Geopolitics and Energy in the
Middle East

by Anthony Cordesman
September 15, 1999

This report, by CSIS Middle East expert Anthony Cordesman, focuses on the key question: can the Middle East act as a stable supplier of oil and gas exports at market driven prices. In a region marred with intraregional and internal conflicts, serious economic problems, and major demographic challenges, this is not an easy question to answer. The report breaks down these and other geopolitical issues by country and offers a comprehensive overview of the entire region. 

Executive Summary

The Middle East dominates world energy exports. It has about 64% of the world's proven oil reserves and 34% of its gas reserves. According to estimates by the U.S. Department of Energy (DOE), it exported an average of 17.7 million barrels of oil a day (MMBD) in 1995. This was 47% of the world total of 37.7 MMBD. The DOE projects that Middle Eastern oil exports will reach 39.8 MMBD by 2020. This will be 60% of the estimated world total of 66 MMBD. Similar estimates are not available for gas exports, but Algeria, Libya, Iran, Qatar, Oman, and the UAE will play an important role as world suppliers.

The percentage of this oil that flows from the Gulf to the United States at any given time has little strategic or economic importance. Oil is a global commodity and the U.S. is required to share all imports in a crisis under the monitoring of the International Energy Agency. The U.S. will pay the same globally-determined price as any other nation. Further, the U.S. economy is dependent on the health of the global economy and on energy-intensive imports from Asia and other regions. In this case, what comes round must go round.

The critical geopolitical issue affecting the region is whether the Middle East will act as a stable supplier of oil and gas exports at market driven prices. This is not easy to predict in a region that has many intraregional and internal conflicts, serious economic problems, and major demographic problems. The Middle East is so heavily dependent on the income from energy exports that few nations will voluntarily limit their export revenues. War has had a major impact on energy exports in the past, however, and sanctions affect key exporters like Iran, Iraq, and Libya. New questions are also beginning to arise as to whether the Middle East can finance the energy development it needs without more privatization and much higher rates of foreign investment.

In several cases, Middle Eastern states are either already at war, or there is a serious risk of future conflict. Mauritania is the scene of a low-level race war between Arabs and Black Africans. Morocco is still in the process of a long war with the Polisario for control of the Western Sahara. Algeria is involved in a bitter civil war between its ruling military junta and Islamic extremists. Tensions have grown between Libya's leader, Muammar Qadhafi and Libya's Islamists and there is low-level fighting in a number of areas. Also, the Egyptian government is fighting Islamic terrorists.

In spite of the Arab-Israeli peace process, Israel is still formally at war with Syria and Lebanon, and faces a serious rejectionist threat from terrorists, Iran, and Iraq. Israel is also involved in an active low-level conflict on its northern border with the Hezbollah - a Shi'ite Islamic movement with strong Iranian and Syrian sponsorship. Lebanon remains under Syrian and Israeli occupation, and its factions still present the threat of another round of civil war.

The Southern Gulf states are relatively stable, but serious tensions exist between Bahrain and Qatar, there is civil violence in Bahrain, and Saudi Arabia and Yemen continue to clash along their common border. While Iran may be becoming more moderate, there is still a serious risk of internal clashes between its "moderates" and "traditionalists," and it presents a major problem in terms of both proliferation and continued hostility to any U.S. presence in the Gulf. Iraq remains a serious potential threat to Kuwait and Saudi Arabia, and is certain to resume its military build-up and efforts to proliferate the moment UN sanctions are lifted.

The Red Sea area is the scene of several conflicts. The Sudanese civil war threatens to enter its second decade, and the death toll from fighting and starvation will probably exceed well over one million. Yemen faces growing tensions between its government and key tribal groups in the South, and continues to clash with Eritrea over the control of islands in the Red Sea.

Most Middle East states suffer from internal political, economic, and demographic problems that compound these intra-regional conflicts and tensions. Virtually all Middle East states have repressive regimes with a high degree of authoritarianism - regardless of whether the ruler is called a King, Sheik, Sultan, President, General, or Ayatollah. Virtually all suffer from weak or failed economic development, high rates of population growth and a virtual youth explosion, aging and largely authoritarian regimes, and serious problems with internal stability.

