Energy Gloom, Market Forces, and Foreign Policy

The prevailing opinion concerning the longer-term outlook for energy markets is one of doom and gloom. The argument is that the energy security of the United States is at risk on three levels. Supply is declining as reinforced by the stories of “peak oil”. Much of the available supply is left is in places that are geographically and politically inhospitable. This supply is also controlled by national oil companies which may have not so hidden agendas of using oil as a weapon. Those areas of new supply or countries less friendly to the United States are being captured by countries like China through long-term contracts to control the ultimate destination of the oil.

Opinion is falling in line that this inevitable combination will create an environment where there is little chance for significant price declines. The strong stable prices in back-month futures are a manifestation of these views. The issue is whether there is anything that can be done about this situation. Some quarters are pressing arguments that foreign policy should respond to these security threats.

An alternative view is that these energy fears are exaggerated. The response to market forces and the current structure of oil market may be enough to solve problems of supply without the need for more activism in foreign policy. Eugene Ghotz and Daryl Press, writing for the Cato Institute provide a market force argument with Policy Analysis #589 “Energy Alarmism: The Myths That Make Americans Worry About Oil “. Their view is that that the fears outlined above are an overreaction and that they should not be the focus of policy for the United States. Prices are driven by markets forces that cannot be adjusted by an activist foreign policy to stabilize supply and prices. While their conclusions are sound, they do not provide help with solving the gloomy picture and their simple analysis shows that supply disruptions over the last thirty years, while ultimately brought back in line to meet demand, can have a strong impact on price.

The argument for “peak-oil” may be the easiest argument to refute based on market dynamics. Given the economics of extraction, more oil will be found at higher prices and economies will respond through conservation and finding substitutes. The response to prices will occur regardless what are the details of overall supply or whether there is a need for a new energy era independent of oil. However, this belief in market forces does not provide guidance on the mechanics of the transition. The ethanol craze is a perfect example how the transition to substitutes may be long, filled with inefficiency, and a costly drain on capital.

Inhospitable regions stifle investment not just because of geography but the threat of expropriation by governments. While foreign policy activism may not be a solution, there is no simple market solution to supply problems which may exist because of unfriendly investment environments. Market forces cannot work when governments interfere with the extraction process. Cartels have excess capacity which can be used to increase supply when needed, but the behavior of cartel members is not guaranteed in a volatile geopolitical environment. The use of force as a potential threat to minimize oil disruptions is costly and may be ineffective.

The current China policy of strategic purchases reminds one of classic mercantilist arguments. China’s activities in this area may not be a threat to western countries if the net result is more oil produced. The needs of China could be met by contractual investments and the remaining could be used by other demanders. Any increase in supply could be beneficial to all market users.

Geopolitical risk is real and may not be solved with active foreign policy initiatives. Market prices will adjust market behavior to any energy disruption. Unfortunately, these forces will have real effects and costly reactions during the period of transition. There are no easy solutions to energy market problems. Prices will not see strong downward adjustments. The threat of low probability geopolitical risk will imply higher prices in the longer-run even if there are high inventories in the short-run. This is why we are in a period of steep contango for crude oil.