Security of oil supplies: Issues and remedies

Security of oil supplies: Issues and remedies

European Energy Studies This series closely monitors the issues and developments in the field of European energy law and policy by providing an in-depth scholarly and research based yet a practical written and accessible source of information. The aim of this series is to publish up-to-date research for both practitioners and academics. It shall serve as comprehensible tool of knowledge offering detailed insight into the different pillars of EU energy policy tackling the underlying energy policies, legislation, energy economics and regulatory affairs, geopolitics and energy sources.

Volume 1

A New Architecture for EU Gas Security of Supply Jean- Michel Glachant, Manfred Hafner, Jacques de Jong, Nicole Ahner, Simone Tagliapietra

Volume 2

EU Energy Innovation Policy Towards 2050 Jean-Michiel Glachant, Nicole Ahner and Leonardo Meeus

Volume 3

The Geoeconomics of Sovereign Wealth Funds and Renewable Energy Simone Tagliapietra

Volume 4

Security of Oil Supplies: Issues and Remedies Giacomo Luciani

Volume 5

Shale Gas in Europe Cécile Musialski, Werner Zittel, Stefan Lechtenböhmer and Matthias Altmann

Volume 6

A new Euro-Mediterranean Energy Roadmap Manfred Hafner, Simone Tagliapietra and El Habib el Andaloussi

Security of oil supplies: Issues and remedies Written by

Giacomo Luciani

CLAEYS & CASTEELS 2013

© The author 2013

ISBN 9789081690485

The paper and board used in the production of this book is sourced exclusively from replanted forests.

\All rights reserved. This publication, in whole or in part, may not be copied, reproduced nor transmitted in any form without the written permission of the copyright holder and the publisher. Applications to copy, transmit or reproduce any part of this work may be made to the publisher.

Published in 2013 by

Claeys & Casteels Law Publishers bv Deventer (Netherlands) – Leuven (Belgium) P.O.Box 2013 7420 AA Deventer Netherlands www.claeys-casteels.com

Table of contents

Table of Contents List of Figures and Tables

xi

Introduction

1

Acknowledgements

7

Chapter 1: Global Oil Supplies: The Impact of Resource Nationalism and Political Instability 1.1 Introduction 1.2 Resource Nationalism 1.2.1 Restrictions on Access 1.2.2 Depletion Policies 1.2.3 Conclusions on Resource Nationalism 1.3 Restrictions on Exports 1.3.1 Export Policies 1.3.2 Taxation Policies 1.3.3 Market (Volume/Price) Policies 1.3.4 Domestic Pricing Policies 1.3.5 Conclusions on Restrictions on Exports 1.4 Political Instability 1.5 Conclusions

9 15 16 20 29 30 20 34 35 36 37 38 43

Chapter 2: Armed Conflicts and Oil/Gas Security of Supply 2.1 Introduction 2.2 Trends in Armed Conflict 2.3 Historical Experience of Oil Supply Interruptions due to Conflict 2.3.1 Interstate wars 2.3.1.1 The Iraq-Iran war (First Gulf War) 2.3.1.2 The Iraqi Invasion of Kuwait (Second Gulf War)

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45 47 50 51 55 58

Table of contents

2.3.1.3 The US-led Coalition Intervention for Regime Change in Iraq (Third Gulf War) 2.3.1.4 War, Sanctions and Iranian Petroleum Production 2.3.1.5 Concluding considerations on interstate wars 2.3.2 Civil wars 2.3.2.1 Nigeria 2.3.2.2 Angola 2.3.2.3 Sudan 2.3.2.4 Libya 2.4 Violent non-State Actors (Terrorism) 2.5 Conclusion

58 60 61 62 62 67 67 70 71 79

Chapter 3: Restrictions of Passage, Accidents and Oil Transportation Norms: Impact on Supply Security 3.1 Introduction 3.2 Oil Chokepoints 3.2.1 The Gulf Countries and the Strait of Hormuz 3.2.2 The Malacca Strait 3.2.3 Bab el-Mandeb 3.2.4 Panama 3.2.5 Suez 3.2.6 Turkish Straits 3.2.7 Baltic Sea 3.3 Threats to Navigation outside Chokepoints 3.3.1 Global Piracy 3.3.2 The Danger of Oil Spills in Enclosed Seas 3.3.4 Tanker Traffic in the Mediterranean 3.3.5 Major normative developments 3.4 Scenarios of Supply Interruption and Potential Remedies

81 83 85 93 98 100 101 104 109 112 112 115 116 117 118

Chapter 4: Strategic Oil Stocks and Security of Supply 4.1 Introduction 4.2 Conceptual Problems Concerning Strategic Stocks 4.2.1 Defining the Threat

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121 121 123

Table of contents

4.2.2 Predictability and Adequacy 4.2.3 Cost-benefit Analysis 4.3 Legislation on Strategic Stocks: Frameworks of the IEA, the US and EU 4.3.1 The IEA’s Emergency Response Systems 4.3.2 The US Strategic Petroleum Reserve 4.3.3 EU Legislation in Force Regarding Oil Stocks 4.3.3.1 Council Directive 2009/11/EC of September 14, 2009 4.4 Alternative Approaches to Oil Stocks for Enhanced Security 4.4.1 Encouraging Companies and Major Consumers to Hold More Stocks 4.4.2 Prospects for a Cooperative Approach to the Management of Strategic Stocks

125 127 128 129 132 134 135 138 139 142

Chapter 5: The Functioning of the International Oil Markets and its Security Implications 5.1 5.2 5.3 5.4 5.5 5.6 5.7

Introduction A Short History of Oil Price Regimes Speculation vs. Fundamentals Dislocation of benchmarks Structural Causes of Oil Price Instability Structural Changes in the Supply of Liquid Fuels Containing Price Volatility 5.7.1 Encouraging the freer trading of major crude oil streams 5.7.2 Relying on Longer-term Pricing 5.7.3 Exploring Price Bands 5.7.4 Managing Stocks 5.7.5 Pursuing Demand Security 5.7.6 Pursuing Vertical Integration 5.8 Conclusion

145 147 150 153 158 160 162 164 166 167 169 171 172 174

References

177

ix

List of Figures and Tables

List of Figures and tables Figures Figure 1.1: Major Oil Supply Disruptions and Price Impact Figure 1.2: World Oil Production 1965-2011 Figure 1.3: Oil production of four main Gulf producers, 1913-1960 Figure 1.4: Qatar: oil production 1965-2011 Figure 1.5: Venezuela: oil production 1965-2011 Figure 1.6: Algeria oil production 1965-2011 Figure 1.7: Russian Federation: Oil Production 1985-2011 Figure 2.1: O il production of Iran, Iraq, Kuwait and Saudi Arabia, 1978-1991 Figure 2.2: Kuwait: Daily average crude oil production, 1946-2007 Figure 2.3: Iraq and Kuwait: Monthly Oil Production 1990-96 Figure 2.4: Iraq oil production 1970-2011 Figure 2.5: Iran oil production 1970-2011 Figure 2.6: Nigeria oil production 1965-2011 Figure 2.7: Angola oil production 1965-2011 Figure 2.8: L ibya Monthly Oil Production, November 2010 to August 2012 Figure 2.9: Abqaiq Figure 2.10: Colombia oil production 1965-2011 Figure 2.11: Attacks on Iraq’s Oil Infrastructure 2003-7 Figure 2.12: Attacks on Iraqi Oil Pipelines, 2003-7 Figure 2.13: Attacks on Iraqi Oil Personnel 2003-7 Figure 2.14: I raqi Monthly Oil Production January 2004 to December 2010 Figure 3.1: The Strait of Hormuz Figure 3.2: Oil disruption price estimates Figure 3.3: The Malacca Strait Figure 3.4: The Lombok Strait Figure 3.5: The Kyaukphyu to Kunming Oil and Gas Pipeline Figure 3.6: China’s crude oil imports by source, 2011 Figure 3.7: The Strait of Bab el Mandeb Figure 3.8: Net Tonnage of Merchandise crossing the Panama Canal

xi

11 13 18 23 24 26 28 52 56 57 59 61 63 66 71 72 73 74 76 77 78 86 90 94 96 97 98 99 100

List of Figures and Tables

Figure 3.9: The Suez Canal Figure 3.10: Traffic through the Suez Canal Figure 3.11: The SUMED pipeline Figure 3.12: The Bosphorus Figure 3.13: N umber of Tankers Transiting the Turkish Straits, 1996-2010 Figure 3.14: The Samsun to Ceyhan Oil Pipeline Project Figure 3.15: The Oresund Strait Figure 3.16: The Oresund Strait Figure 3.17: Pirates’ attacks off the Horn of Africa Figure 4.1: Strategic stocks’ availability and drawdown rate Figure 5.1: Crude Oil Prices 1861-2011 Figure 5.2: Prices for WTI and Brent, January 2010 to October 2012

101 102 103 105 106 108 110 111 114 130 148 155

TABLES Table 1.1: Major World Oil Supply Disruptions Table 3.1: Chokepoints Table 3.2: Passage of energy products through the Suez Canal Table 3.3: Pirates’ Attacks on ships by type

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12 84 103 113

Introduction

Introduction Oil has always been identified as a “strategic” commodity, and attracted the interest of governments. This interest has frequently been articulated in terms of “control” or “security of supply” - terms whose exact meaning is seldom clearly defined. When Winston Churchill, then First Lord of the Admiralty, decided in 1913 to acquire an interest in the Anglo Persian Oil Company, in conjunction with his plan to turn the British fleet from coal to oil, his concern was security of supply for the fleet. Oil was then viewed as an important input for military activities, something that the armed forces needed – not as a vital commodity for the entire economy. Daniel Yergin2 writes that before the First World War the French Prime Minister Clemenceau - who was rather famous for his “bon mots”- had said “When I want some oil, I’ll find it at my grocer’s”. He partially changed his mind during the war and insisted that a French company should have a participation in the newly established Iraq Petroleum Company, before he agreed to transfer control of Mosul to the United Kingdom, in return for the protectorate on Syria. Yet Clemenceau’s early statement captures a fundamental question: is oil just a commodity, which is available to any party willing to pay the going price; or is it a resource which is neither easily nor transparently traded, and is best appropriated through political control or the use of military force? Until after the Second World War, coal remained the main source of energy for the civilian economy. Oil was sometimes very important in the conduct of war hostilities, and the lack or availability of it may have played a crucial role in the outcome of some important battles during the war. But it is only in the 1950s and 60s that oil became the main source of energy of the industrial countries, thanks to the abundance of reserves discovered - notably in the Gulf, which substituted the United States as the world’s main source of oil. 2

Daniel Yergin “The Prize” Chapter 10, page 173

1

Introduction

Increased dependence on oil from the Gulf – today sometimes dubbed an “addiction” – accentuated the security profile of oil. The possibility of an interruption of oil supplies was considered to have potentially catastrophic consequences for the industrial countries, and “control” of oil was considered a valuable political asset or tool (in the assumption that access could selectively be denied). European security depended on the United States in many ways more than one, but the US’s enhanced engagement, after the United Kingdom’s withdrawal from East of Suez in 1967, was one important component of the total picture. However, such enhanced US engagement prevented neither the attempt to use oil as a weapon in 1973 (in fact, the embargo launched by OAPEC – the Organization of Arab Oil Producing Countries – was mainly directed to the United States because of their support of Israel), nor the Revolution in Iran and the subsequent war that Iraq launched against Iran in 1980. Thus, it appears that the securitization of oil has affected its availability negatively rather than positively. The international oil market has always proven to be resilient and efficient in redistributing flows of available oil to satisfy demand. Oil has very much behaved as a transparently traded commodity, which any party can get for the going price. It has proven impossible to segment the international oil market and target a specific country - “control” has not yielded any lasting benefit, except pecuniary. Even South Africa under apartheid, notwithstanding its severe isolation and the sanctions that had been imposed on the country, was always able to procure the oil it needed. After 1973 the “oil weapon” lost its credibility altogether; it did so because it was ineffective and had backfired against those attempting to use it. Almost invariably, sanctions have been imposed by oil importers unto oil exporters, rather than the other way around. Arguably, the imposition of sanctions on oil exporters has done more damage to the availability of oil than any other political act or form of conflict. Nevertheless, the standard line, which all politicians seem prone to repeating - and is normally accepted as self evident and unquestionable fact - is that the Gulf is unstable, thus oil supplies are not secure. This volume is the outcome of research originally conducted in the context of the SECURE project supported by the European Commission under the 7th Framework Program. The project touched all aspects of energy, not just oil,

2

Introduction

and is one of several projects concerning energy security – a further confirmation of the importance attributed to this aspect. We tackle the issue of oil supply security under different angles. The first chapter deals with the potential for deliberate reduction of supplies on the part of exporting countries because of so-called “resource nationalism”. This includes all aspects of government policy that may result in exports lower than would obtain in a perfectly liberal scenario – such as excluding international oil companies from having access to resources or subsidizing domestic consumption through lower than international prices. It is concluded that “resource nationalism” is motivated by the desire to maximize the benefit of the oil exporting country and its ability to promote transformation of the national economy. It is also shown that resource nationalism is a cyclical phenomenon, closely linked to fluctuations in the price of oil, which inevitably affect the bargaining positions and fairness of outcomes under existing contracts. With respect to production volumes, intensified resource nationalism has sometimes led to larger production, sometimes (indeed more frequently in recent times) to smaller. The second chapter deals with the consequences of armed conflict on oil supplies. Conflicts are divided into interstate and intrastate, and the latter category is further articulated to encompass civil wars and non-state actors’ violent behavior. The record points to the fact that, while undeniably war has sometimes seriously affected the exports of the countries involved, nevertheless the international system has mostly been able to compensate such losses with increases from other sources. In fact, oil installations have generally proven to be much more resilient than normally maintained, and the recovery from damage speedier. The reverse effect, the impact of oil on conflict, may in fact be more relevant. Oil is a crucial source of revenue, which has allowed in some cases belligerent parties to defer acknowledging defeat, and has thus extended the duration of conflict much beyond what might have been expected otherwise, magnifying losses, both human and economic in sectors different from oil. The third chapter discusses the danger that waterways, which are essential for the flow of oil – either globally or for specific regions – may be closed by either voluntary action or accident. When discussing dependence from Gulf oil, the most frequently heard hypothesis is that the Strait of Hormuz might be closed, and it is widely maintained that this would prevent any oil from flowing out of the region. The chapter proposes a more nuanced understanding of

3

Introduction

the situation, and argues that it would be quite difficult to close Hormuz for an extended period of time. This points to the conclusion that it is indeed appropriate to worry about this eventuality and take measures to guarantee that the Strait might be reopened swiftly, in case of an attempt at closing it; yet the probability of closure is not very high. On the back of available evidence, it is also argued that problems may well occur far away from the so-called choke points, in the open seas. This is supported by the record of attacks in conjunction with international hostilities (the “tanker war” during the IraqIran war) as well as by more recent episodes of piracy. The next chapter discusses the potential role of strategic stocks, critically assessing the effectiveness of current policies and suggesting alternatives. In a nutshell, it is found that in a context in which oil availability is almost never physically restricted, but scarcity is reflected in price movements which have a tendency to occur even before any physical scarcity may emerge (and thus prevent the latter from emerging), the very concept of strategic stocks as opposed to commercial stocks is undermined. We note a growing tendency to admit or authorize the use of strategic stocks to contrast price increases rather than physical shortfalls in supply – but then it is not clear when an increase in prices should be resisted through the release of oil from strategic stocks, as causes for price movements are seldom clear and univocal. The last chapter focuses on the functioning of the international oil market and argues that the perception of insecurity in oil supplies is to a large extent tied to the unsatisfactory price discovery mechanisms, which we currently rely upon. Volatile prices discourage investment and pave the way to fragile, insufficient supply; and the public perceives sudden price changes as a factor of insecurity. Hence a reform of the international oil markets – which were never properly designed, but arose spontaneously in response to successive opportunities and challenges – is a very important step in the direction of greater security, and a valid alternative to securitization discourses. The experience of the Libyan revolt and civil war against the regime of Colonel Gadhafi further supports most of the above conclusions. Libya is a country whose oil potential has remained underexploited, due to the protracted sanctions that the country was subjected to, preventing international oil companies from investing there. Once sanctions were lifted in 2004, companies rushed in, but the fruits of renewed interest and investment were scarcely visible when the revolt broke out.

4

Introduction

The outbreak of the revolt caused the disappearance of Libyan oil from the market, creating a shortfall of some 1.6 million b/d. Saudi Arabia ramped up production, but fell short of fully compensating for the Libyan shortfall because there were no takers. True, Saudi oil is not the same quality as Libyan oil, and some refineries might have had some trouble in processing it – but this should have led to a widening of quality differentials, and redirection of several crude streams, rather to the Saudi oil going unsold. The latter was clear manifestation of the fact that the market was sufficiently supplied. Nevertheless, prices increased in the Brent market. Uncertainty in Libya and the eventuality of a revolutionary contagion to Saudi Arabia and other GCC countries were frequently mentioned as potential reasons for such “security premium”. However, there is little logical or empirical evidence directly connecting the price increases to these political and military events: expectations of investors and traders in the paper market favored a price increase, and the price increased even in the face of little support from fundamentals. In June 2011, the International Energy Agency decided to release 2 million barrels from oil stocks, after OPEC had refused to officially increase production quotas, even though Saudi Arabia has made clear that it would continue to produce above quota to compensate for the Libyan shortfall. The release had temporary, very limited impact on prices. Even after the victory of the rebels prices barely diminished – if at all. The civil war came to an end in August 2011, and the level of production existing before the outbreak of hostilities was recovered already by May 2012, meaning that the shortfall of Libyan oil lasted approximately one year. Once again, oil installations have demonstrated that they are more resilient than most people make them. Ex post, the Libyan revolution will be recorded as further evidence of the fact that political-military events do not create major problems to global oil supplies and hardly justify a militarization of the issue. Rather, the market has worked well in redistributing oil barrels, and the problem, if there is one, lies in the excessive influence of expectations and sentiment on price discovery. Giacomo Luciani Geneva, November 2012

5

Acknowledgements

Acknowledgements Research for this book was conducted in the context of the SECURE project, generously funded by the European Commission, DG Research under the 7th Framework Program. The project was led by Manfred Hafner, whose role in preparing and steering the project has been absolutely essential. The project was conducted by a consortium of 15 European research institutions, led by the Observatoire Méditerranéen de l’Energie (OME) and the Eni Enrico Mattei Foundation (FEEM). The Gulf Research Center Foundation was one of the members of the consortium, and I was the principal researcher for the Foundation. Over the three years of the project, I was assisted with background research by several former students of mine. In addition to François-Loïk Henry, who helped me in the research for the chapter on strategic stocks, I wish to acknowledge in particular: Sarin Abado, François Flament, Daniel Morris and Tobias Thiel. Any shortcomings and errors are attributable exclusively to me. GL

7

Chapter 1 – Global Oil Supplies: The Impact of Resource Nationalism and Political Instability

Chapter 1 Global Oil Supplies: The Impact of Resource Nationalism and Political Instability 1.1 Introduction Geopolitical threats to hydrocarbon production and exports include several typologies: ‘resource nationalism’, i.e. the voluntary adoption of policies on the part of the government of the producing country; ‘political instability’; and international or domestic conflict, including terrorism. In the perception of international oil markets operators, politicians and the wider public these different threats are frequently bundled together: oil producing countries, whether in the Middle East and North Africa or anywhere outside of the OECD or NATO, are frequently labeled as “politically unstable” – therefore unreliable suppliers. However, the nature of the instability and its precise connection to oil production and exports is seldom explicated or analysed, frequently leading to conclusions that are unwarranted. While the meaning of “resource nationalism”, “political instability” and international or domestic conflict may appear evident, all of them require further definition and discussion. In real life, the exact boundaries between resource nationalism, political instability, and conflict are sometimes blurred. In this chapter, we shall include under resource nationalism all policies undertaken by the national governments of the producing country that either restrict access to resources to a subset of potential players; or create separation between the domestic and international markets; or, finally, directly impose quantitative limitations on production and exports. Restricting access to some players generally means favouring national over international companies: the advantage may be absolute, meaning that no foreign companies are allowed; or relative, meaning that national companies face fewer restrictions (e.g. may own the majority of a joint venture, while foreign companies are only allowed to be the junior partner; or may have access to some resources

9


that are not open to foreign investors) or enjoy more favourable terms. In some cases, privately owned national oil companies face the same restrictions as foreign owned companies, and only state owned players are admitted; while in other cases private national companies are allowed, but may not have the same advantages as state owned companies. All policies included under resource nationalism may result in lower exports, either directly, meaning that the domestic market is supplied with priority to exports (or domestic prices are lower than international prices, which amounts to the same), or exports are quantitatively restricted (e.g. by OPEC quotas); or indirectly, because non participation of some or many of the potential investors leads to lower discoveries, slower development, and lower production at any moment in time. Political instability encompasses changes in policies that are the result of changes in the structure of power, i.e. in the government in place. Admittedly, once a new government is in place it should be regarded as the incumbent government, and its policies therefore would fall under the previous category of resource nationalism. However, the concept of political instability deserves separate treatment because it aims at measuring the stability of policies in case of changes in government. Besides, there is the possibility that endemic political instability, i.e. very frequent changes in government or the perception thereof, might create such a climate of uncertainty around oil policies that foreign actors are discouraged from considering investment. Political instability may be the outcome of constitutional processes – as is normal in democracies, that are meant to allow alternation in power in a context in which various checks and balances limit the power of the majority – or extra-constitutional transitions, which we may group under the two main typologies of ‘coup d’état’ and ‘revolution.’ Coups d’état are typically carried out by a minority that is a junior component of the existing power structure; while a revolution may be the outcome of a mass movement and originate from power outsiders. Both cases may be more or less violent. The distinction is mainly one of duration: coups d’état typically lead to a change in government or regime within a relatively short time; while a revolution is likely to last longer and may turn into civil war or a terrorist wave. In this sense, civil wars or terrorism may be viewed as the outcome of failed or on-going revolutions that drag on in time. The distinction might be subtle, but the rationale for explicating it in our discussion is clear: if only limited violence is used, material damage to infrastructure and installations, including oil installations, will not be an important concern; the change in political equilibria and priorities will be the main concern. On the other hand, when extensive or prolonged use of violence occurs,

10


Figure 1.1: Major Oil Supply Disruptions and Price Impact

Source: EIA

oil installations may be damaged, either deliberately or accidentally. Obviously, two different sets of issues will need to be considered in the two cases. The literature on oil supply interruptions has developed a fairly universally accepted list of historical events that are characterized as “major disruptions.” Figure 1 from the Energy Information Administration of the US illustrates these events. There are eight events considered in this chart, of which five are international conflicts (the Suez war, the Six Day war, the Yom Kippur war, the IranIraq war and the Iraqi invasion of Kuwait), two are domestic political events (the Iranian nationalization and the Revolution), and one is a combination of the two (the cluster of Venezuelan strike, unrest in Nigeria and intervention in Iraq). A slightly different listing is proposed by the International Energy Agency (see Table 1.1). Both lists only consider “major disruptions.” In speaking of disruptions, the question must be asked: disruption relative to what? The very concept of disruption subsumes a concept of “normal state” which is being disrupted by the event in question. But what is the “normal state”? The analysis requires a counterfactual, a view of the world as it would have been, had the event not occurred: but defining the counterfactual is in fact extremely difficult, because the event is likely to trigger a very large

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Table 1.1: Major World Oil Supply Disruptions Gross peak supply loss Date Event (mb/d) September 2005 Hurricane Katrina/Rita 1.5 March-December 2003 War in Iraq 2.3 December 2002 – March 2003 Venezuelan strike 2.6 June-July 2001 Iraqi oil export suspension 2.1 August 1990 – January 1991 Iraqi invasion of Kuwait 4.3 October 1980 – January 1981 Outbreak of Iran-Iraq war 4.1 November 1978 – April 1979 Iranian revolution 5.6 Arab-Israeli war and October 1973 – March 1974 Arab oil embargo 4.3 June-August 1967 Six day war 2.0 November 1956 – March 1957 Suez crisis 2.0 Source: International Energy Agency.

number of responses including from actors that are not directly involved in the event itself. It is very difficult to formulate a credible counterfactual that takes into account the myriad of adjustments that an event will trigger. Speaking of disruptions to oil supplies, we should ask whether we should consider only cases in which an existing level of supply that was achieved before the event took place was disrupted, i.e. reduced by the event itself; or also cases in which political developments prevent the level of oil supplies that would have occurred otherwise, i.e. cases of lost production that never materialized, but might have materialized had the event not occurred. Both views are problematic. If we focus on disruptions only, should we consider supply developments only in the country/region affected by the event, or at the aggregate global level? In many cases, we see that in the event of a shortfall in production in one country, production in other countries was increased to compensate, and in the end global supplies were not disrupted at all, or disrupted minimally.

12


Take for example the crisis of 1973-74, the so-called first oil crisis, subsequent to the Yom Kippur war, when the Organization of Arab Oil Producing Countries (OAPEC – not to be confused with OPEC) attempted to use oil as a weapon against the United States and the Netherlands, viewed as key supporters of Israel. Consideration of the evolution of aggregate global oil supplies (Figure 1.2) shows that in fact production remained stable between 1973 and 1974, and only declined the following year. Similarly, in 1978-79 the Iranian revolution subtracted 5.6 million barrels per day (according to the IEA: the EIA has a lower figure), but global production actually increased by 2.7 million barrels per day year on year. Production then declined between 1979 and 1983: the decline in 1979-80 was slightly smaller than the shortfall cause by the outbreak of the Iran-Iraq war, but the latter obviously played a role; however the decline continued in subsequent years, when in fact production in both Iran and Iraq recovered Figure 1.2: World Oil Production 1965-2011

Source: BP Statistical Review of World Energy 2012

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somewhat: this shows that the underlying cause of the decline was lack of demand due to excessively high prices: had Iran and Iraq been able to produce more, some other country would have been obliged to produce less, or prices would have fallen further; in any case, there was no shortage of oil on the global market. Global production remained stable in 1990-91 notwithstanding the shortfall caused by the Iraqi invasion of Kuwait: other producers were able to ramp up their production and substitute for the lost volumes from the two belligerents. It declined again between 1998 and 1999 and between 2000 and 2003, two periods when no political crisis was evident: the decline was in response to market factors. Finally, production increased in 2003 and subsequent years until 2008, notwithstanding the strike in Venezuela, the war in Iraq and hurricanes in the United States. It declined in 2009 because of the global economic crisis. In short, global oil production is affected by global economic developments much more than by specific political or military crises. It would be a mistake to assume as counterfactual a world in which everything works smoothly and all production facilities are run at nameplate capacity. In the end, reality never conforms to the optimum, in the sense that global oil production never is equal to what producers would independently aim at (i.e. excluding cases of capacity deliberately left non utilized). A ‘normal’ level of attrition must be envisaged, which is commonly due to a plurality of accidents, technical or political, and short-term demand considerations. The gap between desired and actual production is not constant: the difference between what is theoretically possible and what is actually achieved may widen or become narrower, and any political or military crisis may tend to widen the difference; however, the shortfall caused by a specific crisis may be, and in fact frequently is, compensated by opposite movements elsewhere. Most systems normally function below capacity, but if need be they can also work above capacity. This means that the flexibility and reactivity of the system may well be greater than is normally assumed. It is deemed usually that working above capacity is not sustainable in the long run; but what is the definition of sustainable? How long is the short run? Working above capacity may in fact be feasible for months in a row before major problems emerge. Adding to this the consideration that some countries deliberately keep their production below capacity, and it becomes clear that the actual impact of a crisis depends not only on the size of the immediate shortfall that it causes,

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but also by the broader conditions of the market and the availability of voluntary or involuntary excess capacity elsewhere in the world.

1.2 Resource Nationalism Resource nationalism comprises all policies undertaken by the national governments of the producing country that restrict access to resources to a subset of potential players, create separation between the domestic and international market, or directly impose quantitative limitations on production and exports. This definition encompasses a wide variety of policies: • Access to resources may be forbidden absolutely on environmental or strategic grounds (an example is US restrictions on offshore drilling, partially lifted by the Obama Administration, then re-imposed following the Macondo well blowout in 2010, and again lifted a few months later); or limited, delayed or otherwise hindered by the opposition of the local population or authorities on environmental or ‘fair share’ grounds (an example of both issues being tar sands in Canada, or tight oil and gas deposits in France). More frequently, access is restricted to specific categories of players: national companies, either solely state-owned or also privately owned; either on their own or in partnership with foreign companies in a junior position. • Secondly, access to resources may not be restricted to specific categories of players, but the development or pace of resource exploitation may be constrained in order to conform to OPEC quota discipline or support OPEC action to manage the market (including in countries that are not members of OPEC, but may at times find it convenient to follow the lead of OPEC and refrain from maximizing exports); or for extending the productive life of the fields. • Thirdly, restrictions may be imposed on exports, to benefit domestic consumers and industrial users. All the above-listed policies allow for considerable variation and flexibility in implementation. Resource nationalism is, therefore, a phenomenon that should be viewed as having ups and downs, and may be adapted to circumstances.

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1.2.1 Restrictions on Access

Restrictions on access may exist de facto or be enshrined in the law of the country. The extreme case is Mexico, where exclusion of foreign companies from upstream oil is written into the Constitution. The Constitution of the Islamic Republic of Iran does not go to the same extreme: it forbids concessions and production-sharing agreements and only allows for service contracts to be offered to foreign enterprises – a rule that the government has tried hard to work its way around, without much success. Elsewhere, restrictions exist in practice although they may not be publicly acknowledged. Saudi Arabia is a case of de facto yet openly proclaimed restrictions, a situation which allows for exceptions and adaptations. In fact, Chevron has seen its concession in the Partitioned Neutral Zone between Kuwait and Saudi Arabia confirmed and extended; and four international consortia have been allowed to conduct exploration for gas in the Empty Quarter, with Saudi Aramco as minority partner (but they would not be entitled to any oil that they may find). The International Oil Companies’ (IOCs’) access to resources is therefore not completely excluded. The Russian Federation exemplifies a case of progressive restrictions that are imposed de facto and are not presented as explicit policy: it just so happens that IOCs have progressively been squeezed out of the country on a case-bycase basis and to a variable extent. In all countries, the operations of international oil companies are governmentregulated and subject to either a concession or a production sharing agreement or some other form of contract. In the negotiations for the conclusion of whatever legal document may be required, the government has influence on the choice of the company or composition of the consortium that will hold the contract, and can impose the desired level of national participation on a case-by-case basis. It would be hard to find instances of countries giving no preference to national players. Even Norway adopted a partially resource-nationalist stance at least until the beginning of the current century and the privatization of Statoil – i.e. at a time when Norwegian production had passed its peak. Restrictions on access are therefore found in degrees, and countries may change their position along the scale of openness/closure depending on

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circumstances. Some major producers never resorted to nationalization – Abu Dhabi being a prominent example. Others resorted to partial nationalization – i.e. nationalization of some, but not all companies: Libya and Nigeria are notable examples. Finally, countries that had resorted to full nationalization later changed course and again opened to international investors: Venezuela, Algeria and Qatar are all cases in point. Historically, access of international oil companies to resources has progressively faced more stringent restrictions. Indeed, IOCs used to enjoy predominant access and control before 1970, and lost their position in the following decade. Previously to 1970, episodes of nationalization had been few and far between in time. Foreign interests in Russia were nationalized following the Bolshevik revolution, an event whose importance went well beyond the oil sector. At the time, oil was not yet an important source of energy, and discoveries elsewhere in the world quickly made up for the loss in Russian supplies. Mexico nationalized in 1938, twenty years after the constitution barring foreign investment in oil had been approved (1917), and well after Mexican oil production had peaked (1921). When finally foreign companies were nationalized, Mexican production stood at 20% of the peak. But the truly paradigmatic episode had been the Iranian nationalization of 1951. When Mohammed Mossadegh nationalized the Anglo-Iranian Oil Company in March of that year – on a dispute about the extent of royalties to be paid – the company had, so to speak, just begun to significantly build up production. Iran began producing oil already in 1917, but it was not until the end of World War II that output picked up in a significant way. Furthermore, the nationalization occurred at a time when several other major Gulf producers were increasing their production significantly, and oil was abundant. Anglo-Iranian - which later became British Petroleum and, today, BP – called for a boycott of Iranian oil and succeeded in preventing any other party from buying oil from Iran. The boycott succeeded, Iranian production was annihilated and the loss of it was offset with increases in Iraq, Kuwait and Saudi Arabia. Growing economic difficulties provided the backdrop against which the MI6 and the CIA orchestrated the fall of Mossadegh in 19532. 2

Yergin, op. cit. Chapter 23 pages 450-478

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Figure 1.3: Oil production of four main Gulf producers, 1913-1960

Mossadegh’s defeat marked relations between IOC’s and their host governments for the following two decades, during which governments tried to extract concessions from the companies on various fronts, but abstained from threatening nationalisation, for fear of a boycott. It is only in 1970 that the Libyan government of Muammar Ghadafi, who had come to power one year earlier, succeeded in imposing to companies operating in the country a unilateral reduction of production, and selectively expropriated some of the companies. Calls for solidarity and a boycott went unheeded. This marked a fundamental shift in the bargaining power of producing governments versus the international companies, that became fully evident in 1973: in the rest of the decade a wave of nationalizations took place, and the international companies lost control of the bulk of the reserves in many, yet not all, of the major oil producing countries. The major shift in control of the 1970s, however, remains a one-off episode in the history of the industry. Countries that did not nationalize then did not do so later, and a few of those that nationalized reopened their doors to foreign investment under substantially different conditions. In the 1990s and early 2000s, it had been predicted by some that the pendulum would swing back, and international companies would be able to acquire

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much more direct control over reserves. This was linked to the expectation that Russia and other former Soviet countries would open up and become fully accessible, and the elimination of the Saddam regime in Iraq would be instrumental in opening the doors to that country once again. In fact, while international companies have been allowed relatively free access to resources in Azerbaijan and Kazakhstan, Russia has been a source of multiple disappointment and setbacks. In other countries, the expected opening has either failed to materialize (e.g. Kuwait) or the positions gained by the international companies have remained very limited (e.g. Brazil or Venezuela). Iraq conducted two rounds of bidding in 2009, which led to the awarding of 10 service contracts (that is, contracts that do not offer the IOC the possibility of booking reserves) on conditions that are extremely demanding for the companies involved. International companies were able to obtain better terms in the Northern Kurdish region of the country, although the central government in Bagdad never recognized the deals signed by the authorities of the Kurdish region and actively boycotted the companies involved. Initially, international companies abstained from investing in the Kurdish region to avoid the wrath of Bagdad, but in 2012 Exxon broke ranks, notwithstanding having signed one of the major service contracts allocated by Baghdad, and other companies appeared ready to follow suit. As any potential production from the Kurdish region is necessarily much smaller than what could come out of the fields controlled by Baghdad, this trend is a clear indication that international companies considered the terms of their involvement in the Baghdadcontrolled fields too harsh to be attractive. The Kuwaiti government appears to have given in to opposition from the Parliament and renounced “Project Kuwait”, which it had pursued for no less than 20 years; this quarrel has become closely entangled with the more serious constitutional quarrel between the Amir and Parliament concerning whether the government should be an expression of the the preferences of the former or the latter. Finally, Iran has sought greater involvement of the international oil companies for years, and blames unilateral US sanctions for the difficulties it has encountered. This explanation is not entirely convincing, and certainly Iran may need to create more attractive conditions to spur serious IOC involvement, including allowing equity participation in the reserves – but this may well happen if an extended period of low oil prices prevails and the government feels the need to push production to meet its expenditure requirements.

