Energy Studies Review

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Issue 1 Volume 6 Article 2
5-9-1994
Oil: Economics and Political
Antoine Ayoub
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Oil: Economics and Political
Abstract
This article deals with the evolution of the international petroleum sector since 1973 with a special view to
interdependence between the economic and political factors that influence it. Two issues are focused upon:
(1) the effects of the nationalization of oil companies on the sharing of oil rents and on changes in the
structure of the oil market; and (2) the determination of oil prices. The latter involves a discussion of, on the
one hand, the political and economic behaviour of the United States and Saudi Arabia and, on the other, the
combination of cooperation and conflict that has tended to characterize relations among OPEC countries.
This article is available in Energy Studies Review: http://digitalcommons.mcmaster.ca/esr/vol6/iss1/2
This article deals with the evolution of the international
petroleum sector since 1973 with a special view to
interdependence between the economic and political factors
that influence it. Two issues arefocused upon: (1) the effects
of the nationalization ofoil companies on the sharing ofoil
rents and on changes in the structure ofthe oil market; and
(2) the determination of oil prices. The latter involves a
discussion of, on the one hand, the political and economic
behaviour ofthe United States and Saudi Arabia and, on the
othr:r, the combination of cooperation and conflict that hilS
tended to characterize relations among OPEC countries.
Carhele presente une synthese et une tentative d'explication
de l'evolution du secteurpetrolier international depuis 1973
en tenant compte du phenomene de l'interdependance entre
lesfacteurs economiques et lesfactwrs politiques. Deux points
sont priviIegies. Le premier est l'examen des effets des
nationalisations (facteur institutionnel) sur la partage de la
rente pitroliereet les modifications des structures du marche.
Le deuxieme point met l'accent, d'une part, sur les
comportements economiques et politiques des Etats-Unis et
de l'Arabie-Saoudite, et d'autre part, sur Ie "conflit-
cooperation" entre les pays et l'OPEP, pour expliquer la
determination et revolution des prix.
Antoine Ayoub'is Professor of Economics at Universite
Laval in Quebec and Visiting Professor at Universite
Pantheon-Assas, Paris II. This paper is based on notes
from a seminar given by him when he was awarded
the College de France Medat June 4,1991.
Oil: Economics and
Politics
ANTOINE AYOUB
1. Introduction
Until the Gulf crisis of 1990-91, many were
arguing that oil had lost its strategic role, that
it had become an ordinary commodity governed
by the standard laws of the market, and that the
market would peacefully solve any conflict
within OPEC or between OPEC and the oil-
buying countries. "Desert Storm" blew down
those convictions by demonstrating, if it was still
necessary, the strategic and vital role of oil.
Furthermore, it indicated again the interdepen-
dence between economics and politics in ev-
erything concerning oil.
Such interdependence may appear as evident
to anyone involved in oil management in either
the public or private sectors. It is not the case,
however, for economists at universities who have
studied the market structures and price mechan-
isms involved. For them, the oil market has been
another area in which to apply standard formal
economic analYSis, without taking into account
the role of politics. The results of these exercises
have often appeared to be in a vacuum, far from
the real world.
Indeed, 20 years after the oil shock of 1973,
the academic literature is abundant but inconclus-
ive.
1
Despite the great sophistication of the
models describing the behaviour of OPEC and
1/ See, among others, the surveys by Griffin and Teece
(1982), Gately (1984 and 1986), Barbet (1983), and
Ayoub and Percebois (1987).
Energy Studies Review Vol. 6, No.1, 1994 Printed in Canada 47
Ayoub: Oil: Economics and Political
Produced by The Berkeley Electronic Press, 1994
oil prices, the question remains an "open" one
(Gately, 1984, p.l113) and econometric testing of
all the models does not seemconclusive (Griffin,
1985; and Fischer, 1987). In short, an assessment
of those many years of work is apparently
disappointing. The past does not seem to be
explained in a way that would satisfy a majority
of economists, and the predictions regarding
future prices do not tend to be confirmed by
what is subsequently observed on the market.
This lack of consensus is, sadly, neither new
nor unique in economics. In the context of this
discussion, however, it offers an advantage: a
margin of freedom in our search for new ap-
proaches to the problem. The approach I have
chosen is deliberately institutional, in the sense
that it tries to tackle and understand economic
phenomena (and change in them) by accounting,
as much as possible, for institutional changes and
geopolitical factors. It is true that such an ap-
proach is difficult to formalize, but that may be
the price to pay to be closer to the complex
reality of the oil sector.
In my view, neither the thesis of oil as an
"ordinary commodity" (allowing explanation by
economics alone), nor the thesis of a "plot"
(allowing explanation by politics alone and
attributing any changes to the occult actions of
some country), appear satisfactory as ways of
understanding the problems and the evolution
of the oil sector. Consequently, I have tried since
the beginning of the 1970s to analyze this
evolution by taking into account, as much as
possible, the convergence and the divergence of
both economic and political interests, which has
sometimes led the actors to a compromise and
sometimes to a rupture. This article gives me an
occasion to bring earlier papers up to date and
to clarify, develop, and correct some propositions
already formulated (Ayoub, 1975, 1976a, 1976b,
1986,1988,1990,1991). Without fully sharing all
their conclusions, I note that many authors have
adopted the same institutional approach used
here. It is possible to mention, among others,
Moran (1982), Mohnfeld (1984), and Verleger
(1988).
By adopting such an approach, I admittedly
bear the risk of setting out on a difficult path
without a safety belt. For, despite the important
48
and recognized role of political factors in econ-
omic activity, there is not to my knowledge a
theory that has succeeded in integrating, within
a consistent and formal framework, the effects
of political power within an economic analysis.
It is precisely for this reason that what follows
does not claim to defend a thesis but rather pro-
poses for discussion a framework which will per-
haps allow one to understand better the complex
reality of the oil sector.
My arguments are organized around two
points that I consider fundamental. The first is
an attempt to trace back the effects of the
nationalization of oil companies (i.e., an
institutional change) on the sharing of oil rents
and on market structure (a phenomenon of
disintegration and of vertical reintegration). The
second point will deal more particularly with oil
price determination and the influence of political
factors on that determination. In this regard, the
emphasis will be put on the linkage of Saudi
Arabia and the United States and on the
"conflict-cooperation game" within OPEC.
II. Nationalization and Oil Rent
Sharing
During the 1960s and 1970s, national sovereignty
over natural was one of the main de-
mands of a majority of newly independent Third
World countries. The dominant idea at the time
was that political independence would be an
empty concept if it was not accompanied by a
transfer of the ownership and control of the
resources of foreign firms, mostly multinational,
to the national public sector.
The oil sector did not escape the
consequences of such an idea; indeed, it was a
favoured ground for its application. Thus we can
consider the abolition of the concession system
and the nationalization of the oil companies in
the OPEC countries as perhaps the most
important turning point in oil history
1988). It is this major institutional change -
much more important than the 1973 fourfold
price increase, which was its consequence - that
is the starting point for an analysis of the evolu-
tion of the overall economic structure of the oil
sector. The first issue to deal with is the sharing
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of oil rents.
Oil Rent: Definitions
Recall that oil production generates various sorts
of rents and quasi-rents: scarcity rent (A), monop-
oly (or, more generally, imperfect market) rent
(r
m
), and Ricardian differential rents (rd)' Because
the exploitation of a reserve of a non-renewable
resource takes place through time, the determina-
tion of the path of its price is really a dynamic
question. However, we can represent the price
at a given moment in time as
as the return received by certain units of a
resource due to some advantage they have in
production relative to other units which are
nevertheless essential for the achievement of
market equilibrium (Percebois, 1989). Thus,
at a given time, even in a competitive market,
some production units (or resource deposits)
involve different (average and marginal) costs.
Consequently, a deposit that can be exploited
at lower cost than the marginal deposit
extracts a rent from buyers.
Why Nationalize'
where p' is the equilibriumprice in a competitive
market, C is the marginal cost of the resource (in
this case crude oil), and Ais the scarcity rent.
The above assumes that all firms (with each
firm defined by a single homogeneous deposit)
are identical. Nowrelax this assumption, as well
as the competitive market assumption, allowing
firms to have some monopoly power.
Considering the case in which monopoly power
is identical for all firms, (1) is replaced by
where P would be the price in an imperfect mar-
ket and C and rd can vary across firms.
It is useful to recall the definitions and the
conditions that result in the above mentioned
natural resource rents:
• Scarcity rent (user cost), A, is, despite the tenru-
nology, a cost and not a rent. It pays for the
exhaustion (or the non-renewability) of the
resource, assuming that the supply is fixed.
Once the assumption of a fixed stock is
accepted, Ais greater than zero. A competitive
market does not eliminate A; only the relax-
ation of the fixed stock assumption could do
that. On the other hand, Acan rise or fall and
is affected by changes in the marginal cost of
a barrel of oil.
• Imperfect market rent, r
m
is a function of market
structure. This form of rent vanishes complete-
ly in a perfectly competitive market and is at
its maximum in the presence of a pure mono-
poly.
• Differential rent (Ricardian), rd' can be defined
p' = C + A, (1)
(2)
1n light of the above definitions, we can now ask:
was it necessary for OPEC members to
nationalize the oil companies? Were the takeovers
only the result of an exacerbated nationalism and
the political independence recently acquired -
factors that certainly had their influence - or
were they also a response to a much more precise
economic constraint? In other words, were these
nationalizations not the perfect example of the
interweaving of economics and politics?
If we admit that the "oil game" is in the end
a matter of rent sharing, the nationalizations (or
other similar legal arrangements, such as
association, participation, etc.) which the majority
of the OPEC countries declared at the beginning
of the 1970s, and sometimes long before, have
a raison d'ffre and a justification.
From equations (1) and (2), and for the case
where the two partners (the owner and the
franchise holder) are involved in the production
process, it is obvious that the sharing between
them of all the rents (A, r
m
and rd) is influenced
by the knowledge that each has of the real values
of p', P and C. If this condition is not satisfied,
the bargaining power of the uninformed partner
is very weak and the informed partner is likely
to impose the sharing rules (Ayoub, 1975).
Before 1973, the "informed" partners surely
were the foreign independent companies,
particularly the Majors. The producing countries
were considered as "sleeping partners," content
with taxing the companies according to more or
less complicated formulae, such as the "tax paid
cost," or apparently more radical formulae such
as "fifty-fifty." Reality was a lot simpler: the
49
Ayoub: Oil: Economics and Political
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rigorous enforcement of those formulae, or even
negotiations about their concrete use, were-
directly and exclusively dependent on the
information provided by the oil companies to the
producing countries about P; P and C.
Regarding the production cost C, the oil com-
panies were the only ones to explore for and
produce crude oil in the host countries. Con-
sequently, they were the only ones to know about
the reserves and the production costs involved.
Concerning p" and P, the situation was even
more complicated because the system of vertical
integration and internal transfer prices that had
been adopted by the Majors at the beginning of
the 1920s so dominated the market that it was
practically impossible to find your way from the
prices of oil products to the price of crude oil.
In such a situation, one way for the
producing countries to find out the true values
of P; P and C was to nationalize the companies
and thereby gain direct control over their
national reserves and production. In almost no
time, the OPEC countries found themselves the
owners of large and growing quantities of crude
oil that they had to market directly. After having
been collectors of taxes and fees from the oil
companies operating on their territory, those
countries became in a short time the holders of
the world's most important oil reserves and the
world's principal producers and sellers of crude
oil. The OPEC market was born.
The changes brought about by the
nationalizations during the 1970s can be
considered, justly, as the really historic breaking
point in the process of oil policy-making in these
countries. In them we find a perfect example of
an institutional change that induces a whole set
of economic phenomena, either directly or
indirectly.
Regarding the particular question of rent
sharing, the only possible conclusion - and in
fact, the one we observed in reality - is that
with the elimination of the concession system and
the recovery of direct control over their resources,
the OPEC countries obtained the means not only
to change rent sharing to their advantage, but
also to extract the full rent at the production
level.
But the nationalizations also had another
50
effect, maybe more important than rent sharing:
the determination of the amow1t of rent available
to extract. Indeed, once the producing countries
became the sole owners of their resources, they
had to face a serious question: how can this rent
be made as great as possible through time or, to
be more precise, how can the net present value
of their known stock of oil in the ground be
maximized? Such a question immediately leads
one to the quantity-price equation which
ultimately determines the size of the rent at a
point in time and its trend through time. This
question will be discussed again in section IV.
III. Nationalization and Market
Structures
Breaking Vertical Integration
As a second effect, the nationalizations led to the
breaking up of the market system built and man-
aged by the Majors since the 1920s. This system
was based on: (a) vertical integration from the
"well to the pump;" (b) horizontal (geographic)
concentration allowing the management, under
a common authority, of deposits dispersed in
different countries; and (c) an agreement, implicit
or explicit, between the companies regarding
market sharing (Ayoub, 1986 and 1988).
Until the beginning of the 1970s and with the
help of this system, the Majors had under their
control the exploration, production, transpor-
tation, refining, and distribution of between 70
to 80% of all crude oil and oil products
consumed in the "free world" outside the United
States.
The direct consequence of this system of
control was undoubtedly stability in oil markets,
in contrast with the chaos and wastage of
resources that had prevailed before. Although
from time to time there were tensions and
associatedincidents - foreseeable consequences
of competition from independent firms outside
the agreement - these had marginal i m p ~ c t s on
price levels, which were in a downward trend
until the 1970s (see Figure 1).
The nationalizations imposed a clear break
with this system: an important link in the oil
chain, the production and marketing of crude oil,
Energy Studies Review, Vol. 6 [1994], Iss. 1, Art. 2
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IP''''Ylvan,an IR,,,'an Io;,eo'O'Y 0'
I""'"
Pool-war I
IL"'"
OPEC Introd,,, N&tbock I
Oil Boom Oil Exports Spindletop, Shortage ReCllnstruction Iranian
Pricing and, later,
World
Begin
Taxas
in US Supplies Production Quotas
Events
!",matra
Growlh 0' I
I"..n,m
S'''I
yoml !,ran,an
Production Venezuelan Field
Crisis
KiPpur. Revolution
Begins Production Discovered
W"
80
60
50 mH+m.-j.m · mm ................•....... m m m • m 'm........ . m' mmm.m....•.......\ m .
40 +! f' I
30 !; ,! , .....................................•........
20
10 , .....•
1940-49 1980-69
Current $
Figure 1: Price of Crude Oil since 1861
Source: BP Statistical Review of World Energy, 1993.
was put under the direct control of the OPEC
countries. This induced the disintegration of the
system run by the Majors and the imple-
mentation of a dual system, with the OPEC
countries controlling the upstream activities
(production and marketing of crude oil), and the
oil companies controiling the downstream
activities (transportation, refining, distribution,
and sale of oil products).
As a result of this dual structure, the inte-
grated system of the Majors could no longer
work as before, while the OPEC system, neither
vertically nor horizontally integrated, revealed
itself, after some years of trying, to be unable to
Constant (1992) $
take over control of the whole sector from the
oil companies.
This consequence of the new structure, al-
though written in the facts as early as 1973, was
temporarily hidden by the fear of an oil shortage,
justified or not, that was prevalent throughout
the 70s, and by the particular relations between
the largest producing countries of the Gulf and
the previous concessionary companies. The na-
ture of these relations (long-term contracts,
discount of official prices, phase-out clauses, etc.)
induced a sort of artificial vertical integration
(Verleger, 1988). When, from 1981 onwards, trade
in oil switched from being a sellers' to a buyers'
51
Ayoub: Oil: Economics and Political
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market, this transitory system did not hold up
and the path was cleared for the expansion of
free markets.
Many consequences have been observed fol-
lowing the nationalizations and the changes in
market organization that they induced.
Access ofthe Majors to oil: A direct observable
effect of the nationalizations was a radical change
in the competitive position of the Majors in the
market for crude oil (Mohnfeld, 1984). Between
1973 and 1982, these companies lost around 50%
of their share of the crude oil market, from 30
million barrels per day (MMbbl/ d) to around
15.2 MMbbl/d, while "free world" demand
decreased by only 15% over the same time
period. Even more significant, in 1982 the Majors
could only rely on 6.7 MMbbl/d of production
from the reserves under their control, while the
corresponding number in 1973 was 255
MMbbl/ d - a decrease of 74% in less than 10
years. In other words, the Majors were becoming
important net buyers of crude oil after having
for a long time been vertically integrated sellers
to their own refineries.
Breakdown oflzorizontal concentration: The de-
crease in the share of the Majors in the crude oil
market was accompanied by the entry of new-
comers - the non-OPEC producers - attracted
by the increase in oil prices of the 70s. This
increase stimulated themto explore and produce
at home. (Examples are Norway, Mexico, Great
Britain, Egypt, and some African and Asian
countries.) The Herfindal index of horizontal
concentration in an industry went from 1600 in
1965 to around 930 in 1986 for the crude oil
production industry, and from 1250 to around
600 for the exploration industry (Verleger, 1988).
This indicates that the nationalizations not only
indirectly favoured free entry into the market,
but also, and by this very fact, created a further
destabilizing factor for OPEC, as we will see
below. Even more to the point, the large majority
of the new producing countries (especially those
from the Third World) followed the OPEC
example by nationalizing oil at home and
creating public oil companies.
Restructuring of the refining sector: The
decrease in the direct access of the Majors and
of other companies to the oil reserves of the
52
OPEC cow1tr!es pushed them to rationalize their
world refining and distribution network in order
to decrease their dependence on OPEC crude oil
and preserve, as much as possible, their inte-
grated structure as companies. Thus the world
refining capacity of the Majors decreased from
23.3 to 14 MJ\1bbl/d between 1973 and 1982. This
trend toward rationalization was to be reinforced
by the increase in the refining capacity of son1e
of the OPEC countries, that wanted to sell not
only crude oil, but also refined products.
Expansion of Free Markets
In the wake of a declining OPEC the most
important market was witl10ut question the spot
market (i.e., the Rotterdam free market). This
market had, of course, been operating since the
1930s, but was fulfilling only a complementary
role in the Majors' delivery system for refined
products (Abu Khadra, 1980). With the
nationalizations and the emergence of the OPEC
market, the spot market changed in orientation
and in size. In orientation because it started
dealing in crude oil as well as refined products;
in size because as the OPEC market was de-
clining, the number of transactions on the spot
market was increasing. From the beginning of
the 80s, "the spot" became the reference market
in world crude oil trade.
The consequences of the expansion of the
spot market and the important role that it ended
up taking on, to the disadvantage of the OPEC
market, can be summarized in the following
points.
Increase in the number ofparticipants: The num-
ber of active participants in the crude oil market
increased substantially. While it was previously
reserved for a few large companies, today's oil
market is invaded by an increasingly large num-
ber of actors: the national oil companies of the
OPEC and the non-OPEC countries; the private
and public companies of the consuming nations
(from multinationals to medium-size comparues);
and finally, the traders and brokers.
Multiplication ofcomplementary markets: As the
spot market functions a lot like the stock
exchange, its development made oil prices
volatile and the risks to be borne fairl y high. To
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decrease these risks or to provide protection
against them, parallel markets developed, such
as the forward market, which in turn led to the
option market. Many saw in this evolution a
"standardization" of oil and its transformation
from a strategic product to an ordinary
commodity. Without going that far (the events
of 1990-91 in the Gulf reducing this conclusion
to nothing), and without taking a position as to
whether the free markets were stabilizing or
destabilizing (see Artus, 1989, on this point), we
can nevertheless assert that the development of
these markets made price control more difficult
for OPEC than was foreseen.
Market structure and prices: The combination
of the two above mentioned consequences did
indeed result inan industrial structure favouring
competition or, at the very least, made it more
cli£ficult to reach oligopolistic agreements. This
development of free markets, with its conse-
quence of making it less easy to control prices,
gave rise to two opposing impacts on OPEC. On
the one hand, it had a destabilizing effect, in the
sense that the existence of a flourishing and ac-
cessible free market was an easy "way out" for
an OPEC member who did not wish to respect
its own quota. As one would expect, the pattern
was widely imitated. On the other hand, it had
a stabilizing effect, or rather provided an incen-
tive for cooperation, in the sense that the free
market, by bringing prices down, made it more
profitable for OPEC countries to reestablish
agreement rather than seeking individually to
profit from their own actions. Many examples
can be found in the recent history of OPEC and
the oil industry of these two effects, although
they also show that the second effect is more
important in a buyers market.
Return to Vertical Integration?
Many years ago, Frankel (1948) reached two
important conclusions in his masterly study of
the international oil sector. The first is that
"non-stop" competition, when it reigns over the
oil industry, either leads to a general failure, or
to the survival of a monopoly. The second is that
"there is no doubt that always and everywhere,
there has been an irreversible tendency toward
concentration, integration, and collusion."
About 40 years later, he again confirmed
these conclusions in a recently published paper
(Frankel, 1989). The arguments used to make his
point are simple but penetrating (or rather
penetrating because they are simple). For him,
oil is a high-risk industry, not only because of
the random aspects of exploration, but also
because of the large inveshnents required in the
other phases of production (transportation,
refining, and distribution). To decrease this risk,
or as protection against it, the producers have
the incentive to diversify their exploration in
space to be able to compensate for disappoint-
ments (dry wells) with other successes
