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How to break the oil cartel

Irwin Stelzer

The Hudson Institute

To say that current disputes about energy policy are producing more heat than light, is to do more than make a bad pun. We have Al Gore and the Democrats blaming greedy "Big Oil" and the all-oil-industry team of George Bush and Dick Cheney for the recent run-up in gasoline prices.

To add to all this, we have the Republicans hinting that the Gore family's association with the Armand Hammer's Occidental Petroleum Company, and Bill Clinton's lack of credibility with the Middle Eastern oil producers, are the real culprits.

All good fun but not particularly enlightening. The simple fact is that America, once again, finds a portion of its economic future being determined at meetings of the Organisation of Petroleum Exporting Countries (Opec) oil cartel in Geneva; or by Saudi Arabian princes and ministers in Riyadh; or by a now-deposed oil minister in Mexico City; or by Castro-supported populist president Hugo Chavez in Caracas; or by Opec's new man, Venezuelan oil minister Ali Rodriguez Araque, recently described in the New York Times as once "active in a Cuban-inspired guerrilla group in the 1960s and ... still a member of a party that is on the far left fringe of Mr Chavez's coalition."

These three countries - Saudi Arabia, Mexico, and Venezuela - are America's largest suppliers of crude oil. Clearly, they are a crowd not particularly devoted to the free market principles of Adam Smith, or to any extant version of capitalism.

Instead, these countries are devoted to colluding to restrict the supply of crude oil to raise its price well above that which would prevail in competitive markets - which is why American consumers this summer found themselves confronted with oil selling for $ 30 per barrel, at least three times the price that would prevail in a competitive market. That is why motorists found themselves filling their tanks with gasoline priced at more than $ 2 per gallon.

The economics that confront American energy policy makers are not overly complicated. Over three quarters of the world's oil reserves are located under the firmament of members of Opec. Another 2.7 per cent is located in Mexico, an Opec fellow-traveller.

The United States contains only 2.8 per cent of the world's proved reserves. It also produces about 10 per cent of the oil and accounts for about 25 per cent of the world's consumption.

In short, America is not, and can never be, self-sufficient in oil. On the supply side, although there would be more oil to be found if environmental restrictions on the exploitation of new areas offshore and in the Arctic were eased, there is not enough oil in America for them to tell Opec to peddle its barrels somewhere else.

On the demand side, even though some efficiencies in the use of energy remain - we have already picked the low-hanging fruit - our economy is too energy -intensive, which is another way of saying efficient (compare energy-intensive US agriculture with the labour-intensive agriculture's of, say, India and China); the distances we travel too great; the pace of business too demanding; and the desire for comfort of an affluent population too insistent, for self -sufficiency to be a reasonable goal.

It has taken Washington policy makers some time to recognise that self -sufficiency is not an available option - if indeed they have.

When the Arabs first unsheathed the oil weapon in October 1973 in response to America's support of Israel during the Yom Kippur War, the then President Nixon responded: "Let us set as our national goal ... that by the end of this decade we will have developed the potential to meet our own energy needs without depending on any foreign sources."

Allocation and price controls for oil and gasoline were chosen for realising the goal of independence from imports.

Needless to say, the decade ended with the United States even more dependent on foreign oil than it had been when Nixon set the self-sufficiency target. This is despite - some would say because of - the pursuit by his successors of similarly interventionist policies.

Not to be outdone by his predecessor, President Ford pursued the illusory goal of self-sufficiency by attacking both the supply side - encouraging greater use of coal and providing greater incentives for domestic exploration - and the demand side (auto fuel efficiency standards), while at the same time creating a Strategic Petroleum Reserve (SPR) to provide a buffer against another supply shortage. He also continued price controls on crude oil.

Jimmy Carter proved that intervention is a bipartisan policy. He created the now-egregious Department of Energy to wage what he unfortunately termed "the moral equivalent of war" (which quickly became known by its acronym, "Meow", not one designed to strike terror into the hearts of Opec). The usual mix of supply-side subsidies, notwithstanding the failure of such efforts in the past, and demand-side constraints followed, as President Carter appeared , sweater-clad, to urge Americans to shiver a bit more in the winter and sweat a bit more in the summer - and to do without hot water in federal facilities.

