$18 Per Barrel Crude

The following book excerpt illustrates the international oil industry's strategy to price alternative fuels and energy conservation out of the market in the late 1980s (bold emphasis added).  For confirmation of the success of this strategy, see WTRG Economics' Oil Price History and AnalysisFor information on other factors that go into industry calculations of optimum prices, see Jay Hanson's views.

Yergin, Daniel. 1991. The Prize: The Epic Quest for Oil, Money, and Power. Simon & Shuster. New York.

"Hara-Kiri" and $18 a Barrel (pages 758-761)

Yet no one really had any idea of how to behave in a competitive environment, nor indeed any experience. One OPEC veteran, Alirio Parra, a senior official of Petroleos de Venezuela, struggled to find some historical context. He had begun his career as an assistant to Juan Pablo Perez Alfonzo during the formation of OPEC and, in fact, had been sitting with Perez Alfonzo when the invitation to the founding meeting had arrived in 1960. Now the dissolution of OPEC seemed at hand. Searching his mind for some starting point, Parra recollected a book he had read many years earlier, The United States Oil Policy, published in 1926 by John Ise, a professor of economics at the University of Kansas. Parra finally found a battered copy in Caracas and brought it with him to London where he read it carefully.

"The unfortunate features of the oil history of Pennsylvania have been repeated in the later history of almost every other producing region," Ise had written then. "There has been the same instability in the industry, the same recurrent or chronic overproduction, the same wide fluctuations in prices, with consequent curtailment agreements, the same waste of oil, capital, and of energy." Ise described one episode in the 1920s as a "spectacle of a vast overproduction of this limited natural resource, growing stocks, overflowing tanks, and declining prices, frantic efforts to stimulate more low and unimportant uses or to sell for next to nothing.... It was a case of 'being choked, and strangled, and gagged, by the very thing people most wanted oil.'.' " Ise added, "Oil producers were committing 'hara-kiri' by producing so much oil. All saw the remedy, but would not adopt it. The remedy was, of course, a reduction in the production." Although Ise had written the book sixty years ago, the language and the diagnosis sounded all too familiar to Parra. He made notes.

Thereafter, Parra was one of the handful from the exporting countries who began trying to work out a new pricing system that took into account the fact that oil and energy markets were, after all, competitive. Consumers had choices. That led him and the others to focus on a new price range of $17 to $19--and, more specifically, $18 a barrel--$11 less than what had been the official price of $29 a few months earlier. Somehow, this seemed to be the "right" price. Parra and a couple of others spent a week in May holed up in the Kuwaiti embassy in Vienna discussing the rationale for the new price. Correcting for inflation, it took oil prices back to where they had been in the mid-1970s, on the eve of the Second Oil Shock. Now, $18 seemed to be the point at which oil was again competitive with other energy sources and with conservation. It appeared to be the highest level that the exporters could attain and still achieve their goals of stimulating economic growth in the rest of the world and thus energy demand. It would reignite demand for oil and cap or perhaps even reverse the seemingly unstoppable non-OPEC production. Eighteen dollars "is inconvenient for my country," one senior OPEC official said to a friend, "but don't you think it's the best we can do?"

In the last week of May 1986, six oil ministers met in Taif in Saudi Arabia. One of the ministers commented that some of the others were predicting that oil prices would fall as low as $5 a barrel. "None of those present wants to give oil away to the consumer or to give the consumer a present," noted the Kuwaiti oil minister. But, he added, the old $29 a barrel had done OPEC "more harm than good."

Yamani categorically stated Saudi Arabia's position: "We want to see a correction in the trends in the market. Once we regain control of the market by increasing our share, we will be able to act accordingly. We want to regain our market power."

The ministers in attendance all confirmed their support for $17 to $19 a barrel and agreed on the need for a new quota system to go with it. What would have seemed heresy a few months earlier was now becoming the accepted wisdom. For, amid all the confusion and disarray of this latest oil crisis, a new consensus in favor of $18 a barrel was very definitely emerging out of the wreckage of the old. "It was a process of osmosis," said Alirio Parra. And not only producers, but consumers liked it, too. The Japanese, as importers of more than 99 percent of their oil, might have been expected to prefer the lowest possible price. That was not the case. Two problems would result if prices were too low. First, this would undercut the large and expensive commitment they had made to alternative energy sources, leading, they were sure, back to higher oil dependence and eventually to renewed vulnerability, and setting the stage for another crisis. Second, since oil constituted a substantial part of Japan's imports, very low prices would enormously swell Japan's already-huge trade surplus, further accentuating the severe conflicts with American and Western European trading partners. Thus, one found throughout the Japanese oil industry and government a belief in "reasonable prices," which happened to come out to about $18 a barrel.

