Why Gas Won't Get Cheaper

By Jyoti Thottam

You don't have to be a commodities trader to worry about West Texas crude. Most of us know the price of gasoline to the penny, and it's starting to really pinch. President Bush made the rising price of oil a focus of his prime-time news conference last week. But as Bush has acknowledged, lowering the price of oil isn't that easy. "You can't wave a magic wand," he said. Oil, unlike other products and services that are manufactured and sold, obeys the laws of geology, not just supply and demand. "You don't make more oil," says Sam Shelton, director of the Strategic Energy Initiative at Georgia Tech in Atlanta. The world has to work with what it has. TIME's Jyoti Thottam explains:

o Is the world running out of oil?

No, but that doesn't mean we're off the hook. "There is enough oil, but most of the easy oil, the cheap oil has been got out," says David Wyss, chief economist at Standard & Poor's. Energy experts obsess over whether we've reached "Hubbert's peak," the point at which oil reserves are 50% depleted. That's because the remaining 50% gets increasingly harder and more expensive to extract. At some point in the next decade or so--estimates range from 15 to 25 years--the world's oil production will peak. Yet demand for oil will continue to rise, increasing 50% over the next 50 years.

o So, cheap oil is now just part of history?

Correct. "Oil prices have moved to a higher level, and they're going to stay there," says Wyss. Expect crude to remain around $50 a barrel, while gasoline could reach $5 a gallon within the next few years. There will always be blips in both directions. A hard landing for the Chinese real estate market, for example, could stall growth and cause a sudden drop in oil prices. "People would be terrified [by such an economic slowdown]," says Jim Rogers, a prominent commodities investor. "But it wouldn't last." Politics can also create short-term volatility: trouble in Saudi Arabia or political instability in Venezuela, Russia or Iran would cause price fluctuations. So could speculators. Last week's $5-a-barrel price dip came thanks to profit taking in the market. "Hedge funds have been bailing out of their positions," says Bill Greehey, CEO of oil refiner Valero Energy. "You've got a lot of hot money."

o Will other sources of energy, like wind power or nuclear power, save the day?

Only if they replace oil consumption. Building nuclear plants or wind farms to produce electricity, for example, won't add a barrel of oil to the world's supply because we generally don't use oil for electricity. Most electric-power plants run on coal or natural gas, another fossil fuel that will eventually peak, although later than oil will. Building more terminals to receive liquefied natural gas, as Bush has suggested, simply makes it easier for us to import more natural gas.

o An adviser to Saudi Arabia's Crown Prince Abdullah blamed high gas prices partly on the lack of U.S. refinery capacity. Are the Saudis correct?

Not quite. Oilman T. Boone Pickens has long made a similar case, and President Bush addressed those concerns by suggesting last week that refineries could be built on decommissioned military bases. But refinery capacity is not the major driver of higher gas prices. "The greater shortage is in the oil itself," says Rogers. Gas prices have been rising along with the price of crude. If gas prices were climbing while crude oil's remained flat, that would tell you there was a bottleneck pushing up prices. That hasn't been the case.

o Is there a smart way to invest when oil prices are rising?

Yes, but it isn't necessarily in oil. Rogers says he isn't buying oil right now. But he is watching certain regional economies very closely. "A lot of places in the U.S. are going to boom," he says, because they are rich in oil or other natural resources. As a result, he adds, "retailers in Texas are going to do a lot better than retailers in Massachusetts."

o Why is demand for oil rising?

Look at China and India. The world's two largest countries are experiencing blazing economic growth, fueling a booming thirst for oil. The rest of the world's appetite for oil hasn't diminished. Use in the U.S.--still far and away the world's largest oil consumer--is growing along with economic activity by 200,000 barrels a day annually while domestic crude-oil production stagnates. Britain, long an oil exporter from its North Sea reserves, will soon become a net importer. Last year world oil production increased, but demand for oil rose faster.

o Will technologies like hybrid cars, which run on a combination of gasoline and electricity, lower the price of oil?

Eventually, yes. As long as tight supplies exert upward pressure on prices, the only way to get relief is to knock down demand for oil. Any technology that makes cars more efficient would do that, and hybrid cars are nearly 50% more fuel efficient than even the leanest conventional cars available today. The government offers tax credits for people who buy hybrids, but hybrids may not take off unless gas prices climb significantly higher. "At $3 a gallon, they start looking pretty sensible," Wyss says. Hydrogen-powered cars could make an even bigger dent in oil demand, but they won't be commercially available for 10 to 20 years.

o Will higher oil prices cripple the U.S. economy?

The doomsday scenario, outlined most alarmingly in the recent book The Long Emergency, by James Howard Kuntsler, goes like this: gasoline will soon get so expensive that most Americans simply won't be able to afford it. Suburbs, strip malls, interstate highways, the infrastructure of the modern U.S. economy just won't work anymore without cheap oil, and the U.S. will have to reinvent itself or risk falling into decay. That dire prophecy, though, is really all about timing. Georgia Tech's Shelton, an engineering professor and oil-futures expert, says the extent of the economic damage depends on how fast oil prices rise. A slow climb "gives people time to adjust," he argues, and affords industry time to develop new or more efficient technologies. Crude prices have been steadily rising over the past two years--to nearly $60 a barrel, compared with $30 in early 2004. While individuals are certainly feeling the pinch, the economy overall so far has continued to grow.

Remember, too, that energy spending is not so crucial to the economy as it once was. It was 14% of GDP in 1981, compared with 7% today. "We can take these kinds of prices," says S&P's Wyss. "Relative to income, they're not that high." A gallon of gasoline, after all, is still about the same price as a gallon of bottled water. He calculates that the average person would need to work 42 min. to earn the money for a week's commute; back in the 1970s, it was 102 min. "That explains why we're still buying SUVs," he says. Once oil gets to, say, $100 a barrel, "it starts to get more difficult."

o Crude-oil prices fell below $50 a barrel last week. Why didn't the price at the pump drop?

Although world oil prices react instantly to the headlines, any rise or fall in crude oil takes a while, sometimes months, to show up at the pump. When refiners buy the crude they process into gasoline, they usually do so on long-term contracts. That means their cost is locked in from 30 days to six months at a time. Refiners can't quickly adjust their raw-material costs, so those who own retail gasoline businesses, which are less profitable than refineries, continue to pass the cost along to the consumer as long as they can. Rogers cautions patience. "It takes a while for [a price drop] to work its way through the system," he says. "This will get to you eventually." o

To view a collection of our past coverage of the oil industry, visit time.com/oil