Hussein Abdallah* examines the declining real price of oil against the soaring nominal price US President George Bush and Vice-President Dick Cheney rushed to the Middle East to discuss the alarming rise in the nominal value of oil price. But at $110 per barrel, this figure is in fact lower than what the real price of $140/b should be -- if oil pricing had been calculated justly over the past 60 years. Between 1947 and 1970, Western oil companies, which controlled all oil activities and pricing of Middle East oil, reduced the nominal price of crude oil from $2.18 per barrel in 1947 to $1.80 in 1960. Despite upward market forces trends, it froze at this value until 1970. For their own industrial reasons, Western countries encouraged Arab oil production to jump from less than one million barrels per day (b/d) in 1947 to 15 million by 1970, and to 22.5 million in the mid-1970s. This should have pushed oil prices up, but the cartel of Western oil companies blocked the rise and reigned in prices to serve their economies. Oil exports were almost barter traded between oil exporting countries in the Middle East in return for commodities and services from industrialised members of the Organisation for Economic Cooperation and Development (OECD). Since the export price index of OECD countries increased from 100 to 260 between 1947 and 1970, the real price of oil (in terms of the 1947 dollar value) was eroded to no more than 70 cents during this period. Consequently, the share of Middle East exporters, who were entitled to only 50 per cent of oil profits, did not exceed 30 cents per barrel in terms of 1947 dollars, or 85 cents in 1970 dollar value. In addition to reaping economic gains from such artificially reduced price, the treasuries of Western countries were able to grasp the lion's share of oil rent. This is defined as the price to the consumer, net of all costs from the well to gas stations. Moreover, oil importers decided to carry out oil refining on their own territories instead of the more economically sound decision to do this in oil exporting countries. Naphtha, which was a surplus product of oil refining, encouraged the vast and rapid expansion of Western petrochemical industries. Meanwhile, Western countries refused to allow Arab oil producers to expand their refining capacity. The Europeans claimed that much of their refining capacity had become idle as a result of the price hike for crude because of the October 1973 War. Western markets also used dumping sanctions to block Arab petrochemical products on the pretense that they used as feedback subsidised natural gas. In an effort to recover oil prices, delegates from Gulf countries met in Vienna on 8 October 1973, with their peers from major oil companies who offered a maximum price increase of $0.45 -- from $3 to $3.45/b. Feeling empowered by Egypt's victory in the Suez Canal two days earlier, the Gulf delegates -- joined by the Iranians -- refused the offer and decided to raise the price unilaterally. For the first time in the history of oil industry, the value of oil was independently raised by oil producers from an unfair $3/b to $11.65 starting 1974. The nationalisation of the oil industry was also accelerated and completed in 1974, making oil pricing the exclusive right of the producing country. Five years later, following the Iranian Revolution in 1979, oil prices peaked at $33 per barrel. Oil rent, which netted $53.25/b in Western Europe in 1980, tilted in favour of oil exporters, whose share peaked at $34/b (64 per cent of rent). The treasuries of European oil-importing countries collected $19/b, or 36 per cent of net rent. The price for European consumers reached $65.50/b that year. Consequently, Arab oil receipts jumped from $14 billion in 1972 to $75 billion in 1974, and continued rising to reach a peak of $213 billion in 1980. However, Western industrial countries who remain the major oil importers, succeeded in restoring control over oil prices by coordinating their energy policies, individually and collectively. This included the creation of the International Energy Agency (IEA) in 1974 to contain the rising power of the Organisation of Petroleum Exporting Countries (OPEC), and to promote the interests of its members in the field of energy at large and oil in particular. One way of containing OPEC, was for IEA members to stockpile large commercial and strategic oil reserves and use them to push down oil prices. For example, the US strategic petroleum reserves (SPR) now top 700 million barrels. In 1979, OPEC's production capacity was above 31 million barrels per day and fully utilised to meet OECD member demand of which a significant portion was directed to commercial and strategic reserves. Concomitantly, the IEA set up and executed energy policies which between 1974 and 1986 resulted in the reduction of worldwide oil consumption by six million b/d, and raised oil supplies outside OPEC members by eight million b/d. OPEC's utilised capacity was cut in half to nearly 15 million b/d, leaving the idle capacity and Western diplomacy as pressure tools to reduce oil prices. At the beginning of the 1980s, the value of oil eroded and finally crashed in 1986 from $28/b to $13 -- going as low as $7/b in July of that year. Over the period 1987-2004, the nominal price of oil settled at around $18/b under pressure from OPEC spare (closed) capacity, and continuing diplomatic pressure. Meanwhile, the prices of goods and services imported by oil exporting countries from industrial countries were increasing. This rendered the real price of oil to drop to an average of $5/b in terms of 1973 dollars -- the year which witnessed the correction of oil prices from $3 to nearly $12 thanks to Egypt's victory over Israel. While crude oil prices fell, the taxes imposed by industrial countries on petroleum products increased. In Europe, taxes leaped from an average of $22/b in 1986 to $65 in the 1990s, which is approximately 70 per cent of the retail price for consumers. Again, between 1986 and 2002, oil rent distribution was tilted against oil producers whose share diminished to only $12/b (allowing for a replacement cost of nearly $6), and was no more than 15 per cent of net rent. European governments collected $65/b, or 85 per cent, of oil rent, while the price for European