Slawomir Raszewski - Research Associate at the European Centre for Energy and Resource Security (EUCERS) in the Department of War Studies, King’s College London, United Kingdom
Resume: The global energy market continues to be driven by the political economy of oil production and trade. Energy markets have come full circle returning to their fundamentals: oil is there to stay and play an important role in the era of slow melting of the oil surplus.
Crude oil returns as a key commodity on the global oil market and, therefore, a closer look is needed to identify the main challenges and opportunities. This article attempts to give an insight into the dynamics in the Middle Eastern oil and gas market and the way it shapes the global energy situation.
The “war of attrition” within the Organization of Petroleum Exporting Countries (OPEC) for the retention of the market share has raised a question of the cartel’s future and, more broadly, changes in the political economy of the Middle Eastern oil market. With the impact of U.S. shale production being the “usual suspect” in international oil market discussion, the rivalry between the Islamic Republic of Iran and the Kingdom of Saudi Arabia opens yet another chapter of what seems to be a steady demise of the function OPEC was set to play at the time of its establishment. The Iranian-Saudi rivalry, which reverberates in conflict-ridden Syria and Yemen, is the key development that affects the global oil order in a profound way. The petroleum cartel’s main function—oil price-setting by production-adjusting—was put into question at OPEC’s November 27, 2014 meeting. Following the meeting, commentators pointed out to structural changes within the group, involving OPEC’s cohesion and ability to manage the oil market. OPEC’s long-standing policy of defending the oil price by setting the group’s output ceiling to prevent a reduction of revenues from international oil trade has been the key “weapon” OPEC has had at its disposal to defend a “fair price” of crude. Indeed, since its foundation and throughout the “oil shocks” of the 1970s, OPEC was the key player in the international political economy of petroleum trade exercising the production-quota leverage, a power which the group arguably no longer enjoys. Recurring oil price crises have been pushing the group into reaching out to the non-OPEC producers to alleviate the impact of ups and downs of the global oil market’s supply and demand sides. At the backdrop of the structural changes, the group’s consultations with non-OPEC producers such as Russia, the world’s third largest oil producer, provide for a new mechanism of oil governance. It is believed that Saudi Arabia’s unquestionable leadership and its ability to influence international oil dynamics are reaching their limit and a more dynamic oil outlook may be emerging in the coming years. Considering volatile trends on international oil markets and possible changes in the global oil supply and demand, the Saudi domination may be further undermined by the arrival of new market players. The “usual suspect” in this respect is the U.S. unconventional production, which in a large part has been idle in response to the Saudi-Iranian market share competition. Shale oil is there to stay due to the robustness and scalability of smaller projects. Any loss of Saudi Arabia’s oil output parity within OPEC is likely to strengthen Iran’s position on the market. However, Asia is likely to remain Tehran’s main export destination.
Iran’s Re-Entry to International Oil Markets
The lifting of the international sanctions against Tehran in January 2016 brought Iran away from economic isolation, opening up the way for increased exports of crude to global oil market. With the energy sector in mind, Iran has embraced the focus on oil export maximization, inevitably influencing the price of oil as it is re-integrating into the world economy. According to the International Monetary Fund (IMF), the Iranian economy outlook is likely to be positive for both oil and non-oil economy. Yet the ongoing transition to lower oil prices is putting pressure on exporters, which can only be mitigated by higher oil export volumes in order to increase oil revenues. Post-sanctions forecasts assume that the potential growth of oil production in Iran in the short- to mid-term with the natural gas supply will continue. The Iranian oil production rebound took many analysts by surprise; and, contrary to what was expected to take years, the Islamic Republic’s production has reportedly returned to the pre-sanctions levels. According to the International Energy Agency, Iranian supply of oil rose to almost 3.6 million barrels per day (mb/d), a level last hit in November 2011, that is, before the tightening of the sanctions.
Increased production of Iranian crude is a trend that puts the country in a very interesting position on the markets as it is regaining its production levels to the pre-sanctions levels and improving Iran’s export standing. With circa 2mb/d earmarked for exports, Iran is currently right after Iraq (nearly 4.4 mb/d) and Saudi Arabia (nearly 10.20 mb/d), which remains at the helm of OPEC’s exporters. In the global oil perspective, Iran is the fourth-largest producer after Iraq, Saudi Arabia, and the Russia Federation. Iran enjoys a fairly solid portfolio of consumers, mainly outside of Europe. The key export destinations of the Iranian oil include China, Japan, and India—countries that have seen substantial demand over the last couple of months. Unrestricted production and exports of oil by the Iranian government puts the National Iranian Oil Company (NIOC) in a unique position. At the same time, it raises the question of production ceilings. The statement by the Saudi Arabia’s new Oil Minister Khalid Al Falih suggests scepticism over Iran’s ability to continue further acceleration of Iranian oil production.
