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The Fading Arab Oil Empire

June 28, 2012 Topic: OPECEconomic DevelopmentDefenseEnergy Regions: Middle East

The Fading Arab Oil Empire

Mini Teaser: Major developments in the oil sector are decisively undermining the once-defining role of the Middle East in the global energy market. The region’s potency in global affairs is on the wane, making Obama’s pivot to East Asia well-timed.

by Author(s): Paul D. Miller

PRESIDENT OBAMA’S pivot to East Asia is well-timed. The geostrategic importance of the Middle East is vastly overblown. The region matters to the United States chiefly because of its influence in the world oil market, but that influence has been in terminal decline for a generation, a fact almost wholly unnoticed by outside observers. A confluence of developments—including rising prices and production costs, declining reserves, and the availability of alternate fuels and unconventional sources of oil—will decisively undermine the defining role of the Middle East in the global energy market. Meanwhile, the United States has vital interests at stake elsewhere in the world at least as pressing, if not more so, than its interests in the Middle East. These include thwarting the proliferation of weapons of mass destruction, fighting transnational terrorism and maintaining stability in key strategic locations of the world.

For centuries prior to World War II, the Middle East was considered strategically irrelevant. Alexander the Great marched across the impoverished Arabian Peninsula only because it lay between him and his goal: the fabled wealth of Persia and India. The region was merely an expanse to be crossed for traders on the Silk Road between Europe and China in the Middle Ages. The great empires of modern Europe turned to every other region in the world, including Africa, before colonizing the Middle East late in the age of empire because the vast desert appeared to be of little use to them. The British occupied Egypt in the nineteenth century and invested in the Suez Canal not because of anything Egypt had to offer but because it was the fastest way to get to India.

The contemporary strategic importance of the Middle East stems from its comparative advantage in producing oil, a commodity vital to the modern world economy. This comparative advantage is based on four factors. First, Middle Eastern oil is the cheapest in the world to produce because of simple geology. Middle Eastern oil lies under flat desert, not under an ocean or in the Amazonian river basin. In 2008, producing a barrel of oil cost between $6 and $28 in the Middle East and North Africa, compared to up to $39 elsewhere in the world and up to $113 per barrel of oil shale.

Second, most Middle Eastern oil is a superior product. The chemical properties of Middle Eastern “light sweet” crude oil make it easier and cheaper to refine than the “heavy” crude of Venezuela, for example. Third, Middle Eastern oil developers benefit from economies of scale because the cheap oil there is so plentiful. Even today, the region is still home to more than half the world’s proven, commercially viable conventional oil reserves and a third of world oil production. Fourth, the Middle East’s dominance of oil production and reserves makes it “too big to fail,” which effectively lowers producers’ risks. Buyers believe, with justification, that neither the governments in the region nor the developed world would allow a significant disruption to oil production (especially after the embargoes in the 1970s backfired).

This comparative advantage translates into global power and influence because of the modern world economy’s high demand for oil. Oil was used for lighting and lubrication long before the industrial era, but the modern market for oil started in 1886, when Karl Benz invented a machine for automated mobility powered by an internal-combustion engine fueled by refined petroleum. In a remarkably short time, the world abruptly ceased using steam, coal and animals to power the transport of people and goods, transitioning almost entirely to petroleum products. One hundred twenty-five years after Benz patented the automobile, Americans consumed thirty-six quadrillion BTUs of energy from petroleum. This provided 94 percent of their transportation-energy needs and 40 percent of their industrial-energy consumption; it also accounted for more than a third of the nation’s entire energy demand. The United States’ experience has been mirrored in countries across the globe. Global transportation—by car, truck, airplane, bus, motorcycle, boat and even some trains—is overwhelmingly powered by fuels derived from oil.

THESE TWO factors—the Middle East’s comparative advantage in oil production and the world economy’s need for oil to power transport—made the modern Middle East what it is today. The region would not be as strategically important otherwise.

