While oil is essential to fuel economic growth, its supply is volatile, subject to short- term interruptions as well as longer-term lapses in the rate of supply development. As a consequence, any lapses carry with them substantial economic costs and give rise to concern over “oil security.” In the past, these prospects led to government attempts to preserve US “energy independence” via a number of policies designed to insulate itself from world markets. Some are now calling for a repeat of this experience. However, such past efforts were abysmal failures, which aggravated rather than solved these problems, before being quickly abandoned. Today a return to such policies would be even more futile. Our best assessment is that sustaining modest economic growth worldwide for the next several decades will require massive new investments in oil and gas.
The world energy markets are inherently global, and no single country can exempt itself from the interdependencies of that market. Geographical differences in the location of supply and demand will continue to expand trade. Differences in resource ownership and access to capital and technology will require increasing cooperation between IOCs and NOCs. The consuming and producing countries share a mutual interest in this expansion, and in avoiding volatility. In fact, these interdependencies generate a web of mutual interests between producers and consumers, which can provide a basis for reducing the security problem. While there is no certainty that cooperation in expanding supplies over the next several decades will succeed, there is certainty that the cost of failing to do so will be enormous.
What is the oil security problem?
Given the key role of oil to economic growth, and the heavy concentration of oil supply in the Persian Gulf region, the oil security problem came to be articulated in the 50s and 60s as the vulnerability of Western economic growth to events that might interrupt such supply (Bohi, Russell et al., 1978). These fears actually materialized in 1973 as a group of oil exporting countries attempted to influence US foreign policy via an oil embargo, and a transfer of control over the oil assets in those countries from the major international oil companies (IOCs) to a group of state owned national oil companies (NOCs). While the actual reduction in supply was small and temporary, the reduction in the rate of supply growth was of longer-term significance. Prices rose sharply in 1973, triggering a recession and a reduction in economic growth throughout the remainder of the 70s. This damage was repeated in 1979 when the Iranian revolution triggered another supply disruption, followed by another recession. The episode clearly illustrated Western vulnerability to economic damage from supply inadequacy, and the potential for such damage to compromise the independence of US foreign policy, which remains the essence of the oil security problem (Lee, 2003).
Independence is not an option
The initial US response to the events of the 70s was a futile attempt to insulate itself from the global oil market. Price controls, product allocation schemes, and subsidies to alternative fuels were attempted in the name of protecting US “energy independence.” In rapid succession, each of these interventions failed to reduce dependence and, in some cases increased vulnerability (1). By 1980, all were abandoned in favor of reliance on markets and prices to guide the patterns of oil use and volume of oil traded (Kalt, 1981). Today, in response to recent increases in world oil prices, some are again calling for government intervention to promote energy independence. But such a pursuit today would be even more futile than it was in the 70s, for several reasons. First is the fact that the domestic resource base (consisting of 3% of world reserves) will not support it. The US Department of Energy estimates that sustaining modest economic growth will require about a 30% expansion of US oil supplies by 2020. With domestic production declining, imports must rise, reaching 63% of consumption by 2020. Even if reversal of these trends were feasible, it would be futile to pursue such independence in a global market, since all participants face the same price, regardless of their level of imports (Toman, 2002). Consequently, a change in US import dependence or a shift in US bilateral trade relationships with a particular area may do nothing to change the size or composition of global supply, thus leaving global vulnerability unchanged. Given that energy independence has proven neither feasible nor desirable, our only options involve managing the risks faced by participation in this market (Nivola, 2002).
