The Venezuelan Oil Crisis

In June 2004, the price of oil reached $42.33 a barrel-the highest point ever in 21 years of trading on the New York Mercantile Exchange-pushing average U.S. gasoline prices to more than $2 per gallon. The surge had numerous causes, including market speculation, shortfalls in the U.S. capacity for refining crude oil, higher Chinese demand, and insecurity in the Middle East. The root of the crisis, however, lay closer to home: in Venezuela, where a general strike in late 2002 and early 2003 had severely constricted the flow of oil and gasoline for several months.

For the first time, the U.S. oil supply was significantly disrupted by strife in a region other than the Middle East. The Venezuelan strike was also the first disruption not caused by a war, revolution, or embargo, but rather by a slow, debilitating political standoff. It came at a particularly bad time for the United States, combining with civil unrest in Nigeria and the U.S. invasion of Iraq several months later. And it highlighted the challenges Washington faces in responding to new threats to its oil supply.

Of course, the U.S. management of the crisis in Venezuela could have been significantly better. Distracted by the Iraq debate and planning for the war, U.S. officials did not focus sufficiently on events in Venezuela prior to the strike. When they did take note, both Washington and the oil industry misread Venezuela's political situation and underestimated the impact the showdown there would have on the flow of oil. Had an early warning system and response strategy been in place, Washington could have ensured that the oil market was better supplied to weather the uncertainty. The Venezuelan crisis should thus serve as a warning: more disruptions in the U.S. oil supply are likely, and unless serious efforts are made to improve Washington's analysis and response mechanisms, the system will continue to fail.

A SHIFT TO INSTABILITY

The world oil market-and Washington's relationship to it-has changed dramatically since 1991, the year of the last major oil disruption (caused by the Persian Gulf War). For one thing, the United States is now more dependent on oil imports than ever before. In 1950, it imported just one-tenth of its oil supplies. By 1973, the share of imported oil had grown to one-third. Today, the United States gets nearly two-thirds of its petroleum from abroad.

The United States and the rest of the world have also come to depend on much less stable suppliers than in the past. A gradual decline in production in Western countries such as the United States and the United Kingdom and an impending decline in production in Norway has led oil consumers to turn elsewhere to offset the loss and meet growing demand. Many of these new suppliers, however, are politically and economically unstable, as Venezuela has demonstrated. This instability has complicated Washington's efforts to diversify its oil supplies beyond the problematic Middle East, focusing more on oil producers in Latin America, West Africa, and the former Soviet Union-a strategy the United States developed after the 1973 Arab oil embargo.

Making matters more dangerous, the United States and the rest of the world now have little excess oil available to make up for a serious supply shortfall. Whereas 30 years ago, U.S. commercial stocks provided four months of import cover in case of a crisis, today they provide a buffer of less than two months. Meanwhile, global spare production capacity has dropped below three million barrels per day, less than five percent of total oil supply.

Washington is thus more exposed than ever to a serious disruption in its oil supply-especially if several regional crises occur simultaneously. Such a scenario is not hard to imagine: attacks on oil terminals in Saudi Arabia, violent insurgency in Iraq, ethnic clashes in Nigeria, sabotage by Chechen separatists in the former Soviet Union, and an oil embargo in Venezuela are all possible in the foreseeable future. As long as the United States remains dependent on oil, it will be vulnerable to such events. Yet as the crisis in Venezuela showed, Washington is not fully prepared to deal with them.

THE SURE THING

Prior to 2003, the United States had viewed Venezuela as a stalwart production hub. Indeed, Venezuela steadily supplied some 15 percent of U.S. oil and gasoline imports-often a larger share than was delivered by Saudi Arabia. Venezuela, along with Mexico and Canada, had become essential to the U.S. diversification strategy.

In American eyes, Venezuela had at least two things going for it. First, it was reliable. As a non-Arab and non-Middle Eastern member of the Organization of Petroleum Exporting Countries, it had continued exporting oil during the 1973 Arab oil embargo and had provided additional supply during the shortages brought on by the 1991 Gulf War. Its reserves were (and still are) among the largest outside the Middle East, with estimates ranging from 77 billion to 1 trillion barrels.

