CHAPTER 13: OPEC AND CRUDE OIL

Oil is the major fuel used by people today. Because oil is liquid, it is easy to mine by drilling and pumping rather than excavation, and it is easy to transport in tankers and pipelines. Nevertheless, the history of oil supply has been dominated by the time and place of discoveries, with enormous results on the history of the 20th century. It has also been dominated by a few individuals, companies, and nations, with greed, superb intelligence, and unbelievable stupidity. Before we get into that, however, I want to make the point that petroleum and petroleum products have been minor components in international trade for thousands of years.

Bitumen and Egyptian Mummies.‹Bitumen is a spongy cake-like substance that forms when much of the volatile content of crude oil has evaporated off. Because it is light enough to float, bitumen "rafts" form from oil seeps deep under the Dead Sea, and eventually pop to the surface where they can be collected from rafts or boats. In ancient time, bitumen was much in demand by the Egyptians for use in preserving mummies, and a bitumen trade built up across the Sinai Desert. Nasty little wars broke out over these trade routes, and the rise and fall of the Nabateans of Petra is linked with this trade. The Chinese invent Oil Drilling.‹The Chinese used oil from natural seeps as fuel to boil salt. They invented the oil pipeline, using lengths of bamboo to take oil to the salt pans. As an extension of this technology, they pounded bamboo vertically into the seeps, thus inventing oil drilling as they penetrated deeper and deeper. The technology was much admired by a European visitor early in the 19th century, and (with iron pipe instead of bamboo) was transferred to the west. Finally it was used in the first large-scale oil drilling ever attempted, in the eastern United states.

John D. Rockefeller

The modern oil era began in northwest Pennsylvania in the mid-19th century, as shallow fields were tapped. The demand for oil was not great: its major use, after refining, was as kerosene for oil lamps. Even moderate discoveries (by today's standards) flooded the market, crashing prices at least temporarily. The early days of the oil industry were characterized by boom and bust, as new discoveries first overwhelmed demand, then lagged behind it. Prices fell from $10 a barrel in January 1861 to 10¢ a barrel in December 1861, but were up to $7.25 a barrel again by September 1863, down to $2.40 in 1867. Fortunes were made and lost in boom towns and stock speculations that rivalled any in the gold industry.

The innovation that allowed some control over the chaos was the oil pipeline. Barrels (real barrels, made of oak) were expensive, sometimes worth more than the oil they contained. They were expensive to transport on wagons, too. By 1866, pipelines, made of wood at first, had been built to the major producing fields, transporting oil to railheads where tanker cars could be filled. After that, there was only one real choice: the oil flowed to the nearest industrial city for refining, Cleveland, Ohio.

It was the genius of John D. Rockefeller that found a way to take advantage of this situation, which was merely a matter of simple geography. The oil fields were scattered in rough country, owned by small-time entrepreneurs, and new discoveries were unpredictable in location and size. They were, however, likely to occur in the same region, and they would be connected by pipelines to the existing rail network, and funneled to Cleveland. After refining, the kerosene was marketed nation-wide.

Rockefeller reasoned that the way to control the oil industry was within the transportation and refining section. In particular, refineries were comparatively long-term investments. At the age of 20, Rockefeller had entered business just as the Civil War began, and made a lot of money supplying the Army with wheat, salt, and pork. In 1863 Cleveland was connected with the Pennsylvania oilfields by rail, and Rockefeller and a partner opened an oil refinery in Cleveland. In 1866 he bought out his partner, and at the age of 26 owned the largest refinery in the city. Using the size of his shipments to negotiate low prices for railroad transport, outcompeting his rivals for price and quality, Rockefeller and his Standard Oil Company became the largest oil company in North America, amalgamating and controlling the refining side of the industry. By 1879 Standard Oil controlled 90% of the refining capacity in the United States, and all the pipelines flowing out of the Pennsylvania oilfields.

In the 1880s, Standard moved into oilfield production too. By 1890, it was producing or buying over 80% of the oil produced in the United States, and refining and selling it. Standard was exporting kerosene, too: half of the kerosene it produced was exported, mainly to Europe, and kerosene was the fourth-largest American export commodity.

At the end of the century, the Standard Oil Trust controlled the oil industry of the Americas, while Shell was a major player in much of the rest of the world.

Three major events altered this situation: in 1901 the great Spindletop gusher brought Texas oil into the picture, eventually bringing Gulf and Texaco into the big leagues; in 1911 the US Government used anti-trust legislation to break up the Standard company; and the World War of 1914-1918 brought to everyone's attention the fact that petroleum was now vital to waging and winning wars. The scene was set for oil to dominate much economic, political, and military thinking, and that situation continues today.

The Seven Sisters

We know now that most of the world's oil production and most of the world's oil reserves will be in the Middle East for the foreseeable future. The predominant oil-bearing region lies in an arc from Iraq and Iran through Kuwait and Saudi Arabia, with the smaller Gulf States like Abu Dhabi and Bahrain on the fringe of the belt. But that was not known until early in the 20th century.

In 1904 an Armenian businessman, Calouste Gulbenkian, reported to the Turkish Sultan Abdul Hamid on the oil potential of the then Turkish provinces in Iraq: the Sultan promptly transferred large areas into his own personal possession. The Iraq Petroleum Company was formed in 1914, with capital coming from a consortium of British and Dutch companies.

The Anglo-Persian Oil Company, which eventually evolved into BP, struck oil in Iran in 1908, and in 1911 Winston Churchill, then head of the British Admiralty, used Government money to buy half of the company on behalf of the Royal Navy. Churchill also decided that new British battleships would be fueled by oil rather than coal, and the Iranian supplies were very valuable to the British in World War I.