Economic development has been poor since the end of the oil boom in the late 1970s. The Middle East only averaged 0.2% annual economic growth from 1980-1990, only 6% of its average annual population growth. This situation has improved since 1990, but growth averaged less than 3% before the economic collapse in Asia and similar collapse in world oil prices in late 1997. Population growth slightly outpaced real economic growth throughout the 1990s.

Some states like Kuwait, Qatar, and the UAE have so much oil and gas wealth per capita that they can buy their way out of their mistakes indefinitely. Most Middle Eastern states, however, still suffer severely from economic mismanagement and excessive state control of the economy. Structural economic reform has begun in Algeria, Morocco, Tunisia, Egypt, Jordan, Lebanon, and Bahrain. This reform, however, remains highly uncertain and Egypt is the only state undergoing such reform that has carried it forward to the point where it has a serious prospect of success.

The other Middle Eastern states have very uncertain near to mid-term economic prospects, and this is true of most oil exporters as well. The Iraqi economy is in near collapse. The Iranian economy is in a serious crisis, compounded by deep ideological conflicts over how to deal with the issue. Algeria's efforts at reform are blocked by civil war. Qadhafi's mismanagement and UN sanctions have blocked much of Libya's development. Bahrain no longer has significant oil reserves. Saudi Arabia has experienced over a decade of budget deficits and has only about 40% of the real per capita income it had at the peak of the oil boom. Oman is also experiencing serious development problems.

Ineffective programs to control population quickly compound failed leadership and economic mismanagement. Population growth still averaged 2.7% during 1995-1996, and exceeded 3.4% during the period from the late 1960s to 1990. The region experienced negative real economic growth during much of the 1980s, and economic growth only averaged about one-third of population growth during the 1990s - before the collapse of oil prices in 1997. The regions average per capita income dropped by 1.8% during 1995-1996.

Roughly 40% of the region's population is now under 17 years of age. The region's educational system is under extreme stress, and real and disguised unemployment for males between 18 and 25 years probably averages over 20%. The average per capita income of the Middle East is now about $2,100 using the World Bank method, and compares with $23,800 for high-income states. Urbanization without development, proper infrastructure, and housing intensifies the region's problems. The percent of urbanization in the total population rose from 37% in 1970 to 57% in 1996.

This combination of low oil prices, high population growth rates, and a failure to modernize and diversify the overall economy threatens to turn oil wealth into oil poverty. The Southern Gulf states have only about 40% of the real per capita income they had at the peak of the oil boom in the early 1980s, and little prospect for anything other than a slow decline. Kuwait, Qatar and the UAE maintain high per capita incomes, but Saudi Arabia is becoming increasingly marginal, Iran has a per capita income of well under $5,000, Algeria has $1,520 dollars, and Iraq's per capita income is unlikely to be higher.

The Impact of Low Oil and Gas Revenues on Regional Energy

The most serious issue affecting the entire Middle East is the impact of relatively low oil revenues on nations with high population growth and economies with limited diversification. Oil prices peaked at nearly $70 a barrel in constant 1998 dollars in 1980. They dropped to well bellow $20 a barrel in 1986, and have generally stayed bellow $20 a barrel ever since. The "oil crash that began in 1997 led to a series of unexpected cuts in oil prices that reached lows of $10 a barrel and cuts in annual oil revenues that approached 30-40%. The resulting cuts in oil revenues have affected every major oil and gas producer in the Middle East and have reduced the region's ability to maintain both welfare payments and entitlements, and short-term investment. It is too soon to predict the length and intensity of low oil revenues, but they have, at a minimum, had a serious short-term impact.

The "oil crash" has had a dire impact on economies which have failed to modernize and diversify, the impact of sanctions on several critical suppliers, the size of future demand for exports, national policies to increase production and export capacity, and the ability to obtain the investment necessary to implement those policies. It affects political stability and influences a wide range of social problems, most importantly the impact of very high rates of population growth, the inability to sustain past welfare and entitlement programs, and the need to create new economic structures which offer suitable employment and incentives for investment.

Most of these problems began long before the "oil crash," and have continued now that oil again costs $17 to $20 a barrel. They are the result of years of over-reliance on oil wealth, economic mismanagement, and the failure of regional governments to realistically plan and budget for the future. Some key Middle Eastern governments are entering their 10th year of budget deficits. Saudi Arabia and Iraq are key cases in point. Other countries are at least at the beginning a major structural crisis in which they cannot afford to implement their five year plans, and cannot fund both their present levels of entitlements and investment. Cases in point include Algeria, Syria, Bahrain, Iran, Oman, and Yemen. Most Middle Eastern governments now face a major short-term budget crisis, and this seems to include even states with relatively high ratios of exports to population: Kuwait, Qatar, and the emirates other than Abu Dhabi and possibly Dubai.

