The equilibrium price range of oil

Ener,+y Pnlk~,

Vol 23, No. I. pp. 3.549, 1995 Ekwer Science Ltd Printed m Great Britain 0301421595 $10.00 + 0.w

The equilibrium price range of oil Economics, politics and uncertainty in the formation of oil prices

Pierre-No61 Giraud CERNAIEcole des Mines de Paris, 60 Bd Saint Michel, 75006 Paris, France.

This paper attempts to clarify the articulation between economic and political factors in the formation of petroleum prices. It begins with defining the political factors. Then it gives a definition of the ‘dynamic equilibrium price’ of a mineral commodity market. The essential point is that when actors control significant low cost reserves and will not or cannot adopt behaviour of a ‘substantial economic rationality’ then the economic analysis does not allow a unique dynamic equilibrium price to be determined. However, it does permit definition of an equilibrium price range within which political preferences may be expressed. Finally, the paper draws some conclusions on what could be discussed within the scope of a new oil producer+onsumer dialogue. Keywords:

Oil; Market; Politics

The interweaving of political and economic factors in the historical evolution of oil prices was and remains obvious to almost all experts (cf. for example, Yamani, 1992). However, analyses differ greatly in their interpretation of the exact nature of this interweaving and the relative importance of the two factors. Since the mid1980s there has been a tendency to stress the role of economic factors and to reinterpret the recent history of petroleum in this direction. For example, during the 1970s OPEC was overwhelmingly considered a politically driven cartel capable of fixing prices at any level below those of substitutable energy resources. Today, certain experts affirm that OPEC never actually had real market control. This thesis of the predominance of economic factors is supported by the governments of those countries which are reluctant to take part in the dialogue initiative between oil consumers and producers started by Venezuela and France in 199 1. If need be, these govemments are willing to discuss ways of improving the functioning of markets, but consider any discussion of price levels to be useless, and even harmful.

At the other extreme, some experts such as Professor Mabro (1991a), while recognizing that day to day prices are fixed by ‘free’ markets and therefore fluctuate like other commodities, consider that these fluctuations remain near average levels characteristic of ‘episodes’ in petroleum history. These episodes are separated by crises. Following a crisis, according to Mabro, it is essentially political factors which determine the new level of relative stability, this being within a large range of possible levels. This paper attempts to clarify the articulation between economic and political factors in the formation of petroleum prices. We must begin by defining the political factors. The first section is therefore devoted to definitions, something which, as a matter of curiosity, is rarely done in the literature. The generally implicit understanding of ‘economic and political factors’ is obviously a source of confusion. The second section gives a definition of the ‘dynamic equilibrium price’ of a mineral commodity market. The essential point is that when actors control significant low cost reserves (which is the case in the petroleum industry), and these actors

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The equilibriumprice range of oil: P-N Giraud will not or cannot adopt behaviour corresponding to ‘substantial economic rationality’ (Simon, 1978), then economic analysis does not allow a unique dynamic equilibrium price to be determined. However, it does permit definition of an equilibrium price range within which political preferences may be expressed. The third section draws from the preceding discussion the definition of a number of oil price thresholds and ranges which allow the links between economic and political factors in oil price formation to be clarified. The fourth section verifies that this model permits an interpretation of the evolution of oil prices since the early 1970s. The fifth draws some conclusions on topics that could be discussed under the aegis of a new oil producer-consumer dialogue.

Economic and political decisions The fact that a large proportion of international petroleum flows comes from the Middle East and the CIS, which are considered politically unstable (for many decades for the first, and probably a number of years to come for both) obviously makes the petroleum market particularly vulnerable to events affecting these areas, such as civil strife and wars between nations. Such events may be qualified as ‘political’ without highlighting semantic difficulties, even if important economic interests intervene. What needs to be clarified is the definition of economic and political in the ‘normal’ functioning of oil markets, ie in the decisions made by industrial actors and governments in terms of investment, the level of utilization of production capacities, taxes, regulations on production, transport, consumption etc. Economic decisions It must be emphasized that the fact that a market has a non-competitive structure does not necessarily imply that there is room for political decisions. When one actor holds market power, the exercise of this power in its own best economic interests may not be considered political. A group of dominant producers, confronted with the competition of a fringe of ‘price takers’, which fixes a price trajectory aimed at maximizing the sum of its discounted revenues, is thus acting in an economic manner. If this was the case with OPEC, political factors would not determine oil prices, except in periods of crisis brought about by events such as those mentioned above. Likewise, governments which tax the consumption of certain petroleum products behave in an economic manner, exploiting a weak long-term price elasticity of demand and therefore depriving governments of producing nations of a rent which they themselves could earn if they were to organize themselves in such a way as to exert control over the market. Even the tax proposed by the EC Commission on fossil fuels, which is currently

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considered by OPEC as a hostile ‘political’ measure (ie without economic justification), could be defined as an economic decision if it could be proved that such a tax was the most efficient (meaning the least costly collectively) means of combating the consequences of an increase in the greenhouse effect, and that the cost of the tax was less than the cost of the greenhouse effect which it seeks to avoid (which assumes that it is feasible to give a monetary value to this kind of externality). In short, the decisions which are unquestionably economic are those that are ‘substantially rational’. According to Simon (1978), a particular entity behaves in a substantially rational manner when it classifies all future possible states of the world according to its preferential system and makes decisions leading to the most favourable situation for itself, taking into account the behaviour of other actors. This, of course, assumes that it is possible to know the future states of the world (or at least attribute probabilities) as well as the relations between its decisions, those of other actors, and these future states. This also assumes that an actor can always compare two separate states of the world; in other words, the variations of these parameters that define these states must be commensurable. Within these hypotheses, a utility function may be defined for each actor in which the variables are made up of all or a portion of these parameters. Thus, the decisions made by the actors result in a maximization under constraints of their utility functions.’ In other words, whatever the market structure and whatever the initial distribution of property rights on the factors of production, if all the decisions made by the actors concerned are guided by a substantial rationality, then purely economic models could be designed which would determine, for example, the price of oil. Having defined economic decisions, we must now look at other types of decision, those which are either based on redistribution (outside the market) of property rights, particularly those rights concerning the factors of production, or which are not substantially rational. This set is itself divided into two. Either the actors do not have the information or the capacity or the time to make the necessary calculations or, more basically, it is not possible to construct a utility function for the actors, which is the case when the parameters that determine their choices are not commensurable.* ‘It should be pointed out that for a producer, maximization of a utility function does not necessarily mean maximization of revenues or profits, which are only isolated cases. The objective of a producer may be, for example, to obtain a given revenue Its utility will then increase as long as it is not reached, then decrease if it passes the desired level. As will be seen, economic models of the petroleum market were established on this kind of hypothesis. Cf Cremer and Salehi-Isfahani (1989). *In other words when the actor is faced with multicriteria choices.

