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Oil: An Agenda for the 1980s

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A year ago, in reviewing the problems of oil supplies and Western security, I focused on the deplorable developments that had occurred during 1979, and emphasized the grave dangers involved if most of the oil-consuming nations remained dependent on oil from the Organization of Petroleum Exporting Countries, and were unable to achieve effective international coordination of their energy policies.1 It now appears appropriate to examine how circumstances have changed-or remained unchanged-during the intervening year, and to suggest lines of action, for both the short and medium term, that should be pursued vigorously.

Events since the spring of 1980 continue to make apparent the inherent dangers for the non-communist world of dependence on insecure sources of oil supplies. Despite generally abundant oil availability, OPEC nations raised official crude oil prices from an average of $20 per barrel in September 1979 to $32 per barrel by August 1980. In the following month came yet another major oil supply disruption, this time the result of the outbreak of war between two OPEC nations, Iraq and Iran. This war, which still continues, brought about a sudden reduction of approximately four million barrels daily (b/d) in available world oil supplies, and for a while threatened an upheaval of the same magnitude as followed the 1978-79 Iranian Revolution.

However, this time the major oil-consuming nations and their oil companies were in a considerably stronger position. Very substantial oil inventories had been accumulated in response to events of the previous year. Through the availability of these stocks, weak oil demand, and the prompt Saudi Arabian action of increasing its production to partially offset lost Iranian and Iraqi oil exports, the importing nations managed to avoid the disastrous spot-market competition which had done so much to cause the price explosion of 1979. Nevertheless, in December 1980 the OPEC nations imposed still further price increases, bringing the level of permitted "maximum" official sales prices up to $41 per barrel. And, by January 1981, the average of official OPEC sales prices had risen to $35 per barrel.

The ensuing world oil glut and accompanying price weakness served to highlight the crucial role of Saudi Arabia within OPEC. The Saudi decision to increase its production from a "normal" level of 8.5 to 10.2 million b/d and to maintain its "marker" crude price at $32 per barrel represented a determined effort to persuade other OPEC nations to moderate their price increases. These Saudi actions helped the major oil-consuming countries to fare much better than might have been expected in the face of the Iraqi and Iranian supply reductions.

Meanwhile, the combination of three factors-economic recession in the industrialized nations, the progressive removal of price controls on oil produced in the United States, and the response of international oil markets in general to substantially higher oil prices-began to have a major impact on oil demand. Oil consumption dropped significantly in Western Europe, Japan and especially the United States-where the required level of oil imports declined to 6.5 million b/d in the first quarter of 1981 from 7.9 million b/d over the same period a year earlier. It began to appear that improved energy conservation together with the expansion of non-oil energy sources might lead to a situation where future requirements for OPEC oil would be very substantially lower than had been generally forecast prior to 1981.

At the same time, the position of OPEC countries was beginning to show signs of fundamental change. The Iranian Revolution had brought home to all of them the grave dangers of forced-draft economic development, with all its difficult political and social implications. Most of these nations also were concerned about the drastic impact of worldwide inflation on the value of investments they were continuing to make in the industrialized world. Thus, many OPEC nations increasingly emphasized the desirability of limiting output, so as to produce only the amounts of revenue needed for their national economic needs. Moreover, they increasingly realized that if in fact they limited production and exports, they could in many circumstances expect to see substantial price rises in the resulting tight oil market. And they might be able to cover their revenue needs even with lower levels of production.

In contrast, other OPEC members, Saudi Arabia in particular, demonstrated an acute awareness of the potential damage that would be inflicted on both major industrialized nations and less developed countries by a policy of limiting output in order to raise real (inflation-discounted) oil prices. The Saudis also realized that such higher prices, by accelerating the pace of conservation and production of oil and non-oil energy substitutes outside OPEC countries, could seriously restrict current, and even more so future, levels of demand for OPEC oil. But, with the first group of OPEC countries strongly resisting the Saudi policy of price moderation, the Saudis have been unable to achieve their goal of a unified pricing structure for OPEC. The OPEC meeting at Geneva in May 1981 again failed to reach agreement, with both sides maintaining their price positions (stabilizing prices for the time being, possibly for the rest of 1981), the majority of the participants agreeing on a ten percent reduction in output, but the Saudis adhering to their present production level of 10.2 million b/d. The continuing conflict within OPEC underscores how difficult and complex a task it remains for consuming nations to reach any meaningful accord with OPEC on long-term pricing and supply policies.

These latest developments, following the major structural changes of the international oil industry from the early 1970s, raise questions which must be addressed from a long-term perspective. In the following analysis, I will review the problems posed for the world oil economy during the 1980s-a period for which the strategic, economic and physical preconditions are, to a substantial degree, already apparent. The main thrust of this analysis will be directed toward the issues posed in achieving a balanced accommodation between the vital interests of oil importers and exporters, and the consequences that might ensue if such efforts should unfortunately fail.

First we must consider the outlook for oil in the non-communist world. Do the circumstances of the present oil glut indicate that the world's oil importers will cease to be perilously dependent on OPEC oil exports?

Second, how can the oil-consuming nations better marshal their existing and potential energy resources in an effort to ease the extent and consequences of continued dependence on imported oil? This has to do not only with massive production and conservation efforts but with much more effective coordination of policies to deal with potential disruptions of oil supplies.

Third, assuming that the oil-importing countries are able to achieve comprehensive energy policies, how might such policies assist in moving toward an essential accommodation with the oil-exporting countries, and what are the realistic prospects for such an accommodation?

