The Great Oil Fallacy

Among the unchallenged verities of U.S. politics, the most universally accepted is that of the crucial strategic and economic significance of oil, and particularly Middle Eastern oil. On the right, the need for oil is seen as justifying an expanded and assertive military posture, as well as the removal of restrictions on domestic drilling.  On the left, U.S. foreign-policy is seen through the prism of “War for Oil,” while the specter of Peak Oil threatens to bring the whole system down in ruins.

The prosaic reality is that oil is a commodity much like any other. As with every major commodity, oil markets have some special features that affect supply, demand and prices. But oil is no more special or critical than coal, gas or metals—let alone food.

Let’s start with some numbers. The United States currently uses about nineteen million barrels a day, of which about eleven are imported, mostly from within the Western Hemisphere. Imports from the Persian Gulf supply about 15 percent of total U.S. oil demand, a share that has declined over time.

At a price of $100 a barrel, expenditure on oil is around $700 billion a year, or 4 percent of GDP. That’s comparable to the amount spent on accommodation and restaurant services, and far smaller than, say, the health care or financial services sectors.

Imports from the Persian Gulf cost $73 billion in 2011, of which Iraq received around $20 billion. So, if the multi-trillion dollar Iraq war really was a “war for oil,” it was exceptionally ill-advised.

Oil has become steadily less important as an oil source in recent years. U.S. consumption of petroleum for gasoline peaked in 2005, well before the recession, and economic recovery has not produced a rebound. Consumption of oil per person has been declining since about 1980. At least as far as the United States is concerned, Peak Oil is an event in the past, not the future.

Moreover, while oil is a very convenient fuel for many purposes, there are few for which it is essential. Cars can run on liquefied natural gas, ethanol or biodiesel, not to mention electricity. High prices have already led to the abandonment of oil in many uses for which it was once the preferred fuel, such as electricity generation.

If oil is a commodity of modest importance, why does it loom so large in the thinking of U.S. policymakers and the general public? The answer, undoubtedly is the memory of the OPEC oil embargo imposed in retaliation for U.S. support of Israel during the Yom Kippur war of 1973. This shock was followed by months of queues and rationing, and by the double-digit inflation and high unemployment of the late 1970s.

Given this sequence of events, it was easy to conclude that control over oil exports is a powerful weapon in the hands of the OPEC states, and that shocks to the supply and price of oil represent a major cause of economic crises. Neither of these conclusions was correct at the time, and any validity they once had is long gone.

Although the galloping inflation of the late 1970s came after the oil shock, its causes came much earlier. Inflation rates had been rising since the mid-1960s, fueled by LBJ’s attempt to prosecute both the Vietnam War and the War on Poverty without raising taxes. The Bretton Woods system of fixed exchange rates, the anchor for price stability in the postwar period, had broken down in 1971, when Richard Nixon cancelled the convertibility of the U.S. dollar into gold.

At the same time, Nixon introduced a wage and price freeze, to be followed by a system of controls, and appointed John A. Love as the first “energy czar.” The general price and wage controls were quickly abandoned, but controls on oil were tightened even further. Meanwhile, global commodity prices were soaring. The exception was oil, where a tight cartel of oil companies, the so-called “Seven Sisters,” held prices down despite the complaints of producers, whose own cartel, OPEC, was in its infancy. But market reality was moving in favor of the sellers and against the buyers.

In these circumstances, the Yom Kippur war set off a perfect storm. Arab anger produced a surge of solidarity that enabled OPEC to cut supplies and boycott the United States. Since oil is essentially untraceable, the boycott would have been purely symbolic if the Nixon Administration had allowed gasoline prices to rise, so that supply met demand. Instead, Nixon imposed a state-by-state system of rationing, and individual states adopted their own controls, supplementing the nationwide system based on license plate numbers.

The oil shock was mostly a consequence, not a cause, of the inflationary crisis that began in the 1970s. Some economists, notably James Hamilton of UCSD, argue that despite this, oil shocks have an independent effect in causing recessions, but this is very much a minority view in the economics profession.

If oil is economically unimportant, how about the use of oil embargos as a strategic weapon? Not only does the Strategic Reserve provide ample protection, but the U.S. energy sector is far more flexible and resilient than it was in the 1970s. An example was provided by Hurricane Katrina, which knocked out nearly 20 percent of U.S. oil production and nearly 40 percent of refining capacity, but had little effect on the economy as a whole.

In reality, producer countries dependent on a single commodity are far more vulnerable to oil embargos than are consumers. There has been no attempt since 1973 to restrict U.S. oil supplies, but embargos and sanctions have been applied to Burma, Iran, Iraq, Libya, Venezuela and others.

Given the limited importance of Persian Gulf supplies for the United States, those who argue its importance often claim that the United States is providing a free supply-protection service to Europe and Japan. But Europe doesn’t seem to be worried about Persian Gulf oil supplies: EU energy security debates are dominated by the problem of dependence on Russian gas. And while Japan worries more, those concerns weren’t enough to stop the Japanese government closing all nuclear power plants in response to the Fukushima disaster.

As in other areas of policy, the battles of the 1960s and 1970s continue to shape thinking about oil. It’s time to recognize that in the second decade of the 21st century, oil is just one commodity among many in an economy that is mainly driven by services and information.

John Quiggin is a professor of economics at the University of Queensland, Australia and adjunct professor at the University of Maryland, College Park. He is author of Zombie Economics: How Dead Ideas Still Walk Among Us (Princeton University Press, 2010).

The National Interest Online