The New Geopolitics of Oil

Joe Barnes, Amy Jaffe and Edward L. Morse

THE NATIONAL INTEREST

Special Energy Supplement

Winter 2003/04

We are entering a potentially historic moment of opportunity in U.S. oil strategy. The current reassessment of U.S. foreign policy is perhaps more far-ranging than any undertaken since the onset of the Cold War in the late 1940s. Energy strategy is a key part of this reassessment, an impetus driven in large part by renewed public concerns about our oil dependence on the Middle East.

Counter-intuitively and (in many cases) counterproductively, our efforts to externalize our energy problems takes us to places where our influence is significantly weaker than inside our own borders. Increasingly, many Americans worry about the cost—in money, lives, and U.S. credibility—of trying to secure stable oil supplies by attempting to dominate the Middle East. Our domestic political inability to forge rigorous compromises to achieve energy security—with liberals calling for greater conservation and conservatives for increased domestic production—has left official Washington reduced to vocal but fruitless hand-wringing about increasing U.S. oil imports and our continued dependence on Middle East oil.

Rhetoric about “breaking opec” is more a wish list item than a practical aim. Indeed, much of the debate about U.S. energy policy, with its stress on achieving lessened dependence on foreign supplies through largely unilateral action in the foreign arena, flies directly in the face of harsh market realities. The foremost of those realities is the role of increasing consumption—especially by the United States—in driving petroleum markets. Accepting this reality is a vital first step in forging a practical medium- to long-term strategy that will minimize the risks of severe supply disruption and skyrocketing prices.

A Most Unsatisfactory Status Quo

No one is satisfied with the current energy policy status quo; but few seem willing to make the hard decisions and uncomfortable compromises necessary to do anything about it. And no party has sole ownership of the status quo. It represents a continuation of the policy of successive Administrations in Washington over the past quarter century in encouraging diversity of global oil production, cooperation with major oil producers—especially Saudi Arabia—to ensure stable markets, research in alternative fuels as a hedge against long-term price increases and reliance on a robust strategic petroleum reserve for use in cases of extreme market volatility.

The Bush Administration has continued to pursue much of this agenda, as outlined in its formal energy strategy (the so called “Cheney Report”). While many of the domestic elements of the Report were and remain controversial, most of its language devoted to the international arena could have been written under the Clinton Administration, or indeed under Bush I, Reagan, or Carter.

The centerpiece of the status quo is “the special relationship” with Saudi Arabia – a strategic quid pro quo under which the United States would guarantee the security of Saudi Arabia in return for Riyadh’s cooperation in keeping a reliable flow of moderately priced oil to international petroleum markets. The first pillar of the special relationship is the decisive role that Saudi Arabia plays in international oil markets. Riyadh is not only the world’s largest exporter of oil, but possesses a quarter of the global petroleum reserves and, significantly, excess capacity for use in an emergency. The second pillar is the ability and willingness of the United States to intervene militarily should Saudi Arabia be threatened. Washington did so, most notably when it rushed troops to Saudi Arabia when Iraq invaded Kuwait in 1990.

The September 11 attacks, however, renewed the impetus to reassess the U.S.-Saudi relationship. The fact that Osama Bin Laden and 15 of 19 suicide bombers were Saudi nationals lent the long-standing neoconservative critique of Saudi Arabia great public salience. Since 9/11, neoconservative commentators have stepped up their attacks on Saudi Arabia, openly branding the Kingdom as an “enemy”, and have included Riyadh in the list of Middle East capitals—along with Tehran and Damascus—where “regime change” would be desirable.1

Despite this firestorm of criticism, the formal U.S. relationship with Saudi Arabia has not changed. Saudi Arabia has diligently—albeit more quietly—continued to raise its oil production in times of war and/or market emergency. Senior officials in both Riyadh and Washington also continue to downplay differences. Indeed, Energy Secretary Spencer Abraham has cultivated Saudi Arabia, even going so far as to suggest tacit U.S. approval of opec price bands and financially supporting the establishment of a secretariat for a new international energy forum in Riyadh.

