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Prospects for a new “oil dialogue”: An examination of the arguments

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1984
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Issues that need resolving; prospects of success

Jahangir Amuzegar

The stabilization of the world petroleum market is considered by many a desirable international objective. It is argued that oil prices are more sensitive than prices of other commodities to political, psychological, and speculative factors, and their wide fluctuations are directly harmful to a steady growth of world trade and global prosperity. It is further contended that sheltering petroleum prices from sharp and sudden changes (like the price explosions of 1973 and 1979 or the slump of 1982–83) is in the best long-term interests of both consumers and producers. According to this view, orderly price changes help (1) maximize producers’ economic benefits by giving them incentives to engage in development planning with greater assurance; and (2) protect consumers against capricious changes in their economies or costly expenditures on price-sensitive conservation measures and on alternative sources of energy.

On the basis of these contentions, some energy experts believe that a new oil crisis should not be allowed to happen through ignorance or neglect. Major oil exporters and importers should try to regulate oil price, supply, and related matters through an “oil dialogue” between, for example, the Organization of Petroleum Exporting Countries and the Organization for Economic Cooperation and Development. What are the validity and limitations of these arguments?

Dialogue: past attempts

In the aftermath of the 1973–74 oil crisis, President Giscard d’Estaing of France took the initiative to convene an international conference on energy and related issues among OPEC members, industrial countries, and non-oil developing nations—the Conference on International Economic Cooperation. But despite 18 months of deliberations and debates, CIEC produced neither a consensus nor much substantive result. Within a few months of the 1973 oil price rise, an oil “glut” emerged; that, together with a number of new developments, put an end to the urgency of any serious cooperation between major oil exporters and importers. Among these developments mention must be made of the rapid adjustment of the industrial economies to their external imbalances; the possibilities of recycling petrodollars to the deficit oil importing countries; subsequent new oil finds in the North Sea, Alaska, and Mexico; a gradual but steady decline in real oil prices; and finally the establishment of the International Energy Agency within OECD to deal with oil crisis management.

Convinced of the desirability of orderly price movements, and the necessity of collaboration with oil importers, OPEC tried to develop a long-term strategy to deal with future decisions on supply and prices. But in spite of the efforts within OPEC, including the establishment of a special committee and preparation of draft recommendations, no feasible strategy has yet emerged that has the support of all its members.

The interruption of the Iranian oil supply in 1979, and the panic after the outbreak of hostilities between Iran and Iraq in 1980, pushed spot market prices up from about $12 a barrel to over $40 within a few months. The new, much higher, structure of prices was followed, for a number of reasons, by a period of protracted worldwide unemployment, stagnant or negative growth, low industrial productivity, declining world trade, growing protectionism, currency instability, rising budget deficits, and reschedulings of debt by developing countries. There has been a new chorus of suggestions in the last two years for international cooperation on energy—including calls from France’s foreign minister, Saudi Arabia’s oil minister, and the Commonwealth Secretariat*

The new impetus for a dialogue on oil has been based on the assumption that the revival of economic activity in the United States and other industrial countries is likely to lead to a magnified growth in oil demand as a result of three facts: the recent efficiency achieved in the use of energy has reached the stage of diminishing returns; the many conservation measures adopted by consumer countries have saved energy only at the expense of other capital and labor resources; and the inability of consumers to continue to save imported oil without wasting domestic energy.

A new impetus

Given the anticipated increase in demand later in the decade, the time is considered particularly ripe for fresh attempts at oil market stabilization, for many reasons. First, the uncertainties and miscalculations involved in the oil price shocks during 1974–83 convinced many observers that national budgets, industrial and commercial fuel policies, energy investment decisions, development planning, and so on should not be left vulnerable to the changes in national moods consequent on price fluctuations. The future risks of such fluctuations are believed to be particularly high due to the growing size of the spot market. Prior to 1979, this market (which consists of short-term deals involving a tankerful of oil at a time), accounted for less than 5 percent of transactions. Now spot sales are thought to have grown to absorb more than a fifth—and possibly as much as 40 percent—of noncommunist oil trade. (British Petroleum, for example, is said to buy half of its crude in the spot market, and Saudi Arabia sells nearly 10 percent of its exports there.) Despite the recent establishment of markets in crude-oil futures in New York, Chicago, London, and Singapore, hedging possibilities are still limited, and no one can predict how much spot prices might fluctuate in a new crisis or what disproportionately larger effects those prices may exert on contract sales.

