Banking on Saudi-Parabia

April 2, 2012 | 00:00

How the US policy shipwreck over Iran is undermining the credibility of Saudi Arabia and the IEA

Banking on Saudi-Parabia

Lulled by dreams of energy independence, the US thought it could slap sanctions on Iran without having to pay a price at the pump. That has proven to be a miscalculation. Now, rather than abandoning its Iran policy, the US is relying on Saudi Arabia and the Paris-based International Energy Agency (IEA) to bring down oil prices and prevent the world economy from going under. According to energy security specialist Matthew Hulbert, this is a highly risky policy which could seriously hurt the credibility of both Riyadh and Paris. He warns that "until the US ditches its energy independence myth and gets back to current reality, the Saudi-Parabia ship is going to struggle to make it to port over the next decade." The world is entering dangerous waters.

Saudi Oil Minister Ali al-Naimi is trying to pour oil on troubled waters (photo: Tim Boyle/Bloomberg)

After all the hype over new-found global energy (unconventional gas and oil) abundance, we're back in a familiar position - desperately looking to Riyadh to fill any supply gaps on the oil market to smooth prices and keep Western economies from ticking over. Why not you might ask? Steady OPEC supply and Western demand have been the lifeblood of the global economy from decades past. What's more, they're the juice that will keep the world rolling as demand shifts East and cheap exports continue to flow West.

This would be true under normal circumstances, but these are anything but normal circumstances, since we are faced with a crisis of our own making in Iran. However, instead of following through on our own sanctions logic to let market forces take their course, we are now leaning heavily on Saudi to provide the first prophylactic measure to ameliorate prices. Next on the list are the emergency stocks of the International Energy Agency (IEA).

Putting aside the irony of Saudi tankers being urgently dispatched to the US to help squeeze prices back under '$4 a gallon' at US pumps, we have a deeper problem here that will blight us for the next decade or more. The US has torn up the OPEC supply script, and genuinely believes it is about to become the 'new Middle East' on the back of new resource finds. It is possible that this might come true in the long term, but in the short term, American energy dislocation has created a policy shipwreck over Iran. Further crashes will undoubtedly follow, so long as the gap between US energy independence and global realities plays out.

This situation should come as a serious wake-up call for Saudi Arabia and the IEA.They are both in the same precarious boat. Washington does not seem particularly bothered if this 'Saudi-Parabia' ship ends up sinking, so long as the US can float on a lake of new domestic resources.

Libya meets Iran

This awkward new dynamic actually first cropped up in Libya - in what we might call the 'passive' version of US independence. The US failed to take the kind of assertive action required to rapidly remove Ghaddafi, let alone secure the long term future of Libya. US Secretary of Defence Robert Gates bluntly told the Europeans to sort things out amongst themselves. That would never have happened had the US not been sitting on new reserves, with the spread between WTI prices in the US and Brent oil prices in Europe wider than ever. US imports also rather conveniently dropped to a ten year low.

If anything, the default US position was looking towards the 'Saudi-Parabia' formula to fill potential shortfalls, rather than taking assertive military action. The Saudis put more oil on the market; concocted new blends and shuffled supply decks to hold prices below $130/b. To shore things up, the IEA became step two, providing light sweet grades to the market from its emergency stocks. These moves brought the UK and France more time to finish off a distinctly patchy military intervention. Given no actual physical lack of supplies occurred, the IEA move was at best, controversial. But 'easy' Saudi-Parabian oil was deemed a quicker (and cheaper) fix than ramping up US military efforts to save European blushes.

Fast forward to Iran, and what we get is the 'aggressive' form of US energy independence. Where Iran markedly differs from Libya, is that this is a crisis of own (US) making. What's more, Washington has probably overplayed its hand. The core assumption from growing US energy independence was that the

America can't just shut up shop and say 'US oil for US consumers at US prices' - at least not yet
US could place nuclear proliferation as a higher policy priority than oil market stability, and not pay much of a price for doing so. If America could turn the cheek in Libya, then it should also be free to turn the screw in Iran - safe in the knowledge that it would be immune to price pressures emanating from the Middle East. Let's not forget, US natural gas prices have just dropped to a ten year low to $2.2 per mmBtu on the Henry Hub, US oil supply growth outstripped anyone else's last year in the conventional realm, and (commercial) crude oil stocks are approaching record highs in Cushing, Oklahoma.

All true, but at the end of the day 'regionalised gas' is not 'global oil'. America can't just shut up shop and say 'US oil for US consumers at US prices' - at least not yet. What happens in the Gulf of Aden still affects what happens in the Gulf of Mexico.