By the end of World War I the central place of petroleum in world strategy had become obvious, and the dramatic thirst of military operations had led to fears that there would be a global oil shortage, and to quick appreciation of the profits to be made in such circumstances. American companies, who had been unwilling to explore abroad when vast oilfields were being discovered at home in Texas and California, began to look overseas, and the American government began to use considerable political and economic pressure to try to force American companies into the European-dominated consortia in the Middle East. However, new fields came on line in the 1920s, and the big companies were soon worrying instead about an oil glut. By 1928 there were negotiations between BP, Shell, and Exxon*

*I have used the modern names of oil companies in the discussion that follows to save confusion: thus, "Exxon" rather than "Esso"; I call the largest oil companies "the majors".

in a Scottish castle, and the so-called Achnacarry Agreement set out working principles to avoid competition at the marketing end of the oil industry. The agreement specifically excluded the US market because of its powerful anti-trust legislation, but there is no question that the companies had no intention of serious competition there if they could hammer out an agreement for the rest of the world.

The Economist of London praised the Achnacarry Agreement as "an example of the effectiveness of international cooperation in oil marketing." The Economist was pleased with the "stability" of the prices of oil and gasoline, but it's not clear whether the articles was written with the seller or the consumer in mind. Mobil, Gulf, and Texaco had joined the three founder companies by 1932, to make six. The results for producers were very rewarding: stable (but higher) prices gouged the consumer for decades, and "pirates" were dealt with summarily whenever possible.

With the Achnacarry Agreement in hand, each large company could feel that it would be able to negotiate a market share for its oil without seeing petroleum prices crash. The stage was now set for serious prospecting, and for staking out major oilfields, even though every company could see that it would not be in a position to pump all the oil that it found. After 1928, therefore, the era of the great Middle East oil strikes began, though Middle East production remained low.

In 1928 the six-year negotiations over Iraq were completed, and the Iraq Petroleum Company was re-divided. 5% went to the formidable Mr. Gulbenkian, and the other 95% was shared equally between the British (BP), the Dutch (Shell), the French (CFP, the Compagnie Française Pétrole), and a Rockefeller-controlled American group (Exxon + Mobil). The Iraq company was essentially set up as an accounting company, to share the production costs and the crude oil between the partners.

On June 1, 1932, Socal (now Chevron) struck oil in Bahrain, the first strike in the Arabian peninsula. In 1933 BP extended its Iranian lease for another 60 years. Gulf joined with BP to explore a Kuwaiti concession in 1934. But 1938 marked the major turning point in Middle East oil history: Gulf and BP struck the Burgan field in Kuwait, and Chevron struck oil in Saudi Arabia.

Oil did not begin to ship from Saudi Arabia until 1946 because of World War II, but it was clear that Chevron's discovery had made it overnight into a major, globally powerful company. Its oil was marketed through Texaco's global sales network under the name Caltex, while the Saudi part of the partnership was called Aramco, the Arabian American Oil Company.

King Ibn Saud of Saudi Arabia became impatient for more cash return from his oil fields, and Aramco (Chevron + Texaco) began to expand Saudi production and to sell oil at a price that undercut Texas prices. Even so, production costs in the Saudi oilfields were so low that the partners were making a larger profit than anyone could make from Texas production. The implied threat and gentle pressure brought the other companies into negotiation, and soon Chevron became a seventh major partner in the international selling agreements. (This may have had something to do with the fact that at the time the Rockefeller interests were still the largest shareholders in Mobil, Exxon, and Chevron.) By a major reorganization in 1947, Mobil and Exxon bought into Aramco, leaving Chevron, Exxon, and Texaco with 30% each, and Mobil with 10%. This meant, in essence, Rockefeller control over Aramco.

Even so, Saudi production was nowhere near full capacity. Complex conditions were negotiated between the big companies to ensure that new production from the Middle East would be marketed without major competition. A US government report said in 1952 that the seven international oil companies operating in the Middle East were jointly controlling oil prices. This report gave rise to the expression The Seven Sisters for the companies involved: the four Aramco members, Exxon, Mobil, Chevron, and Texaco; the Kuwaiti partners Gulf and BP (British Petroleum); and Shell, which had a share in the Iraq Petroleum Company, and had enormous marketing capacity. Although they had a stranglehold on Middle East oil as early as the 1930s, the Seven Sisters were still in control as late as 1972, when they produced 91% of the Middle East's oil and 77% of world supply outside the US and the communist countries.

The Seven Sisters thus controlled Middle East production, in a way that would have seemed inconceivable to John D. Rockefeller. It was also obvious that the oil industry was susceptible to control at the refining and marketing end of the market, as the Standard Oil Trust had shown at the turn of the century. The break-up of the Standard Oil in 1911 had effectively warned off any overt attempts at controlling the large American market for a long time, but the same constraints did not apply to the rest of the world. The cartel's activities in controlling marketing were widely known and often approved during the 1930s, as we saw. The United States.‹In the United States, the oil companies had to be much more circumspect in their efforts to control production or marketing. Although the Standard Oil Trust was broken up into several dozen "independent" units in 1911, there was a great deal of interlocking share holding, and the Rockefeller interests held enough shares in enough of the companies to influence mutual interactions. In 1938, for example, Rockefeller interests held 20% of Exxon, 16% of Mobil, 12% of Chevron, and 11% of Amoco, and since all the other shares were widely dispersed, that was considered "working control" in all four companies by the Government.

Fortunately for them, the major oil companies (majors) had already negotiated the basic Achnacarry Agreement when a major crisis erupted for them in Texas. On October 3, 1930, the gigantic East Texas field was discovered by an independent wildcatter, and new crude oil began literally to pour into the domestic market in 1931. The oil companies were faced by a dramatic new source of oil that they did not control. They began to buy up leases in the new fields, but the quantity of oil was too great to be absorbed easily, and the East Texas fields were soon producing a million barrels a day, one-third of all United States production.

The majors were able to survive the crisis by their control over refining and marketing. However much new crude oil was found, it still had to be refined and marketed through a system that was already tightly controlled. The majors, in effect, could simply state what they would pay for crude oil from the new fields. As new oil began to flow, that price was about 70¢/barrel.

