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David Burwell

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Of Oil Prices and Elephants

Posted: 04/16/2012 12:00 pm

Six wise men of Industan, of learning much inclined, went to see an elephant, though all of them were blind, that each by observation might satisfy his mind.

The debate over gas prices, what causes them to soar and crash, and who is to blame, is a parlor game played out in Washington at the start of the driving season every spring, and even more so in presidential election years. It is a redundant, blind-leading-the-blind discussion. So, let's see if we can parse the arguments made by the proponents of the various "truths" about gasoline prices to find the culprit. By analogy, we will track the arguments to the classic J. G. Saxe poem, "The Blind Men and the Elephant," with oil being the "elephant" in the room.

The first approached the elephant and happening to fall against his broad and sturdy side at once began to bawl, "This mystery of an elephant is very like a wall."

The wall of worry -- that some natural (like a hurricane) or man-made (such as a terrorist act, a war, or an embargo) disaster will cut off our access to oil and drive gasoline prices higher. This is a fear that oil exporters of any stripe diligently encourage. And it is partly true--Hurricane Katrina cut off both access to oil and caused refineries to shut down, causing a gasoline price spike.

But the United States, like all net oil importing nations, have set up strategic petroleum reserves to safeguard access to oil in times of such interruptions. The U.S. strategic reserves already have more than 200 days of U.S. oil imports safely stored in salt domes in Texas. Absent an OPEC-like coordinated embargo, which would do more damage to OPEC than to oil importers (see below), these interruptions will be short term and the price hike mild. So risk of supply interruption can't fully explain the problem.

The second, feeling of the tusk, cried "Lo what have we here, so very round and smooth and sharp? To me 'tis mighty clear, this wonder of an elephant is very like a spear."

The spear of the gas tax
-- a tax that pierces the heart of every American driver. But the 18.4-cent federal gas tax is less than 5 percent of the price of a gallon of gasoline. It is also getting smaller as a percentage every day as gasoline prices rise. Add state and local gas taxes and the average is still only 12 percent of the total price per gallon -- one of the lowest in the world. It also has not risen since 1993 -- even though fully 60 percent of Americans think the gas tax rises every year.

While this tax is supposed to keep our transportation infrastructure in good shape and performing efficiently, it is so inadequate to meet present needs that the quality of U.S. infrastructure has fallen, according to the World Economic Forum, from fifth in 2001 to twenty-third place globally. So gas taxes -- while a minor contributor -- can't be the culprit either.

The third approached the elephant, and happening to take the squirming trunk within his hands, thus boldly up and spake, "I see," quoth he, the elephant, is very like a snake."

The snake of speculation -- this argument appears to have some merit, especially if one compares global daily consumption of oil (89 million barrels) to actual oil traded on public commodity markets every day (over three billion barrels). Clearly most oil traded is done by those who have no intention of ever taking possession of it. This argument is bolstered by commentators who note the existence of "dark pools" of oil traded privately between oil companies, banks, and investment companies as a kind of reserve currency.

These private trades are estimated to be many multiples higher than publicly-traded oil stocks and can lock up inventories, thus causing prices to soar even in times of low demand and high supply. A recent study by the St. Louis Federal Reserve estimates that speculation accounts for about 15 percent of the oil price rise over the last ten years. But it also says that "fundamentals (supply and demand) continue to account for the long-term trend in oil prices." This snake, if it has a bite, is not poisonous.

The fourth reached out with eager hand, and felt above the knee, "what this most wondrous beast is like is very plain" said he, "tis clear enough the elephant is very like a tree."

The ever-growing tree of demand expansion -- true, global demand for oil has risen over the last decade, from 76 million barrels per day in 2000 to 87 million in 2010, but supply has kept pace. Moreover, OECD oil consumption has peaked and is now in decline, and new, unconventional oils have expanded potential supply to meet all needs far beyond the time their carbon emissions will push global temperatures to catastrophic levels.

The simple fact is that the OPEC nations, with 77 percent of global proven oil reserves and 42 percent of production, have models that calibrate the exact amount of that oil to put on the market to secure maximum financial return. The United States, representing about 10 percent of global production but 20 percent of global consumption, cannot substantially affect the oil price -- nor can more drilling. In fact, America already has more than 50 percent of all the in-use wells in the world. Canada, which produces 50 percent more oil than it consumes, has higher gasoline prices than the United States.

The fifth, who chanced to touch the ear said, "E'en the blindest man, can tell what this resembles most -- deny the fact who can; This marvel of an elephant is very like a fan."

The fan of inflation -- the theory goes that as the U.S. continues printing money to cover its trillion-dollar deficits, inflation will rise and, with it, the price of oil, since it's priced in dollars. Nice idea. But inflation remains tame while the price of oil has doubled since the depth of the Great Recession in early 2009. Inflation may be a future culprit, but it certainly is not pushing oil and gas prices up anytime soon.

The sixth no sooner had begun about the beast to grope, than seizing on the swinging tail that fell within his scope; "I see," said he, "the elephant, is very like a rope."

The rope of the resource curse -- this is a little-understood contributor to the world oil price that may eventually hang the oil-exporting economies. These economies, primarily the OPEC countries, Norway, and Russia, are heavily dependent on export sales of their natural resources -- especially oil -- to fund their national budgets. Over 50 percent of the federal budget of the Russian Federation is from taxes on sales of exported oil, and this percentage is much higher in some Middle Eastern countries.

These revenues are then disbursed to subsidize their social contracts with their citizens -- cheap energy and low-cost housing, without which social unrest would accelerate. This requires ever-rising oil prices. Ten years ago, Russia could fund its social contract at a world barrel price of oil of $20. But by this year, Moscow's budget needs an average price of $115 a barrel to break even. The Middle Eastern states are feeling the pinch as well: Barclay's Capital recently estimated that the cost of the Arab Spring alone pushed the break-even point for Saudi Arabia's budget from $78 a barrel to $91 a barrel -- to fund the extra spending needed to prevent social unrest from threatening the regime.

So, if gas prices are the elephant, did the six wise men find their answer?

So six blind men of Industan disputed loud and long, each in his own opinion exceeding stiff and strong; though each was partly in the right, they all were in the wrong!

As it is with elephants, so it is with oil prices -- plenty of "wise men" talking about what drives oil prices and all are partly in the right -- but mostly in the wrong. For the real answer on what is driving gas prices higher, let's look into the mirror.

We all hate high gasoline prices but we love the lifestyle that gasoline supports: the freedom of the open road -- flat, straight, fast, and free (with no tolls). We buy up cheap land where you can "drive until you qualify" for a home mortgage (with interest deductible). We then expect the government to build and maintain the infrastructure that supports our 50-mile commute to work, even though we oppose the gas taxes that fund all the infrastructure that provides these very same lifestyle benefits.

Until we grasp the reality that the price of oil is directly related to how we waste it, we will continue to dedicate countless hours and endless column inches looking for a different culprit. The elephant in the room is not the price of gasoline -- it is us.

David Burwell is the director of the energy and climate program at the Carnegie Endowment for International Peace.

 
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