These budget problems have already led to under-investment in infrastructure, economic diversification, and state industries other than the petroleum sector. Even the petroleum sector has suffered in some cases, although "starving the hand that feeds you" presents obvious enough problems for most Middle Eastern states to think twice. Since the fall of 1997, however, government revenues have generally fallen at least 33% below projections, and governments are approaching the short-term crisis level in many cases.

The traditional rentier patriarchy no longer has all the money to function, and state industry cannot attract enough outside or internal investment to meet national needs. Most of the 1998 budgets in the Middle Eastern energy exporting states are in chaos, as members scramble to cut expenditures, raise revenues, and minimize budget deficits. Signs of the seriousness of this issue are the fact that Saudi Arabia faces an $8 billion deficit in the coming year, as has already been discussed, and Crown Prince Abdullah's speech in November 1998, warning that the state would have to cut social services.

Demographics compound the impact of low oil and gas export revenues on regional economies and increase the risk of political unrest. Regional population growth still averaged 2.7% during 1995-1996, and exceeded 3.4% during the period from the late 1960s to 1990. The result is the virtual "youth explosion" where roughly 40% of the region's population is now under 17 years of age. The region's educational system is under extreme stress, and real and disguised unemployment for males between 18 and 25 years probably averages over 20%. These problems are further compounded by labor migration and the slow breakdown of the region's traditional family, clan, and tribal system, which is based on villages and the extended family.

The percent of urbanization in the total population rose from 37% in 1970 to 57% in 1996, and will probably rise to well over 70% by 2020. The Southern Gulf states already have only about 40% of the real per capita income they had at the peak of the oil boom in the early 1980s, and little prospect for anything other than a slow decline. Kuwait, Qatar and the UAE maintain high per capita incomes, but Saudi Arabia is becoming increasingly marginal, Iran has a per capita income of well under $5,000, Algeria has $1,520 dollars, and Iraq's per capita income is unlikely to be higher.

Many states, including virtually all Southern Gulf states, are heavily dependent on foreign labor at a time when many of their own younger citizens lack not only jobs but also the training and work ethic to get them. In many cases, these problems are reinforced by poor immigration policies that are routinely violated by the toleration of illegal immigrants, the issue of visas for money, and the existence of laws that require major benefit packages for native labor, thus making it difficult to hire or fire native labor. Some countries are trying to solve the problem with erratic purges of foreign labor, but most still lack consistent policies.

Earlier swings in oil revenues have contributed to the present problem. OPEC oil revenues were worth around $77 billion in constant 1990 dollars in 1972. After the October War and the 1974 oil embargo, they leapt to levels of around $340 billion and then dropped back to less than $300 billion during 1975-1978. The fall of the Shah of Iran and the start of the Iran-Iraq War drove them to a new peak in 1980, when they were worth $438.8 billion. An oil price collapse began in 1985, and revenues dropped to $83 billion in 1986. They gradually rose back to levels of around $150 billion a year in early 1997, but a new "oil crash" began late that year. Major production cuts led to a rise in oil prices in 1999, but total revenues are still projected to reach only $84.6 billion. Many countries are beginning to rethink their plans to increase production capacity and their attitudes towards private and foreign investment.

If low or low-to-moderate oil revenues continue for several years (and no obvious end appears in sight), the resulting cut in government revenues will probably force many Middle Eastern countries to cut their budgets and development plans in ways that result in significant economic, social, and political tradeoffs. The International Monetary Fund stated in May 1998 that the decline in oil export revenues "would pose a serious risk to the growth outlook" for the Persian Gulf region, "and particularly for the region's largest oil exporters such as Saudi Arabia and Kuwait …if sustained." Current indications make it probable that many countries will experience negative real growth, particularly in their GNP.

