Gulf bottleneck: Middle East stability and world oil supply.

Cooper, Richard N.

Richard N. Cooper is Boas Professor of International Economics at Harvard University.

Since the disturbances caused by the Iraqi invasion of Kuwait six years ago, the international flow of oil has gone uninterrupted and unimpeded, but that tense summer of 1990 rekindled memories of the volatile oil prices of previous decades. In 1973, 1979, 1980, and 1990, major disruptions in the flow of Middle Eastern oil caused world oil prices to surge, and in 1986, the practical collapse of the Organization of Petroleum Exporting Countries (OPEC) led to a 50 percent drop in prices. The Middle East remains the key to the stability of global energy markets. With the world's dependence on the region poised to increase dramatically, what are the prospects for continued calm in Middle Eastern oil markets?

Middle Eastern oil implies reserves located in the Persian Gulf because other oil sources in the Middle East are far less important: Algeria and Libya are relatively inelastic suppliers, Egypt consumes most of the oil it produces, and Sudan is inhospitable to foreign investors. This leaves the Arabian peninsula oil producers--Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Oman, Qatar, and Yemen, in order of oil exports--and Iraq and Iran as the primary international suppliers of oil in the Middle East.

Fueling Global Growth

The world economy is in relatively good balance at present and can look forward to reasonable growth over the next decade or two. Economic performance in Japan and Europe has been lackluster recently but will likely improve early in the next century. Growth is robust in the Far East, South Asia, and Latin America, while the United States is growing at or near its potential. Growth in the former Soviet Union will pick up from the no-growth adjustments of the past few years, and even Africa may turn in a better performance, although that continent is economically too small to affect the world economy.

Modern economies are still based heavily on energy, though the efficiency with which it is used is improving steadily and is vastly greater than it was 25 years ago. Developing countries, in particular, are relying increasingly on hydrocarbon fuels as they move from subsistence to manufacturing economies. Oil is still the unmatched fuel for transportation, and with modernization, the demand for transportation has increased substantially. Synthetic oil can be made from coal and from natural gas, but it remains uncompetitive in cost relative to petroleum.

Taking these and various other factors into account, the US Department of Energy projects world demand for oil to grow by 30.4 million barrels per day (mmbd) between 1995 and 2015, or by 44 percent (rather less than the projected 49 percent growth in total energy demand). Of this increase in demand, only 7.5 mmbd are projected to come from today's developed countries of Europe, Japan, and North America. The remaining 22.8 mmbd increase in demand will be generated by today's relatively poor countries, including 14.1 mmbd from Asia (excluding Japan). China alone will increase its demand for oil--and thus its oil imports--by five mmbd.

Perhaps surprisingly, the world will not have difficulty supplying these increased quantities of oil. Technological developments have greatly improved the prospects for, and reduced the costs of, identifying and developing new oil reserves, both on land and under water. But the most economical oil remains in the Persian Gulf region, and if the countries of that region are willing to undertake the necessary investments in exploration and development, this great increase in demand can be satisfied at only modest increases in price. The US Department of Energy projects that the price of oil in 2015 will be US$25.43 a barrel (in 1994 dollars); other forecasters assume an even lower price.

Based on these price and investment assumptions, oil production outside of OPEC will grow by less than three mmbd between 1995 and 2015, leaving a 28 mmbd increase to come from OPEC countries. Of the OPEC countries, Venezuela can be expected to be the only significant contributor from outside the Persian Gulf. This leaves over 25 mmbd of additional production--equal to total OPEC oil production in 1994 (18 mmbd of which came from the Persian Gulf)--to come incrementally from the Gulf. If these projections are realized, the share of world oil production coming from the Persian Gulf will rise from 29 percent in 1994 to over 46 percent in 2015.

We know from the experiences of 1973-74 and 1979-80 that a several-fold rise in oil prices, generated by an actual or an anticipated shortage of oil (actual oil production did not fall in 1979, but the anticipation of shortage led to extensive buildup of stocks), can wreak havoc on the economies of countries around the world. Fluctuations in oil prices, after all, were largely responsible for the stagflation--deep recession combined with inflation--of the 1970s and the developing-country debt crisis of the 1980s. The economic damage from oil price shocks can be severe. How high is the risk of another such disruption?

