the past. Its failure to predict the oil price crash in
1986, 1998 and 2009 is a point of note and also, the instability of its
pricing mechanisms due to politics and cheating cast a doubt on OPECs
reliability to manage oil price.

Setting the target range for oil price

In providing guidance on how to set a target range oil prices, it is
important to note that even though one of the aims of OPEC besides
stabilizing the price of oil is to make high revenue from high oil price,
OPEC is more concerned about the impact of a global demand shock and
fall in demand for OPEC crude which leads to low prices, on its economies.
Santis (2003) concluded that Saudi Arabia as a dominant firm does not
have any incentive to alter oil prices due to welfare concerns, this also can
be further explained by the impact of the past oil price crash on state
budgets and fiscal stability. It is however critical to take cautious approach
in setting a target range for oil price due to the mistakes made in the past.

47
Managing spare capacity
The ability of OPEC to manage its spare capacity is important when
considering setting a target range for its oil price. Adequate spare
capacity will enable OPEC to stabilize the market by increasing supply in
the event of disruptions caused by low demand for OPEC oil due to an
increase in exploration and production outside OPEC and the subsequent
increase in non- OPEC supply. If this happens, oil prices will crash its effect
on the economies of OPEC countries is always negative as earlier
explained. When there is low capacity, OPEC appears lose control in the oil
market any longer as the market will lose confidence in OPECs ability to
stabilize the market in the event of supply disruptions. This will however
lead to stock piling which will lead to a crash in oil prices. Most OPEC
countries (besides Saudi Arabia who had excess capacity to the tune of
1.95mb/d in 2000) do not have adequate space capacity to respond to
increase in demand which makes them gain little during output increases
(Kolh, 2002). Although expanding capacity is a long term project due to
high cost and technical expertise, it is critical to the long term relevance
of the OPEC group in the oil market.

Consumption patterns of oil consuming countries

The consumption patterns of major oil consuming countries in the OECD

and non OECD countries need to be considered. According to the EIA, the
United States (US), being the worlds largest oil consumer, consumed
18,771,000 barrels/day and 5,954,000 barrels/day (31%) was imported
from OPEC in 2009. It is reasonable to suggest that a fall in the demand
for OPEC crude by the US could have a significant impact on oil prices if
not well managed. The EIA also projects that the increase in U.S. crude oil
production in the Gulf of Mexico and elsewhere, combined with increasing

48
bio fuel and coal-to-liquids (CTL) production and decreasing petroleum-
derived fuel demand, is expected to reduce the need for imports in the
long run. U.S. petroleum import dependence falls from 51% in 2009 to
45% by 2035 in EIA's reference case projection. With this in mind, setting
the price of oil close or equal to marginal cost is crucial for the future
demand of OPECs crude oil.

According to the BP Statistical Review of World Energy 2010, as OPEC

production fell by 2.5 million b/d, production outside OPEC rose by
450,000b/d, due to an increase of 460,000b/d in the United States. The
rapid industrialization on China and India caused disruptions in the oil
market in 2008 as lack of spare capacity was inadequate to meet the
rising demand. And as we have seen so far, the resulting effort by OPEC to
get oil prices to recover has always led to them over supply the market in
most cases to send prices crashing again. Calls by China and India on
OPEC to reduce oil price recently due to its damaging effect on their
economies is a reference point, if this is not examined, conservation, fuel
switching and increase in oil exploration by these oil consuming
industrialized economies could also have a negative impact on oil prices.

Better information management

As explained earlier, the price band mechanism failed due to the power it
gave to market speculators to increase oil stock which is inversely related
to oil price (IEA Monthly Oil Market Report, 2000). The more recent
method of sending signals to the market though speeches and press
releases is a better way of managing information and staying
unpredictable. More so, as OPEC got more used to operating as a cartel, it
realized that regular meetings and monitoring of market dynamics is
better for its management of spare capacity which is important for the
sustainability of its market share.

