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The Oil Problem

The new $50 oil is here to stay; there's talk on the street of $80 per barrel. What next?

11:00 PM, Mar 14, 2005 • By IRWIN M. STELZER
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WHEN THE OPEC CARTEL convenes this week it will have to deal with demands that it rev up its capacity to supply the world with the increasing amounts of oil that America's drivers and shivering homeowners, China's industries, and even Europe's stalled economies need. The International Monetary Fund has leaked the chapter of next month's World Economic Outlook in which it calls for OPEC to provide "much better protection" against price spikes by increasing its spare capacity from about 2 million barrels per day to between 3 million and 5 million barrels. And the Federal Reserve Board's latest survey of the state of the U.S. economy warns that manufacturers are regaining sufficient pricing power to enable them to pass on higher costs to consumers.

Worse still, both the experts and the markets agree that high prices are here to stay. Saudi Arabia's oil minister, Ali Naimi, predicts that prices will be in the $40-$50 range for the foreseeable future; the futures market is suggesting that no relief is in sight from the $55 level; the Department of Energy agrees; David O'Reilly, CEO of ChevronTexaco warns, "The time when we could count on cheap oil . . . is clearly ending"; and there is talk on the street of $80 oil.

That triggers fears of inflation, sending long-term interest rates up and share prices and the dollar down, insuring that the Fed will raise short-term rates by another quarter of a point, to 2.75 percent, when its Federal Open Market Committee meets on March 22. There is a growing fear that long-term interest rates, which have stayed remarkably low, will now shoot up and prick what many see as the house-price bubble, driving consumers from the malls and stalling the robust, 4+ percent economic growth that has finally begun to create large numbers of jobs.

Not likely, says Gavyn Davies, chairman of the U.K.'s Fulcrum Asset Management, and a shrewd observer of the economic scene. He points out that the "productivity miracle of the late 1990s seems not to have run its course, and will for a while continue to offset upward pressures on costs."

So, concerns about the near-term impact of oil prices in the $55-headed-to-$60 range are probably overblown. Nervousness, yes; panic, no. The more important question relates to the longer-term ability of the industry to supply oil in sufficient quantities to prevent high prices from reaching levels that do indeed trigger inflation and growth-stifling monetary tightening.

The Saudis have promised to do their share by raising output by 40 percent, to 12.5 million barrels per day, over the next four years. And there is increasing hope that the massive reserves locked in Canada's tar sands might come to market some time in the not-too-distant future. But many experts doubt the ability of the Saudis to increase production much beyond the 9 million barrels the Kingdom now pumps every day. They point out that the market needs sweet, light crude oils, rather than the heavier, sulfurous stuff that lies under Saudi sands and also fear that Russia's hostility to private investment will further curtail output in that oil-rich country.

Which brings us to the demand side of the oil market. Bijan Mossavar-Rahmani, head of international independent Mondoil Corporation, says that exclusive concentration on increasing supply is consuming nations' way of avoiding responsibility for adopting sensible polices to limit demand. "If the consumers don't like growing demand and prices to match, they can raise taxes on petroleum products, mandate conservation measures, loosen environmental standards, invest in alternatives, open up their own backyards to drilling, and draw down strategic and other reserves. Bitching about Arab sheiks and Venezuela's Chávez won't do it."

He has a point. President Bush has been urging Congress to invest in alternatives and open up Alaska to drilling, which they has so far refused to do. But he has steadfastly refused to increase taxes on oil consumption, despite the fact that such increases would redirect moneys now flowing to Saudi Arabia to the Treasury.

"We have met the enemy and he is us," moaned cartoon character Pogo, in what is not a bad description of American policy. Money from oil taxes that could be funding the war on terror is instead going to Saudi Arabia to support radical clerics and train terrorists. Or it could be used to lower other levies, or to shore up the Social Security system that Bush claims is in crisis. Meanwhile, every $1 increase in oil prices sends over $10 billion into the already overflowing coffers of OPEC members.

Fortunately, markets--even the cartel-ridden oil market--eventually work their will in three ways. First, sustained high oil prices will sooner or later encourage oil companies to step up the exploration activities they have long deferred in order to increase payouts to shareholders. Second, the premiums paid for light, sweet crude oils will get so large that refiners will find it profitable to invest in facilities to process more abundant, cheaper oils.

Finally, continued high oil prices will once again persuade consumers to cut back their use of gasoline and fuel oil. Gasoline prices have passed the $2 per gallon mark, a bargain by high-tax European standards, but a price that gets the attention of America's drivers. It will take time for them to react, as the current stock of automobiles will last a long time. But react they will, as they have in the past. It is no accident that America now consumes far less oil per unit of GDP than it did in the good old days of $3-per-barrel crude oil.

Until those adjustments occur, however, consumers will have to look to the supply side for relief. And my guess is that they will be looking in vain for a good while.

Irwin M. Stelzer is director of economic policy studies at the Hudson Institute, a columnist for the Sunday Times (London), a contributing editor to The Weekly Standard, and a contributing writer to The Daily Standard.