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.

In the oil and gas sector, Americans must help the Russians and the Kazakhs determine the most efficient export routes for Russian and Caspian oil and arrange financing for these capital-intensive projects. This move would be radically different from the policy pursued in the 1990s, when the United States pushed export routes that tried to free the Central Asian states from Russian and Iranian control rather than pursuing the most economically viable options. Moreover, Lukoil recently stated it would even consider participating in the U.S.-backed Baku-Ceyhan pipeline, which will bring oil from the Caspian to Turkey's Mediterranean coast. As elsewhere, global investors should be free to pick winners and demand corporate reform and increased production when economically justified. Investors remain the best positioned to make demands on those managers who still do not understand that the company's interests are aligned with the interests of its shareholders.

HOW LOW CAN YOU GO?

The emerging battle for market dominance between Russia and Saudi Arabia is a clash between two extremely different cultures and involves radically different agents. True, both the Russian and the Saudi governments are unusually dependent on the revenues generated by oil or gas exports. But this dependence aside, the Russian oil sector is a lot more like the United Kingdom's than it is like Mexico's or Norway's -- let alone that of the former Soviet Union. The Russian government has extremely limited powers over how Russian firms allocate their sales or investments. Moscow can encourage or limit access to pipelines under government control, but it cannot control what companies do.

In contrast, Saudi Arabia is governed by a royal family that sees its interests as part and parcel of the state it rules. The national oil company, Saudi Aramco, is the state's sole instrument for pursuing its aims. Saudi Aramco's commercial interests are those of its shareholder -- the state -- and the society over which its shareholder governs. On the Russian side, however, the state has become increasingly a representative institution that provides for the public good through taxes. Yet it owns a rapidly decreasing amount of the country's energy resources and enjoys no monopoly over the Russian oil industry. The state has ceded this terrain to a group of publicly traded companies eager to expand rapidly in a competitive international environment.

When Saudi Arabia and other OPEC members sought Russian cooperation last fall in managing the international oil market, they had a simplistic and wrong-headed view of Moscow's position. Encouraged after gaining the cooperation of Mexico, Norway, and Oman in a previously oversupplied market in 1998, the Saudis did not understand the new Russia. It was becoming better off financially, but its government remained too weak to actively limit the country's oil exports. Nor was Moscow so dependent on oil revenue that it had to cooperate with the Saudis. Thus Riyadh made a tactical error: it tried to blackmail Moscow by threatening a price war.

Russia did not take kindly to the threat. First, its biggest companies, which had worked so hard in raising oil production over the past two years, especially Yukos and Surgutneftegas, resented any attempts to limit their exports as unwarranted state intervention into corporate plans. They also saw the move as a violation of an explicit agreement between the government and the private sector, in which companies would become more transparent and pay taxes but remain free to grow with less government interference. Second, there was widespread Russian anger at the blunt OPEC effort to blackmail Moscow. Riyadh's oil policy was seen as an extension of Saudi support for Afghanistan's anti-Russian rebels in the 1980s, the independence movement in Central Asia in the late 1980s and early 1990s, the Chechnya conflict, and Islamic educational institutions in Russia -- all considered threatening to Russian interests. But Moscow's reaction was also calculating. Both Moscow and the Russian companies knew that Russia depended far less on the international price of oil than did Saudi Arabia. Some Moscow officials therefore welcomed a price war, which they saw Russia as outlasting. (The income and capital expenditures of Russian firms are ruble-based, so these companies benefit from a ruble depreciation against the dollar.)

Like Saudi Arabia, OPEC was also miffed. Russia's initial rebuff of the approaches of OPEC's leaders, when they sought Russia's cooperation in reducing output, angered virtually all its members. The OPEC countries were annoyed that Russia was increasing its output so aggressively at a time when OPEC countries were restraining themselves. And just as the Russians equated Riyadh's position on oil with Riyadh's support for anti-Russian institutions, the OPEC world saw a direct attack on its own values. From OPEC's perspective, Russia was stealing market share that rightfully belonged to countries with far deeper oil reserves.

From Moscow's perspective, however, Russia was reclaiming lost market share. Indeed, Moscow sees the history of oil in the 1980s as one of a price war declared by Saudi Arabia on all other oil-producing countries. The aforementioned Saudi-engineered price collapse of 1985-86 led to the implosion of the Soviet oil industry -- which, in turn, hastened the Soviet Union's demise. From this perspective, Moscow's companies were simply reclaiming the international market share that had been stolen by Riyadh 15 years earlier.

In any event, both sides decided to declare a truce by the end of 2001. Russia concluded that cooperating with OPEC and other independent oil producers was in its best interest -- for now. In the end, Moscow felt that a price collapse would be bad for the world economy and the stability of oil exports.

Despite the truce, however, the battle is not over. When it comes to compliance in preventing overproduction, Moscow and Riyadh remain suspicious of each other. Russia is increasingly convinced that it could withstand a price collapse better than any of the OPEC countries. Moscow has made no excuse for its inability to fully enforce compliance, but it knows that nature is on its side; tanker loading at the Black Sea and Baltic terminals is always reduced during the harsh winter months. Moscow also believes (rightfully) that its exports are far more transparent than those of OPEC members, whose exports are measured by journalists rather than by government customs data. And Moscow knows that Saudi Arabia has been exceeding its export quotas over the past year far more egregiously than anyone else has. Recriminations will fly from both sides in the months ahead.