A Tale of a Whale: Why High Oil Prices May Not Be So Bad After All

August 27, 2008

The sunbathers on the windswept beaches of Nantucket this holiday weekend will have paid a premium price to boat or fly to the quaint and elite resort island 30 miles south of Cape Cod. The cost of oil has pushed marine and aviation fuels to dizzying levels, hiking the tab for what is already a pricey vacation.

Those same lovely beaches were the setting for another oil story during the early years of America's colonization and nationhood: Nantucket was one of the centers of the whale oil industry. Economist Gerry Keim, associate dean for the W. P. Carey MBA, describes how islanders would keep watch on the shore, and when they sighted a whale they would row through the waves, harpoon it and drag it back to land, where they would process the blubber for the oil that was prized for lighting.

Whaling wrote the early history of Nantucket, but the rise and decline of the industry also sheds light on the present -- the reasons why Nantucket's vacationers had to pay so much for marine and aviation fuels. The fundamentals of economics are at work -- the impact of market forces on innovation and industries -- and long term, high oil prices may turn out to be not so bad after all.

The power of price

In the early 1700s, catching whales was as easy as watching for them to appear close to shore. But as the young nation's population grew, so did demand for whale oil lamps, and when the easy catch was depleted, hunters went to sea. Ships grew ever larger and technology advanced; the industry figured out how to process the animals at sea.

In 1846, Keim said, the whaling fleet numbered 200, and whale oil was sold for 88 cents a gallon. As immigration swelled the population, demand spiked. The resulting widespread hunting made whales harder to find, and the combination of demand and scarcity drove prices higher. By 1866, the harvest of the 700-ship whaling fleet was sold for $2.55 per gallon. The high price made suppliers even more willing to invest capital in the effort to bring more whale oil to market, Keim explained.

"Perhaps there were some running around at that time saying gee, we're going to run out of whales at some point -- aren't we in danger of winding up in the dark?" Keim said. "But interestingly enough, that big increase in spending to find more whales came at the same time as an increase in spending to find alternatives."

Residents of Pennsylvania had been finding surface oil since the early days of settlement, Keim said, but the oil was dirty and gave off a noxious odor when it burned. Coal oil presented the same problem. But by 1859 the investment in complementary products paid off with the invention of a clean-burning lamp. Around the same time, developers had learned to drill wells: "Deep wells -- 10, 15, 20 feet below the surface," Keim quipped. "That was a deep well at that time."

By 1886 the availability of a more affordable source of artificial light reduced demand for whale oil and dropped the price to 75 cents a gallon. By 1900 the mighty whaling fleet had shrunk to 75 ships.

"We never ran out of whales and we didn't end up in the dark," Keim said. "All of that happened as a natural transition driven by the market signals." Demand and rising prices were the incentive for exploration for whales and for investment in an alternative source of light. The market's call for a lower-priced solution was satisfied.

The economics of oil

Keim did his research on the whale oil crises when he was a young faculty member in Texas in the mid-1970s. During that decade the nation experienced two "energy crises" featuring long lines at the pump, rapidly growing demand and concerns about supply. People said oil was a finite resource and expected it to run out, and then, they worried, "it's going to be terrible," Keim remembered.

"As an economist I thought that's not likely to happen," he explained. "We're not likely to run out of something that's valuable as long as we allow it to be sold in the marketplace."

As the price of a valuable commodity rises, Keim pointed out, consumers adjust their behavior. In the case of gasoline, for example, we are taking short-term measures such as organizing our errands for efficiency, carpooling, taking public transportation or changing driving habits (going slower to save gas). If high prices persist, we will take advantage of other opportunities. When it's time for a new car we will buy something that's more fuel efficient. We may move closer to work or to public transportation. In other words, while there are few close substitutes for gas itself, we find substitutes for the way we use it.

On the supply side, Keim said, "rapidly rising prices create a financial incentive to find more of the product [oil] and to find more substitutes." Everything from drilling to exotic new technologies will find more investor interest. Keim noted advances in solar technology and battery-operated automobiles as examples of innovation.

The private sector is the appropriate place for these innovations to incubate, he said. "There are hundreds of companies out there trying to develop substitutes for the way we use petroleum -- competition and the lure of profits will generate improvements."

The role for government, he said, is linked to climate control issues. The alternative technologies compete against what are actually subsidized prices for oil, he said. The external costs of fossil fuels -- such as the expenses incurred because of degraded air quality when people choose to drive their cars -- are not reflected in the price of gas. "If we measured the real costs of using oil and tried to affect the market cost by a carbon tax or a trading scheme" then clean technologies might compare more favorably, he said.

Keim, whose research also includes the relationship between business and government, does not expect the presidential candidates to address these issues, however. "Complex issues are generally not discussed during election campaigns," he said. And, "anything that suggests that the price of gas will not come down in a year or two will not be addressed." McCain's proposed tax holiday, which would have lowered the cost of gas this summer "might be appealing in an election year, but it's going in exactly the wrong direction," he said.

The real cost of oil also includes "the geopolitical cost of being dependent on sources in parts of the world where there are political factors that come into play," Keim added. The cost of clean technologies should be weighed against the risk of dependency on countries where supplies could be interrupted.

High prices: a good thing?

The worst thing we could do is implement price controls, Keim said. In fact, high oil prices may just be good for us in the long run. The market will function today in the same manner it did when petroleum was replacing whale oil: "Rising prices will encourage people to economize and will provide incentives to develop substitutes."

Bottom Line:

  • High demand and high prices for whale oil spurred investment in alternate energy sources in the mid-19th, resulting in the birth of the petroleum industry.
  • The high demand for and high price of petroleum is creating incentives for the development of alternatives to petroleum today.
  • The element of ownership provides a measure of protection against running out of a valuable commodity.
  • Keim says that we're not likely to run out of something that's valuable as long as we allow it to be sold in the marketplace.
  • The private sector is best suited to develop alternative energy sources, Keim said, but government could play a role by finding ways for the true cost of oil to be reflected in its price.
  • Policy measures that would manipulate the price of oil downward would foil the natural transition that is being driven by market signals.