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Finance & Development, March 1982
Article

Review article: Oil and the world economy—a different perspective

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1982
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Ferdinand E. Banks

The Political Economy of Oil

Lexington Books, Lexington, MA, U.S.A., 1980, xiv + 241 pp., $25.95. Nazli Choucri

International Energy Futures:

Prices, Power, and Payments

The MIT Press, Cambridge, MA, U.S.A., 1981, x + 247 pp., $27.50. Paul Hallwood and Stuart Sinclair

Oil, Debt and Development: OPEC in the Third World

Allen & Unwin, Inc., Winchester, MA, U.S.A., 1981, xii + 203 pp., $29.95.

Salah El Serafy

These three recent additions to the growing literature on energy economics show the seriousness that now characterizes the treatment of a subject that has been aptly described by Professor Banks as one of the three most important topics in economics today. (The other two topics are population and nonfuel mineral resources, about which he is less optimistic than energy.)

All three books, in my view, are worthy of being brought to the notice of the readers of Finance & Development, and I propose to review them from a perspective which may be unfamiliar, but which, I believe, will throw light on this vexing subject.

Briefly, Bank’s book is the most analytical of the three, written with exuberance and humor, and economists will derive from it the most benefit. It is essentially a teaching book, using energy as a background for the economics. Miss Choucri, being a professor of political science, succeeds in illustrating in her work how energy economics and politics influence the distribution of world power. Her book is weakest, however, in the economic relationships that underpin her model, and there the reader will be puzzled by the unsure use of economic concepts, notably the elasticity concept. Lastly, Hallwood and Sinclair’s book brings together a useful collection of data (though on the whole predating 1979) on the recent predicament of the developing countries, but it is marred by a weak analytical framework, a strong bias against the Organization of Petroleum Exporting Countries (OPEC), and a reluctance to use the wealth of data so patiently marshalled to reach a balanced synthesis.

For roughly a quarter of a century following the end of World War II, the world experienced unprecedented prosperity in which both the developed and developing countries shared. General price rises were moderate, exchange rates relatively stable, and employment, particularly in the industrial countries, was steadily expanding. This felicitous constellation of economic phenomena was shattered in the early 1970s, and the course of global economic progress has since been difficult and uneven. Inflation and unemployment appear to have become endemic. Considerable imbalances have developed in the external payments of many countries, and a widespread slowdown in economic activity appears to have taken root. The developing economies have been particularly adversely affected by depressed export markets and higher import prices, the latter most notably for petroleum and to a lesser extent for manufactures, food, and services. Aid to the developing countries is less readily available and their foreign debt and its service have soared.

One of the major controversies of our time has centered on the role of the oil price explosions of 1973–74 and 1979–80 in creating the difficulties outlined above, and on the influence of OPEC on these prices. In this article, while commenting on the books under review, I shall argue that oil prices had to rise to reflect oil’s growing scarcity; that the oil exporters, as a group, are poor and less developed countries which need to develop; and, finally, that the rises in petroleum prices could only have been a minor factor behind the widespread economic difficulties of the present.

The growth of world economic activity in the 1950s and 1960s, particularly in the Western market economies, was associated with growing demand for energy, which rose annually by roughly 5-6 per cent. Helped during that period by discoveries of large petroleum deposits in the Middle East, consumption of petroleum, stimulated by attractive relative and declining real prices, grew much faster than that of total energy, and it gradually displaced coal as the leading fuel in the industrial world. By the early 1970s, after a decade of growth of oil demand reaching nearly 8 per cent per annum, petroleum accounted for three quarters of the total energy consumption of the Organization for Economic Cooperation and Development (OECD), and industrial society had become intricately organized around the availability of cheap petroleum.

However, toward the end of the 1960s the world annual consumption of petroleum was beginning to exceed additions to reserves through new discoveries. Yet the oil industry, then dominated by the multinational oil corporations, resisted the price increases that would have checked the growth in demand. OPEC, which had been formed in 1960, had no teeth as a pressure group and could not match in bargaining power or technical knowledge the coherence and authority of the oil companies’ oligopoly.

The latter, often operating under short-term concessions, tended to accelerate extraction, but as the host countries later gained ascendancy their longer-term concerns began increasingly to be reflected into policies for conservation. One may venture the speculation that had oil been traded in a more freely competitive market, with better knowledge available to participants than was then current, the change that occurred in the global supply/demand balance from the late 1960s onward might have resulted in a gradual rise in prices and averted the trauma of price explosions that took place in the 1970s. An eventual adjustment to the projected increase of energy scarcity, however, would still have been necessary.

