SYMPOSIUM: POLICY IMPLICATIONS OF THE PRICE OF OIL.

Copaken, Robert R. ; Kern, Nathaniel R. ; Steenhagen, Jim 等

The following is an edited transcript of the eighteenth in a series of Capitol Hill conferences convened by the Middle East Policy Council. The meeting was held on March 30, 1999, in the Dirksen Senate Office Building.

CHAS. W. FREEMAN JR., President, Middle East Policy Council

On a visit about a month ago to the Gulf region, I was struck by the degree of open-mindedness and receptivity to new ideas for economic and even political reform that seemed to be sweeping the region. There is a rule of thumb there that at $16 per barrel of oil, no one sees a need to make any decisions on reform. At $13, the need is perceived, but there are reasons to wait, in the hope that the price will go up. And when the price is below $10, people see the need to make decisions immediately. The effect of the wobble up in price to about $16 will be one of the topics today.

A month ago the oil-producing monarchies of the Gulf seemed much like businesses in a recession, forced to make decisions that had been long delayed, and very likely to emerge from the fiscal crisis as businesses do from recessions, more competitive and more prosperous. Now I wonder whether they will continue to feel this urgency.

Low oil prices, despite the technological improvements in the business, have had the effect of driving out of business marginal producers or producers who could not make a profit out of business. Much exploration has halted. Oversupply in the face of reduced demand leads in time to the contraction of supply and a return to higher prices. Whether that is what is happening now or whether we are simply seeing the temporary economic effects of political decisions is not clear to me.

In any event, it is clear that oil producers in the Gulf have come to share with multinational corporations like Boeing and others a strong interest in seeing an early recovery from the Asian financial crisis, particularly in seeing the Japanese reflate their economy at high speed. Without the recovery of Japan, Asia will not recover; without the recovery of Asia, the world will not recover. Oil prices will continue to be depressed, and markets for durable goods, especially large capital goods like aircraft, will also continue to be depressed.

The crisis over low oil prices should have reminded the United States of our peculiar vulnerability to fluctuating prices. In most countries the vast majority, perhaps 85 percent, of what consumers pay at the pump for gasoline consists of taxes. Those taxes can be adjusted upward and downward. And since the market price is only 15 percent or so of what consumers are paying, changes in that price have little effect on domestic markets. When prices are low, by contrast, the United States, which doesn't have this insulating effect of high taxes, benefits greatly. Inflation is then low. We have benefited in the recent boom in the United States from low oil prices. But when prices rise, their effect on the possibility of inflation in the United States will be quite great.

Finally, when oil prices are very low, there is virtually no incentive to pursue alternative sources of energy, and the issue of global warming, which many are concerned about, gets even less attention and action than usual.

We are here today to talk mainly about the effects of the oil-price roller coaster on our friends, the oil producers in the Gulf, on their political stability, which some have seen as threatened by their inability to continue to fund the extraordinarily generous welfare states they have created, and on their capacity to continue to cooperate with us in addressing common security challenges, whether from Iraq, from Iran, or from the continuing impasse between Arabs and Israelis.

ROBERT R. COPAKEN, Senior Middle East Energy Analyst, U.S. Department of Energy

I'd like to begin with a disclaimer: my remarks are strictly my own views and don't necessarily reflect either DOE or U.S. government policy.

Having said that, I'd like to begin by talking a little bit about the recent March 23 OPEC meeting. The ministers agreed to cut 1.7 million barrels a day from the market, with another 400,000 to be cut from non-OPEC production. This amounts, if it comes to pass, to a total cut of 8 percent of OPEC production.

Why might it be different this time? And what was the Saudi role in producing this accord? First of all, an agreement like this is only engineered by having consultations in advance of the meeting. Then when you come to the meeting, you basically ratify the decision that's already been reached. Unless you've seen the back and forth traveling, the consultations beforehand -- sometimes private, sometimes public -- you're not likely to see much of a result come out of the meeting.

In this case, I think the Saudis were trying to do three things. They'd like to keep international oil markets as stable as possible. Second, they oppose high prices that discourage demand growth or lead to rapid rise in non-OPEC production. Finally, they want to maintain (or regain and maintain) a dominant market share for Saudi oil, especially in the key U.S. market.

Their position in 1998 was number three, after Venezuela and Canada. The Saudis like to be at least in that top three or four in terms of their share of our market. The agreement was engineered in part because of the lowest oil prices that OPEC has seen in more than 25 years, and fear is always something that drives markets. There was also a factor of cooperation between OPEC and non-OPEC producers. Mexico, Norway, Oman and Russia also contributed to reaching this goal. The accord is due to take effect on the first of April, the day after tomorrow, so we'll have to wait and see just how much compliance there is with it. Inevitably, in this kind of situation, as the price rises, the incentives to cheat on quotas rise with it.

My remarks this morning concern two alternative Gulf futures, one optimistic, the other less optimistic. The Gulf Cooperation Council states are stable regimes in an unstable region, next to two countries with which we have troubled relations, to say the least: Iraq and Iran. It is difficult to generalize, so I'm going to concentrate my brief remarks on Saudi Arabia and Kuwait.

The economies of these states are at a crossroads. To their credit, some Gulf leaders have already recognized that they can't continue to provide the same level of services that they did when oil prices were much higher. Rapid population growth (3.4 percent a year in Saudi Arabia) combined with a population 60 percent of which are under age 20, plus the need for job creation, at the current level of oil prices, place increased pressures on Gulf states' stability.

The technology and information revolution, satellite TV, access to the Internet, and telecommunications have all started to pose new challenges to traditional rulers as they race against time to stay ahead of their curious citizens. Social unrest and discontent may grow, bringing with them increased social and political demands. There is a sort of unwritten social contract between rulers and ruled that implies that the absence of political participation is to be compensated for by generous social benefits and subsidies. Current low oil prices and a narrow tax base threaten that accountability and the welfare state it supports. Since the Gulf still represents the strategic prize for access to which global competitors contend, the United States is likely to remain the 911 emergency call for the Gulf states whenever threats to their security appear.

What is necessary for these Gulf states to enjoy a bright and optimistic future? Economic and political reform must go hand-in-hand. Otherwise, the region risks being isolated and left behind as global trends of trade liberalization and investment go elsewhere. Only 7 percent of all trade in the Middle East is between states within the region. This compares with 20 percent in Latin America, 30 percent in Asia and 60 percent in Europe. Most important, this level has been stagnant for the past decade. By comparison, intraregional trade has served as a major engine of growth in Europe, the Americas, Asia and increasingly in Africa.

Austerity measures may not be enough. They may need a structural economic-reform agenda. Among the items that ought to be on that agenda are reduced subsidies and promoting privatization. One should remember that privatization is not a purely technical task but also a highly political process. It cannot succeed without active support from most stakeholders.

How did the Gulf states get themselves into this predicament? The windfall that was brought about by oil-price shocks in the 1970s resulted in a massive wealth transfer to both oil exporters and their neighbors, who benefited from migrant remittances and aid flows. This windfall enabled a massive increase in public investment that fueled growth until oil prices collapsed in the mid-1980s.

Many companies had been lulled into believing that oil prices could only go one way: up. But as hoped-for forecasts of return to pre-1986 price levels failed to materialize, both producers and international oil companies realized they had to reduce costs or face extinction.

Over the next decade, a whole new geopolitical map emerged that put these countries in line with global trends of deregulation and free markets, with profound consequences for the energy industry. Why has the move towards privatization proved so slow in this region? One partial explanation may be that governments failed to realize that natural monopolies like oil don't need to be owned by the government in order to be controlled by the government. There needs to be either public ownership and the capture of economic rent, or private ownership and the appropriate taxation of the oil sector.

Another explanation may be that in many statist economies there is a reluctance to share power, which is equated with a stream of revenue. Therefore, sharing equates to a loss of power and influence. If incremental change is not forthcoming, in the end there may have to be massive shock therapy, with all the dislocation associated with such an approach. Gulf leaders can delay making the difficult choices, but they cannot avoid them.

