VOL. XLV

No 37

16-September-2002

 

 

Arab-US Energy Needs In Perspective

 

By Herman Franssen

 

The following is the text of an address delivered by Dr Herman Franssen to the National Council on US-Arab Relations and US-GCC Corporate Cooperation Committees at the 11^th Annual Arab-US Policymakers Conference in Washington DC on 9 September. Dr Franssen is the President of International Energy Associates. Previously he was the Senior Economic Advisor of the Minister of Petroleum and Minerals in Oman. Prior to that he was Chief Economist of the International Energy Agency and served in various positions with the US Congress and Department of Energy.

 

Prior to 1973, global oil demand had been rising at an average of 5-6% per year and most of the rising oil demand was met from newly discovered super-giant oil fields in the Middle East and North Africa. Between 1960 and 1973, the Middle East share of global oil production rose from 16% (1.75mn b/d) to 37% (21.1mn b/d) or 42% if North Africa is included. In 1973, Western Europe and Japan were importing almost all of their oil requirements and respectively 66% and 80% of their oil imports came from the Middle East. Cheap oil from the region certainly helped accelerate the economic recovery in post-war Europe and Japan. In the regional political arena, the future also looked bright for the West.

 

Despite the heavy reliance on the Middle East, oil supply security was not considered a major issue. The main reasons were the strong strategic alliances between the US and Iran as well as the Kingdom of Saudi Arabia, which rapidly became the region’s largest oil producer.

 

The US, which had been oil independent until about 1960, was importing 5.9mn b/d or 35% of its oil consumption in 1973, of which only 13% came from the Middle East (versus 65% from Latin America). By contrast Western Europe and Japan imported almost all of their oil in 1973 (respectively 14.3mn b/d and 5.8mn b/d) and most of it came from the Middle East.

 

In early 1973, all signs pointed at continued robust OECD economic and oil demand growth and rising oil imports from the prolific oilfields of the Middle East and North Africa. However, political events in the Middle East caused two severe oil shocks from which the OECD never fully recovered. Perhaps with the exception of the second half of the 1990s in the US, the OECD economies never returned anywhere near the sustained high growth rates experienced prior to the first oil shock.

 

The oil embargo of 1973-74 and the subsequent major oil price hikes and asset nationalization by most Middle East oil producing countries, changed the world of oil profoundly. In the context of the current US frenzy to reduce dependence on Middle East oil, it is important to note that the US – which was only marginally dependent on Middle East oil compared with Europe and Japan – suffered as much from the adverse economic impact of the oil price explosion as its OECD allies. This was despite the fact that the US was only marginally dependent on Arab and Iranian oil compared with Europe and Japan. US efforts to protect its economy from the oil shock of 1973-74 through a series of domestic oil price controls and rationing which created product shortages, gave false signals to the market and brought about serious distortions in the US economy and the US petroleum industry.    

 

Many politicians believe that lower dependence on Middle East oil will protect the US from the adverse impact of potential oil shocks. US and global economic developments proved them wrong. Oil is a global commodity. Following a supply disruption, oil will flow to the buyers able to pay the higher price. In such circumstances, the major losers are the poor oil importing developing countries. The cost to the US and global economy of serious supply disruptions is not a physical shortage of oil but the inflationary impact of higher energy prices on the economy.

OECD Dependence On Middle East Oil

(Mn B/D)

 

	1973	1985	2000
Total OECD Oil Demand	39.2	32.0	46.3
OECD Oil Imports	25.7	17.4	26.5
OECD Oil Imports from Middle East	16.2	6.7	10.4
Of which:
US Imports from Middle East	0.8	0.6	2.5
% of Oil Imports from Middle East	11	11	23
Europe Imports from Middle East	10.3	3.0	3.7
% of Imports from Middle East	68	35	37
Japan Imports from Middle East	4.4	2.8	4.2
% of Imports from Middle East	81	66	79

 

The Arab oil embargo of 1973 and the Iranian revolution of 1979 caused a more than tenfold increase in oil prices. These events were major contributors, respectively, to the post-1973 and post-1979 inflationary spirals and global recessions. Market forces, supplemented by OECD government policies, brought about a sea change in OECD oil consumption and production. Within a decade most industrial oil use (including electrical power plants) had shifted to nuclear power, coal and natural gas. The latter had hitherto been largely a US fuel, but gradually began to make inroads in Europe’s residential/commercial sector.

