Energy Intervention Today

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Jerry Taylor and Peter Van Doren

February 2009

Overview
Energy Prices Are Too High
We Need to Conserve Energy
We Need to Invest in Alternative Energy
Energy Markets Are Broken
Peak Oil
National Security
Conclusions
 

Overview

Large-scale federal intervention into America's energy markets began in the 1930s and lasted for four decades. Many rules were imposed to control prices, restrict imports, and distort markets in various other ways. The shortcomings of this heavy regulatory climate became apparent during the energy crises of the 1970s, prompting policymakers to reverse course and begin deregulating oil, natural gas, and coal markets.

However, energy markets continue to be regulated and subsidized in many ways today, and federal policymakers are quick to find new reasons to intervene. One factor that promotes intervention is the cyclicality of energy markets, which prompts consumers and producers to variously complain about prices being too low or too high. Other factors that promote intervention include national security and environmental concerns. In response to these concerns, various prescriptions are often proposed, including price restraints, windfall profits taxes, and tax incentives or subsidies for conservation and alternative energy.

The following sections look at some of the common arguments for energy market intervention, and discuss why those arguments fall short.
 

Energy Prices Are Too High

When energy prices rise sharply, federal policymakers are quick to take the side of consumers and argue that producers are taking unfair advantage. When gasoline prices rise, for example, policymakers often claim that excess oil company profits are to blame, and they seek price controls or windfall profits taxes as a remedy.

However, periods of high and rising gas prices are typically caused by normal market forces. After being flat or falling since 1981, U.S. gasoline prices soared between 2003 and mid-2008. The main cause was strong global economic growth during that period, which boosted crude oil demand. A fundamental factor in energy markets is that short-term supply is fairly inelastic or unresponsive to price changes—it takes time for new supplies to be discovered, developed, processed, and brought to market.

As such, there was a roughly 6 to 21 percent increase in global demand for oil between 2003 and mid-2008, but that was enough to create the roughly 300 percent increase in gasoline prices during that period.1 Note that the 1980s experienced the opposite pattern. One study found that oil demand fell 7 percent because of the recession in the early 1980s, but that was enough to cause a collapse in oil prices by mid-decade.2

The claim that the major oil companies cause price spikes and that they earn excess profits is not correct. In 2007, average oil and gas company profit margins (net income as a share of revenues) were about the same as the manufacturing sector as a whole. Alternately, looking at return on equity, oil industry returns have been somewhat higher than the manufacturing sector in recent years, but oil industry returns were lower than average during the preceding 20-year period.  

One thing to remember is that the big investor-owned oil companies are not really capable of controlling global crude oil prices. ExxonMobil, British Petroleum, Shell, Chevron, and ConocoPhillips together accounted for only 15 percent of the production of the top 100 oil companies in 2007. These five Big Oil firms control just 4 percent of the global oil reserves held by the world's top 100 oil companies. It is also not true that the major oil firms have excess market power downstream in refining and retailing. Indeed, Big Oil is actually losing downstream market share.

Curiously, complaints about energy prices being too high flies in the face of other often-heard demands that America should consume less energy or seek energy independence. Policies to discourage imports would raise domestic prices by preventing lower-cost fuel from entering the U.S. market. Similarly, most proposed policies to conserve energy or reduce greenhouse gas emissions would increase energy prices. And note that the relative insensitivity of the atmosphere to modest changes in greenhouse gas emissions implies that a massive increase in energy prices would be needed to reduce consumption enough to potentially make a difference on global temperatures.
 

We Need to Conserve Energy

While consumers get angry that energy prices are too high, many analysts and environmentalists worry that prices are low. They believe that if prices are too low, Americans won't conserve enough energy. But how much conservation is the right amount? If Americans are forced into excessive conservation measures, the costs will outweigh the benefits and society will be worse off.

