Oil geopolitics isn’t a topic many would take natural interest in. Yet, I’m convinced it’s one of the most effective routes to understanding how the the world works. Why?
Geopolitics quickly becomes complex. The deeper you dive in, the more apparent its interconnectivity and transdisciplinarity becomes. It’s easy to get stuck in the Valley of Stupidity – where more knowledge and reading on the topic makes you feel less confident about how much you know.
Fittingly, analyzing geopolitics through the lens of energy allows one to observe the complex global system through first principles. Similar to the mantra of “to understand how the world works, follow the money,” we can also say “to understand how the world works, follow the energy flows.” Following energy flows enables us to establish bias-free ground truths. We can then build up additional more bias-prone facts, i.e. political issues – on top of these ground truths.
“To talk about energy and the economy is a tautology: every economic activity is fundamentally nothing but a conversion of one kind of energy to another, and monies are just a convenient (and often rather unrepresentative) proxy for valuing the energy flows.” – Energy and Civilization, Vaclav Smil
Since the most of our energy needs throughout the 20th century (and now) have been met by oil, it makes sense to understand oil.
Another benefit of studying geopolitics through the lens of is that oil as a commodity is very simple to understand. Unlike microchips or other rare earth metals etc. It’s pumped out of the ground, moved around, then turned into useful things, or burned to get machines to do useful things.
This is a four part series.
Part 1 (this post) covers 3 key points. One, familiarity with who the key sellers (net producers) and buyers (net consumers) are. Two, how the US has shifted from being the biggest importer to now the biggest exporter. All thanks to advances in extraction techniques (Shale Revolution) from around 2010. Three, the withdrawal of the US from the Middle East as a consequence of this.
Part 2, oversimplifies the messy mosaic of the Middle East. In particular, revealing that most conflict in the region today are mostly proxy wars between Saudi Arabia and Iran. This exemplifies key geopolitical challenges among rivals in an oil producing region.
Part 3 covers 2 key points. One, China’s geography challenge in securing energy supplies, and its response: the Belt and Road Initiative. Two, Europe’s adamant reliance on Russian energy. This exemplifies key geopolitical challenges for an oil importers.
Part 4 is more of an overflow that I’ve intentionally excluded to keep Parts 1-3 as lean as possible. This includes touching on how oil markets work, key points for other countries, non-state actors, and other ancillary factors such as the transition to renewables.
1. The fundamentals
Oil geopolitics reduced to first principles is really just the interaction of 4 factors.
(i) Source. Some countries have oil, others don’t.
(ii) Sink. Some countries need to import lots of oil, others are self-sufficient.
(iii) Route. Some countries control key shipping lanes, others are at the mercy of those that do.
(iv) Dynamics. Both absolute quantities and relative positions of each country for the above 3 factors perpetually changes over time.
So before we take a deeper dive into the geopolitical dynamics, we’ll first establish the fundamental facts. This includes understanding who the top producers and top importers are. Who has the most reserves. What the value chain looks like and who has the lowest production cost. How these rankings have changed over time, and the consequences of these changes.
But first we need to clarify that whenever I say oil, I’m really referring to crude oil. It’s the naturally-occurring black liquid that’s drilled out of the ground. It’s the raw, unprocessed form of oil that’s typically shipped around. Crude oil is then refined into other types of oil or materials – e.g. the transparent petroleum we’re more familiar with.
Why oil use is so widespread? Relative to other energy sources it’s cheap, easy to use, store, transport, and has reliable performance. Since it powers tanks, ships and planes, it also has crucial military importance.
Prices are typically measured in barrels (~160L). Note: not all crude is the same. Densities vary. But most crude is ~135kg/barrel. Prices fluctuate, but historically about $30-$60 per barrel.
The world produces about 90m bpd (barrels per day). Almost half of which comes from the top 3 producers – US, Saudi Arabia, and Russia.
Here’s a dynamic view on how this has changed over time.
The above shows gross production. However, for a more meaningful grasp on oil flows we should look at net production. That is, production minus consumption. This is a good proxy for net exports (assuming all excess production is exported rather than stored).
Below are the same top 15 gross producers in the order we saw above, but showing estimated net exports.
Ranked by net exports, we get the chart below. A more meaningful visualization than the gross production measures more typically quoted.
Oil production is a flow. Oil reserve is a stock.
Oil reserve: amount of crude oil confirmed by geophysical studies in a country’s territory that can technically be recovered at a feasible cost.
The reported amount of reserves a country has keeps changing because: (i) extraction technology keeps improving, (ii) economically feasible production cost depends on market prices, (iii) new deposits are discovered.
Venezuela and the major Middle Eastern producers have deep reserves.
1.3. Production unit economics and value chain
Looking at production volume alone as selling power is misleading. Not all production is equal.
We must also look at the unit cost of production, which varies substantially. Especially when measured as total cost including capital costs and taxes. This ends up being about $10 a barrel in Middle East, and about $20 elsewhere.
Cheap producers have more flexibility to engage in a price war.