And finally, what actions are needed to contain and possibly deter contingencies which could disrupt the vital flow of oil from the OPEC countries, especially those in the Persian Gulf? In this regard, what must be considered are not only the dangers of Soviet actions, but also intraregional conflicts, political turbulence or changes of regime in individual producing countries, and the threats that might be posed by drastic changes in the oil policy of one or more producing countries.

II

The experience of the past 18 months is clearly reflected in the latest authoritative projections of world energy balances in the 1980s. Taking account both of the sharp decline of oil demand that has already taken place and of the continued stimulus of higher real oil prices on energy conservation and production of oil and non-oil energy resources outside OPEC, most forecasts now generally anticipate only slight, if any, expansion in non-communist world oil demand over the decade. In contrast, forecasts made as recently as the late 1970s, although projecting only a moderate rate of oil demand growth, nevertheless typically projected a substantial increase in the volume of oil required.

Thus, the latest comprehensive projection by Exxon concludes that oil demand in the non-communist world, excluding OPEC countries, will remain approximately unchanged at 50 million barrels per day through the decade, with the demand of OPEC countries themselves raising the overall total from 53 to 56 million b/d by 1990.2

These Exxon projections are predicated on only moderate real growth of the non-communist world's gross national product (GNP)-three percent per year versus five percent over the 1960s, but roughly comparable to the economically troubled 1970s-and on very substantial further improvements in the efficiency of energy utilization. (In the case of the United States, for instance, there would be a projected decline of energy required per thousand dollars of GNP from 5.9 barrels per day of oil equivalent in 1979 to 4.8 barrels by 1990-in terms of constant 1979 dollars.) On these assumptions, but taking account of substantial increases in consumption among the less developed countries (LDCs), total non-communist world energy consumption would increase from 98 to 125 million barrels per day of oil equivalent (b/doe) over this period, or an average annual rate of growth of 2.2 percent.

Exxon anticipates massive development of non-oil energy resources between 1979 and 1990. Total non-oil energy supplies would increase from 45 to 69 million b/doe and their share in meeting non-communist world energy demand would increase from 46 percent in 1979 to 55 percent by 1990. For example:

-Gas supply would rise from 18 to 23 million b/doe despite the effects of sharply declining production from current sources of supply.

-Coal output would advance from 17 to 26 million b/doe even excluding expanding volumes of coal used in the production of synthetic oil and gas.

-The combined contribution of nuclear, hydro, geothermal, solar, gasohol, and other miscellaneous sources of commercial energy would rise from ten to just under 20 million b/doe, accounting for the largest part of the non-communist world's incremental energy supply.

Reflecting the increased incentives provided by higher real oil prices on efforts for exploration and development of new sources of oil supply, total oil production outside OPEC is forecast to advance from 21 million b/d in 1979 to 26 million in 1990. This increase would include a rapid commercial expansion of synthetic liquids production (from such sources as shale oil, tar sands and coal), which would rise from current fractional amounts to upwards of two million b/d. To meet the non-communist world's oil needs of 56 million b/d, the level of OPEC production required would still be 30 million b/d, less than the 32 million b/d OPEC produced in 1979 but five million b/d above the currently depressed OPEC production level of approximately 25 million b/d.

The Exxon projections also indicate that during the present decade annual non-communist world oil production will exceed new discoveries, and accordingly, the reserves-to-production ratio will decline from 29 years to about 24 years by 1990. This is predicated on the assumption that OPEC countries maintain their oil output at levels that accommodate the future needs of the oil-importing countries and do not restrict production in order to stretch the life of their reserves.

In sum, although it now appears that conservation and alternate energy supplies will combine to make oil demand a significantly smaller percentage of total energy use than it has been in the past two decades, the projections still indicate a major oil requirement and continued substantial dependence on OPEC oil. Even if the total oil demand should fall by 1990 substantially below that projected by Exxon, there is no realistic prospect that either the major industrialized countries or the LDCs can become anywhere near self-sufficient or reliant on non-OPEC sources.

Moreover, as the current world oil surplus well illustrates, the world remains enormously dependent on the production policies followed by one key OPEC country, Saudi Arabia. However, the Saudi policy of maintaining its oil production well in excess of market requirements and at prices well below the general OPEC level provides no realistic basis for anticipating long-term oil market weakness. In an interview on U.S. television, Saudi Oil Minister Yamani bluntly described the 1981 oil situation as a glut that "we engineered . . . in order to stabilize the price of oil." Sheikh Yamani also indicated that the Saudis could "live happily" by reducing their production from over ten million b/d to as little as six million b/d if such a reduction were required to support a unified OPEC pricing policy.

If world oil demand should remain depressed and if surplus production should continue (reflecting either a continuation of current Saudi production policies or the effects of possible restoration of Iranian and Iraqi production, or both), real oil prices will tend to decline as long as such conditions prevail. However, it is extremely unlikely that the Saudis would continue their present policy if oil prices were to tumble below the current Saudi level. Moreover, protracted oil market weakness and declining real oil prices would inevitably retard energy conservation, slow the pace of development of non-OPEC energy resources and thereby detract from efforts by oil importers to decrease dependence on OPEC oil.

