The piece below appeared in The…

                              The piece below appeared in
         The Georgetown Journal of Law & Public Policy, Summer 2008, Vol. 6, No. 2

                                       The Energy Security Obsession

                                    by Jerry Taylor and Peter Van Doren



         Among the most fashionable preoccupations in foreign policy circles is "energy

security." Although it is unclear what exactly energy security means, foreign policy elites have

long been concerned about reliance on foreign energy. Fear of embargoes and supply

disruptions affects how Western nations deal with oil and gas producing states, what sort of

policies are pursued in the Middle East, and even fundamental questions of war and peace.

         That's unfortunate, because a nation that is self sufficient in energy is no more "secure"

than one that relies on imports for all its energy needs. Given the global nature of oil markets

and the increasing globalization of natural gas markets, willingness to pay market prices will

secure all the energy a nation could possibly wish for during peacetime. Worries about producer

blackmail are only a bit less far-fetched than worries about alien invasion. 1 Simply put, reliance

on oil and natural gas ­ imported or otherwise ­ is not the Achilles heel of the Western

industrialized world.

         We confront each of the major worries regarding energy security in turn. First, we

consider the argument that reliance on foreign oil necessitates a U.S. military presence and

related security guarantees to oil producers abroad. Second, we examine the proposition that the

United States must maintain friendly relationships with oil producers to secure foreign oil at



Jerry Taylor and Peter Van Doren are senior fellows at the Cato Institute in Washington, DC. Peter Van Doren is
also editor of Cato's Regulation magazine.
1
  Many economists that specialize in oil economics doubt that there are significant national security externalities
associated with gasoline consumption. See Douglas Bohi and Michael Toman, The Economics of Energy Security
(Norwell, MA: Kluwer Academic Publishers, 1996).


                                                          1
reasonable prices. Third, we investigate the argument that oil consumption fuels terrorism by

increasing the flow of money to Islamic militants. Fourth, we consider the argument that oil

consumption props-up unsavory regimes and international bad actors to the detriment of U.S.

interests abroad. Fifth, we explore the claim that the commercial emergence of liquefied natural

gas (LNG) threatens to trigger the creation of a second global energy cartel and thereby add a

"gas weapon" to the arsenal of those already wielding an "oil weapon." Finally, we reflect on

why there is such a wide gulf between the way foreign policy elites view energy security and the

way economists view energy security. We find that none of the popular worries we consider

herein to have merit.



No Blood for Oil

        Many believe that reliance on foreign oil requires consumers to militarily defend friendly

exporting states and to ensure the safety of oil supply facilities and shipping lanes. Those

marching under banners declaring "No Blood for Oil" seem to believe that's the case, as do most

mainstream foreign policy analysts. 2

        Simple economics suggests otherwise. Oil producers will provide for their own security

needs as long as the cost of doing so results in greater profits than equivalent investments could

yield. Because Middle-Eastern governments typically have little of value to trade except oil,

they must secure and sell oil to remain viable. 3 Given that their economies are so heavily

dependent upon oil revenues, Middle-Eastern governments have even more incentive than do



2
  See, for instance, Steven Mufson, "A Crude Case for War?" Washington Post, March 16, 2008, p. B1, and Andrew
Bacevich, "The Real World War IV," Wilson Quarterly 29:1, Winter 2005.
3
  Oil revenues, for instance, are 40-50 percent of Iranian government revenues and 70-80 percent of Saudi
government revenues. See Energy Information Administration, "Country Analysis Briefs," available at
http://www.eia.doe.gov/emeu/cabs/contents.html accessed on November 14, 2006.


