Impact of Supply and Demand on Price

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Many of these economic troubles are related to the fact that the United States has a free-market economy. In such an economy, the basic economic principle of supply and demand for the most part governs the price of energy supplies, including oil, gas, and electricity. This principle theorizes that as demand for a product or service increases, supply decreases, thus triggering an increase in price, which keeps demand in check so that supply can keep up with it. Similarly, the theory goes, if the supply is greater than the demand, lower prices are maintained, helping to prevent demand from dropping down to the point where the good or service is not purchased at all. Because this principle generally drives the market for energy, changes in either supply or demand can trigger sudden fluctuations in price.

Yet a free market is an abstraction that is implemented to different degrees in real markets. Types of factors that limit the freedom of markets include regulations (such as trade agreements or minimum wages), government interventions, and lack of economic competition. For example, even in countries that have a free-market economy, the government sometimes intervenes to prevent the economy from spiraling into a recession or to lessen the hardship that price increases may cause for citizens. The even- and odd-numbered license plate restrictions placed on gasoline buying during the 1979 oil crisis provide one example; in this case, however, the measure backfired, exacerbating the energy crisis and its negative effects on the economy.

In the case of oil, the freedom of the market is also limited by the fact that several nations who control significant reserves of oil formed a cartel in 1960. Founded to gain leverage over the major oil-producing companies at the time, OPEC coordinates oil production policies among its member nations, standardizing the amount of oil its members export. Since OPEC produces 40 percent of the world's oil, it has the potential to exert a good deal of influence over the price of oil worldwide by regulating the supply side of the market. Some critics say that OPEC artificially inflates its proven oil reserves figures to generate an R/P quota that trends downward, suggesting scarcity, thus justifying higher prices. OPEC has also been accused of producing oil from older oil fields that are nearing depletion, enabling the organization to report lower production rates, which then can also allow for higher prices. Yet there are limits to OPEC's ability to regulate prices. The nations of OPEC are highly dependent on oil exports for their economic stability, so driving prices too high by restricting oil supply too much could generate a decrease in demand that would adversely affect their economies.

In the United States government subsidies are another limitation to the free determination of oil prices. Subsidies are government funds allocated to lower the price of a particular good or service, usually with public interests in mind. Many people criticize U.S. oil subsidies for their potential to mask the true cost of oil and artificially keep it just low enough so that demand for oil will continue at the present level or even increase. Oil subsidies, along with the hidden "environmental costs" of oil (such as air pollution caused by motor vehicle usage), give oil an artificially low price. Some commentators say that the main purpose of oil subsidies is to maintain the financial health of large, influential oil companies. They cite the "artificial underpricing" of fossil fuels as the primary reason for U.S. fossil fuel overconsumption.29 Many commentators have suggested that instead of an artificial lowering of the price of oil, the price should be artificially increased by increasing gasoline taxes so as to stave off further upswings in U.S. gasoline consumption and spur greater efforts toward the development of fuel alternatives. In 2004 the General Accounting Office (GAO), a nonpartisan, independent accounting office of the U.S. Congress, estimated that a new gasoline tax of 46 cents per gallon could help reduce oil consumption by 10 percent over the next 14 years.30 No such legislation yet exists, however. And one criticism of the Bush administration's Energy Policy Act of 2005 is that it encourages additional subsidies for the oil industry, such as reduced corporate taxes, reduced average gasoline sales taxes, and federal grants for programs that are beneficial to oil companies.

On the other hand, in the earliest days of the U.S. oil industry, the tendency of oil prices to drop too low presented more of a problem to the U.S. economy. For example, around the time of the Great Depression, the huge leap in U.S. oil reserves that resulted from the Joiner discovery in 1930 caused a glut of supply that then drove the price of oil down to 10 cents a barrel in 1931. This wreaked havoc on the economic stability of the oil industry and had ripples in the economy as a whole. The New Deal administration, however, helped to restore some measure of stability, and World War II stimulated the oil business enormously.

