All Commentary
Sunday, November 1, 1987

Voluntary and Coercive Cartels: The Case of Oil

An important policy consideration is the ability of cartels to control prices. Too often this issue is discussed without distinguishing between voluntary, or free market cartels and coercive, or state-supported cartels. This distinction is fundamental. Coercive cartels distort the market, resulting in serious inefficiencies which harm consumers. Voluntary cartels, on the other hand, enhance market efficiency and therefore benefit consumers. An examination of the various monopoly and cartel arrangements in the oil industry will highlight these distinctions.

1. Origins of the Oil Industry[1]

By the turn of the nineteenth century, whale and sperm oil had replaced wood and peat as the principal new energy sources. The whale industry boomed. By the 1850s whale and sperm oil prices began to soar as whales were being slaughtered faster than they spawned. Selling for less than 25 cents a gallon in the 1820s, whale oil prices rose to over $3 a gallon by mid-century, and occasionally reached as much as $10 a gallon—the equivalent of about $200 a gallon at today’s prices.

Such high prices naturally led to the search for substitutes. Coal oil was viewed as the most likely replacement. But after visiting scientists at both Dartmouth and Yale, in 1854, a New York lawyer, George Bissell, became interested in the commercial possibilities of crude oil. He founded the Pennsylvania Rock Oil Company and hired an out-of-work drifter, “Colonel” Edwin Drake.

The usual method for producing oil at the time was to dig pits and allow the oil to seep to the surface where it was then skimmed off. Too little oil was obtained by this method to make it economically viable, and Drake decided that a more efficient method might be to apply to oil the same techniques that were used in searching for water and salt: drill for it. At Titusville, Pennsylvania, in the summer of 1859, Drake struck oil at 69½ feet and the crude oil industry was launched.

Supplying 25–30 barrels a day at $20 a barrel, Drake’s well grossed $600 a day. Word quickly spread and the northern Pennsylvania landscape was soon dotted with oil rigs. Within a decade the Oil Creek Region of Pennsylvania was producing nearly 5 million barrels of oil a year and the price per barrel plummeted to 10 cents, less than the cost of the barrel itself. By 1870 about 75 per cent of the oil refineries were losing money.

2. The Standard Oil Monopoly

John D. Rockefeller, who in the 1860s founded what was to become Standard Oil, resolved, as John Chamberlain put it, “to ‘stabilize’ the oil market by eliminating competition.”[2] Between 1860 and 1870, Standard Oil’s share of the market rose from less than I0 per cent to nearly 90 per cent. During the so-called “oil war” of the 1870s, Standard began to buy out its competitors. Those who refused to sell were often driven out of business by Standard’s prices. But the reason Standard was able to “buy out” so many of its competitors—by 1874 it had purchased 21 of the 26 Cleveland refineries—was that given the depressed state of the oil market at this time many wanted to be bought out and, as D. T. Armentano noted, the simple fact of the matter is that “the original cost of a refinery in 1865 was irrelevant in 1875” and Standard “paid the best market prices for properties that were almost bankrupt and so inefficient that most were subsequently closed down by Standard.”[3]

Legend has it that those who refused to be bought out were driven out of business by Standard’s “predatory pricing,” i.e., selling below cost to drive competitors into bankruptcy and then exploiting the monopoly position by raising prices. There is no doubt that Rockefeller was a “savage competitor.” But it is equally clear that Standard Oil did not practice predatory pricing. Such a policy, John McGee has pointed out, “would have been foolish; and, whatever else was said about them, the old Standard organization was seldom criticized for making less money when it could readily have made more.”[4]

For one thing a policy of predatory pricing is very costly, and its cost is directly proportional to the firm’s share of the market. Thus, predatory pricing is most costly to the largest firm in the industry since it has the largest share of the business. Losing more money than any other firm in the industry is hardly a way to establish “market dominance.” Second, the notion of predatory pricing is logically flawed since it assumes “a ‘war chest’ of monopoly profits to see the firm through the costly battles,” thereby implying that it already possesses the very monopoly the policy is supposed to achieve.[5]

Rather, in an industry characterized by waste and inefficiency, Rockefeller made Standard a model of efficiency and innovation. Standard Oil was the first firm in the industry to emphasize research, the first to expand its operations beyond the Appalachian area, the pioneer in developing overseas markets, in exploiting economies of scale, and in developing new marketing techniques. Thus, while the price of kerosene fell from 26 cents to 8 cents a gallon between 1870 and 1885, Standard was able to reduce its costs from 3 cents a gallon in 1870 to .45 cents in 1885. Standard, notes Armentano, “was relatively efficient, and its efficiency was being translated to the consumer in the form of lower prices for a much improved product, and to the firm in the form of additional profits.”[6] Standard Oil’s success resulted not from the illogical notion of predatory pricing but from the efficiency of its operation.

