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Achieving Energy Security

What is the oil security problem?

The connection of a security problem with oil use can be traced to early 20th century concern over access to fuel as the world’s major navies shifted to oil power. Modern day concern over oil security, however, is broader than access to military fuel. Growing energy demand has been a fundamental characteristic of virtually every country that has undergone successful industrial development, and oil is typically a major component of this mix. Given the key role of oil to economic growth, and the heavy concentration of oil supply in the tumultuous Persian Gulf region, the oil security problem came to be articulated in the 50s and 60s as the vulnerability of global economic growth to events that might interrupt such supply.

These fears materialized in 1973 as a group of oil exporting countries attempted to influence US foreign policy via an oil embargo, combined with seizure of oil assets in those countries. While the actual reduction in supply was small and temporary, the reduction in the rate of supply growth was of longer-term significance. Prices rose sharply in 1973, triggering a recession and a reduction in economic growth throughout the remainder of the 70s. This damage was repeated in 1979 when the Iranian revolution resulted in another supply disruption, followed by another recession. These episodes clearly illustrated global vulnerability to both short-run disruption and long-term supply restraints. This vulnerability to economic damage from supply inadequacy remains the mainstream definition of the oil security problem. We are currently in the grip of a tight worldwide market in which robust global demand is chasing increasingly scarce global supply, and the key to resolving this tightness is promoting responsiveness of both global supply and demand to the market price signals.

We have learned to manage vulnerability to short-term oil interruptions

Progress has been made in this area. While global dependence on oil imports has generally increased since 1980, vulnerability to short-term interruptions has not. The world has weathered several major interruptions since 1980, namely the tanker war in the late 80s, the invasion of Kuwait in 1990, and the invasion of Iraq in 2003, none of which has produced economic damage approaching either the magnitude or the duration of the 70s disruptions. In part, this is attributable to measures adopted to manage such risks, including building strategic reserves, promoting free trade and investment, and developing traditional diplomatic and military instruments to secure that trade. In part, it is attributable to favorable market or political trends, such as the decline in the share of oil in GDP and the increased access to potentially productive lands as a result of the breakup of the Soviet Union. But primarily, it was due to the fact that OPEC since 1980 has had available a large volume of excess capacity, which it has generally used to offset any such shortfalls.

What is the natural gas security problem?

The roots of the natural gas security problem are generally regional rather than global, stemming from a lack of diversity of transport routes between major consuming and producing regions. Historically, this has resulted from regional reliance on a single or small number of fixed pipelines, although this is now changing as liquefied natural gas grows more common, thus opening remote and previously stranded supply sources, diversifying potential supply sources and thereby serving to progressively globalize gas markets. As this market evolves, there are likely to be mutually beneficial security effects on both oil and gas markets.

But there are new challenges ahead

To assert that we have learned how to cope with short-term interruptions does not suggest that the energy security problem has been solved. On the contrary, there is much about the current situation to suggest that new challenges are ahead. First is the sheer magnitude of the prospective growth in demand likely to be required to sustain modest global economic growth. A variety of recent forecasts by the International Energy Agency, the US Department of Energy, and the OPEC Secretariat estimate that sustaining a 3% rate of annual growth in the global economy over the period to 2020 will require an expansion of between 24 and 28 mmbd in global oil supplies. The growth in demand for natural gas worldwide is expected to be even larger.

Satisfying this demand will require an enormous development effort on the part of both OPEC and non-OPEC suppliers. To meet the anticipated demand, supply would need to expand at over 1.5 mmbd annually through 2020. From 1985 until 2004, for instance, global oil demand rose by 23 mmbd, or an average of 1.2 mmbd each year, suggesting the need for a 25% increase in the rate of supply growth. But this significantly understates the rate of new capacity development that would be required to meet such growth. Only about 30% of the recent supply growth has been from new capacity in non-OPEC countries; about 70% came from OPEC producers, primarily from the Persian Gulf. Virtually all of this OPEC growth involved the restoration of previously installed capacity idled by the events of the mid 70s, rather than installation of new capacity. However, given that such excess capacity has now largely been absorbed by demand growth, future supply expansion will require new investment, and in some cases, new technologies. In the three forecasts noted, the demand for OPEC oil by 2020 reaches between 48 and 50 mmbd, more than a 50% supply expansion from current levels, equivalent roughly to doubling supply from the Persian Gulf in 16 years.

If these magnitudes were not in themselves sufficiently daunting, the institutional challenges facing such an expansion of supply are formidable. While past non-OPEC expansion in areas such as Alaska, the North Sea, and the Gulf of Mexico have occurred in countries with secure institutional frameworks for investment, future developments are likely to be increasingly in less certain institutional settings, such as Russia, West Africa, or Latin America, where property rights, taxation, and governance issues affecting the oil and gas industry are in many cases unresolved. Even in places where the security of investment is not a problem, such as the US, there are numerous restrictions placed on access to some of the most promising remaining prospects. Moreover, while an expansion by OPEC is essential to meeting these demands, there is to date no OPEC expansion underway even remotely consistent with these forecasts. Finally, in addition to the challenges of developing upstream capacity, there are additional challenges in developing downstream facilities needed to accommodate these volumes.

