The New Axis of Oil

June 1, 2006 Tags: DiplomacyOil SandsPeak Oil

The New Axis of Oil

Mini Teaser: A structural shift in energy markets creates new geopolitics.

by Author(s): Flynt Leverett Pierre Noel

WHILE WASHINGTON is preoccupied with curbing the proliferation of weapons of mass destruction, avoiding policy failure in Iraq and cheering the "forward march of freedom", the political consequences of recent structural shifts in global energy markets are posing the most profound challenge to American hegemony since the end of the Cold War. The increasing control that state-owned companies exercise over the world's reserves of crude oil and natural gas is, under current market conditions, enabling some energy exporters to act with escalating boldness against U.S. interests and policies. Perhaps the most immediate example is Venezuela's efforts to undermine U.S. influence in Latin America. The most strategically significant manifestation, though, is Russia's willingness to use its newfound external leverage to counteract what Moscow considers an unacceptable level of U.S. infringement on its interests. At the same time, rising Asian states, especially China, are seeking to address their perceived energy vulnerability through state-orchestrated strategies to "secure" access to hydrocarbon resources around the world. In the Chinese case, a statist approach to managing external energy relationships is increasingly pitting China against the United States in a competition for influence in the Middle East, Central Asia and oil-producing parts of Africa.

We describe these political consequences of recent structural shifts in global energy markets by the shorthand "petropolitics." While each of these developments is challenging to U.S. interests, the various threads of petropolitics are now coming together in an emerging "axis of oil" that is acting as a counterweight to American hegemony on a widening range of issues.1 At the center of this undeclared but increasingly assertive axis is a growing geopolitical partnership between Russia (a major energy producer) and China (the paradigmatic rising consumer) against what both perceive as excessive U.S. unilateralism. The impact of this axis on U.S. interests has already been felt in the largely successful Sino-Russian effort to rollback U.S. influence in Central Asia. But the real significance is being seen in the ongoing frustration of U.S. objectives on the Iranian nuclear issue. This will likely be a milestone in redefining the post-Cold War international order--not merely because Iran is likely to end up with at least a nuclear-weapons option, but because of what that will imply about the efficacy of America's global leadership.

Structural Changes

THE AGE of oil has clearly entered a new chapter, as strong demand and a shortage of productive capacity have generated a significantly higher trading range for crude oil than the world has experienced during the last twenty years. The dramatic rise in demand has been fed by high economic growth in emerging markets (where the increments of energy demand associated with specific increments of economic growth are usually greater than in OECD countries), particularly China and India. Overall, surging demand for crude oil from emerging economies has been the most immediate factor exerting upward pressure on prices.

A second element defining the recent structural shift in the international oil market is shrinking surplus productive capacity all along the supply chain. (Global oil supply has increased in recent years, but not as much as demand.) The degree that oil producers around the world expand their productive capacity is likely to be the most important factor affecting oil prices in the future. Not surprisingly, one finds a range of views about the possibilities for relieving the current supply "crunch."

There is significant evidence that there is, in fact, more oil to be discovered and produced, or recovered from already-producing fields, around the world--at the right price and with appropriate levels in investment. Thus, we do not share the unrelieved pessimism of those who argue we have reached the peak point of global oil supplies. However, we are also not inclined to accept the unrestrained optimism of some economists, who argue that high prices will, as they have in the past, necessarily attract the investment required to expand production relative to demand growth. Our skepticism flows primarily from the reality that the upstream oil sector--the exploration and production of crude oil--is far from an open and competitive environment. After 25 years of massive investment by multinational oil companies in exploration and development in oil-producing areas outside of OPEC and the former Soviet Union, the cost of replacing reserves in this "competitive fringe" of the oil industry, where the upstream sector has been relatively open, is now rising rapidly. Meanwhile, a high proportion of the remaining areas suitable for comparatively low-cost renewal of reserves, mostly in the Middle East and former Soviet Union, are off-limits to the international oil industry.

The next quarter-century of the oil age will therefore look quite different from the previous quarter-century: The rise in demand and the decline of several non-OPEC countries' production will have to be met by increased supplies of conventional oil from the Middle East and the former Soviet Union, as well as by unconventional oil (oil shale, tar sands and extra-heavy oil) and synthetic liquids (gas-to-liquids, coal-to-liquids and bio-fuels). Prices will likely be much higher on average and more unstable than in the past, with demand continuing to bump up against productive capacity.

