Monday, September 08, 2008

When Is Cheaper Oil Bad?

Talk about a reversal of fortunes. A mere two months since oil was flirting with $150 per barrel, OPEC is considering production cuts to defend a $100 price floor and reputable journals are suggesting that $80 could soon be in sight. Whether this is interpreted as the popping of a speculative commodities bubble or the market's rational response to slowing demand from a weakening global economy, cheaper oil would present policy makers with a dilemma. In particular, it could force some of them to consider unpopular steps to rein in demand, since the market may stop doing that for them.

Cheap is in the eye of the beholder. Not many years ago, forecasts of $80/bbl oil seemed unrealistically high, and $100 belonged in the realm of fantasy. The inflation-adjusted high from the last energy crisis equates to around $94/bbl in 2008 dollars, so until oil finally crossed the $100 mark, we could comfort ourselves with comparisons suggesting that our problems hadn't yet attained the same scale as in the 1970s and '80s. When crude oil approached $120 in April, the average US gasoline pump price hit $3.50/gallon, and US demand began to drop with a vengeance, compared to the prior year. The shock waves from $4 gasoline in June and July are still reverberating. Yet if crude continued its slide and ended up near $80, and refining margins remained as weak as they have been, we would shortly see pump prices beginning with a "2", again.

The benefits for the US economy would be substantial. At $80/bbl, our national oil import bill would be more than $150 billion per year lower than with $120 oil. Gasoline at $2.75/gal., instead of $3.75, represents a $140 billion boost for consumers, larger than the proposed second stimulus package. Lower prices, however, would also inevitably lead to higher demand. That might begin to strengthen oil prices again, creating something of a roller-coaster effect. More importantly for those concerned about climate change, it might reduce the urgency of the switch to more fuel-efficient vehicles, putting a greater burden on other planned policies to manage US greenhouse gas emissions.

Some of the other implications of a respite from high oil prices look helpful and less politically stressful. US carmakers need a couple of years to retool to produce more efficient cars here, similar to the ones they already make in Europe. As long as the oil-price decline was broadly viewed as temporary, resulting from factors likely to reverse again, once the global economy resumed strong growth, they wouldn't be tempted to ease up on their efforts. And they must still meet a 35 mile-per-gallon fleet-average fuel economy standard within a few years. The same logic would probably hold for airlines that need time--and profits--to bring more fuel-efficient planes into their fleets and reconfigure their route systems.

Nor would lower oil prices necessarily be bad for the alternative energy sector. Ethanol makers are expanding production to fill a federal mandate, and their sales to refiners and gasoline blenders wouldn't be hurt much if ethanol reverted to costing more than wholesale unleaded gasoline. And renewable electricity technologies such as wind or solar power should be largely unaffected, since their output doesn't compete with oil, and their funding doesn't derive from it--yet.

On balance, then, the negatives of falling oil prices might be felt most severely by two groups with as little in common as one could possibly imagine: oil companies and politicians. As long as oil prices were going up, Senators, Representatives and presidential candidates could support measures to reduce greenhouse gas emissions, while simultaneously arguing that fuel prices were too high. Now, if oil prices keep dropping, the disconnect between lower fuel prices and lower emissions will become more evident. Environmental groups would push harder for Congress to enact measures to control CO2, such as cap & trade or a carbon tax, either of which would translate into higher prices at the gas pump. That would confront our leaders with the stark choice between publicly supporting steps that would certainly raise gasoline prices, or setting aside concerns about climate change in the interests of helping a weak US economy. I take no delight in that prospect.

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