Reassessing the Oil Security Premium

World oil supply disruptions lead to U.S. economic losses. Because oil is fungible in an integrated world oil market, increased oil consumption, whether from domestic or imported sources, increases the economic losses associated with oil supply disruptions. Nevertheless, increased U.S. oil production expands stable supplies and dampens oil price shocks, whereas increased U.S. oil imports boosts the share of world oil supply that comes from unstable producers and exacerbates oil price shocks. Some of the economic losses associated with oil supply disruptions—gross domestic product losses and some transfers abroad—are externalities that can be quantified as oil security premiums. To estimate such premiums for domestic and imported oil, we take into account projected world oil market conditions, probable oil supply disruptions, the market response to oil supply disruptions, and the resulting U.S. economic losses. Our estimates quantify the security externalities associated with increased oil use, which derive from the expected U.S. economic losses resulting from potential disruptions in world oil supply.

Does a cost arise from the average person using more oil given the chance that civil strife or an attack on a crucial pipeline somewhere in the world will disrupt oil supplies? And, in a global market, does it matter whether consumers are filling their tanks with gasoline produced with American or foreign oil?

Fluctuating oil prices and unstable foreign oil suppliers have renewed U.S. concerns about energy security. There’s good reason to worry: 10 of the 11 U.S. recessions since World War II have been preceded by sharply rising oil prices. 

In a new discussion paper (DP 10-05), “Reassessing the Oil Security Premium,” Nonresident Fellow Stephen P.A. Brown and Stanford economist Hillard G. Huntington explore the security externalities that arise from oil consumption and what a policy to integrate these costs into the market might look like. 

defining the Security Premium 

Buyers will take into account the expected costs from oil supply disruptions that directly affect them, but tend to ignore costs imposed on other consumers. The oil security premium is an attempt to quantify the externality portions of the economic losses associated with the potential disruptions in world oil supply that result from increased consumption. 

Further complicating matters, consumers cannot distinguish between a barrel of oil produced in Saudi Arabia and one produced in Alaska because all oil is sold on the same market, with prices moving together. However, domestic oil production is stable, whereas production outside the United States contains unstable elements, giving policymakers a reason to differentiate between domestic and imported oil even if consumers cannot. 

Conclusions 

Brown and Huntington find that the principal security externalities associated with oil consumption are GDP losses and income transfers to oil suppliers abroad. The authors also show that although U.S. consumption of either domestically produced or imported oil yields security externalities, the premium is lower for domestic sources. This is because consumption of domestic oil increases the share of stable supply in the world market. 

The authors estimate the oil security premium on domestically produced oil to be $2.28 per barrel in 2008, rising to $4.45 in 2030 (in 2007 dollars), while that for imported oil is $4.45 per barrel in 2008, increasing to $6.82 in 2030. This means that the oil security premium for U.S. oil is currently $2.17 less than for foreign oil. 

Policymakers could integrate these costs into the market through measures, such as a tax on domestic oil consumption with an additional import tariff on foreign supplies. Still, Brown and Huntington suggest that reducing oil use is more valuable than boosting domestic production: “In any case, our estimates suggest that energy security is more greatly enhanced by policies to reduce overall oil consumption than by those that substitute domestic production for imports.”