The members of the Organization of the Petroleum Exporting Countries (OPEC) negotiate over production allocations. This is as opposed to restricting their choice set to non-cooperative or fully cooperative strategies. There are two stages in the OPEC decision tree and one stage in the non-OPEC case. In the first stage, OPEC producers negotiate over production allocations taking into account both their own and non-OPEC second stage responses. In the second stage, OPEC, and non-OPEC producers such as Guyana then choose their activity levels (i.e. production, investments in capacity, and reserve development) simultaneously. OPEC producers take the quota restrictions as given and enforceable whereas non-OPEC producers take the price path as given. (Huppmann and Holz 2012).
Nonetheless, reserve additions together with geological constraints can rationalize a U-shaped price path and bell-shaped production profile for new petroleum-producing countries like Guyana. The key mechanism that explains this phenomenon is that reserve additions relax the geological constraint on extraction which can lead to a pattern of increasing (falling) production (prices) followed by falling (rising) production (prices) when the new reserves added fail to offset the depletion effect (Okullo et al. 2015).
Highlighted Features:
- The increasingly important role for unconventional resources in meeting future oil demand. That is, in addition to conventional crude oil, countries must take account for oil supply from tar sands, shale oil and natural gas liquids.
- Production is constrained by capacity, which is accumulated through investments. Capacity grows slowly because of (i) the positive marginal cost for installed capacity that avoids its wasteful installation, and (ii) because of exogenously given, history-based physical limits on its periodical expansion. The exogenous constraints reflect limits on the ability of producers in a given region to access capital and construct production capacity.
- Depletion rates, that account for the natural decline in reservoir productivity, are integral to a countries field development (Cairns and Davis 2001). These impose reasonable upper bounds, as dictated by geological constraints, on the share of reserves that can be extracted in every period. Empirical data indicate that most extraction regions quickly approach a maximal depletion rate, after which extraction progresses at a constant fraction of the reserve base. Guyana must consider what its rate of extraction should be and how it should correspond to reserve to production ratios over the next five and ten years.
- Reserve development is endogenous to a country’s supply model. It is assumed that producers know with full certainty the size of their initial reserves and resource endowments. Producers must, however, convert resources into reserves through costly development to facilitate extraction. Reserve development together with geological constraints can rationalize U-shaped prices and bell-shaped production profiles.
- A new oil-producing country like Guyana should be able to have a sufficiently detailed representation of the global oil market supply for OPEC producer and other non-OPEC countries. On the demand side, the emphasis is on the pattern of consumption and energy transitions of the Organisation for Economic Co-operation and Development (OECD) and non-OECD countries.
The oil producers’ objective is to choose allocations for production, investments in capacity, and additions to reserves in order to maximize the discounted sum of net profits. These choices are made subject to dynamic changes in developed reserves, installed capacity, and the depletion of undeveloped resources. In each production period for a country, a set of (instantaneous) constraints ensure that production neither exceeds installed capacity, nor the geologically extractable reserve base, and that capacity can only be expanded gradually in line with historical and financial limits. For each OPEC producer, the pre-negotiated level of output, i.e., the quota, restricts output choice. It must be assumed that quotas are enforceable. That is, the negotiated production allocation is never exceeded although, a producer may choose to underproduce it.
Cartelization
Exogenous changes in the factor of cooperation among oil producers draw the conclusion that there is a strong incentive for OPEC to structure itself as an imperfect cartel because of: (i) heterogeneities within the cartel, (ii) the presence of the non-OPEC fringe such as Guyana, and (iii) an inelastic demand curve that makes it unlikely for OPEC to negotiate stringent production allocations.
The question of whether OPEC is a cartel or not has been the subject of several econometric studies. Unfortunately, no consistent answer arises from these exercises. Moreover, the focus should be on whether OPEC members have an incentive to cheat and not OPEC’s cartelization structure itself.
The question of what OPEC’s preferred degree of collusion is can be done using a tractable empirically calibrated global oil market. In reality, OPEC behaviour is of course influenced by several political and economic uncertainties that can be difficult to incorporate into a non-OPEC country’s production option. Nonetheless, this should not prevent Guyana from trying to understand OPEC behaviour on the basis of the best available data. Overwhelmingly it has been concluded that OPEC is a cartel that is characterized by imperfect collusion. In the words of Adelman (2002), OPEC is a clumsy cartel or in the words of Smith (2005) a bureaucratic syndicate.
Imperfect collusion arises because the cartel has to balance both internal and external interests. Balancing internal interests means that the cartel has to assign quotas in a manner that would not cause some members to exit the arrangement. This as is indicated; requires giving larger production quotas than would be implied by effective collusion, more especially to smaller producers. To balance external interests, OPEC has to ensure that its production is large enough so as to crowd out non-OPEC supply that thrives under situations of high prices. Effective collusion generates high prices. To achieve these prices, OPEC must cut output far beyond levels the fringe can offset; this increases the cartel’s gains. Nonetheless, because non-OPEC production also thrives under situations of high prices, perfect collusion of OPEC benefits the non-OPEC fringe more than it does OPEC. The optimal and most plausible strategy for OPEC, therefore, is one of keeping prices fairly low so as to discourage production, investment in capacity, and exploration in non-OPEC countries, but still high enough to provide positive benefits to its members from collusion. This strategy is captured in the imperfect cartelization arrangement (Okullo and Reynès 2016).
Effects of changes in the discount rate, income elasticity, changes in the growth rate of Gross Domestic Product (GDP), and energy efficiency on OPEC cooperation do not affect the conclusion that OPEC is an imperfect cartel. They nonetheless influence the time path of the cooperation between countries and companies. A higher (lower) discount rate leads to lower (higher) cooperation levels, a higher (lower) level of income elasticity leads to a higher (lower) levels of cooperation, a faster (slower) GDP growth rate implies higher (lower) levels of cooperation, and finally a higher (lower) level of energy efficiency results in lower (higher) levels of cooperation.
The effects on the cooperation level are ambiguous, however. Given the above, an important and yet general contribution is the introduction of a tractable model for new oil producers such as Guyana that can be used to study cartelization in cases where there is imperfect collusion between parties. Implied in the coefficient of cooperation is the extent to which producers scale back output in order to mark-up prices.
Therefore, such strategies can be seen in the International Energy Agency (IEA) May 2020 report which highlighted that global oil supply is set to fall by a spectacular 12 mb/d in May to a nine-year low of 88 mb/d, as the OPEC+ agreement takes effect and production declines elsewhere. For some OPEC countries, e.g. Saudi Arabia, Kuwait and the UAE, lower May production is from record highs in April. Led by the United States and Canada, April supplies from countries outside of the deal were already 3 mb/d lower than at the start of the year.
