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Policies of Scale: Efficient Global Policy

Let’s Get Real: Energy Independence is an Unrealistic and Misleading Myth

Confusion on Energy Policy in the 2012 Election

Energy, like every topic that is not the economy, will be a secondary issue in this election (unless oil prices increase dramatically). That does not mean it is unimportant. In fact, energy is vital part of getting economic policy correct. The largest component of energy in the US is oil, which accounts for 37% of primary energy consumption.[1] The median US household spent a record $4060 on gasoline in 2011, equal to 8.2% of their household income.[2] That is a large chunk of change, and when you consider the related geopolitical and environmental consequences of such heavy oil usage, energy – and oil in particular – ought to be a pressing matter of concern.

Thus far, when energy has been discussed, the foci are “energy independence” and “alternative energy.”  Although far from dominating energy markets, the latter is quickly becoming a significant source of US energy consumption and will likely to continue to gain market share. The concept of energy independence, however, is unrealistic, largely undesirable, and misleading. I am going to tackle the façade of the energy independence argument in this piece and in doing so will try to explain the issues actually affecting national energy policy. This piece will focus on oil because (1) it is our most used source of energy and (2) it is our major energy import.

At the heart of the energy independence idea is the rationale that achieving energy independence will unhook us from world energy prices and disengage us from the geopolitical consequences Americans find unpalatable, namely massive engagement in the Middle East. Neither is true, and in fact they’re not even remotely plausible outcomes.

If there is one take-away I want the reader to remember, it is this: the goal of self-sufficiency in energy supplies – especially in oil – misdiagnoses the problem as one characterized largely by importation of oil. Rather, energy security, the implications of energy on the economy, and America’s reliance on imported oil is a function of the importance of oil consumption in the domestic economy regardless of its source. The only way to reduce the cost of gasoline is by consuming significantly less of it, while the only way to ensure minimal political and security insulation from oil is to stop using it.

Oil is a Global Commodity

Oil is a global market and therefore a globally priced commodity, and so long asAmericaconsumes oil and abstains from protectionist policies, self-sufficiency of oil would still mean buying and selling oil at the world price. Because oil is available from dozens of countries and hundreds of companies, and because it is relatively easily shippable, there is only a single global market for oil no matter where the consumer is located. Oil prices are set in open commodity markets, and oil is traded globally, which means that prices are affected by events around the world and decisions made by countries and companies unassociated with theUnited States.

The way the oil production supply chain functions means it would be impossible to separate  domestic and foreign gasoline. William Nordhaus of Yale University illustrates the globally integrated oil market nicely as a “bathtub” that:

“…contains the world inventory of oil that has been extracted and is available for purchase. There are spigots from Saudi Arabia, Russia, the United States, and other producers that introduce oil into the inventory; and there are drains from which the United States, Japan, Denmark, and other consumers draw oil from the inventory. Nevertheless, the price and quantity dynamics are determined by the sum of these demands and supplies and the level of total inventory, and are independent of whether the faucets and drains are labeled “U.S.,” “Russia,” or “Denmark.”[3]

A useful example of how oil consumers are beholden to the global oil market is Europe’s experience in the aftermath of Hurricane Katrina. After Katrina, gas prices in Europe soared as a result of the damage to US refineries even though those facilities sent very little gas to Europe. Even if the USdoes not import one barrel of oil from the Middle Eastor any other region, the price US consumers pay at the pump would still be a function of worldwide supply and demand, just as it was for Europeans after Katrina.[4]

The extent of our vulnerability is not a function of how much oil we produce domestically. Britain produces more oil than it needs, but its self-sufficiency does nothing to alter its gasoline prices or its vulnerability to global price volatility.[5] Likewise, the US, so long as it uses significant amounts of oil, will be susceptible to the global oil market no matter how much of our consumption comes from domestically produced oil.

