The Ten Inconvenient Truths that shape our new energy world order

April 26, 2011 | 00:00

The Ten Inconvenient Truths that shape our new energy world order

Analysts and decision-makers everywhere are trying to find their bearings in a world that has undergone a radical transformation in just a few months' time. Matthew Hulbert, Senior Fellow at the Centre for Security Studies (CSS) at the Swiss Federal Institute of Technology in Zürich, draws ten lessons from the recent perturbations on global oil markets plus one grand conclusion: forget about fundamentals. Politics is now what matters in the oil market.

1. The West's long term 'swap agreement' with the Middle East – repression in exchange for oil – is pretty much broken.

This is the first and easiest lesson to draw from the recent political upheavals. The core belief that ruled the world oil order was that when oil prices are high the Sheikhs are safe. This no longer holds water.

Unrest spread when benchmark prices were trading at a healthy $95 per barrel and, as the IEA has pointedly reminded us, OPEC is expected to stuff a staggering $1,000 billion into state coffers by the end of the year should prices remain firm. That kind of figure should have been more than enough to keep octogenarian Arab regimes on life support mechanisms. The fact that it's not (or will only buy leaders a little more time) means that crony capitalism has failed. It hasn't created the kind of broad-based buy-in needed to help quell the Arab street.

People see high unemployment, rising inflation, economic hardship, ongoing repression, lack of freedoms and widespread abuse by security and intelligence organizations. They also see elites enriching themselves on the back of soaring oil prices. The grievances are of course not new, but the fact that the Arab street is now willing to do something about them, certainly is. The upshot is that much more will need to be done in the oil countries to stimulate employment and equitable growth. And that means that not only credible (and inclusive) political systems must be put in place and political rights acknowledged, but it will inevitably entail broader control of natural resource wealth as part of the package.

2. Oil markets will remain inherently jumpy when it comes to the slightest sign of unrest in the Middle East and North Africa (MENA).

Contagion took hold far more rapidly than most analysts ever thought possible in 2011 and could well do so again, at least as far as market sentiment is concerned. The (mis)perception of risk and fear of physical shortages have always been far more potent market factors than the operational realities involved. That was the case in 1973, in 1979, in 2008 and it will be the same in 2011. Only more so, because this time there is a big difference with the situation in 2008, and that relates to our third inconvenient truth.

3. The most fundamental 'fundamental' of all – the stability of Saudi Arabia – can no longer be taken for granted.

The Kingdom has pledged to splash $129 billion in the coming years to improve social conditions, but has also shown it has no qualms about using brutal tactics: an unsubtle blend of ‘concession meets repression’, one might say. (With a PS to the US thrown in: play ball on this, or you can forget any more extra oil being put on the market anytime soon.) It is also telling that the House of Saud sent

King Abdullah's refusal to engage in meaningful political reform now, will more likely than not come with considerable implications for the future
reinforcements to neighbouring Bahrain to ensure the al-Khalifa dynasty does not become the thin end of a Shia wedge. To say that hasn’t gone down well across the Shia world would be an understatement, but the ‘market signal’ is at least abundantly clear from King Abdullah: ‘stability’ will be maintained in Bahrain and Saudi Arabia, at any economic and political cost. Of course the fact that the message needed to be sent makes it clear that stability is more uncertain than ever.

The problem with the Saudi response is that it is only a short term survival hedge, not a long-term strategy to address the real fundamental of ensuring long term political stability. King Abdullah’s refusal to engage in meaningful political reform now, will more likely than not come with considerable implications for the future. Those next in line to take over the Saudi throne are 83 and 77, and they both prefer repression to concession. But it’s far from clear whether such processes can be internally managed anymore.

Unfortunately for the oil market, Saudi Arabia is fairly crucial when it comes to maintaining market stability, as is clear from our fourth inconvenient truth.

4. The turmoil in Tunisia, Egypt and Libya has brutally highlighted that Saudi Arabia is the only game in town as far as excess supply is concerned.