The Edge of Instability

It is usually suggested that the Persian Gulf is a turbulent and politically unstable part of the world. In fact, there has been remarkable political stability in the region, at least as measured by the longevity of its leaders and key decision-makers. King Hussein of Jordan came to the throne 45 years ago in 1952. President Hafez al-Assad of Syria has been in power since 1971, and the leaders of Libya, Oman, and the UAE have each been in power for over 25 years. Saddam Hussein has been president of Iraq since 1979 and was a key government figure even before he assumed that role. Hosni Mubarak became president of Egypt after Anwar Sadat's assassination in 1981, and King Fahd of Saudi Arabia rose to power in 1982. As Crown Prince, Fahd had been the Saudi decision-maker for seven years before his coronation. Even the Iranian revolution and its clerical regime are now 18 years old.

Compared with many other parts of the world, this is a picture of durability and stability to outsiders and residents alike. In South America, for instance, most countries changed not only leaders but governmental regimes during the 1980s and also introduced extensive changes in both economic and human rights policies. African nations typically face periodic coups, punctuated by civil or tribal wars. Even democratic Turkey had military coups in 1970 and 1980, although in both cases the military leaders returned the country to democracy after a few years.

What then makes the Middle East seem turbulent and politically unsettled? There are at least three reasons. First, there has been continued, although diminishing, official hostility toward Israel from most Arab states in the region and from revolutionary Iran since 1979. Syria, for example, is still formally at war with Israel. Much public resentment toward Israel persists among Arab populations, fed by Israel's occasional intransigence toward Palestinians, even while governments one by one slowly come to terms with Israel's existence.

Second, many states in the region have designs on their neighbors. In fact, only Jordan has settled borders. In addition to Palestinian territorial ambitions toward Israel and its occupied territories and Syrian concern over the Israeli-occupied Golan Heights, Iran and Iraq have ambitions of their own. Iran has sought to destabilize the regimes of several other countries and has occupied several islands in the Persian Gulf claimed by the UAE. Iraq has long coveted Kuwait, formally recognizing its borders with Kuwait in November 1994, but only after a test of wills with the United States in which Iraq provoked a preemptive US military deployment by moving tanks, artillery, and other forces toward the Kuwaiti border. After the resumption of limited Iraqi oil exports in early 1997 under UN Resolution 986 relieved domestic economic pressure on Saddam Hussein, he threatened to raise oil prices to Jordan if that country did not crack down on Iraqi opposition groups there. There is every reason to suspect that Hussein, subdued but unreconstructed, would move against Kuwait again if he thought he could do so with impunity. To complicate matters further, several countries are actively trying to develop weapons of mass destruction and the means to deliver them. As a result, many Middle Eastern governments feel threatened by their neighbors.

Third, some governments face strong and even violent dissent from their own citizens. All Middle Eastern governments except Israel's are in many respects authoritarian, with Syria and Iraq ruled by especially cruel and brutal dictators. Effective political opposition is not undertaken mainly by potential democrats and civil libertarians, but rather by religiously or ethnically motivated enemies of the existing regime. The rulers of Syria and Iraq are drawn from minorities of the population and have not hesitated to suppress opposition from other groups violently. Moreover, Islam as a religion and as a creed for political organization holds political rulers accountable to the rule of law as well as to specific religious injunctions on behavior. Rulers that deviate from acceptable behavior, therefore, risk religious wrath, and authoritarian regimes provide no peaceful outlet for this dissatisfaction, although Jordan's parliament is beginning to address this problem. The clerical regime in Iran faces the age-old tension between Islamic severity and Persian indulgence, as well as tensions with Iranians who wish to be part of the modernizing world.

During the next decade, several Middle Eastern countries will face acute problems of succession. Since today's rulers have often successfully avoided cultivating potential political rivals, they have few capable potential successors. Assad of Syria (aged 67 and ailing), Mubarak of Egypt, Muammar al-Qaddafi of Libya, and Hussein of Iraq all lack designated or competent successors. As these regimes come to an end, serious, perhaps violent, struggles for power will occur in these countries. In contrast, democratic Israel, clerical Iran, and most of the kingdoms have regular and accepted processes for succession, with royal succession perhaps being the smoothest and least disruptive.

