Oil - Coping with change

With Mossadeq's fate serving as a warning to those who might challenge the international oil companies and their sponsors, the 1950s and 1960s were the golden age of the postwar oil regime. At the peak of their influence in the 1950s, the seven major oil companies controlled over 90 percent of the oil reserves and accounted for almost 90 percent of oil production outside the United States, Mexico, and the centrally planned economies. Moreover, they owned almost 75 percent of world refining capacity and provided around 90 percent of the oil traded in international markets.

Despite these strengths, the system contained the seeds of its own demise. The Iranian crisis demonstrated that threats to Western access to Middle East oil could come from within the region. Although the United States did not rule out the possibility of Soviet military intervention in the Middle East, U.S. threat assessments increasingly focused on the decline of British power, instability within the countries of the region, the anti-Western cast of Middle Eastern nationalism, and turmoil resulting from the Arab-Israeli conflict.

The Suez crisis grew out of the nationalization of the British-and French-owned Suez Canal Company by Egyptian nationalist leader Gamal Abdel Nasser in July 1956. The Suez Canal was an important symbol of the Western presence in the Middle East and a major artery of international trade; two-thirds of the oil that went from the Persian Gulf to western Europe traveled through the canal. Viewing Nasser's action as an intolerable challenge to their position in the region, the British, together with the French, who resented Nasser's support for the Algerian revolution, and the Israelis, who felt threatened by Egyptian support for guerrilla attacks on their territory, developed a complex scheme to recapture control of the canal and topple Nasser through military action.

The plan, which they put into action in late October, depended on U.S. acquiescence and cooperation in supplying them with oil if the canal were closed. The Egyptians closed the canal by sinking ships in it. In addition, Saudi Arabia embargoed oil shipments to Britain and France, and Syria shut down the oil pipeline from Iraq to the Mediterranean. Incensed by his allies' deception, concerned about the impact of their actions on the Western position in the Middle East, and embarrassed by the timing of the attack—just before the U.S. presidential election and in the midst of the Soviet suppression of the Hungarian revolt—President Dwight D. Eisenhower put pressure on the British, French, and Israelis to withdraw. The United States refused to provide Britain and France with oil, blocked British attempts to stave off a run on the pound, and threatened to cut off economic aid to Israel. The pressure worked. Following the withdrawal of Anglo-French forces, the U.S. government and the major oil companies cooperated to supply Europe with oil until the canal was reopened and oil shipments from the Middle East to Europe restored.

In the wake of the Suez crisis, President Eisenhower pledged to protect Middle East states from the Soviet Union and its regional and local allies. In addition, the United States sought to bolster its friends in the region through economic and military assistance. With the exception of Lebanon, where fourteen thousand U.S. troops landed in July 1958 to shore up a pro-Western regime, most of these friends were authoritarian monarchies, demonstrating that despite its rhetoric about democracy, the United States was primarily interested in access to oil. Israel presented the United States with an additional dilemma. On one hand, it was pro-Western and militarily the most powerful country in the region. On the other hand, U.S. support for Israel was a major irritant in relations with the Arab states of the Middle East, including the key oil-producing countries in the Persian Gulf.

The Suez crisis highlighted the growing importance of Middle East oil for western Europe. During the 1950s and the first half of the 1960s, the United States was capable of supplying its oil needs from domestic sources, and Middle East oil went mainly to western Europe and Japan. Some Middle East oil made its way into the United States, and, more importantly, Middle East oil displaced Venezuelan oil from European markets and led to an increase in U.S. oil imports with consequent pressure on prices and high-cost domestic producers.

The question of oil imports presented U.S. policymakers with a strategic dilemma. If what would be needed in an emergency was a rapid increase in production, oil in the ground was of little use, and even proved reserves would not be particularly helpful. The need could only be filled by spare productive capacity. Too high a level of imports would undercut such capacity by driving out all but the lowest cost producers. Moreover, reliance on imports, especially from the Middle East, was risky from a security standpoint because of the chronic instability of the region and its vulnerability to Soviet attack. However, restricting imports and encouraging the increased use of a nonrenewable resource would eventually under-mine the goal of maintaining spare productive capacity and preserving a national defense reserve.

