Oil and the Iranian-Saudi “Cold War”

One of last month’s most interesting developments in Persian Gulf power politics played out not in the Middle East, but in Vienna, Paris, and Washington.  For these Western cities were the venues for an important series of exchanges that revealed much about the changing balance of power among the Middle East’s major oil producers, including the Islamic Republic of Iran and the Kingdom of Saudi Arabia.  In particular, these exchanges underscored how Saudi Arabia’s current regional strategy — which we have previously described as “counter-revolutionary” — is weakening the Kingdom’s position.

Saudi Arabia came to last month’s OPEC ministerial meeting in Vienna determined to get the oil producers’ group to raise production quotas for member states, in order to lower oil prices around the world.  The Saudis have long had a more conservative view of the price elasticity of demand for crude oil than their OPEC brethren.  Under current circumstances, however, the Kingdom had a number of other reasons for wanting to engineer a reduction in oil prices — something that the United States and other Western countries were eager to see.

Among other considerations, lowering oil prices is seen in Riyadh as a way of increasing economic pressure on the Islamic Republic.  In this regard, it is useful to review the speech given last month by Prince Turki al-Faisal (Saudi Arabia’s former intelligence chief and Ambassador to the United States, whom we know and regard as a highly capable diplomat, strategist, and defender of the Kingdom’s interests and regional position) to a closed-door gathering of U.S. and British military officers at a NATO air base in the United Kingdom.  According to the Wall Street Journal, which obtained a copy of Turki’s remarks, the Prince told his audience that “Iran is very vulnerable in the oil sector, and it is there that more could be done to squeeze the current government.”  More pointedly, Turki said that “Saudi Arabia has so much [spare] production capacity — nearly 4 million barrels per day — that we could almost instantly replace all of Iran’s oil production.”

Additionally, Saudi officials apparently hoped that, by getting OPEC to raise production quotas, it might be possible to “de-throne” Tehran as the long-time holder of the group’s second-highest production quota (after Saudi Arabia).  Iran currently has little surplus productive capacity which it could quickly bring on line to take advantage of an increase in its own quota.  Thus, if OPEC agreed to raise members’ quotas, Saudi Arabia and its allies could argue that the increment by which the Iranian quota would prospectively be increased should be distributed among other members — members which could actually fill it.  This would be an important symbolic defeat for the Islamic Republic — and, just as importantly, a defeat inflicted on Tehran by Saudi Arabia.

Understandably, the Islamic Republic came to the OPEC ministerial meeting determined to keep these things from happening.  Given the Kingdom’s long acknowledged leadership role in OPEC, most Western oil market analysts assumed that Saudi Arabia would be able to deliver an increase in production quotas.  Many traders acted accordingly; the price of oil traded through so-called “futures” contracts went down in the days leading up to the meeting, reflecting the market’s sense that OPEC would agree to increase production quotas, thereby setting the stage for higher production by Saudi Arabia and other member states.

But, once the OPEC ministers got down to business in Vienna, things turned out differently from what many analysts and traders had anticipated.  Other Gulf Arab producers, like Kuwait, supported the Saudi position.  But, to put it simply, the Islamic Republic won the battle.  With strong support from Algeria, Angola, Iraq, and Venezuela, Iran turned back the Saudi initiative for OPEC to raise production quotas.  Iran’s OPEC governor, Mohammad Ali Khatibi, reported that the Saudis “were very angry” at the outcome.  This seems highly plausible, as the Kingdom’s long-serving Oil Minister, ‘Ali Na’imi, said publicly that the June meeting was “one of the worst meetings we have ever had.”

In the wake of the Vienna meeting, Saudi Arabia announced that it would break its own OPEC quota, so that it could unilaterally increase production, from roughly 9 million barrels per day (bpd) to about 10 million bpd, to make up for some of the volumes of Libyan oil that have come off the market since March.  But, then, the Obama Administration effectively declared that it had no confidence Saudi Arabia would be able to manage the market unilaterally.  More specifically, the Administration worked with several of America’s European partners and the Paris-based International Energy Agency (IEA, the OECD-affiliated association of major oil-importing countries) to engineer the release of 60 million barrels of oil, over a 30-day period, from the strategic petroleum reserves of the United States and other Agency members.

