The American Half-Trillion Dollar Problem

As I primer to this section, I must note two things.

• I'm not an economist nor do I have much academic training in economics.
• I'm not an alarmist--I did not buy any candles, canned foods or bottled water in the days before Y2K; I took the Spadina streetcar (unmasked) during the SARS outbreak in Toronto; and I didn't think that World War III was imminent on September 11^th, 2001.

That said, I do think the U.S. crude oil trade deficit numbers are quite alarming. In this post I'll try to explain why.


What's so Alarming?
The U.S. is the third biggest producer of oil in the World. Most people don't know this because it's overshadowed by the fact that they are also the World's largest consumer of oil (they use 23% of global production). The difference is a 15.5 million barrel a day trade deficit. The worst part about this is is that with declining domestic oil production, rising prices, and relatively stagnant demand, the problem seems poised to get considerably worse in future years and there's no end to the problem in sight. Below is a chart of domestic (United States) crude oil production.

As you can see, production peaked in 1970 and spiked again in 1985 due to heavy investment initiatives following the 'oil crisis' of the early seventies. With the subsequent decline, despite record prices, is a clear that as a whole, oil production in the United States is in the late stages of Secondary recovery and in many areas Enhanced Oil Recovery (EOR). This means higher production costs for lower recovery rates. Few areas on American soil remain unexplored (Alaska for example still has some potential). This declining trend is not going to miraculously reverse itself, and the crude oil trade deficit will likely only widen.


Why didn't Government do anything?
What's clear is that the Bush administration realized not only that the US was "addicted to oil", but also that this could present a serious problem for the future. In their defense, I'm not sure anyone anticipated such high prices at this time (NYMEX CL:$127/bbl on May 19, 2008). One thing Bush's administration did was to push the development of "clean coal" technology knowing the abundance of domestic coal supplies. Secondly, they banked on the idea that Enhanced Oil Recovery projects could somehow stop the declines of domestic oil supply by subsidizing these projects. Recall in my last post (How High Will They Go?) I used the analogy of drying clothes to illustrate how much more difficult and expensive it is to remove the last bit of fluids from mature reservoirs. I now see advertisements on US television networks noting that the United States has plenty of domestic oil reserves to meet demand. While there is still plenty of domestic oil, it won't be coming out of the ground quickly or cheaply. I'm not sure who paid for these ads but it could have been the Independent Petroleum Association of America (IPAA) who are looking to get more government subsidies. Bush has repeatedly begged OPEC to raise quotas to no avail, but Saudi Arabia has recently agreed to raise production by 300,000 barrels a day. This could help bring down prices a bit in the coming days.


Didn't the U.S. invade Iraq to secure supply?
Haha. Well, many people certainly believe this, but I will try to avoid the controversy of this claim and just state the facts. The stated reasons for the Iraq War were weapons of mass destruction (before) and humanitarian causes (after). It could just be a coincidence that Iraq also has the second largest volume of proven conventional oil reserves in the world at 112 billion barrels. Still, I can't think of a good explanation why former Secretary of Defense Donald Rumsfeld had a change of heart after cordial meetings with Saddam Hussein in this 1983 video from the National Security Archives. Regardless of the reasons, even if oil security were the true goal of the war in Iraq, then it undoubtedly failed in this regard. Iraqi oil production is down about 400,000 barrels a day since the start of the war. Prices have gone up steadily since news of the war broke, and instability in the region is now much higher than it was under Saddam Hussein. An very recent op-ed in the Boston Herald has some more perspectives on this (link).


How big is the problem?
At the oil prices of the last century, the deficit wouldn't present too much of a problem other than during the oil embargo years. Now, it adds more than half a trillion dollars to the trade deficit each year (assuming a very conservative oil price of $90/bbl). Perspective: US$500 billion is about the same as total annual U.S. military spending! And it means indirect funding of countries like Iran and Sudan, who sell their oil to other countries at near-market prices. The chart below shows the monetary deficit in inflation-adjusted 2007 US dollars (with consumption and production rates plotted on the right axis as areas). It is only plotted up until the end of 2007. If oil prices average $120 a barrel in 2008, Americans will be paying US$1.8 billion a day in exchange for foreign oil imports. Thankfully Canada will get to add nearly 20% of this to its GDP.


Consequences?
I would liken it to a huge battleship going full speed and then having a giant anchor thrown overboard. Initially, it may have enough momentum to keep going for awhile, but unless action is taken quickly, it will slow and come to a dead stop. Some of the more pessimistic economists I have heard claim the American economy is in worse shape for the future than it was at the start of the great depression. I personally don't see this level of severity because with 25% of the world's oil consumption, a recession alone should reduce demand enough to bring down oil prices. Another saving grace is that many of the international oil and gas corporations are American, which means they will bring some of this deficit back into the country in the form of profits.


What next?
Well, certainly dwelling on the past won't do anything. But solutions need to be found, and quickly. Next up is a look at America's energy options for the future. Keep it locked..