Glut and Cut

By the early 1960s, there was far more oil available on the world market than even the multiplying demand for automobiles and passenger jets could sustain. Compounding this glut, the Soviet Union had restored its oil fields to near full production and was aggressively selling on the world market. The major companies were forced to discount the price at which they sold their Mid-East oil, but they still had to pay the producing nations the official price for crude oil they’d set under the 50/50 agreements. This meant the companies had to discount their oil at the pump and were only receiving 40 or even 30 percent of the profits.  They were, however, still making a handsome profit thanks to a clandestine scam worked out with the US state department that allowed the companies to deduct the extra money they paid the producing nations as losses on their US corporate tax bill.

Still, they were not prepared to absorb the depressed oil prices alone. In 1959, BP unilaterally cut the posted price of oil by 10 percent outraging the oil exporters. Two men in particular – Juan Pablo Perez Alfonso of Venezuela and Saudi oil minister Abdullah Tariki - began planning a new oil producers cartel that would stand up to the Seven Sisters. Then, in 1960, Exxon cut the posted price of oil once again, forcing all the other majors to follow suit. This cut into the national economies of the oil producing nations all of whom depended on their oil profits for the bulk of national revenue. Within a month, Alfonso and Tariki convened the major exporting countries – Saudi Arabia, Venezuela, Kuwait, Iran, and Iraq – and they agreed to establish a new organization to protect their interests. It would be called the Organization of Petroleum Exporting Countries, OPEC for short, and it would maintain the price that the producing nations wanted on the global market.

The oil companies realized they’d made a big mistake but it was still hard for them to believe that this new organization could have any real clout. For the next decade, the seven major companies paid lip service to OPEC while also undermining it by cutting deals with individual member nations.

Still, OPEC’s potential and the West’s growing dependence on Middle East oil worried the Western powers. Global demand for oil was finally catching up with supply and by 1970, the production glut was over. Unfortunately for the US, this rise in demand came just as US domestic production peaked reached 11.3 million barrels a day. Never again would it be so productive, and the nation that had come to take cheap oil for granted would from this point on be dependent on foreign oil to meet its needs. The US could no longer count on the security surplus of oil it had maintained for over 50 years. Though it didn’t know it yet, America had discovered its Achilles heel.

By the start of the 1970s, the oil producing powers could see it was their oil, not that of the United States, that mattered most to the world economy. There had been a 21 million barrel increase in demand for oil in the non-Soviet world since 1960 and two thirds of that demand was being met by the Middle East.

Just as the world’s oil consumers were dependent on Middle East oil, so were the major oil companies. And that gave OPEC great power whenever it chose to use it.

OPEC’s first thrust was spearheaded by Libya.  Under the aggressive tack of a new dictator, Colonel Muammar Qadaffi, threatened to nationalize all of its oil fields unless foreign companies improved upon the 50/50 split. Libyan oil was crucial to the economies of Western Europe – it was easily refined into gasoline and had cheaper transportation costs than Persian Gulf oil - and the companies took his threats very seriously. As soon as Qadaffi upped the old 50/50 deal to 55 percent in Libya’s favor, Iran demanded a similar deal. Knowing they’d have to offer the same deal to the other Gulf states, the companies agreed to a 55/45 split in the exporters favor in 1971 along with a 35 cents increase in the posted price of crude oil to be renewed annually.

It didn’t last. Within two months, Libya had strong-armed the companies into another price increase and the new agreement would be whittled away by the exporting nations over the next two years.

By 1973, the market price for crude oil had doubled from its 1970 level. But if the Mid-East producers were making more money, so were the oil companies. OPEC had intended to reduce the companies’ take and redress the balance towards the producing nations, not increase it. Now in October 1973, OPEC announced its intention to set new prices without consulting with Big Oil. The new prices would reflect the desires of the Middle East, not America, Japan or Europe. As Saudi oil minister Sheik Ahmed Yamani declared in the fall of 1973, “The moment has come. We are masters of our own commodity.”