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In short, resource nationalism may be viewed as rather normal behaviour on the part of governments of oil-producing countries. It may have multiple manifestations and come in degrees, rarely entirely excluding IOCs from access to resources. Much of the issue of resource nationalism is related to expectations, i.e. the extent to which IOCs judge terms on offer in each country as sufficiently attractive. Opinions on this differ between companies, depending on the terms available elsewhere, alternative investment opportunities and price levels, industry structure, technology etc. The point is: resource nationalism is a manifestation of the fact that each producing country wishes to maximize its share of the rent and limit the companies’ share of the same. It is a market relationship in which the strength of the bargaining position of each side shifts over time. In this sense, resource nationalism restricts oil production; but this is the outcome of producing countries protecting their interests, as all market participants do, and a consequence of imperfect and asymmetrical information, i.e. a form of market imperfection . 1.2.2 Depletion Policies

In historical experience, we find instances in which governments of oilproducing countries conflicted with international oil companies because they felt the latter underexploited the resources entrusted to them, as well as cases in which the opposite was true. Iraq offers a clear case of a long-lasting conflict with the international oil companies (dating from at least the late 1950s and possibly even earlier), which was due to various sources of tension, one of which was the Iraqi government’s justified belief that companies were sitting on its oil resources without adequately exploiting them. In turn, throughout most of the 1950s and until the nationalization of 1973, the companies jointly owning the Iraq Petroleum Company (which directly or indirectly controlled all oil concessions in Iraq) were deliberately underinvesting in Iraq because of enduring conflicts over tax-related issues, and preferred to invest and increase production in other countries in the region, notably Iran, Kuwait and Saudi Arabia. Although Iraqi reserves were more important that those of both Iran and Kuwait, Iraqi production remained well below that of its neighbours. Thus, the Iraqi nationalization of 1973 was motivated, among other things, by the desire to significantly expand production and exports. In fact, following

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the nationalization, Iraqi oil production increased more rapidly during the rest of the decade than in previous decades. The increase came to a halt when the war with Iran broke out and production was negatively affected. Thereafter, Iraqi oil production is a story of repeated recoveries curtailed by war or the imposition of sanctions, until the US-led intervention of 2003. Since then, the new Iraqi government has again pushed for an increase in production, and reopened the doors to foreign companies, albeit with limited success (and possibly too timidly: it is not clear whether the limited progress is due to persistent operational difficulties or to the low margins allowed by the contracts that the companies were led to sign – or a combination of both). However, the Iraqi case pre 2003 exemplifying resource nationalism motivated by a desire to increase production is rather an exception. In most cases, resource nationalism is coupled with a desire to limit the pace of the draw down of reserves, while openness to foreign investors is motivated by the opposite desire to speed up the exploitation of reserves or encourage new discoveries. The latter is also a function of prices: as governments have certain budget requirements, if prices decrease the urgency of increasing production is more acute. On the contrary, when prices tend to increase – as was the case in the 2004-2008 period – increasing production becomes less important and maximizing the extraction of the additional rent takes priority, frequently encouraging resource nationalist attitudes. The international oil companies always tend to maximize short-term production, within limits imposed by good field management practices aimed at maximizing total recovery, because the earlier the oil is extracted the higher will their rate of return be. In contrast, the host government in some cases prefers to slow down exploitation and keep more of the oil in the ground, and will see less of an incentive in engaging or offering enticing terms to foreign investors. This dynamic is well exemplified by several major oil producing countries. Saudi Arabia is the main example of an explicit conservationist policy. The Kingdom has enunciated a strategy of not exceeding a production level which it may confidently maintain for a period of at least 50 years: no profitmaximizing company would consider such an extended plateau, as the discounted value of oil to be produced 50 years from today is normally deemed very low (although in fact it very much depends on our expectation of the future evolution of prices at that time, about which we have essentially no information at all).

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According to available statements, Saudi Arabia believes that the maximum level of production defined in this way is 15 million b/d, including some use of currently non-proven reserves. New discoveries or a reassessment of known fields may alter this conclusion, and lead to a higher – or lower – ceiling. (Also note that it is not clear whether the 50 year time horizon is to be interpreted as sliding or fixed from a given, and undefined, initial date. No statement exists concerning the beginning of the ‘countdown’). The adoption of this rule translates into rates of exploitation that are low by international comparison. Kuwait has had a similar attitude: production peaked in 1972 and was thereafter deliberately reduced because of conservationist sentiment in the government and public opinion – at the same time as the foreign concessionaire (the Kuwait Oil Company, a 50/50 joint venture of BP and Gulf Oil) was nationalized. Kuwait’s production decreased rapidly in the early 1980s as part of OPEC’s effort to defend high prices, and recovered in the second half of the decade, only to be completely erased when the country was invaded by Iraq. Thereafter, the goal of the government has been to increase production and reach back to the level of 3 million barrels per day of pre-1972 times. To this end, it has pursued a project for a limited opening to international oil companies (Project Kuwait) since the early 1990s. However, the Parliament has systematically opposed Project Kuwait, taking a more rigidly nationalist and conservationist attitude. The Parliament has also urged the government to clarify and independently verify the status of the country’s reserves, taking into account the opinion of those experts (such as IHS Energy – Petroconsultants) who believe that the official figures for Kuwaiti reserves are exaggerated. The government has resisted doing so, and, as mentioned already, has in essence abandoned Project Kuwait after twenty years of unsuccessful attempts to get the required legislation approved. Qatar offers an other interesting case, also with respect to the tendency for resource nationalism policies to be revised and even reversed depending on the circumstances. Qatar followed the tide and completely nationalized its oil sector in 1973, but very soon production started to decline. Thus the country reversed course and reopened to foreign companies, which were able to restore and even increase production (it is still rapidly increasing to this date).

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Figure 1.4: Qatar: oil production 1965-2011

At the same time, Qatar has been pushing to exploit the giant North Dome gas field, which Shell had discovered in 1971 and considered not to be commercially viable. The push led to launching numerous projects to turn Qatar into the world’s foremost exporter of LNG: However already in 2005 - well before all the projects were completed – Qatar announced a moratorium on new projects, waiting to see how the field would behave following the increase in production, and not to risk excessively rapid depletion. The moratorium has remained in place well beyond its initially expected duration and is unlikely to be lifted. Thus even in Qatar conservationist preoccupations play an important role. Outside of the Gulf, practically all of the producing countries are concerned with maximizing their production and exports and adopt what they consider to be appropriate policies to this end. Some countries that at one stage had adopted a resource-nationalist attitude later changed course and allowed international oil companies back in. Two notable cases in point are Venezuela and Algeria. The Russian Federation may also be included in this list, if we consider the shift in policy that followed the collapse of the Soviet Union.

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Figure 1.5: Venezuela: oil production 1965-2011

Venezuela nationalized the foreign companies present in the country (among which the most prominent were Shell and Exxon) in … and established PDVSA as a holding company of the former IOC subsidiaries. Production declined rapidly due to a combination of aging fields (before 1980) and OPEC restrictions in the attempt to defend prices (1980-85). In total, production more than halved passing from a peak of 3.8 million barrels per day on average in 1970 to 1.7 million barrels per day on average in 1985. Thereafter, recovering the past level of production became a priority and the policy of “apertura petrolera” was inaugurated, inviting foreign companies to again invest in marginal or more difficult fields. This, together with attempts to increase production from the extra heavy oil deposits of the Orinoco Belt led to a remarkable recovery until 1998, while the country openly ignored OPEC quotas and PDVSA pursued a policy of international downstream integration aiming at transforming itself into a Venezuelan IOC. This strategy came to an abrupt end with the election of President Hugo Chavez –- a case of constitutional transfer of power leading to major oil policy reorientation. The main accusation that critics addressed to PDVSA, and Chavez upheld, was that it undermined OPEC through non-respect of quotas, and did not pursue the maximization of government revenue, on the contrary

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embarking on projects that were not revenue maximizing.3 Notwithstanding repeated changes at the top of the company, Chavez was not immediately able to assert control over PDVSA, and the company started acting as a force of the opposition. The conflict came to a head between the end of 2002 and the early months of 2003, when the company proclaimed apolitically motivated strike and oil production almost stopped. Eventually, the strike failed and Chavez fired a third of the company’s technicians and managers, subjecting it to strict political control. The dramatic loss of competencies that this entailed has meant that ever since the company has struggled to maintain production. Since then, the government’s main preoccupation has been to demonstrate that the country is still capable of filling its OPEC quota (thus resisting a reduction of the same), rather than avoid overproduction. However, the urgency of increasing production was moderated by the rapid increase in prices since 2004, which brought significant additional income to the Venezuelan government. In 2005 the government moved to impose a unilateral change in the terms of the contracts under which foreign companies had been operating in the country since the “apertura”: a majority of the companies involved accepted, but ExxonMobil and Conoco resisted and were expropriated. International arbitration ensued leading to Venezuela being condemned to pay damages of … Following the collapse of oil prices in the latter part of 2008, Chavez has again signalled a desire to attract investment from international companies, but does not appear to have had much success. In the meantime, the government has announced a huge re-evaluation of its reserves, which have passed from 80 billion barrels in 2005 to 296.5 billion in 2011 – essentially thanks to having classified a much larger share of the Orinoco extra-heavy oil deposits as proved reserves. Today Venezuela claims to have the world’s largest oil reserves, and posts a ratio of reserves to production (R/P: a measure of the intensity of exploitation) of close to 300 (meaning that at current levels production could be sustained for 300 years). It is therefore clear that the country has no conservationist preoccupation at all, and truly aims at expanding production. Thus, the Venezuelan case demonstrates that even a highly ideological political government such as Chavez’s adopts more or less stringent nationalistic 3

Among several critical articles, see: Bernard Mommer, “Sovereignty and Oil”, Oxford Energy Forum no. 50 (August 2002): 16-17; Bernard Mommer, “Fiscal Regimes and Oil Revenues in the UK, Alaska and Venezuela”, OIES, June 2001 (http://www.oxfordenergy.org/pdfs/WPM27.pdf?PHPSESSI%20 D=a5f4cd5bfe859f3d446c41b8462aae35), and Juan Carlos Boue, “The Internationalisation Programme of PDVSA” (mimeo) (http://www.oxfordenergy.org/pdfs/Internationalisation.pdf).

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attitudes depending on its production targets. Today, Chavez would like to attract more foreign investment especially in the Orinoco Belt, but the reputation of his government is such that few companies are ready to sink the very large up front investment which is needed to set up production in the difficult conditions that exist in that region. Algeria nationalized the French companies operating in the country in 1971. Production continued to climb with some oscillations until 1979, then declined, but less dramatically so than in the case of Saudi Arabia, Venezuela or Kuwait. The minimum point was touched in 1983: then a steady recovery began. However, the price collapse in 1985 caused serious financial strain to the Algerian government, which had become seriously indebted in the pursuit of a strategy of expansion of heavy industry. Riots in protest against austerity measures took place in 1988, and a process of democratization was initiated, which was expected to culminate in multiparty elections at the end of 1991. In this context, a process of reopening of the Algerian upstream was also initiated, accelerating in the summer of 1991, when Sid Ahmed Ghozali became Prime Minister and Nordine Ait Laoussine Minister of Energy. However, the Figure 1.6: Algeria oil production 1965-2011

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democratization process was abruptly interrupted by a military coup d’état, and in the summer of 1992, after President Boudiaf was assassinated in suspicious circumstances, the Ghozali government resigned, and was replaced by a government under the leadership of Belaid Abdessalam, the father of state-led industrialization. The opening to foreign investors was not reversed, but progressed more timidly. It appeared to move forward again with greater determination after 1999, when President Bouteflika appointed Chekib Khelil as Energy Minister. Khelil proposed a new law, which would have redefined the role of Sonatrach, creating separate entities to regulate the upstream (i.e. the granting of new concessions) and downstream segments of the industry. This would have left Sonatrach competing against foreign investors potentially on a level playing field, thus also creating conditions allowing the partial or even complete privatization of the national oil company. The specter of privatization spurted significant resistance, especially on the part of the powerful trade unions. The draft law was withdrawn from Parliament in 2003, on the eve of new elections that confirmed Bouteflika in the presidency. Khelil again proposed his reform in 2005, and this time it was approved by Parliament. However attitudes soon changed again: the increase in oil prices rekindled the nationalist sentiment: in 2006 foreign companies were hit with a windfall profit tax, and amendments were approved to the reform law of the previous year reasserting Sonatrach’s privileged position. The Algerian experience therefore well illustrates the interplay of long-term factors – notably the desire to increase production, which has been a constant since independence – and short-term factors connected to domestic political events (the coup d’état and the subsequent civil war) or price fluctuations (the rapid price increase between 2004 and 2008 again supporting a more nationalist stance). As in Venezuela, oscillations in resource nationalism in Russia have been motivated by political concerns (related to control of domestic political assets) as much as by the desire to increase production and movements in prices. Russia experienced a period of chaotic opening during the Yeltsin presidency, during which former state-owned companies were privatized and foreign companies were allowed to invest in a not very well-defined legislative environment. The government repeatedly submitted to the Duma draft laws envisaging that production sharing agreements would be either the standard or in any case an allowed form of upstream contract, but the Duma never approved such legislation. As in Kuwait, the sentiment of the elected representatives of the people proved more nationalist than the wishes of the government.

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Figure 1.7: Russian Federation: Oil Production 1985-2011

The attitude of the Russian government gradually changed following the shift from the Yeltsin to the Putin administration. The latter moved to re-establish government control, first on companies formally owned by the state, but which had negotiated an extraordinary degree of autonomy for themselves (notably Gazprom); then also on some of the privatized companies, notably Yukos; and finally on some of the foreign-controlled interests, notably the Sakhalin 24 and Kovykta5 projects, and TNK-BP.6 Having reorganized the state interests around the two poles of Gazprom and Rosneft (the former primarily but not exclusively a gas company, the second primarily an oil company, both majority but not entirely owned by the government) the 4 This is one of two PSA agreements signed under Yeltsin and ‘godfathered’ notwithstanding the failure to approve a proper law on PSAs. Both are based on the distant and difficult island of Sakhalin. The main partner of Sakhalin was Shell, until end 2006, when Gazprom acquired a 50 percent stake in the project. “Gazprom, Shell, Mitsui, Mitsubishi Sign Sakhalin II Protocol” official Shell website, http://www.shell.com/home/content/ media/news_and_library/press_releases/2006/sakhalin_protocol_21122006.html, accessed May 13, 2010. 5 Kovykta is a large condensate and gas field in Siberia which BP was forced to sell to Gazprom in 2007. See “Kovykta Project” official BP website (http://www.tnk-bp.com/operations/exploration-production/projects/ kovykta/), accessed May 13, 2010. 6 BP’s appointed CEO of TNK, Robert Dudley, was forced to resign in 2008. He was substituted by Milhail Fridman of the Alfa-Access Renova Group, signalling loss of control on the part of BP, which however maintained 50 percent ownership. A new CEO, Maxim Barsky, was appointed to take over at the beginning of 2011. See Financial Times, January 24, 2010, http://www.ft.com/cms/s/0/ae2a3c34-090e-11df-ba88-00144feabdc0.html.

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government signalled a fresh interest in international alliances, notably with respect to difficult reserves, such as the Shtokman gas field, or frontier exploration in the Artic. However at the time of writing the Shtokman project, in which Total and Statoil are involved in association with Gazprom, appears to have been indefinitely shelved by the Russian side; and the initial alliance of Rosneft and BP to explore in the Artic had to be abandoned due to opposition from BP’s partners in TNK-BP. Eventually, Rosneft took over the full ownership of TNK-BP acquiring both the equity stake of BP and that of its Russian partners. BP obtained a 20% participation in Rosneft – which is sizable but still very much of a minority stake. In the Russian case, establishing a direct relationship between resource nationalism and levels of production is tricky. Production levels were highest under the Soviet Union, peaking in 1987. Thus, the decline in production began a few years before the end of the Soviet state, and might have contributed to the crisis of the latter. After the collapse of the Soviet state in 1991, production declined rapidly until 1994, then stagnated until 1999: this just happens to be the period during which Yeltsin was president. Production again increased rapidly in the early years of the next decade and reached a new peak in 2007, slightly declining in 2008, which is when Putin left the presidency, but recovering thereafter. A reading of oil production as a function of political leadership would obviously be simplistic, and in any case certainly does not corroborate linking oil sector openness with higher production and resource nationalism with the opposite. 1.2.3 Conclusions on Resource Nationalism

We shall tentatively conclude that depletion policy is a determinant of resource nationalism in some, but not all cases. The key supporting case is Saudi Arabia: this is certainly very important as the country controls close to a quarter of the world’s proven conventional oil reserves. But there is plenty of evidence to the contrary. In most cases, resource nationalism appears to be rather motivated by rent maximization. Hence we see more restrictive policies adopted when prices are increasing, because the producing country’s government will conclude that whatever arrangements are in place do not allow the country to obtain a ‘fair share’; and at the same time the government and/or the national oil company will enjoy larger financial resources and will feel that they can undertake

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whatever investment is needed on their own, without recourse to IOCs. Conversely, when oil prices are low, increasing export volumes will be more important and financial resources for investment will be scarcer: the contribution of IOCs is more important. The spectrum of attitudes depends primarily on structural factors rather than political or ideological inclinations. Some countries — primarily those endowed with larger reserves — find nationalist attitudes more attractive than others, while a large number of countries — notably those endowed with relatively smaller reserves — never seriously considered excluding IOCs. It may appear that some countries are beset by ideological limitations that they would like to shrug off, but cannot (Mexico? Kuwait? Iran?). But then one should not underestimate the nationalist sentiment in domestic public opinion (Russia, Venezuela, Iraq, and Kuwait). Looking toward the future, no fundamental shift is to be expected in the current pattern. Rather, there will be oscillations, with some countries opening up at times and closing off at others, depending on circumstances such as price levels, availability of resources, the need for expensive Enhanced Oil Recovery (EOR) technology and the like. At the same time, some countries will surely remain almost entirely closed and others will continue to rely on IOCs, as they have done up to now.

1.3 Restrictions on Exports Resource nationalism restricts access to resources to national players; restrictions on exports include policies through which exports of oil and/or gas are limited, even if access to resources is not limited and IOCs are allowed to invest and operate. Generally speaking, the existence of restrictions to exports will discourage IOCs from investing in the country, however this is far from being a universal or systematically applied rule, and numerous exceptions exist. 1.3.1 Export Policies

In some cases, we see countries adopting policies that purely and simply prohibit the export of hydrocarbons. This is seen most frequently in the case of natural gas — in some cases also for specific petroleum products such as gasoline — to protect domestic supplies.

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Policies banning or restricting the export of natural gas are notable and more widespread than often realized. The rationale is very simple: natural gas is a resource, which should be reserved to fuel national consumption and development. Countries producing both oil and gas frequently view oil as primarily destined for export, but gas to be reserved for domestic consumption. This attitude has solid economic grounds, because the netback fiscal benefit of exporting gas is generally much lower than that of exporting oil. The higher incidence of transmission costs, whether by pipeline or as LNG, except for very short distances, reduces the potential rent that may be derived from gas production and export. Hence gas is sometimes (only too frequently, in fact) purely and simply considered not worth developing (massive flaring still takes place in major producing countries such as Nigeria, Angola or even Algeria) or even not worth exploration. Among the major oil-producing countries, Saudi Arabia has a policy of not exporting any natural gas, and reserving production exclusively for national users. There is, properly speaking, no ban on natural gas exports: simply no export project has ever been contemplated. For a long time, Saudi Aramco was not interested in exploring for natural gas. As domestic consumption increased and strains appeared in the availability of natural gas, this position has now changed. Nevertheless, it is not without reason that IOCs have been invited to explore for natural gas, while oil remains off limits. Take the example of the UAE, which was the first exporter of LNG from the Gulf, and now is forced to import from its neighbor, Qatar, or from Iran (a contract to import gas from Iran into Sharjah never became operational because the Iranian side wanted to renegotiate the price it had agreed to, and the importer refused to do so). Abu Dhabi has given the go-ahead to the exploitation of sour gas in the Shah field, which is expected to have a substantially higher marginal cost than gas exploited until now.7 Critics of Abu Dhabi’s LNG export policy are bound to ask whether it was wise to export gas for a financial return that was relatively small and in any case not needed. Even Qatar, which is now the most important global exporter, accounting for one third of total global LNG trade in 2011, imposed a moratorium on new 7 The Abu Dhabi National Oil Company (ADNOC) had selected ConocoPhillips as its partner in this project, but the latter suddenly withdrew from the project in May 2010; MEES 53 (no.18): 20. It was later substituted by Occidental, which is believed to have obtained more favorable terms.

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projects, in order to have time to assess the behavior of its major field, the North Dome. This moratorium is expected to remain in place well into the next decade, and in fact it is not clear that it will ever be lifted. Qatar may opt for a slow depletion policy, similar to that pursued for oil by Saudi Arabia; and/or it may give preference to adding value to the gas through industrial transformation at home – again, similar to what Saudi Arabia has done. The experience of the giant Pearl gas to liquids (GTL) project that Shell has completed in the country may play a major role in influencing future decisions, given that the large gap in prices between oil and gas per unit of caloric content certainly encourages transforming gas into “petroleum products”. Much then will depend not only on the behavior of the field, but also on the evolution of demand and prices. Gas exports from Iran remain controversial and a strong current exists in the Iranian Majlis (Parliament) that favors gas being used for domestic consumption exclusively. While the government authorities officially favor export projects and seemingly promote them, in fact the only operational export project is the pipeline to Turkey, which has witnessed throughput shortfalls in winter, when gas is in high demand in the domestic Iranian market. Other countries in which gas exports have been highly controversial are Bangladesh and Bolivia. The case of Bangladesh is quite typical, with industry and government in favor of an export pipeline to India, but unable to overcome nationalist sentiment in public opinion. In the case of Bolivia, controversy over gas exports was instrumental in determining the collapse of the Carlos Mesa administration and the election of Evo Morales. The new president nationalized gas production and scrapped a project to export gas to Peru for liquefaction and further export to the US; however, pipeline gas exports to Brazil continued. Exports of LNG from Venezuela have been on the drawing table for two decades at least, but little progress has been made. Besides tabling phantasmagorical ideas of pipelines across the Amazon to serve the Brazilian market, or soliciting Iranian technical assistance in establishing an LNG plant, President Chavez has simply not pursued gas exports. In the case of Venezuela, we may possibly attribute the negative outcome more to the incompetence or dogmatism of the president and his administration than to the desire to conserve gas for national use, as a significant opposition to natural gas exports does not appear to exist.

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What about Europe? The Netherlands has exported gas for decades but avoided increasing exports beyond a level that was considered appropriate in order to preserve the long-term life of its reservoirs. Norway is exceptional in that it is a major gas producer that until recently has had essentially no domestic market for gas; its power requirements being met entirely through hydropower. But elsewhere in Europe, gas has been consumed in the country where it was discovered, and export projects were not normally considered at all. The UK is a relatively small exception, exporting gas through the Interconnector pipeline for as long as it has had gas available for export. But even in a free market environment, gas companies prefer to serve their regular customer base rather than maximizing returns through gas exports, and gas has not flown from the Continent in response to higher prices in the UK whenever supplies were tight. Finally, it is interesting to point to the debate currently underway in the United States, since the shale gas revolution has turned the expectation of an increasing reliance on imports of LNG to satisfy domestic demand upside down, and the price of gas in the domestic market has declined to a level that makes LNG export from the United States increasingly attractive. The question is: will exports be allowed? A total ban is excluded, and some export projects have received formal approval: but to what extent the gap between domestic prices in the US and prices in Europe and the Far East will be allowed to close through exports? It may very well be that exports will be limited to a level that allows maintaining a low domestic price for natural gas, and support the process of reindustrialization that has taken shape since prices decreased dramatically. We shall conclude that de facto reserving gas for national consumption is very common behavior. Only countries with very large reserves relative to domestic consumption contemplate gas exports. The refusal to export is made easier by the difficulty of establishing a gas export project, meaning that numerous obstacles have to be overcome before an export project can be successfully established, and opposition to exports has a relatively easy task. The drive to establish export projects is most frequently associated with foreign IOCs whenever they – rather than national companies – have discovered the gas, because exports promise faster and more reliable valorization (in convertible currency, not exposed to domestic administrative interference) than domestic sales. However, the interest of the IOC does not always coincide

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with the interest of the country, and gas export projects are frequently very controversial. 1.3.2 Taxation Policies

Export taxes are a tool not only to extract at least part of the rent generated by oil and gas production, but also to favor domestic consumers by creating a differential between domestic and international prices. The rationale for imposing an export tax, rather than resorting to other forms of taxation such as income taxes or royalties, is that it is easy to collect while other forms of taxation may be much more difficult to assess. Thus, export taxes may be used to extract some of the possible rent from the export of agricultural products – especially when a large number of small producers are involved. However, this rationale holds little water in the case of crude oil, whose production is relatively easy to monitor and is normally carried out by a few large-scale companies. When it comes to oil, an export tax is a very rudimentary form of taxation, and is thus rarely used. The most important and widely debated case of taxes on crude oil exports is that of the Russia Federation. Export taxes on crude oil also exist in Argentina and Vietnam. China has an export tax on oil produced by foreign joint venture partners offshore since 2006. Kazakhstan imposed an export tax on crude oil in 2003, but abolished it in January 2009. The Russian export duty has been identified as a disincentive to expand production. Oil companies lack stimulus to increase production because of the high tax burden. The Russian petroleum fiscal system is quite sensitive to world oil prices, but absolutely insensitive to the costs of oil production. In 2009, the Energy Ministry indicated that under the current tax regime, only 64 percent of brownfields and just 7 percent of greenfields in Russia were profitable to exploit. The government is afraid that moving from calculating the tax based on revenues to accounting only the profit of the companies may lead to substantial decline in revenue. Oil export duties are still a very important source of revenue for the state treasury, providing for more than half of the oil and gas revenue of the federal budget, and, therefore, about one-fifth of all budget revenues. In the longer run, it is likely that export taxes and duties on crude oil will be substituted for by other, more effective and less distorting forms of taxation.

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1.3.3 Market (Volume/Price) Policies

Exports may be restricted because the government pursues a market intervention strategy (whatever the target of the same) and modulates exported volumes in order to achieve certain price objectives. The obvious case is collective action by OPEC to impose and modulate quotas. OPEC quotas are imposed on total production, not on exports – but in fact the determination of quota levels is primarily influenced by international market conditions and accumulation of stocks, and domestic requirements are added to whatever is believed to be the optimal volumes of crude oil to be added to the market. Non-OPEC oil exporters may also adopt restrictions to exports in cases of severe weakness in oil prices: they are then ‘encouraged’ to align themselves to OPEC practices, either explicitly or implicitly. The clearest case happened in 1998-99, when Saudi Arabia pressured Mexico and the Russian Federation into unilaterally reducing exports in order to prop up prices. Some producers enforce restrictions on the resale of exported crude oil, and only sell to final customers (refiners). Most Gulf producers do not allow secondary sales (i.e. reselling) of their crude oil, this being a key reason that a market for their crude does not exist or is very opaque. Saudi Arabia even differentiates prices as a function of destination, and has different price formulas for shipments to the Far East, to Europe and to North America. The rationale for this policy is rent maximization, while guaranteeing the competitiveness of Saudi crude oil on all major markets (notably the US market, which Saudi Arabia wants to serve for political reasons). Destination restrictions are not quite the same as restrictions on overall exports, and do not necessarily translate into less oil being available globally. They will just translate into a distortion of flow patterns for global oil trade relative to what they would obtain in the absence of them. The situation is rather more complicated for natural gas, where destination restrictions are common, in part imposed by the limited availability of pipeline transmission capacity, in part imposed by way of contractual agreement. Although the European Union has declared destination clauses in long-term gas supply contracts illegal and unenforceable, very little gas flows from one importing country to another.

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Rent maximization must be recognized as a legitimate interest of any exporting country and is not likely to be abandoned. 1.3.4 Domestic Pricing Policies

It is very common for oil and gas producers – indeed, for a large number of developing countries – to enforce domestic prices that are lower than international prices. In most cases, this is done through the determination of administrative prices for gas and petroleum products, which the national oil companies must respect. IOCs will not easily be bound by such discipline and will tend to export to higher international prices: then either the domestic market is served exclusively by the national companies, or forms of export restrictions are imposed, openly or surreptitiously. The rationale for offering lower than international prices to domestic final consumers is as easily understood as it is faulty. The problem might not exist if international prices were more stable and increased only gradually. But the wide swings and price explosions as experienced in the first half of 2008 are difficult to pass on to domestic consumers in countries which export the vast majority of their oil and gas. As hydrocarbons are generally sold by government-owned entities, increasing domestic prices will shift purchasing power from the population to the government at a time when the latter is likely to be already flush with cash. That oil and gas importing developing countries should also maintain domestic prices artificially low, sometimes at substantial cost to the Treasury, is less easy to understand, but the practice is so widespread that there can be little doubt about its traction. Obviously, artificially low domestic prices will tend to result in relatively high demand, discouraging conservation and the efficient use of energy as well as the development of alternatives. Generalizing on this issue, we may say that the problem resides in the lack of consensus on the appropriate policy towards the cost of energy to the final consumer. The use of lower domestic prices as a tool for encouraging industrialization and economic diversification is, however, a separate matter and is rather more defensible than enforcing low prices to the final consumer. Of course, situations must be judged on a case-by-case basis, and it is possible that feedstock and/or

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energy prices may be truly excessively low. However, it should be recognized that governments compete globally to attract industrial investment from global corporations that enjoy considerable discretion in deciding where to locate a new plant or expand capacity. At the same time, once the locational decision is made, investors become captive of the host country, especially in the case of large production facilities with very high up-front investment costs, as is the case for the petrochemical, steel, aluminium and other basic industries. In this context, investors will require assurance that their key cost elements, including feedstock or energy supply for energy intensive industry, will be available at favorable conditions. From the point of view of the oil-exporting country, it is desirable to have a large base of captive customers, as global corporate investors become once they have decided on a location for their capacity. It is therefore justified to offer such price discounts as may be necessary to attract the desired investment. Offering low-cost inputs is therefore a valid and effective industrial and development policy, and has yielded excellent results. The impact of this policy on global energy supplies is minimal, and security concerns do not offer a valid reason for criticism. That some of the industrial countries object to these practices because they damage competitors established in the oil and gas-importing countries is understandable, but one cannot expect that the oil and gas exporting countries, which frequently have only limited opportunities of competitive advantage, should give up on using one of the few effective tools at their disposal. Indeed, it may be argued that encouraging industrialization and the local transformation of hydrocarbons into various intermediate and/or final products may in the end support global energy security, because restrictions will never apply to the export of such higher value-added products. If more of the industrial processes based on hydrocarbons were to take place in the oiland gas-producing countries the demand of the importing countries would be relatively reduced, and the incentive of the exporters to maximize production and exports would be much greater. 1.3.5 Conclusions on Restrictions on Exports

Restrictions on exports are widespread and take many forms. The problem is more acute for natural gas, but domestic demand may be favored over exports also in the case of oil and oil products. All forms of restrictions are, in a sense,

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a threat to security of supply, because they result in lower production and exports ceteris paribus. That said, it would not make much sense to attempt to estimate the impact of such export restrictions on global oil and gas supply, and their respective costs. In the absence of such policies, in a perfectly rational world in which all national interests are aligned, oil and gas production would be higher than it actually is. Depending on one’s view of available resources and on the likelihood of supplies peaking because of the physical and technological impossibility of maintaining production, the fact that production is lower than might otherwise be the case could be seen as good or bad. Some view high oil and gas prices as a positive development, because they encourage savings and alternative sources of energy. Attitudes may also change if success in reducing the global dependence on oil and gas is such that the expectation of hydrocarbons becoming more valuable is reversed. Short of that, we expect restrictions on export are likely to continue, and, in the case of natural gas, possibly worsen, as older fields decline and domestic demand increases.

1.4 Political Instability Political instability refers to government/regime change leading to changes in policy, whether brought about by constitutional or non-constitutional means and it differs from conflict. Government change can take place by constitutional means or may be the result of a break in constitutional continuity, i.e. a regime change. In the latter case, it can play out quickly or develop into civil war. The boundary between the discussion of political instability and that of conflict is between a quickly concluded coup and a drawn-out civil war or insurgency. In historical experience, it is difficult to see any fundamental difference between constitutional and non-constitutional changes in government when it comes to oil and gas export policies. In the vast majority of cases, neither category leads to significant changes in oil and gas policies: the latter are most frequently motivated by structural factors that are not influenced by the political order. The examples of changes in government, which have led to no consequential change in oil policies, are too numerous to mention.

