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Strategic Analysis:
A Monthly Journal of the IDSA
The Current Oil 'Crisis': Implications for India
By Shebonti Ray Dadwal
*
Introduction
Just a year ago, no one could have predicted that oil prices would treble from less than $10 a barrel in one year. But a quarter of a century after the 1973 Arab oil embargo, which threw the world oil markets in turmoil, fears of another Organisation of Petroleum Exporting Countries (OPEC) initiated oil crisis is once again looming, with crude oil prices hovering around the $30 a barrel mark, threatening the world economy with consequences ranging from a slight rise in inflation to a dangerous recession.
The reason why this sudden hike in oil prices has taken the world by surprise is because despite earlier price swings and the steady erosion of OPEC's market share and therefore prestige, the cartel has never been able to get its act together and compel its members to cooperate for the greater good of the organisation as a whole. As a result, OPEC, which was once believed to be the most powerful group in the world and a powerful arbitrator of oil prices, saw itself being written off as a spent force, no longer able to control its own member states from busting quotas set for each producer.
Now, in what seems to be an incredible feat, OPEC has not only managed to impose cutbacks on each producer, but has also managed to commit the major non-OPEC oil producers to a production cut, and, more importantly, has ensured that cheating on production was kept to a minimum.
Though this exercise brought cheer to the producers, who had seen their oil revenues and consequently their economies plunge into deficit, it was now the turn of the oil consumers, who had benefited enormously from the oil price depression, to helplessly watch their import bills rising to alarming levels.
OPEC's turnaround from an almost defunct and powerless group to a rejuvenated and powerful organisation not averse to holding the international energy market hostage for its own ends and the impact this has had on the international oil market - and especially on India, will be examined in this article.
Supply Manipulations
Whenever there is an imbalance between demand and supply there are usually two ways to sort out this imbalance–(1) To let price take care of the imbalance and (2) impose restraints on supply or demand. If there is not enough supply, the consuming countries can restrain demand by imposing price controls, and if there is not enough demand, producers can cut production. The latter is what the oil producers did over the last one year 1 .
In the earlier part of its history, the oil industry was marked by more than one attempt to manage supply, but none have met with much success, mainly because they stuck for too long to a crude price that failed to bring a long term equilibrium between supply and demand. One was the supply management system administered by the oil majors during the first 12 years of OPEC's existence (1960-72), when prices were deliberately kept under $2 per barrel. This in fact was responsible for the first oil shock of 1973 as demand soared and supply did not keep up, though the Arab governments also added a political hue to their (successful) attempt to wrest control of their oil industries from the majors. The second was the supply management system administered mostly by Saudi Arabia in OPEC during 1982-85. The kingdom single-handedly maintained an official selling price of $28 per barrel despite shrinking demand and the emergence of new sources of supplies worldwide. This inevitably led to the price of oil crashing in 1985-86. 2
The problem with identifying a price that would suit everyone is that nobody knows what that magical figure is. Some have suggested that it should be just a fraction over what the low-cost producers produce at, i.e., around $3 per barrel. But that removes a large number of high-cost producers from the scene, leaving the low-cost producers to supply the vast majority of the world's consumers and advance their depletion. Therefore, the world needs some of high-cost production and it is this figure, albeit a higher one, which will tend to set the world price. There have been some suggestions that the current equilibrium price should be somewhere between $11-18 per barrel. But though it is necessary to resort to some sort of supply management, it is the market that should play the major role in arbitrating between supply and demand, as was happening before the price collapse in 1997. 3
The First Oil Crisis
The end of World War II brought about a phenomenal increase in the demand for oil and consequently production of crude oil in the Middle East increased bringing large revenues to the producing countries. This, however, highlighted not only the importance of oil for these governments, but also emphasised the dependence of these economies on oil revenues. Along with this realisation came the resentment of the lack of control these producing countries had on their oil industries, and when the oil majors unilaterally refused to increase oil prices in 1959 and again in 1960, first the oil producers succeeded in creating OPEC, which provided them the opportunity to wrest more power from the oil majors over pricing and production and then, over time, nationalising their oil industries.I
