ORNL-6851



## OIL IMPORTS: AN ASSESSMENT OF BENEFITS AND COSTS

Paul N. Leiby Donald W. Jones T. Randall Curlee Russell Lee

Oak Ridge National Laboratory

November 1, 1997

Prepared by the OAK RIDGE NATIONAL LABORATORY Oak Ridge, Tennessee 37831 managed by LOCKHEED MARTIN ENERGY RESEARCH, INC. for the U.S. DEPARTMENT OF ENERGY under Contract No. DE-AC05-96OR22464November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs Acknowledgments and Notes

In draft form, this report was widely circulated and reviewed within government circles. We thank those reviewers for their comments, many of which have been incorporated, without suggesting that they concur with our conclusions. We reserve for ourselves all responsibility for errors. Helpful comments were offered in particular by William White, Jack Riggs, Hilary Smith, and Len Coburn of the U.S. Department of Energy; Mark Mazur and Michael Toman, then at the Council of Economic Advisors; Lori Krauss, Office of Management and Budget, and Alicia Munnell and Eric Toder of the Department of the Treasury. We also thank David Bowman of the University of Tennessee for his valuable suggestions and assistance.

Since the completion of this document, new research has been completed on the macroeconomic impact of oil price shocks [Hamilton 1996, Hooker 1996, Davis and Haltiwanger 1997, and Davis, Loungani, and Mahidhara, 1997]. While we do not utilize this material in the document, we briefly discuss some of the new findings in an appendix. Overall, this latest empirical research has confirmed the significant links between oil price shocks and macroeconomic performance, and identified some industry-level reactions to oil price movements.

The authors of this report may be reached by mail at: Oak Ridge National Laboratory P.O. Box 2008, MS 6205 Oak Ridge, TN. 37831 Or by e-mail at: Paul N. Leiby leibypn@ornl.gov Donald W. Jones jonesdw@ornl.gov T. Randall Curlee curleetr@ornl.gov Russell Lee leerm@ornl.govNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs ii TABLE OF CONTENTS: SUMMARY

S1.0 INTRODUCTION AND BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-1

S2.0 STUDY CONTEXT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-2

S3.0 STUDY FOCUS ON MARGINAL EXTERNAL COSTS AND BENEFITS OF OIL IMPORTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-3

S4.0 NET BENEFITS OF OIL IMPORTS AND THE OIL IMPORT PREMIUM . . . . . . . S-4

S5.0 THE OIL IMPORT PREMIUM: IMPORTED OIL COSTS NOT REFLECTED IN PRICE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-5 S5.1 Long-Run Recoverable Cartel Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-6 S5.2 Oil Market Disruption Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-7 S5.3 Costs Which May Not Vary at the Margin With Oil Imports . . . . . . . . . . . . . . S-9

S6.0 ESTIMATION OF THE ECONOMIC COMPONENTS OF THE OIL IMPORT PREMIUM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-11

S7.0 CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-19November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs iii TABLE OF CONTENTS: BODY OF REPORT

1.0 INTRODUCTION TO THE SOCIAL COSTS OF OIL IMPORTS .................1

2.0 FRAMEWORK FOR ASSESSING OIL COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2.1 The Interdependence of Consumption, Production, and Imports .............6 2.2 Import Incremental Benefits are Largely Internalized . . . . . . . . . . . . . . . . . . . . . . 6 2.3 The Issue of a Reference Point: Costs Relative to What? . . . . . . . . . . . . . . . . . . 8 2.4 Marginal Imports and Marginal Welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 2.5 The Base Import Premium and the Optimal Import Premium . . . . . . . . . . . . . . . 10 2.6 Bases for Expert Disagreement: Views of the Costs of Oil Market Instability to the U.S. Economy and Oil Exporter Market Power . . . . . . . . . . . . . . . . . . . . . . . . . 12 2.7 Understanding Different Estimates of Import Costs, and Organizing the Potential Cost Categories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

3.0 NONCOMPETITIVE MARKET COSTS: EXISTENCE AND MEASUREMENT . . . 17 3.1 Variation of Opinion on OPEC Monopoly/Cartel . . . . . . . . . . . . . . . . . . . . . . . . 17 3.2 Taking Action on Monopoly/Oligopoly Power in International Trade . . . . . . . . 19 3.3 Costs of Noncompetitive Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 3.4 Monopsony Power and the Monopsony Premium . . . . . . . . . . . . . . . . . . . . . . . . 25 3.5 Numerical Estimates of the Monopsony Premium . . . . . . . . . . . . . . . . . . . . . . . 29

4.0 DISRUPTION COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 4.1 Conceptual Issues in the Definition of Disruption Costs . . . . . . . . . . . . . . . . . . 37 4.2 Oil Futures Markets and Other Private Hedging Opportunities . . . . . . . . . . . . . 38 4.3 Direct Costs of Disruptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 4.4 Indirect Costs of Disruptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

5.0 NUMERICAL ESTIMATES OF THE OIL IMPORT PREMIUM . . . . . . . . . . . . . . . . . 52 5.1 Previous Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 5.2 Updated Estimates of Broadman and Hogan's Oil Import Premium . . . . . . . . . . 58 5.3 Estimation of the Most Robust Economic Components of the Oil Import Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

6.0 CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 6.1 Cost Categories and Estimation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 6.2 Noncompetitive Market and Disruption Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 74 6.3 Military Security Costs of Oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 6.4 Environmental Externalities Associated with Imports . . . . . . . . . . . . . . . . . . . . 76

APPENDIX A: CALCULATION OF MAXIMUM NET BENEFITS . . . . . . . . . . . . . . . 77

APPENDIX B: LIMITATIONS OF THE OIL IMPORT PREMIUM APPROACH . . . . 79

APPENDIX C: CARTEL RENT PAYMENTS TO OIL EXPORTING COUNTRIES . . 80

APPENDIX D: MARKET POWER AND OIL MARKETS . . . . . . . . . . . . . . . . . . . . . . 81November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs iv APPENDIX E: NEW EVIDENCE ON THE RELATIONSHIP BETWEEN OIL PRICE SHOCKS AND THE MACROECONOMY . . . . . . . . . . . . . . . . . . . . . . 84

REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86November 1, 1997 Summary, ORNL-6851

1 Net imports for the first nine months of 1994 averaged 46 percent, up from 44.2 percent in 1993 and 40.7 percent in 1992. The previous peak year was 1977 with 46.6 percent, which was exceeded in May-September of 1994 [EIA, Monthly Energy Review , Table 1.8, November 1994].

2 The quantity of net imports is projected to grow 70 percent between 1992 and 2000 and oil prices are projected to rise 14 perce nt over the same period, so the value of net imports is projected to rise 94 percent.

Oil Imports: An Assessment of Benefits and Costs S-1 OIL IMPORTS: AN ASSESSMENT OF THE BENEFITS AND COSTS

SUMMARY

S1.0 INTRODUCTION AND BACKGROUND

This study examines the costs and benefits of the marginal barrel of oil imports.

United States (U.S.) oil imports have grown substantially over the last decade, and are expected to climb to 60 percent of consumption by 2010. 1 U.S. oil trade is large, in financial terms. The U.S. annual bill for imported oil is about $50 billion, with the long-term cost from 1980 to 1992 totaling $742 billion. According to Energy Information Administration (EIA) projections, by 2000, the annual bill for oil imports will exceed $100 billion in 1992 dollars. 2 In general, free trade confers enormous benefits on the U.S. society, as does the use of oil. However, in cases where the market for a commodity is not fully competitive, is subject to price shocks, and may involve social costs not borne by the users of the commodity, the magnitude of oil imports or consumption could be a

concern.

The Federal government has developed a set of policy objectives to ensure an adequate and reliable supply of oil to drive the U.S. economy:

 Reducing the likelihood and size of severe oil supply disruptions through political and military policies;

 Minimizing the impacts from an oil price shock by building and maintaining a Strategic Petroleum Reserve (SPR), which now has about 563 million barrels of oil, and by establishing international arrangements, such as the International Energy Agency's coordinated emergency response mechanism;

 Reducing the intensity of energy use in the economy;

 Maintaining a cost effective, viable, domestically-based oil industry; and

 Encouraging development of natural gas and other alternatives to oil, as well as policies that promote fuel switching.

Given these policies and the importance of oil in the economy, it is worth asking whether the current level of oil imports is efficient from the perspective of society as a whole.

On December 9, 1993, the Clinton Administration released the Domestic Natural Gas and Oil Initiative (DNGOI), outlining a plan for reducing America's dependence on foreign oil. One element of the plan was to study the benefits and costs of oil imports. Consumers will buy or import oil untilNovember 1, 1997 Summary, ORNL-6851

3 At the margin, private benefits must equal the price, otherwise no purchase would be made if the benefits were too low, or more would be

purchased if the benefits were greater than the price.

Oil Imports: An Assessment of Benefits and Costs S-2 the benefits of the last barrel bought by the last or "marginal" buyer are equal to its price. 3 However, at the margin, the "true" cost of oil imports may be higher than the price because of possibilities such as economic harm from the influence of Organization of Petroleum Exporting Countries (OPEC) on world oil markets, price spikes from oil supply disruptions, or environmental damage from the importation of oil. The difference between the true incremental cost of oil imports and the market price of oil is called the oil import premium, a term commonly used in the energy security literature.

This study has three purposes:

 To identify the possible social costs of oil imports that are not included in the price paid by consumers;

 To discuss the possible size of these costs; and

 To highlight the reasons for differences in cost estimates.

S2.0 STUDY CONTEXT

The study focus is on the costs and benefits of oil imports, which, while quite important, is only a part of a larger perspective on oil. Besides importing oil, the United States is the world's largest consumer of oil and the world's second largest producer of oil. Like oil imports, consumption and production of oil have their costs and benefits. Moreover, oil consumption, production, and imports are interdependent, so that induced changes in one, such as oil imports, must affect one or both of the other two. While this study attempts to isolate the effects of imports, some of the potential costs identified in this study are not uniquely associated with imports, but rather may be also associated with oil consumption. For example, even oil consuming countries with little or no net oil imports may find that their economies are sharply affected by an oil price shock as their domestic oil prices rise along with world oil prices.

In isolating oil imports, no policy changes are specified in the study. Without modeling specific policy changes, nothing can be said about what changes may occur in oil consumption or oil production and hence in the costs, benefits, distributional effects, and other properties of oil consumption or production. Consequently, the study results apply to the costs and benefits for oil imports alone.

While the present study's independence from specific policy is advantageous in several respects, it cannot be used, without further policy analysis, to support or reject any particular policy change. Any proposed policy would have to be examined for its costs and benefits across oil consumption, production, and imports, as well as its effects in other markets, government costs if any, and the nonquantifiable but important aspects such as foreign policy, trade policy, and military issues. Even if there are external costs associated with oil imports -- and this study notes the differences in professional opinion on that issue -- it is possible that government policies might not be able to improve upon the situation. The best policy might be directed at consumption, production, or stockpiling rather than imports. Finally, this study does not resolve the extent to which existing policies -- such as taxes on oil use, tax incentives for domestic production, or spending programsNovember 1, 1997 Summary, ORNL-6851

4 Strictly speaking, not all of the unaccounted social costs in the oil import premium are technical externalities. Rather, some stem from other market failures not reflected in the price of oil such as a lack of a complete set of risk markets to allow oil users to anticipate oil price shocks. For example, see Verleger (1990) for the assessment that such incompleteness of risk markets has resulted in inadequat e excess refining capacity in the United States. Further, the oil import premium includes costs that result from such circumstances as OPEC influence on the oil market.

5 This identity omits the minor effects of inventory changes. Also, the United States does export some petroleum. To account fo r that in this equation, imports could be changed to net imports.

Oil Imports: An Assessment of Benefits and Costs S-3 that benefit domestic production -- may address or mitigate external costs of imports. For example, transportation fuels face taxes that exceed the amounts placed in transportation trust funds. In raising the price of fuels above private marginal costs of production, these taxes may help internalize some of the social costs of fuel use.

S3.0 STUDY FOCUS ON MARGINAL EXTERNAL COSTS AND BENEFITS OF OIL IMPORTS

This document reviews the external costs and benefits of oil imports, that is, those costs and benefits which are not included in the market price of oil. 4 The focus is on marginal, or incremental, external costs and benefits -- the change in total external costs and benefits caused by a change in imports. As discussed further in Section S4.0, the full, or "social," marginal benefits of oil imports generally can be captured by private buyers, leaving no marginal external benefits excluded from the price of oil imports. So the remainder of this analysis focuses exclusively on external costs.

A number of external costs are associated with oil imports or use. Some of these costs are related to activities other than imports, the most important being consumption, which is a major determinant of environmental externalities. Other costs, such as military security costs, may be associated with imports, but it is difficult to assess the proportion of them which should be assigned to imports; and since they may not vary with the level of imports, it is particularly difficult to determine marginal costs. These two major categories of external costs of oil are discussed in this study, but the focus of the study is on the more narrowly defined external economic costs, which vary with the level of oil imports because the environmental externalities of oil imports seem to be small, and the military costs which are difficult to define.

Within marginal assessments, studies can take an equilibrium or a partial approach. An equilibrium approach is policy-based and examines the direct and indirect changes in all relevant variables for a small change in the policy variable of interest. The equilibrium effects are those which occur after all consumers, producers, and importers have adjusted to the direct and indirect consequences of the policy and the market has balanced. In contrast, a partial approach takes a narrower view that looks only at the direct changes in market outcomes and costs for a small change in the level of imports, holding all else fixed.

A simple identity relates imports, consumption, and production of oil in the United States: 5

U.S. oil imports = U.S. oil consumption - U.S. oil production.

Since imports are the difference between domestic consumption and production, the analysis of any oil policy would benefit from the evaluation of its full equilibrium effects on imports, consumption, and production, and their attendant economic, environmental, and energy security consequences. For example, the equilibrium effects of an oil import fee, an oil consumption tax, and a domestic oilNovember 1, 1997 Summary, ORNL-6851

6 To analyze the changes in domestic supply or demand associated with a change in imports would require knowledge about the polic ies used. The present study is concerned with efficiency rather than policy. Additionally, the strict focus on import changes avo ids confusing any externalities which may be attributable to consumption or supply with those of imports.

7 The economically efficient level of imports is the level where marginal social costs and benefits are equal. As imports declin e, the premium declines. Calculating the premium at the current level of imports rather than the (lower) efficient level would indica te too high an external cost (see Figure A.1 of Attachment A).

Oil Imports: An Assessment of Benefits and Costs S-4 supply incentive would differ. However, this study does not evaluate a specific policy but instead takes a first step by considering only a subset of the relevant issues. The focus here is exclusively on the effect of changing imports, without considering particular changes in domestic supply or demand. 6

The oil import study uses a marginal partial approach: "marginal" because it is based on incremental changes in imports, and "partial" because it does not consider changes in production and consumption. This is a good means of isolating the costs and benefits directly attributable to oil imports to get a sense of the magnitudes involved, independent of policy choice. It avoids ascribing costs or benefits to imports which may not depend on imports per se , and is a precursor to policy analysis.

The oil import premiums reported include only those external costs which arise from changing oil imports. They exclude costs which arise from changes in consumption or production, or which do not vary with the level of imports. Because of the "marginal partial" approach taken here, more information is required to assess the merits of policies affecting oil imports, production, or consumption. For example, insight into the value of a particular prospective policy affecting oil market balances could be gained by coupling the results of this study with a similar one on the marginal social costs and benefits of oil production and consumption.

S4.0 NET BENEFITS OF OIL IMPORTS AND THE OIL IMPORT PREMIUM

This study assesses the incremental costs saved and benefits foregone by the United States with a small departure of oil imports from their economically efficient level. 7 The costs saved include both the marginal external and private costs, and the benefits foregone include both marginal external and private benefits.

For a society, net benefits of a quantity of imports purchased during a given time period are the social benefits from oil imports minus the social costs of oil imports. Social benefits are composed of private benefits and external benefits. Likewise, social costs are composed of private costs and external costs.

Private benefits are the benefits received by the buyer from using imported oil, which at the margin will equal the price paid. External benefits would be the benefits received by third parties not involved in the sale or purchase of oil imports. If one person's purchase of imported oil confers some benefits on someone not purchasing that oil, the marginal social benefit of imported oil would exceed its marginal private benefit, which is equal to its delivered import price. These potential benefits of oil imports are not included in the price, or are "external" to the price. In practice, however, the full marginal benefits of oil imports generally can be captured by private buyers, and there are no accepted significant external benefits of oil imports. Thus, at the margin, socialNovember 1, 1997 Summary, ORNL-6851

8 We consider these possible benefits briefly. External Environmental Candidate Benefit : Imports may displace domestic production, thereby lessening the domestic pollution associated with production. However, there is very nearly a consensus among analysts that most environmental externalities as sociated with oil production and transportation have been internalized at the margin by additional insurance requirements, safety regulations, and private anticipations of law suits and fines in the event of spills and other damages. Consequently, the marginal external env ironmental benefits of oil imports can be expected to be small, as are the estimates of their marginal external environmental costs.

External Resource Allocation Candidate Benefit : To the extent that the tax code encourages domestic oil production, the marginal resource cost of domestic oil production is higher than the world price of oil. However, this study does not consider the effects of fo reign or domestic tax provisions on allocative efficiency.

Oil Imports: An Assessment of Benefits and Costs S-5 benefits of oil imports are the private benefits. This study examines possible candidates for such external marginal benefits of oil imports , holding constant oil consumption and domestic production to avoid counting either external benefits of consumption or avoided external costs of production as external benefits of imports.

The partial analysis conducted in the study omits consideration of induced changes in domestic production or consumption because such changes depend upon policies which are not specified. Possible external benefits of imports which have been proposed by some include less domestic pollution, fewer tax distortions, and more efficient allocation of capital. 8 These candidate benefit categories would arise from changes in production, which our partial marginal analysis excludes. We conclude that the full social benefits of marginal oil imports can generally be captured by the buyer, leaving no marginal social benefits excluded from the price. This study, therefore, focuses on the external costs of marginal imports.

S5.0 THE OIL IMPORT PREMIUM: IMPORTED OIL COSTS NOT REFLECTED IN PRICE

The oil import premium consists of cost components that are not reflected in the private cost or price of oil imports, and which vary at the margin with imports . Candidate costs for the oil import premium can be grouped into: recoverable costs due to the exercise of market power by OPEC, costs due to oil market disruptions and price shocks, environmental and health damages specific to imports, and costs of strategic insurance such as the military programs and the SPR. This study groups environmental and strategic insurance costs into a separate category that either cannot be shown to depend significantly on imports (but instead may depend on oil consumption), or may not vary at the margin with imports. For completeness, this study considers this category of costs briefly (Section S5.3), but excludes them from current estimates of the oil import premium. What remain are essentially the economic portions of the premium.

This summary considers only the principal components of the economic portion of the oil import premium: recoverable rent from the exercise of exporter market power, increased import costs during disruptions, and incremental macroeconomic adjustment losses during disruptions. Other economic components which have been presented in the literature are discussed in the full report, but are omitted here because they are less securely grounded (in theory and empirical fact) and are small in magnitude in any event.November 1, 1997 Summary, ORNL-6851

9 Mabro (1992) has found oil price behavior to conform to patterns predicted by the exhaustible resource model during disruptions but concludes that during most periods (the undisrupted time) OPEC supply is guided by cartel principles.

10 See, e.g., Adelman and Shahi (1989), U.S. DOE 1996.

Oil Imports: An Assessment of Benefits and Costs S-6 S5.1 Long-Run Recoverable Cartel Rent

Most oil market analysts credit OPEC with having some ability to affect oil prices, and many conclude that oil prices are higher than competitive levels. Although higher priced oil has deleterious effects on parts of the U.S. economy, this has no substantive policy relevance unless something can be done about it. If the United States could do something to lower the noncompetitive world oil price but does not, then there is an opportunity cost of not doing so. The United States may be able to pay less for imported oil through economic policy or foreign policy, as discussed in Appendix D. The portion of the cartel rent which is recoverable by reducing imports may be seen as an external cost.

Cartel rents arise because the world price of oil may reflect some market power, and these may vary at the margin with oil imports. Clearly, this cost component is a direct consequence of the level of imports, rather than United States supply or demand, since it is the net United States call on world import supply which creates the marginal cost. We call the portion of cartel rent which varies at the margin with imports the ìrecoverable cartel rent.î For the United States to recover any cartel rent by varying imports, it must have some monopsony power (i.e., the United States must have sufficient consumer buying power to affect the oil price), and OPEC must have limited ability or willingness to offset monopsony power through retaliation. The degree of United States monopsony power depends on the elasticities of supply and demand in regions other than the United States and OPEC, and on the relative size of United States imports in the world market. The parameters used here are adopted from current data and from assumptions in the United States Department of Energy (DOE)/EIA's Oil Market Simulation Model.

There are essentially two views about the size of the monopsony premium. One view is that it is ofsome significance. For cartel rents to exist in the first place, there must exist some degree of noncompetitive supply behavior. This claim has been justified on three arguments. First, empirical evidence [Griffin (1985), Jones (1990), Dahl and Yucel (1991)] suggests that OPEC supply behavior conforms more closely to an (imperfect) output-sharing cartel than a confederation of competitive suppliers. 9 Second, most estimates of the marginal cost of production are well below the prevailing price. 10 The failure of oil exporters to produce more oil even though their costs are below the market price -- presumably because of their recognition that if they do, it will reduce the price of oil -- is itself evidence of price power. Third, any price premium associated with the depletability of oil is likely to be small given the large resource base and the ability to replenish reserves with improved technology and greater effort.

The other view is that cartel rents currently are minimal (though they could grow in the future). One reason offered is the limited cohesion of the cartel. Bohi and Toman, on the basis of an informal inspection of petroleum production data, question whether OPEC supply behavior has been consistent with a cartel. They question whether OPEC cohesion is a reasonable assumption given the current rivalries and indebtedness of its members. MacAvoy (1982) has offered calculations suggesting that the difference between a (roughly) competitive oil price and recent world oil prices is close to the depletion premium which a market with perfect foresight should charge for an exhaustible resource (i.e., OPEC may be doing little, if any, more than charging this competitiveNovember 1, 1997 Summary, ORNL-6851

Oil Imports: An Assessment of Benefits and Costs S-7 depletion increment). Teece (1982) suggested that revenue absorption capacity, rather than market power, may have limited OPEC output in the past. Neither MacAvoy's nor Teece's suggestions have been widely accepted.

S5.2 Oil Market Disruption Costs

The oil price shocks that accompany large disruptions in the supply of oil have a ripple effect throughout the economy. When faced with a sudden and unanticipated large oil price shock, businesses and individuals struggle with pure price effects and income effects. Pure price effects arise because petroleum is more costly relative to other products and services so that users of petroleum need to make adjustments in what they buy: labor, capital, and materials for businesses; and goods and services for individuals. Income effects come about because with higher petroleum prices, their incomes do not go as far.

These effects come about in part because of the incompleteness of low-cost, accessible markets where businesses and individuals can deal with the oil-market uncertainty in advance of a potential price shock and with the consequences, should one occur. These might be thought of as insurance or risk markets. While oil stockpiling and futures market transactions are available to hedge or spread some of the private risk, without a full set of such markets, prices may not fully reflect a future characterized by the chance of oil price shocks. In addition, futures markets provide neither a mechanism nor an incentive to hedge away all social risk. A root cause of social risk is the lack of means to quickly adjust a company's work force and capital stock in an oil price shock, and various regulations (such as windfall profit taxes that have been used in the past) that inhibit the most efficient use of capital equipment and oil stockpiles to respond to fluctuations in oil prices. To the extent that the existing markets are inadequate to perfectly handle these needs, there is a market failure and an oil import premium component associated with oil price shocks.

When oil prices spike, the principal losses are increased payments for imports and macroeconomic adjustment losses. But future disruptions in oil supply are not certain to occur. Thus, each of these costs must be adjusted for the probability that an oil supply disruption will, in fact, occur.

Increased Payments for Imports

Upward oil price shocks cause oil demand to fall, but U.S. consumers pay more for the remaining imports. The increase in the U.S. oil import bill (for the remaining imports) is a cost which may not be fully accounted by private oil consumers and producers when making long-lived investment decisions prior to the shock. Because there may not be adequate markets to allow U.S. oil consumers and producers to fully anticipate and insure against the effects of oil price shocks, the increase in the oil import bill can reflect a cost not fully captured in the price of oil. See Appendix C for further detail. The import premium does not measure the total expected effect of shocks on import payments, but rather the marginal change in expected payments for imports during disruptions due to an incremental change in the level of pre-disruption imports.

While the existence and relevance of these costs seem acceptable to many analysts, there is not unanimity on that score. The principal argument against including the higher cost of imports during shocks as a social cost is that many market mechanisms do exist in the economy to provide the efficient forecast of expected oil price shocks and to protect against them, and that policy cannot do better. This is largely an empirical question that has not been fully resolved. Bohi and Toman (1993) have argued the case that developments in oil futures markets, conservation, and fuelNovember 1, 1997 Summary, ORNL-6851

11 Futures markets are only one of a variety of ways in which the private sector can protect itself against the vagaries of price shocks (others include flexible energy use technologies and oil storage). Whether this package of hedging options is producing an efficient l evel of insurance is an open empirical question. Nonetheless, this study does include a potentially large role for such hedging strategies by assuming that at least 25 percent and up to 100 percent of the expected price increase from a low-probability oil price shock i s effectively hedged and internalized.

Futures marketsí functions include providing insurance for hedgers and a mechanism to incorporate information on future market conditions into current prices. Providing insurance requires that futures prices contain a risk premium, which implies that fu tures prices are biased relative to future spot prices.

There are reasons to question whether the futures markets can internalize shock costs. First, there is no evidence that oil fut ures markets provide effective signals regarding future oil price shocks. In fact, repeated studies have shown that futures prices are bias ed estimators of the actual future spot price, and add essentially no predictive content beyond that provided by the current spot price [e.g., S erletis and Banak (1990), Moosa and Al-Loughani (1994)]. This means that we cannot count on futures markets to inform oil consumers about impending disruptions, and to take precautionary measures, such as stockpiling or increased hedging. Second, futures markets, in general, reallocate the financial burden of price shocks between hedgers and speculators. The aggregate shock costs are still borne by someone in the economy. Storage, not futures markets, provides arbitrating between low and high value periods (Newbery and Stiglitz, 1981 :188). Third, futures markets provide an opportunity to hedge private risks, but there is no incentive for private agents to hedge social risks, which include GNP losses and increased payments for imports. To the extent that there are macroeconomic consequences or other social consequences of price shocks not fully included in private decisions, the social risk premium due to shocks will exceed the pri vate risk premium. "A consequence of this possible gap between the premia would be lower investment by the private market in hedges agai nst energy price fluctuations than is socially efficient" [Toman 1993:1199]. Fourth, most of the futures transactions have a forwa rd date of less than one year. With the short-term characteristics of the oil futures markets, there is no clear mechanism but which thos e markets can affect long-run investment decisions, such as investments in durable energy-using capital equipment. While no single one of th ese arguments may be completely compelling, together they suggest that we cannot be confident that the futures markets completely i nternalize or avoid the potential costs of oil price shocks.

12 Potential GNP is that level of GNP which could be produced under conditions of full employment.

Oil Imports: An Assessment of Benefits and Costs S-8 switching have been crucial changes in the economy's ability to protect itself against oil price shocks since the first OPEC embargo of 1973. They also question whether long-term government actions can improve on market outcomes. 11 In the premium estimates presented below, the proportion of the expected increase in import prices due to disruptions which has been efficiently anticipated by private agents is treated as a parameter. A range of values is considered.

Macroeconomic Adjustment Losses

The U.S. economy adjusts to movements in oil prices. If the movements are gradual, the adjustment can be smooth and routine, and the adjustment costs are minimal. Severe oil price shocks come infrequently, and not always in the same direction: prices nearly quadrupled between 1972 and 1975, more than tripled between 1978 and 1981, and plunged by 50 percent from 1985 to 1986. In the short-run, the economy must adjust by re-balancing output and inputs of labor, materials, energy, and capital in ways that may end up costing more than is necessary in the long-run (more than the loss of potential GNP). 12 Wages and prices do not adjust immediately to the new price of oil for a variety of reasons, including cost-of-living provisions in labor contracts and entitlement programs. Also, substitutions of other energy sources and other factors of production for oil take time because of the durability of (economic value tied up in) energy-using equipment. The GNP level that can be reached in the short-run is necessarily lower than that which could be reached if the economy were able to adjust to the long-run, optimal, prices and wages. Bruno and Sachs (1985, Chapter 3) offer a clear exposition of alternative mechanisms by which short-term adjustment losses follow a supply shock. Over a dozen empirical studies have linked GNP losses to oil price rises; among the more recent studies reporting this are Hamilton (1985), Mork (1989), Mory (1993), and Mork et al. (1994). Despite changes in the oil market, Tatom (1993) and Mork et al. (1994) have found similar responses to oil price shocks from the early 1970s through 1992. Most of these studies useaggregate economic measures, although some recent ones [e.g., Loungani (1986)] use industryspecific data.November 1, 1997 Summary, ORNL-6851

13 The industry data were disaggregated at the 3-digit ISIC level.

14 Bohi and Toman question the underlying hypothesis that any oil price change gives rise to adjustment costs. However, the obser ved asymmetric effects of price declines are not inconsistent with the theoretical predictions. See Lilien (1982), Gilbert and Mor k (1986), and Hamilton (1988) for a theoretical discussion; see Loungani (1986), Mork (1989), Mory (1993) and Mork et al. (1994) for empirica l evidence.

15 This is a possibility, although the magnitude of the phenomenon has not been tested empirically, given the limited data. Here the possible disruption size reductions assumed to be small, i.e., between zero and 10 percent of the amount of import reduction.

16 It has also been argued that reduced imports could lower the probability of opportunistic price shocks, by reducing cartel market share and the value of exploiting short-run market power [e.g., Suranovic (1994), Greene (1991), Wirl (1985), Fromholzer (1981)]. This p ossible effect is not included in this study.

Oil Imports: An Assessment of Benefits and Costs S-9 Bohi (1989, 1991) and Bohi and Toman (1993) have been the principal writers expressing reservations about the source of macroeconomic adjustment losses following the oil price shocks of the past two decades. Using simple statistical techniques with disaggregated data 13 for a number of Organization of Economic Co-operation and Development (OECD) countries, Bohi did not detect larger-than-average employment or output losses in energy intensive industries following the 1973- 74 and 1979-80 supply shocks. Additionally, Bohi and Toman interpret the failure to observe a macroeconomic boom following the 1986 oil price crash as further evidence of an unreliable relationship between oil prices and macroeconomic performance rather than an asymmetry in
response. 14 While the view that there are no significant losses attributable to oil price shocks is a minority view in the published literature, Bohi's work raised questions about how important oil price movements are to macroeconomic performance. Many of the published studies are based on highly aggregated time series data. Since Bohi was unable to identify patterns with more disaggregated data, which are consistent with the aggregated results, some issues remain unresolved. An alternate interpretation offered by Bohi for the aggregate economic contractions associated with the price shocks of the 1970s is that they were caused by inappropriate macroeconomic (monetary and fiscal) policies. The most recent empirical evidence casts doubt on this hypothesis (for a summary see Jones, Bjornstad, and Leiby 1997, and the Appendix E).

