Energy—Ten years after

One way to determine which political and economic events truly are significant is to check whether their anniversaries provoke retrospective newspaper articles and conferences attempting to identify what we have (or should have) learned in the intervening years.

On this scale, the oil embargo of 1973 has done quite well. The past several months have seen numerous discussions in the press about the meaning of "the energy decade," conferences with titles such as "The Oil Embargo Legacy: Ten Years and Counting" and—the ultimate certification—a ten-part series in The New York Times.

What have we learned?

Many different lessons of the last ten years have been offered. Some observers say it now is clear that government price regulation only distorts energy markets and offers little protection to consumers. Others see an end to the "era of oil." Still others feel the chief lesson is that economic growth and energy use do not have to move in lockstep.

Leaving these points aside for the moment, I would like to nominate a more sweeping suggestion: what we should have learned during the last ten years is that basing policy and plans on the assumption that prevailing energy market trends will continue can be very dangerous. Two fundamental changes have occurred in energy markets since the beginning of 1973. First, energy supplies display extreme short-term sensitivity to political events. Second, high energy prices produce dramatically different energy demand-supply relationships. Each of these changes, which many now say were predictable, caught the energy world by surprise and, as a result, had major consequences. Indeed, the accompanying problems helped push the world economy into its current sad state. The last ten years cannot be described as a period of great success for energy policymakers.

In that time, the price of oil has jumped 345 percent in real terms, even after the recent downturn. The sharp price hikes of 1973-74 and 1979-80 were at least partly responsible for triggering deep, worldwide recessions. In the United States, households near the poverty level often were pushed over the edge by soaring heating bills. Abroad, the oil-related debts of the developing nations placed unprecedented strains on the international financial system. Perhaps most ominous of all, the United States was forced to announce that, because of oil, the Persian Gulf had become an area of vital strategic interest—making more conceivable a catastrophic confrontation with the Soviet Union.

Not all of this should be ascribed to the general failure to anticipate the two previously mentioned market changes. As a depleting resource, oil may face long-term increases in cost. And even if prepared for the new energy developments, industrial economies could not make easy and swift adjustments in energy use patterns. But in the final analysis, things were worse than they had to be, and a good part of the reason is that government and industry responses always seemed to be one step behind the market.

Underrating political factors

Take the first important change—the increasing sensitivity of energy supplies to political events. The inability to anticipate this was, of course, a major contributing factor to the disruption caused by the 1973-74 embargo and to the ability of Saudi Arabia and other oil producers to sustain the price hikes that followed that event. This failure often has been discussed since.

Unfortunately, despite all the discussion, government and industry continued to underrate the influence of political factors on world oil production. For example, attributing little importance to politics, many forecasters in 1974 and 1975 predicted that "revenue-maximizing" production increases by Organization of Petroleum Exporting Countries (OPEC) would lead to prices being forced down. In fact, predictions of OPEC's collapse were so widespread that U.S. policy-makers actually spent a lot of time trying to set up a $7 per barrel floor price mechanism to protect investments in alternatives to OPEC oil.

Emergency Unpreparedness

Even worse, as a result of the general tendency to downplay the likelihood of further significant, politically related interruptions in oil supplies, emergency planning measures were given low priority. True, after 1974, the formulation of responses to potential oil supply disruptions had begun. The industrialized nations set up the International Energy Agency (IEA) to coordinate energy policies, including stockpiling for emergencies and sharing oil during future crises. In the United States, the Department of Energy was authorized in 1976 to purchase 500 million barrels of oil by 1982 for a petroleum stockpile, the Strategic Petroleum Reserve (SPR). And Congress asked the president to draw up a gasoline-rationing plan for use during emergencies. But a singular lack of urgency surrounded these responses. The effectiveness of IEA's sharing system was—and is—a question mark, and worried member governments made sure the plan would go into effect only in the event of an extremely large disruption. In the United States, technical problems and stingy funding prevented a rapid filling of the SPR. And—whether a merciful outcome or not—the Carter administration dragged its feet in preparing the gasoline-rationing plan.

Thus, when the Iranian revolution began to affect oil production in November 1978, the oil-consuming nations were unprepared. In 1978 Iranian production averaged 5.2 million barrels per day (mmbd). In January 1979, production fell to 410,000 and, for the entire year, averaged only 3 mmbd. Despite this shortfall, the IEA's emergency sharing mechanism was not triggered. The U.S. Strategic Petroleum Reserve, which then held only 91 million barrels, was not used. No gas-rationing plan could pass Congress until after the worst part of the shortfall was complete. In brief, there was no coherent response—a factor that undoubtedly contributed to panic buying on the international spot market and helped push the price of oil from $13.11 per barrel in January 1979 to $31.39 per barrel in December 1980.

