The Shocks of a World of Cheap Oil

THE NEW GEOPOLITICS OF ENERGY

Oil prices have been flirting recently with $25-$30 per barrel, levels almost reminiscent of the oil shocks of the 1970s. Rising energy prices have been accompanied by the usual hysteria about dwindling supplies and potentially dangerous transfers of wealth, tempting policymakers to consider ways of dealing with a coming oil crisis. But contrary to much received wisdom, the energy problem looming in the early 21st century is neither skyrocketing prices nor shortages that herald the beginning of the end of the oil age. Instead, the danger is precisely the opposite; long-term trends point to a prolonged oil surplus and low oil prices over the next two decades.

Paradoxically, this scenario of plenty could destabilize oil-producing states, especially those in the ellipse stretching from the Persian Gulf to Russia. And although the economies of the United States and oil-importing developing nations would by and large benefit, the backfire of low oil prices could undermine U.S. policy assumptions and imperil U.S. interests.

Both the popular and the elite media -- from Parade asking "Could It Happen Again?" to Scientific American, no less, proclaiming "The End of Cheap Oil" -- are peppered with forecasts of gloom and doom about energy security. But the "sky-is-falling" school of oil forecasting has been systematically wrong for more than a generation. In its dramatic 1972 "Limits to Growth" report, the group of prominent experts known as the Club of Rome wrote that only 550 billion barrels of oil remained and that they would run out by 1990. In fact, the world consumed 600 billion barrels of oil between 1970 and 1990, and there are today more than a trillion barrels of proven reserves (recoverable at current prices under current conditions). This figure is likely to continue rising even as global consumption exceeds the current 73 million barrels a day. Indeed, the International Energy Agency says that there are 2.3 trillion barrels in ultimate recoverable reserves, and if unconventional sources such as tar sands and shale are included, the number may well be greater than 4 trillion barrels.

The scarcity forecasters -- in some cases, the same people who forecast in the 1970s that oil would cost $100 per barrel by 2000 -- are not only still wrong, they also have it exactly backward. The world's problem is not scarcity but glut. This is true despite the current Saudi-engineered production cutbacks by the Organization of Petroleum Exporting Countries (OPEC), which boosted oil prices off their $8-per-barrel lows. Seasoned oil-market watchers know that this fragile deal among oil producers could dissipate quickly, particularly as financial pressures ease over time, tempting OPEC to release some of the 5 million barrels per day currently being held back from the market.

As OPEC squirms, big and small oil producers around the globe continue to announce new finds and new plans to expand capacity. The latent supply potential in Iraq, Russia, Africa, and elsewhere -- combined with more modest economic expansion in Asia -- belies the Cassandra-like predictions that the world will soon deplete its oil assets. In turn, the prophecies of dried-up wells obscure the far more likely prospect: a sustained oil glut and long-term low oil prices, which will have very different -- and largely unconsidered -- political and strategic consequences. The 1998 dalliance with $8 barrels hinted at the possibilities, with the economic meltdown in Russia and a forced succession in wealthy Brunei. The Arab states of the oil-rich Persian Gulf, non-OPEC producers, and consumers are simply not prepared for a new geopolitics of energy.

Neither, frankly, is Washington. The political reverberations of a sustained oil glut should not be underestimated. Several important regimes -- in the Gulf states, Russia, the former Soviet republics, and such key Latin American countries as Venezuela, Mexico, and Colombia -- count on healthy oil revenues for calming restive populations, assuaging social tensions, and in some cases, nation-building writ large. Without the salve of rising oil revenues, many of these nations can expect to see heightened political instability, social unrest, or even civil wars, which could be grimly reminiscent of recent Balkan slaughters. In the Gulf, such instability could trigger the next oil shocks in the form of short-term disruptions. The 1991 Gulf War demonstrated the West's capacity to defend important oil regions from traditional external threats like the Iraqi invasion of Kuwait. But America's painful experiences with revolutionary Iran in the late 1970s and the Balkans in the 1990s are grim reminders of how hard it can be to cope with internal instability. The new dynamics of the global oil market have profound implications for U.S. national security policy. Washington had better gird itself.

