The most startling surprise in the international economy during the 1980s has been the fulfillment of prophecies made five years ago—often voiced, seldom believed—that oil prices would decline significantly from their peak price of over $40 a barrel in 1980-81. Prices have, in fact, fallen to less than $12 a barrel on the spot market this past winter.
There is almost universal agreement that, on the whole, lower oil prices are beneficial to the world economy. But very low prices will pose very big problems. A further dramatic decline in oil prices will have a revolutionary impact on world politics and the international economy of a magnitude tantamount to that of the oil price increases in 1973-74 and 1979-80.
An explanation of the events that will be triggered by an oil price collapse depends, first, on an understanding of the peculiar nature of the international oil trade, so unlike that of other commodities, and second, on a determination of exactly what happened this past winter. Then the conditions that would allow a free-fall in oil prices can be defined. The consequences of such a price drop, including the implications for Western energy security, will become evident. And appropriate policy responses can be discussed.
Whatever emerges in the coming months, it is clear that the oil sector, with its fundamental effects on international economic and political affairs, will never again be anything like what it was.
The international petroleum industry has always been somewhat special and different from other commodity sectors. Given its pervasive influence on industrial growth, and the record of government and industry interventions over the decades, the oil sector has not generally functioned as a free transparent market in which price is determined by the interaction of many buyers and sellers. At most times in the past, rather, oil has been traded through a contrived mechanism to balance supply and demand. The market has also been a source of dynamic change since before the turn of the century, when oil was first produced in commercial quantities.
Throughout this period, beginning roughly in 1890, oil prices have experienced sharp cyclical change in a remarkably consistent pattern. The dollar price of oil in real terms has gone from trough to peak roughly every ten years, and then moved from peak to trough in the decade following. In the cycle that preceded the current phase, oil prices had reached a floor of less than $3 per barrel (in 1976 dollars) at the end of World War II, rising to a peak of about $4.25 in 1958. Throughout the 1960s, the real price of oil steadily declined, as low-cost Middle Eastern oil came on the market, and finally reached its trough at about $3.90 per barrel during 1969-70.
The last cycle was the most volatile, with the peak reached by oil prices in 1981—about $12.50, in real price terms—representing a 225-percent increase over the previous decade. If the pattern continues, we will be in for a long price decline that will probably reach bottom in the early 1990s, when price levels will hover at a level, expressed in 1986 dollars, of $8 to $10 per barrel.
The 20-year boom-and-bust pattern of the international oil market has shown another interesting pattern: each recent price trough has brought with it a reorganization of the petroleum industry, uniting governments and companies in actions to limit the damage of price declines and a contracting petroleum production cycle.
The first such extraordinary effort came with the price trough of 1932, when an oil glut developed in the United States. Oil companies and the governors of the various oil-producing states came together and agreed to impose production restraints. At various stages the Texas Railroad Commission and the U.S. federal government managed this "cartel." In the period after World War II, the "Seven Sisters" (the major international oil companies), which had discovered and developed new supplies outside of traditional sources, especially in the Middle East, worked together informally to expand and contract production when market balancing was required. In the late 1950s, another price trough resulted in the creation of the Organization of Petroleum Exporting Countries, which eventually developed strong mechanisms to control production levels and prices. OPEC had been formed in an effort to shift the burden of adjustment away from the oil producing members and back to the United States. Through the tumultuous 1970s, OPEC appeared to provide a successful mechanism for supporting prices via production restraints, but it was only in the early 1980s that the mechanism was actively tested. In early 1973 virtually no one imagined that an oil revolution was at hand, or that its impact would effect fundamental changes in the world’s economy, the security of the West and the structure of the energy industry.
Today we can observe a similar set of revolutionary conditions, even though as recently as three years ago few foresaw that a price collapse could occur as rapidly as it has. This is because, until last year, the gradually accelerating decline in oil prices was both masked and tempered by the appreciation of the U.S. dollar. Oil is priced in dollars, so Europe and Japan appeared to be paying more for their oil in 1985 than in 1981, and most OPEC countries’ earnings were modestly improved. Now, as the dollar has depreciated relative to other currencies, the consuming countries have gained the benefits of lower oil prices, just as the exporters have suffered.
Last fall, oil prices began to firm up on the spot market as the winter heating season approached; then, in January and February 1986, they tumbled by more than $15 in just a few weeks. Why did the oil market, which had been weakening for four years, suddenly appear to collapse out of control?
