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OIL AND WAR
Part 1: OPEC in the line of
fire
By Dinkar Ayilavarapu
Saddam Hussein has to go. When the United States
says so, it takes a fool to bet against it. Wasn't
former Panamanian leader Manuel Noriega taken care of
similarly years ago, and that was when no oil was
involved. Now how does one expect Saddam to survive when
there are billions of petrodollars at stake?
On
the surface, it's about weapons of mass destruction.
Scrape the surface, it's the oil. Dig a little deeper
and then you confront the prime reason for the next Gulf
War. For too long America has lived with the
Organization of Petroleum Exporting Countries (OPEC) and
its artificial quotas of production leading to
artificially high prices of oil.
September 11
provided the pretext to get rid of the cartel by
bringing the second largest reserves of oil buried under
the sands of Iraq into the open market. Getting rid of
Saddam is just incidental (or collateral damage) in the
war of the US against OPEC and its ringleader, Saudi
Arabia.
The OPEC mechanism
Formed in 1960 at Baghdad, OPEC now
comprises 11 major oil-exporting countries (Venezuela,
Algeria, Nigeria, Libya, Saudi Arabia, Qatar, United
Arab Emirates, Kuwait, Iraq, Iran and Indonesia).
Officially, "OPEC seeks to ensure the stabilization of
oil prices in international oil markets with a view to
eliminating harmful and unnecessary fluctuations, due
regard being given at all times to the interests of
oil-producing nations and to the necessity of securing a
steady income for them; an efficient, economic and
regular supply of petroleum to consuming nations; and a
fair return on their capital to those investing in the
petroleum industry."
Crude oil, at end
2001
|
Reserves
bn
barrels |
Production
m barrels/day
|
| Saudi
Arabia |
261.8 |
8.8 |
| Iraq |
112.5 |
2.4 |
| UAE |
97.8 |
2.4 |
| Kuwait |
96.5 |
2.1 |
| Iran |
89.7 |
3.7 |
| Venezuela |
77.7 |
3.4 |
| Russia |
48.6 |
7.1 |
| US |
30.4 |
7.7 |
| Libya |
29.5 |
1.4 |
| Mexico |
26.9 |
3.6 | Source: BP Statistical Review of World
Energy
On the ground, this has meant that a
cartel of oil producers has kept international oil
prices high. Each country is allocated quotas of
production, which is just right to keep the prices of
oil internationally stable and reasonably high.
So when prices are low, the members cut their
production to boost the oil price and, in all fairness
to the cartel, when the prices are high they boost
production to bring them down, as they did in the 1991
Gulf War (but then who wants to act smart with around
250,000 Marines in the backyard).
Higher
oil prices obviously harm oil consumers. What is not
known is that higher oil prices may benefit the producers
in the short run, but in the longer term they harm them.
In the 1970s, OPEC twice jacked up the price of
oil drastically, pushing the world into recession and
thus reducing oil consumption for a longer period. Keeping
prices high is like killing the goose laying the golden
eggs, for its meat.
Phillip Ellis of the Boston
Consulting Group has studied oil markets for a long
time. According to him, oil prices internationally exist
in two bands - the peace band of US$22-$28, and the war
band of around $50. But conventional economics of demand
and supply tell us the oil price should be around
$17-$18 per barrel and falling.
OPEC follows a price-defense
strategy to keep the price of international
crude substantially above the $18 mark. This
has led to very poor capacity additions in the OPEC member
states, and in the case of the big ones, like Saudi
Arabia, large under-utilized capacities. Also, since the
1970s, the world has started looking for and buying oil
from elsewhere, which has sharply reduced OPEC's share
of both world oil production and trade. Higher prices
have helped OPEC countries to reap profits, but at the
cost of market share, which, as most strategy professors
would say, is suicidal.
 OPEC has a phenomenal
ability to fire blanks. This is because not all members
have equal reserves, and hence the quotas aren't equal.
Thus cuts in production aren't uniform, hurting some
countries more than others.
