In the medium term, the United States must diversify its reliance upon international oil markets. Energy independence was never a credible policy, because energy prices depend upon international price movements and the United States cannot and never has been able to act as an energy autarchy. But in what direction should the United States diversify?
By Matthew Parish*
Contemporary American policy in the Middle East is often known by the moniker “energy dominance”, but it is often not understood precisely what this means. One aspect is a long-standing US policy of energy independence: that is to say, promoting development of domestic US sources of hydrocarbon production to decrease reliance upon Middle Eastern and other sources of oil and gas. The Trump administration has continued this policy, through deregulation of environmental issues pertaining to the hydrocarbon industry, promoting shale oil production and hydraulic fracturing technology, and advancing the development of domestic refinery and LNG liquification capacity. In one sense energy independence has already been achieved: the United States now exports more hydrocarbons than it imports, and America is the world’s biggest oil producer. Nevertheless none of these policy innovations are particularly novel, save perhaps the extent of environment deregulation. They are the result of several decades of fairly consistent US energy policy.
There is another aspect of recent US energy policy that is novel. This is the use of paper – i.e. commodities derivatives – and working with allies with high elasticity of hydrocarbon supply (i.e. the ability to increase or decrease hydrocarbon production on short notice) to influence prices on the international commodities markets. The distinctive feature of contemporary US policy might be described as keeping oil prices within a reasonable band in terms of US dollar prices. In other words, one might say that the United States is acting to peg the US Dollar to oil, or they have placed the US Dollar on an “oil standard”, just as some currencies used to be pegged to a “gold standard”.
The purpose of doing this is laudable: to prevent oil market shocks and to mitigate the previously apparently perennial cycle of hydrocarbon commodity market boom and bust, pursuant to which oil prices periodically suffered shocks (both up and down) chiefly in consequence of geopolitical events, many of which were typically in the Middle East, that might be perceived as influencing future supply by traders on the volatile futures and other derivatives markets. These shocks were obviously artificial: the actual supply of oil required to meet global demand has never been in doubt, and in the contemporary era ever greater reserves are being found all over the world. Moreover technology is rendering the costs of exploiting these newly discovered reserves ever more economically feasible. The shocks were created by speculators in hydrocarbon paper, who had taken bubble positions that inevitably burst in consequences of geopolitical events they never expected.
Oil shock prices are bad for everyone. They are bad for consumers (and those who supply them), who cannot plan for the requisite level of demand that varies in consequence of anticipated changes in supply. They are also bad for producers. Hydrocarbon-based economies need reliability in anticipated revenues in order to plan their development. Production-based industries need constancy of price to invest: US shale oil is economical above a certain price given a specific technological capacity, but uneconomical below. A producer will not want to invest in a long-term technology that may appear profitable today but not so tomorrow should the oil price be dramatically depressed. Rational political and economic decisions for both producers and consumers are taken given assumptions about long-term trends in prices. Short-term price oscillations render those assumptions difficult or impossible to work to.
Contemporary energy policy was developed by two members of the US administration who both departed office during the relatively early period of the Trump White House. They are Rex Tillerson, former CEO of oil giant ExxonMobil and the 69th US Secretary of State; and Gary Cohn, a sometime senior executive at investment bank Goldman Sachs who served as the 11th Director of the National Economic Council in the White House. Their plan for stabilising hydrocarbon prices and avoiding future oil shocks, leaving oil prices within a band of tolerable stability against the US Dollar, consisted of two components. Both involved reaching an arrangement with the United States’ principal oil-producing Middle Eastern ally, Saudi Arabia. Saudi Arabia has the highest elasticity of production of any major global hydrocarbon producer. Saudi Arabia is able, through its national oil company Saudi Aramco, to increase or suppress supply more rapidly than any other such country, and to that extent it can decisively affect global market prices. Hence one aspect of the US policy to stabilise oil prices is that whenever the United States perceives a movement in global oil prices relative to the US Dollar that has the potential to take the price outside a reasonable band, the United States asks Saudi Arabia to exercise its elasticity and increase or decrease production so as to maintain the price trend within the agreed acceptable band.
The other aspect of the policy is to cancel and re-denominate Saudi-held US hydrocarbon paper (i.e. commodity derivatives issued by US banks) in terms to more closely tie the expected future price of that paper to current oil prices, hence reducing the capacity for speculation in the commodities derivatives markets. Saudi Arabia would hold a greater plurality of that paper, something it could do due to its substantial US dollar reserves in its sovereign wealth fund and the fact that holding derivatives relating to an underlying commodity in which, due to its elasticity of supply, it could exercise substantial influence over the price of the physical commodity, made taking positions in such derivatives presumably relatively non-risky.