There is an explicitly political dimension to these developments. As the "competitive fringe" of the upstream oil sector has been exploited by the multinational oil industry, the percentage of the world's oil reserves held by publicly traded international oil companies (IOCs) has declined, while the percentage held by state-owned national oil companies (NOCs) has increased. Currently, 72 percent of the world's proven oil reserves are held by NOCs. The ten-largest upstream companies in the world, measured by booked reserves (not market capitalization or production), are all NOCs. ExxonMobil--the largest publicly traded IOC in the world and the iconic symbol of "big oil"--is only the twelfth-largest upstream company in the world in terms of booked reserves. This means that NOCs and their parent governments, not IOCs and their shareholders, ultimately control the pace of development of upstream oil and gas resources.

Under current conditions of rising demand and tight supply, this is giving energy-exporting countries a more subtle but also more durable basis for enhancing their influence and generating new strategic options for themselves than that displayed by OPEC during and immediately after the 1973-74 oil embargo. Only now is the world seeing the full extent of the "OPEC revolution" of the early 1970s: Beyond an explicit cartel of oil producers, there is today an implicit cartel of resource-owning governments that control a large share of the world's known reserves of oil and natural gas. The power of this implicit cartel has been dormant for three decades; its actualization is an event of major economic and political significance that is generating critical challenges to America's regional interests and global standing.

Markets and the Russian Agenda

RUSSIA STANDS as perhaps the leading exemplar of supply-side trends. After several years of uncertainty and contestation, President Vladimir Putin has successfully reasserted a definitive measure of state control over Russia's upstream oil and gas sectors, with NOCs like Gazprom and Rosneft playing increasingly important roles, the country's pipeline network firmly in government hands, Russian private-sector companies operating within parameters established by Moscow, and formidable barriers in place to large-scale foreign investment.

Suggestions just a few years ago that Russia could supplant Saudi Arabia as a swing producer for the global oil market were misplaced. There is no evidence that Putin or other senior leaders aspire to such a status, or that the Russian oil industry could muster what it would take to play such a role. Nevertheless, under Putin's presidency the internal conditions have been established for Russia to derive a significant measure of external leverage from its status as an important energy producer. In this regard, Putin wants to use Russia's presidency of the G-8 this year to transform Russia's international status from that of a mere (albeit major) energy supplier to that of a global supplier of energy security.

Moscow is using its market power to push back against the United States in arenas where it perceives U.S. infringement on its interests. Since the collapse of the Soviet Union, the list of accumulated Russian grievances over U.S. initiatives has grown ever longer: NATO enlargement, abrogation of the Anti-Ballistic Missile Treaty, basing of U.S. forces in Central Asia, the Iraq War and support for the "color revolutions" in states neighboring Russia. Through the late 1990s, Russia's ability to respond to these provocations was negligible. The Russian military was bogged down in Chechnya, and low oil and gas prices contributed to economic weakness--epitomized by Russia's 1998 currency crisis--making Russia dependent on the United States and other international players for assistance. In recent years, however, Russia's autonomy has been reinforced by high energy prices, and Putin and his advisors have decided they can use this market power to "push back" against the United States.

Russia's unfolding strategy for bolstering its influence in the "near abroad" exemplifies this approach. In some cases, as in the recent controversy over Russian gas shipments through Ukraine, the Kremlin's initiatives seem heavy-handed and not particularly productive. But its approach has been quite effective in establishing a new sphere of influence in the Eurasian south.

Much Western commentary on Russian policy in Central Asia has focused on Moscow's recent successes in establishing military bases in Kyrgyzstan and Tajikistan and encouraging Uzbekistan to evict U.S. military personnel from the Karshi-Kanabad air base. The real stow, however, is rooted in energy and Russia's rising market power. Since 2003, Moscow has worked assiduously to establish a new sphere of influence in Central Asia, using regional autocrats' interest in resisting U.S. pressure to democratize, and China's interest in avoiding "encirclement" by U.S. forces, to maximize pressure on America. Russia's status as a major energy producer has given it important tools for pursuing Putin's regional strategy: investment capital with which to assume a leading role in the development and marketing of Central Asian energy resources (with NOCs like Gazprom acting as effective agents of Kremlin policy) and control over access to Russia's state-owned pipeline system, which is essential for moving Central Asian oil and gas to markets in Europe.

