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How to Handle Oil Price Volatility

Authors: Michael A. Levi, David M. Rubenstein Senior Fellow for Energy and the Environment and Director of the Maurice R. Greenberg Center for Geoeconomic Studies Daniel P. Ahn, Adjunct Fellow for Energy Nicolas Loris, Energy Policy Analyst and Senior Research Fellow, The Heritage Foundation Daniel J. Weiss, Senior Fellow and Director of Climate Strategy, Center for American Progress Robert McNally, Founder and President, Rapidan Group
Interviewer(s): Toni Johnson
March 19, 2012

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A recent spike in oil prices has the Obama administration considering whether to dip into strategic oil reserves to ease pain at the pump. What the United States should do to address oil price volatility is open for debate. Five experts weigh in:

CFR's Michael A. Levi says policymakers should focus responses along two dimensions: blunting volatility and helping consumers cope with the consequences. Similarly, CFR's Daniel P. Ahn says the oil market will feature "unavoidable price swings," and that managing volatility requires greater market transparency as well as engaging and cooperating with the oil market's leading consumer and producer countries.

Nicolas Loris of the Heritage Foundation focuses on opening up currently off-limits areas to domestic drilling, while Daniel J. Weiss at the Center for American Progress says the United States should modernize fuel economy standards and invest in alternative fuels, electric vehicles, and public transportation. Energy expert Robert McNally offers a suite of ideas, including giving the G20 more responsibility, reducing oil subsidies that inflate emerging market demand, and resisting the temptation to use strategic reserves to manage prices.

Michael A. Levi, David M. Rubenstein Senior Fellow for Energy and the Environment and Director of the Maurice R. Greenberg Center for Geoeconomic Studies

There is a myth, popular among both politicians and the public, that high oil prices are the greatest economic risk that the United States faces when it comes to energy. They're wrong; wildly changing prices, not high ones per se, are what really do damage. Rapidly rising prices drain consumers' wallets without giving them time to adapt; frequent change also makes long-term investments more difficult. People may applaud when prices crash, but to turn a clichť on its head, what goes down must go up.

Policymakers should focus their responses along two dimensions: steps that blunt intolerable volatility and ones that help consumers cope with the consequences of whatever remains.

Policymakers should focus their responses along two dimensions: steps that blunt intolerable volatility and ones that help consumers cope with the consequences of whatever remains.

Some volatility is natural and quite tolerable. Markets aren't perfect predictors of the future, which means that prices will shift to and fro. Since there's no reason to think that governments would be smarter, they usually shouldn't try to override what the markets do. Moreover, modest volatility can prompt consumers to take steps, like shifting to more fuel-efficient cars that will help them if volatility later explodes.

There are, however, exceptions to the general rule that government should stay out of the market. Markets are ill-equipped to handle the sorts of large price swings that would result from major geopolitical events like, for example, a confrontation with Iran. Those sorts of occasions call for the government to use the Strategic Petroleum Reserve in order to buffer the market.

Moreover, in many cases, other governments' market interference through things like oil subsidies makes volatility worse; there, U.S. diplomatic efforts to help reduce those distortions are wise.

There is more, though, that government can do to help consumers cope. A fifty-dollar price swing is only half as bad if you're using half as much oil. Strict fuel economy regulations can steer people in that direction. So would a gas tax, perhaps as part of a comprehensive fiscal package, though the prospects remain remote. Helping consumers get access to hedging products--in essence, helping democratize oil derivatives rather than trying to shut them down--could also help them better deal with gyrations.

All of these would pay off over the long term. The best bet for the next few months is an increasingly wild ride.

Daniel P. Ahn, Adjunct Fellow for Energy

Higher oil prices have obvious costs, such as steeper energy bills for households and companies, more inflation, and a larger trade deficit. But even volatility to the downside carries negative repercussions, creating disincentives for conservation, efficiency, and investments in renewables. The United States also remains a significant (and growing) producer of hydrocarbons, and downside price volatility can make proper business and risk-management decisions in the energy and energy-intensive sectors challenging.