Therefore Saudi Arabia could prevent oil price shocks associated with prior excessive speculation on the derivative markets. The United States would tell Saudi Arabia when to increase or decrease production, and when to buy or sell commodities derivatives. In this way, oil price would remain within an agreed band. This would be attractive to the United States, because oil prices could remain in a band that permitted development of its own hydrocarbon industry (including shale oil) that requires a relatively high oil price in order to be economical. It would also be attractive to Saudi Arabia, that could plan for a comprehensive regime of economic and political development premised upon an element of certainty about future hydrocarbon revenues.
Various collateral political understandings were achieved between the United States and Saudi Arabia incidentally to this mutually beneficial scheme. The United States would reverse its prior policy of rapprochement towards Iran, the Middle Eastern state most hostile to Saudi Arabia and that also pursues a policy of meaningless aggression towards America’s principal ally in the region, Israel. The United States would acquiesce in Saudi Arabia’s war against the Houthi insurgency movement in Sana’a, the capital of Saudi Arabia’s impoverished neighbour Yemen. Saudi Arabia’s cautious internal social reforms would be supported by the United States. Saudi relations with Israel would remain discreetly cordial. And so on.
These collateral understandings were called into grievous question with the murder of the Saudi dissident Jamal Khashoggi, a resident of the United States and a journalist with a major US newspaper, on 2 October 2018. The consensus soon reached was that Saudi security forces had engaged in a sophisticated and brutal murder of Mr Khashoggi while he was present at the Saudi Consulate in Istanbul to attend to regular consular business. Whoever may ultimately be determined responsible for this act (and at the time of writing the United States has taken no formal position on the issue), the United States was shocked that such an event could take place within the diplomatic mission of so trusted an ally and inevitably felt betrayed that its ally could suffer so gross and public an abuse. There have been calls for sanctions, punishment of Saudi Arabia, and cancellation of lucrative arms contracts.
The fact of the matter, however, is that the United States will not be able to take overly-punitive action against Saudi Arabia without disrupting its policy of energy dominance. That is because for all the benefits of pegging the dollar to an oil standard, this policy requires the ongoing cooperation of Saudi Arabia; any severe punitive measures will surely render that cooperation fragile or even dissolved. Moreover Saudi Arabia owes US banks a substantial amount of money in the commodities papers it has taken positions on as part of the US energy dominance policy.
What policy should the United States therefore adopt, given this unfortunate turn of events? Pushing for regime change in Saudi Arabia is probably unattractive. Attempts to influence political processes for succession in foreign countries with very different political cultures rarely end in a satisfactory way. A country must take its allies as it finds them. Should it turn out that the rulers or senior leaders of an ally are unpalatable, then one might privately (not publicly) make one’s dissatisfaction clear. But taking forceful measures to impose new leadership in Saudi Arabia assumes that one has a better leader in mind (and who knows whether they will actually be better once they are in power?). It is also unpredictable. What if the pressure or imposition does not work out? What if the entire House of Saud collapses?
Saudi Arabia is a wealthy country with weak legal and political institutions centred upon the premise of absolute rule by a governing family accepted by a mostly but not entirely placid populace on the basis that they live well enough under the regime as is. Were a regime with weak institutions intentionally or inadvertently dismantled through interference the consequences of which would inevitably be uncertain, there could be social collapse. The worst case scenario would be a massive, wealthy ISIL in the Gulf. The other Gulf monarchies are known to be afraid of precisely this outcome. The entire region, and beyond, could be destabilised for decades. There could be no successful policy of energy dominance under those circumstances.
On the other hand, and US internal political considerations aside (the fact that the murder of Jamal Khashoggi came so close to the US mid-term elections was hardly convenient), permitting the Kingdom of Saudi Arabia to pay no penalty for what happened might be as potentially a grave mistake. That is because the untroubled succession from a now elderly but for the most part restrained and wise generation of ruling Saudi royalty to a younger and inexperienced generation is far from guaranteed. King Salman of Saudi Arabia is 82, and his lifespan is finite. Should a younger generation form the view that it can flout international norms of diplomacy and decent conduct, and treat its ally with unpunished contempt, then there is no guarantee that Saudi Arabia will continue to abide by any of the precepts of energy dominance inherent in its current tentative continuation of macroeconomic cooperation with the United States. The whole deal might unravel, leading to price shocks the political consequences of which for Saudi Arabia with its immature institutions would surely be far graver than the consequences for the United States with its sophisticated and time-tested institutions of democratic government.
