The Truth About Oil Security Sorry, we're stuck with foreign oil. But that doesn't mean we can't make our economy less vulnerable.
By Justin Fox

(FORTUNE Magazine) – The Middle Eastern countries under which most of the world's oil is buried are positively seething with discontent. Crude prices are near their highest levels in a decade. House and Senate negotiators are hammering out an energy bill meant to reduce dependence on foreign oil. And the White House really has it in for that Saddam fellow. After nearly a decade of blissfully ignoring such matters, lots of important people suddenly agree again that the security of our oil supplies is an important concern.

But what the heck is oil security? For all the talk about it in Washington and in the media, a clear definition is hard to come by. Here's our stab at one: Oil security means shielding the U.S. from the economic damage caused by sudden, sharp rises in oil prices. That's it.

Being physically cut off from oil, a fate suffered by Germany near the end of both world wars, is not a real worry. The danger is that wars, terrorism, accidents, natural disasters, or political decisions might suddenly and significantly decrease the supply of oil and send prices skyrocketing.

When you get right down to it, the oil security concerns of the U.S. aren't a whole lot different from those of Western Europe or Japan or China. "There is no separate thing called U.S. oil security," says Daniel Yergin, chairman of Cambridge Energy Research Associates and author of The Prize, the definitive history of oil's role in world affairs. "U.S oil security is part and parcel of world oil security."

As a result, talk of reducing U.S. reliance on oil imports--the energy bill passed this summer by the House of Representatives states a goal of reducing U.S. dependence on foreign energy sources (mostly oil) from 56% to 45% by 2012--is largely irrelevant. In 1990, Britain was producing more than enough oil from its North Sea wells to supply all its domestic needs. But the oil those wells produced was part of the global oil market, and when global oil prices shot up after Iraq's invasion of Kuwait, the British economy was still hammered.

So how does an oil-guzzling country like ours avoid getting hammered?

There's always the 580 million-barrel U.S. Strategic Petroleum Reserve, established by Congress after the 1973-74 oil crisis. President Bush announced last November that he wanted to boost the reserve to 700 million barrels, enough to supply U.S. needs for just over a month. But releases from the reserve (one during the Gulf war and three during the Clinton administration) have been haphazard and controversial. If we could ever come up with a consistent approach to drawing down the oil--perhaps with a market-based trigger that doesn't rely on presidential decree--the reserve could make a big difference during temporary supply disruptions. And the very presence of sizable government reserves in the U.S. and elsewhere since the mid-1980s may have helped prevent the kind of panicked hoarding that made gassing up the car such a pain in 1973 and 1979.

But in a world that consumes two billion barrels of oil a month, the billion barrels of strategic reserves in the U.S. and other oil-consuming countries can only go so far. As Winston Churchill put it on the eve of World War I, "Safety and certainty in oil lie in variety and variety alone." If we get our oil from lots of different countries, then trouble in one or two of them will be less devastating. After the rise of OPEC and the rise in oil prices in the mid-1970s, the world found other places to drill for oil, most notably the North Sea. Now, with the North Sea oilfields on the decline, the hope is that Russia, Alaska, deep-sea oil in the Gulf of Mexico and off the coast of Africa, and possible gushers yet to be discovered will continue to provide alternatives to the Persian Gulf.

The sole way to make that happen is for oil prices to stay high (they were near $30 a barrel at the end of August). Only then is it worth the oil companies' trouble to seek new sources of supply and new ways of pumping it to the surface. There is something distinctly perverse about this: To keep high oil prices from damaging our economy, we need high oil prices. But that's how energy economics works. High prices now lay the groundwork for lower prices in the future--and vice versa.

The main problem with the quest for variety is that it's eventually going to stop paying off. Estimates of oil reserves are fraught with uncertainty and prone to manipulation, but nobody in the oil industry disputes that the bulk of the world's oil still to be pumped lies under the sands of Saudi Arabia, Iraq, Kuwait, Iran, and the United Arab Emirates. Over time, variety will decrease and dependence on Persian Gulf oil will only grow. Over more time, even that oil will run out (the current estimate is that we have 40 to 50 years of oil reserves left, but nobody really knows). Then variety will simply mean finding other ways to make our cars go.

Which leads us to the big question: If we want to make the U.S. economy less vulnerable to oil shocks, shouldn't we make ourselves less dependent on oil? Well, yes--unless doing so wreaks even more economic havoc than what we're trying to avoid. To an extent that is already happening: The world's major economies are significantly less dependent on oil--and energy in general--than they were in the early 1970s. In the U.S., energy consumption per dollar of GDP has been dropping for decades; it's now at about half the level it was in 1949 (in constant dollars).