AN EMBARASSMENT OF OIL RICHES

Wrong-headed predictions of scarcity are as old as the oil trade itself. A rich and embarrassing history precedes such predictions: in 1885 the U.S. Geological Survey predicted "little or no chance of oil in California," in 1914 the U.S. Bureau of Mines forecast a ten-year supply of oil in the United States, and the list goes on.

The latest scarcity theorists are exemplified by one of the world's most prominent petroleum geologists, Colin Campbell. He has argued in many industry, policy, and scientific journals that growing global consumption of oil, driven by the emergence of a modern, industrialized Asia-Pacific, is dramatically raising demand. This rise, he warns, will collide with a slowdown in new oil discoveries, leading to another energy crisis. By 2003, global production will peak and the oil age will start to end.

So why have average oil prices not risen much in real terms in nearly a generation? One reason is profound changes in the oil and gas markets. But perhaps more significant, over the last quarter-century, a veritable technological revolution in the oil and gas business has harnessed the information revolution in ways few predicted.

Since 1980, when control of crude-oil prices in the huge U.S. market ended, international crude-oil markets have become increasingly global and transparent -- a trend eased by the advent of oil futures and derivative markets. Oil is no longer sold mainly through exclusive, secret, long-term, fixed-price contracts among a handful of major suppliers. Rather, oil pricing has been forced into the open, so oil and oil products have been sold mainly at market prices among many players, including financial institutions with no stake in oil-industry assets. In this commodified market, arbitrage typically generates similar prices worldwide, adjusting for differing oil quality and transport costs. The key factor in this new, more efficient global oil market is transportation. Most sellers strive to sell their oil to the closest market to maximize revenues.

As oil trade centers more on transport costs than on political relationships, oil-flow patterns from the Middle East are shifting, thus altering the geopolitics of oil. Increased oil production in Venezuela, Colombia, Canada, Brazil, and the U.S. South has begun crowding more-distant Persian Gulf oil out of the U.S. market. When growing oil imports from the Atlantic basin (the North Sea and West Africa) are added in, the divide widens. In the coming decade, the United States will increasingly rely on oil from within the western hemisphere and the Atlantic basin. It is East Asia's dependence on Middle Eastern oil that is rising substantially, not America's.

Many analysts expected that non-OPEC oil production would be short-lived. But they missed the technological advances -- including computer-assisted, three-dimensional imaging that lets geologists "see" underground oil pockets -- that slashed the costs of developing hard-to-tap reserves and improved the chances for new discoveries. Moreover, better platform designs and drilling methods have also let companies recover more of the oil they find. These technological gains have dramatically lowered the cost of finding and producing oil and natural gas and given energy consumers ample, inexpensive supplies just at the time that earlier forecasts had predicted a shortage. They have extended the life of existing wells and allowed the oil industry to double the amount of oil recovered -- in many cases from about 20 to 30 percent to between 50 and 60 percent. The average U.S. costs for finding oil fell from about $15 per barrel in the 1980s to just $5 per barrel in 1998. Drillers are four times as successful at finding natural gas and six times as successful at finding oil as they were before the 1973 oil crisis.

Now that finding and producing oil is cheaper and easier, more and more countries are getting into the act. During the last two decades, pundits predicted that oil production from outside OPEC would decline by 3.6 million barrels per day (b/d), or about 13 percent, thereby driving oil prices up. Instead, non-OPEC production rose by more than 4 million b/d, or about 15 percent. Although problems in the Russian and Chinese oil industries and a sudden collapse in oil prices combined to reduce non-OPEC production by 800,000 b/d in 1998, supplies are already rebounding. They will probably continue to do so over the next decade as oil technology advances. Ample, accessible new reserves will soon come on-line in the waters off the Gulf of Mexico, eastern Canada, and western Africa, as well as onshore in central Africa, South America, and frontier areas in the former Soviet Union and the far reaches of the Arctic. Moreover, some of this new production can be shielded from short-term price swings if owners sell their output in new, sophisticated financial markets for oil, using long-range derivatives.

Contributing to this trend toward ample supply are the technological improvements that have made more efficient use of energy. Energy use has also been held in check by technological advances in residential and industrial use as well as in power generation. For example, from 1980 to 1995, the amount of energy used in the United States per constant dollar of GNP declined from $16.47 to $13.44. Europe and Japan made even bigger gains in efficiency.

