Economic Development of the Middle East: Oil companies relationships before OPEC - Olga Guerrero Horas

8/9/2019 Economic Development of the Middle East: Oil companies relationships before OPEC - Olga Guerrero Horas

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Economic Development of the Middle East: 15PECC341Lecturer: Dr. Massoud KarshenasTutor: Dr. Randa Alami

How would you characterise the relations between the oil companies

and the producing countries in the Middle East prior to the formation

of OPEC? (1901-1960). Discuss by highlighting the concessionary

agreements, the cartelisation of the global oil market, and the pricing

policies of the companies.

Olga Guerrero HorasMA International Studies and Diplomacy

Student number: 261969Word count: 2723 (excluding footnotes)


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Introduction

Oil has been part of the history of the Middle East since the discovery of the worlds

biggest oil fields in Persia in 19081. Today, oil is considered to be the most important

single commodity in the economic life of the industrializing and industrialized

countries2. The major share of proven oil reserves in the world are found in the Middle

East and North Africa Region (MENA)3. Consequently, this geological wealth of the

MENA has had implications for the region at all levels. Oil is said to have defined the

regions governments, economies, and geopolitics ever since4.

The strong desire of Western powers to control over the resources and the trade

increased since the turn of the XX century and it has since then shaped the relations

between Western oil companies and the Middle East producing countries.

In order to characterise these relations between the oil companies and the producing

countries in the Middle East prior to the formation of OPEC, I will begin by analysing

the oil industry in the Middle East and the characteristics that make it extremely

productive or profitable. This will bring us to consider the characteristics of both

producing countries and oil companies. I will then explore the components of these

initial relations: concessionary agreements, the cartelisation of the global oil markets

and the pricing policies, illustrating with examples such as Iran and Saudi Arabia. The

characteristics of these, as well as a series of events, will help us understand the

growing discontent from the 1950s onwards that lead to the formation of OPEC in

1960. Throughout this essay, I will attempt to highlight the exploitative nature of the

Western powers relation with producing countries.

Oil and the Middle East

In the period leading up to World War I, Western powers became increasingly aware of

1James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975), 9.


3Massoud Karshenas, Middle East Oil prior to the formation of OPEC.Lecture, SOAS, London, October 20th,

2009.4

Kevin Rosser, Happy Birthday? Middle East Oil is turning 100. Hold the Bubbly, St. Antonys College Database

(2007), www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdf

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the importance of oil as a military commodity. Establishing and maintaining an

economic control of the MENA region and thus of its petroleum became the main

focus of Western rivalries5. This was partly due to three factors which make the oil in

the MENA extremely productive and profitable: MENAs natural characteristics, labour

costs and Muslim civil law.

The first factor concerns the geological characteristics of the region. It has close to 70%

of the Worlds proven oil reserves6. The Burgan field in Kuwait alone was estimated to

hold 62 billion barrels, ten times the estimated capacity of the biggest oil field in the

United States7. The majority of this Middle Eastern oil deposits are found close to the

coast, not very deep and the rock formations are very porous. The second factor is given

by Muslim civil law. It states that the subsoil and its minerals belong to the state and not

to the owner of the land8. Thus, once oil companies were granted concessions to explore

there were no other impediments and no one else could constrain their research or drill

wells in the area covered by their granted concession9. Finally, the labour costs in the

MENA were initially lower10. Although oil is a capital intensive good, the cheap labour

also played a role in lowering production costs.

These three factors resulted in a reduction of the production costs. Fewer and shallower

wells had to be drilled and the advantages of to the pipelines to the Mediterranean.

Overall, production costs were significantly lower. For example, in 1959 the gross fixed

assets per barrel of daily crude oil capacity amounted to only $290 in the Middle East,

compared to $3,190 in the United States11. Thus, the total costs per barrel in the Middle

East were estimated in 10 cents, whereas producing a barrel in the United States would

cost $1.2212.

