Robert McNally on energy at U.S. Congressional Hearings

[I think it is interesting to know what Congress hears about energy from experts, and what the official U.S. energy policies are.  It is frustrating that Energy Return on Invested (EROI) is never discussed, even by intelligent analysts like McNally.  Nor is the enormous ecological harm of biofuels – their stripping of topsoil, depletion of aquifers, their dependence on natural gas based fertilizer and oil, destruction of rainforests to grow palm oil, negative EROI, and the myriad reasons why cellulosic biofuels are unlikely to be developed discussed at hearings (i.e. “Peak Soil“).  Well, what else can be expected of a scientifically illiterate congress and public?  With so many leaders crowing energy independence, the train is picking up speed as it heads for the ecological brick wall, not slowing down. 

Alice Friedemann  author of “When Trucks Stop Running: Energy and the Future of Transportation, 2015, Springer]

House 113-2. February 13, 2013. American Energy Outlook: Technology, Market and Policy Drivers. U.S. House of Representatives. 119 pages.

Testimony of Robert McNally

We must recognize that our standard of living is closely and inextricably linked to fossil fuels.

It is hard to overstate but often overlooked how much modern civilization depends on continuous access to the substantial flow of fossil fuels from producers to consumers. The displacement of bioenergy [i.e. wood] with coal made the industrial era possible. Subsequent use of oil and natural gas augmented coal and enabled our modern transportation and electricity sectors to develop. Concentrated and abundant energy stores of coal, gas and oil power virtually all we do at the current state of technological development.

Transportation, which is critical to food supply chains and other core systems society needs to function, today runs almost entirely on oil.

Electrical generation taps a more diverse suite of fuels but much of it, too, is fossil fuel powered.

“Energy,” as Nobel chemist Richard Smalley noted in 2003, “is the single most important factor that impacts the prosperity of any society.” Fossil-based energy or hydrocarbons–oil, gas, and coal–are far superior to other primary energy sources because they are dense, highly concentrated, abundant, and comparatively easy to transport and store. That is the case now, and it is expected to be the case in the coming decades. The latest EIA International Energy Outlook forecasts that world energy consumption will rise by 53 percent by 2035 and fossil fuels ’ share of total energy consumption will rise from 74 to 79%.

Patience about the time it takes to transform energy systems

The pace of energy transformations depends on both the availability of economical stores of energy and the development of devices that can turn those energy stores into “work” such as light, heat, and mobility. Major energy transitions take a very long time, measured in decades if not generations.

The respected energy expert Vaclav Smil in 2008 “ Moore’s Curse and the Great Energy Delusion, The American Magazine:

“Energy transitions” encompass the time that elapses between an introduction of a new primary energy source oil, nuclear electricity, wind captured by large turbines) and its rise to claiming a substantial share 20 percent to 30 percent) of the overall market, or even to becoming the single largest contributor or an absolute leader (with more than 50%) in national or global energy supply. The term also refers to gradual diffusion of new prime movers, devices that replaced animal and human muscles by converting primary energies into mechanical power that is used to rotate massive turbogenerators producing electricity or to propel fleets of vehicles, ships, and airplanes. There is one thing all energy transitions have in common: they are prolonged affairs that take decades to accomplish and the greater the scale of prevailing uses and conversions the longer the substitutions will take. The second part of this statement seems to be a truism but it is ignored as often as the first part: otherwise, we would not have all those unrealized predicted milestones for new energy sources.

The main reason why it would take many decades to transform our energy system is that our energy system is colossal. Developed countries have made, and continue to make, enormous investments in recent years in fossil energy production, transportation, refining, distribution, and consumption systems and devices that could not quickly be replaced in any reasonable scenario, even if an alternative energy source was available. Whether one regards our society’s massive investment in and dependence on hydrocarbons as an addiction or a blessing, it is here to stay for many more decades.

Humility and restraint about predicting, much less attaining, arbitrary and aggressive energy targets

The historical record is littered with overly optimistic or scary predictions and policy targets , by experts and non-experts alike. While energy surprises can be humbling for analysts, too often leaders and observers ignore technology, geology, and economics and either predict or prescribe unachievable targets.

