The US-Russia Commercial Energy Summit marked yet another milestone in the transition from the Cold War to a new strategic order. Ever since the Gulf War, when the Soviet Union stood aside while the US organized its international coalition to displace Iraqi forces from Kuwait, US-Russia relations have continued to undergo profound historic changes. While the US has been busy consolidating its Cold War victory and pushing the globalization of market democracy, Russia has been struggling with the task of transforming itself and finding a new role in this changing international order. A tumultuous market transition, marred by controversy but still on track, has given Russia a new embrionic set of economic and political values which it shares with the US. Nevertheless, it has been the issue of energy supplies which has brought the two ex-arch enemies from the Cold War era increasingly closer together. "The cold war is over,” claims US Commerce Secretary Don Evans. “Today our relationship with Russia is defined by new business agreements instead of the arms agreements of years past." This new relationship forms part of the US’s new strategic policy to diversify its international sources of petroleum and is likely to have profound implications for US policy in the Middle East and Central Asia and for the geopolitics of oil.

The New US-Russia Partnership
Attended by state officials from the commerce and energy departments of both countries, along with senior executives from more than 100 US and Russian energy companies, the Houston summit (October 1 and 2) provided a venue “to advance policies that will embrace cooperation and success in the US and Russian commercial energy relationship,” declared Amy Jaffe, the senior energy adviser at Rice University’s James A. Baker III Institute for Public Policy, which helped organize the summit.

The results of this closed meeting will continue to make themselves known over the coming months, but already some important announcements have been made public. On the first day of the summit, the US Ex-Im Bank signed a memoranda of understanding with three large private Russian oil firms (Lukoil, Yukos and Sibneft) to extend up to $100mn in financing to each company in order to support their purchases of US equipment and services to further develop Russian oil and gas reserves. Marathon Oil Corporation also struck a deal with Russia’s largest state-owned oil firm, Rosneft, to create a joint venture next year for the transportation to the US and marketing there of 100,000 barrels per day (bpd) of crude oil from the Urals. “Today’s actions are in accordance with President Bush’s National Energy Policy,” declared Ex-Im Bank’s Vice Chairman, Eduardo Aguirre Jr., “which calls for diversification of oil and other fuel sources by strengthening global alliances and international relationships”.

The new US-Russia partnership was given a significant boost by the events of September 11 and the subsequent war in Afghanistan. Russian diplomatic and military collaboration were of utmost importance to the US campaign against the Taliban. Russian participation in the “War on Terrorism” and its role in the containment of radical Islamic militancy has been a clear example of this growing cooperation based on a new set of common US-Russian interests. Fighting Islamic terrorism in Afghanistan, for example, has facilitated the Russian government’s efforts to contain Islamic rebels in Cechyna. While the Afghan war introduced further US interests into the area, it also created the possibility for renewed Russian influence in other parts of Central Asia.

However, the war on terrorism and the possible actions against Iraq have created new risks and opportunities for the US-Russia relationship. A US-led regime change in Iraq could potentially threaten Russian political and economic interests which have returned there during the 1990s – unless the US finds a way to bring Russia deeper into the fold.

Russian Oil Interests in Iraq
Russian interests in Iraq have concentrated on oil. This should come as no surprise, considering that the most successful Russian companies to grow and garner credibility internationally, particularly since the Russian debt crisis of 1998, have been oil companies. Furthermore, Iraq offers -- more than any other single country, barring perhaps Russia itself -- the possibility of significantly increasing reserves and output through further exploration and development (Iraq’s 112bn barrels of proven reserves make it the world’s second largest reserve holder). In 1997, Russia’s largest oil company, Lukoil, negotiated a $4bn deal to develop the 15bn barrel West Qurna field in southern Iraq. Yet Lukoil, despite its 68% controlling stake in the project, never actually began operations due to the US-sponsored sanctions against the regime of Saddam Hussein. However, now Iraq is threatening to cancel this agreement should the company not quickly begin work in West Qurna. Meanwhile, the Iraqi National Congress, the exile group in London which now appears to be the group with the best chance of establishing itself as the post-Saddam government, has warned that oil agreements reached by foreign companies with the Hussein regime will not necessarily be honoured in a post-Saddam future.

