The Folly of Energy Autarky

Sunday, June 17, 2012

The following is an article Gal Luft and Anne Korin wrote for the July/August 2012 issue of The American Interest:

The United States stands on the cusp of a global strategic advantage of huge significance. It is now within our grasp to cut the Gordian knot of energy policy, transforming our economic prospects in a fairly short period. Seizing this advantage does not require or depend on an esoteric technological breakthrough. It does not require allied assistance. It does not require a great deal of citizen sacrifice, discipline or patience. It does not require new taxes or convoluted cap-and-trade schemes. It merely requires that the Administration and the U.S. Congress get their collective head straight for once about a policy area in which politically ecumenical futility has been the norm for nearly forty years.

It has been an article of faith at least since the Nixon Administration that, in order to strengthen its energy security and, through that, its international position generally, the United States should reduce its dependence on imported oil, particularly from the Middle East. The only significant difference between Republicans and Democrats on this point has been their choice of methods: Republicans have generally preferred supply-side solutions (“Drill, baby, drill!”), while Democrats have generally preferred demand-side responses such as greater conservation and efficiency, and higher energy taxes to encourage both. Withal, imports grew by leaps and bounds both in relative and absolute terms from 36 percent of consumption in 1973 to 60 percent in 2005.

Leaving aside for the moment the actual reasons that successive U.S. Administrations failed to achieve what all professed to be a critical national security goal, the fact of the matter is that the goal of import reduction was misguided. Typical Americans throughout the years have labored under a series of misconceptions about how the international oil business works, the most common of which is that exporters have the ability to fine-tune the destination of their oil exports for political or commercial purposes. This is simply not true. Think of the oil market as a swimming pool: Producers pour oil in, consumers take oil out. The oil itself is totally fungible, and everybody faces essentially the same price. While individual producing countries may have contracts with consuming countries, most oil is purchased on the spot market for an international price. This arrangement is enabled by the fact that the international oil companies determine what happens to the oil once it enters the global market. With rare exceptions, the governments of oil-exporting countries are simply unable to control where their oil goes.

Thus, the Arab oil-producing countries declared an embargo of the United States and certain selected European countries in the context of the October 1973 Middle Eastern war, but whatever modest shortage resulted from these actions was distributed evenly by the companies. There was no special, acute shortage in the United States; the long gas lines and price hikes had much more to do with panicked consumer behavior and the outright bungling of the Federal energy bureaucracy. But to this day most Americans believe otherwise.

During the Cold War American statesmen and strategists worried that the Soviet Union or its allies might be able to interdict or otherwise disrupt the flow of oil, particularly from the Middle East, to America’s European and Asian allies. They worried that war or revolution in the countries of the region might have a similar effect, as seemed to be borne out in 1978–79, during the throes of the Iranian Revolution. These were not unreasonable concerns at the time. More recently we have worried about the direct and indirect flow of oil revenues to anti-American actors, be they states or non-state actors, and the physical disruption of supply by major attacks on Persian Gulf oil facilities. Again, these are not unreasonable concerns. But what has never made any sense is the argument that reducing oil imports—or even achieving oil self-sufficiency—would have shielded the United States from the consequences of such events. Yet the idea that energy independence is mainly about the security of supply is still the one stuck in the heads of most Americans and even most policymakers. Not to put too fine a point on it, this assumption is completely wrong, and our inability to rid ourselves of this generic misunderstanding is still leading us to overlook a readily available remedy for our problems.

The problem we face is not about supply but about price. In recent years America’s volume of imported oil has dropped significantly even as the price we have paid and are still paying for it has sharply increased. It follows, then, that the policy options we ought to consider differ significantly from those of the past half century. Yet there seems to be something seriously the matter with our mental clutch. We’re stuck in the wrong gear, and we’re not getting anywhere. That needs to change, now.

Up to Speed

To understand more fully what the problem is and what we need to do about it, consider that in recent years America’s energy landscape has turned a corner—not thanks to, but largely despite, the actions of the U.S. government. U.S. net imports of petroleum declined from 12.5 million barrels per day (mbd) in 2005 to 8.6 mbd in 2011. U.S. import dependence dropped from its 60 percent peak in 2005 to 46 percent, the level it was back in 1995. This 30 percent reduction in just seven years in the level of imports is equivalent to three times the number of barrels nominally imported from Saudi Arabia.

Some of the reduction is due to a recession-induced drop in consumption; some has to do with increased vehicle fuel efficiency standards; some with a ramp up in ethanol blending; and some with a ramp up in domestic oil production. Since 2008, technologies like deep-water drilling, hydraulic fracturing and horizontal drilling have increased U.S. crude oil output by 18 percent. In the past year alone, the U.S. onshore rig count has grown by 30 percent. About a million barrels per day emerged from a new source, tight oil, which is extracted from dense rocks. North Dakota, the center of the tight oil transformation, has become the fourth largest oil-producing state behind Texas, Alaska and California. For the first time in decades, the United States is experiencing an oil boom—or at least a boomlet.

