Shock Absorber: Stabilizing World Oil

In the twentieth century, oil has fueled not only the world's economy, but also some of the most dangerous international crises. Shocks caused by sudden swings in the price of oil and struggles for control of its supply have been major sources of instability and war. Since the end of World War II, several crises -- Suez in 1956, the Iran-Iraq war in 1980s, Iraq's invasion of Kuwait last year -- have aroused the United States to reaction, in the most recent case to war. But without a program for the aftermath, this kind of activism, or rather re-activism, is not a constructive or adequate approach.

The aftermath of the Gulf War offers a rare opportunity to restructure the world regime for oil. Geopolitically, this latest "oil war" was a necessary response to aggression, yet our victory changed almost nothing about the oil system that helped ignite the conflict. On the contrary, it left the Organization of Petroleum Exporting Countries (OPEC) free to reimpose its manipulation of oil supplies and prices, as it quickly proceeded to do in March 1991. Nonetheless, while leaving the oil market largely unchanged, the war revived demands for greater security of oil prices and supplies. At the same time, financial institutions are continuing to try to cope with the international debt burdens persisting from previous oil shocks. Coincidentally, there are growing efforts by the environmental movement to reduce reliance on oil because of its effects on the world's atmosphere. And the end of the Cold War now permits a more cooperative international role for the world's largest oil producer, the Soviet Union.

Many people take the swings of the oil market simply to be a fact of life; some insist as a matter of principle that the market be left to itself. Against a background of rising consumption of oil, sharp oscillations in price and supply, exploitative pricing by the world oil cartel, and the increasing dependence of the United States, Japan, and other industrial countries on oil imports, American policy has been mostly laissez faire. We treat oil as though it were the free competitive market that it assuredly is not. The Bush administration sees no problem in this posture. In the 1992 Economic Report of the President, the Council of Economic Advisors takes credit for sitting on its hands during the recent oil crisis. The council claims that the oil and gas markets, "freed from earlier price controls and restrictions," together with the underlying fiscal and monetary system, "functioned well" to prevent any serious economic dislocations. Actually, oil prices soared, then fell, and are now at a historic low. What saved us last year was the 1990-91 recession, which reduced demand for oil, plus the willingness of the largest oil producer and Saddam Hussein's mortal enemy, Saudi Arabia, to raise production.

Broadly, there are two alternatives for resolving the long-term problem. Either we move to a truly free international market in oil, or we adopt strategies of improved international regulation. I argue that there is virtually no prospect of a genuine free market and that, if we had one, it would have serious drawbacks. The alternative is a new framework of collective security to halt the recurrent oil shocks, wild swings in oil prices, and the use of oil for international blackmail or war. By stabilizing price and supply, a new oil regime could benefit both producers and consumers and promote the long-term development of better sources of energy.

Why Oil is No Free Market

Almost since the first oil wells were drilled in the 1860s, the production of oil has been controlled by a cartel -- first by the Standard Oil Trust and then, after the trust's dissolution in 1911, by the big oil companies known as the Seven Sisters. These companies, together with the smaller independents whom they dominated, controlled supply and price by pooling production and by taking guidelines from the Texas Railroad Commission and other regulatory agencies, so as to limit output in the United States and abroad.

As the petroleum-producing nations in the Third World gradually took over control of their own oil fields, they came together in OPEC, which was formally established in 1960 largely in response to Soviet dumping of oil at that time. But it was not until the 1970s that OPEC imposed severe supply cuts and price boosts: first in 1973-74, reacting to the Arab-Israeli War, and then in 1979-80, after the overthrow of the Shah of tan. These shocks led directly to global recession, extreme distortion of international payments, and huge foreign debts that weigh down many Third World countries to this day.

The ability of a handful of companies and governments to manipulate oil price and supply reflects the special structure of the oil industry, which mocks the canons of a free market. Economists make a strong case that free markets achieve allocative efficiency by rewarding the lowest-cost producers. But when turning from ideal to actual markets, many economists forget their own defining conditions for free competition. Each product must be offered by numerous independent producers to numerous independent purchasers, all of whom have approximately equal economic strength and perfect information and operate within well-understood parameters of technology, tastes, and governmental regulations. These conditions do not remotely fit the oil industry.