Nevertheless, even at the height of its success Standard was never able to fully monopolize the market. Between 1880 and 1895 Standard’s share of the refining market fell from about 90 per cent to 82 per cent despite the fact that during the same period it reduced its prices from 9 1/8 cents a gallon to only 5.91 cents. Standard’s share of the market began to decline rapidly after 1900, i.e., well before the court-ordered dissolution of the “monopoly” in 1911, when gas and electricity began to cut deeply into kerosene sales. And the discovery of huge oil reserves in Texas, Oklahoma, and California—reserves which literally dwarfed those in the oil regions of Pennsylvania—further undercut Standard’s position. By 1901, John Chamberlain has written, “the Rockefellers could no more dominate oil than King Canute could dominate the tides.”[7]

Clearly, it was the free market, not the courts, which thwarted Standard Oil’s attempts to monopolize the oil industry. Even more importantly, the case of Standard demonstrates that there is nothing evil or pernicious about a free market “monopoly.” On the contrary, the consumers were the chief beneficiaries since the pinnacle of Standard’s success coincided with the lowest prices in the history of the industry. In short, so long as there are no legal barriers to entry, i.e., so long as the market is free, no firm, even if it is the sole producer, can prosper unless it is able to benefit the consumers better than its competitors, actual or potential.

3. Domestic Cartels: The Role of State and National Governments

With a steady stream of new discoveries, domestic and foreign, the oil industry was beset during the first part of this century by what Christopher Tugendhat calls “an embarrassment of riches.” The market price for oil fell from $1.30 a barrel in the late 1920s to 5 cents a barrel by 1930.[8]

The “waste” of both oil and natural gas during this time was astonishing. Since oil was more valuable than gas, wells were often permitted to simply “blow wild,” allowing the gas to escape until oil was reached. The Bureau of Mines estimated that in Oklahoma between 1910 and 1912 the quantity of gas “wasted” or lost totaled 100,000,000,000 cubic feet annually. This was equivalent to 5,500,000 tons of coal, or enough to supply the fuel needs of nearly one million families for three years. This was not an isolated occurrence. The Glenn Pool field in Kansas “wasted” 50,000,000,000 cubic feet of gas between 1906 and 1912. The Cook Pool field in Texas allowed gas to escape at the rate of 250,000,000 cubic feet a day for 34 days before oil was produced. And the Santa Fe Springs field in California lost 50,000 cubic feet of gas for every barrel of oil produced.

Enormous quantities of oil were also lost. With the market flooded with oil, the excess was often stored above ground in gullies, creeks, and earthen reservoirs, where as much as 50 per cent was lost through seepage, evaporation, or burning. Stanley Clark reports that in 1914 the Healdton, Oklahoma oil field was so saturated with oil that motorists driving near the field complained that their autos were “axle-deep in oil.” In the Cushing, Oklahoma field some 25,000 barrels of oil were allowed to run into the Cimarron River. And a nearby cotton field was “covered with oil for one fourth of a mile in all directions.”[9]

The tremendous loss of this nonrenewable resource not only bothered the industry but offended the public, which viewed such activities as amoral if not actually immoral. And after the repeated failures of numerous industry price-fixing schemes and proposed production cutbacks and shutdowns, the industry turned to government for help.

Originally the industry looked to the state governments. But while several producing states established agencies to control production, with Texas’ Railroad Commission and Oklahoma’s Corporation Commission being the best known, enforcement was difficult. Illegal or “hot” oil continued to be produced in great quantities and transported across state lines, hampering state enforcement agencies. Thus, state regulation proved ineffective and prices remained “distressed.” As Robert Engler writes:

Voluntary restrictions on drilling and output along with private prorationing by the pipelines were inadequate for checking rising production. State laws were limited and disparate. . . . [Thus], the president of the API [American Petroleum Institute] pleaded for federal intervention to end the flush and famine cycles with their accompanying price fluctuations.[10]

A “Petroleum Code”

On March 7, 1933, just three days after President Franklin Roosevelt assumed office, the industry appealed to him for Federal assistance, and the President called a meeting for later that month. The result was the creation of a national “Petroleum Code” whose provisions, Engler notes, “paralleled the recommendations of the API.” The oil bill was included as part of the National Industrial Recovery Act and passed on June 11, 1933. It gave the Secretary of the Interior “the power to fix prices, wages and hours of labor and to limit production to demand, and to control the importation of oil.”[11] The drilling of any new well now required the advance consent of the Department of the Interior. Moreover, on July 12 the President issued an executive order making the shipment of “hot oil” a Federal offense. The result was quick and clear. In May 1933, the price of crude oil was 25 cents a barrel. By October it had risen to $1.08.

