Energy Independence or Interdependence? Integrating the North American Energy Market

“Let us set as our national goal,” President Richard Nixon proclaimed more than a quarter-century ago, “that by the end of this decade we will have developed the potential to meet our own energy needs without depending on any foreign sources.”

Although President George W. Bush’s energy plan is a lot less utopian, and indeed has certain merits, one of its suppositions, too, seems to be that Americans will be better off if they reduce “reliance on foreign energy.” During the 2000 election campaign, the Bush camp rhapsodized about bygone days when “one of America’s greatest strengths was its energy self-sufficiency.” The theme has since been reiterated frequently, for the United States now produces at home less than half the oil it uses. In the words of the House majority whip, Tom DeLay, “America faces a serious degradation of our national security unless we move at once to reduce our dependence on foreign sources of energy.” (Which “foreign sources of energy”? Presumably, we are not debating inflows from friendly places like Canada and Mexico. But hold on; I will return to that subject shortly.)

Cobbling at Home

For all its persistent political fascination, the self-sufficiency logic is fundamentally flawed. In 1973 the United States imported little more than a third of the petroleum it consumed. Yet the U.S. economy then proved far more, not less, exposed to the shock of rising international oil prices than it was two years ago when those prices soared again while our dependence on foreign oil reached an all-time high. The extent of a nation’s vulnerability, in other words, is not a function of how much energy it produces domestically or buys from abroad. Britain, for instance, produces more oil than it needs. But its self-sufficiency scarcely shielded British consumers from the sudden spike in gasoline prices in the summer of 2000. The reason is simple. Petroleum prices everywhere are set in a world market—and no country, even a net exporter, can readily repair to an energy policy that says, in effect, “Stop the world. I want to get off.”

More consequential for economic stability than the share of fuel supplied by foreign sources is a nation’s relative energy-intensity and susceptibility to inflationary pressures. To produce a dollar of GDP, America today requires about 30 percent less energy than it did 30 years ago. So our economy now is less vulnerable to the effects of energy price increases. The economy is also far less inflation prone than it was in the 1970s. Consequently, even the tripling of global crude-oil prices between 1998 and 2000 did little damage.

Although you might not know it from listening to the rhetoric in Washington, this country still produces all but about a quarter of the “energy” it needs. Yes, imports of oil have increased (mostly because Americans choose to drive far more, and use much less efficient motor vehicles, than do consumers in other industrial countries), but imported oil is just one part of the picture. Nearly all of what propels the nation’s electric generators—coal, gas, nuclear power, hydropower, and non-hydro renewables—is domestically produced. About 85 percent of our primary heating fuel, natural gas, is made in the U.S.A. (almost all the rest comes from Canada).

The quest for ever-greater energy independence was fanciful in Nixon’s time and would be no less quixotic today. The days when the United States was a low-cost producer of oil are history. Squeezing additional supplies from the remaining domestic reserves will require increasingly elaborate operations, many of which may be prohibitively expensive if proper environmental safeguards are factored in and if world prices sag, as they have repeatedly in the past 15 years. In a free market, it is hard to see how such projects can compete with various foreign sources where production costs are lower. Most of the oil extracted by the Organization of Petroleum Exporting Countries (OPEC) costs less than $5 a barrel to produce.

It is wasteful to insist on making at home those commodities that can usually be supplied more cheaply from somewhere else—just as it makes no sense for me to cobble my own shoes instead of “importing” them from a shoe store. Funneling scarce resources into enterprises in which we no longer have a comparative advantage means leaving less capital and labor available to other industries—ones that could put those resources to better use. Society’s living standards are lowered, not secured, by the pursuit of autarky.

Prudent Policy

All this is not to say that no additional reserves of oil are worth recovering within U.S. territory. Wherever feasible, they should be found and used. Adding their output to the world’s supply is desirable, just as it is worthwhile to get more from any industry that can competitively make products the world needs.

Nor do I mean to suggest that a disruption of the global oil supply would no longer have an adverse impact on the U.S. economy. Suppose that another crisis in the Middle East were to take a large volume of oil—say, 7 million barrels a day (mbd)—off the market. Suppose, also, that after drawing down perhaps 2.5 mbd from strategic petroleum reserves no other sources were available to make up for the shortage. Brookings economist George L. Perry estimates that the world price of crude could hit $75 a barrel. An increase that big could add as much as 5 percentage points to inflation and would promptly deepen the recession throughout the industrialized world.