This has presented a problem for Lukoil and other Russian companies like Slavneft (an oil services firm which as recently as October 2001 signed a $52mn service contract to drill at the Tuba field in southern Iraq). Furthermore, the recently proposed $40bn Iraqi-Russian economic agreement also included many opportunities for Russian oil companies to explore in Iraq’s Western desert near the border with Iran. This effort, which now seems at least temporarily stalled, was partly designed to help Iraq eventually pay back some $8bn in loans contracted during the days of the Soviet Union, something that the current Russian government would be loathe to forfeit unnecessarily.

The US campaign to wage war on Iraq has now pushed Russian interests in Iraq into a difficult corner. If the Putin government throws its weight behind the Hussein regime in an effort to protect both private and public Russian interests there, it would risk sacrificing its improved relations with the US, and all for what would likely prove to be a losing cause. This would likely leave Russian firms cut out from a post-Saddam Iraqi economy, including the potentially massive development of Iraqi oil reserves. On the other hand, supporting the US initiative also risks seeing Russian interests lose their currently priveleged position in Iraq to US-based oil companies. Nevertheless, it is still possible for Russia and the US to find a common interest in a new regime in Baghdad, should both countries agree to cooperate more fully with each other economically and politically. Such a development would also place pressure on Europe to at least grant tacit consent to US plans, as French oil firms have also made headway in Iraq, while even Spanish firms have recently made a bid to position themselves there (in late September, Repsol and Cepsa signed contracts with Iraq to purchase some 6mn bbl during October and November under the UN-sponsored Oil for Food program). Hence, the logic of George Bush’s visit to Russia last May and the recent bilateral energy summit in Houston.

A New Driving Force in US-Russian Relations
The US’s recent rapproachment with Russia has of course developed within a much broader security context. Indeed, now that the US has achieved unrivalled military strength, sustained by an economy which most consider to be the strongest and most flexible in the world, there are only two obvious potential weaknesses that might undermine the US’s dominant influence in world affairs. The first would be the possible erosion of dollar hegemony should the euro take on a greater role as an international currency (see Paul Isbell, The Shifting Geopolitics of the Euro, Análisis del Real Instituto, 23-09-02, ARI 57/2002). The second vulnerability derives from the US’s continuing dependence on petroleum imports from the OPEC countries, particularly those in the Middle East. The US currently imports about 60% of the oil it consumes and most estimates see this figure rising to 70% by 2020. This is the inescapable conclusion (barring significant development of alternative energy sources) stemming from the fact that while the US currently consumes one-quarter of the world’s oil, it holds less than 3% of total world reserves. Furthermore, a constant theme running through the conclusions and policy recommendations of the recent National Energy Policy Development Group (headed by Vice President Dick Cheney) is the importance of diversifying petroleum sources as a way to augment US energy security – an objective which the NEDP group considers to be a primordial trade and foreign policy priority.

In this context, the US has much at stake in seeing Russia fully develop its oil and gas potential, particularly in light of the additional US objective of collaborating in the creation of a stable and democratic Russia. This objective is important for two reasons: first, a successful Russia would provide a key example to the world of a sustainable transition to market democracy by a former Communist superpower; second, a stable Russia is a vital foreign policy goal due to the potentially dangerous nuclear arsenals that still remain in Russia and some of its CIS partners. Russia, on the other hand, dependent on oil and gas for 40% of its current exports and 50% of its government revenues, would naturally be interested in increasing its influence in world oil markets.