(marketable discoveries): this is the raison d'etre
of horizontal concentration. "What is true for
exploration is also true, according to hir'l, in the
other phases of the industry. Hence, the goal of
vertically integrating two or more phases is to
decrease risk and insure an acceptable average
rate of return on a consolidated investment. We
can add two other incentives: the availability and
control of the supply of crude oil and the
potential for capturing the refined products
market. For Frankel the conclusion is that
"integration is the natural habitat of the oil
industry;" it leads, further-more, to a certain price
stability through time.
Although this view is not fully shared by
Adelman (1972), who does not see "natural"
reasons for integration and concentration in the
oil industry, Frankel's thesis and his conclusions
are nearly a credo for the professionals, and the
behaviour of decision makers in the oil industry
confirms the rendencies expressed therein.
Regarding the relation between integration and
price "stability," Hubbard (quoted by Verleger,
1988) thinks that vertical integration favours
short-term price stability, while horizontal
concentration favours long-term stability.
Whatever is the outcome of this debate, it re-
mains that in the last 10 years a clear willingness
has been observed on the part of a few OPEC
countries to invest in the refining and
distribution sectors in the United States and
Europe. This trend took two fonns (Ayoub, 1988):
direct control (the Kuwaitian case), or shared
control in joint ventures with the Majors (Saudi
53
Ayoub: Oil: Economics and Political
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Arabia with Texaco in the US) or with private
oil companies of lesser importance (the cases of
Venezuela, Libya, Mexico, etc). Currently, OPEC
members' acquisitions in downstream activities
outside their borders represent 7.4% of total
refining capacity in Europe and the US (about
1.77 MMbblj d). (See Petroleum Intelligence
Weekly, 1990.) If we add to these acquisitions the
contribution to exports of refineries built in most
of the OPEC countries, we canreasonably talk
of a new restructuring of the oil industry as a
real, although hesitant, pOSSibility (Bourgeois et
Perrin,1989). -
OUf conclusion at this stage is that a return
to a form of vertical integration at the world level
will never be achieved without taking into ac-
count the radical institutional change involved
in the nationalizations. The forms that such an
integration will take will be closer to a partner-
ship between each OPEC country and the oil
companies than to exclusive control on the part
of the oil companies, as was the case before 1973.
On the other hand, paradoxical though it may
seem, it is precisely the nationalizations that have
led, by their effects on market structure and
prices, to a more pointed awareness of the inter-
dependence between producing countries, con-
suming countries, and the oil companies.
IV. Oil Prices: An Economic Observation
and Two Political Constraints
If we had to sununarize the overall oil pricing
problem, we could say that it is characterized by
the existence of a floor price that has not been
pierced since 1973, and by the absence of an
agreed upon and stable ceiling price. The
existence of the floor price is the consequence of
the adoption by the United States of a preference
for security rather than for narrowly defined pure
economics. The absence of a ceiling price is a
demonstration of the contradictions within OPEC
which divide members between those who
advocate a "short plan" and those who prefer a
"long plan."
A Floor Price Ne-ver Breached
Figure 1 shows the evolution of the average price
54
of crude oil from 1900 to the present. One notes
the sharp contrast between the period 1900-1970
and the one that begins in 1973. While the first
long period seems characterized by relative
stability, the second is clearly dominated by
abrupt and large fluctuations.
Indeed, the average price (in current dollars)
changed from US$1.90 jbbl in 1972, to $11 jbbl
in 1974, to $36jbbl in 1981, back to $14jbbl in
1986, to $17jbbl in 1989, and to $18-19 jbbl
currently. Over a 20-year interval prices have
exploded twice (in 1973j74 and 79 j80), collapsed
(in 1986), been almost stagnant (1975-1978), gone
down steadily (1981- 1985), and been highly
volatile and uncertain (from 1987 to now).
Despite this stormy history - Which took
mischievous delight in frustrating any attempt
at rationalization, explanation, or prediction -
it is nevertheless possible to find a constant
requiring an explanation. From 1973 to now,
annual average oil prices never went below the
threshold of $14-15jbbl in nominal terms and
$18-20jbbl in real terms (1991 US$). Even during
the price war of 1986, prices went down to
$7jbbl for only a few days, while for the whole
of 1986 the average price was about $14jbbl.
Looking closely, there seems to be some- sort of
floor price that has not been pierced during the
period under consideration.
This constant in oil price determination is
even more worrisome because over the period
nearly all of the likely configurations of market
and pricing structures were experienced. First,
in regard to controlling prices, we saw in
succession the official OPEC price system
(1973-80), the mixed system of official and spot
prices (1981-85), domination by the spot price
(since 1986), and its regionalization (Dubai, Brent,
West Texas Intermediate). Second, in regard to
market structure, we observed the passage from
a vertically and horizontally integrated structure
by the oil companies to a dual structure (the
producing countries controlling the upstream
activities, the oil companies the downstream
ones), the emergence and development of free
markets at the expense of the OPEC-market, and
the beginning of new shapes of vertical
integration linking some producing countries and
some companies. Finally, in regard to the
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composition of aggregate supply, since the
beginning of the 1980s we have recorded a con-
tinuous decrease in the market shares of the
OPEC countries to the advantage of the non-
OPEC countries (from 60-65% in the 70s to 30-
35% in the 80s), along with many attempts by
OPEC countries to regain their shares, even by
waging price wars, like the devastating one of
1986 (Ayoub, 1988).
If we were to adopt a "happiness" criterion
of the sort suggested in economics textbooks to
characterize a market dominated by a monopoly,
such a rocky and unrelenting story might lead
us to claim that it was OPEC that introduced
disruptions and competition in a sector of the
economy which unti11973 was obviously living
in a dreary tranquillity! But reality is even more
complex. How can one explain the existence of
a floor price, and especially its persistence lmder
diverse market structures?
The Logic of Cost
The first explanation of this phenomenon, the
easiest and certainly the most widespread, especi-
ally among English-speaking economists, can be
briefly summarized by referring to the work of
Adelman (1986), a representative of this school
. of thought.
Adelman starts from the observation that the
replacement cost of a barrel of oil
2
extracted in
1978 in the US was nearly 69 times higher than
the corresponding cost in Saudi Arabia.' In this
light, he argues that economic logic necessarily
leads to three conclusions.
1) Scarcity does not explain the price level
(neither the current price, nor the floor price).
2) In a competitive market with such a cost
spread between Saudi Arabia and the US,
demand would first be satisfied by the
producers with abundant reserves and low
costs (Saudi Arabia and the Gulf countries),
and only then by contributions from
2/ Its marginal cost, which is, according to Adelman,
the sum of the marginal extraction cost and the
marginal cost of the :"'lvested capital required to
maintain or increase production.
3/ $O.13/bbl in Saudi Arabia and $8.06/bbl in the US.
producers with low reserves and high costs
(the US and the rest of the world). The
differential rent that the first group of
countries now collects would then tend to
decrease, and could in the long run even
vanish completely.
3) Closing the argument, if prices did not fall
to a level near the lowest costs, it was,
according to Adelman, because OPEC is a
cartel, the function of which was to establish
a dam against a fall in prices. "If the dam
breaks, so will the price" (Adelman, 1986,
p.394).
The Logic of Security
Initially very attractive, the cost argument fails
to take into account the equally meaningful
geopolitical factors or, more precisely, the
question of the security of oil supplies. The first
consequence of strict economic logic is that, in
a free market, low-cost petroleumwould quickly
drive out high-cost petroleum. In the case of the
US, this would mean a radical decrease, and
eventually a complete cessation, of oil
production, with a parallel increase of
dependence on foreign suppliers. This would
have been conceivable in principle if the world
consisted of a single political entity, rather than
a group of sovereign entities, different from one
another by their interests and objectives. And it
is true that the US wants to avoid complete
dependence on a country or a group of countries
in a politically explosive region.
All the more so because the nationalizing of
the oil multinationals by the producing countries
through the 1970s had launched a kind of
dialectic relation between resource control and
the security of supply. The more the producing
countries increased their control, the more the
importing industrialized countries tried to
decrease their dependence on oil as an energy
source and on OPEC as a supplier (Ayoub,
1976a).
In fact, US policy tried to substitute national
oil, to the extent it existed (in Alaska, for
instance), and more generally non-OPEC oil
(from the North Sea), for OPEC oil. Thus, the
difference in the production cost between these
55
Ayoub: Oil: Economics and Political
Produced by The Berkeley Electronic Press, 1994
two types of oil can be considered as the cost of
security. This cost can even be measured and
quantified. Indeed, if the cost of OPEC-oil is Co
and the cost of non-OPEC oil is C
n
' we can write
the cost for security C
s
as
(3)
en can even be considered as the "floor price"
of crude oil that the US tries to maintain on the
market. This cost is, furthermore, the major por-
tion of the differential rent of the OPEC
countries.
Even if we hear from time to time that the
US lacks an energy policy, it is nevertheless clear
that it has for a long time had a precise strategy
involving two objectives. The first has been to
avoid a significant increase in its oil dependence.
This implied the acceptance of some increase in
price in support of that objective, though at the
same time it did not want to jeopardize the rate
of economic growth. The second strategic objec-
tive has been to assure the security of its necess-
ary oil imports, especially in regard to those
imports originating in the nervous Gulf region.
Consequently, if the current oil price was
around the average cost of using: the American
deposits, the first objective WaS to an extent real-
ized. The spread in production costs between the
US and Saudi Arabia would be the price to be
paid by the US to preserve its national oil indus-
try from closure and to provide some margin of
protection from foreign imports. The second ob-
jective, to ensure the security of imports, of
course required other actions than maintaining
a certain price level. These were: a policy on
strategic stocks; better cooperation, within the
framework of the International Energy Agency,
for the allocation of stocks in case of emergency;
the reinforcement of bilateral relations with the
Gulf countries (especially with Saudi Arabia), etc.
The US pursued these actions during the last 20
years, while making it clear from time to time,
that they were not excluding the use of military
power in the last resort to protect the security
of their oil supplies at a "reasonable price"
(Hogan in Griffin and Teece, 1982).
As early as 1974, Henry Kissinger even spec-
ified the level of this price by saying that, for the
US, a price above a ceiling of $7/bbl (1974 US$)
56
would, according to him, strangle the economy.
However, the ceiling he suggested was a price
which, while not discouraging the exploration
and production of substitutes for oil, did not
endanger economic growth. Throughout the
1974-1981 period, Saudi Arabia tried, without
great success, to lead OPEC to adopt this price.
Hence, the price suggested by Mr. Kissinger was
in fact becoming the "floor price," while the
official OPEC price could be seen as the "ceiling
price" which evolved in response to the
organization's concerns that high oil prices would
encourage substitution.
During the presidencies of Nixon, Ford and
Carter, American policy consisted mostly of
putting pressure on the OPEC countries to let
go of their policy of increasing prices and move
as closely as possible toward the floor price, as
conceived of here. The switch of the market in
1981, which was mostly a consequence of this
short-sighted policy of price increases, was to
reduce the market shares of the OPEC countries
more and more, and to trigger off many conflicts
among its members, conflicts which have now
become 1-- ermanent.
The culmination of this situation was without
doubt the price war of 1986, in which at one
point the famous floor price was almost pierced.
The reaction of the US was fast, since George
Bush, then Vice-President, was sent to Saudi
Arabia to ask it to stop the price war and to
bring the prices back to the floor price level of
the time, $15-16/bbl. In a few days, the prices
indeed rose from $7-8/bbl, their lowest level, to
$16-17/bbl. This clear and direct intervention,
in the middle of the period of Reaganite
conservatism on economic matters, shows suffi-
ciently the vital interest of the US in the
maintenance of a floor price which would satisfy
to the greatest extent possible its objective of
relative oil autonomy. This episode also shows
the convergence of the interests of Saudi Arabia
(along with those of other smaller countries in
the Gulf, such as Kuwait and UAE) with the
interests of the US in maintaining a current price
level not too far from this floor price, neither too
high nor too low.
But why do the countries of the Gulf want
to defend this price? The answer to this question
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sends us directly to the second contradiction of
the oil system: the opposition between the "long-
term plan" and the "short-term plan" within
OPEC. The considerable difficulties which
prevent the Organization from finding and
maintaining a ceiling price agreeable to everyone
are the direct consequences of this opposition.
Long Plan and Short Plan
As early as 1975, I had the occasion, with other
observers, to focus on a deep contradiction within
OPEC which evidently constitutes one of the
major causes of its instability (Ayoub, 1975): the
problem of the determination of the optimal price
level ("ceiling price") for the member countries
as a group (Al-Chalabi, 1986).
Two conceptions were in opposition to each
other and have remained so since the first oil
shock. Each possesses its own logic which in the
end follows directly from a physical reality, not
easily subject to modification, and from an econ-
ornic reasoning that implies constraints.
For the low-population Gulf countries, with
limited financial needs, large stocks, and extreme-
ly low extraction and development costs (no
more than $0.50jbbl on average), the oil price
should be maintained at a competitive level with
respect to the costs of substitutable forms of
energy. Price increases, according to this logic,
should be spread over a long time period to
protect the in-ground value of the stocks of these
countries from the premature competition of
other energies. This position, the "long plan," is
the basis of the behaviour of cOlmtries like
Kuwait, United Arab Emirates, and the most
important among them, Saudi Arabia.
On the other hand, for other OPEC countries,
with relatively more modest stocks and larger
populations and financial requirements, the
optimal valuation of their in-ground stocks leads
them, with a logic just as meaningful as that of
the first group of countries, to be inclined to an
increase in oil prices in a relatively short period.
Their goal is to ensure that oil prices get as close
as possible, and faster would be better, to the
costs of substitutes. This is because when the
latter become available on the market, the oil
stocks of those countries will be either exhausted
or in decline. This is the "short plan" of countries
like Algeria, Indonesia, Nigeria and Venezuela.
lran and lraq are in this respect in a particular
position given the sizes of their reserves, their
populations, and their financial requirements. The
deadly and devastating war in the 1980s between
these two countries considerably increased their
financial requirements and led them to adopt the
"short plan" despite their large hydrocarbon
reserves.
To summarize the positions of these two
groups, we can say that the first tries to optimize
its revenues at the margin by adjusting quan-
tities, while the second tries to do the same by
adjusting prices. There is not, to my knowledge,
a solution, either theoretical or practical, that
could completely and simultaneously satisfy
these two groups of countries. In other words,
there is no single optimal price that would
protect the interests of the OPEC countries taken
as a whole and, at the same time, the interest of
each country taken individually. The only
peaceful solution to this problem is compromise,
and all the more so since the 13 members of
OPEC are sovereign states, each with its own
(international, regional and national) political
vision and its own alliances. By definition, such
compromise is a function of bargaining powers
at the time considered.
Indeed, assume that each country determines
its price according to an objective function f
i
dependent on many variables (Xi' ..., X
g
, ..., X
n
).
According to what we have written above, these
variables are not only economic, but also
political, strategic, social, etc. For the OPEC
countries taken as a whole; we then have a series
of objective functions corresponding to the
number of members. This series can be written:
1 IIi i i
1, (X, ,...,Xgr"'X
n
), ... ,jJX, ,...,X
g
,. ..,X
n
),
N N N
.. ·IN(X
,
,. ..,X
g
""'X
n
)
with (i=l,. .. ,N) and (g=l,. .., n).
Because of the interdependence among them,
it would be impOSSible to maximize all of these
functions simultaneously. It is thus necessary to
introduce a composite function of the type:
57
Ayoub: Oil: Economics and Political
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(5)
in which the variables are the own functions of
each country. The maximization of Q can be con-
sidered if: (a) for each function, the variables are
introduced (Xl' X
2
, ..., X
g
, ... , x,,) in a way such
that Q becomes a function of these variables; and
(b) if we can put weights on the relative import-
ance of the different functions f
1
, f
2
, ... , f
i
, ... , f
N
by a system of given prices. Given the nature of
these variables (economic
1
but also strategic, pol-
itical, social, etc.), it is clear that only a political
trade-off can determine, at a given moment in
time, the relative weights of these variables for
each country, and the relative weights assigned
to each country in the composite function (see
Ayoub, 1975).
The lack of a collective optimal solution does
not, however, exclude the possibility of two strat-
egies, both sub-optimal in other respects. The first
is the competitive market, with the risk of a price
war, especially when the market is overcrowded,
as in the 1980s. The second possible strategy is
a compromise within OPEC between the optimal
positions of each different country or group of
countries. The latter strategy is relatively easier
to put in place and more likely to succeed when
each member produces at a level close to its pro-
duction capacity, as was the case in the 1970s.
When each country produces well below its capa-
city, as has been the case since 1981, the same
strategy is less likely to succeed and the associ-
ated compromise is fragile. Recent history gives
us many examples of these strategies and of their
limitations (Ayoub, 1988).
To illustrate the importance of the effect of
political factors on both the stability of OPEC and
its survival, we can again take the example of
Saudi Arabia. On purely economic grounds, this
country holds in its hands the key to the whole
situation because it controls around 40% of the
total reserves of all the OPEC countries. In prin-
ciple, then, the economic and social damage that
this country can cause the others to suffer if it
decides to go its own way are without compari-
son to the damage it might itself suffer if all the
other countries were to collude against it. The
1986 price war demonstrated this. But this same
example also demonstrates that Saudi Arabia had
58
to stop t ~ s price war and to 10\-\7(:-[ its production
when the political reactions of the suffering coun-
tries began to be felt. The latter included not only
the other OPEC coulltries, but also the US.
Given these conditions, it is not really
necessary to resort to a conspiracy theory to
explain the behaviour of the Gulf countries in
regard to pricing policy, especially in the cases
of Saudi Arabia and Kuwait. On the one hand,
we have seen that this policy has coincided with
that of the US, which favours a current price that
is not too high, nor too far from the floor price.
On the other hand, this convergence in economic
interests is strengthened by the needs of these
vulnerable countries for military protection,
which they try to obtain from the US.
The following conclusions can be w1derlined:
• There is a floor on the average price that has
never been pierced since 1973, despite nwner-
ous changes in market structures.
o This floor price, currently in the range of $18-
20/bbl in nominal dollars, approximately cor-
responds to the average production costs of
American (and Canadian) deposits.
• The maintenance of this price since 1973 has
not allowed the US to realize energy indepen-
dence (a costly project and, in any case, a
chimera), but it has preserved a certain energy
autonomy. In the case of a completely free and
competitive market, this floor price would not
have resisted, and the US would have been
totally dependent on foreign oil (mostly that
of the Gulf). That is not the case today.
o The fact that this floor price did hold
throughout this period is not because OPEC
is a cartel, but rather because Saudi Arabia has
agreed to defend it by adjusting its production
according to the state of supply and demand
(except for the short gap of the price war).
o lfSaudi Arabia, Kuwait, and the UAl: adopted
the policy of moderated increases in prices by
increasing production, it is on the one hand
because this policy corresponds to t h e ~ r own
economic interests and on the other because
it ensures them of political and military prok,-
tion by the US.
Energy Studies Review, Vol. 6 [1994], Iss. 1, Art. 2
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v. Conclusions
The nationalizations of oil resources in the OPEC
countries and the transfer of their management
from the foreign oil comparues to the
gov€ITlffients of these countries set in motion a
series of events.
Regarding oil rents. this institutional change
first induced an internalization of rents by the
producing countries and then led to the emerg-
ence of a differential (Ricardian) rent. which was
in effect supported by the policies of the indus-
trialized countries (especially the US) designed
to develop national substitutes for imported oil
in order to increase their independence from the
OPEC countries.
Regarding the structure of oil markets. the
nationalizations led to the breakup of the systems
of vertical and horizontal integration of the
Majors and to its replacement by a new dual
structure with OPEC controlling the upstream
activities of the oil sector and the oil companies
controlling the downstream ones. This transform-
ation also facilitated the growth of free markets
for crude oil.
Regarding price determination and OPEC be-
haviour, prices move betvveen a floor price deter-
mined by the costs of substitute deposits in the
US, while the determination of ceiling levels by
OPEC appears to rest on successive compromises
which are necessarily fragile.
Overall it appears obvious that oil is a stra-
tegic product, despite the appearances created
by the existence of spot markets, forward trading,
options, etc. The determination of prices and
quantities depend not only on economic consider-
ations, but also on political imperatives in
international, regional, or national spheres.
If we have to characterize the oil market
using available models from economic theory,
researchers should consider an adjustment to the
bilateral oligopoly model, with the US and Saudi
Arabia as the principal actors. Detailed analysis
of the economic and geopolitical factors that de-
termine the behaviour of these tvvo countries is
then a necessity.
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ca/esr/vol6/iss1/2 .Oil: Economics and Political Abstract This article deals with the evolution of the international petroleum sector since 1973 with a special view to interdependence between the economic and political factors that influence it.mcmaster. on the one hand. the political and economic behaviour of the United States and Saudi Arabia and. The latter involves a discussion of. and (2) the determination of oil prices. on the other. This article is available in Energy Studies Review: http://digitalcommons. the combination of cooperation and conflict that has tended to characterize relations among OPEC countries. Two issues are focused upon: (1) the effects of the nationalization of oil companies on the sharing of oil rents and on changes in the structure of the oil market.

