182. Action Memorandum From the Assistant Secretary of State for Economic and Business Affairs (Katz) to the Under Secretary of State for Economic Affairs (Cooper)1

U.S. Oil Strategy Toward Saudi Arabia

Issue

The uncertain conditions in the world oil market, as a result of the cessation of Iranian oil exports, emphasize the need to update our strategy to encourage Saudi Arabia to continue to meet the world’s essential energy needs.

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Our immediate objective is:

—to convince Saudi Arabia to continue to produce all the oil it can to help offset the shortfall owing to the Iranian situation.

Over the longer term, we seek:

—to obtain a Saudi decision to expand production capacity more rapidly; and

—to produce conditions propitious for a freeze of OPEC oil prices in 1980.

Background and Analysis

The strikes in Iran’s oil sector, which began to interrupt oil exports in late October, led other OPEC nations—particularly Saudi Arabia—to produce higher than normal levels of oil in November and December. Tight oil market conditions and uncertainty over the likely course of events in Iran were important factors behind the Saudis’ failure to press OPEC members to decide upon a lesser price increase at the December 16 meeting.2

In normal circumstances, the world oil industry adjusts to seasonal demand by building stocks during the second and third quarters of the calendar year, and drawing down stocks during the first quarter and part of the fourth. Since late December, the cessation of Iranian oil exports has withdrawn about 5.5 million barrels per day (mmb/d) from normal oil supplies. Saudi Arabian production has increased to about 10.5 mmb/d, or 2 mmb/d more than would have been anticipated at this time. Other OPEC members—primarily Kuwait and Iraq—have also increased oil output, and there is ample economic incentive for other oil producers to maximize output. We estimate that an additional 1 mmb/d is being supplied to the world oil market by producers other than Saudi Arabia. The remaining “shortfall” of somewhat over 2 mmb/d is being met by drawing down stocks. World oil stocks were very high late last year, partly as a result of seasonal stockbuilding and partly owing to anticipatory purchases in advance of the expected OPEC price increase.

With restoration of at least half of Iran’s normal exports within the next few months and continued additional output by other producers, oil market conditions will be manageable, though tight for the rest of the year. Unless conditions improve more rapidly than now seems likely, however, it would be futile to attempt to roll back any portion of OPEC’s announced quarterly price hikes. A more feasible objective would be to ensure that sufficient oil will be available to meet normal [Page 585]demand, avoid hoarding, reduce the chance for market-induced price increases in the remainder of this year, and set the stage for a price freeze in 1980.

In the immediate future, there is a danger that Saudi output ceilings or other restrictions could reduce incremental oil output needed to help offset the shortfall in Iranian exports. Since mid-1977, Saudi Arabia has maintained a ceiling of 8.5 million barrels per day, calculated as an annual average. Until the Iranian crisis, oil market demand never tested this ceiling. The Saudis have publicly acknowledged an obligation to meet the world’s essential oil needs and since the cutback in Iranian exports have permitted Aramco to produce at maximum sustainable levels.

A Saudi official recently warned Aramco, however, that Saudi Arabia is considering application of the ceiling on a quarterly basis. Aramco responded that this would impede its normal adjustments of output to meet seasonal demand, as well as interfere with the current all-out level in response to the Iranian cessation of exports. A series of exchanges was inconclusive, though it ended with an acknowledgement by a senior Saudi official that Aramco for the present could continue as before. Moreover, Deputy Petroleum Minister Khayyal, in a conversation with our personnel in Dhahran, clearly implied that Saudi Arabia would, at least in the near future, continue to produce over 8.5 mmb/d in order to help meet the Iranian shortfall without referring to the ceiling.3

Even when Iran’s production is restored in large measure, it will be necessary for higher than normal liftings from Saudi Arabia to continue. Strict application of the Saudi ceiling could interfere with the satisfaction of deferred demand and normal second and third quarter rebuilding of stocks by the oil industry.

Because the Saudi output ceiling has in the past served as evidence of their willingness to restrain production in order to maintain OPEC prices, we should not expect them to abandon the ceiling publicly or permanently. To do so might provoke cutbacks in production by other OPEC members now helping to offset the Iranian shortfall, especially if they suspected the Saudi action was a prelude to an attempt to freeze oil prices next year. Thus our approaches should be made privately, and we should not make any reference to the price issue while we urge [Page 586]continued maximum production in response to the shortfall in Iranian oil.

The current Iranian situation has driven home the dangers of a world oil market with only 5 percent spare capacity. While Saudi production capacity is adequate for foreseeable world demand over the next few years, present Saudi conservation and investment policies prevent the expansion of that capacity which will be necessary to meet unexpected contingencies as well as essential world needs in the mid and late 1980s. We must plan to discuss with some intensity with the Saudis the need for increased investment in production capacity, keeping in mind the danger that a premature approach might detract from our efforts to encourage the continuation of maximum Saudi production for a sustained period.

Tactics

Our immediate goal is to obtain continued maximum Saudi output to offset the Iranian shortfall, stressing that this need does not end when Iranian exports resume, but will continue for a further time in order to enable the oil industry to replace abnormal stock drawdowns and resume normal stock rebuilding. The attached cable4 instructs Ambassador West to encourage such a Saudi response. The President was advised to suggest that the Guadeloupe summit5 countries also approach the Saudis in this regard. It would be useful if you could inform their Finance Ministers that we will be making our approach shortly.

The next step is to impress upon the Saudis, particularly in light of the fragility of the market balance revealed by the events in Iran, the need to approve additional plans to expand production capacity, both to maintain their own influence within OPEC and to be able to meet increased world oil demand expected in the next few years. This step should be taken by West in a low-key way. It may be desirable thereafter to reiterate it in a more direct way and at a high level, either by the President if Crown Prince Fahd visits the U.S. soon, or by Secretary Schlesinger if he undertakes a trip to Saudi Arabia later this spring.

If we are successful in obtaining Saudi agreement to high production levels throughout the current year in response to the Iranian situation, and if they agree to commence investment in expanded production capacity, this may set the stage for pressing for an OPEC price freeze throughout 1980. Specific presentations on the price issue should be withheld until later in the year unless conditions change markedly.

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Recommendation

That you approve the attached instructions for Ambassador West as a first step in the implementation of our strategy.6

  1. Source: National Archives, RG 59, Central Foreign Policy Files, P790016–0363. Secret. Drafted by Todd on January 12 and concurred in by Crawford (NEA).
  2. See Documents 176 and 179.
  3. According to telegram 21697 to Riyadh, January 26, Aramco sources informed the Department that Saudi Arabia formally notified the company that the 8.5 million barrels per day production ceiling would be raised to 9.5 million for the first quarter and would be applied on a monthly basis. (National Archives, RG 59, Central Foreign Policy Files, P850027–2555)
  4. Attached but not printed.
  5. See footnote 2, Document 183.
  6. A handwritten note dated January 15 reads: “Mr. Cooper requested several changes in the cable and initialed off. Cable returned directly to EB for retyping and transmission.” The cable is telegram 11004 to Jidda, January 15. (National Archives, RG 59, Central Foreign Policy Files, D790020–1041)