Encouraging Petroleum Imports Is A Dumb Idea

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Includes: BNO, BRK.A, BRK.B, BYDDF, CNQ, CRUD, E, OIL, PBR, SSL, TOT, USO, YPF
by: Tristan R. Brown

While I hadn't originally intended for the discussion from "A Science Lesson For Charlie Munger" to be spread across two articles, several commenters raised a number of excellent points that I would like to expand upon due to their macroeconomic and investment implications. As a brief refresher, last week the Berkshire Hathaway ((NYSE:BRK.A), (NYSE:BRK.B)) Vice-Chairman expressed his opposition to energy independence and stated that policymakers were "stupid on this single issue" for promoting it. Mr. Munger further stated that "running out of hydrocarbons is like running out of civilization" and, for this reason, the U.S. should keep its domestic petroleum reserves underground for the inevitable global shortage, consuming foreign petroleum in its stead. Finally, he called for government intervention to correct what he sees as a failure by the free market to account for "basic science." He explicitly called for supporting new forms of energy that can reduce our petroleum consumption starting with "big national grids," which I assume was an oblique reference to Berkshire Hathaway's investment in battery-electric vehicle maker BYD (OTCPK:BYDDF). (He certainly didn't mean corn ethanol, which landed in his "dumb idea" category several years ago.) The logical conclusion of his statement that the pending hydrocarbon shortage is so important that we should "ignore these signals from the market" is that some sort of government intervention is required to both restrict domestic production and encourage imports.

As I've pointed out, Mr. Munger was incorrect when he described the ability of scientists to mix up vats of hydrocarbons as being "conceivable" but unlikely; this is already being done via biorenewable pathways on a commercial scale. Biorenewables aside, however, his contention that "foreign oil is your friend not your enemy," even if that friendship is relative to a doomsday shortage in which the world runs out of hydrocarbons, is also incorrect. To understand why it is useful, look at the recent history of government interventions to subsidize imports of "essential" goods and the extremely negative outcomes of these efforts.

The U.S. trade deficit

Many investors are familiar with "Hubbert's Peak," which was a theory advanced in the 1950s and 1960s that U.S. petroleum production, which was steadily growing at the time, would peak sometime in the early 1970s and then begin a steady and long-term decline. The notion was so unpopular that its originator, petroleum geologist M.K. Hubbert, was supposedly turned away from industry conferences as a result. He ended up being correct, of course (see figure), at least until the technological breakthroughs of the last decade made unconventional reserves accessible.

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One important consequence of declining domestic production was an increased reliance on imports of foreign petroleum, much of it from the Middle East. This resulted in economic disaster during the "Twin Oil Shocks" of the 1970s when trade embargoes cut the U.S. off from the largest exporters, causing the prices of petroleum products to skyrocket to levels not seen on a real basis for another three decades (see figure). Many early U.S. efforts to increase energy independence began during this period, although most of them ultimately faltered during the glut of the 1980s and 1990s.

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The potential of geopolitical supply disruptions is not the most lasting legacy of the 1970s, however. Petroleum also become an important contributor to the U.S. trade deficit, especially as prices began to rise again in the 21st century. By 2001, petroleum imports were responsible for more than half of the U.S. trade deficit (see figure).

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While this fraction fell in subsequent years, its decline was due to a doubling of the value of the imports not attributable to petroleum rather than an actual decline in the absolute value of the petroleum imports (see figure). In 2008 and 2009, petroleum's fraction approached 50% a second time before subsequently falling to a level not seen since at least 2001.

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Source: U.S. Census Bureau

The trade deficit is often viewed as a symptom of declining American competitiveness (or, in the current political vocabulary, "exceptionalism") and the outsourcing of corporate jobs to less expensive operating environments. More than just a symptom, however, the U.S. trade deficit is also believed to be one of the deeper causes of the 2008 financial crisis. Conventional thought on the macroeconomic effects of international trade is that trade deficits and surpluses always balance out in the end, since each side of the trade uses a different currency that can then only be used to purchase goods from the home country. In practice, however, countries trading with the U.S. over the last decade favored one asset in particular, the supply of which happened to be booming: U.S. federal debt (see figure). Foreign ownership of U.S. Treasury securities climbed, ensuring that the dollars that U.S. trading partners received in exchange for their goods (such as petroleum) came back to the U.S. not in exchange for U.S. goods or services, which would have driven U.S. economic growth, but instead in exchange for debt. This demand for debt pushed U.S. interest rates down across the board, driving the supply of debt and systemic risk rather than economic growth. The stage was set for the 2008 financial crisis.

