The Real Question: Should Oil Be Cheap?

Expensive oil hurts, but there's a business case to be made for a floor under the price of crude
Sean McCabe

Amite Foundry & Machine is one of those gritty manufacturers at the heart of American industrial might. The Louisiana company's fiery 2,800F furnaces melt down hunks of recycled scrap steel and recast them into massive parts for trucks, oil rigs, and other heavy equipment. Amite even turned 30 tons of metal from the World Trade Center into the bow of the Navy's USS New York. But the company suffered as manufacturing moved offshore, and the town of Amite, 65 miles north of New Orleans, with its faded white clapboard churches and a main street that time forgot, has suffered along with it.

No more. Amite Foundry's orders jumped 25% in 2007 and 30% more so far this year, spurring the company to hire dozens of workers. Why the turnaround? The price of oil. With the cost of a barrel of crude well north of $120, anything that can provide additional supplies, alternatives, or gains in energy efficiency is booming. One example: Canada's oil sands. They're boosting sales of Caterpillar's (CAT) 380-ton-capacity mining trucks—and Caterpillar uses nearly 50 tons of Amite's steel castings per vehicle. Sure, increased energy and commodity costs make it more expensive to produce and ship steel, says Roy Roux, sales chief at parent Ameri-Cast Technologies, but "high oil prices are mostly good for us."

Paying for the Past

Obviously, the soaring cost of energy is causing plenty of pain for Americans, especially at a time when they're being hammered by declining house values and rising food prices. The pain isn't about to ease, either. "We haven't yet seen the cost of heating," warns R. Neal Elliott of the American Council for an Energy-Efficient Economy. That will kick in this fall and winter, with dramatic increases in the prices of heating oil, natural gas, and even electricity.

But Amite Foundry's resurgence is just one of countless examples of a deeper truth: Expensive energy, in many ways, is good. Why? When the price of oil goes up, people will use less, find substitutes, and develop new supplies. Those effects are just basic economics. Things are so painful now, many economists say, because of the past two decades of cheap oil. Prices stayed low in part because they didn't reflect the full cost of extras such as pollution, so there was little incentive to use energy more wisely. If those extras had been counted, the country would be better prepared for both today's soaring prices and the day that global oil production begins to decline.

That's why there is growing interest, from both the left and right, in a policy that uses taxes to put a floor under the price of oil. Above a certain level—say $90—there would be no tax. But if the world market price dropped below that, taxes would kick in to make U.S. users pay the target amount.

Expensive energy is a powerful medicine. It may hurt when taken, but it brings long-term cures for a host of ills. It compels companies and people to put fewer miles on the car, ditch the SUV, or install more efficient heating, as Eastern Maine Medical Center in Bangor did: The hospital saves $1 million annually with a system it installed two years ago. Higher costs are beginning to nudge America away from its traditional traffic-congested suburban sprawl to denser, less car-dependent communities. Utah has a government-sponsored bike-to-work program. "When the Republican governor of the reddest state in the union is promoting bicycling as a preferred mode of transportation, you know people are paying attention to the price signals," says Keith Bartholomew, professor of urban planning at the University of Utah.

These changes are saving lives—fewer traffic deaths—and improving health as people get out of their cars. A study from Washington University in St. Louis suggests that 8% of the rise in obesity since the 1980s was due to low gas prices, which led to less walking and biking and more restaurant meals. Silicon Valley engineer Andy King parked his Chevy Suburban in favor of a bike for commuting and says he has dropped 35 pounds since February. "It's good for my body and soul," King says.

High energy prices also water the flowers of innovation, making investments in alternatives pay off and juicing the search for more oil. Military-funded researchers have made jet fuel from plants. Toyota (TM) and General Motors (GM) are testing plug-in hybrid cars that can run 40 miles on electricity alone. Companies are building vast expanses of mirrors in the desert to make steam, and thus electricity, from the sun. There are new systems to control power consumption by homes and businesses from afar and programs to insulate inner-city houses, providing energy savings—and jobs. The U.S. uses just over 20 million barrels of oil per day heating homes, powering industry, and fueling cars, trucks, and planes. Energy-saving initiatives, "could easily take 4 million to 5 million barrels a day of demand off the market in 10 years," says Stanford professor Hillard G. Huntington, executive director of the Energy Modeling Forum, a group of energy experts.

