With one swift stroke Iraqi President Saddam Hussein's takeover of Kuwait seems to have overturned the rules of international oil. No matter how the chain of events triggered by Baghdad's military aggression unfolds, the Organization of Petroleum Exporting Countries (OPEC) will no longer be what it once was. Commercial ties between oil-producing countries and their main markets in the consuming industrial countries will be transformed, investment patterns will shift radically, and energy policy in the United States will take on a new meaning.

Saddam Hussein is not responsible, however, for more than accelerating an already rapid pace of change that was transforming the petroleum sector even before last summer. The immediate repercussion of the international embargo of trade with Iraq and occupied Kuwait was a doubling of the price of oil. But even without the recent turmoil in the Middle East, higher oil prices-about $40 a barrel-were almost a certainty for the late 1990s.

No one can dispute that the unfolding of events in the gulf will have a significant short-term impact on oil markets; Iraq's invasion of Kuwait has made it virtually impossible to return to the oil order of the past. Any outbreak of war will obviously affect more than oil prices, as will any continuing U.S. military presence in the gulf, where the legitimacy of traditional political regimes has been sorely challenged. Whether Saddam Hussein will survive the U.N.-imposed embargo, or a war, and whether either will result in an Iraqi withdrawal from Kuwait remain open questions. In any case, the world's new petroleum arrangements will be influenced far less by the denouement of the military situation in the gulf than by developments in the oil arena itself.

The emerging structures of the international petroleum industry make for a more moderate price environment in the long term than was the case in the 1970s. But fostering such an environment will require major policy shifts in key countries, especially the United States. We are entering a new political era in oil matters that requires international cooperation not only in maintaining political stability but also in sustaining tighter ties between oil-producing and oil-importing countries. Such cooperation will be difficult at best. It could turn out to be nearly impossible if, as the decade progresses, the United States is seen as a country that uses military force in order to sustain the appetite of its population for low-priced fuels.

II

Saddam Hussein's power grab came at a time when the major post-World War II institutions, which molded the environment in which the international oil system was embedded, were undergoing radical change.

The Western liberal economy was predicated on the separation of high politics (i.e., the use of force and other security concerns) from low politics (the economic rules whereby participating nations skirmished with one another principally over the rules of distribution, but in which everyone basically agreed that all parties could benefit from an ever-increasing economic pie). The use of force was permissible outside this "lower" realm, but it was deemed illegitimate and too costly to use within it. Iraq's takeover of Kuwait and its threatened domination of other key oil-producing countries in the Persian Gulf breaches this wall between high and low politics over issues of international distribution.

Without question the separation of these two realms was always fragile, and it was frequently tested-most notably, in this context, a decade ago when Iraq attacked Iran. Saddam Hussein's continuing pursuit of "higher" goals and stakes, seeing the oil sector as instrumental to reaching them rather than an end in itself, finally brought to a head the need to rethink the best institutional format for regulating oil affairs.

Working hand in hand with the liberal world economy in shaping the international petroleum sector was the Cold War, which had significant impact on the oil system. OPEC was in a sense a child of the Cold War. It had freedom to act independently because the Cold War's various security umbrellas allowed it to do so.

The split between the United States and the U.S.S.R. and their respective allies kept the oil-exporting countries operating within the "zone of peace" established by the Western powers after World War II. The fears of the United States and its allies of Soviet efforts to control Middle East strategic supplies were mirrored in the internal politics of most oil-producing countries, whose conservative regimes were, with rare exception, anti-Soviet. By and large, the Soviet Union and the other centrally planned economies were parasites on the oil system. Although the Soviet Union is the largest oil-producing country in the world and, today, the second-largest oil exporter, it was largely isolated from the rest of the oil arena. Oil exports, however, were the Soviets' principal link to the world economy and the country's single most important source of foreign exchange. Moscow therefore had to pay close attention to international oil developments; but it was only a passive participant, a beneficiary of actions taken by others.

It was unclear until recently just how helpful the Soviet Union had been in restraining its own clients. In the old Cold War days Iraq would probably not have had the freedom to move against Kuwait. The Cold War guaranteed that any efforts by a regional power to secure a local hegemonic position would be met by countervailing power. Ironically the end of the Cold War facilitated Baghdad's own miscalculation of the international response to its invasion-there is good reason to believe that Iraq thought the response of the United States and the rest of the world would be little more than verbal.

The oil sector, largely because of OPEC's success over its thirty-year history, has also been the key institutional embodiment of the North-South divide. As a result oil has played an important symbolic role in the redistributive issues of the world since the 1960s.

