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Robert FriBack to OpinionRobert Fri

Gas prices are up. Will they ever come down?

The price at the pump is up again, equaling the peak prices of 1980 reached in the wake of two Arab oil embargoes.

But back then prices subsided over the next 20 years and in 1999 they actually fell below pre-embargo levels. So will oil prices come back down? The answer is: maybe not. The forces that drove prices down between 1980 and 2000 have changed and may not again work in our favor.

Perhaps the main reason prices returned to normal following the 1980 spike was that the law of supply and demand stepped in. New supply outside the reach of the OPEC oil cartel came to market, notably in the North Sea and Alaska. And users of oil found ways to do more with less. One measure of this is oil intensity – the amount of energy required to produce a dollar of economic output. In the United States, our intensity of oil use has dropped by nearly half since 1973, and other developed countries have performed as well or better. Inevitably, the combination of more supply and less demand resulted in lower prices.

Greed was the second major force contributing to the drop in oil prices. Oil producing countries in the Middle East rely heavily on their oil income. Whether that income is used to enrich tyrants or benefit citizens, national leaders of petroleum-rich countries have every incentive to keep the oil flowing. And the oil has continued to flow, even though the Middle East is a cauldron of political turmoil. OPEC tried to keep prices up by limiting production, but between 1980 and 2000 many OPEC members produced more oil than the targets set by the cartel. Why? They needed the money. As a result, the cartel didn’t work very well and prices dropped.

Finally, and importantly, crude oil markets functioned during this period as good commodity markets should. They responded to changes in supply and demand with exquisite flexibility. Even if there was a supply hiccup somewhere in the system, the market adjusted almost instantly to cover the shortfall. That flexibility, incidentally, is why it has been impossible to embargo oil shipments to any one country.

These forces were crucial to moderating oil price increases after 1980, but the oil business has changed in ways that may make them less helpful in the future. For example:

  • Rapidly developing countries like China are creating an enormous demand for oil. In the short term, this demand will certainly drive prices higher. Longer term, it’s not clear that demand in these countries will be as sensitive to price as it was among industrialized nations a couple of decades ago. Energy is essential to economic growth, and the desire to grow may simply swamp any inclination to reduce demand in a serious way among developing countries.
  • New supply is harder to come by. There are new oil fields being discovered, but they tend to be in difficult-to-reach and sensitive locations – miles deep in the ocean or high above the Arctic Circle. That makes them expensive and environmentally challenging to develop.
  • While greed surely remains strong among governing elites in oil-producing countries – tyrannical or democratic – new players who may not mind shutting down production have entered the picture. Most important are terrorists who would cheerfully blow up an oil field if it serves their purposes. Because of these and other non-state actors, the chances of a supply disruption are higher now than they’ve been for a long time. A recent study by the Energy Modeling Forum concluded that there is a 50-50 chance of a significant supply disruption in the next 10 years.
  • Markets are showing signs of increasing rigidity. China and other countries are signing up oil supplies for direct delivery from producing countries. At some point, this welter of bilateral deals may get in the way of the oil market’s historic nimbleness. And national oil companies – ones owned by the oil producing nations – have displaced the private sector as the dominant institutions running the world’s oil fields. The result is that oil markets are increasingly responsive to political forces rather than the laws of supply and demand.

Market forces are powerful and could again moderate oil prices, but my guess is that the higher price at the pump is here to stay. If so, energy policymakers should start figuring out how to use a lot less oil. For that reason alone, the Obama administration is right to advocate stricter fuel economy standards and more electric vehicles.