The 1973 oil embargo by some of the Arab countries, which was not and could not have been instituted by the large and disparate OPEC, introduced a political edge into market analysis which has been difficult to eliminate. Popular perception in petroleum-consuming countries has persistently been that the higher prices prevailing for oil since 1973 are simply the product of a cartel. This has adversely affected the emergence of a body of objective economic analysis of the world oil situation, badly needed to serve as a basis for essential adjustments.

Is OPEC a cartel?

Is OPEC a cartel? The question is posed by Hallwood and Sinclair and answered in a statement that typically conveys the tone of their book:

“In the strict form described by the standard economic theory of cartels, it is not. However, we will continue to describe OPEC as a cartel, if for no other reason than everybody else calls it a cartel.” (P. 50)

Not only do Hallwood and Sinclair continue to call OPEC a cartel (defined in the dictionary as a combination of independent enterprises designed to limit competition) but also under the heading “The Welfare Effect of Cartelization” they proceed to demonstrate with the help of Marshallian offer curves the obvious proposition that higher prices benefit the sellers at the expense of the buyers (pp. 51–54).

Miss Choucri, however, shows no doubt at all that OPEC is a cartel, the “breaking up” of which would result in lower prices. Her book describes a simulation model purporting to be a “new, more realistic view of international oil trade” based on an exchange of interests between the oil-exporting countries seeking revenue, the oil importers whose balances of payments and national security are drastically affected by the price of oil, and the oil companies pursuing profits and managing the industry. She holds firmly to the view, for long advocated by the petroleum specialists at the Massachusetts Institute of Technology (MIT), that price should equal marginal cost or else the market is not competitive. “The cost of petroleum production in the Middle East,” Miss Choucri writes, “has always been far below price, even before the 1973 increases, and even then supply and demand did not govern world prices” (p. 3). Such a difference between price and cost in this view consists mainly of a “tax” imposed by the oil exporters and a “markup” representing the margin earned by the oil companies. In considering alternative scenarios for the future of the industry a “breakup of OPEC” signifies to Choucri a cut in the tax rate and a drop in the oil price (Chapter 12).

It was precisely this erroneous approach—namely that oil may be produced, whereas it can only be extracted, and that its “production” cost should determine its price—that led some analysts to predict the collapse of prices when competitive conditions were eventually restored. According to this view, OPEC is a monopoly that exploits the dependence of the oil buyers on a commodity with no viable commercial substitutes in the short run, and a breakup of the cartel would solve the petroleum problem and render unnecessary any other adjustment. Not only have past predictions of price collapse made by some eminent economists and oil specialists proved wrong, a fact which Professor Banks repeats in his book with obvious relish, but such views may have also contributed to confusion and delays in forming and implementing essential policy changes to reduce oil consumption and to encourage the development of substitutes. It should have been clear that the direct cost of oil extraction can no more determine the price of oil than the cost of liquidating an asset can determine its price.

Exhaustible resources

Ever since Hotelling published his classic article on “The Economics of Exhaustible Resources” 50 years ago, economists have been aware that if a resource gets depleted as a result of extraction, its price should rise over time to reflect its growing scarcity. Until substitutes have been developed for it, the cost of extraction can be no guide to price, but the utility to its users can. Consumers are prepared to pay quite a high price for a handy and clean source of energy like oil, limited only by the cost and availability of alternative products yielding comparable utility. Thus the prices of oil in both the long and short terms are necessarily limited by the prices of its substitutes, with the difference between the latter prices and the cost of extraction accruing to the sellers as a rent for scarcity. Eventually, we may be certain, substitutes will be found for petroleum as a fuel, though it is likely that this will take time and require considerable resources, and it is also likely that petroleum will nonetheless remain a valuable raw material for the chemical industry.

Assuming we are able to predict the price at which a substitute for oil will be forthcoming in adequate quantities at a future date, the present oil price will be indicated by discounting such a future price at an appropriate interest rate. If, however, no viable substitute is foreseen sufficiently soon, the buyers will bid the price up, and the sellers, conscious of the diminishing supply, will have to choose between leaving the oil in the ground to appreciate as its scarcity grows or extracting it now in order to invest its value at the current interest rates. Over time, therefore, and barring the development of substitutes, we would expect the price of oil even under competitive conditions to rise to allow the scarcity rent contained in it to increase exponentially at the current interest rate. Where competition among the sellers is lessened, for instance, by large market shares of individual suppliers, we would expect the prices charged during this transitional period to be higher still as the scarcity rent would be equal to the excess of marginal revenue over the marginal cost of extraction. The rise in price would discourage demand and keep it equal to the dwindling supply, until eventually demand had shrunk to the ultimate single barrel that remained and the stock of oil is exhausted. Long before that, however, as every petroleum consumer must hope, this process will be arrested by the arrival of substitutes at reasonable prices.

