INTERNATIONAL ECONOMIC & ENERGY WEEKLY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP88-00798R000200220003-5
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 44
• Document Creation Date: December 27, 2016
• Document Release Date: April 19, 2011
• Sequence Number: 3
• Publication Date: January 24, 1986
• Content Type: REPORT

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Directorate of
Intelligence
International
Economic & Energy
Weekly
24 January 1986
PRODUCTIG4 GROUP
RO)M 3G0
1.1 Q5
685
Seer
DI IEEW 86-004
24 January 1986
685
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Secret
International
Economic & Energy Weekly
24 January 1986
iii Synopsis
1 Perspective-Plunging Oil Prices: Widespread Benefits, But Problems for
Some
3 LDCs: Uneven Impact of a Drop in Oil Price
s
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17 Mexico: The Producer/ Debtor Dilemma
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19 North Sea Oil Producers: Economic Implications of Falling Prices)
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23 Soviet Oil Production and Exports: Outlook for 1986
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Briefs Energy
International Finance
National Developments
directed to Directorate of Intelligence
Comments and queries regarding this publication are welcome. They may be
Secret
DI 1EEW 86-004
24 January 1986
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International
Economic & Energy Weekly
Synopsis
1 Perspective-Plunging Oil Prices: Widespread Benefits, But Problems for
Some
If oil prices do plunge, economic gains would be widespread, but lower oil
prices will create significant problems for several oil-exporting countries.
3 LDCs: Uneven Impact of a Drop in Oil Prices
An oil price decline will provide widespread benefits for most developing
countries. For the heavily indebted LDC oil exporters, however, revenue losses
will necessitate further economic adjustment measures at a time when they are
weary of adjustment.
Persian Gulf producers this year have little chance of raising oil revenues
because of the oil market's limited ability to absorb additional production
without depressing prices further. As a result, these countries face hard
decisions on how to cope with lower revenues amid growing domestic criticism
over how their economies are being handled.
Although the Saudis are still concerned about a long-term market for their oil,
short-term revenue needs have become the driving force behind Saudi oil
policy. Despite the ramifications of recent actions, domestic pressures to end
the recession and the desire to regain a more powerful role in the oil market
point to further wrenching decisions on oil and economic policy.
17 Mexico: The Producer/Debtor Dilemma
The soft oil market probably will force Mexico City to backslide on this year's
austere budget and could derail attempts at economic adjustment. Moreover,
since oil receipts make up 70 percent of export earnings and are about equal to
this year's debt burden, it is becoming increasingly likely that the country will
be unable to fully honor its financial obligations.
Secret
DI /EEW 86-004
24 January 1986
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19 North Sea Oil Producers: Economic Implications of Falling Prices
The United Kingdom and Norway, as net oil exporters, would not be badly
hurt by lower oil prices, but would have problems in dealing with the
substantial loss of oil tax revenue. The United Kingdom could suffer, however,
if lower oil prices triggered a run on the pound, causing London to boost
interest rates.
23 Soviet Oil Production and Exports: Outlook for 1986
The Soviet plan for 1986 calls for raising oil production to more than 12.3 mil-
lion b/d, but the production outlook is precarious. At the extreme, export
reductions, compounded by anticipated oil price declines, could cost Moscow
as much as $4-6 billion in hard currency earnings.
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Perspective
International
Economic & Energy Weekly
24 January 1986
Plunging Oil Prices: Widespread Benefits, But Problems for Some
any event will likely cause wide price fluctuations.
Over the past week oil prices have plummeted. Spot prices for North Sea and
US crudes tumbled to as low as $20 per barrel, a drop of $5 in some cases.
Prices on the highly speculative futures market also fell, although spot prices
for OPEC crudes stayed above the $25 per barrel level. How far prices fall will
depend on the market share that OPEC ultimately stakes out. OPEC
producers will begin a series of meetings next week in Vienna in an attempt to
formalize a market defense strategy. Unless the group chooses a volume below
its current output level, all prices are headed for a major break this year-per-
haps falling well below $20 per barrel. We now believe that there is a 50-per-
cent probability that prices will average below $20 per barrel in 1986. This is
in contrast with the oil industry consensus that prices will average about $22 to
$23 per barrel. Market psychology and uncertainty about producer actions in
the next several months.
Trends in oil demand will provide no relief for producers. We estimate that
1986 non-Communist oil consumption will remain at 1985 levels. With
demand in the spring expected to drop by as much as 3 million barrels per day
below winter levels, downward price pressures will be especially strong during
countries, and the likely fall in interest rates.
If oil prices do plunge, economic gains would be widespread. Our econometric
model indicates that a $20 per barrel average price during 1986-88 would
boost the current forecast for OECD-wide real GNP growth by an additional
0.4 percentage points in 1986, 0.8 percentage points in 1987, and 0.3
percentage points in 1988. The United States would benefit most, while
Canada and several West European economies would also gain. We estimate
that oil at $15 per barrel would almost double these gains. Moreover, most oil-
importing developing countries-particularly the major debtors-would bene-
fit from lower oil import costs, increased import demand in the industrial
On the other hand, lower oil prices will create significant problems for several
oil-exporting countries. Oil-producing LDCs with large debt burdens will be
especially hard hit, although oil-exporting industrial countries also will
experience difficulties:
? Mexico, Nigeria, and Venezuela, which rely heavily on oil earnings to pay
their debts, will be the most negatively affected, even though lower interest
rates will soften the impact of reduced oil revenues.
? Some oil exporters, such as Algeria and Indonesia, could encounter
increasingly serious debt servicing problems.
? Oil-exporting industrial countries such as Norway and the United Kingdom
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will also suffer, at least initially, as the reduction in oil revenues outweighs
the benefits of lower interest rates and inflation.
? The Soviet Union will face diminished hard currency oil earnings, and thus
the prospect of having to divert oil from Eastern Europe to Western markets.
For the oil-exporting LDCs, a drop to $20 per barrel would be manageable for
most, but governments would face politically difficult decisions regarding
import restrictions and budget austerity. At substantially lower oil prices,
however, revenue losses would make the debt servicing burden untenable for
countries such as Mexico, Nigeria, and Venezuela. In this situation, more
debt-ridden LDC oil exporters would be likely to impose restrictions on debt
payments.
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LDCs: Uneven Impact of a
Drop in Oil Prices
earnings.
An oil price decline will provide widespread bene-
fits for most developing countries. For the heavily
indebted LDC oil exporters, however, revenue
losses will necessitate further economic adjustment
measures at a time when they are weary of adjust-
ment. Some oil exporters such as Algeria, Egypt,
and Indonesia-which previously had not been
considered financially troubled-will face increas-
ing debt servicing difficulties and could join the list
of troubled debtors. Further erosion of oil prices-
below $20 per barrel-would certainly push the
heavily indebted oil-exporting countries into serious
financial straits. Some countries may opt to try to
follow the example of Peru and Nigeria by limiting
debt service to a fixed percentage of export
Substantial Benefits to Oil-Importing LDCs
$1.7 billion each, according to our analysis.
According to our econometric model, non-OPEC
LDCs as a group will benefit from an oil price
decline. Heavily indebted LDCs with large oil
import levels will receive the major gains. In addi-
tion to lower oil costs, LDCs would save on debt
servicing costs because of a probable decline in
interest rates. Higher OECD economic growth
spurred by cheaper energy and lower interest rates
also would boost LDC export earnings. For Brazil
and South Korea, a drop in oil prices to $20 per
barrel would mean savings in the first year of about
exports go to OPEC countries.
Oil-Importing LDCs: Million US $
Impact of Changing Oil Prices
Oil
Savings
Interest
Savings
Estimated
Export
Gains a
Combined
Impact
Brazil
780
844
77
1,701
Chile
140
174
11
325
Philippines
356
199
22
577
South Korea
1,365
244
74
1,683
Thailand
550
48
18
616
Turkey
736
140
13
889
Brazil
1,380
1,493
142
3,015
Chile
248
308
21
577
Philippines
630
352
40
1,022
South Korea
2,415
432
138
2,985
Thailand
974
85
33
1,092
Turkey
1,301
248
24
1,573
a Estimated export gains to OECD countries only.
b Argentina is included among the oil-importing LDCs despite
being a small net exporter, because the overall impact of price
declines for Argentina is positive.
Greater Costs to Oil-Exporting LDCs
Against these savings, however, these countries
would face falling demand from oil producers for In contrast, a significant oil price decline will hurt
their exports. South Korea, for example, saw its severely the major LDC oil exporters, especially
construction contract business fall off by 65 percent those already debt-troubled countries-such as
in 1984 as the Middle Eastern countries began to
experience an economic slowdown. Likewise, Turk-
ish gains would be limited because one-third of its
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24 January 1986
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Oil-Exporting LDCs:
Impact of Changing Oil Prices
Million US $
(except where noted)
Revenue Loss
Interest Savings
Estimated
Export
Gains a
Combined
Impact
Combined
Impact as a
Share of
Reserves b
(percent)
World oil at $20 per barrel
-1,661
38
-475
51
-3,575
862
104
-2,609
58
-3,630
169
46
-3,415
416
-3,322
205
45
-3,072
32
World oil at $15 per barrel
Algeria
-2,938
67
91
-2,780
102
Ecuador
-840
90
15
-735
125
Egypt
-1,150
46
29
-1,075
120
Indonesia
-6,325
101
139
-6,085
125
Malaysia
-965
195
75
-695
16
Mexico
-6,325
1,525
193
-4,607
102
Nigeria
-6,422
299
85
-6,038
735
Venezuela
-5,876
363
82
-5,431
58
a Estimated export gains to OECD countries only.
b Include central bank reserves less gold.
