Economic scarcity: forget geology, beware monopoly.

David L. Greene is a Senior Research Staff Member at the Oak Ridge National Laboratory.

Scarcity of oil poses a genuine threat to US energy security. At the same time, the world economy is in no danger of "running out of oil" during the next century. This apparent paradox has important implications

for US energy security. The scarcity threatening US energy security today is an economic, rather than a physical or geologic, scarcity. Economic scarcity does depend on geology, but it can also be created by anticompetitive (monopolistic) behavior or may temporarily result from any of a variety of shocks to the world's oil producing regions. The inability of oil markets to adjust rapidly to sudden changes in supply enables supply shocks, whether deliberate or inadvertent, to produce enormous increases in oil prices and, consequently, immense profits for oil producers together with massive losses for oil consumers. It is the economy's susceptibility to sudden, massive economic losses that makes oil a serious energy security problem for the United States.

Over the past 25 years, the Organization of Petroleum Exporting Countries (OPEC) cartel has used its market power to create or capitalize on oil market disruptions. In October of 1973, the Arab members of OPEC announced an oil boycott against countries that aided Israel during the October War. From September to December, 1973, they reduced their crude oil production by 4.2 million barrels per day (mmbd), about seven percent of world oil supply in 1972. World oil prices doubled. Again in 1979-80, the loss of 5.4 mmbd of production from warring Iran and Iraq, about eight percent of world supply, produced another doubling in the price of oil. Following both shocks, OPEC members restrained their oil output, with the express intent of maintaining the new, higher price of oil. From May to December, 1990, total oil output from Kuwait and Iraq fell by 4.8 mmbd, about 7.6 percent of world production. From the second to the fourth quarter of 1990, oil prices jumped from US$18.50 to US$34.50 per barrel (measured in 1995 dollars). In contrast to previous price shocks, this one was short-lived as OPEC members, especially Saudi Arabia, responded by increasing output by more than three mmbd to replace most of the shortfall.

The oil market machinations of the 1970s and 1980s were very costly to oil consumers and very profitable for oil producers. According to the US Department of Energy, the price shocks and subsequently higher price levels of the 1970s and 1980s cost the US economy trillions of dollars. Between 1972 to 1991, these costs were approximately US$4 trillion dollars--equal to 80 percent of the United States' total expenditures on national defense over the same period. At the same time, many OPEC states were transformed from developing economies to among the richest nations on earth. In 1972, OPEC revenues amounted to US$24 billion per annum, but after the 1979-80 oil price shock, OPEC collected US$287 billion from oil consumers. Today, after ten years of cheaper and plentiful oil supplies, many believe such oil problems to be a thing of the past. This belief, however, is mistaken and dangerous.

After the first oil crisis in 1973-74, many believed that physical oil resources had suddenly become permanently scarce and that oil prices would inexorably continue to rise in the future. This view turned out to be wrong. High oil prices, sustained by OPEC's continuing efforts to restrain production, depressed oil demand and stimulated supply from non-OPEC producers. World oil demand, which had been growing at nearly eight percent per annum since 1960 until just before the 1973-74 price shock, slowed to an average annual rate of 0.4 percent per annum from 1973 to 1985. OPEC oil production, which had been increasing at an annual rate in excess of ten percent since 1960, actually fell at a rate of five percent per year from 1973 to 1985. Oil production by non-OPEC countries, which had been increasing at 5.5 percent annually prior to the first oil price shock, grew at 3.5 percent per annum from 1973 to 1985. As a consequence, OPEC's share of the world oil market shrank from a little over half in 1973 to under a third in 1985. As will be explained below, loss of market share means loss of market power for a cartel. Finally, unable to continue to maintain high oil prices by means of further production cuts, OPEC members began increasing production. Just as suddenly as they had risen, oil prices collapsed from US$37.01 per barrel in 1985 to US$18.67 in 1986 (measured in 1995 dollars).

The oil price collapse of 1986 dispelled the myth of oil's physical scarcity. OPEC, it seemed, had been vanquished by the relentless force of the marketplace. The reports of OPEC's death, however, were greatly exaggerated. Since 1986, oil production by non-OPEC nations has declined by 0.5 percent per year, while OPEC's output has increased at the modest rate of one percent per year. As a result, OPEC's share of the world crude oil market has grown from 30 percent to 42 percent.

