Instability in the Gulf and the Threat to Oil Stability (JCPA-JERUSALEM CENTER FOR PUBLIC AFFAIRS) JERUSALEM ISSUE BRIEF Vol. 4, No. 6 by Antoine Halff 10/20/04)
JCPA-Jerusalem Center Public Affairs
JCPA-Jerusalem Center Public Affairs Articles-Index-Top
The major increase in strategic oil reserves in the consuming
countries could prevent the renewed use of oil as a weapon, as was
the case during the Arab oil embargo of 1973.
In addition, most of the Middle East´s oil today flows eastward
to Japan, Korea, and China, countries that are less likely to be
prime targets in a dispute with Middle Eastern countries.
Assessing long-term prospects, UK and U.S. production is maturing
rapidly. Technology is allowing increased production from previously
remote or unreachable areas, but those areas tend to be depleted
quickly. There are obviously concerns about the stability of Saudi
Arabia as well as Iran.
There remain tremendous oil reserves in Saudi Arabia and Iraq,
but there has been very little actual exploration.
The rise of China as a consumer will have major geopolitical
consequences. China may be expected to be a very cautious, more
visible, and more active diplomatic player in the Middle East as it
becomes a major stakeholder in Middle East stability.
The Declining Threat of Oil as a Weapon
The link between Middle East instability and oil market instability
has changed dramatically in recent years. Obviously, because the
Middle East accounts for such a large part of world oil production,
and for an even larger part of global oil exports, upheaval in the
Middle East always runs the risk of disrupting oil flows, thereby
causing oil markets to soar. But as a matter of policy, the ruling
elites of the Middle East appear to have repudiated previous attempts
to use oil as a political weapon. Saudi Arabia said as much on
repeated occasions in the spring of 2002, when the dying Saddam
Hussein regime, with some backing from Libya, attempted for the last
time to withhold oil exports, ostensibly in retaliation for Israeli
policy toward the Palestinians. However, while Middle East producers
may have buried the oil hatchet in a political sense, it is clear
that OPEC, led by Saudi Arabia, has embarked on an oil policy
designed to maximize export revenues by keeping consumer stocks as
tight as possible, thereby fostering price volatility and global oil
market instability. Although Gulf regimes may have renounced using
oil as a political weapon, in an economic sense, Gulf oil policy may
have become a greater source of market instability than in the past.
Despite the steep rise in oil prices, there are a number of external
factors which may prevent the renewed use of oil as a weapon, as was
the case during the Arab oil embargo of 1973. The first involves the
major increase in strategic reserves in the consuming countries. The
International Energy Agency (IEA) countries, a group of twenty-six
developed countries, have the ability to draw down about 12 million
barrels a day if need be for a period of 3-4 months, and afterwards,
about 9 million. The reserves are tremendous in the U.S., Germany,
Japan, and other IEA countries, serving as a significant deterrent
against the threat of an oil embargo. Key non-OECD economies are now
building up strategic reserves, often guided and advised by the IEA.
China has taken steps to build such reserves, as has India.
An additional factor involves changes in the trade flow since the
1970s. At that time, most of the Middle East´s oil went westward to
the U.S. and Europe, to be consumed in the developed economies of the
West. Nowadays, most of the Middle East´s supplies go eastward to
Japan, Korea, and China, countries that are less likely to be prime
targets in a dispute with Middle Eastern countries. For these
reasons, instability in the Middle East isn´t as much of a threat to
oil supplies as it was in the past.
However, even though, politically, Middle East producers have given
up using oil as a weapon, economically, they have embraced a policy
of keeping the market constantly on edge. OPEC production restraint,
combined with a string of supply disruptions from various exporter
countries, surging demand from China and other emerging economies,
and Western oil companies´ embrace of "just-in-time" inventory
management techniques, has helped drive commercial stocks to record
lows. Preventing stock formation has been an explicit goal of Saudi
oil policy. That means that oil markets are increasingly dependent on
Middle East export flows and current refinery output to meet demand,
and enjoy virtually no stock cushion to draw upon in the event of a
supply disruption. Record-thin stock cover and reduced spare
production capacity foster price volatility and cause markets to
react jarringly to news headlines affecting supply/demand balances.
