Will High Gasoline Prices Spur Innovation?Published: May 14, 2008 in Knowledge@Emory
With oil now $124 a barrel and the average price of a gallon of gas at $3.65, frustrated American consumers are looking for answers—and someone to blame. Why are gas prices so high? Whose fault is it? And what can the U.S. do to improve its energy situation? In an interview with Knowledge@Emory, Ray Hill, an adjunct professor of finance at Emory University’s Goizueta Business School, offers some answers. Hill, who holds a doctorate in economics from MIT and spent ten years as CFO of Mirant Corporation, an Atlanta-based U.S. electricity supplier, says prices are high because demand is high and supply is limited. But be patient. According to Hill, high prices eventually encourage the development of new supplies, technologies, and alternatives, all of which serve to increase supply and moderate demand.
Knowledge@Emory: Should Americans simply get used to higher gas prices, the way Europeans have for years, or do you consider the higher prices temporary?
Hill: The difference between U.S. and European gas prices is higher taxes in Europe. Our gas prices today are about the same as Europe's were in 2001-2002 when oil was $30-$40 per barrel. Today, European gasoline is over $8 a gallon.
I doubt Americans will continue to see gasoline prices at this level for very long, though I don't know how long "very long" is. History tells us that when oil prices spike, new supply enters the market. I have no special skills at forecasting oil prices, but based on past history, I wouldn't be surprised to see the price fall by half over the next few years. Even people who are more pessimistic than I am about the long-term outlook could reasonably conclude there will be some near-term moderation in price. On the other hand, I confess that when oil hit $80/barrel, I thought it more likely we would see a reversion to $60 than a climb to $100.
Knowledge@Emory: Why is the price of gas so high these days? Is it a strategy on the part of oil companies?
Hill: Worldwide demand for oil has been very high in the last few years because of strong economic growth in the U.S. and the developing world. Combine this with supply problems in Nigeria, Mexico, Venezuela and Iraq, and the result is higher prices. Yes, the big oil companies are making a lot of money, but that’s because they invested in producing a commodity that is now very valuable—not because there is any "market manipulation" going on.
Knowledge@Emory: Are high prices an indication that the U.S. is running out of oil?
Hill: No one disputes that we’ll run out of oil eventually. But even the most conservative forecast is that we have two trillion barrels of extractable oil in one form or another, and we’re consuming about 30 billion a year. Doing the math, the most pessimistic guess is we’ve got a 65-year supply. We’re not going to run out of oil any time soon; it’s just going to get more expensive, and it could well run out in a couple of generations. The more optimistic, but very realistic, view is that the supply is not two trillion, but closer to four trillion, giving us 120 years before we deplete our sources. That’s a pretty long time away.
At the same time, we keep using oil more efficiently. The number of barrels of oil used to produce $1000 of real GDP in the U.S. is now nearly half of what it was in the 1970s. Even in China, the consumption of oil per unit of GDP has improved tremendously over the last 7-8 years. Although China’s rapid rise in GDP has created increased demands for oil and affected prices worldwide, their ratio for oil consumption per unit of GDP has gone down.
Knowledge@Emory: What will it take for prices to fall? A recession in China?
Hill: No, it’s not going to take a recession in China. High prices will elicit more investment in oil extraction, which will in turn impact price.
Oil and gasoline demand is very inelastic, which means it does not vary significantly in response to changes in price. As a result, a supply shock or faster than expected growth in demand will cause prices to spike, but the same thing happens in reverse. If higher prices elicit more production, and if enough supply problems—such as those in Nigeria, Iraq and Mexico—are remedied, the price will drop. Add a slowdown in growth, and prices could fall even faster.
Looking ahead, supply may outstrip demand in the next decade. Current worldwide consumption is about 86 million barrels of oil a day. Cambridge Energy Research Associates, a leader in energy forecasting, predicts that world supply within nine years will hit 115 million barrels a day. If that happens, we’ll see a big drop in oil prices, because demand, even if it expands in China and India, is not going to reach 115 million barrels a day by 2017.
