215. Telegram From the Department of State to the Embassy in Saudi Arabia1

147000. For Ambassador West from Under Secretary Cooper. Subject: International Oil Situation.

1. As we discussed during your consultations, I hope that you will be able in next few days to meet with Crown Prince Fahd, Yamani, and other appropriate Saudi leaders to convey our concerns about oil supplies and prices. Prior to OPEC meeting we would like to do whatever possible to restrain inevitable price increase, but more fundamental problem is supply shortage which Saudis in particular are in some position to alleviate.

2. In your discussions you may draw on following points:

—Present price situation, in which spot market prices and surcharges are increasing in an uncontrolled fashion, presents a truly critical situation for the international economy.

—We fully understand and appreciate that SAG has been a force for price restraint and does not wish to see the sort of price escalation world is presently experiencing. We realize that present supply short[Page 666]age has permitted market to drive prices upward, and that decisions at upcoming OPEC meeting may to some degree reflect that reality.

—There is also, however, the related reality of the impact of price increases on the international economy, including poorer countries.

—As we look ahead over rest of year there is even more profound problem that oil supply at current production rates will sharply exacerbate world economic difficulties without contributing to energy conservation measures now in train.

—In the absence of corrective action, international community faces a critical economic situation which could well have unpredictable effects on political stability in developing world and on the political strength of US and its allies as well as Japan. This is a major long-term problem, affecting efforts to control inflation, to maintain a strong dollar, and to promote the sort of constructive economic growth which will permit industrial world to maintain a global balance of power conducive to world peace.

—As SAG is aware, the US administration is making a major effort to deal with this problem, as are other industrial nations. The industrialized countries as a group have committed themselves to reduce their demand for oil from the world market by an amount equivalent to five percent of projected 1979 consumption by the end of the year. In the US we are on track to achieve this goal. As you know, we have already begun implementing an extensive program of fuel switching, voluntary demand restraint measures, and mandatory measures to restrain US demand for oil from the world market. In spite of strong domestic political opposition, the President has put in place a phased program to bring domestic oil prices up to world levels. We are making substantial progress, and intend to persevere for both the short and long run. Other industrialized countries are taking similar actions.

—It is essential that producer countries also make an effort to help stabilize the situation. While we understand the reasons why Saudi Arabia has wanted to limit its oil production, we hope that in these critical circumstances, SAG will see its way clear to produce as much oil as possible until the spot market situation is stabilized and the escalation of surcharges is eliminated and to urge other producers with excess capacity to do the same. We all have an interest in an orderly market and must all work together at such a juncture, since the potential for serious harm to the world is great.

—We would be interested in your views of how much additional supply will be necessary to restore order to the market, taking account of the need to rebuild working stocks to normal levels.

3. In discussion you may wish to draw as you see fit on the following elaboration of the current USG assessment of various aspects of this problem.

[Page 667]

A. Sharp oil price increases would have a severe impact on the economies of oil importers.

The already slackening rate of economic growth in the US would be further slowed if oil prices increased further. This would exacerbate inflation, which we have been trying to keep in check through strong domestic policies, and increase unemployment. The impact on most other developed countries would be even more severe. These adverse effects would be serious in the short run and would have a cumulative effect, thus raising the possibility of another severe recession. The dangers for the LDC’s would be particularly great since they would be affected both by the direct burden of increased oil import bills as well as by inflation and recession in their major trading partners.

—To illustrate, we estimate that the real increase in oil prices thus far this year (including surcharges) over and above the 10 percent price increase announced in December for 1979 as a whole, can be expected by itself to have the following effects this year, even with no further price increase:

Increase inflation by about 0.3 to 0.5 percent in the US and raise national inflation rates in OECD countries by up to 0.9 percent.

Reduce real economic growth by about 0.3 to 0.5 percent in the US and the growth rates of individual OECD countries by up to 0.7 percent.

Increase the number of unemployed in the United States by about 100,000 persons by end 1979 and over 200,000 by 1980.

Increase unemployment and consequently political instability in several industrial and developing countries.

These figures are necessarily estimates, but they show that the shock administered to the world economy is already substantial, that it will be larger next year and that cumulative losses to the world economy from any further large price increases would be severe.

B. Spot market situation and its impact on prices.

—In the short term much of the pressure from oil market imbalances is felt on the spot market. Spot market is a small residual market that is not representative of appropriate or market clearing prices. It is especially sensitive to short-run disturbances. At the current time it is being driven in part by market pressures (supply) and to a large degree by speculative pressures, whose dynamic we must deal with as soon as possible.

