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Vol. 4, No. 6     20 October 2004

Instability in the Gulf and the Threat to Oil Stability

Antoine Halff

  • 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 profits.

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 money.

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 plants.

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.

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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.

Dore Gold, Publisher; Yaakov Amidror, ICA Program Director; Mark Ami-El, Managing Editor. Jerusalem Center for Public Affairs (Registered Amuta), 13 Tel-Hai St., Jerusalem, Israel; Tel. 972-2-5619281, Fax. 972-2-5619112, Email: [email protected] In U.S.A.: Center for Jewish Community Studies, 5800 Park Heights Avenue, Baltimore, MD 21215 USA, Tel. (410) 664-5222; Fax. (410) 664-1228. Website: © Copyright. The opinions expressed herein do not necessarily reflect those of the Board of Fellows of the Jerusalem Center for Public Affairs.

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