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There are a certain number of notable exceptions to this rule, which belong to both categories of constitutional and non-constitutional changes. From this point of view, there appears to be no strong empirical basis for arguing that government changes within the constitution do not entail major shifts in oil and gas policies, while changes outside the constitution do. Certain key cases illustrating political change accompanied by important shifts in oil and gas policies are reviewed below. These include: 1. the appointment of Mohamed Mossadegh as Prime Minister in Iran 2. the coup d’état which led to the demise of the same and the restoration of the power of the Shah 3. the collapse of the monarchy and the coming to power of General Qasim in Iraq 4. the collapse of the monarchy and the advent of Colonel Muammar Qaddafi in Libya 5. the Islamic Revolution in Iran 6. the collapse of the Soviet Union followed by the coming to power of Boris Yeltsin in Russia, and other post-Soviet leaders in the key oiland gas-producing former Soviet republics (Azerbaijan, Kazakhstan, Turkmenistan) 7. the election of Hugo Chavez in Venezuela 8. the election of Vladimir Putin in Russia 9. the election of Evo Morales in Bolivia 10. the collapse of the Saddam Hussein regime in Iraq We believe that these 10 events include all major cases in which power shifts have led to significant changes in oil and gas policies. Minor changes – adjustments to existing policies – occur more or less continuously, and are implemented by existing as well as new governments. Of the 10 cases listed above, four (cases #1, 7, 8 and 9) illustrate constitutional changes, while the rest represent breaks in constitutional continuity, i.e. regime changes. Of the 10 episodes, only two are considered major crises by the EIA, that is the Iranian nationalization of 1951 and the Iranian Revolution of 1978; only the latter is considered a major crisis by the IEA. Other events in the list (the coup against Mossadegh, and possibly the collapse of the Soviet Union) have

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led to shifts in oil and gas policy but in the direction of increasing, rather than reducing, oil and gas supplies. The literature considers the PDVSA strike of 2003 as a political crisis, but strictly speaking this episode did not entail a change in government. If anything, it should be categorised as a failed coup/revolution attempt. The change in government occurred earlier, with the democratic election of Chavez to the Venezuelan presidency, and that was accompanied by a change in oil policies yet not a sudden crisis or shortfall of production and exports. The reason that the rest of these important political changes are not considered as important oil supply crises is exactly that they were not accompanied by sudden declines in oil exports. Changes in oil policies of key exporting countries may entail significant changes in global oil supplies, but will do so over time, not suddenly. It then becomes difficult or impossible to isolate and measure the ‘impact’ of policy shifts, as several other influences may enter into the picture. Considering that the main focus of this chapter is towards the future, not the past, it is appropriate to underline the importance of historical circumstances in which these events took place. We need to question whether such events might be replicated and lead to comparable shifts in oil and gas policy. The nationalization of the Anglo-Iranian oil company in 1951 was instigated by the stubborn refusal of the company and the British government to consider a more equal distribution of tax revenue between the Iranian and the British governments – at a time when Venezuela and Saudi Arabia had obtained agreements for a 50/50 split of the oil profits (Abrahamian 2001: 185-6; Yergin 1991: 450-78). Today, no comparable circumstances exist anywhere. The Shah was able to restore his power and liquidate Mossadegh with the help of the CIA. However 25 years later the Shah lost power again, and since then neither the United States nor any other external power has been able to undermine or ‘moderate’ the Islamic Revolution. With respect to national control of mineral resources, the clock will never turn back in Iran, even if foreign companies may in the future be offered opportunities for more profitable involvement. A US-led coalition did intervene militarily in Iraq to rid the country of the regime of Saddam Hussein, but this experience has proven how difficult it is to influence domestic politics in an oil-producing country: Saddam’s regime survived military defeat (in 1988 against Iran and then in 1991 against the coalition liberating Kuwait) and stringent international sanctions for a decade

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thereafter; in the end, nothing less than massive invasion of the country was required to dislodge him – all with clearly negative results from the point of view of global oil and gas availability. Similarly, the coming to power of Qaddafi in 1969 took on an importance that went beyond the presence of international oil companies in Libya, because it showed that the weapon of boycott, which had succeeded in bringing down Mossadegh, had lost its effectiveness. This opened the door to a rapid sequence of shifts in relations between international oil companies and producing countries’ governments, beginning with the Tehran-Tripoli agreements, finally leading to nationalization in many countries and the shifting of the power to set posted prices from the IOCs to the OPEC governments. The loss of IOCs’ access to resources essentially took place in the 1970s and has not changed much since. This shift in controlling power from the IOCs to the governments is a historical phase, which has now essentially concluded, and a new Colonel Qaddafi taking power in a producing country would not have the same impact as he did back in 1969-70. The collapse of the Soviet Union is also a one of a kind event, which is unlikely to be replicated. The remaining major Communist power in the world – Mainland China – is not a major oil and gas exporter, and is in fact ‘capitalist’ enough. The consequences of the collapse of the Soviet Union on Russia’s openness to international investment and the apparent inverse relationship between the latter and levels of production and export in the transition from Yeltsin to Putin have already been discussed. In the FSU republics of Kazakhstan and Turkmenistan, power has remained in the hands of Soviet incumbents — in the former Nursultan Nazarbayev remains in power to this date and in the latter, Saparmurat Niyazov held power as president until his death in 2006; in Azerbaijan, a period of instability preceded the advent to power of Heydar Aliyev in 1993; the latter was succeeded by his son Ilham in 2003. In all cases, the new independent governments have invited the investment of the IOCs and are pushing to increase production and exports, with variable success, generally well below initial expectations. In all cases, further shifts in power and consequent shifts in oil and gas policies cannot be excluded. In Russia, a swing of the pendulum back to greater involvement of the IOCs is possible, if the national companies fail to at least

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maintain oil and gas production levels in the face of mounting technical difficulties. A revision of policies may or may not be associated with changes in power. In the Central Asian and Caucasian republics, a shift in the opposite direction is possible because of the opaque nature of many deals and outcomes that are not beyond criticism. However, it is unlikely that any change in power may lead to dramatic changes in oil and gas policies, because the countries are objectively in a difficult position and have limited alternative options. Patrimonial regimes continue to rule some of the key oil and gas producing countries, notably Saudi Arabia, Abu Dhabi (UAE) and Qatar; in Kuwait, a patrimonial regime is coupled with a freely elected parliament, resulting in perennial stalemate, as noted earlier. The patrimonial regimes in question have weathered the challenges of recent decades and displayed singular durability. We believe that in all likelihood these regimes will remain very stable because they have very strong roots in society, and control of the oil rent affords them exceptionally strong tools for dealing with society’s aspirations. All that said, the possibility of regime changes in some of the major oil and gas producers in the Gulf cannot be excluded. What might happen to oil and gas policies in this case? As was discussed in detail earlier, Saudi Arabia and Kuwait remain essentially closed to IOC investment, while Abu Dhabi is open but the government controls the activities of foreign oil companies closely. Nationalization is theoretically possible in Abu Dhabi and Qatar, not in Saudi Arabia or Kuwait as there are no foreign companies that may be nationalized. More likely, attention will focus on export levels, and a more conservationist approach may emerge. This would be in line with the experience of Iran at the time of the revolution, and with the precedents of Venezuela and Bolivia. As argued in the previous sections of this chapter, a continuation or accentuation of policies restricting production and exports of oil and gas, or reserving gas especially for domestic uses, is a distinct possibility. Political change may be instrumental in provoking shifts in that direction, unless sufficient incentives exist in the global economic environment to discourage this tendency. Policy shifts in this direction are more likely to be associated with changes in power, including by constitutional means, and are frequently the result of the electoral success of populist leaders, but may very well also be associated with the passage of power from one member of a ruling family to another.

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The experience of Iraq since 2003 is extremely telling of prevailing trends. Notwithstanding the collapse of the Saddam Hussein regime and the occupation of the country by foreign forces, followed by the progressive empowerment of a new constitutional order amidst multiple contradictions and uncertainties, we have not witnessed the unrestrained opening and rapid build-up of production and exports that was touted by some on the eve of the coalition’s intervention. We may look at Iraq as a case of political instability and argue that the reason for the IOCs’ lack of investment and oil production stagnation until 2010 was the difficult security situation, the absence of an oil and gas law, and the continuing controversy on central vs. provincial control of oil policy. Or we may argue that all of the above have been the outcome of deep-rooted resistance to foreign presence in oil and gas, which will never be accepted as fully legitimate in a democratic Iraq. In this, the situation of the Kurdish province differs from the rest because of the profoundly different political history and the enduring experience of autonomy from Baghdad. Indeed, with hindsight it is safe to assert that IOCs would have had a much better chance to invest in Iraq; and oil and gas production and exports from the country would have been larger, had sanctions been lifted in the mid 90s and agreements then on offer allowed to go ahead. This is not to argue that the latter would have been a politically preferable course of action, as this is not a topic for this paper, but is cited as further proof that in recent times authoritarian regimes have been more prone to seeking the help of international investors, while democratically elected leaders are more frequently conditioned by deeply rooted nationalist sentiment.

1.5 Conclusions The discussion and analysis in this chapter have shown that there is no easy and immediate connection between resource nationalism or political instability and global supply of oil and gas. This is emphatically not because political developments are irrelevant when it comes to influencing oil and gas supplies, but because this influence is highly variable and unpredictable. Political factors act as one of the elements that prevent the oil and gas upstream industry from behaving in a perfectly economic-rational way, optimizing supply at all times. Instead, we live in a suboptimal world, in which reality always falls short of what would be possible and ideal.

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The gap between reality and the theoretical optimum is not constant. Political circumstances may influence the gap and let it widen or narrow down. The existence of conditions of financial stability and growth — incentivizing the transformation of a physical asset, such as oil and gas in the ground, into financial assets, or infrastructural/industrial investment — is crucially important in determining the attitude of producing countries towards the desirable level of production and exports. Financial instability, negative returns on financial assets and protectionism against the oil producing countries’ industrial exports all go to support the view that it is best to keep oil and/or gas in the ground. Similarly, expectations about the future level of oil and gas prices influence political attitudes towards oil and gas production and exports. If the market expects that supply will grow scarcer in the face of increasing demand, then the incentive to slow down production and exports is increased. The adoption of aggressive policies aimed at decarbonization and energy efficiency may have an ambivalent effect: there may be a negative announcement effect, because producers will fear demand destruction and invest less in expanding or maintaining capacity; and a positive market effect, when demand is effectively reduced, ceteris paribus. Hence the suggestion might be not to entertain policy objectives that cannot realistically be reached and emphasize cooperation and pragmatism rather than confrontation and extremism. Political instability and resource nationalism have rarely been associated with acute supply crises or shortfalls. Their effect is rather gradual and normally compensated by action in other parts of the system. Today, the system appears quite flexible and capable of withstanding even significant shocks, primarily thanks to excess capacity available in Saudi Arabia. But if Saudi Arabia itself were to get into hot water politically, problems may arise even today. For the longer term, the danger that capacity additions may fall systematically short of demand increases exists and would entail a progressively more fragile system.

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Chapter 2 – Armed Conflicts and Oil/Gas Security of Supply

Chapter 2 Armed Conflicts and Oil/Gas Security of Supply 2.1 Introduction It is normally assumed that armed conflict affecting oil-exporting countries may constitute a significant threat to global oil supplies. The specter of a regional war suddenly depriving the world of all oil produced in the Middle East is evoked frequently and contributes to creating the impression that oil is an unreliable source of energy. In this chapter, we attempt a systematic analysis of the impact of international or civil wars and violent non-state actors on global supplies, with a view to arriving at a reasonable estimate of the probability that oil supplies may be seriously affected. For the purpose of analyzing their impact on the security of oil or gas supply, we shall distinguish three main categories of armed conflict: 1) “classic” interstate warfare, which is fought primarily by regular armies; 2) civil wars, in which armed forces from opposing sides within the same country engage in violent encounters; and 3) terrorism/banditry. • Interstate wars involve the armed forces of two or more states, generally fighting for control of disputed territory, or engaging in occupation of enemy territory beyond what is contested in order to force the enemy’s surrender. Interstate wars may be preceded, accompanied, or followed by violent acts carried out by smaller or informal forces, and easily combine with resistance, which is frequently labeled as terrorism. That said, an interstate conflict is clearly recognizable because it involves the use of the states’ armed forces: it is sometimes officially declared by the belligerents and has a clearly identifiable end in a peace treaty or at least a ceasefire of indefinite duration.

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• Civil war is different from interstate war because it is fought between forces belonging to the same state and fighting either for redefinition of that state (e.g. secession of a province) or for control of power in the state as a whole. It may be fought between different sections of the state’s army, or between the army and various irregular forces, including militias. The distinguishing feature of a civil war is that either side (or all sides, if there are more than two) controls a portion of the national territory. If one side has no continuous control of territory over time, or loses it, then we fall back to the case of terrorism. Civil wars may attract the active involvement of outside actors (foreign countries) including through direct intervention in the territory of the country experiencing civil war, but such involvement is normally not motivated by territorial disputes and not intended to redraw borders – hence it is not a form of interstate war. • Terrorist activities are distinguished from civil war because one side has no permanent and continuous control of a portion of the national territory. The distinction between resistance, terrorism and banditry is one of motivations and rights, not one of observed behavior. Groups carrying out systematic violent acts against an established state will normally define themselves as legitimate fighters (for national liberation, for freedom, for social justice, for revolution…) and the state under attack will define them as terrorists. In theory, legitimate fighters should only attack military or state targets of the enemy, and avoid harming the civilian population. Terrorism refers specifically to the tactic based on creating widespread terror in the population with acts of indiscriminate violence, leading to pressure on the state to yield or compromise. In this context, attacks on civilian economic installations, such as oil fields or refineries or logistic facilities, are not strictly speaking acts of terror, because they aim at inflicting economic damage to the state rather than terrorizing the population – nevertheless we normally refer to them as acts of terrorism (sabotage would be more appropriate). Banditry is distinguished from all of the above because the objective is material gain: however, in practice, politically motivated violent actors who require funds and resources to continue their fight may engage in acts that are primarily motivated by material gain or may enter into tactical or strategic alliances with forces whose main objective is material gain.

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Because of the close proximity of these different forms of armed violence, we shall in the rest of this paper refer to the technically preferable terminology of “violent non-state actors” to encompass all forms of violence on the part of non-state actors who do not continuously control a portion of the state territory. Conflict waged by violent non-state actors is asymmetrical, in the sense that normally regular forces are much superior in military power than the insurgents or terrorists, but the latter manage to hide and escape retribution, including thanks to the active support of civilian population. In some cases, the residual control that state forces exert on portions of the territory is rather tenuous, but if the state decides to assert such control it is in a position to do so with little challenge. In a civil war, the state loses control of a portion of its territory and is not immediately in a position to overcome the resistance of the adversary if it tries to reassert control. As far as our discussion is concerned, this distinction is important because in a civil war the state may lose access to some oil resources, while in the case of violent non-state action the state may not be able to avoid damage to oil installations but maintains access to the same.

2.2 Trends in Armed Conflict Armed conflict has been a constant of human history, but the forms it takes have constantly evolved, and arguably this evolution has accelerated since the end of World War II. The frequency, duration and scope of interstate conflict have dramatically diminished. This is universally recognized, and unlikely to change in the future. There are clearly understood causes for this evolution: • The strategic equilibrium reached between the two superpowers during the Cold War, which dissuaded either side from risking direct conflict. This has fundamentally survived the end of the Cold War and of the historic rivalry between the capitalist West and Communist East. Instead, a pattern of proxy wars prevailed for as long as ideological opposition continued to exert an influence, but has greatly declined since.

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• The role of the United Nations system in offering an alternative for the resolution of conflicts (through mediation or the pronouncement of the International Court of Justice) and, more importantly, in frustrating the objective of war by making international recognition of changes in boundaries or of conquest almost impossible. • The reduced importance of territory for the economic well being of the people, as shown by the fact that some of the most prosperous economies may be either based on relatively small territory or, in some cases, not even politically independent (e.g. Hong Kong). • The reduced readiness of public opinion to accept the high cost of war in terms of human life and dislocation. Today, interstate war in its classic form has almost completely disappeared in all parts of the world, except the Middle East.2 In contrast, civil war and the use of violence on the part of non-state actors have continued. A majority of large-scale conflict which solicited major power intervention in the past 50-60 years originated as civil wars: Korea, Vietnam/ Laos/Cambodia, former Yugoslavia, Afghanistan, more recently Libya. Other civil wars did not solicit direct major power intervention but have had significant impact nevertheless: Nigeria (Biafra), Angola, Zaire, Congo (Brazzaville), Sudan, Somalia, Lebanon3, and Yemen, for example. We may also regard the intervention of the US-led coalition in Iraq as outside intervention in a civil war (the Baghdad government had in fact lost control over Northern Iraq; nevertheless this is a sui generis case, because the opposition to Saddam was not able to operate in the rest of the country). Systematic conflict research indicates that conflict intensity is not random and is linked to certain crucial historical phases or turning points. For reasons that we have already discussed, interstate conflict is disappearing: although it would not be wise to completely rule out the danger of new 2

Several international research centers systematically monitor conflicts and maintain quantitative databases to measure conflict numbers, types and intensity. I refer in particular to the Center for Systemic Peace at George Mason University (http://www.systemicpeace.org/conflict.htm); the Uppsala Conflict Data Program (UCDP) in association with the Peace Research Institute of Oslo (PRIO) at http://www.pcr.uu.se/research/UCDP/ index.htm; the Heidelberg Institute for International Conflict Research (http://www.hiik.de/en/index.html). 3 Major outside powers did briefly intervene in Lebanon, but this did not last long. Syria’s intervention, in contrast, lasted for an extensive period and seriously threatened Lebanese independence – but the international community did not allow this to happen, and Lebanon has remained independent.

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interstate wars erupting, nevertheless we should consider this as a low probability event. Further detailed analysis would show that a majority of wars are fought over relatively short periods of time (the major recent exception being the Iraq-Iran war, which turned into something resembling the First World War in Europe) and then resolved either by the decisive military victory of one side (where military victory does not necessarily translate into political victory) or stopped by forceful international pressure and intervention. The international system effectively works to discourage revisionism and war fighting. We also see that domestic conflicts, sometimes leading to outside armed intervention, are primarily linked to complex historical transitions that leave unresolved issues behind. We can thus cite the process of decolonization (in the Near East; in South and Southeast Asia; in Africa) as being a primary cause or occasion for violent domestic conflict. In some cases, a period of acute instability is followed by consolidation of existing structures and eventual progressive decline of the use of violence. This process may be said to have concluded in Southeast Asia (where it has been extraordinarily costly in terms of human casualties), and conflicts have been essentially frozen elsewhere (between India and Pakistan; in the Balkans) but a clear trend towards pacification is not visible elsewhere, notably in Sub-Saharan Africa. In the Near East, the main conflict (between Israel and its Arab neighbors) has progressively been reduced in scope, following the peace treaties signed with Egypt and Jordan, and the freezing of war with Syria. Lebanon still constitutes a problem area; otherwise the conflict has now become a purely Israeli-Palestinian affair, into which Arab neighbors are not willing to be drawn or intervene militarily. The future of Iraq and Afghanistan also remains uncertain, and the intentions of Iran are not clear – claims over Bahrain keep resurfacing from time to time, although not in the form of official policy. The collapse of the Soviet Union has been another occasion for violent conflict, and tensions have cooled but not disappeared. Notably, the Caucasus remains an area rife with conflict, such as between Azerbaijan and Armenia, Georgia and Russia, and secessionist movements in some Russia republics. At the same time, the relationship between Turkey and Armenia remains very difficult, but has improved following the visit of the Turkish President Abdullah Gul to Armenia in September 2008.

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2.3 Historical Experience of Oil Supply Interruptions due to Conflict In Chapter 1 we referred to the lists of major supply interruptions established respectively by the US Energy Information Administration and the International Energy Agency. In EIA’s list we find eight events in total, of which five are international conflicts, two are domestic political events, and one is a combination of the two. IEA’s list differs somewhat, but the two lists concur on six armed conflict events, which caused major disruptions; these are: 1. 2. 3. 4. 5. 6.

The Suez Crisis or War The Six-Day war The Yom Kippur war The Iraq-Iran war The Iraqi invasion of Kuwait The US-led Coalition intervention in Iraq.

Of these, the first two (Suez crisis and the Six-Day war) affected global oil supplies primarily because the Suez Canal was closed – for a short period in the first case and a much longer period in the second. The shortfall was due to limited availability of tanker capacity rather than of crude oil per se. The Six-Day war and the long closure of the Suez Canal led to the development of VLCCs and ULCCs to circumnavigate the African continent. The direct effect of the war on oil supplies was not significant at all: in fact the Egyptian fields in the Sinai continued to be operated throughout the period of Israeli occupation between 1967 and 1973, and disruption to production was minimal. The Yom Kippur war disrupted oil supplies indirectly, because OAPEC declared an embargo on two importing countries, the US and the Netherlands. In this chapter, I shall focus attention on the analysis of the three remaining interstate war episodes, all involving Iraq, notably the Iraq-Iran war, the Iraqi invasion of Kuwait and the Coalition intervention in Iraq (which we shall refer to as the first, second and third Gulf war, respectively). Among civil wars, we shall consider specifically the experience of Nigeria. “Nigerian unrest” is considered one of the causes of the 2003 major supply disruption by the EIA, while it is not included in the IEA list. Neither list includes the Biafra secession as a cause of major disruption. We shall briefly

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cover both episodes in our analysis – as well as, more superficially, other important civil wars, notably Angola, the Sudan, Algeria and finally Libya. 2.3.1

Interstate wars

2.3.1.1 The Iraq-Iran war (First Gulf War) The Iraq-Iran war is especially important for our analysis because it is the only historical example of an interstate war between two major Gulf producers, which was bitterly fought over an extended period of time (eight years) with very high cost in terms of human life and surprisingly limited intervention on the part of outside powers. It was, in other words, the “perfect storm” or “nightmare scenario.”4 The war began on September 22, 1980, when Iraqi troops entered Iranian territory; and ended with a ceasefire on August 20, 1988. It is quite clear that oil played a major role in the war inasmuch it gave the two opponents the wherewithal to continue the fight for such a long time. Had the two belligerents had normal diversified economies, either one or the other or both would have collapsed much earlier under the extraordinary burden of the war. Instead, access to oil revenue and the authoritarian nature of the political leadership on both sides imposed extraordinary human costs on their respective people. Given the importance of oil as the economic and financial basis for conducting the war, it is hardly surprising that both countries repeatedly attempted to interrupt the enemy’s oil exports. The remarkable fact is that both failed: exports continued at levels that, in the light of the decline in international demand and OPEC’s attempts at rationing production, may be considered ‘normal’. All three major OPEC producers experienced very substantial decline in their production levels in response to the decline in OPEC’s overall international oil market share, rather than because of the war (see Figure 2.1). If we consider the period 1970-8, we find that Iran produced on average 5.308 million 4

The analysis in this paragraph is based primarily on Giacomo Luciani, “Oil and Instability: The Political Economy of Petroleum and the Gulf War,” in The Gulf War: Regional and International Dimensions, eds. H. Maull and O. Pick (Francis Pinter, 1989).

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Figure 2.1: Oil production of Iran, Iraq, Kuwait and Saudi Arabia, 1978-1991

barrels per day (b/d), Iraq 2.037 million, Kuwait 2.650 million and Saudi Arabia 7.223 million. In the period 1982-7, Iran produced on average 2.249 million b/d, i.e. 42 per cent of the previous level, Iraq 1.506 million b/d, equal to 74 per cent of the previous level, Kuwait 1.103 million b/d, equal to 41 per cent of the previous level, and Saudi Arabia 4.976 million b/d equal to 69 per cent of the previous level. Thus, Iraq fared better than Saudi Arabia, and Kuwait fared worst of all, even though the latter two countries were not belligerent. Iran did fare worse than Iraq, but then Iranian production declined most drastically in 1978-80, i.e. because of the revolution, not because of the war. The impact of the war appears to have been very significant only in l980-1, when both Iranian and Iraqi production was very low (but Kuwait’s was also low), while Saudi Arabia was pumping at an extraordinarily high level. In the first days of the war, Iran attacked the pipelines through which Iraq exported oil to the Mediterranean across Syria and Turkey. But by the end of

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November 1980, Iraq had resumed exports via Turkey at an estimated level of 400,000 b/d. At the same time, Iraq also attacked Iranian export installations and caused considerable disarray, but within a month Iran was already exporting again, to the tune of 3-400,000 b/d. The severest impact on oil production was at the very beginning of the hostilities; subsequently, both belligerents maintained much higher production levels despite the increased intensity of attacks on oil installations. This shows that installations may in fact be far less vulnerable than is often assumed, and emergency organization and procedures may be highly effective in maintaining a minimum level of operation. Iraqi exports to the Mediterranean via Syria continued until April 10, 1982 when the pipeline was closed, not because of Iranian attacks, but because of unilateral action on the part of the Syrian government. In previous months, Iranian planes had repeatedly attacked the pipeline, but Iraq was able to repair the damage rapidly: those attacks never made much difference to the level of Iraqi exports. This suggests that the use of costly and vital combat aircraft to attack targets that could be easily repaired offers dubious cost/benefit profile. In fact, even the Syrian action did not prevent an increase in Iraqi exports in 1982 over the previous year. Possibly in retaliation for the closure of the pipeline across Syria, Iraq first attacked Kharg, the main Iranian loading terminal, on August 25, l982, initially causing a halving of export flows. But only a week later, export levels had been restored to the previous July peak of 1.8 million b/d. Iraqi military action did not prevent a major increase in Iranian exports in 1982 over the previous year. Following the closure of the pipeline across Syria, Iraq moved swiftly to increase the capacity of the line across Turkey and to acquire a new outlet by building a pipeline across Saudi Arabia. A pipeline across Jordan to Aqaba was also considered5 but abandoned because of its proximity to Israel. The Iraqi government, one suspects, might have been willing to run the risk had they needed that pipeline badly enough, but given OPEC’s resorting to production quotas, Iraq could not hope to increase its oil exports much beyond what was allowed by its existing outlets. 5

This project was revived in 2012

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Relying only on the Turkish and Saudi pipelines in operation, Iraq could achieve a level of exports of 3.2 million b/d, which is quite high in the light of excess supply in the international oil market. While technically Iraq could produce more and consistently reserved for itself the right to do so (in spite of OPEC ‘s efforts at regulating supply), it is far from clear that it would have been able to achieve its goals under conditions of peace. Iran never attacked the Iraqi pipeline across Turkey, nor did it exert diplomatic pressure on Turkey to have it closed. The fact that Turkey was able to maintain good relations with both belligerents is quite remarkable: the possibility of an Iranian pipeline across Turkey was discussed at the time – and rejected because of Iran’s insistence on an outlet to the Black Sea6 rather than to the Mediterranean, as the latter would inevitably come very close to the head of the Iraqi pipeline. Turkey’s ability to maintain neighborly relations while actively supporting Iraqi oil exports was a further indication that economic interests can, under appropriate conditions and using diplomatic skill, be isolated from political and military conflicts. Overall, the experience of the war suggests that overland oil transportation via pipelines is more resilient to attacks than maritime outlets and sea transportation. While the Iranian oil terminal at Kharg Island was able to continue operations (albeit far below its theoretical maximum capacity), its well-advertised air defense system could not prevent substantial damage. Iraq intensified attacks on Kharg in the spring of 1984, and then again in August 1985. But even these attacks were more effective from an economic point of view – driving up the cost of insurance for tankers venturing to load Iranian oil and obliging Iran to discount heavily to compensate for this – than in physically obstructing loadings and exports. In fact, Iranian exports in 1985 were marginally higher than in the previous year. Iran addressed the problem by conducting a successful shuttle operation between the islands of Kharg and Sirri – the latter being located at the mouth of the Gulf – and loading for export at the latter. In 1986, Iran came increasingly under stress in its export operations, and exported volumes declined somewhat (by 7.3 per cent) compared to the 6

At that time, there was little or no preoccupation for tanker traffic through the Turkish Strait. In fact, Iran used to export to Romania and ship oil through the straits into the Black Sea.

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previous year. Again, however, the physical decline in exports was less important than the parallel collapse in oil prices. Iran attempted to retaliate for Iraqi attacks by mining the waters of the Gulf and searching ships passing through Hormuz. These actions triggered international intervention, but had no tangible effect on the exports of other nonbelligerent Gulf countries. This proved that Iran’s ability to close the Straits of Hormuz is very limited, as we shall discuss in detail in chapter 3. Certainly, Iran would have the capability to block traffic through Hormuz, if no party were to intervene to keep it open: this is, however, a very unlikely scenario. Mining Gulf waters is also unlikely to be effective, unless it is carried out on a large scale. Given the lessons of the Iran-Iraq war, the world thus can afford to be less nervous about the danger of interruptions in the flow of oil exports from the Gulf. In the 1970s, threatening scenarios, such as a complete interruption of exports from the Gulf, or blockage of Hormuz because of terrorist attacks were frequently conjured up. Interestingly enough, they still are, notwithstanding lessons of experience. In fact, after the Iraq-Iran war it became clear that – short of physically occupying the wells – there is little that an attacker can do to deny permanently an outlet to an enemy’s oil exports.

2.3.1.2 The Iraqi Invasion of Kuwait (Second Gulf War)

The Iraqi invasion of Kuwait was closely linked to the outcome of the First Gulf War, which had left Iraq seriously weakened from a political point of view, yet still commanding a military machine that was much more powerful than that of any of its neighbors (except Israel). Kuwait and Saudi Arabia had financed Saddam’s war against the Iranian regime with “loans”, which Saddam had felt were in recognition of a solidarity obligation, and as such not truly meant to be repaid, while Kuwait insisted on repayment. Faced with an impossible situation, Saddam revived an old revisionist claim of previous Iraqi governments and invaded Kuwait, annexing it as an Iraqi province.

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Figure 2.2: Kuwait: Daily average crude oil production, 1946-2007 Kuwait: Daily average crude oil production Source: OPEC Annual Statistical Bulletin 2008

3500 3000 2500 2000 1500 1000 500

19 46 19 49 19 52 19 55 19 58 19 61 19 64 19 67 19 70 19 73 19 76 19 79 19 82 19 85 19 88 19 91 19 94 19 97 20 00 20 03 20 06

0

The invasion provoked the collapse of oil production in both Iraq and Kuwait, because of the immediate international reaction and the boycott of exports of both countries. Otherwise, the invasion per se did little damage to the oil installations. However, when the international coalition formed to liberate Iraq launched its offensive, the Iraqi troops set on fire more than 600 Kuwaiti oil wells: thus the major damage was done not by the hostilities per se, but by deliberate sabotage on the part of the withdrawing Iraqi troops. The last fire was extinguished on November 6, 1991, but it took until mid 1993 for Kuwait to recover its previous production level. The war was important for its multiple lessons. Firstly, it made clear that the international community and the major Western powers (the two concurred on this occasion) would not tolerate a major revision of the region’s political map. It is now clearly understood that any repetition of an attempt to cancel an existing independent state from the map would be forcefully resisted. Secondly, the war confirmed that when modern military forces are involved and advanced weaponry is available, the conflict is likely to be short and have a clear winner. In this respect, the previous Iran-Iraq war – which

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Figure 2.3: Iraq and Kuwait: Monthly Oil Production 1990-96

Source: Data from EIA International Petroleum Monthly, various issues

reverted to a mode of fighting resembling that of the First World War in Europe – was an exception, due to the fact that both sides had limited access to modern weaponry. A short war is less likely to involve attacks to oil installations, as the benefit of depriving the enemy of oil revenue is felt only in the long run. Thirdly, it was shown that the only way to inflict extensive damage to oil installations – especially upstream oil installations – is to be physically present on each well. Only a force controlling the territory can inflict major damage to oil installations – but normally if the enemy already controls the territory it will not have an incentive to destroy oil installations. What happened in Kuwait was sabotage on the part of a retreating army, which, in the end, did no good to the loser. Even so, the impact of the fires and of the huge oil spill provoked by the deliberate emptying at sea of two laden tankers moored at the Sea Island oil terminal was in the end much less than initially feared. The world was entirely deprived of Kuwaiti production for a period of a little less than one year, and production recovered gradually in the following 18 months. Iraqi production was curtailed because of sanctions imposed by the United Nations, not because of war damage. The loss of both countries’ production was made up by an increase in Saudi production, but had this not been the case strategic

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stocks available under the IEA program would have been sufficient to cope with the situation. In fact, the use of US strategic stocks was authorized by the President in advance of the launch of the offensive but was soon called off because prices collapsed and there was no need to continue sales from the strategic stocks. 2.3.1.3 The US-led Coalition Intervention for Regime Change in Iraq (Third Gulf War)

The end of hostilities in the second Gulf War did not bring the conflict to a final resolution. Sanctions against Iraq continued for another 12 years, until an international coalition led by the United States was formed to bring down the regime of Saddam Hussein. Sanctions did have an impact on the availability of crude oil to the world, and there is little doubt that Iraq would have produced more than it did, had international oil companies been allowed to sign the contracts that were on offer during the 1990s. (At the same time, it could be argued that in the absence of sanctions those contracts would not have been on offer). Arguably, sanctions imposed by importers have had very significant impact on oil production, much more significant than most conflicts, terrorism or “resource nationalism”. The loss of production consequent to sanctions was not much of a concern to the US and Europe until the early 2000s, because the global market was well supplied and prices remained low (or gradually declined). This situation changed at the turn of the century, and when the coalition offensive was launched in 2003, it was felt by many that increasing Iraqi oil production and breaking the back of Iraqi oil nationalism was one of the major goals of regime change.7 If this had indeed been an important objective, it was totally missed – just as for other purported objectives. As the chart shows, Iraqi oil production had significantly increased in the late 1990s, following the introduction of the “oil 7

On perceptions and views at the time of the invasion, see Walid Khadduri, “Iraq: Future of the Oil Industry” in Regime Change in Iraq: the Transatlantic and Regional Dimensions, eds. C.-P. Hanelt, G. Luciani and F. Neugart (EUI and Bertelsmann Stiftung, 2004).

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Figure 2.4: Iraq oil production 1970-2011

for food” program. However, the deterioration of the political climate and the intervention of the coalition forces cause a new sharp decline and it is only in 2011 that the production level of 2000 could be surpassed – still remaining below the previous peaks of 1979 and 1989. The military operation of the coalition forces did not last long, beginning on March 20, 2003, and being effectively finished on April 15. On May 1, President Bush addressed the nation from the deck of the USS Abraham Lincoln, claiming “mission accomplished.” The next phase, commonly dubbed the “insurgency”, was technically a widespread wave of violent action on the part of non-state actors, not entirely coordinated in a single opposition force. This led to extensive losses of human life and widespread sabotage of oil installations. If we consider the fact that in 1979 Iraq had produced an average of close to 3.5 million b/d, and in the subsequent 30 years (1980-2009), its production averaged 1.7 million b/d, we may say that the cost of the three successive wars in which Iraq was embroiled was of the order of at least 1.8 million b/d on average, which adds up to 19.710 billion barrels cumulative over the period.