the academic literature is abundant but inconclusive. that it had become an ordinary commodity governed by the standard laws of the market. Gately (1984 and 1986). the oil market has been another area in which to apply standard formal economic analYSis. pour expliquer la determination et revolution des prix. Furthermore. The latter involves a discussion of. and (2) the determination of oil prices. Barbet (1983). Indeed. without taking into account the role of politics. Two issues arefocused upon: (1) the effects of the nationalization ofoil companies on the sharing ofoil rents and on changes in the structure ofthe oil market. 1 Despite the great sophistication of the models describing the behaviour of OPEC and 1/ See. sur Ie "conflitcooperation" entre les pays et l'OPEP. sur les comportements economiques et politiques des Etats-Unis et de l'Arabie-Saoudite.1. 6. Introduction Antoine Ayoub 'is Professor of Economics at Universite Laval in Quebec and Visiting Professor at Universite Pantheon-Assas. The results of these exercises have often appeared to be in a vacuum. "Desert Storm" blew down those convictions by demonstrating. the strategic and vital role of oil. if it was still necessary. Deux points sont priviIegies. however. the surveys by Griffin and Teece (1982). 1994 Printed in Canada 47 Produced by The Berkeley Electronic Press. Carhele presente une synthese et une tentative d'explication de l'evolution du secteurpetrolier international depuis 1973 en tenant compte du phenomene de l'interdependance entre lesfacteurs economiques et lesfactwrs politiques. the combination of cooperation and conflict that hilS tended to characterize relations among OPEC countries. Until the Gulf crisis of 1990-91. Paris II. among others. it indicated again the interdependence between economics and politics in everything concerning oil. For them. Such interdependence may appear as evident to anyone involved in oil management in either the public or private sectors. Le premier est l'examen des effets des nationalisations (facteur institutionnel) sur la partage de la rente pitroliereet les modifications des structures du marche. et d'autre part. on the othr:r. for economists at universities who have studied the market structures and price mechanisms involved. d'une part. Le deuxieme point met l'accent. This paper is based on notes from a seminar given by him when he was awarded the College de France Medat June 4.Ayoub: Oil: Economics and Political This article deals with the evolution of the international petroleum sector since 1973 with a special view to interdependence between the economic and political factors that influence it. It is not the case. Energy Studies Review Vol. many were arguing that oil had lost its strategic role. the political and economic behaviour ofthe United States and Saudi Arabia and. far from the real world. No. on the one hand.1991. 20 years after the oil shock of 1973. and Ayoub and Percebois (1987). Oil: Economics and Politics ANTOINE AYOUB 1. 1994 . and that the market would peacefully solve any conflict within OPEC or between OPEC and the oilbuying countries.