Mexico, Nigeria, and Venezuela-that rely on oil
revenues to pay their foreign debts. Other oil-
exporting LDCs such as Algeria, Egypt, and Indo-
nesia may also face serious debt servicing difficul-
ties. Our analysis of the major oil-exporting LDCs
outside the Persian Gulf indicates that a fall in oil
prices to $20 per barrel could reduce export reve-
nues in these countries by as much as 30 percent.
Lower interest rates and higher OECD economic
growth will provide minimal help when compared
to the sizable oil revenue losses. Our analysis
indicates that only Mexico-with a relatively small
proportion of its debt at fixed interest rates-
benefits significantly from an interest rate decline.
At $20 per barrel, Nigeria, for example, will
receive less than $50 million from export gains to
the OECD, but experience oil revenue losses of
$3.6 billion.
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Adjustment Options
To compensate for lost revenues, policymakers in
oil-exporting LDCs will have to draw down foreign
exchange reserves, cut imports, boost oil exports,
obtain new money from international creditors, or
undertake some combination of these actions. Of
the major debt-troubled LDC oil exporters, only
Venezuela has a reserve cushion large enough to
cover its revenue loss if oil prices fall to $20 per
barrel. Other producers such as Ecuador, Egypt,
and Indonesia-whose losses would equal about 70
percent of their foreign exchange-are not likely to
rely solely on their reserves.
At the same time, the substantial import cuts that
LDCs have already made in the past three years
will make further cuts politically more difficult.
Furthermore, most LDC producers cannot boost oil
exports to a level that would significantly improve
their current account position. As a result, LDCs
probably will seek new loans from creditors. Bank-
ers, however, will be more reluctant to lend given
the LDCs' deteriorating ability to service their
debts. A fall in oil prices to $20 per barrel could
change the list of debtor countries receiving assis-
tance from the Baker plan, as LDC oil exporters
would require a larger percentage of the funds
available, while LDC oil importers would need less
financial help.
At $15 per barrel-our worst case scenario-LDC
oil exporters will face grave economic difficulties.
Erosion of oil prices to this level would certainly
push the financial needs of the heavily indebted oil-
exporting countries beyond the resources of the
Baker plan unless additional strong austerity mea-
sures were taken. Their net revenue losses would
outstrip reserves and require adjustment well be-
yond that of the past few years. Mexico, Nigeria,
and Venezuela-whose combined external debt to-
tals $155 billion-would stand to lose nearly
$19 billion in revenues in one year, making their
Estimating the Impact of an Oil Price Decline
Our two scenarios present the costs and benefits to
LDCs in the first year of an oil price decline. World
oil prices drop by $6.50 to $20 per barrel in the first
scenario, and by $11.50 to $15 per barrel in the
second. To determine the amount of interest savings,
we assumed each $5 per barrel decline in the price of
oil would lead to a decline in interest rates of I
percentage point. These declines were then applied to
estimates of the amount of debt each country held at
floating interest rates, using BIS and World Bank
data. The estimates of LDC export gains assumed a
1-to-1 relationship between changes in OECD growth
and changes in the OECD demand for LDC exports.
OECD growth projections were derived from our
Linked Policy Impact Model (LPIM) of the world
economy.
debt servicing burden untenable. Nigeria-like
Peru last July-has already limited debt payments
to a percentage of its export earnings. We believe
that in the face of substantial oil revenue losses
other oil producers would consider similar restric-
tions.
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Persian Gulf OPEC States:
Increased Financial Strain From
Lower Oil Prices
7
Persian Gulf OPEC producers ' this year have little
chance of raising oil revenues because of the oil
market's limited ability to absorb additional pro-
duction without depressing prices further. As a
result, these countries face hard decisions on how to
cope with lower revenues amid growing domestic
criticism over how their economies are being han-
dled. Iran and Iraq will have to make the deepest
domestic cutbacks because foreign exchange re-
serves already are at minimal levels and could be
forced to find a solution to the six-year-old conflict.
Even if Saudi Arabia sharply increases production
and exports, financial difficulties probably will
remain.
Adjusting to Lower Revenues
Last year's soft oil market again forced the Persian
Gulf OPEC states to cut spending. Aggregate oil
exports (including natural gas liquids) of these
countries dropped to an estimated 7.9 million b/d,
down from 9.0 million b/d in 1984, and the
weighted average price per barrel was down $1.30:
for the decline in demand for OPEC oil, and its
current account recorded an estimated $18 billion
deficit in 1985.
accounts have remained in surplus because sparse
populations and declines in economic activity
made cutting imports easier. Nonetheless, these
economies have suffered and many financial in-
stitutions are on the brink of failure.
? In Kuwait, Qatar, and the UAE, the current
largely at the expense of the civilian sector-to
bring its deficit down to a more manageable
$1 billion.
? Iran lopped almost $4 billion off its import bill-
Persian Gulf OPEC States: Billion US $
Current Account Balances, 1980-85
Saudi 47.5 49.7 7.5 -15.0 -20.0 -18.0
Arabia
Iran
Iraq
-1.0
-4.9
? Iraq's $2 billion rise in oil revenues was offset by
a similar rise in imports, leaving its current
account deficit only slightly improved.
In addition to import cutbacks, most Gulf countries
have either drawn down or slowed the growth of
their foreign assets. Saudi Arabia financed much of
its current account deficit from foreign exchange
reserves. Liquid reserves, however, were down to
$70 billion; the rest consisted of loans to LDCs and
substantial cash and oil credits to Iraq.
Kuwait, the UAE, and Qatar all added to their
foreign assets, but not by the magnitudes of the
current account surpluses. We believe fears of
Iranian attacks, stagnating economies, and banking
problems have spurred considerable capital flight in
all countries and inhibited the growth of reserves.
For Iran and Iraq, the continuation of the Gulf war
has helped force liquid reserves to minimal levels.
Secret
DI IEEW 86-004
24 January 1986
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Persian Gulf OPEC States:
Official Foreign Assets, 1980-85
Billion US $ OPEC Oil and Financial Prospects, 1986
Kuwait
54
62
69
67
70
74
UAE
27
33
35
39
35
39
Qatar
6
8
8
9
10
11
Because of the soft oil market, the Gulf OPEC
states will have little chance to raise oil revenues
unless other suppliers are willing to reduce produc-
tion, an unlikely scenario. If oil prices were to fall
to $20 per barrel in response to an additional
1 million b/d of OPEC production, Gulf revenues
could fall by nearly $12 billion; at $15 per barrel,
Gulf revenues could decline by $27 billion
Under either price scenario, Iran and Iraq would
face difficult decisions. If oil prices remain steady,
continued high production for Iraq and low import
levels for Iran will limit deficits to $1-2 billion. A
Price
Stability
$20 per
Barrel
Production Under Different
Price Scenarios a (thousand b/d)
Total
17,300
18,300
Saudi Arabia b
4,000
5,000
Kuwait b
1,000
1,000
UAE
1,250
1,250
Qatar
300
300
Iran
2,350
2,350
1,800
1,800
$15 per
Barrel
19,300
5,000
1,100
1,300
300
2,500
1,800
Revenues Under Different
Price Scenarios (billion US $)
Total 127.7 104.0 83.1
Saudi Arabia 28.3 28.7 21.5
Kuwait 7.2 5.4 4.6
UAE 11.2 8.5 6.6
Qatar 2.9 2.2 1.7
Iran 14.8' 11.2
Different Price Scenarios c (billion US $)
Total - 20
Saudi Arabia -20
Kuwait 5
collapse in prices to $15 per barrel could push UAE
revenues below $10 billion for each. With no Qatar
reserves and little ability to increase sales, they Iran
-44 -66
-20 -27
3 2
would experience current account deficits of up to Iraq -2 -6 -8
seven times current levels. Other OPEC -10 -22 -28
For Saudi Arabia, financial difficulties probably
will remain whether oil prices and production re-
main steady or prices fall to $20 per barrel. Assum-
ing that Riyadh's imports and net services remain
at 1985 levels, we believe that Saudi Arabia will
have to cover only a $2 billion increase in its
current account deficit next year. Nonetheless,
liquid foreign assets would decline to below
a Including natural gas liquids.
b Including Neutral Zone.
c Based on 1985 import levels.
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Soft Oil Markets: Heavier Burden
for the Gulf Combatants
inflated prices.