They range from period cries of imminent peak oil, through confident predictions in the 1950s that nuclear energy would be “too cheap to meter”, to President Nixon ’s declaration that the US would be energy independent by 1980. Widespread adoption of electric cars or deployment of renewable energy technologies has a long and sad history of failure going back over a century. Just six years ago, Congress passed a law mandating 36 billion gallons of biofuels consumption by 2022 that EIA analysts say cannot be met given economic and scientific realities. In July 2008 former Vice President Al Gore called for the US to commit to producing our entire electricity supply from renewable sources within 10 years. Though he described the goal as “achievable” and “affordable” not one energy expert I am aware of would agree this is even remotely possible. At best, arbitrary and aggressive targets can mislead the public about the complexities and uncertainties involved in energy market transformations and at worst when such targets are married to costly mandates or subsidies, they can become expensive policy errors. I would respectfully recommend policy makers abjure from basing policy on arbitrary, unrealistic targets, much less basing mandates or subsidies on them. Energy transformations are more akin to a multi-decade exodus than a multi-year moonshot, as pretending otherwise misleads citizens and distracts from serious debate about real circumstances and solutions.

Senate Hearing. June 23, 2015. American Energy Exports: Opportunities for U.S. Allies and U.S. National Security. Subcommittee on Multilateral International Development, Multilateral Institutions, And International Economic Energy, And Environmental Policy

Oil and natural gas are the lifeblood of modern civilization. Their abundance and affordability are prerequisites for thriving economic growth, high living standards, and ample employment. They are also an essential requirement for our national security. U S foreign policy has historically benefited from our strong position as a producer and exporter of energy. While we were known as the “Arsenal of Democracy” during World War II, we were equally an “Arsenal of Energy” , supplying nearly six out of seven barrels consumed by the Allies. 1 Even after net crude imports began rising steadily after the war, our control of spare production capacity enabled us to supply our allies and prevent economically damaging price spikes that would have resulted due to oil supply disruptions associated with Middle East conflicts in 1956 and 1967.

But after the energy, geopolitical, and economic convulsions of the 1970s , our confidence in our domestic abundance and control shifted to apprehension about dependence and vulnerability. For the past forty years our foreign and national security policy planning has prioritized preparing against supply interruptions and price spikes, protecting Middle East oil fields from hostile control , an d protecting the supply lines between the region and global markets. In this respect, the tremendous and unexpected boom in domestic oil and gas production in recent years is an enormous blessing for our country. In the last ten years, our net oil imports fell from 12.5 mb/d to 5 mb/d (in the first quarter of 2015) or from 60% to 24% of supply. 2 For the first time since the 1950s, most official projections see U.S. net energy imports, which includes all fuels, declining and eventually ending. 3 Our newfound abundance does not mean we can ignore the Middle East, which holds nearly half of the world’s prove n oil reserves and supplies one-third of global production. That region will remain a source of potential price and supply shocks, and its stability will therefore remain a vital national interest. But our domestic boom does confer enormous benefits and require s that we change our thinking about energy.

It is important to realize that we need not export large quantities of gas to benefit from a foreign policy standpoint. Just having the option to buy from the US strengthens the bargaining power of our allies when they negotiate long term contract prices with suppliers like Russia. Last December, Lithuania opened a costly LNG import terminal, an example of an ally willing to pay a security premium for diversified source of supply. Lithuania’s new terminal forced Gazprom to drop its prices to Lithuania, reportedly by 20%.

Natural gas

While much attention is paid to the spectacular turnaround in our oil supply and imports, it is worth remembering our need for imported liquefied natural gas (LNG) underwent a similar and surprising transition. Between 2002 and 2007 our LNG imports had more than tripled, and officials were expecting another doubling. We were building terminals to import from suppliers like Qatar and Russia . But after the shale gas revolution increased proven reserves by 77% from 200 billion cubic feet (bcf) in 2004 to 354 bcf last year, we are now on track to become a net natural gas exporter by 2017, according to EIA.

1 A History of the Petroleum Administration for War , 1946, p. 1.

2 June 2015 Short Term Energy Outlook, Table 4a.

For historical data, see EIA. In 2005, total product supplied was 20.8 mb/d and net imports were 12.5 mb/d.

3, slide 2

McNally, B. July 19, 2011. Outlook for US Biofuels. 2011 Agricultural symposium, Federal Reserve Bank, Kansas City, Missouri

My outlook for biofuels is, in a word, stark.

First, corn ethanol’s political power in Washington has peaked and is now in surprisingly rapid decline. Future policy support is blocked, and past policy supports are being scaled back. No one expected such a dramatic turnabout, the speed and extent of which is startling. Corn ethanol will be lucky to hold on to a 15 billion gallon per year (bgy) blending mandate, and other, “advanced” biofuel mandates are likely to be reduced by future Congresses or EPA. This shift in policy support for corn ethanol is not yet fully factored into commodity market analysts’ and energy investors’ expectations.

