The international petroleum industry

Energ3 Pol&T. Vo[. 25. No. 2, pp. 143 157. 1997 © ~997 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4215/97 $17.00 + 0.00

ELSEVIER

PII:S0301-4215(96)00117-6

The international petroleum industry Competition, structural change and allocation of oil surplus J. W. B a d d o u r CERESUR

- U n i v e r s i t b d e la R b u n i o n

The aim of this paper is to show that in the last thirty years the world oil industry has gone through three successive stages in the evolution of marginal production costs, corresponding to three different organizations of the market: the majors order (1929-73), the OPEC order (1974-86) and the consumer-countries order (1986 to the present). These orders all differ as far as organization of competition or the conditions of oil surplus distribution are concerned. By provoking a break with industrial structure and the established balance of power between actors, it seems that each successive reversal in the evolution of the production costs' trend results in an oil crisis, and subsequent backlash, and that these change the organizational dynamics of the industry. The oil crisis of 1973, which announced the end of the majors order and its replacement by OPEC, thus occurred at the moment when the production costs' trend went through a transition from a decreasing stage to a growth stage. A new change in this trend in the mid-1980s, from a growth stage to a decreasing one, was the cause of the 1986 backlash which led to the replacement of the OPEC order by that of the consumer-countries order. © 1997 Elsevier Science Ltd. All rights reserved. Key~ords: Oil order; Production costs; Oil surplus

The oil crises and backlashes of the last three decades have given the world oil industry a particular competitive dynamic. A number of approaches have been used to study this dynamic, and the inherent market uncertainty that it generates, without however reaching any satisfactory conclusions. These approaches have tried to reduce an extremely complex phenomenon exclusively to its economic or social/political dimension. In an industry where the strategies of states (producer or consumer) and the issue of national sovereignty are of primary importance, to depend solely on the theory of the firm as an analytical approach is undoubtedly a way of ignoring the potential impact of such strategies and the presence of certain institutions (e.g. OPEC) on the working of the industry. Hence the interest of an oil order designed to function as a politico-economical regulator of the market. Even though this concept has the merit o f showing the role of powerplay and the way in which economic and political factors intervene, it is nevertheless imprecise as concerns the stakes of competition and the causes of change in the balance of power between actors. In this regard it is necessary to clearly define the protagonists' common, and much disputed, objective.

According to Chevalier (1973), it is the creation and appropriation of oil surplus that constitutes the main stake in the confrontation between the actors, namely, the companies and the producer and consumer states. However, identifying the actors' competitive objective raises the question of the means required to attain it. This is mainly because the creation and appropriation of oil surplus largely depends on the type of organization (full, bicephalous or imperfect) that the actor is able to impose on the market. Moreover, the efficiency of the organization, as regards the appropriation of oil surplus, depends on the ability of the actors in controlling all or a part of the economic and geopolitical power specific to the industry. Although the rules on which the organization is based do not show a perfectly rational construction, they do illustrate the historical evolution of the balance of power between the actors. In order to fully understand how oil surplus is distributed between the actors of the industry, it is necessary to identify the factors that determine the cogency of each protagonist in imposing the organization. Chevalier (1973) proposes that this depends on two factors that have been evident throughout the history of oil: the cost evolution trend and 143

144

The international petroleum indust~: ,£ W. Baddour

the degree of social awareness. In the past cost evolution has not received much critical attention, one reason for according it an important place in the present approach. The main assumption of the present analysis is that since its beginnings the oil industry has gone through three successive stages in the evolution of marginal exploration-production costs. In the first period, 1859-1970, the production costs' trend decreased, on a world scale. In the second stage which covers the period 1970-85, the trend of costs was reversed as they increased. Lastly, due to the effect of technological innovation and a continuous investment policy by the multinational firms, cost evolution was once again reversed from the mid-1980s onwards, a decreasing trend which has since continued. The aim of this study is to show that each of these stages corresponds to an oil order characterized by a particular organization as regards the functioning of the world oil market. Different by nature, the alternating world oil orders have conferred an intense organizational dynamic on the oil industry, a fact which accounts for the high fluctuation in market prices in the last thirty years.

Specificities of the oil industry In order to highlight the main specificities of the oil industry, its basic conditions must necessarily be studied. Although industrial economists unanimously agree that the basic conditions do in fact influence the structures of an industry, these are for the most part either taken for exogenous or studied in the same framework as that of the structures. Angelier (1991) emphasizes that two opposing attitudes prevail as far as consideration of the basic conditions is concerned. For some, it is question here of significant facts which evolve due to the effect of forces external to the industry but which, however, remain unaffected by the strategies of the firms responsible for it. To the contrary, others consider that both the basic conditions and the structures are likely to be the target of the leading firms' strategies. Although the latter attitude is more unlikely, it does offer a possible explanation in that it seems to fit the framework of the objective: that is, highlight the specificities that condition the behaviour of the oil industry. O f the main features that characterize the functioning of the oil industry, the following can be mentioned: (l) It is an activity whose functioning relies on the exploitation of a natural resource often considered as being physically non-reproducible, at least not by human means. This specificity implies taking account of the notion of 'cost of use' which explains why producers are often led to include a scarcity rent in prices, that is, a supplementary production factor that expresses the cost supported by a producer/collectivity as a result of the exhaustion of the resource in question. (2) It is a global and multiproduct industry. Global because of the importance of petrol in world energy consumption, and also as a consequence of the distances between the main producer and consumer zones.

(3)

(4)

(5) (6)

(7)

Multiproduct because the refining of a barrel of crude oil results in numerous products, certain of which have substitutes (e.g. fuel) and others not (petrol). It is an industry made up of various activities (exploration, production, transport, refining and distribution), each of which may be located in a different place and under the control of a different actor. It is highly capital intensive. Thus, entry to its sectors is restricted to those important financial groups capable of assuming the considerable capital outlay. This constraint indicates the existence of high entry barriers and an historical tendency toward industrial concentration. Due to the random nature of exploration, it is an extremely high-risk industry. It is an industry with marked disparities, in the sense that crude oil, besides not being an homogeneous product, has a production cost that can vary both in time and in space. It is an industry where surplus distribution brings together three protagonists: oil exporting and importing countries and the multinational firms.

