Opecs oligopolistic market and effects on oil prices

The main focus in this essay is to explain the characteristic of the Oligopoly Market Model and explain how the dynamics of the Oligopolistic market can influence the price of a product and different strategies used by firms together to create an inelastic demand for the product to optimize profits

The second part of the essay concentrates on how OPEC as organizations has control on the world’s Oil prices. Different scenarios are enumerated in the following report, where OPEC has used strategies to control the market and capitalized on the Oligopoly model

TABLE OF CONTENTS

Sr. No.

Particulars

Page No.

1.

Executive Summary

2

2.

Introduction

4

3.

Characteristics of the Oligopoly Market Model

5

4.

Analysis on how OPEC as an Organization manipulates the World’s Oil prices

10

5.

Recent news on OPEC and its control on oil production , whilst the instability in Middle East and the African region

13

6

Reference list / Bibliography

15

Introduction:

Microeconomics entails the economic activity of consumers, producers or group of producers and consumers and the market in which they interact. It is study of buyers, sellers, prices and profits. Market economy refers to the developed and the industrialized economies in the world. Market economy is in which people specialize in the production of array of goods and services and meet their food and material needs through exchange (http://www.referenceforbusiness.com/encyclopedia/Man-Mix/Microeconomics.html)

Market economies can vary based on the supply and demand and it is the best determinant to analyze the Market. While most of the developed nations can be classed as having a mixed economies because they allow market forces to drive most of their activities like the government interactions in order to provide stability. (http://www.investopedia.com/terms/m/marketeconomy.asp)

There are a number of market structures like: Perfect Competition Model; Monopolistic Model; Monopoly and Oligopoly with each having their own characteristics for the economists to understand why each business behaves differently in that market. However the objective of this assignment is to understand what happens in Oligopoly market structure.

The latter part of the assignment, we are going to analyze how the OPEC is acting as oligopoly in the petroleum industry and the impact it has on the oil prices and how it has impacted the economy of the world.

Analysis OF Oligopoly MARKET MODEL

An oligopoly is a market dominated by a few producers, each of them has control over the market. The word ‘Oligopoly’ is derived from Greek words oligio, meaning ‘few’ and polein, meaning ‘to sell’. The few leading dominant firms have a high level of market concentration in the Oligopoly structure. Oligopoly is best defined by the behavior of the firms within a market than its market structure. Generally an oligopoly exists when the few leading firms have nearly 60% of the market share and when the demand is inelastic and accounts for the maximum sales.

Few Characteristics of an oligopoly

Although there is no definite method to predict how firms determine the price and the output in Oligopoly, but generally an oligopoly exhibits the following features:

Product branding: Each firm in the market sells a differentiated product and has its own niche in the market.

Entry barriers: There are significant entry barriers for smaller firms in an oligopoly market, which prevents the dilution of competition in the long run and maintain enomorous amount of supernormal profits for the dominant firms. Smaller firms generally operate on the periphery of the market, but is not significant enough to make the impact on output and market prices.

Interdependent decision-making: Dominant firms collude with each other and determine the price and taken into account the reaction of their rivals to change in market price or output

Non-price competition: Non-price competitions are a consistent characteristic of the competitive strategies of oligopolistic firms.

There are two types of Oligopoly namely collusive and un collusive oligopoly. In collusive oligopoly, Firms directly collude with each other and forms cartels to have a control on the market price. In Tacit collusion, firms have a mutual understanding to cut out competition. Price leadership is where the dominant firm has the power tro change the price and then the rest of the market follows suit. In un-collusive oligopoly Game Theory is used where the firm makes a strategic decision to either make immediate profits or destroy the rivals market share, which in turn has a huge effect on the market.

