The rising danger of high oil prices

By Henry A. Kissinger and Martin Feldstein Published on www.iht.com: September 15, 2008

The tripling in the price of oil from $30 a barrel in 2001 to more than $100 today represents the largest transfer of wealth in human history. The 13 OPEC members alone are expected to earn more than $1 trillion.

Inevitably, this must bring with it major political consequences. Not the least significant aspect of this political and economic earthquake is that it is exacted from the world's most powerful nations by some of the world's weakest. Yet the victims stand by impotently as if the price of oil were some natural event determined by a competitive economic market that is uninfluenced and uninfluencable by political forces.

But the price of oil is not determined in a traditional competitive market. Major producers can and do raise or lower the price of oil by reducing or increasing their rate of production. And since today's oil price also reflects expectations of future supply and demand, these monopolistic suppliers are able to manipulate and compound the volatility of the market by statements about their future intentions.

The monopoly suppliers will continue to have strong market power until the consuming nations sharply reduce their dependence on imported oil and develop a political strategy to counter political manipulation of the oil market or the use of the vast OPEC surpluses to blackmail the economies or individual industries of the consuming nations. Failing such efforts, the high and rising price of oil will produce profound political and economic consequences:
In the advanced industrial countries, the high price of energy will reduce the standard of living, sustain an unfavorable balance of payments and lead to increasing inflationary pressures.

The impact of rising oil prices on the standard of living is even greater in developing countries. Because fuel and food costs are a larger part of households' spending, and food production requires inputs of oil in petrochemical fertilizer and for transportation, higher oil prices lead to political instability.
Even with the drop in oil prices to around $100 a barrel, the Middle East oil exporters will receive over $800 billion in 2008.

Much of that revenue goes to a handful of countries with small populations. For example, the Abu Dhabi Emirate, with a population of 850,000 but only about 400,000 citizens, has proven oil reserves of 92 billion barrels and financial wealth derived from previous energy sales of more than $1 trillion. This concentration of oil income and wealth makes these wealthy but strategically weak states targets of radical neighbors.

It also gives them a disproportionate political influence on world affairs, in two ways.

First, a portion of these vast oil revenues are passed on to radical groups throughout the Islamic world, such as Hezbollah, through public and private so-called foundations. The madrassas that preach jihad are largely financed by oil money.

Second, revenues from high oil prices are recycled into the rapidly growing sovereign wealth funds of the OPEC countries, which invest these surpluses in the economies of the developed countries. Abu Dhabi has more than $1 trillion of investable funds.

The explosive rise in oil prices has tempted more assertive policies. Resources are being shifted from passive investments in U.S. and European government bonds to corporate equities and to the outright purchase of American and European businesses. As these new investments multiply, they may tempt the creditors into a growing influence over Western economies.

This state of affairs is intolerable in the long run. The foreign policy of industrialized nations must not become a hostage to the oil producers. The industrial nations must find ways to discourage the creditors from threatening to sell, or actually to sell, large quantities of U.S. bonds, driving up long-term American interest rates to levels precipitating an economic downturn, or to target particular firms or industries by selling shares acquired by sovereign funds.

So long as consuming countries sit by passively or deal with the challenge on a largely national basis while hoping to benefit from the efforts of others, the present dangers will continue, if not increase.
Ultimately, all consumer nations are in the same boat. A global recession will respect no national frontiers. No single nation is able to establish a permanently preferred position among the producers. No single nation can alter the supply situation entirely by its own efforts.

The oil-consuming nations are in a position, however, to shape both the economic and political global balance provided they coordinate and, to some extent, pool their efforts.

America should play a major role in this effort. Rather than wait passively for the next blow to fall, the major consuming nations - the Group of 7, together with India, China and Brazil - should establish a coordinating group to shift the long-term trends of supply and demand in their favor and to end the blackmail of the strong by the weak. Russia should be invited to participate in this effort.

Coordinated actions could bring down the price of oil by reducing and, in the long term, eliminating the speculative pressures behind recent price rises and by establishing a coherent supply policy.

Many of the measures recommended to achieve this - such as conservation, the development of domestic oil supplies and alternative sources of renewable energy - will take some years to become effective. However, even before the balance of market power has been transformed, the expectation of change will reduce the price of oil.
A cooperative policy should also include emergency sharing arrangements to counter selective boycotts or interruption of supplies.

The 2008 price rise was driven by changes in the expected long-term demand for oil while supplies remained largely static. By the same token, actions that will cause a slower growth of future demand and a more rapid rise in supply will translate relatively quickly into a lower current price.

A change in U.S. national energy policies is essential. But that will be much more effective as part of a coordinated international effort.

In the United States, oil is used primarily as gasoline for vehicles. Outside the U.S., oil is primarily used for heating and electricity generation. Coordinated policies should therefore focus on reducing U.S. gasoline use, while foreign countries could contribute by shifting from oil to hydro, clean coal technology or nuclear power to generate electricity.

Increasing the supply of oil deserves high priority. American policies to increase supply by expanding drilling and by developing oil shale need to be matched by policies to increase supply abroad. That requires more investment by state-owned oil providers, the primary sources of oil today. The oil consumers are in a position to use diplomatic measures to establish a new balance between producers and consumers.

Some of the policies to reduce the price of oil would also reduce U.S. dependence on imported oil without eliminating it. The United States will remain an oil importer until gasoline for vehicles is replaced by batteries or hydrogen. At the same time, for an interim period, efforts to increase the supply of oil and of other carbon fuels may make it more difficult to reduce total carbon emissions.

But because of the profound political consequences of a high oil price, reducing the price of oil must be the immediate, paramount objective.

Henry A. Kissinger heads the consulting firm Kissinger & Associates. Martin Feldstein is a professor of economics at Harvard University and was President Ronald Reagan's chief economic adviser.