The One Sure Way to Drive Gas Prices Down

Drilling for more oil or raising taxes on oil companies won’t help drivers at all.

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There's a saying in the oil industry: The cure for high oil prices is high oil prices.

It's not as circular as it sounds. When oil prices get uncomfortably high, something decisive tends to happen that depresses demand for oil, pushing prices back down. Sometimes surging oil prices trigger a recession, which usually does the trick. Costly oil also gives businesses and consumers a strong incentive to conserve, tap into other forms of energy, and even change their behaviors and business models. Motorists start to combine trips, take the bus, ride a bike, or even walk. Businesses become more efficient and use new technology to cut fuel costs. Rising oil prices also give regulators a stronger hand to insist on higher mileage standards, more research into fossil-fuel alternatives, and other reforms meant to reduce oil dependence.

[See 10 reasons you don't need a hybrid.]

The scenarios differ, but there's one common thread: When demand for oil falls, prices fall. The one proven way to push down the price of oil and gas is simply to use less of it.

With oil prices hovering around $100 per barrel and gas prices cresting $4 per gallon in many states, all the predictable ideas for lowering oil and gas prices are surfacing. President Obama recently agreed to relax regulations and speed permits so that oil companies can do more drilling on U.S. territory, a sop to drilling advocates who think more domestic oil will solve the problem. Big oil companies like ExxonMobil and BP are taking the usual hits, with calls to eliminate tax breaks they get and even impose windfall taxes on their surging profits.

Some of these ideas may be sensible in their own right, but they won't push down oil or gas prices. Here's why:

More domestic drilling might slightly enlarge the world's supply of oil someday, and make the United States a bit less dependent on imported oil. But there's simply not enough untapped oil on U.S. territory to make much of a difference. Americans consume nearly 19 million barrels of oil a day, or seven billion barrels per year, mostly in the form of gasoline. Imported oil accounts for slightly more than half of that. Total known reserves of domestic oil amount to 21 billion barrels, enough to meet America's needs for about three years. If we burned all of that, we'd be totally dependent on foreign oil. New oil becomes available from time to time, which is why the United States is consistently able to meet about half of its own needs for oil. And it's possible that more aggressive exploration might lead to new domestic discoveries. But the trend has been going the other way, with known reserves today about 45 percent lower than they were in the 1970s. Plus, untapped oil tends to be more expensive to reach, and it would take years to tap and pump it anyway.

[See why gas and food prices are likely to drop.]

More and more, oil appears to be a scarce commodity the United States will never have enough of, at current consumption levels. And the balance is likely to tilt increasingly in favor of nations that have a surplus of oil. The International Monetary Fund points out that oil prices have drifted upward over the last decade because demand for oil is rising faster than supply, a divergence that could intensify in coming years as China, India, and other rapidly growing economies sharply increase their use of oil, while known supplies mature. "The global oil market has entered a period of increased scarcity," the IMF wrote in its most recent World Economic Outlook. If it continues, price shocks like the one in 2008—when oil hit $147 per barrel—could become more common, and perhaps more severe. The United States doesn't have nearly enough oil to change that equation.

Tax changes might be in order for oil companies, but they wouldn't do anything to change gas prices. Oil companies get about $4.4 billion worth of federal tax breaks each year. Some of those are ancient provisions going back as far as 1913, which probably ought to be updated or eliminated. Other tax breaks apply to many types of manufacturers—not just oil companies—and are meant to encourage domestic production that employs American workers. But even if Washington alleviated the tax breaks completely and gave the entire $4.4 billion in savings to motorists, it would be a negligible amount.

[See 3 reasons to stop hectoring Big Oil.]

Here's the math: Americans buy nearly 140 billion gallons of gasoline per year. At $3 per gallon, that totals $420 billion per year. At $4, it's $560 billion. Shaving the total by $4.4 billion would lower gas prices by a grand total of 3 cents per gallon. If the government seized the annual profits of the nation's three biggest oil companies—ExxonMobil, Chevron, and ConocoPhillips—and gave that money to motorists, too, it would make a bigger but not a decisive difference. The Big Oil 3 earned about $61 billion in 2010, and if you used that to offset gas prices, they'd fall by about 44 cents per gallon. To do that, of course, the government would have to nationalize the oil companies (which would be illegal), operate them as nonprofits, and run them as efficiently as their CEOs do under the scrutiny of shareholders and Wall Street analysts. But since Americans want smaller government, not an expanding one taking over publicly owned companies, this seems unlikely.

The one thing that does lower oil and gas prices is a drop in consumption, which creates an oversupply of oil and gasoline and brief bursts of euphoria at the pump. This is most evident during recessions, like the one that gathered steam in the fall of 2008, when a financial meltdown nearly occurred. By the end of 2008, oil prices had sunk to $44 per barrel, from a summer peak of $147. Pump prices plunged from an average high of $4.05 in July 2008 to $1.59 at the end of December—a 60 percent drop in just six months.

[See why car buyers should wait six months to buy.]

That was obviously an extreme example, and there's an important caveat: Oil prices only fall if total world demand falls. If demand declines in some countries—thanks to conservation, say—but continues to go up in others, then that's likely to keep modest upward pressure on prices. And that's what seems likely to happen over the next several years. While America's oil consumption has declined on a per-capita basis, and as a share of the world's total, demand in China, India, and other fast-growing nations could go up by more.

That blunts the benefits of conservation, higher gas mileage, and improved energy efficiency, since the gains are diluted by rising demand elsewhere that keeps pricing pressure firm. But using less oil is still the best remedy for high prices, no matter how it's achieved. It keeps prices from being higher still, and lowers out-of-pocket expenditures on gas. And anything that encourages the use of other kinds of energy—whether it's natural gas, battery-powered cars charged off the grid, hydrogen-powered futuremobiles, or something as yet unimagined—raises the odds of a breakthrough alternative to oil. That would be the ultimate way to slash demand for the world's most addictive form of energy.

Twitter: @rickjnewman