Iran already has suffered severely from the soft oil
market. During the past two years, only Saudi
Arabia has experienced a larger decline in its oil
revenues. Tehran slashed imports by one-third in
1985 to preserve foreign exchange assets of about
three months' import coverage. The vulnerability
of its oil exports to Iraqi attack has heightened
regime concerns about a financial crisis and the
need for such reserves. Import cuts have caused a
contraction in all sectors of the economy except
agriculture. Industrial production and construc-
tion have suffered considerably from a lack of
imported materials and spare parts, increasing
already high unemployment. Consumers can find
some goods only on the black market at highly
mise to end the six-year-old conflict.
The soft oil market and the potential for lower-
possibly sharply lower-oil prices are adding to
the economic and political woes of Iran and Iraq.
Neither country-wants to impose additional auster-
ity measures that would reduce morale. Both,
however, lack sufficient foreign assets to ride out a
fall in revenues. Indeed, Iraq has already contrib-
uted to downward pressure on oil prices with the
opening of its pipeline through Saudi Arabia.
Possible Iranian a forts to export more oil and
shore up its finances would add still more pres-
sure. A sharp oil price drop-below $20 per
barrel-would threaten both regimes, and perhaps
could spur Tehran and Baghdad to seek a compro-
Saudi Arabia.
Despite a great reluctance to increase downward
pressure on oil prices, Iran's new Minister of
Petroleum, Qolam Reza Aqazadeh, may be tempt-
ed to ease economic troubles by using some of
Iran's I million b/d surplus oil production capacity
to increase export volumes. Aqazadeh is closely
associated with Prime Minister Musavi and other
ministers who have long advocated increasing oil
sales. Moreover, Aqazadeh has threatened to ex-
port two barrels for every one Iraq exports through
A collapse of oil prices to the $15 level would cut
further into essential consumer and military goods
imports. Tehran might claim the price fall was
engineered by Western enemies of Iran and threat
en to close the Strait of Hormuz or attack Gulf
states who "support the West. " These threats
would be largely for domestic consumption be-
cause such actions would risk Western military
intervention. Economic difficulties are likely to
lead to a rise in public discontent. This could
weaken the radical Musavi cabinet, already under
attack by conservatives for the poor state of the
economy, and favor more moderate clerics in a
post-Khomeini power struggle. Moreover, the re-
gime may be pressed to reach an accommodation
on the war.
Iraq'sfinancial position has improved a bit since
the opening of the Saudi pipeline last October, bu
a major price drop would cause significant eco-
nomic hardships. Financial aid from Arab allies
and debt reschedulings based on an anticipation
higher oil revenues have so far prevented sharp
cuts in consumer imports. Iraq's oil exports are
near capacity, however, and a collapse of world Jo l
prices could force Baghdad to trim living stan-
dards for its already war-weary populace.
Although Iraqi President Saddam Husayn still
retains a strong grip on power, popular morale i
depressed and could worsen with deteriorating
economic conditions. Iraq's conduct of the war a
its relations with Saudi Arabia and Kuwait cou
both be affected. Baghdad might increase its at-
tacks on Iranian oil facilities or other economic
targets in an attempt to press Iran. On thefinanc
side, Iraq would increase pressure on its Arab
allies-Saudi Arabia and Kuwait-to maintain,
rather than trim, large aid flows. Moreover, sho
term debts with Western Europe and Japan pro
bly would have to be rescheduled.
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Secret
$50 billion. If prices fall below $20 per barrel, we
believe financial difficulties would worsen signifi-
cantly.
Kuwait, the UAE, and Qatar would be able to
maintain small current account surpluses at 1985
expenditure levels, under all price scenarios. All
could face reserve drains, however, if Iranian at-
tacks or declines in public confidence spur further
capital flight.
The moderate Gulf countries, especially Saudi Ara-
bia, will have to continue to cut budget expendi-
tures and imports this year as oil prices fall. In
Saudi Arabia, even with spending cuts, reserve
drawdowns will be necessary. We concur with the
US Embassy's assessment that the Saudis probably
will draw $5 billion of ARAMCO funds for budget
support early this year. The Saudis also probably
will borrow on international credit markets before
liquid reserves fall much below $50 billion
With no official debt and
significant reserves, Riyadh is a solid credit risk.
Given the bleak outlook for oil revenues, all Gulf
governments also will have to make some difficult
decisions about their domestic economies. Re-
trenchments in budget spending and imports will
have to continue. Growth in GDP in these countries
probably will shrink this year, and little growth will
occur until the demand for OPEC oil increases-
probably in the 1990s.
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Before the Storm
Mounting economic pressures and frustration with
OPEC indiscipline have forced Riyadh to reevalu-
ate its oil policy. Although the Saudis are still
concerned about a long-term market for their oil,
short-term revenue needs have become the driving
force behind Saudi oil policy. Riyadh's recent
aggressive pricing and production decisions indi-
cate that the Saudis are prepared to let prices drop
sharply to force cooperation from both OPEC and
non-OPEC producers. Despite the ramifications of
recent actions, domestic pressures to end the reces-
sion and the desire to regain a more powerful role
in the oil market point to further wrenching deci-
sions on oil and economic policy.
Saudi Arabia's efforts to cut expenditures and limit
imports have been insufficient to contain growing
budget and current account deficits, or to slow the
drain on the country's financial reserves. Riyadh
failed to balance the FY 1985/86 budget (22
March 1985-11 March 1986) despite spending cuts
totaling 8 percent that even included cancellation
or postponement of a number of defense projects.
Unlike previous cutbacks, which primarily hurt
expatriate laborers and foreign companies, these
cutbacks had a direct impact on Saudi citizens.
Moreover, popular dissatisfaction with Riyadh's
handling of the economy has been compounded by
the growing perception that the royal family has
insulated itself from the effects of the recession.
Saudi Arabia's problems worsened as oil produc-
tion fell. Weak demand for OPEC oil caused Saudi
output to plummet to a 20-year low of 2.2 million
b/d last August, far below the 3.8 million b/d
target upon which the current budget is based.
Faced with a budget deficit approaching $25 billion
and a current account deficit of $18 billion, Riyadh
began drawing on its financial reserves at a rate of
nearly $2 billion per month-a pace that would
exhaust foreign reserves in less than three years.
Riyadh has had limited options to ease mounting
economic pressures:
? Draw down international liquid assets by more
than $10 billion a year-which the Saudis, in our
judgment, would be reluctant to continue.
? Keeping the budget deficit at $10 billion, which
would have required cutting expenditures by an
additional $15 billion-an almost impossible feat
because of political and bureaucratic constraints.
? Borrow funds on the international market.
? Unilaterally boost oil production.
Riyadh Breaks Ranks
Saudi Arabia decided late last summer that boost-
ing oil production was its most palatable option to
avoid further belt-tightening, even if this risked a
price war. To that end, Riyadh renounced its role
as OPEC's swing producer. King Fahd also assert-
ed Saudi Arabia's right to price its oil unilaterally.
Subsequently, a, series of contracts based on net-
back pricing' were signed. This move effectively
discounted Saudi prices by $1 to $2 per barrel, and
the volume of
netback contracts quickly rose to 2.2 million b/d,
more than half of current export levels.
The new Saudi marketing strategy sent a signal to
other oil producers that Riyadh will give top priori-
ty to national interests and ensure a growing
demand for its oil.
' The netback price is a price equivalent to what a barrel of crude
oil is worth after it has been refined into products such as gasoline
Secret
DI IEEW 86-004
24 January /986
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Secret
Evolving Saudi Oil Policy
vrni, announces win aeieno
million b/d "fair share" of market. Saudi
Saudi output--7.4 million b/d output-5 million b/d
OPEC ceiling drops to 17.5 Saudi output up to 4 million b/d.
million b/d OPEC meeting ends in disarray.
Saudi output-6.6 million b/d
First OPEC price cut-down Saudis abandon swing producer
$5/barrel role-sign netback deals.
Ceiling reduced-17.5
million b/d Nine OPEC ministers meet in
Saudi output-4.7 million b/d Taif; King Fahd statement
admonishes OPEC for over-
OPEC sets 1983 ceiling-18.5 production. Saudi output-
million b/d 2.7 million b/d
Saudi output-5.3 million b/d
OPEC lowers price $I to
$28/barrel
Saudi output-3.5 million b/d
OPEC ceiling reduced to 16
million b/d
Saudis officially agree to be
swing producer.
Output-4.2 million b/d
Million b/d
-
To
8
crude oil production'
Saudi
6
4
2
1985
J
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Saudi Arabia: Oil Production Under
Various Oil Revenue Targets
$15 per barrel of oil
$20 per barrel of oil
$26.50 per barrel of oil
Saudi Arabia's current revenue needs will be a key
determinant of its oil production decisions and,
thus, of world oil pricing this year. We believe the
Saudis are loath to cut defense expenditures fur-
ther, and last year's deep budget cuts make further
reduction in civilian spending difficult. Therefore,
Riyadh probably will seek to bolster oil revenues to
$35 billion, which, with an additional $15 billion in
nonoil revenue, would allow expenditures of $50
billion without drawing down foreign assets or
borrowing in the international market. Ensuring
this $35 billion level, however, would require oil
production of 4.6 million b/d at a $26.50 per barrel
price.