Stringent measures to prevent cheating

Saudi Arabia as the dominant oil supplier in OPEC is known to suffer the
most when there is a collapse in oil prices. This has led it to react strongly
when cheating by member countries on their quotas lead to a fall in oil
prices which reduces the market share and revenue of the oil dependent
country. More disciplined approaches to compliance on the quota system
needs to be enforced to enable any price agreements by OPEC achieve its
objective.

49
Influence of OPEC on price
OPEC's influence on the market has been widely criticized, since it
became effective in determining production and prices. Arab members of
OPEC alarmed the developed world when they used the oil weapon
during the Yom Kippur War by implementing oil embargoes and initiating
the 1973 oil crisis. Although largely political explanations for the timing
and extent of the OPEC price increases are also valid, from OPECs point of
view, these changes were triggered largely by previous unilateral changes
in the world financial system and the ensuing period of high inflation in
both the developed and developing world. This explanation encompasses
OPEC actions both before and after the outbreak of hostilities in October
1973, and concludes that OPEC countries were only 'staying even' by
dramatically raising the dollar price of oil.

Oil Economics

OPEC is a swing producer and its decisions have had considerable

influence on international oil prices. For example, in the 1973 energy crisis
OPEC refused to ship oil to western countries that had supported Israel in
the Yom Kippur War or 6 Day War, which Israel had fought against Egypt
and Syria. This refusal caused a fourfold increase in the price of oil, which
lasted five months, starting on October 17, 1973, and ending on March 18,
1974. OPEC nations then agreed, on January 7, 1975, to raise crude oil
prices by 10%. At that time, OPEC nations, including many whom had
recently nationalized their oil industries, joined the call for a new
international economic order to be initiated by coalitions of primary
producers. Concluding the First OPEC Summit in Algiers they called for
stable and just commodity prices, an international food and agriculture
program, technology transfer from North to South, and the
democratization of the economic system. Overall, the evidence suggests
that OPEC did act as a cartel, when it adopted output rationing in order to
maintain price.

Since currently worldwide oil sales are denominated in U.S. dollars,

changes in the value of the dollar against other world currencies affect
OPEC's decisions on how much oil to produce. For example, when the
dollar falls relative to the other currencies, OPEC-member states receive
smaller revenues in other currencies for their oil, causing substantial cuts
in their purchasing power. After the introduction of the Euro, pre-invasion
Iraq decided it wanted to be paid for its oil in Euros instead of US dollars
causing OPEC to consider changing its oil exchange currency 8 OPEC & its
influence on Price of Oil

50
to Euros, although after Iraq's invasion, the interim government reversed
this policy, and the subsequent Iraq governments stuck to the US dollar.
Member states Iran and Venezuela have undergone similar shifts from the
dollar to the Euro.

OPEC Basket

OPEC basket is a weighted average of oil prices collected from various oil
producing countries. This average is determined according to the
production and exports of each country and is used as a reference point
by OPEC to monitor worldwide oil market conditions. The new OPEC
Reference Basket (ORB) Introduced on 16 June 2005, is currently made up
of the following: Saharan Blend (Algeria), Girassol (Angola), Oriente
(Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait
Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine
(Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).
OPEC daily basket price stood at $93.96 a barrel on Thursday 13th January
2011

Production Allocation

OPEC allocates quotas to its member countries every few months. The
most popular view is that these nations agree to increase global demand
by restrict its production but as stated earlier Saudi Arabia takes a
different stand. The recent allocation data has no distributions allocated
from November 2007

OPEC Reserves

OPEC's ability to control the price of oil has diminished somewhat since
the Gulf War due to the subsequent discovery and development of large
oil reserves in Alaska, the North Sea, Canada, the Gulf of Mexico, the
opening up of Russia, and market modernization. As of November 2010,
OPEC members collectively hold 79% of world crude oil reserves and 44%
of the worlds crude oil production, affording them considerable control
over the global market. The next largest group of producers, members of
the OECD and the Post-Soviet states produced only 23.8% and 14.8%,
respectively, of the world's total oil production. As early as 2003, concerns
that OPEC members had little excess pumping capacity sparked
speculation that their influence on crude oil prices would begin to slip. 9
OPEC & its influence on Price of Oil

Who gets What - by OPEC

Although the popular view is that OPEC is responsible for all the volatility
of crude oil prices globally, the research division of OPEC contradicts this

51
view by regularly analyzing and publishing the Who gets What from a
litre of imported oil of the G7 countries. The latest report published in
November 2010 states the following.