Problems in the Key Gulf States

Virtually all of the region's energy wealth is concentrated in the Gulf. The Middle East as a whole may have about 64% of the world's proven oil reserves and 34% of its gas reserves, but over 90% of these oil reserves are in the Gulf. Similarly, the U.S. Department of Energy (DOE) estimates that the Gulf averaged 15.4 MMBD worth of exports in 1995, 14 MMBD in 1998 in spite of the "oil crash", and will reach 37.2 MMBD by 2020. In 1995 this equaled 41% of all world exports, out of a total of 47% for the entire Middle East. The Gulf is projected to produce 56% of all world exports by 2020, out of a total of 60% for the entire Middle East. Given the DOE's reference case estimate of Gulf production and the probable range of uncertainty, Gulf production will increase from 22.8 million barrels per day in 1997, to 42.2 million barrels per day in 2020. This is a potential increase from 29% of all world production in 1997 to 38% in 2020.

The Gulf also has major gas reserves, and is becoming a major exporter of liquid natural gas. While the Russian Federation dominates the world's reserves with 1,700 trillion cubic feet, or 32.9% of the world total, Iran alone has 15.7% of the word's gas reserves and Qatar and the UAE have another 10%. In total, the Gulf has over 33% of the world's reserves. The rest of the Middle East adds another 3%.

Saudi Arabia is the key to stable world oil exports. It has well over 260 billion barrels of proven oil reserves, or one-quarter of the world's total. Saudi Arabia is the pivotal oil exporter in the Gulf, the Middle East, and the world. It is the world's largest "swing" producer, and Saudi Arabia plays a critical role in ensuring moderate and stable oil prices. It is also the world's largest oil producer, and the growth in Saudi oil production will outstrip the growth in all of the nations in the Former Soviet Union, in spite of major increases in production by the former Soviet republics in the Caspian and Central Asia. The U.S. Department of Energy estimates that Saudi Arabia will increase its production from 8.6 million barrels per day in 1990, and 11.4 million barrels per day in 1997, to 11.1 (11.2-11.6) million barrels per day in 2000, 13.7 (12.4-14.8) million barrels per day in 2005, 14.1 (12.9-17.3) million barrels per day in 2010, 16.2 (13.3-21.9) million barrels per day in 2015, and 20.0 (17.8-27.4) million barrels per day in 2020.

Even before the "oil crash," Saudi Arabia had serious financial problems. In 1997, it had a $4.5 billion budget deficit. Since that time, the decline in oil revenues has created a major challenge for the Saudi government since oil export revenues account for nearly 90% of total Saudi export earnings. The Department of Energy estimates that Saudi Arabia earned about $45.5 billion in 1997 and that these revenues fell by 28%, to around $30.1 billion in 1998 (Saudi Arabia loses an estimated $2.7 billion for every $1/bbl fall in the price of oil). This helps explain why Crown Prince Abdullah met with several major oil companies during his September 26, 1998 visit to Washington. The companies included Mobil, Texaco, Exxon, Chevron, Arco, Phillips Petroleum, and Conoco, and during the meeting, Prince Abdullah invited them to help develop Saudi Arabia's massive oil resources. He called for proposals by November 10, 1998. The details of these proposals have not yet been released. Saudi Arabia may pursue similar policies for gas.

Saudi Arabia does not face any imminent risk of instability, but it will enter the twenty-first century in the midst of major political, social, economic, and military transitions. External transitions include the reemergence of Iraq as a major force in Gulf security and the world oil market, Iran's uncertain shift towards political moderation and regional cooperation, the failure of the Southern Gulf states to develop their military forces effectively and develop meaningful collective security arrangements, creeping proliferation, and the need to redefine dependence on the U.S. for security. They also include the continuing uncertainties in the world energy market, a factor that drives virtually every aspect of the Saudi economy.

Iranian oil production has come close to restoring the levels of over 5 MMBD it produced in the peak years before the fall of the Shah. It produced only 1.6 MMBD in 1980, and under 3 MMBD during most of the Iran-Iraq War. Production has risen from around 3.1 MMBD in 1990 to 3.6 MMBD in 1995, however, and DOE projects that it will rise to 4.3 MMBD in 2005 and 5.5 MMBD in 2020. These latter numbers are highly uncertain.

Iran has faced major problems in terms of oil revenues. Iranian oil revenues peaked at around $40 billion in 1990 constant US dollars in the mid-1970's. Iran was the cause, not the benefactor of the peak in oil revenues in 1980. Oil revenues were only around $13 billion in 1997, dropping to $8.1 billion in 1998, and they are projected to rise to $9.2 billion in 1999. This does not come close to "oil wealth" in a nation of well over 60 million people.

