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Global Economic Trends: $100 Per Barrel Oil: Consequences for U.S National Security [Rush Transcript; Federal News Service]

Speakers: Robert D. Hormats, Vice Chairman, Goldman Sachs International, The Goldman Sachs Group, Inc., Edward L. Morse, Managing Director and Chief Energy Economist, Lehman Brothers, and Philip D. Zelikow, White Burkett Miller Professor of History, University Of Virginia
Presider: Paula Stern, Chairwoman, The Stern Group, Inc.
February 13, 2008
Council on Foreign Relations

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PAULA STERN: I remind y'all to turn off your cell phones and BlackBerrys and other wireless devices and put away your castanets and tambourines. I'd like to also remind the audience that this meeting is on the record.

Now, you were invited to a discussion tonight entitled "$100 Oil: Consequences for U.S. National Security." As tonight's presider, however I've taken the liberty of retitling this event to "$92 Oil" -- (laughter) -- not a hundred dollars.

But since our speakers remain the same, I think you're going to get your money's worth. You have their bios. These three gentlemen combine deep practical experience in the international foreign policy world, together with academic credentials indicating well-honed analytic skills.

In fact, every one of us on the podium has a Ph.D. from the Fletcher School of Law and Diplomacy. There is only one exception: Ed Morse. His Ph.D. is from Princeton. (Laughs.)

Bob Hormats is the vice chair of Goldman Sachs International. He's helped shape U.S. energy policy since his days on the Nixon-Kissinger National Security Council, when we had to have a response to the Arab oil boycott during the '73 Yom Kippur War.

And Ed Morse heads research at Lehman Brothers. And his three-decade career in the petroleum sector includes his service as deputy assistant secretary of State for --

EDWARD L. MORSE: Under Bob, by the way.

STERN: Under Bob. (Chuckles.)

ROBERT D. HORMATS (?): (I worked for Ed for a number of ?) --

STERN: I missed that. (Chuckles.) The way you write it -- that you served under -- or during the Carter and Reagan administration.

MORSE: It's true.

STERN: It's -- and Phil Zelikow --

MORSE: (Inaudible.) Yeah.

STERN: Well, we've all had -- that's the wonderful aspect of tonight is that all three of y'all have had such great experience here in Washington, as well as thinking about this outside the Beltway.

Phil Zelikow is now back at the University of Virginia, after serving in George Walker Bush's administration in a wide range of high-level advisory positions, including counselor to the secretary of State.

Well, now to the issues. Oil prices have risen nearly fivefold since 2002. And oil prices have topped a hundred dollars a barrel earlier this year and have, as I said, pulled back amid the fears of a recession in the world's largest economy, the United States. Most analysts blame rising demand and tight supply globally. And that has attracted, however, floods of investment money, and it's also exaggerated the effects of supply disruption.

I would ask you, Ed, as our guru, as Bob says, our petroleum guru here, if you would start us off by discussing the international energy market and give us a primer, if you will, on supply, demand and price, and help us understand these volatile price gyrations.

And I would ask a further question, and if you would, explain what you mean when you write that oil's not a normal commodity and is the most glaring exception to the rules of trade and investment underpinning globalization. And if you'd give us a little bit of detail on OPEC's role in this price instability, I'll stop asking questions. Ed?

MORSE: And I still have seven minutes?

STERN: Yep.

MORSE: Well, thank you very much. I will do my best to telegraph kind of seven answers in seven minutes to three questions.

And let me start with the hundred-dollar oil issue, or $92 oil issue. And I could start by saying it's sort of tenfold what it was in 1998, even if it's fivefold of what it might have been in 2002, and I think that's one interesting issue.

Although if we think of it in terms of how much refiners actually have to pay in real terms for real oil, we're only 60 percent on our way to where the peak was in 1981. So a hundred dollars might be a terrible number in a lot of ways, but it's not nearly as terrible a number for consumers or for the economy or the economies of the world as it was 30 years ago.

What's equally interesting about the price is not just the average price level, which a year ago actually was $72.67 for the year as a whole, but rather the split or the spread between the low price and the high price for the year, which a year ago was $72 average price or $73 average price. We saw 49 and we saw a hundred. And a hundred-dollar variation is not necessarily a one-time event, and indeed I fully anticipate we'll see $40 to $50 difference between the high and the low this year as well. And the essential reason for that is the same is the same as the essential reason for rising prices, namely the world has become tight on supply, and you might want to think about demand for two or three minutes. You might want to think about China for two or three minutes. But the real issue is not a demand issue; the real issue is a supply issue.

My second point is that this is -- although you'd never know it from watching presidential debates or reading the platforms of any presidential candidate regardless of their political strife -- but this is essentially not a domestic U.S. problem, but it's essentially an international problem. And the solutions, while U.S. domestic actions might be important, these solutions reside internationally and not in the domestic marketplace, and we ought not to -- we ought not to deceive ourselves that this is a set of problems, whether you look at the oil price or the price of natural gas or the price of electricity generation or the lack of power generation compared to global demands. This is a general energy problem. We think of it in terms of oil, and it's a global problem.

