Energy Realpolitik

In early 2003, when debate was surfacing in the United States whether to invade Iraq, a Council on Foreign Relations working group drafted a monograph outlining the problems that such a policy would face. As I explained at the time as part of that effort, Iraq’s oil industry was in tatters and it would take years, not months, to restore it. It was clear prior to the 2003 war that Iraq’s oil could neither pay for the war, nor be nearly enough to fund its reconstruction. Given the news that the United States has recognized the speaker of the democratically elected National Assembly Juan Guaido as interim President of Venezuela in defiance of ruling strongman Nicolas Maduro, the question about how long it would take Venezuela to restore its oil production under a new government is likely to arise. Like Iraq, Venezuela will need massive amounts of money to rebuild deteriorated national infrastructure. Also like Iraq, Venezuela’s oil industry has suffered serious damage, and the damage could arguably be harder to restore than in Iraq. The invasion of Iraq took place in 2003. Iraq’s oil production is now gaining ground, but that positive trajectory took almost a decade to establish, as seen in figure 1.  It might seem relevant to note that Iraq faced a destructive war in 2003, followed by years of civil war and more recently, a battle to expunge ISIS and therefore its oil installations took a military beating that won’t be analogous in Venezuela. That is certainly true. But the fact is that there has been tremendous violence on the ground in Venezuela with multiple armed groups looting and raiding the country’s key infrastructure, and the oil sector has been targeted across the country. The violence has caused many of the international oil companies previously operating in the country to withdraw. One challenge that will face any new government, were one to be able to emerge, is that there are multiple renegade armed groups operating inside Venezuela, including Cuban mercenaries and others deeply entrenched in drug trafficking. This has made and will continue to make guarding Venezuela’s oil industry a major challenge. Further complicating any oil sector transition, the Venezuelan military has virtually taken over as the gate keeper on the operation of the oil industry. The employment ranks of state firm PDVSA is said to now total as many as one hundred and sixty thousand people, up from its normal ranks of forty thousand in the years prior to the election of Hugo Chavez. Organizations like the Military Corporation for Mining, Petroleum and Gas Industries (Camimpeg) created in 2016 actively intercept the flow of income from the oil sector. Camimpeg’s soldiers have been working to suppress strikes by oil workers unions at oil fields around Lake Maracaibo, and Petroleum Intelligence Weekly is reporting that soldiers often siphon off barrels and engage in illegal smuggling for payments for stolen oil being included at Venezuela’s ports in larger shipments to Russia and China. Last week Guaido bravely told a public rally that “We will not permit the continued use of public funds by a gang of thieves so they can continue stealing,” but acknowledged that gaining control of Venezuela’s offshore assets like Citgo Petroleum in the United States would take time. In fact, Guaido’s opposition government will need time to develop the leadership and capable administrative staffing that it would require to run an industry as technically complex as oil and gas.   The condition of Venezuela’s oil industry is dire. Of its four refineries, only one is running. Fires, explosions, looting and mis-operation has shuttered most of Venezuela’s refining capacity. Refining throughput is estimated at just under three hundred and fifty thousand barrels per day (b/d), mainly from the large Amuay Bay facilities, compared to its prior operational capacity of 1.5 million b/d. The Cardon, El Palito and Puerto La Cruz facilities face equipment failures and manpower shortages. PDVSA has also abandoned the Isla refinery on the Dutch Island of Curacao, which it had operated under a lease. The refining problems have led to gasoline and diesel shortages across Venezuela. Venezuela has experienced a sharp oil production decline over the past two years, dropping from 2.2 million b/d in early 2017 to about 1.1 million b/d currently, as is seen in figure 2. The declines result from chronic technical mismanagement and underinvestment in the sector over a decade or more and massive arrears to suppliers such as international drilling companies and equipment suppliers who have slowed activity in Venezuela over the past year or so to limit unpaid bills. Other more recent problems are also taking their toll, including shortages of basic equipment, logistical problems on export loading ports, corruption, and labor unrest, worker desertions, and mass resignations. Historically, Venezuela’s conventional fields near Lake Maracaibo have required constant intervention because their natural decline rate is among the highest in the world at 25 percent. Venezuela’s heavy oil extraction operations are labor and equipment intensive and requires cash purchases of diluent on the international market. Estimates are that it would take an injection of over $20 billion of new investment to reverse the current downward path on production. Given this cost, the extent of existing damage, and the deterioration of PDVSA’s workforce, a reversal of Venezuela’s oil industry woes might prove more difficult even than war-torn Iraq.      