The answer can be found in decisions taken in Saudi Arabia in the summer and fall of 1985. The Saudis decided to flood a weak market, with the intention of pushing prices down rapidly. They made certain their oil would be sold by changing the method by which it was priced. Traditionally the Saudis, like other OPEC producers and non-OPEC producers such as Mexico, Britain and Norway, had established official sales prices. The new approach—called netback pricing—assured refiners buying Saudi crudes of a profit on each barrel processed and sold as gasoline, diesel, fuel oil and other petroleum products. Through this new pricing scheme, Saudi oil was valued by the market price of the products into which it was refined (e.g., gasoline, heating oil), less the costs of refining and transportation. Saudi production increased from a low level of 2.5 million barrels or less a day to a new targeted daily level of 4.3 million barrels or more. Why did the Saudi government change its traditional, conservative approach to selling crude oil?
Let us look at the context of the past half-decade. The 1980s began with a nervous and tight oil market. The revolution in Iran and the curtailment of Iranian production in 1979-80 spurred an increase in the price of oil by more than two times, to $30 per barrel and above for oil sold under term contract and to more than $40 per barrel sold on a spot basis. These high prices, coming on top of the pricing revolution of 1973-74, ushered in a world recession. They also served to accelerate the search for oil outside OPEC, to encourage energy-saving investments, and to make virtually all competitive fuels (e.g., nuclear power, natural gas and coal) attractive alternatives to petroleum. Thus, demand for oil dropped, even as new oil supplies from non-OPEC sources were brought into production.
In order to protect the price of internationally traded oil, OPEC reached a series of internal agreements, first made in 1982-83 and updated several times thereafter, to restrict its members’ production to 18 million barrels per day (in contrast to the OPEC peak production level of 31 million barrels per day, reached in 1981), and to allocate that production among its members by quota. Some ten million barrels a day of production capacity had to be left untapped, or shut in, in order to balance supply and demand at a price in the range of $25 to $28 per barrel. Saudi Arabia, with by far the largest reserves in OPEC (and the world), assumed the role of swing producer, adjusting its production level up and down to balance supply with demand and to protect the price. OPEC’s bet was that a revival in world economic activity would soon commence, bringing with it higher demand for oil and more robust OPEC production.
The bet was lost. Instead, OPEC saw its role in world oil trade diminish as new supplies outside OPEC came into the market. Through new investment, British and Norwegian production grew to new record levels in 1983, 1984 and 1985. India and Brazil, two of the largest developing countries, moved rapidly from being large importers toward achieving oil self-sufficiency. Other developing countries began to produce and export oil, and because of conservation, industrial restructuring and fuel switching in the industrial countries, oil demand never rebounded as the OPEC strategists had expected.
The members of OPEC, the Saudis and other Persian Gulf states in particular, saw their plight worsening. OPEC’s share of free-world oil production shrank from a high of 55 percent in 1973 to 30 percent in 1985, and the cartel was unable to market production at its targeted volume. Despite a widespread view that the lower-producing OPEC countries were "cheating" by producing at levels higher than their quotas, the remarkable feature of the oil market during 1981-85 was that OPEC held together so well. It did so essentially because Saudi Arabia was willing to be the swing producer and adjust its production downward to balance the market. The result was low Saudi production and Saudi oil income of $28 billion in 1985 as opposed to its peak income of $113 billion in 1981.
OPEC came to understand that it could not go on playing the role of market balancer and price supporter alone. But despite several efforts to gain the support of Britain and Norway, the North Sea producers refused to limit their production. Instead, in order to protect their market shares, Norway and Britain abandoned administered pricing in 1984 and let the market determine the price for their crude. By last summer, the Saudis recognized that the only way they could be assured a minimally acceptable income was to reduce prices and increase production, punishing the North Sea producers with lower income in hopes of gaining their future cooperation.
What are the chances of success for this new Saudi gamble? Is there any way OPEC and non-OPEC producers can together or separately regain control over the oil market and assure a higher minimum price? Should the Saudis again fail in their tactics, what would be the consequences—for them, for OPEC, for other oil producers and for the world economy? The answers depend on certain fundamental changes that can now be discerned in the international oil industry.