The equilibrium price range

Three types of political decision The redistribution (outside the market) of property rights. For economic models, initial property rights are considered exogenous. The functioning of markets itself continuously modifies the distribution of property, naturally including rights over production factors. Economics, however, does not offer an indication of whether an initial distribution is superior to another, except when comparing the utilities of two actors, which in general economics refuses to do. Decisions on modifications to property rights outside the market (meaning those decisions which do not result in a freely and reciprocally agreed market transaction) cannot be considered economic. When a particular state makes this kind of decision, it can be considered as political in the first meaning of the term. The nationalization of private assets is an example. Procedural rationality. When the future is uncertain, ie when the future states of the world are impossible to know with precision, or when they are known but it is impossible to attribute probabilities, the maximization of a utility function is impossible (in theory). In practice, this is equally the case when an organization does not have the time or the means of information and calculation to carry out the maximization. The organization therefore behaves according to a rationality that Herbert Simon has described as ‘procedural’. On the one hand, decisions are guided less by objectives of utility maximization (revenues, profits etc) than by objectives aimed at attaining a ‘satisfactory’ level of utility. On the other hand, the decisions made depend on the organization itself: its acquired experience and its ‘routine’ internal functioning. Theorists of the ‘evolutionist’ approaches have, however, attempted to model this kind of behaviour. In these models, the agents do not optimize globally but rather locally, meaning they make decisions ‘near’ to what they have already done and know how to do. This leads to phenomena of ‘path dependency’ (the paths followed always depend on the past) which, if not calculable by an algorithm of optimization, can at least be simulated. Despite these commendable theoretical efforts, this kind of decision may be considered as partly political in nature, although in a different way from the preceding example. In such a case the history of an organization (and particularly the conflicts and crises it has weathered), means that the decisions it takes may deviate from the strictly rational in ways that cannot be predicted or modelled. Societal value systems exercise a similar influence. In an urgent crisis situation it is not possible to weigh the pros and cons of each possible decision: an organization acts by reflex, and its reflexes are conditioned by its history. In this conception, however, the organization is also a place of learning. When an organization finds itself in a

ofoil: P-N Giraud

completely new environment, its rationality will at first lead it to take decisions which are possibly very different from those which would have allowed it to reach its economic optimum. Each decision is therefore a sort of gamble, testing the functioning of the real world, particularly the behaviour of other actors. If the environment stabilizes, decisions may then converge, thanks to the process of learning, in the direction of economic rationality, with the importance of political influences (in the second meaning defined here) diminishing. The non-monetary objectives. The third category of political decisions stems from a substantial rationality (relating the means and the clearly defined objectives) but one in which the objectives may not be expressed in monetary terms, and are not therefore commensurable with economic objectives. Such, for example, is the case of supply security for each oil importing nation. It is conceivable that a government should calculate the ‘optimal’ level of dependence regarding its oil imports as a function of various crisis scenarios and as a function of the evaluation of all the economic consequences of these scenarios. Such attempts have been made, but without great success. In practice, it becomes obvious that the definition of the desired level of dependency evades monetary evaluation. In other words, the government of an importing nation cannot calculate trade offs such as less security for more growth or vice versa. Another interesting example, because it has been used in the construction of ‘economic’ models of the petroleum market,” is the hypothesis that certain oil producing states limit their objectives of gain from petroleum revenues to their ‘absorption capacity’. Everything depends on what indeed determines this ‘absorption capacity’. If we assume that the producing nations limit their revenues (and therefore their production at a given price) not only because their internal investment capacity is limited but also because they give a high-risk coefficient to external financial investment, then this is an economic decision. The desired level of revenue may in this case be calculated as a function of well defined and monetarily assessable parameters. However, this hypothesis is very fragile, because what limits internal investment capacity, particularly in the long term, remains uknown. As many studies have shown, a better hypothesis is that the petroleum rent has internal and external politically destabilizing effects.4 Under these conditions, the rent is not only a condition of governments maintaining control but also a permanent threat to the stability of this control. The ‘desired’ level of rent by these governments, which is not necessarily the maximum level that would be economically ‘Cf. for example Cremer and Salehi-Isfahani 4For a recent analysis see Bomsel (1992).

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accessible over the long term, is therefore fundamentally determined by objectives of political survival in the short or even very short term. The various factors that determine this level are complex and many are not assessable monetarily: the volume of rent to be redistributed within and outside the country, the required armament level etc. The difference between the two hypotheses is essential, since in the first case, there is an economic rationality, therefore predictable behaviour, and in the second case, there are important objectives that may be significantly varied over time as a function of the judgement of political leaders, without the economic parameters changing.5 This third kind of decision may be considered as political in the wider meaning of the word, since the objectives pursued are to do with the security of states and the stability of governments. The petroleum industry: a high density of political decisions In our opinion, it is unquestionable that political decisions, in one of the three definitions (or a combination of the three), have been and are being made within the petroleum industry. Obviously, some decisions in the real world are always political, whatever the industry. Nevertheless, there are industries where the hypothesis of the economic behaviour (substantially rational) of nearly satisfactory approximation to all actors is a reality. Economic analysis may then be deployed: it models the relationships between behaviour and price and production trends, taking into account structural considerations (long- and short-term price elasticity of supply and demand, cost structures, number and concentration of actors etc). Once the hypotheses have been stated, the result is unique; the economic models are deterministic.6 In our opinion, however, the petroleum industry is characterized by a high density of political decision making, although not necessarily a constant one. The reason for this is that of all the actors (firms, traders, speculators, governments etc) which intervene in the petroleum industry, only for private companies (primarily Western firm~)~ traders and speculators does ‘We do not mean that presently, for example, the actual level of the rents earned by the governments in the Gulf area is considered as satisfactory. But since the hypothesis of a limitation of the desired rent has been introduced into the economic literature, we must point out that such behaviour would certainly be political, independently of whether this type of behaviour has been observed in the past or could be adopted in the future or not. 6We do not ignore the problems of ‘dynamic inconsistency’ where behaviour with rational anticipations may sometimes bring about an indeterminate future. The solution may therefore be indefinite or unstable. However, by modifying the hypotheses, the effort of economists may get rid of these uncertainties. Cf. for example, Newbery (1981). ‘The nationalized companies of certain producing countries in the Third World may be added here, including certain small producers of OPEC which act as simple price takers, meaning that they try to maximize their production at the market price.

