Making Sense of America's Energy Power Surge

TNI Book Excerpt: "If prices drop too far, U.S. oil production will stagnate or even fall, reversing the stimulus that had prompted lower prices in the first place."

Editor’s Note: The following is an excerpt from Michael Levi’s recent book The Power Surge: Energy, Opportunity, and the Battle for America’s Future, now available on paperback.

Adding up the prospects from all the different U.S. oil resources quickly leads to a conclusion that, in principle, U.S. oil production has the potential for very large gains. But a fundamental question remains: Is this good news just for the oil industry, or could it have much bigger consequences for the United States? After all, oil is special. It evokes intense worries about vulnerability to high prices, hostile foreign producers, and nefarious oil companies closer to home. There is good reason to think that oil is different: if the price of oil spikes, or an oil shortage hits, you have no large-scale alternative to oil-based fuels for your car. Oil has been the subject of frequent fretting since it burst on the scene over a century ago, but contemporary worries can be traced back to the 1970s—those who were alive during the 1973 energy crisis can remember how the U.S. economy was knocked on its back by hostile Middle Eastern suppliers and how U.S. national security was fundamentally undermined as a result. Those who weren’t there to experience it have heard the tales of gas lines and economic turmoil, and drivers all continue to confront the reality of high prices at the pump.

For many people, this is why the promise of a renaissance in U.S. oil looks so exciting. Before 1973, the United States didn’t depend on imports from abroad, let alone from a shaky Middle East. (It imported some oil, but by choice, not necessity; its goal was to conserve U.S. resources for the future.) After 1973, everything changed. “This is the energy equivalent of the Berlin Wall coming down,” says Robin West, an authority on oil markets who served in the Ford and Reagan administrations. “Just as the trauma of the Cold War ended in Berlin, so the trauma of the 1973 oil embargo is ending now.”

It’s a common sentiment. Critics, though, take umbrage with claims that domestic oil production will slash prices, insulate the economy, or transform U.S. national security. In early 2012, Media Matters, a liberal research organization, collected quotes in a report called “20 Experts Who Say Drilling Won’t Lower Gas Prices.” (I made their list, though as you’ll see in a moment, I don’t quite agree.) They emphasize the fact that, as the Congressional Budget Office has noted, “greater production of oil in the United States would probably not protect U.S. consumers from sudden worldwide increases in oil prices,” suggesting the economy as a whole could not be insulated either. And they sharply question the security benefits of greater domestic production: according to the Energy Security Leadership Council, a bipartisan group of prominent business executives and retired military and government leaders from across the political spectrum, “as long as the United States remains a large consumer of oil, no level of domestic fuel production can meaningfully improve energy security.”

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Open any Economics 101 textbook and you’ll learn what determines oil prices: it’s the collision of supply and demand. High prices make production more attractive and encourage people to cut back how much they use. If prices get too high, supply outstrips demand, and an oil glut develops; eventually, prices crash. Too low a price will do the opposite, dissuading production while encouraging people to use more oil, which leads to a shortage of crude. Markets eventually settle on prices that avoid both unsustainable outcomes.

This helps in quickly settling one of the battles between oil enthusiasts and skeptics: since oil is traded globally, prices depend on how much is produced in the entire world, not how much is pumped from the ground in the United States. A world where the United States produces ten million barrels of oil every day won’t necessarily have lower oil prices than one where it produces five million. After all, U.S. oil production was higher in 2010 than in 2009, but oil prices were higher, too.

Score one for the skeptics. But there’s less to this victory than meets the eye. If the United States increases its oil production, and output from the rest of the world remains unchanged, total world supply will rise. This means that, everything else being equal, prices will fall below what they otherwise would have been. (If they don’t, people will use the same amount of oil they did before, and all the new oil will have nowhere to go.) The big question is how much.

You might think this would be easy to nail down: figure out the historical relationship between oil supply and oil prices and use it to predict the future impact of producing more oil. The first big problem, though, is that there are a lot of things that influence the price of oil. This means teasing out the influence of new supplies isn’t straightforward. Worse, if the relationships have changed over time, the results are even less reliable. Still, economists have come up with some reasonable guesses—and the implications are striking. A team at the International Monetary Fund recently estimated that a 5 percent increase in world oil supplies would eventually cut oil prices roughly in half. (Even this was a best guess: they gave nearly one-in-four odds of a drop either twice or only half as large.) This sort of change might be produced by an increase of about five million barrels a day in U.S. oil supplies. The possibility of slashing oil prices in half by increasing U.S. oil supplies by five million barrels sounds huge. The problem, though, is we’ve seen only half of the story.

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