Samuelson: Learning From the Oil Shock

We all know that gasoline is at $4 a gallon and 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. Though there will be fluctuations, the underlying rise in prices, he says, will have pervasive and often 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. Already, he says, China's steel exports to the United States are falling while U.S. production is rising.

• Inflation becomes more stubborn and harder to control. For years, the Federal Reserve has focused on so-called core inflation—prices minus energy and food. The justification for ignoring food and energy is that large price changes usually reverse themselves. But if oil and food prices 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) and "won't be coming down any time soon."

• Two distressed industries—home building and autos—suffer further. "In two years, there will be fewer Americans driving," he says. Higher gasoline prices push people to mass transit, bicycles and their feet. 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. As a practical matter, the world may have arrived at Peak Oil: that condition when dwindling oil reserves no longer permit much, if any, 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 oil reserves are behaving as if Peak Oil is already here. They're hoarding a scarce commodity by limiting new exploration projects. 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 (might Iraq surprise with large gains?). In the United States, prices have already led to less driving. In March—the latest month available—highway travel was down 4.3 percent from a year earlier. Buying patterns for vehicles have shifted. Through May, car and light-vehicle sales dropped 8.4 percent from a year earlier, and most of the decline reflected SUVs (down 31 percent) and pickups (21 percent), 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, or 1.2 million barrels a day, projects the International Energy Agency. Many of these countries subsidize fuel so that final customers are insulated from price increases. Gasoline is about 25 cents a gallon in Venezuela and about 60 cents in Saudi Arabia, Kuwait and Iran, notes Rubin. China also subsidizes fuel.

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 revenues 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, used by governments to cement their alliances: offered to friends at a discount; withheld from rivals.

What to do? How can we retrieve some of our lost power? The first thing is to get out of denial. Stop blaming oil companies, "speculators" and other scapegoats for a situation not of their making. Next, we need to expand oil and natural-gas drilling in the United States, including Alaska. No, we can't "drill our way" out of this problem. But we can augment oil supplies and lessen price strains on global markets. It might take 10 years or more, because new projects are huge undertakings. But delay will only aggravate our future problems, just as past errors aggravate present problems.

Finally, we need to let high prices work. Aside from encouraging fuel-efficient vehicles and disciplining driving habits, they may also stimulate development of 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, about 40 percent to 60 percent of today's levels, says Cole. It's a worthy idea and can be done with a standby tariff. It would activate only if prices hit the threshold. We know that 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.