 

On the supply side, high oil prices opened up high cost North Sea and Alaskan oil provinces for development and, nationalization of oil reserves in many Middle East countries forced the international oil companies to look elsewhere for oil. The embargo had left a lasting impact on OECD countries, which established the IEA, charged with coordinating OECD energy security policy. The IEA countries agreed to build strategic oil reserves to avoid the chaos in the oil market following the 1973 oil shock.

 

In comparison with the panic and confusion following the 1973-74 oil embargo and to a lesser extent the 1979-80 Iranian production implosion, the OECD members are now better prepared to cope with oil supply disruptions for a period of 6-12 months. If, however, more dramatic, semi-permanent political changes were to take place in the Middle East, and especially among the Arab countries, the impact of a prolonged major supply reduction from the region would provide an entirely new situation.  

 

It took time for the full impact of the higher prices of the 1970s to work its way through the energy economies of the OECD countries in terms of lower economic activity, energy efficiency improvements, fuel switching and vast E&P activities from the North Sea to Alaska. But up until the impact was felt, the Middle East oil producers benefited greatly from the 1970s price hikes. However, once the impact of the price explosions on oil demand and supply became apparent in the early 1980s, demand for OPEC oil fell sharply and Gulf producers, the residual producers within OPEC, suffered most in terms of market share losses. Since then, Middle East oil producers have stated time and again that they would never use the oil weapon again.

 

The oil weapon was not used lightly in 1973; it was a weapon of last resort. One cannot rule out that under specific conditions, when tested to the limit, some major Middle East oil producers might be forced to employ this weapon of last resort, even though they are fully aware of the medium and long-term adverse consequences. This becomes clear when one examines the impact of the two oil shocks on OECD oil consumption and production.

 

Between 1973 and 1985, OECD oil consumption fell by almost 10mn b/d and OECD oil production rose by about 3mn b/d. Subsequently, OECD oil imports fell from 26mn b/d to 17mn b/d and imports from the Middle East from 16mn b/d to less than 7mn b/d between 1973 and 1985. Leaders of countries hostile to the governments of the major oil producing countries in the Middle East felt that the region’s importance as the dominant oil producer had been dealt a deadly blow. However, the emergence of new economic powers in Asia, coupled with a returning appetite for oil in the US, steadily turned the market again in favor of the Middle East oil producers.

 

Lack of a determined and consistent US energy policy to curb oil demand growth and stimulate domestic production was not without effect. Coupled with a more market-oriented OPEC pricing policy, and robust economic growth in particular in the second half of the 1990s, it turned US and OECD oil import dependence around once again in favor of the Middle East. OECD oil imports between 1985 and 2000 rose from 17mn to 26mn b/d and imports from the Middle East from 6.7mn b/d to 10.4mn b/d. US dependence on imported oil had fallen to 4.6mn b/d in 1985, rose to 7.4mn b/d in 1990 and a record 11mn b/d in 2000. US dependence on Middle East oil fell marginally from 0.8mn b/d in 1973 to 0.6mn b/d in 1985 and then rose to 2.5mn b/d in 2000. 

 

Unaware of the impact of the Asian financial crisis on Asian economic growth and oil demand, OPEC mistakenly increased its production ceiling in December 1997. Oil prices collapsed and subsequent declining global E&P activity caused non-OPEC production to stagnate. However, in time, OPEC regained market share. By December 2000 Saudi Arabia was the only country left with significant spare capacity. If a major oil supply disruption had occurred at that time, it would have had terrible consequences for oil prices and the global economy.

 

For almost two decades in which US oil import dependence rose rapidly, three US Administrations (Republican and Democratic) paid little attention to the issue of rising oil demand and import dependence other than in the context of environmental policy. When the IEA’s International Energy Outlook of 2002, in its reference case, projected US oil imports to rise to 14.3mn b/d in 2010 and 16.7mn b/d in 2020 (63% of projected oil consumption), it raised few eyebrows in political Washington.