Diagram of the firm and the Market in an Oligopoly

http://rds.yahoo.com/_ylt=A2KJkK4Us69NsmAABdKjzbkF/SIG=122htrmi5/EXP=1303389076/**http%3a/www.foolonahill.com/mbaairoligopoly.jpg

The Kinked Demand Curve Theory:

Paul Sweezy, an American, developed the Kinked Demand Curve Theory in the late 1930s. Normally in an oligopoly market the firms are in consensus to maintain a standard and constant price of the product, which creates inelastic demand and generates supernormal profits. If a firm decides to increase its price, without colluding or collaborating with the other dominant firms, the other firms in the market decides retain the same price. In this case the firm that has increased the price will soon lose its market share and a considerable amount of revenue. On the other hand, if that firm in the oligopoly market decides to lower its price, the other firms in the industry too will have to do the same to retain their market share and then all firms will lose its revenue. It is then better to remain at a constant price to avoid losing revenue or market share. This is what Price Rigidity means. If there is a change in the price , the demand curve will kink around the prevailing market price as it will undergo further stabilization of the price when the firms will take care of the changes in the cost. In the figure shown below, the MR curve is discontinuous because at ‘a____b’ there will be no change in demand as the production and the price is the same. When the cost increases, the marginal cost curve moves upward from MC 1 to MC 2 and the demand curve kinks. Thus the firm can maximize profit only at price P and quantity q.

Dollars per unit

MC2

p

Kink curve

MR¢

MR

D

D¢

MC

MC1

b

a

q

q/t

0

The kinked demand curve model predicts periods of relative price stability under an oligopoly and businesses will focus on non-price competition to reinforce their market position and to boost sales , revenues and profit.

The importance of non-price competition under oligopoly

Non-price marketing strategies have two separate aspects :

Product differentiation strategy is used by firms to convince the buyers their products are different from those of competitors.

Product variation strategy involves in creating minimal variation to the product to attract buyers

Non-price competition also involves huge amount of advertising and marketing strategies like special packaging, promotional events, sponsorship, having a Brand ambassador for the product, which will boost the brand image to attract demand and generate brand loyalty among consumers.

Price leadership

Many economists, such as Stigler (1947b) , Bain ( 1960) have described various type of price leadership. These have been classified by Scherer (1970) into three types: dominant, collusive and barometric price leadership. The dominant type is considered to describe where the dominant firms, which are larger in size and has the major chunk of market share establishes the price leadership position and the other minor firms being the followers . In the collusive type, the principal firms set prices, which are then followed by the other minor firms and the price level is rather monopolistic than competitive. Scherer ( 1970 p170 ) has stated that the price leaders temper their price policies in order to suppress intra – industry conflicts in this case . Finally in the Barometric price leadership the price is set around the competitive level (Ono, Y. (n.d.). Price Leadership: A theortical Analysis. In Economica (pp. 49, 11-20). Musashi University).

Explicit collusion under oligopoly

In the collusive Price leadership, in order to curb market uncertainty, dominant firms engage in some form of collusive behaviour and decide to engage in price fixing agreements or cartels. The aim of this is to maximise joint profits .This behaviour is considered as illegal by the UK and European competition authorities.

Collusion is often deemed as a desire to achieve joint-profit maximisation within a market, to control supply and to prevent price fluctuations in an industry.

It can be concluded that cartel as a whole is maximising profits, but the individual firm’s output is unlikely to be at their profit maximising point and if any of the firms breaks their agreement with the cartel, there will be excess supply in the market and sharp decline in the price.

Collusion in industry is easier to achieve when:

There are only a small number of firms in the industry.

Entry barriers are protected by larger firms

Demand is fairly inelastic in price and the market demand is not too variable

Output of the firms in the cartel is easily monitored and to keep a control on the total supply and it will be easy to identify if any of the firms are trying to cheat on their output quota

Most cartel arrangements experience difficulties and tensions among them and some producer cartels collapse completely . There are several factors that can create problems within a collusive agreement between suppliers:

Falling market demand during a slowdown or recession puts pressure on individual firms to reduce prices to gain profits or least maintain their revenue.

Exposure of illegal price fixing by market regulators

Vested interest: The firm in the cartel aims finds it profitable to raise its own production to gain more profits and not adhere to the cartel output quotas. Disputes among the cartel how to share out the profits. (http://tutor2u.net/economics/revision-notes/a2-micro-oligopoly-overview.html)

Followed is Analysis how OPEC as an organisation has collusively collaborated to form a cartel to control the world’s oil prices, thereby depicting the Oligopoly Market model.

The Organization of the Petroleum Exporting Countries (OPEC) is a intergovernmental organization, consisting of 12 oil producing and exporting countries. The members are Algeria, Angola, Ecuador, the Islamic Republic of Iran, Iraq, Kuwait, the Socialist People’s Libyan Arab Jamahiriya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates & Venezuela.

