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VOL. 1, NO. 4
APRIL 2006

EconomicLetter
Insights from the

FEDERAL RESERVE BANK OF DALLAS

Running on Empty?
How Economic Freedom Affects Oil Supplies
by Stephen P. A. Brown and Richard Alm
Oil prices have marched upward in recent years, ending nearly

The extent of economic

two decades of relatively cheap energy. The weekly benchmark price for

freedom in the countries

a barrel of West Texas Intermediate rose from $32.20 at the end of 2003

with the world’s oil

to $42.56 at the end of 2004 and to $59.49 at the end of 2005 (Chart 1).

supplies will greatly

In April 2006, oil reached an all-time high of more than $75 a barrel,

affect how well that

measured in current dollars.1

oil is delivered

In explaining today’s high oil prices, many analysts point to surg-

to consumers.

ing demand from China, India and other rapidly industrializing countries
and cyclical growth in U.S. consumption. When added to existing demand
from Europe, Asia and elsewhere, these increases have outstripped any
gains in global production and reduced excess capacity to near zero. The

More than half the world’s oil
lies in countries that exercise
excessive state control.

EconomicLetter 2

FEDERAL RESERVE BANK OF DALLAS

analysts expect economic development to continue apace in China and
India, with their appetites for oil
growing as fast as or faster than their
economies.2
Are we running out of oil? The
question always arises when oil prices
spike. Some experts—including
Matthew Simmons, author of Twilight
in the Desert: The Coming Saudi Oil
Shock and the World Economy—argue
that world oil production is at or near
its peak and prices will just continue
to rise, perhaps toward $200 a barrel
or more. Industry veteran T. Boone
Pickens also sees oil prices going
nowhere but up.
The center of gravity among energyindustry experts isn’t as alarmist. The
U.S. Energy Information Administration,
the International Energy Agency and
Daniel Yergin’s Cambridge Energy
Research Associates all see sufficient
oil resources to supply generations to
come. Price pressures will moderate as
new production reaches the market.
Today’s proven reserves total 1.3
trillion barrels, but the U.S. Geological
Survey estimates the world’s remaining
conventional resources at 2.6 trillion
barrels.3 Canadian tar sands boost the
estimate to 2.8 trillion barrels.
Keeping the global economy
chugging—including the Chinas and
Indias—requires about 85 million barrels a day. At current rates of use, 2.8
trillion barrels should last 90 years.
Most likely, oil use will continue to
rise, but conventional resources and
tar sands should still be sufficient for
60 to 70 years. Other unconventional
oil resources, such as shale oil, will
greatly extend the time horizon at
which we run out of oil.
Having oil is one thing. Delivering
it to a growing market is another.
World economies differ greatly in their
capacity to organize enterprises, adopt
new technologies, raise capital and
supply what consumers want. When it
comes to increasing oil production,
economic systems matter quite a bit.
More oil would flow onto world markets and prices would be lower if

major oil resources were in countries
where producers responded freely to
market incentives. The extent of economic freedom in the countries with
the world’s oil supplies will greatly
affect how well that oil is delivered to
consumers.
Where the Oil Is
The world’s oil wealth is concentrated in a relatively few countries.
Four of the five nations with the
largest oil reserves are in the Middle
East: Saudi Arabia at 267 billion barrels, Iran at 133 billion barrels, Iraq at
115 billion barrels and Kuwait at 104
billion barrels. Canada joins the top
ranks on the strength of Alberta’s tar
sands, which have expanded Canada’s
oil-producing potential by a factor of
15. Taken together, the top five
nations account for three-fifths of the
world’s oil reserves.
Oil reserves are also large in the
United Arab Emirates, Venezuela,
Russia, Libya and Nigeria. Adding
these countries to the big five producers raises the total to 86 percent of
world reserves. Significant oil deposits
can be found in a dozen or so other
countries, including the United States,

More oil would flow
onto world markets and
prices would be lower if
major oil resources were
in countries where
producers responded
freely to market
incentives.

Chart 1

Oil Prices Keep Rising
Dollars per barrel
80

70

60

50

40

30

20

10
’97

’98

’99

’00

’01

’02

’03

’04

SOURCE: The Wall Street Journal.