Rising oil imports led to demands by domestic producers and the coal industry for protection against cheaper foreign oil. In contrast, the President's Materials Policy Commission, appointed by President Truman in January 1951 and headed by the chairman of the Columbia Broadcasting System, William S. Paley, had called for a policy of ensuring access to the lowest cost sources of supply wherever located. The commission's report, issued in June 1952, rejected national self-sufficiency in favor of interdependence, arguing that the United States had to be concerned about the needs of its allies for imported raw materials and about the needs of pro-Western less developed countries for markets for their products. Although the commission admitted that self-sufficiency in oil and other vital raw materials was possible, it argued that it would be very expensive, that the controls necessary to make it possible would interfere with trade, that it would undercut the goal of rebuilding and integrating western Europe and Japan under U.S. auspices, and that it would increase instability in the Third World by limiting export earnings.

Nevertheless, after attempts to implement voluntary oil import restrictions failed, the Eisenhower administration, in March 1959, imposed mandatory import quotas, with preferences given to Western Hemisphere sources. Although the Mandatory Oil Import Program (MOIP) seemed to be a victory for advocates of national self-sufficiency, the result, ironically, was to make the United States more dependent on oil imports in the long run because the restrictions meant that increases in U.S. consumption were met mainly by domestic production.

High levels of oil use were built into the U.S. economy in several ways. Following World War II, the U.S. transportation sector was transformed as automobiles, trucks, buses, airplanes, and diesel-powered locomotives replaced steam and electric-powered modes of transportation. Between 1945 and 1973, U.S. car registrations increased from 25 million to over 100 million, and per capita gasoline consumption in the same period skyrocketed as fuel efficiency fell and gas-guzzling car models grew more popular. Neglect of public transportation and dispersed housing patterns fostered by increasing suburbanization further fueled increased automobile use. In addition, the nation's truck population grew from 6 million in 1945 to around 21 million in 1973, and trucks increased their share of intercity freight traffic from 16 percent in 1950 to 21 percent in 1970.

Public policy aided and abetted these changes. Since the early 1930s, the so-called highway lobby had been promoting public expenditures for highway construction. Between 1956 and 1970, the federal government spent approximately $70 billion on highways, as contrasted with less than $1 billion on rail transit.

The dramatic rise in U.S. oil consumption, coupled with a shift in investment to more profitable overseas areas, decimated the U.S. reserve position. By 1965, the U.S. share of world production had fallen to about a quarter and by 1972 to a fifth. The U.S. share of world oil reserves declined even more drastically, from around 46 percent on the eve of World War II to a little more than 6 percent in 1972. With U.S. oil consumption continuing to climb, domestic production was no longer able to meet demand, and oil imports rose from 9 percent of U.S. consumption in 1954 to 36 percent by 1973.

U.S. oil import restrictions also put downward pressure on world oil prices by limiting U.S. demand for foreign oil. Beginning in the mid-1950s, increasing numbers of smaller, mostly U.S.-owned companies challenged the majors' control over the world oil economy by obtaining concessions in Venezuela, the Middle East, and North Africa. Drawn by the lure of high profits, aided by the increasing standardization and diffusion of basic technology and the security provided by the Pax Americana, and unconcerned about reducing the generous profit margins available in international markets, the newcomers cut prices in order to sell their oil. Pressure from the production of these companies, coupled with the reentry of Soviet oil into world markets in the late 1950s, exerted a steady downward pressure on world oil prices.

Declining oil prices led to a resurgence of economic nationalism in the producing countries, whose incomes were reduced. In September 1960, following cuts in posted prices (the price on which government revenues were calculated) by the major oil companies, the oil ministers of Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela met in Baghdad and formed the Organization of the Petroleum Exporting Countries. OPEC was able to prevent further declines in posted prices, and a strong increase in world demand in the 1960s allowed the companies to increase production, thereby maintaining their overall level of profits. As new sources of African production entered the market later in the decade, however, market prices resumed their downward trend.

