For years, auto and energy industry watchers wondered how high the price of gas would have to climb before consumers in the U.S. — still the world’s biggest automobile market — would change their driving habits. Now they know. As the price neared and passed $4 per gallon in the late spring and summer, American motorists cut back on their driving and started to shun the fuel-hungry small trucks and sport-utility vehicles that had been profit centers for U.S. auto manufacturers. Many even switched to mass transit, the poor step child of America’s transportation mix since the 1950s.

The change in consumer attitudes about fuel efficiency has been so swift and widespread that the American vehicle manufacturers have found themselves once again behind the curve relative to their Asian and European competitors, just as they did following the oil embargo of 1973. But after the 1973 embargo and an oil price spike in the 1970s and early 1980s, the price of gasoline in the U.S. declined. Almost immediately, U.S. automakers began introducing big minivans, powerful new SUVs and luxurious pickup trucks. Consumers loved them, and small cars were displaced from the top of the U.S. sales charts.

Will that happen again, or has the cost of energy — not to mention growing concerns about global warming — triggered a long-term shift in the automobile marketplace?

Wharton management professor John Paul MacDuffie, co-director of the International Motor Vehicle Program, believes that the changes this time are more likely to stick. “It certainly feels and looks like that right now,” he says, citing a key variant in the auto industry of 2008 versus the 1970s and 1980s. “What’s different now is that there are these alternative technologies such as hybrids and fuel cells; some are in the marketplace, some are rushing to market and others are in the pipeline.” In the 1980s, “there weren’t really any brand new technologies that promised significant or permanent reductions in fuel consumption. [Auto manufacturers’] only option was mainly just to build a smaller product.”

Making the situation even worse for automakers is that the high price of oil is driving up other costs — for energy to run its plants and distribute its products, and for raw materials. The cost of steel has doubled since the beginning of the year.

Smaller cars are also part of the industry’s response this time. Autos such as Daimler-Benz’s Smart Car, Honda’s Fit and GM’s Aveo — all comparatively tiny vehicles of the sort once popular only in Europe and Asia, where gas prices have long been higher than in the U.S. — are now entering the U.S. market. GM announced in July that it hopes to introduce a minicar called Beat, which has been successful overseas, to the U.S. by 2012. But automakers in the U.S. — and in Europe and Asia — are also rushing to expand their offerings of hybrid engines, which employ an electric motor to work in tandem with a traditional internal combustion engine to provide a boost in gas mileage. The electric motor is powered by batteries that are recharged by the petroleum-powered engine when the vehicle is cruising at high speed, or when the vehicle brakes or coasts. Some manufacturers, including Ford, GM and Toyota, have said they aim to start selling “plug-in” hybrids in which the electric motor can take on more of the work because of more powerful batteries that can be recharged between trips by plugging them into a standard wall outlet.

Many Unhappy Returns

Consumer demand and the manufacturers’ scramble to serve it can be seen in the sales numbers. Auto sales in the U.S. fell 18% year-to-year in June, mostly due to sparse sales of once popular light trucks, which include pickup trucks and SUVs. Those light trucks represented 55% of all U.S. vehicle sales in 2005. In the first half of 2008, their share was down to 47%. In May, General Motors announced it would close four truck and SUV plants and roll out more fuel-efficient vehicles.

Ford, for its part, announced in June that it would delay by two months the introduction of its redesigned F-150 pickup truck, which for years was the nation’s top-selling vehicle. The new 2009 model will instead debut in the late fall of this year. In addition, the company said it will reduce by 90,000 its production of pickups and sport utility vehicles in the second half of the year. And even though Ford said it plans to build additional fuel-efficient cars, it expects to produce 25% fewer vehicles overall than it did during the second half of 2007. “As gasoline prices average more than $4 a gallon and consumers worry about the weak U.S. economy, we see June industry-wide auto sales slowing further and demand for large trucks and SUVs at one of the lowest levels in decades,” Ford chief executive Alan R. Mulally said in a statement. “Ford has taken decisive action to respond to this accelerating shift in customer demand away from large trucks and SUVs to smaller cars and crossovers.”

Certainly, the cost of oil rises and falls based on a wide range of factors. But the factors driving the price higher today — such as fears about future supply and increased demand from the emerging economies of China and India — appear to be long-term elements and have led many economists to conclude that oil prices won’t decline in the short-term. “The price of oil is likely to remain high,” says Wharton management professor Mauro F. Guillen. “On the demand side, Chinese and Indian consumers are eager to substitute cars for bicycles or public transportation. On the supply side, geopolitical conflict and scarce refining capacity are creating bottlenecks. Both forces are causing higher prices. I’m afraid that high oil prices are here to stay, at least for the next three to four years.”

Another result of $4 per gallon gas is that Americans are driving less. A Wall Street Journal review of Federal Highway Administration data found that U.S. drivers logged 11 billion fewer miles in March than a year earlier. The 4.3% decline was the biggest-ever year-over-year reduction in miles driven. The highway and other data led University of California, San Diego, economist James Hamilton to conclude that U.S. drivers “have reached a tipping point. There are a lot of hard numbers that show that we’ve actually reached a point where people are responding,” according to the Journal report.

The Same Mistake Twice

Should Detroit have seen that “tipping point” coming? “Maybe, probably,” says MacDuffie, admitting benefits of hindsight. “When gas prices spiked in 1980, the U.S. was making very big, gas-guzzling vehicles. So they were very vulnerable to competition from the Japanese and European manufacturers who were used to selling [fuel-efficient cars] in a market where gas prices were much higher. So you would think the U.S. automakers, having lived though that experience once, might be guarded about letting that happen again.”

