Dialogue 1

Dialogue

Vol. 13, No. 2

United States Association for Energy Economics: An Affiliate of the IAEE

The Geopolitics of Oil: The Impact of Russia, China and India

Will We Run Out of Crude?

Energy-GDP Relationship in the USA, 1949-2003

713

17The U.S. Electric Power Industry: Policy Forest and Jurisdictional Trees

20

Hubbert, Hotelling and Risk: The Three Causes Behind Peak Oil 14

August 2005

USAEE Mission StatementThe United States Association for Energy Economics is a non-profi t organi-

zation of business, government, academic and other professionals that advances the understanding and application of economics across all facets of energy de-velopment and use, including theory, business, public policy and environmental considerations.

To this end, the United States Association for Energy Economics:• Provides a forum for the exchange of ideas, advancements and professional

experiences.• Promotes the development and education of energy professionals.• Fosters an improved understanding of energy economics and energy related

issues by all interested parties.

Dialogue 2

!!!!! PLAN TO ATTEND !!!!!Fueling the Future: Prices, Productivity, Policies, and Prophecies

25th Annual North American Conference of the USAEE/IAEESeptember 18 – 21, 2005

Denver, CO – Omni Interlocken ResortWe are pleased to announce the 25th Annual North American Conference of the USAEE/IAEE, Fueling the Future: Prices, Productivity, Policies, and Prophecies, scheduled for September 18-21, 2005, in Denver, CO at the Omni Interlocken Resort.

Plenary sessions will be interspersed with concurrent sessions designed to focus attention on major sub-themes. Ample time has been reserved for more in-depth discussion of the papers and their implications. Some of the key themes and sessions for the conference are as follows:

Fossil Fuels RelianceNational Energy Policy for the 21st CenturyFuture Fuels and Use: Hope for Tomorrow

Experience in Electricity Market Restructuring: The Bad, The Ugly and the Not So BadEnergy Policy Gone Awry

Non-Conventional Energies: Probable to ProvenDecoding the Future: An Overview of Shell’s New Global Scenarios

Renewable Energy: Back to the Future?Confirmed and/or invited speakers include:

Douglas J. Arent, National Renewable Energy LaboratoryJoseph Desmond, California Energy CommissionThomas Drennen, Sandia National LaboratoriesJohn Edwards, University of Colorado at BoulderJean-Pierre Favennec, IFP-ENSPMMark Finley, BP AmericaS. David Freeman, Renewable Resources GroupJanet Gellici, American Coal CouncilMichael “Mickey” Glantz, Nat’l. Center for Atmospheric ResearchDaniel M. Kammen, University of California BerkeleyRobert Alfred Lamarre, Lamarre Geological Enterprises, LLCDoug Larson, Western Interstate Energy CouncilAmory Lovins, Rocky Mountain Institute

There are 30 planned concurrent sessions. Given the location of the meeting in Denver, CO, we anticipate a good draw to our concurrent sessions with over 140 confirmed speakers.

Denver/Boulder, CO are inspiring cities and a great place to begin or end a vacation. Single nights at the elegant Omni Interlocken Resort are $135.00 per night. Contact the Omni Interlocken Resort at 303-438-6600 or 1-800-THE-OMNI to make your reservations. Conference registration fees are US $600.00 for USAEE/IAEE members and US $700.00 for non-members. Our current program announcement can be found by visiting http://www.iaee.org/en/conferences Please take advantage of the pre-registration discounts and make both your conference and hotel reservations as soon as possible. September in Colorado is a celebration! Further information on Denver, CO may be obtained at: http://www.denver.org Further information on Boulder, CO may be obtained at http://www.bouldercoloradousa.com For further information on this conference, please fill out the form below and return to USAEE/IAEE Conference Headquarters.

Fueling the Future: Prices, Productivity, Policies, and Prophecies25th USAEE/IAEE North American Conference

Please send further information on the subject checked below regarding the September 18-21, 2005 USAEE/IAEE North American Conference.