Second, Washington is unlikely to help ethanol surmount the main public policy impediment to greater biofuels blending–i.e. the 10% of gasoline “blend wall.” Washington’s new power constellation and fiscal austerity imperative will limit the future regulatory or fiscal support needed to push ethanol into intermediate blends (e.g. E15) or E85. In the absence of high public support, future growth in ethanol will require technical breakthroughs that dramatically lower costs and allow for production at the commercial scale.

Finally, when ethanol is blended at levels below the blend wall, prices will depend on ethanol’s suitability as a substitute for gasoline, which in turn depends on oil prices. Oil prices are likely to see greater cyclical swings as OPEC is not investing in enough capacity to retain an adequate supply buffer with which to dampen volatility. Greater oil price swings will reduce certainty and bedevil investment in conventional and bio-based energy.

When OPEC supplanted the United States 40 years ago as the dominant force in global oil markets, oil prices rose and imports soared, and energy security became a top policy priority. To promote the growth of a domestic transportation fuel supply, Washington exempted ethanol from part of the federal motor-fuel taxes, placed a tariff protection on imports, mandated government fleet purchases, and extended loans and loan guarantees for ethanol plant investment and federal R&D. Later, policymakers added pro-ethanol incentives in federal fuel economy rules and provided a volatility waiver to the formula in the oxygenated and reformulated fuels programs.

Although President Reagan pared back some support for ethanol, Republican ethanol champions such as Senators Dole, Lugar, and Grassley, as well as longtime Senate Energy Committee Chairman Pete Domenici, protected the blending credit, and the tariff protection survived and was increased. Ethanol has historically enjoyed strong voting blocks in the House and Senate, and the importance of Iowa’s role in the presidential nomination process is not lost on aspiring presidential candidates.

In the 1990s another rationale for ethanol blending emerged: environmental protection. The 1990 Clean Air Act Amendments (CAAA) mandated oxygenates in gasoline to reduce carbon monoxide emissions resulting from gasoline combustion.   And as ethanol’s chief competitor in the oxygenate market–MTBE–was phased out due to concerns over water contamination, ethanol benefited further. In the last decade, both energy security and environmental rationales for ethanol blending combined to create a third, and by far the biggest, political wave of support for ethanol. Terrorist attacks and oil price gyrations renewed national alarm about energy security, and the reduction of greenhouse gas emissions became the holy grail of the environmental movement.

By offering benefits and political support to both causes, ethanol supporters succeeded–via the 2005 and 2007 energy policy acts–in achieving a new and powerful policy support for ethanol–a large and direct blending mandate. Specifically, in 2007 Congress ordered that the US blend 15 bgy of ethanol into gasoline by 2015, which translates into a conversion of some 40% of the US corn crop into 10% of the gasoline pool. And the nation must consume another 21 bgy of advanced cellulosic, not corn starch-based) ethanol by 2022. From a n energy policy and political perspective, the ethanol mandate is probably the single most impactful energy policy Washington has implemented in the last 11 years.

From a financial market perspective, it is no secret that neither Wall Street nor the oil industry is terribly fond of ethanol on its merits. But market participants have come to believe ethanol is a winner in Washington. As Senator Feinstein observed: “Ethanol is the only industry that benefits from a triple crown of government intervention: its use is mandated by law, it is protected by tariffs, and companies are paid by the federal government to use it. Investment in ethanol production and actual blending soared. Commodity analysts and traders began to assume a greater part of future liquid fuel demand would be met by biofuels. And oil companies began to acquire ethanol facilities and started to view corn fields as upstream energy assets.

Looking around

As we turn to the near past and present, it is striking to watch how ethanol’s fortunes have fallen so hard and so fast in Washington. The change was completely unexpected and is still underway, and market participants have been slow to realize it. I must admit, as one who has been noting the turnaround in ethanol’s fortunes over the recent years, the collapse in recent weeks has been breathtaking.

