The Saudi-Soviet Cold War

For most countries, the condition of the public finances is driven by factors as diverse as whether the country is at war or peace, its level of employment, and its demographics. However, for some, the prices of natural resources are also of extraordinary importance. This is especially true for petrostates, nations whose economies are overwhelming driven by the export of oil. For the governments of these countries, oil is a blessing and a curse.

True, oil production can provide for large tax revenues and other benefits, but oil prices in international markets can be very volatile. When governments come to count on oil revenues to support their public finances, it can spell trouble. In the 1970s, the Soviet Union came to count on oil money to make up for economic stagnation in other sectors of its state-led economy. When a profound change in policy caused oil production in another country, Saudi Arabia, to take off in the 1980s, the effects helped trigger the economic breakdown of the Soviet Union and the end of the Cold War. Indeed, Saudi sheiks and kings have as much claim for ending the Cold War as Reagan or Gorbachev.

Soviet Oil

The Soviet Union had been a large producer of oil since before the Second World War. In the 1930s, owing to its rich oil fields in the Caucasus, the country was the second largest producer in the world after the United States. It produced more oil than the rest of Asia combined and four times more than the only other European producer of note, Romania. This production was augmented in the late-1960s by Siberian oil discoveries that occurred just in time for exploitation during the subsequent oil shock triggered by the Arab oil embargo in 1973.

Indeed, with American production diminishing, the Soviet Union became the largest oil producer in the world in 1974. The timing was perfect; the oil shock the previous year caused world prices to quadruple and the windfall helped make up for stagnation in other sectors of the Soviet economy, such as in its inefficient industrial and agricultural output.

The latter of these was legendary. For much of its history, the prospect of Russia becoming a net importer of food would have sounded preposterous, as silly as foreseeing Saudi Arabia becoming a net importer of oil. Nevertheless, it was happening, and this was due more to poor organization than weak investment or neglect. In fact, while the USSR was producing sixteen times more grain harvesters than the US, it was actually harvesting less grain.

So, in the 1970s, it was oil that saved the Soviet fiscus from the balance of payments crises faced by other socialist economies in Eastern Europe. At the time, oil and gas was accounting for two-thirds of Soviet exports to OECD countries. These were the nations with which it needed to trade, regardless of ideological or even military rivalry, in order to acquire the hard-currencies with which to make grain purchases and other imports. Critically, oil exports were the most important source of hard-currency for the USSR, even more so after prices surged still further after the Iranian Revolution disrupted that country’s production in 1979.

Saudi Oil

At the same time, a newer oil superpower was emerging in the Arabian Peninsula. In Saudi Arabia, commercial production started in the late 1930s but the country remained a negligible producer until the 1950s. By the 1970s and 1980s, this had changed, and Saudi Arabia became the so-called ‘swing producer’, able to adjust its own production to fix the price of oil in the world to whatever it wished, at least in the short-run. Along with its OPEC allies, the country did precisely this during the 1973 Arab oil embargo which took prices from $3.50 to $15 per barrel.

Much like the Soviet Union, OPEC couldn’t turn down such a windfall of easy money in the 1970s. Consider that Saudi Arabia was able to pump oil out of its oilfields for as little as $0.50 per barrel. Ostensibly, the embargo was designed to punish Western allies of Israel during the Yom Kippur War. However, the policy remained in place even after it was clear Western policy towards Israel was not changing, lending evidence that the real motivation was nothing more than resource nationalism and the desire for riches. After all, as a result of the embargo, OPEC oil revenues rose over 1,100% from 1970 to 1974.

That said, the Saudis were judged to be the cautious hand on the tiller at OPEC, less keen on mixing politics and oil policy than other member states. The country’s leadership was more conscious of the threat posed by alternatives to oil and the potential for production outside OPEC members. True, reserves were scarcer and production lower in Europe, North America, and elsewhere in Asia, but that would no doubt change if prices rose too high. More so than other OPEC members, the Saudis were concerned with market share along with pricing, and not merely the latter alone. This was at least in part because the country was producing well under its capacity and could handle lower prices better than most because of its extra-low production costs.

Sheikh Ahmed Zaki Yamani

Crafting Saudi oil policy in its formative decades was Sheikh Ahmed Zaki Yamani who was made Energy Minister in 1962 by Prince Faisal, the future King. Yamani’s aims became so instrumental to the state of the industry, that he became the most important man in oil, referred to as simply “Mr. Oil” by some. Regardless, Yamani returned to Saudi Arabia following a Harvard education in 1956, in the days before OPEC existed and when the country produced just 5% of the world’s oil. The industry would change tremendously during his 24 years at his post.

In office, Yamani presided over much of the growth in Saudi oil and was instrumental in the Arab oil embargo. Despite that involvement, Yamani generally argued against price increases at OPEC summits otherwise dominated by his impetuous counterparts. Yamani believed that volatile prices would hurt producing and consuming countries alike, reducing the industry’s size and efficiency, two things that benefited large low-cost exporters like Saudi Arabia. Compared to other OPEC members, Saudi Arabia took a slightly more market-oriented approach to fixing oil prices.

One might think that OPEC would enable stable, even if not market-determined, prices for oil. However, the cartel was imperfect; oil producing countries frequently cheated under the quota system. When the fiscal authorities of oil producing countries got used to high levels of spending and needed more money, they ordered their energy ministers to increase production, regardless of quotas. There were no sanctions against members who produced over their limit, so many produced at capacity. Combined with weakening global demand following a recession and the second of two oil shocks, this caused oil prices to slide from nearly $40 a barrel in April 1980 to $28 four years later.

