Energy: Addicted to oil

30 June 2007

The history of the modern Middle East is bound to the rise of the oil industry. Producer states want to reduce their dependence on the sector, but will find it hard to sever their ties.

As Iran continues to test the will of the Western world with its nuclear programme, and Iraq continues to sink into civil conflict, the precariousness of Western energy security is discussed more widely than ever.

Certainly it was a major talking point for MEED readers at the magazine’s conception in 1957. Oil had only just begun to flow freely as the Suez crisis was gradually wound up and a raft of new energy development programmes promised “mutually beneficial trading relations” between all countries. Israel had recently withdrawn from Gaza and Sharm el- Sheikh, while the Syrian government had given the green light for the Iraq Petroleum Company’s pipelines to finally be repaired.

Just one year later, the security dilemma between the West and the Middle East re-emerged. This time the cause was instability in Iraq. MEED summed up the dilemma of Iraq in July 1958, raising issues that sound eerily familiar 50 years later as the country attempts to formulate crucial new oil laws:

“At the time of writing, direct news from Iraq is scarce and often unconfirmed and in the rush of events the economic policy of the new regime in Iraq remains a matter of speculation,” MEED reported. “There is no doubt, however, that by its importance as an oil producer supplying mainly West European countries, future Western reactions to the new government in Iraq must be conditioned to a large extent by its economic policy.”

Other regional developments in these early years would become yardsticks for energy security. Few predicted the profound effect the founding of Opec on 14 September 1960 would have on the region.

The group was initially set up as a protest against pressure by major oil companies to reduce oil prices and payments to producers. After starting life as an informal bargaining mechanism for the sale of oil by Third World nations, by the 1970s Opec had started to exercise its considerable power. During the 1973 oil crisis, Opec alarmed the world by declaring it would no longer ship petroleum to nations that had supported Israel in its conflict with Syria and Egypt. Soon after, members agreed to use their leverage over the global price-setting mechanism to quadruple world oil prices. The reigning Western oil conglomerates suddenly faced a unified bloc of Middle East producers, who realised they could control their own oil destiny.

The Shah of Iran confirmed as much in 1973. Buoyed by Opec’s newfound power, Iran warned that the days of paying over the odds for basic materials were over: “You [Western nations] increased the price of wheat you sell us by 300 per cent, and the same for sugar and cement,” the Shah said. “You buy our crude oil and sell it back to us, redefined as petrochemicals, at a hundred times the price you’ve paid to us... It’s only fair that, from now on, you should pay more for oil. Let’s say 10 times more.”

It was a huge turning point in the power of Middle East producers, who realised their enormous deposits of crude were the best international political weapon available. Predictably, the US was not impressed. Three weeks after the Arab oil embargo, former US President Nixon introduced Project Independence, pledging the US would, within seven years, “meet our own energy needs without depending on any foreign energy source”. But as Pulitzer Prize-winning author Daniel Yergin, chairman of Cambridge Energy Research Associates (Cera), points out, in the decades since Nixon’s speech the US has gone from importing one-third of its oil to more than 60 per cent - and its share is set to continue rising.

While the Middle East was flush with oil revenues in the 1980s, 33 economic development was fleeting as a series of conflicts provoked unrest. At the start of the decade, Iraqi President Saddam Hussein demonstrated his thirst for oil, ordering an all-out invasion of the Iranian oil province of Khouzestan. Hostilities continued throughout the decade. The fabric of Opec was also tested. By the middle of the 1990s, the organisation’s aggressive price policy was resulting in a massive loss of oil market share, with Middle East producers forced to cut supply to support prices.

Opec finally abandoned its price defence strategy in 1985. Oil prices fell to less than $10 a barrel. By the time the war in Kuwait was declared over in 1991, the US appeared to have forsaken President Nixon’s dream of energy independence.

“By 2010 we will need [a further] 50 million barrels a day,” US vice-president Dick Cheney said. “The Middle East, with two-thirds of the oil and the lowest cost, is still where the prize lies.”

