By William Apfel, CFA
From the Winter 2014 Edition of Values

Higher oil prices. That’s the one goal that might be shared by oil company executives and anyone concerned about climate change.

We know why oil company executives love higher prices: They mean more revenue, better returns on past investments, and richer values for their stocks and stock options. And if a trend toward higher prices is expected to persist, the benefit multiplies: The price of fossil fuel company stocks is determined as much by the perceived value of their in-ground assets as their current earnings; an expectation that oil prices will trend higher over the long term makes those assets more valuable.

The advantage of high fuel prices is equally clear for environmental activists. No single determinant of fossil fuel use is more important than price. All else equal, we drive more, buy larger cars and bigger homes, and pay less attention to energy efficiency when prices are lower. As important, the profit incentive to develop carbon-free energy alternatives narrows with every drop in the long-term expectations for fossil fuel prices.

But wait. Should we really hope for a big increase in fossil fuel company profits, big executive pay packages, and booming fossil fuel company stock prices? Of course not. Big profits will lead companies to increase their exploration and development budgets so that they can extract ever more carbon-heavy assets. High oil prices will discourage consumption, it’s true, but if more fossil fuel production is the result, the environmental benefits won’t be sustained.

So, while higher prices are an appropriate goal, they must be a component of sensible energy policy. The alternatives have been well articulated by economists: a market based cap-and-trade system or direct carbon taxes. These approaches will discourage demand without adding financial incentives for developing new fossil fuel resources. The revenue collected can be redirected in a variety of useful ways. A reduction in payroll taxes on middle and lower income workers might have wide political appeal; funding research for investments in promising alternative energy sources would directly address the urgent need to replace fossil fuels.

It’s no secret that far too little has been done to address the threat of climate change—and recent developments in global energy markets add to the challenge. Just since June, oil prices have plummeted, falling roughly 30 percent. While there are multiple causes for the price drop, a few factors are clear. In particular, surging energy prices during the middle years of the past decade motivated a boom in fossil fuel investments, reinforcing the trend toward deep water drilling and unleashing the fracking (or tight oil) boom. U.S. petroleum production has risen 60 percent since 2008, now matches levels not seen since 1972, and rivals that of Saudi Arabia and Russia, long the global leaders. Meanwhile, global demand has trailed earlier forecasts. Some of this is due to increased regulation of carbon emissions in the industrialized world and the efficiency and innovation that are the market’s response to higher prices. But slowing growth in emerging market economies and weak growth in the developed world are probably bigger factors.

Given the total picture, we have little to rejoice in the recent drop in oil prices. Yes, it might be gratifying to see new downward pressure on oil company profits, and lower prices will ease the financial burdens facing middle and lower income families. And if you have taken a stand against burning fossil fuels by divesting your holdings in oil company shares, celebrate the public attention that accompanies your bold statement. But recall that the reason oil company stocks have slid these past few months is that the world is awash in cheap oil. Next time any of us fills the tank of our car—whether Prius or gas-guzzler—for less than $3.00 per gallon, we should take a moment to consider the consequences of that seeming bargain for the future of our planet.