The question now does not--and never did--concern the physical scarcity of oil. It is the economic scarcity of oil that matters to our economic welfare and threatens our energy security. As every economics student has been taught, if a resource has a cost, it is scarce to at least some degree. Oil commands a price in the marketplace and, therefore, in the context of economics, oil is a scarce resource. Whether or not oil is a scarce resource is therefore hardly an interesting question. Whether oil producers will be able to manipulate the economic scarcity of oil to their own benefit and at the expense of oil consumers in the future is an interesting question indeed. Answering this question requires an understanding of the fundamental factors that permit an oil cartel to wield market power. It also requires an explanation of how the noncompetitive pricing of oil, and especially oil price shocks, harm the economies of oil-consuming countries. Only after these phenomena are understood can one ask whether similar oil price shocks could happen again, whether a country's economy remains vulnerable to them, and what, if anything, would be done about it.

Oil Abundance and Economic Scarcity

Imagine a world in which more oil can be found merely by looking for it; a world in which one can, with extra effort, squeeze more oil from already depleted fields; a world in which resources that are not oil can be changed into oil and in which the same amount of work can be done with much less oil than previously required. This is the real world. It is the world of the fixed, finite stock of oil that will someday be used up that is make-believe.

Oil is not an exhaustible resource. This once heretical view is now more widely accepted among leading resource economists for two reasons. First, the history of oil markets has been that, until 1973, more oil has always been discovered and developed without any increase in its real price. Citing the history of US oil reserves and oil production, M. A. Adelman has explained better than anyone else that "oil reserves are not a fixed stock to be allocated over time, but an inventory, constantly consumed and replenished by investment."

The second reason that markets do not treat oil as if it were an exhaustible resource is that the world's endowment of oil or oil-like resources is known to be quite large relative to current rates of consumption. What are the world's oil resources? The answer turns out to depend on how one defines resources, and how one defines oil. This is not a flippant observation. It is technology that defines both of these terms, and technology is ever changing. If we use the concept of proven reserves, oil that is known to exist and can be produced economically at prevailing prices, the world has approximately 1 trillion barrels. According to the US Department of Energy, the world presently consumes about 23 billion barrels per year. This gives a reserve-to-production ratio (R/P, a measure of size more than a prediction of lifetime) of 45 years. The US Geological Survey recently estimated that the world's ultimate resources of conventional oil, both discovered and undiscovered, amounted to 1.7 trillion barrels, raising R/P to 75 years. But current methods of oil extraction recover only 34 percent of the oil in the ground. The American Petroleum Institute has estimated that if the technology of oil recovery improves as it has in the past, 2.8 trillion barrels of oil eventually could be produced for an R/P of 120 years. If known reserves of unconventional, heavy, and extra-heavy oil could be economically refined, oil resources would expand to 3.4 trillion barrels, with an R/P of 150 years. Beyond this, there are an estimated 14 trillion barrels of oil equivalent in oil shale and tar sands that could be used if technology and economics permitted and if the world were willing to suffer the environmental consequences.

Concentrated Reserves and OPEC Power

The problem is not that we are about to "run out" of oil. The problem is that the world's conventional oil resources are concentrated in relatively few countries who are able to manipulate the economic scarcity of oil to their advantage and to the disadvantage of other countries and who have done so in the past. Our best estimates of the totality of the world's conventional oil resources indicate that OPEC countries own more than half of them. Published, credible estimates of OPEC's share range from a low of 55 percent to a high of 64 percent. The difference is due to greater optimism on the part of analysts at the US Geological Survey about the extent of petroleum resources in the former Soviet Union and, to a lesser extent, in the United States, Canada, Mexico, and China.

Because OPEC members are drawing down their reserves at half the rate of the rest of the world's oil producers, it seems almost inevitable that OPEC's share of the world oil market will grow. For example, the US Energy Information Administration predicts that OPEC's share of the world oil market will rise from its current level of 42 percent to reach 48 percent by 2005, and will climb to 52 percent by 2010.

Economic analysis can inform us about what OPEC can do, but cannot predict what OPEC will do. Objective conditions, such as the distribution of world oil resources, the size and structure of oil consuming economies, and the technologies of oil production and consumption determine the potential market power of the OPEC cartel. Given information about the key objective factors, economic theory can explain what OPEC could do, and even what it would be most profitable for OPEC to do. Predicting the behavior of a confederation of sovereign states is largely outside the domain of economic analysis. Yet, by revealing what influence the OPEC cartel could exert on energy markets, what would be in its economic interest, and the consequences for the US economy, economic analysis provides invaluable insights into how world oil markets are likely to behave in the future.

