Sprinting Blindfolded to a New Equilibrium


Everyone except the fabulously wealthy and the truly disconnected knows energy has become much more expensive in recent years, but it's worth taking a step back and examining just how much it has jumped and what we should (and should not) conclude about the impact on nearly all aspects of modern life.

The raw data provides a startling enough starting place. Since 2004, the U.S. retail price for gasoline has leaped from $1.53 per gallon to $4.10, and oil has skyrocketed from $28 per barrel to over $140. The retail price of natural gas, largely ignored by U.S. consumers during the summer, has increased from $9.71 per thousand cubic feet to $14.30 (its highest price ever for the month of April), and even coal has risen from $19.93 per short ton to $25.40. Electricity, closely tied to the price of natural gas and coal, has increased from 7.61 cents per kilowatt hour to 9.14.

Whether this rise in oil prices was triggered by the fundamentals of supply and demand, politics, collusion among oil producers or a lack of investment in developing oil fields around the world (I strongly favor fundamentals), or you think we're headed toward a peak in world oil production very soon or decades from now (I'm firmly in the "very soon" camp), the bottom line is that the economy doesn't care about causes or rationalizations, just prices.

Economics, the study of the allocation of scarce resources, tells us that economies constantly adjust themselves in response to price changes. One company raises the price of the tennis rackets they manufacture, so some customers will buy a competitor's product or forego buying a new racket this year or take up another sport. Many such events constantly send overlapping ripples throughout an economy, causing the quantities demanded and supplied of many goods and services to rise and fall slightly. In econo-speak, the entire system seeks a new equilibrium in response to a change in the price of one good or service relative to substitutes. Talking about minor price changes for non-critical items is the normal background noise of a healthy economy. But energy, especially oil, presents an entirely different scenario.

Virtually everything we buy depends on the price of oil to some degree. Raw materials, finished goods, customers, and the people who perform services all need to be transported. Oil and natural gas are also critical components in making plastics and many chemicals and fertilizers, and fossil fuels provide 70 percent of the energy consumed to generate electricity in the U.S. In most applications, trying to find a substitute for fossil fuels on the scale and immediacy we'd prefer is impossible without paying a very high price. (As the old line goes, I can do a job for you quickly, cheaply, or well -- pick any two.)

When the price of such a significant and unique resource rises so much and so quickly we've pole vaulted over a mild jostle to the system and gone straight to a deep, pervasive, game-changing shock.

The sheer magnitude of this shock explains why there is so much talk in the financial press lately about which of the Big Three car companies could file for bankruptcy within a year. Ford, GM, and Chrysler are in a desperate race against time. Can they radically overhaul their product lines to meet the rapidly shifting demands of their customers before they run out of cash?

Given the high cost and long development time to create a new car model, this is a daunting task, to say the least. By comparison, the commercial airline industry is in far worse shape, as they don't have the potential to save themselves via converting to electric vehicles or plug-in hybrids. Even using biofuels to run their jets is more wishful thinking than a real-world solution, and is at least a decade away from widespread application. Unless the price of jet fuel drops dramatically and fairly soon, the downsizing and bankruptcies we've already seen among airlines will be only the beginning of their "adjustment."

So, all is gloom and doom, right? Well, no, and this is the point that's so easy to overlook. Even though energy prices have been rising for years, we're still in the very early stages of the U.S. economy's reaction; what we've seen to date is much more the initial impact than our individual and collective response.

Still, it's not hard to find media stories about the increased use of public transportation, people driving less overall, and more workers telecommuting or converting to a four-day workweek. Plus, we're awash in reports of how 2010 will be a sea change in the car business, with several companies offering plug-in hybrid and full electric vehicles in the U.S. A further complication is the virtual certainty that soon the U.S. will overtly begin to rein in CO2 emissions, whether via a carbon tax or a cap-and-trade system.

Beyond that we have the growing challenge of generating enough electricity to meet traditional demands plus the additional burden of recharging electric vehicles, all the while reducing CO2 emissions and finding enough water to cool thermoelectric plants (nuclear, coal, oil, and natural gas) in a world where climate change is creating drought in inconvenient places. With so many large and powerful forces suddenly in motion at once, trying to make firm predictions about the quantity demanded or the price of any fossil fuel is a revelation of one's hubris or insanity.

The last thing we should do is fall into the trap of making simplistic, linear extrapolations. You can barely Google any energy related topic without finding references to the impending "death of the suburbs," a topic Joel Kotkin addressed recently and I commented on both here and on my own site. Similarly, you can find numerous other opinions that grossly underestimate the inherent flexibility (and therefore unpredictability) of entire economies. Many of them are based on a fallacy that roughly says: "We use a lot of oil to do X. Oil will get more expensive, so therefore we won't be able to do X." These comments almost never mention the possibility that we'll find ways to do X with far less oil, or that we'll fill the same need by doing Y, or that savings in oil consumption in other, less critical, parts of the economy will buy us time to change how we do X.

In more concrete terms, how many people really think that more expensive oil will stop us from making medical supplies or fueling trucks that deliver food? Isn't it more sensible to assume that we'll cut back on far less critical uses, like pleasure boating or flying for vacations, and keep the increasingly scarce oil flowing to life-and-death applications?

Humanity has just begun an unprecedented, expensive, painful, and, above all else, unpredictable journey. The end of the age of cheap energy will no doubt reshape almost everything we do, from decisions about personal consumption to our governments and public policies, to our institutions and businesses, to our cities. Our collective future will be a lot of things, but "dull" isn't on the list.

Lou Grinzo runs the web site The Cost of Energy , and is an economist by training, a programmer, technical editor, and writer by profession, and an energy geek by genetic predisposition.