It is unclear to a economic novice like me why OPEC is not cutting down production and raising oil prices. I have read several journalists commenting upon this on the internet but perhaps an economist can explain this current fact better.

  • $\begingroup$ You mean raising oil prices? $\endgroup$
    – FooBar
    Dec 15 '14 at 15:08
  • $\begingroup$ @FooBar - yes I will make the edit. $\endgroup$
    – gansub
    Dec 15 '14 at 15:10

The OPEC scenario is quite well described by a market with Cournot Competition. That is, while collusion would lead the highest total profits to the sum of the participants, each invididual participant would gain by increasing his production a little bit.

Without observing the quantity of each participant and proper enforcement, that's the outcome the model predicts - and reality concurs.

  • $\begingroup$ Note also that under Cournot competition, the degree of pricing power depends on the elasticity of residual demand. Recent development of unconventional oil sources indicate that this elasticity is higher than previously thought, which decreases the benefit to cartel members from restricting supply. $\endgroup$ Jan 6 '15 at 1:00
  • $\begingroup$ But how does this explain why OPEC could cut production and double prices overnight during the 70s? One needs to account for the proportion of Saudi Arabia oil production then and now and plug that back in a more nuanced Cournot model. $\endgroup$
    – CarrKnight
    Jan 10 '15 at 16:28
  • $\begingroup$ @CarrKnight: One explanation I've heard for the experience of the 70s was that oil companies initially feared having their assets confiscated by middle eastern governments, and were therefore pumping oil like crazy to get it out of the ground while they still owned it. This artificially depressed prices. When OPEC formed and the uncertainty about nationalization was resolved, prices jumped back up to their "normal" levels. I have not thought hard about how plausible this story is, but I know at least one Nobel prize winner who believes it (though he might not want to be quoted). $\endgroup$ Jan 10 '15 at 17:16

To appreciate why OPEC can´t do this now, we have to understand a little better why they were able to do it in the 1970´s - temporarily at least. The received wisdom on the 70´s crisis is a little oversimplified.

There are two key things going on at that time, one was that US oil consumption was steadily increasing throughout the 60´s, which is what led to the crisis; the other was the fall out from the collapse of the Bretton Woods agreement in 1972 which had also led to oil being significantly mis-priced (too cheap in dollar terms essentially). The doubling of prices resulted from the combination of the two factors, not just from the OPEC oil sanctions.

Fast forward to 2015. The situation with respect to supply is now the reverse, due to fracking, oil supply is increasing with respect to demand, rather than dropping as it was back then. We don´t have any similar level of financial crisis to muddy the waters. OPEC could reduce their production, but they are a much lower percentage of total oil production than they were then, fracking is still increasing, so it´s unlikely to have much effect. Put all that together, and throw in that it didn´t work for very long back in the 70´s - the financial crisis was probably responsible for far more disruption than the oil sanctions actually were - and OPEC has no reason to try this.

This is especially the case when the financial dynamics behind fracking are considered. As the oil price drops more and more oil sources become unprofitable, and will either be shut down or put on hold, eventually restoring some kind of equilibrium to the market as the new supply/demand levels assert themselves.


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