Successful oil market management depends on three basic conditions. The first is a limitation on the number of major participants in the market: the fewer the better. The second is the ability of the major players to take decisions to rationalize production, deciding where, for how long, and under what circumstances production is to be shut in. The third relates to the degree to which the petroleum industry is integrated, with networks of close ties between upstream activities (i.e., oil production) and downstream activities (oil refining and marketing). The more integrated the industry, the more amenable the market will be to constructive management.
Bearing this in mind, it can be seen that the revolution of the 1970s in the petroleum sector was manifold. It involved not only the quadrupling of oil prices and the emergence of a powerful OPEC cartel, but it also involved a wave of nationalizations in the developing countries, including Kuwait, Venezuela, Iraq, Peru and Saudi Arabia, of the oil-producing properties of the international oil companies. In the 1970s, nationalized firms accounted for nearly three-quarters of international production and included virtually all of the important oil exporters in the developing world.
Beyond the obvious transfer of equity interests, these nationalizations brought about fundamental and quite unintended changes in the structure of the oil market. They broke the linkages between the developing world’s oil production and that of the industrialized countries, an essential connection if world production is to be rationalized. The nationalizations motivated the international oil companies to accelerate their search for oil in new frontier areas, including the North Sea and developing countries where governments permitted the companies to make reasonable profits. And finally, the nationalizations broke the tight coordination of production and refining, long considered a prerequisite to managing the petroleum economy by reducing price volatility.
The cumulative result of the developments of the 1970s is a paradoxical imbalance in the oil market, one that only invites pressures for substantially lower prices. For the past four years, supply and demand have been balanced only because the lowest-cost producers (the Middle East) have shut in their production. Meanwhile, the highest-cost producers have pumped oil at near maximum capacities and have had every incentive to expand production. This condition is exactly the opposite of what one would anticipate in a truly free market.
In a transparent and efficient marketplace, prices should decline toward the level of production expenses in the least-cost producing countries, and production capacity of higher-cost producers would be shut in until such time as demand warranted the production of higher-cost oil. In today’s world, this would mean closing down production in the North Sea, Alaska and offshore North America, and the expanding of production in the Arabian peninsula. But the opposite has happened.
To further distort the classic model, new oil production is now anticipated from the North Sea, from new entrants to the ranks of oil producers and exporters such as Colombia and North Yemen, from steady increases in production elsewhere among importers in the developing world (Brazil and India), and from expected increases in Iraqi and perhaps Iranian production—once they are no longer at war—due to the completion of new pipeline outlets.
Non-OPEC production should rise by some 500,000 barrels a day in 1986, reaching nearly 28.8 million barrels, and by an additional similar amount in the following two or three years. With demand basically flat at 45.5 million barrels, even if prices fall, requirements for OPEC oil will average no more than 16.5 million barrels a day this year, some 700,000 barrels less than last year. This spring and summer, world oil demand is expected to drop to 44 million barrels a day; demand for OPEC oil should be no more than 15.6 million and perhaps as low as 14.5 million barrels—the lowest level since the oil price surge of 1973.
Furthermore, with the separation of production and refining operations, the volume of oil bought on the spot market rose in the late 1970s through the early 1980s from about five percent to perhaps 50 percent of all traded oil, creating enormous price volatility and, eventually, downward price pressure. Organized futures markets in petroleum products and crude oil came into existence in New York and London to compensate for the new volatility, providing opportunities not only for hedging, but also for speculation.
These structural circumstances bore down on the largest and most flexible of the producers, Saudi Arabia. By shutting in their production, Saudi Arabia and other OPEC countries have, in effect, subsidized the prices for the high-cost producers in the United States, Mexico and the North Sea countries. Saudi Arabia has now demonstrated its frustration at the heavy revenue burdens incurred by subsidizing oil production outside of OPEC. Its new policy of higher production is thus partially punitive in nature, aimed at forcing non-OPEC exporters and other producers to share in the burden of balancing the market.
These new efforts will accelerate another structural change in the petroleum market and the petroleum industry: OPEC has, at least for the time being, lost its role as a key player in the political economy of oil.
The members of OPEC are basically interested in maximizing the rents to be gained from oil exploitation. They also, as a group, have wanted to make certain that the burdens of any market adjustments, introduced to compensate for changing conditions of supply, demand and price, are pushed onto the oil-importing countries and the international oil companies. As of winter 1985-86, this approach had failed.
