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Oil

Pump power
Blame OPEC for rising oil prices and forget the real problem in the Middle East. Wrong!

Hashem Farhang
December 16, 2004
iranian.com

I have been a Petroleum Engineer for more than forty five years. The misconceptions about the organization and the routine attack on OPEC and its members; have prompted me to write this little note for all and especially Iranian and Iranian-Americans. What I write may ruffle some feathers but I hope criticism will be based on facts not general declarations or personal opinions.

OPEC is an international organization of eleven developing countries which rely heavily on oil revenues as their main source of income. Membership is open to any country which is a substantial net exporter of oil and which shares the ideals of the Organization. The current Members are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. OPEC's eleven members collectively supply about 35 per cent of the world's oil output, and possess more than three-quarters of the world's total proven crude oil reserves.

Since oil revenues are so vital for the economic development of these nations, they aim to bring stability and harmony to the oil market by adjusting their oil output to help ensure a balance between supply and demand. Twice a year, or more frequently if required, the Oil and Energy Ministers of the OPEC Members meet to decide on the Organization's output level, and consider whether any action to adjust output is necessary in the light of current and anticipated oil market developments.

OPEC was formed at a meeting held on September 14, 1960 in Baghdad, Iraq, by five Founder Members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. OPEC was registered with the United Nations Secretariat on November 6, 1962.  The present day estimate of total reserve of just over 811 Billion Barrels (last estimated in 1999) represent about 77% of world oil reserves.

Provided the question of Politics and trust are resolved OPEC can provide an increasing amount of oil to meet the expected growth of global oil demand. OPEC currently produces about 35 per cent of the world's crude oil; but that is forecast to grow to more than 50 per cent in the next quarter of a century. The 40% production (35% export), however, represents 55% of crude oil trade.

History
To understand the establishment of OPEC, one has to pay a little attention to the history of oil industry in the founding countries and the relationship of the international oil companies with their own as well as the host governments. Initially the most active international oil companies in the Middle East were those of Europe, namely the British Petroleum and the Royal Dutch Shell. These two companies had much in common with their Governments, almost one and the same for a long time (The British Government owned 51% of BP and a small interest in shell; while the Dutch Government independently and through Queen Juliana of Holland owned majority interest in Shell). 

Because of these inseparable entities and interests; the then Imperial British government treated any little demand on these two companies as an attack on the British Empire and the then uniquely commanding Royal Navy would respond by sending war ships to the vicinity of the victim country (Gun Boat Diplomacy). This close relationship between the oil companies and their Governments, of course, proved very useful during the WWII; the companies enjoyed military protection with enormous income at high prices and unquestioned support from the home governments. The government, in return, enjoyed hundred percent supply cooperation. The case with American companies was much different in that while they provided the U.S. Government the supply she needed, they had no special relationship that would necessarily be to the detriment of other producing regions or their own general consumers; the competition was in control; as we shall see later.

With the exception of Saudi Arabia where Aramco (a consortium of major American oil companies) was operating; the rest of the Middle East, starting from Iran in 1908, Iraq in 1927, Kuwait and Bahrain in 1932 were mainly the domain of the two European oil companies. After the war, Shell sold its interests in Kuwait to Mobile (a sale that Shell regretted for ever and never forgave itself), and as time went by and America became the dominant power, the subsequent discoveries like those in what is now known as the United Arab Emirates after 1960s were mostly by Americans. The American concessions, Initially because of a famous American philanthropist, was based on a genuine 50/50 arrangement. This arrangement was far more equitable than those offered by the European Imperialistic oil companies.

In Iran the 1906 agreement provided a mere 12.5% Royalty (7 to 1 in favor of the oil companies - remember the 1 to 1 ratio of the Aramco) and this after deductions of cooked up costs and books. Additionally the company enjoyed unrestricted imports and exports, all free of Duty and Custom charges. In 1936, with a lot of propaganda and hoopla, the split was improved a little to 16%. Things were going badly for the original producing country and the oil industry in Iran was in turmoil. In 1952 the country, in retaliation against the injustices of the Anglo Iranian Oil company, the precursor of the British Petroleum, nationalized its oil industry. Initially America aware of the unfair arrangements (remember Aramco was from the start a 50/50 arrangement) supported Iran in its struggle.

This caused enormous problems for Britain and after a couple of years, for the first time, the American administration of the time, under the undue influence of the two paranoid Dulles brothers, who in turn were themselves misguided by the cunning British Prime Minister, Churchill, sided with the oil companies of Europe and toppled the democratically elected government of Iran and the American oil companies came to Iran for the first time.

The change of international politics and the unstoppable aspirations of the people everywhere that were mostly encouraged by a rivalry between the Soviets and the West, championed by America, plus the natural American tendency of fair game and the public interest at large, forced the American government to gradually move away from blatant support of the oil companies and assumed a less biased policy.

