In this important essay the Author deals with the structure and the functioning of the oil market and the causes of its instability, listing a series of policies that would mitigate the instability and therefore reduce the shocks to the economy.
Up to now the books about oil and the oil industry have been based on an historical narrative, that is, they present the events from which the author gets the elements to explain the present and guess how the future will develop. Giacomo Luciani ‘s book “Security of Oil Supply: Issues and Remedies” (Claeys and Casteels) which is the number six of the European Energy Studies, is different. The book seems to have an objective, that to present an analysis and then advance some proposals to alleviate the great uncertainty that dominates the oil economy. The author prepared some time ago a proposal to reduce the prohibition to resale OPEC oil, which did not obtain the consensus of the producers, but still remains an important proposal. The book will close with recommendations on the way to reduce the great uncertainty that is typical of the oil market, and that affects negatively the oil industry.
It concentrates on some aspects that seem to shape in a way or another both the structure and the development of the oil industry. First, it starts from the behaviour of one of the main protagonist, the Producing Countries, and considers the effects on the industry of their position and of what he calls “the resources nationalism”, the willingness to keep the resources for the advantage of the producing country, and its population, and to get maximum advantage, that is, the highest price, for the maximum length of time, from their natural resources.
Second, he considers the vulnerability of the industry from armed conflicts both between States and within States, and, third, the effects of blocking the physical bottlenecks defined by geography, and by the routes followed by oil transport. Then, the book evaluates the effects of stocking oil, and finally, analyses the present oil market, and its security implications. The book makes a detailed examination of the disruptions of oil supply, quoting a number of cases:
The “Suez Crisis”, 1957,
The “Five-Days war 1967,
The OAPEC Embargo 1974,
The Iranian Revolution 1979,
The Iraq-Iran War 1981,
The invasion of Kuwait from Iraq 1991,
The Venezuelan Strike, December 2002 –March 2003,
The USA War against Iraq
And, having a different nature, the Katrina Tornado in 2005.
Of all these, only one, the Iranian Revolution in 1978-79 had relevant effects, which lasted for quite a while. The Iranian oil production was drastically reduced in order to prolong the life of the Iranian reserves and the duration of the oil income. In fact, Iranian production never went back to the pre-revolution level, causing a change in the world oil supply, which lasted for some years, but by 1983 oil production had started again to grow, without any relapses.
The book concludes that ”oil and gas installation appear to be much more resilient to armed conflict that is normally acknowledged. .... Interstate wars are a low probability event ... in contrast, civil war or violent non-state action “ are more frequent. In historical experience, civil wars have caused limited damage to existing installations....” To judge from the recent events on the between Algerian - Libyan border, such operations seem to be getting larger in men and weapons, more damaging to plants and equipment, and more important, to human life. Basically, all serious upheavals did not really disrupt crude oil production and consumption. Then the book examines the impact on supply security, of “restriction of passage, accidents, and transportation norms.” It checks the major Oil Choke Points: The Hormuz Strait; The Malacca Strait; The Bab el Mandel Strait; The Panama Canal; The Suez Canal; The Turkish Strait; The Baltic Sea.
In the first case, Luciani reminds us that “the Gulf has known a “Tanker War “ between 1980 and 1988 during the Iraq-Iran war... which added some cost to shipping oil but never seriously hindered oil exports ... no specific attempt to close the Strait was made-meaning that from the military point of view this was not considered either easier, or more advantageous that attacking the tankers elsewhere in the Gulf. “ Moreover, given the development of pipelines in the area, “Kuwait and Qatar are the only major Arab Gulf exporters that at present absolutely have no alternative but to ship the oil trough Hormuz.”.
Through the Malacca Strait flows the oil traffic to China, Korea, and Japan. China has already pursued diversification building a pipeline across Myanmar; Bab el Mandel Strait on the Arabian Peninsula is important to the tanker traffic from the Gulf to the Mediterranean Sea. Closing it would not be easier than closing the Hormuz. Circumnavigation of Africa, which happened when the Suez Canal was closed, would be easy as a solution, if that Strait would be blocked. The Suez Canal, and the Sumed pipeline and the Turkish Strait, the Bosporus, are by far less difficult and scarcely dangerous , the latter having been partly substituted by a cross Turkey pipeline. Finally, the Baltic Sea is relevant for the potential increase of Russian oil exports to Europe. In conclusion , the impact of these passages on the oil security happen to be not be very serious, given the experiences already acquired, and the activity of the countries directly interested in its availability . Furthermore, piracy up to now has not exercised any serious influence on the oil transport.