Analysed in this context, the Houston summit makes perfect sense. Before September 11, US dependence on Middle Eastern oil was increasing, while global petroleum demand was growing by between 1.5 million barrels per day (mbd) and 2mbd each year. Although the current economic slowdown could take some pressure off demand, the long term trend is clear: continued, even growing, dependence on Middle Eastern oil. Both the US Department of Energy and the International Energy Agency (IEA) recently projected that global oil demand could grow from 77mbd to 120mbd in 20 years, mainly as a result of higher demand in the US and Asia. The NEDP group sees US oil consumption rising from 19mbd in 2000 to 27mbd in 2020 and imports climbing by 7.5mbd during the same period. These estimates assume that, without any significant change in policy, most of the increased supply would come from OPEC (whose production is expected to rise from 28mbd in 1998 to 60mbd in 2020). Without any significant changes in the international oil scenario, most of this increase would logically have to come from the Middle East and, in particular, from Saudi Arabia. Recent high prices have begun to stimulate more activity in Russia, the CIS countries, and Africa, but this is likely to take some years to come on line and would in any case require a major multi-billion dollar investment push from the US and European oil industries and their counterparts in Russia. Russian Energy Minister, Igor Yusunof, has recently estimated that the Russian oil industry needs $50bn in investment over the next eight years to reach its true potential. Yet this was precisely the agenda of the Houston summit.

The Traditional US-Saudi Oil Nexus
For decades the key political relationship in the political economy of oil has been the US-Saudi Arabian axis. Until last year, Saudi Arabia supplied 1.7mbd of the nearly 11mbd imported by the US, more than any other competitor. Since then, Saudi exports have decline somewhat to just over 1.5mbd (displaced by Canada as the US top supplier after September 11). This reflects the US attempt to reduce dependence on Saudi Arabia in the aftermath of the terrorist attacks. Since September 11, US-Saudi relations have been significantly strained, principally due to the perception that Saudi Arabia is ambivalent with respect to the US war on terrorism. The fact that 15 of the 19 suicide terrorists implicated in the September 11 attacks carried Saudi passports (to say nothing of Osama bin Laden’s own Saudi origin) has not helped. To this must be added the Saudi refusal to allow the US military to use Saudi Arabia as a springboard for any military action against Iraq. US imports have also risen somewhat in 2002, reflecting the US policy to increase the supplies in its Strategic Petroleum Reserve (SPR).

Nevertheless, before September 11 it was taken for granted that not only was Saudi Arabia the principal supplier of US oil but that it would likely remain so for the foreseeable future. Indeed, part of Saudi Arabia’s complex oil strategy has always been to maintain its number one position in the US market with the objective of cultivating the perception of Saudi Arabia’s strategic centrality in US foreign policy. Saudi Arabia has traditionally even paid a price for this centrality, selling its oil to the US for a discount of approximately $1/barrel (bbl) and providing a total subsidy to US consumers of more than $600mn a year. Until now, the US has been expected to protect Saudi Arabia politically and militarily, absorbing in the process the resulting contraints on its own foreign policy in the region. In principle, the Saudi regime would be interested in maintaining such an arrangement, as the US market has been seen as the principle source of increasing demand for Saudi oil far into the future. Because the Saudi regime is basically dependent on oil exports for its survival, the US market would logically continue to be of overriding significance.

Saudi Arabia’s traditional importance in the geopolitics of oil has been due not only to its position as the single largest reserve holder (262bn bbl of proven reserves at the end of 2001, 25% of the world’s total and about one-third of OPEC’s total) or the world’s largest producer (8.5mbd), but also to its role as the market’s major “swing producer”. In addition to its current daily output, Saudi Arabia nurses the single largest amount of spare capacity in the world (some 3mbd, according to some oil exports enough to displace the entire production of another large exporting country in the event of a supply disruption), lending it important leverage over the world price of oil. If supply is cut incidentally or purposefully by another producer (or should demand suddenly spike), Saudi Arabia can bring into production enough spare capacity to maintain price stability in the oil markets, making it of supreme strategic importance to the US, Europe and Japan. On the other hand, in the event of production increases, either by OPEC partners attempting to free ride or by non-OPEC countries attempting to increase market share or lower prices, Saudi Arabia can cut production to shore up the price. Given that its oil is particularly cheap to extract (less than $1/bbl compared to $6-$8/bbl in the Gulf of Mexico or the North Sea), the Saudis are the only oil producers capable of engaging in a price war by increasing production significantly and driving the price down to around $10/bbl (something it did in the 1980s to discourage “free riding” and again in 1998 when Venezuela broke its OPEC quotas to temporarily displace Saudi Arabia as the number one supplier of oil to the US). At such low price levels, Saudi Arabia has traditionally been able to survive longer and more comfortably than most other world oil producers, giving it enormous leverage in the geopolitics of oil.

