‘Goldilocks’ and the fantasy about the ‘fair price’ of oil

Robin Mills

• Last Updated: July 26. 2009 11:25PM UAE / July 26. 2009 7:25PM GMT

In 1969, the Shah of Iran, visiting Washington for Eisenhower’s funeral, offered to sell the United States a million barrels of oil per day for 10 years at US$1 per barrel. The Americans found the price too high, and turned the offer down. By 1974, with the first oil shock underway, oil was selling for $12. Arguments about a “fair oil price” have continued ever since.

But is this idea of fairness even meaningful? What is a “fair” price for oil, acceptable to both buyers and sellers? Could the world agree on such a price?

This concept of fairness is an interesting one. We do not often talk about the fair price of a Porsche, a mobile phone or a Starbucks coffee. It is accepted that these items are priced in a competitive market, and we are free to buy, or not, as we choose.

Oil is different, because it is a largely homogeneous commodity, essential to modern economies, where one group of suppliers (Opec) exercises strong market power. An unhappy history still colours debate over oil pricing. Opec’s very formation in 1960 was triggered when western oil companies made unilateral cuts in the official selling prices used to calculate their tax payments to the aggrieved host nations. For another decade after the 1973-4 crisis, Opec had the upper hand – production cuts led to high prices. The consuming countries formed the International Energy Agency (IEA) to fight back.

The debate recently seems to have been driven by the extraordinary fluctuation of oil prices. When oil reached $147 per barrel in July last year, as the world was slipping into the economic crisis, the price was clearly too high for consumers. When in February 2009, it plunged below $35, many oil exporters faced budget crises, and ambitious expansion plans were shelved.

Whatever the actual level, there is general agreement that excessively volatile prices are bad. Consumers choosing between a Hummer and a Prius, companies investing billions in a deep-water oil fields and governments relying on oil revenues to fund health and education all want some certainty on future prices. But such stability is elusive. As both oil demand and supply respond only sluggishly to changing prices, small physical imbalances can shift the market enormously.

Even if we can see through the clouds of volatility, it is hard to find a basis for a reasonable price level. As recently as 2003, Opec had an official band of $22-$28. Perhaps it should be $40-$50, the point at which the more prudent Opec states can balance their budgets? Or $80, thought enough to make extraction of the voluminous Canadian oil sands commercial? Sheikh Khalifa, the President of the UAE, recently suggested that $70-$75 was fair, the Russian president Dmitry Medvedev talked of $70-$80, King Abdullah of Saudi Arabia proposed $75, while major oil companies are budgeting on $60-$70.

So on the producers’ side, there appears to be consensus on a price just below the cost of major alternatives. Yet consumers might not agree, as Gordon Brown, the UK prime minister, suggests that Opec production cuts would be “scandalous” in the current recession. Inflation-adjusted prices have been above Opec’s indicated level for only six years in the last hundred. Expensive oil is sufficient to encourage costly new supply, such as Brazilian deep-water oil, and to drive consumers to conserve. India and China are already raising petrol prices, while the Obama administration is tightening fuel economy standards. Oil averaged $19 per barrel from 1985-2002; perhaps the new “Goldilocks price” is around $50 per barrel.

So what matters is not whether a price is “fair”, but whether it is efficient. Oil has to be competitively priced against alternatives, such as electric cars, and cheap enough so that consuming economies can grow. Since most industrialised countries tax oil use heavily, they cannot justifiably complain about Opec’s pricing policy. Consider that the UK, which consumes about as much as Libya produces, earns some $45 billion (Dh165 bn) annually in fuel taxes, greater than Libya’s oil revenues of some $36 bn. Nor should consumers naively expect that oil exporters, however pro-western, would raise production so much that prices, and overall revenues, would plummet.

On the other hand, the price only has to be high enough to permit investment in new fields to stave off depletion and meet growing demand. Major oil nations may want to secure excess revenues to fund national budgets, but that depends on international oil markets, not on the altruism of their customers. Anyway, exporters are not a homogeneous group, any more than importing nations. Qatar and the UAE might be comfortable as low as $40-$50 per barrel, while Venezuela, Iran and Iraq seek $90 or more.

The balance of power between consumers and producers shifts over the course of industry cycles. When China is growing rapidly, or Nigerian oil is interrupted by militants, prices have to rise. When the world falls into recession, or a flood of supply arrives from Iraq or Brazil, prices must fall. We cannot imagine that the same “fair price”’ would be appropriate in these very different circumstances. The world would not manage to reach consensus before the situation had changed again – as the Shah and the US found.

Prices, though, were stable from 1931 to 1970, despite the Great Depression and Second World War. Again from 1986 to 2000, despite the first Gulf War, volatility was relatively low. In both cases, the key was spare capacity, that could be turned on or off at short notice to counter the unexpected. So, rather than talking about a “fair price” on which consumers and producers will never agree, a more fruitful approach would be for consumers to bear some of the cost of creating a safety margin and tackling energy insecurity. Such co-operation might be more productive than rhetorical flourishes about “fair prices”. The alternative is not attractive for either side – continuing destabilising price swings in the short term, strains within Opec and an ongoing drift away from oil in the longer term.

Robin Mills is a Dubai-based energy economist and author of The Myth of the Oil Crisis