US economic growth tied to balanced energy policy

However, while the US is more insulated from energy price shocks, it is not immune to them. The latest round of energy supply problems have had, and continue to have, negative economic impacts, with the most visible effects on particular regions and specific industries.

While tight world oil supply conditions produced sharply higher crude oil prices much of last year, local supply problems-not confined to oil-had just as important an impact on consumers. There have been natural gas supply shortfalls and price spikes, electricity supply shortfalls and spiraling costs in California, and price spikes in Northeast heating oil and Midwest reformulated gasoline that went far beyond changes in crude oil prices.

In light of these developments, any discussion of a US energy policy must extend beyond global oil considerations; focus equally on measures to ease very painful, local energy bottlenecks; and minimize prospects of their recurrence.

This article discusses some guidelines that the new US administration and Congress should consider as they begin to grapple with the directions of future US energy policy.

First and foremost, there is no single policy action or any single fuel that can resolve all US energy concerns. Any sound energy policy must incorporate two principles, balance and diversity.

A balanced mix of policies must be considered, addressing the supply side-a low priority for the prior administration-as well as the demand side. A balanced approach would include a review of the previous administration's treatment of the "orphan" of recent energy policy, coal, and the "stepchild," nuclear energy.

A further consideration is that, especially in the case of energy, modest supply gains can have disproportionately large effects in avoiding local price spikes. Finally, the California electricity crisis highlights the critical importance of regulatory and market flexibility and the high cost paid when they are absent.

Oil policies

Under any realistic energy scenario, it is inevitable and unavoidable that the US will continue to import a substantial share-currently more than 50%-of its oil requirements. However, import dependence, per se, should not be viewed as wholly undesirable. Availability of these imports, even at current prices, keeps energy costs to the US economy far lower than they would be otherwise.

Moreover, major oil producers, including key members of the Organization of Petroleum Exporting Countries, view the US market-the largest in the world-as critical for their own economies and have acted to deepen their ties to it.¹

Import dependence should not be confused with vulnerability to disruption in world oil supplies. As long as the US participates in the world oil market, it will feel the impact of supply disruptions wherever they occur, because they affect worldwide oil prices. Thus, while supply diversity is expected to remain a cornerstone of US energy policy, it does not reduce the need for a large, viable Strategic Petroleum Reserve.

SPR revitalization

The best insurance against disruptions is having a large stock of replacement oil that the government can release promptly. The SPR already exists, and a top priority for the new administration should be to review the adequacy of its current level and funding as well as the type of events that will activate its use.

The SPR was designed to minimize economic dislocation during clear-cut supply interruptions, not as an economic tool to dampen price hikes, the purpose for which it was used in October last year. The administration of former President Bill Clinton used the SPR in an attempt to lower crude prices through the "swap" of 30 million bbl of oil.

The effects proved fleeting and the precedent unfortunate. The new administration should ensure that the SPR be used exclusively for its original purpose.

The SPR's size has declined relative to US import requirements, and the administration should consider raising the amounts in storage over a time, with due allowance for market conditions.

The SPR has declined in absolute volume from an average of 592 million bbl in 1994-95 to an average of 565 million bbl last year.

As a result of the release under the swap arrangement last fall, the amount in storage as of December was down to 541 million bbl, lower than any year since 1987, although the volume is expected to move back up as the swap volumes are repaid.

The decline in SPR volumes has been even sharper when measured in terms of import coverage-the number of days' supply of net crude oil and products imports accounted for by SPR oil. Last year, the SPR averaged 56 days of net oil imports, down sharply from early 1990s levels in excess of 80 days' supply (see chart).

Moreover, if the SPR remains at about 570 million bbl-its current level adjusted for repayment of swapped oil-and imports rise in line with the US Department of Energy's latest projections, coverage will fall to 46 days by 2005.² Given the large amount of existing spare storage capacity, adding to the SPR would require minimal expense to the government beyond acquisition cost for the crude. At the very least, it would end this downward trend.

