The Future of Oil

A vivid shot of the oilfield development in Saudi Arabia's vast al-Rub al-Khali desert. It is facilities such as these which must cope with rising global oil demands

The international oil industry has a long history of interruption from political turmoil. Of the 28 countries that experienced civil conflicts over the course of the twenty-first century, approximately a third of them were oil producing nations*. Control of oil facilities often becomes the key to leverage in these civil conflicts, as seen most recently in the struggle by the Libyan opposition to stay afloat in the campaign against Libyan strongman Colonel Muammar Qadhafi. Political strife also takes its toll on oil operations. Local workers abandon their posts and foreign technicians are often evacuated, in some cases causing a slowdown or even cutoff of oil production. Splinter groups bomb critical facilities to deprive the ruling parties of revenue and fuel, causing disruptions that last until infrastructure can be repaired.

The prospects that the Arab Awakening could sweep across the Middle East sent oil prices skyrocketing. The sudden outbreak of large-scale anti-government protests in Egypt was the first event to rock global oil markets, as fears that oil traffic through Egypt’s Suez Canal would be curtailed raised spot oil prices by around 5 percent in a matter of days. The announcement that Iran was sending naval ships through the Suez Canal pushed UK Brent prices even higher, to over $103 per barrel. While the Canal was never closed, pending oil exploration deals were put on hold and Egyptian natural gas operations were disrupted by the explosion of the Arab Gas Pipeline, leading to a month-long suspension of natural gas exports to Jordan, Syria, Lebanon, and Israel. No sooner had the market adjusted to the news from Egypt, when civil war in Libya forced the evacuation of foreign oil operators, fully shutting in Libya’s oil output of 1.5 million barrels per day (bpd). Meanwhile, European sanctions on Syria have reduced Syrian oil exports from 120,000 bpd to almost zero. In Yemen, political volatility so far has nearly halved the country’s normal oil output, and a worsening of hostilities could prove more destructive. Overall, prior to the unrest in Tunisia, oil prices rose from $92 per barrel in January 2011 to $120 per barrel by April, after violence erupted in Libya.

[inset_left]Qadhafi may be gone, but it is anyone’s guess how quickly the country can resume oil production[/inset_left]

Oil markets were quick to recognize a contagion effect for Middle East politics. Conditions for social unrest that would drive the Arab Awakening—high unemployment among young populations, dissatisfaction with the levels of personal freedom and human rights, economic stagnation, corruption and lack of government accountability—exist across the oil-producing regions of the Middle East. Oil production totaling 21 million bpd in seven countries (Algeria, Libya, Syria, Yemen, Iraq, Iran and Saudi Arabia) is potentially at risk, and a new kind of oil price premium emerged, only recently dislodged by negative global economic news. The Arab Awakening portends greater volatility in oil markets over time as the changed political outlook raises questions about the longer term effects of political turmoil and broadened political participation on investment in oil productive capacity throughout the Middle East.

Shaking Up the Market: Why the Physical Toll Will Last Longer Than We Think

As dramatic as it has been, oil price volatility from last spring does not tell the full story of the oil impact for the Arab Awakening. The short term rise in oil prices belies a greater problem: Markets have yet to take into account the more lasting effects that shifting Middle East politics will have on regional oil industries. History teaches us that abrupt regime change in oil-producing states can lead to a prolonged period of low oil output, often lasting decades. The length of the period of decline is determined not only by the level of damage to existing infrastructure that might ensue from political unrest or civil war, but more significantly by the process of consolidating power that follows the transformation of internal politics.

The long-term cycle of underinvestment in oil capacity that has accompanied revolutionary change in political leadership in the Middle East still plagues oil markets today. Iran’s oil production averaged around 6 million bpd in the late 1970s, but a crippling oil worker’s strike in December 1978 halted production and contributed to the fall of the shah. By early 1980, with the rise of Iranian revolutionary leader Ayatollah Khomeini and the start of the Iraq-Iran war, Iranian output had fallen to 1.5 million bpd. Today, three decades later, the country’s oil output capacity has recovered to only 3.5 million bpd—far below its pre-revolutionary levels.