Triple Shock

Just as OPEC ministers were convening to discuss new prices, Egypt and Syria, supported by the Soviet Union, launched a surprise attack on Israel, the start of the Yom Kippur War. Israel, in danger of being overwhelmed, called on the US for help. And when the US military first flew in supplies to its ally (albeit reluctantly) and then okayed a $2.2. billion military aid package for Israel, the Arab nations reacted with indignation.

First, OPEC raised the posted price of oil by 70 percent, bringing it up to $5.11 a barrel, the same price it was currently trading on a now very jittery spot market. Then Saudi Arabia announced its intention to cut off all oil exports to any nation that supported Israel.  The other Arab states all did the same.

In the past, the US might have shrugged off this oil blackmail, confident that its powerful Texas, Oklahoma and California oil fields would simply ramp up production to meet the fall in supply. But those days were over. Saudi Arabia was now the only nation with enough excess producing capacity to act as the “swing” producer – upping production to match a shortfall elsewhere in the world. And Saudi Arabia was the one causing the shortfall.

The embargo, combined with OPEC’s price hike, caused panic around the world. By November, oil prices had jumped from $5 to $16 a barrel. At the time, the Nixon administration was so distraught over the embargo that it drew up plans to send troops to the Middle East to seize oil fields in Saudi Arabia, Kuwait and Oman. According to British intelligence documents, the US contemplated holding onto the oil fields for up to 10 years in order to maintain its energy security.

In the end, the Arab states lifted the embargo on Western Europe after those countries pledged their support for the Arab position but waited until the spring of 1974 to resume shipments to the US. OPEC had shown that the Arab states now controlled oil prices and now the main Middle East members began nationalizing their oil industries. The Seven Sisters found themselves frozen out of Saudi Arabia, Iraq and, with the 1978 overthrow of the Shah, Iran as well.

The Ford administration took immediate action. In 1975, it established the Strategic Petroleum Reserve, an emergency stockpile of up to 1 billion barrels of oil that would be stored in empty salt caverns underneath the Texas and Louisiana coast and could be accessed in times of an energy emergency. Today the reserve holds nearly 700 million barrels of oil – just over one month’s supply of America’s total daily oil consumption. The same year, Congress passed the Energy Policy and Conservation Act establishing the first ever fuel economy standards for US cars and trucks.

In 1978, western consumers suffered a second oil shock when the Shah of Iran was toppled by the Islamic revolution of Ayatollah Khomeini. In the process, the US embassy in Tehran was stormed, 50 hostages taken and all foreign oil companies were thrown out of Iran. This time, Saudi Arabia upped its own production to meet the shortfall but panic once again gripped the world oil markets. Crude oil prices shot up to over $30 a barrel.

Just when it looked like things couldn’t get worse, the Iraq regime of Saddam Hussein invaded Iran in 1980, sparking a war involving two of the world’s most important oil producers and triggering the third oil shock. Crude prices went over $30 a barrel once again.

The Rise of Big Oil

The lessons of the First World War were all too obvious – the Great Powers needed oil to survive. And while new finds were being made in the US and Mexico, one region of the world was attracting more interest than any other – the Middle East. Pre-war the US had been content to develop its domestic reserves and leave foreign prospecting to the Europeans. Now, it was adamant that Britain and France should not carve up the Middle East alone.

Britain and France had agreed to divide up responsibility for the Arab lands of the Ottoman Empire, which had been allied with Germany during the war, but had now disintegrated.  Central to their ambitions was Mesopotamia, which Britain quickly renamed Iraq, and specifically the region around Baghdad and Mosul that were believed to hold huge oil reserves. Iraq’s potential had first been identified by a savvy Armenian oil prospector, Calouste Gulbenkian. In 1914 he put together the Turkish Petroleum Company, a syndicate involving Anglo Iranian, Shell, Deutsche Bank and himself, holding five percent of the concern.