Both Canada and Norwaywere net oil exporters for the entire period of the 2003-2008 when global oil prices steadily increased, and both nations remained net exporters through the price spike in 2011. In both cases, domestic retail fuel prices tracked global oil prices almost perfectly. Adjusted in a common currency and excluding taxes, retail fuel prices in Canada and Norway moved in lockstep with global crude and also with retail fuel prices in the US. In fact, during this period, gas prices were cheaper in the US than in either Canada or Norway.[6]

In 1973 the US imported just over a third of its petroleum, yet the economy proved far more, not less, exposed to the shock of global oil prices than it was two years ago when prices soared again while dependence on foreign oil reached an all-time high.[7] Since 2005 production in the US has been steadily rising, and we now produce about 1.5 million barrels more than we did six years ago. Over the same period of time, however, oil hit a record of $147 a barrel.[8] What is more, it is largely because of these high prices that new American production is possible; low gas prices actually stifle American production and hurt that sector of the economy because US production costs make US oil less competitive at more affordable barrel prices.

The Oil Market is Not a Free One, and We Cannot Treat it As if it is Free

One of the arguments for energy independence is that it would lower gasoline prices because we could apply free market principles to the energy market to eliminate its distortions. This last part implies a truth; the oil market is not a free market and does not operate on free market principles. A majority of the world oil supply is produced by members of the oil cartel, OPEC. As much as 90% of conventional (inexpensive) oil reserves are held by national oil companies whose investment and production decisions are far removed from the free market ideal.[9] 40% of the world’s oil reserves are in Saudi Arabia, Iran, and Iraq, a large portion of which are developed by national oil companies.[10]

As a whole, the oil industries in OPEC countries do not function as profit-maximizing firms seeking to expand market share. Instead, investment levels are determined, at least partially, as part of a strategy to achieve specified price targets. Because of these distortions, the application of American market capitalism would be ineffective in achieving free market outcomes.

Our current oil boom is a major source of confidence for those who believe we can achieve energy independence, and within this sense of American ingenuity comes the belief that America’s free market principles will further set us free of this distorted, anti-capitalist global oil market. However, there are real questions about the relevance of the new American oil boom for the global supply-demand balance. If OPEC follows historical patterns, its members will view these developments as a signal to forestall investments, reduce production, and keep the global balance tight, essentially neutralizing America’s effect on prices. We can make our domestic oil market as free as we like, but OPEC can and would respond (with easy) unilaterally to re-distort the market. There is no free market for oil.

Why Importing Oil is Necessary

The amount of petroleum we and other industrial countries import is so enormous that operating our societies and economies without it over the next several decades will be impossible (Deutch). American consumption makes us an outlier. To put it in context, the US consumes as much oil as China, Japan, Russia, and Germanycombined.[11]

Oil prices are set in open markets and are the result of a series of individual speculations of supply and demand, as well as expectations about the future balance of supply and demand. Numerous factors effect these assessments, from oil consumption and production levels in dozens of countries to currency values, national and international economic policies, geopolitical events, improvements in technology, and weather. As long as we are large consumers, we cannot be independent of global oil markets or global oil prices.

After hurricanes ravaged the Gulf Coast, disabling refineries as they went, cities across the southeast were hit with gas shortages. The reason they were short-lived, however, was because we were able to import additional supplies to fill the gap. In addition to gas imports, we are buying crude from Angola, jet fuel from South Korea, natural gas from Trinidad, coal from Columbia and uranium from Australia.[12] These imports show that the energy market is global, that it is unavoidable, and actually beneficial from economic and energy security perspectives, to source in the global market where trade specialization produces the best products from reliable suppliers at the most competitive prices.