One reason they might have dropped their guard was the irresistible profit margin in light trucks. “The trucks and SUVs had fat profit margins. Even if [the automakers] saw it coming, it would have been hard to shift resources to build more hybrids. The U.S. auto industry has been struggling with a lot of problems for a long time,” MacDuffie notes. “They felt that they could not move away from the SUVs and pickups because they needed the profits from those products to cope with the other difficulties they were having. … Labor and benefits costs were one of the largest problems.” Those costs also meant that Detroit “was slow to make their factories flexible,” which in turn made it more difficult for them to shift quickly from one product to another, adds MacDuffie. So, when U.S. manufacturers decide to reduce inventories of, say pickup trucks, they generally close one or more of the factories that make them. In their European factories, Ford and GM both make fuel efficient cars that are popular in that market. But the companies have said it would be impractical to ship those cars to the U.S. because of weakness of the dollar relative to the Euro.

A question more important than whether Detroit should have seen the coming of the tipping point is what the U.S. Big Three and their competitors in Europe and Asia should do now, according to both MacDuffie and Guillen. “The long-term challenge is to develop truly competitive hybrid or hydrogen cars. We need to make the investments now, so that they become available in 15 or 20 years,” Guillen suggests. “In the short run, we need to incrementally improve fuel efficiency and help people switch to more efficient cars.” Late as they may be, MacDuffie says he is heartened by Detroit’s aggressive investments in alternative engine technologies. “I expect eventually to see hybrids offered across every manufacturer’s full range of models. One good thing is that they are … expecting a more permanent shift in consumer demand. So they are actually closing down truck and SUV capacity and working hard on these new technologies.”

Guillen agrees that Japanese and European manufacturers “are the best positioned right now.” But, he adds, “Don’t write down GM and Ford yet. They will become much nimbler and smaller [and] they are already investing in hybrid cars. They will probably manage to catch up with Toyota.”

The Clock Is Ticking

But can the U.S. manufacturers do what they have to do fast enough? Can they develop the technologies, design the vehicles, retool the factories and sell the new cars before they run out of money? That will be a tough fight, MacDuffie says. European and Asian manufacturers have invested billions to build flexible assembly plants throughout the United States, all with the latest robotic technology. And when Detroit last stumbled over gas shortages in the 1970s and 1980s, Korean manufacturers such as Kia and Hyundai were not even factors in the U.S. market. Today, Hyundai not only sells cars in the U.S. but builds them here as well.

MacDuffie believes that Ford, GM and Chrysler each should be able to get access to the capital they need to shift to a more fuel-efficient product line and avert rumored bankruptcy filings. “GM is certainly feeling an unexpected cash crunch,” he notes, “and the company’s stock has hit an historic low. But [GM executives] have the potential for raising cash by selling some things. They could even go to the capital markets to get more money. I don’t see them lacking in options to deal with the cash crunch.”

GM, which maintains a narrow and shrinking lead over Toyota for the most sales in the U.S. market, has said it may be interested in selling its Hummer division, and is reportedly considering the sale of its Saab, Buick and Pontiac divisions. The cars in many of the GM divisions differ only cosmetically and often are built on identical platforms, sometimes even in the same plants. In the end, MacDuffie says, GM will have to weigh the marketing and sales value of maintaining each division against the money it would save through consolidation. That calculation led GM in 2000 to begin phasing out its Oldsmobile division.

Meanwhile, investor Kirk Kerkorian, who spent $1 billion to buy a 6.5% stake in Ford, recently told BusinessWeek that he would be willing to invest “a few billion dollars” if the company finds itself short of cash. Kerkorian, who has a reputation for fighting with the management of the companies he invests in, “likes what [Ford CEO Alan R.] Mulally is doing to reduce the size of the company and wean it off its dependence on light truck profits, says MacDuffie. “Chrysler in a way seems to be the most squeezed,” he notes, although its new private equity owner, Cerberus Capital Management, “has a lot of ways to get cash.” 

Even though the stocks of Ford and GM (Chrysler is privately held) might seem like a takeover opportunity, MacDuffie suggests that the companies “have enough problems” to stave off serious interest. Those problems should also dissuade most bargain-hunting individual investors from picking up Ford and GM shares. “I think for most investors, there is too much uncertainly in these shares.” He agrees with CNBC Mad Money host Jim Cramer, who has labeled the shares as “too dangerous to own.”

A strategy that could help the Big Three, says MacDuffie, is to partner with each other or with overseas competitors to share research and development costs for new power trains. GM, BMW and Daimler-Benz have been working jointly since 2005 to develop an advanced hybrid system which is expected to appear in some of their vehicles by 2010. Ford and Nissan have licensed Toyota’s hybrid technology to power hybrid versions of the Ford Escape and Nissan Altima. “When people talk about a company’s core competency — meaning the one thing that the company would never give up — I often reach for the example of car companies and their engines,” MacDuffie observed. “But, lo and behold, over the last decade, there has been a steady increase in companies buying engines from other companies.”

Still, he doubts that the internal combustion engine, a technology that is now more than 100 years old, will soon fade into history. “Eventually there will be a fuel cell or hydrogen based alternative coming along, but I don’t see that anytime soon because the infrastructure costs are so massive,” MacDuffie says. “There will continue to be innovations to the internal combustion engine…. There’s often a kind of last-gasp dynamic in which there is a flurry of innovation before an old technology is finally replaced by a challenger.”