With the benefit of hindsight, signs of the trend shift emerged in 2008, when agricultural commodity prices soared as ethanol was ramping up in response to the 2007 RFS. Of course, other factors were also at work in the commodity price boom. But there had been no prior official analysis by EIA or anyone else of the impact of the RFS on grain prices. Unusually for such a major energy policy initiative, Washington mandated first but analyzed and debated later. Now well underway, the food versus fuel debate will rage for years. But in Washington perception matters as much as reality, and the perception was and is that biofuels mandates contributed to rising food prices. The second shift came in 2009, when the always-tenuous alliance between the environmental community and the ethanol community began to sour. While g reen groups appreciate d corn ethanol’s utility in reducing carbon monoxide, they were irked by exemptions from tough rules limit ing vapor pressure. Nor did they like the fossil fuel consumption, land-use impacts, and life-cycle carbon emissions associated with higher ethanol blending. But as long as cap-and-trade was on the table in the late-Bush and early-Obama administrations, Greens held their noses and allied with ethanol. Greens did lay some traps in the path of potential corn ethanol growth by insisting in the 2007 RFS that biofuels blending above 15 bgy come from more efficient, less carbon emitting sources than corn, such as cellulosic ethanol.

But in the last two years, the Great Recession and Republican gains in the 2010 election have taken cap and trade off the table, and as a result the falling out has gathered steam. Now that the chief rationale for the ethanol-green alliance has fallen away, tensions are laid bare and the gloves are coming off. Green groups are stepping up opposition to ethanol on grounds that it emits high amounts of carbon on a life cycle basis and that blending credits are an expensive way to cut carbon emissions. The Congressional Budget Office estimated blending credits cost about $750/ton of CO2 equivalent reduction. 2

The third, and I would argue most important, challenge corn ethanol faced was the emergence of fiscal austerity and the need to tighten fiscal policy, which is now the primary focus of the Republican-controlled House and also the top priority of the Senate and White House. And given the size of our fiscal imbalances and the election outlooks of most observers, it is fair to assume Washington’s budget cutting imperative won’t be going away soon. Even those without a strong anti-ethanol bias found it hard to justify continuing a blending credit for a product whose demand is mandated. Environmental groups joined with their usual foes on letters to Congress opposing E15.

Long envied, courted, and respected, ethanol now finds itself vulnerable, low-hanging fruit and facing an “unholy coalition” environmentalists, fiscal conservatives, the oil and food industries, and small engine manufacturers able and willing to block its growth and take back its prior gains.

The first tangible signs that corn ethanol was in trouble in Washington came during the E15 debate in 2010, when Congress and the White House failed to direct EPA to grant ethanol the sweeping waiver for E 15 it desired. Then the Tea Party and Republican House came to town. Turning first to E15, the House voted twice to deny federal funding for E15 blending pumps and storage tanks, by 262-158 and 283-128, and by 285-136 to block E15 waiver implementation.

Then the $6bn per year blending credit moved to the center of the bulls-eye. In June, the Senate voted 73-27 for a Coburn/Feinstein proposal to end the blending credit immediately rather than wait for end-year expiration. A strong reversal from the 1990s, when it was the anti-ethanol forces that typically lost Senate votes with counts in the 20s.

The most recent indication of how far corn ethanol’s star has fallen came during President Obama’s recent news conference–actually the first Twitter town hall. He raised eyebrows calling corn ethanol producers “probably the least efficient producers [compared with cellulosic]” and saying “ it’s important for even those folks in farm states who traditionally have been strong supporters of ethanol to examine are we, in fact, going after the cutting-edge biodiesel and ethanol approaches that allow, for example, Brazil to run about a third of its transportation system on biofuels. Now, they get it from sugar cane and it’s a more efficient conversion process than corn-based ethanol. And so us doing more basic research in finding better ways to do the same concept I think is the right way to go.” The President reportedly has put the blending credit on the table to help offset a continuation of the payroll tax cut.

Adding further support to the negative outlook for ethanol, official energy analysts making long term projections of fuel mix are becoming more cautious about biofuels growth . Whereas International Energy Agency IEA projections had ethanol accounting for almost half of gasoline demand growth in the last five years, IEA now projects the fuel will account for less than a quarter of demand growth in the next five, despite higher projected oil prices, 3 due to higher corn prices and greater uncertainty aro und mandates. 4 IEA sees global biofuels rising from 1.8 mb/d to 2.3 mb/d by 2016, displacing some 5.3% of gasoline and 1.5% of diesel by 2016 on an energy content basis. 5 IEA does not expect cellulosic biofuels to achieve widespread cost competitiveness with conventional gasoline until 2030, despite aggressive mandates. EIA, March 24, 2011. , slide 4.

IEA projects advanced biofuels will rise from 20 kb/d now to 100-130 kb/d in 2016. Even DOE’s forecasting arm, the Energy Information Administration, projects the US will fail to meet advanced biofuels targets by 2022.