The historical Libyan case is also instructive: When Muammar Qadhafi rose to power in 1969, Libyan oil production averaged 3.2 million bpd. The new revolutionary government called for an increase in the official posted price for oil, threatening to shut down production entirely should the West resist its demands. By 1975, Qadhafi’s strident approach to oil policy had driven Libya’s oil output to less than 50 percent of its capability. Ten years later, with Qadhafi still firmly in power, oil production had dropped to a mere one million bpd. The dramatic decline of Libya’s oil output during the first two decades of Qadhafi’s rule points to the difficulties of marrying revolutionary politics with the technically challenging task of running a multi-billion dollar oil infrastructure. In the 2000s, Libya’s economy began a slow and steady recovery aided by more conciliatory policies and a strong international market, but oil output never came close to pre-revolution levels, even with foreign assistance.

With Qadhafi’s fall from power officially recognized on August 21, 2011, the task that lies ahead for the National Transitional Council (NTC) and subsequent leaders is perhaps more challenging than that faced by Qadhafi in 1969. On top of the ancient social chasms that have reemerged, the country’s economy is in dire straits, foreign operators have fled and security concerns in-country appear likely to keep most international operators from returning in the foreseeable future. Qadhafi may be gone, but it is anyone’s guess how quickly the country can resume oil production. The International Energy Agency, for example, is projecting that full production will not resume until 2015. No matter how well the transition to elective rule transpires in Libya, the lengthy process of nation-building and legitimization of authority is certain to hinder the level of investment required to repair the damage to oil facilities, reassemble the workforce and resume operations for a period of months, if not years.

Political Participation, Factionalism and Oil Funds

To assume that the cycle of oil infrastructure underinvestment will be limited to countries undergoing revolutionary change is overly optimistic. The problem of oil in emergent electoral democracies is no less thorny. The broadening of political participation and related competition for public and private goods can give a disproportionate priority to short-term considerations as well as fueling counterproductive, factional infighting on the subject of oil investment and related spoils. The few examples of nascent electoral democracy in the Persian Gulf have not yet been favorable to oil development. In Kuwait, political discord between an unpopular, royally appointed prime minister and coalitions in the partially elected National Assembly have stalled the implementation of planned oil sector expansion projects­. In Iraq, social protests, sectarian political infighting and competition for national power and resources among regional leaders are all contributing to delays in the implementation of major billion dollar oil infrastructure expansion projects.

Kuwait’s Oil Ministry intended to increase production capacity from 2.9 million bpd currently, to 4 million bpd by 2020, but the embittered political quarrelling in Kuwait has rendered the proposal highly unattainable, while at the same time weakening the credibility of Kuwait’s oil sector in the eyes of foreign investors. The National Assembly’s longstanding posture of blocking progress on major expansion programs in the oil industry remains problematic for the emirate, whose mature fields will increasingly require enhanced recovery techniques to stave off declines in oil production. Kuwait’s national oil company requires outside assistance to meet the technically challenging problems emerging in Kuwait’s oilfields, and its domestic industry lacks the manpower and expertise to develop new reserves on its own.

However, opposition in the National Assembly against foreign participation does not appear to be wavering, especially in the charged atmosphere following the Arab Awakening. In February 2010, state firm Kuwait Oil Company (KOC) signed a five-year deal with Royal Dutch Shell to develop deep gas reserves in non-associated gas fields in northern Kuwait. Kuwait has been desperate to find more natural gas to power rising local industrial and electricity demand. At the time, it was hoped that Shell’s deal with Kuwait would not raise objections from parliament, since the development of associated natural gas with the aid of a foreign partner appeared less politically sensitive than oil development in Kuwait; plus, the natural gas to be developed would aid the reduction of domestic power shortages—a more popular mandate than increasing new oil production for export. Shell’s assistance was only invited after KOC ran into its own production problems trying to develop the resources without assistance.

In spite of its obvious benefits, the deal still ran amok in parliamentary politics. The National Assembly is now conducting an investigation into KOC’s award of Shell’s $800 million enhanced technical services agreement (ETSA) for the gas work and has forced the Oil Ministry to conduct a similar investigation. Parliamentarians have questioned whether the deal was open to fair competition. The move follows the resignation of Kuwait's deputy prime minister, Sheikh Ahmad Fahad Al-Sabah, who had been a rising force in the energy sector as head of Kuwait’s Development and Infrastructure and Energy Committee. Sheikh Ahmad resigned his post in June to avoid a grilling from parliament after being accused of corruption and mismanagement. The National Assembly’s response to the Shell deal is said to be stalling the possibility that other foreign firms will sign ETSAs with Kuwait until the controversy is settled – an example where elective politics is no friend to oil expansion.

