Seminar Paper Department of Economics Harvard University Spring 1989; NUPI-report no. 130 July 1989. 58 pages. ISSN no.0800-0018.

Ole Gunnar Austvik:

Strategies for Reducing U.S. Oil Dependency
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This report focusses on strategies for reducing the costs of U.S. dependency on imports of crude oil. The model presented demonstrates how security of supply can be considered as an externality in the imports of oil. On the other hand, if domestic production is increased in order to reduce imports, externalities destructive for the environment may increase. The analysis shows how the optimal level of domestic production, imports and consumption of oil can be found taking the externalities of security of supply and the environment into consideration.

In order to reduce the sensitivity and vulnerability dependence on foreign oil, the paper argues in favor of a continuous reliance on the Strategic Petroleum Reserves (SPRs). Use of the SPRs dampens the immediate shocks in a situation of disruption and reduces the sensitivity dependence. However, a heavy reliance on stock policy is not necessarily reducing the possible longer term vulnerability dependence on foreign oil. Therefore, also the level of imports should be considered reduced. The report argues that domestic U.S. production could not (of reserve and cost reasons) or should not (of environmental reasons) be increased. Thus, a reduction in imports of oil should first of all be met by reduced consumption. A combination of a tariff on imports and a tax on domestic production have the potential to regulate imports and domestic production in an optimal manner taken the externalities into consideration. However, the report recommend a gasoline tax. The argument is that it probably will be politically difficult to introduce taxes on domestic oil producers simultaneously with the introduction of a tariff. As a single remedy introduced, a gasoline tax will usually be more optimal than a tariff.

NOTE: For a discussion of military options for reducing the problems connected with oil dependency, see see Austvik "The War Over the Price of Oil: Oil and the conflict on the Persian Gulf", International Journal of Global Energy Issues Vol.5, No.2/3/4, pp.134-143. London October 1993. ISSN 0954-7118 (

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Table of Contents


1.1. Dependency, Sensitivity and Vulnerability
1.2. The U.S. Oil Balance
2.2. Environmental Concerns
2.3. Combining Security and Environmental Aspects
3. POLICY OPTIONS 3.1. Oil Import Fee
3.2. Gasoline Tax
3.3. Conservation and Switching Policies
3.4. Stockpiling



Again, the U.S. is becoming more and more dependent on foreign oil. Consumption is increasing at the same time as domestic production is decreasing. Imports were in 1988 above the level prior to the first oil price shock in 1973/74, even though still below the level prior to the second, starting in 1979. Most observers agree that the market for crude oil today does not seem to involve any great danger of a major disruption. But experts have been wrong before. Nobody foresaw the second price shock in 1979/80 starting after Ayatollah Khomeiny's take-over in Iran. If the trend in increasing U.S. imports continues over the next years, the U.S. may face as great or even greater dependency on foreign oil as prior to the second shock.

This paper focusses on strategies for reducing U.S. dependency on foreign supplies of crude oil. Both possible modifications of the trend towards increasing imports as well as the immediate emergency problems in case of a disruption will be discussed.

The first Chapter makes an attempt to distinguish a country's "normal" dependence on imports of a commodity from sensitivity and vulnerability dependence. The second part of Chapter One shows figures for U.S. consumption, production and reserve development.

The second Chapter discusses how the risk for disruptions in supplies may be viewed as an externality in imports and, thus, consumption of oil. The model presented also demonstrates how environmental externalities as a result of increased domestic production can be evaluated together with the security-of-supply problem. This is of particular importance if the security problem is sought solved (partly) by increased domestic production.

Chapter Three discusses how fiscal policies and conservation and switching strategies can be used in order to reduce imports. Special weight is assigned to the role of stocks as a means in an emergency situation. Some foreign policy considerations are also included in the Chapter.

Chapter Four summarizes the discussion and suggests some policy options. The options are discussed with emphasis on the effect they have on variables as dependency, vulnerability, the budget, the environment, administrative and political feasibility and oil exports and importers, respectively.


The situation in the oil market and the likelihood for and magnitude and duration of disruptions will be taken as exogenous variables in this paper. We assume that there is some possibility that a crisis may occur again. Our objective is to focus on how a given situation of disruption can be dealt with and prepared for.

