Dependence on oil creates national security issues. There's too many people who have got oil that may not like us.

—George W. Bush, 2007

The world oil market controls the price you pay for gas at your neighborhood gas station. Taxes, gas station profits, and oil-refinery profits also take their toll, but when you see the price of gas go up twenty cents in one week, that’s the world oil market in action. There’s no escaping it. Even if your gas station sells gasoline made from 100 percent American oil, the price will go up exactly the same amount. Even if you buy American corn ethanol, the world oil market will hit you just as hard.

This spells bad news for the most popular path to energy independence—alternative fuels. But there are two other paths that the world oil market treats more kindly—conservation and electric cars. Conservation defeated OPEC years ago, and conservation wins again when it comes to protecting American consumers.

Oil Tankers Make the Market

Although oil tankers are expensive to build, they move so much oil so cheaply that they add relatively little to the price of oil. Cheap transportation of oil keeps oil prices aligned around the world.

For example, America buys more oil from Canada than from any other country, and Canadian companies can sell oil profitably for $60 a barrel. Did this help us when the world price went to $100 per barrel in early 2008? Unfortunately, it did not. Canadian companies, like all oil companies, can sell their oil anywhere in the world with only a small charge for transportation. So when China or Germany is paying $100 per barrel, Canada is not going to sell oil to the United States for $60 a barrel.

The ability of oil companies to sell anywhere with only a small transportation cost means no oil company will sell oil much below the world price of oil. That is what creates a single world oil price. Because there is basically only one price, it doesn’t really matter who America buys from. Buying from Canada is no protection at all. If there’s a shortage, the price we pay will go up just the same. (See also Military Oil.)

A significant supply disruption anywhere in the world will cause a price shock everywhere, so a world market may seem to increase the danger. But it also dilutes the shock by spreading it over the whole world. In another way, having a unified world oil market provides excellent protection. OPEC cannot harm the U.S. supply of oil without harming the whole world equally.

Even if America bought most of its imported oil from OPEC, cutting us off would cause us no special harm. Here’s what would happen. Our oil companies would immediately offer to buy oil at a bit above the world price from any oil company in the world. Since any of them could make money by buying at the world price and selling to us for a bit more, many would be happy to do so. In fact, they would compete to get our business and that would keep us from having to pay much more than the going price. For a very small premium above the world price of oil, we would get all the oil we want at the world price, in spite of OPEC.

Put more simply, if OPEC cut 5 million barrels a day from the United States, or from Japan, or from any where else, the effect would be the same. The price of oil would rise, perhaps very significantly, but the world-oil market would assure that the pain was shared evenly. All countries would buy less because of the high price and not because of whom OPEC favored or embargoed. OPEC can cause a shortage and raise the price, but it cannot effectively target any country.

These considerations tell us that the world oil market behaves quite simply in at least two ways.

• Any country can buy all it wants at the world price.

• All countries must pay the same world price for oil.

These two points provide all the understanding of the world market needed to analyze the three paths to oil independence.

Three Paths to Independence?

There are three basic approaches to energy independence that differ in the way they are affected by the world oil market. These approaches are:

• Produce more liquid fuel domestically (fossil and non-fossil).

• Use less liquid fuel (conservation).

• Use electricity not produced by liquid fuel (electric cars).

“Liquid fuel” includes various alternative fuels and not just oil, because the “oil market” actually extends to all liquid fuels that can substitute for each other in the transportation system. They don’t have to be perfect substitutes, there just has to be some fairly cheap way to use one in place of the other.

For example it’s quite easy to use more ethanol and less gasoline or vice versa. Any time two fuels are good substitutes their prices are very closely tied together, so we can think of them simply as part of the world liquid-fuel market. Nebraska has tracked the wholesale price of ethanol and gasoline since 1983 and ethanol has averaged only 3¢ per gallon more than gasoline, even though their prices don’t track perfectly every year. For our purposes, ethanol can be considered part of the world oil market.

The next step is to apply what we know about the world market for liquid fuels to each of these strategies.

The Produce-More Strategy. Producing more has long been the strategy favored by the oil industry, although they are not at all keen on farmers producing more ethanol. In any case the “produce-more” strategy is so popular that other strategies are often overlooked.

We can produce more liquid fuel by converting corn to ethanol, converting soybeans to diesel, drilling for oil in Alaska’s National Wildlife Refuge, or converting coal to gasoline. In the future there will be even more options, some better, some worse. They all have different costs and different pros and cons. To the oil companies, alternative fuels include liquid coal, shale oil, and oil from federally restricted areas. To ecologists, alternative fuels are renewable biofuels. With regard to energy security, alternative fuels are all the same. Their effects on global warming, however, differ sharply.

President Bush promises we will be making 35 billion gallons of alternative fuels by 2017. So you might think we are well on our way to energy independence and are at least partly protected from the next OPEC oil shock. Unfortunately, even with all that ethanol, an oil shock would hit U.S. drivers just as hard as it would without the extra fuel. But there will be one big difference. The alternative-fuel producers will make a killing. If we are using 35 billion gallons of ethanol, they will sell each of those gallons for exactly the same price as OPEC-based gasoline, and the oil producers will pocket the price increase as profits. That’s how the world market works.

