Saturday, May 13, 2006

Posner on Oil Dependence

Richard Posner is right to say high gas prices aren’t necessarily a bad thing. High prices provide a market signal that induces consumers to curb their consumption, producers to expand supplies, and entrepreneurs and engineers to seek out potential oil-substitutes. That said, I couldn’t let this passage go by without comment:
Furthermore, a large part of the world's oil supply comes from nations such as Venezuela, Nigeria, Iraq, Iran, Saudi Arabia, and Russia that are actually or potentially unstable, hostile to the United States, or both, and it would be prudent to reduce our dependence on such suppliers.
Posner here invokes the old shibboleth of dependence on foreign oil. The problem, as I’ve noted before [second post contains a correction to the first], is that there’s more than one kind of dependence. In one sense, we are dependent on foreign oil just because we’re dependent on oil. A reduction in demand for oil would reduce this kind of dependence. But in another sense, we are dependent on foreign oil because, and to the extent that, whatever amount of oil we consume comes disproportionately from other countries. To be more precise, since oil is sold on a world market, the real question is not the origin of the particular barrels we get, but what percentage of the world’s oil supply comes from hostile or unreliable producers. And it turns out that this form of dependence could actually increase as a result of a reduction in demand for oil. Why? Posner gives the reason himself, without seeming to recognize its significance:
Just as an increase in demand will cause higher-cost oil to be produced -- oil that would not have been economical to produce when the market price was lower -- so a reduction in demand will cause that higher-cost oil to be withdrawn from the market and so the average price of oil will fall. In effect, income of the producing nations will be transferred to the consuming nations in the form of gasoline taxes imposed by those nations.
In other words, if the price of oil fell, the highest-cost oil producers would drop out of the market while the lowest-cost oil producers would stay in. And who are the lowest-cost oil producers? Saudi Arabia, Venezuela and Nigeria (when they’re not having riots and strikes), Iran and Iraq (when they’re not having civil wars), etc. The result? Although we would be less dependent on oil, we’d also be more dependent on unstable and/or hostile countries to meet our remaining oil needs.

So which form of dependence matters? I think probably both. Posner’s right to suggest that reduced demand (possibly induced by a gas tax) would cut into the profits of the foreign producers. That’s a good thing if, say, you’re concerned with depriving terrorists of funds. On the other hand, if you’re worried about the vulnerability of our economy to sudden price shocks brought on by civil strife, war, geopolitical tensions, and so on, then you might prefer higher prices as a form of insurance that keeps the higher-cost but more reliable producers in business. Trade-offs are tough like that.


Gil said...

Isn't the instability of some of the oil producers already built into the the price? Doesn't it already affect the price without artificial interventions like taxes?

I can understand the argument that there are externalities (like contribution to pollution, global warming, etc.) that might be mitigated by price interventions (although I'm skeptical of the alarmist facts, or the likelihood that the government will find an appropriate level), but I really don't get this assumption that the market is underestimating the instability of sources.

If there is any underestimation, it's probably because we've led people to expect that we'll intervene militarily whenever oil supplies are threatened.

Maybe we should do less of that.

Genius said...

Insightful post Glen.
I think that the US pushes up oil prices by getting involved. Giving money to a despot to crush resistance might push prices down (depending on how it is done) but invading or any similar sort of active involvement pushes them up and supply down (take iraq for example).