from Energy, Security, and Climate and Energy Security and Climate Change Program

Why the United States Should Respond to Oil Price Volatility By Reducing Oil Consumption

A service truck drives past an oil well on the Fort Berthold Indian Reservation in North Dakota (REUTERS/Andrew Cullen).

June 16, 2016

A service truck drives past an oil well on the Fort Berthold Indian Reservation in North Dakota (REUTERS/Andrew Cullen).
Blog Post

This post is co-authored by Sagatom Saha, research associate for energy and foreign policy at the Council on Foreign Relations. Read the report from a recent CFR workshop on oil price volatility. The workshop, hosted by Michael Levi and Varun Sivaram, was made possible by the support of the Alfred P. Sloan Foundation.

Last month, CFR’s Greenberg Center for Geoeconomic Studies convened a workshop to discuss the causes, consequences, and policy implications of oil price volatility. Most of the roughly forty experts in attendance agreed that volatility—which the workshop defined as price swings in either direction of up to a year—will persist for the foreseeable future. They also broadly agreed that at least some instances of volatility have serious economic and geopolitical consequences.

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But when it came to proposing policy measures to reduce volatility, controversy replaced consensus; few participants rallied around any recommendation, warning of side effects from trying to manage oil prices. In fact, the only policy recommendations that did attract widespread support were ones that reduced the U.S. economy’s exposure to oil markets by lowering consumption, the only surefire way to decrease the risks from volatility.

These discussions happened against the backdrop of a changing global energy landscape. In particular, participants reflected on future sources of “swing supply” to balance supply and demand and moderate oil price volatility. Uncertainty over whether Saudi Arabia has abdicated its historical role as swing supplier and if U.S. shale oil can instead play that role suggests that there is no end to volatility in sight. But, as the workshop report notes, “Given Saudi Arabia’s large spare production capacity—still the world’s biggest—most workshop participants still see the kingdom playing some role as the producer of last resort.”

Figure 1 from the report on CFR’s oil price volatility workshop
Figure 1 from the report on CFR’s oil price volatility workshop

Having established that volatility is likely to persist, the workshop explored its economic and geopolitical consequences at home and abroad. Although the academic literature more commonly focuses on the effects of oil price levels—i.e., high or low oil prices—participants honed in on the effects of price volatility independent of price level. The workshop report elaborates:

Even low [oil] prices, if paired with volatility, do not necessarily lead to an economic boost [in the United States], some participants suggested. Fluctuating prices can make consumers wary of spending, thus dampening any stimulus effect of lower oil prices.

…For oil-exporting countries, some participants noted that price volatility, more than the price level, is particularly problematic. That is because, as one participant put it, it is easier to build a budget that works with oil at $50 per barrel than one that works when oil zooms between $20 and $80 a barrel.

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But participants were hard-pressed to provide recommendations to U.S. policymakers for how to reduce the volatility of global oil prices. For example, Columbia’s Jason Bordoff wrote a post for this blog arguing that the United States should not use its Strategic Petroleum Reserve (SPR) as a “Federal Reserve of Oil” to buffer global price volatility on a regular basis. Such a strategy would have grave side effects, including muting price signals to producers and consumers and depleting the SPR, impairing its intended ability to counteract major oil market disruptions.

The workshop also explored ways to reduce the elasticity of oil supply and demand—at least theoretically, more price-responsive demand and supply should reduce price volatility. But targeting elasticity can yield impractical policy proposals, like taxes on producers that increase as their production decreases. And some policies that enjoy broad support, like U.S. fuel economy standards, might actually be undesirable if evaluated only by the effect on demand elasticity:

Efficiency standards that make the automobile fleet cleaner can actually end up decreasing elasticity and increasing oil price volatility, one participant noted. If cars get better mileage, gasoline prices will matter less to drivers, and consumers will not cut down consumption.

Even if more efficient U.S. cars can increase oil price volatility, the effect is likely washed out by the salutary effects of consuming less oil. (Indeed, we recently studied U.S. fuel economy standards and found that the benefits far outweigh the costs.) This does not mean that reducing U.S. oil consumption will mitigate all of the risks of oil price volatility—around the world, volatility still threatens U.S. economic and geopolitical interests. And it is not always a bad idea to try and increase elasticities—the United States should advocate for global reform of fuel subsidies that can insulate major economies from the price signals of oil markets. But to reduce the effects of oil price volatility on the U.S. economy, it is likely best to reduce U.S. exposure to the global oil market rather than attempt to tame it.

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