                                                      2
consuming states to worry about the security of oil production facilities, ports, and shipping

lanes. 4

           In short, whatever security our presence provides (and many analysts think that our

presence actually reduces security 5 ) could be provided by incumbent producers were the United

States to withdraw. The fact that the Saudi Arabia and Kuwait paid for 55 percent of the cost of

Operation Desert Storm suggests that keeping the Straits of Hormuz free of trouble is certainly

within their means. 6

           The same argument applies to al Qaeda threats to oil production facilities. Producer

states have such strong incentives to protect their oil infrastructure that additional Western

assistance to do the same is probably unnecessary. While terrorists do indeed plot to disrupt oil

production in Saudi Arabia and elsewhere, there is no evidence to suggest that producer-state

security investments are insufficient for the job. 7

           The U.S. "oil mission" is thus best thought of as a taxpayer-financed gift to oil regimes

and, perhaps, the Israeli government that has little, if any, effect on the security of oil production

facilities. One may support or oppose such a gift, but our military expenditures in the Middle

East are not necessary to remedy a market failure.



Must We Kiss the Producers' Ring for Oil?



4
  J. Robinson West, "Saudi Arabia, Iraq, and the Gulf," in Energy Security, Jan Kalicki and David Goldwyn, eds.
(Washington: Woodrow Wilson Center Press, 2005), pp. 197-218.
5
  Robert Jervis, "Why the Bush Doctrine Cannot Be Sustained," Political Science Quarterly 120: 3 (Fall 2005), pp.
351-377.
6
  Saudi Arabia and Kuwait paid approximately $33 billion (55 percent) toward the total cost of Desert Storm and Desert
Shield, which was $60 billion. The U.S. share was only $6 billion (10 percent). Defense Department press release 125-
M, May 5, 1992.
7
  The Saudi government is responsible for the security of intrastate pipelines, oil processing facilities, and shipping
terminals. Despite the potential vulnerability of their oil production and export network, repeated and determined
terrorist attacks against the same have had no consequential impact to-date.


                                                           3
        Many foreign policy analysts think that U.S. oil imports are dependent upon friendly

relationships with oil producing states. 8 The fear is that unfriendly regimes might not sell us oil

­ a fear that explains why former Federal Reserve Chairman Alan Greenspan supported the two

Gulf Wars against Iraq. 9 Maintaining good relations with oil producers, however, is said to

interfere with other foreign policy objectives ­ such as the defense of Israel and the pursuit of

Islamic terrorists ­ and increases anti-American sentiment in producer states with unpopular

regimes. 10 And of course, it could lead to war. 11

        The problem with this argument, however, is that its fundamental premise is incorrect.

Friendly relations with producer states neither enhance access to imported oil nor lower its price.

        Selective embargoes by producer nations on some consuming nations are unenforceable

unless (i) all other nations on Earth refuse to ship oil to the embargoed state, or (ii) a naval

blockade were to prevent oil shipments into the ports of the embargoed state. That's because,

once oil leaves the territory of a producer, market agents dictate where the oil goes, not agents of

the producer, and anyone willing to pay the prevailing world crude oil price can have all he

wants. 12

        The 1973 Arab oil embargo is a perfect case in point. U.S. crude oil imports actually

increased from 1.7 million barrels per day (mbd) in 1971 to 2.2 mbd in 1972, 3.2 mbd in 1973,


8
  For the long and desultory history of this belief, which has guided foreign policy in both Republican and
Democratic administrations without exception since 1970, see Adelman 1995. To cite just one of many striking
examples, the Bush administration in 1990 sought "a rapprochement" with Persian Gulf countries, particularly Saudi
Arabia and Iraq, which the administration believed "will be crucial to the USA's economic viability in the 1990s."
Adelman 1995, p. 291.
9
  Bob Woodward, "Greenspan: Ouster Of Hussein Crucial For Oil Security," Washington Post, September 17, 2007,
p. A3.
10
   See, for instance, Michael Scheuer, Imperial Hubris: Why the West is Losing the War on Terror (Potomac Books:
2007) and Marching Toward Hell: America and Islam After Iraq (Free Press: 2008).
11
   Ibid.
12
   This is such an obvious point that energy economists rarely bother to explore the issue in detail. To understand
how the world crude oil market works is to understand that embargoes are unenforceable. See Philip Verleger,
Adjusting to Volatile Energy Prices (Washington: Institute for International Economics, 1993) and M.A. Adelman,
The Genie out of the Bottle: World Oil Since 1970 (Cambridge, MA: MIT Press, 1995).


