8/14/2019 1-1 Jacoby ocr

1/8

OIL AND THE FUTURE: ECONOMIC CONSEQUENCESOF THE ENERGY REVOLUTION

NeilH. Jacoby*

I n any examination of the world economy and its prospects, the "energyrevolution" must occupy a prominent place. Energy is the prime moverof industrialized nations. It is essential to the economic progress of thedeveloping countries. Crude oil now supplies about half of the world'senergy; and it will continue to be a dominant source for the remainder ofthis century.The energy revolution exploded early in 1974, after the Organization ofPetroleum Exporting Countries (OPEC) cartelized 90 percent of the world'sexported crude oil, quadrupled the price, and its Arab members put atemporary embargo on shipments to the United States. These shockingactions produced radical structural changes in the world economy-changesdestined to continue far into the future.When oil moved from about $3 to about $12 a barrel in the United States,natural gas prices in the uncontrolled intrastate market rose from about$0.45 to about $1.75 per MCF; steam coal shot up from about $7 to about$28 per ton; and prices of nuclear fuel mounted proportionately. Drasticallyhigher energy prices caused a marked fall in consumption of energy in theOECD nations, whose governments augmented the decline by adoptingconservation measures. Higher prices triggered a quest for new sources ofenergy. They generated the goal of energy independence by the UnitedStates.Some of the deeper and longer-term consequences of the energyrevolution within the next decade are: (1) slower economic growth of theUnited States and OECD economies, and faster economic growth of theOPEC economies; (2) dampened growth of energy consumption, includingoil, in the industrialized nations; (3) the renaissance of coal and theaccelerate

8/14/2019 1-1 Jacoby ocr

2/8

46 THE JOURNAL OF ENERGY AND DEVELOPMENTsupply and price of OPEC oil, and the role of the multinational oilcompanies. I

Illtematiollal Changes ill Capital Formatioll alld Ecollomic Growth RatesOne obvious economic consequence of the energy revolution will be amassive shift of capital from the major oil-importing nations to the OPECcountries. When the price of crude oil quadrupled, payments due to theOPEC countries from the rest of the world expanded by some $65 billions ayear. Even after deducting expanded payments for the imports used tocarry out their ambitious development plans, the OPEC members will have$40 to $50 billions a year of surplus funds to invest abroad.Capital investment in the OPEC nations will rise greatly in coming years,and this will accelerate their economic growth. IfHorace Greeley were alivetoday, he would surely say, "Go Middle East, young man.'" By the sametoken, capital formation, productivity gains, and economic growth of theOECD countries will be dampened. They will save less because they mustpay more for high-priced energy, and this will depress their growth rates.In the case of the United States, which has made energy independence anational goal, capital formation in the domestic energy industries mustmount rapidly, if the goal ofenergy independence is to be achieved. Energymust absorb a larger part of available savings, leaving less to finance capitalformation in other sectors of the economy. Energy prices will rise furtherwhen price controls on domestically produced oil and gas are removed, asthey must be to provide adequate incentives to a widened search fordomestic reserves. More of the real resources of the economy will be

channeled into the provision of energy, l e a v i n ~ less for other purposes.The probable shortage of domestic capital makes it desirable that theUnited States import capital from other countries, including the OPECmembers. During the post-World War II era, the United States has been aprodigious exporterof capital. Direct investment abroad by American firmshas reached a cumulative total of more than $100 billions. Now, an inflowingtide of investment by foreigners in the United States appears likely. Themore rapid inflation of production costs in most foreign countries has madethe United States a relatively attractive location for manufacturingoperations. (Volkswagen finds it can make its celebrated "beetle" at lowercost in New Jersey than in Wolfsburg, Germany.) The climate for foreigninvestment by American multinational companies has deteriorated. Andchanges in United States tax laws, which formerly favored foreign

IThese topics are treated in the author's recent book. Multi"ational Oil: A Study i"II/dustrial DYI/amics (Ncw York: The Macmillan Company. 1974).

8/14/2019 1-1 Jacoby ocr

3/8

ENERGY REVOLUTION'S CONSEQUENCES 47investment, now tip the scale in favor of domestic investment. For all thesereasons. an inflowing tide of foreign investment in the United States islikely. If it takes place. it will help to close the gap in capital supply,strengthen the United States balance of international payments, andhopefully restore the battered United States dollar to its pristine role ofmonetary leadership in the world.