 

Oil supply security was a minor policy issue in the US until the 11 September attacks on the World Trade Center and the Pentagon. Since then, the mood of the Administration has changed and there is a new determination to increase the Strategic Petroleum Reserve (SPR) and reduce oil import dependence on the Middle East in favor of importing more oil from West Africa, Latin America, Canada, Russia and the Caspian region.

 

But the new policy once again fails to address the real issues, ie, long-term unconstrained US oil demand growth and the inability to make adequate Federal acreage available for domestic E&P. The strange notion that zero imports from the Middle East will somehow protect the US economy from the adverse economic impact of a possible major oil supply disruption appears to have survived. One of the few positive energy policy actions taken by the US Administration is the strengthening of the SPR. 

 

Future Dependence On Middle East And Arab Oil

In the current low oil demand, high oil price world, demand for OPEC and Middle East oil is rising at a snail’s pace. However, even in this low growth world and with steadily rising non-OPEC production, the “call on OPEC” through the end of 2003 is estimated at around 25.5mn b/d by Petroleum Economics Ltd (PEL) London. About 17mn b/d (19mn b/d including North Africa) representing 67% of current OPEC production or 22% of global oil production come from the Middle East. There is no way the world could adjust to a scenario without the Middle East for any length of time short of facing an economic calamity.

 

Many global oil supply assessments conclude that incremental non-OPEC production will slow, if not decline, later in this decade even at currently prevailing prices. All scenarios point at sharply rising demand for Middle East oil in the next decade (2010-20). Both the IEA and EIA show significant growth in demand for oil from the Middle East even in this decade. Although their timing and extent of dependence on Middle East oil differs, all analysts agree that the importance of the region to meet future global oil demand will steadily rise. PEL estimates demand for Gulf crude oil in 2010 at between 17mn b/d (high price scenario) to 22mn b/d (low price scenario).

 

The EIA’s International Outlook of 2002 estimates global demand on the Gulf in 2010 as high as 28mn b/d in its Reference scenario, with the Saudi share estimated in excess of 12mn b/d. In either case, Saudi Arabia remains the number one world oil exporter. US imports from the Gulf amounted to 23% of total oil imports in 2001; at 1.7mn b/d Saudi Arabia was the largest oil exporter to the US from the Gulf region.

 

Base case scenarios suggest that along with rising US oil imports, imports from the Middle East will increase in the coming decade. However, rising oil production in the Atlantic basin, a determined effort by Russian companies to export oil to the US, and a government policy aimed at reducing oil imports from the Middle East, could reduce oil imports from the region later in the decade. Those who argue in favor of further reducing the share of oil imports from the Gulf region maintain that this would enhance US supply security, an argument I hope we have already thoroughly squashed.

 

Saudi Arabia has until now had a strategic interest in remaining one of the largest (if not the largest) oil exporters to the US (for export diversification and strategic reasons). If US refiners were to import more oil from the Atlantic Basin and less from the Middle East in the future, some Saudi exports would be diverted to Asia. Such a move would not have any noticeable positive impact on US oil supply security. 

 

The Special Role Of Saudi Arabia In The Global Oil Market

Saudi Arabia, which holds a quarter of global oil reserves and produces about 10% of world oil output, has been a major player in the oil market since the 1960s. Oil was discovered in 1938 and production reached 1mn b/d by 1958, 2mn b/d in 1965 and 3mn b/d in 1969. In 1972, Saudi Arabia became the largest OPEC oil producer at 5.7mn b/d (Iran 5.1mn b/d), accounting for 20% of OPEC production and 13% of global oil production. In 1980, Saudi production peaked at 10mn b/d (annual average) or 36% of OPEC and 16% of global oil production.

 

Ever since the late 1970s Saudi Arabia has played a very constructive role in the oil market, balancing the kingdom’s internal financial requirements with the interests of the oil consuming countries in stable and moderate oil prices. When oil production fell in Iran and Iraq at first during the Iran revolution and later during the Iran-Iraq war, Saudi Arabia increased oil production to prevent another price hike. During and after the Gulf war, the kingdom quickly reacted to the supply shortfall by rapidly increasing production, thereby avoiding a damaging oil price spike.