The majors now began to promote policies under the cloak of "conservation" that would limit "wasteful" production: it was already clear that pumping oil too rapidly from a field could damage long-term production. The ends were entirely correct and respectable, of course, but certainly the conversion to conservation was well timed. As the majors decided that free-for-all production must stop, they filled Austin, Texas with lobbyists, and in November 1932, the Texas legislature passed the Market Demand Act. Under "conservation," the law defined as "prohibitable waste" any production that was in excess of "market demand."

As soon as the Act became law, the majors dropped their offering price to 25¢ a barrel on January 1933, and then to 10¢ a barrel. Naturally this cut production dramatically, as "market demand" dropped. The majors bought up tens of millions of barrels at give-away prices before many of the independents went out of business, and the price did not rise back up to $1 a barrel until September 1933, as the majors gained control.

In 1935 Congress passed an Interstate Compact to Conserve Oil and Gas and the Connally Act. Between them, these laws assigned strict production quotas to each State. In the end, US domestic production was limited under the cloak of conserving natural resources. Once again, the ends were admirable, but it's clear that the legislation was passed on behalf of the majors. By 1958 Texas oil wells were allowed to pump oil for only 97 days a year. The legislation was used to hold down production in order to maintain stable prices.

Oil companies of all sizes acted through Congress to keep down their taxes through the infamous depletion allowance. In 1972 the IRS estimated that the nation was losing $2.35 billion a year in tax avoidance through the depletion allowance. In 1974, while corporate tax rates were 48%, the 19 largest oil companies paid an average of 7.6% as taxes. This had repercussions throughout American business: for example, if one combines the petroleum, motor vehicle, and aircraft industries of the United States as vital to its economic and military security, the petroleum companies held 60% of the assets of this part of US industry and paid 9% of its taxes. The auto industry held 32% of these assets but paid 79% of the taxes.

The other major (and frightening) post-war impact on domestic US oil supplies was a deliberate policy decision to serve the domestic market largely from American oil wells. Under the pretext of a quota system to protect "national security," (so that the US would not become too dependent on foreign oil), cheap foreign oil was kept out of the United States, while domestic fields were rapidly depleted. In the 1960s, for example, domestic prices rose gradually, although prices dropped by about 40% in foreign markets. Furthermore, overseas competitors like the Western Europeans and the Japanese benefited from low energy prices, while US industry paid increasingly higher prices.

In 1952 the Attorney General began criminal antitrust proceedings against the major oil companies, but these were halted by the personal intervention of President Truman on January 12, 1953, in the last few days before he left office. The Eisenhower administration regarded the enforcement of the antitrust laws as "secondary to the national security interest," though it was never clear how national security was involved. By the end of 1953 the case had been transferred from the Department of Justice to the State Department under John Foster Dulles, at the same time as Dulles' old law firm was hired as defense counsel by the oil companies. This effectively ended the proceedings, and abuses continued at every level, from interference with governments to price gouging the individual consumer.

By 1970, 94% of US domestic reserves were held by only 20 companies. The top eight oil companies in terms of their holdings of US domestic oil reserves were also the top eight in production, the top eight in refining, and the top eight in marketing: they were the American five of the Seven Sisters, Exxon, Mobil, Texaco, Chevron, and Gulf, plus Shell, Amoco and Arco.

The extent of cartel control can be judged by working out the cartel's best strategy, and then comparing that against the actual behavior of the market. The cartel would best be served by stimulating and then satisfying an increasing market for petroleum products on a global scale. More sales mean more profits, as long as selling prices are kept high and stable, and production costs are kept low. The facts are that world consumption of crude oil rose at a clockwork 9.55% a year from 1950 to 1972, through economic times that ranged from boom to recession, through war and peace, through crises such as the successive Arab-Israeli Wars, the Vietnam War, and the nationalization in Iran in 1951­1953. Profit and Greed.‹Oil profits were unbelievable. In 1947, Saudi oil cost 19¢ a barrel plus 21¢ royalty, and Bahrain oil cost 10¢ a barrel plus 15¢ royalty. Consumers were paying $1.80 a barrel and more for that same crude oil. Even when development costs of the oilfields were figured into the selling price (as they should be), the oil companies were making a great profit.

In fact, profit margins increased enormously in the 1950s and 1960s while production costs decreased. The volume of oil shipped increased, and the advent of supertankers decreased shipping costs while selling prices were increased. In the late 1960s, Middle East oil that was delivered to Europe and the United States at $2 and more a barrel had cost less than 40¢ to produce and ship. In 1957 half of Gulf's profits came from its share in the Kuwaiti oilfields. Aramco's profits averaged 57% of its invested capital in 1952­1961.

But the most creative way for the majorss to maximize their global profits and to satisfy the producer nations at the same time was to take advantage of tax legislation in the United States on "foreign tax credits." Suppose that Exxon pumped oil in Slobbovia, and paid tax at 35% on its operations there, at a time when company tax rate was only 15%. The foreign tax credit specified that Exxon could calculate the "extra tax" of 20% it had paid the Slobbovian Government, and could deduct that amount from its tax bill in the United States. As critics pointed out, this essentially involved the American tax payer in a direct subsidy to the Slobbovian government, except that the check was written on the American taxpayer by Exxon. All the majors used this tax avoidance scheme from the early 1950s, and it helped to maximize their profits.

How? Surely they were paying the same tax bill, even though the US taxpayer received a smaller amount than before? The trick used by the companies was to have the producer nation increase its tax rate instead of its royalty rate. If the Saudis had pressed for increased royalties, the companies could have deducted that expense only from their profits. Because the Saudis (who didn't care where the money came from) took their cut in taxes, the companies could deduct the same amount, not from their profits, but from their US tax bill. Careful calculation and negotiation between the companies and the producer countries could allow the companies to gain the maximum benefit by manipulating this tax loophole.

The US National Security Council was involved with the US Treasury in promoting this scheme, even though it meant a major shortfall in the US government's tax revenue. Tax lawyers were even sent by the US Treasury to Saudi Arabia in 1950 to help that country formulate the necessary company tax laws to start the scheme. In 1951 the Kuwait contract was revised in the same way; Iranian taxes on the new Iran consortium were set up in the same way in 1954; and the pipelines through Lebanon were taxed in 1956.