On the whole, there are two specific factors which influence the strategic behaviour of actors. The first deals with the incompatibility that exists between the functioning of the industry and the pure and perfect competition paradigm. History has shown that without organized competition the working of the industry leads to a general state of bankruptcy, or otherwise to a monopoly by the surviving actor (Frankel, 1948). The second deals with the idea that the functioning of the industry produces important rents, and that appropriation of these leads to incessant struggle between the actors. Several approaches have already been proposed in order to study the competitive dynamic that characterizes the industry.

The traditional approaches The strong dynamic of the oil industry, which resulted from the oil crises and backlashes, aroused a great deal of interest from specialists. Several approaches were consequently used for studying this dynamic, of which the following were among the most important: the Hotelling approach, the political approach and the cost approach. The Hotelling approach.

Although the physically non-reproducible nature of fossil resources was noted as far back as the 19th century, by Jevons (1865) and in this century by Marshall (1906), 1 it was only in 1931 and with the publication of Hotelling's article The Economics of Exhaustible Resources that the economic foundations of exhaustible natural resources were

IJevonspredicted the end of the Industrial Revolutionin Britain due to coal. In 1860 by introducing the notion of royalties, Marshall showed that the specificityof mineral resourcesrequired differentmanagementmethodsand price formationcomparedto other natural resources.

The international petroleum industo,: ,Z W. Baddour

clearly laid down. In brief, the theory specifies that the optimization of the value of a depletable resource implies that its price must necessarily increase at the same pace as the discount rate. Post-Hotellian work (e.g. Percebois, 1989) has shown that the exhaustion of a depletable resource is slower in the context of a monopoly than in a pure and perfect competition system. For his part, Hotelling did not take account of extraction costs. This was subsequently assessed by static analysis (de la Granville, 1980) and later using dynamics (Fourgeau et al., 1981; Adelman, 1986), methods which contributed significantly to Hotelling's law, and which in fact have surpassed it. These developments have led to the conclusion that although energy sources exist in unlimited quantities, their placing at disposal would require, in a given state of techniques, equally unlimited investments. However, questionable non-renewable nature of oil, undoubtedly reduces the validity of this approach as explanation.

The political approach Contrary to the standpoint of economists, promoters of this approach deny the importance of economic phenomena and only retain geopolitical criteria. They consider that pricing is not subject to rational calculation, but instead expresses the balance of power between the actors in the industry. Chevalier (1973) emphasizes that although this method perfectly describes the evolution of the balance of power between producer and consumer countries and multinational finns as well as the intervention of economic and political factors, it does not explain the underlying reasons for the evolution. Barber (1983) has argued that this is the starting point for certain economists (e.g. Frank, Ayoub, Blain, Morin and Stoffeace) and also the conclusion reached by Rifai.

The cost approach This approach includes two different but nevertheless concurrent studies. The first is that of the famous American economist, Adelman (1972). Working from Marshall's notion of long-term market equilibrium, he provided a detailed study of production costs which enabled him to highlight long-term trends in industry. However, as Chevalier (1973) has remarked, this method is too exclusively economic and tends to leave out the incidence of political factors, even though these are fundamentally important. The second approach concerns Angelier's (1976) theory of rent and that of oil surplus by Chevalier (1973). Barbet (1983) remarks that these approaches are relatively similar in that they both accord great importance to crude oil production costs in the establishing of powerplay within the oil industry. More Marxist-orientated, Angelier's analysis privileges phenomena linked to the production sphere and insists on the importance of monopoly rents. For his part, Chevalier puts the emphasis on oil surplus and considers that appropriation of surplus constitutes the driving force behind the oil industry, This surplus is distributed between the actors present in the different stages of the sector. Furthermore, he considers that the evolution of cost structure (passing from a

145

diminishing stage to a growth stage) conditions the structure of the oil industry and modifies the balance of power between the actors. Finally, oil prices should be in line with the cost of the last socially necessary deposit.

An oil order orientated approach Before the first oil crisis specialists had practically never encountered, at least from an economic point of view, major problems in interpreting the evolution of the structure of the world oil industry; especially as the logic of the evolution had always conformed to the competition approaches in force at the time. The wave of nationalizations that preceded or followed the first oil crisis, and also the increasing differentiation in the number of actors, brought about a total break with the characteristics of the old structure. Competition could no longer take place between actors of the same nature. In addition to the strategies of the private multinationals, it was now also necessary to take account of those emanating from the new actors, themselves each of a different nature. Whether it be a question of consumer or producer countries, it is evident that all actors apply different policies and do not fix the same objectives. Henceforth, the situation now concerns actors whose logic of behaviour does not obey the same rationality criteria as that of private firms. The differentiation takes place not only at the level of their status (private multinationals, state owned companies), of their motivations (maximizing profits and income for some, supply security for others), of their behaviour (collusive or conflictual, rational or irrational), but also at that of their specificity (level of economic and social development, technological innovation, knowledge accumulation, quality of human capital) and their performance. This diversity at the level of the participants' characteristics clearly shows that the functioning of the oil market and its structural changes cannot be reduced exclusively to the behaviour of finns operating in the world oil market. Thus, the imperfect functioning of this market is not only due to the collusive behaviour of private firms. As some say, it is above all the result of repetitious governmental intervention by the producer and consumer countries in the market, and also the existence of certain institutions whose motivations go beyond the strict economic sphere (OPEC, IEA, OAPEC etc.). Despite the potential impact that governmental intervention and the existence of these institutions has on the functioning of the industry, certain studies tend to underemphasize the role of states by assuming that the functioning of the oil industry can be reduced simply to the behaviour of the firms operating in it, namely Western firms and OPEC firms. 2 Such an analysis evidently incurs a number of risks. First, it assumes (by equally ranking state and private

2penrose (1968) deals with oil economics by means of the large multinational firm. This led to highlighting the growth and price strategies implemented by multinationals and showed the internal logic of the system in which they operated. The behaviour of exporter and importer countries is less clearly explained.