This non-uniform
sharing of pain has led the smaller members of the
cartel to cheat on their quotas. Students of game theory
would be aware that in most cartels the dominant
strategy for the players is to cheat, and the dominant
strategy equilibrium established is very stable.
But paradoxically, the equilibrium attained by
not cheating is highly unstable. John Mitchell, an
energy analyst at Britain's Royal Institute of
International Affairs, believes OPEC collusion can't be
sustained, simply because the ratio of production to
reserves varies greatly among OPEC members, so the
incentive to increase output rather than stabilize it
varies greatly.
So for the smaller fry
like Algeria, Nigeria and Libya (who also happen to
be habitual cheaters) it makes much more sense to
produce more than their quotas to exploit the high prices;
but if the bigger producers do the same, the prices
crash. So it's the little players who benefit while the
large ones like Saudi Arabia suffer. The good thing for
the Saudis is that they produce so much oil that they don't
feel much pain.
The other hot topic that
divides OPEC is the price the cartel should set. Here,
Saudi Arabia would prefer $20, but the smaller producers
like Venezuela prefer the price higher at $30. So
usually the price set is a compromise between the
parties, making none happy, and inducing further
cheating by the smaller players.
Perhaps the
biggest beneficiaries of OPEC-driven prices are the
non-OPEC producers of oil. Since the 1970s the oil
market has changed drastically. The third largest
non-OPEC producer of oil is Mexico, which has nothing to
do with OPEC, and in the 1990s the Russians entered the
business as well.
OPEC has
kept its production constant (or increased it slowly),
while world demand has risen rapidly. High prices of oil have
attracted new investment into the business to feed the
ever-growing demand for oil. OPEC keeps its production
stable and doesn't welcome new investment, and hence all
this money flows into hitherto non-conventional sources,
such as Siberia, Chad, Angola, the Caspian Sea basin,
Mexico and elsewhere.
Deutsche Bank estimates
that by the year 2004 world oil production would
outstrip demand by as much as 1 million barrels a day.
Sheik Ahmed Zaki Yamani, the former Saudi oil minister
and the architect of the 1973 oil embargo, now doing oil
consulting from London, says that in the normal course
oil prices would drop to $10 by 2004, which OPEC
wouldn't be too happy to see.
High oil prices
have enriched the non-OPEC players, like Mexico, Norway,
Angola and Russia, while the relative prosperity of the
OPEC states has crashed (Saudi per capita income has
fallen from $24,000 in the golden days of the 1970s to
about $7,000 now). As newer oil flows in from outside
OPEC, prices reduce steadily and the OPEC mechanism
threatens to become self-defeating.
America's
strategy
Since the two
OPEC-induced oil shocks in the 1970s and the consequent recession
of the 1970s and the early 1980s, America started to
focus on getting oil from non-OPEC states to Western markets.
This has undoubtedly been a successful operation
as the OPEC share of world oil has shrunk from a peak of
about 90 percent in the 1970s to 39 percent (OPEC claims
is 41 percent) in 2001. But however low the share of
OPEC oil may be, the cartel still controls anywhere
between 65 to 77 percent (depending on whose estimates
you trust) of the world crude reserves, and about 55
percent of the world's traded oil is still from OPEC. In
the long run, it's the cartel that holds all the aces.
After the demise of the Soviet Union, America
had the opportunity to exploit the huge Russian reserves
that came onto the open market. In the 1990s all of
America's efforts have been focused on getting non-OPEC
oil into the market, so they have gone about building
bridges with the Russians, repairing those with the
Mexicans and even trying to get rid of Hugo Chavez in
Venezuela. The strategy has been reasonably successful,
as borne out by the fact that only 7 percent of American
crude now comes from Saudi Arabia, which is less than
the 8 percent it gets from Mexico and comparable to the
7 percent coming from Norway. But still, America's OPEC
exposure is about 25 percent of the 20 million barrels a
day that it requires.