We are interested in the degree to which GNP adjustment losses vary with the level of imports. The GNP adjustment losses depend upon the size of the oil price increase as well as the vulnerability of the macroeconomy to adjustment losses for a price shock of a given size. The vulnerability to adjustment loss is widely recognized as depending on the level of oil consumption rather than imports. Although consumption is a major determinant of the total shock effect on GNP, there is

a marginal effect of imports as well. This arises because the pre-disruption imports level may affect the size of the price shock. In this analysis, there are two mechanisms by which this may occur. First, changing the level of imports could alter slightly the distribution of oil disruption quantities, that is, marginally change the expected size of the oil shortfall by either creating excess capacity or reducing the supply flows at risk of disruption. 15 Second, changing the pre-disruption level of imports changes the starting points on the oil import supply and demand curves from which the disruption deviates. As a result of either of these mechanisms, the proportional size of the price shock may be diminished. 16

S5.3 Costs Which May Not Vary at the Margin With Oil Imports

As noted previously, most of the external environmental costs of oil derive from consumption rather than imports, and accordingly they are omitted from this analysis. The remaining external environmental costs which can be attributed to marginal imports are small, and they are omitted from the subsequent reporting simply to focus discussion on the external economic costs. MostNovember 1, 1997 Summary, ORNL-6851

17 The benefits of the SPR are included in this analysis, insofar as the SPR reduces the magnitude of price shocks. Therefore, if marginal SPR costs were identified, they would be relevant.

18 If there are significant foreign local external environmental and health costs, from a world economic efficiency perspective, o il prices may be too low, if prices are otherwise at efficient levels.

19 A few of the environmental cost categories, such as large oil spills from shipping, do not occur regularly. Thus, the procedur e is to multiply the effects of large but infrequent costs by an estimate of the probability that they will occur.

20 Hall (1992); See Technical Appendix for further detail.

Oil Imports: An Assessment of Benefits and Costs S-10 treatments of military costs in the literature have used average cost measures (per barrel of imports), which should be distinguished from the marginal costs considered here. Additionally, the attribution of military expenditures to particular missions has proven difficult and the current lack of consensus precludes any secure assignment of those costs at the present time. Even if some military costs were believed to be attributed to dependency on oil imports, those costs may not vary with imports, precluding any marginal cost estimates. Accordingly, this study does not include military costs in any oil import premium estimates. Costs of the SPR also have the property of general insensitivity to changes in imports. Therefore, although these costs may contribute to the average cost of imports and are discussed in Section S5.3.3, they are excluded from this marginal analysis of the oil import premium. 17

S5.3.1 Environmental Costs

For all stages of the oil fuel cycle beyond petroleum production and transportation, the environmental and health costs for domestic and imported oil are the same. The environmental and health costs of oil production in foreign countries are not internalized in the price and are not an economic cost for the United States, although they have implications for world welfare. 18 The incremental environmental costs of transporting imported oil are small (less than $0.23 per barrel (BBL)) and appear to be largely internalized for both domestic oil and imported oil, due to existing laws and regulations. 19

S5.3.2 Cost of Strategic Insurance - Military Costs

Frequently mentioned as candidate costs of oil imports not fully reflected in the price of oil are military costs, such as a portion of those for military forces defending the Persian Gulf/Middle East, and other costs incurred as insurance against disruptions, such as those incurred for the SPR. Not usually mentioned, but belonging in that group, are a portion of the foreign policy and foreign aid costs for countries in the Middle East.

One perspective is to consider military costs closely related to oil import levels. For example, the only estimate of a statistical relationship between oil imports and defense expenditures found a marginal military cost of oil imports of $7.32/BBL (1982$). 20 That implies that if oil imports were to increase by 1 million barrels per day, or 365 million barrels per year, military spending would rise by $2.7 billion. This crude estimate is based on the modeling assumption that statistically regressing changes in military expenditures on changes in all oil imports reflects the response of military expenditures to oil imports, independently of other determinants of changes in military expenditure.November 1, 1997 Summary, ORNL-6851

Oil Imports: An Assessment of Benefits and Costs S-11 The Department of Defense (DOD) estimates that the costs of Operation Desert Storm, spread over ten years of world oil consumption was roughly $0.25/BBL; spread over Persian Gulf exports forNovember 1, 1997 Summary, ORNL-6851

21 DOD Assistant Secretary for Economic Security Joshua Gotbaum in testimony before the U.S. Senate Foreign Relations Committee on March 27, 1995 gave the $0.25 per barrel estimate. The FY 1995 incremental costs of heightened U.S. presence in the Persian Gu lf after Operation Desert Storm is $957 million, of which $225 million will be offset by contributions from other nations.

22 Only one analyst [Hall (1992)] provided an estimate of the marginal costs associated with the reserve of $1.50 to $2.30 per bar rel. While these marginal SPR cost estimates are presented, this report does not add them to the other marginal cost calculations due to t heir preliminary nature and in order to focus on purely economic external costs.

Oil Imports: An Assessment of Benefits and Costs S-12 ten years it would be $1.08/BBL. 21 These are not marginal costs, however.

An alternative perspective attributes military costs to a host of military and foreign policy objectives, only some of which involve oil supply and trade. It is argued further that any U.S. military program intended to assure reliable oil supply might be justifiable to support the interests of U.S. allies even if the U.S. imported substantially less oil. In this view, military expenditures are essentially fixed and unresponsive to oil import levels.

The variation of military costs with imports has not been definitively assessed. Since military costs are problematic, they are omitted from the premium estimates reported here.

S5.3.3 Cost of Strategic Insurance - SPR Costs

Some argue that the analysis for the SPR in some ways is similar to the analysis of military costs. Like national defense costs, taxpayers' expenditures to maintain and to be able to use the SPR are part of the federal budget, and are not reflected in the price of oil. By releasing oil during severe disruptions in supply, the reserve can keep the price of oil down during these events and, thus, reduce the economic damage. The potential to use the reserve thus affects price, but its costs are not directly reflected within prices. The size of the current SPR is based on an interagency study performed in 1990. That study, based on an estimated risk of disruption that was quickly undercut by the 1990 Iraqi invasion of Kuwait, reached the conclusion that the SPR program essentially is at a breakeven size. Prior an subsequent studies suggest that a larger SPR may be beneficial. The Externality Subgroup and the Strategic Petroleum Reserve Office (SPRO) provided estimates of
average annual carrying costs (O&M costs) from $0.50 to $0.66 per barrel of oil in the reserve. Average costs are distinct from the marginal costs derived in the economic premium analysis. 22 The efficient size of the SPR depends on both the level of consumption and imports. Without a more definitive indication of how efficient SPR expenditures would vary at the margin with import levels, it is premature to add any cost associated with the reserve to the other components of the oil import premium.

S6.0 ESTIMATION OF THE ECONOMIC COMPONENTS OF THE OIL IMPORT PREMIUM

The estimates of the oil import premium provided here are based on current oil market prices and quantities, and use estimates of long-run oil market responsiveness derived from DOEís Oil Market Simulation Model, 1994 version (OMS94). The estimation method used is consistent with most recent approaches in that it does not include environmental components. Instead, the method focuses on the marginal value of import reduction at current and economically efficient import levels considering only disruption costs and long-run economic costs. The approach used here accounts for trade-offs among the economic components of the premium.

The bulk of external economic costs of imports fall into three major categories which commonly areNovember 1, 1997 Summary, ORNL-6851

23 This is because the marginal costs are calculated at the efficient level of imports, which decreases somewhat as more cost cate gories are included. For higher levels of imports, the difference between marginal social cost and marginal private cost is greater. If calculated at the current level of imports, premium values would be somewhat (10 percent to 25 percent) larger. It is standard to report premium values at the efficient level to avoid overstating them.

24 Strictly speaking, a cartelized or monopolistic supplier will not have a well-defined supply curve. However, when a large cons umer with market power initiates a demand reduction there will be a series of actions and reactions between the consumer and the large p roducer. The change in the supplier's asking price, which ultimately results from this interaction, is summarized here with a supply ela sticity parameter, which approximates the cartel's tradeoff between oil price and output.

Oil Imports: An Assessment of Benefits and Costs S-13 referred to as: long-run recoverable cartel rents which vary at the margin with imports; increased import costs during disruptions; and macroeconomic adjustment costs attributable to imports. Much of the disagreement among experts regarding the external economic costs of oil imports can be illuminated by highlighting the role of two critical beliefs regarding the oil market -- the effectiveness of supplier market power in raising the world oil price and the susceptibility of the oil market to unanticipated shocks. For instance, if an expert believes that OPEC has exercised virtually no effective market power in raising the world oil price above what it would have been without OPEC, then the external cost category of cartel rents disappears. Alternatively, if an expert believes that disruptions to the oil market have been fully incorporated into expectations and buffered by hedging mechanisms such as futures contracts, then the disruption cost categories have zero values. Of course, many experts' opinions would fall between the extremes of "perfect" competition and highly effective market power and between the extremes of full and zero economic anticipation of disturbances.

This summary offers numerical evidence on the conditions which would lead to variations in each of the three components of external economic cost. A way to estimate the total cost of each component is identified, and the marginal variation of that cost component with respect to imports is calculated and reported. This approach avoids attributing any costs which do not vary at the margin with imports.

The following series of tables reveals the sensitivity of the three principal, potential economic externalities of oil import to important oil market conditions. Separate tables report on each of the three components individually, while a summary table aggregates these costs. In each of the three individual-component tables, the reported costs are calculated under the condition that the costs in the other two categories are zero. When these costs are aggregated in the final table, the values reported are calculated simultaneously, which tends to slightly reduce each cost category. 23

Cartel Rents

Table 1 describes the sensitivity of external costs from marginal cartel rents to the degree of OPEC cartel power. OPEC response to U.S. import changes is characterized by its willingness to sacrifice output to maintain price. Rather than attempt a dynamic model of OPEC supply response behavior, a simple parameter represents the long-run response of OPEC production to the price reduction caused by a U.S. import demand reduction. 24 The production response parameter ranges from a completely elastic OPEC response (full offset of demand reduction by supply cut-back, keeping price levels unchanged) to a completely inelastic response (equivalent to a vertical supply curve, keeping supply unchanged).November 1, 1997 Summary, ORNL-6851

25 These short-run elasticities are consistent with anticipated rates of short-run supply and demand adjustment toward long-run re sponse levels. In the DOE's OMS model, these adjustment rates average about 10 percent per year, depending on the region, hence the s hort-run elasticities are about 10 percent of the long-run levels. The long-run elasticities used are derived from OMS, as reported in the main report.

26 Two possible ways that reducing imports could reduce the size of potential disruptions are by either creating persistent excess capacity or by reducing the flow of oil supply or trade subject to interruption. The marginal effect of import level on disruption size is specified as a percentage, indicating the fraction of a barrel reduction in disruption size per barrel reduction in imports. The incremental effects on disruption size considered are between zero and 31 percent of import reduction in Tables 3 and 4, and between zero and 10 perce nt in the narrowed summary Table 5.

Oil Imports: An Assessment of Benefits and Costs S-14 Table 1. Marginal Cartel Rents, 1993 $/BBL

OPEC Supply Response to U.S. Import Demand Changes (And Resulting Price Changes)
Perfectly Responsive (Elasticity  ) Highly Responsive (Elasticity = 5) Moderately Responsive (Elasticity = 1) Completely Unresponsive (Elasticity = 0)

0.00 0.90 2.86 6.63

Notes: All other cost components are assumed to be zero (i.e., zero net disruption risk, or disruptions are completely anticip ated and hedged, and no marginal effect on macroeconomic disruption losses). These numbers are calculated using the total elasticity of net import sup ply. The total elasticity of net import supply to the United States is calculated using the OPEC production response elasticity and long-run supply and d emand elasticities for non-U.S., non-OPEC regions derived from the EIA's OMS94 model. Oil Import Costs During Disruptions

This component, which corresponds to the added cost for oil imports during a disruption, is almost universally accepted and included in the premium. It is also clear that import costs during a disruption vary at the margin with the level of imports prior to the disruption, and there is little danger of confusion with a consumption or production effect. There are two issues: given a disruption, by how much will prices rise; and how much of the increased import costs due to the price rise has been anticipated and internalized by private agents? The price rise during a quantity shock is determined by short-run demand and supply elasticities. A reasonable assumption for these elasticities is 10 percent of the long-run price elasticities derived from the DOE/EIA OMS94 model. 25

Table 3 reports the sensitivity of oil import costs during disruptions to various market conditions. First, zero, medium, and high disruption probabilities are considered. It is possible that reducing imports will reduce the risk of disruptions by reducing either their probability or their size. This study does not consider possible effects of import levels on disruption probability. However, the analysis explores the effect of a zero marginal effect of imports on the size of disruption and of a non-zero marginal effect, 26 under the high and medium disruption probability conditions. Finally, under each characterization of the marginal effect of imports on disruption size, the consequences of anticipation and the use of hedging opportunities by consumers are considered. Such anticipation and hedging may partially internalize the higher cost of imports during disruptions. Most studies include the whole increase in the cost of imports during a disruption in the premium estimate. Here, we are more conservative. The fraction of the shock costs avoided by anticipation and hedging is varied from 25 percent to 100 percent. The external costs will be zero with 100 percent anticipation and hedging. Table 3 assumes that all cost components other than increased import costs during disruptions are zero: i.e., that there are no cartel rents and that labor, capital, and product markets operate smoothly enough to avoid all macroeconomic adjustment costs. In these estimates, the SPR is used fully, except for the smallest disruptions (1 MMBD), in which cases only half of the SPR isNovember 1, 1997 Summary, ORNL-6851

27 Included are the 1973 Arab-Israeli war and embargo, the 1979 Iranian Revolution, the 1980 Iran-Iraq war, the 1988 U.K. Piper Al pha Platform explosion, and the 1990 Persian Gulf War. Three of these events had long-lasting price effects, and two lasted only a few months.

28 The expected number of disruptions large enough to exceed non-SPR offsets is 1 in 50 years, under these assumptions.

29 The mid-case assumptions used in the DOE/Interagency 1990 SPR Size Study included about 13 million barrels per day of surge sup ply capability from excess foreign capacity (6 MMBD), foreign strategic stocks (3 MMBD) and U.S. Stocks (4 MMBD) which was presumed available to offset any disruption before prices could rise. In reality, prices would rise at the onset of a severe oil suppl y disruption but prompt release of stocks and surge production in the magnitudes envisioned by the 1990 study would quickly cut into any price r ise.

30 In these estimates, we assume that the SPR is always applied. The import premium would be higher, if this is not the case.

Oil Imports: An Assessment of Benefits and Costs S-15 used, assuming that half is withheld to protect against the event of a large disruption.

The disruption components of the oil premium (increased imports costs and GNP adjustment costs) are each weighted by the probabilities of disruption. Historically, five events since 1973 have caused substantial price rises (greater than either $4.00/BBL or 20 percent of prevailing price), for at least a few months. 27 The average price increase observed for these historical events was 110 percent of the pre-disruption price, or equivalently the average shock size was $10.00/BBL. Thus the frequency of shocks over the last 25 years has been roughly one in five years, with an expected shock size per year (counting no-shock years as zero) of about $2.00/BBL. Most analysts expect the future frequency and size of disruptions to be lower, although there is little agreement regarding how much lower.

An inclusive range of disruption probabilities would include the possibility that there will be no disruptions large enough to exceed the available excess production capacity and U.S. and foreign strategic reserve drawdown capability. This result closely approximates the mid-case assumptions used in the DOE/Interagency 1990 SPR Size Study (DOE90), as well as the revised disruption probability and offset assumptions developed for the DOE/EIA modeling work in this study, if all disruption offsets are available. Under these assumptions there is little probability (0.3 percent, or 2 percent excluding the SPR draw), 28 of a disruption exceeding the full range of offsets, and the expected (probability-weighted) price increase due to shocks is nearly zero ($0.04 in 1995). In contrast, many previous studies of the premium have considered expected disruption price increases of $2.00 to $3.00/BBL [e.g., Hogan and Broadman (1988), Huntington 1993)].

The approach to disruptions adopted by the DOE90 Study restricts concern to net quantity shortfalls in the oil market. The estimated frequency of gross quantity shortfalls is loosely based on historical observation. The DOE90 Study applies multiple offsets (e.g., excess production capacity, fuel switching, strategic stock draws) to gross supply losses in a manner that completely eliminates any price rise for most disruptions. As a result, there is a very low probability of price shocks (compared to history or to other oil disruption analyses). 29 In general, the DOE90 net disruption probabilities are closely approximated by zero in the tables. However, since most of the assumed offsets are from excess production capacity in Persian Gulf region, it may be optimistic to assume that they are fully and promptly available during disruption. An alternative approach would recognize that only a fraction of these offsets may be applied, and even then only after price rises high enough to provide a strong signal. 30 The "medium" and "high" net disruption probability cases in the tables roughly correspond to the DOE90 gross disruption probabilities with reduced offsets as shown by Table 2.

Of the three disruption probability cases reported in the tables below, for the zero net disruption case, the annual expected price increase due to shocks is zero. For the medium and high net disruption probability cases reported here, the expected price increase due to shocks is $0.67 andNovember 1, 1997 Summary, ORNL-6851

31 DOE 90 study probabilities are given as continuous Weibull distributions. These were converted to discrete disruption size pro babilities by constructing bins around the stated values with conditional expected value approximately equal to the bin value.

32 The DOE Interagency 1990 study (T2/T3 Working Group) assumed a GNP elasticity range of -0.02 to -0.04, with a preferred value o f - 0.025 (page 5-1).

33 The macroeconomic costs of a disruption, while debatable in magnitude, are more closely proportional to the level of oil (or en ergy) consumption than imports. Considering oil consumption valued at $106 billion in 1994, rather than gross oil imports at $51 bill ion, a doubling of price would increase the oil consumption bill from $106 billion to $212 billion at current (comparatively low) pric es. (The undisrupted import bill is projected by DOE to rise faster than GNP, by about 5 percent per year through 2010). These estimate s make the higher shock-loss estimate seem large, but certainly not extreme. The guiding factor for the high-end shock cost estimate was the application of the most recent estimates of percentage shock costs, which surprisingly are comparable to or slightly higher tha n those of the early 1980s.

The 21⁄2ñ6 percent range for GNP elasticity with respect to oil price is consistent with the most recent empirical studies [Mory (1993), Mork, Olsen and Mysen (1994)], which include adjustment costs. These studies include data from the early 1950s to the period o f and

Oil Imports: An Assessment of Benefits and Costs S-16 $1.31 respectively. As seen below in Table 2, the "medium" probabilities used here for net disruption sizes substantially exceed the DOE90 Study probabilities for comparably-sized disruptions net-of-offsets, but the "high" probabilities are lower than the corresponding DOE90 study probabilities if one excludes non-SPR offsets: 31

Table 2. Comparison of Annual Disruption Probabilities For Varying Non-SPR Offset Assumptions

Disruption Size

1 MMBD 3 MMBD 6 MMBD
DOE90 Midcase, Net Disruptions (full offsets) 0.8% 0.6% 0.15%
This study, Medium Case, Net Disruptions 1 6.7% 1.0% 0.5%
This study, High Case, Net Disruptions 13.0% 3.5% 0.5%
DOE90 Midcase, Gross Disruptions (no offsets) 38.0% 24.0% 6.0%

1 The size of the price shock accompanying the disruption events varies with the assumed SPR drawdown strategy and the GNP loss feedback effect (which when larger, will reduce demand and dampen the price increase). Typically, price increases for the three net disruption sizes are $3.7, $11, and $32 per barrel, respectively.

Macroeconomic Adjustment Costs Component

Again the analysis includes only those marginal external costs which are attributable to imports. The first mechanism by which the GNP adjustment losses may be affected by changes in imports is through possible incremental changes in net disruption size. It is represented by a parameter indicating the marginal reduction in disruption quantity per barrel of reduction in imports. This parameter is called the "marginal effect of imports on disruption size." The analysis uses values between 0 and 31%, the latter figure being the current U.S. share of world net imports from OPEC.The second mechanism, the dampening of proportional price changes, is implemented in the shortrun and long-run equilibrium calculations of the model. The analysis approximates GNP adjustment losses with a GNP oil-price elasticity, which is assigned values between -0.025 and -0.06. This means that an oil price doubling will cause adjustment losses of between 2.5 percent and 6 percent of GNP. The 2.5 percent figure is used by the 1990 DOE/Interagency study on SPR size, and is about one-half of the value commonly used prior to that date. 32 The 6 percent figure is supported by Mory (1993), and Mork et al. (1994). 33November 1, 1997 Summary, ORNL-6851

following the 1990 price shock. The macroeconomic consequences of the 1990 oil shock have been found to be similar in magnitud e to previous shocks [Tatom (1993)]. The studies accounted for asymmetric effects of positive and negative price shocks, and [Mory (1993)] included other macroeconomic variables (such as money supply) without altering the fundamental result.

34 Some argue that the entry for zero net disruption probability is consistent with the outcome if one believes that recessions af ter oil price shocks stem completely from other causes, such as poor macroeconomic policy. Others point out that the macro policy argument i s a case not proven and with some evidence against it. The notion of "efficient" future macro policy is problematic, given informationa l limits during a disruption, conflicting objectives, (e.g., output maintenance and inflation avoidance) and the theoretical ambiguities regarding the appropriateness of alternative macro policy measures during price shocks. Thus, even if macro policy is an important contribut or, it may be neither completely avoidable nor completely separable from the issue of oil imports. Moreover, the most recent empirical wo rk strongly supports the view that oil price shocks have a large effect on economic activity, even after accounting for macroeconomic polic y.

Oil Imports: An Assessment of Benefits and Costs S-17 Table 4 reports the effects of various conditions on the magnitude of macroeconomic adjustment costs. Again, a variety of circumstances contingent upon the probability of disruption -- high, medium, or zero -- are compared. 34 Under the conditions of high and medium disruption probability, the consequences are explored, in a nested fashion, of the size of the marginal effect of imports on disruption size (again, zero and positive) and, under those conditions, the effects of the size of the GNP elasticity with respect to oil price shocks. Table 4 assumes that all cost components other than macroeconomic adjustment costs are zero: i.e., that there are no cartel rents which vary with imports and that disruptions are 100 percent anticipated and hedged.November 1, 1997 Summary, ORNL-6851

Oil Imports: An Assessment of Benefits and Costs S-18Table 3. Increased Import Costs During Disruptions, 1993 $/BBLZero NetDisruptionProbabilityMedium Net Disruption Probability High Net Disruption ProbabilityNo Marginal Effect of Importson Disruption Size5%-31% Marginal Effect ofImports on Disruption SizeNo Marginal Effect of Importson Disruption Size5%-31% Marginal Effect ofImports on Disruption Size100%Anticipation& Hedging75%-25%Anticipation& Hedging100%Anticipation& Hedging75%-25%Anticipation& Hedging100%Anticipation& Hedging75%-25%Anticipation& Hedging100%Anticipation& Hedging75%-25%Anticipation& Hedging0.00 0.00 0.17-0.44 0.00 0.4-2.14 0.00 0.20-0.85 0.00 0.82-3.94Notes: All other costs components are assumed zero for these calculations.Disruption probabilities: The annual probabilities for a one-year interruption in import supply to the U.S. are:Disrupted Quantity 1 MMBD 3 MMBD 6 MMBDMedium Probability 6.7% 1.0% 0.5%High Probability 13% 3.5% 0.5%SPR (600 MMBD) is fully utilized, except for smallest disruption (1 MMBD), which is offset by one-half. The expected price increases are $0.67 for the medium disruption probability and$1.31 for the high disruption probability.Table 4. Macroeconomic Adjustment Costs, 1993 $/BBLZero NetDisruptionProbability orZero SpilloverEffectsMedium Net Disruption Probability High Net Disruption ProbabilityNo Marginal Effect of Importson Disruption Size5%-31% Marginal Effect ofImports on Disruption SizeNo Marginal Effect of Importson Disruption Size5%-31% Marginal Effect ofImports on Disruption SizeLow GNPElasticity*High GNPElasticity*Low GNPElasticity*High GNPElasticity*Low GNPElasticity*High GNPElasticity*Low GNPElasticity*High GNPElasticity*0.00 0.44 0.63 0.70-1.96 1.13-3.49 0.84 1.22 1.35-3.62 2.18-6.48Notes: *High GNP Elasticity = 0.060; Low GNP Elasticity = 0.025.Disruption Probabilities defined as in Table 3.November 1, 1997 Summary, ORNL-6851

35 The extreme case of fixed OPEC supply was omitted, the high disruption probability case was dropped and the marginal effect of import reductions on disruption sizes was limited to the more modest range of zero to ten percent.

Oil Imports: An Assessment of Benefits and Costs S-19 Summary of Combined Costs

The key determinants of each cost component are identified, and narrower ranges of assumptions considered, based on judgment regarding the likely range of conditions. 35 Table 5 reports summary costs for simultaneous calculations of multiple cost components. The components reported above are not purely additive, since they are calculated jointly at the efficient level of imports. A range of estimated costs for each component is given. This table reports ranges of marginal external costs which depend on the further conditions reported in more detail in the individual tables.

Table 5. Narrowed Ranges of Marginal External Costs of Oil Imports 1993 $/BBL

Cost Components Zero (Negligible) Probability of Net Disruption, or Negligible External Effects of Oil Price Shocks Medium Probability of Net Disruption 2 , Non-Zero External Shock Effects

No Cartel Rents Exist Some Cartel Rents Exist 1 No Cartel Rents Exist Some Cartel Rents Exist 3

Cartel rent ZERO 0.90-2.86 ZERO 0.89-2.59
Increased import costs during disruptions ZERO ZERO 0.00-0.51 0.00-0.50

Macroeconomic adjustment costs ZERO ZERO 0.44-1.60 0.4-1.51

TOTAL ZERO 0.90-2.86 0.44-2.11 1.30-4.60

1 This range reflects a range of OPEC production response elasticities from 5 to 1.

2 The parameters generating the minima of the ranges are: OPEC production response elasticity = 5; 100 percent anticipation and hedging; zero marginal effect of imports on disruption size; and GNP elasticity = 0.025. The parameters generating the maxima of the ranges are: OPEC production response elasticity = 1; 25 percent anticipation and hedging; marginal effect of imports on disruption size = 10 percent; and GNP elasticity = 0.06.

3 If the lowest OPEC production response elasticity is specified to be 0 (the case of fixed OPEC supply) rather than 1, then th e upper range value for cartel rent is 6.17 rather than 2.59, and the upper range for the total is 8.09, rather then 4.60.November 1, 1997 Summary, ORNL-6851

Oil Imports: An Assessment of Benefits and Costs S-20 S7.0 CONCLUSIONS

While the approach used in this study identifies the potential premium associated with oil imports, it does not indicate preferred methods or policies for improving social efficiency. Thus, the following conclusions deal only with the issues related to computing the potential premium.

 Many analyses suggest that there appears to be a difference between the price of imported oil and the full marginal costs to the nation; that is, there may be costs not included in the price consumers pay for imported oil.

 The sizes of the components of the oil import premium are highly dependent on the likelihood and size of oil disruptions and the economic response to various events. Important factors include the extent of cartel power and noncompetitive pricing in oil markets, the nature of producer and consumer responses to U.S. policies, the likelihood of disruptions of different sizes, the extent to which oil consumers have hedged against oil price shocks through futures markets and flexible technologies, and the response of monetary and fiscal policies to change in oil prices. This study discusses various views and suggests reasonable ways to narrow the range of assumptions.

 A contrary view is that the external costs of oil imports are near zero. If the exercise of market power by OPEC is insignificant, and if unanticipated net disruptions are very unlikely or their external effects are very small, then the import premium is close to zero. If one believes that no effective cartelization exists but that net disruption risks are nonzero and there are significant market imperfections associated with these risks, then the premium is larger.

 The marginal economic costs not counted in the price are likely to fall within a range from the benign perspective of close-to-zero costs to a less benign view of oil markets of $4.60 per barrel of imported oil. There may be other costs associated with imports, yet which may not change with the level of imports, so they are not included in this figure.

 Of the components omitted from the import premium estimates presented here, the environmental costs associated with incremental oil imports stem mostly from oil transportation. These costs are quite small, probably $0.23 per barrel or less, and appear to be largely internalized by existing laws.

 The strategic insurance costs for oil-related military preparedness and for the SPR do not vary directly with the level of imports, so they must be treated differently from the marginal economic costs reported here. Additionally, the allocation of these costs per barrel of incremental imports is problematic. In particular, while safeguarding oil trade does entail some military costs, the best low-end average cost estimate of the Persian Gulf War is $0.25 per barrel.Oil Imports: An Assessment of Benefits and Costs S-21 ORNL-6851



## OIL IMPORTS: AN ASSESSMENT OF BENEFITS AND COSTS

Body of Report

Paul N. Leiby Donald W. Jones T. Randall Curlee Russell Lee

Oak Ridge National Laboratory

November 1, 1997

Prepared by the OAK RIDGE NATIONAL LABORATORY Oak Ridge, Tennessee 37831 managed by LOCKHEED MARTIN ENERGY RESEARCH, INC. for the U.S. DEPARTMENT OF ENERGY under Contract No. DE-AC05-96OR22464November 1, 1997 ORNL-6851

1 The term market failure has been standard in the economics discipline since Bator [1958] for describing conditions in which the market outcome is inefficient, i.e., is not Pareto optimal [Cornes and Sandler 1986:17].

Oil Imports: An Assessment of Benefits and Costs 1 1.0 INTRODUCTION TO THE SOCIAL COSTS OF OIL IMPORTS

The levels of oil production, imports, and consumption raise concerns because they may have undesirable side effects which their market prices do not signal to consumers. Underlying this possible excess of social cost over market prices is the possibility that domestic and/or world markets for oil may be subject to market failures. 1

This report reviews the full social benefits and costs of oil imports. As discussed further in Section 2.0, it is generally accepted that the social benefits of oil imports equal their private benefits (i.e., there are no significant benefit spillovers from importing). The benefits of oil imports at the margin are thus believed to be represented accurately by oil's market price. Accordingly, this document focuses its attention on costs. It surveys the conceptual issues surrounding the social costs of oil imports and offers a range of quantitative estimates of what those may be. It would be premature to conclude that, for example, the full social cost of oil is so many dollars and cents per barrel higher than the market price. The diversity of professional opinion neither supports nor justifies such confidence or precision at this point. However, review of the components which various experts believe to comprise the full social cost can clarify why opinions differ and help foster the discussion which may lead to improved consensus.