While not a monopoly, the oil industry is close to it: an "oligopoly" consisting of a few sellers of a fairly uniform commodity, for which there are no close substitutes in quality or price. Since the number of buyers is large, each seller has a relatively large market share, making all sellers vulnerable to any substantial expansion by one of their rivals. As a result, they are watchful and distrustful of each other and have a strong motivation to abandon independent action in favor of collusion: to go follow-the-leader on production and pricing or to form an explicit cartel like OPEC.

In the face of steadily rising demand for a commodity such as oil, the sellers' tendency is to keep production lagging and let the price rise. If prices are not rising fast enough to satisfy them, they can cut deliveries, either leaving their oil securely in the ground or stockpiling it in tanks. Substitutes for oil, generally more expensive or more dangerous to use, pose little threat. As the cost of producing oil is far below the usual price, oligopolists obtain prices that are secure and frequently exorbitant. Under this kind of structure -- whether in oil, diamonds, or proprietary drugs -- the celebrated virtues of the free market are hardly to be seen.


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The demand for oil, like its supply, also does not fit the ideal model of the market. Because energy is a necessity, and oil is relatively cheap, the long-term demand for oil seems to be "inelastic" over a considerable range of prices. In other words, while cutting prices does not induce much more consumption, sellers can raise prices significantly without sacrificing sales (although sharply higher prices would reduce low-income purchases and eventually promote substitutes for oil).

Yet another market imperfection of oil lies in its externalities (the effects external to oil buyers and sellers). The costs of environmental pollution are not factored into the price of oil, unless governments devise appropriate taxes on emissions. In fact, governments subsidize oil use by building airports, roads, and water and sewer systems for suburban land development.

OPEC's Prices, America's Policies
From these general characteristics of the oil market, we can deduce the pricing strategy of OPEC. As a cartel representing governments of producing countries, in collaboration with the big international oil companies, OPEC must aim at setting oil prices as high as possible, without setting off adverse demand and supply reactions. The optimal prices will avoid triggering political protest or trade retaliation from importing countries, reduction in the long-term demand for oil, additional output from sources of oil outside OPEC, or the development of potential energy substitutes. Forty dollars a barrel proved too high to avoid damage of this kind to OPEC's interests, but twenty dollars causes no problems, even though the cost of extracting oil is only a few dollars at the wellhead.

So long as OPEC stays within these broad limits, only two major threats to its power are likely. Some members may seek to produce and sell more oil than the quota allows them and at prices discounted below the cartel's agreed level. And some may try to boost that price by forcing other members to curtail output, as Iraq sought to do in conquering Kuwait.

The prospect for true arms-length competition in oil is negligible. A real free market would require, among other things, many more independent producers of oil and a system of auction bidding for all oil supplies, without any fixed long-term contracts and any collusion among or between producers and buyers. In other words, we should have to smash OPEC and break up the big oil companies -- none of which would go gladly into that dark competitive night. In the unlikely event we had a true free market, with prices falling toward the marginal cost of extraction, the lower prices would increase oil use and its associated pollution and discourage research on alternative sources of energy. So a true free market in oil is probably undesirable as well as impractical.


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Laissez-faire assumptions, however, continue to guide energy policy in the United States. The "national energy strategy" formulated in 1990 by the U.S. Department of Energy presented President Bush with a long list of recommendations aimed at curbing demand and expanding supply. The plan relied chiefly on deregulation and tax incentives and avoided mandatory controls, subsidies, and other new governmental interventions. Nonetheless, the President swept aside these modest proposals, with their tender care for the oil industry and its consumers.

