Some Aspects of Oil Economics: can we still be surprised?
Elena VARTENIUC
March, 2007
Abstract:
This article outlines some peculiar aspects that define
the economics of oil, beyond de geopolitical aspects that normally surround it.
One such case refers to the implications of the US economic policy for the
evolution of the oil market. It then takes an insight tour into what is really
happening in the realm of the Iranian oil. The European approach to energy
safety is then analyzed.
Table of Contents
SECTION I 2
Oil Power Between Theory and
Practice. 2
SECTION II 7
Petrocurrencies and US
monetary-policy. 7
SECTION III 13
How does Iran fit the puzzle?. 13
SECTION IV: 16
Europe in the oil puzzle: 16
Conclusions: 19
Bibliography: 20
Many stories were borne around the black gold in the modern history of the
world. Intrigues and conflicts for the supremacy of this indispensable resource
shaped the relations between the world powers because it promised to be the
support for growth and progress of the new world. And so it was! This is why
those who possess it today enjoy an enviable power which unfortunately can be
both destructive and self-destructive.
Economists conceptualize this by calling it monopoly power. The fundamental
consequence of monopoly is that it results in inefficiently low production.
Another, more obscure implication is that it allows for no “consumer surplus”.
This implies further that somehow the consumer has a deficit of power mainly
because it cannot turn to another producer when it deems the price is too high
as is the case in the competitive scenario.
Monopoly over oil resources tends to be less complacent with this theoretical
framework because monopoly power in the real world is subject to a much more
interesting dynamics. Why is that so? I can identify at least a few reasons. In
fact my current analysis will bring forward abundant evidence in support of the
peculiarities of the oil market.
For one, consumers are not so powerless because in some cases they can dilute
the monopoly power by shifting to substitutes of oil. Since oil is not the
final aim of consumption but the energy it incorporates, alternative energy
resources can bite into the monopoly power of the producers and force them
somehow to provide this resource at a “more reasonable” price.
This means that substitutability helps to recreate to some extent the world of
competitive markets where the producers are not price-setters. Oil can be
substituted by gas in some cases. But substitution has its limits. Oil is
irreplaceable as a raw material for goods like fertilizers or plastic
(Liechtenstein, 2006). Transportation
is overwhelmingly based on fossil fuels( 98%). Technologies developed to the
aim of loosening this excessive sectoral oil dependence like hydrogen based
fuels still need some time before becoming operational. This means that, as
transportation needs increase with the emergence of new economic powers like
China and increased world population, the monopoly of oil will be still
triumphant in this important area.
The limited substitutability problem is aggravated by the peak oil production.
In 30 years oil production will be 30-40% of what it is today, (Liechtenstein,
2006) . On the background of increased transportation needs, decreased
per-day production due to the increased difficulties of extracting oil will on
the other hand increase the monopoly power of oil owners.
This may not be exactly so, however, since more advanced technologies could be
alternatively developed in order to make it easier and cheaper to extract deep
oil. Even if that is not so, the difficulty of extracting oil or the higher
expenditure needed to extract equal amounts of oil does not necessarily
translate into greater monopoly power in the general sense. This is because the
oil producers themselves might not benefit from this situation either since
they may have to pay more. The final result depends on the balance of powers
which will determine who is likely to bear the extra-costs: the consumer, the
producers or both. This is a second example of why monopoly over oil is not to
be understood in the textbook way.
Stern (2007) makes the same case by pointing at the fact that high prices
do not only prove market power but scarcity also. Therefore the final price
must also include a reservation price which would allow an optimal
inter-temporal allocation of oil revenues before these resources are completely
wasted.
There are however instances where producers can behave as a monopoly and refuse
to operate at full capacity just for the sake of reaping higher profits.
Although in theory this can happen, it is also known that the oil producers
failed repeatedly to coordinate their production levels due to the overly
appealing profits they could get under free-riding behavior: i.e. supply over the
quota commonly agreed and cash in the monopoly high price. In the same article,
Stern tells the story of failed coordination in which Saudi Arabia came out
losing: during the 1982-1985 policy the Saudis wanted to defend the falling
price by reducing supply. This failed because the already high prices since
1973 had pushed up non-OPEC production while the other OPEC members were
shirking and were not participating in the price defense. This situation
resulted in a 75% market share and revenue decline and forced the Saudis to
reverse policy and increase production. The side effect was the steepest
decline per year in the oil price ever. This is where I make my third point
over the non-conventionality of oil monopoly.
However,
a recent IEA (2004) analysis shows that the high oil prices since 1999 are
partly a consequence of OPEC supply management policies. OECD imported more
than 50% of its oil needs in 2004 at costs higher by 20% as opposed with 2001.
The same report estimates that a rise in oil prices from 25 to 35 $ per barrel
leads to a loss of 0.4% in GDP on average in the first and second year,
together with the rise in unemployment and inflation.
In
instances where such a pooling of monopoly power is successful, this can be
eroded by the reserves countries may accumulate just to avoid such national
security problems. This consumer response is likely to be victorious based on
how long the cartel members can abstain from overriding but more importantly
whether they can make it without the windfall of revenues coming from oil
trade. But data shows that oil dependence on the side of the oil demand is
matched to some extent by the revenue dependence of the oil suppliers. It is
not completely matched if price does not equal the competitive price, that is marginal
cost of producing one extra unit of oil is not equal to the market price.