The second reason advanced to justify a new dialogue is the rare opportunity provided by the current quasi-equilibrium in the world oil market. The argument is that the world economy has now adjusted to the post-1979 oil price rises, and all parties have an interest in maintaining this equilibrium. Demand for OPEC oil may stabilize at 18–19 million barrels a day over the next year or so. At the same time, prices are expected to remain unchanged in nominal terms through 1985, and in real terms for another year or so after that—barring unforeseen events. According to this view, this relative price stability helps remove a long-standing obstacle to an eventual producer-consumer accommodation and provides an oil price level that could lay a reasonably satisfactory base for future price adjustments.

Third, there are uncertainties regarding potential new sources of supply, and there is a need for major consumers to hedge against future scarcities. The rising economic and political costs of alternative sources of energy—from cleaning high-sulfur coal and liquefying tar sands to protecting people against nuclear hazards or harnessing the sun’s rays—seem to have made the goal of energy independence in the United States and the West a distant, if not totally unrealistic, prospect. With sustained economic recovery in the industrial countries, and continued modest growth in the developing world, some energy analysts believe that toward the end of the 1980s, world oil demand may surpass installed capacity, and a new oil crunch may be in the offing—putting OPEC in a better bargaining position.

The major oil importing countries, anxious to protect the value of their massive investments in alternative sources of high-cost energy and in energy conservation devices, may find a fourth reason for seeking an accommodation with major producers. Sudden and drastic reductions in oil prices are likely to jeopardize the viability of these costly outlays—as witnessed by cancellations of several oil exploration and synthetic fuel projects in the aftermath of the 1983 oil price cuts. An arrangement to stabilize prices and supply could play an important role in producing and maintaining an international energy balance in the coming years. The latter, in turn, could be a pivotal part of an international commercial and financial system necessary for global economic stability and growth.

In short, exporters and importers, having emerged from a decade of tumultuous and largely unproductive ups and downs in petroleum prices and supplies, are expected to have learned from experience. After the oil shocks of 1973–74 and 1979–80, the major oil importers must be convinced that a steady, moderate, and predictable change in the price of oil—in line with world energy supply and demand conditions—might be preferable to periodic haphazard fluctuations in oil availability and prices. The declines in 1975–76 and 1981–82 in the global demand for oil, in turn, must have awakened the major oil exporters to the recognition of their critical politico-economic dependence on oil revenues, and the extreme vulnerability of their economies to falling oil demand.

Diverse interests

Even if better management of oil supplies and prices and a rational stabilization of the world petroleum market were undisputed, launching an oil dialogue would be no easy task. First, it would need a unified direction and purpose on the part of the potential negotiating parties. Judging from press accounts, a good many unconcealed differences—on such issues as production quotas, benchmark prices, and quality differentials—seem to exist among exporters. OPEC’s low- and high-absorbing producers differ in their attitudes toward national quotas and prices according to their ability to use revenues in a given time frame. Different volumes of petroleum reserves also result in divergent views on the basic oil price among OPEC members. The low-reserve countries are chiefly interested in as high an oil price as the market will bear. But those whose reserves promise to last several decades—and particularly if they also happen to be low absorbers—are mainly concerned to keep crude petroleum prices always slightly below those of its closest substitutes, to check accelerated developments of alternative oil supplies, and to protect their oil market for a long time to come. Dissimilar political or strategic considerations present still another source of intragroup conflict.

