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.

Although the U.S.-Saudi axis is often neglected, it can be blown out of proportion. When the ties between the two countries appeared to fray after September 11, some press reports asserted that this separation of interests was unprecedented. It is true that Riyadh had expressed considerable displeasure with the Bush administration over the U.S. abstention from its former active role in the Arab-Israeli peace process. But even before then, Washington and Riyadh clashed over oil prices; the Clinton administration even pressured other key OPEC countries into increasing oil production.

It would be more accurate, in sum, to see the common interests of Washington and Riyadh as the intersection of two large and unwieldy sets of goals. In both countries, the size and value of that connection have been undergoing serious review since September 11. To the degree that Washington decides to take action to reduce the U.S. economy's dependence on oil, it can greatly affect the scale of increased oil production over the next few decades. It is because of that opportunity that the Russian challenge to Saudi Arabia has become tremendously important.

BUST AND BOOM

It did not take long after the Soviet collapse for Western oil firms, investment banks, and policymakers to begin eyeing the oil reserves of Russia and Central Asia as a competitive alternative to Middle Eastern crude oil. But the region's promise quickly evaporated as investors became bogged down in a swamp of corruption and the difficulties of doing business in rapidly changing economies.

By the early 1990s, as oil exports from the former Soviet states plummeted, Middle Eastern producers started promoting their own energy resources as a cheaper alternative to redeveloping the oil infrastructure of the former Soviet Union. Saudi Arabia and Kuwait even spoke of opening their oil and gas sectors to foreign investment as a way to attract investors who might otherwise look to the post-Soviet Commonwealth of Independent States (cis). Assisting OPEC's efforts were high-profile scandals in Russia and Central Asia and the lack of protection of minority shareholder rights in the Russian oil sector. A wary Western media even questioned the initial estimates of Russian and Caspian oil reserves.

But today, two advantages for the cis are clear. First, its reserves are much larger than previously assumed. Second, oil production capacity in the Middle East has stagnated for 20 years. Indeed, overall OPEC production capacity is actually lower today than in 1980. The Middle East producers have no proven ability to exploit their resources beyond the levels that international companies achieved before they were nationalized in the 1970s. Meanwhile, as exploration and production advance in such places as Kazakhstan, the reserve potential of the cis will enlarge substantially. Eni, ExxonMobil, and others are developing what may be a giant field at Kashagan, estimated to contain 50 billion barrels. Lukoil, Russia's largest oil producer, recently discovered a field of 5 billion barrels of proven reserves in the Russian part of the Caspian shelf; seismic data suggests that the field's vast size could triple the initial estimates inside the license area alone. The discovery rate in Azerbaijan has been, in any case, disappointing, but conservative forecasts show that the Caspian shelf holds 75 billion barrels of oil -- 115 percent of what bp Amoco credited to the entire cis in 2000.

Meanwhile, the Russian oil industry accelerated its consolidation after the 1998 financial crisis ended in a devalued ruble, which in turn enabled Russia to rapidly increase exports. As a result, the industry could focus on developing its known core assets and exploring new assets more efficiently. Russian oil exports began to rise in 2000 for the first time since the Soviet era. By the time Vladimir Putin was elected president in March 2000, Russian firms were ready to capitalize on the internal reforms that they had begun years earlier. Russia's producers also benefited from long-term relationships they had developed with foreign firms, including Conoco, bp Amoco, ExxonMobil, Royal Dutch Shell, Halliburton, and Schlumberger.

Thanks to this process, the cis oil sector is now expected to increase exports by at least 2 mbd between 2002 and 2006. The Baltic Sea's export capacity could grow by as much as 0.4 mbd by 2004, mostly from Russia's four biggest producers through the Baltic Pipeline System. The Caspian Pipeline Consortium, which links Kazakhstan's oil fields to the Russian ports on the Black Sea, will likely add 1.5 mbd by 2006-8. Exports from ExxonMobil and Shell projects in Sakhalin, in Russia's Far East, should add another 0.2 mbd by then as well. Indeed, the resources along Russia's Asian frontier might be as vast as those in Central Asia. And Yukos, Russia's second-largest producer, is preparing to export to China about 0.5 mbd from its fields in eastern Siberia.

To compete with international oil firms and meet the demands of minority shareholders (including foreign investment funds), Russian producers have begun to improve their often awful corporate governance records. The migration toward internationally accepted financial reporting standards has forced them to adopt better managerial and production practices. Efficiency tools such as better software now enable many Russian managers to rationalize production, thereby increasing profitability and the effectiveness of long-term corporate investment. Recently implemented judicial reforms and tax harmonization should translate into a better business environment for all Russian firms.

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