                                                        4
and 3.5 mbd in 1974. 13 Instead of buying from Arab members of OPEC, the United States

bought from non-Arab oil producers. The customers that were displaced by the United States

bought from Arab members of OPEC. Beyond the modest increase in transportation costs that

followed from this game of musical chairs, the embargo had no impact on the United States. 14

         In short, it does not matter to consumers to whom the oil is initially sold. All that matters

to consumers is how much oil is produced for world markets.

         Do oil producing nations allow their feelings towards oil consuming nations to affect

their production decisions? Historically, the answer has been "no." The record strongly

indicates that oil producing states, regardless of their feelings toward the industrialized West, are

rational economic actors. After a detailed survey of the world oil market since the rise of OPEC,

oil economist M.A. Adelman concluded, "[w]e look in vain for an example of a government that

deliberately avoids a higher income. The self-serving declaration of an interested party is not

evidence." 15 Prof. Philip Auerswald of George Mason University agrees, stating "For the past

quarter century, the oil output decisions of Islamic Iran have been no more menacing or

unpredictable than Canada's or Norway's." 16



Exceptions That Prove the Rule

         If energy producers are wealth-maximizers, what do we make of countries that are selling

oil and natural gas to others at below-market rates? For instance, Russia sold oil to Cuba at

below-market prices during the cold war; Russia continues to sell natural gas to Ukraine at

13
   Energy Information Administration, Annual Energy Review 2004, Table 5.3.
14
   For an overview of the impact of the embargo on the United States, see Edward Fried, "Oil Security: An
Economic Phenomenon," in Oil and America's Security, ed. Edward Fried and Nanette Blandin (Brookings
Institution, 1988), pp. 56­59, Francisco Parra, Oil Politics: A Modern History of Petroleum (I. B. Tauris, 2004), pp.
184­85, and Adelman 1995, pp. 112-113.
15
   Adelman 1995, p. 31. Former OPEC Secretary-General Francisco Parra makes the same point. Francisco Parra,
Oil Politics: A Modern History of Petroleum (New York: I.B. Tauris, 2004).
16
   Philip Auerswald, "The Irrelevance of the Middle East," The American Interest, May/June 2007, p. 22.


                                                          5
below-market prices but has ended its subsidy to Georgia as relations have soured; and China

sells oil to North Korea at low rates and used this as leverage to induce North Korea to bargain

over its nuclear weapons program. 17

        Two conclusions seem reasonable. First, sellers have leverage in natural gas markets that

is not possible in oil markets because oil can be transported easily while natural gas is shipped

through pipelines. Buyers have few near-term alternatives if natural gas sellers reduce

shipments. As liquefied natural gas gains market share, however, natural gas markets will look

increasingly like world crude oil markets, and the ability of Russia or other states to extract

concessions from consumers will dissipate.

        Second, the Russia­Cuba and China­North Korea cases involve poor countries receiving

foreign aid in the form of low-priced oil. We are unaware of any wealthy western countries

receiving such in-kind aid from oil-producing countries.

        What if a radical new actor were to emerge on the global stage? For example, if the

House of Saud were to fall and the new government consisted of Islamic extremists friendly to

Osama bin Laden, the new regime might reduce production and increase prices. 18 But that

scenario is by no means certain given that Iran ­ despite all its anti-western rhetoric ­ has not

reduced oil output out of hostility towards the West. 19

        Regardless, the departure of Saudi Arabia from world crude oil market would probably

have about the same effect on domestic oil prices as the departure of Iran from world crude oil


17
   See Steven Lee Meyers, "Russian Gas Company Plans Steep Price Increase for Georgia," New York Times
November 3, 2006, p. A12 and Joseph Kahn, "China May Be Using Oil to Press North Korea," New York Times
October 31, 2006, p. A12.
18
   Bin Laden has said on many occasions that he thinks the Saudi monarchy keeps oil prices below true market value
in order to maintain friendly relations with the West.
19
   While it is true that oil production in Iran was about twice as high under the Shah than it has been under the
Islamic Republic, almost all analysts agree that this reflects the damage down to the oil infrastructure during the
1980-88 war with Iraq, the "brain drain" that has occurred in response to the revolution, and poor state management
of Iranian oil assets ­ not the intentional result of state policy.


