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Bush and Oil Prices

Omkar Goswami

Located in one of the most beautiful promenades in Europe, the headquarters of the Organisation of Petroleum Exporting Countries (OPEC) must rank as one of the worst looking buildings in the world. On the banks of the Danube in the heart of Vienna, it is white, squat and devoid of any aesthetics — almost as poor as the organisers pseudo art deco logo.

This ugly building houses the globe’s most powerful cartel. OPEC was formed as a permanent inter-governmental organisation in September 1960. From its inception, OPEC’s objectives have been explicitly cartel-like, and I quote:
“OPEC’s objective is to co-ordinate and unify petroleum policies among member countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.” (emphasis mine)

OPEC has 13 member countries. It began with five: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Subsequently, others joined the organisation: Qatar, Indonesia, Libya, the UAE, Algeria, Nigeria, Ecuador and Angola.

There is no doubt that over the last couple of years, the OPEC has become an incredibly successful cartel. From end-January 2007, it has kept global crude prices higher than $50 per barrel; from April 2007, at levels higher than $60; from September 2007, at above $70; from the second half of October 2007 at above $80; from late February 2008, at over $90; and from 14 March 2008 at over $100 per barrel. As I write this article, the OPEC’s weighted average basket was quoting at $111.66 per barrel. More ominously, on 28 April, the OPEC president, Chakib Khelil, Algeria’s oil minister, warned of the prospects of crude at $200 per barrel.

Applied game theory explains why it is very difficult to maintain successful price or quantity cartels over long periods. More often than not, cartels tend to fail because of ‘free-rider’ problems. Even when all members informally agree to restrict supplies to obtain a high price, a few always have incentives to quietly deviate. A small producer is tempted to produce a bit more than what was agreed to, assuming that he can free-ride on the price and also not get detected.

Moreover, the punishment to deviations is very difficult to implement and, hence, not credible. The classical response to free-riding is for every other member, especially the big producers, to immediately increase output, drop prices and hurt the deviant. But the act of doing so hurts all non-deviants as well. That makes the cure more painful than the disease — and explains why cartels historically live with some free-riding in good times, and face difficulties in reaching quantity / price fixing agreements in periods of poorer demand.

In fact, until 2007 the OPEC was not viewed as a price gouging cartel. Barring 1973 and 1979, it has see-sawed between cutting and raising quantities. Till September 1999, crude was ruling at below $20 per barrel; and it remained below $30 right up to March 2004. So, what has made the OPEC so successful in not only maintaining hard prices, but steadily stepping these up to over the $110 mark?

Economists will tell you about the rising demand from India and China, uncertainties in supplies, and the role of commodity speculators. These are valid. But to my mind, the biggest factor of them all is a man called George W. Bush.

If Bush had only alienated Hugo Chavez of Venezuela, the oil consuming world would have breathed easier. But he has put off Iran, the UAE and, most importantly, its biggest oil producing ally, Saudi Arabia. Gone are the days when the President of the US could have a quiet word with the King, and have the Saudis exercise restraint on the OPEC. Not so long ago, Bush’ father, George W.H. Bush, was welcomed as an honoured guest of King Fahd at Riyadh. Today, King Abdullah doesn’t feel the same about the son or his emissaries. For instance, Dick Cheney’s last visit to Saudi Arabia was only politeness. The Saudis are irritated with Bush’ confrontational style; with the US upsetting their neighbourhood, and not bothering to consult with them in any substantive way.

Thus, Thanks to Bush’ bellicose body language, the Saudis watch from the sidelines. Not once since September 2007 has the largest producer in the OPEC spoken of increasing supplies to dampen prices. With the Saudis remaining quiet, every other producer is making hay, including US-haters like Mahmoud Ahmedinejad of Iran and Hugo Chavez.

The US has become public enemy number one in the Middle East. And we are all paying the price. Long live Dubya!

 Published: Business Standard, May 2008


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