speculations on an oil tariff

Assuming that the United States decides to impose a $25 per barrel tariff on all imported oil (crude and product) – and Canada and Mexico were not exempt — let’s explore how this might affect:

a. The volume of oil imported into the United States?

Volume responses to a $25 tariff would vary over time. In the near-term, there would only be a negligible decrease in the volume of oil imported (given a low short-run elasticity of energy demand) as industries, supply chains, and consumers remain highly dependent on existing petroleum infrastructure. The redistribution of the tariff (with tax reductions) would partially offset the incremental cost to businesses and consumers, but the policy is unlikely to completely offset the macroeconomic effects of a 33% increase in a key industrial input.

In the mid-term, as industries and generators begin to shift away from higher-cost imported oil, domestic oil producers might begin building out untapped Arctic capacity and utilities might begin diversifying their energy portfolios into lower-cost fossil fuels and alternative energy technologies. Together, these processes should cause a more substantial decline in import volumes.

In the long-run, a more fundamental shift away from a high-carbon, high-cost, oil-dependent economy is likely to unfold, at which point oil imports would begin to decline more precipitously as demand for energy is almost completely replaced with lower-cost substitutes. This progression is an example of a typical “adjustment lag”.

b. The world price of oil?

Again, in the very short-term we might expect a modest decline, partially offsetting the cost of the tariff. Given that America is one of the world’s largest energy importers (importing roughly 2/3rds of its annual consumption), it would still need to source oil externally or risk seizing up its industrial capacity. Thus, aggregate import demand would remain relatively stable and prices would likely settle somewhere between $75 and $100.

Over the mid-to-long-term, major OPEC suppliers would have room to lower prices given their lower relative cost of production, while growing demand from China and India would partially offset declining American demand.

Finally, as the U.S. begins to substitute away from oil as a key energy input in the long-run, global aggregate demand for oil will inevitably decrease, assuming that emerging market demand doesn’t continue to grow at its current pace in perpetuity. This will put considerable downward pressure on prices over time as oil exporters adjust to a situation of extended excess supply-at least while total global oil reserves remain relatively plentiful.

c. The domestic price of oil?

With stable near-term volumes of oil imports, domestic producers will be able to undercut the combined $100 price of global oil by a considerable margin. That said, given profit motives and diminished competition, it is unlikely that they will continue to sell oil domestically at $75/barrel. A more likely near-term equilibrium would be slightly higher than $75 (absorbing some of the $25 tariff as profit). These higher prices (and profits) should stimulate increased investment in the oil industry, particularly in the country’s untapped Arctic reserves.

In the mid-to-long-term, as import dependency declines along with domestic demand, domestic oil prices should decrease in step with global prices.

d. The volume of domestic oil production?

Given a competitive cost advantage, you would expect the volume of domestic oil production to increase after the tariff was imposed, as industrial oil consumers shift purchases toward lower-cost domestic suppliers. However, this substitution is subject to the availability of additional domestic production. Given that American production has been declining since the 1970s, it is unlikely that such additional domestic supply would be available without significant advances in extraction technique.

e. The price of oil in Europe compared to the United States?

In the near-term, the price of oil would likely be lower in Europe than in the United States, with an absence of similar protectionist policy and exposure to global oil prices.

In the longer-term, as global aggregate demand declines with falling U.S. demand, you would expect European prices to decline as well. However, USD/EUR currency fluctuations or a shift of global oil markets from New York to London might also affect the European price in domestic/regional currency terms.

f. The price of coal in the United States?

Given America’s considerable natural bounty and coal’s potential as a low-cost substitute for oil in the generation of electricity, prices will likely increase in the near-term as utilities and governments rush to invest in coal-fired power generation to diversify away from comparable oil-based facilities. The price of coal, however, will also be affected by any carbon pricing legislation, a particularly likely outcome if the country shifts a sizeable portion of its generating capacity from lower-emitting oil to high-emitting coal.

g. The size of the United States’ current accounts deficit?

The size of the US current accounts deficit would likely decline as a result of lower imports and the incremental foreign transfers generated by the tariff. Over time, as reliance on foreign oil diminishes, the current account will continue to decline as imports decline relative to exports. One mitigating factor is the volume of oil-intensive exports (plastics, chemicals, etc.) that would become less competitive as a result of higher domestic oil prices.

h. The cost of petroleum based fertilizer in India?

There might be upward pressure on petroleum-based fertilizer supplied by the U.S. into India, but other global producers in Canada, the FSU, Europe and elsewhere who are unaffected by the tariff could make up for uncompetitive American supply and keep Indian prices from rising. American exporters would suffer economically, but given their lack of dominant market share, Indian markets would likely be insulated from any tariff policy, and may even benefit over time from falling global oil prices as input costs decline among competing global suppliers.

i. OPEC sales of oil?

In the short-run, OPEC sales volumes would likely remain stable, given inelastic demand in America, but over time prices would be expected to come down as the cartel competes for shrinking American demand. As long as the cost of production in OPEC is $25 less than the cost of production in the U.S., OPEC could still sell into the American market at a profit. Given the $2 cost of extraction in Saudi Arabia (for example) and a $15-$25 cost in the U.S., it isn’t unreasonable to expect that OPEC could reduce their prices enough to compete with American domestic production and still earn a handsome profit-albeit with lower total sales.

j. Efficiency of European auto fleet?

As oil prices come down over time, there might be less pressure on European legislators to regulate fuel economy into the European fleet or encourage the shift toward biofuels. That said, investments in these technologies and the infrastructure required to support them have been underway for years. Europe has embraced oil resource scarcity and is committed to environmental responsibility, and is consequently shifting away from petroleum dependence. Lower oil prices may slow R&D in hybrid or electric vehicles and the infrastructure to support them, but considering the other benefits of fuel economy that Europeans value-beyond the price competitiveness of their transportation fuels-the auto fleet will probably continue to pursue long-term efficiency gains.