The Middle East and Global Energy Markets

Jon Alterman: Frank Verrastro is a senior advisor with the Energy and Climate Change Program at CSIS. For many years, he served alongside me at CSIS as senior vice president and the longtime director of longtime director of what was then the Energy and National Security Program. He's worked in the White House, the Department of Energy, and the Department of the Interior, and he had a number of senior jobs in the energy industry, including as a senior vice president at Pennzoil. Frank, welcome to Babel.

Frank Verrastro: Thank you, Jon. I’m glad to be with you.

Jon Alterman: President Biden is going to Saudi Arabia in a few weeks. Is that going to relieve high energy prices?

Frank Verrastro: Among myself and my colleagues, we’ve been discussing what the quid is and what the quo is in this particular meeting. If you're going to Saudi Arabia to ask for additional supplies now—because Saudi Arabia and the United Arab Emirates are the only two countries that probably have excess capacity—it's the absolute wrong time. Saudi Arabia is in the middle of the summer. The summer burn is when they supply crude oil for electricity generation in the country, so their ability to add huge volumes is limited right now. It doesn't make a lot of sense—especially if you look at the gasoline situation now. People are talking about the crunch at the end of this quarter not really being crude oil but more about refining capacity.

Jon Alterman: It sounds like even if the Saudis wanted to help the president on oil, they really can't.

Frank Verrastro: What they could do is maybe some marginal production increase, but in fact, the Organization of Petroleum Exporting Countries (OPEC) totally is like two and a half million barrels a day under quota. Certain countries like Algeria, Nigeria, Angola, and Libya are all below quota, and they're not going to come up anytime soon.

Jon Alterman: Is there a market-signaling effect that the Saudis could have that would at least send a message to the markets that more oil is coming? Would that matter?

Frank Verrastro: That would help nominally, but quite honestly, countries in the International Energy Agency (IEA) have already released crude oil stocks that are in excess of a million barrels a day for the rest of the summer. That hasn't helped a whole lot. It doesn't look like the loss of Russian oil, so far, has been all that significant. The original thought was that 3 million barrels a day would be taken from the market—which I thought was a wildly outrageous estimate. If that had happened, prices would be higher, but so far, the actual reduction in Russian oil is somewhere between half a million and a million and a half barrels a day. Now, it is being rerouted. Oil that is not going to Europe is going to Asia—mostly to China and India—and it's being sold for discount prices. That's actually good for the world because it reduces the shortfall.

Jon Alterman: Are Middle Eastern States poised to replace Russia as an energy supplier to Europe?

Frank Verrastro: Transportation logistics and oil quality are two very important considerations when you look at what refineries can handle to make and process products that consumers regionally need. Europe uses diesel fuel, and we're sending a lot of diesel fuel to Europe right now. They're sending gasoline back to the East Coast because we don't have a lot of refining capacity on the East Coast, and that happens all the time. But the shipments between Europe and across the Atlantic basin take a lot less time than rerouting from Asia. Logistically, moving these different supplies and finding refineries that can utilize the shipments and still make products they want is really difficult—and it's expensive. The world can replace a 2 million barrel a day shortfall from Russia. It cannot replace a 7 million barrel a day shortfall from Russia. There's just no other big supplier like that.

Jon Alterman: We've been talking about oil. Gas is another part of the equation, and Russia supplies a lot of gas to Europe. There is an increasing amount of gas that is being produced in the Mediterranean. Is this going to create a renaissance for Mediterranean gas—or perhaps even not a renaissance, but a moment of birth for Mediterranean gas to make it geo-strategically important?

Frank Verrastro: Mediterranean gas has been right on the cusp for a while now when it looked like they were late to the party. When you looked at LNG suppliers from Qatar or the United States or pipeline gas from Russia, the question was, “where would they fit in a world that wants to decarbonize, and where some of these supplies come in late?” Europe has got to decide between their decarbonization and their “de-Putinization” policies here. It's going to be very difficult to live without gas in the short term. The conversions that people talk about for alternative fuels and renewables are not going to happen this year. That's not going to happen next year, so for the next several years, they're going to be looking for alternative energy supplies. I think one of the problems is that, rhetorically, the commission hasn't given up on the green agenda—and they shouldn’t. But they don’t want long-term contracts because they feel that, if you look 20 years into the future, those long-term contracts undermine their environmental goals. Most of these new suppliers—especially in the LNG field—need these long-term contracts to justify investments and to get payout over a longer period of time. Unless you just want to buy spot gas—and then you'll pay whatever the going price is—that's really difficult. On the other hand, the Asian buyers are willing to pay higher prices and enter long-term contracts. The second point about the Eastern Mediterranean gas is that the competition is going to get a lot stiffer. It looked like there were opportunities for Egypt, Jordan, and Israel to collaborate on different projects. But, I think that the people who feel that they’re faster to the table may try to capitalize on this opportunity, and you are going to see a lot more conflict in some of these areas. I think boundary disputes will happen. Infrastructure and pipeline laying could be a point of contention. The United States is also already having problems with the cost of getting steel for new projects. The United States is going to be bidding against others that want to have access to the market during this window where gas has an opportunity. There's a limited amount of people coming out of the Covid-19 pandemic who can manufacture steel. Steel manufacturing is really expensive, and logistic supply lines just aren't there, So, now, there are a lot of people trying to get in that space in a short period of time before they hit a decarbonization wall.