Here is how the system worked in the early 1950s. Before the foreign tax credit was used, Middle East oil was sold at $1.75 a barrel; production costs and royalties totalled 41¢, leaving $1.34 pre-tax profit per barrel. About 43¢ went on US taxes, leaving a net profit of 91¢ per barrel for the company.

In the new scheme, there was still $1.34 pre-tax profit. But if Saudi taxes were tuned to yield the Saudi government half of the profit (67¢), the company could now deduct that 67¢ from its American taxes. Not only would it not pay the 43¢ it used to, it could protect or "write off" some of its US profits against tax, with each 43¢ of deduction worth about 24¢ of US profit protected against taxation. The company would make a net profit of 91¢ a barrel, just as it did before. The Saudis receive their royalties as before, plus 67¢ tax. The American tax system would lose the 43¢ the company used to pay, plus another 24¢, that is, the American tax payer would lose the 67¢ that the company paid the Saudi government, and would have to come up with the missing amount.

The transfer of funds was enormous, and growing. In 1951 Aramco's US tax bill fell from $50 million the year before to $6 million, while the Saudis received $110 million instead of $66 million. By 1955 the annual loss was $154 million.

OPEC was founded in 1960, and began to press for further increases in oil revenue. Soon the companies began another scheme to accomplish this without loss to themselves, based on the foreign tax deduction: they began to base their calculations for taxes and royalties, not on the actual sales price of crude oil, but on a mythical "posted price" that was simply a number written on a piece of paper. This procedure increased the revenue to the OPEC countries, and the loss to the US tax payer.

This system ran until 1975, when the bills began to come due for the Vietnam War; but even then, the abuses were constrained rather than eliminated. And as it happened, the losses to the producers and the companies were more than made up by the post-1973 rise in absolute prices (and profit margins).

In the end, the greed and manipulation broke the system, as everyone involved wanted more and more. The history of oil prices from 1960 to today reflects human failures rather than economic principles.

A Producer Nation‹Iran. In 1951 the new nationalist government in Iran, led by Mr. Mossadeq, tried in vain to get BP to agree to the same kind of profit-sharing that American majors had negotiated with the Saudi and Venezuelan governments. Finally the Iranians lost patience and nationalized the oilfields.

The majors, acting together, struck back by boycotting Iranian oil, refusing to handle any crude oil produced by the fields under the new regime. Their control over transport and refining was so thorough that Iran's oil exports dropped from $400 million in 1951 to $2 million in 1951 and 1952. The deficit to oil supplies could be made up easily because the Middle Eastern fields were being operated at much less than capacity, and additional pumping from Kuwait, Saudi Arabia, and Iraq not only made up the difference, but delighted the three Arab nations concerned, who have no particular liking for the non-Arab Iranians.

Finally crisis overtook Iran in 1953: the Shah tried and failed to dismiss Mossadeq, and had to flee the country. By the time the Mossadeq government collapsed under its own inefficiency and the Shah was restored to the throne, BP was well and truly frozen out of Iran. Real or suspected CIA involvement in the Shah's restoration sowed some of the seeds of the violent anti-Americanism that continued during the Shah's later repressive years.

The State Department was involved in choosing the American participation in any reformed Iranian oil company, apparently a quid pro quo for "liberating" the oilfields. The ultimate share-out was only 40% for BP, which had owned the oilfields before nationalization; 14% for Shell; 7% each for Exxon, Gulf, Mobil, Chevron, and Texaco; 6% for the French CFP, and 5% for a few American independent oil companies. In other words, although the American companies were now present in strength, the majors still controlled this enormous oil resource.

Because the majors had potential production from so many Middle Eastern fields, they could in effect choose which fields they would exploit and which they would pump at low production levels. Where there were consortia, production levels were controlled by a specific formula. Since the four American companies in Aramco, and Gulf in Kuwait, were rich in crude oil, they had no real interest in major new production. Production from Iran and Saudi Arabia was held at much less than capacity. Partly because of US government wishes, however, these two countries increased production more than others, to keep the Shah and the King happy, and to allow them (especially the Shah) the money to outfit their armed forces with the newest American hardware. If the majors increased production in Iran and Saudi Arabia by 12% and 10% respectively, more than the 9.55% that global demand would stand at good prices, production had to be held back even more in other rich oil-producing areas. Kuwait and Iraq were usually chosen as the producers to have low production rates: from 1958­1972, their production increased 5.9% and 5.1% respectively. Discoveries in other nations (such as Oman) were simply not developed at all. This was the fatal flaw in the system: sooner or later, producer nations would realize the extent of the manipulation, and react to it.

For example, Iraq was manipulated by neglect. The partners in Iraq Petroleum discovered a great number of likely fields in the 1930s, but were slow to drill them. They already had access to enormous fields in Saudi Arabia, Iran, and Kuwait, and Iraqi oil production was simply not needed (except possibly by the Iraqis!). Iraq Petroleum became notorious for this kind of tactic, which it also used in Qatar and Syria. Even today no-one has any clear idea just how large Iraq's oil reserves are, except that they are much greater than its current production implies.

The Iraqis finally lost patience and in 1961 nationalized all concessions in Iraq that were not then being exploited. Eventually they set up their own national company and nationalized all the oil fields.

Libya and The Rise of OPEC, 1955­1970.‹The Libyan government of King Idris granted oil concessions in 1955. The Libyans were well aware of the way the petroleum industry worked, and were anxious to keep the country's oil out the hands of the majors. Most concessions were granted to independent operators. As a result, when large fields of high-quality oil were discovered, they were developed quickly, instead of being held to slow rates as in Iraq and Kuwait. Occidental Oil in particular, under the dynamic and eccentric Armand Hammer, began to produce large quantities of Libyan oil.

