Why $2.18 Gas May Be A Good Thing
By Nelson D. Schwartz

(FORTUNE Magazine) – If ever there was an argument about why last year's invasion of Iraq wasn't a war for cheap oil, it can be found at service stations across California. In early March the cost of a gallon of gas in the Golden State hit an all-time high of $2.18, and across the country things aren't much better--filling up a Ford Explorer in Ohio will set you back $40, enough for a night out for two at the Olive Garden.

When the war began exactly a year ago, most observers (including FORTUNE) expected that the end of the fighting would usher in a new era of cheaper energy, as fresh crude flowed from Iraq and political tensions in the Middle East eased. It hasn't worked out that way--crude prices have risen more than 20% since December, to over $37 a barrel, with the slow recovery of Iraq's oil industry and stronger than expected demand from China and the U.S. threatening to push oil toward the $40-a-barrel mark.

In the past that kind of oil price shock might have portended serious economic pain, not to mention a political nightmare for the incumbent President--remember Jimmy Carter? But while high gas prices will be a worry for President Bush in battleground states like Ohio and Michigan come November, they're unlikely to spell economic or electoral disaster this time around. In fact, pricey gas--Hummer owners, please sit down if you're reading this--may actually not be so bad for us in the long run.

Before we get to that particular bit of economic heresy, let's look at why surging energy prices have barely slowed the recovery. "We are just not as energy intensive as we used to be," says David Wyss, chief economist for Standard & Poor's. "Back in the early 1980s the average household spent more than 8% of their income on energy. Today they spend about 4.5%." At the same time, manufacturers have become much more fuel efficient, with energy costs typically adding up to less than 5% of overhead. J.P. Morgan chief U.S. economist Bruce Kasman adds that the jump in oil prices has only shaved a few tenths of a percent off the 5% economic growth he expects for 2004. "Even though prices are high, the shock to the system is rather muted," he says, noting that energy prices have risen more gradually this time around than in 1990 or 1979, when they doubled or tripled in a matter of months. Another reason the economy (and President Bush) might not have so much to fear from the latest oil surge: The $30 billion in extra fuel costs consumers now face is more than made up for by the $50 billion in new tax cuts signed into law last year.

With the peak summer driving season still a few months away and demand for heating oil easing as spring arrives, many experts now expect oil prices to drop back a bit, perhaps to around $30 a barrel or so. But with China's booming economy pushing global energy demand higher and U.S. gasoline consumption rising 2% to 3% annually (not to mention jitters about supply from Venezuela), it's unlikely prices will go much lower anytime soon.

Which brings us back to the heresy part. Just as global warming gets talked about when temperatures peak in the summer, says Wyss, high energy prices force people to consider alternative fuel sources as well as the need to actually conserve energy. Indeed, this year's oil rally has renewed talk of the Hubbert Curve, a decades-old theorem that seeks to pinpoint when oil production inevitably peaks. It may be a little early to start preparing for a Mad Max--like era of Darwinian struggles for a few drops of petrol, but the fact is that oil is a finite resource. "With China and India, we have an enormous increase in energy demand, and I don't see where that supply is going to come from," says Wyss. "In the long run prices are likely to go up, so it's better to start adjusting to it now than getting hit with a shock later." Indeed, the low oil prices that prevailed for much of the 1980s and 1990s were a direct result of the gains in fuel efficiency that followed the oil shocks of the 1970s. Says Wyss: "Maybe at $2.50 a gallon, people will think twice about buying that six-mile-a-gallon Humvee." --Nelson D. Schwartz