Government intervention might be appropriate if there was proof of a market failure—that is, if people refused to conserve even if it made economic sense to society. But there is no evidence of market failure in conservation. When energy prices are low, the market is properly signaling that the cost of using the resources is low. And when prices are high, consumers and businesses respond quite strongly over the long term with demand-reducing efforts. For example, American consumers have responded to higher gasoline prices in recent years with the purchase of more energy efficient vehicles. Clemson University economist Molly Espey and others have found that consumers do accurately value the savings of improved fuel economy in their purchase decisions.3

In recent decades, market forces have been behind huge improvements in U.S. energy efficiency. The amount of energy consumed for each unit of gross domestic product has fallen dramatically since the 1970s. Economist Gilbert Metcalf found that if U.S. energy intensity were still at the level of 1970, the nation would be consuming 187 quadrillion BTUs annually.4 Instead, the United States consumes 98 quadrillion BTUs annually, and thus we have cut our energy intensity almost in half since 1970. Most of that improvement likely came from natural market processes, not government policy.

Consider, for example, the rising energy efficiency of household appliances. Federal efficiency standards for appliances went into effect in 1990, and appliance efficiency has improved since then. But appliance efficiency also improved markedly between the early 1970s and 1990 as a market response to rising electricity prices.5 As one example, the average energy consumption of U.S. refrigerators fell from 1,800 kWh per year in 1974 to just 800 kWh by 1990—before appliance standards went into effect.
 

We Need to Invest in Alternative Energy

Along with concerns about conservation, many policymakers are eager to expand the federal role in developing alternative energy technologies. The Department of Energy has funded the development of alternative fuels since the 1970s to try and move the economy away from oil, coal, and gas.

The problem is that nobody knows which particular energy sources will make the most sense years and decades down the road. But this level of uncertainty is not unique to the energy industry—every industry faces similar issues of innovation in a rapidly changing world. In most industries, the policy solution is to allow the decentralized market efforts of entrepreneurs and early adopting consumers figure out the best route to the future. Government efforts to push markets in certain directions often end up wasting money, but they can also delay the development of superior alternatives that don't receive subsidies.

The federal government's track record of picking winners in industry and technology is very poor, and the Department of Energy has subsidized more than its share of failed projects as discussed in a related essay. Consider "clean coal" research, which is aimed at burning coal in efficient and less polluting ways, which might make sense if private companies were funding such research. But the federal government has been subsidizing clean coal for more than two decades, with generally poor results.

In 2001, the Government Accountability Office found that many federally subsidized clean coal projects had "experienced delays, cost overruns, bankruptcies, and performance problems." Of 13 projects the GAO examined, 8 had serious delays or financial problems, 6 were behind schedule by up to seven years, and 2 went bankrupt. Some projects have had successes, but a project in Alaska illustrates the more typical result of federal subsidization. The Healy Clean Coal Plant gobbled up $117 million of federal taxpayer money, but the project never worked as planned, it cost too much to operate, and it was finally closed down as a failure.

We do not pretend to know what America's energy future will look like, but we should leave it to entrepreneurs and consumers to figure it out, as we do in most other industries. Nonetheless, there are steps that the federal government can take to generally foster investment in energy supply and conservation, such as reforming the federal tax code.

A 2007 study by Ernst and Young found that federal tax rules create hurdles for energy investment.6 The study compared tax rules for capital investment between 11 advanced economies, and found that the United States has less favorable tax rules than most other countries for investments in petroleum refining, electricity, pollution control equipment, electricity smart meters, and other items.

Another reform would be to repeal tax preferences for home ownership under the income tax. These tax preferences favor the acquisition of particularly large homes.7 Larger homes need more heating, cooling, and lighting, and thus the tax code has an anti-conservation bias. In sum, rather than riddling the tax code with narrow breaks for particular energy technologies, policymakers should focus on reforming the anti-investment and anti-conservation features already in the code.
 

Energy Markets Are Broken

Many pundits have argued that modest supply and demand responses to oil price changes are evidence that oil markets are broken. If high prices do not induce significant energy conservation or new oil production, then government must act to do what the market will not.

The problem with that argument is that it confuses short-term with long-term market responses. In the long run, both the supply and demand for energy are quite elastic. Past experience, for example, suggests that a 10 percent increase in energy prices will eventually lead to a 5 percent reduction in energy demand.