The vast majority of the 4 million barrels per day (mb/d) of slack in the system is all in Saudi hands, with the Kingdom pumping around 9 mb/d. Kuwait, UAE, Algeria, Iran, Iraq, Venezuela, Angola and Nigeria are all pretty much maxed out. Russia doesn’t look all that much better outside the cartel.

This means that the world economy will continue to rest on the fate of a single producer, and one producer alone. You’d think this would focus OPEC minds to try and get back towards some kind of 'collective' swing production, but signs for that are far from promising. Asian demand is rapidly rising and will take up any new slack, regional MENA consumption is going up sharply, and will continue to do so in markets were subsidies remain high and price signals weak. Expect export margins to narrow accordingly.

If anything, the political swing is going the other way – the likes of Oman, Yemen, Bahrain and Syria might only be small producers in their own right, but collectively they amount to around 1.5 mb/d – production that all must be regarded as politically shaky. Kuwait, UAE and Qatar are on safer ground, but if things go awry there it would amount to a massive 6.5 mb/d collective production loss.

Note too that in markets where significant political unrest has hit, production has already slipped. Even in Egypt, where the military went to great lengths to safeguard key energy assets, production fell. Iraq is another example. Production has failed to get back above 2.7 mb/d since the invasion of 2004, and with the political outlook looking as fragile as ever, the real aim is to maintain and marginally increase output levels wherever possible, not overseeing exponential supply growth.

Libya will prove to be no different, irrespective of how things play out on the ground. It's simply impossible to separate 'the commercial' from 'the political' when it comes to oil production in the Middle East – or indeed, anywhere else. And there is something else here that is often forgotten in the talk about the global crude oil market, namely that the oil market is not the same everywhere. Which brings us to lesson 5.

5. Oil is not as fungible or elastic as we would like to think.

Despite the fact that state implosion in Libya only reduced global output by around 1%, it has posted 30% increases in global benchmark prices. The key factor here is that sweet grades used by European refineries are in short supply compared to heavy crudes of the Gulf. Gaps have been filled by shuffling the decks of West African production heading to Europe, and excess Asian consumers taking heavier crudes. Should instability sweep across Algeria wiping out the bulk of sweet oil supplies feeding 2.8

There are simply no price moderates left in OPEC ranks – merely gradations of hawks – all of whom increasingly regard $100/b as a crucial break-even price for oil
mb/d to European refineries from Algiers and Tripoli, we might find out just how fragile the market is. That’s before we consider the prospect that election season in Nigeria could cause major slippage in West African output. It was, after all, strikes in Gabon that pushed benchmark prices over $120/b. Such minor events are, (or rather) should be, the core problem for producers across the board: relatively small geopolitical fracas will increasingly dictate benchmark prices. Nobody can truly say they are in control of the market, and certainly not if more explosive geopolitical events in the Strait of Hormuz, Malacca Straits or Bab-el-Mandeb ignite. A quick look at the state of Yemen, and the political powder-keg is easy to see, as is the lint, should Saana fail to stop the sparks spreading further.

The fact we went from $147/b to $33/b in the space of six months less than two years ago, should tell hydrocarbon states all they need to know about the perils of demand destruction. With prices up 250% on the $33/b low, it's entirely possible that the global economy could snap again; oil prices are dragging down growth across the OECD while driving double digit inflation in emerging markets. That will inevitably require interest rate hikes serving to constrain growth. The exact point at which oil breaks the global bank will always be contested, and the dollar is certainly not what it once was, but the fact that OPEC has shown relatively little resolve to take the heat out of the market, tells us that it is unwilling to do so.

The core reason for this is that state handouts designed to win political support, alongside massive energy subsidies shielding consumers from price rises, are creating serious non-discretionary budgetary challenges. That's long been the case for the likes of Venezuela, Algeria and Iran, but even Saudi Arabia purportedly now needs $88/b to balance its books – a staggering increase from $20/b required a few years back.

The geological cost of production has never been more out of sync with the geopolitical cost of survival than today. There are simply no price moderates left in OPEC ranks – merely gradations of hawks – all of whom increasingly regard $100/b as a crucial break-even price for oil. Riyadh actually cut production last month by a hefty 800,000b/d – a sharp reduction from over 9mb/d produced earlier in the year. Such cuts will do nothing to help supply cushions, or indeed take pressure off Brent via discounted grades of crude. The ‘circle’ is thus as a clear as it is vicious: producer states need higher prices to feed domestic spending, which in turn will drive bullish price expectations.