Less directly, the oil boom of the last few years has fueled much higher rates of growth in the Russian economy, helping to turn the Russian service sector into a provider of jobs for Central Asian expatriates. Remittances from the expatriate workers constitute an increasingly important source of income for several Central Asian states--perhaps as much as 30 percent of GDP in Tajikistan, for example--which gives Moscow another lever of influence over these states.2

Russia has also used its energy-based market power to bolster its political influence in other strategically vital regions in ways that could potentially weaken America's international position. Perhaps most notably, Moscow has taken advantage of its market power to reinforce and enhance its otherwise sagging strategic position in East Asia. Although geopolitical legacies and existing transportation infrastructure orient Russian energy exports toward Europe, Moscow has used the prospect of substantial energy exports from eastern Siberia and the Russian Far East to markets in East Asia to make itself a major factor in the foreign policies of both China and Japan, playing on the interests of Beijing and Tokyo in balancing traditional sources of hydrocarbons from the Middle East in their energy profiles.

The Asian Challenge

OF COURSE, the market power of energy suppliers like Russia is an outgrowth of escalating demand-side pressures. As noted earlier, increased demand, especially from emerging Asia, has been one of the most important factors exerting upward pressure on oil prices since 2003: According to the U.S. Department of Energy, 40 percent of oil-demand growth worldwide since 2001 has come from China alone. Despite a slowdown in China's oil-demand growth in 2005, many market forecasts show demand growth in Asia continuing at impressive rates for years to come.

In the current climate, the political impact of these demand-side pressures is exacerbated by consumer countries' increasing reliance on statist strategies to secure access to hydrocarbon resources on privileged bases, rather than relying solely on international markets to meet their energy needs. The best example of this approach is China's. In 2002, around the time that Hu Jintao became general secretary of the Communist Party, China formally adopted a "going out" (zou chu qu) policy of encouraging its three major NOCs--the China National Petroleum Corporation (CNPC), the China National Petrochemical Corporation (Sinopec), and the China National Offshore Oil Corporation (CNOOC)--to purchase equity shares in overseas exploration and production projects around the world, and to build pipelines, particularly to Siberia and Central Asia. The goal of the "going out" strategy is to secure effective ownership of energy resources and transportation infrastructure, measures that China perceives as essential to improving the country's energy security. The adoption of the policy was effectively a codification of long-standing practice, as Chinese energy companies had already engaged in these activities since the 1990s.

China has pursued the "going out" strategy in a wide range of oil-producing regions, including the Caucasus, Central Asia, East and South Asia, Africa and Latin America. In the Middle East, China has employed the strategy in various ways with a number of oil-producing states, including Algeria, Egypt, Iran, Libya, Oman, Saudi Arabia, Syria, Sudan and Yemen. Beijing supports the efforts of Chinese energy companies to win deals with regular high-level visits to and from regions in which the companies are seeking access. China also follows up its network of energy deals by increasing exports of manufactured goods and capital to countries where its NOCs are operating. In some cases, the Chinese appear willing to put expensive packages of side investments on the table in order to secure energy deals, as was recently the case in Angola and Nigeria. Chinese and other Asian NOCs participating in bidding rounds in a number of countries have shown a willingness to pay high prices in order to secure exploration and production contracts, sometimes overbidding IOCs.

However, while increased demand from Asian economies has a very direct effect on global oil prices, the impact of China's statist strategy on the market is probably not as dramatic as some assessments would suggest. It seems doubtful that Chinese NOCs' fledgling efforts to lock up petroleum resources will succeed in keeping a critical mass of oil reserves off an increasingly integrated and fluid global oil market. There is also no reason to anticipate that China's willingness to pay market premiums for privileged access to oil resources in various parts of the world will bolster upward pressure on prices generated naturally by rising demand. The opposite is more likely: The flow of "cheap" Chinese capital into global exploration and production is increasing competition among oil companies to access reserves and forcing IOCs to increase spending and take more risks. Other things being equal, this should bring more oil, not less, to market.