 

Saudi Arabia was able to come to the rescue in the 1980s and 1990s because the kingdom maintained considerable spare capacity. No other oil producer has ever been able and willing to play this role to the extent Saudi Arabia has.  Should Saudi Arabia ever abandon this policy (it has no intension to do so), global oil supply security would be greatly affected. Global oil supply security rests on the twin pillars of the strategic stocks of the IEA member states and Saudi spare capacity. By international agreement, IEA members are obliged to draw strategic stocks under specific conditions; Saudi Arabia has no such obligations but for the past two decades has used its spare capacity effectively in case of supply disruptions.

 

One of the differences between the IEA strategic stocks and Saudi spare capacity is the size. The IEA members can release strategic stocks at a combined rate of perhaps 5mn b/d for about four months or less than 3mn b/d for half a year. A June IEA study has shown that the IEA stockdraw potential is sufficient in magnitude and sustainability to cope with the largest cited historical supply disruption. This is more than sufficient to deal with the kind of crisis we faced in 1973-74 and 1979-80. However, in case of a serious lasting oil supply crisis arising from wars or revolutions, IEA member countries may be reluctant to maximize strategic stock withdrawal and, in the end, the 1.3bn barrels of public stocks might not be adequate in a serious lasting supply disruption.

 

By contrast, Saudi Arabia has currently 2.5mn b/d to 3mn b/d of spare capacity and the kingdom will be able to produce at the higher rate for years. Under most supply disruption scenarios, the kingdom would be willing to do so. The ability and willingness to produce 2.5mn b/d to 3mn b/d from spare capacity is a feature unique to Saudi Arabia. Other Gulf states together have another 1.3mn b/d of spare capacity and other OPEC members aside from Iraq perhaps another 1.2mn b/d. There is negligible spare capacity outside of OPEC and it is unlikely that any non-OPEC country will develop spare capacity and leave it idle waiting for a crisis to come.

 

Most OPEC countries have spare productive capacity due to current oil market conditions (weak demand and high incremental non-OPEC production). Only Saudi Arabia has a policy of actually maintaining spare capacity, both to influence OPEC policy and as an insurance policy against price hikes arising from oil supply disruptions.   

 

Challenges Facing Middle East Oil Producers

Market Challenges: In 2000, average OPEC crude oil and NGL production was 30.8mn b/d (28mn b/d of crude oil only) and most OPEC countries were producing at or very close to capacity. About 80% of global spare productive capacity was located in Saudi Arabia and much of the remaining spare capacity was located in the Gulf.

 

Market conditions have changed with the downturn in the US economy; oil demand has stagnated and non-OPEC production has increased. The net result has been a rise in OPEC spare capacity of some 7mn b/d of which about 45% is in Saudi Arabia alone and 80% in the Middle East as a whole (excluding North Africa). If global economic growth remains anemic for one or more years to come and OPEC succeeds in maintaining oil prices in the OPEC desired trading range of $22-28/B, demand growth is expected to remain modest (about 1.5% per annum) and incremental non-OPEC supply for the foreseeable future is projected to rise at close to the rate of global oil demand growth. If this happens, demand for OPEC oil could stagnate for the next few years at a time when several OPEC countries are adding to productive capacity. Tensions between OPEC and non-OPEC as well as within the OPEC family are bound to rise.

 

Once Iraq sanctions are lifted, productive capacity from proved reserves could rise within a few years to some 4mn b/d, thus adding to OPEC’s headaches. Coping with the challenges from within OPEC and from non-OPEC will not be easy. In 1986 OPEC could afford to challenge non-OPEC in a fight for market share because key OPEC members had amassed vast foreign exchange reserves in the years prior to 1986.

