Gasoline Prices, OPEC, and Biofuel

Gal Hochman, Deepak Rajagopal, and David Zilberman

ARE UC Berkeley

ICABR meeting Ravello 2009

Outline

• Modeling gasoline prices

▫ Competition-cartel-cartel of nations

• Opec with Biofuel• Opec with Biofuel

• Simulations-

▫ How much does biofuels affect fuel prices and produciton

▫ How inaccurate are estimates based on model

▫ What will happen to oil price and production with and without biofuels

Biofuel models ignore OPEC

• The literature on the economics of biofuel, and its impact on fuel prices, assume competitive energy market. This literature ignores the energy market. This literature ignores the “elephant in the room” – OPEC

▫ We need to understand how OPEC operates, so we can explain

� How OPEC responds to biofuels

� How biofuels impact fuel markets

� And the welfare implications of biofuels

Traditional models of OPEC are flawed

• Some explain OPEC’s price response assuming Competitive profit maximization

▫ Griffin and Teece, 1982; Alhajii and Huettner, 2000a and 2000b (Saudi Arabia acts as the dominant producer). dominant producer).

• Other assume OPEC is a cartel of firms (COF)

▫ Adelman 1982; Dahl and Yucel, 1991; Gately, 1984; Green, 1985; Griffin 1985; Griffin and Xiong 1997; Gulen, 1996; Horn, 2004; Loderer, 1985.

• But OPEC is a Cartel of Nations (CON)

Crude Oil Markets and empirical Crude Oil Markets and empirical analysisanalysis• Energy markets are not competitive

• Empirical analysis we performed supports the hypothesis that the major oil supplier (OPEC) hypothesis that the major oil supplier (OPEC) behaves like a cartel of nations (CON) and subsidizes domestic consumption

• Cheap oil policies guide pricing behavior in oil markets

Comparing the alternative models

• A competitive model

• A cartel-of-firms• A cartel-of-firms

• A cartel-of-nations

Competitive model

Supply OPEC

PAll consumers pay the same price- which equals to

Demand opec

Global demand

Quantity of fuel

equals to marginal costs

PcAggregate

Supply

Cartel of firms

Supply OPEC

P

Pm

All consumers pay the same price, albeitLarger than the marginal costs

Demand for opecGlobal minus non opec supply

Quantity of fuel

Marginal Revenue

Pm

The Cartel of nations (CON) model: Oil rich countries• Politicians in the exporting country design the

export tax to maximize the sum of its consumers’ and producers’ net welfare plus the export tax and producers’ net welfare plus the export tax revenue

• The optimal export tax equals one over the import demand elasticity.

Cartel of nation (CON)

• OPEC decides on export oil price paid by foreign consumers and domestic oil

• Domestic oil price= export oil price -export tax ( wedge)wedge)

• Decision maximizes sum

▫ Domestic consumer surplus +

▫ Exporter revenues –

▫ Cost of production

Decision rule

• Set quantities where

• Marginal Revenue of export=

• Domestic (inverse) demand=

• Marginal cost• Marginal cost

• Export price = Based on export demand greater than

• Domestic price = marginal cost=marginal revenue of export

• There is a wedge between foreign and domestic price

Cartel of nationP

P

All consumers pay the same price, albeitLarger than the marginal costs

Demand for (GloGlobal minus non opec supply)

Marginal cost OPEC

Quantity of fuel

Marginal Revenue

PE

Opec countriesdomestic demand

Demand for OPECnet domestic demand

PD

Cartel of NationsThere is a wedge between domestic price in OPEC nations, and the international crude oil price p*>p

P

P *

P

Q

MX

S

X C

DX

DD

Implications from the cartel of nations model

• International oil prices are highest under cartel of nations, and lowest under competition.

• The oil rich countries pursue domestic cheap oil policies, which in turn reduce the supply of oil to the rest of the world

Basic facts about OPEC: Gasoline prices and crude oil

• OPEC Countries are price makers- facing a downward sloping demand curve for crude oil

• From the 1970s, oil is extracted by firms that are controlled by political decision

• Gasoline and diesel prices in OPEC countries are much lower than elsewhere.

▫ The price of super gasoline in Venezuela was 12 cents a liter in 2006.

Anecdotal evidence

• Gasoline and diesel prices in OPEC countries are much lower, as compared to the rest of the world. world.

• Although before 2000 the difference between gasoline prices in OPEC countries and in the rest of the world is stable, it grows at an increasing rate after 2000.

