Energy and Geopolitics II: The World ex-United States

Middle East Oil Wells

OVERVIEW

Outside of the United States and Canada, most of the world’s oil and natural gas is owned and produced by governments or government-dominated companies with minority shareholders. Two examples of the latter, public companies with stockholders, are Petrobras in Brazil and Gazprom in Russia.  But government officials, especially the president, control management and make the important decisions.

Production and investment decisions are not made based on financial criteria alone.  Often, internal political or foreign geopolitical factors are more important. Many countries' economies and government budgets depend critically on oil and natual gas revenue from exports. Maintaining internal peace and welfare programs are more important than rational economic considerations.

What this means is that production and distribution decisions in these countries are made using different criteria than by private companies in the United States and Canada. Producing and exporting oil and natural gas are mostly political decisions. Petrostates like Russia, Brazil, Venezuela, Nigeria, Algeria and other countries in the Middle East and Africa have not used their oil and gas revenue to industrialize or diversify their economies.  Generating revenue for government, not profits for investment, is the main concern of these countries.  

For many countries, exporting oil or natural gas (and other commodities) is the major source of hard currency revenue and government income.  Domestic spending, importing consumer goods, government social welfare and subsidy programs, foreign policy and even internal stability and corruption depend on commodity export earnings. As does servicing foreign borrowing, which has grown rapidly in the last six years. 

With much greater potential supply of oil and natural gas because of new discoveries and innovative production technology, and growing substitutes, no one country or small group of countries will be able to control global supply or price.

Among the fossil fuels, the long run outlook (20 years) of natural gas appears to be the best.  Even without the fall in natural gas prices, the global trend away from coal to gas to generate power will likely continue and increase demand for gas. In Asia, however, both coal and natural gas production are increasing because of the huge increase in the demand for electricity.  

Massive increases in profitable reserves and technological changes in production and distribution will permanently bring down prices of natural gas in high-cost areas like Asia and Europe. LNG, more tankers and interconnect pipelines will make the global gas market more integrated, more like the global oil market.

Three new potential major producers of natural gas are Argentina, Bangladesh and Egypt.  Qatar and Australia have completed and can expand large new LNG complexes. Some of Qatar’s new gas revenue is supporting Sunni fundamentalist groups in Syria and Iraq.

Substitutes for oil and gas should be cost competitive in the near future.  Solar, especially decentralized solar on buildings, will continue to grow rapidly as the technology improves and the costs keep coming down.  Adoption of solar will accelerate if battery storage costs come down and countries don’t have to build or expand electricity plants and grids.  Solar panel costs are falling rapidly and Elon Musk says his new lithium battery plant in Nevada will reduce storage costs by 30%.  Wind turbine currently depends on subsidies but there is some new technology that may eliminate the gigantic windmills (375 feet high) and lower costs.  

Many countries are looking at nuclear again because of major advancements in technology and safety.  There are currently 437 nuclear power reactors operating worldwide. 60 more are under construction, another 165 are planned, and 331 more are proposed.  The number of nuclear power plants in the world could easily double in the next two decades. China alone plans to build 46 new ones by 2020.  Japan, which paid $270 billion to import fossil fuels (mostly natural gas) in 2013, currently plans to start up 15 shut-down nuclear power plants.  On the other hand, Germany is shutting down the last of its 17 nuclear power plants, substituting solar and wind (interruptible) backed by gas.

Other sources of energy beyond the use of fossil fuels are being researched and developed in laboratories.

The key is how long oil and gas prices stay at current levels and what the new equilibrium prices will be.  This is not just an economic question.  Domestic policies, like China’s and America’s policies to reduce carbon emissions from coal, and geopolitics will play key roles.  Also, there will be major shifts in where oil and gas are produced, who exports, new technology and the expanding importance of substitutes.  

THE EASTERN MEDITERRANEAN

Huge new natural gas fields have been discovered in the eastern Mediterranean.  The largest so far are in the coastal waters of Israel, Gaza, Egypt and Cyprus.  The fields may extend north to Greece, Lebanon and Syria.  Israel, now self-sufficient in natural gas, could supply Palestine and Jordan. Pipelines could be built from Israel, Gaza and Egypt to Cyprus and then another set to Greece, which would connect into the proposed integrated pipeline systems of central Europe and, through Austria, to the rest of Europe.  Or a pipeline could be built to connect with the large pipeline running through Turkey to Europe.  South-Central European countries could eliminate their almost complete dependence on Russian natural gas and threaten “reverse flow” to Ukraine.  Egypt already has an LNG plant and other producers could construct them, expanding their geographical market for their gas.