After the war, Britain and France agreed to let the US companies, Standard of New Jersey (Exxon), Socony (Mobil) and five other US companies take Deutsche Bank’s stake in what was now called the Iraq Petroleum Company.  With Britain overseeing Iraq, the local puppet rulers rubberstamped a very favorable concession for the foreign companies - exclusive drilling rights in Iraq until the year 2000.

Gulbenkian, wary of being squeezed out by the major oil companies, was insistent on one condition in the contract: no member of the Iraq Petroleum Company would undertake operations anywhere else within the Middle East lands of the former Ottoman Empire without the joint cooperation of the other members. There was just one problem – no one was really sure just how far the Ottoman lands extended. So when the new members of the company came together to finalize the deal, Gulbenkian took a red pencil and drew a rough line on a map around what he understood to be the Ottoman lands. Inside the line lay all of Iraq and Saudi Arabia. Gulbenkian’s guess had fortuitously pinpointed the greatest oil fields in the world and it put them in the hands of Western oil companies. In establishing a de facto non-compete agreement between Shell, BP, Exxon and Mobil, Gulbenkian’s Red Line agreement, as it became known, created a cartel out of the world’s pre-eminent oil companies. As for Gulbenkian, he got to keep his original stake in the company. He would forever be known as Mr. Five Percent.

The Second Great Oil War

Twenty years after the end of World War I, Europe once again found itself facing war. This time, all the powers knew that oil would make the difference between victory and defeat. The US once again used its plentiful oil fields to supply its own war needs and those of Great Britain. But Germany, just as in the First World War, was forced to undertake a risky strategy to capture foreign oil supplies.

Germany believed that its key to victory was a series of short overwhelming mechanized attacks – the blitzkrieg – and at first it was very successful. One reason for the blitzkrieg was that Hitler knew he didn’t have enough oil to compete in long drawn-out battles. To counter this weakness, Germany had two goals in mind – its Panzer tank divisions would punch through Russia and snatch the Baku oil fields before continuing on to secure the grand prize of Iraq and Iran. But Operation Blau, as this grand oil grab was called, faltered before it could ever reach Baku. The German army had to travel thousands of miles to reach the Caucuses and the speedy Nazi tanks outran their own fuel supply lines. Short of gas, and caught in the heavily defended Caucasus mountains, the armored divisions had to be refueled by camel trains as their own trucks had run out of gas. In its desperation to capture Baku, Germany left its sixth army stranded and short of fuel outside Stalingrad. Surrounded by Soviet forces after a six-month siege, the Germans needed only to fight for 30 miles to escape. But their tanks only had 20 miles of fuel in them. The decision to strand the sixth army by refusing to divert the Baku-bound forces was taken by Hitler himself. “Unless we get the Baku oil, the war is lost,” he told his commander of the forces in the Caucasus.

Fuel shortages would continue to bedevil both sides as the war went on. General Erwin Rommel, father of the Afrika Korps, the most mobile and effective tank division Germany possessed was undone in North Africa when the allies destroyed his refueling lines of supply while the hard-charging American General George Patton and his rampant Third Army was prevented from what could have been an early and decisive invasion of Germany in 1944 by a lack of fuel. “My men can eat their belts” he said, “but my tanks have gotta have gas.”

The United States may never have entered the war were it not for Japan’s desperation to capture the oil fields of Indochina. As early as the mid-1930s, Japanese economic planners had come to the conclusion that Japan’s plans for the aggressive colonization of Southeast Asia would fail unless it controlled its own oil destiny. That meant invading the oil fields of the Dutch East Indies but this strategy risked an attack by the US, who already wary of Japan’s imperial ambitions, had recently moved the American fleet from California to Pearl Harbor in Hawaii. Faced with Japan’s invasion of Southern Indochina and its new alliance with Germany and Italy the US had frozen all Japanese financial assets cutting off its ability to purchase US oil.