We have learned to manage vulnerability to short-term interruptions
We have made progress in this area. While US import dependence has generally increased since 1980, vulnerability to short-term interruptions has not. The world has weathered several major interruptions since 1980, such as the invasion of Kuwait in 1990 and the invasion of Iraq in 2003, neither of which produced economic damage of either the magnitude or the duration of those in the 70s. In part, this is attributable to measures adopted to manage such risks, by the building of strategic stocks, the promotion of free trade and investment, and the development of traditional diplomatic and military instruments to secure that trade. In part, it is attributable to favorable market or political trends, such as the decline in the share of oil in GDP and the increased access to potentially productive lands as a result of the breakup of the Soviet Union. But primarily it was due to the fact that OPEC since 1980 has had available a large volume of excess capacity, which it has generally used to offset any such shortfalls. But there are new challenges ahead But to assert that we have learned how to cope with short-term interruptions does not suggest that the oil security problem has been solved. On the contrary, there is much about the current situation to suggest that new challenges are ahead. First is the sheer magnitude of the prospective growth in demand likely to be required to sustain modest global economic growth. A variety of recent forecasts by the International Energy Agency, the US Department of Energy, and the OPEC Secretariat estimate that sustaining a 3% rate of annual growth in the global economy over the period to 2020 will require an expansion of between 24 and 28 mmbd in global oil supplies. Some suggest that this growth is unachievable, due to resource exhaustion. While recent analyses suggest that these concerns are premature (Caruso, 2005; CERA, 2005), satisfying this demand will require an enormous development effort on the part of both OPEC and non-OPEC suppliers. At first glance, this does not appear so different from recent experience. From 1985 until 2004, global oil supply rose by 23 mmbd. But only about 30% of this supply growth was from new capacity. About 70% came from OPEC, primarily from restoration of capacity idled in the mid 70s. However, now that such excess capacity has been absorbed by demand growth, future expansion will require new investment. In the three forecasts noted, the demand for OPEC oil by 2020 reaches between 48 and 50 mmbd, more than a 50% supply expansion. Moreover, regardless of whether it is feasible, to date there is no OPEC expansion underway consistent with these forecasts. Outside of OPEC, the institutional challenges facing such an expansion of supply are also formidable (Kochlar, Ouliaris et al., 2005). While past non-OPEC expansion in areas such as Alaska, the North Sea, and the Gulf of Mexico occurred in countries with secure investment frameworks, future developments are likely to be in less certain institutional settings, such as Russia, West Africa, or Latin America. Even in places with secure investment environments, such as the US, there are numerous restrictions placed on access to the most promising remaining prospects. Finally, apart from the challenges of developing upstream capacity, there are additional challenges in developing downstream facilities needed to accommodate these volumes. Interdependence is fundamental characteristic of emerging market environment One of the key implications of the emerging trends in global oil markets is that of growing interdependence. The first interdependence is that of trade, stemming from the geographical dispersion of supply and demand. Consumption growth will become increasingly concentrated in the developing countries over time, primarily in Asia, while supply will become increasingly concentrated in the Middle East, West Africa and Russia (United States, Energy Information Administration, 2005). The second form of interdependence arises between resource owners and producing companies. This interdependence arises from the separation that occurred in the 70s between the resource owners (host governments) and the producers (IOCs). As a result of this separation, currently only about 6% of the world’s reserves are actually fully accessible to equity participation by the IOC’s. About another 12% is accessible under terms negotiated with the NOC’s, leaving 77% under exclusive control of the NOCs (Blum, 2005). At first glance, both dependencies may be viewed as favoring the producing country or company, but such an interpretation does not withstand scrutiny. That is, a trading relationship is clearly a mutual dependence, with both parties hoping to gain from the transaction. The consumer faces risks of uncertain supply; the producer faces risks of uncertain demand. There may be an appearance of greater risk to consumers, since their costs are realized in the short run. Generally, the oil exporting country faces the risk of demand erosion that may occur more gradually, but ultimately poses larger risks (al-Moneef, 2003). For instance, oil export revenues comprise 38% of Saudi Arabia’s GDP, while oil import costs comprise 1.5% of US GDP. Likewise, a cooperative arrangement between NOCs and IOCs is built on voluntary agreements premised on mutual acceptance of risk for mutual gain. The IOC’s have the capital and technology to develop the resource, but have few of their own. The NOCs have the resource, but often are hard pressed for the capital or the technology to develop it (2) (Wood Mackenzie, 2003).