Clearly, building up emergency stockpiles in the industrial countries is the first line of defense against such a disruption. Having access to spare production capacity outside the disrupted fields is also helpful. If the strategic reserves contribute 2.5 mbd and the extra capacity could add 1 mbd, a potential 7 mbd loss would be reduced by half. Under these circumstances, according to Perry, the price of oil would go to only $32 a barrel, so that regular gasoline would cost roughly $1.75 a gallon—a change well within the range of price variation in recent years. But notice: the surge capacity is a global, not a national, imperative. As long as it is available somewhere amid the earth’s extensive assortment of reliable producing areas, much of the global shortfall (and the price shock for American consumers) will be offset.

Some of this cushion already exists. The supply side of the international petroleum market today is a lot more diversified than it was in the dark days of 1973, when the Arab oil embargo wrought havoc. The share of oil the United States buys from the Persian Gulf now represents less than a quarter of U.S. oil imports, down from almost 30 percent in 1980. Fully half of the oil we import comes from within the Western hemisphere. A number of large suppliers, outside OPEC as well as within it, are not operating at full capacity. If past is prelude, they would almost certainly put more oil on line amid the high prices of a tight market.

To gain additional insurance in an economically efficient fashion over the longer haul, policymakers should enhance trade relations with the stable suppliers that have abundant energy resources. Conveniently, at least two of them happen to be in the immediate vicinity. President Bush, to his credit, has spoken of the “need to recognize the energy potential of our neighbors, Canada and Mexico.”

Opportunities in North America

The United States is the world’s second largest producer of oil, Mexico the eighth. But with proved reserves around 23 percent larger than those of the United States, Mexico holds considerable promise for increased production. The same goes for our northern neighbor. No country, not even Saudi Arabia, exports more oil to the United States than does Canada. In the years ahead, Canada is likely to make a larger contribution as much more output from recent discoveries, such as Newfoundland’s enormous Hibernia Field, comes on stream. The bulk of Canada’s hydrocarbon resource base is still unrecoverable at current prices and with existing technology, but it is potentially immense. Alberta’s oil sands, for instance, might contain the equivalent of an estimated 300 billion barrels of oil, more than all of Saudi Arabia’s proven reserves. To put matters in perspective, if eventually even just one-quarter of this source were to become available, it would meet all the combined demand of both countries for nearly a decade (at current rates of consumption).

Opportunities for expanded development and trade of natural gas throughout North America ought to be more fully exploited as well. Canada now furnishes around 14 percent of U.S. requirements. New fields are being developed off Canada’s east coast between Newfoundland and Nova Scotia. In addition to providing heating fuel for Nova Scotia and New Brunswick, the offshore source could at last bring an end to New England’s anomalous dependence on heating oil.

More could be done. Vast quantities of gas, possibly several hundred trillion cubic feet, remain untapped in an area stretching across the Western Canada Sedimentary Basin to Alaska. Known deposits in Alaska and the Yukon alone exceed 70 trillion cubic feet—more than three years of total U.S. consumption at present levels. Official estimates of Mexican proven reserves of natural gas are reportedly half that, but recent estimates by the Gas Technology Institute suggest that as much as 65 trillion cubic feet of gas could turn up in the Burgos Basin of northeastern Mexico.

The importance of bringing more natural gas to the North American market cannot be overstated. Gas can readily displace oil in various ways—as a heating fuel, as a fuel for electric generators (substituting for the oil-fired ones that comprise about half of Mexico’s generating capacity, for example), and to an extent, even as a transportation fuel. More important, this relatively clean-burning fuel is the leading alternative to coal. To meet America’s anticipated demand for electricity in the near future, as much as 200,000 additional megawatts of electric power may have to be produced nationwide. Across the continent, power plants will spew fewer air pollutants, particularly greenhouse gas emissions, if they are powered by natural gas instead of coal.

NAFTA’s Unfinished Business

The energy markets of the United States, Canada, and Mexico would have realized more of their potential by now if the North American Free Trade Area (NAFTA) had integrated them more completely. But in the energy sector, NAFTA stopped short of achieving a truly open framework for trilateral trade and investment.

The main roadblock remains on the Mexican side, where constitutional provisions, nationalistic sentiment, and raw politics combine to maintain state-owned monopolies that retard growth of that country’s oil, gas, and electricity industries. According to the World Bank’s estimates, Mexico ought to be financing approximately $10 billion each year in energy development and infrastructure just to meet its own projected demand, never mind those of its trading partners. Yet, Petróleos Méxicanos (Pemex) is required by law to transfer as much as a third of its annual revenues to the Mexican treasury. During 2000, close to $30 billion in Pemex earnings was turned over, funding 37 percent of the government’s general budget but leaving the company unable to plow adequate revenues back into new exploration and production. Not only do Pemex and the public power company, Comisión Federal de Electricidad (CFE), perennially underinvest; the system of national enterprises (and, in the case of CFE, underpriced electrical rates) also discourages private investors from underwriting Mexico’s essential energy projects.

