WHEN AND WHY THE SUPPLIERS OF OIL MATTER / GEOPOLITICAL FUTURES

When and Why the Suppliers of Oil Matter

More often than not, it doesn’t matter where oil comes from. But the exceptions to this rule can be critical.

By Phillip Orchard

There have been several key changes in the global energy landscape in recent years. The surge of U.S. crude production, the reimposition of sanctions on Iran, efforts by OPEC to goose prices, instability in producers like Venezuela and Libya, and rapacious appetites in emerging economies have reconfigured long-established oil flows across the world. Last week, for example, newly released data showed Saudi crude exports to the U.S. Gulf Coast dropping to nearly a fifth of levels a year ago. The week before, Saudi Crown Prince Mohammed bin Salman made high-profile visits to Pakistan, India and China to woo new buyers and investors. There are countless dimensions to the geopolitics of energy security. Price swings can lead to a surge in prosperity and clout in one country while wreaking havoc on the internal politics of another. Countries have routinely proved willing to meddle in the internal politics of oil-rich states to protect commercial energy interests. Territorial disputes become an order of magnitude more explosive when energy riches are at stake. But the geopolitical importance of where an importer gets its crude from, or to which countries a producer sells its oil, tends to be overstated – and often overvalued by policymakers. More often than not, it just doesn’t matter. As a general rule, a barrel of oil is easy to move, easy to blend with barrels from another producer to meet quality requirements, and easy for importers to buy at market prices. It’s a largely fungible commodity sold on a deeply integrated global marketplace. Still, there are exceptions to this rule, in which trade is driven by non-market motives and in which crucial dependencies can take root. And as the current upheaval in oil markets shakes out, it’s the exceptions that are worth watching most closely.   A ‘Global Bathtub’? Economists often refer to the international oil market as a “global bathtub” – one with many spigots and many drains, but one holding the bulk of the world’s oil supply with broad consistency in value. This is because oil is generally a global commodity. Most crude is cheap to move across a variety of modes of transportation, from ships (responsible for around half of all oil shipments) to trains to pipelines, without having to be substantially altered to accommodate any particular one (unlike, say, natural gas, which must be liquefied before loading on a ship and then regasified after offloading). The ease and low cost of modern ship-born transportation (it can cost less than $2 to move a barrel of oil from the Middle East to the U.S. or East Asia) means any country with a viable port terminal can buy crude from just about anywhere in the world.

