The Equilibrium Price Range of Oil

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The equilibrium price range of oil

Economics, politics and uncertainty
in the formation of oil prices
Pierre-Noël Giraud
Energy Policy
Volume 23, no. 1, 1995, pp. 35-49.
The equilibrium price range of oil Pierre-Noël Giraud
Summary
This paper attempts to clarify the articulation between economic and political factors in the
formation of petroleum prices. It begins with defining the political factors. Then it gives a
definition of the ‘dynamic equilibrium price’ of a mineral commodity market. The essential
point is that when actors control significant low cost reserves and will not or cannot adopt
behavior of a ‘substantial economic rationality’ then the economic analysis does not allow a
unique dynamic equilibrium price to be determined. However, it does permit definition of an
equilibrium price range within which political preferences may be expressed. Finally, the paper
draws some conclusions on what could be discussed within the scope of a new oil producer-
consumer dialogue.
Key words
Oil, Market, Politics
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The interweaving of political and economic factors in the historical evolution of oil prices was
and remains obvious to almost all experts (cf. for example, Yamani, 1992). However, analyses
differ greatly in their interpretation of the exact nature of this interweaving and the relative
importance of the two factors. Since the mid-1980s, there has been a tendency to increase to
stress the role of economic factors and to reinterpret the recent history of petroleum in this
direction.
For example, during the 1970s, OPEC was overwhelmingly considered a politically driven
cartel capable of fixing prices at any level below those of substitutable energy resources. Today,
certain experts affirm that OPEC never actually had real market control. This thesis of the
predominance of economic factors is supported by the governments of those countries which are
reluctant towards the dialogue initiative between oil consumers and producers started by
Venezuela and France in 1991. If need be, these governments are willing to discuss ways of
improving the functioning of markets, but consider any discussion of price levels to be useless,
and even harmful.
At the other extreme, some experts such as Professor Mabro (1991a), while recognizing that day
to day prices are fixed by ‘free’ markets and therefore fluctuate as other commodities, consider
that these fluctuations remain near average levels characteristic of ‘episodes’ in the petroleum
history. These episodes are separated by crises. Following a crisis, according to Mabro, these
are essentially political factors which determine the new level of relative stability, this being
within a large range of possible levels.
This paper attempts to clarify the articulation between economic and political factors in the
formation of petroleum prices. We must begin by defining the political factors. The first section
is therefore devoted to definitions, something which, as a matter of curiosity, is rarely done in
the literature. The generally implicit understanding of ‘economic and political factors’ is
obviously a source of confusion. The second section gives a definition of the ‘dynamic
equilibrium price’ of a mineral commodity market. The essential point is that when actors
control significant low cost reserves (which is the case in the petroleum industry), and these
actors will not or cannot adopt behaviours of a ‘substantial economic rationality’ (Simon, 1978),
then economic analysis does not allow a unique dynamic equilibrium price to be determined.
However, it does permit definition of an equilibrium price range within which political
preferences may be expressed. The third section draws from the preceding discussion the
definition of certain number of oil price thresholds and ranges which allow the link between the
economic and political factors in oil price formation to be clarified. The fourth section verifies
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that this model permits an interpretation of the evolution of oil prices since the early 1970s. The
fifth draws some conclusions on topics that could be discussed under the aegis of a new oil
producer-consumer dialogue.
Economic and political decisions
The fact that a large proportion of international petroleum flows comes from the Middle East
and the CIS, which are considered politically unstable (for many decades for the first, and
probably a number of years to come for both) obviously makes the petroleum market
particularly vulnerable to events affecting these areas, such as civil strife and wars between
nations. Such events may be qualified as ‘political’ without highlighting semantic difficulties,
even if important economic interests intervene. What needs to be clarified is the definition of
economic and political in the ‘normal’ functioning of oil markets, i.e., in the decisions made by
industrial actors and governments in terms of investments, the level of utilization of production
capacities, taxes, regulations on production, transport, consumption, etc.
Economic decisions
It must be emphasized that the fact that a market has a non-competitive structure does not
necessarily imply that there is room for political decisions. When one actor holds a market
power, the exercise of this power in its own best economic interests may not be considered
political. A group of dominant producers, confronted with the competition of a fringe of ‘price
takers’, which fixes a price trajectory aimed at maximizing the sum of its discounted revenues,
is thus acting in an economic manner. If this was the case with OPEC, political factors would
not determine oil prices, except in periods of crisis brought about by events previously
mentioned.
Likewise, the governments which tax the consumption of certain petroleum products behave in
an economic manner, exploiting a weak long-term price elasticity of demand and therefore
depriving governments of producing nations of a rent which they themselves could earn if they
were to organize themselves in such a way as to exert control over the market. Even the tax
proposed by the EC Commission on fossil fuels, which is currently considered by OPEC as a
hostile ‘political’ measure (i.e. without economic justification), could be defined as an economic
decision if it could be proved that such a tax was the most efficient (meaning the least costly
collectively) means of combating the consequences of an increase in the greenhouse effect, and
that the cost of the tax was less than the cost of the greenhouse effect which it seeks to avoid
(which assumes that it is feasible to give a monetary value to this kind of externality).
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In short, the decisions which are unquestionably economic are those that are ‘substantially
rational’. According to Simon (1978), a particular entity behaves in a substantially rational
manner when it classifies all future possible states of the world according to its preferential
system and makes decisions leading to the most favorable situation being the one which is most
accessible for itself, taking into account the behaviour of other actors. This, of course, assumes
that it is possible to know the future states of the world (or at least attribute probabilities) as
well as the relations between its decisions, those of other actors, and these future states. This
also assumes that an actor can always compare two separate states of the world; in other words,
the variations of these parameters that define these states must be commensurable. Within these
hypotheses, a utility function may be defined for each actor in which the variables are made up
of all or a portion of these parameters. Thus, the decisions made by the actors result in a
maximization under constraints of their utility functions.1
In other words, whatever the market structure and whatever the initial distribution of property
rights on the factors of production, if all the decisions made by the actors concerned are guided
by a substantial rationality, then purely economic models could be designed which would
determine, for example, the price of oil.
Having economic decisions, we must now look at other types of decision, those which are either
based on redistribution (outside the market) of property rights, particularly those rights
concerning the factors of production, or which are not substantially rational. This set is itself
divided into two. Either the actors do not have the information or the capacity or the time to
make the necessary calculations or, more basically, it is not possible to construct a utility
function for the actors, which is the case when the parameters that determine their choices are
not commensurable.2
Three types of political decisions
The redistribution (outside the market) of property rights.
For economic models, initial property rights are considered exogenous. The functioning of
markets itself continuously modifies the distribution of property, naturally including rights over
1
It should be pointed out that for a producer, maximization of a utility function does not necessarily mean
maximization of revenues or profits, which are only isolated cases. The objective of a producer may be, for example,
to obtain a given revenue. Its utility will then increase as long as it is not reached, then decrease if it passes the
desired level. As will be seen, economic models of the petroleum market were established on this kind of hypothesis.
Cf. Cremer and Salehi-Isfahani (1989).
2
In other words when the actor is faced with multicriteria choices.
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production factors. Economics, however, does not offer an indication of whether an initial
distribution is superior to another, except when comparing the utilities of two actors, which in
general economics refuse to do. Decisions on modifications outside the market (meaning those
decisions which do not result in a freely and reciprocally agreed market transaction) cannot be
considered economic. When a particular state which makes this kind of decision, it can be
considered as political in the first meaning of the term. The nationalization of private assets is
an example.
The procedural rationality
When the future is uncertain, i.e., when the future states of the world are impossible to know
with precision, or when they may be known but it is impossible to attribute probabilities, the
maximization of a utility function is impossible (in theory). In practice, this is equally the case
when an organization does not have the time or the means of information and calculation in
order to carry out the maximization. The organization therefore behaves according to a
rationality that Herbert Simon has described as ‘procedural.’ On the one hand, decisions are
guided less by objectives of utility maximization (revenues, profits, etc.) than by objectives
aimed at attaining a ‘satisfactory’ level of utility. On the other hand, the decisions made depend
on the organization itself: its acquired experience and its ‘routine’ internal functioning.
Theorists of the ‘evolutionist’ approaches have, however, attempted to model this kind of
behaviour. In these models, the agents do not optimize globally but rather locally, meaning they
make decisions ‘near’ to what they have already done and know how to do. This leads to
phenomena of ‘path dependency’ (the paths followed always depend on the past) which, if not
calculable by an algorithm of optimization, can at least be simulated. Despite these
commendable theoretical efforts, this kind of decision may be considered as partly political in
nature, although in a different way from the preceding example. In such a case the history of an
organization (and particularly the conflicts and crises that it has weathered) means that the
decisions it takes may deviate from the strictly rational in ways that cannot be predicated or
modeled. Societal value systems exercise a similar influence. In an urgent crisis situation it is
not possible to weigh the pros and cons of each possible decision: an organization acts by reflex,
and its reflexes are conditioned by its history.
In this conception, however, the organization is also a place of learning. When an organization
finds itself in a completely new environment, its rationality will at first lead it to take decisions
which are possibly very different from those which would have allowed itself to reach its
economic optimum. Each decision is therefore a sort of gamble, testing the functioning of the
real world, particularly the behaviour of other actors. If the environment stabilizes, the decisions
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may then converge, thanks to the process of learning in the direction of economic rationality,
with the importance of political influences (in the second meaning defined here) diminishing.
The non-monetary objectives
The third category of political decisions stems from a substantial rationality (relating the means