The crude basket price of OPEC may fluctuate widely but OPEC claims its
percentage share of cost per litre of oil has remained steady.

Impact of Kyoto protocol on OPEC

Environmental concerns have forced mankind to diversify into alternate
sources of energy. The possible losses that OPEC countries may incur due
to threat by these Non- Conventional sources have triggered a debate on
the green paradox (Sinn 2008). This paradox is based on the assumption
that suppliers of oil feel threatened by a decline of future prices due to
gradual reduction of oil consumption in abating countries. If this reduction
reduces the discounted value of the oil price in the future more than at
present, the oil producing countries will expand production in the short run
which will increase oil consumption and thus accelerate global warming.
OPEC stated that its Nations are dependent on oil exports and hence need
to be compensated for the adverse impacts arising due to KYOTO Protocol.

CRUDE OIL PRICE MOVEMENTSOF OCTOBER 2016:

Crude Oil Price Movements Despite the small improvement in

global crude oil benchmarks and price differentials for most
light sweet components, the OPEC Reference Basket (ORB)
slipped slightly in September to $42.89/b, but was up
marginally for the quarter, ending more than 40% higher than
the record-low 1Q16. Year-to-date (y-t-d), the ORB value is
about 27% lower at $38.54/b. Both oil futures averaged up,
strongly supported by a late-month rally. Oil futures were

52
caught in one of their most volatile weeks amid uncertainty
about the pace of the rebalancing of fundamentals. Prices also
fell under pressure amid reinforced fears of a global glut.

With the announcement to tackle the persistent oversupply,

prices surged with ICE Brent nearing the $50/b level. Oil prices
were also supported by unexpected four consecutive weekly
draws in US crude stockpiles. ICE Brent ended up 8 at
$47.24/b, but dropped around 24% on the year. NYMEX WTI
increased 43 to $45.23/b, but slipped about 19% y-t-d. Both
contracts ended the quarter lower. The ICE Brent/NYMEX WTI,
or transatlantic, spread narrowed to $2.01/b, but was still not
enough to encourage additional significant US imports of WAF
crudes and other Brent-related grades

THE OIL FUTURE MARKET:

The oil futures market Both oil futures across the Atlantic edged
up in September, being greatly pushed up by a late-month rally
in the oil complex. Oil futures had been caught in one of their
most volatile couple of weeks in months amid uncertainty
regarding the pace of rebalancing of fundamentals. Toward the
end of the month, with the announcement by OPEC that it
aimed for a production target with a view to rebalancing the
market next year, prices took a considerable amount of support
with ICE Brent nearing the $50/b level.

The development was seen as the first step of a process, with

concrete action being discussed further over the next two
months, potentially also including a contribution from non-OPEC
producers, particularly Russia. Oil prices were also supported
after US government data showed a surprise drop in domestic
crude stockpiles for four weeks in a row.

The month-long drawdown in crude stocks was a surprise after

a massive 14-mb storm-related drop in inventories at the
beginning of September. Inventories were expected to rebound
after the big drop, but instead, stocks have continued to decline
with reduced imports. Nevertheless, crude oil prices fell under
pressure before the OPEC Meeting, amid reinforced fears of a
global glut. Falling US equity markets and a rising dollar also

53
weighed on crude futures and other commodities denominated
in the greenback.

