Prices Transform Oil into a Weapon

Alongside the fear that high oil prices will dampen global economic growth lies another serious threat: It is increasingly likely that certain oil-producing states may use the valued fuel as a political weapon – and effectively so, according to Ian Bremmer. Given the current state of global markets, any interruption of output will likely drive up prices. At the same time, petro-states are confident that even if prices soar, demand will remain constant. These circumstances may prove tempting to an oil-producing state considering cutting, or threatening to cut, its supply to certain customers. Venezuela has already threatened to cut oil exports to the US, but Iran – with its rogue nuclear program and mistrust of Western governments – may prove to be an even greater danger. "In any case," Bremmer concludes, "developed nations' reliance for energy on some of the world's most politically volatile states – Iran, Venezuela, Russia, Sudan – creates ideal extortion conditions that favor some of the world's most unsavory regimes." – YaleGlobal

Prices Transform Oil into a Weapon

Ian Bremmer
Monday, August 29, 2005

NEW YORK Market concern that high oil prices will cut US (and global) economic growth may finally have reached a tipping point. From Wal-Mart's chief executive blaming lower-than-expected earnings on rising energy costs to reports that the International Monetary Fund foresees oil prices helping to dampen growth prospects for the eurozone, more and more analysts are warning that only the timing and the scale of the impact are now in doubt. Beyond the implications for markets, there is a related political risk. It's increasingly likely that oil-producing states may try to use oil as a weapon with which to achieve political goals.

There are two reasons that oil has become an effective weapon. First, there is very little spare production capacity in global oil markets. Both OPEC and major non-OPEC countries are producing at close to full tilt. Global markets are likely to remain tight for at least the next two or three years, and Chinese energy demand will continue to rise sharply. With global oil markets so taut, even small interruptions in output put disproportionate upward pressure on prices.

Second, petro-states are rethinking their assumptions about the elasticity of global demand for oil. When oil sold for $30 a barrel, they accepted the conventional view that substantial price hikes might lower demand - and hurt their bottom lines - as importing states actively looked for new sources of oil, energy alternatives and other ways to cut fossile-fuel consumption. Now that oil sells for well above $60 a barrel, without (so far) a sharp drop in demand, energy-exporting states are changing their minds. Some now believe they can push the price still further and increase profits without a drop in demand.

The danger is that these factors make it much more likely that an oil producing state with a political axe to grind will cut output to certain customers (or at least threaten to do so), essentially take a small amount of oil off the market, and profit from the resulting price hike. This sharply increases the market power - and political leverage - of oil-exporting states, even for marginal producers. That makes diplomatic disputes with these countries more difficult to resolve.

In fact, it's already happening. The United States imports some 14 percent of its oil from Venezuela. President Hugo Chávez has repeatedly threatened to cut exports to the United States if Washington continues to antagonize his government. Ultimately, Venezuela's oil economy remains so deeply integrated with that of the United States that Chavez would be hard-pressed to withstand the self-inflicted economic damage from a diversion of so much oil away from US ports. But in the current environment, prices rise on the threat alone.

The more substantial threat comes from Iran. The country's new president, Mahmoud Ahmadinejad, has made clear that he mistrusts Western governments and that Iran will continue to develop its nuclear program. Several members of his newly appointed hard-line cabinet, including the new oil minister, Ali Saeedlou, argue that US-led collusion with petro-states (especially Saudi Arabia) keeps even today's oil price artificially low. Indications are that if Iran's nuclear program is referred to the UN Security Council, Saeedlou, who has little energy-related experience, may threaten to divert oil exports away from countries that support the United States (Japan and Britain, in particular).

Iran's supreme leader, Ayatollah Ali Khamenei, may well impose some restraint on the use of oil as a weapon. And in any case, most of Iran's oil is traded on global markets. But Khamenei's intentions aren't clear. He may be less interested in market stability than in achieving political and security goals. And some of Iran's exports are dedicated to oil-reliant developed states. The mere threat of a reduction in energy exports - even if it involves only 200,000 barrels a day - could have enough impact on demand-driven markets to be considered the world's largest potential supply threat to already high oil prices.

In any event, the leverage the threat gives Iran makes it increasingly likely that Tehran will remain intransigent in negotiations over its nuclear program. So when Iran says it has options if the Bush administration chooses to escalate the conflict, it may well be right. Of course, if Iran overplays its hand, it raises the probability of a US or Israeli strike on an Iranian nuclear facility. That eventuality would certainly push oil prices higher.

Even if it becomes obvious that energy prices are slowing global growth, there may be little oil-dependent states can do in the short term to constrain demand. It's not at all clear that Saudi Arabia, the only viable swing producer, can bring new oil to market fast enough to match rising consumption. And, of course, the Saudis may not mind the increased profits from tighter supply either. In any case, developed nations' reliance for energy on some of the world's most politically volatile states - Iran, Venezuela, Russia, Sudan - creates ideal extortion conditions that favor some of the world's most unsavory regimes.

Ian Bremmer is president of the Eurasia Group and a senior fellow at the World Policy Institute.

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