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This was only in part the consequence of war-related destruction of facilities; to a large extent it was the consequence of embargoes on sales of replacement equipment and purchase of crude oil, coupled to prohibition for foreign companies to invest in Iraq. Furthermore, in the absence of such hindrances, Iraqi production would likely have increased. How fast? It is difficult to answer such a question because of course one should take into account the equilibrium of global demand and supply, the evolution of prices, and the likely impact of OPEC quotas; but we know that Iraq could easily produce at least 6 million b/d, possibly many more, and in 30 years the investment to reach this capacity would likely have been made. Therefore, although the successive conflicts set in motion by Iraq over this period never resulted in an acute shortage of global oil supplies, it is clear that a lot of barrels never came to the market which may well have been available in the absence of wars. 2.3.1.4 War, Sanctions and Iranian Petroleum Production

Estimating the effects of the war and sanctions on Iranian production is much more complicated: the war ended for Iran in 1988, and the country has been living in peace since (peace, of course, is different from entertaining good relations with the international community). Nevertheless, Iranian oil production has not recovered to anywhere near the level that it reached in 1972 and 1975. The initial decline was due to the strikes that were part of the Revolution as well as to the conservationist attitude that prevailed immediately after the Revolution: the opposition has always been critical of the Shah’s policy of insisting with the Iranian Consortium that production should be increased. However, with the onset of the war with Iraq the attitude changed completely, and the further decline in 1980-81 was due to the initial phase of hostilities, when Iraqi troops managed to occupy a portion of Iranian territory. But already in 1982 production recovered somewhat, again surpassing 2 million barrels per day, and could be maintained above that level until the end of the war notwithstanding the continuation of hostilities and attacks, as described already. After the war ended in 1988 production increased further, but the level of 4 million barrels per day was passed only in 2003. The painful climb-back may

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Figure 2.5: Iran oil production 1970-2011

be attributed to the combination of external sanctions and internal infighting and lack of pragmatism, which have seriously hindered the potential for attracting outside investment. In short, the poor outcome is largely due to Iranians themselves and is also, to a large extent, the fruit of choice rather than necessity. Call it resource nationalism or simply sectarianism – war is by now too distant to offer a credible justification. 2.3.1.5 Concluding considerations on interstate wars

Interstate wars have become rare occurrences, because of an international environment which is increasingly effective in preventing them or, when they break out, quickly putting an end to hostilities. The major recent exception to this rule has been the Iraq-Iran war, which lasted eight years. Even that war had a limited impact on oil availability, partly due to the fact that it took place at a time when the “call” on OPEC oil was dramatically decreased and even OPEC members not involved in the war had to drastically trim down production.

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In historical experience, wars per se do not, cause lasting major disruptions to oil supplies: they may cause very little disruption at all, or significant disruption but for the short term only. Experience has proven many times that oil-related facilities are more resilient that is normally assumed, and more easily repaired. However, the repetition of war and perpetuation of domestic and international conflict has hindered the “optimal” development of resources in one of the key regions of the world. There is little doubt that, had the Near East not experienced the three successive Iraqi wars and more recently the Iranian nuclear standoff, production from the region could have been significantly larger. Nevertheless, this may not mean that in a scenario of prevailing peace more oil would have actually been produced, because world demand might not have increased more rapidly than it actually did. 2.3.2 Civil wars

In contrast to interstate wars, civil wars remain relatively frequent and, in many cases, long lasting. The United Nations system has successfully intervened in some cases to put an end to the worst excesses of civil wars, but in many other cases the consensus, which is needed to intervene, has not materialized. Because any intervention by the use of military force requires the approval of the UN Security Council, and the latter can be paralyzed by the veto power of one or more of the five permanent members, we have cases of civil wars that continue for years. 2.3.2.1 Nigeria

The case of Nigeria offers a good example of the impact of civil war and then continuing strife because of serious unresolved domestic political and institutional issues. It is not considered in the literature as one of the major disruptions of oil supplies – indeed, none of the civil wars in oil-producing countries in historical experience has caused a major disruption in the global oil market (not even the Bolshevik revolution and the subsequent Russian civil war). Nevertheless, civil wars have an impact on the development and valorization of oil resources.

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Figure 2.6: Nigeria oil production 1965-2011

The war, which followed the declaration of independence of Biafra from Nigeria lasted three years, from 1967 to 1970. It was an extremely bloody war, with some estimates of casualties running to 3 million dead, primarily civilians, in large part because of starvation. The Nigerian oil deposits are primarily located in the Eastern part of the country, and this may have provided an encouragement to secession, although it was probably not the main cause. Oil installations were affected, and the civil war had consequences on Nigerian production. In the first year of the civil war (1967), average daily production declined about 24 percent, from 417,000 b/d to 319,000 b/d. The decline continued the following year, when Nigerian production reached a minimum level of 141,000 b/d. However, by 1969 production jumped and surpassed the level recorded before the war. The war ended two years later: after 1969 production experienced very rapid increase until 1974 – indeed this was the period of fastest increase in Nigerian oil history.

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The recovery of oil production in 1969 was due to the fact that by that time the Nigerian federal forces had conquered back most of the Biafran territory. The Shell-BP and Safrap (ELF) operations were the most affected given their large presence in the Eastern region. Safrap stopped production during the period of the war and was accused by the Nigerian government of supporting Biafran separatism – the French government was quite sympathetic to the secessionists. Shell-BP production decreased from 367,000 b/d in 1966 to 43,000 b/d in 1968. But Gulf Oil, whose production was mostly offshore, increased its production from 51,000 b/d in 1966 to 98,000 b/d in 1968 and 186,000 b/d in 1969.8 This indicates, in any case, that the Biafran separatist forces did not engage in extensive and systematic destruction of the oil installations, thus making recovery relatively easy. After 1974, Nigerian oil production has mostly fluctuated between 2 and 2.5 million barrels per day. A major decline was experienced in the early 1980s due to policy mistakes in the context of declining global demand at the time, more so than to reduced OPEC quota or production difficulties (Ahmad Khan 1979). After hitting a trough in 1983, production has gradually recovered with various ups and downs, reflecting ethnic tensions and conditions of growing insecurity in the oil producing regions. Indeed, the end of the Biafra civil war did not solve the root causes of the problem. Ethnic tensions have continued, fuelled by a sense of grievance of the local populations, who feel deprived of their “fair share” of the oil revenue. Many communities in the oil-producing region in the country’s southeast, the Niger Delta, resent not receiving what they consider to be fair compensation. The government has been largely unable or unwilling to provide for infrastructure and development from oil revenues, which has meant that most residents of the Delta continue to live in poverty. Hundreds of thousand barrels of oil a day are illegally bunkered (stolen) and used to finance the purchase of weapons and political influence by rebel groups. As their political influence grows, these groups increasingly threaten the government’s stability. There is a debate on whether the “root” of the conflict and tension in the Niger Delta is ethnic conflict and grievances left unaddressed on the one hand, or opportunism and the benefits of instability on the other. There is evidence for both sides. The International Crisis Group (ICG) has observed that “freelance fighters are said to offer their services for hire to kidnap expatriate 8

Sarah Ahmad Khan, Nigeria: the Political Economy of Oil, (Oxford, 1994).

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oil workers on behalf of aggrieved communities in return for a share of ransom payments.”9 On the other hand, it is clear that it is only certain ethnic groups, like the Ijaw, that have been outspoken against oil extraction, a fact that would seem to support the ethnicity-based theory. Security is also hard to maintain because of the nature of the region’s geography. The swampy Delta is a collection of hundreds of communities, some of which are completely isolated by water. Boats are the primary mode of transportation for some communities, especially on market days, making the security of facilities a more difficult proposition. It should be noted that one particularly major grievance of local communities is the continued practice of gas flaring. This has been outlawed since 1984, but deadlines for implementation have been repeatedly extended and it is estimated that approximately 40% of the gas produced is still flared. Estimates of the volume of oil, which is shut-in due to civil unrest or insecurity, or stolen from pipelines, vary over time and are not very reliable. In June 2008, an attack on Shell’s largest producing field, Bonga, was carried out, despite being more than 100km offshore. Bonga is responsible for 10 percent of Nigerian output, about 200,000 bpd. A process of reconciliation was launched in the Delta in 2009 and appears to have had some success. Nevertheless at the time of writing estimates of the volume of “bunkering” remain of the order of 150,000 barrels per day, which is certainly far from indifferent. This oil is not only stolen from the pipelines, but also brought at sea and exported through tankers that wait for it and have been contracted for the purpose. Such brazen behavior may possibly be better classified as organized crime that is tolerated if not protected by some government authority – rather than a manifestation of civil war. 2.3.2.2 Angola The Angolan civil war erupted immediately after the country became independent from Portugal and lasted 27 years, from 1975 to 2002. It was at 9 International Crisis Group, “Fuelling the Niger Delta Crisis”, Africa Report no. 118 –September 28, 2006 page 7. See also International Crisis Group, “The Swamps of Insurgency: Nigeria’s Delta Unrest,” Africa Report no. 115, August 3, 2006; and “Nigeria: Ending Unrest in the Niger Delta,” Africa Report no. 135, December 5, 2007.

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the same time a war for the control of power in Angola proper and a war against the secession of the Cabinda enclave, where onshore oil production is located – although the secessionist forces were effectively defeated earlier in the war, and the struggle continued with forces based in the Angolan hinterland. The civil war has had limited impact on the progress of Angolan oil production. Figure 2.7 shows that production somewhat declined for a period of 7 years following independence (1975-82). This was a time when OPEC production was contracting while other non-OPEC producers were expanding rapidly (North Sea, Alaska, and Mexico, for example). Gulf Oil, which was the main producer in the Cabinda enclave onshore and in shallow waters, initially withdrew from the country, but was soon convinced to return. This outcome was due to the pragmatism of the Angolan government but also to the keen interest that the company had for the Angolan reserves, which it knew very well to be extremely prolific and convenient.

Figure 2.7: Angola oil production 1965-2011

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Subsequently, new discoveries were made offshore and mostly at significant distance from the coast – the flagship Girassol field is located 150km offshore. This meant that oil operations were effectively not in contact with hostilities, which concentrated in the interior of the country. Production growth accelerated between 1982 and 2002, then even more steeply after 2002 and until 2008, when Angolan production is considered to have peaked. The further acceleration beginning in 2002 coincides but is largely unrelated to the end of the civil war. It is justified by exploration success in the deep offshore in the previous years and by the IOCs desire to educe costs by bringing production to market as quickly as possible. Contrary to the attitude of other producing countries, Angola has manifested little conservationist sentiment, and does not appear to be worried of the fact that production may have peaked already in 2008. In fact, if a causality link exists between the acceleration of production and the end of the civil war, it is probably in the opposite direction: increasing production allowed the central government to muster larger financial resources and acquire the military edge, which in the end led to the defeat of the UNITA rebel movement. 2.3.2.3 Sudan

Sudan has known civil war almost without interruption since its independence. The first civil war lasted 17 years, from 1955 to 1972, and saw the South of the country fighting for greater autonomy from the North – due to ethnic and religious differences. The second civil war started in 1983 and was concluded only in 2005. The referendum held in January 2011 sanctioned the independence of South Sudan. Oil was discovered in the country in the mid 1970s, but production only began in 1993. The original discoveries were made by Chevron, which later divested its interests because of frustration with the political and security situation. It was followed by several other companies, which eventually also withdrew because of the difficult situation. Today, the major producing company in the country is China’s CNPC, and other relevant companies are Malaysia’s Petronas and India’s ONGC Videsh. It is not without significance that only state-owned companies of non-western countries have remained active in the country.

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Figure 2.7: Sudan oil production 1993-2011

It is clear that the development of oil in Sudan has been hindered by the civil war and, following the independence of the South, by the continuing conflict – now an interstate conflict - between the latter and the North. That said, it is also to be noted that production has increased rapidly between 1998 and 2008 – that is throughout the final stages of the civil war, which ended only in 2005. The extent of total Sudanese reserves – including potential new discoveries in both North and South Sudan – is a question open for some controversy. The Oil and Gas Journal lifted its estimate of Sudan’s reserves from 563 million barrels in 2006 to 5 billion in 2007. The BP Statistical Review of World Energy is even more generous, attributing to Sudan reserves of 6.7 billion barrels by the end of 2009. If these estimates are confirmed, clearly the country has the potential to become a much more important producer, and we should conclude that the war has indeed significantly slowed down the development of oil production. In contrast, production has been declining since 2008 – in the period when the peace agreement was being implemented – and according to some South Sudanese production would soon decline (in this view, the Sudanese

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government would have accelerated the exploitation of proved reserves, taking out of the ground as much as possible before the South’s independence). It has also been proposed that oil, and in particular the fact that the discovered reserves to some extent straddle across the boundary between North and South Sudan, has been a motivation of the civil war and continues to be an underlining motivation of the current inter-state conflict. In this respect, while reviewing the various potential causes of the civil war, Christine Batruch wrote: “When peace is achieved, it will be easier to determine which of these elements played the decisive role in the conflict and its eventual resolution. What is clear, however, is that the war began years before the presence of oil was even suspected, and it was only after oil was produced that a material basis for a sustainable peace was seen to have been achieved. It is only then that an active, internationally mediated peace process began.” (Batruch, 2004) Similarly, Achim Wennman (2011) argues that better understanding of the available oil resources has played a positive role in helping reaching a compromise between North and South and opening the door to Southern independence. Thus the experience of the civil war in Sudan is different from that of other countries – notably Nigeria and Angola – because when oil was discovered, the central government was not able to allow for sufficient development and export as to generate a stream of revenue, which eventually might have allowed defeating the armed opposition. Instead, the civil war prevented oil exports and revenue, creating conditions whereby the two sides were encouraged to reach compromise.10 After the South’s accession to independence, conflict soon broke out concerning both the exact delimitation of the border and the transport fee that the South should pay to the North for the use of the pipeline to Port Sudan that is the only outlet to the sea for South Sudan’s oil. In the course of the dispute, the South unilaterally terminated all oil production and pursued the possibility of an alternative pipeline through Kenya. At the time of writing, the two sides have reached a compromise – which most observers consider shaky and unlikely to last – to resume production and shipping through the existing pipeline to Port Sudan. 10

This thesis has been developed in particular by Achim Wennman, in “Breaking the ‘Conflict Trap’? Addressing the Resource Curse in Peace Processes” Global Governance, A Review of Multilateralism and International Organizations 17, no. 2 (April-June.2011).

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2.3.2.4 Libya

Our last case of civil war considers the situation in Libya between February and … 2011. In the wake of similar protests in Tunisia and Egypt, demonstrations first broke out in Benghazi on 16 February, quickly spreading to other parts of the country and bringing oil production to a halt in many fields, primarily due to the prompt withdrawal of the personnel of foreign operators. Saudi Arabia immediately announced that it was ready to step in and compensate for any shortfall of Libyan production (MEES 54:9 pag.1-3). Subsequently, the situation of production remained clouded. It was not clear whether and to what extent production continued at some fields; whether the obstacle was the unavailability of logistics (impossibility to load at harbors whose control changed hands several time; unavailability of ships willing to take the risk); or finally whether sanctions that were promptly enacted by the US and Europe in an effort to speed up the collapse of the Gadhafi regime were responsible for the decline of exports. However, there were recurrent news of occasional cargos being lifted, and at the beginning of April Qatar offered to market crude produced from fields under the control of the rebels (MEES 54:14 page 1). In the next four months positive and negative news concerning Libyan production alternated. By August the regime had fallen and the phase of recovery started: the crisis was intense but short in duration. When it ended, pessimistic expectations were voiced concerning the speed of recovery – as well as a lot of speculation concerning the likelihood of “political” management of oil resources (to recompense countries that had supported the revolution, and punish those that had not been happy about the explicit intervention of the international community in the conflict). None of these were supported by subsequent facts. Figure 2.8 details monthly Libyan production from November 2010 to August 2012. The impact of the crisis is very clear: production declined precipitously between February and August 2011, then quite rapidly recovered, and by February 2012 Libyan production had almost completely been restored. Hence, the Libyan civil war offered one further illustration of the fact that such conflicts are unlikely to provoke long-lasting damage to oil installations.

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Figure 2.8: Libya Monthly Oil Production, November 2010 to August 2012

However intense the conflict might be, if it is short lived prompt recovery is highly likely.

2.4 Violent non-State Actors (Terrorism) We have met the impact of violent non-state actors already in the case of Nigeria, and seen how oil operations may become problematic in heavily populated areas if the government has less than full control of the territory. Whether the threat is motivated by gain rather than political considerations (greed rather than grievance) has some importance, because presumably the acquiescence of bandits can be bought – although legal authorities may be opposed to that and possibly the cost might be considered excessive. In contrast, politically motivated non-State actors aim at embarrassing the state

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or crippling the national economy, and are thus supposedly interested in damaging oil installations per se, rather than as too for access to financial resources. We have had several instances of terrorist attacks to oil and gas installations, but none ever had serious or lasting consequences. The closer that we may have gotten to a crippling attack has been when a group related to al Qaida attempted to attack the Abqaiq facility in Saudi Arabia in February 2006. Abqaiq is an oil field and a key gathering and processing center in Saudi Arabia, and contains some critical installations. It is a vast site, and industrially relevant installations occupy an area of some 4 km2. Notwithstanding the secrecy that normally covers such events, we have in the literature some detailed accounts of what happened (Al Rhodan 2006): these specify that the attack, carried out with two successive car bombs driven by suicide terrorists, managed to penetrate only the first out of three successive layers of security. In other words, the attack failed because the site was sufficiently protected – and protection was increased thereafter. Figure 2.9: Abqaiq

Source: Google Earth

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I would add that, even if the attackers had gained access to the inner core of the industrial installation, inflicting crippling damage would not have been easy. A first requisite would have been for the terrorist to know exactly which of the installations present in the area is critical. This is not something that a layman can easily find out. Secondly, the installation is vast, and inflicting serious damage would have required a large number of systematic explosions. This is something that only a much larger force methodically dedicated to the task could have achieved. The episode is interesting because it is one of the very rare cases in which non-state actors have attacked serious and well-protected installations. In most cases, terrorists will attack overland pipelines, which stretch for long distances across frequently scantily populated territory. Pipelines are therefore extremely soft targets that are essentially indefensible for most of their length. But as it is easy to blow up a pipeline, it is easy to repair it: the damage is repaired in a matter of very few days and the benefit of the operation is close to zero.

Figure 2.10: Colombia oil production 1965-2011

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The extreme case of attacks to a pipeline is probably that of Colombia, where the Caño Limon pipeline was attacked an estimated 950 times between 1980 and 2000. Only in 2001 the pipeline was attacked 170 times, causing an estimated loss of $500 million. However the following year the number of attacks fell dramatically to 29, thanks to a much larger deployment of security to protect the line. The Cusiana-Cupiagua pipeline operate by BP was attacked much more sporadically, apparently because much of it is buried underground. In the first six months of 2012, attacks numbered 67 – meaning that strengthening security hardly is a definitive solution. Nevertheless Colombia has been exporting oil throughout: it could have exported more, but in the end it managed quite well. Colombia’s extreme case demonstrates that even a well-rooted guerrilla movement that the government has been unable to effectively eliminate over decades will succeed in damaging but cannot completely cripple oil production

Figure 2.11: Attacks on Iraq’s Oil Infrastructure 2003-7

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and exports. There is no other country that comes anywhere near the same level of violence against oil installations. Another interesting, if extreme, case is that of Iraq, where a widespread insurgency followed the intervention of the United States and their allies in 2003. Iraq’s oil sector was a target of insurgent activity almost since the beginning of the US occupation in April 2003. The first recorded attack took place in mid-June 2003, merely two months after the occupation of Baghdad. Within a relatively short period, operations by different insurgent groups were able to inflict considerable damage, rendering many sectors of the state’s oil industry partially or totally non-operational. At that time, counter-measures to prevent or reduce the number and the effectiveness of the attacks had limited and short-lived success. The insurgents’ targeting strategy was comprehensive in its geographical coverage. Operations against targets related to the oil industry were conducted in the northern region of the country as well as in the central and southern region. Thus no part of the country was safe from or out of reach of the insurgents. Initially, attacks on oil sector installations in the northern region and the Baghdad area far exceeded attacks in the southern region. However, since the first attack on the southern pipeline in late February 2004, operations became widespread, extending to most of the country. The targeting strategy was comprehensive in its nature encompassing attacks almost on every segment of the Iraqi oil industry infrastructure The oil and gas pipeline network is the most vulnerable and widely spread part of Iraq’s oil infrastructure. Indeed, attacks on pipeline networks constituted the most common form of attack; over 280 attacks or sabotage operations were carried out between mid-2003 and 2007. Attacks were aimed at the destruction or disabling of the pipeline network, as well as at preventing the repair or restoration of the network. To achieve this goal, insurgents attacked the same section of the pipeline repeatedly, and almost immediately after repair work was completed, to show that repairing the pipelines is a hopeless task. At the same time, repair teams were frequently subjected to attacks. In the period 2003-2007, almost 90 attacks were carried out on oil sector personnel. As a result, Iraq’s oil sector lost between 10-15 percent of its work

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Figure 2.12: Attacks on Iraqi Oil Pipelines, 2003-7

Source: Gulf Research Center

force. Attacks targeted the civilian staff including the top management, engineers and technical staff, workers, and contractors besides the entire work force of the oil ministry. Attacks also targeted the security forces, which provide protection for oil infrastructure. It is interesting to note that attacks on pipelines were especially frequent in the early period of the insurgency and declined with time, while the opposite was the case for attacks on personnel. This may be interpreted as meaning that the insurgents realized that the pay-off from attacking pipelines was limited, and gradually shifted to attacking personnel – i.e. shifted from sabotage to genuine terrorism. Almost every key installation -- including oil wells, storage tanks, pumping stations, gas and oil plants, oil ports and off-shore export platforms, refineries, and other critical facilities -- was targeted. Attacks on and destruction of oil wells in both northern and southern oil production regions became frequent since March 2004. Oil administration sites were also frequently targeted. The headquarters of the Ministry of Oil in Baghdad was subjected to frequent attacks by car bombs and mortar shells, as were the offices of the regional oil companies in other parts of the country.

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Figure 2.13: Attacks on Iraqi Oil Personnel 2003-7

Source: Gulf Research Center

Attacks on oil transport, mainly trucks, road tankers, and trains carrying oil products, were widely carried out with a number of objectives. Oil trucks supplying the occupation forces with fuel were a major target. Oil trucks were a target not only for destruction but also for hijacking as road tankers were widely used as an effective instrument in suicide bombing operations. The capacity of these trucks to carry large amounts of all kinds of explosives (solid, liquid explosives or chemicals) makes them a favorite weapon for insurgent and terrorist groups. Attacks on major targets, especially large buildings, were carried out by using an oil tanker filled with explosives and driven at high speed toward the target. In April 2004, three suicide boats attacked the Basra offshore oil export terminal. Attacks were very effective in rendering many facilities partially or totally non operational. Attacks on the Iraq-Turkish pipeline rendered it non operational for a long period. Every day that this pipeline was not operational, Iraq’s economy was losing approximately $7 million. Three suicide boats attacked the Basra offshore oil export terminal. Though the terrorists failed to damage the facility, this attack alone cost the country some $40 million in lost revenue. Attacks on personnel (on and off duty) undermined morale and affected commitment; the Iraqi oil sector has lost overall 10-15% of its work force. During the period 2003-2007 attacks resulted in a very difficult investment and development climate

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Figure 2.14: Iraqi Monthly Oil Production January 2004 to December 2010

However, by 2009 the number of attacks became irrelevant, and the government was able to attract international oil companies to sign service contracts at terms universally recognized as very favorable to the government. Attacks on pipelines concentrated in the period April 1004 to April 2005. The chart of monthly Iraqi oil production shows that during this period there were extreme fluctuations, with moths when production fell precipitously and then recovered just as rapidly. Attacks on personnel concentrated in 2006-7, and during that time variations were also quite wide but production never managed to go above 2.1 million barrels per day. Thus it appears that the

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insurgency eventually made a significant dent into Iraqi production, which we may roughly estimate at 500,000 barrels per day. That said, ups and downs in production continued also in 2008-10, but then production remained always above 2.1 million barrels per day, averaging 2.4 million. Complete security has not been restored in Iraq even in 2012, and the situation continues to hinder the progress of the various projects undertaken to increase Iraqi production capacity. In Iraq, oil operations are close to population concentrations: political instability and continuing use of violence on the part of non-state actors therefore affects oil activities even if it is not systematically directed against them.

2.5 Conclusion Our analysis of several historical experiences of oil supply interruptions points to two main conclusions. The first conclusion is that oil and gas installations appear to be much more resilient to armed conflict than is normally acknowledged. Major damage is inflicted only in cases in which hostilities take place in the immediate vicinity of the installation (initial phase of the Iraq-Iran war, initial phase of the Biafra war, Sudanese civil war), or one side has control of the installations and chooses to sabotage them (Iraqi troops in Kuwait, MEND in Nigeria). But this is rare. Interstate wars are a low-probability event; they are generally confined to two main belligerents and contained: there has been no repeat of the Indochina situation – in which the Vietnam conflict progressively acquired regional dimensions and engulfed neighboring countries – not even in the Middle East, where conditions might be prone to the spreading of conflict; and wars between regular armed forces are most likely to be intense and brief, thus reducing the strategic benefit of attacking oil installations. In contrast, civil wars or violent action on the part of non-state actors are phenomena whose frequency has not diminished at the global level (it has diminished in some regions and increased in others, as if this were a “phase” that each region has to go through). In historical experience, civil wars have caused limited damage to existing installations, but they have hindered the desired investment in new development and attainment of target production levels.

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Cases in which violent action on the part of non-state actors has inflicted significant damage to existing installations include the “insurgency” phase in Iraq and MEND in Nigeria. In both cases, the relevant non-state actor was based in the same territory as oil installations, close to population centers, over which the government did not have much control. If oil installations are in remote or inhabited locations – as is the case in Algeria or Angola and many other countries including Saudi Arabia – then the cost-benefit balance of attacking oil installations is considerably worse for the non-state actor (installations are more easily protected; the attacker does not have superior knowledge of the terrain; and it is more difficult to withdraw in time to avoid major casualties). However, it is very obvious that the government’s inability to overcome or reabsorb violent opposition discourages international oil company investment even if the violence does not affect the vicinity of oil and gas installations. Discouragement is not the same thing as completely preventing: investment projects will be more expensive if undertaken in a country that cannot guarantee security – but if the expected return is large enough projects will be undertaken. Oil companies display different attitudes towards risk: some are willing to take risks that others would shy away from. Intra-state conflict may become endemic and discourage oil and gas upstream investment for extended periods of time. In this respect, intra-state conflict should be added to accidents, natural disasters, corruption, and non-violent political conflict hindering investment to form a category of obstacles which may be more or less statistically predictable, and at any moment in time prevent global oil and gas production from reaching their theoretical “optimum” or “desired” level. The intensity of the phenomena or the extent of the discrepancy between what is achieved and what would be optimal varies over time, justifying the need for reserve capacity and strategic stocks. But this need should not be measured against the theoretical optimum: it should be measured against the average that is normally achievable.

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Chapter 3 – Restrictions of Passage, Accidents and Oil Transportation Norms: Impact on Supply Security

Chapter 3 Restrictions of Passage, Accidents and Oil Transportation Norms: Impact on Supply Security 3.1 Introduction Security of oil supplies is a multifaceted issue: it relates to the availability of resources and production capacity, to the continuing willingness on the part of producers to supply importers, and to the availability and reliability of logistics. Enhancing security of supply entails adopting policies that tackle all the dimensions of the issue. The logistical aspects are frequently mentioned as a source of uncertainty, generally as part of a long list of other potentially disturbing factors. In this chapter, we focus on seaborne transportation of oil and oil products and consider how the logistics of oil maritime transportation may affect oil supply security. There are several different dimensions to this question: 1. restrictions of passage, meaning willful interference with the freedom of navigation on the part of riparian or other actors, including both state and non-state actors; 2. accidents involving one or more tankers and entailing environmental or other damages, which may lead to the temporary closure of international waterways; and 3. oil transportation norms, that is the rules governing navigation and passage through specific waterways. These different aspects may affect oil maritime transit through important sea passages (straits, ‘chokepoints’) as well as in the open seas. We discuss key maritime chokepoints in detail, but it should be stressed at the outset that

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restrictions of passage and accidents may very well occur in the open seas and have equally significant implications, and the effects of norms other than those specifically directed at critical sea passages are felt everywhere. A large proportion of global oil traffic is seaborne. Approximately 50 percent of globally produced oil, and an even higher percentage of internationally traded oil, is transported by sea. According to INTERTANKO, over a 10-year period (1999–2008), the total crude oil transported by sea increased 16.5 percent, going up from 7,980 to 9,300 million tons.2 International trade in crude oil and petroleum products is a very substantial share of global merchandise trade. The fact that oil is a liquid and can easily and cheaply be transported in tanker ships is one of the essential qualities that have supported the ‘success’ of oil as a primary source of energy. Other fossil fuels – coal and gas – are much more difficult to transport, for different reasons. Gas especially can only be transported either by pipeline or, following liquefaction, as liquefied natural gas (LNG) in specially designed ships where it is kept at a very low temperature. Furthermore, growth in oil maritime transport must be set in the context of the increasing importance of transport by sea in general. Advances in maritime technology have brought about a revolution in maritime transport and a huge lowering of the cost of transporting goods over long as well as short distances. This is a key development that is supporting globalization and making it possible. With the spread of fast ferries (ships that normally operate at 25-30 knots of speed), maritime transport and especially that of the roll-on/roll-off kind – in which entire lorries or trailers board the ship without loading/unloading their cargos – is frequently faster than overland routes, especially in enclosed seas, such as the Mediterranean, the Red Sea or the Gulf. The EU has been speaking of ‘highways of the sea’ to complement major overland transport axes, meant to facilitate the intensification of trade. There are at least two important implications of this trend: • The first is that the principle of freedom of navigation on the high seas – the core principle of international maritime law – is today 2

INTERTANKO, “Tanker Facts 2009”, INTERTANKO, London, 2009.

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universally supported by all countries. This principle has not been challenged by any state in many years; while in the past it was primarily of interest to the main trading nations and the superpowers, today it is of crucial importance to almost all countries. • The second is that the sea-lanes are becoming increasingly crowded, with bigger and faster ships crossing in different directions – pointing to the need for prudential policing of maritime traffic. The problem is that this requirement does not square easily with the principle of absolute freedom of navigation in the high seas and international straits. The first section of this paper looks at major chokepoints and discusses the characteristics of each of them. The second section discusses hazards that are not specifically linked to chokepoints. The third section reviews major normative developments. The final section introduces scenarios of supply interruption that might be provoked by the threats discussed in the previous section and potential remedies.

3.2 Oil Chokepoints According to the US Energy Information Administration (EIA), “chokepoints are narrow channels along widely used global sea routes. They are a critical part of global energy security due to the high volume of oil traded through their narrow straits.”3 The European Commission’s paper on energy network infrastructures4 has the following definition: Chokepoints are narrow channels used for transit of large volumes of international sea trade including oil. The concerns related to chokepoints can be different: geopolitical in the case of transit through potentially unstable areas, environmental and in particular in relation to damage from an accident, 3

Energy Information Administration (EIA), “World Oil Transit Chokepoints”, Country Analysis Brief, EIA, Washington, D.C., January 2008 (http://www.eia.doe.gov/cabs/World_Oil_Transit_Chokepoints/Background.html). 4 European Commission, Network Oil Infrastructures – An Assessment of the Existing and Planned Oil Infrastructures within and towards the EU, Commission Staff Working Document accompanying the Green Paper “Towards a Secure, Sustainable and Competitive European Energy” (COM(2008) 737), SEC(2008) 2869, Brussels, November 13, 2008.

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economic if transit through a chokepoint requires long waiting times, security in connection to possible terrorist attack etc. Chokepoints therefore represent critical bottlenecks in the energy transport network since they transit high volumes of crude and products and the impact of interruptions of transit through them would affect severely the global oil market. The list of chokepoints considered by each institution differs somewhat: the International Energy Agency (IEA) focuses especially on passages in the Middle East (Hormuz, Bab el-Mandeb, Suez) and the Malacca Strait, while the EIA and the European Commission also include Panama and the Turkish Straits. The European Commission additionally includes the “Baltic Sea”, that may be considered to encompass the Danish Straits which give access to the sea. Other notable passages – such as the Strait of Gibraltar – are not normally included in the list (see Table 1). These passages are deemed especially important for global oil traffic. The IEA has estimated that the share of global oil consumption that transits through Hormuz might increase from 21 percent in 2004 to 28 percent in 2030, while the importance of the Strait of Malacca might only be marginally less (close to 24% in 2030). Table 3.1: Chokepoints

Lists of chokepoints Hormuz Malacca Bab el-Mandeb Panama Canal and pipeline Suez Canal and SUMED pipeline Turkish Straits Baltic Sea

EIA X X X X X X

Source: Author’s compilation.

