Chapter One
Oil
Let’s not kid ourselves: america’s first and most important interest in the
Middle East is the region’s oil exports. However, this interest has nothing to
do with how much oil we import from the Middle East. Instead, oil is our number
one interest in the Middle East because our economic well-being relies generally
on plentiful oil. That is true both because of the direct importance of oil to
our own economy and, indirectly, because of its importance to the economies of
the rest of the world-whose trade is vital to our economy. The Middle East plays
a critical role in global oil production and therefore in the well-being of the
global economy, of which our own economy is an irreducible part.
The American economy, as well as that of every other developed nation and
ever-greater numbers of developing nations, is addicted to oil. In the words of
one recent study, “Oil is the lifeblood of modern civilization. It fuels the
vast majority of the world’s mechanized transportation equipment: automobiles,
trucks, airplanes, trains, ships, farm equipment, the military, etc. Indeed,
according to the Department of Transportation, oil accounts for a whopping 97
percent of the energy used for transportation in the United States. Oil is also
the primary feedstock for many of the chemicals that are essential to modern
life.” Petroleum products are a critical input into the American economy not
merely for transportation (which accounts for about two thirds of all American
petroleum consumption) but also for industrial production (including plastics)
and even some power generation. Petroleum accounts for 40 percent of all of the
energy used in the United States, far more than either of the next two biggest
sources of American energy, natural gas and coal, which account for only 23 and
22 percent, respectively. In all, the United States consumes roughly 20 million
barrels of oil per day, accounting for almost a quarter of global oil
consumption by itself.
What this means is that oil is a critical input into the United States’ economy,
and any major, sudden increase in the price of oil can have a calamitous effect
on our way of life. As former Federal Reserve Chairman Alan Greenspan testified
to the Congressional Joint Economic Committee in April 2002, “all economic
downturns in the United States since 1973, when oil became a prominent cost
factor in business, have been preceded by sharp increases in the price of oil.”
In fact, nine of the last ten U.S. recessions were preceded by an increase in
crude oil prices, and statistical tests have demonstrated that this was not
coincidental. Many economists already believe that the tripling of oil prices in
the last four to five years is creating the conditions for another such
recession.
It is the price of oil, not its source, that is critical to our economy and
those of our major trading partners. Oil is fungible, meaning that a barrel of
oil can be burned anywhere in the world and have the same effect. That also
means that a tanker full of oil can be sold anywhere in the world, to anyone-and
always to the highest bidder. So the fact that we import most of our oil from
Canada, Mexico, Venezuela, and Saudi Arabia does not mean that we are immune to
problems with Russian oil exports; exactly the opposite. If there is a problem
with Russian oil exports, the countries that normally buy from Russia will
simply go looking for their oil somewhere else and will likely be willing to pay
a higher price to get it. If they are, then our normal Canadian and Mexican
suppliers will sell to them instead of to us, unless we meet the new price.
Thus, the price of oil is determined by the classic patterns of supply and
demand. Whenever the demand increases faster than the supply or the supply
unexpectedly drops, the price of oil rises-and it rises for every country,
including the United States, no matter where we get our oil from.
Although the source of our imported oil is irrelevant, the amount of oil we
import does have some relevance. The fact that the United States imports
significant quantities of oil (about 65 percent of the oil we consume) means
that we cannot insulate ourselves from the direct impact of oil disruptions
caused by sudden imbalances between the global oil supply and global
consumption. If domestic American production accounted for all, or nearly all,
of American consumption needs, then in time of crisis the government could
suspend the impact of market forces by imposing price controls. In other words,
if we imported only a very small amount of oil, we could divorce ourselves from
the global price of oil at a rather low cost. But given how much we import, it
is not economically feasible to do so. As long as we rely on oil for our energy
needs while importing a significant amount of oil, our economy will be tied to
the international oil market.