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Source: Wikipedia

Recognition of the U.S. trade deficit's distortional impact on the economy caused President Obama in 2010 to set the goal of doubling U.S. exports within five years. With only two years to go, the country is clearly on the wrong track, with the most recent monthly trade deficit data showing an 8% increase in the size of the trade deficit since Obama's announcement. That the deficit isn't even worse is due to the declining share of the trade deficit attributable to petroleum, both as a fraction of the total and in absolute terms. The portion of the May 2013 trade deficit (the most recent for which data is available) attributable to petroleum was $12.4 billion, or roughly half of its October 2005 value of $24.3 billion. A return to the 2005 figure would have increased the May 2013 trade deficit to more than $64 billion (compared to the January 2006 record of $71 billion). The decline in U.S. petroleum imports in absolute terms can be attributed to a number of factors, including increased domestic production, higher CAFE standards, and increased fuel ethanol consumption.

While the U.S. trade deficit is still much too large to prevent distortional effects, that it has declined at all is largely due to the 50% fall in the absolute value of the share attributable to petroleum imports. Mr. Munger's proposal to reverse course and replace domestic petroleum production with foreign imports would cause the U.S. trade deficit to surpass even the highs of the last decade. In 2012 the U.S. produced 2.4 billion barrels of petroleum domestically. Had this volume been instead imported from abroad at the 2012 average import price of $101.11/bbl, then the current monthly trade deficit would be $72.5 billion. This figure was never reached on a real basis during the trade deficit "crisis" years of 2005 and 2006. While quantitative easing by the Federal Reserve has pushed foreigners out of U.S. Treasuries, that program will end at some point. Meanwhile, the lack of any serious efforts by President Obama and Congress to tackle the federal deficit ensures that the supply of federal debt will continue to be high when that time comes. The U.S. government should be encouraging efforts to shrink the trade deficit under these circumstances, not increase it in the manner that an increased reliance on foreign petroleum would.

Import subsidies

The unspoken but logical result of Mr. Munger's proposal to replace domestic petroleum production with foreign petroleum imports via government incentives would be an either explicit or implicit subsidy of those imports. (An example of an implicit subsidy of petroleum imports is government military spending used to keep the Persian Gulf open to petroleum tankers.) Economic historians are very familiar with the Smoot-Hawley Tariff Act that was passed by Congress in 1930, which raised tariffs on a very large number of imported goods. While the goal of the legislation was to promote economic growth via protectionism and head off what ultimately became the Great Depression, America's trading partners retaliated with tariffs of their own and U.S. exports plummeted, causing the very economic harm that it was intended to prevent. In the words of Federal Reserve Chairman Ben Bernanke, the tariff legislation was "highly counterproductive" and "contributed to the depth and length of the global Depression."

While less common, import subsidies can spark a similar type of trade war among international trading partners. In its perverse way, the logic underlying import tariffs and import subsidies is quite similar: both are implemented with the goal of increasing the supply of critical goods to the domestic population. The only difference is that import tariffs operate with a longer timeframe since they limit supply until such time as the domestic industry can meet domestic demand, thereby insulating it from trade disruptions. Given this similarity, it shouldn't come as a surprise to learn that past attempts by countries to maximize their domestic supply of a critical good via import subsidies have been met by similar measures in other countries, ultimately causing more harm than would have otherwise occurred.