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European Commission Green Paper X X X X X X X

IEA X X X X


3.2.1 The Gulf Countries and the Strait of Hormuz The concentration of oil reserves and production in Gulf riparian countries inevitably inflates the volume of internationally traded oil that originates in the Gulf and must transit through the Strait of Hormuz. The Strait of Hormuz is 21 nautical miles (nm) wide at its narrowest point, which is considered to be from Larak Island (Iran) to Great Quoin (Oman). Sovereignty over the strait is divided between Iran and Oman, with the latter possessing the Musandam peninsula, which defines the strait. The current navigation channels lie just north of the two Omani islets of Great and Little Quoin, entirely in Omani territorial waters, and are 2 nm wide in each direction with a 2 nm dividing lane. These are represented in Figure 3.1. It should be noted, however, that in the past (until 1979) two narrower shipping lanes were in use between Little Quoin (where the main lighthouse is located) and the tip of the Musandam Peninsula, entirely in Omani territorial waters. In fact, the waters are deeper there and farther from the Iranian coast. If water between the Quoins and the tip of the Musandam Peninsula is included, the Strait is wider than 21 nm. It is thus clear that the Strait is not, after all, as narrow as frequently represented. “Closing” the Strait is not something that can be achieved easily through a physical obstacle or use of firepower from the shore – especially since control of the water is divided between two separate nations. The obvious threat to freedom of passage through the strait comes from Iran – no one seriously considers the possibility that Oman might wish to impede passage. The potential threat of closure from Iran has been evaluated in detail by Caitlin Talmadge.5 The author argues that it is not in the interest of Iran to close the strait as an offensive first move, as this would damage Iran itself and would certainly provoke retribution from the international community. Nevertheless, “if the United States or Israel attacked Iran, the restraint that previously characterized Iranian behaviour in the strait might evaporate. 5 Caitlin Talmadge, “Closing Time: Assessing the Iranian Threat to the Strait of Hormuz,” International Security 33, no. 1 (Summer 2008): 82–117.

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Figure 3.1: The Strait of Hormuz

Source: http://www.longstrangejourney.com/desert-storm-in-pictures/ from-the-book/8472201?originalSize=true

Indeed, in 2006 Iran’s supreme leader, Ayatollah Ali Khamenei, cautioned that although Iran would not be ‘the initiator of war’, if the US punished or attacked Iran, then ‘definitely the shipment of energy from this region will be seriously jeopardized’. The Iranian

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oil minister made similar comments, hinting that ‘if the country’s interests are attacked, we will use all our capabilities, and oil is one of them’. One can imagine other events that could bring Iran to the same point of desperation – for example, if it were losing a conventional war with any of its neighbours and wanted to open another front as a punitive measure or distraction. Short of the extreme case in which the United States pre-emptively destroys much of Iran’s military, there is an intermediate range of scenarios in which Iran is deeply threatened yet parts of its military are still intact and functioning. It is in this context that threats to block the strait could become reality.”6 Iran could attack ships passing through the Strait in three main modalities: with firepower based onshore; with firepower based on ships, small boats or submarines; and with mines. As long as no measures are taken to protect ships, and no reaction to possible attacks is envisaged, Iran may effectively systematically attack most ships. If firepower is used, this may allow discretion, notably excluding ships carrying Iranian oil; however if the Strait is mined, this may potentially impede the transit of ships carrying Iranian oil as well. But the point is that the assumption of no reaction is totally unrealistic. If ships were attacked, the reaction would be immediate: ships would be organized in convoys and protected, passage would take place farther from Iranian shores, South of the Quoins, and potential sources of the attack would be quickly taken out. Any attack on ships in Omani waters would be an act of war against Oman, and Omani and UAE territory would be available for counterattacks, without mentioning the very substantial American naval presence, which includes an aircraft carrier. It is important to recall that the Gulf has known a “Tanker War” between 1980 and 1988: during the Iraq-Iran war both sides attacked tankers from neutral countries in the attempt to undermine the oil exports of the two belligerents, or exert pressure on Arab non belligerents perceived to be supporting Iraq. This long episode has been analyzed in detail in the literature7 for its various 6

Ibid., 88.

7

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implications on the military and diplomatic level. Here I will limit myself to underlining two key facts: 1. The Tanker War added some cost to shipping oil out of the Gulf but never seriously hindered oil exports from the region nor had a visible impact on oil prices; 2. The hostilities against tankers took place throughout the Gulf, and no specific attempt was made to close the Strait – meaning that from the military point of view this was not considered either easier or more advantageous than attacking tankers elsewhere in the Gulf. Experience therefore tells us that indeed tankers can be attacked and some damage inflicted, but even when that happened and for a period of no less than 8 years, closing Hormuz was not attempted. The point is that it would not be as easy as frequently believed. Talmadge’s very detailed analysis of the potential for closure of Hormuz concludes: “the notion that Iran could truly blockade the strait is wrong – but so too is the notion that U.S. operations in response to any Iranian action in the area would be short and simple. The key question is not whether Iran can sink dozens of oil tankers, which would be difficult. Tankers are resilient targets. Their immense size, internal compartmentalization, and thick hull plates allow them to survive hits by mines and missiles that would sink warships. Their crude oil absorbs the impact of an explosion and is difficult to ignite. Historically, their captains have proven receptive to the strong financial incentives to sustain shipping. The question is whether Iran can harass shipping enough to prompt U.S. intervention in defence of the sea-lanes. Given that the United States has staked its credibility on promises to do just that, this is a threshold that Iran’s significant and growing littoral warfare capabilities can cross, even with fairly conservative assumptions about Iranian capabilities.”8 8

Ibid., 84-85.

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Therefore, a threat of closure of the strait, even if partial or limited in time to a period of several weeks is possible. “It does not take much imagination to suggest that the traffic in the Strait of Hormuz could be impeded for weeks or longer, with major air and naval operations required to restore the full flow of traffic.”9 This however is entirely different from “closing” the Strait to all traffic for an extended period of time, so as to seriously affect global oil supplies. It is especially difficult to believe in the possibility that Hormuz might be closed by genuine or pretended terrorists (non governmental actors). On July 28, 2010, a Japanese tanker was attacked with explosives while transiting through the Strait, having loaded 270,000 tons of Abu Dhabi crude and being in route to Japan. The tanker’s outer hull was damaged, but the inner hull was not fissured, and no oil was spilled. The tanker was able to continue to a UAE port on the Indian Ocean for repairs. This confirmed that tankers are resilient targets and much more substantial firepower is needed to inflict serious damage to them. In 2007, the Joint Economic Committee of the US Congress published a study on The Strait of Hormuz and the Threat of an Oil Shock.10 Rather than discussing the potential for closure of the strait subsequent to military action on the part of Iran, the study assumes that this is possible and investigates the potential economic impact of such a closure. It draws the following key conclusions: “A closure of the Strait of Hormuz has the potential to reduce the flow of oil by far more than any previous disruption, both in absolute and percentage terms. … Nevertheless, the OECD countries have enough oil in primary inventory to last them more than eight months, should Persian Gulf oil cease to flow.”11 The study also refers to various estimates of the potential impact of a closure of the Strait of Hormuz on the price of oil. These are summarized in Figure 3.2. The first two estimates refer to a scenario in which the closure of the strait is mitigated through fuel switching, the rerouting of some shipments, and the release of oil from strategic storage. The remaining two estimates, to the 9

Ibid., 116. US Congress, Joint Economic Committee, The Strait of Hormuz and the Threat of an Oil Shock, Washington, D.C., July 2007 (http://www.house.gov/jec/studies/2007/Straight%20of%20Hormuz%20Study.pdf). 11 Ibid., 5. 10

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Figure 3.2: Oil disruption price estimates

Source: US Congress, Joint Economic Committee (2007).

right in the figure, refer to scenarios of unmitigated loss of supplies – for one month in the estimate of the EIA and for three months in the estimate of the GAO (Government Accountability Office). These calculations are interesting not so much for the absolute level of the price forecast – which obviously is contingent on market conditions at the time the disruption occurs – as for the difference in outcomes, which points to the importance of emergency preparedness and the availability of mitigation measures. In this context, it is crucial to underline the potential role of pipelines allowing Gulf oil to be exported from terminals that are outside the Gulf and do not require transit through Hormuz. Of the five major Gulf oil exporters, three (Iran, Saudi Arabia and the UAE) have ports outside the Gulf: Iran and the UAE on the Indian Ocean, outside Hormuz; and Saudi Arabia on the Red Sea. Indeed, Saudi Arabia has a pipeline (known as the ‘Petroline’) with a capacity of 5 million barrels per day (b/d) running from the Eastern Province, where the oil is produced, to the

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Red Sea port of Yanbu, and it has been exporting crude oil and products from there for more than 20 years.12 Abu Dhabi recently completed the building of a pipeline from Habshan to Fujairah, which has a capacity of 1.5 million barrels per day, and allows the country to export up to 70% of its total exports out of Fujairah, which is on the Indian Ocean. It may be surprising that such a pipeline has not been built earlier: this may be due either to Abu Dhabi’s desire not to depend from Fujairah for the exportation of its oil – notwithstanding the fact that the two emirates belong to the same United Arab Emirates; or to a prevailing perception in Abu Dhabi that closure of the Strait is not, after all, such a vital threat. Iraq does not have a maritime outlet outside the Gulf, and indeed even its outlet on the Gulf is insufficient and cannot accommodate very large crude carriers. For this reason, over the years it has developed several notable alternatives: • a pipeline running from the fields in northern Iraq across Turkey to the Mediterranean port of Ceyhan; • a pipeline running from the fields in northern Iraq across Syria to the Mediterranean port of Banias; and • a pipeline from the fields in southern Iraq across Saudi Arabia to the Red Sea port of Yanbu (known as ‘IPSA’). The operations of all of the above have been disrupted by political or military interference at various times. Currently, only the pipeline to Ceyhan 12

The pipeline has been operating at much less than its rated maximum capacity because most customers of Saudi Aramco prefer to lift from Ras Tanura in the Gulf rather than from Yanbu. Nevertheless, a study conducted for the Baker Institute of Public Policy (M. Webster Ewell, Dagobert Brito and John Noer, An Alternative Pipeline Strategy in the Persian Gulf, James A. Baker III Institute for Public Policy, Rice University, Houston, TX, 2000, http://www.rice.edu/energy/publications/docs/TrendsinMiddleEast_AlternativePipelineStrategy.pdf) concluded that the throughput of the existing pipeline system can be significantly increased with the use of drag reduction technology. As many as 11 MBD could be moved through the combined Petroline-IPSA system for an investment of $600 million. Alternatively, a noticeable increase in Petroline throughput can be obtained for as little as $100 million. All options require an additional annual cost of roughly $50 million to hold DRA (drag reduction agent) inventory, or additional investment to build DRA production capacity in Saudi Arabia. The additional cost of moving oil during a crisis by this route is less than $1 per barrel. This is clearly economically feasible in the event of a SoH (Strait of Hormuz) closure; the price of oil will rise more than $1 per barrel in this case, covering the additional costs. It is just as clearly not economically viable as a routine peacetime alternative: Yanbu exports are already economically unattractive (compared to Ras Tanura) for most Saudi customers, and adding DRAs would increase costs of oil at Yanbu even further.

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through Turkey is normally in operation, albeit at a low level. The pipeline had an original design capacity of 1.6 million b/d, but was repeatedly attacked during the Iraq–Iran war and more recently during the phase of insurgency in Iraq; it is estimated to have a maximum capacity of 900,000 b/d at the moment. The Kirkuk–Banias pipeline has been inoperative since 1982, but there has been talk of reactivating the pipeline, and Iraq has signed a protocol with Russia’s Stroytransgaz to this effect. Still, this pipeline remains hostage to the vagaries of relations between Syria and Iraq, which are far from having been fully normalized. More recently, the eruption of civil war in Syria has further discouraged consideration of recommissioning the pipeline. Finally, the IPSA pipeline to Yanbu has been inoperative since Iraq’s invasion of Kuwait in 1990. A segment of the pipeline across Saudi Arabia has been converted to carry natural gas – the pipeline in Saudi territory was paid for and belongs to Saudi Arabia. The utilization for gas transmission is less than optimal, because an oil pipeline is not built to withstand the normal operating pressure of gas pipelines, and thus its capacity is very low. The possibility of restoring this pipeline to transport oil to the Red Sea (be it Iraqi or Saudi or even Kuwaiti) should not be excluded. More recently, Iraq has been considering the possibility of a pipeline across Jordan to Aqaba. During much of the Iraq-Iran war, Iraq was able to export crude oil out of Aqaba thanks to a fleet of tanker trucks carrying a constant stream of oil into that port. A special oil berth was built at Aqaba and was used starting 1986. As noted, Iran has potential oil export outlets outside of the Gulf, but so far has developed no significant capacity to do so. This is paradoxical and clearly shows that Iran itself does not take too seriously the threat that it might resort to close the Strait, for example through massive mining. In this case, Iran would be the first to suffer, certainly more so than Saudi Arabia, the UAE or Iraq. In the end, Kuwait and Qatar are the only major Arab Gulf oil exporters that at present have absolutely no alternative but to ship oil through Hormuz. An unpublished study13 on building a network of pipelines that would allow all 13

Belkacem Bechka GCC Integrated Alternate Crude Oil Export System; Opportunity for Creation of GCC Reference Blend Marker, Dissertation submitted in fulfillment of the requirements for the Executive Master in Oil and Gas Leadership, Graduate Institute of International and Development Studies, Geneva 2012

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GCC countries to be able to export crude oil independently of Hormuz has concluded that the additional cost that this would entail is limited, considering the value of the commodity14. In conclusion, a threat to freedom of navigation through the Strait of Hormuz is a scenario that cannot entirely be discarded, but should be nuanced. There is universal consensus on the conclusion that as long as a credible commitment on the part of the US to keep the strait open exists, its closure can only be temporary. In all likelihood, it would also be partial. In any case, mitigation measures are of the utmost importance – to react to a possible emergency and even more to prevent an emergency by reducing the expected benefit of closing the strait. Mitigation measures may be of a general kind, such as strategic stocks, or specific; among the latter we should in particular mention oil pipelines to loading terminals outside the Gulf, the use and expansion of which should be encouraged. 3.2.2 The Malacca Strait

Essentially all traffic between the Far East and points west of Singapore passes through Malacca. According to the International Maritime Organization (IMO), at least 50,000 ships sail through this strait every year – many, many more than just tankers. Far from being a reason for comfort, this consideration should all the more encourage finding a solution that may take tankers out of the strait, as in the end they are the one component of traffic that is most easily substituted. At its narrowest point in the Phillips Channel of the Singapore Strait, Malacca is only 1.7 miles wide, and thus entails a natural bottleneck as well as the potential for collisions, grounding or oil spills (Figure 3). Sovereignty over the waters of the Malacca Strait is divided among Singapore, Malaysia and Indonesia. The literature does not consider the hypothesis that any of these three states might willfully attempt to close the strait or attack vessels transiting through them, but the possibility of attacks on the part of nonstate actors – as well as of accidents with environmental consequences that would require at least the temporary closure of the strait to navigation – must 14

In the assumption that this would be considered a strategic project entirely financed from the government budget at zero interest rate, the cost varies depending on the chosen configuration but never exceeds 2 dollars per barrel.

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Figure 3.3: The Malacca Strait

Source: IMO.

be considered. The Malacca Strait is frequently associated with endemic acts of piracy, but here we shall not differentiate between banditry (piracy) and terrorism or politically motivated action; we shall speak of non-state actors as a potential source of threat. Although international statistics report very large numbers of both vessels entering the strait and violent attacks, it is necessary to distinguish among the types of vessels and between local and long-distance traffic.15 When this distinction is made, it is clear that crude oil tankers (and LNG tankers) are among the least vulnerable categories of ships transiting the strait. In Bateman et al. (2007), the authors recognize that “[a] successful terrorist attack on a crude oil tanker could cause massive economic and environmental 15

This discussion is based on Sam Bateman, Joshua Ho and Mathew Mathai, “Shipping Patterns in the Malacca and Singapore Straits: An Assessment of the Risks to Different Types of Vessel,” Contemporary Southeast Asia 29, no. 2 (2007): 309–32.

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damage”, but they believe that this is unlikely. Experience in the ‘Tanker War’ (during the Iran–Iraq war) demonstrated that tankers are more resilient targets than normally recognized. Furthermore, “[t]hese vessels are also less vulnerable to piracy or sea robberies when underway due to their size and speed. It is virtually impossible, and certainly highly dangerous, for a small craft to attempt to get alongside such a large vessel travelling at its normal operational speed.” We should note, however, that the successful hijacking of the Saudi tanker Sirius Star off the coast of Kenya in November 2008 appears to contradict this conclusion. Interestingly enough, Malacca also sees considerable traffic of oil product tankers, LPG tankers and petrochemical product tankers. The authors recognize that these vessels – typically much smaller than large crude oil carriers, and in some cases not adequately maintained – could become more significant targets or ‘tools’ of terrorist activity, also in light of the higher flammability and explosive potential of their cargo. The Institute of Defence and Strategic Studies (IDSS) in Singapore conducted a comprehensive analysis of piracy and armed robbery attacks in the Malacca and Singapore Straits over a period of 10 years.16 The IDSS analysis revealed that the larger tankers, container ships, and LNG and car carriers on international voyages are not attacked unless they slow down or stop for some reason. These analyses are only partially reassuring. If on the one hand they tend to dismiss the danger that large vessels carrying substantial volumes of oil and LNG may be attacked, they seem to point to the considerable vulnerability of smaller vessels, which in turn may lead to catastrophic accidents and the temporary closure of the strait. While this issue is of concern primarily to the countries in the Far East (a closure of Malacca would not entail a global loss of crude supply, just a shortage of crude available to the Far Eastern countries), it is nevertheless worth considering also from a European point of view.

16 Sam Bateman, Catherine Zara Raymond and Joshua Ho, Safety and Security in the Malacca and Singapore Straits — An Agenda for Action, IDSS, Singapore, 2006.

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Figure 3.4: The Lombok Strait

Source: Google Maps

It is to be noted that already today larger tankers exceeding the dimensions and draft permitted in the Malacca Strait utilize the Lombok Strait between the islands of Bali and Lombok in Indonesia to access the South China Sea. This passage is longer and requires navigating through several other straits in Indonesian and Philippine waters before actually getting to the South China Sea, but it constitutes a valid alternative. It should also be noted that over the years several projects for creating a bypass pipeline across the Malay Peninsula, either through Malaysian and Thai territory or exclusively through Malaysian territory, have been proposed. So far, none of these appears to have made significant progress towards implementation. The key cause for that, as for many other proposals for a bypass around sensitive straits, is the lack of a clear economic incentive to justify the investment. We discuss this issue in broader terms in the remedies section of this chapter. On its part, China has pursued diversification from dependency on the Malacca Strait through the building of a pipeline across Myanmar, running from

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Figure 3.5: The Kyaukphyu to Kunming Oil and Gas Pipeline

Source : Mizzima News 18 January 2012. http://www.mizzima.com/business/6436china-now-no-1-investor-in-burma.html

the deep-water port of Kyaukphyu to Kunming in China17. This pipeline in under construction and will definitely be implemented, as it has obvious strategic importance for China, and easily makes commercial sense18 by avoiding a long circumnavigation. The pipeline crosses the Kachin State in Myanmar, where a rebellion is underway, which has originated armed clashes; so far, however, the pipeline appears not to have been affected. It will have a capacity of 440,000 barrels per day, which is limited in the context of Chinese oil imports from Africa and the Middle East. 17 Bo Kong “The Geopolitics of the Myanmar-China Oil and Gas Pipelines” in Edward Chow and others Pipeline Politics in Asia: The Intersection of Demand, Energy Markets, and Supply Routes 18 Nevertheless, the project has not been exempt from criticism, both for its cost (Kong, cit.) and for negative humanitarian implications (“The Burma-China Pipelines: Human Rights Violations, Applicable Law, and Revenue Secrecy” EarthRights International March 2011).

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Figure 3.6: China’s crude oil imports by source, 2011

Source: EIA, from FACTS Global Energy

3.2.3 Bab el-Mandeb

The Strait of Bab el-Mandeb is located between Yemen on the Arabian Peninsula and Djibouti in the Horn of Africa, and connecting the Red Sea to the Gulf of Aden. It is of importance to all tanker traffic from the Gulf to the Mediterranean, which normally includes tankers heading to northwest Europe and the US. Alternatively, this traffic can also circumnavigate Africa and thus very large crude carriers, which cannot pass through Suez, routinely follow this alternative route. The distance across is about 20 miles. The island of Perim divides the strait into two channels, of which the eastern is 2 miles wide and 30 meters deep, while the western has a width of about 16 miles and a depth of 310 meters.

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Figure 3.7: The Strait of Bab el Mandeb

Source: Google Maps

In past years, South Yemen was under the political influence of the Soviet Union and the possibility that the strait might be closed in the event of war was considered. Djibouti houses the most important French foreign military base, and also hosts a significant US contingent. The domestic security situation in Yemen justifies some concern. Not only has the country become a haven and redeployment base for elements linked to the al-Qaeda galaxy, but also the danger of state failure and decline comparable to neighboring Somalia is real. This may well create conditions whereby non-state actors may engage in violent action against oil targets in the strait. That being said, closing the Bab el Mandeb would not be easier than closing Hormuz, and much less oil transits through the former than through the latter. Even if Bab el Mandeb were to be closed entirely, circumnavigation of Africa is an alternative (the world has experienced this already, when the Suez Canal, rather than Bab el Mandeb, was closed). Furthermore, piracy has become endemic not just in the strait, but also across the entire offshore area of Yemen and Somalia, reaching out to offshore Oman on one side and offshore Kenya on the other. Therefore, the issue is not specifically Bab el-Mandeb,

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but more generally security of navigation at sea in the Gulf of Aden and Indian Ocean, as discussed in Section 2

3.2.4 Panama Panama is not vital for Europe and has limited importance for oil traffic globally: as shown in figure 3.8 the fastest growing and most important segment of vessels transiting through the canal is container ships, while tankers are a relatively minor component. Approximately 0.5 million b/d of crude oil and products transits through the canal. The largest vessels that are capable of transiting the Canal are called “Panamax”, and for oil tankers this means a capacity of about 55,000 DWT. Currently the canal is being enlarged, and the “New Panamax” vessels will have larger capacity, for oil tankers possibly reaching 100,000 DWT.

Figure 3.8: Net Tonnage of Merchandise crossing the Panama Canal

Source: Autoridad del Canal de Panamá, Plan Maestro del Canal de Panamá, Chapter 3

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There is hardly a credible scenario of political developments in Central America that may entail the closure of the Panama Canal due to willful act of Panama itself or any form of violence. While accidents are always possible, there is every reason to expect that all measures will be taken to avoid them, as the Canal is an important source of revenue for the government of Panama.

3.2.5 Suez The Suez Canal, like the Panama Canal, is not an international waterway, but a transit facility entirely controlled by Egypt (Figures 4 and 5). The canal was closed between July 1956 and April 1957, and then again between the Six-Day War in June 1967 and until June 1975. Although there is at present no reason to expect that the government of Egypt might consider

Figure 3.9: The Suez Canal

Source: “The Suez Canal”, Howstuffworks.com (http://geography.howstuffworks. com/africa/the-suez-canal.htm).

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Figure 3.10: Traffic through the Suez Canal Traffic through the Suez Canal 1,000,000

70

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Source: Suez Canal Authority (2008).

closing the canal again, and a peace treaty has been signed between Egypt and Israel eliminating the closest potential cause of conflict and closure, historical experience shows that it can happen. As the canal is fully under Egyptian control, acts of piracy or terrorism against ships in transit would indicate a severe lapse of security conditions in the country. In 2008, 146.7 million metric tonnes of crude oil and products transited through the Suez, equal to 3 million b/d (Table 3.2). Since the canal has no locks, the only serious limiting factors for the passage of tankers are draft and height due to the Suez Canal Bridge. The current channel depth of the canal allows for a maximum of 16 metres of draft, meaning many fully laden supertankers are too deep to fit and either have to unload part of their cargo onto other ships (‘transhipment’) or to the SUMED pipeline terminal before passing through the canal. Tankers capable of passing through the canal fully laden are called ‘Suezmax’. The typical deadweight of a Suezmax ship is about 150,000 metric tons and the beam 46 meters. Also of note is the maximum headroom limitation of 68 meters, which is the height above water of the Suez Canal Bridge. There is

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Table 3.2: Passage of energy products through the Suez Canal

Tankers LNG

No. of vessels 2007 2008 3,470 3,795 358 429

Tonnage 2007 2008 145,934 146,658 32,776 38,987

Source: Suez Canal Authority.

additionally a width limitation of 70.1 meters, but only a handful of tankers exceed this size and they are excluded from Suez by their draft in any case. Improvements are underway that will increase the maximum draft to 22 meters, in order to allow supertankers. Until then, supertankers must discharge part of their cargo at the entry of the channel and reload it at the other end, transported along the way by the SUMED pipeline. The SUMED pipeline, with a capacity of about 2.5 million b/d, links the Ain Sukhna terminal on the Gulf of Suez with Sidi Kerir on the Mediterranean (Figure 3.11). SUMED consists of two parallel 42-inch lines, and is owned by Figure 3.11: The SUMED pipeline

Source: EIA, Department of Energy.

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the Arab Petroleum Pipeline Co., a joint venture of EGPC (50percent), Saudi Aramco (15 percent), Abu Dhabi’s ADNOC (15 percent), three Kuwaiti companies (15 percent total) and Qatar’s QGPC (5 percent). The pipeline has been in operation since January 1977. Overall, the Suez Canal/SUMED system, notwithstanding past interruptions, strikes the observer as being very reliable and unlikely to face interruptions. This is primarily because the system is controlled by a single jurisdiction, is not an international waterway that can be used free of charge, and is in fact a major source of revenue for the Egyptian government. This creates a strong incentive to maintain the confidence of the international community in the availability of the system and to invest in improving quality and operational capabilities. 3.2.6 Turkish Straits

The prospect of greatly increased tanker traffic across the Turkish Straits – in particular the Bosphorus – has been a cause of concern for the Turkish government and international observers for longer than a decade. The concern is stirred by a combination of natural, institutional and environmental factors. Natural factors include the shape of the straits, with the narrowest point in the Bosphorus no more than 700 meters across, numerous bends and significant currents (Figure 7). Institutional factors include the fact that according to the Montreux Convention of 1936, passage through the straits is free, to the extent than even pilotage is not obligatory and no tolls are imposed (which of course discourages the installation of costly traffic regulation and control equipment). Environmental factors include primarily the consideration that the Bosphorus is today entirely encapsulated in the Istanbul urban area and any accident would have an immediate impact on a very large number of people. The number of tankers transiting the strait reached an average of 28 per day in 2007, and in excess of 10,000 per year during the past three years (Table 3).

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Figure 3.12: The Bosphorus

Source: Planet Ware: http://www.planetware.com/map/turkey-bosphorus-map-tr-tr21. htm .

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Tankers have had to wait for permission to transit in the southbound direction (i.e. from the Black Sea) from time to time, but no systematic statistics on waiting times are available. Delays are longer in winter, when weather conditions are less favorable. In short, traffic congestion in the Bosphorus adds to the cost of shipping but has not reached crisis proportions. The Turkish Straits are the sole outlet for oil exported from Russia, the Caucasus and Central Asia through terminals located on the Black Sea. Russia exports oil by pipeline to Central Europe and by sea through terminals located either on the Black Sea or on the Baltic Sea or to the Far East. Azerbaijan can now export oil directly to the Mediterranean through the Baku–Tblisi–Ceyhan pipeline. Kazakhstan exports oil through the Caspian Pipeline Consortium (CPC) pipeline, leading to the terminal near Novorossiysk, on the Black Sea. Therefore, the volumes of crude oil that will need to transit through the Turkish Straits is a function of the evolution in the logistics of Russian and Kazakh oil exports, plus to some extent oil consumption in the Black Sea region itself (possibly satisfied by supplies originating outside the Black Sea). Figure 3.13: Number of Tankers Transiting the Turkish Straits, 1996-2010

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Investing in bypass pipelines that may drastically reduce the number of tanker passages (considering that tankers are not the only vessels passing the straits) would appear to be a wise policy. The key difficulty is that so long as there is no toll for passage through the Turkish Straits, no alternative commercial route can compete. The only cost for utilizing the straits is the waiting time at the entrance, which has not become a major issue except during specific periods (generally in conjunction with bad weather in the Black Sea). International maritime law not only provides that freedom of passage cannot be impeded, but also requires that passage be at no cost. In the extreme case of the Turkish Straits (which are considered international waterways as per the Montreux Convention, notwithstanding the fact that they are so narrow and densely inhabited, with Turkey controlling both shores), not even the use of a pilot can be imposed. Clearly such rules were conceived in a now distant past, in which the intensity of traffic was incomparably less, and the danger of accidents not a significant consideration. International law gave absolute priority to the interests of maritime nations requesting freedom of passage – or as in the case of the Turkish Straits, to the interests of countries that would otherwise be almost landlocked, such as the Soviet Union in the winter months when the country’s northern ports are closed by ice. In cases where major waterways are not international – for instance, the Suez and Panama Canals – passage is regulated and must be paid for, thus laying the commercial basis for the establishment of alternatives and competition. Suez and Panama clearly demonstrate that it is not difficult to establish alternatives to congested navigation channels, provided that the cost of congestion is properly assessed and charged to the user. In both canals there is both a physical limitation to the draft of vessels that can transit and a fee for transiting vessels. Yet neither limitation applies to the Turkish Straits. This explains why discussions about several potential pipeline schemes to bypass the straits have been going on for two decades, but none has yet taken off. It is a classic free-rider situation: as progress in any bypass scheme would reduce congestion in the straits, and passage through the latter would remain for free, each party concerned has an interest in waiting for the others to take the initiative.

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Figure 3.14: The Samsun to Ceyhan Oil Pipeline Project

There are three main pipeline projects currently on the table to create alternatives to shipping oil out of the Black Sea through the Turkish Straits: the Samsun–Ceyhan project (aka TAPCO, the Trans-Anatolian Pipeline Company), the Burgas–Alexandroupolis project and the Constanta–Trieste project (aka PEOP, the Pan-European Oil Pipeline). The first project is being promoted by Calik Enerji and ENI, and has reportedly reached the commercial stage – that is, the sponsors are looking for shippers ready to commit to using the pipeline. At the beginning of 2011 it was announced that two Russian companies, Rosneft and Tatneft, would join the original sponsors in the implementation of this project.19 Nevertheless, two years later no concrete progress had been made to lay the pipeline. 19

Middle East Economic Survey 54, no. 1-2, 3, January 10, 2011.

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It is not clear, in fact, whether Russia intends to abandon the Burgas– Alexandroupolis project. The Burgas–Alexandroupolis oil pipeline is the solution preferred by Transneft, which has sought an engagement on the part of users of the CPC pipeline bringing oil from Kazakhstan to Novorossiysk to use this bypass. The pipeline is supported by Greece, but the Bulgarian government has shown much less enthusiasm, and at the time of writing it is not clear whether the project will go ahead. Finally, the Constanta–Trieste pipeline would have the advantage of taking Caspian oil to a destination where it could be transferred to pipelines serving refineries in Central Europe and northern Italy, instead of being again loaded onto ships. In April 2007, EU Energy Commissioner Andris Piebalgs and ministers from Romania, Serbia, Croatia, Slovenia and Italy signed an intergovernmental agreement designed to create the Pan-European Oil Pipeline, but since then no visible progress has been made and a credible industrial sponsor is still lacking. The persistent stalemate in promoting one or the other of these conflicting projects creates an avoidable threat to oil supplies, which the EU should address with the highest priority. 3.2.7 Baltic Sea

The European Commission (2008) Staff Working Document on Energy Network Infrastructures mentions the Baltic Sea as a potential chokepoint. The Baltic Sea is an enclosed body of water, and an accident may have serious environmental consequences. In this way, the Baltic Sea is similar to the Mediterranean, only smaller and thus possibly even more vulnerable. Nevertheless, it is not appropriate to consider the entire sea a chokepoint. Rather, the difficulty may be defined as the passage through the Danish Straits, which is very narrow. The Oresund, separating Copenhagen from Malmö, is indeed narrow, partially encumbered by the Oresund Bridge, the central span of which is 490 meters, with a vertical clearance of 57 meters (lower than the clearance of the Suez Canal). Most of the maritime traffic uses the Drogden Strait to the west, under which a tunnel runs to the Peberholm artificial island where the bridge starts.

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Figure 3.15: The Oresund Strait

Source: Google Maps

The Drogden at its narrowest point is 250 meters wide. Large ships can enter the harbors of Copenhagen and Malmö from the north, but the depth south of this line is insufficient for modern shipping. In the 2.7 nm-wide water between Copenhagen (Amager) and Saltholm the depth is 5 meters or less, except for a 1 nm zone at the ship channel from Copenhagen, the Drogden, where it approaches 10 meters. The official depth at medium water listed for the Drogden is 7.7 meters.20 The potential for a major increase of Russian exports through the Baltic is therefore likely to raise issues for navigation through the ‘Baltic Straits’. According to Seppo Liukkonen,21 From the shipping point of view an essential fact of the Baltic Sea traffic is the draft limitation. The shallowness of the Danish Straits does not allow ships 20

Gunnar Alexandersson, The Baltic Straits (Leiden: Martinus Nijhoff Publishers, 1982). Seppo Liukkonen, “Technical Requirements for Year-round Baltic Sea Tanker Traffic” (not dated) (http:// www.google.ch/search?client=opera&rls=en&q=tanker+navigation+baltic+straits&sourceid=opera&ie= utf-8&oe=utf-8).

21

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Figure 3.16: The Oresund Strait

Source: Google Earth

with draft deeper than 15.4 m to sail to the Baltic Sea. This limits the tankers useful at the Baltic Sea to the so-called ‘Aframax’ size, i.e. to the size of less than 150,000 tons in dead weight. From the environmental point of view the IMO has named the Baltic Sea as a special sea area with several restrictions for the discharge of oil, oily water, oily waste and garbage into the sea as well for the emissions into the air. Additionally, the Helcom (Baltic Marine Environment Protection Commission) has issued several recommendations for safe shipping and protection of the marine environment at the Baltic Sea. The positive aspect of the Baltic situation is the high level of cooperation among riparian countries, institutionalized in the Helsinki Commission (HELCOM), which constantly monitors traffic and accidents especially in view of avoiding or containing pollution. HELCOM represents an example of regional cooperation that should be fostered in other areas of the world presenting similar problems.

