The High Cost of Cheap Oil

American consumers are getting a welcome reprieve at the pump — gas is cheaper than at any point since 2008.

Thanks to major shifts on both the supply and demand side of the global energy market, American families are seeing gas prices under $2 a gallon just as economic growth finally reaches pre-recession levels. Good news, right?

Not for the stability of some of the world’s most strategically important nation-states, it’s not. Cheap oil comes at a high price for a number of places already under tremendous security pressures.

A quick look at what oil money buys — and who wins and loses in bust times — makes it clear that global security can take a hit even as Western consumers fill up for less.

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Above — Joint Chiefs chairman Gen. Martin Dempsey in Jeddah, Saudi Arabia.At top — a mock oil refinery fire in Indiana. DoD photos[/caption]

Saudi Arabia

Saudi Arabia and its neighbors may have the most to lose when it comes to low oil prices. “It’s a huge deal for exporting countries, for countries like the big Gulf monarchies,” Jim Krane, a professor of energy geopolitics at Rice University told War Is Boring.

“These countries are getting about 80 percent of their budgets from crude oil exports, about 40 percent of their GDPs. For them, these wild swings in crude oil prices are really disruptive.”

Saudi policy actually helped spark the current downturn in prices. Already facing increased production in Iraq, Libya and North America, and reduced demand thanks to European austerity policies, Saudi Arabia saw an opportunity to undermine high-cost competition in North America and elsewhere.

The idea was to protect Saudi Arabia’s primacy in the global oil market, and so it used its position in OPEC — the international cartel of state oil companies — to keep production at its highest and prices at their lowest.

This gambit has failed.

In the United States, oil firms have shelved some of their most expensive drilling projects, but production has only dipped slightly. The downturn seems to have helped these oil companies become more efficient, and lower their costs in ways that will likely stick with the industry even when prices rise again.

Unfortunately for the Saudis, this comes at a time of unprecedented regional instability, including major security threats from Islamic State and a new war in Yemen against the Shia Houthis. The Saudi government has already had to make major draw-downs to its foreign reserves, and began issuing bonds for the first time since 2007 earlier this year.

“Those countries with currency prices pegged to the dollar are feeling the full effect of this price decline,” Krane said.

Saudi Arabia can’t weather the effects of this bust by letting its currency drop, but Krane is still confident the Saudis can make it through this bust intact. “Saudi Arabia is a different place than it was in the ’70s and ’80s. It’s got a larger population, a more sophisticated economy.”

Still, for a country so closely identified with the international oil economy, the current price decline is certain to make its rulers uneasy.

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Gas flare in Kirkuk, Iraq. William John Gauthier/Flickr photo[/caption]

Iraq

Saudi Arabia may have the sophistication and resources to ride out this decline. Iraq, on the other hand, is exposed in unique ways.

“Iraq, Venezuela, Nigeria, Algeria, countries with larger populations with respect to their exports and economies dominated by crude oil revenues will be feeling a lot more pain,” than the big Gulf exporters, Krane said. “These countries haven’t set up sovereign wealth funds, they haven’t squirreled away foreign currency for when times get tough so they are finding themselves without a cushion.”

Iraq is, of course, still seething from a civil war, foreign occupation and decades of totalitarian rule favoring the Sunni Arab minority. What little peace the country has is dependent on oil payoffs now imperiled by low prices and the high costs of the war with Islamic State.

For Iraq, cheap oil means difficulty financing its military and increased likelihood of domestic unrest as Baghdad considers “austerity footings,” as Krane calls it.

Iraq’s precarious circumstances — which also includes an emerging currency crisis as it struggles to keep up with a dollar-pegged dinar — demonstrate the Catch-22 oil-exporting countries are facing right now.

The best way to get prices back up would be to dial back production in a big way, reducing supply. These countries, however, need whatever revenue they can get just to meet basic bottom line obligations. They have thus dialed production as high as it can go. Iraq is producing at record levels — four million barrels per day — making it the second largest OPEC producer after Saudi Arabia.

This, of course, keeps prices low, which necessitates high production, which keeps the vicious cycle turning.

The scenario is why nations form cartels in the first place, and the current oil price crisis begs the question as to whether OPEC’s role as the linchpin of international oil production may be over — a development which would have big impacts on global security.

“I still think OPEC’s got a lot of influence on prices at least in the short term,” Krane says. But the roles the traditional big players have played is changing rapidly, and rapid change — by definition — cannot produce stability.

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Russian Pres. Vladimir Putin at the Eastern Economic Forum on Sept. 4, 2015. Kremlin photo[/caption]

Russia

Russia’s largest enterprise is the state-owned natural gas company Gazprom, but the Kremlin has taken a curious track in regards to one of Gazprom’s most important customers — it invaded them.

Ukraine was both one of Gazprom’s largest foreign customers — and thus an important source of foreign currency — and a strategically valuable transit point for Russian gas heading to European markets. Now those markets are less available to Russia, which is instead seeking buyers in China and elsewhere. China’s recent economic stumbles and the emergence of Australia as a new gas source for East Asia are not helping Russia at all as global energy prices stay low.

Russia allowed its currency to fall, which has helped “ameliorate the pain” associated with the price bust, Krane added.

Still, most Russian regions — the country’s equivalent of states — are now in or near fiscal default and depending on Moscow for bailouts. In Russia, this fiscal pressure has an ominous edge to it, as the country is still a major military power with a ring of much weaker countries around it. Russian Pres. Vladimir Putin could trade docility bought with oil and gas-financed welfare for the patriotic outpouring of war.