If supply exceeds demand, the price can drop very sharply. We may never see gas at $2 a gallon again, but in the past two decades oil prices have bounced up and down. We had $40 a barrel of oil in 1980, $17 in 1990, and in 1998 the actual price (not adjusted for inflation) went as low as $11 a barrel. That would be the equivalent of a fall from $120 a barrel to $30, or just 25 percent of its current price. Though such a precipitous change might not happen again, it has occurred in the past.
Knowledge@Emory: Are you suggesting that high oil prices are a good thing?
Hill: Yes and no. As far as the macro-economy is concerned, higher prices function like a tax from abroad, which lowers our real income. This reduction in real income is something we have to accept; trying to reverse it through economic stimulus will just take us back to the stagflation of the 1970s.
On the positive side, higher prices signal to Americans the need to cut back on consumption and to the oil industry the need to search for and develop sites that were too expensive to extract a few years ago.
Attention to price also encourages the development of alternative energy sources, the object of considerable investment these days.
The Saudis don’t like it when the oil price crosses higher thresholds for exactly this reason. When oil hit $40 a barrel in 1980-81, the Iranians were chiefly responsible, which irritated the Saudis. They warned Iran that the West would develop sources of alternative energy that would put them all out of business a lot sooner than they wanted. This is a notion economists call limit pricing. Indeed, the price of oil dropped after that. The Saudis have always believed that oil prices should vary within a certain range. They recognize that high prices encourage the development of fuel cell technology or something else, which once developed, won’t go away, undercutting the value of oil. But in the face of current worldwide supply problems, coupled with a burst of demand from China and India, the Saudis have lost control over pricing. If prices don’t drop, we’ll see an even bigger investment in alternative energy sources. Once that investment is made, those alternatives will be around forever.
Knowledge@Emory: In response to the call for price remedies, Senators McCain and Clinton have proposed a summer gas tax holiday. Is that a good idea?
Hill: One has to ask, what is the point? I don’t mean that facetiously. If you want to offer temporary relief to American consumers because of the slowdown in economic growth, then fine. A temporary cut in the gas tax has similar effects to a tax rebate. It’s just another form of stimulus that makes people feel better. The advantage is that it’s not a form of price control, which would send a disincentive to producers to produce more oil. So, in these limited terms, such a proposal is justifiable.
But you also have to take into account that a gas tax holiday will contribute to a bigger deficit over the long term. The short-term stimulus effect will be modest, and a future generation will pay for it in higher taxes. The proposal is not pointless, but it is a gimmick, in the words of Obama, because there’s no free lunch anywhere.
Knowledge@Emory: Some members of Congress have suggested pushing oil companies to invest more money in renewable energy. Would that accomplish what they hope?
Hill: If our primary concern is high gasoline prices, requiring oil companies to invest in alternative energy would be counter-productive. The best way to lower the price of gasoline is to invest in extracting and refining more oil.
Of course, we have other goals as well, such as reducing greenhouse gases. We can pretend that investment in alternative energy addresses both goals—lower gas prices and lower emissions—but that would be a delusion.
I would guess that 99 percent of economists believe the right way to promote alternative energy is with a general “carbon tax” so that the market can sort out the best solutions, rather than having them mandated by politicians.
I also question the mechanism. Encouraging the oil companies to invest more in alternative energy sounds great. But if you were to propose that Congress direct the oil companies to invest more of their dollars in specific areas, I believe even the most liberal American would question Congress’s competence and right to do so. It’s inadvisable for Congress to tell oil companies where to invest their resources.
In any case, there’s not really any need to push the oil companies to invest in renewables. Huge amounts of capital are pouring into every conceivable form of alternative energy—solar cells and hydrogen fuel cells and everything you can think of. GE’s wind turbine unit reportedly can’t produce windmill turbines fast enough to meet demand.
