Global Energy Markets: Worse Than You May Think

Anna Chambers and Nikolas K. Gvosdev

Speaking at a briefing on global energy markets, organized by The National Interest, a leading authority on international energy issues warned that the United States could face an acute energy crisis—including supply disruptions and price increases to $70 per barrel for oil and $2.80, or more, per gallon for gasoline—in the next few years.

J. Robinson West, founder and chairman of PFC Energy, one of Washington’s most influential international energy consulting firms, is a former Assistant Secretary of the Interior in the Reagan Administration and a member of the advisory council of The National Interest.  Former National Security Advisor, Brent Scowcroft, moderated the discussion at The Nixon Center.

Using his essay “The Future of Russian Energy” (in the Summer 2005 issue of The National Interest) as a departure point, Mr. West noted that after 9/11, many were predicting that, to reduce dependence on Saudi Arabia, the United States would increase its reliance on Russia as an alternative source of supply. “I am here to tell you,” he declared, “that Russia is not the key to America’s energy future.” 

The energy sector is being mismanaged in Russia, he observed, and there is no competent bureaucracy to oversee operations.  More broadly, West asserted, the country’s political leadership has not set clear priorities for what it wants.  The heavy and inefficient hand of the state is bearing down on the energy sector and little has been done to improve weak management accountability.  Moreover, he said, despite high oil prices, Russian firms are not investing in upgrading existing infrastructure or developing new pipelines and fields.  As a result, PFC Energy’s analysts no longer feel that Russian oil production is set to peak at 10 million barrels per day in 2008—they see production reaching a lower plateau much sooner.

In part, due to uncertainty following the Yukos case, foreign investors are still reluctant to come into Russia, West said.  Yet, he added, Russian energy sector managers do not seem to understand that the oil business requires constant reinvestment and take money out of their companies instead.  Gazprom—as a company—is making less now than it was three years ago, when oil prices were around $20 per barrel.

In fact, West argued, one of the curses of the Russian energy sector is the equally high prices for oil and gas- as a result, there is no incentive for the government to reform while money is still flowing in in such large supply.  There is a lot of “gravy” circulating widely instead.  Of course, he continued, these problems are not unique to Russia.  State oil companies hold 77 percent of world oil reserves and high prices are discouraging needed changes (and funding massive public sector spending) in Mexico and other countries as well.

Global energy markets are in a peculiar stage today in which demand is not being dampened by rising prices, West said, creating a situation where—in the absence of reinvestment—there is nowhere for the excess capital to go.  Today’s markets are also unique in that what is and will remain a cyclical business does not seem susceptible to the normal cycling down after a price boom.  The price of oil will fall significantly from today’s levels again in the future, West asserted, but asking when is like asking a Maine lobster fisherman if he’s been a fisherman all his life; the answer will likely be “Not yet.” If you ask him if the fog will rise, he answers, “Always does.”  Unfortunately, finding the specific answers to these questions that business leaders and policy-makers crave is extremely difficult.

West also noted that the high level of uncertainty in today’s energy market is a key driver of high prices.  There are considerable political uncertainties hanging over most of the major producers—including Russia, Venezuela, Iran, Iraq and Nigeria, he explained.

The very real problem of declining production compounds these uncertainties.

In Iraq, West said, the petroleum sector is in a shambles.  The interim government does not have the authority to make binding deals, and the professional cadres in the oil ministry are being replaced by “acolytes of Chalabi.”  As a result, he continued, corruption is increasing to such a point that Anglo-American oil firms will not be able to do business in Iraq—leaving the field open to Chinese, Russian or other less constrained companies.

West continued, pointing out that Iranian production is declining as well, and a new team is coming to power that is more prepared to pursue Iranian interests in the region, which could lead to conflict.  This new team is also not interested in international investment and ideologically opposed to the presence of foreign companies, he concluded.  Turning to Venezuela, West described the state oil company as being on the verge of collapse, and the Chavez government as unstable.  Mexican production is about to drop due to aging fields and infrastructure, and the Mexican constitution prohibits international investment in its oil sector.  Moreover, Mexican politicians have been diverting a cash flow out of PEMEX into other projects, leaving little for reinvestment, he concluded.  For politicians, West said, “oil is like plumbing … as long as it works they don’t care” about efficient operations or long-term sustainability.  This leads to underinvestment in infrastructure, pipelines, and development of new assets.

