Crude Volatility

As the 1960s dawned, titanic shifts in the global oil market had begun to erode the foundations of the Texas Era of price stability. Texas Era regulators and major oil company executives had used every tool in the supply manager’s toolkit to stabilize prices at high levels—quotas, market share agreements, pooling arrangements, and price formulas. While oil state regulators and major oil companies did not formally cooperate, both had the same overriding goals: Calibrate the flow of oil to the market to roughly equal demand. Prevent excess production and investment in infrastructure. Avoid price busts. But with sweeping changes in the patterns of oil supply and demand as well as increasingly assertive anticolonial movements in the Middle East steadily gathering force, the stage was set for chaos in the oil world.

After World War II, the Seven Sisters not only started losing revenue from their concessions (as noted earlier in 1948 Venezuela imposed a formula requiring majors to share profits from oil concessions on a 50–50 basis and other producing countries in the Middle East soon followed suit)—in some cases, they began to lose control altogether. Iran provides a good illustration of how the majors as well as various governments in the volatile region, at least initially, were able to react to shifts in the global oil market without disturbing price structure in a big way.

Hoping to replicate Mexico’s nationalization of its oil industry thirteen years earlier, in April 1951 the newly elected and fiercely nationalist Prime Minister of Iran Mohammad Mossadegh signed a law nationalizing the country’s oil assets. The ejection of BP—Iran’s sole southern concessionaire, then called the Anglo-Iranian Oil Company—prompted threats and reprisals from London. BP and her six other Sisters promptly boycotted Iranian oil exports, forcing the country’s production to fall to near zero. The sudden loss of Iran’s oil spurred U.S. officials to activate some of the procedures and policies used during World War II to encourage maximum oil output and efficient transportation, and the majors increased production from their concessions in Saudi Arabia, Kuwait, and Iraq. Although world production rose by three times more than the amount of Iran’s lost supplies by 1952,¹ the United States and the United Kingdom were concerned enough about permanently losing Iran’s oil and about possible communist encroachment that in early 1953 they began preparing and executing steps to undermine Mossadegh and replace him with a friendlier premier. Mossadegh was overthrown in a coup in August 1953, the Shah was reinstated, and the door to the West reopened (wider than before, as Washington insisted that BP share its Iranian concession with other companies, including U.S. independent producers).²

Once the embargo was lifted, the new participants in Iran’s production had to find a way to integrate Iran’s exports without flooding the market. It was a tricky endeavor, not helped by the Shah’s determination to make up for lost export revenue from 1952–1954 by raising output. The majors turned to Saudi Arabia. Exxon, present in Saudi Arabia and about to enter Iran, appealed to Saudi King Ibn Saud’s anticommunist feelings to ask that he reduce Saudi production to accommodate Iranian oil’s return to the market. The King grudgingly agreed, but insisted that Iran’s production be limited to only the amount needed to keep the communists at bay.³ By first increasing sales from concessions outside Iran and then reducing them to accommodate Iran’s return, the majors were able to handle the political and market disruption without much swing in oil prices.

But while nationalization was reversed in Iran and the majors were able to minimize market disruption, the dynamics were indicative of a larger trend that was not in the majors’ favor. Anticolonial, nationalistic sentiment swept away regimes in other major oil-producing countries where the Seven Sisters operated. The intensely anti-western feeling stemmed mostly from Egypt’s Arab nationalist leader Gamal Abdel Nasser, who was idolized by revolutionaries in the Middle East. Nasser regarded western oil concessions as an intolerable affront and a humiliating legacy of colonialism. He promoted Pan-Arab solidarity and political unification, instilling a will throughout the Arab world to singly and collectively confront the West. Since Egypt did not have much oil, Nasser’s Pan-Arabism did not translate into collective attacks on the Seven Sisters’ concessions.

While Pérez Alfonzo had been in exile in the United States, he had closely studied the Texas Railroad Commission (TRC) and other quota-setting states. Deeply impressed, he concluded that Venezuela and other producers needed the same thing—a strong cartel to ensure fair and stable prices for oil producers.⁴ Pérez Alfonzo retained a TRC consultant to advise him on how quotas operated.⁵

The main reason Pérez Alfonzo favored an international cartel was because Venezuela’s production costs were about four times higher than those in the Middle East (about $0.80 per barrel versus $0.20, respectively.) As a high cost producer, Venezuela stood to benefit if lower cost Middle Eastern producers restrained their production. Just as TRC quotas benefitted higher cost wells at the expense of lower cost ones forced to curtail production, Pérez Alfonzo hoped that high cost Venezuela could shift and share the burden of cuts by including low cost Middle East producers in collective production restraint agreements. Moreover, Pérez Alfonzo was an ardent physical conservationist and believed Texas-style quotas would prevent excessive production and depletion of reserves.⁶

But Pérez Alfonzo would have to deal with more immediate problems before he could realize the dream of cartel. Just as Pérez Alfonzo assumed office, President Eisenhower announced new oil import quotas, stemming from domestic U.S. political opposition to rising imports. Quotas were a special threat to Venezuela; 40 percent of its exports went to the United States.⁷ Venezuela’s close proximity to the United States had offset higher costs relative to its competitors in the Middle East, but Eisenhower’s new quotas swept that away.