Thirdly, I would like to note that it's pernicious in part because the U.S. has acted so badly in the system with respect to energy, in particular, but not only with respect to energy. And I throw this to Bob in a sense; I'd like to contrast one element of what's been happening in the world over the last six months to what happened in the world a little bit longer ago in the early '70s. And that is at a time when oil producers were accumulating large amounts of cash and where they were pegged to the dollar and where the dollar and the U.S. government's ability to lead the world in a lot of respects were dependent not only upon how oil markets were working but how financial markets were working; unlike the 1970s when Bob's then boss, Henry Kissinger, and Secretary Simon actually understood the difference between what was happening in energy, what was happening in security and what was happening in the financial world. And there's some deals internationally that try to neutralize some arenas, including the financial arena, from impacting national security and impacting the energy arena. Nothing has been done by this administration at all, and nothing has been discussed in Democrat, Republican discussions of this issue about what those linkages might be, and I'd leave that for discussion.

A fourth point -- and I'll be quicker and quicker as I go through -- we -- all of us have noticed, of course, that ExxonMobile managed a week ago to freeze some $12 billion worth of Venezuelan assets over an investment dispute that had a value of some $2 billion -- a very disproportionate action. But the interesting thing about the action to me was that ExxonMobil is looking for the rule of law in an arena that has been remarkably devoid of the rule of law -- remarkably devoid of it in terms of trade and investment issues.

And I'll go back, Paula, to the point you raised about something that I write. It's really remarkable that the two largest segments of the world economy, which are oil, in terms of volume and value of trade and agriculture, that these two areas have the greatest exceptions to the rules of GATT, the rules of reciprocity in both trade and investment. And that not only is turning out to have been a big mistake, but is largely a function of U.S. government policy. It was us -- it was we who decided not to allow liberal rules of trade and investment to exist and flourish in the energy arena. And in fact, the only place it exists is among OECD countries. Outside of OECD countries, we don't allow it to exist. ExxonMobil is latching on to the little of rule of law that allows them to have leverage.

And the issue of Venezuela, which I point is an investment flow issue and we can come back to that in discussion, is important for my fifth set of points, which is that this is not -- despite what people who talk about peak oil say, this is not a geological problem. This is a geographic problem and a geopolitical problem. And let me put some bones on that. The price of oil would not be $100 a barrel, it would not even be $50 a barrel, if we had more transparent and biting rules of trade and investment.

And the fact that we allow countries to be exceptional in this regard has resulted in the following: Venezuela, which was producing 3.6 million barrels a day in 1998 when Hugo Chavez became president and now has the capacity to produce 2.2 (million barrels), has the geology to produce 5.5 (million barrels), or 3.3 million barrels a day more than it's now producing. Iraq, which was producing 2.8 million barrels a day when we attacked Saddam in 2003, is now producing 2 (million barrels); it could be producing 6 (million barrels.) That's 3.9 (million barrels) more than it's now producing. Nigeria, which is producing 2.2 (million barrels), has infrastructure that would enable it to produce 3 (million barrels), should be producing 4 (million barrels), given its geology. That's another almost 2 million barrels a day.

So 9 million barrels a day just out of Venezuela, Iraq and Nigeria based on politics. That's not a geological problem. That's a political problem. And that doesn't include Mexico, the former Soviet Union, Saudi Arabia and other Middle East countries, to which I would add another 6 million barrels a day. So the world really could, from a geological perspective, be producing 15 million barrels a day on an 85 million barrel a day base that it's not producing. That is not a geological supply problem. That is an international investment problem, and our minds ought to be on that problem rather than on other sorts of things. That's the challenge.

The sixth issue is Iran. I didn't want to mention it other than in the context of saying high oil prices certainly restrict our freedom to act against Iran. It is an impingement upon U.S. ability to act in its national security interests.

And let me end with the seventh point, which is, you know, what should the solutions be? The solutions really ought to be designed to spread what has been done in the OECD to the rest of the world, to make trade and investment in energy normal rather than abnormal. And we could start with China and India and some of the easier places, of countries that, if not democratic, certainly are integral parts of the global economy, benefit from globalization, benefit in their, you know, perceivable national interest in terms of rules of trade and investment. And we should whittle it away in other places where we can bring influence, maybe starting with Mexico after that. So I will end with that. Hope I've been a little bit controversial and given us meat for discussion.

STERN: Extremely helpful. Thank you so much.

Bob, I'm wondering if you will pick up from there and talk about the implications of what Ed says is a(n) international problem wherein solutions are international and reside internationally. But talk now about the implications for the United States and domestically, and whether we can also, as a nation, help at least contribute to a solution domestically here at home, through our own choices.

HORMATS: Okay. Well, thanks.

First let me just underscore the point that Ed has made, two points that I think are particularly important, one of which is, he's quite right; it is a global problem. You really can't treat it as a national issue. Although there are certain things we can do nationally, it needs to be treated as a global issue.

And second, it is primarily a supply-side rather than demand-side issue. Demand gets a lot of the attention -- China, India, elsewhere -- but the fact is that for a period of time in the '70s and '80s there was a lot of investment in new capacity, which gave the world a lot of spare capacity. That investment, by and large, for a series of reasons, some of which -- many of which are political, like Ed mentioned, a lot of that investment has more or less petered out or has become very sluggish, and now there's only a very narrow gap between the availability of supply and the world's demand for the oil.

