May 25, 2004

The $40-a-Barrel Mistake


So what's the reason for the spectacular rise in crude oil prices to more than $40 a barrel? While there is plenty of blame to go around, responsibility rests largely on the defective if well-meaning policies pursued in the last couple of years by the two most important countries in the global oil market: Saudi Arabia and the United States.

This year's oil saga has its roots in the Venezuelan oil strike that took place in the winter of 2002-2003 and removed some 200 million barrels of crude oil and gasoline from the world market.

In response to the strike, the United States made two strategic mistakes. First, it refused to compensate for the drop in supply by releasing oil from the Strategic Petroleum Reserve. (Understandable, given a war on the horizon.) Second, it accepted assurances from Saudi Arabia that the kingdom would increase production to make up for the Venezuelan shortfall.

Missing from the picture? Geography. Venezuelan oil can get to the United States in six days; Saudi oil can take up to two months to make it to American refineries. To complicate matters, Saudi Arabia was slow to increase output, waiting until late January and early February of 2003 to raise production, 45 days after the Venezuelan disruption began.

These problems were compounded by the administration's determination to use the strategic reserve only in dire emergencies. Under previous administrations, reserve oil was often released after a natural disaster or a spike in prices. This kept prices down because oil traders tended to believe that prices consistently above $35 a barrel would lead to the use of the reserve and options were priced on that belief. With its policy, the Bush administration essentially told the market that there would be no effective lid on prices.

How can the administration rectify its mistakes? It could calm the market by moving away from its emergency-only stance. It could also stop buying oil to add to the strategic reserve. The government has done a good job making sure that the reserve is at its 700-million barrel capacity. But now that we are close to that goal there is no reason to keep buying oil at exorbitant prices.

And Saudi Arabia? The Saudis have benefited from being the world's residual supplier. Estimates are that the windfall from higher prices and higher production in 2003 came to some $42 billion. Over the past year, the Saudis have increased output to make up for lost flows from Venezuela, from a strike in Nigeria and, of course, from the disruption associated with Iraq.

Like the Americans, though, they have made mistakes. Their insistence in OPEC on high base prices for oil combined with Washington's virtual removal of a price ceiling has made life a lot easier for speculators. In addition, their release, in a public-relations effort, of previously secret data about their reserves and their production capacity has had the reverse effect of damaging their credibility. After all, if they hid this information from the world, what else could they be concealing? Finally, Saudi Aramco's inability to get oil to refiners on a timely basis has undermined its control over global prices.

So what can the Saudis do? They can begin moving oil from their production base to storage facilities in Asia, Europe and North America, shortening the supply chain and making them a genuine supplier of last resort. With these steps, both the Saudi and the American governments can recapture the credibility necessary to lead and shape the global oil markets.

Edward L. Morse, deputy assistant secretary of state for international energy policy from 1978 to 1981, is an adviser to Hetco, an oil trading company. Nawaf Obaid, the author of "The Oil Kingdom at 100: Petroleum Policymaking in Saudi Arabia," is an adviser to the Saudi government.

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