What can history tell us about cartels in commodity markets?

Recent developments in oil markets have led to intensive debates about OPEC’s viability and its role in the global crude oil market. OPEC, which was founded in 1960 to “coordinate and unify petroleum policies among member states”, currently accounts for about 40 percent of global crude oil production. At present, the organization has 12 active member countries: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Qatar, Libya, United Arab Emirates, Algeria, Nigeria, Ecuador, and Angola. OPEC began playing an important role following its decision to impose an embargo on oil exports in 1973, which resulted in a quadrupling of oil prices in 1973/74 and was also instrumental in a tripling of prices in 1978/79. Efficiency gains and new oil suppliers, along with disagreements among various OPEC members (especially during the Iran-Iraq war in the 1980s and First Gulf War in the 1990-91), reduced the cartel’s role. It began intervening again following the Asian financial crisis in 1997, when oil prices dropped to less than $10/bbl, by setting targets within price bands.

In the past four years (until November 2014) OPEC’s objective was to target a price range of $100-110 per barrel. Following strong supplies from unconventional oil producers (especially shale oil in the United States), weak global demand, an appreciating U.S. dollar, and the unexpected lack of disruptions to oil supplies from geopolitical developments in the Middle East, OPEC decided, in its November 27, 2014 meeting, not to restrict supplies. The landmark decision, contrary to market expectations, not only set in motion a sharp slide in oil prices (which had already declined by almost 30 percent since their June 2014 highs) but also induced price volatility.

Perhaps OPEC’s decision not to act is a recognition of its diminishing power in oil markets, a view that has been expressed often. What is certain is that over time, as technology advances, unconventional oil supplies strengthen, and energy sources diversify, OPEC’s role in the global oil market could become even less relevant as experience shows with international agreements that attempted to manage commodity markets.

Efforts to manage world commodity markets in order to achieve price objectives are neither new nor unique to crude oil. A number of commodity agreements, often negotiated among producing and consuming nations in order to stabilize prices at levels deemed fair to both, were put in place following World War II. These included wheat, sugar, tin, coffee, and olive oil. A renewed effort took place after the 1970s commodities price boom, with the agreements typically backed by the United Nations and extended to other commodities, including cocoa and natural rubber. These agreements had legal clauses regarding the tools to manage the corresponding markets, including export restrictions and inventory management. But, over the long term, the price and trade restrictions imposed by some of the agreements on global market conditions either encouraged the emergence of competitor products (e.g. for tin) or the entry of new producers (e.g. for coffee). As a result, all of these agreements (except crude oil) eventually collapsed.

Tin. First negotiated in 1954 with the objective of maintaining prices within a desired range through the management of buffer stocks, the International Tin Agreement (ITA) collapsed in 1985 following several years of insufficient funds to maintain stocks. Because the Agreement made tin prices higher and stable, new tin producers outside the Agreement entered the market: Brazil, for example, increased its market share from 1 percent in the 1960s to 10 percent in the 1980s. Higher tin prices also encouraged the development of a substitute product, aluminum, which gained market share by capturing the growing demand from the beverage can producers. Between the 1950s and 2000s, global tin output grew by 65 percent while that of aluminum grew by 125 percent.

Coffee. In 1962, coffee-producing countries, accounting for 90 percent of global coffee output, and almost all developed coffee-consuming countries signed the International Coffee Agreement (ICA) with the objective of stabilizing world coffee prices through mandatory export quotas. Elevated coffee prices encouraged the emergence of new producers. For example, during the course of successive ICAs (until 1989, when the final iteration collapsed), two non-ICA members, the former USSR and the German Democratic Republic, provided Vietnam with technical and financial assistance to develop its own coffee industry. In 1970, Vietnam produced just 0.7 percent of the 59 million bags of global production. By the early 2000s, it had overtaken Colombia as the world’s second-largest coffee producer after Brazil. It now accounts for 20 percent of global coffee production.

Natural Rubber. The last of such arrangements, covering natural rubber, collapsed during the Asian financial crisis due to currency developments of three key producers, Indonesia, Malaysia, and Thailand. A buffer stock of rubber was used to maintain rubber prices within a desired range. The buffer stock manager was authorized to buy or sell rubber when its price (indexed into the domestic currencies of the three producers) dropped or exceeded a certain level. Because of weak global demand (partly due to the Asian crisis), U.S. dollar-denominated rubber prices declined and should have triggered production cuts. However, the currencies of the three main rubber-producing countries devalued sharply during the Asian crisis and raised the local-currency prices of rubber, triggering a production expansion in the rubber pricing mechanism. This inconsistency eventually led to the collapse of the agreement.

Yet, there is a key difference between OPEC (the only surviving commodity organization seeking to actively manage a global commodity market) and the earlier commodity agreements: OPEC does not have a legal clause on how to intervene when market conditions warrant, thus, allowing it to respond flexibly to changing circumstances. It could well be “dormant” for some time and in, say a decade, become active again. But, if history is any guide, OPEC’s actions and effectiveness may well be limited as it competes with nimble new technologies and producers.
This post is based on the recently launched World Bank Policy Research Note titled ‘The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses’. The Note builds on the analysis of oil markets, published in the January 2015 editions of the World Bank’s Global Economic Prospects and Commodity Markets Outlook.

This article originally appeared on The World Bank’s Prospects for Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

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Author: John Baffes is a Senior Economist with the Development Prospects Group.

Image: The shadow of a woman is cast at the Old Building of Bank of Japan’s head office in Tokyo. REUTERS/Toru Hanai.