286. Briefing Memorandum From the Assistant Secretary of State for Economic and Business Affairs (Hinton) and the Assistant Secretary of State for European Affairs (Vest) to Secretary of State Muskie1


  • The Impending Oil Crisis: Policy Options

I. Summary

There is a serious risk the world will face an oil supply shortfall of 1 million barrels per day (mb/d) or more through the first half of 1981. Unless the U.S. and other major oil importing nations take immediate and strong actions, we risk a repeat of 1979 when market panic turned a small shortfall into a more than doubling of oil prices. The world economy can ill afford another such shock. The present International Energy Agency (IEA) policy of encouraging stock drawdowns and avoiding abnormal spot market purchases can be successful only as long as market participants believe that a resumption of oil supplies from Iran and Iraq will occur during the first quarter of 1981 or before. As that belief fades, many companies and governments suffering shortfalls will enter the spot market and drive up prices; this is already beginning. The IEA nations need to act before the end of this year to restrain oil import demand and to ensure that oil will be available to countries and companies experiencing serious shortfalls if we are to avoid a sharp increase in oil prices. There are four major options for an internationally coordinated response—reinforce present voluntary policies, impose politically binding national oil import ceilings, trigger the IEA emergency oil sharing system, or combine ceilings with a selective triggering of the IEA system. Under all four options, but particularly the last three, the U.S. would be required to adopt strong, politically difficult domestic energy policy measures. State, DOE, and the NSC (Henry Owen) are consulting with other IEA members and with the White House and OMB and will have a recommendation for you and Secretary Duncan to send to the President early next week.

II. The Problem

The war between Iraq and Iran has taken 3.8 mb/d of oil imports off the world market, over 8% of non-communist production. Since [Page 902] world consumption has declined, we can simply do without some of this oil—about 1 mb/d. Another 1–1.5 mb/d is apparently being made up through increased production from the Saudis and other OPEC nations. This leaves a shortfall of over 1 mb/d, which is now being met by above normal stock draw-downs and some belt-tightening by nations without adequate stocks. Depending on a number of factors—how much additional supply is made available by OPEC nations, whether companies and individuals begin to hoard oil, and whether the war expands or interferes with Gulf shipping, the shortfall could become much larger.

The current shortfall is not distributed evenly among countries and companies. The US lost a very small percentage of of its oil. France lost 30%, Italy 15%, Japan 8%, Turkey 70%, Brazil 43%, and India 45%. (Turkey and Portugal are in especially difficult straits; supplies probably can be found for Portugal, but it is proving much more difficult to meet Turkey’s needs.) Also many small nations depended on Iraq for most of their oil needs and at concessional terms. Even in countries which have lost little overall, certain companies have suffered substantial losses. This means that even though world stocks are high, some nations and companies are experiencing serious difficulties now and others will soon. If they are unable to secure adequate supplies from other producers, they will turn to the spot market to make up their shortfall. India and others have done so already.

Spot market prices have already increased, in some cases over $5 per barrel. As the war and the shortfall continue, prices will rise much faster; they will soon surpass the $40+ levels reached in 1979 and will likely break the $50 per barrel level by early 1981. Eventually, as in 1979, official OPEC prices will be raised in response. OPEC ministers meeting in Bali on December 15 to set new prices will be very attentive to price trends on the spot market. Also in December, long term contracts for 1981 between producer countries and companies will be negotiated. Some producers, in response to rising spot prices, will impose surcharges of probably $5–$7/bbl on their official prices (more than 15% above current prevailing prices).

The consequences of oil price rises are significant. The CIA has estimated that each $10 per barrel rise in the price of oil results in a .7% increase in inflation in the first year in OECD countries (plus another .7% in the second year) and a .5% decrease in economic growth in the first year (.3% and .2% in the second and third years). The effects on developing countries are even more severe.

IEA nations agreed on October 1 to take steps to avoid abnormal purchases on the spot market and to meet any shortfall through stock draws. This has had some effect, but cracks in the IEA facade are appearing. Stocks are largely in private hands and companies will be re [Page 903] luctant to draw them down even at normal rates if they think that the shortfall will continue into 1981. The current IEA policy is based on jawboning and persuasion; it cannot force companies to draw down stocks, nor can it reallocate oil to IEA or non-IEA nations or companies facing the most serious shortfalls to prevent them from resorting to the spot market. Producer allocation of additional production will help some, but far from all, of those in need.

The IEA Governing Board meets November 20–21 and IEA ministers on December 8–9. We believe that strong action must be taken if we are to avoid another economic disaster on the order of 1979. The IEA can reduce pressure on prices in two ways: 1) reducing demand for imported oil, thereby making extra oil available generally to nations and companies which need it, and 2) reallocating oil to those countries and companies in need. The former is necessary to cover a shortfall, but taken alone may not be sufficiently rapid or direct to stem rising pressure on the spot market; the latter would better meet the spot market problem, though there is no formal IEA mechanism to redirect oil to non-IEA countries.