A fundamental principle of the theory of competitive markets is that production of a commodity will expand until the cost of the last unit produced equals the market price. A competitive market is characterized by the inability of any one producer (or colluding group of producers) to affect the market price. A producer with market power, on the other hand, finds that by restricting production, it can cause the price to increase. The price that a perfect monopolist should charge to make the greatest profit is given by a simple formula that depends on the extent to which demand for its product responds to changes in price (the price elasticity of demand, which defined as the percent change in the quantity demanded for a one percent change in price). For example, according to the formula, if the price elasticity of demand is -2 (meaning that a one percent price increase will cause demand to fall by two percent), the price that maximizes the monopolist's profits will be twice the competitive market price.

But when a producer does not control the entire market, its market power is limited by the ability of other producers to respond to its pricing and production decisions. OPEC finds itself in this position. Whereas OPEC can coordinate, albeit imperfectly, its production decisions and influence market prices, the rest of the world's producers behave competitively. In economic jargon, OPEC is an imperfect monopolistic cartel of the von Stackelberg type. For a von Stackelberg monopolist, the profit-maximizing price depends not only on the price elasticity of demand, but on its own share of the market and on the supply response of the rest of the world. The "rest-of-world" supply response is defined as the number of barrels the rest of the world will supply, at constant market price, in response to a one barrel reduction in supply from OPEC. If the supply response equals -1, then a one barrel reduction in supply by OPEC will be met by a one barrel increase in supply by the rest of the world's producers, the market price remaining unchanged. If this were the case, OPEC would have no market power and would maximize profits by charging the competitive cost.

Over a short period of time, the ability of producers and consumers to respond to a change in the price of oil is far more limited than in the long run. It takes time to mobilize resources to discover, develop, and bring new oil resources to market. It takes even longer to replace oil-using automobiles, airplanes, and industrial plants. Typically, the long-run response to changes in oil prices are on the order of ten times the response that can be accomplished in one year. This fundamental fact has enormously important implications for the world oil market. It means that the price that yields OPEC the greatest profits in the short run cannot be sustained over the long run. The prices that would give OPEC maximum profit for a single year are too high to be sustainable for more than one year. Nevertheless, the cartel can make fabulous profits by employing a "hit and run strategy" of restricting production to double or triple oil prices for a few years at a time.

Prior to 1973, with oil prices below even the long-run sustainable price, OPEC's market share grew rapidly as world oil demand increased at the rate of about eight percent per year. In 1973 and 1974, OPEC members restricted output, causing the first oil price shock, but also halting the growth of their market share. In a static market, OPEC would have had to sacrifice market share in order to cause prices to rise. The price shocks of 1979 and 1980 were accompanied by just such a loss of market share. At this point, OPEC took a conscious decision to defend the higher price level by cutting back on production. But to reduce production, OPEC had to give up market share, and giving up market share meant giving up market power. This inevitably led to a downward spiral of OPEC revenues; from US$287 billion in 1980 to US$131 billion in 1985. As the untenability of the situation became clear, OPEC cohesiveness cracked, with Iraq jumping ship first and increasing production in 1985. When Saudi Arabia abandoned the defense of higher prices in 1986, oil prices collapsed. Even so, prices did not collapse to pre-1972 levels but rather to levels closer to the long-run, sustainable monopoly prices.

Since 1985, OPEC has gradually regained market share as world oil demand began increasing once again. The US Department of Energy's 1996 oil price and OPEC output projections reflect the seemingly inevitable recapture of market share by OPEC, which holds the majority of the world's oil resources, the overwhelming majority of the world's low-cost reserves, and which is drawing down its reserves at half the rate of the rest of the world.

How Oil Dependence Damages the US Economy

Opportunistic use of market power generated fabulous profits for OPEC members during the 1970s and 1980s, but also caused enormous losses to oil consuming economies such as the United States. Oil price shocks and noncompetitive oil pricing inflict three types of costs on oil consumers. First, wealth is transferred from oil consumers to producers. Second, the economy's overall ability to produce is diminished by oil's greater economic scarcity. Third, when price movements are sudden and drastic, inflation and unemployment cause additional losses of output. These three components are distinct and cumulative. Between 1972 and 1991, the sum of losses to the US economy from these three causes amounted to over US$4 trillion.