But the Middle East’s comparative advantage in energy production and the world’s need for oil both peaked around 1974, and both have been in long-term decline ever since. In reaction to the oil embargoes and disruptions of 1974 and 1979, the Western world embarked on a generational and largely successful effort at energy conservation. The United States’ energy intensity—a measure of how much energy is used per dollar of GDP—has been cut in half since 1973, falling from 15,400 BTUs per dollar to 7,470 in 2010, according to the U.S. Energy Information Administration. This unheralded success means that because of advances in efficiency and conservation practices, the world economy is less dependent on all forms of energy, oil included, than previously. Additionally, the world’s energy needs are being met by an ever-expanding menu of inputs, including nuclear power and renewable sources. In 2010, petroleum’s share of America’s energy sources was the lowest it had been since 1951. The world economy’s oil intensity, or “the amount of oil needed to produce one dollar of GDP,” in the words of the International Energy Agency (IEA), “has fallen steadily over the last three decades.” That is not the whole story: “The decline has accelerated since 2004, mainly as a result of higher oil prices, which have encouraged conservation, more efficient oil use and switching to other fuels.” The introduction of electric and hybrid cars in recent years, while still in its infancy, promises to accelerate the decline in demand for petroleum-based fuels.

The Middle East’s comparative advantage in oil production also is eroding. It will always have a superior product, but the three other factors comprising its advantage are disappearing. First, oil-production costs in the Middle East are certain to rise. Oil is so cheap in the region because it is easy to get out of the ground. But as the world uses up the cheapest and most easily developed oil, Middle Eastern crude will become more costly to produce. Some fields in the Middle East have been producing continuously for eighty years and are rapidly maturing (meaning they are almost past their peak production). Saudi Arabia in particular has a high percentage of mature or maturing oil fields. Thirteen of the twenty largest oil fields in the world are located in the Middle East, and they all entered production between 1928 and 1968. As a field passes its peak, it becomes more technically difficult and costly to extract its oil. This is especially true once a developer switches to secondary, tertiary and unconventional methods to extract the remaining oil. Production costs in the Middle East inevitably will rise in coming years; that is as certain as the laws of geology and economics. The oil market will be characterized increasingly by harder-to-develop, more expensive oil.

This trend will accelerate as demand for oil increases in the developing world and prices rise. After the oil-price spikes of the 1970s, the rest of the world invested in oil production (and energy conservation). The Middle East’s share of production fell to less than 19 percent by 1985, its lowest point since 1953. Overcapacity then caused prices to collapse, and the Middle East recovered its relative position in the market, but the episode shows what is in store for the future. Prices are on a long-term and relentless increase, driven largely by rising demand in places like China and India; global liquid-fuel consumption is likely to reach 111 million barrels per day by 2035—up from 85 million barrels per day today. Prices have risen sharply since 2002, partly because of political instability in the region but also in part because of the long-term, underlying pressures on the market. This is likely to spur worldwide investment in capacity, further eroding the Middle East’s market share over the next decade.

Second, rising prices are a powerful incentive for producers to develop new production capacity in other regions and through unconventional methods. Oil recovered from secondary and tertiary drilling technology or from shale, sand and deep-water rigs will become more commercially viable as prices rise. The Middle East’s market share will shrink, and other regions will start to benefit from the same economies of scale that Middle Eastern producers have enjoyed, leveling the playing field. Already, the Middle East accounts for a decreasing amount of the world’s proven oil reserves. It accounted for 56 percent of reserves in 2010, its second-lowest point since 1953. This was down from 66 percent in 2002 and below the long-term average of 61 percent over the last three decades. Even those numbers may be inflated; much of the Middle East’s reserve growth in recent decades came in a single leap, from 1986 to 1987, when several states reported sudden and massive increases in their estimated reserves without further exploration or technological development. Industry experts speculate these “paper reserves” were primarily a bargaining tool in negotiations between OPEC states—because OPEC members’ production quotas are linked to their proven reserves, claiming more reserves allows them to produce more. Reported figures since then are unreliable. Even under the inflated numbers, the Middle East accounts for only 46 percent of remaining reserves of oil and liquid natural gas ultimately recoverable with conventional means, according to the IEA.