What are the competing futures that I'm suggesting the Gulf leaders face? I'm going to leave you with some open questions here, awkward questions perhaps, to stimulate thought rather than with any firm conclusions.

Is this the beginning of a new generation of Gulf leaders and a new era of reform, or is this the beginning of a new era of increased threat to energy security and regional stability? Are low oil prices a reliable guide for the future? The past is not necessarily a guide to the future. High debt to GDP ratios are unsustainable over the long term. Non-OPEC supplies are growing more slowly. There's been an acceleration of the decline rate of older fields due to the use of new technology, horizontal drilling, for example. Low oil prices exacerbate this problem.

The Gulf states need to develop their non-oil sectors, particularly the service sector. The statistics are significant. As a percentage of government spending, the ratio of oil revenues are, in general, very high: 70 percent in Kuwait, 86 percent in the UAE, 90 percent in Saudi Arabia.

Openness to new foreign investment in the oil, gas, power and petrochemical sectors would free up more government resources for other uses. Kuwait plans to introduce operating-service agreements instead of production-sharing agreements (PSAs), and its new foreign-investment law is moving toward passage in the Kuwaiti parliament.

To sum up, we can probably expect that the tension will continue to exist between two apparently conflicting goals: one, our energy security; and two, our increased dependence on imported Gulf oil.

AMB. FREEMAN: When I spoke of the open-mindedness and receptivity to new ideas that characterized the Gulf in the past several months, I had in mind, in part, an issue which is not related to political reform per se, but to efforts to reduce dependence by the Gulf monarchies on royalties from oil. In the United States if a developer takes a piece of desert and develops it as an industrial city with a residential community, he costs the federal government, the state government, the county government a lot of money. They have to hire police, establish sewer lines, build schools, hire teachers, and so forth. But they get that money back from taxes on the increased private-sector activity that takes place in the area developed.

In the Gulf countries, when you develop a piece of desert, you cost the government a lot of money to hire police, to build schools, and so forth, and the government doesn't get it back because it doesn't have taxes on economic activity. In fact, some of the things which were recently being discussed were tax reform, equalization of taxes on local and foreign nationals, value-added taxes in the context of WTO admission, and the like.

In addition, the hidden tax on business, called passive agency (agents who do nothing but lend their name to enterprises), constitutes a hidden tax on profits and may account for the fact that there is between $420 billion and $500 billion in private Gulf money invested not in the Gulf but outside. Political risk is not the issue; the issue is return on investment. When you're through paying agents and doing other things, your return on investment in the Gulf is low by comparison with what you can earn in other markets. So steps like those taken recently in Qatar to get rid of agency of this kind will open the possibility of repatriating much of the money that has been abroad.

NATHANIEL R. KERN, President, Foreign Reports Inc.

My basic premise is that the stability and security of Saudi Arabia are important to the United States. I am pleased to note that over the past years Americans who are strong supporters of Israel also came to agree with that premise. Over the past two weeks, Saudi Arabia has forged a new OPEC and non-OPEC agreement that has resulted in a corrective 40-percent increase in oil prices. The question I wish to raise is the implication of this agreement, particularly for foreign investment in Saudi Arabia's upstream oil sector.

When there is an imbalance between supply and demand, there are two ways to arbitrate this imbalance. One is to let price do it. That's how markets work every day. The other is to impose artificial restraints on supply or demand. If there is not enough supply, consuming governments can ration demand and impose price controls. Some of you are old enough to remember the gasoline lines and odd-even days of 1973-74.

If there is not enough demand, producers can ration production by trying to impose quotas on supply. This is what the Saudis and OPEC did again last week for the third time in 12 months, creating a club of OPEC and non-OPEC producers, who supply about a third of the world's oil supplies. Over the past year, these producers have made agreements to cut supplies by a little more than 15 percent from their one-third share of the market.

As long as consumers don't feel they are being gouged by the producers, there is no outcry that OPEC is an evil cartel. We can use the neutral term of supply management to describe what OPEC is trying to do. Producers reach for these artificial supply-management systems either because they believe they will work over the long run or because they believe their financial crises are so great right now that they have no choice, even if they are true believers in free markets. In the case of Saudi Arabia's actions over the past two weeks, I think a combination of these two reasons impelled the kingdom's leadership to act. The history of the oil industry has been marked by various efforts to manage supply, beginning with the Standard Trust, to the Texas Railroad Commission and the Connolly Hot Oil Act, to the Seven Sisters, to OPEC, and finally to the somewhat expanded OPEC and non-OPEC Pacts of 1998 and 1999.

But there are also two glaring historic examples of supply management systems collapsing because they stuck for too long to a crude-oil price that failed to bring a long-term equilibrium between supply and demand. One was the supply-management system administered by the majors during the first twelve years of OPEC's existence (1960-72), when posted prices were kept below $2.00 per barrel. Demand soared and supply did not keep up, leading to the first oil-price shock of 1973. The second was the supply-management system administered mostly by Saudi Arabia's leadership of OPEC during the period 1982-85. Saudi Arabia singlehandedly maintained an Official Selling Price for Arabian Light of $28 per barrel during a time when demand was shrinking and new sources of supply were emerging all over the world. That inevitably led to the price crash of 1985-86.

The problem with any supply-management system is identifying the right equilibrium price. Ideally, that price should work to bring supply and demand back into balance so that supply management can become unnecessary.

Directly after last week's OPEC meeting in Vienna, Saudi Oil Minister Ali Naimi told the press that the agreement was, "geared to reducing the surplus inventory." OECD stocks of oil and oil products this January were about 10 percent higher than they were three years ago, when prices were at $20 per barrel.

If the purpose of the latest OPEC meeting indeed was to work off excess stocks, then it stands to reason that once these excess levels have been reduced to more normal levels in terms of days-forward supplies, then the emergency that required the new round of cuts will be over, and the current supply-management system will become increasingly less necessary. But if the price that the supply-management system attains is too high, then producers will need to make deeper and deeper production cuts until the system eventually collapses because producers won't cut anymore.

The problem with identifying the right equilibrium price is that nobody knows how to do it. The majors didn't know how to do it in the 1960s. Saudi Arabia didn't know how to do it in the early 1980s.

Some have suggested that true equilibrium price is just a fraction over what the low-cost producers in the world can produce at -- around $3 per barrel. But that would require the low-cost producers to supply the vast majority of the world's current oil consumption and would deplete the low-cost producers' currently proven reserves in two decades. None of the low-cost producers wish for such rapid depletion even if they had faith that they could replace a substantial portion of their depleted reserves with new finds. As long as the world needs some of the production from higher-cost producers, it is the higher-cost incremental barrel that will tend to set the world price. Some have suggested that today's equilibrium price is somewhere between the $11 we have just left and the $18 to which producers now say they aspire.

Maybe the best approach for producers when they feel impelled to revert to supply management is to send clear signals to the market that the supply-management system is a stop-gap measure, aimed primarily at reducing a stock overhang or overcoming some other temporary problem and that the producers will be back to business as usual sooner rather than later.

By business as usual, I don't mean that all vestiges of supply management should be dropped. But I do mean letting price play the major role in arbitrating between supply and demand. Price was working moderately well as a balancer of supply and demand up until the collapse of the Asian economies in late 1997. OPEC for several years had stuck with a largely fictional production ceiling of 25 million barrels per day while those producers who could increase production did, and those who could not, did not. At the Jakarta OPEC meeting in November 1997, OPEC ratified almost all of the past years' over-quota production with new quotas, but the meeting probably didn't result in any significant amounts of oil being released to the market. It was the Asian collapse -- and an unseasonably warm winter -- which caused prices to plummet in the few months after the Jakarta meeting, not the decisions taken at Jakarta.