The new consensus was evident in the United States, as well--in the government, on Wall Street, in banks, among economic forecasters. The gains from falling oil prices (higher growth and lower inflation) would outweigh the losses (the problems of the energy industries and the Southwest). But that was true only up to a point, at least according to the new view. At some level, the pain and the dislocation in the financial system, along with the discomfort to politicians, would start canceling the benefits, and that point, by general consent, fell somewhere between $15 and $18. The Reagan Administration was rooting for the efforts to reestablish the price around $18. Such a price would give a strong boost to economic growth, while helping to restrain inflation, but it was also a price at which the domestic oil industry could scrape by and would thus greatly reduce the pressure for a tariff. As a result, the Administration could maintain its commitment to "free markets" and would not have to take any action. When all things were considered in these circumstances, the most desirable thing to do was nothing.

But consensus was one thing. Putting together a new deal was quite another. And the efforts in that direction were failing, even though the loss of revenue was becoming excruciating for many oil exporters. The Arab Gulf states, which greatly increased the volumes they sold, were the least hurt. Kuwait's revenues were down only 4 percent, Saudi Arabia's 11 percent. The price hawks, which happened to be the countries most belligerent and hostile toward their customers in the West, were the ones hit hardest. Iran's and Libya's oil earnings in the first half of 1986 were down 42 percent from the same period in 1985. Algeria's were down even more. For more than economic reasoning, Iran was the country most disadvantaged. Even as its revenues were plummeting, it was having to finance the war with Iraq, which had entered a new, more intense phase. The Iraqi air war against tankers and facilities was taking a rising toll on Iranian export capabilities. How could Iran continue to fight the Ayatollah Khomeini's holy war against Iraq and Saddam Hussein without money?

Something would have to be done soon. Saudi Arabia had been maintaining its output at its old quota level, but now indicated that it would start pushing its production to higher levels. Even more oil would be coming onto the market. In July 1986, Persian Gulf crudes were going for $7 a barrel or less. Enough was enough, and the leaders of Saudi Arabia and Kuwait were anxious to bring the "good sweating" to an end. They, too, were worrying about prospects for revenues. Moreover, the volatility and uncertainty were too unsettling, too likely to increase broader political risks around the world. Virtually all OPEC decision-makers had concluded that the market share strategy was, at least in the short term, a failure. But how to get out of it without sinking back into the bind that had precipitated it in the first place? The only way out was new quotas. But who would get what? Some of the exporters insisted that Saudi Arabia resume its swing role, to which Yamani replied, "Not on your life. We all swing together or not at all. On this point, I am as stubborn as Mrs. Thatcher."

By July, OPEC experts had worked out on paper a detailed rationale for the new pricing: a range of $17 to $19 a barrel would lead to an improved world economic outlook, stimulating oil demand: "It could be an effective instrument for slowing and arresting the pace of fuel substitution" and "will definitely discourage future developments of high cost oil." But, if prices were any lower, the exporters would run a grave risk: "strong protectionist measures in the major consuming countries of the industrialized world," including "the imposition of an oil imports tariff in both the U.S. and Japan." They remembered Eisenhower's import restrictions much better than most Americans.

But still there was the matter of quotas, which would require renewed cooperation among the fractious OPEC exporters, and there appeared to be little hope that anything could be worked out when OPEC next met in Geneva, at the end of July and the beginning of August 1986. Iran, in particular, had signaled its opposition to new quotas. But in the course of the meeting, the Iranian oil minister, Gholam Reza Aghazadeh, appeared in Yamani's suite for a private discussion. He spoke through an interpreter. Yamani was so startled by the message that he insisted that the interpreter translate it again. It was reiterated. Iran, said the minister, was now willing to accept the temporary, voluntary quotas pushed by Yamani and others. Iran had, in fact, backed down. Its oil policy was more pragmatic than its foreign policy.

The market share strategy was over. But in announcing the restoration of quotas, OPEC insisted that it would not carry the burden itself; non-OPEC would have to cooperate. And agreements were subsequently worked out in which various non-OPEC countries indicated that they would do their part. Mexico would cut its output. Norway promised not to cut back but rather to reduce the growth in its output. At least that was something. The Soviet Union had stood aside from most of the discussions. In May 1986 a senior Soviet energy official had derided the notion that the Soviet Union would ever formally cooperate with OPEC. The Soviet Union was not a Third World country, he insisted. "We are not a producer of bananas." It was true in a way; one could not find bananas in Moscow. But, bananas or not, Soviet officials could read their balance of trade accounts, and the loss in terms of hard currency earnings from oil and gas, if continued, could be devastating for the plans to reform and revive the stagnant Soviet economy that were just beginning to be formulated under Mikhail Gorbachev. The Soviet Union promised to contribute a 100,000-barrel-per-day cutback to OPEC's efforts. The pledge was vague enough and the job of tracking Soviet exports sufficiently difficult that the OPEC countries could never be sure that the Russians were really as good as their word. But in the immediate turmoil, the symbolism was important. The next step to cool off the good sweating was for OPEC to formalize quotas and do something about price. But there was an interlude.6