Sanctions

A high level of import dependency means the US will have a continuing interest in the timely development of diverse supply sources. There is one particular aspect of US policy, unilateral sanctions, that conflicts with this interest in promoting supply diversity.³

Unilateral sanctions, generally an ineffective policy tool, have often done more harm to US entities and US allies than to the targeted country.

US presidential proclamations authorized under the International Emergency Economic Powers Act of 1977 put into place regulations prohibiting US companies from investing in, or importing oil from, two oil-rich countries, Libya and Iran.

Under the Iran-Libya Sanctions Act (ILSA) of 1996, the US also attempted to restrict investment in these two countries by other non-Iranian and non-Libyan companies, an effort that has proved unsuccessful.

US relationships with Iran and Libya have been difficult-at times hostile-and there appears little prospect of early normalization. However, there have been tentative steps taken toward normalization, and further moves should be considered. Allowing ILSA to expire this August would remove a source of contention between the US and its allies and could encourage Iran and Libya to move further toward normalization of relations.

The same reasoning, however, does not apply to the sanctions imposed on Iraq. Those are international, not unilateral sanctions, and are imposed on a country still in defiance of United Nations resolutions. Although Iraq contains the world's largest oil reserves after Saudi Arabia, removal of sanctions must await a change in Iraqi policies that permits a return to normal international relations.

US supply development

The US interest in developing timely supply sources should apply within its own borders as well as elsewhere in the world. From strategic-and balance of payments-perspectives, what could be more secure than market-justified enhancements to its own domestic supply?

In this regard, access to acreage must be the cornerstone of a sound energy policy. The most immediate access issue is the Arctic National Wildlife Refuge (ANWR) coastal plain, generally conceded to be the most likely area for significant new supplies of US oil.

A decision to allow exploration and development in ANWR should rest on a rational analysis of whether industry practices and regulatory oversight mechanisms are sufficiently developed to allow operations in ANWR in a manner that would minimize risks in what is an environmentally sensitive area.

Unfortunately, the issue has taken on ideological baggage that so far has prevented any moves toward compromise. A similar state of affairs delayed the development of Alaska North Slope oil in the early 1970s.

Only after the oil crisis of 1973-74 did Congress finally break the logjam and permit North slope development to proceed. The North Slope continues to be the US's most prolific source of domestic oil. Even so, production, as anticipated, has declined significantly from peak levels.

This decline is projected to continue, although investment efforts by companies involved in the North Slope are moderating the rate. This process of decline, however, has created spare capacity in the existing pipeline and related logistics systems.

As a result, the infrastructure requirements associated with bringing potentially large new volumes of oil from ANWR to market would be much lower than if these facilities were not already in place.

In addition, the US Department of the Interior's Minerals Management Service has just completed a report assessing the undiscovered, conventionally recoverable oil and natural gas resources located outside known oil and gas fields on the US Outer Continental Shelf.

The mean estimate is 75 billion bbl of undiscovered conventional recoverable oil and 362 tcf of natural gas. Approximately one half of each is estimated to be located in the Gulf of Mexico. This would strongly suggest that the US is still a viable source of oil and natural gas.

Pending regulations review

While the SPR protects against global supply disruption, the US continues to face the prospect of specific, local supply disruptions and price spikes. These can be addressed more effectively through greater caution in applying existing policies than through any new policy initiatives.

The spike in Midwest gasoline prices this past summer and the periodic hikes in California gasoline prices resulted directly from environmental regulatory actions that effectively restricted alternative sources of supply when local supply capabilities faltered.

More broadly, prices of Phase 2 reformulated gasoline were elevated, to a certain extent because traditional non-US suppliers could not meet the new specifications within the timetable set by regulators.

There is a need to review pending regulatory actions, notably those concerned with the timing of low-sulfur diesel phase-in and methyl tertiary butyl ether phase-out, to ensure that requirements don't again surpass the industry's ability to comply and to supply those products.