And one of the problems -- and there are a number -- Ed's talked about a number of the geopolitical problems. Another is that replacement of existing reserves has become increasingly expensive, in part because some of them are in places people don't want to go. In other cases they are in areas where it's just very expensive to do the finding and the drilling; also because, partly for cyclical reasons, the cost of the steel, the cost of the equipment, the cost of the expertise has gone up, which makes the threshold price of developing new energy considerably more expensive, so that there a number of common international reasons why we're not getting as much supply capacity on line. Some are geopolitical, some are geological, and some of them are simply -- the cost structure of developing or improving the capability of some existing oil production areas has just become more expensive.

Now, one of the things I was asked to do was try to talk a little bit about how this affects the U.S. economy, and then I'll just briefly touch on some of the things that we ought to be doing. And I think that by looking at where we've come from over the last several decades, we'll come to some of the conclusions about how to address at least some of these oil-related issues.

One of the interesting things is to compare this period to the period of the '70s and very early '80s. And I'll just tick off a few of the comparisons, because I think they illustrate a number of macroeconomic points that also lead to some energy policy issues. One is that when we confronted the crisis of the mid-'70s, after the Yom Kippur War and then later in the decade, early part of the next decade, there was a lot of inflationary pressure in the country. And when oil prices went up, it just added to those inflationary pressures.

The second was how the Federal Reserve dealt with the problem, and that is very different today from the way it was. At that point, because there was so much concern about inflation, and inflation beginning to build up, or building up further, the Federal Reserve reacted to oil price increases not out of concern that they would slow growth down by imposing a big tax on the economy, which oil price increases do, but that they would further exacerbate inflationary pressure. And the Fed took a much more restrictive set of policies than it has done in the current environment, where monetary policy tends now to treat oil price increases as a tax more than as an inflationary phenomenon, which gets built into the economy of any country.

In addition, business investment, at that point, was very weak. Business investment when the big price increases started, 2003, 2004, was very strong in this country. So you didn't have that negative problem. Because when we had the problems in the 1970s and early '80s, business investment by and large was very weak.

Another important phenomenon is, and this goes to the international point, which is very critical. That is, at that point, most of the other economies in the world were relatively weak also. And high oil prices, particularly vis-a-vis the emerging economies, really slowed down their growth very badly, so then American exports to these countries weakened. This is certainly not true today. Many of the big oil-importing countries are doing very well despite higher oil prices.

And I think it's very important, when we look at this, and it goes to the point that Ed's made: to look at the oil issue not simply as an energy issue which, to be sure, it is. But how they deal with their problems and whether they can deal with them also will affect their future economic growth. And therefore it's extremely important, from an energy and from an economic, macroeconomic or international trade point of view, to work out a cooperative framework with them to help them find ways of addressing their energy issue in a way that helps them to reduce their energy demand, or increase energy production, and also to do it because it's very much in our interest that these economies continue to grow at a relatively rapid rate.

The other thing that was very interesting was that there was an attempt in the 1970s and '80s to avoid forcing Americans to confront the higher price of oil, to avoid use of the market mechanism. There was -- perhaps some of you will remember this -- there was old oil, and there was new oil, and there were allocations among them. You got vouchers if you were too dependent on new oil, which was not controlled, whereas old oil was controlled. So there wouldn't be a windfall profit to those people who produced the old oil. And there would be an incentive for people to produce the so-called new oil.

It was a mess, and the government got very much involved in this. The price mechanism didn't work, so the government got involved in the allocation system, with these vouchers and various kinds of things.

And I think one thing that's very important is to let the price mechanism work to the extent it can or should. And one of the problems is that if you look at the incentives to produce new energy sources, either oil or gas or biofuels of various kinds, it is very important that the price incentives be available, and there be a level of confidence about those prices.

One of the ideas that was tried in the '70s and '80s -- didn't work, because the politics didn't enable it to work -- was the notion of a floor price. It got a huge negative reaction in the Congress, as you might imagine. But the idea was to provide those people who were investing or were considering investing in alternative fuels -- to provide them with the incentives to make those investments, whereas at the time it was Kissinger's view, and Tom Enders', who many of us worked with, and others, thought that if you allowed the price to go up and then created the circumstance where the price would plummet, you would have no incentive for new production.

So that was, again, one of the debates that took place during that period, and in fact not giving people some level of security about the price in this country, that was part of the debate over whether or not you could actually find new ways -- new sources of domestic energy. And not just for the United States; other countries as well. They're subject to the same kinds of volatility, and those people who would like to invest in those countries also would have an interest in having some measure of security based on either some kind of floor price or some -- I know Phil's going to talk about this in a little while -- perhaps some kind of price that gives them a greater degree of confidence that if they make these big investments and they're very big investments, they get a measure of security out of it.

Finding some way of doing that -- it may not be possible, but we want to find as many ways as we can to reduce dependence and have some kind of -- now, some of these may work even without that government intervention, some may requre it, but that's a debate we ought to -- we ought to have.

The other thing that took place at that point was that during this period, trucking and aviation were very highly regulated, so you really couldn't allocate oil within those sectors in a very efficient way. And the last point is that there was no futures market at that point. And one of the things that's been very helpful in smoothing out the market volatility is that you now have a very active futures market, so you don't get these big rises and falls of inventories.