5James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975), 7-8.6Massoud Karshenas, Middle East Oil prior to the formation of OPEC.Lecture, SOAS, London, October 20th,2009.

7 Charles Issawi,An Economic History of the Middle East and North Africa, (New York: Columbia U.P.,1982),

195-196.8

ibid, 197.9

ibid10

ibid11

Charles Issawi,An Economic History of the Middle East and North Africa, (New York: Columbia U.P.,1982), 196-197.12

ibid.

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Despite the lower costs, revenues from the oil industry were unstable13. The reasons for

the oil industrys instability have long been discussed. The high risks, high ratio of fixed

to variable costs and low price elasticities have been present since the beginning of the

oil industry. Economists such as Paul Frankel have argued that the oil industry is

different as it is not self-adjusting in terms of supply, demand and price, which makes it

an inevitable monopoly14. This idea has been refuted by both Professor Adelman and

Penrose, who think the oil industry is self-adjusting and behaves like any other15.

The geological wealth and comparative advantage in the production of crude oil left

MENA countries with the responsibility to produce a wasting asset that must be

exhausted but yields variable revenues16. This is what brought oil companies and host

governments together in the production of petroleum.

Oil Companies and Producing countries in the Middle East: Initial relations

Foreign oil companies have been present in the Middle East since the first half of the

XX century. In order to understand the basic character of the initial relations between

producers and host countries in the Middle East we should first consider the

characteristics of both parties. This allows us to understand why the bargaining power

was so uneven and the consequences this would have for the concessionary agreements,

the structure of the oil market and the implications for oil prices.

The emergence of the oil industry coincided with the formation of modern states and the

end of imperial rule17. The Middle East then had the lowest socioeconomic development

levels in the world and it could not develop oil without foreign aid18. Governments were

corrupt and economically bankrupt which lead them to grant concessions for oil

explorations as an easy solution to fill the royal treasury19. Most importantly,

13Kevin Rosser, Happy Birthday? Middle East Oil is turning 100. Hold the Bubbly, St. Antonys College Database

(2007), www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdf

14 Anthony Sampson, The Seven Sisters: The Great Companies and the World They Make, (London: Hodder and

Stoughton, 1975), 29.

15 ibid 29-30.16

Kevin Rosser, Happy Birthday? Middle East Oil is turning 100. Hold the Bubbly, St. Antonys College Database

(2007), www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdf17

ibid18

ibid.19

James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975), 9.

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http://www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdfhttp://www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdf


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governments had no knowledge of the oil industry. All these factors weakened the

bargaining position of host governments and lead to an exploitative relation of oil

producing countries20.

On the other hand, the oil companies satisfied all the conditions for a strong bargaining

position: they were technologically advanced, they could operate in collusion with each

other for their own benefit, they were horizontally and vertically integrated (controlling

all parts of the industry) and were supported financially by their colonial home

governments.21 This uneven bargaining power resulted in an oligopolistic oil industry

controlled by the Seven Sisters 5 American and two British oil companies before the

1920s22. The Seven Sisters were: Standard Oil of New Jersey (Exxon), Standard Oil of

New York (Mobil), Gulf Oil, Socal (Chevron), Anglo-Persian (BP) and Royal Dutch

Shell23.

Concessionary Agreements

The nature of control over the production and the distribution of revenue between oil

companies and producers were given by the concessionary agreements. These

agreements granted by the host government stipulated the company to which the control

was given, the size of the area given for exploration, the duration of the agreement and

the distribution of the revenue between the two parties24.

As it was explained before, initially the oil companies had a strong bargaining power, so

the first concessionary agreements granted by Middle East states were extremely

favourable to the oil companies. This is illustrated by examples such as Iran and Saudi

Arabia concessions.

When in 1901 the Persian government signed a concession with the British engineer

William DArcy, it was established that he would have 60 years to search for, obtain,


2009.21

ibid22

Anthony Sampson, The Seven Sisters: The Great Companies and the World They Make, (London: Hodder and

Stoughton, 1975), 58.23James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975),28.

