Misconceptions dominate the oil debate

by Bassam Fattouh

Since the Sept. 11, 2001, attacks, there have been growing misconceptions about Saudi Arabia's key position in the oil market. These misconceptions, though usually politically motivated, have become part of the conventional wisdom and are beginning to dictate US energy policy and its strategic agenda.
After Sept. 11, many US analysts doubted whether Saudi Arabia could still play the role of swing producer in the global oil market. Matthew R. Simmons, chairman of Simmons & Co. International, an investment bank specialized in the energy industry, claimed that Saudi Arabia's oil production is extremely fragile and could witness a severe decline in the coming years. This was echoed in The New York Times, which claimed that Saudi Arabia's oil fields are now "in decline, promoting industry and government officials to raise serious questions about whether the kingdom will be able to satisfy the world's thirst for oil in coming years."

These assertions are usually followed by suggestions that the United States no longer needs to rely on the kingdom as a swing producer. Instead Russia, the emerging energy giant, can assume this role. For instance, an article in Business Week by Jeffery Gorton called for America to "help Russia accelerate its production and its exports to undermine Saudi Arabia's role as the pivotal swing producer."
Surely these doom-laden predictions mean that Saudi Arabia is becoming less important to the oil market.
"Nonsense," says the Economist. "Ignore the headlines and look instead at geological and market realities, and it quickly becomes clear that Saudi Arabia remains the indispensable nation of oil. The Saudis not only export more oil than anyone else, but they also have more reserves than anyone else -- by a long shot."

The growing scepticism toward Saudi Arabia as a key supplier of oil is unwarranted. After all, the kingdom's record as swing producer has been highly reliable in filling the oil gap during disruptions to world supply. The Economist highlights several examples, including the Iran-Iraq war, the first Gulf war, during civil strife in Venezuela and Nigeria that curbed output from both countries, and last year's invasion of Iraq.
Also, there are many reasons why no other country, including Russia, can ever become a swing producer. As J. Robinson West explains in a Washington Post article, "the first reason is the weather. Should Russia bring the wells on line, constant production would be necessary or they would freeze and explode. It rarely freezes in Saudi Arabia." Furthermore, Russia's private oil companies could not afford to leave wells idle, as the Saudi government can.

Another tenet of the conventional wisdom is that by exporting to the US, Saudi Arabia subsidizes American consumers in return for US protection. Edward Morse and James Richard make this point in Foreign Affairs, arguing that "Saudi Aramco, the state oil company, earns about $ 1 a barrel less on sales to the United States than on sales to countries of Europe and East Asia. That discount translates into a subsidy to US consumers of $ 620 mm per year. In return, the United States deploys military forces in the Gulf which is of course also expensive."
This simplistic view of a bazaar type exchange of money for protection is flawed. Even if Saudi Arabia does not export a single barrel of oil to the US, it is impossible to conceive a situation in which disruption of Saudi oil supplies to the rest of the world would not influence prices in the US market. Thus, US strategic interests will always dictate defending and securing flow of oil from the kingdom regardless of whether Saudi Arabia increases or decreases its share in the US market.

Another related misconception both among some Western and Arab observers is that Saudi Arabia possesses an "oil weapon" which it can use to punish other nations. They point to the 1973 oil crisis as evidence. However, Morris Adelman, a professor from MIT, points out that "whether a supplier loves or hates a customer does not matter because in the world oil market, a seller cannot isolate any customer and a buyer can not isolate any supplier."
This leads us to refute a related misconception: the US should aim at achieving "energy independence" from the kingdom. This issue has been raised repeatedly, especially during election campaigns. In a speech on 29 July accepting the nomination as Democratic presidential candidate, Senator John Kelly told his audience that he wants "an America that relies on its own ingenuity and innovation -- not the Saudi royal family.

Such calls within the US and elsewhere for "energy independence" are just political slogans based on flawed reasoning. Energy policy aimed at increasing domestic production and reducing or diversifying the sources of imports is both wasteful and ineffective. The reality remains as professor Adelman notes "that every barrel in the world competes with every other" regardless of where this barrel is produced.
Another tenet of the conventional wisdom is that even if Saudi Arabia has the vast reserves it claims to have, without opening the oil sector to foreign investment it will not be able to boost its production capacity and generate the required additional spare capacity to meet growing demand. This argument is usually coupled with scepticism on whether Saudi Aramco has the financial capacity and the technical experience to deliver the goods.

Edward Morse and James Richard for instance argue that "Moscow may have far more going for it than Riyadh. Yukos, LUKoil, and other companies are dynamic and growing... Riyadh, on the other hand, might have vast known reserves, but it also has a closed state monopoly. Most alarming, Saudi Arabia has been unable for 20 years to increase its production capacity."
So far there is nothing to indicate that Saudi Aramco suffers from the problems that cripple other state-owned institutions, such as being squeezed for funds for further investment and development. In fact, recent records suggests the opposite. Just consider the impressive development of the Shaybah field that started production in 1998. Saudi Aramco financed and managed the Shaybah field, including the planning, design, construction, drilling, development and production of the field.

It is unclear whether inviting foreign investment is less costly than government financing. Robert Mabro, president of Oxford Energy Institute, argues that this depends on two sets of factors: "First, the size of the differentials between the rates and terms at which the country can borrow in the international capital market and the cost of capital to the foreign firm. For Saudi Arabia this differential is much smaller than for many developing countries."
More importantly, it is not necessarily true that the lower capital costs of the foreign investor will be passed to the country.
"On the contrary, the foreign company will ask for a return on its investment that includes compensation for a wide range of risks. This compensation is likely to be greater than the above-mentioned differential in the Saudi case."

Unfortunately, these and other misconceptions that dominate the oil debate are having their impact on oil prices through speculation in the futures markets. Saudi Arabia's only weapon is its spare capacity through which it can send signals to the futures market.
If speculators are bearish, Saudi Arabia can announce production cuts. If the market is bullish, it can announce production increases to lower prices. However, as these misconceptions become more dominant, the Saudi weapon is becoming less effective in calming the oil market.

Bassam Fattouh is a lecturer in financial studies at the School of Oriental and African Studies in London.