New producers, consumers, issues rapidly changing supply picture

PETROLEUM IN THE NEXT CENTURY-2

Kjell Roland
ECON Centre for Economic Analysis
Oslo

The belief in the early 1970s that the health of the economies of member countries of the Organization for Economic Cooperation and Development (OECD) would depend on the mercy of OPEC began weakening in the mid-1970s.

The boycott of Israel, the U.S., and the Netherlands by oil exporters in the Gulf subsequent to the Yom Kippur war in 1973 had moved oil to the center of western power politics. Escalation of Muslim fundamentalism in the region and the downfall of the Shah of Iran, the West's closest ally, kept attention on security of supplies of oil. In the U.S. and other OECD countries, consumption of oil was projected to increase, while production from domestic sources and "friendly" producers was on the decline. Nobody doubted that net imports were increasing.

The question was: where would the oil come from? The fear was that the West increasingly would have to rely on supplies of oil from a region hostile to its values and culture, and unstable because of domestic and regional political tensions.

The perception that the West was doomed to be overly reliant on the Middle East is explained by the regional distribution of reserves. From 1965 to the end of the 1980s, the share of global oil reserves in the Middle East varied between 55% and 60%. In the 1990s, the share has shifted upwards to 65-67 % (Fig. 1 [51,155 bytes]).

Yet despite the continuing dominance of Middle East reserves and the continuing instability in the region, no longer does the West (or the East) appear to be preoccupied with the security of supply issue now that Iraq has been neutralized.

The non-OPEC miracle

One reason why dependence on OPEC oil is less prominent as a political concern in the West today, is that far more oil has been discovered and is being produced in countries outside OPEC and the Former Soviet Union (FSU) than was expected. Production in the rest of the world (ROW) has been increasing steadily over the past 3 decades, on the average of 600,000 b/d per year (Fig. 2 [47,030 bytes]). As share of world production, oil from ROW increased substantially, starting in 1975, from 32% to 49% in 1985. Since then, the share has stayed around 47%.

Past projections of ROW production were too low while price expections were too high. ROW production was consistently expected to peak within a few years and then decline. History proved otherwise.

Our inability to project production for the ROW is perfectly illustrated by official Norwegian projections of North Sea production, which have been systematically biased on the low side (Fig. 3 [47,699 bytes]). The success of exploration and development has far outpaced expectations both in new petroleum provinces like the North Sea and existing producing countries like China, the U.S., and Mexico (Fig. 4 [37,948 bytes]).

Competitive, transparent markets

A third reason why security of supplies is seen as less of a problem today than in the 1970s and first part of the 1980s, is the fact that world crude and product markets today are better structured to fend off disturbances in the physical supplies of oil. In the 1970s, most oil traded internationally was moved along physical supply chains owned by the former seven sisters [Standard Oil Co. New Jersey (Exxon), Royal Dutch Shell, British Petroleum Co. Ltd. (BP), Mobil Oil Corp., Standard Oil Co. of California (Chevron), Texaco Inc., and Gulf Oil Corp.] and a few other major oil companies.

Interruptions in upstream activities in one part of the world would in those days end up as curtailment of supplies to particular customers at the end of a chain of supplies.

Today, interruptions of supplies affect prices globally, but do not end up as curtailment of supplies to particular customers. Liquid, transparent, and well-functioning markets for crude oil, as well as most products, decouple the physical and the financial risks of interruptions. Global markets have put all of the consuming nations on a more equal footing and they all face the risk of a financial burden due to temporally high prices.

Price hikes, taxes

Who gained from the price hikes of the 1970s?

OPEC's position in terms of resources and production of course raise the issue of cartel power. Many fear that heavy reliance on OPEC oil may tempt Persian Gulf producers to raise prices by curtailing production. The lesson learned from the price hikes in the 1970s is that they did not actually serve the interests of the big oil exporters. In the longer term, governments in consuming countries proved to be the big winners.

This is apparent when studying the change in revenues from a barrel of oil after the last decades (Fig. 5 [35,909 bytes]). While the producing end of the system (company plus host government) in 1980 received US$60, this was reduced 15 years later to only US$17. On the other hand, governments in consuming nations increased their take from US$15 to US$26. Thus, today governments in importing nations earn more than double what governments in oil-exporting nations earn per barrel produced and consumed.

Increases in taxes in particular seem to accelerate in periods where the price of oil is on the decline, like 1986-87. More-detailed studies suggest that volatility in prices in itself is bad for the exporters due to the existence of a ratchet effect. When oil prices increase, the blame is on OPEC. When they decline, consuming nations soon increase taxes to "stabilize" the price to consumers. Consumers do not react with the same hostility to increased taxes when the price at the gas station is stable or declining. From OPEC (and Norway's) point of view, history proves that the initial sweet taste of high prices may easily turn sour as time goes by.

