October 20, 2011


Energy: Friend or Enemy?: a review of The End of Energy: The Unmaking of America's Environment, Security, and Independence by Michael J. Graetz  William D. Nordhaus, 10/27/11, NY Review of Books)

If we look at both the rhetoric and substance of oil policy, particularly oil dependency, much thinking is misguided because of misconceptions about the nature of oil dependency. We can usefully think of the oil market as a single integrated world market--like a giant bathtub of oil. In the bathtub view, there are spigots from Saudi Arabia, Russia, and other producers that introduce oil into the inventory. And there are drains from which the United States, China, and other consumers draw oil. Nevertheless, the dynamics of the price and quantity are determined by the sum of these demands and supplies, and are independent of whether the faucets and drains are labeled "US," "Russia," or "China." In other words, prices are determined by global supply and demand, and the composition of supply and demand is irrelevant.7

Why is crude oil an integrated world market? The reasons are that the costs of transporting oil are low, different crude oils are largely interchangeable, and the different crudes can be blended. This means that crude oil is fungible, like dollar bills. A shortfall in one region can be made up by shipping a similar oil there from elsewhere in the world. US oil policies make no more sense than trying to lower the water level in one end of the bathtub by taking a few cups of water from that end.

We know that the world oil market is unified because there is a single price of crude oil that holds no matter what the source. For example, we can look at whether prices (with corrections for gravity and sulfur) in fact move together. A good test of this view would be to ask whether a benchmark crude price predicts the movement of other prices. Looking at crude oil from twenty-eight different regions around the world from 1977 to 2009, I found that a 10.00 percent change in the price of the "Brent" crude oil--a blend of crude often used as a benchmark for price--led to a 9.99 percent change in the price of other crude oils. These correlations among crude oil prices are markedly higher than are observed for virtually any other traded good or service.

The implication of the bathtub view is profound. It means that virtually no important oil issue involves US dependency on foreign oil. Whether we consider pollution, macroeconomic impacts, price volatility, supply interruptions, or Middle East politics, our vulnerability depends upon the global market. It does not depend upon the fraction of our consumption that is imported.

I will use two examples to illustrate this point. A first hardy perennial is the idea that we should limit our consumption to oil from "secure sources." This might mean concentrating on Canada and Mexico, or perhaps relying only on our own output, or we might even exclude Alaska lest it someday decide to secede.

These policies make no sense in an integrated world oil market. Suppose that the United States limited its imports to completely reliable sources--ones that would never, ever cut off supplies--and specifically prohibited imports from unreliable country A. This would lead country A to send its oil to other countries. In an integrated world market, the result would be simply to reallocate production from non-A countries to the United States to make up the shortfall here and eliminate the excess there. Unless a country actually changes its flow into the world bathtub, there will be no impact on the United States of sourcing imports from secure regions only.

Another useful example is sanctions and embargoes. These are often launched as ways of putting economic pressures on countries. The US imposed oil sanctions on Libya from 1986 to 2004 and then again this year; and on Iran from 1979 to the present. The rationale of these policies was to reduce demand for oil from offending countries and decrease their export prices and revenues. But these were only partial in that they did not cover the entire world, including smugglers. The bathtub theory of the world oil market would predict that there would be no effect for the same reason that reducing dependency has no effect: production would simply be reallocated among other countries.

What actually happened during the embargoes? The data indicate that prices in Iran and Libya were virtually unchanged. This is exactly what the bathtub model predicts because, to a first approximation, such embargoes should be expected to have no effect on world prices or production, no impact on the target countries, and no impact on the United States or other consuming countries. They are purely symbolic measures.

The conclusion is that oil policy should focus on world production and consumption and not on the portion we import, and should focus as well on the externalities from our consumption in the form of pollution and global warming. This means primarily that oil consumption should face its full social cost. The major external cost that remains to be addressed is climate change. Until countries put an appropriate price on carbon emissions for oil and other fossil fuels, energy policy will be incoherent, and energy and environmental policies will be working at cross-purposes. The National Research Council estimates cited above used a damage cost of $30 per ton of CO2 emissions. This is somewhat higher than estimates from my own work but is a reasonable target for a US carbon price over the next decade or so. If phased in gradually through a cap-and-trade or carbon tax, such a price would help promote both fiscal and environmental goals.

Posted by at October 20, 2011 9:50 PM

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