How We Got to $3 a Gallon
The United States has the energy policy it deserves, although not the one it needs. Having been told for years that their addiction to cheap gasoline was on a collision course with increasingly insecure supplies of foreign oil, Americans are horrified to discover that this is actually the case. But for all the public outcry and political hysteria, high gasoline prices haven't significantly hurt the economy -- and may not do so. Since 2003 the economy has grown about 3.6 percent annually. It's still advancing briskly. That may be the real news.
But first, how did we get to $3 a gallon? The basic story is simple enough. Oil was cheap in the 1990s. From 1993 to 1999, crude prices averaged about $17 a barrel. Low prices discouraged exploration and encouraged consumption. China emerged as a big user. In 1995 global demand was about 70 million barrels daily; now it's almost 84 million barrels daily.
Spare production capacity slowly vanished, meaning that now any supply interruption -- or rumor of interruption -- sends prices up sharply. An Iraqi pipeline is attacked; prices jump. Nigerian rebels menace oil fields; prices jump.
These pressures get transmitted quickly to the pump, because there are few fixed-price contracts in the oil business. At each stage of distribution -- from producers to refiners, from refiners to retailers -- prices are adjusted quickly. They're often tied to prices on major commodities exchanges, where oil and other raw materials are traded.
"A gas station will get a delivery every four to eight days at a different price," says Mary Novak of Global Insight. Even between deliveries, station owners may push prices up because they know that "for my next tankload, I'll have to pay the market price."
Of course, profits have exploded. Production and refining costs haven't risen in tandem with prices. To the extent that oil companies have their own crude reserves -- as opposed to buying from producing nations -- they've reaped a bonanza. From 2002 to 2005, profits for most U.S. oil companies more than quadrupled, to almost $140 billion a year, the American Petroleum Institute reports. But the really big winners are the oil-producing countries. In 2005 their oil revenue exceeded $750 billion, up from $300 billion in 2002. (Crude oil and taxes represent about three-quarters of the retail price of gasoline; refining, distribution and marketing account for the rest.)
It's conventional wisdom that big increases in oil prices usually trigger a recession -- or at least a sharp slowdown. Why haven't they? One oft-cited reason is that the economy has become more energy-efficient. True. Compared with 1973, Americans use 57 percent less oil and natural gas per dollar of output; compared with 1990, the decline is 24 percent. Cars and trucks have gotten more efficient, though not much more so since 1990. New industries (software programming, health clubs) use less energy than the old (steelmaking, farming). But there's a larger reason: The conventional wisdom is wrong .
Big oil price increases in the past (1973-74, 1979-80 and 1990-91) did not cause recessions, though recessions occurred at roughly the same time. The connection has been repeated so often that most people probably accept it as gospel. But much economic research has concluded that it's a myth. These recessions resulted mainly from rising inflation -- inflation that preceded higher oil prices -- and the Federal Reserve's efforts to suppress it. Higher oil prices merely made matters slightly worse. In 1980, for example, consumer prices rose 12.5 percent; excluding energy prices, they increased 11.7 percent.
This may explain the economy's resilience. One hopeful sign: most nonenergy companies aren't yet passing along higher energy costs to their customers. "Businesses have had wide profit margins," says Mark Zandi of Moody's Economy.com. "They may be willing to eat the higher costs." In 2006, he expects the economy to grow 3.5 percent, with average unemployment of 4.7 percent.
Indeed, he thinks oil prices may retreat to about $50 a barrel, from today's levels of about $70, later this year. Higher prices will slightly dampen demand, and added supplies will create some spare production capacity. Naturally, he could be wrong. Energy economist Philip K. Verleger Jr. thinks oil could be headed for $100 a barrel, with inflation going to 5 percent and inducing a recession. Continuing strong oil demand will collide with rigid supply (both production and refining). The conventional wisdom -- wrong in the past -- could be right in the future.
Whatever happens, the larger question is how Americans build on this episode. It may feel good to vilify the major oil companies and the oil cartel. But that won't help. We now import 60 percent of our oil; large imports will continue indefinitely. So far, we've escaped a true calamity. We may not be so lucky in the future. We could minimize our vulnerabilities to supply interruptions and price increases. We could open up more acreage (including Alaska) to drilling. We could orchestrate -- through tougher fuel economy standards and a gradually rising energy tax -- a big shift toward more-efficient vehicles. Once again, we've been warned. Will we continue to ignore it?