U.S. Oil Dependence Remains a Problem

War and terrorism have changed a lot about how we think about oil markets. But one thing they haven’t changed during the past 14 years is the fact that excessive dependence on oil in our domestic energy mix exposes us to potentially serious economic and security risks. And they have not changed the importance of taking action to cut oil consumption in the U.S. economy.

In 1989, I argued that the Organization of Petroleum Exporting Countries (OPEC) would be able to control energy prices by the mid-1990s unless policy actions were taken to prevent it. Price control would enable OPEC to extract rents–charge a lot more for its oil than it cost to produce–that would be a drag on the economies of oil consumers. Moreover, since the bulk of OPEC production is in the Middle East, the famous political instability of that region would expose consumers to price shocks. Those risks did not depend on how much OPEC oil a consumer imported; world oil markets would ensure that all consumer nations experienced the same high and potentially volatile prices.

That is pretty much what happened. As oil markets tightened during the 1990s economic boom, a reasonably well-disciplined OPEC became the world’s swing producer, or market regulator. As such, OPEC, and especially Saudi Arabia, could adjust production to exert a strong influence on world prices. Not surprisingly, two wars in the Persian Gulf and terrorism at home produced the expected price excursions, which happily did not last too long.

OPEC’s position is unlikely to change anytime soon. Growth in oil consumption will resume as the world economy recovers. Developing nations will stake an increasing claim on oil; China, for example, has swung from a small oil exporter in 1989 to an importer of almost 2 million barrels per day. On the supply side, some growth in oil production outside OPEC is likely, but the Middle East retains the dominant share of oil reserves on which future production will be based. For years to come, OPEC seems likely to remain the global swing producer. The key question is how OPEC will go about setting prices.

For the past few years, OPEC pricing policy has been fairly benign, successfully holding the per-barrel price in the $22 to $28 range. That price is intended to keep OPEC’s revenue high without creating so much competition from new sources as to erode its market control. The oil revenues enrich governing powers and families, while making life tolerable for the general population. Luxury for the few and calm for the many has been more than enough reason to keep the oil flowing during the procession of political crises that have beset the region. It’s why turmoil in oil markets has been relatively short-lived.

Currently, however, OPEC’s comfortable position has become precarious. Control of the world’s second-largest oil reserve–Iraq’s–is up for grabs. Terrorists seem eager to destabilize governments in the Middle East as well as undermine U.S. influence there. It’s too soon to predict how the political situation will play out, but the range of possibilities is broad. One current view is that the fall of the regime of Saddam Hussein is but the first step toward more democratic, market-driven societies throughout the region. Another is that the more radical elements will seize control and use oil as a weapon to redress grievances.

How will the political resolution affect oil markets? Clearly, the latter outcome would only increase the risks posed by excessive dependence on oil. Unfortunately, it’s not clear that the happier outcome would do much to reduce those risks. A more stable and globally integrated Middle East has much to recommend it, of course. Democracies presumably don’t start oil wars any faster than they start other kinds, and more open markets would encourage the investments needed to keep OPEC oil production growing. Yet even the most democratic of swing producer governments is unlikely to volunteer to sell its oil for less than the markets will bear; at least, none does so today. So it’s not unreasonable to expect that even the best political outcome would leave oil consumers paying a high price for increasing use of OPEC oil. Nor is it unreasonable to expect a less-than-optimal outcome in the troubled Middle East.

All of the above suggest that we face much the same problem we did 14 years ago: how to reduce our oil dependence. The main lesson of the intervening years is that cutting demand is the essential policy. Since 1989, non-OPEC production has been reasonably constant, which is no small success. Looking ahead, developments in the former Soviet Union and in Africa suggest that there is good potential for holding production steady. But aside from the collapse in demand that accompanied the breakup of the Soviet bloc, world oil consumption has grown at more than 2 percent annually since 1989.

Regrettably, the recommendations I offered for reducing oil demand in 1989 look a lot like the policy agenda I would recommend today. Even in those days, imposing a gasoline tax and creating an alternative motor fuel to depress and ultimately replace oil consumption were not new ideas. Despite the senior-citizen status of those proposals, their implementation is more urgent today than ever before.