and Verleger (1988). By adopting such an approach. there is not to my knowledge a theory that has succeeded in integrating. This article gives me an occasion to bring earlier papers up to date and to clarify. which was its consequence . In this regard. 1976a. Vol. In the context of this discussion.mcmaster. The first issue to deal with is the sharing 48 http://digitalcommons. appear satisfactory as ways of understanding the problems and the evolution of the oil sector.1991). 6 [1994]. an institutional change) on the sharing of oil rents and on market structure (a phenomenon of disintegration and of vertical reintegration). The oil sector did not escape the consequences of such an idea. Moran (1982). among others. as much as possible. mostly multinational. The second point will deal more particularly with oil price determination and the influence of political factors on that determination. Mohnfeld (1984). Thus we can consider the abolition of the concession system and the nationalization of the oil companies in the OPEC countries as perhaps the most important turning point in oil history (P~nrose. It is possible to mention. Art. The dominant idea at the time was that political independence would be an empty concept if it was not accompanied by a transfer of the ownership and control of the resources of foreign firms. In short. 1988). and correct some propositions already formulated (Ayoub. the convergence and the divergence of both economic and political interests. develop. I note that many authors have adopted the same institutional approach used here. 1. an assessment of those many years of work is apparently disappointing.. neither the thesis of oil as an "ordinary commodity" (allowing explanation by economics alone). This lack of consensus is. 1986.e. nor the thesis of a "plot" (allowing explanation by politics alone and attributing any changes to the occult actions of some country). Nationalization and Oil Rent Sharing During the 1960s and 1970s. neither new nor unique in economics. it offers an advantage: a margin of freedom in our search for new approaches to the problem. and Fischer. 1975. I admittedly bear the risk of setting out on a difficult path without a safety belt. however. For. within a consistent and formal framework. The past does not seem to be explained in a way that would satisfy a majority of economists. the effects of political power within an economic analysis. It is precisely for this reason that what follows does not claim to defend a thesis but rather proposes for discussion a framework which will perhaps allow one to understand better the complex reality of the oil sector. It is this major institutional change much more important than the 1973 fourfold price increase. The first is an attempt to trace back the effects of the nationalization of oil companies (i.Energy Studies Review. I have tried since the beginning of the 1970s to analyze this evolution by taking into account.1988. II. the question remains an "open" one (Gately. as much as possible. Without fully sharing all their conclusions. 1987).that is the starting point for an analysis of the evolution of the overall economic structure of the oil sector. to the national public sector. which has sometimes led the actors to a compromise and sometimes to a rupture. it was a favoured ground for its application. 2 oil prices. in the sense that it tries to tackle and understand economic phenomena (and change in them) by accounting. for institutional changes and geopolitical factors.ca/esr/vol6/iss1/2 . sadly. national sovereignty over natural res~)Urces was one of the main demands of a majority of newly independent Third World countries. The approach I have chosen is deliberately institutional. 1984. My arguments are organized around two points that I consider fundamental. and the predictions regarding future prices do not tend to be confirmed by what is subsequently observed on the market. It is true that such an approach is difficult to formalize. the emphasis will be put on the linkage of Saudi Arabia and the United States and on the "conflict-cooperation game" within OPEC. Consequently.1990. 1976b. but that may be the price to pay to be closer to the complex reality of the oil sector. Iss. In my view. 1985. despite the important and recognized role of political factors in economic activity. p.l113) and econometric testing of all the models does not seem conclusive (Griffin. indeed.

