Oil markets under political and military stress

Oil markets under political and military stress

S. Das, P. N. Leiby, R. Lee, G. R. Hadder and R. M. Davis

Econometric and linear programming models were used to evaluate petroleum markets during a politically based disruption and, alternatively, during a military confrontation in 1995. The market scenarios were characterized by a substantial loss of exports from the Persian Gulfregion. The hypothetical disruptions resulted in substantially higher prices and reduced supply and demand of refined products, especially fuels for transportation. Oil from the Strategic Petroleum Reserve mitigated the impacts, though the International Energy Agency’s oil sharing agreement was not a factor. Keywords: Oil market forecast; Supply disruption; Modelling

World oil markets are subject to many disruptive forces, including natural disasters, changing economic institu- tions, political volatility and war. Table 1 offers a chronology of examples of such forces, many having occurred in the Persian Gulf region. This paper focuses on this region as a sensitive point ofworld oil trade, and considers two extremely disruptive scenarios in that region. In 1995, two models were used to develop global forecasts for Business-As-Usual (BAU) conditions and for the two disruption scenarios [3]:

l The econometric oil market simulation (OMS) model estimates the price at which global supply and demand for oil are in balance. Aggregate supply, demand, and price data from the OMS model and from a Disruption Impact Simulator (DIS) version of the OMS model [ 181 are used for some of the input data requirements of the Petroleum Allocation (PAL) model.

The authors are with the Energy Division, Oak Ridge National Laboratory, Oak Ridge, TN 37831-6205, USA, operated by Martin Marietta Energy Systems under contract no DE-AC05-84 or 21400 with the US Department of Energy.

Juanita Hunt was the key person in word processing and putting the pieces of the paper together. Her contribution is gratefully acknowl- edged. The authors gratefully acknowledge sponsorship through the Mobility Fuels Technology Program of the US Navy Energy and Natural Resources Office, Office of Naval Research under the guidance of Alan Roberts. Computer resources were provided by the Energy Information Administration (EIA).

Final manuscript received 3 1 October 1989.

0 The PAL model [8,20] is a linear program that estimates global petroleum movements for different market scenarios. In the PAL model, crude oils are described in terms oftheir source regions and by their ability to yield refined products. The products are defined by the aggregatecategoriesof liquified petroleum gases, gasoline, jet fuel, distillate fuel, residual fuel and other refined products.

Market scenarios

Based on a review of Department of Energy (DOE) forecasts, it was concluded that in the forecast year of 1995, virtually all excess crude production capacity will be in the Persian Gulf area [5]. Furthermore, the free world oil consumption that is met by imports from Persian Gulf countries is estimated to increase from 18% in1986 to 28% in 1995. Forthesereasons,political or military events which influence Persian Gulf exports remain the primary source of oil market risk. The two disruption scenarios were selected to represent extremely severe but plausible political and military events in the Middle East. Both disruptions were assumed to involve a major reduction in the Persian Gulf export of crude oil and refined products. Some curtailment of production and exports from other regions was also considered.

The business-as-usual scenario The disruption scenarios were compared to the refer- ence 1995 business-as-usual (BAU) scenario, which was developed from the most recent official mid-case fore-

204 Ol40-9883/90/030204-07 0 1990 Butterworth-Heinemann Ltd

Oil markets under political and military stress: S. Das et al

Table 1. Chronology of example events which could affect oil markets [2,10-161.

7 January 1986 I4 April 1986 I May 1986 13 July 1986 20 December 1986 26 January 1987 I2 March 1987 I7 May 1987 13 July 1987 21 July 1987