Transfer of wealth is the most straightforward and yet most controversial component of the costs of oil dependence. When prices rise above normal competitive market levels due to the exercise of market power by OPEC, or even when a short-term crisis causes a price shock, wealth is transferred from oil-importing economies to oil-exporting economies. The quantity of wealth transfer is equal to the quantity of oil imported multiplied by the difference between the actual market price and the normal competitive market price. Over the period 1972 to 1991, noncompetitive oil pricing cost the US economy approximately US$1.5 trillion in transferred wealth. Clearly, the United States' vulnerability to transfer of wealth is directly proportional to the quantity of oil it imports. Oil imports do matter.

The transfer of wealth is controversial because it results not from a loss of economic output but from a change in ownership. If oil producing economies use their windfall to purchase a sufficient amount of US goods and services, the US gross domestic product (GDP) need not decrease as a result of the transfer of wealth. Nonetheless, there is a real loss to the US economy, whether or not petrodollars return to the United States to maintain the level of final demand, because the ownership of those goods and services passes to the oil producing economies. Simply put, oil exporters become richer, oil importers poorer.

When oil prices rise, they signal to the economy that oil has become more scarce. It matters little whether the price rise is due to physical scarcity or to the use of market power. A world in which oil is more scarce is a more difficult world in which to make a living. In other words, there is a loss of the potential to produce economic output. When oil prices rise, the US economy suffers a loss of potential GDP. How significant this loss is depends on how much oil the US economy consumes and on how readily it can substitute other factors of production for oil. Whether prices rise suddenly or gradually, there is still a loss of potential GDP. The total amount of oil the United States consumes matters too, not just the amount it imports.

When prices rise suddenly and drastically, the economy cannot adjust immediately to the change. The new oil price regime requires accompanying adjustments in wages and interest rates, and changes the relative amounts of capital, labor, energy, and materials needed to produce most efficiently. But labor and capital markets need time to adjust, and the technology embodied in capital equipment cannot be instantaneously transformed. The result is less than full employment of the factors of production, and further losses in GDP. Such "macroeconomic adjustment" losses cause GDP to fall below the full employment GDP, which has already been reduced by the impact of higher oil prices on the economy's potential GDP.

While there are a great many estimates of the combined effect of the two kinds of GDP losses, much less is known about the relative sizes of the components. Numerous empirical and simulation studies over the past 20 years suggest that a doubling of oil prices reduces US GDP by about five percent for several years. The size of the impact in any given year is related to total expenditures on oil as a percent of GDP. That is, the larger the share of US expenditures that goes to oil, the more damaging an oil price shock will be to the economy, all other factors being equal. Thus, GDP losses do not depend directly on imports, but rather on the price of oil and the quantity of oil used by the economy.

Today, the US economy appears to be about as vulnerable to oil price shocks as it was prior to the first shock in 1973. Oil costs as a share of GDP were 1.5 percent in 1973 and stood at 1.4 percent in 1996. Use of petroleum energy per dollar of GDP has decreased considerably, but the higher price of oil today has made up most of the difference. Electric utilities have all but abandoned the use of oil to generate power, and residential and commercial use of heating oil has decreased as well, concentrating oil use in the transportation and industrial sectors. Transportation, whose demand for petroleum is notoriously unresponsive to price, now accounts for more than two-thirds of US petroleum consumption. According to data gathered by the US Department of Energy, the United States imported 46.2 percent of the petroleum it consumed in 1996, just 0.3 percent shy of the all-time record high of 46.5 percent set in 1978. These indicators suggest that a future oil price shock would be about as harmful to the economy as those of the past.

Is OPEC Dead?

The collapse of oil prices in 1986 and the ensuing decade of lower oil prices have convinced some that OPEC will never regain control of world oil markets. The creation of the Strategic Petroleum Reserve (SPR), the deregulation of energy markets, the establishment of an oil futures market, improving relations in the Middle East, the US military presence in Saudi Arabia, and downstream investments by OPEC have all been cited as reasons why the oil dependence issue is passe. None of these objections, however, affects the fundamental determinants of OPEC market power, as discussed above. Still others argue that the experience of the 1980s taught the OPEC countries a lesson that they will not try to repeat. Of course, it was that "lesson" that made them rich.

Certainly, there have been some changes for the better. Since 1985, world oil demand has been growing at an average rate of 1.8 percent per annum, far less than the eight percent rate that preceded the first oil price shock. Since 1994, however, oil demand has grown at a 2.5 percent annual rate and may be accelerating. At 42 percent of world crude oil supply, OPEC's market share remains below 50 percent. There is evidence that technological advances, such as three dimensional seismic imaging, horizontal drilling, and advances in off-shore drilling methods have reduced the cost of finding and developing oil resources outside of OPEC. It is possible that such changes increased the rest-of-world supply response, thereby weakening OPEC's market power. This is an important subject and worthy of careful investigation. On the other hand, there is some evidence that the greater concentration of oil use in the transportation sector may have decreased the price elasticity of demand, which would strengthen OPEC's market power.

