After Iraq: Oil and Geopolitics

May 21, 2003
By Charles Kohlhaas

It is an understatement to say the aftermath of the war in Iraq is proving to be a difficult period.  World media attention is focused on anti-American demonstrations and the failure of the American military to establish civil order.  Diplomats and commentators debate and opine on how, and by whom, a stable government, an orderly social system and a functioning economy should be established in Iraq ; as well as what actions the United States will take regarding other Middle Eastern countries and North Korea .   

At this point, it is obvious the follow-up process will not be a smooth one and the result will probably not be the orderly, federal democratic system envisioned by the Bush Administration—at least not until after a long period of turmoil and conflict.  Oil fields and facilities were damaged much less than was expected before the war.  A return of production to supply the domestic Iraqi oil market may take only a few months.  A return to significant volumes of oil exports, however, will need to overcome several political and legal—as well as operational and investment—obstacles. As such, Iraq may not realize its potential as a source of large increased supplies of oil to a growing world market for several years, if at all.   

For several decades, the United States , as a matter of its own enlightened self-interest, has undertaken to establish and maintain security of oil supply for all the world’s economies.  Any serious consideration of energy or foreign policy must recognize that now, and for the foreseeable future, oil represents the life’s blood of the international economic order. Despite the delusions of anti-globalization protestors and street demonstrators, the secure supply and low price of oil not only allow wealthy countries to prosper but also define the margin in poor countries as to whether people eat or go hungry, have the medicines they need or send their children to school.  

The Iraq affair highlighted a coincidental development in international economics.  Combined with the strike in Venezuela and political unrest in Nigeria , it showed the world’s discretionary surplus oil productive capability is much less than had been previously estimated.  As world economies resume normal growth with accompanying increases in oil demand, the world is likely to be faced, for the first time, with oil-supply shortages and persistent upward pressure on prices over the next several years. 

Oil prices have declined since the end of the war due to the return of Iraqi and Venezuelan production and a seasonal spring demand slump, but this price drop should not induce a false complacency regarding supplies.  A prolonged trend of increasing prices would severely restrain economic recovery in the United States , Europe and Japan .     

Oil shortages would be particularly disruptive to stability in Asia , the area of fastest economic and oil demand growth.  Japan is still in a prolonged depression and barely avoiding financial collapse.  China has been an oil importer since 1993, while India has always been dependent on imports.  Both are rapidly industrializing.  China continues to modernize its military and is already laying claim to large areas of the South China Sea and its potential oil and gas resources.  The need for oil supplies without American guarantees of free access and stability will only increase China ’s temptation to solve its energy needs by force.  Since the U.S. lost its Philippine bases, piracy has become one of the fastest-growing industries in Southeast Asia .  China also borders Russia and Central Asian countries with large oil and gas resources and could become belligerent about access to those supplies.  

Indonesia , the only OPEC producer in Asia , has been disintegrating since the Bre-X gold mining fraud was exposed in 1997. It is now under its fourth government in 5 years, the middle class has been wiped out, investment has stopped, and religious strife and civil disorder are increasing with no improvement in sight.  Amid the rising discontent and disintegration, Islamic terrorist groups are becoming aggressive.  Indonesia is the world’s largest Islamic country and is strategically located; over one-third of the world’s sea-borne commerce passes through Indonesian waters.  The combination of a sick Japan , an expansionistic China and an unstable Indonesia mixed with oil shortages is an excellent recipe for future conflict and instability.  

But the oil industry is not responding to the prospect of impending shortages.  Capital budgets are not increasing and worldwide drilling and exploration activity is down.  Oil prices are too volatile.  Projects that require investments of billions of dollars that require years to be repaid at low rates of return are not attracting capital.  In addition, after 20 years of severe cost-cutting, oil companies are without research laboratories, experienced staffs or young engineers trained in petroleum engineering.  

Another coincidental aspect of the Iraq affair was that it came just when Russia ’s president had reached out to the United States , supporting its war on terrorism and establishing a rapport with the American administration. France, who passed Italy as the largest purchaser of Russian crude and thus has become the largest source of foreign income to Russia , and Germany , the largest foreign investor in Russia , used their clout successfully to elicit Russian support for an anti-Iraq-war position.  