Externalities are still looming high on the Iranian economic re-integration agenda. What still holds Tehran back is the remaining international sanctions that keep the main banking players away. With the ongoing “war of attrition” with Saudi Arabia over the market share, Iran is seeking options to fully resume business activities in the oil sector, but that is still likely to take some time.
Saudi Arabia’s Overproduction and Oversupply
OPEC’s Doha talks held on April 17, 2016 aimed to achieve the first global oil deal in fifteen years among the world’s major oil producing nations. However, the meeting failed to produce conclusive results. The fiasco of the Doha talks coincided with the rise of Prince Mohammed bin Salman Al Saud, the deputy crown prince of Saudi Arabia and minister of defense, as the key oil decision-maker of Saudi Arabia. Prince Mohammed’s stance on the low price of oil and insistence on a collective (including Iran’s) freeze of oil production indicates the Saudis’ readiness to continue increasing the crude output. Saudi Arabia’s decision resulted in upholding the “oil glut” by continued overproduction, with the primary reason behind Saudi’s actions being to turn its crude into “oil weapon” that could wipe out Iran from the global oil competition. As a result, Saudi Arabia’s crude oil production reached nearly 10.2 mb/d in April 2016, making it the largest oil producer globally.
Yet the face of Saudi petroleum is changing. It is driven by new ideas and Prince Mohammed’s conviction about the inevitable need to shift away from dependence on oil revenues in the long-term perspective. A blueprint of broader economic and social changes in Saudi Arabia includes the creation of the world’s largest sovereign wealth fund with more than $2 trillion in assets; restructuring Saudi Aramco, the Kingdom’s energy champion; diversifying away from petroleum assets; and, thus, ending the Saudis’ nearly total dependence on oil revenues. Saudi Arabia’s plan to pursue a large-scale modernization of its economy to reduce its dependence on crude sales includes expanding the manufacturing industry, partly by employing oil-based chemicals to produce materials that can be used in the manufacture of other consumer products (such as plastics). This political shift is likely to receive substantial support among energy consuming regions. The country was criticized for its excessive use of energy in the past, and reform of its energy market and, above all, the problem of energy subsidies are yet to be tackled. Saudi Arabia’s internal energy consumption levels have been discussed in the context of energy efficiency and progressive liberalization of the system that relies heavily on state subsidies. The move towards economic diversification is a step to address both internal and external energy challenges, which in the future may even lead to liberalization of the energy sector to meet the ambitious assumptions set out by the Saudi leaders.
Saudi Arabia and Yemen
While much focus has been devoted to the Syrian civil war and its regional and international impact, much less attention has been paid to the tip of the Arabian Peninsula. Conflict-torn Yemen has been the key bone of contention between Saudi Arabia and Iran. Following the end of the Yemeni civil war, a coalition of Arab countries led by Saudi Arabia has supported the domestically contested Yemeni government while conducting airstrikes of what it considers armed rebels, the Houthis. Saudi Arabia-Yemeni relations have a long history of political animosity, a trend that continues to the present day. Yet the latest conflict comes at a very complex time. Post-sanctions Iran has been voicing opposition to Saudi Arabia’s military intervention in Yemen, seeing it as leverage to change the balance of power in the region. The Saudi Arabia-led coalition in Yemen has been backed by nine Arab states. The United Arab Emirates (UAE) had been Saudi Arabia’s main supporter up until June 2016 when it decided to stop combat operations to exert pressure on the Saudis. The termination of combat operations by the UAE is likely to change the situation on the ground in Yemen and limit Saudi Arabia’s ability to fight a proxy war. Any change in the balance of power in the conflict holds the promise of benefiting the interests of the Islamic Republic, Saudi Arabia’s main regional rival.
Iraq and the Kurdistan Regional Government
The oversupply of oil has had impacts on other existing and prospecting producers in the Middle East. Iraq, the second-largest OPEC producer after Saudi Arabia, has been seeking to increase its oil output up to 6 mb/d by 2020, a strategy that is viewed with scepticism by major oil companies operating in the country. In 2015, the Iraqi federal government’s ability to pay national oil-producing companies was affected by the financial situation, which had worsened due to low prices of oil and the war in the north of the country. Internal Iraqi politics—the federal government’s conflict with the Kurdistan Regional Government (KRG) and political infighting in Bagdad—puts a strain on the country’s plans to increase oil production.
Fragmentation of the Iraqi energy governance structure remains a key challenge. The long-standing controversy over the oil revenue sharing between the central government in Baghdad and the KRG has been exacerbated by the low price of crude oil, hitting the oil-based revenues and prolonging the quarrel between Bagdad and Erbil.
