Is OPEC a (successful) cartel?

The Organization of the Petroleum Exporting Countries (OPEC) was founded in Baghdad in 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Nowadays the international organisation counts 14 Members.

OPEC’s mission is:

  • to coordinate and unify the petroleum policies of its Member Countries and
  • ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.

It seems pretty obvious that OPEC is acting as a cartel. Indeed, the general perception is that OPEC has been able to control the prices and the production of the oil industry. Nonetheless, no competition authority has gone after the organisation so far, to my knowledge. Similarly, I could not find any record of a successful civil law suit.

Is the long, undisturbed life of OPEC only the consequence of politics and pragmatism? Has OPEC been able to continue exist because of faulty rules of procedure or due to the impossibility to apply antitrust legislation to such an international organisation?

But most importantly, has the market finally adjusted itself to prevent OPEC from exercising market power and behave anticompetitively?

Indeed, there are evidence showing that OPEC was never really in control of the market because its Members did not respected the cartel’s decisions [here]. In any case, due to changed conditions of the oil industry, some commentators are arguing that OPEC is no longer able to exercise a decisive influence on the oil’s price.

A successful cartel

A cartel is a group of similar, independent companies which join together to fix prices, to limit production or to share markets or customers between them [here].

Economics tells us that firms have always the incentive to cheat. However, under certain conditions, cooperation can be sustained as the Nash equilibrium.

Sustainable collusion occurs when:

  1. Market players repeatedly interact;
  2. The cheating by one player can be (easily) detected by the other cartellists;
  3. There is a high enough discount factor;
  4. The threat of retaliation is credible; and
  5. Coordination is feasible.

If we simplified to the extreme, likelihood of collusion increases if there are (i) few market players (ii) producing an homogeneous good, (iii) having a similar cost structure, (iv) the spare capacity necessary to retaliate, (v) enjoying a collectively high market share, (vi) in a transparent market (vii) with significant barriers to entry and expansion.

Is OPEC still a successful cartel?

The OPEC’s mission screams to the world that the organisation is acting to distort free competition in the oil industry. No secrecy, no rooms filled with smoke, everything is done under the sun.

Even assuming that the procedural obstacles to start an antitrust case against OPEC can be overcome (e.g. international immunity, cross-border jurisdictions, the need to qualify as an “undertaking” according to EU law), are there the elements to find an antitrust infringements? In other words: is OPEC a successful cartel? Can OPEC really hinder competition in the market?

When it comes to Article 101 TFEU, the anticompetitive conduct must have an appreciable effect on the EU market. Hence, even in case of infringement by object, the undertaking should be allowed to prove that its conduct had no such appreciable effect on the market.

The debate on “restriction by object” and “restriction by effect” is far from being settled. I will limit myself in stating that any cartel that does not enjoy a significant market power would be shooting itself in the foot by trying to restrict competition. [The “by object/effect” issue is excellently discussed here, specifically in relation to OPEC].

OPEC’s Members own 3/4 of the world’s oil reserve. They produce 40% of the global demand and  their exports represent about 60% of international traded oil.

The numbers above seem to hint that OPEC has some substantive market. However, many have started to doubt that OPEC can still effectively control oil’s price. Indeed, OPEC seemed unable to prevent the 2008 price race, despite the fact it increased its production quotas to the highest level in history.

In the past few years few events have contributed to erode OPEC’s power. The development of substitutes of oil products play now a competitive constraint on OPEC’s ability to increase prices. If the cost of a barrel goes too high, the switch to other energy sources will become more convenient, attracting further investments; shale oil prices are constraining OPEC’s ability/willingness to increase prices, for example [here]. Non-OPEC countries also influence OPEC’s strategy. Russia is now the biggest oil producer, as well as the number 1 energy producer [here]. Russia, as much as Saudi Arabia, depends on oil exports for a great  portion of their budget revenues. The two countries put energy issues at the heart of their foreign policy and use oil (and in Russia’s case, natural gas) as tools to achieve political objectives [here]. Russia’s increased production kept under control OPEC’s behaviour, even in the face of a high demand [here].

Other factors that influence the sustainability of the OPEC’s cartel are the differences in production costs of the OPEC’s members, the different weight that oil’s revenues play in their national economy, and their different policy’s objectives [here].

Moreover, a sustainable cartel needs a credible retaliation mechanisms. While Saudi Arabia, the biggest oil supplier, usually keeps at hand more than 1.5 – 2 million barrels per day of spare capacity for market management [here], the rest of the Members have little room to increase production [here].

If OPEC has no influence on oil’s price, what does?

Normally, prices drop when supply and demand increase and vice versa. But in the oil world, demand and supply are only part of the equation. Elements of geopolitics, environmental concerns as well as the oil’s status as the preferred source of energy complicate the picture [here].

The production costs per barrel depend on technological progress and the characteristics of the resource stock [here], which are independent from OPEC.

In the long-run the two factors that drive oil price are: the global demand and the future supply. The former is directly linked to the constant population growth and the increasing need for oil of emerging countries. The latter is highly uncertain to remain stable given that supplier countries manage their reserve more and more independently from the needs of third parties. There is no concrete reason for them to respond to the needs of importing countries and establish a low price [here]. So even in the absence of OPEC the price is very unlikely to go below costs of production.

Zietlov argued that factors that play a greater influence on the oil’s price than OPEC’s market power are:  the steady increasing of global demand, the temporary supply constraints, the US dollar exchange rate, and the growing importance of resource pragmatism and nationalism.