Factors driving US Oil Production

Far more consequential for America’s economic stability and national security than the share of fuel imported is our relative energy-intensity and susceptibility to inflationary pressures. Oil is incredibly important to the US. In 2010, petroleum fuels accounted for 37% of primary energy demand, more than any other fuel.[13]

The value of petroleum consumed in the US has ranged from $47 to $895 billion per year over the past four decades, or between 2.6 and 8.5% of gross domestic product. During the past five years, average household spending on gasoline, which had fallen sharply to $3663 in 2009, reached a record $4060 in 2011, equal to 8.2% of the median household income.[14]

Put another way, the increase in spending on gas by the average household between 2001 and 2008 effectively offset the income tax reductions over the same period. The payroll tax cut signed into law in 2011 provided households with an additional $108.6 billion in take-home pay while the increases in gas prices cost American households an additional $104.4 billion in fuel spending compared to 2010.[15] While the economy is narrowly avoiding a double-dip recession, the increased spending on fuel has weakened consumer spending elsewhere and acted as a drag on growth.

Rising domestic production is expected to reduce imports while meeting consumption growth. However, this can only do so much to lessen the vulnerability of the economy to high and volatile oil prices. To shield the US from the global market and its volatility, the US would have to regulate domestic production by either blocking or taxing imports, establishing a price floor, and outlawing or taxing exportation of domestic production, none of which are advisable policies.

There remains reasons to be cautious about potential domestic oil production capacity as well, particularly with respect to the development of onshore resources which are still in early stages of development and quite expensive to pursue. Downside risks could come in the form of falling oil prices and faster than expected well decline rates. Extracting these resources also requires the investment of substantial capital. The bottom line is that development of domestic resources is becoming increasingly expensive, necessitating high oil and gas prices to ensure profitable returns.

The American Petroleum Institute released a study in 2011 that said that if every piece of federal land, excluding national parks, was open for drilling, North America could produce an additional 10 million barrels of oil per day by 2030, equivalent to roughly 10% of world oil production. At today’s consumption level, that would eliminate the need for any other imports. Yet the Energy Information Agency looked at the effects of drilling off the East and West Coasts and the west coast of Floridaand projected that after OPEC adjusted its production to reflect increased US outputs, gas prices would drop by a maximum of 3 cents per gallon.[16]

By 2030, the world is expected to consume over 100 million barrels of oil per day, and it is far from conclusive that the impact of the additional 10% of supply achieved by producing North America’s near-full capacity would have any meaningful effect on oil prices given the continued rise in demand up to and beyond 2035 expected by every projection, especially when US proven oil reserves are only the twelfth largest in the world.[17] Getting every little bit of additional supply from domestic reserves will require increasingly elaborate operations, many of which may be prohibitively expensive if proper environmental safeguards are factored in and if world prices sag, as they have repeatedly in the past 15 years. In a global market, it is hard to see how such projects could compete with various foreign sources where production costs are much lower. Most of the oil extracted by OPEC countries costs less than $5 per barrel to produce[18] with total upstream costs of Middle Eastern crude at $16.93 per barrel.[19]

Conversely, the Department of Energy reports US average upstream costs of $74.20 per barrel between 2006 and 2008, which is a good reference point for current production costs given recent dynamics in global oil production costs.[20] Even if all government regulations on oil production and refining were removed, the cost of domestic production would be more expensive than OPEC production by multiples.

US production costs are high, and require high barrel and pump prices to be economically viable. Thanks to high prices today, America is achieving record oil production. However, producing more here does not mean that more oil will stay here. Because of global markets, if China, India, or another country was willing to pay more on a given day, then that is where the oil will go.[21] We see this in America’s increasing oil exports.

There are good reasons to want energy independence: increased oil and gas drilling in the US does create many good paying jobs, reduce reliance on foreign oil and reduce the trade deficit. However, make no mistake: it will have little to no impact on gas and oil prices because the amount of extra oil that could be produced from fully producing our resources is essentially insignificant in the context of what the world produces and consumes.

Domestic Oil Demand

Energy consumption correlates with the strength of our economy: a weak economy means weak oil demand and weak gas prices. Combined with our increasingly efficient vehicle fleet, rising domestic output is expected to help reduce US oil imports. Structural changes in the economy, rising energy standards and prices, and improved efficiency have combined to begin this transition.