Natural gas, electricity, coal, and nuclear

Unanticipated political influences on supplies also popped up in other energy markets. In natural gas, the shortages of 1976 prompted Congress to pass the Natural Gas Policy Act (NGPA) of 1978, a compromise measure that decontrolled the price of some gas and allowed other gas prices to escalate gradually toward market levels. Misunderstanding the importance of this legislation, the industry went about its business in the same way, with pipelines bidding anxiously for supplies while paying little attention to price and producers borrowing huge sums to produce and explore for gas reserves. But under the NGPA the problem of the natural gas industry—at least for the time being—changed from excess demand to excess supply. Thus, gas pipelines were left with contracts for supplies they could not sell and some producers of high-cost gas went broke. And government regulation designed to "back" gas out of certain markets looked foolish.

For electric utilities and for the coal and nuclear industry supplying them, the environmental movement was an important new political factor. Prior to the 1970s it was unusual to see major energy projects delayed, let alone canceled, because of environmental considerations. Nor were operations seriously restrained by air or water pollution regulations. In general, companies were able to evaluate projects almost entirely on the basis of how the investment would affect the company's earnings.

All that changed with the public's increased sensitivity to environmental issues. The Clean Air Act of 1970 and amendments to that act in 1977 restricted sulfur dioxide, nitrogen oxide, and particulate emissions from the burning of coal and forced many utilities to install expensive "scrubbers" to reduce such emissions. And, just as it is adjusting to that law, coal-burning utilities are faced with the prospect of acid rain legislation that could force additional, expensive antipollution investments. Again, it looks as if those utilities that underrated the influence of the environmental movement will be penalized. On the nuclear power side, the accident at Three Mile Island in 1979 lent perhaps decisive weight to the arguments of the antinuclear activists who claimed that overwhelming safety, health, and environmental dangers were associated with nuclear power. As a result, safety standards were made more rigid and several plants were forced to shut down for short periods to bring them into compliance.

Planning for future disruptions

Has the importance of political events been fully recognized after these and other experiences? The answer is somewhat mixed. On the positive side, government planners have devoted much effort (with some results) to planning for oil disruptions. By late 1983, the SPR contained 341 million barrels, a size that would allow its effective use in any future disruption. The IEA periodically tests its sharing mechanism, although its efficacy in actual emergencies remains to be demonstrated. Every flare-up in the Middle East is examined for its possible effects on oil supplies.

Less encouraging is the expectation, underlying most of government and industry planning, that energy-supply trends will shift only gradually in coming years, with insignificant year-to-year fluctuations. Several plausible scenarios could prove this view incorrect. In oil, many have pointed out the likelihood of another supply disruption in the Middle East. But there are other, less frequently mentioned, potential political influences on supply. One example is the possibility of political unrest in Mexico (which many Latin-America experts cite) that could restrict oil production in the country that now is the leading oil exporter to the United States and a major source of oil for the SPR. On the other side of the coin, the Iran-Iraq war could end and flood the oil markets with as much as an additional 3 to 5 mmbd of oil. In domestic markets, different types of politically inspired options, such as new natural gas regulation or environmental laws, easily could appear despite a recent political climate that favors less stringent regulation.

It should not be concluded that political forces necessarily are dominant. In the long term, supplies and prices may return to the path they were on prior to politically inspired diversion. But the past ten years have made clear that the damage political factors can wreak in the short term merits considerable attention.

Demand on historical demand paths

The second fundamental change on the energy scene in the last ten years is the reaching of price levels high enough to upset the preexisting demand and supply patterns of every major energy product. Before 1973, and for several years thereafter, it was assumed that prices could rise substantially without either significantly influencing energy consumption or increasing supply. This belief was bolstered by continuing increases in the consumption of oil, natural gas, and electricity in the face of sharply higher prices after 1973.

Lack of faith in the ability of prices to restrain growth in energy demand also created a host of beliefs that drove energy planning in government and industry. For one thing, it provided support for price controls on oil that were in place from 1971 until 1981. Since it was mistakenly thought that high prices would not dampen demand, those who advocated controls argued that allowing oil companies to set higher prices would merely increase corporate profits while doing little to reduce consumption. Partly as a result of oil price controls and the accompanying regulatory system, imports grew more rapidly than would otherwise have been the case—from 6.3 mmbd in 1973 to 8.8 mmbd 1977. By 1983, however, they were down to an average of well below 5 mmbd.

