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THE WALL STREET JOURNAL: In Oil’s New Era, Power Shifts To Countries With Reserves

Crude Calculations

Middle East Consumes More
As U.S. Seeks Security;
‘Higher Prices for Years’
What Sen. Lugar Saw in Libya
By BHUSHAN BAHREE and CHIP CUMMINS
June 14, 2006; Page A1

There is more to today’s oil crunch than temporary jolts to supply and demand. What is also roiling the energy world is an enduring shift in the balance of power between the fuel-guzzling West and oil-rich developing countries.

Since World War II, the industrialized world has relied on stable and affordable supplies of crude to fuel economic growth. The U.S., Europe and Japan together needed more oil than they could produce. The developing world had plenty of oil, but little use for it and few alternative markets. So industrialized countries tapped the cheap resources of poor ones.

Now this mutual dependency is unraveling and a new order is taking shape, turning the tables on America, its allies and other big energy consumers. Major exporting nations have concluded that they have more leverage than ever before over consuming countries.
 
Two forces are behind this change. The accelerating industrialization of the billion-person economies of China and India means that global energy demand is likely to keep growing rapidly for years to come. And just as important, the world’s top crude-producing countries are keeping a tighter grip on their spigots.

Saudi Arabia and other oil-rich states have balked at making the large investments Western policy makers think are necessary to meet demand in coming decades, although they plan to expand production somewhat in the medium term. Moreover, these nations are using more of their oil at home to meet surging domestic demand, driven in part by new industries that were once the preserve of the developed world.

“The idea is to use [the] advantage of the availability of energy and build industries on that basis,” said Saudi Arabian oil minister Ali Naimi in a recent interview in Riyadh, as the sound of jackhammers pounded through the windows of his office overlooking the booming city. “Any industry that requires intensive energy will be welcome in Saudi Arabia.”

In addition, petro-states from Iran to Ecuador are flexing their muscles, brandishing fossil-fuel supplies as a weapon in diplomatic disputes, or tearing up contracts with foreign companies.
 
Major importing nations are scrambling to adapt. Energy security has emerged as a central foreign-policy concern from Washington to Beijing. Last month, a U.S. House of Representatives subcommittee held hearings on how to cope with nations that use oil as a weapon. Jaap de Hoop Scheffer, secretary-general of the North Atlantic Treaty Organization, said last month that the alliance would consider using force if energy-supply lines were threatened, a major broadening of the group’s mandate. “As far as oil and gas is concerned, I think NATO could play a role to defend the sea lanes,” he told European parliamentarians.

Major Western oil companies are also struggling to adjust. Ninety percent of the world’s untapped conventional oil reserves are in the hands of governments or state-owned oil companies, far more than was the case several decades ago. It doesn’t appear that the planet is running out of crude, as proponents of the “peak oil” theory have argued. But some oil experts foresee the big Western oil companies running out of easy-to-tap oil, and most of them are already turning to harder-to-recover reserves.

Royal Dutch Shell PLC and Exxon Mobil Corp. are making gargantuan bets on liquid fuels derived from natural gas. Shell and Total SA of France are extracting fuel from the gooey tar sands of Canada. ENI SpA, the Italian oil major, this month paid $900 million for the right to explore for oil off the shores of Angola. The search for new reserves has become “a nightmare,” says Paolo Scaroni, ENI’s chief executive officer.

Oil accounts for 98% of the fuel used by the world’s cars, trucks and planes. With new crude supplies lagging behind demand growth, a new energy economy is emerging in which a mosaic of other fuels will supplement crude, some energy experts contend. “Bio-diesel,” a specially processed vegetable oil that is often mixed with petroleum, and clean-burning liquids squeezed from natural gas are among the resources that will become essential for keeping the world humming, they argue.

“The transition away from oil may take 20 or 30 years, but it has to start now,” says Joseph Stanislaw, an energy adviser at Deloitte & Touche USA LLP.

Crude has tripled in price since 2002 due to swelling demand, supply outages and slow growth in output. Oil hit a record of $75.17 a barrel in April, and yesterday settled at $68.56, down $1.80.

Wealthy industrial nations have weathered oil crises before. A wave of shocks in the 1970s and 1980s, including oil-field nationalizations and the 1973 Arab oil embargo, sent prices soaring and tilted power toward exporting nations. But rich Western nations stayed in the driver’s seat because they were the main consumers of exports. And the U.S. and Europe had vast and proven oil reserves in Alaska and the North Sea, which they exploited when developing-world suppliers refused to cooperate.

Three decades later, the Western world no longer has such leverage. Crude-oil production by nations who aren’t members of the Organization of Petroleum Exporting Countries is widely expected to peak around 2010. Outside of Russia and the Middle East, the biggest opportunities today are in deep waters off politically volatile Africa and in the Caspian Sea, not in the West.

