International Planning for Future Oil Crises

With oil markets glutted, prices falling, and oil exporters seemingly powerless to change these trends, one might question whether anything needs to be done now to plan for future oil crises. Conservation, energy efficiency, and other private-market adjustments also have weakened the threat of oil interruptions, and governments of several oil-consuming countries—particularly the United States—have built strategic stocks of oil to cover temporary shortages. Moreover, most of the Western industrialized nations now belong to the International Energy Agency (IEA), which since 1974 has sought to promote both short-run and long-run energy security.

In our view, however, additional efforts on a international scale are needed to enhance IEA members' preparedness for future oil disturbances and price shocks. With the volatile Middle East still an important source of world oil supplies, the risk of disruption by no means has disappeared; and because the region has three-quarters of the world's known oil reserves these risks will increase as the current glut diminishes.

Despite improved energy policies in individual oil-consuming countries, moreover, oil security inherently is an international concern because these countries are interconnected through the world oil market. Cooperation among them could offset the effects of a temporary interruption in oil supplies, but in fact the major oil-consuming countries did not cooperate effectively during the two oil crises of the 1970s. On the contrary, government policies in several countries actually made matters worse. And it is doubtful whether the existing IEA crisis-management plan could significantly lessen the impact of a future oil-supply crisis. Indeed, recent changes in the oil market render much of the plan obsolete.

Experience indicates that cooperation is elusive in the midst of a crisis. Governments must evaluate their interests and form agreements before a crisis begins, and the current state of world oil markets provides the right conditions—and the time—to achieve such agreements. Unfortunately, the very existence of the IEA plan, regardless of its ineffectiveness, together with sharply divergent positions among IEA members, appears to have blocked progress at strengthening institutional arrangements. To illustrate, in 1984 the United States proposed that the IEA rely primarily on expanded and coordinated strategic oil stockpiles to defend against oil-market instability, while eschewing restraints on oil demand and other forms of intervention in oil markets. Other countries expressed their preferences for demand restraints as a first line of defense. The debate was concluded without much change in the IEA agreement.

There are, to be sure, substantial theoretical arguments in support of increased stockpile coordination. These arguments are incomplete, however, because they focus on the gains to participants assuming the program is carried out, rather than on the willingness of IEA members to carry out the plan. This flaw is serious because countless examples have shown that policy decisions are not driven entirely by economic benefit-cost comparisons.

To address this aspect of the international oil-security problem we suggest a mixed-response strategy, with primary emphasis on use of the Strategic Petroleum Reserve (SPR) by the United States and on restraint of oil demand by other IEA members. Unlike the status quo, this strategy calls for measures that are concrete, coordinated, and market-oriented. But unlike coordinated stockpiling, it should be more compatible with the divergent interests of IEA members. To establish a backdrop for our plan, we first review briefly the nature of recent changes in the oil market and the policy positions of the United States and other IEA members.

Changes in the oil market

Since the formation of the IEA in 1974, changes in the international oil market have altered the potential benefits from cooperation and shaped accordingly the policy positions of member countries. In particular, these changes have affected the incentives of both private oil purchasers and oil-exporting nations in ways that suggest future supply disruptions will develop and play out differently from those of the past.

The price increases of the 1970s dampened worldwide oil demand, which has not risen appreciably until very recently despite a resurgence in economic activity. In addition, demand has become more flexible as consumers have adapted to price uncertainty. The share of the market supplied by the Organization of Petroleum Exporting Countries (OPEC) also has declined with increased availability of both non-OPEC oil and competing fuels. These developments have reduced OPEC's ability to control prices because demand for its oil is more sensitive to changes in its price. With demand down and alternative sources of fuel available, consumers no longer have to accept OPEC price hikes and OPEC as a group probably would suffer from actions that overprice its oil, as has occurred in the past. In contrast, it appears that OPEC now has an interest in oil-price stability rather than in constantly elevating base oil prices.

In addition, both the stability and the efficiency of the oil market have increased markedly with the growth of spot markets and the introduction of futures trading. The spot market, in which oil is sold for cash or immediate delivery rather than on a long-term contract basis, now is more likely to be a significant source of supplies in a crisis—it dried up in past disruptions—and futures trading provides a convenient vehicle for hedging risks. Thus, private inventories can be expected to be far more stable in future disruptions than in past ones, when panic buying transformed small or negligible supply reductions into large price shocks.