Looking Ahead

Discussion about weakening the RFS has already started in Washington. Senator Inhofe (R-OK) and Representative Issa (R-CA) have introduced the Fuel Feedstock Freedom Act, which would allow states to withdraw from the RFS. However, state opt-outs are likely to be logistically difficult if not unworkable. Eventually either Congress or EPA will probably reduce the mandate to prevent it from colliding with the blend wall and raising gasoline prices. The ethanol lobby saw the blend wall danger and first tried to surmount it by getting EPA approval for “intermediate” blends above 10%, such as 15% ethanol or E15. Ethanol forces are trying to secure federal funding and indemnification for intermediate blend infrastructure and consumer acceptance. While EPA (grudgingly, I suspect) granted partial approval for E15 blends, they did so in the full knowledge that very little is likely to be sold due to large remaining infrastructure compatibility, cost and liability concerns, as spelled out in a recent GAO report. 9 Even ethanol-laden companies like Marathon and Valero said they would not offer E15. While ethanol forces took heart when Senator McCain’s bill against ethanol pump funding failed 40-59, it is far from certain that Congress will be in the mood to grant ethanol additional funds or legal protection to enable E15 growth.

Grains and oil converge

From a commodity market perspective, it is noteworthy that grain and fuel prices are becoming more correlated and volatility is going up. Wallace Tyner noted the rapid explosion in ethanol’s market share has established a high and positive correlation between crude oil and corn that has not previously existed. Below the blend wall, the price of crude will drive ethanol prices. Above the blend wall, the price of corn will drive ethanol prices. There are also important linkages between the RFS and higher grain price volatility. As the RFS mandate rises, it will introduce a price-insensitive source of demand for corn. That in turn will impart greater price volatility back onto agricultural markets.   Two academics recently estimate d that at times when the RFS is driving ethanol demand instead of high oil prices relative to corn, inherent volatility in US grain markets will rise by about 25%.   And volatility of US coarse grain prices in response to supply side shocks in energy markets will rise by almost one-half.

A word about biodiesel and wind energy

Biodiesel history has mirrored that of corn ethanol. The inventor of the diesel engine, Rudolph Diesel, actively considered agricultural feedstocks as a fuel. But petroleum distillate established a dominant position, though oil price hikes of the 1970s renewed interest in homegrown alternatives.

Commercial production of biodiesel began in the 1990s, but only increased sharply since 2004 when a $1 blending/production credit was implemented.   In 2005, supplemental credits for the “renewable diesel tax credit” (“renewable” diesel does not use alcohol in conversion) and “small agri-biodiesel production credit” also went into effect. Biodiesel production was around 30 million gallons before 2005, but by 2008 was over 700 million gallons per year, with a large portion exported (though the EU has since imposed an import tariff that has hurt US exports). Biodiesel remains expensive compared with petroleum distillate. Biodiesel economics feature a high correlation between soybean oil and conventional diesel prices, since it takes a gallon of soybean oil to produce a gallon of soy-based biodiesel. In addition, soy-based biodiesel has a slightly lower energy content than conventional diesel. Bruce Babock, of Iowa State University, has noted biodiesel marginal costs are $2 per gallon higher than diesel, requiring a $1.00 credit and $1.00 RIN price. 12 This makes most analysts cautious about the outlook for biodiesel growth. IEA projects biofuel-based distillate will account for only 4% of diesel demand growth in the next five years, compared with having taken 9% over the last five. 13 EIA expects US biodiesel use to rise from 0.1% of total liquids supply or 0.6% of diesel fuel consumption in 2010 to 0.6% of total supply and 3.0% of diesel demand by 2035. 14 The $1 per gallon biodiesel blending credit does not attract as much support or opposition as the ethanol blending credit. Because biodiesel blending, and therefore subsidy costs, have been lower, it has avoided the attention of the budget cutters, so far. But being small has its downsides too–Washington has frequently let the biodiesel credit expire with barely a whimper. When the credit last expired in 2010, the industry estimated production fell 42 percent and nearly 9,000 jobs were lost. Production fell despite a retroactive and rising RFS mandate, and exports were hurt by an EU import tariff.

As for wind, challenges to large-scale commercialization are fairly well understood. They include intermittency, austerity, distance from load centers, political opposition, and low natural gas prices. However, I am skeptical that $4 per Mmbtu natural gas will endure for too long, given questions about the economics and politics of shale gas production as well as strong political opposition to new nuclear and coal build-out. But ultimately wind cannot scale unless large cost and technological barriers are broken, not the least of which are storage and transmission and public opposition on footprint grounds is overcome.