Despite this common purpose, the members of OPEC differ significantly one from another. Some (e.g., Saudi Arabia and the smaller producers around the Arabian peninsula) are high-reserve, low-population countries, the remaining members have low reserves and a high population. From another perspective, the relationships within OPEC are based on the fact that one producer, Saudi Arabia, is so much more significant than the others.
In this respect, the bargaining relationships within OPEC look strikingly like those within NATO. OPEC and NATO both are comprised of like-minded governments, targeting a common external "enemy," but also relating to one another through an array of asymmetrical relations: a large country at the "core" and many smaller and less influential countries around the "periphery." Within NATO it is the interest of the U.S. government to maximize its own freedom in dealing with the Soviet Union and to assure that its allies undertake policies that do not undermine its bilateral relations with the U.S.S.R. Similarly, it is in the interests of the smaller NATO countries to restrain the United States, to make its behavior more regular and predictable, and to maximize their own freedom of action to pursue individual foreign policies vis-à-vis the countries of the Eastern bloc.
OPEC, too, is comprised of a large country at the core of the organization (Saudi Arabia) and smaller countries along the periphery. It has been the Saudi intention for the past decade to maintain a moderate international petroleum sector, one in which the life of petroleum as an important commodity in international trade is stretched out as long as possible. This has meant that although the Saudis do not want to see the price of oil fall precipitously, they have also not been eager to see the price increase dramatically. It has been the Saudi objective to maximize its own freedom and to constrain that of its OPEC partners. Similarly, it has been the goal of virtually all of Saudi Arabia’s partners in OPEC to enlarge their own freedom to produce and price oil and to keep Saudi behavior predictable and constrained. That tension between Saudi Arabia and the other OPEC producers resulted in the stalemate that the Saudi decision to regain its market share broke open.
Given their large external financial reserves, their links to banks in the industrialized countries and their military links to the United States, the Saudis are torn between the Western industrialized countries and their OPEC partners. From this perspective, it can be concluded that Saudi Arabia’s recent behavior reflects an understanding that a fundamental structural shift is required in the way the international petroleum sector is governed. The older ties among OPEC countries may become less relevant than the process of establishing new alignments among oil producers and consumers.
The upshot of all these circumstances is clear. A radical restructuring of the oil industry and the oil market is about to take place. That restructuring will require new approaches to the sensible management of the petroleum economy. What is required is a simplification in the number of major participants in the market, a mechanism to organize production in correlation with demand, and a reintegration between upstream and downstream petroleum operations. This restructuring will not take place without an intervening step: namely a radical collapse in oil prices sometime during the next 18 months, perhaps as early as this summer. Oil prices in the range of $8 to $10 per barrel cannot be dismissed.
What will be the consequences of such a price collapse? If Saudi Arabia’s gamble to push the costs of adjustment onto non-OPEC producers fails, as the preceding analysis of structural changes in the petroleum sector implies it might, there is no logical stopping place for the price of oil above $8-$10 per barrel. Oil industry analysts agree that production capacity will not be restrained for reasons of cost unless the price falls below $8 per barrel. Furthermore, at various points between $10 and $20 per barrel, new investments in energy conservation cease. New capital expenditures by oil companies are also reduced, eventually almost to the point of elimination.
Absent political intervention, and given the extraordinary overhang of supply, with OPEC’s production capacity still some ten million barrels per day higher than current production levels, this situation can continue for a long time. With oil prices dropping toward $10 per barrel, it should take at least five years before lack of investment in new supplies and increases in demand triggered by low prices begin to push prices upwards again—excluding, of course, the occurrence of a new supply disruption. Lack of new investment will result in dramatically decreasing production levels in certain parts of the world, probably most significantly in the United States. With oil priced at less than $16-$18 per barrel, new investments in the more costly techniques of secondary and tertiary recovery will cease. At less than $15 per barrel, stripper-well production, responsible for about one million barrels a day today, will be terminated. Overall, we can anticipate a decline in U.S. domestic production on the order of ten percent per annum.
In a relatively short period of time, therefore, Western economic security will begin to be threatened by a substantial decline in new energy investments. Given the steep rate of decline of some domestic reserves, the maintenance of American production at levels covering two-thirds of domestic consumption requires a constant effort to assure that new reserves are brought into commercial production. These reserves tend to be high cost and to require investments in secondary and tertiary recovery not needed elsewhere, particularly in the Middle East. Price uncertainty alone leads to the postponement of such investments. Very low prices preclude them.