Before 1970 the only significant oil-producing countries shut off to Western companies were the Soviet Union and Mexico, whose nationalizations of foreign firms were associated with national revolutions. By the end of the 1970s nationalizations and national monopolies over exploration and production had become the norm in Algeria, China, Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. New national oil companies were formed virtually everywhere but the United States; during the 1970s some 70 percent of the oil reserves of the world was nationalized. And, for practical purposes, the majority of developing countries that still allowed foreign firms to operate within their borders severely restricted the scope of their activities and their profitability.

Yet this aspect of the international petroleum order was also being challenged by events in the 1980s, which were rapidly reintegrating the oil-producing countries into the oil sector and eroding the powerful force of redistributive politics.

III

Some of the revolutionary storms within the oil industry are obviously rising from the Middle East. But others are gaining their initial momentum in Europe, and in the Soviet Union, where oil output recently peaked at over 12 million barrels a day, about 20 percent of global output and almost 50 percent higher than the next biggest producer, the United States. Two related changes unfolding in the U.S.S.R. are beginning to have an enormous impact on the international petroleum sector. Soviet oil production is declining, perhaps precipitously, after having increased by 25 percent during the last decade. This decline is already having an impact on world markets, where Soviet exports decreased by ten percent last year. And the Soviets may have no choice but to reduce supplies to the West. This is only one indication of a tightening market.

In order to slow and eventually reverse this decline in output, the Soviet Union, which nationalized its oil industry nearly three-quarters of a century ago, is now reopening its territory to foreign firms for resource exploitation. Reopening the Soviet oil sector portends a phenomenal reversal of the sometimes rampant resource nationalism of the past twenty years.

This process is being repeated elsewhere; it has already taken place in Algeria, China and Vietnam. Venezuela has announced it will soon reopen key parts of its oil sector to foreign firms. Mexico is trying to find an acceptable political formula to have private contractors restart drilling. Iran has already found ways to bring in foreign drilling companies and is expected to increase its reliance on foreign companies. Iraq was about to announce at least two field-development contracts involving foreign companies when the invasion interfered. There are indications that, despite official denials, Saudi Arabia has been in negotiation with Japanese and other national firms to accelerate development of its resources and explore for new supplies, possibly in exchange for joint-venture marketing arrangements. And while, before the Iraqi attack, it appeared that Kuwait would be the only non-concessionary country left in the world, now even Kuwaiti officials indicate that "everything is up for discussion," pending their return.

One impetus away from state monopoly control over the oil sector has been the lack of financial and other resources. The low oil prices that prevailed throughout the 1980s have unmasked the nationalistic claim of virtually all oil-producing nations that they could develop oil resources efficiently on their own.

The maturation of the oil industry in oil-exporting countries reinforces this trend away from resource nationalism and toward internationalization. The 1980s witnessed stunning growth in the international activities of some national oil companies in non-concessionary countries. Driven by the internal logic of the oil industry during a period of low prices, the state oil companies of Abu Dhabi, Kuwait, Libya, Mexico, Nigeria, Saudi Arabia and Venezuela began to invest heavily abroad in refining and in petroleum product distribution networks. Driving this radical internationalization of state firms that had hitherto stayed within their own national borders were low prices, fierce competition for markets and the need to secure outlets for large volumes of crude oil.

Once governments nationalized the oil reserves of the international majors, they cut themselves off from the international distribution chains of large companies like British Petroleum, Exxon, Mobil and Shell. Moreover, in the low-price conditions of recent years, these companies no longer had to buy as much oil from outside their own systems. But the very act of entering the international arena also forced many companies from the developing-country exporters to confront the need for reciprocity in investment relations-an issue they easily avoided in the 1970s. Once that issue was raised it was probably only a matter of time before they too would reopen investment opportunities in their own domestic oil sectors.

Politics are pushing in the same direction. One lesson of the Kuwait invasion may well be that national security is enhanced rather than diminished by enabling foreign firms to take a robust equity position in one's own oil sector. Foreign government protection of its national citizens, including its corporations, can be a convenient instrument of national security policy.

Evidence for a coming boom in the petroleum and natural gas sectors can also be found in two other phenomena: enhanced market power being gathered by a handful of oil-producing countries-mostly in the Middle East-and the extraordinary evaporation of spare production capacity over the past few years that made replacement of lost Kuwaiti and Iraqi barrels so difficult this past summer. The upshot will almost inevitably be a supply squeeze in the next two to three years, and a renewed explosion in oil prices that no government is well prepared to confront or to manage.

The signs of a turning point in the oil industry's business cycle were clear well before the Iraqi invasion of Kuwait. World oil prices have been moving up, at least in nominal terms. In 1986-87, for example, benchmark West Texas International crude sold between $12 and $16 a barrel; before mid-summer 1990 the range had increased to $18 to $23 a barrel. Oil industry cash flows and investments in new exploration were also recovering, with the latter up a hefty 40 percent worldwide during the same period.