24ibid, 7.

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exploit, develop, render suitable for trade, carry away and serve natural gas, petroleum

and asphalt throughout the whole extent of the Persian Empire25. The concession

reinforced the long established presence of Britain in the region who was the main

shareholder and largest customer for oil. The area available for Anglo Persian Oil

Companys use was of 500,000 squared miles and it was exempt from taxation. The

gains of the Persian government from this concession were 20,000 in cash, 20,000 in

company stock, 16% of annual profits and a rent of $1,800 per year.26 However,

according to Hershlag, between 1919 and 1930, the profits from Anglo Persian

amounted to 200 m, less than 5% (10m) were paid to the Iranian government27.

Similarly, in 1933 Saudi Arabia would grant a tax-free concession to Socal. It would

also be for a length of 60 years and covered most of eastern Saudi Arabia. The Saudi

government would receive 5,000 a year until oil was discovered, a 50,000 loan

against future royalties and a 100,000 loan once oil was discovered. 28Such terms were

liberal, reflecting the kings need for funds, his low estimate of future oil production

and his weak bargaining position29.

The cartelisation of the global oil market

The dominant presence of the Seven sisters in the Middle East, facilitated by these oil

concessions, had tremendous implications for the global oil market. By the end of

World War II the Seven Sisters were locked into joint production and marketing

arrangements that virtually guaranteed the absence of significant competition30.

The exclusive rights granted to the oil companies to pursue all operations connected

with the oil industry from exploration to production as well as refining, transport and

marketing31 would define the structure of the oil market. Each company became

25George W. Stocking, Middle East Oil(Vanderbilt, 1970), 10.


27Zvi Yehuda Hershlag,Introduction to the Modern Economic history of the Middle East, (Leiden: E J Brill,1964)

quoted in Massoud Karshenas, Middle East Oil prior to the formation of OPEC: The Evolution of ConcessionaryAgreementsLecture, SOAS, London, October 27th, 2009.28

ibid, 27.29

Country studies, Country Studies: Saudi Arabia Oil Industry, http://www.country-studies.com/saudi-arabia/oil-

industry.html30James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975), 28.

31Charles Issawi,An Economic History of the Middle East and North Africa, (New York: Columbia U.P.,1982), 195.

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vertically integrated and this provided the basis for maintaining a monopolistic pricing

industry. Thus, by 1949 the seven companies controlled not just 92% of the reserves

outside the United States, Mexico and the USSR but also 65% of the crude reserves in

the world, 77% of the refining capacity, 66% of the tanker fleet and all the major

pipelines outside the United States and the USSR32.

Moreover, such a vertical integration at all levels would also develop a horizontal

integration of the major oil companies, who would behave as a single entity through

joint ventures, long-term supply contacts and market sharing agreements33. Such

cooperation among firms is reflected by the Red Line(1928) and As Is(1928)

collusive agreements. The purpose of this horizontal integration was to stabilise markets

and profits form these companies, which had interests in several countries.

Cooperation in production was achieved through the Red Line Agreement. It

formalized the corporate structure of Turkish Petroleum Company (TPC) which was

owned by Anglo-Persian (later British Petroleum, 47.5%), Royal Dutch Shell (22.35%),

Deutsche Bank ( 25%, later transferred to the French) and the Armenian Gulbenkian

(5%)34. The agreement restricted production except at the express decision of the TPC

and prohibited any of its shareholders from independently seeking oil interests in the

former Ottoman Empire territory35.