The Neoconservative Vision for Oil Policy

So, are there alternatives to the unsatisfactory status quo? Some neoconservatives offer one: a radical shift of policy that would see Washington play an altogether more assertive role in the oil arena. Diversity of supply would not just be an economic end but a strategic means. The United States would attempt to drive down the price of oil, break the ability of the Organization of Petroleum Countries (opec) to set prices, and deprive unfriendly states—including Saudi Arabia—of revenue. The neoconservative approach resembles U.S. oil strategy during the Cold War, when, during the Reagan Administration, Washington encouraged Saudi Arabia to suppress prices in order to cause economic damage to the Soviet Union.

Neoconservative concerns (and increasingly left of center commentators as well) center on a belief that oil revenues permit countries like Libya, Iran and Saudi Arabia to sustain authoritarian regimes and promote anti-American policies. Collusion on production levels through opec, in turn, sustains those rents at a high level. Saudi Arabia, though nominally an ally of the United States, plays a particularly pernicious role under neoconservative ideology, by using its immense oil revenues and leadership in opec to promote the Kingdom’s own brand of fundamentalist Islam—Wahabism—in the Middle East and Central Asia.

At one level, the neoconservative argument is logical: low oil prices—in addition to providing substantial economic benefits for the U.S. and global economies—will reduce the revenue available to oil states, which sponsor terrorism or pursue the acquisition of weapons of mass destruction. But it both overestimates the ability of the United States to sustain low international oil prices and underestimates the consequences of a general decline in oil prices for oil producing allies of the United States. It assumes that the United States will be able to persuade major oil producers like Russia and a post-occupation Iraq to pursue policies against their own economic interests. And, not least, the neoconservative alternative neglects the very huge risks should its approach actually succeed and prompt sufficient hardship in Saudi Arabia to cause a “regime change” in Riyadh. Indeed, recent history demonstrates that any radical domestic political change in oil producing countries leads to suppressed output, whether that change is in an “anti-American” direction (the Islamic revolution in Iran) or a “pro-American”one (the collapse of Communism in the Soviet Union).

Russia to the Rescue? Maybe, Maybe Not

Reducing—if not ending—our reliance on Saudi Arabia requires cooperation with other major oil producers. Russia leads the list. Russian oil output has recovered sharply from its lows of 6 million bpd in the mid-1990s. It reached 8.6 million bpd by mid-2003 and is expected to exceed 9 million bpd by the beginning of 2004. Exports show an equally dramatic increase, now making Russia the largest non-OPEC exporter in the world, and second only to Saudi Arabia in total world exports.

There are a number of reasons for the recovery of Russia’s oil sector. They include greater political stability, improved legal environment, lower domestic costs because of the ruble devaluation of 1998 and higher world oil prices since 1999. But the rise of private Russian oil companies—notably Lukoil, Yukos, Sibneft and tnk—has clearly been a powerful impetus for expansion. While an ongoing conflict between Yukos and the Kremlin has recently cast a shadow over this success, the new Russian companies remain a dynamic force in the Russian oil sector. A further expansion in exports by nearly two million bpd by the end of the decade is by no means impossible, but will depend on how destructive to investor sentiment the Kremlin’s prosecution of Russian oil trendsetter Yukos turns out to be.

U.S.-Russian cooperation on energy in general and oil in specific has been high on the agenda of Bush-Putin summits beginning in the summer of 2001, culminating in the creation of a U.S.-Russian Energy Dialogue after the two Presidents met in May 2002. Given Russia’s surprising accommodation to the U.S. need for Central Asian bases to serve as a “staging area” for the campaign in Afghanistan, expectations were high that a new “axis of oil” between Moscow and Washington could be formed—with Russia supplementing, if not displacing, Saudi Arabia.

But Russia faces serious obstacles in its quest to equal, much less surpass, Saudi Arabia, in international oil markets. Despite significant strides over recent years, the Russian business climate remains marked by inadequate rule of law protections, and standards of transparency, accountability, and protection of minority shareholder rights are honored as much in the breach as in adherence. There is a clear Russian preference for its own industry –most recently a resurgence of assertion by state-controlled firms. In short, despite the acquisition of tnk by British Petroleum, Russia may find it difficult to attract the tens of billions of dollars in private investment necessary to make its ambitious oil expansion plans a reality.