The upshot was the moment that Persian petroleum pressures started translating into $4 a gallon at US pumps, Washington held back on driving home a truly effective sanctions policy. But rather than abandoning sanctions, the US continued its Iranian bluster while at the same time trying to get back prices under $4 at the pump. The problem is that these two policy aims are mutually incompatible, but the charade will go on all the way to US presidential elections in November 2012.

As a result, the US is more than happy to let China and India quietly source Iranian crude to help itself out of its $4 problem. Worse, the US has had to fall back on the Saudi-Parabia ‘quick fix’ option. As Obama explicitly stated: “There is a sufficient supply of petroleum and petroleum products from countries other than Iran to permit a significant reduction in the volume of petroleum and petroleum products purchased from Iran”.

That sounds good for the White House appearing to 'get tough' with Tehran, but it's the last thing the US should be doing if it was truly serious about stopping Iran in its tracks. If it wanted sanctions to stick, the US should allow prices to rise, the Saudis should withhold oil from global markets - and especially from China and India to force them to align with the West on Iran - and the IEA should keep reserves firmly under lock and key. Instead of all that, we are doing the exact opposite.

The problem for Saudi Arabia and the IEA is that this is putting their credibility (and capabilities) on the line. And it's Washington's energy independence penchant that's put them there. The underlying fact here is that Tehran can always dig in deeper against international sanctions than the US can go against its own political cycle - a painful reality that Riyadh and Paris have to face. It’s hard to see how both institutions won't lose out.

Saudi collateral damage

Let’s take Riyadh first. Despite popular media portraying high oil prices as welcome news for major oil producers, US sanctions against Iran are about the last thing the Saudis want right now, not least because they have put the spot-light on how much spare capacity the Kingdom actually has. The blunt

What this means is that the Saudis, if not totally losing market control, have at least had some of their rope cut as the swing producer in the cartel
answer is probably not much. The world was always far better off assuming the Saudis could hit 12.5mb/d (million barrels per day) production rather than putting this faith to the test. The combination of Iranian sanctions and supply slips across the oil world will almost certainly see the Saudis having to pump over 11mb/d in the coming months (up from what the IEA in its latest Monthly Oil Market report has described as a "heady" 10 mb/d in February). That's a scary prospect as far as physical (and paper) markets are concerned, particularly given poor refining margins that make Saudi off-take a sticky proposition for Western players.

Despite the positive messages Saudi oil minister Ali al-Naimi has been putting out, markets simply haven’t budged. The news that Riyadh has 12 million barrels in international storage in Rotterdam, Okinawa and SidiKerir failed to shift Brent prices. Likewise the 60 million barrels of additional crude from commercial storage in the Kingdom was a welcome, but not sufficient message to ease market concerns. Traders already know that Saudi Aramco's Arab Medium and Arab Heavy is a close match to Iranian grades, so repeating this line, which al-Naimi did in a letter to the Financial Times on March 28, doesn't really help.

Al-Naimi also claimed that Riyadh can ramp up production a further 25% at the drop of a hat, but this claim is not seen as credible by most market watchers. The 'price signal' that most traders noted instead was the re-opening of Saudi fields mothballed 30 years ago, not to mention rig counts hitting an all-time high in the Kingdom. What traders also know is Saudi Arabia needs to burn 600,000b/d of oil for its own power generation, a number that could hit 1m/b in August as peak summer demand kicks in, a development that will bring total Saudi domestic consumption to around 3mb/d. Other regional producers have the same problem. Like it or not, things are basically at full stretch in the Gulf.

What this means is that the Saudis, if not totally losing market control, have at least had some of their rope cut as the swing producer in the cartel. Little wonder that call options on the oil exchanges in London (ICE) and New York (NYMEX) have hit $200/barrel. These prices could be remarkably prescient if we see further outages of any major players. Even China is struggling to keep its own domestic production at 4mb/d as depletion is setting in.

This hits on a very inconvenient truth, namely that the Saudis will struggle to cover incremental gaps, let alone more explosive outages. And that's before we even consider the regional political picture facing Riyadh. Irrespective of Iranian ambitions, the Saudis remain deeply concerned about political stability in its oil-rich Eastern Province, especially with continuing problems in neighbouring Bahrain. State implosion in Yemen is seen as an internal issue the Saudis have to tend to in the South, while political instability in Iraq is problematic further North.

