Feature

Don't Be Crude

Why Barack Obama's energy-dependence talk is just demagoguery.

"Energy independence" has become a byword on the American political scene, and invoking it is now as essential as baby-kissing. All the recent U.S. presidential candidates employed it, and to this day, the White House Web site lists as a guiding principle the need to "curb our dependence on fossil fuels and make America energy independent." Expect a whole new round of such rhetoric when the global economic recovery begins, and with it, higher oil prices return.

But this "energy independence" motto is political posturing at its worst -- a concept that is unrealistic, misguided, and ultimately harmful to energy-producing and -consuming countries alike. And it is often deployed as little more than code for arguing that the United States has a dangerous reliance on my country of Saudi Arabia, which gets blamed for everything from global terrorism to high gasoline prices.

Saudi Arabia holds about 25 percent of the world's proven oil reserves, is by far the largest exporter of oil, and maintains the largest spare production capacity in the world. U.S. oil production started to decline in 1970, while U.S. energy needs have skyrocketed since that time, and the United States is now the world's largest oil consumer. There is no technology on the horizon that can completely replace oil as the fuel for the United States' massive manufacturing, transportation, and military needs; any future, no matter how wishful, will include a mix of renewable and nonrenewable fuels.

Considering this, efforts spent proselytizing about energy independence should instead focus on acknowledging energy interdependence. Like it or not, the fates of the United States and Saudi Arabia are connected and will remain so for decades to come. This realization need not strike fear into the hearts and pocketbooks of Americans. Saudi Arabia has a long record of specific actions that prove its strong commitment to providing the world with stable energy supplies. We have consistently pushed for lower prices than any other OPEC members have, and we sharply increased supplies after the Iranian Revolution, during the first Gulf War to replace the loss of Iraqi production, and immediately after the Sept. 11, 2001, terrorist attacks -- all in order to calm jittery global markets.

In fact, Saudi Arabia's oil policy has been consistent for the last 30 years: work to ensure the stability of the world's energy supply. Today, a barrel of oil generally costs around $70. To put this into context, we should recall that even during the spike of 1973, the price of oil in 2008 dollars was just slightly over $100.

High oil prices have undoubtedly given those calling for U.S. energy independence a new talking point. But here, too, it's important to understand what is really going on. Following the irrational and unsustainable price spike of the past few years, Saudi Arabia undertook investments to make sure the world would not be surprised by such a supply failure again. After investing almost $100 billion to reach 12.5 million barrels per day of sustained capacity, today we hold about 4.5 million barrels per day of spare capacity (or more than 90 percent of the global total), enough to replace the second- and third-largest OPEC producers overnight if the world needed more oil.

We admit that, like the United States and other countries, we were surprised by the way prices escalated in recent years. Many people blame demand from China and other emerging markets. But the sad fact is that four oil-producing countries failed to live up to production expectations. In 1998, Iran, Iraq, Nigeria, and Venezuela were producing 12.7 million barrels per day. Everyone -- including major companies such as BP and our own planners at Saudi Aramco -- expected them to be producing 18.4 million barrels per day in 2008. Instead, due to civil strife, failed investments, or in the case of Iraq, a U.S. invasion, they were producing only 10.2 million barrels per day. That drove the price part of the way up. Then speculators, in the form of hedge funds, did the rest.

Another factor in rising oil prices is the shortage in the world's refining capacity. In the United States, for example, not one new refinery has been built in more than 30 years. Add to this problem another: "boutique oil," the different grades of gasoline required in different localities. I encountered one of these anomalies when I visited Chicago three years ago. There is an oil refinery 50 miles from Chicago, but it does not supply the city with gasoline because the grade does not comply with Chicago's standards. Instead, Chicago has to import its gas from the East Coast. Prices at the pump would be much lower if there were direct supplies from the refinery to the city.

There are many causes behind last year's oil price spike, but Saudi Arabia is not one of them. Unlike large oil companies, which have been slow to respond to the supply crunch with more capital investments, the kingdom realized that such investments -- even if they seem counterintuitive in the short term -- are essential to avoiding catastrophic energy shocks. We have proposed a billion-dollar fund to promote research into making fossil fuels more environmentally friendly and have promoted the International Energy Forum to bring together producers, consumers, and the oil companies that extract, refine, and sell oil. Although it has yet to get the full support of consumers, the forum has held regular meetings to discuss relevant issues.

