Turning Point In Oil Policy

Events have moved so rapidly that it is difficult for most of us to accept that the United States has entered a new energy era. No longer do ever-declining real energy prices support economic growth as they have for most of this century. Fear and misunderstanding of this change has made adjustment to it both inefficient and incomplete. Unfortunately, the policy response to the energy "crisis" has been to attempt to deal with the changed relative price of energy as a matter of income distribution rather than of resource allocation. We have looked at the changed level of energy security and domestic self-sufficiency as a matter for bombast rather than for careful evaluation and remedial action, and at the adjustment process itself as though it were a matter of politics rather than economics.

The economic issues surrounding the appropriate reaction to the change in the relative price of energy were confused because of how the price increase was imposed. It was exceedingly difficult for many observers to recognize that, no matter how little its justification or contorted its legitimacy, the OPEC price increase raised the real opportunity cost of oil to U.S. consumers. Thus, to base consumption decisions on less than the imported price of oil would cause too much oil—and too few other resources—to be used. This excessive consumption of oil would be paid for by reduced consumption of goods consumers valued more and, as a result, the value to consumers of the output of the economy—measured in want-satisfying power—would be reduced. By the same token, to price domestic oil at less than oil's imported price would prevent U.S. producers from producing high-cost oil, but would pay foreign producers to do so.

The nation did not respond to such arguments based on economic rationality, however; instead, we adopted a policy which attempted to keep oil prices down. Whether this policy was based on ignorance or on a deliberate choice to subsidize energy consumption is irrelevant. What counts is that, despite the economic losses involved, the nation chose the control course which led to lower oil prices and reduced consumer welfare.

I would like now to examine some of the decision points at which the choices were made that led to this result. The first was to retain price controls on oil after the price controls on other items were allowed to expire with Phase IV of the Economic Stabilization Act. The price of "old" oil was not allowed to increase with the cost of imported energy, and thus, for crude oil, a multi-price system was created. When petroleum products shortages disappeared in mid to late 1974, refiners with relatively high-cost crude supplies lost their markets and faced bankruptcy. Rather than to decontrol all prices, the policy response was to equalize the cost of crude to different refiners by requiring those with price-controlled supplies to subsidize their competitors who purchased a disproportionate amount of high cost foreign and domestic crude. All consumers were thus faced with product prices based on the average, not the incremental, price of oil. The political effect of this second critical decision was to create vested interests in controls where none existed before, and to eliminate some industry pressure for abandoning controls. Its economic effect was to increase energy consumption and imports and to lower allocational efficiency.

The President came forward with his own program in early 1975. The twin criteria embedded in this program were allocational efficiency and distributional neutrality. Its key provisions were four:

1. Petroleum would be priced at its opportunity cost—the cost of imports plus some premium for insecurity. Based on this price, individuals could choose how much oil they would buy. The higher price (as compared with the controlled price) would both reduce domestic demand and increase domestic supply, thereby lowering imports.
2. The quasi-rents (profits) of domestic oil producers due to the OPEC-inspired petroleum price increase would be taxed away by means of a "windfall" profits tax. The rate of that tax would decline over time as investment behavior caught up to the change in price expectations. Thus, oil producers would retain only a limited amount of the initial increase in revenues, but would be induced to invest in more costly prospects, knowing they would be compensated when production from them came on-stream.
3. The revenues collected from tariffs on imported oil and gas, from energy excise taxes, and from the windfall profits tax would be redistributed to consumers. Consumers would thus be compensated for the price increase due to decontrol. Decontrol would therefore lead to lower energy consumption but not to appreciably lower consumer real purchasing power.
4. The final provision of the President's energy program was to neutralize, to the extent possible, the remaining employment effects of the OPEC price increase.

While the President's program was being prepared, the third critical decision on energy policy was made. The President accepted a six-month extension of the Emergency Petroleum Allocation Act to provide Congress time to consider the issues carefully. Otherwise, decontrol would have occurred automatically February 15, 1975, unless a veto of the extension were overridden.

Unfortunately, no congressional action followed, and as 1975 dragged on, the country became even more confused and divided on energy policy. As the sense of urgency declined, and as the 1976 election year drew nearer, there was less and less willingness to make the hard decisions that were required and more and more temptation to temporize.

After a number of last-minute extensions of controls and of efforts to put a phased decontrol program into place, the fourth critical decision was taken, as Congress passed the Energy Policy and Conservation Act (EPCA), which was signed by the President on December 22, 1975.

EPCA represents a substantial reversal of the policies originally formulated by the Administration. It is no longer feasible to place primary reliance on private behavior to achieve energy security goals. Government action of an ever-widening scope will be required as uncertainty and the lack of market incentives dampens both domestic energy supply and consumer conservation activities. While, under EPCA, the President may remove price controls after forty months, the price of domestic oil may not then be much closer to the world price than it is now, and pressure to retain controls will consequently be great. Special interests in regulation will be well established, onerous regulations will have lost some of their capacity to shock, and adjustments to resource misallocation will be well under way. Consequently, in my opinion, it is not unreasonable to conclude that as the EPCA became law, a turning point was passed in U.S. energy policy. Perhaps from now on, the most important events determining our energy future will occur in offices and meeting rooms in Washington and in the Middle East, not in the oil fields of Texas or Alaska. For oil companies, the "great discoveries" of the future will be made by lawyers finding loopholes, not by geologists discovering another Prudhoe Bay field.

I have examined only a few of the critical decisions regarding energy that have been taken in the past few years. No attention has been paid to the international scene, to the ways in which legislation was transformed into regulations, to environmental issues that impacted upon energy and to such vital energy matters as developments in the federal regulation of the field price of natural gas.

It is my conclusion, however, that at virtually every crucial step, with one building upon the other, the decision has been to reject or weaken a market solution to the adjustment problems brought on by higher relative oil prices and to substitute instead central controls and collective decision making. While the rhetoric has occasionally enunciated the advantages of a different course, actions have not followed words. The result is that, to a significant degree, the events of October 1973 and before not only spelled the end of the era of cheap energy but, for better or worse, also set in motion forces which may alter in an essential way the process by which energy choices are made in the United States.