Keeping More Wealth at Home

Such reductions, in turn, have potent virtues. They cut pollution and slash carbon dioxide emissions, which cause global warming. They reduce the need for a military presence to ensure global commerce in oil. And they slow the flood of dollars to the Middle East, Russia, and Venezuela, keeping more wealth in the U.S. instead of handing it over to often unfriendly suppliers. This effect would grow with a tax that set a floor on price, cutting demand. And the tax revenue—the difference between the floor and the world price—would stay in the U.S. to boost investment. "I don't think anyone can deny we'd be better off if we were not shipping billions of dollars to Chávez, Putin, and the Saudis, and developing products and services we can sell abroad instead," says Andrew J. Hoffman, professor of sustainable enterprise at the University of Michigan.

America has been here before. Although the country was shaped by an utter lack of concern over energy costs, the 1970s oil shocks changed that. "We never thought about the fact that everything depended on cheap energy," says Columbia University professor Kenneth T. Jackson, author of Crabgrass Frontier: The Suburbanization of the United States.

The myth of unlimited energy took a tumble as oil prices soared. By 1980, crude had jumped to $103 per barrel (in today's dollars). The country responded, buying smaller cars, passing stricter fuel economy standards, making industry more efficient, and boosting oil exploration and drilling. Americans learned to use half as much energy per dollar of gross domestic product as they did before the crisis—gains that have paid off handsomely. "All the heavy lifting we did in the 1980s to reduce reliance on energy has made us less vulnerable to the energy shocks today," says Tufts University economist Gilbert E. Metcalf.

But that momentum toward greater energy efficiency was soon lost. Within five years, because of the substantial reduction in demand, the world was awash in oil. The Saudis slashed production from 9.9 million barrels per day in 1980 to 3.4 million in 1985—and still weren't able to keep the price per barrel from plunging below $11 in 1986 (the equivalent of $22 today).

For two decades, oil prices stayed relatively low—with predictable results. Americans bought millions of SUVs. Investment in alternatives, oil drilling, and efficiency withered. The National Renewable Energy Laboratory shut down its algae biofuel program. "In the U.S., we get fired up about doing something when oil prices are high, then when prices drop, we forget about it," says Fred Tennant, vice-president for business development at PetroAlgae, a biofuel startup in Melbourne, Fla.

Prices are sky-high again, and the invisible hand is pushing hard. Americans are driving less—gasoline use was down 5.2% in early July compared with the same period last year. Sales of Ford's (F) F-Series pickup, the longtime best-selling vehicle in the country, are off 22% this year, while for the 31-mpg Honda Fit, sales are up 69%.

Gas prices reached a tipping point for Ann Arbor (Mich.) auto repair shop owner Dikran Khanian. His extended-cab Chevy Silverado pickup had "a seat like a La-Z-Boy, and the power was exhilarating," he says. But when his truck was totaled in an accident last year, he felt some relief along with the shock. The crash freed him to buy the 22-mpg Honda Element he'd been eyeing. "I was in love with the Silverado's big engine, but some things have to come to an end," he says. Khanian has cut back on driving, taking his recycling to the supermarket when he buys groceries instead of making two trips, and he's eased off on the accelerator. "My friends say: 'Dick, you drive like an old woman,'" he muses. "I say" 'Don't you know you can save 20% just by controlling your big toe?'" Now his gasoline bill is $200 a month, one-third of what he'd be paying with the Silverado.

Long-Term Uncertainties

Add together the actions of millions of drivers like Khanian. Throw in a switch to ocean shipments from air freight for some tech products, a new airplane dispatching system at UPS that means less time spent idling, Adobe's (ADBE) move to turn off fans in the parking garage when they're not needed, and myriad other small initiatives. Then toss in lower demand around the world and factor in increased supplies from Canada's tar sands and growing crude production in OPEC countries and elsewhere.

You can see where this is going. Wall Street has. With oil demand slowing and supplies headed up, prices are off more than $20 from their July 11 record of $147.27. "I don't think anyone believes prices that high were here to stay," says Massachusetts Institute of Technology economist A. Denny Ellerman.

Just as the low prices of the late 1980s and '90s undid some positive effects of expensive oil, the mere possibility that prices could fall is weakening the market forces pushing toward greater energy efficiency. What really drives behavior is not the actual price, but the perception of where costs will be over the long term. That helps explain why Americans didn't cut back while gasoline prices climbed a few years ago. "After Katrina, gas got close to $3, and then prices moderated," says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University. Only when gas broke the $4 barrier, with no relief in sight, did the wake-up call come.

Strong as it is, that call is being muted by uncertainty about where prices will go. Some experts see $200-per-barrel oil in their crystal balls; others predict $75 or lower. As a result, technologies that should make economic sense at $100 per barrel aren't being funded, says venture capitalist Vinod Khosla. "We are getting the worst of both worlds—high prices and low investment," says Khosla, a co-founder of Sun Microsystems (JAVA) and now a backer of alternative energy ventures.

