March 24, 2008
Series Editor: Ian Parry
Managing Editor: Felicia Day
Assistant Editors: John Anderson and Adrienne Foerster
This week we are very pleased to introduce Hill Huntington, a leading economist on oil policy. In his commentary, Huntington discusses recent research that attempts to judge the likelihood of a future oil price shock and also how much damage a price shock would cause to the U.S. economy.
Next week's commentary, by Robert Poole, will take a look at the nation's very first experiment with electronic charging to reduce peak-period traffic congestion.
The Oil Security Problem: "Deja Vu All Over Again"
Today, three of every five barrels sold on the world petroleum market originate from relatively insecure regions: the Persian Gulf, North Africa, Nigeria, Angola, Venezuela, Russia, and the Caspian states. Political, military, or terrorist events could disrupt oil markets and quickly double oil prices. If these events happen at a time when monetary authorities find it difficult to control inflationary expectations, a trend much more likely today than just two months ago, the world could return to the 1970s and stagflation.
Reducing our vulnerability to such events is the main task for oil security policy. Curtailing imports from our major oil trading partners (Canada and Mexico) is unlikely to benefit us, because these sources are relatively secure. But reducing our imports is important only if we can reduce the market share of vulnerable supplies in the world market. Doing so would mean that disruptions will remove less oil from the market and therefore cause less severe price shocks.
Our vulnerability also depends upon how closely our infrastructure is tied to petroleum use. When disruptions cause oil prices to double, the higher price applies to any oil used in the U.S. economy. It does not matter whether we are relying on imports, domestic supplies, or even close substitutes, like ethanol and other bio-fuel options. For this reason, efforts to reduce oil demand may be more valuable than efforts to simply replace vulnerable imported supplies with domestic supplies of oil or ethanol.
Pursuing energy security is relatively simple in conceptual terms. The nation is buying an insurance policy against future recessions caused by unanticipated oil price shocks. Today's insurance policy should cost no more than the value of avoiding these possible damages. Higher avoided damages could be due to either a greater probability of a disruption happening somewhere in the oil market or to more serious economic impacts from such a disruption.
Since experts disagree on both issues, it is often difficult to implement this principle empirically. For example, a recent Oak Ridge National Laboratory study computed the hidden social costs attributable to oil based upon a range of different views. Their estimates ranged widely from $6 to $23 per barrel, with a mid-point estimate of about $13 per barrel.
Stanford University's Energy Modeling Forum recently completed two studies that may help resolve some of the uncertainties related to damage estimates associated with oil insecurity.
In the first effort, a working group of geopolitical and oil-market experts assembled to provide expert judgment on the risks of one or more disruptions at some point over the next 10 years. The experts identified specific disruption events and the conditions that could make them more or less likely. From there, they evaluated the probability that a certain set of events could happen and the amount of oil removed from the market in each case. Four separate oil-producing regions were considered: Saudi Arabia, other Persian Gulf nations, Russia and the Caspian states, and a set of heterogeneous countries including Libya, Nigeria, and Venezuela.
The experts concluded that another disruption, given today's conditions, is very likely. At some point over the next 10 years, there is an 80 percent chance that at least one disruption of 2 million barrels per day (MMBD, or 2.4 percent of the total market) or more would last one month or longer. Those familiar with playing with a well-shuffled deck of cards will immediately recognize this probability as exceeding the chances that you would draw a club or a red suit.
Compared to previous periods, the risks today are greater for disruptions below 7 MMBD. Not only are there more insecure regions today than in the past, but fewer opportunities exist to reduce the size of any disruption with offsets from excess oil production capacity in undisrupted regions. These offsets tend to be highly concentrated in Saudi Arabia and hence are unlikely to be available if oil is disrupted in that country.
In the second study, macroeconomic experts gathered to discuss the likely economic impacts resulting from oil price shocks. An important distinction concerns the nature of an oil price increase. During the 1970s and early 1990s, oil supply disruptions caused prices to rise suddenly and sharply. These price shocks were fundamentally different from the price elevation occurring over recent months, when oil prices have been rising more gradually than during the 1970s. Price shocks are likely to create great uncertainty, forcing firms and households to delay their investment, producing spillover effects throughout the economy. Price elevation, on the other hand, may anger the car owner who fills his gasoline tank, but it is unlikely to delay investment and lead to a recession.
The other unknown is how economic policymakers will respond to disruptions. Over the last few years, inflationary fears around the world have been very low, which has allowed monetary authorities to ease the money supply to offset lost economic output without creating additional inflationary pressures. In recent months, however, inflationary fears have grown and may become more intense yet. These developments would make it much more difficult for governments to intervene and offset lost output without exacerbating future inflation.
Hillard Huntington, Executive Director, Stanford University's Energy Modeling Forum
Huntington received his Ph.D. in economics from the State University of New York at Binghampton in 1974. At the Modeling Forum, he conducts studies to improve the usefulness of models for understanding energy and environmental problems. His current research interests include modeling electricity competition, energy price shocks and energy market impacts of environmental policies.
If inflationary fears tie Mr. Bernanke's hands, does the nation have a fallback position? Yes, although it seems unlikely that the political process will adopt these policies. First, larger public oil stockpiles would have limited value without a more explicit "trigger" mechanism for releasing oil during emergencies. Second, domestic ethanol or Alaskan oil supplies could replace more vulnerable supplies, but these approaches do nothing for our infrastructure's oil dependence. Third, vehicle fuel efficiency may be more valuable because it does both, reducing vulnerable supplies as well as our economy's reliance upon oil. And finally, automobile insurance rates could discourage excessive driving by being based partly on the miles driven by each person. More than a half century ago, the very possibility of oil vulnerability shocked the western world with the closure of the Suez Canal. Despite other major disruptions since that explosive event, there has been little evidence of "learning by doing" in current oil security policy.
Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.
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Beccue, Phillip and Hillard G. Huntington. 2005. Oil Disruption Risk Assessment, Energy Modeling Forum Special Report 8. Stanford University: Stanford, California, August.
Bohi, Douglas R. and Michael A. Toman. 1996. The Economics of Energy Security. Norwell, MA: Kluwer Academic Publishers.
Huntington, Hillard G. 2005. Macroeconomic Consequences of Higher Oil Prices, Energy Modeling Forum Special Report 9. Stanford University: Stanford, California, August.
Leiby, Paul N. 2007. Estimating the Energy Security Benefits of Reduced U.S. Oil Imports. Oak Ridge National Laboratory ORNL/TM-2007/028. Oak Ridge, Tennessee, Revised July.