The Crude Enforcer

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For the Western military attaches driving from Kuwait into Iraq, the spectacle must have been an eye-popper. As the travelers headed toward Baghdad, having been blithely waved on by Iraqi border guards, they counted dozens, then hundreds, then as many as 3,000 Iraqi military vehicles rumbling toward the frontier, carrying what the foreigners estimated to be 30,000 fighting men. While representing only a fraction of Iraq's army of 1 million, the two divisions headed for the border outnumbered tiny Kuwait's entire armed forces by a ratio of 3 to 2.

Iraqi President Saddam Hussein was putting muscle into an economic threat he had made a week earlier, when he promised to do "something effective" to prevent his putative allies, Kuwait and the United Arab Emirates, from continuing to depress oil prices by overproducing. "Iraqis will not forget the saying that cutting necks is better than cutting means of living," he declared. "O God almighty, be witness that we have warned them!"

In the end, his crude parade of force proved effective. Believing the belligerent Saddam might actually follow through, Kuwait and the U.A.E. fell limply into line last week at the midyear meeting of the Organization of Petroleum Exporting Countries in Geneva. Though the two gulf states were formerly vocal advocates of relatively low oil prices, both were intimidated by Saddam's guns into acquiescing to the first hike in OPEC's target price in four years, from $18 per bbl. to $21 per bbl.

For OPEC customers, who in recent years have been lulled into complacency by low prices, the outcome in Geneva should come as a wake-up call. "Happy days are here again for OPEC," said a Royal Dutch/Shell Group official in Geneva. While a sharp rise in prices will be delayed by the current glut of crude on the market, the pinch could come this fall. For the U.S., the price nudge will be another burden on an economy that is already dancing on recession's edge. More serious still are the deeper implications of the suddenly changed dynamic within OPEC. No longer is the moderate, predictable Saudi Arabia the undisputed potentate of the oil cartel. Now the ruthless, power-mad Saddam, one of the scariest figures on the world stage today, has seized the title.

Iraq's bully tactics provoked anger in Washington, where indignation is already running high over the Middle Eastern country's use of chemical weapons and its attempts to develop nuclear arms. Both houses of Congress voted to impose economic sanctions, with the tougher Senate bill proposing to cut off $1.2 billion in loan guarantees and ban the sale of weapons and sensitive technology to the country.

Within OPEC, Saddam had an excuse for adopting the tough-cop role. In an organization filled with quota cheaters, Kuwait and the U.A.E. have been among the most incorrigible in exceeding their agreed-upon production limits, 1.5 million bbl. and 1.1 million bbl. a day, respectively. This year each country has been pumping as much as 2 million bbl., driving the average price of an OPEC barrel from $20.50 in early January to a mere $13.60 in June.

In the past, Saudi Arabia had been the one to stabilize OPEC's overall production level. As the so-called swing producer, the rich Saudis would cut back their output to offset the excess pumping of other members. In 1986 the Saudis got tired of playing the sucker and flooded the market with their unrivaled stores of crude, pushing prices down in an attempt to punish the cheaters and force them to play straight. That method proved of little value in taming Kuwait and the U.A.E., which have rich petroleum reserves and tend to favor lower prices as a way of discouraging Western countries from pursuing alternative energy sources. But Iraq desperately needs higher prices, and Saddam reckoned he had something more powerful than the Saudis' economic clout with which to frighten the renegades: the mightiest army in the Arab world.

When Iraq was fighting Iran from 1980 to 1988, Baghdad wasn't bothered by the double-dealing of Kuwait and the U.A.E. Much of Iraq's oil industry was shut down by the war, so crude prices were irrelevant to the country. Baghdad even shared in the two cheaters' profits to the extent that it received $10 billion to $20 billion in loans from them for its war effort. But now that the cease-fire with Iran is two years old, Iraq is rebuilding its oil industry. With an output of 3.14 million bbl. a day, Iraq is tied with Iran for the rank of OPEC's second largest producer. Both trail Saudi Arabia's output of 5.42 million bbl.

With such a huge piece of the action, Iraq estimates that every $1 drop in the price of a barrel of oil costs it $1 billion a year in lost revenue. The country can ill afford those lumps as it struggles to repair the ravages of the war and repay $40 billion in foreign debt to the West. In theory, Iraq could boost its income by pumping more oil, just as its wayward neighbors % have. Experts believe the country's reserves could be tapped at a rate of 5 million bbl. a day. But Iraq lacks the modern equipment to do so and cannot manage the cost of the investment.