Let me just close on the following note, and that is, I think that Ed's point is a very important point, and it has not gotten into the American political debate. And that is, in the '70s and '80s there was an understanding that you've got to look at the oil-producing countries not just as suppliers of oil or suppliers of capital, but they were very important in the geopolitical world view of Kissinger at that point and many others also.

And there was an attempt to integrate them into the global system in an orderly way through various kinds of dialogues. One was the dialogue on the new economic order, and there were all sorts of other things. There was also -- that was the period in which the International Energy Agency was developed to maintain solidarity among the oil importing countries because there was a feeling that oil-producing countries would pick them off one by one unless there was some degree of cohesion amongst them to avoid that kind of thing occurring.

Now we have -- now the stakes are even bigger. We're much more dependent on imported oil than we were then, 60 percent dependent. Not only are we dependent on oil to a greater degree, we're dependent on their capital to a greater degree.

Now, Americans -- and again, the political debate in this country -- you wouldn't know it by listening to anyone who's talking, because they're not talking about this -- if you're a country that has an enormous capacity for consumption, and particularly an enormous capacity to consume oil, which we do, and a very low savings rate, which we have, it is just a mathematical certainty that we're going to be dependent very heavily on foreign capital. Who's going to be the supplier of that capital? Countries that earn a lot of money through their exports, either exporting oil or exporting other goods, like China.

So at some point this dialogue -- and we maintain this little dialogue in the G-7, the G-8 and others, but somehow or other we're going to have to find a mechanism for providing these countries with the sort of support and the incentives to integrate themselves more into the global energy system so that you don't have this high level of uncertainty that we have today, and match that with a far greater degree of coordination on the question of imports of foreign capital, because the two are very much, in the current economic environment, the same.

And the worst kind of reaction is the one that you begin to see in this country; that is a sort of economic xenophobia which says, you know, we don't -- this trade is very threatening to us, the foreign capital is very threatening to us. If that kind of mentality takes place, then the kind of coordination or cooperation that I think is critical simply won't occur and we'll just have domestic backlash.

STERN: Okay. Thank you, Bob.

I'd like to ask Phil if he would come in and deal with the second half of the title of our evening's program, which is the consequences for U.S. national security. It may be that, over the past 30 years or so that we've been dealing with high oil prices and the issue of increasing dependency, that we had at one time a plan to integrate OPEC into the global system, but I think, as suggested by some of the comments that I heard from Ed, they still are very much an exception to many of the rules of the road. And we are left with dealing with government-owned sources of supply and we have not -- we don't have a kind of a normal trading relationship as we do with other commodities and in other areas.

And obviously, this dependency is extraordinarily important to how the U.S. manages its relations in the world, the extent to which we have the kind of leverage to do the types of things that we've done in a constructive leadership role in the past. So I'm wondering if you could elaborate on some of those consequences for our role both in exercising leverage and what the challenges may be in terms -- new challenges to our national security.

PHILIP D. ZELIKOW: Well, that's very well put, Paula.

Let's suppose you think about the major challenge that faces the United States in the terms Paula just used, as how are we going to play a central role -- not a dominant role, but a central role in stably managing continued prosperous globalization, if globalization is a dominant trend we see around the world, if the United States is going to be central in figuring out how we cope with the challenges of globalization. How do these issues of very high energy prices affect the American ability to play that role?

I think, actually, they have a very significant effect on it. In general, the problem is the problem of an increasingly dangerous and unstable environment surrounding your work that you're not managing, you're just -- an environment of greater and greater risk. Let me break that down in five ways, first. I'll put some of these things very simply and a little too vividly, so you'll forgive me if it sounds a little too simplistic.

First problem is high oil prices help bad leaders lead badly. It helps bad leaders lead badly, A, because they adopt bad energy policies. They're not very constructive participants in the world energy market. As many of you know, the major oil companies do not actually own most of the world's oil reserves. Almost all of the world's oil reserves are either owned by governments or by government-owned oil and gas companies. And so what they tend to do is they tend to underinvest in creating new supply, and they tend to politically manipulate the distribution of supply. Both of these things then, over the long haul, dramatically exacerbate the inability of the world energy market to keep pace with demand in the way it should, based on geology, just along the lines that Ed Morris was talking about a few minutes ago.

It helps bad leaders lead badly, B, because they have bad development of their own countries. This is the oil curse argument that most of you are familiar with. You don't have to make hard choices about how to live in an interdependent world, because you're insulating yourself from a lot of healthy interdependence and you're invited to adopt autarkic policies.

C, it helps bad leaders lead badly, because it subsidizes their propensity to bad behavior. So Venezuela has a lot of money to throw around making mischief in places like Colombia. And then you can see Iran, which is thumbing its nose at fairly -- increasingly formidable Western sanctions because it takes solace in the simply colossal flows of money it's taking in from its oil and, to a lesser extent, gas sales. And then there is the example of Putin's Russia.

This argument about bad leaders leading badly is relatively familiar, though. Let me talk about a second point that's a little less familiar. The high oil prices are reinforcing a problem of global investment management. You remember in the early period of the oil price spikes of the '70s and '80s, people talked a lot about how all these countries were recycling petrodollars, and then we had a Third World debt crisis that came out of that that few people here will remember. Think now about how the petrodollars are being recycled. Well, you read about things like sovereign wealth funds, for example, that are disposing colossal sums of money.