However, it was not till the onset of the Yom Kippur War in 1973, and the successful use of oil as a political weapon that the Arabs fully realised the power they wielded through OPEC. While the outbreak of the war caused a drop of around one million barrels of oil per day (mb/d) in supplies because of the closure of pipelines from Iraq and Saudi Arabia to the eastern Mediterranean coast to minimise loss on account of possible damage to pipelines, it was Iraq which first used oil as a political tool. On October 7, 1973, it nationalised two American companies–Exxon and Mobil–as well as the Dutch affiliate of British Petroleum Company to punish Holland's "flagrantly hostile attitude, and its support for the Zionist enemy." Soon after, the decision to cut production incrementally by 5 per cent per month was taken until Israel withdrew from occupied Arab lands and the rights of the Palestinians were restored. 4
But in hindsight, it was the eventual hike in the price of oil which caused more damage to the international market and global economy than the production cuts. On October 16, OPEC decided to increase the posted prices of oil by 70 per cent after negotiations with international oil companies failed. OPEC announced that the cost of oil to the producing companies would no longer be a matter for negotiation but would be set by market prices. A week later, they announced a further hike of 130 per cent. 5
According to some analysts, the price rise was "the Arabs' essay into economic warfare", and warned that "under these conditions rapacious governments would soon find an excuse to impose fresh restrictions on production so as to recreate the state of artificial shortage which is so profitable to them..... Consumers of oil must accept the fact that OPEC has now evolved into what is probably the toughest cartel the world has ever known, with the power to restrict supplies and hold the consumer to ransom." 6
Other than the price rise and production cuts, OAPECII also imposed a "selective embargo" to punish those countries which openly helped Israel, viz., the USA and Holland. When Washington announced $2200 million in emergency military aid to Israel in October 1973, Libya, followed by Saudi Arabia, Algeria, Kuwait, Qatar, Bahrain, Dubai and Abu Dhabi decided to suspend oil exports to the US. Oman followed soon after. It was also decided that the Arab states would take full administrative control of US oil companies operating in their countries and that their (i.e., the states') holdings in these countries should be steadily increased till the US changed its pro-Israel stance. A few days later, a total oil embargo was imposed on Holland too because the Dutch government and the oil companies had been supporting Israel throughout the war. 7
Effect of the Oil Crisis
Though there is no disputing the fact that the industrialised West was affected by the oil crisis in that other than having a negative fallout on their economies and leaving a lasting impression on future economic, business and political practice, the oil embargo did not achieve the goal (either the short or long-term) which the Arabs had hoped for. While the demands regarding Palestine and Israel remained unfulfilled, the initial success of raising the oil price and the huge revenues that it created for the producers were soon offset by the cracks that appeared in OPEC's set up. And though the embargo imposed on the US remained in place till March and the Netherlands till July 1974, the Arabs soon realised that they were losing politically and economically, and lifted the embargo. However, OPEC did manage to earn a formidable reputation. In fact, the Arabs were themselves taken by surprise at the initial success of their strategy, prompting the then Kuwaiti oil minister, Abullatif Al-Hamad, to say, "You don't realise that on the 16th of October, we got as great a shock as you did. We thought we were pygmies facing giants. Suddenly we found that the giants were ordinary human beings". 8 For from what was once regarded as nothing more than a loose and toothless trading organisation, OPEC now was "transformed from just another trade association into an immensely powerful cartel–arguably the most powerful the world has ever known". 9 However, it was unable to consolidate its position and use the oil weapon effectively mainly because of the relentless growth in non-OPEC supply which has ironically been encouraged by OPEC itself thanks to the oil nationalisations and a pricing policy which justified the economic development of high cost reserves. 10
Amongst the industrialised countries, Japan was probably the hardest hit by the oil crisis. In 1972, Japan imported some 87 per cent of its oil, 80 per cent of which came from the Middle East. Since Japan had not done anything to cultivate special relations with the Arabs, it was not granted any favoured treatment, prompting its then Minister of Trade, Yasuhiro Nakasone to say that a lack of oil supplies could "Provoke a civil war in Japan such as that triggered by rice hoarding in the past" as "Oil is blood to industries in Japan." 11 In fact, the outgo of foreign exchange for its oil imports saw its reserves come down from $19 billion to $13 billion in one year, and threatened to be washed away completely in a few months.