I August 1987 March 1988

April 1988

May 1988

July 1988 March 1989 April 1989

President Reagan imposes economic sanctions on Libya. US warplanes bomb Libya in response to terrorist attacks. Crude oil discounts on top of netback pricing are introduced and oil prices plunge. US active drilling rig count drops to 663, the lowest level since World War II. All OPEC members except Iraq agree to cut oil production by 7% in order to raise oil prices to $18/bbl US oil production falls by 250 000 barrels per day in 1986, after four years of production increases. Earthquake shuts down Ecuador’s crude oil export pipeline. CLSS &ark is struck by Iraqi missile, killing 37 -&hors: Toll of merchant ships attacked in the Persian Gulf since 1981 reaches 330: 133 vessels have been lost. US Navy begins escorting retlagged Kuwaiti tankers in the Persian Gulf. &i&town hits mine on the first transit of the Gulf. Iranian demonstration in Mecca results in 402 deaths. West German submarine in a naval exercise rams steel jacket leg on North Sea drilling platform. In the Dutch North Sea, Swedish ferry sinks and closes down 50 000 barrel per day pipeline. US guided missile frigate Samuel B. Robertson is mined in the Persian Gulf, with serious damage and 10 injuries, triggering US action against Iran. US attacks Iranian platforms in Sirri and Sassan fields, using surface vessels. The Josan, an Iranian missile attack boat, attacks US ships off Sirri and is sunk by return fire. Two Iranian fighter jets attack a US warship, which returns fire, and Iranian speedboats attack the Willi Tide, a US registered supply boat, off the United Arab Emirates. Reagan administration policy is revised to permit US warships to protect neutral merchant ships under attack in the Persian Gulf. Explosion at Shell Norco refinery results in a temporary shutdown of 220000 bbl/day refinery capacity (90000 bbl/day catalytic cracker loss). Destruction of Piper Alpha production platform results in a loss of 130 000 bbl/day oil and 20 million fts gas. Exxon Valdez accident causes temporary cutback of Alaskan production of more than 1000 000 bbl/day. Britain’s North Sea Brent pipeline system explosion causes an oil loss of 472 000 bbl/day.

cast of DOE’s Energy Information Administration [4,5]. Additional detail was gathered from the most recent officially documented Department of Energy models, including OMS, DIS, and the 1990 PAL model BAU case.

The political disruption . A politically based disruption scenario, hereafter to be called the political disruption, was constructed to represent an extreme version of the types of disruptions which occurred in 1957,1973 and 1979, when sovereign regimes in the Middle East intentionally reduced exports [17]. In the political disruption, the regimes collaborating in the embargo consist of all Persian Gulf nations, plus sympathetic countries in Northern Africa. Physical interdiction of petroleum transport channels need not be assumed for the political disruption.

The political disruption was assumed to occur in the first quarter of 1995, as follows. Persian Gulf, Libyan and Algerian exports of crude oil and refined products decreases by 50% (an 8.9 million bbl/day loss), and output from other OPEC countries surges to maximum capacity (0.38 million bbl/day gain). Strategic petroleum reserves (SPRs) are drawn down in both the USA and Japan, at up to 4.5 million bbl/day (the US maximum rate) and 0.9 million bbl/day, respectively. There is no net change in private inventories. The total supply loss is about 3.1 million bbl/day. Levels of petroleum consumption and production are governed by market forces, and price adjusts to the level which

ENERGY ECONOMICS July 1990

assures that import demand for OPEC oil equals the available OPEC supply. The International Energy Agency (IEA) oil sharing rule is interpreted to mandate reallocations only if some country’s market-based supply is below its minimum supply right as defined by the sharing rule. A summary description of the political disruption is given in Table 2.

The military scenario A second, even more severe scenario includes a major military confrontation in Europe, accompanied by the physical interruption of virtually all petroleum exports from Middle East suppliers. This scenario, hereafter to be called the military scenario, also implies heightened activity for naval, ground and air forces.

The military scenario was assumed to span the first three quarters of 1995, with three distinct phases, as follows. The tension begins with a politically based embargo, followed by an intense major power conflict during the second quarter, both in Europe and the Middle East. In the third quarter, the conflict is resolved, and normalization begins with the partial restoration of oil flow.

A summary description of the military scenario is given in Table 2. After examining the multi-period disruption using DIS, the worst quarter (the second) was selected for detailed analysis using the PAL model.

In the second quarter, exports from the disrupted Middle East region (Persian Gulf OPEC, Libya and Algeria) drop to zero. The total loss of crude and

205


Table 2. Summary description of the scenarios.

