Friday, June 13, 2008

Oil is too expensive

The reason oil is too expensive is that the current price encourages seeking out new oil that is expensive to produce. That is not the same as the reason oil is expensive.

The US Senate defeated a windfall profits tax measure that would have taxed oil companies on the high price of oil. It was defeated on a cloture vote: 51 to 43, a majority supported the closing of debate. It is getting close and one can guess that in November, this will be a deciding factor in some senate races and is already an issue in the presidential race:

There is not really a good reason not to capture the portion of the profits that are made on domestically produced oil since the only use for them is to reinvest in oil exploration which is becoming fruitless. But, capturing the profits does not do anything about the price of oil except to push it up a little faster since the oil exploration is not yet entirely fruitless. But, oil exploration is pointless now and for this reason it needs to be strongly discouraged. The way to discourage oil exploration is to reduce the price of oil rather than to stomp on a bunch of profit brushfires. While prices are high, some one somewhere will be exploring and finding oil that is expensive to produce even if we (in the US) manage to keep that from happening here through tax policy. Then everyone will be able to buy just as much oil as they can afford and the cancer of expensive oil will metastasize right back here where we might have stamped out incentives to find expensive oil. But, if the price of oil is reduced below the cost of producing expensive oil, then only cheap oil will be pumped from the ground and no one anywhere will bother to explore for expensive oil.

We can tell that oil is too expensive when people are working to be able to get to work or when people who have retired are choosing between heat and food. The promise of oil has been broken and it is time to give it up as a bad job. So, we need to make sure that people can get to work and keep warm while having something to eat. And, we need a good portion of the remaining cheap oil to get through to a point where these things can be done without using any oil. How do we ensure that we get that cheap oil at a price that reflects what it costs to produce rather than the scarcity of oil compared to how we use it now? We need to be sure that we are not using oil any faster than the remaining cheap oil can be pulled from the ground. If we try to go faster than that, we'll encourage people to look for more expensive oil since oil will seem scarce and thus worthy of investment.

Our policy should be focused on keeping oil inexpensive and to do that we need to aggressively phase out the use of oil. There are some sectors where we can't do this such as aviation, but in most we can move rapidly, and, more importantly, we can move rapidly enough overall. If the US alone, were to cut its per capita consumption to seven gallons a week down from nine, (think carpools and second small cars) we'd cut world consumption by about 6%. Dropping another weekly half gallon a year for fourteen years would cut world consumption by 25%. That is surely enough to keep the world on the cheap oil supplies out to 2025 or so since these supplies will be extended a bit by the reduced demand.

How to implement this policy? We might try simply restricting imports by a quarter or so. This would surely drop the world price of oil below $20/barrel. But, the domestic price of oil would likely be pretty high, $400/barrel or so, and this would encourage all sorts of foolishness in terms of looking for expensive oil domestically. We don't want to encourage that.

We could try imposing a tax, say $380/barrel, and that should solve the problem of encouraging exploration for expensive oil domestically and abroad, but is might be destabilizing for the government since the revenue would cover much more government spending than current taxes and we were warned by the chairman of the Federal Reserve at the beginning of the current administration that paying our national debt would be a bad thing. Also, since domestic oil prices would be even higher than now, we will have failed on the getting to work and keeping warm and eating portion of our problem.

Usually, when we have something serious to undertake, we ration. If we can get gasoline down to about $0.60/gallon by being careful how we use it, then our shared sense of accomplishment should help us do the rest of the transition down to using no gasoline at all. We have an existing rationing plan and it includes a white market in rations. This means that rations can be sold/traded, placing the cost of (rationing imposed) scarcity on the rations slips rather than the fuel. Getting to work or staying warm end up costing less though you might be making a choice on how to convert either of those two within a few years.

Just now, such an effort is doable, but if we wait for expensive oil to gain a greater share of the world total production, then controlling prices by controlling demand will be more difficult since there will be a floor price for much more of the production. In that situation, we will need to reduce our oil consumption probably just as much, but we won't gain the benefit of getting the cheap oil at a low price.

The core reason oil is too expensive is that the current price encourages exploration for expensive oil. Oil is useful when it is cheap to produce and cheap to buy, but it becomes harmful when it is expensive to buy, and even more harmful when it is expensive to produce since this places a price floor that no amount of consumption control can break. It is crucial not to spend resources on exploring for expensive oil. At present, only the US, as a single market entity, has the power to force only cheap oil to be produced and to end exploration for expensive oil. Others could, in combination, have a similar effect, but may not have the existing coordinated plan in place and thus may not be able to take such action before too much expensive (to produce) oil is on the market. The US should implement rationing as soon as possible to drive down the price of oil below $20/barrel and encourage other countries to also restrain demand. A window of perhaps 20 years of $20/barrel oil might be achieved through managed demand, plenty of time to manage a transition away from oil at low cost.