However, it was the developing countries, which were the main victims of the oil price hike. Initially, the developing countries heralded the OAPEC decision as a new dawn in world politics, and the oil crunch took on the colours of a battle between the South versus the North. But as the Arab states made it clear that they would under no circumstances follow a dual pricing policy in favour of these countries, it was the developing world which suffered far more than the industrialised nations. For while the huge price hike forced them to pay out more for their oil imports, the cut in non-oil imports resorted to by the industrialised countries, most of whom were the developing world's biggest customers, also hurt their economies. According to a World Bank study, the increase in the oil import bill for the developing countries in 1974 was around $4,500 million. 12
When the crisis began, India, like many other developing countries which enjoyed friendly relations with the Arab states, had hoped that it would be given favourable treatment. However, OPEC expressed its inability to adopt a dual pricing system. In 1973 India's oil import bill was to the tune of around $414 million, and it was projected to go up to around $1,350 million in 1974 because of the price hike. This was around 40 per cent of its potential export earnings, and twice the amount of its existing foreign exchange reserves. The other South Asian oil importing states like Pakistan and Sri Lanka were similarly affected. 13
According to estimates made at the time, the oil revenues of the Gulf states–Saudi Arabia, Kuwait, Libya, Iran and Iraq–in 1974 quadrupled from around $13 billion in 1972 to around $52 billion. Hence the oil weapon gave the oil producers enormous access to wealth at the time as well as financial clout.
The Current "Crisis"
However, a quarter of a century after the Arab oil embargo, the world's and especially the Western countries' lingering nightmare that the petrol pumps might run dry once again seemed remote. Following in the footsteps of the Asian financial crisis in 1997-98, which saw demand for oil among the largest consumers in Asia dropping to all-time lows, and a mild winter in the Northern Hemisphere reducing chances of reducing the huge oil inventories, it was OPEC that was feeling the pinch of lack of demand for their oil supplies.
In a sense, this was a repercussion of the 1973 oil crisis. Vowing not to be caught out again, the West invested in its own oil. The major companies, sent packing by the nationalisations which swept OPEC producers, invested heavily in regions like the North Sea. New technologies were invented to slash the cost of finding crude. Power generators in nations without oil turned nuclear and then increasingly to cleaner fuels like natural gas. Consumers also became more efficient. High taxes in most parts of the industrialised world, with the exception of the US, have replaced high prices as the incentive for efficiency gains, so much so that in Europe, tax now counts for more than 80 percent of the price of gasoline. In fact, oil demand growth in the 1990s was quelled to little more than 2 per cent a year, from 7 percent annually in the 20 years before the 1973 embargo, while OPEC's 40 percent share of global production came down from two-thirds in the 1970s.