The organization’s principal objectives are:

To unify the policies of petroleum among the Member countries in order to safeguard their individual and collective interest;

To avoid price fluctuations and to ensure stability around of oil prices in the international markets; and

To provide an efficient economic and regular supply of petroleum to the world and ensuring fair returns to the ones that are investing in the petroleum industry.

Detailed report done by Jim Saxton on OPEC Strategy to sustain high oil price to obtain supernormal profits and deterring any new entrant into the market , which in turn has generated high Oil Price Volatility

OPEC’s strategy The OPEC cartel has strategically maintained to keep high price in an oil market under pressure from rising demand. It has encountered short run capacity constraints in the past, but OPEC did not increase its oil output or bring the price to a lower manageable level. On the contrary OPEC cut the oil output intermittently, this behavior tests the limit of what can the market bear in terms of price increase.

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Hence price volatility does not imply weakness of the cartel, it is a strategic decision made by the cartel to optimize on supernormal profits. Even though oil revenue more than tripled from $183 billion in 2002 to $580 billion in 2006, the cartel increased its oil output only by a mere 17 percent and increased its price from $ 22.00 to $ 28.00 per barrel.

In practice, if firms decide to monopolize existing sources of supply, they cannot control the price, because they do not control demand and the prospect of market entry by rivals is high. High prices will induce lesser demand and lesser consumption and buyers will seek to alternative inputs, thus making the entry of the competition into the market higher. A dominant producer or supplier has a choice to either harvest profits in the short run by inflating price at the expense of losing its dominance in the future, or it can decide to charge a moderate price that sustains its market position and generates supra-competitive profits over time. Until the end of 2003, OPEC pursued this strategy with an explicit price band of $22 to $28 per barrel.

OPEC’s change in strategy. Starting in 2004, the demand for oil howed a sharp increase expecially from developing countries like China and advanced economies proved more resilient to rising oil prices than previously believed, which induced inelastic demand for oil , which proved to be immensely beneficial for OPEC . In addition, the cost of other competing sources of oil are exorbitantly high . For example, the non-conventional Canadian oil sands-a growing market entrant was subject to much higher production costs than Alaskan or Mexican oil when it was first developed in the early 1970’s. Thus all these as changing market conditions gave a boost to OPEC strategy and strengthened its position. OPEC abandoned its announced price target range of $ 22.00 – $ 28.00 per barrel and put off setting a new one. It was clear that OPEC believes that a higher price had become sustainable. OPEC offers mostly platitudes when price surges but intervenes decisively when short-term forces push it back.

OPEC’s power to restrict output. The cartel’s true strength lies in holding back a flood of cheap oil. OPEC holds most of the world’s oil reserves and has extremely low production costs OPEC members costs within the Persian Gulf have costs of less than $5 per barrel, and OPEC member costs outside the Persian Gulf average less than $9 per barrel. OPEC’s share of conventional oil reserves is 80 percent and 70 percent if Canadian oil sands are included. Since 1977, the oil supply in the rest of the world has increased from 32.2 to 50.7 million b/d. OPEC’s oil output today is barely more than in 1977, even though it could easily drill more wells. In all of the Middle East, there are 11,948 producing oil wells, which is fewer than the number found in Brazil, 11,995.3 OPEC’s share of the oil market was 52 percent in 1973, reached a low of 29 percent in 1985, and since 1994 has been about 40 percent. The artificial scarcity created by the cartel shifts the market’s focus away from cost and to the cartel’s expected output behaviour of not managing expectations. When the cartel fails to send clear and reliable signals, speculation and hedging strategies arise. Oil buyers build precautionary inventories supplemented by governments (e.g., the Strategic Petroleum Reserve), the use of financial hedging instruments increases and raising credibility issues on OPEC’s intentions.

