TCS Daily

Understanding Petroleum

By Pete Geddes - November 27, 2002 12:00 AM

Two questions nag America's energy policy. First, when will America move from fossil fuels? Second, what is the next source of BTUs?

No one knows the answers - but knowledgeable people agree the shift won't come soon. Aside from temporary shortages caused by political disruptions, the world is awash in cheap oil and will be for a long time. Supplies of coal are even cheaper and far more abundant.

But a change is coming. When it occurs, it's likely to resemble the 17th century transition in England when coal replaced wood, and then again in the 19th century when oil displaced coal. Fortunately for the environment, in the developed world, the transition will be to cleaner fuels.

Some find it frustrating not knowing what our energy future holds, but an uncertain future is the only one we have. Here, however, are some things we do know.

First: There is no energy crisis. Oil prices are moderate in constant dollars and the price of gasoline has been on a steady downward trend since 1920. Despite recurrent alarms, the world is not (and has never been) in immediate danger of running out of oil. Oil reserves depend more on price and technology than on geology.

Finding oil is expensive and risky. Thus, when petroleum prices are low, there is little incentive to search for more. When oil becomes scarce, rising prices create incentives for exploration.

Higher prices do two other important things. They increase conservation and spur the search for substitutes. For example, alternative fuels such as compressed natural gas and hydrogen could replace gasoline if oil prices rose high enough to make them competitive.

Second: In the near term, alternative energy (e.g., solar and wind) can't compete with fossil fuels. The Energy Information Agency predicts that by 2020 all renewables will account for less than 4 percent of U.S. energy supply. In 1999 they contributed 3.37 percent. Toward the end of the century they are likely to be significant. But for the next few decades, almost all new energy demand will be met by fossil fuels or nuclear power.

Reasonable people argue that energy-efficient technologies could compete if corporate subsidies were removed. However, the political reality precludes this possibility. Carl Pope, executive director of the Sierra Club, and Ed Crane, president of the libertarian Cato Institute, recently wrote in the Washington Post regarding last session's energy bill, " The... bill crafted by the Democrats... has a hurricane of subsidies, tax breaks and regulatory preferences for every energy industry you can imagine. And despite Democrats' green rhetoric, the... bill rains roughly the same level of subsidies on the fossil fuel and nuclear power industries as it does on 'green' energy technologies...."

Third: The U.S. will remain dependent on imported oil. This is because our reserves have been almost fully explored and developed. Undiscovered oil in ANWR and the Rocky Mountain Front can only marginally increase domestic supply. But even if every drop of oil we consumed came from domestic sources, international shortfalls would raise domestic oil prices. That's because global economic forces ultimately trump regional markets. Thus, regional prices for crude oil match world prices. For example, in 1979, Great Britain - which was totally energy independent due to production from its North Sea fields - had oil price spikes as high as Japan, which imported all of its oil.

Fourth: The market process does a better job managing energy fluctuations than do politicians. Markets effectively ration the available supply to those willing to pay the increased costs while inducing others to conserve and substitute. An important benefit of prices set by the market is that they force people to act as though they cared about what others want.

The energy crisis in the 1970s was mainly caused by President Nixon's price controls. The perverse incentives of such polices always generate unintended consequences. For example, oil price controls kept prices artificially low. This crushed incentives for bringing new production on-line. Concurrently, lower prices stimulated consumption while discouraging conservation.

We can return to those nagging questions with one clear answer. When considering our energy future, remember these truths: politicians are opportunistic, brains are excellent substitutes for BTUs, and markets give incentives to put brains to work.

Pete Geddes is Program Director of the Foundation for Research on Economics and the Environment (FREE) and Gallatin Writers. Both are based in Bozeman, Montana.

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