It is important to recognize that tensions within the region will not disappear even with a complete and amicable settlement of the Arab-Israeli disputes and a formal conclusion of the peace process. Paradoxically, disagreements with Israel provided some common cause for Arab states and permitted them to submerge other fundamental differences among them. But territorial disputes and societal discontent will not disappear with a peace agreement, and Arab-Israeli discussions will probably make only fitful progress over the next two decades, so that the issue will also continue to nag at the region.

It is also worth noting that the Persian Gulf is embedded in a larger region of tension and potential for violent conflict. Mutual suspicion between Greece and Turkey periodically threatens to break into open hostility, with Cyprus as a focal point. So far, this has been prevented by their joint membership in the North Atlantic Treaty Organization (NATO) and ties with the United States. Further to the East, the Kashmiri problem entered its fiftieth year in 1997, with no hint of a process that could lead to its resolution. While neither India nor Pakistan wants war, their mutual suspicions could result in a fatal miscalculation. Afghanistan remains embroiled in civil war, as does Tajikistan of the former Soviet Union. Conflicts in the neighborhood could embroil countries in the oil-exporting Persian Gulf, at least indirectly, if oil exporters are tempted or expected to provide financial support to one of the antagonists. While this remains a risk, the distances involved are substantial--Kuwait is about as far from Karachi and from Istanbul as Boston is from Miami--and disruption to oil flow is possible but unlikely.

Incentives and Interdependency

Despite the potential for instability, oil producers have little incentive to disrupt production and will likely try to limit any interruption to oil flows. Oil accounts for over 85 percent of the export earnings of most of the Gulf countries, except for Qatar, where oil accounts for 75 percent of export earnings. More significantly, oil sales account for three-quarters or more of government revenues since the oil is owned by the state in all these countries. Imports, especially food imports, are critical to maintaining the living standards of the populations. The governments of these countries are therefore vitally dependent on their oil exports for the well-being of their citizens and for their own survival. To a high degree, the interests of oil-exporting countries and those of oil-importing countries converge: the latter badly need oil, and the former badly need the revenue from its sale. The two groups have a common interest in maintaining a steady flow of oil into world markets. When Iraq invaded Kuwait in 1990, its primary objective was to seize the revenues from Kuwait's oil production (and perhaps Kuwait's large overseas assets as well), not to throttle the production of Kuwaiti oil. If successful, however, Iraq probably would have intimidated Saudi Arabia into cutting back production enough to raise the world price from the then-prevailing US$18 a barrel to, perhaps, US$25 a barrel.

The interests of oil producers and consumers, however, are not perfectly aligned concerning oil prices. Here there is some divergence of interest between importers and exporters, but, more importantly, among oil exporters themselves. Saudi Arabia, Kuwait, and the UAE have very large proven and probable oil reserves, 90 to 150 times their current annual production. Iraq and Iran have somewhat smaller oil reserves relative to normal production, although Iran has very large reserves of natural gas.

The consequence of these divergent reserve-to-production ratios is that Iraq and, especially, Iran have a greater interest in higher oil prices than do other, larger-scale producers. Of course, all producers can gain through higher prices in the short run, and these countries' financially-strapped ministries of finance welcomed the price increase of late 1996. Given the heavy world dependence on Persian Gulf oil expected in the next two decades, Persian Gulf producers could raise prices in the short run if they all acted together to cut back on production. However, cooperation among these states has proven difficult since each wants the others to bear the burden of restricted output.

Furthermore, the lesson of the 1973 OPEC decision, led by the Shah of Iran, to triple oil prices has not been lost on those with large oil reserves: while the revenue gains were large in the first few years, this price increase not only generated a world recession but also induced extensive energy conservation, which is still proceeding over 20 years later. Technologies stimulated by the high oil prices of the seventies are still being installed as old equipment and buildings are gradually replaced by newer, more energy-efficient variants. Countries with large oil reserves fear a decline in the value of those reserves if effective substitutes for oil are found and therefore desire relatively stable but remunerative prices, low enough to inhibit the development of higher-cost, alternative sources of oil supply as well as energy-saving innovations. However, these processes of induced innovation and replacement of existing capital take a long time; countries with relatively low reserves have everything to gain by high prices in the short run, provided that other countries restrain production to achieve them.