Just to refresh your memories, the price of our benchmark West Texas Intermediate averaged $17 in 1995, $21 in 1996, $19 in 1997, and $13 in 1998 -- before it fell below $10 in December.

Because the relatively high oil prices that prevailed during 1996 and 1997 didn't cause the Asian collapse or the warm winter of 1997-98, lower prices would not have averted either of these events. But lower prices during 1996-97 probably would have averted the severity of the oil-price collapse of the past twelve months because there would have been fewer supply additions and more demand.

The only real supply restraint that existed during 1996-97 was in Saudi Arabia, which held about 1.5 million barrels a day off the market, and to a lesser extent in Kuwait and the UAE. Every other producer was maxed out.

Saudi Arabia correctly sees benefit in maintaining a cushion of spare capacity because it makes the kingdom strategically important and because using spare capacity during an emergency can also moderate extreme price spikes, which only tarnish the reputation of oil for consumers. If the latest supply-management effort agreed upon in Amsterdam and Vienna two weeks ago does work out in the long run to bring down stock levels and increase price, Saudi Arabia could be looking for an orderly transition back to a supply-management system where price plays a larger role, as it did in 1996 and 1997, but where the issue of collective producer responsibility for maintaining spare capacity would also be addressed.

Given oil supply's susceptibility to disruption, it is in the interest of all producers to maintain some cushion of spare capacity in order to enhance the product's reputation as a reliable fuel supply. But an agreement among producers to maintain a given level of spare capacity does not have the inherent disadvantage that a production-quota system has, which tends to tether producers to static rather than dynamic and forward-looking production parameters.

Last September here in Washington, Saudi Crown Prince Abdullah shook the oil world by hosting a meeting of the top executives of seven American oil companies and asking them for proposals for their companies' investments in Saudi Arabia's petroleum industry, the upstream side of which had been closed to any foreign investment for two decades.

Various elements within Saudi Arabia have been wrestling with the implications of the crown prince's initiative ever since, and elements of this internal debate were on public display last month, particularly when Energy Secretary Richardson visited the kingdom at the beginning of February.

It is only natural that some in Saudi Arabia, who are justifiably proud of the role Saudi Aramco has played as a Saudi-run and Saudi-owned company, felt that foreign investment might threaten Saudi Aramco's standing. But another element of the internal Saudi debate has sought to portray any foreign investment in Saudi Arabia's oil upstream as unnecessary and undesirable.

Several rationales have been advanced in favor of private-sector investment in Saudi Arabia's oil upstream. One is that any monopoly like Saudi Aramco will only benefit from being exposed to competition. Another is that American investment in Saudi Arabia would help strengthen ties with the United States, which have proven valuable for Saudi Arabia's security but which also may have been fraying at the edges. The Saudi government is set up, with a Ministerial Committee, to evaluate the contributions either of those factors might make to the Saudi national interest.

But the Saudi government may also wish to evaluate another common-sense reason for Saudi Arabia to open its doors to private sector investment in its upstream oil sector. The world's bigger oil companies spend each year around $80-90 billion exploring for and developing new oil supplies around the world. Does Saudi Arabia want these companies to invest all their money in Saudi Arabia's competitors in the oil business, or does it want them to invest some of their capital in Saudi Arabia?

Those who would resist opening up Saudi Arabia's oil upstream have an answer to this apparent common-sense question: there is an unlimited pool of capital available for investment in new oil production and, therefore, any new investment by oil companies in Saudi Arabia would not result in reduced expenditure elsewhere. Consequently, they argue, opening up Saudi Arabia would just bring a bigger and bigger glut of oil to world markets. These same voices scoff at the notion that there is only a limited pool of capital available for investment in new oil projects by pointing to the vast billions that upstart Internet companies have raised.

Whether there is a limited or unlimited pool of capital available for investment in new oil exploration and development is key. If there is a limited pool, then Saudi Arabia benefits as much by attracting investment as by sucking it away from competitors. If there is a limited pool of capital, Saudi Arabia would also benefit because it would allow market forces to determine how that capital is allocated. The capital-allocation process is by nature forward-looking. By making capital-allocation decisions, companies help to determine where oil will be produced two, five and ten years from now. When the producers rely on quota systems, they base decisions on today's or even yesterday's production parameters. Markets are future-oriented -- they don't look back to some quota agreement reached nearly a decade ago to decide where the future should be.

My own view is that as long as Saudi Arabia is not perceived by capital markets and oil companies as the iron-clad guarantor of artificially high oil prices, then the pool of capital is measurable and limited. Thus when companies invest in Saudi Arabia, they will invest less elsewhere.

The price of oil and the return on investment in oil exploration are, of course, the major determinants of how much capital will be invested in exploration. If the returns on investment are perceived to be very high, many unusual sources of capital can be tapped for oil investment. In the late 1970s and early 1980s, many non-traditional investors poured money into limited partnerships to invest in oil exploration, expanding the pool of capital available for oil exploration. However, these limited partnerships and their ability to attract capital have been virtually extinct since 1986. Other nontraditional sources of finance for oil exploration, like the Japanese government's largely unfruitful support for the Japanese National Oil Company, have been slower to die but are expiring.

In fact, the oil business has not been characterized in recent years by a lot of new entrants into the field. Rather it has been characterized by consolidation through mergers and acquisitions and by successful companies buying back their own stock rather than issuing new equity. It is not attracting the kind of capital that is chasing Internet stocks.

The primary sources of capital for the oil industry are the retained earnings of oil companies and bank lending. Banks will lend to big oil companies because they are credit-worthy. They are credit-worthy because they exercise seasoned management over a broad portfolio of risks. Lending to the international oil industry includes risk in at least three broad categories: price risk, political risk and project risk. Because of their integrated nature, the majors carry some insulation against price risk. Geographic diversity provides them insulation against political disasters that may strike in individual producing countries. The number of different projects in which a major company invests at any given time also provides insulation against individual project failures due to poor commercial or technical judgment.

However, there is a limit to how much money the companies wish to borrow, because their stock prices are a direct function of their debt-equity ratios. Investors are wary of any oil company whose debt approaches 40 percent of its total capitalization because that level of debt is unsuitable for a risky industry.

The debt-to-total-capitalization ratios of 14 major oil companies rose sharply after the poor financial performance of 1998. The debt ratios of these companies stood as follows at the end of the following years:

1994 1995 1996 1997 1998

38% 37% 33% 31% 39%

The 14 largest companies used the relatively good years of 1994-97 to pay down some $23 billion of debt -- a 20-percent reduction.

Of course, some of the companies have healthier balance sheets than others. Both Exxon and Royal Dutch have debt-cap ratios of 18 percent, which in Exxon's case will rise to 21 percent after the acquisition of Mobil. BP Amoco has a debt-cap ratio of 25 percent; Chevron, 30 percent; Texaco, 38 percent; Arco and Conoco, 50 percent; and Phillips, 46 percent. If companies with low debt-cap ratios want to borrow, they can easily do so and thus increase the pool of capital available for petroleum investments. But Salomon Smith Barney's annual survey of capital spending plans by the industry shows that the majors as a whole are planning to cut worldwide capital spending by 17 percent for 1999. The companies with the healthiest balance sheets plan the largest cuts, with Royal Dutch planning a cut of 23 percent; BP, 22 percent; Exxon and Mobil, 14 percent and 15 percent respectively. The major companies are doing what they always do, policing themselves.

Therefore, the ability of the companies to raise additional money from banks is at both practical and self-imposed limits. Companies were able to raise some project-finance money for 1996-97, notably Mobil finance for Qatargas and Conoco for its Venezuelan Petrozuata project. Project finance raises money from non-traditional sources, generally with limited recourse to the sponsors of the project. That window of project-finance money closed in early 1998 because of the Asian collapse and the uncertain price of oil. Two other Orinico projects similar to Petrozuata tried and failed to raise project finance in 1998; these projects are on indefinite hold.