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3.3 Threats to Navigation outside Chokepoints The discussion of chokepoints has evidenced that in several cases the threat to navigation is not limited to the chokepoint itself, but is extended to the high seas in its proximity. Indeed, an analysis of accidents and piracy attacks to oil tankers, in particular, shows that the largest number of significant events took place at a considerable distance from the chokepoints, inviting the consideration of shipping conditions in a much broader spectrum of situations. We discuss two specific categories of threats that have attracted considerable attention in recent times: piracy attacks and pollution from accidents. Obviously, there might be military threats to shipping originating from state actors in the riparian countries, but discussing all potential threats of this kind would lead us too far. Suffice to repeat what we stated at the beginning: that freedom of navigation is increasingly of interest to all countries, not just the maritime powers, and we see no episodes of interfering with maritime traffic on the part of state actors other than for legitimate and accepted purposes anywhere in the world. 3.3.1 Global Piracy

Surprising as it might be, piracy has been increasing in recent times (Table 3.3). According to the International Maritime Bureau, attacks on ships increased a further 10 percent in 2010, mostly by pirates based in Somalia. A Chatham House briefing paper published in October 200822 proposes a systematic analysis of the problem and notes that it has been growing for 10 years at least. The report observes that the increased piracy threat translates into increased transportation costs – for much more costly insurance, for premiums to be paid to crew members, for time lost, and for ransoms to be paid… The One Earth Future (OEF) Foundation has established a task force and monitoring initiative (oceansbeyondpiracy.org), which published a report 22

Roger Middleton, “Piracy in Somalia: Threatening Global Trade, Feeding Local Wars,” Chatham House Briefing Paper, Chatham House, London, October 2008.

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Table 3.3: Pirates’ Attacks on ships by type 2006 35 9 0 4 239

Chemical and product tankers Crude tankers LNG tankers LPG tankers Total

2007 52 25 1 5 263

2008 55 30 0 6 293

2009 69 41 1 5 410

Source: International Maritime Bureau (2010).

estimating the cost of piracy.23 The report points to the fact that there has been a very significant increase in ransoms paid to rescue hijacked ships. In 2010, the average ransom paid was $5.4 million, up from an average of $150,000 in 2005. The report estimates that a total of $238 million was paid in ransom in 2010, up from $177 million in 2009. But this is just the tip of the iceberg, as a multiplicity of indirect costs should be added, including the cost of maintaining a naval presence whose effectiveness has proven to be limited – pushing the total to an estimated $7 billion per year or more. This estimate (a cost of 7 billion US$) has been confirmed for 2011. There are several options to deal with the issue but none is easy. The UN Security Council unanimously passed Resolution 1851 in 2008, opening the door to the deployment of a Nato, a EU and a US naval mission. Other countries are also participating in the patrolling of the seas, and repressive action against Somali pirates has had some successes – but hardly enough to stem the phenomenon. It may be surprising that all the most powerful navies of the world are unable to put an end to the activities of poor and badly armed former fishermen motivated by economic desperation, but facts confirm that this is the case. Deploying armed personnel aboard merchant ships, or arming the ship’s crew has sometime been adopted as a possible remedy, but may lead to unwanted consequences24

23

Anna Bowden (ed.), Kaija Hurlburt, Eamon Aloyo, Charles Marts and Andrew Lee, “The Economic Cost of Maritime Piracy,” OEF Working Paper, OEF, Louisville, CO, December 2010 (http://oceansbeyondpiracy. org/obp/cost-of-piracy-home). 24 In February 2012, two Italian marines aboard an oil tanker mistakenly shot and killed two Indian fishermen which they took for pirates, and were subsequently imprisoned in India.

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Figure 3.17: Pirates’ attacks off the Horn of Africa

Source: International Maritime Bureau

Although the naval presence of concerned countries in the area has increased, the daring of attacks appears to have increased even more. The most recent and extraordinary case has been the hijacking of the Saudi tanker Sirius Star 450 miles off the coast of Kenya (indicated by pointer A in the map below) on November 17, 2008: all about this event has been unprecedented: the distance from the coast, the size of the vessel (318,000 DWT, 330 m of length, one of the largest tankers in the world), the volume of oil transported (2 million barrels), the ransom that was finally paid (reportedly 3 million dollars). The hijacking of the Sirius Star thus represents a turning point in the record of piracy at sea and possibly also of the international reaction to this phenomenon. Obviously, if such a large ship can be successfully attacked, basically all ships are vulnerable. And if an attack can take place at such distance from the coast, the discussion of chokepoints is pretty much irrelevant. Piracy prevention and repression must take an entirely new dimension.

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Thus, piracy has become a significant economic burden and one that has no easy solution at hand, short of recreating an effective government structure in Somalia and enforcing law and order. That being stated, piracy is not in any sense subtracting significant volumes of oil from global supplies – it is simply adding to the cost and time of transportation (ships must circumnavigate Africa to avoid pirate-infested waters; hijacked ships are delayed, but eventually ransoms are paid and they resume their journeys).

3.3.2 The Danger of Oil Spills in Enclosed Seas Oil spills from accidents involving tankers are a major source of concern and motivation for the international regulation of tanker traffic. Also in response to such concerns and to the rules that have been adopted in international fora to prevent damage to the environment, the number of spills has very much decreased over time, notwithstanding the significant increase in the quantities of oil transported by sea. According to International Tanker Owners Pollution Federation (ITOPF),25 the number of large and medium-sized spills has greatly declined over the years. With the fall in numbers there has also been a reduction in the total volume of oil spilt, although data show very clearly that a few very large accidents are responsible for most of the damage – therefore, even a single large accident in the future may change the picture quite radically. Statistics also show that spills (fortunately) do not occur primarily in enclosed seas or at chokepoints, but frequently in oceans and large bodies of water. Nevertheless, it is logical that worries about environmental damage become more acute when tankers ply the waters of enclosed seas, where the damage is potentially much greater. Limitations to the freedom of navigation imposed because of environmental concerns may affect European energy supply in the future, especially with respect to the Mediterranean Sea. The Baltic is a problem as well, but much less oil transits through there. The Gulf, the Red Sea and the Black Sea are also potentially highly problematic, but the ‘political equilibrium’ between oil 25

See the ITOPF website (http://www.itopf.com/).

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and environmental interests in those areas is very much more in favor of oil interests, and action to limit tankers’ freedom of navigation accordingly is less likely.

3.3.4 Tanker Traffic in the Mediterranean A Study of Maritime Traffic Flows in the Mediterranean Sea was recently conducted by Lloyd’s Marine Intelligence Unit on behalf of Regional Marine Pollution Emergency Response Centre for the Mediterranean Sea (REMPEC) in the context of the SAFEMED project sponsored by the European Commission.26 The study asserts that the most significant change in overall traffic patterns in the Mediterranean in the coming years will be the development of export routes for crude oil from the Caspian region, which is currently shipped predominantly via Black Sea ports through the Bosphorus. Northern European demand for energy is likely to see an increase in LNG transits via the Mediterranean from gas fields in the Gulf and the Far East. If planned LNG terminal developments actually take place, the density of LNG tanker deployment around the Italian coastline will increase significantly. The study, therefore, supported concerns that were already evident at the political and diplomatic levels in previous years. In May 2003, the Euro-Mediterranean conference of energy ministers in Athens recognized the broader nature of the problem:27 Ministers confirm that, in view of recent accidents involving the maritime transportation of hydrocarbons and the particular vulnerability and sensitivity [of the] Mediterranean sea for this type of transport, it is important to consider the advisability of reducing the maritime transportation of hydrocarbons in the Mediterranean by the development of oil pipelines if these are shown to be technically, economically and environmentally feasible. 26

Lloyd’s Marine Intelligence Unit, Study of Maritime Traffic Flows in the Mediterranean Sea, REMPEC, Valletta, Malta, July 2008. 27 Ministerial Declaration by the Euro-Mediterranean energy forum adopted by participants at the conference in Athens on May 21, 2003.

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3.3.5 Major normative developments

International navigation is a highly institutionalized area of international relations. Maritime law has been one of the earliest branches of international law to be developed, to regulate encounters at sea of ships of different nationalities. In this section, we focus exclusively on recent norms affecting tanker traffic and potentially bearing consequences for security of supply in Europe. Generally speaking, international maritime law protects freedom of navigation, and individual riparian countries or regional groups of countries cannot restrict freedom of navigation even through territorial waters, if these are deemed to be relevant for international traffic. In this context, the most important international instrument affecting oil transportation at sea is the International Convention for the Prevention of Pollution from Ships (‘MARPOL’). The MARPOL Convention is the main international convention covering prevention of pollution of the marine environment by ships from operational or accidental causes. It is a combination of two treaties adopted in 1973 and 1978, respectively, and updated by amendments through the years.28 In 1992, MARPOL was amended to make it mandatory for tankers of 5,000 deadweight tons and more ordered after July 6, 1993 to be fitted with double hulls, or an alternative design approved by the IMO (Regulation 13F in Annex I of MARPOL 73/78 (Regulation 19 in the revised Annex I, which entered into force on January 1, 2007). In subsequent years, further amendments were adopted to accelerate the phasing-out of single hull tankers. The final deadline for phasing out single hull tankers was 2010. Tankers that have double bottoms or double sides but 28

The 1973 MARPOL Convention was adopted on November 2, 1973 at the IMO and covered pollution by oil, chemicals, harmful substances in packaged form, sewage and garbage. The Protocol of 1978 relating to the 1973 International Convention for the Prevention of Pollution from Ships (‘1978 MARPOL Protocol’) was adopted at the IMO “Conference on Tanker Safety and Pollution Prevention” in February 1978, held in response to a spate of tanker accidents in 1976–77. As the 1973 MARPOL Convention had not yet entered into force, the 1978 MARPOL Protocol absorbed the parent Convention. The combined instrument is referred to as the International Convention for the Prevention of Marine Pollution from Ships, 1973, as modified by the Protocol of 1978 relating thereto (MARPOL 73/78), and it entered into force on October 2, 1983 (Annexes I and II).

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not properly speaking double hulls may be kept in service for a few more years, but will also need to be retired soon. This new norm has caused the retirement of a large number of ageing tankers. Yet an even larger number of new tankers are on order and there is no shortage of capacity in sight.

3.4 Scenarios of Supply Interruption and Potential Remedies This chapter has reviewed several potential causes of restrictions to passage, ranging from hostile acts on the part of states, to actions by non-state actors such as terrorists or pirates, and limitations to navigation linked to environmental protection. The general conclusion that can be drawn from this discussion is that there is no scenario of interruption to maritime oil and gas transportation that may cause a severe physical shortage of oil, in general or specifically for Europe. Even the most problematic of cases – the attempted closure of the Strait of Hormuz – could not have the catastrophic consequences sometimes discussed: a good share of Gulf production could be evacuated from ports outside Hormuz, and the strait is unlikely to be totally closed. Whatever disruption occurred to passage, it would not last for more than two or a maximum of three months. The shortage of crude oil stemming from such circumstances could be dealt with through the drawdown of strategic stocks held by governments under the IEA program. A further conclusion is that in almost all cases potential tensions could be easily allayed if responsible governments took the necessary steps to create alternatives, notably pipeline bypasses, or to curb illegal activities. It has been argued that the main obstacle preventing the required investment in transportation alternatives is the lack of a well-functioning market mechanism for burden sharing. Although excessive reliance on congested straits may result in losses to individual shippers because of longer waiting times, higher insurance rates or acts of piracy, this does not translate into the willingness to participate in investment, which should be carried out by third parties. In most cases, the temptation of free riding prevails, and no one underwrites the required investment. Where passage must be paid for, the resulting income stream supports investment to increase capacity and accommodate growing demand.

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Supply interruptions consequent to the closure of major sea lines may be addressed by the EU directly and indirectly. Directly, the Union can more forcefully pursue projects intended to reduce vulnerabilities, such as excessive passage of tankers through the Turkish Straits. Eventually, ‘congestion charges’ may need to be imposed, not differently from what is done for private cars in central London and several other major cities. Freedom of navigation and the right to free passage cannot be sacrosanct principles to be applied in all circumstances, even where resources are objectively scarce. Indirectly, the Union can pursue these goals through agreements with partner countries aimed at facilitating investment in infrastructure that may reduce vulnerabilities and the danger of accidents, and through the promotion of international compacts to enforce ever more stringent standards for oil, oil products and chemical tankers.

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Chapter 4 – Strategic Oil Stocks and Security of Supply

Chapter 4 Strategic Oil Stocks and Security of Supply 4.1 Introduction Holding strategic oil stocks is at first sight an obvious tool to address potential disturbances in supplies. Rationally defining the desirable size of stocks and designing rules for their predictable use is an elusive task, however. In the first section of this paper some conceptual problems related to oil stocks are discussed, including a brief review of the economic literature on optimal stock holding. In the second section, a review of the legislation in force is presented, examining the experience of the Strategic Petroleum Reserve of the US, the emergency response systems of the International Energy Agency (IEA) and, finally, EU legislation. On the basis of this background, the third section discusses opportunities for novel approaches to the management of stocks in the event of supply disruptions.

4.2 Conceptual Problems Concerning Strategic Stocks Strategic stocks are a well-recognized policy tool to alleviate supply disruptions – at least since Joseph advised the Pharaoh that Egypt would need to withstand seven lean years after seven fat ones. Nevertheless, the literature on the subject does not appear to be well developed, and indeed the state of the debate, especially with reference to the strategic storage of oil and gas, is surprisingly rudimentary. In this first section, we focus on a list of conceptual problems that are encountered in the definition of a sensible policy for strategic stocks. As with most issues, it will appear evident that the question is not one of yes or no, but of the modalities and details of defining a policy.

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Actually, defining a rational storage policy is a deceptively simple task. The rationale for storage is initially compelling, but is found to be extremely problematic when looked at in greater detail, as noted by Wright and Williams (1982): Without divine assistance in forecasting stochastic production, the storage decision is considerably more complex than the one Joseph faced, and the role of storage quite different. In fact, several commonly held impressions about the role of storage of commodities such as grains are incorrect. Rather than stabilising production, storage actually accentuates its variability. Rather than causing a mean-price-preserving decrease or a mean-output-preserving decrease in the dispersion of price, storage generally causes a more complex modification of the distribution of price. Rather than being most effective at eliminating short-falls in consumption, storage actually is more effective at eliminating the incidence of exceedingly high consumption. The point is that, in the absence of sufficient knowledge about future production, it is impossible to make rational choices about when and to what extent stocks should be accumulated or liquidated. Nevertheless, companies routinely maintain certain levels of stocks, and governments also sometimes do so for “strategic” reasons. In the past, planning for war obviously included accumulating stocks in the expectation that supply might be disrupted. In theory, strategic stocks are clearly differentiated from commercial stocks. The latter are held by private companies or final consumers to guarantee the smooth functioning of their plants or vehicles between the discrete re-fills of tanks, or in the expectation of financial gain in case the future price might be higher than the current one. Commercial stocks are therefore determined by the requirements of the stockholder, the size of available storage facilities and expectations about future prices. Private operators make decisions concerning the size of their storage facilities and the extent to which these are kept full on the basis of their assessment of the ease of procuring fresh supplies, the forecasted requirements and price expectations. The outcome of these complex and highly diffuse stockholding decisions by ‘the market’ is a system that may be very stable – if large stocks are normally held – or quite brittle. This is plainly not something that public authorities are responsible for, yet neither can they be indifferent. If, to put it

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very plainly, a car owner remains stuck on the motorway because s/he failed to keep the car tank sufficiently full to reach the next station, then that is the individual’s problem. If, however, all car owners normally fill up their tanks to the full and well before the tanks are empty, a considerable amount of aggregate stock will be established – which may help in the event of supply disruptions. This tells us that the stability of the system is a function of commercial stocks (those that are held by companies trading in oil and products) but also final users’ stocks – be they individual or industrial users. Changes in expectations may affect supply conditions – e.g. if final users expect a possible disruption in supplies, they may attempt to increase their stocks, thus creating a surge in demand which further tightens supplies. Commercial and financial players will tend to anticipate this normal reaction and bid prices higher. Private operators are expected to deal on their own with all ‘normal’ discontinuities in supply, those that are an intrinsic part of the system and are easily predictable; but will also tend to react to unusual circumstances or threats that are political or military in nature, anticipating or paralleling the action of their respective governments. Public strategic stocks, on the other hand, are meant to deal with extraordinary situations, which constitute a security threat to the nation. Obviously, this may apply to a situation of open warfare, in which case the distinction may be very clear; but as we move from extreme conditions to more nuanced situations, the question of whether any given situation should be considered “strategic” or “commercial” becomes increasingly blurred. 4.2.1 Defining the Threat

The first prerequisite for elaborating a sensible, strategic stock policy is an accurate definition of the ‘threat’ (or ‘accident’ or ‘event’) against which the stocks are intended to provide a buffer. This is indispensable not only to allow for a discussion of the adequacy of the tool (are strategic stocks an appropriate tool, and if so, what is the required size of them?), but also of the costs and benefits of resorting to this tool. In relation to oil supply, the threat may be defined as either a physical shortfall or a major change in prices. The two aspects are patently related, because a

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physical shortfall will inevitably lead to an increase in prices. (In fact, the mere possibility of a shortfall influences expectations and brings about an increase in prices even before the shortfall actually occurs – if ever). Physical shortfalls may be the result of a cut in production or exports of a major exporting country or group of exporting countries. Alternatively, shortfalls may also stem from the voluntary or accidental closure of a particular transportation or transit facility. The latter may affect a specific group of importers without necessarily impacting on global supplies, leading to restricted availability of crude or products in specific markets. With respect to European supplies, the logistics and sources of supplies are sufficiently diversified, so it is difficult to envisage localized disruption.2 Hence, when we speak of the European situation, the threat that we should consider is primarily the shortfall in global supplies that may result from a cutback in production or exports on the part of one or a group of major producers. Demand for oil is constantly increasing, but the pace of change may vary quite significantly; global supply is the algebraic sum of declines in certain fields and increases in other fields. Accidents or disturbances of greater or lesser impact happen in the industry all the time, and some producing countries have lived in a state of more or less constant turmoil for decades: we may be hard put to define the ‘normal’ state of affairs against which the deviation, or ‘accident’ that we wish to protect against, is measured. This situation is evidenced by experience over the past decade, during which supply tensions and price increases have been linked to an array of events, including war in Iraq, but also strikes or disturbances in Nigeria or Venezuela, hurricanes and other acts of God – while demand has increased much faster than anyone expected. Prices increased in 2008 to a level never seen before: Was this due to the Iraq war, the unexpected increase in demand in China or the mortgage crisis in the US, pushing investors to seek safe haven in acquiring a physical commodity like oil? Or was it simply the market at work, reflecting the circumstances of the day – exceptional in the sense that each day is different, but no more? As discussed in Chapter 1, the IEA considers that the most important supply disruption in historical experience was consequent to the Iranian revolution, 2

See chapter 3 in this volume.

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when 5.6 million barrels per day (b/d) were lost for a period of six months. This loss was nonetheless compensated by increased production in other countries, and total world oil production actually increased from 63.3 to 66 million b/d between 1978 and 1979; it declined in subsequent years in response to a decline in demand.3 So, was there a crisis? The oil market is quite ‘nervous’ and tends to anticipate a supply shortfall with considerable price hikes, rather than waiting for it to happen. Consequently, it is frequently the case that we pay the price already while the discussion is still going on, whether the physical shortfall is fact or fiction – which is not a condition conducive to the orderly and predictable use of strategic stocks. In other words, situations in which there is a single and clearly identifiable cause of a significant supply shortfall will be extremely rare. The precedent of the 1973 embargo by OAPEC (Organization of Arab Petroleum Exporting Countries) is unlikely to be repeated, and remains quite isolated. Other episodes of open war involving oil-producing countries, notably Iraq, Iran and Kuwait, have had a variable impact on supply and expectations have been as important, if not more so, than facts. A definition of the threat based on price variations would be, in this respect, much clearer than one based on physical supply changes. Yet if the trigger event for the use of strategic stocks is defined as a change in prices, the distinction between strategic and intervention stocks – the latter being instruments for managing prices on the market rather than tools for addressing a security concern – becomes blurred. 4.2.2 Predictability and Adequacy

For the adequacy of stocks to be rationally discussed, it is necessary that we have some understanding of the probability of the event against which we are trying to protect ourselves. All insurance policies are based on the statistical evaluation of the probability of an event occurring and the cost of it. Even in such seemingly absolute state objectives as guaranteeing the integrity of the state we follow a probabilistic approach, in the sense that no state actually incurs the expense that would be required to be able to protect itself against any imaginable external threat. 3

See chapter 2 in this volume.

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All discussions of strategic stocks in economic literature tend to relate to their use in agriculture or other sectors in which production is not known a priori, but the probability distribution of outcomes can be estimated. In the case of global oil supplies, we have a plethora of smaller accidents, industrial or socio-political, which cause actual production to deviate from the desired level; these may possibly be predicted statistically, but are not the main source of concern. It is implicitly assumed that these smaller disturbances are part and parcel of the normal functioning of the industry, and protecting against them is the task of private actors. The adequacy of military preparedness is measured against some scenario on the use of a country’s armed forces, which defines their intended capabilities. This could well be done also with respect to strategic oil storage: we might discuss what kind of accident we intend to protect against, and attempt to attribute a probability factor to it in order to guide a rational decision. This, however, is not frequently done. Notably, reference is commonly made to ‘political instability’ and ‘volatility’ in the Gulf, somehow hinting at the possibility that all of the Gulf countries’ oil suddenly might disappear from the scene. Any considerate discussion shows this to be almost impossible.4 Alternative scenarios might be more plausible, but the compelling need for large strategic stocks would quickly evaporate. After all, the Gulf has been politically unstable and volatile for decades, and existing oil stocks have been used for genuine military circumstances only in 1991 when hostilities began against Iraq to roll back the invasion of Kuwait – and then too late, when the market had already turned around. Our analysis in previous chapters has shown that scenarios such as the sudden disappearance from the market of the entire production of Saudi Arabia are not credible. The Iraq–Iran war offered an experience of protracted conflict between two main Gulf producers, yet both continued to export throughout the war and a serious shortfall occurred only in the initial months of the conflict, and was easily compensated by production increases elsewhere in the world. At the time of writing, the most credible imminent threat to global oil supplies is a boycott of Iranian oil imposed by the United Nations in connection with the Iranian nuclear program. This threat should be assigned a very low probability, because the necessary consensus within the Security Council would be 4

See Chapters 1 and 2.

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very difficult to achieve; in any case, there is presently sufficient unused capacity in neighboring countries to compensate for the disappearance of Iran from the market. Strategic stocks might be needed, if at all, simply as a temporary source to fill the gap while other producers ramp up their output. For this, they are very abundantly sufficient. 4.2.3 Cost-benefit Analysis

In deciding on the rationality of holding strategic oil stocks and their optimal size, we should be able to engage in a proper cost-benefit analysis. It is commonly assumed that a shortfall in oil supplies may constitute a security threat or inflict serious economic damage to industrial countries. Nevertheless, when considering the impact of oil price increases – which would be the immediate manifestation of oil supply shortages – the literature overwhelmingly suggests that this is limited and certainly far from being considered catastrophic or a security concern. The estimation of the impact of a disruption in oil supplies is problematic. The results critically depend on an array of assumptions about possible production increases from non-impacted sources, about market reactions and consequent price increases, and about the policy reactions of the affected importing countries. Indeed, it is clearly unrealistic to pretend to model the market response to a supply disruption: we can hardly predict market response in normal circumstances, even less so in exceptional ones. In practice, we see at present a tendency to conceptualize a supply disruption as a sudden jump in price – thus eliminating the need for specifying a function linking a physical disruption to the consequent movement in prices. This means that a physical supply disruption will be considered serious if it leads to a serious jump in prices; if prices do not move very much, the disruption is not there. Yet while a jump in prices is a necessary condition, it is still not a sufficient one for authorities to agree on the existence of a supply disruption, because prices frequently register wide swings even at times when no physical disruption is visible. But can we consider that a significant jump in prices is security threat per se, which must be countered by resorting to the use of the strategic stocks? If so, under what conditions? First of all, in many industrial countries – with the notable exception of the US – energy products are heavily taxed. This is done for general budgetary

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purposes, but is also frequently justified for reasons of curbing consumption, to reduce import dependency or mitigate the impact of emissions on the environment (or both). Whatever the reasons for imposing high excise taxes on energy products, the fact is that the consumer is accustomed to paying prices that are well above market realities. At the very least, this means that the consumer is shielded against market price increases, in the sense that the price increase as felt by the consumer is percentage-wise much less than the increase in international market prices. In addition, the consumer might further be shielded because in the event of a very severe increase in international prices, such as would justify the liquidation of strategic stocks, excise taxes might be reduced. Of course this measure would not eliminate the impact on the trade balance, and it would have a negative effect on the government budget, thus requiring macroeconomic adjustment; however, if the supply shortfall is temporary, then financing might be preferable to adjustment. If, on the other hand, the supply shortfall is permanent or sustained, then strategic stocks would be of no avail, and adjustment would be required anyhow. In other words, strategic stocks represent a tool to cushion and not eliminate supply shortfalls, and changes in excise taxes are a valid alternative in that function. Even ignoring the possibility of modulating excise taxes, the experience of the period 2004–08 leads us to the conclusion that the impact of changes in oil prices on GDP is limited. While oil prices kept climbing in the years 2004–07, economic policy-makers of the industrial countries frequently voiced the concern that growth would be affected and pleaded for moderation by OPEC. Yet economic growth only suffered when the real estate bubble burst in the US, and more decisively so when the fragility of the financial system was exposed by the collapse of Lehman Brothers. High oil prices may well have played a role in the final outcome, but they certainly were neither the sole nor the main culprit.

4.3 Legislation on Strategic Stocks: Frameworks of the IEA, the US and EU A cooperative approach to strategic stocks has been established among the major oil importing countries within the International Energy Agency institutional framework. Major importing countries have national legislation that must at least conform to the IEA’s requirements, but may go beyond the same. Accordingly, in this section we examine first the IEA’s Emergency Response System, then existing legislation in the US and the European Union.

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4.3.1 The IEA’s Emergency Response Systems

The International Energy Agency (IEA) was established in the wake of the 1973 export restrictions to the US and other selected industrial countries imposed by OAPEC. Ensuring security of supply and solidarity among the major industrial countries is a core objective of the IEA. The Agency’s emergency response system is, therefore, a key feature of the organization. The International Energy Program (IEP), which is contained in the IEA’s governing treaty, commits participating countries5 to the following measures: • maintain emergency oil reserves equivalent to at least 90 days of net oil imports; • undertake programs of demand-restraint measures to reduce national oil consumption; and • participate in oil allocation among IEA countries in the event of a severe supply disruption. The IEA also has an additional set of coordinated drawdown of strategic stocks and other response measures, known as the Coordinated Emergency Response Measures (CERMs). These were established by an IEA Governing Board Decision of July 1984 and updated more recently. In taking this decision, the Governing Board recognized the importance of responding rapidly to a supply disruption in order to minimize the potential economic damage. CERMs may apply even if the oil supply disruption is not acute enough to activate the IEP emergency measures. The decision to activate emergency response measures would also be taken by the IEA’s Governing Board. The Governing Board receives advice from industry experts, through the Industry Advisory Board. The IEP is clearly directed to compensating for physical disruptions rather than to sudden changes in prices. The institutional brochure states: “Although supply shortages may bring about rising prices, prices are not a trigger for a collective response action, as these can be caused by other factors and the goal of the response action is to offset an actual physical shortage, not react to price movements.”6 5 6

See the IEA “Agreement on an International Energy Programme” (as amended September 25, 2008). See International Energy Agency, IEA Response System for Oil Supply Emergencies, IEA, Paris 2012, page 3

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Figure 4.1: Strategic stocks’ availability and drawdown rate

Source: International Energy Agency, IEA Response System for Oil Supply Emergencies, IEA, Paris 2012

IEA net oil-importing countries have a legal obligation to hold emergency oil reserves equivalent to at least 90 days of the net oil imports of the previous year. At the end of 2011 IEA member countries held 4.1 billion barrels of public (1.5 billion) and industry (2.6 billion) oil stocks,7 which represented 143 days of net imports. Industry stocks include commercial stocks as well as strategic stock obligations imposed by the respective governments: it is not possible to clearly demarcate what is commercial and what is strategic in the industry stock pool. The duration of available stocks is a function of the drawdown rate (see Figure 4.1). In the case of a drawdown rate of 4-4.5 million b/d, the duration would be approximately one year. In addition to drawing down oil held in strategic storage, the IEA countries may adopt various policies to reduce consumption. It is indeed clear that not all uses of petroleum products are essential or of strategic importance. The IEA has published a major study on the potential for reducing consumption in times of crisis.8 7 8

Ibidem, page 7. See International Energy Agency, Saving Oil in a Hurry, IEA, Paris, 2005.

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IEA’s emergency response system has been activated on three occasions: • at the eve of the outbreak of hostilities for the liberation of Kuwait from Iraqi occupation (Desert Storm) in 1991 • after damage caused by Hurricane Katrina in the Gulf of Mexico in 2005 • to compensate for the disappearance of Libyan oil due to the civil war in 2011. In the first occasion, the IEA activated its contingency plan on January 17, 1991 to make available to the market 2.5 million barrels of oil per day. The price of oil had increased significantly since Kuwait had been invaded by Iraq, and exports from both countries had collapsed. However, the shortfall of oil exports from Kuwait and Iraq was compensated by increased exports of other major producers, notably Saudi Arabia: consequently conditions for an immediate activation of the emergency response mechanism were not fulfilled. On the even of the launch of the military campaign to liberate Kuwait it was feared that the beginning of hostilities might provoke further tensions on the market (primarily because of the possibility that Iraq might retaliate attacking oil facilities in Saudi Arabia). Contrary to these expectations, the market correctly predicted that hostilities would not last long and no further damage would be caused to oil supplies. It thus turned around almost immediately after the outbreak of hostilities, and the IEA’s intervention proved unnecessary. In relation hurricane Katrina, the IEA member countries decided to make available to the market the equivalent of 60 million barrels through the use of emergency stocks, increased indigenous production and demand restraint. This was, however, primarily a US emergency, as oil supplies in the rest of the world were not affected at all. Finally, the IEA decided to activate a release to compensate for the disappearance of oil exports from Libya in 2011. The civil war in Libya lasted from February to August of that year, and the decision was announced in June. Other producers, notably again Saudi Arabia, had increased production in order to compensate for the shortfall, but it was said at the time that differences in oil quality still justified a release. It was decided that strategic stocks would be drawn down by 2 million barrels per day for an initial period of 30 days, for a total of 60 million barrels. It should be noted that Libya produced

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less than 2 million barrels per day before the civil war. Prices immediately declined on the Brent market, and after an initial period of one month, the action was discontinued. In other circumstances, preparations were visibly made to use the strategic reserve, although in fact no release was approved. This happened in 1999 in connection with the Y2K scare, which proved entirely unfounded. Preparations were made again in 2003, when global oil markets were tight, affected by low inventories and a high degree of uncertainty with strikes in Venezuela, disturbances in Nigeria and the war in Iraq. The possible use of the strategic reserve was also prominently discussed in the summer of 2012, although no specific hostilities were visible at the time, because oil prices were driven up by the fear of a possible attack on Iran due to the latter’s uranium enrichment program, and the possible consequences of such action. The US government was in favor of a release, but other members of the Agency, notably Germany, opposed it. Considering that oil prices are driven by expectations as much as – if not more than – by hard facts, the question arises whether use of the strategic reserve is an appropriate tool to influence expectations. In fact, in the realm of expectations it might not even be necessary to actually release oil from the reserve, but simply publicly agitate the possibility that this may happen to obtain the desired effect on prices. 4.3.2 The US Strategic Petroleum Reserve9

According to the US Department of Energy, the US Strategic Petroleum Reserve (SPR) is the largest stockpile of government-owned emergency crude oil in the world. Established in the aftermath of the 1973–74 oil embargo, the SPR is intended to provide the President of the United States with a response option should a disruption in commercial oil supplies threaten the US economy. It also allows the US to meet its IEA obligation to maintain emergency oil stocks, and it provides a national defense fuel reserve. The federally owned 9 This section is based on the US Department of Energy (DOE) website article, “Strategic Petroleum Reserve – Profile”, DOE, Washington, D.C., updated March 16, 2011(b) (http://www.fe.doe.gov/programs/reserves/ spr/index.html).

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oil stocks are stored in underground salt caverns along the coast of the Gulf of Mexico. Oil accumulated in the SPR reached a peak of 727 million barrels – the total capacity available – at the end of 2009. Decisions to withdraw crude oil from the SPR are made by the president under the authority of the Energy Policy and Conservation Act of 1975, which declared it to be US policy to establish a reserve of up to 1 billion barrels of petroleum. The SPR has been used three times, in conjunction with IEA-approved releases discussed in the previous paragraph. In January 1991, 17 million barrels were sold in conjunction with Desert Storm; a test sale of 4 million barrels had been carried out in August of 2010, soon after Iraq invaded Kuwait; thus a total of 21 million barrels were sold in that occasion. In 2005, 11 million barrels were sold in conjunction with the Hurricane Katrina emergency. In 2011, 30.6 million barrels were sold in conjunction with the Libyan civil war. Furthermore, 28 million barrels were sold under nonemergency conditions in 1996-97. Finally, the reserve has been used repeatedly for “exchanges”, i.e. temporary loans of crude oil to specific companies because of short-term logistic problems in the US. The Department of Energy claims that the size of the SPR makes it a significant deterrent to oil import cut-offs and a key tool of foreign policy. However, no proof is offered for this statement: since 1973, one can hardly think of any case in which oil-producing countries may have considered cutting off oil exports – either to the US specifically or in general; this may or may not be due to the purported deterrent effect of the SPR. As of 2012, the reserve held close to 700 million barrels of oil, representing about 80 days of imports. The import coverage measured in number of days has been increasing since 2010 because of declining imports. Indeed, it has been proposed that the expected further decline in net imports may lead to systematic liquidation of the reserve10. Conditions for the utilization of the SPR are defined by the Energy Policy and Conservation Act (1975).11 In essence, the reserve is specified for use in the event of a “severe energy supply interruption”, which is primarily defined as 10

Philip K. Verleger “Major SPR Oil Sales Likely Over Next Few Years”, Petroleum Intelligence Weekly, September 17, 2012, page 7. 11 Energy Policy and Conservation Act of 1975, Public Law 94-163, 89 Stat. 871, 42 U.S.C. 6201 et seq.

