war on the rocks

A Primer on the Geopolitics of Oil

January 17, 2019

Last year was a wild one for the oil industry. Between January and October, oil prices rose to almost $80 per barrel — a 25 percent increase since the start of the year — thanks to fears stemming from Washington’s withdrawal from the Joint Comprehensive Plan of Action with Iran. In the months that followed, due to increased U.S. shale oil production, weak consumer demand, fears over the future global economic outlook (exacerbated by the prospect of a Sino-U.S. trade war), the Trump administration’s decision to authorize waivers to various countries to continue importing Iranian oil, and the inability of the Organization of Petroleum Exporting Countries (OPEC) and Russia to cut production sufficiently, prices cratered. This collapse wiped out any earlier gains and, combined with the threat of U.S. anti-trust legislation, has called into question the future of OPEC. Qatar, a marginal oil producer but the holder of the world’s largest reserves of natural gas, even chose to leave OPEC.

At a time like this, it is tempting to think that oil will finally become just another commodity rather than one of the most important factors in global geopolitics. The experience of the past century would suggest that some caution is in order before strategists denigrate oil’s future significance. Oil will remain the world’s single largest source of energy for the foreseeable future, and the balance between global supply and demand remains perilously narrow. A major disruption in just a single major oil producer could send prices skyrocketing again and quickly push the world into a recession. U.S. production growth in the short run appears limited, especially as higher interest rates may starve small U.S. firms of the cheap capital they require to finance their operations. Despite their success in boosting U.S. oil production, most shale oil firms are notoriously unprofitable. Investors are tiring of the companies’ flawed assumptions and questionable business practices and are urging them to focus less on production and more on profitability, which could mean lower output until prices recover. If U.S. production growth fails to keep pace with global demand growth, the relative power advantage over pricing would again shift back to OPEC, which, along with Russia, controls over 55 percent of global oil production and 80 percent of proven reserves. Finally, the collapse in Venezuelan output has removed an important source of non-Middle Eastern oil from world markets. Accordingly, it is incumbent upon U.S. national security professionals to understand how the oil industry functions and keep the stability of global oil production high on their list of priorities.

When it comes to that, the only adage that has stood the test of time is, “What goes up, must come down,” and vice versa. Or, to put it another way, every boom lays the seeds for the next bust. The roots of the current deluge of shale oil production go back much further than the price increase following 2003, which climaxed in 2008 with oil prices touching $147 a barrel. In fact, the original impetus were the energy crises of the 1970s. The specter of future supply shortages and price hikes encouraged the Department of Energy to create a number of tax breaks for U.S. oil producers to expand domestic production. These incentives proved vital to one Texas oil man by the name of George Mitchell, whose firm pioneered the cost-effective application of hydraulic fracturing to release previously inaccessible supplies of oil and natural gas. Just as important as measures to increase supplies were efforts to curb the growth in consumption, most notably through the Corporate Fuel Economy standards after 1975. The introduction of these standards averted the consumption of as much as 1.5 trillion gallons of gasoline during the following three decades.

Oil remains fundamentally different from other commodities from both an economic and a national security perspective. Let us leave aside for the moment the fact that cheap oil is indispensable to the American culture of consumption and the post-World War II liberal project of ameliorating class conflict through economic growth. Like other extractive industries, the supply of oil is not simply a function of the demand for it. As many of us learned in Economics 101, for most products the supply is determined by the overall demand. If the demand for shoes exceeds supply, producers will make more shoes until there is oversupply. A surplus of shoes will drive down prices and discourage further production. Eventually, economists tell us, the supply of shoes will come into a state of equilibrium with demand. This is not the case with oil. For one thing, demand for oil, particularly refined petroleum, is inelastic in the short run. If, for example, the price of gasoline jumps tomorrow by $1 per gallon, you are unlikely to stop driving to work the day after tomorrow. You may, however, adopt certain lifestyle choices over long run that reduce your petroleum consumption. On a macro level, this means that there will always be stable short-term demand for petroleum irrespective of moderate fluctuations in price, but that doesn’t tell us much about the supply of oil.