Up to now we have focused our review of prospects for world energy balances on the distribution of oil supply and demand for oil-importing countries as a whole, rather than for individual countries. There are, however, widely divergent degrees of dependence on imported oil as between the United States (37 percent of oil supply in 1980), Western Europe (81 percent) and Japan (virtually 100 percent). But all of us have become so interdependent in our political, economic and strategic exposure that there is no individual salvation for any one country. If the United States, for instance, were able to achieve a substantial degree of energy independence, it would of course be an extremely welcome development. However, the less fortunate circumstances of our allies would, nevertheless, still dangerously impinge upon us.

Moreover, even if oil-importing countries do their utmost to reduce their import dependency, and OPEC countries maintain levels of oil production as needed by oil importers and establish a pricing and development policy which (at least from their viewpoint) might be described as moderate, the potential financial effects on the overall well-being of the oil-importing world could still be grievous. For the poorer industrialized and less developed countries, it could be even crushing.

In addition to the continuing economic vulnerability of the importers, the events of the past 18 months have again underscored the variety and depth of the political and strategic problems which affect the Persian Gulf. These could, at practically any time and any place, interrupt oil production and thus supplies to importing countries-as they have now done three separate times in the past eight years. Contingencies could arise from the Soviet threat, regional fighting, internal upheavals, terrorism, the festering Arab-Israeli issue, or a sudden shift in the production and pricing policy of one or more OPEC countries. It is nearly certain that we will have to cope with one or even several of these contingencies in the years ahead.

The overriding conclusion is thus inevitable. Even in the short-to-medium term no firm reliance can safely be placed on the future availability of the required volumes of Middle East oil at manageable prices. If nothing else, the experience of the 1970s should have taught us this. In spite of the present world oil glut, the outlook for most of the 1980s still looks to be highly precarious and, accordingly, it would be extremely imprudent if oil importers were to base their planning for the future on current market conditions.

III

In facing the prospects of long-term dependence on imported oil and uncertain oil balances, the consumer nations must redouble their efforts toward instituting a comprehensive, coordinated energy policy. The consumer nations must deal with two types of problems which require close cooperation-improving their energy resources position and coping with oil supply contingencies. It would be the height of folly if efforts to cope with these problems were relaxed because of current easing of world oil balances. These issues should be confronted now in the calm of loose world oil balances rather than later in the storm of some future crisis.

Once in place, a coordinated policy is essential for an effective accommodation between importers and exporters. Except during the present phase of a supply glut, individual importing countries and their oil companies have in the past acquiesced in practically any demand by OPEC countries regarding the volume and price of oil supply and even certain political terms as well. They have been inclined to do so out of fear that refusal to submit to the stipulated terms and conditions might jeopardize their ongoing oil supply position. It is not surprising that oil producers have acquired an unrealistic sense of their own power. Unfortunately, they have thus acted as if they could afford to ignore the real degree of interdependence between the political, economic and strategic welfare of the importing and producing countries.

During the 1970s, the essential failure of oil importers to achieve effective cooperation among themselves can be traced, to a considerable extent, to the major shortcomings of U.S. energy policy and the consequent inability of the United States to provide world leadership. After the 1973-74 oil price shock, artificially low oil prices and a rapid buildup of oil imports made it extremely difficult for the United States to assume a constructive role vis-à-vis the rest of the oil-importing world in the coordination of international energy policy initiatives. However, as a result of decontrol of oil prices, sharply declining oil imports, and a revived commitment to building the Strategic Petroleum Reserve, the United States is now in a much stronger position to induce, if not insist on, cooperation among consumer nations.

A comprehensive resources policy on the part of consumer nations must deal with a number of complex issues. Concerted endeavors are vital on the following fronts:

-An optimum energy conservation effort must be pursued through the operation of the price mechanism, tax incentives and other suitable measures. It should be noted, however, that there are obvious limits to how far conservation can successfully be carried before the cost of achieving additional energy savings would exceed the benefits to be derived. Equally, economic vulnerability to any future supply shortfall would increase as conservation progresses because there would be that much less "conservation fat" left.

-A sustained program for oil and gas exploration and development must be put into place, supported by the necessary price and tax incentives. Wherever possible, the creation of a surge productive capacity that would only be available during supply emergencies should be encouraged. In addition, technological and financial assistance for oil projects of LDCs should be extended.

-A policy to replace oil and gas by coal, wherever feasible, should be pursued through investment, tax and other incentives. But if this should prove to be insufficient, direct government involvement may be required; mere market forces may not in all instances be effective, as in the case where electric utilities are able automatically to pass on higher oil costs to their customers. Additionally, an internationally coordinated research effort should be undertaken to cope with the environmental hazards of expanded coal use such as air pollution, acid rain, and the problems that might be posed by the possible "greenhouse effect" (i.e., a warming of the earth's atmosphere with a potentially dangerous rise in the level of ocean waters, bringing possible detrimental consequences for coastal areas and also for agriculture).

-The production of synthetic oil and gas should be established and expanded as a matter of highest priority. In addition to a multinational cooperative effort on synthetic fuels research, joint efforts may also be necessary for the commercial development of new productive facilities because of the concentration of coal, shale oil, tar sands and very heavy crude oil in relatively few countries. In this respect, curtailment of the operations of the newly created U.S. Synthetic Fuels Corporation may well prove to be counterproductive. Because of unresolved technological problems, the huge financial cost involved, and the long-deferred and uncertain payout from investment, it is highly questionable whether private industry will launch as massive an effort in this field as is required without substantial government support.

