The Political Economy of Oil

American motorists understandably are angry and frustrated by the sharp rise in gasoline prices over the last few weeks. At this time last year, a gallon of self-service unleaded regular sold for less than a dollar. Now the national average price for the same gallon is over $1.60. Prior to the recent ministerial meeting of the Organization of Petroleum Exporting Countries (OPEC), the Energy Department was predicting prices of between $2.00 and $2.50 per gallon this summer as the aggregate demand for gasoline is increased by vacation travelers. Although the OPEC agreement to increase production might prevent this extreme outcome, gasoline prices are likely to remain high for some time.

If recent history is a reliable guide, it is only a matter of time before politicians will feel obligated to respond to demands from their constituents to “do something” about high gas and diesel prices. The problem is that the “somethings” that politicians think of to do are usually notable for their unforeseen adverse effects.

To begin with, things are not as bad as they seem. Adjusted for inflation, today’s gasoline prices are far below their 1981 peak of $2.50 per gallon (in 2000 dollars). Additionally, since incomes have increased substantially since the late 1970s, families spend a smaller portion of their incomes on transportation costs, including gasoline.

But there is cause for concern. Sustained high energy costs can ripple through the economy, dampening the boom, if not helping to precipitate a recession. In addition, the US has become dangerously dependent on imported oil: in 1963, imports constituted 20 percent of US oil consumption, in 1986, 38 percent, and in 1999, 54 percent. Since 1992, US consumption has risen by 15 percent while domestic production has declined by 17 percent. As a result, some analysts predict that within the next 15 years, 70 percent of the oil consumed in the US will come from imports.

The reason for the increase in gasoline prices is clear. OPEC has cut production and even though that organization produces only 40 percent of the world’s output, the aggregate supply of oil has declined. Accordingly, the price of crude oil, including that produced by major non-OPEC suppliers to the US market, e.g. Canada and Mexico, has risen to around $30 a barrel. The price of refined products has follow suit.

Economically, OPEC’s production cutback made sense. Because of reduced demand last year resulting from a mild winter in North America and the Asian recession, the world was awash in crude oil. As a result, oil prices plummeted to around $10 per barrel last winter.

The surprise was not that oil producers would reduce output but the magnitude of that reduction arising from the unprecedented cooperation between Saudi Arabia, a pricing “moderate” and Iran, a “price hawk.” The former cut its production to 7.44 million barrels per day (MBD), substantially below the 8 MBD it previously had announced as it production floor. This constituted over one third of OPEC’s 1.7 MBD reduction. Non-OPEC countries, e.g. Russia, Mexico, Norway, and Oman also reduced output, creating a 2 MBD shortfall that drained oil inventories and boosted oil prices to $34 per barrel in early March.

Meanwhile, because of environmental regulations, domestic producers have been unable to reduce the shortfall, although rising prices should have been expected to increase output. Many proven reserves, for instance off the cost of California and in Alaska, are off limits to exploration and drilling. These reserves are substantial: the US Geologic Survey estimates that Alaska’s Arctic National Wildlife Refuge (ANWR) contains as much as 16 billion barrels of oil.

These factors have combined to create the current supply conditions. Meanwhile, it is unlikely that there will be a substantial decrease in the quantity of oil demanded over the next couple of months. As the economists would say, the demand for oil is inelastic in the short run, although adjustments will occur over time as consumers find substitutes. So what do we do?

First of all, policy makers must avoid the mistakes of the 1970s. This means, above all, rejecting the demagogic call to impose price controls on petroleum products and to punish producers and distributors whose only “crime” is trying not to sell their commodity at a loss. As anyone who paid even the slightest attention in an Economics 101 course remembers, when governments set a price for a good below that established by the market, the quantity demanded at the controlled price exceeds the quantity supplied, resulting in a shortage. That was the precise effect of the price controls on gasoline during the two “energy crises” of the 1970s.

The effects of price controls were exacerbated by other wrongheaded policies during this era. The long gas lines created by price controls were made worse in some geographical areas by the Carter administration’s Energy Department. For instance, DoE established rules distributing gasoline supplies to gas stations based on consumption patterns from 1972. As a result, areas of rapid growth faced even more severe shortages. Then there was the infamous “windfall profits” tax designed to punish oil countries for alleged profiteering. But since it applied even to newly discovered oil, its main impact was to discourage the exploration and drilling that would have increased oil supplies.

Policy makers should also reject calls to release oil from the Strategic Petroleum Reserve (SPR). The purpose of the SPR is to provide a hedge in the event of a national security emergency. A price rise, no matter how inconvenient, does not constitute such an emergency. This is especially true in light of the fact that while in 1985 the SPR held the equivalent of 100 days of imports, it now holds only 55 days because US imports now constitute 54 percent of total US oil consumption. In addition, using the SPR to affect oil prices will discourage oil companies from maintaining inventories, a major hedge against unforeseen reductions in supply.

So what does that leave? Most consumers do not realize that combined federal, state, and local taxes constitute nearly 40 percent of the price of a gallon of gasoline. They also do not realize that the fastest growing federal tax is the gasoline tax, which has increased over fourfold since 1980 to its current level of 18 cents per gallon. Congress could provide some relief to consumers by reducing this tax.

The United States could take steps to lessen the cooperation between Saudi Arabia and Iran when it comes to OPEC pricing. Some observers claim that Saudi Arabia’s decision to cooperate with Iran has been driven by considerations of realpolitik arising from concerns about a perceived weakening of US policy toward Iraq. The US should take steps to reassure Saudi Arabia.

Finally, the US should reduce the environmental restrictions on domestic exploration and production. Anyone seriously concerned about US energy dependence cannot ignore the fact that the oil reserves in the ANWR alone constitute the equivalent of 30 years of Saudi imports. Any environmental risks posed by opening such areas to exploration and drilling are dwarfed by those resulting from the tanker traffic necessary to transport imported oil.

Prudence dictates that government balance environmental concerns against energy requirements, not sacrificing one to the other. But because exogenous factors fortuitously have combined to keep energy costs low over the last few years, the Clinton administration has tilted toward the former at the expense of the latter.

Conditions could conceivably get worse. Vice President Gore, whose radical environmental vision is on display in his 1992 book, Earth in the Balance has opposed any attempt to reduce the federal gasoline tax. He also helped to negotiate the Kyoto global warming treaty. These two actions are intertwined.

The Kyoto pact, if ratified, would require the US to reduce its “greenhouse gas” emissions to seven percent below 1990 levels by 2012. Since these emissions are substantially higher now than they were in 1990, compliance with the Kyoto treaty would mandate massive cutbacks in US fuel usage. Required reductions could be achieved only by means of an unprecedented increase in fuel taxes. Given Mr. Gore’s attachment to the sort of environmental extremism inherent in the Kyoto pact, his election as president this November could very well cause us to remember the time when gasoline cost only $2.50 per gallon as the good old days.

P>Mackubin Thomas Owens is professor of strategy and force planning at the Naval War College in Newport, RI, and an adjunct fellow of the Ashbrook Center. The views expressed here are his own and do not reflect the position of the War College, Navy Department, or Department of Defense.