People often talk about oil “production,” but oil is not actually produced like, again, shoes. It is mined, and the supply at any given point in time may or may not correspond to the prevailing demand. That is to say, if available production and inventories cannot satisfy demand, one cannot immediately boost production — you have to make do with what is available. Things are a little different, however, in the long run. The most important factor shaping long-run supplies is the price of oil, not its demand. The price of oil is not simply a function of existing demand, but also a myriad of factors including expectations about future consumption (often tied to forecasts concerning economic growth) and supplies or shortfalls, including a geopolitical risk premium. The higher the price, the greater supply of oil on the market, because a higher price increases the quantity of oil that can be extracted profitably.

This fact has important ramifications concerning the lifespan of global oil reserves. If you ask geologists “How much oil is there?” they will give an answer based on their existing knowledge of the earth’s subsurface resources and currently existing technology. Geology is not, however, a predictive science. Rather, its task is to understand change over time. One might extrapolate from past trends, but this is a risky endeavor because it presumes that our knowledge will not change. That is why geologists have, historically, been terrible at forecasting the lifespan of oil reserves. Every few decades, a few have sounded the alarm that reserves will run out within a generation or less. They reached these conclusions based on the knowledge and means they had available at the time, but advances in technology or new discoveries subsequently rendered those predictions laughable.

If you pose the same question to economists, you will get a different response: “Tell me what the price of oil is.” That price will, in turn, inform assumptions about the profitability of exploiting known and probable reserves (i.e. those with a greater than 90 percent probability of existence vs. those with a 50 percent chance) as well the rate of investment in new technologies to find and extract unknown reserves of oil. The surest way, an economist will argue, to guarantee long-term supplies of any extracted raw material is to provide a high price floor — usually through a government guarantee to purchase an unsold stocks at a minimum price. This fact alone should ameliorate current fears over China’s stranglehold over the global production of so-called “rare earth minerals” — a somewhat misleading term used to refer to a number of elements vital to the production of modern electronics. Should China, which currently produces five times more “rare earth minerals” than the number two producer (Australia), try to limit their export, the resulting higher prices would simply incentivize U.S. producers to reopen domestic mines that are currently unprofitable due the prevailing price and regulatory framework, not to mention boosting production elsewhere in the world.

Economists get this fact right, but national security professionals would be wise not to take everything economists tell them as gospel. One of their most prevalent shibboleths about the oil industry is that oil is fungible, which is a technical way of saying that one type of oil can be substituted for another. To explain how this affects the oil market, economists developed the so-called “bathtub” analogy — the supply of oil is like water in a bathtub, and additions or subtractions from one part of the bathtub affect the total supply of liquid. Unfortunately, the analogy is misleading. As any oil trader will tell you, not only is oil not fungible, but there is also no such thing as a single, “global” oil market, where oil is freely traded between producers and consumers with minimal state interference.

For one thing, crude oil is not a uniform commodity. Depending on its chemical composition, crude oil can be either “sweet” or “sour” depending on its sulfur content; or “heavy” or “light” depending on its gravity (i.e. whether it is heavier or lighter than water). These distinctions matter because refineries can only process one type of crude oil at a time. The process of converting them to handle another can take between months and years. Even if another refinery was available that could process the oil, it might not have sufficient capacity to handle the additional throughput. At best, one could say that refined petroleum products are relatively more fungible within their specific geographical locale. Gasoline produced in the United States can be consumed by cars in Canada, for instance, although both the federal government and several states have various regulations concerning emissions and additives — but this is a far cry from the “bathtub” analogy. As for a “global” market, how can one say that such a thing exists when a significant portion of the world’s oil production is not publicly traded? The oil Venezuela, for instance, sends to China to repay its loans or cover interest payments may count against global oil production figures, but it is hardly available for global consumption. Just how much oil is traded away from global commodity markets is hard to tell, but an estimate of 20 percent seems plausible.

So much for the economic reasons why oil is different. What about the national security factors? Oil is indispensable to sustaining a nation’s war machine. Granted, no economy in war or peace can function without a host of raw materials, but when was the last time anyone fought a “chromium war”? To understand why oil is different from other extracted raw materials, let us consider two other commodities that are also vital to modern economies: bauxite (for aluminum production) and copper. Nations require copious amounts of both, yet their geopolitical significance is muted in comparison to oil — why?

