Courtesy Reuters

Oil and Unrest

What Uprising in the Arab World Means for Energy Supplies

With political unrest spreading across the Middle East and North Africa, 2011 might turn out to be as momentous a year for the global geopolitics of oil as was 1971. Many of the factors behind the current protests -- high unemployment, large income disparities, rising costs of living (especially for food), and ruling gerontocracies and kleptocracies -- have their roots in the emergence of the region's petro-states, a process that was cemented that year.

In 1971, the oil-producing countries of the Arab world tried to shift the balance of power between themselves and Western oil companies and consumers. Libya -- negotiating on behalf of itself and Algeria, Iraq, and Saudi Arabia -- declared that they, and not foreign companies, would set the price of oil flowing into Europe. As a result, prices to Europe, the main market at the time for traded oil, increased by 35 percent overnight. At the same time, members of the Organization of Petroleum Exporting Countries (OPEC) raised taxes on oil companies from 50 percent or less to as much as 80 percent. Also in 1971, Libya nationalized BP's oil concession in the country, and Algeria nationalized 51 percent of the French company CFP's operations.

That same year, the United States pulled out of the Bretton Woods system and moved away from the gold standard, effectively devaluing the dollar; OPEC, whose oil receipts are denominated in dollars, compensated by raising prices. Meanwhile, Libya began to use what Muammar al-Qaddafi, who had taken power in 1969, called his country's "oil weapon" against the West. The nation reduced its output from 3.35 million barrels a day in 1970 to 2.25 million by 1972, dropping even further to 1.6 million in 1973, when the Arab countries invoked an oil embargo in order to raise prices and revenue. In short, 1971 marked the beginning of a new era.

The oil trade that followed was marked by inherent conflict. As one OPEC country after another nationalized its oil industry, the integrated nature of the global oil trade, in which the international majors owned everything from the wellhead to the means of wholesale delivery, began to fall apart. Companies started looking elsewhere for oil, but with less success now that they no longer enjoyed easy access to low-cost supplies.

Oil pricing became a zero-sum game: every rise in prices benefited producers at the cost of consumers, and every reduction in price benefited consumers at the expense of producers. Producers grew skeptical of markets and saw an array of potential plots against them, from consumer taxes on gasoline to efforts to replace oil with natural gas and renewable energy sources. And they blamed speculators rather than their own production levels for higher prices. Governments that came to rely on oil revenues grew unwilling to share the gains, at least at first, with their populations -- a trend that came to be known as the "resource curse."

Then the price of oil began a nearly two-decade slide. Between 1981 and 1985, the price of oil fell from $35 a barrel to $10, and then stabilized at around $20 a barrel for much of the 1990s (although it did plunge once again in 1998 to $10). Over the same period, the populations of OPEC countries started to mushroom, as both life expectancy and fertility rates rose. With oil revenues falling and populations growing, per capita income began to decline. Yet governments did little to diversify their economies; in fact, oil-producing states did not begin to invest in diversification and increase spending on social welfare until the spectacular rise in oil prices. (Other oil producers, Libya among them, did not even try.)

This neglect contributed to the many factors underlying the current wave of civil unrest, especially to the region's stagnant incomes and unemployment rates. Now, with the contagion spreading to the oil-congested area of the Arabian Peninsula and Persian Gulf, the likelihood of an oil apocalypse is no longer implausible: in such a scenario, domestic upheaval would bring civil strife and violence, which in turn would lead to a reduction or cessation of oil production. A true apocalyptic scenario would see these events take place in major producers such as Saudi Arabia.

To date, unrest in Egypt has led to a limited and localized disruption in energy supplies from or through the country. Egypt is a modest exporter of natural gas, both through shipments of liquefied natural gas by sea and via pipeline to neighboring Israel, Jordan, Syria, and Lebanon. An explosion in early February on the major Egyptian pipeline in the North Sinai disrupted flows to neighboring countries for a short while. (It remains unclear if the explosion was an act of sabotage or an accident.) But even more important, neither the Suez Canal (through which about nine percent of total global trade, including oil, flows) nor the Sumed pipeline (which brings about 1.5 million barrels of oil a day from the Red Sea to the Mediterranean) have been disrupted.

The ongoing violence in Libya has had a more consequential impact on oil prices. To date, some 750,000 barrels a day of Libyan crude oil have been lost; Saudi Arabia claims to have replaced all of that supply. But Libyan and Saudi oil are not interchangeable. Libya's crude oil is known for its high quality: most of the 1.5 million barrels a day that the country produces is light and sweet, which means it is low in sulfur (hence its "sweet" smell) and is easily refined into high-demand petroleum products such as gasoline and diesel fuel. Only 25 percent of global crude is of similar quality; the loss of Libyan crude represents about nine percent of that pool. Saudi oil, however, is heavy and sour, making it -- at best -- an imperfect substitute for Libyan supply. Moreover, the Libyan export market is concentrated in the Mediterranean, with oil going mainly to Italy, France, Spain, Switzerland, and Germany. Thus, compared to oil from most Middle Eastern countries, the loss of Libyan oil has an especially pronounced effect.

Political unrest has spread to neighboring Algeria, whose crude oil is also light and sweet. Together, Libya and Algeria produce close to 2.7 million barrels of oil and natural gas a day. This is a significant figure: for comparison, Iran and Yemen, two other energy-producing countries undergoing domestic turmoil, supply 2.4 million barrels a day.

Civil demonstrations have also cropped up in Bahrain, a small country that is a bridge away from Saudi Arabia's Shia-dominated Eastern Province, the site of most Saudi oil production and reserves. Similarly, Oman has witnessed mass protests, and activists in Saudi Arabia are calling for them, too. The specter of political turmoil in the Gulf countries raises fears over the disruption of oil supply at the Strait of Hormuz, through which about one-third of the global seaborne oil trade flows, carried by 30 large tankers a day. More than 75 percent of all oil consumed in Asia travels this route.

Two issues of concern about Saudi Arabia have arisen. The first is the protection of its oil facilities, including major oil and gas separation plants and transit points, from terrorist attacks. The second is whether the country really can, as it has claimed, produce 12.5 million barrels a day, about 4.5 million above its OPEC quota. For every barrel of oil Saudi Aramco produces to replace lost crude oil from Libya or elsewhere, Saudi Arabia has a barrel less of spare capacity. The possibility of price spikes in the future is directly correlated to fears that Saudi Arabia does not actually have this level of spare capacity.

The many domestic factors that have led to the recent turmoil across the region are not going to disappear in 2011. Virtually no oil-producing country in the region has been able to diversify its economy away from oil. Almost all are seeing domestic oil consumption rising rapidly as governments subsidize gasoline, diesel, and power in an attempt to deliver material well-being to their citizens. Cheap energy is critical to the legitimacy of these regimes, making price spikes politically difficult. So far, only Iran has been able to raise domestic gasoline prices -- and that is only because of its lack of refining capacity and the squeeze of the U.S.-led embargo on gasoline deliveries to the country. Oil consumption within the Gulf countries rose from 4.8 million barrels a day in 2000 to 7.8 million in 2010, eroding exports and raising the minimum price of oil needed for oil-producing states to break even on their extraction and production costs. As a result, those states dependent on oil from the region are facing troubling prospects: a near-term loss of supply due to the current disruption and a longer-term loss of supply due to growth in domestic consumption.

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