Lessons from a Failed Cartel

Nobody is celebrating the silver jubilee of the 1973 oil crisis which suddenly made the Organisation of Petroleum Exporting Countries (OPEC) rich beyond its wildest dreams. The event was then hailed as a historic watershed, for two reasons. First, developing countries thought they had found a new tool, cartelisation, that could make most of them rich at the expense of the West, transforming the global balance of power. Second, many people (including supposed experts) believed the world was about to run out of oil.

Both notions turned out to be ga-ga. From running out of oil, the wold today has such a glut that prices have plummeted. Oil sells in the Gulf today at $ 10 per barrel, exactly the same price as in late 1973.

Far from becoming leaders of a new economic paradigm, OPEC countries stand exposed as one more bunch of failed monopolists. The most successful developing countries are those who do not produce a drop of oil (Singapore, Taiwan, Hong Kong, Korea). They have proved that prosperity lies in increasing productivity, not cartelising commodities.

I re-print here an advertisement in the US press on January 21,1976. It pictures a dismayed baby with the caption, “By the time he’s out of 8th grade, America will be out of oil and gas.” Such alarmism used to be paraded daily as unimpeachable wisdom, the world over. The CIA believed it, and feared for the security of the US. I remember Indian journalists sneering at western diplomats, “You are now all finished.”

Not all were deceived. For instance The Economist, the British weekly, declared that OPEC, like all cartels, would eventually collapse, so the rise in oil price would be temporary. Indians shrugged this aside as the ranting of a market fundamentalist.

Now, common sense should tell you that if the price of a commodity goes up, this will (a) induce consumers to buy less (b) encourage fresh investment in oil exploration and production (c) induce R&D to conserve energy and find substitutes for oil. Thus, any cartel actually digs its own grave by rigging up prices. This yields big immediate gains, but soon induces a fall in demand, fresh investment by rivals, and a search for conservation/substitutes that eventually produces a glut again.

However, in 1973, self-styled experts said oil was a special commodity outside the laws of economics; that the West (and indeed all modem economies) were so deeply addicted to oil that they could not shake off the habit. So demand for oil would stay high, shortages would worsen, and soon the world would run out of oil.

Why did intelligent people talk rubbish for so long? Because for several years after 1973 oil prices stayed high. This was made possible by special (but ultimately unsustainable) sacrifices by Saudi Arabia.

A cartel works by cutting production, and so assigns a production quota to each member. But when demand weakens, this most affects its weaker members. These are tempted to cheat and exceed their quota, eroding the cartel.

Despite some cheating, OPEC succeeded for years. With huge reserves, but a small population, Saudi Arabia could afford to slash production and yet meet its needs. So it sacrificed its own revenue to maintain that of others. Saudi production cuts kept OPEC in business when demand fell after the 1973 price hike.

Unwittingly, OPEC was helped by the refusal of western governments to pass on the price hike to their citizens. Some cut taxes on petroleum products to cushion the price hike. This, however, reduced the incentive of consumers to conserve energy. Many countries (including the supposedly free-market USA) imposed price controls on domestic oil and gas. Naturally, demand did not dampen much. Thus, a combination of Saudi production cuts and western foolishness kept OPEC going.

This foolishness ended when President Reagan came to power and decontrolled US oil prices. US imports sank 30 per cent in a single year. The subsequent global recession further shrank world demand.

For the first time, OPEC came under real pressure. It got temporary relief from the Iran-Iraq war which destroyed much production in the Gulf, causing the second oil shock (prices shot up to $ 34 per barrel). But the writing was on the wall. Many smaller OPEC members (like Mexico, Indonesia and Algeria) had borrowed merrily against future oil revenue, and in 1982 found they could no longer service this debt.

The temptation to cheat on quotas increased. Finally Saudi Arabia got fed up of sacrificing itself for the others, and increased production in 1985. The price of oil crashed, and the cartel became a shadow of its former self.

Why did so many western experts fail to see what The Economist couldf Partly because of juvenile environmentalism, predicting that consumerism would empty the world’s natural resources. This view failed to appreciate that, in a market economy, scarcity itself induces enough conservation and exploration to keep consumption at a fraction of total mineral reserves.

OPEC spurred research in energy conservation, so today all machines and vehicles are incredible energy-efficient compared with 1973. R&D has made possible exploration in ever-deeper waters. In 1973, world oil reserves equalled 20 years’ consumption. More than 20 years have passed, yet world reserves now exceed 30 years of consumption.

It has always been thus. In 1917, the US interior department reported that only 27 years of oil remained in that country. In 1920, the US Geological Survey reported that only four years were left. The end did not come in 1924: Reserves had by then gone up to six years’ requirements.

Exploration constantly yielded new oil reserves that exceeded consumption. By 1975, thef US had enough for 12 years more. We are now in 1998, and the supposed day of doom keeps receding. New deep-sea drilling technology is opening up for exploration areas bigger than the entire land mass of the world.

Why were developing countries myopic enough to think OPEC had opened the way to the promised land? Many developing countries are oil importers, and were hit hard by OPEC’s cartelisation. Yet they supported OPEC to the hilt. They had two sets of reasons. One group of developing countries consisted of commodity exporters, who hoped they too could cartelise their way to riches (some saw it as divine retribution for colonialism). The second group (including India) hoped OPBC would act as a Third World leader to extract trade and aid concessions from the West.

The common refrain in all this was, how do we get rich quickly without effort? None of these groups saw increased productivity as the way to becoming rich. All preferred to use arm-twisting of some sort to get rich without becoming more productive. They seriously thought wealth-creation was a wrestling match.

Today we know otherwise. Muscle may work in some circumstances, but prosperity depends above all on raising skills and productivity. Real wealth lies not in minerals, but human capabilities. Amartya Sen has long stressed this point, and today we declare him a visionary genius. But in the 1970s, we sang a different tune as we bowed and scraped before Saudi Arabia. I remember PC Alexander briefing journalists at the Cancun economic summit in 1981. “We are following Saudi Arabia’s line; may I say, shamelessly following its line.” Not Amartya Sen’s line, of course.

The silver jubilees of failures are usually ignored. Yet we have as much to learn from failures as successes. The lesson of 1973 is that cartelisation will not make you prosperous even if you dress it up in labels like “revenge for colonial exploitation” or “justice for commodity producers”. Listen instead to Lee Kwan Yew, who took Singapore’s GNP per capita to $ 26,000, against Saudi Arabia’s $ 7,000. “The world does not owe you a living. Your hard work, your innovative approach, your high rate of savings, and above all your productivity performance can alone ensure prosperity.”

What do you think?