_____ Registration Information _____ Sponsorship Information ____ Exhibit Information ____ Accommodation Information

NAME: TITLE: COMPANY: ADDRESS: CITY,STATE,ZIP: COUNTRY: Phone/Email:

USAEE Conference Headquarters28790 Chagrin Blvd., Suite 350

Cleveland, OH 44122 USAPhone: 216-464-2785 Fax: 216-464-2768 Email: usaee@usaee.org

Visit the Conference website at http://www.iaee.org/en/conferences

Michael C. Moore, University of CalgaryShirley J. Neff, President-Elect, USAEEAmy Jaffe, Rice UniversityJim Mulva, CEO, ConocoPhillips, Inc.Fereidoon Sioshansi, Menlo Energy EconomicsAndrew Slaughter, Shell Exploration & Production Co.Philip Herald Stark, IHS Energy GroupJames L. Sweeney, Stanford UniversityWim Thomas, Shell International plcTaff Tschamler, KEMA, Inc.Hermann-Josef Wagner, University of BochumThomas J. Woods, Platts Research & ConsultingJay Zarnikau, Frontier Associates, LLC

Dialogue 3

Despite persistent production increases by OPEC na-tions and U.S. oil inventories substantially rebuild-

ing, oil prices are still trading above $50 per barrel. Not surprisingly, this topic has been getting a lot of attention this year.

Our members helped improve the understanding of recent price trends in the Ninth Annual Washington En-ergy Policy Conference sponsored by the National Capi-tal Area Chapter of USAEE and the International Energy and Environment Program of the School of Advanced International Studies at Johns Hopkins University. This

program was held in Washington, D.C. on April 26, 2005 and it was entitled, “Higher Energy Prices: New Paradigms and Policy Responses.”

I helped kick off the first session on the world oil market by raising the key uncertainties about what is happening in the market place. Roger Diwan of PFC Energy gave a presentation on “When Structural and Cyclical Events Collided”. Roger said that soaring demand and to some degree low supply growth are cycli-cal factors that have led to higher prices. The structural changes that have oc-curred are concerns about energy security, the increased role of hedge funds in the market and the shrinking of OPEC’s spare capacity. He also talked about the long response times on both adding new supply and reducing demand.

Dr. Edward Morse of Hess Energy Trading presented his view that higher oil prices have resulted in part from an influx of financial investors into the market because of undervaluation of oil assets and the potential upside for prices. How-ever, he did not believe a “speculative bubble” has been created compared to the Dot.com bubble of the 1990s as evidenced by the fact that oil and gas assets have been under-priced, not over-priced. I might add that another obvious difference to the dot.com bubble is that the energy industry has hard assets.

Martin Tallett of Ensys Energy and Systems Inc. focused on the refining sec-tor. He stated that complex environmental and permitting requirements, the clo-sure of some refineries that cannot be efficiently upgraded, high compliance costs to meet new fuel and emissions standards, poor refining margins historically, and the availability of product imports have combined to constrain U.S. refinery growth. Looking into the future, he believes a big question will be whether refin-ers will be compensated for switching away from MTBE or whether they will be liable for MTBE clean up.

The remainder of the day dealt with natural gas and coal, electric power and new technologies. We heard from the various speakers that natural gas and coal have also evolved to higher prices. The PowerPoint presentations of many of the conference speakers are available on the Internet at:

http:/www.ncac-usaee.org/conf_2005_program.htm.Given present deliberations on the Energy Bill, I wanted to share the results

of the energy policy survey the USAEE conducted last fall. There were 155 re-sponses to the survey from USAEE members, and the results were tabulated by JDRC & Associates. The first question asked was. “What long-term priorities should U.S. energy policy address in the next two years?” The choices are shown below along with the priority rankings that resulted from the survey (1= highest priority, 11=lowest priority in list):

• Reliability & safety of infrastructure (1)• Energy conservation / efficiency (2)• Security of energy supplies (3)• Sustainability (reducing carbon & other emissions) (4)• Securing new natural gas supplies (5)• Reducing U.S. oil import dependence (6)

Contents

FeaturesPresident’s Message 3Editor’s Corner 5Calendar 28

ArticlesThe Geopolitics of Oil: The Impact of Russia, China and India Leonard L. Coburn 7

Will We Run Out of Crude? Lewis L. Smith 13

Hubbert, Hotelling and Risk: The Three Causes Behind Peak OilDoug Reynolds 14

Energy-GDP Relationship in the USA, 1949-2003Christopher M. Chima 17

The U.S. Electrc Power Industry: Policy Forest and Jurisdictional Trees Vito Stagliano 20

DialogueVol. 13, No. 2 ($10.00)

August 2005www.usaee.org

Dialogue

Dialoge is a tri-annual publication of the Unit-ed States Association for Energy Economics. Subscriptions are dependant on membership with USAEE. Reprints are available for $10 US and Canada.