Mid East supplies

To summarize, dependence on OPEC oil has proved to be less of a problem than foreseen in the 1970s and 1980s. Even if reliance on the Middle East is still an issue in Washington, it attracts far less attention today. Several reasons explain why.

Over the past couple of decades, what we learned was not only that the West was dependent on continuous supplies of oil from the Middle East, but also that the countries in this region were overly dependent on exporting oil to the West.

Also, we learned that high prices set in motion very strong forces in the market place. At prices above US$25/bbl, demand for conventional crude oil tapers off. Consumers switch to other sources of energy wherever possible. On the supply side, oil from tar sands in places like Canada and heavy oils in the Orinoco belt in Venezuela become profitable on a large scale at high prices. Similarly, middle distillates could profitably be produced from natural gas or even from coal. Thus, even if the Middle East producers would like to take advantage of their substantial production capacity to raise prices, there are limits to how far they could move, and they may easily hurt themselves in the medium-to-long term.

The preceding arguments assume the rational responses by decision makers who maximize revenues. An entirely different matter is the fact that the Middle East is likely to remain highly unstable. Revolutions, wars, and political turmoil in the region are prone to affect the oil market. If or when stability is challenged in the region, oil prices are likely to be affected in the short-to-medium term. Thus, security of supplies may still turn out to be important in energy policy.

New logic for security

The geopolitics of oil may change in the future when the center of gravity in international economics shifts to the Asia-Pacific region. Security of supplies has in the past been related to the OECD, in particular to U.S. import dependence (Fig. 6 [45,107 bytes]). To address the nation's strategic dependence on imported oil, the U.S. at different times developed strong ties to one or more of the big Middle East oil producers. Billions of dollars have been, and are still being, spent on armaments and personnel to support this policy.

In the future, we may see similar strategies pursued for similar reasons, but most likely with other means from countries in Southeast Asia. China, as an example, is expected to rapidly develop a hefty import dependence in the oil market (Fig. 7 [45,859 bytes]).

Production in China is stagnant, and consumption has for the past 5 years been increasing by 8% annually. If China sees its national interests at stake, one should not doubt that the country is able and willing to undertake whatever action thought to be necessary. Thus, the perception of security of supplies may very well resurface as an important energy policy issue, but involving new actors and geopolitical interests.

The means likely to be used to pursue these policies would include mutually beneficial deals between the countries involved. China does not command the military force that would allow it to engage in direct military actions in the Gulf. However, it may be willing to export-or rather barter-modern armaments. In addition to armaments, nuclear technology could make such an alliance very attractive to several of the regional or would-be regional powers in the Gulf.

Multinationals as neo-colonialists

By 1970, prospects for the eight Western majors [(Standard Oil Co. New Jersey (Exxon), Royal Dutch Shell, British Petroleum Co. Ltd. (BP), Mobil Oil Corp., Standard Oil Co. of California (Chevron), Texaco Inc., Gulf Oil Corp., and Cie. Francaise des Petroles (Total)] looked troubled. Indeed. Gadaffi's rise to power in Libya the year before was definitely a harbinger of things to come. Supplying 25% of Western Europe's oil imports, Gadaffi started out with a strong bargaining position. He used it. One year after coming to power, he forced Occidental Petroleum, totally dependent on Libyan oil for its downstream markets, to accept income taxes on oil and significant production reductions.

This move had an important demonstration impact. It set off a domino effect in terms of changed power relations between OPEC and western oil majors. This culminated in the quadrupling of oil prices at the outbreak of the Israeli-Arab War in October 1973.

Even if the longer-term financial burden of high oil prices was largely pushed forward to oil-importing countries, the oil majors were never again to resume the leading role in the global political economy of oil.

This display of the importance of the countries in the Middle East had ramifications far beyond the oil industry. At the time of OPEC's standoff with the oil majors, political aspirations born out of decolonization were already being translated into demands from countries all over the developing world for economic independence.

They had won political independence, but remained humbly dependent on former colonial powers and multinational corporations (MNCs) for economic power (Fig. 8 [62,320 bytes]).

Blends of nationalism and socialism went well together to form a dominating strategy for new and vulnerable nation states. The OPEC "earthquake" demonstrated a promising way to translate abstract "dependency theory" into practice. Encouraged by and aiming to capitalize on OPEC's unprecedented achievement, poor-country governments adopted various blends of approaches in open defiance against established rules of the game: from total decoupling from the world economy in the most extreme cases, to the more moderate but still radical (and, in hindsight often self-defeating) strategies of self reliance, import substitution, and widespread nationalization in strategic economic sectors.

