Foreign Affairs: "The Battle for Energy Dominance" By Edward L. Morse and James Richard
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The Battle for Energy Dominance By Edward L. Morse and James Richard From Foreign Affairs, March/April 2002
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. James Richard is a portfolio manager at Firebird Management, an investment fund active in eastern Europe, Russia, and Central Asia.
RUSSIA VS. SAUDI ARABIA
The American campaign against terrorism may be grabbing the headlines, but another battle is being waged with perhaps equally significant long-term implications: the contest for energy dominance between the world's two largest oil exporters, Saudi Arabia and Russia. This battle will have fundamental consequences for the world's economy, U.S. energy security, Russia's global role, the future relevance of Saudi Arabia, and the clout of the Organization of Petroleum Exporting Countries (OPEC).
The contest emerged suddenly and unexpectedly. For each of the past two years, Russia has quietly but persistently increased its annual oil output at a rate of nearly half a million barrels a day (mbd) -- the largest single increment of increased output of any country in the world. With the world economy and world oil demand stagnating, Saudi Arabia and its OPEC partners therefore opted to reduce their output by 3.5 mbd. Then, on January 1, 2002, OPEC cut output by another 1.5 mbd to stave off a price collapse. Even though Moscow made a symbolic cut in output as well, OPEC has not welcomed Russia's gain at the cartel's expense.
Russia and the Soviet successor states can easily continue to increase oil output at this rate for years to come. The victims of that increase, in all likelihood, will be Saudi Arabia, Kuwait, and other oil producers with state monopoly companies that disallow foreign investment. The only oil not threatened by Russia's rise is the petroleum developed by international companies outside of the key OPEC countries of the Middle East.
The Russian increases have come as a surprise, especially for OPEC. As recently as 1996, oil output from the post-Soviet states amounted to barely 7 mbd. Many people forgot that Moscow's state-owned enterprises once produced more than 12.5 mbd before the Soviet collapse -- the largest amount of oil ever produced by a single country, representing one-fifth of global production. That sum is one-third more than Saudi Arabia's peak share at the end of 2000.
After undergoing tremendous transformation since the fall of the Soviet Union, Russia's firms have arrived on the world stage. Although vast room for improvement remains, Russia's oil leaders have largely transcended their robber-baron days. Backed by improved rule of law, they are seeking to protect their new wealth and meet the performance criteria dictated by the financial markets, especially because their firms' shares are now publicly offered. As a result, they are beginning to reinvest capital at a rapid rate. Thanks to them, Moscow is poised to assume a far more significant position in the world petroleum sector than ever before.
Russia's oil revival has coincided with a downturn in the global economy and the first major reduction in the global demand for oil since the early 1980s. The nearly 1 mbd increase in its production over the last two years came at a time when OPEC cut output, thus losing market share, to put a floor under prices. Not surprisingly, Moscow's motivations are being questioned and are often seen as an attempt to grab power in the global arena. But Russia's petroleum revival has also coincided with the terrorist attacks of September 11, which have provided Moscow a chance to displace OPEC as the key energy supplier to the West. Moscow's political leaders, as well as its corporate leaders in oil and gas, are portraying Russia's oil firms as stable sources of supply, willing to add output to the market to keep prices reasonable and thus revive the global economy. In the eyes of these leaders, the new geopolitics of energy can help Moscow gain both economically and politically. In economic terms, energy production lets Russia integrate itself into the industrialized West. In political terms, energy resources can be used to buttress Moscow's goal of becoming a key partner of the United States.
KING OF THE HILL
Even before September 11, concerns had been raised over American reliance on Middle East oil. Global oil demand has been increasing by between 1.5 and 2 mbd each year, a rate of growth with alarming long-term consequences. The U.S. Department of Energy and the International Energy Agency both project that global oil demand could grow from the current 77 mbd to 120 mbd in 20 years, driven by the United States and the emerging markets of South and East Asia. The agencies assume that most of the supply required to meet this demand must come from OPEC, whose production is expected to jump from 28 mbd in 1998 to 60 mbd in 2020. Virtually all of this increase would come from the Middle East, especially Saudi Arabia.