Professor Banks has, with the use of the concept of “economic rate of recovery”, argued that even while oil is still plentiful in a given reservoir, economic reasons (on top of technical ones related to field pressure and other factors) impel the oil vendors to reduce the rate of extraction once a critical “reserve to production ratio” had been reached. He does not, in my view, succeed in explaining the economic reasons behind such a reduction in supply or why, once the critical level is reached, extraction should decline asymptotically at a constant rate. He seems aware, however, of the inadequacy of his elaboration of this key concept in his book and, in the final chapter, he still promises his readers that he “will show below” the economic reasons why “no more than a fraction of a given oil field’s reserves should be removed in any given year” (p. 209). Unfortunately, he runs out of space before he does so.

OPEC and prices

With the relatively low demand elasticities facing individual sellers in the crude oil market, especially in the short run, and with the aid of the hypothesis of backward rising supply curves (at least in some cases), we need not search for collusion or group monopoly power to explain why the oil suppliers would prefer higher prices and lower extraction rates to lower prices and expanded supplies. This is particularly so when we realize that the so-called capital surplus oil exporters lack productive investment outlets for their sales proceeds and when faced with uncertainty about these investments would rather leave the oil undisturbed underground to be used by their future generations.

It is worth noting that OPEC has never imposed sales quotas on its members. Constitutionally all OPEC decisions must be unanimous; and though it has been in the habit of meeting periodically to declare higher prices, it has frequently followed rather than led the spot market. This spot market has been small and therefore volatile, often reflecting conditions of panic-buying and may therefore have given the wrong signals to OPEC. Fundamentally, however, OPEC has attempted to fix only the price of the Saudi marker crude, whereas considerable and unregulated differentials have tended to prevail for the various other crudes, reflecting among other factors differences in location and quality. Besides, as more recent events have shown, the interests of the various members of the group are not necessarily identical. Saudi Arabia, in particular, on account of its vast petroleum reserves, has emphasized the need to moderate price rises in order to slow down the development of substitute energy supplies in the industrial countries. For me, the key to price determination lies essentially in the individual extraction policies of the oil exporters, and the breakup of OPEC, pace Miss Choucri, in my view, would have little effect on either sales or prices.

Terms of trade

Another interesting aspect of the oil question that receives attention in these books is the impact of the higher prices on world income, prices, and trade. The improved terms of trade of the oil exporters meant great transfers of purchasing power from the buyers to the sellers. The actual gains accruing to the oil sellers, whether members of OPEC or not (and it should be noted that half the crude oil extracted outside the centrally planned economies is not OPEC oil), were much less than the losses incurred by the consumers whether importers or domestic users. As oil supplies were not readily expandable, oil price rises had the effect of setting into motion substantial advances in the prices of other energy sources. With the general rise in energy prices, the energy users suddenly found much of their capital stock and residential and transport equipment had become obsolete in varying degrees, having been built to designs better suited to cheap energy.

It was therefore tempting to those who found the adjustment intolerable to believe that oil prices were being artificially raised by a cartel, that the cartel was bound to disintegrate, and that the whole energy problem would go away as prices eventually collapsed. Since energy affects the more advanced economies in complex ways, energy prices have assumed the dimensions of a major macroeconomic variable. Rather than raising energy prices, many consuming countries found it politically expedient, at least initially, to follow energy pricing policies that have contributed to high consumption and pursued macroeconomic policies that have contributed to inflation. More recently, high interest rates and other monetary and fiscal measures have depressed aggregate effective demand and reduced the demand for energy. Higher real energy prices are finally reaching the ultimate energy users, inducing further conservation and spurring the search for oil substitutes.

Developing countries

The impact of higher petroleum prices on developing countries has varied greatly. A number of these possess some petroleum deposits, and a few are net exporters. As in the case of the United Kingdom, with its virtual self-sufficiency in energy, many of the petroleum surplus developing countries have found that they still can face economic difficulty and balance of payments deficits. The subgroup of developing countries that has faced the largest increases in its petroleum import bills is one whose development has been most spectacular during the 1960s and early 1970s: countries like Brazil, South Korea, Turkey, and Yugoslavia, particularly those that had resorted to open-market policies and integrated their economies into the world trading system. Also seriously affected have been the poorer African and Asian countries that drew little benefit from the offsetting, or partly offsetting, flows of aid from, and trade with, the OPEC countries. Among the developing countries that have benefited greatly from such flows are the countries of the South Asian subcontinent, practically all countries in the Middle East, and several others in Africa and the Far East.

To focus only on the oil import bill of developing countries, ignoring the gains from trade that has expanded as a result of the oil boom and the enormous workers’ remittances and other service exports to OPEC, is inadequate. Hallwood and Sinclair devote much of their Chapter 6, entitled “OPEC Aid,” to showing the impact of various levels of oil prices on the oil import bills of a number of developing countries, taking into account the aid received by them from OPEC but not workers’ remittances or their merchandise and service exports to OPEC.