and the clearly defined objectives) but one in which the objectives may not be expressed in
monetary terms, and are not therefore commensurable with economic objectives.
Such, for example, is the case of supply security for each oil importing nation. It is conceivable
for a government to calculate the ‘optimal’ level of dependence regarding its oil imports as a
function of various crisis scenarios and as a function of the evaluation of all the economic
consequences of these scenarios. Such attempts have been made, but without great success. In
practice, it becomes obvious that the appreciation of the desired level of dependency evades the
monetary evaluation. In other words, the government of an importing nation cannot calculate
trade offs such as less security for more growth or vice versa.
Another interesting example, because it was used in the construction of ‘economic’ models of
the petroleum market,3 is the hypothesis that certain oil producing states limit their objectives of
petroleum revenues to their ‘absorption capacity’. Everything depends on what indeed
determines this ‘absorption capacity’. If we assume that the producing nations limit their
revenues (and therefore their production at a given price) not only because their internal
capacity of investments is limited but also because they give a high-risk coefficient to external
financial investments, then this is an economic decision. The desired level of revenue may in
this case be calculated in function of well defined and monetarily assessable parameters.
However, this hypothesis is very fragile, because what limits internal investment capacity,
particularly in the long term, remains unknown. As many studies have shown, a better
hypothesis is that the petroleum rent has internal and external politically destabilizing effects.4
Under these conditions, the rent is not only a condition of governments maintaining control but
also a permanent threat to the stability of this control. The ‘desired’ level of rent by these
governments, which is not necessarily the maximum level that would be economically
accessible over the long term, is therefore fundamentally determined by objectives of political
survival in the short or even very short term. The various factors that determine this level are
complex and many are not assessable monetarily: the volume of rent to be redistributed within
and outside the country, the required armament level, etc. The difference between the two
3
Cf. for example, Cremer and Salehi-Isfahani (1989).
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hypotheses is essential, since in the first case, there is an economic rationality, therefore
predictable behaviour, and in the second case, there are important objectives that may be
significantly varied over time as a function of the judgement of political leaders, without the
economic parameters changing.5
This third kind of decisions may be considered as political in the greater meaning of the word,
since the objectives pursued are to do with the security of states and the stability of
governments.
The petroleum industry: a high density of political decisions
In our opinion, it is unquestionable that political decisions, in one of the three definitions (or a
combination of the three), have been and are being made within the petroleum industry.
Obviously, some decisions in the real world are always political, whatever the industry.
Nevertheless, there are industries where the hypothesis of the economic behaviour (substantially
rational) of nearly all actors is a satisfactory approximation to reality. Economic analysis may
then be deployed: it models the relationships between behaviour and price and production
trends, taking into account the structural considerations (long- and short-term price elasticity of
supply and demand, cost structures, number and concentration of actors, etc.). Once the
hypotheses have been stated, the result is unique; the economic models are deterministic.6
In our opinion, however, the petroleum industry is characterized by a high density of political
decision making, although not necessarily a constant one. The reason for this is that of all the
actors (firms, traders, speculators, governments, etc.) which intervene in the petroleum industry,
only for private companies (primarily Western firms)7 traders and speculators does substantial
economic rationality offer a reasonable approximation to their behaviour; they are subject to the
constraint of the capital valorization. Furthermore, this first group now controls only a very
small portion of the world crude production. Consequently, the various models of the petroleum
industry which have been proposed over the last 20 years (cartel models, Stackelberg’s
4
For a recent analysis, see Bomsel (1992).
5
We do not mean that presently, for example, the actual level of the rents earned by the governments in the Gulf area
is considered as satisfactory. But since the hypothesis of a limitation of the desired rent has been introduced into the
economics literature, we must point out that such behaviour would certainly be political, independently of whether
this type of behaviour has been observed in the past or could be adopted in the future or not.
6
We do not ignore the problems of ‘dynamic inconsistency’ where behaviour with rational anticipations may
sometimes bring about an uncertain future. The solution may therefore be indefinite or unstable. However, by
modifying the hypotheses, the effort of economists may get rid of these uncertainties. Cf. for example, Newbery
(1981).
7
The nationalised companies of certain producing countries in the third world may be added here, including certain
small producers of OPEC which act as simple price takers, meaning that they try to maximize their production at the
market price.
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oligopoly, competitive models with minimum revenue objectives, etc.) and which, by nature,
assume a substantial economic rationality by all actors, are far from being satisfactory.8
Using our typology of political decisions, we can characterize recent petroleum history in the
following way. The petroleum industry first experienced a number of political decisions, in the
first meaning of the word, of major importance at the beginning of the 1970s: the
nationalization of reserves in OPEC nations.9 In certain countries, particularly those of the
Persian Gulf, these reserves which are the most abundant and least costly in the world. As will
be shown later, it is clear that decisions about these reserves are critical to the long-term
equilibrium of the petroleum market. Fundamental property rights have thus changed hands. As
a consequence, new actors have appeared in the industry, with a specific procedural rationality:
OPEC nations and OPEC itself. These new actors have had to learn how to use their new rights
over the years. In particular, the learning has been about the reactions of world demand and
production outside OPEC to oil prices. The 1970s and 1980s were therefore very intense periods
of political decision-making of the first and second kind. In addition, they also saw the third
type of political decision: the implementation of policies on supply security and the voluntarist
development of alternative energy sources in some importing nations, as well as the growing
overlap, arising from the influx of petroleum rents in the Middle East, between oil price policies
and conflicts within the region.
As far as OPEC nations are concerned, certain experts today hypothesize that the intensity of
political decisions began decreasing at the end of the 1980s. This would be mainly the result of
the experience acquired over the last 20 years by the oil exporting nations of the Middle East.
This learning process would have lead to the weakening and the loss of specificity of procedural
rationality by these actors and thus to decisions which increasingly approximated to a
substantial economic rationality.10 We do not deny, as we will see below, the reality of a
learning process. But first we believe that it is far from having yielded enough information on,
for example, price elasticity of world oil consumption and of non-OPEC production, to allow
OPEC, or the core of it, to behave as a profit maximizer. At best, it is a very ‘poorly-informed
maximizer’, as Gately has suggested (Gately, 1984). Therefore, political factors of the second
type (due to procedural rationality) therefore remain. Second, the Middle East region is far from
political stability. Among other factors, including the absence of a resolution to the Palestinian
8
Cf. for example, Gately (1984), and Griffin (1985) for critical analyses and tests of these models.
9
We will not go into a precise legal discussion at this point. What is important is that the power of decision-making
concerning exploration, development and production has changed hands.
10
For proof of this economic maturity, these experts highlight, for example, an attitude more open to cooperation
with Western oil companies.
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question, the destabilizing political effects of the high concentration of petroleum rents in the
hands of a few governments will continue. It is therefore also certain that political decisions of
the third kind (promoting government stability and state security) will continue to influence the
petroleum industry.
Nevertheless, my purpose in this paper is not to assess precisely the relative importance of
political and economic factors. It was first to define a rigorous definition of the political factors
and to suggest a typology. It is now to assess, if we assume the remaining significant (although
not precisely known) influence of these factors, what can be stated from an economic point of
view.
What can an economic analysis achieve?
Once significant political factors intervene, is economic analysis useless, and will it be
necessary to resign oneself, as some have, to the price of oil being fundamentally politically
determined? In our opinion it is not. Economic analysis may, for example, determine whether or
not there are price paths which, without maximizing the revenues of the actors, could
nevertheless be decided and held by them. Even if any attempt in determining the optimal
trajectory would be useless, an economic analysis does however provide a definition of the
maneuvering space within which the changing political preferences may be implemented. We
will show this by first defining the notion of a dynamic equilibrium price in a mineral
commodity market.
The dynamic equilibrium price
Definition of the dynamic equilibrium price
One must first define the dynamic equilibrium price for a mineral-commodity market, such as
the one which equals the growth rate of capacities and that of consumption. A mineral
commodity market can only be stable if there is a continuous ‘cushion’ of surplus production
capacities in relation to the average consumption. This cushion is necessary in order to absorb
the conjunctural fluctuations in demand (meaning the consumption plus the demand of stocks)
and the possible failures of certain production capacities. In its absence, the equilibrium
between supply and demand could only be re-established through large fluctuations of the price,
due to the weak short-term price elasticity of as much the production as the consumption.
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Conversely, this cushion must not be too significant because excessive surplus capacities may
favour the starting of price wars.11
As a result, the dynamic equilibrium price of the market is that which maintains a satisfactory
cushion. From an initial equilibrium situation, it therefore is the one which creates growth in the
capacities at the same rate as consumption. This dynamic equilibrium price results in the
intersecting of a dynamic curve of consumption with a dynamic curve of capacities. These
curves are formed as shown in Figure 1.
The dynamic consumption curve
Let us assume a price level which to remain stable over time. Let us also assume that the price
of different substitutes are equally stable and that there is regular economic growth (a constant
growth rate). It may be hypothesized that under these conditions, the consumption growth rate
will remain stable over a number of years. Indeed, if we consider the world consumption, it can
be reasonably assumed that the long-term revenue elasticities and the long-term price elasticities
are relatively stable over time. 12 A dynamic consumption curve may be defined which provides,
for each price level assumed to be stable, the growth rate of global consumption. For petroleum,
however, it is not possible to build a hypothesis on the independence of world economic growth
and the price of oil; but this is not an obstacle in the construction of the curve. This may be
interpreted as such: all factors, other than the price of oil, determining the world growth being
assumed constant as well as the price of all petroleum substitutes being assumed constant, the
