II. SAUDI ECONOMIC POLICIES AND THE TWIN OIL SHOCKS

Between 1960 and 1970 Saudi oil revenues quadrupled, measured in current dollars. Even when corrected for inflation, they had more than tripled. This was due mainly to higher output, augmented by an improvement in the profit-sharing agreement with the Arabian American Oil Company (ARAMCO), a consortium of four American oil companies that had a concession on almost all Saudi oil production. But despite the massive rise in government revenues, Saudi Arabia was still suffering from deficits toward the end of the 1960s, both in its budget and in the current account of the balance of payments (exports of goods and services, minus imports of goods, services, and transfers). In short, government spending (and imports) had initially lagged behind rising revenue but soon caught up with and then surpassed it.

A study of the Saudi economy in the 1960s by Donald Wells was prescient:

The experience of Saudi Arabia during the 1960s suggests that both the desire and the capability for increasing expenditures rapidly were present. Whenever revenues increased, rises in expenditures followed quickly, almost automatically . . . [The gap between revenues and expenditures closed whenever the Saudis had had time to adjust to the new levels of income.1

This pattern was repeated in the 1970s despite the fact that the oil shock of 1973-74 produced revenues many times greater than oil exporters had ever experienced.

How did the Saudis deal with the deficits of the late 1960s? In fiscal year (FY) 1970, they finally succeeded in restraining the growth in public expenditures, but did not reduce spending. The solution to their economic woes came from exogenous developments in the world oil market, not a more rational spending policy at home. Prices, which had been quite stable in nominal dollars in the 1950s and 1960s, rose strongly in the early 1970s, even before the Arab-Israeli war of October 1973. The average annual rate of growth in world oil consumption since the 1950s had been 7-8 percent, implying a virtual doubling every ten years. Saudi Arabia's good fortune was that in the early 1970s a number of unrelated developments took place. Possibly of greatest importance was the fact that U.S. oil production peaked in 1970, followed by years of decline until Alaskan oil began to flow in 1977. Oil production in Venezuela, which had been a major supplier to the United States, also peaked in 1970. The 1969 revolution in Libya resulted in production cutbacks in 1970. Kuwait also reduced output in the early 1970s, and Iraq's nationalization of foreign oil companies in 1972 reduced its output for a while.

Saudi Arabia took full advantage of these new opportunities and virtually doubled its oil production and exports between 1970 and 1973. Since both the volume of exports and prices were rising, Saudi oil revenues rose sharply from $1.1 billion in FY1969 to $3.4 billion in FY1972, creating large surpluses. As a result, public spending, which had been restrained in F'YI970, increased sharply in the following two years.1 The deficits of the late 1960s were soon forgotten.

THE FIRST OIL SHOCK, 1973-74

Shortly after the outbreak of the October 1973 War, Saudi Arabia and other Arab oil exporters declared an embargo on oil shipments to the United States and other countries deemed friendly to Israel, and announced a sharp cutback in total oil output in order to pressure Washington and others to adopt a pro-Arab policy in the ongoing conflict. This did not, however, put a severe dent in the actual oil production of OPEC members. Iran and other non-Arab members of OPEC did notjoin the embargo; on the contrary, they increased their production. And whereas Saudi Arabia's output in the last quarter of 1973 was 10 percent lower than during the first nine months of the year, it was significantly higher than the last quarter of 1972. Indeed, the statistics for Saudi oil production in 1973 show an average output of 7.7 mbd, as compared with 6.1 mbd in 1972, an annual increase that had no parallel in earlier years. For most Arab oil producers, and for oil producers as a whole, 1973 output exceeded 1972 output despite the embargo, and this was certainly true of non-Arab members of OPEC. In short, actual Arab production cutbacks in the last quarter of 1973 were far less than had been anticipated by the oil buyers. Saudi output actually rose in the first quarter of 1974, despite the fact that the Arab oil embargo was not rescinded until March of that year.

