The Disruption of Cartel on Oil Prices

The disruption of cartel on oil prices

A cartel is defined as a group of firms that collaborates to make output and price decisions (Smith 2016). The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum exporting countries (OPEC) is one of the best known examples of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.

Oligopolistic is defined as a state of limited competition, in which a market is shared by a small number of producers or sellers. Oligopolistic firms join a cartel to increase their market power, and members work together to determine jointly the level of output that each member will produce and the price that each member will charge. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oil producing firms form a cartel like OPEC to determine their output and price, they will both face a downward sloping market demand curve, just like a monopolist. In fact, the cartel’s profit maximizing decision is the same as that of a monopolist, as the graph demonstrates. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel’s profits are equal to the area of the rectangular box labeled abcd in Figure. A cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.

However, once established, cartels are difficult to maintain, as cartel members will be tempted to cheat on their agreement to limit production (Smith, 2016). By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel’s profits. Therefore, there is a built in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and could explain why so few cartels actually exist.

While global oil reserves are probably relatively ample, their distribution is likely to be increasingly concentrated on the Middle Eastern members of OPEC, which already account for around two thirds of global proved reserves. Outside the Middle East, newly discovered resources have become smaller and more expensive to develop, being increasingly offshore. The OECD baseline scenario used here generates a trend rise in the real oil price from $27 per barrel in 2003 to $35 a barrel by 2030, both prices expressed in year 2000 dollars, if initial OPEC/non OPEC market shares are maintained over the projection rate (Sheffield, 2016). Higher GDP growth assumptions, or higher income elasticity’s of demand, especially in China and the rest of the non-OECD, could imply that prices rise significantly more than in the baseline case, or that OPEC is prepared to increase its market share significantly (from 38 per cent in 2003 to around 55 per cent by 2030) (Sheffield, 2016).

Over the longer term, behavioural responses to higher prices could constrain cartel-like behavior. In the short run, the low price elasticity’s of global demand and non-OPEC supply make oil prices highly sensitive to supply and demand shifts. Price volatility, compounded by geopolitical tensions, raises uncertainty about underlying price trends may depress oil exploration. OPEC’s excess capacity is currently the lowest in three decades, providing little cushion to raise supply in the event of unexpected oil market disruptions.