 

One of the major issues facing OPEC countries, including Saudi Arabia, is how to maintain their oil market share at oil prices needed to meet budget requirements. A recent study by Dr Sharif Ghalib of EIG implies that Saudi Arabia requires an oil price of $25/B to meet the kingdom’s budget. Dr Ghalib’s finding have been confirmed by other senior economists working in the kingdom. However, if prices are maintained at this level through OPEC supply management, Middle East oil production may have to be frozen at close to current levels for several years to come.   

 

How to Cope With The Non-OPEC Challenge

Since the beginning of non-OPEC cooperation with OPEC, non-OPEC contributions to production cuts have been largely symbolic with the exception of a few countries. The Former Soviet Union (FSU) has paid lip-service to OPEC’s calls for production constraints but actual production data from various statistical sources show no proof of such production cuts in the past.

 

Non-OPEC producers will only cooperate with OPEC once OPEC increases market share, allows prices to fall to below $15/B (Brent) and keeps prices at that level for months. Short of such draconian measures, past experience has shown that few non-OPEC oil exporting countries will actually assist OPEC in its effort to manage oil supplies around a price level of $22 to $28/B. OPEC’s dilemma is that only lower prices ($20/B or less) will reduce non-OPEC incremental production growth and increase consumption; but most OPEC countries need more than $20/B to balance government budgets. Time will tell how OPEC will resolve this dilemma.

 

The non-OPEC production challenge, at $25/B or higher oil prices, will reduce demand growth for OPEC oil at a time when many OPEC producers are adding capacity. Pressures in particular from non-Middle East OPEC producers for higher quotas are expected to rise along with capacity growth. Iraq’s productive capacity is dependent on the outcome of the ongoing confrontation with the US. In the medium to longer term, however, with or without regime change, Iraq’s production is bound to rise and may ultimately rise above 6mn b/d. Friction is bound to rise within OPEC on how to deal with rising capacity and Iraq’s production ambitions.

 

One way to deal with the situation is to allow higher quotas and accept subsequent lower oil prices. Lower prices will increase demand growth; reduce non-OPEC incremental supply; and enable OPEC to accommodate internal capacity growth. The challenges to OPEC to maintain production volumes and oil prices in the medium and longer term at a minimum level required to meet minimum budgetary needs, are rising. OPEC has faced similar challenges before and has been able to resolve the price/volume dilemma at a cost to both OPEC and non-OPEC oil producers.

 

The Russian Challenge

Former Soviet Union (FSU) oil production peaked at 12.8mn b/d in 1988 and fell sharply after the USSR broke up. The FSU reached bottom production in 1996 at 7.2mn b/d, of which Russian production accounted for 6.1mn b/d. Privatization of the oil industry coupled with the fall of the Ruble led to a boom in upstream investments in the Russian oil industry. Russian production rose from 6.1 to 7.1mn b/d between 1996 and 2001. Western investment in the Caspian raised production in the region from 1.2mn b/d in 1995 to 1.6mn b/d in 2001. Net FSU exports rose from 2.6mn b/d in 1995 to 4.6mn b/d by 2001. In the same period, Saudi oil output fell from 7.8mn b/d to 7.5mn b/d.

 

Petroleum Economics Ltd projected that total FSU production may increase by another 1.6mn b/d between 2001 and 2005 and net exports by some 1.3mn b/d or almost 350,000 b/d annually. These numbers are in broad agreement with those of Robert Ebel of CSIS, one of the foremost Russian energy experts in the US. In 2005, FSU oil exports could amount to 5.8mn b/d , while Saudi exports (due to OPEC quota constraints) may perhaps not exceed 6-7mn b/d. FSU oil exports will challenge Saudi and Middle East export in Western Europe and to a lesser extent in the American market.

 

Beyond 2005, the FSU production outlook is more difficult to project. Caspian oil production and net exports are expected to continue to rise for at least another decade and could amount to 1.5mn b/d by 2010. Depending on the post-2005 Russian production outlook and oil demand growth, Russian oil exports in 2010 could amount to 4-5mn b/d. On the negative side, Russian oil reserves have reportedly declined by 15% in the past decade. Robert Ebel wrote that while Russian oil production has grown by about 1mn b/d since 1996, what is not known is how much of the incremental oil production in Russia came from: old Soviet practices of pulling fields to the maximum; how much from well repairs; how much from new production in existing fields and how much from new fields. Unless we get better data, it will prove difficult to gauge future production capacity of the Russian Federation. At this time, however, it is sufficient to say that Russia and the Caspian have become formidable oil nations, ready to challenge Middle East oil producers, in particular in the Atlantic basin.

