Real Energy Independence: Making Oil No Longer “Strategic”

We need more researchers like Anne Korin, co-director of the Institute for the Analysis of Global Security, to set the record straight in Washington and around the globe about our nation’s so called “dependency” on foreign oil. There are some big misconceptions among politicians, the media, and the public about our reliance on Middle East oil, Korin told the audience at the 2013 Financial Analysts Seminar. Korin’s two visionary books, Turning Oil into Salt and Petropoly, clearly explain where the real problems lie with regard to our country’s use of petroleum products and present innovative solutions that are well within our grasp.

“To understand American politicians’ perspective on energy security or energy policy making, you have to look at the failed paradigm of decades and decades of obsession with import levels when it comes to oil,” Korin said. Politicians and citizens remember only the lines at the gas pumps during the 1970s oil embargo and wrongly blame a supply disruption. The real reasons for the shortages, Korin said, were price controls, government manipulation, and rationing that did not allow markets to clear at the right price. As politicians vowed to “never let this happen to us again,” our society became obsessed with imports — even as the facts showed that imports from the Persian Gulf as a percentage of US consumption have never been more than 15% (today imports represent 9% of petroleum consumption in the US).

One of the key problems is the rise in the price of oil on global markets. “The definition of energy security,” said Korin, “is reliable supply at an affordable price.” Affordable price is the other side of the equation, and although import levels have dropped, the amount spent on oil has dramatically increased. From 2005 to today, the spot price for Brent Crude has gone from around $50/barrel to more than $100/barrel. Korin explained that investors need to look at the true problem — that is, where the oil price is being set in global markets.

Why OPEC Matters

“We haven’t learned the correct lessons over the last 40 years. Many in Washington believe that OPEC doesn’t matter in setting the price of oil. People need to change their thinking about OPEC. Understanding OPEC is very, very important to see where the price of oil is going in global markets,” Korin said.

Recent oil and natural gas discoveries in North America have led US policymakers to mistakenly think this is the solution to all of our problems — that we will no longer be reliant on imports and oil prices will come down. Unfortunately, this is far from reality; prices will continue to be driven by OPEC unless the United States can first change factors on the demand side.

Since 1973, the world’s population has risen from 4 billion people to 7 billion people, and there are four times as many cars on the road. Over that period, world GDP has risen 14 times — from $5 trillion to $70 trillion — and global oil demand has risen from 55 million barrels a day (mbd) in 1973 to 88 mbd today. Amazingly, OPEC’s share of global oil supply in the last 40 years has declined from 54% to 33% while their production level has remained constant at 30.4 million barrels a day. This is despite the fact that: (1) OPEC sits on three-quarters of all conventional oil reserves in the world; and (2) discovery and lifting costs in the Persian Gulf are among the lowest in the world ($2.50 per barrel in Saudi Arabia).

“If oil supply from the places where the oil is easiest to extract had matched the growth in oil demand from the emerging markets, we would not be facing the price levels we are today,” said Korin. “Imagine a world where Exxon, Chevron, BP, and Shell represent three quarters of the oil reserves yet they account for just a third of global oil supply. They would be charged with violating anti-trust laws. You can’t bring anti-trust action against sovereign regimes.”

Effects of the Arab Spring

In addition, Korin believes Washington has not paid enough attention to the effects of the Arab Spring on oil prices. When Hosni Mubarak fell in 2011, other leaders in the Middle East wanted to assure this did not happen to them, so they increased subsidies to the people. In Saudi Arabia, King Abdullah significantly increased subsidies to Saudi citizens for food and fuel and also increased salaries to Saudi government workers (a large percentage of the population) and outright grants to the population. “If you subsidize something, people are going to use more of it,” Korin said. With a population smaller than France and Canada, Saudi Arabia is the  sixth largest consumer of oil in the world and consumption within the country is rising.

The Arab Spring and increased subsidies that followed have accelerated budgetary expenditures in the Middle East. To remain solvent and balance their budgets, countries have two choices when the major export is a commodity like oil: (1) Sell more oil at a lower price per barrel; or (2) sell less oil at a higher price per barrel. Given the Saudis’ motivation to preserve their oil reserves for the next generation, they have chosen the second option. (And they’re also running through their cash reserves.)

Korin encourages investors to look at Saudi Arabia’s “break-even price of oil,” or the price required to balance the country’s budget. Saudi Arabian analysts project that the break-even price will go from $90 in 2015 to $118.5 in 2020, to $175.1 in 2025, to $321.7 in 2030.

Reframing the Problem

To ensure energy security, Korin recommends reframing the problem. In her book Turning Oil into Salt, Korin and her coauthor, Gal Luft, discuss the history of the commodity, salt. Originally it was the only way to preserve food — and therefore it was a strategic commodity. Today with so many methods of food preservation no one cares about salt prices or supply sources. “That’s what energy independence ought to mean,” Korin said. “Not cutting ourselves off from global markets, but rather making oil no longer strategic.”

Korin argues that today OPEC acts as a monopolist in the oil market, and due to the petroleum-only vehicle, it also acts as a monopolist in the transportation fuel market. Breaking the lock of gasoline as the primary transportation fuel is the key to bringing down oil prices and making it less strategic. In other words, “We need to open transportation fuels to commodity arbitrage,” Korin said. It is the offering of competitive fuels that will drive oil prices down.

How Do We Get There from Here?

In Brazil and China, demand is growing for flex-fuel vehicles. Brazil performed a perfect real-world experiment in the early 1980s when the country moved from 100% petroleum cars to 100% ethanol cars. The experiment failed when sugarcane ethanol prices rose dramatically above the price of oil and the population that had 100% ethanol cars was very unhappy. Then automakers in their attempt to meet California air quality regulations came out with a car that could use either gasoline or alcohol, and consumers could finally choose at the pumps which fuel was most economical. Brazilian drivers were ecstatic, and by 2007 90% of new cars in Brazil were flex fuel.

Then turning to the United States, Korin said that given the high availability of natural gas, one possibility is to produce flex-fuel cars that could run on gasoline and methanol, not just ethanol. These vehicles cost auto manufacturers just $100 more to produce as compared to gasoline-only cars. The alcohol methanol is a liquid fuel cheaply produced from natural gas (and coal). Right now there is a “multi-party coordination problem,” or in other words, a chicken and egg problem. In order for auto manufacturers to get interested in producing methanol run cars, there must be fuel stations that offer methanol at the pump. In order for fuel stations to spend the $20,000–$30,000 to switch their pumps over to offer methanol, at least 15% of the vehicles in their area must be able to use the fuel.

Korin believes politicians in the United States, Japan, Europe, and China need to step in to open their country’s vehicles to fuel competition and act as a coordinator for all the parties involved — automakers, oil companies, station owners, and consumers. “Big oil has particularly great incentive to get behind this movement,” Korin said. “International oil companies are already replacing their oil reserves with natural gas reserves and will eventually connect the natural gas to methanol dots.”

Sometimes governments need to step in to break up a monopoly. “If you read Hayek or Friedman, there is a case for breaking up monopolies or cartels, in a careful way,” said Korin. Free markets, on the other hand, should determine the best technologies, the best fuels, and the best fuel mixes. With competition as Korin suggests, oil will become more like salt and will no longer be a strategic commodity.

This year, the 2014 Financial Analysts Seminar will be held in Chicago on 21–24 July. Learn more about the agenda and speaker details on our website.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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