Iran is a nation that is still deeply in the process of revolutionary change, and which is deeply divided between "moderates" who have broad public support, and "conservatives" who control the military, security system, and most other governmental institutions. The "moderates" now seem to be the strongest faction, and change may take a peaceful and positive course. Iran's regime has become steadily more pragmatic under President Rafsanjani and President Khatami, and more concerned with Iran's national interests and economic development in the Gulf than the export of revolution. Since the election of President Khatami, there are growing signs that Iran may evolve a more tolerant approach to defining an Islamic state, one that emphasizes the humanitarian and moral strength of Islam as opposed to the attempt to force other nations into accepting its concept of a repressive and outdated theological rule and social customs.

Revolutions, however, can become more extreme as well as more moderate. Iran's pragmatists and moderates still face strong radical opposition. Iran's revolution may yet become the captive of ambitious leaders or elites. Conservative or extremist reaction can suppress the positive trends in political and social development, and nationalism and regional ambition can turn ideology into an excuse for aggression. Economic failure can also become an excuse for aggression, as can the need to justify authoritarian rule and social repression.

Whatever happens, Iran will have vast strategic importance. The U.S. Department of Energy estimates that Iran holds 93 billion barrels of proven oil reserves, or roughly 9% of the world total. It estimates that Iran will expand its production from 3.9 million barrels per day in 1997, to 5.5 (4.5-6.4) million barrels per day in 2020. To put these numbers in perspective, DOE estimates that Iran will maintain a steady 5% share of world production from 1997 to 2020. Iran also influences the development of energy resources in the Caspian and Central Asia. Iran sees itself as a natural transit route for oil and gas exports from the landlocked Central Asian countries to world markets.

Iraq's is one of the most troubled and repressive states in the world. It has vast oil resources and great potential wealth, but it is a nation that has been in continuous crisis for most of the last decade. Iraqi oil production peaked at around 3 MMBD in the late 1970's, and was at 2.5 MMBD at the start of the Iran-Iraq War. Oil revenues peaked at $43.6 billion in constant 1990 U.S. dollars in 1980, and they dropped to levels around $8 billion or less during the Iran-Iraq War. Iraq's invasion of Kuwait led to an oil embargo, production levels as low as 0.6 MMBD, and negligible oil revenues. A UN "oil for food" deal allowed Iraq to resume major exports in 1997, but oil revenues never came close to the ceiling the UN permitted. Oil revenues were $4.9 billion in 1998, although Iraq's rejection of OPEC quatas have led to production of well over 2.0 MMBD, and estimated revenues of $7.4 billion in 1999. DOE projects production levels of 2.8 MMBD in 2000, 3.8 MMBD in 2010, and 5.9 MMBD in 2020. However, such estimates are very uncertain.

There is little chance that its economy or aggressiveness will improve decisively as long as it is under its present regime, and the aftermath of the Gulf War has scarcely improved this climate. For more than a half-decade, the "war of sanctions" has kept Iraq under a mix of sanctions, inspection regimes, and export and import controls that have left it politically isolated and economically crippled. During this time, Iraq has been deprived of overt access to arms imports and the technology it needs to proliferate. Iraq's neighbors, including Iran, have been able to continue their efforts to proliferate and build-up their conventional forces, as well as develop their economies.

Iraq must be regarded as a major military threat to the security of the world's supply of oil exports. There has never been a three-month period since the cease-fire in early 1991, in which Saddam Hussein has not provoked a new confrontation with the UN, his neighbors, or the West. Iran may be the rising military power in the Gulf, but Iraq's conventional military forces have been extensively reorganized since the Gulf War, and have regained a substantial part of their pre-war military capabilities. Iraq remains a major proliferator. Although Iraq has lost many of the capabilities it possessed at the time of the Gulf War, its half-decade long struggle to preserve its weapons of mass destruction and missile capabilities continues. At the same time, Iraqi production is critical to meeting future world oil demand. The U.S. Department of Energy estimates that Iraq will increase its production from about 1.6 million barrels a day in 1997 to 5.9 (4.7-7.2) million barrels per day in 2020. To put these numbers in perspective, Iraq would produce 5.2% of the world's oil in 2020.