We now live in a period of constant structural market instability, as
a result of Middle East economic policies designed to maximize
dependence and volatility, deter non-OPEC production, and maximize
OPEC policy alone cannot be blamed for single-handedly causing the
current high prices, but it is a key contributing factor. Oil prices
have recently hit highs that we hadn´t seen since the first Iraq war.
Much of the increase reflects surging demand from China and
elsewhere, combined with endemic infrastructure capacity constraints
and persistent fears of supply disruptions. But those factors would
not have caused prices to surge if OPEC policy had not helped deplete
the market´s safety cushion - just as OPEC´s price ambitions would
not have been met without those external developments.
Production capacity is stretched to the limit across the supply
chain, from the wellhead to the gasoline pump. Supply concerns have
spread from the Middle East to other producer countries, notably
Nigeria and Venezuela. On top of that are additional concerns
stemming from new environmental requirements in the U.S. and
elsewhere. In the U.S., new gasoline sulfur limits are to be
implemented nationwide this summer, even as New York and Connecticut
join California in switching to MTB-free gasoline. It is feared that
these regulations will, in effect, reduce the volume of gasoline that
U.S. refineries will be able to produce and will thus increase U.S.
dependence on imports from other regions. In the face of those
factors, OPEC´s policy of production constraints and production
targets serves to keep the market on edge by preventing the formation
of a needed inventory cushion.
Ironically, one might argue that some of the steps that consumer
countries have taken to prevent the use of oil as a political weapon
have contributed to the emergence of this new economically-driven
instability in the market. That is because the build-up of very large
strategic reserves appears to function as an encouragement to private
companies to lower their own inventories, under the assumption that
in the event of a disruption, the strategic reserves will be drawn
upon. The price of oil would then drop rapidly, as we saw at the time
of the Gulf War when the IEA implemented a release and the price
dropped considerably in only one day.
Price Increases Linked to Expanding Demand
Oftentimes, when we think of risks to the oil market´s stability, we
tend to focus on supply. In the last few years, however, a major
factor that has driven the instability in prices and, in recent
months, fueled the price rally has been demand instability,
especially the unexpectedly steep growth of Chinese and Asian demand.
This has helped OPEC to keep global production tight despite soaring
FSU output, and thus to keep prices very high.
While the Chinese economic expansion may become overheated and
temporarily slow down, it is clear that in the longer term Chinese
economic growth will continue to go hand in hand with steep increases
in oil consumption. Moreover, as China takes over from the U.S. as
the neighboring economies´ number-one trading partner, Chinese
economic development will have a growing impact on regional economic
growth, and thus regional oil demand growth from Japan to Southeast
Asia. Indian oil demand may also take off soon for reasons of its own.
Even as it limits the scope for using oil as a political weapon in
the future, Asia´s growing share of global oil demand has played a
crucial role in facilitating OPEC´s goal of keeping global commercial
stocks tight and oil prices high. The rise of the "East-of-Suez
market" is closely linked to the Gulf producers´ switch from a
politically-minded oil policy to one devoted to fostering oil market
instability for economic gain.
There had long been speculation that OPEC´s high-price policy would
eventually backfire - that it would hurt demand while boosting
investment and supply growth from non-OPEC countries, thus causing a
rebound in stocks and a fallback in prices. That has yet to happen.
In Asia, price effects on demand have so far been absorbed by
offsetting income gains. While the global surge in oil demand has
been accompanied by very strong supply growth, new production has
been offset by a string of supply disruptions, declines at older
fields, and unexpectedly strong demand growth. Among OPEC countries,
rising output has led to a steep fall in spare capacity, as it has
not been matched by a corresponding expansion in upstream investment.
In non-OPEC countries, investment has significantly lagged behind
profits, development expenditures have outstripped exploration
spending, and all too often companies have preferred to boost
reserves and output through mergers and acquisitions rather than
through organic growth. For a long time, uncertainty over the
sustainability of high prices also helped restrain investment.
Long-Term Oil Market Prospects
In the longer term, OPEC´s high-price policy may still backfire.
Meanwhile, the growth in demand, especially in China and India, will
precipitate deep changes in the world energy market. Ultimately,
those changes will likely help redefine the role of Middle East oil
producers as key world energy suppliers. Asia´s growing energy needs
mean it is becoming increasingly dependent on Middle East exports.
