OPEC: The crude, hard truth

In the wake of the preponderance of fracking, a method of extracting crude oil from the ground by hydraulic means, there has been a large amount of criticism charging that the process has a serious environmental impact.

The debate has particular significance in Pennsylvania, because much of the development of fracking has occurred throughout the state. While this issue might not seem relevant to city dwellers, over the summer, Allegheny County approved shale drilling to take place by the Pittsburgh Airport, through which many Pitt students have flown.

The decision of whether or not to allow fracking to take place requires a detailed cost-benefit analysis, weighing the environmental and health costs against the increases in employment and oil output. Indeed, many critics have rightly charged that too little weight is placed on the costs of the process in the pursuit of lowering unemployment.

Whether or not this is the case, crude oil output has become large enough that we must add a few items to the benefits side.

This change comes in light of the recent announcement this past Thursday from the Organization of the Petroleum Exporting Countries (OPEC) that they will not cut petroleum production targets.

Originally founded in 1960, OPEC is an oil cartel, consisting of twelve countries, which aims to control the production and global price of petrol. The organization is well known for the gas shortages it caused in the US during the 1970s with the decision to impose an oil embargo.

Historically, OPEC has tried to use its market power to keep the global price of oil at around $100 a barrel. With the current price at $73, one would expect the organization to cut production, thereby reducing the global supply of oil and increasing its price.

However, OPEC did not decide to do so, leaving the world to wonder why. While there are certainly many reasons — both economic and political — a simplified look at the economics of the situation might provide elucidation.

Presumably, the basic goal of an economic cartel is to maximize the profits of the members. For a single firm in a large market, this is usually not possible, as the firm is forced to sell at a market price that it cannot influence by changing production.

However, if a collection of firms create a cartel, they may be able to have a large enough market share how they can impact the market price by changing production. According to the U.S. Energy Information Administration, OPEC crude oil production comprises around 40 percent of global output — additionally, 60 percent of the oil traded globally was produced by the organization. 

While a more detailed analysis is required to say for sure, it’s a safe bet that OPEC can impact the global price of crude oil.

Thus, the cartel must set a production level such that it is maximizing group profits, while taking into account that by producing more oil, it will lower the price and decrease revenue per barrel.

In general, theory tells us that the creation of a cartel will lead to a higher market price and a lower total output for the relevant market. However, it is a common misconception that cartels (and monopolists) are able to charge an arbitrarily high price for whatever they are selling and reap the benefits — in fact, the cartel is still subject to market forces — but less so than a small firm, allowing it to reap certain benefits at the expense of the consumer.

Therefore, we can conclude that, most likely, OPEC decided not to lower production targets because its impact on market price was not large enough to significantly lower the global price of oil so that OPEC could make a larger profit at this lower output.

Clearly things have changed since the 1970s. Part of this situation can be attributed to a lack of global demand, as Europe continues to struggle with large levels of government debt and Chinese growth remains well below its former double-digit levels.

However, as many observers have pointed out, OPEC’s decreased influence is largely a product of increased output in the US due to fracking.

Thus, by allowing fracking to occur, the U.S. gains the benefit of a weakened OPEC and increased oil independence. Additionally, lower oil prices lead not only to decreased prices at the pump, but also to lower prices in the entire economy — as oil or gas is an input to almost any good. These large consumer benefits must also be counted.

That being said, before bringing out the drills, remember that U.S. oil producers have been hit hard by the announcement, as the lower oil prices means lower profits for them. Further, some have argued that OPEC is attempting to harm the burgeoning fracking industry to solidify its position in the market — so overall, we can only be certain that this announcement has brought more to consider in the ongoing debate over shale oil extraction.

Write to Thomas at teh18@pitt.edu.