Fuel Pump PricesFuel Pump PricesFig. 4: Average Prices at the Fuel Pump

60

80

100

120

0

20

40

Year

Gasoline: OPEC member 11 23 18 20 17 22 28

Gasoline: not OPECmember

62 65 60 65 64 88 104

Diesel: OPEC member 5 11 11 13 12 17 26

Diesel: not OPEC member 47 47 41 49 49 72 90

1993 1995 1998 2000 2002 2004 2006

GH6

Diapositiva 18

GH6 The generic concept of subsidization relates to a benchmark whereby fuel pricing is commercially calculated with respect to world market prices.In this sense, subsidization takes place when the actual pump price is below the benchmark price. Because these benchmark prices are difficult to calculate with precision, on paper, fuel prices are considered to be subsidized if they are below the average U.S. price level, after deducting ahighway tax, which in the United States is equal, on average, to 10 US cents per liter. We apply a similar logic to non-petroleum and petroleum producing countries. Although petroleum-producing countries have their own national supplies, and therefore their low cost prices can be classified as non-subsidized prices, we reject this classification. If the volume of oil consumed domestically was sold on the world market, it would have achieved higher prices.G H; 02/10/2008

Taxes and SubsidiesTaxes and SubsidiesFig. 3: Super gasoline taxes and subsidies

10

20

30

40

50

-40

-30

-20

-10

0

year

OPEC member states -21 -11 -14 -27 -23 -32 -35

Non-OPEC 30 31 28 18 24 34 41

1993 1995 1998 2000 2002 2004 2006

Diapositiva 19

GH7 G H; 02/10/2008

The wedgeThe wedge between domestic and international pricesvaries among OPEC

COUNTRY Wedge

Venezuela -0.83

Iran -0.83

Saudi Arabia -0.54

Algeria -0.29

Indonesia -0.29

varies among OPEC countries

Indonesia -0.29

Kuwait -0.55

UAE -0.38

Qatar -0.6

Iraq -0.95

Libya -0.63

Nigeria -0.51

Angola -0.24

Strategy of the analysis

• Actually we stated from a Helpman Grossman estimating weight simultaneously elasticity demand for OPEC and the weight given to demand for OPEC and the weight given to consumers and producer surplus in opec countries

• We found that the the weight is equal

• So we can use the con model

The results: Demand elasticity

• The elasticity of the residual demand for oil-importing countries

(i.e., )-0.1941*

(0.1111)

-0.2177**

(0.0909)

Consumption intensity 0.0021***

(0.0005)

0.0015***

(0.0005)

*1/ε−0θ

importing countries decreased after 2000 by more than 75 percent (the elasticity decreased from -5.15 to -2.36). These numbers are consistent with the literature.

Consumption intensity (0.0005) (0.0005)

Revenue/real GDP-0.0272**

(0.0120)

-0.0179&

(0.0109)

Dummy equals 1 if year greater

equal 2000

-0.2288*

(0.1199)

-0.1916*

(0.0993)

Core OPEC countries-0.5323*

(0.2848)

System Weighted R^2 0.7406 0.9896

( )1. ., i e θ

The results: Optimal Export Tax

• OPEC countries, although placing more weight on consumers (the parameter is significant at a 10

(i.e., )-0.1941*

(0.1111)

-0.2177**

(0.0909)

Consumption intensity 0.0021***

(0.0005)

0.0015***

(0.0005)

*1/ε− 0θ

is significant at a 10 percent level), set their wedge close to the wedge set by politicians who maximize aggregate welfare (the sum of the welfare of domestic consumers plus industry’s profits).

Consumption intensity (0.0005) (0.0005)

Dummy variables equals 1 for

Venezuela

-0.0272**

(0.0120)

-0.0179&

(0.0109)

Dummy equals 1 if year greater

equal 2000

-0.2288*

(0.1199)

-0.1916*

(0.0993)

Core OPEC countries-0.5323*

(0.2848)

System Weighted R^2 0.7406 0.9896

( )1. ., i e θ

Policy implications:

• OPEC pricing behavior can be approximated using the CON Model.

▫ Although consumption of crude oil in the Middle

“One industry source estimated Saudi Arabia had reduced exports, as opposed to production,

by around 900,000 barrels per day (bpd) compared with a peak in August” (CNBC.com,

November 4 2008).

▫ Although consumption of crude oil in the Middle East, Algeria and Venezuela together currently amounts to 10 percent of total world consumption of crude oil, consumption grew from 2005 to 2006 by 3.5%, 3.4%, and 4.3%, respectively --much faster than it did in the rest of the world, where crude oil consumption grew by an insignificant 0.7%.

Biofuel and crude oil

Biofuel models ignore OPEC

• The current literature on the economics of biofuel, and its impact on fuel prices, assume competitive energy market. competitive energy market.

Competitive (or Cartel of Firms) Competitive (or Cartel of Firms) Models Yield Misleading Results Models Yield Misleading Results

• How much do we error if, instead of modeling Cartel-of-Nations, we assume a competitive oil market? Cartel of firms?