There may be a more fundamental problem with the policy of energy dominance: China is not happy with it and is quietly doing everything it can to undermine it. That is because the policy sets hydrocarbon prices too high for China’s massive consumption levels. China wants to shift the global market in hydrocarbons from being producer-focused (as it always has been) to being consumer-focused. As the world’s biggest consumer of hydrocarbons, and with the world’s largest accumulated reserves, it may have the market power to do that. The introduction of the Shanghai Exchange may be a precursor to China engaging in buyers’ auctions for hydrocarbons as a means of driving down global prices. Pursued to its logical extreme, that would entail default upon the massive quantities of global hydrocarbon paper and hence global depression. Precisely because these consequences would be so grave, and would ultimately damage the Chinese economy as much as it would anyone else, China is likely to move cautiously in this regard. Nevertheless the underlying problem is systemic. Currency pegs are not sustainable, because eventually people run out of the money necessary to distort the market in maintaining them. The abortive recent attempt of the Swiss government to peg the Swiss Franc to the Euro is an illustrative recent example of this.
In the short term, the United States has no choice but to muddle along and hope that saner heads in Riyadh prevail. Saudi Arabian society relies upon cordial economic relations with the global economy, and international diplomatic outrages make that increasingly difficult. Some penalties must be applied to incentivise Saudi Arabia to move in the right direction, but they must be applied judiciously. The situation must be watched meticulously in Saudi Arabia, and in due course a decision must be made as to whether the House of Saud is a sustainable form of government for the bulk of the Arabian peninsula in light of the inter-generational transition. If it is not, then serious thought must be given to how to plan for dramatic change. This issue is fiendishly difficult.
In the medium term, the United States must diversify its reliance upon international oil markets. Energy independence was never a credible policy, because energy prices depend upon international price movements and the United States cannot and never has been able to act as an energy autarchy. But in what direction should the United States diversify? Iran is barely an attractive option, given the country’s irrationally aggressive foreign policy both in the Levant and towards Israel. Until Iranian political society has reformed itself internally, engagement with Iran does not seem a realistic option. Russia is another example of an unattractive partner with whom to diversify. Russia has its own Khashoggi moments, as the Skripal nerve poisoning affair in the United Kingdom illustrates. Russian economic and financial policy is arguably substantially more erratic than that of Saudi Arabia. Venezuela is yet another option, but the country Is run by an unreconstructed Marxist seemingly determined to, and succeeding in, driving his country, his economy and his people into penury and self-destruction.
Ultimately all of these putative partners for a US policy of energy diversification suffer from a similar problem: the question of transition in a country with weak institutions. Venezuela’s Maduro hangs on only because the country’s ostensible institutions of democracy are too frail to remove him. Russia’s Vladimir Putin is ageing, and all the talk in Moscow is of what happens in the course of the succession of power after his resignation or death. Iran’s polity is dominated by a series of ageing clerics, and as with Saudi Arabia it is not clear how a stable transfer of power can be effectuated. If regime change and intentional interference is typically ill-advised because we are too ignorant to know how to do it well, then we may just need to wait and see.
In the final analysis, the choices for the United States are stark. Should it consider generational transition in the House of Saud unsustainable irrespective of leadership, the United States should prepare itself for the hard-headed foreign policy decisions it will need to take to stabilise the Middle East in the face of a disintegrating wealthy Gulf monarchy. The United States will be more able to do this proficiently if it has extracted itself, insofar as is possible, from Wall Street derivative positions related to the Saudi economy, and the United States has found another partner to pursue energy stability. But on that scenario it may be better to ensure that Saudi Arabia’s disintegration is gradual, or at least deferred so as to give the United States time to extract itself. If Saudi Arabia’s disintegration is not viewed as inevitable, then the United States may be compelled to take a position upon how to influence restructuring of the succession while King Salman is still alive.
If the United States does decide to diversify, it may be a matter of choosing the least of various evils. Although the Maduro regime in Caracas probably cannot reasonably be dealt with, the domestic situation in Venezuela is so dire that regime change may be less costly and unreliable than in any of Russia, Iran or Saudi Arabia. Moreover Venezuela is closer to home, better understood and there is a more solid domestic US constituency to pursue it. Regime change in Iran would be highly uncertain by reason of the country’s large size, complex culture and difficult history in its relations with the United States and the United Kingdom. Russia is impossible to attempt regime change, because it is too big and too complex and Russian history has a habit of pursuing its own convoluted internal course irrespective of the attempted influence of outsiders. This is a depressing litany of options, but some selection of the foregoing appears now to be the choice facing the US administration’s policymakers.
*Matthew Parish is an international lawyer based in Geneva, Switzerland and a former UN peacekeeper. He has published two books and over 250 articles on the subject. In 2013 he was elected as a Young Global Leader of the World Economic Forum and he has was listed as one of the three hundred most influential people in Switzerland. He is currently a candidate of the United Kingdom of Great Britain and Northern Ireland for appointment to a position of Under Secretary General of the United Nations with an agenda for institutional reform.
The views expressed in this article do not necessarily reflect the views of TransConflict.