146

The international petroleum industry: J. W. Baddour

firms) that the behaviour of OPEC firms is subject to the same constraints as that of the multinationals. While in reality OPEC firms find themselves confined to the role fixed by their governments, and consequently do not have any autonomy of action or management, unlike private firms which enjoy total autonomy in all fields. Second, use of such terminology risks suggesting that the management of oil resources by OPEC members is subject to the same rationality and efficiency criteria specific to private firms. Some studies contradict the idea that OPEC members behave in a cartel fashion, with each adopting a dynamic optimization behaviour (Dahl and Yucel, 1990). Third, such an analysis risks disregarding the role of consumer countries and the influence they exercise, directly or indirectly through their strategies, on the competition and on the functioning of the industry. In these conditions, it is clear that by resorting to firms' behaviours for a comprehensive understanding of structural changes in the oil industry, there is a risk of disregarding the potential impact of other actors' strategies which influence both the competitive dynamics of the industry and the performances of its actors. Although the theory of the firm is obviously indispensable, it would be unwise to use it as the sole means of understanding the dynamics of the oil industry. To do so would entail the risk of not covering all the factors which influence the functioning of the industry, and consequently, the possibility of masking the powerplay taking place at a global level between the companies and the producer and consumer countries for the appropriation of the resulting rent.

Definition of the oil order orientated approach. The main conclusion so far is that none of the explanations about pricing is satisfactory, or at least no more than those previously advanced. None is capable of explaining the evolution of the industry's structure and that of the strategies of its main groups. All shed some light on the evolution without however considering it in more detail. It seems that an ensemble of more complex and far-reaching forces have come into play. In this perspective, it is clear that the oil problematic must be integrated into a framework capable of taking account of the ensemble of factors that influence the development of competitiveness. In an industry such as that of oil, the question of national sovereignty and the presence of states (producer or consumer) as active actors constitutes an important strategic parameter, and one that must necessarily be taken into consideration if the structural changes of the industry are at all to be understood. Hence, the interest of the concept of an oil order. This can be defined as 'a stable historical configuration of economic rules dealing with market control and geopolitical relations, and one which enables the dominant actors (states or companies) to impose the rules of the game on the following actors and thereby serve their own interests' (Bergesen, 1989). Although the concept has the merit of emphasizing the role of factors whose pricing logic is not necessarily economic, it is nevertheless imprecise as concerns the objective

that all actors in the oil game forcibly seek to attain. As Chevalier (1994, p 327) remarks, the stake in the confrontation between the actors of the oil game is the creation and appropriation ofoil surplus, estimated in 1992 at $1000 billion. Identification of the objective raises the question about the means required in order to obtain it. However, it must be understood that the creation and appropriation of oil surplus are largely dependent on the type of organization that the actor succeeds in imposing on the market. Moreover, the form and efficiency of the organization (full or bicephalous control) are conditioned by the capacity of the actors to control either all the economic and political powers (as was the case with the majors cartel), or almost all (the OPEC order and consumer countries). The present analysis relies on the main assumption that since its beginnings the oil industry has gone through three successive stages in the evolution of marginal exploration production costs. It should be noted that theoretically there is no reason for costs to evolve in long stages as oil exploration remains a random activity. It shall be shown that each of the stages corresponds to an oil order and that it is the passing from one stage to another which ensures the alternation of the world oil orders.

The majors oil order The objective function of multinational firms can easily be resumed: the maximization of their profits. Profit gain is extremely important because it not only allows them to undertake operations which require enormous cash flow (drilling and exploration), but also conditions their survival and existence in an industry where some operations have a high risk incidence. In periods of increasing costs, firms' financial situations should usually improve as crude oil prices tend to align with the marginal production cost which is higher than average cost. However, the oil industry has not always operated in a situation of increasing costs. Observers agree that from its birth in 1859, and up to 1970, the industry acted under the effect of huge reserves discovered in Venezuela and the Middle East, a stage of decreasing costs. In other words, the 'economic reproduction' cost of crude oil tends to be lower than its technical production cost. Furthermore, the price war which the majors carried on in the 1920s, a period characterized by the downward trend of production costs, made them realize that their survival depended on stopping the war and on a willingness to organize the market in such a way as to eliminate inter-competition. In 1928, at Achnacarry in Scotland, with the express aim of removing this competition, the foundations were laid down for what was effectively a first organization of the market on a world level. Bearing in mind the following criteria-market structure, the distribution of oil surplus between the actors and the long-term tendency of the evolution of production c o s t s - it is evident that this organization lasted up to 1970. In this fashion came into being what is now commonly known as the majors order (or majors cartel), a reference which has gone down in history because of its vertical and horizontal integration.

The international petroleum indusuy: J. W. Baddour

10% Refining, transport ,ution

Taxes imposed h,, French govern

10% Producer ;ountries

...........i:i~i~i:.iiiiiiiiii!iii!i~iii!iii!i' ' ~:i...........

Figure 1 Decomposition of receipts received from a barrel of gasoline sold in France Source." L '&nergie en action, Total, 1994.

147

cluded, and which subsequently serves as the reference basis for all future calculations of growth; and the so-called policy of 'conservation of reserves' inside the USA. In order to stop the rapid depletion of national reserves, due to the 'capture rule' which led each US owner to maximally produce by draining off the most possible amount of oil at the expense of his neighbours, the US government and firms decided to place the maximum number of potential foreign oil sources under American control. By considering this context it is easier to understand the US opposition to the San Remo agreement concluded between France and Britain in 1920, a move which denied all countries, except the two signatories, access to the Middle East. In 1928 the USA managed to invalidate the agreement and two US majors (Standard Oil of New Jersey and SoconyMobil) entered into the capital of the lraq Petroleum Company, acquiring a joint share. Even better, by adopting a vigorous competitive strategy, the US broke the Red Line Agreement (signed in 1928, it curtailed all individual action and competition within a certain area) when EXXON and Mobil succeeded in moving alone into Saudi Arabia, without the prior accord of their partners.

The principle rules of the majors order. The aim of the Achnacarry agreement was twofold: fix the quantities of oil exchanged on the market and the prevalent price level, The agreement did not include the USA as it went against its antitrust law.