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Prices can sometimes differ slightly from one region to another because of political, geographic and infrastructure factors, and quality can vary. But since various grades can be blended together to meet the processing specifications of a refiner, the spread between most grades is relatively narrow, ensuring that importers typically have ample choice in suppliers at market rates. Ultimately, a barrel of oil from Saudi Arabia usually ends up having comparable value to a barrel from Angola. Fungibility often allows the market to function globally in scale. A useful comparison is natural gas. The commodity cannot be moved around the globe nearly as cheaply or easily as crude, so prices vary considerably more from one regional market to another. This is beginning to change as countries build out infrastructure for LNG. But the liquefaction process and associated infrastructure are still expensive enough – accounting for as much as 30-40 percent of the price of the commodity – to make LNG uncompetitive against compressed natural gas transported via pipeline in most cases. As a result, countries are far more likely to remain dependent on pipelines to meet their natural gas needs – and besides, pipelines themselves are expensive to build, and they are captive to a small number of suppliers (and vice versa). In the past couple decades, natural gas dependencies have taken on greater geopolitical importance than those stemming from crude. For example, Russia’s cutoff of natural gas supplies to Europe via Ukraine at the height of winter in 2006, 2009 and 2014 illustrated how an exporter can leverage natural gas dependencies for strategic gain. Countries are rarely able to weaponize oil in such a manner. Exporters may band together to try to limit supply to affect global prices, as demonstrated with mixed success repeatedly by OPEC. Two countries may operate outside the global market by forging special arrangements that serve narrow commercial or strategic aims. (Around a fifth of global production is not sold on markets.) But in these situations, the global oil market otherwise still functions normally, with most importers still able to ensure stable supplies from various sellers at market rates priced transparently against a handful of benchmarks. Countries can easily avoid long-term dependencies. A major exporter like Saudi Arabia is rarely in a position to exploit its energy relationship with a major buyer like India in service of strategic aims. In other words, Riyadh can’t expect to gain much by threatening to cut off oil supplies if New Delhi doesn’t, say, end its partnership with Iran on the strategically important Chabahar port. It may take some time for India to adjust, and the risk of a short-term economic crunch may be problematic. But any leverage Riyadh has would be fleeting, as India eventually could just boost imports from a combination of Qatar, Nigeria and any number of other suppliers instead. And for all the industry upheaval it has triggered, the shale revolution in the U.S. and elsewhere won’t change this dynamic. The introduction of a new major oil exporter – one that happens to be the world’s largest oil consumer, the protector of global sea lanes and a non-OPEC member, to boot – will only help ensure an environment of plentiful supply and unhindered flows across the global commons.   The Exceptions There are several exceptions to the global bathtub where oil buyer-seller relationships are determined by factors beyond supply and demand – and, thus, where it can matter quite a bit geopolitically from where an importer gets its crude or to whom a producer is selling it. In these circumstances, dependencies are most likely to form, and an importing country’s desire for the lowest possible price of crude could take a back seat to its broader strategic interests.   When Buyers Lack Sellers This dynamic typically involves landlocked countries that cannot easily draw from the global bathtub, tethering them to suppliers by train or pipeline (or to transit states through which the crude is transported). Belarus is one such example. In 2017, Belarus produced enough oil to meet only around one-fifth of its consumption. It purchased more than 99 percent of its crude imports, valued at $5.23 billion, from Russia but accounted for just 5.5 percent of Russian oil exports that year. There’s a clear dependency here – and one that Russia, which sees Belarus as indispensable to Russian security, has a strategic interest in leveraging. Indeed, the two are locked in a yearslong dispute over plans to remove discounts on Russian oil – re-exports of which account for nearly a third of Belarus’ export revenue – with Moscow occasionally sharply reducing oil flows to the country in an attempt to strongarm Minsk into compliance. The dispute may be motivated, at least in part, by Minsk’s occasional efforts to find some strategic balance between Russia and the West. Regardless, Belarus is in an uncomfortable position. On March 1, Belarusian President Alexander Lukashenko announced that the country was exploring alternative sources of oil, potentially via ports in Ukraine and the Baltics, though Minsk has made several such proclamations in the past. Dependencies can also stem purely from geopolitical isolation. North Korea is the most prominent example. The U.N. sanctions implemented in 2016 have only deepened its near-total oil dependence on China and, to a much lesser extent, Russia. In the unlikely event that China deemed it worth the risk of pushing the North to the brink of collapse, it could impose a blanket embargo on oil exports to the Hermit Kingdom.   When Sellers Lack Buyers The second exception typically occurs when geographic, economic and geopolitical conditions limit the number of buyers available to an exporter. This often involves situations where a country’s crude cannot be moved to port easily or cheaply, making producers more dependent on markets that can be served by pipelines or, less often, rail. Canada, for example, has to sell nearly all of its oil mined in its central provinces to the United States, creating a growing dependency on its mercurial southern neighbor. Geopolitical factors like sanctions can also restrict producers’ access to the global market and force them into dependencies. The most prominent example here is Iran, which has been forced to court buyers that are willing to buck U.S. pressure since oil sanctions were reimposed in November.

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Russia, meanwhile, is grappling with both geographic and geopolitical constraints on its oil exports. The bulk of Russia’s vast untapped unconventional reserves are located in eastern Siberia, half a continent away from the closest major port at Kozmino. The only realistic way for Russia to get the crude to market has been by building the 3,000-mile (4,800-kilometer) Eastern Siberia–Pacific Ocean pipeline, work on which began in 2005. Theoretically, the pipeline enables Russia to dump its crude into the global bathtub. And as recently as 2011, 75 percent of the pipeline’s crude went to Japan, South Korea and the U.S. But in an era of low oil prices, considering the high cost of building and maintaining the pipeline, it has made economic sense to send more than 90 percent of the ESPO crude to the closest major consumer market: China. In 2017, 21 percent of Russian crude went to China. Last year, Russian exports to China increased another 19 percent. New cross-border pipeline spurs are expected to cement China’s position as the primary consumer of ESPO crude for the foreseeable future.