Dampelled Growth of Energy ConsumptiollA second long-term consequence of the energy revolution will be a

decline ill the rate of growth of energy consumption. World energyconsumption rose at a compound annual rate of about 6 percent after WorldWar II. In the future much higher prices and conservation measures willprobably reduce the expansion in global energy consumption to somethinglike 4 percent a year.

The post-World War II expansion in the use of crude oil was very muchfaster than for energy in general, because of the rapid displacementof coalby crude oil in Western Europe and the Communist countries.Consumption of crude oil in the world outside the United States and Canadavirtually exploded after World War II, maintaining a compound growth rateof I I percent between 1948 and 1972. Growth in the United States andCanada was at a modest 4.5 percent rate.

One may expect the growth of oil consumption abroad to decline to theneighborhood of 6 to 7 percent a year, and in the United States to fall toaround 3 percent a year. Such a decline assumes that the United StatesCongress will approve of legislation that leads to the goal of energyindependence by 1985. It also assumes that the price of oil will remain highby historical standards, but not necessarily as high as it is now.Slower growth of.oil consumption will. of course, moderate the growth indemand for oil production and refining facilities. The long hectic boom inrefinery, pipeline, tanker and marketing facilities ended when the age ofcheap energy passed into history.

Changes in Patterns of Energy ConsumptionA third economic consequence of the energy revolution is the renaissance

of coal and acceleration of nuclear energy. 22Because shale oil. coal gasification and liquefaction. geothermal. solar and other newenergy sources will not play an important role in United States energy supply before 1985.

they are not considered herein.

8/14/2019 1-1 Jacoby ocr

4/8

48 THE JOURNAL OF ENERGY AND DEVELOPMENTThe European Economic Community expects a reduction in the role of oilfrom 65 to 42 percent of its energy consumption by 1985, a rise from 9 to

15 percent in nuclear energy, and a rise from 17 to 24 percent in naturalgas - which has lagged in European usage. In the United States we mayexpect similar shifts in the pattern of energy use, except for natural gas.Dwindling reserves, resulting from incredibly inept regulation by theFederal Power Commission, will unfortunately inhibit natural gas fromexpanding its role in the American economy during the next decade.Instead, domestic oil resources in Alaska and the outer continental shelveswill be tapped, and coal and nuclear fuels will come into wider use.Expansion of coal production raises issues of worker health and safety inthe case of deep mining, and of environmental preservation in the case ofstrip mining. Much ofour coal contains an unacceptably high sulfur contentthat we do not yet know how to remove at reasonable cost. And, despiteheavy mechanization of mines, the productivity of miners has droppedalarmingly during recent years for reasons not fully understood.Expansion of nuclear power also confronts problems. One is to findsocially ac.ceptable sites with adequate cooling water. Another is fear ofnuclear accidents. This fear is based on ignorance, because the probabilityof being injured by a nuclear accident is much less than that of being killedby a falling meteor! Safe disposal of radioactive wastes is also a concern.Hopefully. the proposal to establish a limited number of Nuclear EnergyCcnters, in lieu of dispersed siting of nuclear reactors and fuel processingplants, will be adopted. Once the siting deadlock is broken, nuclear energy'ihould move toward an important position in the United States energy'ipectrum. The nuclear industry, including uranium mines, fuel refiners andreprocessors. and makers of reactors and power equipment. will havebooming markets.The Sh(ti from Foreign to Domestic Energy InvestmentThe national goal of energy independence implies a massive shift inUnited States energy investment from foreign to domestic locations. Wehave noted factors bringing about this shift. Already, multinational oil

companies are curbing foreign exploration and development budgets. Theyarc secking to expand their domestic activities.It is vitally important, however. that Congress act soon to strengthen

i l lcellti l 'es to domestic i ,,"estmelll in oil and gas exploration, and to thedcvclopment of othcr fuels. Unless Congress improves the climate forcncrgy invcstment. encrgy companies will diversify their operations intononcnergy industries. Is this not the moral to be drawn from Mobil'sinvcstmcnt in Marcor. from Standard of California's investment in Amax,

8/14/2019 1-1 Jacoby ocr

5/8

ENERGY REVOLUTION'S CONSEQUENCES 49and from Gulf's flirtation with Rockwell International?The first essential step is to remove price ceilings on domesticallyproduced oil and gas. The present ceilings not only deter investment inexploration and secondary recovery, they lead to excessive consumption ofthese nonrenewable fuels by keeping prices artificially low. Producersshould by required to invest profits resulting from such removal in energydevelopment. A second necessary action is to establish terms for leasing theouter continental shelves for exploration.