I recite this history to emphasise that energy policy does strange things to sensible people; it encourages them to look for non-market solutions to any perceived problem. If supply falls short of demand at existing price levels, and prices start to rise, policy makers jump in to subsidise production and/or artificially curtail demand - anything to give voters the impression that politicians are doing their best to shield consumers from price increases.

But the failure of past interventions in energy markets cannot be taken to mean that a policy of laissez-faire is the optimal one in the circumstances. For energy markets have been, and to some extent still are, characterised by significant market failures. It was not so long ago that the prices of energy failed to reflect the externalities associated with energy use, including the environmental impact of fossil fuel consumption and the macroeconomic cost of the supply interruptions periodically inflicted on the world by Opec in pursuit of monopoly and Arab foreign policy goals.

It would be a brave person who would argue that consumers need still more information about the relative costs of using and conserving energy.

Major industrial and commercial consumers are well aware of the arithmetic, and any who are not can count on an educational call from their friendly Enron salesman. Residential consumers now benefit from informative bill stuffers, comparative price information in the popular press, labels on refrigerators and other appliances, and exhortations from their youngsters, who are exposed in school to much anti-energy use, environmental propaganda.

Unfortunately, that leaves one problem that warrants government attention - Opec. It is one thing to tell the government to stay out of markets that are effectively competitive; it is quite another to suggest inaction when the nation is faced with a Saudi Arabia-led supplier cartel with control over the price of a commodity that is vital its economy.

As Robert Priddle, executive director of the International Energy Agency (IEA) put it in a recent interview, "I smile a bit when I hear this (oil) market described as a free market. It's a market where the producers make a deliberate determination of controlled level of production in order to force the price, and that clearly cannot be a free market."

But to suggest government intervention is easy; to describe just what that intervention should be is harder. Start with clearing the underbrush, start by ignoring what both Gore and "W" suggest. First, Gore, and his attack on "big oil."

It is unlikely that oil companies suddenly decided to risk fines and imprisonment by very publicly jacking up the price of gasoline - and by so much as to cause a near-riot at the pumps of mid-western gasoline stations. After all, if they had the will and the power to conspire to raise gasoline and fuel oil prices, they surely would not have waited until a spike in crude oil prices and costly environmental requirements.

Unfortunately, it is not only his demonising of "big oil" that makes Gore look so foolish. He continues to pursue this myth of energy independence.

Bush's suggestion that we talk sweet reason to Arab oil producers is a bit less silly, primarily because, unlike Gore's interventionist proposals, it is likely to do no harm. "I would work with our friends in Opec," he says, "to convince them to open up the spigot to increase the supply." Remember, it is W's father who made the case for higher oil prices to shore up the undemocratic Arab regimes that badly need revenues to provide the social services that anaesthetise their increasingly pained middle-classes.

Following in his father's footsteps, Bush would have us rely on persuasion, this time to lower rather than to raise oil prices. But, if that persuasion is of the sort that one uses with "friends", it is doomed to failure. Only if the velvet glove is removed from the malled fist will Bush be able to talk prices down to levels below those that the Saudis' economic models suggest are the maximum they can extract from American consumers: without the four consequences that concern them: prices so high as to cause a recession; a shift to other fuels; a drop in the value of their investments here and in other countries; or so outraging Americans that they decide it is not worth the further expenditure of blood and treasure to protect them and other Arab regimes from their Iraqi brethren and internal enemies.

That price appears to be something like $ 25 per barrel. This is as low as Bush will be able to persuade the Saudis to allow prices to fall - especially since their fellow cartelists object to increasing production when prices exceed $ 30. It is Saudi self interest, not the persuasive powers of the Texas governor, anyhow not certain about the evils of high oil prices, that will determine the price of oil in the absence of an energy policy.

The magnitude of the cartel's exaction can best be measured against what the price oil would likely reach in the absence of a producer cartel. The best estimates of Middle Eastern producers with whom I have spoken is that they can explore for, find, develop, and produce oil from new fields at a cost of less than $ 5 per barrel, and that they can produce oil from already-proved reserves at a cost of between $ 1.50 and $ 2 per barrel. Even if these estimates are off by an order of magnitude - and there is no reason to believe that they are - oil at $ 25 includes a cartel surcharge of $ 20 per barrel. We import about nine million barrels of oil every day, making the extraction at least $ 65 billion annually, a sum in excess of the tax cut Al Gore has been promising voters.

Irwin Stelzer is Senior Fellow and Director of Regulatory Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.

Copyright © 2000 by Hudson Institute.

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