Petroleum Prices and the New Energy Act

Public uncertainty about energy policy was relieved only slightly by enactment of the Energy Policy and Conservation Act in December. In news stories, this legislation had frequently been labeled an "omnibus" bill, connoting comprehensive attention to energy matters. The term may have been warranted by the length of the bill—well over two hundred pages. But, in fact, the legislation left untouched numerous critical issues—natural gas price regulation, strip mining controls, federal support for synthetic fuel commercialization, and expanded uranium enrichment capacity, to name only a few. If the indecision on petroleum pricing was over, much remained unsettled at the end of 1975.

The principal feature of the compromise act signed by President Ford is the initial lowering of federal price ceilings and the retention of federal control of prices on domestically produced crude oil for forty months, with provision for periodic price increases. At the end of this "phase-out" period, crude oil prices are to be determined once again in the market place. (By 1979, as a result of this extension, the United States will have been involved in petroleum price-setting for six years—since enactment of the Emergency Petroleum Allocation Act in 1973, which occurred several months before the Yom Kippur war. As is sometimes true of federal crisis legislation, the "emergency" appears to be fairly enduring.)

The arithmetic of oil pricing. In the absence of federal intervention, American refiners would pay the going world price for crude oil, which is to say, the monopoly price exacted by the OPEC cartel (currently up to $12 a barrel, delivered to the United States, exclusive of the $2 import duty which the president abolished when he signed the new bill). The OPEC price governs because American producers of crude oil—their output falling and their rate of production at close to full capacity—have relinquished their leverage on prices to foreign countries, notably Saudi Arabia. In order to preclude domestic output from selling at the cartel price—which would give excessive profits to domestic producers and impose additional burdens on consumers, the U.S. government has been maintaining a price freeze of $5.25 a barrel on oil produced from wells operating in 1972 up to the volume of output from those wells in that year. This "old-oil" segment of U.S. production has been accounting for about 60 percent of domestic output. The remaining 40 percent of U.S. output—"new oil" from wells brought into production since 1972 or from additional output from preexisting wells operating at above 1972 rates of output—has not been subject to price controls. It has therefore been selling at near the price level of imported oil. The weighted average of old and new domestic crude oil was around $8.75 a barrel in late 1975; when combined with imported oil, which accounts for 37 percent of U.S. supplies, an overall average price of approximately $10.70 a barrel results ($9.45 without the effect of the import duty).

The new Energy Policy and Conservation Act maintains the distinction between old and new oil on U.S. production but, in addition, establishes control over the composite price. It sets the starting level for the weighted average at $7.66 a barrel, or a reduction of more than $1.00 from the prevailing $8.75 level. This implicitly forces some downward price adjustment in the new-oil component of domestic production—from the duty-protected $14.00 a barrel to around $11.30; but because sellers had been permitted to defer the pass-through of higher crude oil costs until some later time of their choosing—and had taken advantage of that provision. the initial lowering of the composite price may exert little downward pressure on refined-product prices at the retail level.

Starting with the initial $7.66 price on January 1, 1976, the president can permit the composite price for domestic crude oil to rise 10 percent annually. Barring disapproval by Congress, and beginning in April 1977, the 10 percent factor can be breached to allow for new production from certain high-cost oil fields, such as North Slope Alaska.

Conservation and stockpiling. The act contains several other noteworthy provisions. The most significant of its numerous conservation items is a mandatory fuel-economy standard averaging 27.5 miles a gallon for new-car fleets. Manufacturers are compelled at risk of civil penalty to achieve it by 1985 in a staged sequence. The new law also authorizes the government to create a strategic petroleum reserve designed to achieve, within seven years, a storage capacity equaling three months of imports. (Imports at the end of 1975 were running at a rate exceeding 6 million barrels a day.) Although the act defers the specifics of implementation pending submission of a Federal Energy Administration (FEA) plan by December 1976, the strategic stockpile policy may be the most important part of the new legislation. It is the provision that comes closest to addressing directly the problem of foreign supply cutoffs.

The act provides for federal assistance in state energy conservation programs but hinges such support on some bewildering conditions. For instance, states must prepare energy-demand projections, embodying conservation strategies that would yield a 5 percent energy saving below the levels of demand otherwise prevailing. The appropriate baseline standard of reference is, however, not spelled out.

Controls versus the market. An intense lobbying effort had been directed against the Energy Policy and Conservation Act by domestic oil producers and others who claimed that higher prices were needed to spur exploration and development. (Some independent refiners and "crude-short" producers supported the bill or equivocated.) Opponents of the act also questioned whether the government's "old-new" oil price mechanism could cope for long, with the complex characteristics of oil reservoirs. More generally, there was uneasiness over the federal bureaucracy's deepening encroachment into the oil markets. The FEA's record in pricing and allocation decisions has been, probably through little fault of its own and perhaps by necessity, one of intermittent confusion, and it has led to public misunderstanding.

It is not easy to sort out reasonableness from hyperbole on the price question, quite apart from the fact that the intricacies of the provisions and the proposed interplay between Congress and the president may set the stage for more wrangling, acrimony, uncertainty, and suspicion. Surely, the financial return to U.S. producers, and especially producers of old oil, should not be dictated by the whim of a foreign monopolistic combine. But what level of prices is required to promote improved recovery of known U.S. wells and spur the search for new oil fields? The matter is embedded in such vast ignorance and controversy that only highly tentative judgments are warranted. For example, whether oil output is deliberately being held below economically feasible production rates is a currently raging issue. (It is one of the key questions scheduled for discussion at a 1976 RFF seminar which will probe the concept of "maximum efficient rates" of production—or MERs—and its usefulness as a measure of performance—a newly important concept that has found a place in the 1975 energy act.) Beyond that, much depends on whether one accepts expansive or conservative estimates of future discoverable petroleum resources; for, under highly conservative geological assumptions of the future potential, prices would not make much difference in lifting the supply prospects.

Early in 1975 Congress showed an unwillingness to countenance even a modest tax increase on gasoline. In the new legislation, the Congress once again comes down squarely against using the price mechanism as the most forceful and direct means of dampening future energy consumption. Allowing prices to rise and siphoning off some portion of the resulting corporate revenue through a "windfall profits" tax is another option that the House Ways and Means Committee considered early in the year, but like much else in those initial probings, its support eroded as the election year grew nearer. And not without cause: after all, real energy prices have already moved up sharply over the last several years. Still, the course finally chosen is more apt to protect the economy from added inflationary and recession-inducing shocks than to lessen dependency on foreign supplies.

One must also be cautious in assessing the potency of price-triggered conservation practices. Thus, nationwide energy consumption since the fall of 1973 seems to have fallen somewhat, but not greatly, below the levels to be expected in a period of severe economic recession. Certainly, the steep price increases since the fall of 1973 have not yet induced anywhere near the degree of retrenchment in the use of energy that numerous econometric analyses would have suggested. Perhaps demand restraint may require a longer adjustment period, since consumers are locked into energy-using "capital goods"—housing, appliances, transport—permitting initially only moderate reduction in consumption. For the long run, a favorable portent is the rising share of new-car production that is being devoted to fuel-saving models (a market phenomenon, incidentally). If the shift to smaller cars endures, it will almost certainly signify at least some deceleration of future energy-demand growth.