Kuwait plays a vital role in any projection of the world's future oil supplies. Kuwait contains an estimated 96.5 billion barrels of proven oil reserves, over 9% of the world total. Before recent cutbacks in production because of low oil prices, Kuwait was producing an estimated 2.4 million barrels per day (bbl/d), including 250,000 bbl/d of Neutral Zone production. Kuwait is one of the two major oil exporting powers that can rapidly increase production in an emergency, and its role as a swing producer may increase over time. The U.S. Department of Energy estimates that Kuwait will expand its production from 2.6 million barrels per day in 1997, to 3.2 million barrels per day in 2010, and 5.2 million barrels in 2020.

The sharp drop in oil prices has had serious implications for Kuwait's finances. For 1998, Kuwait oil export revenues are expected to reach $6.4 billion, down 40% from $11.8 billion in 1997. In March 1998, Kuwait's Finance Ministry asked state bodies to cut spending by 25% for the remainder of the fiscal year ending June 30, 1998. In April, Kuwaiti oil minister Saud al-Sabah warned that Kuwait could face an "economic catastrophe" if Kuwaiti crude remained at $10.50 per barrel. In early May, Kuwait's Supreme Petroleum Council decided to increase domestic fuel prices by 40%-50%. Kuwait has pledged to cut 225,000 barrels per day from its February 1998 oil production. Since that time, Kuwait has raised the price of services like water, electricity, health care and local telephone service.

Like Saudi Arabia, these pressures are driving Kuwait and the Kuwait Supreme Petroleum Council towards a new oil strategy. Kuwait initially considered joint ventures with foreign countries in 1991, as part of its effort to fund economic recovery and develop its northern oilfields in ways where it was felt that foreign investment would strengthen the West's commitment to Kuwait's defense. These deals never moved forward due to nationalist and Islamic opposition and Kuwait's relatively rapid recovery. This time the situation may be different.

Kuwait's national security is also a paramount issue. Kuwait's geography, small size, and limited population make it one of the most vulnerable Gulf states. Its location on Iraq's border has been the source of continuing Iraqi threats, military confrontation, and invasion. Kuwait is keenly conscious of the fact that Saddam Hussein remains in power, that Iraq has not abandoned its desire to annex Kuwait, and that Kuwait is dependent on the U.S. for its survival. The defense of Kuwait will pose a continuing challenge to U.S. power projection, particularly as Iraq rearms and rebuilds its weapons of mass destruction.

The UAE is a rentier state of seven small city-states or emirates. Most of its population consists of foreign workers, and there are long-standing tensions between its largest emirates (Abu Dhabi, Dubai, and Sharjah), and the less wealthy mini-states to the east. Oil revenues, gas wealth, and vulnerability, are the glue that holds the UAE together. The U.S. Department of Energy estimates that the UAE will increase its production from 2.7 million barrels per day in 1997, to 4.9 (3.7-5.7) million barrels per day in 2020.

Much has depended, however, on the political skills of Sheik Zayed, the ruler of Abu Dhabi, to use diplomacy and oil wealth to hold the UAE together. Sheik Zayed is aging and his sons have yet to show they can replace his political skill. The principal foreign threat is Iran, which is also a major trading partner - particularly with Dubai. The major dispute dividing the two countries is the sovereignty of three islands that divide the major shipping channels in the Gulf: Abu Musa, the Greater Tunbs, and Lesser Tunbs. Oil revenues have also dropped from a peak of $29.9 billion in 1980, in constant 1990 U.S. dollars, to levels around $11 billion in 1997, and 7.5 billion in 1998.

Bahrain, Qatar, and Oman are not major oil producers, but any geopolitical analysis of the Gulf must consider the risk that the rise of a radical or unfriendly regime could pose in any of these states. Qatar is also a major potential gas producer, with the third largest reserves in the world. All three states also play an important role in U.S. power projection. Bahrain is the host to the U.S. 5th Fleet. Qatar has agreed to allow the U.S. to preposition a brigade set on its soil, and Oman provides prepositioning and port facilities.

Ability to Fund Investment to Increase Oil and Gas Production

The uncertainties surrounding future demand and future oil and gas export revenues are creating serious long-term problems in forecasting the rate of increase in Middle Eastern oil and gas production capacity. Unfortunately, an examination of current estimates of energy investment costs indicates that there is no clear way of estimating future regional and country-specific investment requirements beyond relatively near term projects. One imperative goal for policy making is to give this kind of "what if" modeling high priority and to consider just how much investment and reform is needed in each key producer country.

