International Politics

	Vol. 224 No. 12
DR. A. F. ALHAJJI, CONTRIBUTING EDITOR, MIDDLE EAST

Vanishing excess capacity in the Middle East: Who is the culprit? Recent, record-high oil prices are not surprising. Since the late 1990s, this author has warned in this magazine and elsewhere that excess Middle Eastern oil production capacity has been declining. Most experts, analysts and journalists have overstated OPEC members' excess capacity, including Saudi Arabia.

How did we get here? Well, current political and economic events may have played a role in raising oil prices, but it was a small one. Even without these events, the average WTI price would have exceeded $40/bbl. One must look at the long-term factors that have affected oil prices for the answers.

Short-run vs. long-run. We should distinguish between factors that affect oil prices in the short run from those that affect rates in the long run. The short-term items are those political, economic, technical and natural factors that cause daily fluctuations in oil prices around their mean. They do not determine the long-term direction of oil prices. However, they do determine the upper and lower limits in the short run.

Looking at recent months, we find prices affected by several short-term political factors (Iraq, Venezuela, Nigeria, Russia and terrorism). In addition, there were economic factors (economic growth, OPEC output cuts, lower stocks, speculation, labor strikes, high natural gas prices, and filling of the SPR); natural factors (hurricanes in the Gulf of Mexico and sandstorms in Iraq); and technical factors (refinery outages, adjustments for environmental laws, and the UN Shipping and Port Security Code). These factors caused oil prices to fluctuate around a certain average, but they did not raise the average, itself. Therefore, these events do not fully explain a $56/bbl price.

Long-term factors include major political, economic and technical events that determine the direction of oil prices, and shift the mean of prices for an extended period of time. These factors, which include wars and sanctions, affect production capacity. Over the past 24 years, we find virtually no increase in Middle Eastern oil production capacity. In fact, some countries, such as Saudi Arabia and Kuwait, produce less oil today than they did in the 1970s.

Excess capacity has declined since the late 1990s and vanished in recent months. Data indicate that long-term oil prices are negatively correlated with excess capacity. Statistical analysis indicates that excess capacity is the most significant variable in the long-term oil price trend. The continued decline in excess capacity has steadily boosted the average oil price. The above-mentioned, short-term factors cause prices to fluctuate around a new mean.

Role of long-term factors. Several political and economic factors have prevented Middle Eastern oil producers from expanding output capacity in recent years. US foreign policy is one of the main political factors – foreign policymakers overrode the stated objectives of the energy policy of security and diversity of oil supplies. They imposed sanctions on several oil producers in the Middle East and Africa.

One of the most important results of the sanctions policy is its contradiction with long-term objectives of US national security. Sanctions depleted the oil resources of US allies, such as Canada and Mexico, while they preserved the oil reserves of countries with governments that antagonized the US, including Iraq, Iran and Libya. Sanctions prohibited international oil companies (IOCs) from investing in these countries. Data indicate that most new reserves have come historically from the Middle East. This trend changed when the US and the UN imposed sanctions on Middle Eastern oil producers.

Other major political events that affected capacity expansion are also related to US foreign policy. They include the Iraq-Iran war between 1980 and 1988; Iraq's invasion of Kuwait in 1990 and the Gulf War that followed in 1991; the war on terrorism; and the US occupation of Iraq since March 2003.

These events have drained the financial resources of Persian Gulf countries, increased their debt, and lowered investment in output capacity. They have also expanded instability, delayed political and economic reform, and prevented IOCs from investing in these countries. Production capacity expansion was one of the unintended victims of US foreign policy.

Political events and the revenue needs of financially strapped Gulf governments contributed to major economic events that prevented Middle Eastern oil producers from expanding capacity. These economic events included the two market collapses of 1986 and 1998 – 1999. Dollar devaluation in the last two years also has long-term implications for the oil market. It has contributed to the problem of vanishing excess capacity. Dollar devaluation decreases supply and increases demand.

US policy is to blame. Vanishing excess production capacity has raised oil prices to record highs. We have seen how US foreign policy blunders, in concert with a weakening dollar, have contributed to a variety of political and economic problems. If the US wants to ensure steady, stable and relatively cheap oil supplies, it should reduce the contradictions between its energy and foreign polices, eliminate unilateral sanctions, and encourage upstream investment globally. Who is the main culprit behind the vanishing excess capacity? It is US foreign policy. 

Dr. A. F. Alhajji is an associate professor of economics in the College of Business Administration at Ohio Northern University in Ada, Ohio, specializing in international and energy economics. Previously, he was an award-winning, visiting professor of economics at Colorado School of Mines. He is a regular contributor to this column.