However, when the price of Brent crude dropped below $10 per barrel, the oil producers pushed the panic button. From January 1998 to March 1999, the oil producers–both OPEC and important non-OPEC producers like Mexico–met several times and began to incrementally– if not systematically–implement production cuts agreed to. They knew that a small marginal cut to the tune of around 7-10 per cent would in a few months lead to a price increase of 80-100 per cent. At first the international market was sceptical about OPEC's ability to adhere to the production cuts, given the cartel members' propensity for quota busting. Also, initially, the cuts seemed to have no effect on the huge inventories that had built up over the last two years, and prices remained low. However, gradually the price crept upwards first to around $15 per barrel, then $18/b and then in March 2000, while benchmark Brent teetered and then crossed the $30/b mark, WTI closed at $34.13, sounding alarm bells in consuming countries. 14
At first the Organisation of Economic Development & Cooperation (OECD) countries, who have managed to reduce their dependence on oil as a primary energy source, took the price hike in their stride, as the inflationary effect on their economies was modest (at 2 percentage only). But as prices kept up their unwavering ascent, the International Energy Agency (IEA) pleaded to oil producers to increase output to prevent inflation and restore depleted stocks 15 . Washington too thought it prudent to send the US Energy Secretary Bill Richardson to try and persuade the major oil producers to increase production and contain the volatility in prices. Though the Saudis and Iranians after a meeting on March 8, 2000 noted that "....the recent rising oil price levels and their continued volatility are not in the long-term interests of producers and consumers", they have not made any firm commitment to increase production even stating that market fundamentals and reality do not point to supply shortages and that in the second quarter of 2000, all parameters fail to justify increasing supply as there was a dip in demand. Many producers were of the view that the price volatility was temporary due to excess demand during winter months and were in favour of waiting till the end of the year before increasing supplies. 16
However, due mainly to us pressure a decision was taken on March 29 (after 2 days of acrimonious debate) to increase production slightly by 1.7 mbd by OPEC and another 400,000 b/d by non-OPEC countries like Norway, Mexico and Oman. This fell far short of the US urging to increase production by 2 mbd, and is designed to keep prices at a level suitable to the producers, i.e. between $20-25 a barrel.
Impact of Current Price Hike on Consumers
Thanks to the lessons learned from the 1973 oil crisis, the industrialised countries, have, consciously and systematically, reduced their dependence on oil. Whereas prior to the crisis, oil demand in the OECD countries comprised around two-thirds of total global demand, today, these same countries now consume less than a third of total world consumption. This is partly due to the strict conservation policies followed by the governments of the industrialised countries as well as the conscious research and development of alternative sources of energy, including natural gas and nuclear power, as well as unconventional sources of energy such as wind, solar and more recently, development of hydrogen as a source of energy. At the same time, though oil still continues to be an important source of energy, especially for transportation, the Western countries have turned increasingly towards non-OPEC sources of supply, such as the North Sea and Mexico as well as South America, and more recently are investing huge amounts to develop the Caspian region as well as offshore Africa as a source of oil as well as natural gas.
Hence, today, while the US continues to be the largest consumer of crude oil, it has reduced its imports from the Arab Gulf states from around 19 per cent in the early 1990s to less than 17 per cent currently. The same case applies to Japan, which previously imported 90 per cent of its oil, 80 per cent of which came from the Middle East. Today Japan only imports less than 55 per cent of oil, though this mainly comes from OPEC sources.
However, as in the 70s, it is still the developing countries, especially those belonging to the Asia-Pacific region that continue to be vulnerable to oil politics. With their economies growing at a brisk pace, notwithstanding the 1997-98 financial crisis which overtook some of the South East Asian economies, demand for energy is burgeoning in this part of the world. For instance, China, which till 1993 was a net oil exporter, now has to import around 850,000 b/d, which is expected to go up to 1.8 mbd by 2005. By 2010 China's net imports of oil (crude and refined products combined) are forecast to reach 2.8 mbd. 17
India fares no better. Projected to become one of the seven largest consumers of energy within a decade, India's indigenous oil and gas reserves are not expected to last beyond 2014-16 at current levels of consumption. Currently, India produces less than 33 million tonnes of oil compared to demand for around 96 million tonnes, calling for imports to the tune of around 64 million tonnes. India's oil import dependency has gone up from around 37 per cent in 1989-90 to around 68 per cent in 1999-2000, and with no major accretion to its domestic oil production expected, its import dependency is expected to go up to around 90 per cent by 2010. 18
Therefore, with all the developing countries of Asia becoming increasingly reliant on energy imports, and with oil constituting a large portion of those imports, any price hike is bad news, as it would have a bearing on a country's forex reserves. For India specifically, the oil import bill is projected to go up to around Rs 60,000 crores, against an earlier expected outgo of around Rs 54,000 crores. 19 This is a huge amount to pay for any single commodity.
Concerned about the current increase of around 175 per cent in oil prices and its impact on the global economy in the long term - though the inflationary impact on the OECD countries has been relatively low till now, the US government has urged the oil exporting countries to increase production and bring an end to this artificial increase in oil prices. India too has urged these countries to keep the interest of the global economy in mind and rationalise prices.