However, the type of crisis will affect the choice of policy. Under which circumstances should a possible new price shock be a serious concern? How will the choice of policy be affected by the gravity of the potential crisis? Clarifications of the dimensions of sensitivity and vulnerability interdependence between nations may give some help in sorting out these questions.

1.1 Dependency, Sensitivity and Vulnerability

Dependency can be defined as a situation where a nation does not possess the capacity to produce 100 per cent of its own needs. According to this definition, most countries are dependent on imports of a whole range of commodities. Dependency is thus a normal state of affairs. A country can be sensitive, vulnerable or neither in it's dependency of the commodity when it's price or availability changes. This will be a function of the magnitude and duration of the change and the country's ability to adjust to the changed environment. It also varies with the importance of the commodity in the economy. Obviously, changes in the supplies of oil is in and by itself more important for most countries than changes in the supplies of for example fishing hooks.

Sensitivity dependence is measured by the degree of responsiveness within an existing policy framework. It may reflect the difficulty to change policy within a short time and/or bindings to domestic or international rules. Vulnerability, on the other hand, is a measure of the ability to adjust to changes in the availability or price of a commodity on which the country depends. Thus, vulnerability is represented by the costs caused by external price shocks even after policies have been altered. In economic terms, vulnerability can be represented by the potential for significant losses of output or welfare.

A country can become more sensitive or vulnerable in a given state of dependency if the commodity originates from one powerful state as opposed to if it is multilaterally dependent. It will also depend on whether the supplying nations are antagonistic or friendly in their relations to the purchasing country or not. Foreign politics will therefore be an important instrument for reducing dependency in addition to the domestic measures. For oil, however, it is important to notice that a sensitivity or vulnerability dependence can occur even if a country does not import oil from any 'risky' source at all. If the price of imports from 'secure' sources varies with the insecure sources, as is the case for oil, the problem still persists. During a disruption anyone can normally purchase the oil they want. The problem is that this oil costs so much in a crises that serious damages are brought on to the country's economy. And the oil market today functions so well that a price change in one part of the world, quite immediately affects prices anywhere else. Therefore, the U.S. can be rather independent on insecure oil supplies (e.g. from the Persian Gulf) and still be dependent on price fluctuations (e.g. on Mexican, Venezuelan, Canadian or North Sea oil). Thus, for oil, the security of supply issue can be limited to a question of costs for the society when the price changes.

The costs of the dependency on imports of a commodity are measured both by the increased expenditures on imports as well as the costly effects of changes on societies and governments. The change in policy will depend on political will, governmental ability, resource capabilities as well as international rules. A sensitivity dependence occurs in "the short run or when normative constrains are high and international rules are binding". A vulnerability dependence occurs when "normative constraints are low, and international rules are not considered binding". Thus, a country's sensitivity can be significantly different from it's vulnerability.

As dependency on imports is a normal state of the economy, government policies should aim at eliminating or reducing sensitivity and vulnerability. The two may be interlinked however; reduced import of oil reduces dependency at the same time as it reduces the possible sensitivity and/or vulnerability.

In the model presented in Chapter Two, we relate the security problem to the magnitude of imports. The quality of this measurement for sensitivity and/or vulnerability dependence can be modified. If two countries import the same quantity of oil and one of them has the option to shift to alternative energies or increase domestic production and the other not, the first country is less vulnerable than the other. This ability to shift depends both on the elasticity of demand and, as in the case of U.S., on the elasticity of domestic supply. The speed of the adjustment of demand and supply is important in determining the degree of dependency in the short and the long term, respectively. If a country changes from being inelastic in it's demand for imports in both the short and long term to inelastic in the short and elastic in the long term, the country's dependence on imports may change from vulnerable to sensitive.

Also the energy intensity in the economy is important. The U.S. has for example a much higher consumption of energy pr. unit of GNP than in Western Europe. Changes in the oil price will, therefore, have larger impact on U.S. economy than on Western European economies. The level and use of inventories will also affect the dependency. A release of inventories can be perceived as equivalent to an increase in domestic production and reduces the damages to the economy in the short run. The role and use of inventories will be discussed in more detail in Chapter 3.4.