etc. Before 1973." Reality was a lot simpler: the where p' is the equilibrium price in a competitive market. we can represent the price at a given moment in time as p' = C + A. despite the tenrunology. we can now ask: was it necessary for OPEC members to nationalize the oil companies? Were the takeovers only the result of an exacerbated nationalism and the political independence recently acquired factors that certainly had their influence . Thus. A. 1994 . • Differential rent (Ricardian). However. were these nationalizations not the perfect example of the interweaving of economics and politics? If we admit that the "oil game" is in the end a matter of rent sharing. the "informed" partners surely were the foreign independent companies. From equations (1) and (2). more generally. 1975). It pays for the exhaustion (or the non-renewability) of the resource. even in a competitive market. (1) is replaced by (2) where P would be the price in an imperfect market and C and rd can vary across firms. imperfect market) rent (rm ). the determination of the path of its price is really a dynamic question.Ayoub: Oil: Economics and Political of oil rents. assuming that the supply is fixed.) which the majority of the OPEC countries declared at the beginning of the 1970s. allowing firms to have some monopoly power. Ais greater than zero. A competitive market does not eliminate A. r m and rd) is influenced by the knowledge that each has of the real values of p'. rd' can be defined 49 Produced by The Berkeley Electronic Press. and sometimes long before. have a raison d'ffre and a justification. Oil Rent: Definitions Recall that oil production generates various sorts of rents and quasi-rents: scarcity rent (A). (1) as the return received by certain units of a resource due to some advantage they have in production relative to other units which are nevertheless essential for the achievement of market equilibrium (Percebois. and A is the scarcity rent. only the relaxation of the fixed stock assumption could do that. is. participation. some production units (or resource deposits) involve different (average and marginal) costs. This form of rent vanishes completely in a perfectly competitive market and is at its maximum in the presence of a pure monopoly. The producing countries were considered as "sleeping partners. On the other hand. a deposit that can be exploited at lower cost than the marginal deposit extracts a rent from buyers. the nationalizations (or other similar legal arrangements. and for the case where the two partners (the owner and the franchise holder) are involved in the production process. • Imperfect market rent. Once the assumption of a fixed stock is accepted. the bargaining power of the uninformed partner is very weak and the informed partner is likely to impose the sharing rules (Ayoub. particularly the Majors. a cost and not a rent. at a given time. as well as the competitive market assumption. such as the "tax paid cost. it is obvious that the sharing between them of all the rents (A. It is useful to recall the definitions and the conditions that result in the above mentioned natural resource rents: • Scarcity rent (user cost). Now relax this assumption. Considering the case in which monopoly power is identical for all firms. Why Nationalize' 1n light of the above definitions. and Ricardian differential rents (rd)' Because the exploitation of a reserve of a non-renewable resource takes place through time." or apparently more radical formulae such as "fifty-fifty.or were they also a response to a much more precise economic constraint? In other words. C is the marginal cost of the resource (in this case crude oil). The above assumes that all firms (with each firm defined by a single homogeneous deposit) are identical. If this condition is not satisfied. P and C. 1989). such as association. r m is a function of market structure. Consequently. A can rise or fall and is affected by changes in the marginal cost of a barrel of oil. monopoly (or." content with taxing the companies according to more or less complicated formulae.

The nationalizations imposed a clear break with this system: an important link in the oil chain. The changes brought about by the nationalizations during the 1970s can be considered. they were the only ones to know about the reserves and the production costs involved. Concerning p" and P.these had marginal imp~cts on price levels. to be more precise.foreseeable consequences of competition from independent firms outside the agreement . 2 rigorous enforcement of those formulae. Vol. III. the OPEC countries obtained the means not only to change rent sharing to their advantage. those countries became in a short time the holders of the world's most important oil reserves and the world's principal producers and sellers of crude oil. After having been collectors of taxes and fees from the oil companies operating on their territory. Although from time to time there were tensions and associated incidents . the OPEC countries found themselves the owners of large and growing quantities of crude oil that they had to market directly. The direct consequence of this system of control was undoubtedly stability in oil markets. in contrast with the chaos and wastage of resources that had prevailed before.mcmaster. production. P and C. the production and marketing of crude oil. This question will be discussed again in section IV. 1. the nationalizations led to the breaking up of the market system built and managed by the Majors since the 1920s. of deposits dispersed in different countries. Regarding the production cost C. Art. one way for the producing countries to find out the true values of P. between the companies regarding market sharing (Ayoub. 1986 and 1988). Regarding the particular question of rent sharing. Iss.and in fact. and (c) an agreement. either directly or indirectly. they had to face a serious question: how can this rent be made as great as possible through time or. The OPEC market was born. refining. This system was based on: (a) vertical integration from the "well to the pump. But the nationalizations also had another effect. and distribution of between 70 to 80% of all crude oil and oil products consumed in the "free world" outside the United States. under a common authority. the situation was even more complicated because the system of vertical integration and internal transfer prices that had been adopted by the Majors at the beginning of the 1920s so dominated the market that it was practically impossible to find your way from the prices of oil products to the price of crude oil. transportation. In them we find a perfect example of an institutional change that induces a whole set of economic phenomena.Energy Studies Review. the only possible conclusion . the Majors had under their control the exploration. In almost no time. which were in a downward trend until the 1970s (see Figure 1). Until the beginning of the 1970s and with the help of this system.ca/esr/vol6/iss1/2 . weredirectly and exclusively dependent on the information provided by the oil companies to the producing countries about P. maybe more important than rent sharing: the determination of the amow1t of rent available to extract. Nationalization and Market Structures Breaking Vertical Integration As a second effect. or even negotiations about their concrete use.is that with the elimination of the concession system and the recovery of direct control over their resources. as the really historic breaking point in the process of oil policy-making in these countries. P and C was to nationalize the companies and thereby gain direct control over their national reserves and production. 6 [1994]. the one we observed in reality ." (b) horizontal (geographic) concentration allowing the management. once the producing countries became the sole owners of their resources. 50 http://digitalcommons. Consequently. Indeed. how can the net present value of their known stock of oil in the ground be maximized? Such a question immediately leads one to the quantity-price equation which ultimately determines the size of the rent at a point in time and its trend through time. implicit or explicit. justly. but also to extract the full rent at the production level. In such a situation. the oil companies were the only ones to explore for and produce crude oil in the host countries.