World oil consumption rose 8.1 percent in 1973, but world oil production rose even more rapidly-by 9.3 percent. Why then were there sharp price increases? The answer lies in the anticipation of future shortages, which led to massive speculation, stockpiling, and a sharp rise in spot prices. OPEC price hikes followed, with Saudi light oil almost doubling in price in October 1973 to over $5 a barrel and more than doubling again in January 1974 to about $11 a barrel. The latter price hike took place about two months after the cessation of hostilities.1

The rising volume of Saudi exports combined with massive price increases raised oil revenues to unprecedented dimensions. Government oil revenues in FY1974 were $26.8 billion, almost eight times FY1972 receipts.2 Flush with funds, the authorities raised public expenditures, but they could not be increased that rapidly, creating a massive budgetary surplus in FY1974 of $18.5 billion, compared with $1.3 billion just two years earlier. The trend was similar in the balance of payments, with the current account surplus reaching $23.0 billion in 1974 as compared with $2.1 billion in 1972.3

Saudi leaders responded to such huge revenues by commissioning foreign consultants to formulate a development plan for 1975-80 that was far more ambitious than its predecessor. Saudi development plans are a compendium of proposed government spending plans during a five-year period, including capital outlays (investment) as well as current expenditures. The new plan called for total public expenditures of $142 billion, six times actual spending in the previous five years, measured in current dollars. Even after taking inflation into account, the planned increase in public expenditures was enormous. At the time, foreign analysts were sure that actual spending would be far less than planned. They were still blinded by the view that Saudi Arabia and other small-population oil-exporting countries did not have the "absorptive capacity" to implement most of the planned projects within the five-year time frame, and would therefore continue to accumulate massive financial surpluses.

Like the First Development Plan (1970-75) the more grandiose Second Development Plan (1975-80) emphasized infrastructure construction (roads, ports, airports, electricity, water, housing), urban as well as rural development, and health and educational facilities. An especially heavy emphasis was placed on spending to raise the overall standard of living of individual Saudis. The second plan differed markedly from the previous plan in its aim to diversify the economy through the large-scale development of both heavy and light industry, and to a lesser extent, agriculture. The goal was to wean the economy away from its almost complete dependence on oil. A Royal Saudi Commission was established to oversee the construction of two major industrial centers, one in jubail in the oil region on the east coast, and the other in Yanbu on the west coast. Plans were devised to harness the gas emitted in crude oil extraction into a mammoth gas-gathering system, providing energy for water desalination and the generation of electric power, as well as raw materials for world-scale petrochemical plants. The plan also called for the construction of oil refineries designed mainly for export. Other planned industries included steel, aluminum, fertilizers, cement, plastics, and various light industries. The goal of economic diversification was a hallmark of the 1975-80 plan as well as of those that followed.

The implementation of the plan proved far more difficult than had been projected. Many of the investment projects were abandoned or postponed, others were curtailed in scope, and still others were far from completion when the plan period ended in mid-1980. Nonetheless, the Saudi government confounded the skeptics and succeeded in spending not just the $142 billion originally allotted in the development plan, but an additional $45 billion, amounting to total government outlays of $187 billion in 1975-80. Overspending was due to a number of factors. The cumbersome and inefficient bureaucracy effectively stretched out the time allotted for implementation, thereby raising costs. A woeful lack of skilled Saudis necessitated the large-scale importation of foreign labor and management. The government sharply increased subsidies of all kinds for both producers and consumers. A massive growth of the bureaucracy greatly expanded current expenditures on salaries and "perks" (what Westerners would call corruption). And military expenditures went far beyond those stipulated in the plan.