Oil is a commodity, but it possesses characteristics different, at least in degree, from other common commodities such as grains or metals. First, in common with most mineral commodities, it must be taken from where it is found--it cannot be grown or raised under suitable conditions. However, oil is extraordinarily concentrated in small parts of the world. Some 30 percent of current world production and over 60 percent of known reserves are located in the Persian Gulf region (U.S. DOE 1994:287), an area whose political and cultural instabilities are exacerbated by the opportunities represented by its vast oil wealth. This locational circumstance introduces possibilities for monopolistic (or, technically speaking, oligopolistic) behavior in the world oil market. Second, in conjunction with the locational concentration of oil reserves, the world's flexibility in substituting away from oil as a fuel has been more limited than is the case with most other mineral products. For other minerals, varying alloy proportions, production methods, and even synthetic substitutes are viable options. Third, the concentrated sources and limited substitutability away from oil in modern, industrial economies may combine to leave nations vulnerable to serious adjustment problems when faced with supply shocks. Fourth, all stages of the oil fuel cycle--extraction, refining, delivery, and final use--impose unintended, but nonetheless undesirable, impacts on the environment, ranging from oil spills to automobile exhaust.

These characteristics can contribute to a departure of the full social cost of oil from the price paid for a delivered barrel of oil or for a gallon of gasoline at the retail pump. The unaccounted social costs may include problems associated with noncompetitive markets (e.g. higher prices paid to noncompetitive suppliers); losses due to the risk of oil price shocks; environmental and health externalities; and military program costs. Some of these differences between private and social costs derive from oil production (e.g., some environmental disturbances in oil fields), others from consumption (e.g., automobile emissions or the exposure of the economy to shocks), and some mayNovember 1, 1997 ORNL-6851

2 It is important to stress that the term "excess wealth transfer" is not intended to invoke a neomercantilist obsession with avo iding trade. To the contrary, free trade under competitive conditions increases social welfare. Rather the concern here is with transfers beyo nd the actual resource costs of the commodity, i.e. beyond that which would occur under competitive conditions. The term wealth (or income) transfer is in common use in the oil economics literature [e.g. Bohi and Toman 1993 or Eastwood 1992] when discussing the full costs of oil.

3 At the margin, private benefits must equal the price, otherwise no purchase would be made if the benefits were too low, or more would be purchased if the benefits were more than the price.

Oil Imports: An Assessment of Benefits and Costs 2 derive explicitly from imports (e.g., the possibility of excess international wealth transfers 2 through cartel rent). Some are difficult to assign to a single activity. The interest here is in costs which vary directly with imports.

Although not technically correct, many analysts place all potential market failures and their associated costs under the heading of "externalities." "Externality" has become a convenient shorthand for any and all market failures that cause a deviation of full costs or benefits from price, and that may call for some type of government intervention. Unfortunately, lumping all market failures under one heading masks the sources and types of potential costs associated with oil production, imports, and consumption. More importantly, it blurs the types of government actions that can be taken to either offset the impacts of these market failures or directly correct the sources of the failures. Given this caveat, the study adopts the commonly used, broad definition of externality.

1.1 Study Focus on Imports

This report focuses on oil imports rather than consumption or production, not because imports per

se are presumed to have higher social costs than consumption, but because imports are of more immediate policy interest for the Domestic Natural Gas and Oil Initiative. U.S. oil imports have grown substantially over the last decade, and are expected to climb to 60 percent of consumption by 2010. In general, free trade is highly beneficial to U.S. society, as is the use of oil. However, in cases where the market for a commodity is not fully competitive, is subject to price shocks and physical interruption, and may involve social costs not borne by the users of the commodity, the magnitude of trade, in addition to consumption and production, could be a concern.

Consumers will buy or import oil until the benefits of the last barrel bought by the last or "marginal" buyer are equal to its price. 3 However, at the margin, the "true" cost of oil imports may be higher than the price because of possibilities such as the influence of Organization of Petroleum Exporting Countries (OPEC) on world oil markets, price spikes from oil supply disruptions, or environmental damage from the importation of oil. The difference between the true cost of oil imports and the market price of oil is called the oil import premium.

This study has three purposes:

o to identify the possible social costs of oil imports that are not included in the price paid by
consumers;

o to discuss the possible size of these costs; and

o to highlight the reasons for differences in cost estimates.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 3 Accordingly, the report identifies underlying conditions which appear critical to differences of opinion regarding the full social costs of oil imports and presents estimates of the per-barrel cost premiums which would be associated with those conditions.

Most of the analysis and debate about social costs of oil imports has centered on whether significant costs arise from noncompetitive market structures and oil price shocks. Non-competitive costs are those associated with monopoly or oligopoly power among producers and those involving monopsony power among certain importing countries. Disruption costs include possible social costs deriving from the difficulties an industrial economy experiences in preparing for or adjusting to large oil price shocks. With a subject as extensive as the economics of oil, it is to be expected that scholars and other experts may reach different conclusions regarding features of oil markets. While diverse research on some topics in the economics of oil has led to a broad consensus, if not unanimity of opinion, other important topics, including elements of the social cost of imports, continue to experience some sharp differences of professional opinion. Much of the current diversity of opinion can be attributed to differing assessments of the character of competition in the world oil market, of the volatility of that market, and of the consequences of volatility. For example, while some scholars find little persuasive evidence that the world oil market is at all close to being competitive, and have even calculated numerically what they believe to be the monopoly rent in the world oil price, others find little persuasive evidence that market power is being exercised by suppliers. The significance of these disagreements is that different characterizations may lead to quite different estimates of costs, and an inappropriate choice of policy could be very expensive. In deference to the variety of expert opinion on oil's social costs, we use the terms potential cost or potential social cost

. 1.2 Overview of the Study

Section 2.0 introduces several concepts involved in the definition and measurement of the social costs of oil imports. First, there is the interdependence among total consumption, imports, and domestic production, which can create confusion when attempting to isolate the incremental costs of imports alone. Second, the base against which costs are measured must be specified because different choices of base will yield different assessments of costs. Third, closely associated with the choice of base, marginal cost concepts may be used to inform different types of policy decision. Fourth is the concept of an optimal oil import premium, or the difference between the social cost and the market price of imported oil when the volume of imports is at its socially optimal level. Finally, the concepts of the world oil market's competitive structure and volatility, or susceptibility to major supply disruptions, are presented in a two-dimensional continuum which facilitates identification of the grounds for several important differences of expert opinion regarding social costs of oil imports.

Section 3.0 discusses the social costs an importing country may experience as a consequence of suppliers exercising market power--technically a condition of oligopoly or cartel but commonly called monopoly power in the literature--and the possibilities that relatively large buyers may be able to exert influence over the price of a commodity which they buy--called monopsony power. Monopsony power need not be used even if it is possessed, but in the presence of the exercise of monopoly power by a seller, some exercise of it may be justified as a corrective measure. Nevertheless, it is possible that strategic or non economic considerations might dictate restraint inNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 4 using monopsony power even in such circumstances. In the oil market, both supplier-cartel power and U.S. buyer monopsony power together are required to jointly motivate and enable the partial recovery of cartel rents. In this case, the recoverable cartel rents comprise a long-run component of the import premium.

Section 4.0 reviews a number of social costs which may arise through the limitations of an industrial economy in adjusting smoothly and rapidly to a sudden shock in oil supply. The magnitude, and even the existence, of most of these components of social costs of oil imports have been questioned in recent literature despite widespread, apparent evidence of those costs. This chapter reviews the diversity of reasoning used to arrive at the different conclusions.

Section 5.0 presents a series of numerical estimates of the oil import premium deriving from the potential costs of non-competitiveness and supply shocks, under a range of circumstances. This controlled construction of additive components facilitates identification of the relative quantitative importance of different sources of social costs and the sources of different opinions about the size of overall costs.

Before embarking on the remainder of the report, we offer a precis of conclusions.

! While the approach used in this study identifies different estimates of the premium associated with oil imports, it does not indicate preferred methods or policies for improving social efficiency. For example, diplomatic options could be effective substitutes for strictly economic policies. Few policies are costless, and the costs and benefits of policies should be compared to the magnitudes of problems they are intended to alleviate to see if an improvement actually can be made.

! Virtually all of the identified components of the oil import cost are subject to disputes regarding their validity and to uncertainty regarding their magnitude.

! The principal direct effects of an import reduction would follow from its ability to reduce the world price of oil in the face of noncompetitive supply, and from reducing the quantity of oil which is subject to higher import costs during a disruption. If world oil supply is deemed to be not subject to substantial exercise of market power and stable, then the United States has no motive to take this action.

! Although there is a debate about the competitiveness of world oil supply, there is empirical evidence available that supports viewing the Organization of Petroleum Exporting Countries (OPEC) as an imperfect cartel rather than an association of competitive producers. The behavior of oil prices, as contrasted to their level, is also not well explained by exhaustible resource theory. The most common view in the literature is that the cost of oil above its marginal extraction cost includes some cartel rent as well as scarcity rent. Other analysts believe that world oil markets are not subject to substantial exercise of market power.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 5 ! If the United States has a motive but little ability to influence world oil price through its imports, then a large component of the import premium, the recoverable cartel rent (also called the monopsony premium), is near zero. The strength of U.S. buying power in world markets depends largely on the supply response of OPEC and other producers and the demand response of other consuming countries.

! Some of the costs attributed to noncompetitive supply (long-run inflation and balance of payments/exchange rate costs) are not well established theoretically or empirically. These components are excluded from the final premium estimates presented.

! The principal uncertainties regarding the disruption-related import costs are the likelihood of price shocks and the ability of the oil market and other input and product markets to anticipate and accommodate them smoothly with existing mechanisms.

! A long record of econometric analyses has repeatedly yielded evidence of a statistical relationship at the aggregate level between oil price disruptions and macroeconomic losses. Nonetheless, some recent, conflicting evidence suggests the need for a more careful disaggregated analysis. The contribution of macroeconomic adjustment losses to the oil import premium hinges on the marginal ability of import reductions to reduce shock size, either by influencing quantities of oil trade at risk or by reducing relative price rises.

! Quantitatively, the premium estimates are composed of three main components of roughly equal sizes: avoidable cartel rents; increased import payments during disruptions; and incremental macroeconomic adjustment losses.

! The marginal economic costs not counted in the market price fall within a total range of zero to $10.00 per barrel of imported oil but more likely within a range from zero to $4.60 per barrel of imported oil.

! Of the components omitted from the import premium estimates presented here, the unaccounted environmental costs associated with incremental oil imports stem mostly from oil transportation, and are quite small, probably $0.23 per barrel or less.

! The strategic insurance costs for oil-related military preparedness and for the Strategic Petroleum Reserve do not vary directly with the level of imports, so they cannot be added to the marginal economic costs to influence policy decisions on reducing imports at the margin. Additionally, the allocation of these costs per barrel of incremental imports is problematic. In particular, the clear attribution of military expenditures to particular missions has defied resolution to date, making a reliable assignment of some portion of those costs to imports impossible at present.November 1, 1997 ORNL-6851

4 This identity omits the minor effects of inventory changes. Also, the United States does export some petroleum. To account fo r that in this equation, imports could be changed to net imports.

Oil Imports: An Assessment of Benefits and Costs 6 2.0 FRAMEWORK FOR ASSESSING OIL COSTS

2.1 The Interdependence of Consumption, Production, and Imports

The issues of possible market imperfections and social costs do not arise from imports alone, but also hinge on levels of consumption and production. This report focuses on oil imports rather than on consumption or production not because imports per se are presumed to have higher social costs than consumption, but because imports are of more immediate policy interest for the Domestic Natural Gas and Oil Initiative. While consumption may entail significant environmental costs, and it is an important determinant of our exposure to price shocks, such factors are outside the scope of this study.

A simple identity relates imports, consumption, and production of oil in the United States: 4

U.S. oil imports = U.S. oil consumption - U.S. oil production.

Since imports are the difference between domestic consumption and production, the analysis of any oil policy would benefit from the evaluation of its full equilibrium effects on imports, consumption, and production, and their attendant economic, environmental, and energy security consequences. For example, the equilibrium effects of an oil import fee, an oil consumption tax, and a domestic oil supply incentive would differ. However, this study does not evaluate a specific policy but instead makes a first step by considering only a subset of the relevant issues. The focus here is exclusively on the effect of changing imports, without presuming particular changes in domestic supply or demand.

The oil import study uses a marginal partial approach: "marginal" because it is based on incremental changes in imports, and "partial" because it does not consider changes in production and consumption. This is a good means of isolating the costs and benefits directly attributable to oil imports to get a sense of the magnitudes involved, independent of policy choice. It avoids ascribing costs or benefits to imports which may not depend on imports per se , and is a precursor to policy analysis.

The oil import premiums reported include only those external costs which arise from changing oil imports. They exclude costs which arise from changes in consumption or production, or which do not vary with the level of imports.

2.2 Import Incremental Benefits are Largely Internalized

Private benefits are the benefits received by the buyer from using imported oil, which at the margin will equal the price paid. External benefits would be the benefits received by third parties not involved in the sale or purchase of oil imports. If one person's purchase of imported oil confers some benefits on someone not purchasing that oil, the marginal social benefit of imported oil would exceed its marginal private benefit, which is equal to its delivered import price. These potentialNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 7 benefits of oil imports are not included in the price, or are "external" to the price. In reality, however, the full marginal benefits of oil imports generally can be captured by private buyers, and there are no accepted significant external benefits of oil imports. Thus, at the margin, social benefits of oil imports are the private benefits.

The partial analysis conducted in the study omits consideration of induced changes in domestic production or consumption because such changes depend upon policies which are not specified. Holding constant oil consumption and domestic production also avoids counting external benefits of consumption or costs of production as external benefits of imports. Possible external benefits of imports which have been proposed by some include less domestic pollution, fewer tax distortions, and more efficient allocation of capital. These candidate benefit categories would arise from changes in domestic oil production, which our partial marginal analysis excludes. Nevertheless, after examination, it appears that at least two of these three possible external benefits of imports would be limited even if changes in production were considered. The proposed external benefits are revised here for completeness.

External Environmental Benefit

Imports may displace domestic production, thereby lessening the domestic pollution associated with production. However, there is very nearly a consensus among analysts that most environmental externalities associated with oil production and transportation have been internalized at the margin by additional insurance requirements, safety regulations, and private anticipations of law suits and fines in the event of spills and other damages. Consequently, the marginal external environmental benefits of oil imports can be expected to be small, as are the estimates of their marginal external environmental costs.

External Resource Allocation Benefit

To the extent that domestic oil production is subsidized through the tax code, the marginal resource cost of domestic oil production would be higher than the world price of oil. In this case, substituting imports for more costly subsidized domestic production would reduce external production costs, which might be interpreted as an external import benefit. Again, the present analysis, by holding constant domestic production, does not account for this effect, the magnitude of which is not known.

External Investment Benefit

Some have noted that reduced imports may require the use of scarce capital to increase domestic production, and thereby adversely influence the U.S. economy. For this capital saving to be an external benefit of imports the marginal resource cost of domestic oil production must exceed the market price, which is likely to occur only under the implicit tax subsidization argument discussed above.

Thus, even a more inclusive analysis of the full equilibrium effects of import changes on production and consumption may not reveal substantial external benefits of imports. Regardless, in the absence of such a full equilibrium analysis, it is proper to exclude marginal external benefits deriving from the reduction of domestic production, and no other marginal external benefits of imports have been identified by researchers.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 8 2.3 The Issue of a Reference Point: Costs Relative to What?

When assessing the costs of oil, we must choose an appropriate reference point, that is, answer the question "costs relative to what?" Three reference points for comparison are: perfect market conditions; optimal levels of imports given market imperfections; and a marginal (small incremental) change in imports from a given level. At one extreme, the costs of oil imports can be measured relative to the competitive ideal. Such an ideal world would have competitive supply and demand,no unanticipated price shocks, and no unpriced environmental damages. In other words, the perbarrel costs of oil could be compared to the costs that would exist in the absence of market failures. Using the competitive ideal as a reference point would provide a general view of the magnitude of costs which we might wish to recover. This may be a useful guide for research and motivate the search for cost-effective solutions. It would offer no insight, however, on whether government can or should do anything about oil use or imports to avoid these costs. It would be a mistake to treat all costs beyond those of the competitive ideal as avoidable, since that implicitly assumes the existence of costless government actions which totally eliminate the market failures.

Secondly, the potential costs of oil may be defined in terms of the difference between the optimal (efficient) level and the current level of costs, recognizing that some government programs are already in place to respond to potential market failures. Since government action is not costless, the pragmatic issue is one of balancing the costs imposed by government intervention against the expected value of that intervention. The goal is to approach an efficient level of oil import costs, not to reduce those costs to zero. This optimal level is dependent on a host of conditions about the structure of the domestic and world oil markets, the vulnerability of the domestic and world oil markets to price shocks, and the relationship between oil markets and the macroeconomy. The efficient or optimal level of costs and imports may not be attainable with policies which are cost effective and pragmatically acceptable, but the concept has the merit of being a desirable reference point.

A third alternative reference point is the cost that would be caused by a marginal (small incremental) change in oil imports from the current, or alternatively, from the optimal, level. A small incremental reduction in imports may not be an efficient goal, but it has the virtue of being an achievable reference point. The marginal reduction in social costs of a change in import levels also reveals the amount we should be willing to pay (per barrel) to achieve that modest change. Hence, marginal cost is a useful guide for incremental policy.

2.4 Marginal Imports and Marginal Welfare

In examining the full costs of oil imports, one could estimate total costs, average costs, or marginal costs. Total costs (in dollars or dollars per year) must be measured relative to some reference value or alternative. Examples are relative to a perfectly competitive market [Greene and Leiby (1993)], or relative to optimal U.S. policy regarding import levels [e.g., Broadman and Hogan (1986), (1988), Huntington (1993)]. Average costs (estimated in dollars per barrel) require similar decisions about the reference point, as well as requiring that oil costs be carefully segregated into those attributable to consumption and those attributable to imports, so that the correct denominator can be used.

The principal method used in this report is the marginal analysis of U.S. welfare, employing the concepts of the economic welfare function and the oil import premium. The marginal costs of imported oil (in dollars per barrel) are the incremental costs associated with a unit change in oilNovember 1, 1997 ORNL-6851

5 Technically, marginal cost is the derivative of total cost, and is based on an infinitesimal change in oil use.

6 Naturally, net benefit also depends on levels of oil production and consumption, but we are abstracting from these issues here.

Oil Imports: An Assessment of Benefits and Costs 9 W

( q iu )  B i ( q iu )

P
w q iu C

e ( q iu ) (1)

W 

social  W ( q iu )
 q iu  B  i  ( P
w q iu )
 q iu  C

e ( q iu )
 q iu

 B  i P
w  q iu P 

w  C

e ( q iu )
 q iu (2)

W 

social P iu P
w q iu P 

w   C

e ( q iu )
 q iu (3) imports. 5 Their estimation does not require that we know total costs, but only how total costs change with the level of oil imports. The usual analytical approach is to begin with a functional description of how U.S. economic net benefits depend on the level of oil imports. The term net benefits means the difference between benefits and costs. Here we begin with a representation of U.S. economic net benefit or welfare (relative to an arbitrary reference point), W ( q iu ), which depends on the quantity of U.S. imports ( q iu ). 6 Given the focus on imports, it is convenient to combine the domestic demand and supply curves into a net import demand curve. This corresponds to combining the private benefits of consumption and the private costs of domestic production into an import private net benefits function B i ( q iu ). The net economic welfare function includes import benefits B i ( q iu ), the direct costs of imports ( P

w q iu ), and all other costs associated with externalities, shocks, and market failures ( C

e ( q iu )), which producers and consumers do not ordinarily consider.

The marginal welfare from a change in imports is then the marginal private benefit of imports less the marginal direct cost of imports less all the other marginal non-private costs identified:

The oil import premium is defined as the difference between the marginal private net benefits of oil and the marginal social net benefits. Since it is generally believed that the social benefits of imports equal the private benefits, the import premium is the difference between marginal social costs and marginal private costs. In this case, the marginal social benefit is accurately measured by the price U.S. consumers would be willing to pay for oil, given the import quantity q iu . This price, P iu ( q iu ), corresponds to the point on the import demand curve above quantity q iu .

The marginal private cost of oil is the prevailing world oil price, P
w . So the marginal private net benefit of imports is P iu ( q iu ) - P
w . The oil import premium, π , being the difference between marginal private and marginal social value, is:November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 10 π ( q iu ) W  private W  social

 P iu P
w W  social

 q iu P 

w   C

e ( q iu )
 q iu (4)

As will be discussed below, the first term of the premium corresponds to the monopsony or consumer buying power premium. The second includes all other marginal social losses such as the expected disruption losses.

2.5 The Base Import Premium and the Optimal Import Premium

The premium can be measured under base conditions (of essentially free-market policy) or under conditions where policy has reduced import demand. The former estimates the social gains from an incremental imports reduction from the current base level, while the latter estimates the social gains after imports have been reduced by a non-trivial quantity. Once the socially efficient level of imports is identified (that which maximizes social net benefit), the "optimal" import premium which applies at that level can be estimated. Note that neither the premium nor imports is necessarily reduced to zero at the optimal level. Many studies of oil import costs seek to estimate the optimal premium, since it serves as a guide for longer-run policy after a transition to lower imports has been made. As imports decline, the premium declines. Calculating the premium at the current level of imports rather than the (lower) optimal level would indicate too high an external cost.

A graphical representation may clarify the concepts of the base and optimal premia. Under freemarket policy, import demand will adjust until the marginal private benefit equals world price, and the marginal private net benefit is zero. This is shown by the intersection of the import supply and demand curves in Figure 2.1, at imports level M
o . The base premium, π (M
o ), is shown as the difference between the private marginal cost (import supply) curve P

w and the social marginal cost curve C' social above imports level M
o . The base or "free market" premium provides an estimate of the potential social gain from reducing imports by a small amount from their current level.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 11 Implicit tax associated w/ level M'
Exporter's DWL



### Oil Imports 

### $

M' 

### M o 

### Import Supply (P w 

### (q) = C'private)

US Import Demand (P d 

### (q) = B'private) Social DWL 

### P d'



### P wo



### P w' Tax Transfer 

### Marginal Social Cost (C'social(q))

Gains to US consumers from world price change Import Premium at free-market import level M o



### =P do

C 

social ( M )  P d ( M )  B  social ( M )

P d ( M )

P
w ( M ) τ ( M )  π ( M ) (5) Figure 2.1: Deviation Between Marginal Social Cost and Marginal Private Cost of Imports Implies a Premium

If a policy is introduced to reduce imports below the free market level, M
o , to any other level, say M , then the marginal private benefits diverge from private costs. The foregone marginal consumption benefit exceeds the foregone private cost of imports. The difference between the new private benefit P iu ( M ) and the new world price P
w (

M ) corresponds to an implicit tariff, τ ( M ), which would be needed (in the absence of other policy) to reduce imports to the level M . At the free market level M
o the implicit tariff is zero. While reducing imports to level M reduces private marginal net benefit by τ ( M ), the gap between social and private marginal costs is also declining. When imports are reduced to the level M  , the gap between private benefits and private costs just equals the gap between social marginal costs and private marginal costs (the import premium), and no further reduction is beneficial. This is the optimal imports level, and the implicit tariff equals the optimal import premium. Note that this is also the imports level at which the social marginal cost intersects the private demand curve (Figure 2.1), so social: marginal costs equal private marginal benefits, which equal social marginal benefits:November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 12 The oil import premium is a useful concept for summarizing non-market costs, but should not be interpreted as an instrument of policy (NES Draft 1990:9). For example, Plummer et al . (1982)make the clear point that the two basic components of the import premium associated with noncompetitive market costs and disruption costs each may motivate a different policy. The import premium indicates the marginal social value of a sustained reduction in imports, but does not indicate the most efficient policy for achieving that reduction. Similarly, the disruption component of the import premium should not be interpreted as the marginal value of stockpiling against a disruption, in order to offset imports during a disruption. This value could be estimated separately, as in the Plummer et al . (1982) "stockpiling premium," or numerous other stockpiling studies [e.g., Teisberg (1981), Hogan (1982), Leiby and Lee (1988), DOE/Interagency Study (1990)].

2.6 Bases for Expert Disagreement: Views of the Costs of Oil Market Instability to the U.S. Economy and Oil Exporter Market Power

2.6.1 Divergent Views

The current disagreement about potential oil costs is explained in part by different views among analysts regarding the potential exercise of oil exporter market power and the possibility of market failure costs to the U.S. economy following oil price shocks. To highlight this, a simple 2-by-2 diagram is useful.

Figure 2.2 presents a simple two-dimensional matrix that represents alternative "Views of the Effects on the U.S. Economy" and "Views of Oil Exporter Market Power." The two polar views of the effects on the U.S. Economy are "Minimal Market Failure from Oil Market Instability" and "Substantial Market Failure from Market Instability." The minimal market failure view describes a world where oil price shocks are largely anticipated and hedged against that possibility, and the U.S. economy is one that smoothly and efficiently adjusts to the sudden increase in oil prices. Substantial market failure would describe a world where oil price shocks were largely unanticipated and little hedging is done in anticipation of oil price shocks, and where the economy underperforms in trying to adjust to the oil price shocks.

Price shocks can be of two general types: (1) temporary price shocks that may last for a few months, but not more than a few years; and (2) sudden, large, and long-run price increases that reflect a sudden movement to a new price plateau and a fundamental change in the world oil market. For the most part, analysts have focused on price shocks of the first type. This is an important distinction because the opportunities for policy action in the two cases will differ. A temporary price shock could be eliminated by a sufficient drawdown from public stocks, which would avoid all the associated costs. However, in the case of a sudden movement to a new price plateau, the long-term price increase is not preventable through buffer stocks, and the mitigative effects of other policies need to be explored. In either case, the short-run adjustment costs associated with the movement to that new price level are potential costs of concern.

The two polar views of exporter oil market power can vary from a minimal exercise of oil exporter market power to substantial exercise of market power, with many alternative market structures between the two. With a minimal exercise of exporter market power, the world is one where OPEC has little capability to control oil prices, and oil prices are close to levels that would occur inNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 13 

### Minimal Exercise of Oil Exporter Market Power Substantial Exercise of Oil Exporter Market PowerMinimal U.S. EconomyMarket Failure FromOIl Market InstabilitySubstantial U.S. Economy MarketFailure From Oil Market Instability 

### View of Oil Exporter Market PowerViews of Effects on U.S. Economy Potential Events Shipping Spills Storage Leaks Evaporation/Combustion

Potential Costs

External Health and Environmental Cost Routine Price Volatility Costs Potential Events Exercise of Monopoly and/or Failure to Exercise Monopsony Power by U.S.

Potential Costs

Excess Wealth Transfers to Oil Exporting Countries Higher Oil Costs, Loss of Potential GNP Environmental Costs Reduced Due to Lower Consumption

Potential Events Accidential Interruption of Production or Transportion

War Terrorism Natural Disasters Unrest (Labor Strikes, Change in Regime)

Potential Costs

Surplus (Potential GNP) Losses Excess Wealth Transfer to Oil Exporters Macroeconomic Adjustment Costs Military Security Costs Costs of Policy/Contingency Measures (e.g., SPR)

Lesser/Speculative Macro Costs

Aggregate Demand Shortfall (Short-run Leakages) Inflationary Effects Capital Investment Effects Potential Events Opportunistic Exercise of Monopoly Power During a Disruption Significant Changes in Market Structure Resulting in Oil Price Spikes and/or Changes in the Probabilities of Price Spikes Significant Changes in Political Objectives of Producing Countries Failure of Importers to Exercise Deterrence

Potential Costs

Costs of the Same Types, but Potentially More Severe if Monopoly Power is Exercised Higher Likelihood of Disruption

Military/Security & Political Costs:

Preparedness costs for potential conflicts over supplies Cost of assuring availability of oil to military during conflict competitive markets. At the other end of the range, a world with substantial exporter market power would be one where OPEC sets the world oil price to its preferred level.

Figure 2.2: Potential Costs of Oil Imports and ConsumptionNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 14 Each world view is associated with particular events and categories of potential costs (see Figure 2.2). The upper-left region is representative of an essentially competitive oil market with the U.S. economy suffering only minimal market failure costs in the event of a severe oil price shock, but with the possibility of health and environmental externalities. In the upper-right region, the economy still is characterized by minimal market failure, while oil exporters are assumed to wield substantial market power and health and environmental externalities remain. The lower-left region is representative of a competitive oil market and a U.S. economy that is characterized by substantial market failure costs in response to price shock plus health and environmental externalities. The bottom-right region contains the most severe cost conditions: the oil market is characterized by oil exporters having substantial market power, the economy suffers from market failure costs after oil price shocks, and health and environmental externalities remain. Note that potential costs are cumulated as we move to the right and down. Only the added costs of moving from one market view to another are highlighted in the figure. The four quadrants constitute four different world views, and are discussed in turn below..

2.6.2 Minimal Oil Exporter Market Power/Minimal U.S. Economy Market Failure

Some contend that today's world oil market shows little evidence of supplier market power or vulnerability to price shocks. To defend that position, they argue that although there may be severe oil price shocks in the future, these shocks are anticipated and hedged, and the U.S. economy will smoothly and efficiently adjust to an oil price shock. They point to the factors mitigating price shocks: the increased use of spot and futures markets; pricing methods such as netback pricing (when used, ties the price of crude to the market price of products); the existence of the U.S. Strategic Petroleum Reserve (SPR); and greater flexibility of domestic suppliers and demanders to adjust to price fluctuations. For example, a study by Tussing and Van Vactor (1988) points to the widespread introduction of facilities to accommodate fuel switching and to allow greater domestic supply, especially in the areas of transportation and refining (where there is now greater ability to refine heavy crude oils and residual oil into gasoline and other light distillates).

While acknowledging that members of OPEC are capable of influencing the market price of oil, advocates of the no substantial exporter market power view argue that OPEC has not exercised its market power historically and that other factors explain members' behavior [e.g., Bohi and Toman (1993), MacAvoy (1982) and Teece (1982)]. They point to OPEC's reduced market share and explain past oil price increases as the results of individual political events and demand-side responses, not the exercise of monopoly power. They argue further that although the United States may possess monopsony power in the world oil market, it does not follow necessarily that a potential monopsony position should be exploited. Some analysts argue that U.S. monopsony power is, in fact, very limited, and any declines in U.S. demands are apt to be offset partially by increases in other countries' demands [e.g., Walls (1990)]. The main argument against the use of monopsony power, however, is the potential retaliation of major exporting countries [Nesbitt and Choi (1988)]. If OPEC is not already earning monopoly profits the exercise of monopsony power could bring greater cohesion to the would-be cartel. Increases in world oil prices could result, which would leave the United States worse off.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 15 Therefore, in this world view, costs associated with market failures in the U.S. economy from oil price shocks and oil exporter market power are limited and thus not important for policy. Potential costs of oil production, imports, and consumption are reduced to those associated with environmental and health externalities. (Environmental and health externalities are discussed in detail in another section of this report.)