A growing share of US import requirements will come in the form of finished products, principally transportation fuels. Thus, changes in US product specifications must increasingly be sensitive to the global market's ability to respond in a timely fashion. The increasing boutique-like quality of US product markets heightens the probability of periodic, short-lived price spikes above and beyond any increases in crude oil prices.⁴

Natural gas risks

Natural gas has been the unqualified favorite fuel of US policy-makers. It is clean, capable of highly efficient electric-power generation, and comes almost entirely from US and Canadian sources.

Until recently, natural gas has also been cheap, with wellhead prices during the 1990s averaging less than $2/Mcf (less than $11/boe). As a result, natural gas has become the fuel of choice for nearly all of the new electric-power generating capacity. Natural gas is projected to meet more than 90% of the growth in electric power requirements.

A policy that promotes natural gas use must be accompanied by a complementary policy that encourages access to acreage and the development of infrastructure to deliver and store the gas.

In addition, the sharp escalation in natural gas prices over the past several months offers a clear warning against excessive reliance on a single energy source, regardless of its inherent attractiveness.

A particular feature of natural gas, the strong seasonal peaks in its use by residential and commercial customers, adds to the need for caution. In the winter months, natural gas use by residential and commercial customers increases sharply, especially by customers in the coldest sections of the country, that, incidentally, are also furthest away from major US producing areas.

To meet this peak demand in an economic fashion, the industry relies on a combination of storage and interruptible contracts with customers, most notably electric power generators, which, in exchange for lower prices, agree to give up supplies when required in order to enable the supplier to meet the demands of firm customers.

When natural gas supplies are ample, weather conditions mild, and storage high, interruptions can be minimal, but these conditions were not applicable last winter or this one. As a result, interruptible (and spot gas customers) have been pushed into the market for alternatives, mainly oil, with disruptive impacts on the market for heating oil in the Northeast last winter.

Supply diversity needed

As natural gas increases its penetration of the US energy market, it is critical to recognize the risks associated with such strong seasonal peaks. Some action has already been taken at the state level. New York and New Jersey have imposed requirements that interruptible customers either have a certain number of days' supply of alternative fuels in place at the beginning of the heating season or hold contracts for equivalent amounts from secure suppliers.

Currently, the US has minimal information available on the extent of interruptions and fuel switching and on the alternative fuel holdings of interruptible customers. At the very least, the gathering of such information should be a top administration priority in order to have a solid basis for formulating policy to mitigate the possibilities and consequences of local natural gas supply interruptions.

Among the lessons to be learned from the California experience is the importance of maintaining a balanced, diversified portfolio of energy sources for electric power generation. In this regard, owners of both new and existing natural gas units should be encouraged to invest in and maintain alternative fuel backup capability.

More generally, the US national interest in power-sector supply balance should promote a reevaluation of policies regarding coal and nuclear energy.

Coal, nuclear fuels

Coal and nuclear have been the fuels least favored by policy-makers and the general public.

Coal is a much dirtier fuel than natural gas, and in most cases, oil, while nuclear is viewed as inherently dangerous in terms of worst-case scenarios regarding nuclear accidents and the long-term problems of spent-fuel storage and plant decommissioning.

Yet both fuels are playing key roles in preventing difficult electric power supply situations from becoming much worse, and neither can be ignored in any realistic energy policy.

Unlike natural gas and crude oil, coal prices continue to be low and stable, with costs to utilities, on a MMbtu basis, currently running at about one fourth of oil costs and less than one fifth of natural gas costs.

Coal-fired electric power generating units provided just over half of all US electricity in the first 10 months of 2000. With natural gas-generated power expected to provide about 90% of projected long-term growth in electricity requirements, coal's share clearly will decline.

Government policy can constructively influence future fuel choices in a manner that could mitigate the decline in use of the US's most abundant fuel. The administration should continue to expand research on clean-coal technologies to ensure that coal is not handicapped by inadequate technology options to meet environmental concerns.

Although nuclear energy accounted for only about 20% of the total electric power generated in the US last year, it accounted for nearly one third of the growth. The performance of nuclear plants has improved dramatically, with the average capacity utilization factor approaching 88% in the first 10 months of last year, up from 84% in the comparable 1999 period and far higher than the 74% average for the 1990s.

