Tag: saudi arabia

Event February 27th: U.S. Military Posture and Persian Gulf Oil

Since at least World War II, U.S. foreign policy has been shaped by the necessity of securing scarce oil supplies. And for more than 30 years, it has been shaped by a commitment to safeguard the flow of oil from the Persian Gulf. Many of the defining moments in U.S. foreign policy since then– including the Arab oil embargoes of the 1970s, the 1980s ‘tanker war’ and even the 1991 Persian Gulf War – have been shaped by this commitment, perhaps most clearly articulated by President Carter in 1980:

Let our position be absolutely clear: An attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and such an assault will be repelled by any means necessary, including military force.

Yet recent years have seen profound changes in the global oil market. Growth in U.S. domestic production – a result of the shale gas revolution – has returned the United States to the top of global hydrocarbon producer rankings for the first time in decades. A more general shift in production from global south to north has made the United States substantially less reliant on Middle Eastern sources of oil, and more on close neighbors like Canada.

These changes, combined with dramatic shifts in the Middle Eastern balance of power raise a key question: should the United States continue to use its military to guarantee the flow of oil from the Persian Gulf?

On February 27th, Cato will host a book forum to discuss the recently published book Crude Strategy: Rethinking the U.S. Military Commitment to Defend Persian Gulf Oil. The book addresses many of these key questions, pulling together an interdisciplinary team of political scientists, economists, and historians to explore the links between Persian Gulf oil and U.S. national security.

The book’s essays explore key questions such as the potential economic cost of disruption in oil supply, whether disruptions can be blunted with nonmilitary tools, the potential for instability in Saudi Arabia, and the most effective U.S. military posture for the region. By clarifying the assumptions underlying the U.S. military presence in the Persian Gulf, the authors conclude that the case for revising America’s grand strategy towards the region is far stronger than is commonly assumed.

The discussion will feature the book’s editors, Charles Glaser, Professor of Political Science and Director, Institute for Security and Conflict Studies at the George Washington University and Rosemary Kelanic, Assistant Professor of Political Science, Williams College. Joining them will be Kenneth Vincent, Visiting Fellow, Institute for Security and Conflict Studies, George Washington University and John Glaser, Cato’s Associate Director of Foreign Policy Studies.

The event promises a fascinating discussion on the energy security roots of America’s foreign policy in the Middle East, and the future of the U.S. commitment to the region’s oil supplies. You can register for the event here.

Trump Administration Begins Threat Inflation on Iran

In an op-ed for the Boston Herald last week urging the Trump administration to uphold the Iran nuclear deal, I noted that the precise posture that the Trump White House will have toward Iran is not yet known. Today, we got our first insight into just how confrontational that posture will be. And it doesn’t look good.

Trump National Security Advisor Michael Flynn said in a White House briefing that, “As of today, we are officially putting Iran on notice.” According to Flynn, Iran’s recent test of ballistic missiles, which he said is “in defiance of UN Security Council Resolution 2231,” along with an alleged attack on a Saudi naval vessel “conducted by Iran-supported Houthi militants” in Yemen, serve as evidence of “Iran’s destabilizing behavior across the entire Middle East” and make clear that the nuclear agreement signed by Iran and the P5+1 has “emboldened” Iran to act nefariously in the region, “plac[ing] American lives at risk.”

Flynn’s statement amounts to heated, combative rhetoric over rather trivial issues. Only one of the incidents cited by Flynn was an Iranian action. While it’s true that Iran supports the Houthi rebels in Yemen, it has never been clear exactly how much support they give and it is doubtful Iran has the kind of leverage over the militants that make them qualify as strategic proxies. At the end of the day, whatever instability is caused by Iranian support for the Houthis, it doesn’t hold a candle to the regional instability caused by Sunni jihadists, like al-Qaeda-linked groups and ISIS, that have been supported with funds coming out of Saudi Arabia and other Arab Gulf states. Rather than berate the Saudis with threatening bombast in a White House briefing, though, Washington continues to aid the Saudi military as it relentlessly bombs Yemen, killing thousands of civilians, putting millions at risk of starvation, and committing acts that a United Nations panel said could amount to crimes against humanity

With regard to Iran’s ballistic missile test, the reality is far less alarming than Flynn’s words suggest. The nuclear deal itself doesn’t prohibit these missile tests. And as Dan Joyner, professor of international law at the University of Alabama School of Law, explains, “the assertion that Iran’s ballistic missile tests…violate UN Security Council resolutions is incorrect because, as of Implementation Day, all UNSCR’s adopted prior to that date regarding Iran are terminated except for Resolution 2231. And the language that Resolution 2231 employs in addressing Iran’s ballistic missile activity is legally nonbinding language…[T]here can thus be no violation of a legal obligation that doesn’t exist.”

