Ensuring global energy security will require economists and policymakers to rethink the macroeconomic fallout of energy disruptions.
Folks are rightly worried about the economic fallout from the war in Iran. The closing of the Strait of Hormuz raised the price of gasoline, jet fuel, and other petroleum products globally. In Europe and Asia, which rely heavily on liquefied natural gas imports, natural gas prices have skyrocketed. Beyond energy, prices for products significantly linked to Middle East suppliers, such as fertilizer and helium, have similarly increased.
Even when safe and predictable transit through the strait is restored, it’ll take time for the consequences of the disruption and its resolution to propagate through the global economy. Already, some regions are being forced to ration. Economists expect additional price increases, as the effects to date force businesses further downstream to raise their prices, as well. Rising prices and rationing raise further concerns about inflation and an economic slowdown.
What should we do? In the short run, there are limited options for governments and private actors to mitigate the effects of a global reduction in the supply of essential goods like petroleum and natural gas. Some burdens can be shifted, but the pain of less product and higher prices will be felt somewhere. Over a longer time horizon, however, we can and should ask how the events in Iran may inform policies to address future energy security and reduce the risk of future disruptions.
My colleagues at Resources for the Future (RFF) have a long history of thinking about energy supply disruptions and potential solutions. A useful way to frame energy security—and the costs of losing it—is as an externality arising from our use of, and dependence on, certain energy sources like oil and petroleum products. Consumers generally do not consider the full costs of potential disruptions when they decide to purchase or indirectly depend on various types of energy. They may consider the risk that fluctuating prices may pose to their wallets; they may even seek to hedge that risk. But energy consumers are unlikely to consider how their consumption, aggregated to the whole economy, creates a macroeconomic risk that is bigger than the sum of its parts. That macroeconomic risk can be estimated, valued, and turned into an estimated security cost, or “premium.”
Credit: noomcpk / Shutterstock
Studies from 10 years ago suggest a premium of about $5 per barrel of oil in the United States. (Past studies have focused on oil, given that the dependence on and risk to natural gas supplies is a relatively new phenomenon.) Estimates typically focus on both (1) the macroeconomic risk of a lower GDP and (2) trade effects.
The first measure captures the risk of depressing the US GDP or growth in economic activity due to a sudden and sustained jump in the price of oil and petroleum products, as we’ve recently seen.
The second effect estimates the value of those products shipped to and from the rest of the world. This trade effect has a diminished, even negative, role in calculating the premium, as the United States has become a net exporter of oil and petroleum products. But even when the United States was a significant importer, this trade effect was consistently estimated to be a smaller component of the security premium than the GDP effect. As my RFF colleagues have consistently emphasized, “energy security” is not fundamentally about net oil imports; energy security is about reducing the risk of a slowdown in economic activity.
(While my focus is on the macroeconomic risk to a country, companies can estimate their own security premiums by quantifying their own specific cost implications of price shocks of varying size and duration. They can even reference the same tables of prices and probabilities used in the macroeconomic estimates.)
One can, of course, dig into the many uncertainties and limitations of any particular estimate of the security premium for a country (or a company). For example, a variety of non-GDP externality effects can arise from oil disruptions—for example, additional military or foreign policy costs—suggesting that these estimates are too low. These estimates also focus on costs to the US economy. Over the past month, we have seen much larger effects in Europe and Asia from disruptions in oil and natural gas markets. The global energy landscape is shifting, too: changing trends in oil and gas supply and demand mean that the risks today are different from both the past and the future.
Quantifying the Benefits of Energy Security
Despite the caveats, the notion of a security premium is a useful framework for understanding how we can value and improve future energy security. First, it gives us a mechanism to think through the benefit-cost analysis of efforts or policies to address energy security.
For example, when we think about the value of fuel economy standards on cars in the United States, one benefit to include—aside from the pocketbook savings of lower gasoline costs to households—is the additional savings for the country from lower macroeconomic risk. This lower risk would be measured as the oil premium multiplied by the amount of gasoline saved. We could also ask how much a policy decision to fill the Strategic Petroleum Reserve reduces the impact or likelihood of a supply disruption. That is, arguably a larger reserve both gives us additional ability to reduce the impact of any shock through larger releases and may dissuade foreign actors from pursuing a disruption in the first place. We could translate that reduced probabilistic impact into a corresponding reduction of the security premium. That change, multiplied by the volume of oil consumption, would be the benefit in a benefit-cost calculation of expanding the reserve.
