The threatened unleashing of the Arab oil weapon has sent world oil prices to a six-month high and triggered an extreme case of jitters throughout the industrialized world. A few days ago, Iraq announced a 30-day suspension of oil exports and its plans to go to the Arab League to demand a 6-12 month embargo on all Persian Gulf oil exports to the United States. Iranian Foreign Minister Kamal Kharrazi says that his country will support Iraq's call for a U.S. embargo, which is not surprising given that Iran hasn't exported oil to America since 1992 anyway. The Arab street is violently demanding that our "friends" in the region go along with the embargo and Arab leaders are moving slowly but inexorably towards some kind of action.
There's less here, however, than meets the eye.
Iraq, for instance, normally produces about 4 percent of the world's oil supply. If production outside of Iraq remained constant, if demand didn't change, and if Iraq's cutoff were permanent, the suspension of Iraqi production would increase oil prices by 40 percent. Yet since Iraq's announced production cutback, world oil prices have risen only 1 percent. This tells us that market actors don't expect the cutoff to last long and that other suppliers are more than capable and - as importantly - more than willing to meet the shortfall. If Iraqi exports resume after the announced 30-day suspension, global supply will only have been reduced by 0.2 percent for the year (that is, if all other production were held constant) - hardly worth worrying about.
In fact, the 27 percent increase in crude oil prices since February has as much to do with a physical reduction of supply in the world market as it does with other factors, such as economic recovery in the United States, the seasonal increases associated with the onset of the summer driving season, and fears of future instability in the Middle East. These are all factors that temporarily increase demand. It's telling, for instance, that oil inventories in the United States have grown from 318 million barrels to 325 million barrels in one month. Instability in the Middle East always results in stockpiling, setting off a competition between future and present consumption. When the political crisis breaks, the price spike will break along with it.
But what if a full-fledged Arab oil embargo were indeed launched against the United States? As an unidentified OPEC official told the Agence France Presse last week, "As far as the organization is concerned, there are no talks of an oil embargo because no rational and sane human being would really back such a move, because it will certainly backfire on all of us. If two or three countries agree to suspend exports, rest assured that there are other producers that will come strongly to the market to offset that supply in the market." While that's not to say that the Arab oil producers won't jump off that economic cliff anyway, he's right to worry that an embargo would probably boomerang on embargoers.
The reason is simple: Once oil is in a tanker or refinery, there is no controlling its destination. During the 1973 embargo, for instance, OPEC oil that was exported to Europe was simply resold to the United States or ended up displacing non-OPEC oil that was diverted to the U.S. market. U.S. oil imports were no more disturbed at the end of the day than Soviet grain imports were disturbed by the short-lived and ineffectual 1980 grain embargo. Saudi oil minister Sheik Yamani conceded afterwards that the 1973 embargo "did not imply that we could reduce imports to the United States ... the world is really just one market. So the embargo was more symbolic than anything else."
But how does that square with the popular belief that the October 1973 embargo quadrupled world oil prices, spawned shortages, and sent the United States into an economic tailspin? Well, world oil prices did indeed skyrocket. But it had less to do with the embargo than it had to do with the panic stockpiling triggered by tensions in the Middle East, tensions that broke into open war by October. While Arab oil production was cut by 340 million barrels between October and December, that cutback was less than the inventory buildup that occurred earlier in the year. There was still plenty of oil to go around. But few were willing to sell it given the fear of a future dearth.
The shortages in the United States had little to do with the embargo. Price controls imposed in August 1971 by the Nixon administration prevented major oil companies from passing on the full cost of imported crude oil to consumers at the pump. "Big Oil" did the only sensible thing: It cut back on imports and stopped selling oil to independent service stations in order to keep its own franchisees supplied. By the summer of 1973, gasoline prices were exploding, pumps were running dry, and long lines were commonplace. And that was before the Arab oil embargo or production cutbacks were announced.
Congress responded by making matters worse with the September 1973 Emergency Petroleum Allocation Act. Gasoline distribution would henceforth be rationed and the price of "new" oil - including imports - was decontrolled even though "old" oil was not. Perversely enough, this exacerbated the shortages that the EPAA was trying to remedy. That's because long-term contracts - the means by which most oil was sold at the time - did not rise to meet spot prices. Contract holders thus had a strong incentive to stockpile as much oil as they could at the very time when inventories should have been released on the market.
Embargoes should not worry us. Production cutbacks should. But it's unlikely that the Arab world will cut off its nose to spite its face. As a Kuwaiti oil official told Reuters recently, "how can we support our Palestinian brothers if we do not have revenues?" Without petrodollars, the OPEC Arab states return to camels and tents and lose all influence on the global stage. And today the Arabs dominate only 40 percent of the world market as opposed to the 70 percent they held in 1973. This means that the world is a lot less vulnerable than it once was to the short-term effects of the oil weapon. The only fearsome thing about the oil weapon is fear itself.