Tuesday, February 16, 2010

"The Impending Oil Shock": An Exchange

By Nader Elhefnawy

This is an electronic version of my contribution to a Survival Forum in which I responded to the comments of Amy Myers Jaffe and Michael T. Klare to mt April 2008 Survival article, "The Impending Oil Shock," published in Survival 50.4 (August 2008), pp. 61-82. Survival is available online at informaworldTM.

I would like to start by thanking Amy Jaffe and Michael T. Klare for their comments regarding my article. While they agree with many points of my assessment, they also point to a number of items they find problematic. Jaffe argues that I have underestimated the flexibility of the market and the prospects for peaceful adaptation to the new conditions, particularly by the United States. Klare suggests I did not give sufficient attention to the prospects of a Sino-American military competition, to which energy politics is already contributing.

Jaffe observes that 'investors in alternative energy . . . in Elhefnawy's world could invest far more capital without any fear that fossil fuels would fight back.' The article focused on long-term energy security, rather than financial advice to investors, and therefore warranted a more cautious consideration of the issue, extending to an examination of worst-case scenarios. Nonetheless, Jaffe's characterisation of my position is not entirely inaccurate. The flexibility of markets is not infinite, and natural-resource scarcities remain an important limitation on their capacity for generating solutions.1 A return to 'cheap oil' (a problematic concept in itself) is no exception. All the signs-the smaller size of newly discovered deposits, the growing shortfall between new discoveries and the depletion of proven supplies, the emphasis on areas where exploration and extraction are more difficult and costly (like offshore fields), the broadly falling energy return on energy invested (EROEI)-strongly indicate a trend toward diminishing marginal returns on investment in oil production. The relatively slow process of enlarging oil production is also a factor, deferring even the hope of a price drop to a point at which this trend will be even more advanced.

Of course, cutbacks in consumption driven by high prices could help in the interim. However, energy consumption is relatively inelastic, and the energy shortages of the 1970s did not cause consumers to fundamentally reduce their use. Rather, high prices temporarily held down growth in consumption. Substantial, lasting reductions require structural changes like the conversion of infrastructure and vehicle fleets, which tend to be gradual when driven by the market.

Moreover, energy efficiency may also be an area of diminishing marginal returns on investment. While the rise in global energy efficiency in the 1990s (measured in terms of the energy input needed to produce a unit of gross domestic product) kept pace with the progress of the 1970s and 1980s (about 10% per decade), the distribution of the gains of the years 1990–2003 is cause for concern.2 It was concentrated not among advanced states, but those rated 'lower middle income' by the World Bank-economies which in the natural course of development did away with very easy inefficiencies, rather than pushing the envelope.3

In fact, the most efficient among the large states saw their improvement stagnate during these years; the progress of Japan and Italy flat.4 The more impressive gains of Germany, Britain and the United States are likely due to how far behind they were to begin with-'easy' gains, as in the case of many developing nations.5 This trend might be attributable to low oil prices affording little incentive to make a greater effort, but that remains speculative.

The booms and busts Jaffe mentions as comparable to this decade's should also be examined closely. The 1956 crisis was due to the closure of the Suez Canal. The oil shocks of 1973 and 1979 involved concerted action by the Organisation of Petroleum Exporting Countries (OPEC). The 1990 shock was a result of UN sanctions taking Iraqi and Kuwaiti production offline.

In short, all four shocks were partly attributable to deliberate political decisions regarding oil production, transportation or price, to which the 2003 shock offers no analogue. It is also worth remembering that prices tended to fall through the 1980s and 1990s despite the Iran–Iraq War, sanctions against Iraq and periodic war scares in the Persian Gulf, and reached their low point in 1998, a particularly anxious year where Iraq's relationships with the UN and the United States were concerned. The ongoing war in Iraq and international tensions regarding Iran's nuclear programme therefore seem insufficient to account for the current prices ($138 a barrel), which exceed the earlier 1981 record by over 40% in real terms.

The real issue is that oil producers have less slack for absorbing shocks of all kinds. Rising consumption in Asia is certainly a factor, but still leaves the question of why producers have failed to keep up: partly due to a fixation on short-term profit-seeking, but also reflecting the diminishing marginal returns that make rectifying the situation more difficult.