Despite falling prices, the spectacular increases in oil consumption enhanced the position of Middle East oil in the world oil economy. At the same time the U.S. oil position was eroding, the Middle East and North Africa were becoming the center of the world oil industry. By 1972 these areas accounted for 41 percent of world oil production and contained almost twothirds of the world's proved reserves. Reacting to the changing circumstances, the region's oil producers, along with other OPEC members, began to pressure the oil companies to gain control of pricing and production decisions.

The profound political, economic, and strategic consequences of the U.S. involvement in the Vietnam War and the overall course of the Cold War reinforced the geological and economic factors that gave Middle East oil increased importance. By the early 1970s, the Soviet Union had achieved rough strategic parity with the United States, which raised the risks involved in U.S. intervention in the Middle East. Moreover, in the midst of the Vietnam War, the British decided to end their military commitments "east of Suez." To make matters worse, U.S. relations with the Arab oil producers, including Saudi Arabia, were becoming increasingly strained owing to U.S. support for Israel following the 1967 Arab-Israeli war, which left most of Palestine under Israeli control.

When the United States moved to airlift arms to Israel during the 1973 Arab-Israeli War, the Arab members of OPEC imposed an embargo on oil shipments to the United States and the Netherlands and reduced shipments to other countries, depending on their position in the Arab-Israeli dispute. The oil companies carried out the embargo, though they undercut its political purpose by shifting non-Arab oil to the embargoed countries and distributing the cutbacks so that both embargoed and nonembargoed countries had their oil imports cut by about 15 percent. Arab OPEC members unilaterally raised the price of oil by 70 percent in October, and by December the price had quadrupled from its level before the embargo. Although Iran and other non-Arab OPEC members did not join the embargo and cut back production and exports, they were happy to go along with the price increases spurred by the embargo and production cutbacks.

Differences among the United States and its allies on higher oil prices and on the Arab-Israeli conflict undercut attempts at a unified response to the embargo. Although there was some tough talk about military action to regain control of the Middle East oil fields, the reality of the Cold War and fears during the Gulf War of 1991 (later borne out), that use of force would lead to the destruction of the oil fields, prevented such action. U.S. allies, noting that higher international oil prices could provide the United States, which was much less dependent on imported oil than they were, with a means of reversing the decline in its share of world production, doubted the U.S. commitment to lowering oil prices, further complicating a unified response.

The United States sought to salvage the old oil order by organizing the Western consuming nations in a united front against OPEC. In February 1974 the U.S.-initiated Washington Energy Conference laid the groundwork for the establishment later in the year of the International Energy Agency. The IEA called on member states to reduce their reliance on Middle East oil by diversifying their sources of energy and adopting policies promoting reductions in oil consumption.

The United States also moved to shore up its position with the oil-producing countries. In 1969, President Richard Nixon had announced that the United States could no longer intervene directly in all parts of the world, but rather would rely on regional allies, which it would provide with arms and other assistance to carry out their tasks. In the Middle East, the United States looked to Iran and Saudi Arabia as the "twin pillars" of pro-Western stability in the region, and rewarded the two monarchies with almost unlimited access to the latest U.S. military equipment. Between 1970 and 1978, for example, the United States sold Iran over $20 billion worth of military equipment and training. The United States also provided massive military and economic assistance to Israel following the 1973 war, viewing the Jewish state as a strategic asset and counter to Soviet client-states such as Syria and Iraq. Egypt (after 1973) and Turkey also received large amounts of U.S. aid.

The Arab oil embargo had a major economic impact. Higher oil prices intensified the economic problems faced by the United States and the other Western industrial countries in the 1970s, especially inflation, which was now accompanied by stagnation and increased unemployment. Non–oil-producing developing countries were also hit hard as they had to pay higher prices for products from the developed countries as well as for oil. Many countries borrowed large sums from Western banks to cover their costs, a move that contributed to the Third World debt crisis of the 1980s when the United States sharply raised interest rates in late 1979.