Conclusion
Therefore, can the current "crisis", which has been artificially created by the cutback in production by around 5 mbd to bail out the oil revenue dependent producers, be compared to the 1973 OPEC decision to increase prices and use oil as a weapon to pressure the US and its allies into political and economic submission?
In 1973 the world economy did reel from the use of the oil "weapon", so much so that it managed to not only disrupt the US economy (according to some analysts, it cost the US economy more than the immensely costly Vietnam war), and the more OPEC-dependent European countries, but nearly put the energy import-dependent developing economies back by a couple of decades. However, the industry has changed fundamentally since the 1970s. Though oil prices are once again at an all time high, there is no danger of a supply shortfall; in fact oil is coming into the market from every corner of the globe. Recently, an article published in Foreign Affairs scoffed at the idea of an impending oil crisis being caused by dwindling oil supplies and rising energy prices. The authors claim that though there will be a crisis, it will be caused not because of a shortage in the international market, but due to a prolonged oil surplus and low oil prices and revenues, which will have a political fall-out, including domestic instability in oil-producing states, which in turn will have repercussions on regional and world security. As proof of their prognosis, they cite that while in 1972 it was believed that by 1990, the world would run out of oil, consumption in fact went up by 50 billion barrels and according to the IEA, there are 2.3 trillion barrels of oil in ultimate recoverable reserves, and if unconventional sources such as tar sands and shale are included, the number may exceed 4 tb. 20
It is a fact that high prices encourage exploration and development, even in high-cost areas, evidence of which can be seen in the current restoration of interest in the Caspian region and offshore West Africa. At the same time, this diversification of oil sources act as an insurance policy against supply disruptions. Also, the growing role of natural gas in the overall energy mix provides a further buffer. Information technology has also allowed the industry to search for oil and even make a profit at $15 per barrel, which is about half the threshold price for exploration activities just a decade ago.
At the same time, governments in general are having increasing trouble keeping up with new global competition and the pace of technological change. The traditional boundaries of the nation state are being eroded by the lowering of trade barriers, the increase in foreign investment and the rapid integration of capital markets that is being driven by the communication revolution. Today, governments have less say over what happens in their domestic economies. Neither are the oil companies seen as extensions of their governments, serving national objectives. One of the lasting lessons of the oil crisis is the way in which markets can, given flexibility, sort out seemingly intractable problems.
Today, though the oil producing states have (once again) succeeded in manipulating production to increase prices, it is unlikely that they will be able to sustain a unified stand in maintaining production cuts. Even as early as 1976, some of the Arab countries had realised that their economies were inextricably linked to the world economy. At the OPEC conference in Doha the same year, the Saudi government's refusal to increase prices stemmed from the realisation that the health of the OPEC economies was linked to that of the Western economies, and inflation caused by oil prices would rebound on them. 21 Today, with the Arab states even more dependent on their oil revenues, they literally cannot afford to play political games when their economies are in such dire need of capital.
Finally, in 1973, the world was unprepared to deal with the Arab decision to use oil as a weapon. That is no longer the case and the 1973 crisis spawned a number of contingency plans, including maintaining strategic reserves, which would negate any attempt to use the "weapon" effectively. Hence it can be assumed that the present cutback is directed at no more than reducing the surplus inventory, as OECD stocks of oil and oil products were about 10 per cent higher at the start of 1999 than they were three years ago, when prices were $20 per barrel. Once excess stocks are reduced and the emergency which required the cuts will be over, the current supply management system will become increasingly less necessary.
However, for developing countries like India, who over the years, will become major oil consumers, and becoming increasingly dependent on imports for their energy, any price fluctuation can have a negative impact on their budgets and their economy as a whole. In an oil price shock like those witnessed in 1973, 1981 and 1991 India would be vulnerable to the heavy drain of foreign exchange and consequent macro-economic instability.