Copper, at first glance, should have the same national security significance as oil. Try running an economy without copper wiring, and you may wonder why the United States doesn’t trade copper for blood. Copper production is even more concentrated than that of oil — a mere four countries (Chile, Peru, China, and the United States) produce more than half of the world’s copper today. Copper, however, can be stockpiled relatively easily compared to oil. Recent U.S. consumption of copper has hovered around 1.8 million tons annually, one third of which is imported. By contrast, the United States consumes over seven billion tons of petroleum products annually, of which 20 percent — roughly 1.4 billion barrels — are net imports (imports minus exports). Moreover, nations in the past have been able to bolster their national supplies of copper by recycling copper from consumer or industrial goods. The same does not apply to oil products, most of which cannot be salvaged after their initial use.

What about bauxite? Unlike copper but like oil, the cost of stockpiling large quantities of bauxite is prohibitive. Unlike both copper and oil, beyond North America, production and supplies of bauxite are diffuse. While the United States is not well endowed, it has easy access to major suppliers in the Caribbean, most notably Jamaica and Guyana. The latter also happens to a budding oil producer that depends on U.S. protection against Venezuela, with which it has a century-long border dispute.

Bearing these facts in mind, what sort of strategies should great powers adopt to meet their current and future energy needs? Traditionally, the choice has been between energy security and energy independence. Although the terms are often used synonymously, they mean quite different things. The distinction is a meaningful one because pursuing one strategy often comes at the expense of another. Basically, energy independence can either mean self-sufficiency within one’s borders or limiting one’s import dependence by relying on certain suppliers to the exclusion of others from specific regions or modes of transport (e.g. overseas vs. overland). Internal self-sufficiency has never been a plausible option for any great power besides the United States and Russia. Even Nazi Germany only sought self-sufficiency by expanding production of fuel synthesized from coal as a temporary expedient until it could take what it needed in the Soviet Union and Middle East by force.

In the U.S. context, energy independence has meant favoring imports from North American or Western Hemispheric suppliers rather than Middle Eastern ones. China has a followed an “all of the above” approach that conforms to the guidance former U.K. Prime Minister Winston Churchill offered a century ago: “Safety and certainty in oil lie in variety and variety alone.” Nevertheless, there appears to be a clear Chinese preference for developing sources of oil that cannot be interdicted at sea by the United States — hence the focus on closer economic ties with Russia and Central Asia and the development of pipelines that might allow Chinese tankers to avoid maritime chokepoints.

Energy security, by contrast, is a strategy that seeks to guarantee secure supplies at stable prices. The major difference between the two has to do with their relationship to prices. Under a strategy of energy security, the actual origin of supplies is irrelevant — what matters is finding the most efficient supplier, which usually means the cheapest. By contrast, nations that value independence must usually accept a higher price. A higher price, in turn, can promote inflation or have negative effects on a country’s balance of payments. It is therefore surely not a surprise that most of the countries that have sought energy independence have been authoritarian regimes or at least ones with heavily regulated internal economies and managed international trade. Private firms, especially the multinational major oil companies, have historically opposed energy independence, which often works to the advantage of their smaller, domestic competitors. The United States, perhaps not surprisingly, has pursued contradictory objectives. On the one hand, policymakers have often bowed to consumers’ demands for low prices. On the other, they have lamented the United States’ dependence on overseas suppliers, which the U.S. government identified as a national security risk as early as World War II. Therefore, it yielded to the political pressure of domestic oil producers, who clamored for tax breaks and import quotas to protect them from cheap imported oil. Pursuing self-sufficiency and low oil prices simultaneously guaranteed neither security nor independence in the decades that followed. Only high prices (or greater profits through tax rebates) can incentivize the search for new supplies and technologies, whereas low prices may reduce long-term supplies, thereby leaving consumers at the mercy of future price spikes.

Who will provide the price stability that is at the heart of any strategy of energy security? For the first 100 years of the oil industry, the major oil companies did, sometimes abetted by local regulations like pro-rationing in Texas (limiting oil production to specific quotas below 100 percent capacity — ostensibly to prevent waste but, in practice, to stabilize prices). Starting in the 1970s, the key player became OPEC. As much as consumers may despise OPEC, they should be wary of an oil market where no one is capable of promoting price stability. Assuming Congress passes the so-called “NOPEC” legislation that has been floating around since 2007, the long-term consequences may be unpleasant. Specifically, the law would reclassify OPEC’s efforts to control oil prices by increasing or reducing the cartel’s oil production as a violation of U.S. anti-trust law. The law would also eliminate sovereign immunity (i.e. that governments cannot be sued without their consent), thus exposing OPEC’s member nations to criminal prosecution in U.S. courts and potential forfeiture of their assets in any U.S. jurisdiction.