Interdependence is the solution, not the problem
While the producer and consumer countries, as well as the NOCs and IOCs, face fundamental differences of interest with their trading or operating partners, they also face a mutual interest in the orderly development of a market within which they can achieve their mutual goals. It is a fundamental error to characterize the security problem as the exclusive province of the consumer countries resulting from repeated hostile actions by producing countries. Only the 1973 embargo can be so characterized. Ironically, each of the other interruptions was attributable either to conflicts among producer countries or embargoes imposed by consuming countries. Moreover, in dealing with the short run supply interruptions since 1980, it has been producer actions, rather than the use of strategic stocks or other emergency measures by the consuming countries, that have played the greatest role in limiting the economic damage associated with each disruption. Perhaps the greatest challenge to future security is presented by the disappearance of excess capacity within OPEC (International Monetary Fund, 2005b). Its use provided both a source of surge capacity that reduced the impact of short run interruptions and a source of new supply to accommodate demand growth over time for nearly two decades. From the standpoint of the dual security problem – replacing supply lost to short-term interruptions and providing for long-term capacity growth, it provided the bulk of the world’s protection. In a very real sense, however, world supply has reached a crossroads. In this setting, additional reliance may be placed on other protective measures such as strategic stocks to replace supply lost to short-term disruption, and to free trade and investment to develop the interdependence to assure adequate long run growth. While it is by no means certain that adequate investment and new supplies will be forthcoming, it is inevitable that failure to do so will have costs. The IMF estimates that a $5 per barrel increase in price could reduce world GDP as much as $100 billion annually (International Monetary Fund, 2005a). The magnitude of these potential losses suggests the enormous value of finding a basis for cooperation in such expansion.
(1) For instance, by holding prices at below world market levels, US policy actually encouraged a level of oil use higher than that which would have occurred without such controls.
(2) A 2003 study by Wood Mackenzie found that the only OPEC country that has been able to develop significant new capacity without direct IOC participation has been Saudi Arabia.
References
al-Moneef, M. (2003). "Internal Challenges to OPEC and its Member States." Middle East Economic Survey 46 (November 17).
Blum, J. (2005). National Oil Firms Take Bigger Role. Washington Post. Washington DC: D01.
Bohi, D. R., M. Russell, et al. (1978). Limiting oil imports: an economic history and analysis. Baltimore, Published for Resources for the Future by the Johns Hopkins University Press.
Caruso, G. (2005). When will world oil production peak? 10th Annual Asia Oil and Gas Conference, Kuala Lumpur, Malaysia.
CERA (2005). Worldwide Liquids Capacity Outlook to 2010. Cambridge, Massachusetts: 60.
International Monetary Fund (2005). "Economic Prospects and Policy Issues." World Economic Outlook April: 68.
International Monetary Fund (2005). "Will Oil Markets Continue to be Tight?" World Economic Outlook April: 68.
Kalt, J. P. (1981). The economics and politics of oil price regulation: federal policy in the post-embargo era. Cambridge, Mass., MIT Press.
Kochlar, K., S. Ouliaris, et al. (2005). What Hinders Investment in the Oil Sector? R. Department, International Monetary Fund.
Lee, H. (2003). Oil and Security Executive Session: Rapporteur's Report. Belfer Center for Science and International Affairs, Cambridge, Massachusetts, Harvard University.
Nivola, P. (2002). "Energy Independence or Interdependence? Integrating the North American Energy Market." Brookings Review 20(2): 24-27.
Toman, M. A. (2002). "International Oil Security: Problems and Policies." Brookings Review 20(2): 20-23.
United States, Energy Information Administration (2005). International energy outlook. Washington, D.C., Energy Information Administration.
Wood Mackenzie (2003). Driving Force: The Growing IOC Role in OPEC. London, Deutsche Bank AG, November 24.
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