Till very recently, India did not have an energy security policy or contingency plans to fall back on in crisis situations. Neither is it a member of any organisation like the IEA, which was born in the aftermath of the 1973 crisis to protect members from any future disruptions in the energy market. With India's hydrocarbon demand growing at a rate of 6 per cent per annum and its reserves showing no signs of picking up, it needs to formulate a policy whereby not only its short-term but also its long-term energy needs are secured. A tentative step has been taken recently with the recent launch of the "Hydrocarbon Vision 2020" programme, which is aimed at securing the country's energy requirements over the next two decades. With the country's hydrocarbon reserves showing signs of rapid depletion, the government introduced the New Exploration Licensing Policy (NELP) in 1997 in an effort to promote investment in the exploration and production of domestic oil and gas and boost indigenous reserves. Though the initial response of international companies to bidding for exploration blocks under NELP were modest, it is expected to pick up along with the rise in price of oil. Other obstacles to foreign investment also need to be looked into, such as the continuation of the administered price mechanism (APM), limited pipeline infrastructure, and controls on private companies' rights to market transport fuels. Continuing subsidies on petroleum products like diesel and kerosene result not only in wide distortions in consumer prices but also lead to over-consumption, which in turn increases demand.
Like the OECD countries, developing countries also need to develop their non-hydrocarbon sources of energy, such as hydro and nuclear power, as well as develop alternative non-conventional sources of energy such as solar and wind power, to reduce hydrocarbon imports. However, this can only happen in the medium to long term. Therefore in the short-term, these countries will continue to be dependent on hydrocarbons for their energy requirements. However, there is a growing gap between supply and demand in the region which necessitates that energy security cooperation be put on the policy agenda of these countries. And the prospect of settlement of the gap may depend on the success of multilateral cooperation. Cooperation in energy security issues becomes more important for developing Asian countries in the light of the fact that unlike industrialised countries, which have adequate foreign capital, resources and the mechanism to use sophisticated technology, to enhance their energy security, Asian countries have neither the financial resources or the unifying institutions to deal with energy security issues. 22 However, the proximity of the Asian countries to each other and the need to share the same energy sources requires joint and cooperative consultation, especially in areas of infrastructure and technology development, the effect on the environment as a result of rapid industrialisation and regional security. Confidence building measures among the Asian countries is a prerequisite for the creation of technology-oriented alternatives for solving the enormous energy problems the entire region will have in future.
Endnotes
Note *: Research Officer, IDSA. Back.
Note 1: Middle East Economic Survey, April 5, 1999 Back.
Note 3: Middle East Economic Survey, April 5, 1999 Back.
Note 4: S. Manoharan, The Oil Crisis: End of an Era, (New Delhi: S.Chand & Co. (P) Ltd, 1974). Back.
Note 5: Daniel Yergin, The Prize: The Epic Quest for Oil, Money and Power, (London: Simon & Schuster, 1993). Back.
Note 7: Ibid. Also see Manoharan, n. 4. Back.
Note 8: Andrew M Sheriff, "Oil and the Middle East- An Investigation of the Arab Oil Weapon", Political & Economic Review, (University of Limerick), 1998. Back.
Note 10: Oxford Energy Forum, October 1999. Back.
Note 11: Manoharan, See n. 4. Back.
Note 14: Middle East Economic Survey, March 13, 2000 Back.
Note 15: Middle East Economic Survey, February 28, 2000 Back.
Note 17: Middle East Economic Survey, January 25, 1999 Back.
Note 18: The Hindu, February 23, 2000 Back.
Note 19: Business Standard, February 23, 2000 Back.
Note 20: Amy Myers Jaffe & Robert A Manning, "The Shocks of a World of Cheap Oil", Foreign Policy, January/February 2000. Back.
Note 21: Peter Bild, "Oil in the Middle East and North Africa", The Middle East and North Africa, (London: Europa Publications Limited, 1993). Back.
Note 22: Jasjit Singh, "Building Interdependence in South Asia: Politico-Security Risk and Opportunities of Transnational Oil/Gas Pipelines", IDSA-ICRIER Project on Challenges to Peace, Prosperity & Security in South Asia: Indian Perspectives, July 1998. Back.