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 long term, Moscow may have far more going for it than Riyadh. Yukos, Lukoil, and other companies are dynamic and growing, and they are now poised to recapture and expand on the production base of the former Soviet Union. Furthermore, they are highly integrated and are forming alliances with international companies, and so they can sell their growing output to enlarging networks in Europe, Asia, and the Americas. Through their joint ventures, they can tap the technology and capital of Western firms in developing new resources, especially in the Far East and the Arctic Ocean.

Riyadh, on the other hand, might have vast known reserves, but it also has a closed state monopoly. Most alarming, Saudi Arabia has been unable for 20 years to increase its production capacity. Nor is its position unique: few OPEC countries in 2002 have more production capacity than they did in 1990 or 1980. The exceptions are countries such as Algeria and Nigeria, whose governments have encouraged foreign investment in the petroleum sector. History does not look kindly on monopoly-company countries. Riyadh has only one clear weapon left: the spare capacity that can be unleashed whenever it chooses to punish those who would challenge its oil supremacy.

WINNERS AND LOSERS

Thanks to the potential growth of Asian and U.S. demand, there could be room in the future for both Saudi and Russian producers to gain market share if they cooperate. But it is more likely that the policies pursued by Moscow and by Washington will restructure the battlefield.

Although Russian oil is not nearly as large in its reserve base or as cheap to produce as Saudi crude, it remains vast and far greater than is generally recognized. Market forces have unleashed a dynamic transition in its oil sector that will allow Russia to challenge OPEC and Saudi Arabia. In an economy governed by market forces, Russian companies are poised to capture the lion's share of growth in demand in China, India, and even the United States, through joint ventures.

The cost structure of the Russian energy industry is a significant factor in the equation. As long as costs are largely ruble-denominated and the ruble is stable, Russian industry is protected from low oil prices, while capital investment flows are sheltered from price volatility. For the Russian government, the situation is more complex, but Russia is also more sheltered from low oil prices than are other exporting countries. Like OPEC exporters, it depends on revenues from export taxes. But unlike OPEC countries, it also takes in significant revenue from domestic sales and from taxes on huge natural gas exports to Europe. Thus the major question is whether Saudi Arabia can afford a sustained price war to block Russian and cis oil development. That feat might require oil at $10 a barrel for two years or more -- a situation as frightening for Riyadh as it is for other OPEC countries.

The critical element that Washington can add is a policy mix that would arrest the growth of U.S. oil demand by adopting a transportation policy that forces greater efficiency. This effort would take the post-September 11 world seriously. If both Washington and Moscow encouraged what their companies and publics already do -- increasing production in both countries while restraining demand in the United States -- the stage could be set for a very new petroleum world. The time has come to recognize that September 11 has opened new vistas for Russia, the United States, and OPEC.