Saudi Arabia and the World Oil Market
The first major event to affect the world oil market post-1971 is, without a doubt, the 1973 Arab-Israeli War, when Egypt, led by Anwar Sadat, launched a surprise attack on Israel in the early hours of October 6th, or Yom Kippur. Sadat’s main purpose in this war was to shake up the status quo; he desired a resolution to, if not the whole Arab-Israeli conflict, at least the Egyptian-Israeli conflict, and thought a war would prompt the Western world, particularly the United States, into working towards that resolution. Prior to this war, oil prices were fairly steady, bumping along in the range of $1-$3 a barrel for most of the 20th Century. With the outbreak of the war, however, prices shot up as Saudi Arabia, along with other Arab oil producing countries, decided to use the “oil weapon” against the United States in an effort to get the US to stop supporting Israel, or at the very least, devote more attention to the problems Israel posed for the Arab world. This oil weapon had been utilized once before, in the 1967 Six Day War, when Arab countries imposed an oil embargo on the US and Great Britain; because the US still had spare oil producing capacity at this time, however, it was able to increase domestic production enough to offset the loss of Arabian oil, and thus oil prices were not affected in any meaningful way.
The 1973 war was different, however, in that the US no longer had spare production capacity; its oil fields, which had for years only produced a limited amount of oil in order to keep prices from collapsing, were now producing at full capacity in order to meet the enormous growth in demand of the past decade which had been driven by cheap cars, the growth of suburbs, and the development of an international highway system. Thus, when Saudi Arabia announced the oil embargo on the US in October of 1973, and also announced it would be cutting its own oil production 5% immediately, and 5% for every month the US didn’t meet its demands concerning Israel, the oil market was hit hard. Previously, the US could just up domestic production, but that was no longer an option. The embargo, then, drove prices up tremendously – from an average of $2.83 per barrel in 1973 to an average of $10.41 per barrel in 1974.
This enormous price increase had serious consequences in both the producing and consuming countries. In the US, higher prices precipitated a scramble by both large oil companies and individual consumers to buy up as much oil and oil products as possible; to this end, gas rationing and lines to fill up on gasoline were seen throughout the country. In Saudi Arabia, the price increase meant a huge revenue increase, prompting the government to introduce subsidies and certain free services to all of its people. Another outcome of the embargo was the US’ sudden commitment to a swift resolution to the Arab-Israeli conflict; to this end, the US worked with Egypt’s President Sadat, and, as progress was made between Egypt and Israel, Sadat himself urged the Arab oil countries to end the embargo, as it had served its purpose. Saudi Arabia, under the leadership of King Faisal, was at first reluctant to end the oil embargo, especially as it had been a joint Arab venture; with Sadat no longer behind the embargo, however, and with more and more oil reaching the market from different sources, including Iran, the embargo was not as effective as it had been at its outset. Thus, in March of 1974, the embargo was lifted. While oil prices ceased to increase at such a dramatic rate, neither did they go down; instead, the years of 1975-1978 saw oil prices mostly stabilize. In 1978, the average price was $13.03 per barrel, just $2.62 over the 1974 price. Interestingly, because of inflation, oil was actually cheaper in real dollars in 1978 than it had been in 1974, when the first major price hike was seen.
So, in this particular instance, we saw Saudi Arabia operating outside of OPEC; it certainly had the support and backing of other Arab members of OPEC, but not the entire organization itself. Indeed, some members of OPEC such as Iran actually worked to increase oil production and thus market share to the US during the embargo. Saudi Arabia, then, working outside of OPEC, managed to drive the price of oil to previously unforseen heights, directly controlling the world oil market by cutting off supply in a time of high demand and raising prices.
The next major event to rock the oil market were the strikes of Iranian oil workers in the fall of 1978, dropping Iranian production from over 5 million barrels a day in 1978 to just over 3 million in 1979, and then to just over 1.5 million in 1980. Of course, it wasn’t just the oil workers striking that caused the precipitous fall in Iranian oil production; the Iranian revolution occurred in 1979, prompting the US to impose a boycott of all Iranian oil, and threaten to seize of assets of any company that did business with Iran. Where Iran under the Shah had once been a staunch ally of the US, and looked to provide oil in times of crisis, Iran under Ayatollah Khomeini was ardently anti-US, and wanted to hurt the US in any way possible.
