Global Policy Forum

By Dinkar Ayilavarapu

Saddam Hussein has to go. When the United States says so, it takes a fool to bet against it. Wasn't former Panamanian leader Manuel Noriega taken care of similarly years ago, and that was when no oil was involved. Now how does one expect Saddam to survive when there are billions of petrodollars at stake?

On the surface, it's about weapons of mass destruction. Scrape the surface, it's the oil. Dig a little deeper and then you confront the prime reason for the next Gulf War. For too long America has lived with the Organization of Petroleum Exporting Countries (OPEC) and its artificial quotas of production leading to artificially high prices of oil.

September 11 provided the pretext to get rid of the cartel by bringing the second largest reserves of oil buried under the sands of Iraq into the open market. Getting rid of Saddam is just incidental (or collateral damage) in the war of the US against OPEC and its ringleader, Saudi Arabia.

The OPEC mechanism

Formed in 1960 at Baghdad, OPEC now comprises 11 major oil-exporting countries (Venezuela, Algeria, Nigeria, Libya, Saudi Arabia, Qatar, United Arab Emirates, Kuwait, Iraq, Iran and Indonesia). Officially, "OPEC seeks to ensure the stabilization of oil prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations, due regard being given at all times to the interests of oil-producing nations and to the necessity of securing a steady income for them; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on their capital to those investing in the petroleum industry."

On the ground, this has meant that a cartel of oil producers has kept international oil prices high. Each country is allocated quotas of production, which is just right to keep the prices of oil internationally stable and reasonably high.

So when prices are low, the members cut their production to boost the oil price and, in all fairness to the cartel, when the prices are high they boost production to bring them down, as they did in the 1991 Gulf War (but then who wants to act smart with around 250,000 Marines in the backyard).

Higher oil prices obviously harm oil consumers. What is not known is that higher oil prices may benefit the producers in the short run, but in the longer term they harm them. In the 1970s, OPEC twice jacked up the price of oil drastically, pushing the world into recession and thus reducing oil consumption for a longer period. Keeping prices high is like killing the goose laying the golden eggs, for its meat.

Phillip Ellis of the Boston Consulting Group has studied oil markets for a long time. According to him, oil prices internationally exist in two bands - the peace band of US$22-$28, and the war band of around $50. But conventional economics of demand and supply tell us the oil price should be around $17-$18 per barrel and falling.

OPEC follows a price-defense strategy to keep the price of international crude substantially above the $18 mark. This has led to very poor capacity additions in the OPEC member states, and in the case of the big ones, like Saudi Arabia, large under-utilized capacities. Also, since the 1970s, the world has started looking for and buying oil from elsewhere, which has sharply reduced OPEC's share of both world oil production and trade. Higher prices have helped OPEC countries to reap profits, but at the cost of market share, which, as most strategy professors would say, is suicidal.

OPEC has a phenomenal ability to fire blanks. This is because not all members have equal reserves, and hence the quotas aren't equal. Thus cuts in production aren't uniform, hurting some countries more than others. This non-uniform sharing of pain has led the smaller members of the cartel to cheat on their quotas. Students of game theory would be aware that in most cartels the dominant strategy for the players is to cheat, and the dominant strategy equilibrium established is very stable.

But paradoxically, the equilibrium attained by not cheating is highly unstable. John Mitchell, an energy analyst at Britain's Royal Institute of International Affairs, believes OPEC collusion can't be sustained, simply because the ratio of production to reserves varies greatly among OPEC members, so the incentive to increase output rather than stabilize it varies greatly. So for the smaller fry like Algeria, Nigeria and Libya (who also happen to be habitual cheaters) it makes much more sense to produce more than their quotas to exploit the high prices; but if the bigger producers do the same, the prices crash. So it's the little players who benefit while the large ones like Saudi Arabia suffer. The good thing for the Saudis is that they produce so much oil that they don't feel much pain.

The other hot topic that divides OPEC is the price the cartel should set. Here, Saudi Arabia would prefer $20, but the smaller producers like Venezuela prefer the price higher at $30. So usually the price set is a compromise between the parties, making none happy, and inducing further cheating by the smaller players. Perhaps the biggest beneficiaries of OPEC-driven prices are the non-OPEC producers of oil. Since the 1970s the oil market has changed drastically. The third largest non-OPEC producer of oil is Mexico, which has nothing to do with OPEC, and in the 1990s the Russians entered the business as well.

OPEC has kept its production constant (or increased it slowly), while world demand has risen rapidly. High prices of oil have attracted new investment into the business to feed the ever-growing demand for oil. OPEC keeps its production stable and doesn't welcome new investment, and hence all this money flows into hitherto non-conventional sources, such as Siberia, Chad, Angola, the Caspian Sea basin, Mexico and elsewhere. Deutsche Bank estimates that by the year 2004 world oil production would outstrip demand by as much as 1 million barrels a day. Sheik Ahmed Zaki Yamani, the former Saudi oil minister and the architect of the 1973 oil embargo, now doing oil consulting from London, says that in the normal course oil prices would drop to $10 by 2004, which OPEC wouldn't be too happy to see.