The Future Supply and Price of OPEC OilWe may assume that the energy revolution is here to stay. The UnitedStates will not return to $3.00 oil, S7.00 coal, and 20-cent natural gas.Nevertheless, a recession in the prices of energy from their present highlevels is very desirable, and some reductions have already been made.Despite deep cutbacks in oil production during the past year, the OPEC hasnot been able to prevent a flooded world oil market and some pricetrimming. Libya and Abu Dhabi have eliminated the premiums formerly

charged for low-sulfur oil. Algeria has concealed price cuts in bartertransactions. And, as the Shah of Iran pointed out in a recent televisioninterview, price inflation in the industrialized nations has already reducedthe real purchasing power ofOPEC's oil by more than 20 percent during theyear and a half that has elapsed since the January 1974 increase. He hascalled for a price increase as an "economic necessity."Because the OPEC is now conducting a publicity campaign to prepareAmericans for another price increase, it is timely to state some facts.Although price inflation started in the United States and oil prices laggedthe indexes for many years, OPEC cannot justify its Persian Gulf price ofS10.25 per barrel on the grounds of inflation. A barrel of .oPEC oil wouldcommand today the same purchasing power of American commodities atwholesale that it had in 1947, if it were priced at $4.88 per barrel - lessthan half the present price. Nor can OPEC argue that it costs $10.25 perbarrel to develop alternative sources of oil. The evidence is that they can bedeveloped for around $8 per barrel. Finally, we should reject OPEC'scontention that a rise in the United States import tax will cause the OPEC toraise its price and will justify that action. OPEC's past pricing actions weretaken in its own interests and without consultation with the United States,and so will be its future actions. The effects of an OPEC price hike and aUnited States import tax are quite different. When the OPEC raises theprice of oil, United States resources flow abroad; when the United/Statesincreases the import tax, those resources stay at home to finance Americanneeds.

8/14/2019 1-1 Jacoby ocr

6/8

SO THE JOURNAL OF ENERGY AND DEVELOPMENTWill the OPEC cartel hold together? If it does, what price of oil will serveits long-run self-interest?Skcptics about OPEC's durability point to the negative history ofinternational commodity cartels - in tin, copper, rubber, sugar, nitrates,and other commodities. Sooner or later, these cartels have been beset bydefections of their members, by rising external competition, or by

tcchnological displacement. They have broken up after rclatively shortlivcs. Skeptics argue that the same growing pluralism of interests thatcroded the ability of the multinational oil companies to bargain collectivelywith the OPEC governments during the 1960s will probably erode OPECcohesion during the 1970s. They believe that OPEC's power will diminishwith the marketing of oil from Alaska, the continental shelves, and theNorth Sea.Although these arguments have weight, it is conservative to assume thatthe OPEC will maintain sufficient cohesion to dominate world oil pricingover thc next five to ten years. Its members have savored the sweet taste offinancial success from their collaboration. Five to ten years must elapsebefore substantial competing sources of petroleum or other fuels outside ofOPEC's control can become available.Assuming that the OPEC continues to be an operational entity, what priceof oil is in its long-run self-interest? OPEC confronts the classic dilemma ofthe monopolist: whether to charge a high price and thereby to accelerate theintroduction of new fuel sources; or to charge a lower price and therebydelay the entry of new competition. Hollis Chenery of the World Bank hasargued plausibly that the current OPEC price is well above the costs ofmajor alternative energy sources, and will lead the OECD countries quicklyto dcvclop altcrnative sources and to reduce imports of OPEC oil. TheOPEC members would realize larger revenues in the long run. he~ ' o n c l u d e s , by reducing thcir price to around $8 per barrel and selling more'Iii than by holding the price at $12 per barrel and selling less oiL"Ncvcrtheless. political and psychological as well as economic factors willdetermine the OPEC's pricing and production decisions. What conditions\\'ould lead the OPEC to minimize the price of its oil - either by achieving areduction or reducing a future increase? I suggest that the necessaryconditions are three: the ending of rapid price inflation, a settlement of theMiddle East conflict. and strong action by the United States to move towardenergy independence.The OPEC will not lower the price of oil until the industrialized nationsdearly have brought inflation under control; indeed, it will raise the price iftwo-digit inflation continues. This is another compelling reason - if anyother wcre needed - to bring world-wide price inflation to an end.

'Hollis B. Chenery . . .Restructuring the World Economy." Foreigtl A.ouirs. January 1975.

