Thursday, August 24, 2006

The New World of Over-Demand and Under-Supply

Towards Energy Autarky

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site

The collapse of the Doha round of trade talks in July raised fears that the world might be about to descend into 1930s style autarky, with a huge negative effect on prosperity. Unless things get very much worse, that’s unlikely in trade as a whole, if only because the historical memory of the 1930s remains strong. However in the energy sector autarky increasingly appears a rational strategy, and free-trading globalization an unattainable and dangerous alternative.

The theoretical economic superiority of globalization rests on a number of foundations, some of which are rather shaky in the modern world. However, its principal requirement is that states themselves (to the extent that they control resources) be economically rational, acting to maximize their own wealth through entering into trade agreements with each other. In such a world, the doctrine of comparative advantage dictates that a country should not worry about losing a particular industry to cheaper competition, because the purchasing power created overseas through outsourcing will increase demand for other products for which it is the low cost producer. In a world of free markets and economically motivated actors, a country will always be able to get the supplies of a particular product or commodity it needs, at a price that reflects the global marginal cost of production.

However, we don’t live in such a world. Not only economically marginal countries such as North Korea and Cuba, but major producers of valuable goods such as Iran and Venezuela are governed by political forces more or less hostile to the United States, and to a lesser extent to the West in general. Other countries, notably Russia and China, are by no means so well disposed to the West as to miss an opportunity to use any economic weapon that falls into their hand – and with great effectiveness too, as has been shown by the collapse of the Orange Revolution government in Ukraine after Russia unilaterally imposed a new pricing regime on natural gas exports in mid winter.

In most manufactured goods, this doesn’t much matter. If China imposes an embargo on the world’s socks, in which it has through aggressive pricing acquired a substantial market share, it may damage Wal-Mart’s profitability for a time but it will cause no long term or even medium term economic damage – other sock producers will take China’s place. Even a strategic item such as steel, in which China now has by far the world’s largest production capacity, is pretty well invulnerable to embargo – iron ore is plentiful all over the world and steel producing capacity remains sufficiently widespread that there is unlikely to be more than a temporary effect from such an embargo.

Thus in manufactured goods, and in most commodities, the free trade globalization model is both the most efficient and relatively invulnerable to supply side shocks. Trade would be disrupted by a major war, but a simple embargo or “cold war” situation would not have a major effect on trading patterns or costs. Protectionism in agriculture or textiles, for example, is both strategically unnecessary and economically counterproductive. Only in a few high-intellectual-property sectors such as software does outsourcing lead to the possibility of economic damage to the outsourcing country that is greater than the benefit it obtains from buying cheaper products. (David Ricardo’s Doctrine of Comparative Advantage falls down if by outsourcing to a cheaper labor environment you allow the outsourcee country to change its relative factor position and thereby gain comparative advantage in the remainder of your product range that you hadn’t outsourced.)

However, in a limited number of commodities, notably oil but also including some metals whose sources are relatively geographically concentrated, both product sources and substitutability are limited, so the globalization model doesn’t work. If all participants in the market were “economic men” this wouldn’t matter – suppliers would compete with each other, and disruption of supply in one area would (possibly after some delay) be made up by one of the other suppliers, who would utilize higher prices to ramp up production. This was the idea between the Athabasca tar sands in Alberta; they required a high oil price to be economically viable, but when that high price was attained they became an economically viable and attractive source of petroleum products. Much of the rejoicing behind the collapse of Communism in the 1990s stemmed from the idea that a capitalist Russia would form a source of supply for the world’s oil needs that was independent of the Middle East and could be relied upon to pump at full blast provided the price was right.

It’s now clear that a large portion of the world’s oil production volume derives from countries whose motivations are not primarily economic. Venezuela under its current government is motivated primarily by dislike of the United States, while Russia is motivated by the strategic leverage brought by its position as a major oil producer. Iran’s motivations are unclear; dislike of the United States and the West is certainly part of them, however. More ominously, the long term political stability and pro-Western orientation of Saudi Arabia, the world’s largest oil producer, cannot be assured in an era when radical jihadism commands substantial popular support across the Middle East. Thus a moderate share of the world’s oil production is already controlled by governments motivated by political/strategic rather than economic objectives; if Saudi Arabia were to fall, the non-economic portion of the world’s internationally traded oil production would become a majority.

While the quixotic resistance of the U.S. Congress to oil drilling in the Arctic National Wildlife Refuge continues, in other respects consumer governments are joining producer governments in autarkic behavior, seeking to control a greater proportion of their energy needs even if this is economically sub-optimal. China is generally fairly autarkist; thus it is no surprise that it has reached a long term supply arrangement with Iran and is seeking others in Latin America. China’s surging oil needs represent the largest single share in the projected increase in oil consumption to 2025; thus “cold war” style conflict with China over oil resources is likely to continue.

Of particular interest in this respect is Wednesday’s Wall Street Journal report that South Africa’s SASOL oil from coal project is in detailed talks with China about technology transfer. There is a certain “Back to the Future” quality about energy news generally – the topics being discussed often had their origins 30 years ago, in the middle 1970s – and SASOL as a major source of world energy is no exception to this; it was a highly fashionable idea in the late 1970s as the gold price soared to $800 per ounce and South Africa appeared the wave of the future. However it should be noted: the last two societies to make substantial use of oil-from-coal technology were apartheid-era South Africa and Nazi Germany; if China is consciously following their road the forces of autarky are strong indeed.

The United States, being at least marginally concerned with global warming, is unlikely to go for oil from coal, which according to the National Resources Defense Council emits 49.5 pounds of carbon dioxide per gallon compared with 27.5 emitted by burning conventional gasoline. Instead, the U.S. has focused attention on ethanol, which its proponents claim is “clean” although they’re only able to reach such a conclusion by counting the carbon dioxide absorbed by the growing plants as well as that emitted in burning the ethanol (unless you grow the plants in the Sahara, or on Arctic tundra, they replace other vegetation and so produce little or no net increase in carbon dioxide absorption.)

However, in a particularly autarkic move, the George W. Bush administration has sought to encourage domestically produced ethanol from corn, which even at $70 per barrel is only marginally competitive, rather than moving to ethanol produced from sugar cane, about half the net price (and less now world sugar prices have dropped from 18 cents to 10 cents a pound) but requiring to be grown in tropical countries, thus mostly outside the United States. Economically, this makes no sense – unless Bush expects a jihad to erupt in the Caribbean – politically, it’s the same old protectionist story.

The use of oil as a political weapon by producers, and the attempts by consumers to lock up long term supply contracts or move to other energy sources that are only marginally competitive even at present prices will keep oil prices at or above $70 much longer than they need to be. Eventually, of course, the oil market will break, reducing Russia once again to a second class power with a bankrupt economy, removing the Middle East almost entirely from the world’s headlines, and producing a fawning Venezuelan government that begs for World Bank handouts to feed its starving people. However that outcome, so devoutly desired by armchair strategists of the neocon persuasion, will only happen in only one way: through a really devastating world recession that slashes oil demand.