If prices slip to $20 per barrel, Riyadh would have
to raise output to nearly 6 million b/d to meet an
oil revenue target of $35 billion. Such an increase
in sales probably would be unattainable in the face
of the fierce competition that would emerge. More
likely, the Saudis would only be able to earn
approximately $30 billion with production of about
5 million b/d. This would force foreign exchange
reserve drawdowns of $500 million per month or
budget cuts of $6 billion-an additional 12 percent
over already assumed cutbacks in the new budget.
If oil prices were to plummet to $15 per barrel,
Saudi output would have to average over 7 million
b/d to meet a $35 billion revenue goal-a level
even less attainable. If Saudi Arabia produced only
5 million b/d worth $22 billion in revenue, foreign
reserves would have to be drawn down at the rate of
slightly more than $1 billion per month or the
budget would have to be pared by an additional $13
billion.
The Saudi Strategy
Riyadh apparently intends to produce more oil to
shore up revenues if prices begin to fall. Over the
past several months, Yamani has referred to the
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Saudi Arabia: Share of OPEC
Crude Oil Production
1978
Total OPEC: 29.8 million b/d
Other OPEC Saudi Arabia
21.5/72 8.3/28
1981
Total OPEC: 22.7 million b/d
Other OPEC Saudi Arabia
12.9/57 9.8/43
1985
Total OPEC: 16.2 million b/d
Other OPEC Saudi Arabia
12.7/78 3.5/22
Indicators of Saudi Intentions
Regarding Oil Policy
Signals of a change in Saudi oil policy include:
Statements by King Fahd or Minister of Petro-
leum Yamani regarding oil production or prices.
? Changes in volumes under netback deals. For
example, growing volumes priced on a netback
basis would indicate that Riyadh intends to keep
production levels high. A reduction in netback
deals, on the other hand, might be a precursor to
cutting back output.
? The emergence of large volumes of oil exports
destined for Far Eastern markets. The region
initially was excluded from netback sales and
thus increased sales would indicate Saudi re-
solve to maintain or increase oil production.
? A liberalization of terms of the netback contracts
or outright price discounting. This would point to
more aggressive marketing tactics.
egy.
? Replacement of Yamani. Yamani's departure
would make it even more difficult for OPEC to
formulate and implement any price defense strat-
possibility of oil prices of $18 to $20 per barrel.
Saudi Arabia may believe that oil prices are too
high and that the only way to spur demand is to
force prices sharply lower. Yamani also asserts that
the Saudis, with ample excess productive capacity,
could maintain revenue levels by doubling current
oil exports even if prices fall to $14. For this
strategy to work, however, either demand for oil
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Secret
will have to grow significantly at the lower prices-
an unrealistic assumption given the unresponsive-
ness of consumption to price changes in the short
term-or Riyadh will need to increase its market
share. If prices begin to fall rapidly, countries
desperate for revenue-such as Nigeria and Mexi-
co-may also try to garner a greater market share,
causing a further downward price spiral.
Saudi Arabia is gambling that non-OPEC produc-
ers, as well as other OPEC members, will curb
output once they see that Riyadh is intent on
ensuring oil revenues. If the other producers dem-
onstrate a willingness to work together, we believe
that Riyadh might then be willing to resume a role
as OPEC's swing producer in an attempt to stabi-
lize prices in the $20 to $25 per barrel range.
Riyadh probably would seek a guarantee from the
group, however, that the Saudis would be able to
secure an annual market share of 4-5 million b/d-
including output from the Neutral Zone.
Cooperation will be difficult to achieve. Most of
OPEC's other members face even more difficult
financial problems and would be hard pressed to
make further sacrifices. Non-OPEC producers are
unlikely to bow to Saudi pressure
Moreover, because of the
complexity of the international oil market, Saudi
Arabia and the other producers could have difficul-
ty regaining control of prices if they decline
rapidly.
Riyadh probably believes that a more aggressive
stance may help shield it from domestic criticism
resulting from economic hardships. Still, if oil
prices plummet, Riyadh might have to become
more flexible about its oil revenue goals because
competition for market share would be fierce. It
could again decide to draw down international
reserves rapidly to cover revenue shortfalls, but this
asset cushion-currently approximately $70 bil-
lion-is insufficient to cover large deficits for a
protracted period. Riyadh probably would also try
to pare expenditures, but this would be difficult to
do without affecting the Saudi population. Such
cuts would also risk growing public dissatisfaction
if the royal family continues to avoid sharing the
burden of lower oil revenues.
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Mexico: The Producer/Debtor
Dilemma
The soft oil market probably will force Mexico City
to backslide on this year's austere budget and could
derail attempts at economic adjustment. Moreover,
since oil receipts make up 70 percent of export
earnings and are about equal to this year's debt
burden, it is becoming increasingly likely that the
country will be unable to fully honor its financial
obligations. Analysts argue that Mexican oil, at an
average of $24 per barrel, is still overpriced by an
average of $1 per barrel. Given the critical need to
maintain market share and export revenues, we
believe the country must demonstrate uncharacter-
istic flexibility and adjust its price accordingly. Our
analysis suggests that Mexico's financial gap this
year may rise $3.3 billion-to a total of $9 bil-
lion-assuming a fall in world oil prices to $20 per
barrel and the likelihood of no appreciable increase
in the level of nonoil exports.
Mexico's latest price adjustment-a 90 cent per
barrel reduction on 30 December-will yield a
revenue loss of about $500 million if targeted
export levels of 1.5 million b/d are maintained.
While this clearly implies an increased burden on
the Mexican economy relative to last year, it is
manageable without making substantially deeper
spending cuts, seeking a debt rescheduling, or
asking for a greater amount of new money. In fact,
government planners already had assumed a $2 per
barrel price drop when they calculated this year's
budget. As a result we still expect that real GDP
will contract by 0.5 to 1.5 percent and the current
account will suffer a deficit on the order of $1-2
billion if oil prices remain at current levels.
worst case scenario. Even though world demand would rise in
response to lower prices, we believe the investment needed to step
up production and the longer term problems of overproducing
Significant Fall in Prices' 25X1 25X1
In the more likely case-that Mexico's oil prices 25X1
fall $6 and stabilize around $18 per barrel 2-the
annual revenue loss would reach $3.3 billion. In
this scenario, the country faces far greater prob-
lems. Unable to offset the loss through increased
internal financing, Mexico would be required to
undergo more severe belt-tightening and seek
greater external assistance in the form of additiona
new lending, debt restructuring, and other help.
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at current export
levels $8 of each barrel sold-abroad is needed to
cover actual costs, $10 to fund social programs, an
the remainder is applied to the debt burden. Conse-
quently, if Mexican oil fell to $18 per barrel, there
would be a direct trade-off between social pro-
grams and debt repayment once sources of new
lending were exhausted. Given the political atmo-
sphere and the fact that the government already
plans to cut spending deeply, we believe Mexico
City would attempt to find a way to reduce debt
payments in order to minimize cuts in social pro-
grams.
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Mexico's loss in oil earnings would be partially
offset after a 6- to 9-month lag by reduced interest
payments as interest rates fell in response to lower
energy prices. We estimate that this price would
lower international interest rates roughly 1 percent-
age point, providing Mexico an $850 million reduc
tion in debt servicing.
' Because of their lower quality, Mexican crudes are priced below
the world average. An $18 per barrel Mexican price corresponds t
/_%.)/\ 1
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DI IEEW 86-004
24 January 1986
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Secret
Tighter domestic austerity and greater foreign as-
sistance probably would enable Mexico to sur-
mount its immediate financial hurdles, but a great-
er share of public spending would have to be funded
through internal financing. As a result, the coun-
try's chronic financial problems-massive deficits
and high levels of inflation and capital flight-
would worsen, increasing the trauma associated
with economic reform.
Oil Price Collapse
If Mexican oil prices would plunge to $13 per
barrel '-a worst case scenario, in our view-oil
revenue losses would total about $6 billion, partial-
ly offset after a lag by an estimated $1.5 billion
saving in interest payments. In the near term, this
oil market collapse would dictate an abrupt shift in
Mexican economic policy, force a suspension of
debt payments, and lead the de la Madrid adminis-
tration to seek substantial assistance from abroad.
Over the longer term, economic restructuring
would put added pressure on the political system.
Mexico's creditors, encouraged by lower energy
costs, might be more forthcoming with increased
lending since oil-importing debtors would be in
better position to service their debts. Still, addition-
al funding would be tempered by the realization
that an improvement in Mexican economic health
would come only well into the future. In addition,
as the positions of oil-importing debtors began to
improve, Mexico City would lose the threat of
inciting multilateral debtor action, a tool we believe
has enhanced its negotiating power in the past. Our
judgment that Mexico will be unable to increase oil
production suggests that the government may initi-
ate a policy of domestic rationing in order to free
more petroleum for the export market. For exam-
ple, by diverting 10 percent of domestic supplies,
$550 million more in export revenues would be
realized. In addition, OECD growth fueled by
lower energy prices and inflation would significant-
ly boost the demand for Mexico's nonoil exports.