If short-term responses to high energy prices seem sluggish, it is because energy savings often require expensive capital stock renewal, such as replacing vehicles and business equipment. It takes more than 10 years for the U.S. auto fleet to turn over, for example. Consumers and businesses do not undertake investment decisions lightly, which is why it can take years of high prices to induce large energy savings. 

For their part, energy producers do not willingly invest billions of dollars to expand capacity if it is unclear whether current high prices will be there when the facilities come on line years down the road. And when producers do respond to higher prices with new investment, they sometimes find that bottlenecks exist elsewhere in the production supply chain, thus reducing the value of their investment. 

Government policies to try and induce quicker supply or demand responses are problematic because the causes of slow market reaction—uncertainty about future prices and the lag time between investments and changes in supply and demand—cannot be remedied by the government. By trying to force quicker market responses to perhaps temporarily higher prices risks imposes unproductive costs on the economy. The government has no more foresight that private market agents do.
 

Peak Oil

A growing number of analysts believe that conventional crude oil is becoming scarce as the world consumes ever-larger quantities of a fixed resource. Many policymakers believe that this is reason enough to subsidize oil alternatives and energy conservation.

At some point conventional crude oil production will peak, but there is little reason to think that day will come soon, given production data in recent decades. If oil were growing scarce, we should see evidence of that in rising crude oil prices. But a rigorous analysis of crude oil prices from 1970 to 2008 by economist James Hamilton found no statistically significant evidence of scarcity. On the contrary, his analysis found that "the real price of oil seems to follow a random walk without drift."8 Hence, we cannot say for certain what most people seem to believe—that oil prices have been increasing over time.

Remember that small changes in the supply or demand of oil have major price impacts in the short run, and that any number of global events can affect short-turn supply and demand. The upshot is that even if prices rose dramatically in the near term, one could not say for sure whether the price rise reflected long-term oil depletion or any number of other supply or demand phenomena common in the oil industry.

Although supporters of peak oil theory are correct that new oil discoveries over the last several decades have been smaller than in the past, it is unknown how much crude oil is yet to be discovered. Predictions about hitting peak oil in the near term might be correct, but there are at least four reasons for optimism that they are not. 

First, high oil prices induce more exploration by oil companies. Economist Klaus Mohn observed: "When the oil price increases, oil companies take on more exploration risk. Consequently, discovery rates will fall whereas the average discovery size will increase."9 His examination of exploration data in Norway found that for every 10 percent increase in oil prices, reserves increase by about 9 percent in the long run.

Second, high prices will induce more production from OPEC countries. The Persian Gulf is one of the least explored areas of the world for oil and natural gas. Only about 2,000 exploratory wells have been drilled in the entire Persian Gulf since its emergence as an oil-producing region. By contrast, the United States has had more than 1 million such wells. Even today, more than 70 percent of oil exploration activity occurs in North America, which holds less than 3 percent of the world's reserves, whereas only 3 percent of exploration occurs in the Middle East, which holds about 70 percent of the world's reserves.

Further, most of the exploration in the Persian Gulf occurred decades ago before nationalization of the oil industry in that region. That suggests that recent advances in exploration technology may not have been applied to the most promising geological formations in the world. Numerous industry experts argue that we will likely discover major new deposits in Saudi Arabia in the future. Russia is also sitting atop very promising but scarcely explored geological formations.  

Third, major new oil field discoveries are not necessary for large increases in global supply. If the industry, for example, could increase average field recovery rates from the current 35 percent to 40 percent, it would increase supply by 300 billion barrels or more, which is akin to adding a new Saudi Arabia or more to the market. Given that field recovery rates have steadily improved over time—they averaged only 22 percent in 1980—there is hope that high prices will induce new investment in extraction technology.

Unconventional sources of crude oil are another source of potential new supply. There may be about 6 trillion barrels of crude in heavy oil and bitumen stocks in the Rocky Mountains and elsewhere in the world, of which 2 trillion barrels may be recoverable.10 By contrast, conventional world oil reserves total 1.3 trillion barrels.        

Fourth, investment in new field production is increasing as oil prices have been fairly high in recent years. A tally in Oil & Gas Journal of known oil projects under way found that 28 million barrels a day of new supply may come on tap from 47 countries over the next two decades, which represents about one-third of existing global production.11 Although production declines from existing fields will offset some of that new supply, it is encouraging that new supplies are still quite robust.
 