—We fear that some OPEC countries will point to high spot market prices as a rationale for increasing surcharges on term contracts. We are greatly concerned that these surcharges will in turn be built into new base prices, for all of the reasons outlined in (A) above.

—In short, we feel that current market pressures have the potential to push short term oil prices far above reasonable long term levels. We [Page 668] are concerned that there will be a tendency for oil prices to “overshoot” in the short term, with serious consequences for stability for the world economy.

—Actions must be taken by consuming countries and by concerned producers to bring the spot market under greater control.

C. Supply/demand outlook for remainder of year.

—We see a dual problem confronting consumers and concerned producers for remainder of 1979: controlling spot market as per (B) above, and dealing with the continued shortfall in supply.

—In order to do their share in bridging this gap the industrial countries have committed themselves to restrain their oil import demand by 2 MBD, which according to present indications should be of substantial effect once the measures have their full effect.

—The United States has already taken measures, in consultations with other governments, to reduce demand on the world market, conservatively estimated to be over one million BD below what it would have been by the end of 1979. This result is based on conservation efforts and efforts to bring on new supply, among which are: Conservation: 200,000–250,000 BD switching from oil to natural gas; 100,000 BD from higher capacity use of non-oil fired utilities to replace base-load capacity in oil-fired plants; 200,000 BD from voluntary saving of gasoline (recent data indicate that gasoline consumption is now 400,000 BD lower than in 1978); 200,000 BD from building temperature controls. Supply: 150,000 BD from increased Alaskan production by end of 1979; 20,000–50,000 from Elk Hills; 60,000–80,000 BD from decontrol in 1979.

—However, many demand adjustment measures will not take full effect until the end of the year or beginning of next year. Moreover, even with demand restraint measures in place, the oil situation will be precarious because of (1) political uncertainties in Iran and consequent vulnerability of its oil supply; and (2) uncertainties concerning how some OPEC countries will behave as demand restraint measures come into effect.

—Therefore, we think it would be highly desirable in the immediate future to have an increase in production to (1) prick the bubble on the spot market; and (2) to be available in case production elsewhere declines, for whatever reason.

SAG cooperation in a joint effort to stabilize and restore order to the world oil market would be extremely helpful at the present time. If SAG could increase production temporarily until conservation and oil import restraint measures of US and other importing countries take full effect, a large and potentially destabilizing loss to world economy could be avoided. US, for its part, will seek to work out procedures to ensure that oil conservation measures of importing countries will be [Page 669] fully effective. This type of joint effort could pave way for a continuing program to avoid a replay of the 1974–75 world recession while dealing realistically and constructively with the long-term adjustments needed for a satisfactory oil and energy future.2

4. Embassies Kuwait and Abu Dhabi should be prepared to raise oil situation with host governments drawing on above as appropriate, but they should await further instructions pending SAG response to US approach.

5. Other Embassies in OPEC countries should provide views on utility and reaction to possible approach on pricing pending SAG response.

6. For Embassies in Summit countries: Followup to US approach to SAG will be discussed at Summit preparatory meeting scheduled for June 15–16.

Vance
  1. Source: National Archives, RG 59, Central Foreign Policy Files, D790260–0365. Secret; Immediate; Exdis. Drafted by Twinam and Rosen; cleared by Katz, Solomon, Owen, and Schlesinger and in NEA, ARA, EA, EB/ORF, EUR/RPE, and AF/EPS; and approved by Cooper. Repeated Immediate to Quito, Abu Dhabi, Algiers, Baghdad, Caracas, Doha, Jakarta, Ottawa, London, Bonn, Rome, and Brussels for the Embassy and USEEC.
  2. On June 10, Gerlach met with Yamani, whom he described as “extremely pessimistic” about the energy picture. Yamani said that Kuwait and the UAE were “insisting” that a price of $20 per barrel be set at the next OPEC meeting, but that Saudi Arabia would “make every effort” to hold the price to $17 per barrel, with an outside limit of $17.50. He thought that a decrease in U.S. oil consumption was the “only hope” of avoiding a major worldwide energy crisis, and that only a major reduction in Free World consumption, or a major recession that produced such a result, would allow Saudi Arabia to maintain a ceiling on oil prices, as it did not have the productive capacity to do so. (Telegram 944 from Riyadh, June 11; ibid., D790264–0594) At West’s June 12 meeting with Fahd, the Crown Prince said that he would “do his utmost” to hold the price increase at the next OPEC meeting to a minimum, and that he was “favorably inclined” to consider an increase in production. (Telegram 4466 from Jidda, June 13; ibid., D790267–0057)