While this may only add to the nation’s fiscal problems in the long-term, the state may have few other options if backed into a corner. If energy prices stay low, that is where it will likely be.

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Protesters in Terrazas del Avila, Caracas. Carlos Diaz/Flickr photo[/caption]

Venezuela

Not only has Venezuela used its oil wealth to finance a sprawling socialist welfare state, it has used it in unique diplomatic schemes. Caracas gave oil away to friendly left-wing governments, and even gave free heating oil to low-income homeowners in the United States.

Venezuela’s Bolivarian Revolution has been wholly dependent on oil revenue, meaning that Nicolas Maduro’s government has a lot to lose in the current bear market.

Every petrostate has a break-even point on oil prices, a point at which revenues meet expenditures. Venezuela’s aggressive spending gives it a high break even price — $161 a barrel according to Citigroup, $89 per barrel after currency devaluation. With crude prices nearly half that, Venezuela is experiencing major strains on its foreign reserves, precipitating one of the world’s worst currency crises.

A currency crisis is especially problematic for Venezuela, as almost all of its domestic consumption is dependent on imports — there is very little manufacturing other than that associated with the oil industry.

What manufacturing Venezuela did have is pulling up stakes, with Ford alone writing off all $800 million of its investments in the country this year. Venezuela now faces major shortages of basic consumer needs including toilet paper, telephone service and even beer.

It also means that there is a burgeoning food crisis.

All of this has exacerbated Venezuela’s most serious internal security problem — crime. Venezuela has one of the world’s highest crime rates, and things have gotten worse. The state has few resources to expand or otherwise improve law enforcement. The judicial system is such a mess that most crimes including murder are committed with impunity.

As long as oil prices stay low, the motives for such crimes will be high, as there is little to lose when committing them. For the security of the average Venezuelan, low oil prices pose a real and immediate threat.

If Maduro and his party decide to bolster their legitimacy by reigniting long simmering conflicts with Colombia or other neighbors, the security threat could move from domestic to international.

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U.N. troops in South Sudan. United Nations photo[/caption]

South Sudan

South Sudan is one of the world’s poorest countries, and the current decline in oil prices is an insult added to existing injuries. South Sudan has extensive oil reserves, but ongoing fighting between the rival Dinka and Nuer ethnic groups has set back production technology.

“In strategic terms low oil prices increase demand,” Krane said, but South Sudan can’t take advantage of this opportunity.

The country’s production has actually declined sharply in the last year as the conflict destroyed important infrastructure. Higher prices would enable redevelopment of this technology, but the current price bust makes that impossible.

Perhaps the worst part of South Sudan’s production struggles is that the country is totally dependent on Sudanese pipelines to transport its petroleum. South Sudan just gained its independence from Sudan in 2011, and relations between the two nations are frosty at best.

Sudan charges high prices to South Sudan for using these pipelines, further eroding revenues. South Sudan wants new pipelines to transport oil through Uganda and Kenya, but ongoing conflict and low prices mean these plans have not made it past the drawing board.

In the end, the country is in the worst possible position with oil reserves that tempt warring parties and external enemies, but few resources to develop these reserves for its own immediate security.

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Natural gas flare in North Dakota. Tim Evanson/Flickr photo[/caption]

North Dakota

For all of the risks the bear market in places like Riyadh, Caracas and Baghdad, we ought not ignore the impact it is having in Minot, Fargo and Bismarck. The United States has become one of the world’s largest oil producers, with drilling most productive on shale formations in Texas and North Dakota.

Texas’ economy is large and diverse, and its major population centers are just as likely to benefit from lower gas prices as they are to be harmed by a crude oil bust. North Dakota, on the other hand, has quickly become dependent on production from its oil rich Bakken Shale, and the price downturn is creating security risks in the Sioux State.

North Dakota had already become a problem spot for drug trafficking — especially methamphetamine — and prostitution. Some worry that many of the state’s unemployed oil workers will resort to criminal enterprises as the energy sector contracts, thus creating a security threat. The experience of busted boom towns in the Wild West may well be recreated in the North today.

But in a broader sense, U.S. domestic production is shifting the global balance of energy power away from Saudi Arabia. “The shale business is going to take some of that swing producer role that the Saudis don’t seem to want right now,” Krane said.

That role — whereby a large producer can easily ramp production up or down in order to maintain a global stability in a commodity price — is “the basis for the security umbrella the United States still provides” to Saudi Arabia.

The Saudis don’t want to “deny that publicly because it puts their external security at risk,” he adds. As America shifts into this traditional Saudi role, it begs the question — why is Washington continuing to provide so much security coverage to the Saudis?

This question may not be answered for decades, but it has huge implications for global security. The longer the downturn lasts — and Krane points out that the last downturn lasted from 1985 to 2003 — the more pressing this answer becomes.

In the end, these six countries are only the tip of the global security iceberg — Algeria, the other Gulf States, Iran, Ecuador and a variety of other countries face security pressures as a result of the oil bust. Cheap oil also drives consumers towards gas-guzzling vehicles, and renewable energy sources look more costly by comparison.

The greatest threat to global security over the coming decades is posed by global climate change, and for consumers encouraged to “invest in consumption,” as Krane says, the short-term incentives don’t really reflect these long-term realities.

Still, for U.S. families struggling with stagnant wages and a slow economic recovery, the extra room in household budgets afforded by cheap gas is very welcome. The final lesson might be the most important of all — the immediate experience of our citizenry does not match the big picture needs of our global community.

This may pose a security threat more significant than any oil price drop ever could.