The administration's plan, put forward in February 1991, mainly stresses expansion of U.S. oil production, chiefly in Alaska's National Wildlife Refuge and off the shores of Florida, while giving only token attention to alternative fuels, energy efficiency, and conservation. The plan would also encourage more pipelines for natural gas and more nuclear plants by easing technical regulations. The program opposes sharp increases in fuel-efficiency standards or in taxes on gasoline and other products. It is essentially a supply-side scheme. There is virtually nothing for international cooperation. In May the Senate's Energy Committee in effect adopted the Bush strategy, voting to allow drilling in the Arctic National Wildlife Refuge and rejecting higher fuel-efficiency standards. If this approach continues to prevail, little will be done to reduce the prospects of new oil shocks and new oil wars. I turn, therefore, to the alternative of collective security.

Buffering the Market

One small step toward international collaboration was taken in 1974, when the United States joined with twenty-one other nations to create the International Energy Agency (IEA), based in Paris. This agency, which mainly gathers statistics on oil, issues reports, and promotes energy research, was also asked to devise a scheme -- thus far never used -- for allocating available oil supplies in the event of a severe dislocation. The IEA does have a role in coordinating any releases from national strategic petroleum reserves, which are physical stockpiles of crude oil, held mostly in underground caverns, that the industrial countries, including the United States, established in the late 1970s. The American reserve amounts to some 600 million barrels, representing 75 days worth of U.S. imports. All the governments together hold almost one billion barrels, equivalent to 250 days' worth of the interrupted imports from Kuwait and Iraq.

At the time of the Gulf oil shock, when crude prices rocketed to nearly $40 a barrel, the Bush administration made only belated and minor use of the strategic reserve. Some critics have called for an enlargement of the reserve and a more adaptive policy on its use. Under a scheme proposed by Philip Verlegen, an economist at the Institute for International Economics in Washington, D.C., the U.S. government would lease, not necessarily buy, additional foreign oil for storage at American sites. The costs would be modest, only a low rental fee. The oil would be available for commercial sale at a pre-arranged price in the United States, beyond the reach of Saddam Hussein or other aggressors.

Another proposal, this one from M. Pierre Beregovoy, the French finance minister, would put a buffer stock of oil under an international authority representing both producing and consuming countries. By selling from the stockpile when prices go high and buying for the stockpile when prices fall low, this arrangement would serve to moderate price swings. Beregovoy's proposal may be acceptable to many countries, except those most fanatically devoted to a free market in oil.

Nevertheless, such a buffer plan has flaws. By stabilizing prices at the current levels, it would not serve to induce much new oil exploration and production. Nor would it set prices high enough to encourage conservation or to stimulate development of alternative forms of energy. In addition, the buffer-stock agency would have no authority to provide subsidies or other compensation to low-income consumers (individuals, firms, or nations) that may suffer from the supported price as long as it stays high.


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Historically, buffer stocks of such commodities as tea, coffee, cocoa, natural rubber, aluminum, and tin show considerable effectiveness, at least for a few years at a time, in coping with tendencies to world overproduction and keeping prices from falling below some producers' costs. Occasionally, buffer stocks have relieved world shortages, as happened with tin in the 1960s and 1970s. Sooner or later, however, the international authorities have broken down as one or another member country decided to pursue its own interest, expanding its sales outside the agreed quotas by offering the commodity below the cartel price.

A major exception to the fragility of most international commodity agreements is the diamond cartel. Under De Beers's management, it has sustained its prices for decades, by controlling the annual supply of raw gems. Taking account of general inflation and the rising demand for diamonds, the cartel has managed to maintain highly lucrative prices that benefit the producers without driving buyers out of the diamond market. A similar arrangement may be feasible for crude oil. But instead of satisfying the appetites of profit-seeking firms, such a system could engage governments to serve a broad public interest.

An International Oil Agency
To create a managed regime in oil, a convention would establish an International Oil Authority (IOA) as the predominant or even the sole purchaser of all crude oil imported by member countries from foreign-owned sources. The authority would resell oil to the refining and distributing companies whether public or private. As conditions changed, the IOA would add to or subtract from its current purchases and its reserve stock.

The objective would be to provide a substantial insulation of domestic oil prices from the short-run trends of supply and demand in the world oil market. The further aim would be to moderate those trends and thereby prevent the two kinds of "oil shock": either gluts of oil that hurt producers and tend to waste oil, or shortages of oil with price spirals that contribute to runaway inflation and recession in oil-consuming countries -- and ultimately in the whole world economy.

