Oil Prices and Regime Resilience in the Gulf

Fareed Mohamedi

Fareed Mohamedi is chief economist at PFC Energy in Washington, DC.

The steady summertime creep of oil prices past $40 per barrel and over an unprecedented $45 surprised most oil analysts, including this one, who were expecting the price to drop after the US-led invasion of Iraq. But no one is likely to have been as stunned as the Bush administration policymakers, like Deputy Secretary of Defense Paul Wolfowitz, who glibly promised post-invasion prosperity for the country “floating on a sea of oil.”

Instead, over a year after the end of “major combat,” insurgents regularly attack pipelines, ports and foreign ships, preventing Iraq from exporting all the oil it can produce. At home, the White House faces Democratic and public pressure to release oil from the Strategic Petroleum Reserve in order to lower gas prices—a move for which candidate George W. Bush castigated the Clinton administration in 2000. Most galling of all to the neo-conservatives must be that higher oil prices, among other factors, have helped political elites in Saudi Arabia, Iran and the Gulf petro-princedoms, once on the regime change wish list, to tighten their grip on power.

Putin’s Pledge

Oil prices broke through the preferred OPEC price range of $22-28 per barrel in the fall of 2002, as it became clear that the US would invade Iraq. War-related anxiety and supply interruptions due to strikes in Venezuela presented the Saudis with an opportunity to reestablish their tarnished reputation in Washington as the “swing producer”—the oil supplier of last resort. Since September 11, 2001, a rising chorus emanating from Washington think tanks had been calling for “replacement” of “unstable” Saudi Arabia with Russia. Russian President Vladimir Putin exploited the panic and assured Bush that Russia would be the new US strategic partner. Mikhail Khodorkovsky, majority owner of Yukos, Russia’s largest recently privatized oil company, traveled to Washington, where he was feted by many of the fretting think tanks. In one particularly amusing moment, Khodorkovsky presented a map of the US and Russia centered on the Bering Strait. Russia was next door, he implied, so it could provide the oil that an “unstable” Saudi Arabia could not. The enthusiasm for Russian oil inflated the stock price of Russian oil companies traded in the US faster than the increase in oil prices during the 1999 and 2002 period. Khodorkovsky and the “oil-igarchs” made more money from Wall Street than from oil.

But in December 2002 and January 2003, when the Venezuelan strike occurred, there were no extra Russian supplies to offset the decline in Venezuelan production. Russia’s privatized oil industry, driven as it is by profit, cannot sit idle and save its production capacity for the day when extra oil is needed. Only one country, for purely strategic reasons, has resolved to do that: Saudi Arabia.

Meanwhile, a fundamental change occurred in Saudi Arabia’s relations with Russia. The Bush administration’s disregard for the UN Security Council in its march to war deeply alienated not only European allies but also Russia and China. As a result, in early 2003 the Kremlin seemed to step back from pledges of a rapid rise in oil production made to Bush in Crawford, Texas after September 11. Domestic economic reasons also prompted Putin to shift his stance. Russia’s “economic recovery” had largely come about because of higher oil prices, higher export revenues and better cooperation from the oligarchs in paying their taxes. Since very little fundamental restructuring of the economy had been achieved, a collapse in the oil price would return Russia to the economic chaos of the late 1990s. Moreover, Putin’s offer of help on the oil price went largely unrequited by US economic assistance. By 2003, the safer bet for Russia was higher oil prices.

Saudi pleas to the Bush administration not to invade Iraq also went unheeded. With Russia in the mood to cooperate, the Saudis sent Crown Prince Abdallah to Moscow in August 2003 to forge an agreement on a host of issues including cooperation on the oil front. It is not clear what the specifics of the agreement were, but there have been apparent changes in Russia’s oil policy. Russia stopped positioning itself in the oil markets as a competitor to OPEC. The government refused to cede control over the country’s extensive pipeline system—the key instrument for managing oil exports. Putin also doubled taxes on the local oil companies, dampening investment and prospects for sharp increases in future supplies of oil. Finally, he imprisoned Khodorkovsky, “nationalized” his shares in Yukos and sent a clear signal to investors that oil production and prices would be used to serve the ends of the state.

The Iraq Factor

Some observers have maintained that the US invaded Iraq for its oil. After the invasion, they may have been surprised by the utter incompetence of the US-British occupation authority and companies such as Halliburton in securing the hydrocarbon riches. Unsecured oil sector facilities led to rampant looting and theft of crude oil and products, while a neglect of the power sector shut down refineries and left pumping stations idle. Iraqi output since May 2003 has fluctuated between 1.5 and 2 million barrels per day, well below pre-invasion levels.

Political disarray has delayed the onset of “new” oil from Iraq. Foreign oil companies had welcomed the prospect of the opening of the Iraqi oil sector, something they had hoped would happen with smart sanctions and along the lines of what Saddam Hussein’s government had proposed as far back as 1990. While they did not in general support the war because of the inherent risks, oil companies did begin to study the assets and the means of securing contracts to develop the country’s vast resources. However, they recognized that the competition for Iraq’s oil sector was going to be intense and that the terms were going to be fairly lean. The extent of the unrest within the country caught them by surprise, as did the pushback of plans to establish a legitimate government with whom they could sign contracts to 2006. Most international companies, while maintaining a keen interest in the Iraqi oil sector, have adopted a wait-and-see posture.