Some other sources of finance are available, notably the issuance of oil-backed bonds by Mexico and Venezuela, or last year's borrowing by Saudi Aramco. But these sources do not necessarily expand the pool of capital available for world-wide petroleum-related investment.

Saudi Arabia can attract oil investment because it is seen as a premier opportunity in all respects. Clearly, when Saudi Arabia attracts capital away from higher-cost areas, like Venezuela's Orinico or the Caspian, fewer barrels of future production will be curtailed than when it attracts investment away from other lower-cost areas. If Saudi Arabia attracts investment away from equally lower-cost areas, it gains a barrel-for-barrel advantage. The barrel that is developed in Saudi Arabia by international oil companies is the barrel which is not developed in the other areas. The primary available lower-cost areas are Iraq, Iran and other states in the Gulf, notably Kuwait. Should U.N. sanctions on Iraq be eased so as to permit foreign investment, either because Saddam Hussein is removed or despite his continued rule, Iraq is ready and waiting for foreign investment because it does not have the luxury of any other course to increase its production and revenues.

The surest route for Saudi Arabia to defeat itself in a competitive world of oil would be to let Iraq attract large amounts of foreign investment because Saudi Arabia kept its doors shut. The same can be said of Iran, which, despite many obstacles, is further along in attracting foreign investment than any of its future competitors in the Gulf. If Iraq and Iran were not so troubled, the plans of either one to bring in investment probably should set the timetable for Saudi Arabia's decision to open its doors.

Besides using the forward-looking capital-allocation process to its advantage, Saudi Arabia can gain other benefits by bringing foreign investment into its upstream oil sector. It would be a mistake to believe the added value foreign companies might bring can or should be confined to the balance sheet for a given project. In some cases, foreign companies may bring significant technologies or efficiencies to the project balance sheet, but mere technologies or efficiencies are not likely to offset the difference between the rate of return that the companies expect and Saudi Aramco's cost of capital. That difference amounts to about $1 per barrel, depending on the capital cost per daily barrel of production.

The technical efficiencies of Saudi Aramco's exploration and production operations might be subject to improvements, but probably the areas of Aramco's operations that are liable to yield the greatest savings and efficiencies include management philosophy, design and procurement, and employment practices and employee benefits. In some of these areas the Saudi government imposes social and security mandates on the company. It is not unusual for governments to impose mandates on protected monopolies, but over time such mandates can represent highly significant costs which are imposed without rational and continuing economic justifications. One of the benefits of operating in a competitive environment is that competition continually forces re-evaluations of how every aspect of a business is run. The cost of not operating in a competitive environment is that forces of inertia set in: government mandates accumulate like barnacles, supplier relationships become increasingly entrenched, and general economic discipline declines.

The government also has to weigh certain benefits to foreign investment that may be exogenous both to the project balance sheet and to perceived benefits from attracting capital away from competitors. These include defense, security and foreign relations. For some years, and for a cost that is small compared to the size of the kingdom's defense budget, the government has directed Saudi Aramco to maintain market share in the United States in lieu of higher margins that could have been attained in Asia. Investment by American companies in Saudi Arabia's upstream clearly enjoys the enthusiastic support of the U.S. government and could be the single most important element in the revitalization of the U.S.-Saudi relationship.

Some would argue that a decision to bring foreign investment into Saudi Arabia's upstream oil sector is not one that should be made on the basis of a current year's supply and demand balance. If there is to be such investment, it will take time for companies and for the government to find their bearings, to sound each other out, and for clear and transparent processes to be established even before any contracts might be negotiated. Upstream contracts generally run for decades. Therefore, any Saudi decision to permit foreign investment in the upstream oil sector first requires a collective and agreed-upon vision of where Saudi Arabia wishes to be decades from now, irrespective of how it wants to manage the market in the immediate term.

The population of Saudi Arabia will be around 37 million in 2025. The world economy is likely to be ever-more competitive and the pace of rapid technological change may continue to accelerate. Government-imposed barriers to trade and to capital movements may continue to fall. The private sector in Saudi Arabia has become a driving force in the national economy, and were it not for the vitality of the private sector, the kingdom's economy would be in a deep recession today. Privatization and deregulation throughout the world have lifted the heavy and sometimes suffocating hand of government from the vitality of private enterprise. If Saudi Arabia wants to become one of the major competitive forces in the world economy rather than protecting itself from outside forces, should it try to wall-off its main industry? Can the Saudi government, through oil revenues, continue over the next quarter-century to provide jobs and high living standards for a growing population on the scale it does today, or should it look primarily to the private sector to do so?

A desultory vision of Saudi Arabia in 2025 would be for the kingdom to be the last country on earth that prohibits private investment in its upstream oil industry and to be the last country on earth where a monopolistic government entity controls oil production. One could hope that Saudi Aramco by that time would have gained greater market share in a world of growing demand for oil, but one can also legitimately fear that hope might be crushed by the heavier and heavier burden of price maintenance at the expense of Saudi production aspirations.

A brighter vision of Saudi Arabia in 2025 would be for its market share to approximate its share of the world's oil reserves, for five or ten or more of the world's largest oil companies to be operating in the kingdom and to bring with that presence full access to their own integrated downstream assets, for Saudi Arabia to become a hub, if not the headquarters, for a number of oil companies, oil-service companies and energy research, regardless of the original nationality of the firms. Today, the top cadres of the Saudi government, of the Saudi private sector, and of Saudi companies like Aramco and Sabic are highly internationalized Saudi citizens who are as able as the nationals of any country to interact successfully anywhere in the world. If a wall is not maintained around Saudi Arabia's main industry, what is there to prevent Saudis, like the Texans before them, from having a hugely disproportionate share of the careers in the oil industry around the world? If any of these visions appear ludicrous to any Saudi, he should ask himself if could have envisaged the Saudi Arabia of 1999 twenty-five years ago.

AMB. FREEMAN: The background here, which all of you understand, is that producers in the Gulf such as Saudi Arabia have production costs per barrel of less than $2. For many producers in other areas, production costs have been well above the $11 price that prevailed for much of the year. This is why they are going out of business. If prices of oil remain very low, then production in the Gulf will steadily gain market share at the expense of other producers. Dependence on Gulf oil imports will therefore go up and could go up to very high levels. But, if oil prices are to remain low, and if market share is to be regained, as Bob Copaken suggested was a major objective of producers in the region, then there is a premium on the efficiency of production. It's not enough to produce below $2 a barrel, there is a premium on getting as much profit per barrel of oil as you possibly can.

JIM STEENHAGEN, Managing Director, Executive Services Group, The Petroleum Finance Company

While these other distinguished speakers will be talking specifically about Middle East policy, I want to use my time to describe the overall state of the oil market, how the oil and gas industry is changing, and how companies view the Middle East versus other opportunities.

First the oil markets. The last 12 to 18 months have been unusually volatile, but the direction has been mostly down. The recent rebound still leaves oil prices well below the average levels of 1996 and 1997. This is having a profound impact on both the finances of producing countries and the oil companies. This price environment has led to a resurgence of interest in OPEC watching. The producing countries' policies, and particularly those of Saudi Arabia, are being followed closely once again.

So what do the price forecasters at Petro Finance see for the medium term? Our team thinks oil prices will remain below $18 per barrel for the next few years, barring major outside shocks. The supply/demand outlook will remain unbalanced unless OPEC restrains production until 2001-02.

We expect that oil-supply growth in 1999 will be held in check by OPEC cuts. And low prices will cut supply in other countries as some production is shut in and some projects are deferred. Demand will get a boost from fuel switching and cheap gasoline. Petro Finance sees oil supplies continuing to grow, albeit slowly in the years ahead as oil companies adapt to lower prices by cutting overhead and using technology to lower production costs.

Fundamentally, there will remain a gap between world production capacity and demand OPEC unused capacity is at 6 mil. b/d, with almost half of that in Saudi Arabia. Balancing the market rests on the shoulders of agreements among OPEC members, and there is not a good track record on that score. The current OPEC agreement is basically a political solution, not a structural one, although to the extent production is actually cut, it may help mop up excess oil inventories hanging over the market.

