America: It’s no more Mr. Nice Guy

THE SCOTSMAN September 21, 2000

In Part 2 of our look at oil cartels, we examine why the US must get tough with its friends so just what is to be done about the oil cartels? One possibility is to do nothing - or its equivalent, demeaningly beg for mercy in various Opec capitals. Cartels, after all, have a history of collapsing when members begin to cheat on their quotas, or when the artificially high prices set by the cartelists attract non-members into the industry, augmenting supply and producing a price collapse.

Both cheating and new entry have characterised the oil industry in the past, so why not apply the famous dictum, attributed to Ronald Reagan, "Don't do something, just stand there," a policy that often served the nation well during President Reagan's terms in office.

The answer is that the new found cohesiveness of Opec, and the rapacity it has recently exhibited, create two problems for such a passive strategy. First, while waiting for the cartel to collapse, American consumers will pay a very substantial annual toll, and suffer the macroeconomic consequences induced by the payment of such a "tax" - slower growth and higher inflation being the most notable.

Second, although best estimates are that there remain substantial undiscovered reserves of oil in non-Opec areas, it is not safe to rely on new entrants to drive down prices in an industry in which incumbent cartelists sit on vast quantities of non-producing, low-cost reserves.

Potential newcomers to the oil game and those who finance them, and existing players who have to decide on their exploration budgets, are well aware that, should their exploration activities threaten the cartel, it can open its valves and make the new entrants' projects uneconomic. That doesn't mean that drillers are completely insensitive to the lure created by higher prices, but it does suggest that they respond more slowly and less completely to oil price run-ups than they would if the threat of Opec predation did not loom over their spreadsheets.

So, too, with developers of alternatives to oil-using technologies. These entrepreneurs have long complained that they find it difficult to get financial backing because potential investors know that the Saudis and their cartel colleagues can at any time force oil prices down and make promising alternative technologies uneconomic.

Mehdi Varzi, oil analyst at Dresdner Kleinwort Benson, believes that within this decade we will see "the long-term demise of oil," in part because "at $ 30 per barrel, almost any form of energy becomes economical." Which is one reason, when prices soared above $ 30, that the Saudis began contemplating increasing output sufficiently to bring prices down to around $ 25. If Mr Varzi's magic number drops, count on the Saudis, with almost 100 years of proved reserves and more to be found with little effort, to bring prices down still further.

They are in the business for the long haul and will do what it takes to discourage investors in new technologies from seizing their markets. Although the development of alternatives to oil as an automotive fuel are likely to continue, other technologies face an uphill battle in the face of Opec's ability to pick price points that can change the economics of these alternatives from attractive to dismal.

These hard facts suggest that passivity is not an appropriate energy policy for America. But neither is the ad hoc intervention that has characterised past policies and that so appeals to Al Gore. Instead, we need a policy that is aimed at making oil markets work better - not as a perfectly competitive market would operate, but at least as an effectively competitive one would.

On the demand side, that means making the prices that signal consumers, who must choose between use and abstinence, correctly reflect all of the costs (private and social) associated with a decision in favour of use. On the supply side, a market-oriented energy policy must eliminate or counteract artificial constraints on the ability of supply to respond to price signals.

The first step in mounting a credible attack on Opec's supply constraints is to recognise that Mexico is a key player in the recent trebling of oil prices. Although not a member of Opec, Mexico brokered a deal between Venezuela and Saudi Arabia that triggered the price rise. Both Venezuela and Saudi Arabia sell large quantities of oil to the United States. For years they worried that if they cut back their production, Mexico would step up its oil output and capture US markets previously served by the two Opec members.

When Mexico decided to participate in any supply curtailment to which Opec members might agree, its energy minister Luis Tellez, brought previously antagonistic Venezuela and Saudi Arabia to the bargaining table and cleared the way for their agreement to close their valves by promising not to open his. Tellez has made no effort to keep his role a secret. He told a Madrid gathering of oil industry executives and policymakers: "To stabilise prices and avert another financial crisis, it was clear that, for the short term, we would have to work with other oil producers to limit production. So, for the first time in Mexican history, we charted an aggressive diplomatic policy to bring together several important oil producers that had been at odds within Opec." The result a trebling of world prices.

Query: why is the American government, which has bailed out the Mexican economy when the peso collapsed and has bestowed the benefits of Nafta on Mexico, reluctant to read the riot act to the Mexican government (and not only on oil matters: Mexico is also way behind in its promised deliveries of water from the Rio Grande)? True: the benefits of Nafta are not Mexico's alone.

American consumers are also beneficiaries of the increased improvement in the international division of labour. But sometimes policy trade-offs must be made, and it would seem that the first step in an effective energy policy, one that aims to bring the price of oil closer to the level that would prevail in a free market, might well be to explain to the Mexicans that they cannot hope to sell the output of their maquiladoras, and their T-shirts, gym shoes, and automobiles to us unless they also offer us oil at competitive prices.

The lost benefit of low-cost Mexican consumer goods would surely be more than offset by the lower oil prices that would result from such a demonstration of our willingness to use our massive purchasing power to persuade Mexico that it is not in its long-term interests to facilitate and participate in the exploitation of the American consumer.

A similar approach might be taken to Kuwait, a nation on which Saddam Hussein still has designs. Kuwait possesses about 10 per cent of the world's proved reserves of oil, but accounts for only some 3 per cent of world output. It is one of the Opec members with large amounts of spare production capacity, giving it the ability to turn on its taps on shorter notice than some other members. Put another way, the country that we saved from destruction, while its ruling family waited out the war in Harrod's, could continue to produce at current levels for well over 100 years without discovering another barrel of oil. We might even consider establishing a policy that relates our contribution to Kuwait's defence to the level of oil output set by the Kuwaiti royal family.

Again, we face a trade-off. If we threaten to abandon the Kuwaitis to their fate unless they step up production, we are threatening ourselves with the loss of the country's oil and the aggrandisement of the Iraqi despot. But the consequences to us would be some inconvenience; the consequences to the Kuwaitis would be annihilation. Guess who would blink first.

Another plank of any sensible energy policy would involve a review of our sanctions program. Libya, Iran and Iraq between them account for almost one -quarter of the world's oil reserves (approximately 3 per cent, 10 per cent and 10 per cent respectively). Our reasons for pressing our balky allies to continue the embargo against Iraq remains as strong, or stronger than ever, although the embargo is increasingly porous and under continuing threat from the French, who boast that they have never allowed questions of morality, or notions of gratitude and loyalty to allies, to interfere with their commercial interests.

But a relaxation of the embargo of Iran might - just might - prove justified if a deal could be struck with that increasingly hard-pressed country. Reliable sources say that Iran's oil industry is badly in need of investment if it is even to maintain capacity at current levels.

It is in our interest as well as Iran's for that country to increase its proved reserves and its capacity to produce those reserves - but only if Iran agrees, in return for the lifting of the ban on American oil company investment, to step up output sufficiently to bring world oil prices closer to the marginal cost of exploration, development and production.