And the broader value chain can oversimplified as:
(i) Production: Exploration, extraction, pay tax to producing country
(ii) Wholesale: Ship it, refine it. Only costs $1 to ship a barrel of oil to anywhere in the world. So proximity to oil sources is not a substantial geopolitical factor. While the distance of the shipping route is negligible, the security of the shipping route, however, is significant. More on this in Part 3.
(iii) Retail cost: Distribute it, pay tax to consumption country. An often neglected fact is that the oil importing Western countries actually make more money from oil taxes than OPEC producers. In 2014, taxes in G7 countries accounted for about 47% of the price of a litre of oil, compared to 39% going to producers (47/39 average ratio). 60/30 for UK, 52/34 for Germany, 15/61 for US.
Now the reverse. Top gross consumers:
But just as we distinguished gross and net production, it’s more meaningful to look at net consumption. Net consumption is a good proxy for net imports.
China clearly emerges as the country most thirsty for oil imports. More on this in Part 3 (coming soon).
No surprise, gross consumption correlates with GDP. Especially when measured in PPP (purchasing power parity) terms. Roughly speaking, $1 trillion annual GDP demands about a million barrels per day.
Looking at the biggest GDP countries above, note that the US and Russia have extremely low import reliance (net consumption divided by gross consumption). While China, India, Japan, Germany have very high import reliance. More on this in Part 3 (coming soon).
With the fundamentals covered, we can now dive into the first moving piece in the puzzle: the US and its recent “Shale Revolution.”
2. The US and the Shale Revolution
2.1. US crude production history
The US was actually the biggest oil producer since the 1860s through to the mid 1970s.
Then the Soviet Union became the top producer in the 1980s, before being overtaken by Saudi Arabia in 1990s and 2000s.
But the US reclaimed the #1 spot in 2015.
So what happened around 2010?
The glorious Shale Revolution.
2.2. The Shale Revolution
Conventional extraction techniques typically drill vertically and pump black gold from a reservoir pool.
Shale oil, in contrast, is trapped between shale rock formations, making it more difficult and expensive to extract.
Hydraulic fracturing i.e. fracking, is an ‘unconventional’ extraction technique where shale is drilled through horizontally, before forcing chemically treated water into the rock to release oil.
2 minute explainer video:
Another way of looking at it:
While this technique has been around since the 1940s, improvements made it commercially viable only a decade ago. This is what enabled the Shale Revolution.
Indeed, shale oil has higher production costs. At ~$25 a barrel, it’s almost triple Saudi’s.
So yes, most shale operations need crude prices to be around $40 a barrel to stay profitable.
However, this break-even price continues to trend down.
Additionally, shale oil operations are more responsive than conventional ones. It goes online really quickly and offline really quickly.
This means that US Shale can effectively act as a soft floor for global oil prices, as opposed to supply-side price determined by OPEC and the likes of Russia.
2.3. Net energy exporter
While the US is still a net importer of crude…
… in September 2019, it became a net exporter when also considering refined oil products (such as petroleum, diesel, jet fuel etc).
Add in natural gas, and the US’s net exporter status becomes more thoroughly pronounced. All thanks to fracking.
Consequently, the US has been importing less from OPEC, while keeping non-OPEC imports constant (although giving Canada a bigger share of wallet within non-OPEC imports).
Here’s another chart showing changing sources of US crude imports since 2000. Notice how much smaller the ‘blobs’ from Africa and Middle East get over time. From 2005 to 2015, Canada went from ~15% of US oil imports to ~45%.
2.4. Withdrawal from Middle East
Almost 200k troops were in Afghanistan and Iraq by the late 2000s. By 2011, most in Iraq withdraw.
And a couple years later, in Afghanistan too.
Unsurprisingly, US troop withdrawal from the Middle East coincides with the timing of the Shale boom. This is reflective of the drastically shifted energy security imperatives in the region.
Now there’s only about 70k US troops in all of Middle East. And with Trump’s contractionist stance on foreign policy, this figure is likely to decline even further.
We shouldn’t overplay this withdrawal though. Middle Eastern oil is still important to the US as the US needs to maintain its control to flows to other countries such as Japan.
Regardless, the US’s new net exporter status extends the range of possibilities for the role that US wants to play in oil producing regions. And whatever moves the US makes, it’ll have momentous second and third order effects on security and markets. When the giant sneezes, the world shakes.
Next, we explore the oil geopolitics of the Middle East, and the new global challenger to US dominance: China.
Exploring oil geopolitics is a useful approach to understanding how the world works for two reasons.
First, observing the energy flows within a complex system provides a first principles based perspective of that system.
Second, getting a grasp on oil politics prompts one to read up on and synthesize ancillary topics such as history, financial markets, and game theory.
Politics is about keeping, increasing, or demonstrating power.
It’s important to first understand where oil is produced and consumed before further exploring geopolitical dimensions.
US security imperatives in the oil-producing Middle East was largely shaped by its oil import reliance from the 1970s through to the late 2000s.
But the US recently reclaimed its spot as the world’s biggest oil producer thanks to new extraction techniques (the Shale Revolution).
Just a few years ago, the US became a net exporter of energy.
This extends the range of possibilities for the role that US wants to play in oil producing regions.
Whatever move the US makes, it’ll have momentous second and third order effects on the world.
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