The faster the decline to $10 a barrel and the longer it lasts, the more significant will be the implications for energy security and inflation in the 1990s. Without sustained efforts to seek out new sources of conventional oil supply, growing demand and diminishing surplus production capacity for petroleum could result in a price escalation in the 1990s not unlike that which the world experienced in the 1970s.
Beyond the economic effects are the political implications for Saudi Arabia and other Middle Eastern low-population oil producers. In the shorter term, a price decline will raise serious problems of political stability in all oil-exporting regimes. It would weaken the ability of the Saudi government to maintain the authority of the king vis-à-vis other members of the extended ruling family, given their sharp reductions in income. It would also affect their feelings toward the West in general, and the United States in particular, provoking a likely nationalistic response based on a belief that Western governments somehow engineered the price collapse in order to punish the Saudi regime (for reasons, for example, associated with America’s ties to Israel). It would possibly further fuel Islamic fundamentalist nationalism in the Persian Gulf. In short, lower prices in a weakened Saudi regime could pose security dilemmas for America’s strategic interests in the Arabian peninsula.
Over the longer run, especially if new exploration expenditures outside the Gulf are dramatically reduced, a price collapse would be a prelude to a reassertion of Saudi dominance in the international oil markets in the next decade, once the surplus production capacity of the world is drawn down. Such a development poses a dilemma for the West: this is true no matter whether one views the situation with the suspicion that heightened Middle Eastern control over the world’s oil supplies will result in sharply higher prices and detrimental conditions for Western economic interests, or whether one believes that greater dependence on Saudi and Middle Eastern oil creates heightened vulnerabilities in fundamental Western economic and security interests. It is perhaps unwise to speculate on what type of Saudi regime will be in place in the 1990s when the United States and other Western countries will again be highly dependent on Middle Eastern supplies. It also matters less what the Saudis have been like in the past than what the implications are for Saudi behavior in the future. A new xenophobic Saudi leadership under circumstances of heightened Western dependence on Saudi oil might be dangerous indeed.
The concentration of extra production capacity that will be held by Middle Eastern countries in the 1990s could well make Western dependence much greater than it was in the 1970s. The "oil weapon" could return with a vengeance. In any event, the Saudi role as swing producer balancing the marketplace will be much more critical. Both the shorter- and longer-term consequences of a decline in oil prices therefore raise significant energy security questions.
Of special significance is the effect of lower prices on the oil exporting countries, especially those most heavily in debt, such as Mexico and Nigeria. Clearly, lower prices will result in lower revenues for virtually all of the oil exporting countries, whether they belong to OPEC or not (assuming OPEC production at its targeted level of 18 million barrels a day). Petroleum Intelligence Weekly, in its January 13, 1986, issue, calculated that $20 per barrel oil would result in total OPEC revenues of barely over $100 billion in comparison to total OPEC revenues last year of over $130 billion and, in 1980, of $280 billion. At $10 per barrel, revenues would drop to $50 billion, with demand levels still not increasing for a few years.
In such a scenario, the financial situation of virtually all indebted oil exporting countries would be jeopardized. Almost none would be able to service debt and also continue to import necessary consumer and capital goods. Political stability, already in question, would be in further danger, and bitterness among the OPEC countries toward one another and toward industrialized countries would be high.
A gentle decline in oil prices through December 1985 already brought nervousness to the international banking community and financial authorities in the United States and elsewhere before the latest price drop. A precipitous decline would create the fear of a tidal wave of bank failures, beginning with the regional banks of the southwestern United States and extending to the money-center banks as well, as the plight of debtors in the United States approaches in severity that of the developing countries.
The oil industry in the United States and elsewhere in the West will obviously be affected by a sharp drop in prices. So will the new crop of state-owned energy enterprises in the developing world. As oil prices fall toward $10 per barrel, the oil industry will bear an increasing share of the loss; governments will have to support a decreasing share because of the structure of most tax regimes. The oil companies’ capital expenditures in new exploration investments will thus decline even more dramatically.
Each of the downward pricing spirals of the past century has resulted in a massive restructuring of the oil industry and in political efforts to put a floor under prices. The international petroleum industry has just adjusted to an extraordinary transformation during the last decade. Fifteen years ago, about 80 percent of the world’s production of petroleum was dominated by the large international oil companies through their international activities. Now the oil industry has become both fragmented and decentralized.