In 1960, Libyan production was still small, but its influence was enough to generate price cutting in the global oil market. Although open figures are not revealed, it's clear that real oil prices fell steadily during the 1960s, as more new oil came on to the market. The majors held back production in their existing Middle Eastern fields, so that the global increase in sales grew at the same steady pace. But their share of the production, and their profit margins, were suffering. Prices paid for Middle Eastern oil fell from close to $2 a barrel to more like $1.20 a barrel.

The majors began to worry how much longer they could continue to restrict production from the Gulf states to stabilize the global market. Exxon was quite explicit about it: "during the [1960s] the advent of large-scale production in LibyaŠ may restrict the growth of Middle East outlet." Of course, it wouldn't necessarily have had that result on a free market, but Exxon did not hide the fact that that would be the result of continued increase in Libyan production on the international market as it was being operated at the time (1961).

By 1968 Exxon realized that it had grossly underestimated the size of the Libyan oil fields, and that the majors were in danger of losing control of the world market. Exxon estimated that Libya would overtake Iran and Saudi Arabia to become the leading producer in the region by 1971. If that happened, the majors would actually have to decrease production in their fields. Exxon realized that the governments of the Gulf States simply would refuse to cooperate with the majors if production were cut from their fields. The majors faced a new era of significant overproduction (as they regarded it), and a dramatic fall in oil prices and profit margins.

By 1970 Exxon's forecast looked as if it would come true. Libya was by then the fourth largest producer in the non-communist world, surpassed only by Saudi Arabia, Iran, and Venezuela. What's more, King Idris had been overthrown by Colonel Qaddafi, and the oil fields were controlled by a new revolutionary government that was not likely to be incorporated easily within the cosy structure of the large oil companies. To add to the problems of the majors, new fields were coming on line in Nigeria, with large but unknown potential.

The resulting dénouement is interesting. The Qaddafi government demanded an increase in royalties to 40¢ a barrel, targeting Occidental in particular as the largest independent company, totally dependent on its Libyan fields. Occidental, and then all the others, had to pay the increased royalty. Qaddafi had now accomplished more for Libya than OPEC had managed to do for its members since its founding in 1960. Stung or stimulated by the Libyan success, OPEC met in Venezuela in December 1970 and demanded similar increases. The majors met and agreed that they would support one another against any OPEC nation (for example, they would supply crude oil from other sources to any company whose production were cut back by an OPEC government), and they asked the US Government to turn a blind eye to the breaches of the anti-trust laws that this agreement had made. (The Justice Department agreed to do so.) The American Under Secretary of State even went to the Gulf, apparently on behalf of the majors, to talk separately to OPEC governments and to try to dissuade them from joint action. This was a clumsy diplomatic blunder, and the US Government's pressure was shrugged off: the Shah of Iran angrily stated that the majors' agreement to collaborate against OPEC was a "dirty trick."

The various producer nations used their leverage to get 20¢ a barrel more for the Gulf States, and the Libyans followed with even more. It's clear that by now the producer nations knew their strength (especially the Libyans), and were playing off the ability of the Libyan independents to curb the majors by pumping large quantities of oil. In this way the political and economic skill of the Libyans, combined with the great good fortune of striking very large and productive fields, was able for a while to take control of events away from the majors.

The Qaddafi government now rapidly began to nationalize the oil companies in Libya, taking some over outright, and forcing the others to yield 51% to the government. But in expelling the Western oil men, Qaddafi severely cut down Libyan production, and crippled the independent refiners and marketers abroad who had been taking market share away from the majors. The Libyans were able to maintain their revenues by charging higher prices for the reduced oil flow, but the majors were delighted by the outcome. They regained their market share of global output, and were able to exploit the sudden weakness of the new independents. More important, the Libyans themselves had removed the threat of Libyan production increase that had been hanging over the majors for ten years. The majors were now back in charge of most of the world's production, refining, marketing, and sales, in a global situation where the threat of overproduction had been removed.

None of this was new: it was a return to the old oil world that had been in place for forty years. What was new was OPEC's realization that it held a great deal of power. Could OPEC now work through the majors to take over effective control of global oil supplies?

October 1973.‹In October 1973 Egypt and Syria invaded Israel without warning, setting off the "Yom Kippur" war that ended with the humiliating defeat of the Arab nations. The same month the OPEC countries met in Vienna to discuss raising oil prices, and with the new realization of their power, simply announced an immediate increase in the price of the standard "Middle East" barrel from $3 to $5.11. They doubled the price again in Tehran to $11.65, effective January 1, 1974. Given that the same barrel had cost $1.80 in late 1970, this represented a six-fold increase since the weakness of the majors had been exposed by the Libyans in 1970. Most major producing nations agreed to strengthen their position by cutting production at least 10%.

The "oil crisis" was comparatively short-lived in terms of supply. The oil companies had had hints from King Feisal of the impending war and had built up stocks. There was no oil shortage in 1973. What was different was the price of oil, passed on to consumers by the majors as they paid more to the producers for their crude. As long as the majors could control the crude oil supply, and as long as the consumer could pay the increased price, the majors could arrange to have at least the same absolute profit margins as before. If they could arrange to keep anything close to their original percentage profit margins, they would make a lot of money. In typical figures for a refinery on the US East Coast, the refining profit per barrel was 95¢ (25% above cost) in 1969, but $4.23 (50%) in 1974. The result was that major oil companies made profits of about 19% in 1974, compared with a historical average of about 11% in the previous decade.

In all of the upheavals, the overriding concern of the majors was clearly to retain control over crude oil shipping, refining, and marketing. This was shown in 1974, when Saudi Arabia demanded the nationalization of Aramco. If there were problems, the Saudis threatened, they would simply offer 3 million barrels a day directly to third parties (outside the majors). In the end, Aramco quietly gave in, in return for contracts by which it would handle all the shipping of Saudi crude.