Rather like any decent ponzi scheme, this works well provided things are on the up, but if OECD demand remains sluggish and Asian growth starts to derail, OPEC will have serious problems. Just as readily as markets have driven prices up, they could bring them crashing back down, pointing us towards our sixth inconvenient truth.

6. We are living in a 'Chirabian' world of Saudi supply and Chinese demand at the heart of a $50/b - $250/b universe.

If Chinese demand goes - a scenario not often discussed, but entirely possible - oil exporting countries would be in serious trouble. Unlike in 2008, when Saudi Arabia alongside other key Gulf producers oversaw major supply restraint to put a floor under prices, they would not be in a position to perform such a role again without cutting deep into foreign reserves. $50/b in that kind of an environment would be everyman for himself - selling as much oil onto the market as possible - and at heavily depressed prices. Producer regimes were lucky to survive the shocks of 2008/9 - they are not likely to do so again, with most of them struggling to hold on at $125/b, let alone $50/b. Low oil prices might temporarily take some of the heat out of the market for western countries, but it would come at a price. The structural necessity for oil exporting countries to maintain high prices will almost certainly play into increased resource nationalism and populist energy policies. That means it will be even riskier for western companies to invest in upstream activities in MENA countries than it is already. And it makes it even more questionable whether the MENA countries will make the investments that are necessary, according to the International Energy Agency (IEA), to boost production and meet demand in the longer term.

But whereas in the past western countries were willing and able to secure their energy needs, perhaps the most alarming developments from the current price hikes and the Libyan crisis in particular are on the geopolitical level, and indeed constitute our next inconvenient truth.

7. The West is no longer willing, and the EU simply unable (beyond individual member states) to safeguards its immediate energy and geopolitical interests.

Lest we need reminding, it's not just sweet oil making its way over the Mediterranean to European refineries from North Africa, but 16% of EU-15 gas supplies, including 43% of Italian and 55% of Spanish throughput. The idea that Ghadhaffi could be allowed to stay in power should always have been a no-brainer – it will be like having a Burma and North Korea rolled into one 500 miles off the Italian coastline. Even if Ghaddafi buries his grudges and re-opened for business, even the most hardened of international oil companies (IOCs) would find it hard to do business in Libya, either due to sanctions or the reputational risk entailed.

So, the fact that the EU, and even more pointedly NATO, have failed to act effectively, points towards a very uncomfortable long-term outlook for European energy supplies. Europe has very little option left but to go 'long' on Russian oil and gas. Forget seriously opening up Central Asia or Middle East supplies to European markets, the EU simply doesn't have the political backbone to pull it off. What's more, producer states know it. Stuttering North African supplies will do very little to reassure those overseeing European 'security of supply', nor will those in sub-Saharan Africa where France and to a lesser extent, Britain, remain willing to get their hands dirty, though not as dirty as Asian national oil companies (NOCs).

The problem is, Russia should hardly be considered a safe bet either. As BP has found out and others will come to learn, upstream risk is formidable in Russia given that contracts are 'pegged' to the political vagaries of the Kremlin. If anything, Moscow’s main interest is to open up Chinese supply routes to leverage its position over core European demand. Arbitrage, not compromise is Russia’s understandable strategic priority.

Things don't look all that much different for the US. Passing up Libya, although understandable for domestic reasons (not to mention, putting the Europeans in their geopolitical place) is likely to come with a significant price tag for Washington. Failure to act in Tripoli will likely come with political costs for

It's not just sweet oil making its way over the Mediterranean to European refineries from North Africa, but 16% of EU-15 gas supplies, including 43% of Italian and 55% of Spanish throughput
America down the line. Most obviously with Iran, who’ll be delighted to see America’s bark is now far worse than its bite, but also with the Gulf States themselves. It was more than obvious that the Arab League (and more specifically, Saudi Arabia) gave US/Europe a free hand in Libya in return for a blind eye on Gulf State ‘domestic’ issues. The clear expectation, particularly from the UAE and Qatar, was that Ghaddaffi would be removed by ‘all means necessary’, as the UN mandate loosely implied. US resolve to safeguard Arab security interests, let alone contain Iranian political aspirations, are thus subject to serious question.