Were that to happen, the most likely outcome is that the cartel’s members would maximize production to secure market share. This would have several negative consequences. One, it would place additional strain on their fiscal health. While some Americans might relish further economic destabilization of rivals such as Iran, the pain would also spread to U.S. partners. Two, all-out production would eliminate what little slack capacity currently exists in the world — approximately two million barrels per day, most of which is in Saudi Arabia. The absence of such slack capacity would leave the market unprepared to boost production quickly to respond to disruptions. In the long run, a glutted oil market would encourage companies to exhaust the cheapest sources at hand and slash investment to boost future capacity. This might be a welcome development if the world is serious about limiting carbon emissions, but it also has the potential to create significant economic harm. The chimera of energy independence will not shield Americans from higher oil prices. Although the United States recently managed to become a net exporter of crude, this was only for one week, and U.S. consumers and firms will still depend on imports to meet requirements for domestic consumption or re-export. This means that the U.S. oil prices are still tied those around the world — shortages abroad will drive up prices, both by increasing the cost of imports or encouraging producers to sell abroad if they can fetch a higher price. The only way to prevent that would be for the U.S. government to adopt extreme measures that are politically inconceivable, at least during peacetime.

The aforementioned risks explain why elements in the U.S. government have historically supported efforts to regulate the oil industry, most notably through the failed Anglo-American Oil Agreement of 1944. What they feared most was a free-for-all like the one that ravaged the U.S. domestic oil industry during the Great Depression, when lower demand combined with new supplies from the East Texas oilfield nearly destroyed the industry by reducing prices to as low as 10 cents a barrel. The United States should therefore think long and hard about whether to adopt the NOPEC legislation. Leaving aside the thorny legal and diplomatic issues raised by prosecuting foreign companies under U.S. antitrust law for indirectly acting in restraint of trade by trying to stabilize global oil prices — a situation similar to the effect of U.S. secondary sanctions that target foreign firms for legally trading with U.S. adversaries like Iran — the United States should not try to destroy OPEC without considering what will come after.

At this point, it is worth sketching out briefly where oil and natural gas diverge. Although the production of both is often closely linked (conventional oil reservoirs derive their field pressure from natural gas), the markets for both products function differently. The most-important difference is that while markets for oil are global, those of natural gas are still regional. That is because the cheapest way to transport natural gas is by pipeline. Overseas transport is an expensive and technologically challenging process due to the need to liquefy and then re-gasify the natural gas. Oil, by contrast, can be shipped on land or sea in whatever form is required without the need for pressurized containers. For that reason, most producers and consumers of natural gas depend on long-term contracts that lock in prices for the latter (usually linked to oil but often at a discount) and amortize the cost of constructing and maintaining pipelines for the former. This factor more than any other probably accounts for Europe’s reluctance to part with Russian supplies of natural gas, but it also limits the ability of Moscow to use natural gas deliveries as a coercive tool, because otherwise it would have no way to cover the cost of maintaining or expanding its natural gas infrastructure. Finally, because of the compartmentalization of the natural gas market, increases in supply in one part of the world will have only a delayed impact on prices in others, which explains the variation in prices between the United States, Europe, and East Asia, although this is gradually changing with the spread of liquefied natural gas (LNG) technology and declining transportation costs.

The question of how recent developments in the oil and gas industry should affect U.S. strategy is a contentious one. Some commentators have even argued in favor of a complete U.S. disengagement from the Middle East. History is an imperfect guide for future action, but it clearly has a great deal to offer in terms of understanding how the oil industry functions and what its relationship is to global geopolitics.

CORRECTION: A previous version of this article incorrectly stated that Qatar is the first country to ever leave OPEC.

 

Anand Toprani is an assistant professor of strategy & policy at the U.S. Naval War College. This piece is adapted from his forthcoming book, Oil and the Great Powers: Britain and Germany, 1914-1945 (Oxford University Press, 2019). The views expressed here are his own and not necessarily those of the U.S. government.

Image: Flickr/wongaboo