by Gal Luft

inFocus Quarterly
Fall 2010

Unlike Europe, which is heavily dependent on Russian natural gas for its electricity generation, the U.S. is essentially energy independent when it comes to its power supply. It does not need to import coal and natural gas, chief sources of electricity generation, and no foreign nation can turn off the United States' power at will. The U.S. energy security challenge boils down to one problem: oil.

Oil is the world's most strategic commodity not because the U.S. consumes or imports a lot of it, but because it enjoys a virtual monopoly over the global transportation fuel sector. This monopoly—almost all of the world's cars, trucks, ships and planes run on nothing but petroleum—enables a small group of nations, most of them members of the Organization of Petroleum Exporting Countries (OPEC), to constrict oil supply, manipulate its prices, and even use it as an economic weapon when conflict emerges, as was the case during the 1973-74 Arab Oil Embargo. While the OPEC cartel owns 78 percent of the world's reserves, it produces only one third of the world's oil—far less than its capacity permits. In fact, today OPEC pumps less oil than it did 40 years ago even though the global economy has doubled over the same period.

U.S. Security and Economic Interests

Most Americans fully understand the national security consequences of oil dependence. After all, petrodollars are the main source of revenue for some of America's sworn enemies. As long as the nations responsible for the spread of Islamic terrorism control the global transportation sector, which underlies the world economy, America will not be able to accomplish its foreign policy goals. But in times of economic adversity, one should also recognize the toxic impact oil dependence has on the U.S. economy.

The United States' oil imports comprise nearly 40 percent of its trade deficit. Under current oil prices the U.S. spends over $350 billion on foreign oil, money that could have stayed inside the country, creating urgently-needed jobs and investment opportunities. In 2008, when oil prices reached nearly $150 a barrel, America's oil bill surpassed its defense budget. Studies show that every recession since the Second World War was preceded by an oil shock. The current recession is no exception. A report by the U.S. Congress Joint Economic Committee determined that "the significant rise in oil prices in 2007-2008 […] was one of the causes of the Great Recession, as consumers faced higher transportation costs and had less money for consumption of other goods and services." Once the economy begins to fully recover, demand for oil will spike and prices of goods and services will rise accordingly, which, in turn, will dampen growth and send the economy into another recessionary period.

For the U.S. economy, oil dependence is a double whammy. While it contributes to economic decline, it allows OPEC governments to not only laugh all the way to the bank but to literally own the bank. In recent years, sovereign wealth funds owned by OPEC members bought chunks of America's prime symbols of economic prowess—places such as Citigroup, Merrill Lynch, Morgan Stanley, Blackstone Group, and the late Bear Stearns. This is only a preview to what is yet to come should oil prices bounce back to the three-digit territory. So if Americans are to prosper again and free hundreds of billions of dollars per year to stimulate the U.S. economy instead of the economies of OPEC, the U.S. must reduce its oil bill and, more important, its vulnerability to oil supply shocks.

Stripping Oil of its Status

Despite the broad agreement on the urgent need to reduce petroleum dependence, America's energy policy still suffers from institutional paralysis. The main reason for the stalemate is that throughout the years the energy problem has not been properly defined and, as a result, policy has been primarily focused on non-transformational, tactical solutions that perpetuate petroleum's domination over the global economy's very enabler, the transportation sector.

The combination of oil's monopoly over transportation and the overwhelming control of OPEC over the world's oil market means that neither efforts to expand petroleum supply through domestic drilling nor those to crimp petroleum demand by imposing mandatory fuel efficiency standards are enough to strip oil of its strategic status. When oil importing countries like the U.S. reduce net demand or expand production, OPEC responds by throttling down its own supply to drive prices back up. In other words, when the U.S. drills more, OPEC drills less, and when Americans use less, OPEC, again, drills less.

In order to achieve energy security the U.S. must change the playing field altogether. The story of salt can act as a guide. Until around the beginning of the 19th century, salt held the strategic position oil does today because it was the only means of preserving food. Salt mines conferred national power and wars were fought over their control. However today, no nation sways history because it has salt mines. Salt is still a useful commodity for a range of purposes. The United States imports much of its salt, so if one defines independence as autarky, the U.S. is not "salt independent." But most would agree there is no "salt dependence" problem in the world because canning, electricity and refrigeration decisively ended salt's monopoly over food preservation, and thus, its strategic importance.

Similarly, ensuring that new cars sold in the U.S. and, by extension, the rest of the world, are platforms on which fuels can compete will spark a competitive market in fuels made from a wide array of energy sources, thus breaking oil's transportation fuel monopoly and eventually stripping the commodity of its strategic importance.

