Unfortunately, when they do, it’s the little guy who’d better look out.

Barely five months before the November 2006 elections, the top target for Washington bluster is clearly the soaring cost of energy.

Of course, even $3-plus per gallon gas prices here are but a fraction of the $7 or so Europeans and others are paying for the equivalent. And, despite being a downer, rising energy prices are still far from pushing the American economy into recession.

Recent polls, however, show some 75 percent of Americans disapprove of the Bush administration’s handling of gasoline prices. Meanwhile, approval of the job Congress is doing has sunk to just 22 percent from 33 percent last month, according to this week’s Wall Street Journal/NBC News polling. Those numbers are reminiscent of the months before the 1994 Congressional elections, when Republicans booted Democrats from power for the first time in a generation.

Ironically--compared to the country’s other problems, such as the busted federal budget, the unraveling of Iraq, continued devastation in Hurricane Katrina-ravaged areas, etc.--the government has relatively little control over energy prices. But with their jobs in jeopardy, Republicans are anxious to be seen as taking decisive action to help American consumers, and increasingly desperate for prices to back off before November 7.

This week, no lesser a personage than President Bush weighed in with a series of actions reminiscent of the so-called “Nixon shocks” of the 1970s, which were designed to halt a run on the nation’s gold reserves. Specifically, the president suspended additions of oil to the US Strategic Petroleum Reserve, relaxed the environmental rules on switching to ethanol as a primary ingredient in reformulated gasoline, proposed increasing mandatory gas mileage standards--particularly for SUVs--and threatened to scale back subsidies for deepwater drilling.

The president also called for stiffer enforcement of anti-gouging laws and unspecified action against market manipulation. And he suggested for the first time that oil companies aren’t investing enough of their profits in activities to boost energy supplies.

Some members of the Republican Congressional majority have tried to turn the issue back on Democrats, charging today’s high prices are in large part due to their opposition to opening Alaska’s Arctic National Wildlife Refuge to drilling. Others are backing a $100 tax credit for consumers to offset higher oil prices, a measure that would be deadly to their parallel efforts to close the yawning budget deficit.

BASHING BIG OIL

The easiest course is to train sights on the oil industry itself.

Senator Charles Grassley (R-Iowa), for example, is demanding the IRS cough up the past five years’ financials of major oils. Democrats, for their part, have proposed punitive measures such as eliminating all $10 billion in planned subsidies for the next five years to encourage production--both in the US and overseas--and imposing a windfall profits tax.

We’ve seen all this before in the energy industry, in particular during the last major bull market for energy during the 1970s and early 1980s. Then, as now, oil companies were accused of gouging consumers on a massive scale. Then, as now, industry practices were scrutinized, from raw capital expenditures to executive salaries.

And then, as now, Congress and the president had relatively little power to control the price of energy.

Lack of real influence, however, didn’t stop government from trying to take dramatic action that time around. President Jimmy Carter, for example, imposed a windfall profits tax on US energy producers at the same time he decontrolled the price of domestically produced oil.

Instead, energy prices were stopped by a combination of four factors. First, people gradually starting using less energy as they trading in their gas-guzzling autos for fuel-efficient cars. Second, alternative energies like nuclear power started to replace the use of oil in generating electricity. Third, there was a major discovery in the North Sea of conventional energy supplies. And fourth, the world was gripped by a major recession, which particularly slowed demand in the developing world.

Of the actions taken by the Carter administration, the only really effective ones were those encouraging new production and the use of conservation and alternatives. But the real catalyst for bringing down energy prices was high prices. Only high oil and gas prices encouraged consumers to buy fuel-efficient cars, utilities to go nuclear and oil companies to develop new supplies outside of the Middle East cartel.

Nothing has changed this time around either. Politicians will fume and flounder around to save their jobs. But only high gasoline prices are going to convince Americans to at least demand a more fuel efficient SUV. And until they do, gasoline is going to be very expensive.

DOING DAMAGE

Unfortunately, a vote-hungry Congress (and executive) can do a lot to delay market forces from taking full effect, thereby prolonging the high price environment. Encouraging a search for scapegoats--rather than a hard look by Americans at how we use energy--is obviously one way to postpone hard choices needed to swing market power back to consumers from producers.

More ominous, however, are steps to punish the industry for alleged unfair profits. EXXONMOBIL’S (NYSE: XOM) retirement package for former CEO Lee Raymond and its first quarter profits of $8.4 billion make it an obvious target for an industry critique. Looking beyond those headline numbers, however, the company clearly faces a rapidly rising cost profile, with the bulk of a massive ramp up in capital spending going to meeting rising rig rents and other developing costs.