If this occurred, it would be a tremendous economic boon to all the countries involved.  So what’s the problem?  Geopolitics.  There are countries involved that don’t like each other.  To say the least.  Besides Israel and Gaza, Cyprus is divided into Turkish and Greek areas.  Would the economic benefits be great enough to overcome political rivalries, many based on long-standing hatred and conflict?

RUSSIA AND EUROPE

Russia is Europe’s largest external source of oil and natural gas.  Europe is Russia’s largest customer for both.  But the conflict in Ukraine has changed the geopolitics.  Russia may pay a very high economic price for its intervention in Ukraine.  

It is also one reason that I don't think Russia will invade and conquer the whole country, as Putin has threaten to do.  Or even increase destabilization pressure.  Europe would expand sanctions, look to new sources of energy and accelerate programs to import less Russian oil and gas. 

While these policies will probably have little short-run effect on the volume of Russian exports of oil and gas to Europe, a longer-run combination of lower prices and less volume would have serious economic consequences for the Russian economy.  Since Putin’s and his successors’ political popularity in Russia partly depends on continuing the high rates of economic growth and standards of living made possible by increased revenue from energy and commodity exports, pursuing an aggressive or confrontational policy against Ukraine and Europe could have serious domestic consequences for the current and future Russian governments.    

Under U.S. pressure, Europe has imposed some economic sanctions on Russia, the most effective being that Russian companies cannot access European financial markets.  As loans come due, the companies, many of which are government owned or controlled, have to borrow hard currency from the Russian government.  Russia’s foreign reserves of hard currency are shrinking.  Over half are committed to future retirement costs, although the fund can be raided. 

New internal capital to modernize old fields and develop new fields is not available.  Global bond markets are closed.  Russia’s response has been to relax rules limiting foreign investment in Russian oil and gas.

In addition, Europe is beginning to institute actions that will reduce its dependence on Russian oil and natural gas, which means lower export earnings for Russia regardless of the change in energy prices.

Europe has large natural gas reserves but will not develop them quickly because of political opposition, lack of infrastructure and more difficult drilling geology than the U.S. 

RUSSIA AND CHINA

China imports more oil than does the United States. Before the tariff batlle, China was importing more U.S. crude oil.  China is about to become a major importer of natural gas as it substitutes gas for domestic coal production.  So China has joined the United States as a large market on the demand side.

Russia is now China's largest supplier of oil.

Russia’s president Vladimir Putin has his own “pivot towards Asia.”  Russia’s main market for oil and natural gas is Europe.  With the expectation that sales will be lower in the future and that older fields are declining in production, Putin has turned to China for capital investment and as a major export market.  China plans on substituting natural gas (and other energy sources) for its dependence on coal (cough, cough).  Russia has a huge new field in eastern Siberia it wants to develop.  The cost is somewhere between $55 billion and $100 billion.  Russia doesn’t have the capital and can’t raise it in western financial markets because of the economic sanctions.  So, apparently, the deal is that China supplies part of the capital and agrees to take the production for the next 30 years.  Although secret, apparently at a low price.  Russia originally announced that sales to China would bring in $400 billion over the 30 years but that was before the large drop in the price of natural gas, especially in Asia, and the reality that there will be a lot more natural gas available from other sources.

Russia is now encouraging China and other Asian countries to invest in Siberian oil and gas.  Knowing that Russia has used oil and gas exports as a geopolitical weapon against Ukraine, Europe, Georgia, Serbia and Armenia, potential investors in China, Japan and South Korea have to be worried about the political consequences of becoming too dependent on Russian oil and gas.  And having their investments expropriated by future Russian government.

There is another complication.  China is rapidly extending its influence into the old Soviet republics in central Asia.  China has offered economic aid, including railroads and natural gas pipelines connecting China and central Asian republics.  One of the world’s largest natural gas fields is in Turkmenistan; this is where Russia gets some of the natural gas it sells to Europe.  There are other possible gas fields.  All of this creates the potential for geopolitical rivalry between Russia and China in the area.

