Time to change our oil policy

Recently, author Roger Howard pointed out a fact that the public, politicians, and less-informed policy wonks frequently forget, which is that oil prices go up and down and the sword cuts both ways: on demanders and suppliers. It follows that oil policy and oil diplomacy can help or hinder depending upon how well policymakers understand the real economics of oil.

Price changes affect the behavior of both parties to the oil trade, and intelligent policymaking makes this observation the foundation of good policy. The Obama mantra has been “change,” and no policy domain needs change more than our oil policy - indeed, our energy strategy as a whole. Hopefully, the Obama advisors will educate the President-elect that some changes can be quickly implemented within a larger context of sensible oil policy for the United States.

The first rule is to keep the price of oil high to the users of oil products! This goal is too often absent from the policy debate. In fact, Obama seems to have it the wrong way around as an advocate of low prices to consumers. The reason for this rule is simple: higher prices deter consumption, both presently and in the future. If there was only one single measure that the new Administration could pass that would be effective, it would be not only to raise taxes on all petroleum products, but also to designate a tax trajectory for the future that signals a rising cost of petroleum products over the next several decades. Such a measure could easily be termed a “national security tax” to indicate that our domestic and foreign security is a cost and that it takes a great deal of resources to fund our security needs. We could even go so far as to create a “lockbox” for these additional taxes to be spent solely on national security needs (broadly defined), including not only the military costs of protecting valued sources of supply in the Middle East but also encouraging alternative energy sources that are less polluting and perhaps helpful on the global warming front.

In some ways, a national energy lockbox that is purely a financial reserve would complement the strategic petroleum reserve (SPR) that is there as a temporary source of supply in the event of a physical blockage on our imported crude oil supplies. The SPR is limited - it just holds oil. A national energy lockbox has a totally fungible resource: money, which can be used for a wide variety of purposes. Yes, such funds can be wasted, but that is true of all government tax proceeds. Importantly, this tax must be variable. It must rise when the crude oil price falls and perhaps fall when petroleum prices rise to very high levels. It is a variable tax wedge that will keep the price at the pump, or the airfield or diesel truck stop, from falling (and inducing more consumption) when crude oil prices fall. It will indicate a permanently higher price of petroleum products that will induce needed substitution away from petroleum-based energy use for the future. A higher price on petroleum-based energy will be a general subsidy for all producers of alternative, non-petroleum-based energy.

President-elect Obama has signaled that major government funds will be allocated to create incentives for alternative energy development. Doing alternative energy that way makes government the inevitable “chooser” of which projects get a subsidy and which do not. Raising the price of petroleum-based products allows the market to respond in its own way, with the market being the judge of the winners and losers. It is clear, however, that the correct tax policy on petroleum products must also carry over to all hydrocarbons, in greater or lesser degree. Between the devil of cheaper coal and the angel of cleaner natural gas, all hydrocarbons are sources of energy and hydrocarbon-based environmental issues. A variable tax on other hydrocarbons should be set consistently with the variable tax on petroleum just to prevent inter-fuel substitution. (For purposes of setting a quick policy into effect, it would be advisable not to contaminate this “security tax” with a “global warming tax” that seeks to retard generation of CO2. That issue can be dealt with quite separately.)

The principal objection that has been levied against higher prices at the pump is that this is a regressive tax, in the sense that often heavy users of gasoline are also working-class job-holders who have to drive significant distances to get to work. There is some truth in that claim, and if “equity” considerations are to be taken into account, it would not be hard to allow some relief from this “variable national energy security tax” through payroll tax rollbacks.

Former vice-president Al Gore has suggested a similar measure, although his ostensible purpose of the petroleum tax was to deal with “an inconvenient truth.”

Still, whatever the merits of the claim that manmade energy consumption drives global warming, the principle that higher-cost energy will induce substitution toward non-hydrocarbon-supplied energy remains valid. And it is also true that while a variable national energy security tax can hit unequally, it could quite possibly mitigate some of the major impact of the tax on those workers least able to afford it. It will take time for our national auto, truck and air fleets to adapt to these circumstances, but the real essence of change is to change now…and keep on changing.

National energy policy is and always will be the handmaiden of lobbyist politics. Everyone has some stake in the game. What is undeniable now - if it was ever a confused matter - is, first, that oil and politics are mixed together both domestically and internationally. The US needs to have its foreign policies sensitized to the cost of maintaining stable global supplies, and that is a real drain on national resources. We should fund these costs less opaquely so that each user of energy knows in part to what purpose his/her tax is being used.

Second, national energy policy should have a lockbox concept so that it is not abused by the “pet projects” of earmarking Congresspersons. Some objection to raising a tax in the face of a serious downturn has been raised, but it is easily countered. For the present, the revenues generated by an energy security tax can be rebated back to the public through the payroll tax system. It can even be structured to allow some disproportionate amount of tax relief to middle and lower ends of the income distribution. That would offset any "macroeconomic" effect of the tax while leaving the “substitution effect” of higher petroleum product prices to work on achieving a reduction in consumption of fuels.

Furthermore, the amount of the rebate could be changed to reflect different macroeconomic circumstances once the current recession is over, at which point the “lockbox” becomes more relevant. The key is to recognize that sending a permanently rising price signal to petroleum consumers will retard their consumption and induce substitution of alternative energy sources. By implementing such a policy, the United States gets another side benefit from an increasingly larger wedge between the price of crude oil paid to producers and the prices of petroleum products paid by users here. That benefit is “insulation” from petroleum price shocks. The larger the wedge, the smaller the impact felt at the pump or the wing tip or the diesel truck stop.

Europe, for example, was insulated to a large degree from the extraordinary run-up in crude oil prices because its prices to consumers were already high. This is one of the few things that informed observers of the EU might wish to recommend to American policy makers. Taxes can be insulators as well as incentives to alternative fuel source production.

Third, the policy needs to be implemented now and it must include a plant that forces rising taxes far into the indefinite future. This we can call the tax trajectory, because it maps a rising tax over time. Innovators of alternative energy production should know what price path they face. Nothing illustrates the effect of highly variable hydrocarbon based energy prices more than the shutdown of the Boone Pickens Wind project as energy prices cheapened dramatically. That setback to alternative energy source production has happened more than once, and we need to have a clear path to energy alternatives, irrespective of what happens elsewhere in the world.

In “Ode to Oil,” Howard gave a clear picture of the double-edged sword nature of fluctuating oil prices. They can help or harm our international relations. The key is to use price variability to our advantage. By staking out a future price trajectory for all to see, the world’s oil producers will know how to plan their own further oil development in an environment of certainty. They might conclude that rising crude oil prices may just not be in their longer term interest.

The higher the price at the pump, the greater the incentives to substitute away from hydrocarbon based energy. Crude oil producing countries will be disciplined not only by the effectiveness of their cartel, but also by the signals our market will be sending. OPEC may or may not be able to control the price of crude oil, but we can control the cost of petroleum products that we use. It is an extremely valuable weapon in economics and in geopolitics. It’s time to make that change.