Reducing U.S. Vulnerability toOil Supply Disruptions

Stephen BrownResources for the Future

Hillard HuntingtonStanford University

Overview

• Wellbeing Oil Security• Increased oil consumption as a security

externality– Does one consumer’s use of an unstable supply

increase the likelihood or size of a disruption?– Is the marginal barrel from an unstable supply?

• How big are the economic shocks?– Mechanisms for magnification– Older and newer estimates

• Preliminary estimates of the oil security premium

U.S. Wellbeing

• Depends on its real income (aggregate output less imports) and nonmarket externalities (pollution, congestion, etc.)

• Potential implications for oil policy:– Reducing vulnerability to world oil supply

disruptions– Improving terms of trade for imported oil– Reduced wellbeing resulting from the pollution

associated with oil use outside our inquiry

not asecurityissue

Improving the Terms of Trade(briefly considered)

• Oil import tariffs can improve U.S. terms of trade for oil– U.S. can exploit monopsony buying power which

individuals cannot• A common analysis in international trade literature

– Not a true externality, rather a transfer from oil-exporting countries

– Does not offset OPEC monopoly power

• May have influenced past policy

Oil Security

• United States draws its oil from the world oil market

• World market includes foreign suppliers that have been historically unstable

• Oil is fungible• Disruptions in world oil supply have led to

episodes of sharply rising oil prices and reduced U.S. GDP

Oil Prices and U.S. Recessions

Oil Security Premium• Costs associated with risk to U.S. economy

associated with reliance on unstable oil– Typically expressed in $ per imported barrel

• An externality– Oil is a fungible commodity– Consumers do not consider whether

• marginal barrel comes from an unstable source• their increased use poses risks to the economy

• Can be imposed as a tax on imported oil

Oil Security Externalities

• If the marginal barrel is insecure, increased consumption reduces everyone’s security

• The effect of one person’s decision to use an additional barrel is relatively small, but the accumulated effects across many individuals is large

• Because effects of disruption are economy-wide, benefits of reduced vulnerability are not excludable

• Individual consumers unlikely to consider the effect of their oil consumption on the overall economy

Oil Security and Externalities(some issues)

• Is the marginal barrel from unstable supply?• Does one person’s increased oil consumption

increase the risk, size or consequences of potential oil supply disruptions?

• U.S. economy unlikely to be organized in a manner to minimize the effects of oil shocks

• Effects seem to be greater than can be explained by simple neoclassical analysis

Magnification of the Economic Effects

• Reallocation of resources (Mork; Davis and Haltiwanger)

• Uncertainty for investment (Hamilton; Ferderer)

• Coordination failure (Huntington)

• Fiscal policy, monetary policy, energy policy may not respond appropriately– Experts may not agree on appropriate policy

• Supply shock reduces aggregate demand in economies experiencing inflation (neo-Keynesian)

Have the Economic Effects Weakened?

• Why the effects might have become smaller– Reduced oil-to-GDP ratio

• but oil use concentrated in sectors with less flexibility

– Greater flexibility in labor and energy markets– Better monetary policy

• Limited empirical evidence• Why the effects might seem smaller

– Supply disruptions not only factor in recent price increases– Estimated effects for 1970s and early 80s same as for

2000s, but other changes in productivity occurred

Sources of Oil Price Shocks

• Oil supply shocks• Speculative price shocks

– fears of future oil supply disruptions

• Increased world oil demand – resulting from U.S. productivity gains– resulting from foreign productivity gains

Smaller Effects in the 2000s

• Better monetary policy• In the 1970s and early 1980s, unfavorable U.S.

productivity shocks reinforced the negative effects of oil supply shocks

• In the 2000s, oil price gains reflect both unfavorable supply shocks and favorable demand shocks– The latter driven by U.S. and foreign productivity

gains– The net effect was higher oil prices and expanding

U.S. GDP

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Quantitative Effects on U.S. GDP

Reference Elasticity

Econometric studies -0.012 to -0.12

Leiby (2007) -0.01 to -0.08

EMF (1987) -0.02 to -0.075

U.S. DOE -0.025 to -0.055

Newer literature −0.018−0.012 to −0.029

Calculating an Oil Security Premium

• Probability of supply disruptions• Price response to disruption• Loss in aggregate economic activity in

response to price increase

Estimated Oil Security Premium

Sources: Leiby (1997, 2007), Authors’ estimates

EFFECT Leiby (1997) Leiby (2007)Newer Research

(preliminary)

Economic Vulnerability

$1.03($1.03-2.05)

$4.68($2.18-7.81)

$2.52($2.26-3.08)

Estimated Oil Security Premium

EFFECT Leiby (1997) Leiby (2007)Newer Research

(preliminary)

Economic Vulnerability

$1.03($1.03-2.05)

$4.68($2.18-7.81)

$2.52($2.26-3.08)

ImprovedTerms of Trade

$2.57($1.54-3.59)

$8.90($2.91-18.40)

$8.90($2.91-18.40)

Total $3.59($2.57-5.64)

13.58($6.71-23.25)

11.42($5.17-21.48)

Sources: Leiby (1997, 2007), Authors’ estimates

Concluding Remarks

• Oil supply disruptions have economy-wide effects• One person’s increased oil consumption may

increase the risk, size or consequences of oil supply disruptions—an externality

• Oil security premium one way to measure the externality

• Leiby estimates the oil security premium at $2.18-7.81 per barrel, with a mean of $4.68

• Newer economic literature suggests less effect on the economy and a somewhat lower premium

Addendum on Foreign Policy

• Concerns about the effect that U.S. oil imports have for U.S. foreign policy options– Money paid for imports come back as bullets– Oil revenues fund regimes hostile to the West

• Oil is a fungible commodity– Our total oil imports matter more than who we

import from– For hostile regimes, total oil revenue matters

more than the source

Foreign Policy Implications of U.S. Oil Dependence(from recent study by Council on Foreign Relations)

• Significant interruption in oil supply will have adverse political and economic consequences in the United States and other importing countries.

• High prices and seemingly scarce supplies create fears that the current system of open markets is unable to ensure secure supply.

• Control over oil revenues gives exporting countries the flexibility to adopt policies that oppose U.S. interests and values

• Oil dependence causes political realignments that constrain the ability of the United States to form alliances and partnerships to achieve common objectives.

• Revenues from oil and gas exports can undermine local governance.• If the U.S. reduced its dependence on oil, it would not have as great an

interest in the Middle East, and could reduce its military posture there.