Terra Firma

The sharp spike in global oil prices over the past six years has shifted the balance of power in international politics. At the same time, the expanding political and market influence now enjoyed by the governments of many emerging market states has helped fuel a further rise in energy prices. The interplay of geopolitics and oil markets underlying these changes flows from emerging problems on both the demand and the supply side. One thing is clear: the growing importance of political risk in global energy trade will be with us for many years to come.

SURGING DEMAND

On the demand side, surging economic growth in emerging-market heavyweights like China and India has sharply increased their energy consumption, as industries in these countries expand their productive capacities – and as tens of millions move from poverty towards middle-class lifestyles.

Consider the recent history of the automobile in China. In 1984, the very first private vehicle was sold in that country. By 2006, 1,000 new cars hit the streets of Beijing every 24 hours. By the end of 2007, there were 15.2 million privately owned automobiles on the road across China. Fewer than 4 per cent of Chinese citizens already own a car, leaving plenty of room for market growth. Similarly, dramatic changes are underway in other developing countries. Sustaining and extending the economic gains for consumers that these changes reveal will prove crucial for the long-term social and political stability of a growing number of emerging market states.

This growth in developing countries has a substantial impact on global energy demand. In 1990, the world consumed 66.2 million barrels of crude oil per day. In 2007, that number climbed to around 86 million barrels. Between 2000 and 2007, China alone accounted for one-third of the overall increase in global oil consumption. The U.S. Energy Information Administration now projects that by 2030, global demand will rise to 118 million barrels per day – and that may prove a conservative estimate. The debate over the precise timing for a peak in global oil production remains unresolved, but it is clear that over the past half decade, surging demand has grown faster than supply, adding upward pressure on prices.

Within developing countries that aren’t blessed with energy wealth, political leaders rely on economic growth and rising standards of living to bolster the legitimacy (and stability) of their governments. Growth and wealth depend on access to increasing supplies of oil and gas. As a result China, for example, has paid above-market prices to secure long-term energy supply contracts, raising costs for everyone else.

In many cases, they are also straining federal budgets by subsidising energy consumption. This is true even for oil-rich countries. In Iran, gasoline costs about 41 cents per gallon, yet heavy subsidies are required as the country’s aging refining sector cannot meet demand despite the country’s ability to produce four million barrels of crude oil per day. In Venezuela, it costs 12 cents and the government-controlled price has been low enough to stimulate a surge in vehicle purchases. In countries without energy wealth, the problem is even more acute. In June, the Indian government scaled back federal spending on energy subsidies, sparking riots over the new, higher cost of diesel fuel. Even after the cuts, India’s government will spend nearly $25 billion this year on oil subsidies. As oil prices move toward a higher equilibrium price, budget-busting federal spending is often the price of domestic tranquillity, in countries as diverse as Malaysia and Cameroon.

SUPPLY-SIDE CHALLENGES

Yet, the primary story of the interplay of geopolitical volatility and energy costs comes from the supply side. The first problem is a simple matter of geography. Most of the world’s future crude oil supplies will increasingly come from West Africa, the Caspian region, the Persian Gulf and the broader Middle East – regions that are especially vulnerable to political turmoil, terrorist and insurgent attacks, war, government collapse and other serious threats. The higher cost of doing business in these states and their territorial waters adds to the pressure on prices.

Recent headlines underline the political risk impacting production in some of the world’s most important oil-producing regions. The ongoing international dispute over its nuclear programme has produced sanctions on Iran – and threats from its leaders to cut oil exports to countries which support them. A military strike on Iran’s nuclear facilities might well push its government to respond with actions that threaten traffic through the Strait of Hormuz, the Persian Gulf passageway through which some 40 per cent of the world’s traded oil moves each day. Oil production in Iraq remains vulnerable to fighting between that country’s rival sects and militias over the profits it generates. Attacks on oil infrastructure in the Niger Delta have shut in as much as 30 per cent of Nigeria’s output.