Venezuela also has the advantage of being geographically close to the United States. This means it takes only six days for Venezuelan oil to reach U.S. shores, which reduces transport costs and allows Venezuela to quickly compensate for supply problems elsewhere in the world-much faster than Saudi Arabia or Russia, which require at least a month to get their oil to the United States. Once trouble began in 2002, however, Venezuela's proximity also turned out to be a liability, since it accelerated and magnified the impact of the disruption. When a problem arose in Venezuela, it took at least five weeks for Saudi Arabian crude to reach U.S. refineries and make up the difference.

The potential danger posed by Venezuela's proximity was just one of the signs that Washington and industry officials failed to recognize, their perception clouded by their confidence in Venezuela's reliability. When the crisis finally struck in December 2002, it had already been months, if not years, in the making. Venezuela's president, Hugo Chavez, was elected in 1998, just as the country's oil sector completed a restructuring that left the state oil company, Petroleos de Venezuela, S.A. (PDVSA), more vulnerable to political manipulation. Once elected, Chavez's moves to consolidate power provoked labor and business groups, leading them to unite against his attempts to control the oil sector.

In April 2002, Venezuela's largest labor union staged a general strike to support a walkout by oil workers over PDVSA management changes. The strike sparked a countrywide protest and galvanized support from anti-Chavez factions in the military; on April 11 the president was forced temporarily to relinquish power. (He was reinstated by the military two days later.) The April events exposed Venezuela's vulnerability to export disruption and elevated the political power of its oil sector. But few in Washington paid attention to the signs.

In December 2002, union and business leaders launched another general strike against Chavez. The strike was starting to weaken, when, on December 3, violent clashes with the National Guard mobilized white-collar oil managers to join the protest. Soon 18,000 PDVSA workers were off the job. Oil production, refining, and export were paralyzed. Over the next three months, the crisis kept some 200 million barrels of oil and gasoline from the world market.

ASLEEP AT THE WHEEL

Washington failed to adequately anticipate the Venezuelan crisis in part because of political myopia. In late 2002, the Iraq debate and preparations for the conflict overshadowed events in Caracas. Senior U.S. energy officials focused their attention on possible disruptions in the flow from the Middle East, not South America. Moreover, those U.S. government and industry analysts who did follow Venezuela underestimated the risk of a disruption. After all, Venezuela had been a steady supplier of oil for more than seven decades and had never suffered a complete halt in its oil production. Previous labor strikes had ended quickly. Analysts also underestimated President Chavez's willingness to sacrifice oil to politics. They were lulled into complacency when he first took office by the way he had defused worries through a string of benign actions, which seemed to give the lie to his fiery speeches.

The United States also faced an information collection problem. Access to Venezuelan government sources dried up after April 2002, when the United States prematurely supported Chavez's brief eviction from office. Washington's recognition of the interim government exacerbated existing tensions between Washington and Caracas once Chavez was restored. Venezuelan government officials became less willing to meet and talk to Americans about their strategy to respond to an oil strike.

The U.S. government was not the only agency that failed to detect the growing crisis. International oil companies also underestimated to some degree the extent and duration of the damage. The oil corporations expected PDVSA management to keep working throughout the strike and to replace striking workers. And they assumed that Chavez would do what he had to do to avoid a production collapse, discounting his ability to survive a three-month strike.

PRIMING THE PUMPS

Once Venezuela's oil stopped flowing, the United States had two options to try to compensate for the shortfall: it could ask other countries to increase production, or it could release oil from the Strategic Petroleum Reserve (SPR), which had been established after the 1973 Arab oil embargo to limit the effects of future disruptions.

Using the SPR could have helped the United States get through the month or so it would have taken for extra oil to arrive from other sources. Prior to the crisis, however, the Bush administration had publicly taken a strong position in favor of letting the market, not government, determine energy supply and prices. Thus Washington decided against an SPR release-a decision that relinquished U.S. control over how to make up the shortfall. Instead, Washington asked for more oil from its other producers, but they were slow to respond.