The dramatic change that occurred in the oil market in 1998 was the impact of falling Asian demand. A closer look at the 1998 figures shows that while the ASEAN nations and South Korea deflated the Asian demand picture, falling Japanese oil consumption had as big or bigger an impact. We see Asian demand coming back slowly in the next few years, while European and Latin oil-demand growth slows this year before picking up speed in 2000.

To sum up our price view, there are weak markets ahead. Demand will be helped by low oil prices, although high European taxes reduce price elasticity there, and much of the world will have sluggish economic growth. We believe Gulf supply will have to be constrained until 2001 or 2002 to avoid even weaker oil prices. After OPEC purges excess world oil inventories it will come down to a question of key producers choosing either higher prices or market share.

The oil industry has always had ups and downs. Typically in the past when prices were high, the industry would overinvest in new capacity and five to ten years later a resulting supply glut would drive prices down. Companies would cut back on spending and projects would be shelved, leading to a shortage down the road. This is the oil-industry version of the "hog cycle" taught in Economics 101, but with longer lead times due to the large capital investments and gestation periods. Even within OPEC, the cycle of fear and quota compliance is usually followed by greed and overproduction. This business cycle has certainly been in evidence among the oil companies in recent years. I went to the security-analysis meetings of the oil majors over the past few years and listened to them talk about their growth targets, with production expected to increase anywhere from 5 percent to as much as 12 percent annually over a five-year period. It's not too surprising that the boom had to end.

What's different about the petroleum cycle this time? This time around there may be some outside forces on the supply side that may prolong the trough of this cycle. The two main factors we see are technology and access to new areas.

* Improved drilling techniques are prolonging fields' lives and making production possible even with lower oil prices.

* Previously closed countries are opening up to investment, such as the former Soviet Union, Algeria, Venezuela and Brazil.

The most important thing to understand about the industry is who controls the resources. Oil is fundamentally a government business: national oil companies control 90 percent of the oil reserves and almost 70 percent of oil production. This is why access is so important to oil companies, and why interest is so high in the possibility of doing deals in the Gulf.

The share of world oil production by international oil companies is slowly increasing, however, as more countries open up to foreign-company participation. The international oil companies' share had sunk to very low levels following the nationalizations of the 1970s. But soon countries like Nigeria, Angola and Qatar began to invite more foreign firms in. Venezuela's opening attracted a huge amount of industry investment. We are now at a juncture where the pace of new access may accelerate, with Brazil and Iran signing deals, and companies lining up for hoped--for entry into Iraq, Kuwait and maybe someday the biggest prize of ail, Saudi Arabia.

National oil companies have become much more sophisticated and better run, but they often still want access to technology and international oil companies' ability to manage large projects. In a low-price environment, they are also seeking access to capital and secure access to markets. NOCs are focused on managing their countries' national interests in their resources and in the domestic markets. This is part of the new "resource nationalism" of the 1990s. NOCs may own the resources, but when it is in the national interest to bring in outsiders to help develop them, they do so. Venezuela is a clear example of this new resource nationalism.

The NOCs have the oil and gas reserves, but in the current environment they lack access to financial resources. For example, Exxon, Shell, BP Amoco, Chevron and others have top-drawer credit ratings. The oil reserves of the largest NOCs dwarf those of the majors, but their credit ratings range from intermediate to poor to non-existent.

Each producing country that opens up to new investment has to offer terms that will attract capital. The global market for exploration rights is highly competitive. Companies are looking for the best trade-off between risk and return. In the worldwide "competition for capital," hot areas are attracting the most attention and investments.

A major industry trend is consolidation. Out of a long list of competitors on the international stage, many have disappeared or are on the block. In addition to the big mergers and acquisitions like Exxon Mobil, Total Petrofina, BP Amoco and now maybe BP Amoco ARCO, there have been numerous smaller firms like Union Texas, Oryx and LL&E that have been swallowed up. Some other firms won't last through 1999. Those that aren't merging are forming alliances to shave costs or to enter new areas. Of the seven U.S. firms invited to submit proposals to Saudi Arabia, Mobil and ARCO may soon be gone, and one or two others may follow.

In the past, the oil companies have had ample finances, but the constraint was on attractive opportunities. This has now shifted to where there are numerous potential opportunities, but capital spending is being cut back due to lower oil prices and consolidation. For most of the 1990s, cash-rich companies were all chasing the same limited set of opportunities. An example of this at the tail end of the boom was the Caspian, which was touted as perhaps having the potential of another Kuwait, if not another Middle East.

For most companies, the majority of their profits come from core areas, areas where they have significant investments, economies of scale and large license areas "locked up." But many of these core areas are mature now, and their biggest challenge is not only to replace the reserves from these areas, but to replace the earnings from the high-margin barrels there. For a company like Mobil, replacing the profitable Arun gas field was driving that company's strategy before its announced merger with Exxon. Major companies are finding that they aren't creating new core areas through exploration, so they are turning instead to production deals. Production deals are for development of reserves that are already known, but the country doesn't have the capital or technology to exploit them.

These production deals lead to new types of risk for companies -- above-ground risks like political and labor issues, environmental sensitivities, transportation routes (as in the Caspian), and even U.S. government policy (as in sanctions).

This problem of replacing core areas helps explain why Saudi Arabia and Kuwait hold such fascination for oil companies. Any upstream deals in these countries would likely have both low exploration risks and low above-ground risks. The Middle East still dwarfs any other region in both reserves and production. The Caspian, for example, barely registers on this scale.

From where is future oil production likely to come? A comparison of the Persian Gulf with the Caspian is striking. For now, both regions have budgetary and market constraints, but for the most part, the Caspian is constrained by low reserves, exploration risk, technical hurdles, security and commercial risks, and transportation bottlenecks. Almost the opposite is true of the Persian Gulf. For now the Gulf is closed or partially closed to upstream foreign investment, while the Caspian has opened up. But for the future we think most roads still lead to the Gulf.

To conclude, where is the industry headed and what are some broad policy implications? First, a return to high oil prices may not be in the cards for some time. Oil is still a government business, but countries around the world are opening up and vigorously competing for capital. The largest companies are getting larger and still have the access to financial resources, but they need to replace their reserves and their earnings. These companies have their eyes on the Middle East as the source of manna that will carry them through this dark period of low prices and maturing core areas. The oil companies are intensely interested in Middle East politics and U.S. policy. Until the Gulf fully opens up for them, they will drill around the world in areas like the deep water and sign deals in places like the Caspian and Brazil.

For the United States, at least one broad policy implication comes to mind. We should not become complacent about oil supplies just because oil prices are low and gasoline is cheap. Our foreign policy should reflect this and recognize that, in the long term, oil is of unique strategic importance.

AMB. FREEMAN: If indeed prices of oil hover around the $18-a-barrel figure that you cite, what are the implications of that for inflation in our relatively unprotected economy? What are the implications for the development of the Caspian, given all of the difficulties that you cite? Is the current price of about $16.50 a barrel the tipping point, below which nothing happens in the Caspian, and above which possibly things happen? And finally, if there is relief, but not adequate relief, and if the effect of the relief is to further delay necessary structural economic reforms in the region, what does that do to the ability of the countries in the region to continue their cooperation with the United States on various security agendas that are of concern to both of us?

GEOFFREY KEMP, Director, Regional Strategic Programs, Nixon Center

I will focus on some of the broader strategic implications of changing oil prices, reinforcing the fundamental point that all the speakers have made so far: for the foreseeable future -- 10, 15, 20 years -- the Persian Gulf is going to remain the strategic prize. No matter what the price of oil, we cannot ignore this.

