SOLVING THE OIL CRISIS IS NOT ROCKET SCIENCE...
by Ryan Geiss - 8/3/2008

[ Context: this article was written at the time of $4.50 gasoline, in the summer of 2008. ]


...but because it takes a lot of time and energy to research, understand, and think it through, 99% of us have no idea what should actually be done about it, on a policy level. I'm writing this to set that straight. If you can follow me just for the duration of this article, I'll walk you through the whole thing. You should be an oil guru, with a complete understanding of how it all works, by the end; and you should understand which solutions are pretty solid, which are totally bogus, and why.

The price of something is generally determined by the available supply of it, versus the demand for it. Whether or not the supply (of oil) is still increasing, or can keep increasing, is up for debate - but we know that eventually (and probably soon), supply (production) will start to dwindle, as we run out of the stuff.

Demand, on the other hand, has increased like mad, thanks to the rich countrys' energy-hungry consumerism, and thanks to the rapid development of India, China, and others. And if you think the current demand pressure is high, just wait five years!

But, there is no conspiracy. The big oil companies are not fixing the prices; they don't need to, because people are oil-mad and NEED the stuff, and are competing for it by paying higher prices before reducing consumption. It's NOT rocket science. If you hear people talking conspiracy, they just don't understand this basic principle of economics. When there isn't enough of something to go around, and people really need it, they start bidding for it. This is simple supply and demand, a fundamental law in economics. The price goes up until, at some point, it is painful enough that some people drop out of the bidding - i.e., until people start driving less. When the price goes sufficiently high that enough people are driving "enough less", reducing the demand to meet the supply, then voila, the price stops moving. (That might be a high price, though.) The price settles at the edge of the pain - where it is just painful enough that some people change their behavior (drive less), to make up for the lack in supply.

Now, how can we fix this problem? There are a few options, and they are not all mutually exclusive. They are: use less; stop speculation (day traders); more domestic drilling; subsidize gasoline (or rebate checks - same principle); or a windfall profits tax on the oil companies.

Oil speculation is sometimes blamed for the recent price spikes. Yes, it is somewhat to blame, because it increases the volatility of the price of a barrel of oil. However, unless someone is consistently stowing away mountains of ready-to-sell barrels, as an investment, then there is no long-term effect on the price - it's just "noise" in the signal. These little spikes aren't fun, but they are dwarfed by the fundamental price rises that accompany deficits in supply. I'm not worried about little daily fluctuations; I'm much more concerned with the long-term: making sure our discomfort is minimized, and that our economy survives.

Using less is always cheapest - it's free. Making more efficient cars also pays itself off, bigtime. But both of these happen naturally, because this is the only possible personal response to high gas prices (...and auto-makers will make what people want). Let's look at the policy options, though - that's the part that people don't seem to get.

First, we could drill more in the U.S. For two reasons, this is the lousiest idea I have ever heard of. (Yeah, it takes a long time to come online, but I'm thinking longer-term than that.) The first reason drilling is not great is that it won't really dent our prices. Oil is traded freely on a global market; if we're producing more here, then everyone else will be bidding for it just like we are, and the producers here will (naturally) sell to the highest bidder - they'd be really stupid not to. So, increasing supply here by 10%, the benefit of that - the demand relief - goes to the whole world. If we use 1/4 of the world's oil (or less as developing nations grow), then for our own demand-relief purposes, as a nation, it's as if we're only producing an extra 2.5% - just one quarter of the perceived benefit. Most people just don't get this. Sure, it will help, but it will help everyone on the planet equally - not just us. (Although, whoever gets the $$ for producing those barrels sure will be rolling in it... more on that in a minute.)

On the flip side, say we become protectionist, and sell our gas only within the U.S. That doesn't work either; unless we can produce 100% of the oil we need at home ourselves, then we are in a bidding war for the fraction that we do have to import. And if half of our oil (imported) is selling locally for $5 a gallon, while the other half (domestic) is selling for $2.50 a gallon, guess which people will want to buy? And guess what that means? HIGH DEMAND. Consumers will say "I'll pay $2.60 if you sell it to me, instead of to him for $2.50; that's still better than $5!!" and so on, all the way until it's "well, $4.90 is still better than $5!". Eventually, the domestic selling price meets the global selling price. You can't diverge from the global commidity price, unless you either fully close your borders (which we can't do because we import most of our oil), or ration, or subsidize.

