Protection From Cartel Induced Extortion

THE SCOTSMAN September 22, 2000

In Part 3 of our cartels report, we consider how the US could use its private oil stock to bring Opec to heel IN SUMMATION of our three-part report on the relationship between the US and Opec (part four begins below), energy is firmly back on the policy agenda. This summer, America's motorists found themselves paying well above $ 2 per gallon for gasoline, and facing the prospect of equally extraordinary prices this winter for the fuel oil with which to heat their homes.

These are only the most visible consequences of the decision of the newly -united Opec cartel to curtail supplies in order to triple the price of crude oil and drive it to the $ 30-per-barrel level. Less obvious will be the reduced rate of economic growth and the increased inflation that will flow from prices that are several multiples of those that would prevail in competitive markets.

Neither US presidential candidate has formulated an adequate response to the rapacious cartel behaviour of the oil-producing nations. Vice President Al Gore proposes to fall back on the failed policies of attacking "big oil" and lavishing subsidies on technologies that are so uneconomic that venture capitalists, awash in cash, shun them. George W Bush, like President Clinton, would rely on pleas to producing nations to open their taps so as to bring down prices.

Neither a policy of attacking oil companies and subsidising alternative fuels nor of begging for mercy is likely to succeed. So long as Opec remains united, America will remain dependent on it for much of the oil on which its industrialised economy depends.

American industry and agriculture are efficient because they rely heavily on oil-driven machinery and transport; substitute fuels or conservation measures that would significantly reduce this reliance are simply not on the horizon - or at best will have an impact only after Opec has extorted a minimum of $ 65 billion annually from American consumers, a sum greater than the tax cut that Al Gore is offering the voters in this election season.

So the stakes are high. Fortunately, America holds some high cards that might shift the balance of fortune its way - but has so far refused to use them.

Mexico is the linchpin of Opec's new unity, having promised Saudi Arabia and Venezuela not to fill the gap in the American market if the latter nations cut back production. Its new president, Vicente Fox, badly needs favours from the United States in the areas of trade and immigration. A policy of "no oil, no freer trade and tougher enforcement of immigration laws" might persuade him to pump some more of his nation's oil.

Saudi Arabia and Kuwait are both sitting on excess capacity. The United States stands between the regimes in those countries and death or exile. An Iraqi take-over would cause America considerable harm, but it would mean ruin for the ruling families of those countries. Given the choice of "produce or perish", it is not difficult to guess which way these regimes would jump.

The cartel is shielded from US antitrust prosecution by laws preventing the Antitrust Division from taking the action it has taken in roughly similar economic circumstances. Those laws can be repealed. Just as we have attached Iranian assets, we could move against the very substantial holdings that Opec governments have acquired in this country.

Taxes on energy use that force consumers to pay the costs of possible supply interruptions and price hikes, offset by reductions in marginal income tax rates and other incentive-stifling taxes, would put the economic costs of relying on imported oil where they belong, and reduce its use.

Cartels don't last forever. Opec's won't. Sooner or later, cheating by members and the development of new supply sources weaken or destroy cartels.

But, in the meanwhile, Opec is in a position to extort huge sums from America and to slow its growth. Tough but sensible policies can create a strong incentive for the oil-producing nations to curb their appetites for monopoly profits.

PART FOUR: That US antitrust laws, statutes from which the Arab and other oil producers have been uniquely exempt for political reasons, could be used to prosecute the oil cartelists there is little doubt. After all, the US justice department has successfully brought actions against German, Japanese, and French cartels in products as diverse as citric acid, lysine, vitamins, and fax paper.

In most of these cases, the cartelists had no offices in America; they merely sold their products there. Indeed, in the case of fax paper, the First Circuit Court of Appeals has upheld the Antitrust Division's suit against Nippon Paper, a company that did not sell directly to the United States but fixed the prices of those who did.

It is of course the case, as my lawyer friends point out, that American law grants foreign sovereigns immunity from antitrust prosecution, and grants similar immunity to companies acting under the compulsion of foreign sovereigns.

But the law is no real barrier to protection if there is a will to move against Opec. For one, the so-called commercial activity exemption allows the Antitrust Division to proceed if it decides that the sovereign governments was engaged in merely a commercial activity, like selling oil.

The Opec members contend, presumably with straight faces, that it is much more than mere commercial activity - it is, they say, the preservation of their national patrimony.

For another, laws can be repealed or amended: this exemption can always be removed.

Such a move would permit the antitrust authorities to take action against the Saudis and other oil-producing countries, all of which have substantial assets in America, assets that could be attached to satisfy any legitimate claims against those governments and the companies co-operating with them to maintain oil prices at anti-competitive levels.

But it seems that a variety of political considerations (most notably pressure from the Arabists in the State Department) have stayed the Antitrust Division's hand.

What the US has received from countries that refuse to cooperate with President Clinton in negotiating a settlement in the Arab-Israeli dispute, and which persist in conspiring to elevate the level of world oil prices, is difficult to discern.

In addition to a touch of diplomatic toughness and enforcement of US laws against price-fixing conspiracies, America should set a policy for use of the Strategic Petroleum Reserve (SPR).

If all efforts to persuade Opec to allow supplies to increase sufficiently to drive prices to more-or-less competitive levels fail, and if it proves impossible to eliminate those environmental constraints on exploration that are not cost-justified, the government might deploy the SPR to countervail those artificial supply restrictions.

It is important to emphasise that the government should play the role of a modern-day, Joseph-inspired Pharaoh only if it is unsuccessful in its efforts to eliminate supply-side constraints.

For there are two reasons to worry that efforts to use the SPR to keep prices closer to competitive levels will not work.