Nevertheless, global consumption and production of many commodities, including oil, are highly insensitive to prices. Therefore, small surpluses or shortages in the physical market must translate into large swings in prices in order to sufficiently adjust demand and supply to restore equilibrium.

Attempts to forcibly manage prices in a kneejerk response to every shock, such as through manual price controls, trading bans or limits, or ad hoc government stockpile releases will only be counterproductive.

Hence, the first recommendation is a negative and unsatisfying one. Oil markets will inevitably feature large and unavoidable price swings, and must be accepted as a natural feature of life. Attempts to forcibly manage prices in a kneejerk response to every shock, such as through manual price controls, trading bans or limits, or ad hoc government stockpile releases will only be counterproductive.

On the other hand, the United States can stake active steps to improve market efficiency and ensure that any volatility that does hit oil markets is fundamental and not avoidable. As discussed in a CFR working paper, improved transparency both on physical demand and supply as well as financial positioning may have real benefits in reducing needless volatility and improving price discovery.

Longer-term dynamics are already under way that may help the United States become more resilient to oil price shocks, including better conservation and efficiency, more substitution into other sources of energy, and new hydrocarbon extraction technologies that may transform the energy balance of the North American continent and beyond. The United States must build an efficient and proper regulatory framework to address and support these dynamics, maximizing the benefits and minimizing the costs.

While the United States should not shy away from proceeding unilaterally when the situation merits it, the United States must also engage with the oil market's leading consumer and producer countries, including newly emerging ones such as China, India, Brazil, and Australia.

The United States must build on the fact that producers and consumers alike share a common interest in reducing price volatility to seek common ground for more tangible cooperation, such as improved physical transparency and strategic stockpile-sharing agreements, despite the challenges of international cooperation.

Nicolas Loris, Energy Policy Analyst and Senior Research Fellow, The Heritage Foundation

The most effective response to oil price volatility is simply to allow markets to work. Government restrictions and regulations impede the market's effectiveness in responding to changes in oil prices. Further, attempts to reduce our dependence on oil by subsidizing alternative fuels or creating fuel efficiency standards waste taxpayer dollars and do little to reduce dependence on oil.

Producers and consumers respond to changes in prices because these changes communicate information. As the price of oil goes up, producers explore and drill for more. Creating an efficient permitting process and reducing the time frame in which environmental groups delay new energy projects by filing endless administrative appeals and lawsuits would bring more oil onto the market quicker. And if President Obama passed the Keystone XL Pipeline at the end of 2011, up to 830,000 barrels of oil would reach the market in 2013.

Opening access and removing mandates and subsidies is the most effective, market-driven approach the United States can take to responding to oil price volatility.

We are the only country in the world that places a majority of its territorial waters off limits to oil and gas exploration. Congress should open areas that are off limits: the eastern Gulf of Mexico, the Atlantic and Pacific coasts, Alaska's offshore, the Alaska National Wildlife Refuge, and lands out west. If access to areas that are currently off limits is increased, it will take time to explore and extract that oil. But that does not change the fact that the nation needs it today and also in the future. When these areas are up and running, the United States could become a significant player in oil supply.

As the price of gas increases, consumers would switch to more fuel-efficient cars without any need to mandate more fuel-efficient trucks and cars. But consumers consider a lot of factors when buying a car, and the government shouldn't obligate consumers to make sacrifices elsewhere, whether in size or safety.

What hasn't and won't work is subsidizing alternative fuels such as biofuels, electricity, or natural gas. The global oil market is a multi-trillion dollar one. If producers have an economically viable technology, then they shouldn't need taxpayer-funded handouts. Venture capitalists will be foaming at the mouth. When the government gets involved, lobbyists start foaming at the mouth.

Opening access and removing mandates and subsidies is the most effective, market-driven approach the United States can take to responding to oil price volatility.

Daniel J. Weiss, Senior Fellow and Director of Climate Strategy, Center for American Progress

The recent spike in oil and gasoline prices has occurred before. Fortunately, we are much better prepared because we are consuming less oil due to the modern vehicle fuel economy standards adopted in 2009. Additionally, in 2011 the United States produced the most oil in eight years, and imports are now less than half of our demand (PDF).

