Energy Conundrums: The Myth of Energy Insecurity

Energy Conundrums

PHILIP E. AUERSWALD

The Myth of Energy Insecurity

Increasing oil imports do not pose a threat to long-term U.S. national security.

The current national debate on energy policy is held together by the proposition that increasing reliance on foreign oil is a national security threat that requires urgent action. Only the character of the needed action is in dispute. Some call for the development of renewable energy sources and conservation, whereas others want increased drilling on public lands and in the Alaskan National Wildlife Refuge. That the contending parties agree on the problem might seem a basis for optimism. Unfortunately, they are united only in being mistaken.

The reality is that increasing oil imports do not pose a threat to long-term U.S. security. The intense concern with oil imports reflects a view of markets that has been rendered obsolete by globalization. Surging prices are driven not by malevolent forces but by largely positive developments in the world economy. Furthermore, oil price increases have the power to succeed where policy and rhetoric have failed, creating powerful incentives for overdue investments that have the long-term potential to increase the productive efficiency of firms, lower costs for consumers, and limit the adverse impacts of global climate change.

Consensus on the security threat rests on the dubious proposition that oil price changes (either sustained increases or sudden shocks) have serious impacts on the overall economy and aggregate welfare. Explanations of how disruptive price movements occur commonly rest on a very basic analysis (taught in introductory college economic courses, or Econ 101) that holds technology constant while growth in demand outpaces supply. Currently, demand is growing because of multiple factors that include the dramatic economic emergence of China and India and their heavy thirst for oil plus the continued growth in U.S. oil consumption. Under these conditions, a simple application of Econ 101 theory would indicate that oil exporters have the capacity to cripple the economies of import-reliant countries by sharply reducing supply and driving up prices. In the real world, however, there is much more to the story.

One problem with the Econ 101 argument is that it requires oil producers to behave in ways that would be as hostile to their interests as they would be to those of consumers. As a group, oil producers are concerned about prices not only in the present but also in the future. It does a producer little good to sell at a very high price today if the effect is to provide customers with an incentive to develop substitutes for use tomorrow. Producers who seek to maximize long-term revenue will want to maintain oil prices stable at the highest price that does not induce substantial investment in substitutes. From the producers’ standpoint, a particularly strong motivation exists to dissuade research investments by customers with an advanced ability to develop alternatives—the United States, for example.

The conjecture that leading oil producers care at least as much about future profits as they do about present ones is born out in both word and deed. Adel al-Jubeir, foreign policy advisor to Saudi Crown Prince Abdullah, offered this summary for the Wall Street Journal in 2004:“We’ve got almost 30% of the world’s oil. For us, the objective is to assure that oil remains an economically competitive source of energy. Oil prices that are too high reduce demand growth for oil and encourage the development of alternative energy sources.” Saudi actions in response to the recent surge in oil prices provide credence to this claim: From 2002 to the first half of 2005, the U.S. Energy Information Agency estimates that Saudi Arabia’s total oil production increased dramatically from 8.5 million barrels per day to 10.9 million barrels per day. Explaining why the Saudis have chosen to “help” the United States and other developed economies by boosting production does not require resorting to conspiracy theories. It only requires understanding Saudi self-interest.

It is a serious mischaracterization to portray oil-exporting countries as behaving in ways that are systematically or consistently hostile to the United States. According to the most recent data from the Energy Information Agency, the top 10 oil exporters to the United States are (in order, excluding the Virgin Islands) Canada, Mexico, Venezuela, Saudi Arabia, Nigeria, Angola, Iraq, Algeria, the United Kingdom, and Ecuador. Iraq, Nigeria, and Venezuela are sources of concern to the international community for different reasons, but the basic point is that the 10 countries look more like a random draw from the United Nations than a lineup of either U.S. antagonists or failing states.

Of course, like all commodities, oil is traded on global markets. U.S. import prices are determined by world aggregate output and demand, not simply by the output of countries that supply the United States. It is possible, perhaps even probable, that new leadership in one or more of the major oil-exporting countries at some point might be willing to put ideological objectives ahead of economic ones—acting “irrationally” from the standpoint of a profit-maximizing behavioral model. The primary economic weapon at the disposal of a rogue oil-exporting country acting in such a manner would be to sharply reduce exports in an effort to destabilize prices. But in doing so, the rogue state would drive prices marginally higher, punishing itself with reduced oil revenues overall while benefiting other oil producers and inducing consumers to change their behaviors. In short, the rogue would suffer, and users would substitute.

