Oil Wars

Today I am going to reprint the testimony before the United States Senate of the Vice-Chairman of Golman Sachs with regard to the global oil situation and its potential impact on the United States. I found it quite illuminating, even if it only confirmed points already known rather than really revealing anything new. Nevertheless, given that those points often passed un-percieved or are even denied it is worth reading this testimony. I'll have more to say about it in follow up posts. Bolding in mine:

Testimony of Robert D. Hormats
Vice Chairman, Goldman Sachs (International)

The Global Oil Balance and its Implications for U.S. Economic and National Security Committee on Energy & Natural Resources United States Senate
January 10, 2007

Mr. Chairman and Members of the Committee:

Thank you for your kind invitation to testify on the critically important subject of the economic and national security implications of America’s oil dependence.

I speak to you today as a citizen concerned about our nation’s increasing dependence on potentially unstable supplies of foreign oil. This dependence creates profound economic, political and security vulnerabilities. Also, a portion of the large amounts of petro-dollars accumulated by a number of suppliers is used in ways that threaten American interests.

By way of background, I was economic advisor to Dr. Henry Kissinger on the National Security Council staff in the mid 1970s when this country experienced its first energy crisis after the 1973 Yom Kippur War, and participated in his Middle Eastern shuttle diplomacy during the period that followed. At that time, I had high hopes that the Arab oil embargo, the sharp increase in the price of oil, and the long-lines at gas stations would produce a bipartisan consensus on energy policy and jolt our nation into a bold and effective effort to reduce oil dependence and future vulnerability. Indeed, some progress was made. The Energy Policy Conservation Act of 1975, championed by our late President Gerald R. Ford, launched a number of bold initiatives to achieve this goal. And the country did accomplish significant improvements in the efficiency of oil use through compulsory mileage standards for automobiles and because U.S. industry and power plants shifted dramatically away from using oil as a fuel.

But when prices fell later in the decade, a sense of complacency set in. Then we were hit by another crisis that caused oil prices to spike at the end of the 1970s; that was triggered by the fall of the Shah of Iran and the Iranian Revolution. Complacency set in once again after that crisis receded and prices fell. Another oil crisis occurred in 1990 when Iraq invaded Kuwait, after which the sense of urgency about dramatic alterations in energy policy and use faded again. Decade after decade our dependence on foreign oil has risen. In the mid-1970s, 35% of this nation’s oil consumption was supplied by imports. Now, three decades later, it is 60%.

After 9/11, again at the beginning of the current Iraq War in 2003, and again during the large price run-up in and the summer of 2006 the country had excellent opportunities and powerful incentives to confront energy vulnerabilities with a bold policy response. The 2005 Energy Policy Act contained a number of positive features — but these measures were not commensurate with the seriousness or the urgency of the energy challenge this country faces.

American dependence on potentially vulnerable oil supplies continues to grow, with little prospect that it will change — despite the fact that we are engaged in a War on Terrorism in which oil imports by the U.S. and other nations provide funds to nations hostile to the U.S. and countries friendly to us. It is often said that “9/11 changed everything!” Sadly, in the area of energy policy it hasn't changed very much. American oil vulnerability continues unabated.

There are several national economic and security consequences of this situation:

— If the situation in Iraq continues to deteriorate and other oil producing nations become more involved, the risks increase to oil supplies not only from disruptions in Iraq but also from greater tensions between the Sunni nations on the western side of the Persian Gulf and the Shiites on the eastern side, with oil facilities and shipments becoming increasingly vulnerable. Moreover, added western pressures on Iran over its nuclear program could lead to oil disruptions or threats thereof;

— The American economy remains highly vulnerable to supply disruptions in oil exporting nations; these could result from acts or terrorism, political instability, efforts to use oil as leverage, or natural calamities;

— High oil prices resulting from strong demand from countries such as the U.S. and other major importers give countries such as Iran and Venezuela added resources to take actions inimical to American interests;

— Oil-dependent friends and allies feel more vulnerable to the pressures and potential use of oil leverage from supplying countries and therefore are reluctant to side with the U.S. on key issues affecting those suppliers;

— Oil-related tensions and competition are likely to intensify—as countries such as China seek to lock up scarce supplies or make political deals to solidify long-term supply relationships, or suppliers such as Russian and Iran use oil as leverage to extract political concessions from consumers.