The transport sector's use of oil is expected to account for more than half of future oil-industry growth, but here too, there is no reason to expect that the oil glut will dry up. The new direct-injection engines being introduced in Japan and Europe may eventually curb the boom in demand for gasoline. Moreover, all the major auto manufacturers have made large investments in post-internal-combustion cars and already have new prototypes of "hybrid" cars (that is, cars that run on both gas and electricity) and fuel-cell cars to be mass-marketed by 2005-15, if not sooner. Toyota and Honda are already marketing hybrid models in the United States that get 80 miles per gallon, and experts say that by 2015, these post-combustion cars will make up at least 20 percent of new vehicles. One leading forecaster, Lawrence Goldstein of Petroleum Industry Research Associates, expects alternative-fuel vehicles to reduce gasoline demand by only 275,000 b/d ten years from now but predicts that such cars may substantially reduce oil demand in the second decade of the new millennium.

Trends in the Middle East also bode well for lower oil prices, particularly as U.S.-led sanctions against Iran, Iraq, and Libya begin to erode. Iraq, with 110 billion barrels in proven reserves, has been held back from tapping them by U.N. sanctions since it invaded Kuwait a decade ago. If sanctions are eased -- after, say, Saddam Hussein is toppled, or the Desert Storm coalition collapses completely -- one can expect to see Iraq's production rates double within five to ten years. And Iraq will not be the only one pumping more in the oil-rich Gulf. Iran and Kuwait are also working to reopen their oil sectors to foreign investors, hoping to boost their capacity to pump out oil, their political clout, and their national security. Saudi Arabia is following suit, both to protect its regional prominence and to stimulate its economy. The Royal Dutch/Shell Group recently announced an $800 million investment in offshore Iranian oil fields, which could further add to the glut.

If Kuwait, Iran, and Iraq get their way, and if non-OPEC production grows at only two-thirds the rate it did between 1985 and 1995, oil markets could be even more oversupplied than in 1998 -- the year prices collapsed to $8 per barrel. To consume all the oil that will probably be pumped out over the next ten years, world oil demand would need to grow by more than 3 percent per year, instead of the 1.8 percent annual growth rate between 1980 and 1995.

ENGULFED

The high probability of oil prices in the $12-$20 range over most of the next two decades will condemn to a perilous future the arc of instability along the southern rim of Eurasia -- from the Balkans to the Caucasus and Central Asia and maybe the Persian Gulf as well. Some oil regimes, such as Kuwait and (to a lesser extent) Iran, are trying to prepare by reforming their social, economic, and political institutions. But others -- as the rhetoric of the leaders of the newly independent states of Kazakhstan, Azerbaijan, and Turkmenistan demonstrates so well -- cling to the notion that oil earnings will miraculously grease the wheels of the current system of handouts from the top. This delusion prevents these countries from implementing difficult but necessary political and economic reforms.

Low oil prices did not inflict pain just in Central Asia and the Middle East. In 1998, they coincided with unprecedented political strains in key oil-producing countries like Russia, Indonesia, and even such Latin American nations as Venezuela, Mexico, Ecuador, and Colombia. Russia has historically relied heavily on oil and gas for its hard-currency earnings and still does today; its oil exports generated $16.1 billion in 1996, some 20 percent of Russia's total export revenue. Russia's recent financial crisis was hastened and worsened by disheartening oil earnings. Low oil prices will complicate the country's troubled transformation and leave it prisoner to its cashless "virtual economy." Elsewhere, Venezuela's flagging economy in 1998 helped elect a military populist, usher in a period of political turmoil, and stymie the implementation of major constitutional reforms. Plunging oil revenues in 1998 also destabilized Mexico, whose traditional political system is groaning with strain.

Unfortunately, U.S. foreign policy toward the oil-rich ellipse between the Gulf and Russia also seems caught in the same delusion as the region's bosses: that generous oil revenues will save the day. Some U.S. bureaucrats even argue that this coming oil wealth will magically create democratic institutions and liberal economies, even though history so far has proven just the reverse.