                                                         6
markets in 1978. The Iranian revolution reduced oil production by 8.9 percent, whereas Saudi

Arabia accounts for about 13 percent of global oil production today. 20 Oil prices increased

dramatically after the 1978 revolution, but those higher prices set in motion market supply and

demand responses that undermined the supply reduction and collapsed world prices eight years

later. 21 The short term macroeconomic impacts of such a supply disruption would actually be

less today than they were then given the absence of price controls on the U.S. economy and our

reduced reliance on oil as an input for each unit of GDP. 22

        So while it is possible that a radical oil-producing regime might play a game of chicken

with consuming countries, producing countries are very dependent on oil revenue and have fewer

degrees of freedom to maneuver than consuming countries. Catastrophic supply disruptions

would harm producers more than consumers, which is why they are extremely unlikely. The

best insurance against such a low-probability event is to maintain a relatively free economy

where wages and prices are left unregulated by government. That would do more to protect the

West against an extreme production disruption than anything else in government's policy

arsenal.



Oil Profits for Terrorists


20
   Data on Iranian production in 1978 and Saudi production in 2006 from the Energy Information Administration;
http://tonto.eia.doe.gov/merquery/mer_data.asp?table=T11.01a and
http://tonto.eia.doe.gov/merquery/mer_data.asp?table=T11.01b.
21
   Adelman, 1995, pp. 187-242.
22
   In 1978 the U.S. used 15,950 BTUs per ($2000) dollar of GDP but only 8,970 BTUs per ($2000) dollar of GDP in
2005, a reduction of 43.8 percent. And the BTUs used in 2005 came less from petroleum than in 1978 (47.5 percent
of 1978 energy consumption was petroleum versus only 40.5 percent in 2005). Energy Information Administration,
Annual Energy Review 2005 Tables 1.3 and 1.5 pp. 9 and 13. For discussions of the macroeconomic effect of oil
price increases, see Rajeev Dhawan and Karsten Jeske, "How Resilient Is the Modern Economy to Energy Price
Shocks?" Economic Review, Federal Reserve Bank of Atlanta 91:3, Third Quarter, 2006, pp. 21-32, David Walton,
"Has Oil Lost the Capacity to Shock?," Bank of England Quarterly Bulletin 46:1, Spring 2006, pp. 105-114,
available at http://www.bankofengland.co.uk/publications/quarterlybulletin/qb060109.pdf, and Eric Fisher and
Kathryn Marshall, "The Anatomy of an Oil Price Shock," Economic Commentary, Federal Reserve Bank of
Cleveland, November 2006.


                                                       7
         Does Western reliance on oil put money in the pocket of Islamic terrorists? To some

degree, yes. Does that harm western security? Probably not ­ at least, probably not very much.

         Before we go on, it's worth noting that only 15.5 percent of the oil in the world market is

produced from nation-states accused of funding terrorism. 23 Hence, the vast majority of the

dollars we spend on gasoline do not end up on this purported economic conveyer belt to terrorist

bank accounts.

         Regardless, terrorism is a relatively low-cost endeavor and oil revenues are unnecessary

for terrorist activity. The fact that a few hundred thousand dollars paid for the 9/11 attacks

suggests that the limiting factor for terrorism is expertise and manpower, not money.