One huge difference of the climate today from the climate 20 years ago is the condition of international capital markets is hugely different than it was 25 years ago. International capital markets are much more globalized, much less regulated, and therefore the question of how you manage -- stably manage these vast investment flows, including from sovereign funds, in this kind of capital market to equalize the balance between the investors in the marketplace and the people seeking the investments in the different nation-states invites consideration of globalized investment frameworks, transparency and the like, that I think actually would form part of a much more interesting and innovative economic agenda for a new administration than just going back to the traditional issues of trade and exchange.

A third problem that's arisen from high oil prices is that it keeps poor people poorer. Just think about it. You know, you've got these anemic patients, right, sitting on the operating table. We're trying to transfuse blood into them, our taxpayers' blood. We're trying to actually dramatically increase the levels of foreign assistance -- huge income transfers, therefore, supposedly going to these very poor countries. And meanwhile, as we pump more and more blood into their anemic bodies, there is this pail filling up next to them of all the blood that's flowing out of their bodies, and that's the blood that's flowing out as they keep shelling out more and more of their income to buy oil. So we're increasing our income transfers to them to lift them out of poverty, and meanwhile they're just transferring that much more money to oil suppliers.

Take, for example, the country of Jordan -- little Jordan, which is an important country in Middle East politics. Jordan actually has had a reasonable government, for a number of years now, that's been trying pretty manfully to adopt reasonable economic policies. It can't really quite get its head above water. And the biggest problem they chronically complain about is high oil prices, because not only does my little metaphor suggest the macroeconomic problem of transfers in, transfers out; if you actually look at the mechanics of who actually pays for oil in those countries, it really is often actually the governments playing a key mediating role in dealing with the effects of oil price shocks because they're subsidizing gasoline prices and things like that.

So it's really stifling our ability to manage the global development issues that are key to getting inclusive, sustainable globalization, to borrow Bob Zoellick's phrase. We're making a huge effort to work on the problems of global poverty, and this is frustrating our success.

Four -- and this is also perhaps a less familiar argument -- when you have a situation of endemic crises that are about to occur, America loses its strategic initiative. We're in a situation where tomorrow, we could find ourselves plunged into a crisis, with no flexibility or ability -- or agility in how to manage it.

Let me give a concrete example. Suppose that terrorists or the Russian government or somebody happened to blow up the key pipeline, the BTC pipeline running through Azerbaijan. Instantly, like tomorrow, we would plunged into a full-fledged global energy crisis over Azerbaijan. The United States would not have a lot of strategic choice about whether to engage in such a crisis.

Because when the energy markets get taut, and the will become more taut in coming years, anything that then disrupts those markets automatically sucks us into a crisis mode, without our ability to preserve our strategic initiative and flexibility to manage risks the way we want to manage them. We'll be pulled to the fire.

And fifth, these endemic high oil prices constrain American options to deal with known risks, and they constrain them very significantly. Let me give you a major example which is, what to do about Iran? This is a first-class foreign policy issue. I think all of you would agree.

Let's suppose that you really aren't interested in military options, at least for now. But gosh, you just kind of wish we could do something about them taking in these billions of dollars through the front door of the store while, in the back part of the store, they're building nuclear weapons. You're kind of thinking, there's something unseemly about international outlaws, branded as such by the United Nations Security Council, bringing in all this money from the international economy while they thumb their nose at the international community's strictures.

Well, if you don't like that, you might be tempted to want to do something to interfere with their energy trade. And gosh, wouldn't it be better to interfere with their energy trade than to have to work on plans to bomb them? Yet anytime you present a proposal for interfering with their energy trade, instantly, well, you can't do that because you'll disrupt the oil markets.

Now, notice, therefore, you have an endemic condition that effectively leaves the United States self-deterred in considering what actually are the most inviting and naturally encouraging options to discourage Iran from pursuing its nuclear weapons program and solve the problem peacefully. That's an example of what I mean about constraining options in dealing with major crises.

So those are a number of ways in which high oil prices are becoming a very high risk factor for the United States in managing its environment, the globalized world. To conclude, though, I'm going to offer a brief prescription, which I'll spend about 30 seconds on, because this is much too big a problem to offer anything but an extremely facile answer.

The facile answer is, the classic answer is, well, how about that we take a vaccine? This is a preventive medicine problem, and a classic form of preventive medicine is a vaccine. What is a vaccine? A vaccine is a -- you deliberately expose yourself to a disease in order to stimulate the antibodies that will then allow you to counter the disease if you were to contract it.

So the United States, in this notion, would actually vaccinate itself against high oil prices on a stable basis. Notice the stable basis point, because one key idea about the vaccine is that it's a controlled exposure to the disease. You control the exposure to the disease so that you can stimulate the antibodies your way, instead of being exposed to the disease in its ambient environment, in which case it will kill you.

That's my introduction to what I hope will be a lively discussion.

STERN: Well, thank you very much. We'll wait to hear exactly what that vaccine is. I think you gave us a little bit of a teaser there, but I'm sure there will be many opportunities to ask questions of all three of our speakers. And I did let them run over, because each had so much to say and there were three of them after all.