My concerns about this untenable and dangerous situation led me— together with a group of other concerned citizens—to join the Energy Security Leadership Council in an effort to press for greater and more resolute national action on this matter—and for an end to the divisive, highly polarized debate that has stymied genuine progress on many fundamental issues. The Council, a project of Securing America’s Future Energy (SAFE), is a nonpartisan group of business executives and retired military leaders. It recently unveiled a report entitled “Recommendations to the Nation on Reducing U.S. Oil Dependence.” (I will discuss a few of these later in my testimony, along with a number of recommendations that I believe can also contribute to progress in this area.) The members of the Council believe that America’s energy security is in a perilous state. Along with my fellow Council members, I am convinced that America’s leaders must move quickly and steadfastly to confront our high level of oil dependence as a profound national security challenge.


ENERGY INTERDEPENDENCE

Calls for “energy independence” offer a false promise to the American people. They also suggest a sort of xenophobia that implies that the U.S. can or should attempt to solve its energy problems with little regard for those of other nations. In fact, oil is a fungible global commodity, which means that events affecting supply or demand anywhere will affect oil consumers everywhere. A country’s exposure to world oil prices or oil price shocks is a function of the amount and types of oil it consumes; the ratio of “domestic” to “imported” oil is only a portion of the problem. Even if the U.S. could substitute domestic energy for all foreign oil—a goal the Council believes to be impossible—American economic prosperity would still be linked to the health of a global economy dependent on international oil flows. So as we work to enhance our own energy security we should also be strengthening international cooperation with oil producers and consumers to improve global energy security, efficiency, and environmentally responsible production and usage.

It is also important to make a distinction between dependence and vulnerability. There are numerous suppliers of oil that are very reliable and that use the funds earned in a constructive fashion. There are others whose facilities are vulnerable to disruption and that use funds in ways inimical to U.S. interests. But a large portion of the world’s oil comes from this in the second category, posing a series of economic, political and security risks.


KEY RECOMMENDATIONS

The Council recommends a goal of cutting U.S. oil intensity — the amount of oil it takes to produce a given amount of GDP—in half by 2030. There is a favorable precedent for this objective. Since the mid-1970s, the U.S. has managed to trim oil intensity by 50%, chiefly by raising the fuel efficiency of passenger cars, virtually eliminating oil as a fuel for electric power generation, and expanding less energy-demanding sectors of the economy, particularly in the area of services. As a consequence, the U.S. now uses half the amount of oil to produce a dollar of GDP, in real terms, as it did just thirty years ago. Unfortunately, however, progress in this area has slowed in the last ten years.

One key goal must be to make America’s prosperity less dependent on a commodity the production level of which responds only very slowly to changes in price. Combine this price inelastic supply with 1) the vulnerability of oil supplies to various types of disruption, 2) the fact that some countries see oil as a political as well as an economic commodity, and 3) the fact that much of the world’s production is in the hands of state owned oil companies, many of which use oil revenue for political or social ends rather than reinvest it in new production capacity, and you have the recipe for severe energy-related economic disorder.

As a result of the halving of U.S. oil intensity since the mid-1970s, the high oil prices experienced in the summer of 2006 represented a smaller relative cost to the economy than in the past. Further reductions in oil intensity would provide a measure of insurance against some of the effects of sudden future oil price shocks or sustained high oil prices. In addition, by boosting the production of alternative sources of energy to displace oil, we can create more production capacity at home, keep more of our money in this country, create a great number of new, high quality jobs in industries that manufacture and utilize new environmentally responsible energy production and conservation technologies, and develop new export products that can be sold to an energy hungry and environmentally conscious world.

The Global Energy Challenge

The global economy is in the midst of a period of extraordinary growth that promises to transform the lives of billions of people, bringing comforts and luxuries to regions where humankind has long struggled for subsistence. Creativity and the drive for a better life are the engines of this tremendous surge in output, living standards and productivity — but like all engines they require energy to function.