According to Stern (2006) calculations, this is currently not the case in
the oil market. The difference between the 10 dollar competitive price and the
approximately 60 dollars per barrel
market price of oil is the estimated monopoly rent explained by OPEC’s market
power due to investment restraint.
The same author goes on to say that an even more competitive price could be
obtained if the importers could coordinate in such a way as to create a
monopsony. Such a proposal does not seem far-fetched since, as argued by the
same author, demand reduction trials by the importers were received with
hostility by OPEC. The rationale behind it is that oil export revenue
dependence may be used as a boomerang against the oil producers. The
International Energy Agency replicates this consumer coordination to some
extent. Alternatively, the non-cartelized part of the producer market could
sabotage the monopoly: currently, this escape seems to be less and less
forceful since only Canada, Denmark, Norway, Mexico and UK are net
exporters.
Although the monopsony hypothesis deserves more consideration it is likely to
remain more theoretical than practical in the same way as the monopoly
situation conceptualized in the beginning of my analysis. This is because in
this game of reciprocal restraint the winner cannot be permanently predicted:
who guarantees that the ingredients for success at some point in time will
always be in place and moreover, if that is the case, always be sufficient to
guarantee victory? This can be easily explained by the business cycle
variations, where in booms a country may need more energy consumption while in
recession demand for oil may be more price
elastic.
Price elasticity of demand is likely to be influenced by many factors indeed.
Monopsony power may be diluted if there is not full cooperation among the most
important consumers, and this can easily be the case given in the present
geo-strategic mapping: suppliers like Iran are increasingly receptive to
important and growing consumers like China or India in order to create security
of demand and build processing plants there by concluding bilateral oil and gas
agreements (Linde, 2005).
In the case of proven reserves, Stern (2007) goes as far as to say that oil is
actually becoming more abundant although absolute under-ground quantity is
decreasing. This is because over time people realized the earth is more oil
abundant than initially thought and in the same time countries accumulated
reserves, which helped keep the reservation price related to scarcity at a
relatively constant level. Scarcity may not be a real issue given that many
reservoirs are not even in production as is the case in Iraq which only uses
20% of its reservoirs.
This line of reasoning is useful to the extent that it eases some of the
hysteria over oil depletion which might unreasonably raise prices. In this case
we would deal with an asymmetric information driven price where producers might
reap extra profits based on markets’ underestimation of available resources: if
the market knew that potential supply is larger, more perceived competition
among suppliers would drive down the price. In this light, we might understand
why OPEC reports of oil reserves may be politically motivated while the public
may not really know how many reserves there are in fact (Leichtenstein,
2006).
I am however skeptical about the truthfulness of this inference if I take
for granted the fact that excessive prices hurt not only buyers but also
sellers in the long run and thus might disincentivise producers from using this
asymmetric information advantage. The effects of previous crises were found to
be net world loss because the propensity to consume in importing countries is
higher than in exporting countries (IEA, 2004). Alternatively it might be
equally true that producers may strike a balance between long-term and short-term
gains.
Now let us consider the following: what if the concerted strike is successful?
Would that be that bad? Think of the oil shocks. Mainly after those oil-shocks
efficiency in consumption increased dramatically. A price closer to impossible to
pay will act like an incentive to innovate. Another incentive is the pollution
damage which today is mostly caused by burning liquid fossil fuels. That could
however have its side-effects, since substitutability can happen away from oil
to carbon which is even more polluting but has more buyer friendly
geography.
On the other hand, the impact may be asymmetric across importers due to their
heterogeneity: developing countries are likely to be hit harder since
they use twice as much energy as the developed countries to produce one dollar
of GDP and are likely to be less able to develop alternative technologies soon
enough.
Another
peculiarity about the oil market is that most oil and gas producing countries,
with few exceptions, have had autocratic regimes for some time: the Persian
Gulf, the Caspian Sea, North Africa, Venezuela, Russia. This more then
complicates negotiations based on reciprocal advantages derived from free
markets (Linde, 2005).
Take the example of Iran. Iran is an autocratic regime. It is currently
developing nuclear facilities and beyond any other scenarios, those resources
could be used to loosen some of the economic dependence on oil revenues, since
more resources will be freed away from domestic consumption.
Moreover, since the winner in such a game depends also on the
transparency of information, Iran may claim that it has not reached its
production capacity but that the limited delivery is merely the result of
successful abstinence, i.e. successful exercise of monopoly power due to low
export dependence. If the third parties believe that to be true, panic on the
consumer size may lead to forecasting price increases and price in such risk
premiums in their products. Self-fulfilling expectations are now well-understood
by economists and they do not only apply to stock markets. That would empower
the Iranian government to reap profits by playing the self-sufficiency card,
when in fact that is not even remotely the case. Stern (2006) describes in this
context how the “oil weapon” works: by disguising export decline in voluntary
cuts, Iran builds the false belief that such a weapon really exists, which in
turn is nothing else but a self-fulfilling expectation.