Petro-alarmism focused on the Middle East often takes a different angle, emphasizing the concentration of oil reserves and spare production capacity in Saudi Arabia in particular. Because shifts in prices are determined on a global scale, some assert that the market power of countries in the Middle East is greater than their total output numbers would suggest, given that they control as much as 90% of the world’s spare capacity. Saudi Arabia alone is believed to possess as much as 30% of the world’s proven oil reserves.

There are two problems with this argument. First, reserve numbers are themselves a function of price levels. At current prices, Canada’s tar sands make our northern neighbor a strong second in oil reserves. Second, and more to the point, reserves are only useful as a strategic weapon in pushing prices down, because they offer the potential of increased output. As just noted, only by withholding output can producers push prices higher. In that respect, Saudi Arabia is no different from other producers in its ability to affect prices unilaterally by restricting production and in so doing reducing its own revenues to the benefit of other producers. As a strategic instrument of aggression, spare production capacity and high levels of oil reserves are thoroughly underwhelming.

For those not persuaded by theory, a look at the historical record is instructive. Between 1981 and 1999, an Islamic fundamentalist regime consolidated power in Iran, terrorists killed more than 300 U.S. Marines in Beirut, al Qaeda staged multiple successful attacks on U.S. interests, including the first attack on the World Trade Center, and a Palestinian Intifada raged in the West Bank and Gaza. Yet oil prices (adjusted for inflation) trended downward throughout the period. The price fluctuations that did occur were by no reasonable measure greater in magnitude than the fluctuations in other commodities during that interval. Indeed, if anything, the numbers suggest that the price of oil is less volatile than that of other globally traded commodities.

Consensus on the security threat rests on the dubious proposition that oil price changes have serious impacts on the overall economy and aggregate welfare.

The lengthy period of decline in real oil prices had precisely the expected impact on the magnitude of U.S. energy R&D: It declined sharply. For example, R&D spending at the Department of Energy declined in real terms from a peak of $6 billion (in 2000 dollars) in 1978 to $1.9 billion in 2005. Indeed, investment in energy as a fraction of total R&D in the United States was by 2005 well below what it had been before President Carter proclaimed in 1977 a “moral equivalent of war” against energy dependency. In the particularly important area of automotive innovation, the substantial technological advances that occurred during these two decades were increasingly directed not at improving fuel efficiency, but rather at increasing the size and performance of vehicles, while keeping fuel efficiency roughly constant. With gasoline at $1.20 a gallon and total gasoline spending comprising less then 2% of a typical household’s budget during the past two decades, most U.S. consumers showed precious little concern about automotive energy efficiency when buying vehicles. Early-1980s visions of the average U.S. automobile ultimately achieving 100 miles per gallon yielded to a late-1990s reality in which sales of low-mileage sport utility vehicles surged, efficiency standards were stagnant, and fuel economy did not improve. Consumption of oil per dollar of gross domestic product grew to be 40% higher in the United States than in Germany and France, where, admittedly, prices are not only much higher (largely because of higher taxes) but travel distances are generally shorter.

The one prominent example of coordinated action by producers to control prices to the detriment of consumers was the 1973 oil embargo. Yet a host of facts undermine the claims that the oil price shock of 1973 caused the recession of 1973–1974. Oil as the single variable explanation is inconsistent with the fact that the U.S. economy rebounded in 1975, even as oil prices continued to rise. Policy decisions—in particular, monetary policy and Nixon-initiated price controls that spanned the period from 1971 to 1979—contributed significantly to the onset of the 1973–1974 recession. During this period, the economies of Europe and Japan, which were also hit hard by the embargo-induced price increases but had no price controls, did much better than the United States.

Although it is possible to construct a macroeconomic model in which oil shocks do cause recessions of the magnitude observed in 1973–1974, most models in the literature predict a substantially smaller effect. Generally accepted models suggest that a 100% increase in oil prices should lead to a 1% drop in aggregate output. Even this far-from-cataclysmic impact is likely an overestimate. In the 24 months before the spring of 2006, the U.S. economy was subjected an unprecedented surge in the price of oil. Still, gasoline prices remain lower in real terms than they had been in 1981. Tight world oil supplies were further affected by the war in Iraq and by Hurricane Katrina in 2005. Yet U.S. economic growth has continued on its upward trend, almost unaffected. Indeed, the increase in the price of oil may have rescued the economy from possible deflation, which was a concern three years ago. In sum, the evidence that the macroeconomy is vulnerable to oil shocks is not nearly solid enough to support the designation of “energy insecurity” as a national security concern.