In late 2007 and early 2008, the prices of several food staples increased by 100% or more; rice prices increased by an astounding 200% in less than a year. Journalists and policymakers, forgetting that rice isn't a biofuel feedstock, quickly blamed U.S. producers of first-generation biofuels and "food versus fuel" entered the lexicon shortly thereafter. It was only later that researchers identified a far more mundane cause behind the price increases: an accounting error. Specifically, the country of Vietnam sold more rice than it owned and, when its leaders became aware of the mistake, imposed limitations on exports. India, fearing that this move was the first sign of a failed rice harvest, quickly did the same and grain prices began to increase. Major rice importers such as Saudi Arabia responded in the worst possible way by subsidizing rice imports to counteract the price increase. Consumption in these countries promptly soared and rice prices continued their upward climb as a cycle of export bans and import subsidies swept the globe (see chart). Ultimately it was discovered during the summer of 2008 that the "failed" rice harvest was actually a bumper crop, and rice prices fell to their pre-panic levels as quickly as they had risen.

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Thailand 100% broken rice prices, 2007-2009 ($/ton). Adapted from Heady (2011).

It's easy to see how a similar increase in prices could occur as the result of Mr. Munger's proposal to increase petroleum imports via government intervention. First, as Mr. Munger pointed out, petroleum-based hydrocarbons are the basis of modern civilization, with the developed and developing worlds alike utterly reliant upon them. Why would the U.S. be the only country to place enough importance on them to merit subsidizing or otherwise encouraging petroleum exports? Second, given both the speed with which past efforts to subsidize imports have swept the globe and the magnitude of the price increases resulting from these subsidies, it is easy to envision how quickly Mr. Munger's plan would collapse under the weight of financial self-interest and public outcry. How long would the American people allow a moratorium on domestic production to stand if a gallon gasoline cost more than $5? How long would their representatives ignore the outcry in an election season? History again offers us a clue: during the 2000 presidential election, eco-warrior and then-Vice President Al Gore called for the release of petroleum from the Strategic Reserve to protect the American public from the punishing gasoline price of... $1.98 per gallon (in 2013 dollars).

For the sake of argument, however, let's assume that domestic reserves remained in the ground even as petroleum prices soared. Perhaps the federal government would mitigate the effect of the high price on consumers by directly subsidizing it (although, as we saw in 2008, that sort of measure can just make matters worse). The effect of this move on the trade deficit would make the levels reached in 2005 and 2006 pale in comparison. This effect would be particularly pronounced since the starting fraction of the deficit attributable to petroleum imports would already be larger than in the past. The macroeconomic situation would be unsustainable, particularly if the cost of the petroleum subsidies was met via the issuance of additional federal debt.

Conclusion

As this article shows, Mr. Munger's proposal to replace domestic petroleum production with foreign imports is a "dumb idea," to use his trademark phrase. U.S. policymakers are still struggling to do more than pay lip service to the lessons of the 2008 financial crisis in terms of the trade deficit, but they have at least established the goal of doubling exports by 2015. Mr. Munger's proposal would instead double the value of petroleum imports, effectively dooming efforts to reduce the U.S. trade deficit. Furthermore, in 2007 and 2008 the world experienced a drastic rise in the prices of grain staples that was ultimately determined to have been caused by a giant cycle of export bans and import subsidies that swept the globe. Past experience suggests that any attempt by the U.S. to replace domestic petroleum production with imported petroleum would be imitated by other major petroleum consumers around the globe, bringing Mr. Munger's plan to a rapid and painful end.

Fortunately for us, the "silly economists and politicians" who support energy independence appear to hold the most sway at the moment, and it is unlikely that Mr. Munger's proposal will come to fruition. In the event that it does gain traction, however, investors could position themselves to benefit. First, the global price of petroleum would likely increase due to the decrease in U.S. production and increase in national import subsidies that would result. While U.S. E&P companies would not benefit, their foreign counterparts such as Canadian Natural Resources (NYSE:CNQ), Eni (NYSE:E), Petrobras (NYSE:PBR), Sasol (NYSE:SSL), Total S.A. (NYSE:TOT), and YPF (NYSE:YPF) would experience increases in both market shares and the values of their reserves. Investors could also purchase The United States Brent Oil ETF (NYSEARCA:BNO), which tracks the price of Brent crude. Other options such as iPath S&P GSCI Crude Oil Total Return Index (NYSEARCA:OIL), Teucrium Crude Oil (NYSEARCA:CRUD), and The United States Oil Fund LP (NYSEARCA:USO), follow the price of WTI crude and would therefore be less attractive, since WTI prices would likely be suppressed relative to Brent prices by U.S. import subsidies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.