The Optimal Price of OPEC’s Oil
The Optimal Price of OPEC’s Oil
Anas Alhajji, PhD
What is the optimal price of OPEC’s oil? Is the current price of OPEC basket the optimal price? What are the characteristics of the optimal price? What are the factors that determine the optimal price of oil? Who determines this optimal price? The answers to these questions are not only complex, but they are also subject to several intricate political, economic, social, technical, geological, and natural factors.
The objective of this article is not to determine the optimal price. Rather, it aspires to illustrate the difficulties in determining the optimal price and provide a general framework that helps develop the ideas and theories that determine the optimal price of oil at any given moment in time. It also intends to spark a debate among experts, policy makers, and the public on this important subject, which OPEC members have not been able to settle.
It is useful within this context to review the lessons that we have learned in the last 35 years, a period that has witnessed great price volatility. Within this period, the price of oil increased from around $3/b in the early 1970s to more than $40/b in the early 1980s. It decreased to a single digit in the mid 1980s only to increase to more than $40/b again after the Iraqi invasion of Kuwait. Prices declined to a single digit again in early 1999, only to exceed $55/b in June, 2005.
Lesson # 1: Oil is a Strategic Commodity
The first lesson is that oil is a strategic commodity. Global interdependence makes oil pricing a complex issue. Oil has been, and will continue to be, a foreign policy tool that dominates any negotiations, including trade talks that do not relate to oil. Oil prices have domestic and international political ramifications, which make OPEC pricing decisions very difficult to make. Therefore, the optimal price of oil from OPEC’s point of view is different from the optimal price outlined in economic theory. The optimal price in economic theory is the price that maximizes profit or revenues. But the price of oil from OPEC’s point of view includes the maximization of domestic and international security, of the benefits of international trade, and of political benefits in terms of political alliances and bargaining power. It might also maximize the overall wellbeing of the nation or its political elite. Raising oil prices drastically, for example, exposes the oil producing countries to occupation, retaliation, boycotts, and trade embargoes. It also tarnishes their reputation in the world and enhances the stereotypical image of these countries in the West. Therefore, the optimal price not only maximizes profits or revenues, but also maximizes several economic and non-economic benefits.
Lesson #2: Future Demand is a Function of Current Oil Prices
The second lesson is that future oil demand depends on current oil prices and their impact on the expectations of oil traders. An increase in oil prices reduces the demand for oil and consequently reduces OPEC revenues. A decrease in prices increases demand at such times OPEC members do not have the revenue to increase investment in additional capacity to meet increasing demand. Consequently, prices will rise sharply. Therefore, the optimal price of oil should stabilize the demand for oil and thus stabilize OPEC revenues.
Lesson #3: Non-OPEC Production is a Function of Oil Prices
The third lesson is that high oil prices stimulate non-OPEC production, almost immediately. While lower prices reduce non-OPEC production, the reduction does not happen immediately. Such variations guarantee continued fluctuation in the future and greater price volatility. The optimal price of oil from OPEC’s point of view should reduce fluctuations and price volatility by allowing non-OPEC supply to grow at a rate that guarantees price stability and sufficient world supply. The optimal price of oil should guarantee an adequate return on investment in non-OPEC countries. It should not be high enough to turn investment in non-OPEC countries into a bonanza for international oil companies, which will reduce OPEC’s market share and lower its revenues. The optimal price should guarantee a steady increase in OPEC’s market share, especially since experts believe that OPEC reserves will last longer than non-OPEC reserves.
Lesson #4: Oil Substitutes are a Function of Oil Prices
The fourth lesson is that there are many renewable and non-renewable substitutes for oil. Higher oil prices in the past have stimulated the use of such alternatives. They also stimulated the technology that reduced the costs of these alternatives. Conversely, low oil prices chocked the development of these alternatives and killed their technology in its infancy. The optimal price of oil should guarantee a fair share for oil in energy consumption. However, since oil is a non-renewable resource, the optimal price of oil should guarantee the availability of alternative resources and technology in the future. In other words, the optimal price would allow the development of alternative technology so the world can transit to the next energy source without catastrophic consequences.
Lesson #5: Energy Conservation is a Function of Oil Prices
The fifth lesson is that high oil prices encourages conservation and consequently lowers demand, which reduces OPEC revenues. Conservation that lowers living standards is futile. Low oil prices lead to wastage. The optimal price of oil encourages meaningful conservation that improves living standards through increased efficiency while it prevents wastage and conserves the oil resources.
Lesson #6: Technology is Irreversible.
The sixth lesson is that technology is irreversible. Charging a price higher than the optimal price would encourage substitution and conservation technology that will not be reversed when prices decline. New technologies that reduce the cost of offshore drilling, for example, will not disappear if prices decline to a single digit. Lower oil prices will not reverse efficient car engine technology or home insulation. The optimal price of oil should not increase to where it stimulates technology that leads to oil demand destruction.
The Optimal Price
The above lessons teach that the optimal oil price from OPEC’s point of view is the price that guarantees political stability in the oil producing areas, a fair share for oil in the world energy consumption, a continuous increase in OPEC’s market share with stable revenues that enable OPEC countries to achieve sustainable development, a steady, efficient, and market-based increase in alternative energy resources, and efficient use of oil resources.
The above definition is very broad to the extent that it raises more questions than answers. It does not help decision makers to price oil exports. Questions abound. What is political stability? What if political stability comes at the expense of democracy? What is the satisfactory percentage increase in OPEC’s market share? What are the factors that determine such an increase? What is the justification for such an increase? What is the optimal share of OPEC? The problem does not stop here. What is sustainable development? What is the percentage of dependence on oil that makes policy makers conclude that OPEC members no longer depend on oil as the main source of income? Is it 50 percent? 40 percent? Or 20 percent? Why?
The answer to these questions will help us define the optimal price of OPEC’s oil. Since it is difficult to answer such questions, OPEC, the oil ministries of OPEC members, and OPEC national oil companies should encourage and support their own national researchers, academics, writers, and philosophers to work to answer such questions. Adequate answers might require several years of research by experts from all fields.
Emphasizing the Political Dimension
Given the intricacies of the politics of OPEC members and the regions they are located in, the issue of the optimal price of oil is very complex. The optimal price should guarantee domestic and international political stability. A decrease in oil prices would prevent OPEC members from building the basic infrastructure needed for sustainable development. It would prevent these governments from providing basic services to their growing populations, lead to deterioration of the political and economic situation, encourage discontent, and contribute to political instability. Historical evidence illustrates that political and diplomatic relations among OPEC members were strained during periods of low oil prices. It also indicates that relations were also strained between OPEC and non-OPEC members. Conversely, high oil prices enabled some OPEC members to build large armies that contributed to political instability in the oil producing countries. The effect of the Iraq-Iran war and the Iraqi invasion of Kuwait still linger today.
While it is difficult to define the optimal price of oil from OPEC’s point of view, the lessons above allow us to set some parameters. We can conclude then that any price that is not optimal will lower the price of oil or OPEC’s market share. Either way, OPEC revenues decline. Economic, social, and political problems would follow. A non-optimal price always leads to problems. The existence of problems does not necessarily mean that the price of oil is not optimal. Several other factors beside the price of oil can cause problems. Dictatorship, human rights abuses, and irresponsible fiscal and monetary policies lead to discontent and political instability. Still, we can expect that if OPEC charges the optimal prices, many benefits will follow, not only for OPEC members but also for the rest of the world and future generations.