Hudson Institute Economic Update

This was originally posted to the email list for interesting-people.org.

IRWIN M. STELZER 21 June 2004


When markets talk, politicians would do well to listen. The oil markets are doing more than mere talking -- they are shouting for the attention of policymakers who seem determined not to listen.

First, we have the recent run-up in crude oil prices, which fluctuate around $40 per barrel. That rise was in part due to the fabulous growth of the U.S. and Chinese economies, which sent demand for oil soaring. But a further driver is OPEC's manipulation of the market, creating a situation in which rising demand cannot elicit the increased supplies that would flow in a competitive market.

Lesson number one for policymakers: it is no longer prudent to ignore the OPEC cartel, or to rely on it for mercy. Trust busters have had time to worry about less important price conspiracies -- the commissions charged for selling old master paintings is less likely to affect the economy than is a conspiracy to fix oil prices -- but have shied away from attacking the OPEC cartel. Now would seem to be the time for the voice of the Antitrust Division to be heard above that of the State Department, ever-eager to avoid a diplomatic row with the house of Saud.

The markets are also saying something about the state of the gasoline market. The margin between crude oil prices and gasoline prices has doubled in the United States, driving refining profits up several hundred percent. Yet, refining capacity has not increased. Oil industry executives with whom I have spoken say that environmental and other permitting restrictions make it virtually impossible to build new refineries. Lesson number two for policymakers: restrictions that were appropriate when crude oil was selling for $10 per barrel and gasoline for $1 per gallon are not economically sensible at current price levels. Revise them to allow more refineries to be built.

These are important messages from the market. But not as important as the persistence of the so-called risk premium of between $5 and $10 per barrel that seems to be built into crude oil prices. Part of that premium is a response to the continued disruption of supplies from important producers. Terrorists in Iraq periodically sabotage that nation's pipelines. Unrest and violence in Nigeria, Africa's largest producer, make that country an unreliable source of oil. Islamic terrorism casts doubt about the reliability of supplies from Kazakhstan.

Add self-inflicted wounds by important producers. Russia, which rivals Saudi Arabia as the world's largest producer, Vladimir Putin and his old KGB buddies have frightened foreign investors by jailing the country's richest oil baron, Mikhail Khodorkovsky. Venezuela's Castro-loving president, Hugo Chávez, has replaced the nation's skilled oil industry managers with political appointees, causing a loss of 500,000 barrels per day of production from that important supplier of the low-sulfur oil most suitable for use in U.S. refineries. Iran's mullahs have stifled the foreign investment that Iran's oil industry so desperately needs.

But even these multiple threats to a steady flow of oil pale by comparison with developments in Saudi Arabia. The Kingdom sits on 25% of the world's known reserves, but that figure understates its importance. The Saudis can tap their reserves for over 80 years without slowing output. And it is well known that the Saudis haven't really attempted to explore for new reservoirs because they already know precisely where some 260 billion barrels are located. "You don't plant potatoes when you have a cellar full of spuds," a grizzled denizen of America's "oil patch" once told me. Not only are the Saudis sitting on the largest known reserves, and on the cheapest, most easily discovered as-yet "unknown reserves," they are also the only country in a position to increase production quickly should some other supplier be knocked out of action.

But Saudi Arabia is no longer the stable rock in a turbulent Middle East sea. The terrorists funded by the Saudis have turned on their benefactors, and are killing foreigners to cause a flight of oil-industry and other trained personnel. They are winning because they seem immune to capture, because many top Saudis insist that it is the Zionists, rather than Al Qaeda, that are causing the mayhem, and because hundreds of thousands of unemployed youths see no future for them so long as the royal family siphons off the nation's wealth to support its opulent lifestyle.

Whatever the reason, it is far from certain that the corrupt geriatrics who run the country will be able to head off the threat to the Saudi industry's ability to produce a steady flow of oil. True, the production facilities are well protected, but by troops of uncertain loyalty. And pipelines are difficult to protect, as are port facilities.

Final lesson for policymakers: prepare for the day when bin Laden and associates are in a position to topple the Saudi regime and withhold supplies of oil, causing a major economic trauma in industrialized countries and a humanitarian catastrophe in the undeveloped world. That means continuing to build strategic reserves, but much more. Alternative sources of energy for transportation uses cannot be available in the relevant time frame, if ever; places such as Alaska take a long while to develop, and anyhow don't have enough oil to matter; renewables such as solar and wind power are not replacements for gasoline; conservation can be useful when prices rise gradually, giving consumers time to adjust to higher prices, but not when there is a price explosion.

I was asked many years ago at a gathering of government and industry experts to lay out an energy policy for America, to cope with a supply interruption. Two words: "aircraft carriers." That remains true today. Iraq is not a war for oil. The next U.S. intervention in the Middle East may well be.


A version of this Update appeared in The Sunday Times (London)

Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.