Degrees of Freedom

The more I think about Tuesday's Congressional hearing on oil, the more convinced I am that much of the frustration of both sides arises from finding themselves in a problem with essentially zero degrees of freedom in the near term. In engineering parlance, that suggests an object that can't move or rotate in any dimension. All of the solutions to the linked problems of energy security, high energy prices, and climate change would take time to implement, with significant inertia to overcome, and none of them could take effect fast enough to provide relief for truckers burdened with $4 diesel fuel, or commuters struggling to pay for gasoline that exceeds $3.50 in some regions. The only short-term fix available to Congress might even make the situation worse, in both the short- and long-term. That leaves the ball in our court, as consumers.

Consider the available options for reducing fuel prices. Contrary to Congressman Larson's assertion, based on complaints from the Connecticut Independent Petroleum Association, that supply and demand is broken, those forces are precisely what determine the street price of gas and diesel. When marketers see their sales spiking and inventories drawing down, they raise prices, and when sales slow and inventories rise, they lower them. Any dealer that is priced too far above his local competitors will see throughput fall, and anyone who prices too low will run out. As I used to remind our marketing managers when I traded gasoline for Texaco's West Coast operations in the 1980s, if you're going to run out, you might as well run out at a high price. Increasing supply seems to be the quickest way to force prices down, since the whole system responds to changes in inventory that result from shifts in supply and demand--the latter being harder to influence directly.

How could we increase supply? Well, Congress was suggesting more renewable fuels. In fact, the 2007 Energy Bill increased the annual Renewable Fuel Standard target for 2008 from 5.4 billion gallons to 9 billion gallons. That compares to 6.8 billion gallons of ethanol actually blended into gasoline in 2007. Even if enough new ethanol plants start up this year to supply the additional 2.2 billion gallons required, the logistics of getting it to blending terminals will be challenging. And while ethanol is cheaper than gasoline today, offering the potential of some price relief, it is not clear that will remain the case. Higher demand for corn pushes up the cost of ethanol's inputs, against a crop expected to be smaller than last year's. That will either squeeze output or raise ethanol prices.

Nor would granting the industry's request for access to more offshore tracts help this year. There's much to be said for the argument that Chevron's Vice Chairman made to the Select Committee on Energy Independence and Global Warming, that it's hard to convince foreign countries to give companies access to their resources, when our own government won't do the same. However, the interval from leasing to first production is at least six or seven years, and probably longer. So when the industry execs were asking for access, it was for the supply we'll need in the 2015-2030 time frame, not 2008 or 2009. Expanding refinery capacity might bring relief sooner, but most of the current spike in gasoline prices is attributable to higher crude oil prices, not unusually high refining margins. And in any case, of the refinery expansions alluded to on Tuesday, such as at Port Arthur, TX , few of them will come on line this year.

As for reducing demand by means of increased fuel economy, that won't manifest quickly, either. The 2007 Energy Bill set a target for increasing the fuel economy of new cars to 35 miles per gallon by 2020, but with the economy slowing and new car sales down significantly from last year, it will take longer than expected to turn over the existing fleet. If every new vehicle sold this year were a hybrid, it would raise the fuel economy of our 230 million cars and light trucks by up to 4%. But despite their rapid growth, hybrids made up only about 2% of the US car market in 2007. And while SUV sales are down--often displaced by "crossovers" that are only marginally thriftier--and small car sales up, the resulting net reduction in fuel consumption could be lost in the rounding, this year.

The only lever left for policy makers to influence current fuel prices was only hinted at in Tuesday's hearing, for good reason. One of the committee members pointed out that federal and state taxes account for 13% of today's gas price at the pump. Those taxes range from $0.26 per gallon in Alaska to more than $0.64 in California, but the one constant is the $0.184/gal. federal gasoline tax. Congress could cut that tax or eliminate it--with serious consequences for the federal highway budget--but the resulting relief would be short-lived. Because it would tend to increase demand without affecting supply, a temporary reduction in the gas tax would eventually be overwhelmed by the rebound of total fuel prices, in order to balance supply and demand. Consumers would see a few months of relief, but the Treasury would be out several billion dollars without achieving any lasting benefit.

Unfortunately, unless I've missed some non-obvious factor, that leaves government and industry with no quick way to alleviate the fuel price increases that have already swamped last year's highs, well before their typical seasonal peak around Memorial Day. That leaves only one party to this situation with the power to change that balance: consumers. If we all drove just 12 miles less per week, fuel demand would fall by 5%, the equivalent of almost half a million barrels per day, or all the ethanol produced last year. The impact of that on gas prices would be much more dramatic than waiting for someone else to fix the problem.