-International cooperation in nuclear research and development is essential, with the problems of waste disposal, nuclear proliferation and plant safety deserving particular attention. In light of the uncertain nature of future energy balances, a large contribution of nuclear energy would be most helpful, if not essential, especially for the many oil-importing countries with a small or virtually non-existent national energy resource base. Accordingly, the development of atomic energy should only be curtailed if the reasons for doing so, after the most exhaustive inquiry, are overwhelming. And even then, international efforts to curtail nuclear energy would probably fail, not only because the Soviet Union would be unlikely to subscribe to such an effort, but also because many of the energy-starved countries might not agree.

-Finally, a major research effort on a coordinated international basis is warranted for the development of energy from so-called exotic sources (e.g., solar, wind and tidal water power) despite the very limited early contribution to energy supplies that can be expected. There is always the chance of a technological breakthrough that could change future prospects.

In addition to establishing a mutually cooperative and progressive energy resources policy, consumer nations must move to develop more effective means of coping with oil supply disruptions. The absence of effective oil importer coordination greatly contributed to the 1973-74 and 1979 oil price explosions. A responsible policy for energy coordination among oil importers must reflect the underlying likelihood of future supply emergencies.

First, the major importing countries should continue to pursue aggressive stockpiling of substantial oil reserves that would be available for use during future crises. The management of oil stocks must be made subject to a joint or coordinated policy as agreed upon by the relevant oil-importing countries. Past experience has demonstrated that the actions of individual nations or companies can easily run counter to the common good. For instance, the special interests of countries or companies in assuring their future supply availability, or in benefitting from an appreciation of the value of their oil stocks as a result of crisis, might induce them to add to rather than withdraw from their reserves during an emergency. Such a course of action would increase the severity of the crisis and contribute to the upward pressure on prices, as occurred during the Iranian upheaval in 1979.

Second, the oil-importing countries and their companies must agree not to purchase oil at above OPEC official sales prices during a crisis period, or at least be penalized if they should do so. This is necessary because importing countries and their companies are tempted to purchase oil at excessive spot-market prices during periods of actual or even feared future supply shortages. Such transactions do not increase total oil supplies but only serve to redistribute such supplies among importers, forcing countries that are thereby deprived of imports into the spot market at ever-escalating prices. In due course, such higher prices tend to establish a new official level of prices as established by OPEC. All of this has occurred in the past and will continue to do so if there is no policy in place for pre-crisis and crisis cooperation.

Third, there is a need for a policy of equitable sharing of oil supplies among the various importing countries during periods of actual shortages. As presently constituted, the International Energy Agency's oil sharing mechanism is only triggered by a seven percent shortfall. This is clearly inadequate inasmuch as an oil price explosion can occur well before the trigger-level is reached. The terms of reference for the IEA should thus be revised to permit an earlier response to an oil supply crisis. An effective policy for the international sharing of supplies would also tend to reduce the pressure on importing countries and oil companies to obtain their requirements on the spot market at whatever cost.

Since the dismal 1979 experience, which pointed up the need for further oil-importer coordination, the IEA Secretariat has been endeavoring to obtain approval from member countries for more responsive crisis management policies. Unfortunately, some of the important IEA countries have continued to resist such changes. It would be most unfortunate for all concerned if such disagreements could not be resolved before the world is confronted by a new supply emergency.

IV

In addition to the energy problems facing oil-importing countries, there are also massive difficulties that confront oil exporters. Oil importers can ignore these only at their own peril. Cooperation, however, can provide a basis for an effective reconciliation of their diverse interests.

To assess the main lines of action for potential importer-exporter accommodation, I will draw upon the underlying assumptions, pricing proposals and policy suggestions contained in the thoughtful report prepared by OPEC's Long-Term Strategy Committee. This committee of OPEC specialists (under the chairmanship of Saudi Oil Minister Yamani since its inception in 1978) presented its recommendations at a special conference of OPEC ministers in May 1980. Although it has become increasingly uncertain whether these specific proposals will be implemented (Sheikh Yamani himself now indicates that some of the committee's proposals may be inappropriate because of changed oil market conditions), the Strategy Report still provides an excellent basis for consideration of issues which must be addressed in order for oil importers and exporters to reach a realistic understanding.3

In its outlook for future world oil balances, the Strategy Report cited the growing reluctance of producing countries to produce oil at rates higher than needed for internal development. Fundamentally, this reflects OPEC's preference, if completely uninhibited, to produce only as much oil as needed for its local demand plus a level of exports that would provide for its revenue requirements. Producing countries would, obviously, be very much interested in extending the life of their reserves and the time span during which they could count on substantial oil revenues. With the nagging doubts about the success of efforts to build up viable national economies (not primarily dependent on oil revenues) and concerns about the many economic and social problems that rapid and forced industrial development pose, many OPEC officials would consider a lower rate of oil production and economic development as more responsive to their national welfare and interest. The maintenance by OPEC of higher levels of output than their national economies require thus imposes distinct obligations on the oil-importing world which it cannot afford to ignore-provided that importing countries, in turn, are able to secure adequate supplies of OPEC oil at prices they can afford to pay.

Steps by oil importers to assist OPEC in achieving its long-term objectives for industrialization must cover a wide range of issues. Oil-importing countries must not consider OPEC purchases mainly as a means for recouping as fast as possible their petrodollar outlays. While it might be difficult to discourage some OPEC countries from engaging in uneconomic or otherwise unsound projects, it should at least be tried, especially where the ultimate futility of such expenditures is only too obvious. However, as long as importing countries and companies compete among themselves for lucrative OPEC contracts without any coordination, each one would feel that if it did not get the order, some competing firm would. Similar considerations should apply to the sales of military equipment which can either not effectively be used by the oil-exporting country, or which might lead to overmilitarization, and provoke adventurism and regional conflict. Such self-restraint by Western suppliers can obviously not be achieved easily-if at all-especially as individual OPEC countries may be determined to proceed with certain industrial or military purchases. But a coordinated effort to establish a rational approach to this problem must at least be attempted.

