EconoMonitor

Policies of Scale: Efficient Global Policy

On The Need For A Federal Oil Reserve

In 1913 the Federal Reserve was established to provide a politically insensitive institution that could make and enforce policy for one of the most important and sensitive elements in our economy: the dollar. Given the disastrous results of the governance of energy, it may now be time to consider a Federal Oil Reserve that would serve a similar mandate: to achieve stable oil prices and supply through policies that aim to unhook the American economy from oil.

I hope no one believes oil is a free market, because it’s not even close. And yet when serious people discuss the energy opportunities and challenges facing our country, they often speak of the subject as though it operates as a free market. And we in the West love our principles because they are based on freedom, whether it is the market or our unique blend of positive and negative rights. But when a market is not free and we behave as though it is, we get screwed. And such is the case with oil. America is getting screwed, and we seem to be oblivious because we have an aversion to acting out of character, and have not gotten our act together and tackled the oil challenge with useful tools.

In 1907 a financial crisis struck America, and the stock market fell nearly 50% from its peak a year prior. Numerous runs on banks and trusts ensued as liquidity fled the market and depositors lost confidence. The panic was triggered when an attempt to corner the market on United Copper Company stock failed. Banks who had lent to the scheme were on the business end of runs that later infected affiliated banks and trusts. Eventually, New York City’s third largest trust combusted.

J.P. Morgan saw what was happening and recognized that the panic was doing no one any good, so he put up large amounts of his own money to put a floor under the market and convinced several of his friends to do the same. Why didn’t the Federal Reserve step in? After all, isn’t injecting liquidity into a dry market one of its central purposes, and exactly what today’s quantitative easing is all about? Well, 1907 was six years before the Federal Reserve was born. The 1907 crisis served as perhaps the most identifiable catalyst for the Fed’s creation, and ever since the Fed has given the private sector a break from the kind of action-taking Morgan pursued in order to help the American economy.

To an energy wonk like me, the details of the 1907 crisis and its role in the creation of the Federal Reserve are compelling because the story suggests the creation of a Federal Oil Reserve might be a good idea. Let’s modernize the 1907 story and talk about the events surrounding the 2011 international intervention in Libya.

In mid January of 2011, demonstrators took to the streets in Benghazi to protest poor governance and corruption. Within two weeks, the government responded to the demonstrators’ concerns by throwing 20 billion euro at their grievances. Around the same time, a popular thought leader called for more protests and was promptly arrested and jailed on likely fallacious charges. The protests that erupted afterwards eventually led to a brutal civil war and the overthrow of dictator Muammar Gaddafi.

By August of 2011 international condemnation of the Libyan government’s actions was so strong that the United Nations Security Council passed Resolution 1973, which authorized an international coalition to create a no-fly zone over Libya to assist the anti-government forces in Libya and bring the war to an end. Although the effort took longer than many expected, its desired outcome was effectively achieved.

The effect of the war and intervention on oil prices was sizable. During the war Libyan oil production fell from around 1.6 mb/d to nearly zero. Over the first five months of 2011, the Brent crude barrel price went from around $95 to $125 before stabilizing around $112 as the Saudis tapped their spare capacity to assure global demand was met.

So where are the parallels? Let’s start with depositors and gas consumers, the “customers.” Both participate in their respective markets but had effectively no control over whether their considerations were taken into account by the people spending their money. Depositors’ money was used in a risky move that failed while gas consumers were hostage to the actions of those of producers who undertook risky actions. Next comes the banks/trusts and the Libyans, the risk takers whose actions cost their customers a lot of money. US GDP in 1906 hit almost $34 billion, but in 1907 fell to just over $30 billion. US gas prices in 2011, meanwhile, rose from just over $3.00 in January to almost $4.00 in May before steadily declining to around $3.50 by year’s end. The harsh effects in both cases were largely felt by the customers. And finally, the saviors: J.P. Morgan and friends, and the Saudis, both of whom injected liquidity into their respective markets in order to calm the situation.

Let’s now bring the story to today. The Federal Reserve has been one of the most respected, if not sometimes revered, institutions in America, although its effectiveness can often be questioned on legitimate evidence. It has, however, proven itself on the whole as being worth its existence. Further, given the financial system that has been built since its inception, it is impossible to imagine the US economy functioning in good health without it.

Now consider today’s oil market, which can be summed up with four points. First, the market is global and oil is fungible, and given the balance of global reserves we cannot influence its price in any effective way with domestic production. Second, volatile swings in oil prices, often provoked by geopolitical events, have occurred just prior to nearly every recession in the past 40 years, serving to complicate government and market adjustments because of high inelasticity of demand (see the correctly caveat’ed argument here and the chart here). Third, as nationally-owned countries take over global reserves and production, the foreign policy and international stability calculations become increasingly risky to America. And forth, even with growth in domestic production, assuming tepid economic growth the portion of income spent on oil will rise (the only question is by how much).

