Don't Panic

A few weeks ago we were facing the prospect of $100 oil by Christmas. Now it appears we might get there this week. As we wrestle with appropriate responses, it's important to remember that we didn't get into this pickle overnight. It has been coming on since at least 2003, when oil prices began the steady climb that has brought them to this level. On a deeper level, however, we've been headed for this juncture since 1991, the last year in which US oil production increased and our imports of crude oil and petroleum products fell. And just as it took more than a decade to reach this point, it's going to take longer to work our way out of it than anyone might wish.

The graph below shows how US demand for liquid fuels has been met, going back to 1975. The steady decline of US oil production since the mid-1980s is clearly visible, as is the steady rise in demand and the resulting growth of imports, which increased in every year from 1992 to 2005, dipping slightly in 2006--though not because of any drop in the demand for refined products.

Data from US Department of Energy, Energy Information Agency website

The thin yellow slice between oil production and imports reflects the impact of biofuels on an energy-equivalent basis. It's mostly ethanol, and even at last year's record production of 4.86 billion gallons, it barely registers at this scale. Expanding the current ethanol mandate from 7.5 billion gallons per year in 2012 to 36 billion gallons, as the President and the Senate have proposed, would reduce our oil imports--at the expense of higher imports of natural gas--but won't close the enormous gap we've created over the last 15 years. Nor is it clear how much further corn ethanol output can expand in the near term, or when next-generation cellulosic ethanol will be available at a competitive cost.

I'm not suggesting this is purely a US problem. Oil trades in a global market, and the rapid economic expansion in Asia has been a big contributor to global demand growth. However, we are still by far the world's largest oil importer, taking more than Japan, China and Germany combined. Trends here have a disproportionate effect on the whole market, not least through the influence of US oil futures on the price of physical oil.

If we look at the next few years, the only strategy that could make a meaningful dent in the problem is conservation, and in that timeframe it wouldn't come from improvements in fuel efficiency, but from changes in our daily consumption patterns. And that's why this problem appears so intractable. The short-term elasticity, or price response, of petroleum products isn't just low because of structural limitations around commuting to work and taking the kids to their activities, but because even at $3.00/gallon the economic benefits we derive from motor fuels far exceed their cost. The trick will be finding ways to bring down petroleum consumption without destroying the economic value its use has created. Achieving that is going to require more efficient cars and more effective biofuels than what we have today, and neither of these will arrive in time to affect the price of oil in 2007 or 2008.