If Exxon is feeling the bite of rising costs, its smaller rivals are similarly afflicted, several times over. Rising royalties and taxes from shared revenue deals with foreign governments are also pushing costs markedly higher. Moreover, the halving of natural gas prices in the first quarter--and continuing forecasts for a drop in oil prices--is a stark reminder that energy is a volatile commodity.

Overly aggressive bets to expand production when prices are high have all too often ended in disaster.

In an environment of soaring energy prices, the fact that taxpayers are dishing out any subsidies for the oil and gas industry sounds incongruous. And in fact, the subsidies are of no great consequence to the likes of ExxonMobil and other giants, who have done little to defend the $2.7 billion in tax breaks from last year’s energy bill against attacks in Congress. The breaks are, however, tremendously important to oil industry little guys.

Simply put, federal subsidies for the oil and gas industry are a drop in the bucket to cash-rich super oils. And as America’s fields have matured, the big boys have done less and less production here and more overseas. In contrast, output here has moved increasingly to smaller producers, precisely the kind of company that depends on subsidies to smooth out the ups and downs of a volatile market.

JOINING FORCES

At this point, it’s too early to see just what Republican Washington will do. The more dramatic the action against the industry, however, the worse smaller companies will likely be hit, this coming at a time when the fry are being increasingly pressured by rising costs.

One impact is likely to be a further acceleration of industry mergers, particularly involving smaller players. By joining forces, a pair of small players can dramatically improve their access to capital, thereby boosting their odds of being able to develop their reserves in a volatile environment. In addition, small companies can often get a better price for rigs and oil services needed to develop those reserves. And improved balance sheets and larger production bases can enable better hedging, locking in the price of future output.

Over the past couple of weeks, we’ve started to see a dramatic acceleration of consolidation in the Canadian oil and gas trust sector, where four deals have been announced in the last two weeks alone. One such deal involves ADVANTAGE ENERGY (NYSE: AAV) and KETCH ENERGY (TSX: KER.UN, OTC: KERFF), neither of which is particularly strong on its own but together stand a better chance of dealing with rising costs and other challenges. In contrast, for small producers that don’t merge, the environment will only get more difficult, even if Congress and the president take no action.

For conservative investors, the best course is still to stick with larger players. That includes CHEVRON (NYSE: CVX), which posted very strong first quarter numbers on a 10 percent increase in oil equivalent production. The results are a clear vindication of the company’s oft-criticized purchase of Unocal last year. It also includes CONOCOPHILLIPS (NYSE: COP), which was just as roundly panned for its now-completed merger with BURLINGTON RESOURCES.

If you own ExxonMobil, stick with it. For one thing, there aren’t that many other AAA-rated companies out there in an industry with virtually guaranteed demand and in such a powerful uptrend. And come what may in the political arena, it will likely come out a winner.

RATES RUN

Interest rates keep running higher. Mortgage rates soared to a four-year high this week, while the benchmark 10-year Treasury note yield closed the week well above the 5 percent mark.

Relatively robust first quarter GDP growth of 4.8 percent has done little to cool inflation fears. Neither did Federal Reserve Chairman Ben Bernanke’s comments that the Fed may take a breather in its now 15-month-long streak of raising rates. And neither did the continuing row over Iran’s nuclear capability, which pressured oil and gold prices upward.

In addition, the Dow Industrials touched a six-year high this week.

That suggests the stock market is taking the bond market’s pain in stride. Historically, we haven’t seen a real turn in bond yields until the stock market takes a hit. That was certainly the case with the rate spikes of summer 2003, spring 2004 and spring 2005.

The real surprise of this rate spike is how the various rate-sensitive investments have been holding up. That’s despite extremely high valuations in some areas, particularly commercial real estate investment trusts. And it’s in stark contrast to what occurred when rates were spiking the past three years.

This could indicate one of two things. The better case is it’s a portent that the ongoing rise in interest rates will prove temporary. The other is there are a lot of yield chasers out there who have not the first clue what it is they own, and so will be prone to panic if rates continue much higher.

My view is we should be prepared for both possibilities. If you’ve been following my advice to “buy the business” when you shop for yield, you should have little problem as long as your companies continue to perform. First quarter earnings season is an ideal time for assessing that.

Aside from making sure your companies are first rate, it’s also a good idea to keep some cash on hand. If rates continue to rise, so will your rate of interest. And you’ll have the means to scoop up bargains when this cycle ultimately reverses.