The Price, and Politics, of Oil

When the U.S.-UK-Australia coalition found that Iraq’s technicians had refused to torch their oil fields or damage pumping stations, buyers looked forward to falling crude prices. But analysts who had predicted that the liberation of Iraq would quickly increase the volume of crude oil coming onto world markets received a bit of a shock.

First, the OPEC cartel agreed to cut output by about two million barrels per day, or at least seemed to.

Then, technicians discovered that Iraq’s oil fields have been more starved of investment than anyone had thought, and that the looting of everything from the buses needed to get workers to the remote fields, to tools and equipment, will slow efforts to restore production to the two-million-barrel-per-day level of the pre-liberation days.

Equally annoying, the UN Security Council refuses to end its oil-for-food program by dropping its sanctions, no surprise since the 2.5 percent over-ride it gets on all sales is used to feed the 3,000-person bureaucracy that administers the program, and Russia and France want to control the awarding of reconstruction contracts.

That places a legal cloud over the title to Iraq’s oil, with the right to sell it claimed by the coalition; the UN; Mohammed Mohsen al-Zubaidi, an exile returned to Iraq to proclaim himself governor of Baghdad; and the several Shiite clerics who are using the freedom won for them by the U.S. military to cry “Yankee go home” at rallies attended by the millions of their co-religionists who constitute 60 percent of the Iraqi population.

Some of these problems can be solved. The U.S. can simply ignore the UN, and start selling Iraq’s oil to fund the nation’s reconstruction and relief. Buyers who are nervous about receiving clean title to the oil can be reassured by American guarantees or some form of title insurance. Or the U.S. can simply buy the oil on its account, paying into a trust fund for the Iraqi people.           

But adding Iraqi oil to world markets might nevertheless prove to be no easy thing. When the Americans promised to create a democracy in Iraq they apparently didn’t consider the possibility that Iraq’s one hundred billion barrels of oil reserves (9+ percent of the world’s total) might end up in the hands of an anti-American Islamic regime similar to that in Iran. If the behavior of Iran (almost 9 percent of world reserves) is any guide, Iraq’s new clerics-turned-oil-moguls will be price hawks—a voice in OPEC for the low-production, high-price scenario that analysts were hoping a democratic Iraq would bring to an end.   

There is worse. In Russia (almost 5 percent of world reserves), Yukos’s acquisition of Sibneft creates a $35 billion company, the seventh largest oil group in the world, measured by market capitalization. That new behemoth is unlikely to be a price-cutting scrambler for short-term revenue. Besides, construction of the pipeline and port infrastructure needed to bring more Russian oil to market will cost some $5 billion and be completed no earlier than 2007. So don’t look to Russia for near-term price relief.

Or to Nigeria, America’s fourth largest source of imports. With opposition parties threatening disruptions to protest the apparently fraudulent reelection of president Olusegun Obasanjo, the African nation is likely to remain less than a completely reliable supplier. Venezuela, another important U.S. supplier, sits on over 7 percent of world reserves, and is controlled by a pro-Castro president who has precipitated a supply-disrupting strike by politicizing the industry’s management, and is running the fields so badly that productive capacity has fallen. Mexico shows no sign of expanding capacity by dropping its ban on foreign investment in its oil business. And petroleum inventories in the U.S. are at their lowest level in more than thirty years.

True, oil markets have recently eased a bit. Gasoline prices are down 14 cents from their mid-March peak of $1.73 per gallon, as additional crude produced by Saudi Arabia before the war reaches our shores, along with record imports of petroleum products. And the slowing of Asian growth incident to the SARS outbreak, continued recession in Germany and France, and reduced air travel everywhere are dampening demand.

So we have two conflicting signals. On the supply side, there are constraints both political and economic: unstable regimes, an active cartel that is threatening to cut back output, and shortages of infrastructure investment around the world. That should mean higher prices. But on the demand side, we have SARS, the collapse of air travel, and slow growth. That should mean lower prices.

Steve Strongin, director of commodity research at Goldman Sachs, has balanced these conflicting pulls on price and decided that crude will likely jump into the low $30s when the U.S. driving season starts in June. But when Iraq’s oil hits the market in significant quantities, a downward move to OPEC’s preferred range of $22-$28 per barrel is likely.

In the end, oil prices may depend on the willingness of OPEC to reduce current output from 26 million barrels per day to the quota level of 24.5 million barrels, and eventually to cut back even further to make room for Iraq to reenter the market. The biggest reductions will have to be taken by the Saudis.

And there’s the rub. If Bush is serious about waging war on terrorism, he will have to put pressure on the Saudis to stop funding the worldwide spread of the creed that underlies it. But the president needs the Saudis. Since he can’t persuade Congress to give him the tax cuts he has asked for, he needs a different stimulus—oil prices low enough keep consumers in the malls, auto showrooms, and real estate agents’ offices.

The ultimate irony: the elder Bush was disliked by many of the younger Bush’s ardent supporters for kow-towing to the Saudi royal family. These folks now find themselves serving a president whose reelection might depend on the favor of those very same royals. That is the price America pays for its inability to develop a policy for reducing its dependence on Saudi oil.

This column appeared in London’s Sunday Times on April 27, 2003.