Consequences and Solutions to America's Energy Crisis

Members of the Committee, I am honored to be invited to testify before your Committee today on the subject of high energy prices.  Currently I am a senior fellow at the Hudson Institute.  From February 2003 until April 2005 I was chief economist at the U.S. Department of Labor.  From 2001 until 2003 I served at the Council of Economic Advisers as chief of staff and special adviser.  Previously, I was a resident fellow at the American Enterprise Institute.  I have served as Deputy Executive Secretary of the Domestic Policy Council under President George H.W. Bush.

As oil prices flirt with $140 per barrel levels, and gasoline exceeds $4 per gallon, Americans are quite rightly asking themselves what's next, and how these prices will affect the economy.

The bad news is that oil prices could sustain these levels for some time.  Oil prices are high due to high global demand, constraints on production—although not on reserves—from oil-producing countries, and the risk of further political disruptions. 

The good news is that the American economy is less dependent on energy than it was in the past.   Although Americans will pay almost $470 billion more for oil in 2008 than in 2007 if prices stay around $135 per barrel, around 3.3% of GDP, these higher prices, while still acting as a tax, have less effect that in prior decades. 

From 1974 to 1985, America spent more than 10% of its GDP buying energy. The peak, in 1981, saw Americans paying 13.7% of GDP in energy costs. In 1973-1975 and 1979-1981, the share GDP devoted to energy increased despite decreases in per capita and total energy use.

Since then, even from 2003-2006, per capita energy consumption in the United States has remained relatively steady, between 340 and 350 million Btu per person, linking our energy consumption to population rather than to GDP growth.

Beginning in 1986 and lasting through the end of the decade, energy as a percent of GDP started to decrease to around 8.0%.  During the 1990s that ratio fell even further, reaching 6% in 1999.  The fast-growing information economy of the 1990s helped to reduce energy consumption as a percentage of GDP because the new sector had relatively low energy consumption.

Energy as a percent of GDP didn't start rising significantly until real prices of energy started rising in 2003. But there are differences between our current situation and that of the 1970s.

First, U.S. energy consumption has been fluctuating around 98-100 quadrillion Btu, hardly rising at the speeds it was in the 1970s, where consumption increased by 13.0 quadrillion Btu over a decade.  Consumption in 2006 was only 5.7 quadrillion greater than in 1996. And we have actually been decreasing our per capita energy consumption since 2004, in contrast to the increases in the 1970s.

Another piece of good news is that Congress has the power to lower energy prices by allowing oil companies to use America's domestic energy supplies. This is a problem that we can fix if we want. The U.S. Minerals Management Service estimates that American untapped oil and gas reserves total 143 billion barrels of oil and 1,050 trillion cubic feet of gas.

Yet for Congress, energy independence illogically seems to mean not using these resources. Cuba, assisted by China, is drilling for oil 45 miles off the Florida coast, but American companies aren't allowed to do the same.

The chairman of the Council of Economic Advisers, Edward Lazear, estimated that for every 2 million barrels a day of additional oil pumped, prices could fall by $30 per barrel, and increased domestic oil exploration could yield 1.5 million barrels a day. But we don't know what's there until we explore. Five years ago no one forecasted that large oil reserves are located in Brazil — and if the Brazilians hadn't drilled, they wouldn't know now either.

Instead of this, Congress has spent its legislative authority on bills that make the situation worse.  Many of the alternative energy solutions passed into law in the energy bill last December will make energy more, rather than less expensive. 

Renewable and corn-based fuels are still far more expensive than oil. The bill requires that a specified volume of renewable fuels, up from the current level of 5.4 billion, be used in motor fuel and home heating oil sold each year.  The mandated amount would rise in 2008 to 8.5 billion gallons, and would increase to 36 billion gallons in 2022.  This raises the prices of gasoline and heating fuels.  If renewables weren't more costly, the government would not have to mandate them.

Curiously, the renewable fuels requirement would apply only in the 48 contiguous states.  The members from Alaska and Hawaii are obviously more clever than those from the lower 48.  In years to come, energy in Alaska and Hawaii will be less expensive than in the rest of the country.

Now it begins to appear that ethanol may not be a panacea.  In fact, more corn may mean more greenhouse gases.