It is also important to recognize that the amount of oil we import is not
terribly meaningful, at least in terms of our interest in Middle Eastern oil
production. Once we cross some immeasurable threshold of importation, after
which it is no longer possible for us to cut off all imports without doing
tremendous harm to our economy, the exact amount we import becomes irrelevant.
Importing 75 percent of our oil is no more harmful than importing 25 percent:
since the price of all of our oil will still be set by the international market
in either case, we are no more vulnerable importing at the higher rate than at
the lower. So merely trying to reduce the amount of oil we import is effectively
useless, unless we can somehow get down to a fraction of current import levels.
Even then, virtually eliminating oil imports, if it were somehow possible, would
reduce the direct impact we would face from a major oil disruption but would
hardly solve the problem because of the indirect impact of higher oil prices on
the U.S. economy through their effects on our trade partners. In the globalized
world of the twenty-first century, foreign trade is a large, and growing, input
into the U.S. economy. The ratio of trade to gross domestic product (GDP) for
the United States amounted to 17 percent in 1985, 23.6 percent in 1995, and 26.2
percent in 2005. So even if we could somehow insulate our economy from the
direct impact of a sudden spike in oil prices, we would still feel its impact
due to a downturn in our trade relations. Higher oil prices would make
foreigners less able to buy our goods and services, while driving up the prices
we pay for theirs. In particular, as a great deal of the annual U.S. deficit is
funded by selling bonds to foreigners (meaning that a great deal of the U.S.
national debt is held by foreigners), a worldwide recession could seriously
affect U.S. finances by constricting global capital markets to the point where
it becomes difficult for Washington to finance the deficit or service the
national debt. These indirect forms of damage could cripple our economy even if
the direct damage did not.
Of course, it is highly unlikely that the United States will be able to greatly
reduce, let alone eliminate, its oil dependency in the next decade or two, no
matter how desirable that would be (and it would be highly desirable, obviously,
for environmental and economic reasons). It was a hopeful sign that even
President George W. Bush recognized that America is addicted to oil and that
this is potentially very dangerous for the country. They say that admitting you
have a problem is the first step to solving it, but we have a long, long way to
go before we can solve this one. Given the difficulty of either slashing
domestic oil consumption or boosting domestic oil production to the level
necessary to eliminate the direct impact of a major shortfall of oil in the next
ten to twenty years, the reality we are stuck with is that major, sudden oil
disruptions will hammer the U.S. economy both directly by jacking up the price
we pay for oil and indirectly by suffocating trade and capital flows. Our
economy would contract suddenly both from the increase in oil prices, which
would boost inflation across the board, and from the sudden loss of trade as the
economies of our business partners contracted as well. In the words of the oil
expert Matthew Simmons, “Only energy has the potential to shut down the entire
world.”
The Economic Impact of Major Oil Shocks
What the above discussion means for the average American is that when the
international price of oil increases, either because the demand for oil is
growing or because its supply has diminished, prices increase and the amount of
disposable income we have drops. As the economist Keith Sill has put it, “Oil
prices affect the economy through a multitude of channels…. The key is that
oil-price changes affect both supply and demand. Changes in oil prices affect
supply because they make it more costly for firms to produce goods; they affect
demand because they influence wealth and can induce uncertainty about the
future.”
First, rising oil prices mean that transportation costs more. That is most
obviously true with car travel, because the price of gasoline at the pump
increases. But oil prices also increase the cost of air, bus, truck, ship, and
rail transportation-which are the ways we move goods from the factories, farms,
and ports to the stores where we buy them and then to our homes. These transport
costs are factored into the price of everything we buy. So if oil boosts the
price of transportation, it ends up boosting the price of nearly everything
else. Another reason that increased oil prices boost all other prices is that
petrochemicals play a very large role in modern production, plastics being the
best example. So anything made with plastic becomes more expensive, and in our
modern world, a lot of things are made in part or in whole from plastics of one
kind or another. Airline travel, train travel, and bus travel also increase in
cost, which hurts everything from sales to tourism. When prices go up across the
board (especially when it happens suddenly, because of an unexpected political
problem affecting oil supplies), the average consumer has less disposable income
and tends to spend less on major purchases-cars, appliances, even houses-all of
which can depress major industries. An increase in the price of oil can also
increase the nation’s trade deficit because we pay more for all of the oil we
import. Thus prices typically go up (inflation), as do interest rates;
manufacturing is hurt; unemployment increases and wages often decline in real
terms; people have less money to spend because they are spending more on basics
like food, heating oil, and transportation; which in turn hurts business,
particularly in the sectors most closely tied to transportation.