Sustained low oil prices also mean tremors in the Persian Gulf -- the site of a fundamental U.S. military commitment. The longer oil prices droop, the more daunting the political, social, and economic challenges that the Gulf countries will face. Social unrest already bubbles under the surface in most Gulf countries, and succession crises may erupt as a generation of aging leaders passes. Populations in the region are swelling at a rate of 4 percent or more per year -- a pattern that foreshadows the worsening demographic bulges caused by large populations under the age of 25 throughout the Gulf. Already, half of the Gulf's inhabitants are under 15 years old, portending daunting problems in education and employment as well as increased strains on local infrastructure and resources such as food, water, health, and electric power. Per capita incomes have plummeted; in Saudi Arabia, for example, real per capita GDP fell from $11,450 in 1984 to $6,725 a decade later. And oil is no panacea. Since 1982, Saudi Arabia has gone from $140 billion in surplus revenues to run up a national debt of almost $130 billion.

As the Gulf's economies shrink, jobs are becoming an increasingly critical problem. In the ten largest Saudi cities, for example, unemployment is socking the middle classes, and about 20-30 percent of Saudis lack jobs. Broad cultural and demographic shifts do not help, either. Many countries, especially Saudi Arabia, now have a large, idle class of students, some favoring religious study. If employment opportunities in the kingdom remain bleak, Riyadh could lose its ability to co-opt this expanding younger generation, which could become a major constituency for Islamist opposition movements.

Distributing economic spoils has been a major vehicle for the Gulf regimes to sustain their power base and legitimacy. In some Gulf countries, as many as 90 percent of the labor force work in government jobs. Political critics and potential opposition leaders are frequently bought off through subsidies, high offices, or other tokens of wealth and status. The regimes also build religious centers, medical facilities, and other services to placate the disgruntled. But economic stagnation has already strengthened local resentment over official corruption and greed and has widened disparities between rich and poor. Without healthy oil revenues to buy off restive populations, the Gulf leaders will be left with only repression to silence foes and quell public discontent, which could fuel even more violent opposition. Radicalized local populations could also threaten the Middle East peace process; disgruntled Gulf states might be tempted to placate Islamist movements by funding the terrorists of Hamas, for instance.

The U.S. military has demonstrated its impressive capacity to handle external threats to the flow of Gulf oil. But how will these more elusive -- and more likely -- internal threats be managed? Internally organized sabotage of a country's own oil installations is a different type of challenge than those solved in the past through foreign military assistance. Nor can the U.S. military easily prevent the oil-supply disruptions that might stem from a violent regime change in the Persian Gulf; witness Iran during its 1979 revolution. One of the lessons of the ill-fated rule of the shah was that pouring arms into the region does little to address the emerging problems of demography, social discontent, and strapped regimes.

LICENSE TO DRILL

Indeed, the lessons America learned so painfully in the Persian Gulf can easily be applied to the accidents waiting to happen in an emerging oil region: Central Asia and the Caucasus. When the newly independent states of Central Asia opened up in 1991 after the Soviet Union disintegrated, the newcomers understandably stirred the interest of the major energy multinationals and Washington. (Caspian oil intrigue even provides the plot of the latest James Bond film.) But as oil companies found less there than met the geological eye, the initial promise of a new Persian Gulf began to fade. The resources of the landlocked Caspian region -- perhaps, over time, roughly on the order of the North Sea -- will take time to develop. By 2010-15, they will provide only three to four percent of the world's oil supply, and that only if their great distance from their main markets does not thwart investment. Nevertheless, the new "Great Game" in Central Asia has become a growth industry, both within the U.S. government and in the policy community. Alas, this new excitement bears no relation to the modest reality of Central Asia. Those in the bureaucracy seeking to expand democracy in the former Soviet republics developed a sense of mission, fearing that the fledgling states would fall prey to Russia, Iran, or China. To underscore its place as a newfound U.S. priority, the region is now handled by new bureaus, an interagency working group, and even its own special envoy.