In the past, West suggested, there was always some excess production capacity that could pick up the slack during any major disruptions—but now, there is nearly none (only two million barrels a day, 85 percent of which is in Saudi Arabia).  Saudi Arabia is equivalent to the central bank of oil production, West said, and, without condoning its domestic governance in any way, Riyadh has been very responsible in managing its key part of the oil sector; Saudi Aramco is very competent and professional.

But even Saudi Arabia has limits on what it can do today.  When a strike in Venezuela halted production, Saudi Arabia increased its production.  But Venezuela is six “steaming days” away from U.S. refineries; it takes 45 days for an oil cargo from Saudi Arabia to reach the United States.

If just one major oil-producing nation stops producing or faces a severe disruption of supply, West warned, oil prices—which closed earlier this week at $60.54—could easily rise over $70 a barrel, which could translate into gasoline prices of $2.80 or more per gallon in the United States.  West suggested several plausible scenarios, such as a coup in Venezuela, that could lead to precisely this outcome.

Many have suggested that sharply increasing demand for energy is fueling a race for resources between China and the United States that will define the future of the energy market, West observed.  But in his view it remains to be determined whether the U.S. and China will cooperate or compete.  He does not believe that the United States and China have to be in “a zero sum game” over energy, and even raised the prospect of Washington helping to facilitate Chinese international investment and access to guaranteed streams of production.

West acknowledged that the bid by the Chinese National Offshore Oil Company (CNOOC) for UNOCAL has raised hackles in Washington, but asserted that the deal will die on its own.  CNOOC has received a 25-year, no-interest loan from the Chinese government—which he described as “a case of Airbus on steroids” that would never receive WTO clearance.  The best way to handle the issue, West said, is to treat it as a commercial transaction.  Then ultimate responsibility lies with the board of UNOCAL, not the U.S. government, to decide whether or not to accept CNOOC’s bid.

In the end, West said, the real problem is that the Bush Administration is not paying enough attention to energy security.  Everyone likes to believe that there is more than enough oil to meet current needs, he noted.  So, for example, when PFC Energy warned that passage and renewal of ilsa (the Iran-Libya Sanction Act) would have a real and negative impact on increasing production, people seemed to think that the oil would come from somewhere else.  Demand is estimated to be 120 million barrels per day by 2030—but PFC analysts cannot see supply increasing much beyond 100 million barrels per day.  Where is the rest of the oil going to come from?  West noted that Saudi Arabia is engaged in a $50 billion investment program, but said this would bring the country’s capacity to 12 million barrels per day and ultimately perhaps 15 million barrels per day, but no more.  At the same time, he argued, the resource base in Central Asia has been “grossly exaggerated” and capital investment is an order of magnitude less than West Africa, where production is much higher.  There will be ongoing competition for Central Asian supplies, but to call it a “Great Game” seems a bit much; rather it would better be described as a series of “knife fights in dark alleys.”

West predicted that 2015 could be the tipping point where global demand for oil exceeds supply and urged all the serious stakeholders in the United States to sit down and assess the situation.  The current American lifestyle—based on the spread of suburbs and exurbs—depends on cheap credit, cheap land, cheap energy and the Federal Highway Act to build roads. It is not the SUV, West said, but Wal-Mart which is the symbol of this way of life—and Wal-Mart’s earnings are starting to decline.  In West’s view, the reliance on cars as a way of life has prevented the elasticity of demand that the current oil price surge should have produced: automobiles are no longer a luxury or just the way people get to work, but an integral and unavoidable part of people’s lives.  As a result, an energy crisis will be a “big deal” politically—the suburbs and exurbs are the heart of Red America, and if gasoline prices top $3 per gallon, Social Security will pale in comparison.

July 8, 2005

This brief was prepared by Anna Chambers, assistant managing editor for The National Interest, and Nikolas K. Gvosdev, editor of The National Interest.

Updated 7/8/05