 

In terms of oil supply diversification, it is doubtful that oil imports from Russia and the Caspian region will be any more secure than Middle East oil. The Caspian countries suffer from some of the same internal problems as some Gulf countries and, in addition these countries are land-locked, making them hostage to neighboring countries’ policies. There is also perception by some analysts and in particular by those who favor marginalizing the Middle East, that Russia will be a more secure source of oil exports to the US than Gulf countries. Russia is likely to follow its own agenda, determined by Russia’s own national interest. For example, Russia appears to have different interests than the US in three countries labeled as the “axis of evil” by the US. There is no apparent security reason why the US should favor Russian oil imports over Middle East oil.

 

The Need For Saudi Oil

Even in the low demand, high non-OPEC production growth scenario, the Middle East still accounts for 65-70% of OPEC production and more than 20% of global production. Saudi Arabia would account for 25%-30% of OPEC production and 8-11% of global production. Under any scenario (even the most conservative demand outlook), Saudi Arabia would need to produce between 7mn b/d and 9mn b/d to meet global oil demand, even taking into account prospects for a slight adjustment of OPEC quotas. Saudi Arabia would remain the single largest oil exporter in the world and the only country with sufficient spare capacity to continue to play its role as one of the pillars of global oil supply security. No other producer will be able to challenge the Saudi position as the largest oil exporter and prime provider of oil supply security in this decade.

 

Can the world rely on Saudi oil? The record of Saudi Arabia as a reliable oil exporter, willing and able to secure an acceptable oil price level and make up for lost production elsewhere, has been established over the past quarter of a century. Aside from the fact that no other country can perform this dual role in the foreseeable future, it is doubtful that any other major oil exporter would be willing to play this role. The US-Saudi relationship has frequently been described as a marriage of convenience. Saudi Arabia has used its oil production power to meet global oil demand generally at an acceptable price level and provided attractive markets for certain US goods and services.

 

In return, the US has provided a security umbrella for Saudi Arabia and the Gulf region. Until 11 September this relationship worked well most of the time. Since 11 September, serious differences have arisen between the two old allies. These differences require intense discussion if they are to be resolved. The overtly hostile, perhaps orchestrated anti-Saudi cabal that has increased in the US since 11 September does not serve US interests.

 

The current system of government in Saudi Arabia can offer the best guarantee that Saudi Arabia will continue its past oil policy which has benefited the world. Saudi Arabia is facing serious demographic and socio-economic problems and the kingdom would be well served to address some of these underlying problems, which have caused some of its citizens to play such a dominant role in the tragedy of 11 September. Rather than attacks on Saudi society and government in the media from prominent politicians, former government officials and poorly informed op-ed writers, it would be more productive to engage in quiet diplomacy in an effort to remove the negative factors, which work against both Saudi and US national interests.

 

The US Government, in turn, should be more open to the concerns expressed by all governments in the region on the issue of Palestine, which is increasingly radicalizing the younger generation in the Middle East and turning them against the US. Only the US Government can and must play an active role in bringing the two parties to the conference table but, it can only do so effectively by being even-handed.     

 

The Saudi Government has a proven record of accommodating global interests in terms of oil policy. One cannot take this for granted, assuming that any Saudi Government will follow a similar policy at any time. We should do well to remember that Iran produced 5.5mn b/d prior to the 1979 revolution. In the 23 years since the revolution, Iran’s oil production, for a variety of reasons, has averaged only a little more than half the pre-1979 level of production. At the end of the Second World War, the three major oil giants in the Middle East, Saudi Arabia, Iraq and Iran, were closely allied to Western interests. Today, only one country remains close to the West. We would be well served to maintain a close relationship with the last of the major oil producers whose oil policy interests are almost identical to ours.