Even with this relief, however, a tremendous gap
would exist between income and expenditures.
We believe that a combination of debt relief,
limited new lending, and increased US imports
would be insufficient to solve Mexico's problems in
the absence of major structural reform. To avert
economic collapse, policymakers would be forced to
implement long-needed structural adjustments,
drastically reducing the role of government in the
economy, and welcoming increased foreign invest-
ment. This type of policy shift surely would cause
intense dissent among the more populist members
of the ruling Institutional Revolutionary Party,
who favor statist policies and view the government
as the "rector" of the economy.
While we
e ib Iieve these policies are mandatory for sustainable
growth, their quick implementation in such a crisis
would cause severe hardships and constitute a
grave threat to social order.
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North Sea Oil Producers:
Economic Implications of
Falling Prices
The United Kingdom and Norway, as net oil
exporters, would not be badly hurt by lower oil
prices, but would have problems in dealing with the
substantial loss of oil tax revenue. If oil prices fell
to $20 per barrel we estimate that both countries
would experience slower economic growth in the
first year following the decline, but that the loss
could be more than made up subsequently. The
United Kingdom could suffer, however, if lower oil
prices triggered a run on the pound, causing Lon-
don to boost interest rates. We also do not believe
that lower oil prices would significantly affect
British or Norwegian energy production during the
remainder of this decade. Beyond 1990, however,
$20 per barrel oil probably would slow the develop-
ment of many small North Sea oilfields and might
deter development of Norway's giant Troll gasfield.
The UK Economy and Lower Oil Prices
By itself, an oil price decline would slow British
economic growth during the first year, but the
economy would quickly rebound during the second
year, according to our Linked Policy Impact Model
(LPIM). A fall in oil prices to $20 per barrel would
cut the value of British oil exports by more than
$4 billion annually. In the first year, we estimate
GNP growth would be reduced by 0.6 percentage
point. Lower exports, both oil and nonoil, and lower
investment would be the -main contributors to slow-
er growth, more than offsetting the stimulus pro-
vided by lower inflation and interest rates. By the
second year, however, the benefits of lower oil
prices to the overall economy would begin to take
hold. Lower inflation and interest rates would boost
consumer spending and investment, while exports
would rebound because of increased growth by
Britain's trading partners. Unemployment would
rise by about 0.2 percentage point in each year
because of higher real wages, but inflation would
be reduced by 1.4 percentage points in the first
year and continue to decline in following years.
A sharp drop in oil prices would have its greatest
impact on government finances. London probably
would not carry out the tax cuts of $2.8-3.5 billion
planned for the March budget, given its determina-
tion to reduce the budget deficit to $10 billion in
the 1986-87 fiscal year. The Treasury's forecast
allows for a drop in oil prices to about $26 per
barrel. Since each one dollar fall in oil prices
reduces tax revenue about $740 million, a fall to
$20 would cost London about $4.4 billion annually.
Our projections are supported by two prominent
London brokerage houses, which recently released
reports estimating that lower oil prices will leave
London no room to cut taxes in March; a third
analysis sees the possibility of a smaller tax cut.F-
The impact of a fall in oil prices to $15 per barrel
would be roughly double that of $20 per barrel oil.
GNP would fall by 1.2 percentage points in 1986,
but would rebound even more stongly in 1987
because of a sharp rise in investment. The fall in
inflation would be greater, 2.5 percentage points in
the first year and almost 2 points in the second. A
$15 per barrel oil price would lower British oil
exports by about $8 billion per year and put
significant downward pressure on sterling. In this
scenario, it is very likely that there would be a
repeat of last year's sterling crisis, and the pound
could approach parity with the dollar unless Lon-
don took steps to stop its fall.
Sterling and Interest Rates
The ultimate impact of lower oil prices on the
British economy will depend on how Prime Minis-
ter Thatcher reacts to downward pressures on the
pound. Using the LPIM, we estimate that if the fall
in oil prices to $20 per barrel is accompanied by a
20-percent depreciation in sterling, 1986 GNP
would still be reduced by 0.5 percentage point but
1987 GNP would get almost a 3-percentage-point
boost, due to highter export volume and investment.
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DI IEEW 86-004
24 January 1986
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United Kingdom: Economic Impact of
Lower Oil Prices a
No change in the exchange rate or economic policy
10-percent depreciation of the pound
20-percent depreciation of the pound
3-percentage-point interest rate hike to prevent
pound depreciation
No change in the exchange rate or economic policy
Percentage point change
from baseline scenario
-0.6
0.6
-1.4
-1.0
-0.5
0.1
-0.8
1.9
-0.5
1.7
1.3
-0.1
2.0
1.9
-1.0
2.2
-0.5
2.9
4.0
0.6
4.2
3.4
- 1.3
3.5
- 1.3
0
-1.4
-0.9
-0.6
0.2
-2.5
1.1
$15 per barrel oil
-1.2 1.0
Results from our Linked Policy Impact Model. The baseline
scenario assumes an oil price of $26.50 per barrel, an exchange rate
of $1.38 per pound, and interest rates of 11.5 percent.
government revenues.
With a 20-percent depreciation, however, the loss
of oil tax revenues would be almost totally offset
because a decrease in the pound/dollar rate raises
the sterling receipts of oil companies and, hence,
In our judgment the actual pound depreciation
resulting from $20 per barrel oil probably would be
less than 20 percent-about 10 percent seems most
likely. In this case GNP is reduced by 0.5 percent-
age point in the first year and boosted 1.7 percent-
age points in the second year, while inflation in
both years is lower than in the baseline scenario.
To keep the falling pound from reigniting inflation,
Thatcher probably would again raise interest rates,
as she did last winter. In fact, London recently
encouraged British banks to raise their base lending
rates by 1 percentage point to 12.5 percent. Efforts
to control inflation through higher interest rates
could more than offset the benefits of lower oil
prices and a lower pound. Such a move would help
Thatcher hold inflation in check but would also
slow economic growth below the 2.5-percent rate
generally forecast for next year. Our model esti-
mates that, if London raises interest rates by an
additional 2 points, it would reduce inflation by 1.4
percentage points, but at the cost of reducing GNP
growth by 1.3 percentage points.
Norway
A drop in oil prices probably would slow economic
growth more in Norway than in the United King-
dom because of oil's relatively larger economic role.
We estimate that a price fall to $20 per barrel early
in 1986 would cut about 1 percentage point from
the expected 3-percent GDP growth rate.' A fall to
$15 could reduce the rate to about 1.5 percent. The
3-percent projection is based on large increases in
investment spending resulting from record profit
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Oil's Role in the Economy
3
damaging traditional exports.
United Kingdom. North Sea oil has provided the
British economy a major boost since production
began in 1975, with crude petroleum now account-
ingfor about 17 percent of British exports and
6 percent of GDP. North Sea oil is important for
the Treasury as well, providing about 7 percent of
government revenues. Production has increased
rapidly, to about 2.7 million b/d last year, al-
though output is likely to peak sometime in early
1986 and decline sharply over the next decade.
While oil has stimulated the growth of new indus-
tries to provide oil equipment and services, it also
has added to problems in older manufacturing
industries by keeping the pound's value high and
Norway.. Oil plays an even larger role in the
Norwegian economy. As in the United Kingdom,
oil production began in the mid-1970s; it reached
800,000 b/d in 1985 and could top I million b/d by
the end of the decade. Norway's oil wealth has to a
3 large extent facilitated expansive economic policies
that over the last decade have enabled Norway to
achieve sustained economic growth with very low
unemployment. Petroleum royalties now finance
about 16 percent of the central government budget,
and petroleum accounts for almost 30 percent of
exports of goods and about 15 percent of net
national income. While there probably has been
some negative impact on traditional industries, it
is less noticeable than in the United Kingdom
because the Norwegian industries generally had
fewer problems to begin with.
UK and Norway: North Sea Oil
Production, 1975-85
I% I I I I I I I I I
0 1975 80 85
85 percent, a drop in oil prices from $26.50 to $20
per barrel would slash government revenue by more
than $1.0 billion, even if oil production increased
by as much as 100,000 b/d this year. A fall to $15
would further reduce revenues by almost $0.9
billion. As in the United Kingdom, the revenue loss
in domestic currency would be less to the extent
that the oil price drop caused the krona to depreci-
ate against the dollar. Nevertheless, Oslo probably
would be faced with its first budget deficit in more
A
than a decade.
down investment.
levels in the last three years. We think that the
government's gloomy forecasts based on the pros-
pect of lower oil prices have already dampened
short-run business expectations, which will hold
The government budget would also be hard hit
because oil accounts for 16 percent of Oslo's tax
revenue. With the marginal tax rate on oil around
The budgetary impact probably would lead to
increased confrontation between the governing
Conservative coalition and the opposition. The mi-
nority government is warning of significantly di-
minished oil tax revenues during the rest of the
decade, but will probably accede to opposition
demands for spending increases this year. Under a
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UK and Norway: Sources of
Government Revenue
Interest and Income and
other 7.4 other taxes 70.4
National
insurance
contributions
15.5
oil exports.
wipe out the surplus expected in 1986. The lost oil
export revenue would almost certainly cause some
depreciation of the krona, but because of Norway's
exceptional economic stability over the last decade
the chance of an exchange rate crisis is much less
than in the United Kingdom. Consequently, the
likelihood of the government imposing restrictive
policies to support the exchange rate is also much
less. At $15 per barrel, a current account deficit
would not necessarily result if increased West
European economic growth boosted Norway's non-
Implications for Energy Production
3
increases in other taxes.