Affected countries and sectors

OPEC disrupted regions in Persian Gulf

OPEC crude and product export disrupted

North Sea crude output disrupted (affects Norway and UK)

Centrally-planned economies net exports disrupted

Undisrupted OPEC surge production (Ecuador, Venezuela, Nigeria)

‘Inventory demand’ (used as proxy for European gas import substitution)

US SPR draw Foreign (Japan) SPR draw Military demand increase

US military NATO US defense industrial base European defense industrial base US military stock draw European military stock draw

Net US military demand increase Net European military demand increase Net military demand increase Net shortfall”

Algeria Iran Iraq Kuwait Libya Saudi Arabia UAE

50% [8910]

0

0

To capacity To capacity [ - 3801 [- 3801

0 0 0 0

- 4500 -1500 -900 -300

100% [ 178001

40%

u2401 100% 19201

To capacity [ - 3801

80% European gas

15501 -4500

- 900

50% [8910]

40% [ 12401 100%

19201 To capacity

[ - 3801 80% European gas

[5501 - 1100

-200

0 0 820 0 0 0 340 0 0 0 410 0 0 0 170 0 0 0 -300 0 0 0 -200 0 0 0 920 0 0 0 310 0 0 0 1230 0

3130 6730 15970 9940

Military Military Military mobilization action normalization Quarter 1 Quarter 2 Quarter 3

Same Same Same

50% [8910]

0

0

aComponents may not sum to total due to independent rounding.

product from this region is 17.8 million bbl/day. Simul- taneously, production from the North Sea is reduced by 40% (1.2 million bbl/day loss), and exports from the centrally planned economies (primarily the Soviet Union and China) fall to zero (0.92 million bbl/day loss). The peak gross loss of output is nearly 20 million bbl/day. Offsetting this loss is surge production from undisrupted OPEC countries (0.38 million bbl/day), drawdown from US and Japanese SPR strategic stockpiles (5.4 million bbl/day and 0.9 million bbl/day) and military stock draws in the USA and Europe (estimated at 0.5 million bbl/day). New sources of petroleum demand arise, as NATO military demand triples and partial mobilization of the defense industrial base adds another 100% to the base level of military demand (for a total increase of about 1.7 million bbl/day). Further oil demand increase is assumed to result from the complete interruption of European natural gas imports from the Soviet Union, of which 80% is replaced by petroleum substitutes (about 0.55 million bbl/day). The net loss of petroleum is about 16.0 million bbl/day. This loss must be met by market-based (price-driven) adjustments in the behaviour of pro- ducers and consumers in the non-OPEC region.

World oil demand

The OMS and DIS models were used to forecast world oil price and regional petroleum supply and demand, under the BAU and disruption scenarios. A comparison of world supply and demand under the different scenarios is shown in Figure 1, with specific numbers given in Table 3. Highlights of the world oil supply-demand forecast include:

The BAU scenario was estimated to have a free- world oil demand of 50.5 million bbl/day. This level is well within the range of most studies [9], but remains a matter of uncertainty. Relative to 1986, when free world petroleum demand was 48.0 million bbl/day, the models project BAU demand to grow at only 0.6%/year while gross US national product grows 2.8%/year through 1995. The disruptions resulted in reduced total crude production, much higher prices, and reduced quan- tity demanded. During the political disruption, the price of crude is 2.0 times the BAU price. During the military scenario, the price of crude is 4.4 times the BAU price. Given assumptions about the low short- run price responsiveness of non-OPEC oil supply,

206 ENERGY ECONOMICS July 1990


Table 3. World oil balance, 1995 BAU, political disruption and military (2nd quarter) scenarios.

Consumption (million bbl/dny)

USA Canada Japan Western Europe OPEC Other countries Total free world

Production (million bbl/dny)

BAU

16.8 1.7 4.6

12.6 4.2

10.6 50.5

Politicsl disruption

15.6 1.6 4.3

11.8 4.2

10.0 47.6

Military

12.1 1.1 3.1 9.4 4.2 7.2

37.2

USA 8.3 8.4 8.6 Canada 1.6 1.6 1.7 Western Europe 3.5 3.5 2.4 Other countries 9.8 9.9 10.2 CPE net exports 0.9 0.9 0.0 Total non-OPEC (excluding SPRs) 23.6 24.3 22.9 US SPR 0.0 4.5 4.5 Japan SPR 0.0 0.9 0.9 OPEC 26.3 17.8 8.9 Total free world 50.5 47.6 37.2

Relative crude oil price 1.0 2.0 4.4

non-OPEC supply increased only 3.3% while non- OPEC demand decreased by 6.3% in the political disruption. In the multi-period military scenario, the second phase (active military conflict and 100% Persian Gulf shutoff) was by far the worst quarter. Sub- sequent PAL analysis focused on this quarter. In the military scenario, non-OPEC supply decreased by 3%, due to the disruption in the North Sea. Total non-OPEC demand fell by 29%. Tradi- tional non-OPEC petroleum consumers, largely civilian, were forced to reduce demand even further (by 33%) due to competition from military demand and

substitution of petroleum products for disrupted Soviet gas. US demand fell by 28% although military demand increased during the military scenario. The demand decline occurred in the civilian sector due to steep price increases. SPR withdrawals were essential for mitigating even more rapid oil price increases in both disruption scenarios. When DIS was modified to examine the IEA agree- ments, it was found that in most instances the minimum supply right was met by the free market outcome, given extra supply from the SPR draw- downs. It was concluded that the IEA agreement