FEDERAL RESERVE BANK OF DALLAS

3 EconomicLetter

’05

’06

Table 1

Proven World Oil Reserves, 2006

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30

Saudi Arabia
Canada
Iran
Iraq
Kuwait
United Arab Emirates
Venezuela
Russia
Libya
Nigeria
United States
China
Qatar
Mexico
Algeria
Brazil
Kazakhstan
Norway
Azerbaijan
India
Oman
Angola
Ecuador
Indonesia
United Kingdom
Yemen
Egypt
Malaysia
Syria
Gabon
World total

Billions
of barrels

Percent of
world
reserves

Cumulative
percentage

266.8
178.8
132.5
115.0
104.0
97.8
79.7
60.0
39.1
35.9
21.4
18.3
15.2
12.9
11.4
11.2
9.0
7.7
7.0
5.8
5.5
5.4
4.6
4.3
4.0
4.0
3.7
3.0
2.5
2.5

20.6
13.8
10.2
8.9
8.0
7.6
6.2
4.6
3.0
2.8
1.7
1.4
1.2
1.0
0.9
0.9
0.7
0.6
0.5
0.5
0.4
0.4
0.4
0.3
0.3
0.3
0.3
0.2
0.2
0.2

20.6
34.4
44.7
53.6
61.6
69.2
75.4
80.0
83.0
85.8
87.5
88.9
90.0
91.0
91.9
92.8
93.5
94.1
94.6
95.1
95.5
95.9
96.3
96.6
96.9
97.2
97.5
97.8
97.9
98.1

1,292.5

100.0

SOURCES: Oil and Gas Journal; authors’ calculations.

EconomicLetter 4

FEDERAL RESERVE BANK OF DALLAS

Mexico, Qatar, Algeria and Norway.
The top 20 countries control more than
95 percent of the world’s oil wealth;
the top 30, 98 percent (Table 1).
The economic policies in these
countries will determine whether
future supplies of oil will keep up
with growing demand.
Oil and Economic Freedom
Relieving the current upward
pressure on world oil prices requires
getting more oil resources out of the
ground and into the supply chains
that feed corner gasoline stations, airlines and electric power plants.
Economic logic and history tell us that
free enterprise systems, with their
reliance on private capital formation
and incentives, better direct resources
to efficiently meet consumer needs. In
a market economy, oil producers, just
like the makers of soft drinks and
computers, respond to higher prices
and expand capacity and output.
Oil exploration and production
require huge investments over long
periods. In the United States, Canada
and countries with a history of stability
and relatively free markets, these commitments involve a strictly economic
calculus. Much of the oil that could
slake global demand, however, lies
under nations that don’t embrace markets as fully. Some subject their
economies, including oil resources, to
extensive state control. Others are
politically unstable or corrupt. Where
markets are underdeveloped, decisions
on oil exploration and production are
skewed by garbled economic signals,
bureaucratic red tape and an uncertainty that leads to greater risks, higher costs, widespread inefficiency and
distorted incentives.
The Heritage Foundation compiles an annual ranking of nations’
willingness to allow markets and private enterprises to guide production.
On a scale of 1 to 5—best to worst—
Heritage’s economic freedom index
rates countries on policies that govern
trade, investment, finance, government
spending, money supplies, labor mar-

ket flexibility, state intervention and
property rights. Heritage assigns
grades, classifying economies as free,
mostly free, mostly unfree or
repressed.4
Just three of the 30 countries that
control nearly all of the world’s oil
wealth score highly enough to be
among the nations that Heritage categorizes as free—the United Kingdom,
the United States and Canada (Table
2). These countries rely on private
companies to run their energy industries, but they have only 16 percent of
world reserves, almost 90 percent of it
in Canada. The United States passed
its production peak in the 1970s, and
the United Kingdom may have done
so recently. Neither is likely to add
much to conventional world oil supplies.
Another six of the top producers
earn Heritage’s mostly free rating.
Because Saudi Arabia, Kuwait and the
United Arab Emirates are in this
group, it possesses a lot of oil—38
percent of the world’s reserves. The
reasonably good Heritage rating indicates these countries’ economies are
stable and functional, but in each of
these countries, the oil industry is controlled by the state rather than private
enterprises.
The remaining countries with significant oil reserves—a total of 21, with
44 percent of the verified oil in the
ground—are laggards in the Heritage
rankings, either mostly unfree or
repressed. They aren’t good candidates
for increasing oil production because
their economies are suspect and their
oil industries are state-controlled.
Iran maintains one of the world’s
most closed economies. Venezuelan
oil production has flagged since
President Hugo Chavez sacked many
key people in the government-run oil
company. Civil unrest has troubled
investment in Nigeria, a country that
operates its oil industry through concessions to foreign companies. Iraq,
which Heritage doesn’t currently rate,
doesn’t seem to be the place to boost
investment and oil production as long

