Oil: "The War Begins"

By John Greenwald

Prices break, and OPEC scrambles to keep them from going into a free fall

From Europe to the Middle East, harried members of the Organization of Petroleum Exporting Countries huddled through the week. The structure of bloated oil prices that OPEC had erected over the past decade, condemning rich and poor nations alike to recurrent bouts of inflation and stagnation, was shaking wildly. Prices had broken and were threatening to go into a free fall.

To prevent that from happening, the oil ministers of Saudi Arabia and several of its oil-rich Persian Gulf neighbors agreed to lower the official OPEC price by an undisclosed amount. The gulf nations were hoping to whip the other OPEC members into accepting the new price floor at a meeting this week. Failure to do so, the Arabs seemed to sense, could mean the end of OPEC. Said a senior OPEC official: "The war begins. It is very dangerous."

Since late 1973, when OPEC jacked up its charge for a barrel of oil from $3.07 to $11.65, crude prices have moved mostly in one direction: up. The big question, especially after the 1979 Iranian revolution ignited a wave of increases that pushed the official price from about $13 to $34, was: How high would the price go? Now the question is: How far will it drop? The answer, as ever, is: Nobody knows.

The cutting actually started two weeks ago when Britain and Norway, which are not OPEC members, dropped their charge for North Sea oil by $3 per bbl., to $30.50. This precipitated the first public break in OPEC ranks. Nigeria, blessed with very high-quality crude oil and burdened by heavy debt, said it was slashing its price by $5.50, to $30 per bbl.

The announcement was stunning, not only for the historic implications of the crack in OPEC but also because the cut is even larger than it seems. A barrel of Nigeria's Bonny Light crude, once refined, yields a higher-priced product mix than does the Arabian Light oil on which the OPEC bench-mark price is based. The Saudis used to insist that the "differential" should be $3, but more recently have reportedly been willing to accept $1.50. Even at that, the official OPEC price would have to fall to $28.50 to make it competitive with $30 Nigerian oil. In Lagos last week, Mallam Yahaya Dikko, Nigeria's top petroleum official, stood behind his nation's pledge to match any further reduction in the price of North Sea oil.

To keep the price cutting from getting out of hand, OPEC members held a desperate round of meetings in Paris and Riyadh. For the first time, non-OPEC members were being welcomed into the discussions. The oil ministers sought out representatives from Britain, Norway and Mexico, a step that symbolized the success of the non-OPEC world's attempt to free itself from the organization's stranglehold. Last year, for the first time in at least 20 years, the rest of the non-Communist world produced more oil than the 13 OPEC nations (54% to 46%).

One result of OPEC's meetings with nonmembers was that Mexico decided to postpone an announcement, scheduled for last Friday, of a drop in its oil prices. The implication was that Mexico would wait to see whether a broad agreement could be reached this week. Although the Saudis and their allies were mum, many experts believed the gulf producers had agreed in Riyadh to cut the official price to $30, too high to compete with Nigerian oil at the new price. But at week's end the British warned that they would make further reductions if OPEC sharply undercut the $30.50 North Sea price.

There were signs the gulf members intend to present their new price, whatever it is, to the rest of OPEC on a take-it-or-leave-it basis. By far the largest producers in OPEC, they could send prices through the floor if they chose to pump flat out. The threat could bring Nigeria and other wayward nations into line. As Mani Said al-Oteiba, oil minister for the United Arab Emirates, declared after the two-day Riyadh meeting, "If the other OPEC nations do not accept this accord, the gulf states will have to cut the price even more."

This is all good news for most of the world's population. Secretary of State George Shultz called it "the economic story of the year" in congressional testimony, and added later in the week that it would help spur the world's economic recovery. Treasury Secretary Donald Regan predicted that the cuts will create "more winners than losers."

On Wall Street, the stock market took off, although the rise was fueled not only by the news of falling oil prices but also by other signs that the U.S. economy was well on the way to recovery. On Thursday, the Dow Jones industrial average closed above 1100 for the first time in history. The week's crop of favorable economic news included a prime-rate cut from 11% to 10 1/2% at several big banks, and a Labor Department report that the Consumer Price Index had risen at an annual rate of just 2.1% in January.