Clearly, the cost of our dependence on oil is negative, and that’s not even factoring in the environmental costs. Yet our response to these externalities has been to proceed as though the simple market mechanism of supply and demand produces an acceptable outcome. Yet notable free marketers Friedrich Hayek, Ludwig von Mises, and Milton Friedman have all agreed that a role of the government is to prevent and break up monopolies. Put another way: they agree that the government needs to directly and forcefully intervene in the market to ensure it does not produce the worst outcome of monopolistic domination by actors who are unacceptably selfish. And many of today’s conservatives and free market capitalists can be witnessed praising CAFE standards.

Yet here we are today with a very terrible outcome from our oil market, many of whose primary actors are operating according to motivations that routinely harm our economy and our lives.  The purpose of the Fed is to “foster growth at high levels of unemployment, with a stable dollar…” Again, although its effectiveness and therefore its design can be debated, its role has been necessary given its goals. Perhaps then an independent Federal Oil Reserve could be created to “achieve stable oil prices and supply through policies that aim to unhook the American economy from oil.” The only real solution to the externality curse of oil is to at least significantly reduce, if not eventually end, our dependence on it. Such a goal, if achieved, would monumentally improve the American economy and therefore support the establishment of such an institution.

Central banks can perform a range of duties, including setting monetary policy and interest rates, managing the supply of money, serving as the lender of last resort, managing foreign exchange and reserves, and regulating and supervising the banking sector. A Federal Oil Reserve (let’s call it “the FOR”) would not be able to execute the equivalent roles given oil can be produced abroad while the dollar is only produced domestically. However, as domestic production increases and we import more from North America (here I’m counting on the Keystone XL Pipeline and Mexico’s production liberalization legislation both going through), the FOR’s ability to influence the market improves a bit.

An obvious power to fall under the FOR could be control over the Strategic Petroleum Reserve (SPR), our emergency stockpile of up to 727 million barrels of oil that can be metered out to the market to calm prices or plug a supply gap (I should note that the appropriate use of the SPR is contested among energy wonks and economists and not everyone would agree with my general characterization of its purpose). Although some worry that the decision to tap the SPR could be made on political considerations, the SPR has been tapped only three times (all for non-political reasons): during Desert Storm, Hurricane Katrina, and in June of 2011 as part of a coordinated IEA effort. Nevertheless, putting the SPR in the control of the FOR would allow for a potentially more effective role of the SPR in effecting the market, especially if other IEA members make similar moves with their strategic reserves.

Piggybacking on the consideration of politically-influenced policy-making, the FOR could also be the prime source for the creation and implementation of policy related to oil consumption. This would be vital as the Saudis have the long-term oil reserves and medium-term economic reserves to hold back their production to mitigate use of the SPR to effect the market. The standard in governance thus far is that numerous federal agencies and both the legislative and executive branches have the ability to implement policy that effects our oil usage. The result has been that the U.S. has been out-maneuvered by non-democratic decision-making abroad while our country has failed achieved energy policies that have achieved any honest measure of long-term effectiveness (even high CAFE standards are only half-effective because they make driving more affordable) – and the future for one looks nonexistent given current trends.

A critical component to breaking the stranglehold of oil is to diversify the fuel market, and this would be a vital function of the FOR. There are a number of economically, technologically, and resource-feasible alternatives available today, especially given the abundance of cheap natural gas that is used to convert some of these fuels into economically feasible alternatives for combustion engines. Further, the technology to convert the existing fleet of cars in this country is widely available and relatively affordable. The problem, however, is one of chicken and egg: what comes first, the re-fueling infrastructure or the wide scale production of vehicles capable of running on multiple fuels?

Thus far the market has not produced an answer, nor has it motivated anyone to put their skin fully in the game. The FOR could provide fuel competition CAFE credits for automakers that move their fleets significantly towards the flex fuel standard while stipulating a mandatory baseline percentage of fleets that can run on multiple fuels. And if courageous enough, the FOR could also move our fuel tax policy towards a Pigovian framework that accurately captures the true cost of each fuel.

The key to a successful FOR would be for it to have the same independence as the Fed does so it avoids today’s political malfunctions retarding policymaking. The lack of progress towards smart, long-term energy policy in this country is costing us real dollars. As I’ve projected, median income earners could be spending as much as 10% of their income on gasoline by 2023, and our GDP per unit of energy use (oil equivalent) has been trending in the wrong direction since 1988 despite monumental efficiency gains over the same period. It is time to stop pretending that the oil market is free and that it takes care of its inefficiencies, distortions, and disruptions on its own. Rather, we must face up to the reality that we are being robbed by this approach and get smart so we stop hurting ourselves.

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