Government revenues-largely from oil-continued to rise after 1974-75, but at a much slower rate. Expenditures, however, did not slow down, escalating from $10 billion in FY1974 to $39.3 billion in FY1977. A small deficit of $1.4 billion emerged that year, followed by a larger deficit of $4.4 billion the following year. Inevitably, the budget deficits were followed by a deficit of $2.2 billion in the current account of the balance of payments in 1978; imports of goods and services had risen astronomically from $2 billion in 1972 to $42 billion in 1978-the inevitable consequence of massive government spending. To put this into perspective, consider that by 1977 Saudi imports (goods and services) had risen to $30.5 billion; in Iran, the world's second-largest oil exporter with a population five or six times that of Saudi Arabia, imports were $25.6 billion. The Shah of Iran was not known for his frugality, but in comparison with the Saudis, he was downright miserly.

The oil shock of 1973-74 had a strong impact on world oil markets in ways entirely at variance with those predicted by the conventional forecasts. Instead of an inexorable climb in oil prices, by 1977 a glut began to emerge, as producers began to discount below OPEC-mandated prices.

Within a relatively few years both oil supply and demand changed significantly. Leaving aside changes in stocks, demand is affected by the rate of (real) economic growth, energy efficiency, and the share of oil in total energy supplies. The 1974-75 recession in the major industrialized countries reduced demand in those years, but even in the prosperous years that followed, the growth rate in oil consumption was far less than in the decades preceding the 1973-74 oil shock. This was due to a steady and cumulative improvement in energy efficiency (e.g., more miles per gallon, less energy per unit of heating and air conditioning, less energy per unit of factory production). At the same time, higher oil prices induced a shift away from oil in favor of other sources of energymainly coal, natural gas, hydroelectric and nuclear power. In the 1950s and 1960s, total energy demand had been rising at about the same rate as economic growth; following the oil shock, energy demand rose much less than the rate of economic growth. In the 1950s and 1960s, oil was displacing other sources of energy, especially coal; following the 1973-74 shock, the reverse began to occur, as oil was being displaced by other sources of energy. The net effect of all these changes was that world oil demand rose by less than 2 percent per annum between 1973 and 1978, as compared with over 7 percent per annum in earlier years. On the supply side, the oil shock was followed by a major world-wide expansion of drilling and development. After 1976, non-OPEC supplies began to rise strongly in Alaska, Mexico, the North Sea, the Soviet Union, and among many smaller producers.

The Saudis were wholly unprepared for the oil glut that began to emerge in 1977. The "experts" had told them that world dependence on Saudi reserves would continue to grow and that real oil prices would continue to rise. In accordance with the 1977 CIA report, U.S. officials had urged the Saudis to expand production capacity from 10 mbd to 16 or 18 mbd in order to satisfy projected world demand in the mid-1980s.

As the oil glut gathered force in 1977 and early 1978, price discounting became more and more prevalent. As the leading exporter, Saudi Arabia was constrained in its actions. While others might increase or at least sustain sales by discounting, Saudi Arabia recognized that any price reduction on its part would soon be matched by its rivals, and it would fail to gain a greater share of the market. This is precisely what happened. OPEC members Iran, Algeria, Libya, and Kuwait led the way in "cheating" on their allotted quotas while Saudi production fell drastically (17 percent); outside OPEC, overall production rose more than 6 percent.1 In short, non-OPEC oil was beginning to displace OPEC oil, and within OPEC, others were capturing part of the Saudi market. In FY1977 Saudi government oil revenues were $32.7 billion, down from $34.3 billion the previous year, while expenditures maintained their upward climb from $30.2 billion in FY1976 to $39.3 billion in FY1977 and a budget deficit emerged. In the following year the deficit was much larger. The deficits were covered by drawing on financial reserves accumulated in earlier years.

The Saudi authorities were concerned both by the new developments in oil markets and by their budget and balance of payments deficits, but they did little to reduce expenditures or sanction the "cheaters" within OPEC. But as in the late 1960s, the Saudis were extricated from their predicament by exogenous forces, this time the wholly unforeseen revolution in Iran.