Making his neighbors quake serves Saddam's other prevailing interest aside from money, which is to project himself as the uncontested superchief of the Arab world. Says Barry Rubin, senior fellow at the Washington Institute for Near East Policy: "Iraq wants to show that it dominates the Middle East, that everyone has to line up behind it or else."

The repercussions for Kuwait go beyond the humiliation at Geneva. Saddam began to pull his troops back from the border last week, but he is not nearly through with his tiny neighbor. Among his demands are $2.4 billion in compensation for oil he claims Kuwait has pumped from Iraqi territory, along the countries' disputed 100-mile frontier. Saddam also wants Kuwait to forgive Iraq's war loans and lease or cede to Baghdad the strategic island of Bubiyan, a large sandbar in the Persian Gulf that blocks much of Iraq's paltry 18 miles of shoreline. No one believes Iraq is actually eager to invade Kuwait to achieve these ends if they can be accomplished through coercion instead. But just the threat of an incursion may be enough to make Kuwait, with its puny military, accede to Iraq's terms.

The other members of OPEC were spooked by the bellicose way Iraq went about bridling Kuwait and the U.A.E. OPEC Secretary-General Subroto called Saddam's means "alarming." By threatening the overproducers, Saddam brought tensions in the Persian Gulf to their highest level since the Iran-Iraq war. So startled was the U.A.E. that it took the unprecedented step of asking the U.S. to conduct joint military maneuvers, a request Washington granted, sending two aerial refueling planes and six combat ships for the exercise. When Baghdad denounced this "imperialist plot," the Emirates, more shaken than ever, denied anything out of the ordinary had taken place.

Despite the stretched nerves in Geneva, OPEC's other producers were delighted with the outcome of Saddam's antics, since discipline on quotas will mean more money for all of them. The 13 members agreed to cap their total output at 22.49 million bbl. a day through the end of this year, an increase over the previous ceiling of 22.08 million but less than the 23.5 million that was actually flowing when Kuwait and the U.A.E. were breaking the rules.

Even before the OPEC meeting began, uncertainties generated by Iraq's brinkmanship had driven the average price of OPEC oil to $16.25 per bbl., from less than $14 per bbl. at the end of June. But because buyers have stocked up on cheap fuel in recent months, it will take some time before the new production cap shoves prices as far as the new $21 benchmark. That level may be difficult to sustain beyond the winter, when fuel demand rises naturally, as OPEC members with spare capacity are likely to press for new, higher quotas.

For now, Japan and the countries of Western Europe, though big oil importers, are not especially worried. They will be cushioned against the increases because OPEC oil is paid for in U.S. dollars, which in recent months have depreciated against other major currencies. Japan can well absorb a price increase because of its enormous trade surplus, which it would like to whittle down anyway. Moreover, after the price shocks of 1973 and '79, Japan put the brakes on oil consumption, mainly through a serious conservation regimen, and did not release those brakes after the crises.

The U.S. has greater cause for concern. The country relies more on foreign fuel today than it ever has, importing 49.9% of its total consumption. If prices rise $3 per bbl., as OPEC wants, the total U.S. import bill will be fattened by about $9 billion, to $63 billion a year. And, unlike the Japanese, Americans tended to relax their efforts to conserve fuel once it became cheap again. At this point, economists do not expect a $3 oil hike to stunt economic growth seriously in the U.S., but even a slight shock is painful with the economy as weak as it is. Last week the government said economic growth during the second quarter slogged along at an anemic annual rate of 1.2%, prompting fears of an imminent recession.

While a repeat of the Arab oil embargo of 1973 seems a distant prospect, Saddam's sudden pre-eminence within OPEC does make it conceivable. The Iraqi despot has made clear that he believes oil should be used as a weapon in the Arab fight against Israel and its supporters, notably the U.S. If Saddam were gradually able to absorb Kuwait -- and Baghdad has long claimed, without any historical basis, that the country should rightfully be part of Iraq -- he would command an additional 10.3% of the world's proven oil reserves, making his country the unrivaled No. 2 oil power.

Given that distasteful scenario, Washington's modest intervention into the affair last week was probably prudent. Baghdad ought to know it cannot terrorize its small neighbors with impunity. "All the Arabs in the gulf want us to help them against Iraq," says Rubin, "even if they can't say so." On the other hand, it is impossible to manage a belligerent like Saddam. America's best insurance against the tyranny of another oil shock remains what it has always been: to reduce dependency by conserving energy, even if prices do not go sky high.

CHART: NOT AVAILABLE

CREDIT: Chart by Joe Lertola

Source: Petroleum Intelligence WeeklyCAPTION: PUMPING UP