This is not just a theory. Almost half of our gasoline is domestically produced, and the cost of producing that gasoline doesn’t change at all when OPEC raises the price of oil. But when the world oil price increases, so does the retail price of all gasoline, whether it is made from domestic oil or foreign oil. There are no low-priced gas stations selling domestic gasoline. There will be no low-priced domestic ethanol stations or low-priced domestic liquid-coal stations either. As we’ve seen, all liquid-fuel prices move together. (See also Control Oil Price?)

So is the produce-more strategy just a hoax? Not quite. It helps in two ways. First, as explained in the previous chapter, producing more (or consuming less) helps reduce the world price of oil. Producing 35 billion gallons of ethanol could reduce the world price of oil two or three percent. Second, it means some of our gasoline dollars that would otherwise flow to OPEC or Canada will instead flow to the American or semi-American companies that make the extra liquid fuel. I say semi-American, because Archer Daniels Midland, the biggest ethanol producer, as well as the big oil companies, are all multinationals and not exclusively American.

So if terrorists blow up a Saudi oil field, alternative fuels will provide no protection for American consumers. If we are using lots of American-made alternative fuel, alternative fuel companies will make a killing off the oil-price shock by charging American consumers the world price of oil.

Robert Gates, Secretary of Defense in the second Bush Administration, led a scenario exercise called “Oil Shockwave.” In it, top former government officials took part in a series of "Cabinet Meetings" and discussed an unfolding energy crisis. The 2005 report concluded in part:

THE MYTH OF "FOREIGN OIL"

Oil is a fungible global commodity that essentially has a single world benchmark price. Therefore, a supply disruption anywhere in the world affects oil consumers everywhere in the world. U.S. exposure to world price shocks is a function of the amount of oil we consume and is not significantly affected by the ratio of “domestic” to “imported” product. The emphasis placed on foreign oil is greatly exaggerated and provides little meaningful insight. [emphasis added]

The Use-Less Strategy. The conclusion of the Gates Oil Shockwave exercise, just cited, points to two further inferences. First, if the “exposure to world price shocks … is not significantly affected by that ratio of ‘domestic’ to ‘imported’ product,” then producing ethanol or more oil domestically will not significantly increase our energy independence. This is exactly what we have just concluded.

Second, since the “exposure to world price shocks … is a function of the amount of oil we consume,” then the path to independence is to consume less. In other words, our second path, the use-less strategy, works.

The math on this approach is simple. If your car uses half as much gasoline, you will be hit half as hard by an oil price shock. If it uses the same amount, but a different kind of fuel, you will be hit just as hard. All liquid fuels change price together. Conservation provides the protection that alternative fuels fail to provide.

Replacing a gallon of gasoline with corn ethanol and conserving a gallon of gasoline both reduce oil use by about the same amount. Conservation does slightly better because alternative fuels, such as ethanol, use a little gasoline in the making. So conservation reduces imports slightly more and lowers the world oil price slightly more than the use of alternative fuel.

What conservation does not do is provide windfall profits to alternative-fuel companies during an oil crisis. Conservation will, however, provide profits for companies, such as auto makers, which supply the technology used for conserving gasoline and oil.

Using less comes in many flavors. Homes heated with oil can be insulated better. We can give car makers stronger incentives for fuel efficiency. We could place an untax on oil (as described in chapter 7). This last approach will stimulate all types of oil conservation.

The Use-Electricity Strategy. Charge your electric car’s battery with electricity made from coal, and you can drive with coal instead of oil. Charge your battery with electricity made from wind or solar, and you can drive without any fossil fuel. Battery technology is not quite up to this challenge, but it is getting close.

This is actually just another form of “use less” liquid fuel, but I mention it separately because it shows that, someday, the United States can become completely energy independent. Unlike liquid fuels, coal is not a good substitute for oil. So an oil price shock changes the price of coal very little. In the long run, non-liquid alternative energy may provide a path to nearly complete energy independence.

Conclusion

Oil price shocks hurt consumers and bring riches to oil companies. This has always been true and it will remain so. It is just the way markets treat producers and consumers when there’s a shortage.

Switching from gasoline to an alternative fuel means staying addicted, and it means an oil price shock will still hurt consumers just as much. But some alternative fuel companies would get a share of the riches that used to go exclusively to oil companies. Again, these are likely to be large multinational corporations, and some may well be oil companies producing “alternative” fuels such as liquid coal.

Conserving fuel reduces our addiction and the pain of an oil-price shock. A gallon not used cannot cost us anything no matter what the price of oil.

The bottom line again strongly favors conservation over increased supply. In the last chapter, conservation proved the best strategy because it was available more quickly and saved much more than increased supply could replace. This time conservation dominates because it helps protect consumers from oil price shocks while increased supply does not. Gallon for gallon, it is also a bit better at reducing the world price of oil.