curve provides the growth rate of the world petroleum consumption for each oil price level. This
curve is situated below a ceiling (depending on the price of substitutes) which is the price at
which petroleum would lose all its markets. This curve bends and moves vertically when the
price of substitutes changes. It bends and moves horizontally when the parameters (other than
the price of oil) determining the world economic growth rate vary.
The dynamic curve of capacities
Let's assume the price to be stable over time. Let's assume as well that the actors holding proven
petroleum reserves act in the following manner: they systematically develop all the reserves on
11
In the history of petroleum, various price shocks were experienced when the cushion was either insufficient or
excessive. In 1979 and 1980, the surplus capacities, taking into account the demand of stocks brought on by the
Iranian revolution followed by the Iraq-Iran war, had disappeared. In 1986, they had become too significant and too
unevenly distributed.
12
In this non-technical paper, we will not further discuss this hypothesis, which may be brought up elsewhere. Cf.
note 13.
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which production is profitable at this price. Under these conditions, taking into account the
various delays when developing these projects and their differing degrees of maturity, a
hypothesis may be made that the capacities will grow, at first estimation, at a constant rate over
several years . The subsequent evolutions will depend on the results of the exploration effort. If
the newly-discovered reserves have a lower development cost, the growth rate of capacities at
the initial price will, everything else being equal, increase. If their development costs are higher,
they will only be exploited after the exhaustion of the reserve at a lesser cost, and the growth
rate of capacities, for a given price, will slow down at a future time. A dynamic curve of the
capacity rate of growth may thus be build for a competitive situation, meaning that it is the best
reserves which are systematically the first to be developed. This curve associates therefore an
increase rate of net capacities (after deducting the rate of exhaustion of exploited reserves) to a
price level in which one hypothesizes that the rate will remain stable at least over a few years.13
This curve is limited to the left portion of the graph by the price pm below which no new
development is profitable. In this case, the capacities decrease to the rate demanded by the
effective management of the only reserves being exploited, that is to say between 6 and 10% per
year. Inversely, beyond a certain price level, pM, the hypothesis may no longer be made of a
steady development rate of capacity; indeed, this capacity would explode if all profitable
deposits at this price were systematically exploited, and the curve could no longer be plotted, at
least not in a two-dimensional graph, as shown in order to simplify the problem.14
If we assume that, in order to balance the exhaustion of existing deposits and the increase in
demand, the proven reserves are systematically exploited by starting with those whose
development costs are the lowest (whatever their geographical location), there is only one
equilibrium level which equals the consumption growth rate and the net capacities growth rate.
The case of the petroleum industry
For a long time now, many oil experts have defended the idea that if all necessary developments
for the replacement of exhausted fields and for the increasing demand had been achieved in only
13
The hypothesis of stable growth rates of capacities at a given price is more of a problem than for consumption;
however, it may be adopted as above in order to simplify the reasoning.
14
A more in-depth construction of the concept of a dynamic equilibrium price allows us to put forward the
simplifying hypothesis that at given price level (assumed stable) there are corresponding constant growth rates over
several years. In particular, this allows us to take into account various factors such as the acceleration of the
development of capacities or substitutions at a given price, and technological developements, which modify
production and utilization costs, and finally, the results of exploration expenditures which may modify the curve of
development costs of proven reserves. In order to achieve this, it is a matter of adding the dimension of time to the
two dimensions of price and growth rate. The production and consumption curves then become surfaces. The level of
the dynamic equilibrium price becomes a path of equilibrium price which links the equilibrium price, pe, the
equilibrium growth rate of consumption and capacities: te and time, t, by a function p(pe(t), te (t), t) = 0.
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the lowest-cost zones, the geographical location of the world petroleum production would be
completely different from what it is today, and the oil prices would have evolved in a much
different manner. It is still obvious today that an economic logic of the optimal allocation of
resources, which should be promoted by a competitive functioning of industry, would lead to a
situation where all the increases in capacity would be made in the areas having the lowest
production costs, meaning the Middle East. The Persian Gulf countries - Saudi Arabia, Kuwait,
United Arab Emirates, Iran, Iraq - whose national oil companies are completely state-owned,
could indeed, if the governments so desired, collectively satisfy any increase in the world
petroleum demand for the decades to come. With a few exceptions (low-cost reserves outside
this area), it is therefore their reserves and only these reserves on which the dynamic capacity
curve in a competitive situation of industry can be plotted: curve 01 (Figure 2). But the state-
owned companies of these countries do not act in this manner. In the petroleum industry, one
must therefore distinguish between two groups among the actors which hold the power to
increase capacities, following the traditional model of the ‘dominating firm with a competing
fringe’.
The first regroups all actors which, as far as the increases of capacities are concerned (by the
exploration and the development of oil fields), behave as ‘price-takers’ according to essentially
economic criteria of the maximization of their revenues.15 They constitute the fringe. The
second group is made up of those, for whatever reasons, that do not develop their capacity as
much as would be possible at a given price and for a rate of ‘normal’ profitability within the
petroleum industry, taking into account the risk of these investments. These constitute the core
and today include: the oil-production companies of Middle East nations, and possibly a few
others from OPEC (Libya for example). Those which make up the fringe include: the
international companies, most of the public companies of the OPEC countries with huge
financial needs, and public companies of other producing nations.16 Based only on its reserves,
the dynamic capacity supply curve of the fringe may be plotted: curve 02 (Figure 2). The
significance of this curve is the following: for each price level, it provides what would be the
net evolution of world capacities if the development of new capacities had taken place only
within the fringe.
Whatever the price level, the producers of the core whose development costs are inferior to
those of the fringe may, if they wish, add capacities to those which are developed spontaneously
15
At this point, there is the question of whether or not they consider their reserves as a stock or a flow, or in other
words whether their development behaviour vis a vis these reserves will include an optimization over time according
to the rules highlighted by Hotelling. Although technically interesting, this problem is of secondary importance.
16
The CIS deserves a special analysis which, in order to simplify, we will not go into here.
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by the fringe. The space between 02 and 01 therefore determines the exact degrees of freedom
of the core producers in terms of capacity expansion. These two curves define a range for the
dynamic equilibrium price: p1 - p2 corresponding to equilibrium rates of growth of the
consumption and net capacities: t1-t2. Obviously, the dynamic equilibrium point (p2, t2), where
the producers of the core carry out no development and therefore witness a decrease in their
production, has little chance of being considered by them as satisfactory. Conversely, it is well
known that they do not have the development policy which would lead to the equilibrium point
(p1, t1). This policy would in fact reduce, by definition, their revenues to a ‘normal’ profit
(including the usual risk premiums associated with the petroleum industry) on the capital
invested by abolishing all rents (other than very limited differential rents resulting from the cost
differences among the low-cost deposits). It is therefore unlikely that it would be judged as
satisfactory, independently of any other consideration. How can one explain their real
behaviour, possibly variable over time, which is obviously situated between the two?
< Fig. 2 >
In the so-called ‘economic’ models of ‘oligopolies with a competitive fringe’, the problem may
be resolved, at least in theory, by attributing to the core a certain kind of substantial economic
rationality, for example: collectively maximizing their actualized revenues or maintaining a
constant level of revenue over time. However, in order to adopt such a behaviour, it would be
necessary for the producers of the core to be familiar with the dynamic curve of consumption
and the dynamic capacity curve of the fringe.17 If they are not very familiar with them, their
behaviour will be guided rather by a procedural rationality and therefore influenced by political
factors, in the second meaning that we gave to this term. In addition, it would be necessary to
assume that they don't have other objectives of political nature in the third meaning mentioned
above (non-assessable monetary objectives), which is obviously not the case in the Middle East.
Whatever the reasons and the procedures of their real behaviour, the essential point of this
analysis remains the following: in a mineral-commodity market, from the moment when there
exists a group of producers having large reserves at low-cost and which do not act according to
a substantial economic rationality, then economic analysis does not allow to determine a unique
dynamic equilibrium price. However, it does permit a definition of an equilibrium price range in
which the political preferences may be expressed. On this basis, it is possible to analyze in a
17
In the case of petroleum, it should be pointed out that the consumption curve does not depend solely on world
growth, or the price of oil or its substitutes. Thus, the decisions of consuming countries in terms of taxes on
petroleum products shift this curve, all other things being equal. It's obviously for this reason that OPEC is against
any tax projects aimed at combating the greenhouse effect. Likewise, the capacity supply curve of the fringe could be
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more precise manner the behaviour of the core producers and the recent dynamics of the world
petroleum industry.
Thresholds and ranges for oil prices
In this section, the objective is to determine the thresholds and ranges of oil prices which allow
to clarify the structure of economic and political factors in the formation of prices.
Market prices
Within the oil markets, the prices are fixed daily by confrontation between the supply and
demand of stocks. These stock supplies and demands are determined by the gaps between the
actual stocks held by producers and consumers (as well as traders), which change in function of
the flows of production and consumption and the stocks desired by these very actors, which
themselves depend on technical parameters and even crucially on their anticipations. The role of
these anticipations in the fluctuations of market prices was effectively shown by recent events.
They were largely responsible for the explosion in prices in 79 and 80, as well as in 90-91
during the Gulf crisis. A short-term model of the oil market which would ignore the influence of
the increase of desired stocks during these episodes and which would only consider the market
‘fundamentals’ (production and consumption flows and the normal level of ‘tool’ stocks) would
be incapable of explaining these price explosions.18
The petroleum market (like all mineral commodities market) is therefore naturally unstable. In
addition, many authors since Frankel19 have demonstrated that if it were subject to strictly
‘competitive’ behaviour by each of the actors, its margins of fluctuations would be very large,
taking into account:
i) the short-term quasi-inelasticity of supplies in case of a sharp price decrease, because

