The Politics of Oil at $35 Jude Wanniski September 13, 2000

In Tuesday’s WSJournal, there is a page two story from Vienna, “At OPEC, Some Say There’s Enough Oil,” which quotes Iraq’s oil minister, Amer Mohammad Rasheed, an OPEC member who opposed the decision to raise production by 800,000 barrels a day. He said Saudi Arabia caved in due to pressure from the United States because of the “silly American election.” The Journal reporters went on to note: “Among OPEC members, Iraq, which produces three million barrels of oil a day, can’t be discounted. Were Iraq to halt its exports for any reason, Saudi Arabia and the handful of other OPEC nations that have spare capacity most likely could not make up the difference. Mr. Rasheed noted that the world can’t do without Iraqi oil.”

It was not exactly coincidence that Secretary of State Madeline Albright yesterday said there would be no use of force in getting Saddam Hussein to comply with the latest UN demands for on-site inspections. It was early September four years ago, remember, when President Clinton kicked off his re-election campaign by bombing Iraq, for no good reason except to remind the electorate that he was commander-in-chief and Saddam was a bad guy. Even then, the price of oil quickly jumped to $25 from $22, although Iraq was producing much less than 3 million barrels daily and there was plenty of surplus world oil capacity. In the intervening years, the UN has permitted Iraq to produce more and use the funds to rebuild its infrastructure so it now could be producing 3 million barrels a day. Because Iraq did not have control over the money received for the sale of its oil, only a specific amount, it had no incentive to slow production when oil was in its steep decline. It simply produced more and more oil in order to hit its permitted dollar amount. It thus contributed to oil’s slide to $10 a barrel.

With North America and Europe heading into winter and oil already at $35, another “October surprise” by the Clinton/Gore administration is most unlikely. Because Saudi Arabia is now for all practical purposes at its productive capacity, Iraq is suddenly the swing producer and everyone knows it. Saddam Hussein could tighten the spigots just a little and oil would climb to $40. He has no incentive to help Al Gore win in November by maximizing production, because the Iraqi government still is getting only a small slice of the receipts from oil sales. Baghdad does, though, have the power to reduce output, to prevent the world oil price from declining.

In the same WSJ story, Robert Priddle, executive director of the Paris-based International Energy Agency (IEA), charged OPEC with “mismanaging markets and creating volatility,” by increasing production in small steps when the world needs a lot more oil. We advised two years ago that the Independent Petroleum Association of America insisted the IEA, which the major oil companies use to track global capacity, had an error of 3 million barrels in its surplus numbers. IPAA’s then-President, George Yates of New Mexico, 16 months ago got an audience with President Clinton, Vice President Gore, Treasury Secretary Bob Rubin and Deputy Treasury Secretary Larry Summers. With oil then at $12, he warned of the IEA error, the problems associated with Iraq’s disincentives, and the mind set of the industry, which had halted investment in productive capacity. He recalls showing the group a chart indicating a rise in price to more than $35 a barrel if nothing were done to alter the forces of increasing demand and declining supply. Rubin simply looked at the chart, smiled and noted how happy the oil folks would be when that happened. In other words, Yates was not taken seriously.

This was the same chill I got in April 1997, when I could not persuade my friends in politics or journalism that the Federal Reserve -- as evidenced by the sharp decline in the price of gold -- unwittingly was causing a monetary deflation that would cause a sharp decline in oil and commodity prices. Erskine Bowles, who was then White House chief-of-staff, asked me to meet with Summers at Treasury. I made my case, was treated politely, but was told that the decline in the gold price was nothing to worry about. Fed Chairman Alan Greenspan agreed, as did the WSJournal and other supply-siders. There is still a great reluctance to acknowledge this underlying cause of the problem the world faces today, which is unfortunate because it short-circuits any discussion that might lead to a solution. As gasoline and fuel-oil prices rise, especially if the next two months are unusually cool, there would be plenty of opportunity to debate the issues in the presidential campaign. More likely, the Democrats will blame the oil industry and its agents, George W. Bush and Dick Cheney, for the mess the world is in.

How long will the mess last? There are optimists on Wall Street who believe there are signs that production now is outstripping consumption and inventories already are building up, on land and at sea. Fred Leuffer of Bear Stearns has been the best of the Wall Street oil analysts in seeing the oil-price decline after the Asian crisis broke in July 1997 and was the most bullish on oil in predicting a rise to $27/bbl. He’s now seeing $20 oil in the not-too-distant future because of the inventory overhang. George Yates, who has been seeing possibilities of oil going to $40 and above, thinks it will be a few years before the oil industry will be comfortable enough to invest in exploration and productive capacity sufficient to provide the world with a safe cushion. If the winter ahead is a cold one, the price increases will be painful, he believes.

 Leuffer, who did not see the monetary beginnings of the problem, may not see the monetary endings. When a deflation occurs, producers who had borrowed dollars against anticipated dollar income, at first react to the decline in price by producing more, not less. The gold price declined by only a third in 1997 as the Fed starved the U.S. economy of liquidity, but oil’s price halved. Producers who normally would react to a sharp rise in prices by adding to capacity, like the Saudis, have had to use all their revenues to pay down debts they took on when their product was at the bottom. When they finally are pulling in more receipts than they need, they then will add to productive capacity in tapping known reserves, but they also can calculate that at $275 gold, oil eventually will settle out at Leuffer’s figure of $20 or so. Some of the downward pressure on oil, of course, is the effect the high price has on economic growth and the demand for oil. Yates points out that you can build a cushion by adding it explicitly, or by having a recession. Natural gas, which not long ago was at $1.50/mcf, is now at $5.30. Some of that has been because of the supply/demand for fuel oil’s BTUs. Much has been the result of the clout of the environmentalists in the Clinton/Gore administration, which close off promising federal lands from exploration. That problem won’t go away if there is a Gore administration as Gore’s mania over global warming compounds that problem. If Bush is to succeed, he will have to tackle this head on, making it the focal point of at least one of his debates with the Vice President.