For the IEA to release stockpiled oil — particularly when it is done so manifestly in an effort to lower prices, not as a response to a profound disruption in global oil supplies — is something that no OPEC member, including Saudi Arabia, can like.  The Obama Administration sought to coordinate the release with Saudi Arabia in advance of the IEA’s announcement of the decision.  But it was an undeniably embarrassing outcome for the Kingdom.

There are a number of important points to be drawn from this episode.  We highlight three of them here.

First, Saudi Arabia does not have as much “market power” in the oil market today as it used to.  Without doubt, the Kingdom retains the ability to defend a floor price for crude oil.  But its ability to drive down prices — which is what the United States and other major oil consumers really care about — is significantly diminished.

With regard to the immediate challenge — replacing production lost as a result of the Obama Administration’s ill-considered, European- and Saudi-backed military misadventure in Libya — the IEA’s executive director remains publicly confident that the Kingdom will increase its production, even after the Agency’s decision to release stockpiled oil.  But, following the IEA announcement, a survey of oil market analysts by Bloomberg found that most think Saudi Arabia will only increase its oil production to around 9.5 million bpd, not 10 million.  Notwithstanding Turki’s comments about Saudi Arabia’s ability to replace all of Iran’s current oil production — and his description of the Kingdom’s current surplus capacity is consistent with estimates by industry experts — it would seem, in the end, that Riyadh is not really prepared to use that capacity to replace all of the lost Libyan production.

This brings us to our second point: It is not clear why any rational market actor would choose, voluntarily, to rely on Saudi Arabia to make up for the volumes that Iran currently puts onto the international oil market.  But this is precisely what Dennis Ross and Obama Administration colleagues who seem just as clueless as he about oil market realities want China and other important oil importers to do.  We cannot imagine that China will willingly go along with such a scheme.

Third, Iran’s ability to cooperate with Iraq on issues pertaining to OPEC production quotas suggests that scenarios positing increasingly intense disagreements between Tehran and Baghdad over oil production are not grounded in reality.  Looking ahead, we expect that post-Saddam Iraq will continue to have much more in common with the Islamic Republic — on oil issues as on other matters — than with Saudi Arabia.

This brings us back to our initial observation that Saudi Arabia’s current regional strategy is actually weakening the Kingdom’s position.  Throughout our careers in government service, and subsequently, we have never been proponents of “Saudi bashing”; quite to the contrary.  As we have pointed out before, Saudi Arabia is not a “natural” state, like Iran or Turkey — or Egypt, among Arab states.  But, in contrast to other Arab states, Saudi Arabia was not created by outside actors.  Rather, it was created by indigenous forces — indigenous dynasty (the Al-Saud), with an indigenously generated ideology (the particular form of Islam flowing from the religious revivalism of Muhammad ibn ‘Abd al-Wahhab in the 18th century).

These characteristics make Saudi Arabia a formidable, “home grown” political entity.  For that and other reasons, we do not expect the Kingdom to be caught up in “Arab spring” demands for fundamental political change.  But we think that Iran is winning the battle for the support of regional publics — and, increasingly, governments — for its positions.  Saudi Arabia, on the other hand, is now pursuing a strategy which is increasingly out of touch with regional sentiment.  That strategy may still produce some tactical victories for the Kingdom.  But, if continued over time, a strategy at odds with regional opinion will slowly but surely diminish the Kingdom’s ability to win others to its side.  This could turn out to be the most important lesson of last month’s OPEC meeting.

Flynt Leverett directs the Iran Project at the New America Foundation, where he is also a Senior Research Fellow.  Additionally, he teaches at Pennsylvania State University’s School of International Affairs.  Hillary Mann Leverett is CEO of Strategic Energy and Global Analysis (STRATEGA), a political risk consultancy.  She is also Senior Lecturer and Senior Research Fellow at Yale University’s Jackson Institute for Global Affairs.  This article was first published in The Race for Iran on 4 July 2011 under a Creative Commons license. 

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