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substantial economic rationality offer a reasonable approximation to their behaviour; they are subject to the constraint of the capital valorization. Furthermore, this first group now controls only a very small portion of the world crude production. Consequently, the various models of the petroleum industry which have been proposed over the last 20 years (cartel models, Stackelberg’s oligopoly, competitive models with minimum revenue objectives etc) and which, by nature, assume a substantial economic rationality by all actors, are far from being satisfactory.8 Using our typology of political decisions, we can characterize recent petroleum history in the following way. The petroleum industry first experienced a number of political decisions, in the first meaning of the word, of major importance at the beginning of the 1970s: the nationalization of reserves in OPEC nations.’ In certain countries, particularly those of the Persian Gulf, these reserves are the most abundant and least costly in the world. As will be shown later, it is clear that decisions about these reserves are critical to the long-term equilibrium of the petroleum market. Fundamental property rights have thus changed hands. As a consequence, new actors have appeared in the industry, with a specific procedural rationality: OPEC nations and OPEC itself. These new actors have had to learn how to use their new rights over the years. In particular, the learning has been about the reactions of world demand and production outside OPEC to oil prices. The 1970s and 1980s were therefore very intense periods of political decision making of the first and second kind. In addition, they also saw the third type of political decision: the implementation of policies on supply security and the voluntarist development of alternative energy sources in some importing nations, as well as the growing overlap, arising from the influx of petroleum rents in the Middle East, between oil price policies and conflicts within the region. As far as OPEC nations are concerned, certain experts today hypothesize that the intensity of political decisions began to decrease at the end of the 1980s. This would be mainly the result of the experience acquired over the last 20 years by the oil exporting nations of the Middle East. This learning process would have led to the weakening and the loss of specificity of procedural rationality by these actors and thus to decisions which increasingly approximated to substantial economic rationality. lo We sCf. for example Gately (1984), and Griffin (1985) for critical analyses and tests of these models. r’We will not go into a precise legal discussion at this point. What is important is that the power of decision-making concerning exploration, development and production has changed hands. ‘OFor proof of this economic maturity, these experts highlight, for example, an attitude more open to cooperation with Western oil companies.

The equilibrium price range

ofoil: P-N Giraud

attempt to determine ‘the’ optimal trajectory were useless, economic analysis could still provide a definition of the manoeuvring space within which the changing political preferences may be implemented. We will show this by first defining the notion of a dynamic equilibrium price in a mineral commodity market.

, PS

~PM--------__-__~~~

The dynamic equilibrium price Definition of the dynamic equilibrium price

i--------I I

Consumption

I

*

TO

Te

Growth Figure

rate of capacities

and consumption

1 The dynamic equilibrium

price

in

a

competitive

situation

do not deny, as we will see below, the reality of a learning process. But first we believe that it is far from having yielded sufficient information on, for example, the price elasticities of world oil consumption and of non-OPEC production, to allow OPEC, or the core of it, to behave as a profit maximizer. At best, it is a very ‘poorly informed maximizer’, as Gately has suggested (Gately 1984). Political factors of the second type (arising from procedural rationalities) therefore remain. Second, the Middle East region is far from political stability. Among other factors, including the absence of resolution to the Palestinian question, the destabilizing political effects of the high concentration of petroleum rents in the hands of a few governments will continue. It is therefore also certain that political decisions of the third kind (promoting government stability and state security) will continue to influence the petroleum industry. Nevertheless, my purpose in this paper is not to assess precisely the relative importance of political and economic factors. It was first to offer a rigorous definition of the political factors and to suggest a typology. It is now to assess, if we assume a remaining significant (although not precisely known) influence of these factors, what can be stated from an economic point of view. What can an economic analysis achieve?

Once significant political factors intervene, is economic analysis useless, and is it necessary to resign oneself, as some have, to the fact that the price of oil is fundamentally politically determined? In our opinion it is not. Economic analysis may, for example, determine whether or not there are price paths which actors can decide on, even though they do not maximize revenues. Even if any

We must first define the dynamic equilibrium price for a mineral commodity market as one which equilibrates the growth rates of capacity and of consumption. A mineral commodity market can only be stable if there is a continuous ‘cushion’ of surplus production capacity in relation to the average consumption. This cushion is necessary in order to absorb incidental fluctuations in demand (consumption plus the demand for stocks) and the possible failures of some production capacity. In its absence, the equilibrium between supply and demand could only be re-established by large price fluctuations, given the weak short-term price elasticity of production as much as consumption. Conversely, this cushion must not be too significant because excessive surplus capacity may encourage price wars.’ ’ As a result, the dynamic equilibrium price of a market is one which maintains a satisfactory cushion. From an initial equilibrium situation, it is therefore one which creates growth in capacity at the same rate as growth consumption. This dynamic equilibrium price results in the intersecting of a dynamic curve of consumption with a dynamic curve of capacities. These curves are formed as shown in Figure 1. The dynamic consumption curve. Let us assume a price level which remains stable over time. Let us also assume that the price of different substitutes are equally stable and that there is regular economic growth (a constant growth rate). It may be hypothesized that under these conditions, the consumption growth rate will remain stable over a number of years. Indeed, if we consider world consumption, it can be reasonably assumed that the long-term revenue elasticities and the long-term price elasticities are relatively stable over time.‘* A dynamic consumption curve may be defined which provides, for each price level assumed to be stable, the growth rate of global consumption. For petroleum, however, it is not possible to build a hypothesis on the “In the history of petroleum, various price shocks were experienced when the cushion was either insufficient or excessive. In 1979 and 1980, the surplus capacity, taking into account the demand of stocks brought on by the Iranian revolution followed by the Iraq-Iran war, had disappeared. In 1986, the surplus capacity had become too large. ‘% this non-technical paper, we will not further discuss this hypothesis, which may be put forward elsewhere; cf. note 13.

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The equilibrium price range of oil: P-N Giraud

r2

TO

‘I1

Figure 2 Dynamic equilibrium of the oil market” a70 = technical rate of decrease in world capacity if no development

is undertaken, (pl, ~1) - @2, 72): ranges for prices and equilibrium growth rates in which the political preferences of the core may be expressed.

independence of world economic growth and the price of oil; but this is not an obstacle in the construction of the curve. All factors, other than the price of oil, determining world growth, as well as the price of all petroleum substitutes, is assumed constant; the curve provides the growth rate of world petroleum consumption at each oil price level. This curve is situated below a ceiling (depending on the price of substitutes) which is the price at which petroleum would lose all its markets. This curve bends and moves vertically when the price of substitutes changes. It bends and moves horizontally when the parameters (other than the price of oil) determining the world economic growth rate vary. The dynamic capacity curve. Let us assume the price to be stable over time. Let us also assume that the actors holding proven petroleum reserves act in the following manner. They systematically develop all the reserves on which production is profitable at this price. Under these conditions, taking into account the various delays when developing these projects and their differing degrees of maturity, a hypothesis may be put forward that capacity will grow, at first estimation, at a constant rate over several years. Its subsequent evolution will depend on the results of the exploration effort. If newly discovered reserves have a lower development cost, the growth rate of capacity at the initial price will, everything else being equal, increase. If their development costs are higher, they will only be exploited after the exhaustion of lesser cost reserves, and the capacity growth rate, for a given price, will slow down at a future time. A dynamic curve of the capacity rate of growth may thus be built for a