Rationing happens naturally, when prices become painfully high, people use less, and prices stop rising, settling in at the edge of discomfort. We could also do government rationing, where each person is allowed a certain amount. However, this is extremely cumbersome to administer (truck drivers need more; how much? etc.) and really sucks for everyone who really NEEDS more gas and would gladly pay for it (to avoid their business being shut down, etc). What we have now works just fine - let individual 'decide with their dollar' (throttle their own consumption based on the pain and price) - there is zero administration, and everything will flow much more naturally.

Subsidies are a bad idea, economists universally agree (although most people, and most politicians, don't understand this). Within an economy, they only serve to keep the price artificially low, which encourages use beyond what is available, which can lead to shortages and outages. Or, in the case of the global liquid market, if just a few countries subsidize, it "feels" good to their citizens, but in the long run, they are shooting themselves in the foot (and other countries, too). Their artifically low prices encourage higher consumption, which worsens the problem (for everyone). Every dollar their citizens save at the pump is a dollar more they have to pay in taxes, so they're paying for it anyway; but they're also making the situation worse for everyone, by over-consuming, which drives the global price up higher - and which also makes their subsidy more costly. So, ultimately, subsidies do NOTHING to solve the problem; they just make it worse.

Rebate checks are the same thing as subsidies; instead of the government using taxpayer money to help lower the cost of a barrel of oil, they just give everyone a check (of their own money) back at the end of the year. It's all the same, and it's all a really bad* idea. (*Although, in combination with a windfall profits tax on oil companies, it's a great idea - this is the only way to keep them from getting super-rich. More on that in a minute!)

Before moving on to the next idea, let me also mention another idea why increased drilling is ill-conceived: because it will be worth so much more if we wait longer. People think we're desperate now - but just wait 20 years! When all of the world's oil is used up, but we still have a bunch offshore and in ANWR (the Arctic National Wildlife Refuge) - they will be total gold mines. (At that point, it might be worth it to cut off our borders, and have our own local supply and demand - it might actually (frighteningly) be worth it.) So, why cash in our chips now, when we know it'll be worth drastically more in the long term? Although I don't personally believe in country vs. country, what nationalistic people everywhere should be pitching is, "let's use up their oil first; then ours will be worth so much more." Another way to put it is: "don't cash in short-term comfort for long-term survival."

The last - and best - idea is a windfall profits tax on oil producers. It should be clear by now that the price of a barrel of oil is set pretty naturally, and that the oil producers just happen to make serious bank off of it (lucky them). But think of the expense to the world! Why not just take that profit and hand it back to the people (via subsidies or rebates)? Well, as already discussed, it does encourage more consumption, which is ultimately bad. However, it could also keep the price at $8 a gallon (manageable) instead of $30 a gallon (total destruction of the economy). It could also buy us an extra, oh, say, 5 years of a functioning economy, while research into alternatives continues.

So how do we move this massive profit out of the hands of oil producers, and shift it back to the people? First, let's try to shift it back to the government - and then the government can use the money to issue rebate checks, or lower income taxes, or whatever. (We're talking about a LOT of money here.) If we can shift the flow of money away from the producers and toward the government, we're solving the real problem.

To do this, we must tax the production of barrels of oil - NOT the sale of gasoline. Taxing production is totally effective, and taxing the sale is absolutely worthless, as far as moving those profits from the oil companies and back into the people's hands.

Let's look at the 'bad' idea first. Say it costs an oil producer $0.50/gallon to produce the oil. The producer then sells the oil at the global liquid market rate, say, $3 a gallon. Their profit is $2.50. Then, Joe drives up to buy fill up his tank. The gas station slaps on the $1.50 in taxes that we're accustomed to (taxation at the point of sale), and Joe pays $4.50/gallon, the price we are familiar with.

Now imagine that tax is increased; so the gas station still purchases gas for $3/gallon, but now adds $3/gallon tax, bringing the pump price to $6/gallon. Joe pays more; but the producers - the primary beneficiaries of skyrocketing oil prices - still made their wopping $2.50. Remember, we want to re-route the flow of money away from the producers, and back to the people. Increasing taxes at the pump does not do that.