And that is only “proven” reserves. Proven reserves comprise oil deposits recoverable under current market prices and with current technology. A better indication of a state’s future share of the oil market is its “ultimate” reserves, which include proven, probable and possible reserves. As the world oil price rises and technology improves, possible and probable reserves become proven. In the Middle East, it is likely that a greater share of ultimate reserves is already proven than in the rest of the world. As prices increase and technology advances, therefore—and more possible and probable reserves become economically viable—the rest of the world will see a disproportionately greater rise in proven reserves.

The picture here is stark: when unconventional methods of oil development are taken into account, including development of heavy oil, shale oil and oil sands, the Middle East suddenly becomes a minor player. There may be as many as 7.9 trillion barrels of potentially recoverable oil left in the world from all sources, according to the IEA, with more than 90 percent of it outside the Middle East. The Middle East dominates the currently proven, conventional and commercially viable reserves, but these reserves account for less than 10 percent of the total oil in the world. Once unconventional methods become commercially competitive, the Middle East will be dwarfed by Canada, the United States and Venezuela.

Finally, as the massive unconventional oil deposits become commercially viable, the Middle Eastern oil industry will no longer be too big to fail. Middle Eastern oil producers will lose the implicit discount on risk they gain from dominating the current world oil market. They will, in fact, be dispensable, making it much harder for them to get a free ride on the implicit guarantees and subsidies they currently enjoy from their host governments. As they devolve from global politicians into businessmen, governments will rightly ask if these guarantees make good business sense anymore.

There has been much discussion about when the world will reach “peak oil,” the point at which we will have used up more than half the total petroleum on the planet. That point is a long way off. But the world is approaching—if it has not already passed—an earlier point that is hugely significant for the global balance of power: the peak of cheap Middle Eastern oil. And that means the Middle East’s comparative advantage is eroding. As the price of oil rises, producers elsewhere in the world will be able to invest in larger operations and benefit from the economies of scale that Middle Eastern producers have always had. And as demand, production costs and prices rise, Middle Eastern producers will be competing with the rest of the world in a much tighter market.

SINCE 1945, the United States has rightly sought to prevent any single power from dominating the Middle East’s oil supplies. An oil hegemon, whether Soviet, Baathist, Nasserite, Iranian or Islamist, would have had the capacity to blackmail the United States and the world with economic warfare. To that end, the United States supported anticommunist monarchies and autocracies in Saudi Arabia, Kuwait and Bahrain, among others, during the Cold War. It has armed Saudi Arabia with a staggering $81.6 billion of arms sales since 1950, almost a fifth of all U.S. weapons shipments. It supported Iraq against Iran in the 1980s before fighting Iraq to defend Kuwait and Saudi Arabia in 1990–1991. After the 2001 terrorist attacks, it further bolstered ties in the region, adding Kuwait, Bahrain and Morocco to its collection of major non-NATO allies, which includes Egypt, Israel and Jordan. In 2003, it invaded and occupied Iraq over fears, later proven overblown, that Iraq’s WMD proliferation might give Saddam Hussein or allied terrorists unacceptable leverage in the region. The U.S. military’s Central Command, formed in 1983, has a forward headquarters in Qatar, and the U.S. Navy’s Fifth Fleet is based in Bahrain. This military infrastructure guarantees a long-term U.S. military presence in the region.

