A New Political Economy of Oil?

• Author: Morse, Edward L.

Today's international petroleum industry is radically different from what it was in the 1970s. Yet it remains as highly politicized as it was in the heyday of resource nationalism two decades ago, when oil occupied the attention of Western governments and the press. Those concerned about oil have dwindled in number, save for the oil exporters who recently had to bear an extraordinary burden of adjustment when petroleum prices collapsed after January 1997. Even so, petroleum issues remain significant in a wider political setting. Less than a decade ago, the United Nations, under U.S. leadership, fought a modern war over petroleum after Iraq seized Kuwait and its oil resources. More recently, the United States has been brandishing the oil weapon through its sanctions policy, conducting the very policy that it fought against a quarter of a century ago.

Since the collapse of the Soviet Union and the end of the Cold War, a new political economy of oil has been evolving. It is characterized by open access to resources not only in the Persian Gulf, where most of the world's oil is located, but elsewhere in the world as well--especially the Caspian Sea basin. This new era is also marked by dramatically improved technology and a shift from government control to government and industry cooperation. Despite the differences between oil politics today and those of yesteryear, however, there remain important continuities between the two eras. This essay will examine the foundations of this new political economy of oil and the forces that will shape a new paradigm for the next century.

THE STRUCTURE OF THE OIL INDUSTRY

Petroleum has proven to be the most versatile fuel source ever discovered, situated at the core of the modern industrial economy.(1) It is the most widely used source of energy, constituting 45 percent of all energy use in the last five years.(2) Despite competition from gas and nuclear energy, it has maintained its prominence largely because it is the only energy source that can be used across the board--in space heating, as an industrial fuel supply and as a means to generate electricity--and because it continues to be unrivaled in the transportation sector. Petroleum remains abundant, inexpensive and more readily and cheaply transported across long distances than any of its competitors.

The industry is divided into two sectors: the upstream and the downstream.(3) The upstream sector involves the marshaling of capital and technology in the search for and development of new supplies. When crude oil is perceived to be in short supply, a great deal of capital is dedicated to exploration and production, almost inevitably resulting in the development of large new oil fields. These fields have very low operating costs in comparison to the price of finding and developing them. For example, a field that costs $10 per barrel to find and develop can be operated and depleted for only $2 to $5 a barrel once the original capital requirements for platforms and other infrastructure have been met. Yet unless a mechanism is found to control this new supply, the market becomes glutted with oil and prices fall, threatening the profitability of the upstream activities that made the discovery possible. This drives out capital and eventually supply, until tightened market conditions restore prices and renew the process.

The other main sector, the downstream, refers to the refining of crude oil into a variety of different products, which are then marketed and distributed to consumers. Like the upstream, the downstream sector is highly capital-intensive. It is costly to build a refinery, but, once it exists, the refining costs are fairly low, with the main cost being the price of crude oil. In other words, once a refinery is operating, the cost of refining an additional barrel amounts to little more than the cost of the crude oil itself. Thus there is a temptation to maximize operational cash flows by driving down incremental costs.

Two cycles define the interaction between the upstream and downstream sectors. One is the process by which crude oil supplies are extracted. This happens in waves, due to the usually long lag time between the initial investments in searching for oil and the actual development of new fields. The upstream sector is affected by a second cycle, which is dependent on refiners' demand for crude. This demand, in turn, is extremely sensitive to the macroeconomic conditions in the market as a whole, based on the tight relationship between economic growth and the demand for petroleum products.

These two cycles are virtually never in sync and are subject to high levels of volatility When there is a supply glut, crude oil producers require secure outlets to buy their petroleum, just as refiners require secure sources of crude when supply is tight. The producers also seek mechanisms to manage oversupply in order to keep prices above their production costs. Similarly, in times of low demand the refiners seek mechanisms to share the market to prevent a price war, which would reduce the price of their products below the levels of operating profitability.

The instincts of various participants in the oil market--producers, refiners, companies and governments--are to take advantage of favorable changes and, when undergoing adverse adjustment, to push the burdens onto others. But dealing with the burdens of adjustment are often more politically urgent than taking advantage of market opportunities. Thus, the history of the industry is marked by the efforts of various parties to band together to share the burdens of adjustment--and to force, collectively, these burdens and costs onto others.

Historically, the main solution to the adjustment dilemma has been for producers and refiners of crude oil to merge their activities and to create well-balanced, integrated units matching crude oil production closely with refining capacity. In this manner, adjustments could be absorbed through natural industrial structures of vertical integration. Meanwhile, governments have gotten involved in several ways, especially in countries were oil production has been important. For much of this century, the United States was the major oil-producing country, and its government worked hard to prevent oversupply by limiting output and setting prices. When new upstream oil provinces were opened around the world, especially in the Middle East, their governments conspired together in 1960 to create the Organization of Petroleum Exporting Countries (OPEC). Initially, OPEC's main goal was to shift the burden of adjustment onto multinational companies and their home governments, especially the United States.(4)

THE "OLD" POLITICAL ECONOMY OF OIL--THE ORTHODOX VERSION

According to the conventional understanding of the 1970s, the main elements of the political economy of oil consisted of four factors: resource nationalism; producer control over oil prices; the use of oil as a political instrument for producing countries and as a tool for the international redistribution of wealth; and the collective response of vulnerable oil-importing countries to that threat (such as the adoption of consumer taxes on petroleum products, the building of strategic reserves and the passing of anti-boycott laws).

Resource nationalism was exemplified by the nationalization of energy supplies. Before the 1970s there were only two major incidents of successful oil nationalization--the first following the Bolshevik Revolution of 1917 in Russia and the second in 1938 in Mexico. During the 1970s, however, virtually all of the oil resources outside of North America passed from international petroleum companies to the governments of the oil producers.

Resource nationalism has had an enormous impact on the structure of the global energy economy, as the nationalization of the upstream sector of the industry served to break, once and for all, the tightly integrated structure of the international energy industry. Companies had become vertically integrated to protect themselves against the burdens of adjustment. Nationalization ended that. As a result, the politics of adjustment shifted to the international level.

A clear extension of resource nationalism was control over oil prices by the oil-exporting countries. During the heyday of resource nationalism, very few governments permitted crude oil or petroleum product prices to be determined by the free market. This was even true in the United States, the largest producer and consumer of the 1950s and 1960s. By the 1970s the international oil pricing mechanism was quite simple. The world's largest exporter, Saudi Arabia, set a price for its largest crude stream, Saudi Light oil, at the export terminal of Ras Tenura on the Persian Gulf. This became the "marker" crude. All other OPEC countries set their prices in relation to the marker, as did many non-OPEC exporters including Britain and Norway.(5)

Since the balance of power in the market was tipped toward sellers, oil prices could be raised at the discretion of governments, which, if they so desired, could increase the rents from oil exploitation and force a shift in income and wealth from the consuming countries. This set the stage for another critical element of the old political economy of oil--the use of the "oil weapon." Thanks to the overall instability of supply, oil became an instrument of foreign policy for oil-exporting countries.

The most noted use of the oil weapon was the embargo imposed on oil sales to the United States and the Netherlands for their support of Israel during the 1973 Arab-Israeli war. This action, undertaken in October 1973 by the Organization of Arab Petroleum Exporting Countries (OAPEC), was designed to punish the governments that were most partial toward Israel and to create a split within the North Atlantic Treaty Organization (NATO).

OAPEC's use of the oil weapon in 1973 had a lingering impact on the political economy of oil throughout...