By 2020, world energy demand is forecast to jump by 50% over 2000 levels, with most of the increase coming in developing countries. The safe and affordable delivery of all this energy is by no means assured. Even if resources turn out to be sufficient in the aggregate, their distribution will not map closely to the topography of demand. The resultant uncertainty of supply and upward pricing pressure will exacerbate international tensions stemming from non-energy issues.

Oil provides only 40% of global energy, but, as the premier transportation fuel, it has emerged as the touchstone of the world’s energy outlook. On both economic and psychological grounds, oil price spikes threaten the prosperity of many nations, including many of the poorest on this planet. They also sow the seeds of tension between exporting and importing nations, among consuming nations, and among different groups within countries. Indeed, since so much oil is used for personal transportation, oil prices have an enormous impact on the pocketbooks of virtually every American family. Correspondingly, policy efforts that impact oil’s cost and availability must take into account the interests of the average American family and quickly become major political issues.

America’s Clear and Present Dangers

For much of the last century, surplus domestic oil production reduced U.S. vulnerability to oil disruptions elsewhere in the world. But America’s oil production is now dwarfed by current consumption. Thus, while the U.S. remains the third largest oil producer in the world, domestic production can satisfy barely 40% of its requirements.

The U.S. generates 28% of the world’s goods and services while consuming roughly a quarter of its oil production. This may seem like a balanced, even favorable energy equation, but closer inspection reveals a different story. Despite considerable progress toward more efficient energy use, America requires substantially more oil to create a dollar of Gross Domestic Product (GDP) than is the case in most other developed countries. Some of this differential in “oil intensity” can be attributed to our nation’s vast size, the dispersion of our population, and less reliance on public transportation. Global military obligations, which are inextricably linked to our commitment to secure the flow of oil for the benefit of all nations, further increase American consumption. But even with these extenuating factors, there can be little doubt that the U.S. can and must use energy far more efficiently.

America’s long-term supply and demand balance is no more encouraging. U.S. oil demand is expected to grow 24% over the next two decades, and even if new discoveries raise its current 3% share of global oil reserves, our nation will almost certainly still require substantial amounts of petroleum imports. Import dependence will also define energy security for our key allies and most of the world’s manufacturing nations. Unfortunately, the developed nations that consume most of the world’s oil are not in a good position to produce the fuels they need.

A large portion of the world’s oil reserves are owned by state-owned or controlled oil companies in non-O.E.C.D. countries. It is worth underscoring this point — especially because when oil prices were rising last summer there were many accusations, misguided in my view, that this was a conspiracy among the big oil majors, when in fact the six largest state oil companies have ten times the reserves of the top six privately owned companies. Some of these state companies are highly efficient and well run, but others are highly politicized and are not able to utilize their profits to increase production or modernize capacity. Because of the large state company role in the world’s oil markets, there is not a “free market” for oil. As a result, a substantial portion of production is politically influenced and production decisions and practices are frequently economically suboptimal. [ this is really funny - suboptimal for whom? - OW]

With each passing year, the global oil trends now at work—rising consumption, reduced spare production capacity, politicized spending decisions, and potentially high levels of instability in key exporting countries—all increase the likelihood of an energy crisis. The odds in favor of a crisis are further heightened by the rise of terrorist movements bent on targeting critical elements of the world’s vulnerable oil production, processing, and delivery infrastructure.

Given today’s precarious balance between oil supply and demand, taking even a small amount of oil off the market could cause prices to rise dramatically. In Oil Shockwave, a cabinet-level oil crisis simulation conducted in 2005 by SAFE and the National Commission on Energy Policy (NCEP), a 4% global shortfall in daily oil supply—only 3.5 million barrels in a 84 million barrel daily market—resulted in a 177% increase in the price of oil, to over $150 per barrel. The simulation was played out by men and women who have served in the highest ranks of the U.S. government; Robert M. Gates, our current Secretary of Defense, for example, filled the role of National Security Advisor. The hypothetical scenarios put before the participants were designed to simulate a decline in world oil production due to regional instability and to terrorism. The incidents were completely plausible, and some, such as unrest in Nigeria, have subsequently come to pass. But there was little these skilled officials could do to stop a gut-wrenching increase in the price of oil. Indeed, one of the major lessons of the simulation was that the Strategic Petroleum Reserve (SPR), the emergency supply of federally owned crude oil, offers only very limited protection against a major supply disruption. Emergency reserves cannot sustain the United States through a prolonged crisis, and it will be extremely difficult to reach political consensus on when it is appropriate to begin using them.

