Responding to Changes in the Price of Oil
In well-functioning markets, the price of a good or service reflects all of the associated costs and benefits—for example, the costs incurred in extracting, transporting, and refining the oil, or the benefits from using gasoline to drive. The market then uses price to achieve the most efficient level of production and consumption. Transportation has largely reacted to changes in energy markets in this way.
High demand for oil, due in part to rapid economic growth in China and India, has helped push oil prices to record levels. The real average monthly price of oil to the refiner was $26 between 1986 and 2004. In 2004, the price to the refiner began to climb, approaching $70 per barrel in 2006 (other oil price measures were higher). For the transportation sector, this is a significant increase in the cost of one of its primary inputs. Normally, as the price of a good rises, consumers reduce how much they use. However, it typically takes years before the transportation sector's consumption of oil is substantially reduced, in part due to the lack of easily available substitutes. Eventually, though, consumers do react to high prices. For instance, hybrid vehicle sales have tripled since 2004, while light truck sales have fallen by 16 percent.
When high oil prices are sustained, as has been the case recently, the market shows renewed interest in investing in new technologies for developing alternatives to oil and improving vehicle fuel economy. Such research and development investments tend to recede when oil prices fall. During the period of high oil prices in the late 1970s and early 1980s, the private sector invested billions of dollars in energy research and development before the price of oil declined. A recent study finds that private investment in alternative fuel technologies again has increased in response to higher oil prices, doubling between 2004 and 2006, constituting 10 percent of the total investment in energy. Because of the transportation sector's delayed response to oil prices, these increases are likely to continue for some time.
The lack of alternatives to oil also means that sudden major oil supply changes—such as when oil production in an entire region is unexpectedly shut down—can lead to large and sudden price increases in the months following the shock. Since oil trades in a global market, the impact on the economy from such shocks does not depend on how much we import, only on how much we consume, and our consumption has been growing. The market has adapted to this threat by investing in more energy-efficient modes of production, investing in alternative energy sources, and increasing holdings of private oil inventories.