Thus the private sector, which initially sought government help to enter the region, has begun drastically lowering its expectations, while an impervious bureaucracy continues on its merry way. Central Asia and the Caucasus are simply not about to spew forth an oil and gas bonanza. Nor, for that matter, must America brace for the threat to world stability that might erupt if the surrounding powers began competing for influence there. Far from entering a new Great Game, relatively weak and inward-looking countries like Iran and Russia have been sucked for the past eight years into what might be dubbed a "Mediocre Game" wherein they are played off by the various Central Asian actors. Central Asia's main problem is not voracious neighbors; as with the Persian Gulf, the principal threat to the region is, and will likely remain, internal instability.

So U.S. policy flies in the face of sensible and sustainable strategy. Rather than concentrating on technical training, agricultural reform, humanitarian aid, and institution-building, U.S. policy focuses on expanding already obtuse military ties that now constitute the main interface between Washington and the key Central Asian states. Indeed, in some cases the United States directly supports the training of Central Asia's military and police forces in a manner reminiscent of ill-advised U.S. activities in Latin America in the 1970s. The vehicle -- and driver -- for these dangerous liaisons is NATO's Partnership for Peace (PFP) program, to which almost all Central Asian states belong. Henry Kissinger has noted that the PFP is essentially therapeutic, aimed at psychological reassurances that are "far removed from the basic NATO mission [and] which water down the function of the alliance."

These new PFP commitments, quite apart from further complicating America's already troubled relations with Russia and China, may create expectations that NATO will intervene if turmoil erupts in places as remote but geopolitically significant as Kazakhstan's borders with Russia and China's Muslim-majority Xinjiang province. (Imagine the American reaction if the Chinese army held joint exercises with Mexico across the border from San Diego.) Although there are good reasons to be enthusiastic about fostering new democracies closer to Russia's flank, the vast entanglements that such intervention would entail are deeply unappealing. The complex problems of the Caspian region -- evidenced by the turmoil in Chechnya, Dagestan, and Kyrgyzstan -- could, if left to fester without the salve of promised oil wealth, make the Balkans look like a pregame warm-up.

Socioeconomic woes threaten to destabilize almost all the governments of Central Asia and the Caucasus. Poverty is widespread and painful. On average, the Caspian region's populations now spend 70 percent of their income on food alone. In Azerbaijan, real GDP contracted by an average of 12.4 percent per year from 1992 to 1997. Kazakhstan's GDP dropped 44.5 percent between 1990 and 1995 and has not recovered much since. Fearful that such privation may make their populations restless, most ruling elites have all but stamped out opposition movements and political dissent, leaving no avenue for change except a convulsion. To make matters worse, the region's states face turbulent successions as the older generation of ex-communists gives up the reins of power. As a new breed of nationalists replaces the old Soviet guard, social and ethnic tensions -- as well as Islamic fundamentalism -- will become more virulent, as they have in Chechnya and Dagestan.

As the promise of oil-driven nation-building in the Caspian region proves elusive and underlying social strains produce full-fledged crises, the United States runs the great risk of drifting into a quagmire that it can neither handle diplomatically nor solve militarily. As a rand Corporation study noted, NATO risks both "mission creep and a developing gap between its commitments and capabilities." Wisely, rand concludes that "NATO's military capabilities [read U.S.]" are "of little utility in preventing 'failed states.'"

THE POLITICS OF OIL SECURITY

Worse still, it is not only the security challenge of defending the Persian Gulf and Caspian oil supplies that will get more difficult in the new century. The politics of defending America's global oil supply will probably become more precarious as the world's oil habits change. The days when the Gulf was America's lifeline are fading; the U.S. economy will be fed largely by oil from relatively nearby sources in its own hemisphere. But Persian Gulf oil's share of the current world market, now at 24 percent, will rise to more than 32 percent by 2010, despite falling use in the western hemisphere. If present trends continue, Asia will obtain more than 90 percent of its imports from the Persian Gulf by 2010, while Middle Eastern oil will likely contribute less than 5 percent of America's total consumption, unless the reopening of the Gulf oil fields to U.S. oil-company investment radically alters the picture. Similarly, no Caspian oil will feed U.S. markets; rather, it will flow to Europe and possibly to Asia.