This is where full-information makes the difference. If instead buyers know
that Iran exploitation runs close to full capacity (so that the low level of
production is not the result of successful monopoly power) and that is coupled
with high government dependence on revenues, this means there is less room for
bargaining on the Iranian side, so consumer power can claim more prominence.
However for this to happen, one must also assume that there are other suppliers
willing to compensate for this decreasing sales share. Successful supply
restraint is more likely in an autocratic regime where contestation of leader’s
decision is less powerful.
Looking at the facts, we can easily see that menaces made these days by
the Iranian regime make the markets really nervous. This is a very good sign
that Iran has an important leverage in the buyer-seller relationship.
Given
the recent rise in oil prices, the discussion about diminishing oil dependence
was prompted as prime-time story in the media. A solution to loosen demand
dependence is to improve efficiency in consumption. Since the oil shocks, net
oil imports decreased on average and the oil intensity halved in the OECD
countries (IEA, 2004). Due to progress in market risk sharing and increased
world capital markets integration, consumers can hedge against volatility.
Lately however, progress on efficiency increases seems to be meager: for
instance, the US has not changed standards for new cars in 16 years (Victor, 2006). Europe is
moving in the right direction but its efforts must be intensified to make a
difference.
There are ways in which the
government could intervene to stimulate efficiency increases. For instance,
stiffer petrol taxes would induce consumers to orientate their demand towards
fuel efficient cars (Victor, 2006). Taxation is however a highly politicized
matter and popular politicians who want to keep the public support for a long
time are reluctant to pass laws that could work against them. This is
especially the case where electoral campaigns are not funded from public money
but from sponsorship. If that sponsorship comes from interest groups who are
not environmental friendly, i.e. carmakers, it is less likely to see such a new
tax enforced.
SECTION II
“The Bush administration would never mention
oil as a reason for going to war.” Klare , 2005
However, it is equally true that securing the oil supplies coming from
the Middle East is an important strategic aspect about which the US security
and defense department must be highly concerned. The diplomacy can work in some
instances if combined with economic incentives; nonetheless there are important
instances where the soft power approach does not work in relation with the
authoritarian regimes hostile to the American power. The American interest
cannot be denied on these aspects, especially if the actions of a reckless
regime like the Iranian one could endanger the provision of oil resources from
the Gulf area.
The nuclear pretext for waging war against Iran was there for some while
already. Why would the US choose this particular moment for starting off
against Iran?
A possible answer could be this one: “It’s simply macroeconomics!” As we have
seen in the first section the macroeconomics of oil is mainly concerned with
the supply monopoly power. However, when restricting our attention to that, we
are neglecting an important part of the puzzle: the monetary side. What could
the monetary side tell us about it?
In order to find substantial answers we first have to look back at how the
world monetary system evolved since the Second World War and focus our
attention on the Bretton Woods design. It should not come as a surprise that
the exclusive dollar pricing of oil is a legacy from that era also. Nowadays
the petrodollar recycling system is an important mechanism which makes the
running of persistent current account deficits affordable for the US.
The reason for that matter is pretty simple: as explained by Wikipedia, petrodollar
recycling happens when you can earn from oil more than you can invest in your
own economy (more than its absorption capacity). To acquire dollars, a country
has to sell goods to the US; for buying those goods the FED can print the
needed money. The dollars thus obtained from trade pay for the Middle East oil.
Exporters can choose to use the dollars by importing US goods and services or
invest the dollars in T-bills or just build their dollar reserves. Thus the FED
only has to incur the cost of printing money to import goods from outside. The
petrodollars return into the American financial system where they can be
further used for crediting the domestic (or foreign) investors and thus promote
growth, further gaining from this operation of intermediation in the same way
as a commercial bank would.
Note what is strikingly particular about the US economy: as it runs deficits,
it does not have to be concerned too much about debt or inflation so long as
the bulk of the world economy wishes to hold and use the extra-dollars printed
by the FED. This is because of the overwhelming role of the dollar as a reserve
currency in the world economy. This escape is not available for a country with
weak currency, for which debt, deficits, depreciation and inflation are more
likely to occur in case of excessive printing of money. This is simply because
the foreigners are not interested in holding the national money but for
purposes of bilateral trade with the country issuing that particular currency.
Although there were several times when the oil producers tried to change
the pricing of oil, the US averted its occurrence. In 1974, keeping oil dollar
monopoly resulted in preferential treatment with the Saudi Arabian Monetary
authority who was allowed to purchase 2.5 billion dollars in US Treasury bonds
( Wikipedia).
Now that we understand the petrodollar recycling system and
keeping in mind that oil is the most traded commodity in the world and its
production rises every year to keep up with world rise in consumption, we can
also understand what is at stake for the US if the contracting of oil were done
in currencies like the yen or the Euro. Stephen Lewis (in Clark, 2006) explains
that it is crucial to the dollar’s dominant role as a reserve currency that
dollar pricing of oil should continue. The implications are multifold and
powerful for the oil economics and more so, for the geo-political and the
strategic mapping of today’s international relations.