Nonetheless, even going into 1985, prices were still far higher than they were before the Iranian Revolution. Both OPEC members and the Soviets believed oil prices had simply reached a higher equilibrium in the early 1980s and that this would be maintained. Many countries embarked on new public spending programs that would prove unaffordable in time. For the Soviet Union, it meant the country was able to spend profligately on arms and maintain support for its client states for a few more years. However, all this rested on the willingness of the swing producer, Saudi Arabia, reducing its own output to maintain higher prices.

Indeed, under Yamani’s guidance, Saudi Arabia spent the first half of the 1980s attempting to support prices by cutting its own production from around ten million barrels a day when prices were at their peak to an almost unimaginably low two million barrels a day by 1985. However, even this was proving insufficient in the absence of production curbs by other OPEC members and rising non-OPEC production. By 1982, the cartel made up just 35% of the global oil market, down from 50% just three years earlier. Non-OPEC supply increased by over five million barrels per day in that period. The culprits were new oil producers like Norway, Britain, and Angola as well as growing output from existing producers like Mexico. Led by cuts in Saudi Arabia, OPEC production sank to under 30% of the global total by 1985.

King Fahd

Many in the Saudi Kingdom wondered why their country was sacrificing its own market share to make the other petrostates rich. These skeptics of Saudi oil policy included the country’s new ruler, King Fahd, who succeeded to the throne in 1982. Fahd was frustrated by Saudi production cuts that were not being reciprocated by other countries. In dismay of OPEC and non-OPEC competitors happily benefiting from the higher prices enabled by Saudi restraint, Fahd made his displeasure with Yamani’s acquiescence to other OPEC members known. He demanded greater output at existing, if not higher, prices, an economic impossibility but a demand that Yamani had to give in to.

At King Fahd’s insistence, Yamani announced on September 13, 1985 that Saudi Arabia would no longer cut production to support prices. The country then began to increase production to win back market share. Oil prices did not immediately fall, but after rising above $30 in November 1985, they began to dive when an OPEC meeting the following month crystalized the new market-share centered strategy. Prices plummeted to $12 by the following March, prices that had not been seen since before the Iranian Revolution. It was not enough to save Yamani’s job though and the King dismissed the veteran oil minister in 1986.

Fiscal Shock

Plunging prices posed trouble for the public finances of petrostates around the world. Saudi Arabia was comparatively unaffected thanks to rising production volumes and an ultra-low production cost. However, oil revenues fell by 64.5% in Venezuela and 76.1% in Indonesia; upset with the continued unwillingness of OPEC to regulate prices, both countries hinted at desiring to leave the organization.

Of course, the damage was even more widespread. By 1987, OPEC members took in under $100 billion from oil sales, about one-third the amount received in 1980, then a staggering $280 billion. While net-consuming countries saw positive effects on inflation, GDP, and employment, net-producers like Mexico ran into fiscal troubles that defined the following decade. Venezuela, which had a Aaa credit rating in 1982, was in default by 1983, before oil prices had even fallen anywhere near their lows.

Of the greatest significance historically though was the impact of the oil glut on the Soviet Union. The fall in prices equated to a loss of $20 billion annually for the Soviet state, according to Yegor Gaidar, Russia’s future Prime Minister, who has written extensively on the role of oil in the Soviet Union’s collapse. The USSR was producing some twelve million barrels a day at its peak, of which it exported perhaps three million barrels a day.

Considering prices fell $19 peak to trough in 1985-86, the lost revenue comes to just under $21 billion in lost hard-currency earnings, backing Gaidar’s estimate. This was a sum equal to a reduction in annual GDP growth of 1% for the Soviet Union, enough to bring the otherwise slow growing Soviet economy to a standstill. That said, because this loss was in hard-currency, it had an outsized impact on the ability of the USSR to import goods and materials from abroad and its ability to meaningfully support its allies.

What’s more, the Soviet Union also had to face the reality of diminishing domestic production as oil fields aged. Together with the falling prices, this removed the last leg from underneath the Soviet economy. Liberal aid to its allies in Eastern Europe and elsewhere had to be suspended and imports were forced to contract to avert a balance of payments crisis. This put strain on the Soviet economy and dissolved the glue that held the Warsaw Pact together.

So it was that the oil policy of Saudi Arabia helped bring an end to the Cold War. Saudi Arabia itself could also be counted among the victors of the Cold War as falling Russian oil output from the mid-1980s to 2000 allowed the Saudis to return to producing ten million barrels a day without putting further pressure on prices.

Lesson

Credit for ending the Cold War is usually placed on Soviet leaders who found themselves forced to disengage from their struggle against the capitalist West because of their own economic disfunction. However, while the causes for this disfunction were mostly domestic in origin, there was a negative shock that came from abroad, the plunge in oil prices over 1985-86. This shock was caused not by the Soviet Union’s adversaries in Western Europe and America but came from Arabia. So dependent was the Soviet economy on oil money that Saudi Arabia’s oil policies had the power to ruin the Soviet fiscal system and the Soviet economy from outside.

More from the Tontine Coffee-House

Read about other financial aspects of Soviet history, including the history of a Soviet-owned London-based bank and bonds issued by the USSR as it looked to foreign borrowing for money. Also consider learning about how Russia’s ‘voucher privatization’ scheme helped shape present business conditions in the country.