Table 2

Oil Economies’ Freedom
Heritage
freedom
index

Percent
of world
reserves

25
11
2

Free
United Kingdom
United States
Canada
Total

1.74
1.84
1.85

0.3
1.7
13.8
15.8

18
5
14
1
6
28

Mostly free
Norway
Kuwait
Mexico
Saudi Arabia
United Arab Emirates
Malaysia
Total

2.29
2.74
2.83
2.84
2.93
2.98

0.6
8.0
1.0
20.6
7.6
0.2
38.1

21
13
16
30
23
12
17
15
20
8
19
27
24
22
26
29

Mostly unfree
Oman
Qatar
Brazil
Gabon
Ecuador
China
Kazakhstan
Algeria
India
Russia
Azerbaijan
Egypt
Indonesia
Angola
Yemen
Syria
Total

3.01
3.04
3.08
3.28
3.30
3.34
3.35
3.46
3.49
3.50
3.51
3.59
3.71
3.84
3.84
3.93

0.4
1.2
0.9
0.2
0.4
1.4
0.7
0.9
0.5
4.6
0.5
0.3
0.3
0.4
0.3
0.2
13.2

10
7
9
3
4

Repressed
Nigeria
Venezuela
Libya
Iran
Iraq
Total

4.00
4.16
4.16
4.51
–

2.8
6.2
3.0
10.2
8.9
31.1

NOTE: 1 = most free, 5 = least free. Heritage does not currently rate Iraq.
SOURCES: The Heritage Foundation; authors’ calculations.

FEDERAL RESERVE BANK OF DALLAS

5 EconomicLetter

Table 3

Big Oil, Big Government
Percent of
world
reserves

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29

Cumulative
percentage

Iran
10.2
Syria
0.2
Saudi Arabia
20.6
Kuwait
8.0
Nigeria
2.8
Oman
0.4
Angola
0.4
United Arab Emirates 7.6
Libya
3.0
Qatar
1.2
Algeria
0.9
Brazil
0.9
Yemen
0.3
Venezuela
6.2
Mexico
1.0
Norway
0.6
Indonesia
0.3
Egypt
0.3
China
1.4
Azerbaijan
0.5
India
0.5
Malaysia
0.2
Gabon
0.2
Kazakhstan
0.7
United Kingdom
0.3
Canada
13.8
Russia
4.6
United States
1.7
Ecuador
0.4

10.2
10.4
31.0
39.1
41.9
42.3
42.7
50.3
53.3
54.5
55.4
56.2
56.5
62.7
63.7
64.3
64.6
64.9
66.3
66.9
67.3
67.5
67.7
68.4
68.7
82.6
87.2
88.9
89.2

Government
intervention
index

5.0
5.0
4.5
4.5
4.5
4.5
4.5
4.0
4.0
4.0
4.0
4.0
4.0
3.5
3.5
3.5
3.5
3.5
3.0
3.0
3.0
3.0
3.0
2.5
2.5
2.0
2.0
2.0
1.5

NOTE: 1 = most free, 5 = least free. Iraq is not included because Heritage does not
currently rate it.
SOURCES: The Heritage Foundation; authors’ calculations.