2.6.3 Minimal Exporter Market Power/Substantial Market Failure in U.S. Economy

In this view of the world, oil exporters have little market power, but the U.S. economy suffers from substantial market failure costs from oil price shocks. The possibility of price shocks raises the prospect of incomplete markets and therefore external costs if producers and consumers are unable to anticipate and adequately "insure" themselves against such market contingencies. These costs result from a broad set of possible market imperfections, including incomplete insurance or hedging opportunities, excessive market uncertainties, rigidities of domestic markets for oil and other goods and services dependent on oil, and/or institutional/regulatory constraints that may cause domestic producers and consumers of oil to under invest in capital equipment and oil stockpiles to respond to oil price fluctuations. Substantial exporter market power, however, is not a serious concern to proponents of this world view.

2.6.4 Substantial Oil Exporter Market Power/Minimal Market Failure in U.S. Economy

In this world view, oil exporters have substantial market power, but there are only minimal market failures in the U.S. economy when there are oil price shocks. Thus, this situation suggests two potential market failures -- health and environmental externalities and potential monopoly/monopsony power. However, if suppliers possess market power, it is an open question what can be done to prevent its exercise. If nothing can be done to counter or prevent the exercise of market power, the long-term cost associated with a higher world oil price may be large, but may not be avoidable. While the avoidability of particular cost categories is not really the issue we seek to address, it is true that the cost estimates of substantial oil exporter market powers provided in the literature depend critically on the assumed ability of changing U.S. import levels to influence OPEC supply, non-U.S. oil demand, and thereby price. These matters are discussed further in Chapter 3.

2.6.5 Substantial Oil Exporter Market Power/Substantial Market Failure in U.S. Economy

In this view of the world, there is substantial exercise of market power on the supply and demand sides and oil market price shocks trigger substantial market failure costs in the U.S. economy. The potential costs of oil imports and consumption are of the same types as identified in the previous discussions of alternative world views, although the magnitudes of the costs may be more severe when markets characterized by oil exporter market power exist in combination with a U.S. economy that suffers substantial market failure costs during oil price shocks. For example, monopolistic producers may take advantage of temporary disruptions in world supplies (e.g., wars, terrorism, natural disasters) to solidify their market power and increase world oil prices. In other words, a supply disruption may allow a "clumsy cartel" to become something closer to a profit maximizing oligopoly. Major producers may also be encouraged to fabricate disruptions. Therefore, the probability of disruption may be larger.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 16 This view of the world also opens the possibility that price shocks could result from a significant shift in world oil market structure. For example, a clear change in the leadership of OPEC, owing to political factors within or between member countries, could result in altered pricing objectives and short-run production shifts. Of equal importance, an acknowledged change in leadership could lead to significant changes in future expectations by oil consumers, with resulting changes in private stock levels and long-term contract prices. The combination of these changes could result in a price shock, even without a disruption in the production of crude oil.

Alternatively, the existence of market power on the demand side may allow oil importers to take actions to deter disruptions. For example, the existence of public oil stocks or the threat of monopsony power may deter producers from fabricating an oil disruption or taking advantage of a supply disruption to increase world oil prices.

2.7 Understanding Different Estimates of Import Costs, and Organizing the Potential Cost Categories

Figure 2.2 highlights the two principal determinants of imported oil costs: the degree to which oil exporters exercise market power and the degree to which market failure costs are imposed on the U.S. economy after an oil price shock. These issues are not well resolved, and the four categorical views described here are variants in the range of expert opinion. It is ranges of opinion, such as those presented here, that explains why estimates of the social costs of imports found in the literature diverge so widely. The simplified 2-by-2 representation of Figure 2.2 also emphasizes that potential import costs fall into two distinct categories: those which would follow from the sustained exercise of oil exporter market power, and those attributable to the market failures in the U.S. economy that lead to potential costs following, and during, an oil price shock. The next two chapters address each of these categories in turn considering whether marginal external costs of imports exist and how they might be estimated. For each of the potential costs listed in Figure 2.2, the actual magnitude and policy relevance of marginal costs borne will depend upon other factors. Principal among these are whether the U.S. can and should mitigate supplier market power by reducing its imports, and whether the possible disruptions entail non-trivial external costs which vary with the level of imports.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 17 3.0 NONCOMPETITIVE MARKET COSTS: EXISTENCE AND MEASUREMENT

The exercise of market power by OPEC, even if imperfect and clumsy, may generate some economic losses to the United States as a net oil importer. The first section of this chapter describes the disagreement about the degree to which OPEC can or does exercise market power. The second section discusses the conditions under which the United States might be able to reduce possible noncompetitive market losses through policy action and whether other considerations might restrain such actions. The third section reviews various costs which monopolistic or oligopolistic behavior of oil exporters may impose on an importer, both directly and indirectly. The fourth section discusses how the exercise of monopsony, or buyer, power over oil prices might be able to counteract the price-raising effects of monopoly power. The final section of the chapter reviews numerical estimates of the monopsony premium, which is the amount of the monopoly effect on price which the exercise of monopsony power could retrieve for a buyer.

3.1 Variation of Opinion on OPEC Monopoly/Cartel

There is significant disagreement about the degree to which OPEC or any set of oil producers can, or does, manipulate oil prices. Although the capacity of OPEC or a subset of OPEC to exercise market power is acknowledged, it is generally agreed that OPEC's power has not been exercised fully. There are several views of how OPEC market decisions are made. For example, Adelman (1980) has viewed OPEC as a "clumsy cartel" that has exercised its power only partially. Others, such as Teece (1982) argue that OPEC decisions are based on the ability of exporting countries to absorb oil revenues rather than the exercise of market power. Once petroleum prices rise beyond a point where revenues cannot be absorbed comfortably, exporters reduce production, so the argument goes. MacAvoy (1982) also takes issue with the conventional wisdom that oil prices reflect significant monopoly power. According to his study, the significant price increases of the 1970s resulted from political events and demand-side responses, not concerted OPEC actions.

Several empirical studies have rejected the hypothesis that OPEC countries behave competitively and have tended to support the notion that OPEC functions as a cartel [e.g., Dahl and Y ̧cel, (1991); Jones (1990); Griffin (1985)]. The very existence of price-setting and production quotas is proof that OPEC is attempting to exercise market power. Others analysts, however, have cited evidence that individual OPEC members have undermined official OPEC price structures and violated OPEC production quotas as proof that OPEC is not an effective cartel [e.g., Okogu, (1990)]. But the issue is not whether OPEC is a perfect cartel, rather the degree to which it exerts market power on world prices.

Following the Persian Gulf War of 1991, some have surmised that OPEC may be finished. This view holds that there are new political conditions in which the interests of the key Persian Gulf producers, Saudi Arabia and Kuwait, are permanently aligned with those of the West, and that the interests of the major producers in withholding production is undermined in any event by debt burdens and development demands, which would tend to undermine Teece's explanation of OPEC behavior. On the other hand, the entire history of the world oil trade has been one of attempts to monopolize [e.g., see Yergin (1991)]. Furthermore, the trends are toward ever-increasing OPEC market share, and the rewards for reestablishing the oil cartel are great:November 1, 1997 ORNL-6851

7 The oil price fluctuates routinely. As of this writing (5/12/95) it is $19.75/BBL for Arabian Light.

Oil Imports: An Assessment of Benefits and Costs 18 "The rewards of monopolizing the world oil industry have been so huge that . . . [if] the cartel collapses it will reappear, perhaps with a partly different membership. Whenever they settle their differences they can cut production, and raise the price." (Adelman, 1990:12)

An imperfect measure of the degree of non-competitive supply behavior could be gained by comparing prevailing prices with estimates of the competitive oil price. Yergin [1991] argues that it is not clear that the world oil market has ever been truly competitive, in the sense of being free from monopolistic influence by states or corporations. If the world oil market was approximately competitive before members of the OPEC cartel disrupted world oil prices in 1973, then the 1972 price, in real dollars, should be some indication of what the price would be today in a competitive market. In 1972, the refiner acquisition cost of imported oil to U.S. refiners was $10.30/BBL in 1993 dollars [U.S. DOE/EIA, (1994)]; the corresponding price was $16.14/BBL in 1993. 7 A second approach is to review predictions by modelers and analysts of competitive market world oil prices. These generally range from $5-$10/BBL, 1990$ [Energy Modeling Forum 1992:103, Greene and Leiby (1993)]. A third approach is to examine data on the costs of developing oil reserves, and make adjustments for any depletion or scarcity rent. Estimated finding and lifting costs for the OPEC countries fall in the range of $0.10 to $3.00 per barrel, with the Persian Gulf producers generally below $1.00/BBL [Adelman and Shahi (1989); Dahl and Y ̧cel (1991)].

Some assert that any scarcity or depletion rent component of the world oil price is small, since, for practical purposes, oil is not an exhaustible resource (Adelman 1990:9). Oil resources are sufficiently large that the market is concerned almost entirely with the marginal cost of developing additional reserves and almost not at all with the eventual depletion of those reserves. Despite several noteworthy efforts to modify and extend the Hotelling (1931) depletable resource model to capture the reality of the world oil market [e.g., Gilbert (1978); Alsmiller, et al., (1985); Marshalla and Nesbitt, (1986); Stiglitz, (1976)] its explanatory power remains limited [Watkins, (1992)]. In fact, Mabro (1992) suggests that the Hotelling model appears to predict oil price behavior only during disruptions, and that a cartel model seems to explain oil prices best during normal, undisrupted periods.

In 1975, world proven oil reserves stood at just over 700 billion barrels. In the next fifteen years, the economies of the world produced and consumed 360 billion barrels of oil. Yet at the end of that period, world proven reserves stood at 990 billion barrels, a net increase of reserves of 290 billion barrels. The fear of exhaustion followed by continual replenishment of reserves is not a new phenomenon; this is the way it has been since the Standard Oil Trust in the early 1880s (Yergin 1991:51-52).

Simply running out of oil is not the problem, even if the Hotelling theory applies, due to the size of the resource base:

"The geophysical limits may bite one day, but this day of reckoning is so far ahead as to have, on any conceivable assumption about discount rates, no impact on price." (Mabro 1992:3)November 1, 1997 ORNL-6851

8 As mentioned previously, "excess wealth transfer" refers to transfers beyond the actual resource costs of the commodity, or wha t would obtain under competitive conditions.

Oil Imports: An Assessment of Benefits and Costs 19 This point is crucial because if it is not the inexorable economics of exhausting the world's oil resources that causes oil prices to exceed marginal extraction costs, then it must be something else, and the widely accepted explanation is the exercise of monopoly power (Toman 1993:1178).

3.2 Taking Action on Monopoly/Oligopoly Power in International Trade

The exercise of monopoly or oligopoly power transfers surplus from consumers to producers and leads to losses of output. When both the monopolistic seller's and the buyers' interests are considered, that is, when the monopoly is a domestic firm, the welfare loss from monopoly is only the deadweight loss. The transfer is not a loss, but rather a redistribution. When the monopolistic seller and the buyers are residents of different accounting units, such as nations, the transfer excess of wealth from consumers to seller can be accounted a cost to the buying nation, although the entire world's welfare will experience mostly redistribution rather than a major amount of lost output. 8 Consequently, there is a potential reason for concern domestically about the excess wealth transfers of monopoly (or oligopoly) rent when international trade is involved.

Foreign monopoly poweróin this case, OPEC market powerócan be offset in international trade only if an importing country accounts for a large enough share of the world market to be able to affect the world price of the product by its buying behavior. A country having such buyer power is said to have monopsony power. By reducing its purchases of the monopolized good, such a country can reduce the world price somewhat. Tariffs, quotas, domestic supply incentives, and consumption disincentives can be used to accomplish such a reduction in imports. Monopsony power also is greater when the price responsiveness of OPEC and other producing and consuming countries is limited. The exercise of monopsony power in an international market characterized by competitive supply conditions would not be desirable, but the use of monopsony power to offset seller market power may be an desirable intervention to correct a pre-existing distortion.

Even if OPEC does behave as an effective cartel, and if the United States could exert countervailing monopsony power to mitigate the excess wealth transfer from the United States to OPEC oil suppliers, there may yet be reasons for the United States not to exercise that power. While such policies might effectively retain monopoly rents for the United States, the political ramifications of such actions might destabilize an important ally within OPEC such as Saudi Arabia. The consequences of such destabilization could be far more costly to United States interests than a continued excess wealth transfer. Some analysts believe that exercising monopsony power may also provoke retaliation by less than perfectly colluding suppliers that more than offsets the rent recapture. Such a scenario entails at least some cartel discipline while characterizing the cartel as too loose to be effective in raising prices in the first place.

3.3 Costs of Noncompetitive Supply

The long-run exercise of monopoly power leads to world and domestic oil prices that are higher than competitive levels. The resulting sustained oil price increases impose long-term costs. A gradual price increase under conditions of full employment will impose long-run consumer surplus losses, higher U.S. production cost, and an excess transfer of wealth to foreign producers in the form of monopoly rent. These losses and transfers will be determined by the domestic long-run curves, not by the capital inflexibilities incorporated in a short-run analysis. When the market has fully adjustedNovember 1, 1997 ORNL-6851

9 Put another way, the world's production possibilities frontier has shifted inward (i.e., the world has become poorer). See, e. g., Pindyck (1980) for a discussion of the scarcity effect.

Oil Imports: An Assessment of Benefits and Costs 20 to a higher, cartelized oil price (with the economy moving to a more constricted production frontier than is achievable with competitive oil prices), a larger fraction of U.S. production goes to overseas claimants as oil import payments.

3.3.1 Direct Costs of Monopoly Power

Sustained Monopoly Rent Costs

The largest component of the cost of oil at non-competitive prices is the excess payments from oil consumers to oil producers. This excess payment beyond what would be paid at competitive prices is called monopoly "rent". The situation of an oil importer facing a noncompetitive supplier is depicted graphically in Figure 3.1. At a competitive price P 1 , the United States would produce Q S1 , consume Q D1 , and import Q D1 -Q S1 . At the higher monopoly price, P 2 , the United States produces a greater quantity, Q S2 , consumes a smaller amount, Q D2 , and imports a smaller amount, Q D2 -Q S2 . The United States must pay much more for the oil it imports, indicated by the area B. The area B is an excess payment of U.S. wealth to foreign producers. Some of this payment goes to pay for the cost of increased world oil production but most of it is monopoly rent. Rents within a society are traditionally not considered economic costs because they are a transfer, not a loss of real resources. While payments abroad of true resource costs are a necessary, and indeed desirable, aspect ofinternational trade, here we are concerned with excess payments -- beyond resource costs -- to noncompetitive suppliers.

Sustained Loss of Economic Output (GDP)

Another cost of higher-priced oil is a reduction in the economy's ability to produce [e.g., Pindyck (1980), Pakravan 1984:15-19]. Higher monopoly oil pricing increases the economic scarcity of oil. The capability of our economy to produce, and also that of the entire world, is reduced. 9 This effect is long-run in nature and does not decrease over time as the economy adjusts to the higher prices. To emphasize the long-run nature of this phenomenon we refer to the loss in "potential GNP." Potential GNP is the technical term for the maximum sustainable or high employment GNP (Samuelson and Nordhaus 1985:79). The loss of GNP from an increase in oil prices depends on the importance of oil to the economy, and the ability to substitute other energy, capital, and labor for oil. Absent any substitution of either capital or labor for energy, the long-run potential GNP loss elasticity with respect to energy price is - σ E , the cost share of energy [Bohi (1989), Ch. 3]. As Bohi (1989) points out, if both capital and labor are gross substitutes for energy the long-run elasticity of potential GNP with respect to the price of energy will certainly be smaller (in absolute value) than

σ

E . We refer to this as the long-run effect of energy prices because it excludes macroeconomic adjustment losses which, in the short-run, will prevent the economy from reaching its long-run, full employment, potential output level. Any short-run adjustment losses are categorized here as disruption losses.November 1, 1997 ORNL-6851

10 If private US supply cost is less than full social cost because of favorable tax treatment, higher domestic oil prices will inc rease the deadweight loss.

11 There is frequently an argument about whether the money represented by B will or will not return to the U.S. economy in the form of increased demand for U.S. exports. From the perspective of the welfare of U.S. citizens the point is, who gets the output of t he U.S. economy? Leiby and Lee (1988) have termed this "Domestic Absorption" versus "Foreign Absorption" of U.S. output. Domestic absorption (how much of our GNP we get to keep) is a better measure of U.S. welfare than gross output (how much we produce).

Oil Imports: An Assessment of Benefits and Costs 21 A B

C P

P

P

Q Q Q Q

Q

Q D S

2

1

S 1 S 2 D 2 D 1

I 2

I 1 D D 

### D D 

### S D



### P 2



### P 1



### Q I2 

### Q D2 

### Q D1



### Q I1 

### Q S1 

### Q S2 

### A B C Figure 3.1: Direct Costs of a Monopolistic or Disruption Price Rise Since the long-run potential GNP loss corresponds to the full factor-employment outcome, this loss may be estimated either with a simple macroeconomic model, or by the social surplus loss triangles in the traditional microeconomic representation of the oil market, but not both. Each method has been used in the past. As discussed elsewhere [Horwich and Weimer (1984), Broadman and Hogan (1986), Leiby and Lee (1988), Greene and Leiby (1993)] the domestic producer cost and consumer surplus loss triangles (areas Aand C in Figure 3.1) measures the fullemployment GNP change associated with a price increase. Any such potential output loss is in addition to the increased payment of rents for imported oil (area B in Figure 3.1). In the oil sector, oil consumption falls from Q D 1 to Q

D2 , with a concomitant loss of consumers' surplus (the triangle C) as a result of the higher price. The consumers' surplus loss for a factor of production like oil equals the lost GNP that would have been produced from the oil. To expand U.S. oil production to Q S2 , capital and labor must be spent; this is represented by the triangle labeled A. 10 This extra production cost is a deadweight loss to the U.S., and to the world economy. Area B, due to increased payments for oil imports, is not a reduction in potential GNP, but an increased claim by foreign interests on U.S. output/GNP [Huntington and Eschbach (1987)]. 11

In estimating the total or average output losses due to costs of imports, the area of the social surplus triangle between the prevailing price and some reference price (basis of comparison) would be calculated and attributed to imports. The problematic step is establishing a reference price or import level for which the attribution of the surplus losses to imports is appropriate.

Estimating the marginal effects of imports on output/social surplus is clearer. To estimate the oil import premium, the marginal gain in GDP/social surplus attributable to an increase in imports must be counted and weighed against any marginal increases in external costs. The change in social surplus is equal to the incremental area under the (inverse) import demand curve P iu ( q ):November 1, 1997 ORNL-6851

12 As mentioned previously, "excess wealth transfer" refers to transfers beyond the actual resource costs of the commodity, or wha t would obtain under competitive conditions.

Oil Imports: An Assessment of Benefits and Costs 22 CS ( q du )  PS ( q su )   q du

q du0 P du ( q ) dq

 q su

q su0 P
su ( q ) dq   q iu

q iu0 P iu ( q ) dq

dGDP pot dq iu  dSS ( q iu ) dq iu  P iu ( q iu ) (6)

The marginal reduction in output is just the import demand price P iu , which equals the marginal net benefits of imports. This term is counted in the marginal welfare expression developed above (Equation 5).

3.3.2 Indirect Costs of Monopoly Power

Several analysts have identified two principal indirect social costs from the exercise of cartel power in the world oil market: a long-run deteriorating effect on the balance of payments (or the value ofthe dollar) and a long-run, cost-push inflationary effect. Subsequent literature on the balance-ofpayments effect has shown greater complexity to the issue and correspondingly less clear directions of effect, and the inflationary cost has both weak theoretical foundations and a very small empirical magnitude at any rate. However, both possible social cost categories have had a stubborn half-life in the oil literature, and we discuss the mechanisms originally envisaged for both simply to air the full range of views on all possible costs. In our "most recommended" social cost calculations, presented in Section 5.3, we exclude both of these cost categories.

Long-Run Balance of Payments Costs (terms of trade)

Nordhaus (1980) first raised the prospect that a substantial trade imbalance due to oil imports could generate indirect macroeconomic costs. If the United States is importing a large amount of oil, the long-run balance of payments constraint necessitates an exchange rate adjustment which worsens the terms of trade for the United States. U.S. goods become cheaper to foreigners, and foreign goods become more expensive to U.S. consumers. In this case not only would there be a substantial excess wealth transfer overseas for oil, but other imported goods would become dearer. 12 The mechanism by which this occurs has been well described elsewhere [Broadman (1986), Hogan and Broadman (1988), Huntington and Eschbach (1987)]. The strength of this effect depends on the fraction of oil payments recycled to the United States, and on the degree to which the U.S. trading partners are also subject to oil-induced currency readjustments. If there is immediate and full recycling, then there is no balance of payments "externality," but the excess wealth transfer or foreign claim on U.S. GNP still occurs.

There is some confusion as to whether this effect is a cost in addition to the transfer of wealth, or simply another manifestation of it. Huntington (1993) argues that regardless, the incremental effect of imports on the terms of trade is small. He notes that the imbalance between savings and investment is far more important over the long-run than oil trade in affecting trade balance andNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 23 π BOP  P i η pe η eq (7) exchange rates. Many other analysts generally assert that the indirect balance of payments effect is small, if it exists at all, and omit it from their premium estimates.

Nordhaus made some simple and admittedly "treacherous" calculations of the balance of payment cost, estimating that the indirect cost may be half of the real resource costs (world price) of oil ($15 in 1979, using 1993 dollars). Hogan (1981) suggests that this figure is an upper bound, since many U.S. trading partners are significant oil importers. The most recent effort to explicitly estimate the balance of payments costs was by Broadman and Hogan (1986). The method extends Hogan (1981), determining the exchange rate variation necessary to restore the trade balance after an incremental increase in imports occurs and an assumed fraction R of any increase in oil import payments is recycled. The balance of payments marginal cost (premium) is the product of the elasticity of import price with respect to exchange rate ( η pe ) and the elasticity of exchange rate with respect to import quantity ( η eq ):

The first elasticity reflects OPEC's desire to adjust the dollar-denominated oil price if the U.S. exchange rate worsens. Broadman and Hogan assume an elasticity of -1.0, assuming producers wish to maintain the purchasing power of their oil. The second elasticity translates the change in import quantity into the necessary exchange rate variation to balance payments. It is sensitive to the recycle rate, and varies directly with import levels (Broadman and Hogan 1986:A-12). The elasticity of exchange rate with respect to import quantity is low when recycling rate "R" is near 1 or the elasticities of import and export demand are high. This is consistent with the expectation that the balance of payments cost is small when trade adjustment is fast and recycling is complete. Broadman and Hogan's (1986) estimate of balance of payments premium at the optimal imports level was on the order of $1/BBL (1993$). A simple adjustment of this cost would multiply by the ratio of the 1993 oil price ($17) to the 1985 price used by Broadman and Hogan ($35, 1993$). Thus, all else equal, the Broadman and Hogan approach would estimate the current balance of payments premium to be about $0.50/BBL.

The balance of payment cost component is less well established empirically or theoretically than other costs (Toman 1993:1188-9). Those who argue against including long-run balance of payments costs note that the net effect on trade patterns of an oil price increase is ambiguous. The initial trade imbalance felt by an oil importer will be experienced by all importing countries, not just the United States. The net effect on international competitiveness and trade depends on each country's ability to adjust to higher oil prices [Marion and Svensson (1986)]. The principal oil exporters spend or invest most of their oil revenues in the oil-importing, industrialized countries, and the net effect on the demand for any particular currency will depend on OPEC's relative spending patterns among those countries [Krugman (1983)]. Additionally, the modeling of this phenomenon to date has not made the important distinction between tradable and nontradable goods in the industrialized countries; the reduction in domestic spending will be allocated among those categories of goods as a consequence of increased oil payments can have a significant effect on the exchange rate. Finally, since oil prices denominated in U.S. dollars, a change in price will alter the demand for U.S. currency by all importers.November 1, 1997 ORNL-6851

13 The inflationary effects of price shocks or one-time price shifts are conjectural and possibly negligible.

14 Note that the Broadman-Hogan premium estimates are at optimal import levels, which will also change as cost parameters change. Hence, this effort to update their estimates is very rough indeed.

Oil Imports: An Assessment of Benefits and Costs 24 Long-Run Inflationary Costs

The potential for a long-run rising oil price trend to induce inflationary costs was also raised as significant issue by Nordhaus (1980). It is not inflation, but the measures to limit inflation, which are thought to impose significant output losses. Hence, one important assumption is the extent to which inflation is accommodated versus eliminated through fiscal and monetary restraint. The costs of controlling inflation stem from market rigidities and imperfect foresight. With perfect flexibility and perfect anticipation, this would not be a problem.

The concern is for inflation following from a long-run trend of increasing prices. 13 Hence, it is an externality associated with the time-rate of price change ( dP/dt ), and therefore the time rate of demand change ( dQ i /dt ). One complication is the volatile sequence of actual price movements, which disguises an uncertain trend. Hogan (1981) noted that the impact of an oil price change on the aggregate price level will be proportional to the value-share of the consumption of oil and related products in GNP (Broadman and Hogan include natural gas consumption). Nordhaus formed quick estimates of the costs of inflation assuming no accommodation, where inflation is generated from the (unexercised) monopsony effect and from terms of trade deterioration. Nordhaus's estimates of $2 to $10/BBL assume that reducing inflation by 1 percent costs 4 percent of GNP for one year.

Following Nordhaus and Samuelson (1985:437-9), and Hogan (1981), Broadman and Hogan (1986, 1988) provided an estimate of the inflationary marginal cost (premium) of imports. The estimation method combines two rules of thumb: a Phillips curve relating inertial inflation to excess unemployment, and Okun's law relating changes in unemployment to changes in output. The Phillips curve suggests that the economy must suffer 2 percentage points of increased unemployment for a year to eliminate 1 percent from inertial inflation [Nordhaus and Samuelson (1985)]. Okun's law implies a 2 percent loss in GNP for each percentage point of excess unemployment, at the margin [Nordhaus & Samuelson (1985)]. This implies a roughly 4:1 link between output loss and the reduction of inertial inflation. The approximation used calculates the long-run impact of inertial inflation assuming full anticipation and accommodation. It then applies judgement to determine the fraction of oil inflation removed through macroeconomic policy actions.

Hogan and Broadman estimate a long-run inflationary optimal premium of $1-$2/BBL (1993$), depending on the magnitude of other premium components. The inflationary premium of Broadman and Hogan is proportional to the fraction of inflation not accommodated, and roughly proportional to rate of oil price inflation and the share of GDP spent on oil and related products. The 1994 DOE International Energy Outlook projects real oil prices to rise at 3.4 percent, compared to Hogan and Broadman's 3 percent. The Hogan and Broadman assumption that 30 percent of inflation would be unaccommodated (eliminated) seems conservative, given current desires to limit inflation. In 1985, the share of GDP spent on oil was 3.6 percent, currently the share is about 1.7 percent, projected to rise to 2.5 percent by 2010. The expenditure share of oil substitutes has grown relative to the oil share, although it is not known which substitutes are included in the Broadman-Hogan calculation. Overall, an updated 1994 estimate of the inflationary premium would be roughly half of its 1985 value ($0.60-$1.00/BBL) and growing as the oil share expands. 14November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 25 Toman (1993:1189) and others find the long-run inflationary cost component to be suspect. The long-run inflationary cost, which some analysts attributed to larger oil imports, relies on an indirect, cost-push mechanism. If increased oil imports caused a higher trend rate of growth in real oil prices, and if that real price trend were somehow turned into an effective cost-push inflationary mechanism, a higher long-term rate of growth of the price level could ensue. Cost-push theories for inflation have declined in popularity since the early 1970s, with a wide acceptance of the concept that inflation is primarily a monetary phenomenon influenced by the relative rates of expansion of the money supply and real production. Furthermore, the share of oil in the price-level deflator is small, leaving only a small component for oil price increases to contribute to general price-level growth. Of course, those who estimate an inflation cost component would hold that matters of numerical magnitude are better resolved by direct calculation than by a presumption of insignificance. If the cost mechanism relies on the monetary authority's unwillingness to completely accommodate oil price increases, then some argue that the problem is one of monetary policy rather than of oil price growth. Finally, even if oil price growth does produce inflationary costs, critics might question the link between marginal imports and the rate of oil price growth.

3.4 Monopsony Power and the Monopsony Premium

This section reviews the basis of possible U.S. monopsony power, and discusses some of the issues involved in the estimation of the monopsony premium. These issues concern how to represent the response behavior of other agents in the world oil market, particularly non-U.S. importers and OPEC. Estimates of this important import premium component alone are provided in section 3.5.

3.4.1 Monopsony Power

Monopsony power is the demand-side counterpart of monopoly power. If monopsony consumers, such as the United States, can reduce their levels of consumption below competitive levels, it is possible to drive down the world oil price and thereby benefit U.S. consumers, as well as consumers in other importing nations. There is significant disagreement about the extent to which monopsony power can be exploited due to potential retaliation by monopolistic producers and to what some interpret to be the very limited monopsony power of the United States.

Most analysts agree that the United States has at least limited monopsony power. However, they disagree about whether that power can/should be exercised. Some argue that the monopsony power of the United States is, in fact, very small. Others argue that the exercise of monopsony power, especially the adoption of an import tariff or quota, would call for retaliation on the part of oil exporters. This argument becomes more compelling given the widely-held opinion that OPEC has not exercised its full monopoly power and is at best acting as a "clumsy cartel." The exercise of monopsony power could lead to greater solidification of the oil cartel and thus result in world oil price increases.

To the extent that the United States has monopsony power and faces market power in oil supply, the failure to exercise monopsony power can be viewed as an opportunity cost. If monopsony power exists, U.S. imports of oil can be reduced by increasing the price of imports (i.e., a tariff) or by directly limiting the quantity of imports allowed (i.e., a quota). The impacts of a tariff or a quota depend on the elasticity of import supply, which is the subject of much debate. The greater the U.S. share of the world oil market, the greater the potential of the United States to exercise monopsony
power.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 26 π monops ( q iu )  P 

w q iu (8)

π monops ( q iu )  P
w ( q iu )

η is (9) The benefits of the successful exercise of monopsony power are of the same types as those associated with a reduction in monopoly power. In other words, benefits can be measured in terms of reduced direct costs (i.e., producer and consumer surplus losses and excess wealth transfers) and indirect costs (i.e., increased savings and a lower balance of payments deficit). A relevant question in assessing these potential benefits is establishing the correct point of reference. Potential monopsony power can be assessed relative to an optimizing monopolist or, for example, a "clumsy cartel." Obviously, one's assumption about potential monopoly power determines, to a great extent, the potential size of monopsony benefits. Another relevant question concerns the response of other importing countries. Will they act collectively with the United States to reduce consumption, will they not react, or will they take actions to actually increase their import levels? One's specific modeling approach and thus the estimated benefits of monopsony actions are very much dependent on the assumed reactions of oil producers and other importing countries.