Second, Iran is not the only energy-exporting state to use its growing market leverage as a political weapon. The governments of Russia and Venezuela have already used hydrocarbon wealth to pick political fights. High prices allow even marginal energy exporters like Ecuador, Bolivia, Burma, Sudan and Chad to punch above their political weight. As supply growth lags further behind rising demand and as prices climb higher, the energy weapon becomes a more potent one.

The power this weapon provides can embolden governments like Iran’s to pursue high-risk political strategies – like aggressive development of a nuclear programme – secure in the knowledge that energy exports will generate plenty of cash and help the country resist international pressure for change. Few governments want to see a nuclear Iran. But the country’s energy customers, especially in Asia, won’t support new sanctions that might ultimately cost them access to badly needed oil and gas supplies. Oil wealth encourages Venezuelan President Hugo Chavez to actively antagonise his best energy customer, the United States, and to form political and commercial alliances with like-minded governments by selling them fuel at cut-rate prices. It emboldens Sudan’s president to defy Western calls for sanctions in response to the violence in Darfur. Newly discovered pockets of natural gas help Burma’s ruling junta shrug off international demands for political reform.

THE POWER OF POLITICAL BUREAUCRATS

Adding to the problem, as energy becomes an ever more precious commodity, the governments of many developing states – both buyers and sellers – are micro-managing their energy policies by investing in national energy champions, state-owned companies that give government officials near-complete control of the country’s most valuable natural resources. Energy markets were once dominated by international oil companies. The largest energy companies in the world today are state-owned firms like Saudi Aramco, Gazprom (Russia), CNPC (China), NIOC (Iran), PDVSA (Venezuela), Petrobras (Brazil) and Petronas (Malaysia). Today’s big multinationals – familiar names like ExxonMobil, Chevron, British Petroleum and Royal Dutch Shell – produce about 10 per cent of the world’s oil and gas and hold just 3 per cent of its reserves. The new energy giants listed above control one-third of the world’s oil and gas production and reserves.

And that’s just the largest of the state-owned firms. Collectively, national oil companies now own more than three-quarters of all crude oil reserves and, in all but a handful of cases, the men who run them ultimately answer to political bureaucrats, not shareholders. State-owned companies based in countries that import most of their energy now compete in Asia, Africa, Latin America and elsewhere to lock up the oil and gas supplies on which sustained economic growth (and the popularity of their governments) will depend. Some of their investment bets may not be good ones. When state-owned energy companies based in developing states buy long-term access to oil and gas supplies from other potentially unstable countries, they risk substantial losses – with ripple effects through their own still-vulnerable economies.

To make matters worse, some of the national oil companies are plagued with the same bureaucratic burdens, corruption and cronyism that weigh on the performance of other state-owned enterprises. Some of these energy companies, like StatoilHydro and Petrobras, manage their operations as efficiently as the best of the energy multinationals, but the state officials who control and manage many of the emerging market-based national energy firms too often divert profits toward political projects. This diversion of capital, most egregious with PDVSA in Venezuela, drains capital from efforts to find new oil reserves, to maintain existing energy infrastructure and to build the pipelines needed to bring new supplies to market. Some divert windfall profits toward family, friends and business allies – and, in some cases, line their own pockets.

These countries will not be able to build mature political and economic institutions overnight. That’s why the risks generated by the injection of politics into energy markets will grow for at least the next decade. The effects of all these risks increase the price that all consumers pay for oil and gas, weighing on growth in America, Europe, Japan and across the developing world.

Politics and political risk have always played a significant role in energy markets. But the enormous transfer of wealth over the past decade from energy-importing to energy-exporting countries and the growing economic and political power wielded by emerging market governments have sharply intensified this problem. Unless and until new sources of energy and the additional infrastructure needed to deliver oil and gas to market come on line, political risk will remain central to the performance of energy markets – and market distortions will continue to influence the conduct of international politics.


Ian Bremmer, President, Eurasia Group

Ian Bremmer is president of Eurasia Group, the world’s largest political risk consultancy. He is also a columnist for Slate, a contributing editor at The National Interest, and a political commentator on CNN, Fox News and CNBC.