Conclusion. Over the decades, OPEC has succeeded in cutting down its oil infrastructure investments and holding back huge stores of cheap oil. It has in the past made enormous profit margins as a result. The higher the margin is, the harder it is to control the price. OPEC can choose to be a price leader by announcing a moderate long-term price range and consistently expanding its oil output to stabilize the market. But instead it has decided to set that strategy aside and instead, the cartel has opted to pursue high prices and gain higher profits, which exceeds given in the current situation. The cartel may overplay its hand in the future. Market and the competing of supply may be more responsive to high and volatile prices in future than what OPEC expects, causing the oil price to decline and OPEC losing its market leadership

(Saxton, Februray 2007)

Recent developments on OPEC’s stand in oil price volatility due to the unrest in the Middle East and the African region

Mideast unrest not affecting oil supply: Venezuela

Political instability in the Middle East has not affected the world’s supply of oil, Venezuela’s oil minister said Wednesday — and if it does, OPEC can increase production to make up for the loss.

Oil Minister Rafael Ramirez announced that he and the senior members of the OPEC were “in permanent consultation” over regional turmoil.

Ramirez said that he spoke with Saudi Oil Minister Ali al-Naimi on Wednesday, and concluded that the most recent unrest did not merit an output increase.

Ramirez, who is also president of the state-run oil concern Petroleos de Venezuela (PDVSA), told the paper that he does not expect the OPEC members to meet in the short term to discuss instability in the Middle East.

Oil prices topped $110 on Wednesday for the first time since early September 2008 after news that a Libyan fighter pilot had disobeyed orders to bomb opposition stronghold of Benghazi.

The news immediately raised fears over production in Libya itself, where many Western oil companies have suspended operations, and in the wider Middle East where many countries are facing protests and undergoing revolution.

Venezuela, south America’s largest oil producer and a founding member of OPEC, has a production of some three million barrels of oil a day.

The Saudi oil minister said Tuesday that OPEC is prepared to meet any oil supply shortage due to regional unrest, and that its members have sufficient spare capacity to do so.

Naimi, speaking in Riyadh, said that market volatility was only short-term and would not result in any shortages in the market.

http://blogs.reuters.com/columns/2011/02/23/arab-unrest-will-be-a-test-for-opec/ – 2/23/2011

Cannot control oil prices beyond $120 says OPEC

Reuters

Paris , April 06, 2011

OPEC has little control on the oil prices, driven by speculators betting on “worst case scenarios” and has already supplied the market with the oil it needs, members of the producer group said on Wednesday.

Oil on Wednesday traded above $122 a barrel for Brent crude, near two half-and-a-half year highs set this week. “There is little we can do in terms of price control,” UAE oil minister Mohammed bin Dhaen al-Hamli told an oil conference in Paris. Already, he said, the Organization of the Petroleum Exporting Countries (OPEC) had increased its output in response to the disruption of supply from OPEC member Libya.

The group, which supplies around a third of the world’s oil, has resisted calls for an emergency meeting before its next scheduled conference in June this year in Vienna. “International markets are choosing to ignore market fundamentals and bet on the worse case scenarios,” Hamli said, adding the market was well-supplied.

Iraq’s deputy Prime Minister for energy affairs Hussain al-Shahristani, a former oil minister, agreed OPEC had done all it could to calm the current situation. “All that OPEC can do is provide the market with the oil it needs and it is doing that,” he said. So far he said there was no sign in prices had damaged economic growth and he did not anticipate the current rally would be followed by a crash as happened in 2008.

Back in 2008 prices reached an all-time high of nearly $150 a barrel in July, before collapsing to less than $40 in December as a financial crisis sparked in the US housing market led to a worldwide recession.

“We have not seen any slowdown in growth this time,” Shahristani told reporters.

http://www.hindustantimes.com/Cannot-control-oil-prices-beyond-120-says-OPEC/Article1-681994.aspx

REFERENCES/BIBLOGRAPHY:

http://www.referenceforbusiness.com/encyclopedia/Man-Mix/Microeconomics.html

http://www.investopedia.com/terms/m/marketeconomy.asp

Ono, Y. (n.d.). Price Leadership: A theortical Analysis . In Economica (pp. 49, 11-20). Musashi University)

http://tutor2u.net/economics/revision-notes/a2-micro-oligopoly-overview.html

Saxton, J. (Februray 2007). Opec Strategy and Oil Price Volatility. United States .

http://www.opec.org/opec_web/en/press_room/178.htm

http://blogs.reuters.com/columns/2011/02/23/arab-unrest-will-be-a-test-for-opec/ 23 Feb 2011

http://www.hindustantimes.com/Cannot-control-oil-prices-beyond-120-says-OPEC/Article1-681994.aspx