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competitive situation, meaning that it is the best reserves which will systematically be the first to be developed. This curve therefore associates an increased rate of net capacity (after deducting the rate of exhaustion of exploited reserves) to a price level which we hypothesize will remain stable at least over a few years.13 This curve is limited to the left portion of the graph by the price pm below which no new development is profitable. In this case, the capacity decreases to the rate demanded by the effective management of the only reserves being exploited, that is to say between 6 and 10% per year. Inversely, beyond a certain price level, PM, the hypothesis may no longer be made of a steady development rate of capacity; indeed, this capacity would explode if all profitable deposits at this price were systematically exploited, and the curve could no longer be plotted, at least not in a two-dimensional graph, as shown in order to simplify the problem.14 If we assume that, in order to balance the exhaustion of existing deposits and the increase in demand, the proven reserves are systematically exploited by starting with those whose development costs are the lowest (whatever their geographical location), there is only one equilibrium level which equals the consumption growth rate and the net capacity growth rate. The case of the petroleum industry. For a long time now, many oil experts have defended the idea that if all necessary developments for the replacement of exhausted fields and for increasing demand had been achieved in only the lowest cost zones, the geographical location of the world petroleum production would be completely different from what it is today, and the oil price would have evolved very differently. Economic logic of the optimal allocation of resources, which should be promoted by the competitive functioning of industry, would lead to a situation where all the increases in capacity would be made in the areas with the lowest production costs, ie the Middle East. The “The hypothesis of stable growth rates of capacities at a given price is more of a problem than for consumption; however, it may be adopted as above in order to simplify the reasoning. 14Amore in-depth construction of the concept of a dynamic equilibrium price allows us to put forward the simplifying hypothesis that at a given price level (assumed stable) there are corresponding constant growth rates over several years. In particular, this allows us to take into account various factors such as the acceleration of the development of capacities or substitutions at a given price, and technological developments, which modify production and utilization costs, and finally, the results of exploration expenditures which may modify the curve of development costs of proven reserves. In order to achieve this, it is a question of adding the dimension of time to the two dimensions of price and growth rate. The production and consumption curves then become surfaces. The level of the dynamic equilibrium price becomes a path of equilibrium price which links the equilibrium price, pe, the equilibrium growth rate of consumption capacities, re and time, f, by a function p @e(r), te(t), t) = 0.

The equilibrium price range of oil: P-N Giraud

Persian Gulf countries - Saudi Arabia, Kuwait, the United Arab Emirates, Iran, Iraq - whose national oil companies are completely state owned, could indeed, if their govemments so desired, collectively satisfy any increase in the world petroleum demands for the decades to come. With a few exceptions (low cost reserves outside this area), it is therefore these reserves and only these reserves on which the dynamic capacity curve in a competitive situation of industry can be plotted: curve 01 (Figure 2). But the state owned companies of these countries do not act in this way. In the petroleum industry, we must therefore distinguish between two groups of actors which hold the power to increase capacity, following the traditional model of ‘dominating firms with a competing fringe’. The first regroups all actors which, as far as the increases in capacity are concerned (by the exploration and the development of oil fields), behave as price takers according to the essentially economic criterion of the maximization of their revenues.15 They constitute the fringe. The second group is made up of those that, for whatever reasons, do not develop their capacity as much as would be profitable at a given price. These constitute the core and today include the oil production companies of Middle East nations, and possibly a few others from OPEC (Libya, for example). Those which make up the fringe include the international companies, most of the public companies of the OPEC countries with huge financial needs, and public companies of other producing nationsI On the basis of its reserves only, the dynamic capacity supply curve of the fringe may be plotted: curve 02 (Figure 2). The significance of this curve is as follows. For each price level, it shows the net evolution of world capacity if the development of new capacity took place only within the fringe. Whatever the price level, the core producers whose development costs are lower than those of the fringe may, if they wish, add capacity to that which is developed spontaneously by the fringe. The space between 02 and 01 therefore determines the exact degrees of freedom of the core producers in terms of capacity expansion. These two curves define a range for the dynamic equilibrium price, pl - p2, corresponding to equilibrium rates of growth of the consumption and net capacities, 71--72. Obviously, the dynamic equilibrium point (p2, 72) where the producers of the core carry out no development and therefore see their production fall, has little chance of being considered satisfactory. Conversely, it is well known that the core producers do t5At this point, there is the question of whether or not they consider their reserves as a stock or a flow, or in other words whether their development behaviour vis-ci-vis these reserves will include an optimization over time according to the rules highlighted by Hotelling. Although technically interesting, this problem is of secondary importance. ‘@Ihe CIS needs a special analysis which we will not go into here.

not have a development policy which would lead to the equilibrium point @l, 71). This policy would, in fact, by definition, reduce their revenues to a normal profit (including the usual risk premiums associated with the petroleum industry) on the capital invested by abolishing all rents (other than very limited differential rents resulting from the cost differences between the lowcost deposits). It is therefore unlikely that this would be judged as satisfactory, independently of any other consideration. How can we explain the real behaviour of these countries, which is possibly variable over time, and obviously situated between the two extremes? In so-called economic models of ‘oligopolies with a competitive fringe’, the problem may be resolved, at least in theory, by attributing to the core a certain kind of substantial economic rationality such as collectively maximizing their actualized revenues or maintaining a constant level of revenue over time. However, in order to adopt such behaviour, it would be necessary for the core producers to know the dynamic consumption curve and the dynamic capacity curve of the fringe.” If they do not know these, their behaviour will be guided by a procedural rationality and will therefore be influenced by political factors, in the second meaning that we gave to this term. In addition, it would be necessary to assume that they did not have other objectives of political nature in the third meaning mentioned above (objectives not monetarily assessable), which is obviously not the case in the Middle East. Whatever the reasons and whatever their real behaviour, the essential point of this analysis remains as follows. In a mineral commodity market, if a group of producers with large low cost reserves does not act according to a substantial economic rationality, economic analysis does not allow a unique dynamic equilibrium price to be determined. However, it does permit a definition of an equilibrium price range within which political preferences may be expressed. On this basis, it is possible to analyse the behaviour of the core producers and the recent dynamics of the world petroleum industry more precisely.

Thresholds and ranges for oil prices In this section, the objective is to determine the thresholds and range of oil prices which allow the interplay of “In the case of petroleum, it should be pointed out that its consumption curve does not depend solely on world growth, or the price of oil or its substitutes. Thus the decisions of consuming countries in terms of taxes on petroleum products shift this curve, all other things being equal. It is obviously for this reason that OPEC is against any tax projects aimed at combating the greenhouse effect. Likewise, the capacity supply curve of the fringe could be significantly modified by decisions, among the concerned countries, to ease taxes on petroleum production.

