Iraq's invasion of Kuwait and the resulting jump in petroleum prices have rekindled interest in energy security. Despite years of research, however, there is a disturbing lack of understanding of many basic issues concerning the workings of petroleum markets and the design of energy policies. Recognition of what we do and do not know about energy security may help avoid the policy mistakes of the past, and give new impetus to filling important gaps in our knowledge about the economic aspects of energy security.
Petroleum issues become highly politicized whenever there are disturbances in the oil market. Although equity is an important concern of public policy, when it comes to oil, visceral concerns about fairness emerge so strongly that they sometimes threaten to obscure how markets actually work and what can be done to change their outcomes without imposing large costs on the country as a whole.
Recent events in the Persian Gulf have resurrected many of the same myths and misunderstandings about energy security that have been around since the oil price shock of 1973. One poorly understood issue is the pricing of oil. Like the price of other commodities, the price of oil is governed by market forces that reflect changes in demand and supply. Thus price movements such as those observed after the Iraqi invasion of Kuwait are neither inexplicable nor inherently irresponsible.
Observed market prices for petroleum depend not just on production costs, which influence supply behavior, but also on willingness to pay on the part of petroleum demanders. A shortage in the market causes the price to rise so that less valuable uses of petroleum are curtailed, and substitutes are sought where possible. Just as important, the anticipation of future scarcity will cause an increase in current petroleum prices. Expectations of impending scarcity register in the market right away, as they did after the Iraqi invasion. If oil prices are expected to rise in the future, inventory holders will bid up current prices as they seek to acquire additional stocks in order to hedge against higher petroleum costs or to profit from the anticipated price increases. (U.S. petroleum product stocks were higher in September 1990 than the year before.) Such a market response serves a useful social function by transferring supplies from periods of lesser scarcity to those of greater scarcity, thus spreading the burden of expected scarcity over time. It is not simply "unwarranted speculation," as the Bush administration has alleged.
In an integrated world petroleum market, price adjustments will occur for both crude oil and petroleum products without regard for national boundaries, import dependence, diversity of supply sources, or the size and historical cost of existing petroleum stocks. Even if a country has enough indigenous oil supplies or inventories to completely negate any shortfall of normal deliveries, current or expected scarcity elsewhere would cause petroleum prices in that country to rise immediately. Such price responses are frequently observed in grocery markets, where a crop freeze or a fad-induced surge in demand can raise prices overnight. And certainly no one expects all prices in residential housing markets to automatically equal historical acquisition costs. We should not expect price behavior in petroleum markets to be fundamentally different.
Although markets are fairly effective at allocating scarce petroleum resources, even in a crisis, there are often cries for government intervention when prices rise quickly, as they did at the onset of the recent troubles in the Persian Gulf. However, past experience shows that intervention in the market allocation of petroleum is risky and unwise, except perhaps in the gravest of national emergencies. This point is amply illustrated by the U.S. government's retention of price controls on domestic oil supplies after the 1973 price jump, which retarded adjustment to the increases in world prices. The point is even more starkly illustrated by the efforts to allocate oil supplies outside the market in 1979, which simply created shortages rather than avoiding them. These experiences provide convincing proof that government authorities do not have the information necessary to supplant market allocations without imposing enormous economic costs.
Another misconception is that world petroleum markets are governed exclusively by a powerful cartel of the Organization of Petroleum Exporting Countries (OPEC) or by international petroleum companies who engineer scarcity at will. While these markets are certainly not textbook examples of perfect competition, viewing them as driven by supplier manipulation is fundamentally inaccurate. Despite popular belief, the oil price shocks of the 1970s had little to do directly with drops in oil supplies; they resulted primarily from turmoil in the market, which caused rapid jumps in demand. While OPEC seems to have some control over petroleum markets (for example, oil prices fell more slowly in the early 1980s than one might have expected in a perfectly competitive market), the limits of OPEC market power are illustrated by OPEC's inability to sustain higher prices after the 1973 disruption or to reverse the 1986 collapse in oil prices.
The ability of international oil companies to control the market is even more limited. Diversification of crude supplies, nationalizations, and the entry of new companies—state-owned and private—have eliminated control of the market by a few large firms. Moreover, buyers and sellers have ready access to a large spot market in which individual cargoes of oil can be bought or sold anonymously, rather than being limited to trade with a few partners through long-term contracts. This spot market has further limited the market power of the major oil companies and OPEC.
Quickly rising oil prices bring cries for government intervention, but intervention in the market allocation of petroleum is almost always unwise.