Jon Alterman: You mentioned Covid-19, and a lot of the discussion I've seen about high energy prices all blame it on the Ukraine conflict. To what extent has Covid-19, and the uncertainty over the pandemic, driven the price spikes that you've seen, and to what extent is a fear of a post-Covid-19 recession driving the reluctance of producers to pump more oil?

Frank Verrastro: That is absolutely the case. Oil and gas production takes years to bring online, and it didn’t happen in 2018 and 2019. The United States has been underinvesting in oil and gas production, in part because there was a sense that we were transitioning to a post-fossil fuel world. Prices for oil and gas were low, and permits and regulations didn't really favor oil, gas, and coal production. When we got to 2020, the bottom fell out. Demand totally went away. In the United States, gasoline demand was down because people weren't commuting to work. Aviation fuel was down because no one was flying due to restrictions. As a result of that, refineries closed, and producers, just like restaurants, shut in uneconomic production and laid off workers. Post-pandemic, we wanted the economies to come back. Well, guess what? The economies in some parts of the world came back stronger than anticipated, and the lags in the supply line created pent-up demand for oil and gas that is only mitigated by higher prices, and that's where we are now. It was OPEC that decided, when prices were low, to enter into the OPEC+ reduction quota system, where they took 7–8 million barrels a day off the market in order to draw down what they thought was excess inventory, because demand wasn't going to be there. So now we're in a situation where the excess inventory is gone; the production capability of a lot of these member countries, even exclusive of Russia, just isn't there and demand is surging. The United States will add a million barrels a day of production this year, but it's light oil. It can only go to certain places, and it's not enough to make up for the shortfall.

Jon Alterman: And if there's a global recession, then there might not be a shortfall at all.

Frank Verrastro: Right. So that's the flip side. Some economists believe that by the end of the second quarter, we could actually be in a nominal global supply surplus—in terms of the supply/demand balance. At the beginning of the year, when China had Covid-19 restrictions, there was concern that if China shut down again, we'd have a situation where demand would crater, and all these prices would go away in terms of new investment. Why do you make those kinds of investments if you're going to be back in a shortage where prices drop back to $60 a barrel? And if this is short lived, and these are long-term investments, how prudent is that? That’s where I think we are right now.

Jon Alterman: How much volatility do you think there is going to be in energy prices over the next 10 years? We have this energy transition inhibiting people's decisions about what to invest in. Certainly, high prices could be encouraging people now to buy electric cars or do other things that reduce demand. Do you see prices going up and down a lot? Do you see this flattening out? Do you see us falling into a curve, or is it going to be peaks and valleys?

Frank Verrastro: I think prices are going to be peaks and valleys. We’re going to be in a position where, for a variety of reasons—supply and demand, technical problems, supply chain issues, geopolitical issues, and weather-related effects—there are going to be acute fluctuations in energy prices. In the United States, we're just entering the hurricane season. Our refineries are running at 95 percent utilization. 50 percent of these refineries are in the Gulf Coast. Even with increased output, if we had a hurricane that took a lot of that supply out, we'd be in a whale of hurt. If you start looking 10 years out, depending on what your mitigation goals are for climate and emissions, it's going to be a really uneven future. I think there was a way to avoid this. If the policies of some of these countries, including the United States, stated at the outset that we’re going to need some portion of oil and gas for the next 20 years and mapped this out, we would see that everyone can't have an electric car now because they don't exist. There's “greenflation” for some of the costs of the components of the electric car. We have rare earth minerals and metals that we just can't have access to because they're controlled by someone else, and the prices will be higher. And with the inflationary impacts, people don't have the money to buy them.

