The Elusive Quest for Energy Security

In the 1860s, the King of Siam offered to send the United States elephants to use as a means of transportation. U.S. President Abraham Lincoln turned down this offer of imported energy, expressing a preference for domestic steam engines.

President Obama has echoed his idol’s preference for energy independence, stating on more than one occasion that the United States has to break its “cycle of dependence on foreign oil.”

World oil prices are hovering around $100 a barrel and have been on a roller coaster over the past few years. This has kept energy security as a priority in U.S. policy circles and among pundits. Nearly 400 bills with the term “energy security” were introduced in the U.S. Congress over the past four years. And New York Times columnist Tom Friedman’s angst over energy policy, if only it could be harnessed, would power a small city.

Luckily, energy security is not solely in the hands of policymakers and pundits. Since the oil shocks of the 1970s, the actions of millions of consumers and producers have enhanced energy security — arguably far more effectively than many policy actions.

One key way in which they have done so is diversification. Recent IMF research [PDF] documents that businesses have increased the number of sources from which they import oil, making them less vulnerable to disruptions from any one source.

The United States, for instance, buys crude oil and gasoline from more than 40 countries and jet fuel from more than 25. Canada and Mexico have grown in importance as suppliers, whereas countries of the Persian Gulf supply only about 10% of all the oil consumed in the United States. For the OECD oil-importing countries as a whole, diversification in sources of oil supplies increased significantly during the 1990s and has remained roughly constant since then.

Countries have also increased their use of natural gas, and are importing it from many more sources as well. Norway has continued to grow in importance as an exporter of natural gas, and several new producers have emerged — Qatar, Turkmenistan, Nigeria, Egypt and Australia. Diversification in sources of natural gas has increased steadily over the past two decades.

Canadian oil sands have also become an important part of the global energy picture, but do not receive adequate attention. Oil guru Dan Yergin notes that Canada’s estimated recoverable reserve of petroleum is second only to Saudi Arabia’s. And Canada’s placid political environment makes it a reliable and steady source of energy supply.

While the general trend is toward increasing diversification, there are significant differences across countries in their exposures to particular suppliers. For instance, countries like the United Kingdom and Italy get over a quarter of their oil imports from Libya, compared with less than 3% for the United States.

Overall, the United States and the United Kingdom have much more diversification in their sources of energy supplies than Japan or countries in continental Europe. Within continental Europe, larger energy importers such as France and Germany are much more diversified than smaller importers such as Finland and the Slovak Republic.

Diversification in sources of energy supplies is one of the structural changes that has given countries a bit of extra resilience to spikes in the price of oil. As IMF chief economist Olivier Blanchard has noted, there have been two other important changes.

The first is a change in how wages respond to oil spikes. In the 1970s and 1980s, workers were able to bargain for an increase in their wages to compensate them for the increase in the consumer price index (CPI) caused by oil price spikes. The increase in wages then led to even higher prices, feeding a wage-price spiral.

In turn, this placed central banks in a tough spot, as they had to choose between battling the recessionary consequences of the oil spikes and their inflationary consequences. Over the past decade, however, increases in the CPI caused by oil spikes have not fed a wage-price spiral.

The other change is the increase in central bank credibility. Over the past two decades, major central banks have become much better at establishing an anchor for inflation expectations. Hence, in many countries the public is much less fearful that oil prices will have inflationary consequences than was the case in the past. This allows the central bank to be much more supportive of promoting recovery in the economy rather than having to raise interest rates to dampen inflationary expectations.

All these structural changes have reduced the sensitivity of the economy to oil spikes. In joint work with noted economist Jordi Gali, Blanchard estimates that, for the United States, the effects of an oil spike on output and inflation are only a third as large today as they were two decades ago.

Nevertheless, fears about the impacts of oil prices often have policymakers rushing to take unilateral steps to boost their energy independence. This is a quixotic quest. Energy is increasingly traded in global markets from which no country can secede.

The United States exports some fossil fuels, just as Saudi Arabia and Iran import to meet some of their needs. Robert Bryce, the author of “Gusher of Lies: The Dangerous Delusions of Energy Independence,” notes that in 2005 the “Saudis imported 83,000 barrels of gasoline and other refined oil products per day,” and Iran imports 40% of its gasoline needs.

Bryce also notes that energy discoveries are increasingly made by global teams. In September 2006, a huge oil field that could boost U.S. reserves by 50% was discovered in the deepwater of the Gulf of Mexico. In addition to demonstrating the technical prowess of the deepwater drilling industry — the well was drilled in 7,000 feet of water — the find exemplifies the “accelerating globalization of the energy business.” The well was drilled by two U.S. companies along with a Norwegian firm, Statoil, which operates in 35 countries.

The globalization of energy markets is only likely to grow as natural gas grows in importance. Traditionally, natural gas has been traded in regional, intra-continental markets. But as the costs of transporting natural gas over water have fallen, trade among continents has increased dramatically. The International Energy Agency estimates that the international spot trade of gas has grown by a factor of ten over the last decade.

A lasting solution, therefore, lies not in unilateral attempts by one country (or by the group of energy-importing countries) to become energy independent, but in a global context where everyone tries to improve the supply-demand balance in energy markets.

The needed response has three main elements: bolstering oil supplies, making oil use more responsive to price signals and nudging along a transition from oil to other fuels and renewable sources of energy.

First, on the supply side, increased investment in the oil sector is crucial in bringing greater stability to oil prices. Surges in oil prices in recent years have only brought forth very modest increases in capacity. The sluggish response appears due to rising exploration and development costs and the lack of predictable regulatory and tax regimes that would provide adequate returns for expanding supply and infrastructure. Political turmoil of course makes it all the more difficult to sustain increased investment.

Second, making oil demand more responsive to oil price changes is critical as well. In 2008, IMF First Deputy Managing Director John Lipsky noted that “relatively low gasoline taxes in the United States, low domestic prices in China and heavily subsidized and controlled prices in many oil-exporting and other developing countries discourage” the demand-side response that is needed. Policies to increase energy efficiency — for instance, through better fuel-efficiency standards — can also strengthen the demand response.

And third, as a recent IMF paper noted, development of sustainable alternative sources of energy would lower the risk from possible oil scarcity.