The number of important producing companies, now including national oil companies as well as those owned by private shareholders, increased several fold. Today the national oil companies command an equal footing with the majors and independents as significant market participants. The international integration that once involved production abroad and refining in one’s home country has been broken. And the number of parties participating in the international petroleum trade has increased from fewer than 20 to more than 100.
The future structure of the oil industry is by no means easy to foresee, but a radical rationalization seems inevitable. As a result of recent acquisitions and efforts to ward off corporate takeovers, the number of oil companies in the United States that have accumulated potentially dangerous levels of debt has increased. State-owned international oil companies, like Kuwait Petroleum Company and Petrobras of Brazil, which have engaged in wide-ranging international exploration, could well be giants among the survivors in the next decade. They will be joined by such companies as Petróleos de Venezuela as it proceeds to acquire substantially larger downstream assets in the consuming countries of Europe and North America.
The petroleum industry that will emerge from this shake-out will be rationalized along lines involving an amalgam of state-owned and private enterprises with multiple joint ventures between them.
A precipitous price collapse would, in short, carry with it revolutionary consequences that now can only be partially discerned. What can be done to guard against the most dangerous consequences of a price collapse?
Various political actions have been proposed to prevent a free-fall in oil prices to the $10 level or below. Any of them, to be effective, would require increasingly unlikely and delicate coordination between OPEC and non-OPEC countries, between producing and consuming countries, between governments and multinational companies, or among the consuming countries on their own. Failing such an unlikely coordinated political intervention, we can anticipate a radical price drop soon; prices should then hover at extraordinarily low levels for at least a half-decade. Moreover, with ample supplies and a reluctance on the part of companies to hold inventories due to market uncertainty, the oil consuming world will experience price volatility over an annual cycle in response to higher winter heating season demand for crude oil and overall lower summer demand.
In recent months a number of experienced observers of the oil industry have reminded us of the error of considering the international petroleum market to be like other commodity markets. Melvin A. Conant and Paul Frankel, for example, have been arguing for more than a year for a substantive dialogue between OPEC and non-OPEC producers and between producers and consumers. Walter J. Levy has frequently warned that the West ought not to be lulled into a false sense of security by the oil glut that emerged after 1981. These warnings have been unheeded so far. The imminence of a price collapse reminds us that such pronouncements stem from long experience and observation of the petroleum sector and of the fragile underlying political base that has supported international oil prices over the past few years.
Analysis of the international petroleum economy and its momentous political implications is a relatively easy first step. It is quite another matter to lay out policy proposals for addressing the worst ramifications of a price collapse. If a destabilizing price collapse is to be prevented, a new regime for managing the petroleum sector is required, a regime to provide mechanisms of coordination among producing and importing countries, among consuming countries, between private companies and government companies, and between companies and governments. With all these interests at stake, no simplified solution could satisfy them all.
Yet simplified responses are what come out of politics. Thus, proposals for the immediate imposition of barriers to the import of petroleum and petroleum products into the United States are already receiving attention in the U.S. Congress. Import barriers would protect prices for U.S.-based producers and, therefore, would also protect bank loans to the oil industry. This solution has also become increasingly attractive in the United States in light of the budget deficit. Tariff barriers would raise government revenues and protect producer interests within the United States by providing a de facto floor price for petroleum production.
This policy approach had an intellectual force in the recent past, when the oil market was tight and when conservation and fuel-switching were to be encouraged. Under past conditions, an import fee would also have served to recapture some of the "rents" of oil production that OPEC countries were receiving. In today’s climate, however, a unilateral import fee would create more problems than it would solve. A "go it alone" policy by the United States would actually have pernicious ramifications for virtually all the oil exporting countries of the world. It would also create significant trade frictions with our most important industrial trading partners.
In a slack market, with a supply overhang, oil would be competitively poised to enter the U.S. market at the domestic U.S. price minus the tariff barrier price. World oil prices would thereby tend to be depressed even further in any competitive effort by foreign producers to gain access to the U.S. market. In short, what might work satisfactorily in a tight marketplace would be counterproductive in a slack market. A tariff would defeat any interests the U.S. government might have in trying to assist other producing and exporting countries, such as Mexico and some of the OPEC countries. And it would completely ignore the effects that significantly lower prices would have on Britain, Norway and Canada.