It was at this point that Japan took its own fateful plunge – the pre-emptive attack on Pearl Harbor in an attempt to destroy US influence in the Pacific. To a degree they were successful. The December 7, 1941 assault decimated many ships in the fleet. But the Japanese also made a big mistake. They failed to hit the four and a half million barrels of oil stored at Pearl Harbor. If they had destroyed America’s Pacific oil reserves the whole fleet would have been immobilized.

Over the next four year, Japan would be methodically expelled by Allied forces from the Pacific islands and Southeast Asia. And with each defeat, it saw its access to oil dwindle. By the time the first atomic bomb was dropped on Hiroshima in August 1945, Japan was already a spent force. The US navy was sinking every Japanese oil tanker before it could return home from the Dutch East Indies and the Japanese Navy didn’t have enough fuel to leave its home base. The shock of the atomic attacks ended the war, but it was a lack of oil that defeated Japan.

The Start of the Addiction

Perhaps it was because of Samuel’s understanding of maritime trade or maybe it was because Shell now had large excess reserves of Borneo fuel oil following its recent merger with Royal Dutch, an East Indies-based rival, but Samuel led the campaign to make the British Royal Navy abandon coal-fueled ships in favor of oil.

Since the late 1890s, Britain and Germany had been caught up in an increasingly high-stakes naval arms race. Central to both sides’ military ambitions was control of the world’s oceans. The British admiralty was dead set against switching to oil – not least because, while Britain enjoyed great reserves of coal, it had no oil of its own. Nevertheless, after a decade of lobbying, Samuel finally got the ear of a new First Lord of the Admiralty, the young Winston Churchill.

Churchill quickly grasped the advantages of an oil-fueled battle fleet. Between two such well-matched imperial powers as Britain and Germany, naval superiority would tip the balance and Churchill saw how Britain could achieve that. Oil fuel allowed faster cruising speeds and faster acceleration than coal furnaces. It took up less room allowing for greater armaments and manpower. It was also cheaper to operate. In April 1912, Churchill took the “fateful plunge” as he described it and commissioned a series of new battleships all dependent on oil.

In one swoop, Churchill had made the security of Great Britain dependent on foreign oil. Yet the lure of oil - its mobility and the advantage it afforded the British fleet at war - was enough to persuade him. With oil, Churchill wrote, “we should be able to raise the whole power and efficiency of the Navy to a definitely higher level; better ships, better crews, higher economies, more intense forms of war power.” As he put it, “mastery itself was the prize of the venture.”

Churchill found the oil he needed to run his navy in Persia where a new company, Anglo-Iranian Oil had struck a rich seam of oil. Yet despite the company’s potential, it was desperately short of capital. In 1913, Churchill announced that, in the interests of national security, the government would buy 51 percent of the company and Anglo Iranian would sign a long-term contract to supply fuel oil to the British Navy. The agreement stipulated that the company must always remain a British concern and, to protect its investment, the government increased its military presence in Persia. Anglo Iranian would soon change its name to British Petroleum, or BP. And Great Britain had become the first Western power to tie its economic and national security to Middle East oil. Others would soon follow.
The First Oil War

Nowadays we take technology in warfare for granted. Ever since the first Gulf War in 1991, the media has fallen over itself to catalogue new military inventions – be it stealth fighters, smart bombs or real-time video footages of the battleground that can be monitored from thousands of miles away. But, as Germany and the allied powers of Great Britain and France squared off in 1914, neither side understood the differences that the internal combustion engine would bring to modern conflict.

The First World War dragged on in an increasingly bloody stalemate for four years as each side introduced more deadly mobile weapons and the carnage grew exponentially. In 1916, the tank was introduced to combat and by 1918, the allied forces were using over 150,000 cars, trucks and motorbikes to transport troops and supplies. During the course of the war, the combustion engine also took to the skies. In 1915, the Royal Air Force had only 250 planes to call upon; by war’s end, British industry had produced 55,000, France 68,000 and Germany 48,000.

