Energy Security: How Valuable is Caspian Oil?

Lucian Pugliaresi

Lucian Pugliaresi is the president of LPI Consulting, Inc. in Washington, D.C. LPI Consulting provides advisory services on petroleum developments and environmental policy. Mr. Pugliaresi worked on energy security issues at the National Security Council during the Reagan Administration.

* * *Summary

The United States has invested considerable political resources with the goal of developing Caspian Sea energy resources and ensuring they flow to markets through countries that are friendly to the U.S. However, estimates of the volumes of Caspian oil are quite modest. According to analysts, Caspian oil will achieve peak production of between 3 and 5 million barrels per day over the next 10 to 20 years. Even if Caspian oil development potential improves, production from the region is not likely to meet even 5 percent of 2020 world demand.

Considering the assessments of modest quantities of Caspian oil, why has this region received such high-level attention from Western governments? The answer to this question lies in the field of energy security: additional supplies, even at modest levels of output, can make an important contribution to limiting the market power of the major producers as well as reducing to some extent the percentage of world oil production subject to disruption. Therefore, this marginal oil can bring about a lowering of prices and can enhance energy security.

Background

Due to the concentration of low-cost reserves in the Persian Gulf, the Saudis and some of the Gulf producers are likely to play a growing role in regulating oil prices and may be in a position to exercise, or even be politically motivated to exercise, considerable monopoly power on oil prices. In recent years, the major Persian Gulf producers have been successfully limiting output to sustain higher prices. Under these circumstances, any new worldwide production ends up reducing the net demand for Saudi and Gulf oil by an equal amount. Such shifts in net demand for Gulf petroleum can act as a catalyst to encourage the Saudis to adopt a lower price strategy. It is in these instances that new (marginal) production can provide very large benefits by reducing the import costs for all consuming countries across the entire volume of petroleum imports.

Thus, since the early 1990s the United States has attempted to diversify energy sources through petroleum development among the successor states of the Soviet Union. Among other foreign policy objectives in the region, the U.S. has focused on oil production and transport because of its potential to make an important contribution to U.S. energy security. Of particular interest to U.S. policy makers are the oil and gas producing countries of Azerbaijan, Kazakhstan, and Turkmenistan. In addition, Georgia and Turkey have important roles as transit points for moving oil to western markets. Turkey is also a principle consumer of oil and gas from the region.

U.S. policy initiatives to encourage new production have not been limited to Central Asia and the South Caucasus. The U.S. has invested considerable effort in encouraging institution building and investment-friendly legislation in Russia to promote petroleum development there as well as a host of similarly modest efforts in Latin America and Africa.

The Energy Security Problem

The energy security problem is a direct result of the concentration of low cost petroleum resources in the Persian Gulf- a small, distant, and at times unstable region. From the perspective of the major oil importing countries, such a large concentration of low cost reserves presents two kinds of vulnerabilities or risks.

The first vulnerability stems from the possibility that a relatively small number of producers could restrict output to the world market, and as a result, charge prices over the long term that are substantially higher than those which would prevail in more competitive markets. One could argue that restricting output and achieving higher prices is in fact the very purpose of OPEC, although, until the 1999 price recovery, the organization had not been very effective at achieving this since the late 1970''s. Higher prices result in wealth transfers from consuming countries to producing countries. Of course, the reverse trend occurs when prices move downward.

An important consequence of the 1973-74 Arab oil embargo was a structural shift in the ownership and control of the vast Gulf resources. By changing expectations on future production levels of the major Middle East oil producers, the 1973-74 Arab oil embargo brought about a sustained increase in the value of oil. As Middle East reserves were nationalized and transferred to the control of the host countries, expectations for future production from the region were scaled back and prices responded accordingly.

The so-called second oil price shock in 1979 can be seen in a similar light, as the Iranian Revolution sent a signal that the region was in for a period of instability. The prior view that future output from Iran and Iraq would expand substantially was no longer plausible. The point here is that in both cases, prices were affected by changing expectations on future production levels. In both cases, the severe economic losses experienced by the consuming countries coupled with the fear of physical shortages led Western countries to put into place a range of energy security initiatives, some of which remain in effect today (e.g., strategic petroleum stocks).
The second vulnerability is the potential for a disruption in supplies, either short or long term, to the world market. Such a disruption could occur either from a conflict or revolution in a major producing region. An interruption in Middle East supplies clearly would raise short-term prices worldwide and bring about large wealth transfers from importers to exporters. Whether a short-term disruption would lead to a medium or long-term increase in prices would depend on whether a large volume of reserves was removed from the market and on the speed and cost at which new supplies could be developed. In any case, the long-term value of petroleum would clearly shift upward substantially if access to the world''s largest low cost reserves were denied to the market. Any such price shift would bring about severe economic dislocations and impose related security concerns on the West.

A key feature of the world oil market is that oil is a fully integrated commodity (e.g. factors affecting prices and flow in one place affect the overall price of oil). Thus a disruption in supplies from the Persian Gulf or a reemergence of restrictive production policies by Middle East oil producers (as occurred after the 1998 price collapse) harms both the U.S. and the other oil importers based on the economic value of petroleum in each country''s economy and not based upon the level of imports from specific regions. In today''s integrated market, a supply disruption anywhere leads to a price increase everywhere. However, as long as a relatively small volume of oil can adjust to price signals, supplies will be reallocated in very short time periods. Accordingly, there is great importance to ensuring diversity of suppliers.
To address these vulnerabilities, associated with the market power of producers as well the potential for a disruption in supply, several policy instruments are called for. Among the more important are:

1. Strategic Petroleum Reserve: The role of the SPR is to ameliorate the costs of a disruption and dislocation to the domestic economy by releasing supplies in an emergency and muting the price increases. Whether Western governments can effectively manage this policy instrument is an open question.
2. R&D: Research and development of alternative sources of energy. Such an effort was viewed as highly important at one time, but now is relegated to more modest levels. This effort is heavily dominated by conservation and environmental interests and remains under $1 billion per year. There is clearly an important role for government in undertaking long-term research into alternative energy sources, but historical analysis suggests the alternative fuels of the future will largely be driven by private sector initiatives.
3. Sustaining Political/ Military Alliances in the Gulf: U.S. policy in the Persian Gulf and with the Arab world is not a single purpose strategy. The U.S. is a close ally of Israel, concerned about Iranian acquisition of weapons of mass destruction, and containment of Iraq. However, within these constraints, U.S. policy seeks to maintain a strong political/military relationship with key producers, e.g., Saudi Arabia, Kuwait, Qatar, and UAE, Oman. Such an approach seeks to keep the Gulf open to freely traded supplies and it seems that the U.S. presence in the region acts as a force to lower (but not necessarily eliminate) the chance of conflict in the Gulf.

Diversification of Supplies Outside the Persian Gulf: The Caspian Contribution

While Caspian oil may provide only a small percentage of total world production, since these new supplies are added "at the margin" they can have disproportional impact on world oil prices and erode some of the political control of the OPEC states. These additional supplies, even at modest levels of output, can make an important contribution to limiting the market power of the major producers as well as modestly reducing the percentage of world oil production subject to disruption. Therefore, this marginal oil can bring about price reductions and/or limit increases across the entire volume of oil consumed by importing countries. Thus, a final component of U.S. energy security strategy is the diversification of supplies to regions outside the Persian Gulf, such as the Caspian Region. Even a modest reduction in world oil prices offers large-scale benefits to a major oil-importing country like the United States, which is likely to be importing 15 million barrels per day in 2020.