The prospect of the return of Iraqi oil in sizable quantities had threatened to upset the cooperation between OPEC members which had kept prices well above $20 a barrel despite a world recession in the wake of September 11. Some member states felt that Saudi Arabia had gotten the lion’s share of the market share that Iraq had ceded in the 1990s. Out of fairness, these states argued, they should be able to produce and sell more oil once Iraq returned. Dissension within OPEC ranks could have led to a price war.

The persistent and apparently insoluble problems of the Iraqi oil sector, at least in the short run, combined with the long delays in new investment completely erased the fears that OPEC would have to deal with higher flows from Iraq. In fact, the war removed Iraqi flows right after Venezuelan production went offline and put another dent in world crude oil stocks. As a result, OPEC was producing full tilt with Saudi Arabian output reaching over 10 million barrels per day for a short period. The last time the Saudis produced at that level was in 1979 during the Iranian oil workers’ strike that contributed to the downfall of the Shah. OPEC cooperation is intact.

Waiting for More

International oil companies have invested heavily in high technology to extract the remaining petroleum in non-OPEC countries and seek out fresh discoveries. But in general, even as new upstream oil developments in Brazil, West Africa, the Caspian and Russia come online, they are barely offsetting the declines in production in an increasingly mature non-OPEC oil patch. The international oil companies and national oil companies that operate in non-OPEC areas are finding it harder to raise output and are watching their costs rise as a consequence of maintaining current output.

Moreover, for the international oil companies, the number of places to invest outside of OPEC countries is shrinking. In general, higher oil prices have considerably tightened terms in most countries and, in some cases, have dissuaded governments from making their sectors available for investment because at these prices their own national oil companies have adequate financial resources to get the job done. As a result, more international oil companies are chasing after a diminishing set of assets. Most OPEC governments, especially those in the Gulf, know this and are essentially waiting for world oil demand to accrue to them.

After the war, world economic growth began to recover in ways that were kind to the oil and finance ministers of the Gulf—home to roughly two thirds of the world’s proven petroleum reserves. The 2003 recovery had two poles of growth: the US economy, which was boosted by a massive fiscal and monetary stimulus, and China. Between 2002 and 2003, Chinese oil consumption grew by nearly 40 percent. Since its domestic production remained stable, Beijing had to order a massive increase in imports, which came largely from the Gulf. Cash infusions like this, coupled with the trends toward decline in production elsewhere in the world, are reminders of the continuing geostrategic importance of Gulf reserves. The John Kerry campaign platform’s call for less dependence on “Middle Eastern” oil rings hollow in light of these developments. The US and the world will continue to become more dependent on supplies from the Gulf as long as oil consumption grows. Given structural changes taking place in China and India and consumer hostility (exploited by politicians) to suppressed hydrocarbon demand in the US, consumption is more than likely to keep growing.

Closing the Opening

Low oil prices in the 1990s looked like the harbinger of political liberalization in the Gulf countries. The need to develop gas resources prompted some observers to speculate that economic reforms, including a greater role for private investment, foreign and local, would follow. Political and economic reforms would be self-enforcing. A political opening would bring political stability and confidence, encourage investment and set the country on a new sustainable growth path. Several governments in the region signaled just these intentions. Crown Prince Abdallah signaled a “gas opening” in 1998 which would be the cutting edge of a much wider opening in the infrastructure and industrial sectors of the economy, followed ultimately by the Kingdom’s accession to the World Trade Organization. Bahrain, Kuwait and the United Arab Emirates all received membership faster by tearing down barriers to entry for foreign businesses. Even Iran passed a new investment law, a new banking law and freed trade in a large number of goods and services.

But now the regimes have far less incentive to take these new regulations seriously. High oil prices have stabilized budgets and led to accumulation of foreign assets. The confidence of the skittish private sector in the Gulf economies is back. Gulf businessmen have also grown concerned that their investments in the West could be frozen or nationalized as part of the “war on terrorism.” These businesses have repatriated sizable funds to invest in local real estate and stock markets. So without much effort in the way of reform, Gulf governments have solved the chronic financial problems of the 1990s and even restored some buoyancy to their economies. Job creation has been lagging, but by closing parts of the economy to foreign workers and through stronger growth, the regimes have stanched growth in unemployment.

In the wake of the invasion of Iraq, anti-American sentiment has grown in the region, leading to an increase in violence. Ominously for world oil supplies, terrorists have pointedly targeted oil sector facilities in Saudi Arabia. Unsuccessful in hitting these targets, the terrorists began going after foreigners, some of whom work for the oil industry. These attacks have added another risk premium to prices, further boosting the foreign earnings of Saudi Arabia and other oil-producing governments.

Higher oil prices exacerbated by direct and indirect US attempts to change the political landscape in the Middle East have fortified these regimes. They have been further bolstered by an adroit use of political “reforms”—elections to national and local parliaments, for example—which pretend to give a greater voice to the population. Governments have also positioned themselves “on the side of the people” on issues like Palestine and the invasion of Iraq. All in all, the invasion of Iraq and the neo-conservative dreams of regime change leave the current Gulf state system—rentierism and authoritarianism—more resilient and robust then at any time in the last 20 years.