         That observation is strengthened by the fact that there is no correlation between oil profits

and Islamic terrorism. We estimated two regressions using annual data from 1983 to 2005: the

first between fatalities resulting from Islamic terrorist attacks and Saudi oil prices and the second

between the number of Islamic terrorist incidents and Saudi oil prices. In neither regression was

the estimated coefficient on oil prices at all close to being significantly different from zero. 24

         Consider: Inflation-adjusted oil prices and profits during the 1990s were low. 25 But the

1990s also witnessed the worldwide spread of Wahabbi fundamentalism, the build-up of

Hezbollah, and the coming of age of al Qaeda. Note too that al Qaeda terrorists in the 1990s



23
   Calculation from "Fatally Flawed Premise: Why Anti-Oil Weapon in War on Terror Won't Work," Energy
Détente 27:11, Lundberg Survey, Inc., November 30, 2006.
24
   Data on international Islamic terrorism incidents and fatalities were taken from the MIPT Terrorism Knowledge
Base, an interactive website maintained by the Memorial Institute for the Prevention of Terrorism;
http://www.tkb.org/. Data on that website comes from the RAND Terrorism Chronology and RAND-MIPT
Terrorism Incident databases; the Terrorism Indictment database; and DFI International's research on terrorist
organizations. Nominal Saudi oil prices were obtained from Energy Information Administration, Annual Energy
Review 2005 p. 169 Table 5.19 "Landed Costs of Crude Imports From Selected Countries" and deflated with the
GDP deflator. Unit root tests suggested that fatalities and Saudi oil prices had unit roots but terrorist incidents did
not, so the former were first differenced before the regressions. Even after first differencing, auto correlation existed
so autoregressive terms were added to each regression, which further weakened the insignificant relationships.
25
   OPEC oil price data available at the interactive online "Petroleum Navigator" dataset maintained by the U.S.
Energy Information Administration; http://tonto.eia.doe.gov/dnav/pet/hist/wtotopecw.htm.


                                                           8
relied upon help from state sponsors such as Sudan and Afghanistan ­ nations that aren't exactly

known for their oil wealth or robust economies.

         Producer states do use oil revenues to fund ideological extremism, and Saudi financing of

madrassas and Iranian financing of Hezbollah are good examples. But given the importance of

those undertakings to the Saudi and Iranian governments, it's unlikely that they would cease and

desist simply because profits were down. They certainly weren't deterred by meager oil profits

in the 1990s. 26

         The futility of reducing oil consumption as a means of improving national / energy

security is illustrated by the fact that states accused of funding terrorism earned $290 billion

from oil sales in 2006. 27 Even if that sum were cut by 90 percent, that would still leave $29

billion at their disposal ­ more than enough to fund terrorism given the minimal financial needs

of terrorists. 28



Rents to Bad Actors

         When oil prices are high, so too are oil profits for infra-marginal (low-cost) producers.

Even if those profits do not find their way to international terrorists, they serve to prop up many

regimes we find distasteful. Oil producers in the Second and Third worlds often use their robust

flow of petrodollars to squelch human rights at home and to menace neighbors abroad. 29 Many


26
   Although little is known about funding trends associated with Iranian support for Hezbollah, the Iranian
government probably spends no more than $25-50 million on Hezbollah a year. Anthony Cordesman, "Iran's
Support for Hezbolla in Lebanon," Center for Strategic and International Studies, July 15, 2006, p. 3. Even less is
known about Saudi contributions to Islamic extremism. See Alfred Prados and Christopher Blanchard, "Saudi
Arabia: Terrorist Financing Issues," RL32499, CRS Report for Congress, Congressional Research Service, Updated
December 8, 2004.
27
   Lundberg Survey, 2006, p. 8.
28
   Ibid.
29
   For a brief review of the academic literature on this subject, which is somewhat mixed, see Paul Stevens,
"Resource Impact: Curse or Blessing? A Literature Survey," The Journal of Energy Literature 9:1, June, 2003, pp.
22-24.