m m m • m 'm.an Oil World Events IR.... N&tbock I Pricing and.m.m Field Discovered S'''I yoml W" !. was temporarily hidden by the fear of an oil shortage. Constant (1992) $ was put under the direct control of the OPEC countries.... distribution.. although written in the facts as early as 1973......:~ ... .. later..... and the oil companies controiling the downstream activities (transportation..'an Oil Exports Begin Begins Io..... etc. Taxas Shortage I""'" in US ReCllnstruction Pool-war I IL"'" Crisis Iranian OPEC Introd.•.. When.-j.\ m .. ....matra Production Venezuelan Production Growlh 0' I I".. that was prevalent throughout the 70s.... justified or not. from 1981 onwards..n.. m' mmm.. revealed itself.'... 1993.! .. refining..•...... This induced the disintegration of the system run by the Majors and the implementation of a dual system.... after some years of trying.. ..) induced a sort of artificial vertical integration (Verleger.. .....m · mm ... Production Quotas KiPpur. The nature of these relations (long-term contracts.• 1920~29 1930~39 1940-49 1950~59 1980-69 Current $ Figure 1: Price of Crude Oil since 1861 Source: BP Statistical Review of World Energy. trade in oil switched from being a sellers' to a buyers' 51 Produced by The Berkeley Electronic Press... neither vertically nor horizontally integrated.........eo'O'Y 0' Spindletop. with the OPEC countries controlling the upstream activities (production and marketing of crude oil)... 40 +! f' I 30 !.... the integrated system of the Majors could no longer work as before... 20 10 . As a result of this dual structure. and sale of oil products).. This consequence of the new structure. 1994 ...Ayoub: Oil: Economics and Political IP'' Boom 'Ylvan.... and by the particular relations between the largest producing countries of the Gulf and the previous concessionary companies. to be unable to take over control of the whole sector from the oil companies. while the OPEC system.. discount of official prices. 1988)..ran. Supplies !".an Revolution 80 60 50 mH+m......•. phase-out clauses.....

its development made oil prices volatile and the risks to be borne fairl y high. This market had. While it was previously reserved for a few large companies.Energy Studies Review. this transitory system did not hold up and the path was cleared for the expansion of free markets. the number of transactions on the spot market was increasing. the Majors were becoming important net buyers of crude oil after having for a long time been vertically integrated sellers to their own refineries. This increase stimulated them to explore and produce at home.7 MMbbl/d of production from the reserves under their control.e. but also refined products. From the beginning of the 80s. while the corresponding number in 1973 was 255 MMbbl/d .3 to 14 MJ\1bbl/d between 1973 and 1982.. but also. of course. and by this very fact. Increase in the number ofparticipants: The number of active participants in the crude oil market increased substantially. been operating since the 1930s. Great Britain.the non-OPEC producers . the spot market changed in orientation and in size.a decrease of 74% in less than 10 years. In other words.attracted by the increase in oil prices of the 70s. in size because as the OPEC market was declining. 1988). (Examples are Norway. and finally. To 52 http://digitalcommons. Expansion of Free Markets In the wake of a declining OPEC the most important market was witl10ut question the spot market (i. the Rotterdam free market). 1980). Between 1973 and 1982. Egypt. Vol. created a further destabilizing factor for OPEC. Restructuring of the refining sector: The decrease in the direct access of the Majors and of other companies to the oil reserves of the OPEC cow1tr!es pushed them to rationalize their world refining and distribution network in order to decrease their dependence on OPEC crude oil and preserve. these companies lost around 50% of their share of the crude oil market. Mexico. 1. the private and public companies of the consuming nations (from multinationals to medium-size comparues).) The Herfindal index of horizontal concentration in an industry went from 1600 in 1965 to around 930 in 1986 for the crude oil production industry. Access ofthe Majors to oil: A direct observable effect of the nationalizations was a radical change in the competitive position of the Majors in the market for crude oil (Mohnfeld. today's oil market is invaded by an increasingly large number of actors: the national oil companies of the OPEC and the non-OPEC countries. their integrated structure as companies. as much as possible. but was fulfilling only a complementary role in the Majors' delivery system for refined products (Abu Khadra. With the nationalizations and the emergence of the OPEC market. the traders and brokers. that wanted to sell not only crude oil. In orientation because it started dealing in crude oil as well as refined products. and from 1250 to around 600 for the exploration industry (Verleger.ca/esr/vol6/iss1/2 . while "free world" demand decreased by only 15% over the same time period. from 30 million barrels per day (MMbbl/d) to around 15. the large majority of the new producing countries (especially those from the Third World) followed the OPEC example by nationalizing oil at home and creating public oil companies.mcmaster. Multiplication ofcomplementary markets: As the spot market functions a lot like the stock exchange. in 1982 the Majors could only rely on 6. 6 [1994]. This trend toward rationalization was to be reinforced by the increase in the refining capacity of son1e of the OPEC countries. Art. Many consequences have been observed following the nationalizations and the changes in market organization that they induced. and some African and Asian countries. The consequences of the expansion of the spot market and the important role that it ended up taking on.2 MMbbl/d. Even more significant. to the disadvantage of the OPEC market. Iss. 2 market. as we will see below. Thus the world refining capacity of the Majors decreased from 23. Breakdown oflzorizontal concentration: The decrease in the share of the Majors in the crude oil market was accompanied by the entry of newcomers . This indicates that the nationalizations not only indirectly favoured free entry into the market. can be summarized in the following points. "the spot" became the reference market in world crude oil trade. Even more to the point. 1984).

he again confirmed these conclusions in a recently published paper (Frankel. on this point). either leads to a general failure. such as the forward market. and collusion. 1988): direct control (the Kuwaitian case). the goal of vertically integrating two or more phases is to decrease risk and insure an acceptable average rate of return on a consolidated investment. Frankel's thesis and his conclusions are nearly a credo for the professionals. the pattern was widely imitated. it remains that in the last 10 years a clear willingness has been observed on the part of a few OPEC countries to invest in the refining and distribution sectors in the United States and Europe. or rather provided an incentive for cooperation. although they also show that the second effect is more important in a buyers market. refining. when it reigns over the oil industry. which in turn led to the option market. made it more cli£ficult to reach oligopolistic agreements. in the sense that the free market. Frankel (1948) reached two important conclusions in his masterly study of the international oil sector. To decrease this risk. 1988) thinks that vertical integration favours short-term price stability. 1989). not only because of the random aspects of exploration. Return to Vertical Integration? Many years ago. As one would expect. Although this view is not fully shared by Adelman (1972). and distribution). For Frankel the conclusion is that "integration is the natural habitat of the oil industry. Hence. On the other hand. or to the survival of a monopoly. or shared control in joint ventures with the Majors (Saudi 53 Produced by The Berkeley Electronic Press. oil is a high-risk industry. or as protection against it. 1989." Hubbard (quoted by Verleger. The first is that "non-stop" competition. "What is true for exploration is also true. 1994 . further-more. Whatever is the outcome of this debate. but also because of the large inveshnents required in the other phases of production (transportation. The arguments used to make his point are simple but penetrating (or rather penetrating because they are simple). who does not see "natural" reasons for integration and concentration in the oil industry. it had a stabilizing effect. made it more profitable for OPEC countries to reestablish agreement rather than seeking individually to profit from their own actions. in the sense that the existence of a flourishing and accessible free market was an easy "way out" for an OPEC member who did not wish to respect its own quota. we can nevertheless assert that the development of these markets made price control more difficult for OPEC than was foreseen. gave rise to two opposing impacts on OPEC. This development of free markets. and without taking a position as to whether the free markets were stabilizing or destabilizing (see Artus. Market structure and prices: The combination of the two above mentioned consequences did indeed result in an industrial structure favouring competition or.Ayoub: Oil: Economics and Political decrease these risks or to provide protection against them. Without going that far (the events of 1990-91 in the Gulf reducing this conclusion to nothing). there has been an irreversible tendency toward concentration. to a certain price stability through time. Regarding the relation between integration and price "stability. according to hir'l. The second is that "there is no doubt that always and everywhere." About 40 years later. integration. Many examples can be found in the recent history of OPEC and the oil industry of these two effects. while horizontal concentration favours long-term stability. For him. by bringing prices down. On the one hand. Many saw in this evolution a "standardization" of oil and its transformation from a strategic product to an ordinary commodity. at the very least. it had a destabilizing effect. We can add two other incentives: the availability and control of the supply of crude oil and the potential for capturing the refined products market. This trend took two fonns (Ayoub. with its consequence of making it less easy to control prices. and the behaviour of decision makers in the oil industry confirms the rendencies expressed therein. the producers have the incentive to diversify their exploration in space to be able to compensate for disappointments (dry wells) with other successes (marketable discoveries): this is the raison d'etre of horizontal concentration. parallel markets developed. in the other phases of the industry." it leads.