8/14/2019 1-1 Jacoby ocr

7/8

ENERGY REVOLUTION'S CONSEQUENCES 51A durable settlement of the Arab-Israeli conflict is another prerequisite toa minimum price for OPEC oil. It was r es entm ent of United States supportof Israel that led the Arab members of OPEC to support high-priced oil andto pu t a temporary embargo on oil shipments to th e United States. They areunlikely to e xe rt t hei r considerable influence in the OPEC in favor of amoderate price policy until there is durable peace in the Middle East . Thebroad terms of a mutually satisfactory settlement. which must be

guaranteed by the Soviet Union as well as by the United States. are clearenough. Soviet cooperation probably can be gained by a United Statescommitment to provide the U.S.S.R. with the developmental assistance iturgently desires in order to strengthen itself against t he t hr ea t it perceivesfrom mainland China. What is now needed is pressure by the twosuperpowers upon their client states to move steadily toward an agreement.The third major precondition to a minimum OPEC price is visiblemovement by the United States toward the goal o f e ne rg y independence.For a y ea r a nd a half. Congress has been floundering in a sea of indecision.while United States dependence upon OPEC oil has risen day by day. Thepassage of a national energy policy has put the American political system toa crucial test. Will Congress have the wisdom and political fortitude toimpose higher domestic energy prices in the short run in order to free theUnited States from t he t hr ea t of energy pressure upon its foreign policiesand. probably. to benefit from lower energy prices in the long run? That hasbeen the basic issue raised by President F or d' s e ne rg y p ro gr am . Needlessto say. OPE C's m anager s are impressed by actions and not by rhetoric.

I f the United States. and t he o th er OECD nations. act promptly to satisfythese three conditions. they will increase the probability of averting OPECincreases and may even achieve price reductions.

All Illtematiollal Commodity Agreemellt 011 OilBy what process should strategic oil pricing and production decisions be

made in the future? Certainly. decisions concerning so vital a commodity asoil should not be left to th e ullilateral determination of a cartel of smalloil-exporting countries. The present system is unstable because it servesonly producer interests. It denies weight to consumer interests.A practical arrangement would be to make the supply and price of oil thesubject of an illtemational commodity agreemellt. Such an agreement mightbe negotiated by the OECD and the OPEC countries under the aegis of theInternational Energy Agency. It would fix for several years in advance aprice rallge for crude oil and a range of production levels that the OPECwould agree to maintain. Oil prices could be adjusted according to an indexof world wholesale prices. The oil-importing countries could pledge

8/14/2019 1-1 Jacoby ocr

8/8

52 THE JOURNAL OF ENERGY AND DEVELOPMENTtechnical aid in economic development and opportunities for investment ofsurplus OPEC oil revenues.Such an international commodity agreement would not supplant markets.It would specify only an agreed range of prices. Competition among oilcompanies would continue to allocate petroleum supplies and to determinetransaction prices. The concept of an international commodity agreement onoil was advanced as long ago as 19.63 by Sheikh Abdullah Tariki of SaudiArabia. It is an idea whose time has come.

The Future Role of Multinational Oil CompaniesFinally, let us consider the future of the multinational oil companies. Mystudy of the structure and behavior of the foreign oil industry after WorldWar II revealed an increasingly competitive industry. By e\:'ery economictest, market competition among multinational oil companies served theworld's consumers of petroleum products well. For this reason, theyshould - and I believe they will - play an important role in oil's future.Ultimately, the OPEC members probably will nationalize all

foreign-owned crude oil reserves and production assets. Even so, this wouldinvolve less than one-quarter of the gross fixed investment of the foreign oilindustry - $32 billions out of $134 biilions. More than three-quarters of theindustry's investment is in pipelines, tankers, refineries. chemical plantsand marketing facilities lying outside of the control of the OPEC members.For many years, the OPEC members will need the expertise of themultinational oil companies in refining, transporting and marketing crudeoil and petroleum products. They will need the technological talents of themultinational companies in exploring for and developing their oil resources.The companies will probably operate with "service contracts." Theseprovide that any oil that is found shall be divided in agreed proportionsbetween the government and the company. Such contracts have been madein Libya, carrying an 81-19 percent split of the oil. Other service contractshave been made in Bolivia, Venezuela, Peru, and Saudi Arabia. Under sucharrangements, the companies have no title to foreign petroleum resources.They are simply paid for their services with oil that they can take away,without paying taxes, royalties, or prices to the government of theproducing country. I f the provisions of such "service contracts" arehonored by the producing countries, they can provide a basis for profitablemultinational oil operations. To conclude: the multinational oil companiesdo have a future, not only in world oil operations but also as agents for theOPEC countries in their drive for technological development and industrialprogress.