The plight of the smaller and poorer countries as a result of their worsened terms of trade (on account not just of petroleum but also of imports of food, manufactures, and services) calls for aid. During the past few years, official development assistance from the so-called capital surplus countries within OPEC has been running at 3–4 per cent of their gross national product—roughly ten times the percentage granted by the members of the OECD’s Development Assistance Committee. And yet, as I shall argue presently, OPEC aid was even more generous than these figures indicate, since their national incomes have been grossly overestimated.

Despite the popular perception that the members of OPEC are affluent, we must remember that they include the large populations of Indonesia and Nigeria, and that the nations that appear at the head of the international tables for per capita income aggregate no more than a few million people. Per capita “income” for OPEC as a group is, in fact, little more than half the world average.

A close look at the economies of the oil exporters shows them to be poor in infrastructure, human capital, income generating assets, and natural resources other than petroleum. They are, besides, highly dependent on the outside world for a wide range of imports including technology, food, and labor. The social indicators (for literacy, infant mortality, life expectancy) even of their most affluent members are more akin to those of the medium- and low-income developing countries than of the truly richer nations of the North which are sometimes shown with lower per capita incomes. The fact is that the oil exporters draw their wealth down as they sell their oil, and the time will certainly come when they have no more oil to sell.

In his major work Value and Capital, published for the first time in 1939, Professor Sir John Hicks, a pioneer of national income analysis, warned that receipts from the sale of a wasting asset cannot all be reckoned to income, since part of these receipts must be set aside and invested in order for them to yield income that would replace the asset after it has been exhausted. In my article cited in the list of “Related reading,” I have built on this approach to calculate the income content of the proceeds from oil sales, given the life expectancy of the oil reserves and the interest at which the funds set aside are invested. For OPEC as a whole, this income content amounts to no more than one third of the oil receipts, and this would establish their per capita income at about one quarter of the world average. Should we ask this group to liquidate its principal natural resource to subsidize richer countries that may be genuinely facing liquidity problems? Much more constructively we should help them recycle their financial surpluses in profitable investments for the benefit of both the developing and developed countries, as well as their own.

Trade and debt

It is worth stressing how small the oil flows are in comparison with international trade and world income, and yet Professor Banks attributes the weakness of the U.S. dollar (at the time he was writing) primarily to the oil prices. A complete analysis of U.S. exports of goods and services to OPEC, in my view, would undermine this contention. At US$35 a barrel, the entire OPEC trade in oil is worth annually something like $300 billion and world oil trade about $500 billion. Total world merchandise trade has reached $2,000 billion a year and world income over $10,000 billion.

During the past decade the international indebtedness of the Third World has greatly expanded, so has debt service on account also of high interest rates and shorter maturities. Estimates have put the increase between 1973 and 1981 in non-oil developing countries’ long-term external debt outstanding at more than $300 billion. The same countries, particularly the relatively more affluent ones, were in addition resorting to large-scale borrowing on shorter term in the Eurodollar market to the tune of $30 billion annually toward the end of the 1970s. Should OPEC be blamed for this? Hallwood and Sinclair examined the presumed culpability of OPEC in this respect and reached a “not guilty” verdict. They observe that the largest increase in debt, accounting for nearly two thirds of the total, was accounted for by ten developing countries, namely, Argentina, Brazil, Chile, Egypt, India, Israel, Mexico, Pakistan, South Korea, and Turkey. It will be noted that quite a few of these are either net exporters of petroleum or otherwise have benefited greatly from the oil boom through expanded trade and workers’ remittances. The poorer developing countries on the whole have not been creditworthy enough to incur more indebtedness through the Eurodollar market which has tended to cater more to the needs of borrowing OPEC members and the other more fortunate developing countries.

In their varying ways all three books discussed contribute to a better understanding of an important subject that has been plagued by controversy.

Related reading

    M. A.Adelman, The World Petroleum Market (Baltimore, MD, Johns Hopkins University Press, 1972).

    LoringAllen, OPEC Oil (Cambridge, MA, Oelgeschlager, Gunn and Hain, Publishers, Inc., 1979).

    GottfriedHaberler, “Oil, Inflation, Recession and the International Monetary System,”Journal of Energy and Development (Spring1976).

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    HaroldHotelling, “The Economics of Exhaustible Resources,”Journal of Political Economy (April1931).

    D. M.G.Newbery, “Oil Prices, Cartels, and the Problem of Dynamic Inconsistency,”The Economic Journal (September1981).

    SalahEl Serafy, “Absorptive Capacity, the Demand for Revenue and the Supply of Petroleum,”Journal of Energy and Development (Autumn1981).

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    Robert M. Solow, “The Economics of Resources or the Resources of Economics,”American Economic Review (May1974).

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