domination by the spot price (since 1986). Despite this stormy history . Over a 20-year interval prices have exploded twice (in 1973j74 and 79 j80). This constant in oil price determination is even more worrisome because over the period nearly all of the likely configurations of market and pricing structures were experienced. in regard to controlling prices. Libya. While the first long period seems characterized by relative stability.mcmaster. From 1973 to now. Indeed. On the other hand. First.Energy Studies Review. and its regionalization (Dubai. the emergence and development of free markets at the expense of the OPEC-market.ca/esr/vol6/iss1/2 . OPEC members' acquisitions in downstream activities outside their borders represent 7. the mixed system of official and spot prices (1981-85). and by the absence of an agreed upon and stable ceiling price.77 MMbbljd). West Texas Intermediate). Even during the price war of 1986. and to $18-19 jbbl currently. to $11 jbbl in 1974. Vol. we observed the passage from a vertically and horizontally integrated structure by the oil companies to a dual structure (the producing countries controlling the upstream activities. paradoxical though it may seem. to $17 jbbl in 1989. although hesitant. of crude oil from 1900 to the present. Art. and been highly volatile and uncertain (from 1987 to now).sort of floor price that has not been pierced during the period under consideration. to $36jbbl in 1981. One notes the sharp contrast between the period 1900-1970 and the one that begins in 1973. Looking closely. explanation. the oil companies the downstream ones). in regard to market structure. there seems to be some. Finally. in regard to the 54 http://digitalcommons. and the beginning of new shapes of vertical integration linking some producing countries and some companies.) If we add to these acquisitions the contribution to exports of refineries built in most of the OPEC countries. it is precisely the nationalizations that have led. to a more pointed awareness of the interdependence between producing countries. and the oil companies.1985). The existence of the floor price is the consequence of the adoption by the United States of a preference for security rather than for narrowly defined pure economics. Mexico. the second is clearly dominated by abrupt and large fluctuations. by their effects on market structure and prices. Currently. we saw in succession the official OPEC price system (1973-80). annual average oil prices never went below the threshold of $14-15jbbl in nominal terms and $18-20jbbl in real terms (1991 US$). we canreasonably talk of a new restructuring of the oil industry as a real. 2 Arabia with Texaco in the US) or with private oil companies of lesser importance (the cases of Venezuela. etc). (See Petroleum Intelligence Weekly. the average price (in current dollars) changed from US$1.90 jbbl in 1972. 1. consuming countries. pOSSibility (Bourgeois et Perrin. prices went down to $7 jbbl for only a few days.1989). Brent. 6 [1994]. collapsed (in 1986). The forms that such an integration will take will be closer to a partnership between each OPEC country and the oil companies than to exclusive control on the part of the oil companies. gone down steadily (1981.4% of total refining capacity in Europe and the US (about 1. been almost stagnant (1975-1978). while for the whole of 1986 the average price was about $14jbbl. The absence of a ceiling price is a demonstration of the contradictions within OPEC which divide members between those who advocate a "short plan" and those who prefer a "long plan. Oil Prices: An Economic Observation and Two Political Constraints If we had to sununarize the overall oil pricing problem. or prediction - IV.Which took mischievous delight in frustrating any attempt at rationalization. 1990. Iss." A Floor Price Ne-ver Breached Figure 1 shows the evolution of the average price it is nevertheless possible to find a constant requiring an explanation. back to $14jbbl in 1986. we could say that it is characterized by the existence of a floor price that has not been pierced since 1973. as was the case before 1973. OUf conclusion at this stage is that a return to a form of vertical integration at the world level will never be achieved without taking into account the radical institutional change involved in the nationalizations. Second.

1986. for instance). to the extent it existed (in Alaska. 2) In a competitive market with such a cost spread between Saudi Arabia and the US. 1) Scarcity does not explain the price level (neither the current price. p. since the beginning of the 1980s we have recorded a continuous decrease in the market shares of the OPEC countries to the advantage of the nonOPEC countries (from 60-65% in the 70s to 3035% in the 80s). nor the floor price). he argues that economic logic necessarily leads to three conclusions. the easiest and certainly the most widespread. the function of which was to establish a dam against a fall in prices.Ayoub: Oil: Economics and Political composition of aggregate supply. and could in the long run even vanish completely.06/bbl in the US. US policy tried to substitute national oil. The more the producing countries increased their control. How can one explain the existence of a floor price. 3/ $O. especially among English-speaking economists. so will the price" (Adelman. In the case of the US. 3) Closing the argument. The first consequence of strict economic logic is that. with a parallel increase of dependence on foreign suppliers. The Logic of Security The first explanation of this phenomenon. The differential rent that the first group of countries now collects would then tend to decrease. can be briefly summarized by referring to the work of Adelman (1986). for OPEC oil. if prices did not fall to a level near the lowest costs.394). along with many attempts by OPEC countries to regain their shares. different from one another by their interests and objectives. according to Adelman. a representative of this school . like the devastating one of 1986 (Ayoub. Thus. And it is true that the US wants to avoid complete dependence on a country or a group of countries in a politically explosive region. "If the dam breaks. 1976a). even by waging price wars. This would have been conceivable in principle if the world consisted of a single political entity. the cost argument fails to take into account the equally meaningful geopolitical factors or. of oil production. In fact. the sum of the marginal extraction cost and the marginal cost of the :"'lvested capital required to maintain or increase production. it was. and only then by contributions from 2/ Its marginal cost. according to Adelman. of thought. because OPEC is a cartel. in a free market. If we were to adopt a "happiness" criterion of the sort suggested in economics textbooks to characterize a market dominated by a monopoly. demand would first be satisfied by the producers with abundant reserves and low costs (Saudi Arabia and the Gulf countries).' In this light. the question of the security of oil supplies. Adelman starts from the observation that the replacement cost of a barrel of oil2 extracted in 1978 in the US was nearly 69 times higher than the corresponding cost in Saudi Arabia. Initially very attractive. 1988).13/bbl in Saudi Arabia and $8. 1994 . the more the importing industrialized countries tried to decrease their dependence on oil as an energy source and on OPEC as a supplier (Ayoub. low-cost petroleum would quickly drive out high-cost petroleum. rather than a group of sovereign entities. and more generally non-OPEC oil (from the North Sea). the difference in the production cost between these 55 Produced by The Berkeley Electronic Press. this would mean a radical decrease. more precisely. and especially its persistence lmder diverse market structures? The Logic of Cost producers with low reserves and high costs (the US and the rest of the world). such a rocky and unrelenting story might lead us to claim that it was OPEC that introduced disruptions and competition in a sector of the economy which unti11973 was obviously living in a dreary tranquillity! But reality is even more complex. which is. and eventually a complete cessation. All the more so because the nationalizing of the oil multinationals by the producing countries through the 1970s had launched a kind of dialectic relation between resource control and the security of supply.

the ceiling he suggested was a price which. 1. the reinforcement of bilateral relations with the Gulf countries (especially with Saudi Arabia). then Vice-President. The second strategic objective has been to assure the security of its necessary oil imports. As early as 1974. since George Bush. Throughout the 1974-1981 period. which was mostly a consequence of this short-sighted policy of price increases. Consequently.ca/esr/vol6/iss1/2 . without great success. that they were not excluding the use of military power in the last resort to protect the security of their oil supplies at a "reasonable price" (Hogan in Griffin and Teece. a price above a ceiling of $7/bbl (1974 US$) would. it is nevertheless clear that it has for a long time had a precise strategy involving two objectives. to lead OPEC to adopt this price. 2 two types of oil can be considered as the cost of security. the price suggested by Mr. This episode also shows the convergence of the interests of Saudi Arabia (along with those of other smaller countries in the Gulf. strangle the economy. Even if we hear from time to time that the US lacks an energy policy. according to him. Vol.Energy Studies Review. However." while the official OPEC price could be seen as the "ceiling price" which evolved in response to the organization's concerns that high oil prices would encourage substitution. The switch of the market in 1981. in which at one point the famous floor price was almost pierced. The US pursued these actions during the last 20 years. This cost can even be measured and quantified. better cooperation. neither too high nor too low. while making it clear from time to time. was sent to Saudi Arabia to ask it to stop the price war and to bring the prices back to the floor price level of the time. to ensure the security of imports. In a few days. Kissinger was in fact becoming the "floor price. Art. Iss. This implied the acceptance of some increase in price in support of that objective. 6 [1994]. Indeed.ermanent. The first has been to avoid a significant increase in its oil dependence. The reaction of the US was fast. as conceived of here. while not discouraging the exploration and production of substitutes for oil. But why do the countries of the Gulf want to defend this price? The answer to this question 56 http://digitalcommons. This cost is.mcmaster. Ford and Carter. did not endanger economic growth. The second objective. such as Kuwait and UAE) with the interests of the US in maintaining a current price level not too far from this floor price. Saudi Arabia tried. During the presidencies of Nixon. shows sufficiently the vital interest of the US in the maintenance of a floor price which would satisfy to the greatest extent possible its objective of relative oil autonomy. for the allocation of stocks in case of emergency. if the cost of OPEC-oil is Co and the cost of non-OPEC oil is C n' we can write the cost for security Cs as (3) en can even be considered as the "floor price" of crude oil that the US tries to maintain on the market. the first objective WaS to an extent realized. the major portion of the differential rent of the OPEC countries. within the framework of the International Energy Agency. 1982). in the middle of the period of Reaganite conservatism on economic matters. American policy consisted mostly of putting pressure on the OPEC countries to let go of their policy of increasing prices and move as closely as possible toward the floor price. was to reduce the market shares of the OPEC countries more and more. the prices indeed rose from $7-8/bbl. of course required other actions than maintaining a certain price level. The spread in production costs between the US and Saudi Arabia would be the price to be paid by the US to preserve its national oil industry from closure and to provide some margin of protection from foreign imports. though at the same time it did not want to jeopardize the rate of economic growth. if the current oil price was around the average cost of using: the American deposits. Hence. especially in regard to those imports originating in the nervous Gulf region. These were: a policy on strategic stocks. furthermore. $15-16/bbl. Henry Kissinger even specified the level of this price by saying that. The culmination of this situation was without doubt the price war of 1986. to $16-17/bbl. etc. conflicts which have now become 1-. for the US. and to trigger off many conflicts among its members. This clear and direct intervention. their lowest level.