As Edward L. Morse and James Richard have argued, “Saudi spare capacity is the energy equivalent of nuclear weapons, a powerful deterrent against those who try to challenge Saudi leadership and Saudi goals.” (see The Battle for Energy Dominance, Foreign Affairs, no. 81, March-April, 2002) Unlike the nuclear deterrent, however, Saudi spare capacity has been actively used when perceived as essential to maintaining its dominant market share. Furthermore, until now, there has been relatively little counterweight among producers to stop it, while lower oil prices have typically been seen in the US as a propicious development for the economy. This equivalent of the “nuclear deterrent” in the oil markets has long formed the foundation of the US-Saudi relationship. Only recently has this been put into question. If the solidity of the US-Saudi relationship has eroded, it is only to be expected that US foreign policy would now seek to gradually undermine this strategic strength of the Saudis. Such a strategic objective becomes more central in light of growing concerns about the stability and future of the Saudi regime. 

US Oil Diversification
Assuming the US does not undertake a major policy shift to encourage alternatives to petroleum, a combination of the following strategic objectives would help diversify its supply, raise world oil production, and potentially erode Saudi Arabia’s “nuclear” swing producer weapon: (1) Collaboration with Russia (and other CIS oil-producers) to increase production and augment infrastructure capacities to handle higher oil flows; (2) participation in the development of untapped potential in Iraq; and (3) tightening of links with other producers and potential producers in non-OPEC areas like Africa.

Russia and the CIS
The recent Houston summit – with a wide range of official and private sector oil issues on the agenda- was clearly a move in this direction. By bringing together US and Russian oil firms, the Bush adminstration hopes to facilitate private sector collaboration that would unite US capital and technology with new potential Russian output. The Putin adminstration no doubt has seen this as an opportunity to also bargain for the maintenance of Russian interests in a post-Hussein Iraq and in the flurry of pipeline projects now underway to deliver future Caspian Sea production to market. A firm US-Russian oil partnership would also help Russian companies secure access to international capital markets and state-of-the art technology needed to expand oil production and infrastructure to further stimulate the Russian economy.

Indeed, should all of the current Russian and CIS plans for increased production come to fruition, the former Soviet Union countries could match Saudi exports relatively quickly and perhaps even recapture some of the oil market dominance they enjoyed at the end of the Cold War when the Soviet Union was the world’s largest producer with output of 12.5mbd (the highest level of any single country producer ever). Already Russia is the second-largest producer and exporter in the world, producing 7mbd and exporting over 4mbd (compared to Saudi Arabia’s 8.5mbd and 7.6mbd, respectively). However, such a production increase would necessarily imply much higher levels of participation in the CIS zone by foreign oil companies, a process that is likely viewed by Washington as a way to cement links with Russia and Central Asian countries and buttress US influence there. This is also in line with the evolving US strategic agenda to redraw the geopolitical map of Central Asia (see William Pfaff, The Impact of September 11 on the World Order, Real Instituto Elcano, Seminario internacional: El mundo un año después –en el aniversario de los atentados del 11 de septiembre en Estados Unidos, September 11, 2002).