Even under normal conditions, oil dependence has severe economic consequences. In 2005, direct outlays for imported oil accounted for a third of the country’s $800 billion current account deficit. In 2006 prices, these outlays have gone still higher. By diverting funds away from domestic consumption and investment, oil imports put a drag on U.S. economic growth and undercut the nation’s long-term competitive position. Oil dependence also adds billions to our defense expenditures by making overseas protection of oil supplies a high strategic priority.
China

Before I turn to a discussion of recommendations, I want to touch upon the rise of China and how that impacts U.S. energy security. Some observers have insisted that clashes between the U.S. and China over energy are inevitable. Chinese companies are buying oil properties and concluding long-term supply contracts around the world. A few of China’s deals are in countries such as Venezuela, Iran and Sudan, with which the U.S. has strained or no relations. Also, China’s surge in oil demand was seen, incorrectly, by some as a reason for higher prices last summer. And China’s increased coal production concerns U.S. environmentalists.

But the fact is that the U.S. and China have many common interests in the energy area and thus many reasons to cooperate. Consider these facts:

- The U.S. is the world’s biggest oil importer. China is the world’s fastest growing oil importer. High prices and supply instability harm both nations. Price increases in the summer of 2006 primarily reflected the lingering affects of sluggish world investment in production and refining in the previous decade, and market perception of high political risk that could disrupt oil deliveries, which both nations have an interest in correcting.

- Chinese, like Americans, are concerned about their environment. China faces colossal and urgent environmental problems, as anyone who has visited Beijing during the winter has experienced first hand. U.S. companies have great expertise in clean energy technology that could help.

- The U.S. and China have a similar interest in open sea lanes for oil.

- Both nations also desire a secure business and legal environment for their energy investments in emerging economies as well as stable and growing supplies from world exporters.

When I look at China and the U.S., I see two nations that have an enormous interest in cooperation in pursuit of energy security. Several areas are ripe for a common effort.

- A Joint Business-Government Commission on Clean Coal Technology; this could help China develop and utilize its massive amounts of coal in an environmentally responsible way and boost U.S. exports of technology and equipment in this area.

- Joint research on alternative fuels, which should also include experts from Japan, would draw on the best talent in these three countries. This could lead to breakthroughs in, or broader dissemination of, non-carbon based production and use technologies.

- Strengthen U.S.-China cooperation in the context of the International Energy Agency.

- Consultation with one another, and with other regional nations, to maintain open sea lanes; that could reassure China that the U.S. will not use its naval power to leverage China on oil.

- Strengthen established regional groups that include China, the U.S., and other Pacific nations to address environmental and energy supply issues.

Helping China to increase domestic energy output using state-of-the-art, environmentally responsible, technologies would slow the growth of its oil import dependence, reduce imbalances in global markets, dampen global price pressures, and contain the process of global warming. And cooperation on these broad energy issues can strengthen broader U.S.–China ties. The alternative—frequent energy confrontations—benefits neither country.

There Are No Silver-Bullet Solutions

Success in improving the nation’s energy security posture will demand significant public and private investment—supported by meaningful tax and other non-tax incentives like loan guarantees—over a sustained period. Because of the volatility of markets and the strategic role of oil, a considerable amount of government support is needed to provide the necessary incentives through a supportive and reliable regulatory, and tax environment if we are able i) to reduce America’s oil vulnerability; ii) strengthen this nation’s capacity to produce oil and alternative sources of energy; and iii) utilize energy more efficiently and in an environmentally responsible way. The U.S. is capable of major breakthroughs if all elements of our society work together.

The good news is that we Americans have it within our power and our technological and financial capacity to take meaningful steps to reduce oil dependence and increase energy security using both proven methods and technologies and our ingenuity and entrepreneurial capacity to develop new breakthroughs.