As The Wall Street Journal reports, “UN Security Council Resolution 2231, which endorsed the deal, ‘called upon’ Iran to avoid any activity related to missiles designed to be capable of carrying nuclear warheads.” It’s hard to confirm one way or the other, but for what it’s worth Iranian Foreign Minister Javad Zarif told the Journal that none of Iran’s missiles are designed to carry a nuclear warhead and the tests involved “conventional warheads that are within the legitimate defense domain.” Given that Iran has verifiably rolled back its nuclear enrichment program over the past year, it makes sense that they would have little interest in designing missiles that can carry nuclear warheads, especially given the added international scrutiny it would needlessly attract.

Flynn’s statement indicates an eagerness to stir up tensions with Iran over relatively innocuous issues. This will undoubtedly be perceived in Tehran as threatening, thereby bolstering the more hawkish voices in Iran and undermining the future viability of the Iran nuclear deal, despite the fact that, as the International Crisis Group recently reiterated, “It has delivered so far on its narrow objective: effectively and verifiably blocking all potential pathways for Iran to race toward nuclear weapons.” 

What They Didn’t Tell You on the Saudi Road Show

The Saudis have just completed peddling their new $15bn bond issue (with more to come). One thing that’s been swept under the rug is a smoking gun. A smoking gun because it’s an indication of just how much trouble the Kingdom is in.

The most telling sign of the depth of the Saudi welfare state’s troubles is the fact that they switched from the lunar-based, religious Hijri calendar to the western Gregorian calendar on October 1, 2016. The reason for this radical change is simple economics.

The Gregorian calendar has 10.9 more days than the Hijri calendar, meaning that the public sector can cut costs through the dilution of wages—same pay spread over more working days. In another move that touches on sensitive religious matters, the Kingdom has announced that it will increase visa charges for people completing their religious pilgrimage, the Hajj. Even in the Kingdom of Saudi Arabia, economics has trumped religion.

Congress Takes on the U.S.-Saudi Relationship

In yesterday’s Washington Post, a headline proclaimed: “Saudi Arabia is Facing Unprecedented Scrutiny from Congress.” The article focused on a recently defeated Senate bill which sought to express disapproval of a pending $1.15 billion arms sale to Saudi Arabia. Unfortunately, though the presence of a genuine debate on U.S. support for Saudi Arabia – and the ongoing war in Yemen – is a good sign, Congress has so far been unable to turn this debate into any meaningful action.  

Yesterday’s resolution, proposed by Kentucky Senator Rand Paul and Connecticut Senator Chris Murphy, would have been primarily symbolic. Indeed, support for the bill wasn’t really about impacting Saudi Arabia’s military capacity. As co-sponsor Sen. Al Franken noted, “the very fact that we are voting on it today sends a very important message to the kingdom of Saudi Arabia that we are watching your actions closely and that the United States is not going to turn a blind eye to the indiscriminate killing of men, women and children.” This message was intended as much for the White House as for the Saudi government, with supporters arguing that the Obama administration should rethink its logistical support for the war in Yemen.

Unfortunately, opponents of the measure carried the day, and the resolution was defeated 71-26. These senators mostly argued that the importance of supporting regional allies outweighed any problems. Yet in doing so, they sought to avoid debate on the many problems in today’s U.S.-Saudi relationship. In addition to the war in Yemen – which is in many ways directly detrimental to U.S. national security interests, destabilizing that country and allowing for the growth of extremist groups there – Saudi Arabia’s actions across the Middle East, and funding of fundamentalism around the world are often at odds with U.S. interests, even as it works closely with the United States on counterterror issues. As a recent New York Times article noted, in the world of violent jihadist extremism, the Saudis are too often “both the arsonists and the firefighters.”