Seen from this perspective, the war in Iraq is described by Lewis as the first
oil-depletion and oil-currency war of the 21st century. The US –Iran
conflict can be paralleled to the Iraqian one, beyond the nuclear perspective,
from the debt based monetary policies of the US. On the background of
escalating competition for the energy supplies, the erosion of dollar hegemony
will more than probably shape the future trends on the world oil market.
Indeed, some Arab countries may choose to build a portfolio of reserves in
order to hedge the risk of dollar depreciation. The dollar is likely to
depreciate substantially if there is excessive printing of dollars by the FED (
I will discuss the implications of this later on), if $-pegged regimes are
shifted towards floating regimes ( China for example) or if contracting of oil
sales is done in other currencies, say inside international oil bourses. Are
these trends far-fetched?
The Chinese economy is likely to continue its breath-taking export-led growth
which allows for piling up valuable dollar reserves. The undervalued Rimini is
an advantage for the Chinese. It is therefore unlikely that the Chinese
government would favor an appreciation of the currency since the symmetric
depreciation of the $ will carve in into the real value of its foreign
reserves. As the economy grows, for the fixed peg to be sustainable, the
Chinese have to accumulate reserves; the stronger the US dollar, the less
dollar reserves will be needed to back up the peg. China may first want do
diversify its reserves portfolio as well as its trading partners. If that does
not happen, the floating is less likely also. The international bourses of oil
are however running projects in countries like Iran, China and Russia: the
Iranian bourse just failed to open last March.
Having said all these, one can better envisage the potential gains from a
successful war against Iran. A conqueror or alternatively liberator has more
room in deciding to whom to assign contracts, in what currency and where to
divert the oil supplies. Some authors go so far even as to consider that the
Saddam overthrow is closely related to his express will of contracting oil in
other currency than the dollar. According to Petrov (2006), Saddam
demanded Euros for his oil in 2000 but after the war started this was no longer
the case. If that line of thought were true, Iran’s will to start an oil bourse
may be enough reason to pre-empt not only a nuclear power but to pre-empt a
major related economic loss. If this is true the EU has a duty to be a
watch-dog of Iranian nuclear intentions as much as of US’s excessive
pre-emptive behavior.
What could possibly be wrong with these arguments? Are losses related to
changing the petrocurrency likely to be that significant?
Those who argue against the $ price of oil, explain losses for the trading
countries in terms of their inability to fence off the currency risk: the
exporters have to receive dollars, but dollars may lose their value in national
currency terms. It is similarly the case for the importers.
Those who make this claim forget that there is a world market out there for
hedging against currency risk. One can hedge in such a way as to trade-off the
risk of the dollar for the risk of the Euro, for instance simply by buying
forward Euros against forward Dollars. The petrodollars can be traded
everywhere on the world foreign exchange market in exchange for probably other
hard currencies or for currencies with which the oil exporting countries trade
mostly. In this way the reserves portfolio can be diversified and possibly some
of the currency risk associated with dollar devaluation traded off.
But if most of the dollars turn back to the US it must be partially because the
investors choose the US economy for its market competitiveness and stability.
We could alternatively imagine a monopoly Euro-pricing of oil. But if most of
trade and investment is done with the US, then there would be a demand for US
dollars on the world markets anyway, which would keep up the value of the
dollar and prompt it as a reserve currency. The Saudi Arabian authorities would
have probably not bargained for the US T-bills if they were not truly
rewarding. That is to say the reserve currencies are an expression of the
economic strength of the country issuing it; the reserves are likely to be
determined by the endogenous laws of economics more than by “exogenous
hegemonic imposition”!
However monopoly pricing of oil does have some advantages for the US. At least
one thing is certain: all trade in oil is done in dollars, all increase in oil
production is traded in dollars, thus since liquidity is needed on this market,
the demand for dollars shifts up. This demand will exercise an appreciation
pressure and keep a relatively stable value of the dollar as the FED continues
to print money. My opinion is that an interesting line of research would be to
uncover the extent to which the printing of US money goes together with the
growth in oil trade. This pattern is likely to be obvious in the future as the
petrocurrencies change and as the peak oil is reached and oil production
decreases.
Alternatively, if governments only wished to hold Euros, they would only need
dollars for oil trade. Even if oil trade share were small in total trade, the
dollar would still not be weak because demand for oil is inelastic and thus
demand for dollars would have to be inelastic also. This would cancel off the
competitive advantage argument. This or the other point could be proven by
looking at some statistics; however I am doubtful that the dollars circulating
in the world economy originate only from the purpose of paying for some oil:
people do want dollars for trading other goods also due to their stability and
strength ( there are cases also when partial dollarisation occurs). It would be
more difficult to disentangle oil generated strength from competitiveness
generated strength, that is true. I conclude this line of argument by saying
that the truth most probably lies in the middle.
To continue, it is worth I think to pop up the more interesting question: what
would happen if, more realistically and based on comparative economic power,
the Euro gained equal weight in the world reserves? The result would be that
maybe the Americans would not afford printing so much money without incurring
costs in terms of dollar depreciation, inflation and debt increase, thus the
deficits would have to come down to some extent. Is this loss in “free
deficits” enough reason to try stop changes in the oil contract currency by
waging another war against Iran?