28

26

0 Demand

B Busmess-as-usual

P PolItIcal dlsruptlon

4

2

0 B PM B PM B PM B P M B PM B P M

USA Canada Japan Western Europe OPEC Other

Figure 1. Comparison of world supply and demand under different scenarios.

ENERGY ECONOMICS July 1990 207


lo- SPR -Strategtc petroleum 0 12 - ; II

g IO

29

18 -2 7

26

z5

%4 53

2 I 0

BAU Polltbcal Mllltary

Scenarios

Figure 2. Projected crude oil supplied to refineries in the USA.

would not lead to substantially different allocations from the market outcome under these circumstances. Further analysis using the PAL model was based on the free market allocation of supply.

Crude supply and refinery output in the USA

Figure 2 shows the projected crude oil supplied to refineries in the USA under the BAU, political disruption and military scenarios. The major patterns in crude supply were:

l In the BAU, imports exceeded domestic production of crude oil. This reflects a continuation of the current trend of less domestic production and increased imports.

l Imports into the US decreased dramatically in the political disruption and military scenario. Imports

0

were almost zero under the extreme military scenario that was hypothesized. The low import levels reflect the drastic reduction in supply from the Persian Gulf; reduced demand for crude oil in response to higher prices; and diminished reliance on foreign sources because of the heavy drawdown of SPR crudes and increased production of domestic crude oil. SPR drawdown was very effective in softening the imme- diate shock of Persian Gulf disruptions to the USA, as well as to other countries. Both the political disruption and the military scenario resulted in near-maximum drawdown of the SPR, 4.3 million bbl/day, and led to somewhat higher production of domestic crude oil.

Refinery output in the USA is illustrated in Figure 3, which identifies output in the major refined product categories during each of the scenarios. The major results for US refined product output were:

Total refined product output in the BAU was 15.2 million bbl/day. Relative yields of products in the BAU were 39.4% gasoline. 8.6% jet fuel, 22.4% distillate fuel, 7.2% residual fuel and 22.4% other products. Compared to the BAU, total output declined by 4.6% in the political disruption and by 14.5% in the military scenario. In the political disruption, the most significant decline was in jet fuel production, from 1.3 million bbl/day to 1.1 million bbl/day. In the military scenario, the most noticeable decline was in gasoline output, from 6.0 million bbl/day to 4.8 million bbl/day. As a result, civilian transport activities could be dramatically changed. Also very significant in the military scenario was a decline in jet fuel production from 1.3 million

0

t

B : Busmess-as-usual

7 P : Polttlcal disruptlon

M : Mllltary

0 B P M B P M 0 P M BPM B P M Gasolme Jet fuel Dlstlllate fuel Residual fuel Other

Figure 3. US output in the major refined product categories.



through normal market means. The IEA sharing rule is fulfilled without non-market reallocations. Supply obligations, as maximum allowed consumption levels, will be ignored if all supply rights are met. If substantial emergency supply from the SPR is anticipated we should neither count on the IEA sharing agreement to reduce significantly the cost of a disruption (as expected by Badger [l]), nor be concerned about the problems and costs of its implementation (anticipated by Horwich and Weimer [q).

The Energy Information Administration (EIA) [6] has studied a hypothetical disruption similar to the military scenario in this study, though not nearly as extreme. In the EIA scenario, the disruption occurs in 1995 and lasts for six months due to the closure of the Strait of Hormuz. The USA responds to the disruption by drawing down the SPR at maximum rates at the same time that other countries in the market economies draw down their own government-controlled stocks. The net world oil availability is reduced by 10 million bbl/day during the disruption period. They concluded that the economic effects of the disruption would depend on the way in which the market would respond. The economic effects of the disruption would be dampened if suppliers and end-users draw down commercial inventories in an effort to fill the supply gap, while consumers reduce energy use. Under this situation, EIA predicted that world oil prices would increase only 1.5 times the business-as-usual price. For our military scenario the situation was more severe. Net crude oil loss was much higher (ie 16 million bbl/day) thereby resulting in higher crude oil prices of 4.4 times the business-as-usual case. In the political disruption, the projected price effect was more severe than the EIA scenario in spite of a smaller net crude oil loss of 3 million bbl/day. This apparent inconsistency may be due to the shorter duration of the political disruption, and presumably less elastic demand than in EIA’s six month disruption.

