Oil and terrorism: a distinguished scholar offers three scenarios for the future.

• Author: Perry, George L.

The terrorist attack of September 11th raised important questions about what may lie ahead for the world oil market and what it could mean for the U.S. economy. On three occasions in the past--the first two OPEC price shocks in the mid and late 1970's and the Gulf War at the start of the 1990's--trouble in the Middle East led to higher oil prices.

The map of world oil supply has changed noticeably since the mid 1970's, with important new sources of supply coming on stream from the North Sea, Mexico, China, Alaska, and elsewhere. Most recently Russian production, which fell by half after the breakdown of the former Soviet Union, has started to rise and is projected to continue rising for years. Russia is already the world's third largest producer and second largest exporter of oil. Yet the Persian Gulf producers led by Saudi Arabia still account for over a quarter of the world's oil supply and continue to be the key to the market.

The position of the United States in the oil market has gradually changed over time (table A). Its oil use leveled off during the 1980's as consumption responded to conservation measures and to the higher prices at the start of the decade. By contrast, U.S. consumption rose 16 percent over the following decade. U.S. oil production declined slowly and its share of world production fell to below 12 percent in 2000 from nearly 24 percent in 1970. As a result of these different trends in consumption and production, imports have risen substantially and now provide half the U.S. oil supply.

While that makes the United States more reliant than ever on imports, that reliance makes no meaningful difference to its exposure to crises in the oil market. Oil is freely traded around the world and cargoes get diverted to the highest bidder. So allowing for quality differences and transportation costs, oil is always available to the United States at the world price and, absent price controls, domestically produced oil sells at that same price. In the present situation, the risk to the U.S. economy comes down to how events affect the world supply-demand balance for oil.

THE LIKELY OUTCOME FOR THE ECONOMY: DEMAND EFFECTS AND OIL PRICES

The immediate economic impact of the terrorist attacks has been to depress the outlook for the U.S. and world economies by curtailing air travel and raising uncertainty. Most economists agree the U.S. and world economy are in a recession, though how long and deep it will be is unclear. This downturn in economic activity is noticeably reducing world oil demand. The Saudi led OPEC cartel (1), which still accounts for 40 percent of world supply, is negotiating, both with its members and with producers outside OPEC such as Russia and Mexico, to reduce production so as to stabilize prices.

Historically, OPEC's ability to control prices has been uncertain. At times the cartel's unity has eroded, leading to steep price declines. And over the longer run, as demand responded to higher prices and supply from other parts of the world expanded, the cartel has been unable to sustain the higher real price for oil it had achieved by 1980 (figure A). Today the cartel may have trouble getting the cooperative production cuts that would be needed with a serious world recession. Unless the Saudis themselves are willing to make most of the needed cuts, prices, which had fallen by $8 a barrel by late November, could fall noticeably further.

Supply-demand imbalances brought prices down to nearly $10 a barrel in the mid-1980's and again in the late 1990's. Today such a price decline would directly help the ailing airline industry, for which fuel is the main variable cost. And it would further slow the already low rates of inflation in the industrial nations, making it more likely that inflation-phobic...