Supply regulation Supply regulation is ensured by adopting two principle rules: the so-called 'established positions' rule which ensures acceptance by all the signatories of their market share at the time when the agreement was con-

Worm common pricing The majors' objective was to make US marginal crude oil, locally extracted, competitive worldwide. The system retained was that of 'a single quotation from a single basis point: the Gulf of Mexico. The idea behind the system was to fix the world price of crude oil, no matter its production point and extraction cost, at the level of production costs prevailing in the US ports on the Gulf of Mexico. The result was that crude oil from the Middle East was inflated by a fictive freightage cost equivalent to that of transport to its destination from the Gulf of Mexico.

100 --

80--

60-~ 40

20

Taxes imposed by French government Refining, transport and distribution Producer countries

1973

1981

1991

F i g u r e 2 D e c o m p o s i t i o n o f receipts received from a barrel o f finished products sold in Europe (19905)

Source: 1973 and 1981 Shell, L'&nergie en quelques chffres; 1991 OPEP, in Peff'ormance Profiles qf Major Ener~, Producel:9 1992, Energy Information Adninistration.

148

The international petroleum industo,: J. W. Baddour

Fable I The weight of the majors in the international oil trade (%) Control of oil deposits a Seven majors Other international companies

1950

1957

1970

100 98,2 1.8

100 89.0 l 1.0

100 68.9 I. 1

1980

Table 2 The evolution of production costs per barrel of oil (average production cost (S/b)) OECD Latin (Canada, America USA and Western Europe)

100 30 70

aOil production excluding the United States and socialist countries.

Source: Percebois (1989, p. 424).

1970 1975 1984

1.71

6.92 12,23

0.79 1.67 4.08

Middle East and Far East and Africa

World (outside USSR and Eastern Europe)

0.15 0.36 1.12

0.55 1.22 6.42

Source: Percebois (1989, p. 407).

The system, known as Gulf Plus (subsequently revized) had three main points of interest for the majors and the US (Percebois, 1989): (1) it confirmed US domination of the oil world; (2) by artificially aligning the international price of crude oil with the technical production costs of taxed crude oil, the system allowed US produced crude oil to remain competitive; and (3) the system allowed the majors to capture differential rents and a monopoly rent. The preceding analysis clearly shows that the logic behind the rules which assured the market organization for close on 50 years was not solely economic, but also reflected the political dimension and evolution of the powerplay specific to the actors at the time.

The distribution of oil surplus As market organization naturally profits those who impose it, it follows that the majors' record is remarkable as regards market share and the appropriation ofoil surplus. The complete control which they imposed on the industry ensured them appropriation of not only different differential rents produced throughout the oil chain but also that of a monopoly rent (see Figures 1 and 2). It also gave them almost full control of deposits and the distribution channels (Table 1), although from 1950 onwards it was evident that their control had weakened, due to the competition from the independent firms and companies of oil importing countries. Figures 1 and 2 show that the producer countries were the main losers in this new market organization, because they now found themselves in a situation where they no longer controlled the quantities produced, nor the levels of exportations or pricing. Their new role saw them as mere collectors of taxes and royalties.

The erosion ofi the majors order The functioning of the industry in a stage of decreasing costs led the majors to collaborate more closely so as to avoid competition that would be detrimental to all. By coordinating their production and fixing a common price, they thus established entry barriers capable of dissuading their competitors. But as with every industry functioning in a situation of decreasing costs, entry incentive remained very strong in spite of the entry barriers. For this reason, from the 1950s onwards, the majors order was the object of a destabilization campaign conducted by firms outside of the order (the independents, mostly US) and companies of consumer countries.

If the independents sought to reinforce their market power by gaining access to cheap crude oil deposits (the Middle East), in order to counter the competition imposed by the majors, consumer countries for their part tried to attain more strategic objectives (energy independence on the level of oil distribution, refining and, if possible, production). This period saw the creation of national oil companies in the importing countries (ENI, JAPEX) and the internationalization of certain independent f r m s . Even though competition from the 'outsiders' dealt a blow to the power of the 'seven sisters', it did not succeed in weakening it. The efforts of the independents and the national companies did nevertheless compel the majors to lower crude oil prices between 1950 and 1960, a downward trend which angered producer countries as they realized that it would lead to a reduction of their income. In 1960 they founded OPEC in order to counter the drop in posted prices. Despite these events the majors' dominant hold on the market remained almost intact. Neither the presence of the independents or the creation of OPEC and the national companies managed to destabilize the majors order, which continued right into the early 1970s to impose its conditions on producer and consumer countries alike. Although the drop in crude oil prices between 1955 and 1970 took place in a context of high growth, it accelerated the substitution of oil for other energy sources (notably coal). The retard of nuclear energy increased the advance demand for oil products. Toward the end of the 1960s the multinationals began to worry about the deterioration in the reserves/production relation (the Rome Club). The necessity of prospecting new areas (Alaska, the Arctic, the North Sea, offshore) was obvious to the majors if they were at all to satisfy the further increase in world demand. Production costs in these areas soon proved to be higher than first estimated. Consequently, the marginal cost of crude oil was no longer the development cost of Middle Eastern deposits, but that of deposits in Alaska and the North Sea. The situation had gone from a stage of decreasing costs to a growth stage (see Table 2). If the exploitation of new deposits was to be profitable it was necessary that there be a rise in world oil prices. As Chevalier (1974) clearly showed, the reversal of the situation led to important disruptions on the world oil scene: producer countries obtained in a few months what they had called for in vain over a decade. The first oil crisis heralded the end of the majors order and its replacement by the OPEC order.

The international petroleum industry: J. V~ Baddour

The OPEC order The reversal in marginal production costs at the beginning of the 1970s brought about a profound change in the actors' respective positions. It placed producers in a strong position as they sold a product whose valorization rose, and also because the surplus at their disposal increased as the price rises and takeover of their reserves went ahead. This situation allowed them to impose their conditions both on the oil companies and importer countries. The era of the OPEC order had begun. Considering that market organization privileges the interests of the actor/s imposing it, it was evident that the rules of the game of the OPEC order would be completely different from those which had characterized the majors order, and subsequently lead to a new distribution of surplus between the actors. OPEC was made up exclusively of Third World members and its objective was straightforward: recuperate the control of their resources, then use the revenues from the sale of these resources to further their economic and social development. This objective function is an essential element in any attempt to understand OPEC's behaviour during its domination of the market. Although the price rises of the first oil crisis can be justified by the reversal of marginal production costs and the scarcity of supply, those resulting from the second oil crisis remain (from the point of view of the firm) economically and rationally unjustifiable, especially in view of the context at the time: the drop in oil demand (in particular that from OPEC reserves), the low rate of economic growth, the increase in non-OPEC production etc.

