I. INTRODUCTION

Every year since 1983, Saudi Arabia has incurred large budget and balance of payments (current account) deficits. As a consequence, it has exhausted the bulk of its once-huge financial reserves, and since 1987 has been borrowing heavily, at first internally and more recently externally, in order to cover the deficits. The reasons for this drastic reversal in Saudi Arabia's fortunes and its economic and political implications are the subject of this study.

In 1977, the U.S. Central Intelligence Agency (CIA) published a very pessimistic study which-because of its source and dire predictions-received wide publicity. According to that study, oil prices were forecast to rise sharply, with a concomitant increase in dependence on OPEC and especially Saudi oil:

Between 1979 and 1985, increasing world demand and stagnating oil production in the major consuming countries will result in increased reliance on OPEC oil. By 1985 we estimate that demand for OPEC oil will rise [from 31 million barrels per day (mbd) in 1976] to 47 to 51 mbd. Even if all other OPEC states produce at capacity, Saudi Arabia will be required to produce 19 to 23 mbd if demand is to be met. This is well above present Saudi capacity of 10 to 11 mbd and projected 1985 capacity of at most 18 mbd ... prices will rise sharply no matter what Saudi Arabia does. Although our forecast ... broadly resembles other official and private forecasts, we are more pessimistic about the implications.... Although Saudi Arabia has the reserve potential to meet increased world demand between now and 1985, we doubt the Saudis will be able or willing to do so . . . the rates of [Saudi] production needed to satisfy [projected world oil demand] would generate . . . enormous [Saudi financial] surpluses.

If the CIA and almost all other official and private forecasts were pessimistic during the years following the first oil shock of 1973-74, their predictions were almost apocalyptic following the second oil shock of 1979-80, which was triggered by the 1979 Islamic revolution in Iran. A CIA forecast published in August 1979 asserted that "supply disruptions caused by developments in Iran have advanced the timing of [the oil] price increases" projected in the 1977 study. In other words, the authors of the CIA study suggested that the sharp price hikes engendered by the second oil shock would have taken place eventually, even if there had been no Iranian revolution, but that they might have been gradual. The study went on to report that "the Saudis have long made it clear that they regard oil production much in excess of what is required to cover current needs to be a concession to the Western countries, the U.S. [United States] in particular." Western countries, and especially the United States, were expected to adopt a strong or stronger pro-Arab stance in the Arab-Israeli conflict as a quid pro quo for Saudi willingness to pump more oil than it presumably required to satisfy its revenue needs. The report quotes Saudi officials who expressed doubts regarding the wisdom of accumulating "massive financial assets," instead suggesting that Saudi Arabia should reduce its production. 2

Following the second oil shock of 1979-80 the forecasts made by almost all oil "experts" in and out of government were extremely pessimistic. In retrospect, it is clear that they overrated the power of OPEC and especially its leading member-Saudi Arabia. A 1981 U.S. Congressional Budget Office (CBO) study projected that at the prevailing prices there could be an oil shortage of 4.5 mbd in 1985, rising to 10.5 mbd by 1990. This implied that prices would rise in real terms (corrected for inflation) by an average of 5-6 percent annually until 1990. The study concluded that the OPEC countries, and especially Saudi Arabia, would continue to accumulate large financial surpluses and that "as their surpluses grow, producing nations will keep them down by keeping their oil in the ground. Oil in the ground, it was argued, was more valuable than if it were pumped and sold at the prices of the early 1980s. This was based on the forecast that oil prices would continue to rise in real terms. Indeed, a 1981 World Bank study projected real price increases of 3 percent per annum until the end of the century.

Based on the testimony of a host of expert witnesses, a U.S Senate committee reached the following conclusion in December 1980:

Even if all present plans to reduce oil consumption, increase indigenous [oil] production, and accelerate the use of alternative fuels succeed, the industrialized countries will remain heavily dependent on imported oil from unreliable or insecure sources [i.e., the Middle East] for the rest of this century, or well into the next, [leading] to higher prices, and greater political and military concessions in return [for the willingness to sell more] oil. . . . Several producing countries [i.e., Saudi Arabia and other small population major Arab oil exporters] are earning far more in revenue than they are able to spend.... Dependence on Persian Gulf oil means that at least for the next ten to fifteen years, the industrialized countries can expect to live in a world of steady increases in [real] oil prices, lower economic growth, inflation and stagnant or sluggish [economic] growth.

The Senate committee report was written when oil prices were over $30 per barrel. Pessimism was pervasive and almost unanimous, and had a powerful impact on U.S. policy, political as well as economic. At the same time, these reports had a powerful impact on the budgetary profligacy of Saudi Arabia and other oil exporters, which accounts in large measure for Saudi financial problems since 1983.

To say that the "conventional" or "consensus" forecasts were way off the mark is an understatement. They were akin to forecasting economic prosperity and instead experiencing a severe depression, or forecasting price stability and then experiencing hyperinflation.