Within consumer countries, too, there are sharp philosophical, economic, and institutional disparities standing in the way of a common interest in a dialogue. Some OECD members are philosophically averse to any regulatory actions in commodity trade. This philosophy, however, is not wholly shared by the majority; many appear to regard oil price stability (indeed, the stability of commodity prices in general) as desirable and useful, and they do not seem to object to a constructive dialogue on raw materials, especially petroleum. The magnitude of dependence on imported oil is another reason for the diverse attitudes of industrial countries toward oil negotiations.

Some major consumer nations have a special or privileged business relationship with the oil exporting group, which may affect their attitude toward a dialogue. Six of the seven major oil companies—the so-called Seven Sisters—are of U.S. or U.K. registry. One has a double U.K.-Dutch nationality. And a “half-sister” is French. Since these transnational oil companies are still OPEC’s principal operating, marketing, and distribution agents, they can serve as a special conduit for specific negotiation between their home and host countries without the necessity of institutionalizing such contacts or broadening the dialogue’s process or content. Some consumer governments also enjoy old political ties and traditional bonds of amity with certain major oil exporters. They may wish to protect the exclusivity of these relationships, and be reluctant to bring a larger, more interventionist, and less manageable oil importing group to the bargaining table. As regards the framework for negotiations, some large industrial consumers are most likely to favor the International Energy Agency; others seem to prefer the more limited forum of the European Community.

An agreed agenda

The delicate and complex task of formulating a mutually acceptable agenda within a mutually agreeable time frame is another stumbling block to a prospective dialogue. As matters stand, the different interests and attitudes that delayed finalizing CIEC’s terms of reference for several months, and reduced the chance of a more substantive outcome, still exist. Most OECD members might, à la rigueur, be induced to engage in a dialogue on energy alone, if it were to take place under strict conditions and with few major participants. But the appeal of a formally organized forum with a comprehensive or open-ended agenda is not widespread. Even a rather limited OECD group would represent different shades of interest to be reconciled. The non-oil OECD countries might be induced to accept a broader agenda and a somewhat wider forum; but the oil producing members seem more firmly against broadening the dialogue to nonenergy issues. And even some who may agree to a limited oil dialogue may still not support it actively, for fear that limited negotiations would open a Pandora’s box of debate on a much broader range of North-South economic issues.

On the OPEC side, similar disagreements on the agenda and its scope appear to exist. Some members seem to lean toward a limited list of issues, others toward linking energy to such topics as trade, investment, aid, and industrialization. Some may be willing to cooperate with selected OECD consumers on a more limited basis, while others may press for a full-fledged global negotiation in a North-South context, and under United Nations auspices. Even if these diverging interests were to be internally harmonized, and a mutually satisfactory agenda put together, the timing of the dialogue may still remain a thorny problem, as bargaining strengths change with the years.

Scope of consensus

Given such an array of conflicting interests, objectives, attitudes, and perceptions among major oil producer and consumer governments, are there any prospects for an oil dialogue? If the oil market continues to be a buyers’ market, OPEC could expect little or no interest on the consumers’ side for a dialogue, and may show no eagerness itself to negotiate from weakness. Should economic recovery in the industrial world help raise the demand for oil, as discussed earlier, the chances for negotiation may increase as consumers are more likely to go to a negotiating table to seek stable oil supplies. Ironically enough, substantial uncertainties on both sides may help expedite the dialogue because it is partly through future price and supply ambiguities that parties may be induced to closer cooperation.

But even under favorable circumstances, OPEC must first deal with several threats to its internal stability. Some 30 to 40 percent of excess total capacity must be gradually adjusted to the market demand for OPEC oil. The desire by virtually all members to supply more than would meet aggregate needs must somehow be accommodated. A consensus on possible criteria for quota allocations would have to be obtained. A mechanism for monitoring and implementing OPEC resolutions would have to be devised. And effective provisions should be made for revising overall output ceilings, and adjusting individual quotas, every time the demand for OPEC oil appreciably changes. The organization should also be able and willing to help its own members suffering from temporary high foreign exchange needs in a slack market.