Other direct and
indirect taxes
51.2
demands for spending increases this year. Under a
$20 per barrel scenario-and even more so under a
$15 one-Conservative opposition to spending in-
creases would probably strengthen, because re-
duced oil tax revenues are unlikely to be offset by
With net oil exports likely to be between 600,000
b/d and 650,000 b/d this year, a $6.50 fall in the
price per barrel would cut annual export revenue by
close to $1.5 billion. Norway's current account
balance already has been declining from its $3.2
billion peak in 1984, and this loss would just about
A $20 per barrel oil price would not significantly
affect British or Norwegian energy production
during the remainder of this decade; Norway might
even boost output somewhat to offset the lost
revenue. Beyond 1990, however, the lower price
could impede the development of the smaller, high-
er cost oilfields that London is counting on to slow
the inevitable decline in oil output. More ominous-
ly, by pulling down the price of natural gas, the
lower oil price could threaten the development of
Norway's Troll gasfield. Even $15 per barrel oil
prices would not substantially reduce energy pro-
duction during the remainder of the decade, bar-
ring a decision by Oslo to restrict output to prop up
prices. North Sea output would, however, certainly
decline in the 1990s, and development of Troll
would become uneconomic if prices stayed that low.
This giant gasfield continues to be Western Euro-
pe's principal alternative to greater reliance on
Soviet gas after 1995.
3
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Soviet Oil Production and Exports:
Outlook for 1986
Soviet oil production in 1985 fell-for the second
consecutive year-to about 11.9 million b/d, more
than 300,000 b/d below the 1984 level. Hard
currency receipts from oil exports dropped about
$3.5 billion-down roughly 25 percent. The Soviet
plan for 1986 calls for raising oil production to
more than 12.3 million b/d, but the production
outlook is precarious, particularly for the key
Tyumen' region, which accounts for 60 percent of
oil output. On the basis of the oil industry's recent
record of rising investment and falling output,
together with extensive discussion in the Soviet
press of a widespread lack of equipment, skilled
manpower, and effective management in the indus-
try, we conclude that:
? Even with the planned boost in investment for the
oil industry, production is unlikely to rise above
the 1985 level.
? Depending on the degree of slippage in the supply
of resources to the oil industry, national output
could fall another 300,000 b/d.
? Despite conservation and substitution efforts, do-
mestic oil consumption is likely to remain at 1985
levels.
? Oil exports to hard currency countries will proba-
bly again bear the brunt of any production
shortfalls. At the extreme, export reductions,
compounded by anticipated oil price declines,
could cost Moscow as much as $4-6 billion in
hard currency earnings.
Trouble in the Tyumen' Region
Development of Tyumen's largest and best oilfields
began more than twenty years ago and the era of
"easy oil" has certainly come to an end. Further
Estimated,
b Plan.
attempts to increase-or even sustain-production
will be obstructed by several factors:
? Production is overly dependent on output from
eight to 10 large but overworked oilfields devel-
oped during 1964-73. Production from most of
them has peaked and output will probably con-
tinue to fall in 1986.
Secret
DI /EEW 86-004
24 January 1986
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? There is little likelihood for the imminent discov-
ery of a new supergiant oilfield. New capacity
will have to come from developing a much larger
number of remote fields that are smaller, struc-
turally more complicated, and far less productive
than the oilfields developed during the 1970s.
According to Pravda, however, the Soviets
planned to commission 26 oilfields during 1981-
85, but only 13 are producing. We judge that the
plan to bring 18 new oilfields on line in 1986 is no
more likely to be met.
? Average flow from new wells has been steadily
declining-from 1,250 b/d in 1975 and 490 b/d
in 1980 to about 220 b/d in 1985.
? Because of excessive water injection, the share of
water produced with oil in Tyumen' has risen
from 14 percent in 1975 to more than 50 percent
in 1985, sharply escalating the demand for reli-
able pumping equipment and also increasing the
production costs. Currently, pumps are used on
more than 70 percent of the producing wells in
the region, compared with about 20 percent in
1980.
? The Soviet press reports that production and
support infrastructure in the Tyumen' oil re-
gion-pipelines, injection facilities, and storage
tanks-is from four to five years behind the level
needed to support planned production. Moreover,
much of this equipment has been ravaged by
corrosion.
In 1985 Moscow sustained Tyumen' production by
transferring substantial equipment and labor.re-
sources to this region from the older producing
regions. Sustaining output in 1986 would require
an additional increase in allocation of similar re-
sources to Tyumen'. Further transfers, however,
could result in accelerated loss of output in the
older regions that could-because flow rates from
new Tyumen' wells can no longer be assumed to be
greater than those in some of the older regions-
cause national output to decline.
Prospects for Production
We judge that General Secretary Gorbachev is not
altering the thrust of oil policy and continues to
favor production growth despite the high cost and
the negative consequences for needed exploration.
In reaction to the two-year decline in production,
Moscow plans to raise oil output by more than 3
percent and increase oil investment by 31 percent
in 1986. We do not believe that the measures
outlined in Gorbachev's Tyumen' speech in Sep-
tember-increased application of science and tech-
nology, better equipment, a sharp increase in hous-
ing construction and the availability of amenities-
are capable of increasing production in 1986. Al-
though pressure from Gorbachev-most notably
the firings of high oil industry personnel for poor
performance-may lead to stepped-up production
from older fields in the short run, such gains will be
insufficient to push national output above the 1985
level and will be extremely difficult and costly to
sustain for more than a year at best.'
Moscow plans to allocate over 14 billion rubles to
oil industry investment in 1986, most of which will
be used in Tyumen'. Much of this investment,
however, will be absorbed by sharply rising costs
associated with providing sufficient capacity just to
offset depletion. Some of the main factors contrib-
uting to this result are:
? In the past the Soviets were able to compensate
for the downward trend in average well flows by
more intensive drilling of established fields. Ac-
cording to the Soviet press, this option may no
longer be available, and an increasing number of
new fields must be tapped in areas remote from
infrastructure.
' The new regime, in addition to replacing the Soviet oil minister,
removed key personnel in Tyumen'. Moreover, two production
associations that run oil operations in the European USSR were
given control over three West Siberian production directorates in an
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? The costs for developing the smaller and more
remote fields are escalating, but investment funds
reportedly are allocated on the basis of the lower
costs previously experienced in developing fields
in more favorable locations-essentially dooming
new output plans.
? On the average, 20 percent of the production
wells in Tyumen' stand idle.
? The leadtime for new equipment orders means
that delivery and timely installation in Tyumen'
will not be possible much before next winter,
when the ground is frozen hard and winter roads
can be built. The new fields are located generally
to the north of existing oil operations in areas
entirely lacking infrastructure.
Other Producing Regions
In aggregate, the oil and gas condensate output
from the other producing regions has been declin-
ing since 1975 and will very likely fall again in
1986, although the drop may not be as large as in
previous years. Newly developed oilfields on the
Buzachi Peninsula in Kazakhstan and in the Caspi-
an Basin (onshore and offshore), together with new
condensate output from Karachaganak, Astrak-
han', Shurtan, and Dauletabad, will help to offset
declining output from the old regions west of the
Urals. Production from the Volga-Urals area-the
USSR's second-largest producing region-has ex-
perienced annual declines averaging about 200,000
b/d since 1978
Can Oil Consumption Be Reduced?
We believe that domestic oil consumption-which
grew rapidly during the 1970s-has essentially
stabilized. Of the major oil products-gasoline,
kerosene/jet fuel, diesel fuel, lubricants, and fuel
oil-we judge that the only oil product for which
there exists a substantial opportunity (because of
either improvements in efficiency or substitution)
for reduced consumption is fuel oil.2 Nonetheless,
during 1981-85 Moscow did not decrease the vol-
ume of fuel oil consumed by thermal power
plants-a main goal of the oil conservation effort.
Our analysis indicates that the volume of fuel oil
consumed by power plants remained at nearly the
same level in 1985 as in 1980-about 2.5 million
b/d, 28 percent of total apparent oil consumption.
Despite successes in substituting natural gas for
fuel oil at many power plants, fuel oil consumption
by coal-fired power plants increased during 1981-
85 because of low-quality coal and coal shortages,
thus offsetting the potential savings in the oil-to-gas
conversion program.