consumers remained at around $100/b throughout the 1990s. Instead of cutting costs on consumers, European governments opted to raise oil taxes during this period. The rate of investment in upstream oil industry is a key determinant of how much spare crude oil capacity will be available, making it a key determinant of oil pricing. Smaller spare capacities sharply increase pressure to raise prices. In late 2001 and early 2002, oil prices were as low as $18/b and the world's spare capacity was as large as eight million b/d. However, while spare oil capacity was declining due to rising world oil demand, investment in capacity expansion by OPEC members was greatly reduced because of the eroded real price of oil and shrinking oil export receipts. Many of them had to borrow money to meet budget deficit during the 1990s. By 2003, world economic growth began to show unprecedented rates of around five per cent per year. Consequently, world demand for oil jumped from 78 million b/d in 2002 to 84 million b/d in 2006, at an average growth rate of 1.9 per cent per year. The spare oil capacity, which drove oil prices down was diminishing due to lack of investment in capacity expansion. Demand on OPEC oil was growing and its oil exports grew over the period 1987-2006 from 15 million b/d to 28 million b/d, accounting for a 13 million b/d decline in spare capacity. Meanwhile, OPEC domestic oil consumption which had grown during this period from 3.4 million b/d to 6.4 million b/d, further reduced the spare capacity by three million b/d. Therefore, today's spare oil capacity has reached a bottom of less than two million b/d of heavy oil. This is mostly in Saudi Arabia, waiting for a buyer because of its quality which is lower than Western standards. The US and Europe recently mandated greater use of low-sulfur diesel for environmental reasons. OPEC is now unable to do anything about oil pricing because it has become mainly driven by demand rather than supply. Almost all OPEC member countries are producing at a maximum capacity, as are non-OPEC producers. OPEC's new expected capacity of four million b/d by 2010, together with near stagnant non-OPEC supplies of around 50 million b/d, will fall short of meeting rising demands on oil. There are also temporary factors which are pushing the price of oil up, including geopolitical tension caused by the US occupation of Iraq, and Washington's threat to strike Iran under false pretences. Those are particularly serious and overwhelming factors since they are looming over the Arabian Gulf which contains two thirds of world's oil reserves. Oil speculation in commodities markets such as New York, London, Tokyo, and more recently the Dubai Mercantile Exchange (DME), also affect the price of oil. Since oil is particularly a vulnerable commodity, speculation by corporates, macro hedge funds and institutional investors, make it easier to influence the price and to make a profit from the volatility of the oil market. Hedge funds come at the market from different directions and are using more sophisticated trading techniques without much interest in fundamentals (real demand and supply). They trade in "paper barrel" which volume is more than five folds the trade in physical oil or "wet barrel". No one knows how much money has gone into the market from hedge funds, which account for most of oil speculation trading, because they aren't subject to traditional reporting standards. Partly initiated by the weakness of the US dollar, institutional investors such as pension and mutual funds have become the newest comers onto the energy speculation markets. These investors may not understand the market's complexity and thus do not behave in predictable ways -- increasing volatility. Some institutional investors use the expertise of hedge funds or investment banks rather than attempting to manoeuvre the market alone. In brief, a lot of money is poured into such markets by investors in search of above average returns. Altogether, the failure of spare oil capacity to accommodate precipitous oil demand growth over the period 2003-2006, as well as other geopolitical and speculative factors, have pushed the price of oil from $28/b in 2003 to $36 in 2004; then $50 in 2005, $61 in 2006, $69 in 2007 and to over $90 during the first quarter of 2008. Calculating the real price of oil depends on three criteria which were intensely negotiated and agreed upon in the early 1970s between OPEC members and major oil companies. First, the 1971 Tehran Agreement provided for a 2.5 per cent annual rise in the price of oil to cover for inflation; second, the agreement provided for a further 2.5 per cent rise to compensate oil producers for the fast depletion of oil reserves. Finally, following the US dollar devaluation in December, 1971, the first Geneva Agreement raised oil prices by 8.5 per cent to compensate for the devaluation of the US dollar -- which is used to price oil. The second Geneva Agreement of June, 1973, raised the price of oil by 11.9 per cent to compensate for a second dollar devaluation in February 1973. While the Tehran and Geneva agreements are no longer valid, they serve as good models for gradually escalating prices without the shocking jumps witnessed today and in the 1970s. OPEC has calculated the effect on oil price of inflation and dollar devaluation factors between 1973 and 2006. Accordingly, the nominal oil price in 2005 was $50.64/b, while the real price was only $10.41/b in terms of the 1973 dollar and net of inflation in this period. Likewise, in 2006 the nominal price of oil was $61.08/b while the real price was $12.22. Hence, the real price of oil today, factoring in net inflation and dollar devaluation is only 20 per cent of the nominal price. But OPEC has yet to look into the issue of depletion compensation. Over a period of 35 years (1973-2008), real oil prices should have risen from $11.65/b to today's level of $27.65/b. However, since the real price today is only 20 per cent of the nominal price using two of the three escalation factors, the nominal price using all three factors should have been $140/b. This figure, of course, is much higher than the $110/ b which caused Bush and Cheney to take the trouble of visiting major Gulf oil producers. * The writer is an energy and petroleum consultant.