Electrification

So how can the United States do it?

In the coming decades, a shift from cars powered by petroleum fuels to ones powered by electricity (whether plug-in hybrid electric vehicles or pure electric vehicles) will have a significant impact on the oil market. Electricity is cheap, clean, scalable, and readily available. Most importantly, 98 percent of U.S. electricity is generated from non-petroleum energy sources like coal, natural gas, nuclear power, and renewable energy. The fact that only 2 percent of U.S. electricity is generated from oil is conveniently ignored by elected officials from both sides of the aisle who often swear by nuclear, solar, and wind power as alternatives to oil. This is simply untrue. Build as many nuclear reactors and wind farms you wish and you might displace coal or natural gas—but not oil.

The vision of electrification is indeed both compelling and exciting, which explains why so much has been done for its advancement by the auto industry, the investment community, and the government. Not a day goes by without industry news about rolling out new designs of electric vehicles or new breakthroughs in battery technology. The U.S. Congress and both the Bush and Obama administrations provided a policy framework in support of electrification. The Emergency Economic Stabilization Act of 2008 (a.k.a. the bailout) provided tax credits of up to $7,500 per car to early adopters of plug-in electric vehicles. The American Recovery and Reinvestment Act of 2009 (a.k.a. the stimulus) allocated $2.4 billion in federal funding for electric vehicles and advanced batteries as well as transportation electrification demonstration and deployment projects. Several other electrification bills are pending before Congress.

But the shift to an electrified transportation system will take time. Studies project that pluggable vehicles will not penetrate the market deep enough to make a dent in our oil consumption before 2030. This means that in the interim period the world economy will be at the mercy of OPEC and highly vulnerable to oil shocks. In April 2010, the U.S. Joint Forces Command warned that there could be serious oil shortages by 2015 with a significant economic and political impact. In September, a study by the German military warned of the potential for a dire global economic crisis in as little as 15 years as a result of an irreversible decline in world oil supplies. This means that while pursuing vehicle electrification, the U.S. must develop solutions that could enable near term competition to oil in the liquid fuel market.

In the Interim: Flex Fuel

A simple technical fix, which according to GM costs $70 per car, could do the trick if added to every new vehicle sold in the U.S. Flex fuel vehicles ensure that cars powered by internal combustion engines can run on any combination of gasoline and a variety of alcohol fuels such as methanol (made from coal, natural gas, and biomass) or ethanol. An Open Fuel Standard ensuring new cars are flex fuel vehicles would open the transportation fuel market to affordable fuels made from energy sources beyond oil. For example: The spot price for methanol, currently under one dollar a gallon, is competitive on a per-mile basis with gasoline. The U.S. has growing reserves of natural gas from which methanol can be made. In fact, a new MIT report determined that methanol "is the liquid fuel that is most efficiently and inexpensively produced from natural gas" and that "in contrast to advanced biofuels (such as cellulosic ethanol) and electrically powered vehicles, the basis for the economic viability for methanol as a transportation fuel is much better established." But because the cars sold in America are not flex fuel vehicles, methanol cannot access the fuel market.

An Open Fuel Standard would not only enable alternative fuels to compete at the pump but it would also put a virtual cap on the price of oil. As in the case of Brazil, where most new cars are flex fuel, consumers would opt for the most economic fuel on a per mile cost basis and thus shift to substitute fuels the next time OPEC allows oil price to exceed a certain threshold. Since no automaker can afford to give up on the U.S. market, the Open Fuel Standard would become a de-facto global standard. Cars sold anywhere in the world would be flex fuel vehicles, allowing small and developing countries in Africa, Latin America, and South Asia to grow domestic alternative fuel industries, generate revenue from fuel exports, and protect themselves against economically devastating oil shocks.

Competition at the Pump

In September 2010, OPEC celebrated its 50th birthday. Half a century of a transportation sector dominated by OPEC has led the United States to accept the cartel's shenanigans as a fait accompli. It shouldn't.

In a modern global economy where free trade, open markets, and strict anti-trust laws are bedrock principles, there is no room for a cartel dominating any commodity—not least the most strategic one of all. An Open Fuel Standard would enable the U.S. to challenge OPEC for the first time using the weapon the cartel fears most: competition at the pump. Conversely, failing to pass an Open Fuel Standard and thus maintaining oil's virtual monopoly over transportation fuel, and with it the strategic importance of the commodity and the power of the oil cartel, is the best birthday gift the U.S. Congress could give OPEC.

Gal Luft is executive director of the Institute for the Analysis of Global Security (IAGS). He is co-author of the book Turning Oil into Salt: Energy Independence through Fuel Choice.