Iraq’s experience with electoral democracy has been similarly unfriendly to the development of its energy sector. Despite the commencement of oil expansion projects totaling 7 to 9 million bpd, Iraq’s emerging political deadlock has proved a barrier to getting the projects squarely off the ground. The spread of localized demonstrations in Iraq in the spring of 2011 by citizen groups frustrated by the dearth of basic services has exacerbated existing problems for the oilfield expansion programs, further disrupting the Iraqi government’s fragile coalitions and diverting funds and electric services away from the oil sector. As in the case of Kuwait, political jockeying breeds tunnel vision: the redirection of those funds and electric services—a classic case of rent distribution—has stalled the oilfield expansion projects, since the electricity needed both to pump seawater north to the southern oilfields as well as to fuel desalination plants is no longer available from the national power grid. Foreign oil companies say they are continuing to experience major delays and are questioning their ability to execute current contracted production targets given ongoing infrastructure development problems. According to a Baker institute working paper, foreign companies are still at an early stage of mobilization, and political decentralization inside Iraq remains a barrier to rapid implementation of projects to develop the oil, gas and electricity sectors.

As political participation broadens across the Middle East, countries are being forced to widen the distribution of economic benefits and patronage within their borders. As Arab publics increasingly weigh in on oil policy, changes in oil strategy will certainly take place.[3] With governments facing pressures to expand public services, a trade-off occurs in which public funds are diverted away from the oil industry to social welfare services and salaries. Thus, the region will mortgage its future. Money diverted away from oil field expansion will translate into less future oil income as the demands of local populations grow larger and more expensive. Meanwhile, domestic fuel subsidies not only make it harder for national oil companies to turn a profit that can be reinvested, but they also expand the base of fuel-related entitlements that become harder to suppress. Mexico and Indonesia have already learned this hard lesson.

In the immediate term, the higher price of oil seems to stave off regime collapse. The public is led to believe by Islamists and other opposition groups that high oil prices are the key to improving quality of life. Yet demand for oil in the long run will prove elastic, and high prices will eventually prompt global buyers to increase fuel efficiency and advance unconventional energy substitutes, such as is now apparent from the boom in shale gas resources in North America.

The upshot of the region’s current political trends is that the Arab Awakening could easily and accidentally block the future expansion of oil production in the region. Thus, optimistic forecasts regarding the expansion by the Organization of Petroleum Exporting Countries (OPEC) of oil productive capacity over the next couple of decades may not materialize. As events unfolded in Tunisia, Egypt and Libya in early 2011, the amount of surplus oil that OPEC could offer the market shrank considerably. OPEC spare capacity fell from 4.74 million bpd to 4.08 million bpd during the Arab Awakening. By June, with Libya’s pre-war production of 1.69 million bpd no longer available, OPEC spare capacity had decreased to 3.21 million bpd.

In the decades following 1979, trends were no more positive. OPEC’s oil productive capacity sat at 38.76 million bpd in 1979 against demand for its oil of 34 million bpd. By 2005—some 26 years later—OPEC’s capacity had fallen to 30.6 million bpd against demand for its oil of 29.9 million bpd. Assumptions that OPEC will supply the additional 12.5 million bpd beyond its current output needed by global markets to balance higher oil demand projected for 2030 goes against both the grain of history and the current reality of the Middle East. With nearly every Arab member of OPEC—together totaling 44.6 percent of proven crude oil reserves worldwide—in the throes of political conciliation, the cumulative effect on future investment could be substantial. Even in the United Arab Emirates, where high state subsidies have largely shielded the government from public protest, these very subsidies have squeezed the country’s national oil industry’s profit margins so tightly that the government will soon be left with only two options: massive subsidy cuts or reallocation of investment away from oil. Should the same fate befall Saudi Arabia, the oil market’s oil supply powerhouse and de facto central banker, it could be a rocky ride indeed.

*Khair El Din Haseeb notes:``Transformation of these regimes into democratic ones which incorporate the participation of their peoples in primary decision-making processes will preclude their national security from remaining at the mercy of the United States...The Arab peoples will demand ‘just’ prices for their vital oil and gas resources, commensurate with the price increases of various goods in the West. They will not permit their regimes to continue to sell oil at current prices." In Haseeb, “On the Arab Democratic Spring: Lessons Derived," Contemporary Arab Affairs, April 21, 2011

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