As U.S. imports from the Persian Gulf diminish, the expensive U.S. military role of "guardian of the Gulf" will become increasingly vulnerable to those at home calling for more burden-sharing. Sophisticated supporters of the U.S. Gulf presence argue that, in a global market, oil is fungible; defending oil anywhere means defending it everywhere. But that still does not mean that Europe and Japan should leave the job to the United States. Will Congress and the U.S. public continue to support spending blood and treasure to protect the Gulf while such allies -- and recipients of the region's fossil fuels -- as the European Union and Japan play virtually no military role there? Such questions have colored the debate about expanding NATO's post-Cold War role beyond Europe.

These new energy-driven linkages between Gulf suppliers and East Asian consumers also raise other important regional strategic questions. Since the mid-1990s, China and India have ended decades of energy self-sufficiency and become net oil importers. Their import needs are expected to mushroom by some five to ten million barrels per day over the coming decade. As China's energy needs have grown, its sources of supply have moved up the agenda of Beijing's decisionmakers. China's rising hunger for oil imports means that it will depend more on the same energy resources and sea transportation lanes shared by the United States, Japan, and other industrialized countries. And here, the oil glut may boost Asian energy security. After all, if oil supplies are ample, China may relax, rely on the market to provide energy security, and feel less pressure to build a blue-water navy to "compete" for energy supplies with Japan, South Korea, and India.

Still, China, which conceives of itself as an emerging great power, probably will not be comfortable relying on the U.S. Navy to defend the sea lanes through which its own Persian Gulf oil lifeline will have to be strung. Even before the accidental NATO bombing of the Chinese embassy in Belgrade, Beijing fretted in its 1998 defense white paper that the U.S. de facto security system of Pacific alliances was "a threat to peace and stability." If China thinks it is more vulnerable in energy, it could become more assertive, particularly if U.S.-Chinese relations turn adversarial. But if generous supplies of oil at moderate prices persist, energy issues might actually provide a good opportunity for cooperation between China, its neighbors, and the United States. Regional energy security could be assured and environmental goals met by helping China enhance its natural-gas industry and imports.

LOOK CLOSER

A world of persistently low oil prices will pose real challenges for U.S. national security. Not only is Washington unprepared to handle these problems, but current policies are likely to exacerbate them. This point is perhaps most stark in the unbridled promotion of U.S. ties to the authoritarian regimes in the Caspian basin -- ties that could drag the United States and NATO into local conflicts in which energy and strategic interests are marginal. Central Asia, a complex region with a moderate oil potential that is hard to commercialize, is no replacement for the Persian Gulf. A less ambitious U.S. Caspian policy, rooted in a hardheaded understanding of America's limited interests there, would both avoid Balkan-style entanglements and reduce the number of irritants in U.S. relations with Russia and China.

Complacency and misperception too often prevent effective policymaking on energy. Scarcity is not the only scenario to fear. Burden-sharing questions are better addressed sooner rather than later to lessen the chance of tensions among major oil consumers during a crisis. The lessons of the past century should have taught us that politics, not geology, has ruled our oil-supply fate. Politics and diplomacy brought the price of oil from $8 per barrel to $23 last year; the internal politics of the Persian Gulf have repeatedly disrupted U.S. oil supplies in the past and could do so again in the future.

But there is no escaping the importance of the Gulf. As U.S. dependence on Middle East oil wanes and Asian reliance grows, a new set of issues will arise: rivalries between Asian countries for oil supplies and complex problems about sharing the burden for keeping the Gulf's oil flowing freely. These issues can be assuaged in much the same manner in which the West coped with the 1970s oil crises. Major consumers, particularly emerging economies in Asia, can cooperate to create greater energy security for all participants -- from joint oil-stockpiling programs to developing natural-gas grids and alternative energy sources.

Properly assessing America's strategic situation in a world of cheap oil requires a comprehensive policy review. Aid to oil-producing countries -- given in, say, the Caspian basin in hopes of ensuring a more reliable oil supply -- should not be limited exclusively to military assistance but should be linked to political and social institution-building and diversified economic development. In turn, such reforms will better insulate these shaky countries from the internal turbulence caused by volatile oil revenues. Supply would be more secure, and the citizens of oil-producing nations would gain more from the natural wealth their countries control. Both producers and consumers thereby win -- regardless of where oil prices eventually wind up.