Thus, when we use the magnitude of imports as a measurement of sensitivity or vulnerability dependence in Chapter Two, many other factors are assumed to be constant. Even if this is a simplification, it illustrates an important dimension of the problem.

1.2 The U.S. Oil Balance

The U.S. is one of few countries in the Western world that have not increased taxes on gasoline and other oil products as a response to the decline in world oil prices in 1986. The consumers have benefitted immediately and fully from the price drop. Thus, demand has increased with some 400,000 barrels a day (O.4 mbd) in each of the three years 1986-87-88. Western Europe has increased gasoline taxes to an extent that consumers have experienced rather small declines in prices. The result has been that the increase in consumption in Western Europe has been more or less insignificant compared with changes in the U.S..

However, while the drop in energy prices benefitted consumers and the overall U.S. economy, it undercut the oil industry. A number of 'stripper-wells' have been closed down, reducing production each of the last three years with some 200,000 barrels per day. The U.S. has proved to be the world's highest cost producer. Furthermore, with low oil prices and better drilling prospects abroad, the industry has to a large extent found it profitable to devote exploration efforts in other countries than in the U.S. Long lead times between exploration, production decisions and actual production indicate that it may take several years to turn this trend, if so was decided.

In sum, the result has been an increase in imports in the size of 2 mbd since 1985. Consumption in 1988 was estimated to almost 17 mbd and production to 8.2 mbd, with total imports amounting to ca. 6.2 mbd, and 8.8 mbd if products are included. Thus, the increase in total petroleum imports has been some 30 per cent and crude imports some 45 per cent over 3 years.

Seen in a longer perspective, i.e. the last two decades, oil production has, in fact, been rather stable in the U.S., varying between 8 and 9 mbd. After a drop in 1974 and 1975, consumption, on the other hand, rose somewhat in the second part of the 1970s, but has been dampened for many years in the 1980s. With low oil prices, demand is increasing again and in 1987/88 it reached the level of 1973/74, even though it is still below the level of 1977/79.

Could the U.S. increase domestic production of crude oil in order to reduce imports? Are the reserves big enough? It is normally not easy to determine what are the reserves in an oil field or for a country. It may, however, be helpful to distinguish between 3 different concepts. Current reserves are those that are known to be profitably extractable at current prices. Potential reserves are defined as a function of the price people are willing to pay. Thus, the size of the potential reserves are changing with the price of oil. The endowment is the natural occurrence of resources in the earth's crust. The third concept is geological rather than economic, and represents the upper limit on the availability of terrestrial reserves. Theoretically, the price of oil can become so high that a resource can be physically depleted. However, in practice, when the price becomes too high, backstop prices will set upper limits for how high the price of oil can be and thus how much of the endowment can be extracted. The current and potential reserves set the frames for the economic scarcity of a reserve. The higher the price of oil, the larger the current reserves. The size of the potential reserves depends, on the other hand, on the expectations made for the development of the oil price.

When we in addition to the problems of definitions take into consideration the technical difficulties in measuring underground reserves, the interest for oil companies to estimate low reserves in order to push depreciation costs ahead in time and possible political interest in estimating low reserves of security reasons, reserves figures must be studied with great care. Oil reserve figures for the U.S. are excellent examples of this problem. For 25 years the reserve figures have shown a steady readjustment and almost every year the U.S. has had 8-10 years left to produce before the reserves were totally depleted! At the end of 1987 the figures were reported to be:

If decision-makers should base policies on these figures, quite dramatic conclusions should be drawn. Continuous readjustment of reserves tells us that it would be premature. However, the figures indicate that the endowment of oil in the U.S. is not infinite. Even in huge price hikes as in the seventies, production proved to be rather inelastic. Substantial upwards adjustments in production do therefore not seem to be a policy that is sustainable in the long run. Therefore, we argue that the size of U.S. oil imports can first of all be regulated by reduced consumption.


The situation for an oil-consuming country with both domestic oil production and some imports, can be illustrated as in the graph 2.0.1. Long run supply curve for U.S. domestic production is represented by the upward sloping curve CAE. Domestic short run supply is assumed much more inelastic, as illustrated by the vertical line through A. This is because it takes time for producers to adjust to a new price environment. Uncertainty about a new price level may also delay producers' decision of changing output. Therefore, a change in the price of oil may not affect output significantly in the short run.