  • Babcock, Bruce, The State of Biofuels Today, Iowa State University, April 2011
  • Babcock, Bruce A., Mandates, Tax Credits, and Tariffs: Does the U.S. Biofuels Industry Need Them All? CARD Policy Brief, Iowa State University, March, 2010
  • Babcock, Bruce and Carriquiry, Miguel, A Billion Gallons of Biodiesel: Who Benefits?,
  • Iowa Ag Review Online, Winter/2008,
  • Congressional Budget Office, Using Biofuel Tax Credits to Achieve Energy and Environmental Policy Goals, July 2010
  • Congressional Research Service, Intermediate-level Blends of Ethanol in Gasoline, and the Ethanol “Blend Wall,” January 28, 2010
  • General Accounting Office, Biofuels: Challenges to the Transportation, Sale, and Use of Intermediate Ethanol Blends , June 2011
  • Glozer, Ken G., Corn Ethanol: Who Pays? Who Benefits? Hoover Institution Press, 2011
  • Hertel, Thomas W., and Beckman, Jayson, Commodity Price Volatility in the Biofuel Era: An Examination of the Linkage Between Energy and Agricultural Markets , July, 2010
  • International Energy Agency , Medium Term Oil and Gas Market Report , June 2011
  • Tyner, Wallace E., The Integration of Energy and Agricultural Markets, presented at the 27th International Association of Agricultural Economists Conference, Beijing, China, August 16-22, 2000
  • Tyner, W., Dooley, F., Hurt, C., and Quear, J. Ethanol Pricing Issues for 2008. Industrial Fuels and Power, 2008


Serial No. 112-89. December 16, 2011. Changing energy markets and U.S. National Security. House of Representatives. 69 pages

Robert McNally, President of the Rapidan Group, on Changing Energy Markets and US National Security.

Oil is the only major energy commodity we import and lies at the center of our national security concerns.  Our energy security is and will remain strongly linked to trends and developments in the global oil market, not just our import share. We are and will remain vulnerable to price shocks caused by tightening global supply-demand fundamentals and geopolitical disruptions anywhere in the global oil market. And the strategic importance of the Persian Gulf region and its enormous, low-cost hydrocarbon reserves is likely to grow in the coming decades as Asia taps them to fuel growth. Our geopolitical and homeland security interests will remain closely bound to the security of the Persian Gulf region, the sea-lanes to and from it, and the ability to prevent Gulf countries from spending their windfalls on threats to US and global security.

It must not be overlooked that the world urgently needs new productions just to offset declining production in mature fields. The global oil industry needs to find an amount equal to two-thirds of existing conventional production, or 47 mb/d, in coming decades just to offset declines in mature fields. This is in addition to the new oil needed to meet demand growth in Asia and the Middle East.

Ethanol accounts for about 10% of gasoline, and EIA projects all biofuels will rise from 4% of liquids supply in 2009 to 11% by 2035.

While higher US and hemispheric production can and should help fill the gap, OPEC and the Persian Gulf producers hold the bulk of the world’s low-cost, proved reserves (70% and 55%, respectively).

Foreign policy makers should take into account three global energy market changes that will pose large challenges to our energy and economic security. The first is voracious growth in demand for energy, as well as for other natural resources, particularly from densely populated, fast-growing Asia, especially China and India. Achieving modern living standards in developing countries is impossible without consuming large amounts of dense, storable, reliable, and affordable energy. By these measures, fossil fuels are and will remain far superior to alternatives, especially in transportation. Unfortunately, no large scale, commercially viable alternatives to oil exist or are visible on the horizon. The US and other developed countries have made massive investments in oil fields, pipelines, terminals, refineries, tanks and dispensing stations in past decades. And rising Chinese, Indian and other Asian and Middle Eastern economies are starting to do the same.

Second, China and India are going to become tremendously dependent on flows of oil from the Middle East. The International Energy Agency projects China’s oil import dependence will rise from 54% in 2010 to 84% in 2035, and India’s will rise from 73% to 92% over the same period.3 The lion’s share of these imports will come from the Middle East. This is going to make China and India extremely concerned about protecting their access to Gulf supplies and sea-lanes, which is already a strategic concern for the United States.