3.4.2 Issues in Estimating the Monopsony Premium

Since the United States is a large consuming nation, in theory it could influence world oil prices by altering its level of imports. The monopsony premium is the marginal reduction in excess wealth transfer resulting from imports reduction. The "monopsony cost" of imported oil is the failure of oil consumers to collude and use their market power to recapture monopoly rents transferred to oil exporters (Murphy, Toman, and Weiss 1986:68). Broadman (1986:243) has described the monopsony cost effect as follows.

"If an increase in the demand for imports leads to a rise in the world price of oil, the increase in price affects all imports .... In this case, the demand increase by the marginal importer produces an external cost by raising total payments abroad for oil imports by more than the price [it pays]."

In the exposition above on the import premium, the first term in the premium of Equation (4) corresponds to the monopsony premium. The monopsony premium is just the incremental change in world oil price induced by the import reduction times the level of imports:

Here the prime symbol (  ) denotes the derivative with respect to import levels. If η is is the supply elasticity for oil imports, then the imported oil monopsony premium is also expressed as:

The social cost exceeds the private cost by P / η is . This formula shows explicitly that the monopsony premium will vary with world oil price, import levels, and the price elasticity of net supply of imports to the United States. If the supply of imports is very elastic, the monopsony premium will be very small, and very large if supply is inelastic.

Estimating the monopsony premium has always been recognized as difficult because it requires the specification of non-U.S. response, and particularly OPEC response, behavior (Plummer 1981:6). Should the United States reduce imports through some policy measures, the following categories of response are possible:November 1, 1997 ORNL-6851

15 The elasticity of net import supply can be decomposed into the elasticity of OPEC supply ( η sO ) and the elasticity of net import demand from non-U.S., non-OPEC regions ( η iN ):

π monops  P
w η i

η i  η sO q sO η iN q iN q iU

 π monops  P
w s U η sO η iN (1

s U )

where s U is the share of world net exports imported by the U.S.

Oil Imports: An Assessment of Benefits and Costs 27 ! Non-U.S. Importer Responses

- Market-based (some limited increase in demand as price drops, no policy change) - Joint/Coordinated policy effort with United States - Contradictory/Compensating policy

! OPEC Supply Responses

- Maintain production at cartel-agreed levels - Partial (elastic, unitary elastic) - Cartelized - Full Offset (perfectly elastic) - Cartelized - Retaliatory (no supply curve)

Non-U.S. Importer Response Representation

For some premium estimates, the limited response of non-U.S. importers is approximated by fixed non-U.S. demand or supply. A more defensible and common approach is to include a market-based response by other importers and non-OPEC producers as prices fall, partially offsetting the monopsony power of the United States. The monopsony power of the United States and the size of the monopsony premium increases with the share of world oil trade comprised by U.S. imports. 15 The United States current and projected imports as a share of OPEC exports (non-OPEC net imports) is around 30 percent (U.S. DOE/EIA 1994), so the elasticity of non-U.S. import demand is an important parameter.

The marginal benefits to the United States of a coordinated policy with other oil consuming nations would be greater than those of a unilateral action, because of the global nature of the monopsony gains. The estimated import or consumption premium would be correspondingly higher, when thefree market outcome is compared to a coordinated policy. Under coordinated policy action, nonU.S. importers are typically assumed to reduce their consumption in the same proportion as the United States [e.g., Stobaugh (1979)]. The early Energy Modeling Study [EMF-6 (1982)] considered the base monopsony premium or "buying power wedge" for both unilateral and joint OECD action. Tests with nine oil models all indicated that the base monopsony premium was 3 to 3.5 times larger given coordinated OECD action (Gately 1982:46). Joint action by the United States and other importers effectively increases the share of world oil trade under monopsony control, andNovember 1, 1997 ORNL-6851

16 An extreme alternative to joint action by importers is the possibility of contradictory/compensating measures in other importin g countries. Brown and Huntington (1994) note that Hoel's (1991) work on unilateral environmental actions also applies to unilateral oil con servation efforts: unilateral action by the United States could weaken its bargaining position with other importers who are considering c omparable policy. In this case other countries could relax their efforts and, in theory, world oil imports could increase.

Oil Imports: An Assessment of Benefits and Costs 28 increases the monopsony premium faster than linearly with the share of imports monopsonized (see previous footnote). 16

OPEC Supply Response Representation

Most estimates of the monopsony premium component assume some positive relation between price and OPEC supply, or include OPEC supply in a world import supply curve [e.g., EMF-6, Gately (1982), Broadman and Hogan (1986), Walls (1990), Huntington (1993)]. If OPEC is a true monopolistic supplier, then there is no well-defined conventional upward-sloping supply curve. A monopolist sets a price in inverse proportion to the elasticity of demand for its product, so in this case it may be more important for an import demand policy to increase demand elasticity than reduce the quantity demanded.

Nesbitt and Choi (1988) offer one polar alternative representation of OPEC supply. They apply a depletable-resource cartel model of OPEC behavior to estimate the effects of an import tariff and conclude "the degree of monopsony power that can be exerted by the United States is small, indeed almost minuscule" (Nesbitt and Choi 1988:46). They estimate that a $10.50 tariff such as that proposed by Broadman and Hogan would sharply reduce U.S. imports (by 30 percent in the first year) but would only reduce world oil price by $1.30/BBL. The insensitivity of world price to demand results from their assumption of a highly elastic world supply, and the treatment of oil supply according to dynamic depletable resource theory, in which price paths are strongly driven by the estimated resource base size and backstop price. Alternatively, viewing OPEC as a von Stackelberg monopolist suggests that while the elasticity of import supply may be ill-defined, the price charged will depend on U.S. consumption via the effect of U.S. consumption on OPEC's market share [Greene (1991), Greene and Leiby (1993)]. If the world could somehow reduce OPEC's market share enough, there would be pressure for prices to return toward competitive market levels.

Some critics of the monopsony premium approach question whether the exercise of monopsony power would be a justifiable interference in oil markets. If monopsony power can lower monopoly prices, why not use it to lower competitive market prices as well? Why not use it in all phases of international trade? According to standard theory, there are two good reasons: 1) competitive market prices produce an economically efficient allocation of resources; and 2) the indiscriminate exercise of monopsony power would likely shatter painstakingly negotiated free trade agreements. In short, there is too much to lose. But if free trade in competitive world markets is the goal, then judicious use of monopsony power against monopoly pricing may be a step in the right direction, while indiscriminate use of monopsony power against competitive producers is counterproductive [Greene and Leiby (1993)].

3.5 Numerical Estimates of the Monopsony Premium

As Table 5.4 shows, many of the early estimates of the monopsony premium [Plummer et al. (1982), EMF-6] are quite high, reflecting high base-price forecasts limited world supply elasticities. Broadman and Hogan (1986) carefully subdivided premium components, and estimated the monopsony premium assuming OPEC would drop price by $.50/BBL for each MMBD reductionNovember 1, 1997 ORNL-6851

17 Huntington's full premium estimates including disruption and monopsony premia range from $8/BBL to $14.3/BBL in 1988 dollars. Converting to 1993 dollars and subtracting the disruption premium of

 $3/BBL yields the reported range for the monopsony premia.

Oil Imports: An Assessment of Benefits and Costs 29 of imports. Their optimal premium estimates of $1.50 - $5.00/BBL varied depending on base price and the magnitude of the disruption/security risk (the premium components interact when determining the optimal level of imports).

Some, but not all, recent studies are skeptical of policies to reduce imports, arguing that the elasticity of import demand in the rest of the world is fairly high [  1.8 Walls (1990)] and that with limited import share the United States is essentially a price-taker on world oil markets with no significant monopsony power. The effective elasticity of net supply to the United States estimated by Walls is greater than 12.0, given any world supply elasticity greater than 0.5. This stands in stark contrastto the implications of the set of oil market models surveyed in EMF-11 (1992), which exhibit longrun regional supply and demand elasticities of well under 1.0 and elasticities of net supply to the United States of between 2.0 and 3.0, given unitary OPEC supply elasticity [based on Huntington (1991)]. Huntington (1993) used a linear approximation of these models and estimated a range of optimal premia from $5 to $13/BBL (depending on the model), with an average of $9. 17

The U.S. Department of Energy's Oil Market Simulation (OMS) model was included in the EMF-11 study. The 1994 version of the model was obtained to generate updated monopsony premium estimates. This model conforms to current EIA projections for oil price, and regional supply and demand levels. It also includes a partial-adjustment framework with smaller short-run elasticities and larger long-run elasticities. As in the Huntington (1991) report on the EMF-11 study, the OMS was run over two price paths to allow the estimation of long-run price elasticities for five world regions. The estimated elasticities are listed in Table 3.1, along with the EMF-11 implied elasticities for comparison.

Table 3.1: Estimated Long-Run Demand and Supply Elasticities Based on EMF-11 Models and Updated OMS-94

Model Year DEMAND SUPPLY

U.S.A Other OECD NonOECD U.S.A Other NonOPEC
OMS90 (20 yr) 2010 -0.327 -0.465 -0.149 0.340 0.170 CERI (20 yr) 2010 -0.441 -0.452 -0.455 0.196 0.144 HOMS (20 yr) 2010 -0.308 -0.381 -0.280 0.522 0.510 FRB-D (20 yr) 2010 -0.537 -0.528 -0.400 0.475 0.480 DFI (20 yr) 2010 -0.185 -0.532 -0.190 0.499 0.981 OMS94 (20 yr) * 2010 -0.187 -0.458 -0.223 0.604 0.144 OMS94 (10 yr) 2000 -0.124 -0.271 -0.129 0.245 0.081 OMS94 (1 yr) 1994 -0.122 -0.073 -0.037 0.050 0.021

Source for older models: EMF-11 WP 11.5, H. Huntington, Jan. 1991. OMS-94 elasticities estimated with a similar method.

* While some of these elasticities of OMS94 differ from those of earlier models, the monopsony premium depends on the OPEC respon se and on the elasticity of net demand for imports in non-U.S. regions. For OMS94, the non-U.S. elasticity of net demand for impo rts 0.68, which approximately matches OMS90. Also, tripling the elasticity of U.S. demand modestly lowers the high premium estimat e in Table 5.13 from $4.60 to $3.91. Using -1.0 for the non-U.S. elasticity of net demand for imports ( CERI and HOMS long-run value, while FRB-D = -1.2) reduces the premium from $3.91 to $3.81/BBL.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 30 The elasticity of OPEC supply was taken as exogenous, being either zero (no supply change in response to price movements), unitary, or perfectly elastic (supply adjusts to prevent any price change). The results of experiments with this model are summarized in Figures 3.2 through 3.6. Figure 3.2 shows that the base monopsony premium using long-run (20 year) elasticities lies somewhere between $0 and $6.50/BBL (1993$). Naturally, the premium is highest in the case where OPEC supply has zero elasticity: in this case OPEC holds production fixed, and the price falls by the maximum amount. The amount that price falls depends on the elasticity of non-OPEC supply and demand. If OPEC supply is perfectly price elastic, the monopsony premium is zero. The result for the unitary elasticity of OPEC supply lies right in the middle, $3/BBL at base import levels. Note that the monopsony premium declines with the degree of import reduction, since the reduced import level and reduced oil price make it decreasingly valuable to limit imports.

Figure 3.3 reminds us that the net costs to U.S. consumers could be quite high if import demand is reduced in the face of a highly elastic world supply. In this case domestic production and consumption must make costly shifts with little or no gain in terms of lower world prices. This is the warning raised by Walls (1990), Nesbitt and Choi (1988), and Brown and Huntington (1994): we are uncertain about OPEC behavior, and import reduction policies could be costly (especially if done unilaterally).

The efficient level of import reduction is where the net marginal benefit of import reduction is zero. Figure 3.4 compares the monopsony premium with the net marginal benefit of import reduction. For this illustration, the net benefit number reflects only the monopsony benefits, and excludes other potential sources of import premium. The "net marginal benefit" is the monopsony premium minus the marginal social surplus loss due to reduced consumption. The latter overwhelms the former quickly, here in the zero OPEC elasticity case at around 1 MMBD of reduction. Smaller import reductions would be justified on monopsony grounds with a higher OPEC supply elasticity (as higher elasticities of other supplies and demands).

The monopsony premium, if non-zero, can be expected to increase over time. By the year 2010, due to projected increases in oil price and U.S. imports, the base monopsony premium is about doubled (for the unitary elasticity of OPEC supply case, see Figure 3.5). The monopsony premia estimated from the 1994 version of DOE's OMS model are much lower than those estimated from the 1990 version in the EMF-11 study (Figure 3.6). The difference is largely due to a substantial downward revision in both projected 2010 prices and U.S. imports.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 31 Import Reduction MMBD$/BBL

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00 $7.00

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6

Perfectly Elastic OPEC Supply Unitary Elastic OPEC Supply Zero Elastic OPEC Supply Figure 3.2: 1994 Monopsony Premium Estimates for Different Long-Run OPEC Responses to Import Reductions

Note: Monopsony premium estimates depend critically on assuming OPEC supply response.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 32 Import Reduction MMBD$/BBL

($140.00) ($120.00) ($100.00)

($80.00) ($60.00) ($40.00) ($20.00)

$0.00 $20.00

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6

Marginal Benefit 2010 Marginal Benefit 2000 Marginal Benefit 1994 Figure 3.3: Losses From Import Reduction if Long-Run OPEC Supply Response Perfectly Offsets Import Reductions

Note: Import reduction can impose enormous losses on consumers if OPEC response is to reduce output by the full amount of a U. S. import reduction, and prices consequently do not decline.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 33 Import Reduction MMBD$/BBL

($140.00) ($120.00) ($100.00)

($80.00) ($60.00) ($40.00) ($20.00)

$0.00 $20.00

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5

1994 Premium 1994 Marginal Benefit Figure 3.4: 1994 Monopsony Premium and Marginal Net Benefit for Long-Run Zero-Elastic OPEC Response to Import Reductions

Note: The premium and the net marginal benefit or import reduction. Here the net benefit number only reflects the monopsony benefits, not other potential sources of the full import premium.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 34 Import Reduction MMBD$/BBL

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6

Premium in 2010 Premium in 2000 Premium in 1994 Figure 3.5: 1994, 2000, 2010 Monopsony Premium for Long-Run Zero-Elastic OPEC Response to Import Reductions

Note: The monopsony premia will increase over time, as U.S. imports and oil prices rise. (Based on EIA's 1994 OMS model).November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 35 Import Reduction MMBD$/BBL

$0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6

Premiums for 1990 Model Premiums for 1994 Model Figure 3.6: Long-Run Monopsony Premia Based on Parameters for 1990 and 1994 International Energy Outlook

Note: The monopsony premia estimated from the EIA OMS model are much lower based on the 1994 version than the 1990 version, la rgely due to lower base oil prices in the year 2010.November 1, 1997 ORNL-6851

18 As mentioned previously, "excess wealth transfer" refers to transfers beyond the actual resource costs of the commodity, or wha t would obtain under competitive conditions.

Oil Imports: An Assessment of Benefits and Costs 36 4.0 DISRUPTION COSTS

This section describes three major types of cost that different oil analysts have claimed may be costs of oil supply disruptions. Further, it considers the portion of those costs which may vary with the volume of oil imports. In this sense, the section's ultimate focus is on the marginal disruption costs of oil imports, not simply the total costs of oil supply disruptions. Since the opportunity for private agents to hedge against oil price shocks such as the world has experienced since the 1970s is an important element in protecting against avoidable costs, we also discuss private hedging opportunities, including oil futures markets in particular.

4.1 Conceptual Issues in the Definition of Disruption Costs

Studies of the value of "oil security" for the United States typically have focused on the economic costs of supply interruptions or price fluctuations. Some analysts find a substantial value of oil security while others find less clear room for intervention policies. For example, Broadman & Hogan (1988) obtain expected benefit values between $6.80 and $8.50 per barrel, in 1993 dollars. In contrast, Bohi & Toman (1993) remain skeptical of numbers valuing oil disruption premia and question how much of the economic consequences of supply disruptions is a genuine externality and how much represents the predictable operation of markets or failure of macroeconomic policy.

The social cost components which may derive from disruptions or the risk of disruptions include:

! short-run loss in producers and consumers surplus (during a disruption); ! increased excess wealth transfer (during a disruption) 18 ; and ! macroeconomic adjustment losses (short-run transitional macroeconomic consequences).

Typically, the costs of price shocks are divided into direct and indirect costs, although these terms are sometimes used differently by different analysts. Here, we define direct costs as those which accrue directly to oil markets. Included are incremental domestic oil production costs (known as deadweight losses), domestic consumption benefit losses, and increased payments for imports. Indirect costs result from the inability of the macroeconomy to either prepare fully for or adjust smoothly to oil price shocks. A host of mechanisms have been proposed by which these indirect disruption costs might arise, but most are only informally specified, and inadequately validated empirically. Consequently, analysts commonly group the hypothesized, indirect macroeconomic adjustment mechanisms together as unspecified adjustment costs, and seek empirical support for a simple functional form relating price increases to adjustment losses. This section reviews the direct and indirect costs of disruptions.

In estimating the import premium associated with each of these categories, we identify what is included in the cost component, and discuss the degree to which the component may vary with the level of imports. As with the noncompetitive market premium components discussed above, the estimate of marginal costs due to imports is conceptually simpler and more analytically sound than estimating total or average costs. This is largely due to the attribution problem: if the costs are notNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 37 influenced at the margin by imports, then how much of the costs are assignable to imports? On the other hand, the conundrum remains that certain "inframarginal" costs (such as macroeconomic disruption costs) occur, and are borne in total or on average, because we consume imports and because imports (or exports) link us to volatile world oil markets.

Each of the disruption components is an expected cost, that is, their possible values for alternative disruption sizes are weighted by their assumed probabilities. Most analyses of the disruption premium specify a probability distribution over the losses in supply quantity. Less common is the approach of specifying a probability distribution over price shocks without reference to supply [e.g., Huntington (1993)]. The advantages of the quantity-based shock approach is that it allows explicit modeling of how demand levels, demand price responsiveness, stockpiling, or other disruption offsets (U.S. DOE/ Interagency Working Group 1990) can mitigate the price consequences of the shock. It requires that a price disturbance have an identifiable cause and imposes the discipline ofa fairly smoothly functioning market when estimating consequences. The advantages of the priceshock approach is that it is simpler, and admits the possibility of sharp short-term price disturbances stemming from only modest supply losses (e.g., inventory effects), sudden shifts in the political or national security situation, or changes in market structure or resource ownership [Curlee and Russell (1992)].

4.2 Oil Futures Markets and Other Private Hedging Opportunities

The present study implicitly includes a role for the futures market and other private hedging by assuming that 25% to 100% of the expected price increase from a low-probability oil price shock is effectively hedged and internalized. In view of the literature on the functions of futures markets in general and the characteristics of the oil futures markets in particular, we believe that this may be optimistic, giving excessive credit to futures markets' ability to hedge oil price shocks. Here we review some salient conclusions about futures markets in general, the operations of oil futures markets in particular, and the research literature on their performance. We conclude this subsection with a brief review of other private hedging opportunities.

The literature has identified two principal functions of futures markets, the provision of insurance for hedgers and a mechanism to incorporate information on future market conditions into current prices. The former function requires that futures prices contain a risk premium, which implies that futures prices are systematically biased relative to future spot prices. The latter function operates more efficiently the more accurately futures prices predict future spot prices. There is clearly a tension between these two functions, since the provision of hedging insurance distorts the information content which futures prices convey about expectations of future market conditions. The existence of a risk premium in futures prices and their unbiasedness characteristic as predictors are both empirical questions in the study of all futures markets--agricultural, metals, foreign exchange--not just those for crude oil and refined petroleum products. Newbery and Stiglitz [1981:185], summarizing the empirical literature, report that, "for many markets the hypothesis of zero bias is reasonable, but for thin markets or markets which for institutional reasons are unattractive to speculators the risk premium may be positiveî. Tomek and Robinson [1981:264] concur in their assessment of the empirical research on agricultural futures markets.

For storable commodities such as grains and crude oil, the principal contribution of futures markets is to coordinate and insure stock holding activities, offering relatively little price-stabilizationNovember 1, 1997 ORNL-6851

19 An alternative perspective is the limited ability of futures markets to provide price stabilization insurance is an indicator t hat the private costs of uncertainty are small.

Oil Imports: An Assessment of Benefits and Costs 38 insurance [Newbery and Stiglitz, 1981:191]. 19 Newbery and Stiglitz note that, ". . .it should be stressed that futures markets do not generate the arbitrage benefits (that is, the benefits of transferring goods from low-value to high-value states) which the storage associated with price stabilization can produce" [1981, p. 188]. Noting that most agricultural futures contracts operate within the period six months ahead of the spot price, they suspect that the advantages to be gained from more distant contracts diminish to the vanishing point, relating the functioning of a futures market to the length of the production period (not just agricultural production). The oil futures markets also share this characteristic. Despite the growth in oil futures trading in recent years, in mid-March 1995, on the NYMEX, 44% of the volume of light sweet crude futures fall within 4 months of spot delivery, and 75% are within 10 months. (The futures markets for heating oil and unleaded gasoline continue to be much more heavily loaded toward the first three to four months than is the case for crude.)

Translating these general observations on futures markets to oil futures markets, it is useful to note that any risks hedged by futures markets are private risks. First, no divergence between private risk and social risk is involved. The creation of a futures market in crude oil does indeed eliminate the problem of a "missing market"--for private oil price risk--but it does nothing to help drive together private and social risk if private assessments underestimate social risk. Second, storage, not futures markets, moves oil from use in low-value periods to use in high-value (scarcity or disruption) periods. Third, while futures markets can reduce private price risk over a rolling six-month (or thereabouts) time horizon, they serve no clear function with regard to longer-term risks. They can alter short-run production and supply behavior of producers--principally oil refiners--but do not bring far future information into current pricing and capital investment decisions. Consequently, they are not able to help firms adapt their energy-using equipment to decade-horizon risks of oil supply disruptions. Finally, futures contracts are zero-sum exchanges of risk; one party to the contract wins at the expense of the other, so the economy as a whole does not avoid increased oil payments.

The futures market academic literature has focused to a great extent on the issue of the unbiasedness of oil futures prices as predictors of future spot prices. The null hypothesis, of course, is their efficiency in transmitting information to the spot market. The empirical results have been mixed. For the West Texas Intermediate (WTI) futures market, Dominguez [1989] accepted the efficiency hypothesis for three- to six-month futures and rejected it for one- and two-month futures, but noted the particular thinness of the market beyond the two- to three-month contracts. (In the Brent futures market, Weiner [1989] reported that fewer than 2% of the transactions from 1983 to 1989 involved contracts four or more months in the future.) Serletis and Banak [1990] found that forecasts basedon current spot prices are commonly as reliable as those based on futures prices. Moosa and AlLoughani [1994] criticize the econometric tests used in several other studies of oil futures markets. Using the most sophisticated time-series econometric techniques directed at the oil futures market to date, they find that WTI futures prices are both biased and inefficient forecasters of future spot prices, although they decline to generalize their findings to futures markets for other crudes, such as Brent.

As an additional theoretical problem in appealing to futures markets as the effective solution to externalities of oil price shocks, Toman has raised the question whether the volume of private hedging could be adequate. To the extent that there are macroeconomic consequences or otherNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 39 social consequences of price shocks not fully included in private decisions, the social risk premium due to shocks will exceed the private risk premium. "A consequence of this possible gap between the premia would be lower investment by the private market in hedges against energy price fluctuations than is socially efficient" [Toman 1993:1199].

Additional private hedging opportunities also exist to safeguard against oil price shocks. Some of these, such as private stockpiling, have long existed as private options. Others, such as investment in flexible energy technologies, have emerged as part of the industrial world's response to the oil price shocks of the 1970s. Private stockpiling, to the extent that it is used as a private hedge against oil price shocks, is supplemented by the Strategic Petroleum Reserve. Regarding stockpiling, in 1973, OECD countries held 2.6 billion barrels of petroleum stocks, about 44 days of total world consumption. At the end of September 1994, OECD stocks amounted to 3.7 billion barrels, or some 57 days of world consumption. Government-owned reserves accounted for the full difference in stocks held between the two times (U.S. DOE/EIA 1995, Tables 1.1c, 1,3, and 1.6). The extent of the adoption of flexible energy technologies in the transportation sector and other petroleum-using sectors is an open empirical question. Altogether, the evidence on whether this package of hedging options is producing an efficient level of insurance is an open empirical question.

Despite the existence of efficient hedging or insurance markets, society is still concerned about the aggregate losses from shocks and, in general, would want to take cost-effective measures to reduce them. For example, even if adequate insurance markets and privately purchasable capital equipment exist to protect against floods, there may still be social value at the margin to measures which reduce the aggregate expected damage of flooding. Market failures which might produce a socially suboptimal quantity of hedging and other insurance may not be directly attributable to oil imports, but rather to seller market power or to oil consumption in general. Nonetheless, if the quantity of imports has a marginal impact on the macroeconomic cost of an oil price shock which itself is partly attributable to socially inadequate hedging, such a marginal impact is still attributable to import levels.

4.3 Direct Costs of Disruptions

4.3.1 Market Consequences of a Temporary Price Shock

Consider first the oil market (direct) consequences of a temporary oil price shock. Figure 3.1 (which was used to describe possible long-run noncompetitive price increases) may also serve as a graphical representation of the different direct disruption cost components. In this interpretation of Figure 3.1, it is assumed that the United States is a price taker on the world oil market, i.e., the domestic price is set by the world price. The oil import level is determined by the difference between short-run domestic oil supply, S D , and short-run domestic oil demand, D D . If the world oil price jumps from P 1 to P 2 , domestic oil production increases, domestic oil consumption decreases, and oil imports decrease. In the long-run, changes in domestic production, consumption, and imports are defined by the long-run domestic supply and demand curves. However, in the event of a sudden and unexpected price jump, changes in production, consumption, and imports are defined by short-run domestic supply and demand curves which are more price inelastic (steeper) than the long-run

curves.

The domestic oil market experiences three types of direct costs as a result of the price shock: (1) added production costs due to the expansion of higher-cost domestic supply (deadweight loss triangle A in Figure 3.1); (2) increased payments from oil importing countries to oil exportingNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 40 C

disr

 FE  1
2 ∆ P ( Q iu ∆ Q iu  Q iu ) (10)

C

disr

 FE  C disr

 SS  C disr

 WT

 1
2 ∆ P ∆ Q iu  ∆ P ( Q iu ∆ Q iu ) (11) countries (B in Figure 3.1); and (3) a consumer surplus loss (C in Figure 3.1). Horwich and Weimer (1984) present a detailed interpretation of the various geometric areas in Figure 3.1. They show that areas A and C (the change in social surplus) can be equated with the direct net losses in potential Gross National Product (GNP) from an oil price increase. Area B represents an increased domestic payment to foreign producers of oil. As such, area B entails no direct effects on domestic potential GNP, but is an additional payment to foreign producers and therefore should be considered a cost of a price shock to the United States. The area to the left of the domestic supply curve and partitioned by P 1 and P 2 is an increase in domestic oil revenues above any costs incurred in producing that given quantity of oil. This area is thus a transfer from domestic consumers to domestic oil producers. Although this transfer may raise equity concerns and may contribute to some indirect costs (e.g., see the below discussion on this "oil price drag") the transfer is not considered a cost of an oil price increase.

4.3.2 Calculating the Short-Run Loss in Social Surplus and Increased Excess Wealth Transfer During a Disruption

A common approach to estimating marginal reductions in disruption losses begins by calculating the loss from a disruption as the additional transfer of wealth abroad plus the deadweight U.S. social(consumer plus producer) surplus loss during the disruption. Together, these measure the "fullemployment" (of labor and other factors of production) disruption loss. In contrast an early study by Plummer et al. used a compact macroeconomic model, ETA-Macro [Manne (1980)], to estimate full employment disruption losses. Sometimes the short-run losses in producer and consumer producer surplus are supplemented or replaced with an estimate of GDP macroeconomic adjustment losses, in which productive factors are unemployed due to short-run rigidities (see Section 4.4 below).

To calculate the social surplus losses and the increased excess wealth transfer during a price shock, we begin with a simple microeconomic representation of the oil market. Suppose a disruption occurs which causes a world price change ∆ P and a shock-induced reduction in U.S. imports ∆ Q iu . In the linear approximation the social surplus and excess wealth transfer cost is given by the area of the trapezoid (see Figure 3.1):

These costs may be subdivided into the social surplus (or potential output) loss and the increased excess wealth transfer:

The social surplus loss is the usual triangle under the import demand curve, whose area is smaller when U.S. import demand is less elastic and ∆ Q iu is small. When the oil price rises during a disruption, imports decline (by ∆ Q iu ) but U.S. consumers pay more per barrel to foreign producers for the remaining imports ( Q iu - ∆ Q iu ). Thus the excess wealth transfer is increased.November 1, 1997 ORNL-6851

20 Huntington's results actually reflect the net present value of a long-run reduction in imports divided by the NPV of barrels re duced, given the annual price shock probability and various model assumptions about supply and demand dynamics. The NPV per discounted barr el over 20 years turns out to be about 10 percent greater than the result for the single year 2000.

21 Plummer et al . (1982:30) are explicit about their assumption that the private sector does note fully anticipate the size or frequency of disruptions. They assert that given perfect foresight and flexibility, the direct microeconomic portion of the disruption prem ium becomes

zero.

Oil Imports: An Assessment of Benefits and Costs 41 C 

disr   C disr

 SS  Q iu   C disr

 WT  Q iu

  ∆ P  Q iu 1
2 ∆ Q iu  ( Q iu ∆ Q iu )   ∆ Q iu  Q iu 1
2 ∆ P

∆ P  ∆ P (12)

E [ C  disr

 WT ]  E [ ∆ P ] (13) 4.3.3 Calculating the Import Premium Components for Direct Disruption Costs

For the oil import premium approach, we are interested in the marginal expected disruption losses as imports change. The marginal change in (full employment) disruption loss due to an incremental change in base or imports is found by taking derivatives:

The third term on the right ( ∆ P ) is the direct value of avoided higher import payments during a disruption, per barrel reduction of the pre-disruption imports level. This is captured by most import premium studies. Some studies [e.g., Huntington (1993)] simplify by omitting the possible secondary effects of long-run import policy on the disruption price increase ∆ P or the shock-induced import reduction ∆ Q iu . These terms reflect the fact that changing the base level of imports, Q, may alter the volume of imports at risk to disruption, and the magnitude of the resulting price shock. If short-run elasticities are small, ∆ Q iu is small and the other terms are of second and higher order. Alternatively, Broadman and Hogan (1988) treat those secondary effects explicitly.