Nuclear fuel has thus become an increasingly reliable, low-cost provider of base-load electricity. The administration should try to maintain this capacity, as long as it can be operated efficiently, economically, and safely.

While the market is the best determinant as to what type of new power plants should be built-and to date the market has said "no" to new coal and nuclear plants-a sound energy policy should ensure that the regulatory regime does not force premature losses of existing capability.

In the case of coal, the current wide fuel-price differentials would probably make it easier for environmental regulators and operators of coal-generating units to reach compromises that promote orderly installation of clean-burning technologies.

The administration should design policy that encourages early resolution of outstanding conflicts without conceding any long-term environmental objectives.

From a greenhouse gas perspective, there are important, favorable externalities associated with carbon-free nuclear power. In the case of nuclear power, policy should be oriented toward early decisions regarding the extension of existing plants' operating licenses.

Operators need time to plan and implement investments that would effectively extend the useful life of nuclear units. It also should be kept in mind that decommissioning is a costly, long-term, complex process that also requires substantial lead-time.

California lessons

The California electricity crisis and its agonizingly slow, painful path to resolution offer a number of important policy lessons (see related story, p. 29).

However, state policy-makers, environmentalists, and industry participants making wrong guesses about electricity demand and supply conditions when designing the California deregulation program is not one of them. Instead, the lessons stem from the reasons the system could not adjust to changing realities without falling into crisis.

As others have highlighted, the descent into outright crisis has much to do with the caps on electricity prices for retail customers and the prohibition imposed on the utilities against entering into long-term supply contracts.

Whenever prices are free to respond to supply shortfalls, as happens frequently in the California gasoline market and happened last year in the Midwest gasoline and Northeast heating oil markets, the result is a temporary surge in prices which, in turn, is moderated over time as supply responds to the higher price signals and demand is reduced.

In each of these cases, consumers were upset by the price spikes and, in some cases, suffered hardship-but there were no outright shortages or need for rationing. A government program, the Low Income Home Energy Assistance Program (LIHEAP), already in place to relieve hardship among home heating customers, was expanded to meet increased needs.⁵

In California, however, price caps have inhibited the demand response to supply shortfalls, and balance has required an unprecedented level of service interruptions and the occasional institution of rolling blackouts.

The compulsory, full exposure of the utilities to higher, spot-market prices, combined with their inability to recover those higher costs because of the price caps, imposed unrecoverable financial losses on the utilities.

The keystone of California's deregulation program was the open market for electricity, but the disconnect between prices the utilities paid for gas supply and prices they could charge customers has led to the program's collapse. The California Power Exchange has ceased operations, and most power is being purchased from generators on an out-of-market basis.

The financial extremis of the major utilities in California has forced the state itself to become a major purchaser of electricity and to spend its own money making up the difference between the negotiated prices it pays and prices that can be charged to consumers.

All this is taking place when normal electricity requirements are well below summer peaks. Gradually, the various state and local regulatory authorities are addressing other important contributors to the crisis.

The governor has issued emergency orders to expedite the process of licensing new power plants and to require air quality management districts to modify emissions limits that are limiting the ability of power plants to operate.

The state is also planning to establish an emissions-reduction credit bank to ensure that new peaking units can acquire the emissions offset credits they need in order to operate.

The Southern California Air Quality Management District is proposing to freeze emissions allowance requirements for power generators and provide a means for them to acquire additional allowances at a fixed price.

These actions do not represent a retreat from environmental objectives. Instead, they are an attempt to introduce flexibility into a system that, to date, has had virtually none. Now that the state is a major purchaser of electricity, it appreciates the need to move away from excessive reliance on the spot market and is itself attempting to negotiate long-term supply arrangements.

Of course, if greater flexibility had been in place from the start, the extent of the current crisis would have been greatly diminished. The overriding policy lesson from the California experience is that regulatory and market flexibility are critical elements in preventing supply shortfalls from becoming crises.