Here's an illustration: The jump in U.S. gasoline prices from 1999 to 2000, when OPEC got its act together after years of disarray, was eerily similar to the jump from 1973 to 1974. Expressed in 1996 dollars, the average price rose from $1.11 to $1.41 a gallon in 1999-2000 and $1.16 to $1.45 a gallon in 1973-74. But in the meantime, real per capita income in the U.S. had risen 62%. So that 40-cent price hike in 2000 hurt the economy a lot less than the 39-cent price hike in 1974.

Some of the U.S. economy's reduced energy dependence can be credited to conservation, mainly during the 1980s. Even now, after a decade of low energy prices, per capita energy consumption in the U.S. is still below its late-1970s peak. More important, the focus of the U.S. economy has been shifting from energy-hogging heavy industry to services and high tech.

We may simply be able to continue relying on this economic shift to make us less vulnerable to oil shocks--and assume that when the world actually starts running out of oil, higher prices will send automakers and drivers scurrying for alternatives. But there are two problems with that approach: One is that the switch from oil to whatever comes next will be long and wrenching, so there might be an advantage to embarking upon it sooner rather than later. The other is that burning oil and its byproducts gives off carbon dioxide, which appears to be warming up the world's atmosphere.

So if we want to wean ourselves from oil faster than would otherwise happen, how do we do it? First, go about it gradually. Remember, the whole point of oil security involves shielding the economy from harm, so hitting economic growth over the head with draconian regulations wouldn't make a lot of sense.

The simplest way to reduce oil consumption is to tax it. The U.S. has about the lowest energy taxes in the developed world, and it's hard to find an economist who doesn't argue for a higher gasoline tax--or a carbon tax designed to fight global warming, which would favor natural gas and renewable energy over oil, but favor oil over coal. However, advocating gas taxes and carbon taxes is seen as political suicide. It's the right thing to do, but it isn't going to happen anytime soon.

One way to reduce oil use without resorting to taxes is to impose automotive fuel economy standards, which Congress did in 1974. The resulting Corporate Average Fuel Economy (CAFE) standards helped bring sharp improvements in gas mileage in the late 1970s and early 1980s. But in recent years the rise of the SUV, brought on in part by CAFE's laxer fuel standards for "light trucks," has actually been bringing overall fuel economy down.

There have been several unsuccessful attempts in Congress to subject SUVs and pickup trucks to the same fuel standards as cars--effectively punishing automakers for doing what Congress (inadvertently) told them to 28 years ago. A better solution is what a National Research Council committee proposed earlier this year: a new, flexible CAFE standard that would take vehicle weight into account and allow automakers to trade mileage credits among themselves.

Another measure that could indirectly reduce oil use would be emissions restrictions on carbon dioxide--a step that, like a carbon tax, would favor oil over coal but promote most other energy sources over oil. The rules could be fashioned after U.S. restrictions on sulfur dioxide, which allow for emissions trading by polluters.

Instead of such bold moves to reduce oil dependence, what lawmakers have mostly given us lately are lots of subsidies and grants to those who would produce oil alternatives, from fuel cells to windmills to ethanol brewed from corn. Creating pork-barrel constituencies for alternative-energy projects isn't the worst thing Congress could have done. But what we need even more are laws that force us to confront the (admittedly hard to estimate) true costs of our oil habit--in terms of environmental damage, economic insecurity, and military spending in the Middle East--and then let good old American ingenuity figure out what to do about it.

That said, it would be nice to know whether anything's waiting in the wings for oil to make its graceful exit. The best candidate right now is natural gas. It is abundant and found all over the world. The biggest reserves appear to be in Russia, not Saudi Arabia. It burns much cleaner than oil or coal. And here's the clincher: It's the cheapest source of hydrogen for those fuel-cell engines that are supposed to transform cars into environment-friendly machines.

Shifting to natural gas as the world's premium fuel is a "historical imperative," says Michael Economides, a University of Houston chemical engineering professor and an oil guru. But in the near term the U.S. is more likely to experience a shortage of the stuff than a glut. A big move to natural gas to fuel electric power generation is coinciding with what appears to be a peaking of gas production in the lower 48. New pipelines from the gasfields of Alaska and Canada could ease potential shortages, but getting them built is a hugely controversial business. The longer-term solution--building a network of U.S. ports that can accept tanker shipments of liquefied natural gas (there are currently only two LNG terminals in operation in the continental U.S.) from around the world--brings with it a couple of problems. One is that Americans will have to accept permanently higher natural gas prices for LNG to make economic sense. The other is that, with homeland security such a big concern these days, building dozens of facilities to handle huge quantities of potentially explosive gas is not going to be popular.

If natural gas can't do the job, then we may have a problem. Nuclear power and coal come with all sorts of familiar liabilities. As for windmills, solar panels, and the like, they can and surely will all play a role in the future. But none approach the portability, efficiency, and (up to now) low cost of oil. It may be that the oil century is over. But that doesn't mean we won't end up missing the stuff.