The organization of the oil market by OPEC OPEC's effective take over in 1973 resulted in profound ~tructural changes in the market. It went from being a vertically integrated market to a disintegrated one (Ayoub, 1986): the producers controlled the oil industry upstream, the majors controlled it downstream. Moreover, this role and its consequent movement of nationalization s caused a shift in the methods and intensity of competition on account of the emergence of new actors (firms and producer states). In view of this increasingly competitive context, OPEC attempted to reorganize the market in its favour. However, the absence of OPEC downstream of the industry considerably handicapped its attempt and reduced its scope of action upstream. It turned out that the only powers left to it, to assure continued control of the market, were those which secured its control of the industry upstream i.e. the modelization of its production capacities. Thus, it can be considered that OPEC's organization of the market relied essentially on two rules: the first consisted of maximizing income by controlling production; the second concerned the direct marketing of crude oil by the member states (state to state contracts).

The maximization of income From the beginning, and in confomaity with the rule of Hotelling's theory, OPEC sought to use its new authority - a result of the reversal of the evolution of production costs and the take over of its own re-

149

s e r v e s - to provoke important rises in crude oil prices and consequently in income. OPEC's first decision did in fact consist in unilaterally imposing such price rises (oil prices quadrupled in 1973). However, even though OPEC's main objective was the maximization of income, the means of attaining it varied between each member country according to the importance of its natural resources base and its population. In this respect, two types of policies can be roughly distinguished: certain states (with capital intensive needs and high absorption capacities) sought, so as to increase income, to couple the price rises of crude oil with a relative rise in their own production. This was the case with countries such as Algeria, Iran, Iraq, Indonesia and Nigeria. To the contrary, other countries sought to reduce their production by simply contenting themselves with the increased income that resulted from the rise in crude oil prices (the Gulf countries and Kuwait in particular). However, the situation reversal after the second oil crisis, the transition from a context of supply scarcity to one of relative abundance and drop in demand, all this was not enough to persuade OPEC to change its objectives and strategies. Yet, when it decided to impose production quotas on its members so as to maintain a high price level, OPEC was obliged for the first time in its history to operate as a cartel. The timing of this decision, to maintain high prices when the market was in surplus, proved to be a fatal strategic error and one for which OPEC was shortly to pay the consequences.

The methods of marketing crude oil The maximization of income led OPEC members to handle the marketing of their crude oil themselves. Determined to exercise complete control over the income they derived from oil sales, OPEC members adopted marketing methods which accorded a central role to the state. These were in effect longterm state to state contracts between consumer and producer countries. However, due to the diversity of the buyers (the majors and the tradings), OPEC was in reality obliged to practise less effective methods o f marketing crude oil. In addition to the state to state contracts, those concluded with the majors and the tradings now also had to be taken into account. In general, state to state contracts accounted for most of the exchanges at least up to the second oil crisis. OPEC members were subsequently forced to sell their crude oil directly on the free market, a direct result of the importing countries abolishing long-term state to state contracts (they preferred to buy on the free market where crude oil prices were slightly lower than official prices). OPEC was characterized by its decisions (important and unilateral price rises, selective embargoes, the use of oil as a trade weapon etc.). It must be remembered that OPEC and its methods were only possible, firstly, as a result of the reversal in marginal production costs at the beginning of the 1970s, and secondly, because of the structural changes which took place in international relations (the end of colonialism, the growing influence of the Third World, the adoption by the United Nations of the

150

The international petroleum indust~." J. W. Baddour

180 ......

PIB +60 Energy demand +20 (%)

160 ...........

~ ~ ~ ~ ~"

Petroleum demand -8 (%)

_~~~

140 s

120

t

s

100

~

" , . . . . . " "

"".,

.

..,"-,

80

__

.... ",. ....

• .................

.....

,..

....'"

,

-

60 40 20 0 1973

I 1975

I 1977

1979

1981

I 1983

I 1985

I 1987

F 1989

1991

Figure 3 Energy control efforts Source: OECD.

Oil surplus distribution and actors "performance

principle establishing the right o f each country to enjoy sovereignty over its natural resources). It should be noted that OPEC also enjoyed - some would say profited - from the implicit or explicit support o f the USA and the oil companies. The former for strategic reasons both internal (to reduce importations) and external (to weaken European and Japanese competition), and the latter to ensure the profitability o f new deposits situated in not easily accessible areas.

The least that can be said is that OPEC did not have any difficulty in deciding, even unilaterally, on important price rises. The 1973 rise, in response to a turnaround in the trend evolution o f production costs and an apparent scarcity o f oil and, contrary to the 1 9 7 9 - 8 l rises, seemed inevitable if supply was at all to adjust to demand. OPEC members took advantage o f a particularly favourable context and attempted to modify oil surplus distribution in their favour.

3.5

3.0

2.5

2.0 (.9 1.5

1.0

0.5

0 1900

I

I

[

I

1910

1920

1930

1940

Figure 4 World petroleum consumption Source: API BP Statistical Review.