Arguably, the Chinese strategy of competing for access to hydrocarbon resources challenges the rules-based international order for trade and investment in energy that the United States has long championed. At a minimum, statist initiatives to secure effective ownership over hydrocarbon resources in foreign countries--with an attendant willingness toward corruption, offering soft loans, and making investments in unrelated sectors and infrastructure projects as part of these initiatives--undercut OECD standards for export financing and other good-governance criteria. And there is a risk that the Chinese approach will be taken as a model by others. This is already happening to some extent with India's Oil & Natural Gas Corporation (ONGC), which is pursuing equity oil deals in many of the same places as the Chinese NOCs--in some cases, as in Iran and Sudan, in consortium with them. Last year, for example, China and India announced an "agreement" aimed at preventing competition over hydrocarbon assets between Chinese NOCs and ONGC from driving up the prices of those assets, as happened in the contest to buy Canada-based PetroKazakhstan. There is also a resurgent debate in Japan as to whether it should take a more statist approach to external energy policy to meet the Chinese challenge. But we are still far from a turning point of massive defections from the market by major consumers and suppliers.

Nevertheless, while the market impact of statist strategies like China's may be minimal, Beijng's "going out" strategy is rapidly becoming a source of geopolitical tensions between China and the United States, with potentially significant implications for the development of the world's most important bilateral relationship during the first quarter of the 21st century. China's search for oil is making it a new competitor to the United States for influence, especially in the Middle East, Central Asia and Africa. China's energy-driven engagement in the Middle East is creating new foreign policy as well as commercial options for energy exporting states, including those at odds with U.S. foreign policy goals, like Iran, Sudan and Syria. (With regard to Sudan, Beijing went so far as to use its status as a permanent member of the Security Council to block the imposition of sanctions on Khartoum over the Darfur genocide.)

In Central Asia, China's interest in diversifying its external sources of energy to mitigate its reliance on the Persian Gulf has motivated Beijing's leading role in the Shanghai Cooperation Organization's campaign to undercut U.S. influence in Central Asia. In oil-producing African countries, Chinese and other Asian NOCs make available to host governments a supply of exploration and production capital that is free from any good-governance and transparency conditions. This, combined with high oil prices, is weakening the leverage that Western governments and international financial institutions can use to improve management of the oil sector and reduce corruption in these countries.

Additionally, Beijing's statist approach to energy security is raising geopolitical tensions with Japan, with prospectively a negative impact on the development of a regional political framework to anchor growing trade and financial interdependence in the world's most dynamic economic zone. Competition between Beijing and Tokyo for specific energy deals in a variety of settings, a bilateral dispute about sovereignty over possible natural gas reserves in the East China Sea, and jockeying over the ultimate destination of a projected Russian eastern oil pipeline have all contributed to the ongoing deterioration of Sino-Japanese relations. Unless these tensions can be ameliorated, it will be increasingly difficult for the United States to manage China's rise on the East Asian scene in a way that ensures long-term regional stability.

Over time, Russian oil and gas could be a major factor buttressing closer Sino-Russian strategic collaboration. Putin's recent meeting with Hu in Beijing, during which the two leaders concluded an agreement for Russia to begin exporting natural gas to China by 2012, was the fifth such meeting in the last year. In theory, a successful commercially grounded oil and gas relationship between Russia and China could be positive for at least some U.S. interests by mitigating China's sense of energy insecurity through reduced dependence on the Middle East (and U.S.-secured Asian maritime routes for their transport). But Moscow is clearly playing on Beijing's sense of energy insecurity to foster a closer geopolitical partnership.

The Axis of Oil and Iran

THE IMPLICATIONS of the new petropolitics and an emerging axis of oil for America's international influence are illustrated by the way these forces are frustrating U.S. objectives on the Iranian nuclear issue. The policies of key players on this issue are conditioned far more by calculations about the economics and geopolitics of energy than was the case during the run-up to the Iraq War. As the Western powers consider what sort of action against Iran they might collectively support, it is clear that their options in the Security Council are severely limited by Russian and Chinese resistance to the imposition of sanctions or other strongly punitive measures.