But Americans don't hear all this from their political leaders. In one of his very first speeches as U.S. president, for instance, Barack Obama declared that "America's dependence on oil is one of the most serious threats that our nation has faced." He said that it "bankrolls dictators, pays for nuclear proliferation, and funds both sides of our struggle against terrorism," and announced what he called "the first steps on our journey toward energy independence."

The allure of demagoguery is strong, but U.S. politicians must muster the courage to scrap the fable of energy independence once and for all. If they continue to lead their people toward the mirage of independence and forsake the oasis of interdependence and cooperation, only disaster will result.

Joe Raedle/Getty Images

Feature

Subpriming the Pump

Oil wealth used to hurt only those who had it. Now, it's hurting everyone.

The resource curse has gone global.

For years, oil wealth was mostly a danger to those, paradoxically, who possessed it. Resource-rich Middle Eastern countries, and their labor-exporting neighbors, failed for decades to invest adequately in their people or to diversify their economies. A massive influx of oil receipts and worker remittances discouraged investment in sectors conducive to steady long-term growth, fostered corruption and patronage, inflated regional real estate and stock markets, and provided irresistible incentives for governments to spend with wasteful, shortsighted abandon.

But today, the Middle East's resource curse is spilling over into the international financial system. Unanticipated petrodollar flows are fueling financial bubbles, financing a Middle Eastern arms race, and damaging the global economy through speculative oil-price feedback loops. All the elements of previous boom-and-bust cycles in the 1970s and 1980s and again in the past decade remain in place.

What's happening is both comfortingly familiar and terrifyingly new. Sudden surges in oil-revenue flows to and from the Middle East -- known as "petrodollar recycling" -- have certainly been a problem before. But in the last few years, they have become critically destabilizing. Today's Great Recession has generally been understood as a story about real estate excesses and regulatory shortcomings. But it's also a cautionary tale about the increasingly pernicious role that oil is playing in the global economy.

Into the middle of this decade, economists' worries were focused on global imbalances between China and the United States. For Harvard University economist Lawrence Summers, now a top White House advisor, the world was caught in the grip of "a balance of financial terror." Deutsche Bank researchers argued that this temporary imbalance, wherein Chinese excess savings financed excess consumption in the United States, constituted nothing less than an informal sequel to the Bretton Woods international financial system, one they thought would be sustainable for a few more years.

But this optimistic analysis overlooked a major piece of the global economic puzzle: oil receipts. Leading into 2006, the capital exiting Saudi Arabia and Kuwait alone matched the funds leaving China (approximately $200 billion per year). For five years, from 2003 to 2008, the Middle East's massive petrodollar outflows, combined with excess liquidity due to low interest rates and a voracious appetite for credit risk, fueled bubbles in global financial markets, including real estate, credit derivatives, and ultimately commodity prices. The investment frenzy pushed markets into what the late economist Hyman Minsky called "Ponzi finance." Unsustainable serial financial bubbles distorted incentives toward the financial sector and away from investments more conducive to long-term economic growth, such as infrastructure and research and development, especially for alternative-energy fuels.

In this way, interconnected financial markets have globalized the resource curse, and all countries with relatively open economies and limited capital controls are now exposed to energy-market risks as a result -- even ones as diverse as Britain, Russia, and the United States, which are blessed with their own plentiful supply of fuels. As we saw last year in spectacular fashion, financial contagion feeds back and amplifies demand-driven spikes in oil prices, exacerbating the eventual real-economy slowdown that economist James Hamilton and others have noted.

How did this happen? Capitalist economic systems, as Minsky, Charles Kindleberger, and other economists have argued, are intrinsically unstable. Prolonged periods of economic growth invite growing appetites for risk, as optimism about rising profits and lower rates of bankruptcy lull investors into a false sense of security. Optimism ultimately grows into euphoria, which former U.S. Federal Reserve Chairman Alan Greenspan famously called "irrational exuberance," as investors bid up asset prices with ever increasing leverage. Meanwhile, financial-sector lobbyists convince legislatures to ease or underexpand prudential regulations and "unleash the power of laissez-faire capitalism." Myopically, the seeds for financial disaster are sown.

During boom times, as we saw in the years leading up to 1973 and again after 2002, the rise in oil demand strengthens oil producers, which reap massive profits by intentionally underinvesting in oil-production capacity. Oil prices continue to rise, filling their treasuries with a sudden influx of capital that cannot be absorbed at home. Petrodollars flow out, seeking returns in already inflating financial markets and pushing bubbles to dangerous levels.

