South-Western College Publishing - Economics  

Oilís Well That Ends Well: The Benefits of Restricting Oil Production
Subject Oligopoly, Cartels
Topic Product Markets
Key Words Prices, OPEC, Trade deficits, Tax revenues, Cooperation
News Story Saudi Arabia, Mexico, and Venezuela, which supply 48 percent of U.S. oil imports, have agreed to reduce their production of oil by 1.5 to 2 million barrels a day. World production is 73 million barrels daily. When the Organization of Petroleum Exporting Countries (OPEC) meets, it may also restrict output.

Oil prices had been declining. From $27 a barrel in early 1997, they had plummeted to less than $12 in June 1998. OPEC had increased production while non-OPEC output had risen due to the emergence of new petroleum exporters and cheaper finance and technology. Meanwhile, the Asian crisis occurred and the 1998 winter in the Northern Hemisphere was warm. As a result, oil-producing countries suffered due to trade deficits and reduced tax revenues. This prompted the tripartite agreement. Oil prices soon rose to $13.65.

The agreement was not easy. Venezuela had been trying to increase its market share in the U.S. The three countries had to agree that they would not steal market share from each other. Also Venezuela and Mexico did not want to reduce output as much as Saudi Arabia did. Maintenance of higher prices depends on the cooperation of other countries.
(Updated August 12, 1998)

Questions
  1. a.   What is a cartel?
    b.   Do Saudi Arabia, Mexico, and Venezuela constitute a cartel? Why?

  2. Draw a price-quantity diagram of the market for oil. Show the supply and demand curves.
    a.   Illustrate what happened in the market for oil from early 1997 until just before the tripartite agreement. Show the changes in demand and supply, and the implications for the equilibrium price and quantity.
    b.   Add a marginal revenue curve to your diagram. Assuming that the oil producers secure widespread agreement to act in unison, essentially as a monopolist, show the new equilibrium price and output. (Treat the supply curve as the marginal cost curve.) Is your diagram consistent with what happened to price and output in the news story? Explain.

  3. There is skepticism that the cartel will not be effective for long. How would the following features of the oil market hinder the cartelís effectiveness?
    a.   The large number of producers other than Venezuela, Mexico, and Saudi Arabia
    b.    Low-cost finance and technology
    c.   Trade and falling tax revenues in individual countries
    d.   A renewed desire by Venezuela to increase its market share.
Source S. Liesman, B. Bahree, and J. Friedland, "ĎBig 3í Exportersí Pact To Cut Oil Output Signals Seismic Shifts," The Wall Street Journal, June 23, 1998.

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