So I would like now to invite questions and answers and ask, as you are recognized and receive the microphone, to speak directly into it and to state your name and your affiliation. Please keep your questions concise, so that as many people as possible can ask.

I saw your hand first, and if you want to specify who you would like to answer it, I think it would be a little easier.

QUESTIONER: Well, it's to Bob and Ed, actually. I think -- my name is James Nathan (sp). I'm from Auburn University in Alabama. There are between -- I think I have this right, I may not -- between Lehman and Goldman Sachs there's a different analysis of future prices. Layman projects of quite high price in a fairly short order, and I mean -- excuse me; I got it backwards -- Goldman projects quite a high price in rather short order, and Lehman projects a radical drop, I think, in rather short order. I just wondered what was the root cause of this discrepancy.

More importantly -- but

STERN: If that's your question -- (off mike) --

QUESTIONER: It was an observation, actually. My question is: What happens if there is a collapse in prices for investment? Do you --

STERN: Thank you. I think that's two questions, and I -- we've got three speakers up here.

Short-term prices and --

MR. : Actually, I just want to answer Jim's question and refer to something Bob was talking about.

The future's market is a very good mechanism for risk management. The amount of liquidity in it, which some people say is going to evaporate -- that's another debate -- is really unbelievably high compared to what it was. Five years ago there was 500 million barrels worth of liquidity in that market. Today there's three-and-a-half billion barrels worth of liquidity in the market. The forward curve going out to 2017 provides a price somewhere between the upper '80s and the '90s; it actually goes down a bit and goes up a bit. That provides a mechanism, as Bob indicated, that didn't exist 30 years ago for people who are making investments, either buying other companies or investing in oil sands or investing in other things, to ensure that they're going to get a return on that investment. And we're seeing the capital deployed; it's just being deployed more slowly and more inefficiently than it otherwise might be. And it's more inefficient because of all the impediments on the other side of it, the monopoly countries that don't allow investment in them from allowing those investments to take place.

MR. : Yeah, I agree. And our scenario is -- we call it oil spike scenario. Argen Murphy (sp), who's a terrific analyst, has developed -- his -- there are just two fundamental points. One is the only way you're going to get a drop, at least in our view, in the near term is for there to be a sharp decline in demand, demand destruction, because, for the reasons Ed has mentioned, there's not likely to be a big surge in new production in the near term anywhere -- geopolitical regions -- (inaudible). And they're mostly all controlled by national oil companies or monopoly companies that are either inefficient or won't let some of the more efficient companies in.

The oil spike element is based on the fact that there's some invulnerabilities around that with a very tight supply-demand relationship something somewhere is going to disrupt a supply. Could it be the Azerbaijan pipeline? Could it be some disaster in Nigeria or Venezuela decides to act irrationally or terrorism in the Gulf somewhere? So ours is not necessarily a steady state phenomenon, but it's a phenomenon that occurs when you get very, very tight supply-demand relationships and something disrupts that supply.

STERN: Okay. Thank you, Bob.

Allan -- and I hope we will get some questions, a little bit longer-term questions, about consequences as well as just what today's and tomorrow's prices might be.

QUESTIONER: Thank you. Allan Wendt. My question is directed mainly at Ed Morse. Ed, you mentioned briefly Mexico. What are the prospects that Mexico might change its constitution and allow foreign investment in the oil sector, and how much difference would that make? And then, a related question, what about our own continental shelf, given the supply-demand constraints? Is there any prospect that the Congress will take another look at that issue?

STERN: Okay, everybody seems to be getting two questions in there, and -- (laughs) --

MORSE: Yeah. Mexico is easier to talk about than the U.S. I'll defer on the U.S.

There is no doubt, Allan, that the Mexican government, even more than the last government or administration of Mexico wants to do something about this, because they have not done any exploration whatsoever in deep waters, and it's clearly the case that Mexican deep waters are going to be prolific in hydrocarbon. And so directionally, it's clearly an easing of constitutional prohibitions that prevent direct foreign investment. They are very, very active in trying to figure that out and trying to figure it out, you know, before very long from now.

STERN: Thank you. Question here, please.

QUESTIONER: Ariel Cohen, the Heritage Foundation. I'm a senior research fellow in international energy security and a Fletcher Ph.D.

STERN: Yeah. (Laughs.)

MR. : Wow.

QUESTIONER: A question about not what, but how. I totally agree with Dr. Morse that having the rule of law and having, for example, a WTO regime, which doesn't exist now, for energy investment would be nice. But if you are, let's say, Hugo Chavez or Putin or the king of Saudi Arabia, why on earth would you agree to that? And if you won't agree to that voluntarily, what are the tools in the toolbox of our policymakers to encourage these gentlemen and ladies to agree to this nice OECD investment regime? Thank you.

STERN: Thank you.

MORSE: Yeah, Ariel, we've had a little bit of a discussion between us on this subject in the past, and you know, it's hard to go through, in a brief period of time, a lot of history.