And while the core of Russia’s increased oil production has come from giant oil fields in Western Siberia, new investment is needed to exploit reserves in more remote areas including the Timon-Pechora region, eastern Siberia, the north Caspian Sea and the Russia Far East. Development of these distant resources is very important to Russia’s future but faces technical, economic and bureaucratic barriers. Not only is the geographic terrain extremely challenging, but Russia’s uncertain tax and legal regimes have created disincentives to foreign and even domestic investment in these ambitious new “greenfield” investments. Uncertainty about whether and under what incentives private companies will be able to invest in the future pipeline infrastructure needed to service these remote, but prolific oil fields has created apprehension as well. The United States has been pressing Russia to reform the state oil pipeline monopoly Transneft and its pipeline sector, but reform is slow in coming.

Even more profoundly, the Russian oil sector lacks three characteristics that permit Saudi Arabia to play its unique role in world oil markets. First and most importantly, Russia has next to no unutilized capacity. This stands in stark contrast to Saudi Arabia, with excess capacity—in the 1.4-1.9 million bpd range in 2003—sufficient to stabilize world oil markets should a major disruption occurs. The importance of the Kingdom’s excess capacity was proven again this year, when it increased production by over a million bpd in the run up to the war in Iraq; without such Saudi intervention, prices might have risen well above $40 per barrel.

Second, Russian oil is relatively expensive, with much of the planned expansion in production slated for geographically remote and geologically challenging fields. This makes Russia’s continued production expansion far more vulnerable to a sharp and sustained decline in oil prices than Persian Gulf production. Saudi Arabian oil, in contrast, is among the cheapest in the world to produce—allowing the Kingdom, at least potentially, to weather price declines with less pain.

Third, Russian is not yet a global player. Saudi Arabia has managed to be a base load supplied of oil to the Western Hemisphere, East Asia and Europe, with the first two of these markets areas of high growth. Russia, on the other hand, is basically a European supplier, with virtually no commercial ties to East Asia or North American, to bolster and reinforce its political ties. Russia is considering more global strategies but accomplishing global status might take more reforms than Moscow, with its statist orientation and coterie of state monopolists, is willing to commit to.

Iraq Is No Picnic, Either

With the removal of the regime of Saddam Hussein, Iraq has joined Russia as a possible alternative to Saudi Arabia. Iraq possesses 11 percent of world’s proven oil reserves, second only to Saudi Arabia. While its oil sector never fully recovered from the disruption associated with the war with Iran and chronic under-investment during the 1980s, it nonetheless achieved production as high as 3.5 million bpd before the Gulf War of 1991. Under optimal circumstances, Iraq could be very attractive to foreign investors, not least because of its low production costs and proximity to both the Persian Gulf and Mediterranean Sea, giving it easy access to major European and Asian markets.

Some estimate that Iraqi oil production could reach 6–7 million bpd by the end of the decade, making it the world’s third largest exporter after Saudi Arabia and Russia, and current plans are to reach 2.8 million bpd by 2005 and 5–6 million bpd sometime after 2010. But these estimates, while geologically possible, might prove to be optimistic for any number of political reasons. Whatever the ultimate course of the U.S. occupation of Iraq, it is clear that security will remain a concern for some time to come. Efforts to resume production since the war have already been hindered by widespread sabotage and lawlessness. Even returning production to the 2.5 million bpd per day level will represent a significant achievement given the vulnerability of oil production and transportation facilities in both the north and south of the country.

It will be expensive to expand Iraqi production, requiring either substantial foreign investment or high levels of foreign aid. At the best of times, Iraqi oil revenues only topped $10 to $12 billion dollars in recent years, with humanitarian assistance taking up 70 percent of those funds. Moreover, Iraq is far from offering the physical security, political stability and legal environment that will make it instantly attractive for major foreign investors. Talk of privatizing the state-owned Iraqi oil industry in order to accelerate investment is particularly premature. The list of obstacles to privatizing the Iraqi oil industry is daunting. It will require, inter alia, the reorganization of the current Iraqi oil industry, enactment of a new body of business law, creation of a regulatory regime, settlement of contentious issues of regional revenue-sharing, rescheduling of Iraq’s foreign debt, adjudication of outstanding disputes over concessions granted by the regime of Saddam Hussein, and, not least, some level of democratic legitimacy. Even partial privatization (turning over new oilfield development and greenfield projects to the private sector) will face most of these obstacles.