France is trying for a realignment of world power with typical and obvious French tactics--to ally France with Germany to control the European Union and, with such a large economic block, attract Russia into an alliance.  A combination of united European economies with Russian resources would establish an economic and political block to rival, and possibly displace, the United States .   

This strategy was severely undermined by the rebellion of certain European countries (the UK, Italy, and Spain), combined with various Eastern European countries who are not yet members of the EU but who supported the American position on Iraq.  Jacques Chirac saw his plans to stop the war thwarted by a combination of this rebellion against the French mandates and by Bush’s disdain for European opinion which were then followed by exposure of close French relations with Saddam Hussein.  He may have achieved his longer-term goals, however.  Putin is now actively seeking closer economic ties with the European Union and has proposed a common market of Russia , Ukraine , Belarus , and Kazakhstan with the EU that will be discussed further at an EU – Russia summit on May 31.  

United States relations and meetings with Russia mainly concern military matters.  The United States needs to restore the relationship with Putin and develop and nurture non-military political and economic aspects.  Oil can be a tool to do that, especially Russian oil exported to Asia to stabilize a region of continuing Russian concern.  The U.S. can also establish independent free-trade relations with Eastern European countries and others who supported it with respect to the war and undermine efforts to develop united European economic or political strength.   

The strike of oil workers in Venezuela , concurrent with worries about oil supplies from Iraq , revealed the lack of worldwide surplus productive capacity.  It also focused attention for a short time on the deterioration of political stability in several Latin American countries.   

If the United States is to develop secure, long-term and diverse supplies of oil for world economic stability, it must devote diplomatic attention to restoring relations with Russia and Latin America .  As the world’s largest importer, the U.S. can use oil as a tool to stabilize the political and economic systems in Russia and in several Latin American countries where potential oil reserves are large and oil production represents a large part of the economy.  

The primary diplomatic objective should be to create favorable investment conditions in those countries.  Such conditions include favorable fiscal terms, safe working conditions, lack of corruption, expeditious bureaucratic action, and a fair system of legal enforcement and dispute resolution.  In addition, a major requirement is a stable, long-term oil pricing system, consistent with expectations of investors in large projects, and must be at a level that will also stabilize the income stream of host countries.  Reserves in Russia and Latin America , for technical reasons, are very large at certain prices but vulnerable to low prices.  Low oil prices significantly disrupt the economies of those countries and destabilize their political and social systems.  For instance, the reserves of the Russian Far East region are huge at $25 per barrel but are mostly non-commercial at $10.  

An efficient free-market system operates best with minimal government interference.  Government participation is required, however, to provide an environment in which a market system can operate safely, fairly, and efficiently.  Private market participants have no authority to establish or change international systems.  Only government can use oil as a tool to achieve international geopolitical objectives.  

A relatively simple policy can meet many of these needs.  The U.S. needs to establish long-term purchase contracts with supplier countries for a large portion of their oil exports at fixed, moderate prices.  For instance, the United States , in a cooperative government-industry action, could contract to buy 500,000 barrels of oil per day at $25 per barrel from the Russians at the export terminal on the Pacific for their planned new pipelines.  Details of amounts and price would be negotiated specifically; this volume would be about 50 percent of planned capacity.   

Such a policy would provide a stable investment climate for construction of the pipelines and development of the fields to supply them.  It would also contribute to stability in the Russian economy that is dependent on oil for foreign income, develop secure supplies for the growing Asian market, complement OPEC’s price structure, and balance French and other European political influence in Russia .  

Similar contracts should be written with Venezuela , Mexico , Argentina , Peru and Colombia.  The amount, price, and length of the contract would be specific to each country.  Such contracts would act as a flywheel on the world oil pricing system, remove investors’ fear an oil price drop caused by the production they develop coming on stream, and prevent high price spikes from disrupting world economies because new diverse supplies at moderate prices would be available.   

The current oil pricing system, establishing oil prices by trading short-term contracts on the NYMEX, was established in the early 1980’s to pull price control away from OPEC.  This pricing system worked fine for the last two decades, a period of surplus supplies, but it no longer meets our economic or geopolitical needs.  It is time for another change. 

Dr. Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed, and consulted for major and independent companies in the international oil and gas industry.  He has written on questions relating to oil for In the National Interest in the January 15, February 12, and March 5, 2003 issues.