The United States had previously banned U.S. entities from trading in new Venezuelan government debt beyond the thirty days customary for letters of credit for oil trade. U.S. entities were similarly banned from trading in existing debt held by the Venezuelan government as well as trading in new debt instruments with maturity beyond ninety days. Citgo, as a U.S. entity, was forbidden to make financial distributions back to Venezuela. Last week, U.S. National Security Advisor John Bolton reiterated the Trump administration goal to disconnect “the illegitimate Maduro regime from the sources of its revenue.” With the U.S. recognition of Guiado as interim President of Venezuela, one option will be to establish a special purpose bank account for the opposition government in the United States, to include revenues that involve payments by American firms involved in business dealings in Venezuela. U.S. refiner Valero has been a major importer of Venezuelan crude, and Chevron Corporation has ongoing oil field operations in the country. The U.S. Department of State has already served notice to the U.S. Federal Reserve to recognize Guaido as the primary agent for access to Venezuelan financial assets in U.S. banks.  The practicalities of implementation remain to be seen. There is speculation that Venezuela will stop shipping any oil to the U.S. including to Citgo to avoid transfer of any funds to the Guaido-led interim government. That means in effect the current U.S. actions have already in effect embargoed imported Venezuelan crude to Citgo and other U.S. buyers. In a sign that Maduro regime is already taking a different approach, state PDVSA issued a tender early last week for the open market sale of four million barrels of Venezuelan crude oil slated for delivery in late January and into February. Black market sales of oil and refined products either by truck or otherwise have been a staple of declining oil regimes over the last few decades, and could possibly sustain Maduro with some cash even if his regime has difficulty maintaining official government exports. The situation with Citgo Petroleum is also a sticky problem with the Trump Administration. The wholly Venezuelan owned U.S. refiner also imports crude oil from Venezuela and purchases Canadian and other crude oil for its three refineries. Citgo is among the largest U.S. branded gasoline marketer in the United States. Citgo’s refineries produce roughly 4 percent of U.S. refined petroleum products. At its peak, Citgo supplied close to 9 percent of annual sales of U.S. retail gasoline. The firm is a major supplier to the Chicago area. Prior to the recent political events, investors who hold Venezuela’s unpaid bonds in Citgo had been organizing and were expected to push for a restructuring. Canadian miner Crystallex won a legal judgement against Venezuela last year that would have facilitated it to seize and sell Citgo as compensation for Venezuela’s 2007 nationalization of a gold mine. Venezuela still has $1.5 billion in settlement payments to make to ConocoPhillips as part of its 2007 nationalization of the American oil company’s assets in Venezuela’s oil sector. It is unclear how the unraveling of Citgo’s financial structure would proceed under a new Venezuelan government. Guaido has specifically announced plans to create a new board for Citgo but has been mum on how it might restructure the liens against the company’s assets and revenues. In 2016, Caracas used a 50.1 percent stake in Citgo as collateral for new bonds. Russian state oil firm Rosneft also has a $1.5 billion lien on the other 49.9 percent share of Citgo. Additionally, Venezuela remains highly indebted to China, which extended over $60 billion in aid during the rule of Hugo Chavez. To date, Venezuela has been repaying this latter debt slowly over time in the form of oil shipments. Geopolitically, the oil situation in Venezuela presents a difficult and complex challenge for U.S. diplomatic and treasury officials. On the one hand, the United States is helped by the fact that the Organization of American States (OAS) issued a resolution declaring Nicolas Maduro’s January 10 reelection “illegimate.” The United States has been leaning on allies and the United Nations to address the humanitarian emergency that has been created by the exodus of several million Venezuelans to neighboring countries. But China and Russia, which have invested heavily in the Maduro regime, are likely to push back on efforts to topple it, arguing at the U.N. Security Council that wider intervention is interfering with sovereign internal affairs. Both countries are heavily embedded in the Venezuelan oil sector.   Given the complexities of how Venezuela has tried to insulate itself over the years from U.S. pressure using friendly oil investors as leverage, it will be tricky for the Trump administration to proceed to back a Guaido presidency without creating a disruption in Venezuelan oil production and exports as an unintended result. Presumably, a new government would be in a position to receive some debt forgiveness combined with a broad restructuring of its government debt. In doing so, the demands of Russia and China will have to be factored in to ensure a lasting resolution of Venezuela’s indebtedness. The obvious importance of Citgo inside the U.S. refining system and as a key preserved asset for Venezuela should give pause to all parties about the relative stakes of failing to find a creative diplomatic solution to the current stand-off. Implementation of a political transition on the ground inside Venezuela, given the multitude of rogue military gangs operating within the country, may still make geopolitical deal-making just the tip of an iceberg for restoring stability to either the country and to its oil industry.  