A simple fact explains this conclusion: 63 percent of the world's proven oil reserves are in the Middle East, 25 percent (or 261 billion barrels) in Saudi Arabia alone. As the largest single resource holder, Saudi Arabia has a unique petroleum policy that is designed to maximize the benefit of holding so much of the world's oil supply. Saudi Arabia's goal is to assure that oil's role in the international economy is maintained as long as possible. Hence Saudi policy has always denounced efforts by industrialized countries to wean themselves from oil dependence, whether through tax policy or regulation.
Saudi strategy focuses on three different political arenas. The first involves the ties between the Saudi kingdom and other OPEC countries. The second concerns Riyadh's relationship with the non-OPEC producers: Mexico, Norway, and now Russia. Finally, there is Saudi Arabia's link to the major oil-importing regions -- most importantly North America, but also Europe and Asia.
Given the size of the Saudi oil sector, the kingdom has a unique and critical role in setting world oil prices. Since its overriding objectives are maximizing revenues generated from oil exports and extending the life of its petroleum reserves, Riyadh aims to keep prices high as long as possible. But the price cannot be so high that it stifles demand or encourages other competitive sources of supply. Nor can it be so low that the kingdom cannot achieve minimum revenue targets. The critical balancing act of Saudi foreign policy, therefore, is to maintain oil prices within a reasonable price band. Stopping oil prices from falling below the minimum level requires cooperation from other OPEC countries and occasionally from non-OPEC producers. Preventing oil prices from rising too high requires keeping enough spare production capacity to use in an emergency.
This latter feature is the signal characteristic of Saudi policy. The kingdom can afford to maintain this spare capacity because of the abundance of its oil reserves and the comparatively low cost of developing and producing its reserve base. In today's soft market, in which Saudi Arabia produces around 7.4 mbd, the kingdom has close to 3 mbd of spare capacity. Its spare capacity is usually ample enough to entirely displace the production of another large oil-exporting country if supply is disrupted or a producer tries to reduce output to increase prices. Not only does this spare capacity help the kingdom keep prices in check, but it also serves to link Riyadh with the United States and other key oil-importing countries. It is a blunt instrument that makes policymakers elsewhere beholden to Riyadh for energy security. This spare capacity is greater than the total exports of all other oil-exporting countries -- except Russia.
Saudi spare capacity is the energy equivalent of nuclear weapons, a powerful deterrent against those who try to challenge Saudi leadership and Saudi goals. It is also the centerpiece of the U.S.-Saudi relationship. The United States relies on that capacity as the cornerstone of its oil policy. That arrangement was fine as long as U.S. protection meant Riyadh would not "blackmail" Washington -- an assumption that is more difficult to accept after September 11. Saudi Arabia's OPEC partners must also cooperate with the kingdom in part to prevent Riyadh from producing a glut and having prices collapse; spare capacity also serves to pressure key non-OPEC producers to cooperate with Saudi Arabia when necessary. But unlike the nuclear deterrent, the Saudi weapon is actively used when required. The kingdom has periodically (and brutally) demonstrated that it can use its spare capacity to destroy exports from countries challenging its market share. This tactic is the weapon that Saudi Arabia could use if Moscow ignores Riyadh's requests for cooperation.
Saudi Arabia has triggered its spare capacity twice in recent history, once when prices were especially low. Both cases demonstrated that the kingdom will accept those low prices so long as it suffers less than its targets do. In 1985, Saudi Arabia successfully waged a price war designed to force other oil producers to stop "free riding" on Saudi oil policy. That policy meant that those states had to cooperate with the kingdom by reining in production enough to allow Saudi Arabia to produce the minimum level that it targeted. Oil prices fell by more than half within a few months, and Saudi Arabia immediately regained the market share it had lost in the preceding four years, mainly to non-OPEC countries.