Washington chose to underwrite global oil supplies from the Middle East over the past fifty years, not because it consumed the overall bulk of supplies, but because it afforded the US a superpower role in doing so. Ensuring the safe flow of hydrocarbons to global markets in the East and West sits at the fulcrum of global affairs. Execute that, and much else follows as the geo-economic and geopolitical lynchpin of the world – lose it, and you start to look like a distinctly ordinary power.

The US is still obviously the dominant external actor in this regard, but Libya is a sign of things to come from a nation suffering structural economic flaws and sharply divided political opinion as to its place in the world. Whether Arab states are willing to price oil in dollars without associated security guarantees remains to be seen, but in the midst of their internal crises, it’s clear where they have been looking for their demand security: Asia.

Beijing is already officially the world’s largest consumer of energy, it expects to post 45% oil demand increase by 2035, which will equate to over 80% import dependency. Given the Communist Party’s holding of US debt, it is of course now largely Beijing’s call as to how long they keep bankrolling the US to perform a global security role. And this leads us to the next inconvenient reality.

8. China is happy to keep free-riding on the US strategic presence in the Middle East for now.

Although China will be heavy consumers of Middle Eastern oil, they remain highly unlikely to do any heavy lifting rebuilding states. It has massively enhanced its hydrocarbon links with producers across the region over the past few years, striking deals not only with Kuwait, the UAE, Qatar, Yemen and Oman, but also with Saudi Arabia, Iraq and Iran. Ultimately China knows that Arab supplies will always trump Persian output, which underpins why 'Chirabia' rather than 'Chiran' will be the overriding relationship Beijing wants to get right in the Gulf. It's also one the US has been happy to foster by letting China source more Arab oil to squeeze Iran.

But what this also highlights is that the Saudi-Iran relationship is at the heart of US-China relations in the region. The more the Middle East resembles a 'Chimerican lake' the more China will be expected to take up some of the security slack. However, China will keep supply options open for as long as possible wherever possible. 'Security of supply', 'diversity of supply' and 'reducing price risk' through equity oil deals are the foundations upon which China’s energy policy has been built. That means no meddling in the internal affairs of Gulf States, even though meaningful reforms are clearly now in everyone's best interests to put oil producing states on a more stable footing.

If we put that a little more bluntly and translate it into security terms, China remains a consumer of geopolitical stability, not a provider of it. For all the hype around China's 'String of Pearls' strategy spanning from the Persian Gulf to the Chinese mainland via the Strait of Hormuz to the Malacca Straits

Europe has very little option left but to go 'long' on Russian oil and gas
and beyond, this basically amounts to little more than a maritime insurance policy should the US 5th fleet in Bahrain haul anchor too quickly, not a blueprint for ensuring global oil supplies. The fact that China only belatedly removed personnel from Libya underlines its lack of operational experience, let alone maritime power projection capabilities involved.

This is hugely concerning for future global oil production, and leads us straigth to our nexth truth.

9. Two-thirds of the world's proven oil reserves are not only sitting on politically shaky ground, they are doing so in the midst of an external power vacuum.

The vacuum will get significantly bigger as US power ebbs and Chinese oil flows, albeit without political or security guarantees in place. It also has the potential for conflict should Washington and Beijing misread each other’s actions. This will inevitably be a long transition period with aspiring regional players, ballot boxes and populist foreign policies put into the mix.

Core question number one: would the US intervene in Riyadh if the Al Saud looked as though it was about to be toppled? Beijing’s could see that as a last ditch power play – or as Washington's residual responsibility to fill external power vacuums. Similar scenarios could apply in Iran, albeit for very different reasons.