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The equilibrium price range of oil: P-N Giraud

The stability over the short requires the implementation swing capacity sufficient

term of

Zone 3: inevitable reduction in the demand addressed at the core

f

Zone

of natural instability

which may only be maintained if prices are stabilized within the dynamic equilibrium zone , Within this zone, political preferences may be expressed, without destabilizing the market

Floor

price

Maximum equilibrium price tolerable by the core

25

Zone 2: zone of the dynamic equilibrium prices

Minimum equilibrium price = Price in a strictly competitive situation

zone

Zone 1: oil shock inevitable Market

prices

Dynamic

equilibrium

prices

Figure 3 Thresholds and ranges of petroleum prices economic and political factors in the formation to be elucidated.

of prices

Market prices Within oil markets, prices are fixed daily by interaction between the supply and demand of stocks. These stock supplies and demands are determined by the gaps between the actual stocks held by producers and consumers (as well as traders), which change as a function of the flows of production and consumption, and the stocks desired by these very actors, which themselves depend on technical parameters, and even crucially on their anticipation. The role of anticipation in the fluctuations of market prices was effectively shown by recent events. They were largely responsible for the explosion in prices in 1979 and 1980, as well as in 1990-9 1 during the Gulf crisis. A short-term model of the oil market which ignored the influence of the increase of desired stocks during these episodes and which considered only market fundamentals (production and consumption flows and the normal level of tool stocks) would be incapable of explaining these price explosions. l8 The petroleum market (like all mineral commodity

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markets) is therefore naturally unstable. In addition, many authors since Frankel” have demonstrated that if it were subject to strictly ‘competitive’ behaviour by each of the actors, its margins of fluctuations would be very large, taking into account: (1) the short-term quasi-inelasticity of supplies in a case of sharp price decrease, because the avoidable costs are only a small portion of total costs;20 ‘“It should be pointed out that future contracts with various maturity dates, including long term (6 months or longer) are, from this point of view, a stabilizing factor, even if they introduce a short-term volatility (see below). 19For an assessment of the analyses see Frankel(1989). *‘In economics, the only assessable costs are those deriving from a decision and they are always evaluated in relation to a reference situation where this decision is not made. Avoidable costs are those avoided by the decision to stop production of a deposit. Contrary to the view sometimes put forward, these are not just operating costs. The costs of reconstitution of the reservoir underground must be added as well. If the decisions to cease production, followed by decisions to restart production, create specific costs (compensation payments for unemployment, maintenance costs of well during stoppage etc), then we must subtract from this sum described above the total of these costs divided by the number of non-produced barrels. This implies that any precise evaluation of avoidable costs demands an anticipation of the duration of the stoppage, and therefore of the future evolution of prices.

The equilibrium price range of oil: P-N Giraud

(2) the short-term inelasticity of supply to price in a case of price explosion as soon as the maximum utilization of capacity is reached; (3) the quasi-inelasticity (short-term) of demand to price in both cases. As far as price fluctuations in the market are concerned, four different zones of petroleum prices may be distinguished (Figure 3, left side). At the bottom, is the floor price zone. Oil prices would inevitably penetrate this zone during a price war carried out without any extra-economic hindrance, meaning that each actor would be a pure price taker maximizing its profits (in other words minimizing its losses). This zone has an upper limit which is the avoidable costs of marginal fields. What is this level? Adelman (1986) estimates that a price of US$12/bb12’ would have only a limited immediate effect on North American production, but would halt development, leading to an annual decline in the production of exploited fields. According to him, the price would need to drop to US$6/bbl in order to provoke the immediate shutdown of half of the production capacity in the USA (the price would need to fall to US$3 for the same to happen in the North Sea). Mabro (1991b) estimates the floor price to be even lower at US$2.50/bbl. We will assume the zone of the floor price to be below US$8. This estimation does not need to be precise since, as will be shown, the market price has never penetrated this zone. Within this floor price zone, purely economic forces take over, automatically bringing the situation back to a supply4emand equilibrium. Just above this zone, we may define a zone of ‘political+conomic braking’, in order to take into consideration the fact that price wars have certain limits within the petroleum sector, as shown in 1986. After the price war had been started in 1986, the price should have, if the market had been perfectly competitive, dropped into the floor price zone and driven the marginal producers out of the industry.** A powerful coalition of interests succeeded in producing armistice before this point was reached. This is a well known phenomenon and there is no need to elaborate further here. This armistice is largely an economic decision. Indeed, as prices drop, the ‘cheaters’ within the initial group of swing producers (see below) are punished, and the number of those wishing to cooperate increases. The price 2iAdelman’s data were converted to 1991 US dollars using a deflation index of export prices for products manufactured in the OECD. In fact, production costs since 1986 have actually decreased in real terms, according to industry opinion. Therefore the floor prices expressed in 1991 US dollars are probably lower. **In fact, in 1991 US dollars (deflation index of export prices for products manufactured in the OECD), they hardly reached the US$13 level, and only temporarily.

war then reestablishes the subjective conditions for a coalition which is in the economic interests of its members. However, strictly political factors, as we have already defined them, also come into play, particularly fears of social and political destablization in certain regions or producing countries which push governments (the USA for one, despite its economic liberalism) to encourage producers to act strictly according to their economic interests. This is why we may call this zone ‘political-economic’ braking. It is situated between US$13 and US$8. This US$13 level is, however, only an estimation. Since it does not depend solely on economic factors, it cannot be determined with certainty, and it tends to change over time. In reality, it is one of the forms under which the compromise takes place between the political preferences of the various actors which will now be discussed. At the top of the scale there is the ceiling zone of economic braking. In a situation where demand exceeds supply, when the price increases, the forces which reduce the initial disequilibrium do not immediately exert themselves before the price reaches a certain level. These forces react on both supply and demand. For demand, it is a question of behavioural energy savings which may respond rapidly, because by definition they do not require investment; and rapid substitutions by competing energy sources. These rapid substitutions can only be achieved in bi-energy installations. Furthermore, the volume concerned is low for petroleum products; beyond this, investment is necessary. Whether or not substitution is undertaken depends not so much on the level reached by prices but rather on consumers’ anticipation of the future evolution of prices. Macroeconomic effects induced by large increases in petroleum prices reduce world growth. In this case, the reaction delay is obviously several months at least. On the supply side, experience has shown that capacity is never totally saturated, even if this appears to be the case. In a number of different areas, marginal investments allow short-term marginal increases of production; however, anticipation of the future evolution of prices continues to play a role. These four types of force therefore act to reestablish market balance. Some react as soon as prices increase but their intensity increases slowly; others reach their full intensity more rapidly but only at high-price levels (real or anticipated). Once started by a demand exceeding immediately available capacity, the increase in prices is fast because the process of disequilibrium is at first cumulative: the increase of price augments stock demand, thus increasing the disequilibrium. For petroleum, as for most mineral commodities, the braking forces only start effectively reducing a significant initial imbalance at high price levels, levels which are much higher than the costs

