Commentary

The Saudi’s Con Game

This article originally appeared on National Review Online on May 14, 2002.

Saudi Crown Prince Abdullah’s recent visit to the Bush ranch and the leaked Saudi threat of turning the oil weapon against America prompted politicians and pundits to worry about whether our “special relationship” with the House of Saud could survive the ongoing violence in the Middle East and about the catastrophic consequences that might accrue if it didn’t. This “special relationship,” however, is a self-serving fiction that has governed American foreign policy for far too long. In short, the Saudi regime has pursued a policy of economic predation and political blackmail for as long as they’ve dominated world oil markets.

A review of that record is long overdue. In 1967, for instance, Saudi Arabia led an ineffectual oil embargo against the United States to protest our support for Israel in the Six Day War. In 1971, the Saudis again threatened an embargo lest the consuming nations accepted massive new OPEC production taxes, a levy codified in the so-called “Tehran Agreement” that began the long march towards higher prices. The agreement, which was supposed to last five years, was effectively torn up after only six months once the Saudis realized that they could extort more money from the consuming nations. In early 1973, Saudi oil minister Sheik Yamani on two occasions threatened “economic war,” warning that “industries and civilizations would collapse” if consuming nations tried to fight further OPEC’s price increases.

Even though the West complied, the Saudis took the lead in organizing the 1973 oil embargo and production cutbacks, sending oil prices from $2 a barrel to $7. In 1974, despite promises to the contrary, they initiated another round of production cutbacks and tax hikes, sending oil prices to $11 a barrel. In 1975, King Faisal again threatened a crisis “far more severe than the last one” unless the Israelis withdrew from Arab lands.

In 1978, OPEC, under Sheik Yamani’s direction, quietly established a goal of raising the price of crude oil to just below the cost of producing synthetic liquid fuels, which suggested a price of $60 a barrel (a whopping $136 in today’s terms). They began their campaign in January 1979 when a series of Saudi production cutbacks set-off the second price explosion, culminating in prices at $34 a barrel ($60 a barrel in today’s money) by October 1981. The only reason that crude oil prices never reached the levels dreamed of by our Saudi “friends” was the advent of independent oil commodity markets (particularly futures markets) and, in the words of the Kuwaiti oil minister at the time, because of “a consistent underestimation of potential supply and a consistent underestimation of the consumers’ ability to adjust their demand … led OPEC to overestimate their strength.”

After desperate Saudi attempts to stave-off collapse failed, Vice President George Bush traveled to Riyadh in 1986 to implore the Saudis to arrest the price slide because — I kid you not — the administration feared the effect of cheap oil on the world economy. Since by this time the Saudis were feeding the collapse in order to inflict pain on competitors who needed a lesson in production discipline, they naturally responded to Bush’s pleas by … increasing output still more.

Once the price war was over the Saudis encouraged Iraq to put the screws to Kuwait to punish that country’s history of cartel-breaking overproduction. Only when “the enforcer turned robber,” according to MIT professor Morry Adelman, did Saudi Arabia reverse course and call for Western intervention. But even then the Saudis fed the resulting price spike by refusing to increase production for over a month. Their refusal to fully tap their excess production capacity prolonged the economic damage.

Which brings us to another oft heard argument, that Saudi Arabia’s policy of not producing near as much oil as it could is in our best interest because untapped production capacity serves to stabilize oil prices. While it’s generally good for consumers when spare capacity can be tapped in the event of unforeseen market dislocations, the Saudis have never used their excess capacity for that purpose. Instead, the Saudis use that excess capacity to discipline — and thus, to empower — OPEC.

Cartel watchers realize that excess production capacity is absolutely necessary to sustain bargaining power within OPEC. Without the ready Saudi threat of flooding the market, cartel members would have an almost irresistible incentive to cheat on their agreed-upon production limits. Accordingly, spare Saudi production capacity is the main thing that keeps the OPEC cartel afloat and international price wars over oil from starting.

So, does a well-functioning cartel really serve to stabilize prices? In the past several years world oil prices have bounced around between $10 and $35 a barrel, which doesn’t suggest a great deal of stability. In fact, the cartel makes prices more unstable than they otherwise would be. That’s because higher prices and higher revenues enable cartel members to withstand financial pressure to cheat on their production quotas, which promotes still higher prices. Lower prices, on the other hand, strengthen the need for cash, which weakens the resistance to quota cheating and promotes still lower prices. Thus, market movement in either direction tends to speed-up-not slow-down-the velocity of price movement, making markets less rather than more stable. Indeed, the oil price explosions faced over the past 30 years have been unrelated to scarcity and entirely due to the cartel.

Summarizing the record of the past 30 years, Adelman concluded in his magisterial book Genie Out of the Bottle: World Oil Since 1970, “we look in vain for an example of a government that deliberately avoids a higher income. The self-serving declaration of an interested party is not evidence.” OPEC’s long record of huffing-and-puffing over Israel — and related promises of more oil in exchange for support of the Palestinian cause — has simply served as a useful cover for production decisions that would have been made regardless. But if the West thinks that crossing Persian Gulf suppliers will result in economic retaliation — or that reduced support for Israel will translate into lower oil prices — so much the better from the Saudi perspective. That policymakers have never noticed the lack of relationship between American foreign policy in the Middle East and Saudi oil-production decisions is a mystery to me.

The bottom line is that the Saudis, no matter what they might like us to believe, are not doing us any favors by selling us oil at $24 a barrel that, without the collusion, would probably go for no more than a third of that. Threats that the Saudis might turn hostile if we don’t change course in the Middle East are laughable — they went hostile a long time ago.

Jerry Taylor is director of natural-resource studies at the Cato Institute.