That's why Khosla and many economists and energy experts are pushing the idea of a floor on the price of oil. The certainty of a relatively high price would stimulate enough investment in alternatives, efficiency, and new supplies to keep future prices from rising much above that level, Khosla argues. It adds no new pain, since the tax would start only after consumers and companies have already gotten considerable relief from today's prices. It would have been better to tax citizens decades ago—forcing Americans to become more energy-conscious—but that was a near-impossibility politically. Since external forces have now accomplished the same thing, though, a floor is a good second-best, economists say.

It's not quite that simple, of course. Some big industries will be hurt by any policy that boosts energy prices: Airlines, shipping companies, manufacturers, utilities—indeed, anyone who can't easily cut back. And if oil were the only fossil fuel to be taxed, it could bring a distorting shift toward natural gas and coal. So it would be better, some economists say, to institute such a levy as part of a broader energy policy. With growing concern over global warming, a tax on carbon dioxide emissions makes the most sense.

Another danger is that Uncle Sam would fritter away the new revenue. Some economists suggest using the money to invest in oil alternatives, while others would return it to people in, say, lower income taxes. Again, it's basic economics: Use taxes to keep prices high for something we want to use less of—oil—and use the money to reduce the cost of things we want more of—growth and productivity. There's a debate about whether the benefits of such a tax-shifting strategy are outweighed by the loss of innovation that might result from government intervention. But many economists say any negative effects would be relatively small. "It may not be a free lunch, but it's clearly a lunch worth paying for," says Stanford economist Lawrence H. Goulder.

Take the Train

British Columbia has shown that it's politically possible, too. On July 1, it added a small tax on gasoline designed to account for the costs of carbon dioxide emissions. The revenue will be returned in reduced income and business taxes. To ease the initial sting, the government sent each citizen a check for $100 at the end of June—a move that will help lower-income people who are struggling with higher energy prices. Taxing energy, and returning the money to people in other ways, "is pretty much an economist's dream," says Ian Perry, senior fellow at Resources for the Future, a Washington think tank.

If the U.S. manages the difficult feat of keeping the price of energy consistently high, what will the future look like? For a glimpse, take a ride on Atlanta's transit system, MARTA, with Kerri Hochgesang. The cost of commuting in her Nissan Xterra (NSANY) had ballooned to $460 per month, so in late June the 32-year-old lawyer switched to the train. "I thought it would be miserable and take forever," she says. It didn't: Her 25-mile commute is now 45 minutes instead of an hour and 20 minutes, and she can read instead of dodging traffic. "It's newfound 'me' time," says Hochgesang.

Thanks to new riders like Hochgesang, trips on MARTA in June and July are up 13%, year-on-year. Says Beverly Scott, MARTA's chief: "My husband jokes with me: 'You're the only one I know that jumps around the room going, Yeah! Yeah!'" when gas prices go up. Rush-hour traffic around Atlanta is down as much as 15%, says Mark Demidovich, an engineer at the Georgia Transportation Dept. "That converts to 10,000 or 12,000 fewer cars a day," he says.

Change doesn't come quickly. Few people will quickly move downtown or near transit stops because of high gas prices, says Charles J. Courte�manche, an economics professor at the University of North Carolina, Greensboro. But when they move for other reasons, they'll make different choices. Courte�manche did: In May he moved from a St. Louis suburb a half-hour's drive from his office to downtown Greensboro, a 10-minute bike ride to work. "We've probably passed the zenith of the suburban auto-oriented planning era," says Royce Hanson, chairman of the Montgomery County (Md.) Planning Board.

No one discounts the pain of high energy costs. But it can also bring real gains. The New York Times reports that teenage cruising is down nationwide. Whirlpool (WHR) says sales of high-efficiency washing machines are up, saving both water and energy. At the National Renewable Energy Laboratory, algae biofuel research is back, funded this time not by the government but by Chevron (CVX) and ConocoPhillips (COP), which could use plant oils in their refineries. Clever policy ideas, such as a "crusher" tax credit to smash SUVs and use the steel to make fuel-efficient cars, are sprouting in Washington. And in Maine, "people are coming out of the woodwork to invest in energy efficiency or alternatives," says John Kerry, director of the Governor's Office of Energy Independence & Security. "I think energy costs will become an economic engine."

Business Exchange related topics:Global Power and EnergyOil PricesU.S. Energy PolicyOil and Gas

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