Editor: Wumi Iledare

Submissions

Articles, notices, news of chapter events and relevent energy news can be sent to the editor.

Wumi IledareLSU Center for Energy StudiesEnergy Coast & Environment BuildingBaton Rouge, LA 70803-0001wumi@lsu.eduFax: (225)578-4541Tel: (225)578-4552

President’s Message

(continued on page 4)

Dialogue 4 Dialogue 5

President’s Message (continued from page 3)

• Rely on free markets (7)• Electricity restructuring (8)• Fuel price stability (9)• Lowest cost fuel to consumers (10)• Other (11)

Results show that members are most concerned about the reliability and safety of energy infrastructure. It is interesting to note that the pricing categories received some of the lowest rankings. However, if the votes for lowest cost fuel to consum-ers were combined with the votes for fuel price stability, pricing would have ranked third. Based on comments from one of the respondents, they didn’t vote for pricing because there was little that governments could directly do about it. Rather, “the key issue is availability of energy supplies at reasonable prices. This has to be achieved through a combination of increased supply and reduced demand. The result would be more fuel price sta-bility, supply security etc.”

The second question the survey asked was, “How impor-tant is energy policy compared with other national priorities?” The choices are shown below along with the rankings that re-sulted from the survey (1=most important, 8=least important policy on list):

•The war on terror (1)• Health care (2)• Budget deficit (3)• Social security (4)• Energy policy (5)• Unemployment (6)• Environmental / carbon policy (7)• Other (specify) (8)

Our voting members did not believe that energy policy was the highest priority but rather that it was the 5th highest prior-ity.

The final question we asked our members was, “In the proposed Energy Policy Act of 2003, how important are each of the following major provisions in meeting priority energy goals?” The choices are shown below along with the survey results. The statistic provided below in bold is the percent of respondents that believed this policy item offered significant help or was very important in meeting priority energy goals. The other categories (not shown) were that the provision was either flawed, neutral or they didn’t know.Conservation

a. Tax credits, grants, low-income subsidies, and voluntary pro-grams that act to reduce the cost and use of energy in the building sector (38%)

b. Mandatory standards to reduce the use of energy in the building sector (55%)

c. Industrial programs providing tax credits for combined heat and power generation, blended cement, and voluntary programs to reduce energy intensity (45%)

Reducing U.S. oil import dependence

d. Tax credits for alternative fuel vehicles (51%)e. Establishment of a renewable fuels standard (3.1 billion gallons

in 2005, rising to 5 billion gallons by 2012) (32%)

f. Ethanol and biodiesel tax credits (20%)

Security of energy supplies / fuel price stability / environmental

g. Elimination of the use of MTBE in gasoline (47%)h. Elimination of oxygen content requirements for reformulated

gasoline (41%)

Securing new gas supplies

i. Extension of royalty relief to natural gas production from deep wells on existing leases in shallow water (37%)

j. Establishment and funding of a research program for ultra deep water and unconventional natural gas and other petroleum re-sources from royalty payments (44%)

k. Section 29 credits for unconventional fuels production (33%)l. Enabling legislation and assistance (tax incentives or loan guar-

antees) for constructing the Alaska natural gas pipeline (32%)

Reliability and safety of infrastructure

m.Establishment of a series of tax credits for natural gas gathering, distribution, and high-volume pipelines and gas processing facili-ties (19%)

n. Provisions to improve the reliability of the electricity transmis-sion grid. (81%)

Reducing carbon and other emissions

o. Tax incentives and other provisions to encourage generation from renewable power sources (58%)

p. Tax incentives and other provisions to encourage generation from nuclear energy (35%)

The policy provision responding members believed would help the most are provisions to improve the reliability of the electricity transmission grid. Members believed that the most flawed policies were the establishment of renewable fuels stan-dard and the ethanol and biodiesel tax credits, where respec-tively, 28% and 27% (figures not depicted here) of respondents believed these provisions were flawed.

