NS4054Fall Term 2015

Oil Security 2025

Overview I

• Commission on Energy and Geopolitics, Oil Security 2025, 2015

• As late as 2010 U.S. looking to be increasingly oil import dependent

• Would have had major repercussions

• Exposed to physical supply shocks

• Meant that US would remain heavily engaged in regional politics in major oil producing regions

• Protecting critical energy infrastructure, and

• Guaranteeing free flow of oil supplies

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Overview II

• Today U.S. oil outlook has been dramatically altered

• Recent events have shattered conventional wisdom and altered many long held beliefs concerning

• Developments in domestic energy markets, and

• Innovative technological change

• High oil prices and improvements in drilling technology have helped unlock massive light, tight oil (LTO) resources in North Dakota, Texas and elsewhere

• Before recent oil price drop

• U.S. crude output expected to increase to 8.5mbd in 2015 up from 5mbd in 2008

• Shale boom expected to last for more than a decade

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Overview III

• At same time various demographic, economic, and policy factors have resulted in

• U.S. net liquid fuel imports declining by 50% from 2005 high – decline of more than 6mbd

• In 2011 U.S. actually became net exporter of refined petroleum products – first time since 1948, and expected to continue

• Would have exported crude if ban not in place

• Changes likely to have profound consequences for U.S.

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Overview IV

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Overview V

• Domestic energy abundance will have many impacts

• As net imports fall country is retaining a substantial quantity of capital that would ordinarily been sent abroad

• Glut of natural gas liquids has dampened prices increasing real incomes

• Lower energy prices increases competitiveness of domestic manufacturing

• Stimulates billions of dollars of new investment in petrochemicals

• Rapid expansion in drilling activity has directly created tens of thousands of jobs and many more indirectly

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Overview IV

• National security, foreign policy and geopolitical impacts of U.S. energy abundance more subtle and less understood

• Major changes are expected in global economics, and

• Regional security dynamics, particularly in the Middle East and North Africa (MENA) – with benefits for U.S.

• Some effects just speculation at this point

• U.S. could disengage militarily from volatile oil producing regions

• Less opportunities for free-riding of other consuming countries

• Larger security role for high energy importing countries like China and India

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Overview VII

• Can say with more certainty that

• Many long term U.S. oil suppliers such as Algeria, Angola and Nigeria have already begun to develop new markets as U.S. demand for their oil falls

• Costs of transitioning to new markets along with lower revenues could have important social, political and economic impacts on these and other countries.

• Concern over the fact that U.S. will need to balance a combination of sometimes competing interests – diplomatic, military and economic

• At present we do not have a framework for examining likely possibilities – represents a major gap in our long-term policy planning.

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Overview VIII

• To overcome this limitation, report develops a scenario-based analysis through 2025

• Aimed to help explore likely impacts of rising U.S. oil production on countries and regions around world specifically

• Middle East and North Africa

• Sub-Saharan Africa,

• Russia and

• China

• We will look at these forecasts when we get to each section

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Oil in the U.S. Economy I

• Oil derives its strategic significant from its role in the U.S. economy and transportation sector in particular

• Petroleum fuels account for about 37% primary energy demand

• More than any other fuel

• Significant decline from 1977 when represented 47% primary energy demand

• Transportation sector accounted for around 70% of total U.S. oil demand

• Total cost of petroleum fuels consumed in U.S. ranged from $300 billion to $900 billion over the past four decades

• Amounts to between 2.6 and 8.5% GDP

• Last five years averaged about $840 billion or about 5.5% of GDP

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Oil in the U.S. Economy II

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Oil Markets I

• Due to heavy reliance on oil, American consumers and businesses are fully exposed to oil prices

• Few opportunities to choose less costly alternatives in the short run – demand is price inelastic

• If oil prices jump, consumers divert expenditures away from other items – can cause a recession

• Oil prices are a function of global supply and demand• Oil very fungible and relatively easy to ship• Essentially a single global market for oil• Prices set in open commodity markets• Means prices affected by events in oil producing and oil

consuming countries• Can even be significantly impacted by events in countries

that are neither large oil consumers nor producers

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Oil Markets II

• Oil related crisis have arisen from either:

• Supply side shocks as 1973-73 OPEC oil embargo, or

• Demand side shocks – 2002-2008 rapid growth in increasing imports from 2.3 mbd to 10.2 mbd

• As important as demand growth in last decade wrong to conclude supply side factors currently unimportant in determining global oil prices

• At a fundamental level concerns about long-term availability of global oil supplies reinforces market’s perception that rapid demand growth will be unsustainable

• In part concerns about supply side growth originate from fact that nearly 80% of worlds proven plus probable reserves held by national oil companies (NOCs)

• Chokepoints always a potential threat to supplies 13

Oil Supply Chokepoints

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Oil Markets III

• NOCs often forced to deposit production revenues into treasury where diverted to other purposes

• Leads to underinvestment in some of world’s lowest cost, most accessible reserves

• No real free market for oil in the pure competition sense

• The OPEC cartel and spare capacity

• Simple gauge of supply-demand balance in global market at any point in time is level of spare production capacity in OPEC countries

• As a cartel OPEC maintains individual member production quotas that vary depending on