Two critical factors are involved. One is the impact the current "oil crash" is having on the budgets and investment capabilities of Middle Eastern oil exporting states. The second is the slowly increasing structural problem caused by rising populations, high welfare and entitlement programs, high military and arms expenditures, and low long-term revenues. Saudi Arabia, for example, experienced a 7% cut in its GDP during 1998. It began to increase prices in key subsidized areas like electricity in November 1998, but it still faces a deficit of around $13 billion, or 10% of its GDP. Saudi Arabia now faces the prospect of serious budget deficits well beyond 2001. It already has been forced to steadily cut investment to pay for operating expenditures. Even if oil prices recover to $20 a barrel after 2002, Saudi Arabia will face a demographic bulge that will make it very difficult to find all the funds it needs for investment.

Iran only made it through 1998 because of $3.0 billion in debt refinancing, by accepting a $6.0 billion budget deficit, and by paying for this year's food imports with part of next year's oil exports. Egypt's current account surplus in 1997 turned to a $2.1 billion deficit in 1998. Qatar, the UAE, and Oman face major cash flow problems which are forcing them into near-term cutbacks in some key energy projects while trying to find long-term solutions through foreign investment. Oman and Qatar's gas-based export programs, however, face serious financing problems, potential delays, and downsizing.

The latest World Bank estimates of economic growth for Middle East are anything but reassuring. They show that the GDP of the Middle East had a dismal history of economic growth even before the "oil crash." The Middle East had the lowest rate of growth of any region in the world during the 1980s. It grew by an average of only 2.1% per year during 1980-1990, versus 7.5% for East Asia, 5.6% for South Asia, 1.6% for Latin America and the Caribbean, and 1.8% for Sub-Saharan Africa. It grew by an average of only 2.9% per year during 1990-1997, versus 10.7% for East Asia, 5.7% for South Asia, and 3.4% for Latin America and the Caribbean. This performance is particularly striking because IMF studies show that the oil exporting nations in the Middle East lag badly behind the more diversified states and only grow at about 50% to 60% of their rate.

The World Bank projections are 1.5% for 1998, 0.7 for 1999, 2.5% for 2000, and 3.3% for 2001, but these averages have only projected levels for a recovering East Asia. For the period 2001-2007, the World Bank projects an average growth rate of 3.1%, which is almost exactly the projected increase in population. These projections compare with an estimate of 6.6% growth for East Asia, 5.5% for South Asia, 5.0% for Eastern Europe and Central Asia, and 4.4% for Latin America. The World Bank tends to be optimistic in its forecasting for the Middle East, and its actual growth rates could easily be a percent or more lower.

Most Middle Eastern states have been relatively successful in using state revenues to fund energy investments in the past. It now seems likely, however, that foreign investment and the domestic private sectors must assume a much larger share of the burden if the region is to produce anything like the energy output projected in DOE and IEA estimates. Relying on market forces might still lead to enough cost-effective investment, particularly given the oil industries history of investing in reserves, future market share, and development even in periods of low oil income.

The era of being able to safely rely on state oil and gas revenues to fund maintenance and modernization may well be over. Middle Eastern governments do not need to abandon state industries, state investment, and state control over energy resources, but fundamental reforms are needed to increase the ratio of foreign and domestic private investment. There currently, however, is no Middle Eastern country where market forces are allowed to operate without serious state interference and only a few countries - Bahrain, Egypt, Qatar, and Oman - are making serious progress. This helps explain why nearly all oil producing countries in the Middle East are currently examining ways in which to privatize some aspects of its energy investment and obtain foreign investment.

At this point in time, however, there is no meaningful way to establish whether they will persist in these plans if oil and gas revenues rise, how successful they will be in obtaining the capital they need, how much money any given country requires, and how well investments will be managed. Middle Eastern regimes tend to back-peddle on reform the moment oil revenues rise to moderate levels, and many face resistance from nationalists, Pan-Arab socialists, state-oriented technocrats, and Islamists. Virtually all states want to maximize revenues, but also have powerful elements that want to conserve resources for the future.

The pipeline politics of the Caspian and Central Asia are the most obvious case in point, but the lack of clear future plans to move oil out of Iraq and to develop cooperative plans for infrastructure development in the Southern Gulf may actually affect much larger amounts of oil and gas. The lack of any cooperative plans for pipelines to the Indian Ocean is particularly striking. There are no reliable analyses and forecasts of the overall increases that are planned or required to meet the demand for exports and increased production capacity. It is clear, however, that major increases could be required in ports, pipelines, supporting utilities, and in tanker fleets. These flows of oil will coincide with a growing demand to minimize inventories and for marginal efficiency in supply.