With the completely-inelastic short-run demand approximation ( ∆ Q iu =0), the expected direct marginal disruption cost is just the expected disruption price change:

This is exactly the result reported for Huntington (1993) in Table 5.4, who considers a 10 percent annual probability of a $38 (1993$) price spike. 20 This result raises an important point regarding the disruption premium. The import premium is intended to reflect the difference between the marginal social costs of imports and the marginal private costs of imports. In the case of the normal market premium, the marginal private cost is given by the world price of oil. The portion of disruption costs which are "internalized" in private decision making depends on the degree of foresight by private consumers and their opportunities to act on their expectations through diversification, contingent markets, or other means. Of the disruption cost components identified, the strongest case can be made for excluding some portion of the expected price change component ( E ( ∆ P )) from the premium, on the grounds that it could be anticipated and internalized by private agents. Nonetheless it is commonly included in the optimal premium calculations. The optimal premium is usually calculated as the difference between marginal benefits (demand price) P iu and normal market world price P
w at the optimal import level Q iu * [e.g., Hogan 1981:293, Plummer et al . 1982:30, 21 Broadman and Hogan (1988), Huntington (1993)]:November 1, 1997 ORNL-6851

22 Whether the existence and use of futures and forward markets actually internalize macroeconomic shock externalities rather than simply stabilize spot prices remains an open question, both theoretically and empirically. Internalization of macro shock externalities is a different matter from straightforward price stabilization, and involves the effects of individuals' separate decisions on other individu als' activities. Other hedging mechanisms, such as stockpiling and diversification, exist, but they existed during the previous oil price shocks , and presumably their effects operated then.

Oil Imports: An Assessment of Benefits and Costs 42 π  π ( Q iu )  τ ( Q iu  )  P iu ( Q iu )

P
w ( Q iu ) (14)

π  π ( Q iu )  τ ( Q iu  )  P iu ( Q iu )

P
w ( Q iu )  E [ ∆ P
w ] (15)

π disr  π disr

 SS  π disr

 WT  π disr

 GDP

π disr

 SS  1
2 E  ∆ P  Q iu ∆ Q iu  ∆ P  ∆ Q iu  Q iu

π disr

 WT  E  ∆ P  Q iu Q iu ∆ Q iu ∆ P  ∆ Q iu  Q iu  ρ E ∆ P (16) Alternatively, we could calculate the premium as the difference between marginal benefits and the expected world price P
w + ∆ P
w at the optimal import level Q iu * :

This latter formulation assumes that consumers are foresighted and have options, hence the private marginal cost includes both the normal market price and the expected price increase due to disruption. A useful approach is to parameterize the degree of consumer foresight and internalization, with the scalar ρ E . The premium estimates assume that consumers internalize the portion ρ E E[ ∆ P
w ] of positive price shock direct costs for various choices of ρ E . 22 We continue to assume that individual consumers do not recognize the marginal effect of their decisions on the magnitude of price shock, the degree of demand responsiveness during a shock, or any macroeconomic shock consequences.

The disruption premium components are defined as the expected value of the various disruption cost components. More generally, the disruption premia can be decomposed into the portions attributable to social surplus ( π disr-SS ), excess wealth (rent) transfer ( π disr-WT ), and transitional GDP adjustment losses ( π disr-GDP ):

The disruption excess wealth transfer premium is analogous to the undisrupted market monopsony premium, except that the lower short-run elasticities during a disruption suggest that the monopsony wedge is greater (conditional on the occurrence of a disruption). The GDP adjustment portion of the disruption premium, π disr-GDP , is discussed in the next section.

4.4 Indirect Costs of Disruptions

The GDP adjustment losses depend upon the size of the proportional price increase as well as the vulnerability of the macroeconomy to adjustment losses for a price shock of a given size. The vulnerability to adjustment loss is widely recognized to depend on the level of oil consumptionNovember 1, 1997 ORNL-6851

23 It has also been argued that reduced imports could lower the probability of opportunistic price shocks, by reducing cartel market share and the value of exploiting short-run market power (e.g., Suranovic 1994, Greene 1991, Wirl 1985, Fromholzer 1981). This possible effect is
not included in this study.

Oil Imports: An Assessment of Benefits and Costs 43 rather than imports. Although consumption is a major determinant of the total shock effect on GDP and has its own marginal effect, there is a marginal effect of imports as well. This arises because the pre-disruption imports level may affect the size of the price shock, as the social surplus portion of equation (16) shows. In this analysis there are two mechanisms by which this may occur. First, changing the level of imports may alter slightly the distribution of oil disruption quantities, that is, marginally change the expected size of the oil shortfall by either creating excess capacity or reducing the supply flows at risk of disruption. Second, changing the predisruption level of imports changes the starting points on the oil import supply and demand curves from which the disruption deviates. As a result of either of these mechanisms, the proportional size of the price shock may be diminished. 23

4.4.1 Possible Mechanisms by which Indirect Disruption Costs Could Arise

Indirect costs can arise in addition to the direct costs, due to the limited ability of the macroeconomy to adjust smoothly to the price shock. The extent to which these costs are the result of a market failure, however, is debatable. The costs are based on the assumptions that: (1) oil plays a crucial role in overall economic activity; and (2) our macroeconomy's short-term adjustment possibilities are limited by various institutional constraints. Several mechanisms by which adjustment costs may arise in response to a price shock have been discussed in the literature over the past two decades, not all of which remain widely accepted among students of the problem. For thoroughness, we give a brief noncritical overview of potential costs which have been suggested in the literature. We review these more thoroughly in the subsequent sections.

Inflexible Wages

The most important short-run adjustment cost is based on the possibility that real wages will not adjust to maintain full employment when there is an oil price shock. An increase in oil prices will decrease the consumption of oil and will lower the marginal productivity of labor. If real wages can not be reduced, employers will decrease employment, and GNP will be reduced.

Adjustments to New Relative Prices

In addition to wage rigidities, adjustments to changes in the relative price structure for all energy sources and all goods and services may occur also. While the economy is adjusting constantly to new relative prices, the notion is that oil is of such great importance to the total economy, that the adjustment costs associated with an oil price change are of special significance. GNP losses may occur as the economy adjusts to the new long-run demand mix.

Premature Obsolescence of Capital Stocks

An oil price shock may lead to premature obsolescence, or otherwise inefficient utilizations, of energy-using capital stocks. New energy prices may cause some capital stock elements to be no longer competitive with more efficient capital goods; and some capital stocks may become obsolescent prematurely because of a general decline in the demands for expensive, energy-intensive products. A reduction in capital services will result in a reduction of potential domestic output.November 1, 1997 ORNL-6851

24 As mentioned previously, "excess wealth transfer" refers to transfers beyond the actual resource costs of the commodity, or wha t would obtain under competitive conditions.

25 Much of this discussion in this section is based on Greene and Leiby (1993).

Oil Imports: An Assessment of Benefits and Costs 44 Oil Price Drag

Horwich and Weimer (1984) identify reductions in aggregate demand from the "oil price drag" as a potential problem (sometimes called "leakage"). As indicated in Figure 2.2, a price shock will transfer wealth from domestic consumers to domestic and foreign producers. 24 The oil price drag results from the inability of domestic and foreign oil producers to spend the incremental revenues they receive during the price shock. Aggregate demand therefore is reduced temporarily.

Domestic Inflationary Pressures

Higher oil prices will result in short-term domestic inflationary pressures. There is disagreement, however, about the existence and extent of this problem and whether an oil price shock will lead to a one-time inflationary jump or be a catalyst for a longer-term inflationary spiral.

Reduced Domestic Savings and Investment

Some analysts [e.g., Broadman, (1986)] suggest that an oil price shock can lead to reductions in domestic savings and investment and thus reduced capital formation. Lower economic growth will follow. While earlier theories of economic growth indicated little effect of the savings rate on the growth rate, recent theories of endogenous economic growth have revealed more important links between savings and growth [e.g., Romer (1986)].

Estimating each of these potential indirect costs without overlap poses serious challenges. Also challenging is the disaggregation of adjustment costs that are directly associated with oil markets and adjustment costs that occur in the macroeconomy.

An important distinction among these disruption cost components is that some depend largely on import levels while others depend on the level of total oil consumption. Although the excess wealth transfer associated with a price shock is a direct function of oil import levels, surplus losses and the indirect costs of a price shock are determined primarily by the level of domestic oil consumption. The possible exception to this statement is the relationship between the level of oil imports and the oil price drag (i.e., shifts of revenues to foreign producers may be more damaging than shifts to domestic producers).

4.4.2 Issues in Macroeconomic Adjustment Costs: Short-Run, Long-Run, and Policy

The remarkable correlation and apparent causal link between oil price shocks and subsequent economic recessions has received extensive attention from energy economists [e.g., Hamilton (1983), Hickman (1987), Bohi (1989); see Toman 1993:1192-8 and Mork 1994 for surveys]. 25 As discussed in the previous section, the existence of monopoly induces both a transfer of wealth and a loss of social surplus (potential GDP). Of course the continuing transfer and GNP loss fromNovember 1, 1997 ORNL-6851

26 Broadman, (1986 p. 245), makes this same argument in terms of the "monopsony wedge" effect.

27 Numerous other types of macroeconomic costs can result from an oil price shock. These include "leakages" in trade that may aff ect the United States' balance of payments, as well as producing a shortfall in aggregate demand. This leakage or "fiscal drag" effect depends on oil exporters' (and domestic oil producers') short-run marginal propensity to spend. Huntington (1993) notes some evidence tha t oil exporters are attracted to dollar-denominated assets as a short-run means to hold new-found wealth (see Hickman et al . 1987:41), so that the fiscal drag may be limited. Another type of macroeconomic cost can result from consumption-investment shifts due to the in ternational and domestic redistribution of income. To the extent that the new distribution of oil revenues results in a greater or lesser propensity to consume, this too can affect aggregate demand. Price shocks may also affect the willingness of producers to invest in capital e quipment, thus affecting the rate of economic growth. For a discussion see, e.g., Goulder (1985).

28 The estimation approach of Broadman and Hogan [1988] explicitly includes the proportion of inflation accommodated as one of its parameters. However, this is used for the long-run inflationary costs, not disruption costs.

Oil Imports: An Assessment of Benefits and Costs 45 monopoly will rise when a price shock occurs because the price increase is even greater. 26 But oil price shocks also generate what Pindyck (1980:2) has termed "secondary" effects or what Huntington and Eschbach (1987, p.201) call "macroeconomic adjustment costs." Macroeconomic adjustment costs arise because imperfect adjustment in the short-run to a major oil price increase will cause the economy to contract more than is necessary in the long-run (more than the loss of potential GNP). Wages and prices will not adjust immediately to the new price of oil for a variety of reasons, including cost-of-living provisions in labor contracts and entitlement programs. Also, substitutions of other energy sources and other factors of production for oil will take time because of the durability (economic value tied up in) energy-using equipment. 27 Hickman (1987:141) explains: "Stability considerations suggest that prices, and hence output, will probably overshoot the long-term equilibrium . . . ." The GNP level that can be reached in the short-run is necessarily lower than that which could be reached if the economy were able to adjust at the long-run, optimal prices and wages. Figure 4.1 illustrates how the economy will overshoot its long-run loss of production possibilities by moving first to a point that is long-run inefficient (2), and then to a point that is on the new long-run production possibilities frontier (3).

Short-term macroeconomic adjustment costs occur in addition to the longer-run loss of potential GNP. Macroeconomic adjustment costs are a temporary (several year) excess loss of GNP, that is suffered in addition to the loss of potential GNP due to the increased economic scarcity of oil. Huntington and Eschbach (1987:200) also emphasize that excess wealth transfers and the oil price shock losses of real GNP measured by macroeconomic models are additive. Their argument that macroeconomic models ignore the oil wealth loss arises from the way GNP is measured and is essentially an accounting problem [see also Toman (1993)].

The level of macroeconomic adjustment losses is an empirical question. In practice, the losses may also depend on the choice of fiscal and monetary policy. Oil price shocks may produce governmental policy responses that exacerbate the problem. If a deflationary monetary policy is pursued to deal with the effect of the oil price shock on inflation (rather than an expansionary policy to accommodate the price increase and return the economy as quickly as possible to full employment), one could argue that part of the cost should be attributed to monetary policy rather than to the price shock itself (e.g., Bohi 1989:84-85). Attempts to prevent the redistribution of income (e.g., due to "windfall" profits) may also produce excess economic costs. Some analysts attribute most of the historical GDP loss following disruptions to misguided macroeconomic policy [e.g., Bohi (1989), Bohi and Toman (1993)]. However, others maintain that a tradeoff must be made between the inflationary effects of accommodation and the output reductions of fiscal and monetary control [Nordhaus (1980), Rasche and Tatom (1981), Broadman and Hogan (1988), Huntington (1993)]. Thus the macroeconomic adjustment losses will depend in part on the extent to which temporary inflation can be tolerated and an accommodative policy may be pursued. 28November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 46 OIL PRICE DECREASE

GoodsServices 3 2

1 OIL PRICE INCREASE

GoodsServices 1 3

2

1. Initial Output Level

2. Output at Suboptimal Use of Factors 3. Output at Long-Run Optimal Use of Factors Figure 4.1: Effects of Oil Price Shock-Induced Scarcity on Short-Run and Long-Run Output

It is important to distinguish between these short-run adjustment costs and the possibly permanent reduction in potential GNP which would be caused by a rapid, but long-term, change in energy prices, effectively shrinking the production possibilities of the entire economy. Hamilton (1988) has developed a real (i.e., non-monetary) business cycle model which illustrates how the effect on the economy is not limited by the dollar share of energy in GNP but rather on the dollar share of products whose use depends importantly on energy, i.e., on the elasticity of substitution between energy and other inputs and products in production and consumption. Macroeconomic adjustments also include financial rearrangements which may appear to be far removed from oil--effects on balance sheets of both firms and individuals; portfolio effects in the stock and bond markets--which may reduce aggregate demand or shift its sectoral composition in ways that cause dislocations in various parts of the economy.

4.4.3 Direct Empirical Evidence on Macroeconomic Adjustment Costs

Recently, some questions have been raised about the existence and magnitude of the macroeconomic effects of oil price shocks. It is useful to review the literature regarding these effects, to weigh the arguments. A number of studies have found significant and apparently causal correlations between oil price shocks and macroeconomic performance in the United States and in other countries: Mork and Hall (1980a, 1980b), Bruno and Sachs (1982, 1985), Hamilton (1983, 1985), Burbridge and Harrison (1984), Davis (1984, 1985), Santini (1985), Loungani (1985, 1986), Gisser and Goodwin (1986), Mork (1989), Tatom (1993), Mory (1993), Mork et al. (1994), all of which find significant effects of oil price shocks, although commonly differing across countries and among oil price-shock episodes. Estimated values of the oil-price elasticity of GNP for the U.S. have ranged between -0.02 and -0.06. Analysts have obtained different results regarding the symmetry or asymmetry of macroeconomic response to oil price shocks, but as closer attention has been paid to that question, econometric evidence has pointed toward some degree of asymmetry for most, but not all countries examined. Gilbert & Mork (1986) have developed the theoretical underpinnings for asymmetric aggregate responses, highlighting that an economy incurs adjustment costs regardless of theNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 47 direction of an oil price shock. According to Lilien's (1982) dispersion hypothesis [see also the model of Hamilton (1988)], any relative price shock which requires reallocation of labor (possibly other factors as well) involves periods of unemployment as specialized factors search or retrain. Mankiw (1990, p. 1654), in summarizing the empirical research on the hypothesis, notes that the accompanying reduction in income may lower the demand for all products during such a period of labor reallocation. Energy price shocks have been found to be the principal type of external disturbance which propagates such a process of unemployment (Loungani 1987). In the case of a price decline, such as occurred in 1986, whether the aggregate GNP response is positive (symmetric to the case of positive price shocks) or negative (asymmetric) is an empirical matter of whether production frontier effects (expansion of full-adjustment production opportunities when oil prices fall) or adjustment costs dominate.

Toman (1993), relying on Bohi (1989, 1991), and Bohi and Toman (1993) have questioned these findings. Bohi's monograph (1989) and corresponding article (1991) examined output, employment, and energy intensity in some twenty 3-digit ISIC (International Standard Industrial Classification) industries in Germany, Japan, the United Kingdom, and the United States over the two periods 1973- 75 and 1978-80, and using zero-order correlation analysis found no strong or consistent correlations between energy intensity and industry-level activity. He also reported finding no evidence of wage rigidity during these periods. Toman (1993, p. 1198), relying principally on the negative findings of Bohi, concludes his assessment of macroeconomic effects of oil price spikes with, "While Bohi's analysis does not represent the last word on the subject, it does shift a considerable burden of proof to those who would favor a strong link between energy price shocks and macroeconomic losses."

Despite the theoretical exposition of asymmetric macroeconomic responses to oil price shocks offered by Gilbert & Mork (1986), Toman considers the evidence of asymmetry in macroeconomic response to oil price drops as casting further doubt on the econometric findings of strong effects of price spikes. In a separate discussion of asymmetric macroeconomic responses to oil price shocks, Bohi and Toman (1993, p. 1104) may underemphasize Mork's (1989) important confirmation of Hamilton's (1983) econometric analysis of the macroeconomic consequences in the United States of oil price shocks between 1948 and 1980: "Hamilton looks at correlations between energy prices and GNP before 1981 and concludes that higher energy prices cause recessions, while Mork finds that the same statistical methods applied to data extended through 1986 give a different impression." In fact, Mork's (1989, p. 743) assessment of his own findings is, "The results now strongly confirm a large negative effect of oil price increases . . . . The coefficients for price declines , on the other hand, are smaller and of varying signs." Clearly, Bohi's largely negative findings regarding industry-level responses during the two major oil shocks of the 1970s raise important questions which warrant further econometric investigation with more sophisticated techniques.

Bohi and Toman (1993) attribute most of the apparent macroeconomic cost following oil shocks to inappropriate macroeconomic policy, although they have not econometrically tested such an hypothesis. Nonetheless, some of the more recent studies (e.g. Mory 1993), attempt to account for monetary policy in their estimates, yet still find losses after oil price rises. Furthermore, Hamilton's (1983) findings of a stable relationship between oil price shocks and GNP from the end of World War II through 1980 raises questions about Bohi's policy explanation for the 1973-74 and 1979-80 shocks.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 48 The important distinctions between the Bohi study and other contradictory empirical work are in the degree of aggregation and the econometric methods used. To shed new light on this question of the macroeconomic cost of oil shocks would require applying sophisticated econometric techniques to data at various levels of sectoral and regional aggregation.

4.4.4 Evidence on Macroeconomic Adjustment Costs from Simulation Models

The evidence on the magnitude of these adjustment costs comes in two forms, direct empirical studies of the effects of oil price shocks on aggregate economies and simulation studies of energy in the aggregate economy. Over the past fifteen years, regression analyses of oil shocks and macroeconomic performance consistently have shown strong, negative impacts of oil price increases on GNP and employment (some of these studies are referenced below). The strength of the effects varies among industrialized countries, and more recently it seems to be emerging that the effects are asymmetric, that is while sharp increases precipitate sharp or mild recessions, price drops do not cause economic booms. Different models, different time periods and different data series have been used in obtaining these results, so while some differences are to be expected, the consistency of the negative macroeconomic effects found across the corpus of these studies reinforces the findings of any individual study.

The simulation models offer another kind of evidence since, admittedly, little comes out of such a model which is not put into it by the modeler. The contribution of the simulation studies to assessment of the macroeconomic adjustment cost of oil price shocks comes not from the appearance of the effect, since that is built into the models, but rather from the ability to examine in a controlled fashion the magnitudes of effect deriving from particular combinations of parameters reflecting various characteristics of the oil market and the aggregate economy. The parameter values used in the simulations are derived from empirical experience--price elasticities of demand for oil, etc. The results of these models should not be accepted uncritically, as their creators and users themselves warn. Bohi and Toman (1993, p. 1104) believe that, "The main source of skepticism about the results of these models is that the equations of the models employ parameters estimated from limited experience with price shocks over the 1950 to 1980 period." Hamilton (1983) found substantial continuity of the GNP-oil price shock relationship between the period from 1949 through 1972 and the period from 1973 through 1980, and Mork (1989) found that extending the later period through 1986 strengthened the relationship Hamilton found between oil price increases and GNP. Another problem for these energy-economy simulation models lies in assessing their correspondence to purely theoretical counterpart models. The simulation models are empirically implementable compromises of accepted macroeconomic models using the IS-LM curve, or a related, framework, but it is unclear exactly what macroeconomic specifications underlie various equations in the simulation models. Eastwood (1992) has found the numerical pattern of wage adjustment in the EMF-7 modeling study (Hickman et al., 1987) consistent with a Phillips-curve model of real-wage stickiness, and he raises the question whether that specification parallels the U.S. empirical experience. Similarly, the international linkages of the simulation models generally do not distinguish between tradable and non-tradable goods, a distinction which has been found of critical importance in open-economy macroeconomic models.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 49 GDP  GDP 0 P
P 0  e (17) 4.4.5 Methods for Simulating the Macroeconomic Adjustment Costs of Disruptions

Early studies used a multiplier approach to estimate indirect adjustment costs. As mentioned above, the Plummer et al. study used a compact macroeconomic model to estimate the benefits of oilconsumption. During a simulated disruption, ETA-Macro provided the value of short-run fullemployment output. Indirect macroeconomic adjustment losses associated with wage and pricerigidity and unemployment were estimated by applying a multiplier to the estimated loss in fullemployment output.

More recently, a common approach for estimating the frictional or adjustment losses in GDP is to assume a constant elasticity form for GDP with respect to oil price shocks:

where GDP 0 and P 0 are undisrupted levels of GDP and price, and e is the percentage change in GDP per percentage change in oil price. This approach came into wide use [e.g., Leiby and Lee (1988), Broadman and Hogan (1988), DOE/Interagency SPR Study (1990), NES Oil Externalities Draft (1990)] after the Energy Modeling Forum 7 (EMF-7) study, in which estimates of e were generated. This method is usually presumed to incorporate also any short-run macroeconomic losses due to the inflationary effect of a price shock.

An important issue for the present purpose is whether possible GDP adjustment costs would imply a premium on marginal import use. The macroeconomic adjustment costs due to disruptions are widely believed to be proportional to levels of oil consumption rather than imports. Since macroeconomic adjustment losses are not necessarily a function of imports per se , they may not vary with incremental import changes (Plummer et al ., 1982:29; Huntington 1993:16). Previous studies of the import premium have adopted one of three ways to deal with this issue:

1. Omit GDP adjustment costs of disruptions altogether, since they depend on consumption levels and are not expected to change at the margin with imports, at least to a first order approximation [e.g., Huntington (1993)]. This approach implies that consumption remains fixed, and import reductions must be achieved by domestic supply increases. The accuracy of this first-order approximation is an empirical issue.

2. Assume that some fraction ( ρ c ) of the marginal imports change is accomplished by changing domestic consumption, and include the appropriate share of GDP adjustment losses in the premium [e.g., Plummer et al . (1982:30) who assume ρ c =1 to establish a maximum estimate of the import premium. Another related approach was used by Hogan (1981:292) who included a multiplier m on the direct disruption costs to account for indirect macroeconomic costs, thereby implying a non-zero marginal indirect macroeconomic cost].November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 50 3. Include an explicit formulation describing how marginal import changes alter the determinants of the GDP adjustment losses, and indirectly affect the level of those losses [e.g., Broadman and Hogan (1988) assume that adjustment losses depend on the relative size of the price shock and include terms for the marginal effect of pre-disruption imports on the base price and size of the price shock].

Because the purpose of the present study is to assess the marginal external costs of oil imports, the third approach is adopted in the numerical calculations presented in Section 5.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 51 5.0 NUMERICAL ESTIMATES OF THE OIL IMPORT PREMIUM

This section reviews previous estimates of the oil import premium reported in the literature; recalculates Broadman and Hogan's (1988) detailed import premium components using up-dated information on price, GDP, market shares, etc.; and offers revised premium estimates relying on arestricted group of external cost components. The revised estimates are based on the BroadmanHogan methodology, excluding some of its more controversial cost components.

5.1 Previous Estimates

This section reviews, in tables, the methodology, scenarios (parameter assumptions), and resulting estimates of the oil import premium from seven studies. The premium estimates are broken down into the Noncompetitive Market and Disruption components, with more detailed cost components provided where available.

Table 5.1: Economic Cost Components - Methodology

Component Plummer et al ., (1982) Broadman and Hogan (1986, 1988) Huntington (1993) NES Oil Externality Draft (1990) Miscellaneous
Monopsony Effect (Normal Market Increased Prices and Excess Wealth Transfer) Y Y - uses isoelastic LR curves Y - based on multi-year model effects N Y [EMF-6 (1982), Walls (1990)]

LR Social Surplus Loss N - (small) Y - (marginal loss is demand price) Y - (marginalloss is demand price) N

LR Potential GNP Loss N - (small) N N N

LR Balance of Payments Costs N Y - exchange rate varies with import N N

LR Inflationary Costs N Y - Phillips Curve & Okun's Law N N

Cost of Policy: SPR Y - includes
monopsony effect of SPR acquisitions N N Y - no marginal cost; report average cost

Military and National Security Costs N N N (no marginal effect of imports) Y - no marginal cost; report average cost Hall: est. linear function of imports
SR Social Surplus Loss in Disruption Y - use SR macro model Y YN

Increase Excess Wealth Transfer During Disruption Y Y YYTable 5.1: Economic Cost Components - Methodology (cont.) November 1, 1997 ORNL-6851

Component Plummer et al ., (1982) Broadman and Hogan (1986, 1988) Huntington (1993) NES Oil Externality Draft (1990) Miscellaneous

Oil Imports: An Assessment of Benefits and Costs 52

Macroeconomic Losses DuringDisruptions (Adjustment Costs) Y - (but minimal marginaleffect of imports) Y - price elasticGDP form, marginal effect of imports N - (assume no marginal effect of imports) Y - (simple GNP-elasticity form)

SR Balance of Payments Costs/ Leakage or Fiscal Drag N N NN

Dynamic Considerations SR elasticity of substitution for oil is 10% of LR. Dynamic stockpile management Different singleperiod SR and LRelasticities of demand and supply Imposes LR shifts in U.S. production or consumption, 1989-2010. Calculates discounted costs per discounted barrel shift. Multi-period SPR size model with independent sequential SR equations

Basic Approach, Other Notes: Combines insights and general results from a suite of related studieson oil modeling, monopsony wedge, and SPR value.Marginal premia computed
at base import level. Integrated framework considers marginal variation in each componentwith imports, computes premium at optimal level of imports. Results from 7 oil modelsfrom EMF11, for two fixed pricepaths, benchmark linear import supply and demand. curves. Then calculates year 2000 premium at optimalimport level. Focuses on non-market costs of imports due to disruption risk. Uses SPR size model from DOE 1990study. Premium computed
at base (nonoptimal) import level, on $/BBL consumed basis.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 53 Table 5.2: (Base) Assumptions For Noncompetitive Market Economic Cost Estimates

Parameter Plummer et al. (1981) Broadman and Hogan (1986, 1988) Huntington (1993) NES Oil Externality Draft (1990) Miscellaneous
Base Prices Unknown $27.00 (1985$) Base prices flat at $18 (1988$) IEO 90 projections

U.S. Demand and Import Levels Imports 6.3 MMBD Imports 6.0 MMBD Imports vary by EMF model, 9-22.9 MMBD in year 2000, average = 15.8 MMBD IEO 90 projections

U.S. Demand andSupply Price Responsiveness Assume demand declines with imports Constant elasticity LR (0.5) Assume linear net import demand Fixed normal market levels

Non-U.S. Demand and Supply Price Responsiveness Unknown Part of linear import supply Assume linear net import supply Fixed normal market levels Walls: demand elasticity 1.8

Non-U.S. Demand and Supply Policy No change No change No change Foreign stock draws, else no change Walls: none

LR OPEC Supply Behavior Mix of 3 Gately models Part of import supply curve,slope $.50/BBL/ MMBD Replaced with assumed fraction (~20- %) of tariff shifted to foreigners LR monopsony calculation, elasticity 0.0 Walls: 0.5-10 elasticity

Disruption Deterrence None None None None

Discount Rate 8% N/A 5% 10%November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 54 Table 5.3: (Base) Assumptions for Disruption Economic Cost Estimates

Parameter Plummer et al. (1982) Broadman and Hogan (1986, 1988) Huntington (1993) NES Oil Externality Draft (1990) Miscellaneous
Disruption Probability 20% annual probability of 3 MMBD loss, 10% annual probability of loss of 10 MMBD 1 (steady state) 2 13% annual probability of 1 MMBD, 3.5% probability of 3 MMBD, 0.5% probability of 6 MMBD loss of import supply to U.S. 3 10% annual probability of $30/BBL price shock (1982$) Base: 1% probability of > 15% loss (8.1 MMBD), 7.5% probability of > 5% loss (2.7 MMBD).Alts: probabilities are 1.5%, 8.5% respect.
Disruption Duration 1 year initial, with  50% probability of continuation 1 year 1 year 6 months

SPR Policy Optimal stock management and size forpremium estimate Rule: 1/2 of shortfallor 1/2 of reserve Unstated (incorporated in assumed price jump) Cases: no use vs. full offset of shortfall (600 MMBD reserve)

Other Disruption Offsets None None None 6.9 MMBD average, foreign stock, excess capacity, fuel switching GDP SR Response to Price Change Unknown -0.05 elasticity of GDP NA -0.025 elasticity of GDP
Short-run Demand and Supply Responses SR elasticity of oil substitution = 0.04 Linear SRcurves, elasticity 0.05 SR elasticity (fixed $30 price shock) Increase w/ disruption size, .10-.22 1 st quarter
Short-run OPEC behavior Follows pricereaction function Part of SR import supply Completely elastic at shock price Fixed production (elasticity 0.0)

1 Disruptions are proportionally shared according to consumption levels regardless of the size of disruption.

2 Base Case Disruption Probability Transition Matrix Disruption, t Disruption, year t+1 Normal 3 mmbd 10 mmbd Normal 0.85 0.10 0.05 3 mmbd 0.425 0.05 0.075 10 mmbd 0.20 0.30 0.50 LR Stationary 0.70 0.20 0.10

3 Broadman and Hogan consider four cases of disruption probabilities (World View 2 is base): Annual Probabilities: One Year Int erruption in Import Supply to U.S.
World View 1 MMBD 3 MMBD 6 MMBD W0 0.0% 0.0% 0.0% W1 6.7% 1.0% 0.5% W2 13% 3.5% 0.5% W3 26% 6.7% 2.2%November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 55 Table 5.4: Economic Cost Components: Estimates ($/BBL Imports, Unless Otherwise Stated, 1993$)

Component Plummer et al ., (1982) Broadman and Hogan (1986, 1988) Huntington (1993) NES Draft (1990) Miscellaneous
Monopsony Effect (Normal Market Increased Prices & Excess Wealth Transfer) $5.20- $10.40 a. $1.50 b. $5.00 c. $2.70 a. $5.70- $13.20 b. $9.10 EMF-6, w/ different OPEC assumption. 1 U.S.: $10.00- $23.00 Joint:$31.00- $68.00 Walls: < $1.60
LR Social Surplus Loss $0.00

LR Potential GNP Loss $0.00

LR Balance of Payments Costs a. $0.91 b. $0.89 c. $1.96
LR Inflationary Costs a. $1.90 b. $1.30 c. $2.00
Cost of Policy: SPR a. $0.0 b. $0.0 $0.0 MC $0.66/BBL Consumed Hall: $1.10- $1.70 MC

Military and National Security Costs a. $0.0 b. $0.0 $0.00 MC $1.90/BBL Consumed AC Hall: $10.90 MC

Noncompetitive Market Subtotal $5.20- $10.40 a. $4.30 b. $7.20 c. $6.70 a. $5.70- $13.20 b. $9.10 EMF-6 U.S.: $10.00- $23.00
SR Social Surplus Loss in Disruption $0.00 $0.00

Increased Excess Wealth Transfer During Disruption $15.60- $38.10 a. $3.80 b. $3.80

a. $0.20-$0.60 b. $0.60-$1.70 Macroeconomic Losses DuringDisruptions (Adjustment Costs) $5.20-$6.90 (assuming consumption reduced with imports, $0 otherwise)November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 56 Table 5.4: Economic Cost Components: Estimates (cont.) ($/BBL Imports, Unless Otherwise Stated, 1993$)

Component Plummer et al ., (1982) Broadman and Hogan (1986, 1988) Huntington (1993) NES Draft (1990) Miscellaneous
Disruption/ Security Subtotal $20.80-$45.00 a. $10.20 b. $9.30 c. $0.00 a. $3.80 b. $3.80 a. $0.20-0.60 b. $0.60-$1.70

TOTAL ECONOMIC $26.00-$55.40 a. $14.50 b. $16.50 c. $6.70 a. $9.50-$17 b. $12.90 a. $0.20-0.60 b. $0.60-$1.70

1 EMF-6 Monopsony Premium Estimates (1993$)

Model Gately IEES IPE Salant/ ICF ETA/ Macro WOIL Kennedy OIL-TANK OIL-MAR

Joint: $31 $50 $31 $48 $68 $36 $52 $47 $68
U.S.: $10 $16 $10 $14 $23 $12 $14 $14 $23
OPEC assum. target capital utility target capital utility target capital utility inter-temporal optimize price-reaction function target capital utility fixed production market prices target capital utility target capital utility

Notes: Plummer et al (1982) Cases vary mostly by disruption frequency. Variation in non-disruption costs due to alternative buying power assumptions. Broadman and Hogan (1986, 1988) a. High price b. Low price c. Secure imports Huntington (1993) a. Low estimate - high estimate b. 6-Model Average NES Draft (1990) a. Midcase disruption probability and excess capacity b. High disruption probability and low excess capacity For both cases (a) and (b), the low end of range corresponds to immediate SPR use and the high end of range corresponds to no SPR use.November 1, 1997 ORNL-6851

29 We are grateful to Professor William Hogan for providing work files which clarified his approach.

Oil Imports: An Assessment of Benefits and Costs 57 5.2 Updated Estimates of Broadman and Hogan's Oil Import Premium

This section provides new estimates of the economic oil import premium, based on updated parameters, and for a variety of assumptions. First we review the critical assumptions which must be made for estimation. Estimates are then provided, broken down by each premium component, for assumptions spanning the range of views offered by energy analysts. The estimates are based on current oil market prices and quantities, and use estimates of long-run oil market responsiveness derived from the Department of Energy's Oil Market Simulation Model, 1994 version (OMS94). The resulting economic portion of the oil import premium varies between $0 and $10, depending on the view adopted. It is not necessary to conclude from this wide variation that we know nothing about the level of the oil import premium. Rather we may conclude that we know a fair amount about how different premium estimates arise, and what confluence of events and conditions is required for the premium to be large or small.