 

The oil industry might be a perfect example of the need to trust the market to eventually adjust itself. Similarly, the oil’s industry provides an example of how market shares are not always indicative of real market power.

However, if now the market seems to have adjusted to a level playing field, it could also go back to a less competitive scenario. For example, things might change if Russia decides to formally join the organisation, so bounding itself to abide OPEC’s decision and increasing OPEC’s spare capacity, necessary to retaliate [here].

P.s.: In the EU, the Commission would have the option to go after OPEC also for infringement of article 102 TFEU. However, from the above I conclude that in spite of the high market shares, OPEC is not able to behave independently of the other market players, hence its Members should not be found to enjoy collective dominance.

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Is economics helpful when it comes to cartels?

Economics implies that cartels are inherently unstable and so should be short-lived because they price above the Nash equilibrium. However, the evidence is cartels are often long-lived.

When players interact for an infinite number of times, as do firms in real markets, they can escape the short-run Nash equilibrium of the Prisoner Dilemma. In the context of infinite interaction, a collaborative behaviour becomes sustainable depending on the benefits of cheating, the credibility of the punishment’s threat and the discount factor.
“Punishment” refers to the reaction of non-cheating firms to an infringement of the collusive agreement: non-cheaters will move away from the cartel equilibrium towards a more competitive equilibrium, so that the cheater’s profit is reduced. Stability of the cartel is ensured by a punishment mechanism that makes the benefits derived from deviation smaller than the benefits of keeping colluding. An effective punishment mechanism should be strong enough to deter cheating, but also credible. It is in every cartel member’s interest to set the punishment mechanism as high as possible, but credibility follows from each non-cheating firm’s interest to implement it if a breach actually occurs. The punishment mechanism should hurt the cheating firm more than the non-cheating ones; hence, it must correspond to the latter’s profit-maximising behaviour.

Economics’s contribution to anti-cartel enforcement

Ex ante, economics can be used to prevent the formation of cartels by prohibiting mergers that would ease collusion. As tacit and explicit collusion rest on the same economic principles, the criteria used to identify tacit collusion in merger review processes can provide guidance also for the detection of explicit collusion.

Ex post, competition law enforcement can benefit from economic analysis because the latter can provide evidence:

  1. on the plausibility that an industry is/was cartelised, i.e. it can
    a) suggest where to look for a cartel, and
    b) reveal whether, given the characteristics of the market, the cartel
    allegation is credible; and
  2. on the impact that a cartel has had in the market.

Unfortunately economics is unable to establish with certainty whether a market is cartelised: economic models can be employed as screening devices, but further investigation will always be necessary.

Likelihood of collusive behaviours

Economics can help identify markets that are prone to cartelisation and establish whether the cartel allegation is credible given the market’s characteristics. However, economists tend to reject the idea of prosecuting cartels on economic grounds only because patterns of prices under collusion and competition are often similar; moreover, economics cannot distinguish between no collusion and unsuccessful collusion, and it cannot distinguish between tacit and overt collusion.

Structural and behavioural markers represent – complementary – screening tools; they identify suspicious behaviours, but cannot provide hard evidence of collusion. Indeed, they could produce false positives, or negatives, because they cannot distinguish between tacit and express collusion or because market players can evade them. Moreover, not all noncompetitive behaviours infringe competition law.

Estimation of the cartel’s effect on the market

Economics is useful to assess the cartel’s effects on the market. The actual cartel’s impact is of relevance for damages actions, but it can also have a bearing on the size of the fine imposed.

The harm suffered by the direct purchaser of a cartelised product has three elements: (i) the direct effect – the quantity of product purchased multiplied by the increase in price as a result of the cartel; (ii) the output effect – the increase in the purchaser’s selling price that is a likely consequence of its input prices increasing, leads to a reduction in the demand for its products; and (iii) the passing-on effect, which occurs when the direct purchaser raises its selling price in response to the increase in output costs, therefore reducing the harm it suffers

The consequence of a cartel on the market can be estimated by understanding what would have happened absent the wrongful conduct: the claimant’s position during the cartel is compared to the position that he would have been in “but for” the anti competitive behaviour. The difference between the claimant’s profits in the counterfactual world to the one in the cartelised scenario is the amount of compensatory damages due to the claimant. To estimate the counterfactual profit we need to know, or estimate, the following:

  1. the amount of the overcharge;
  2. how much lower would have been the selling price at the lower input costs; and
  3. the level of sales occurred at this lower price.

Direct evidence can be useful to quantify the damage; however, economists have developed different helpful tools to carry out the calculation. Comparator-based methods assume that the counterfactual scenario is representative of the likely non-infringement scenario and that the difference between the infringement data and the data chosen as a comparator is due to the infringement. Cost-based methods estimate the non-infringement price by using some measure of production costs per unit and adding a mark-up for a profit that would have been reasonable in a competitive market. Financial methods compare the counterfactual profitability and the actual profitability of the claimant or the defendant. These approaches can estimate the likely non-infringement scenario but cannot delineate it with certainty and precision.

 

In conclusion, even though economic cannot provide hard core evidence of collusion, it is a useful tool to detect cartels and understand their effects in the market. However, the quality of the answers economics can provide is only as good as the data available and as appropriate as the approach chosen.

***

Ayers, I., How cartels punish: a structural theory of self-enforcing collusion, in Columbia Law Review, 1987, pp. 295-325.

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010.

Friedman, J.W, A non-cooperative equilibrium for supergames, in Review of economic studies, 1971, pp. 1-12.

Harrington, J.E. Jr., Behavioral screening and the detection of cartels, EUI-RSCAS/EU Competition 2006 – Proceedings, 2006