The Code established a rather complicated system known as “prorationing,” in which the Interior Department would work through state agencies such as the Texas Railroad Commission to restrict production and thus raise prices. Each month the industry would supply the Bureau of Mines with information regarding the expected demand for oil. The Bureau then would fix production quotas for each producing state. The states were obliged to adhere to these quotas by virtue of their “voluntary” membership in the Interstate Compact to Conserve Oil and Gas, better known as the Compact Commission. Each state commission would then allocate its quota among the producing fields within the state. Production in excess of the prorationing orders was subject to confiscation.[12] When the Supreme Court declared the NRA unconstitutional in May 1935, Congress promptly passed the Transportation of Petroleum Products Act, better known as the Connally Act after its sponsor, Texas Senator Tom Connally, thereby keeping the components of the complicated price-fixing scheme—prohibition of “hot oil,” input restrictions, and production quotas—intact.

But why the appalling waste of oil and gas? Usually reference is made to the magnitude of the new oil discoveries, both in the U.S. and abroad, which drove prices down, and to the relatively primitive technology, which made regulation of gas pressure and the control of gas and oil flows very difficult. There is no doubt a kernel of truth here, but there is a far more fundamental, underlying factor: the property rights of an owner of a plot of land, or more precisely the lack of such rights, to the minerals lying beneath the surface. According to the prevailing legal doctrine known as the “rule of capture”:

The owner of a tract of land acquires title to the oil and gas which he produces from wells drilled thereon, though it may be proved that part of such oil or gas migrated from ad joining lands. . . . A landowner, however small his tract, or wherever located on the producing structure, may drill as many wells on his !and as he pleases and at such locations as meet his fancy, and he is not liable to the adjacent landowner whose lands are drained as a result of such operations. Likewise he may by means of a compression or vacuum pump, increase the production from his well though the result may be to drain his neighbor’s property. The remedy of the injured landowner . . . has generally been said to be that of self-help—“go and do likewise.”[13]

Clearly, the “role of capture” made it rational, in fact necessary, to “waste” oil and gas. By legalizing what, in effect, was the principle of “loot thy neighbor,” the “rule” required property owners to follow the strictly short-ran policy of drilling and producing as rapidly as possible. Even if an oilman or speculator felt that the price would rise in the future, he could not hold the oil or gas off the market, for if he stopped his operations and capped his wells while his adjacent competitors continued their activities, the owner would lose both his oil and his capital investment.

For example, an operator near the town of Okmulgee struck a huge natural gas reservoir. He offered to sell it to the gas company. The company refused the offer but was able to get the local authorities to require the operator to cap his well to prevent the gas from escaping. The company then acquired the gas by drilling its own well on an adjacent plot of land and tapping into the same reservoir.[14]

“Wasting” Oil and Gas

Because of the “rule of capture,” drilling at times became “so intense that the legs of derricks would intersect,” says Tugendhat. Consequently, underground pools often would lose pressure so rapidly that great quantities of oil, perhaps as much as 90 per cent, would be lost, or recoverable only by expensive repressuring.[15]

Thus, the property owner was caught in a bind. He could not chance storing oil and gas underground where it could be looted by adjacent competitors. But neither could he afford to store much of it above ground since the cost of storage usually exceeded the market value of the product. Given the “rule of capture,” the only “rational” policy was to permit wells to run open, allowing the “excess” oil and gas to be “wasted.”

There can be little doubt that had the courts adopted the doctrine of “correlative rights” or “ownership in place”—that the landowner owns the oil and gas originally beneath his surface—the situation would have been much different. There would have been about as much chance of companies wasting their oil and gas as there is of a cattle rancher or chicken farmer wantonly destroying his entire stock of healthy animals. Since ownership in place would have required that an adjacent operator caught draining another’s oil or gas would make reparations to the original owner, the principle would have permitted oil and gas to be stored underground, ready for use when prices began to rise. The result would have been to permit, in fact encourage, operators to adopt long-run conservation policies, thereby moderating the “flush and famine” cycles and their corresponding price fluctuations so bemoaned by operators and consumers alike.

In brief, the “rule of capture” produced appalling waste which was seen to justify government intervention to restrict production. But, as is so often the case, one intervention leads to another. As production was restricted and prices rose, imported oil began to enter the country and “illegal” domestic oil was produced. The former was dealt with by the imposition of tariffs, the latter by the Connally Act. Had the courts adopted a sensible approach to property rights, oil would not have been wasted and the justification for government intrusion into the industry would not have arisen.

There are additional ramifications. From about 1930 to 1970, Federal policy was to keep domestic oil prices high, relative to international prices, by a combination of pro-rationing and import restrictions. The result, sometimes referred to as a “drain America first” policy, was to artificially stimulate the consumption of American oil while reducing the consumption of foreign oil.