This is not to say that oil cannot 'fight back.' Declines rarely follow a straight downward trajectory, but it seems reasonable to expect that those who do fight back will give more and get less, that the curve will get steeper. It only muddles the issue to say that prices will at some point go down. The real issue is how much we can reasonably expect them to go down, and for how long before prices start to go back up again. For instance, will prices return to the low of the 1990s, when they hit $10 a barrel–a drop of 90% from today's prices, after adjustment for inflation? Will they even come close?

That seems unlikely at best. Besides, it is worth remembering that when oil fought back against alternatives in the past, it did so politically as well as through the market. Where renewable energy should have enjoyed the protected status of an 'infant industry' on the grounds of energy independence and ecology, such support was withdrawn in the United States in the early 1980s.6 While this was done in the name of the free market, renewable energy did not compete on a level playing field but one tilted in favour of fossil fuels, the beneficiary of a long and ongoing history of subsidy.7 Fossil-fuel-related R&D was funded by the government at approximately twice the level (and nuclear-related R & D, at four times the level) of renewable energy for the 1972–95 period.8 Such subsidies make the 'cheap' oil to which Jaffe refers illusory in an important sense (even without considering problematic externalities like climate change, which Jaffe rightly raises).

Despite these disadvantages, the cost of renewable-energy production has steadily dropped relative to oil since the 1970s, so that wind is increasingly competitive. Given recent experience, this trend can be expected to continue (though not indefinitely). A true repeat of the late 1980s and 1990s with regard to the energy markets is thus highly unlikely, barring perverse public-policy decisions.

However, while Jaffe characterises my assessment as a 'doomsday scenario' at which future readers will scoff, the parameters laid down here leave a wide range of possibility with regard to the speed with which that scarcity develops, the severity of the resulting problems, and the room for manoeuvre actors will have in which to adapt to the new situation.

Peaceful, progressive responses are conceivable, and one can point to real achievements. Denmark, for instance, derives a fifth of its electricity from wind energy, and reduced its fossil-fuel use by a comparable margin in the 2001–05 period, all while maintaining one of the highest living standards in the world.9 Unfortunately, Denmark is the exception rather than the rule; others are proving slow to follow, and even were the propensity to do so greater, not all countries can adapt as easily. Considerable variation exists in this respect among even the advanced industrial countries.

This brings me to the second major point, the case of the United States. As Jaffe notes, America's status as the world's single biggest consumer of energy and oil positions it to have a greater positive impact on the situation than any other single actor. It is also the world's biggest spender on technological R&D, and has enormous potential to produce energy from photovoltaic solar, wind and other renewable sources.10 All these resources can be mobilised to meet the challenge.

Nonetheless, the United States has further to go than other developed nations, and a number of particularly severe obstacles to overcome. These include the country's overall low energy efficiency, underdeveloped renewable energy industry, and a 'culture of oil' deeply embedded in national attitudes, consumer habits and physical infrastructure. The US economy may not be as robust as it appears, and is already suffering the consequences of its deindustrialisation and trade deficits (possibly coming to a head in a currency crisis), which complicate adaptation.

Meaningful action on all these issues will take considerable political will, extending to a fundamental rethinking of the economic legacy of the 1980s. There is little sign of this as yet, either at the level of federal policy (though many US states and even localities have been more active), nor in public discourse about the issue, which remains mired in inoffensive platitudes. I am not arguing for economic determinism, but taken together these factors threaten America's position as a global power.

The issue of global power status, of course, raises Klare's concern over the risk of military competition between the United States and China. I agree that China, along with the United States, will be the major country most adversely affected by contracting oil supplies. China's robust growth, strong currency and heterodox economic policies have, for the time being, constrained the effect of oil-price rises on its economy (just as they constrained the effects of the 1997–8 Asian financial crisis). However, over the long term, deepening scarcity will take its toll.

Klare is also right to note China's support of its energy policy with diplomacy and arms sales in recent years; the resulting frictions with US interests in Central Asia and elsewhere; and the danger not only of an increased risk of a great-power military clash, but the resulting diversion of resources and attention away from more useful investments. Indeed, the pursuit of energy security through military means has already exacted a high price. What might the United States have accomplished if it put even a small fraction of the money spent on securing the Persian Gulf since 1973 into developing alternate energy sources?