Another point about which there seems to be confusion is the difference between dependence on oil imports and vulnerability to energy disturbances. Import dependence can impose long-term costs on the economy. These costs stem from the transfer of wealth abroad for oil purchases, whether or not petroleum markets are disrupted. In contrast, the costs of short-term petroleum market disturbances depend on the importance of energy in economic activity and the sensitivity of economic activity to relative changes in energy costs, not on imports per se. Hence it is not that useful to address market disturbances by attacking imports and seeking to expand long-term U.S. oil supplies, as the Bush administration has recently proposed. The differences in the costs of short-term petroleum market disturbances and the costs of long-term import dependence are illustrated by the sharp recession Great Britain experienced after the 1979 oil price shock, even though it was rapidly approaching oil self-sufficiency, while Japan experienced virtually no economic downturn in 1979 and has continued robust growth, even though it is totally dependent on petroleum imports.
A related misconception is that energy security problems associated with petroleum market disturbances are directly linked with the physical availability of oil supplies. While people still refer to the disturbances of the 1970s as embargoes, such events are impossible—the market widely shares any imbalance between demand and supply. Nor are petroleum market disturbances driven just by supply changes, as already noted. Above all, the economic consequences of oil price shocks depend on petroleum prices, not just physical availability. This point seems to be missed by the Bush administration in its insistence that use of the U.S. Strategic Petroleum Reserve (SPR) is unnecessary because no physical shortages are being detected. Significant shortages never will be detected in a well-functioning market, but price increases signaling increased resource scarcity can be. These price changes should be the focus of policy.
Finally, it is generally not recognized that energy security is an international problem that transcends any one country's supply situation or energy policy measures. Effective measures to countervail energy disturbances require at least some international cooperation. For example, the SPR's maximum current release rate of roughly three million barrels per day could easily be overwhelmed in the oil market by a worldwide surge of panic buying. Only a concerted effort to release stocks or curb surges in demand by other countries, notably the industrialized nations belonging to the International Energy Agency (IEA), could make a significant impact in this situation given the relatively small share of any country in world oil consumption (see table 1).
Gaps in knowledge
In spite of considerable research undertaken since the 1973 oil price shock, there are critical gaps in knowledge about the behavior of the petroleum market and the costs and risks of disturbances in the market. Current ability to accurately project longer-term changes in petroleum supply and demand—especially OPEC behavior and technical change—is woefully limited. The same is true of current ability to understand or predict short-term responses during a crisis (particularly panic-driven inventory changes) and to gauge in advance the probabilities of oil market disturbances of various magnitudes and duration. These points are illustrated by the surprise that greeted the marked decline in the ratio of energy use to GNP after the price increases of the 1970s and the abrupt decline of petroleum prices in 1986.
The costs of both long-term oil import dependence and short-term energy price disturbances are also unclear. For example, increased petroleum imports by a large buyer like the United States may increase the cost of all petroleum imports due to a bidding-up of world petroleum prices. However, there is considerable disagreement about the magnitude of such a cost. Still more disagreement surrounds other possible social costs associated with expanded petroleum imports—costs that result from the effects of oil imports on inflation, the trade balance, and vulnerability to future shocks.
Regarding short-term energy price disturbances, it has long been an article of faith among most energy security analysts that such shocks cause considerable economic losses through unemployment, lowered productivity, and reduced capital formation. Some macroeconomists have disputed this view, however. In a recent study, Douglas R. Bohi of Resources for the Future finds that the evidence does not support a strong connection between energy prices and the macroeconomic performance of several industrial countries. He concludes that misdirected macro-economic stabilization policies may be the real culprit behind the poor macroeconomic performance many countries suffered after the oil price disturbances of the 1970s. Thus it seems clear that analysts can no longer uncritically postulate large macroeconomic losses from energy price disturbances.
Uncertainties about petroleum market behavior and the costs and risks of disruptions make consensus on the resolution of policy issues difficult.
The Strategic Petroleum Reserve could provide over three million barrels of oil daily; surprisingly little is known about when and how to use it
As a consequence of the uncertainties concerning long-term changes in petroleum supply and demand, short-term responses during a crisis, and the probability of oil market disturbances, as well as the costs of long-term oil import dependence and short-term energy price disturbances, there is no analytical consensus to support the resolution of key policy issues. In the United States, such issues include the size of the Strategic Petroleum Reserve and the timing and pace of its use, the structure of energy taxation, and the long-term support of research and development.
Recommending a bundle of security policies for petroleum markets used to be fairly easy. The standard view was that petroleum imports should be lowered significantly through a sizable tariff—except in a crisis—to lower world oil prices and lessen the economy's exposure to future crises. The only concern about the size of the SPR was that the target size of 750 million barrels was too low given the usefulness of stocks for ameliorating disruption costs. In addition, it was thought that stocks generally should be used early and aggressively in a crisis to forestall panic buying, a spiraling macroeconomic problem, and a ratcheting of oil prices to a new plateau. It was also thought that long-term research and development policy should make a concerted effort to develop conservation methods and to find other supply options, even if these options were not currently cost-effective. The belief was that they probably would be in the future.