This is a guest post by Benjamin Silliman, research associate for Energy Security and Climate Change at the Council on Foreign Relations.  Earlier this month, the U.S. Department of Defense (DoD) released a congressionally-mandated report detailing the challenges climate change poses to the U.S. military. Citing increased exposure to recurrent flooding, drought, desertification, wildfires, and thawing permafrost, the report highlights how climate change affects U.S. military readiness to respond to national security emergencies. The report includes a list of selected events where mission related activities at military installations were compromised due to environmental vulnerabilities as well as a brief list of policies taken to mitigate future damages. To quantify the extent to which the military is threatened by climate change, the report tracked seventy-nine priority American domestic installations chosen by their critical operational roles. While the public report was circumspect on details given the sensitive strategic nature of the subject, it did identify climate change as an important and tangible threat to the U.S. military. The report represents another in a series of public acknowledgements that spans four administrations that the military is not immune to extreme weather. Last year, numerous concrete examples raised public awareness of the issue. In October, category four Hurricane Michael thrashed the Florida coast with winds reaching one hundred and thirty miles per hour on Florida’s panhandle. In its way was U.S. Air Force Base Tyndall, which houses not only the headquarters of the Florida Air National Guard, but also the 325th Fighter Wing, a major combat force of F-22 Raptors and a principle training center and testing site for their pilots, maintenance crews, and equipment. The base, like surrounding civilian areas, was not able to regain a normal operating status for almost a month. During the recovery period, critical training and maintenance schedules for the almost a third of the nation’s F-22s was disrupted, forcing the fighter jets to relocate to other regional airbases less able to run such a high volume of them. Additionally, rebuilding has been costly and time consuming, thereby diverting man-hours and resources that could have been spent on other matters. The situation starkly demonstrates how a severe weather event can be tumultuous for critical but routine activities such as patrolling and training. Tyndall is not the only base exposed to weather related threats. Of the seventy-nine installations analyzed in the report, 67 percent reported that they are currently facing problems from recurrent flooding, and 76 percent reported that flooding has the potential to create vulnerabilities in the next twenty years. Acute extreme weather events, like hurricanes, have a higher probability of occurring in the future due to climate change. This means there is possibly more stress that could come to Tyndall and other coastal bases in the future. California’s wildfires have also taken their toll on nearby military bases. The Marine Corps Mountain Warfare Training Center, which is based near the Sierra Nevada, was forced to evacuate in September of last year when wildfires got too close. According to the DoD report, 46 percent of the installations analyzed are now vulnerable to wildfires. This is in addition to facility vulnerabilities from drought, which, in turn, increases the risk of fire in Western Regions of the country. Stressed water supplies from extended periods of drought can also require contingency planning for when bases are must be temporarily put out of commission. Of course, protecting operational bases against severe weather events is not the only worry the military has in the face of climate change. The warming of the poles has also opened a new strategic landscape which directly connects the United States and Canada to Russia and China via the Arctic Ocean. As ice that used to cover the ocean melts and it becomes possible to move significant traffic through the area, policing the region against China and Russia will become a critical, and expensive, mission for the U.S. Navy. Arctic ice melt will also increase the extent to which foreign military vessels have access to North American shores. Beyond direct U.S. military activities related to the homeland, the DoD report mentions that the U.S. military carries out significant humanitarian and disaster relief efforts, as directed by the United States Agency for International Development (USAID). If climate change does lead to an increased severity of global natural disasters, the military may need to expand its capacity to deal with traumatic events in different parts of the globe, on top of expanding requirements and strains at home. Climate change also threatens increased destabilization in regions outside of the United States, which may put strain on deployed troops or even require U.S. military intervention. Sea-level rise could threaten rapidly developing cities along the coast of Africa like Mogadishu, Djibouti City, and Mombasa with damaged infrastructure and compromised water supplies. Any major displacement from these major cities would be a geopolitical risk and put even more strain on the already stressed global immigration channels. This could also cause an increase in piracy if economic conditions deteriorate around the Horn of Africa. With so many present and future challenges being exacerbated by changing global climate patterns, it is important that military leadership internalize these threats and examine the entire military system to prepare for the challenges it will be facing. The DoD report lists some of the activities currently being undertaken by the military. Major initiatives include designing construction standards to better