Procedural and Political Factors:

The actions we propose will depend on what emerges from our consultations with other IEA nations, especially Japan, the UK, and FRG, and France and the domestic measures the U.S. is willing to adopt to support our efforts in the IEA. The IEA Secretariat appears to be advocating a triggering of the sharing system. We will discuss this with IEA Executive Director Lantzke in Washington next Sunday. We do not yet have a full readout of the positions of the other major countries, though at the October Governing Board meeting2 the Germans appeared more amenable to setting ceilings than we expected. We foresee difficulties in persuading the UK to agree to ceilings or triggering. Since the UK is almost a net exporter, it is shielded from many of the direct effects of a shortfall; also it fears that a system of ceilings would indirectly give other countries some control over its production levels. After we are more certain of what measures we can implement domestically, we will be able to deal with the British, Germans, Japanese and others more effectively.

The Options

Option 1: Reinforce Present Policies

IEA nations would continue to persuade their companies not to resort to the spot market and to draw down stocks to meet shortfalls. To [Page 904] strengthen our efforts we could use more forceful jawboning and adopt voluntary stock targets. While this would be the path of least political resistance in the IEA and would require the least sacrifice by the U.S. in the short-term, it would not be adequate to prevent a substantial price increase if the shortfall continues.

Option 2: Adopt National Oil Import Ceilings

IEA nations (and France) could adopt ceilings to reduce oil import demand by an amount sufficient to cover the entire world shortfall or the IEA share of that shortfall (over 75%). The reduction could be allocated among IEA nations as a proportion of imports or consumption; though the former would be more advantageous to the US, it would more politically feasible and equitable to base ceilings on consumption. Thus, if the shortfall were 1 mb/d, the US would have to absorb an import cut of 470,000 b/d resulting in an import ceiling of about 6.6 mb/d (including territories). While some believe we can achieve this through present policies and mandatory fuel switching by utilities, (assuming no abnormal stock building), additional measures might be needed.

Advantages: IEA nations will probably accept ceilings, although negotiations will be difficult. Ceilings could be set to cover the entire world shortfall, not just the IEA share as would be the case with the oil sharing system (Option 3). Ceilings can be flexible enough to take into account factors such as economic growth prospects, recent changes in consumption levels, etc., that are not fully taken into account in the oil sharing system.

Disadvantages: There is no guarantee that IEA nations will take the domestic demand restraint measures necessary to achieve their ceilings. Even if they try to do so, they may not succeed since few if any would adopt a fail-safe measure like a quota. Also nations might not act with the speed necessary to take pressure off the spot market. Monitoring is difficult; success can only be determined after some months. Ceilings do not provide for directing supplies to oil short IEA and non-IEA nations; this would have to be done indirectly through consultation with oil companies. A ceiling system would not automatically provide legal authority for IEA governments to implement strong domestic measures.

Option 3: Trigger the Oil Sharing System

A “general trigger” is possible when the IEA as a whole has a shortfall greater than 7% of a base period (the previous four quarters with a quarter lag). Any member with a 7% shortfall can pull the “selective trigger” and the other nations will make up any shortfall above that 7%. Since IEA oil consumption has been declining, the IEA’s oil supplies were almost 7% below the base period even before the Iran/ [Page 905] Iraq war. The shortfall may cross the 7% general trigger threshold if lost Iranian/Iraqi oil is not substantially made up. If it does not, the general trigger threshold could possibly be reduced to less than 7% by unanimous vote.

Advantages: This system could be implemented quickly, making use of a previously agreed mechanism and formula. It would give the U.S. and other IEA governments legal authority to implement strong domestic measures such as enhanced demand restraint, domestic oil allocation, and stock controls. It would make oil available to hard-hit IEA countries and companies reducing the tendency to resort to the spot market. Its operation is based on monthly estimated data, ensuring prompt monitoring and response to changing conditions.

Disadvantages: The system limits each country to its formula share of available oil; this could hold Turkey, Portugal, Greece and Italy, for example, below needed import levels. The U.S. would be required to supply oil to other countries, amounting to 200,000–300,000 b/d for a group shortfall of 1–1.5 mbd (however, this will probably be less than under ceilings). The need to compensate U.S. companies which gave up oil could eventually force the U.S. to implement domestic oil allocation—which poses political and practical problems. The system allocates oil according to a base period (July 1979–June 1980) which does not reflect current oil requirements. It does little for non-IEA countries. The margin of error of data used makes it difficult to trigger for a small shortfall. Further, the system, though tested, is yet untried. Finally, triggering could cause market nervousness.

Option 4: Selective Trigger with Ceilings

Oil import ceilings could be combined with a selective triggering for hard-hit IEA countries such as Austria, Greece, Ireland, Italy, Portugal, Spain, and Turkey.

The advantages and disadvantages of an import ceiling system are applicable to this option. In addition, while this option would provide some direct assistance to hard-hit countries, relief would be limited to 93% of the base period. These countries might be better off with only a ceiling system if additional supplies could be assured informally. Also countries in a technical trigger situation but not really short of oil (Germany, the U.K., Belgium, Switzerland, and probably the U.S.) might be tempted to trigger to avoid incurring an obligation to supply oil to other countries; this would make the system unworkable.

  1. Source: National Archives, RG 59, Central Foreign Policy Files, P870012–0201. Confidential; Exdis. Drafted by Hecklinger and Bullen and cleared in E, EUR/RPE, S/P, NEA/RA, and EA.
  2. The October 21 meeting is summarized in telegram 33213 from Paris, October 22. (Ibid., D800505–0165)