Importing countries must also be prepared to accept the output of new OPEC industrial facilities without discrimination. Admittedly, this might present problems when such output would replace production from existing facilities within the oil-importing world, or when, as is frequently the case, such output is subsidized by non-commercial local supply of energy or feedstock for, say, petrochemical production, or is financed by non-commercial loans. In the latter type of situation, depending on the circumstances, the imposition of some countervailing duties may have to be considered. Nevertheless, to reach a mutual accommodation of long-term economic interests for both sides, constructive and determined efforts must be made to deal with these issues.

Oil exporters must also be provided non-discriminatory access to investment opportunities for their surplus funds within importer countries. This would lead to an increase of OPEC ownership in the importers' domestic means of production, including equity interest in corporations, real estate and so on. Where exclusions from such ownership are necessary for security or other essential national interests, they must be applied only on a non-discriminatory basis. Moreover, consideration might also be given by appropriate international institutions to make available to producing countries non-transferable, no- or low-interest bearing bonds that are indexed against inflation.4

A closely related area requiring exporter-importer cooperation is the establishment of effective mechanisms to provide financing for oil-related deficits of the weaker oil-importing countries. Private financial institutions which up to now have handled a substantial part of this transfer may over a period of time not be able to continue at the levels that would be required. Also, there may be a need for arranging for a lender of last resort to supplement, or perhaps even to replace, a sizable part of the private recycling flows.

In dealing with the oil-related financial problems of the less developed oil-importing nations, the OPEC strategy document proposed that an international aid program be set up to provide LDCs with financial assistance through loans or grants for balance-of-payments and development purposes. To accomplish this objective, OPEC suggested that a new international organization be established jointly by OPEC and industrialized countries to provide financial aid and technical expertise for the development of the LDCs' energy resources.5

OPEC countries with large financial accumulations must be brought increasingly into the international financial support network. Since their own prospects for economic development depend on the solvency of their oil customers, it is obviously very much in their own interests that OPEC countries increasingly cooperate with the financially strong oil-importing countries and international financial institutions. In this way a financing and transfer program could be established that would extend over a number of years, rather than operate on an uncoordinated short-term or ad hoc basis. The implementation of such a financial assistance program, however, would pose many negotiating problems such as that of respective OPEC-OECD financial contributions. In this connection, it should also be noted that the World Bank last year proposed to set up an energy affiliate, to be jointly financed by OPEC, the OECD and the Bank. This effort, it was hoped, would lead to a doubling of energy production by the oil-importing LDCs from the current 7.8 million b/d oil equivalent to over 15 million b/d by 1990, resulting in gross foreign exchange savings at present prices of about $90 billion. It is to be regretted that the United States recently announced that it will neither support the creation of such an organization nor participate in it; I hope this decision will be reconsidered.

The pivotal issue of oil pricing must also be directly confronted as part of the framework for eventual exporter-importer accommodation. OPEC's Strategy Report suggested that oil prices should increase in line with the impact of inflation on international trade and with changes in certain currencies. There also would be a gradual rise in real oil prices-related to the real growth of GNP in OECD countries.6

The Strategy Report's pricing position, however, does not answer the key question of what oil price level would provide a reasonable and acceptable base for future escalation under a long-term pricing formula. During the period between 1978 and May 1980, when the OPEC committee prepared its strategy document, crude oil prices rose from about $13 per barrel to some $30 per barrel-a rate of increase far in excess of the committee's own pricing policy proposal. Moreover, OPEC itself stated that "oil prices should in the long-term approximate the cost level of alternative energy supply" and, as Sheikh Yamani explained, this ultimate level should be attained "gradually, not all at once."

Present OPEC prices have even as of now substantially reached the estimated cost of some alternative supplies.7 Moreover, any realistic approach to oil pricing must provide for a decline as well as for an increase of the real and also the nominal price of OPEC oil when circumstances warrant it. At this time, there is clearly no valid reason for an advance in the real price of OPEC oil. Rather-in line with the Report's own stated policy goals-real oil prices should decline, as it will take many years before substantial quantities of alternative energy can become available. This issue is a proper subject for review by OPEC countries and the importing nations.

In dealing with the problems posed by oil shortages, the OPEC strategy document made a number of recommendations. For the financially weak less developed oil-importing nations, the Report advocated, as a general policy, preferential treatment for the security of oil supplies on the basis of an internal agreement among all OPEC members.8 The Report also suggested that some price restraint may be called for during shortages because the "bulk of crude and demand for petroleum products is influenced more by the policies of producing and consuming governments than by a free market equilibrium." Once a shortage is over, it considered the possibility of two options-either freezing prices in real terms until the floor price catches up or, alternatively, establishing a new floor price and moving forward from there.