We're here today to discuss how oil prices have changed policy and vice versa. I think it's worth remembering that many of us had our baptism in this subject in the 1970s, when the issue was the impact of high oil prices, caused initially by the 1973 Arab-Israeli war and the subsequent oil embargo on the United States. That led to the spiraling increase in prices. It pointed out the growing dependency of the West on the Middle East. It led to a whole new school of literature about the redistribution of world power, where the OPEC countries would become the world's bankers and we would all have to go cap in hand if we wanted to do anything. It coincided, of course, with great fear about the growth of Soviet power-projection capability. Remember, the Cold War was still on, and the Soviets had the potential to interdict our oil supplies in a future war.

I think this is relevant, because if you think back, this crisis didn't last very long. The Western countries coordinated their efforts quite successfully. There were major efforts at conservation; alternative oil sources were sought, and because the price was high, regions like the North Sea became profitable. We established a strategic petroleum reserve; we established a very effective Western strategy to defend the Persian Gulf. Then in the 1980s, the Iran-Iraq War erupted -- an event that had it occurred five or six years earlier would have panicked us -- and went on for eight years, having marginal effects on oil supplies. When the Gulf War came in 1991, because it coincided with growing supply, an economic downturn, and the strong military capability of the West, Saddam Hussein's invasion of Kuwait had an only minor impact on the oil market in the early days of the crisis.

What we see today, it seems to me, is the reverse of that situation. Here we are talking about the implications of falling oil prices. The other speakers have cogently discussed the reasons why, so I will not repeat them, except perhaps one point: Two years ago, most of us, including myself, were writing about the growing demand for world oil, particularly from the Middle East, driven in large part by the booming economies of Asia. And all the projections and trend lines showed more and more oil flowing to Asia in the twenty-first century, and that in turn having a major impact upon geopolitics, because the Asians were going to become more involved in the Middle East. Well, that long-term trend line may well still apply. But, I don't think any of us foresaw the dramatic events that took place in Asia 18 months ago. The collapse of the Asian economies was a much unanticipated event that radically changed the short-term oil market and depressed prices.

In terms of strategic implications of this issue, I'd like to focus on two components: dependency and stability. There is no doubt that low oil prices increase our dependency on Gulf oil. As others have said, it is extremely cheap to produce. The Persian Gulf is the producer of last resort. The appetite for petroleum, despite the Asian downturn, is not diminishing. You only have to look outside this building to see the extraordinary consumption patterns of Americans: more and more sports-utility vehicles guzzling more and more gas. Think back to the days when we all used to buy Volkswagens.

This means not only that the dependency of the entire industrial world is growing, but also it provides opportunities for oil companies to become more involved in investments in this region, since low prices deny the producers the capital they need to expand their industries. This, in turn, creates a growing two-way relationship. You could argue that one of the impacts of low oil prices has been to strengthen the Western presence in the Persian Gulf, even though that gives rise to some questions about the political desirability of that presence, because another issue we're concerned with is stability.

There is no doubt that there are dangers for the Persian Gulf if oil prices fall below a certain level. This could have an impact on domestic stability, and anything that impacts on domestic stability affects regional politics, which in turn affects the American commitment and the whole military infrastructure that we have built up in the region. Of course, it's not just the Gulf that we should be looking at. You don't need to be a genius to see that some of the problems that Russia is facing today, that Indonesia has faced, that even the State of Texas has faced, can be traced to low oil prices. It's been mentioned that in the Caspian Basin, which two years ago was the darling of meetings like this, and everyone was talking about the new black-gold rush, low oil prices have slowed the pace of investment and the enthusiasm for alternative energy sources.

In the Gulf itself, it is interesting to see how each of the countries has begun to adapt to the realities of low oil prices, with the same political motivations that the West adapted to high oil prices in the 1970s. Iran, Saudi Arabia, Qatar and Kuwait, all in different ways, have talked about and in some cases are instituting reforms. There is even talk that in Saudi Arabia women will be allowed to drive automobiles because, as The Wall Street Journal pointed out three weeks ago, 500,000 male chauffeurs have to be imported into Saudi Arabia in order to drive cars, and that is a drain on the economy. Qatar has just had national elections, in which women voted. These are important changes that hopefully will continue. And Chas. Freeman was right to point out that one of the dangers of increasing the price of oil in the short run may be that this dampens the appetite for reform.

But, if you look at the strategic dimensions, there are two countries that we are primarily worried about, Iran and Iraq. In the case of Iraq, while there is absolutely no love for Saddam Hussein anywhere, there is a marked reluctance to think, talk or even encourage the prospects that this gentleman might be violently overthrown any time soon. The exception would be Kuwait, for obvious reasons. But there is one reason that I think is relevant to our discussion this morning. A change of regime in Iraq could lead to Iraq's soon resuming its position as one of the world's premier oil producers. Iraq has potential second only to Saudi Arabia. The cost of producing Iraqi oil, after a period of years, would be very low, and this in turn would further diminish the price, at a time when everyone is worried about the impact that low prices are having on stability. You can see why there may be some less than noble reasons for wishing to see the status quo remain in Iraq.

Iran is a totally different situation. We hope to have better relations with the new regime, but as yet do not. And as long as the United States and Iran remain in a standoff, as long as there are fears about the proliferation of weapons of mass destruction, there is a real danger that this region could once more be plunged into hostilities. Therefore, I see no alternative but for the United States to remain deeply committed to the protection of the Gulf. If there were a major crisis in the Gulf that led to supply disruptions, we would be the first to feel it, even though we don't get most of our oil from the region, because of the impact on the price of oil.

So I conclude by saying that for many reasons -- economic, political and strategic -- there really is no way out, and the Persian Gulf will, for the foreseeable future, remain the strategic prize.

AMB. FREEMAN: If the overhang in global oil supply was about 2 million barrels, and if that overhang has now largely been eliminated by OPEC's actions and agreements, and if that has produced a price of about $16.50 a barrel, is that price going to cause those who had been withdrawing from production to come back in? Given the technological improvements that Jim referred to, is it going to result in increased production outside the Gulf?. This gets to the question that Nat Kern asked: Can the oil producers in the Gulf continue to depend on quotas? Or should they look to price as the mechanism for guiding the balance between supply and demand? What are the trade-offs between attempts to administer the market through quotas and recognition of price factors? Second, is there any prospect that governments in the Gulf, roughly 75 percent of whose revenue comes from this completely unpredictable, fluctuating commodity, can break their dependence on oil royalties, or are they going to go on riding this roller coaster? I think the two questions are related.

MR. KERN: Nobody knows what the equilibrium price is. I don't know it; Sheikh Yamani didn't know it in the eighties. The majors didn't know it in the sixties. There are going to be more supplies and less demand at a higher price -- that we know. But we don't know what the equilibrium price is. That's what makes it hard.

MR. STEENHAGEN: Certain areas will come back into production at $16 a barrel, like the Gulf of Mexico. Heavy oil probably still isn't profitable at $16 a barrel. But as the companies get better and better at using technology to lower their costs, we're going to see more supply than we have in the past, with even lower prices.

DR. COPAKEN: We don't have enough wisdom to determine what is an appropriate price level. We just know that some prices are too low and some prices are too high. I think that the OPEC countries, and the Gulf countries particularly, will continue to rely on quotas, at least for the near term. They feel that oil is too important to be left to the vagaries of the market.

AMB. FREEMAN: I was struck that two of the speakers, both Nat and Jim, were confident that Crown Prince Abdullah, in inviting proposals from oil companies, had been referring to some sort of upstream oil-production possibility. I wonder whether that was, in fact, what he was inviting. I have heard a lot of talk in Saudi Arabia about gas being opened up for private exploitation. I've heard mixed things about upstream oil, as opposed to downstream investment. Why do you think that what is at issue here is the reopening of Saudi Arabia's oil sector to direct private participation from abroad?

