Will Political Turmoil in the Middle East Destabilize Global Oil Markets?

Over the last 18 months, the Middle East has undergone a dramatic political transformation, even as several long-term trends that were already under way continue to reshape the region. As discussed in an earlier post, countries in the Middle East are more divergent and the sectarian divide between Sunni and Shia Muslims is growing, led by the rivalry between Iran and Saudi Arabia, two countries viewed warily by Israel.

At the same time, with a wave of untested Islamic parties assuming the reins of power in several key countries, massive demographic and economic pressures continue to mount and US influence in the region continues to decline.

Against this backdrop, professor Meghan O’Sullivan, director of the Geopolitics of Energy Project at Harvard’s Kennedy School of Government and an adviser for the campaign of Republican presidential nominee Mitt Romney, delivered a keynote address at the recent CLSA Investor Forum in Hong Kong in which she identified several short-term threats to stability in the region, as well as a number of longer-term risks that could prove destabilizing to global oil markets.

O’Sullivan, who also served as deputy national security advisor to US President George W. Bush, made the following predictions:

• Iran military strike on the horizon. A military strike on Iran’s nuclear facilities, either by Israel or the United States, is highly likely within 10 months of the November US presidential election, O’Sullivan believes. Iran continues to make progress toward developing nuclear weapons and has again turned down a diplomatic solution from the U.N. Security Council. A nuclear-armed Iran is, in her assessment, unacceptable to the United States, Israel, and their allies — not only for the threat Iran itself poses, but also because Iran’s acquisition of nuclear weapons could lead to nuclear proliferation in the Gulf region, an especially dangerous prospect given tensions between Iran and Saudi Arabia (and, more generally, between Sunni and Shia Muslims), O’Sullivan contended. Israel’s strike on Syrian nuclear facilities in 2007 and Iraqi facilities in 1981 were both met with little or no retaliation, she noted. But the Harvard professor expects that a strike on Iran would be met with significant, nonconventional retaliation. The Strait of Hormuz is the most important oil transit choke point in the world, and the Iranian military has built a strong presence there over the years, she pointed out. (Yesterday, in fact, Iran announced that it had test fired several missiles in the strait, and US President Barack Obama, speaking before the United Nations, said that a nuclear Iran “would threaten the elimination of Israel, the security of Gulf nations, and the stability of the global economy.”)
• No end in sight for Syrian unrest. The Syrian uprising will drag on, even after the current regime is replaced, O’Sullivan said. Sectarian tensions are spilling over into Lebanon and particularly into Iraq, which is now the second-largest producer of oil in the world. Any instability in that country would certainly affect oil markets.

According to O’Sullivan, Saudi Arabia figures prominently into the medium-term risks for global oil markets. In addition to being the largest producer in the world, Saudi Arabia is also the country with the largest spare capacity and is therefore key to stabilizing global oil supply in the event of any disruptions. King Abdulla has weathered the Arab Spring using both repressive crackdowns and patronage, she said, and has handed out an extra $130 billion in off-budget spending for wage increases, housing programs, and the like. Still, O’Sullivan argued that Saudi Arabia must confront several major challenges:

• Succession planning. There are hundreds of princes in the next generation vying for the throne, many of whom control different parts of the security services machinery. There is significant potential for severe conflicts during the transition, she said.
• Unemployment woes. Although annual growth has checked in at around 5% for five years in a row and the economy runs huge surpluses, Saudi Arabia has a massive problem with the “educated unemployed.” Almost 45% of college graduates can’t find a job, O’Sullivan said. Since 2005, the government has sent about 200,000 students abroad for tertiary education. These students are now returning — and new pressures for political reform could build if their career expectations are not met.
• Massive social spending needs. Given Saudi Arabia’s demographic and labor market challenges, commitments to social programs will need to be huge in the coming years, O’Sullivan said. She cited research from a local bank which concluded that by 2030 Saudi Arabia will require oil to rise to $300 per barrel in order to meet all of the country’s social spending requirements.
• Potential for sectarian strife. Saudi Arabia must manage internal sectarian conflict given its Shia minority in the eastern province, which boasts the highest oil production in the Kingdom. In addition to the country’s rivalry with Iran, Saudi Arabia may also increasingly come into conflict with Iraq as both countries vie for dominance of the global oil market.

O’Sullivan also identified the following longer-term risks to energy:

• Underinvestment. World energy security is declining, and geopolitics isn’t the only contributing factor. There is a decline in investment in oil production projects in the Middle East. That’s because, increasingly, foreign capital is encountering prohibitions or suffering significant discrimination as investors compete for oil and gas projects in the region. Meanwhile, domestic sources of investment capital are constrained as social programs get priority over upgrading oil production capacity. At the same time, domestic oil consumption is growing rapidly as countries in the Middle East attempt to diversify their economies away from the oil and gas sector by building industries that create more jobs, many of which are energy intensive. (One research report, O’Sullivan noted, has predicted that Saudi Arabia will become a net importer of oil by 2030.)
• Iran sanctions. Economic sanctions against Iran will take a long time to unwind, O’Sullivan predicted, even if there is a quick resolution of the nuclear issue. In the case of Iraq, she noted, sanctions that were imposed on the country after the ouster of Saddam Hussein won’t be unwound until this year — a process that has taken a decade. Oil production capacity in Iran will likely require a similar time frame before it is restored to originally anticipated levels.
• Social unrest. The young population of the Middle East could be an important engine of growth and prosperity, if appropriate reforms in education, youth training, and labor markets are implemented to restore balance from the mismatch of jobs and skills, and to encourage entrepreneurship by changing the cultural stigma of failure. Authorities recognize that the public sector cannot provide all the jobs that are needed, and they have been trying to shape policies and programs to nurture entrepreneurs in the region. Still, a lack of economic opportunity among Arab youth could lead to more social unrest.
• Increasingly complex business environment. In the past, there were just a few powerful families that controlled the economic levers in the Middle East. But with regime change, there are now more stakeholders and fewer opportunities for “one-stop shopping” when it comes to business deal-making. In Libya, for example, the political map remains unclear and the complexity of doing business could increase if the country opts for multiple layers of government (federal, state) versus a single, central government. In addition, many of the new constitutions in the region have ambiguities, and there are cases in which multiple investment regimes and legal frameworks are in place for the oil and gas sector — in the same country. Iraq is a case in point: Regulations in the Kurdish north are more business-friendly than in other parts of the country. There is also a rise in resource nationalism.
• US disengagement from the region. The Obama administration has been talking about moving toward a disengagement from the Middle East and pivot to Asia in its foreign policy. But this is easier said than done, O’Sullivan contended. The key long-term trends she identified in her talk strongly suggest that the Middle East will require a lot of attention from the United States over the next decade, and that the United States cannot seriously disengage without a huge cost to American interests.

In the last 18 months, challenges have become more evident in the Middle East, although the youthful population, energy resources, and the will of the people to bring about reform are all positive signs for the long term. However, in O’Sullivan’s view, investors should be very cautious when betting on a positive future in the short term.

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