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of marginal producers. 23 Like a space object reentering the atmosphere, the increase in price will first brake very little, and will then brake more strongly. The lower limit of the ceiling zone of economic braking may now be discussed. This limit is difficult to specify exactly (as is the outer limit of earth’s atmosphere). It would be necessary to represent graphically an increasing density of forces rather than a limit. In order to simplify this, let us assume that the braking starts taking place at US$30, intensifying at US$40/bbl. The three types of instability of petroleum markets Between the zone of the ceiling price of economic braking and the floor zone lies the natural instability zone. If the petroleum industry was indeed competitive in the true sense of the economic theory, meaning that no actor could influence prices, the market price would fluctuate violently between the two extreme zones. In the event of even slight overproduction, there would be no ‘rational’ cut in production until the price dropped below the avoidable cost of the marginal capacity, the floor price, and it would remain there until the overcapacity was reabsorbed. Every durable increase in demand would send the price into the ceiling zone where the overcapacity would be restored. Here, we find a mechanism that generates, for competitive mineral commodities markets, a wide-ranging instability (since the floor zone and ceiling zone are very far apart), which we will call the first instability type. Many metals experience this kind of instability. Throughout its history, however, the petroleum industry has only once found itself in this situation, at the very beginning in the USA. Except for exceptional periods, there have always been groups of entities to stabilize prices, via the implementation of swing capacity. Since the nationalization of oil fields during the first half of the 1970s this role has been played by a subgroup of OPEC, sometimes with different members in the group some of which are core producers (as defined above) and some fringe producers. It should be pointed out that this is independent of the official position of individual members. In the oil industry, taking into account the weakness of marginal costs in relation to the price, every producer that chooses not produce to its full capacity is playing the role of a swing producer. This stabilization by swing capacity is far from perZ3T~o remarks: in the case of metals, there is a fifth force - the increase in recycling, meaning a resort to scrap metal sources. In certain cases, this is the principal force. This does not, of course, exist for oil. The braking forces may only start effectively reacting above the substitute price level or the backstop technology. It is clear that this is only implemented and only acts as a braking force if the actors are convinced that the prices will remain above levels of substitution on a long-term basis. 24Cf. note 21.

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feet. Production cannot be modified from day to day, nor can it change as fast as anticipation and desired stocks which, as pre-viously mentioned, influence the market price. Swing capacity may nevertheless hold prices in a range of US$2 to US$3 with cycles (not necessarily steady) of approximately a few months. This kind of fluctuation, which we will call the second instability type, is inevitable within the scope of a true market functioning. In reality such instability worries no one since futures markets allow operators to protect themselves from this type of instability and since they do not have significant macroeconomic incidences. However, futures contracts and their derived financial instruments on oil and refined products themselves introduce a third instability for which the range may exceed US$l/bbl and over much shorter periods, from one day to one week. The fluctuations of the second and third kind could be reduced by an improvement in the functioning of markets, physical and financial. As we will reiterate in the conclusion, this is a point of consensus within the current petroleum dialogue. Fluctuations of the first kind can only be controlled by an efficient implementation of swing capacity. The essential problem for holders of these capacities is therefore to know at around what level the market prices may be stable over the long term (ie over several years) and whether this level is unique. The answer depends on the existence of a dynamic equilibrium price range, as defined above.

Dynamic equilibrium prices As far as dynamic equilibrium prices are concerned, it is again possible to determine economically three price zones (Figure 3, right side). The lower zone, which we call zone 1, is well determined by the lowest of the dynamic equilibrium prices defined above, this being the price which would allow a profitable financing in the lowest cost zones of all the capacity increases which are necessary in order to cope with increasing consumption at this price, taking into account the exhaustion of existing deposits. It is relatively easy to evaluate the upper limit of this zone, which is the equilibrium price in a competitive situation, in other words the point (pl, ~1) of Figure 2. Indeed, when taking into account the importance of low-cost reserves of the core producers and the relatively flat character of the develoument cost curve for these 1 reserves (which is translated by the quasi-levelling of the curve 01 of Figure 2), this equilibrium price depends very little on the dynamic curve of consumption. Adelman estimates this to be around US$5/bb1.24 We will adopt this estimation in Figure 3. It should be pointed out that this competitive dynamic equilibrium

The equilibrium

price is at a lower level than the market floor price defined by the avoidable costs of marginal deposits. This is an unquestionable indicator that the industry has not functioned competitively in the past. If prices remain within this zone over the long term, by definition investment would be insufficient. Once the initial overcapacity had been absorbed, an oil shock would become inevitable. Conversely, the upper zone, called zone 3, is defined by the maximum of the equilibrium prices tolerable by the core. We are indeed hypothesizing that core producers, even if incapable, for lack of information or for political reasons, of maximizing their revenues, nevertheless have minimum revenue objectives. For example, it may be estimated that stability of their production, and therefore of their revenues, is the minimum they can accept. A higher price, which would lead to a continuous reduction in the residual demand they face, would set off a reaction in the form of a price war to gain back market shares. Other minimum objectives along the same lines may also be attributed to them: the maintaining not of their revenues but of their market share, which will lead their revenues to increase as world demand for oil grows, etc. The prices which correspond to such objective hypotheses may be economically determined, provided that both the dynamic capacity curve of the fringe and the world consumption curve are known. Certain models of the world petroleum market have estimated this limit, on the hypothesis of production constancy within OPEC, to be around US$28/bbl. Since OPEC in its entirety does not make up the core, the price leading to constancy of production of the core would be lower, say equal to US$25.2s The meaning of the dynamic equilibrium

zone

The intermediate zone, number 2, is the zone of the dynamic equilibrium prices of the petroleum market. All the prices of this zone 2 are dynamic equilibrium prices in the sense that they allow the financing of 25The US DOE estimated in 1992 that with a price remaining constant from 1990 to 2000 at US$I5/bbl, the demand faced by OPEC would increase by Il.1 Mbbl/d in 20, and at a price of US$24 by 3.4 MbbI/d. The price which would lead to a constant demand is therefore superior at US$25. A simple approximation puts the figure at US$28. For its part, OPEC (Miramadi and Ismail, 1992) provides for US$21 an increase by 6.8 Mbbl/c for the demand aimed at OPEC in the year 2000, and for US$30, a reduction of 2.2 Mbbl/d. The same approximation would therefore put back to US$28, the price leading to a constant demand. These estimations, however, concern the demand faced by OPEC. In order to deduce the demand on the core, meaning essentially Gulf countries, it would be necessary to know the production evolution of non-core OPEC countries at this price, which in our hypothesis belongs to the fringe. If at this price of US528, production increased, which is probable, then the ceiling would be lower. We assumed a price of US$24. This estimation is not a result of any precise calculation: this paper should basically be understood a means of methodological clarification.

price range of oil: P-N Giraud

developments necessary to cope with the increase in consumption at this particular price. The main aspect differentiating these developments is their geographical distribution between the producers of the core (lowcost zones) and those of the fringe. At the floor of this zone, only developments among core producers can be financed. As for the ceiling of this zone, core producers are content to maintain a constant production capacity. There are no economic forces which will prevent core producers choosing any price level within this zone and maintaining it over the long term. In order to achieve this, it is sufficient for them, from the point of view of increases in capacity, to behave collectively vis-ci-vis the fringe like the core of a Stackelberg oligopoly. They first choose a price level within zone 2. At the chosen price level, they let the fringe make all the increases in capacity which are profitable for the fringe at this price, and they add the capacity necessary to maintain a sufficient cushion of swing capacity. Second, they use, either themselves or in association with certain fringe producers, the maintained swing capacity to effectively stabilize the market near the chosen price level. These two conditions are sufficient and equally necessary. Their necessity indicates, inversely, the potential sources of instability: an implicit or explicit disagreement between the producers of the core on the desired price level within the dynamic equilibrium zone; and even in the case of an agreement, a poor coordination of investment decisions over time. In both cases, either the swing capacities disappear or increase excessively, which may rupture the cohesion between swing producers. Short-term regulation is therefore no longer possible. Within zone 2 it must be stressed that the producers of the core have to (by definition of the ceiling zone) increase (or at least maintain) their capacities. By definition as well, they can do this because in this zone these investments are profitable for them (it is only in zone 1 that they would no longer be profitable). A price shock resulting from insufficient investment may therefore, in theory, always be avoided if the price remains in this equilibrium zone, provided that the core producers make the required capacity extensions at the right time. As we indicated above, the main difficulty for the core producers is in estimating the ceiling of dynamic equilibrium zone. Even if they had precise estimations of development costs for the various regions (from the core to the fringe) and of the long-term price elasticity for the demand of petroleum, the following would remain uknown: (1) world economic growth; (2) possible new important discoveries among fringe (which would, of course, influence