And will Iraq decide to opt out of opec? The idea that a grateful Iraqi citizenry will relinquish its rights to high oil prices out of gratitude to the United States for their liberation seems, to put it gently, farfetched. At a minimum, continued Iraqi membership in the short- to medium-term would appear to hold little downside risk for a new regime in Baghdad.2 However the questions of privatization and opec membership are decided, Iraq will, barring a collapse into chaos, become a more important producer during the years ahead. In the short run, however, the unstable situation in Iraq there may ironically make the United States more dependent on Saudi oil, not less, depending on how well other countries do in increasing world oil supply.

Other Sources, Other Problems

Even if, due to relatively poor global economic performance in recent years, the projection for world oil use by 2010 has been lowered from 100 billion bpd to 89 billion bpd, producing an additional 12 million bpd of oil—particularly in light of the constraints that Iraq and, to a lesser extent, Russia, face—will be no mean task. A quick tour d’horizon of oil producing regions reveals just how daunting that challenge will be. In Central Asia and the Caucasus, political instability, corruption, unstable customs, inadequate tax and legal regimes, as well as complex transportation issues (including problems created by Moscow), continue to be impediments to bringing major amounts of oil to market. Major increases in Latin American oil output are similarly blocked by regulatory, political and environmental barriers. Faced with debilitating civil strife in Venezuela and a slowing pace of energy sector reform in important countries such as Brazil and Mexico, the United States will be forced to look elsewhere not just for increased oil imports, but even for the level of oil we have been receiving from our southern neighbors. Elsewhere, production in the North Sea is rapidly approaching its geological peak. And most of Asia remains very disappointing in terms of easily accessible, low-cost fields.

This means that, besides Russia, whose future is dependent on a stable investment and legal system not quite in place, the United States can expect to be most dependent on Africa for its increased need for oil imports. According to Baker Institute estimates, Africa, including North African producers such as Libya, could double output to 10 million bpd by 2010, alleviating some dependence on the Middle East. But, current political turmoil in West Africa, most notably Nigeria and Angola, raises real questions about the reliability of already established African production.

Moreover, the United States faces a global competitor: China, which has an active place in Sudan’s oil sector and has been pursuing a toehold elsewhere in the continent’s oil wealth. Chinese participation in Africa has been accompanied in some cases by Chinese military delegations selling arms, a situation of some concern giving the proclivity towards ethnic and political strife in some key oil producing countries in the region. East Asia frequently pulls one million bpd from West Africa to feed its growing appetite for high quality West African crude.

Ironically, the one supplier the United States might truly benefit from encouraging is Canada, with its 175 billion barrels of tar sand resources—is not being actively pursued. If anything, U.S. politicians have gone out of their way to slight our northern neighbors, backing a natural gas pipeline route that ignores the location of Canadian resources in favor of political featherbedding the city of Anchorage, and fanning disputes over other Canadian non-oil imports such as beef, softwood, wheat and potatoes and potentially salmon, without any regard for the energy consequences of the relationship. Oil sands projects could be a key alternative for the American consumer, with production, which has already reached 800,000 bpd, is expected to rise by 1.5 million bpd by 2010 if currently proposed projects can meet their targets, possibly higher if new projects, under consideration, are added. But even these promising resources face environmental barriers since the process of mining the sands emits carbon and requires the utilization of large quantifies of water.

What Are Our Options?

Our ability to shape production policies by Saudi Arabia, Russia and—in time—even Iraq is hugely constrained. In fact, the jury is still out on whether the three countries may find ground for common production policy to sustain prices higher than optimal from the U.S. perspective. Saudi Arabia remains, at least in theory, in a position to drive prices sufficiently low to compel Russian long-term production restraint. Given the importance of oil to Saudi Arabia’s economy and finances, Riyadh would not undertake such a policy lightly. But it has done so before—not just against the Soviet Union in the 1980s, but more recently, against Venezuela in the late 1990s. In fact, many Venezuelan opposition leaders believe it was the Saudi 1997–98 price war that undermined their industry and led to the advent of Hugo Chavez, leaving the South American continent and the American consumer equally concerned about the turmoil created and squarely dependent on Saudi largesse to get out of the problem. In a word, Riyadh flexed its oil muscle, showing wayward fellow oil producers and the U.S. government alike that it had everyone under its thumb.