With growing market power increasing Russia's capacity for strategic initiative, its calculus of interests regarding the Iranian nuclear issue has become more complex than most Western analysts and policymakers understand. Moscow's policy agenda toward Iran has expanded significantly. Russia continues to have important economic interests in Iran. Moscow anticipates a substantial increase in high-technology exports (for example, civil nuclear technology) to Iran over the next decade. The Iranian market is also potentially lucrative for Russian exporters of conventional weaponry, one of Russia's main sources of foreign-exchange earnings alongside hydrocarbon exports. But over the last three years, Russia has also come to see Iran as an important geopolitical partner in its efforts to rollback U.S. influence, not only in Central Asia but in the Caucasus as well. Moscow's recent proposal to resolve the impasse between the Islamic Republic and the West over Iran's nuclear activities by establishing Iranian-Russian joint-venture entities for uranium enrichment was calculated to serve all of these interests. Such a scheme would allow Moscow to maintain and even expand an Iranian market for its nuclear technology, while also nurturing its developing strategic partnership with Tehran.

It is also increasingly evident that the current leadership in Moscow views the Iranian nuclear issue as an opportunity to frustrate the Bush Administration's unilateralist inclinations. Russian Foreign Minister Sergei Lavrov--formerly Russia's permanent representative to the UN for ten years and a master of Security Council politics and procedure--and his colleagues anticipate that, in the end, the United States may take unilateral military action against Iran, including the Russian-built reactor at Bushehr. They do not expect to be able to block such action anymore than they could block the invasion of Iraq, but they are working prospectively to impose serious costs on the United States for a military strike against Iran by ensuring that Washington lacks international legitimacy for its actions.

For its part, China's approach to the Iranian nuclear issue is directly linked to its assessment of its requirements for energy security. Beijing has already put down a marker, in the form of its opposition to UN sanctions against Sudan, that it will oppose the imposition of multilateral sanctions on an energy-producing state in which Chinese companies operate. In private conversations, senior Chinese diplomats and party officials describe Beijing's policy on the Iranian nuclear issue as seeking to balance a range of interests: a secure supply of oil, nonproliferation and regional stability, the defense of important international norms (including the peaceful resolution of disputes and the sovereign right of states to develop civil nuclear capabilities), securing China's northwest border (meaning Xinjiang province, where there is a significant Muslim population), the development of Chinese-Iranian relations, the development of U.S.-Chinese relations, and the positions of the European Union and Russia. It seems increasingly clear that, in their efforts to balance this set of interests, Chinese officials will remain deeply resistant to the imposition of sanctions on Iran. And as long as Russian opposition provides China with political cover, Chinese officials seem to calculate that they will not have to choose between relations with Iran and relations with the United States.

China's willingness to protect Iran from international pressure would also complicate Western efforts to impose meaningful sanctions on Iran through a "coalition of the willing." Without Chinese participation, a voluntary ban on investment in Iran's energy sector by Western powers would, at this point, be little more than a symbolic gesture, as U.S. companies are already barred from doing business in Iran by U.S. law, and most European IOCs have put potential projects on hold because of the political uncertainties. In recent years, though, Chinese NOCs have committed themselves, at least in principle, to substantial investments in Iran's energy sector, thereby mitigating the impact of restrictions on Western investment.

With the Bush Administration having ruled out direct and broad-based strategic discussions with Iran aimed at a "grand bargain" that would include a resolution of the nuclear issue, the United States and its European partners are headed down an ultimately futile path in the Security Council. The Security Council's failure to deal effectively with the Iranian nuclear issue will confront the United States, during the last two years or so of the Bush Administration's tenure, with the choice of doing nothing as Iran continues to develop its nuclear capabilities or taking unilateral military action in the hope of slowing down that development. Each of these choices is likely to damage American leadership in the world: Doing nothing will highlight U.S. fecklessness, while unilateral action without international legitimacy will further strain America's international standing (and probably not meaningfully impede Iran's nuclear development).

