Room for Growth

Politicians in Washington are grappling with how to address rising gasoline prices, but most of their answers—from repealing tax breaks for oil companies to expanding offshore drilling—are unlikely to make much of a difference any time soon. The Arab awakening, coupled with Iran’s accelerated pursuit of nuclear weapons, ensures that energy prices will likely remain elevated for a long time. In the near- and long-term, those events are leading to less energy produced and exported from the Middle East and North Africa than there otherwise would be, as well as greater risk to their transport. Among the more important things the United States could do to arrest this course of events and improve the global economy is lend its fullest support to restoring Iraq’s oil industry.

The most immediate and direct threat to oil supply is the turmoil occurring in oil-exporting nations. The countries that have experienced the most upheaval—Libya, Syria, and Yemen—are relatively small energy players. In 2010 they collectively produced about 2.3 million barrels per day and exported approximately 1.5 million barrels per day, or less than 2 percent of the 86.7 million barrels per day that were consumed globally. Libya, however, produces a high quality variety of oil for which there is no spare global production capacity, and therefore its drop-off in production has contributed to a boost to prices.

The Arab unrest also means the transit of oil has become more risky, thereby increasing prices still further. There are three key chokepoints in the region: the Strait of Hormuz, through which 17 million barrels per day, or one-third of the global oil trade, passes; the Suez Canal and Sumed Pipeline in Egypt, through which 3 to 4 million barrels per day pass; and Bab el-Mandeb, between Yemen on one side and Somalia, Djibouti, and Eritrea on the other, through which over 3 million barrels per day pass. In Egypt, the breakdown of authority has already led to attacks on the natural gas pipeline in the Sinai, which feeds Israel and Jordan. The most threatened chokepoint in the near-term, however, remains Bab al-Mendeb. Despite hundreds of millions of dollars in U.S. military assistance to Yemen, pirate attacks off the Yemeni and Somali coast remain frequent. And if Yemen slides into even greater chaos, oil tankers in the region will be further endangered.

We must expect that the Arab upheaval will percolate and occasionally erupt over many years. That is because the turmoil is the result, in part, of structural factors: Many of the states are not cohesive nations, but artificial constructs, and almost all have experienced demographic booms resulting in legions of unemployed young people. More immediately, there are various local factors at play, including, depending on the country, authoritarianism, corruption, lack of economic development, sectarianism, secessionism, and religious extremism. Clearly, these issues will not all be resolved in the near-term.

Moreover, we should also expect, as energy analyst Edward Morse has argued, that the energy-exporting countries that experience conflict will not restore their energy production to pre-conflict levels anytime soon. Such has been the case in recent decades: Iran’s current oil production is only about 60 percent of its peak output under the Shah in 1974; Iraq’s output is only 77 percent of its 1979 peak, the year before the Iran-Iraq war began Iraq’s economic spiral; Venezuela’s production is only about 69 percent of the pre-Hugo Chavez peak in 1998; and Russia’s output is 87 percent of the 1987 Soviet-era peak. Of course, each of these countries has distinct reasons for its output problems—including wars, breakdown in government controls and security, and political interference—but overall, the pattern remains clear: Political turmoil often leads to long-term declines in a country’s energy sector.

Finally, whatever challenges the Arab upheaval presents, it is Iran’s nuclear development that poses the greatest strategic threat to the United States and will perhaps have the greatest impact on the oil market. According to the research of Blaise Misztal, Associate Director of Foreign Policy at the Bipartisan Policy Center, Iran has overcome delays caused by the Stuxnet virus and has raised the efficiency and output of its antiquated centrifuges by over 50 percent in the last year, getting awfully close to developing nuclear weapons capability. Aiding the Iranian nuclear effort has been the spike in oil prices. About half of Iran’s state revenue derives from oil exports, and because international sanctions and other factors have caused its oil production to decline about 17 percent over the last three years, it can only increase revenue through higher oil prices. No single non-military factor would likely limit Iran’s revenue and therefore hinder its nuclear program as much as low oil prices.

A nuclear Iran would further embolden the agitated Shia populations in Bahrain and oil-rich Saudi Arabia. Some oil-producing neighbors would likely feel compelled to accommodate Iran’s desperate need for higher oil prices by agreeing to scale down their production. Such a scenario also has the potential to set off a proliferation cascade across the Middle East, radicalize the region, end hope for an Arab-Israel peace, allow nuclear materials to reach Iran’s terrorist allies, and perhaps back up the country’s threats to destroy Israel. As these developments play out over months and years, a significant conflict in the Middle East, possibly involving the United States, will become more likely, and the region’s long-term oil supply unreliable. The net result will be soaring oil prices.

Over the past three decades, whenever there was a major disruption of supply, the United States could often count on Saudi Arabia to utilize some of its spare oil production capacity, sometimes after some pleading. This not only benefitted the U.S. and the global economy, but it also offered the Saudis significant extra revenue and geopolitical leverage, with an added bonus of precluding the development of alternative fuels that would compete long-term with its ample oil reserves. But this time around, after suggesting in late February that they would make up for any supply shortfall from Libya, the Saudis declared in April that they actually reduced oil production. Riyadh claimed it was because the market was sufficiently supplied. Experts differ on what Saudi production actually has been in recent months and why it made the April  statement. Lawrence Goldstein, a leading energy expert, argues that the Saudis were responding to market conditions, but he acknowledges that the Saudis’ unusual April declaration certainly invited the perception of a possible political motivation. Indeed, it has been widely reported that the Saudis have been furious at the Obama administration’s public calls for Egyptian leader Hosni Mubarak to step down, its warnings to the Bahraini and Saudi governments not to forcibly repress demonstrations, and for other U.S. policies that the Saudis perceive to have undercut their security.

