Thursday, February 02, 2006

Oil Addictions, Oil Detox

The most-noted part of President Bush’s State of the Union speech was his declaration that the U.S. is “addicted to oil,” and his announcement of a goal to reduce oil imports from the Middle East by 75 percent by 2020. Easier said than done.

First, it is worth thinking about why imported oil is even an issue to begin with. Contrary to what many claim, the threat from overconsumption – that we will run out of oil – is in isolation a nonissue. The world did not fall apart when forests began to run out back in the days when they were cleared for heating only o be replaced by whale oil, nor when whale oil seemingly in danger of exhaustion only to be replaced by petroleum. Oil is a scarce commodity like any other. If it begins to run out (and there is a growing body of thought known as Peak Oil which believes exactly that, although this is disputed), the price system is the best way to manage this growing scarcity. If people are free to bid on oil to put it to competing uses, it will provide incentives to find more, to make sure that those who can create the most value with it get their hands on it, and for creative entrepreneurs to find alternatives, as happened in the two prior examples.

Rather, the problem about which President Bush is concerned is a market failure peculiar to imported oil, and from unstable developing countries in the Middle East and elsewhere in particular. To take an arbitrary example, if five dollars of every 60 dollars paid for a barrel of Saudi oil ends up funding the jihad, the consumption of that barrel has a social cost in excess of what the buyer paid for it. (The argument that oil consumption warms the planet and is therefore also externally costly applies if true to any oil consumption, imported or not, but for a variety of reasons I ignore this problem here.)

While the U.S. does not inordinately import oil from Saudi Arabia (we get more from Venezuela and Mexico), there are fundamental economic laws that currently give the Gulf States an advantage in world oil markets. Whereas before the 1973 oil embargo oil was often acquired by long-term contracts with a single nation, that crisis helped generate a market for oil that looks like that for most commodities and financial assets. Oil is globally traded, and so ultimately those with the lowest production costs will be able to sell. Individual countries' supplies cannot be constrained by consumer choices. And for now the production costs are lowest in the Gulf States, especially Saudi Arabia, where the oil is much easier to extract. Alternate sources such as the tar sands in Alberta, which potentially hold huge reserves, must be feasible not just in the engineering sense but in the economic sense. In other words, it is not a question of whether the technology to enable the extraction of oil exists, but whether the resources required to do so can be acquired at an opportunity cost low enough relative to what consumers will pay for the output that results.

If the alternatives are costly enough, lots of technology can be made economically feasible. As far back as World War II an isolated Germany with few alternatives was able to make liquid fuels out of coal, as did South Africa during the apartheid years. But we do not face those kinds of constraints now, and so it is difficult to avoid Saudi oil dominating the market. Even if the U.S., for example, imposes a huge gasoline tax, driving down demand, that would harm high-cost producers the most and the Saudis the least. An import tariff on oil would be better, but is prohibited by WTO rules. With the Saudis having acceded to the WTO last year, discriminatory tariffs on Saudi oil exclusively are also prohibited, and would be difficult to enforce in any event because of the fungibility of oil. Raising the price of oil through taxation or other legal restraints raises the competitive advantage of global oil for the cheapest producers, whether they sell it in the U.S., Europe, India or China. Even if we managed to buy less Saudi oil, they would sell it elsewhere. (Such measures would be problematic for a variety of economic and philosophical reasons in any event, but I leave those aside.)

So victory also goes to the cheapest producers, and the cheapest producers are at this moment in history in the most problematic and dysfunctional parts of the world. Oil, like other commodities, facilitates corruption and war. Human resources can often leave when they are abused by the state. If they earn too little, for example, Canadian doctors and nurses can go south. Or, to take a non-monetary example, ambitious but religiously observant Turkish female college students who are prohibited by Turkish law from wearing their head coverings on campus can go to college in the U.S. and Europe, as they are apparently doing more and more. Unless the government seizes extraordinary power as in, say, a totalitarian society, the ability to abuse human resources is limited, because they are mobile. (It is precisely for this reason that totalitarian societies impose emigration controls.)

But natural resources are different. They sit in the ground undisturbed until someone takes them out, and control over the land where they are is thus most of what is needed to profit from them. And so the money at stake from control of such immobile resources generates violence to control the income flows those resources yield, with corruption – bribes demanded of foreign oil companies, e.g. – being one of the ways in which this income is, for lack of a better word, “earned.” Because of this “natural resource curse,” control over the oil money in Saudi Arabia, Kuwait, etc. is immensely lucrative, just as it is in Venezuela, Nigeria and Mexico. This partly explains why these societies are so corrupt. But only in the Gulf is there an important fraction of the population or, in the Saudi case, perhaps even the authorities, with warlike attitudes toward the modern world, with oil sales enabling that hostility to be funded. (One could argue that Venezuela is in a different way heading down this same path.)

So low-cost producers will always edge out high-cost ones, and that is right now very dangerous. Ironically, this may be an argument for eliminating the cost advantage of Gulf producers as quickly as possible by using more of their oil. If there are diminishing returns to Gulf oil production, then as the oil disappears their cost advantage will too. Indeed, there are now reports that Kuwait’s oil reserves are already only half the official estimate.

This is highly speculative, but one thing is not. The most foolish answer to whatever problems are posed by our “addiction” would be some sort of government Big Program to achieve “energy independence.” Our energy “dependence” is trade, and is governed by al trade by the cost of production and the value of alternatives to consumption of oil. The alternatives to it are best sorted out by competitive experimentation – by allowing entrepreneurs to explore alternative energy sources as they have in the past and letting consumer willingness to pay and resource cost (i.e., whether they can earn a profit) be the judge of whether the alternative is worthwhile or not, by allowing Americans to decide at the individual level how best to respond to increasing oil scarcity. Because any sustained effort to promote “independence” will not be like the Apollo project – an engineering problem more than an economic one for which there is an unambiguous measure of success. Rather, a government program to find alternatives to oil will be consumed in an orgy of rent-seeking – of ludicrous subsidies to ethanol farmers or (as in the 1970s) “synthetic fuels” producers whose manufacturing process somehow never gets to be efficient enough for the subsidies to end.


Anonymous Chubby said...

Very informative. God knows if our government, as corrupt as it is, gets into the game, we'll be back to whale blubber in 50 years or so.

5:19 PM  

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