The estimation method is consistent with most recent approaches [e.g., Broadman and Hogan (1988), DOE NES Oil Externalities Subgroup (1990), Walls (1990), Huntington (1993)] in its focus on the marginal value of import reduction at current and optimal import levels, and in its division of the premium into long-run noncompetitive market costs and expected disruption costs. Like these approaches, the dynamic behavior of the oil market is simplified by using long-run and short-run price-responses (elasticities) for major supply and demand regions, with linear approximations of short-run behavior. A range of OPEC supply responses are considered. In the interest of completeness and consistency, the accounting framework follows Broadman and Hogan (1988), since that study estimated the most inclusive set of potential marginal cost components. 29 The approach accounts for tradeoffs among components and for potentially important second-order effects of long-term imports reduction. Adopting this comprehensive approach does not predetermine the answer, however, because the framework admits the possibility that many components are of limited importance, given suitable assumptions.

5.2.1 Important Uncertainties

The many previous efforts at estimating the oil import premium indicate which conditions and parameters are most important. Based on the above review of components and approaches, the following are known to be among the most important determinants of the estimated premium size.

! OPEC supply behavior ! Demand/policy behavior of other importers ! Fraction of long-run inflation accommodated (versus eliminated through macro policy) ! Import payments recycling rate ! Disruption probabilities ! Disruption offsets (gross versus net shortfall distinction) ! SPR policy (size and drawdown during disruptions) ! Short-run net-import demand elasticities ! Degree of disruption anticipation/expectation ! Macroeconomic policy during disruptionsNovember 1, 1997 ORNL-6851

30 Included are the 1973 Arab-Israeli war and embargo, the 1979 Iranian Revolution, the 1980 Iran-Iraq war, the 1988 UK Piper Alph a Platform explosion, and the 1990 Persian Gulf war.

31 DOE 90 study probabilities are given as continuous Weibull distributions. These were converted to discrete disruption size pro babilities by constructing bins around the stated values with conditional expected value approximately equal to the bin value.

Oil Imports: An Assessment of Benefits and Costs 58 5.2.2 Treatment of Disruption Probabilities

The disruption components of the oil premium (increased imports costs and GNP adjustment costs) are each weighted by the probabilities of disruption. An inclusive range of disruption probabilities would include the possibility that there are no net disruptions, that is, no disruptions large enough to exceed the available excess production capacity and U.S. and foreign strategic reserve drawdown capability. This result closely approximates the mid-case assumptions used in the DOE/Interagency 1990 SPR Size Study, as well as the revised disruption probability and offset assumptions developed for the DOE/EIA modeling work in this study, if all disruption offsets are available. Under these assumptions there is little probability (0.3%, or 2% excluding the SPR draw), of a disruption exceeding the full range of offsets and the expected (probability-weighted) price increase due to shocks is nearly zero ($0.04 in 1995). In contrast, many previous studies of the premium have considered expected disruption price increases of $2 to $3/BBL (e.g. Hogan and Broadman 1988, Huntington 1993).

The approach to disruptions adopted by the 1990 DOE SPR Size Study restricts concern to net quantity shortfalls in the oil market. That approach applies multiple offsets (e.g. excess production capacity, fuel switching, strategic stock draws) to gross supply losses in a manner that completely eliminates any price rise for most disruptions. The estimated frequency of gross quantity shortfalls is loosely based on historical observation. An alternative approach, used in some of the cases examined here, would recognize that only a fraction of these offsets may be applied, and even then only after price rises high enough to provide a strong signal. Historically, five events since 1973 have caused substantial price rises (greater than either $4/BBL or 20% of prevailing price), for at least a few months. 30

The DOE90 study applies large offsets to the gross disruption sizes considered, and as a result there is a very low probability of price shocks (compared to history or to other oil disruption analyses). In general, the DOE90 net disruption probabilities are closely approximated by zero in the tables. However, since most of the assumed offsets are from excess production capacity in Persian Gulf region, it maybe optimistic to assume that they are fully and promptly available during disruption. The "medium" and "high" net disruption probability cases in the Tables roughly correspond to the DOE90 gross disruption probabilities with reduced offsets as shown by Table 5.5.

For the medium and high disruption probability cases reported here, the expected price increase due to shocks is $0.67 and $1.31 respectively. As seen below, the "medium" probabilities used here for net disruption sizes substantially exceed the DOE90 study probabilities for comparably-sized disruptions net-of-offsets, but the "high" probabilities are lower than the corresponding DOE90 study probabilities if one excludes non-SPR offsets: 31November 1, 1997 ORNL-6851

32 Note: Omitted from the current estimates is the marginal change in GNP adjustment loss which might follow from the effect of th e base import level on the base consumption level, since consumption is held constant.

Oil Imports: An Assessment of Benefits and Costs 59 Table 5.5 Comparison of Annual Disruption Probabilities for Varying Non-SPR Offset Assumptions

Disruption Size

1 MMBD 3 MMBD 6 MMBD
DOE90 Midcase, Net Disruptions (full offsets) 0.8% 0.6% 0.15%
This study, Medium Case, Net Disruptions 6.7% 1.0% 0.5%
This study, High Case, Net Disruptions 13% 3.5% 0.5%
DOE90 Midcase, Gross Disruptions (no offsets) 38% 24% 6%

5.2.3 Premium Components Estimated, and the Direct and Indirect Effects Included

The premium components estimated here include the major categories discussed in Sections 3 and 4. Each premium component corresponds to the marginal effect of changing long-run (base) imports on one cost component. Hence some premia necessarily involve indirect or second-order effects. An important lesson from the numerical results is that such effects, while commonly omitted, are not necessarily insignificant. Included are 32 :

! Noncompetitive Market Components

- Recoverable Cartel Rents (Monopsony Effect) The marginal effect of long-run imports reduction on the undisrupted period price, times the level of imports [standard approach (see 3.4.2)]. - Balance of Payments Cost Effect the incremental trade deficit due to oil imports on exchange rate and cost of other imports. Depends on the recycling rate [see Equation (7)]. - Long-run Inflation Costs The marginal costs of controlling incremental inflation due to imports, given rising real imports price. Depends on the marginal effect of imports on oil price, the rate of price growth, and the consumption of oil and close substitutes. Proportional to the fraction of inflation unaccommodated i.e., eliminated by macro policy [based on Broadman and Hogan (1988)].

! Disruption Cost Components (All disruption components are expected marginal costs, hence are proportional to the probability of disruption)

- Disruption Social Surplus Loss The marginal change in disrupted period social surplus "triangles" due to: a. the effect of base imports on disruption price change ∆ P i ; and b. the effect of base imports on demand response during disruption, ∆ q i .November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 60 - Disruption Increased Imports Costs The marginal change in the increased costs of imports during a disruption due to: a. the effect of base imports level q i on disruption imports level q i + ∆ q i , altering loss exposure for any given disruption price change ∆ P i ; and b. the effect of base imports on disruption price change ∆ P i , altering disruption excess wealth transfer for any given disrupted imports level q i + ∆ q i

. - Disruption GDP Adjustment Losses The marginal change in GDP adjustment losses (which are a function of oil consumption, base GDP, and disruption relative price change) due to: a. the effect of base imports level on the disruption price change ∆ P i ; and b. the effect of base imports level on base price P i , and thereby the relative disruption price change ∆ P i / P i . 5.2.4 Updating Original Broadman and Hogan Estimates for 1985 With 1994 Conditions

As reported in Table 5.4, the mid-case estimate of the total economic premium by Broadman and Hogan was $14.50 per barrel (1993$), based on 1985 conditions. We might expect the premium to be much lower now, given lower oil prices and reduced U.S. share in the world oil market. For the purposes of comparison, the Broadman and Hogan estimates were re-generated, with parameters altered to match 1994 oil market conditions (See Table 5.5). Note that for this initial comparison, the disruption probabilities were not "updated" since they remain uncertain, moreover the goal is to examine the effect of changing base-market conditions on the import premium. Looking at the entries in Table 5.5, we see that a number of market developments since 1985 are expected to lower the import premium. The base oil price is lower, oil is a smaller share of total expenditures, and less important in the U.S. total trade flows. U.S. imports and demand are a somewhat smaller share of world oil trade or demand (from 36 percent to 31 percent), making import reduction less effectivefor reducing the size of a potential disruption (shortfall) to the United States. The priceresponsiveness of foreign net imports supply to the U.S. (from OMS94 implicit elasticities) is greater, so the expected world price change per unit imports change is lower. The smaller expenditure share of oil indicates smaller GNP adjustment losses during disruptions, and the SPR is larger.

The principal development contributing toward a larger import premium is the substantially higher 1994 import level. We see from Table 5.7 that all components of the premium are reduced except those relating to the monopsony wedge or excess wealth transfer during normal and disruptedperiods. The undisrupted-market monopsony premium is slightly larger than in the BroadmanHogan estimate for 1985. With the optimal premium lower overall ($9.91 compared to $14.51), there will be a smaller import reduction at the new optimal level, therefore leaving the monopsony premium relatively larger. Using the updated Broadman-Hogan base assumptions, the total economic import premium, at the optimal import level in 1994, is still around $10 per barrel. Note that the base premium ($14.60 in 1994, $23 in 1985), evaluated at the current level of imports rather than the optimal level, will always be higher than the optimal premium. It is important to bear in mind, however, that these import premium estimates are uncertain, and depend strongly on disputed assumptions. The next section explores how that $10 premium estimate can erode, if certain important assumptions are changed.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 61 Table 5.6: Updated Oil Market and Economic Parameters of Broadman and Hogan (1988) Study of 1985 versus 1994 Conditions

Assumption Broadman and Hogan (1988) Value, 1985 Updated Comparison Value, 1994 Source/Comments

Base Oil Price (1993$/BBL) $35.52 $16.91 Annual Energy Outlook 1994

Rate of Growth in Real Oil Price 3% 3.4% Annual Energy Outlook 1994, long-run growth rate, Base price path
Base U.S. Oil Imports 6.0 MMBD 9.0 MMBD Annual Energy Outlook 1994
U.S. Exports (93$ Billion) $299 $464 Int'l Financial Statistics, 1994
Non-Oil imports (1993$ Billion) $375 $498 Int'l Financial Statistics, 1994

Reduction in Disruption Size per BBL Reduction in Base Imports (BBL/BBL) 36% 31% Based on U.S. share of world demand (U.S. share of world imports is comparable)

Slope of Long-run Imports Supply Curve ($/BBL per MMBD Imports Change) $0.50 $0.37 Based on OMS94 regional elasticities, and OPEC price elasticity of 1.0 (see Table 3.5)
U.S. Long-run Elasticity of Demand -0.5 -0.19 OMS94 implied elasticities

U.S. Long-run Elasticity of Supply 0.50 0.60 OMS94 Implied Elasticities

GDP ($ Billion) $5300 $6381 Annual Energy Review 1993 p. 361
Oil Expenditure Share of GDP 3.5% 1.74% Calculation from above (combined oil & gas shares roughly in same ratio)
Elasticity of GNP with Respect to Disruption Price Rise (GNP Adjustment Cost Parameter) 0.05 0.025 Consistent with a reduction in the oil expenditure share of GNP from to 3.448% to 1.76%, also consistent with DOE 1990 SPR Size Study Mid-case.

SPR Size (Million BBL) 500 600 Approximate current size
Disruption Probabilities See Table 5.3 Unchanged Defer for later sensitivity analysisNovember 1, 1997 ORNL-6851

33 Those components proportional to the reduction in world demand would be about 2-3 times greater, at the base import level. How ever, other components more dependent on the U.S. level of imports or consumption (e.g., balance of payments costs due to worsening t erms of trade) would be less affected. Furthermore, the optimal premium (premium at the optimal level of imports) would be reduced by less than the base level premium.

Oil Imports: An Assessment of Benefits and Costs 62 Table 5.7: Comparison of Premium Estimates 1985 vs. 1994, With Updated Market Parameters (Optimal Premium, $/BBL Imports, 1993$)

Component 1985 Broadman and Hogan est. (1986, 1988) 1994 Simple Updated Estimate
Recoverable Cartel Rent (Monopsony Effect) $1.46 $1.85
LR Balance of Payments Costs $0.91 $0.32
LR Inflationary Costs $1.90 $0.97
Noncompetitive Market Subtotal $4.27 $3.14
SR Social Surplus Loss in Disruption $0.56 $0.22
Increased Import Costs During Disruption $2.95 $2.96
Macroeconomic Adjusted Losses During Disruptions $6.73 $3.60
Disruption/Security Subtotal $10.24 $6.77

TOTAL ECONOMIC $14.51 $9.91

Notes: See Table 5.5. Disruption probabilities unchanged in updated estimate. LR - Long-Run, SR - Short-Run

5.2.5 Sensitivity of Import Premium Estimate to Alternative Oil Market Conditions

The import premium estimate of $10/BBL was constructed using updated assumptions from Broadman and Hogan (1988). While inclusive, this does not constitute the highest estimate consistent with prevailing conditions and the range of plausible assumptions currently offered. The disruption probabilities, while higher than those used in recent DOE studies [e.g., DOE SPR Size Study (1990), DOE NES Oil Externalities Draft (1990)], imply a lower expected price increase than those used by Huntington (1993), for example, or many earlier studies (see Table 5.7). The estimated premium would be up to 50 percent higher if it were assumed that OPEC members will defend their output quotas (were completely inelastic), and allow price to fall further. It would also be greater if one assumed that other OECD importers acted jointly with the U.S., reducing their imports in the same proportion. 33November 1, 1997 ORNL-6851

34 This study assumed a one percent annual probability of a disruption greater than or equal to 15 percent of world demand (8.1 MM BD), and includes offset of 8.25 plus an SPR annual draw capability of 3.3 MMBD. A disruption large enough to exceed all offsets (and t hereby increase prices) has a probability of 0.005.

35 Note that these estimate are by no means precise, and the reporting of two decimal places is done only to indicate some of the smaller relative changes between components and cases.

Oil Imports: An Assessment of Benefits and Costs 63 Table 5.8: Comparing Expected Disruption Price Increases

Study Expected Price Increase

Huntington (1993) $3.00/BBL
Broadman and Hogan (1988), applied to 1994 $1.81/BBL base, $1.66/BBL at optimal imports
DOE SPR Size Study (1990), Mid-Case $0.04 - $0.13 34 , 1994 to 2010

On the other hand, substantially lower premium estimates are obtained when one questions the key assumptions in turn. To highlight the reasons why oil import premium estimates vary so widely, we can show how the methodology used above admits estimates ranging from $10/BBL to near zero, as assumptions are varied. The selection of particular assumptions is left to the reader as a subjective and empirical question beyond the scope of this paper.

Nine cases were considered, starting from the updated Broadman and Hogan estimates. The changes considered in each case also apply to the successive cases (i.e., are cumulative). The results for each premium component are reported in Table 5.9. 35

Case 1: OPEC Supply Moderately Price Responsive

Here OPEC supply elasticity is 1.0, and the resulting elasticity of net import supply to the United States is about 5. This implies a moderate degree of monopsony power for the United States. The direct monopsony premium at the optimal import level is $1.85, substantially lower than many previous estimates of that premium component alone. For a given elasticity of imports supply, the base monopsony premium is proportional to price [see Section 3, Equation (8)]. The constant of proportionality is one over the elasticity. Hence for a base oil price of $16.90, the base monopsony premium in this case is about $3.30. When interactions with the other premium components are accounted, and the optimal import level determined, the monopsony premium estimate is substantially smaller ($1.85). However, this case emphasizes the many other potential components of the oil import premium can have non-trivial values, depending on important details of how the oil market and economic policy work. These components are often omitted.

Case 2: Highly Elastic OPEC Supply

OPEC suppliers may defend price, by cutting back production to offset most of the import reduction (OPEC elasticity equals 5.0). Here the elasticity of net import supply to the United States is about 18, comparable to the range considered by Walls (1990). The base monopsony premium is $0.96, comparable to Walls' estimate of under $1, and the optimal level is $0.54. The inflationary cost component, which also depends, in part, on the responsiveness of the base oil price to marginal import changes is a bit lower. It is noteworthy that while the long-run economic premium components decline, some of the disruption premium components are a bitNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 64 higher than in Case 1. This is an example of the interactions among the optimal premium component estimates, which are often compensating [Broadman and Hogan (1988)]. In this case, since import reductions are less effective in reducing price, at the optimal level the undisrupted world oil price and the import level are somewhat higher. Accordingly, the optimal disruption premium is slightly higher while the normal market economic premium is lower.

Case 3: Low Balance of Payments/Term of Trade Costs

If payments for oil imports are quickly and fully "recycled" by the subsequent foreign purchase of U.S. goods (either by oil exporters or others), or if there are offsetting capital account adjustments, then the terms of trade losses induced by the imbalance of payments are minimized. In this case we assume that the proportion of oil import payments quickly recycled is 75 percent, rather than 25 percent. The balance of payments premium, already modest, decreases in direct proportion to the recycling rate.

Case 4: Low Inflationary Costs

The long-run inflationary costs depend on the fraction of oil-induced inflation left unaccommodated by macroeconomic policy. If all of the inflationary effect of an anticipated long-term oil price growth is accommodated (100 percent rather than 70 percent is left unchecked), then output losses are avoided, and this premium term becomes zero. The same is true if one takes the view that oil pries are not a major source of long-term inflation. As in other cases, the total premium declines by less than the long-run inflationary premium term, due to interactions.

Case 5: Import Levels Have No Marginal Effect on Disruption Sizes

Changes in import levels could alter the effective size of disruptions subsequently faced by the United States [Broadman and Hogan (1988)]. Possible mechanisms include the creation of idle production capacity, the alteration of sharing rights under the IEA International Energy Program, reduced oil trade flows subject to interruption (accidental or intentional) and the reduction in output levels from potentially disrupted sources. Previous cases considered the possibility that import supply net disruption sizes decrease with marginal reductions in normal market imports. The marginal reduction rate assumed was 31 percent, roughly matching both U.S. imports as a share of world oil trade, and U.S. demand as a share of world oil demand. In this case the marginal reduction in disruption size per barrel imports reduction is five percent. With minimal effect of imports on disruption size, the disruption premium components are substantially reduced. Note that none of the estimates produced for Table 5.9 assume any effect of imports on the likelihood of disruptions (sometimes called the deterrence effect).

Case 6: Private Expectations Internalize Disruption Price Increase

Oil prices represent the marginal cost of oil to private consumers. The price of oil in an undisrupted market is universally agreed to be borne by private agents, and therefore fully internalized. Oil consumers may also anticipate some of the disruption-related price increases when making oil-related decisions. Accordingly, some fraction of the expected price increase due to disruptions is internalized, depending on the foresightedness and expectations of private agents. This portion of the disruption cost should be excluded then from the social import premium. It is assumed that the share of disruption price increase internalized is 75 percent,November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 65 rather than the more common assumption of zero percent. If so, the total optimal premium decreases by $1.25, that is, somewhat less than 75 percent of the $2.00 expected price increase in Case 5.

Case 7: Zero GDP Adjustment Costs During Disruption

Some analysts assert the connection between oil prices and economic activity is not that strong, provided effective macroeconomic policy is used to limit potential transitional losses of GDP due to oil price shocks. This possibility is modeled with a GDP elasticity with respect to disruption price of zero. The $1.80 macroeconomic adjustment loss premium component from Case 6 is eliminated, and the total premium declines by $1.20. Note that the hypothesized existence of the GDP adjustment loss implies an income-induced contraction of demand during a disruption. Conversely, assuming that the GDP loss does not occur eliminates the anticipated income shift of demand, effectively decreasing the expected price elasticity of demand during disruptions. Hence the expected price shock size grows, from $2 to $2.40. This also explains the increase in expected disruption costs.

Case 8: More Stable World with Lower Disruption Probabilities

The disruption probabilities used by Broadman and Hogan are higher than those used in some recent studies, although lower than others (see Tables 5.3 and 5.7). In this case the disruption risk is halved, with the expected oil price increase at base import levels declining from $2.40 to $1.20. The disruption premium components are likewise halved.

Case 9: Minimal Oil Exporter Market Power and Minimal U.S. Economy Market Failure

This case is modeled with a zero probability of any net shortfall in supply after the application of offsets and the SPR. That is, there is a zero probability of price shocks from any source. Equivalently, the ruling assumptions could be that the adverse economic consequences of paying more for oil during an oil supply disruption would be 100 percent anticipated and that the U.S. economy will smoothly and efficiently adjust to the oil price shock. There also is no long-term premium due to the exercise of seller market power, and thus no motivation for U.S. intervention. In this case, all of the premium components reduce to zero, except for a minor balance of payments term which suggests some cost associated with oil's part of the continuing trade deficit.66Table 5.9: Range of Oil Import Premium Estimates(Optimal Premium for 1994, 1993 U.S. Dollars Per Barrel)Case: 1 2 3 4 5 6 7 8 9AssumptionsComponents1994 SimpleUpdate ofBroadmanHoganEstimateHighlyElasticSupply,LowMonop-sonyPowerLowBalance ofPaymentsCosts, FastRecyclingLessInflationaryAccommodationMinimalEffect ofBaseImports onDisruptionSizePrivateExpectationsInternalizeDisruptionPriceIncreaseZero MacroeconomicAdjustmentCostsMore StableWorld(disruptionprobabilitieshalved)PerfectlyStableWorld, NomonopsonypowerRecoverable Cartel Rent $1.85 $0.54 $0.55 $0.58 $0.72 $0.79 $0.85 $0.87 $0.00Long-run Balance of PaymentsCosts$0.32 $0.35 $0.12 $0.12 $0.16 $0.18 $0.19 $0.20 $0.21Long-run Inflationary Costs $0.97 $0.77 $0.77 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Long-run Economic (NormalMarket) Subtotal$3.14 $1.66 $1.44 $0.70 $0.88 $0.96 $1.04 $1.07 $0.21Short-run GNP Loss inDisruption$0.22 $0.22 $0.22 $0.21 $0.00 $0.00 $0.06 $0.03 $0.00Increased Import Costs DuringDisruption$2.96 $3.03 $3.05 $3.14 $1.89 $0.35 $0.86 $0.43 $0.00Macroeconomic AdjustmentLosses During Disruptions$3.60 $3.64 $3.66 $3.74 $1.71 $1.83 $0.00 $0.00 $0.00Disruption/Security Subtotal$6.77 $6.88 $6.93 $7.09 $3.60 $2.18 $0.92 $0.46 $0.00TOTAL ECONOMICESTIMATE$9.91 $8.54 $8.37 $7.79 $4.49 $3.15 $1.97 $1.53 $0.21Notes Moderatemonopsonypower,(OPECelasticity =1)OPECmaintainsprice byoffsettingimp.reduction(elasticity=5)Rapidrecycling offoreign oilrevenue (75percentversus 25percent)U.S. macropolicy doesnot tradeoutput forinflation(accommodation 100percentversus 70percent)dε/dqi= .05rather than.31 (U.S.importshare),εisdisruptionsize to U.S.Share ofdisruptionpriceincreaseinternalized75 percentversus 0percentGDPelasticitywith respectto oil price =0 (versus0.025)Disruptionprobabilityhalved(expectedpriceincrease$1.20 versus$2.40)Zeroprobabilityof netdisruption(afteroffsets andSPR),OPECsupplyperfectlyelastic.Disruption probabilities from Broadman & Hogan (1988). See Table 5.5.36 This is because the marginal costs are calculated at the efficient level of imports, which decreases somewhat as more cost cate gories are included.

37 Strictly speaking, a cartelized or monopolistic supplier will not have a well-defined supply curve. However, when a large cons umer with market power initiates a demand reduction there will be a series of actions and reactions between the consumer and the large p roducer. The change in the supplier's asking price which ultimately results from this interaction is summarized here with a supply elast icity.

67 5.3 Estimation of the Most Robust Economic Components of the Oil Import Premium

The estimates of the oil import premium provided here are based on current oil market prices and quantities, and use estimates of long-run oil market responsiveness derived from the Department of Energy's (DOE) Oil Market Simulation Model, 1994 version (OMS94). Calculations are made with the Broadman and Hogan model. The estimation method used is consistent with most recent approaches in that it does not include environmental components. Instead, the method focuses on the marginal value of import reduction at current and economically efficient import levels considering only disruption costs and long-run economic costs. The approach used here accounts for trade-offs among components and for potentially important second-order effects of long-term reduction of imports.

The calculations presented in this subsection eliminate the controversial balance of payments and inflation costs because of the weakness of their theoretical foundations. Social surplus losses during disruptions are small in any event, and we omit those possible costs to avoid distraction from the three most important and robust cost categoriesóavoidable cartel rent, increased import costs during disruptions, and macroeconomic adjustment costs during disruptions.

Tables 5.10 through 5.13 reveal the sensitivity of the three principal, potential economic externalities of oil imports at the margin to important oil market conditions. For each component, a numerical measure of the total cost is identified, and the marginal variation of that cost with respect to imports is calculated and reported. This avoids attributing any costs which do not vary at the margin with imports. Tables 5.10 through 5.12 report on each of the three components individually, while Table 5.13 aggregates these costs. In each of the first three of these four tables, the reported costs are calculated under the condition that the costs in the other two categories are zero. When these costs are aggregated in the final table, the values reported are calculated simultaneously, which tends to reduce slightly each cost category. 36

Cartel Rents

Table 5.10 describes the sensitivity of external costs from marginal cartel rents to the elasticity ofOPEC response. Rather than attempt a dynamic model of OPEC supply response behavior, the longrun response to a U.S. import reduction is represented with a simple OPEC response elasticity parameter. 37 The range of that parameter is from completely inelastic (a vertical cost--or supply-- curve) to completely elastic OPEC oil supply.November 1, 1997 ORNL-6851

38 These short-run elasticities are consistent with anticipated rates of short-run supply and demand adjustment toward long-run re sponse levels. In the DOE's OMS model, these adjustment rates average about 10% per year, depending on the region, hence the short-ru n elasticities are about 10% of the long-run levels. The long-run elasticities used are derived from OMS, as reported in the mai n report.

Oil Imports: An Assessment of Benefits and Costs 68 TABLE 5.10: MARGINAL CARTEL RENTS, 1993 $/BBL

OPEC Supply Response to U.S. Import Demand Changes

Perfectly elastic (elasticity  

###  ) Highly elastic (elasticity = 5) Moderately elastic (elasticity = 1) Completely inelastic (elasticity = 0)

0.00 0.90 2.86 6.63

Notes: All other cost components are assumed to be zero (i.e., zero net disruption risk, or disruptions and completely anticipated and hedged, and no marginal effect on macroeconomic disruption losses). These numbers are calculated using the total elasticity of net import supply. The total elasticity of net import supply to the U.S. is calculated using the OPEC supply elasticity and long-run supply and demand elasticities for non-US non-OPEC regions derived from the EIA's OMS94 model.

