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Shale is Not Forever: Why America Should Continue Protecting Gulf Oil and Gas Flows

July 8, 2019 Topic: Security Region: Middle East Blog Brand: Middle East Watch Tags: OilShalePersian GulfEconomicsWar

Shale is Not Forever: Why America Should Continue Protecting Gulf Oil and Gas Flows

A stout U.S. military deterrent to those who might threaten oil and gas flows from the Gulf does not guarantee stable prices, but it helps reduce the risk of both damaging spikes and the geopolitical risk premium that markets generally price-in during periods of instability in the region.

De Beers tells us that “a diamond is forever.” But the carbonaceous cousin of diamonds, U.S. unconventional oil, may “not be forever.” U.S. energy-security policies towards the Middle East and Gulf region should take this reality into account. Thus, American voters and their elected representatives must educate themselves on the importance of continued U.S. leadership in protecting energy flows out of the Gulf.

Reducing America’s Gulf oil security role is politically tempting. The American public is tired of the Afghan and Iraqi conflicts and oil output in Texas alone is now larger than that of every individual OPEC member save for Saudi Arabia. Saudi Aramco now sends more than 70 percent of its crude oil exports to Asia and U.S. direct oil imports from the Gulf region have declined significantly. These factors are already influencing policy. Consider the weak U.S. response thus far to at least six recent attacks on shipping near the Strait of Hormuz—epitomized by Washington’s recent attempt to shovel responsibility for Gulf area maritime security onto allies rather than leading.

But what if the dynamic American industrial and transport economy still depends on crude oil in 2035? In this very probable scenario, American security abdication in the Gulf could undermine some of our most vital strategic interests. U.S. oil prices rapidly reflect global events no matter how much oil we produce domestically. Also, being the world’s largest single oil producer does not decouple our economic and strategic wellbeing from happenings in the Gulf region. Thus, U.S. policymakers should stop and think hard before pulling back from a vital regional security architecture that took decades to build—and which works best with strong U.S. leadership.

Domestic Oil Abundance Distorts U.S. Policymakers’ Strategic Thinking

Oil abundance has fueled borderline hubristic foreign-policy actions. The White House campaign to cut off Iran’s entire oil exports would have been viewed as unthinkable ten years ago. The idea of NOPEC legislation has gained renewed political traction. And now, oil abundance appears to be driving a mercantilistic new policy approach based on the idea that because the U.S. directly imports less Gulf oil, it should no longer take a lead role in defending the free flow of supplies from the region. After multiple damaging attacks on tankers near the Strait of Hormuz, Gen. Paul Selva, vice chairman of the Joint Chiefs of Staff, made the following statement on June 19, 2019:

“If you think back to the reflagging operation, the ‘Tanker War,’ as it was nicknamed, where we reflagged and escorted tankers so that they could flow in and out of the Strait of Hormuz, we got a substantial amount of our oil from the Persian Gulf. We are now in a position where the bulk of that oil goes to . . . countries in Asia, and none of those countries have shown any predilection to pressing Iran to stop what they are doing. What was true in the 1980s, is not true today. We are not wholly dependent on the movement of Saudi, Kuwaiti, Qatari and Emirati oil in and out of the Gulf to sustain our economy.”

The general’s statement misunderstands oil market realities. Producers in the Gulf region currently account for roughly one-third of the world’s total oil supply. This is actually a larger share than in 1980 when the United States first declared itself willing to use military force to ensure that no hostile outside power could gain control over energy flows from the region. Natural gas prices are also globalizing as the liquefied natural gas (LNG) trade expands and Qatari exports via the Strait of Hormuz account for 25 percent of globally traded LNG volumes.

Exhibit 1: Gulf Producers’ Share of Total Global Oil Supply, 1965–2018

Source: BP Statistical Review of World Energy 2019

 

While the United States now directly consumes less Gulf-sourced oil than it did prior to the Shale Boom, Gulf oil underpins the marketplace that sets the prices American consumers ultimately pay for oil-derived goods and even other commodities. These include agricultural products such as corn and soybeans, whose prices are deeply influenced by what happens in the oil markets.

