Energy, Security, and Climate

Ask someone to identify a big geopolitical consequence of the ongoing U.S. oil production boom and odds are high that they’ll invoke Iran. (Every one of the links in that last sentence is an example.) Without surging U.S. oil production, they’ll argue, sanctions on Iranian oil exports would have led to a massive oil price spike. Here is a concrete case of the oil boom yielding greater U.S. freedom of action in the world, and a harbinger, it would seem, of things to come. The historical account seems right, but it’s tough to see how the Iran experience might be repeated. The upshot is that the lessons for  future U.S. freedom of action – and for geopolitics more generally – are being badly over-read. To understand how the U.S. oil supply boom helped make room for Iran sanctions, think about the impact of the supply boom first, and the sanctions second. How would the oil boom have affected the market around 2012 – the year that the oil export sanctions started to really hit Iran – had there been no curtailment of Iranian exports? In principle, rising U.S. output might have deterred others’ investment in oil production. But the gap between the emergence of the U.S. oil boom and the imposition of Iran sanctions was too short to allow any such shifts to meaningfully affect actual production. (Remember this for later.) Only two responses to accommodating rising U.S. supplies would have existed. First, prices could have fallen, encouraging greater oil demand and (at some point) shutting in some other supplies. Second, some oil producers (notably Saudi Arabia) could have voluntarily curtailed their production, bolstering prices but increasing spare capacity in the market. The actual outcome would certainly have been a mix. Now bring the Iran sanctions back in. To the extent that higher U.S. production would have otherwise encouraged greater spare capacity, this spare capacity could in turn have been used to blunt the impact of lower Iranian exports. To the extent that U.S. production would have otherwise encouraged lower prices, any actual price impact of the Iran sanctions (due to inability to fully offset lower exports through others’ spare capacity) would have happen against a lower base price, yielding a lower absolute price. And, to the extent that other commercial projects had been shut in, some would have come back online in the face of falling Iranian exports, partly offsetting the reduced supplies. Indeed this is basically what happened – except instead of occurring in a 1-2 sequence, so that analysts could easily disentangle the two dynamics, everything happened at the same time. New spare capacity didn’t emerge because it was being used up to cover Iranian shortfalls just as it was, in effect, being created. Lower prices didn’t emerge because, just as U.S. production was pushing prices down, lower Iranian exports were offsetting that impact. This is why, when people say that the U.S. oil boom created room for Iran sanctions, they’re basically correct. This same logic, though, can help us understand why this experience doesn’t tell us much about the future. Recall from a few paragraphs back: “In principle, rising U.S. output might have deterred others’ investment in oil production. But the gap between the emergence of the U.S. oil boom and the imposition of Iran sanctions was too short to allow any such shifts to meaningfully affect actual production.” The upshot was that adjustments had to occur through spare capacity or large price shifts instead. But this constraint vanishes when you look out over the longer term. At this point, higher U.S. production ought to be affecting investment decisions around the world, and more important, before long that in turn ought to be affecting actual production. Much of the impact of higher U.S. production on world prices might be neutralized by reduced oil supply investment, and hence production, elsewhere. This means that net downward pressure on prices should be greatly reduced. To be certain, there should be some net addition to supplies, and hence somewhat lower prices, which would help accommodate future sanctions. But, over the medium to long run, the effect on prices should much more muted than it is in the short term. Even more important, the boom shouldn’t boost spare capacity in the system over the long haul. Imagine, for example, that Saudi Arabia expects U.S. production to be so high that it anticipates having to curtail its own production in order to maintain high prices. In the short run, the only way it can do that is by boosting spare capacity. In the longer run, though, it can reduce investment in production. Doing that would yield the same oil revenues at lower cost and with the same amount of spare capacity that Saudi Arabia originally desired. (Since spare capacity is ultimately a political tool, the amount of it Saudi Arabia actually wants shouldn’t change with rising U.S. oil production.) The one thing that doesn’t leave the world with, though, is an increased ability to deal with new shocks – and, as a corollary, it doesn’t leave the United States with new freedom of action. The only way around this is if U.S. supply growth continues to surprise to the upside. In that case, the world will generally be oversupplied, resulting in lower prices, higher spare capacity, and greater U.S. freedom of action to do things like Iran sanctions. It’s essential to be clear, though, that this requires more than merely high and rising U.S. production – it requires high and rising U.S. production well beyond what market participants currently anticipate. Given the frenzy over U.S. oil production, that’s a high bar to meet. Indeed it seems at least as plausible, given all the current excitement, that surprises will be on the downside. In that case, we should expect the opposite of what happened around the Iran sanctions – higher prices, less spare capacity, and reduced U.S. freedom of action. You won’t see me betting either way – including on the idea that a new world of easier-to-use energy sanctions is upon us.