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Learning From the Oil Shock

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By Robert J. Samuelson
Wednesday, June 18, 2008

We all know that gasoline is at $4 a gallon and that oil is at $135 a barrel. But if you think that's the end of the story, don't talk to economist Jeffrey Rubin of CIBC World Markets. By Rubin's reckoning, we've barely passed the halfway point on a steady march upward that will take gasoline to $7 a gallon and oil to $225 by 2012. Despite fluctuations, the underlying rise, he says, will have pervasive and surprising side effects. Among them:

· U.S. manufacturers benefit, because rising ocean-freight costs -- reflecting fuel prices -- make imports more expensive. Some production returns to the United States, and some shifts from Asia to closer exporters (Mexico over China). Since 2000, estimates Rubin, the cost of shipping a 40-foot container from East Asia has gone from $3,000 to $8,000. With oil at $200 a barrel, the shipping cost would be $15,000.

· Inflation becomes more stubborn. For years, the Federal Reserve has focused on "core inflation" -- prices minus energy and food. The justification is that large food and energy price changes usually reverse themselves. But if they move steadily higher, that logic collapses. "While core inflation may be barely over 2 percent, that's only of solace if you don't eat or drive," Rubin says. Overall inflation is twice that, about 4 percent.

· Two distressed industries -- homebuilding and autos -- suffer further. "In two years, there will be fewer Americans driving," he says. Higher gasoline prices push people into mass transit and car pools. Home prices take another hit, especially in distant suburbs with long commutes. "People won't be able to afford what they used to afford," he says.

Do not underestimate oil's fallout. The world may have arrived at Peak Oil, when dwindling oil reserves no longer permit much annual increase in production. This may not be literally true; estimates of vast undiscovered oil reservoirs imply that Peak Oil is decades away. But governments that control 75 percent or more of known reserves are behaving as if Peak Oil is already here. They're hoarding a scarce commodity by limiting new exploration. Meanwhile, production at some old fields is dropping rapidly. Spare capacity has been depleted as demand outruns new supply.

High prices close the gap. The grim price outlook by Rubin and others presumes that this situation persists. Of course, they could be wrong if higher prices cause demand to drop sharply and supplies increase unexpectedly. Saudi Arabia recently signaled a modest production increase. In the United States, prices have already led to less driving. In March, highway travel was down 4.3 percent from a year earlier. Buying patterns for autos have shifted. Through May, sales of sport-utility vehicles dropped 31 percent from a year earlier, reports WardsAuto.com. Oil demand is also stagnating in Europe and Japan.

But higher demand from developing countries and oil producers is offsetting the lower demand of wealthy countries. Consumption in these countries will rise 3 percent in 2008, projects the International Energy Agency.

There's been a huge transfer of power to oil producers. Even at $100 a barrel, Saudi Arabia, Kuwait and the United Arab Emirates will earn almost $8 trillion in oil revenue between now and 2020, estimates the McKinsey Global Institute. More troubling are the political implications. "This has really strengthened the Iranians, Russians and Venezuelans to be more provocative in the world," says Larry Goldstein of the Energy Policy Research Foundation. Although governments control crude supplies, private companies have dominated distribution. Anyone can buy oil at a price. Now oil could become a political commodity offered to friends at a discount, withheld from rivals.

How can we retrieve some of our lost power? The first thing is to get out of denial. Stop blaming oil companies and "speculators." Next, we need to expand domestic oil and natural gas drilling, including in Alaska. Although we can't "drill our way" out of this problem, we can augment oil supplies and lessen price strains. It might take 10 years or more, because new projects are huge undertakings. But delay will only aggravate our future problems.

Finally, we need to realize that high prices may stimulate new biofuels from wood chips, food waste and switch grass. Production costs of these fuels may be in the range of $1 a gallon, says David Cole of the Center for Automotive Research. If true, that's well below today's wholesale gasoline prices. To assure new producers that they wouldn't be wiped out if oil prices plunged, we should set a floor price for oil of $50 to $80 a barrel, says Cole. This could be done with a standby tariff that would activate only if prices hit the threshold. Oil prices are unpredictable, and should a price collapse occur, Americans wouldn't be deluded into thinking we've returned permanently to cheap energy. We've made that mistake before.


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