Third, oil prices are going to gyrate more wildly than in the past as Saudi Arabia and OPEC’s ability to prevent price spikes erodes due to reduced spare capacity. This transition is overlooked but just as important as the first two noted above. The world oil market is leaving the relatively stable OPEC era and entering a new “Swing Era” in which large price swings rather than cartel production changes will balance global oil supply and demand. The Swing Era portends much higher oil price volatility, investment uncertainty in conventional and alternative energy and transportation technologies, and lower consensus estimates of global GDP growth. Ironically, Western governments and investors will miss OPEC, or at least the relative price stability OPEC tried to provide.

In summary, soaring Asian energy demand, sharply increasing Asian dependence on the Persian Gulf, and wild oil price gyrations pose major challenges to US energy security and foreign policy.

What is the future role of OPEC? What happens to price stability?

The changing role of OPEC, with its implications for oil price stability, is the most important, and so far overlooked, feature of global energy markets. It will have enormous consequences for US economic and foreign policy, especially in our bilateral relations with Saudi Arabia, as noted further below. In short, soaring global demand and constrained supply growth is causing OPEC to lose its spare capacity cushion and therefore its ability to stabilize oil prices. While intuitively OPEC losing control may seem like a good thing, it actually means global oil prices, and therefore our pump prices, are going to swing much more wildly in the future, at times high enough to contribute to recessions as they did in 2008.

As a commodity, oil exhibits what economists call a very low price elasticity of demand. In plain English, this means supply and demand are very slow to respond to price shifts. Oil is a must-have commodity with no exact substitutes; when pump prices rise, most consumers have little choice in the near term but to pay more rather than buy less. And on the supply side, it takes years to develop new resources, even when the price incentive to do so rises sharply.

Since the beginning of the modern oil market, producers have tried to mitigate the tendency of oil prices to swing wildly. Standard Oil, the Texas Railroad Commission and the “Seven Sisters” (major western oil companies) succeeded at stabilizing prices by controlling supply, most importantly by holding spare production capacity back from the market and using it to balance swings in supply and demand. The 1967 Arab oil embargo did not lead to a major oil disruption or price spike, partly because the United States had spare capacity in reserve and increased production to make up for lost Arab producer exports. The 1973 Arab oil embargo did lead to an oil price spike, mainly because the year before – in March 1972 to be exact – the United States ran out of spare capacity.

OPEC took over control of the global oil market from the US and the Seven Sisters in the early 1970s. Since the mid-1980s, OPEC’s main tool to stabilize prices has been holding and using spare production capacity. If demand jumped unexpectedly or if supplies were suddenly disrupted, OPEC producers with spare capacity, especially Saudi Arabia, would release more oil, reducing the need for prices to swing in order to balance supply and demand.

But the years 2005-2008 marked the first time spare capacity ran out in peacetime since 1972. As in 1972, the reason was demand was racing faster than production. But today, no new cartel waited in the wings to satisfy global crude appetites. In 2008, market balance was achieved by sharply rising oil prices along with the financial crisis. While many in Washington, Paris, Riyadh, and Beijing publicly blamed speculators, energy experts and economists pointed instead to strong demand for a price inelastic commodity running up against a finite supply.

Going forward, OPEC will still be able to influence how and when oil prices bottom. It can and will likely still take oil off the market to keep prices from falling or to raise them, as it did in late 2008 and 2009.

But OPEC’s ability – really, Saudi Arabia’s ability – to prevent damaging price spikes has eroded. Therefore a replay of 2005-2008 is more a question of when than if. Global GDP growth remains oil intensive. When it picks up (and there are many macroeconomic risks currently, so the timing is uncertain), net non-OPEC supply growth is not expected to rise fast enough to meet incremental demand, requiring OPEC producers to increase production. OPEC is not investing enough in total production capacity to meet demand growth and still maintain the 4-5 mb/d spare capacity buffer needed to assure market participants it can respond to disruptions or tighter than expected fundamentals by adding supply. Saudi Arabia, the main spare capacity holder, says it will hold only 1.5 to 2.0 mb/d of spare capacity, and most other OPEC countries hold little if any back in spare.

As OPEC falters, the price mechanism will return to balance the market through demand destruction, enforcing the iron law that consumption cannot exceed production. Even if our import dependence declines, we will still be vulnerable to price gyrations that are very harmful for consumers and producers and will bedevil economic and foreign policymaking.4

What role do/should energy markets play in U.S. national security policy? In U.S. defense posturing?

