Changing Times for Oil Imports and Energy Policy

After several years of disuse, the nation's energy policy machinery is again clanking into motion. Past experience suggests that making energy policy, particularly involving oil imports, is a chancy business. To reduce the risk of making bad policy, it would be wise both to remember what we have learned about managing energy problems in the past and to consider how times have changed.

Some fundamental features of the worldwide oil situation have not changed very much since the late 1970s. For instance, the world's principal reserves of low-cost oil remain concentrated in the nations of the Organization of Petroleum Exporting Countries (OPEC). This concentration is increasing as the countries of the free world outside OPEC use up their oil reserves faster than OPEC. Moreover, 80 percent of OPEC's reserves are concentrated in six of its thirteen member nations: Kuwait, Saudi Arabia, the United Arab Emirates, Iraq, Iran, and Libya.

OPEC's pivotal position is not likely to change anytime soon, considering that two-thirds of the largest oil fields discovered to date are located in its member countries. Thus, OPEC will have a dominant market position for a long time to come. At issue is whether it can and will use its position to influence oil price and supply.

OPEC's behavior is largely shaped by its need for oil revenues. Thus, production that is well below capacity leads to cheating on production quotas, which in turn undermines effective cartel behavior.

Unlike the case of some cartels, however, capacity production by all of its members is not a prerequisite to OPEC effectiveness. Since the Arab Gulf states have small populations and large oil production capacities relative to other OPEC members, these Gulf states—and especially Saudi Arabia—can produce below capacity and still generate significant per capita revenues. It appears that when total OPEC production is around 80 percent of capacity, revenue needs are sufficiently satisfied to allow OPEC to behave as an effective cartel.

The need for oil revenues also appears to create a propensity to maintain OPEC production despite the inherent political instability in the Middle East. Only two political crises in the past twenty years have had a major effect on oil supply. It is worth noting that production curtailments in 1973 and 1979 were not among them.

Non-OPEC countries, by contrast, find themselves in a very different position on oil reserves. The general prognosis is that these countries currently possess smaller, higher-cost reserves, and that future exploration will yield up reserves of a similar nature.

The United States provides a good case in point. Proved U.S. reserves of about 30 billion barrels are now producing oil at less than 9 million barrels per day. By the end of the century, however, these existing reserves will support production of only 1 million or 2 million barrels per day, even at relatively high prices. So new reserves must be found to support domestic production.

U.S. oil will remain costly

The United States has substantial potential crude oil reserves of about 300 billion barrels. However, the oil yet to be discovered lies in relatively small and scattered fields. Tapping the oil potential in this country will require extensive drilling and expensive recovery techniques, meaning that the United States will remain a high-cost producer.

Outside the United States, non-OPEC production grew by almost 30 percent between 1979, when the last oil shock occurred, and 1985; however, these reserves do not appear to have much more growth potential. The general view is that the remaining crude resources in the free world are increasingly remote or deep and therefore costly to develop.

Overall, then, two fundamental features—the relative cost and location of oil reserves and the forces that shape OPEC behavior—have not changed very much in recent years. But another fundamental—the structure of oil markets—has changed significantly.

World oil markets are currently more efficient than they were before 1980. Creation of an active futures market and the growth of the spot market are both lessening the likelihood of frequent major price swings, although they probably encourage short-term price instability. Also, a large spot market reduces the chances of inventory panic, a major cause of the 1979 price spike.

Widespread use of netback pricing, that is, determining the price of crude oil based on product market prices, is another important development in world oil markets. It tends to make crude prices more volatile by more closely linking them to highly competitive product markets. The importance of netback pricing is underscored by OPEC's current attempts to return to posted prices.

Finally, it should be noted that large changes in oil supply and demand require large investments, which take time to put in place.

These long lead times result in relatively low short-run elasticities that complicate adjustment to oil price changes. They also increase uncertainty and thus reduce the inclination to invest, a factor that is now limiting future capability to adapt to higher oil prices.

These fundamentals provide the basis for insights into the future price and availability of oil in the U.S. economy.

The characteristics of the marketplace suggest that oil prices are likely to remain moderately unstable but relatively low well into the 1990s. Though OPEC may try to impose production quotas to increase prices, the move is likely to have little lasting effect until excess worldwide production capacity is dried up. And efficient commodity markets in crude oil, coupled with strong product market competition, suggests that prices will fluctuate in the meantime.

After excess capacity has disappeared, OPEC will be better able to influence prices, which may then rise more sharply. It would be in OPEC's own interest to manage prices at a level somewhat below the marginal cost of new production elsewhere in order to maintain price stability at these higher levels. Excessive increases would again set loose the market forces that resulted in the price collapse of 1986.

The share that domestic oil supplies will contribute toward meeting U.S. demand appears to be increasingly limited. The current investment climate for oil and gas exploration is poor, and domestic production is predicted to shrink from its current level of about 9 million barrels per day to a maximum of 6 million barrels per day by the turn of the century. Absent a reduction in U.S. exploration and development costs, this downsizing of the U.S. oil industry seems highly probable.