That's all melodramatic stuff for sure, but on a more mundane level, this same Chimerica dissonance is playing out across producer states daily. Africa, Central Asia, the Middle East, and even Latin America all know US power is on the wane; they also know that their economic 'demand security' (hydrocarbon or otherwise), will increasingly emanate from Asian shores. The upshot is that resource-rich states are increasingly empowered to play off competing Western and Eastern commercial interests. This can

Core question number one: would the US intervene in Riyadh if the Al Saud looked as though it was about to be toppled?
already be seen in Central Asia where Russian, European, US and Asian suitors all want to sit at the table, and in Africa, where resource rents invariably go to the highest or indeed most corrupt bidders. In Latin America, it’s now an increasingly fine line between those playing the market and those draining the state, while Russia will clearly use hydrocarbon endowments to re-establish regional dominance in Eastern Europe and the Caucuses, and indeed, to complicate Sino-Central Asian energy relations.

The common denominator here is not just that this is taking place without a credible external security framework in place, but that it will be bad for consistent international investment, bad for market transparency and bad for market liquidity. There‘s a reason why India's national oil champion, ONCG, is begging New Delhi to provide $280bn of foreign reserves to help secure upstream reserves. Oil is once again a state based game – both on the supply and demand sides of the ledger, but with no common rules agreed.

This brings us to our tenth and final truth.

10. If consuming countries really want to reduce inherently unsound dependence on OPEC production, they have little choice but to massively expand domestic output.

Enhancing strategic reserves will only ever go so far. OPEC still controls over 30% of the physical oil market pumping out around 29 million barrels a day. It sits on over 80% of proven reserves, a figure that equates to around 1,000 billion barrels of oil compared to non-OPEC 273 billion barrels.

The upside is that current benchmark prices clearly support investment in difficult offshore prospects at the moment – not just in the enormous Brazilian deep water field finds of Tupi and Iracema, but also in technically recoverable oil in the United States' outer continental shelf and deeper waters alongside onshore and shallower state water resources. According to some estimates 175 billion barrels of oilsands can be put to production at $80 a barrel, and a staggering two trillion barrels of shale oil could become commercially viable at $100+/b. That’s even without considering the prospects that Arctic production could hold for further US and Canadian production.

But there's a catch here. Political risk is just as acute, if not more deadly, in the US than anywhere else in the world. Just ask BP smarting from their Macondo Presidential/Congressional lashings. The idea that offshore US production will only ever be a straight ‘home run’ is a story few IOCs will now ever believe. And for those wondering about political risk in Canada, just ask BHP Billiton. They couldn’t

Political risk is just as acute, if not more deadly, in the US than anywhere else in the world
navigate state legislators in Saskatchewan, let alone the Federal Government, when trying to purchase Potash in 2010. Even the British Government is still playing the old game of tax hikes on dwindling North Sea production. 'Dirtier' oils will get caught up in the climate debate as well, despite the ironic fact that few politicians will genuinely ever look to price hydrocarbons out of the market to keep carbon emissions at 'safe' levels.

The West remains very good at talking about 'the market' but horrifically bad at steering it towards geopolitically desirable ends. That’s exactly what OPEC will be banking on to prevent massive global oversupply irrespective of high benchmark prices. That's not a debate that the likes of China and India are likely to get bogged down in.

The fact that the US doesn't want to fully admit that oil remains an interdependent game (President Obama reiterated recently that the US wants to reduce its dependence on foreign oil), and that the EU is simply incapable of thinking, let alone acting strategically, will inevitably leave us with a $50-$250 outlook.

Just as the world missed its chance to strike a decent bargain in 2008/9 to set a credible price band, provide a common rule book on resource investment and perhaps most critically, encourage political reform and economic diversification in producer states, it will probably miss the same chance again in 2011.

Who knows, things might dampen down for a while. But oil markets are not only fundamentally broken, we don't even have any 'pure' fundamentals left to work with. That is, none beyond the dawning of a Sino-Saudi 'Chirabian' energy world, a world the west will increasingly fail to influence in future.

Hence our final inconvenient conclusion, built on ten inconvenient truths: politics really is what matters for oil now, with a sharp disconnect between production, price and fear. We can only hope that the new players of today prove to more adept than the old ones, or market perturbations will assuredly crack the unsound political foundations upon which future global energy supplies depend.


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