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The Truth Is, We Need Even Higher Oil Prices

September 14, 2000|EDWARD N. LUTTWAK | Edward N. Luttwak is a senior fellow at the Center for Strategic and International Studies in Washington

It was very nice of the Organization of Petroleum Exporting Countries to agree to sell another 800,000 barrels a day, but that does not begin to solve the petroleum problem.

It is not just that the quantity involved is actually quite small--these days, after a generation of ever-increasing consumption, an extra 800,000 barrels per day only amounts to a 3% production increase for OPEC members, or roughly 1.5% of total world production. Neither Russia nor Mexico belong to the organization (let alone Norway or Britain). With U.S. oil stocks very low and the recovery of the East Asian economies underway, it would take much more production to keep prices from rising, and OPEC certainly has enough installed capacity kept idle. But to say that an extra 800,000 barrels a day is not a solution does not mean that a much bigger production increase would be better.

In fact, the exact opposite is true: The only solution for high petroleum prices are even higher petroleum prices. If crude oil is cheap, there is no investment in other energy sources and less effort is made to conserve, thus eventually guaranteeing acute shortages and even higher prices than today.

That is the paradoxical truth that has paralyzed Western governments since the oil-price explosion of 1999. The rise of petroleum prices from less than $10 a barrel to more than $30 threatens to trigger a wave of inflation that would inevitably be followed by sharp increases in interest rates, which would in turn cause a recession. That would end the miraculously long U.S. boom in the worst possible way.

As for Europe, just now beginning to recover from years of slow growth and double-digit unemployment, it is certain that the European Central Bank will react to any more inflation by further increasing interest rates, strangling the recovery. That the euro also happens to be low against the dollar for entirely different reasons is not supposed to influence the bank--its only mission is to keep prices stable. Yet of course it has some effect, simply because the entire euro-scheme would blow up if the Germans become sufficiently alarmed by what is happening to their savings. Inflation and its repercussions are not the only danger, however. With higher petroleum prices, European consumers have less money with which to buy other things, cutting internal demand at a time when Europe's economic recovery is already fragile precisely because Europeans are not consuming enough.

So there are very good reasons to wish for much lower petroleum prices. At $15 a barrel or less, there would be no inflationary impulse, interest rates could go down instead of being driven up, and there would be no income transfer to weaken internal demand in Europe.

But there are even better reasons to wish for high petroleum prices--in fact, even higher than the recent peak of $35 a barrel, which in real terms is less than the level of 20 years ago.

Almost two decades of cheap petroleum have had devastating effects on both the demand and the supply side of the world's energy balance. The great conservation efforts, originally launched in the aftermath of the 1973 Arab oil embargo and the resulting explosion in oil prices, have been abandoned. By 1975 even Americans, with their passion for large cars, were buying mostly so-called compacts with four-cylinder engines, and the smallest cars on the market were the ones most in demand.

In recent years, with gasoline prices already low and still falling, sales of U.S. compact cars have been declining, while the market for the smallest and most efficient cars virtually came to an end. More than 60% of American car buyers were not content even with full-sized eight-cylinder cars, choosing instead so-called sports utility vehicles--in fact powerful four-by-four trucks, which have been getting bigger and bigger. The latest monsters offered by GM and Ford have huge six-liter engines, so the typical user goes to work or to shop, usually alone, in a vehicle big enough and powerful enough to carry two cows and 10 cowboys, which naturally burns gasoline in proportion.

Even in Europe, where high excise taxes meant that the U.S. low point of 20 cents per liter could never be reached, gasoline prices have been low enough to encourage a very definite shift in demand to bigger vehicles. It was symptomatic of an atmosphere of energy abundance that Volkswagen was not satisfied with the purchase of Rolls-Royce, maker of famously heavy and thirsty cars. It also decided to revive the Horch super-car brand once favored by Adolf Hitler, while Daimler-Benz is reviving the Maybach. For such cars, today's top-of-the-line 12-cylinder, five-liter engines would only be the minimum option.

Overall improvements in automotive technology have certainly increased propulsion efficiencies since 1973, but in both the United States and Europe, and in Japan as well, buyers have not opted for lower fuel consumption, preferring higher power levels instead.

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