Sheikh Ahmed Zaki Yamani, Saudi Arabian Minister of Oil
Landon Lecture
March 28, 1983
Control and Decontrol in the Oil Market
The pattern of economic life which exists today in the world outside centrally planned economies can rarely be described as "a purely free system." I come from a country which staunchly believes in the principles of free trade and the pursuit of private enterprise. These principles are not transplanted into my community, but rather deeply embedded in our Islamic tradition and precepts which regard the human initiative as a fundamental will of God. In the words of the Quran:
"He hath subordinated land to your labour, so disperse in its wide alleys and eat from what He bestowed upon you."
Similarly, this is a country which is a firm believer in the free system, both for itself and for others. The free system has always functioned with admirable success and efficiency to the benefit of people everywhere.
It is not a coincidence that I come at this moment to speak before this distinguished audience about certain aspects of energy. Our two countries not only share common principles of economic life, but are also among the largest world producers of energy, the utilization of which has been subordinated to certain swift variations with damaging consequences. At times these changes have favored the interests of the oil producers, whereas those of the consumers were damaged. At others, the interests of the producers were damaged while those of the consumers were served. When a supply shortfall existed, prices were pushed to extremely high levels leaving the consumers with a high bill to pay for imported oil. Conversely when demand fell, prices tended to slide downwards, depriving the exporting countries of vital earnings essential for their development plans. In both instances, the price of oil tended to hurt a single party at a time. These oscillations may underscore the contention that the reason for the damage is the absence of a correct judging system under which the price would be set at an equilibrium of supply and demand. The fact that demand has risen and fallen sharply over the last twelve years is evidence enough that, most of the time, the price has overshot the equilibrium level in both directions.
Let us examine some historical events in retrospect and see whether this contention is valid. During the 1950s and 1960s the price of oil was kept at a low level. During this period it remained almost unchanged in nominal terms, which meant that its value depreciated in real terms. This was accomplished only because of the control exercised on production and distribution of this commodity by a group of international oil companies. Such suppression prevented the price of oil from finding its true market level as warranted by the upward movement of all other relevant indicators such as demand, output, energy productivity, prices, labor wages, and incomes.
When the pricing power was restored to the owners of the oil resources, the price, which at one time seemed to have stabilized in the mid-seventies, once again overshot its true value in the early eighties. At that time the indicators, although not readily visible to analysts, were pointing in the opposite direction, namely declining demand, receding output, falling inflation, and stagnant real wages. Nonetheless, the price continued to rise. Market signals failed to reach the price setters, and pressure suddenly mounted to reduce prices massively.
What further complicated the situation is the role played by stock manipulation. It is commonplace now to reiterate the well-known argument that oil stocks management had swerved 360 degrees in the fulfillment of its objectives. Instead of building up stocks when supply was abundant at cheap prices, the managers replenished their stocks to the brim during supply shortfalls and higher prices. Instead of drawing down stocks at periods of high demand and high prices, they are drawing them down when demand and prices have fallen. Should we deduce from those past events then that control was a failure, and that the oil market should be left entirely free for inherent forces to guide the price towards equilibrium for the benefit of the world community? In fact there is a school of thought which advocates this kind of approach. Let us try to investigate this approach and see for ourselves what would be the outcome of its application. In trying to portray a reasonable scenario, our assumptions should also be reasonable and consistent. First it should be remembered that if a purely laissez faire system is assumed for the oil market, such laissez faire must be assumed to apply to other energy sources, international trade, and all other relevant variables. This is essential if a meaningful evaluation is to be made. Under this background let us assume that the oil market is left entirely free from any kind of control, and that its price fell to $15 per barrel. Then the following chain of events may conceivably take place in the short term:
(A) At $15 per barrel for the marker crude, the price of fuel oil could drop to $10 per barrel, undercutting American coal GIF the Atlantic Seaboard by about $5 per barrel. Coal demand and eventually U.S. coal production would fall by about 2 million barrels per day of oil equivalent as end users in the electricity generation industry shift back to fuel oil.
(B) Costly U.S. stripper wells, as well as new production, may drop by another 1 million barrels per day.
(C) North Sea oil production, whose cost is about $15 per barrel on the average, is bound to decline by a further 1 million barrels per day.
(D) Coal imports to West Europe and Japan, whose cost is in the range of $19 per barrel of oil equivalent, may be entirely halted, shifting the resulting energy gap in favor of oil to the tune of 1 million barrels per day of oil equivalent.
In sum, demand for OPEC oil will soon rise by an amount of 5 million barrels per day.