This is clearly a concern for Asian countries, and it may well lead
to policy responses that could change the rules of the oil game.
Middle East exporters face challenges of their own, both internally
and externally, and will also become increasingly dependent on Asia,
thus boosting Asia´s leverage in the region.
Clearly, the Middle East role in global oil markets will be deeply
affected by the outlook for oil production elsewhere. In some of the
fields that were developed after the oil shocks of the 1970s,
production is declining. In aging fields such as those in the North
Sea, the fall has been dramatic. U.S. onshore production is also
declining rapidly. Technology is allowing increased production from
previously remote or unreachable areas, but those areas tend to be
depleted quickly. Those factors will compound the effect of concerns
over the political stability of Middle East producers. There are
obviously concerns about the stability of Saudi Arabia as well as
Iran, potential factors which could create a run in prices.
But elsewhere, production is growing. Middle East producers face
stiff competition from rising rivals, particularly Russia. Last year,
Russia overtook Saudi Arabia as the world´s largest oil producer.
Steep production gains are expected from West Africa (Angola) and
Latin America (Brazil). Canadian oil sands output has been surging,
and retains huge untapped potential.
Those external challenges will be compounded by internal ones. The
future of Iraq will be key. If Iraq is developed and becomes more
stable, there is a potential that sources will be developed which
could undermine the ability of OPEC to keep the market tight.
Meanwhile, internal pressures are building from some of OPEC´s
smaller producers, such as Nigeria and Algeria. Those countries have
been increasing their production capacity by attracting investments
from international players. Those outside companies want to see a
return on their investment. There has been speculation for years that
Nigeria, which suffers from a large external debt, would soon leave
OPEC in exchange for relief from international lenders.
Are there great oil reserves still to be discovered? It is believed
that there are tremendous amounts of oil in Saudi Arabia and Iraq,
but there has been very little actual exploration. Iran also has
significant reserves, but they are much more difficult to develop,
and the fiscal environment would need to be improved to attract real
Although high prices so far have had only limited impact on demand,
price effects tend to come with a lag. One form they could take is
fuel diversification. Both China and India have been aggressively
boosting their natural gas economy. Coal is also enjoying a major
revival worldwide. Technologies that just a few years ago seemed very
far away and uneconomical are now becoming more affordable and
attractive, like gas-to-liquids, which is a process that makes
gasoline, diesel fuel, and all kinds of oil products from natural
gas. This process can be applied to other forms of energy such as
coal. One key benefit is that GTL products are environmentally
extremely clean. There are several large GTL projects underway in
Qatar at the moment, and China is in talks to build coal-to-liquids
Finally, the rise of China as a consumer will have major geopolitical
consequences. There has been concern in some quarters that because of
China´s energy needs, it will get closer to Saudi Arabia in an unholy
alliance that will play against Western and U.S. interests. However,
China might actually play a very different kind of role in the Middle
East, becoming a major stakeholder in Middle East stability. One
should remember that China is not immune from Islamist extremism and
terrorism. Some of the al-Qaeda fighters in Afghanistan came from
China´s Xinjiang region, and there has also been Islamist unrest in
Chinese provinces where Islam is a tiny minority. It is reported that
China refused Saudi Arabia the right to open a consulate in Xinjiang
and has denied Saudi Arabia and Iran the right to organize cultural
events there. China may be expected to be a very cautious, more
visible, and more active diplomatic player in the Middle East as it
becomes a major stakeholder in Middle East stability.
Russian oil is flowing in the Ashkelon-Eilat pipeline from the
Mediterranean to Eilat and onward to Asia. Some of the Arab producers
are trying to block this by preventing tankers that have called at
Eilat or Ashkelon to go to an Arab port afterwards. This appears to
be slowing down the movement on the pipeline somewhat, but ultimately
there is probably not much the Arabs can do to block this flow.
* * *
Antoine Halff is a Principal Analyst for the Oil Industry and Market
Division of the International Energy Agency. This Jerusalem Issue
Brief is an expanded version of his presentation at the Institute for
Contemporary Affairs in Jerusalem on March 29, 2004.
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