The IOA would enter into long-term purchasing contracts with the governments and the private oil-extracting companies in the exporting nations. These contracts would specify the quantities and qualities of petroleum to be purchased over a span of years at guaranteed prices. The prices might differ from producer to producer according to differing extraction costs, but would assure moderate and stable profits to each producer.

These benefits should attract the participation of most countries and companies without making adherence compulsory. To induce countries such as Venezuela and Mexico to accept the offered contracts -- and to stay away from OPEC-type extortion -- the IOA might seek to link these contracts to another round of debt reduction. And to get the cooperation of the USSR in the new authority the IOA might help arrange for technical assistance and capital investment to revive Soviet oil production.

Under this system, no oil-importing country or company will buy at a higher price than the IOA would charge for the desired oil supply. Likewise, hardly any seller will offer a lower price than the IOA would pay under long-term contracts, except perhaps when facing needs for higher revenue in an emergency, in such cases, special financial relief from the International Monetary Fund might represent a welcome alternative.

As the bulk of the world's internationally shipped oil would soon pass through the IOA -- moving from most of the producers to most of the foreign consumers, at guaranteed profitable prices -- the countries presently belonging to OPEC would come under great pressure to join the IOA, lest their share of the oil market shrink.


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How practical is it to propose an international agency for oil in the face of the worldwide oligopoly conditions in this industry? Actually, the success of OPEC during three decades demonstrates that it is entirely feasible to get agreement among a number of governments. Oil consumers have accommodated themselves to the elevated prices of the cartel, as long as it produced reasonable predictability. However, a regulated public cartel is a vast improvement upon a predatory private one.

Of course, the pricing policies of the IOA must be set to reconcile the interests of oil-producing and importing countries. In most products, the prospects of such a reconciliation are small. But there is a certain concurrence of producer and consumer interests in moderately high oil prices. Naturally, the oil-exporting countries want to sell all that they produce at a high sustained price. But they may accept somewhat lower prices for the sake of averting market fluctuations and substitutes for oil. And the importing countries also need price stability, as well as prices high enough to encourage the conservation of oil use and the development of alternative fuels.

To be sure, if the IOA were to set an exorbitant selling price, the regime would break down. Conversely, if the IOA offered too low a price, suppliers would cease cooperating. The adequate margin between the IOA's selling price and buying price would be learned by experimentation (what economists call tatonnement), with a view to preserving for all parties the benefits of stabilized oil markets.

These arrangements would do more than just directly avert an oil-generated inflationary spiral and associated economic slump. In some future crisis, they may help to avoid some hated effects and hard-to-en-force emergency devices: gas-pump waiting lines, gas and oil rationing, a general price freeze, severely reduced speed limits, and restrictions on heating and air conditioning. They would also avoid windfall profits to our oil companies, excessive dependence on imports of oil, and ecologically adverse use of domestic oil sources. And they would prevent the manipulation of foreign supply by an antagonistic cartel, aggressive dictator, or terrorists bent on using oil to obtain power.

In July the ministers of twenty-five principal producing and consuming countries initiated a promising dialogue on ways to regulate and stabilize the oil market. Only the U.S. took a negative stand.

If an international oil agency seems too radical a departure, an intermediate step might be a more vigorous international buffer-stock program. Such an effort could cope with short-term economic fluctuations as well as physical shortages in the oil market. But it would go well beyond the mere "coordination" of nationally held reserves currently left to the IEA. Such a modest advance might evolve into a genuine agency of collective security that would help to control the powers of the oil oligopolists, minimize the vulnerability of oil-importing nations, develop other sources of energy, and move toward broader ecological goals.

Of course, these arrangements run counter to the philosophy of laissez faire and movement toward deregulation. However, in the aftermath of the junk-bond collapse and savings-and-loan fiasco, amidst tottering insurance companies and the continuing problems of health care, urban infrastructure, and the endangered physical environment, laissez faire and deregulation have lost appeal. So, too, in oil, we must face up to the large problems for which positive collective action is the better cure.

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