EconomicLetter 6

FEDERAL RESERVE BANK OF DALLAS

as its future remains clouded by insurgencies and political uncertainty.
Taking into account state control
of petroleum resources provides a
somewhat different view of oil and
market forces. The Heritage Foundation’s
freedom index includes a measure of
government intervention, based in part
on the share of revenues derived from
state-owned enterprises. In petroleumrich countries, this almost always
means oil.
On this scale, more than half the
world’s oil lies in countries that exercise excessive state control (Table 3).
Governments dominate Middle East oil
production, with countries fully owning
the industry or allowing only minority
partners from the private sector.
Two-thirds of the oil reserves are
in nations Heritage rates as mostly
unfree or worse on government intervention. Adding Iraq, a nation with a
history of state control, the proportion
climbs above three-quarters.
Although today’s prices give private companies incentives to drill for
oil, government ministries don’t
always take full advantage of market
opportunities. They may be mired in
red tape. They may treat the oil industry as a cash cow, choosing to rake in
revenue without incurring the costs of
investing in new capacity. They may
prefer to reap the gains of monopoly
prices.5 Saudi Arabia, for instance,
maintained a relatively constant capacity to produce oil from 1994 to 2001.
It has increased its capacity only a little over the past five years. Mexico
has considered inviting foreign investment into its energy sector, but government-owned Pemex retains control
and has done little to expand capacity.
Heritage’s government intervention score applies to the entire economy, not just the oil sector. Russia’s relatively good ranking on this measure
doesn’t reflect the fact that Moscow
ministries remain a dominant player in
the energy industry. Despite recent
overtures to attract foreign investment
to the oil industry, the 2004 takeover
of Yukos, a previously private and

richly endowed producer, still casts a
cloud over Russia’s energy sector.
Implications for Oil Prices
A large part of the world’s oil
reserves are outside the easy reach of
free markets, with their incentives and
disciplines. Oil prices are rising—not
because the world is running out of
oil but because the bulk of reserves
are in countries where market incentives cannot work fully or in the
hands of monopolists who may be
exercising their power by restraining
investment.
Because of the mismatch
between reserves and economic systems, today’s oil prices are higher
than they would be in a world of free
markets. Tomorrow’s oil prices are
likely to be higher, too, because producers, divorced from market incentives or with an incentive to restrain
production, are likely to underinvest
in new capacity.
High oil prices have flooded the
oil producers with cash. At the same
time, they’ve strained household
budgets in the consuming countries.
So far, though, the economies of the
United States, other major industrial
nations and the newly industrializing
countries have continued to grow.
They’ve withstood the price shock
because greater energy efficiency has
made them less dependent on oil and
supplies have risen to meet increasing
demand.
Even so, many consuming
nations are concerned about the
prospects of continued upward pressure on oil prices as markets tighten.
They wonder how much more their
economies can endure. A future of
ever-escalating oil prices doesn’t bode
well for economies in many parts of
the world.
To a great extent, rising oil prices
are self-limiting. Higher oil prices
encourage conservation and development of unconventional oil resources
and alternative fuels. Higher oil prices
should also help overcome at least
some of the difficulties in developing

the vast conventional reserves not
fully connected to the market. In the
long history of natural resources, the
prospect of scarcity and higher prices
has provided ample incentive for
innovation.
Brown is director of energy economics and
microeconomic policy analysis and Alm is
an economics writer in the Research
Department of the Federal Reserve Bank of
Dallas.

Because of the mismatch
between reserves and
economic systems,

Notes
The authors thank Julia Carter and Raghav
Virmani for research assistance.
1 Using inflation-adjusted dollars, oil would have
to reach $96 a barrel to match the record set in
April 1980.
2 For China and India, the income elasticities of
oil demand are about 1.4, which means oil consumption rises 14 percent for every 10 percent
increase in gross domestic product. Year-to-year
changes in energy efficiency slightly dull the
income effect on oil consumption.
3 Conventional oil resources are those produced
by drilling wells. Unconventional oil resources,
such as tar sands and shale oil, are produced
through other technologies.
4 Data for this discussion are from The Heritage
Foundation, 2006 Index of Economic Freedom.
The Fraser Institute produces an index with
country rankings similar to those shown here but
provides less extensive coverage of oil-producing
nations.
5 See “OPEC’s Incentives for Faster Output
Growth,” by Dermot Gately, The Energy Journal,
vol. 25, no. 2, 2004, pp. 75–96.

FEDERAL RESERVE BANK OF DALLAS

today’s oil prices are
higher than they would
be in a world of
free markets.

7 EconomicLetter

EconomicLetter

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