CHAPTER 4
CHALLENGES TO
OPEC

54
OPEC was organized in the early 1960s by Saudi Arabia, Iran, Iraq, Kuwait
and Venezuela with the primary goal of unifying the five countries oil
export policies and hopefully dictating a high price for their oil. The five
countries certainly possessed that power when the cartel was initially
formed, and while the cartel still produces about 40 percent of the worlds
oil, OPECs dominance has declined over the years. Today, only Saudi
Arabia and to a certain extent the United Arab Emirates, Qatar and Kuwait
retain the ability to voluntarily adjust production levels. OPECs other
members Libya, Algeria, Nigeria, Ecuador and Angola must maintain
production to finance their national budgets. Effectively, this means that
OPEC wields nowhere near the power it once did. Even a producer of Saudi
Arabias size is barely able to change the price of oil through boosting or
cutting production.

A new wave of oil production outside the cartel has already hit. Production
in the United States has increased to an estimated 8 million barrels per
day the highest level since the 1980s. Elsewhere, production is set to
take off in Canada and potentially Brazil. At the same time, increased
production outside OPEC is dwarfed by the ambitious expansion plans put
forward by OPEC members Iraq and Iran. While production outside the
cartel is manageable, together with Iraq and Irans plans it could
represent a significant threat to oil prices in the latter half of the decade.

55
Iraqs energy sector has been revitalized after the past five years and is
now producing nearly 3.5 million barrels per day. Its oil ministry has set
several ambitious goals, including production hitting 9 million to 10 million
barrels per day by 2020. Iran, too, sees prospects for boosted production
on the horizon. Complementing the negotiations with the United States on
a possible long-term rapprochement, Iranian President Hassan Rouhani
has started a significant reform campaign hoping to bring oil production
back to the pre-sanction level of 4.2 million barrels per day within six
months and increase it to the pre-revolution level of 6 million barrels per
day within 18 months. To be clear, both goals are not attainable within
their respective time frames, but significant increases are possible.

The amount of production that comes online in Iraq will largely depend on
two factors. First, the political system and violence will shape the pace of
investment and regulatory procedures, such as issuing contracts and
permits. Second and more important, there are logistical limitations to
bringing online that level of production in such a short period of time.
Some of these limitations can be overcome with proper coordination
between international oil companies, oil services providers, the Shia
surrounding the Basra region and the various political interest groups in
Baghdad. Adroit cooperation between all of these parties is unlikely,
meaning Iraq will fall short of Baghdads lofty goals, but Iraq can reach
about 5 million to 6 million barrels per day by 2020, and closer to 6 million
to 6.5 million barrels per day within a decade.

For Iran, the challenge is somewhat simpler, since its limitations are
largely caused by external sanctions. As seen in other countries, typically
when oil production has been interrupted following regime change,
sanctions and other causes, production levels rarely reach the level
achieved prior to the disruption. However, should sanctions be removed,
Iran could quickly revive about half of its offline production within 12 to 18
months about 500,000 to 750,000 barrels per day. In the longer term,
there are some reasons to believe that Iran could buck the trend and
increase its production back to previously achieved levels, and perhaps

56
even increase it, but the time frame would be measured in years, not
months. All of this, of course, is subject to geopolitical events that could
slow the process down or stop it entirely such as internal backlash in
Iran and a slow timetable for negotiating with Washington. After bringing
shut-in production back online, Iran (like Iraq) is more likely to slowly
increase its daily oil production by about 250,000 to 300,000 barrels per
year, pushing Rouhanis goals to after 2020.

OPEC Going Forward

OPEC is facing short-term and long-term challenges. In the near term,

rising production in the United States and Canada has been unexpectedly
quick increasing by 1 million barrels per day in each of the past two
years. Although most of the U.S. increase has been offset by production
taken offline due to instability in Libya, added U.S. exports have already
forced Saudi Arabia to reduce production levels at times to maintain
prices. U.S. production is set to grow by another 1 million barrels in 2014,
potentially straining OPECs preferential price points.