Our government -- series of governments under very different political parties have been really horrendous on the issue of Russia and the former Soviet Union. We've had Democratic and Republican administrations that have tried to do deals rather than think about the rule of law with respect to encouraging Russian governments to take win-win solutions. And the Europeans haven't helped, nor have we helped in terms of the lack of a dialogue between ourselves and Europeans, where, whether it's ourselves or the chancellor of Germany or the president of France or Italy, have each perceived national interest as predominating over what might be in everyone's interest.

It's not too late. I mean, we collectively hold a lot of keys to things that the Russian government might want, and you know, combinations of carrots and sticks, on giving Mr. Putin things that he might want that we can help him get -- or Russian governments; that's the shorthand for it -- rather than looking out for perceived national interests in a very national -- in a very narrow frame, is the way to proceed.

You know, I think the subject you have raised is a subject that think tanks ought to be spending their time on. And the council should have been doing it with its own Task Force on Energy. It's taking these international issues seriously and trying to figure out win-win solutions. We're not going to do it in this kind of discussional context, but it's not beyond human imagination to get there, if the objectives are kept in mind.

STERN: Thank you very much.

Mitzi and then we'll go from there.

QUESTIONER: I'm Mitzi Wertheim of the Center for Naval Analyses. First of all, I'd like to know what your vaccine is. But more importantly, I'd like to ask all three of you -- it seems to me you're talking about a two-part equation, and I think there's a three-part equation: energy, economy and the environment. How does the environment fit into the way you think about it? It seems to me it's been not at all a part of your conversation.

And CNA did a study on national security and climate change, which is environmental consequences. And they seem to be rather substantial.

STERN: Thank you.

Would you tell us about your vaccine? And maybe can get into the kind of U.S. domestic policy responses to the conundrum we're facing.

ZELIKOW: Well, it's to induce stable and predictable higher prices, so that instead of -- so you have a high level of stability and predictability for investors and consumers in being able to estimate the likely price of oil and essentially, therefore, insulate yourself against sudden shocks by controlled inducement of those shocks on your terms now, while the supply crunch is still relatively manageable, instead of on somebody else's terms, five or 10 years from now, when all of these conditions will be much worse.

And then, by the way, by doing that on a controlled basis, I think you then actually stimulate the antibodies of the market to then give you the kind of powerful response you need, because they have stability of expectations in making their decisions.

STERN: And I would ask if you would respond to the next -- second question that Mitzi had, because I am interested in the U.S. domestic political fortitude in dealing with our demand side of the equation. That is, what role there is in conservation and in alternative energy sources that may be less environmentally degradating from the point of view of global warming, for example, and hydrocarbon.

ZELIKOW: Yeah. I -- like some folks at McKenzie (sp) and Ken Mehlman and some others, I really don't like the term "energy efficiency" and "energy conservation."

STERN: Okay.

ZELIKOW: I love the term "energy productivity."

STERN: Okay.

ZELIKOW: These terms matter. And I've -- you'll notice I've tried to introduce some ideas with a different vocabulary. But I think the vocabulary matters. I think the way these issues are framed is important, because I think actually if you develop a situation in which America has inducements to excel in the construction of highly energy-productive technology and products, this will actually be an important source of competitiveness and growth for the American economy.

For example, the fact that Boeing can manufacture a 787 Dreamliner out of composite materials that are 20 percent more energy-efficient than Airbus has won Boeing a lot of orders. That's not something that's -- that's not something America does to wear a hair shirt. It's something America does to grow its economy.

STERN: Thank you.

Yes?

QUESTIONER: Yeah. Bob Lieber, Georgetown. There are some forecasts -- for example, Cambridge Energy Research has forecast -- or at least Dan Yergin has -- last year a substantial increase in world oil supply over the next, oh, four or five years, something like that, in double digits. Others have suggested that the incentives for key OPEC countries are to not expand, because that leaves them stuck with spare capacity. It's in the world's interest but not theirs.

I'm curious where any of the three of you come down on this, in terms of your expectation about any give on the supply side in the next few years.

STERN: And if you would, you know, put that in perspective also in terms of what that means, medium- and long-term as well. Ed?

MORSE: Yeah. I really dislike council meetings to be the record, because then you can't give smart-aleck answers to questions like the one Bob raised.

STERN: Oh, go for it!

MORSE: I'm going to do it anyway.

Dan Yergin has had that forecast every year for the last 20. So you know, how seriously do you take it? As seriously as you might have in 1990. I don't perceive that, and most people who look at this don't perceive that. That's not to say that if the flows were coming from the countries that I ticked off in my comments -- Nigeria being one, Iraq being one, Mexico being one -- that we wouldn't have more abundance.

So, you know, I think the world is in a supply problem that only the market can get us out of. And one of the interesting things about that is that the market is, in fact, getting us out of it. We have now legislation that I would note is fairly bipartisan. We have actually on the issue of environment, energy and hydrocarbon use virtually no disagreement across the aisles in the U.S. at the moment, and you can't tell very much of a difference between a John McCain platform on this and a Barrack Obama or a Hillary Clinton platform on it when it comes to these issues.

We're doing some things by law, some things by the economy, and I will just tick off two of them. Admittedly, this is a U.S. thing and not global, but it has global repercussions. We now have CAFE standards on SUVs that are tighter than the CAFE standards of 1988. And had they been enacted in 1988, the U.S. government would have enabled U.S. consumers to consume, I would say, roughly 3 million barrels a day less gasoline or less energy than we now are. And if that were the case, the price of oil would be significantly lower than it now is. And this is transformational; it's transformational on another generation.