The International Energy Agency, the industrialized world’s energy-market watchdog, has forecast that world oil demand will rise 37% by 2030, to 115 million barrels a day from about 85 million today. But the oil-producing nations with the greatest pumping potential either will not or cannot tap their resources sufficiently to meet those projections.

The Paris-based IEA has long expected the Saudis, who now supply about nine million barrels a day, to contribute 18 million to 20 million barrels a day toward that figure. In an interview, however, Mr. Naimi suggested that the Saudis are unlikely to go much beyond 15 million barrels due to concerns about depleting reserves too fast and damaging fields by pumping too quickly. Other suppliers, including Mexico and Kuwait, also appear unwilling or unable to meet the expectations of Western planners.

OPEC members have expressed concern that demand projections such as the IEA’s may be overstated. The IEA has concluded that because OPEC does not appear to be investing as much in production as expected, global oil supplies probably won’t reach the agency’s 115-million-barrel target for 2030. “We are likely to see higher prices for years to come,” says Fatih Birol, the IEA’s chief economist.

Demand patterns have also changed markedly. During the 1970s oil crisis, oil consumption was still concentrated in the industrialized West and in the Soviet Union, which produced more than enough for itself and its satellites. Today, the Saudis and their OPEC allies have many more big, attractive markets, starting with India and China.

Producing nations also face booming demand at home. Gasoline use in Iran, where the capital city is clogged with cars, is rising by 10% a year. Oil demand in the Middle East has risen by 13% since 2003, a growth rate nearly as high as China’s. The Middle East was consuming 6.1 million barrels a day at the end of 2005, compared with 6.6 million barrels for China. This soaring demand equaled about one-third of the increase in global crude supplies, including from OPEC.
 
Saudi Arabia, which sits on a quarter of the world’s oil reserves, also intends to consume more crude at home. The world’s largest oil exporter is building new industries that rely on petroleum in an effort to leverage its primary resource, much as China did when it harnessed its vast labor supply to become a global manufacturing power. Mr. Naimi says one of his biggest goals is to create export-oriented fertilizer and aluminum industries.

At Turaif Camp in the Arabian Peninsula’s northern desert, state-owned metals giant Ma’aden has dug an open-pit test mine for phosphates, an ingredient in fertilizer. Piles of the white mineral glitter in the sun, sprinkled with tiny fossilized sea creatures. Nearby, workers are digging another mine to excavate bauxite, the raw material of aluminum. These mines are part of a $10 billion project that will include a new coastal city with aluminum and fertilizer factories — all powered by Saudi’s huge reservoirs of heavy crude.

Other oil exporters are using their oil resources in more belligerent ways. Last month, Ecuador expelled Occidental Petroleum Corp. over a contract dispute. Bolivia’s president nationalized his country’s gas fields, dispatching troops to 53 fields and ordering foreign firms to renegotiate contracts. In April, Venezuela seized fields from Total and ENI.

The new supply-demand landscape has left the West increasingly vulnerable. The IEA estimates that the 26 industrial countries that are members of that organization will need to import 85% of their oil by 2030, compared to 63% today.

This is forcing a rethink of U.S. and European diplomatic and military strategy. For half a century, the energy-security formula had been simple: Protect the oil-supply lines from the Middle East, and the industrialized world would be safe. President Carter codified that thinking in the Carter Doctrine of 1980, which declared Persian Gulf oil a vital national interest and vowed to use military might to defend the region from attack.

When Arab members of OPEC embargoed oil exports in 1973, the West responded by squirreling away strategic stocks of oil for dire emergencies. The oil embargo ultimately fizzled, and the U.S. re-established close ties with Saudi Arabia. After Iraq invaded Kuwait in 1990, the Saudis swiftly increased production to make up for almost all the oil lost in Iraq and Kuwait. They did the same before and during the invasion of Iraq in 2003.

But the Middle East is no longer the shock absorber it once was. Last fall, when hurricanes devastated U.S. oil facilities in the Gulf of Mexico, the Saudis already were pumping about as much as they could. The U.S. and its allies orchestrated a release of strategic stockpiles to stave off shortages.
 
Regions outside the Persian Gulf now are capable of supplementing Western supplies. But that means the West must build alliances and deploy ships and troops to protect modest supply routes as far afield as the Caspian Sea, the Andean region of South America and West Africa. Now every oil field matters.

