The Economics of Oil

With the Opec ministers meeting in Osaka this week, the economics of oil are uppermost in many minds at a difficult time for Middle East politics and diplomacy.

After Iraq's U-turn on United Nations' weapons' inspectors the expectation is for no change in Opec output quotas. That should stabilize prices at their present levels, allowing for the fact that quota busting is already high enough to keep prices stable.

But it should not be forgotten that Opec can get it wrong. It was only in 1998 that the cartel foolishly opted to raise production after the Asian crisis had caused demand to plummet. The impact was immediate and oil prices of $10 damaged Opec economies considerably.

Indeed, only the much better prices of 2000, 2001 and now 2002, have restored the treasuries of Opec members to their former glory. Where will the oil market move to now?

Much still depends on what happens in Iraq. The United States is bristling for a fight and hopes to achieve a UN mandate for military action against Saddam Hussein. The fact that the oil market hardly shifted after his U-turn suggests that the market believes that little has changed.

If the US attacks Iraq and swiftly achieves a regime change, then the oil market will register little more than a brief spike in prices. However, anything like a more long and drawn out military campaign would send prices much higher, $40 to $60 per barrel on some estimates.

For oil economies this would mean a windfall gain, unless supplies were seriously interrupted in which case higher prices would not translate into higher revenues.

In the meantime, Saddam Hussein's regime probably keeps oil prices up to $5 per barrel higher than they would be without a 'war premium', and it is understandable why some states might prefer that he remained in power for their own immediate economic benefit.

However, the wider benefits to the Middle East economy of not having a moribund and isolated Iraq would be quite considerable. Foreign direct investment would certainly improve, both into Iraq and for the surrounding region, and that would help economic reform, both from the point of view of capital markets and privatization.

That is the optimistic scenario. On the other hand, the post-Saddam Middle East might become very unstable, with militant religious groups up in arms at US interference in Arab internal affairs. But that is the pessimists view. More likely the Middle East will prove a very good place to do business.