These inventions increased mobility on the battlefield, spreading the conflict over a far greater area than military planners had ever imagined. And it changed the odds of warfare. Even the finest infantry and cavalry was no match against the new fighting machines. Over 13 million people died and millions more were wounded during the four-year conflict.

It took huge quantities of oil to supply both sides’ war effort. Oil production at Anglo-Persian’s operations increased ten-fold from 1912 to 1918 and in 1917, Great Britain, with an eye to Mesopotamia’s oil potential, captured Baghdad from the Turks. Yet Britain and France still found themselves facing huge oil shortages at the height of the war. There was only one place they could turn for help – the United States. By 1917, the US was producing 335 million barrels of oil, 67 percent of total world output, and nearly one quarter of that was sent to Europe. In total, the US supplied 80 percent of the allies’ wartime petroleum needs. One quarter of that came from Standard Oil of New Jersey.

Germany’s oil problems were even more severe. Cut off from overseas oil by the allied naval blockade, it had only one other option – the oil fields of Romania. Yet despite a full-press effort to capture the oil fields, British saboteurs got there first putting Romanian oil out of action for five months. On November 11, 1918, Germany, faced with an acute oil shortage for the coming winter, surrendered. As Lord Curzon, a member of Britain’s War Cabinet, triumphantly announced, “The Allied cause had floated to victory on a wave of oil.”

Big news from South America as new populist president Evo Morales brings all natural gas production under state ownership.

Call it the Chavez effect - national producers all over the world are realizing that their oil and gas supplies are a potent political weapon in these unsettled energy times….and they are adding to the uncertainty with their actions.

Bolivia’s actions follows Russia’s announcement last week that it may not give Western Europe a guaranteed market for its natural gas.

Couple these recent events with Venezuela flexing its petro-muscles, Iran adding it’s own cornered beast threats, and the continued role that China is playing in competing for world oil and you have petropolitics playing out on an unprecedented global scale.

Fascinating and horrifying to watch.

It seems like a suitable day to jump back into Petropulse blogging - what with oil prices hitting $74 a barrel this morning on the UK’s trading exchanges.

Iran, Nigeria, tight US gasoline inventories and continued high demand are all contributing the on-going price crunch.

The Observer speculates today that Iran crisis ‘could drive oil over $90′. Actually, the paper is quoting the Economist Intelligence Unit when it comes up with this figure but that hardly diminishes the sense of concern being felt around the world as the UN security council decides how to proceed against Iran’s nuclear build-up.

Bit of perspective here. The last time oil prices hit $90 (adjusting for inflation that is) was in 1980. The reason then? Iran again as prices spiked to all-time highs following first the fall of the Shah and then the start of the Iraq-Iran war.

With global supplies remaining tight for the foreseeable future (the Observer article quotes another analyst who estimates it will take two years for producers to recover spare production/refining capacity), any other oil shock - are we all keeping an eye on Nigeria? - will be bad in the short and long term.

No, it’s not a new Persian hit TV show, this NYT story is about the very real fear over what UN sanctions might do to Iran’s oil industry.

With excess capacity more an illusion than an option at this point (no matter what Saudi Arabia says to placate Western concern), any disruption in global supply stemming from Iran cutting its oil output will have an immediate effect on prices.

Iran produces twice as much oil as Iraq and is the world’s fourth largest producer. Any wonder why they don’t feel like being pushed around?

Iran’s warning that it could withhold supplies of crude and hence send global prices soaring may already have done the required damage.

Energy prices spikedin early January when Russia briefly turned the taps off on Ukraine and Europe experienced a knock-on effect. The mere threat by the world’s fourth largest producer that if might wreak havoc on global prices is bound to send the futures exchanges into furious action today. Look for crude prices to acquire a very expensive fear factor premium.