withstand natural events and developing research programs to better understand facility risks from environmental vulnerabilities. However, the report was very limited in its scope as compared to the mission of the DoD. For example, it neglected to cover international installations or the Marine Corps. It also did not provide congress with strategies to prioritize resources for mitigating future threats. Moving forward, the DoD should expand on the initial report to fill in missing gaps and provide congress with more actionable budget recommendations. Specifically, DoD should develop and maintain a separate fund dedicated for research and systematic improvements to address these environmental vulnerabilities. The DoD should also commission robust studies for each Geographic Combatant Command to better understand how climate change may impact each region of the world in which the United States has strategic or militaristic interests. This will be important for understanding how climate change could impair access or movements of deployed troops and equipment and allow the military to improve planning for future types of climate-related missions the military may have to conduct. Contingency plans are needed for vulnerable bases that might need to be evacuated or otherwise go offline due to a natural disaster. Dangerous skepticism at the highest levels of political leadership can still limit the DoD’s ability to respond adequately to the changing world. The report was sent directly to Senator Jim Inhofe, chairman of the Committee on Armed Forces, who is notable for his speeches on the Senate floor denying the existence of climate change. What Congress decides to do moving forward from this initial report could have lasting implications for national security. Congress could call for more robust analytical reports and create new funding channels to drive research and preparation for environmental specific threats, or Congress could ignore the report, claiming satisfaction, and leave the military scrambling to work on this important issue by diverting resources from other budgets and performing sub-par preparation. So far, little news has surfaced from Congress about the report, indicating that it may be business as usual for the DoD.

Mohammed Barkindo, Secretary General of the Organization of Petroleum Exporting Countries (OPEC), is worried about the U.S.-China trade war. Even though oil prices seem to be stabilizing, Barkindo told CNBC News that OPEC was “concerned about the lingering trade disputes.” Last week, it was reported that China’s car sales fell by 6 percent in 2018, the first annual decline seen in more than twenty years, amid signs that China’s economy could be slowing down and consumer sentiment turning more pessimistic. Chinese oil demand, which represents over 12 percent of total world demand, is a linchpin to global oil markets. When China’s economy slows significantly, the effect on oil prices can be dramatic, potentially leading to single digit prices, which has happened in the past. Typically, an economic slowdown in China has historically sent shockwaves through the rest of Asia, weakening oil demand across the region. Oil traders, OPEC, and just about everyone else is hoping that Beijing’s planned stimulus will be sufficient to turn trends around, staving off what is feared to become broader global recessionary pressure. But this time around, the situation is more complex than what a Chinese stimulus could be able to address. Larger, more geopolitical issues are looming. These geopolitical factors will be harder to resolve and could easily become structural. Bruce Jones of Brookings argues that U.S.-China relations are at a turning point which he defines as the “closing of an era of expanding cooperation.” Jones argues that President Xi Jinping’s more assertive global and military strategy, combined with his crackdown on domestic dissent and internment of Xiajiang Muslims, is prompting a reevaluation of China, not only by the Trump administration but by a larger cross section of American political leaders, academia and business leaders. The previous American assumption that the deepening of commercial, diplomatic and cultural ties between the United States and China would transform China into a status quo power and liberalize China’s internal political development is now being seriously questioned. China’s flirtation with consumerism has not produced a society trending to openness and its nascent local environmental movement has not spurred on democratic principles, as previously supposed. Rather, what was ten years ago a decentralizing political culture has snapped back to central authoritarian rule revolving around a strongman leader who has removed term limits for his post. In a sign that progress on trade issues is not moving in the right direction, the U.S. Department of State and Canada’s Foreign Ministry recently issued a travel warning for China due to arbitrary enforcement of local laws and possible special restrictions on U.S.-Chinese dual nationals. The warning comes in the wake of the arrest of Meng Wanzhou, the chief financial officer of the giant Chinese tech firm Huawei, in Canada, at the request of the United States. The Chinese firm, China’s largest telecom equipment maker, has been under U.S. investigation for alleged violations of American trade control laws with Iran. China issued a similar warning to some of its state-run companies to avoid business trips to the United States, Britain, Canada, Australia and New Zealand.     