Is OPEC Fracked?

By: Craig McNeill

Founded in 1960, the OPEC cartel quickly developed into a strong force on global oil markets having the ability to influence prices for the benefit of its 12 member states.  Most famously in the early 1970s, they choked the US oil market with an embargo which led to a fourfold increase of prices in less than a year.  However in light of recent changes in energy markets, most notably the fracking revolution in the USA and the ever-increasing global trend towards a higher reliance on renewable energy, OPEC will have to change its strategy in order to maintain its strength in the world.

Generally, cartels are formed to take advantage of what is called a “prisoner’s dilemma” situation in game theory.  In the case of OPEC, this is where all member states agree to limit the production of oil to influence a rise in price, leading to greater revenues for its members.  Yet, the incentive for a member to take advantage of the price increase by raising production can lead to the collapse of the cartel.  Typically OPEC has deal forcefully with members deviating from their production quotas, and having managed to survive internal tensions during the Gulf War, its strength has shown to be resilient.  However, OPEC can only control its instabilities if it can continue to dominate global oil supplies.  If global demand decreases, its ability to influence prices decreases.  This not only leads to revenue instabilities but also to political instabilities within the cartel.

The introduction of shale is a great example of how a substitute product can affect the market to impose a strain on the biggest players.  As the shale revolution has a large potential for growth in the USA (with the IEA estimating US energy independence by 2035) and Asia within the next few decades, OPEC’s market share will be threatened.  Due to this, it will soon face difficulties in maintaining its existence.  To put this into perspective, imagine if all the coffee shops in St Andrews agreed amongst themselves to limit the amount of coffee they sell.  Students would then be forced to pay a higher price to stay awake in the library as the demand for coffee would exceed its supply.  However, if a new shop opened selling energy drinks, the coffee shops’ market share of caffeinated drinks would decrease and their ability to keep their prices high would be weakened.  Thus the incentive for breaking the agreement is increased, leading to the collapse of the St Andrews coffee cartel.

Currently OPEC represents around 40% of global oil supplies and can no doubt survive today’s geopolitical tensions.  However with the US increasing its oil production from 5MMbd (million barrels per day) in 2008 to 8MMbd in 2013, OPEC is losing one of its largest customers.  Now that Asia is the biggest consumer of oil from OPEC, there is the real threat that China may manage to develop its own shale reserves (which are believed to be even greater than in the US).  OPEC’s only choice then would be to lower its prices to keep feeding the Asian market but this plan would only have a finite lifetime before the economic benefits of shale and energy independence come into fruition giving OPEC an uncertain future.

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