But while America’s oil imports dropped, its foreign oil expenditures climbed by almost 50 percent, from $247 billion in 2005 to $367 billion in 2011. The share of oil imports in the overall trade deficit grew from 32 percent in 2005 to 58 percent in 2011. The price of a gallon of regular gasoline nearly doubled. Despite lower demand, U.S. drivers spent more last year on gasoline than in any prior year.

Clearly, and surprisingly to those trapped in old ways of thinking, the volume of U.S. imports and the cost of those imports have moved in opposite directions. While America became more self-sufficient and more fuel-efficient, it became poorer and got deeper in debt. If one accepts the traditional mantra of energy security as “availability of sufficient supply at affordable prices”, then whatever points we gained on the availability front were offset by those lost on the affordability side of the ledger. The latter matters more—especially in a time of economic adversity.

All but two of the post-World War II recessions were preceded by a sharp spike in oil prices; there is no question that the fivefold increase in oil prices since 2003 has contributed to the current economic dislocation. For perspective, forty years ago, at the zenith of the Cold War, the United States spent $4 billion on oil imports, an amount that equaled 1.2 percent of the defense budget. In 2006, the United States paid $296 billion, equal to half of the defense budget. By 2008, U.S. foreign oil expenditures grew so much they almost equaled the entire defense budget.

The energy security paradox of the 21st century, then, is that a country can reduce oil imports but end up paying a much higher oil import bill. What this means is that, given the current state of the global economy, a new oil shock—whether caused by war in the Persian Gulf, instability in North Africa or Nigeria, or even anxious investors rushing to buy oil futures to hedge against falling currencies—would sink Western economies. As it is, the rising cost of oil is hollowing out the U.S. economy, and no fuel economy standards or new oil discovery will stop this tide. What is needed is a new energy paradigm.

Cost, Not Volume

As we have already noted, dreams of autarky in oil still dominate U.S. energy policy discourse. The pledge to cut a third of oil imports by 2020 is at the core of President Obama’s energy policy, and talk about reducing imports from the Middle East continues to be one of the best applause lines of all presidential and congressional candidates across the political spectrum.

This rhetoric relies on two false premises. First, America is not dependent on the Persian Gulf for its oil supply. Imports from the Persian Gulf never exceeded 15 percent of total U.S. petroleum consumption; currently, the figure stands at 9 percent. And again, these numbers are really nominal, since oil is fungible and swap arrangements the oil companies employ to reduce transportation costs make it impossible to know where any given barrel of oil really came from. Most U.S. oil imports originate in North America.

Second, even if all U.S. oil imports originated from Canada and Mexico, America would be just as vulnerable to the impact of oil price spikes due to volatility in the Persian Gulf and other unstable regions as it is today. Self-sufficiency in oil would not, indeed cannot, shield U.S. consumers from oil price shocks. In 2008, when oil prices reached an historic high, the United Kingdom produced most of the oil it needed, yet the price spike affected its citizens just as much as it did Americans. When the price of oil spikes, it spikes for everyone. The United States imports hardly any oil from Libya, but when the 2011 Libyan upheavals caused a supply disruption, American motorists were as affected by the resulting $25 per barrel price hike as the motorists of Libya’s major oil purchasers.

The inability to keep the price of oil at bay, not the volume of imports, is the crux of America’s vulnerability. But—and this is the critical yet still generally unrecognized key to the solving the energy puzzle—the price is what it is because virtually all the cars and trucks in the world are unable to run on anything but petroleum-based fuels. Oil faces no competition from other energy commodities in the sector from which its strategic importance stems, namely transportation. Since consumers are unable to choose between different commodities, suppliers do not need to compete for market share by increasing production capacity and supplying lower prices. And that, in turn, leads us to OPEC.

One can argue (and many have) that OPEC isn’t particularly adept at managing its response to fluctuations in the oil market month to month or week to week. But this is simply indisputable: OPEC controls 79 percent of the world’s conventional oil reserves, but its members account for only 36 percent of global production. If investor-owned oil companies such as Exxon, BP, Shell and Chevron were sitting on top of 79 percent of the world’s conventional oil reserves, they wouldn’t account for but a third of global supply. They’d probably account for 68 percent, or 82 percent, or something in that range. And if not, they’d be slapped with an anti-trust lawsuit. Anti-trust lawsuits, however, don’t work against sovereign regimes such as those that comprise OPEC. It shouldn’t be surprising that OPEC’s production capacity is so low since OPEC is a cartel, and a cartel aims to maximize profit by constricting supply. Thus, in the past three decades, global GDP grew sixfold, yet OPEC’s crude production increased by barely 15 percent. This is despite the fact that in 2007 the cartel inducted two new members, Angola and Ecuador, with combined daily production capacity equivalent to Norway’s. (Ecuador actually rejoined OPEC in 2007; it had left the organization in 1992.) In other words, OPEC keeps production capacity well below what its reserves allow, creating a supply level designed to keep prices at a certain level.

