The Myth of the Oil Weapon by David Henderson

The Myth of the Oil Weapon

Our foreign-policy establishment believes the U.S. must intervene to keep oil flowing from the Mideast. In reality, all America needs to do is demand it.

by David R. Henderson

In a recent interview with Charlie Rose to drum up publicity for his book, The Age of Turbulence, former Federal Reserve Chairman Alan Greenspan argued that the reason to make war on Iraq was that an unchecked Saddam Hussein would have threatened the world’s oil supply. Greenspan gave no evidence or argument for his assertion. But in making it, he confirmed the views of many opponents of the war, and even some supporters, that the Iraq War was, or at least should have been, about oil. He also joined a long list of prominent people who have made the case for war for oil ever since the Organization of Petroleum Exporting Countries formed an effective cartel that raised the world price from $3 a barrel to $11 in the fall of 1973.

That’s too bad, because the case for making war for oil is profoundly weak. The pragmatic case against war for oil, on the other hand, rests on a few simple facts. First, no oil-producing country, no matter what it does to its oil supply, can cause us to line up for gasoline. Second, an oil-producing country cannot impose a selective embargo on a target country, because oil is sold in a world market. Third, the only way one country’s government can hurt another country using the “oil weapon” is by cutting output, which hurts all oil consumers, not just the target country; helps all oil producers, friend and foe alike; and harms the country that cuts its output.

Consider how long the foreign-policy establishment has taken as accepted the idea that the U.S. government needs to use military force to keep the world’s oil supply flowing. In March 1975, Harper’s published an article, “Seizing Arab Oil,” authored by “Miles Ignotus.” The author’s name, Harper’s explained, “is the pseudonym of a Washington-based professor and defense consultant with intimate links to high-level U.S. policy makers.” Many insiders speculated that the piece was written by Edward Luttwak, still a prominent military analyst. In it, the author expressed frustration at the high price of oil and argued that no nonviolent means of breaking the cartel’s back would work. Even massive conservation, he argued, was unlikely to solve the problem. Moreover, he claimed, “there is absolutely no reason to expect major new discoveries.” So what options were left? “Ignotus” wrote, “There remains only force. The only feasible countervailing power to OPEC’s control of oil is power itself—military power.” He argued at the time that military force should be exerted on Saudi Arabia.

That article, though one of the most articulate, was far from the only call for an American invasion of a Middle East oil country. Of course, no such attack occurred in the 1970s. But this kind of extreme thinking made respectable the idea that the U.S. government should seriously consider invading countries in the Persian Gulf to drive down the price or assure the supply of oil.

On Jan. 1, 1975, just two months before the Harper’s article appeared, Secretary of State Henry Kissinger stated that military force should not be used “in the case of a dispute over price,” but should be considered “where there is some actual strangulation of the industrialized world.” In May of that year, Secretary of Defense James R. Schlesinger made further threatening noises.

In 1977, President Jimmy Carter issued an order for the U.S. military to start a Rapid Deployment Force to give the United States the ability to quickly send a substantial invasion force to various parts of the world. After the fall of the Shah of Iran in 1979, the Rapid Deployment Force became focused on the Persian Gulf. In 1983, during the Reagan administration’s tenure, this force became known as U.S. Central Command.

Its cost, even in years of relative peace, has been high. Although the U.S. government tends to hide the cost of various programs, making it hard for economists, let alone average citizens, to discern, one analyst, Earl Ravenal, estimated the fiscal year 1985 budget for CENTCOM at $59 billion, $47 billion of which, he claimed, was for the Persian Gulf alone. That amounted to a full 1 percent of GDP. In today’s dollars, that’s $89 billion.

This was only the beginning of serious U.S. planning for an invasion of the Middle East over oil. In January 1980, after the Soviets had invaded Afghanistan the previous month, President Carter, in his State of the Union address, announced the “Carter Doctrine,” which stated:

Let our position be absolutely clear: 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.

A decade later, the U.S. initiated the first Gulf War, at least partly over oil. President Bush stated that his military action was, among other things, about “access to energy resources that are key ... to the entire world.” He claimed that if Saddam Hussein had gotten greater control of oil reserves in the Middle East, he would have been able to threaten “our jobs” and “our way of life.” Secretary of State James A. Baker III claimed that Saddam Hussein, by controlling much of the world’s oil, “could strangle the global economic order, determining by fiat whether we all enter a recession, or even the darkness of a depression.” And the ever-present Henry Kissinger wrote that an unchecked Saddam Hussein would be able to “cause a worldwide economic crisis.”