The first is that the private sector might reduce its own inventories in tandem with the government's increase in the SPR. Private companies hold inventories for a variety of reasons: to protect long-term customers in the event of a supply interruption; to assure the steady operation of capital -intensive facilities such as refineries, to profit from price spikes that might emerge in temporary periods of increased demand.

However, if the government stands ready to perform that function, the incentive to incur the costs of carrying inventory is reduced. This seems to have been the case in oil-consuming countries, according to a Harvard University study:

" . . . While the size of strategic stockpiles has grown in the United States, Japan, and some Western European countries, the size of private stocks has fallen significantly. The net effect has been that the total size of the industrial countries' oil stockpiles was smaller in 1987 than at the start of the decade. Indeed, the growth of strategic stockpiles may have contributed to the drawdown of commercial inventories."

A second reason for being wary of relying on government use of a strategic reserve as an effective policy tool is quite simply the history of the SPR so far.

The US has pumped into storage some 570 million barrels, but has never quite figured out how to use it. Policymakers, from the president on down to officials at the Department of Energy, seem to believe that this reserve is to be used only when the last drop of available oil has been consumed.

Use of the SPR to contain price increases has been rejected by politicians from both parties, who seem unencumbered by the knowledge that an increase in supply tends to have a dampening effect on prices.

Most recently, US energy secretary Bill Richardson said that the SPR should not be used to affect prices. The spurt in oil prices, he said, "is not an emergency supply problem, it's a price problem".

So instead of calling upon this resource in times of price spikes, the US looks to their Opec "friends" in Saudi Arabia and Kuwait to increase supply, something they will do only when Saudi Arabia, the leader in these matters because of its huge excess capacity, becomes convinced that prices have reached a level that threaten to throw the American economy into a recession.

If there are any doubts that the oil in the SPR is likely to remain there, unused, in perpetuity, consider this. During one of the largest military buildups in the history of the world - our massing of forces to drive Saddam out of Kuwait - oil prices doubled. But the reserve remained untouched as the Bush-the-elder administration held to the view that a war in the largest oil -producing region of the world, and a consequent doubling of oil prices, did not constitute an emergency.

It is, of course, the case that the SPR is only a limited buffer against supply interruptions, since the 570 million barrels it contains are the equivalent of only about 60 days of imported oil.

If US policymakers could get over the notion that the SPR is never to be used as a mechanism to protect against cartel-induced extortion, they could use the SPR to force the cartel either to cut back production more sharply than it would if the SPR were not being drawn down, or maintain output at reduced levels for a longer period to achieve its price target.

Another strand of a comprehensive energy policy is to address the demand side. Measures might include increased taxes on oil use, with the proceeds used to reduce marginal income tax rates and other initiative-stifling taxes.

If it is the case that oil embargoes or cartel-induced price run-ups can threaten the US with dire macro-economic consequences (despite the reduced reliance of the industrialised countries on energy in general and oil in particular), including rising unemployment, then the cost of such economy-wide upheavals should be reflected in the price of oil products.

Richard Berner, chief US economist at Morgan Stanley Dean Witter, estimates that every $ 5 increase in the price of a barrel of oil knocks 0.3 percentage points off the US GDP over a year. That suggests that the recent run-up can cost the economy something like a full percentage point of GDP.

Perhaps add one percentage point to the inflation rate, according to Mark Zandl, of Regional Financial Associates. This may not be a problem at a time when the economy is booming, but in less pleasant economic circumstances the loss of that much GDP will have quite noticeable consequences.

Besides, if higher oil prices are chosen as the means of slowing an overheating economy, it would be far wiser to raise taxes on oil (and, I repeat, keep those funds from spendthrift Washington politicians by reducing other taxes in parallel) rather than to allow Opec to do the equivalent by raising prices.

Finally, the US should re-examine the cost-benefit analysis that have led to making oil storage more expensive, with a consequent reduction in vendors' willingness to maintain inventories, and to restrict domestic exploration and production. It might have made sense to ban offshore drilling and Arctic exploration when oil was selling for $ 10 per barrel. But the calculus that led to restricting domestic supplies of oil at that price may not hold when potential output is valued at three times that level.

Although calculations showing that the environmental costs of opening now -restricted areas are exceeded by the benefits of increased domestic production are unlikely to persuade the greenest of the greens that the national interest dictates a change in policy, anything other than a Gore -dominated EPA might well find such arithmetic persuasive.

The Department of Energy has already recently trebled its mean estimate of recoverable oil reserves along the coast of Alaska's national wildlife refuge to 10.3 billion barrels, which would represent an addition of at least one -third to America's oil reserves.

Of course, if it is anticipated that an era of higher oil prices has been entered - higher either because the cartel remains effective or because of policy decisions to reflect externalities in market prices - then just as current supply-side restrictions should be examined, so should there be a determination as to whether demand-side measures that were uneconomic when oil was selling at $ 10 per barrel are worth pursuing when prices are two or three times that level.

Keep in mind, however, that by getting the prices of oil and its products right - at competitive levels, and including all costs associated with their use - there is little scope for government action on the demand side except to make any minor, as-yet-unattained improvements in the flow of information to consumers as might be cost-effective.

It should be emphasised that none of the components of a market-oriented energy policy involves government control of prices, or subsidies to producers of oil or alternative technologies. Such policies have failed in the past, and are certain to fail in the future.

A programme of encouraging more competition by weakening the cartel through diplomatic pressure and antitrust actions, to devise a strategy for the manipulation of the strategic reserve, and to adjust environmental and tax policies to the new reality of the increased cohesiveness of Opec members, is one that will make energy markets work better, without inviting the long arm of government into the marketplace.

In short: America has the diplomatic and legal weapons with which to blast the cartel; it has so far chosen to leave them in their holsters.