How Opec's hawks turned dove - and saved the western world

The oil cartel that sparked recession in the 70s is now cast as an economic cavalry

Larry Elliott and Charlotte Denny Thursday January 9, 2003 The Guardian

Thirty years ago, the idea of Opec meeting as the world was planning war in the Middle East would have sent shivers down the spine of the markets. But at this Sunday's assembly in Vienna, the 11-member oil producers' cartel will be playing the role of John Wayne riding to the rescue of the world economy.

As oil prices last week surged well above $30 a barrel to their highest level for two years, Saudi Arabia - the world's largest oil producer - let it be known it was prepared to back an extra 2m barrels a day production for the world's energy supplies. The announcement provided immediate relief to a jittery market: prices fell by more than a dollar.

The Opec meeting has been called to discuss the Saudi plan. Opposition from the rest of the cartel could mean a smaller boost to production but, as the only producer with significant spare capacity, the Saudis hold all the important cards.

Kuwait's oil minister, Sheikh Ahmad al-Fahd al-Sabah, said yesterday an increase of between one and 1.5 million barrels per day was the most likely outcome. This would add between 4% and 7% to Opec's 23 million barrels a day production.

It's all a far cry from 1973, when the launch of the Yom Kippur war sparked an Arab boycott of the western states supporting Israel. Oil prices soared fourfold to $11, killing off the long post-war boom in the west that had seen record increases in living standards. A second price increase at the end of the 1970s and a third at the time of Iraq's invasion of Kuwait in 1990 had the same outcome - recession in the west accompanied by a period of falling oil prices.

Both Opec and the west have learned from the past three decades' destabilising shocks that a managed market makes sense for exporters and for importers. Despite the arrival on the scene of new, non-Opec producers like Russia, the members of the Opec cartel still account for 40% of world output. More to the point, the Saudis are the linchpin not just of the cartel but of the whole oil market.

"Non-Opec countries tend to run always at full capacity and so the spare capacity is almost entirely in Opec countries", said Paul Horsnell, an oil analyst at JP Morgan. "While there is a common perception that Russia in particular could somehow help, the reality is that they cannot."

Two factors account for the price of oil rising above $30 a barrel at the turn of the year. First, the drum beats of war from Washington grew louder, raising fears that early 2003 would see the long threatened US-led attack on Iraq. Secondly, a strike paralysed Venezuela's refineries, cutting off supplies from the world's fifth biggest oil exporter and the source of 13% of America's oil imports.

These factors pushed prices well above the $22-28 a barrel price band that Opec believes guarantees a decent return for producers without strangling the global economy. At the present juncture, with the US, Europe and Japan all struggling, cheap energy is regarded by economists as a crucial ingredient for recovery.

Paradoxically, the Saudis seem more concerned about the impact of a $30-plus a barrel price on the global economy than the Bush administration. If the White House ordered it, the US could draw down from its massive strategic reserves stashed away in four salt caverns in Texas and Louisiana. America's stockpile stands at an all time high of 600m barrels, enough to keep the world's biggest economy running for 60 days - even if all imports stopped overnight.

So far, Mr Bush has declined to turn on the taps - even though as a former oil man he knows how vital crude is for the American economy. The administration's own macroeconomic forecasters believe the US is robust enough to withstand a crude price of $30 a barrel - still well below its peak of the early 1980s once inflation is taken into account. Moreover, they point out that petrol prices at filling stations have increased by far less than the cost of crude would suggest.

Mr Horsnell says the White House is also wary of giving an open-ended commitment to fill the hole in the market left by the shutdown of Venezuela's oil industry, fearing that it could run down the reserves at a time when a far greater crisis is looming in the Persian Gulf.

Raiding the reserves now, before a shot has even been fired, would open the Republicans to the same charge they levelled at Bill Clinton in 2000 - that they were using a strategic economic weapon for political purposes.

The Americans, along with virtually every oil market analyst, are also assuming that a war - should it happen - will be short, sharp and decisive. A far more troubling eventuality would be Saddam Hussein not only removing Iraq's 2m barrels a day from the market but also launching successful strikes on ports in Kuwait and Saudia Arabia. Under those circumstances, analysts are convinced the price would quickly spiral.

Goldman Sachs has worked on a scenario under which oil supplies are disrupted by Iraqi attacks on Saudi and Kuwaiti fields, which would send the price to $50 a barrel and cut growth in 2004 from 2.4% to 1% in the US and from 1.9% to 1% in Euroland; but its analysts put the chance of this at only 15%.

But even a war that goes according to the Pentagon's plans may have some serious consequences for the oil market.

The dream scenario for Washington is that the ousting of Saddam Hussein is followed by the creation of its own Middle Eastern client state - which will ensure security of cheap supply of oil. By and large, this was what underwrote western prosperity in the golden decades of the 1950s and 1960s.

But cheap oil is a problem for the rest of the Middle East, particularly Saudi Arabia which, even though it is the world's lowest cost producer, needs an oil price of around $25 a barrel to generate the revenues to mollify its young and increasingly radical population.

The country has one of the world's highest birth rates, with half the people aged below 15. Every year a fresh cohort graduates into unemployment or dead end jobs in the bureaucracy, ideal recruits for Islamic fundamentalists.

The ruling Saud royal family - accutely aware that Saudi is a one-commodity economy - knows that a crash in oil prices could have disastrous political consequences at home.

This, ultimately, is the dilemma for the new generation of Opec doves. They have abondoned using oil as a political weapon, and have no intention of slapping boycotts on the US and the UK should the bombs start falling on Baghdad. But if they prove too compliant with America they may find their autocratic regimes under pressure from angry anti-west populations. Even Opec in its 1970s pomp would struggle to fix the oil price in those circumstances.