Ok - so what happens if we place the tax on the production of a barrel of oil? Everything changes. Say we slap on a $2/gallon production tax. If the producer was spending $0.50 to produce it, thanks to the whopping new tax, it now costs them $2.50 to produce it, and when they sell it competitively ($3/gallon), they only make $0.50. Their profit margin went from an unheard-of 83% ($2.50 profit on $3.00 of revenue) down to 16% ($0.50 profit on $3.00 revenue) - a common and reasonable margin for a corporation. (The key is to tax them just enough to eat up most of their profits, but leave some, so they continue to operate.) Notice that the price of gas at the pump is the same! - the producers can't just raise their prices, because they have to compete with a global market - nobody would buy their gas if they try to sell it above $3 a gallon. But now, instead of windfall profits being made by oil producers based in the U.S., you now have 80% of that profit ($2.00 out of $2.50) flowing back to the government, where it can be used to fund renewable energy, or offset income taxes. Basically, it goes from the hands of these rich oil companies, back into the hands of the people.

It could be implemented in this way, as a tax on the production of a barrel of oil; it could also be accomplished by making a new tax bracket for corporations whose gross margins exceed, say, 30% (perhaps limited to companies peddling limited natural resources). Either way, the principles are the same, and it would solve the problem.

There is one (and only one) point of resistance we can expect: implementing this would utterly smash oil stocks, because their profits would drastically drop. Expect resistance because of that. So, yes, it will hurt those investors - but those investors are artificially rich right now, making serious bank off of a commodity that really should be returned to the people. And this is the only real way to do that.

There is a bonus for the first countries to do this, too: their oil producers have less incentive to drill now, while everyone else is drilling like crazy, to sell their oil at these "high" (relative to the past - not the future!) prices. That means that our oil producers would tend to relax, and save their oil more for the future, more than producers in other countries - and that will pay off for them bigtime, in the long run.

THE ECO FACTOR

On an environmentalist note: don't worry about the oil - there's not enough carbon in oil to destroy our planet. The real carbon threat is COAL, which, without a little legislative help (and your support), we could burn for centuries. As oil skyrockets, we'll turn to electric cars, and coal is our cheapest form of electricity, so we'll burn twice as much coal as we do now, in order to keep driving. So, COAL is the real carbon threat.

What alternatives are there? Photovoltaic solar (power from pretty solar panels) is about four times as expensive as coal - i.e., not even remotely viable on a large-scale yet (imagine paying 4X what you pay now for electricity!) (and remember: the money has to come from somewhere). However, wind is only about 20% more expensive than coal or [already-subsidized] nuclear, on average. But electricity sells on a national liquid market - the grid. But power producers don't want to build wind, because their profit margin is 20% higher if they build coal. If you want them to build wind, that's the problem to fix!

Fortunately, with a tiny bit of no-brainer legislation from congress, we could slap a 20% tax on coal. Yes, we will pay for it (our electric bills will go up 20%). However, pipe that money into subsidies for building wind and concentrated solar (mirrors and sterling engines - not expensive photovoltaics), and voila, they start replacing coal. Between oil disappearing, transportation shifting to electric (already cheaper, per mile driven), and coal shifting to RE (renewable energy), our carbon crisis is 90% solved. And the extra 20% we're paying for RE-over-coal is dwarfed by the amount we're saving by driving on wind power (electric) instead of $8-a-gallon gasoline - everyone wins, both the consumer and the environment.

I do recognize that there are storage issues with wind, and that it can come and go. (Concentrated solar can use molten salt to cheaply store heat all night, on the other hand.) However, we can safely get up to 40-50% of our power from wind, without worrying about this too much. Let's get to that mark, and then worry about how to solve the other 50-60%. (My hunch is that we'll have come up with some pretty excellent solutions by then, judging by how huge the demand for it will be.)

We need congress to tax coal (and channel the money into RE) to the tune of about 20%. As individuals, we need to tell congress, loud and clear, that we are happy to pay 20% more for electricity, to save our planet. We also need to be supportive of wind in our neighborhoods - no nimbyism (not-in-my-back-yardism). And we need to call politicians out on it, when they suggest short-term solutions. These problems need long-term solutions - we (literally) can't afford anything else.



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