- The Washington Times - Monday, May 13, 2002

If oil exports from Saudi Arabia are interrupted, the world price could triple to more than $60 a barrel (42 gallons), at least for several months. How vulnerable is the United States and what should be done to prepare for this eventuality?
The attacks of September 11 have exposed some of the fissures within the kingdom. On the one hand, the royal family has been supporting, financially and politically, the terrorist al Qaeda to assure continued backing from fundamentalist Islamic clerics. On the other hand, the regime has permitted the stationing of U.S. troops in Saudi Arabia to protect against incursions from Iraq. But the presence of foreign troops also heightens the danger of internal rebellion; it creates resentment among the growing number of well-educated but jobless Saudis, and incites the anger of fundamentalists against the regime that tolerates as Osama bin Laden puts it "infidels on holy Islamic soil."
To gauge the impact of political scenarios on world oil prices, it is important to understand that, theoretically at least, there exists an optimum price for oil as seen by the Saudi regime and other Arab producers, who form the "core" of the OPEC cartel.
This core controls oil wells with the lowest lifting costs and therefore the highest profit margins. It can or should adjust its oil production, and thereby manipulate the world price, to maximize over time the discounted value of its stream of profits. Any deviation from the optimum path can significantly reduce this value. Therefore, even though the core has excess production capacity, it does not use it fully since this would drive the price below the optimum value. This optimum price path (over time) can be calculated, taking into account the delayed reactions (to the world price) by other oil producers, both within and outside of OPEC, who are "price-takers" that always produce at their maximum capacity.
Many factors determine the optimum price-path for the core; but as the theory makes clear, the chief factor is the perceived value of future profits and therefore the discount rate perceived by the core producers.
Accordingly, if the Saudi regime feels threatened by a possible takeover, it may adopt a short-term point of view that makes future oil profits appear less valuable. This translates into a high value for the discount rate and increased production levels that could drop the world price to perhaps $10 a barrel or even lower. The larger volume of oil sold will offset to some extent the lower profit per barrel. While this low price provides a temporary boost to consumers, cheap oil will have a negative impact on oil production in the United States and other oil nations: It will discourage exploration, force the closure of uneconomic wells, and also delay development of alternative energy sources.
One can counter such Saudi actions by imposing a variable import fee (not a fixed tariff) that provides a domestic price floor of, say, $15. Exporters, like Iran and others, who are crucially dependent on oil revenues, may threaten or take more drastic action: They could sabotage pipelines, destroy loading platforms, and even sink oil tankers to reduce Saudi exports. Thus the low world prices may not last very long.
The other extreme price scenario would follow from an actual takeover, whereby the Saudi family loses control of the oil and its revenues. The new regime, put in place through an internal revolt by political opponents or by Saudi Shi'ites, or perhaps by a foreign power, may simply continue to sell to the world market to reap the substantial profits that come from the difference between a world price of about $25 per barrel and lifting costs that are well below $5.
Most likely, this new regime will be unfriendly and may decide not to sell oil to the United States. In that case, we are back to the situation that existed in 1973 during the so-called Arab oil embargo. The excess oil sold to the rest of the world simply displaced other oil that we could then buy. Since oil is fungible, the world market will be not be much disturbed by such a swap and prices will continue at reasonable levels.
However, if the new regime acts irrationally and actually reduces oil output or even destroys wells, as Saddam Hussein did in Kuwait the world market will react to the shortfall by raising the price to all consumers in oil-importing countries and even in oil-exporting countries. Informed opinion places the new price at about $65 a barrel, about $40 above the present price at least for several months, until demand moderates and also new supplies come on line. The impact would be devastating for developing nations that import most of their oil and have few alternatives. But the price rise would have little effect on the U.S. It would up the price of gasoline at the pump by only $1 a gallon and hardly affect the price of electricity, which is mostly produced by coal, nuclear and hydro.
In case of such a takeover and major price jump, the affected world community may feel compelled to "liberate" the wells of Arabia and restore production. But having done so, it might not return the wells to the original owners, who by then will have departed to hotels on the Riviera or to the Dorchester in London. Instead, the world community in its wisdom may invoke the clause made famous in the Law of the Sea negotiations and declare the oil resource to be the "Common Heritage of Mankind." Profits of between $50 billion and $100 billion a year would then flow to needy people on this globe rather than to Saudi princes. The oil may be considered as Arab patrimony and distributed among the needy in Arab countries. Or it may become Islamic oil, or just the common heritage of all mankind. The world oil market doesn't care where the profits go.
As far as the U.S. is concerned, neither of the extreme price scenarios should last long nor have much effect on the American economy. One wonders, therefore, why so many of our strategic military planners are so concerned about Saudi oil security.

S. Fred Singer is emeritus professor of environmental sciences at the University of Virginia and a visiting Wesson Fellow at the Hoover Institution at Stanford University. He authored a monograph on "The Price of World Oil" and is also co-author of "Free Market Energy."


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