The decision not to tap the SPR was complicated by the then-looming conflict in Iraq. The United States was preparing for war with an oil-producing country in an oil-producing region, and U.S. officials were unsure what effect that would have on the market. No one knew, for example, how long it would take Iraq to resume the exportation of oil, or whether the war would disrupt supplies from neighboring Kuwait and Saudi Arabia. Washington feared that using the SPR to make up for the lack of Venezuela's oil could limit the U.S. capacity to address an even larger potential disruption in Middle Eastern oil.

To minimize future supply problems, Washington should undertake several important reforms: improve scenario planning and alert systems, modernize its SPR policy, expand its response strategies, and develop guidelines for coping with multiple disruptions at once.

To conduct the first of these reforms, Washington should undertake more specific and creative contingency planning for crises in any country that produces more than one million barrels per day. It should plan for the possibility of disruption in these states caused by political unrest, social instability, labor strikes, embargo, war, and terrorism, and it should highlight specific threats to the U.S. oil supply. As part of the process, Washington should develop a list of crisis indicators-political, security, and operational-that, if spotted in any of the countries concerned, would then trigger U.S. contingency plans. To help monitor these risks, the U.S. government should create a national energy council. This goal could be accomplished by reviving the foreign policy elements of the National Energy Policy Development Group (which produced a new National Energy Policy but then disbanded in May 2001) and building them into a permanent forum that would review risks in oil-producing countries. Critics will argue that such advance planning would have little impact on final policy decisions, which tend to be made on an ad hoc basis. But thinking through possible scenarios before a crisis actually erupts can give government a head start on preventing them or mitigating their worst side effects. Given the uncertainties in today's market, it would be far better to err on the side of caution.

Washington must also modernize its SPR policy. Venezuela's proximity to the United States accelerated the urgency of the disruption and complicated efforts to secure additional supplies. Today, many companies buy and sell oil on the open market, rather than through fixed contracts. They outbid competitors for replacement supplies so that physical shortages are masked by price swings. The growth of the futures market has changed the nature of supply problems. Most oil trades are speculative and do not result in physical delivery of oil.

In times of crisis, market speculation magnifies actual price changes. Between November 2002 and May 2004, for example, prices fluctuated from $26 a barrel to $42 a barrel. Moreover, replacing commercial inventories has become just as important as replacing actual supply. With future threats to the oil supply looming on the horizon, the oil market must be reassured that inventories are sufficient to cover demand when another problem arises. The prolonged wait-and-see SPR approach adopted by the Bush administration in December 2002 was ineffective in curbing market speculation. Strategic stocks should be used more readily and early in a crisis, to address short-term disruptions and prevent price spikes caused by speculation.

The United States should also expand its other options for responding to a disruption in its oil flow. For example, the U.S. government should encourage Saudi Arabia and other producers to move more of their oil supplies to storage facilities closer to the United States and other key markets in Europe and Asia. This forward placement of supplies would minimize delivery time during crises, giving producers more time to assess market factors. To ensure cooperation from Riyadh, Washington must formalize its currently ad hoc bilateral oil discussions with the kingdom. Having a permanent mechanism in place for talking to the Saudis about oil could have helped during the Venezuelan crisis, when conflicting information from U.S., Venezuelan, and industry officials about the severity of the disruption delayed the Saudi response. Getting the Saudis to cooperate might still be difficult, but it would be in their best interests to do so, since it would help them regain their credibility as a reliable U.S. supplier, ward off Russian and other attempts to capture the U.S. market, and, in the event of a future crisis, preempt an SPR release.

Next, the U.S. government must develop clear guidelines for analyzing multiple supply disruptions. As the United States planned for a disruption in Iraqi oil before the war, it underestimated the impact of the Venezuelan crisis and the possibility of another supply problem in Nigeria. Washington should develop the ability to respond to multiple threats simultaneously or concurrently, since oil is a global commodity.

Recent attacks on Saudi Arabia have reinforced the importance of finding sources of oil outside the Middle East. Merely diversifying U.S. oil suppliers, however, will not guarantee energy security by itself. In the past, Washington has acted as though the risk of a major supply problem did not merit preemptive planning for worst-case scenarios and responses. But the Venezuelan crisis has shown just how shortsighted that approach was. If the United States hopes to avoid a world in which oil regularly sells for $40 a barrel, it must get much better at dealing with new threats to its supplies-and fast.