The Battle for Energy Dominance

Edward L. Morse and James Richard

From Foreign Affairs, March/April 2002

Summary:  Thanks to a steady increase in oil output in recent years, Russia is now poised to displace Saudi Arabia as the key energy supplier to the West. But the kingdom has not welcomed Russia's gain. The emerging contest for oil dominance between Russia and Saudi Arabia will profoundly affect U.S. energy security, Russia's global role, Saudi power, and the Organization of Petroleum Exporting Countries, not to mention the global economy.

Edward L. Morse is Executive Adviser at Hess Energy Trading Company and was Deputy Assistant Secretary of State for International Energy Policy in 1979-81. James Richard is a portfolio manager at Firebird Management, an investment fund active in eastern Europe, Russia, and Central Asia.

Saudi strategy focuses on three different political arenas. The first involves the ties between the Saudi kingdom and other OPEC countries. The second concerns Riyadh's relationship with the non-OPEC producers: Mexico, Norway, and now Russia. Finally, there is Saudi Arabia's link to the major oil-importing regions -- most importantly North America, but also Europe and Asia.

Given the size of the Saudi oil sector, the kingdom has a unique and critical role in setting world oil prices. Since its overriding objectives are maximizing revenues generated from oil exports and extending the life of its petroleum reserves, Riyadh aims to keep prices high as long as possible. But the price cannot be so high that it stifles demand or encourages other competitive sources of supply. Nor can it be so low that the kingdom cannot achieve minimum revenue targets. The critical balancing act of Saudi foreign policy, therefore, is to maintain oil prices within a reasonable price band. Stopping oil prices from falling below the minimum level requires cooperation from other OPEC countries and occasionally from non-OPEC producers. Preventing oil prices from rising too high requires keeping enough spare production capacity to use in an emergency.

This latter feature is the signal characteristic of Saudi policy. The kingdom can afford to maintain this spare capacity because of the abundance of its oil reserves and the comparatively low cost of developing and producing its reserve base. In today's soft market, in which Saudi Arabia produces around 7.4 mbd, the kingdom has close to 3 mbd of spare capacity. Its spare capacity is usually ample enough to entirely displace the production of another large oil-exporting country if supply is disrupted or a producer tries to reduce output to increase prices. Not only does this spare capacity help the kingdom keep prices in check, but it also serves to link Riyadh with the United States and other key oil-importing countries. It is a blunt instrument that makes policymakers elsewhere beholden to Riyadh for energy security. This spare capacity is greater than the total exports of all other oil-exporting countries -- except Russia.

Saudi spare capacity is the energy equivalent of nuclear weapons, a powerful deterrent against those who try to challenge Saudi leadership and Saudi goals. It is also the centerpiece of the U.S.-Saudi relationship. The United States relies on that capacity as the cornerstone of its oil policy. That arrangement was fine as long as U.S. protection meant Riyadh would not "blackmail" Washington -- an assumption that is more difficult to accept after September 11. Saudi Arabia's OPEC partners must also cooperate with the kingdom in part to prevent Riyadh from producing a glut and having prices collapse; spare capacity also serves to pressure key non-OPEC producers to cooperate with Saudi Arabia when necessary. But unlike the nuclear deterrent, the Saudi weapon is actively used when required. The kingdom has periodically (and brutally) demonstrated that it can use its spare capacity to destroy exports from countries challenging its market share. This tactic is the weapon that Saudi Arabia could use if Moscow ignores Riyadh's requests for cooperation.

Saudi Arabia has triggered its spare capacity twice in recent history, once when prices were especially low. Both cases demonstrated that the kingdom will accept those low prices so long as it suffers less than its targets do. In 1985, Saudi Arabia successfully waged a price war designed to force other oil producers to stop "free riding" on Saudi oil policy. That policy meant that those states had to cooperate with the kingdom by reining in production enough to allow Saudi Arabia to produce the minimum level that it targeted. Oil prices fell by more than half within a few months, and Saudi Arabia immediately regained the market share it had lost in the preceding four years, mainly to non-OPEC countries.

Then, in the 1990s, OPEC member Venezuela challenged Saudi Arabia by deciding to maximize its production. Although Venezuela had an OPEC quota of 2.3 mbd, Caracas embarked on an ambitious policy designed to eventually triple its production capacity. Caracas knew it could not do this on its own, so it reopened its nationalized resource sector to foreign investment. By the winter of 1996-97, Caracas was producing 3 mbd, knocking Saudi Arabia from its position as number one supplier to the United States. In response, Riyadh first tried reasoning with Caracas. When diplomacy failed, Saudi Arabia raised its production by close to 1 mbd and induced the oil price collapse of 1998. Riyadh's actions were tough but effective. By engineering a price drop, it had to withstand a painful drop in income -- but it achieved its main goals. Saudi Arabia reasserted its OPEC leadership, reestablished itself as the prime supplier of oil to the United States, and induced non-OPEC producers Mexico and Norway to support OPEC's revenue-maximizing goals.

UNCLE SAM NEEDS THEM

Riyadh's relations with Washington are much more complex than they appear on the surface, because they involve unspoken understandings and a number of useful fictions. September 11 has complicated these understandings, because the publics in both countries are suspicious of the cooperation between the two governments. Washington recognizes Saudi Arabia's critical role in the global oil sector, especially Riyadh's price moderation. Saudi Arabia, in turn, plays its Washington cards diligently. The kingdom has protected its position as the top U.S. supplier. Today, Saudi Arabia supplies around 1.7 mbd of the roughly 10 mbd imported into the United States -- a market share higher than that of any competitor. The kingdom maintains this share to show how important Saudi supplies are to the United States. The Saudi leadership can thus ensure that Washington will help defend Saudi Arabia, which means not only the defense of the kingdom's oil fields and territorial integrity but the defense of the House of Saud.

This role does not stem directly from Saudi Arabia's position as the world's largest supplier. Indeed, if oil trading were left to market forces, the kingdom's oil exports to the United States would fall by half. Instead, Saudi Arabia pays a price for its market share, a price that fluctuates each month as market forces change. Saudi Aramco, the state oil company, earns about $1 a barrel less on sales to the United States than on sales to the countries of Europe and East Asia. That discount translates into a subsidy to U.S. consumers of $620 million per year. In return, the United States deploys military forces in the Persian Gulf, which is of course also expensive. And given U.S. sensitivity to Riyadh's policy concerns on an array of issues, from the Arab-Israeli peace process to Kosovo to Central Asia, Washington pays the additional price of being constrained in its own foreign policymaking.

One of the hidden aspects of the relationship is the Saudi dependence on the United States for providing an expanding market. Although Asian demand for oil is expected to grow dramatically in coming decades, no other economy rivals that of the United States for the growth of its oil imports. Over the past decade, the increase in the U.S. share of the oil market, in terms of trade, was higher than the total oil consumption in any other country, save Japan and China. The U.S. increase in imports accounts for more than a third of the total increase in oil trade and more than half of the total increase in OPEC's production during the 1990s. This fact, together with the fall in U.S. oil production, means that the United States will remain the single most important force in the oil market. The hope of Saudi Arabia and OPEC for an increased market and for greater market share is uniquely dependent on growth in U.S. demand. Hence it is not for security alone that Riyadh depends on the United States but for the very economic basis of the Saudi regime, which relies almost entirely on oil for revenue.