Political and security challenges in Iraq are high on the agenda as they have increased volatility of the bargaining power between Erbil and Baghdad, especially with regard to the status of the oil-rich Kirkuk region. The KRG capital of Erbil has witnessed oil revenue falling significantly, which, in turn, has coincided with a political upheaval and uncertainty in Baghdad. The KRG’s geopolitical focus—interconnection to Turkey and ability to export crude oil directly to consumers via Turkey—has benefited Erbil’s external trade options while disengaging if from the central government in Baghdad. Exports of the KRG oil have continued by pipeline to Turkey, generating significantly lower revenues due to low oil prices. The KRG exported circa 0.5 mb/d in May 2016 using the oil pipeline. Both Iran and the KRG expect new transportation and transit options to strengthen the latter’s position on the oil market. Amid the disagreement between Baghdad and Erbil, suggestions were made in 2014 to connect the KRG with Western Iran by a dedicated oil pipeline. If completed, this oil pipeline will secure and diversify the KRG’s oil supply and go into competition with the existing Turkey-bound outlet. The pipeline lends a new dimension to the controversy over how revenues should be managed and shared between the Kurdish regional authority and the central government in Bagdad. The KRG says it is ready to strike a deal with the central government subject to a share of $1 billion a month. While such a deal is rather unlikely in the current political context, advancing the Iran-championed oil pipeline would enhance the KRG’s economy.
Turkey, Israel, and Russia
Outside of the OPEC countries of the region, Turkey is likely to start a new phase in its relations with Israel and Russia. Turkey and Israel witnessed steady deterioration of relations since the Justice and Development (AKP) party came to power in Ankara. Their relations deteriorated sharply following the 2008 Davos developments and, two years after that, the Gaza flotilla raid by Israeli defense forces. The Turkish-Russian political spat is a recent foreign policy dilemma for Ankara. The shooting down of a Russian military aircraft by Turkish forces in the vicinity of the Syrian-Turkish border in November 2015 brought the Ankara-Moscow cordial policy dialogue—including in the energy domain—to a standstill. While Ankara’s policy of reconciliation with Israel and Russia is yet to be established, it is already opening up a number of energy opportunities. The cancellation of the $11 billion-worth Turkish Stream pipeline project designed to diversify Russia’s gas export routes was a serious blow to Ankara’s hopes for securing additional sources of supply to meet the country’s growing energy demand. The warming up of Russia-Turkey relations facilitates rapprochement and, as emphasised by the head of Russia’s Gazprom, the natural gas company is ready for dialogue. After more than six years of the split between Israel and Turkey, on the June 27, 2016, both parties announced a reconciliation deal. The normalization of Israeli-Turkish relations is expected to boost energy security and energy diversification or, more broadly, economic cooperation in the energy sphere. Israel’s offshore production is largely intended for export and requires long-distance pipelines to deliver gas to consumers. If implemented, both the Turkish Stream connection to Russia via the Black Sea and the offshore interconnection to Israeli gas infrastructure will enhance Ankara’s long-standing aspiration to become a regional energy trading hub.
Iran-Saudi Relations: The Litmus Test for Global Oil Supply
Current political and economic developments in the Middle East have reverberated around arch-rivalry between Tehran and Riyadh. In the petroleum domain, the conflict between the two regional powers is quintessentially economic. Iran’s reintegration into global economy and its potential gains from the post-sanctions trade in oil put pressure on the Saudis as well as other OPEC and non-OPEC states. Within OPEC, Saudi’s insistence on cutting production to an agreeable level backfires due to the difficulty of ensuring full compliance and enforcement of the decision by the group members. Beyond OPEC, the Saudis’ focus on Iran alone is unlikely to provide any measured response to the global oil supply. Indeed, a production freeze will make little or no effect even if complied with by Tehran, given oil production by Russia, which is not an OPEC member. The only way for the Saudis to achieve any significant result is to act together with Russia and Iran. Following the meeting between Saudi Prince Mohammed and Russia’s President Putin it was announced by Russian Energy Minister Alexander Novak on January 27, 2016 that Moscow was prepared to discuss a supply cut of 3-5 percent, or 300,000=500,000 barrels per day (b/d). There is, however, little evidence the deal can be made and, as market leading analysts say, it is unlikely to materialize.
* * *
The global energy market continues to be driven by the political economy of oil production and trade. The Middle East continues to play an enormous role in the global supply of crude oil, while that of OPEC has diminished. Production outside of the group has been ramped up in recent years by new supply from unconventional production in the United States, a trend which is likely to continue impacting the conventional production. The evidence of that has been the Saudi-Iranian rivalry over the market share following Iran’s re-entry into the international oil trade at pre-sanctions levels. Energy markets have come full circle returning to their fundamentals: oil is there to stay and play an important role in the era of slow melting of the oil surplus.