It can be argued that there would be significant incentives to make an import tariff barrier multilateral by extending it well beyond the United States to include our industrial partners and Mexico as well. In all likelihood, a U.S. administration would probably seek to extend a tariff wall on a multilateral basis.
One system, in fact, is already in place through which the industrialized countries could collectively protect their gains in conservation, their future production base of petroleum and other conventional fuels, and their banking and trading system. It lies in the International Energy Agency (IEA), created in 1974 in the aftermath of the first oil shock, which includes nearly all of the 24 members of the Organization of Economic Cooperation and Development (OECD).
It should be recalled that the IEA, which is widely identified with its emergency oil-sharing arrangement, also has as a goal the promotion of petroleum resources within the IEA area. A mechanism instituted in 1974 to encourage ‘‘indigenous" IEA production was a floor under the price of oil; at that time the floor price was $7 a barrel. Political interests could now be refocused on a minimal floor price for oil on the order of $15 a barrel through the IEA mechanism.
In addition to protecting indigenous production and existing conservation gains, a tariff wall around the IEA to protect a minimum oil price would serve other interests as well. It would help resolve trade frictions among the industrialized countries with respect to petroleum products and petrochemicals, which are already heightened and which would be further exacerbated by a unilateral U.S. tariff. A multilateral oil tariff would serve financial interests by preventing panic and providing a rational basis for the settlement of at least a significant portion of oil-related debt. In all likelihood, it would be a condition of any U.S. administration’s consent to such a scheme that it take in all of North America (including Mexico) and potentially much of the Western Hemisphere (i.e., Venezuela, Ecuador and possibly Colombia) within the tariff wall.
The IEA solution would have a more cosmopolitan impact if Mexico were to be protected by the tariff wall. Placing an effective floor under Mexican oil prices through Mexico’s incorporation in the network would, first and foremost, be of importance to the United States for bilateral foreign policy reasons. Beyond that, it would be of interest to the banking community. Mexico, Brazil and Argentina together are the three largest debtor countries, responsible for nearly 30 percent of all outstanding developing-country debt. Argentina, being self-sufficient in oil, would have no need to require inclusion under the tariff wall’s protection. Brazil, as a net oil importing country, would, on the whole, be better off with much lower oil prices so long as it was able to maintain adequate incentives for domestic exploration and production. Only Mexico, among the large debtor countries, could gain substantially from inclusion in this system.
An expanded IEA tariff wall would clearly provide one of the few viable options for dealing with a price collapse, as it would help serve many highly politicized interests and take advantage of an institutional framework that already exists.
In the long run, however, a solution based on the IEA and its mechanisms would be inadequate to the tasks ahead. It would, by providing special preferential arrangements for North Sea, U.S. and Mexican oil, polarize relationships between the IEA countries and the rest of the world, in particular OPEC countries and other indebted developing countries. It would permanently solve neither the difficulties inherent in the petroleum sector, nor those in the financial and trade arenas.
An IEA solution would exclude OPEC from any role other than that of marginal supplier, or balancer, of the international petroleum market. And it would probably not serve the interests of many governments and companies whose relationships with producer governments and national oil companies have become far more complex than was the case in 1974. It is tempting, therefore, to look at an alternative approach, which has been proposed at various times during the past ten years or so: a global oil compact involving all of the major oil exporting and importing countries.
Even if a global compact among all parties concerned could be achieved in the current context or in the aftermath of a price collapse, there is a significant residue of mistrust concerning how long such an agreement could last. No one has forgotten how difficult it was for the Saudis in the late 1970s and early 1980s to induce discipline among OPEC countries to prevent prices from escalating so rapidly and to such high levels as to ensure OECD conservation, decreased demand, and the substitution of other forms of energy for oil. Nor have they forgotten how rapidly recent OPEC production and pricing agreements have disintegrated.
Western governments would understandably refuse to be involved in an agreement that would shore up OPEC countries today, since the OPEC countries would be expected to be the first to break such an agreement once the demand/supply balance tightened again. An even greater set of political forces is reluctant to engage in any market intervention, given the recollections of how market interventions have worked in the past: they have given rise to corruption, they have been unmanageable, and they have created distortions in the economy at least as onerous as the management of those interventions themselves.