A series of structural changes in the 1970s on the demand side made the US significantly less reliant on oil. The federal government reacted to the 1973-1974 oil embargo with a series of policy initiatives, most notably President Gerald Ford’s Energy Policy and Conservation Act that established the corporate average fuel economy (CAFE) standards for passenger vehicles. CAFE was successful in achieving its purpose: on-road fuel efficiency of vehicles improved sharply.

Between 1975 and 1990, the period during which these first CAFE standards were phased-in, the efficiency of all passenger cars improved by 44% while light duty truck efficiency improved by 53%. Ford also signed into law the Power Plant and Industrial Fuel Use Act, which extended a ban on burning petroleum fuels in power plants that were capable of burning coal. Oil consumed for power generation fell from 1.7 million barrels per day in 1978 to 478,000 barrels per day in 1985. All told, the oil intensity of the US economy fell by 33% between 1977 and 1985 due to the combined effects of CAFÉ and the Fuel Use Act.[22]

In 2005, US imports of crude and petroleum products accounted for 60% of final energy consumption. By 2011, that figure had fallen to 44.7% and by 2025 it could be as low as 37.9% with the new Obama CAFE standards. The biggest contributing factor to this decline in oil consumption is vehicle fuel economy standards, which are the most important energy security accomplishment in decades.

The transportation sector is the biggest driver of US oil consumption, representing over 70% of America’s oil needs. In 2010, the sector relied on petroleum-based fuels for 93.2% of its energy sources.[23] As a result of this complete reliance on oil, American consumers and businesses, and the economy by extension, are fully exposed to oil prices with practically no means to choose less costly alternatives in the short term.

The combination of high petroleum prices, which are unlikely to decline significantly in the future, and rising automotive efficiency have essentially put a ceiling on US demand. With this dynamic in place on the demand side, rising domestic production can be expected to displace imports on a near 1:1 ratio. This has largely been the case of the past several years, as net imports have fallen from their all time high in 2005.

But with oil a globally traded and priced commodity, fuel efficiency is not enough on its own. The long-term goal of energy policy must be to break the stranglehold of petroleum on the US economy, of which transportation represents almost three-quarters of consumption. Only massive decreases in oil usage in the transportation sector will be effective in lessening America’s susceptibility to the negative national security and economic aspects of oil.

The Other Big Problem: Price Volatility

Given our oil dependency, the biggest threat to the US from energy-related issues comes by way of price volatility, which creates uncertainty and economic dislocation and affects planning and budgetary decisions for government and consumers, resulting in less efficient resource allocations and ultimately preventing the US economy from maximizing its potential. These effects are clearest to the American consumer based on their experiences with prices at the pump

Because oil is priced on a global market, world events impact oil prices, and therefore the volatility of geopolitics play a significant role in driving the volatility of oil prices. One way of considering this impact is the role speculation, which is based on world events, has on oil and gas prices. Goldman Sachs estimates that the each million barrels of speculation in the oil futures adds about 10 cents to the price of a barrel of oil. The speculative premium of oil prices, given current trading figures, contributes as much as $23.39 to the cost of each barrel, or $0.56 per gallon of gas.[24] Thus, the role the world has on prices in the US is quite significant, and unavoidable.

So long as the US economy relies heavily on consuming oil, as it does and is projected to do for the indefinite future, no amount of US production will produce either low gas prices or stable gas prices.

A More Useful Way to Think About Energy

The nature and meaning of energy independence is widely misunderstood. Although increased domestic oil production does have clear positive effects on the US economy, it will not insulateAmericafrom the risks of oil dependency. This can only be accomplished by reducing the role of oil in our country. Our nation cannot achieve energy security so long as we are economically beholden to oil, which is priced on a global market that does not resemble a free one.