The United States still obtains nearly 40 percent of its total primary energy supply from crude oil, and is thoroughly tied into the global oil trade through exports and imports. Therefore, growing oil self-sufficiency in fact does not reduce U.S. dependence on stable oil flows from the Gulf or shield it from the effects of an oil market disruption caused by events in the Gulf. What happens in the Persian Gulf almost instantly prices itself into oil and refined products markets in the United States. The pricing of U.S. crude grades, including West Texas Intermediate (WTI) at the Cushing and Midland oil hubs, Bakken crude in North Dakota, and Louisiana Light Sweet on the Gulf coast all trade in lockstep with Brent—the signature international crude oil pricing benchmark that the Saudis and other major Gulf exporters commonly index to.

 

Exhibit 2: U.S. Crude Oil Price Trends by Grade vs. Dated Brent Europe Spot Price, $/Barrel

Source: Bloomberg

While the absolute price per barrel of each oil grade varies for logistical and quality reasons, the prices for all of these crudes move rapidly in response to global events, especially those in the Middle East. This was true even before U.S. law changed in late 2015 to allow crude oil exports, and the pricing linkages between U.S. crude hubs and global markets have only tightened since, even as perceived U.S. “oil supply self-sufficiency” has risen. Even if the United States eventually produces more oil than it consumes, many of the barrels are the “wrong” type of oil for the U.S. refining system, which was optimized for heavier, high sulfur grades from abroad. Thus, we will export light sweet, and import heavy sour, a meaningful portion of which comes from the Gulf region. This again reinforces prices linkages with the global oil markets.

The impacts of oil price swings manifest at the individual consumer level, the one which matters most to politicians. Put bluntly, the impact of an incremental $0.50 (or more) per gallon of gasoline will be the same to Jane and Joe consumer whether the United States produces two million barrels per day of oil or twenty million.

A stout U.S. military deterrent to those who might threaten oil and gas flows from the Gulf does not guarantee stable prices, but it helps reduce the risk of both damaging spikes and the geopolitical risk premium that markets generally price in during period of instability in the region. To that point, if traders believe that America’s political leaders lack the will to get fully—and timely—involved in restoring secure oil transit, the geopolitical risk premium priced into each barrel would likely remain higher for longer. And such price moves would directly impact U.S. consumers regardless of how much Gulf oil the U.S. imports.

Furthermore, while the shale boom itself will likely keep the United States among the top global oil producers for some time to come, it is facing increasing geological and economic headwinds. Capital providers’ sharpening demands for sustainable financial returns are forcing producers to reduce spending while also fighting against the high natural decline rates inherent to unconventional wells completed using hydraulic fracturing. Simultaneously, increasingly dense thickets of wells frequently cause the “child” wells drilled to fill in acreage to be less productive than the “parent” wellbores upon which many tracts’ oil production forecasts were originally based.

U.S. unconventional resource developers have repeatedly demonstrated formidable technical competence and an ability to grow production despite tremendous geological, logistical, and macroeconomic (i.e. commodity price) obstacles. But as the headwinds increasingly exert themselves and investors show themselves to be less accommodating than they were during the 2014–2017 timeframe, the risk increases that U.S. production will remain enormous, but also fall short of the projections that advocates of U.S. “energy dominance” are hanging their hats on. And even if production exceeds expectations, the United States cannot drill its way out of global oil market interconnectedness.

Thus, maintaining a robust military presence in the Gulf region to deter and constrain threats to oil shipments is in the United States’ national-security interest. If the United States continues pulling back as the Gulf’s lead physical oil security provider, then the policy decisions to do so appear predicated on both a misunderstanding of oil markets and unsustainable geological assumptions. Abdication would put the United States in a position where a future crisis could force it and its allies “to reconstruct security architecture at a cost likely much greater than that of maintaining and adapting the existing framework.”