Knowledge@Emory: What about ethanol? Should that be supported more?
Hill: U.S. corn-based ethanol is a bad idea.
John Deutch, a professor of chemistry at MIT and a former director of research at the U.S. Department of Energy, wrote a nice summary in the Wall Street Journal a couple of years ago. Experts agree that it takes at least two thirds of a gallon of oil to produce an “energy equivalent” gallon of ethanol in the U.S., resulting in only a modest net amount of oil saved.
In addition, diverting corn to ethanol production drives up food prices and creates environmental issues surrounding land allocation, water usage, and fertilizers. It’s hard to imagine a worse, less cost efficient remedy than corn-based ethanol production.
The problem isn’t ethanol itself. The problem is that North America produces ethanol from corn. Brazil, for example, distills ethanol from sugar cane, which is more cost efficient. The reason is that God gives Brazil more free energy from sunshine, and so the Brazilians can distill ethanol from sugar cane, which is much more energy-rich.
Estimates of the energy ratio in Brazilian ethanol production are around 33% (and in some sources higher), meaning it takes only one-third of a gallon of oil to produce an energy equivalent gallon of ethanol. One easy way of making a small dent in energy costs would be to drop the high tariff that keeps Brazil’s sugar-based ethanol out of the U.S.
Knowledge@Emory: What are your thoughts on electric cars as part of the solution to our energy and environmental problems?
Hill: It depends on which problem you’re talking about. One goal is to reduce our dependence on foreign oil. That’s a security problem. We also want to reduce greenhouse gases. That’s another problem, distinct from the goal of reducing environmental problems more generally. Burning fossil fuels produces lots of other harmful emissions that we try to control, quite apart from concerns about global warming.
Which problem electric cars solve depends on the technology that ultimately succeeds in being commercially viable. The original technology was for electric cars that would get their power from the grid—that is, plug into an electrical outlet. This kind of electric car would help to some degree to end our dependence on foreign oil, because the electricity is generated by natural gas and coal. But is burning coal to produce electricity going to help solve the problem of greenhouse gases and other harmful emissions? Probably not. We experience some net gain because power plants are more efficient than internal combustion engines and electric cars use braking energy as a source. For a city like Atlanta, it may help reduce other forms of emissions. We could generate the electricity in south Georgia, for example, where there’s not a pollution problem, and then ship the electricity to Atlanta. This wouldn’t diminish greenhouse gases, but it might alleviate Atlanta’s pollution problems.
Hydrogen fuel cells are an alternative that reduces our dependence on foreign oil and cuts other emissions but continues to produce greenhouse gases. Other battery technologies can come close to being “zero emissions” but are presently too expensive to represent a viable choice for most American consumers.
Knowledge@Emory: Is the current political response anything like what you remember from the OPEC oil crises in the 70s?
Hill: Notwithstanding the fact that we’re in an election year, and a pretty heated one, the political response is not nearly as irrational as it has been in the past. About all that has happened is that Congress asked the oil companies to come and testify so they could say nasty things about them.
Politicians responded with much greater irrationality in the 1970s. During the first crisis, the government actually attempted to control the price of oil. For a brief time, we even had a two-tier price system. Everybody understands that capping the price of oil reduces the incentive for producers to find new supplies, and that’s terrible in the long run. Rising prices fuel the discovery of new sources of oil. In the 70s, the U.S. government tried to avoid discouraging producers by capping the price on existing oil while allowing the price of new oil go up.
This created a nightmare, because the government somehow had to keep track of what was “new” oil and what was “old” oil. It also created counter-productive situations for producers. For instance, after a rise in oil prices, companies would have to go though the process of reclassifying established wells as “new” before they could employ more expensive technology to extract additional oil from an existing source.
Congress is currently complaining about the high price of oil, but at least it’s not doing anything egregious to the oil companies.
Knowledge@Emory: So, what’s the best strategy for the U.S.?
Hill: Let the market work. Anything else is likely to make things worse in the long run.