Those policies were largely sensible efforts to maintain the security of world energy supplies. However, they make less sense in light of the brewing realities in the world oil market. These developments—the world’s increasing energy efficiency and the Middle East’s loss of its comparative advantage in oil production—will take time to play out fully. But they have been under way for several decades already. In two decades or so, the global oil market and the Middle East’s geopolitical influence will be dramatically different from what they are today. The Middle East will remain an important player, but it will no longer be able to act as the “central bank of oil,” as the princes of Saudi Arabia style their kingdom. Moreover, it will forever lose the ability to credibly threaten to wield oil as a weapon. The sword of Damocles that has implicitly hovered over the West since the 1970s will be gone.

That means the central goal of U.S. foreign policy in the Middle East will essentially be achieved: no power will be able to threaten the United States with unacceptable leverage over the American economy. That is because oil itself will be less important, and the world oil market will be more diffuse and diverse. The importance of this development cannot be overstated. It is a tectonic shift in the geopolitical balance of power, a strategically pivotal development only slightly less momentous than the fall of the Soviet Union. It is the slow-motion collapse of the Middle Eastern oil empire.

In turn, the United States can and should begin to adapt its foreign policy to reflect these realities. It can look with more complacency on the rise and fall of particular regimes across the Middle East and North Africa. The Arab Spring, even if it brings to power moderate Islamist governments, is unlikely to threaten American interests. Washington also can play a less active part in conflicts between states, reverting to a role more like its indirect support for Iraq against Iran and less like its direct involvement in the 1991 and 2003 Iraq wars. Further, it can speak out more freely against tyranny and human-rights abuses, especially in Saudi Arabia, one of the most oppressive countries on earth. It can reclaim its position as the advocate of global liberalism, undoing the damage to the U.S. brand done by its close association with Middle Eastern dictators.

THE UNITED States has additional interests in the Middle East, but they are outweighed by those in other parts of the world. For example, the region is a hotbed of terrorism and may become a major locus of WMD proliferation. But South Asia hosts terrorist groups, including Al Qaeda, that threaten the United States more directly. Further, South Asia is home to two declared nuclear powers. Thus, South Asia—not the Middle East—should be the focus of U.S. counterterrorism and counterproliferation efforts in coming decades.

Additionally, the Middle East has two of the world’s most important choke points for ocean-going trade: the Suez Canal and the Strait of Hormuz. But governments in the region, heavily reliant on exports, have strong interests in keeping trade routes open. Despite Iranian leaders’ recent threats, no government is likely to cut off its own economic lifeline voluntarily. Meanwhile, the Malacca Strait in East Asia will remain important for a diverse array of ocean-going trade for the foreseeable future.

Finally, the United States rightly is committed to Israel’s security. If Iran succeeds in building a nuclear weapon, Israel could face a potential existential threat—the same threat fellow U.S. allies in East Asia, including South Korea, Taiwan and Japan, have been facing from North Korea since 2006. Once again, U.S. interests in the Middle East are no more, and probably less, important than U.S. interests in other regions.

The changing realities of the world energy market do not mean the United States can or should ignore the Middle East. Certainly, Israel’s security and Iran’s behavior will keep the region a focus for policy makers’ attention. But, placed in a global perspective, the United States has more or deeper interests at stake in other regions of the world—especially Europe and Asia—than in the Middle East. Budget cuts are concentrating minds inside the Beltway with newfound discipline. And a new presidential term begins next January, either with President Obama or Mitt Romney taking over. This confluence of events gives American policy makers a powerful opportunity to reassess U.S. grand strategy, along with its attendant military-deployment and force structure. As they do so, they should recognize the emerging realities in the Middle East. Our rationale for guaranteeing the region’s stability in exchange for cheap oil is fading, and that mission quickly is becoming more trouble than it is worth.

Paul D. Miller is an assistant professor of international-security studies at the National Defense University. He previously served as director for Afghanistan on the National Security Council staff from 2007–2009. The views expressed here are his own.

Image: Getty

Image: Pullquote: Our rationale for guaranteeing the Middle East's stability in exchange for cheap oil is fading, and that mission quickly is becoming more trouble than it is worth.Essay Types: Essay