This suggestion for price restraint during future supply disruptions-if it could be implemented-is most constructive. What OPEC countries need for this purpose is the ability to draw on a substantial reserve productive capacity for dampening price increases during a period of oil shortage. Such a reserve could also provide for an unexpected surge in demand so as to make certain that it can be covered without discontinuities. Experience has shown that a mere supply/demand balance is not enough to eliminate upward pressure on prices. With a very uncertain future, maximum availability of oil should at least exceed world demand by several million b/d; otherwise the markets will get nervous. As asserted by the Report, "all the risks in supply forecasts are on the downside." Accordingly, the industrialized countries would require an OPEC assurance of secure oil supplies at manageable prices. Only then will it be possible to establish the confidence of importers in future oil availability.

Finally, how then to establish workable arrangements for future oil exporter/importer dialogues? The OPEC paper recommended starting with informal talks on selected issues with experts from a few countries on each side, to be followed, if successful, by formal OPEC-OECD discussions. This would appear to represent a realistic approach that should be acceptable to the importing countries. It is especially welcome that the strategy paper does not insist that oil discussions must also include all the outstanding issues between the industrialized world and the LDCs.

In practice, initial discussions should include those countries in the two groupings that would in fact have substantial capability to carry out the decisions reached, and would also possess sufficient influence to ensure that such decisions would be implemented by at least most of the other relevant members of their group. This might involve, as lead nations, Saudi Arabia, Kuwait, Venezuela, and, perhaps, Iraq on the side of OPEC; and the United States, Great Britain, Germany, France, Japan, and possibly Italy on the side of OECD.

V

Despite efforts to reach a balanced accommodation with the oil exporters and despite efforts to cope more effectively with oil supply disruptions, the oil-importing countries may nevertheless be confronted by contingencies that could endanger at any time the oil fields and transport routes to the importing countries. Even with Iraqi and Iranian production cut back to a very low level as a result of the war between the two countries, perhaps as much as 15 million b/d or about two-thirds of OPEC's current exports would potentially be at risk. The threat to Persian Gulf oil supplies can come, as we have already noted, not only from Soviet overt or covert operations, but also from the Arab-Israeli conflict, intraregional disputes, internal upheavals or revolutions in major producing countries, and terrorist attacks on oil facilities.

Indeed, the ultimate political, economic and strategic destiny of the importing countries is held hostage in the Persian Gulf, particularly in Saudi Arabia. U.S. Secretary of State Alexander Haig has warned that a potential disruption of access to Persian Gulf oil "would constitute a grave threat to the vital national interest. That must be dealt with; and that does not exclude the use of force if that is necessary."

To keep the threats to oil supply under some measure of control, the diplomatic and economic policies of the major importing countries must be carefully balanced and coordinated. It will not be easy to reconcile the diverse interests and positions of the various members of the Western alliance, including Japan, but the underlying common concern in assuring secure access to Persian Gulf oil on manageable terms is overwhelming. What is at issue is the survival of NATO and the whole alliance as an effective and cohesive world power group. Because the stakes are of such magnitude, it should be possible to reach an agreement on a coordinated policy aimed at containing potential threats to the continued availability of Persian Gulf oil.

Such a coordinated policy should include not only the necessary measures for continuing close consultation, but contingent agreement on a limited direct or indirect military contribution by U.S. allies. But the major responsibility for any potential response by force by oil-importing nations falls on the United States because no other Western power can match U.S. military resources. Moreover, no other Western country has the means to check Russia, which would certainly be sorely tempted to interfere in any confrontation affecting oil-importing and producing countries. It is self-evident that a struggle over oil might easily trigger hostilities between the two superpowers. But if the United States is prepared, as it must be, to intercede against a Soviet move into the oil-producing areas of the Persian Gulf, it must equally be prepared to respond to a non-Soviet event, or one not traceable to the Soviets, which threatens the essential flow of oil.

There are many problems which stand in the way of gaining effective regional support for U.S. efforts to defend the Persian Gulf. Even though the Saudis and other producing countries must be aware that they would need protection against hostile Soviet moves, they somehow hope not to be drawn into any East-West conflict. Nearly all of the Persian Gulf nations desire to keep our military power at best at an "over the horizon" distance, and for it to be at their call only when they have become directly involved. They thus ignore that when help finally arrives it may be too late to save them. They apparently fear that a U.S. military presence in their countries would threaten their internal and external security rather than enhance it.

The likelihood that Saudi Arabia or other relevant Middle East countries will give the United States substantial military-related facilities is remote. Such Western facilities, as Prince Saud, the Saudi Foreign Minister, has put it, would be like "lightning rods" that would provoke the Soviets to ask for the same rights. In the meantime, the United States is confronted by the hostility of Iran, Syria, Libya and others in the general area. Colonel Muammar Qaddafi, the Chief of State of Libya, only recently advocated an escalation of pan-Arab activity in order to launch a strategic counteroffensive against U.S. imperialism in the Middle East.

Under these conditions, the military potential of the United States in the area must necessarily depend on rapid deployment forces and limited base or supply facilities in Oman, Bahrain, Somalia, Kenya and the Indian Ocean island of Diego Garcia. Even a limited military presence in the area could well have the character of a tripwire.

In countries where our supply facilities are located, we would apparently be prepared to strengthen their internal security forces. In many instances, the entrance fee for obtaining access to facilities would involve supplying military hardware to the country concerned. While this can provide only very limited, if any, capabilities for these countries to resist Soviet incursion, it might well strengthen their position against internal opposition-but it might also tempt them to engage in military adventures against their neighbors to settle old debts. As a matter of fact, the United States may have to contend with a host of problems in those nations where it has been able to obtain facility or supply rights. These problems could affect not only the security and dependability of U.S. tenure, but draw the United States into these nations' internal and external problems-with many potentially difficult and unpredictable consequences.