Most sensibly not, because in that case, the US would have to wage war against
any other nation trying to change the petrocurrency. Will the US try to close
more preferential deals to avoid this? Most likely, yes.
As noted above, an important dollar depreciation would result from excessive
printing of money by the FED. This money would allow the US to keep on
incurring deficits. In case of loss in dollar hegemony, this would likely
backfire similarly with the case of weak currency countries. However, as shown
in the paragraphs above, printing money has its costs even in the presence of
dollar hegemony. This should not be overlooked if we want to understand
the economics behind the foreign policy of the US.
Another way in which the monetary economics can have surprising implications
for foreign policy and oil markets is the following: some authors contend that
the oil shocks were due not to a supply side shock but due to the inappropriate
monetary policy led by the US.
Gillman ( 2001) notes that the standard explanation of oil price
changes is the sudden ability of Arab nations to exert cartel-monopoly power
enforced with an embargo. That explains the so-called “supply shock” oil price
increases. In the last years ( since 1999) no such sudden monopoly power was
obvious however, although the price of oil increased sharply.
In the same time, between 1999 and 2001 the US inflation doubled and the
European inflation tripled. A conventional wisdom in economics is that if the
nominal rate of interest is too low in boom periods and the marginal product of
capital is on the rise, there is going to be an imbalance between supply and
demand, demand being in excess. Inflation follows as a result of too loose a
monetary policy stance while the demand for investment is greater than
available savings.
A drop in real interest rates due to high inflation may motivate a jump in oil
prices to keep the present discounted value of the oil producing firm constant,
Gillman argues in his paper. Jumps occur because of the rigid contracting (
sticky oil prices with fixed price contracts over a long period of time which
do not allow for continuous adjustment of prices to keep the PDV constant) and
overshooting in the oil price happens as a consequence ( price rise in excess
of equilibrium price). In Gillman, Granger causality tests show that causation
actually went from inflation to oil prices around the historical oil price
jumps.
How can that be explained more intuitively? If producers forecast inflation and
therefore terms of trade deterioration and dollar depreciation, they also
forecast that real revenues of oil exports will decrease. To fence-off
this decrease in value, producers will have to raise the price of contracts
proportional to the rise in inflation. Since there is mostly dollar dependence
of revenues, the full impact of US inflation will be seen in prices. If Euro
reserves are used also, European inflation will push up the prices proportionally
with Euro’s share in the oil producers’ portfolios. If this hypothesis is true,
given ECB’s commitment to low inflation, building more Euro based reserves
would probably lead to more stable oil prices and consequently to better world
growth perspectives. Of course, once that cycle has started inflation is
aggravated by the spread of high oil prices into the economy.
In many ways, this situation is a “deja-vu”, only maybe at a smaller scale.
Recall that in the ‘1970s, before the Arab oil shocks, the Bretton Woods system
was in place. The jump in inflation with the 1999-2001 oil price jumps is no
more a coincidence than the Bretton-Woods breakdown around the 1973 oil shocks.
In order to work, the Bretton Woods system was based on US dollar pegged
currencies and required no convertibility ( Wikipedia); dollars had to be
pumped into the world economy, so more dollars had to be printed and trade
deficits had to be run ( reversing the trend from US trade surpluses) in order
to provide the liquidity needed to an increasing world trade. This is what
happens now at the smaller scale of the oil sector due to the
non-convertibility of oil prices. The US acted as the central banker of the
world, and the dollar was the currency of inter-world trade.
The system broke down due to accelerated growth of US money supply generated by
running government deficits needed to finance the Vietnam war. Deficits are
needed today also to finance the war in Iraq. As in the past, the US defense,
(or more exactly, its pre-emptive wars) is at least partly financed by running
persistent current account deficits and by relying on the dollar’s overwhelming
importance as a reserve currency.
Nonetheless this policy stance is likely to diminish in its effectiveness,
since new alliances get built and new petrocurrencies are arising. Meanwhile,
if the FED prints too much to finance the war in Iraq, we can expect further
oil hikes, naturally not because of sudden monopoly engagement of the
Middle-Easterners.
When the BW members deemed that the deficit policy was irreversible and lost
their belief in the dollar and in the American economy, the member countries
gave up supporting the peg by refusing to accumulate dollar reserves. High
inflation resulted when they stopped buying excess US dollars. All these were
happening in 1973, the year of the first oil shock. The 1974 inflation was
therefore a consequence of inflation generated oil price hikes and not of a
supply side shock. Penrose (in Gillman, 2001) observes that attempts to raise
the oil price by OPEC were justified as offsetting the cumulative effect of US
inflation and future related erosion of revenues. Spero and Hart (in Gillman,
2001), observe that inflation and dollar devaluation lowered the real value of
earnings from oil.