Not foreseeing the market adjustments resulting from higher energy prices also contributed to fears of shortage and made many energy investments look more desirable then they would have otherwise. Several studies forecast resource exhaustion within the foreseeable future unless drastic action was taken. Backed with such "evidence," Congress passed legislation designed to restrict consumption of oil and natural gas for certain uses deemed "non-essential" or where coal could serve as a substitute. Impetus was given to large-scale energy projects which, if pushed to the maximum, would be ready just in time. The Synthetic Fuels Corporation, created in 1980 with authority to spend as much as $88 billion, was the most notable of several examples.

The assumption that demand trends would remain on historical paths also was common in industry. From 1963 to 1971, total U.S. energy consumption had grown at an annual average of 4.4 percent. Oil and natural gas companies created huge exploration budgets in the expectation that this sort of growth in consumption would continue. In electricity, where the size of investments makes looking at the long term critically important, electric utilities proceeded with plans to build large new nuclear and coal-fired plants. Without these facilities, projections showed the likelihood of brownouts and electricity shortages. As late as 1978, the electric power industry was projecting annual demand growth of more than 5 percent for the subsequent ten years.

Finally, not having to worry about prices made it possible to limit the uncertainty about the future. Thus, forecasts based on extrapolations of the past gave seemingly acceptable estimates of where demand would be in the future. Sometimes the calculations conveyed spurious accuracy by being carried out to a couple of decimal points. In general, not factoring in the reaction to price changes contributed to the notion that those in charge knew what they were doing, enabling leaders in government and industry to map out bold, ambitious plans for the future.

The trends turn

Unfortunately for these planners, beginning in 1979 demand trends for almost every energy product began to decline in reaction to higher prices. Compared to the first six months of that year, U.S. oil consumption in 1983 has fallen 23 percent, natural gas use has dropped 8 percent, and electricity demand has declined 2 percent. Total energy consumption has dropped 14 percent in this period. The trend also is apparent in other industrialized nations. As late as the third quarter of 1983, oil consumption in the OECD countries was below depressed 1982 levels despite the early signs of economic recovery.

Meanwhile, available low-cost energy supplies have grown. Oil production outside of OPEC countries increased from about 24 mmbd in 1973 to around 34 mmbd in 1982, with substantial additions coming from Alaska, the North Sea, and Mexico. The decline in the production of oil and gas in the United States seems—at least for the time being—to be halted.

For those with investments in high-cost energy supplies, the impact of the change in trends was serious. Oil service and equipment companies that had expanded to meet increased demand suddenly were forced to retrench. Oil and natural gas producers saw their profits dive. And, most critically, the electric utility industry found itself with a host of partially completed, unneeded power plants, many of them nuclear. Moreover, construction costs had soared in the years since the plants were ordered, making the cost of completing them prohibitive. It was no surprise, then, that many plants were canceled; in one case (the Washington Public Power Supply System), a massive default on bonds occurred. No new nuclear plants have been ordered since 1978.

What happens next?

The financial distress that accompanied these events has helped ease general acceptance of the idea that rising prices can place important limits on energy demand and encourage supply. Some still predict fairly large consumption increases will return with the reemergence of economic growth. The U.S. electric utility industry, for example, projects demand growth of more than 3 percent annually in the next ten years. However, the majority of planners within government and industry now accept that prices—including the lagged effect of past increases—will continue to hold down demand. Indeed, many are assuming that demand never again will grow at anything like the rates achieved in the 1960s and 1970s. In the wake of the experience of the past decade, these observers display more certainty about the relationship between economic growth and demand than perhaps is warranted. Nevertheless, this view of demand, along with the demonstrated flexibility on the supply side, seems to justify the Reagan administration's cutback on research and development expenditures and elimination of programs designed to enhance conservation. Similarly, a combination of low demand growth projections and less pessimism on the outlook for conventional energy supply has supported industry moves to back out of alternative energy investments. For example, the Synthetic Fuels Corporation still was barely active in 1983, three years after it began operation. As a result, it seems plausible that the United States will be, confronted by a truly ironic situation. Having been burned by a refusal to believe that one trend will change and that price would limit demand, Americans now may be victimized by too-ready acceptance of a new trend and a belief that it is unswerving.

Avoiding this trap requires measures that acknowledge explicitly the uncertainty surrounding energy. In brief, such an approach would include greater government funding for basic energy research and development directed at a variety of different technologies. To allow for smooth adjustment to fast-changing market realities, it also would be desirable to make markets as free from price regulation as is politically possible while increasing direct aid for lower-income families in times of rapidly rising energy prices. A high priority should be placed on preparing for energy emergencies and on economically justified conservation activities that would allow industry and government to postpone some of the massive investments in energy supply that are so risky in the present environment. Most of all, the success of energy planning should not depend on the continuation of today's price, supply, and demand trends. After all, if anything has been learned about energy in the last ten years, it is that today is not a very good indication of what will happen tomorrow.