Of course, this upset of Iranian oil had a marked effect on world oil prices; the average spot price for a barrel of oil jumped from $13.03 in 1978 to $29.75 in 1979 – an increase of 228 per cent. A year later, Iraq launched a surprise attack on Iran, starting the eight-year Iran-Iran war, and further disrupting supply of oil; in 1981, Iran produced an average 1.38 million barrels of oil a day, down from 5.88 million barrels a day just five years earlier; that same year, Iraq produced only 1 million barrels a day, down from 2.51 million just one year earlier. Oil prices reached a high point in 1980, hitting $35.69 a barrel, but then slowly dropped, falling to $27.53 a barrel by 1985.
During this period, Saudi Arabia went through several different production phases. In 1978, the Saudis actually decreased their oil production, dropping to an average 8.3 million barrels a day, down from 9.25 million a year earlier. This served to add to the increase in price; following the double impact of the Iranian revolution and the Iran-Iraq war, however, prices shot up even further, and the US approached Saudi Arabia seeking an increase in production in order to achieve lower prices. At this point, there was still a good amount of tension between the US and Saudi Arabia, left over from both the Saudi’s 1973 embargo, and the US’ hand in engineering the Egyptian-Israeli peace agreement. Despite these tensions, the relationship between the two countries was one that could not be lightly broken; Saudi Arabia depended on the US for arms and protection, and the US depended on the Saudis for oil, and, with the Iranian revolution having just overthrown the US-backed Shah, to provide a point of stability in the region. Thus, Saudi Arabia did respond to the US request, increasing production to an average of 9.53 million barrels a day in 1979, 9.9 in 1980, and 9.82 in 1981. Even though prices did begin to fall after 1980, they did not fall much; the increased production, then, was not enough to drive prices down significantly.
With prices so high, many OPEC member countries rushed to produce as much oil as possible, hoping to cash in on the high spot prices. Saudi Arabia, however, chose to take a long-term view of the market, and saw that if oil production continued to be high, the market would be flooded with oil, and prices would collapse. Additionally, with prices so high, demand for OPEC oil was significantly lower, especially as conservation efforts spurred by the first oil shock of 1973 began to come into play.
Specifically, Americans began to drive cars which were more fuel-efficient, as well as utilize different forms of energy, such as nuclear reactors, while European countries began to impose heavy taxes on gasoline, causing lower European demand. Another reason demand was lower for OPEC oil was because with prices so high, it became economically viable for oil companies to search for and produce oil in other areas, particularly Alaska and the North Sea, putting even more oil on the market.
All these factors led OPEC to institute a quota system, in which each member country would only be allowed to produce a certain limited amount of oil in the hopes of keeping prices from falling. As the largest OPEC producer, Saudi Arabia was called upon to make the largest production cuts; to this end, production in Saudi Arabia fell from an average 9.82 million of barrels of oil a day in 1981 to a mere 3.39 million of barrels of oil a day in 1985. Other OPEC countries, however, didn’t adhere to the quotas; in fact, some sought to increase production, including Iran and Iraq, in order to continue making record profits. Thus, the cost of cutting production fell mainly on the Saudis; acting as the “swing producer” of OPEC was losing them both money and market share.
Saudi Arabia’s position as swing producer had dire consequences for the country’s finances. The massive oil revenues of the 1973 oil shock had allowed Saudi Arabia to put away a huge amount of money in banks; even as production dwindled in the early 1980s, costs for the government continued to rise, and thus the surplus money was being spent up. A good deal of the money spent went to finance Iraq in its war against Iran, which was seen as a threat to the Saudi royal family with its calls for exporting Islamic revolution; money was also spent to ensure that the Saudi population continued to have the luxuries which were promised and paid for in the 1970s.
After four years of losing money and market share, Saudi Arabia finally decided it had had enough of carrying the other OPEC countries, and chose to increase production, looking to gain its market back. In 1986, Saudi production increased to an average 4.87 million barrels of oil a day; that same year, however, oil prices collapsed. The previous year, a barrel of oil was selling for $27.53; in 1986, that same barrel sold for $13.10. This massive price collapse can be partly attributed to the decrease in demand due to the conservation efforts and alternative oil supplies mentioned earlier, but it can also be attributed to Saudi Arabia’s increased production; more oil for sale meant lower prices.
Here, it is tempting to come to the conclusion that during the early 1980s, when Saudi Arabia was working within OPEC’s framework of quotas, it was responsible for the high oil prices, and thus controlled the world oil market. This assumption would be a mistake, however. The high oil prices were caused by the disruption of Iran’s and Iraq’s oil production; Saudi Arabia’s acts as swing producer merely helped support a price that had already been established; it did not drive that price, and it did not control that price. Indeed, even as Saudi Arabia cut production in efforts to keep prices high, prices continued to fall through the early years of the 1980s.