But American oil tended to be more costly than foreign oil. Even as early as 1930 a barrel of Venezuelan oil could be produced and shipped to the U.S. for 75 cents while the production cost for a barrel of domestic oil was about $1.75. And as American oil was being depleted, with the ratio of domestic reserves to annual production falling from about 20 to 1 to only 12 to 1 by 1960, costs began to rise. Meanwhile, with vast new discoveries, especially in the Mideast, the world reserves to production ratio rose to 40 to 1. For the Mideast it stood at 100 to 1.[16] While a barrel of Texas oil sold for $3.45 in the 1960s, a barrel of Persian Gulf oil sold for less than $1.00 and its cost of production was estimated at 10 cents.

Largely for military and national security reasons, duties on oil imports were relaxed during the 194Os, falling to just 10½ cents a barrel so long as the volume remained less than 5 per cent of domestic production and doubling if imports exceeded 5 per cent. Given the low import duties, rising domestic costs, and the international glut, imports began to soar.

In 1948 the U.S. became a net importer of oil. In 1950 imports were about 5 per cent of domestic production. By 1954 they were nearly 17 per cent and the industry began to push for higher tariffs. In 1955 the President’s Committee on Energy Supplies and Resources suggested that imports not be allowed to rise above their 1954 level but recommended enforcement through “voluntary restraint” implemented through the oil companies. Voluntary restraints proved ineffective and, with imports well over 20 per cent of domestic production, mandatory quotas were decreed by President Eisenhower in 1958.

The quotas succeeded in shoring up domestic prices but created what Fortune termed “carnage in the world market.” “Now that the U.S. is so hard to get into,” said Fortune of the foreign producers, “where can they sell it and at what price?. . . . Prices abroad . . . are taking a beating. More and more crude . . . is being sold at reduced rates.”[17]

With about 90 per cent of the budgets of the Mideast governments coming from oil revenues, the price collapse wrought havoc. Panicked by the price declines and angered at their virtual exclusion from the U.S. oil market, the producing countries began to map out a counter-strategy in 1959. In 1960 the Organization of Petroleum Exporting Countries, a “cartel to confront a cartel” as one delegate put it, was formed.

There is no doubt that in the absence of government intervention domestic oil prices would have been lower and international prices higher. Nor can there be any doubt that proportionally less American oil and more foreign oil would have been consumed. Finally, it is quite possible that with open access to the American market; and thus both higher prices and a larger volume of sales, OPEC might never have been formed. The next question is: What has been the impact of OPEC?

4. International Cartels: Achnacarry to OPEC

There has been a great deal of public concern over the repeated oil industry attempts to cartelize itself in order to regulate competition and raise prices. But in every case the results fell considerably short of the goals.

The first concerted effort to establish an international cartel occurred when secret meetings, sponsored by the “Big Three”—Jersey, Shell, and Anglo-Persian—were held at Achnacarry Castle in Scotland during the summer of 1928. The result, officially termed the Pool Association of September 17, 1928, but more commonly known simply as the Achnacarry Agreement, was an ambitious plan to “stem the rising tide of competition” by “freezing the market in its existing mold.” Prices were to be determined by the “Gulf-plus pricing system” i.e., oil prices throughout the world would be equal to oil prices in the Gulf of Mexico plus shipping costs.

But agreement was short-lived. First, the members themselves found it next to impossible to agree on production quotas and price levels. And second, the “majors” were unable to secure cooperation of the “independents” who, Tugendhat says, “continued to export their oil at lower prices than the cartel members.” As a result, “by November 1929 the association had collapsed.”

There were repeated attempts during the next half decade to develop workable modifications of the Achnacarry Agreement. These included the 1930 Memorandum for European Markets, the December 1932 Heads of Agreement for Distribution, and the June 1934 Draft Memorandum of Principles. But, as Tugendhat says, these agreements “were treated rather like the Ten Commandments, as a set of rules to which all pay lip service but few follow to the letter. . . . For all their power, the majors could never gain complete control over most of the larger markets, any more than Rockefeller had been able to impose his will in the United States during the 19th century.”[18]

In brief, the extensive experience of the oil industry with voluntary cartelization—cartelization not enforced by government—clearly shows that it was never effective in controlling either production or prices. It has been estimated that no more than 50-60 per cent cooperation was ever attained, and it seems likely that this figure exaggerates the amount of actual collusion since it ignores the role of markets in spontaneously equalizing prices for the same products. Moreover, the only way the majors could “control” their markets was through the maintenance of low prices accompanied by, as in 1966-67, periodic “price wars” to drive out the independents. Since cartels are supposed to be bad because of their ability to exploit consumers by charging high prices, the question is: If this is the way voluntary cartels operate, what is the harm? The answer: There is none!

But what of OPEC, which is normally seen as the prime example of a cartel which has been effective in controlling oil prices? There are two important questions: (1) Is OPEC a coercive or voluntary cartel? (2) How effective has it been in controlling prices?