Table 1. Regional Petroleum Consumption, 1987
The uncertainties about petroleum market behavior, disruption risks, and disruption costs noted above cast at least some doubt on every one of these propositions. Imports may not be so deleterious as they were once thought to be, and the ability of individual nations to influence oil prices through collective buying power may be limited. If macroeconomic costs of energy price disturbances are less serious than had been thought, then the argument for reaching a strategic petroleum reserve of 750 million barrels—let alone increasing it—is weakened. The increased liquidity of the oil market and the growth of spot trading also weaken the case for rapidly draining the reserve in a crisis, since there is less cause for panic—that is, sources of supply will be available for those willing to pay the price. Moreover, the fact that oil prices are not on an inexorable climb, as demonstrated by the 1986 collapse in oil prices, means that the market will not inherently forgive mistakes in estimating the cost and performance of new energy supplies or conservation methods. This complicates the job of picking winners in energy research and development policy.
As noted above, any effective energy security policy actions will require some international cooperation. Despite the existence of the International Energy Agency, there is profound uncertainty about the potential responses of other industrialized nations to changing oil market conditions and the degree to which these nations will coordinate energy policy responses to short-term disturbances.
Although the IEA provides an important forum for communication and long-term cooperation, the treaty that established it in 1974 contains an extremely misguided program for bureaucratically reallocating oil supplies during a short-term crisis. Fortunately this program is fairly widely perceived as counterproductive and probably will not be exercised. However, there are only limited measures for effective cooperation in its place. There are understandings among the United States, Japan, and West Germany for coordinating the use of strategic oil stocks in a crisis, but the strength or scope of these understandings is unclear. The official IEA position continues to be that countries may pledge to pursue a variety of different responses to a disturbance, including restraints on oil demand, as well as the use of stocks. Yet little has been done—at least publicly—to create a sense of mutual assurance that concerted and productive policy actions will be undertaken. Even if such assurances did exist among governments, their practical effects would be muted if the private sector did not believe them.
The degree to which developing countries might be expected to cooperate on long-term oil market issues is even more uncertain. While the current share of total world energy used by these countries is fairly small, this share is likely to grow significantly in the future. Thus cooperation on long-term energy policies that includes the developing countries may be of substantial value. However, such cooperation now appears elusive, particularly in light of disagreement over what common interests need to be addressed.
As long as the economic dimensions of the market disturbance arising from the invasion of Kuwait remain limited, policy responses should be restrained.
Policy options
The uncertainties described above highlight the need for economic policies that may provide benefits under a wide variety of circumstances and that avoid doing significant harm. In the context of the market disturbance arising from the Iraqi invasion of Kuwait, it is important to allow market adjustments without bureaucratic intervention and not to overreact as long as the economic dimensions of the disturbance remain limited.
As of mid-September, oil prices had risen considerably from their pre-crisis levels and the U.S. economy was showing some signs of weakening. However, there was no outbreak of panic petroleum buying, and other oil producers appeared ready to offset part of the drop in supply that occurred after the invasion of Kuwait. Moreover, the macroeconomic indicators were disconcerting but not yet disastrous.
Under these circumstances the best policy response may be to undertake some accommodation in macroeconomic policies while otherwise awaiting developments. The Strategic Petroleum Reserve could be used in an effort to offset part of any macroeconomic costs from the oil price increases, particularly if macro-economic policies are hostage to the federal budget crisis. But using the SPR at this juncture may be of limited value. Any psychological advantage from its use probably was lost after the first few days following the invasion; the SPR's effect in lowering oil prices now would be limited, particularly in the absence of international cooperation. Any price effects from the five-million-barrel total sale of oil from the SPR, announced by President Bush in September, will be especially modest, since this quantity represents less than one-third of U.S. oil consumption each day. The only significant value from the sale will be in assessing how the drawdown system works. To have a significant effect on oil prices, a much higher drawdown rate probably would be needed. This might be imprudent given the limited current dimensions of the crisis and the risk of the crisis worsening if tensions grow further in the Persian Gulf.
In the future a different set of policies may be needed. But this point only underscores perhaps the most important lesson for energy policy imparted by the latest Persian Gulf crisis: the need to cope with pervasive uncertainty in world petroleum markets. In the face of this uncertainty, the difficulties of designing energy policies are only compounded by the continuing lack of knowledge about how petroleum markets operate and about the potential benefits or costs of different energy security measures. Despite the large volume of research on energy security since the early 1970s, much remains to be done.
Michael A. Toman is a senior fellow in RFF's Energy and Natural Resources Division.
A version of this article appeared in print in the October 1990 issue of Resources magazine.
A version of this article appeared in print in the October 1990 issue of Resources magazine.