The book then moves on the matter of stocks. The stocks are considered important since long time, and the International Institutions and single countries have created a system of crude oil storage, which every now and then is called upon, in cases in which the supply of oil seems to become insufficient or in serious danger. The book differentiated between the commercial stocks and the “strategic” ones, which are kept by the various countries, and controlled by the International Energy Authority. It makes an exhausting presentation of the history of the stocks and goes into the technical detail of the various cases in which the stocks have been called to support the commercial supply.
The problem, however, comes from the fact that even the smaller fear of a supply reduction produces automatically an increase of crude oil prices, which will tend to reduce demand. The price reaction is instantaneous, much faster than the decision to draw down the stocks: on the other hand, the increase in price is the signal which alerts the countries to the possibility of using stocks to reduce the price just increased. However, the market may not be so elastic, and during the process from crude oil to the roadside gasoline station the price may not be changed so rapidly , and therefore the decision of drawing down crude from the stocks may in fact have a effect on the market. In order to make the stocks efficient, Luciani consider useful “playing down the difference between strategic and commercial stocks” and facilitate cooperation between major importers and exporters to create a cushion of unused capacity to compensate supply shortcomings”. The last chapter of the book “The functioning of the International Oil market and its Security Implications“ deals with the main problem, the structure and the functioning of the oil market. The causes of instability of the oil market can be expressed synthetically in few points.
Investments represent the cost of finding oil. If oil is found, it will be produced even if prices go below the break –event point. A well, or a field, would be shut down only if prices go below the direct cost of production. Energy security is a function of investment, which in turn depends upon the probability to find new additional resources. Therefore a functioning market would be representing the new discoveries, but in fact prices are unpredictable, and the security of supply depends on prices.
Furthermore, investment takes a long time to find oil, and to create the structures for producing it, and to transport it the market. The recent technology to look for oil under the seas has increased the cost and the time necessary to find and produce oil.
Finally, demand and supply are rigid in the short term. We have a global market, and supply interruptions are immediately translated into higher prices, and this is the real mechanism of “rationing” demand. The history of prices goes back to the very origin of the oil era. From 1920 to 1970 the prices “posted “by the large international companies “the seven sisters” were declining, also due to new discoveries in Middle East and North Africa. The “sisters” lost control gradually from 1969 to 1973. OPEC was created and the crude produced by its members was declared “non negotiable” after the first sale. So OPEC crudes could not define the market price. From 1973 up to 1985 producer’s countries defined prices with increases due also to political events, like the Yom Kippur war in 1973, the Iranian Revolution in 1978-79 and Iran–Iraq war. OPEC producers did not consider the creation of new sources of oil outside OPEC, in the North Sea, in Alaska, and Mexico. In 1985 Saudi Arabia abandoned the OPEC posted price and decided to sell its oil on a netback basis for two years.
Prices collapsed, and the market went to a “reference price” that is, price of a negotiable oil , in practice a US WTI (West Texas Intermediate) crude and the Brent from the North Sea. As a consequence the volatility of prices increased. A “Futures Market” was established, with a tendency to increase the price, based on a belief of the scarcity of oil. In the early 2000 violent increases happened without any justification, apart from the functioning of the Futures Market. From this point onwards, the price of oil depends upon the vagaries of the financial market, and has ceased to be a useful signal for corporate deciders having to set up long-term campaign for finding new oil reserves. The market is now driven by expectations on the future. However Brent and WTI are not large enough: WTI has transport problems, and Brent is not enough, so North Sea crude was added. These crudes are not really useful as price definition. After such a realistic analysis the book lists a series of policies that would mitigate the instability and therefore reduce the shocks to the economy:
“Encourage freer trading of major crude oil streams, notably those from the Gulf;
Increase reliance on long time pricing;
Enforce an internationally agreed price band;
Manage stocks
Offer demand security through take or pay contracts;
Encourage vertical integration.
“None of these approaches is sufficient to stabilize prices, but collectively they may very well succeed in reducing the extreme volatility ...which “will never be eliminated, because it is a structural feature of the oil industry, but it may be contained, and energy supply would be perceived as being much more secured.”