the avoidable costs are only a small portion of total costs;20
significantly modified by decisions, among the concerned countries, easing the taxes on petroleum production.
18
It should be pointed out that future contracts with various maturity-date including long-term (6 months or longer)
are, from this point of view, a stabilizing factor, even if they can introduce a short-term volatility (see below).
19
For an assessment of the analyses see Frankel (1989).
20
In economics, the only assessable costs are those deriving from a decision and they are evaluated always in relation
to a situation of reference where this decision is not made. The avoidable costs are those that the decision to stop the
production of a deposit allows to avoid in relation to a situation where one continues to produce. Contrary to what is
sometimes put forward, these are not just the operating costs. The costs of reconstitution of the barrel underground
must be added as well. If the decisions to cease production, followed by decisions to restart production create specific
costs (compensation payments for unemployment, maintenance costs of wells during stoppage, etc.), then one must
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ii) the short-term inelasticity of the supply to the price in case of a price explosion as soon
as the maximum utilization of capacities is reached;
iii) the quasi-inelasticity (short-term) of the demand to price in both cases.
As far as price fluctuations in the market are concerned, a first partition may be made,
distinguishing four different zones of petroleum prices (Figure 3).
At the bottom, there is the zone of the economic floor price. Oil prices would inevitably
penetrate this zone during a price war carried out without any hindrance of extra-economic
order, meaning each actor would be a pure price-taker maximizing its profits (in other words
minimizing his losses). This zone has an upper limit which is the avoidable costs of marginal
fields. What is this level? Adelman (1986) estimates that a price of US$12/bbl21 would only
have a limited immediate effect on the North American production, but would halt
development, leading to an annual decline in the production of exploited fields. According to
him, the price would need to drop to $6/bl in order to provoke the immediate shutdown of half
of the production capacity in the U.S. (the price would need to fall to $3 for the same to happen
in the North Sea). Mabro (1991b) estimates the floor price to be even lower at $2.50/bl. We will
consider the zone of the floor price to be below $8. This estimation does not need to be precise
since, as will be shown, the real price has never penetrated this zone. Within this floor price
zone, purely economic forces take over, bringing the situation automatically back to a supply-
demand equilibrium.
Just above this zone, one may define a zone of ‘political-economic braking’, in order to take
into consideration the fact, that price wars have certain limits within the petroleum sector, as
shown in 1986. After the price war had been set off in 1986, it could have, or should say should
have, if the market had been perfectly competitive, dropped into the zone of the economic floor
and brought out the marginal producers of the industry.22 The coalition of interests was very
powerful in order for the armistice to intervene beforehand. This is a very well-known
phenomenon and there is no need to further elaborate on this point. This armistice is largely an
economic decision. Indeed, as the prices drop, the ‘cheaters’ within the initial group of swing
producers (see below) are punished, with the number of those wishing to co-operate, in order for
subtract from this sum described above the total of these costs divided by the number of non-produced barrels. This
implies that any precise evaluation of the avoidable costs demands an anticipation of the duration of the stoppage,
and therefore of the future evolution of prices...
21
Adelman’s data were converted to 1991 US$ by using a deflation index of export prices for products manufactured
in the OECD. In fact, the production cost since 1986 has actually decreased in real terms, according to industry
opinion. Therefore the floor prices expressed in 1991 US$ are probably lower.
22
In fact, in 1991 US dollars (deflation index of export prices for products manufactured in the OECD), they hardly
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this to cease, continuing to increase. The price war then re-establishes the subjective conditions
of a coalition which is in the economic interests of its members. However, strictly political
factors, in the sense that we have already defined, come into play as well. It is particularly the
fears of social and political destabilization in certain regions or producing countries, which push
governments (the United States for one, despite their shown liberalism) to strictly encourage the
producers to act according to their economic interests. This is why we may call this zone
‘political-economic’ braking. It is situated between $13 and $8. This $13 level is however only
an estimation. Since it does not depend solely on economic factors, it cannot be determined with
certainty, and it tends to change over time. In reality, it is one of the forms under which the
compromise takes place between the political preferences of the various actors which will now
be discussed.
Above, there is the ceiling zone of economic braking. In a situation where demand exceeds
supply, when the price increases, the forces which reduce the initial disequilibrium do not
immediately exert themselves nor before the price reaches a certain level. These forces react
both on supply and demand. For the demand, it is a question of: i) behavioural energy savings
which may respond rapidly, because by definition they do not require investment, ii)
substitutions by competing energy sources. These rapid substitutions can only be achieved in bi-
energy installations. Furthermore, the volume concerned is low for petroleum products; beyond
this, investments are necessary. Whether or not they are undertaken depends not so much on the
level reached by prices but rather on consumers'anticipations on the future evolution of prices,
iii) macroeconomic effects induced by large increases in petroleum prices, reducing world
growth. In this case, the reaction delay is obviously several months at least. On the supply side,
experience has shown that the capacities are never totally saturated, even if they appear to be. In
a number of different areas, marginal investments allow in the short term marginal increases of
production; however, the anticipations on the future evolution of prices continue to play a role.
These four types of force act therefore on re-establishing the market balance. They are
characterized by various intensities which depend on: the price level, anticipations of its
evolution, and, at various levels, time. Some react as soon as the prices increase but their
intensity increases slowly; others reach more rapidly their full intensity but one which only
manifests itself at high-price levels (real or anticipated).
Once started by a demand exceeding the immediately available capacities, the increase in prices
can only be quick because the process of disequilibrium is firstly cumulative: the increase of
prices augments the stock demand, thus increasing the disequilibrium. For petroleum, as for
reached the US$13 level and in a very temporary manner.
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most mineral commodities, the braking forces only start effectively reducing a significant initial
imbalance at high-price levels, meaning much higher than the costs of marginal producers.23
Just like a space object re-entering the atmosphere, the prices will first brake very little,
followed by a greater force of braking due to price and time. The ceiling zone of economic
braking may now be discussed. Its lower limit is difficult to specify exactly (as is the outer limit
of earth's atmosphere). Rather than a limit, it would be necessary to graphically represent an
increasing density of forces. In order to simplify this, let us assume that the braking starts taking
place at US$30, intensifying at US$40/bl.
The three types of instability of the petroleum markets
Between the zone of the ceiling price of economic braking and the floor zone there is the natural
instability zone. If the petroleum industry was indeed competitive in the true sense of the
economic theory, meaning no actor could influence prices, the market prices would greatly
fluctuate between the two extreme zones which would be in reality, the only stable market
positions. In the event of even slight over-production, there would be no ‘rational’ cut in
production until the price drops below the avoidable cost of the marginal capacities, which is
the floor price, and it would remain there until the overcapacity is re absorbed. Next, every
durable increase in demand would send it into the ceiling zone where the overcapacity would be
restored. Here, one finds a mechanism that generates, for competitive mineral-commodities
markets, a wide-ranging instability (since the floor zone and ceiling zone are very far apart)
which we will call the first instability type.
Many metals experience this kind of instability. Throughout its history however, the petroleum
industry has only found itself in this situation during the very beginning in the United States.
