Oil Prices And Cartel Behavior: Reflections On 1986 by Bill O’Grady of Confluence Investment Management LLC

Since last summer, oil prices have suffered a precipitous decline. The weakness is mostly due to supply and demand factors; however, because oil is a market with an active cartel, the decision by the cartel leader, Saudi Arabia, to allow prices to decline is also a key factor in price weakness.

This isn’t the first time the kingdom has fostered a price breakdown. There were two other episodes in which the Saudis led oil prices lower. In 1986 and 1998, the kingdom boosted production and allowed prices to decline in a bid to maintain its market share.

In this report, we will focus solely on the geopolitics of the 1986 event. The analysis will begin with the basic economics of oil and cartels. From there, we will detail the history of the kingdom’s decision to abandon OPEC’s price targets in 1986 and the geopolitical fallout that emerged in the coming years. We will compare and contrast the 1986 situation to the present situation. As always, we will conclude with potential market ramifications.

Oil Markets and Cartel Behavior

A cartel is a group of producers who band together to control supply and manipulate prices. In the U.S., this behavior violates anti-trust rules and is often referred to as “price fixing.” Despite these legal restrictions, the oil markets have nearly always exhibited cartel-style behavior. The Standard Oil Trust, created by John D. Rockefeller, controlled the oil markets from the 1870s into 1911, when the government broke the trust due to anti-competitive behaviors. In the early 1930s, during the East Texas oil boom, the Texas Railroad Commission (TRC) effectively acted as a cartel by allocating production among oil producers in the state. Although the activity of the TRC was on shaky legal grounds, the governor of Texas argued that aggressive “wildcatting” was leading to reservoir damage and thus it was in his power to preserve the oil fields in his state. Other oilproducing states created similar regulatory bodies. By the early 1970s, U.S. oil demand had risen to absorb all of America’s oil output. At this point, OPEC became the dominant cartel.

The primary reason oil is susceptible to cartel behavior is due to the fact that production is often “lumpy.” Major oil finds tend to flood the market, driving down prices and increasing volatility. At the same time, in the short run, the demand curve for oil is insensitive to price. This means that sudden increases in supply lead to a rapid decline in prices and little increase in the quantity of oil demanded. If producers are not restrained, they can react to the rapid price slide by boosting production to maintain revenue. This can lead to further overproduction, collapsing prices and damage resource recoverability in oil reservoirs.

The goal of the cartel is to fix a price that is (a) high enough to compensate for the opportunity costs of keeping some production offline and produce revenue in excess of the market clearing price, and yet b) not too high so as to promote non-cartel production and encourage conservation. The cartel can purposely reduce production to lift the price; this not only creates a higher price but also a supply buffer. This unused capacity can be expanded or reduced in order to defend the target price. A properly functioning cartel will lead to a market with very low price volatility.

Getting a price “just right” is very hard. The first problem is that markets are not static. Demand will change due to external forces like income growth, seasonal patterns, expectations, etc. At the same time, productive capacity outside the cartel will tend to behave based on normal market incentives; if technology improves, for example, supply could increase without higher prices. Since production techniques tend to improve over time, the cartel may face persistent pressure to maintain the target price. Thus, what may be a proper price at one point in time may be too high or too low at a later date. Second, there is tension between the size of cartel membership and management. Obviously, the greater production capacity that the cartel controls, the easier it will be to manage prices. However, the more individual members there are within the cartel, the greater the incentive is to cheat. Although all cartel members benefit from supply reductions, a member that overproduces increases his revenue by selling at the cartel-controlled price at the expense of cartel members that comply with output discipline. Although it is rational for the individual member to cheat to maximize revenue, if all members cheat then the market will be over-supplied and all will be worse off.

The 1985-86 Production Decision

As Saudi Arabia became the largest producer within OPEC, it explicitly took on the role of “swing producer” within the cartel. This meant that the Saudis would adjust their production to meet a set price. As world production rose or demand fell, the kingdom would reduce its output to maintain price levels.

Saudi Arabia took on this role to enhance its status in the Middle East and in the world. When the kingdom began acting as swing producer, its decisions on production and its pronouncements were newsworthy events. However, two trends conspired against OPEC and Saudi Arabia. First, the U.S. suffered through the only “double dip” recession in postwar history as the short 1980 recession was soon followed by the much deeper 1981-82 downturn. At the same time, Europe was in recession for nearly 30 months starting in December 1979. Slowing global growth reduced consumption. The combination of weak economic activity in the developed world along with high prices led to increased conservation efforts.

Oil Prices

This chart shows U.S. oil consumption on a per capita, per annum basis. As the chart shows, by the late 1970s, the average American was consuming nearly 31 barrels of oil per year. Even when consumption dipped in the mid-1970s, due primarily to the 1973-75 recession, demand made new highs during the recovery. Demand fell precipitously during the 1980 and 1981-82 downturns. But, as the economy recovered, demand remained well below previous peaks. This change was not anticipated by oil producers. They expected the trend in demand witnessed from the mid-1960s into the late 1970s to be maintained. High prices and supply insecurity had led to dramatic improvements in conservation, putting pressure on prices. It should be noted that the Reagan administration removed price controls in the early 1980s, which had kept prices low but had also caused the infamous gasoline lines; gasoline lines were gone, replaced by higher market clearing prices, which accelerated conservation. At the same time, high prices spurred oil production. The Saudis found themselves trying to defend a price level that was being undermined by rising production and falling consumption.

Oil Prices

This chart shows inflation-adjusted West Texas Intermediate oil prices along with Saudi oil production. Note that oil prices started declining in the early 1980s. To try to maintain prices, the kingdom steadily reduced output. Despite these output cuts, prices continued to slide. In 1981, Saudi oil revenues were $119 bn. By 1985, they had declined to $26

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