The arrest of Meng Wanzhou is just a small part of a larger policy afoot to rein in China’s voracious appetite for sensitive American technologies. The Trump administration is giving high priority to the U.S. national security implications of China’s push into artificial intelligence, automation, and information technology as well as Beijing’s willingness to gain sensitive U.S. technology by a variety of means, including outright intellectual property theft. Last year, the Trump administration blocked Broadcom, the Singapore-based chip maker, from taking over American firm Qualcom, citing Broadcom’s relationship with foreign entities such as Huawei. The U.S. Commerce Department also banned Chinese telecommunications equipment firm ZTE from using U.S. components amid accusations that the Chinese firm had violated U.S. sanctions against Iran and North Korea. The ban was lifted after ZTE paid a hefty fine, replaced its leadership and agreed to U.S. compliance inspections.  But the U.S. administration’s views on U.S.-China trade are wider than the specifics of telecommunications technologies like 5-G. At issue is a broader view on the security of globalized supply chains. Some louder voices inside the administration’s internal U.S. trade policy debate argue that the United States should shrink dependence on China for U.S. and global supply chains. They argue that China’s massive Belt and Road Infrastructure Initiative (BRI) and its industrial policy, China 2025, could threaten the U.S. ability to maintain reliable and cost competitive cross border trade on which the U.S. economy and the military rely. Disruption to U.S. international supply chains could have serious consequences for the U.S. economy, jobs and the competitiveness for U.S. companies, for example, as became apparent for businesses that relied on components produced in Fukushima, Japan when it was hit by a tsunami back in 2011. The U.S. military is also vulnerable to supply chain disruptions involving materials and products from China, especially strategic minerals. Conservatives are starting to beat the drums regarding these risks. China’s BRI has proven an effective mechanism to get Beijing preferential access to investments in ports and other transportation infrastructure. Almost 70 percent of global container traffic flows through Chinese owned or Chinese invested ports, according to a survey by the Financial Times.  But China’s investment in logistics businesses include more than sea ports and warehouses. It also covers energy infrastructure and pipelines, trucking, railways, airports, and shipbuilding. The United States has been forced to respond with an infrastructure fund of its own, despite President Trump’s previous distaste for foreign aid programs. But it is unclear if the U.S. will be able to counter the pernicious financial devastation that can be wrought when a major Chinese infrastructure project goes badly in the developing world, especially in oil for loan deals in Latin America and Africa. It is important to understand this wider context when evaluating how U.S.-Chinese trade negotiations could progress in the coming weeks. Temporary hiatus in conflicts has been seen as good news for oil exporters but it could belie larger problems ahead. If the United States is thinking about how to dismantle its reliance on Chinese supply chains, it is safe to assume Chinese strategists are doing the same. That’s bad news for American oil and gas firms that were counting on China as a steady customer for rising exports. China’s imports of U.S. crude oil averaged 377,000 barrels a day (b/d) in the first seven months of 2018 but were zero by September of last year. That’s out of over 2 million b/d of total U.S. crude oil exports and 9.6 million b/d of Chinese imports. U.S. sales of liquefied natural gas were only 4 percent of China’s total 1.53 million tons of LNG imported in 2017, but tellingly, were the third largest market for U.S. sellers. Going forward, U.S. oil and gas exporters alike were expecting their sales to China to be much higher. Access to the Chinese market was also considered critical for the success of future natural gas export projects in terms of financing and end-demand. Lingering uncertainties about U.S.-China trade issues are making it harder for American LNG export promoters to push forward credible deals to beat out Qatari and Russian gas sales ahead of looming multi-year contract renewals. It’s not just the threat of more tariffs that could plague U.S. industry in the future or even the slowdown in Chinese demand for oil and gas more generally, though these would be a problem for U.S. producers as well. It is also that the rougher the U.S.-China divorce over technology supply chains and logistics infrastructure, the less likely China will feel comfortable relying on American oil and gas supplies. The days when U.S. and Canadian energy to China could have seemed like among the most secure sources could well be over, at least for now, reducing the value to Chinese firms of a 5 year or 10 year contract with an American firm, even if backed with an invitation for an upstream or export facility equity investment. A temporary truce in the trade war could produce an immediate home for some U.S. spot cargoes in China, but it’s going to be hard to inspire confidence for lengthier contractual commitments.  American oil and gas will have to shift to other markets. At first glance, this could seem like good news for Russia or Saudi Arabia who will have an easier time selling energy to China. But the longer process of dismantling of intensive trade links between the United States and China could eventually produce major headwinds to both the U.S. and Chinese economies. As markets start to wake up to such risks, it will be harder for the price of oil to rally, even with supply cutbacks. OPEC Secretary General Barkindo expressed "cautious optimism" on U.S.-China trade disputes being favorably dispensed because both countries “want to see these issues resolved.” But chances are it will be a long, drawn-out process of recalibration.