California is also demonstrating the extremely high costs of waiting until after the fact to introduce them.

Demand

Although this article focuses mainly on supply, a balanced energy policy must also address demand. The most critical policy is to allow market forces the lead role in determining demand for energy and for particular fuels.

By and large, the industry has learned from the earlier unhappy experiences of price controls on oil and natural gas, and the government has generally favored staying out of energy markets for the past 20 years.

Government, nonetheless, has significant influences on demand through its regulatory policies. There is room here for adjustments in order to remove distortions and to promote market flexibility. In the case of CAFE (Corporate Average Fuel Economy) and emission standards, PIRINC supports the current move to treat as cars the minivans, sport utility vehicles, and other vehicles currently classified as trucks but used primarily as passenger vehicles.

Other government actions such as the Energy Policy Conservation Act that establishes alternative-fuel vehicle requirements for fleets are proving to be expensive, ineffective, and, on occasion, embarrassing, as indicated by the widespread use of dual-fueled ethanol cars to fulfill the mandate-and the minimal actual use of the fuel.

Government clearly has a role in promoting basic research in alternative fuels and advanced technologies supporting long-term energy efficiency and achievement of environmental objectives.

Technological advances allow use of less energy and more environmentally benign energy sources while sustaining economic growth for the long term. The main concern is that the government resist the temptation to "pick winners," a practice that in the past has led to very expensive mistakes.

References

1. Logistics and price competitiveness determine the major sources of US oil imports-the reason Mexico, Canada, and Venezuela are such prominent US suppliers. OPEC countries in the Persian Gulf provide a prime source of incremental oil supplies to consuming countries overall, including the US, which gives them a strong interest in promoting stable supplies from this region.
2. The Reference Case Forecast of the 2001 Annual Energy Outlook released by the Energy Information Administration on Dec. 22, 2000, calls for net imports of crude and products to reach 12.15 million b/d in 2005.
3. Currently, the US has unilateral sanctions against about 70 countries. In addition to the well-known cases of Iran, Libya, and Sudan, countries subject to sanctions include such surprising entries as Canada, Italy, Japan, Nigeria, Venezuela, and Mexico for a host of reasons ranging from environmental issues concerning fishing practices to enforcement issues concerning drugs.
4. California Air Resources Board (CARB) gasoline in California is a case in point. Since the program's implementation of unique product specifications in 1996, gasoline price spikes and volatility have become the norm rather than the exception on the US West Coast.
5. The administration should consider increasing the funding for LIHEAP and possibly broadening eligibility to help minimize hardships that may arise if and when California allows the necessary price increases to take place.

The authors

John H. Lichtblau is chairman and CEO of Petroleum Industry Research Foundation Inc. (PIRINC), New York. He headed PIRINC as executive director during 1961-1990. He has served since 1968 on the National Petroleum Council, an industry advisory group appointed by the US Secretary of Energy, and is a member of the Council on Foreign Relations. Lichtblau also is chairman of PIRA Energy Group, a private consulting firm. A leading international expert on the petroleum industry and petroleum economics, he has authored a number of publications, has been a frequent witness at congressional hearings on energy policy, and a keynote speaker and lecturer at conferences and seminars. Lichtblau performed his undergraduate work at the City College of New York and graduate study at New York University.

Larry Goldstein is president of PIRA Energy Group and president and a member of the board of PIRINC. He has been a member of the Petroleum Advisory Committee of the New York Mercantile Exchange and a contributor to studies by the National Petroleum Council. He served as a board member and treasurer of the Scientists Institute for Public Information.

Ronald B. Gold is a consulting senior adviser to PIRA Energy Group and a consulting vice-president of PIRINC. He retired from Exxon Corp. at yearend 1997, where he was company economist and manager of the Energy Outlook division for Exxon Co. International. Gold also has worked for the US Treasury Department, Office of Tax Analysis, and was an assistant professor of economics at Ohio State University. Gold has an undergraduate degree from Brooklyn College, City University of New York, and an MA and PhD in economics from Princeton University.