Perhaps the best way to understand this is through the metaphor of a homeostat or, even better because more specific, a Watt’s steam governor. OPEC decides on an ideal price level—one that covers expenditures but does not induce excessive conservation in its customers—and then adjusts supply accordingly. So when major consumers reduce net demand for whatever reasons, OPEC responds by throttling down supply to drive prices back up to its ideal price level, what it calls a “fair” price, or just sitting on its hands while developing world demand picks up the slack. The thing is, this “fair” price keeps rising. In 2004, OPEC’s “fair” price was $25 per barrel. Two years later it was $50. In 2010, OPEC’s secretary general, Abdalla Salem El-Badri, argued for $90, and by the end of 2011, with OPEC’s oil revenues topping $1 trillion, he adjusted the price to $100.

OPEC’s “fair” price is based ultimately on the budgetary needs of the cartel’s members, whose appetite for petrodollars has increased significantly since the onset of the so-called Arab Spring. Hoping to avoid the fate of leaderships in Egypt and Tunisia, Persian Gulf regimes have showered their people with gifts and subsidies. Saudi Arabia alone almost doubled its budget, committing $129 billion to entitlement programs. Despite a petrodollar-induced budget surplus in 2011, this expensive response to the protests will likely increase the break-even price the Saudis need in order to balance their budget in the coming years to at least $110 in 2015. Other OPEC members, especially Iran, Iraq, Venezuela and Nigeria, will also seek higher oil prices. OPEC’s modus operandi of keeping the money coming is based on upward adjustment in the “fair” price of oil rather than on selling more oil.

Another reason for OPEC’s rising break-even price is the cartel members’ own oil consumption habits. Saudi Arabia is the world’s largest oil producer, but due to its rapid population growth and heavy subsidization of fuels, the Kingdom is also the world’s sixth largest oil consumer. With an internal demand growth rate of 7–9 percent per year, Saudi Arabia, currently using 2.8 mbd, is projected to consume roughly six mbd by 2030. Oil analysts counting on Saudi Arabia’s production capacity reaching 12 mbd tend to forget that half of Saudi Arabia’s oil will be burned within the Kingdom instead of reaching the world market.

Natural Gas Against Oil

In light of this dynamic, competing on the same playing field with the current set of major oil exporting countries is playing a game America can never win. The cartel’s financial needs will drive it to respond to defensive behavior by its clients to the degree that any slack isn’t taken up by increased developing world demand. This is easy for a cartel to do: Drill for more oil at home, and the cartel can simply reduce production to return to a tight supply-demand relationship; increase fuel efficiency, same response; mandate a specific small volume of non-petroleum fuels in the market over an extended period, same response. So it doesn’t matter how well we follow the Republicans’ “drill baby, drill” or the Democrats’ conservation and efficiency; we’ll still be on the same treadmill we’ve been on for decades.

In order to get leverage against manufactured increases in the price of oil, consumers must be able to respond to price changes as they occur. Drivers cannot rapidly change the fuel economy of their vehicles, but, with vehicles that enable fuel competition, they could choose to purchase a less costly substitute fuel as an immediate response to changes in oil price. In other words, they could fuel switch. That’s the only way oil’s monopoly over transportation fuel can be broken. Luckily for us, the current glut of cheap natural gas provides a unique opportunity to do just that.

Historically, natural gas prices tracked oil prices. But the emergence of shale gas, projected to reach 43 percent of U.S. natural gas production in 2015, has disconnected the prices of the two energy commodities. Since the collapse of financial markets in 2008, oil prices have rebounded more or less to their pre-2009 level, whereas natural gas prices remained suppressed and have even fallen. The utility and chemical industries, the two primary natural gas users, are limited in their ability to absorb more gas. If prices remain low, the natural gas industry will have little incentive to invest in further growth, and shale gas development will slow significantly. If, however, more vehicles could handle fuels made from natural gas, the industry would have the certainty it needs to continue to expand this job-creating sector.