While even gradual oil price increases can be harmful to the U.S. economy,
sudden shocks, in which oil prices skyrocket quickly (in a matter of months or
even weeks) and unexpectedly, are of far greater consequence. Over time, market
forces allow the economy to accommodate itself to new oil prices. Higher prices
will likely produce inflation, worsen the trade balance, possibly weaken the
dollar, and overall cause some diminution of economic activity, but they are
unlikely to be catastrophic. Gradual increases also allow people and businesses
to switch over to other sources of energy, especially if the higher price of oil
makes alternative sources more attractive. Moreover, businesses can plan for the
changes and adjust their operations accordingly. Thus even the steep increase in
the price of oil from $18 per barrel in 2001 to $70 per barrel in 2005 to $110
per barrel in 2008 has hurt the U.S. economy, but because it has transpired over
years, not weeks, it has not been crippling.
The problem with sudden, unforeseen shocks is that people cannot suddenly switch
their cars or boilers from oil to another source overnight, nor can businesses
plan to adjust their spending, revenues, and prices quickly enough. In many
cases, people and businesses are simply prevented from doing things that are
part of their daily lives (like driving to work) without any opportunity to
adapt. It is why a major oil shock can almost literally bring the economy to a
halt.
In economic terms, sudden disruptions in the oil supply serve as shocks to the
U.S. economy that cause “stagflation,” a very painful type of recession
featuring both high inflation and high unemployment. It is something of an
economic “perfect storm” and can be very damaging. Relatively mild oil price
shocks in 1973 and 1979 (both of which were caused by Middle East crises) were
responsible for the worst recessions in the last forty years of U.S. history.
The problem is that it is possible to envision plausible scenarios in which
future crises in the Middle East could cause much worse price shocks than those
of 1973 and 1979, causing much worse recessions.
Strategic Reserves
One other piece of the complicated puzzle of American interest in Middle Eastern
oil is the question of strategic oil reserves. After the 1973 oil shock and
recession, the governments of the United States and several other industrialized
countries decided to begin building strategic petroleum reserves to mitigate the
impact of future disruptions. Today, the United States has nearly 700 million barrels in its strategic reserve, and there are another 700 million barrels or so in the combined reserves of Germany, Japan, and several other countries. Since global oil consumption averaged 85 million barrels per day (bpd) in 2006, these reserves could theoretically cover all oil demand for sixteen to seventeen days. However, that is a ridiculous standard because it is impossible to imagine a scenario where all oil production was disrupted. The more relevant question when trying to ascertain the impact of an oil shock is “How much production is taken off the market and for how long-and how quickly can Washington and other governments release oil from their strategic reserves onto the market to make up for the amount of oil lost?” If past crises are any guide, the answer to the question of how quickly strategic reserves can be released onto the market is about 2.5 million barrels per day, which could be supported, in theory, for about 560 days. This could eliminate the impact of a mild oil shock but would do no more than take the edge off a major disruption, and unfortunately, instability in the Middle East creates the potential for just such major disruptions.
(Continues…)
Excerpted from A Path Out of the Desert
by Kenneth Pollack
Copyright © 2008 by Kenneth Pollack.
Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Random House
Copyright © 2008
Kenneth Pollack
All right reserved.
ISBN: 978-1-4000-6548-6