The first question is relatively easy to answer. According to its principal founder, Venezuelan Minister of Mines and Hydrocarbons, Dr. Juan Pablo Perez Alfonso, OPEC was to be a “worldwide Texas Railroad Commission.” Its goal has been to raise and then control the international price of oil by restricting its production. But the Texas Railroad Commission is a government agency. Since it can use the apparatus of the state to compel companies to comply with its edicts, the Texas Railroad Commission and other state regulatory agencies have been the key components of a coercive cartel.

It is true, of course, that OPEC members are countries. But they are sovereign countries. Thus, no OPEC member can coerce any other member. Nor is there any supra-OPEC agency empowered with coercive authority. Thus, the effectiveness of any OPEC agreements depends on the voluntary acquiescence of its members. In short, OPEC is a voluntary cartel, or a “club” as Perez Alfonso put it. It is a Texas Railroad Commission without the power of the state to back it up.

The second question is more difficult to answer. How effective has OPEC been in controlling prices? First, OPEC was formed in 1960 with the stated purpose of raising prices. But its members never could agree on a scheme to reduce production, and it was clearly ineffective during its first decade. In 1960 the volume of oil in international trade was 9.0 million barrels a day; in 1970 it was nearly 26 million barrels. Thus, “the price of oil did not go up; in fact it declined through the 1960s.”[19]

It is the “price shock” of 1973 that is commonly seen as the beginning of OPEC’s control over prices. In October of that year OPEC announced an embargo on oil to the United States because of U.S. support for Israel in the 1973 Arab-Israeli War. OPEC also announced a cutback in production and a price rise to $5.12 a barrel. In December the price was increased to $11.65 a barrel, a quadrupling of prices in just a few months. Doesn’t this indicate market control by a voluntary cartel?

There are several factors which need to be considered to understand why this is not the case. First, there is substantial evidence that by 1970 the oil “glut” was gone and the world, in fact, was facing an oil “shortage.” Demand for oil had increased 7 per cent a year from 1950-73. In 1940, for example, coal accounted for two-thirds of the world’s energy. In 1965 coal and oil each accounted for 37 per cent of total energy consumption. By 1980, oil’s share of world energy consumption stood at over 40 per cent; coal’s had fallen to 30 per cent.

On the other hand, due in part to the artificial stimulus of the controls on foreign oil, U.S. reserves were quickly being depleted. This problem was compounded by the fact that as new sources of domestic oil became increasingly difficult to find and extraction costs rose, U.S. production peaked and by the early 1970s was actually declining.[20]

The result of these trends was an extremely “tight” market. This is shown by the fact that prices began to rise even before the 1973 embargo. In February 1971, for example, oil prices rose 50 cents a barrel. And by early 1973, months before the October embargo, prices on the spot market—a free market for small quantities of “excess” oil—were up to $20 a barrel, or over five times the official or “posted” OPEC price at the time.

Second, an analysis of oil industry profits shows that with rising production costs associated with offshore and deep drilling, the high returns of the I950s were gone. During the 1960s profit rates fell below those in the far less risky manufacturing sectors, and by the early 1970s they stood at an all-time low.[21] Since incentives and exploration are closely related, it is clear that domestic production could not be maintained much longer at their current levels in the absence of significant price increases. In fact, U.S. production was already declining.

The final factor is the 1973 Arab oil “embargo.” An embargo is an attempt to punish a country or region by imposing an abrupt halt in the flow of a particular good, in this case oil, to the embargoed country. When the embargo is imposed, prices in the embargoed country should rise while production in the embargoing countries should be curtailed. And when the embargo is lifted, production in the embargoing nations should increase, causing prices in the embargoed countries to return to “normal.” The problem is that the 1973 “embargo” didn’t work this way. First of all, although prices did quadruple, the embargo was never very effective. It was marked by massive “cheating” and defections among cartel members. Moreover, OPEC production declined less than 15 per cent in 1974-75, and its exports to the “embargoed” U.S. increased dramatically between 1973 and 1977. And finally, rather than declining at the termination of the embargo, oil prices actually increased slightly.

All these factors indicate that, as Paul MacAvoy put it, OPEC “never really controlled the world crude oil market. Rather, market forces were the dominant factor all along.”[22] The pre-1973 prices were far too low to be maintained much longer.

High prices are neither good nor bad in themselves. Prices are signals revealing relative scarcities. The embargo merely highlighted how swiftly, dramatically, and unexpectedly the situation had changed from glut to famine. It also stimulated a market response to the new situation. In fact, the temporary 15 per cent decline in OPEC production appears less likely to have been the product of a conscious cutback by OPEC than a rational response to reduced world demand stemming from the 1974 recession. OPEC’s policy, both collectively and individually, has been aptly described as that of “’groping’ toward an unknowable ‘optimal’ pricing path,” that is, of charging what the market would bear.[23]

Likewise, the doubling of prices in 1979 cannot be attributed to cartel-like behavior by OPEC for, as Dermot Gately notes, by 1979 OPEC discipline “had broken down.” Rather, the price rise was a result of another tightening of the market—prices on the spot market reached $40 a barrel—due to attempts by consuming countries to stockpile oil and thereby protect themselves from a possible loss of access to Mideast crude following the political upheavals in that region, especially in Iran. While the panic buying was in response to political events, there can be little doubt that oil prices were market-driven rather than cartel-determined.