The long-term effects may be summarized as follows:
(A) A pronounced decline in exploration and development of new oil fields.
(B) A pronounced reduction in gas supplies.
(C) A slowdown in the erection of new nuclear plants.
In the financial sector, oil-producing countries, especially those with substantial foreign debts, may withhold their debt repayments or even declare insolvency. Surplus countries now in need of more funds may resort to the withdrawal of their reserves held in Western banks. Those banks and other financial institutions, finding themselves squeezed between massive deposit withdrawals by one group of developing countries and failure in debt repayments by another, are bound to collapse. International trade will also suffer as developing countries' ability to import goods from the industrialized countries is greatly weakened. In fact most of the decline witnessed in international trade during 1982 came as a result of negative growth in oil trade.
Should low prices be sustained for a few years, a new demand for oil will be generated from increased economic activity as a result of the rebound in the world economy which now appears on the horizon. New demand, which may come on top of that which has been shifted from non-OPEC sources, may in a few years gather momentum and bring pressure to bear on the price once again, pulling it to new high levels, and the world may witness the emergence of a new cycle of volatile oil prices. In brief, history will repeat itself. Consequently our scenario for freely determined market prices obviously has not brought about the desired solution. But if previous efforts to control the market have failed, and if a free market mechanism is also bound to fail, then what is it that will not fail? In answering this question, it should be remembered that oil is not an ordinary commodity like tea or coffee. It is a strategic commodity. If it is not guided properly it is bound to create many difficulties of a non-economic nature. This element in itself is reason enough to create a feeling of anxiety that renders its price extremely sensitive to supply security considerations; hence its extreme volatility. In dealing with oil, the market mechanism can provide the best criteria to determine its value provided the element of volatility is catered to. Volatility tends always to obscure the real value of oil as signaled by market forces. This blurring phenomenon explains why control measures in the past 10 years did not bring forth the right pricing decisions. Their failure, however, is not proof that the concept of control itself is inadequate. Nor is it the result of the failure of the free market system itself. Failure lies in the misinterpretation by the controlling body of the proper market signals relevant to the equilibrium price when they occur. The free market is extremely essential as a reference for indicating the true price. The existence of a controlling body is also necessary for setting out the right price as signaled by the market. It must also be assigned with the additional function of moderating volatility and psychological vagaries, which inherently permeate the market, particularly the spot market. Oil is too important a commodity to be left to the vagaries of the spot or futures market, or any other type of speculative endeavor. OPEC, despite its short-comings, is still the best body to assume the role of price setter. Mistakes were committed in the past, but they will serve as a lesson in the future.
When I talk about control, I do not mean cartelization. Control even under the freest of market systems is resorted to frequently as a moderating tool of certain wild market forces. Recent history of economic life abounds in examples of administrative intervention in the market at all levels. High interest rates, that were introduced more than two years ago, did not come about as a direct consequence of demand and supply of capital funds. They were determined by a governing body as a potent instrument of combating inflation. Inflation is an economic malaise which comes to the surface when the rate of price increases surpasses that of goods and services. If the excess is moderate, it is acceptable, but it turns into a contagion when the excess is great or runs out of control. Inflation can occur during stagnation and also after the stage of full employment is reached. Inflation, like oil price volatility, is one of those things which do not conform to the model of a free-market mechanism. The only means of combating it lies in control by a public authority. Unfortunately, in the case of inflation control, the cost to the community can be enormous, particularly if the trade-off is employment and prosperity. In the energy sector, another form of intervention may be relevant. When demand for oil and energy was diagnosed in certain communities as excessively high, a misallocation of resources was spotted by the energy planners. The market price alone, even at its high levels, was not in itself enough to point out the long term scarcity of oil resources. Moderating factors designed to reduce demand were therefore introduced outside the free-market system. Rules and regulations were enacted for setting out certain standards for energy consuming machines and space accommodations, in spite of the consumers' choice. The resulting saving in consumption was a great success, but again the trade-off was further unemployment and lower production rates. That was due to the time lags resulting from the slow transition of affected industries in their restructuring activities designed to accommodate the new measures. We in Saudi Arabia have suffered a great deal at periods of high demand as well as at those of low demand in terms of revenue, while trying to apply policies reasonably based on market realities. Recent developments could perhaps persuade many oil producers to adopt such policies. OPEC is now seeking price determination polices whose objective is to set the price on an equilibrium course, that should, of course, be dynamic, and then to protect this level in a manner which balances supply and demand, thus furthering the cause of stability.