Second, it seems likely that estimates of future risk premiums will be higher for some time, even after the war in Iran ends. The current disruption (in terms of daily physical volume prevented from reaching global markets) is several times larger than previous market shocks and is comparable to the largest and lowest-probability shocks in our previous research. Moreover, we now have a much more concrete idea of how an event like the effective closure of the Strait of Hormuz would occur. So does Iran. Both of these features of the current disruption will make analysts revise their assessments of both the probability and the magnitude of future oil shocks. Unless Iran’s capacity for future disruptions is substantially weakened for many years, it seems a revised security premium will be higher because of the current conflict.
Credit: Jean-Phillippe Tournut / Getty Images
Third, the longer-term solutions identified in previous discussions about security premiums are still relevant: namely, the need to diversify, shift toward more secure supplies, and reduce consumption of petroleum products. More pathways to these solutions have emerged—most notably, electric vehicles provide a practical alternative to gasoline vehicles.
At the same time, a new risk has emerged with its own set of similar solutions. What’s now become a security risk for some regions is their increased reliance on natural gas that’s tied to global markets of liquefied natural gas. In the past, these regions would have sought domestic coal, domestic natural gas, nuclear power, hydroelectric power, or renewable energy resources. Now, renewables are much cheaper, and battery storage is available to firm up intermittency. And, in the future, lower-cost nuclear and geothermal energy may provide even more secure options for electricity generation. Policies promoting these approaches can provide net benefits to society by lowering the security premium. Worth noting are the concerns about technologies for which much of the supply chain is in China or other countries that pose a different kind of security risk. These risks, related to capital costs, are fundamentally different than the risks faced by oil and gas, related to operating costs.
The energy security benefits of these diversification opportunities are highlighted in countries like China and Pakistan. These countries face very different consequences during the current disruption than other Asian countries, in part based on their choices to expand electric vehicle use and renewables over the past decade. Some countries have begun increasing coal use in response to the war in Iran, making use of idle capacity. However, coal has additional environmental costs that otherwise must be managed or factored into any benefit-cost analysis, especially as a long-term energy security solution.
Fourth, a tempting and generally false narrative asserts that limiting trade could be a reasonable, long-term way to improve a nation’s energy security. Here, three points are worth noting. First, the risk of domestic disruptions can increase with limits on trade. Trade provides a way to share and dissipate domestic market risks. Second, limits on trade that reduce US exposure to global risk may increase global risk in other countries—and, as long as the US economy remains broadly linked to other economies, those risks can come back to Americans through global macroeconomic effects. A slowdown or recession outside the United States will reduce demand for US exports and reduce the income derived from US foreign investments. Finally, trade limits can be economically costly. RFF colleagues highlighted this more than 10 years ago, in reverse. They demonstrated that eliminating the then-existing ban on crude oil exports from the United States could reduce gasoline prices and increase oil security.
The Sum of the Parts vs Each of the Parts: Energy Price Shocks Are Felt Unequally
This discussion so far has focused on aggregate costs to the economy due to disruptions in oil and energy supply. Lurking beneath these aggregate costs can be significant effects on some individuals and communities, even when aggregate effects are small.
At a minimum, we know that winners (domestic producers and communities tied to oil and gas production) can arise alongside losers (oil and gas consumers). We also know that energy price shocks are regressive: poorer households spend larger fractions of their income on energy, and we have observed that variation in energy expenditure within income groups is even larger than across groups. Meanwhile, many households face energy insecurity, leaving them ill-prepared for shocks. Businesses exposed to significant volatility in energy prices can reallocate the risk of energy price shocks through contracts (as can producers: Mexico has regularly insured its exposure to sharp declines in oil prices). Businesses also may have some ability to raise prices for customers. But significant risk remains for households, particularly less affluent households, with no easy solutions once shocks occur. This concern argues for not just a focus on an aggregate benefit-cost analysis of policies to reduce macroeconomic risks, but also a focus on how price shocks more generally affect different households.
I expect we will see a renewed interest in reducing nations’ vulnerability to energy disruptions and increasing energy security owing to recent events. New technologies and opportunities are available, but the broad strategy from past experience remains: diversify, shift toward more secure supplies, and reduce consumption of vulnerable energy products.