Even if our import dependence falls, the US will still have a vital national security interest in the Persian Gulf region. Instability or disruptions in the Gulf will be felt quickly and directly at the pump in the US. Gulf producers will earn billions of dollars in revenue, and the US has an interest in seeing that those dollars do not finance terrorism or other threats to our security. And the US will need to ensure no country can use oil as a weapon or threaten vital trade routes and chokepoints.

While the US must find ways to share the costs, burdens, and responsibilities for protecting the global energy commons, our interest in preventing a regional or external hegemon from dominating the Persian Gulf will remain as vital in the next thirty years as it was in the past. The Carter Doctrine and its Reagan corollary must remain cornerstones of our energy security doctrines. The Carter Doctrine states: “An attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and such an assault will be repelled by any means necessary, including military force.” And its Reagan corollary extends the policy to include hegemonic threats to our Gulf allies by hostile regional powers, like Iran.

It will be especially important to repair and strengthen the fraying US relationship with Saudi Arabia. The relationship will likely loosen somewhat as Saudi Arabia and other Gulf producers see future sales growth and profits in Asia instead of the western hemisphere. But something bigger is at stake: The grand bargain whereby the US provides Saudi Arabia protection from regional and global adversaries in return for Riyadh ensuring stable oil supplies and prices. This grand bargain has served our national and economic interests, and mitigated occasional wars and disruptions in the region.

At present, each side is less certain the other can uphold his end of the bargain. If, as noted above, Saudi Arabia can no longer prevent oil price spikes from damaging the economy, it becomes less important in global affairs and US foreign policy. And if the US can no longer protect Saudi Arabia from a nuclear, belligerent Iran, then Riyadh’s interest in cooperating with us in many areas, including counter-terrorism and regional security, could decline.

Vulnerability of current and future energy markets to terrorism

Terrorists understand the vulnerability of energy infrastructure.  One consequence of low spare capacity is that any disruption, even of a relatively small size, can lead to an oil price spike. We saw this earlier this year in Libya, when the world lost about 1.7 mb/d of supply, equal to about half of total OPEC spare capacity. Prices jumped about $15 per barrel, helping to push gasoline prices here up to $4.00 per gallon and thereby hurting family budgets and economic growth.

What role does energy play in China’s foreign policy? What can be done to check China’s energy development in the western hemisphere?

China’s leaders are preoccupied with finding resources to supply its voracious growth, including energy resources. As its oil imports increase rapidly, China has followed an energy strategy similar to our policies over recent decades. As the US did forty years ago, China is reacting to the prospect of high and rising dependence on imports by building strategic stocks and implementing fuel economy and other efficiency standards. China is also fostering the growth of globally competitive energy companies and diversifying its sources of energy. And it is developing political relationships and strategic capabilities to protect its investment and supply lines.

China’s energy security policies could pose major indirect threats to our national security if Beijing concludes it can and should ignore our national security interests when engaging with foreign producers. This is of concern with Sudan, Venezuela, and especially Iran.

The Energy Information Administration (EIA) estimates US shale gas production has increased twelve-fold over the last decade, now amounting to 25% of total production. EIA projects shale gas will rise to 47% of total production by 2035. Whereas a few years ago we faced the prospect of importing increasing amounts of liquefied natural gas (LNG), we are now permitting export facilities. This new supply holds the potential to revitalize our chemical industry and economically depressed regions of our country, use more natural gas in electricity generation, and possibly fuel natural gas vehicles (though the cost of converting car and truck fleets and fueling infrastructure to natural gas would be very high and the transition would be long, making it impractical except in some centrally-fueled commercial fleets).

Even if we didn’t import a drop from the Middle East, our vital national interest there would remain. The Middle East and the Persian Gulf is and will remain the world’s most important energy region. As of 2009 it held 56 percent of global proven oil reserves, nearly all of those in the Persian Gulf.

With a higher market share and higher prices, Middle Eastern oil producers are going to earn trillions and trillions of dollars in revenues. We must remain engaged in that region partly to ensure that windfall is not spent to threaten us or our allies.

Another interest is to make sure that China and India’s soaring dependence on Middle East oil flow, mentioned earlier, does not lead to strategic competition or conflict. The International Energy Agency sees China’s import dependence headed over 84 percent and India’s over 92 percent by 2035.

U.S. foreign policy can and should aim to share the costs, burdens and responsibilities of protecting the Gulf and sea lanes with other friendly and capable importers. Such cooperation exists to some extent already, such as with multi national anti-piracy patrols. But for the foreseeable future only the United States can play the role of guaranteeing the stability of the Persian Gulf.

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