When coupled with the increase in government-controlled stocks since the early 1970s, these changes suggest that the appropriate objectives of cooperation have changed greatly since the IEA was formed. With the improved flexibility of the oil market, the objectives of overcoming targeted embargoes (through an oil-sharing plan, for example), of attenuating ratchet-like boosts in base oil prices, and of forestalling panic buying become less important than dampening short-term price rises. By the same token, while early release of strategic stocks may be desirable, a massive early sale to hold down the floor price of oil or to offset panic is less likely to be warranted. Indeed, with greater motivation by the private sector for early use of stocks to reap capital gains (versus panic retention of inventories), in many situations a policy of modest but accelerating stock sales by governments may be wise, assuming private stocks rebound from their existing, historically low levels.

In light of these developments, let us now review the IEA agreement and the policy positions of the United States and other IEA members. Following the 1973-74 Arab oil embargo, the IEA was established by members of the Organization for Economic Cooperation and Development (OECD) to coordinate responses to oil-supply uncertainties and price instability. (Of the twenty-four OECD members, only Finland, France, and Iceland did not join the IEA.) The underlying motivation for the agreement was that, through cooperative action both in crisis situations and over the longer term, member countries' self-interests would be better served than through uncoordinated, and especially conflicting, responses.

The centerpiece of the IEA crisis management program is a formal plan for sharing oil supplies that would equalize the burden of a disruption, along with less formal requirements on members to undertake their own preparedness measures. These latter provisions include strategic petroleum stocks and restraints on petroleum demand, depending on the circumstances of the individual countries. Many critics argue, however, that this system would not be worth much during an oil emergency. In particular, the oil-sharing scheme is unlikely to alter the distribution of supplies from that dictated by the market, while other provisions are vague exhortations with no force as a basis for cooperative action.

Stocks vs. demand restraint

The United States has taken the lead in attempting to forge agreement on IEA cooperation in the building and early use of stocks. As stated by Energy Secretary Donald Hodel in testimony before the House Energy and Commerce Committee's Subcommittee on Fossil and Synthetic Fuels on February 21, 1984, "In a major disruption, the early sale of SPR oil in large volumes ordinarily is the best policy for SPR use. . . . The marketplace needs to know in advance that this is our general policy."

The United States also has pressed for stock coordination within the IEA, while, opposing the use of restraints on oil demand during a crisis. The emphasis on stock coordination appears to be motivated by a concern that other countries would take no effective action or even negate a U.S. drawdown by expanding their own inventories. As stated subsequently by Hodel, "The thing that concerns us is that our reserves are comparable to the reserves maintained by our allies. Otherwise we get into this difficult situation that, come a crunch where we say we're going to draw . . . and they're reluctant to draw, we'd be making a partial gift to them. We're not inclined to do that."

The opposition to government-regulated demand restraint has been enunciated by Allen Wendt, deputy assistant secretary of state for international energy and resources policy, before the Oxford Energy Seminar on September 12, 1984. "In a disruption, we prefer demand restraint that comes from price increases. We have doubts whether government regulation can do the job, whether government action would not cause additional economic losses, and whether governments will be willing to suffer the resulting political harm."

The United States has encountered strong opposition from other IEA members over the use of oil reserves as a first line of defense. Most are unwilling to undertake the financial burden of building stocks and see the small inventories they would hold as inconsequential. West Germany and Japan do hold significant reserves, but they have no indigenous sources of supplies and are inclined to hold their stocks as a last-line resort while emphasizing demand restraint early in a crisis.

The United States has achieved some progress in advancing its point of view within the IEA, but it has not prevailed. Quoting Wendt again, the United States has achieved agreement "that a consultative group of those nations in a position to contribute meaningfully will meet to work toward timely, coordinated stock draws." However, the official IEA position, as stated in an October 1984 press release, continues to be that stock draw-down and demand restraints can be substituted for one another: "The mechanics of the arrangements are flexible. They are designed to involve all IEA governments in countering excessive price movements, and not just those that are able to deploy significant amounts of stocks. Countries will be able to use stocks, demand restraint, and fuel switching, or a combination of these."

The strength of the U.S. position in this debate would appear to have been undermined further by the Reagan administration's proposal for a moratorium on filling the Strategic Petroleum Reserve. The IEA position also is weak, however, because it does not specify instruments for restraining demand and thus gives latitude to members to use ineffective non market measures.