Except for exceptional periods, there were always groups of entities in order to stabilize prices,
thanks to the implementation of swing capacities. Since the nationalization of oil fields during
the first half of the 1970s, this role has been played by a subgroup of OPEC, with sometimes
different members among the group, and in which there are, according to the period, all
producers of the core (defined above) as well as certain producers of the fringe. It should be
pointed out that this is independent of individual member positions. In the oil industry, when
taking into account the weakness of marginal costs in relation to the price, each producer that
23
Two remarks: i) in the case of metals, there is a fifth force: the increase in recycling, meaning a resort to other
metal sources which are scraps. In certain cases, it is the principal force. This of course does not exist for oil. ii) The
braking forces may only start effectively reacting above the substitute price level or the backstop technology. It is
clear that this is only implemented and only acts as a reminding force if the actors are convinced that the prices will
remain on a long-term basis above levels of substitution.
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does not saturate its production capacities makes these capacities play the role of swing
capacities.
By the role of swing capacities, this stabilization is far from being perfect. These capacities
cannot modify their production from day to day, neither can they change as fast as the
anticipations of desired stocks, which as previously mentioned, influence the market prices.
They may nevertheless hold the prices in a range of US$2 to US$3 with cycles (not necessarily
steady) of approximately a few months. This kind of fluctuation which we will call the second
instability type, is inevitable in the scope of a true market functioning. In reality however, they
don't really bother anyone since the future markets and their derived instruments are made so
that operators may protect themselves from this type of instability and since they don't have
significant macroeconomic incidences. However, the future contracts and derived financial
instruments on oil and other products themselves introduce a third instability for which the
range may pass the US$1/bl and where the periods are much shorter: from one day to one week.
The fluctuations of the second and third kind may be reduced by an improvement in the
functioning of markets, physical and financial. As we will come back to in the conclusion, this
is a point of consensus within the current petroleum dialogue. The fluctuations of the first kind
can only be controlled by an efficient implementation of the swing capacities. The essential
problem for the holders of these capacities is therefore to know at around what level the prices
may be stable over the long term (i.e.: over several years) and whether this level is unique. It is
at this point that we will come back to the notion of the dynamic equilibrium price and the role
of the core producers.
Dynamic equilibrium prices
As far as the dynamic equilibrium prices are concerned, it is possible to determine economically
three price zones (Figure 3).
The lower zone, which we call zone 1 is well determined by the lowest of the dynamic
equilibrium prices defined above, this being the one which would allow a profitable financing in
the lowest-cost zones of all the capacity increases which are necessary in order to face the
increasing consumption at this price, taking into account the exhaustion of existing deposits. It
is relatively easy to evaluate the upper limit of this zone, which is therefore the equilibrium
price in a competitive situation, in other words the point (p1, t1) of Figure 2. Indeed, when
taking into account the importance of low-cost reserves of the core producers and of the
relatively flat character of the development cost curve for these reserves (which is translated by
the quasi-leveling of the curve 01 of Figure 2), this equilibrium price depends very little on the
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dynamic curve of consumption. Adelman estimates this to be around US$5/bbl.24 We will adopt
this estimation in Figure 3. It should be pointed out that this competitive dynamic equilibrium
price is at an inferior level to the market floor price, defined by the avoidable costs of marginal
deposits. This fact is an unquestionable indication that in the past, the industry did not function
in a competitive manner. If prices remain over the long term within this zone 1, by definition,
the investments would be insufficient. Once the initial overcapacity has been absorbed, an oil
shock would become inevitable.
Conversely, the superior zone, called zone 3, is defined by the maximum of the equilibrium
prices tolerable by the core. We are indeed hypothesizing that the core producers, even if
incapable, by lack of information or for political reasons, of maximizing their revenues,
nevertheless have minimum objectives concerning their revenues. For example, it may be
estimated that the stability of their production, meaning therefore of their revenues, is the
maximum effort that they can accept. A higher price, which would lead to a continuous
reduction in the residual demand addressed at them, would set off a reaction on their behalf in
the form of a price war in order to gain back market shares. Other objectives along the same
lines may be attributed to them as well: the maintaining not of their revenues but of their market
share, which would cause their revenues to increase as the world demand for oil grows, or even
a constant portion of the world revenue, etc. If the determination of the objective of the
minimum tolerable revenue obviously reveals a political analysis, the prices which correspond
to each objective hypothesis may be economically determined, provided that both the dynamic
capacity curve of the fringe and the world consumption curve are known. Certain models of the
world petroleum market have estimated this limit, in the hypothesis of production constancy
within OPEC, to be around $28/bl. Since OPEC in its entirety does not make up the core, the
price leading to constancy of production of the core would be lower, say equal to US$25.25
The meaning of the dynamic equilibrium zone
24
Cf. note 21.
25
The US DOE estimated in 1992 that with a price remaining constant from 1990 to 2000 at US$15/bl, the demand
addressed at OPEC would increase by 11.1 Mb/d in 2000, and at a price of US$25 by 3.4Mb/d. The price wich would
lead to a constant demand is therefore superior at $25. A simple approximation puts the figure at US$28. For its part,
OPEC (Miramadi and Ismail: Perspectives de l'offre pétrolière et investissements requis, Paper presented at the
World Energy Conference, Madrid 1992) provides for US$21 an increase by 6.8 Mbd for the demand aimed at OPEC
in the year 2000, and for US$30, a reduction of 2.2 Mbd. The same approximation would therefore put back to
US$28, the price leading to a constant demand. For these estimations however, it concerns the demand addressed at
OPEC. In order to deduce the demand to the core, meaning essentially Gulf countries, it would be necessary to know
the production evolution of non core OPEC countries at this price, which in our hypothesis belongs to the fringe. If at
this price of US$28, this production should increase, which is probable, then the ceiling would be lower. We assumed
a price of US$25. This estimation is not a result of any precise calculation: this paper should basically be understood
a means of methodical clarification.
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The intermediate zone, number 2, is the zone of the dynamic equilibrium prices of the
petroleum market. All the prices of this zone 2 are dynamic equilibrium prices in the sense that
they allow the financing of developments necessary in order to face the increase in consumption
at this particular price. The main thing differentiating these developments is their geographical
distribution between the producers of the core (meaning therefore low-cost zones) and those of
the fringe. At the floor of this zone, only the developments among the producers of the core may
be financed. As for the ceiling of this zone, the producers of the core are content with
maintaining a constant production capacity. The meaning therefore of this dynamic equilibrium
zone is the following: no economic force conflicts with the choice by the core producers for any
price level within this zone and maintaining it over the long term. In order to achieve this, it is
sufficient that: i) from the point of view of increases in capacity, they behave collectively vis-a-
vis the fringe as the core of an oligopoly of Stackelberg: they choose a price level and at the
chosen price level, they allow the fringe to make all increases in capacity which are for the
fringe profitable at this price, and they add the necessary capacities in order to maintain a
sufficient cushion of swing capacities; ii) they use, themselves or in association with certain
producers of the fringe, the maintained swing capacities in order to effectively stabilize the
market near the chosen level price.
These two conditions are sufficient and equally necessary as well. Their necessity indicates,
inversely, the potential sources of instability: i) an implicit or explicit disagreement between the
producers of the core on the desired price level within the dynamic equilibrium zone, ii) even in