A number of Russian observers believe that their oil industry can weather such a price war. This is easy to say with prices above $25 per barrel. Should prices fall precipitously say, to below $15 per barrel, Russia will be faced with both plummeting revenues and declining investment. Moscow will be sorely tempted to cooperate on production levels with Riyadh, as it did in 1999–2000, in order to raise prices. Whether this is the reason that Moscow and Riyadh recently signed an agreement to cooperative on oil price stability is an open question.

In time, even Iraq may find its interests diverging from the United States in terms of production and pricing policy. In the short run, those interests converge. The rapid recovery of the Iraqi oil sector is, rightly, a top priority for both Washington and Baghdad. But those interests can and will diverge should increased Iraqi production threaten an oil price war. In the case of both Russia and Iraq, the neoconservative alternative fails to take into consideration the fundamental fact that the interests of oil suppliers and consumers diverge. What is good for the United States may not be good for a post-Saddam regime in Baghdad.

Missing from this discussion are any serious measures to address the demand side of our reliance on Middle East oil. Current U.S. oil demand is about 20 million bpd, of which only 40 percent is produced domestically. Indeed, the consistent growth in U.S. oil imports is an overwhelming factor in global oil markets—one, which official Washington refuses to recognize despite criticism from allies in Europe and Japan. U.S. net imports rose from 6.79 million bpd in 1991 to 10.2 million bpd in 2000. Global oil trade, that is the amount of oil that is exported from one country to another, rose from 33.3 million bpd to 42.6 million bpd over that same period. This means that America’s rising oil imports alone have represented over one third of the increase in oil traded worldwide over the past ten years—and over 50 percent of opec’s output gains between the years 1991 to 2000 wound up in the United States.

Ironically, the United States is so busy managing the diplomacy of its relationships with oil suppliers that we have failed to give highest priority to the international relationships where common interest may be the strongest –other major oil consuming nations. Reliance on coordinated policy responses through the International Energy Agency (iea) in Paris need to be remolded to meet changing market conditions. When the iea was founded as an offshoot of oecd membership, its members were responsible for more than 75 percent of global oil trade. But with the emergence of China, India and other growing non-oecd markets, the iea’s membership has become increasingly isolated from the real operation of the international market and new sources of oil demand growth. The ideas behind the iea remain valid; it is critical for oil importing countries to bind themselves collectively to meet pending disruptions. But the membership and scope of the organization has become too narrow and it is time to rethink ways to include critical emerging markets within the consuming countries’ emergency response mechanism. One can imagine that a coordinated iea stock release in a time of great market disruption will be less effective if China responds by buying up oil in a panic and hoarding it than if China itself has strategic stocks to contribute into the market. The iea may also need to consider new steps to counter disruptions in other important fuels beyond oil such as natural gas which is taking a larger and larger share of energy markets in major consuming countries but will also be shipped from distant suppliers, making it increasingly susceptible to the same political and accidental disruptions as oil.

True, the Bush Administration has initiated dialogue with the eu on hydrogen fuel research and other alternative energy but joint research in energy technologies, like the purview of the iea, must extend as broadly as possible to include the largest future oil consumers. Still, before the United States can truly show leadership in forging links with fellow oil consumers, it must gain some credibility by demonstrating a willingness to curb its own unrestrained oil addiction. Then, by example, America might be in a position to initiate a truly global effort to encourage conservation policies, to conduct multi-lateral research and development programs, and to disseminate promising energy technologies.