Shocked at the import quotas and offended by special exemptions Washington granted only to Canada and Mexico, Pérez Alfonzo at first tried to cut a special deal with the United States. He flew to Washington to propose a hemispheric oil system in which Venezuela would be assured a slice of the U.S. market. U.S. officials showed no interest in Pérez Alfonzo’s proposal and offered no response.⁸ Insulted, Pérez Alfonzo turned his attention to Middle Eastern producers, and to propose his plan for an international cartel modeled on the TRC. He hoped and expected nationalism coursing through Middle Eastern countries would prime them to join in his plan.

In July 1958, Iraqi army officers overthrew Iraqi King Faisal II, murdering him and his strongly pro-Western prime minister, Nuri es-Said. Before the coup, Iraq and the majors operating the Iraq Petroleum Company had been amicably negotiating the terms of their relationship, but relations with foreign oil companies soon soured under the new and shaky military regime.

In the meantime, the Seven Sisters’ profits were being squeezed as they were forced to sell their oil at lower actual market prices but were at the same time obligated to calculate profits tax payments and royalties on higher, administered prices that existed on paper but did not reflect supply and demand realities.⁹ For the majors, it was only fair that producer governments share the burden of lower oil price by receiving less revenue. So the majors reduced administered prices in 1959. The major’s move to reduce these administered prices turned out to be just the spark Pérez Alfonzo needed to ignite producer anger against majors—and to convince them of the need for a cartel. Incensed, Egypt’s Nasser convened the First Arab Petroleum Conference in Cairo in April 1959. Pérez Alfonzo saw his chance to implement his Texas-style producer cartel plan and led a delegation to the conference, one of two non-Arabs to attend. (Another non-Arab, Iranian Manucher Farmanfarmaian, director at the National Iranian Oil Company, attended the conference as an observer, though not in an official capacity.) Delegates noisily railed against foreign oil companies and decried the concession system as a humiliating relic of an outdated colonialist era, but the conference produced little. However, Pérez Alfonzo worked assiduously and quietly on the sidelines to sell his plan to create a collective organization of producers that would confront the majors.

The pivotal meeting was between Pérez Alfonzo and Saudi oil minister Abdullah Tariki, who was quickly won over and became a strong proponent of Pérez Alfonzo’s plan. While Venezuela and Saudi Arabia were vastly different in terms of production costs and experiences as oil producers (Venezuela old, Saudi Arabia new), they shared a common connection to the United States, as the same American companies (Exxon, Mobil, Texaco, and Chevron) operated concessions in both countries.¹⁰ Pérez Alfonzo and his new friend and collaborator Tariki convinced Farmanfarmaian and delegates from Iraq, the United Arab Republic (UAR, Egypt and Syria’s short-lived union), and Kuwait, to sign a secret gentlemen’s agreement referred to as the Maadi Pact calling for annual consultations to discuss, among other things, the coordination of oil production.¹¹

While the Maadi Pact was the first step toward creating a producer organization, it was fairly inconclusive. But the majors soon gave producing countries the push they needed to unite. Pressure on the majors’ profits had continued with soaring production of cheap Soviet production, and Exxon—desperate to stanch the losses—initiated a second round of cuts in administered prices in August 1960, this time by 7 percent.¹² The move was controversial even within Exxon, with CEO Jack Rathbone insisting on the cut over the objections of colleagues and advisors who warned of a potentially vicious blowback from host governments. Exxon’s unilateral move, made without consultation with producer governments, was followed by other majors. Rathbone’s nervous colleagues were proved right; later, they would dub him the “Father of OPEC.”¹³

With the second round of administered price cuts, a senior Exxon executive in Iraq who had opposed the cut, noted, “all hell broke loose”—he was lucky to get out of Baghdad alive.¹⁴ The Seven Sisters’ collective if disjointed imposition of administered price cuts spurred producer governments toward a collective response. “OPEC couldn’t have happened without the oil cartel [Seven Sisters],” one Kuwaiti said, “We just took a leaf from the oil companies’ book. The victim had learned the lesson.”¹⁵

Following Exxon’s administered price cut, Pérez Alfonzo—OPEC’s real father—sprang into action. Joined by Tariki, his immediate goal was to transform the Maadi Pact from a gentlemen’s agreement into a firm alliance able to confront the majors. Iraq’s new revolutionary government was happy to host a meeting of aggrieved producers.¹⁶ Iran, Iraq, Kuwait, Venezuela, and Saudi Arabia met in September 1960 in Baghdad and formed the Organization of the Petroleum Exporting Countries, OPEC. Collectively, OPEC producers accounted for “over 80 percent of the world’s oil exports.”¹⁷

OPEC’s immediate focus was on preventing any further erosion in its share of income from the concessions. At the heart of the struggle between OPEC members and Seven Sisters was a disagreement on how to share what industry called the “rent”—the margin between relatively low costs of production and the high prices of petroleum products sold in consuming countries. The rent was big and flowed in two directions—to company profits and to government tax revenues. The implementation of 50–50 profit share by the producers ten years earlier was an attempt to claw more rent from the Seven Sisters. The Seven Sisters’ cuts in administered prices in 1959 and 1960 were an attempt to recapture rent from the producers. But the tide was turning toward host governments and away from large western oil companies operating colonial-era concessions.