While the results of the study provide some insights, the analysis also had some limitations that should be addressed in future research. Expectations of price changes can have an important (temporary) effect on market demand because oil companies and consumers may decide to build or to use their stocks. The impact of changes in crude oil prices on product demand will also depend on government policies, prior to as well as during a disruption. For example, if protective duties (eg import tax) are levied by the government prior to a disruption, then the impact of a disruption on the demand for oil products is less severe [ 191. The economic effects of a disruption would be intensified if consumption were to remain close to predisruption levels (ie consumption is relatively inelastic) while commercial inventories are built up in anticipation of future price

bbl/day to 1 .O million bbl/day, even though military jet fuel demand was assumed to increase to three times the BAU level. Most of the increased military jet fuel demand was assumed to be met at the expense of reductions in civilian jet fuel demand that were the result of higher prices caused by both the disruption in oil supply and the increased military demand.

l Total US distillate fuel production was relatively unaffected in the two disruption scenarios.

Discussion

Great reductions in worldwide crude oil production lead to severe disruptions. Prices become higher and demand declines. Larger reductions in demand are more likely to occur in the civilian sector than in the military sector. Within the civilian sector, the transport sector seems to be affected most by these disruptions. The implications are reduced civilian air, automobile and truck travel. This would change the availability of certain goods and products (particularly those that are transported to markets or that depend on transported materials). Also car-pooling and other travel patterns would change.

Withdrawing 4.5 million bbl/day from the SPR mitigated much of the impact of the disruptions. The availability of SPR stocks freed what would have been US imports to be used mostly by European countries. If the SPR was depleted prior to (or later in) the disruption, however, then the impacts would have been much more severe. The world oil market is very interde- pendent. This is added reason for other oil consuming nations to create or to add to their national strategic oil stockpiles in order to cushion the world economy from the effects of an oil disruption. Notwithstanding, strategic oil stockpiles can be depleted if a disruption persists for a long period of time. Thus, such stockpiles offer only limited production. In the longer term, switching more to other fuels like natural gas or implementing conservation measures will dampen the effects of future oil market disruptions.

It is commonly [7] expected that the International Energy Agency’s emergency oil sharing agreement, if enforced, will significantly alter the allocation of oil during a disruption. The sharing rule specifies supply rights for those countries comparatively short on oil, and supply obligations for those countries receiving comparatively more oil during the disruption. However, simulations revealed that given a large SPR draw the IEA sharing agreement will lead to few if any reallocations of oil. A market-based allocation will dominate the IEA proposed sharing. A large release of SPR allows the total available supply to be more than the total supply rights. Thus, using the SPR enables the minimum supply rights to be met for virtually all countries



increases (caused by uncertainty over the disruption’s

duration or magnitude). None of the above important

issues (ie -price expectations, government policy or inelastic demand) has been-considered in our analysis.

References

Daniel B. Badger, ‘International cooperation during oil supply disruptions: the role of IEA,’ in G. Horwich and D. L. Weimer, eds, Responses To international Oil Crises, American Enterprise Institute for Public Policy Research, Washington, DC, 1988. Chevron Corporation, World Energy Outlook, San Francisco, CA, October 1987. S. Das, G. R. Hadder, P. N. Leiby, R. Lee and R.M. Davis, Navy Mobility Fuels Forecasting System Phase IV Report, ORNL-6517, Oak Ridge National Laboratory, Oak Ridge, TN, September 1988. Energy Information Administration, US Department of Energy, Annual Energy Outlook 1986, DOE/EIA- 0383(86), Washington, DC, February 1987. Energy Information Administration, US Department of Energy, International Energy Outlook 1986, DOE/ EIA-0484(86), Washington, DC, April 1987. Energy Information Administration, US Department of Energy, International Energy Outlook 1989, DOE/ EIA-0484(89), Washington, DC, March 1989. G. Horwich and D. L. Weimer, Responses To Inter-

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Oil markets under political and military stress