Yet the advocates of war for oil have never confronted some basic realities. Economists often get a bad rap for their pessimism, but an understanding of how oil markets work leads to optimism about a secure oil supply.

When many Americans over age 50 worry about Middle Eastern producers playing havoc with the world oil supply, they think back to the gasoline lines of 1973 and 1979. But those fiascos weren’t forced by a foreign producer. The U.S. government was responsible. President Nixon had imposed a freeze on all prices on Aug. 15, 1971. He gradually decontrolled prices, but when OPEC raised the price in the fall of 1973, Nixon’s price controls prevented the price of oil and gasoline from rising sufficiently. Whatever else economists may argue about, they agree that a price control that keeps the price below what would have otherwise existed in a competitive market will cause a shortage. The reason is that at a price below the competitive price, consumers will demand more and producers will supply less. President Ford and Congress altered the price controls, and President Carter inherited and kept them. When the world oil supply tightened again in 1979, we had another shortage. Simply by refraining from controlling the price, therefore, we can avoid, and have avoided, gas lines.

To say that a reduction in the supply of oil cannot cause a shortage is not to say that it cannot cause harm. Any country that is a net importer of a good will be harmed by the higher price if the supply of that good falls. But the key is that the supply must fall. If supply does not fall, nothing important changes.

Imagine that the government of Country A currently sells oil to people in Country B and wishes to harm people in Country B by refusing to sell or by reducing sales. What happens next depends crucially on whether Country A cuts its own oil production. Assume that Country A maintains production. This means that Country A must look around for people in other countries to sell the suddenly freed-up oil to. Here’s where it gets interesting.

In 2006, the five most important exporters of oil to the United States, in order of importance, were Canada, Mexico, Saudi Arabia, Venezuela, Nigeria, and Iraq. Total imports from these countries were 59 percent of U.S. imports. Of these five, the one most likely to want to hurt the United States is Venezuela or, more accurately, Venezuela’s government under Hugo Chavez. But interestingly, Chavez has done the exact opposite, actually subsidizing oil imports to the northeastern United States. But imagine the worst: imagine that Chavez wanted to target the United States using the “oil weapon.” Say he cuts sales by half to 753,000 barrels a day. The U.S. will respond by scrambling to find other sources of oil. Where will it find them? Let’s go back to Chavez. He needs to find people in other countries to sell this 753,000 barrels a day to. Let’s say he ships the oil to buyers in China. Then those buyers in China will find that they want to buy 753,000 fewer barrels from their suppliers, say Iraq or Saudi Arabia. Presto! The American buyers’ problems are solved because they can get their 753,000 barrels elsewhere. In short, when the government of one country tries to selectively target people in another country, but still wishes to maintain output, it can’t succeed. The selective “oil weapon” is a dud. It’s like a game of musical chairs with the same number of chairs as players. The game would be awfully boring, which is why it is not played that way. But in the case of international trade, boring is good.

It is unlikely that the government of Venezuela or of any country would maintain output simply by selling the freed-up supply to people in only one other country. It is also unlikely that people in the targeted country would get supplies from producers in only two other countries. But that complication doesn’t change the conclusion.

Also, one main reason for the particular pattern of oil exports and imports is transportation cost: if you’re in New Orleans, why buy from Iran when the cost of shipping from Venezuela is much lower? It follows, therefore, that when a country’s government disrupts this pattern by cutting off oil supplies to a nearby country, transportation costs rise. The higher transportation cost acts as an excise tax, the burden of which is typically shared by the buyers and sellers. The disrupting government would be hurt by having to accept a somewhat lower price from a more distant buyer. The people in the disrupted country would be hurt by having to pay a somewhat higher transportation cost to get their oil. But the maximum hurt in either case would be no more than the difference in transport costs, and this would be a small amount, probably under $1 per barrel. For the hypothetical 753,000-barrel production cut, therefore, the maximum hurt to U.S. consumers would be $753,000 a day or $275 million a year—less than $1 per year per U.S. resident.

