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.

RUSSIA VS. SAUDI ARABIA

The American campaign against terrorism may be grabbing the headlines, but another battle is being waged with perhaps equally significant long-term implications: the contest for energy dominance between the world's two largest oil exporters, Saudi Arabia and Russia. This battle will have fundamental consequences for the world's economy, U.S. energy security, Russia's global role, the future relevance of Saudi Arabia, and the clout of the Organization of Petroleum Exporting Countries (OPEC).

The contest emerged suddenly and unexpectedly. For each of the past two years, Russia has quietly but persistently increased its annual oil output at a rate of nearly half a million barrels a day (mbd) -- the largest single increment of increased output of any country in the world. With the world economy and world oil demand stagnating, Saudi Arabia and its OPEC partners therefore opted to reduce their output by 3.5 mbd. Then, on January 1, 2002, OPEC cut output by another 1.5 mbd to stave off a price collapse. Even though Moscow made a symbolic cut in output as well, OPEC has not welcomed Russia's gain at the cartel's expense.

Russia and the Soviet successor states can easily continue to increase oil output at this rate for years to come. The victims of that increase, in all likelihood, will be Saudi Arabia, Kuwait, and other oil producers with state monopoly companies that disallow foreign investment. The only oil not threatened by Russia's rise is the petroleum developed by international companies outside of the key OPEC countries of the Middle East.

The Russian increases have come as a surprise, especially for OPEC. As recently as 1996, oil output from the post-Soviet states amounted to barely 7 mbd. Many people forgot that Moscow's state-owned enterprises once produced more than 12.5 mbd before the Soviet collapse -- the largest amount of oil ever produced by a single country, representing one-fifth of global production. That sum is one-third more than Saudi Arabia's peak share at the end of 2000.

After undergoing tremendous transformation since the fall of the Soviet Union, Russia's firms have arrived on the world stage. Although vast room for improvement remains, Russia's oil leaders have largely transcended their robber-baron days. Backed by improved rule of law, they are seeking to protect their new wealth and meet the performance criteria dictated by the financial markets, especially because their firms' shares are now publicly offered. As a result, they are beginning to reinvest capital at a rapid rate. Thanks to them, Moscow is poised to assume a far more significant position in the world petroleum sector than ever before.

Russia's oil revival has coincided with a downturn in the global economy and the first major reduction in the global demand for oil since the early 1980s. The nearly 1 mbd increase in its production over the last two years came at a time when OPEC cut output, thus losing market share, to put a floor under prices. Not surprisingly, Moscow's motivations are being questioned and are often seen as an attempt to grab power in the global arena. But Russia's petroleum revival has also coincided with the terrorist attacks of September 11, which have provided Moscow a chance to displace OPEC as the key energy supplier to the West. Moscow's political leaders, as well as its corporate leaders in oil and gas, are portraying Russia's oil firms as stable sources of supply, willing to add output to the market to keep prices reasonable and thus revive the global economy. In the eyes of these leaders, the new geopolitics of energy can help Moscow gain both economically and politically. In economic terms, energy production lets Russia integrate itself into the industrialized West. In political terms, energy resources can be used to buttress Moscow's goal of becoming a key partner of the United States.

KING OF THE HILL

Even before September 11, concerns had been raised over American reliance on Middle East oil. Global oil demand has been increasing by between 1.5 and 2 mbd each year, a rate of growth with alarming long-term consequences. The U.S. Department of Energy and the International Energy Agency both project that global oil demand could grow from the current 77 mbd to 120 mbd in 20 years, driven by the United States and the emerging markets of South and East Asia. The agencies assume that most of the supply required to meet this demand must come from OPEC, whose production is expected to jump from 28 mbd in 1998 to 60 mbd in 2020. Virtually all of this increase would come from the Middle East, especially Saudi Arabia.

A simple fact explains this conclusion: 63 percent of the world's proven oil reserves are in the Middle East, 25 percent (or 261 billion barrels) in Saudi Arabia alone. As the largest single resource holder, Saudi Arabia has a unique petroleum policy that is designed to maximize the benefit of holding so much of the world's oil supply. Saudi Arabia's goal is to assure that oil's role in the international economy is maintained as long as possible. Hence Saudi policy has always denounced efforts by industrialized countries to wean themselves from oil dependence, whether through tax policy or regulation.