the case of an agreement, a poor co-ordination of investment decisions over time. In both cases,
either the swing capacities disappear or increase excessively, which may cause the cohesion
between swing producers to rupture. Short-term regulation is therefore no longer possible.
Within zone 2 of the dynamic equilibrium prices, it must be particularly highlighted that the
producers of the core must (by definition of the ceiling zone) increase their capacities. By
definition as well, they may do this because in this zone these investments are profitable for
them (it is only in zone 1 that they would no longer be profitable). A price shock resulting from
insufficient investments may therefore, in theory, always be avoided if the prices remain in this
equilibrium zone, provided that the core producers make the required capacity extensions at the
right time.
As we indicated above, the main difficulty for the core producers is in estimating the ceiling
zone of dynamic equilibrium. Even if they had precise estimations on development costs for the
various zones (from the core to the fringe) and on the long-term price elasticity for the demand
of petroleum, the following would remain unknown:
i) the world economic growth;
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ii) possible new important discoveries among the fringe (which would of course influence
the rhythm of the capacity developments in this zone; thus for a given price, the residual
demand addressed at the core producers);
iii) the evolution of policies, particularly fiscal, of consuming countries and fringe
producers.
Nevertheless, this analysis highlights the link between economic and political factors in the
evolution of oil prices. Zone 2 defines the area where political preferences, in the third meaning
already defined, may be expressed.; this means the pursuit by the core producers of objectives
which are not assessable monetarily, and are aimed at maintaining the stability of governments
and the security of states. It also defines the area in which the tests of a poorly informed profit
maximizer are not, in theory, destabilizing (for example, the core, if supposed to be a collective
profit maximizer, fixes a price level within the area, observes trends in demand, modifies the
level if necessary, while remaining in the area, and so on...). Therefore this is the area where the
learning process can converge smoothly.
It is uniquely in zone 2 that the price of oil may be politically influenced. Any attempt to
maintain the prices in zones 1 and 3 provokes the implementation of economic forces which
would inevitably force it out of these zones. In this sense, the price of oil would not know how
to escape from ‘the laws of market economy". For all this however, can it be maintained (as
many experts and government officials have asserted especially since the oil glut of 1986) that
the political factors are incapable in separating, other than temporarily, the petroleum prices
from a level economically determined by only market forces? In our opinion, it cannot. The
political factors such as have been defined can influence oil prices for long periods within
zone 2.
The political preferences of the core and of the U.S.
The political preferences, which may therefore be freely expressed in zone 2, are primarily
those of the core producers. In extracting industries, those holding the low-cost reserves are
always the ones which finally control the system. However, in the current world, they find it
hard to isolate themselves from political preferences of the large importing nations of the
OECD, and more importantly, the United States. Neither can they ignore any longer the
financial constraints which weigh heavily on certain producers of the fringe being largely
indebted to OECD countries. For example, if it were shown that a price of around $13/bl (thus
within the equilibrium range) would maximize the long term revenues of core producers, it is
very unlikely they would have the political means to maintain this price over a long period of
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time, while they would have the economic means. This is due to two reasons: i) the political
pressures of other OPEC producers which, despite everything, the core needs in order to share
the responsibility of the short-term market regulation, ii) the political pressure of the United
States.
Concerning the ‘desired’ price of oil, the United States are (even if they obviously never use this
term) in an ambiguous position, mainly because of their opposing groups of interests on this
issue. Lower prices favor the trade balance and economic growth, but seriously penalize the
American petroleum industry (and more generally the American producers of fossil fuels),
eventually leading to a rapidly increasing dependence on foreign oil. Higher energy prices are
beneficial to the American oil industry and are now supported by many ecologists. It is
therefore difficult to determine the preferences of the United States for a specific price level of
oil. There is rather a certain range of indifference for which the position by the government is
agreed in terms of the relative importance of pressure groups and of its perception of the degree
of acuteness and priority for the principal problems which influence the international oil price.
This range is situated however above a threshold determined mainly by the issue of foreign
dependence and supply security, meaning therefore a politically-determined threshold.26 Thus,
only the prices found in the upper part of zone 2, meaning higher than US$15-16, are at the
same time dynamic equilibrium prices and politically-acceptable prices by the actors. This limit
might of course change, particularly in function of the perception by the United States on
problems of supply security, a perception which is itself dependent on the world geopolitical
situation, the regional political situation, the level and the solidarity of their alliance with Saudi
Arabia, etc.
An interpretation of the large price fluctuations of oil since the end of the 1960s
This analysis outline may be tested by verifying whether or not it allows a coherent
interpretation for the majority of the principal events which shaped oil history since the end of
the 1960s. The large price fluctuations of oil since the end of the 1960s may, in our opinion, be
interpreted in the following manner (Figure 4).
Before 1973, the price was at the border of zone 1. In the Arab-Persian Gulf, the price in 1970
26
During the first oil crisis, Kissinger in 1974, had explicitly fixed this threshold by indicating that the reasonable
price of oil for the USA was US$7/bl, or in 1992 US$ (deflation index: export prices of the OECD): US$17/bl. In
reality, Kissinger spoke of US$7 as a ‘maximum’, beyond which the Western economies would be, according to him,
‘strangled’. However, in the context of this conflictual period, the term ‘maximum’ may be replaced by ‘reasonable’
and satisfactory.
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was $1.20/bl. When using a deflation index of OECD export prices, this corresponds to $3 in
1985, which could be compared to the development costs of OPEC reserves that Adelman
(1986) evaluated for the end of the 1970s (in 1985 US$). This results in a price superior to costs
of Gulf countries, but inferior to costs of Venezuela, Nigeria and Mexico. The question
therefore is to know whether or not in 1973, at a price of around $1.2, the Gulf countries alone
could have continued to meet the growth in consumption which at the time was around 7% per
year (non-communist world).27 The response, in purely economic terms, is yes. Their reserves
and their lower production costs would have permitted it; however, in order for this to be
accomplished, it would have required: i) that the international companies which were then
operating in these countries make heavy investments in them, ii) that the USA be satisfied with
the disconnection between their domestic market and the world market. These two conditions
were not present. At the end of the 1960s and particularly since the Algerian and Libyan
revolutions, the international companies were convinced that the nationalism among producing
nations could not be indefinitely contained. As the risks of nationalization became real, they
were not prepared to invest as much as would have been necessary within the core nations.
Regarding the U.S., The USA was also ready to come out of its oil isolation.28 Under these two
conditions, the oil crisis was inevitable, as is generally believed today, but not just for economic
reasons: the prices were not really within zone 1 (which figure 4 points out), where the crisis is
economically inevitable, but at the upper border of this zone: at this level, the slightest
restriction (political in origin) of investments in the Gulf should have created pressure on oil
prices.
From 1974 to 1979, the price was near the upper limits of zone 2. This in fact generated a
vigorous development of capacities outside the core. This growth, taking into account the delays
in development, began to materialize at the end of the period, while energy substitutions and
savings were implemented. The oil shocks of 1979 and 1980 were brought on by sudden
increases of desired stocks more than by a real saturation of production capacities. Nevertheless,
one may assume that the core maybe did not sufficiently develop its capacities during this