                                                         9
foreign policy elites argue that oil consumption thus harms national security by strengthening

these bad international actors. 30

        It is unclear to what extent oil profits are associated with human rights abuses or

militaristic activity. There are plenty examples, after all, of relatively long-lived regimes with

terrible human rights records ­ such as North Korea ­ with no oil revenues to speak of, and this

is the case even within the same socio-economic regions. Denuding Iran and Libya of oil

revenues might produce a government that looks a lot like Syria; denuding Venezuela of oil

revenues might produce a government that looks a lot like Cuba; and denuding Russia of oil

revenues might produce a government that looks a lot like Russia used to be. After all, all of

these "bad-acting" petro-states yielded unsavory regimes even when oil revenues were a small

fraction of what they are today.

        The claim that oil revenues increase the threat those regimes pose to their neighbors

seems reasonable enough, but here again, it is unclear to what extent this is true. Pakistan is a

relatively poor country with no oil revenues to speak of, but it has still managed to build a

nuclear arsenal and is constantly on the precipice of war with India. Impoverished, oil-poor

Egypt and Syria have at various times been the most aggressive anti-Israeli states in the Middle

East. Russia launched its war with Chechnya before oil revenues engorged its Treasury.

        While we have no doubt that ­ all other things being a equal ­ a rich bad actor is more

dangerous than a poor bad actor, the marginal impact that oil revenues have on "bad acting"

might well be rather small. The fact that unsavory petro-states have been fully capable of

holding on to power, oppressing their people, and menacing their neighbors during a decade

30
  Representative arguments include Richard Lugar and R. James Woolsey, "The New Petroleum," Foreign Affairs,
January/February 1999, pp. , as well as any of a number of columns written on this topic by Thomas Friedman for
the New York Times. Those arguments are embraced by most foreign policy elites, as evidenced by National
Security Consequences of U.S. Oil Dependency, Task Force Report 58, Council on Foreign Relations (Council on
Foreign Relations Press: October 2006),


                                                      10
associated with the lowest inflation-adjusted oil prices in history (the 1990s) suggests that

nothing short of rendering oil nearly valueless will have any real effect on regime behavior.

        For the sake of argument, however, let's assume that there is some incremental benefit

associated with reducing oil revenues to bad-acting oil producers. Unfortunately, we have only

very blunt and imperfect instruments at hand to achieve that end. Policies that might reduce oil

consumption would reduce oil demand ­ and thus, reduce revenues ­ for all oil producers,

whether they are bad actors or not. Producers in the North Sea, Canada, Mexico, and the United

States (which collectively supplied 20.1 million barrels of oil per day in 2006, or 24 percent of

the world's crude oil needs that year) would be harmed just as producers in Venezuela, Iran,

Russia, and Libya (which collectively supplied 20.3 million barrels per day in 2006). 31

        Given there was plenty of "bad acting" in 1998 when we saw the lowest real oil prices in

world history, it's unlikely that even the most ambitious set of policies to reduce oil consumption

would have much effect on bad acting. Accordingly, we doubt that the foreign policy benefits

that might accrue from anti-oil policies would outweigh the very real costs that such policies

would impose on both consumers and innocent producers. We suspect that there are better

remedies available to curtail bad behavior abroad.



An LNG Cartel?

        Growing demand for natural gas and the declining costs associated with liquefying and

transporting natural gas by ship has led most energy economists to conclude that natural gas

markets, which have historically been continental and thus regional, will soon look very much




31
  Energy Information Administration, International Petroleum Monthly, May 8, 2007;
http://www.eia.doe.gov/emeu/ipsr/t22.xls.


                                                      11
like oil markets. 32 While liquefied natural gas (LNG) is still more expensive than conventional

natural gas delivered via pipelines, regional price discrepancies are so great that international

trade in natural gas is on the rise. 33

        The emergence of LNG and the advent of an international gas market has prompted

several major gas producers ­ such as Russian president Vladimir Putin ­ to entertain the idea of

a global cartel of natural gas producers. 34 Accordingly, a number of foreign policy elites are

alarmed ­ not relieved ­ by the rise of LNG. One OPEC is bad enough. Who wants a second?