In this upsurge of economic radicalism, MNCs were the main culprits. They came out as spiders in the web of dependence that threatened to strangle lofty political aspirations in quagmires of economic misery. The oil majors had set bad precendents, in this way of thinking, but others were following suit. Examples such as ITT's flagrant violation of Chilean political integrity in the early 1970s served to focus the image poor countries had of immoral and cynical multinationals. In more general terms, to quote a representative textbook criticism of MNCs:

"In sum, argue critics, multinational corporations create a distorted and undesirable form of growth. Multinational corporations often create highly developed enclaves which do not contribute to the development of the larger economy. These enclaves use capital-intensive technology which employs few local citizens; acquire supplies from abroad, not locally; use transfer prices and technology agreements to avoid taxes; and send earnings back home. In welfare terms, the benefits of the enclave accrue to the home country and to a small part of the host population allied with the corporation." (Spero, 1981).

Whatever the mix of reasons, a robust image was created throughout the 1970s and into the 1980s of multinational companies as socially irresponsible and largely detrimental to the interests of developing country economies.

The wave of nationalizations and other policies that constrained MNC scope of action mattered as much to oil companies as to any other multinational corporation.

The number of oil groups affected by these third world policies was also increasing, as internationalization rapidly emerged as a serious business option for national companies such as Statoil.

It is striking, therefore, to note the contrast between this negative image and the present scramble by third world governments for the attention of prospective investment by multinational companies. The change is no less than a complete U-turn, which has been made over less than a decade. This negative image changed over the past 15 years, and today falls into the category of fallacies of the past.

To the extent the interface of MNCs with developing country governments is criticized today, it is not the investment or investment performance that is in focus, but the fact that many are hesitant to invest in the poorer parts of the developing world.

Note, for instance, the presentation of the United Nations Commission for Trade & Developments' 1997 Trade and Development (Financial Times 15.9.97): "Poor suffer because rich fail to invest." United Nations Commission For Trade and Development, long the stronghold of OPEC-type challenges to multinational corporations, has changed its key mission into that of assessing how developing countries best can be integrated in and benefit from economic and financial globalization.

Even communist countries like China are today inviting majority bids from multinational companies into key strategic infrastructure investments, and use the volume of Foreign Direct Investment (FDI), largely by MNCs, as a key economic success indicator. The level of development aid and FDI is shown in Fig. 9 [48,962 bytes].

A number of factors serve to explain the U-turn in third world attitude towards MNCs and foreign direct investment:

Mexico's default on its mounting burden of foreign debt in 1982 set off a debt crisis with severe consequences for developing countries throughout the 1980s. In the harsh policy climate that was shaped by the debt crisis, any hope of collective third world action against anybody, dissipated. It proved impossible to copy OPEC, and cracks were already growing wide in the OPEC wall.

Also, the majority of developing countries were, and are, net oil importers, and thus came out as major victims of OPEC's price hike strategy.

Throughout the 1980s, mounting debt burdens and related hardships led large parts of Africa and Latin America into a deep and sustained economic crisis. Many experienced a vicious cycle of rising debt payments and decreasing inflow of capital.

Private banks had had their fingers burned and virtually stopped lending to debt-ridden countries. In such a situation, to continue keeping foreign investment at bay was a dubious luxury only North Korea and Cuba could afford. The debt crisis literally forced upon poor countries a radically changed attitude to multinational companies.

Finally, the end of the cold war around 1990 and the ensuing victory of "market economics" over "socialism" or "planned economies" served to stamp out what was left of support for anti-MNC policies in developing countries. No superpower existed any longer to legitimize such attitudes. In less than 2 decades, MNCs went from pariah status to that of potential saviors.

All this is not to say that MNCs will not run into difficult investment situations in developing countries. Shell's experience in Nigeria, Total's controversial entry into Iran, and Unocal's troubles in Burma are but a few of recent controversies specifically involving oil companies.

A major difference, though, is that it is no longer developing country governments, but Western Non-governmental organizations and sometimes Western governments (e.g., the U.S.) that place conditions on MNC involvement in particular countries.

With continuing oil industry internationalization, environmental, social, and political demands on global petroleum investments are bound to intensify. Such demands, however, take place squarely within the paradigm of market-oriented development and growth. The notion of multinational companies as vehicles of neo-colonialism is definitely a fallacy of the past.

Editor's note

This is the second article in a six-part series that began last week (OGJ, Feb. 23, p. 56). Please see that issue for details on the scope of this series and on the report from which these articles are drawn.

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