Lower demand and higher domestic production increases energy security and reduces money paid to other nations. However, these improvements have not lowered oil prices because they are set on the global market led by the OPEC cartel.

Our last two presidents recognized that there are no quick fixes for high oil prices. President George W. Bush said that "if there was a magic wand to wave, I'd be waving it" to lower them. President Obama warned that "there are no silver bullets short-term when it comes to gas prices--and anybody who says otherwise isn't telling the truth."

Instead, this long-term problem requires long-term solutions. We must continue to modernize fuel economy standards, and invest in alternative fuels, electric vehicles, and public transportation. These measures would lessen our oil dependence and vulnerability to future price hikes.

We must continue to modernize fuel economy standards, and invest in alternative fuels, electric vehicles, and public transportation. These measures would lessen our oil dependence and vulnerability to future price hikes.

High prices led to record oil company profits in 2011. It makes little sense to spend $4 billion on annual tax breaks for Big Oil. Instead, we should invest these revenues in measures to reduce oil dependence.

McClatchy News found that Persian Gulf tensions led to Wall Street speculators "piling into the market, torquing the Iranian fear factor into ever-higher prices." We can burst this speculative bubble by selling some oil from the nearly full Strategic Petroleum Reserve and its international counterpart to boost supplies. Past releases of up to 30 million barrels cut prices.

Last week, rumors of a reserve oil sale reduced prices. Bloomberg reported, "Oil fell…on reports that President Barack Obama discussed a release from the U.S. Strategic Petroleum Reserve with UK Prime Minister David Cameron." Wall Street speculators' reactions contributed to the price drop, and demonstrate the urgency of regulators enforcing rules to reduce speculators' ability to boost prices.

Robert McNally, Founder and President, Rapidan Group

Drawing heavily on an essay co-authored with Michael A. Levi in Foreign Affairs, the following recommendations would enable our country to better acclimate to higher oil price volatility, which is driven primarily by structural supply, demand, and spare capacity trends in the global oil market.

First, more reliable data would dampen short-term volatility by reducing uncertainty and facilitate timely investments in production capacity, limiting the amplitude of price extremes over the long term. This is low-hanging fruit, and the priority should be improving OPEC and fast-growing Asian country data.

Second, encourage more supply domestically, in our hemisphere, and around the world. While the United States cannot escape oil price volatility emanating from a global, fungible, and widely traded market, reduced import dependence will strengthen economic resilience to price shocks and diversification of oil production outside the volatile Middle East, and will help reduce the frequency and amplitude of geopolitically driven price swings.

When the United States finally gets around to serious fiscal reform, taxes on gasoline and diesel should be gradually increased while compensating for those hikes by lowering payroll taxes.

Third, encourage well-regulated but expanded hedging through financial markets. Demand by oil-consuming and producing companies to transfer price risk to those willing to bear it is going to rise. Enact sensible reforms and police against manipulation and fraud, but do not enact blanket restrictions on financial market participants on the mistaken view that they are causing the volatility.

Fourth, resist the temptation to use the Strategic Petroleum Reserves. The SPR and Department of Energy are not well-suited to stabilize global oil prices. Reserves are too small relative to market flows, information is too poor, and SPR interventions would be politicized. If Washington sells SPR every time gasoline prices rise, we will end up with no SPR, more volatile prices, and less protection against severe supply interruptions.

Fifth, elevate the G20 initiative to reduce oil subsidies to make demand more responsive to oil price changes.

Sixth, address the demand side by reallocating public funds currently spent on mature energy technologies toward research and development for alternative technologies at the early stages of development. When the United States finally gets around to serious fiscal reform, taxes on gasoline and diesel should be gradually increased while compensating for those hikes by lowering payroll taxes. This shift would not only discourage consumption while rewarding work; it would also shield consumers from price volatility: if taxes accounted for a larger fraction of the pump price of gasoline and diesel, swings in the underlying price of crude would be less consequential.

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