Even for people who don't drive or worry about global warming, this is a vital subject.  Ethanol has been driving up food prices by attracting agricultural resources to corn, and diverting corn from the food supply to gasoline.  Gone are the days when corn was routinely 5 ears for $1 and eggs were $1 a carton.

Ethanol doesn't even reduce greenhouse gases, as two new papers in the journal Science showed earlier this year. The authors argued that the production of ethanol causes more harmful emissions of CO2 than it prevents.  Other research has shown that even a moderate increase in our use of ethanol is not cost-effective, because America does not have the infrastructure to use it efficiently.

The problem is that the more ethanol we produce, the more greenhouse gases we generate. Princeton University professor Timothy Searchinger, along with other researchers, wrote that corn-based alcohol doubles greenhouse emissions over 30 years and causes increases that continue for 167 years. 

That happens because higher corn prices encourage farmers all over the world to transform their land from forests and unplanted fields to corn.  Opening new land to agriculture volatilizes the CO2 stored in dead trees, dirt, and other biomatter, thereby increasing the atmospheric CO2. The paper found this release to be massive, dwarfing any potential benefits.

 A companion paper in Science, by the Nature Conservancy's Joseph Fargione, showed that converting undeveloped land to biofuel production releases 17 to 420 times more carbon dioxide than annual greenhouse gas reductions due to ethanol's substitution for gasoline.  Only if biofuels are made from waste products or grown on idle farm acres are greenhouse gases reduced.

This might suggest, then, that there are ways of producing biofuels that do not lead to more greenhouse gases.  Energy Policy Research Foundation vice president Larry Kumins disagrees.  His paper, published in the Oil and Gas Journal last November, shows that the present supply of ethanol in the American economy, about 8 billion gallons a year, or 5% of the gasoline pool, is optimal.  Congressional mandates of even a small increase to 9 billion gallons this year will have harmful effects, and a level of 35 billion gallons, as Congress has mandated in 2020, is currently impossible.

Here's why: because ethanol separates from gasoline in the presence of water, blends of ethanol and gasoline that many of us put in our cars cannot be transported by pipeline.  Instead, ethanol is shipped by rail or tank truck, at greater cost than the transport of gasoline, and mixed with gasoline near the point of distribution. That's why 10% ethanol-gasoline blends are not available all over the country, only in major metropolitan areas.

As well as promoting costly alternative energy, last December's energy bill does not help expand domestic oil and national gas supplies.  The bill does not allow increased exploration and development, even using environmentally-friendly technology, in areas that are now off-limits, such as parts of the Rocky Mountains, the Outer Continental Shelf, and the Gulf of Mexico, and the Arctic National Wildlife Refuge in Alaska.  It bans development in some areas currently open, such as the Roan Plateau in Colorado.

And the world needs more oil.  Global oil consumption has been steadily increasing, yet, 2007's annual average world oil supply fell by 268,000 barrels per day compared with 2006.

The chief investment constraint is that the bulk of the oil-producing resources are in the hands of OPEC governments, rather than private firms, and the governments aren't using their resources to bring more capacity on line. Private companies want to help out by investing in OPEC countries, but the trend is for OPEC to discourage foreign investment by demanding less favorable terms of access, as well as higher royalties and taxes.

Beginning in 2001, the growth in OPEC production began to diminish as production began to collide with stagnant capacity due to nearly a three-decade lapse in investment.  

Furthermore, both in and out of OPEC, state owned oil companies in Venezuela, Russia, Mexico, and Nigeria are examples of governments that have punished profitable companies by restricting their revenues from investment. 

For example, the head of Yukos, Mikhail Khodorkovsky, is imprisoned in a Russian jail, while President Vladimir Putin, who put him there, is still in power rather than stepping down in accordance with the Russian constitution.

Even Canada, our largest source of oil exports, is raising taxes on oil producers.  The government of the province of Alberta, the source of Canda's oil, is increasing royalties by 20%, a total of $1.4 billion a year.  And Prime Minister Stephen Harper is powerless to act.

Although we will always rely on foreign imports for some of our energy, we need to make use of our own resources.  Why should we beg the Saudis to increase their production, when we won't do the same ourselves?  An indication that we are starting environmentally-clean development here will put us in a more favorable bargaining position, not just now, but for years to come.  This problem is not going away, and the time to act is now.