In the meantime the oil companies enjoying enormous powers by proxy; were controlling the prices at the well as well as the pump. The price at the well which they had to share with the producing countries were kept low which meant that they had a policy of arbitrarily fixing Persian Gulf crude oil prices at a level that they could get away with.

At the Pump, however, the consumers paid little attention to the price of gas; since they were under the impression (substantially correct) that the normal competition in the market place took care of that. And if anytime people complained of excess prices, there were always the greedy rulers of the Middle East and the taxes at home to blame. The greedy producers and the local taxes at the pump were always identified as the culprits for any complaint against higher prices.

In a sense the tax portion of the complaint was true as the Governments in the consuming countries of Europe were having a larger income in taxes alone as compared with the total income of the Governments of the producing countries. Although the Greedy Rulers of these countries were being blamed; few people were aware or much cared that the same rulers were nothing but the puppets of their own governments. 

The companies meanwhile used the same consumer complaints at home to lower the price of crude in the Persian Gulf, a few pennies at a time, and thus adding more to their already enormous profits. The consumers were then advised to wait for the price to take effect that was in the pipeline. However, as we all know; seldom the price of gas reflected the price of crude, at least not when the price of crude is on downward trend. The lower the price at the wellhead the less they had to pay the host countries and the more their profit margins.

To further manipulate these forced pricing structures, they invented a number of artificial pricing mechanisms with ambiguous names like Persian Gulf prices, Posted prices, Rotterdam & London prices and finally wellhead and Texas Sweet crude prices in America. The posted prices were cleverly calculated as the price of wellhead prices in the United States less the "handling and transport" costs to deliver the oil transported from the Persian Gulf to Texas.

In those days of course there were only the oil company themselves that had the major tanker fleets. Also since, prior to 1971, United States was a net exporter of crude oil, there was no real figure of transport costs to the United States and any imports of crude from the Persian Gulf was simply a swap arrangement anyway; meaning that the nonexistent oil transport cost to the United States was simply a ploy to subtract a fiction cost from the price of crude at the production source - Persian Gulf.

The Governments of producing countries, under enormous pressures of their people, gradually were forced to get together and do something about the oil prices on which the income sharing was based. These governments finding the general atmosphere in the consuming countries a little less belligerent; started talking among themselves to join in an association to speak more or less with one voice against the united International Oil Companies.

Much to their delight and encouragement they found that the host governments of these giant oil companies were not uncooperative (in the meantime the British Government had sold its interests in BP). Further the producing countries solicited (and were solicited by) the representatives of the thousands of independent oil companies throughout America; to see what an organization of the less powerful producers could do to combat the monopoly control of the giant oil companies. After all the Independent Oil Companies of America were having an enormously difficult time, competing with Persian Gulf prices arbitrarily set by the giants, the so called Seven Sisters.

Without an adjustment of world crude oil prices, the entire domestic oil production in America was in jeopardy.

On the other hand, for security reasons, the Governments in consuming countries, particularly in America, were encouraging multi source availability of crude oil resources. However, at the posted prices of the Persian Gulf, no exploration, development and production could take place unless the prices reflected the real costs of oil discoveries elsewhere in the world. Additionally the possibility of the Persian Gulf oilfields falling into the Soviet sphere of influence had to be considered.

For all these reasons - viability of Independent Oil companies, encouragement of explorations elsewhere (deep seas and oceans, Alaska and North Sea etc. - the establishment of an association along the general lines of present day OPEC was thought desirable. If the prices did gradually increase to truly reflect international producing prices; it would have the effect, on the one hand, to increase the income of the producing countries, which in itself would more easily combat the Communist propaganda and at the same time satisfy the nationalistic aspirations of the local people, which had been so badly and unwisely put down by the likes of the CIA arranged Iranian Coup and on the other hand, a gradual increase in the price of crude would make exploration elsewhere in the world a definite possibility. This was because they no longer had to compete with the ridiculously cheap oil of the Middle East.

It was in fact the direct result of the OPEC, several years later, that oilfields like those of the North Sea and Alaska became an economic possibility. There was no way that crude oil price of $1.78 per barrel of the early Sixties, would allow Production of oil in offshore and deep sea places. With better prices, many undesirable and environmentally difficult parts of the world could have their oil discovered and thus alleviate local poverties and at the same time combat Communist propaganda.

So gradually the oil prices were allowed to move up and once the governments of the producing countries saw the benefit of higher oil prices economically, they employed it as a local political tool to boost their standing with their own population. As a result there was a competition between the countries of the Persian Gulf, each to claim as the champion for bringing about OPEC.