The recently formed Gulf Cooperation Council may improve some aspects of Persian Gulf security, but it certainly lacks the ability to cope with Soviet incursions. The Council (whose members are Saudi Arabia, Kuwait, Qatar, the United Arab Emirates, Bahrain and Oman) aims to promote economic harmonization, and perhaps very gradual political integration and eventually cooperation on defense and internal security. Apparently, as indicated by the UAE Minister of Petroleum, the group also plans to improve and coordinate the land, sea and air defense of oil fields and terminals. However, many of the member states of the Gulf Cooperation Council lack critical elements of the necessary political, military, educational and human assets. None of them possesses more than a symbolic navy and small land and air forces-which even in the case of Saudi Arabia depend on massive foreign assistance.

In case of a terrorist attack or of regional fighting that would endanger oil installations, an effective joint oil defense and a rapid repair capacity for oil facilities, if and when implemented, could prove to be invaluable. There remain, however, some nagging doubts about the staying power and operating capability of regional organizations. Past experience has not been too comforting in the light of national jealousies and fears.

It is noteworthy that the new organization does not include Iraq. While one of the reasons for this omission might be Iraq's war with Iran, there probably is also a substantial amount of distrust and fear about potential Iraqi ambitions for hegemony over Arab Gulf states.

Meanwhile, the Iraq-Iran War continues to pose a wide array of problems which could severely endanger the security of oil supply. The longer the war lasts, and the more remote the chances for a settlement that restores Iranian sovereignty to the thalweg line of the Shatt al Arab, the more likely is the risk of the disintegration of Iran. Iran is threatened by separatist efforts by its large Arab, Kurdish, Azerbaijani and Baluchi minorities and by conflicts between moderates and radicals in the political as well as religious arena.

Clearly, the disintegration of Iran would be a disaster both for the region and for Western interests. It could involve a danger of confrontation with the Soviet Union, a breakdown of the country into various ethnic units, or a takeover by a radical faction, such as the communist Tudeh Party. Any Iraqi takeover of or control over the oil-producing Arab-populated area of Khuzistan would not only strengthen the Iraqi goal of hegemony over Persian Gulf countries, but would also leave the remaining parts of Iran without oil production. They would in fact become international basket cases that would be up for grabs by the Soviet Union or by other neighbors. A takeover of the government by the Tudeh Party would put the western shore of the Persian Gulf under communist control.

If, on the other hand, Iraq should be unable to achieve the main objectives that caused it to enter the war, its government might be in jeopardy, with an extremely uncertain outcome for its own political future. In any case, as of now, Iran is trying its best to unseat the present Iraqi government by inciting its Shi'a majority against the ruling Sunni minority.

If the war should continue indefinitely into the future, the possibility cannot be excluded that Iranian and Iraqi oil facilities would again become targets for attack. Worse still, as a desperate and last gesture, the country threatened with defeat might also try to destroy other oil facilities in the region or attempt to sabotage the flow of oil through the Strait of Hormuz.

In the light of these contingencies, what can or should be done? There are at this stage of the game very few options available. But the deep concern of the United States and its allies about the possible consequences of the war must be made clear to all parties concerned, and especially to the Soviet Union. In particular, we should state that we would not acquiesce in any spreading of the war to other areas; nor would we recognize a takeover of the Iranian government by the minority Soviet-inspired or perhaps even Soviet-directed Tudeh Party.

We must, of course, be prepared to face Soviet opposition to such a policy. This is a risk we may have to take, because the consequences of doing nothing might be even worse. The basis for any actions that may have to be taken would be the actual or implied prohibition against aggression under international law or under the U.N. Charter.

The present situation concerning Iran and Iraq illustrates the dangers that may arise either from a regional war or from an internal insurrection. The most obvious justification for Western intervention in either case would be a request for assistance by an involved party.9 In the case of an insurrection, it would be easiest if the existing government were to ask for help. But even without such a request, intervention would most likely be considered if the revolutionaries receive military or other support from outside hostile forces such as the Soviet Union or any of its proxies. Such outside support would tend to transform the internal struggle into an external one.

If the revolutionaries do not receive any open foreign help, and the threatened government has not been able to ask for Western support, we would still have to consider how best to protect our vital interests if revolutionaries, once in power, cut off essential oil exports. If we are prepared to act in the event of an internal upheaval which jeopardizes our security and is supported by some Soviet assistance, we might equally not be able to afford to remain passive if a link to the Soviets is not self-evident. The basis for action would be the inherent right of every nation of self-preservation.

In addition, there remains the possibility of a nonviolent event that drastically reduces the supply of oil from the Persian Gulf. Even a peaceful change of government or an abrupt shift in the oil policy of major producers could disastrously interfere with the flow of oil if this were to result in a sudden substantial cutback in oil exports or a massive price increase that importers are just not able to pay. As Sheikh Yamani put it, "Saudi Arabia . . . alone is in a position to inflict very severe damage on the world economy as a whole or a selected group of nations. . . . If the Saudis simply cut production to the level needed to meet their own development plans there would be a depression in the United States in which the rate of unemployment would at least double, the price of oil would double again and the inflation rate would rise."