Instead of trying to shore up falling prices by playing OPEC’s swing producer once again, Saudi Arabia continued to produce more oil, and in 1988 was up to an average of just over 5 million barrels a day. Again breaking OPEC ranks, Saudi Arabia, in an effort to win back the market share it had lost due to production cuts, introduced the “netback” system, where oil companies and refiners were guaranteed a base price for a barrel of oil, and Saudi Arabia got whatever profit could be madeover that base price. Thus, there was little to no risk for the oil companies in buying Saudi oil; they would always get a certain amount, no matter what the market price of oil was at the time. In this manner, Saudi Arabia managed to gain most of its market share back.
In this instance, Saudi Arabia can be seen to be controlling the world oil market. Saudi Arabia’s actions, which were outside of OPEC, and indeed directly broke the quota system, caused OPEC to reevaluate its system of regulating member countries’ production. Tit was with this in mind that OPEC decided it wanted to control both prices and market share of member countries. This decision pleased the small members, who were interested in a controlled price, since they saw oil as a commodity which, for them, could be depleted at any moment, making high prices very important; it also pleased the larger members with lots of oil, who saw oil as a commodity which they would be selling for a very long time, and thus day-to-day prices were not as important as retaining buyers for their product. OPEC ultimately settled on a target price of between $17 and $19 per barrel of oil; however, rather than setting this price as an official selling price, the price would be reached by managing production quotas of the various member countries.
The end of the 1980s and the first months of 1990 saw demand for oil climb once again; this was spurred by the low prices of gasoline and the introduction to the US market of bigger, less fuel-efficient vehicles. The next major event that would rock the world oil market, however, occurred in July of 1990, when Iraq’s Saddam Hussein invaded Kuwait, laying claim to Kuwaiti oil fields. If this invasion had been successful, it would have put Saddam in control of almost as much oil as Saudi Arabia in terms of proven reserves.
Saddam’s moves prompted an almost immediate U.N. embargo against all Iraqi and Kuwaiti oil, taking almost 4 million barrels of oil a day off the market. Utilizing the new quota system, however, OPEC countries were able to increase production across the board. Of particular importance was Saudi Arabia, which, in 1989, was producing 5 millions barrels of oil a day, but had the capacity to produce over 10 million barrels a day. Thus, Saudi Arabia was largely able to offset the loss of Iraqi and Kuwaiti oil; in 1990, Saudi production was up to 6.41 million of barrels a day, and in 1991, 8.12 million barrels a day.
Even with the increased production of countries such as Saudi Arabia, oil prices did experience a slight jump due to the 1990-1991 Gulf War: a barrel of oil was an average of $15.62 in 1989, but an average of $20.45 in 1990. This price jump, however, was temporary, as oil was back down to $16.63 in 1991. At this point, then, Saudi Arabia was acting as an effective swing producer in that it was producing more oil to make up for Iraq’s and Kuwait’s lost production. Still, it was working within OPEC’s framework, and was in no way controlling the oil market; other OPEC states also increased production during the Gulf War, including Nigeria and Iran.
Through the mid-1990s, OPEC did a good job keeping oil prices around the $17-$19 range; 1993-1994 saw prices hover around $15 a barrel, 1995 prices rose to an average $16.10 a barrel, and in 1996 and 1997, a barrel of oil was an average of around $18.00. Throughout this time, production levels also remained fairly consistent, with Saudi Arabia producing around 8.25 million barrels of oil a day for the same years, 1993-1997. These years, then, were fairly stable for the oil market, with no huge increases or decreases; there was no need of either Saudi Arabia or OPEC to control the market, as it was effectively controlling itself.
The last months of 1997 and the year 1998 saw a change to this stability, however. Due to the fairly strong market, OPEC decided to raise member countries’ quotas; just a few weeks later, the Asian market crashed, and with the crash came a large reduction in demand for oil, and thus a serious drop in the price of oil. At points in 1997, oil was as low as $12 a barrel, and 1998 saw prices at times drop to $10 a barrel. This price drop hurt Saudi Arabia immensely, as it no longer had the huge bank reserves it had had during the 1980s; the Saudis had spent the last of their surplus financing the Gulf War, and the price drop of 1998 hit them hard.
