Deja Vu All Over Again.

• Author: Adelman, M.A.

The Organization of the Petroleum Exporting Countries or OPEC control the price of oil through brinkmanship. They have two goals. As a group, they must restrict output to keep the price higher, but each individual member wants the others to bear the burden of restricting output. So they patch up deals, which in time break down and must be re-patched. It's trial and error. Raising the price of oil is easy. Cut production and keep the market guessing when it will be increased. Buyers will do the rest. A wave of extra precautionary demand for hoarding, not use, raises the price. Then speculative demand raises it even more. Once the higher price is set, the temporary extra demand disappears. OPEC can only keep the higher price if they can permanently restrain production and sales. If they raise the price too high, they lose so much in sales that on balance they lose revenue. They can only find the optimal price or the monopoly ceiling by, again, trial and error.

Today OPEC is at or near the limits of its power. They are in a market share trap. They have less than half the world market, but they bear the whole burden of any production cutback. Furthermore, even if a cutback is worthwhile for the group as a whole, if Saudi Arabia expects others to cheat and throw the whole burden on to them, they will veto a price hike or an output cut. They still have some freedom to move and I think the OPEC nations will make a deal soon and raise the price again, moderately. Then the cheating and the jockeying starts all over again. The consensus view looking to the longer-term is that OPEC will gradually emerge from the market share trap. Non-OPEC production is expected to decline. Then consumers must go with begging bowl to the Persian Gulf and try to cultivate good relations there to induce them to expand capacity "enough for our needs." I think this is far-fetched. OPEC excess capacity is permanent. Each member must bargain with the others over production shares. The only way to have bargaining power is to have excess capacity. Without it, you cannot threaten the others and you get no respect. What's good for the individual though is bad for the group.

By late 1991, even after the loss of Kuwait and Iraq, capacity was already in excess. The others were urging Saudi Arabia, "You do the right thing. You cut your production." The excess will keep growing over the years. Kuwait is now producing about one fourth of prewar and expects to be back at prewar in 1993. They say they won't stop there. Other members are also expanding.

Editors' note: Professor Adelman gave this talk at the CATO Institute on January 16, 1992 in a forum entitled National Energy Policy: Markets or Mandates. We have transcribed it from the online...