Most oil-company stocks, however, failed to share in the rise. Atlantic Richfield, for example, which has enormous reserves of Alaskan crude, dropped 2% during the week. The four U.S. partners in Aramco, which pumps most of Saudi Arabia's crude, held up better than the rest. The reason: any cut in the official OPEC price will help end the squeeze that the four--Exxon, Standard Oil of California, Mobil and Texaco--have suffered as the spot oil price (see chart) has fallen below the $34 that they now pay the Saudis.

Expectations that lower oil prices could forestall a renewed outbreak of inflation led the bond market to boom, and prices of everything from silver futures to soybeans fell. Gold tumbled $60 during the week. Experts estimate that every $2-per-bbl. drop in oil prices cuts U.S. gasoline costs by 50 per gal. at the pump, so motorists should soon feel some gains. Home heating-oil prices also will decline.

The drop in oil bills is already having a perverse effect on the price of natural gas, which is regulated in so byzantine a fashion that declines in fuel-oil prices actually push some gas prices up. Lately, falling oil prices have inspired industrial users to switch from gas to oil. In a more rational world, this should cause gas prices to drop as well. Thanks to regulation, however, a decline in demand for gas merely forces homeowners and other customers to pay more because they must pick up the fixed costs of the system.

The rules were written without a thought that oil prices could trend lower, and President Reagan on Saturday proposed that they be scrapped over the next three years. Claiming that decontrol would push gas prices down in light of the current oil glut, not send them soaring as many consumer groups contend, he announced that he would introduce sweeping legislation to deregulate gas pricing. At the same time, he said, he would propose keeping a rein on cost "pass-throughs" to consumers.

Reagan's plan faces a rough road in Congress, but all sides agree that, with oil prices falling, something must be done about gas. Says Robert Means, director of analysis for the Federal Energy Regulatory Commission: "The whole system could break down in the next six months. We are facing a genuine emergency."

The biggest benefit of falling oil prices, it is often observed, is that they could have the force of a big tax cut. Data Resources, an economic forecasting firm, estimates that a $5-per-bbl. price cut would save U.S. households an average of $85 a year in energy expenses. Boosts from the energy reductions should then stimulate consumer spending on everything from chewing gum to cars.

Experts have been hotly debating the impact of tumbling oil prices on the international banks, which have a lot of their assets tied up in loans to countries and corporations that have been betting on a continued rise in the price of oil. Many analysts now believe that the problems of loans to oil-producing countries will be offset by gains experienced by energy-importing nations whose oil bills would be cut. At a breakfast with reporters at Washington's Sheraton Carlton Hotel last week, Commerce Secretary Malcolm Baldrige noted that eight out of ten developing countries would benefit from a drop in oil prices. Any lowering of prices exerts downward pressures on interest costs, he noted, and that will prove an enormous relief to borrowers. Thus, the price drop should prove a help to energy-importing Brazil, which owes foreign banks about $84 billion, while Mexico, which owes $82 billion, remains a trouble spot.

Now fears are beginning to surface that cheaper oil will induce consumers to return to their old wasteful habits. The lower price could indeed push consumption up, but worries of a huge short-term surge in demand are unreasonable. It is true that industrial users with burners equipped to switch quickly from gas to oil are doing so. A 1979 Government study suggests that the U.S. could consume an extra 500,000 bbl. per day of oil (a 3% rise in total consumption) if such switching became widespread. But otherwise the short-term response is likely to be limited. Explains Economist Joy Dunkerley of Resources for the Future, a Washington think tank: "If you've bought an efficient car, you don't run out and buy a bigger one once the price of gas drops 15-c-. If you've installed insulation, you don't just tear it out. People have made the investment, and they'll live with it." Coping with a bear market in oil will require some adjusting, but all things considered, it is a pleasant prospect. -- By John Greenwald. Reported by William Stewart/Beirut and Bruce van Voorst/ New York, with other bureaus

With reporting by William Stewart, BRUCE VAN VOORST This file is automatically generated by a robot program, so viewer discretion is required.