The Economics of the Saudis’ “Take-the-Money-and-Run” Strategy

As the Financial Times reported on 12 July, Saudi Arabia’s oil-output reached record highs in June 2016. Increasing production 280,000 barrels/day to 10.6m b/d, Saudi Arabia has once again waved off OPEC’s request not to glut the market with oil. 

As it turns out, economic principles explain why the Saudis began, in late 2014, to pump crude as fast as they could – or close to as fast as possible. In fact, there is a good reason why the Saudi princes are panicked and pumping. 

Let’s take a look at the simple analytics of production. The economic production rate for oil is determined by the following equation: P – V = MC, where P is the current market price of a barrel of oil, V is the present value of a barrel of reserves, and MC is the marginal recovery cost of a barrel of oil.

To understand the economics that drive the Saudis to increase their production, we must understand the forces that tend to raise the Saudis’ discount rates. To determine the present value of a barrel of reserves (V in our production equation), we must forecast the price that would be received from liquidating a barrel of reserves at some future date and then discount this price to present value. In consequence, when the discount rate is raised, the value of reserves (V) falls, the gross value of current production (P – V) rises, and increased rates of current production are justified.

When it comes to the political instability in the Middle East, the popular view is that increased tensions in the region will reduce oil production. However, economic analysis suggests that political instability and tensions (read: less certain property rights) will work to increase oil production.

Let’s suppose that the real risk-adjusted rate of discount, without any prospect of property expropriation, is 20% for the Saudis. Now, consider what happens to the discount rate if there is a 50-50 chance that a belligerent will overthrow the House of Saud within the next 10 years. In this case, in any given year, there would be a 6.7% chance of an overthrow. This risk to the Saudis would cause them to compute a new real risk-adjusted rate of discount, with the prospect of having their oil reserves expropriated. In this example, the relevant discount rate would increase to 28.6% from 20% (see the accompanying table for alternative scenarios). This increase in the discount rate will cause the present value of reserves to decrease dramatically. For example, the present value of $1 in 10 years at 20% is $0.16, while it is worth only $0.08 at 28.6%. The reduction in the present value of reserves will make increased current production more attractive because the gross value of current production (P – V) will be higher.

 

So, the Saudi princes are panicked and pumping oil today – a take the money and run strategy – because they know the oil reserves might not be theirs tomorrow. As they say, the neighborhood is unstable. In consequence, property rights are problematic. This state of affairs results in the rapid exploitation of oil reserves.

That Saudi Sinking Feeling

The rate of growth in a country’s money supply, broadly measured, will determine the rate of growth in its nominal GDP. For Saudi Arabia, the following table presents a snapshot of the relationship between the growth in the money supply (M3) and nominal GDP.

 

The chart below shows the course of M3. Following the oil price plunge of September 2014, the growth in M3 has slowed. The rate of nominal GDP growth will follow.

Why is the money supply growth rate declining? Since the plunge in oil prices, the Saudis’ current account has dipped into negative territory. This has to be financed, and the Saudis have used their stash of foreign reserves to do the financing.

Economic Lessons from Muhammad Ali

Since the passing of Muhammad Ali, the establishment has been working in overdrive to convince us that the great boxer was a member of their club. In doing so, the wisdom and wit of Ali has been on display.

Muhammad Ali’s lessons on economics, however, have been absent. Economics? Yes. The lessons were developed in a most edifying book by Donald Sull, The Upside of Turbulence: Seizing Opportunity in an Uncertain World. New York: Harper Collins, 2009 – a book that Mohamed El-Erian recommended to me.

The economic lessons are summarized in “The Boxer Matrix.” A boxer’s fate is determined by a combination of his absorption capacity (read: can he take a punch?) and agility (read: can he avoid a punch?). In the Boxer Matrix, the ideal position to be in is the Northeast quadrant: where Ali and Joe Louis boxed. But, while Ali always had terrific agility, he had to train and think his way to an above average absorption capacity. This capacity was on display in his “Rumble in the Jungle” bout with George Foreman. It was then that Ali’s “rope-a-dope” tactic was executed to perfection.

This brings us to Ali’s message on economics, with particular reference to countries that are heavily dependent on the production of oil. In turbulent times (read: oil price plunges), countries like Saudi Arabia, Venezuela, and Nigeria experience a great deal of pain because their oil-dependent economies aren’t diversified. In short, they lack agility. This is reflected in their position in the lower half of the Boxer Matrix.

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