Interdependence is fundamental characteristic of emerging market environment

One of the key implications of the emerging trends in global oil markets is that of growing interdependence. The first interdependence is that of trade, stemming from the geographical dispersion of supply and demand. Consumption growth will become increasingly concentrated in the developing countries over time, primarily in Asia, while supply will become increasingly concentrated in the Middle East, West Africa and Russia. The second form of interdependence arises between resource owners and producing companies. This interdependence arises from the separation that occurred in the 70s between the resource owners (i.e., host governments and national oil companies (NOCs)) and the producers (i.e., independent oil companies (IOCs)). As a result of this separation, currently only about 6% of the world’s reserves are actually fully accessible to equity participation by IOC’s. About another 11% is accessible under terms negotiated with the NOC’s, and 6% is held by the Russian oil companies. This leaves 77% under exclusive control of the NOCs, inaccessible to IOC ownership. At first glance, both dependencies may be viewed as favoring the producing country or company, but such an interpretation does not withstand scrutiny. That is, a trading relationship is clearly a mutual dependence, with both parties hoping to gain from the transaction. The consumer faces risks of uncertain supply; the producer faces risks of uncertain demand. There may be an appearance of greater risk to consumers, since their costs are realized in the short run. Generally, the oil exporting country faces the risk of demand erosion, which may occur more gradually, but ultimately poses larger risks. Likewise, a cooperative arrangement between NOCs and IOCs is built on voluntary agreements premised on mutual acceptance of risk for mutual gain. The IOC’s have the capital and technology to develop the resources, but have few of their own. The NOCs have the resources, but often are hard pressed for the capital or the technology to develop them.

Nationalism and geopolitics are growing threats to global cooperation

Two growing threats to realization of this potential are the repoliticization of global supply by geopolitical events and the worldwide resurgence of economic nationalism that has either limited access to resources, or begun to poison investment climates required to sustain capital commitments necessary to support such expansion. Key countries such as Saudi Arabia and Kuwait are still off limits to foreign capital. Major suppliers like Venezuela, Nigeria and Iraq have seen their exports drop significantly because of their domestic policies and social unrest. Continued terrorist activity in Iraq holds its productive capacity below its prewar level. Venezuela, which in 1999 aspired to increase its productive capacity to 6.6 million barrels a day, now typically falls short of half that level, and has unilaterally altered contract terms to reclaim $5.4 billion from the international oil companies. Recent nationalization actions by Bolivia are following a similar course. Similarly, Russian actions to control Yukos, increase export taxes, and limit participation by IOCs have already greatly slowed the growth of Russian oil production, which last year grew only 2.3%, compared with 9% in 2004 and 10.7% in 2003. The Centre for Global Energy Studies estimates that geopolitics and renewed nationalism have reduced global oil supply since 2000 by as much as 7.8 million barrels a day.

Other barriers threaten to tap industry’s capacity to invest

In addition to the above barriers to investment opportunities, other barriers threaten industry’s capacity to invest. In the UK, increasing taxes threaten to aggravate the decline in North Sea production. In the US, a variety of confiscatory and discriminatory taxation schemes threaten to tap industry’s income, and to reduce its competitiveness in foreign operations. And these two countries represent two of the most stable fiscal regimes industry faces. Uncertainty in areas ranging from taxation to outright nationalization typifies the investment climate in Latin America, West Africa, and Russia.

Interdependence is the solution, not the problem

It is in the mutual interest in these growing interdependencies that solutions to the energy security problem must be found. That is, while the producer and consumer countries, as well as the NOCs and IOCs, face fundamental differences of interest with their trading or operating partners, they also share a mutual interest in the orderly development of a market within which they can achieve their mutual goals. It is a fundamental error to characterize the energy security problem as the exclusive province of the consumer countries resulting from repeated hostile actions by producing countries. Only the 1973 embargo can be so characterized. Ironically, each of the other interruptions was attributable either to conflicts among producer countries or embargoes imposed by consuming countries. Moreover, in dealing with the short run supply interruptions since 1980, it has been producer actions, rather than the use of strategic stocks or other emergency measures by the consuming countries, that have played the greatest role in limiting the economic damage associated with each disruption. One challenge to future security is presented by the disappearance of excess capacity within OPEC. Its use provided both a source of surge capacity that reduced the impact of short-run interruptions and a source of new supply to accommodate demand growth over time for nearly two decades. From the standpoint of the dual security problem – replacing supply lost to short-term interruptions and providing for long-term capacity growth, it provided the bulk of the world’s protection. In a very real sense, however, world supply has reached a crossroads. In this setting, additional reliance may be placed on other protective measures such as strategic reserves to replace supply lost to short-term disruption, but principally to a reliance on markets, with freedom of trade and investment to develop the interdependence to assure adequate long-run growth of both traditional hydrocarbon energy, as well as alternatives.

In addition, governments should implement policies that allow and encourage the application of private capital to develop existing and new sources of energy to ensure a diverse and robust supply.

Effective international policies to deal with deliberate security breaches

While market forces will go a long way toward leading countries and companies to develop the required capacity by exploiting their mutual interests, it would be naïve to ignore the potential for deliberate breaches in the fabric of global security by countries seeking unilateral advantage. But it would be equally naïve to ignore the market’s own potential for penalizing such breaches, or to ignore the potential for trade sanctions, targeted imperfectly at such violations, to go awry. One such challenge to future security revolves around Iran’s growing nuclear aspirations, and its potential for threatening to withhold oil supplies in the event of actions by the global community to frustrate such ambition. Many are suggesting the possibility of the UN Security Council or individual countries imposing trade sanctions on Iran. However, trade sanctions against Iran are unlikely to have the intended result, whether imposed bi-laterally or multilaterally, with tremendous costs to the imposing countries. If smart or targeted sanctions aimed at decision makers and elites are ultimately imposed, it will be critical to maintain a united front in a manner that does not harm political or trade relations with others allied against nuclear proliferation in the Middle East.

The high cost of failure

While it is by no means certain that adequate investment and new supplies will be forthcoming, it is inevitable that failure to do so will have costs. The IMF estimates that each $5 per barrel increase in price could reduce world GDP as much as $100 billion annually. The magnitude of these potential losses suggests the enormous value of finding a basis for cooperation between consuming and producing nations.