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a physical shortfall. The definition abounds with less than precise parameters: the interruption must be of “significant scope and duration” and must have “an emergency nature”; it must also have a “major adverse impact on national safety or the national economy.” In establishing whether a severe energy supply interruption has occurred, however, one of the criteria is also whether “a severe increase in the price of petroleum products has resulted from such [an] emergency situation”; what exactly constitutes a severe increase in the price of petroleum products is not said. In addition, the Act also envisages the possibility that the reserve might be used pre-emptively, to prevent the manifestation of a severe energy supply interruption. In short, the Act attributes considerable latitude to the president in deciding if and when to draw down from the reserve. 4.3.3 EU Legislation in Force Regarding Oil Stocks

The legislation currently in force in the EU concerning oil stocks is Council Directive 2009/11/EC of 14 September 2009.12 Council Directive 68/414/EEC of 20 December 1968 was the first piece of legislation on this matter.13 The Directive notes the growing dependence of the EU on oil imports and the gravity of the consequences of “any difficulty, even temporary, having the effect of reducing supplies of such products imported from third States”, but does not specify what exactly is meant by “difficulty”. Council Directive 98/93/EC of 14 December 1998 introduced several modifications to the 1968 Directive. The 1998 Directive refers to “any difficulty, even temporary, having the effect of reducing supplies of such products, or significantly increasing the price thereof on international markets”, thus not clarifying the exact definition of “difficulty”, and indeed opening the door to 12

Council Directive 2009/119/EC of 14 September 2009 imposing an obligation on Member States to maintain minimum stocks of crude oil and/or petroleum products, OJ L 265/9, 9.10.2009. 13 Council Directive 68/414/EEC of 20 December 1968 imposing an obligation on Member States of the EEC to maintain minimum stocks of crude oil and/or petroleum products, OJ L 308, 23.12.1968.

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the possibility that not just a physical shortfall, but also a significant increase in prices might be considered one.14 On September 11, 2002, the Commission proposed a new set of measures for improving the security of energy supplies, as it believed that the tools existing at the time were not sufficient. The proposition did not receive the approval of the Parliament and was withdrawn in 2004. In particular, there were objections to the proposal to adopt stocks for 120 days while the international norm had settled at 90. In 2006, Directive 2006/67/EC was promulgated, which was meant as a summary document of the previous Directives (68/414/EC, 72/425/EC and 98/93/EC) in the interest of clarity, and therefore did not introduce any new provisions. 4.3.3.1 Council Directive 2009/11/EC of September 14, 2009

In September 2009, the European Council enacted a new directive on stocks to replace and cover the scope of the previous directives, achieve a higher level of coherence with IEA standards and thus reduce bureaucratic procedures. It also aimed at harmonizing emergency mechanisms among member states. Stockholding obligations

The stockholding obligations remain at 90 days, but the emergency reserves are henceforth to be based on net imports and not on consumption, as stated in a summary given by the Commission: Under Council Directive 2006/67/EC of 24 July 2006 imposing an obligation on Member States to maintain minimum stocks of crude oil and/or petroleum products, stocks are calculated on the basis of average daily inland consumption during the previous calendar year. However, stockholding obligations under the Agreement on an International Energy Programme of 18 November 14

Council Directive 98/93/EC of 14 December 1998 amending Directive 68/414/EEC imposing an obligation on Member States of the EEC to maintain minimum stocks of crude oil and/or petroleum products, OJ L 358/100, 31.12.1998.

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1974 (hereinafter “the IEA Agreement”) are calculated on the basis of net imports of oil and petroleum products. For that reason, and owing to other differences in methodology, the way in which stockholding obligations and Community emergency stocks are calculated should be brought more into line with the calculation methods used under the IEA Agreement. The text also allows for the reserves to equate to 61 days of daily consumption instead of the 90 days of imports if the former amount is higher: Indigenous production of oil can in itself contribute to security of supply and might therefore provide justification for oil-producing Member States to hold lower stocks than other Member States. A derogation of that kind should not, however, result in stockholding obligations that differ substantially from those that apply under Directive 2006/67/EC. It therefore follows that the stockholding obligation for certain Member States should be set on the basis of inland oil consumption and not on the basis of imports. The Directive adds the obligation for each member state to have at least onethird of the reserves composed of oil products in proportions corresponding to the consumption patterns of the member state (IHS, 2009). Member states have an obligation to ensure that stocks are available and physically accessible. In this regard, they are responsible for putting in place arrangements for the identification, accounting and control of these stocks. A register containing information on emergency stocks (the location of the depot, refinery or storage facility, the quantities involved, the owner of the stocks and their nature) should be established and continually updated. A summary copy of the register shall be sent to the European Commission once a year. The Directive leaves the door open to the possibility of setting up specific stocks for a list of refined products. EU powers

Additional powers are granted to the EU, such as reviewing and auditing stocks maintained by member states (IHS, 2009). The purpose of this measure is to enable the European Commission to coordinate a EU contribution in the event of IEA action.

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Stockholding entities

The Directive wishes to encourage the setting up of central stockholding entities (CSEs) in the form of non-profit making bodies or services.15 Under the conditions and limitations laid down by the Directive, CSEs and member states may delegate some aspects of the management of stocks to another member state with stocks on its territory, to the CSE set up by the said member state or to economic operators. The CSE shall maintain oil stocks (including the acquisition and management of these stocks).16 Coordination Group

The Directive sets up a Coordination Group with the task of reviewing the security situation of the Union in Art. 17: A Coordination Group for oil and petroleum products is hereby set up (hereinafter the “Coordination Group”). The Coordination Group is a consultative Group that shall contribute to analysing the situation within the Community with regard to security of supply for oil and petroleum products and facilitate the coordination and implementation of measures in that field. The Coordination Group shall be made up of representatives of the Member States. It shall be chaired by the Commission. Representative bodies from the sector concerned may take part in the work of the Coordination Group at the invitation of the Commission. Emergency procedures

No specific rule is set up by the Directive concerning the usage of the stocks. In particular, it does not propose a definition of an emergency. In Art. 20 it asserts that 15

Art. 7(1): “Where a Member State sets up a CSE, it shall take the form of a body or service without [a] profit objective and acting in the general interest and shall not be considered to be an economic operator within the meaning of this Directive.” 16 Art. 7(2): “The main purpose of the CSE shall be to acquire, maintain and sell oil stocks for the purposes of this Directive or for the purpose of complying with international agreements concerning the maintenance of oil stocks. It is the only body or service upon which powers may be conferred to acquire or sell specific stocks.”

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Member States shall ensure that they have procedures in place and take such measures as may be necessary, in order to enable their competent authorities to release quickly, effectively and transparently some or all of their emergency stocks and specific stocks in the event of a major supply disruption, and to impose general or specific restrictions on consumption in line with the estimated shortages, inter alia by allocating petroleum products to certain groups of users on a priority basis. Two kinds of situations are envisaged: • If an international decision to release stocks affecting one or more member states has been taken (probably by the IEA), the member states can use their stocks and must notify the Commission so that the Coordination Group can be alerted. Or the Commission can directly recommend to member states to release some of their stocks. • If one member state experiences difficulties and no international decision has been taken, the Commission shall arrange for consultation with the Coordination Group and inform and coordinate with the IEA. If a major supply disruption is deemed to have occurred, the Commission shall authorize the release of some or all of the quantities of emergency stocks and specific stocks.

4.4 Alternative Approaches to Oil Stocks for Enhanced Security The analysis in the previous sections points to some significant shortcomings in the current design of strategic stock policies. Below we summarize the key problems: • The rules for the activation of strategic stocks are nebulous – the main objective is expected to be compensation for physical shortfalls of supply, but price movements anticipate any such shortfall and crises manifest themselves as price rather than quantity shocks. Undoubtedly, prices are far more volatile than the quantities supplied. At the same time, price shocks may also be independent of actual/ expected changes in the quantities supplied. • Strategic stocks necessarily have a limited duration; experience has consistently shown that the availability of unused capacity in major

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producing countries is much more important and effective in compensating for physical supply shortfalls. • The accumulation of strategic stocks should not be viewed in isolation from commercial stocks and possible demand-management policies in case of supply emergencies. • The desirable size of strategic stocks is difficult, if not impossible, to determine. The effect of accumulating stocks on markets and prices is not clear and could result in increased volatility, rather than the opposite. In light of the above considerations, we present and analyze two main, innovative approaches to oil stocks: • playing down the distinction between strategic and commercial stocks, and adopting policies to encourage accumulating and holding stocks on the part of all operators; and • facilitating cooperation between major oil importers and exporters with a view to encouraging and consolidating the existence of a sufficient cushion of unused capacity to compensate for supply shortfalls. 4.4.1 Encouraging Companies and Major Consumers to Hold More Stocks

We should clearly distinguish between the wisdom of maintaining large public stocks and that of encouraging large(r) private stocks. The problems we have been highlighting concerning public stocks are very much related to their public nature – that is to the need to have clear activation criteria, cost-benefit analysis and differentiation between emergency contingencies and market intervention. None of these arguments applies to privately held stocks, and the wisdom of encouraging private actors in the industry to hold larger stocks would appear to be beyond discussion. The drive towards cost-cutting and the maximization of return on invested capital has meant that all companies have strived to minimize their working capital, and one way to do so is to reduce stocks and progressively eliminate all redundancies in one’s logistics system. The consequence is much greater vulnerability to supply disruptions; however, this is clearly not considered much of a problem by the financial community, whose analysis influences the

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market evaluation of the stock. This is not a problem just for oil; it is a problem for network energy and for other industries as well. The debate about insufficient investment under conditions of market liberalization is ongoing, and may be expected to eventually converge on solutions that will re-establish some stability and resilience in the system. Nonetheless, this debate mainly concentrates on network energy, and appears to have overlooked the problems of the oil industry. The alternative should be considered of adopting regulations at various stages in the industry mandating a certain level of stocks and redundancies in several crucial facilities, which may contribute to the overall reliability of the system. In a sense, this is what is done when oil companies are mandated to maintain stocks equal to at least ‘x’ days of consumption – except that these stocks are then called ‘strategic’ and are not freely controlled by the companies themselves. Companies should be mandated to maintain stocks of crude and products as well as maintain a certain redundancy in capacity in crucial logistics or refining capacity, which the companies might more flexibly resort to when they feel a need to do so. For example, companies might be required to maintain a minimum average level of crude oil stocks over a 12-month period, but drawdowns might be allowed in the event of specific tensions or shortages. Encouraging private operators to hold larger stocks requires that institutions and facilities should be established to manage stocks in a flexible way, which is more in line with market signals. Managing stocks in response to price signals can be a profitable operation and contribute to dampening price fluctuations. Investors may choose to buy and sell purely paper barrels or they may decide to hold physical barrels; the latter option is likely to have a beneficial effect on price stability. The objective of government regulations should, therefore, be to encourage private investors to hold physical stocks. Today, individual investors (the doctors and dentists of Chicago fame) and large financial investors shy away from physical barrels and only want to deal in paper. Encouraging the holding of physical stocks requires passing legislation that will make it easier to build and maintain storage. This is partly an issue of environmental and fiscal rules, and partly an issue of market organization. Physical storage operators (who shall be separate legal entities from the owners of the stored oil) should be empowered to issue certificates convertible into physical

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barrels17: oil deposited in storage would be exchanged for such certificates, and certificates could be used to withdraw oil from storage. There is nothing exotic about this, but such a facility and a market for the certificates that it might issue does not exist18. Governments may well decide to facilitate this development by establishing an agency to build and manage such a storage facility – which can be established at the national or regional level or both – and issue certificates to oil depositors. The possibility of depositing oil would be open to all, including the national oil companies of oil-exporting countries. Major trading companies already maintain storage facilities, but the phenomenon is limited and not sufficient to influence crude oil prices. Much larger storage facilities are needed, and the private sector may not be attracted to establishing them. Nevertheless, the business of operating storage facilities per se may very well be profitable if investment in physical stocks develops as envisaged here. The EU might decide to invest in the creation of storage facilities and offer their free use to producers wishing to ‘deposit’ their crude in them. Producers would retain ownership and control of the crude under normal circumstances, but the EU would be allowed access under emergency conditions. Producers might receive a certificate for the crude they deposit in this storage, which they might use as collateral to borrow from the financial system. The European Investment Bank might specifically be mandated to issue loans against these certificates, e.g. to finance investment in creating unused capacity in the same producing countries. The availability of such an ‘oil deposit window’ would encourage producing countries to abandon the attempt to modify their production levels in anticipation of changes in market balance: experience has told us that such expectations can prove unfounded, leading to even worse 17

The IEA accepts that strategic oil stocks might be held in the form of “tickets”, which are similar but not altogether coincident with the concept we are proposing here. According to the IEA, “Tickets are stockholding arrangements under which the seller agrees to hold (or reserve) an amount of oil on behalf of the buyer, in return for an agreed fee. The buyer of the ticket (or reservation) effectively owns the option to take delivery of physical stocks in times of crisis, according to conditions specified in the contract.” IEA website, “Explanation of stockholding tickets” 18 Important storage facilities exist at Cushing, Oklahoma, which is the point of delivery of the WTI contract on Nymex. In this sense, it may be said that Nymex serves as the market for exchanging volumes of crude oil held in storage at Cushing, and investors have the option of keeping oil in storage there. However, nothing of the sort exists for Brent nor for other important crude oil streams. As will be discussed in the next chapter, the WTI market suffers from serious dislocation due to insufficient pipeline capacity to take rapidly increasing crude oil supplies out of Cushing.

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market imbalances. The ability to divert oil to a deposit window in the event of weak demand or to withdraw from it if there is unexpectedly strong demand would enhance the ability of major producers to maintain prices at levels close to their targets. Storage facilities could be set up in all appropriate locations, not necessarily in the territory of the country or group of countries establishing them. Indeed, it might be very interesting to establish large storage facilities at critical logistical junctures, such as the Suez Canal or the Malacca Strait, or in conjunction with pipeline projects to bypass these places.

4.4.2 Prospects for a Cooperative Approach to the Management of Strategic Stocks

The hypothesis of some kind of cooperative management of supply emergencies was originally contained in the informal agreement between Claude Mandil, who at the time was the Executive Director of the International Energy Agency, and the Minister of Petroleum of Saudi Arabia, Ali Naimi, in the run-up to the 2003 war in Iraq. The agreement envisaged that Saudi Arabia would use its unused capacity to make up for any shortfall in global supplies of crude oil, and the IEA would abstain from using its strategic stocks. The agreement set a powerful and extremely significant precedent, because it implicitly asserted that existing unused capacity in Saudi Arabia – and to some extent in other GCC countries as well, although the role of Saudi Arabia is quite unique because of the extraordinary elasticity of the Kingdom’s oil production – is the first line of defense against unexpected and undesirable interruptions or disturbances in the regular pattern of crude oil supplies. In contrast, non-OPEC countries normally produce at full capacity and do not have a policy of systematically maintaining unused capacity that might be resorted to if there is a shortfall in other countries’ exports. It is only within OPEC, and indeed within the Gulf, that significant unused capacity is systematically maintained. Ever since this early informal agreement, the main industrial countries, led by the US, have consistently pressed major Gulf producers to maintain significant unused capacity and persist in investing even at times of slack demand. Nevertheless, the importing countries do nothing to share the investment burden required to maintain such unused capacity. Indeed, the importing

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countries constantly claim that the producing countries should allow more involvement by the international oil companies in investing upstream – despite the international oil companies certainly not being interested in investing in unused capacity. It is probably impossible to envisage that the governments of the importing countries would contribute to the financing of investment in unused capacity; however, in the context of a cooperative approach to dealing with supply emergencies, the investment by producing countries in unused capacity should be credited to them as their contribution to the overall stability of the system. The pace of investment in new capacity and the possibility of maintaining a sufficient cushion of unused capacity are closely connected to the discussion on ‘demand security’ that has featured prominently in the preoccupations of the main oil-exporting countries. Open market economies can hardly offer demand security to specific suppliers, because this would require a segmentation of the market and restrictions to the freedom of competition. However, a degree of demand security might be achieved towards individual exporters or groups of exporters through the joint establishment and management of sufficient storage capacity to compensate for any unexpected variation in demand or supply in the short term. Thus investment in maintaining much expanded storage capacity might be viewed as a contribution to oil market stability on the part of the importing countries, to parallel the effort of exporting countries to maintain sufficient unused capacity. The underlying theme of these proposals is that the purpose of maintaining stocks should be changed from being a tool for confrontation to becoming a terrain for cooperation. Originally, strategic stocks were conceived of as a tool to resist the possible political use of oil supplies, a memory of the 1973 OAPEC attempt to use oil as a weapon. It mattered little that OAPEC’s attempt was ultimately a total failure. But sufficient water has passed under the bridge to allow us to conclude that what is needed is a policy to manage stocks in a cooperative manner with major producers, in order to stabilize oil markets and prices. Major producers have today clearly embraced a policy aimed at guaranteeing consumers that supplies will be sufficient – and increasingly are also preoccupied with the concern that unstable prices might eventually undermine acceptance of their primary export. The interests of exporters and importers, therefore, tend to converge at least to some extent – i.e. on the desirability of a more orderly and predictable evolution of oil markets, to which cooperative management of stocks might substantially contribute.

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Chapter 5 – The Functioning of the International Oil Markets and its Security Implications

Chapter 5 The Functioning of the International Oil Markets and its Security Implications 5.1 Introduction Energy security is primarily a function of investment. If investment in new capacity, logistics and transmission, and emergency preparedness is timely and adequate, energy security will be guaranteed. Investment in a market economy is a function of the expected revenue stream, which in turn is a function of prices. Reliable and predictable price signals are a prerequisite of adequate investment. If prices are very volatile and/or unpredictable, enterprises will not be confident enough to invest. Energy security will be imperiled. A well-functioning market is, therefore, a key component of security. Ideally, the market should generate stable and predictable prices, i.e. prices that can be modeled on the basis of structural factors within a sufficiently narrow band to allow enterprises to have a reasonably good vision of the revenue stream that their investment might generate. The main obstacle to oil and gas security of supply is the growing volatility of prices and their fundamental unpredictability. This leaves enterprises exposed to very high risk and will discourage some of them. In these circumstances, it is to be expected that enterprises will tend to be conservative, and underinvest. Security itself is also dependent on prices. Customers feel secure if they can buy all the energy they need at prices that they can afford. A purely physical concept of security (meaning availability of the quantities of energy that are in demand at any moment in time) has little meaning, because demand

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varies with price. There always is a price at which demand will exactly equal supply – it may be a very high price, however, at which some final customers may not be able to satisfy their “essential needs.” Oil, specifically, has a global market and any supply interruption that one can think of is quickly translated into higher prices, this being the key mechanism for rationing demand and redistributing supplies among different bidders. In the end, oil is almost never physically unavailable. But even “essential needs” are a function of prices, in the sense that in the long run customers will adjust their consumption habits to the expected cost of energy and their disposable income. In the short term, such adjustments may be difficult, and what creates insecurity is the experience of price volatility, the fact of being surprised by sudden jumps in prices – especially sudden price increases – which were not and could not be expected. Hence, energy security is as much a matter of perception as of objective availability. Consumers make decisions on the basis of the historically prevailing level of prices: energy may be expensive or cheap – in the sense of absorbing a large or small share of their consumption basket – but they will adjust their lifestyles accordingly. Lifestyles and per capita energy consumption in Europe and Japan are quite different from those prevailing in North America, because for decades energy has been relatively expensive in the former, and considerably cheaper in the latter. Nevertheless, consumers in Europe and Japan are not insecure because they had to devote a larger share of their income to energy than their North American counterparts – their level of consumption has adjusted to the price environment. Well-functioning oil and gas markets, therefore, are not only a prerequisite of energy security through their influence on investment and future availability; they are a component of security, because volatile and unpredictable prices are part of the definition of insecurity. This chapter looks at the evolution of prevailing international oil price regimes over the past decades and at past attempts at stabilizing prices and the reasons why they failed. This historical background helps us understand the causes of today’s growing volatility and potential remedies to the same. The current reference-pricing regime will then be introduced, and the debate on the causes of increasing volatility and whether the market responds to fundamentals or is dominated by speculators will be summarized. This debate is very much underway.

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Next, we shall discuss structural causes of volatility in the oil and gas markets. It is normally accepted that, even if the current market is reformed, volatility can be contained but not eliminated. What institutional arrangements can we envisage which will create enough long-term convergence in prices whereby investment will be sufficient to meeting future demand? In the concluding section, I discuss how this relates to other aspects of the analysis of oil security, notably the geopolitical aspects and policies for strategic storage and cooperation with the exporting countries.

5.2 A Short History of Oil Price Regimes Figure 5.1 is a very well-known and widely-quoted representation of oil prices in nominal and real terms since the inception of the oil industry. The chart shows that oil prices were extremely volatile in the early days of the industry because output increased suddenly whenever there was a new discovery, then declined rapidly as fields were overexploited due to the law of capture in the US and poor technological understanding of petroleum geology. The industry experienced one long stretch of stable oil prices from the early 1920s to the early 1970s: a 50-year period of progressive expansion with slowly declining prices, which was made possible by very large discoveries in the Middle East coupled with oligopolistic control on supplies by the so-called seven (or eight) sisters2, the major international oil companies of the time. This control — albeit slowly yet systematically eroded by “oil independents” and other newcomers — succeeded in guaranteeing the “orderly” development of capacity, in line with the rapid growth of demand. Oil supply security was guaranteed by the seven sisters, although not necessarily at the lowest possible price to the final consumer, nor with the fairest possible distribution of financial benefits between the various parties involved. The seven sisters lost control of the oil market between 1969 and 1973. In 1969, Muammar Qaddafi seized power in Libya in a bloodless coup, overturning the Sanusi monarchy. Very soon, he started putting pressure on the 2

Anthony Sampson, The Seven Sisters: The Great Oil Companies and the World they Shaped” 1975; Edith Penrose, “The Large International Firm in Developing Countries: The International Petroleum Industry” Cambridge, MA: MIT Press, 1967.

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Figure 5.1: Crude Oil Prices 1861-2011

Source: BP Statistical Review of World Energy June 2012, page 15

companies by imposing unilateral production cuts. Some of the companies present in Libya had no significant assets elsewhere in the world and conceded to Libyan requests. Qaddafi found that it had become possible to play the companies against each other. This demonstrated that the bargaining power had shifted from companies to producing countries and led to the so-called Tehran-Tripoli agreements, and then progressively to a complete shift of control from the companies to the producing countries3. The companies had unilaterally “posted” a price for the crude they were producing. The role of the posted price was primarily to calculate taxes due to the host governments, avoiding the controversies that would have arisen had “market prices” been used instead. There was, in fact, no transparent and easily observed international oil market at the time. In 1973, the power of fixing posted prices shifted from the companies to the exporting countries. This opened the door to a period of intense instability in 3

Parra, Francisco “Oil Politics – A Modern History of Petroleum” London (Tauris) 2004, pages 122-5

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prices, which went on from 1973 to 1985. Prices grew rapidly until 1980 and collapsed thereafter. Prices increased in the 1970s because of political events: the Yom Kippur war of 1973, the Iranian Revolution of 1978-79, and the beginning of the Iraq-Iran war in 1980. Prices were pushed to historical highs and OPEC just simply sanctioned the level that was generated by short-term panic buying and supply disruptions. Notwithstanding the opposition of some of its members, notably Saudi Arabia, a longer-term vision of OPEC’s interests did not prevail: no consideration was given to the danger of demand destruction and growing non-OPEC supplies, although it was rather clear at that time that significant volumes of oil would be made available to the market from new producing provinces, notably the North Sea, Alaska and Mexico. OPEC attempted to defend its posted price by cutting back on production and enforcing quotas on its members. Non-compliance eroded OPEC’s solidarity, already badly challenged by multiple conflicts between its Middle Eastern members. In 1985, Saudi Arabia abandoned the posted price system and resorted to netback pricing. The netback price regime was short-lived, lasting only about two years. It led to a collapse in crude oil prices, partly because OPEC quota discipline broke down and production increased, and partly because netback pricing tends to guarantee refiners’ margin and encourages refineries to run at full capacity, flooding the market with products, and eventually drawing down the netback value of the barrel. Hence was inaugurated the era of reference pricing, which is the prevailing regime to this date. Reference pricing means that the price of crude oil which is not freely traded is indexed to the price of crude oil which is freely traded, plus or minus an adjustment factor which is periodically reviewed by the producing country depending on market conditions. In this system, the producing country can manipulate the adjustment factor, but by far the major influence on the price of any non-traded crude comes from variations in the price of the benchmark crude, to which it is tied. Two markets have emerged as benchmark for all other crude oils — that is Brent in the UK and WTI in the US. This regime has proven more resilient in the face of political disturbances, but volatility has monotonously increased and has exploded since 2007. The reason for increased volatility

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has been the progressive shift from referencing physical oil prices to referencing futures. “Initially,” writes Robert Mabro, “the marker prices were spot WTI, dated Brent, or spot ANS4. The logic is that a marker price must be generated in a physical market where the transactions are sales and purchases of barrels of oil. Thus ‘market-related’ meant a relationship to prices arising at the margin of the physical market. This conforms to a fundamental economics principle that prices are determined at the margin.”5 However, physical oil transactions became increasingly unreliable because of dwindling physical volumes and the ease with which the market could be influenced. As futures trading developed, originally as an appendix of the physical market intended to provide liquidity, but subsequently to attract trading many times in excess of that of the physical market, the balance of price discovery has shifted from physical oil to futures.

5.3 Speculation vs. Fundamentals We are now in the midst of a major controversy concerning whether “speculation” is excessive, or “investors” are simply providers of badly-needed liquidity and better equipped to collectively judge longer-term trends. Do oil prices nowadays respond to fundamentals or to speculation? According to some, prices respond to fundamentals and indeed “investors” or “speculators” are better judges of long-term trends than “commercial” traders, i.e. the oil companies. Throughout the 1990s and well into the early years of this century, major international oil companies maintained that the price of oil at $18 per barrel (on average in the 1990s) was too high and would prove untenable. This opinion, it should be added, shaped the major companies’ investment policies, leading to very conservative investment decisions, and a preference for mergers and acquisitions over development of new projects. Against this view, a current of opinion insisted that oil is finite, and production will inevitably peak. Various versions of the peak oil theory have been proposed at different times, and heated controversy has characterized this debate. 4

Alaska North Slope Robert Mabro, “The International Oil Price Regime - Origins, Rationale and Assessment,” The Journal of Energy Literature, Volume XI, no. 1 (June 2005): 3-20. 5

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The futures market signaled a tendency to an increase already in 2002 and early 2003. Prices had increased already in 2000, but this spike had been deemed untenable by a majority of experts. In early 2003 the expectation was that prices would again fall, following the US and allies’ intervention for regime change in Iraq, which would lead to an increase in Iraqi production and exercise pressure on OPEC. Instead, 2004 saw an unexpected increase in demand and further price increases. The futures market signaled a tendency towards higher prices through a persistent contango6, which at the time was deemed unjustified. The market was signaling its fundamental belief that oil would become relatively scarce, due to demand increasing faster than supplies. This is not the same as necessarily expecting a peak: all that is required is an expectation that supply will grow more slowly than demand, or the marginal cost of production will increase. Today, most experts would agree that the market was right, and preachers of low oil prices had been wrong. However, in 2007 and even more so in 2008 the market was shaken by such violent swings that it is impossible to find a rational justification in fundamentals’ shifts. There was no dramatic demand increase or supply restriction to justify the doubling of prices between the beginning of 2008 and July of the same year, followed by a dramatic collapse in the latter part of the year. Such swings can only be understood as part of the turbulence that hit financial markets, of which today’s futures oil market is part and parcel. The price of oil is, therefore, highly exposed to financial markets’ vagaries and disequilibria, and has ceased to send a useful signal to corporate decision-makers for the purpose of sanctioning long-term investment. From the point of view of security of supply, if all that a major disruption can cause is a major swing in oil prices, but the same kind of swing can happen also in the absence of a major physical disruption: then what is the point of worrying about disruptions? 6

At any moment in time, prices for several future months are quoted on the market. We therefore can observe a price curve, whose front is represented by the front (next traded) month, while the back extends several months (even years) into the future. The market is said to be in a contango when prices for the front month are lower than prices for subsequent months. The curve, therefore, begins on a rising slope, then peaks and decreases. The opposite situation is called backwardation, and is found when prices for all subsequent months are lower than the price for the front month. In this case the curve is downward sloping throughout. Because of the decreasing value of money in time (the discount rate), the “normal” condition of the market is backwardation.

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The key point that needs to be highlighted is that the market is today driven primarily by expectations. Fundamentals (demand and supply) are one of the elements that influence expectations, but certainly not the only one. Investors may take a position in the market because they believe that the global economy will do better, and demand for oil will increase; because they expect that inflation will increase (notably in the US) and prices will be driven up (oil and other commodities being viewed as a better store of value in the long run); because interest rates change, and facilitate the accumulation of stocks or investment, increasing demand or supply, depending on the specific analysis; or, finally, because of perceived political or military threats. Expectations may apply to the relatively short term or the longer term. As many future months are traded on the market, investors may choose to take a position for the short run (the next few months, also called the front end of the curve) or for the more distant future (distant months or maturities longer than two or three years – the so-called back end of the curve). Investors betting on the back end of the curve will be influenced by expectations concerning the evolution of oil production costs (peak oil theory, expectations about the availability and cost of non-conventional oil sources) or even distant political and economic events (e.g. within the relevant period of time China will know a major political crisis…). The two sets of expectations – for the short and long term determinants – are tied by arbitrageurs, who trade to profit from perceived excessive time differences. Thus the front and back ends of the curve are not independent of each other, but interrelated; it may happen that short-term consideration drive price changes, but also that the curve is primarily influenced by longer-term expectations. Explosive or excessive variations occur whenever expectations align and the market comes to believe a dominant story. If the vast majority of investors concur – possibly for entirely different reasons – that prices should go in one direction, either up or down, then prices will move in that direction pretty much independently of fundamentals. As this movement then is amplified by the large pool of momentum or algorithm traders, very wide price fluctuations may be witnessed – as in 2004-9. Experience tells us that a lower boundary exists to fluctuations: some (few) producers will be pushed out of the market if prices fall very low, and even before that point it may be expected that OPEC and other major producers will decide on some collective action to support prices. Eventually, these

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factors will succeed in reversing expectations and sustaining a recovery of the market. However, it is not at all clear that an upper boundary also exists: demand is rigid to price in the short term, and the only effective mechanism limiting demand is via income, i.e. if a recession is precipitated. In fact, it is always asserted that high oil prices may damage the global economy, or prevent a recovery. The implied loss in income may be viewed as a security concern – at least economic, if not political or human security. However, to what extent an increase of oil prices will trigger a recessionist impact on the economies of the oil importing countries crucially depends on the response of the fiscal and monetary policy response of the latter. Under certain conditions, the impact may indeed be limited.7 In fact the crisis that has plagued the industrial economies since the fall of 2008 originated in the financial sector (the collapse of Lehmann Brothers) rather than in the oil market. Since the violent fluctuations of 2008-9, the market has recovered some stability because expectations have not aligned towards movement in one clear direction. With respect to the long run, the belief that oil must necessarily become scarcer and more expensive has been dented by the extraordinary increase in tight oil production in the United States, supporting a view that oil will again be abundant and relatively cheap – though certainly not as cheap as it was throughout the 1990s. In the short term, persistent economic difficulties in the OECD and doubts about the survival of the euro have balanced the psychological effects of the “Arab Spring” and the continuing conflict with Iran concerning the latter’s uranium enrichment program. Throughout 2010 and 2011, supply has been largely sufficient to satisfy demand, even during the short Libyan civil war – and this would have been the case even if the IEA had not resorted to a release from strategic stocks. Nevertheless, prices have tended to slowly climb, recovery on average the level of 2008 (although not the peak level of 140 $/b that was reached in the summer of that year).

5.4 Dislocation of benchmarks As mentioned earlier, reference pricing is based on indexing the price of crude oils that are not freely traded to the price of other crude oils that are freely 7 Christopher Allsopp and Bassam Fattouh “Oil and International Energy” in Oxford Review of Economic Policy Spring 2011 pages 17-21

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traded. The latter function as benchmarks – or reference – for the determination of the price of all crude oils. Historically, two crude oils have developed into being the main global benchmarks: Brent and WTI. There are good reasons why these two crude oils became benchmarks: they are both produced by several independent producers competing with each other (this being true more of WTI than of Brent); they are controlled by private companies that are supposedly not influenced by political motives; they are produced and traded in major industrial countries with well developed dispute resolution systems; and the respective futures markets are located in the two largest financial centers of the world, New York and London. Both Brent and WTI are good quality crude oils – light and sweet, i.e. containing little sulfur – and as such quite interchangeable. However, they are not representative of global supply, in which the largest component is medium and sour crude oils (such as the crude oils from the Persian Gulf). There is also a fundamental difference between Brent and WTI. Brent is a crude oil which is made available at Sullom Voe in the Shetlands, and as such is a seaborne crude: it must be loaded on a ship, and once it is aboard a ship it can relatively easily travel to anywhere in the world. In contrast, the WTI contract refers to deliveries at Cushing, Oklahoma. Cushing is a location where various continental US oil pipelines converge, and which therefore can receive oil from domestic Midwest producers, from Canada and from the Gulf of Mexico. Cushing therefore is a continental barycenter, which is connected by pipeline to refineries in the central US. However neither refineries in the East Coast nor refineries in California and the rest of the West Coast can easily receive crude oil out of Cushing. Until a couple of years ago this difference was not important. Domestic US continental production was insufficient to satisfy demand, and Cushing “attracted” crude oil from Canada and the Gulf of Mexico. Cushing was therefore a center of demand, while Sullom Voe was a center of supply: the normal price relationship was that Brent would fetch a slightly lower price than WTI – assumingly to cover the cost of taking a barrel from Sullom Voe to Cushing – but otherwise the two crude oils would be priced very closely to each other. This increased confidence in the market, which was seen as composed of two interdependent and mutually supporting halves – still essentially one same market.