The worldwide dependence on OPEC oil was aggravated by the U.S. government’s imposition of price controls on domestic oil and gas in 1973. It is ironic that the U.S. government, which for decades had artificially stimulated the production of U.S. oil, responded to the “shortage” by imposing price controls on domestic producers which, by discouraging domestic production, artificially stimulated increased reliance on foreign oil.

Finally, it should be noted that consumers reacted to the higher energy prices just as one would expect—higher prices stimulated more efficient use of energy. Between 1973 and 1984 the Western industrialized nations increased energy efficiency by one-third. As a result, by 1984 energy consumption was actually less than it was in 1973, despite higher GNPs.[24] Between 1973 and 1985 OPEC’s share of world crude oil production fell from 56 per cent to 30 per cent. During the same period, oil’s percentage of total energy production declined from 48 to 39, while the shares for oil substitutes such as coal, gas, nuclear, and hydroelectric all rose.

It therefore became increasingly difficult for OPEC to maintain prices at their 1979 level. Between 1979 and 1985 OPEC production was halved, falling from about 30 to 15 million barrels a day, with Saudi Arabia bearing the bulk of the cutbacks. Finally, in an attempt to increase its dwindling oil revenues, Saudi Arabia reversed course in November 1985, and began to increase production. Oil prices plummeted, with OPEC members trying to underbid not only nor-OPEC countries, but each other as well.

In brief, OPEC never was able to act with the cohesion required for the successful operation of a cartel. While OPEC may have affected the timing of the oil price increases, it does not appear that it affected their ultimate levels. The quadrupling of prices in 1973 was not the result of cartel price-fixing, although it may have appeared that way at the time, but reflected the dramatic change in the world oil situation. Moreover, the increases helped to rationalize a market that had become badly distorted due to decades of government meddling. Finally, the normal market-induced adjustments to higher prices stimulated a movement away from OPEC oil and, ultimately, the 1985 collapse of OPEC prices.

From Achnacarry to OPEC, history shows that attempts to create international oil cartels with the ability to control prices have uniformly failed. To the extent that they “controlled” the market, they have done so by keeping prices extremely low. To the extent that they have increased prices, they have been undercut by non-member rivals, and the cartels have collapsed.

5. A Sensible Energy Policy

The final issue is to determine a sensible energy policy. Such a policy may be defined as one which assures access to ample energy at minimum cost, i.e., with the least sacrifice of other goods and services.

Businesses must operate efficiently to earn profits or at least avoid monetary losses. Those that provide consumers with what they want at the lowest prices earn the largest profits. Those that fail to do so suffer losses and, if changes are not made, go bankrupt.

Government, in contrast, is inherently inefficient. Government does not acquire its revenues by the voluntary purchases of consumers but by compulsion, i.e., taxes. These are then allocated among a multitude of competing programs and agencies.

There are two fundamental differences between the operations of businesses and governments. First, payments to businesses are voluntary. Payments to governments are compulsory. Second, payments to businesses are made in exchange for specific goods or services. That is, they are part of the same transaction. But with government, payments and receipts of services are two distinct operations. Payments are made at one time; services are rendered at another time. Payment may be made by one set of individuals; services may be rendered to another set. The problem is that since there is no direct market test for government services, there is no way for consumers to evaluate their effectiveness and worth.

For example, government may claim that there is a shortage of roads, police, teachers, or oil, but it has no market test to see whether there actually is a shortage. And since government is not in a position to ascertain accurately the relative demands for its services, there is no way for it rationally to allocate its revenues among its competing uses.[25] This has important ramifications for energy policy since if access to energy can be achieved through other, non-governmental, methods, then efficiency considerations would rule out the use of government.

The question then is: Is government necessary to insure access to ample energy? Energy access can be achieved by (1) securing access to oil, (2) developing adequate substitutes for oil, or (3) a mixture of the two.