the the

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rhythm of the capacity developments in this zone, and thus for a given price, the residual demand faced by the core producers); (3) the evolution of policies, particularly fiscal, of consuming countries and fringe producers. Nevertheless, this analysis highlights the link between economic and political factors in the evolution of oil prices. Zone 2 defines the area where political preferences, in the third meaning already defined, may be expressed. This means the pursuit by the core producers of objectives which are not assessable monetarily, and are aimed at maintaining the stability of governments and the security of states. It also defines the area within which the tests of a poorly informed profit maximizer are not, in theory, destabilizing (for example, the core, if assumed to be a collective profit maximizer, fixes a price level within the area, observes trends in demand, modifies the level if necessary, while remaining in the area, and so on). Therefore this is the area where the learning process can converge smoothly. It is uniquely in zone 2 that the price of oil may be politically influenced. Any attempt to maintain the prices in zones 1 and 3 provokes economic forces which would inevitably force it out of these zones. In this sense, the price of oil would be unable to escape from the ‘laws of market economy’. For all this, however, can it be maintained (as many experts and government officials have asserted especially since the oil glut of 1986) that political factors are incapable in moving, other than temporarily, petroleum prices away from a level economically determined by market forces alone? In our opinion, it cannot. Political factors as defined can influence oil prices for long periods within zone 2. The political preferences

of the core and of the USA

Political preferences, which may therefore be freely expressed in zone 2, are primarily those of the core producers. In extracting industries, those holding the low cost reserves are always the ones which finally control the system. However, in the current world situation, they find it hard to isolate themselves from political preferences of the large importing nations of the OECD, and more importantly, the USA. Nor can they any longer ignore the financial constraints which weigh heavily on certain producers of the fringe, being largely indebted to OECD countries. For example, if it were shown that a price of around US$12/bbl (thus within the equilibrium range) would maximize the long-term revenues of core producers, it is very unlikely that they would have the political means to maintain this price over a long period of time, although they would have the economic means. This is for two reasons: the political pressures of other OPEC producers which, despite everything, the core

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needs in order to share the responsibility of the shortterm market regulation; and the political pressure of the USA. The USA is in an ambiguous position on the ‘desired’ (even if it never uses this term) price of oil, mainly because of opposing interest groups. Lower prices favour trade balance and economic growth, but seriously penalize the US petroleum industry (and more generally US producers of fossil fuels), eventually leading to a rapidly increasing dependence on foreign oil. Higher energy prices are beneficial to the US oil industry and are now supported by many ecologists. It is therefore difficult to determine US preferences for a specific level of price. There is rather a certain range of indifference over which the government’s position is agreed in terms of the relative importance of pressure groups and its perception of the degree of importance of the principal problems influenced by the international oil price. This range is, however, situated above a threshold determined mainly by the issue of foreign dependence and supply security, meaning that this is therefore a politically determined threshold.26 Thus, only the prices found in the upper part of zone 2, ie prices higher than US$15-16, are at the same time dynamic equilibrium prices and also politically acceptable to actors. This limit might, of course, change, particularly as a function of US perception on problems of supply security, a perception which is itself dependent on the world geopolitical situation, the regional political situation, the level and the strength of the US alliance with Saudi Arabia, etc.

An interpretation of the large price fluctuations of oil since the end of the 1960s This outline analysis may be tested by verifying whether or not it allows a coherent interpretation of the majority of the principal events which have shaped the history of oil since the end of the 1960s. The large price fluctuations of oil since the end of the 1960s may, in our opinion, be interpreted in the following way (Figure 4). Before 1973, the price was at the lower border of zone 2. In the Arab-Persian Gulf, the price in 1970 was US$1.20/bbl. Using a deflation index of OECD export prices, this corresponds to US$3 in 1985, which could be compared to the development costs of OPEC reserves that Adelman (1986) evaluated for the end of the 1970s (in 1985 US dollars). This results in a price above the 26During the first oil crisis, Kissinger in 1974 had explicitly fixed this threshold by indicating that the reasonable price of oil for the USA was US$7/bbl, or in 1992 US dollars (deflation index: export prices of the OECD) US$17/bbl. In reality, Kissinger spoke of US$7 as a ‘maximum’, beyond which the Western economies would be, according to him, ‘strangled’. However, in the context of this conflictual period, the term ‘maximum’ may be replaced by ‘reasonable’ and satisfactory.

The equilibrium price range of oil: P-N Giraud Zone 3: dynamic instability because the demand addressed at core producers is decreasing

35.00

30.00

2 n yc

25.00

5

20.00

t.

15.00 Zone

2:

dynamic

equilibrium

10.00

5.00

o.oc

____ ____ ____._._ _._________ . . . . _.______________ .__.____._-__-._-._. Zone 1: oil shock economically inevitable

I I I I I I h I I I I I I I I I, 70

1975

1980

1985

I I I I, 1990

Figure 4 Price of petroleum

and dynamic equilibrium zone (deflation index: exports of OECD manufactured products)

of Gulf countries, but below the costs of Venezuela, Nigeria and Mexico. The question therefore is to determine whether or not in 1973, at a price of around US$1.2/bbl, the Gulf countries alone could have continued to meet the growth in consumption, which at the time was around 7% per year (non-communist world).27 The response, in purely economic terms, is yes. Their reserves and their lower production costs would have permitted it; however, it would have required the international companies which were then operating in these countries to make heavy investments, and the USA to be happy with the divergence between its domestic market and the world market. These two conditions were not present. At the end of the 1960~ and particularly since the Algerian and Libyan revolutions, international companies became convinced that the nationalism among producing nations could not be indefinitely contained. As the risks of nationalization became real, the companies became unprepared to invest

costs

27We should note that this is virtually what they had done until this point. Between 1963 and 1973, non-communist world consumption increased by 23.5 million bbl/d, non-communist world consumption excluding the USA increased by 17.5 Mbbl/d and Middle East production grew by 14 Mbbl/d (rising from 7 to 21 Mbbl/d). Taking into account the fact that the USA was at the time virtually isolated from the rest of the world in terms of oil, this confirms a nearly competitive situation.