Once its own house is in order, OPEC’s second major challenge would be to reach a mutually beneficial accommodation on prices and output levels with the non-OPEC oil exporters—Mexico, Norway, the U.S.S.R., and the United Kingdom. These producers follow the normal behavior of newcomers to a shared-monopoly market, taking advantage of an administered price structure without paying its necessary costs. Their surplus crude is sold in the world market at or near OPEC prices, forcing OPEC to serve as a buffer or residual supplier. As in a classical oligopoly case, the outsiders have every reason to want to be shielded by OPEC, and have no economic interest in an oil price collapse. Yet, as long as the demand for oil—and particularly OPEC oil—is weak, and every producer vies for a larger share of a buyers’ market, the possibilities of cooperation disintegrating, or of a price war erupting, cannot be ruled out. Some observers go so far as to believe that if OPEC could come to terms with other net oil exporters on oil prices and supplies, it could successfully achieve oil market stability, and might safely ignore the arduous task of a rapprochement with oil importers.

OPEC would also have to obtain the goodwill and collaboration of the multinational oil companies in its market strategy. While the magnitude of the major oil companies’ remaining world market power may be debatable, some OPEC authorities believe that the 1979–81 stock build-up by the multinationals exaggerated the normal demand for oil and contributed to the oil price explosion. An excessive depletion of inventories in late 1981 and early 1982 allegedly aggravated the slack market, and reinforced expectations of falling prices. This was followed by a further depletion of inventories, and a still weaker market. To the extent that the major oil companies’ inventory behavior, for whatever motives, might be destabilizing, OPEC’s goal of orderly and predictable output management cannot be achieved without their support and cooperation.

As indicated previously, the oil market is no longer tightly controlled by a few sellers and a few buyers with little or no true bargaining; it is a substantially decontrolled market with a large number of independent suppliers, intermediaries, and newcomers. In such a market, oil companies can rationally be expected to build up inventories when oil prices are rising (or expected to rise) and to accelerate drawdowns on their stocks when prices are falling (or expected to fall). This is likely, particularly when the cost of inventory maintenance is high, due to high real rates of interest.

For the companies to act differently, they must be given certain compensating incentives. During periods of rising demand, for example, the companies could be induced to purchase oil from cash-short OPEC members for deliveries at later dates under proper safeguards. In this way, petroleum stocks belonging to consumer countries could be kept underground at zero storage costs (instead of filling up the oil tanks or salt domes at considerable expense). The sellers, in turn, would receive badly needed foreign exchange at once. In times of slack, the companies could be induced to follow the “normal” drawdown policies by using their “prepaid” underground stocks; or, if necessary, they could be subsidized for their interest payments involved in keeping crudes stored in other facilities. Through this process, upward pressures on demand and prices can be reduced by eliminating the need for inventory build-up when the oil market firms up, and the effects of fast drawdowns on prices can be checked when the market begins to weaken. In both cases, the overall economic costs might be less than the damage caused by price instability, and can thus be underwritten by all interested parties. In calculating costs and benefits of this approach, allowance would have to be made for possible adverse effects on the forward market, as well as the risks of possible future nondelivery of prepaid stocks.

A limited dialogue?

At present, the differences in ideology and outlook among members, aggravated by recent intragroup dissension, appear to reduce possibilities for a comprehensive OPEC-OECD conference. A useful dialogue, however, may be possible among certain countries in each group that share certain common interests in a limited and narrowly defined program. Such a commonality of interests and purpose now exists among the moderate and conservative members of OPEC, on one side, and some leading industrial economies on the OECD side. These countries could establish informal (and, if necessary, unpublicized) contacts and exchanges at the experts’ level on selected issues to improve mutual appreciation of the current and future oil and energy markets. Such contacts and discussions may take place between the secretariats of OPEC and OECD; between the OPEC (or OAPEC) secretariat and the International Energy Agency; or by better coordination of a host of ongoing dialogues in the form of university seminars, oil company conferences, experts’ gatherings, and professional conventions in which the representatives of both groups regularly participate. The gains from such collaboration, however, would be substantially reduced if it were to arouse suspicion among non-participants either within OPEC or in the industrial countries and become counterproductive to the long-term objectives of a broader oil dialogue.

