Will High Oil Prices Stall Economic Recovery

Just as the Indian economy—and world economy—are recovering from last year’s recession, trouble in the Middle East has pushed up the price of oil again. It almost touched $ 30 per barrel before receding to around $ 25 per barrel.

This raises two questions. First, will President George Bush’s avowed aim of toppling  Saddam Hussein lead to new tensions in the region, and send oil prices soaring, as in the  1991 Gulf War? Second, will high oil prices push the world into a double-dip recession?

After the September bombing of the World Trade center, President Bush got support from all over the world for his war on terrorism. This facilitated US action in Afghanistan, and Bush assumed similar support for other operations like toppling Saddam. After all, other Arab states had supported his father in the Gulf War of 1991. Many European countries were ambivalent or opposed to using military force against
Saddam. But after Afghanistan, Bush believed he could act  unilaterally in Iraq.

The Palestinian intifada has changed all that. Israel says it is being targeted by suicide bombers just as the World Trade Centre was. It claims the right, no less than  the US, to defend itself militarily. Bush is sympathetic. After all, Israel has long been regarded as a valuable strategic ally of the US.

But this notion is a major error. Israel is actually  a strategic liability that cripples the US in the Middle East. This does not mean the US should dump Israel unceremoniously. It should deal fairly with an old friend, even if it is a liability. But there is no case for pretending that Israel is strategically valuable.

In the early part of the  Cold War, when many Arab states were pro-Soviet, Israel was clearly a dependable US ally with similar ideological moorings. The rise of OPEC and two oil shocks showed the US that even ostensibly Arab states could nationalize American oil companies and jack up the price of oil to soak western consumers. However, the US found it expedient to live with  OPEC, and use its political influence with Saudi Arabia to keep the oil tap flowing. Friendship with both Israel and Arab oil producers seemed compatible.

Today, the intifada has changed everything. For most Arabs, the main enemy is not Saddam but Sharon. The US cannot hope to keep Arab states in its coalition while ignoring events in Palestine. Any US attack on Iraq will need bases in Arab countries, which will be denied as long as Palestine is ablaze. Saddam has cleverly exploited the situation by declaring one month’s embargo on oil supply to the US.

Right now,  Arab states see Saddam rather than Bush as an ally. They see Israel rather than Saddam or the Hamas as the mother of all terrorists. So much for Bush’s global coalition.

Bush has expressed fears that high oil prices may halt the US economic recovery, and cost him elections to the Senate and House of Representatives later this year. The fact is that the US today needs Saudi Arabia much more than it needs Israel. Saudi Arabia has the world’s largest reserves, 260 billion barrels of oil. It  produces 7.4 m. barrels/day  a day, almost entirely for export. Russia is not far behind with production of 7 m. barrels/day. But a lot of Russian production is for domestic use, and its output falls sharply in winter.

Moreover, Saudi Arabia is the only country to keep spare capacity of 3 million barrels/day at considerable cost. This is a political decision, not commercial. It enables Saudi Arabia to play the role of swing producer, filling gaps that appear in world supply and then withdrawing in times of glut. It is the oil guarantor of last resort. Without Saudi Arabia, cyclical oil booms and busts would be far sharper.

Iraq produces 2.3 m. barrels/day , 4 per cent of world output.  Because Saudi Arabia is available as swing producer, the US can shrug aside Saddam’s oil embargo. Projections suggest that world dependence on Middle East oil, and Saudi oil in particular, will increase sharply in coming decades.  So  Arab oil states will become even more strategically important to the US.

In this context, Israel is a major liability for the US. Israel’s military forays in the West Bank have ended any chance of early action against Iraq. Indeed, a report in the Financial Times quotes British experts as saying no military action against Iraq looks likely for at least a year.

To maintain his global coalition, Bush realizes that he must pressure Israel and try and bring about peace in Palestine. Last September, he declared that all who were not with the US were against it. Today the Arabs are not with the US, yet he dare not treat them as foes. He needs their oil.

Which brings us to the next question: how will this affect the price of oil and the global recovery?  I am an optimist. First, Saudi Arabia’s role as a swing producer provides some insurance against an explosive price increase. Second, the recent spike in oil price owed a lot to political turmoil in Venezuela, which shut down  production of 2.5 m. barrels/day, more than Iraq’s output. Now that its controversial President Chavez has resigned, Venezuelan production will resume, and that has immediately calmed prices.

What about Bush’s determination to kick out Saddam? Well, even if he manages to put out fires in Palestine—which is by no means certain—that will take time. And even after that, it will take time to organize diplomatic support and military logistics. Mobilizing troops and arms for the Gulf war in 1991 took his father almost six months.

So, for at least a year, do not expect a fresh Gulf war to send oil prices spiraling. The global recovery from recession should be complete well before that.

What do you think?