Oil, Security, and Energy Independence

Fred Smith, FedEx founder and chairman, is a dedicated advocate of free marketsexcept when it comes to energy, which he believes requires government intervention

The man who built FedEx (FDX) into one of America's most successful companies calls himself a "market liberal," which is more or less the opposite of a political liberal. FedEx Chairman, President, Chief Executive, and founder Frederick Smith wants government to keep its hands off business as much as possible. He even sits on the board of directors of the Cato Institute, which advocates "limited government, individual liberty, free markets, and peace." In a speech last year to Cato benefactors, he said: "It is impossible, from a managerial standpoint, for the federal government to do the things it is trying to do today."

But on one important issue—energy independence—Smith opposes the Cato line and actually advocates greater government involvement. Smith believes so strongly that more must be done to secure U.S. energy independence that he became co-chairman of the Washington-based Energy Security Leadership Council, along with General P.X. Kelley (Ret.), former Marine Corps commandant and member of the Joint Chiefs of Staff. This month, the council put out a 64-page report detailing what it thinks should be done. Among the proposals: higher, though more flexible, standards for vehicle fuel efficiency; incentives to manufacture hybrid gasoline-electric vehicles in the U.S.; funding for research on alternative fuels; and government permission for energy companies to drill for oil in Alaska and the Outer Continental Shelf.

To Smith, the danger of energy independence was illustrated on Dec. 14, when OPEC voted for a 2% production cut—its second cut in two months—even though oil is above $60 a barrel (see BusinessWeek.com, 12/14/06, "OPEC Shuts Off the Spigot").

In the Wrong Hands

Smith's divergence from the small-government credo of the Cato Institute has put him at odds with Cato's staff experts on energy. To dig into why Smith favors government intervention in the energy sector, though not elsewhere, BusinessWeek on Dec. 14 interviewed Smith and separately contacted Cato analyst Jerry Taylor, a senior fellow specializing in energy issues.

Smith told BusinessWeek he doesn't see his position with the Energy Security Leadership Council as a departure from his free-market principles because "the oil market is anything but a free market." Says Smith: "Quite the contrary, it's a cartel, which were it operated in the U.S., would result in a violation of many U.S. laws. About 90% of the world's proven oil reserves today are not owned by private companies. They're owned by national companies, many of which are arms of states that have a great antipathy toward the U.S."

In Smith's view, taking a free-market approach to dealing with the OPEC cartel is "like going out to play basketball and the other team is ready to play football. It's an enormous economic and national security risk for the U.S."

Factoring Military into the Equation

His main solution is to make the U.S. less dependent on oil, which is primarily used as a transportation fuel. "We need reduced energy intensity," Smith says. "The reason the U.S. has not had a much more severe reaction to the runup of oil prices over the last several years is the relative improvement in energy efficiency. If the country doesn't take steps to do that again in the future, and we continue on the path that we're on, then we will have at some point almost certainly a major national security challenge or a severe economic disruption much, much greater than we've gone through."

Smith has a bachelor's degree in economics from Yale University, so he knows how to state his case in economics lingo. America is using too much oil, he says, because the producers and consumers of oil aren't taking into account the full cost of oil, which includes military expenditures to secure access to foreign sources of petroleum. In economics jargon, dependence on hostile or unstable oil-producing nations is a "negative externality" of consuming oil. Says Smith: "We spend $50 billion to $60 billion on protecting the oil supply line. Iran has threatened to shut down the Straits of Hormuz. Russia just withheld natural gas supply from Europe."

Cato's Taylor isn't afraid to disagree with Smith even though Smith sits on the organization's board. "Let's be real here," says Taylor in an interview. "Everybody on our board probably disagrees with us on something. My sense is that Fred agrees with us more than he disagrees with us."

Textbook Economics

Says Taylor: "I don't think energy security is a very real worry right now. You can always have as much oil as you want as long as you're willing to pay for it."

Taylor says he's not sure whether OPEC is all that effective in keeping the price of oil above where it would be in a completely free market. But in an e-mail, Taylor writes: "To the extent that governments interfere in oil markets, they do so by restraining production which, in turn, produces oil prices that are too high, not too low. This means that we consume less oil than is optimal from a theoretical perspective."

Taylor's argument is textbook economics: In the absence of price controls, the economy will use a certain amount of oil based on its costs and benefits. The problem with a cartel is that by driving up the price of oil, it causes the economy to use less than the most efficient amount. In short, suppressing oil consumption is inefficient. Taylor continues, "The report in question, however, suggests that the right remedy for governmental action that produces less oil than is optimal is to move away from oil altogether. This makes little sense to me."

Issue of National Security?

That's fine for pure economics, but what about Smith's national security argument? Taylor responded to this question by referring BusinessWeek to a recent blog post about Smith's report, called "Another Blue Ribbon Energy Report Falls Flat."

In short, Taylor argues that no oil producer can stop oil from reaching the U.S. Even if one nation—let's say Iraq—were to stop selling oil directly to the U.S., it would have to sell it to some other country. That country, in turn, could resell it to the U.S. Writes Taylor: "As long as someone is willing to buy oil from a producing state and then sell it to the U.S., no shut-off is possible absent military force."

That leaves the possibility that some important producer will shut down its fields deliberately to drive up the price of oil and damage the world economy. Not likely, Taylor writes: "Producers need oil revenues more than consumers need the oil. Even vitriolic anti-American regimes such as revolutionary Iran, Iraq under Saddam Hussein, and Libya prior to our recent rapprochement, have shown no interest in committing the economic and political suicide entailed in shutting down the only significant source of revenue they have."

In the end, arguments about energy independence aren't based purely on economics. For Smith, who served in the Marines during the Vietnam War, there's an emotional aspect as well. "One big difference is, I've seen up close and personal what the cost of military conflict really is," Smith says. "With two years in Vietnam under my belt, I don't want to see a bunch of American kids fighting 15 years from now over an issue that could have been solved if the U.S. had treated this as a national security issue. A lot of people forget that the triggering event of World War II was the U.S. oil embargo against Japan. I just want the price to go up at a modest, sustainable rate and for oil not to be a source of economic depression in the U.S."