Demand is illustrated by the downward sloping curve EB. This curve also represents the marginal social benefit of consuming oil. The price set in the world oil market is illustrated by the straight line, Popec = p. U.S. production takes place in A and consumption in B. Quantity imported is represented by the distance B-A. With no import, equilibrium will be in E, with much higher price and lower quantities. The curves are drawn linear for simplicity reasons.

2.1 The Security Problem

If a disruption occurs, the price of crude oil moves from p to p# as illustrated in the graph 2.1.1. The loss in consumer surplus of the price shock will be the area NDBO. Because of rigidities in the expansion of domestic production, U.S. suppliers would not be able to immediately increase production to K along their long-run supply curve. In the short run they will produce the same as before, but at a higher price, i.e. in M instead of in A. They gain the area NMAO as a result of the increased prices. If they had been able to move to K, they would have gained NKAO, which is an even larger area.

The net (short run) loss to society is represented by the area MDBA. DBP is deadweight loss for consumers, and MDPA transfers of wealth from domestic consumers to foreign producers. In the longer run, if the new price level is sustained, domestic producers will adjust to K and gain MKA in addition to NMAO. Therefore, the area MKA is benefits for foreign producers in the short run and for domestic producers in the longer run. A price shock therefore causes larger damage to the total economy in the short than in the long run. Consumers loses the area NDBO in both the short and long run.

Let's assume that the imported quantity B-A is viewed as a security problem, because of these losses in consumers' surplus in case of a disruption. We assume that the security problem is considered to increase as quantity imported is increasing. One way to interpret the security problem connected with imported oil is that the individual consumers, by buying oil and making investments and behavioral adjustments with the expectations that oil shall continue to flow at current prices, is imposing an externality to the society. They do not take it into account, because they are to small to influence the situation, the costs of increased stockpiling, emergency plans, or possible military interventions in the Persian Gulf to secure the supplies.

The social cost they impose on society is illustrated by the upward sloping curve AFG in the graph. The shape and slope of it will be influenced by many of the factors discussed in Chapter 1.1. As imports grow, the costs to society are increasing in order to minimize the likelihood of severe disruptions and to deal with the disruptions if they occur. The U.S. government could improve national welfare by changing consumption and domestic production decisions to reflect the total costs of oil imports, not just the private costs reflected in market transactions.

With these external costs included, consumption should have been in F where marginal social costs equal marginal social benefits. In B, the point which the market realizes, marginal social benefits equal marginal private costs. In this point, marginal social costs exceed marginal social benefits, and the loss is represented by the shaded triangle BGF.

U.S. security of supply problem is, in this model, a function of the U.S. dependency (quantity imported). As discussed in Chapter 1, this is a simplification of the real sensitivity and vulnerability problem. The problems of dependency on foreign oil not only varies with imported quantity, but also with the stability of the oil market, the number of suppliers in the market, the elasticity of demand and supply (short and long run), the energy intensity (for example measured by the quantity of oil needed per unit of output or GNP) in the economy and many other factors outside this model. Nevertheless, a partial consideration of the problem may be helpful in order to design appropriate policies in a situation where other variables can be thought of as rather constant over the relevant time horizon.

If by some means or another, the U.S. government succeeded in realizing the price p* for consumers with import prices remaining as before (i.e. by taxes or tariffs), point F would be realized for consumers. Consumption in F is socially optimal, as the marginal social cost curve expresses how much society is willing to pay in order to reduce the negative effects of import dependency. If point F was achieved by a tariff domestic producers would increase production up to point H (after some time).

If a disruption occurs in this situation, with prices shooting to p#, consumers would lose NDFO', an area much smaller than NDBO. Producers would gain the area NLHO' in the short and NKHO' in the long run. The net loss for the society would be LDFH in the short run and KDFH in the long run (supposing that the remedy, e.g. the tariff is removed when prices went up to p#). The position of the marginal social cost curve implies that the losses LDFH and KDFH, for the short and long run respectively, are acceptable risks to take in case of a price shock. The damage, if a disruption occurs, is reduced to an acceptable level at an acceptable cost.