To increase oil production by 18 mmbd over the next two decades will require a great deal of investment by Persian Gulf countries in oil well development and infrastructure for collection and shipment. Will those countries undertake the requisite investment in time? All these countries are experiencing rapid population growth with few opportunities for productive employment. At 3.6 percent a year, Iraq and Saudi Arabia have among the highest population growth rates in the world. Oil revenue is desperately needed to provide for increased housing, education, fresh water and sanitary facilities, as well as for employment. This will encourage these countries to invest in increased production capacity if they believe that doing so will allow them to sell more oil. As long as political stability seems likely, these states can borrow the necessary funds in world capital markets against future oil revenues.

For these reasons, Persian Gulf governments are unlikely to disrupt the flow of oil deliberately. There is one possible exception: as suggested above, Iran would welcome much higher oil prices if they could be brought about without restricting Iranian oil production--that is, by restricting production in Saudi Arabia, Kuwait, the UAE, or Iraq instead. To achieve this, Iran could perhaps harness Shi'i oil workers in eastern Saudi Arabia. This minority in a predominately and emphatically Sunni country could be encouraged to strike or riot on either religious or political grounds. The much higher percentage of foreign oil workers in Kuwait and the UAE make successful agitation in those countries less likely. Such a possibility is of concern to the Saudi Arabian government and has led it to adopt stringent security measures against possible Iranian subversion as well as political and religious policies aimed at minimizing potential dissidence among Shi'i Arabs.

The Wrench In the Pipeline

Although most governments are unlikely to disrupt the flow of oil, non-state actors or governments that perceive that they have nothing to lose can significantly interfere with the flow of oil from the Persian Gulf. There are two sources of exit for Persian Gulf oil. One is through pipelines to loading terminals in the Gulf and then to tankers which exit through the Strait of Hormuz. The other is through pipelines to loading terminals on the Red Sea in Saudi Arabia or the Mediterranean Sea in Turkey. Before reaching the loading terminals, the oil must be gathered from disparate oil fields and separated from gas and other unwanted materials. There are four potential bottlenecks at which oil flow could be disrupted: gas-oil separators (large, expensive pieces of equipment), pipelines to terminals, large loading terminals (which are relatively few in number), and the Strait of Hormuz. For oil pumped to the Red Sea, the Suez Canal might seem to be a significant bottleneck. Ironically, the closure of the Suez Canal for the 15 years following 1967 encouraged the use of supertankers, which are too large to use the Suez Canal but offer cost-effective transportation. Since these vessels do not use the Suez Canal, blockage of the Suez Canal would have only limited impact on oil markets. Furthermore, the most rapidly growing markets for oil will be in Asia, and tankers destined for ports there can exit the Red Sea to the south without using the Suez Canal.

Gas-oil separators are highly specialized and expensive machines with long procurement lead times. A loss could be significant but can be avoided by installing excess capacity and pre-ordering spare machines, as Saudi Arabia has allegedly done. Pipelines are long and vulnerable and can be cut without too much difficulty. But they are just as easy to repair. Loading terminals are robust and relatively easy to protect physically against major raids, except raids by a well-armed foreign power. Of course, successful protective, preventive, and remedial measures require that a government is effectively in charge. As noted, governments have a strong interest in maintaining the flow of revenue from oil. By the same token, however, well-organized dissident groups may wish to deny revenue to the government. Civil war or even major and persistent guerrilla actions could be highly disruptive, but they are also highly unlikely during the coming decade. As long as the region remains politically stable, major disruptions will be difficult to effect. Should that stability erode, gas-oil separators, pipelines, and loading facilities become significantly more vulnerable.

Interfering with the flow of oil through the Strait of Hormuz would require significant effort. Despite its constrictive appearance on a map of the world, it is not a small body of water. The Strait is about 35 miles wide at its narrowest point (twice the width of the English Channel) and exceeds 45 meters in depth through most of its width, sloping gradually from the Iranian side to over 200 meters deep off the coast of Oman. The two traffic channels--one for incoming vessels, the other for outgoing, separated by two miles and each two miles wide--lie wholly within the territorial waters of Oman at the narrowest point of the Strait. In the mid-1990s, traffic averaged around 60 ships a day, roughly one-quarter of which were tankers. While this is heavy traffic, it is only one-third of the traffic which passes through the slightly narrower Strait of Malacca, and somewhat lighter than the traffic through the much narrower Bosporus.