We have practically banned new thermal power plants based on coal. It is difficult -- nearly impossible in Texas to build a new coal-fired plant, and that's because at the grass roots, we are an extremely environmentally sensitive country. Now, it's not clear whether this is going to give us endemic brownouts and blackouts, which it might 10 years from now, but there has been a response in the marketplace. If you just look at Texas, where we've got an incredible amount of market-induced wind-power investment, windpower is now responsible for, like, 10 percent of the total Texas power grid. That's a very, very large number. And unlike like more than a 2 or 3 percent number, which at the margin does affect competitive conditions, a 10 percent number growing to 15 percent really will affect competitive conditions and will have an impact on the cost of power to the consumer, which will be a very good one while also helping the country obtain the same kind of objectives of (as one ?) on the environment and on energy efficiency.

MR. : And just one more thought on supply. If you look at where the supply's going to come from, it's very hard to see where you're going to get this surge in supply. In the non-OPEC countries, it's flat or going down -- North Sea and many places. Where it's going up is Russia, and Russia's questionable in many respects for reasons that you're aware of. And they're having trouble keeping up their existing fields, and developing new fields is very expensive, with a lot of confusion in their energy system.

And the OPEC countries, for reasons that we've been discussing, many of these national oil companies are not developing new oil at an optimum rate for a variety of reasons, and many of them are very reluctant to allow foreigners to come in to do it for them. Many of the -- much of the money, instead of going into new production, has to go into social purposes, some of which are very noble, but it means they're not going into new oil production. So it's very hard to see where you're going to get a robust supply-side response in the next four or five years outside or inside of OPEC.

STERN: Question here, and then we'll go into the back.

QUESTIONER: Spurgeon Keeny. I'd like to follow up on Zelikow's answer to the previous question on vaccine. I know he may want to -- he's avoiding the word "taxation," but I assume you mean you would like to have a substantial tax -- flexible tax -- on gasoline and possibly other products. I wonder how -- is that the correct interpretation? And I wonder how you and other members of the panel feel about this proposal.

STERN: Thank you for following up. (Chuckles.) You've been smoked out.

ZELIKOW: Like most Americans, I positively recoil at the suggestion that we should have higher taxes. (Laughter.) I'm just trying to propose a preventive energy policy that tries to provide stable expectations for successful operation of the free market. Now, we can then get into name calling -- (laughter) -- about what that means.

But to make the point more seriously, I'll just underscore again it really matters how you frame these discussions and the vocabulary you choose to use, because it also has to condition is this about a general revenue measure or is this about an energy policy enabling the marketplace, providing truth in pricing to incorporate externalities, et cetera, et cetera, et cetera? And that's the way I'd prefer to answer your question, Spurge.

STERN: Okay, one --

ZELIKOW: I'm maintaining message discipline here.

STERN: This is going to have to be the last question, because two of our speakers have to head back to New York.

(Cross talk.)

QUESTIONER: Ian Telly (ph), Dow Jones. This is for Mr. Morse and Mr. Hormats. Mr. Morse mentioned Venezuela, the Exxon case, freezing of assets. That points to integration of some of the national companies, the oil producers, into Western rule-of-law countries and the leverage that that gives. Is that a signal -- firstly, is that a signal to other countries -- Russia is an example as Gazprom increasingly integrates into Europe -- that they must play ball under rule of law?

And secondly, you mentioned sovereign wealth funds. Do they not offer the opportunity for integration into the markets that might, as you pointed out, give the leverage for playing ball on a --

MORSE (?): You actually raise some very rich questions. And if we had the time to look at it, I think there is a good set of answers there, in that the rise of sovereign wealth funds in countries that are undergoing really dramatically transformational change -- in these countries, and you can look at every one of the GCC countries, even Saudi Arabia in this regard to some extent -- is doing something that it never did before, and that is, applying property rights at home, property rights in real terms, property rights in terms of financial rights, and property rights abroad through those investment flows.

And I think the lever or the opportunity that's provided because of the natural need for reciprocity that accompanies that expansion of property rights domestically and internationally is the right kind of lever to focus on to pull it back into an energy investment environment.

HORMATS (?): I think that's right. And I would add one other element that's parallel to that, and that is, I don't think we so much have leverage over them. They've got a lot of money, and they can use that money however they want to use it. But they don't want their investments in the U.S. or elsewhere politicized. They would like to be able to make good economic investments, and we don't want them by the same token to politicize the investment from their perspective. In other words, to use them for things other than for commercial or profit purposes.

So we need their money, they need good places to invest. Neither we nor they want this to be politicized to the point where investments are restricted or are used for political, i.e. non-economic, purposes. There's a lot of room for overlap and for convergence here.

STERN: Well, I want to thank all three of our speakers tonight. Clearly when it comes to leverage, the most leverage we have here is home if we can overcome our domestic political inertia to do something in response to the conundrum we've been discussing.

But from the point of view of the Council on Foreign Relations, I think there's an awful lot that we still can do to take up some of the ideas that Ed and Phil and Bob have all shared with us tonight. So I'd like you to join with me in thanking them. (Applause.)

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