Explained: What Is OPEC And How It Decides The Prices Of Crude Oil

Organization of Petroleum Exporting Countries (OPEC) is an intergovernmental group of 13 petroleum-producing countries. With its headquarters in Vienna, OPEC countries produce about two-fifths of the world¡¯s crude oil.

At the same time, they possess more than 80% of the world¡¯s total crude oil reserves. In 2020, they produced about 37% of the world¡¯s crude oil.

These numbers are enough for one to understand the influence OPEC countries have on oil production and hence on oil prices.

Reuters

Genesis of OPEC

Prior to the formation of OPEC much control over the oil market was dominated by a number of multinational companies called ¡®Seven Sister¡¯.

These were the companies that managed the production of crude oil in most parts of the world including many parts of the middle east. The companies control of oil in the middle east was due to British influence/ control over the region post-world War 1.

After the second world war, countries in the middle east began to regain their control, simultaneously the oil production in these countries came under state control. The Multinational Oil Companies still exerted control over the oil market at the time.

In the late 1950s and early 1960s, these oil companies reduced the oil prices for middle east countries and Venezuela.

Baghdad Conference: A new beginning

To counter these actions by oil companies, the representatives of Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela met at the Baghdad Conference held on 10-14 September 1960.

This happened despite strong opposition from the west particularly the US. the main objective of this conference was to secure the best prices for the oil produced within these countries.

This conference became the foundation of what is today known as OPEC. Later many countries joined and left the group.

According to the OPEC website, its mission is, ¡°To coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil market in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.¡±

The OPEC has and exerts great influence on the prices of crude oil. They have done that many times in history.

Demand, supply and price control

The mechanism by which they control prices of crude oil is the basic economic concept of supply and demand. Like almost all products, the price of crude oil is determined by its supply and demand in the market.

The equilibrium between the supply and demand of petroleum determines its price. Hence, only the change in demand and/or supply can alter the prices in a free market.

Since OPEC as producers have no influence over the demand for petroleum they tend to change its supply in order to influence the price.

They simply increase or decrease the supply of crude oil to change the prices.

For example, if under normal demand for crude oil, OPEC countries decide to increase the production of crude oil, this will result in more supply of crude oil in the market.

With no change in the demand, more supply would mean a decrease in the price of crude oil. In the same way, if it decides to decrease the supply, there would be less crude oil to buy from the market resulting in an increase in the prices of oil.

In order to keep prices of the oil stable, OPEC countries usually maintain a quota of oil supply. OPEC countries together decide the amount of oil to be produced by them. while keeping in mind the demand for oil in the market, OPEC decides the amount of crude to be produced by member countries.

Speculation plays a key role

Another mechanism of pricing is the future supply based on some speculations. The prices in the market are also influenced by speculation demand and speculation supply.

These simply are the supply and demand based on speculations of suppliers and consumers.

For example, if the producer thinks that the demand for a product might increase in future, he or she might increase the production of that product, influencing the price.

In the same way, OPEC might alter its supply based on speculations hence affecting the price.

Influence on oil market

OPEC and its member countries on multiple occasions have influenced the oil market due to different reasons.

Sometimes the reason was simply profit, at times to adjust according to the changing financial and market conditions and many times politics. The most prominent example of oil politics is the 1973 oil embargo.

The Arab OPEC countries along with other non-OPEC Arab countries under the banner of OPEAC (Organization of Petroleum Exporting Arab Countries) announced an oil embargo on the countries supporting Isreal during Yom Kippur War. During the war countries especially the US helped Isreal, particularly with weapons.

This really angered the Arab countries who in response proclaim an embargo against these countries. These countries included the US, Canada, UK, Japan among others.

By the end of the embargo, the prices of crude oil had risen by nearly 300%. Another example of oil politics was the recent 2020 Saudi-Russia oil price war. This was after OPEC wanted Russia to reduce its oil production to maintain the oil prices. After Russia refused to corporate.

Saudi Arabia increased its production reducing the oil prices by more than 30%.

In today¡¯s world when most of the industries, factories, and most individuals are heavily dependent on petroleum products, OPEC as an organization can be instrumental in ensuring a stable supply of crude oil in the market.