On the domestic front, any politically plausible mix of conservation policy or increase in domestic production will leave the American oil-guzzling outlook largely unchanged. While the idea of “grand compromise”—which would include opening up not just the Arctic National Wildlife Refuge but vast tracks of politically sensitive U.S. coastal shelf to production and, at the same time, imposing stringent new automotive standards—may be theoretically appealing, it stands little chance of passage as Capital Hill’s November failed effort so well demonstrated. A shift to fuel cell technology and hydrogen–based technology, proposed by the Bush Administration and concretely pursued, may eventually reduce U.S. petroleum imports, but the time-frame involved runs to the decades, not years. Moreover, this hydrogen economy is dependent on scientific breakthroughs that are in no way guaranteed and, it presumes plentiful local natural gas supplies that are iffy, at best. Indeed, the administration’s decision to focus on the “hydrogen economy” is viewed by many as an effort to deflect a more politically painful, but immediately plausible policy to make a here and now effort to switch to hybrid automotive technologies that could immediately reduce consumption through increased efficiency. General Motor’s commitment to produce 1 million hydrogen fuel cell cars a year by 2012 seems pretty small when put up against the expectation of 100 million vehicle growth rate in the traditional gas-guzzling American transportation fleet over the same time period. Clearly, a bigger, bolder policy with greater short to intermediate-term impact is needed. All U.S. government fleet vehicles should be highly efficient hybrid vehicles or electric power cars. Higher taxes could at least be placed on inefficient vehicles, and a larger gasoline tax should be targeted directly to truly bold (read, Manhattan project style) scientific research on nanoscience and energy, solar energy and electricity storage.

Still, realistically, no matter what happens on the demand side in the United States, there is no escaping the need for increased overall world output to keeping prices reasonable despite rising world (and U.S.) demand. But the United States will do itself a disservice by indulging in the fantasy that it can create this supply by diplomatic pressure or military action. Like it or not, the maintenance of Saudi Arabia as a supplier of last resort is a necessary hedge against short- to medium-terms disruptions for which there is no replacement on the horizon. Over the course of the last year, such disruptions have occurred in both Venezuela and Nigeria. There is every reason to believe that the kingdom will remain of feature of international oil markets for years to come. Far from replacing the U.S.-Saudi Arabian “special relationship” with an “Axis of Oil” between Moscow and Washington, the new approach can at best create an “oil triangle” with its points at Washington, Riyadh, and Moscow, perhaps eventually adding Iraq or Canada into the mix.

Still, lower oil prices should remain a U.S. goal, not only to wean unstable regimes from the ill-effects of undiversified economies, but to give most of the world, including the 1.6 billion people on the planet lacking energy services altogether, a chance to achieve prosperity. This goal can only be achieved by de-politicizing oil. The United States should turn back to multinational agencies and push more seriously for new ways to bring the rules of global oil trade and investment in harmony with the rules governing other trade in manufactures and services. Liberalization and open access to investment in all international energy resources would mean their timely development rather than today’s worrisome delays. Rather than try to accomplish this on an American bilateral basis, the U.S. should lead the industrialized West to make a joint effort, possibly considering discriminating actively against products from countries that do not permit investment in their energy resources, much the way most favored trade status and the wto have been used to bring better practices in other industrial sectors. This is a tough policy, but ultimately, few of the top oil producing countries have used their oil wealth constructively to diversify their economies and improve the lot of their populations.

Still, we must recognize there is, in short, no easy or perfect fix to our energy dilemmas. Any post-9/11 reassessment of our energy strategy must accept this reality. But it should focus on measures that will allow us to achieve practical progress instead of on risky, expensive alternatives that continue to ignore the demand side of our energy quandary. All that is lacking is the political will—and leadership—necessary to move beyond what could be called, without exaggeration, a policy of denial.

Joe Barnes is a research fellow at the Baker Institute for Public Police at Rice University and a former member of the State Department Policy Planning Staff.  Amy Jaffe is the Wallace Wilson Fellow for Energy Studies at the Baker Institute and Associate Director of the Rice University Energy Program. She is project director for the Baker Institute/Council on Foreign Relations task force on Strategic Energy Policy chaired by Edward Morse. Edward L. Morse is Executive Adviser at Hess Energy Trading Company and was Deputy Assistant Secretary of State for International Energy Policy in 1979–81.

1 See, for example, “Our Enemies, the Saudis”, by Victor David Hanson, Commentary, July-August 2002.

2 Of course, should Iraqi production increase dramatically, oil revenue on a per capita basis could rise even if prices fall considerably. A future democratic government could conceivably find it in its interests for domestic political reasons to leave opec—but that will remain an open question for some time. Full privatization of the Iraqi oil sector, however, would make its participation in opec extremely problematic. With production and transportation facilities in private hands, it would be very difficult for Baghdad to constrain production and exports. This is surely one of the great appeals of privatization from the neoconservative point of view.