As has been expressed, the US is effectively unable to control gas prices at home. The most direct mechanism for doing so is taxation, although this represents only 12% of the cost of a gallon of gas. 62% is the price of crude; refining costs and refining profits are 12%; and distribution, marketing, retail costs, and profits are 14%.[25] The costs associated with these four components are all likely to increase over time (and are only attributable to government regulation to limited extents), and with demand outside the countries of the Organization of Economic Cooperation and Development group expected to grow by 15.7 million barrels per day between 2010 and 2035, the price of gasoline is likely to remain at well over $3 per gallon indefinitely as the new sources of oil coming online are costing more and more to access and produce.

Given this, the smart approach to US oil policy is to promote domestic production while, more importantly, promoting efforts to get off of petroleum; this is the key to unhooking America from the economic disadvantages of oil.

 


[1]Energy Information Agency (EIA). “Total Energy: Primary Energy Consumption by Source and Sector, 2010.” Retrieved from: http://www.eia.gov/totalenergy/data/annual/pecss_diagram.cfm

[2] Ibid, SAFE, Oil Boom

[3] Nordhaus, William. “The Economics of an Integrated World Oil Market.” Keynote Address, International Energy Workshop. June 17-19, 2009. Retrieved from: nordhaus.econ.yale.edu/documents/iew_052909.pdf

[4] Deutch, Philip J. (2005). Energy Independence. Foreign Policy, No. 151. 20-25.

[5] Nivola, Peitro S. (2002). Energy Independence or Interdependence? Integrating the North American Energy Market. The Brookings Review, Vol. 20, No. 2. 24-27.

[6] SecuringAmerica’s Future Energy (SAFE). The New American Oil Boom: Implications for Energy Security. 2012.

[7] Ibid, Nivola

[8] Hargreaves, Steve (2012). America’s oil boom – at a cost. CNN Money. February 28, 2012. Retrieved from: http://money.cnn.com/2012/02/27/news/economy/oil_boom/index.htm

[9] Ibid, SAFE, Oil Boom

[10] SecuringAmerica’s Future Energy (SAFE). Congressional Briefing Book, 2012.

[11] SecuringAmerica’s Future Energy (SAFE). Oil and the Trade Deficit: Rising Energy Expenditures and US Energy Security. May, 2012.

[12] Bryce, Robert (2008). 5 Myths About Breaking Our Foreign Oil Habit. The Washington Post. January 13, 2008. Retrieved from: http://www.washingtonpost.com/wp-dyn/content/article/2008/01/10/AR2008011002452.html.

[13] Ibid, EIA, Total Energy

[14] Ibid, SAFE, Oil Boom

[15] Ibid, SAFE, Oil Boom

[16] Ibid, Hargreaves

[17] Ibid, SAFE, Congressional Briefing Book

[18] Ibid, Nivola

[19] Ibid, SAFE, Congressional Briefing Book

[20] Ibid, SAFE, Oil Boom

[21] Bittle, Scott and Johnson, Jean. (2012). Presidents and the Price of Oil. The Great Energy Challenge: A National Geographic initiative in partnership with Shell. February 27, 2012. Retrieved from: http://www.greatenergychallengeblog.com/2012/02/27/presidents-and-the-price-of-oil/.

[22] Ibid, SAFE, Oil Boom

[23] Ibid, SAFE, Oil Boom

[24] Lenzer, Robert. (2012). Speculation In Crude Oil Adds $23.39 To the Price Per Barrel. Forbes. February 27, 2012. Retrieved from: http://www.forbes.com/sites/robertlenzner/2012/02/27/speculation-in-crude-oil-adds-23-39-to-the-price-per-barrel.

[25] Energy Information Agency (2012). What do I pay for in a gallon of regular gasoline? Updated July 27, 2012. Retrieved from: http://www.eia.gov/tools/faqs/faq.cfm?id=22&t=5.

4 Responses to “Let’s Get Real: Energy Independence is an Unrealistic and Misleading Myth”

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