None of these policy options augers well for OPEC. Nor is there necessarily a convincing case that OPEC would be able to "organize itself" to deal with the problem. The protectionist wall that will probably emerge around the IEA is also more likely to lead individual OPEC countries to try to make their own side deals with the industrialized governments in order to gain market share. Their distrust of one another, the history of failure of sustained concerted action in OPEC during the past four years, and the need of the most severely indebted OPEC countries to maximize their revenues by expanding production would, in all likelihood, keep OPEC fragmented. The prospects are therefore exceedingly low for OPEC members to act together. So, the possibility of OPEC reaching a marketing agreement with the industrial countries is also low.
The main weakness in any possible market rationalization program that the consuming or producing countries, acting separately, might take relates to the structure of the international petroleum market. A coherent line of action requires strong linkages among the major oil producers in the world. It also requires integrated linkages between upstream production activities and downstream refining and marketing operations. Neither of these linkages is strong under present conditions.
An international oil market with slack demand, such as today’s, could be regulated through coordinated action by producers to shut in production and withhold excess supplies from the marketplace. Similarly, the integrated linkages between production and refining could enable the major international companies to shift their profits between production and refining activities, depending on the state of the marketplace.
In today’s world, how might such a rationalization of the petroleum market and industry develop? What actions along these lines can we anticipate from the Saudis and other participants in the world oil market?
Let us take another look at the two elements that form the necessary conditions for a new rationalization of the petroleum market: coordinated production and reintegration of upstream and downstream activities.
Coordination of production on a worldwide basis has proved to be the most elusive of goals for OPEC since 1982. OPEC could not manage this on its own, as the marginal or balancing supplier to the world market. It failed in efforts to co-opt the non-OPEC exporters. And it was unable to induce cooperation from international oil companies, with whom it had severed its ties through the nationalizations of the 1970s. But a basis might well exist to crystallize a new form of production rationalization, with or without the erection of a protective wall by the IEA countries. The Saudis are one key to this issue; the other key is the condition of the marketplace today and the plight of many of the large producing companies.
Given the extraordinary indebtedness of some major oil companies, one can imagine that a precipitous collapse of oil prices might create conditions conducive to a deal between some of these companies and some of the principal producing governments, especially Saudi Arabia. Once prices collapse, some of these companies will be desperate to find ways to sell or finance their debt, as a matter of corporate survival. One can imagine a process through which an entity of the Saudi government, or of the governments of other oil exporting countries, would offer to purchase the non-OPEC reserves of these companies. For the oil exporting country, a choice would then exist; it could shut down these newly acquired reserves in order to increase the market share from its own domestic production; or it could shut down production at home and produce from the newly acquired reserves within the protected barrier.
A related possibility would be to arrange a swap of assets between the exporting countries and the production companies. Here the same companies would gain equity access to lower-cost oil in the Middle East, while the exporting countries would gain downstream refining and marketing assets in exchange. For the companies to be induced by such a swap offer, a "kicker" would need to be offered, via lower taxes or lower costs, to provide them with higher cash flow to service their debt. So long as some reserves would be shut in, an asset swap would have the same effect as a sales/purchase arrangement between strong national oil companies and weak international oil producing companies.
If this type of arrangement were worked out on a sufficiently large scale, the objective of rationalizing production could be achieved on a global basis. Nor would such an arrangement have to be tremendously extensive. As long as two million to four million barrels of oil production were thus managed, a basis could be provided for putting a floor under oil prices through production controls, thereby benefiting most of the parties involved.
To a substantial degree the market is already creating incentives to tie together the interests of producers with those of refiners. Many of the OPEC countries have moved into downstream activities, either by building refineries in their own countries, as is the case with Saudi Arabia, or, as Kuwait and Venezuela have done, by purchasing downstream operations within the consuming marketplaces in Europe and the United States.
Crises create strange partnerships. The circumstances of a price collapse could well do this not only with respect to rationalizing production, but also with respect to reintegrating upstream and downstream operations. With an impending price collapse, the high-reserve, low-population oil exporting countries would almost certainly take further steps to integrate themselves into the consuming marketplace. The national oil companies in the producing countries would thus be assured market access as the oil market becomes reintegrated. And the companies would gain new cash replenishment via partial sale of their downstream assets. And in a price collapse, downstream assets will have a much higher relative market value than will reserves.
The world has been abruptly reminded that the petroleum industry is cyclical and volatile. Its cycles are long term, but they involve enormous magnitudes of change in their impact on the petroleum industry itself, on oil end-users and on the macroeconomies of the world.