Today's Rogues Had Better Be Tomorrow's Suppliers

UN and U.S. sanctions affect three critical oil and gas producers in the Middle East: Iran, Iraq, and Libya. There is no way to know how long these sanctions will last, or how much impact they will have on energy developments. It is clear, however, that sanctions affect short-term energy developments in these states. The EIA currently projects that several of these states will make major increases in their oil production capacity and they may also make major increases in gas production.

It is unclear that Iran, Iraq, or Libya can meet these goals because of both sanctions and the "oil crash." Each country is continuing to invest in energy development, but there is no question that sanctions have meant serious cutbacks in the scale of investment, and have greatly complicated energy planning. The impact of sanctions also interacts with the current drop in demand for oil imports and in oil revenues - which create additional reasons to avoid or delay investment. Sanctions can present significant problems in developing the most cost-effective expansion of oil and gas production in several critical countries, and could increase the vulnerability of world oil markets if supply interruptions take place in other areas. Sanctions against Iran also complicate the cost-effective development of Caspian and Central Asian oil resources, while U.S.-driven sanctions tend to exclude U.S. companies from the Iranian, Iraqi, and Libyan markets without imposing similar constraints on their competitors.

More broadly, sanctions against energy investments ignore the fact that such investments actually require counterpart investments from the sanctioned country, and that the cash flow from abroad is tied to progress payments over a period of years. They ignore the fact that the profits from many investments only come three to five years in the future, when the government may well have changed.

Energy Wars: The Gulf Interruption/Oil Embargo Case

The EIA estimates that oil prices increase by $3-5 per barrel for every one million barrel per day of oil disrupted, and that the growth rate of the U.S. Gross Domestic Product growth rate will be reduced by between 0.3-0.5 percentage points. In other words, if U.S. GDP is expected to increase and a 3.0 percent or one million barrel per day oil supply disruption occurred, the U.S. GDP would be expected to grow by only 2.5-2.7 percent (a reduction of 0.3-0.5 percentage points). Table Seven shows that there has been a long history of different types of interruptions in oil supply since 1954. Ever since the oil embargo of 1974, the West has planned for the contingency of another oil embargo. The fall of the Shah and the Iran-Iraq War has since added another dimension to this kind of interruption crisis case: A cut off of all exports through the Gulf and the Strait of Hormuz.

Arab or Gulf embargoes now seem unlikely. The Arab oil-exporting states have a desperate need for cash flow, and most have shown little solidarity with the Palestinians since Arafat supported Iraq in 1990. Even in 1974, the "embargo" led the world market to rapidly increase production in other areas, and the crisis was caused as much by the world's inability to track supply in real time as by any shortfall in supply. This situation was largely resolved by improved tracking and reporting after a less intensive crisis following the fall of the Shah of Iran. Neither the "tanker war" between Iran and Britain and the U.S. in 1987-1998, or the Gulf War in 1990-1991, led to critical price rises or hoarding.

This raises serious questions about worst case crisis or conflict planning contingencies that need to be addressed in sizing strategic reserves, oil infrastructure and distribution systems, and creating national and IEA efforts to plan for emergencies and share oil in the future. It is important to note that the Gulf interruption case cannot be dismissed. Iran is already focusing its limited defense resources on improving its capability to threaten traffic through the Gulf and develop weapons of mass destruction. Iraq is almost certain to reemerge as a mid- to long-term threat to the moderate Gulf states and the West, and with long-range strike systems and weapons of mass destruction.

The practical difficulty is to draw some balance between the worst possible case, which would be a total halt to the production and exports, and the kind of "worst case" that should be used for realistic planning. There is a clear need, however, to consider the mid to long-term impact of Middle Eastern political instability, under-investment in the expansion of energy facilities, and proliferation. As discussed earlier, past EIA projections have indicated that any Gulf interruption case will have steadily more serious consequences, and that a major Gulf interruption case would probably trigger a global economic crisis. While these estimates may well be too high, the Gulf of 2005-2010 will probably be a region with enough weapons of mass destruction to go far beyond the kind of conventional threats that Iran is currently developing.