The chairman of the State Committee for Oil
Products has indicated that, despite efforts to econ-
omize on the use of fuels and lubricants during the
first nine months of 1985, automobile transport
exceeded its planned allocation by more than
46,700 b/d of gasoline and 8,500 b/d of diesel fuel.
We believe that oil consumption will remain essen-
tially flat in 1986 because:
? The demand for oil products-such as gasoline
and diesel fuel-in the transportation and agri-
culture sectors will probably grow.
? There is little opportunity to reduce oil consump-
tion in the residential sector.
? The requirements for nonfuel oil products-such
as lubricants and plastics-will probably remain
constant.
? Fuel oil consumption in the electric power indus-
try-which accounts for about 70 percent of total
fuel-oil consumption-will probably decline only
marginally in 1986 due to continuing problems
with low-quality coal and coal shortages.
3 In 1986, the USSR plans to save about 25,000 b/d of gasoline-
about 2 percent of current gasoline production-by using liquefied
compressed gas to power about 100,000 automobiles. Increased
demand for gasoline as a result of new automobile production-
about 1.3 million vehicles annually-will easily offset this saving.
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Implications for Exports
If Moscow can stem the decline in production, the
Soviets will at best be able to maintain total oil
exports this year at the 1985 level-an amount we
estimate to be 10 percent below the 1984 level. In
the event output falls by as much as 300,000 b/d in
1986, Moscow could be forced to reduce exports an
additional 10 percent.
Moscow opted to absorb most of the 1985 produc-
tion decline through reductions in oil exports to the
West-at a cost in earnings of $3.5 billion-while
sustaining deliveries to its Communist partners.
Maintaining 1986 oil exports to the developed West
at last year's level-depressed by about 25 percent
from 1984 levels-will continue to cost the Soviets
much-needed hard currency-the more so if world
oil prices drop further. Earnings from gas exports
are scheduled to increase substantially by 1990, but
will fall short of compensating Moscow for the
expected decline in oil export revenues.
Tough Options
Nonetheless, we believe it likely that exports to the
developed West would, at least initially, bear the
brunt of further reductions in oil production, cost-
ing the Soviets almost $1 billion for every 100,000
b/d decrease (at $27 per barrel). But the Soviets
may still need to make some tough additional
choices on how to allocate available exports in
1986. The East European countries, heavily depen-
dent on Soviet oil, are already suffering from
shortages. A cut in oil deliveries would cause them
major economic difficulties at a time when they are
under pressure to export more finished products to
the USSR. Moreover, Moscow would have to weigh
carefully the attendant risks of economic instability
and increased political tensions that could result
from a reduction in oil deliveries to these nations.
Political considerations will also make it difficult to
cut deliveries to Cuba, Nicaragua, and Moscow's
other Third World client states, which account for
almost 10 percent of Soviet oil exports.
Oil deliveries to other Third World countries repre-
sent 6 percent of Soviet oil exports, providing the
Soviets with another area where deliveries could be
reduced. India receives the majority of this amount.
Moscow, however, has shown concern for the politi-
cal and strategic aspects of its relationship with
India and would probably be reluctant to make a
reduction there.
Impact on Hard Currency Earnings
At the extreme, export reductions, compounded by
anticipated oil price declines, could cost Moscow as
much as $4-6 billion in earnings, presenting Mos-
cow with onerous choices between rapidly expand-
ing its debt and reducing hard currency imports.
Last year's fall in revenues was the major contribu-
tor to Moscow's deteriorating financial position. To
offset earnings reductions, the Soviets stepped up
borrowing dramatically and postponed some
planned purchases.
the approval of the 1986
purchasing program has been delayed, in part,
because of hard currency shortages. Recent person-
nel changes in the Foreign Trade Ministry and
Gosplan could also be delaying the required ap-
proval.
While Moscow could partially compensate for re-
duced earnings through further borrowing and
larger gold sales, major additional import cuts may
well also be in the cards, especially if Moscow
cannot arrest the decline in oil production and if
the fall in export earnings becomes particularly
sharp:
? Additional gold sales of $2-3 billion are possible,
but any further sales would seriously affect gold
prices, a reaction which the Soviets generally try
to avoid.
? Traditional Soviet financial conservatism would
probably put a brake on continued Soviet
borrowings.
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Anticipated drops in Soviet grain imports in 1986
may give Soviet planners some flexibility to avoid
serious cuts in machinery and equipment imports.
In fact, large equipment orders last year could
mean some increase in imports for major develop-
ment projects. However, major adjustments to im-
ports in 1987 would almost certainly be necessary
to prevent a sharp increase in Soviet debt service
ratio in light of declines in oil export earnings and
recent borrowing activity.
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Energy
Record Chinese Energy China's energy production for 1985 showed marked growth in coal, oil, and
Output in 1985 power for the second straight year. Recent discoveries at existing onshore
fields boosted oil production to 2.5 million b/d, up more than 9 percent over
1984. Coal output grew by almost 8 percent to 850 million metric tons.
Electric power production reached 407 billion kilowatt-hours, up 8.6 percent.
Totals have not yet been released for hydropower or natural gas production,
but both were up 6 percent over comparable 1984 figures through November.
Secret
DI IEEW 86-004
24 January 1986
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New Peruvian
Debt Signals
many coal mines.
Economic reforms and foreign technology have helped the Chinese increase
energy output while encouraging conservation. Nonetheless, serious energy
shortages continue. Most of the increased oil production was exported to earn
foreign exchange, and bottlenecks in transportation have caused backlogs at
Talks held on 15 January between Peru and its Western creditors could prove
crucial in shaping President Garcia's stance on repayment of debt.
representative
bankers in New York met with a Peruvian Government
to outline
terms for reopening debt talks.
The government's
agreement to meet with the bankers is a concession and reflects Peru's concern
over its deepening financial isolation. Western bankers are angry and frustrat-
ed by the debt impasse and are applying heavy pressure. At a minimum Garcia
may decide to pay IMF arrearages rather than foresake $500 million to $1 bil-
lion in World Bank loans this year. Public pressure by creditors could backfire,
however, and cause the volatile Garcia to repudiate some of Peru's debt.
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French Arms
Credit Crackdown
We be-
lieve that the credit crackdown reflects Paris's concern that it has extended too
much credit-Egypt's military debt to France, for example, is $1.4 billion.
Nonetheless, because the arms sales program is important for political reasons
as well as for reducing procurement costs for the French military, we expect
liberal financing to resume as payments are received from previous loans.
Morocco by loaning 50 percent of the purchase price.
Ministry of Finance vetoed a proposal to finance a Mirage 2000 sale to
France recently has restricted the availability of arms credits for Third World
states that already have large military debts to France until Paris can be
assured of their ability to repay. Paris recently changed its delivery policy for
Egypt's Mirage 2000s to one plane at a time, as payment for each is received,
according to attache reporting. In addition, the
East European After securing $3.4 billion in syndicated loans from Western banks last year-
Borrowing To Continue up 70 percent from 1984-Eastern Europe will remain active in the interna-
tional loan market in 1986. The region's financing needs remain high with
Eastern Europe's hard currency trade balance likely to deteriorate for the
second consecutive year. In addition, Hungary, East Germany, and Romania
still face large debt service requirements. Banks appear willing to provide new
credits to most East European borrowers-at least in the near term-because
of the shortage of lower risk borrowers among the developing countries. Banks
Secret
24 January 1986
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 and Yugoslavia will remain shut out of the syndicated loan market.
will prefer lending to East Germany, Bulgaria, and Czechoslovakia. Lenders
are likely to keep a closer eye on Hungary, however, which many bankers fear
has overborrowed, and remain cautious toward Romania. Debt-ridden Poland
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Italian Wage
Indexation System
Reformed
National Developments
Developed Countries
Italy adopted a new automatic wage indexation system on 1 January that, on
average, will reduce workers' protection against inflation, although compensa-
tion for the lowest paid workers will rise. In contrast to the previous across-the-
board indexation, the new two-tiered system indexes 100 percent of the first 25X1
$335 of monthly wages but only 25 percent of the remaining pay. In addition,
wages will now be adjusted semiannually rather than quarterly. As a result,
wages for the average worker will now automatically rise 0.5 percent for each
percentage point increase in inflation, compared with 0.6 percent under the old
system. Confindustria, the major business association, opposed the two-tiered
system proposed by the unions, but welcomes the lower degree of automatic
compensation because it will allow business to increase its use of incentive pay
to encourage worker productivity. The unions accepted the lower automatic
protection in the hope that it will increase their wage bargaining power in
contract negotiations. 25X1
Irish Fiscal Policy Lower-than-anticipated tax revenues will force Dublin to maintain its tight
To Remain Tight
fiscal policy in the 1986 budget due on 29 January. Last year's tax revenues
were about $122 million below target because of concessions on the value-
added and excise taxes and higher-than-expected unemployment, which
reduced income tax revenues. Last month, Prime Minister FitzGerald told the
31 Secret
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Turkey's Defense
Industry Fund
negotiations could push that figure higher.
legislature that the government now has little room to make tax cuts or raise
public-sector pay and still reach its target of reducing the public-sector.
borrowing requirement to 11 percent of GNP by 1987-it was 15.7 percent of
GNP in 1985. Despite its political benefits, the Prime Minister believes that a
tax cut would only add to Ireland's large national debt, half of which is owed
to foreigners. Although Dublin benefited from lower interest rates, total
foreign borrowing continued to increase in 1985, and there is little hope for an
improvement. FitzGerald plans to stick to his government's pledge of putting
public finances in order by cutting spending. Dublin probably will not reach its
spending targets, however, because the government is already expecting
expenditures to be $32 million above target, and the public-sector wage
separately to contribute more to help develop Turkish defense industries.