Of course, the government of an oil-producing country can do substantial harm to the people of another country by cutting the amount of oil it produces and sells. (I use the word “government” here on purpose because outside Canada, the United States, and Britain, almost all the world’s oil is produced by governments.) But any government that wants to hurt a particular country by reducing its oil supply faces three huge problems.

First, an oil producer cannot single out particular countries or consumers to hurt. If one oil producer cuts supply, then, all other things being equal, the world oil supply drops and prices rise. All oil consumers are hurt, and their hurt is proportional to the amount of oil they use. Thus the “oil weapon” is an incredibly blunt instrument that, when used, will hurt friend and foe alike.

Second, the oil-producing country, by cutting output, will cause the world price of oil to rise, which will help other oil-producing countries that don’t reduce their supply. So for example, if Iran’s government chooses to reduce its supply of oil to hurt the United States, it also helps its avowed enemy, Saudi Arabia.

Third and finally, to continue with the weapon analogy, the oil weapon blows up in its user’s face. Specifically, any country that produces less than about 10 percent of the world supply will find that the price increase it gets will not compensate for the reduction in revenues due to lower production.

Consider the case of Saddam Hussein in 1990. When he took over Kuwait, he controlled oil production of 4.3 million barrels per day in a 60 mbd market. His motive for taking over Kuwait was probably not, as Kissinger, Baker, and Bush I feared, to cut output and increase the price at all, but simply to have more oil to sell. A thief does not steal a television set to watch TV; he steals a TV to fence it. Similarly, an oil thief wants to steal oil to sell it.

Nevertheless, imagine that Saddam Hussein, wanting to hurt the United States, had cut output by 1 mbd. (You have to use your imagination here because Saddam was a U.S. ally.) This would have been 23 percent of 4.3 mbd, but only 1.7 percent of world output. Let’s bias the analysis in favor of a large hurt on the United States and a small hurt on Saddam by assuming the inelastic end of the range of economists’ estimates of the short-run elasticity of demand for oil, an elasticity of 0.1. This would mean that every 1 percent reduction in output would cause a 10 percent increase in price. Therefore, a 1.7 percent reduction in output would have caused a 17 percent increase in price, raising the world price from about $20 a barrel to about $23.40. The harm to the United States, which was importing about 8 mbd at the time, would have been $27 million a day, or $9.9 billion a year. At the time, this would have less than 0.2 percent of GDP. Note also that even with this $3.40 per barrel increase, Saddam Hussein would have accrued less revenue than he would have if he had not cut output at all. He would have brought in $77 million a day, or $28.2 billion a year. But had he not cut output, he would have brought in $86 million a day, or $32.4 billion a year.

It’s true that by producing less, Saddam would have had lower costs, so let’s bias the analysis in favor of his getting a gain from cutting output by assuming that the cost of oil production for the last 1 mbd was $5 per barrel, a number that most observers would regard as being on the high side. Then his cut in output would have saved him $5 million a day. So he would have given up $9 million a day in revenue to save $5 million a day, which would not have been a good deal for him. In short, there is good reason to think that if Saddam was as ruthless as he appeared to be, he would have wanted to cut output by less than 1 mbd, or maybe not at all.

It goes without saying that 1 mbd is less than 4.3 mbd. Therefore, the estimated damage from the hypothetical 1-mbd cut in oil output by Saddam Hussein is well below the actual damage done to the United States by the United Nations’ 1990-91 restrictions on output from Iraq and Kuwait, restrictions for which the U.S. government was a key instigator.

Moreover, even these estimates of hurt are overstated. Why? Because producers in other countries do not sit passively by when the price of oil rises. When the price increases, producers produce more, in part because sources of supply that weren’t worth exploiting at the previous lower price are worth tapping at a higher price. This increased production moderates the price increase from a given producer’s cut in output, further limiting the damage that can be done to countries that are net importers of oil.

In 1776, Adam Smith wrote in The Wealth of Nations, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner but from their regard for their own self-interest.” Similarly, it is not due to the benevolence of the world’s oil suppliers that we get our oil but from their regard for their own interests. Our oil supply is secure, not because our government threatens to use force against those who would make it insecure but because the world’s oil suppliers want to make money.

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David R. Henderson is a research fellow with the Hoover Institution and an economics professor at the Naval Postgraduate School in Monterey, California. He is co-author of Making Great Decisions in Business and Life.