        Suspicion that LNG is bad news for consumers because the LNG market might

eventually be captured by some future producer cartel overlooks the fact that LNG is bad

economic news for gas pipeline owners (like Russia) and good economic news for everyone else

(like Europe). Producers in some markets did not need cartels prior to LNG; they were the sole

providers to begin with. Low-cost LNG technology allows producers everywhere to enter

markets anywhere. Thus, reluctance to embrace LNG is essentially a preference for more rather

than less market concentration, with or without a cartel.

        Some political actors recognize this, but they worry that market actors are not

demonstrating sufficient interest in LNG investments. Hence, a number of Europeans have

called for a continental energy strategy that would direct public and private investment towards




32
   Dagobert Brito and Peter Hartley, "Expectations and the Evolving World Gas Market," The Energy Journal 28:1,
2007, pp. 1-24.
33
   In 1993, 3 billion cubic feet (bcf) of LNG was exported around the world. By 2007, 7.63 bcf of LNG was so
exported. Data from the Energy Information Administration;
http://www.eia.doe.gov/emeu/international/gastrade.html. For a summary of the prospects for growth in inter-
regional LNG markets, see Donal Juckett and Michelle Michot Foss, "Can a `Global' Natural Gas Market Be
Achieved?" in Energy & Security: Toward a New Foreign Policy Strategy, Jan Kalicki and David Goldwyn, eds.
(Johns Hopkins University Press: 2005), pp. 531-552.
34
   Steven Lee Myers, "Pact with Iran on Gas Sales is Possible, Putin Says," New York Times, February 2, 2007, p.
A10. For an alarmist read on this development, see Ariel Cohen, "Gas OPEC: A Stealthy Cartel Emerges,"
WebMemo 1423, Heritage Foundation, April 12, 2007.


                                                       12
the construction of LNG terminals and supply infrastructure. 35 If LNG will liberate Europe from

reliance on Russian gas, it is thought, then European states should ensure that the market moves

towards LNG as quickly as possible.

        Rarely, however, do we hear a convincing narrative about why market actors are

systematically under-investing in LNG. For the moment, LNG is still substantially more

expensive than natural gas delivered via pipeline from Russia, and market actors are not as

convinced as politicians that LNG is an economically attractive means of insuring against

Russian supply disruptions. Politicians may feel otherwise, but why their judgment of disruption

risks ­ or their judgment about optimal risk hedging strategies ­ is superior to the judgment of

thousands of market actors with a direct financial incentive to get such things right, is unclear.

Economist Friedrich Hayek's insight ­ that market actors are, in aggregate, better informed than

political actors 36 ­ would seem to hold here; market judgments are better informed than political

judgments.

        Regardless, should consumers be worried about the advent of a natural gas cartel? Well,

they should not celebrate its arrival, but it is uncertain to what extent a cartel would actually

increase natural gas prices. Surprisingly enough, there is very little concrete evidence for the

proposition that OPEC has, on balance, increased world crude oil prices above where they might

have been absent the cartel. 37

        Cartels, moreover, are quite difficult to hold together in practice. That's because

members face a multilateral prisoner's dilemma game. If all members comply with their



35
   "A European Strategy for Sustainable, Competitive and Secure Energy," SEC(2006) 317, Commission of the
European Communities, March 8, 2006.
36
   Friedrich Hayek, "The Use of Knowledge in Society," American Economic Review 35:4, September 1945, pp.
519-530.
37
   James Smith, "Inscrutable OPEC? Behavioral Tests of the Cartel Hypothesis," The Energy Journal 26:1, 2005,
pp. 51-82.