Regardless of the April incident, the Saudis now have other reasons for not wanting to tamp down oil prices. Fearful of further domestic turmoil, major oil-exporting regimes have been very keen to maximize their revenues in order to lubricate their social welfare systems. For example, the Saudi king recently pledged $130 billion in additional social spending, which equates to about two-thirds of the country’s approximately $200 billion in oil export revenue in 2010. As a result, the price of oil that Riyadh needs to balance its budget is expected to increase from $68 per barrel in 2010 to $110 per barrel in 2015. Other regional governments have also increased their social spending recently and thus the implicit breakeven price for their oil. While the Saudis, alongside other countries with large energy reserves and small populations, have historically sought relatively moderate oil prices, it’s likely that they will now demand a higher price range to help satisfy their newfound dire needs for greater revenue.

Furthermore, the demand to calm a restive populace does not just lead to a greater need for revenue, but also means there will be less oil to export than there otherwise would be. This is because regimes in the region which feel threatened will need to continue to subsidize domestic fuel consumption at the same or even higher levels lest a domestic price spike create more political turmoil. This should contribute to continued, if not accelerated, growth in consumption, leaving even less oil to be exported. (The major exceptions have been Iran and Iraq, which have reduced their gasoline subsidies in recent years for different reasons.) In fact, oil-exporting countries in the Mideast have been among the leading sources of global energy consumption growth over the last decade.

While the United States cannot count on Saudi Arabia to the same extent as before, the one development in the region that can partly offset a deleterious rise in future oil prices is the recent growth in Iraq’s energy sector. The least developed OPEC country, Iraq offers the greatest growth potential in oil supply over the next decade, as well as the possibility of supplying Europe and Asia with significant quantities of natural gas and liquid natural gas. A relatively stable Iraq would be an energy superpower. Its oil reserves could equal Saudi Arabia’s, and its production capacity could potentially equal current Saudi capacity as well. After inking deals to scale up oil production in the country in 2009, oil companies are now investing a great deal of money in the country and Iraqi oil output is rising beyond the production range it has experienced since 2004. The country now produces about 2.7 million barrels per day and has the potential to more than double that figure in several years.

Increased oil production in Iraq, moreover, will not only benefit the U.S. and the global economy, but in the zero-sum game of the global oil market, growth in Iraq’s oil and gas sector will come at the expense of Iran. Constrained by declining output volume, Iran’s energy revenues can only grow significantly through higher prices, while Iraq—after long under-utilizing its vast potential—has the potential to advance its economy through increased oil export volume. Iranian and Iraqi production goals are therefore in direct conflict, in other words, and it is an important U.S. interest to help Iraq and hurt Iran. (Notably, Saudi Arabia might at some point significantly raise its oil production for the sole purpose of undercutting Iran, but it cannot play that role now to the same extent as before due to domestic pressures.)

The success of Iraq’s oil sector, however, is by no means guaranteed. To ensure continued production and export growth, the country’s challenge—beyond maintaining political stability and security—is to expand and secure its existing oil export routes to Turkey and the Persian Gulf, as well as to diversify into new routes that can serve both Asian and Western markets. Indeed, diversification of exports is essential to Iraq’s energy security, as well as that of the global economy. The Iraqis, in principle, appear to understand this, but they seem to be going about some of it the wrong way. For instance, Baghdad signed a memorandum of understanding with Damascusto build a new export line through Syria, which makes little sense: More crude oil can be shipped to the Mediterranean by expanding the Turkish pipeline, while the real demand growth is coming from Asia. A Syrian line would also seem counter to Iraq’s strategic interests, given that Syria has been a transit point for jihadists entering into Iraq over the years. It would also undermine U.S. strategic interests, since an export pipeline would offer greater revenue to the Assad regime and help it stay afloat amid severe domestic unrest. Instead, Iraq should build an export pipeline to the Red Sea in Aqaba, Jordan, an alternative that offers an opportunity to export oil both to Asia, where demand is growing, and to Europe and the United States.

The Obama administration can help Iraq achieve greater energy security. It should discourage Baghdad from pursuing a Syrian pipeline and encourage the building of a Jordanian line. The administration should also discuss with Iraq the importance of the U.S. Fifth Fleet continuing to play its role beyond this year in helping protect Iraq’s offshore oil export terminals—through which most of Iraq’s oil exports flow—until the country’s navy is strong enough to do so alone. Whatever the United States can do to support and secure Iraq’s energy growth will not only facilitate Iraq’s economic development, but will also bolster U.S. economic and strategic objectives.

Of course, it’s impossible to predict exactly how the Arab awakening and Iran’s nuclear program will develop. But as matters stand today, both developments will have negative short- and long-term impacts on the U.S. energy security. Yet, by helping Iraq’s energy sector to grow securely, the United States can mitigate a portion of these unfavorable trends while bolstering a crucial ally in the region.

Michael Makovsky, a former energy market analyst at investment firms, is Foreign Policy Director of the Bipartisan Policy Center and director of its Meeting the Challenge series on U.S. policy toward Iran.

Originally appeared in The New Republic on May 16, 2011.