Beyond speculating whether Iran might cut off oil exports in response to sanctions or military action, commentators tend to overlook the implications of the current controversy's outcome for the geopolitics of global energy. How the nuclear issue plays out will largely determine Iran's future as an oil and gas supplier. Iranian oil production relies heavily on a small number of old, "super-giant" fields, where output has plateaued and could soon start to decline. These old fields need massive infusions of investment and technology to increase their recovery rates. Iran is not Saudi Arabia and cannot make the investments itself. Since reopening its upstream oil sector in 1994, Iran has actually taken in only around $10 billion of foreign investment in oil exploration and production, due to a lack of political consensus on the country's oil policy, a difficult and opaque negotiating process, and unattractive contractual terms. Similarly, Iran needs large-scale investment and technology transfers to develop its gas-exporting potential. If the nuclear controversy leads to Iran's further isolation from Western IOCs, there would be a powerful incentive for Tehran to turn to Chinese and other Asian NOCs, supplement their investment capital with expertise from more technologically advanced Russian companies, and rely on government-to-government marketing deals. This would significantly reinforce the economic and political logic behind the axis of oil.

Possible Policies

ONE STEP Washington needs to take is to facilitate broader and deeper cooperation between the International Energy Agency (IEA) and China and India. Because these states are not members of the OECD, they are not formally eligible for membership in the IEA, and they have not yet built up the minimum levels of stockpiled oil and petroleum products defined by the IEA for its members. Notwithstanding these barriers, it is clearly in the interests of the United States and its Western partners to establish much closer coordination between emerging Asian economies and the IEA, especially to persuade these states to rely more on international markets and less on exclusive supply deals to meet their energy needs.

At the same time, the United States needs to change its approach to promoting expansion of global energy supplies. It will take more than exhortations about market logic to change elite attitudes and government policies regarding upstream resource development in key energy-producing states. These elites have, by and large, determined that values other than pure market efficiency have priority in their calculations about resource development. Traditional American advocacy of liberalization and internationalization of upstream oil and gas sectors needs to shift decisively toward encouraging NOCs in key producing states to increase investment in productive capacity.

The larger reality is that U.S. foreign policy is ill suited to cope with the challenges to American leadership flowing from the new petropolitics. Current policy does not take energy security seriously as a foreign policy issue or prioritize energy security in relation to other foreign policy goals.

The United States cannot change the course of Moscow's energy policy or foreign policy, but American diplomacy can mitigate Russian policymakers' threat perceptions in exchange for more cooperative Russian behavior. This would require the United States to reach a set of strategic understandings with Moscow encouraging mutual respect for each side's critical interests--and also to make clear privately that Washington and its Western partners will not recognize Russia as a provider of energy security as long as it plays geopolitically on the energy security of others. Vice President Cheney's recent public denunciation of Moscow, coupled with the Bush Administration's refusal to reconsider its strategic approach to Russia, is hardly likely to achieve positive results.

To deal more effectively with China, Washington must recognize that, despite some acknowledgement in Beijing that the "going out" strategy may prove a poor energy security policy, there is still a widely held perception within the Chinese establishment that the international oil market is a foreign (primarily American) construction, operated by Western IOCs in accordance with their interests, and that China cannot bet its energy security on that construction. U.S. policy should encourage Chinese and other Asian NOCs to move along their own paths of internationalization. In this regard, the U.S. Congress's resistance to CNOOC's potential acquisition of Unocal last year sent precisely the wrong message to China.

More broadly, U.S. policymakers need to remember that, even for a global hegemon, to govern is to choose. Washington cannot continue to disregard the impact of its foreign policy choices on the interests of key energy-producing states like Russia if it expects these states not to use their market power in ways that run counter to U.S. preferences. And, similarly, Washington cannot ignore the energy security interests and perceptions of rising consumer countries like China and avoid consequences reflected in these countries' foreign policy choices.

1The term "axis of oil" is not new and has been used by various commentators to describe a number of oil-focused relationships, such as the U.S. Saudi strategic partnership or a possible coordination between India and China in their quest to secure external energy resources. We use the term, in a manner similar to Irwin Stelzer, to describe a shifting coalition of both energy exporting and energy importing states centered in ongoing Sino-Russian collaboration.

2The authors are grateful to their colleague Fiona Hill for this point.

Flynt Leverett is senior fellow at the Brookings Institution's Saban Center for Middle East Policy and has been appointed visiting professor of political science at the Massachusetts Institute of Technology. Pierre Noel is research fellow at the French Institute of International Relations (IFRI) in Paris. He will join the Electricity Policy Research Group at Cambridge University's Judge Business School in September.

Essay Types: Essay