Carbon Dioxide Emissions and the Price of Oil

Did the prospect of an agreement on Greenhouse gas reductions lower the price of oil in the last week, or was it geopolitical risk re: Iran? Whatever the facts of the last week, shouldn’t credible demand reduction policies decrease the current price of oil via expectations feedback? Why isn’t this being discussed as a policy opition?

The price of crude oil fell in the last week and is up a little again today, with the story line that changing prospects of a deal with Iran were the determinant. But another possibility is that the G-8 discussions that seemed as if they might lead to a consensus in favor of greenhouse gas reduction led oil market participants to see a future with higher taxes or carbon fees levied on the demand side, and with better efficiency standards — all leading to lower demand for oil and also the likelihood that more economic rent would be captured on the demand side rather than leaving it to OPEC and other producers.

The mechanism is that market participants seeing a lower future supply price path for oil want to put more on the market now and in the near future, rather than holding supplies and production capacity for later. (Pure speculators, to the extent that they play a role, amplify this response.) Since many countries can increase supply much faster than anything the US could do domestically, credible demand-reduction policies are much more likely to reduce the price of oil now than anything the US can do on the supply side.

If this analysis is correct, then the US and other consuming countries should be moving urgently to put greater taxes (or, if you insist, fees via cap and trade) on carbon-bearing fuels, offset by payments to ease the economic pain and encourage transition to other fuels (not proportionately to future usage though–that would defeat the incentive). One reason we didn’t do thisin the 1970s and 1980s was that there was some fear that OPEC would retaliate — but now in climate change we have the perfect excuse to act in our own economic interest (to take the scarcity rent back from the producers). This is needed in the long run to control global warming but could also give us a short term breather in reducing oil prices and helping to avoid a global economic downturn that would otherwise result from the clashing of supply and demand curves that are inelastic. (The only way for the economy to equilibrate in this context is through the macroeconomic aggregate demand response.)

What’s wrong with this vision, other than the political resistance to higher taxes of any kind and the oil men in the White House?