Foreign sources of supply, therefore, will become increasingly important in the future. Results from recent studies commissioned by Conoco, the National Petroleum Council, the Gas Research Institute, and the Aspen Institute reflect the consensus that flat or slightly higher domestic demand combined with declining domestic production will likely result in imports rising to half or more of total U.S. consumption by 1995.

Why is the U.S. vulnerable?

The idea of U.S. vulnerability stemming from this increased dependence on foreign sources of supply needs to be closely examined. The potential supply of oil from foreign sources is adequate in quantitative terms, and efficient markets and ample transportation make it physically available. Moreover, rising oil prices need not have catastrophic economic consequences, as demonstrated by the Japanese economy after the 1979 oil price shock. Where, then, does U.S. vulnerability lie?

One cause could be a cutoff of imported oil. However, the likelihood of a supply disruption large and permanent enough to actually make oil unavailable for essential uses in the United States seems fairly remote in today's world.

OPEC's propensity to produce and the existence of a large and efficient spot market are factors that greatly mitigate the effects of minor supply reductions. A major supply disruption would most likely be precipitated by a political event whose ramifications extended well beyond energy policy per se.

The other form of potential vulnerability that should be examined is adverse economic effects arising from higher and unstable prices. Given projected price instabilities and ultimately higher prices dictated by OPEC, these adverse effects are quite likely—and so are worth worrying about.

In paying for imported oil, wealth is transferred out of the United States to oil producers, thus reducing income available to create domestic demand. Moreover, when oil prices rise, the economy must make adjustments, which in turn can lead to economic disruption. These adjustments are made more difficult if oil prices rise (and fall) rapidly. Finally, rising prices result in the movement of wealth from consumers to producers, which makes consumers unhappy whether the producer is at home or abroad.

Because oil prices are the same for oil from any source, the extent of these adverse economic effects depends only on the U.S. level of oil imports. This nation's vulnerability due to its dependence on foreign oil supplies is affected by at least two major factors in addition. The first of these—the total amount of oil used in the economy—is an even more important factor than the level of imports. The more oil we use, imported or not, the larger our input costs become as prices rise. The movement of wealth from consumers to producers also depends on total demand, because consumers lose wealth when prices rise whether that wealth stays in the country or goes abroad.

In addition to the total amount of oil used, a second important factor is that oil is an international problem. The demand that soaks up excess OPEC capacity is created by all importers, and the severity of a disruption depends on how all countries manage available supplies and stocks.

Thus, the level of U.S. imports is only one of several factors that determine our vulnerability. Imports are largely responsible for the income effect: that is, the more oil the United States imports, the more money it sends abroad. U.S. imports are a major part of world oil trade, and thus they indirectly influence oil prices. But this country would be economically vulnerable to oil price shocks even if it imported nothing.

To make the problem even more complex, conventional views about the impact of oil price shocks on economic performance are now being challenged. According to RFF senior fellow Douglas R. Bohi in his recent study of oil price shocks and how they affect economic performance, rigidities in the economy appear to amplify the effects of adjusting to higher or unstable oil prices. If this is so, care should be taken in developing policy responses to energy issues, especially policies that impose additional economic rigidities.

We should worry about U.S. energy security, but we should do so with a broader vision than one that focuses exclusively on the level of oil U.S. imports. With this—and the uncertainties of forecasting—in mind, let us consider several important steps that can be taken to reshape energy policy within the oil sector.

Costs, conservation, and diplomacy

First of all, the cost of new oil production should be reduced both in the United States and elsewhere. Technology has a critical part to play in this process, and it may be appropriate for the government to sponsor research in this area.

The United States should also continue to reduce its reliance on oil. Measures to reduce oil's value in industrial output would minimize adjustment problems. Increased levels of conservation should be sought throughout the economy, but particularly in the transportation sector.

The government can play a useful part in encouraging energy conservation in the transportation sector through the continuation of auto efficiency standards. Pressing forward with research and development of the methanol fuel and electric vehicle options would also provide good insurance.

In addition, because oil is an international problem, energy security should be an important and permanent foreign policy objective. Steps to diversify oil production, promote price stability, and head off the growing appetite for oil in developing countries have much merit. The United States would benefit greatly from having a domestic energy policy firmly in place to serve as the starting point for active diplomacy.

Another important policy aim should be an attempt to insulate the domestic economy against the effects of price shocks and potential disruption. The Strategic Petroleum Reserve offers a powerful tool for moderating major price swings; the United States would benefit from an increase in its size.

Risks of market intervention

Beyond these policy objectives that are rooted in the fundamentals of the oil situation, restraint is advisable. Energy is a long-term problem, and quick fixes will do more harm than good. Because the fundamentals change slowly, mistakes are not soon discovered or soon repaired. For instance, though an oil import fee could somewhat reduce imports by depressing demand and possibly temporarily retarding the domestic decline in production, it could also impose serious short-term costs on consumers and industrial users of oil. An import fee would, after all, increase the price of all the oil we use, not just the part that is imported.

More important, an import fee is just the sort of rigidity that could make matters worse in unforeseen ways. Price supports in the 1980s could distort signals to the producing sector just as price controls in the 1970s distorted the response of the consumer sector, with a similarly negative outcome. It would probably be wise to let producer readjustments go forward unattended by excessive market intervention.