An important symbol of this increasing US-Russia oil collaboration has been Tyumen Oil’s shipment of some 300,000 bbl of Russian oil to the US Strategic Petroleum Reserve (SPR) which arrived only days after the Houston Summit. While Yukos delivered the first direct shipment of Russian oil to the US last July, the Tyumen sale represents the first Russian oil ever to contribute to the SPR (with stocks now close to 600mn bbl, out of a capacity of 700mn bbl). This marks a clear change in the strategic nature of the US-Russian partnership. Russian energy minister, Igor Yusufov, also visited one of the US’s SPR sites at Bryan Mound near Freeport, Texas, just before the Houston Summit, becoming the first person from the former Soviet Union ever to visit one of the US’s SPR locations. Russian oil firms are also enthusiastic about the prospect of deeper collaboration, particularly if the US allows them a stake in the oil production of the post-Hussein Iraq. Russia’s two largest oil firms, Lukoil and Yukos, have both expressed their interest in deepening cooperation with the US and its oil industry, primarily as a way to garner investment, technology and collaborative partnerships.

There has also been a significant change in perception in Moscow and among the Russian oil industry with respect to Russia’s capacity to withstand a Saudi-led price war. Before the Russian crisis of August 1998, the ruble was pegged to the dollar. Therefore, when oil prices fell in 1997 and 1998, Russian firms were hit hard by the significant decline in revenue and a loss of competitiveness. However, now that the ruble is free floating, the exchange rate is capable of cushioning much of the negative effects of lower international prices in dollars. Whereas in 1998, the decline in oil prices had a negative impact on the Russian current account balance, contributing to the pressure on the ruble and its eventual collapse, in the current context of a floating ruble the exchange rate could adjust to such a negative shock through depreciation, thus minimizing the negative effect on the competitiveness of Russian oil firms whose costs remain ruble-based.
This heightened flexibility has renewed Russian confidence that its industry might be able to absorb much lower world prices should the Saudis attempt a price war to undermine further Russian efforts to increase production and capture market share. The Houston summit also provided a negotiating venue through which the Russian oil industry might garner some form of US assistance to subsidize Russian losses in the event of a Saudi price challenge that took oil prices below the threshold where Russian oil companies are profitable. Such a development (possibly embodied in a Russian or even a joint US-Russian SPR) would be of extreme interest to the US, as it would signal a significant erosion of the “nuclear power” implied by Saudi Arabia’s current position as the world’s sole important swing producer, thus increasing US policy leverage over Saudi Arabia and freeing its hands in the Middle East and Central Asia. This change in perception has no doubt been an important ingredient in the new Russian enthusiasm to explore deeper cooperation with the US.

Iraq
The US’s efforts to stimulate a regime change in Baghdad could also facilitate the multiple objective of increasing world oil output, stabilizing oil prices at or around $20/bbl and weakening Saudi “swing” power. Its enormous reserves and large potential to increase output over the coming years – given adequate new investment – makes Iraq the only really covetous prize on the world’s oil map over which the US could hope to exert primary influence. Expanded US influence there would not only help achieve the above-oil related goals, but might also facilitate US involvement across the entire Middle East and Central Asia. The Houston summit, timed as it was to correspond with the Bush administration’s intense diplomatic campaign to convince the world of the necessity and legitimacy of a war against Iraq to oust Saddam, suggests that it was also conceived as a tool to bring Russia – with its important UN Security Council veto power- deeper into the US fold, assauge its fears with respect to growing US influence in these regions, and to reveal that Russian and US interests in Central Asia, the Middle East and the world oil market are mutually shared.