• Current global economic climate, and

• Geopolitical considerations 15

Oil Markets IV

• Adherence to individual quotas is not always strong

• OPEC production capacity typically exceeds combined output of members – much of surplus at any time in Saudi Arabia

• Spare capacity allows market manipulation but also useful– provides short term buffer in event on unexpected supply disruptions or demand surges

• Rule of thumb – markets comfortable when OPEC spare capacity is equivalent to four percent of global demand

• In 2000 about that level

• Starting in 2003 spare capacity reduced

• Worker strike Venezuela

• Hostilities in Iraq

• Fell below one percent in 2003-04 when prices started to climb 16

Oil Markets V• 2007-09 global economic recession and financial crisis

ultimately brought reduced oil demand, lower prices and high levels of OPEC spare capacity

• Strong global recovery in 2010 – especially in China caused oil prices to increase by 12.7%

• Arab Spring and supply disruptions brought return of sharply higher prices in 2011

• Though 2012-13,

• Ongoing challenges to Libyan oil production and export

• International sanctions that removed Iranian oil from market

• Growing unrest in Iraq that affected output and

• Host of issues in Nigeria that contributed to an additional sharp decline in OPEC spare capacity which was just 1.8% of global demand in Q3 2013

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Oil Markets VI

• Various entities on supply-side have extremely different motivations and incentives that drive their decision making

• In case of many OPEC members, little incentive to over-build spare capacity that sits idle majority of the time just as means to keep markets calm.

• Over the long-term even Saudi Arabia considers the anticipated effects of investment levels in other global regions wihen making decisions about its own capacity

• In general the oil industries in OPEC mambers do not function as profit maximizing firms seeking to expand market share

• Instead investment levels determined in part to achieve specified price targets

• Around $100 per barrel going into 201418

Oil Markets VII

• Price and spending targets driven by urgent need to maintain generous domestic spending programs to placate restive populations.

• Concludes that if OPEC adheres to its historical pattern, members will view developments such as rising non-OPEC production as signals to forestall investments in new production capacity, tighten quotas and keep the global balance tight

• In fact IEA has been warning of a looming global supply crunch by end of decade due to pattern of underinvestment in Middle East oil production capacity

• As will see Saudis actually increased production and investment – want to drive shale out of business and become central player in oil

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Oil Markets VIII

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Oil Markets IX

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Oil Markets X

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Oil Markets XI

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U.S. Military and Oil Dependence I

• Throughout 20th century and into the 21st, U.S. only country with the capacity to protect energy infrastructure and supply routes around the globe.

• This capacity combined with critical importance of oil to U.S. economy has forced the country to accept the burden of securing world’s oil supply

• Engagement comes at an expense

• Rand study placed cost of this defense burden between $67.5 billion and $83 billion annually, plus an additional $8 billion in military operations.

• Means that between 12 and 15% of defense budget devoted to guaranteeing free flow of oil

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U.S. Military and Oil Dependence II

• Fuel consumption by military has also increased substantially over time

• Between the Vietnam War and the 21st century conflicts in Iraq and Afghanistan a 175% increase in fuel used per soldier per day – annual growth of 2.6% over 40 years.

• In 2011 DOD spent $17.5 billion on fuel for vehicles and equipment up from $4.6 billion in 2005

• Stranglehold oil has on U.S. and global economies has also undermined country’s ability to deal with difficult foreign policy challenges

• Strong case can be made that effective implementation of sanctions on the Iranian oil industry were undermined by impact such sanctions would have had on oil prices – and therefore economies of major oil consumers.

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U.S. Military and Oil Dependence III

• Another example – Syria Q3 2013

• Syrian government accused of using chemical weapons

• President and advisors debated over conducting military strike on get government tares

• Price of oil rose from around $102 to $116 from June to August

• Possibility of further upward price pressure and resulting effect on continued economic recovery became important consideration

• Even prompted discussion about release of oil from the U.S. Strategic Petroleum reserve

• Notable that this price impact and discussions occurred despite Syria’s oil production less than 0.1% world supplies and zero U.S. imports

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Scenarios Overview

• Scenarios comprise combination of low and high cases for global oil demand and global oil supply

• Allows rising U.S. production to be analyzed within appropriate context of a global oil market

• Group of “wildcards” – difficult to predict developments could have a significant impact on either global oil supply demand

• Based on scenarios report makes recommendations that aim to better position the U.S. in the future

• Want to see how to

• Strengthen the country’s capability to minimize global oil supply disruptions

• Enhance its resiliency in face of any such disruptions and

• Bolster response capabilities27

Scenarios – Assumptions I

• Four scenarios are developed to assess potential impacts of global oil demand and supply dynamics on regional and country economies

• By considering different possible trends in global oil demand and supply, scenarios provide

• Framework for assessing range of potential geopolitical impacts of U.S. oil abundance and

• What they mean for national security and foreign policy

• Help structure discussion for possible policy actions

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Scenarios – Assumptions II

Scenarios: Results I

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Scenarios Results II

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Scenarios Results III

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Scenario A I

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Scenario A II

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Scenario B I

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Scenario B II

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Scenario C I

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Scenario C II

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Scenario D I

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Scenario D II

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OPEC Spare Capacity

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Price Movements

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Production Costs

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Scenarios – Summary