More important, private oil company upstream investments in exploration and oil field development were higher in real terms than at any time since the price crash of 1986. Capital expenditures were also shifting away from the acquisition of oil reserves owned by other companies, from paying past debts and from developing reserves discovered in the late 1970s and early 1980s, toward the leasing of new, unexplored acreage and the drilling of an increasing number of wildcat exploration wells (although away from mature, high-cost areas like the United States and Canada).

The transitional period between the oil industry's deep recession of the past few years and its coming boom is bound to be bumpy, and it is being hastened by the recent Middle East crisis. We can expect upward and downward price gyrations over the next couple of years. Short-term market perturbations are bound to continue to haunt the oil sector as it moves from a period of sustained weakness and oversupply to one of tightness and price increases, with the world market testing the limits of the industry's capacity to produce oil.

IV

It is crucial to understand what happened to oil supplies in the past twenty years. During the 1970s oil prices escalated at an unprecedented rate and to previously unheard-of levels, from about $1.50 a barrel at the beginning of the decade to nearly $40 a barrel by the decade's end. As a result, most OPEC countries nationalized the reserves of the international companies. Those countries both inside and outside of OPEC that did not nationalize the industry severely restricted foreign company activities and raised the taxes they had to pay. Investments in new exploration were thus focused outside OPEC. The impact of this concentration of new exploration-and of some major new discoveries made as the 1960s came to an end-is now obvious: non-OPEC production increased significantly well into the 1980s. Free-world oil output outside of OPEC increased from 20.7 million barrels a day in 1980 to 26 million in 1987-a rise of 30 percent-and has stayed at that level ever since. In the same period the Soviet Union, China and other Eastern countries boosted their output from 12.5 million barrels a day to 15.5 million, an increase of 25 percent.

The repercussions of this surge in new output were profound. OPEC exporters lost market share to non-OPEC producers and they lost in absolute levels of sales because the total oil market was shrinking. Consumption fell by 5.4 million barrels a day in 1985 from its high of 64.5 million in 1979. The annual average of OPEC's total output fell from 31 million barrels a day at the beginning of this decade to a low of 14.5 million in 1985, an extraordinary loss of more than 53 percent. Demand, however, has now rebounded completely and hit a record level last year at about 64.7 million barrels daily. While peak OPEC output has recovered, it is still 23 percent below its high more than a decade ago.

Worsening OPEC's plight were substantially lower prices and volumes in the mid-1980s. Earnings for the group, without adjusting for inflation, fell from a level of about $200 billion in the early years of this decade to less than $70 billion in 1986. They were about $100 billion in 1989 and are likely to reach only $150 billion this year, despite the 100 percent run-up in prices last summer.

With depleted income and rising social and other domestic needs, it is no wonder that exporting countries and OPEC by and large failed to invest in new oil-production capacity during the last ten years. Standing at nearly 39 million barrels a day in 1979, before the ouster of the shah of Iran, output capacity dropped to less than 27 million barrels in 1988. Thus while OPEC was producing at 58 percent of capacity in 1985, recent levels, even before last summer's events, were closer to a much more precarious 85-90 percent.

As for demand, high prices in the 1970s had a pronounced impact on the use of oil, which actually declined worldwide during the early 1980s. The reasons go well beyond the economic slowdowns that accompanied rising oil prices in the 1970s. They include the substitution of other fuels for oil, conservation and investments in new energy-saving technologies. Equally profound was the impact of demographic factors in the United States and Western Europe, whose aging populations led to slowdowns and even reversals in demand for new housing, new automobiles and driving time. (Older drivers do not use cars as much as those 18 to 35 years old, and the number of people in the younger age groups in industrial countries declined during recent years.) This structural demographic factor has been too readily ignored. Another era of demographic growth in the United States is set for the 1990s and this, too, will profoundly affect the supply-demand balance.

V

What are the prospects for the global supply-demand balance in the 1990s?

If the major economies of the world do not enter a deep and prolonged recession, oil demand is poised to rise steadily. In some parts of the world the increase could well be five percent annually-a rate that has not been seen since the early 1970s. The reasons are simple. Higher per capita income combined with high rates of economic growth in some newly industrialized countries will inevitably keep the rate of demand high. A slowdown in Asian-Pacific demand now appears unlikely in the years ahead, even if the 10-14 percent rate of increase registered recently in some of these countries for certain petroleum products tapers off.

There will be another large increase of young people entering the job market in the United States beginning in 1993-94, as the children of the postwar baby-boom generation come of age. This increase will be accompanied by more demand for housing, automobiles and the like. In other words, we can expect higher gasoline demand in the 1990s. Moreover at no time in the coming decade should we expect that significant inroads will be made to restrain the use of oil as a transport fuel. Regardless of government encouragement of the use of natural gas derivatives, gasoline will reign supreme until well into the next century.

This coming surge in demand for gasoline is likely to be buttressed by higher oil consumption in the industrial and commercial sectors. There has recently been a reversal of the strides made in energy efficiency in the industrial countries during the late 1970s and early 1980s. At that time, as a result of industrial restructuring and the long-term impact of capital investments in energy-saving technologies, the ratio of oil demand to economic growth fell considerably. The low oil prices of the past half decade have resulted in much less investment in energy efficiency. Moreover economic growth in the 1980s, combined with higher industrial capacity utilization, brought older, less energy-efficient plants back into use. And because of the long lead times required for new capital investments, it will again take years to register an impact on consumption.

The supply side seems to be relatively bleak. According to conventional wisdom, non-OPEC oil production looks likely to peak around 1992-93 and then start a very slow decline. The same viewpoint argues that OPEC production capacity will increase in an orderly enough fashion to keep an effective cap on the price of oil, which, before last summer's events, was expected to hold steady or actually decline in real terms until 1992-93, and then increase modestly for the rest of the decade.

It is difficult to conclude that non-OPEC oil output will remain steady in the range of 25 million to 27 million barrels a day. Certainly, there are signs of new production coming on stream in places like Yemen, Brazil, India, Norway, Angola, Malaysia and Papua New Guinea. These sources may provide a total of 1.5 million to 2 million barrels a day of incremental supply by 1995. But there is nothing on the horizon to match the giant oil fields discovered in the 1960s and 1970s in non-OPEC countries. These discoveries enabled Alaska's North Slope production to go from scratch to nearly 2 million barrels daily, Mexican production to rise by 2 million barrels daily, and North Sea output to add nearly 4 million.

Meanwhile, due to the lack of investment in new oil exploration for most of the past decade, output will be dropping rapidly in some of the mature non-OPEC producing countries, including the two largest producers in the world, the United States and the U.S.S.R. Nor can the situation be reversed rapidly. On average it takes nearly a decade to explore in offshore waters and bring new fields on stream, and lead times for onshore production average three to five years.

The U.S.S.R. is beginning to see rapid declines in output. Official statistics put this at about 1.3 million barrels a day over the last year and a half, while some analysts believe the drop to be even greater. It appears safe to assume that over the next five years another million barrels per day of Soviet output will be lost, probably much more than that, even with the infusion of outside expertise and capital. In the other very large producer outside of OPEC, the United States, official government forecasts see output sliding between one million and 2.5 million barrels a day from 1988 to 1995.

Mexican output is sliding from a lack of investment. As domestic consumption increases rapidly, exports are expected to fall by some 500,000 barrels a day by 1995. And the same situation is unfolding in other producing countries, including the United Kingdom. In my judgment, the result is clear-non-OPEC oil output will not remain stable; it will fall. The question is whether the decline will be a modest 500,000 barrels a day or a heftier 2 million or more.

Most incremental demand for oil in the years ahead will have to be filled by OPEC members, which will also have to replace declining non-OPEC output. Will they be able to do this, even if they want to? And will new disruptions like this past summer's create shortfalls that will be nearly impossible to make up?

It is no secret that many OPEC countries want to see oil prices rise to past levels or higher so that their income losses of the last decade can be recouped. They have suffered greatly. But some of the largest OPEC countries, especially in the Middle East, do not want to see a price rise, and their motivations are equally transparent. They involve both economic and political calculations.

Producers like Saudi Arabia, Venezuela and Kuwait (before the invasion) fear the consequences of higher prices on the world economy, given the size of their investments overseas and in their own domestic oil sectors. They want to prevent a deep recession. They want to avoid the impact of higher prices on oil demand, the development of oil supplies outside of OPEC, and any increased challenge to oil by alternative fuels. They have a long-term economic perspective based on their robust oil reserves, whose economic lives they want to stretch out. Even Venezuela, where oil production costs are higher than those in the Middle East and where short-term international debt and domestic problems make a price rise welcome, has been a moderate price-setter.

In political terms, Saudi Arabia, Kuwait and other Arab producers want to avoid a price increase for which they could be blamed, as they were in the 1970s, thus setting back their political relations with the United States. To achieve their non-oil foreign policy objectives, they want to be seen as reliable suppliers of oil at moderate prices. But will they be able to manage this?

Before the Iraqi invasion, OPEC Secretary General Dr. Subroto saw the need for the producer group to increase annual output capacity by one million barrels a day between now and 1995. This view looks conservative given the Iraqi crisis. He also stated that to increase output capacity, investments of $60 billion or more would be needed, a number that seems excessively high but attainable if foreign investments are encouraged. It would be heroic to assume that OPEC countries will have the added capacity to restore 32 million barrels daily by 1995. Even more heroic is the assumption that capacity can be added in steady increments-capacity additions, by their nature, tend to be "lumpy."

In the final analysis, it appears likely that oil prices are going to rise significantly in the 1990s. Even if oil prices fall again to less than $20 a barrel after the current crisis is resolved, it seems largely irrelevant to ask whether such prices can remain stable or increase only modestly. It is time to address the question of how oil markets and the structure of the oil industry will react to steep price increases. Will we see a repeat of the severe boom and bust cycle of the 1970s and 1980s? Or will something emerge to soften the cycle's impact on producer and consumer country incomes and economic activity levels? What new relationships are likely to characterize the industry, especially as the old order passes?

Regardless of how the Iraqi invasion of Kuwait is resolved, four aspects of the emerging international petroleum sector now appear inevitable.

OPEC, long regarded as a major hub of the international oil markets, now appears to be in institutional decay, its role increasingly outmoded by the economic and political logic of the petroleum sector's evolution. Yet whether OPEC will be replaced by new institutional arrangements, and what they might look like, remain open issues. Second, and reinforcing OPEC's decline, the decade will see robust growth in international exploration and production, with private and state companies investing in places previously off limits to them. Third, due to the radical and continuing reintegration of the international oil industry, a much more reciprocal and tightly linked international market is emerging, binding producing and refining centers together more than at any time since the early 1970s. But, finally, more bargaining leverage is falling once again into the hands of exporting countries.

VI

After OPEC, then what? Major signs of a change in perspective, from that of producers versus consumers to one of a common undertaking to deal with mutual problems, were seen long before the events of August. These included direct discussions between the United States and Arab OPEC countries, including Saudi Arabia and Kuwait, on oil supplies for the U.S. Strategic Petroleum Reserve, an inventory of some 600 million barrels set up to alleviate the effects of another Arab oil embargo such as that instituted in 1973-74. Such an arrangement would have been much more than a symbolic recognition of the importance now placed on commercial rather than political matters. It would have indicated that the world's leading exporters and the world's most ravenous consuming country have a joint interest in dealing with oil inventories.

As the oil industry becomes more commercialized there is a logical tendency to have relevant actors deal with problems on a mutual and reciprocal basis. Both OPEC and the informal non-OPEC grouping had already seen the need for forums to discuss common problems in the areas of demand, environmental regulations on oil use, and refinery upgrading investments.

There are good reasons in both industrial and developing exporting countries to foster new arrangements. But to do so, two types of new institutions must be put in place. First, common ground must be found on which governments and companies can interact on an equitable basis, transcending the divisions represented by OPEC and the 21-member International Energy Agency. Arrangements can evolve through a set of overlapping yet distinct forums, ranging from bilateral intergovernmental cooperation to broader organizations. Elements of the IEA and OPEC could even come together to deal with such common problems as adding to world output capacity and the buying and release of crude oil inventories, especially given the role inventories have played in exacerbating wild price jolts, like those of last summer.

Second, the petroleum sector is the only major part of the international economy that lacks broadly based institutions to deal with commercial disputes as commercial disputes, and to find ways to forge an international consensus on market issues. The need for institutional frameworks to regulate the types of issues that will inevitably arise due to economic interdependencies in a post-Cold War world is obvious. A better time has never come than now, or after the current crisis is resolved, to break down the confrontational politics that currently characterize the oil sector.

To make any such institutions work, however, another equally fundamental set of norms must be developed. These norms revolve around the recognition that atavistic attitudes, like those underlying Iraq's aggression, have no place in an interdependent world economy fueled by oil. Assuring that the emerging era is one in which such atavisms are controlled may require new international security structures that go far beyond the world of oil. The new post-Cold War world is a place where would-be regional powers will be tempted to enlarge their bases of influence, thereby affecting the basic economic structures on which global well-being depends. Whatever mechanisms are developed to provide stability to replace those of the Cold War, the institutional norms of international oil arrangements need to be rethought and redesigned.

VII

Investment in international exploration will significantly expand in this decade. This time, unlike the late 1970s and early 1980s, it will involve not only forays into areas previously withheld from oil company investments, but it is also likely to involve novel forms of joint ventures between state-owned and private-sector firms. As a result the industry will become more tightly knit and open, breaking down the confrontations that have prevailed for the past two decades.

Underlying the push toward more international exploration will be the rise in oil prices. In the late 1970s, when the last exploration boom got under way, oil companies were politically frozen out of many countries that had just nationalized their oil industries. As a result the price of exploration rights-licenses and taxes-rose dramatically because the relative supply of exploration areas actually was reduced. Now the move away from national monopolies over exploration will significantly reduce the costs imposed on companies by governments and could actually give rise to a new set of investment structures unlike anything the world has previously known.

The reopening of areas previously off limits for foreign companies is being propelled by economic necessity and political change. In economic terms, after more than a half decade of under-investment, human resource needs are especially lacking in Saudi Arabia, Iran, the Soviet Union and, to some degree, Iraq. Technology is lacking almost everywhere, including Venezuela, the Soviet Union and Mexico. Moreover, financial constraints confront virtually all oil-producing countries that up to now relied predominantly on their own national oil companies.

Equally important is the political change that makes it possible for countries like the U.S.S.R., Venezuela, Mexico, Algeria and, potentially, even Saudi Arabia and Kuwait to reopen their sectors to foreign company exploitation. The nationalizations of the 1970s and the experience of countries in developing their own national resources have demonstrated that these countries could in fact substantially undertake the tasks once administered solely by the international firms. But there is a significant "power" element as well. The nationalizations of the 1970s and the growth of national oil companies alongside the international majors has led to a commercial negotiating framework that is more balanced. Today Saudi Aramco and Venezuela's state company, PDV, are on the same scale as Exxon and Shell as giants of the oil industry. Their story is repeated throughout the developing world-in Brazil, Mexico, Indonesia, Nigeria and elsewhere.

The series of joint ventures in refining, marketing and petrochemicals undertaken with international companies over the past decade have demonstrated that national companies can, in partnership with foreign firms, learn more and do more. It is no longer a case of "us versus them." It is now much more an issue of how differing endowments of geology, capital, technology and human resources complement one another.

In addition, state-owned enterprises in the developing world are becoming increasingly involved in foreign exploration and production. These countries include Brazil, Kuwait, the U.S.S.R., and the private companies of Japan that are being financed by the state-owned Japan National Oil Company.

It may be hard to imagine that some countries that are now much more favorably inclined toward foreign firms will not close their doors somewhat as oil prices increase. But it is equally hard to imagine that some countries now opening their doors will not keep them open. While the oil world at the end of the decade will not look like the neatly ordered environment of the 1960s, when the "seven sisters" companies were responsible for the lion's share of international exploration and production, it will inevitably look a lot different from today's. In particular when the next slump takes place in the international oil industry, it will be much better managed than was the case when prices crashed in the 1980s. With the rise in international exploration and production and the increase in joint ventures between state-owned and private firms, companies will be better able both to plan new investments and to cut back on production on an equitable basis. The burdens of adjustment will thus likely be spread more evenly than they were in the 1980s when they fell entirely upon OPEC.

VIII

Two of the major structural changes in the oil industry during the 1980s were its massive consolidation, particularly in the United States and the North Sea, and the movement toward reintegration on an international basis. The oil industry, having undergone its consolidation, is now poised for a dramatic expansion. There is no reason to believe that reintegration will now come to an end. If anything, it is likely to continue.

It has often been argued that full integration is the "natural state" of the oil sector, given the economics of both exploration and production and of refining and marketing. Each process is capital intensive. Yet, once investments are made, the cost at the margin of producing a barrel of oil or processing a barrel of oil products is low. Both types of investments are also risky since the markets in which each operates are highly competitive. In addition each end of the industry is cyclical, but their cycles complement one another. When demand for crude falls, refiners, having lower feedstock costs, can boost profits to the degree they can maximize refinery runs. When demand for crude is high, feedstock costs are high and, given the competitive nature of products markets, refiners' profits are squeezed. Integration reduces risks over time for both ends of the industry.

The drive toward reintegration by oil-exporting countries in the 1980s was a natural reaction to the extremes set in motion by nationalization in the 1970s. It was propelled by the need to find secure markets in a time of excess supplies. But even as oil markets tighten, the reintegration process will likely continue. For some large producers, like Saudi Arabia, the integration process has in many respects just begun. Its domestic export refineries and foreign refining ventures are already covering a lower percentage of total oil production than last year when output was lower. As Saudi output rises, it will need long-term arrangements with buyers. Unless the government itself can confront the nightmarish task of renegotiating several million barrels a day of contracts quarterly or semi-annually, the only secure way to market Saudi oil will be through the now nationally owned Aramco network. The same can be said of other large oil exporters.

At the consumer end of the market, opportunities for reintegration are likely to grow rather than to shrink. The large Japanese market has yet to be penetrated by new foreign investment by producer-country firms. If that country is to obtain secure sources of crude, it will need to open its doors to such investments. Oil companies, meanwhile, are scrambling to enter the Soviet Union, which may well become the hub on which a reintegrated international oil industry is built.

A much more integrated international oil economy is therefore likely to develop during this decade. And that almost certainly also means a more moderate and open petroleum sector.

IX

As the oil markets turned soft in the 1980s, a revolutionary change took place in the way oil was priced and marketed. At the start of the decade, the world seemed to be permanently stuck on a system of fixed prices established by governments. OPEC was at the center of this pricing system and, within OPEC, the largest producer, Saudi Arabia, established the benchmark price. By the end of the decade, however, the "market" seemed to reign supreme-virtually all oil is now sold at prices determined by the laws of supply and demand, and governments' only role is to change adjustment factors in pricing formulas. Exporters, rather than importers, thus took the risk of price changes.

Now, as markets tighten, change is again in the offing. We are likely to see enhanced bargaining leverage in the marketplace for sellers at the expense of buyers. But free markets are likely to remain with us, even if the rules of trade are tilted more heavily toward accommodating the interests of sellers.

Oil prices in the future are much more likely to be limited by the price of alternative fuels, especially in markets where oil competes head to head with gas and, to a lesser extent, with coal and nuclear fuels. This is now substantially the case in the electric power sector and somewhat in the commercial and residential sectors.

The entry of key OPEC countries into the refining and product distribution markets in the United States and Europe, and continuing prospects for further downstream integration in Japan, work in the same direction. Key producers, including Venezuela, Saudi Arabia, Libya, Nigeria and others, now have a direct interest in both ends of the market, which will almost certainly reduce their incentives for politically engendered price increases.

Moreover the whole structure of the market has changed with the development of organized futures markets in the London International Petroleum Exchange, the New York Mercantile Exchange, and Singapore's Simex. Since these markets are based on crudes that are unlikely to be priced on an official basis, there will be a continuing bias in the trading system toward market-based pricing.

Also moderating markets will be an array of political factors that are less tangible but no less significant. Even without the Iraqi invasion there was a predisposition within key Middle East countries to strive for price moderation. The responses of industrialized countries to the Iraqi invasion reinforces that attitude. If there is a regime change in some of these countries, the logic of their economic and political circumstances will make it likely for them to seek and develop the types of reciprocal ties that make for a more moderate oil sector.

X

U.S. energy security is far easier to define conceptually than it is to work out in practice. The reason is not only because sensible people have different views of the national interest but, more important, because politicians' short-term interests almost always prevail over long-term strategic requirements.

As an energy-rich country that nonetheless depends on oil imports, U.S. energy security requires a combination of three elements. It needs to reduce consumption, to diversify its national fuel supplies and to maximize the exploitation of domestic resources while recognizing that complete energy independence is impossible to achieve. Yet for the past decade the government has had a de facto energy policy that minimizes the development of national oil and gas resources, maximizes gasoline consumption, and relies increasingly on energy resources concentrated in oil and gas. This is not surprising. The United States is a schizophrenic society in oil matters-a huge producer and an even more enormous importer. Resolving the competing claims and interests of consumers and producers is nearly impossible.

Recent debates over the development of domestic oil and gas have been confused by two almost irrelevant issues. First, when oil prices collapsed in the mid-1980s, there was much wasted discussion on border taxes as a means of artificially raising domestic oil and gas prices to subsidize high-cost local production. Second, debates over environmental issues mistakenly focused attention on issues of land management rather than on how oil and gas production could be spurred on existing exploration lands.

The key issue involved in stimulating higher domestic production-our fiscal system-has been set aside, largely because the federal budget deficit did not appear to warrant tax concessions and few in government or industry were willing to come forward with creative ways to deal with energy taxes. While the oil industry has been its own worst enemy, pushing for lower taxes rather than tax reform, the Reagan administration instituted a series of tax changes that actually hurt the oil and gas industry.

The oil and gas industry is preeminently international. Companies making oil investments focus their interest on areas that bring them relatively high returns on capital. Here the United States has become decreasingly competitive. Its system of taxing oil and gas investments is not a neutral instrument; Washington actually discourages investments today.

Key elements of the U.S. fiscal regime need to be reviewed and revised. The U.S. federal tax system (setting aside what state governments do) is based on a combination of royalty payments made on each barrel of oil produced, and on income taxes. The royalty or severance tax system in place is the same one that existed when Colonel Drake made the first commercial oil discovery in Pennsylvania nearly 140 years ago. It is a regressive system that has been abandoned almost everywhere else in the world.

The U.S. fiscal regime has two major flaws that discouraged investment in the 1980s, with prices uncertain. First, since royalties are paid on every barrel of oil produced, they impede rapid cost-recovery. In a price-uncertain world, companies make investments in countries that permit rapid cost-recovery and avoid those where rapid cost-recovery is impeded. Second, a steep royalty system encourages the premature abandonment of oil fields. That is because the cost of secondary or tertiary recovery methods, which would stretch out the life of oil fields, are frequently uneconomic due to royalty payment obligations.

There are some easy ways to fix these shortcomings, which could probably add 300,000 to 500,000 barrels a day to the U.S. production base. Royalties could be abandoned as they have been elsewhere. Or they could be suspended-completely in the case of enhanced recovery, or temporarily, to allow more rapid investment recovery in the early years of field production.

The progressive elements of the U.S. tax system-those related to corporate income tax-also impede rather than encourage new investments. Recent changes, including the 1986 Tax Reform Act, have limited depletion allowances, the use of so-called passive losses, and imposed, through the alternative minimum tax, higher rates than the industry has historically experienced, at the very time that low prices were restricting the amount of cash flows available for new investments. In some cases the combination of federal and state severance and income taxes puts the government's total take at the highest level in the world.

Both the progressive and regressive nature of the U.S. tax system as it applies to oil need to be reviewed, along with taxes and other disincentives to consumption. Gasoline and other transport fuels remain low-cost items in the United States. In real terms, gasoline cost about the same earlier this year as it did before the price escalations of the 1970s. With half of U.S. oil consumption based on transportation fuels, it is time for the United States to join virtually all other industrial countries in imposing taxes that will discourage consumption and foster investments in a more energy-efficient transportation fleet. Reimposing efficiency standards on the automobile industry would also move in that direction.

In addition to policies to encourage production and discourage consumption, the federal government also has a legitimate role to play in research and development, especially in areas that look to be far removed from the immediate commercial interests of industry. This includes research in alternative transportation fuels, especially natural gas.

Energy security policies aimed at production, consumption and use of alternative fuels all are geared to a longer-term time horizon. In the short term, the government also has the wherewithal to deal with the immediate disruption that resulted from the embargo on Iraqi and Kuwaiti oil in ways that suit its long-term objectives. The administration apparently turned toward urging OPEC producers with spare production capacity to increase their output before reviewing what it could do on its own or in tandem with other members of the International Energy Agency. This was a mistake for two reasons.

First, armed with a nearly 600 million barrel strategic oil stockpile, the government could have prevented the economic dislocations associated with the price spike above $25 a barrel. It could have done so through an early release of the reserve inventories-even a modest release would probably have calmed markets in the immediate aftermath of the U.N. embargo. It could also have mandated a company drawdown of inventory, knowing that disruptions always engender additional stocking and impede de-stocking. Companies, uncertain about their future supplies, tend to hoard oil rather than release it, just as they did in 1973-74 and 1978-80. Instead the government allowed the mechanisms of the world's futures and forward markets to distort prices and encourage speculative bidding, which was unwarranted because of the overstocking that had taken place over the previous year.

Second, if the United States and other IEA governments had acted to cap commercial stocks and to release government inventories before they encouraged Saudi Arabia, Venezuela and others to produce more oil, they would have been in a better position both for short-term and long-term policy. In the short term, they would have demonstrated to the producers that the situation engendered by Iraq's invasion was in fact international and required actions by both importing and exporting countries. They would have signaled that this is a house we all live in, and it is time for each to do its share. Instead they made it politically more difficult for the producers to respond, by in effect saying to them, we, the profligate consumers of oil, need more and you, the producers, have an obligation to provide it.

The current crisis provides the kind of opportunity for setting in place a bold new architectural arrangement involving key exporters and importers that could benefit all parties in the 1990s. Management of international stocks is inevitably central to such discussions, given the role that excessive stockpiling or de-stocking has traditionally had in destabilizing oil prices.

Whether or not the United States and other industrial countries learn appropriate lessons from the latest crisis and undertake new meaningful energy policies to help the restructuring of the world's energy institutions remains an open question. The petroleum sector has dealt the world more wild cards in the last twenty years than virtually any other key segment of the world economy. While the wild card recently placed on the table by Iraq is changing many of the rules of the game, it is unlikely to affect them very substantially in the long run. The oil system has been moving in directions based much more on the economic logic that has governed its growth than on specific government acts. But government policies can make a big difference in ameliorating or worsening conditions.

If the arguments put forward above are basically correct, prices are going to rise, regardless, this decade. Governments may be able to affect the pace of the increase, especially during disruptions, but they are unlikely to avert it. Rather, the logic of the evolution of the oil system is likely to prevail, until at least one additional truly wild card is dealt-the one that shows the world how a commercially and technically efficient non-oil transport fuel can be developed, and oil's role in the world economy is significantly reduced.

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  • Edward L. Morse is Publisher of Petroleum Intelligence Weekly. He was Deputy Assistant Secretary of State for International Energy Policy, 1979-81.
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