In the longer term, Iran and Iraqs production is the key issue. Should Iran
and Iraq together boost production to a reasonably achievable level of 11
million barrels per day by 2020, that would represent an increase of 5
million-6 million barrels per day above present levels. OPECs export
quotas have already been a source of tension among its members, but
producers have always found ways to skirt around them. That may no
longer be possible. While Irans domestic consumption will increase
significantly, the potential export increases are still too high for Saudi
Arabia to offset. This will cause stress within the organization among
regional rivals Iran, Iraq and Saudi Arabia. Saudi Arabia may ask Iran and
Iraq to voluntarily limit export growth, but without other incentives there
is no reason to believe they would do so when it is in their short-term
economic interest to boost exports as much as possible.

Increased exports by Iran and Iraq also play into the broader rivalry
between Saudi Arabia and Iran over issues such as the Syrian civil war

57
and Iranian influence in Saudi Arabias border regions as well as its oil-
producing Shiite-dominated Eastern Province. Historically, Saudi Arabia
has argued for increased production from the cartel to preserve OPECs
market share, since high prices have helped encourage alternative energy
development elsewhere, whereas Iran and Iraq have argued for moderate
production levels and strong prices. Additionally, while Saudi Arabia can
afford to sell oil at $85 per barrel, many of the governments surrounding it
need prices at or above $100 per barrel, and Riyadh does not want to see
its neighbors engulfed in even more turmoil than they already are due to
lower oil revenue. Iran and Iraq are pursuing this boost for their long-term
production and believe they can do so without reducing prices by relying
on increased demand from developing Asian markets.

Asia is now the worlds biggest net importing region bigger than Europe
and North America combined. Naturally, this has led to increased
codependence between OPEC and developing Asian countries, principally
India and China. Indeed, China has massive projects with Saudi Arabia,
Iraq and Iran. Chinas footprint has expanded dramatically in Venezuela
and it imports about 15 percent of its oil from OPEC member Angola. India
has also deepened its connections to OPEC countries and has emerged as
Nigerias biggest customer.

As OPECs biggest customer, Asia will continue its strong demand in the
near future, and so stress on OPEC will not necessarily mean lower oil
prices. The impact on long-term prices is less certain, however; the price
will be determined not only by the size of Asian growth in the future, but
by global oil supplies in non-OPEC countries as well. While OPEC
historically has been used as a political tool to increase oil prices or place
an embargo on exports, as can be seen from the 2008 price spike, OPECs
modern challenge is more concerned with keeping oil prices reasonably
low, not artificially raising them or embargoing oil. In order to preserve its
long-term health, OPEC will need to preserve relatively low oil prices, both
to ensure that developing markets in Asia can afford to keep buying the oil
and to prevent alternatives such as shale oil, electric cars or natural gas-

58
to-liquids technology from becoming more economically
feasible. Furthermore, tempered oil prices for consumers in Asia will only
reinforce the regions economic growth, contributing to increased demand
for OPECs oil.

Few other challenges that OPEC is facing are:

Uncertainty in Global Demand, Structural shift in demand from

developed world to developing world.
Non-OPEC oil-producing nations (Russia , Norway, Canada, Mexico
etc.)often increase production when OPEC cuts it.
Russia overtook Saudi Arabia as the worlds biggest crude supplier
in 2009.
OPECs share of production has gone down from around 51% in the
mid-1970s to just over 40% now.

Problem of Member Cohesion within OPEC nations:-

Maintaining quota discipline within the cartel.

Existence of factions within OPEC, which are generally classified into three
groups:

1. The group led by Saudi Arabia, the UAE and Kuwait, who are in
favour of increased supplies and moderate pricing,

2. The group led by Libya, Iran and Algeria, who are insistent on
decreasing output for higher prices,

The in-between group including Nigeria, Venezuela, Indonesia who

have been known to take sides depending on their own
economic/political agenda.
Middle-Eastern Strife & Political instability in OPEC oil-producing
countries - Mostly authoritarian states that use oil money as a
means of sustaining political power.
Future technological developments in areas of renewable energy
sources - According to IEA (International Energy Agency), the
increase in renewable usage will far outstrip annual growth in

59
energy liquids(crude oil and natural gas) as a source of the world's
power Crude oil, OPEC will become less important in the energy
equation.