The Strait of Hormuz is thus much too large and too deep to be physically blocked, as the Suez Canal was in 1967. Shipping could, however, be attacked by military forces, and the Strait could be mined by a national power of some means. Iran is establishing the means by which to do both. In addition to a formidable air force, Iran has acquired two Kilo-class submarines from Russia and has two more on order. It has also acquired land-based silkworm missiles from China and has located them near the Strait. Iran mined the Persian Gulf during the 1980-88 Iran-Iraq war, especially after Iraqi planes attacked its off-shore oil-loading terminals, and presumably maintains a large inventory of mines.

Such actions in the Strait of Hormuz--in the territorial waters of Oman--would be an act of war. Conceivably, Iran could deny responsibility for mine explosions that damaged one or several ships. It could even feign participation in mine searches. The presence of mines would inhibit commercial shipping, and insurance rates on Gulf-bound vessels would rise substantially, perhaps prohibitively. Some disruption could be caused, although, short of war, the disruption would be strictly temporary. Even in the event of war, the Strait could be made safe for navigation in a few weeks if US forces were engaged to do so. Furthermore, it must be kept in mind that Iran has no immediate interest in preventing oil from being shipped out of the Persian Gulf--or merchant goods from being shipped into the Gulf--since it is highly dependent on both the oil revenues and the imported goods. An attempt by Iran to block the Strait of Hormuz would be an act of desperation, induced only by extreme provocation, such as an attempted embargo or blockade.

Approach, Assist, and Diversify

What can the rest of the world, and the United States in particular, do to reduce its vulnerability to disruptions in the supply of Persian Gulf oil, on which the world will become increasingly dependent over the next few decades? First, it can avoid isolating Iran to the point where mining the Strait of Hormuz would become tempting to Iran. Second, it can help Saudi Arabia to secure its physical facilities, encourage the installation of some excess capacity, and perhaps even share some of that cost. Third, it can continue to diversify sources of energy, through a vigorous program of research to improve energy efficiency and to develop economic alternatives to oil as a fuel for motive transportation.

Fourth, the United States can continue to develop sources of oil other than the Persian Gulf. This is partly a question of developing new technologies to open up hitherto inaccessible areas, such as deep-water continental shelves, and to improve extraction rates from existing wells. It is also a question of political and economic steps to open up known economic sources of oil, of which the Caspian Sea region is the most promising. Caspian oil and gas deposits are extensive, and it might be possible to extract them economically, but they are far from major markets and even export through pipelines will be expensive.

Ironically, the most economic route for a pipeline might be through Iran to the Persian Gulf. That obviously would not reduce dependence on the Gulf region. Alternatives involve pipelines through Russia or Georgia to the Black Sea, increasing congestion in the narrow Bosporus, or through Armenia or Iran and Turkey to the Mediterranean. Russian domestic and international politics provide the major near-term obstacle to finding an acceptable route, but that problem will presumably be solved in the next several years. Ultimately the Caspian region--Turkmenistan, Kazakhstan, and Azerbaijan--could produce as much as six mmbd of oil, contributing considerably to the growing world demand for oil.

Fifth, the International Energy Agency should maintain its emergency oil sharing plans, which inter alia involve the requirement that members (basically Europe, North America, and Japan) maintain oil stocks equal to at least 90 days of imports. A major component of this is the US Strategic Petroleum Reserve, (SPR) which at the end of 1996 stood at 564 million barrels, down 28 million barrels from the previous year. It would be a mistake to sell off more SPR oil for transitory budgetary gains just as the world is once again entering a period of tight oil markets and rapidly growing demand for oil.

The interests of oil producers in the Middle East and oil consuming nations are fundamentally aligned. There is no incentive for the governments of the region to constrict supply or interfere with global energy markets. Furthermore, the Middle East is far more stable than is commonly assumed. Despite these compelling reasons for calm with respect to the stability of Middle Eastern energy supplies, Middle Eastern oil production facilities, pipelines, and shipping channels are quite vulnerable both to non-state actors and to regional powers, should they choose to interfere. As the world becomes increasingly dependent on Middle Eastern oil, it is critical that importing nations begin laying the groundwork for future stability by working to improve relations with supplying countries, protecting oil facilities in the region, and developing other energy resources.