National Security

The alleged national security costs associated with oil consumption—a key rationale offered for energy market intervention since the 9/11 attacks—are nonexistent. For one thing, U.S. military protection of Middle East oil producing countries makes no sense, as those countries have a very large incentive to protect their own resources. And even if some producing countries fell into the hands of governments that were less friendly to the United States, those countries would still sell their oil on world markets, and thus such political changes would not change world oil markets much at all.

Similarly, embargoes by producer countries against the United States—as occurred in 1973—are ineffective because producers cannot control the destination of their oil once it is released into the market. A rogue anti-American state would have to sell its oil in international markets somewhere, and American importers could simply change the source of oil that supplies U.S. consumers.

Since 9/11, many pundits have argued that our supposed dependence on Middle East oil has helped fuel terrorism. In other words, that our purchase of oil from abroad creates profits for undemocratic governments, and those profits ultimately flow into the hands of terrorists. In fact, our own statistical analysis has found no correlation between the level of oil profits and the degree of Islamic terrorism activity around the world. That is, there is no correlation between oil profits secured by anti-American oil producers and "bad acting" by people in those countries.

The reality is that terrorism is relatively inexpensive to fund, and both poor and wealthy foreign governments and their citizens have taken part in it. International terrorism is a foreign policy and criminal problem, not an energy problem, and it would only damage our economy to treat it as an energy problem.
 

Conclusions

We have discussed why it is unlikely that there are failures in energy markets that require federal intervention through regulations, taxes, and subsidies. But even if there were market failures, that would be only a necessary condition for intervention, not a sufficient condition. One must further demonstrate that the government is actually capable of remedying market failures and that intervention would produce more benefits than costs. That is no easy task. Government policymakers are hobbled by poor information, politicians are generally not policy experts, and short-term political considerations heavily color government policy. For these reasons, Department of Energy budgets have been chock full of boondoggle projects over the decades, and federal regulatory intervention in energy markets has proved to be very damaging, as discussed in related essays. 

Energy experts are hard-pressed to find any examples when past federal interventions produced positive economic outcomes. As energy economist Richard Gordon puts it, "The dominant theme of academic writings is that governments have done more harm than good in energy," a view "almost universally supported by academic energy economists, whatever their political outlook."12


1 Severin Borenstein, "Cost, Conflict and Climate: U.S. Challenges in the World Oil Market," Working Paper no. 177, Center for the Study of Energy Markets, University of California Energy Institute, June 2008.

2 Ibid.

3 Molly, Espey, "Do Consumers Value Fuel Economy?" Regulation 28:4, Winter 2005-6, pp. 8-10

4 Gilbert Metcalf, "Energy Conservation in the United States: Understanding Its Role in Climate Policy," National Bureau of Economic Research, Working Paper no. 12272, May 2006, p. 2.

5 Ronald Sutherland, "The High Costs of Federal Energy Efficiency Standards for Residential Appliances," Cato Institute Policy Analysis no. 504, December 23, 2003, p. 5.

6 Ernst & Young for the American Council for Capital Formation, "International Comparison of Depreciation Rules and Tax Rates for Selected Energy Investments," May 2, 2007.

7 The homeowner tax preference results from the combination of the mortgage interest deduction and the exemption from taxable income of imputed rent on homes.

8 James Hamilton, "Understanding Crude Oil Prices," Energy Policy and Economics Working Paper no. 023, University of California Energy Institute, June 2008.

9 Klaus Mohn, "Efforts and Efficiency in Oil Exploration: A Vector Error-Correction Approach," Energy Journal 29:4, 2008, p. 72.

10 International Energy Agency, Resources to Reserves: Oil and Gas Technologies for the Energy Markets of the Future (Paris: Organization for Economic Cooperation and Development, 2005).

11 Guntis Moritis, "Project Being Developed Encompass a Diverse Mix," Oil & Gas Journal, June 9, 2008.

12 Richard L. Gordon, "The Case against Government Intervention in Energy Markets," Cato Institute Policy Analysis no. 628, December 1, 2008.

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