Thinking seriously: about energy and oil's future.

• Author: Schlesinger, James

THE RUN-UP in gasoline and other energy prices--with its impact on consumers' purchasing power--has captured the public's attention after two decades of relative quiescence. Though energy mavens argue energy issues endlessly, it is only a sharp rise in price that captures the public's attention. A perfect storm--a combination of the near-exhaustion of OPEC's spare capacity, serious infrastructure problems (most notably insufficient refining capacity) and the battering that Hurricanes Katrina and Rita inflicted on the Gulf Coast have driven up the prices of oil and oil products beyond what OPEC can control--and beyond what responsible members of the cartel prefer. They, too, see the potential for worldwide recession and recognize that it runs counter to their interests. But the impact is not limited to economic effects. Those rising domestic energy prices and the costs of fixing the damage caused by Katrina have weakened public support for the task of stabilizing Iraq, thereby potentially having a major impact on our foreign policy.

What is the cause of the run-up in energy prices? Is the cause short term (cyclical) or long term? Though the debate continues, the answer is both.

Clearly there have been substantial cyclical elements and "contradictions" at work. For several decades, there has been spare capacity in both oil production and refining. Volatile prices for oil and low margins in refining have discouraged investment. The International Energy Agency, which expresses confidence in the adequacy of oil reserves, urges substantially increased investment in new production capacity and has recently warned that, in the absence of such investment, oil prices will increase sharply. (1) Such an increase in investment clearly would be desirable, but it is more easily said than done.

In the preceding period of low activity, both the personnel and the physical capacity in the oil service industry have diminished--and it will take time to recruit and train personnel, to restore capacity and to produce equipment. It is interesting to note that the capacity of OPEC itself has shrunk in this last quarter-century from 38 million barrels per day (BPD) to 31 million BPD. The bulk of the shrinkage occurred in Iran, Iraq and Libya, which have been the targets of both U.S. and international sanctions. Though knowledgeable people were aware of the shrinkage of spare capacity, it was still thought to be adequate--until the recent surge of demand, especially from China and the United States, brought us to the point that it was insufficient to satisfy the growing demand at prevailing prices.

Three additional points should be kept in mind. First, crude oil production capacity has not been wholly exhausted. The minister of petroleum of Saudi Arabia, Ali Naimi, points to the unutilized 1.5 million BPD in his country and states that he stands ready to serve additional buyers. The minister is making something of a rhetorical point: For the moment, that additional crude oil production capacity is unusable. There is a mismatch between the types of crude available and what refiners are able to process. For many decades there has been a marked excess of refining capacity--and very low margins in refining. There has been only a modest incentive to invest in additional capacity. With sufficient light crude apparently available, there has been little incentive to invest in capacity to process the heavy, sour crudes of the sort still available in Saudi Arabia. That is not to say, however, that there has been no investment. Here in the United States, far too much of the investment has been channeled into the capacity to produce the numerous boutique blends of gasoline, some thirty at last count--a foolishness mandated by the different state regulatory bodies.

Second, it is the international oil companies (IOCs) that have lots of cash. Their inclination has been to invest in new production capacity, counting only on prices being in the range...