If the projections of the CBO had been realized, oil prices in 1990 would have been about $95 a barrel. Instead, prices in 1990 averaged $22 a barrel ($5 higher than in 1989) due mainly to the Iraqi invasion of Kuwait in August of that year. If the relatively conservative World Bank projections had been realized, prices would have been over $90 a barrel in 1993; in fact, at the end of 1993 prices were about $16 per barrel. Instead of rising as predicted, oil prices have fallen sharply from an average of $33 a barrel in 1981-82 to $18 per barrel in 1991-92 in nominal (i.e., not corrected for inflation) dollars. In real terms the decline has been far steeper.1 Of course, there have been price fluctuations due to weather conditions, wars, revolutions, accidents, etc., but the overall trend in oil prices is unmistakably downward. Measured in real dollars, oil prices in 1992-93 returned to the average price in 1973-74. Since oil prices are denominated in dollars, for countries like Japan and Germany whose currencies have risen strongly against the dollar, current real prices are actually much lower than they were two decades ago.

What is particularly noteworthy is that the overall decrease in oil prices since 1981-82 prevailed despite exogenous factors that put upward pressure on prices. These included the Iran-Iraq War of 1980-88, which sharply reduced oil production and exports in both countries; the Iraqi invasion of Kuwait in August 1990; the subsequent war to expel Iraqi forces in January / February 1991; the maintenance of UN sanctions on Iraq ever since; and a steep decline in production in the former Soviet Union from a peak of 12.6 mbd in 1987-88 to 9.1 mbd in 1992.2 These external events have enabled Saudi Arabia and other OPEC and non-OPEC states to expand their production and exports.

The 1977 CIA study-as well as others-had projected that demand for OPEC oil would rise from 31 mbd in 1976 to 47-51 mbd in 1985; instead, demand fell sharply. OPEC production dropped precipitously to 17 mbd in 1985. The CIA study projected that demand for Saudi oil in 1985 would rise from 8.8 mbd to 19-23 mbd in 1976. In reality Saudi output rose only to about 10 mbd in 1979-81 as a result of the 1979 Iranian revolution and the Iran-Iraq War, which began in September 1980 and sharply reduced output from those two countries. In 1985 Saudi output fell dramatically to its 1970 level of 3.7 mbd. Saudi Arabia was forced to abandon its role as OPEC's "swing" producer (balancing world supply and demand) and instead cut prices sharply in order to expand its markets. Like other OPEC countries, it ignored OPEC decisions on prices. As a result of its new policy, Saudi output rose to about 5 mbd in 1986-89. The Iraqi invasion of Kuwait in 1990 and the UN embargo on Iraqi exports, combined with the sharp drop in former Soviet production, enabled the Saudis to expand output further to 8.9 mbd in 1992. Other OPEC and non-OPEC producers enjoyed a more modest rise in output from the lows of the mid-1980s.

Conventional wisdom in the 1970s and early 1980s had projected huge and growing OPEC financial surpluses, with the Saudis enjoying the lion's share. In reality, much lower prices combined with a much lower volume of exports sharply reduced Saudi oil export revenues from a peak of $111 billion in 1981 to an annual average of $22 billion in the latter half of the 1980s. In 1990-92, Saudi oil export revenues averaged $43 billion per annum thanks to the Gulf War of 1990-91, the ongoing embargo on Iraii oil, and the continued decline in former Soviet oil production. Nonetheless, the budget and balance of payments deficits that had afflicted Saudi Arabia every year since 1983 persisted.

One of the bugaboos prevalent until the mid-1980s was that world oil reserves were being exhausted and that dependence on the huge reserves of the Middle East would increase. In reality, world oil reserves have risen sharply from 600 billion barrels in 1970 to I trillion barrels in 1992. One of the very few unconventional oil analysts, Professor Peter Odell of Holland, noted: "It is ironic that conventional wisdom through the 1970s and well into the 1980s was fearful for the future of oil on the grounds of the near exhaustion of reserves." In fact, world reserves are currently at their highest level ever. In 1970 experts calculated that the world's supply of oil would last for thirty years; however, discoveries of new oil fields and extraction technology increased that figure to 43 years in 1992.

The major sources of error in the conventional forecasts were underestimating the effects of the oil shocks on supply and demand, and neglecting the impact of international developments on the oil policies of Saudi Arabia and other major oil-exporters. The conventional forecasts simply assumed that Saudi Arabia and other small-population countries could not increase their spending as rapidly as they were earning oil income, and would therefore accumulate huge financial surpluses. There were innumerable studies on the presumed problem of "recycling OPEC financial surpluses." But from the point of view of oil markets, it meant that Saudi Arabia alone (or along with a few other wealthier members of OPEC) could always eliminate an oil glut by reducing output. This would give the OPEC cartel unusual power.