If anything, the Arab Spring has morphed into a 'Salafist Awakening' sponsored by many of the Gulf monarchies to make sure the thin end of the wedge is at least made of monarchical wood. Internecine wars are being fought with Arab Nationalist Republics for political influence and sway. The chances of all this ending well, let alone delivering secular liberal democracy remain slim. Surely deeply concerning news when we consider there is no viable alternative to international oil markets beyond Riyadh.

Parabian (sleepless) nights

The fact things are so tight for Saudi Arabia probably explains why the US is playing the IEA card so early in the game. If the Saudis can no longer quell the market, threatened stock releases might do the trick. The US, UK and latterly Japan and France have already got around the table twice to consider release - President Obama has since reiterated the line on the stump in Washington DC. Ultimately there comes a time when the market will see this as a bluff unless words are followed by actions.

Unfortunately, when they do, it will deal a bitter blow to IEA credibility on two levels. The first is if releases are predicated on a bilateral (US, UK, France, Japan) basis, you'd have to seriously ask what the purpose of the IEA is. Writing long reports and sipping nice coffee in Paris? More likely than not, the IEA will probably bite the political bullet and follow the US lead. This would not only make the OECD Agency look like a subsection of the US State Department, the bigger snag is that the strategic reserve is simply the wrong tool to use over Iran.

The reserve was only ever meant to be used to fill actual (or imminent) supply shortages. This is why it was deployed in 1990-91 (Gulf War 1) and in 2005 over Hurricane Katrina which disrupted oil production the Gulf of Mexico. Libya was the third and last time the IEA released emergency stocks, and this was already controversial. Doing it again now over high oil prices would be a bridge too far. If you release IEA stocks now, then why not in two weeks, two months, two years? The political fundamentals on nuclear enrichment will be exactly the same in Tehran, irrespective of whoever wins the June 2013 presidential elections. The IEA’s emergency stocks are a short-term tool that cannot be used effectively in this long-term Iranian game.

Massive gap

What this all points towards is that we simply don’t have enough slack in the global energy system to make economic pressures tell on Iran. No one doubts the enormous technological breakthroughs that have been made on cheaper (conventional and unconventional) extraction that will stand us in good stead for the future – a dynamic that markets are buying into given backwardation on long term futures. But right now we are pretty much stuck on 91 million barrels a day production, with 100 million looking increasingly difficult to reach. The reason the US didn’t really ‘get this’ before going down a sanctions path on Iran, was precisely because it fell for its own energy independence press. It believed oil supply was abundant, and that any actions taken would not hurt US consumers. None of that has proven to be true, which is why we are back at square one – hoping the Saudis can paper over the cracks to ease prices, and openly flaunting the economic role of the IEA for US political utility.

Until the US ditches its energy independence myth and gets back to current reality, the Saudi-Parabia ship is going to struggle to make it to port over the next decade. What makes matters worse is that the US has been trumpeting the virtues of energy independence at precisely the same time that supply side

The blunt fact is that OPEC market share is going to bigger than ever over the next decade
states are in serious turmoil: Libya, Nigeria, Iraq, Yemen, Syria, and even Venezuela, Russia and Caspian producers. Few expect the US to do any further support work in Iraq, or lift a finger in Sudan. Likewise, US strategic interests in Central Asia now have more to do with vested American concerns over South Asia (Afghanistan) than they do with hydrocarbon provision. The same certainly applies to North Africa. The disconnect between mounting international oil pressures and domestic American rhetoric couldn’t be any sharper.

The blunt fact is that OPEC market share is going to bigger than ever over the next decade. The cartel will control over 50% of physical market share as mature non-OPEC reserves continue to drain and new finds in Russia, Central Asia and Africa struggle to make it to the wellhead. Prospective US reserves and potential production will do nothing to shift the oil needle until at least 2020-2030.

All of which leaves us with a massive geopolitical gap: we have entered a brave new world in which Washington is not only no longer willing to cover prospective supply side gaps through military or political action (Libya), but if needs be, will put its own perceived national security interests ahead of oil market stability (Iran).

Ideally, we would see the real world of global oil prices realigning with the US dream of cheap and abundant 'national oil'. But that's not going to happen. What does this mean for Asian and European consumers? They need to work on the basis that the US will keep buying into its own energy fantasies. That being so, new demand side agreements are needed across the board, and especially between China and Europe. It would also be nice to see more international ships and flags making their way across hydrocarbon oceans as the US steps back and China steps things up.

As to Saudi-Parabia, they need to make sure Asian consumers become a sufficient counterweight to Western folly in terms of contracts, dialogue and institutions. After all, when the US finally goes 'independent' Washington will be Riyadh's biggest supply side competitor. Perhaps the US will then call time on IEA membership as well?

 

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