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But things have changed. Production from unconventional sources in North America has increased much more rapidly than expected. This includes both productions from tar sands in Canada and from shale in the United States. Shale oil produced in the Midwest naturally flows into Cushing and has limited alternatives to that. Thus Cushing suddenly transformed from being an attractive center of demand to being a logistical dead end. Oil started piling up in Cushing beyond the requirements of the refineries that can take feedstock out of there by pipeline. Thus, starting at the end of 2010 the small positive price differential between Brent and WTI (already per se an anomaly, as Brent was historically traded at less than WTI) began widening precipitously, reaching 20 $/bbl in late summer of 2011. This meant that WTI could be bought at 20-25% discount to Brent – something absolutely unheard of. As mentioned, the situation exploded in 2011, but had been visible already since early 2007 at least. One may therefore legitimately ask why nothing was done to remedy to the impending crisis. The answer to that is that specific interests controlling in particular the pipelines from the Gulf saw no interest in taking the initiative, nor the US Administration seems to have concluded that this was something that warranted intervention. Obviously, Midwestern Figure 5.2: Prices for WTI and Brent, January 2010 to October 2012

Source: EIA

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refiners were – and still are – quite happy that they can procure their feedstock at very favorable prices, while East coast refiners in particular are correspondingly very unhappy. Obviously, continental American and Canadian producers also are not very happy. It was only in the fall of 2011 that Conoco decided to sell the Seaway pipeline, which it had used to supply from the Gulf of Mexico refineries that it owned in Oklahoma and elsewhere in the central United States. The new owners immediately announced that the pipeline would be reversed, eliminating what had become a Northward trickle into Cushing and opening the door for sending oil from Cushing to the Gulf, with an expected capacity of some 150,000 barrels per day as of April 2012, increasing to the full capacity of 350/400,000 b/d later on. This announcement was greeted optimistically by the marked, and the Brent-WTI differential narrowed to little more than 5 $/bbl at the end of 2011: but the reversal was purely temporary. In fact, it became soon evident that reversing the Seaway pipeline would not compensate the rising tide of shale oil production, and WTI’s discount relative to Brent deepened to 20$/bbl again – and may very well further widen. There is another pipeline that could be reversed – the Capline – but no plans to do so have been announced by its owners. Furthermore, the Keystone pipeline project – which was expected to bring Canadian oil from tar sands into Cushing and further to the Gulf coast – was at least temporarily rejected by the Obama administration on environmental grounds: even if this decision were to be reversed, and construction of the pipeline begin from the end terminal in the Gulf of Mexico, a considerable wait will be necessary. So currently producers in North Dakota are scrambling to ship at least some of their production East by train, then by barge down the Hudson River in order to benefit of the higher Brent-related price that East coast refiners must pay. There are multiple consequences of this situation. The first is that the United States – at least a large portion of the United States – benefit from lower oil prices than the rest of the world; while crude oil imports are quickly declining (something which is affecting not just oil producers, but also the shipping industry). The second is that WTI has lost the link to global demand and supply and is today purely a regional price, leaving Brent as the only benchmark

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of truly global significance. The third is that the overall credibility of the oil price discovery system has lost credibility, and some well-known weaknesses of Brent have become more important. The third point requires some elaboration. Of the two markets, WTI always attracted and still attracts the greatest liquidity: open interest and trading volumes on the NIMEX have always exceeded those of the ICE Brent futures contract. One wonders for how long investors will be happy to operate on a market that is purely regional rather than open to the rest of the world, and so deeply influenced by logistical bottlenecks: nevertheless, it could also be argued that this market remains very important per se, and possibly less exposed to other vagaries (for example, when Libyan crude ceased to be available because of the civil war in the country the price of Brent was affected, that of WTI was not: put simply, the two contracts today have different risk profiles). It is also true that liquidity on the Brent futures market is sufficient to exclude any danger of manipulation on the part of individual major players. Finally, maybe some liquidity will migrate to the Brent futures market, as physical traders engaged in international transactions will increasingly rely on Brent as the benchmark, therefore will naturally tend to rely on Brent for their hedging and risk management needs. The problem is that Brent is a fast disappearing crude oil. In order to counter the inevitable decline in production, other North Sea crude oils of different quality have been allowed for delivery into the contract: Forties, Oseberg and Ekofisk. This “BFOE” complex still provides sufficient physical liquidity for the time being, although the four crude oils are not of equivalent quality. But the volume produced is declining for all four. Already during the past summer some short-term non-availability of Forties (the largest of the four streams) caused an increase in the price of Brent that was entirely attributable to local conditions and not at all representative of global realities. Thus uncertainty about the reliability of benchmarks adds a further layer of uncertainty to investment decisions, which are crucial for the future of global supplies. When considering a new investment project to, say, produce oil from tar sands in Canada, which price shall the investor assume that will be relevant in the future? Shall it be WTI, Brent or some other benchmark? Not only prices are unstable and essentially impossible to predict: they also depend on specific circumstances affecting the benchmarks, and the oil market may eventually cease to be as global and fungible as we are accustomed to see it.

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5.5 Structural Causes of Oil Price Instability Oil prices, like the prices of most commodities, are unstable because of wellunderstood structural causes. Firstly, investment is the key cost component, while direct costs are relatively less important. This means that once the investment is made and the capacity created, it will be utilized even if prices fall well below the break-even point. It is only if prices fall below direct costs that the producer will consider shutting capacity, and even then it may be costly (in terms of immediate costs or forfeited long-term revenue) to shut in capacity. Secondly, investment gestation times are very long. For a while, the industry boasted that it was able to go from discovery to early production in a much shorter time than in the past, but a few exceptional examples in the offshore of the Gulf of Guinea have since been overshadowed by numerous disaster stories – from the Gulf of Mexico to Sakhalin passing through Kashagan.8 Whether it is field development, pipeline construction, or refinery construction, this is an industry in which five to 10 years easily pass from the moment the investment is sanctioned to the moment it becomes operational. For all practical purposes, this means that investment is made with little or no knowledge of the returns it will bring when it becomes operational. True, the futures market can mitigate this risk and offers contracts and derivatives several years into the future, but liquidity at such distant maturities is thin and the feasibility of massive hedging of investment is problematic. In fact, very few major projects are financed with risk mitigation from the futures market. Thirdly, and most importantly, both demand and supply are rigid in the short term. In econometric studies, short-term price elasticity has consistently been found to be very low, in fact very close to zero.9 Long-term elasticity is more significant, being estimated in a range of .5-.6 for the OECD countries, and much lower for the developing countries. Finally, analysts who have repeated the estimation over time have found that price elasticity is declining – a 8 The Kashagan oil field in the Caspian Sea offshore Kazakhstan was discovered in 2000. The cost of its development has ballooned and the time of first production has repeatedly been postponed. At the time of writing, the field is not yet in operation. 9 See, for example, Christopher Allsopp and Bassam Fattouh, “Oil Prices: Fundamentals or Speculation?” (presentation to the Bank of England June 13, 2008, slides 10, 11 and 13).

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consequence of the fact that oil has been largely substituted with other fuels in uses in which substitution was easy. Income elasticity of oil demand is higher than the price elasticity, meaning that oil demand can effectively be curbed only by way of reducing disposable income, i.e. through a recession. Price elasticity of non-OPEC oil supply is also low – a reflection of the points mentioned above about investment being the main cost component and requiring long gestation. OPEC supply is, of course, considered a political variable, and it is expanded or contracted depending on the organization’s price target and perception of market conditions – no structural elasticity can be measured. The combination of rigid demand and rigid supply means that price signals generated by the market are not very effective in balancing the market. Or, conversely, it means that even very small shifts in the balance between demand and supply will provoke large changes in prices. In essence, this market can truly be balanced only through income and investment adjustments, which are slow and generally considered unwelcome. After all, the purpose of energy security is to maintain income and consumption levels, and concluding that demand and supply can only be balanced through declining income levels defeats the purpose. Any discussion of the functioning of the international oil market in view of fostering security must therefore acknowledge that in the short term demand and supply are unlikely to be exactly in balance, and this will cause wide swings in prices. The challenge is to aim at achieving a better balance of demand and supply in the longer term, so that short-term price swings may be understood as oscillations around a central value, which is the long-term equilibrium price. The search for a long-term equilibrium price is further complicated because of our poor understanding of the dynamics of both demand and supply. Concerning supply, the most frequent procedure is attempting to estimate the non-OPEC component of the total and calculating the required OPEC contribution as the difference between projected global demand and projected non-OPEC supplies. However, estimates of non-OPEC supplies turn out to be significantly off the mark even at very short horizons, such as one year or less. This is all the more surprising since at such short time horizons we know

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very well which fields are in production and how they behave, and precious few surprises would seem to be possible. Instead, estimates of non-OPEC supplies are almost invariably off the mark, and for the past few years they have been systematically in excess of recorded production. The lack of success in predicting demand is in a sense even more surprising – because here we deal with literally billions of decisions makers, whose aggregate behavior should be statistically predictable. In contrast, demand forecasts for any year are constantly adjusted and by significant margins as the year progresses, and in the end the distance from the original expectation to the recorded result can easily be of the order of 1 to 2 per cent. With .05 price elasticity of demand, this alone justifies a 20 percent swing in prices. Thus, at any point in time, we really have very little confidence about future demand and supply, and such lack of confidence fundamentally contributes to the perception of insecurity about energy supply.

5.6 Structural Changes in the Supply of Liquid Fuels In the search for a longer-term equilibrium price for investment, we may have our task facilitated by some important changes that are occurring in the international oil industry. Conventional crude oil is no longer the sole source of liquid fuels. Nonconventional sources will become increasingly important, and the common feature of non-conventional sources is that they are primarily industrial processes in which output is much more easily predictable as a function of investment. The timing and production profile over time also are much more easily predictable. Conventional oil is the realm of uncertainty. Exploration may or may not be successful, and a discovery may be a giant or a small field. Resources in place are never exactly known, and reserves estimates are constantly updated, generally towards an increase, but sometimes in the direction of a decrease. The time required for developing a field and the development cost per barrel of added capacity vary widely across the spectrum and are not always exactly predictable (Kashagan will serve as reminder for a long time). Finally, production from a field generally reaches a plateau rather quickly, but it is not easy to know for how long the plateau will last and how rapid might the decline be thereafter.

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In contrast, unconventional projects may be much more predictable. The availability of the resource is not in question, be it oil sands, Orinoco bitumen or oil shale: in fact, the available resource is so much greater than what is used, as to be practically infinite. What may differ is the pace of implementation and the investment required. In this respect, one should distinguish between tight oil in the United States and other unconventional sources of oil, including tight oil outside of the United States. In the United States, the ownership of underground resources pertains to the owner of the surface rather than to the government. Companies may much more expeditiously acquire licenses to drill from owners of the land and start drilling and producing within a relatively short time. The ease of the process explains how production of tight oil increased at a speed that surprised everybody, just as it happened with tight gas a few years earlier. At the same time, individual tight oil wells decline very rapidly, and production can be sustained only if drilling becomes a continuous activity: if prices were to decline, expensive drilling would also decline, and production with it. We may therefore assume that the production of tight oil in the United States constitutes a rare price-responsive segment of global oil supply: production will increase when prices are high and decline when prices are low, with limited time lag. The characteristic features of production of oil from other non conventional sources, or even from tight rock but in locations different from the United States where a license must be obtained from the government, is that production requires large up front investment with significant implementation lag from the moment an investment decision is made to the moment production becomes available. Such large scale projects frequently take longer and end up being more expensive than initially expected: in any case even an optimistic investor will admit that several years will be needed before a project actually begins producing. Furthermore, generally the output of each project is small by global standards: the attractiveness of non conventional projects is rooted in the fact that once the initial investment is made, the vast reserves available will allow maintaining production for decades with no significant decline in production – differently from most conventional oil projects. But there may not be a “supply shock” out of Canadian tar sands or Venezuela’s Orinoco belt: any additional production will be easily predictable with significant advance notice. There is little danger that a sudden rush of non-conventional projects will cause an unexpected increase in supply and a collapse in prices, which may undermine investment. Output increases from non-conventional projects will be gradual and very predictable.

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As for conventional oil, predictability may also increase because the frequency of very large discoveries has dwindled to almost zero, while the number of declining provinces is increasing. The probability of a sudden increase in capacity is, therefore, very low. As declining fields become a growing share of total oil reserves, the importance of enhanced oil recovery (EOR) increases. The effects of implementing EOR on declining fields cannot exactly be predicted, but the connection between investment and increased capacity is much tighter than with conventional methods. Also, as EOR methods are more widely adopted, the weight of direct costs over investment costs may increase (this depends on the specific EOR technology adopted), and investment and production may become more responsive to prices. From the demand side, it is not clear whether the development of alternatives to the use of fossil liquid fuels may increase or decrease price elasticity. As mentioned earlier, the evidence appears to be that concentration of oil in those uses in which it is most difficult to substitute has further decreased elasticity. However, the appearance of alternatives in the transportation sector may generate greater responsiveness in demand, if the consumer has — directly or indirectly — the possibility of switching from one fuel or source of energy (or mode of transportation) to a different one. The latter is however highly hypothetical and unlikely to have a major impact except in the longer run, i.e. through decisions affecting the renewal of the transportation fleet, availability of public transport, pattern of commuting etc.

5.7 Containing Price Volatility In the light of extreme price fluctuations since 2007, the attention of politicians and experts has been drawn to the need to dampen short-term fluctuations and achieve greater reliability of prices. The pendulum has swung back from the extreme position that advocated exclusive reliance on unregulated markets as optimal, to a position advocating reining in of speculators and pursuit of a “fair for all” price.10 10

The Oxford Institute for Energy Studies held a conference on oil price volatility in October 2009 at St. Catherine’s College. A summary of the discussion, which was held under Chatham House rules, was published in the Oxford Energy Forum #79 of November 2009.

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The experience of the oil price yo-yo of 2007-2009 has been sufficiently traumatic to lead to the emergence of a degree of political consensus on the need to dampen volatility and agree on a price that may be acceptable to all sides. Expressions of concern have been voiced not only by the major OPEC exporters, but also by leaders of the major industrialized countries, notably former British Prime Minister Gordon Brown, French President Nicholas Sarkozy11 and US President Barack Obama. On his part, King Abdullah of Saudi Arabia asserted in 2009 that 75 $/b would be a “fair price for crude oil. This may have helped stabilize the marked around this level of prices for a few months, but then an upward trend started again. At the beginning of 2012, Chinese Prime Minister Wen Jiabao, speaking at the inaugural session of the World Future Energy Summit in Abu Dhabi, was quoted12 as saying: “To stabilize the oil and natural gas market, we may consider establishing, under the G20 framework, a global energy market governance mechanism that involves energy suppliers, consumers and transit countries.” (…) “We need to formulate ... binding international rules through consultation and dialogue, and set up multilateral coordination mechanisms covering forecast and early warning, price coordination, financial regulation and emergency response.” On the same day, the Saudi Minister of Petroleum, Ali Naimi in an interview with CNN said: “Our wish and hope is we can stabilize this oil price and keep it at a level around $100 a barrel. If we were able as producers and consumers to average $100 I think the world economy would be in better shape.” On the basis of this evolution, the proposal has been put forward to establish an international committee that would decide on prices13 or a price band14, similarly to what happens with interest rates (at the national level, though). 11

Gordon Brown and Nicholas Sarkozy, “Oil Prices Need Government Supervision,” Wall Street Journal, July 8, 2009. 12 In The National, Abu Dhabi, January 17, 2012. 13 Robert Mabro has proposed the creation of an independent commission backed by significant research capability and an international convention that would be expected to set a reference price for oil once a month. ENI has proposed the creation of a global energy agency “which might possess the tools to implement concrete initiatives as needed to stabilize the price of oil” (my translation of Scaroni’s original speech, available in Italian from http://www.eni.com/en_IT/attachments/media/speeches-interviews/italian-version-speechscaroni-G8-energia-25-maggio-2009.pdf ) 14 In particular, Bassam Fattouh and Christopher Allsopp, “The Price Band and Oil Price Dynamics,” Oxford Energy Comment July 2009.

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But how would such a consensus be implemented and enforced? How could producers and major consumers agree on sharing the burden of implementation (which presumably would require active market intervention)? 5.7.1 Encouraging the freer trading of major crude oil streams

As we explained, the reference pricing system is rooted in the fact that not all crude oils are freely traded. Two main freely traded crude oils have emerged as benchmarks, but their physical base is insufficiently representative of global supply and demand conditions. Paper barrels have come to play a dominant role in price discovery because physical trading has remained mostly opaque and the availability of information about fundamentals (how much oil is actually being produced, demanded, kept in storage) is so deficient that it does not constitute a solid enough ground for the formation of expectations. Thus widening the physical base by making a larger number of physical transactions visible, and encouraging the free trading of crude oil streams that today are subtracted to trading may well increase the relative weight of fundamentals relative to other determinants of price discovery. There are in fact two parallel issues at stake here: the first is to allow the free trading of crude oils that are currently not available for that; and the second is to organize the trading through exchanges and in a way that may enhance the visibility of concluded deals. Among the crude oil streams that are not available for free trading the most important are the crude oils of the Arab Gulf producers and Iran: these insist that they will only sell to refiners and prohibit secondary sales of their cargoes. Among crude oils which are available for trading but are traded only on a bilateral basis, thus with insufficient transparency, we may mention primarily the Russian crudes. It is sometimes asserted that a free market for these crude streams could not exist because there is only one seller – the national oil company – for each of them. This is certainly not a valid objection, as there exist numerous markets in which there is only one seller, and sales are conducted by auction. The parallel that interests me most is with the market for government bonds, through which the interest rate is eventually set. There is indeed a strong parallel and affinity between oil and money. Government bonds are, by definition, only

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sold by the government, and the Treasury does so through an auction; once sold, bonds can be traded in the secondary market. A market for the major crude oils from the Gulf may be established by conducting regular auctions for them. 15 Auctions must per force take place some time in advance of delivery, so an auction-based market is necessarily a physical forward market. This means that a secondary market is possible between the time the auction is conducted and the time delivery takes place: how long this time should be is one of the key parameters of designing a well-functioning market. The longer the time, which is allowed between the auction and the actual delivery of lots sold through it, the more important is the price discovery function that the secondary market will play. In the government bonds market, the secondary market has a very extended life (equal to the maturity of the bonds); it then plays a very important role and generates signals, which feeds back into the primary auction. Monetary authorities intervene in the secondary market through open market operations to influence the interest rate, and create or destroy money through purchases or sales of government bonds. If an exchange was established at which sufficient volumes of crude oils from several of the Gulf producers were auctioned at frequent intervals, multiple price signals would be generated, which would have very significant influence on the paper markets and on today’s benchmarks. Indeed, expectations would likely entirely focus on the evolution of Gulf prices, creating an entirely different environment. For Russian crude, it has been proposed that a transparent exchange-based market might be created at Rotterdam16. The plan is supported by a group of private investors and is based on the availability of large storage facilities in the Europoort. However it is not clear whether the plan envisages conducting trading through an exchange and with the required level of transparency to generate a truly credible price signal.

15

Giacomo Luciani, “From Price Taker to Price Maker? Saudi Arabia and the World Oil Market,” Rahmania Occasional Paper 03, 2011. 16 “Russians eye trading hub in Rotterdam”, Petroleum Intelligence Weekly October 29, 2012 page 5

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5.7.2 Relying on Longer-term Pricing

Even if speculation is curbed and short-term volatility is successfully dampened, it would be advisable to rely on price signals from longer-term maturities rather than on spot or front month prices. Prices for longer maturities (3 or 6 or 12 months) always fluctuated less than front month prices and are inherently more stable, because they are not influenced by short-term inconsistencies of demand and supply. There is no overwhelming reason why prices to the final consumer should reflect the spot or front month market. Refiners and retailers have the option of hedging forward and could very well be asked to guarantee a price to their customers or give significant advance notice of any variation. The market will not spontaneously generate such behavior: no oil products retailer has conceived of competing on the basis of guaranteeing a price to its customers for a given period of time. The reason is simple: customers cannot be tied to a specific supplier: they would prefer the supplier that guarantees a price in the longer run for as long as that price is lower than the competition, and switch to the competition as soon as it becomes higher. However, if regulations were adopted imposing on all suppliers to guarantee prices for a given period of time and/or announcing changes with sufficient advance notice, the final consumer could not take advantage of prices that may be lower in the short term. It is normally considered that oil products markets are either free or administered, and the latter frequently means prices that are kept artificially low, because governments are reluctant to pass on price increases for crude oil to the final consumers. Indeed, the extensive reliance on administered (and subsidized) prices in developing countries, notably in the fast growing Asian countries, has been singled out as one reason for the rigidity of demand relative to prices: demand is simply shielded from higher prices. What is proposed here is not a system of administered prices, but a set of regulations which would in essence encourage refiners and retailers to hedge on the futures market and lock in prices which they offer to their clients. Requesting retailers to “post” prices which can only be changed with, say, three months’ advance notice would probably yield the best results: competitors would be able to decide whether to follow the moves of the price leader, and price competition

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would still be possible. If prices need to be guaranteed over a set period of time, adjustments will be more difficult and competition will be discouraged. In all cases, coordination in view of price fixing needs to be repressed. The combination of advance notice and limits to the frequency of price changes would represent an increase of energy security for the final consumer per se. In theory, the final consumer could on his own use the futures market and derivatives to reduce his risk and enhance his individual security even in today’s conditions, but in practice this is beyond the means of most consumers. Only large consumers, such as airlines or shipping companies, have done so, and they too are vulnerable to the threat of consumer infidelity whenever their final prices are higher than the competition. Regulations for encouraging systematic hedging would contribute to energy security overall. 5.7.3 Exploring Price Bands

The concept of a price band has been around for some time as a way to dampen volatility through a maximum and minimum price target, which would trigger action on the part of producers and/or consumers as the market price approaches or crosses the extremes of the band. OPEC has had a notional price band between 2000 and 2005. Robert Mabro, Christopher Allsopp and Bassam Fattouh of the Oxford Institute of Energy Studies (OIES) have all argued in favor of a band. Behrooz Baik Alizadeh of the Iranian Ministry of Petroleum has written, “In its 109th ordinary meeting in March 2000, OPEC unofficially introduced its price band mechanism to the market. Within this mechanism, in the case of the average OPEC Basket crude price falling under $22/B for more than 10 successive working days, OPEC member states would be obligated to cut their daily production by 500,000 b/d, and in the case of the price exceeding $28/B for 20 successive working days, OPEC would increase production by 500,000 b/d. Although OPEC took advantage of this mechanism only once, increasing production by 500,000 b/d beginning on 31 October 2000, and gave up the whole idea in January 2005, introduction of this mechanism affected the market psychologically and stabilized prices during the period that OPEC was not inclined to change prices beyond specific limits.”17 17

MEES, February 9, 2009.

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The problem with any price band concept is the instrumentation of intervention required whenever the price approaches the limits. In the absence of appropriate instrumentation, it is not at all clear that the market psychology will be affected – indeed the market may be tempted to challenge the band and test the will of governments trying to enforce the same. A price band may be effective if both importing and exporting countries agree on its limits. It is not clear that such an agreement would ever be possible; although at present it appears that the target prices of both sides are very close. The interests of exporters and importers are in structural opposition, and convergence is likely to be an exception. However, the industrial countries’ concern for climate change and their desire to diversify their energy balances away from fossil fuels and specifically oil and the exporting countries’ fear that oil might be penalized as a consequence have indeed created a new order of priorities for the two sides, such that importers no longer wish to minimize and exporters – some exporters, at least - no longer wish to maximize the price. Secondly, for the band to be a useful concept it would be necessary to enforce supply restraint on all exporters, not just OPEC. It may be argued that the threat of unrestrained expansion of non-OPEC supplies is fading away, because non-OPEC countries are unable to expand their production significantly, and in fact non-OPEC production has already peaked or plateau-ed according to some interpretations. Nevertheless, the importing countries should be ready to defend the lower limit of the band by imposing limitations on imports of oil from non-OPEC countries, if necessary. In the opposite case of prices reaching the upper limit of the band, OPEC countries would obviously be called to use all of their available capacity to supply a tight market. However, if OPEC reached the limit to its capacity and the market remained tight, then the importing countries should be ready to ration domestic consumption, or use “strategic” stocks (more on stocks later). In theory, this would also require concerted action on the part of all importers – something that is guaranteed to be very contentious and difficult to achieve. In the absence of concerted action, free riding on the part of some would prevail. A further difficulty has to do with revisions or adjustments to the band. If the band is adjusted very frequently – à la limite, in response to any price

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movement – it ends up being no restraint at all on volatility. At the same time, a band that is never adjusted is bound to become obsolete and untenable. Finding the optimal middle-of-the-road solution is highly subjective and controversial. If we add that this middle-of-the-road compromise would need to be collectively endorsed by both oil exporters and importers, we could conclude that the task is very difficult indeed. A price band might be useful if it is intended to limit price volatility only within a specified period of time and involves a market-responsive automatic adjustment mechanism. For example, it may be envisaged that the price band would extend x% above and below a central price equal to the average of observed prices in the previous year. In this way, if the price remains consistently close to the upper or lower limit of the band, the central price for the following year will be adjusted and the band moved up or down. The frequency of adjustment of the central price should be inversely proportional to the scope of the band. A system of very frequent adjustments (e.g., weekly adjustments of the central price to a moving average of the observed price over the previous x months) might be compatible with a relatively narrow band (say 10 percent above or below the central price). This would serve the purpose of dampening very short-term volatility. However, if the objective is to create a more reliable investment environment, priority should be given to less frequent adjustments and a wider band. The beneficial effect on investment decisions of a broad-based agreement on a central price is likely to outweigh the uncertainty intrinsic in a relatively broader band. Finally, as mentioned, the effectiveness of a band depends on its instrumentation. Supply restraint may take the form of output limits or the accumulation of stocks, which in turn could be used to counter excessive price increases. This leads us to the possibility of using intervention stocks in addition to strategic stocks, or some hybrid formula of strategic/intervention stocks. 5.7.4 Managing Stocks

Strategic stocks have been discussed in chapter 4. That discussion evidences the ambiguity of strategic stocks and the rules concerning their use, especially with respect to containing price variations.

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In theory, strategic stocks are clearly distinct from commercial or intervention stocks. Strategic stocks are meant to be used in case of supply emergencies and to serve the purpose of guaranteeing energy security. Intervention stocks are meant to maintain prices at a fixed level or within a band. In practice, the distinction is blurred, because the concept of energy security incorporates the notion of affordability, and therefore some notion of a maximum acceptable price. Furthermore, emergencies or disturbances arising from geopolitical events such as wars or revolutions tend to be reflected in price levels more so than in physically available supplies: in the end, demand always is matched by supply. Consequently, strategic stocks whose utilization is based on a strict quantitative criterion (such as is the case for the IEA emergency response mechanism) tend very seldom to be used. Intervention stocks are normally not very well regarded because in all cases in which the defense of a rigid price through the use of an intervention stock has been attempted, the stock facility eventually went bust. A rigid price regime invites speculation, and eventually market forces overwhelm any stock that might be accumulated. At the same time, it stands to reason that stocks should be accumulated at times when the price is declining or low, and liquidated at times when prices are high or increasing. Accumulating stocks even at times when prices are increasing appears intuitively irrational. What this means is that institutions and facilities should be established to manage stocks in a flexible way and in the absence of a fixed price regime. If a band is broadly agreed, as discussed in the previous paragraph, then institutions managing stocks will feel encouraged to sell when the price approaches the top of the band and buy when it approaches the bottom, but it might be dangerous to impose a rigid rule on the stock managers. Hence, as I argued in the previous chapter, governments should aim at institutions and facilities should be established to manage stocks in a flexible way, which is more in line with market signals. This entails either establishing either government- or privately-owned storage facilities, to be managed by independent operators empowered to issue certificates convertible in physical barrels: oil deposited into the storage would be exchanged for such certificates, and certificates could be used to withdraw oil from storage.

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5.7.5 Pursuing Demand Security

In discussions of energy security, the producing countries have frequently stated that they are willing to engage in the investment which is required to meet expected future demand, but they need some demand security, i.e. assurance that the demand will be there as expected. In other words, security of supply begs security of demand. In a free market environment, there can of course be no assurance of future demand. Importing countries are at a loss in responding to the request for demand security, because they possess no tools to guarantee demand. How can this problem be approached? The establishment of storage facilities where oil could be deposited against certificates that may be discounted at financial intermediaries is already a step in the right direction. An agreement to consult and coordinate in the accumulation/disposal of strategic stocks may also be of help. But neither is likely to be viewed as providing sufficient security of demand. The gas industry historically solved the problem through take-or-pay contracts. These were said to place the burden of the volume risk on the buyer and leave the burden of the price risk on the seller. There is no denying that this arrangement, unpopular as it might have become, has allowed the implementation of some very ambitious investment projects and significant improvement in Europe’s energy supplies. But these arrangements only were possible because prices were exogenously generated: gas prices were indexed to oil and oil products prices, to guarantee the competitiveness of gas in marginal uses. In the case of oil, we cannot think in terms of take-or-pay contracts because the price needs to be internally generated. Furthermore, importers (refiners, distributors) operate in competitive markets and have no “ownership” of a stable customer base, as was the case for the gas importers in the monopolistic, nationally segmented gas markets of the past. However, in less competitive economies in which the market for oil and products is more closely controlled by the state, importers (be they major national oil companies or the government itself) could conceivably conclude take-or-pay contracts and index the price to signals generated elsewhere in the world. For example, China,

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India or even Japan could put in place take-or-pay contracts for volumes of Gulf oil, and index the price to Brent or WTI or some other traded market (e.g. the DME Oman contract). This would provide the Gulf producers with significant demand certainty and probably would be viewed with considerable anxiety by importers in the US and Europe. We are not quite there yet, it should be said, although the intensification of relations between the Gulf and the emerging countries in Asia does point in this direction. The drawback of this arrangement is that it would divide the oil market into price-making and price-taking segments; it is to be expected that volatility on the price-making segment would be relatively higher the smaller the pricemaking segment is relative to the price-taking segment. This is the same as saying that oil may be sold on the basis of long-term evergreen contracts or on a short-term basis: price is generated on the short-term market, and this is where all potential demand/supply imbalances will be felt. Such imbalances may be minor when related to global demand and supply, but large when related to short-term trading only. Today, we have a system that is very close to this: prices are indexed to traded markets that are a very small component of global physical supply and demand. The difference is that there are no proper take-or-pay contracts, only evergreen contracts which envisage neither an obligation to supply on the part of the seller nor an obligation to lift on the part of the buyer. In addition, the price directly reflects all the volatility of short-term markets. But an evolution towards takeor-pay contracts closer to those familiar in the gas industry is conceivable. 5.7.6 Pursuing Vertical Integration

Another potential step in the direction of a longer-term perspective to investment in the industry is facilitating vertical integration. In the current downturn, the large, vertically-integrated international oil companies have claimed that their investment plans are unaffected by the downturn and based on their long-term strategy. This may or may not be true, of course. In past years, these same companies have frequently been criticized for allocating larger funds to purchase their own stock and prop up the value of their shares than for industrial projects

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proper. They have also extensively engaged in mergers and acquisitions, leading to the disappearance of several independent corporations – a loss of diversity, which can only negatively affect the vitality of the species. At the same time, it is true that large integrated companies “own” their market thanks to their presence at the retail level and the oligopolistic nature of the business. They therefore enjoy a considerable degree of demand security, although they face price risk and are exposed to price volatility as any other player in the industry. Large integrated companies also have a broader capital base and may be better able to continue funding investment projects out of internally generated resources than smaller independents. Nevertheless, the “old” large integrated companies remain vulnerable to the pressure from financial analysts and investors, who are typically only interested in “returning value” to the shareholders in the short run. The functioning of financial markets does not encourage strategic thinking, as investors can enter and exit a stock at any time and are mostly interested in short-term appreciation. This is a problem for all industrial corporations but is an especially difficult problem for the oil companies, whose outlook is structurally long-term. It is typical of the distorting signals that management receives from the financial market that all attention in recent years has been focused on cutting costs rather than guaranteeing the long-term growth of the company. Thus, it may be noted that security of energy supply is also dependent on the functioning of financial markets and the kind of signals that originate from them. In any case, the problem which affects the behavior of the “old” large integrated companies does not affect the “new” integrated companies: these are the national companies of the major importers which are venturing internationally in order to improve their security of supply as well as the national oil companies of the exporting countries which are investing downstream in order to gain better control of their markets. In both cases, ownership remains either entirely or to a large extent in the hands of strategic investors, frequently the state itself, and strategic thinking is encouraged rather than short-term profitability.

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The growing role of these companies is a factor increasing energy security, because they will invest with a long-term perspective. The activism (or shall we say “aggressive” approach) of Chinese companies to acquiring reserves internationally has frequently been portrayed as being a threat to importers in the OECD – while it should be more properly understood as an example to imitate. Equally, the drive of some national oil companies to integrate downstream, acquiring refining and retailing assets in the importing countries, has frequently been viewed as a threat, as if it entailed a further degree of dependence and loss of control, while in fact it should be viewed as improving security of supply, reinforcing the commitment of the supplier to service his own assets and keeping the market supplied. Hence, vertical integration is important and it is good for energy security. The OECD countries should look into ways in which they may encourage more of a strategic behavior on the part of the “old” integrated majors and preserve the species by putting a limit to the cannibalism represented by mergers and acquisitions. And they should welcome the downstream integration of the national oil companies of major producers, interpreting the will to invest as a commitment to supply.

5.8 Conclusion This chapter has argued that the functioning of markets is a key determinant of energy security. Geopolitical and other threats to physical supply may cause price shocks but, based on historical experience, are unlikely to cause any significant physical shortage. Therefore, insecurity is manifested by price shocks and price shocks are insecurity. However, price shocks may very well originate in the absence of major disturbances to physical supplies, simply as runs originated by investors, or “speculators”, which the market does not correct because both demand and supply are rigid relative to prices. Price volatility is, therefore, a threat per se, in many ways more important and more devastating than potential threats to physical supplies. The cost of price volatility is very high, much higher than the potential cost of possible disruption to physical supply; and it is significant not just in the immediate but even more so in the long run because of the depressive effect it has on energy investment generally.

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Thus addressing price volatility is a key component of energy security policy. Unfortunately, there is no easy recipe to dampen price volatility: this paper has reviewed several approaches that may reduce volatility, notably: • Encourage the freer trading of major crude oil streams, notably those from the Gulf • Increase reliance on long-term pricing • Enforce an internationally agreed price band • Manage stocks • Offer demand security through take-or-pay contracts • Encourage vertical integration None of these approaches is sufficient to stabilize prices, but collectively they may very well succeed in reducing the extreme volatility that has been experienced since 2004. Volatility will never be eliminated, because it is a structural feature of the oil industry, but it may be contained, and energy supply would be perceived as being much more secure.

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