The consequences were clear at a recent NATO conference on energy security in Prague. Addressing NATO officials and oil executives, U.S. Air Force Gen. Charles Wald, at the time the U.S. military’s deputy commander for Europe and Africa, blasted the industry for what he saw as lax security around the world. He ticked off crucial pipelines and energy-transportation choke points in his theater. Such vulnerable points include the Oresund Strait between Sweden and Denmark and a pipeline running out of Chad, a small producer.

The energy-security model laid out by President Carter needs an update, said Gen. Wald, who has since stepped down from his post and is set to retire in July. “You just can’t call 1-800-dial-the-military,” he said. “The oil companies themselves have to start stepping up.” During a break in the session, footage of burning oil facilities flashed across the conference hall’s screen as the 1960s tune “Eve of Destruction” blared.

Officials in Iran and Venezuela have warned they could disrupt oil supplies if threatened by the U.S. In January, Russia briefly shut off natural-gas supplies to Ukraine, which many observers read as a political warning to independent-minded Kiev.

“The power of [energy] coercion is really equivalent to a military attack,” says Richard Lugar, chairman of the Senate Foreign Relations Committee. The Indiana Republican says his stance on energy security hardened in August after a diplomatic mission to North Africa. He spent a night in Libya at Tripoli’s gleaming Corinthia Bab Africa Hotel, where he saw Chinese, Indian and Western oil-company executives vying for business in the country oil fields, which had been closed to U.S. oil companies for two decades before the U.S. lifted economic sanctions in 2004.

Mr. Lugar is now pushing for a treaty with China and India that would spell out ways for the three nations — all large consumers of oil — to cooperate rather than compete in the event of a supply shock. In today’s energy world, he said, natural resources “are strategic weapons.”

Western oil giants are racing to adjust. Ever since Edwin Drake started drilling for oil in Pennsylvania in 1859, launching the modern petroleum age, oilmen have dreamed up technologies to coax more crude from the ground. Goldman Sachs estimates the industry will spend $660 billion over the next six years on big projects. Just 13% of the oil expected from these efforts will come from “traditional” extraction, the firm said. The rest will involve more-complex technology or resources formerly deemed too costly to extract.

Shell, for instance, is spending heavily on projects that have more in common with mining operations than with the exploration efforts of the previous century. It recently paid $400 million for rights to explore for oil buried deep in Alberta. Companies have rushed to the region to mine its oil sands, a tar-like muck that requires expensive excavation and processing. Shell says it doesn’t yet have commercially proven technology to get at the sands, but considers it a risk worth taking.

“I don’t know how long exploration will continue to be a major play” for big oil companies, “but 50 years from now it will be that much more difficult than it is today,” says Malcolm Brinded, Shell’s head of exploration. “You want to get in there now to get access to the best acreage and drill the best wells. You don’t want to hang back in a situation like this.”

Oil surpassed coal as the dominant source of energy early in the 20th century, and was essential to the development of aviation and motorized transport. The world now appears to be in the first stage of a bumpy transition to a system in which oil, while still the economy’s most important fuel, will no longer so thoroughly dominate it.

Henry Groppe, the 80-year-old founder of a Houston-based energy-consulting firm, has watched the industry morph for half a century. He divides oil history into three epochs. The first was a 100-year era of plenty and U.S. control that lasted until 1970, when prices averaged $13 a barrel in 2004 dollars. The second, an era of transition and rising OPEC influence, lasted until 2004 and saw prices average $36 a barrel over that period.

The current era — just two years old by Mr. Groppe’s reckoning — looks to be a messy one, with more potential for supply shocks and clashing over resources. Prices are likely to stay volatile as consumers try to outbid each other for constrained and vulnerable flows of crude. Rising prices tend to act as a rationing device, knocking some consumers out of the market altogether.

“We have entered the era of scarcity and price rationing,” Mr. Groppe says.

PUMPING UP
 
A number of oil-rich states have flexed their muscle this year, amid rising prices.
Jan. 1 — Russia’s Gazprom cuts off gas supplies to Ukraine in a price dispute.
April 3 — Venezuela seizes two oil fields from European oil companies Total SA and ENI SpA.
March 11 — Iranian interior minister vows to use “any means” to counter threats of U.N. sanctions, citing Iran’s proximity to the strategically important oil chokepoint of the Strait of Hormuz. “We have control over the biggest and most sensitive energy route in the world,” he said.
May 1 — Bolivian President Evo Morales orders nationalization of the country’s gas fields.
May 15 — Ecuador announces it will seize an oil field operated by Occidental Petroleum Corp. after a contract dispute.
June 4 — Iranian Supreme Leader Ayatollah Ali Khamenei warns oil shipments will be “seriously jeopardized” if Tehran is punished in its nuclear standoff.
Source: WSJ research

Write to Bhushan Bahree at [email protected] and Chip Cummins at [email protected]

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