period. If the shock had not taken place and if the world growth had extended into the early
1980s at the same rate, it is probable that the market share of the core would have then
stabilized, after having been increased during the second half of the 1970s while waiting for the
non-OPEC capacities to come on line which were developed as a result of higher prices. Its
27
We should note that this is practically what they had done until this point. Between 1963 and 1973, the non-
communist world consumption increased by 23.5 million bbl/day, non-communist world consumption excluding the
USA increased by 17.5 Mbbl/d and Middle East production grew by 14 Mbbl/d (going from 7 to 21 Mbbl/d). Taking
into account that the USA was at the time practically isolated from the rest of the world in terms of oil, this confirms
a nearly-competitive situation.
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because of this that we may say that prices were at the upper limit of zone 2.
The second oil shock, however, clearly forced prices into zone 3, and all the more so since the
floor of this zone dropped with the shift of the consumption curve due to the slowdown of world
economic growth.29 The demand addressed at the core therefore declines rather rapidly, creating
the oil glut of 1986. Putting aside the Gulf war episode where prices underwent only a sharp
conjunctural fluctuation, at what level would they stabilize since the summer of 1986? They
would have unquestionably settled within the dynamic equilibrium zone, at the bottom of the
zone that we have defined above as politically acceptable by the United States.
Thus, since the end of the 1960s, the oil market, after having escaped the oligopoly control of
the seven sisters, experienced large fluctuations, leading it through all the zones which have
been defined above. As a result, all the actors have clearly experienced that there were price
limits for the equilibrium zone. These limits could not be precisely determined, but there did
indeed exist such a zone. The core of OPEC, in particular, experienced a learning process,
which allowed it to test the existence of a ceiling for the dynamic equilibrium zone.
Why a dialogue?
These are the lessons of the learning process which make a dialogue between oil-importing and
oil-exporting countries possible. In the 1970s, the procedural rationality of OPEC countries and
of the organization itself were the product of the history of this organization since its founding
in 1960, which was the struggle for the defense of its revenues, which tended to decrease with
prices. The rationality had to progressively adapt to this fundamental change representing the
passing of control of low-cost reserves to states' hands. At the same time, the existence as well
as the limits of a freedom area where economic and political objectives (in the third meaning of
the term: state security and government stability) could be linked together became increasingly
apparent.
In this newly created climate, the French and Venezuelan governments considered the time to
be right for proposing in July 1991, the opening of a dialogue between states. What may be
discussed? Once recognized by exporting countries as well as by importing nations, which is
28
Cf. note 26.
29
In Figure 4, we have not varied the ceiling level (which determines the constant demand addressed at the core) in
function of world growth. In order to do this, one would require reliable evaluations of the long-term elasticities: i) of
the world oil demand to global GDP and prices, ii) of the supply of the fringe to price, which, to our knowledge, is to
the case.
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already an achievement, that too much instability of oil prices is harmful for all, one area had
been the subject of minimal consensus and allowed a dialogue to begin with the participation,
although somewhat reticent, of the United States. This area concerns the means that actors could
dispose in improving the day-to-day functioning of markets. This is unquestionably useful and
is therefore unnecessary to discuss here the open issues in this area.30 But improving the day-to-
day functioning of markets only address the instabilities of type 2 and 3 that we have previously
defined, i.e.: day-to-day volatility and short term fluctuations due to temporary supply/demand
imbalances and stock buildings and drawdowns. It does not address questions such as: with the
average price level around which these fluctuations occur, are we heading for a price shock
through under- or over-investment? Market mechanisms provide crucial information: the price,
but they do not by themselves actually provide all the information needed to avoid large
fluctuations.31
However, the U.S., Saudi Arabia and certain European countries (which made a unified position
among EEC members impossible on this point) refused to discuss price levels, because they feel
that the market mechanisms always fix the ‘right’ price. According to them, the market just
needs to function freely. If our analysis is exact, then this position is not bearable. If one
assumes the large price fluctuations, which industry experienced since the beginning of the
1970s, to be harmful, we think it could be very useful to discuss the following questions: are
there means for improving the collective knowledge of the ceiling of the equilibrium zone as
well as its economic and dependence floors? The response would seem to be positive. Better
reciprocal information on: i) the development costs of various zones, ii) the consumption
forecasts and the economic analyses of factors which determine consumption, iii) the regulatory
and fiscal intentions of states, etc., could only improve the foreseeable nature of future
evolutions and improve anticipations. Consequently, investment decisions would be closer to
substantial rationality and more coherent. This alone could be able to keep the prices within the
dynamic equilibrium zone and thus avoid large price fluctuations.
One political question would, however, remain. If this zone does not reduce to a simple line, as
we believe, could the political preferences by the actors (core producers, large importing
countries) be discussed? The argument of the U.S. that ‘it's the market which determines the
price,’ in our opinion, has difficulty in disguising its willingness to discuss this issue with only
30
Likewise, the dialogue made progress in recognition of the necessary links between petroleum and environmental
issues, which is also unquestionably useful.
31
Theoretically, only a complete set of forward and future markets up to at least 10 years (more precisely, the
maximum development time of new fields and new technologies at the consumption level) could achieve this. They
obviously do not exist.
Cerna 26
Saudi Arabia, (but Iran and Kuwait have come back, as will Iraq, on the scene). For its part,
Saudi Arabia may find it beneficial not to reveal its preferences. Boussena (1993) pointed out
that it could even opt for a strategy of maintaining uncertainty. By allowing prices to fluctuate,
for example, between $15 and $25/bl, it reduces, all other things being equal, the developments
within the fringe. The demand which will be addressed at it will then be higher than that which
would arise from a strategy of displaying the desired average level and of reducing the
fluctuations around this level. This strategy may however weaken OPEC which Saudi Arabia
needs because it allows it to share the short-term regulation responsibility with certain fringe
producers. In addition, it would make a growing bank financing of the oil industry more
difficult, which many view as essential. Is it therefore in the long-term interests of this country?
In our opinion, discussions on political preferences, together with the creation and channeling of
the information flows mentioned here above, could be the subject of a new dialogue between
exporting and importing countries. It should be clear that this is by no means a commitment in
the negotiation of inter-state agreements on price controls! It is merely a question of improving
information flows on objective matters as well as political preferences or, in other words, of
reducing uncertainties for all actors. Obviously, uncertainty, asymmetric information and hidden
preferences are the ground on which profitable or desirable strategic behaviours can be built.
But if reducing large oil price fluctuations is seen to be of collective interest, is not the
limitation of such possibilities the right price to pay for it?
Acknowledgments
The author acknowledges financial support for the research which has led to this paper from the
General Directorate for Energy and Raw Materials of the French Ministry of Industry, as well as
fruitful comments on early versions from: O. Appert, D. Babusiaux, G. Bellec, J.M. Bourdaire,
S. Boussena, J.M. Chevalier, P.M. Cussaguet, H. Des Longchamps, R. Janin, M. Karsky, M.
Pecqueur, Y. Simon and an anonymous referee. Naturally, all opinions expressed are strictly
those of the author.
Cerna 27
Figures
Figure 1. The dynamic equilibrium price in a competitive situation
ps
pM
Capacity
pe
pm
•
Consumption
τo τe Growth rate of
capacities and
consumption
Figure 2. Dynamic equilibrium of the oil market
ps
02 Supply curve
of the fringe
p2
01 Supply curve
p1
in a competitive
situation
τo τ2 τ1 τ
τo = Technical rate of decrease in the world capacities if no development is