China also borders Kazakhstan, another former Soviet republic.  Kazakhstan is a large oil producer and has the potential to produce more.  Russia sees Kazakhstan as in its sphere of influence.  The president of Kazakhstan was the Communist boss of the republic when it broke away in 1991.  The Chinese, however, have made a number of proposals that would divert some of Kazakhstan’s oil to China.  Russia is not happy about this prospect.

In the long run, this policy could create serious geopolitical problems for Russia.  Supplying China with cheap oil and gas while China expands its influence in Central Asia and renews its claims (legitimate) on eastern Siberia is a dangerous policy.  But that will someone else's problems, not Putin.

OPEC

OPEC has been ineffectual as an oil cartel, probably since 1985 when Saudi Arabia cut production with disastrous results.  Iraq has invaded both Iran and Kuwait to grab large oil fields.  Saudi Arabia and Iran are deadly enemies and compete to dominate the Persian Gulf region (and Islam).  Many of the oil exporting states have seen civil wars and declining production.  OPEC's exports and net exports have been declining while global production is rising. 

OPEC's control has also been eroded by the growth and development of oil production in non-OPEC countries, even before shale.  What shale does is greatly increase potential global oil production in non-OPEC countries if prices rise.  Maybe even more important, shale oil greatly increases oil reserves outside of OPEC countries.  Before shale, a high percent of the proven reserves in the world were in OPEC countries, mostly in the Middle East.  This implied that OPEC's market power would last a long time.  No longer.

NAFTA

NAFTA (The U.S., Canada and Mexico) is the new OPEC.  Almost all of the net increase in global oil production since 2007 has come from NAFTA countries.  Future increases in oil production will come mostly from American and Canadian fracking, and deep-water rigs in the Gulf of Mexico.

NAFTA is the new OPEC also in the sense that the American and Canada companies, using fracking technology, can react quicker to changes in global supply and demand, and subsequent price changes.  New technology, better management and organization, and large cost reductions because of low prices have reduced the break-even cost of shale oil and gas.

The best oil fields in the United States have marginal costs of pumping out and distributing oil about equal to all but the lowest cost fields in the Middle East.  Because of fracking technology, fixed cost/barrel to modernize and expand existing fields is probably higher in most of the Middle East and the rest of the world than expanding or opening new fields in the United States.

The geopolitical implication of all this is the United States could cut off all oil imports from the Middle East and quickly substitute NAFTA oil, mostly American. There are major geopolitical implications if the United States has oil security, doesn’t need Middle East oil and becomes a major exporter of petroleum and natural gas. Maybe the Iranian agreement, over strenuous Israeli and Saudi objections, is an indication of the changing, more flexible geopolitical policies of the U.S. in the Middle East.

SUMMARY

Global demand for energy will continue to increase in the foreseeable future. Global production of all sources of energy, including coal production in Asia, will increase. New technology on both the demand side (electric vehicles and autonomous driving) and supply side (fracking, LNG) will change the economics of energy. This will have geopolitical consequences. Middle East oil will become relatively less important. U.S. exports of oil and natual gas might have geopolitical effects. Development and sales of new technology such as solar and wind, may, in the long run, become more important than fossil fuel extraction.

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This is a summary of prior posts plus new information and conclusions.  The latest related post was on Russia and the Geopolitics of Energy.

For an excellent history of the rise of OPEC, see Daniel Yergin, The Prize.

For an excellent, detailed article on Gazprom, see http://oilprice.com/Energy/Energy-General/How-Russias-Energy-Giant-Imploded.html.  Gazprom has a virtual monopoly on Russian natural gas production and exports.  Its management has very close ties with the Russian government.  Putin has used Gazprom to implement both internal and foreign policy objectives.  Gazprom owns a TV network and a major bank.  Some of its profits were diverted to pay for the incredibly expensive Olympic Winter Games, with billions of dollars ending up in the pockets of oligarchs and government officials.  Overseas, Gazprom has cut off  or threatened to cut off gas supplies to Europe, Ukraine, Georgia, Armenia, the Baltic States, Slovakia and Serbia on orders from the Kremlin. In each case, Gazprom was used as a blunt geopolitical weapon to change another country's democratic or anti-Russian politics.