Energy Realpolitik

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In a sign that anxiety about oil security of supply isn’t what it used to be, the Group of Twenty (G20) meeting broke up this week with no big joint statements regarding how to protect the freedom of navigation in the Strait of Hormuz. From the sidelines, U.S. President Donald J. Trump said there was “no rush” and “no time pressure” to ease tensions with Iran. German Chancellor Angela Merkel said she advocated “very strongly” to get into a negotiating process on the Iranian situation. Chinese President Xi Jinping noted that China “always stands on the side of peace and opposes war.” The latter statement was a pretty mild one given that approximately one-fifth of the oil that passes through the Strait of Hormuz is destined for China. China has given no public indication that it plans to protect its own shipping. Roughly 60 percent of crude oil passing through the Strait goes to China, Japan, South Korea, and India. The biggest statement about oil that emerged from the G20 came from Russian President Vladimir Putin who announced at the sidelines that Russia had agreed with Saudi Arabia to extend by six to nine months a deal with the Organization of Petroleum Exporting Countries (OPEC) to restrain oil output to support oil prices. OPEC then announced at its July 2 meeting in Vienna it had agreed to extend the deal for nine months into the first quarter of 2020. In speaking about OPEC’s deliberations, Iran’s oil minister said OPEC was being used as a “tool against Iran” jeopardizing the cartel’s survival. Last year, Iran told other members it was considering quitting OPEC. These various events say a lot about how the geopolitics of oil has changed and the huge implications those changes have for Iran. A decade ago, countries from the Gulf Cooperation Council (GCC) were of the mindset that they would never let Russia become a member of OPEC. At the same time, Iran was also a major rival to the GCC countries in its overall influence on OPEC outcomes, and both Russia and Iran boasted of their relations with each other in bolstering their respective positions in Mideast regional conflicts. But the new reality is that countries like Saudi Arabia now feel that they can basically ignore Iranian sensitivities at OPEC gatherings and have increased incentive to align with Russia on oil, not only because of the pressing need for revenue but also because of the geopolitical benefits of driving a wedge between Russia and Iran. In turn, Iran may have less to offer Russia as Moscow’s relations with the Arab world continue to improve, except perhaps the possible threat Tehran can make trouble for Russia in Syria or along susceptible pipeline routes. U.S. sanctions against Iran have long been in Russia’s interests to prevent Iranian oil and gas arriving in Europe to compete for its market share. But, Russia has a difficult road to navigate in its relations with Iran and Saudi Arabia since it will want to keep itself an important power broker around many of the Mideast’s current conflicts. This keeps U.S.-Russian interactions on the topic of Iran a challenging one.  The results of the G20 and subsequent OPEC meetings highlight the bind Tehran is in. What will be its geopolitical lever if oil and gas, which might have provided in years past, is no longer working? The large market surplus of natural gas is working against Iran. Japan’s state firm Japan Oil, Gas and Metals National Corporation (JOGMEC), for example, just signed on to Russia’s Arctic liquefied natural gas (LNG) expansion, in a sign that many countries that might have bought natural gas from Iran are looking elsewhere. The expected rising supplies of U.S. LNG are another. Chinese firms have also slowed new rounds of investment in Iran’s oil and gas sector and are increasingly investing in China’s own clean tech industry instead. Iran has to concern itself with the fact that as the United States, Russia, and oil producers in the Persian Gulf region expand capacity, its own reserves may become more likely to become obsolete or devalued if oil demand peaks over time. All this raises the question about how a petro-state like Iran reacts to the possible weakening of oil as a strategic tool. Iran will want to show the world that it still has a bargaining chip beyond its own oil resources. Some analysts are suggesting that by boxing it into a corner, the Trump administration might actually incentivize Tehran to lash out to make clear it is too important to ignore in an effort to drive the United States and others to the negotiating table, much the way North Korean missile tests got President Trump’s attention. Most recently, Iran’s response has focused on restarting its nuclear program. Iranian President Hassan Rouhani announced Tehran would return to its previous activities at the Arak nuclear reactor if the remaining signatories to the nuclear deal do not fulfil their promises. Iran might decide to focus on fast tracking its nuclear program to assert itself and gain leverage at a future negotiation. Alternatively, if it gets no geopolitical traction from restarting its nuclear program, Iran could stick with its grey area attacks on energy facilities to make the point it still has hard power to bring to bear. To date, the rules of engagement on cyber warfare against such targets have been harder to establish. A cyber escalation would be a dangerous outcome that would leave the United States with hard decisions about what kind of precedents to set in an active cyber conflict since a large escalation could lead directly to attempted cyberattacks against the U.S. homeland. Oil markets are betting that Iran will not choose to continue to disrupt shipping through the Strait of Hormuz since doing so would clearly escalate into a military confrontation with the United States. A second possibility, which would require much more diplomacy, is that Iran’s oil woes could prompt its leaders to look at the world with colder realism and come directly to the diplomatic route. One reason that approach could be compelling is that perhaps the real lesson for Iran is not that of North Korea, but of Venezuela whose oil industry is now decimated from years of corruption, lack of financing for maintenance, and an exit of foreign investors. As Mideast oil expert Sara Vakhshouri wrote in a report for the Atlantic Council in 2015, “Most of Iran’s oil fields are old and mature, which means they require further investment and treatments like gas reinjection, in order to maintain current production levels. The country’s oil wells are mostly in the second half of their lives, and are facing continued natural depletion of production capacity at the rate of 8-11 percent per year. It is estimated that Iranian oil fields lose between 300,000 to 500,000 b/d of natural reduction every year due to maturity of fields.” With its oil exports further curtailed this year, Iran should worry about not only losing market share today (and for however long it takes to restore its position in the global economy), but also the possibility that output drops could cause it to lose productive capacity more permanently if oil fields are damaged from forced production curtailment or reduced spending on maintenance over time. As Iran can see from its current failure to incentivize relations with Europe, Russia, India, China, and Japan by offering future stakes in its oil sector—a strategy that worked in the past but is apparently no longer effective—time is not on its side when it comes to preserving its future oil and gas sector opportunities.