60
 CONCLUSION

The formation of OPEC marked a turning point toward national sovereignty

over natural resources, and OPEC decisions have come to play a
prominent role in the global oil market and international relations. OPEC
has survived for more than 50 years, it has had little effect on either the
oil price or oil market dynamics. OPEC has been successful in cartelizing

61
the oil market and in using its power to raise the oil price above
competitive levels by restricting output. On the other there is the view
that OPEC pricing power is not constant and tends to fluctuate depending
on the interaction among OPEC members and on oil market conditions.

OPECs model andlink this evolution to some key events in the oil market.
Main is that OPECs pricing power is not constant and tends to vary over
time. It can lose the power to influence oil prices and organization does
not coordinate its members investment plans, many OPEC countries have
been protected by strong barriers to entry, which stem from ownership
and control of the bulk of low-cost oil reserves. By limiting investment in
their oil sector, OPEC members can control the future flow of oil supplies
into the market. OPEC members investment decisions can affect the oil
market structure and the behavior of the oil price. The decision has
significant implications for the oil and gas (O&G) sector, as it indicates
that OPEC is changing its strategy from gaining market share to one of
stabilizing oil prices and creating a demand-supply balance in the sector.

The Organization of the Petroleum Exporting Countries is a permanent,

intergovernmental Organization, created at the Baghdad Conference on
September 1014, 1960, by Iran, Iraq, Kuwait, Saudi Arabia and
Venezuela. Oil is a fairly uniform commodity, most consumers base their
buying decisions on nothing other than price. OPEC goal is to reduce
oilprice volatility and adjustthe world's oil supply in response to shortages.
OPEC Saudi Arabia as a source of market power. We divide this part into
three sections covering cartel behavior, dominant firm behavior, and
target behavior models. The stream considering the oil market to be more
competitive and referring the price changes to reasons other than market
power.

This stream includes political, and property rights models. Concluded that
under normal conditions, market participants form expectations that
cause price fluctuation in anticipation of OPEC interventions while under
other circumstances OPEC shifts the target zone when it fails to hold the
line with previous targets. They found that OPEC tried to maintain a weak
target zone regime for the oil price, that the oil price is affected by both
OPEC behavior and the markets expectation of OPEC behavior, and they
also suggested that OPEC became more explicit in adopting a target price
zone model.

Publication of OPECs LTS coincides with the Organizations 50th

anniversary and serves to reaffirm its longstanding commitment to market
stability. Its actions, based on consensus-building, are a testament to its
accomplishments over the past five decades and, in this respect, its
positive role and achievements have been widely acknowledged.

Looking into the future and despite the many challenges that lie ahead
OPEC remains steadfast in its determination to stand by its policy of
striving for market stability, which is underscored throughout the LTS. The

62
Organization will continue making investments to expand its production
capacity to not only meet perceived demand for its crude, but also
maintain an adequate level of spare capacity. While reiterating the
importance that OPEC places on security of supply to consumers, it is
equally important to stress security of demand to producers and OPEC in
particular.

Oil is the leading energy source. Given its characteristics liquid, high
energy density, easy to store and transport, affordability oil is a fuel of
choice. It will continue to support the economic development of nations,
contributing to an improvement in living standards and helping to lift
millions of people out of poverty.

The protection of the environment an important pillar of sustainable

development, intertwined with and mutually supportive of the two other
pillars, economic development and social progress is also vital and
achievable. The use of crude oil is not the problem; it is part of the
solution.

OPECs new LTS clearly demonstrates the great significance that the
Organization attaches to the responsibilities it has in providing a key
energy source to the world. It underlines how important oil is to Member
Countries, in terms of their own socio-economic development, and to the
world in general. An increasingly interdependent world calls for an
inclusive approach and genuine dialogue if the many diverse and
increasingly complex global challenges, as well as opportunities, are to be
met efficiently and effectively.

63
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