The effects of globalization

As a general rule, prices are neither weapons of retribution nor harbingers of doom. They are signals that should convey information and guide choice, both in the market and in the policy system. When a price changes sharply, it is natural for a consumer to try to determine what signal is being sent and to adapt behavior accordingly. Uncertainty can lead to consumer anxiety, particularly when political leaders magnify the significance of events.

Oil price increases have the power to succeed where policy and rhetoric have failed, creating powerful incentives for overdue investments that have the long-term potential to increase the productive efficiency of firms, lower costs for consumers, and limit the adverse impacts of global climate change.

Current increases in the price of oil mostly reflect broader changes in the world economy that are driving sustained growth in oil demand. Years of low prices dulled incentives to use energy efficiently and develop new energy sources. Consequently, the capacity to produce, transport, and refine oil is now strained on a global scale. After decades on the sidelines, the world’s two most populous countries and a number of other developing countries are surging economically. Hundreds of millions of new entrants to the global middle class are seeking automobiles and other energy-consuming amenities. Although the manufacturing intensity of the U.S. economy has declined significantly during the past 20 years, manufacturing in China has grown dramatically. China accounted for 40% of the growth in world oil demand during the past four years, recently surpassing Japan as the world’s number-two oil consumer.

From the perspective of global human welfare, more people’s lives have improved more quickly in the past quarter-century than at any time in human history. Fortunately, that trend is not likely to be reversed any time soon. As a consequence, although demand growth may slow, the current level of demand for oil and other natural resources will decline only as the efficiency of energy use increases.

Despite the relentless media attention on rising gasoline prices and the political fallout, the impact of rising prices on consumers has been minimal. From 1980 to 2005, the share of consumer spending on energy actually dropped from 8% to 6%; the 2006 numbers will be higher, but certainly not high enough to signal a consumer calamity. The most recently published data from the Bureau of Labor Statistics indicate that the average household spends $1,333 on gasoline, or 2.6% of income, which is about 1/10 the amount spent on housing. Assuming comparable demand elasticities, an increase of 1% in average housing costs thus has the same impact on household disposable income as a 10% change in spending on gasoline. If the primary policy concern is that consumers with stagnant incomes will be hurt by inflation, a Dutch businessman buying an apartment in New York poses a far greater threat than does a Beijing resident buying gasoline to fuel his first automobile. Yet there are few calls for a national real estate policy.

Specific subpopulations are, of course, particularly vulnerable. A 15-year-old but still relevant study by Massachusetts Institute of Technology economist James Poterba suggests that about 10% of U.S. households spend more than 10% of income on gasoline. These vulnerable households tend to be low-income residents of rural areas. On the other side of the equation, stockholders and executives in U.S. energy companies gain substantially when oil prices go up. It is evident that such widely divergent distributional impacts constitute a significant short-term political and policy challenge. However, a short-term political challenge is not the same as a long-term security threat. Although there is ample reason to expect political leaders to be concerned about rising gas prices, from an analytical standpoint, it remains the case that energy insecurity is a myth.

If the dangers posed by increases in imports are mythical, why are they so widely believed to be real? In part, this is because no organized interest in the policy debate has an incentive to challenge the myth of energy insecurity. For the domestic energy industry (including ethanol producers), alleged threats posed by dependence on foreign oil lend support for an assortment of wealth transfers in the name of the “national interest.” For environmentalists, it provides a rationale for championing investment in renewables. Military hawks are drawn to the notion of energy insecurity because it offers a rationale for additional investments in weapons and personnel. Jihadists and anti-U.S. globalization protesters embrace the energy insecurity myth because it offers a clear and persuasive explanation for their belief in U.S economic imperialism.

This is not to say that arguments made to support claims of energy insecurity are entirely without merit. There is no doubt, for example, that the market for oil today is far more responsive to market fundamentals than it was in the early 1980s, the last time prices were at $3 per gallon (in real terms). Twenty years ago, the spare production capacity of the members of the Organization of Petroleum Exporting Countries (OPEC) was 15 million barrels per day, or about a quarter of global demand, reflecting the organization’s success in curbing members’ output to boost prices. Today, spare capacity is down to less than 2 million barrels per day, or about 2% of global demand. This means that the power of OPEC to reduce prices has diminished; these alleged foes are less able than they have been in the past to keep oil prices low. Of course, at the same time, the strategic oil reserves of the countries of the Organization for Economic Cooperation and Development have grown to more than 1 billion barrels. Oil-consuming countries are in a better position today than in the past to manage the impacts of serious supply disruptions without OPEC assistance. Additionally, technological advance has undoubtedly increased the adaptive capacity of the economy, as evidenced by the lack of an observed macroeconomic impact attributable to the current price upsurge.