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Geopolitical factors have contributed to Russia’s eastward turn as well. As Russia reasserted itself in Eastern Europe over the past decade, it had to contend with the possibility that Western sanctions would sever its access to key markets – particularly Europe, which historically has been Russia’s primary buyer. As a result, even before global oil prices collapsed in 2014, Moscow had been increasingly looking east for buyers. In 2013, for example, Moscow locked itself into a 25-year supply agreement with China. China needs a lot of oil and has a strategic interest in reducing its vulnerability to a potential maritime blockade that would leave it starved for energy. But for the time being, Russia will need Chinese buyers more than China will need Russian crude, creating a modest Russian dependency on Beijing. Russia understands as much and so has explored ways around it, including the pioneering of shipping routes through the Arctic and its renewed, albeit cautious, efforts to settle a World War II-era territorial dispute with Japan.   When Peddling Problematic Crudes The third exception typically involves producers whose particular grade of crude can’t easily be blended with everything else sloshing around in the global bathtub. Examples of problematic grades include heavy (high viscosity), sour (containing high sulfur content and other impurities) crude, often produced from oil sands. Before being blended with other crudes, the heaviest, most sour grades must be refined at specialized facilities that are in short supply, limiting the availability of buyers. The obvious example here is Venezuela, home to the world’s largest technically recoverable oil reserves, much of which is of poor quality. Refineries capable of handling this type of oil are few and far between. Thus, despite being on strained terms with the U.S., to say the least, for the better part of two decades, most Venezuelan crude has continued to flow to the U.S., though it has dropped to just below 50 percent from more than 70 percent in the 1990s. In 2017, its only other major buyers were India and China. The vulnerability created by this dependency has been made abundantly clear with the recent imposition of U.S. sanctions, as well as with U.S. efforts to redirect revenue from the Venezuelan-owned Citgo (which Caracas has used to get a cut of downstream profits) to the Venezuelan opposition.

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Occasionally, the availability of sellers for certain importers can likewise be limited by demands for specific types of crude. South Korea’s petrochemical industry, for example, relies almost entirely on condensate – a form of ultra-light crude that’s derived as a byproduct from natural gas production – from the massive South Pars field, which is shared by Iran and Qatar. Seoul has said it will eventually comply with U.S. sanctions on Iran. But South Korean importers have reportedly struggled to find affordable alternatives and will have to pay hundreds of millions of dollars to overhaul their refineries to handle new sources – something they are reluctant to do given that sanctions on Iran could ostensibly be lifted in the near future if a new nuclear deal is reached or the next U.S. president strikes a new course with Tehran.   When Preparing for a Darker Day Underpinning the theory of the global bathtub is the assumption of certain conditions that, while present today, are by no means guaranteed to be permanent. Most important, it assumes the absence of a great power conflict that would threaten to cut off sea lanes, put a premium on short supply lines, and potentially carve the world into competing blocs with major strategic interests in denying each other the oil needed to fuel their war machines. Historically, major importers have acted as though such a conflict was a possibility. During the Cold War, for example, part of what drove the U.S. involvement in the Middle East was the need the keep reliable sources of oil within reach – and out of communist hands – in case a major war broke out with the Soviet Union. We’re still seeing this sort of behavior today, even though the threat of a major war erupting is low. As mentioned, China’s willingness to lock itself into a long-term supply agreement with Russia stems, in part, from its concern about the ability of the U.S. and its allies to cut off China-bound oil traveling through the Malacca Strait or the first island chain. This is also a driver of certain Belt and Road Initiative projects such as a major pipeline to the Indian Ocean through Myanmar, and Chinese pipelines to Central Asia. Still, even despite the surge in oil bought from Russia, more than 80 percent of China’s oil imports travel through these chokepoints and the easily blocked Myanmar pipeline. If China has a growing dependency, it’s not on Russia but on free and open maritime trade. Accordingly, the more important geopolitical development is the buildup of Chinese maritime forces aimed at deterring a potential blockade. Similarly, Japan’s overwhelming dependence on maritime trade for its energy needs, and its concern about China’s creeping dominance of its littoral waters, is compelling Tokyo’s own naval buildup. It’s not all that important to Japan where its oil comes from – just that sea lanes remain open. In other words, for energy-hungry powers such as these, the focus is less about preparing for the possibility that the global oil market ceases to function and more about preventing a doomsday scenario from emerging in the first place.