I

I

I

I

]

I

I

1950 1960 1970 1975 1980 1985 1992

The international petroleum industiT: J. W. Baddour Table 3 Structure of international crude oil production (%)

OPEC Non-OPEC

1973

1976

1979

1982

1985

53.3 46.7

51.4 48.6

46.7 53.3

32.7 67.3

28.1 71.9

Source: PetroleumEconomist, quoted by Percebois(1989, p. 445)

Control of reserves, be it immediate (through nationalization) or progressive (through participation), allowed producer countries to levy a monopoly rent, and this on top of a scarcity rent which they had already succeeded in including in the selling price. From being mere collectors of royalties and taxes during the majors order, OPEC members had gone on to capture most of the rent to the detriment of the other actors (see Figures 1 and 2). As far as market share control is concerned, the continued policy of high prices at first resulted in the maintenance or a slight decline in OPEC's share of the market, then afterwards, when the market situation seemed to have reversed after 1982, in a drastic drop, falling from 53% in 1974 to less than 30% in 1985 (see Table 3). OPEC undoubtedly underestimated the consequences of a high prices policy on the dynamics of world supply and demand and on its own market share. In order to reverse these effects, it was forced to trigger off a devastating price war which saw price levels fall from US$28 per barrel in 1985 to less than US$10 per barrel in the summer of 1986. The disintegration o f the OPEC order The first conclusion of a comparative study of the two main orders shows that the OPEC order was short-lived compared to that of the majors. This fact was not the force of circumstance, the inevitable consequence of an intrinsic advantage. It was also - and some say above all - the result of the deliberate implementation of strategies which often went beyond strict economic considerations. But whatever the role played by these strategies, it is obvious that OPEC was largely responsible for its own decline. On the whole, the erosion of the OPEC order can be attributed to two main factors: the errors made by OPEC during its domination of the market and the offensive strategies of the other actors. The strategic errors o f OPEC OPEC obviously made a certain number of errors which had extremely negative consequences. The takeover of the market in 1973 and its accompanying measures (the extent and manner in which the price rise was put into effect, the selective embargo against certain countries supporting Israel, the use of oil as an economic weapon) inspired an unprecedented feeling of alarm and distrust in the other actors. The multiplicity of the objectives, which OPEC had set itself by using oil as an economic weapon, reinforced the conviction of the consumer countries and multinationals that it was extremely urgent that an alternate source to OPEC oil be found, no matter the consequences. By constantly trying to maximize incomes by all possible means, and without taking account of the dynamics of supply and demand, OPEC committed a number of conse-

151

quently fatal errors. Firstly, OPEC strategy proved to be more of a short-term optimization strategy than a long-term strategy of optimal management. As Percebois has shown (1989), the price rises (especially those associated with the second oil crisis) were of such a scale that they greatly exceeded the optimal level that OPEC should have respected had its true objective been the defence of its market share. As Rad Serecht (1985) argues, OPEC should have 'adjusted prices according to the profitability limit of competing crude oils and substitute energy sources'. Secondly, the persistent determination to maintain high price levels, despite the stabilization of demand, made it possible for companies to extract oil from high cost land and offshore deposits previously considered as too expensive. As a result, OPEC members had increasing difficulty in finding buyers for their crude oil. This constitutes a paradoxical phenomenon; the least expensive crude oil was progressively supplanted in the market by the most expensive (non-OPEC). The offensive strategies o f the other actors The first oil crisis made importer countries aware not only of their excessive dependence on OPEC exported oil, but also of OPEC's willingness to use oil as a means of destabilizing the capitalist dominated world economic order. It also confirmed the conviction, even that of experts, that the price path was now definitively on a rising trend caused by the sustained rhythm of demand and the absence of new significant oil fields. This certainty, together with the impossibility of any reaction on the part of the importer countries, led their leaders to implement large-scale strategies aimed at reducing their dependence on oil from OPEC areas (the US programme 'independence', the French nuclear power programme). Other more general measures were also adopted by importer countries as a whole: control of energy sources and consumption, policies of substitutions for imported oil, subsidies for the development of national energy sources, added research into alternative sources of energy, technological innovation incentives etc. For their part, the multinational firms tried to diversify their procurement of supply by making the exploitation of certain high cost deposits more profitable, those previously ruled out due to prohibitive oil prices. Three objectives were fixed (Boy de la Tour, 1994): (l) show the existence of new oil territories in areas previously overlooked because extraction was non-competitive with crude oil prices in the 1960s; (2) increase oil production other than that of OPEC and outside of the politically sensitive area of the Middle East; and (3) tap the immense and underestimated inventory of new oil resources: deep offshore, the Arctic, extra-heavy oils, oil shale, asphaltic sands, coal liquefaction etc. Whether for importing countries or multinational firms, the challenge was above all technological, and one involving considerable investment (financial, technological, human etc.) that only the aforesaid actors were capable of taking on. Although it is difficult to estimate just how much state-

152

The international petroleum industry." J. W. Baddour

400 -

Schlumberger x 3.8 ........

350 - . . . . . . . . . . . . . . . .......... 300 -

,,"

BP x 3.9 Exxon x 2.5

~.,,,"

USA x 2.3

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~

Shell x 1.6

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,,,,"

f

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~

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i. I

I I

s"

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150i~ ~

100-

500

1972

I

I

t

I

t

I

t

F

f

I

b

b

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

Figure 5 R&D expenditure in the petroleum industry Source: Rapport annuel.

technological innovation was that operations which would have been impossible, even only a few years back, were now realizable: semisubmersible rigs, deep sea drilling, transport in the Arctic zones, the conversion of distillation waste etc. The results of these strategies was extremely positive both for the multinational firms and the importer countries. On the one hand, the multinational firms managed not only

controlled projects would have costed, it is possible to give a rough estimate of the expenses required by the firms in order to meet such a challenge (see Figure 5). As Boy de la Tour (1994, p. 107) remarked the research budgets of the big companies increased considerably. Between 1973 and the mid-1980s, Shell's R&D expenses increased 60% in volume, Exxon's were multiplied by 2.5, and those of BP and Schlumberger almost quadrupled. The result of such 1200

it" /.----J

1000 .

~ --

NOPEC

. . . . .