Increasing IEA cooperation

Analyses of international cooperation in response to oil shocks require a normative dimension—what governments ideally should do to achieve some specified objective—and a positive, or descriptive, dimension: what governments are inclined to do in pursuit of their own perceived self-interests. The two are related; in particular, normative studies can be useful over the long term to highlight the benefits and costs of alternative measures, thereby shifting the preferences of policymakers in a socially desirable direction. However, it is crucial to maintain the distinction between normative and positive analyses of international energy cooperation to understand not only what is desirable but also what is possible.

This point applies especially to the numerous studies calling for expanding inventory sizes by IEA members and coordinating their use in a crisis. Two assumptions underlie these arguments. The first, which we do not question, is that cooperation would reduce economic burdens from oil-supply disruptions for all members. In fact, benefit-cost analyses indicate that for at least the larger net-importing countries within the IEA (the United States, West Germany, and Japan), expanding stock sizes and drawdown capacities are desirable regardless of what other countries do.

However, the second assumption is more problematic: that individual countries perceive their interests as indicated in the benefit-cost models, so that they naturally would be impelled to seek greater coordination of inventories to reap the benefits of cooperation. In fact, as noted above, IEA members display a wide disparity of opinion concerning the best directions for cooperation and have failed to achieve much progress in harmonizing these views. Thus, while stockpile cooperation remains a laudable objective, it does not now appear to be a practical option. Given the risks of continuing to operate with little in the way of effective agreement for cooperation, it is therefore important to look more deeply at the apparent preferences of IEA members to see what other options might be pursued more successfully.

The larger oil-importing members of the IEA, other than the United States, seem to prefer restraints on demand to use of stocks, but they also appear to share with the United States a willingness to cooperate if—and only if—they are assured of sufficient cooperation by other members. However, these countries have not adopted plans for effective, market-oriented demand restraint measures (like quotas or taxes) in lieu of vague, non-market measures, and this raises concern that their underlying preference is for "free-riding" on the U.S. response. This concern also is especially pronounced in the case of smaller IEA members, whose individual actions would little alter conditions in the world oil market while aggravating the macroeconomic burdens that the crisis imposes.

Nevertheless, incentives for free-riding may not be as strong as these remarks would indicate. In formulating crisis responses to further their own interests, other IEA members will be mindful of how the United States is likely to react. Since the United States holds the vast bulk of government-owned stocks within the IEA, and since these stocks would play a crucial role in a crisis, policies by other members that jeopardize the effective use of the SPR would redound to these countries' loss. This consideration may counter the incentive to free-ride, at least for the larger members that have the greatest stakes in successful cooperation.

Therefore, we conclude that the most desirable current direction for expanding cooperation within the IEA involves a mixed-response strategy in a crisis, one that combines aggressive use of the SPR (and thus continued fill of the SPR at the current time) with a firm commitment to observable, effective, and market-oriented demand restraints by other IEA members. While it is not the best theoretical choice, the strategy clearly would benefit both the United States and other IEA members compared with the alternative of ineffective crisis responses by any country as a consequence of a weak agreement. Moreover, the plan would bridge the disparate interests and positions of LEA members. From the U.S. point of view, demand restraints by other members would have the same effect on the oil market as would additional release of stocks. Demand restraints probably would exacerbate macroeconomic disruption costs faced by those imposing them, but restraints seem to be preferred by other IEA members and would be to their additional benefit by helping to ensure a more effective U.S. response.

Any effort at international policy coordination will confront logistical and political problems in monitoring adherence to the agreement. In particular, hidden tax subsidies can undo the intended effects of demand restraints; but subterfuge also is possible with inventory management. This is all the more true if much of the inventory is not directly owned or controlled by governments. The past difficulties of the IEA in measuring available stocks attest to this point. Because our proposal helps to reconcile conflicting positions of IEA members, we believe that compliance problems would be no worse than with other alternatives.

Finally, we note that as an institution that brings its members together in a forum where expectations of others' conduct can be evaluated and revised, the IEA itself can play a central role in creating an environment of mutual assurance for establishing and following through on an agreement. This function already is embodied in policy-level consultations and in the general sharing of information, about oil-market conditions in particular. Such efforts clearly warrant continuation and expansion.