I woke up this morning thinking I would write a blog explaining just how challenging it would be for Iran to close the Strait of Hormuz for a prolonged period of time. This is not to say that there could not be a battle in the waterway: Iran has lots of conventional weapons, including mines, submarines, a large fleet of speed boats (think the USS Cole bombing), torpedoes, and missile batteries. But I thought to myself, why would Iran want to give the U.S. military the rationale to target Tehran’s largest military assets and destroy them? Then I saw a news report that a short range Katyusha missile hit a site very close to ExxonMobil’s operations center in southern Iraq, near the Zubair oil field, where Italian oil firm ENI is helping restore production capacity. Royal Dutch Shell also has personnel in the area. That brought me back to my father-in-law’s favorite expression “Too clever by a half.” For those of you who don’t know that term, the internet defines it as meaning “annoyingly proud of one’s intelligence or skill and in danger of overreaching oneself.” I don’t think that definition, though accurate, does the phrase justice. The formal definition doesn’t fully convey the high level of arrogance and stupidity involved when someone makes an incredibly large mistake because they think they are outsmarting someone when in reality they are about to create a huge disaster for themselves. Now you could be wondering: Am I talking about Iran or the United States? Let’s talk about both. Iran is so used to working through proxies with no consequences on its ruling elite or its physical motherland that it believes that it can offer these endless, faceless “sabotage” operations with impunity.  On the flip side, the United States is used to stationing an aircraft carrier somewhere and believing that it is a solution to small-scale attacks (e.g. weaker party doesn’t want an actual military engagement so they back down). This, however, fails to recognize that force projection in the age of asymmetric warfare may not be the most effective deterrent. It begs the question of “proportional” response. Iran is hoping for that messy debate. That is why it appears that Iran could be selecting discrete high-value targets with methods that are hard to fingerprint.  That brings me back to Iran’s original threat, when the United States announced it was withdrawing from the Joint Comprehensive Plan of Action (JCPA) nuclear deal and reimposing sanctions on Iranian oil exports. Iranian President Hassan Rouhani said “If one day they [America] want to prevent the export of Iran’s oil, then no oil will be exported from the Persian Gulf.” And that brings me to my favorite parenting advice for raising a two-year old. Don’t threaten something if you don’t intend to carry it through. As the United States considers the uncomfortable decision on how to convey diplomatically or, in the worst case, militarily that continued attacks on oil installations across the Persian Gulf will not be tolerated, it needs to acknowledge that Iran has many ways to harass oil exports to the international market. As I wrote previously, referring to all these efforts as “sabotage” underplays their significance. The inventory of oil attack events to date is starting to be extensive. It includes attacks on shipping via missiles from Yemen, attacks via missiles in Iraq, attacks on oil and petrochemical feedstock shipping with limpet mines, attacks on regional oil facilities using drones, notably in Saudi Arabia, several major cyber incursions against the Saudi oil and petrochemical industry, and sabotage activities that led to explosions on oil pipelines across the region, notably in Bahrain. Then there is the possibility that the contamination of oil coming from Russia to Europe was more malicious than it appeared. I have written a book with economist Mahmoud El-Gamal on the close linkages between the seminal business cycle, the oil price cycle, and Middle East geopolitical violence. We updated that work in a journal article that highlights how the more lasting impact of war-related damage to oil facilities is endemic to lasting oil price volatility. The problem for both the United States and Iran is that the global rules of engagement for asymmetrical attacks on energy facilities are extremely unclear. If the United States hits Iran with traditional fire power against Iranian military targets to deter further conventional attacks on oil exports, will that address the cyber domain or not? Does cyber have to address cyber? The patterns of engagement are unclear and that is dangerous for all concerned. That lack of clarity raises the stakes of a miscalculation, especially on the Iranian side. The anonymous declaration this week in the New York Times that the United States military is stepping up its digital incursions to Russia’s electric power grid highlights the challenge of deterrence. Iranian cyber incursions into U.S. infrastructure date back many years. There is a tendency among geopolitical commentators to dismiss the usefulness of diplomacy in stale conflicts. One often hears talk that there is little possibility for a reset of the Iran nuclear deal, hence no point to dialogue between the United States and Iran either directly or through intermediaries. This is clearly incorrect. The problem with that logic is that diplomacy is often needed so countries do not misunderstand the progression of events that could result from a string of ambiguous situations. In the case of asymmetric attacks on energy, diplomacy is sorely needed to define those ambiguities and bring transparency to what constitutes a clear and present danger.