Since the usual effect of a major price rise is to cut consumption, by economy (conservation) or switching to alternate supplies, one would expect that a continuation of OPEC production at its 1973 rates would tend to bring prices down again, no matter what the wishes of the producers. If OPEC could maintain its prices in the face of restricted demand, production would have to drop. In 1974 production was almost exactly the same as 1973, and in the light of a historical 9.5% increase each year for 20 years, this constitutes a distinct restraint in production. In 1975 there was a real drop in production. Together, these actions ensured that the price remained high. It's quite conceivable that these figures were achieved because the majors as well as the producing nations both benefited from the large price increase, and neither had any interest in seeing that position eroded.

OPEC after 1975.‹The interests of OPEC and the majors coincided to this extent: both wished to see a large volume of oil flow through to consumers at high prices. In these circumstances, OPEC members received large amounts of money in royalties and taxes, and the majors were assured supplies of crude oil with which to supply their global market.

The interests diverged in that the majors did not care where the oil came from as long as it was reliable. They willingly took oil from non-OPEC members like the United States, Britain, and Norway (and rushed to sign contracts with former Communist nations too). The majors were only under the influence of OPEC only as long as OPEC nations held the crude oil that they needed. OPEC nations once again came to depend on the Seven Sisters as soon as OPEC oil became optional rather than necessary for the major oil companies. OPEC Today.‹ There are 13 important members of OPEC. The five largest producers and exporters in the group are in the Middle East: Saudi Arabia, Iraq, Iran, Kuwait, and the United Arab Emirates, and the other members are Libya, Venezuela, Algeria, Nigeria, Gabon, Indonesia, Ecuador, and Qatar. The major oil producing nations outside OPEC are the US, Russia, Britain, and Norway, but the US is a net importer, and the others do not contribute much to the open world market.

OPEC tries to keep oil prices high by keeping production within limits, assigning a production quota to each member. There is always a temptation for producing countries to cheat on the quotas assigned to them by the cartel, especially if they have urgent needs for cash. Cheating is particularly easy on the international oil market. Only the meters on the oilfield pumps and pipelines, and the tanker operators, can keep track of volumes of crude oil, and once on the high seas or into the network of international pipelines, oil quickly loses all traces of its country of origin. With the cooperation of distributors and marketers, any country can pump more than its quota, more or less with impunity.

OPEC has always lacked the ability to monitor and police its members' production. (The majors can and do monitor world oil flow, but apparently do not share information with OPEC, a demonstration that their interests may be parallel with OPEC, but not identical.) In fact, however, just as before, world production remains reasonably stable. This can only be accomplished by action of the majors, and there is little doubt that they do this: from self-interest, not to help OPEC.

For example, in 1989 the oil ministers of the OPEC countries agreed on quotas that totalled 22.1 million barrels a day for the first half of 1990, planning that that volume would keep the price of crude oil on the world market at about $18 a barrel, their target price since 1986. In fact, the OPEC countries between them probably pumped about 23.5 million barrels a day, maintaining a surplus supply of crude oil into world markets, and dropping the price of crude oil. (It had been $20.46 in late January 1990, but reached a low of $13.64 by June 1990.)

By the midyear meeting in July 1990, tempers were running high, and President Saddam Hussein of Iraq massed 30,000 troops on the borders of Kuwait, allegedly one of the OPEC members cheating most on its quota. Saddam Hussein claimed that the loss in revenue to Iraq alone had been $14 billion in 1989. At about the same time, the American Petroleum Institute announced that US imports now constituted an all-time high of 49.9% of consumption, and prices immediately rose to $19.61 a barrel in the anticipation that OPEC would try to squeeze supplies. It was widely anticipated that Hussein's pressure on Kuwait, and the American announcement, would encourage OPEC to set an attainable limit on production of 22.5 million barrels a day, and that the price would reach $20 once again. In fact, on July 27, OPEC agreed on a target price of $21 a barrel at that production level, which was economically unrealistic but perhaps served some internal political agenda. On the day of the news, the international price reached $20.39 a barrel.

Events were rapidly overtaken by Iraq's invasion of Kuwait and the Gulf War that followed. But even then, the temporary removal of Kuwaiti oil as well as Iraqi oil from world markets made very little difference to either supply or price. In fact, as Kuwaiti production was re-established in 1992 and 1993, the world position of OPEC worsened still further. By summer 1993, OPEC countries were pumping 25 million barrels/day, even with Iraqi exports at a virtual standstill. The price of oil remained very low at around $15-$20/barrel for most of the 1990s. The OPEC nations were reportedly able to agree in principle on reducing production to help prop up the price, but could not agree on who was to slow production, or by how much. Meanwhile gasoline was selling in the United States for a cost that in real money was as low as it had been in decades. No-one in the Middle East wanted to say so aloud, but their worst-case scenario in the 1990s was the day that a cash-hungry Iraq released from UN sanctions would once more allowed to export as much crude oil as it wanted to!

In 1999 the price of crude oil dropped close to $12/barrel. This frightened OPEC into real cooperation, and as I write this in early 2000, the OPEC nations seem to be operating at close to their agreed quotas, and the price of crude oil is at a 9-year high, around $30 a barrel. Probably OPEC calculates that this is around the price that the industrial nations can afford to pay without major damage to their currently prosperous economies. It will be up to OPEC to continue to fine-tune their production, without repeating the events that led to the collapse of crude oil prices in the 1980s. The Geopolitics of Oil, 1997: Former Soviet republics.‹The break-up of the Soviet Union had dramatic effects on the oil resources within its boundaries. The old Soviet Union had immense reserves of oil and especially of gas, but a decaying infrastructure that was already resulting in decreased production by the end of the 1980s.

The Soviet Union had a structure of pipelines that essentially gathered production and funnelled it westward into Eastern Europe, where it was sold to the former Soviet satellite countries, particularly to East Germany. Russia, as the largest successor state, retains the bulk of that system, and has huge fields of oil and gas that can continue to provide it with its own fuel supply and a surplus for export. However, many of the fields, even within Russia, require modernization and exploration that present-day Russia cannot afford. Contracts with Western oil companies are slowly and carefully being negotiated, but the precarious nature of Russian politics and the Russian economy are serious problems. As I write, the Russian Government and the largest energy company in Russia, Gazprom, are at daggers drawn over billions of rubles in unpaid taxes. The former Russian Prime Minister, Viktor Chernomyrdin, is also a former chief executive of Gazprom, and depending whom you believe, is either a secret millionaire with immense power, or the only former Soviet bureaucrat who failed to get a share when the government gas industry was privatized.

