Countering Oil Rogues: Target the Price or Volume?

Robert Haddick, TSC Daily -- "Oil rogues," fattened by gluttonous revenues, are again tormenting the United States. The global price of crude oil now exceeds $90 per barrel, surpassing on an inflation-adjusted basis the price recorded in the early 1980s after the chaos caused by the Iranian revolution. Iran is using its bounteous oil revenue to finance a very pricey nuclear-industrial complex. In Russia, President Vladimir Putin intends to use his oil windfall on "grandiose plans" to rebuild Russia's military power. In Venezuela, President Hugo Chavez intends to use his oil revenues to organize and lead an anti-American bloc.

For American policymakers, the problems presented by the new "oil rogues" run from the merely irritating (Mr. Chavez) to the truly destabilizing (Iran as a nuclear weapons state). Future American policymakers will rightfully be reluctant to resort to military force to address such problems. The alternative is economic sanctions, which ultimately means drying up the oil rogue's revenue, his oil windfall.

Revenue equals price times volume. In the past, sharp declines in the price of crude oil have done the trick, crippling oil rogues and their ambitions. The crash in the price of oil in the 1980s was enough to break up a mighty empire, the Soviet Union.

But what if there is no prospect of engineering another collapse in the price of oil such as occurred in the mid-1980s? And would a crash in the price of oil even be desirable to the U.S. and other oil importers?

If price is no longer a usable tool, then volume is the only other way to go after an oil rogue's revenue. Are the U.S. and the West ready to target an oil rogue's crude oil production when a barrel of oil costs nearly a $100?

Why the Soviet Union collapsed

Between 1991 and 1994, right after the collapse of the Soviet Union, Mr. Yegor Gaidar was acting prime minister and minister of economy of Russia. In April 2007 the American Enterprise Institute published a presentation delivered by Mr. Gaidar based on his book about the collapse of the Soviet Union. Drawing on his personal experiences and his access to Soviet archives, Mr. Gaidar concluded that the collapse in the price of crude oil between 1981 and 1986 resulted in a financial crisis inside the Soviet Union.

Starting in the 1970s, the Soviet Union became a large hydrocarbon exporter. The Soviets used this revenue, greatly boosted at the time by large oil price increases in 1973 and 1979, to pay for necessary grain imports, aid to Soviet client states, and, most importantly, the massive Soviet military-industrial complex.

But the oil price crash in the mid-1980s resulted in a financial crisis for the Soviets. Through the end of the 1980s, the Soviet Union was able to paper over its financing shortfall with credit extended from the West, mainly Europe. But when the Soviets reached their credit limit, Mr. Gorbachev no longer had the leverage to maintain central Europe under Soviet military control. The game was over. According to Mr. Gaidar, the 1980s oil price collapse brought down the Soviet Union.

1980s not kind to Iran either

Compared to the 1970s, the 1980s were not kind to Iran either. During and after the 1979 Islamic revolution, Iran suffered a 75% decline in oil production. Production crept upward a bit during the 1980s, but as mentioned previously, the global crude oil price simultaneously crashed. It is very likely that the collapse in Iranian oil revenues during the 1980s contributed to its decision to terminate its long war with Iraq. Certainly it wasn't the only factor; by the mid- to late-1980s, Iraq was receiving battlefield intelligence support from the U.S., Iraq was bombarding downtown Tehran with ballistic missiles, and Iraq was receiving generous financial support from other Sunni countries to help finance its side of the war (squabbles over those loans later contributed to Iraq's decision to invade Kuwait in 1990). But the collapse of Iranian oil revenues in the 1980s surely punctured Iran's post-revolutionary ambitions.

The role of Saudi Arabia

In his presentation, Mr. Gaidar asserts that it was a change in Saudi Arabian oil production policy beginning in 1985 that caused the global oil price to crash, which in turn resulted in so many critical geopolitical consequences. In 1985 the Saudi government had much to fear. The Soviet army was on the offensive in Afghanistan, perhaps on its way to the Arabian Sea. Meanwhile, Iran seemed to be winning a war of attrition against Iraq, not far from Saudi Arabia's own eastern oil fields. Although an oil price crash would cause much pain inside Saudi Arabia, the Saudi government must have concluded that it would hurt its enemies even more. According to Mr. Gaidar, in 1985 Saudi Arabia had the spare oil production capacity to bring down the price of oil and it did so.

Today's potential Iranian nuclear threat would seem to be even more of a problem for Saudi security than the events in 1985. So why doesn't Saudi Arabia repeat what it did in 1985 and use its spare oil production capacity to bring down Iranian oil revenues, and thus dry up the financing for Iran's nuclear program?

It does not appear that Saudi Arabia has, at least in the short-term, sufficient unused production capacity to repeat the dramatic plunge in prices it engineered in 1985. The International Energy Agency's report on global crude oil supply for September 2007 indicates only 2.7 million barrels per day of effective OPEC spare capacity, of which 2.2 million barrels per day is controlled by Saudi Arabia. This compares to daily global crude oil output of 85.1 million barrels per day. Extra Saudi production could reduce prices at the margin. But after this marginal increase was taken up by ever-expanding global demand, the elimination of any effective spare capacity could result in much higher prices as oil traders came to realize that no production overhang remained.

Might high oil prices be a good thing for the West?

As a national security issue, nearly all analysts in the U.S. would welcome a reduction or elimination in America's dependence on crude oil imported from the Middle East. Such a circumstance would greatly simplify American defense planning while also sweeping away many other diplomatic and political burdens. For now, such a state of affairs remains only a dream.

Yet high oil prices are the only way to make progress on greater energy independence. The oil price crash of the mid-1980s killed the then-embryonic alternative fuels industry. It wasn't until the last few years that prices have returned to a level that would make very deep drilling in the Gulf of Mexico, oil sands in Alberta, oil shale in Colorado, coal-to-liquid technology, various bio-fuels, and many other ventures economically feasible. For those interested in escaping from geostrategic responsibilities in the Middle East, one should be glad that Saudi Arabia no longer has the power to bust the price of oil and by doing so wipe out new energy industries.

Sanctions on volume

In the meantime, what should the U.S. and the West do about Iran, Russia, and other potentially troublesome oil rogues? With oil demand continuing to climb and output struggling to keep up, targeting oil rogue production would seem at the very least an act of economic masochism.

What has surprised economists is how little this decade's dramatic jump in oil prices has affected either global economic output or core (excluding food and energy) inflation. Perhaps oil-induced economic trouble is just around the corner, but if so it remains well hidden. In any case, the absence of a broader economic effect from the current oil price surge could give policymakers more confidence to use sanctions against oil rogues.

Economic sanctions targeting an oil rogue's production used to be an unthinkable policy option. Deliberately reducing global oil output was thought to be self-defeating and indefensible.

But when other sanction options have proved ineffective and a military option may be unwise, attacking the volume factor in the revenue equation through sanctions aimed at the rogue's oil industry may be all that is left. And if "sanctions on volume" help encourage energy independence in the West, that would be a welcome bonus.