with limited financial needs. 1975): the problem of the determination of the optimal price level ("ceiling price") for the member countries as a group (Al-Chalabi. not easily subject to modification..Xni ). The considerable difficulties which prevent the Organization from finding and maintaining a ceiling price agreeable to everyone are the direct consequences of this opposition. etc. . In other words... to the costs of substitutes. Price increases.1. .. with a logic just as meaningful as that of the first group of countries. while the second tries to do the same by adjusting prices.Xg ""'X n ) N N N (4) with (i=l. There is not. Each possesses its own logic which in the end follows directly from a physical reality. This is because when the latter become available on the market.. but also political. United Arab Emirates. For the OPEC countries taken as a whole..50jbbl on average). Two conceptions were in opposition to each other and have remained so since the first oil shock. .. lran and lraq are in this respect in a particular position given the sizes of their reserves... at the same time. . and all the more so since the 13 members of OPEC are sovereign states. a solution. Indonesia.. such compromise is a function of bargaining powers at the time considered.N) and (g=l. each with its own (international. For the low-population Gulf countries. It is thus necessary to introduce a composite function of the type: 57 Produced by The Berkeley Electronic Press.Ayoub: Oil: Economics and Political sends us directly to the second contradiction of the oil system: the opposition between the "longterm plan" and the "short-term plan" within OPEC. to my knowledge... to be inclined to an increase in oil prices in a relatively short period. . 1986). To summarize the positions of these two groups. Xg. with relatively more modest stocks and larger populations and financial requirements.... The only peaceful solution to this problem is compromise. according to this logic. should be spread over a long time period to protect the in-ground value of the stocks of these countries from the premature competition of other energies. and from an econornic reasoning that implies constraints. This position.jJX. regional and national) political vision and its own alliances. the interest of each country taken individually.. either theoretical or practical. the oil price should be maintained at a competitive level with respect to the costs of substitutable forms of energy. strategic.. Their goal is to ensure that oil prices get as close as possible. social.. According to what we have written above. This is the "short plan" of countries like Algeria. Nigeria and Venezuela.." is the basis of the behaviour of cOlmtries like Kuwait. their populations.. (X. that could completely and simultaneously satisfy these two groups of countries... large stocks. assume that each country determines its price according to an objective function fi dependent on many variables (Xi' . n)...·IN(X. we can say that the first tries to optimize its revenues at the margin by adjusting quantities... This series can be written: I I i 1. . Indeed. By definition. the "long plan. the oil stocks of those countries will be either exhausted or in decline.Xgi . these variables are not only economic. with other observers. X n )... . I had the occasion. and the most important among them.. The deadly and devastating war in the 1980s between these two countries considerably increased their financial requirements and led them to adopt the "short plan" despite their large hydrocarbon reserves. Saudi Arabia. and faster would be better. . and extremely low extraction and development costs (no more than $0.. it would be impOSSible to maximize all of these functions simultaneously. . the optimal valuation of their in-ground stocks leads them. On the other hand. 1994 . and their financial requirements. to focus on a deep contradiction within OPEC which evidently constitutes one of the major causes of its instability (Ayoub. we then have a series of objective functions corresponding to the number of members. Long Plan and Short Plan As early as 1975. there is no single optimal price that would protect the interests of the OPEC countries taken as a whole and. Because of the interdependence among them. for other OPEC countries.Xgr"'Xn ).

. and the US would have been totally dependent on foreign oil (mostly that of the Gulf). and (b) if we can put weights on the relative importance of the different functions f1 . Kuwait. at a given moment in time. 6 [1994]. Vol. The maximization of Q can be considered if: (a) for each function.Energy Studies Review. In the case of a completely free and competitive market. To illustrate the importance of the effect of political factors on both the stability of OPEC and its survival.. 58 http://digitalcommons.. Given the nature of these variables (economic 1 but also strategic.mcmaster.. . especially in the cases of Saudi Arabia and Kuwait... 2 (5) to stop t~s price war and to 10\-\7(:-[ its production in which the variables are the own functions of each country.). a chimera). especially when the market is overcrowded. the relative weights of these variables for each country. . with the risk of a price war. . then. as has been the case since 1981.. • The maintenance of this price since 1973 has not allowed the US to realize energy independence (a costly project and. fi. and the UAl: adopted the policy of moderated increases in prices by increasing production. but also the US. The latter included not only the other OPEC coulltries. exclude the possibility of two strategies. it is clear that only a political trade-off can determine. The second possible strategy is a compromise within OPEC between the optimal positions of each different country or group of countries.) in a way such that Q becomes a function of these variables. On the other hand.ca/esr/vol6/iss1/2 . but it has preserved a certain energy autonomy. nor too far from the floor price. The lack of a collective optimal solution does not. which they try to obtain from the US. it is not really necessary to resort to a conspiracy theory to explain the behaviour of the Gulf countries in regard to pricing policy. The latter strategy is relatively easier to put in place and more likely to succeed when each member produces at a level close to its production capacity. currently in the range of $1820/bbl in nominal dollars. in any case. this country holds in its hands the key to the whole situation because it controls around 40% of the total reserves of all the OPEC countries. The 1986 price war demonstrated this. and the relative weights assigned to each country in the composite function (see Ayoub.tion by the US. Xg. the economic and social damage that this country can cause the others to suffer if it decides to go its own way are without comparison to the damage it might itself suffer if all the other countries were to collude against it. 1975).. the same strategy is less likely to succeed and the associated compromise is fragile. despite nwnerous changes in market structures. however. x.. o lfSaudi Arabia. Art. When each country produces well below its capacity. the variables are introduced (Xl' X2. The following conclusions can be w1derlined: • There is a floor on the average price that has never been pierced since 1973. approximately corresponds to the average production costs of American (and Canadian) deposits. both sub-optimal in other respects. this convergence in economic interests is strengthened by the needs of these vulnerable countries for military protection. Recent history gives us many examples of these strategies and of their limitations (Ayoub. it is on the one hand because this policy corresponds to the~r own economic interests and on the other because it ensures them of political and military prok. as in the 1980s. we have seen that this policy has coincided with that of the US. but rather because Saudi Arabia has agreed to defend it by adjusting its production according to the state of supply and demand (except for the short gap of the price war). On the one hand.. On purely economic grounds.. f2. Iss. o This floor price. 1. . etc. Given these conditions.. fN by a system of given prices. But this same example also demonstrates that Saudi Arabia had when the political reactions of the suffering countries began to be felt. this floor price would not have resisted. we can again take the example of Saudi Arabia. 1988). That is not the case today. political. social. which favours a current price that is not too high. . The first is the competitive market. o The fact that this floor price did hold throughout this period is not because OPEC is a cartel. as was the case in the 1970s. In principle.

71-93. 381. Overall it appears obvious that oil is a strategic product. -(1986) 'Scarcity and World Oil Prices: The Review of Economics and Statistics. 1-8. juillet-aolit. 85:2:257-74. The determination of prices and quantities depend not only on economic consider- ations. British Petroleum Company (1992) BP Statistical Re-uiew of World Energy.' Energie Internationale.' Revue de l'Energie. forward trading. Qualitative Configuration and Perspectives: OPEC Review. the nationalizations led to the breakup of the systems of vertical and horizontal integration of the Majors and to its replacement by a new dual structure with OPEC controlling the upstream activities of the oil sector and the oil companies controlling the downstream ones. no. (eds. & Percebois. Regarding oil rents. despite the appearances created by the existence of spot markets. A.A. or national spheres. but also on political imperatives in international. no. 163-67. XVII:12:1809-34. Antoine (1975) 'Le marche-OPEP du petrole brut et ses consequences sur les relations entre pays producteurs: Re-uue d'Eeo- nomie Politique. Economica. 311-23. 473-82. decembre. -(1988) 'Le marche petrolier international: instabilite et restructuration: Re-cnle de l'Energie. -(1986) 'Evolution du marche petrolier: de I'integration verticale a la decentralisation/ Revue de l'Energie. -(1976a) 'Les prix petroliers: essai d'explication: Etudes Internationales. (Baltimore: JOM Hopkins University Press). B. Ayoub.Ayoub: Oil: Economics and Political v. This transformation also facilitated the growth of free markets for crude oil. mined by the costs of substitute deposits in the US. 81-93. III I 4 & IV II. 387-97. with the US and Saudi Arabia as the principal actors. no. Barbet. If we have to characterize the oil market using available models from economic theory. AI-Chalabi. Artus. researchers should consider an adjustment to the bilateral oligopoly model. (1989) 'Quand la creation d'un marche it terme peut-elle destabiliser Ie cours au comptant?: Revue Economique. R. & Perrin. J. fE?flexion preliminaires sur la crise du Golfe. Fadhil (1987) 'What is the Optimal Price of Oil from the Producer's Point of View: Middle East Economic Survl?IJ (MEES) 28 sept. June. Detailed analysis of the economic and geopolitical factors that determine the behaviour of these tvvo countries is then a necessity.) (1987) Petrole: marche et strategies. 407. mars. while the determination of ceiling levels by OPEC appears to rest on successive compromises which are necessarily fragile. options. etc.' Economies & Societes. Adelman. Regarding the structure of oil markets. 59 Produced by The Berkeley Electronic Press. 1989-90. 1994 . 432. this institutional change first induced an internalization of rents by the producing countries and then led to the emergence of a differential (Ricardian) rent. VII:1:3-24. Regarding price determination and OPEC behaviour. (1972) The World Petroleum Market. juilletl septembre. Ayoub. Bourgeois. May. London. vol. M. -(1991) 'Le petrole economie et politique. 1-8. -(1990) 'Oil to 2000: Natural Resources Forum. F. P. (1989) 'Les compagnies petrolieres des pays producteurs en developpement s'internationalisent. Economica. Philippe (1983) 'La theorie des prix de l'energie dans la pensee economique: une recenSIon. Conclusions The nationalizations of oil resources in the OPEC countries and the transfer of their management from the foreign oil comparues to the gov€ITlffients of these countries set in motion a series of events. 754-63. -(1976b) 'Prix du petrole et degre de stabilite de I'OPEP: L'Actualite Economique. regional. prices move betvveen a floor price deter- References Abu Khadra. (1980) 'The Spot Oil Market: Genesis. Paris. which was in effect supported by the policies of the industrialized countries (especially the US) designed to develop national substitutes for imported oil in order to increase their independence from the OPEC countries.

9.Then and Now. 359-82. J. Jacques (1989) Economie de l'Energie. 75:5:954-63. 10:2:1-5. Economica. Iss.' Brookings Papers on Economic Activity. no. (1988) 'The Role and Impact of Commocity Market Institutions in the Determination of Oil Prices. vol. 1.' Special Supplement Issue.' Annual Review of Energy. January 15. Moran.Energy Studies Review.' Journal of Economic Literature. 237-84. Edith (1988) 'Defending the Price of Oil. Mohnfeld. September.' Natural Resource Modeling. 1-4. 60 http://digitalcommons. Jr. Anthony.' The Energy Journal. (1984) 'The Trend of Structural Change in the International Oil Industry in the 1980s' Annual Review of Energrj.H. Petroleum Intelligence Weekly (PIW) (1990) 'What's Next for OPEC Downstream Club. 22:3:1100-14.' American Economic Review. (oos. 2 Fisher. 2:1:5-22. (trad. K. Percebois. J. Penrose.' The Energy Journal. & Teece. Lib. Art.mcmaster. Gately. Medicis. Verleger. T. Vol. (1985) 'OPEC Behavior: A Test of Alternative HypothesiS. OPEC Behavior and World Oil Prices (London: George Allen & Unwin) 94-130.ca/esr/vol6/iss1/2 . 9:1:19-25.) (1982) OPEC Behavior and World Oil Prices (London: George Allen & Unwin). Frankel. 155-78. 2. -(1989) 'Principles of Petroleum . C.). Griffin. -(1986) 'Lessons from the 1986 Oil Price Collapse. (1982) 'Modeling OPEC Behavior: Economic and Political Alternatives' dans Griffin & Teece. D. (1987) 'Whither Oil Prices: the Evidence from Theory. 6 [1994]. Paris. ed. Griffin. Paul (1948) L'Economie petroliere. Dermot (1984) 'A Ten Year Perspective: OPEC and the World Oil Market. Ph. 13. James M.

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