Nonetheless, a few qualifiers are in order, particularly where China's position is concerned. The country's wealth, capabilities and prospects are constantly exaggerated. Despite its lengthy investment in military modernisation, China still lacks the power-projection assets of the United Kingdom, let alone the United States. Additionally, while China's relationships with Iran and Sudan rightly raise eyebrows, it is significant that China has become more cautious in pressing its claims in the South China Sea basin since 2001, a situation much closer to home, and where it is far stronger than in the distant Middle East.

Indeed, China relies much less on its military resources internationally than the softer power brought by its economic standing and its effective diplomacy, exploiting the desire for a counterweight among those discontented with US foreign policy.11 This does not rule out a more militarised and confrontational Chinese policy in the future, but the constraints here are greater than many observers appreciate because the situation will be slow to change, in part because (energy portfolio aside) China's economy, too, is not as strong as it appears.

According to a report issued by the Asian Development Bank last year, the miscalculation of purchasing power parity for China may have led to an overestimate of the size of China's economy by 40%, an assessment now widely accepted.12 In short, China is several years behind the position the most optimistic estimates have given it, and much else about its economic performance is also called into question by this rethinking.

China's economic progress has also exacted an appalling social and ecological price. The sharp cleavages between regions and classes (manifest especially in the rural unemployed migrating toward the cities), as well as the destruction of much of the country's natural resource base (evident in the country's expanding deserts and air pollution, and the fouling of the Yellow and Yangtze rivers), bode poorly for the sustainability of China's current course. Those who criticise Europe's trend toward an older population would also do well to remember that China is one of the most rapidly ageing countries in the world.

Indeed, China's condition not only invites comparison with the rise of great powers like the United States, but frustrated ascents to superpower status, like the 'Brazilian miracle' of the 1970s, which astonished the world (as China astonishes it now) before fizzling out. China's collapse may be a more likely consequence of its reliance on oil than a lengthy arms race, though these unfortunate paths are not mutually exclusive.

The optimal future is one in which, as Jaffe argues, the United States and China (and other economic powers like the EU and Japan) lead the international community in a project to improve energy efficiency, build up production from already viable and increasingly attractive alternatives, and further develop the technological state of the art in energy production and use, while extending the benefits of these to even the poorest nations.

However, the rational response is not the only one possible, or even the most likely. There were wide hopes of a similar venture 35 years ago in the wake of the OPEC embargo, but for all the bold rhetoric of the Nixon and Carter administrations, the results of American efforts in particular were dismal. It would be folly to ignore this dismaying precedent, and unfortunately the policy of the United States and China in recent years has not been much more encouraging. A successful and humane response to the problem is possible, but such an outcome cannot be regarded as assured.

1 Thomas Homer-Dixon, Environmental Scarcity and Global Security (Ithaca, NY: Foreign Policy Association, 1993), pp. 67–8.
2 World Bank, 2006 World Development Indicators (Washington DC: World Bank, 2006), pp. 158–60.
3 Ibid.
4 Ibid., pp. 158–60.
5 Ibid.
6 Nader Elhefnawy, 'Toward a Long-Range Energy Security Policy,' Parameters, vol. 36, no. 1, Spring 2006, pp. 108–10.
7 Ibid.
8 Fred J. Sissine, 'Energy Efficiency: A New National Outlook?' Congressional Research Service Reports, 12 December 1996, http://www.cnie.org/nle/crsreports/energy/eng-28.cfm.
9 In 2005, Denmark was consuming 20% less oil daily than it was in 2001, and 37% less than in 1981. US Energy Information Administration, 'World Petroleum Consumption,' International Energy Annual 2005, 6 August 2007, available at http://www.eia.doe.gov/pub/international/iealf/table12.xls. Danish coal and natural gas consumption have also trended downward.
10 Robert L. Paarlberg, 'Knowledge as Power: Science, Military Dominance and U.S. Security,' International Security, vol. 29, no. 1, Summer 2004, pp. 122–51.
11 Chris Zambelis and Brandon Gentry, 'China through Arab Eyes: American Influence in the Middle East,' Parameters, vol. 38, no. 1, Spring 2008, pp. 60–72.
12 See Albert Keidel, 'The Limits of a Smaller, Poorer China,' Financial Times, 14 November 14, http://www.carnegieendowment.
org/publications/index.cfm?fa=view&id=19709&prog=zch. Between 2007 and 2008, the CIA revised its estimate of China's GDP down from $10 trillion to $7tr. See the 2007 and 2008 editions of the Central Intelligence Agency's CIA World Factbook.

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