Let us first consider oil. The major concern is that OPEC now possesses over 60 per cent of proven world reserves. The industrialized nations of the West, including the United States, have 13 per cent. The U.S. alone possesses slightly less than 5 per cent.[26] The fear is that, as Unocal chairman Fred Hartley has put it, given the magnitude of inexpensive off in the Mideast—production costs in Mideast oil fields are estimated at less than $2 a barrel, while costs in Alaskan and North Sea fields are about $20 a barrel—OPEC is in a position to increase production drastically. This would drive down oil prices, thereby “stimulating demand even as it shut down American production and virtually ending this country’s search for new energy sources.” Since this would make the U.S. “dangerously dependent on foreign—OPEC—oil,” America, he says, simply “cannot afford so-called cheap oil.” The proposal is for an oil import fee which would “create a floor price of, say $27 per barrel, which should be high enough to support continued American exploration and development.”[27]

The irony of the proposal is apparent: It would be a return to a “drain America first” policy that, as we have seen, is largely responsible for the rapid depletion of American oil reserves in the first place. Moreover, its ramifications are also clear: By substituting higher-cost American oil for cheaper Mideast oil, an import fee would stimulate the rapid consumption of the already small American reserves, thereby making the U.S. more, not less, dependent on OPEC. Finally, the position reduces itself to the rather paradoxical proposition that the government should institute permanently higher oil prices now because of the possibility of temporarily higher energy prices at some unspecified time in the future.

It is simply not true that “energy security” is directly correlated with the quantity of imported oil. “Energy security” depends at least as much—probably even more—on the diversity of suppliers. The 1973 price increases stimulated the search for oil in many countries. As a result, the oil industry has become immeasurably more diverse. The U.S. now imports oil from close to 30 countries. The problem is that since many of these are relatively high cost producers, an import fee, by isolating the American market from imports, “would push down the world price for oil, thereby discouraging exploration for oil in other countries.”[28] This would reduce the diversity of supply, thereby rendering the U.S. more dependent upon a single supplier—OPEC. In short, the immediate effect of an import fee would be higher domestic energy prices. Its long-run result would be the exact opposite of its intended effect: It would make the U.S. more, not less, dependent on OPEC.

In contrast to an import fee which would create a dual price structure—higher oil prices domestically and lower oil prices internationally-free trade could equalize domestic and foreign prices. Since this would keep domestic prices below what they would be with an import fee, free trade would reduce production of American oil. And, by increasing demand for foreign oil, it would help to maintain the diversity of the current oil market, thereby insuring continued American access to oil. It is logical to conclude, therefore, that the free market is far more likely to insure continued access to oil than a policy of government intervention.

But what of alternative energy sources?

Although there are many who disagree on both the low and high sides, the consensus is that there is somewhere between a 50- and 90-year supply of recoverable oil left in the earth. Clearly, alternatives to oil will have to be developed. Over the past decade the Department of Energy has spent literally billions of dollars to develop such alternatives but, as Christopher Flavin, a Worldwatch researcher and hardly an exponent of the free market, recently wrote: “Crash government programs to develop major new energy sources have generally been dismal failures, and similar efforts to deal with future crises show no signs of being any more successful. But smaller efforts, taken by companies and individuals in response to higher prices, have an excellent record.”[29]

In fact, such government programs have probably done more harm than good. The reasons are not hard to find. Government decisions are based on political, not economic, criteria. The basic problem is the asymmetry between the costs and benefits of government programs. Since the costs of each program are dispersed among the taxpayers as a group, the cost of any particular program to any individual taxpayer is minute. This means that the individual usually is not even aware of the program and, if he is aware of it, would quickly recognize that the costs to him of opposing the program overwhelm the benefits that would accrue to him from the program’s termination. Thus, his rational strategy is to minimize his losses by not actively opposing the program.

But when the beneficiaries of a program are a relatively small group, the benefits can be considerable for each member of the group. Consequently, while the average taxpayer has no incentive to lobby against a particular program, the potential beneficiaries have a strong incentive to lobby for its passage. Given this asymmetry, it’s not difficult to see which side will win.

Gasohol is a classic example. Gasohol is a mixture of 90 per cent gasoline and 10 per cent ethanol. Grain is used in the production of ethanol, and the farm lobby has been able to channel large amounts of tax money into farmers’ pockets by getting the government to establish a program to subsidize the production of ethanol. But it is so expensive that some economists “have compared that process to stretching our supplies of hamburger by adding a few extra pounds of tenderloin steak. The value of the resources necessary to produce gasohol is simply a great deal more than the value of the resources (even at high crude oil prices) necessary to produce straight gasoline.”[30]

The tragedy is that the commitment of large sums of money to such wasteful projects reduces the amount of investable capital and, correspondingly, the degree of innovative activity that normally would occur in the market. Such programs, therefore, actually impede the development of alternative energy sources. For example, the high cost of supplying electricity to the remote rural areas of this country in the early part of this century stimulated the development of windmill and hydroelectric industries. But the decision of the national government to supply rural residents with heavily subsidized and thus artificially “cheap” energy priced these alternative sources out of the market.[31]

Whether the alternative to oil will be coal, nuclear, solar, hydroelectric, an entirely new discovery or invention or, as seems likely, some mix of these, is impossible to tell. But it is clear that the free market, where investors and entrepreneurs risking their own money are rewarded with profits for successful ventures and penalized with losses for unsuccessful ones, is far more likely to produce viable alternative energy sources than the government.

