President Obama and members of Congress are calling for a sharp reduction in the substantial direct subsidies to American oil companies. Many countries also give an indirect subsidy to oil producers and refiners by subsidizing the purchase of gasoline. In Saudi Arabia, for example, subsidies have reduced the price of a liter of gasoline (1 gallon equals about 3 ¾ liters) to 12 cents, which had made gasoline there cheaper than bottled water. The largest subsidies to gasoline are usually found in oil producing countries: Saudi Arabia, Iran (although the Iranian government greatly reduced gasoline subsidies in 2010), Russia, Venezuela, Indonesia, and the UAE. Yet, the economic case for either direct or indirect subsidies to the production and refining of oil is quite weak.
One argument commonly made for subsidizing gasoline prices, especially when, as at present, oil prices are rising rapidly, is that this helps the poor. Yet these subsidies disproportionately favor the middle classes and the rich since poor families in general, and especially those in developing countries like Indonesia, Egypt, and Iran, are much less likely to own cars, and the poor drive fewer miles with the cars they do own.
Since subsidies lower the retail price of gasoline, this increases the demand for gasoline. Especially after subsidies have been in place for a number of years, the response of demand to lower gasoline prices is substantial as consumers drive more miles, shift consumption toward gas-guzzlers, keep older cars on the road longer, and make other adjustments that increase the consumption of gasoline. Government-owned oil producers in countries that subsidize the purchase of gasoline must divert more of their production to domestic use, and hence are prevented from getting the world price for this oil used domestically. Subsides obviously harm poor countries like Egypt that have subsidized gasoline so much that it has gone from being self-sufficient in oil to becoming an importer of oil.
The United States and other developed countries like Japan and those in Europe tax rather than subsidize gasoline consumption. The US is also a large producer of oil, and as I indicated at the beginning, the US does directly subsidize oil producers. Although estimates of the exact value of these subsidies vary, most analysts put them at several billion dollars per year. One justification frequently given for subsidizing domestic producers of oil is that this increases domestic oil production at the expense of imports. Greater domestic production is considered valuable because of national security concerns about the availability of imported oil during world crises, especially oil from the unstable Middle East and from Russia.
However, a fiscally better way to meet national security concerns would be to tax oil imports rather than subsidize domestic producers since an import tax would bring in additional tax revenue, whereas subsidies to oil companies are financed by tax revenue. Also better than subsidies to oil producers would be for the US to encourage rather than discourage offshore drilling for oil, and greater drilling on government-owned lands. President Obama has just indicated that he is taking steps to allow greater oil and gas drilling offshore and on public lands.
From an American national security point of view, the development of effective hydraulic fracturing, or “fracking”, methods to recover natural gas from rocks deep underground is a godsend since the US has enormous reserves of such gas-among the two or three largest in the world. Some states are encouraging greater natural gas production through fracking, although others have severely restricted the use of this procedure because of environmental concerns. Fracking pumps enormous amounts of water deep underground, and this could contaminate water supplies, although the level of this risk is still controversial.
As this discussion indicates, energy policy depends on more than national security concerns since global warming and local pollution caused by fossil fuels are also important. Domestic oil may be better than imported oil from a national security viewpoint, but it is worse from a pollution perspective since producing and refining oil causes local pollution. Domestic natural gas produced through fracking methods directly causes some local pollution, but it is less harmful to the environment than domestic coal, which is the main alternative to natural gas for electricity generation.
A potential alternative to greater domestic production of fossil fuels is much greater output from other sources of energy, like nuclear power, wind, and solar power, which all cause little pollution and are domestically produced. The governments of the US and of many other countries already heavily subsidize wind power and solar energy. Nuclear was making a return to popularity, but the disaster in Japan has as least temporarily greatly stalled its return. Some subsidy may be justified for these alternatives, but energy from either wind or solar is unlikely ever to be produced at a reasonable cost on a large enough scale to replace fossil fuels as the major source of energy. I still support expansion of nuclear power, but the safety issue clearly needs further attention.
It would be preferable to limit subsidies to wind and solar, and increase government support of basic research on various alternative ways to either produce energy, such as with batteries, or contain the pollution from oil, coal, and natural gas. The private sector generally has weak incentives to work on basic research since the results of such research are not patentable. Clearly, governments have very imperfect incentives as well, but still some government help to the private sector seems warranted for basic research in the energy field that is looking for effective ways to reduce pollution and find alternative sources of energy.