High oil prices have enriched the non-OPEC players, like Mexico, Norway, Angola and Russia, while the relative prosperity of the OPEC states has crashed (Saudi per capita income has fallen from $24,000 in the golden days of the 1970s to about $7,000 now). As newer oil flows in from outside OPEC, prices reduce steadily and the OPEC mechanism threatens to become self-defeating.

America's strategy

Since the two OPEC-induced oil shocks in the 1970s and the consequent recession of the 1970s and the early 1980s, America started to focus on getting oil from non-OPEC states to Western markets. This has undoubtedly been a successful operation as the OPEC share of world oil has shrunk from a peak of about 90 percent in the 1970s to 39 percent (OPEC claims is 41 percent) in 2001. But however low the share of OPEC oil may be, the cartel still controls anywhere between 65 to 77 percent (depending on whose estimates you trust) of the world crude reserves, and about 55 percent of the world's traded oil is still from OPEC. In the long run, it's the cartel that holds all the aces.

After the demise of the Soviet Union, America had the opportunity to exploit the huge Russian reserves that came onto the open market. In the 1990s all of America's efforts have been focused on getting non-OPEC oil into the market, so they have gone about building bridges with the Russians, repairing those with the Mexicans and even trying to get rid of Hugo Chavez in Venezuela. The strategy has been reasonably successful, as borne out by the fact that only 7 percent of American crude now comes from Saudi Arabia, which is less than the 8 percent it gets from Mexico and comparable to the 7 percent coming from Norway. But still, America's OPEC exposure is about 25 percent of the 20 million barrels a day that it requires.

This strategy has had its pitfalls. High oil prices have brought fresh investments into oil exploration and drilling in new non-Middle East and non-OPEC regions. But these are the regions which aren't traditionally friendly for exploration. Mexican waters are very deep, the Caspian Sea basin is very turbulent, most of Siberia is frozen, Central Asia is impossible to reach due to unstable neighbors, Chad is inhospitable, and Angola just ended a civil war.

Setting up big drilling stations and building huge pipelines through these places is fraught with risk, which drives the prices of oil from these places up. In addition, the Middle East is one of the richest sources of oil. Every barrel of Middle Eastern oil costs only $1 for exploration, while a single barrel from elsewhere can cost anywhere between $10-$12. Sound economics have driven the Americans into finding a Middle Eastern solution to the OPEC "problem".

America in Gulf War II aims to remove Saddam, and it wants to bring into the world market Iraqi oil, while at the same time demolishing the OPEC mechanism for keeping oil prices high. After Saudi Arabia, Iraq has the highest oil reserves in the world. For the past 10 years this has been out of reach of most of the world. Iraq produces anywhere between zero to 2 million barrels a day, depending on Saddam Hussein's mood and the status of his spat with the United Nations. This has not only acted as a spoiler for OPEC's pricing mechanism (which discounts Iraqi production despite it being an OPEC member), but has also produced the kind of uncertainty in world oil prices that doesn't benefit America. The American plan is to install a friendly government in Iraq with which they can do business.

Under this arrangement, a post-Saddam Iraqi regime would either drop out of OPEC (with American prodding) or ask for a long quota holiday under the pretext of rebuilding the nation. This would unleash a flow of Iraqi oil onto the world market, pushing prices down. In such a situation, either Saudi Arabia would have to risk insignificance in the oil trade, or boost its own production.

With prices down, the oil proceeds of the kingdom would drop drastically. Saudi Arabia can make $60 billion a year, either by producing 7 million barrels a day at $30 or 10 million barrels a day at $17. The odds are that they would go for 10 million barrels, which is full capacity. This would again push the price down, and keep it there. Effectively, OPEC quotas would be defunct and world oil prices would be determined by demand and supply economics. The problem here is that the two parties worst affected by this - Saudi Arabia and Russia (which has made the most by exporting oil when OPEC has kept prices high) - don't like it. And hence their opposition.

The strategy failing or misfiring would have horrible consequences for the American economy. A quagmire in Iraq, or widening of the conflict, or Saudi non-cooperation, would push oil prices up, which a teetering American economy might not be able to take. Peter Hoopers, the chief US economist at Deutsche Bank, estimates that a $1 increase in oil prices costs US customers $2 billion per annum. The consulting firm Economy.com Inc estimates that a $5 increase in oil prices hurts the profitability of non-energy and non-finance US companies by 2 percent. Oil prices have already gone up beyond $30 (up 45 percent), which, according to Daniel Yergin of Cambridge Energy Research Associates (CERA), includes a $3-$5 "fear premium" per barrel due to the war clouds in the Middle East. This before even the first shot has even been fired.

The Americans are making plans to reduce oil price turbulence due to war. The US and Britain have been working through the UN to squeeze Iraqi production down to 780,000 barrels a day; so in the event of war not much Iraqi oil would be missed. They have built up 584 million barrels of oil in their strategic reserves, which is equal to 120 days of OPEC imports.

Europe and Japan have traditionally been more energy efficient than the Americans and would escape severe damage. But here again, according to Toshinori Ito of UBS Warburg, reserves of about 170 days of consumption have been built up by Japan. About 1.2 billion barrels of oil reside in the strategic reserves of the rest of the world. Saudi Arabia has promised to boost production to make up for any shortfall in the war, and even Russia is producing at full capacity of 3 million barrels a day.