J J

800

\

,s \

v

I

600

400

200

0

1973

I

I

I

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I

I

I

I

I

1975

1977

1979

1981

1983

1985

1987

1989

1991

Figure 6 Evolution of offshore oil production 1973-92 Source: Offshore•

The international petroleum indust~: J. W. Baddour

153

1200 = 1000 80O Non OPEC 600400 200-

0 1973

,

1974

,

1 75

1976

1 77

,

,

1978

1979

1 80

1 81

,

,

,

,

1982

1983

1984

1985

Figure 7 Western oil production Source: BP Statistical Review.

to diversify their production sources but also considerably increase their volume of production. In this way, in 1974 North Sea and Alaskan production went from 17 Mtep of hydrocarbons to 326 in 1985. Furthermore, new oil territories were discovered and exploited (Mexico, Brazil, Egypt, India, Yemen etc.). On the other hand, importer countries also succeeded during this period in substantially reducing their consumption; this was the combined result of substitute energy sources, efforts to control energy consumption and weak economic growth (see Figure 3). In 1985, world consumption reverted to its 1973 level (see Figure 4). The combined effects of the new dynamics of supply

and demand (a drop in world oil consumption, an increase in non-OPEC production) resulted in a drastic decline of OPEC's market share: from 53% between 1960 and 1970 it fell to less than 30% in 1985 (see Figure 8). The most spectacular result however was that of the evolution of the production costs' trend. Although the wave of technological innovation which marked exploration and production was chiefly responsible for the important changes in the dynamics of supply and demand, thus frustrating the pessimistic economic forecasts of the early 1970s, it above all effected a profound change in the evolution of the production costs' trend. Oil professionals were

60

50

40

30

20

10

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1960

F

I

I

F

I

r

I

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1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

Figure 8 OPEC's part in world oil production Source: BP Statistical Review

154

The international petroleum industry: J. W. Baddour

Table 4 Development of the investment cost and the acquisition in downstream stages (US$1990) a Spending on exploration and development per barrel added to reserves Acquisition costs of reserves per barrel

1981-1983

1983-1985

1984--1986

1985- 1987

1986-1988

1988-1990

14.51

10.45

10.12

7.86

5.87

4.91

6.97

5.68

5.88

4.44

2.89

2.83

aAverage of the United States of America and the rest of the world.

Source: EIA ( 1991 ).

undoubtedly the first to notice, at the beginning of the 1980s, the trend toward stabilization, even reduction, in production costs. It was nevertheless a while before such a tendency was actually confirmed. Some years later, about the mid-1980s, the downward trend in costs seemed to be permanent (see Table 4). If this was indeed the case, then it meant that the putting into production of new deposits (offshore oil) cost, on a global level, less on average than the exploitation of old deposits. Even better, specialists unanimously agreed that the potential for reduction of technical production costs remained very high (in the region of 30-50%) according to the sectors (Boy de la Tour, 1994). As was the case in the early 1970s, such a change had farreaching consequences as expected. Not only did it profoundly modify price structure and the balance of power between the actors, but also oil surplus distribution. By forcing OPEC to implement an important drop in crude oil prices, the change gave consumer countries the chance to both recuperate the rent share lost by OPEC and also increase their own levyings upstream of the industry. Importer countries got the most out of the new configuration and to a lesser degree, at the expense of producer countries, the multinationals.

The consumer countries order It is no doubt not easy to justify the idea that the predominant order in the world oil market since 1986 has been that of the consumer countries. The main reason is that many observers consider that the actual functioning of the oil industry does not serve the interests of one actor but, to the contrary, those of several actors and especially the leaders of the two main groups: the USA and Saudi Arabia. The aim here is not to argue the validity of the assertion but instead show that the conditions which made it possible to identify the two preceding orders (whose existence is unanimously affirmed by observers) are once again present. Consequently, it is safe to conclude that the actual situation of the world oil industry does in fact advantage consumer countries. It remains to verify whether: (1) the world oil industry experienced an evolution in the trend of production costs (see Tablesl-4); (2) the functioning of the world oil market since 1986 was incompatible with the pure and perfect competition paradigm and if it was consequently organized in such a way that the rules of the game favoured the interests of consumer countries; or

(3) present day distribution ofoil surplus is more fortuitous rather than equitable.

The present functioning of the market isfar-removed from pure and per[ect competition Some observers consider that the price war triggered off by OPEC in 1986 represented a new phase in the functioning of the oil industry. It not only marked a break with OPEC's cartelization of the market but also favoured the rapid expansion of free markets (e.g. the spot market, the futures market, the options market etc.). As these markets were beyond the control of any actors, it consequently seemed that their functioning and resulting prices reflected the evolving conditions of supply and demand. In this regard, many observers believed that oil had become a common raw material. They did so in view of that fact that the market fixed the price levels and reduced the disequilibrium which showed itself on the oil market. One does not have to evoke the Gulf crisis to realize that oil remains essentially different to other raw materials. It is instead more relevant to show that neither the conditions of supply or demand were subject to pure and perfect competition, and that the distortions which were subsequently evident at all levels of the industry signified the existence of market organization. The conditions ofoil supply In a situation of pure and perfect competition, and during a stage of decreasing costs, crude oil prices should align with the lowest marginal production costs. If such was the case (as Adelman pointed out in Gately, 1986), present day crude oil prices should be in the region of less than US$5 per barrel (the average cost of Middle Eastern production) and principally concentrated in the Middle East. If crude oil prices since 1986 evolved on average between US$15-20 per barrel, it was because the prevailing situation of the oil industry was far from competitive. The presence of OPEC upstream of the industry, due to its policy of coordinating the use and development of its production capacities, constituted a major restriction to competition. As Adelman noted, once the restriction was removed crude oil prices dropped to US$5 per barrel. It is not a question of knowing who profited from the existence of OPEC, but simply remembering that at the moment when the organization was about to continue the price war (even though prices had dropped to US$7 per barrel), the then vice president Bush made a visit to Saudi Arabia. The aim of his visit was to convince Saudi leaders of the necessity of stopping the price war and giving OPEC back its role as a regulator of supply, as in the past. The least that can be

The international petroleum industo,: J. W. Baddour Table 5 Tax on oil products in certain consuming countries in 1992

(%) Germany France Japan UK USA

Petrol

Domestic fuel

Light fuel

82 77 46 69 31

30 37 3 11 3

13 22 3 15 0

Source: Baddour(1995).

said however is that the conditions in which supply presently evolves are far from perfect.