A limited agenda could initially focus on an exchange of information and technical data in such areas as projections of oil needs and availabilities in both the developed and the developing worlds; annual oil discoveries compared to yearly oil consumption, and the rising costs of developing new fields; relative growth rates of oil demand in the developed and developing countries; or the coordination of oil consumption and conservation policies in the oil-short countries with exploration and production strategies in the oil-rich nations. Some exchange of information and technical data already takes place between the two groups, and considerable contacts of a similar nature are under way. It must be noted, however, that currently there is a lack of effective communication on individual countries’ positions, not only between the two sides but even within each group. Data on prices, discounts, volume of oil trade, and the like are often jealously guarded by members as classified information.

The collection, exchange, and dissemination of such data between consumer and producer countries and oil companies can go a long way toward allowing a better assessment of supply and demand, and more accurate planning and policy formulation of energy issues—leading to greater market stability. Consumer countries, both developed and developing, could be induced to accept an oil price close to the costs of alternative energy sources, instead of seeking to break up OPEC in the vain hope of turning the clock back to the era of cheap oil. Producers, on the other hand, could realize that a wrongly perceived long-term supply price might encourage new competitive supplies, weaken the industrial countries’ economies, depress overall demand for oil, and ultimately affect their own economic fortunes.

Once a discussion on selected issues is successfully carried out within a special group of representatives from exporting and importing countries and company officials, a more formal and structured OPEC-OECD oil dialogue on the broader issues of supply security and equilibrium price could be ventured. And if its outcome were favorable, the dialogue could be followed by multilateral discussions on such issues as technical assistance to OPEC members in their long-term development objectives, non-oil export drives, investment outlets in the industrial world, and related topics.

In sum, while there are many elements that militate against an early and comprehensive oil dialogue, there are other factors that favor contacts on more limited but still substantive areas of mutual interest. If history is not to repeat itself, oil exporters and consumers have no alternative but to cooperate. As long as OECD is unable to provide adequate supplies of oil from its own resources, it needs a mutual understanding and accommodation with OPEC. OPEC members, in turn, cannot do without their industrially advanced partners and their technologies. And the non-oil developing countries can be indirect beneficiaries of OECD-OPEC cooperation. The alternative seems to be a new era of uncertainty beset by false confidence and threatened by new shocks.

World Bank energy model

A decade has passed since the prices of crude oil quadrupled. Although a relatively short period in the long process of adjustment to changes in energy markets, these past ten years have provided a unique experience with how supply and demand for energy respond to drastic changes in market conditions. A number of analytical studies have also improved the measurement of the quantitative relationships of energy supply and demand. The World Energy and Petroleum Model, developed in the Commodity Studies Division of the World Bank, grew out of the need to incorporate the progress made in analytical studies and the evidence of actual market adjustments in the ongoing assessments of market prospects for energy and petroleum.

The model is a state-of-the-art econometric simulation model, formulated along the traditional lines of modeling the petroleum and energy markets, but incorporating more details than previous models on various fuel markets and interactions between them. The model includes three industrial country regions (North America, Western Europe, and Japan/Australia/New Zealand) and four developing country groups (capital-surplus oil exporters, capital-deficit members of the Organization of Petroleum Exporting Countries, non-OPEC oil exporters, and oil importing developing countries). The centrally planned economies enter the model exogenously, as net exporters of energy.

The world petroleum market is viewed as consisting of a dominant oligopolistic cartel, OPEC, and the competitive fringe, the non-OPEC producers. The model assumes that OPEC sets the international market price of crude oil (mainly on the basis of its revenue implications, although in practice OPEC takes several other factors into consideration) and supplies the resulting demand for OPEC petroleum—world demand net of competitive fringe supplies. (The structure of the international natural gas market is assumed to be essentially the same as that of the petroleum market, and the coal market to be basically competitive, while electricity is treated as nontradable.)

