South-Western College Publishing - Economics  
OPEC Exercises
Subject OPEC, Oil Prices
Topic Aggregate Demand/Aggregate Supply
Key Words Gross Domestic Product, OPEC
News Story

The United States and the rest of the world have been enjoying falling energy prices for most of last year. The Organization of Petroleum Exporting Countries (OPEC) along with major oil producers such as Mexico and Norway are trying to change that. Their plans for oil production have already caused oil prices to increase by 20 percent.

In the last few years, new oil discoveries and disputes within OPEC have resulted in energy prices plummeting to their inflation-adjusted lowest levels since World War II. But a number of events may reverse this downward trend. It appears that the decreased demand resulting from the Asian economic crisis has bottomed. The decline in economic activity in Asia had reduced demand for oil by 1.5 million barrels a day. Iraqi oil production, which had increased in the past year, has also stabilized. Iraq added to the world's oil supply after the United Nations allowed it to sell oil for food. The decline in oil prices has caused oil-producing countries to pare their budgets and, in some cases, accumulate debts. The poor fiscal position of these countries has created an environment that favors cooperation and the discipline to accommodate cuts in oil production.

The oil-producing countries decided to decrease oil production by 2 million barrels a day starting in April. Saudi Arabia, the world's largest oil producer, will decrease production by half a million barrels a day. Iran, Kuwait, Venezuela, Algeria, Libya, Indonesia, the United Arab Emirates, Qatar and Indonesia will have a combined cut of 1.5 million barrels a day. Mexico and Norway, two major producers who are not part of OPEC, agreed to cut production by 350,000 barrels daily.

The ability of these cuts in production to increase world prices depends importantly on the cooperation of Saudi Arabia. Saudi Arabia could destroy the agreement by flooding the market with oil. But low oil prices have caused Saudi Arabia to accumulate a debt of $130 billion - equal to its Gross Domestic Product. The willingness of the Saudi government to cooperate with the production cuts shows its need for increased revenues.

(Updated May 1, 1999)

1. What would happen to the Short-Run Aggregate Supply Curve as a result of higher oil prices?
2. What would happen to the Long-Run Aggregate Supply Curve as a result of higher oil prices?
3. What happens to the aggregate price level and level of real Gross Domestic Product as a result of the changes described in questions 1) and 2)?
4. If policy makers were concerned about these consequences, is there any policy measure that would counter these consequences?
Source Youssef M. Ibrahim, "OPEC Is Poised to Cut Output, Lift Oil Prices", The New York Times, March 22, 1999

Return to the Aggregate Demand/Aggregate Supply Index

©1998  South-Western College Publishing.  All Rights Reserved   webmaster  |   DISCLAIMER