Cooperation in marketing was achieved through the subsequent As Is Agreement,

which pooled world markets and divided them on the basis of present shares of the three

biggest companies: Exxon, BP and Shell. As an example, if in 1928 Shell had 50% of

the Far Eastern crude oil and petroleum products market, Shell only allowed to expand

their output and marketing in as much as the growing demand required36. As a result, an

oil company was not allowed to expand their share in a given market by stealing away

the share of anothers company37. The agreement also involved partnership among the

321949 Federal Trade Commission Report, quoted in: James Stork, Middle East Oil and the Energy Crisis , (London:

Monthly Review Press, 1975), 63.33

James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975), 66.34

Massoud Karshenas, Middle East Oil prior to the formation of OPEC. Lecture, SOAS, London, October 20 th,

2009.35

James Stork, Middle East Oil and the Energy Crisis, (London: Monthly Review Press, 1975), 24.36

ibid.37

ibid.

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three companies in exploration and development of new oil fields38.

The pricing policies of the companies

Both the characteristics of the concessions and the structure of the oil market influenced

significantly the pricing policies of the major oil companies.

The dominance of the United States as the major oil producer and exporter towards the

end of the XIX century and the beginning of the XX century meant that the prices of oil

were based on US oil prices39. US prices were set under the Base-Point Pricing

method, which established Texas as the base point and where oil was extracted at a

certain price and then transport costs were incurred by oil companies to transport oil

from the Gulf of Mexico to the purchasing point40. However, as it was already

highlighted, extraction costs were lower in the Middle East and distance to transport it

to Europe was also shorter, thus prices included a fictional transport cost. Once the

British Navy discovered this, oil companies created a second basing point, the Persian

Gulf, to eliminate the fictional transport cost41.

However, the vertical integration allowed firms to set the price oil with an arbitrary

relationship to its true cost42. To firms, only the combined production costs and the final

aggregate product selling prices mattered. The industry tended to base its monopoly and

its profit in the production stage43. This meant that they could enjoy the exclusivity

granted by concessions, they could decrease the prospect for competition at later stages

and they could benefit from the depletion allowance, which allowed 22% of the profits

from the production stage to be exempt from income taxation44.

Profits made from oil companies in the Middle East were estimated in $12.8 billion


200939

Massoud Karshenas, Middle East Oil prior to the formation of OPEC.Lecture, SOAS, London, October 20th,

200940

ibid.41

ibid42


ibid, 64.44

ibid, 64-65.

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between 1948 and 196045. However, the benefits shared with the producing countries

only amounted to $9.4 billion and hardly anything was shared with the nationals from

these countries. This just accentuates the economic exploitation of Middle East

countries through the cheap and easy access to its resources, which subsidized Western

economies46.

Evolution of the relations: Growing discontent and formation of OPEC

The control these foreign companies and governments exerted over the Middle East was

long tolerated, but once nationalism and resentment began to rise among Middle

Easters, they realised the abuse these oil concessions had given rise to since the

beginning47.

Governments from producing countries increasingly achieved a higher bargaining

power, which was illustrated by the re-negotiation of oil concessions. As a result, the

new concession (1933) to Anglo Iranian Oil Company (AIOC) granted by the Shah of

Iran demanded a fixed amount of royalty payments per barrel, the provision of

information to the government and cut down the area to 100,000 sq km48. This was just

the beginning.

In the post World War II period independent and nationalistic movements began to rise

as old colonial powers retreated. As a result of four decades of abuse and exploitation

at the hands of British imperialists49Mossadeq nationalised AOIC (1951) and Nasser

nationalised the Suez Canal (1956). Fifty/fifty profit sharing agreements being obtained

in other oil producing countries like in Venezuela would also shape the New

Agreements granted by Iran in 1954, significantly increasing the governments

revenues50.

45ibid, 69-70.


47Charles Issawi,An Economic History of the Middle East and North Africa, (New York: Columbia U.P.,1982), 195.

48Massoud Karshenas, Middle East Oil prior to the formation of OPEC: The Evolution of Concessionary

Agreements.Lecture, SOAS, London, October 27th, 200949

James Stork, Middle East Oil and the Energy Crisis , (London: Monthly Review Press, 1975), 50.50

Massoud Karshenas, Middle East Oil prior to the formation of OPEC: The Evolution of Concessionary


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Throughout the 1950s, Middle East governments would become increasingly aware of

the strategic and economic value of the Middle East oil to the West. The increased

revenues from the new concessions, the growth of the world economy, the interest of

smaller independent oil companies would transform the international oil market

dramatically within two decades51.