Then, in the 1990s, OPEC member Venezuela challenged Saudi Arabia by deciding to maximize its production. Although Venezuela had an OPEC quota of 2.3 mbd, Caracas embarked on an ambitious policy designed to eventually triple its production capacity. Caracas knew it could not do this on its own, so it reopened its nationalized resource sector to foreign investment. By the winter of 1996-97, Caracas was producing 3 mbd, knocking Saudi Arabia from its position as number one supplier to the United States. In response, Riyadh first tried reasoning with Caracas. When diplomacy failed, Saudi Arabia raised its production by close to 1 mbd and induced the oil price collapse of 1998. Riyadh's actions were tough but effective. By engineering a price drop, it had to withstand a painful drop in income -- but it achieved its main goals. Saudi Arabia reasserted its OPEC leadership, reestablished itself as the prime supplier of oil to the United States, and induced non-OPEC producers Mexico and Norway to support OPEC's revenue-maximizing goals.
UNCLE SAM NEEDS THEM
Riyadh's relations with Washington are much more complex than they appear on the surface, because they involve unspoken understandings and a number of useful fictions. September 11 has complicated these understandings, because the publics in both countries are suspicious of the cooperation between the two governments. Washington recognizes Saudi Arabia's critical role in the global oil sector, especially Riyadh's price moderation. Saudi Arabia, in turn, plays its Washington cards diligently. The kingdom has protected its position as the top U.S. supplier. Today, Saudi Arabia supplies around 1.7 mbd of the roughly 10 mbd imported into the United States -- a market share higher than that of any competitor. The kingdom maintains this share to show how important Saudi supplies are to the United States. The Saudi leadership can thus ensure that Washington will help defend Saudi Arabia, which means not only the defense of the kingdom's oil fields and territorial integrity but the defense of the House of Saud.
This role does not stem directly from Saudi Arabia's position as the world's largest supplier. Indeed, if oil trading were left to market forces, the kingdom's oil exports to the United States would fall by half. Instead, Saudi Arabia pays a price for its market share, a price that fluctuates each month as market forces change. Saudi Aramco, the state oil company, earns about $1 a barrel less on sales to the United States than on sales to the countries of Europe and East Asia. That discount translates into a subsidy to U.S. consumers of $620 billion per year. In return, the United States deploys military forces in the Persian Gulf, which is of course also expensive. And given U.S. sensitivity to Riyadh's policy concerns on an array of issues, from the Arab-Israeli peace process to Kosovo to Central Asia, Washington pays the additional price of being constrained in its own foreign policymaking.
One of the hidden aspects of the relationship is the Saudi dependence on the United States for providing an expanding market. Although Asian demand for oil is expected to grow dramatically in coming decades, no other economy rivals that of the United States for the growth of its oil imports. Over the past decade, the increase in the U.S. share of the oil market, in terms of trade, was higher than the total oil consumption in any other country, save Japan and China. The U.S. increase in imports accounts for more than a third of the total increase in oil trade and more than half of the total increase in OPEC's production during the 1990s. This fact, together with the fall in U.S. oil production, means that the United States will remain the single most important force in the oil market. The hope of Saudi Arabia and OPEC for an increased market and for greater market share is uniquely dependent on growth in U.S. demand. Hence it is not for security alone that Riyadh depends on the United States but for the very economic basis of the Saudi regime, which relies almost entirely on oil for revenue.
Although the U.S.-Saudi axis is often neglected, it can be blown out of proportion. When the ties between the two countries appeared to fray after September 11, some press reports asserted that this separation of interests was unprecedented. It is true that Riyadh had expressed considerable displeasure with the Bush administration over the U.S. abstention from its former active role in the Arab-Israeli peace process. But even before then, Washington and Riyadh clashed over oil prices; the Clinton administration even pressured other key OPEC countries into increasing oil production.
It would be more accurate, in sum, to see the common interests of Washington and Riyadh as the intersection of two large and unwieldy sets of goals. In both countries, the size and value of that connection have been undergoing serious review since September 11. To the degree that Washington decides to take action to reduce the U.S. economy's dependence on oil, it can greatly affect the scale of increased oil production over the next few decades. It is because of that opportunity that the Russian challenge to Saudi Arabia has become tremendously important.