There are several ways to take advantage of the low cost of natural gas. One way to use natural gas in automobiles is by employing it to generate electricity for plug-in hybrids and electric vehicles. Such vehicles are gradually entering the market. They are clean, cheap to operate, and in many respects outperform gasoline-powered cars. Furthermore, vehicle electrification offers great flexibility. If natural gas prices spike, there is always coal, nuclear or renewable power to rely upon for power generation. (Contrary to popular belief, oil is essentially no longer used to generate electricity: Only 1 percent of U.S. electricity generation is petroleum based, and only 1 percent of U.S. oil demand is due to electricity generation.)

However, due to the high cost of automotive batteries, mass-market penetration of battery-operated vehicles will take a long time. Such cars are projected to account for only 5 percent of vehicle sales in 2020. Not until 2040 will market penetration be deep enough to make a dent in the price of oil.

There is another way to run cars on natural gas via compressed natural gas (CNG) vehicles, which have a dedicated fuel line and a large gas canister in the trunk. But the cost of converting a light-duty vehicle to CNG is more than $10,000—a bad investment for most drivers given that it would take more years than most cars and light trucks are owned by the average person to recoup that in savings.

This leaves only one near term and affordable way of opening cars to natural gas en masse: converting the gas into liquid fuel. A recent MIT study on the future of natural gas determined that the most economical liquid fuel pathway for natural gas is methanol (wood alcohol). Other gas-to-liquids technologies can yield drop-in fuels like gasoline and diesel that can be used in the current automotive infrastructure, but on a per-mile basis these end products are 30 percent costlier than natural-gas-based methanol.

Methanol is a globally traded commodity, and its spot price averages $1.10 per gallon. Add taxes, distribution and retail markup, and on a per-mile basis methanol is substantially less expensive than gasoline. (Different fuels have different energy contents, so the proper price comparison is not per gallon but per mile.) China is already blending 15 percent methanol (made primarily from coal in China) into its automotive fuel, and in recent years 26 of its thirty mainland provinces have carried out testing and demonstrations of methanol fuel and methanol fuel vehicles. The economics of methanol are so favorable compared to gasoline that in China illegal methanol blending has become rampant.

In the United States, methanol blending will not occur without warranty guarantees for the vehicles into which this fuel is poured. In order for vehicles to run on methanol (and other alcohol fuels such as ethanol) in addition to gasoline, they must be tweaked to manage its greater corrosiveness. Essentially, all the tweaks needed are a fuel sensor and a corrosion-resistant fuel line. The cost? About $100 for a car or light truck. No, that’s not a typo: just one hundred dollars.

Such flex-fuel vehicles provide a platform on which liquid fuels can compete, thus placing a variety of commodities (methanol can also be made from coal, biomass and, in the future, recycled carbon dioxide) in competition at the pump and letting the market determine the winning fuels and feedstocks based on economics: comparative per-mile cost. The proliferation of flex-fuel vehicles in Brazil has already driven fuel competition at the pump to the point that in 2008, when oil prices were at record highs, gasoline became the alternative rather than the primary fuel.

Nothing like what happened in Brazil can happen in the United States as long as vehicles are warrantied to run exclusively on petroleum fuels, with non-petroleum liquids confined to a protected and limited market as additives. Over the past seven years, as U.S. import dependence dropped, nearly 100 million new petroleum-only vehicles rolled onto America’s roads, each with an average lifespan of 15 years. This has effectively extended the stranglehold of oil (and its possessors) on our economy by two decades. This is a needless tragedy.

We are solidly on track to continue this needless tragedy. At no point so far in the 2012 presidential elections cycle has any major candidate demonstrated even a rudimentary understanding of the actual problem of foreign oil, let alone articulated a solution for it. Clearly, our objective should not be to reduce the magnitude of U.S. oil imports but rather to diminish the strategic importance of oil altogether. The policy needs to be not about learning to endure the impact that price spikes have on the economy, but about banishing those spikes by placing petroleum in competition with other forms of transportation fuel.

Clinging to old mantras and new supply developments may bring America closer to self-sufficiency, but that will not help forestall economic decline. The most immediate and effective step the U.S. government can take to insulate our economy from oil shocks is to enact an open fuel standard, ensuring that new cars are open to fuel competition. This one act would signal that the U.S. transportation fuel market is no longer captive to oil. The capacity expansion among various fuels that flex-fuel vehicles would stimulate will eventually lead to competition over fuel market share and thus drag down the price of oil. The sooner we adjust our thinking and focus on this game-changing, transformational solution instead of inconsequential, time-buying policies, the sooner we will attain true and lasting energy security.

Gal Luft and Anne Korin are co-directors of the Institute for the Analysis of Global Security (IAGS) and senior advisers to the United States Energy Security Council. They are co-authors of Turning Oil into Salt: Energy Independence through Fuel Choice (2009) and Petropoly: The Collapse of America’s Energy Security Paradigm (Forthcoming, 2012).


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