If the above analysis is correct, then the market is not only more likely to supply energy more efficiently than government, it is also more likely to supply it in ample quantities and without interruptions.

In short, regardless of what OPEC does, the best energy policy is laissez faire.

6. Conclusion

The distinction between voluntary (market-spawned) and coercive (government-created) cartels has been examined. It was found that while coercive cartels have seriously distorted the market, thereby harming consumers and wasting oil, voluntary monopolies and cartels, from Standard Oil to OPEC, have actually benefited consumers by eliminating waste and increasing the overall efficiency of the industry. Finally, it was shown that the free market is far more likely to insure continued access to energy than a policy of government intervention. []

1.   The information on the early history of the oil industry was taken from the following sources: D. T. Armentano, The Myths of Antitrust (New Rochelle: Arlington House. 1972), pp. 63-85; John Chamberlain, The Enterprising Americans (New York: Harper and Row, 1963), pp. 148- 156; Christopher Tugendhat, Oil: The Biggest Business (New York: G. P, Putnam’s Sons, 1968), pp. 9-42; Stanley Clark, The Oil Century (Norman: University of Oklahoma Press, 1958), pp. 341; and Leon Louw, “A Critical Review of Prevailing Energy Predictions and Policies,” presented to the Thirteenth Annual AIESEC Congress on “Energy_’ A Factor in Economic Development,” 1985.

2.   Chamberlain, p. 153.

3.   Armentano, p. 68.

4.   Ibid., p. 74.

5.   Ibid.

6.   Ibid., p. 70.

7.   Chamberlain, p. 155.

8.   Tugendhat. p. 93.

9.   Clark, pp. 147-165. Also see Robert Engler, The Politics of Oil (New York: Macmillan. 1961), pp. 132-139.

10.   Engler, pp. 13%138..

11.   Clark, p. 194. An oil tariff was first embodied in the Internal Revenues Act of 1932. See Clark, p. 239.

12.   See, for example, Howard Williams and Charles Meyers, Oil and Gas Terms (New York: Banks and Co., 1957), pp. 197-198; and Engler, pp. 140-141.

13.   Williams and Meyers. p, 216.

14.   Clark, p. 159. Also see pp. 84-103.

15.   Ibid., p. 99.

16.   Gilbert Burck, “A Strange New Plan for World Oil,” Fortune (August, 1959), p. 96.

17.   Gilbert Burck, “World Oil: The Game Gets Rough,” Fortune (May, 1958), p. 125.

18.   See Tugendhat, pp. 97-111.

19.   “Adam Smith” (a.k.a. George Goodman), Paper Money (New York: Summit, 1981), p. 163.

20.   Charles Doran, Myths, Oil and Politics (New York: Macmillan, 1977), p. 56. And “Smith.” p. 164.

21.   Doran, pp. 51-54.

22.   Paul MacAvoy, “The Punishing Costs of Fixing Oil Prices.” The New York Times (December 29, 1985), Business Section, p, 3.

23.   Dermot Gately. “A Ten-Year Retrospective: OPEC and the World Oil Market.” Journal of Economic Literature (September, 1984), p. 1110.

24.   Norman Fieleke, “The Decline of the Oil Cartel,” New England Economic Review (July/August, 1986), pp- 34-35. And World Resources Institute, World Resources. 1986 (New York: Basic Books, 1986). pp, 114-115.

25.   See Thomas Sowell, Knowledge and Decisions. (New York: Basic Books, 1980). pp. 140-143; Ludwig von Mises, Bureaucracy (New Rochelle: Arlington House. 1969); and David Osterfeld, Freedom, Society and the State (San Francisco: Cobden Press, 1986), pp, 250-253.

26.   The percentages have been calculated from OPEC, Facts and Figures, (Vienna: Carl Umberreuter, 1980). Table, p. 17. See also Christopher Flavin. World Oil: Coping With the Dangers of Success (Worldwatch Paper, 66. 1985). Table. p, 28-

27.   Fred Hartley, “Predatory Saudi Tactics Peril U.S. Petroleum Industry,” Los Angeles Daily News (April 13, 1980). Also see “Import Fees: The Reason Why,” World Oil (May, 1986). pp. 20-24.

28.   G. Anderson and K. J, Kowalewski, “Implications of a Tariff on Oil Imports,” Economic Commentary (September 1, 1986), p, 2.

29.   Flavia, p. 53.

30.   Richard Stroup and John Baden, “Responsible Individuals and the Nation’s Energy Future.” Cato Journal (Fall 1981), p. 432.

31.   Ibid., pp. 427-429.

  • Dr. Osterfeld was assistant professor of political science at Saint Joseph's College, Rensselaer, Indiana.