Does OPEC Rig Oil Prices? The History of how Black Gold Booms.

Competition and U.S. Shale Oil Extraction

While OPEC does possess much of the global oil reserves, they do not have total control. For one, members of the organization don’t necessarily agree on all decisions, sometimes subverting each other’s oil prices in retaliation when negotiations fail.

Furthermore, the U.S. has an existing supply of shale and regularly produces more oil than all other countries. Another Investopedia entry claims, “…with the discovery of shale oil in the U.S.A and advances in drilling techniques, America has re-emerged as a top producer of oil.”

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The U.S. can boost production in order to counter OPEC’s output cuts and price fixing. Also, as alternative energy sources continue to develop, the world’s reliance on crude oil will continue to wane. 

Game Theory and Understanding OPEC+’s collusion 

Collusion occurs when ostensible competitors agree to work together. In business, it manifests in anticompetitive, and often illegal, measures that often involves price fixing and/or bid rigging. Collusion allows businesses to unethically boost profits for goods/services at the expense of customers by decreasing or outright eliminating competition. 

Per Energy Education, a website encyclopedia founded by University of Calgary professor Jason Donev, “The governments of the OPEC countries agreed to coordinate with petroleum firms (both state owned and private) in order to manipulate the worldwide oil supply and therefore the price of oil. When firms agree to collude, that is they agree to a certain price and quantity for a good or service, they create a cartel.” 

You might wonder why Saudi Arabia or Venezuela, for example, do not break off and act independently. They have low production costs and the oil reserves to generate wealth with black gold. We turn to game theory for an explanation for the formation and continued collusion of OPEC+. 

For an individual country focused on generating maximal profits, extracting as much oil as possible is typically the dominant strategy. Regardless of what other ‘players’ are doing, generating as much of a supply as possible is in all player’s best interests (assuming they are acting alone). But everyone amping up supplies creates downward pressure on prices, reducing returns for all.

This situation exemplifies the prisoner’s dilemma. 

Instead of all the nations competing in a free market, the members of OPEC+ have decided to accept some loss in individual control in order to collectively dominate and profit from the oil industry. In essence, OPEC acts as a single player, a single supplier. The organization’s control over the market allows its members to stabilize oil profits at an artificially high rate. 

It should be mentioned that OPEC members have had major disagreements before. OPEC collusion might often happen, but it definitely doesn’t occur all the time. 

The Cartel Effect and the Global Battle for Oil Market Share

OPEC has, over its sixty year tenure, manipulated oil prices, creating ripple effects all around the globe. Only in recent years has the U.S. actually become a genuine competitor to the organization. 

Here are the noteworthy examples of how the U.S. has been negatively impacted by OPEC’s dominion over the oil market:

1973 Oil Crisis in the U.S., or the OPEC Oil Embargo

OPEC’s oil embargo against the U.S. (as well as other countries) became a real possibility when President Nixon decided to break the Bretton Woods Agreement by taking the U.S. off the gold standard in 1971. While the price of gold shot up, the price of the dollar plummeted due to the suddenness of the decision. 

As we mentioned earlier, many of the members of OPEC operated (and continue to operate) as rentier states. This meant their economies, substantially or completely reliant on income generated through oil exports (i.e. petrodollars), suddenly became much less profitable because all of their contracts used USD. 

However, it wasn’t until the U.S.’s decision to assist Israel in the Yom Kippur War in October 1973 that the Arab countries in OPEC retaliated. They started a year-long oil embargo against all countries who had decided to ally with Israel. In that short span, the inflation-adjusted oil prices went up from $25.97 per barrel (bbl) to $46.35 bbl.

After the spike in oil prices caused by the oil embargo, black gold has generally maintained artificially high costs. 

The U.S. experienced a period of ‘stagflation’ (stagnation + inflation) that troubled many Americans from 1973-1975. Due to government mandated wage-price controls, companies could not lower prices on their goods, nor could they afford to pay their workers’ wages. This led to people getting laid off, and an economy that had less and less people willing to spend money. The U.S., while producing gas domestically at full tilt, could not match the supply they had before. They could not keep oil prices down, significantly exacerbating the stagflation. Oil was just  another high-priced necessity Americans struggled to afford.

A sign in front of a gas station in Oregon. Gasoline rationing became a part of American life.

 Photograph taken by David Falconer in May 1974,  from the National Archives and Record Administration.

1979 oil crisis in the U.S.

The second oil-shock of the 70s was a combination of foreign political revolt and domestic policies. Although global oil supply dropped by only ~4%, the reaction of oil markets dramatically increased crude oil prices over the next 12 months, more than doubling to $39.50 bbl, triggering gasoline shortages and long lines at gas stations comparable to the 1973 oil crisis.

The Iranian people revolted against the monarchy in 1978, deposing the Shah Mohammed Reza Pahlavi. When the Iranian revolution came to an end in early 1979, the global supply of crude oil dropped significantly, creating shortages everywhere. The fact that OPEC holds much of the world’s oil supplies, regardless of what they decided to do with it, can create significant issues. Especially when there’s political unrest in the state. 

Nevertheless, the U.S. government must take some of the blame for the domestic policies that made the crisis much more deleterious than it would have been otherwise. Seeing the Iranian revolution, the U.S. decided to regulate oil supplies in early 1979, hiking up prices at the pump. Also the Department of Energy (DOE) inadvertently created supply shortages by forcing large refiners to give some of their supply to smaller operations. While this decision had good intentions, the small refiners simply did not have the resources to efficiently produce usable oil in large quantities.