Demand for energy consists of three end-use sectors (transportation, industrial, and residential/commercial) and one energy transformation sector (thermal power generation). Final energy demand by the industrial and residential/commercial sectors is determined by aggregate output (or income) and energy prices. Fuel shares in all sectors but transportation are determined by a cost-share model of interfuel substitution that assumes competitive cost minimization. The demand specification explicitly recognizes that demand adjustments to higher prices take many years as energy-consuming capital stock is modified or replaced. Another feature is that the long-term price elasticity of energy demand is assumed to be almost as large as typical international cross-sectional, time-series estimates; these higher elasticities are more closely in line with the demand adjustments of the past decade than estimates obtained from time series alone.

At present, the model has an endogenous supply specification only for coal. Supplies of hydro/geothermal and nuclear electricity, synthetic fuels, and competitive fringe supplies of petroleum and natural gas are determined exogenously on the basis of projections available in the Bank and elsewhere. The long-run coal supply model is based on estimates of long-run marginal costs of production.

The model is described in detail in A Model of World Energy Markets and OPEC Pricing, World Bank Staff Working Paper No. 633, March 1984, $5. See back cover for ordering details.

Projections. Simulation results, under a range of assumptions about future economic growth and OPEC pricing, predict that world demand for energy and petroleum is likely to remain relatively low (OPEC production below 27–28 million barrels a day) throughout the 1980s and the early 1990s, even without further increases in the real price of OPEC oil. The main reason is the past two rounds of petroleum price increases. Once the impact of these increases dissipates by the late 1980s, however, the growth in demand for petroleum as well as for total primary energy will resume at substantially higher rates—probably leading to further increases in petroleum prices in the 1990s, unless the non-OPEC petroleum discoveries turn out to be sufficient to match the increases in demand.

Two interesting aspects of the results are the role of developing countries in global energy balances on the one hand and the substitution of coal for petroleum on the other. Based on a medium-growth rate scenario (growth rates of 3 and 4.8 percent per annum for the industrial and developing countries, respectively, between 1985 and 2000), it is clear that the developing countries, both oil importing and oil exporting, will account for an increasing share of world energy consumption—rising from 19.8 percent of total consumption of the market-economy countries in 1978 to 26.8 percent in 1990 and 33 percent in the year 2000. The share of coal in world primary energy consumption is also expected to increase steadily, as long as the current price differential between coal and petroleum is maintained or further widened. It is shown that a widening of the price differential can significantly accelerate the substitution process, or vice versa. With the price of coal increasing imperceptibly in the long run along the supply curve, it would be reasonable to assume that petroleum will become increasingly more expensive than coal in the long run.

OPEC pricing. The model is used to assess the effects on OPEC, in terms of present values of export revenues and remaining reserves, of alternative long-term pricing paths that OPEC may consider. The model assumes that demand for OPEC oil has a price elasticity of less than one in the short run, has almost unitary elasticity in the medium run, and has an elasticity of more than one in the long run. An interesting result of these elasticity values is that the choice between the alternative pricing paths makes only marginal differences to the present values of OPEC’s total export revenues until reserves are exhausted. If a choice has to be made, a path of steady moderate price increases from the second half of the 1980s appears to be superior to the others. However, the rate of economic growth and the degree of energy demand adjustments in non-OPEC countries are of far greater significance for OPEC revenues than the fine-tuning of the pricing path. Revenues of the two OPEC subgroups show greater sensitivity to the choice of a production-rationing regime than to the choice of a pricing path. OPEC revenues are also shown to be sensitive to pricing policies of the oil importing countries.

B. J. Choe

Economist, Economic Analysis and Projections Department, World Bank

Most recently OPEC’s president has called for greater cooperation. Opening OPEC’s seventieth ministerial conference, he re-emphasized “the need for better relations” between oil producers and consumers, and reiterated the organization’s “willingness for dialogue” with consumer governments. (OPEC Bulletin, July/August 1984, p.3.)

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