BUST AND BOOM
It did not take long after the Soviet collapse for Western oil firms, investment banks, and policymakers to begin eyeing the oil reserves of Russia and Central Asia as a competitive alternative to Middle Eastern crude oil. But the region's promise quickly evaporated as investors became bogged down in a swamp of corruption and the difficulties of doing business in rapidly changing economies.
By the early 1990s, as oil exports from the former Soviet states plummeted, Middle Eastern producers started promoting their own energy resources as a cheaper alternative to redeveloping the oil infrastructure of the former Soviet Union. Saudi Arabia and Kuwait even spoke of opening their oil and gas sectors to foreign investment as a way to attract investors who might otherwise look to the post-Soviet Commonwealth of Independent States (cis). Assisting OPEC's efforts were high-profile scandals in Russia and Central Asia and the lack of protection of minority shareholder rights in the Russian oil sector. A wary Western media even questioned the initial estimates of Russian and Caspian oil reserves.
But today, two advantages for the cis are clear. First, its reserves are much larger than previously assumed. Second, oil production capacity in the Middle East has stagnated for 20 years. Indeed, overall OPEC production capacity is actually lower today than in 1980. The Middle East producers have no proven ability to exploit their resources beyond the levels that international companies achieved before they were nationalized in the 1970s. Meanwhile, as exploration and production advance in such places as Kazakhstan, the reserve potential of the cis will enlarge substantially. Eni, ExxonMobil, and others are developing what may be a giant field at Kashagan, estimated to contain 50 billion barrels. Lukoil, Russia's largest oil producer, recently discovered a field of 5 billion barrels of proven reserves in the Russian part of the Caspian shelf; seismic data suggests that the field's vast size could triple the initial estimates inside the license area alone. The discovery rate in Azerbaijan has been, in any case, disappointing, but conservative forecasts show that the Caspian shelf holds 75 billion barrels of oil -- 115 percent of what bp Amoco credited to the entire cis in 2000.
Meanwhile, the Russian oil industry accelerated its consolidation after the 1998 financial crisis ended in a devalued ruble, which in turn enabled Russia to rapidly increase exports. As a result, the industry could focus on developing its known core assets and exploring new assets more efficiently. Russian oil exports began to rise in 2000 for the first time since the Soviet era. By the time Vladimir Putin was elected president in March 2000, Russian firms were ready to capitalize on the internal reforms that they had begun years earlier. Russia's producers also benefited from long-term relationships they had developed with foreign firms, including Conoco, bp Amoco, ExxonMobil, Royal Dutch Shell, Halliburton, and Schlumberger.
Thanks to this process, the cis oil sector is now expected to increase exports by at least 2 mbd between 2002 and 2006. The Baltic Sea's export capacity could grow by as much as 0.4 mbd by 2004, mostly from Russia's four biggest producers through the Baltic Pipeline System. The Caspian Pipeline Consortium, which links Kazakhstan's oil fields to the Russian ports on the Black Sea, will likely add 1.5 mbd by 2006-8. Exports from ExxonMobil and Shell projects in Sakhalin, in Russia's Far East, should add another 0.2 mbd by then as well. Indeed, the resources along Russia's Asian frontier might be as vast as those in Central Asia. And Yukos, Russia's second-largest producer, is preparing to export to China about 0.5 mbd from its fields in eastern Siberia.
To compete with international oil firms and meet the demands of minority shareholders (including foreign investment funds), Russian producers have begun to improve their often awful corporate governance records. The migration toward internationally accepted financial reporting standards has forced them to adopt better managerial and production practices. Efficiency tools such as better software now enable many Russian managers to rationalize production, thereby increasing profitability and the effectiveness of long-term corporate investment. Recently implemented judicial reforms and tax harmonization should translate into a better business environment for all Russian firms.
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