Securing Middle East oil supply is a problem for international oil companies (IOCs) to this day. BP’s Middle East & South Asia president, Michael Daly, recognised as much in 2005, declaring increasing oil production in the Middle East as the most pressing challenge the industry faces.

Unfortunately for global giants like BP, the prize of accessing Saudi oil remains a dream. Daly believes the status quo is only likely to change if IOCs become needed again by the Opec states. “The world’s great IOCs are playing a minimal role in the world’s great oil challenge,” he says. “And it may remain that way for some time.”

Yergin believes this policy could well backfire. “One of the things that has become apparent is that these countries need to think about their own energy supply because of the rapid growth in their economies,” he says.

Yergin points to several Gulf states that may need to re-think parts of their export-oriented hydrocarbons strategy, given their soaring domestic energy needs. The timing of key infrastructure additions will become a major priority.

“Because of the electrification of their economies, they not only have to make sure they have access to supplies but also infrastructure and the market systems to ensure that years from now they will have the domestic energy supplies they need to support economies that will be much bigger than they are today,” he says. Some of that supply will come from a major gas ramp-up in Qatar, which will soon become the global leader in liquefied natural gas (LNG).

Other regional players are joining in, exporting to neighbours as well as distant markets. “I do not think people’s thinking has really caught up with the reality of the new global gas market,” says Yergin. “In the next six or seven years, LNG trade is going to double after taking 40 years to get where it is today.”

High oil prices are also changing the limits of oil and gas production. The International Energy Agency points out that, historically, the Opec Middle East nations have only required a price of $14 a barrel for extraction to be commercially viable. With the floor for oil seemingly well established above $50, enhanced oil recovery, tight gas and sour gas have become realistic exploratory techniques.

“It is amazing to think that less than a decade ago, the focus for industry was a survival agenda and now it is a growth agenda,” says Yergin.

Yergin has spent much of the past year with his Cera colleagues developing likely scenarios for Middle East and global energy markets over the next few decades. While he is able to “confidently predict” the dominant role of hydrocarbons for the next 30 years in the Middle East, he concedes there is no crystal ball for imagining the context that will support high prices in the next 50.

Cera has devised three separate energy scenarios for analysing uncertainties about the global energy future (see Outlook, page 33). While energy prices and geo-political landscapes vary with each scenario, the region remains vitally important as a source of global energy supply.

“The Middle East remains unrivalled in supply-side importance to the world oil market, and therefore continues to attract global attention far beyond what its population size and relatively small share of global economic output might otherwise suggest,” says Yergin

Peter Evans, director of global oil at Cera, says that while the production of oil is relatively steady in all three scenarios, there is a huge difference in revenues generated. “We think of the Middle East as the base load producer for the world,” he says.

“Regardless of what goes on in the world, the Middle East is going to be tremendously important. Of course, the rewards the Middle East reaps will vary greatly depending on the where you live in the region.”

Under the ‘Asian Phoenix’ scenario, Asia becomes dominant economically, providing leaders throughout the region with a new set of relationships that are used to counter the influence of the US and Europe. The opposite scenario - the ‘Global Fissures’ scenario - is that the Middle East will effectively go from a boom to a downturn, despite oil and gas production staying relatively high. “It would continue to be hugely important as a producer, but the huge euphoria around energy and related construction projects would wane,” Evans says.

The ‘Break Point’ situation has the natural gas sector tripling production, rivalling North America.
Most commentators assume that high energy prices will automatically benefit Middle East producers. Yet $100-a-barrel oil could also destabilise the region, opening up new technologies and rival sources.

Critically, oil could lose its dominant position in transport, as both policies and innovation promote alternatives.

Looking further than the next 20 years is “extremely challenging”, according to Yergin.

“People forget that this is a hi-tech industry that continually reinvents itself, so nothing should be ruled out,” he says. “A key question for the Middle East countries, as some recognise, is how they will eventually deal with a slowing of oil and gas revenues, and whether they can transform themselves into countries that can successfully go through cycles - and come out resilient at the other end.”

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