                                                       13
production quotas, and those quotas yield a profit-maximizing amount of global supply from the

producers' standpoint (a very big "if" ­ ascertaining such things is much harder than popularly

believed), then cartel members will profit handsomely. If one member of the cartel defects,

however, cartel members will still profit, but the defecting producer will earn more than it would

have earned had it stuck to its quota (how much more depends on how much spare production

capacity the defecting country has on hand). If a large enough number of cartel members defect,

however, the profits promised by the cartel will disappear for all members. 38

         To make matters worse for the cartel, members are rarely in a position to independently

verify whether fellow cartel members are complying with their production quotas, and decisions

whether to comply or not comply with production limits are made simultaneously. While the

repeated "plays" of the game mitigate against chronic defection to some degree, the history of

OPEC suggests that defection is still the rule rather than the exception. 39

         In any event, an LNG cartel would have far less leverage over consumers than an oil

cartel for a very simple reason; fuel competition in the electricity sector is far more robust than it

is in the transportation sector. If LNG became too expensive, consumers could switch to coal,

nuclear, or renewable energy, all of which are more cost competitive with gas than alternative

fueled vehicles are with oil. 40


38
   For an excellent review of the literature, see How Cartels Endure and How They Fail: Studies of Industrial
Collusion, Peter Grossman, ed. (Edward Elgar, 2004).
39
   See generally Adelman, 1995, particularly the history surrounding the mass defections that occurred in the course
of the run-up to the 1986 price collapse (pp. 201-236) and the Kuwaiti and Abu Dhabi defections that set in motion
the events leading up to the 1990 Iraqi invasion of Kuwait (pp. 272-297). Defection is less a problem for the cartel
at present because OPEC production quotas at the time of this writing seem to allow member states to produce light
crude oil at capacity. When there is no OPEC production restraint, there is no possibility of defection.
40
   The real levelized cost of gas-fired electricity in the United States before government distortions is 5.29 cents per
kilowatt hour (kWh). By means of comparison, the real levelized cost of conventional coal-fired electricity is 3.1
cents per kWh, clean coal is 3.53 cents per kWh, nuclear is 4.57 cents per kWh, wind is 4.95 cents per kWh, and
biomass is 4.96 cents per kWh. Although renewable energy costs are likely underestimated because they do not
reflect the cost of securing back-up generation and additional units of transmission capacity, natural gas is still the
most expensive conventional source of electricity in the United States. While natural gas is cheaper in Europe, the
fact remains that competition in the electricity sector would constrain and LNG cartel to a great extent. Cost data


                                                           14
Foreign Policy Elites & Energy

        The arguments laid out in this paper are rarely encountered in foreign policy circles.

Nevertheless, they represent the orthodox view of economists and corporate analysts who

specialize in the study of oil and natural gas markets.

        When foreign policy elites encounter these arguments in public forums, they tend to

dismiss them as overly theorized economics that assume perfectly informed rational actors and,

moreover, are divorced from geopolitical reality. Energy producers, we are told, are not first and

foremost wealth maximizers. They pursue foreign policy ends and demonstrate a willingness to

sacrifice money to secure those ends. Ideological regimes, moreover, have not always acted

rationally in the past and cannot be counted upon to do so in the future. The possibility that

producer states might become economic suicide bombers ­ immolating their own economies in

order to inflict great economic pain on the West ­ cannot be lightly dismissed.

        The facts, however, indicate that the above narrative is fundamentally at odds with

observable reality. Energy producers have thus far demonstrated a keen interest in near-term

wealth maximization ­ cover stories to the contrary notwithstanding. International actors rarely

if ever act irrationally as an economist would define the term (e.g., they do not act in a manner

that would frustrate their self interest as they perceive it). Fears of "economic suicide bombing"

by anti-Western producer states are greatly exaggerated by an overly pessimistic view of the

harm said bombing could do to Western economies. And worry over embargoes demonstrates a

fundamental ignorance of how international oil markets work.




from Gilbert Metcalf, "Federal Tax Policy Towards Energy," Working Paper 12568, National Bureau of Economic
Research, October, 2006, table 8, p. 36.


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       There are plenty of things for foreign policy elites to worry about. Energy security,

however, is not one of them.




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