Pricing of Oil

A study of the pricing of oil in world markets may shed some light on the analysis of Petrodollars.

Pricing of oil as far back as the 1920's was established on the basing point system. The United States and Mexico were the two main exporters of oil at that time. Therefore, it was natural that the price of oil in world trade was mainly influenced by the price of oil from the Gulf of Mexico. The basing point was simply calculated on the basis of the price of crude oil quoted in the Gulf of Mexico plus transportation costs, irrespective of the point of origin, from the Gulf of Mexico to the point of delivery. For example, if oil is shipped from Abadan in Iran to Calcutta in India, the buyer will have to pay the price of the Gulf of Mexico in addition to the cost of transportation from the Gulf of Mexico all the way to Calcutta. Even with the emergence of Venezuela as one of the major exporters of oil in the late twenties, this basing point system was not disturbed.

However, during WWII and with the emergence of the Middle Eastern countries as important suppliers of crude oil to the West, England became extremely concerned with the phantom freight rate being charged. In 1945 a new basing point system was established in which buyers in the Arabian Gulf would still pay the posted price of oil from the Gulf of Mexico in addition to a freight rate from the nearest supply source. Therefore, it was feasible for Middle Eastern oil to compete geographically with U.S., Mexican or Venezuelan oil in nearby markets.

As the United States became concerned over the depletion of its own oil resources, the growing demand for fuel in Europe led to a substantial increase in the Middle East oil production.

Some writers concluded that in order to direct the oil market towards the Middle East and to ensure conservation of the United States oil resources in particular, Ait was necessary that the relative price of Middle Eastern crude oil should fall so as to enable it to compete with Western Hemisphere oil in Western Europe. Hence in 1945-47 Gulf of Mexico prices of crude were raised by $1.32 per barrel (to $2.68 for crude oil of 34 degrees API) [Arabian] Gulf prices were raised only by $1.17 (to $2.18). By March, 1948, all major Middle Eastern producers had established a uniform [Arabian] Gulf Price of $2.18 per barrel (341), at which price existing freight rates equalized Middle Eastern and Gulf of Mexico based prices in London. In May 1948, [Arabian] Gulf prices were reduced to $2.03. This was intended to make Middle Eastern oil competitive with Venezuelan oil in Western Europe. Since Venezuelan prices continued to equal Gulf of Mexico prices (minus the above mentioned import duty into the United States), while Venezuela-western Europe freight rates were some 154 per barrel lower than United States-Western Europe rates, it was necessary to bring the price of Middle Eastern oil slightly below that of Venezuela. @

Observing oil price movements since 1948, we find that the gap between the price of the Middle Eastern oil and that of the Gulf of Mexico has widened. Not only was Middle Eastern oil priced cheaply, but it was also abundantly produced. Fluctuations in tanker freight rates after WWII created new markets for Middle Eastern oil in the Far East, particularly Japan.

Reviewing the pricing of oil in world trade one can easily deduce the following facts:

1. Pricing of oil in world trade was not determined by the competitive forces of supply and demand, but was actually administered, controlled and manipulated by the international oil companies, mainly by the so-called seven sisters: Standard Oil of New Jersey (Exxon), Standard Oil of California (Socal), Standard Oil of New York (Mobil), Gulf Oil, Texaco, Anglo-Persian Oil (British Petroleum) and Royal Dutch Shell. In my view that those companies having owned most of the oil in the world through oil concessions, pursued an oligopolistic policy to maximize their profits. By keeping the price of oil low, they paid less royalties as they were usually a percentage of the posted price. Furthermore, they marketed their cheap oil to their parent companies, to their own refineries and/or to their own down stream operations, thus widening the gap between the cost of the main input, namely crude oil, and the revenues from the sale of the final products.

2. As a result of an administered pricing of oil, there was a disparity of prices, particularly between oil originating from the Gulf of Mexico and that originating from the Middle East. From 1948 to 1973, the gap between these two sets of prices was widening over time. Thus terms of trade of Middle Eastern exporting deteriorated more rapidly than those of Venezuela.

3. A complicated structure of oil pricing emerged as a result of diversified terms of international oil concessions and historical developments of oil ownership. There is, of course, a market price which reflects the actual price paid for every transaction and which is usually less than the posted price of oil. International oil companies came up with the notion of posted price which is a reference figure used to compute taxes and royalties paid to the Governments or rulers wherever oil was pumped. Then there is a buy-back price which emerged with the implementation of OPEC=s Resolution XVI,90 which stressed the necessity of oil-exporting countries to participate in the ownership of concession-holding companies. The buy-back price is what an oil company pays to the country from where oil is exploited for the percentage of oil produced which represents the governments ownership share in the company. In 1974, for example, the ownership of share of Saudi Arabia in the Arabian-American Oil Company (Aramco) represented sixty percent of the total production. A buy-back price is that price Aramco pays the government of Saudi Arabia on sixty percent of the oil produced.

Needless to say, this type of pricing does not exist in countries which have reacquired the full ownership of their oil production. In other countries which still share oil production with international oil companies, the buy-back price also is less than the posted price. With the current fluid situation of oil issue, I do not think that the multiple and complicated system of oil prices can continue.

4. The Middle East oil was cheaply sold in world markets The following table shows the series of posted price of Saudi Arabian oil, 341, F.O.B. Ras Tanura since 1947. In money terms, in which figures are not adjusted for inflationary component, we find that the posted price declined from $2.18 in 1947 to $1.80 in 1970, a monetary decline of seventeen percent during this period. In order to adjust the posted price of oil, I used the United States Wholesale Price Index of all commodities and an average Gross National Product Price Index of seventeen European countries as two reasonable yardsticks to remove the inflationary component of the price series. When these posted prices were deflated by the US Wholesale Price Index, the price of oil fell from $2.18 in 1947 to $1.25 in 1970, a decline of forty three percent in real terms. The decline was even sharper - sixty eight percent - when posted prices were deflated by an average price index of seventeen European countries. Thus Saudi Arabian oil as an example for other Middle Eastern countries bought less and less in real commodity exchange markets. This also means that the terms of trade of Middle Eastern oil-exporting were deteriorating over time. Furthermore, if we allow for the fact that the posted price is usually above market prices due to price discounts - which were sometimes substantial - one can easily conclude that oil exploitation of Middle Eastern oil was only suited to serve the economic interests of oil importing countries at the expense of oil-exporting nations. Further decline in the price of oil in 1959 triggered the anguish of oil-exporting countries. Therefore based on meetings of Iraq, Iran, Kuwait, Saudi Arabia and Venezuela, the Organization of Petroleum Exporting Countries (OPEC) was formed in September 1960 of which its current member countries are thirteen. The intention was to form a unified front as a means of collective bargaining with an extremely powerful group of buyers which had dictated an oil policy, in pricing as well as in production, along its own terms.