Nonetheless, as oil companies' profits today continue to soar along with the price of oil and gas, oil companies have become the subject of intense scrutiny in the United States. The world's five largest oil companies, including Exxon Mobil and BP Plc, earned record profits in the first quarter of 2006—about $29 billion, or $4.46 for every person on Earth.31 At the same time, by mid-2006 gasoline prices reached about three dollars per gallon and oil was nearly $65 per barrel.

Oil price hikes usually trigger outrage among U.S. consumers and politicians, especially when oil companies continue to report record profitability. In the first half of 2006, some members of the U.S. Congress searched for legislative avenues through which to transfer some of oil companies' economic gains back to average U.S. citizens in order to make up for the high price of oil. For example, in May 2006 the U.S. House of Representatives approved a Democratic plan to renegotiate contracts granted to oil companies in 1998 and 1999 for leasing land in the Gulf of Mexico for oil production. The original leases excused several oil companies, such as Exxon Mobil Corp. and ConocoPhillips, from any additional royalty fees they would have had to pay to account for increases in oil prices. (The agency responsible for the contracts claimed that the price thresholds for royalty relief were omitted by mistake.) The Democratic plan also proposed to take back $10 billion in tax incentives granted to oil companies. The approval of this plan marked the first time that either house of Congress passed a measure designed to address tax incentives and subsidies granted to the oil industry. However, another proposal from Congress, aimed at taxing oil companies for their record profits, met with opposition from the president.

In addition to members of Congress, political activists have pressured the U.S. government to do something about rising energy costs—and something more than the provisions laid out in the Energy Policy Act of 2005. For example, a leader of the Alliance to Save Energy, a nonprofit coalition of business, government, environmental, and consumer groups that advocate energy efficiency programs and reduced energy use, addressed the U.S. House Committee on Energy and Commerce, Subcommittee on Energy and Air Quality, in November 2005. Brian Castelli, the Alliance's chief operating officer and executive vice president, criticized what he viewed as loopholes in the Energy Policy Act of 2005 that would only result in higher oil prices. Castelli's testimony highlights certain energy-price-related concerns that other Americans have also expressed, such as a need to revise CAFE standards according to realistic emissions testing and to classify SUVs and minivans as passenger vehicles instead of light trucks. Castelli also lamented the "startling and immediate effects of Hurricane Katrina and Rita" on energy prices, which, he says, show that we need to balance energy demand and supplies.32 Other activists have looked for evidence that U.S. oil companies are intentionally reducing domestic oil-refining capacity to drive up their profits. The Foundation for Taxpayer and Consumer Rights (FTCR), for example, a U.S. consumer watchdog group, has claimed that internal business memos of Mobil, Chevron, and Texaco show that different tactics have been used to drive independent refiners out of business and create increased-demand conditions that justify higher prices for oil. The FTCR's president claimed that large oil companies artificially shorted the gasoline market for a decade to drive up prices.33 Accusations of oil company price gouging are nothing new; they were suspected during the 1970s oil crisis. They have also been refuted by the many oil economists who observe that high oil prices often occur as the natural outcomes of uncontrollable events such as Hurricane Katrina.

And then there are others who flatly predict that the combination of rising oil prices and a mounting shortage of oil is precipitating a major economic crisis in the United States from which it will never recover. As Jeremy Leggett, an expert in renewable energy and chief executive of a large independent solar electric company in the United Kingdom, writes, "When it becomes clear that there is no escape from ever-shrinking supplies of increasingly expensive oil, there will be a paroxysm of panic. Human society will face an energy crisis of unprecedented proportions, and that, plus the panic, will spark an economic collapse of unparalleled awfulness."34 Whether such doomsaying can be believed, one thing is clear: Energy, particularly oil, has substantial and lasting effects on the U.S. economy that only appear to be increasing in intensity. And many Americans would agree that problems with the price of oil and oil-related economic issues are very much tied to the fact that so much of U.S. oil is imported (more than 65 percent as of January 2007).35 Thus, overdependence on foreign oil is another energy issue that the United States has had to address, and with a particular urgency, in recent years.

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