The Real Question: Should Oil Be Cheap?

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You can see where this is going. Wall Street has. With oil demand slowing and supplies headed up, prices are off more than $20 from their July 11 record of $147.27. "I don't think anyone believes prices that high were here to stay," says Massachusetts Institute of Technology economist A. Denny Ellerman.

Just as the low prices of the late 1980s and '90s undid some positive effects of expensive oil, the mere possibility that prices could fall is weakening the market forces pushing toward greater energy efficiency. What really drives behavior is not the actual price, but the perception of where costs will be over the long term. That helps explain why Americans didn't cut back while gasoline prices climbed a few years ago. "After Katrina, gas got close to $3, and then prices moderated," says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University. Only when gas broke the $4 barrier, with no relief in sight, did the wake-up call come.

Strong as it is, that call is being muted by uncertainty about where prices will go. Some experts see $200-per-barrel oil in their crystal balls; others predict $75 or lower. As a result, technologies that should make economic sense at $100 per barrel aren't being funded, says venture capitalist Vinod Khosla. "We are getting the worst of both worlds—high prices and low investment," says Khosla, a co-founder of Sun Microsystems (JAVA) and now a backer of alternative energy ventures.

That's why Khosla and many economists and energy experts are pushing the idea of a floor on the price of oil. The certainty of a relatively high price would stimulate enough investment in alternatives, efficiency, and new supplies to keep future prices from rising much above that level, Khosla argues. It adds no new pain, since the tax would start only after consumers and companies have already gotten considerable relief from today's prices. It would have been better to tax citizens decades ago—forcing Americans to become more energy-conscious—but that was a near-impossibility politically. Since external forces have now accomplished the same thing, though, a floor is a good second-best, economists say.

It's not quite that simple, of course. Some big industries will be hurt by any policy that boosts energy prices: Airlines, shipping companies, manufacturers, utilities—indeed, anyone who can't easily cut back. And if oil were the only fossil fuel to be taxed, it could bring a distorting shift toward natural gas and coal. So it would be better, some economists say, to institute such a levy as part of a broader energy policy. With growing concern over global warming, a tax on carbon dioxide emissions makes the most sense.

Another danger is that Uncle Sam would fritter away the new revenue. Some economists suggest using the money to invest in oil alternatives, while others would return it to people in, say, lower income taxes. Again, it's basic economics: Use taxes to keep prices high for something we want to use less of—oil—and use the money to reduce the cost of things we want more of—growth and productivity. There's a debate about whether the benefits of such a tax-shifting strategy are outweighed by the loss of innovation that might result from government intervention. But many economists say any negative effects would be relatively small. "It may not be a free lunch, but it's clearly a lunch worth paying for," says Stanford economist Lawrence H. Goulder.

Take the Train

British Columbia has shown that it's politically possible, too. On July 1, it added a small tax on gasoline designed to account for the costs of carbon dioxide emissions. The revenue will be returned in reduced income and business taxes. To ease the initial sting, the government sent each citizen a check for $100 at the end of June—a move that will help lower-income people who are struggling with higher energy prices. Taxing energy, and returning the money to people in other ways, "is pretty much an economist's dream," says Ian Perry, senior fellow at Resources for the Future, a Washington think tank.

If the U.S. manages the difficult feat of keeping the price of energy consistently high, what will the future look like? For a glimpse, take a ride on Atlanta's transit system, MARTA, with Kerri Hochgesang. The cost of commuting in her Nissan Xterra (NSANY) had ballooned to $460 per month, so in late June the 32-year-old lawyer switched to the train. "I thought it would be miserable and take forever," she says. It didn't: Her 25-mile commute is now 45 minutes instead of an hour and 20 minutes, and she can read instead of dodging traffic. "It's newfound 'me' time," says Hochgesang.

Thanks to new riders like Hochgesang, trips on MARTA in June and July are up 13%, year-on-year. Says Beverly Scott, MARTA's chief: "My husband jokes with me: 'You're the only one I know that jumps around the room going, Yeah! Yeah!'" when gas prices go up. Rush-hour traffic around Atlanta is down as much as 15%, says Mark Demidovich, an engineer at the Georgia Transportation Dept. "That converts to 10,000 or 12,000 fewer cars a day," he says.

Change doesn't come quickly. Few people will quickly move downtown or near transit stops because of high gas prices, says Charles J. Courte�manche, an economics professor at the University of North Carolina, Greensboro. But when they move for other reasons, they'll make different choices. Courte�manche did: In May he moved from a St. Louis suburb a half-hour's drive from his office to downtown Greensboro, a 10-minute bike ride to work. "We've probably passed the zenith of the suburban auto-oriented planning era," says Royce Hanson, chairman of the Montgomery County (Md.) Planning Board.

No one discounts the pain of high energy costs. But it can also bring real gains. The New York Times reports that teenage cruising is down nationwide. Whirlpool (WHR) says sales of high-efficiency washing machines are up, saving both water and energy. At the National Renewable Energy Laboratory, algae biofuel research is back, funded this time not by the government but by Chevron (CVX) and ConocoPhillips (COP), which could use plant oils in their refineries. Clever policy ideas, such as a "crusher" tax credit to smash SUVs and use the steel to make fuel-efficient cars, are sprouting in Washington. And in Maine, "people are coming out of the woodwork to invest in energy efficiency or alternatives," says John Kerry, director of the Governor's Office of Energy Independence & Security. "I think energy costs will become an economic engine."

Business Exchange related topics:
Global Power and Energy
Oil Prices
U.S. Energy Policy
Oil and Gas

With Diana Holden in Atlanta and Tatyana Gershkovich in New York