MR. KERN: I was there; I heard them say it in September. I think what has been happening in Saudi Arabia since then is a process of wrestling with the implications. There are people in the oil industry in Saudi Arabia who are very proud of Saudi ARAMCO and very protective of its turf, and they want to keep others out. And there are others, including the Crown Prince and some farsighted people in the kingdom, who are trying to look ahead 25 years from now. They're saying, where do we want to be? Do we want to be the last country on earth with a national oil company that's a monopoly? Are we going to be stuck with maintaining quotas? How are we going to take care of the people? Or is Saudi Arabia going to be a vibrant center, the hub of energy development, with a dozen major companies with major headquarters there?

I think what you're seeing right now is a gradual approach, where the companies have taken months to figure out what would be mutually beneficial to them and Saudi Arabia at this point, and that doesn't mean adding a lot of oil-production capacity. So they're going to be working in gas proposals, revenue enhancements that don't require increased volumes of crude over the next couple of years. And even Ali Naimi, who is probably the least friendly of anyone to this opening, has been saying, We like what we've been seeing in terms of concepts from the companies, we're happy with them, and those companies that embark on this investment in gas and other optimization processes will be the ones we will turn to when we need more spare capacity.

MR. STEENHAGEN: The view in the companies is, if they can make a proposal to help with gas development -- gas-injection technology, something like that -- they would then be in line for upstream oil projects. They see it as a long-term process. They just want to get in the door and be a partner with Saudi Arabia. ARAMCO is certainly a very sophisticated, capable national oil company, so it's difficult to make a case for companies coming in immediately in upstream oil.

AMB. FREEMAN: I think I have the sense from the last point that there is some recognition in Saudi Arabia among members of the ruling family that no matter how good a company Saudi ARAMCO may be, and it is a very good company, a monopoly position inevitably takes its toll in terms of efficiency. Saudi ARAMCO may need a measure of competition to restore the edge that it once had.

Q & A

Q: In early March, the secretary of defense was in Qatar, and I got the record of an interview conducted in the presence of the secretary and the Qatari leader in which a number of journalists asked him whether he was there to sell them more weapons. For a country like Qatar, in the presence of the Qatari leader, this was unprecedented. The real threat, as far as I'm concerned, is not Iran or Iraq, but the erosion of the credibility of the United States among allies like Qatar, or even Saudi Arabia.

For those of us who advocate a policy of engaging Iran, it would send a positive signal if the United States were capable of turning its relationship around with Iran.

DR. KEMP: Of course, we'd like to see an improvement in U.S. relations with Iran. It would improve security in the Gulf, and perhaps then there would not be the need for as many arms purchases. But there are difficulties in improving relations with Iran, not the least of them being that the Iranian government, at this point in time, does not wish to have an official dialogue with anyone from the United States government. But the real issue is Saddam Hussein. He is a major threat to the region. And it may not be as great as it was five or six years ago, but it is still there. And the recent expulsion of the UNSCOM inspectors has not made the situation any better. So, until there is an improvement on these two fronts, it will be most unwise to lower our guard. As to whether or not everything we are advocating that the Gulf states buy is good for them, we can go through each country on a case-by-case basis. There have been complaints about overloading their budgets with unnecessary military equipment. But, frankly, that's a matter for those governments to decide. My guess is that in the last resort, close cooperation at the military level probably is more beneficial than buying a few extra jets.

Q: If Iran and Iraq withhold their oil from the U.S. market now, aren't they really going to control the price later on down the road?

AMB. FREEMAN: It's my impression that both Iraq and Iran would be all too happy to sell their oil to the United States as well as others on a completely uncontrolled basis. Those constraints are imposed by us on ourselves. But you raise an interesting question. It's always been an issue, whether, in fact, those with abundant oil reserves would be better off releasing them into the market now and taking the money they gained and investing it in other things, or whether they would be well advised to leave the oil in the ground on the assumption that sometime in the distant future oil prices might be significantly higher, or oil might be used primarily as feedstock for industry rather than as fuel to drive automobiles and so forth.

Q: The small and medium-sized producers in this country are being forced out of business in record numbers. These producers are our true petroleum reserve against any disruption in the Middle East. What about them?

DR. COPAKEN: The Department of Energy and the Congress both realize the effect that low oil prices have on our domestic industry. The issue is what do you do about it. It's difficult to come up with a quick fix that resolves all the issues that you're talking about. Clearly, there are things that we can do to help the domestic industry in terms of fulfilling the SPR (Strategic Petroleum Reserve), for example, but that's not a panacea. The Congress is loath to impose an increase in the gasoline tax. Once upon a time, we talked about a nickel-a-gallon tax, and what could be done with that. I know that the administration currently is not in a mood to impose additional taxes. But that is one way of increasing conservation. Another way is to help with alternative energy forms, renewables. But there is no quick and easy answer to the problem of low oil prices, except to allow the market to work.

DR. KEMP: The political sensitivity in this country to raising the price of oil through taxation is a reality we have to live with. Short of an emergency, we're not going to see any pressure to raise taxes. Senator Tsongas proposed it in the campaign in 1992 and lost very decisively to Bill Clinton, who did not propose a tax on oil.

AMB. FREEMAN: I think it's fair to say that low oil prices are not regarded by American consumers as a problem at all. Some groups in this country, maybe majorities, see a benefit from the collapse in oil prices; others are hurt by it. Since I'm not in government and have no intention of returning in the near future, I will say very candidly that I think the absence of an American policy decision on this issue over a prolonged period is shocking. I do not believe it is in the interest of the United States to promote energy inefficiency with low prices or to promote dependence on oil imports from one highly volatile region. On the other hand, I'm a realist, and I see no prospect that our policy will be reexamined in the foreseeable future.

DR. KEMP: I agree with that. The one time that could have been done was right after the victory in Desert Storm, when George Bush's popularity was at 90 percent. Maybe he could have made the case. But he didn't right away, and the country was in a recession, and it was an election year. So, we lost the opportunity then, and I don't think we'll get it back again until there's another event like that.

Q: You said rising prices would help reinvest some money into the search for new sources or improvements in technology. How do you see this causing a shift in policy towards Western Africa?

MR. STEENHAGEN: West Africa is a real hot spot right now for deep-water exploration, and improved oil prices are going to help that considerably. Companies are investing a lot of money in offshore Angola, and things may happen in Nigeria to encourage investment there. So I see a lot happening in Western Africa.

DR. KEMP: It depends on how long a price prevails. If we get $16 for a week, and then it drops down, that's not going to change any investment plans that have been shelved. It's a question of duration. We don't know yet.

AMB. FREEMAN: Once I was in the office of a former petroleum minister in Saudi Arabia when his staff burst in to tell him that the reserves in a field south of Riyadh had just been proven. The aide told the minister, it's about three billion barrels. The minister's comment was, it's too small, cap it. In any other part of the world, that would have been considered an absolutely fantastic, giant resource. This illustrates the point several people have made, that for good or ill, the Arabian peninsula, Iraq and points south, have been blessed with a preponderance of the world's oil and gas supplies.

Q: There are multiple reasons given for the containment policies against both Iraq and Iran that prohibit the growth of their petrochemical industries. The primary reason for containment of Iraq and Iran is controlling weapons of mass destruction. But where does trying to diminish the amount of oil that these countries would pour into the market fit in here? Is this a factor in terms of the readiness of Europeans to invest in Iraq's and Iran's petrochemical industries and the reluctance of U.S. industries to do so?

DR. KEMP: I'd make a distinction between Iraq, which is under international sanctions supported by the United Nations, and Iran, which is under unilateral American sanctions, of which there are two components. There is the executive order signed by President Clinton that essentially bans imports and exports from Iran, and prevents American companies from buying Iranian oil. And then there is legislation that the Congress has approved that makes it unlawful for even foreign companies to invest more than $20 million in the Iranian energy sector. This is the subject of great controversy, even here on the Hill. I think it can be asked whether or not this has had any impact in a positive way on Iranian behavior. But I think there's no doubt that U.S. sanctions on Iran have hurt the Iranian energy sector. The argument that would be made here by proponents of that legislation would be, the Iranians need to modify some of their behavior if they wish to see those sanctions lifted. My guess is that if they did make some changes in some of their behavior modes that are so upsetting to people, there would be a great rush to remove these sanctions, because American companies are being or could be left out in the future if the Europeans continue to defy the law.