The conditions o f o i l demand Just as supply is subject to regulation, due to the presence of OPEC upstream of the industry, it is no less true that demand is open to the control of consumer countries. In a situation of decreasing costs and in a genuinely competitive market, and by aligning prices with the lowest marginal production costs, inter-producer competition should profit consumers. In this context, the fall in prices occasioned by the competition between OPEC and non OPEC producers should have profited the end consumer. History shows that this was not the case because of the fiscal policies conducted, to varying degrees, by the ensemble of consumer countries. Furthermore, in a context which saw the trend of costs diminish, not only did these policies deprive the end consumer from benefiting from the drop in production prices, but they also raised prices increasingly. Chevalier (1973) has emphasized that even though the tax levies of producer countries can hardly be considered as monopoly rent, those of consumer coun-

x

tries can be more readily identified as such, more so as it allows them to isolate the domestic market of international competition. Through their policies (fiscal, subsidies, stockpiling) importer countries were thus able to control the conditions of evolving demand and to capture a growing share of rent. One result of the imperfection of supply and demand is that the actual functioning of the world oil market is not competitive, and is consequently open to organization and profits those capable of imposing it i.e. importer countries.

The distribution of oil surplus At this stage of analysis it remains to know who benefits from the actual functioning of the world oil market. The answer entails studying more closely how oil surplus is distributed between the actors active in the market. In a stage where the production costs' trend decreases, due to the effect of technological innovation, the free functioning of the market should make it possible to align consumer prices with the average costs of production. In other words, prices should experience a drop to the same extent as those of import prices since 1986. Table 5 shows that consumer countries managed (through their taxation policies) to not pass the 1986 drop in prices on to consumer prices. This assured them of a dominant position in the market, to the detriment of other actors in the oil game, producer countries and, in particular, households. For their part, the multinationals managed to pull out by implementing policies of technical innovation and product diversification and by adopting new methods of organization and coordination. The continuation of these policies was even easier in view of the downward trend in imported oil prices which had the effect of increasing the leeway of the authorities of

#_

->

T Y p*

P0 Price

Po International price Figure 9 Demand with and without tax

155

Figure 10 Producers profits with and without tax Source: Wirl 1994, pp. 6-7.

156

The international petroleum industry. J. W. Baddour

the consumer countries concerned. As Wirl (1994) has emphasized, the taxation policy of consumer prices depends on the price levels applied by producers. By leading to a low level of demand and environmental externalities, high prices (like those which characterized the OPEC order) do away with the necessity of resorting to a national Pigouvian tax, because the costs of such a tax (collection costs and income distribution) represent more than the benefits that society would otherwise derive. To the contrary, in a context of low prices as is the case today, the governments of consumer countries only have to raise the question of environmental pollution (a topicality) in order to justify important and regular tax increases. P0 signifies the price limit from which all taxation is abolished, which in turn means the levying of decreasing taxes, according to the international price up to the P0 level. As Wirl (1994) remarks, in reality such a strategy causes a simultaneous break in the demand function and in producers' income (see Figures 9 and 10). Taxation policy enabled importer countries to achieve two objectives at the same time. To capture a direct share of OPEC's monopoly rent and to reduce consumption by actively limiting the development of outlets. The regular continuation of this policy since 1986 has made it possible for importer countries, especially European, to appropriate a major share ofoil surplus (see Figures 1 and 2.). In certain European countries the tax share reached more than 80% of end consumer prices (see Table 5).

Conclusion The aim of this paper has been to show that the organizational dynamic of the oil industry can he attributed to the alternation of three world oil orders, each characterized by a different organization of the oil market. Two factors specific to the functioning of the oil industry help explain the recourse to a certain market organization. The first deals with the incompatibility of its functioning with the pure and perfect paradigm (marked disparities in production costs, random activities) and the second results from the existence of significant oil surplus, the appropriation of which constitutes the stake of the competition between the actors of the oil game. Far from showing a perfectly rational construction, the rules of the game specific to each market organization (order) and the resulting distribution of surplus both illustrate the historical evolution of the balance of power that link the actors. The organizational dynamic of the oil industry is determined by the long-term evolution of the production cost trend, in the sense that the passing from one stage to another provokes a break with the old market organization and a profound change both in the actors' respective positions and the conditions of oil surplus distribution. On the whole, three criteria are necessary for identifying a market order: a reversal in the evolution of the production cost trend, a new organization of the market and a new distribution of oil surplus. Going by the assumption that since its beginning the oil industry has gone through three different

stages in the evolution o f exploration production costs, three world oil orders have consequently been identified. Their main characteriztics are as follows: The majors order (1929-73) is characterized by an integrated oligopolistic type organization of the market, one which gave rise to an ensemble of technological innovations (as was the case with steam engines, steel and nowadays information technology) linked to oil production and use. The OPEC order (1974-86), distinguished by a bicephalous control of the world oil market and by the appropriation of surplus to the benefit of producers, generated a new organizational and technological dynamic. The take over of deposits by OPEC and the levying of an immoderate rise in crude oil prices incited the multinational firms and consumer countries to change their strategies. As far as the multinationals are concerned, this change resulted in a willingness to diversify their profession in the petroleum industry, to explore areas previously ruled out as inaccessible (offshore) and to modernize their refinery facilities. Aware that the success of these strategies largely depended on technological innovation, they considerably increased their R&D expenses and coordinated their policies in different fields. For their part, importer countries were led to effect a profound change in their energy programmes and policies, the success of which also depended on technological change (i.e. the US programme 'Independence', the French Nuclear power programme etc.). Although these new strategies enabled multinationals to considerably increase oil production in offshore areas and importer countries to make serious advances in energy efficiency (which substantially reduced their oil consumption), the main result was the change which they provoked in the evolution of the production costs' trend in the mid-1980s, and which has since continued. This change brought about a break with OPEC's organization of the market (the 1986 price war) and led, according to the criterion of oil surplus distribution, to the establishment of a new world oil order: the consumer countries order. This order differs from the others because of its invisible, but efficient, organization of the world oil market. By appropriating the greater part of oil surplus, consumer countries severely limited the leeway of other actors active in the market. Multinational firms managed to pull out of the situation through a policy of close coordination in all fields (knowledge, technological innovation and R&D) and the use of new organizational forms (e.g. research partnerships). To the contrary, producer countries and their firms are confronted with a new challenge~ They not only have to cope with a permanent reduction in their share of oil surplus but also modernize their industry at the risk of being eliminated from the market.

Acknowledgements The French version of this paper was presented to the international conference on 'Knowledge in the Dynamics of Productive Organizations', 14-15 September 1995, Aix-enProvence, France.

The international petroleum industry: J. W. Baddour

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15 7

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