Most of the liberalization of energy trade has been between Canada and the United States. By the time NAFTA was ratified in 1993, Canada had jettisoned the statist energy regime it had erected some 15 years earlier. The government-run monopoly, Petro-Canada, was largely privatized. Gone as well were restrictions on foreign ownership and obstructive price regulations, including the mercantilist practice of imposing supra-market export prices. The result was a rapid rise in Canadian exports after 1983, especially to parts of the American West. By 1991 Canadian natural gas was satisfying approximately 25 percent of California’s gas consumption.

Canada, unlike Mexico, did not insist on major exclusivity provisions for energy industries under NAFTA. Thus U.S. and Canadian interests have launched important cooperative ventures in recent years. The Alliance Pipeline—extending over 2,300 miles from western Canada to Chicago—is probably the most striking example. The jointly financed line can carry 1.4 billion cubic feet of gas to the Midwest, and connecting links will eventually deliver a substantial share to locations as far away as Pennsylvania and New York.

But U.S.-Canada energy flows still are not entirely unfettered. Ottawa can negotiate international trade treaties, but jurisdiction over the disposition of natural resources rests with the provinces. Local disputes over key decisions, such as the routing of natural gas lines from the Arctic to the continental United States, continue to cause delays.

All three NAFTA countries could save energy and score big environmental gains if their electric utility grids interfaced seamlessly. Fewer additional generating facilities might be necessary in the future if power could be readily wheeled around the continent to wherever it is needed. But inadequate transmission capacity, unsynchronized connections, and insufficient deregulation (open access) in various local systems continue to pose obstacles. The deficiencies, moreover, are not limited to links between the United States and Mexico, where cross-border sales of electricity are still negligible. To a degree, problems also persist in and among U.S. regions and some Canadian provinces.

What Next?

The United States is not likely to be well served by any national energy strategy that favors, in effect, a buy-American bias when international trade can meet a sizable share of our energy requirements more affordably. Recent events, if anything, underscore this conclusion.

To succeed without massive subsidies, government policies to encourage homemade energy would have to be supported by a sustained period of steep market prices and also by a long suspension of politics as usual. Neither is likely. The ink was barely dry on the Bush administration’s National Energy Policy when market prices shifted unexpectedly. Natural gas, which had run to $10 per 1,000 cubic feet in early 2001, was closer to $3 by last summer and headed lower. Crude oil plunged from about $30 a barrel in early September 2001 to around $17 a barrel by mid-November. Everywhere, including California (where spot prices of electricity had briefly soared), the energy “crisis”—and thus the urgency of having a “plan”—had faded.

In any case, even the best-laid energy plans are perforce politicized. The Bush initiative is no exception. In the name of furthering “energy independence,” a multitude of interest groups make a pitch for their pet projects. Never mind how costly, amid the legislative logrolling any homespun energy scheme—from ethanol farms to synthetic fuels—can make headway. By the time the House of Representatives had finished with the president’s proposals, for example, it had authorized more than $5 billion in subventions to promote an oxymoron: “clean coal.” (Power plants using coal treated by so-called fluidized bed technology still emit about 10 times more smog-causing nitrogen oxide than do comparably sized plants fueled by natural gas.)

Instead of futile planning to quarantine “foreign energy providers,” U.S. policy should seek deeper integration with some of them, especially the ones next door. In accordance with the aspirations of NAFTA—a genuinely open market for commerce and investment—the three member countries need to be shedding more of their anachronistic energy regulations. In particular, Mexico should be urged to privatize Pemex and the CFE. Before his election President Vicente Fox had intimated that the Mexican government ought to reduce its reliance on Pemex as a cash cow. One way for the United States to encourage reform south of the border might be to swap liberalized immigration rules up here for a firm commitment to restructuring (or, at a bare minimum, much lighter taxation) of the state-controlled energy industries down there.

The United States and Canada, too, can take additional steps congruent with the free-market principles of NAFTA. The installation of new power lines linking U.S. and Canadian utilities, for example, will lag as long as regulators on both sides of the border prevent the utilities from profiting fully from these investments. And negotiating other vital regulatory reforms with our trading partners is complicated by the perpetuation of what they deem to be U.S. trade barriers. Some Canadian provinces complain that “mandated renewable portfolios” in many U.S. states (which allocate substantial market shares of electricity sales to U.S. producers of renewable energy) interfere with exports of electric power from Canada. In 1999, a coalition of independent U.S. oil producers asked the Commerce Department to impose anti-dumping duties on Mexican crude oil.

If politicians in Washington are serious about improving America’s energy security, they would do well to clear away such hindrances, and in Mr. Bush’s words, “make it easier for buyers and sellers of energy to do business across our borders.”