- Improving efficiency: In the view of the Council, the most important thing the U.S. can do to lessen its oil dependence in the near and medium-term is to utilize oil considerably more efficiently. With the goal of once again halving oil intensity — as in the 1980s and 1990s — in the space of two decades, Americans can do much to protect the economy against the effects of oil shocks that can be unleashed by forces beyond our control. Improved vehicle fuel efficiency is the single most important avenue for further cutting the nation’s oil intensity.

- We must face the hard fact that in the U.S. oil is primarily a transportation fuel; unless we can dramatically curb the use of oil in our cars and trucks, we will be unable to reduce our oil dependence. Currently the direction is not positive; through 2030 oil usage by SUVs and light duty trucks is expected to surge by roughly 77%. The transportation sector accounts for nearly 70% of all the oil the country uses; and oil fuels almost 97% of all transportation. With most of the vehicles on the nation’s roads operating at efficiency levels far below what is achievable with currently available technologies, there is a clear opportunity to realize sizable fuel economy gains without overall loss of safety or functional utility. We propose empowering the National Highway Traffic Safety Administration (NHTSA) to mandate annual fuel efficiency increases of 4% while allowing for these increases to be postponed or constrained if economic, technical, or safety impediments are demonstrated.

- Increasing stable supply. As a second means of improving America’s oil risk profile, the Council recommends efforts to increase the production of oil in stable regions of the world, including in the U.S., Canada, and Mexico. We must move beyond the drill/don’t drill debate for this simple reason: by facilitating the discovery and recovery of conventional oil resources, in conjunction with stricter environmental standards, American investment and the capabilities of this nation’s formidable oil experts and oil service companies can ease the tight supply conditions that unsettle oil prices and lessen the probability that even modest supply shortfalls will trigger an international oil crisis. By the same token, a robust nuclear power program also makes great sense.

- Supplies abroad. Just as significantly, by working to ensure the rule of law, sanctity of contracts, and stable investment climates abroad, America can help to lower the likelihood of future disruptions. There a great many potential projects that can enable the world to diversify the sourcing of oil away from its present growing concentration on the Middle East. By utilizing groups such as the International Energy Forum — a ministerial dialogue among major energy producers and consumers established in 2003 — the conditions for increased investment in such projects can be enhanced.

- Developing alternatives. Third, America can lead the way in expanding the availability of alternatives to petroleum-based fuels. Diversifying our transportation fuel supply must be a key part of any comprehensive effort to improve U.S. energy security. Without an expanded supply of alternatives, conventional petroleum will continue to power nearly all of our motor transport. Such reliance on a single non-substitutable input creates profound economic dangers. To date, through the help of federal policies such as the Renewable Fuels Standard, the phase-out of MBTE as an additive, and tax incentives, corn-based ethanol has developed as one of the most successful domestic alternative transportation fuels. Production in the United States rose from 1.4 billion gallons a year in 1995 to about 4 billion in 2005.

Although this growth rate is impressive, it is merely a drop in the bucket when compared to this nation’s annual gasoline consumption of 140 billion gallons; it is equivalent in terms of energy content to only 2% of our gasoline demand. At a maximum, corn-based ethanol may be able to displace 10% of our gasoline use before corn demand outstrips supply. Consequently if we want to have a significant impact on reducing our consumption of petroleum-based fuels, the federal government must encourage the development and commercialization not only of dedicated energy producing crops such as corn and sugar, but also of other potentially large-volume bio-fuels like cellulosic ethanol (which are low cost, do not compete with the food chain, and provide another revenue stream for farmers) that is generated from forest residue and agricultural waste such as wheat straw , switch grass, and corn stover. Technologies like cellulosic ethanol are poised to dramatically raise bio-fuels production by shifting acreage-to output ratios.

However, to transform this promise into reality, existing federal policies, like the federal loan guarantee program for innovative technologies must be fully funded and implemented; and new policies, which encourage and support investment in commercial facilities and related transportation infrastructure must be readily adopted.

There are two specific policy changes that I believe would enhance the development and commercialization of renewable energy.

The first is for Congress and the Administration to take a longer term perspective in the way tax incentives are structured. For example, with respect to the production tax credit (PTC) for renewable energy sources like wind and geothermal, the credit is available to projects that are placed in service before January 1, 2009. Historically this credit has been renewed only for short periods of time and often after great uncertainty and delay. This on-again, off-again process has added significant uncertainty to such projects and increased their costs. Therefore a longer-term extension of the PTC, say for five years would help to avoid such problems.