Oil Import Costs During Disruptions

This component corresponds to the added cost for oil imports during a disruption. Import costs during a disruption vary at the margin with the level of imports prior to the disruption. There are two issues: given a disruption, by how much will prices rise; and how much of the increased import costs due to the price rise has been anticipated and internalized by private agents? The price rise during a quantity shock is determined by short-run demand and supply elasticities. A reasonable assumption for these elasticities is 10% of the long-run price elasticities derived from the DOE/EIA OMS94 model. 38

Table 5.11 reports the sensitivity of oil import costs during disruptions to various market conditions. First, zero, medium, and high disruption probabilities are considered. It is possible that reducing imports will reduce the risk of disruptions, by reducing their expected size. Accordingly, the analysis next explores the effect of a zero marginal effect of imports on the risk of disruption and of a non-zero marginal effect, under the high and medium disruption probability conditions. Finally, under each characterization of the marginal effect of imports on disruption risk, the consequences of anticipation and the use of hedging opportunities by consumers are considered. Such anticipation and hedging may partially internalize the higher cost of imports during disruptions. Most studies include the whole increase in the cost of imports during a disruption in the premium estimate. Here, the fraction of the shock costs avoided by anticipation and hedging is varied from 100% to 25%. The external costs will be zero with 100% anticipation and hedging. Table 5.11 assumes that all cost components other than increased import costs during disruptions are zero: i.e., that there are no cartel rents and that labor, capital, and product markets operate smoothly enough to avoid all macroeconomic adjustment costs. In these estimates, the SPR is used fully, except for the smallest disruptions (1 MMBD), in which cases only half of the SPR is used, assuming that half is withheld to protect against the event of a large disruption.November 1, 1997 ORNL-6851

39 The DOE Interagency 1990 study (T2/T3 Working Group) assumed a GNP elasticity range of -0.02 to -0.04, with a preferred value o f - 0.025 (page 5-1).

Oil Imports: An Assessment of Benefits and Costs 69 Macroeconomic Adjustment Costs Component

Again the analysis includes only those marginal external costs which are attributable to imports. The first mechanism by which the GNP adjustment losses may be affected by changes in imports is through possible incremental changes in net disruption size. It is represented by a parameter indicating the marginal reduction in disruption quantity per barrel of reduction in imports. This parameter is called the "marginal effect of imports on disruption size." The analysis uses values between 0 and 31%, the latter figure being the current US share of world net imports from OPEC.The second mechanism, the dampening of proportional price changes, is implemented in the shortrun and long-run equilibrium calculations of the model. The analysis approximates these losses with a GNP oil-price elasticity, to which are assigned values between -0.025 and -0.06. This means that an oil price doubling will cause adjustment losses of between 2.5% and 6% of GNP. The 2.5% figure is used by the 1990 DOE/Interagency study on SPR size, and is about one-half of the value commonly used prior to that date. 39 The 6% figure is the most recent empirical result (Mory 1993).

Table 5.12 reports the effects of various conditions on the magnitude of macroeconomic adjustment costs. Again, a variety of circumstances contingent upon the probability of disruption--high, medium, or zero--are compared. Under the conditions of high and medium disruption probability, the consequences are explored, in a nested fashion, of the size of the marginal effect of imports on disruption risk (again, zero and positive) and, under those conditions, the effects of the size of the GNP elasticity with respect to oil price shocks. Table 5.12 assumes that all cost components other than macroeconomic adjustment costs are zero: i.e., that there are no cartel rents which vary with imports and that disruptions are 100% anticipated and hedged.November 1, 1997 ORNL-6851Oil Imports: An Assessment of Benefits and Costs70TABLE 5.11: INCREASED IMPORT COSTS DURING DISRUPTIONS, 1993 $/BBLZero disruptionprobability or zerospillover effectsMedium net disruption probability High net disruption probabilityNo marginal effect of imports ondisruption size5%-31% marginal effect ofimports on disruption sizeNo marginal effect of importson disruption size5%-31% marginal effect of imports ondisruption size100%anticipation& hedging75%-25%anticipation &hedging100%anticipation& hedging75%-25%anticipation& hedging100%anticipation& hedging75%-25%anticipation& hedging100%anticipation &hedging75%-25% anticipation& hedging0.00 0.00 0.17-0.44 0.00 0.41-2.14 0.00 0.20-0.85 0.00 0.82-3.94Notes: All other cost components are assumed zero for these calculations.Disruption probabilities: The annual probabilities for a one-year interruption in import supply to the U.S. areDisrupted quantity 1 MMBD 3 MMBD 6 MMBDMedium probability 6.7% 1.0% 0.5%High probability 13% 3.5% 0.5%SPR (600 MMB) is fully utilized, except for smallest disruption (1 MMBD), which is offset by one-half. The expected price increases are $0.67 for the medium disruptionprobability and $1.31 for the high disruption probability.TABLE 5.12: MACROECONOMIC ADJUSTMENT COSTS, 1993 $/BBLZero net disruptionprobability or zerospillover effectsMedium net disruption probabilityHigh net disruption probabilityNo marginal effect of imports ondisruption size5%-31% marginal effect ofimports on disruption sizeNo marginal effect of importson disruption size5%-31% marginal effect of imports ondisruption sizeLow GNPelasticity*High GNPelasticity*Low GNPelasticity*High GNPelasticity*Low GNPelasticity*High GNPelasticity*Low GNPelasticity*High GNP elasticity*0.00 0.44 0.63 0.70-1.96 1.13-3.49 0.84 1.22 1.35-3.62 2.18-6.48Notes:*High GNP elasticity = 0.060; low GNP elasticity = 0.025.Disruption probabilities defined as in Table 5.11.November 1, 1997 ORNL-6851

40 The extreme case of fixed OPEC supply was omitted, the high disruption probability case was dropped and the marginal effect of import reductions on disruption sizes was limited to the more modest range of zero to ten percent.

Oil Imports: An Assessment of Benefits and Costs 71 Summary of Combined Costs

The key determinants of each cost component are identified, and narrower ranges of assumptions considered, based on judgment regarding the likely range of conditions. 40 Table 5.13 reports summary costs for simultaneous calculations of multiple cost components. The components reported above are not purely additive, since they are calculated jointly at the efficient level of imports. A range of estimated costs for each component is given. Rather than expand the summary table into many rows which permit exact reporting of the cost associated with each set of contingency conditions, a simplified format is used which divides conditions into positive and zero disruption probabilities, under which is nested the condition whether or not OPEC exercises cartel power. This table reports ranges of marginal external costs which depend on the further conditions reported in more detail in the individual tables.

TABLE 5.13: NARROWED RANGES OF MARGINAL EXTERNAL COSTS OF OIL IMPORTS (1993 $/BBL)

Cost components Zero (negligible) probability of net disruption, or negligible external effects of oil price shocks Medium probability of net disruption 2,3 and nonnegligible external effects of oil price shocks

No cartel rents exist Some cartel rents exist 1 No cartel rents exist Some cartel rents exist 4

Cartel rent ZERO 0.90-2.86 ZERO 0.89-2.59
Increased import costs during disruptions ZERO ZERO 0.00-0.51 0.00-0.50

Macroeconomic adjustment costs ZERO ZERO 0.44-1.60 0.41-1.51

TOTAL ZERO 0.90-2.86 0.44-2.11 1.30-4.60

1 This range reflects a range of OPEC supply elasticities from 1 to 5. 2 The parameters generating the minima of the ranges are: OPEC supply elasticity = 5; 100% anticipation and hedging; zero margi nal effect of imports on disruption risk; and GNP elasticity = 0.025. The parameters generating the maxima of the ranges are: OPE C supply elasticity = 1; 25% anticipation and hedging; marginal effect of imports on disruption risk = 10%; and GNP elasticity = 0.06. 3 If the maximum marginal effect of imports on disruption sizes is 31% rather than 10% (disruption sizes decrease by 31% of the change in imports), then the upper range values for the total premium increase to $4.60 in the no cartel rent case, and to $6.72 if so me cartel rents exist. 4 If the lowest OPEC supply elasticity is specified to be 0 (the case of fixed OPEC supply) rather than 1, then the upper range value for cartel rent is 6.17 rather than 2.59, and the upper range for the total is 8.09, rather then 4.60.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 72 6.0 CONCLUSIONS

Interest in the social costs and benefits of oil imports stems from concerns that there may be imperfections in the markets for oil, and that consequently the economic decisions by private agents may lead to import levels which impose unintentional and unnecessary costs on the U.S. society as a whole. In this case the level of oil imports would be inefficient, and there may be scope for welfare-improving government action. However, government policies in the name of energy security and efficiency have not always proven to be well designed or implemented. Often, policies motivated by concerns about market efficiency are designed under the pressures of concerns about equity, or with inadequate attention to their transactions and implementation cost. Hence it is increasingly recognized that the existence of a market failure alone is insufficient to justify government action. A large social cost is not a problem in a smoothly functioning competitive market if it is fully reflected in the price paid by the private agents using oil. If it is not, it is loosely called a (generalized) externality. A large cost omitted from the market price of oil may not be a major social problem if other mechanisms exist to partially capture or internalize the cost in private actions (e.g., automobile emission standards, or oil spill liability case law). Finally, even a market failure creating a social cost which is completely omitted from market decisions (for example, if we were to conclude that the foreign oil supply is cartelized) may not justify policies which are inefficiently targeted, or induce private costs beyond any reliably expected gain (in this example, such a case occurs if the U.S. cannot reduce imports without great cost, and if doing so would have little or no desired effect on world oil prices).

Government policy benefits from careful examination of the possible mechanisms of market failure, the magnitude of social losses, and the cost-efficiency of the proposed policy. For this reason, this report seeks to identify, describe, and estimate the various possible social costs and benefits of oil imports which have been raised in the literature over the last two decades. Since there is no discussion or evidence of substantial social benefits from oil importing beyond those which are captured by the private oil buyer, we focus on the costs of oil imports. There is persistent uncertainty regarding both the existence of the problem and magnitude of many of the costs. Our approach is to describe all of the potential cost components, presenting some of the historical debate, and discussing how they might be estimated. The resulting estimation framework applied is agnostic about the magnitude of the oil import problem and even about each of the cost components, since much of the debate about costs can be translated into a debate about parameters and assumptions in the estimation framework.

6.1 Cost Categories and Estimation Methods

The potential costs of imports are grouped into four categories:

! Costs attributable to possible noncompetitive oil market structure; ! Costs due to oil market instability and disruption risks; ! Environmental costs; and ! Military program costs, which may be attributable to concerns about the reliability of oil supply.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 73 For each category, there is a difference of opinion about the existence of a market failure and about the magnitude of costs. The possible external environmental or military costs which vary with the level of imports are small or difficult to assign. Accordingly, these components are excluded from the premium results presented.

The numerical estimates of cost components come from a critical survey, as well as some updated estimates based on recent market conditions and Department of Energy/Energy Information Administration Association (DOE/EIA) projections of future market conditions. The principal method used is the marginal analysis of U.S. welfare, employing the concepts of the economic welfare function and the oil import premium. The focus is on oil imports, with careful attention paid to account only for that portion of costs which varies at the margin with imports.

The marginal import cost (in dollars per barrel) is the incremental cost associated with a unit change in oil imports. The oil import premium is defined as the difference between the marginal social cost of imported oil and the marginal private cost. The import premium indicates the marginal social value of a long-run reduction in imports, but does not indicate the most efficient policy for achieving that reduction.

6.2 Noncompetitive Market and Disruption Costs

To the extent that the world oil market is cartelized, the United States and other consuming nations are paying higher prices for oil than they would in a competitive market. Potential cost categories which may be estimated include:

! Recoverable Cartel Rent or Excess Wealth Transferódue to higher long-run market prices (this is the marginal cost of imports beyond what would be obtained in a free market); ! Long-Run Balance of Payments Costs - sometimes called terms of trade effect; and ! Long-Run Inflationary Costs.

The long-run inflation and balance of payments/exchange rate costs of noncompetitive oil markets are not well established either theoretically or empirically. Therefore they are excluded from the final premium estimates reported. There is some empirical evidence that the patterns of production by OPEC countries are better explained by an imperfect cartel than competitive producers [Griffin (1985), Jones (1990), Dahl and Y ̧cel (1991)]. The long-run behavior of oil prices is also not well explained by exhaustible resource theory [Watkins (1992), Mabro (1992)]. Therefore, at least some of the cost above the extraction cost appears, by elimination, to be monopoly rent. However, others believe that OPEC's current exercise of market power is limited, despite its capacity to do so (Teece 1982, Bohi and Toman 1993).

Estimating the recoverable cartel rent portion of the premium has long been recognized as difficult because it requires the specification of non-U.S., and particularly OPEC, response behavior (Plummer 1981:6). The net costs to U.S. consumers could be quite high if an inelastic import demand is reduced in the face of a highly elastic world supply. Since we are uncertain about OPEC behavior, the magnitude of the monopsony premium is subject to debate. Import reduction policies could be costly (especially if done unilaterally). The marginal benefits to the United States of a coordinated policy with other oil consuming nations would be greater than those of a unilateral action, because of the global nature of the monopsony gains.

The principal premium components associated with disruptions or the risk of disruptions which mayNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 74 be estimated include:

! Increased Payments for Imports during a disruption; and ! Marginal Macroeconomic Adjustment Losses (short-run transitional macroeconomic consequences).

Each of the disruption components is an expected cost, that is, their possible values for alternative disruption sizes are weighted by the disruption probabilities. This makes disruption size and probability assumptions critical for a premium analysis. In most studies, disruption premium estimates prove to be roughly proportional to the expected price shock size during a disruption.

There is an ongoing debate about the existence and magnitude of macroeconomic adjustment losses due to price shocks. A long record of econometric analyses has repeatedly yielded evidence of a statistical relationship between oil price disruptions and aggregate macroeconomic losses. The evidence from the United States covers the period from 1949 through 1986. The relationship between oil price disruptions and macroeconomic losses does not appear to be symmetric with respect to price declines. This apparent asymmetry need not cast doubt on the statistical relationship between oil price spikes and recessions. However, some recent contradictory results using cross sectional and industry specific data indicate that further empirical analysis is needed.

Some analysts have found a substantial value for the disruption premium [more recently, e.g. Broadman and Hogan (1988), Huntington (1993)]. Others find less clear room for intervention policies [e.g. Walls (1990), Bohi and Toman (1993)]. They remain skeptical of numbers valuing oil disruption premia and question how much of the economic consequences of supply disruptions is a genuine externality and how much simply represents poor macroeconomic policy and the predictable operation of markets.

Section 5 indicates how different estimates of the import premium arise, depending on either market conditions or the effectiveness of market and policy institutions. The important uncertainties and assumptions in estimating the import premium are:

! OPEC supply behavior; ! Demand/policy behavior of other importers; ! Fraction of long-run inflation accommodated (versus eliminated through macro policy); ! Import payments recycling rate; ! Disruption probabilities; ! Disruption offsets (gross versus net shortfall distinction); ! SPR policy (size and drawdown during disruptions); ! Short-run net-import demand elasticities; ! Degree of disruption anticipation/expectation by economic agents; and ! Macroeconomic policy during disruptions.

The premium estimates, with restricted cost categories, offered for 1994 conditions range from $0 to $10 per barrel. We believe the range of greater likelihood is zero to $4.60 per barrel. The lowest estimates correspond to a world with insignificant exercise of exporter market power, a high degree of anticipation of the possibilities of oil price shocks, and no connections between oil price shocks and macroeconomic performance. The higher estimates assumes that foreign exporters of oil are exercising at least some market power and gaining monopoly rents, and furthermore that the United States can regain some of these rents by restraining imports. The high-end estimate also is basedNovember 1, 1997 ORNL-6851

41 DOD Assistant Secretary for Economic Security Joshua Gotbaum in testimony before the U.S. Senate Foreign Relations Committee on March 27, 1995 gave the $0.25 per barrel estimate. The FY 1995 incremental costs of heightened U.S. presence in the Persian Gu lf after Operation Desert Storm is $957 million, of which $225 million will be offset by contributions from other nations.

Oil Imports: An Assessment of Benefits and Costs 75 on a significant risk of future price shocks, which is only partially anticipated and hedged by private agents, and on a modest negative connection between these shocks and overall economic performance.

6.3 Military Security Costs of Oil

The strategic insurance costs for oil-related military preparedness and for the Strategic Petroleum Reserve may not vary directly with the level of imports, so they are not added to the marginal economic costs estimated here. Additionally, the allocation of military costs to oil imports is problematic, since military programs have multiple missions.

The Department of Defense estimates that the costs of Operation Desert Storm, spread over ten years of world oil consumption was roughly $0.25/BBL; spread over Persian Gulf exports for ten years it would be $1.08/BBL. 41 These are not marginal costs, however. Since the clear attribution of military expenditures to particular missions has defied resolution to date, making a reliable assignment of some portion of those costs to imports impossible at present.

6.4 Environmental Externalities Associated with Imports

Of the components omitted from the import premium estimates presented here, the environmental costs associated with incremental oil imports stem mostly from oil transportation, and are quite small, probably $0.23 per barrel or less. Furthermore, most of these costs may be internalized by the Oil Pollution Act and other laws.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 76 APPENDIX A: CALCULATION OF MAXIMUM NET BENEFITS

This Appendix shows the calculation of the oil import premium and maximum net benefits when marginal social costs exceeds marginal private costs. In general, the external cost is not completely eliminated at the import level where social net benefits are maximized.

Given the focus of the study on the costs and benefits of oil imports, it is a worthwhile analytical simplification to abstract from levels of U.S. domestic production and consumption, and just focus on the difference between the two, U.S. net import demand. The analysis then proceeds in terms of import supply and net import demand. A further advantage is that it links two variables -- U.S. oil consumption and production -- that policymakers can set to determine the third, oil imports, without requiring explicit assumptions about policy.

Figure A.1 puts the net import demand curve, the import supply curve and the marginal social cost curve together. As drawn, the marginal social costs of imports exceeds the private cost, which is given by the asking price on the import supply curve.

Figure A.1: Marginal Social Cost ScheduleNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 77 Figure A.1 shows several results. At a market quantity Q M , the oil import premium (1) is the amount by which marginal social costs exceed current prices. Q
* is the efficient level of imports, where marginal social costs equal marginal private benefits. Movement away from that point will reduce net benefits (at an import level less than Q
* , marginal private benefits exceed marginal social costs, so quantities should expand; the reverse is true for import levels greater than Q
* ). Moving imports from Q M to the lower Q
* would require giving up benefits equal to areas B + C (area under the import demand curve is total benefit), while benefitting from the cost reduction of A + B + C (area under the marginal social cost curve is total cost). As drawn in the figure, net benefits improve because the reduction in costs exceeds the loss in benefits by the area A. At Q
* , the oil import premium still exists. Thus, maximizing net benefits does not completely eliminate the oil import premium. Oil import premium (2) is the economically efficient value for the quantity Q
* . Depending on the policy chosen, a reduction in net import demand could be accomplished through increases in domestic production and/or reductions in consumption. Alternatively, diplomatic efforts might push the marginal social cost curve down toward the marginal private cost (supply) curve, closing the gap between marginal social and private costs at a given level of imports. In this partial analysis, no presumption is made about policy, and the marginal effects of changed imports are examined without accounting for any possible external costs or benefits associated with changes in consumption or production.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 78 APPENDIX B: LIMITATIONS OF THE OIL IMPORT PREMIUM APPROACH

Oil Import Premium and Quantity Reductions

The economic framework used here considers adjustment of quantities to reduce the size of the oil import premium. That is, the oil import premium is tied to the level of imports, so to reduce the premium, fewer barrels must be imported. That is not strictly necessary. For example, foreign policy actions/initiatives might influence the size of the components of the oil import premium, hence lowering the oil import premium without achieving reductions in quantities.

Uncertainties in Oil Import Premium Estimation

There are many components for which there are notable uncertainties. From previous efforts at estimating the oil import premium, the following conditions and parameters are known to be among the most important determinants of the estimated premium size:

! OPEC supply behavior. - Supply curve existence and shape; degree of supplier market power.

! Demand/policy behavior of other importers. - Importers' coordination of their policies with U.S. policy actions.

! Disruption probabilities. - Likelihood of oil supply disruptions of different sizes. - Connection between oil import level and disruption size or probability.

! Disruption offsets. - Availability of oil stocks and excess capacity to put more oil onto the market during an oil supply disruption.

! SPR policy. - Whether SPR oil is released at the onset of an oil supply disruption or held to some later time.

! Short-run net-import demand elasticities. - Responsiveness of oil consumers to oil price shocks.

! Degree of disruption anticipation/expectation. - Consumers anticipation of, and preparation for, oil price shocks.

! Sensitivity of economic activity to oil shocks.

! Macroeconomic policy during disruptions. - Monetary and fiscal policy during an oil price shock.

For greater elaboration, see the full report.November 1, 1997 ORNL-6851

42 The areas A and C are "deadweight" losses in producers' and consumers' surplus. Their marginal change for a marginal change in imports is reflected by the oil price.

Oil Imports: An Assessment of Benefits and Costs 79 APPENDIX C: CARTEL RENT PAYMENTS TO OIL EXPORTING COUNTRIES

The origin of rent payments to foreign oil suppliers because of a sustained exercise of supplier market power is shown in Figure C.1. This figure shows U.S. demand for oil, labeled D D sloping downward from left to right, indicating that U.S. consumers demand more oil as prices fall. The upwardly sloping line from left to right in the figure labeled S D is the U.S. domestic oil supply. Although the two curves cross, it is at a price above a hypothetical, perfectly competitive world price, P 1 . U.S. producers cannot match U.S. demand at world prices, so imports flow in to fill the gap. At price P 1 , the United States would produce Q S1 , consume Q D1 , and import Q D1 -Q S1 . At the higher supplier market power price, P 2 , the United States produces a greater quantity, Q S2 , consumes a smaller amount, Q D2 , and imports a smaller amount, Q D2 -Q S2 . The United States must pay morefor the oil it imports, indicated by the area B. The area B is a loss, or excess U.S. payment to all oilproducing countries. 42 Some of this extra payment is for the cost of increased world oil production but most of it is noncompetitive rent (excess profit). Rent payments within a society are not considered economic costs because they are a transfer , in this case from consumers to producers, and not a loss of real resources. Rent payments to other countries are a cost to the United States as a nation.

Figure C.1: Cartel Rents (Excess Wealth Transfer) to Oil Exporting Countries

The magnitude of these rent payments is subject to debate. For the purposes of estimating the oil import premium, it is the marginal change in rent for an incremental change in imports that matters. This, in turn, depends on the buying power of the U.S. as a large consumer. Whether the exercise of this power is appropriate depends on the degree of export market power being exercised and the threat of retaliation.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 80 APPENDIX D: MARKET POWER AND OIL MARKETS

Using Economic Policy to Change International Oil Prices

Figure D.1 shows a small importing country, e.g., Denmark, facing international oil prices. No matter what level of oil imports Denmark settles on, the price per unit will be the same. That may not be true for a very large oil importer.

Figure D.1: Oil Importer with No Market Power

Only larger importers with market power recognize that they face a rising supply curve (Figure D.2). Under this scenario, the United States could reduce oil imports from Q M to Q * , and it would pay less for imported oil in two ways. It would pay less because not only is the United States buying fewer imported barrels, but also because the price is reduced on all the imported barrels it did buy. That capability to change prices by changing demand is not reflected in oil prices. Hence, there is a potential opportunity cost if the market power is not exercised.November 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 81 Figure D.2: Oil Importer with Market Power

The United States would not want to exercise buyer market power if world oil market suppliers acted competitively. Exercise of buyer market power, however, could be justified if there were evidence of supplier market power being used. Although not believed universally, the weight of the evidence supports an interpretation of seller market power in international oil markets. If, however, oil suppliers are exercising market power, then supply curves are not well defined. That is because suppliers have enough market power to set prices where it best suits them along buyers' demand curves, rather than in any particular relationship to costs of production and normal profit, as would be the case in purely competitive markets. Thus, buyers with market power can move along a supply curve, while sellers with market power can move along demand curves. But neither supply nor demand curves are well defined if both sellers and buyers have market power. There is no clear solution to the situation where both sellers and buyers have market power.

To get estimates of the economic opportunity costs, the assumptions are made that the United States as a large importer does have market power. International oil prices reflect seller market power, so there is justification for the United States to take action and the degree of seller retaliation will be limited to offsetting some or all of the U.S. imports reduction. The cartel supply response used in this analysis incorporates all strategic interactions among sellers and buyers with market power.

Using Foreign Policy to Change International Oil Prices

The United States is deeply interested in the course of events in the Middle East where most of the world's exportable oil is produced and where most of the world's reserves are located. The military intervention by the U.S.-Allied coalition to reverse Iraq's conquest of Kuwait shows that the United States is concerned not just with oil supplies but with who controls those supplies. Given that thereNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 82 are large amounts of oil under the control of countries with small populations and weak military forces, the Persian Gulf War may not prove to be the last military intervention by the United States that will affect oil supply.

In addition to, or possibly in lieu of, using military expenditures to secure foreign policy goals related to oil security, diplomatic initiatives might be capable of reducing the exercise of cartel power and of reducing both gross and net supply disruption probabilities. These are the two principal sources of any oil import premium which may exist, leaving room for foreign policy as an instrument for reducing social costs of imports.November 1, 1997 ORNL-6851

43 Mork (1989) found, dividing the sample period into segments before and after the 1986 oil price collapse (beginning the second period at 1986:2), that the same model would not fit both periods. This prompted him to examine separate variables for oil price increases and decreases. Otherwise using the same model, the third and fourth quarter lags of the oil price increase variable were negative (both -0.049) and highly significant. The sum of all four coefficients was -0 .144. Mory (1993), using annual data from 1951- 1990, obtained a GNP elasticity of -0.0551, highly significant statistically. With separate variables for oil price increases and decreases, controlling for government purchases and M2 money supply, the GNP elasticity of oil price increases was -0.0671, again statistically significant. Also Mork, Olsen and Mysen (1994) applied essentially the same model as Mork (1989) to the experience of seven OECD countries over the period 1967:3-1992:4. For the United States, the contem poraneous price increase and the first and second quarterly lags were significant, and the sum of the coefficients was -0.054, controlling for money supply changes.

Oil Imports: An Assessment of Benefits and Costs 83 APPENDIX E: NEW EVIDENCE ON THE RELATIONSHIP BETWEEN OIL PRICE SHOCKS AND THE MACROECONOMY

Many of the questions that were current in parts of the literature on the macroeconomic consequences of oil price shocks as recently as 1995 have been largely resolved by new research. A substantial part of this research was sponsored by DOE's Office of Policy in 1996, conducted by independent academics, and presented in a conference in Washington in October of that year. The advisory panel for this effort included Knut Mork, Douglas Bohi, William Hogan and Hillard Huntington. A notebook containing the papers and a summary of the findings is available from Dr. Inja Paik, PO-81/7H-085, USDOE, 1000 Independence Avenue S.W., Washington, DC 20585 (202-586-5589) or from Dr. Hilary Smith, same address (202-586-4295).

In our study on oil imports benefits and costs, the relationship between macroeconomic adjustment losses and sudden oil price shocks is summarized by a parameter called the ìelasticity of GDP with respect to oil price.î This parameter essentially indicates the percentage change in GDP per 1% change in oil price, in response a price shock. Those skeptical about the importance of oil shocks have both criticized this approach and suggested that the GDP loss rate is small, and perhaps even close to zero if one were to properly account for the adverse effects of misguided macroeconomic policies during previous shocks. However, recent studies and new information, including data from the period of the Gulf War crisis, indicate that the elasticity of GDP with respect to oil price is certainly non-zero, and is probably higher than the value of -0.025 that was previously assumed in the DOE90 SPR study.

The earliest inquiries into the GDP-oil price relationship indicated a substantial and strong relationship. Many of the values for GDP elasticity in common use in the early-to-mid 1980s centered around -0.05 (Hamilton 1983, or see EMF 1987 for a sample of early estimates). However, the oil price drop of 1986 did not yield a GDP gain comparable to the GDP losses that had been observed after the price increases of 1973 and 1979. When this observation was included in the statistical studies it led to lower and less significant GDP elasticity estimates. This fact and other doubts which were raised by some researchers (particularly Bohi 1989, 1991) about the reliability of the relationship led to the use of a more modest number (-0.025) in the 1990 DOE SPR size study. Since that study, two threads of research have restored the credibility of the original -0.05 estimate, if not even higher ones.

First, a series of new aggregate econometric studies was conducted to explicitly account for the prospect of a different (asymmetric) response of the economy to positive and negative price shocks, to account for some macroeconomic policy variables, and to include more years of data up to and including the 1991 Persian Gulf event. Research which estimated the GDP elasticity include Mork (1989), Mory (1993), and Mork, Olsen and Mysen (1994)

. 43 These studies generally found elasticities consistent with -0.05 or higher, as well as evidence of strongly asymmetric responses to positive and negative price shocks. For a survey of the research up to 1995 on the macroeconomic impact of oil shocks, see Jones and Leiby [1996]. Second, in 1996, four new studies were commissioned by Oak Ridge National Laboratory on behalfNovember 1, 1997 ORNL-6851

Oil Imports: An Assessment of Benefits and Costs 84 of the U.S. Department of Energy, to focus specifically on the doubts which had been raised by those who were skeptical about the oil price-GDP relationship. These new studies are: Hamilton 1996, Hooker 1996, Davis and Haltiwanger 1997 and Davis, Loungani, and Mahidhara, 1997. Prior to this research, some doubts had been raised regarding whether historical oil price shocks really had substantially contributed to the economic recessions which followed them. The new research shed considerable light on these issues, in each case reinforcing the view that oil price shocks are important influences on macroeconomic activity. The workshop was successful in resolving a number of key issues and paradoxes relating to the macroeconomic consequences of oil price shocks. For example, the research on job creation and destruction showed that indeed we can observe quite significant sectoral dislocations and micro-phenomena in response to oil price shocks. These effects are observable both in individual industries at the 4 digit SIC level (Davis and Haltiwanger 1997) and in state-by-state, aggregate employment data (Davis, Mahidhara, and Loungani 1997). The disaggregated results also strongly supported a view of oil price shocks as allocative disturbances, initially causing job losses in some industries and regions, followed later by job creation elsewhere.

The research confirmed that GNP effects are indeed asymmetric with respect to price increases and decreases, but emphasized that this asymmetry is a natural consequence of the way price shocks affect the economy, not a paradox. The research also undermined optimism that structural changes have occurred in the U.S. economy and the oil market which have reduced the importance of oil shocks, or eliminated their significance altogether. Had a structural change occurred, this would mean that oil price-GNP models which work well up to the mid-1980s would no longer apply, and we should see evidence of structural instability in the econometric estimates as recent history is added. Hooker (1996) showed that when the oil price movements are transformed to account for the nonlinearity of their effect on GNP, and when the analysis is properly conditioned on macroeconomic policy, the relationship between oil price shocks and GNP is both structurally stable and quite significant all the way through recent history. Subsequent events may modify the stability of the exact specification found, but the identification of a stable relationship for the turbulent 1970- 1992 period does undermine the hypothesis that the old oil price-GNP relationship must have changed.

Overall, however, this research demonstrated beyond any doubt that oil price shocks are important business cycle events, even though key features of how they attain that importance remain to be understood better. For further discussion of the findings of these studies and the Workshop which reviewed them, see Jones, Bjornstad and Leiby, 1997. For these reasons it now appears that the current state of knowledge is more indicative of a GDP elasticity closer to -0.05 than the previously used -0.025.November 1, 1997 ORNL-6851

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