This strategy has
had its pitfalls. High oil prices have brought
fresh investments into oil exploration and drilling in new
non-Middle East and non-OPEC regions. But these are the regions
which aren't traditionally friendly for exploration.
Mexican waters are very deep, the Caspian Sea basin is
very turbulent, most of Siberia is frozen, Central Asia is
impossible to reach due to unstable neighbors, Chad is
inhospitable, and Angola just ended a civil war.
Setting up big drilling stations and building
huge pipelines through these places is fraught with
risk, which drives the prices of oil from these places
up. In addition, the Middle East is one of the richest
sources of oil. Every barrel of Middle Eastern oil costs
only $1 for exploration, while a single barrel from
elsewhere can cost anywhere between $10-$12. Sound
economics have driven the Americans into finding a
Middle Eastern solution to the OPEC "problem".
America in Gulf War II aims to
remove Saddam, and it wants to bring into the world market
Iraqi oil, while at the same time demolishing the OPEC
mechanism for keeping oil prices high. After Saudi Arabia, Iraq
has the highest oil reserves in the world. For the past
10 years this has been out of reach of most of the
world. Iraq produces anywhere between zero to 2 million
barrels a day, depending on Saddam Hussein's mood and the
status of his spat with the United Nations. This has not
only acted as a spoiler for OPEC's pricing mechanism
(which discounts Iraqi production despite it being an
OPEC member), but has also produced the kind of
uncertainty in world oil prices that doesn't benefit America.
The American plan is to install a friendly government in
Iraq with which they can do business.
Under this
arrangement, a post-Saddam Iraqi regime would either
drop out of OPEC (with American prodding) or ask for a
long quota holiday under the pretext of rebuilding the
nation. This would unleash a flow of Iraqi oil onto the
world market, pushing prices down. In such a situation,
either Saudi Arabia would have to risk insignificance in
the oil trade, or boost its own production.
With prices
down,
the oil proceeds of the kingdom would drop drastically. Saudi
Arabia can make $60 billion a year, either
by producing 7 million barrels a day at $30 or 10
million barrels a day at $17. The odds are that they
would go for 10 million barrels, which is full capacity.
This would again push the price down, and keep it there.
Effectively, OPEC quotas would be defunct and world oil
prices would be determined by demand and supply
economics. The problem here is that the two parties
worst affected by this - Saudi Arabia and Russia (which
has made the most by exporting oil when OPEC has kept
prices high) - don't like it. And hence their
opposition.
The strategy failing or misfiring would
have horrible consequences for the American economy.
A quagmire in Iraq, or widening of the conflict, or
Saudi non-cooperation, would push oil prices up, which a
teetering American economy might not be able to take.
Peter Hoopers, the chief US economist at
Deutsche Bank, estimates that a $1 increase in oil
prices costs US customers $2 billion per annum. The
consulting firm Economy.com Inc estimates that a $5
increase in oil prices hurts the profitability of
non-energy and non-finance US companies by 2 percent. Oil
prices have already gone up beyond $30 (up 45 percent),
which, according to Daniel Yergin of Cambridge Energy
Research Associates (CERA), includes a $3-$5 "fear
premium" per barrel due to the war clouds in the Middle
East. This before even the first shot has even been
fired.
The Americans are making plans to reduce oil
price turbulence due to war. The US and Britain have been
working through the UN to squeeze Iraqi production down
to 780,000 barrels a day; so in the event of war not
much Iraqi oil would be missed. They have built up 584
million barrels of oil in their strategic reserves,
which is equal to 120 days of OPEC imports.
Europe and Japan have traditionally been more
energy efficient than the Americans and would escape
severe damage. But here again, according to Toshinori
Ito of UBS Warburg, reserves of about 170 days of
consumption have been built up by Japan. About 1.2
billion barrels of oil reside in the strategic reserves
of the rest of the world. Saudi Arabia has promised to
boost production to make up for any shortfall in the
war, and even Russia is producing at full capacity of 3
million barrels a day.
Tomorrow,
Part 2: Russia, and
other wild cards
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