Africa
Finally, there is the new US emphasis on deepening ties with potentially large oil producers in Africa. This prong of US strategy facilitates the objectives of increasing the diversity of supply in an area which is generally considered to be of relatively little strategic value. The possibility for increased US investment in exploration and production would also be welcomed by most African countries with oil potential because of the economic stimulus this might provide to African economies. According to Robert Esser of Cambridge Energy Research Associates (CERA), new discoveries off Angola, Nigeria and other African countries could add another 3mbd to world oil production within eight years. There is a further advantage for the US, however, provided by increased African oil production. Playing the “Russia card” at the Houston summit may have served as a warning sign to Saudi Arabia. In this sense, it is analogous to the Nixon-Kissinger “China card” played against the Soviet Union in the early 1970s. The US could seek to maintain a tight relationship with both major world oil powers, diplomatically playing one off against the other. However, further development of African potential would increase US leverage with respect to both Russia and Saudi Arabia, giving the US and its oil industry more flexibility in the case of difficulties either in Russia and the CIS countries or in the Middle East. Indeed, the “African card” could be a useful lever for placing pressure on the Russian Duma to finally pass legislation to allow for production sharing agreements (PSAs), something which is seen by many US firms as a crucial incentive for stimulating significant US cooperation with the Russian oil industry.

Of course, prongs number one (Russia) and three (Africa) are relatively risk-free. The second prong of US oil strategy (Iraq), however, does imply a number of significant risks. First, there is the potential short run damage to the US and world economies stemming from additional economic uncertainty during the current moment of general economic and financial fragility. Second, there is a significant risk of an oil price spike in the event of an attack on Iraq. (see Alejandro Vigil, Precios del crudo e Irak: mayor incertidumbre, imposible, Análisis del Real Instituto, .) This stems first from the likely disruption of Iraqi supplies during a military intervention which would have at least a temporary negative effect on prices. However, there are a number of unknowns implied by such a military action which could also drive up prices: Would Saddam strike at his neighbors’ production facilities? According to Daniel Yergin of CERA, knocking out significant capacity in the Gulf could easily push prices to about $50/bbl. Might the US military action get bogged down and heighten uncertainty in the world economy and the international oil market? Such an eventuality would likely push the US and world economies into recession. Would Saudi Arabia (3mbd spare capacity) or the other Persian Gulf suppliers (another 3mbd spare capacity among them) react quickly enough to fill the supply gap left by Iraq (currently accounting for about 1mbd in exports to the world market)? During the first Gulf war about 5mbd had to be replaced as Iraqi and Kuwaiti exports evaporated from the market. Today the task would be much easier, at least in theory. But would Saudi Arabia and its Gulf neighbors play ball this time around? Most signs continue to indicate that they would, but with the rising chorus in the Arab world protesting against the possible military intervention, it remains possible that the oil weapon might be used passively, simply by not gearing up space capacity fast enough to avert significant price rises.

The dilemma is heightened by the fact the Bush administration has conceived of the possible military action against Saddam as a response to his regime’s potential support for Al Queda and its development of weapons of mass destruction. The administration’s argument to the world is that the current Iraqi regime represents a clear and present danger not only to US interests but also to those of the international community. Oil, they have argued, does not figure as primary concern in the formulation of US policy toward Iraq. That may be the case, but it would also be difficult to argue that Iraqi oil has not been on the minds of at least some key policymakers in Washington, if for no other reason than the fact that Russia’s current interests in Iraq – and its Security Council veto- make oil of at least secondary concern.

In the short-run, however, Saudi Arabia and its Gulf state neighbors still hold the key to the oil markets. In the best case scenarios, both Russia and Iraq would require three to five years before oil production could be increased enough to offset the Saudi spare capacity weapon. This makes it essential for the US to continue courting the Saudi regime for at least minimal cooperation. The other major producers in the Maghreb, Africa and Latin America have little, if any, spare capacity. Hence, the complicated terrain through which the US must manuevre in order to achieve its ambition of removing Saddam Hussein – an objective on which the Saudi regime remains ambivalent.
In the final analysis, improved US-Russian relations can be credibly interepreted as a signal to Saudi Arabia that its oil dominance is not necessarily a permanent feature of the geopolitics of oil and that in the middle and long run the Gulf kingdom will ultimately depend on the good graces of the US, particularly once the latter has begun to actively construct a more highly diverse non-OPEC oil map. The US-Russia Commercial Energy Summit in Houston was the first visible warning flare in this diplomatic campaign.

Paul Isbell
Senior Analyst for International Economics and Trade
Real Instituto Elcano