But high oil prices in the US can be explained by other inconsistencies
of the economic and foreign policies of the US. They are not only the result of
monopoly, but also of protection of the internal oil production. However this
extra-taxation does not finally benefit consumers unless tax revenues are not
used to alleviate oil dependence. Taxes levied on oil imports will only bite
into the economic growth of the country with long-term effects for the economy
when consumers have to bear the tax costs due to demand inelasticity (
consumption for other goods will be shifted away to pay for oil). Moreover fuel
efficiency policies are in deficit. This means that such a behavior does not
serve security purposes (Stern, 2007) and makes the US energy policy
inconsistent with its external policy. In this case a war waged for purposes of
preserving oil supply security would be even more unjustifiable.
SECTION III
Iran is an interesting example because it concentrates the second largest
proven oil reserves in the world; it currently provides 10% of world oil supply
and it is the world’s fourth largest exporter (Birol, 2005). .Moreover, it
poses a permanent threat to the security of supply, because it is an untamed
regime, which would not back easily in the face of potential sanctions.
In the European public debate, Iran seems very far away from Brussels and the
common voice seems powerless on this matter. On the security aspects regarding
Iran the EU only recently took a stronger position vis-à-vis its nuclear plans,
being usually an adept of the soft politics. Diplomacy does not work very well
however with a regime like that of Iran.
On the map of strategic interests of Europe, Iran is unforgivably prominent.
Iran is related to the future of a flourishing European economy to an extent
greater than acknowledged in today’s public debate. An evaluation of the
implications for the foreign policy of the European Union towards the Iranian
actions and for the European energy policy is therefore badly needed.
As time goes, the economic interests vis-à-vis Iran translate more and more
into ever growing strategic and security constraints. This is mainly because
the energy fueling production comes from a limited pool of fossil fuels
concentrated in the underground of a handful of countries, among which Iran
ranks high. Official specialized reports forecast that world peak production
will take place no later than 2020 (Liechtenstein, 2006). Since an important
feature of the energy sector is the length of time it takes to achieve
significant changes (most of the energy infrastructure today was built 20 years
ago), it becomes obvious why European action is immediately needed in this area
(Henningsen, 2006).
Nowadays the media attention is overwhelmingly directed towards the nuclear
defiance of Iran, although the oil aspects of the external relations of EU
might deserve equal attention. That is simply because the possible sanctions
against Iran include not only prohibition of trade in weapons or nuclear
technology or primary resources but also restriction of oil trade. Prices are
already on the rise and have reached 61 dollars per barrel as this article is
being written and markets are increasingly becoming nervous about the likely
embargo.
Most of the Iranian export revenues come from the oil trade, revenues which
automatically go into the government hands. Since these exports compete with
the domestic consumption of energy, Iran’s claims that it wishes to develop its
nuclear facilities for civil purposes do not seem so far-fetched anymore. For a
government which wishes to keep its export revenues unfettered and obviously a
strategic advantage in relation with its clients, its wish to develop
alternative energy supplies seems at least partly justified.
This is not to say that Iran’s intentions are completely innocent. According to
the geological data submitted by Iran it does not have known reserves of
uranium to support the Bushehr reactor for more than 6 years (or 10 even with
speculative reserves),(Rubin 2006). On the other hand, why would a
country so rich in petroleum need to develop nuclear energy at all? These
questions are enough to raise suspicion about the real intentions of Iran. If
Iran’s intentions are peaceful, this economic plan for gaining some relief in
power generation would not be too useful if not backed by serious investment in
the oil and gas industry also.
Iran’s nuclear behavior is more easily understood within the dynamics of
authoritarian regimes. Such regimes choose sometimes to go against the
democratic ones as their main enemies and try to prove their superiority even
by “unconventional” means. Their aim is to obtain domestic obeisance and
faithfulness by proving their external supremacy and thus gain legitimacy in
front of their people.
The oil weapon or the nuclear one, if taken seriously, are likely to be
important instruments in the external power game for such regimes. Similarly,
considerable energy subsidies are conceded to consumers in order to keep public
support high in Iran. It is therefore not difficult to justify the need for
developing nuclear power and get people’s support while also attracting their
opprobrium versus the foreign infringements. This situation works to the
advantage of the Iranian dictator also in the sense that the present situation
could be the perfect pretext of transforming Iran into a military nuclear power
under the perfect disguise.
The strategic importance of the Iranian oil for the future world oil market
becomes obvious when one takes into account that the Saudi production is close
to its maximum production while US, China and India are expected to increase
their oil consumption by 50% in 20 years. Iran also exports 2.5 million barrels
per day, which is 1 million barrel more than current excess capacity worldwide.
Accordingly James Bartis, senior researcher at Rand Corp estimates that even a
small amount in oil decrease would prop up the barrel price from $ 70 to $ 100
( Foss and Jahn, 2006).
On
top of all that, Iran holds 16% of total world reserves of natural gas and
global demand for natural gas grows faster than for any other source of energy.
This aspect poses a serious constraint to the substitutability discussed above.
After the peak of oil production, gas is likely to be the substitute to
compensate for the decreased oil production. It is also likely to be preferred
to the coal alternative because it is much more environment friendly.
Thus Iran is considered a threat also due to its perceived capacity of using
the oil weapon, not only the nuclear one. Similarly as above, let us ask the
question: what would happen if Iran stopped pumping oil? Stern ( 2007) uses the
same line of reasoning and asks: would there really be a collapse if that
happened? Some evidence of what might happen and how likely such an embargo is
already available.