Motive and Opportunity

Simulations of possible future oil supply reductions by OPEC suggest that the cartel will have both the motive and the opportunity to create price shocks and profit from them. Several studies have demonstrated that successive oil price shocks would produce the maximum profit for OPEC producers. The US Department of Energy has shown that the equivalent of a 5.25 million barrel per day supply shortfall, even as soon as the year 2000, would likely cause oil prices to rise to US$55 per barrel. A recent study which simulated a two-year OPEC supply curtailment in the year 2005 similar in size to those of 1973-74 and 1979-80 (followed by very gradual increase in OPEC output through 2010) concluded that the shock would boost OPEC revenues by about US$600 billion, while the US economy would lose a half trillion US dollars as a result. These simulations take into account the now slower growth of oil demand, but do not explicitly address changes in the technology of oil supply.

Several analysts have assessed the ability of the SPR to defend against a major, sustained supply curtailment and have concluded that the SPR would be of little help. This may surprise some, but it is relatively easy to understand. The US government's strategic oil stocks now amount to 574 million barrels. The total world oil supply shortfall in the typical simulation amounts to 19 billion barrels. Thus, the SPR can replace only three percent of the total supply reduction. Even the entire strategic reserves of all OECD countries could cover only five percent of the total short-fall. The SPR can work well for smaller supply disruptions, and does have a beneficial effect even in the event of a protracted supply curtailment. It is not, however, a panacea for energy security.

Creating economic scarcity through the use of market power is beneficial to oil producers and harmful to oil consumers. The benefits to oil-producing states are enormous. The damages to oil consuming economies are even greater. Huge monopoly profits provide a powerful motive for the noncompetitive pricing of oil. OPEC's rising market share and world oil markets' continuing insensitivity to price confer on the cartel the power to influence markets. The opportunity can arise in any of a number of ways. We have already seen oil market disruptions triggered by the Arab OPEC embargo against Israel's allies in the 1973 October War, a bloody war between Iran and Iraq in 1979-80, and the invasion of Kuwait by Iraq in 1990-91. Future price shocks could be caused by deliberate action to curtail supplies, by wars, insurrections, terrorism, or natural disasters. Depending on the circumstances, OPEC could choose to capitalize on the opportunity and rake in enormous profits or elect to increase production and mitigate the price increase, as Saudi Arabia chose to do in 1991. It seems reasonable to assume that the more money there is to be made, the more likely it is that an opportunity to profit from an oil market disruption will be found.

Can Anything be Done?

If the economic scarcity of oil is inevitable--and if there is no remedy--then there is no use wringing our hands and counting up the costs. But if we could immunize the economy against the future economic scarcity of oil, it would be worth a great deal, perhaps trillions of dollars. But how? The von Stackelberg formula that predicts a cartel's profit-maximizing price also indicates a solution. Actions that reduce OPEC's market share, increase the price elasticity of oil demand, increase the price-responsiveness of non-OPEC oil supply, and slow the growth of world oil consumption, will undermine OPEC's market power. In particular, increasing the ability of oil demand and supply to respond to higher prices both in the short and long run would realize all four goals simultaneously.

Energy technology is the key to immunizing oil-dependent economies against price disruptions. Market elasticities of oil demand and supply depend on consumer preferences and on the relative prices of other factors of production, but, more importantly, market elasticities depend on the technologies of energy use in consumption and production, and on the technologies of oil supply. Defending the economy of an oil-consuming country against the market scarcity of oil will require the development of more energy-efficient oil-using technology (mostly for transportation), the use of more efficient alternatives to petroleum, and cheaper and better technologies for finding and producing petroleum.

To some extent, we can rely on the marketplace to develop the needed technologies. Some of the costs of oil dependence are born directly by producers and consumers, and, to the extent that oil prices signal scarcity and the market anticipates future price shocks, these costs will be internal to market decisions. But much of the cost of oil dependence is a societal cost that markets will ignore, and there are other social costs of oil use as well, such as environmental pollution and the sustainability of our current energy system. Because of this, oil scarcity is an important public policy issue, one that has been virtually ignored for the past decade. It is high time to give it the serious attention it deserves.