The second is to alter the structure of tax incentives to encourage investment from additional categories of investors, including small investors, by enabling them to benefit from tax incentives —thereby increasing the availability and lowering the cost of capital for these projects. For example, the way the law is now written retail investors and taxpayers paying the alternative minimum tax cannot use the production tax credit for investment in wind projects; allowing the use of master limited partnerships for these types of projects would broaden the group of investors who could help to finance them.

It is worth noting that many of the new technologies being developed involve high technical risk, significant costs, and regulatory uncertainties — and that costs of demonstration projects to show that these technologies can be deployed on a commercial scale as well as those associated with their commercial development are significantly greater than the initial R&D costs. Therefore, maximizing the range of investors supplying capital, providing reliable incentives, and creating and funding policies that reduce the significant financial risks associated with these projects are critical to advancing the process of proving and commercializing innovative energy alternatives.

- Managing risks: In the Council’s view, we must manage risk within the interdependent global oil economy. In our dangerous world, threats are one commodity not in short supply. America contributes far more than any other nation to protecting this global infrastructure, and the time has come for other nations to expand their own efforts. All nations have an interest in the stability of the global oil infrastructure, and a variety of international efforts could help to ensure the smooth flow of oil. New multilateral accords should play a role, but there are also opportunities for expanded reliance on existing organizations such as the Gulf Coordination Council, NATO, or ASEAN. A common interest in “oil security maintenance” in partnership with producing nations offers real potential to improve regional security in areas of rising geopolitical competition by creating frameworks for pragmatic international cooperation. Where appropriate, the U.S. should provide exporting countries with diplomatic support as well as with counter-terrorism training and other military aid.

I urge you to review the Council’s detailed recommendations, which are contained in our published report. We will be glad to provide any further clarifications you may require.

The Capabilities of the American People

Last week, the nation mourned the passing of our 38th President, Gerald R. Ford — for whom I had the great privilege of working. President Ford left a legacy of honesty, integrity and decisiveness. These aspects of his leadership were particularly evident in his handling of energy security. In his 1975 State of the Union address, President Ford recognized the energy dangers threatening the country. He expressed a “very deep belief in America’s capabilities,” — its innovative capacity and technological skills—to overcome its growing dependence on imported oil. He also rallied support for fuel efficiency standards. I share President Ford’s optimism in the capacity of Americans to respond to the challenge of growing energy dependence, and his belief that Americans will rally around tougher energy measures, if they are given strong leadership.

America has a long history of pulling together in the face of national security challenges. I am currently completing a book entitled The Price of Liberty: How America Pays for its Wars. In all the major national security challenges of the twentieth century, Americans demonstrated a remarkable willingness to make patriotic wartime sacrifices. During World War I and World War II, American’s not only paid dramatically higher taxes but also participated in massive bond drives to mobilize billions of dollars to support out troops. Roosevelt’s Secretary of the Treasury Henry Morgenthau, when asked about the significance of such drives, said that they were launched not only to raise massive amounts of funds, but also to respond to people who asked “What can I do to help.” Today, the answer to this question lies not in buying more bonds but in buying less gasoline.

Since 9/11 there have been no major bond drives as in past wars —and only limited steps to reduce our dependence on oil. The time has come to recognize that energy security is central to the national security challenges of twenty-first century, and to present the American people with the unvarnished truth regarding how oil affects the struggle in which we are engaged. We must meet the threats we face in the same spirit as our parents and grandparents during past wars—with far-sighted patriotism and willingness to compromise narrow partisan, ideological, philosophical and economic positions in the long-tern national interest.

There are enormous dangers in facing the challenges of a post-9/11 world with a pre-9/11 approach to energy that relies so heavily on oil from some of the most vulnerable areas of the world and sustains price levels that benefit countries such as Iran and Venezuela that seek to undermine our interests and threaten our friends. American leaders and the American people have rallied the country in past wars; the challenge is to do so again,

I thank you again for this opportunity to testify.

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