It should be stressed, however, that as of now major producing countries in general and Saudi Arabia in particular have not been pursuing policies that would confront the importing countries with such stark issues. Saudi Arabia especially has, wherever possible, followed a course of moderation and has exercised its influence to temper the policies of the more radical oil-exporting countries. There is reason to hope that this moderation will continue inasmuch as oil-producing countries must be aware that an unlimited capacity to destroy cannot be safely used without also incurring the risk of being destroyed. Over the past eight years the major oil-importing nations have accepted very great increases in the price of oil; they have responded fully to the economic and financial demands of OPEC nations and are now well along on programs for conservation and alternate energy production that are enabling the OPEC nations to limit their production and to stretch out the period in which their oil resources will be of enormous importance for the long-term development of the OPEC nations. What they cannot accept is any abrupt change of policy, by one or more major OPEC countries, that would have the effect of reducing production or increasing prices beyond bearable limits.

Clearly, forceful intervention can only be the absolutely last recourse after everything possible to achieve a peaceful settlement has failed, and force should only be used when the most vital interests of the importing countries are in jeopardy. From a realistic point of view, for any military intervention to be acceptable or, at least, to be tolerated by the international community, the case for self-preservation must be obvious and self-evident. Such a response must not give the appearance of being merely the brutal or frivolous application of overwhelming power. It is also important that any intervention quickly succeed, not only to retain public support, but to ensure the effective protection of the jeopardized oil resource.

Obviously, any decision on foreign intervention must take account of all military possibilities, especially since such intervention could trigger a preemptive strike on oil facilities by any one of the warring parties or others. Moreover, it is quite possible that during the 1980s there might be a cluster of small nuclear powers in the volatile Middle East-Indian Ocean area, including perhaps Israel, Iraq, Pakistan and India. Contingency planning must certainly address itself to all of these risks. We must also entertain no illusions about the difficulties of maintaining the flow of oil production and exports in war-torn areas in the face of a possible hostile population, or so to speak, of producing oil while sitting on bayonets.

The issues posed here are as serious in their implications for world peace and stability as are those involved in the ultimate nuclear responsibility of the United States for the defense of the Free World. But it is important that everybody concerned be on notice that under extreme conditions, and after all possibilities to resolve a crisis peacefully have been exhausted, the application of power cannot be excluded. No nation can be expected to accept its demise without counteractions.

Whether or not a military response could effectively reestablish access to oil is in many instances by no means certain. However, the willingness, if necessary, to make use of one's deterrent capabilities is the major guarantee, or at least hope, that these capabilities will not have to be tested. The awareness that there exists a risk of a serious confrontation is an essential if unspoken element in establishing bargaining limits between oil exporters and importers.

VI

In this article I have tried to face up frankly to issues that are sometimes put to one side, or discussed only in the internal policy councils of the major nations concerned. I do so in the belief that an honest presentation of positions that would be virtually inevitable in the event of crisis can help to mitigate the chances of any such crisis arising. The importance to the world economy of assured supplies of oil at bearable prices is so great-so essentially unique-that I believe it best to discuss the issues now, at a time when a supply emergency may not appear imminent.

But the main thrust of the article is on the constructive possibilities of the present decade. The world does remain heavily dependent on OPEC oil, and especially on oil from the Persian Gulf. For at least the next ten years that dependence will persist even if the importing nations continue-as they must-to take massive action to conserve energy and use it more efficiently and to expand the production of oil outside OPEC and the production of non-oil energy sources. What has happened to oil prices in the last decade should be ample incentive to maintain and increase these efforts.

Given such policies, and the other actions outlined in this article, however, the way could be open for a realistic long-term accommodation between the interests of oil-producing countries and those of all oil-importing countries. Both in terms of world economic progress and world peace, such a goal is worthy of the greatest possible effort by all concerned.

2 Exxon, "World Energy Outlook," December 1980.

3 Although the text of this report has not been officially released, its key recommendations have been widely summarized both in trade and general publications. My specific point of reference is the summary contained in a special supplement to Platt's Oilgram, May 6, 1980. It is noteworthy that the May 1981 Geneva meeting of OPEC directed the Committee to conduct a "further review of OPEC's long-term strategy and present a report to the conference as soon as possible." New York Times, May 27, 1981, page D13.

4 For further details, see my "Recycling Surplus Petrodollars via Internationally Issued Indexed Energy Bonds," Middle East Economic Survey, April 7, 1980 and The Institutional Investor, July 1980.

5 According to the strategy paper, OPEC's contribution would be based on the cost to LDCs of future oil price increases, put at $3.4 billion per year; and that of the industrialized countries would be related to the rate of inflation of goods exported by them to the LDCs, estimated by OPEC at $9.3 billion annually.

6 According to OPEC's tentative estimates, the inflation adjustment might be six to nine percent a year, and if the GNP of OECD countries were to advance on the average by three percent per annum, this would result in an average floor price increase of some ten percent a year. In nominal terms, prices would thus double every seven years. If this kind of adjustment had been applied between 1974 and 1980, OPEC prices would have risen from $10.84 to $24.26 per barrel. In fact, prices now are some 50 percent above this level, largely because during the 1979 oil supply crisis spot prices increased wildly, followed by a substantial jump in OPEC prices.

7 For example, one major oil company recently stated that shale oil and intermediate Btu gas from coal appear to be competitive with oil at current prices.

8 As LDC oil demand (as also OPEC's own domestic requirements) is expanding much more rapidly than that of the industrialized world, the satisfaction of LDC consumption would require an ever-increasing proportion of total oil availabilities.

9 See "Joining in Other People's Wars," The Economist, March 7, 1981.

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