Can OPEC handle the oil game?

The worldwide oil market is unique, complex, and very difficult to predict. Robert D. Cairns, an economist from McGill University, laid out this message loud and clear in his recent research paper on the oil industry and the importance of OPEC’s involvement. Cairns, who visited the Colorado School of Mines campus last week, explained how OPEC, the Organization of Petroleum Exporting Countries, continues to hold lions’ share of the oil market and cautions that they must be careful in how they use that power.

In the oil market, the primary players must look at the specific attributes of the oil reserves in order to maintain profitability and power in the market. For each individual oil reserve, there are marginal costs involved in extracting and processing the oil. Therefore the optimal point of production for a company producing oil is somewhere between marginal costs and maximum profitability. Cairns explained that the primary players in the oil world, such as OPEC, have the power to control these attributes and predetermine the overall profitability of specific oil reserves by the way they invest in and develop the reserve.

This is important because if the leading oil producer sets their price point above these industry-standard levels, it increases the incentive for more rivals to enter the market, taking away profits from the leading producer. However, if the leading producer sets their price well below the standard, they are wasting their mass-production advantage. If OPEC seeks to maintain their edge in the global oil market, they must set their oil prices and production levels in such a way that the upper limits of production are predetermined, resulting in greater profitability in the long run.

Cairns added that the prime objective for the oil producing states in the Middle East is to perpetuate their dynasty. For the Saudis, this means keeping their ruling house in power for as long as they can. “What do [the Saudis] do with their money? Like many of the oil states, much of the population… is on state payroll, doing essentially nothing. There has not been a Saudi Spring yet. They pay the people to keep quiet.” For the Saudis to maintain this peaceful welfare state, they must continue to be profitable in the oil industry. For them to be profitable, they must be careful in how they predetermine the upper limits of production while not wasting their reserves.

As a result, traditional economic models that determine the development and utilization of natural resources are all but useless when it comes to oil. Oil gives nations and governments power, and without it they are vulnerable. This results in a unique situation in the Middle East. Saudi Arabia now sits on massive untapped oil reserves, as they attempt to maintain that price and production control. This discourages further entry into the market, resulting in greater profitability. Because of this, OPEC now sets the standard for oil production, and any other participant must match their price in order to compete.