A Path Out of the Desert

A Grand Strategy for America in the Middle East

By Kenneth Pollack
Random House. 539 pp. $30
July 25, 2008


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...)


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