Monday, March 03, 2008

Oil Sets All-Time High

Oil prices set an all-time high today on both a nominal and inflation-adjusted basis. Yet gasoline prices are still below their May 2007 highs. Interestingly, oil prices were much lower last May. But gasoline prices surged anyway due to problems at refineries. Today, however, it is oil, the raw material for making gasoline, that is just starting to push gasoline prices higher.

But oil prices are not climbing because of a lack of supply. Instead, they are rising due to demand for oil futures contracts. Investors are pouring money into the commodity because the Fed is trashing the dollar. Because oil is a dollar denominated commodity, it provides a hedge for investors worried about a falling dollar. They are looking for ways to preserve the value of their dollar denominated assets. Eventually, these higher oil prices will drive up the price of gasoline, too.

In the past, higher gasoline prices had little effect on consumption. This is because it takes time for consumers to adjust their behavior. You don't immediately dump your SUV and buy a Civic just because gasoline prices spike. But if you are convinced that higher gasoline prices are here to stay, the next time you are in the market for a new vehicle, you will consider something more efficient. After several years of watching gasoline prices climb higher and higher, consumers are making the switch.

These days automobile manufacturers can't sell SUVs and pick-up trucks without making large concessions. In fact, GM just reported a 19% drop in light truck sales. Consumers are doing the math and they now want more efficient vehicles. At $3 per gallon, if you drive 12,000 miles per year and get 20 mpg, a 50% improvement in mileage saves you $600 per year. At $4 per gallon, you will save $800 per year. If there are three cars in your family and they rack up a total of 36,000 miles per year, at $4 per gallon, the total savings adds up to $2,400 per year.

The government can take steps to encourage conservation. CAFE standards, however, are not the way to go. A better approach is to put a floor on gasoline prices. While I'm no fan of higher taxes, it cannot be denied that taxes are a great way to affect behavior. If we want to reduce our dependence on foreign oil, we should encourage people to consume less gasoline. The best way to do that is to make driving more expensive. However, any incremental revenue the government generates from a floor on gasoline prices should be used to offset other taxes or to fund research into alternative technologies. Using it for general funding purposes would be nothing but a big waste.