As the business cycle turns, the euphoria begins to wane. Investors assess financial risks more accurately. Interest rates rise, further feeding the downswing. The irrational exuberance that amplified the boom quickly reverses course, accelerating the bust. Demand for oil collapses, causing oil prices to crash. Petrodollar flows dry up, hitting financial markets and real-sector growth still harder. Then, reduced liquidity and credit prevent oil exporters from investing sufficiently in productive capacity during the recession, and our story eventually repeats, each time more dramatically than before.

The geopolitical component of this megacycle is equally insidious. As oil-producing countries amass substantial financial reserves, they tend to allocate investment and expenditure disproportionately less to oil-production capacity and more toward areas that benefit the ruling elites. In the Middle East, significant portions of oil receipts have been spent on arms purchases, which protect the ruling class from both external threats and internal challenges -- indirectly, by appeasing military leaders who might pose a threat, and directly, by stifling opposition through robust internal security spending. (Military personnel as a percentage of the labor force is a very high 3 percent in the Middle East and North Africa, and military expenditures as a percentage of GDP are also consistently high, for example 9 percent in Saudi Arabia.)

Oil-importing advanced economies such as France and the United States, which eagerly sell weapons as a means of recycling petrodollars, cannot escape their own complicity in this game. Middle Eastern arms races boost not only the arsenals of national militaries, but also of subnational militias and even terrorist organizations. Iran's long-standing support of Hezbollah, for example, is well documented. The flow of weapons increases geopolitical risks, once again increasing oil prices as fears grow that military conflict or terrorist threats will disrupt supplies. Put bluntly, a little bit of terrorism is good for oil exporters.

And the links between oil and terrorism don't stop there. As oil exporters mimic the consumption behavior of advanced economies during booms, young populations develop highly unrealistic expectations, premised on a sense of entitlement to oil wealth. It's these frustrated expectations that drive youth toward radical and militant ideologies, not poverty per se. In Saudi Arabia, for example, real per capita income in the early 1980s was higher than that of the United States. Saudi nationals were accustomed to free housing, guaranteed incomes, and subsidized electricity and gasoline until low oil prices caused budget cutbacks in the mid-1990s. The Sept. 11, 2001, hijackers, after all, were mainly educated middle-class men. They were undoubtedly influenced by the arguments of Osama bin Laden, who in the 1990s was raging against "the greatest theft in history," arguing that the real price of oil in late 1979 should have persisted for the next two decades.

Needless to say, military spending, distribution of oil rents to favored segments of society, and the resulting culture of consumerism do little to ensure long-term economic development. When oil revenues shrink in the downturn of the cycle, unemployment and reduced rent redistributions feed anger, just when the state's ability to spend on security and population appeasement is waning.

How can we escape the global oil curse? Diversifying and developing Middle Eastern economies to create employment opportunities and absorb occasional petrodollar flows is crucial. Oil exporters also need to think more strategically by investing in oil-production capacity during recessions and amassing aboveground reserves when prices are low to sell when prices are high.

Oil consumers also have long-term options. Large economies such as the United States, Japan, and China can reduce their oil consumption by investing in alternative energy, fuel-efficient technology, and public transportation. They can also wield their strategic oil stockpiles as a cudgel against speculators -- as U.S. President Bill Clinton did with success in the 1990s. During economic downturns, they can restock those reserves to stabilize oil revenues for producers, in the process selling high and buying low. Careful regulation of oil derivatives markets can help to curb harmful speculation.

These sorts of technocratic policy fixes, however, are not nearly enough to address the larger problem. We need high-level international coordination, in part through platforms such as World Trade Organization and G-20 summits. Over the past 50 years, oil importers and exporters have repeatedly sought temporary advantage by treating their mutual relationship as a repeated zero-sum game. Major consuming countries limit access to refining, marketing, and retail fuel outlets and lecture producers on the virtues of free markets when prices are low. In turn, producers invoke nationalism and curb supply when prices are high (while giving the same lectures on the virtues of free markets). Invariably, however, as the cycle has continued to rage on, the resulting gains for one side or the other have been fleeting. Worse, globalization has ensured that economic, geopolitical, and security problems in one part of the world now spill quickly into others, further negating any short-term benefits of myopic self-interest.

Without a change, the next phase of the cycle could be catastrophic. The next banking crisis, for example, might be accompanied by a currency crisis for the U.S. dollar, which has been the linchpin of the international financial system since World War II. Or conventional Middle Eastern arms races could easily turn into unconventional ones, increasing the chances that terrorists will get their hands on weapons of mass destruction.

Today's problems will look trivial in comparison. 

Photo by Gisel Florez for FP; Styling by Brady Taylor Wilson