This transformation culminated with the formation of OPEC in 196052. The

organization was created after the oil companies reduced posted prices by 10% in

August 1959, thus lowering the taxes to be paid to producing countries who would incur

their losses53. OPEC was thus created to co-ordinate and unify petroleum policies

among Member Countries, in order to secure fair and stable prices for petroleum

producers; an efficient, economic and regular supply of petroleum to consuming

nations; and a fair return on capital to those investing in the industry54

Conclusion

Throughout this essay, I have attempted to provide an analysis of the relations between

oil companies and oil producing countries prior to the formation of OPEC. An overview

of the oil industry in the Middle East helped me to illustrate why the Western oil

companies were interested in controlling the production of oil in the region. The low

socio economic development of the region and the corrupt governments gave the

Middle East countries a low bargaining power when it came to dealing with oil

producing countries. As a result, concessions of an exploitative nature were granted to

Western oil companies, who would achieve control over the global oil markets through

cooperation amongst themselves. Companies made a vast amount of profits, but a very

small amount was shared with the governments and virtually no benefits would reach

the population. Thus the rise of nationalism and the realisation of the importance of the

Middle East to Western powers in the 1950s would bring changes to the international

oil market. Concessions were negotiated, oil companies were nationalised and finally,

51Massoud Karshenas, Middle East Oil prior to the formation of OPEC: The Evolution of Concessionary


The Organization of Oil Producing Countries, OPEC Brief History,

http://www.opec.org/aboutus/history/history.htm.53


The Organization of Oil Producing Countries, OPEC Brief History,

http://www.opec.org/aboutus/history/history.htm.

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the oil producing countries would join forces to create an organization to give oil-

exporting countries a collective strength to control the oil revenues on which they had

become increasingly dependant.

Bibliography

Country studies, Country Studies: Saudi Arabia Oil Industry. Available at: http://www.country-studies.com/saudi-arabia/oil-industry.html(Accessed January 17th 2010)

Issawi, C.An Economic History of the Middle East and North Africa. New York: ColumbiaU.P.,1982.

Karshenas, M. Middle East Oil prior to the formation of OPEC. Lecture, SOAS, London, October 20 th,2009.

Karshenas, M. Middle East Oil prior to the formation of OPEC: The Evolution of ConcessionaryAgreements. Lecture, SOAS, London, October 27th, 2009

Rosser, K. Happy Birthday? Middle East Oil is turning 100. Hold the Bubbly, St. Antonys CollegeDatabase (2007). Available at www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdf(Accessed 12thJanuary, 2010)

Anthony Sampson, A. The Seven Sisters: The Great Companies and the World They Make. London:Hodder and Stoughton, 1975.

Stocking, G.W. Middle East Oil. Vanderbilt, 1970.

Stork, J. Middle East Oil and the Energy Crisis. London: Monthly Review Press, 1975

The Organization of Oil Producing Countries, OPEC Brief History. Available at:http://www.opec.org/aboutus/history/history.htm. (Accessed 17th January 2010)

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http://www.country-studies.com/saudi-arabia/oil-industry.htmlhttp://www.country-studies.com/saudi-arabia/oil-industry.htmlhttp://www.country-studies.com/saudi-arabia/oil-industry.htmlhttp://www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdfhttp://www.opec.org/aboutus/history/history.htmhttp://www.country-studies.com/saudi-arabia/oil-industry.htmlhttp://www.country-studies.com/saudi-arabia/oil-industry.htmlhttp://www.sant.ox.ac.uk/antonians/gaudy07/kevin_rosser.pdfhttp://www.opec.org/aboutus/history/history.htm

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Economic Development of the Middle East: Oil companies relationships before OPEC - Olga Guerrero Horas