13 February 2015

The Oil Price Is not a Very Good Strategic Weapon

By Lee Lane
February 11, 2015

The sudden surge of U.S. onshore light tight oil (LTO) production has not only been a spark plug for U.S. economic growth. It has also somewhat dimmed worries about American dependence on oil imports. LTO producers have shown that when oil prices are high, they can swiftly scale up production, while when prices fall, as they have recently, the producers quickly decrease investment levels. This nimbleness allows U.S. onshore drillers to shield the country from some or even most of the harm from supply disruptions.

To some observers, the U.S. LTO boom also represents a new weapon of economic warfare. Adherents of this view correctly note that at present, Iran and Russia are U.S. foes. Increased U.S. oil output tends to lower world oil prices, which in turn undermines Iran and Russia's oil wealth. They also bolster the effect of sanctions against those countries.

However, America also has dangerous rivals that are not oil exporters, and cheap oil may not be an unalloyed strategic gain for Washington. Take the People's Republic of China: Beijing engages in cyber warfare against the United States. Its growing anti-access/area denial arsenal threatens the U.S. Navy. It harasses U.S. allies Japan and the Philippines at sea, bullies Taiwan, and supports anti-U.S. rogue states seemingly wherever it finds them.

Yet China imports 57 percent of its oil - the United States imports just 32 percent. Hence, as oil prices fall, China may well gain relative to America. China poses a long-term, global threat to U.S. primacy. Indeed, the stakes in the U.S.-PRC rivalry greatly exceed those posed by the worrisome, but still largely regional, goals of Moscow and Tehran.

Beyond the ambiguous strategic value of low oil prices, the concept of oil prices as a weapon presumes that the world oil price is subject to more control than it is. Low prices tend to trigger negative feedback. For instance, they could disrupt already fragile exporters such as Nigeria and Iraq - Venezuela is in still more parlous straits. Should the output from any one of these countries fall substantially, oil prices could soar.

The risk tends to grow over time, as low prices cause high-cost producers to lose market share to those whose costs are lower but who are more prone to turmoil. Today, output from Canada and Britain is at risk, as is much of that from U.S. onshore sources. By world standards, LTO is costly to produce. By one estimate, in 2013 LTO producers used 20 percent of the world oil industry's yearly investment to produce just 4 percent of its oil.

Therefore, as world oil prices have plunged, U.S. producers have already begun to idle drilling rigs and lay off workers. If prices stay low, the cutbacks will speed up. By the second half of 2015, U.S. output growth may well end. U.S. producers will still produce hefty volumes of LTO, but they will certainly not free the world from dependence on oil from Russia or the Persian Gulf.

Many pundits lament what they see as overbearing Saudi influence over the world oil price. No doubt the Kingdom welcomes the effects of lower prices on Iran, ISIS, and the U.S. LTO producers. In truth, though, all the Saudis have done is to maintain their own output while the world market softens.

Nor did the Saudis have much choice. When Saudi Arabia has cut output in the past, its partners in the Organization of Petroleum Exporting Countries covertly exceeded their own production quotas, filching Saudi market share while thwarting the effort to defend the price. The Saudis have no need to relearn that lesson. They essentially refused to lead the OPEC price-fixing cartel; not on principle, but because they rightly distrust those with whom they would have to collude.

In time, higher prices could trigger new U.S. LTO growth, as might the development of lower-cost drilling techniques. Neither of these factors, though, is amenable to White House orders or U.S. statutes. That said, wasteful mandates from Washington are increasingly restricting drilling and needlessly raising its costs.

Reforms could, therefore, expand U.S. oil output. In theory, adherents of the oil-as-a-weapon concept might bring needed support to the reform cause, but their case also implies a narrow vision of U.S. foreign policy, and its grounding in reality is doubtful. Conversely, oil is clearly a vital fuel, and increased oil output is a source of GDP growth. The case for regulatory reform, then, might fare best standing on its own economic merits.

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