Peril at the Pump

In the past few months, pundits and politicians have started hinting, ever so cautiously, that an economic recovery might be just around the bend. U.S. Federal Reserve Chairman Ben Bernanke kicked off the festivities in mid-March when he told 60 Minutes that he saw signs of "green shoots." Since then, just about everyone has been crawling on hands and knees searching for this curious plant. In June, the OECD suggested that the economy may have finally hit a nadir, while Paul Krugman recently predicted that the U.S. economy could start growing again by September.

But before anyone gets too bright-eyed, it’s worth remembering that green shoots are, by nature, delicate and easily trampled. And they face one particularly nasty threat right now: rising oil prices. Indeed, an oil-price spike could easily squash the budding recovery before it even gets underway — or worse, hurl the economy right back into another severe recession.

The hand-wringing has already set in, as crude futures have climbed from $44 per barrel in January to about $70 a barrel today. "We can argue whether it is $75 or $100 a barrel that will start to impact economic growth, but it will happen," a recent J.P. Morgan memo warned. This month, British Chancellor of the Exchequer Alistair Darling told the Financial Times that oil prices have "the potential to be a huge problem as far as the recovery is concerned." And two weeks ago, three U.S. lawmakers introduced a bill to modernize the country’s oil reserves and tamp down prices, with U.S. Rep. Peter Welch (D-Vt.) calling the recent creep upward in crude prices a "bad case of déjà vu."

Indeed, recent history gives us plenty of reason to fret about the effect of high oil prices on the economy — at least once those prices cross a certain threshold. A much-cited study by James Hamilton, an economist at the University of California, San Diego, found that U.S. consumers barely noticed when oil prices tripled from $24 to $70 per barrel between 2004 and 2007. But once oil rocketed past that $70 mark — eventually hitting $144 per barrel last July — the effects were cataclysmic. Drivers stopped purchasing SUVs en masse, kneecapping an unprepared auto industry. Home buyers decided that cheap exurban houses weren’t worth it anymore. Consumer spending cratered. All told, Hamilton argues, the price spike alone was enough to plunge the economy into a recession — even without the financial meltdown.

These days, analysts are still arguing over what, exactly, caused the spike of 2007 to 2008. It’s still unclear, for instance, how much blame speculators deserve. But what’s generally agreed is that basic supply-and-demand rules the oil market — and many of the trends that sent prices soaring last year still exist today. Developing countries, including China and India, will soon start growing again at a rapid clip, as will their appetite for crude. The McKinsey Global Institute estimates that those countries will account for a whopping 90 percent of energy growth in the next decade. (Europe and the United States, by contrast, have actually been reining in demand: Vehicle travel in the United States dropped last year for the first time since 1979.)

As the global demand for energy keeps surging, oil supplies are likely to tighten, causing higher prices and greater volatility. The International Energy Agency has warned that production in non-OPEC countries, which make up about 60 percent of the oil market, could soon peak. The credit crunch, meanwhile, has forced many producers to put aside long-term drilling and exploration projects. All told, some 6.2 million barrels per day worth of investments have been delayed — an amount equal to the combined daily production of Iran and Kuwait. To top it off, OPEC has decided to curb its production of late, in part because OPEC members got burned when they flooded the market with oil last summer and then watched prices crash during the recession.

So it’s hardly shocking that analysts are betting on oil to bolt back upward in the near future. Goldman Sachs has predicted that crude prices will hit $85 per barrel this year and $100 by 2010. McKinsey sees a sharp upswing coming sometime between 2010 and 2013, just as the world economy starts expanding again. The worst-case scenario would be if prices kept viciously zigzagging: going high enough to kill a recovery, and then sagging quickly and preventing investments in conservation and alternative energy. In the United States, for instance, recent low prices at the pump have sent consumers once again clamoring for gas guzzlers — the sort of recurring myopia we can expect in a world where oil fluctuates so drastically.

Is there anything that can stop a major, economy-crippling oil spike from happening? No doubt, if prices soar high enough, various members of the U.S. Congress will call for more drilling, both offshore and in the Arctic, just as they did last summer. But the United States likely doesn’t have enough oil left underground to make more than a tiny dent in the world’s supply. And, at any rate, this is hardly a speedy solution.

One short-term step would be for the United States to start using its Strategic Petroleum Reserve (SPR) more strategically. At the moment, the United States and China are rapidly refilling their reserves, adding to the uptick in global demand. (By some estimates, China is adding 400,000 barrels a day — less than 1 percent of global demand, but enough to put pressure on prices.) In the U.S. House of Representatives, a recent bill would direct the Energy Department to sell about 70 million barrels of more expensive light crude and replace it with cheaper heavy crude in an attempt to lower prices and flush out speculators. Although there are no solid estimates for how much this measure would actually reduce oil prices, there’s some evidence that tapping the SPR can help: When then President George H.W. Bush authorized the release of 34 million barrels from the reserves during the Gulf War in 1991, oil prices sunk from $32 per barrel to about $20 within a few months.

Another stopgap action that could help the United States reduce its vulnerability to oil shocks would be to reverse the slow erosion of public transportation. During the oil crunch last year, transit ridership jumped 6.5 percent, and nearly 57 million U.S. households have access to some form of transit, so there’s room for further growth. But amid the current recession, many transit authorities have slashed capacity and hiked fares, and the recent stimulus bill didn’t include any operating aid for these agencies; it only provided money for new, longer-term construction projects. (An amendment to the recent war-spending bill in Congress would allow 10 percent of this money to be used for day-to-day expenses.) Expanding transit capacity would help tamp down oil demand and give at least some people viable alternatives in the event that there’s another crisis.

More significant still would be to convince OPEC — the single biggest determinant of prices — to try to beat back an oil crunch. Indeed, analysts at J.P. Morgan and elsewhere think that only OPEC can prevent a catastrophic short-term price spike. But OPEC has thus far resisted calls to boost production — instead blaming the recent rise on speculators — and oil consumers haven’t had much luck pleading for mercy. "It’s made harder by the fact that there are differences among producers," explains John Duffield, a political scientist at Georgia State University and author of Over a Barrel: The Costs of U.S. Foreign Oil Dependence. "The Saudis are more accommodating and have often been more sympathetic to the concerns of the West. Other countries just want to maximize income — it’s always more complicated than a simple, two-person negotiation." Still, it’s worth a try.

Ultimately, though, none of the shorter-term solutions on hand will address the fundamental problem. The U.S. economy and the country’s infrastructure have been built over decades to depend on cheap oil, which is fast becoming obsolete. Although the Obama administration seems to grasp this fact and announced tighter fuel-economy standards for vehicles this year, there’s more work to be done. One novel suggestion of late has been to implement some sort of variable oil charge that would keep the domestic price of oil more or less stable. When oil prices rise, the tax would decrease; when oil prices plummet, the tax would go up. Not only would that moderate price swings, but it would also create a predictable signal to encourage conservation and alternatives such as electric vehicles.

A transition away from oil will, undoubtedly, be a sluggish process, and any sort of gas-tax idea always seems to cause lawmakers to blanch. But if the United States doesn’t start reducing its dependency now, Americans can expect to be panicking about oil spikes and extreme volatility every few years. And they may have to watch on, helplessly, as violent price swings keep driving the economy back into the ground.