A release of stocks could also improve the situation. A stock release of the size L-M would be equivalent to a shift in the short run supply curve from S1 to S2. The short run situation would then be the same as the situation as if prices before the disruption were raised to p*. The question is, however, whether stocks can be large enough to cover this gap over the time period needed to increase domestic production. We have argued that the long term U.S. supply curve seems rather inelastic to changes in prices. Therefore, a stock release can only serve as a relief for a shorter period of time. The loss for the society will be larger if the U.S. relies only on stock policy to take care of the problem as opposed to adjustment of the size of the import (as well) in a long-lasting disruption situation.

2.2 Environmental Concerns

However, if the security problem is (partly) sought solved by increased domestic production of oil (assuming U.S. oil producers really can increase production), "unacceptable" environmental problems could be the result. The more marginal oil fields are, they will have to be developed at a higher cost and sometimes with increased environmental externalities.

Let's assume that the marginal environmental cost is increasing with quantity produced. The curve through S, R and Q in the graph 2.2.1 illustrates the marginal social costs of domestic oil production. Production represented by the point A imposes an external cost to the society represented by the area SAQ. A social optimal production level at the price=p is represented by the point T, where social marginal costs are equal to price and not by A, where private marginal costs equal price.

Thus, the optimal price of domestic oil for the society should be lower than p when environmental concerns are taken into consideration. This is in contrast with the fact that the society may wish a higher price of oil when considering security of supply aspects. A price increase for domestic producers to p*, as in the previous graph, should therefore be weighed against the environmental concerns one might have.

2.3 Combining Security and Environmental Aspects

In the graph 2.3.1 the social marginal cost of the environment damage of domestic oil production is drawn as in the previous graph with MC(social)=price in R. The marginal social cost of import dependency is drawn as in the security graph, but now it starts in R rather than in A. This is because we take into consideration that domestic production should in fact have been lower than in A as it imposes an environmental problem on society. Thus, the marginal social cost curve representing the import dependency intersects the marginal (social) benefit curve for the society (demand curve) at U. This is higher up than point F in graph 2.1.1. Total social marginal cost curve will follow the curve C-S-R-W-U.

When we consider import dependency together with the environmental problems, consumption of oil should be lower (and the price higher, p' > p*) than with no environmental considerations. If the price equals p', the environmental costs to the society will be represented by the triangle SWV. Domestic output should be lower (represented by the point W), and not by Y as p' would yield in a free market where marginal social costs exceed marginal private costs by the distance YZ.

Thus, when both security and environmental aspects are considered, and with the world oil price at p, consumer prices should be raised to p'= p + t1 (t1 equals the distance UX). But producers' prices should equal p' - t2 (t2 equals the distance UW). The point W has to be on domestic producers' long-run supply curve, but can be both to the right (as in the graph) or to the left of point A, or in A itself as a special case. The position of W depends on the slopes of the two marginal social costs curves and the supply curve.

In the next Chapter we shall discuss some of the options at hand to achieve these socially desirable goals.


Chapter two outlined that an optimal price of oil from a security of supply perspective is in conflict with environmental concerns and vice versa. The security problem can be considered along two dimensions. First to reduce the general level of dependency on foreign oil. Second, at any given level of imports, to reduce the damage by a possible disruption in supply, normally expressed by sharp increases in prices. In this Chapter we shall mainly discuss the role and use of an import fee, a gasoline tax and stock building as means to reduce the security problem connected with imports of crude oil in the United States.

3.1 Oil Import Fee

An import fee would raise the prices paid for all oil in the U.S.. This would lower demand and increase domestic production of oil. The costs to the economy of such an (in economic sense) overall inefficient way of producing would be large. On the other hand, because the U.S. is a very large purchaser, the fee would lower U.S. demand for oil and, thus, partially also lower the world price of oil. That would benefit oil consuming and be negative for oil producing allies. And, as we have mentioned in Chapter 2, increased domestic production may cause unacceptable environmental damages, that is if it is possible to increase production to any significant extent. If domestic production cannot be increased, the fee will distribute incomes from consumers to producers without getting much more domestic oil. In that case, the tariff should be justified by other reasons than security of supply. In a cost-benefit scheme the results of an import fee can in short be summarized as: