Oil Shock

The fate of the Iranian nationalization, ousted Dr Mossadegh, the architect of the nationalization process, faced a death sentence from the new government following the coup of 1954 designed by the British and Americans to resolve the nationalization dispute. Second, there was concern that nationalization would break up the majors’ control of the international oil market leading to price weakness. During the 1960s the majors, through their joint control of Gulf oil supplies, had been able to manage the excess capacity to produce oil in such a way as to mute any downward pressure on prices. Thus the major operating companies such as the Iraq Petroleum Company (IPC), the Kuwait Petroleum Company (KPC), the Arabian American Oil company (Aramco) and the Iranian Consortium orchestrated crude supply to balance the global oil market. However, as new supplies developed in response to greater exploration and development by new companies, national oil companies and the majors; this put growing pressure on the ability of the majors to manage the excess capacity. As the decade of the 1960s progressed, the real price of oil continued to fall, aggravated especially by growing competition among the national oil companies selling crude. It was greatly feared that general nationalizations in the region would simply aggravate such price competition.

Their reluctance to nationalize created a fundamental problem for the governments because they were under growing domestic political pressure to expel the foreign oil companies, seen as tools of the former imperial powers. This clamour to nationalize reached its peak in June 1967 as a backlash against the humiliating defeat of the Arabs in the Six Day War in which both the USA and Britain were seen as being instrumental by the ‘Arab Street’.

In an effort to divert pressures for outright nationalizations, Shaykh Zaki Yamani, the oil minister of Saudi Arabia developed the idea of ‘participation’. This was an attempt to get the majors into alliance with the producing governments to prevent the newer oil companies undermining the price structure. This was to be done by what Sheik Yamani described as a ‘catholic marriage’ (i.e. indissoluble). Thus the producer governments would take an increasing equity share in the operating companies, eventually reaching the controlling figure of 51 per cent. And, at the same time, they would take equity in the downstream activities – refining and marketing – of the majors who owned the operating companies. During the course of the negotiations, this latter demand for downstream involvement was put to one side but the resulting negotiations produced ‘the General Agreement on Participation’ in October 1972. This gave the governments an initial 25 per cent of the operating companies rising to 51 per cent within ten years.

However, while the ‘participation’ saga was unfolding, the oil market was also changing. Two factors were key. First, the announcement and process of ‘participation’ had effectively halted investment in capacity in the Gulf by the majors in anticipation of their losing access to equity oil. Second, following lower prices plus the world economic boom associated with the ‘OECD economic miracle’, world oil demand in the early 1970s began to grow strongly. The result of these two factors was a rapid erosion of the excess capacity which had characterized the oil market in the 1950s and 1960s. This, coupled with the growing pressure by the producer governments for greater control of their oil resources outlined earlier, moved the world inexorably towards the first oil shock.

Since the introduction of posted prices in 1949, the price of oil had been an administered price set by the majors. They had jealously guarded their unilateral ability/right to manage this process. Although they could have set the prices at fairly high levels they chose to set them at the lower range of what would have been possible. This was to pre-empt competition from nuclear, greatly feared by the majors in the 1960s and to prevent their own governments from interfering too much in their operations in response to excessive profitability. The post-Second World War decades had seen plentiful cheap oil fuelling the ‘OECD economic miracle’ causing the governments to ‘leave oil to the oil companies’.

In Libya, in 1970, the new revolutionary government demanded that prices be the result of a negotiated process between themselves and the companies. Their eventual success opened the door to other governments in the region to join the negotiations operating through OPEC. The result was that the price was administered by both companies and governments in a market where supplies were tightening. In October 1973, the governments decided they no longer needed the majors’ involvement in price setting and unilaterally announced two large increases in oil price in October and again in December, effectively quadrupling the international price of oil. They were unaware or uninterested in the competitive implications for oil in world energy markets and were unconcerned about the reaction of consumer governments. This was the first oil shock.

The result was a huge revenue windfall for the region’s oil producers together with a rethinking of the role of the oil sector which will be discussed later. Initially, Saudi Arabia had been uneasy about the magnitude of the price hike but in 1975, with the accession of King Khalid, the higher price was accepted and Saudi Arabia effectively took on a swing role to protect the existing price but, at the same time, preventing it from going higher. Meanwhile, beginning with the Algerian and Iraqi nationalizations of their operating companies in 1972, the agreement on ‘participation’ began to unravel as governments demanded a greater equity share faster. Thus by 1976, with the exception of Abu Dhabi and Libya, the governments in the region had taken over the upstream oil operations. Not only did they now determine price, they also determined production levels and investment in the sector.

The Iranian oil workers’ strike which began in October 1978, followed by the Iranian revolution and the Iraq–Iran War, all conspired to create the second oil shock whereby the price of oil tripled. The whole process of the second shock was driven by panic and misunderstanding as consumer governments, notably the USA and Japan, urged their companies to secure oil supplies at any price. Feeding this was the fact that many appeared to expect an Islamic revolutionary ‘domino effect’ to bring down governments on the other side of the Persian Gulf. This added to the scramble to secure oil supplies which fed the growing upward pressures on price.

In October 1981, OPEC eventually regained control of the market with the marker crude priced at $34 per barrel. However, the consequences of the two oil shocks were now beginning to appear in the market. On the demand side, oil began to be pushed out of the global primary energy mix. On the supply side, there began a major surge in non-OPEC supply. The combination put enormous pressure on OPEC’s ability to defend the unprecedented high price as it struggled with problems of both cheating on production quotas (introduced in 1982) and overestimating the call on OPEC to make the negotiations on quota division easier. Up to 1985, Saudi Arabia was willing to absorb both cheating and error but the result was a collapse in Saudi production from over 10 million barrels per day (b/d) in 1981 to some 2.5 million b/d by the summer of 1985. At that point Saudi Arabia announced a major change in policy away from balancing the market and away from administered oil prices. The result in 1986 was a major price collapse – the third oil shock – with the price falling from the high twenties to the mid-teens in terms of dollars per barrel.

The situation was rescued by a joint understanding between Saudi Arabia and Iran developed during 1986. However, one of the dimensions of this understanding was to drop administered oil prices and instead use a mixture of spot prices of a limited number of crudes – mainly WTI, Brent and Dubai. Since these prices were determined in the marketplace and increasingly in forward and futures markets, they became increasingly volatile. Much of the subsequent history of the oil markets was the story of how OPEC struggled to defend prices, sometimes successfully, sometimes less so. However, the key was Saudi Arabia’s role as market stabilizer. This was achieved because Saudi Arabia was willing and able to carry significant levels of excess capacity. It could then use this to offset the sorts of market disruptions associated with the events of 1990–1 and the events of 2003. In effect, Saudi Arabia became the central banker to the international oil market. This was a unique role which no other producer was able to replicate.

In addition to their impact on the oil market, such events also created significant regional tensions. In particular, the availability of oil revenues was key to allowing Iraq and Iran to wage war during the decade of the 1980s. Thus others in the region had a strong vested interest to ensure some constraints upon those revenues. For example, it seems clear that Kuwait’s cheating in the late 1980s which presaged the Iraqi invasion, was aimed at weakening oil prices in an effort to weaken both protagonists. Thus OPEC deliberations were very much influenced by regional politics.

As the 1990s progressed, the oil producer governments of the region began to look again to the international oil companies for involvement in their oil sector. This was driven by two factors – the battle for capacity and a growing suspicion in some cases of the motivations of the national oil companies. Negotiations within OPEC over quota levels were strongly influenced by capacity. In particular, it was crucial that countries did not produce below their quotas for fear of losing volume in the next negotiations. In a sense, much of the crude producing capacity in the region was a legacy of the work and investment by the majors. Over time, the large fields which dominated production in the region began to tire and require not just attention but attention based upon the latest and best technology. In many cases this required involving foreign oil companies. A second motive for opening was to provide some means against which to benchmark the performance of the national oil company. This was driven by the growing suspicion that these companies were heavily involved in rent seeking, i.e. diverting resources away from the coffers of state for their own purposes. Thus countries such as Algeria, Iran, Iraq, Kuwait and even Saudi Arabia (for gas only) began programmes to secure foreign company investment in the upstream. The record of these attempts has been mixed as often the attempted opening fell foul of domestic politics.

In the future, the central role of the region in the international oil market is unlikely to diminish, at least in the next thirty years or so. Indeed, some such as the International Energy Agency see this role increasing in importance. The logic behind this view rests on the simple fact that in 2002, according to the BP Statistical Review of World Energy 2003, over 47 per cent of world exports came from the region, which also contained over 69 per cent of proven world oil reserves. It also stems from the unique role played by Saudi Arabia in trying to stabilize the oil market. Since the events of 9/11 and the invasion of Iraq in 2003, there has been much talk of the oil importers, especially the USA, finding alternatives in places as diverse as Russia, the Caspian and sub-Saharan Africa. However, the reality is that this is a virtually irrelevant quest. The oil market is truly international. What matters is not being able to get access to oil but the price of that access. If there are problems in the region and the oil price there spikes, it spikes everywhere irrespective of source.

However, at some point in the not too distant future the world will begin to want less oil as changes in technology forced by policy drivers such as the environment and supply security move the world to other fuel sources. When that process begins, the impact of oil on the region will be a function of what is left.