Iran is nowadays actually confronted with a decreasing production capacity
(partly due to the wars it was involved into and partly due to failure to
reinvest in its technology). According to Klare (2005), Iran produces
close to its productive capacity.
Although on the map of suppliers Iran does have a strong position, it is not
invulnerable in the event of an embargo imposition either. The US department of
Energy estimates that the Iranian oil exports finance half of the government
budget. Countries can back up consumption at least for a while: the crude
reserves of International Energy Agency are up to 600 days of Iran’s net
exports, OPEC may add 1.5 billion barrels/day and Russia other 500,000. If the
price rose, it would most likely not grow to the benefit of Iran but to that of
other oil suppliers.
However, members of the UN Security Council are also Russia and China , Iran’s
main allies, where Russia supplies weapons and nuclear technology, and India
imports 75% of its oil needs. This is why a contingent embargo may not last if
the economic interests of these countries are too badly hurt.
Alternatively, perhaps Iran does not even need to use its oil weapon against
its western enemies. It could “democratically” choose its clients. Iran is
increasingly becoming a major supplier of oil and natural gas to countries like
China, India and Japan ( Klare, 2005). This rules out the monopsony
potentiality if for instance these growing clients do not share the same
objectives or are at odds with the external policy of the US. A communist
regime like China is more likely to make good partner of Iran and be defiant
towards the US politics.
Monopsony will never work in the presence of competition among consumers. The
same reasons of why monopoly cooperation might fail can be at the root of
monopsony failure and sanctions ineffectiveness: while US companies are
prohibited by law to do business in Iran, Chinese energy firms are already
closely cooperating with Iran in developing its productive capacities. The case
is similar for India and Japan. These long-term contracts are likely to
have equally long term impacts on the oil competition among buyers. Based on
this comparative advantage in securing demand, Iranian menaces of restricting
oil supplies may, if deemed credible, cause markets to panic and raise prices (
Foss and Jahn, 2006).
So, does Iran really need nuclear power? Stern ( 2006)observes that some
industry analysts project Iranian oil export decline. While the government
heavily relies on oil revenues, the expected depletion rate (rate of depletion
plus domestic demand growth mount to 10-12%), is not offset by actual
investment (partly due to its reluctance to allow foreign investments). The
most optimistic projection is that in 2011 exports will reach 40%-52% of 2006
exports. Despite this obvious mismanagement, Iran real revenues are nearly
their highest ever due to rising price; per capita revenue however fell to 44%
relative the 1980 and the revenue growth was invested in loss making
industries.
Given this current situation ( Stern concludes) it seems like Iran is unable to
use its oil weapon in an effective way even if wanted to, but so long as public
perception is unaware of the real state of the facts, a simple menace may put
up a “fear premium” and help Iran make-up for the lower exports.
SECTION IV:
“It is difficult to develop internal market
with monopolistic suppliers at the borders”
(Linde, 2005)
The relevance of the oil debate is fully apparent for the European countries
which are highly dependent on oil imports (IEA, 2004). In 2004, Europe imported
45% of its total oil imports from the Middle East (Paillard, 2004); it is
primary purchaser of oil from and supplier to Saudi Arabia (38% of Saudi Arabia
imports come from Europe) and, importantly, Iran. EU as a whole is also the
main trader with the Gulf (mostly with Kuwait and the United Arab Emirates).
Europe accounts for 40% of world oil imports which covers 1/3 of its oil needs
(Liechtenstein, 2006); 42% of energy in Europe originates from oil (Villenborg
et al, 2004).
On the background of decreased own oil resources (North Sea oil peaked in 2002
for the UK and in 1997 for Norway) and increased consumption and competition in
world oil imports, EU will remain dependent on oil from the Middle East and, as
oil reserves diminish, increasingly on gas supplies from Russia
(Liechtenstein, 2006). According to some estimates ( IEA, 2004),
oil dependence from outside sources may reach 85% in 2010 and 90% in 2020. As
the numbers show, the EU needs oil badly: total oil consumption is divided
among transport (52 %), industrial production (24 %), household heating (15 %),
and power production (9 %).
Generally, higher prices contribute to higher unemployment and budget deficit
problems. IEA (2004) forecasts that, in the case of a price hike from 25
to 35 $ per barrel, the Euro-zone would suffer the most (by a rise in
inflation by 0.5% and a GDP loss of 0.5%), while the US would suffer the least
because it is less oil dependent (0.3% GDP loss). Japan, while 100% oil
dependent, has low oil intensity of its production and will therefore be less
hurt.
Together with the strategic position of Iran described above, it becomes
apparent why the EU cannot afford to remain a political dwarf and not take a
common stance on energy matters. Future oil supply and demand is crucial for
the EU (Liechtenstein, 2006).