MR. STEENHAGEN: The oil business is a global business. If U.S. companies are not participating in Iran, other companies are perfectly ready to step in. Sanctions just hurt U.S. companies. And the profits that the European and other companies make in those countries that are under sanctions can be used to undercut U.S. firms elsewhere. So I think there are a lot of unanticipated costs to sanctions that must be weighed.

DR. COPAKEN: Sanctions are a blunt instrument; there's no question about that. They very often hurt the country that's imposing them more than they do the targeted country. But there are reasons why these sanctions have been imposed. To the extent that we can get consensus among allied countries, the country that we are trying to target is going to be hurt and, presumably, at some point will feel the need to modify its behavior. But there clearly is a cost and a benefit to be weighed in the imposition of any sanctions. The administration is, in fact, trying to move towards a more balanced view of both costs and benefits in determining whether to impose sanctions.

AMB. FREEMAN: Speaking personally, it's a matter of regret to me that the United States, for whatever reason, appears to have forgotten that there is a wide choice of instruments of national security and foreign policy available to us. We seem, at present, to have only two instruments, sanctions and air strikes. I don't think that that is the full range of our choices. Both sanctions and air strikes are currently being applied in the Gulf. And they're being applied for reasons which have nothing to do with affecting oil prices. Although they have the tendency to keep oil prices above where they otherwise might be, and no doubt that is an ancillary benefit for some of our friends in the Gulf who depend on oil exports for their well-being, it's not the motivation.

Q: To what degree do you think the Saudi thinking about bringing in foreign oil companies is a locked-in strategy? Has it been decided upon as a long-term strategy, or can it be derailed by things like quotas and bumps in the market? Secondly, if it has been decided as a policy, what would be the time frame, and what would slow it down?

MR. KERN: Any policy can be derailed. There's never a guarantee that a policy is going to continue forever along a preordained path. But I think the top leaders in the kingdom know where they want to be 25 years from now, and they know where they don't want to be. The process of getting there is going to have some ups and downs. This latest round of quotas brought Saudi production down to 7.5 million barrels. That gives them three million barrels of spare capacity. Saudi Arabia has always wished to maintain some degree of spare capacity so that in the event there's a war or whatever (as when Iraq invaded Kuwait), they're able to take some of the thrust out of otherwise skyrocketing prices. It also gives them a feeling of importance; other people regard them as important if they have spare capacity. If we can move out of this latest round of quota cuts, which were to address a specific emergency, and more towards a price-oriented system -- such as governed OPEC 1995-97, when no one was obeying quotas -- those who can produce more will, and those who can't will not. You can't just focus on spare capacity as the enemy of price. You must also consider the conscious decisions by producers to maintain a cushion of spare capacity in order to keep the product something that people will have confidence in as not being subject to enormous gyrations in price. You could have an OPEC/non-OPEC meeting in which you would address the question of how much people can produce, but also how much people would withhold from the market for strategic spare capacity. You could get there fairly soon in a transition from where we are now.

DR. COPAKEN: I would agree with Nat. The Saudis have made a conscious decision to maintain this surplus capacity, and there are costs associated with it. We have had numerous meetings with the Saudis over the years at the Department of Energy. They make a point of mentioning the fact that there are costs associated with' maintenance of this surplus capacity. We, in our own way, have done the same thing with the strategic petroleum reserve. That's our cushion, our excess capacity. The Saudis, of course, can maintain theirs at a much lower cost. But it is a conscious decision, and it does reflect their role in stabilizing what might otherwise be severe ups and downs based on shortages in the market.

AMB. FREEMAN: For Saudi Arabia, which measures its oil reserves in centuries rather than years or decades, an intelligent policy is to keep prices low enough so that alternative energy sources are not developed, but high enough so that the current social and economic and political requirements are met. This is always a balancing act. My concern is in line with what Nat said. I don't believe that this balancing act can continue on the basis of quotas. King Canute tried to order the tide not to come in, and, as powerful as he was, he failed. Ali Naimi has no delusions that he can order prices in any long-term context to do anything in particular. The basic calculus for Saudi Arabia requires some kind of reconsideration of the strategy that arose in 1973 and has prevailed since then.

DR. KEMP: There was some discussion at a meeting I was at before it was clear that this quota was going to be reached that one option open to the Saudis was to produce more and more to reduce prices and, therefore, gain market share, but one of the consequences of that for Saudi Arabia would be possibly to destabilize the region and create problems for the Iranians, who could not play the same game. Maybe the Iranian connection had some effect on Saudi decision making.

Q: I just want to refocus our panelists on the Iraqi issue once again. There

are several proposals already on the table. The Russian government, backed by others, proposes lifting the economic sanctions. The United States proposes lifting the ceiling on oil export from Iraq. There is a concern among the Gulf states that at some point, with a new government, there would be a new situation. What would happen to the oil price? Second, even if we have a lifting of the ceiling, this would be just a statement if it were not followed up by an investment in the oil sector, particularly in production equipment. Who will invest in Iraq? How will the United States be involved?

MR. STEENHAGEN: There is a risk that Iraqi production could come on and further oversupply the market. That would be an outside shock to the system. As far as companies that are hoping to invest in Iraq, the understanding in the industry is that most of the main fields in Iraq have already been sort of "divided up" among the major oil companies, with ELF planning to go in to develop one field, Total to do another, and so forth. The companies are ready to move in when the time comes.

MR. KERN: Lifting the ceiling or not is irrelevant unless the price of Iraqi crude goes above $14. The ceiling restrains then, if it's not lifted. I wouldn't envy any investor going into Iraq, given that country's reputation for not living up to its word. I think it would be perilous to invest a large portion of any company's portfolio in Iraq. That company would then take on great risk. Iraq does not have a good reputation for paying its debts, living up to its word or treating people fairly.

DR. COPAKEN: This is an area that we in the department have focused on. The understanding that I have is that the ceiling would be lifted, but only in the context of the food-for-oil program, and that essentially the price effect of any increase in Iraqi production has already been felt in the market. Iraq is not subject to the quotas that OPEC has developed, and it would appear to me that Iraq would not have a significant increase in its production within the next year or 18 months. Iraq could, conceivably, go up to much higher levels, but I think Nat's comment about the environment and the risk of going into a county like Iraq are worth remembering. In the short term, I don't think that any increase in the ceiling is going to have a significant effect on their production level. But, given time and resources, they could go much higher. But they're aware of the market themselves. And they're not going to shoot themselves in the foot by increasing their production willy-nilly.

DR. KEMP: I think this is all correct, assuming a continuation of the current regime in Iraq. The question to ask all these companies in Europe and elsewhere that are trying to squirrel away cozy deals with Saddam Hussein, assuming that sanctions are at some time going to be lifted, is this: What will their position be if there is a radical change of regime in Iraq? Will they still have that preferential position, or will American companies be welcomed back, and the Russians, French and Italians less well regarded? I think that's a risk that the companies now trying to do business in Iraq have to take.

AMB. FREEMAN: The factors that are eroding support for air strikes and sanctions as they apply to Iraq have very little to do with international oil markets. There are a series of issues: sympathy for the suffering of the Iraqi people; fatigue with an apparent policy treadmill; the expense to us and to our friends in the Gulf of a sustained policy of confrontation; and the frictions that arise over these and other issues between the United States and our friends, and between the governments of our friends' countries and some of their own people.

I suspect in the end these issues turn less on the impact of oil prices than they do on judgments made in the region and elsewhere about whether the current U.S. policy will outlast Saddam Hussein. He clearly believes he can and will outlast the policy.3