The problems of the other fragments of the Soviet Union are even more compelling and interesting, however. Some republics ( Ukraine and Belarus are the best examples) have no oil resources, and are dependent on supplies down the old pipeline system from Russia: essentially, the Russians can hold these countries to economic or political ransom for their fuel supplies. It is not an accident that both Belarus and the Ukraine have recently negotiated closer economic ties with Russia, in spite of the considerable distrust built up over the years of economic domination from Moscow. The Ukraine, desperate for energy, continues to operate its dangerous nuclear reactors at Chernobyl, next to the notorious reactor that exploded in 1986, because it has no choice. Without billions of dollars in aid, the Ukraine cannot afford to take proper remedial action to make Chernobyl safe, or to close the remaining plants.

Armenia, cut off from its own pipeline supply because of religious wars with its neighbor Azerbaijan, recently re-opened a Chernobyl-style nuclear reactor which had been closed since 1989 on safety grounds. Again, there was no real choice: electricity supplies were down to a few hours a day even in the capital.

However, the most interesting developments are being played out in the former Soviet republics that do have abundant reserves of oil and gas. Azerbaijan.‹Azerbaijan contains the giant fields around Baku, which have been producing for a century. It was among the oil workers of Baku that the young Stalin learned his trade of fomenting revolution, riot, and sabotage, and it was the lure of the oilfields of Baku that drew the German army into the Caucasus in an ill-fated offensive in 1942. However, the oilfields are old, the infrastructure is decayed, and the pipelines that export the oil all go into Russia. The Azeris could perhaps renovate their fields, and go offshore to exploit promising new territory under the Caspian Sea, but they would always be subject to a Russian stranglehold on the export pipelines.

However, a look at a map brings home the geopolitical difficulties faced by the Azeris. All routes that would take their oil to Western markets have problems. The easiest route would use existing pipelines through Russia to the Black Sea, but that gives control to Russia. The next easiest route is through Iran to the existing network that delivers oil to ports on the Persian Gulf. But the Azeris are ancient enemies of the Persians: many of the inhabitants of northwest Iran are ethnic Azeris, and neither country trusts the other.

To the west, a pipeline through Georgia to the Black Sea would be possible, but Georgia is torn by civil war and is in danger of being blackmailed back into Russian control.

The most sensible pipeline would pass through Armenia to Turkey and the Mediterranean (the Turks and Azeris are Turkic peoples who share a linguistic, religious, and cultural heritage). But the Azeris and Armenians have been at war intermittently for years, a particularly nasty and brutal religious war, and it is vanishingly unlikely that the Azeris would allow the Armenians control over their oil exports in the foreseeable future. Even the Azeri-Georgia pipeline route passes through a part of Azerbaijan that is seriously threatened by the Russian-armed Armenian invaders who currently control some Azeri territory.

The most likely scenario is in the process of developing. The Azeris have signed contracts with a consortium of Western oil companies to renovate and extend the fields. As I write this, Amoco and BP have 17% each, the Azeris hold 10%, and three other US companies are involved. The Turkish government has 7%, and the Russian oil company Lukoil, which runs the pipeline, has 10%. A pipeline through Russia to the Black Sea at Novorossiysk already exists. What the Azeris need is some sort of guarantee that the pipeline will not be closed off arbitrarily, which explains the offer of 10% to Lukoil, to give the Russians a financial interest in keeping it open: a share in the proceeds. This is not an ideal solution, but it looks like the best of a set of bad choices. The Turks are involved because oil will cross the Black Sea from Novorossiysk in tankers, either directly through the Bosphorus, or through pipelines across Turkey to the Mediterranean.

The pipeline from Baku to Novorossiysk runs directly through the city of Grozny, the capital of Chechnya. As everyone knows, the Chechens want independence from Russia. The Russians are unwilling to concede independence, partly because of the precedent it would set for other similar areas, but largely, I suspect, because that would yield control of the pipeline to still another set of hands. The Russians have recently taken Grozny in a brutal battle that left many dead on both sides, and the Chechens are still fighting a bitter guerilla war in the hills. But the Russians now control Grozny and the plains, and the pipeline. I don't think there's any question that the Russian invasion was controlled by the pipeline more than any other factor. The geopolitics of oil has far-reaching implications that we have to understand if we are to appreciate the complexities of the modern world order. Kazakhstan.‹Kazakhstan has a supergiant oilfield, Tengiz, whose current output is also exported through Russia on existing pipelines. Since independence, Kazakhstan has signed contracts with Mobil to develop some smaller fields, and with Chevron to expand and modernize production from Tengiz. The first phase at Tengiz is complete, but the project is suffering slow strangulation because of Russian control of the pipeline. Only limited amounts are allowed down it, bound for Russia, and in return, Chevron receives the same amount of oil delivered to Germany from fields elsewhere in Russia. By incorporating Russian partners, Chevron has negotiated a new pipeline that is to be built through Russia to Novorossiysk on the Black Sea, to that Tengiz oil would be exported directly to world markets.

Until that pipeline is built, both Kazakhstan and Chevron are looking at a losing proposition, because current exports to Russia are too small to make money: Chevron is breaking even on current production, but any reasonable return on its capital requires shipping ten times as much as it does now. Kazakhstan's problem is that there is no other feasible pipeline route: Tengiz is in the north of Kazakhstan. The alternative, through Iran, is just as risky in political terms, and the Kazakhs and Iranians have no better relations than do the Kazakhs and Russians. In any case, no American company is willingly going to build its pipelines through hostile territory, and Iran certainly counts as hostile for Americans in the foreseeable future.

Chevron's problem is that it has "bet the company" on Tengiz: at a projected cost of $20 billion, it is the biggest project the company has taken on since its Saudi Arabian investment more than fifty years ago.

