World oil prices rose rapidly from 2002 before reaching an all-time high in mid-2008. As prices rose, they were punctuated by sharp swings resulting from supply disruptions. Although oil prices have since declined, expectations that prices will rebound and once again be unstable raise concerns about oil security. Past oil supply disruptions have resulted in sharply rising oil prices and reduced economic activity. Ten of the eleven post-WWII U.S. recessions—including the one we’re in now—immediately followed episodes of sharply rising oil prices.
Politicians and scholars regularly emphasize the costs of U.S. dependence on imported oil, but oil’s fungibility means that consumers cannot distinguish between domestic and imported sources. All oil prices move together on an integrated world oil market, and regardless of the source, the global price for a barrel of oil ultimately determines the price at the local gas pump. But the critical security difference between domestic and imported sources of oil, namely the instability of foreign suppliers, is what creates conflict in world oil markets and where policy can be used to good effect.
The desirability of promoting oil security arises only to the extent that the potential economic losses associated with reliance on insecure oil supplies are externalities—costs that are borne by society as a whole, rather than by the parties directly involved in a transaction.
Differentiating between Domestic and Imported Oil
Although domestic and imported oil look very much the same to the consumer, a disruption of foreign supplies would mean higher oil prices in the United States—even if it were importing no oil from the country whose production is disrupted. The reason why is that rising oil prices elsewhere in the world would divert secure supplies from the United States to other markets. Because no oil supplies are secure from price shocks, the increased consumption of either domestic or imported oil increases the economy’s exposure to oil price shocks.
Nonetheless, the U.S. economy’s exposure to oil price shocks does differ for domestic oil and oil imported from countries whose production is unstable. Rising U.S. oil imports reduces energy security by increasing the share of world oil supply that comes from those countries. Conversely, expanding U.S. oil production enhances energy security by increasing the share of world oil supply that comes from stable suppliers.
Oil Security Externalities
To the extent that the economic losses associated with oil supply disruptions are negative externalities that are not taken into account in private actions, they become a concern for economic policy. A number of other costs may arise from potential oil price shocks, but not all of them may be externalities. Negative externalities occur only when a market transaction imposes costs or risks on an individual who is not party to the transaction. (Of course, oil use creates other externalities—such as air pollution and greenhouse gas emissions—that are not associated with energy security.)
GDP Losses. The increase in expected GDP losses resulting from increased oil consumption is likely an externality. Increased oil consumption ups the exposure of economic activity to disruptions. Moreover, individuals buying oil are unlikely to understand or consider how their own oil consumption affects others by amplifying the effects that oil supply disruptions have on overall economic activity—particularly because the GDP losses associated with an oil price shock are well beyond the possible increase in costs that an individual might expect as part of an oil purchase.
Increased Transfers. An increase in U.S. oil imports increases the expected transfers to foreign oil producers during a supply shock, but only part of that increase should be regarded as an externality. When buying oil products, individuals should recognize the potential for oil supply shocks and higher prices. So, the expected transfer on the marginal purchase is not an externality. On the other hand, individuals are unlikely to take into account how their purchases may affect others by enlarging the size of the price shock that occurs when there is a supply disruption. So the latter portion is an externality.
Increased Prices for Imported Oil during Periods of Stable Supply. A rise in U.S. oil imports increases the price paid for all imported oil and that means greater costs for those purchasing imported oil. Such an increase is considered a normal market development that does not result in market inefficiency, and it is not a security issue.
Increased Government Expenditures. Government actions—such as military spending in vulnerable supply areas and expansion of the Strategic Petroleum Reserve—are possible responses to the economic vulnerability arising from potential oil supply disruptions. Sound policy requires that these expenditures be balanced against the externalities of greater oil use rather than as a measure of the externalities.
Limits on U.S. Foreign Policy. An overall dependence on imported oil may reduce U.S. foreign policy prerogatives. These limitations may not be greatly affected by marginal changes in oil consumption, nor is it readily apparent how to quantify such effects. Therefore, they are omitted in quantitative estimates of the security externalities associated with increased oil consumption.
Uses of Oil Revenue. Americans may be unhappy with the uses to which some oil-producing countries put their revenue, but that does not mean the sale creates an externality. The oil purchase itself does not create the unwanted behavior. The absence of a direct foreign policy instrument may make it desirable to use policies that reduce world oil prices, but the use of such a blunt instrument will hurt all oil producers, not just those unfriendly to the United States.
Estimated Oil Security Premiums
In recent research, Hillard Huntington and I estimated the external security costs of U.S. oil consumption. The external security cost of the consumption of domestically produced oil has a mean value of $2.81 per barrel in a range of $0.19–8.70. (All dollar figures are in constant 2007 dollars.) The external security cost of the consumption of imported oil has a mean value of $4.98 per barrel in a range of $1.10–14.35.
These estimates suggest only a moderate oil policy is necessary to respond to the security issues associated with oil use. They are based on projections made by the U.S. Energy Information Administration that show oil prices rising from about $40 per barrel in 2009 to more than $130 per barrel in 2030. In comparison to these oil price projections, the estimated security externalities are relatively modest.
Further Reading:
Beccue, Phillip and Hillard G. Huntington. 2005. Oil Disruption Risk Assessment. Energy Modeling Forum Special Report 8 (August). Stanford, CA: Stanford University
Council on Foreign Relations. 2006. National Security Consequences of U.S. Oil Dependency, John Deutch and James R. Schlesinger, chairs; David G. Victor, director. Washington, DC: Council on Foreign Relations Press (October).
Brown. Stephen P. A. and Hillard G. Huntington. 2009. Estimating U.S. Oil Security Premiums. EMF OP 68 (September), Energy Modeling Forum. Stanford, CA: Stanford University.
Leiby, Paul N. 2007. Estimating the Energy Security Benefits of Reduced U.S. Oil Imports. Oak Ridge National Laboratory Report ORNL/TM-2007/028, revised July 23. Oak Ridge, TN: Oak Ridge National Laboratory.
Stephen Brown is a nonresident fellow at Resources for the Future. He previously served as the director of energy economics and microeconomic policy at the Federal Reserve Bank of Dallas.
