How Should Policymakers Respond to Growing Foreign Oil Dependence?

Dec 1, 2003 | Ian W.H. Parry, Joel Darmstadter

The United States currently consumes almost 20 million barrels of oil a day, more than half of which is imported. And the share of imports in US oil consumption is projected to increase steadily over the next twenty years to around 70%. This trend raises concerns about US dependency on a world oil market, increasingly dominated by supplies from the Persian Gulf, where around two-thirds of the world’s known oil reserves are located.

Fears that politically unstable Middle Eastern countries have the United States by the jugular have led to many calls for reducing US oil dependence

Environmentalists and their Congressional allies have tended to emphasize energy conservation measures, such as higher fuel economy standards for new passenger vehicles and higher energy taxes, while the Bush Administration has pushed for tax and regulatory relief for US energy producers and the opening up of new areas for drilling, such as the Artic National Wildlife Refuge.

However on closer inspection the case for immediate and drastic measures to cut US oil imports looks more questionable. For one thing, the oil intensity of gross domestic product (GDP) has declined by about 50% over the last three decades with improved energy efficiency and structural changes in the economy, and these trends are projected to continue. This means that a given future oil price shock will cause less economic disruption, relative to GDP. And the case for forcing the private sector to consume less oil to reduce the costs of oil price shocks is not ironclad: at least to some extent individuals, and particularly firms, are aware about the risk of future energy price volatility and will already take into account the benefits of reducing exposure to price volatility when making choices about energy investments and conservation measures.

Naturally we would be better off if we could somehow isolate ourselves from the risk of oil price shocks, but reducing oil imports does not automatically reduce our exposure to price volatility. Oil is a fungible commodity meaning that its price in the United States will be driven by worldwide oil market conditions. The only way to reduce the economic disruptions from world oil price shocks is to either reduce the overall oil intensity of GDP through enhanced energy conservation, or to lean against oil price volatility itself through more active use of the Strategic Petroleum Reserve.

Americans would also be a lot better off if world oil prices were determined competitively rather than being manipulated by Middle East countries, acting through OPEC. But again, the ability of the United States to counteract the abuse of market power by OPEC is limited. Most likely, a reduction in US oil imports would have only a moderate effect on the world price, and it is difficult to reduce oil imports, as opposed to total US oil consumption, or to favor imports from secure suppliers (e.g., Canada), without running afoul of WTO trading rules. Moreover, many analysts argue that a modest reduction in US oil imports would not produce much of a dividend in terms of reduced military spending, in part because Middle East military expenditures serve other objectives (e.g., the security of Israel), in addition to oil security.

Is the risk of higher oil prices, and accompanying oil price shocks, likely to increase as production becomes ever more concentrated in Middle East? This is difficult to answer. The Energy Information Administration and other mainstream bodies do not predict a rising trend in future oil prices over the next twenty years, and Middle East governments that did cut off their oil supplies would inflict considerable economic damage on themselves by forgoing a major revenue source. On the other hand, we cannot rule out the possibility of a political takeover by radical groups, determined to harm the United States, no matter how impoverished they make themselves.

Although, in our opinion, calls for radical policies to make the United States self-sufficient in energy are wholly unrealistic and misguided, oil dependency is still a legitimate cause for concern. Leaving aside environmental issues, studies suggest that some modest taxation of oil consumption, perhaps in the order of $3 to $6 per barrel, is warranted on economic grounds, to address the risk of economic disruptions from oil price volatility, and certain market power issues. And a case can be made for more R&D to diversify our energy portfolio thereby making us less oil-dependent over time, and perhaps more active use of the Strategic Petroleum Reserve in coordination with other oil-importing regions.

For a detailed discussion of the analysis underlying this article, see the RFF discussion paper:

The Costs of US Oil Dependency

Ian Parry and Joel Darmstadter