THE SECOND OIL SHOCK, 1979-80

Under the Shah, Iran had been the world's second-largest oil exporter in the 1970s. During the first nine months of 1978, Iran exported about 5 mbd, as compared with Saudi exports of 7.5 mbd. Revolutionary forces curtailed oil output during the latter months of 1978 and in December of that year oil exports ceased altogether. The almost abrupt cessation of Iranian exports gave rise to fears of shortages, and speculators had a field day. The Khomeini forces took over the reins of government in February 1979, and Iranian exports resumed the following month, but at far lower levels than in earlier years.

Following the resumption of oil exports by the Iranian revolutionary regime in the spring of 1979, Iranian output declined steadily. By the summer of 1980 (i.e., before the Iraqi attack) Iran's production had fallen to 1.4 mbd, leaving very little for export. This sharp drop in Iran's output was largely due to internal instability, the exodus or execution of Iranian specialists, and the departure of foreign technical personnel. By then, oil buyers were uncertain regarding the stability of the new regime and its ability to sustain even the lower level of production and exports. Moreover, there were widespread fears at the time that the Islamic revolution in Iran would engulf neighboring countries, including Saudi Arabia, dealing an even more powerful blow to Middle East oil exports. Fears regarding Saudi stability were heightened by the abortive takeover of the grand mosque in Mecca by Islamic extremists in November 1979. The following month, the Soviet Union invaded Afghanistan, and it was widely believed that the Soviets would advance into the oil-rich countries of the Persian Gulf. All of these events gave rise to an unprecedented speculative binge and oil prices continued to rise.

In many respects, events in 1979 were a repetition of 1973 but on a much larger scale. World oil consumption rose by 1.5 percent that year, but despite the far lower level of Iranian output, world oil production rose by 4.3 percent. The gap is a measure of stockpiling. Oil prices skyrocketed from $11-$12 a barrel in 1978 to $24-$30 by mid-1980. OPEC raised its official prices periodically, following increases in the "spot" (free) market, but in reality, oil sellers other than Saudi Arabia were charging even higher prices by attaching so-called "premiums" or surcharges to the prices declared by OPEC. By the summer of 1980 a glut began to emerge (i.e., spot prices were lower than official OPEC prices). A number of OPEC states began to eliminate the premiums and surcharges as a means of reducing prices.

The downward pressure on oil prices was temporarily arrested by the Iran-Iraq war, which began in September 1980. Shortly after hostilities began, Iran successfully blocked Iraqi oil exports through the Gulf, which had been Baghdad's main outlet. Iraq's oil sales declined sharply from 3.2 mbd before the war to a mere 0.6 mbd in 1981. Iranian production had fallen to such a low level in the aftermath of the revolution that the Iran-Iraq War itself had little immediate effect. However, the sharp drop in Iraqi exports did have a significant impact on oil markets.

Despite the war, oil prices again began to soften in the spring of 1981. As long as others were imposing premiums and surcharges, Saudi oil had a price advantage and was able to maintain a high level of sales while others suffered a sharp decline. Toward the end of 1981 OPEC decided to unify prices and raise them from $32 to $34 per barrel. But Saudi Arabia and other OPEC members had seriously misread the market signals. They continued to adhere to the views of the conventional oil forecasters, who asserted that the downturn in demand for oil was temporary, resulting from a recession in the industrialized countries and the utilization of stockpiles accumulated in previous years. What they failed to see at the time was that there were basic structural changes affecting demande.g., continued improvement in energy efficiency and a drive to substitute other sources of energy for oil. This drive was accelerated toward the end of the 1970s by the gradual elimination of oil price controls in the United States, and their complete abolition soon after Ronald Reagan became president in January 1981. Since the United States alone consumed one-fourth of the world's oil, its policies had (and continue to have) a powerful impact on world oil demand. At the same time, non-OPEC supplies continued to rise, and demand for OPEC oil felt the pincers of softening world oil demand and a rise in non-OPEC supply.