In contrast, higher prices enabled the Soviets, who were in the process of developing new oil and gas fields in Siberia, to increase their export earnings. While allowing the Soviets to import large amounts of Western grain and machinery, most of the exports came from new areas east of the Urals, and the cost of developing the necessary transportation infrastructure drained scarce capital from other sectors of the economy. Oil earnings also tended to mask the Soviet Union's increasingly severe economic problems and to reduce incentives for undertaking sorely needed structural reforms. The oil crisis may also have contributed to Soviet decisions to increase their involvement in the Third World in the 1970s, decisions that proved costly not only in terms of resources but also in their negative impact on détente.

The first oil shock also accelerated efforts by oil-producing countries to gain control of their oil industries. While the timing and extent of nationalization differed, most OPEC nations effectively nationalized their oil industries during the 1970s. The equity participation of the international oil companies in OPEC production fell from about 94 percent in 1970 to about 12 percent in 1981. Although they lost control of production and their ability to set prices, the major oil companies received generous compensation. In most cases, the companies maintained access to the oil they had previously owned through long-term contracts and were retained to manage the newly nationalized industries. Moreover, higher oil prices provided the major oil companies with windfall profits, easing the pain of losing formal control of their concessions.

Because it was both a major oil producer as well as the leading oil consumer, higher oil prices posed a dilemma for the United States. On one hand, higher prices could provide U.S. domestic producers with incentives for increased exploration and development, making the nation more self-sufficient in oil. On the other hand, higher prices fed inflation and slowed economic growth. The fact that the oil companies profited from higher oil prices and oil shortages prompted suspicions that the companies had colluded with OPEC to produce such an outcome. These suspicions made it impossible for the U.S. government to remove oil price controls, initially imposed in August 1971 as part of a larger package of wage and price controls. Although lower domestic oil prices lessened the impact of the rise in international oil prices on the U.S. economy, they also encouraged consumption and led to increased demand being met mainly by imported oil. When the second oil shock hit in 1979, the United States was more dependent on oil imports than in 1973.

The overthrow of the shah of Iran in early 1979 provoked this second oil shock, disrupting markets and causing prices to double. The fall of the shah and fears of internal unrest in Saudi Arabia convinced U.S. policymakers that the previous policy of reliance on regional surrogates to guard Western interests in the Middle East was no longer viable. While Israel was useful to counter Soviet clients, too great a reliance on Israel could prove counterproductive by alienating the Arab states. Therefore, the United States began to explore the possibility of introducing U.S. military forces into the region. These plans received a boost from the Soviet intervention in Afghanistan in December 1979, which revived fears of direct Soviet encroachment in the region. In addition, the United States was concerned that Soviet and Cuban involvement in the Horn of Africa, an area in the northeast part of the continent close to the Middle East, could threaten Western access to Middle East oil.

The prospect of losing access to Middle East oil led President James Earl Carter to announce in January 1980 that "an attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and such assault will be repelled by any means necessary, including military force." The Carter administration followed up soon thereafter with steps to create the long-discussed rapid deployment forces for possible use in the region. Planned from the time of the collapse of the shah's regime, the move reflected U.S. belief that local forces were not sufficient to protect Western interests in the Middle East from either Soviet aggression or internal instability. The Carter administration also sought to strengthen the "special relationship" between the United States and Saudi Arabia by continuing to sell sophisticated arms to the desert kingdom and by allowing the Saudis to buy massive amounts of U.S. Treasury securities outside normal channels.

The administration of Ronald Reagan (1981–1989) built on these initiatives, forging a foreign oil policy based on market forces and military power. Reagan began by ending oil price controls, allowing U.S. prices to rise to international levels in the hope that this would provide incentives to domestic producers and spur conservation. The Reagan administration continued the buildup of U.S. forces in the Middle East, transforming the Rapid Deployment Force into the Central Command. The Reagan administration also stressed close relations with Saudi Arabia, and worked with the Saudis and other conservative Persian Gulf producers to drive down international oil prices. Lower oil prices would not only help Western consumers but would also cut Soviet oil earnings. Finally, the United States began filling the Strategic Petroleum Reserve (SPR), established in 1977 to reduce the nation's vulnerability to oil supply interruptions. By 1990 the SPR held almost 600 million barrels of oil, somewhere between eighty and ninety days of net oil imports at then prevailing import levels. The other industrial nations also built up similar, and in some cases higher, levels of strategic reserves. Strategic reserves, although expensive to create and maintain, functioned as a substitute for the spare production capacity that the United States had once possessed.