A new plant to manufacture 35-mm antiaircraft guns will be the first project
financed from the recently established Defense Industry Fund. According to
Turkish press reports, the plant will cost about $66 million, with over
80 percent of the total provided by Swiss investors. Machinery for the plant
will be imported from Sweden. The new fund is part of an ambitious effort by
Turkey to develop a modern defense industry. Proposed by Prime Minister
Ozal last fall and supported by special tax levies, the fund seeks to combine
private enterprise, foreign capital, and government investment to finance
armament production. The new program may eventually help ease the burden
of foreign arms purchases but initially will require substantial foreign financial
and technical assistance. Turkey will also continue asking the United States
Less Developed Countries
Argentine Grain Flood damage to the 1986 wheat crop has forced Buenos Aires to cut back its
Sale Cutbacks grain exports, and Argentina's customers are responding by scaling back their
purchases or reselling grain they had already bought.
the Soviet Union has discontinued talks with Argentina on
Syrian Pound
Falls Further
Secret
24 January 1986
1986 budget.
commitments of about 1 million tons. The loss of at least $500 million in
export earnings, however, will complicate Argentina's efforts to pay interest on
its $50 billion foreign debt and will force further cutbacks in Buenos Aires's
further wheat purchases from the current crop. China reportedly sold back
150,000 metric tons of wheat to Argentina recently at a $2.2 million profit.
The US Embassy in Brasilia adds that Brazil has reduced the amount of wheat
it plans to import under its bilateral agreement with Buenos Aires by
56 percent to 600,000 metric tons. These cutbacks should enable Buenos Aires
to meet its domestic grain requirements while fulfilling remaining export
The Syrian Government's severe shortage of foreign exchange is starting to
make itself felt on the offshore/black market for Syrian pounds. The offshore
rate for the pound has fallen by 50 percent over the past year to 15 pounds to
the dollar, despite the overall decline of the dollar. The Syrian Government
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Crisis Worsening
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and endorsed new cost-cutting measures.
correct the situation.
cannot supply even public-sector enterprises with foreign exchange, forcing
both public and private companies to turn to the black market. While rumors
of an official devaluation are rife, there are no indications that the government
is willing to undertake the sizable devaluation that would be necessary to
Tanzania's foreign exchange shortage has blocked government efforts to
purchase crude oil on credit. Marcotrade, an independent commodity trading
company that has been Tanzania's only oil supplier since September 1985, is 25X1
holding up further deliveries pending total cash payment. Previous terms had
allowed Tanzania to pay installments over a 90-day period for slightly higher
than spot market prices. Marcotrade is following the example of other oil
suppliers, including Angola and Iran, who now demand cash up front as a
result of Tanzanian defaults. Tanzania last received a 30-day supply of crude
oil in late November 1985 and is now experiencing long lines at gas stations,
factory shutdowns, transportation halts, and acute food shortages in the
capital. Dar es Salaam has yet to announce any economic recovery plan as in-
fighting over allocation of meager foreign exchange resources and political
fallout from the recent presidential succession continue to dominate the
government's attention. 25X1
Zambian Economic President Kaunda is pressing ahead with economic reform despite a doubling
Reform Spurs Inflation f inflation to almost 50 percent. Recent government data indicate that prices
r gasoline, shoes, soap, and bread have more than doubled since last fall.
Prices for cornmeal-the main food staple-have increased by one-half, the
result of a sharp reduction in subsidies on corn last September and of a 62-per-
ent currency devaluation since October. Although grumbling in the military
has increased, Kaunda's strong public support for reform and an active
campaign by party and government officials to garner grassroots acceptance
appear to have defused most domestic reaction to the inflationary trend.
Kaunda reiterated his commitment to reform in an 8 January news conference
Ugandan Economy The seizure of power by General Okello in July has not stemmed the economic
Suffers 7 downturn that began under President Obote in 1984. Growth of agricultural
output fell to an average annual rate of 3 percent in 1985/86 from 10 percent
during the period 1982/84. According to US Embassy reporting, inflation
jumped to 160 percent at an annual rate in late 1985, from a 30 percent annual
rate during the first half of 1984. The increase was prompted by higher
defense expenditures, a substantial rise in civil service wages in June 1984, and
lower domestic production. Debt service now consumes about 70 percent of
export earnings. In southwestern Uganda insurgents control about 50 percent
of the coffee crop. Coffee accounts for almost all of Uganda's exports and is a
principal source of government revenue. Despite the recent rise in coffee
prices, substantial shortfalls in exports will further dampen economic activity,
33 Secret
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stem economic decline.
force expenditure cuts or inflationary borrowing, and aggravate the critical
foreign exchange shortage. The government has devalued the shilling by about
67 percent since the coup and increased petroleum prices, but we believe that
further adjustments, along with domestic reconciliation, will be required to
Botswana Announces Botswana recorded its first trade surplus last year, according to press reports.
Trade Surplus
Record Foreign
Investment in
South Korea
Secret
24 January 1986
imports, while a stronger diamond market improves export earnings.
Exports totaled $652 million, exceeding imports by $185 million. Diamonds
remain Botswana's largest export, contributing over 70 percent of total export
earnings. Government officials expect an increase in both imports and exports
in 1986, as a fifth consecutive year of drought forces Botswana to increase food
projects.
South Korea approved $532 million in foreign investment during 1985,
surpassing the government's target by $82 million. Seoul credited the rapid
dismantling of barriers to direct foreign investment-part of a broader
strategy to restructure its economy toward knowledge- and technology-
intensive industries and to reduce South Korea's dependence on debt. Despite
the record, economic policy makers are probably disappointed that only 30
percent went to the manufacturing sector-well below its 63-percent share in
1984. Foreign investors concentrated on the hotel and tourist services sector as
part of a buildup for the 1988 Olympics. Since 1983, an ethnic Korean
businessman residing in Japan has contributed over one-third of the $1.2
billion invested from abroad by building hotels, including $250 million last
year for expansion of a Seoul hotel. Any concern over tepid foreign interest in
manufacturing is probably tempered by the short-term boost to employment
during the current economic slump from labor-intensive hotel construction
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Taiwan To Export In Taiwan's first entry into the world automobile market, Ford Liao Ho will
Automobiles assemble and export 30,000 cars per year to Canada beginning in July 1986.
The car is based on the Mazda GLC. Initially, Taiwan will produce only 5 per-
cent of the car's components-eventually increasing to 50 percent-with the
remainder supplied by Mazda of Japan. Taiwan's ability to compete will
depend in part on government willingness to supply adequate infrastructure
and Taiwan's ability to overcome a reputation for producing substandard auto
parts.
Soviet Interest in Moscow currently is seeking
Western Steelmaking Western assistance in producing high-quality parts for electric steelmaking
Technology furnaces. The expansion of a graphite electrode production plant in Turkmeni-
stan is among the key industrial projects included in the Twelfth Five-Year
Plan (1986-90). Discussions for the $200 million turnkey facility-which will
increase electrode production there 70,000 metric tons per year above the
current 30,000 tons-are now being held with French, British, Italian, and
West German firms. Although the companies contacted by the Soviets are
technically knowledgeable about electric furnace steel production, they are not
at the forefront of high-quality graphite technology. A prime consideration in
awarding the contract will be the availability of foreign credits.
Polish-Soviet Trade
and Cooperation
Problems
Warsaw's failure to meet its export commitments to the USSR last year and
its problems in fulfilling bilateral cooperation agreements were discussed at a
recent Intergovernmental Commission meeting, according to Polish media.
Delays in deliveries, particularly of coal, cement, rolled steel products, and
machinery and equipment helped raised Poland's trade deficit with the USSR
for the first nine months of 1985 to 845 million rubles, the highest level since
1981. In contrast, all other East European countries apparently reduced their
deficits with the USSR last year or even ran surpluses. The Soviets and Poles
at the meeting also criticized each other for low-quality, outmoded exports and
for failing to achieve full cooperation between bilateral enterprises. Poland's
performance demonstrates its dim prospects of achieving the 8- to 10-percent
annual growth in exports implied in its trade agreement with the USSR
covering 1986 through 1990.
Secret
24 January 1986
_ _ Declassified in Part - Sanitized Copy Approved for Release 2011/12/08: CIA-RDP88-00798R000200220003-5
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