undertaken.
(p1, τ1) - (p2, τ2) : ranges for prices and equilibrium growth rates in
which the political preferences of the core may be expressed.
Cerna 28
Figure 3. Thresholds and ranges of petroleum prices
$/bl
40
Zone 3 :
Ceiling zone of economic inevitable reduction
braking The stability over the short term
in the demand addressed
requires the implementation of at the core
sufficient swing capacities
30
Maximum equilibrium price

25
Which may only be maintained if tolerable by the core
Zone of natural prices are stabilized within the
instability dynamic equilibrium zone.
Within this zone, political
preferences may be expressed, without Zone 2 :
destabilizing the market. Zone of the dynamic
equilibrium prices
13 ?
Zone of political-
economic braking
8
Floor price zone Minimum equilibrium price =
5
Price in a strictly competitive situation
Zone 1 :
Oil shock inevitable
Market prices Dynamic equilibrium prices
Fig. 4 : Price of petroleum and dynamic equilibrium zone

(deflation index: exports of OECD-manufactured products)
45,00
Zone 3: dynamic instability

because the demand addressed
at core producers is decreasing
40,00
35,00
30,00
25,00
20,00
15,00
Zone 2: dynamic equilibrium
10,00
5,00
Zone 1: oil shock

economically inevitable
0,00
price of oil ceiling economic dependence

floor floor
Cerna 29
References
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l'Energie, Mars.
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Cerna 30

The Equilibrium Price Range of Oil

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The equilibrium price range of oil

Oil, Market, Politics

Economic and political decisions

Three types of political decisions

The redistribution (outside the market) of property rights.

The procedural rationality

The non-monetary objectives

The petroleum industry: a high density of political decisions

What can an economic analysis achieve?

The dynamic equilibrium price

Definition of the dynamic equilibrium price

The dynamic consumption curve

The dynamic curve of capacities

The case of the petroleum industry

< Fig. 2 >

Thresholds and ranges for oil prices

i) the short-term quasi-inelasticity of supplies in case of a sharp price decrease, because

iii) the quasi-inelasticity (short-term) of the demand to price in both cases.

reached the US$13 level and in a very temporary manner.

The three types of instability of the petroleum markets

Dynamic equilibrium prices

The meaning of the dynamic equilibrium zone

i) the world economic growth;

The political preferences of the core and of the U.S.

Figure 1. The dynamic equilibrium price in a competitive situation

Figure 2. Dynamic equilibrium of the oil market

τo = Technical rate of decrease in the world capacities if no development is

Figure 3. Thresholds and ranges of petroleum prices

Maximum equilibrium price

Market prices Dynamic equilibrium prices

Fig. 4 : Price of petroleum and dynamic equilibrium zone

Zone 3: dynamic instability

Zone 2: dynamic equilibrium

Zone 1: oil shock

price of oil ceiling economic dependence

Simon H. (1978), ‘Rationality as Process and as Product of Thought’, American Economic

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