Higher oil prices worked their way through the economies of the Western industrial nations and Japan to encourage significant increases in energy efficiency. The amount of energy required to produce a dollar of real gross national product declined 26 percent between 1972 and 1986. The gains in efficiency in oil use were even more dramatic: by 1990, 40 percent less oil was used in producing a dollar of real GNP than in 1973. As a result, by 1990 oil played a less significant role in the economies of the Western industrial nations than it had before the two oil shocks of the 1970s.

Higher oil prices also encouraged consumers to switch to other energy sources. While the use of coal and nuclear power increased, both turned out to have significant drawbacks, particularly those relating to the environment, and neither addressed the transportation sector, which accounted for the bulk of oil use. Although U.S. automobile fuel efficiency almost doubled between 1970 and 1990, this gain was partly eroded by a 40 percent rise in total motor vehicle use in the same period. In addition, the number of trucks on U.S. roads tripled between 1970 and 1990, and their fuel consumption doubled.

Higher oil prices also encouraged the development of alternative sources of oil. With higher prices and improving technologies of exploration and development, new sources of oil came on line in Alaska, Mexico, the North Sea, and the Soviet Union. U.S. production increased only briefly, however, and soon leveled off at around seven million barrels a day. Middle East oil production, which had accounted for 41 percent of world output in 1973 and 37 percent in 1977, fell to 19 percent by 1985. In 1986, with supply increasing and demand dropping, oil prices collapsed.

The collapse of oil prices provided a boost to Western economies but it also decimated the U.S. domestic oil industry, forcing the closure of high-cost wells. All producers experienced huge declines in export earnings. The Soviet Union was especially hard hit, and the collapse of oil earnings undercut Soviet leader Mikhail Gorbachev's hopes to use oil revenues to cushion the shock of economic reform. By the end of the decade, the Soviet oil industry was suffering from the same problems affecting the nation as a whole, and production and exports declined sharply.

Although lower prices led to increased demand for oil, producers in the Middle East captured most of the increase because they controlled the lowest cost fields. By 1990, oil imports were making up nearly half of U.S. oil supply, around 70 percent of western Europe's oil supply, and over 90 percent of Japan's oil supply; and 25 percent of U.S. imports, 41 percent of western Europe's imports, and 68 percent of Japan's imports originated in the Middle East.

Nevertheless, after rising sharply in the aftermath of the Iraqi invasion of Kuwait in August 1990, oil prices soon returned to preinvasion levels. The IEA contributed to stability by calling on member countries to make simultaneous use of their respective stockpiles. The success of U.S. diplomacy and military forces in the 1991 Gulf War demonstrated that with the end of the Cold War and the resulting retreat of the Soviet Union from a world role, the ability of the United States to intervene in the Middle East had increased significantly.

Low prices prevailed throughout most of the 1990s despite Iraq's exclusion from world oil markets. Russian oil exports recovered owing to Russia's need for export earnings and the drastic drop in domestic demand because of widespread deindustrialization. The Asian financial crisis of 1997 also kept demand down despite China's increasing imports. In the United States, lower oil prices led to increased consumption, as the number of private motor vehicles, especially gas-guzzling sport-utility vehicles and light trucks, continued to climb. By the end of the decade, the fuel efficiency gains of the 1980s had been lost. Rising consumption and OPEC production cuts led to sharp price increases in 2000 and 2001. What happened in the 1990s may foreshadow a pattern whereby lower prices lead to greater consumption which leads to higher prices which lead to lower consumption which leads to lower prices and the repeat of the cycle. Thus, a foreign oil policy based on market forces and military power has its own set of problems.