This time, the Russians are probably not swayed much by the relative amount of money they can make: the real interest is an economic lever they can use to pressure Kazakhstan.

New developments are even more bizarre. There have been intermittent hints of pipelines through Afghanistan and Pakistan to the Indian Ocean. They would export natural gas from Turkmenistan and oil from Kazakhstan, but they cannot be built while there is still a vicious civil war in Afghanistan. The oppressive fundamentalist Taliban faction currently has the upper hand over most of Afghanistan, but it is not a coincidence that the northern warlords facing them are backed by Russian aid. The last thing that Russia wants is an outlet to the south for the Caspian oil and gas.

Now the Kazakh are talking to the Chinese. The Chinese project an energy shortage as their economy booms. A pipeline from Kazakhstan across Sinkiang to industrial China would be expensive to build, but could make up much of China's projected energy deficit. But who is going to finance it? The Japanese would once have been candidates, but they have economic problems currently. Turkey.‹Nothing is ever simple, and as I write trouble is brewing in the Black Sea. Most people have thought that the difficult part of oil delivery from Azerbaijan or Kazakhstan would be in getting it to the Black Sea. Now, it seems, that may not be true.

Transit to the Mediterranean is most cheaply accomplished by tanker, but that involves navigation through the crowded passage of the Bosphorus. A tanker grounded and burst into flames there only a few years ago, and Turkey is worried that a major disaster could occur even at current levels of traffic, let alone with the increased traffic that would result from new oil flowing from Novorossiysk. Constraints on tankers will undoubtedly increase.

That means that oil is more likely to transit to the Mediterranean in pipelines, which means major capital invested in terminals on the Black Sea coast and the Mediterranean coast. Turkey seems to have assumed that any pipelines would pass through its territory, an attractive proposition to a country that has no oil of its own, and has been subject to some political pressure from its oil-rich Arab neighbors to the south. In fact, the whole pressure on tanker traffic may be a Turkish ploy to ensure just that: the Russians seem to think so. What the Turks would like most of all is a pipeline across Turkey to Ceyhan, a modern oil-shipping terminal that currently has no oil to ship because of the UN embargo on Iraqi oil that used to reach the Mediterranean at Ceyhan. So even the Middle East intrudes on the Caspian situation...

So, the Russians have begun to press for a pipeline that would pass through Bulgaria and Greece to the Mediterranean, by-passing the Turks altogether. This has the Turks furious, especially as they are historic enemies of the Greeks. This enmity is matched, however, by an ancient enmity between the Greeks and the Bulgars (a great Greek hero is an Emperor of Byzantium called "Basil the Bulgar-Slayer"), so we shall have to wait to see how this whole matter is resolved. It all depends on the successful delivery of Azeri and Kazakh oil to the Black Sea, and as we have seen, that is not yet a sure thing for the near future. The Spratlys.‹The Spratlys are a group of islands, mostly coral reefs, atolls and sand bars, scattered in the South China Sea. Most of them are so low that they are under water at high tide, and none is large enough to have any inhabitants. Until recently, they were visited only by fishermen, lurking pirates, and ships straying off course. There was no real reason for any nation to claim the Spratlys, and although there have been various claims at various times, no nation has ever occupied the Spratlys, or exploited them economically.

The Spratlys sit alongside the major ocean routes between Asia and the Middle East. Much of the world's oceanic commerce through the Western Pacific from the Middle East goes through or around the Spratly Islands, including most of Japan's oil imports (which come from the Middle East).

Perhaps more important, the South China Sea may (or may not) have large oil fields that could be exploited from rigs based on the Spratlys, and that has raised for the first time in any practical sense the question of who owns them. Given an economic zone of 200 miles from the nearest land, claimants to one or more of the Spratly reefs could claim ownership of any oil reserves under the entire region.

China claims the entire South China Sea, while Vietnam, the Philippines, Taiwan, Malaysia and Brunei all claim at least some of the Spratlys. Each nation has built some sort of "permanent" structure on a reef it claims, to establish its presence there.

In 1988, the Vietnamese and Chinese navies briefly clashed over the Spratlys, with Vietnam losing six ships.

In 1995, small-scale disputes began to escalate again. In January 1995 group of Philippine fishermen was detained for a week by Chinese "troops" on Mischief Reef, which is 150 miles west of the Philippine island of Palawan. Though it is underwater even at low tide, Mischief Reef is claimed as Philippine territory by the Manila government. Also in January 1995, Vietnam dismissed a warning from China on some disputed islands where the Vietnamese, with Russian collaboration, were conducting "a geological survey".

In March 1995, the Philippines announced that its military had destroyed some "foreign markers" from an atoll and a reef. China said it had built the structures, but they were were simply "shelters for civilian fishermen". Next, the Philippines seized 5 Chinese fishing boats in the Spratlys and arrested more than 60 crew members. They were charged with poaching protected sea turtles, fishing with explosives and cyanide, and illegal entry into Philippine waters. In reply, the Philippines accused China of improperly putting warships in the disputed region and building permanent structures on Mischief Reef. Three days of talks in Beijing between China and the Philippines failed to resolve the dispute.

On March 25, 1995, a Taiwanese patrol boat fired warning shots at a Vietnamese fishing boat near an island claimed by Taiwan. Taiwan said it planned to send a group of armed patrol boats to the area, to erect a monument proclaiming Taiwan's sovereignty over the islands and to help to protect ships in the area from rampant piracy. The project was cancelled at the last minute.

In May 1995 there was another confrontation at sea when two Chinese ships intercepted a Philippine naval vessel carrying 38 journalists to see Mischief Reef. The journalists allegedly saw gun emplacements on four clusters of metal buildings put up on the reef. The Chinese accused the Philippines of encroaching on Chinese sovereignty by taking journalists there.

At the moment, this is low-level mutual harassment. But it escalated in 1999 briefly, and could do so again at any time, by accident or design, with unpredictable consequences. Confrontations are still going on in the Spratlys, and I shall update this story at class time.