It is worrying that, as Paillard (2004) reports, the common policy on energy
does not tackle strategic issues like the security of energy for all EU
members. EU desperately needs a coherent policy mainly because, as a recent
Euractiv article points out, EU is a major player in the energy market but a
dwarf on the political scene. While this is the case, the European Commission
2006 Green Paper says almost nothing about the oil transport sector (Henningsen,
2006). On 4 December 2006, the EU Commission passed the proposal to include
energy in its external relations. These external aspects remain nonetheless in
the backyard of the European foreign affairs and are regarded as national
sovereignty matters. In an expanded heterogeneous Europe, full consensus on
sensitive matters is likely to be a nightmare.
We have seen that inconsistencies are at the root of energy problems in the US.
But inconsistencies in the energy policy are to be found in the EU also. Take
for instance the gas industry. Gas is relevant for the oil future of the EU
because it is a strong candidate for substitution purposes. Although gas can be
characterized by some degree of monopoly, other related energy sectors are
supposed to work on a competitive basis. At times when natural gas is needed to
meet electricity demand, gas is the price setter though it accounts for minor
part of total electricity production. But even if nuclear, hydro and coal
electricity production have lower cost they still sell at same high price as
gas does.
This means there is some kind of cartelization going on in the European markets
and producers are charging monopoly prices based on the same inelasticity of
demand. This means that when the oil constraint will bind more, resulting price
rises in the gas sector would highjack the electricity supply by rising prices
further. Definitely, the Competition Policy of the EU should kick in. In the
European Union, substitution works against consumers (Liechtenstein, 2006):
correlated prices of oil, gas and alternative energy sources due largely to the
low elasticity of demand, will, in the long run, result in the convergence of
their prices.
Lack of significant progress in alternative energy sources and renewables makes
the urgency of tighter cooperation even greater. As discussed in the first
section, some relief from supply shocks can be provided by building emergency
stocks. However, the lack of commitment and cooperation on this matter resulted
in other inconsistencies.
EU participates both in a Common policy on emergency stocks and in the
International Energy Agency–a system which works as a consumer country
organization ( it somehow embodies the monopsony idea we discussed above),
(Willenborg, 2004). So there are 2 systems of emergency out there, which is a
sheer proof of internal disagreement in the EU. The problem (and advantage in
the same time) with the European system is that it requires solidarity at every
time of actual implementation; countries less affected by supply disruption
must come to the assistance of those more severely affected. The problem arises
from the fact that some countries could persistently be more affected by shocks
due to the European heterogeneity in terms of oil dependency and oil intensity.
Coming up with a compensation mechanism is likely to be demanding but not
impossible. Since the benefits of integration are shared, and integration is
likely to deepen, such a system may be easier to build. Just remember that the
whole European project was built on this same idea: to secure the then crucial
commodities to economic development: coal and steel. Today that has changed:
the crucial commodity is oil and the Europeans are not self-sufficient this
time. Of course, it would be impractical to integrate the Middle East into the
European Union to secure vital resources, but at least Middle East should be
well integrated in a strong CFSP as well as in a Common and Coherent Common
Energy Policy.
The
question is now whether these mounting pressures in the energy sector described
all along in my analysis will lead to more unity or more disunity. In the
Brussels - sub-sovereign debate, political and strategic tools are obtained too
slowly and are strategically irrelevant in a rapidly changing geo-strategic
environment (Linde, 2005). For Europe, regulation strategy
clearly lags behind the geo-political changes.
Conclusions:
This article outlines
some peculiar aspects that define the economics of oil, beyond de geopolitical
aspects that normally surround it. One such case refers to the implications of
the US economic policy for the evolution of the oil market. It then takes an
insight tour into what is really happening in the realm of the Iranian oil. The
European approach to energy safety is then analyzed.
In the world of oil,
both producers and suppliers can coordinate in such a way as to obtain a more convenient
price. When they can do so, they are actually behaving in no other way but
optimally: on the one side for the sake of profit maximization and on the other
for the sake of consumption maximization. It is as I said a continuous
interplay, the drivers and consequences of which never stop changing: this is
what makes talking about the economics of oil so special. We could easily talk
about profit maximization, but one cannot neglect the limited resource
constraint, the strategic implications of too aggressive a price policy, the
boomerang effect from too recessionary consequences of high prices or the
innovation boost that can be engendered by those high prices. In the same time,
in this signaling game the consumer is not only preoccupied with getting the
oil at a low price; he is also preoccupied with environment protection, with
developing alternative sources of energy given scarcity and with the political
interplay between the national actors (i.e. imposing an oil embargo in response
to the presence of nuclear weapons developed by dictatorial regimes).
When we have a closer
look however at the types of stakes that are at play when we talk about oil,
some myths tend to be demystified: what if the oil crises were not just a
consequence of monopoly power, but the result of wrong economic policies of the
US; what if Iran did not possess a real oil weapon and what if that was just a
mere Fata Morgana? And what if Iran does need nuclear power to satisfy its
energetic needs?
Certainly, the
discussion above must be included in the general debate of what the European
role should be in the energy market and politics. I have managed to point out
that there are major inconsistencies at the European level in the energy
sector. There are both regulation and diplomacy gaps in the EU which jeopardize
not only the economy but also the security of its citizens. I am confident
nonetheless that, once the full image of the consequences of inaction comes
afloat, the EU leaders will find enough incentive to act together more
purposefully (there are plenty of signals already). I only hope it will not be
too late.
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