as much as would have been necessary within the core nations. The USA was also ready to come out of its oil isolation.** Under these two conditions, the oil crisis was inevitable, as is generally believed today, but not just for economic reasons: the prices were not really within zone 1 (which Figure 4 points out), where the crisis was economically inevitable, but at the lower border of zone 2; at this level, the slightest restriction (political in origin) of investments in the Gulf would have created pressure on oil prices. From 1974 to 1979, the price was near the upper limit of zone 2. This in fact generated a vigorous development of capacity outside the core. This growth, taking into account the delays in development, began to materialize at the end of the period, while energy substitutions and savings were implemented. The oil shocks of 1979 and 1980 were brought on more by sudden increases of desired stocks than by a real saturation of production capacity. Nevertheless, we may assume that the core did not develop its capacity sufficiently during this period. If the shock had not taken place and if world growth had extended into the early 1980s at the same rate, it is probable that the market share of the core would have then stabilized, after having increased during the second half of the 1970s while waiting for the non-OPEC capacities, which were developed as a result of higher prices, to come on line. It is because of this that we may say that prices were at the upper limit of zone 2. The second oil shock, however, clearly forced prices into zone 3, and all the more so since the floor of this zone dropped with the shift of the consumption curve following the slowdown of world economic growth.29 The demand faced by the core therefore declined rather rapidly, creating the oil glut of 1986. Setting aside the Gulf war episode, where prices underwent a sharp incidental fluctuation, at what level would they have stabilized after the summer of 1986? They would have unquestionably settled within the dynamic equilibrium zone, at the bottom of the zone that we have defined above as politically acceptable to the USA. Thus, since the end of the 196Os, the oil market, after having escaped the oligopoly control of the ‘seven sisters’, experienced large fluctuations, leading it through all the zones which have been defined above. As a result, all the actors have clearly learnt that there are price limits for the equilibrium zone. These limits cannot be precisely determined, but they do exist. The core of OPEC, in particular, has experienced a learning process, 2KCf. note 26. *‘In Figure 4, we have not varied the ceiling level (which determines the constant demand addressed at the core) in function of world growth. In order to do this, we would require reliable evaluations of the long-term elasticities of the world oil demand to global GDP and prices, and of the supply of the fringe to price.

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which has allowed it to test the existence of a ceiling for this dynamic equilibrium zone.

Why a dialogue? These are the lessons of the learning process which make a dialogue between oil importing and oil-exporting countries possible. In the 1970s the procedural rationality of OPEC countries and of the organization itself was the product of its history since its founding in 1960, which consisted of a struggle in defence of its revenues, which tended to fall with prices. Then, OPEC’s rationality had to progressively adapt to the fundamental change of the passing of control of low-cost reserves to member states’ hands. At the same time, the existence, as well as the limits, of an area of freedom where economic and political objectives (in the third meaning of the term state security and government stability) could be linked together became increasingly apparent. In this newly created climate, the French and Venezuelan governments considered the time to be right for proposing in July 199 1, the opening of a dialogue between states. What might be on the agenda? Once exporting as well as importing nations have recognized that too much instability of oil prices is harmful for all, one area has been the subject of minimal consensus and has allowed a dialogue to begin with the somewhat reticent participation of the USA. This is the means by which actors could improve the day to day functioning of markets. This is unquestionably useful, and it is therefore unnecessary to discuss here the issues in this area.‘O But improving the day to day functioning of markets only address the instabilities of type 2 and 3 that we have previously defined, ie day to day volatility and short-term fluctuations arising from temporary supply/demand imbalances and stock buildings and drawdowns. It does not address questions such as the average price level around which these fluctuations occur, or whether we are heading for a price shock through under- or overinvestment. Market mechanisms provide crucial information - the price - but they do not by themselves actually provide all the information needed to avoid large fluctuations.31 However, the USA, Saudi Arabia and certain European countries (which make a unified position among EEC members impossible on this point) refused to discuss price levels, because they felt that 30Likewise, the dialogue made progress in recognition of the necessary links between petroleum and environmental issues, which is also unquestionably useful. 3’Theoretically, only a complete set of forward and future markets extending up to at least ten years (more precisely, the maximum pay back period of new fields and new technologies at the consumption level) could achieve this. They obviously do not exist.

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market mechanisms always fix the ‘right’ price. According to those countries, the market simply needs to function freely. If our analysis is correct, then this position is not tenable. If we assume that the large price fluctuations which the industry experienced since the beginning of the 1970s are harmful, we think it could be very useful to discuss the following question. Are there ways of improving the collective knowledge of the ceiling of the equilibrium zone as well as of its economic and dependence floors? The response would seem to be positive. Better reciprocal information on the development costs of various regions, on consumption forecasts and economic analyses of the factors which determine consumption, on the regulatory and fiscal intentions of states, etc, could only increase foresight of future developments and improve anticipation, Consequently, investment decisions would be closer to substantial rationality and more coherent. This alone could allow price to be maintained within the dynamic equilibrium zone and thus avoid large price fluctuations. One political question would, however, remain. If this zone does not reduce to a simple line, as we believe, could the political preferences by the actors (core producers, large importing countries) be discussed? The argument of the USA is that ‘it’s the market which determines the price’. In our opinion, this argument has difficulty in disguising US willingness to discuss this issue only with Saudi Arabia (but Iran and Kuwait have come back, as will Iraq, onto the scene). For its part, Saudi Arabia may find it beneficial not to reveal its preferences. Boussena (1993) pointed out in a recent article that it could even opt for a strategy of maintaining uncertainty. By allowing prices to fluctuate, for example, between US$14 and US$25/bbl, it reduces, all other things being equal, developments within the fringe. The demand which will be faced will then be higher than that which would arise from a strategy of announcing the desired average level and reducing the fluctuations around this level. This strategy may, however, weaken OPEC, which Saudi Arabia needs because it allows it to share the responsibility for short-term regulation with certain fringe producers. In addition, it would make financing of the oil industry, which many view as essential, more difficult. Is it therefore in the longterm interests of this country? In our opinion, discussions on political preferences, together with the creation and channelling of the information flows mentioned above, could be the subject of a new dialogue between exporting and importing countries. It should be clear that this is by no means a commitment in the negotiation of interstate agreements on price controls! It is merely a question of improving

The equilibrium price range

information flows on objective matters as well as political preferences or, in other words, of reducing uncertainties for all actors. Obviously, uncertainty, asymmetric information and hidden preferences are the ground on which profitable or desirable strategic behaviour can be built! But if reducing large oil price fluctuations is seen to be of collective interest, is not the limiting of such possibilities the right price to pay for it?

Acknowledgements The author acknowledges financial support for the research which has led to this paper from the General Directorate for Energy and Raw Materials of the French Ministry of Industry, as well as fruitful comments on early versions from 0. Appert, D. Babusiau, G. Bellec, J.M. Bourdaire, S. Boussena, J.M. Chevalier, P.M. Cussaguet, H. Des Longchamps, R. Janin, M. Karsky, M. Pecqueur. Y. Simon and an anonymous referee. Naturally, all opinions expressed are strictly those of the author.

of oil: P-N Giraud

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