Thus, OPEC’s first significant decision (and, as it turned out, the only significant decision it would make in its first ten years) was to collectively oppose any further cut in administrative prices. While the majors did not perceive OPEC as much of a threat, they stopped cutting administrative prices for good, both to avoid angering the new producer group and because supply and demand fundamentals started to firm up in the 1960s, making further cuts unnecessary.

While presenting a united front against administered price cuts, OPEC members bickered about everything else. Differences were exacerbated by tensions stemming from historical rivalries. Baghdad at first did not even recognized Kuwait’s sovereignty, considering it a province of Iraq. Arab Saudi Arabia and Persian Iran vied for regional dominance and led competing sects within Islam. On oil strategy, Iran and Venezuela differed strongly over OPEC policy: Whereas Caracas wanted OPEC to cut supplies to prop up prices, Iran wanted to increase supply as much as possible while resisting administered price cuts and negotiating for higher royalties and taxes. Quotas were too aggressive for the Shah, whose memories of western embargo and intervention were fresh; he was not eager to overly antagonize western oil companies and their governments, and directly seizing control of supply would violate the concession agreements. (Saudi Arabia was likewise wary of antagonizing the United States, which they looked to as a partner and protector from the Soviet Union.) Legal contracts were still considered sacrosanct in OPEC’s early years, and breaching them was a step too far. Generally, other OPEC members sided with Iran and opposed quotas and collective supply cuts to raise and stabilize prices. OPEC governments depended on the majors for access to global markets and with supply growth exceeding demand, the members of OPEC regarded each other as competitors. Moreover, burgeoning production from countries that were initially outside OPEC, such as UAE, Libya, Algeria, and Nigeria, could offset cuts from the original five OPEC members.¹⁸

So while Pérez Alfonzo pushed for TRC-style supply cuts, OPEC initially chose just to study rather than implement this strategy. Pérez Alfonzo’s leverage within OPEC—his main ally, Tariki—had only weak influence in Riyadh, where the Saudi royal family was distracted by a prolonged power struggle between factions led by King Saud and Crown Prince Faisal that would drag on until 1964. OPEC’s priority, most members agreed, would be to bargain collectively with the majors for higher administrative prices and tax takes—i.e., higher rent.

The five OPEC members set up a Secretariat and agreed to meet twice a year, but policy divisions, rivalries, and turnovers in leadership slowed progress. Iraq stopped attending meetings from 1961 to 1963 over its territorial claims on Kuwait. In April 1965, Venezuela made another push within OPEC (by then expanded to include Indonesia, Qatar, and Libya) to set quotas. OPEC’s economic staff prepared demand forecasts for OPEC crude oil from mid-1965 to mid-1966, as counterparts at the TRC did for Texas crude oil. In July, OPEC members met to discuss how to share this output. But support within OPEC remained anemic, especially since the two biggest proponents of quotas within the organization—Pérez Alfonzo and Tariki—had by then left the scene. Tariki had been replaced by Sheikh Ahmed Zaki Yamani in 1962 and Pérez Alfonzo, who grew steadily disenchanted and then disgusted with the course Venezuela and OPEC adopted in the 1960s, resigned in 1963. (In the 1970s Pérez Alfonzo famously declared “[oil] brings trouble … Look at this locura—waste, corruption, consumption, our public services falling apart. And debt, debt we shall have for years.”¹⁹) So ultimately this first attempt by OPEC to agree on Texas-style quotas was “a farce,” according to former OPEC Secretary General Francisco Parra who participated in OPEC’s early meetings.²⁰ Iran insisted on a high quota and was widely viewed by other members as unlikely to ever make cuts. Saudi Arabia refused to abide by any quota and Libya said it would not consider its quota binding. The agreement was not implemented and each member perused its own separate production policy.²¹

By the late 1960s, OPEC did not have much to show for itself other than fostering a bit more solidarity among member governments and winning some price and tax achievements. OPEC had failed to unify members into a strong organization, much less to implement Pérez Alfonzo’s dream of setting quotas. While the Seven Sisters later regretted their 1960 administered price cut and never repeated it, neither they nor Western countries were overly concerned about OPEC as a threat to oil market stability. The oil companies largely ignored OPEC and continued dealing with individual concession governments.