In addition to that, even places with money to burn will have problems. California said if people went out and wholesale bought electric cars right now, they would have blackouts on the grid because the grid isn't ready. Right now, in most states, if you charge your car at night when the sun is not shining or the wind is not blowing, and there's not adequate capacity and storage, you're probably doing it with coal-based electricity, which is not good for the environment. I think we're going to need natural gas in times of hurricanes and floods. We've got to find a better solution. The industry ought to be working harder in the near term to reduce methane emissions, but the viability of this system, with such a large scope and scale, means that we’re just not ready for the transition tomorrow. By governments saying that we're going to have a more ambitious timeline, I think we're just going to have situations where consumers will suffer and you're going to get a lot of noncompliance until we get there. Now, that doesn't mean we shouldn't do both. We should manage the current crisis and still keep our foot on the gas, in terms of transitioning to a lower-emissions future and a lower carbon future. But we have to be mindful of the scale and scope of the transition, and if the Ukraine situation didn't make that obvious, I don't know what will.

Jon Alterman: What does that mean for Middle Eastern producers and their relationship with the United States?

Frank Verrastro: When I talk to the Middle East folks now, a lot of them feel that they are really in the driver's seat. Some of the regulations, especially in Europe, are going to look for lowest-emission gas or lowest-emission oil. If you're a big producer, and you divide every barrel by the total denominator in the country, that makes you a cleaner burning fuel. If you're a small producer, you don't have that same luxury. I think the IEA made a horrible mistake when they came out with their paper last year that talked about not needing any new production of oil and natural gas anywhere in the world. My sense is that they thought that if you looked at climate c

My sense was that they thought that on an aggregate basis, if you looked at the climate commitments, we could manage with the resource supply that was available now. We would just have to space it out over time.

That doesn’t take into consideration questions like, “What if there's an upheaval in a certain producing country?” I'm sure they never anticipated losing 7 million barrels a day of Russian production. Do you want to be beholden on a geopolitical scale to producers in a volatile part of the world with transportation that has to go halfway around the world, or is it better to have some homegrown energy closer to home?

I think the new security debate is around reliable, affordable, available, and clean energy. But there is a variety of things that fit those categories. It's not all, "Let's go back to total fossil fuels.” I don't think the industry wants to do that, and it shouldn't be doing that because we're going to have to deal with the consequences of climate change. But in the near term, you can only deal with systems that work with what people have—whether it's, utilities, businesses, or average consumers. Consumers can't use energy forms that they can't accommodate in their system, or that are not available, or are too expensive.

For the Middle East, I do think that the OPEC situation has worked well over the past couple of years. If all the sanctioned countries come back in under a quota arrangement—Venezuela, Iran, and new supply from Nigeria and Libya—the volume that could potentially be on the market means that at some point OPEC is going to work to throttle back. I don't know how they do that, especially if others are saying, “For all those years, I was under quota. Now I just want free rein.” If all of a sudden Iran decides that it wants to put two and a half million barrels a day on the market right away, what does that do to Saudi Arabia? I don't think it's going to be an easy path. I do think that the United States needs to reestablish ties with Iran for more reasons than just energy. It seems to me that we are moving into a bifurcated world between the autocrats and the democracies. You can't let the Middle East gravitate towards China or Russia because of the United States and the West decided that we don't need them or want them.

Jon Alterman: Although, they're not very democratic.

Frank Verrastro: I get that, too, but you're dealing with governments and the cards that you're dealt, and I think that's the problem that President Biden is having now going to Saudi Arabia and giving some of the earlier statements castigating Mohammed bin Salman for Khashoggi's murder.

Jon Alterman: You talked about the necessary role for fossil fuels going into the future as we transition toward more renewables, but the other thing we can use oil and gas for is petrochemicals. Petrochemicals and all the plastics that surround us are made from oil and gas. Fertilizer is made from gas. Are those other uses for oil and gas—the rise of petrochemicals, the centrality of petrochemicals to so much of our economy—is that enough to give energy producers in the Middle East a long tail on production, even after the energy transition? Or is it likely to be a commodity—prices will go down and they're really going to have some very hard sledding after 20 or 30 years?

Frank Verrastro: I think a lot can change in 30 years. It's just the difficulty of trying to get a 2030 or a 2035 inflection point. Your point on petrochemicals is well taken. Oil and gas molecules are used in plastics, petrochemicals, foodstuffs, medicines, and components of your automobile that have nothing to do with fuel. They're an everyday in your life. Transportation probably makes up 40 percent of petroleum-based consumption. A lot of the same petrochemicals can be derived from natural gas and lighter hydrocarbons, and some of that will and should occur. It would take a reconfiguration of the refining sector to be able to break down certain oils and make that slate of profitable products, and we're not quite there yet. In fact, we're not there by a long shot, and the question is what demands look like for those ancillary products in the future. That is why I think some of this needs to be more thoughtfully laid out—not just by policymakers and activists, but by engineers and financial people. I think that's what's missing in this conversation.

Jon Alterman: You give us a lot to think about. Frank, thank you very much for joining us on Babel.