• The impact on markets, distribution of resources among groups and nations, and carbon emitted from energy consumption is substantially different among different market structures

Calibrating the ModelCalibrating the Model

We start by making the following assumptions:• The price of a barrel of crude oil is $72 (this

assumption implies an international price of $1.71 per gallon of fuel)assumption implies an international price of $1.71 per gallon of fuel)

• The biofuel mandate equals the global amount of biofuel produced in 2007

• The quantities of crude oil produced and consumed are equal to their level in 2007

• Biofuel is produced and consumed by countries that import crude oil; countries that export crude oil do not produce or consume biofuel

Numerical simulation

• We performed the following exercise:

▫ Building on price and quantity data for 2007 we calibrated the following models, assuming import calibrated the following models, assuming import demand elasticity -1.25 to -2.0 and crude oil supply elasticity 0.25:

� The competitive model

� The cartel of firms model

� The cartel of nations model

Derivation of the competitive equilibrium

Derivation of equilibrium assuming perfect competition:perfect competition:

In equilibrium MC=P

Where P=1.7143 (=72/42)

Derivation of the cartel of firms equilibrium

The outcome assuming cartel of firms.

In equilibrium MR = MC and P = 1.7143

Derivation of cartel of nations equilibrium

In equilibrium, DEX + MRIM = MCEX IM

Price in the oil rich country equals MC, which is less than the international price (which equals the price in the importing country)

Computing the impact of biofuel

▫ The calibrated model is used to compute the surplus in the fuel markets- with biofuel

▫ Next, we assumed no biofuel, and recomputed the ▫ Next, we assumed no biofuel, and recomputed the equilibrium given the specific structure computed.

▫ Finally, we computed the change in producer and consumer surplus in both the exporting and the importing countries, as well as the change in prices and quantities

PricesPrices

Percentage change in fuel prices when biofuel is introduced

Demand elasticity -1.25 -1.5 -1.75 -2

• The Competitive and Cartel models overestimate price changes

• The price in OPEC countries declines more than the international price; OPEC cuts exports not domestic consumption

Demand elasticity -1.25 -1.5 -1.75 -2

Competition -2.52% -2.15% -1.87% -1.65%

Cartel -2.35% -2.02% -1.77% -1.57%

CON: Exporting -17.10% -10.27% -7.40% -5.81%

CON: Importing -2.02% -1.87% -1.68% -1.52%

Wedge 2.65% 2.95% 3.09% 3.18%

Overestimating the price effect

The competition model overestimates the price effect between 9% and 25%, whereas the cartel model overestimate the price effect between 4% and 16%.overestimate the price effect between 4% and 16%.

-1.25 -1.5 -1.75 -2

Competition 25.48% 14.91% 11.00% 8.86%

Cartel 16.45% 7.83% 5.02% 3.65%

QuantitiesQuantities

Millions of gallons

Demand elasticity -1.25 -1.5 -1.75 -2

• The Con model predicts gasoline consumption goes down, whereas total fuel consumption (gasoline plus biofuel) goes up.

Demand elasticity -1.25 -1.5 -1.75 -2

Export country 1,715.30 951.96 664.80 512.98

Import country -3,065.40 -2,200.80 -1,786.10 -1,522.40

Total -1,350.10 -1,248.80 -1,121.30 -1,009.40

Underestimating the quantity effect

The competition model underestimates the oil quantity effect between 37% and 46%, whereas the cartel model overestimate the quantity effect cartel model overestimate the quantity effect between 4% and 16%.

-1.25 -1.5 -1.75 -2

Competition -37.26% -42.55% -44.50% -45.57%

Cartel 16.45% 7.83% 5.02% 3.65%

The Inaccuracies Caused by the The Inaccuracies Caused by the Competitive AssumptionCompetitive Assumption

• The reduction of price due to biofuel is overestimated by more than 10%overestimated by more than 10%

• The reduction in gasoline consumption is underestimated by more than 37%▫ Underestimating the reduction in gasoline

consumption, significantly underestimate carbon savings

Increasing Global Demand for Fuel Increasing Global Demand for Fuel by 20% (as Asians Drive More Cars)by 20% (as Asians Drive More Cars)

• Assume demand for fuels increase by 20%, welfare in importing countries increases by welfare in importing countries increases by more than 12% with the introduction of biofuels.

• Prices now decline by more than 6%.

Indirect Biofuel Effects on Indirect Biofuel Effects on Carbon EmissionsCarbon Emissions

• Biofuel provides alternative fuel supply

• Reduces demand for fossil fuel • Reduces demand for fossil fuel

• Reduces fuel prices

• Reduces incentives to increase supply of dirty fuels (bitumen, oil sands, coal to liquid)

• Reduces green gas emissions

• Work is being done on quantifying these secondary effects

conclusion

• The Con model is a sound model to analyze OPEC and oil markets

• OPEC reduces exports in response to biofuel • OPEC reduces exports in response to biofuel

• Assuming competition tends to overestimate

▫ The price effect of biofuels

• A competition model, on the other hand, underestimate

▫ The reduction in gasoline consumption

▫ Carbon savings

▫ The loss to OPEC countries from biofuel