The sudden loss of revenue in a time when the country really could not afford it caused Saudi Arabia to become extremely price conscious; the country cut oil production, from an average of 8.39 million barrels a day in 1998 to 7.83 million in 1999. That same time period saw oil prices increase once again, from an average of $12.21 a barrel in 1998 to $17.25 a barrel in 1999. This price increase, while partly due to the swift recovery of the Asian market and strong US economic growth, was also due to Saudi Arabia’s commitment to production cuts, as well as the Saudis’ willingness to work with other OPEC countries such as Iran to lower production further. OPEC overall cut production by 1.19 million barrels of oil a day between 1998 and 1999, clearly helping shore up prices. Once again, however, Saudi Arabia was operating within the OPEC framework, and did not control the oil market so much as influence it, right along with other OPEC members.
Following the recovery of prices after the Asian market crisis, OPEC became committed to raising prices further, and to this end introduced a series of production cuts, driving prices up. Where a barrel of oil cost on average $17.25 in 1999, in 2000 the average price was up to $26.20. However, prices were back down to $22.81 in 2001 with the terrorist attacks in New York on September 11th. This price drop was in large part fueled by fears that there would be an economic recession in the US, and, even as that fear grew, prices dropped further, with prices reaching a low of $17.65 in November 2001. When that economic recession failed to materialize, however, all OPEC countries cut production further, in the hopes of bringing prices back up; in the first months of 2002, production in Saudi Arabia was hovering at just over 7 million barrels a day. Ultimately, these price cuts did drive prices up, and in December 2002, prices were back up to $28.39 a barrel, and production was back up as well; Saudi Arabia produced 7.91 million barrels of oil a day that month.
This, then, was another example of Saudi Arabia acting within the OPEC framework, cutting and raising production under the OPEC-determined quota system. In March of 2003, Saudi Arabia bumped up production to offset the loss of Iraqi oil following the US’ invasion of the country; they were able to drop production a few months later, however, as the invasion was not as disruptive to world oil prices as had been forecasted. In fact, Saudi Arabia has largely continued to act within OPEC’s quota system, producing about 9.5 million barrels of oil all throughout most of 2004 and 2005. Even when Hurricane Katrina disrupted oil production in the Gulf of Mexico in fall of 2005, Saudi Arabia stuck to its quotas, despite the near certainty that increasing production would lower prices and could possibly ease relations with the US, which had been rocky since the Saudi’s refusal to provide any aid for the 2003 US-led Iraq War. Far from controlling the market, Saudi Arabia simply produced its quota, and market forces drove prices up.
With such a huge amount of oil being produced by Saudi Arabia, of course any changes in production will have huge and immediate effects on the world oil market and the average price of oil, but, acting as a member of OPEC, Saudi Arabia does not have control of the world oil market; that is, OPEC responds to market forces by raising or lowering quotas, Saudi Arabia follows those quotas, and the market changes accordingly. Examples of this, as explained previously, include the mid-1980s, when OPEC, in a desire to keep prices from collapsing, told Saudi Arabia to cut production, which they did, and for a while, high prices were sustained. Another example is found in Saudi Arabia’s actions immediately following the Asian market collapse; rather than make its own policy, Saudi Arabia worked with the other OPEC states to bring oil prices back up, but not to control the market. It is only when Saudi Arabia steps outside its role as OPEC’s largest producing member that it is able to actually exercise control over the market; this was seen in the 1973 embargo, when actions taken by Saudi Arabia were directly responsible for an increase in oil price, and in 1986, when the Saudis broke the quota system, flooded the market with oil to regain their market share, and drove the price of oil down. Of course, as OPEC’s largest producing member, it is tempting to think that Saudi policy in fact drives OPEC policy, and thus anytime Saudi Arabia operates within OPEC’s framework, it is simply acting out its own desires. Evidence contradicts this thought, however, such as the massive losses Saudi Arabia took in the early 1980s as they struggled to keep prices high, even as other members flooded the market, and the fact that, ultimately, they reversed their position when they had had enough of taking those losses.
Saudi Arabia, then, while certainly influential in the world oil market, is only able to control it in very certain circumstances: when it works outside of OPEC. As mentioned previously, Saudi Arabia has stuck to its OPEC-imposed quotas for the past few years, and oil prices are at record highs; it would appear, then, that Saudi Arabia currently has no reason to act outside of OPEC, and thus will not exercise direct control on the oil market while this lack of a reason to break from OPEC continues. If, however, there comes a time when OPEC’s interests diverge from Saudi Arabia’s interests, and Saudi Arabia decides to step outside the organization and break its quotas, it can be expected that Saudi Arabia, through any decision it makes about oil production or pricing, will in fact be able to exercise direct control on the world oil market. Therefore, it would be advisable for any country which relies heavily on oil, such as the US, to remember this fact, and work to ensure their relationship with Saudi Arabia is strong, so as to receive preferential consideration when and if these circumstances come about.
