When will oil prices recede? No one knows. The conditions that will cause prices to recede are clear: lower demand and higher supply. Policy mistakes that would delay or distort those conditions are clear, too: punitive taxes, breaking up oil companies, price controls, tax holidays on gasoline, and other such mischief under frenzied discussion in Washington, DC.
Whatever the timing, oil prices will fall. Demand cannot rise against limited supply forever. At some point prices become not just annoying but intolerable. At some point consumers quit whining and start conserving. By then, new supply emerges where allowed to do so.
This can happen gradually or suddenly, the latter being the more painful method because of its usual association with economic recession. It happened the painful way the last time oil prices rose because of demand pressure on supply-system capacities. That was in the latter half of the 1990s. Demand collapsed where it had been strongest, in Asia, as Asian currencies lost value and economies withered. Oil prices plunged.
Larger troubles
Will something similar happen this time? There’s no way to tell. Ignoring worst-case scenarios, however, would be imprudent.
Logistical difficulties in the US switch to ethanol from methyl tertiary butyl ether for reformulated gasoline offer hints of potentially larger troubles to come. Without doubt, the switch has increased the cost of gasoline, already elevated in the US by high crude oil prices and refining capacity off line from hurricane damage and storm-delayed maintenance. Duration and costs of the ethanol logistical problems remain unclear. So far, the problems have been worse than expected.
While consumers gripe and politicians bluster uselessly, another looming nightmare of fuel logistics looms, largely unnoticed outside the refining industry and a few regulators. It involves the transition to ultralow-sulfur diesel for highway vehicles. Most refiners must begin making the fuel next month. Sales begin in the fall.
Because quality checks will occur near points of consumption, concern is high about product contamination downstream of refineries. Although refiners will make diesel with sulfur content below federal specifications, the hazard is high that fuel will absorb sulfur from residues in tanks and pipelines through which it passes en route to test locations. Some unpredictable quantity of delivered diesel will be rejected. Spot shortages are possible. They and steps taken to prevent contamination will raise diesel costs and, probably, prices.
What is more, refiners had to invest heavily to meet the new sulfur requirements. The government set a sulfur specification low enough to require new and modified equipment when a slightly higher specification, requiring less-expensive catalytic adjustments, would have delivered equivalent environmental performance. The new, expensive desulfurization capacity probably can meet current demand. A larger question is the extent to which it can accommodate demand growth. Unlike gasoline, ultralow-sulfur diesel isn’t widely available for import.
Yet economic growth, as long as it continues, will push demand for highway diesel. And a major new source of diesel demand is becoming apparent: movement of ethanol to locations where it can be blended with gasoline blendstocks. That movement will grow as a congressional mandate for ethanol phases in through 2012.
Beginning in the second half of this year, then, the costs of making and distributing diesel and ethanol will climb. If crude prices stay near recent levels, retail prices of diesel and reformulated gasoline containing ethanol have no way to go but up. So far, the US economy has been very resilient to increases in fuel prices. But it faces a weightier test in late 2006 and early 2007.
Recession possible?
Is that test enough to cause recession? And if the US slips into recession, what happens to economic growth elsewhere? No one can answer. But the questions define a worst-case scenario with potential to cut oil demand. Recession is the hard way to lower prices. But it does the job.
Against these possibilities, past refusal to lease federal land on behalf of increased oil supply looks misguided. Against these possibilities, threats of windfall profit taxes and the break-up of oil companies look childish.