Hadi Esfahani, Professor,Economics, UI and Clifford E.Singer, Professor, Political Science, UI

The tripling of crude oil prices over the past four years has raised concerns everywhere that the world economy may soon face another round of major instability similar to one during the 1980s, possibly causing and being reinforced by international political disorder. The conflict in Iraq and the recent tension between Iran and Western countries have added to such concerns. Any sign that such tensions may flare up quickly translates into higher oil prices and becomes an actual force that may slow down the economy in oil importing countries. A vivid recent example of this was a 4 percent jump in oil prices on June 4, 2006, when Iran’s Supreme Leader, Ayatollah Ali Khamenei, warned that fuel shipments from the Persian Gulf region could be disrupted if the United States makes a” wrong move.”

Are fears of oil-driven economic and political disruptions around the world real or imagined? Are such perceptions the result of obsessive focus on the old memories of the global economic instability experienced in the 1970s and 1980s, or are they the result of forward-looking analysis of current and future constraints of the global political and economic systems? If the fears are real, how big are the risks of major disruptions? Is intense competition over the world’s oil resources inevitable, or is oil becoming just commodity, rather than a “strategic commodity?” Do changes in circumstances provide better opportunities than in the past for economies to avoid instability?

Here we examine these questions in light of the recent research and debates on the politics and economics of oil. We start by reviewing theca uses and consequences of recent oil price increases and contrast them with the economic circumstances in the 1970s and 1980s. We then discuss the political variables that enter the process or result from it. We conclude by discussing the options for more effective management of energy price volatility or disruptions in oil flows.

Oil Price Shock: Now and Then
While there are concerns about disruptions in oil flows due to conflict, the rise in oil prices over the past four years is also driven by rapidly expanding demand at the same time that the most accessible oil resources are being exhausted. Many economies have experienced robust growth, especially those of the United States and East and South Asian countries. Since the adjustments in patterns of energy use take time and the world economy continues to do well, markets have come to value oil more as an asset for future use, sending prices higher in current spot markets. Of course, this process cannot continue for long. Either there will be major adjustments by switching to alternative sources of energy and by increased energy efficiency, or the world economy will have to slow down.

The oil shocks in 1973-74 and1979-1980 had some similarity tithe present situation. However, in both of those cases, the short run consequence was economic recession, with adjustments in energy use coming over the medium and longer terms and allowing economies to recover and grow again. Interestingly, the current oil price rise doesn’t seem to be prompting a recession yet and may never do so. The reason is that the world economy, especially in developed countries, has gone through major transformations since the 1970s. For example, the United States has since reduced the amount of oil use per inflation adjusted dollar of GDP by a factor of1.6. Production in developed countries is now partly what is called” post-industrial,” relying heavily on high-skill professional services that require less energy to produce than goods made on the factory floor. There has also been an attempt in many countries to diversify, to tap into entirely new sources of energy for transport, and to build flexibility into the production system. For example, in India, the entire New Delhi taxi fleet has shifted to using compressed natural gas. In Brazil, the auto fleet can run on anything from 10 to 85 percent ethanol. All such changes have enabled the world economy to weather the current oil price rise without much difficulty on a global basis and to buy time to explore opportunities for further adjustments.

Another important factor contributing to the robustness of world economy compared to earlier decades is policymakers’ improved knowledge of macroeconomics, especially in the monetary policy area. By learning to focus on the management of inflation, the U.S. Federal Reserve and other financial institutions have tamed expectations about future inflation rates and somewhat diminished self-fulfilling prophecy as unimportant source of instability.

Domestic and International Politics of Oil
Efforts to increase flexibility and the switch to alternative sources of energy have not come automatically. In particular, the oil price slump during the past two decades weakened market incentives to implement energy-saving and flexibility-enhancing investments. In some countries, especially the United States, increasing fuel taxes, which would exact a larger proportion of income from low-moderate income voters is an unpopular approach to managing demand and inducing greater fuel efficiency and flexibility. In some other countries, especially those with oil resources of their own, the public has often resisted taxes outfox suspicion that the raised funds might be channeled towards politicians’ private ends. However, even in countries where fuel taxes have been allowed to rise, shifts in the pattern of energy use have been limited, except in cases where the government has taken more specific steps to encourage innovation, as in Brazil.

At the same time, there have been frequent calls for policies that ensure energy security. These calls reflect view that oil is a “strategic commodity” with important security and international political consequences. This view is deeply imbedded in policymakers’ mindsets despite the lack of evidence that oil is now in anyway fundamentally different from many other commodities whose prices fluctuate from time to time. One way to address this perceived security concern has been to seek control over oil resources and trade routes through political and military means. The implicit adoption of this approach in the past, especially byte U.S. government, has, unfortunately, come at high costs in terms of many other foreign policy goals. The violent antagonism of the radical fringe of a generation of technically competent men from some oil producing countries and their neighbors is the putative resulting security cost that has created the most immediate concern.

More ominously, the perception that energy security is a major driver of U.S. foreign policy has led many around the world to resist U.S. foreign policy goals. The current international tensions over Iran’s nuclear policy are a case in point. Iran’s leaders seem to believe that they are being targeted partly because of the U.S. quest for control over oil resources and, at the sometime, they seem empowered by the thought that the West may find disruptions in oil flows from the Persian Gulf excessively costly. This situation may make any diplomatic solutions to the problem quite hard to achieve, particularly if the U.S. government indeed sees its long-term strategic interests as challenged by Iranian policy and actions.

Options for Effective Management of Energy Markets
Governments around the world have adopted a variety of policies to deal
with their concerns over energy supply. In the United States, the government has maintained strategic petroleum reserves for emergency situations that have never actually arisen, and on one occasion used them for a small attempt at market stabilization. The United States, along with other countries, has used subsidies and tax relief to stimulate domestic oil production. Also, fiscal incentives in some countries have targeted the development of new
technologies and a switch to alternative fuels. In cases where these policies have been more effective, the government has had to resort to its harsher regulatory powers and require a coordinated change for large segments of the market, as in the case of gas-burning taxis in
India and flexible alcohol-mix cars in Brazil. This seems to be important because such technologies have a network character that entails lower costs only when they are adopted at a sufficiently large scale. This is, for example, an important issue for the adoption of specialized tanks, engines, and pumps using alternative fuels.

Broadly through the economy, government also often supports research and development that is too early in the product cycle or needed on too large a scale for industry to come up with itself. Basic research in biotechnology and materials science are examples that could have a large impact on fuel efficiency.

Another important government role that has received little national attention in an energy security context is urban and regional planning. This can range from simple questions like how far it is to the nearest neighborhood store to fundamental questions like how distribution
of financial support for public education affects urban flight and suburban sprawl.

One of the most effective policies pertinent to oil imports might be a federal guarantee of the minimum funds each state-certified school district needs to provide quality education. If effective, such an approach could help reduce the long driving distances that many middle-to-upper income commuters endure to live in a property-tax-rich suburban school district far from city employment centers.

What has been suggested here is that a change in U.S. national security policy away from military interventions in energy-rich regions is a prerequisite for a concomitant change in national energy policy—not the other way around. Ideally, the way in which the occupation of Iraq fell so short of its proponents’ initial expectations could stimulate the awakening needed to motivate such a change. In practice, this is not likely to be the case. Revised national security and energy policies are more likely to evolve together: slowly, painfully, and inefficiently.