A better rationale for being concerned about increasing oil prices is the mounting evidence that resource wealth— and, by implication, the increase of that wealth through higher resource prices—undermines the political development of resource-rich countries. Casual observers have long noted the apparent irony that places rich in natural resources are frequently poor in everything else. It is now apparent that this irony is actually a consequence of predictable distortions of microeconomic incentives that systematically undermine political and economic development. The so-called “curse” of oil is by now a well-established empirical regularity. Of the few countries that appear to have at least partially escaped the curse, most have done so by virtue of small populations; the elites that control the oil wealth make up a large enough share of total population that some degree of equity and stability appears to be achieved. Elsewhere, particularly in populous countries such as Indonesia, Iraq, Iran, Nigeria, and Russia, the corrosive effect of resource wealth on political development is evident. Because behavioral distortions increase when the relative price of the resource increases, it follows that oil price movements and democratic change will move in opposite directions.

That the curse of oil is real is not in debate. What is debatable is its security implications. Surely a responsible policy-maker would not want to fill an adversary’s treasury with petrodollars if it was possible to acquire resources from another supplier. This approach was taken in the faceoff with Saddam Hussein after the first Gulf War. Sanctions probably undermined the ability of the Iraqi regime to maintain the pace of development of some weapons programs, including weapons of mass destruction. Yet by almost any other measure, sanctions were a catastrophic failure. Amending the sanctions, via the United Nations’ oil-for-food program, to reduce their dramatic humanitarian costs resulted in corruption and mismanagement on a grand scale. The lesson learned was that coalitions of ostensibly well-intentioned countries seeking to enforce sanctions are little more effective than coalitions of apparently menacing countries seeking to enforce embargoes. In either case, enormous incentives to cheat undermine coordination and fuel corruption.

Another option for dealing with the curse of oil problem is to challenge the long-term economic viability of oil as a commodity by increasing investment in oil substitutes, preferably derived from an abundant and widely dispersed natural resource that is not itself subject to a future curse. This is a laudable goal, but the question is whether it can be accomplished, given the multiple obstacles that exist, including the fact that powerful economic and political interests in the United States benefit from high oil prices. By this path, we arrive at the capping irony that underlies the myth of energy insecurity: Rather than signaling doom, higher oil prices actually signal hope.

The panacea of high oil prices

Although increasing oil prices do not constitute a legitimate national security concern for the United States, they do create severe distributional inequities at home and undermine the development of democracy abroad. Yet distributional and political downsides notwithstanding, it is almost certainly the case that the benefits of higher prices actually outweigh the costs. In the long run, low oil prices pose a greater threat to national security than high prices.

Oil is a nonrenewable resource, so a shift to other energy sources must occur sometime. The question is when. Low oil prices encourage the deferral of needed investment. When oil prices collapsed in the mid-1980s, so did the market incentives and political will needed to invest in increasing energy efficiency. For a generation, thoughtful commentators recommended that the federal government substantially increase gas taxes, progressively raise vehicle mileage standards, and increase investment in energy efficiency. Under multiple administrations and different configurations of political leadership, the will to effect those changes was absent. Consequently, billions of dollars that could have gone to the U.S. Treasury as a means of changing the structure of energy consumption in the United States are now going to U.S. oil suppliers.

Deferred investments in energy efficiency pose a threat to U.S. national security for one paramount reason: potentially catastrophic climate change. The very real benefit of today’s increase in oil prices is that it may compel investments reducing the probability that tomorrow (that is, in 50 years) Nebraska will be parched, Manhattan will be under water, and coastal areas of the South will be depopulated because of increasingly intense and frequent hurricanes. Of course, the impacts of climate change are complex, and in this area just as in others, adaptations will occur and change will create winners as well as losers. Assigning probabilities to various scenarios is difficult. However, the worst-case scenarios of adverse impacts from climate change are much more severe, and not substantially less likely, than the worst-case scenarios from high energy prices. This fact alone should lead us to at least consider welcoming expensive oil as an antidote to perennial short-sightedness.

The bottom line is that in an open society with a market economy, only prices have the brute power to effect change on the scale required to address real and significant challenges to economic well-being. Today, prices are approaching the levels that 25 years ago induced serious investments in energy efficiency. Long-overdue behavior changes may now occur. And none too soon.


Philip E. Auerswald () is director of the Center for Science and Technology Policy and assistant professor at the School of Public Policy, George Mason University.