I don’t want to focus too much on one topic, but the price of oil and gasoline is on everyone’s mind these days. Especially mine, since I gave a talk today on a panel on “America’s Oil Addiction and National Security” at Dartmouth College. My talk was about ways that the U.S. can (and especially cannot) use foreign policy to affect the price of oil. Foreign policy is a poor tool for dealing with many economic problems, and oil prices are no exception.

Many people in the audience — smart, engaged people, some students and some from the surrounding community — have trouble thinking about oil as an economic commodity. It just seems too important to our prosperity (and to the environment, which came up frequently in the Q&A session) to leave to supply and demand.

But the truth is that there really is an underlying price of oil, set by supply and demand. Demand for oil is increasing, so the price should be expected to rise unless supply shifts up, too. At higher prices, we should expect somewhat more investment to try to increase supply, but supply adjustments take time, and in the interim we pay higher prices. Similarly, over time, higher prices will lead to some adjustments on the demand side: some people will conserve, and others will switch to substitute fuel sources.

I presume this Econ 101 story is not new to very many readers. Newspapers are full of stories along these lines — for example, questioning whether consumers are actually cutting back in the face of high prices (that is, in economic terms, suggesting that demand is quite inelastic, at least in the short term). Over time, I think people will adjust, even if it’s hard to see so far. But even if supply and demand turn out both to be totally fixed — oil does not get pumped at a higher rate, and people decide they simply must buy the limited oil anyway at the high prices — supply and demand will meet: those who are willing to pay will get their oil, and those who pump the oil will be paid to take it out of the ground. Oil will have a price.
On the foreign policy side, the question is, what can we do to affect that price? How can diplomacy, tariffs or threats of economic sanctions, and military actions possibly affect the supply of oil on the world market? In general, they cannot (there are some exceptions in the details, like keeping a few vital sealanes open for supertankers).

But what country owns the land under which oil is located (determined by military conquest) just determines who profits from oil sales, not how much each barrel of oil is worth. Which company owns the rights to take the oil out of the ground and the drilling and pumping equipment similarly does not affect the value of the oil; ownership only determines which shareholders enjoy the profits from selling the oil (or, in a different world, which shareholders would face losses from failed investments).

That’s the sad (or reassuring, to an economist) fact that needs to enter the bipartisan consensus about oil: we can’t use foreign policy directly to change the underlying price of oil. Investment in exploration, drilling, and distribution infrastructure determine supply. Reasonable people can debate the effect of foreign policy on incentives to explore, drill, and distribute oil, but at best foreign policy has a long-term effect through those mechanisms, so foreign policy cannot do much to influence today’s oil price.
Unfortunately, pages and pages are filled with commentary about oil supply and demand no longer matching up. A slew of books on the shelves of airport bookstores warn that we may be passing “Hubbert’s Peak,” after which we won’t be able to find new sources of oil to match the volume of oil that we use up. One of my co-panelists at Dartmouth talked about a “permanent energy crisis” with a “growing imbalance between supply and demand.” He didn’t like what he argues is the current administration’s penchant for trying to fix the problem by sending the U.S. military to oil-producing countries all over the world, but he did want to find an alternative policy solution.

Sadly, he almost didn’t mention price at all, but price is the key economic mechanism that always brings supply and demand into balance, as long as there is a mature market (which there is in oil, with all sorts of futures contracts and derivatives to help us manage its finances).

The thing that people object to is the changing price of oil — the rising price of oil. There is — and should be — a bipartisan consensus that the U.S. would prefer lower oil prices, because we are consumers of oil. (Or, if we take the risk of climate change seriously, perhaps we should have a bipartisan consensus that we prefer higher prices of oil, to discourage our use and carbon emissions: those higher prices would be painful but perhaps worth it).

But lowering consumer gasoline taxes or giving Americans $100 checks to compensate for high gas prices — recent Congressional proposals — won’t affect the underlying truth about oil prices. If anything, they will increase demand for gasoline, which will pull along demand for oil and — you guessed it — drive the price of crude up further still.

Fortunately, leaders from both parties have pointed out the flaws in those pandering proposals: bipartisanship on energy policy occasionally settles on the right answer. But there is still far too much hand-wringing, wishing and hoping that we’ll find a bipartisan foreign policy that will sensibly respond to the higher oil prices. We have bipartisan blue-ribbon commissions working to produce and promote reports that recommend such policies.

Some of their ideas may even be good ones. And the particular commission that I linked to, the National Commission on Energy Policy, even explicitly recognizes an important role for the price mechanism in thinking about energy policy. But I still suspect their hope for a grand policy solution to high energy prices is, well, forelorn.

Related posts:

1. Reconceiving the BP Debacle
2. Dubious Decisions on Drilling: Why Obama Should Reconsider Offshore Drilling in the Wake of the Deepwater Horizon Oil Spill
3. Bipartisan gift to the planet
4. Drilling Our Way to a Climate Change Solution?
5. Moscow’s Annual Energy Row: ‘Kto Kogo’?