Yamani on behalf of the Saudis, Iranian Oil Ministers on behalf of the Shah of Iran; Iraqi Generals on behalf of Saddam and all the other lesser powers of the regions individually claimed complete credit for the creation of OPEC. In reality none had anything to do with it. The confluence and convergence of so many factors plus the common interests of so many divergent entities as was just explained above, was the real cause of OPEC establishment. The puppet governments of the Middle East were in no position to establish an organization that would seemingly oppose the interests of the International Oil companies and their sympathetic (to say the least) host governments.

This development suited all. The oil companies found a perfect villain to blame for any public outrage of price increases at the pumps. For years and years there has been absolutely no relationship between the price of crude and the gas at the pump. Remember when the price of crude was $1.78; that of gas at the pump was about 25 Cents per gallon. Applying the same relationship, as they disingenuously and incorrectly sometimes do, the price of gas at $20 per barrel, would have had to have a corresponding price of gas at the pump of $2.80 Cents per gallon, at $40 per barrel the corresponding gas at the pump would have to be $5.60 and at present $50 dollar oil the gas price would have to be $7.00 per gallon.

But as we have learned to observe, the relationship of crude oil vs. gas has been confusing at best and the direct relationship has always been obscure. The reason we enjoyed, and to a large extent still do, a relatively low price of gas at the pump has been because the oil pricing for the first time was out of the control of the giants and more or less at the control of the market.

Unfortunately, however, the market is a little handicapped by the policy of having barely just enough refining capacity to have a gas price that would truly reflect crude oil price. Market, for all sorts of reasons, is not allowed to function as it should. How many times have we witnessed the price of gas going up a lot more than the corresponding increase of the price of crude on the way up and how slowly and disproportionately the price of gas has come down when the price of crude has collapsed.

So OPEC is now a multipurpose organization and certainly a useful institution: 

1- In America, without OPEC, we would have had no domestic oil exploration and production industry. The industry would have been just one of consumption.

2- In America, without OPEC, we would have had no domestic Independent Oil companies that still generate the biggest employment in the industry.

3- Without OPEC we would have not been able to have the benefit of deep sea drillings and oil fields the like of Alaska, difficult jungles and terrains of Africa and Asia, North Sea and other offshore deep waters.

On the unwelcome side OPEC has been used for Policies and Politics. If you want to develop the Alaskan oil; why not use OPEC as a villain to counter opposition for the environmentally unsound projects. Whether the Alaskan oil in any meaningful way affects the supply/demand equation, or reduces our dependence on Middle East oil, does not matter; the public is likely to fall for it.

On pure politics; why not use Arab and other Middle East people synonymously with OPEC, and get away literally with murder, like the politics of the region. Blame OPEC as a cartel for the price hike and forget the real problem in the Middle East causing the price hike. Meanwhile forget our own speculators to say nothing of the clever control and designed limitations of the refineries and their capacities.

3- The OPEC villain can be used as scapegoat for any shortcoming of the domestic oil industry or the governments and the lobby that supports the industry keeps the OPEC oil question on the front pages.

Conclusion
Let us look at some facts for reflection:

Present world production is just over 82 million barrels/day of which only about a third is allocated to OPEC.

Price of coal quietly went up from $34/ton to over 60 in the past year. What industries politicians do you think benefit from the double ram of oil and coal price hikes

Energy consumption in America is hardly the result of a robust economy but the fictitious and non-productive consumptions in inefficient cars particularly small trucks marketed as SUVs.

Efficiency, much more than alternative sources of energy, perhaps with the exception of Nuclear Power, is the answer.

Thus the security of oil supplies relies upon the security of oil demand. Oil producers - and oil consumers - need to work together to ensure that the security of oil supply and demand are preserved

But in order to expand output, development is essential. Oil producers invest billions of dollars in exploration and infrastructure (drilling and pumping, pipelines, docks, storage, refining, staff, etc) and a new oil field can take 3-10 years to locate and develop. If oil producers are not helped and encouraged to invest enough money and do it far enough in advance, then the world could face a shortage of oil supplies in future.

Reflection: Why is it that owners of 85% of crude oil reserves are allowed to produce only 35% of consumption? 

Is it not silly to suggest and assume that OPEC behaves irresponsibly? Are they not, necessarily, more concerned about issues that undermine the prosperity of the oil industry, than they are given credit for? Is it not well to remember that oil is all the rulers of the Middle East have to feed their population and furnish their lavish life styles?  They would never wish to disrupt or threaten the security of world oil supplies and thereby their own personal safety and security. These rulers have a lot to answer for; but a culprit of oil problems is not among them. 

OPEC, disingenuously and of course self-servingly, complain about oil taxations as the cause of inflated gas prices; and in this they have the consuming countries' population on their side.  But taxation, in my opinion, is one of the more effective ways to discourage waste; and the revenue should be spent on roads and energy efficiency related matters. However, taxation has to be fair and evenly distributed. Presently some countries with high oil taxes actually subsidize domestic coal production, yet coal produces more carbon dioxide (the villain of the greenhouse gases which are believed to contribute to global warming.

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