Moving to a different subject, the program for the USAEE 25th Annual North American Conference in Denver, Colorado (September 19-21, 2005) is shaping up nicely. The theme is: Fueling the Future: Prices, Productivity, Policies and Prophe-cies. The sub-themes that will be addressed are:

• Fossil Fuels Reliance and Reserves• National Energy Policy for the 21st Century• Non-Conventional Energies: Probably to Proven• Renewable Energy: Back to the Future?• Future Fuels and Use: Hope for Tomorrow• Experience in Electricity Market Restructuring: The Bad, The

Ugly, and the Not So Bad• Energy Policy Gone Awry

Other highlights include a presentation from the Hewlett Foundation-sponsored National Commission on Energy Policy on their recently issued U.S. energy policy recommendations and representatives from Royal Dutch Shell to present their new global scenarios of the future. Of course, we can’t have a conference in Colorado without Amory Lovins. He will be joining the plenary session on Future Fuels and Use.

I look forward to seeing you there.Marianne Kah

Dialogue 4 Dialogue 5

Resources for the Future suggests that the U.S. electric power industry is in a state of policy paralysis. The stillbirth of reform of this vital economic sector, according to him is due to several factors, among them are the schizophrenic public perceptions of what constitutes a “market” for power; how “competition” is fostered or avoided; what purpose should be served by “re-structuring,” and what actually constitutes “deregulation.” His conclusion is that the present state of the power sector – neither proverbial fish nor fowl – represents an unsatisfactory policy state, most importantly because the key players in the mar-ketplace engage in a game with variable rules on the basis of unequal handicaps.

As always, members are requested to submit short articles for publication in the USAEE Dialogue. The editor welcomes policy or analytical debates on topical issues of energy concerns between two experts. We would also be delighted to publish your recent research effort on energy policy issues and prob-lems. Send us abstracts of your most recent working papers and unpublished and published research papers. Further, we want to publish short articles on research centers (academic, govern-ment laboratories, etc) around the country working on energy economics and related fields. Thus, included in this edition of the Dialogue is a press release introducing the new Center for Energy Economics in the Bureau of Economic Geology at the University of Texas, Austin.

Please send new articles, notices, news of chapter events, and relevant energy news to the editor via e-mail (wumi@lsu.edu.), by fax (225-578-4541) or by regular mail (Center for Energy Studies, 1107 Energy, Coast and Environ-ment Building, Louisiana State University, Baton Rouge, LA 70803).

Wumi Iledare

Conference Proceedings on CD Rom24th North American Conference

Washington, DC, USA, 8-10 July, 2004The Proceedings of the 24th North American Conference of the USAEE/IAEE are available from USAEE Headquarters on CD Rom. Entitled Energy, Environment and Economics in a New Era, the price is $100.00 for members and $150.00 for non members (includes postage). Payment must be made in U.S. dollars with checks drawn on U.S. banks. Complete the form below and mail together with your check to Order Department, USAEE, 28790 Chagrin Blvd., Suite 350 Cleveland, OH 44122, USA.Name __________________________________________________________________________________________Address ________________________________________________________________________________________City, State, Mail Code and Country __________________________________________________________________

Please send me ____ copies @ $100.00 each (member rate) $150.00 each (nonmember rate). Total enclosed $_________ Check must be in U.S. dollars and drawn on a U.S. bank, payable to IAEE.

USAEE NewsEditor’s Corner

The fall edition of the USAEE Dialogue has three short articles on the global oil market dynamics and the underly-ing forces propelling the rising trend in crude oil prices since January 1999. Dr. Coburn, President of Coburn International Energy Consultants, LLC, argues that in today’s oil market, oil price movement is in response to a high level of uncertainty in the market. He concludes that much of the uncertainty on the demand side focuses on China and to some extent India. The uncertainty in non-OPEC supply focuses on whether Russia will be able to sustain its phenomenal production expansion. He also suggests that OPEC’s reaction to the oil market will lend to increased volatility.

The second article on world oil dynamics attempts to answer the oil exhaustibility question—will the world run out of oil? Lewis Smith provides a “yes” and “no” answer with a caveat that nobody really knows when the world will run out of oil, notwithstanding the current outpouring of fearless forecasts of an early peak for world crude oil production. The article by Doug Reynolds of the University of Alaska at Fairbanks, how-ever, provides three likely forces underlying the peak oil phe-nomenon that could lead to an oil price shock or even a super shock. One is the Hubbert curve, the second is the risk averse nature of oil suppliers, the third is the Hotelling principle. All three are coming together at the same time to create a peak in oil production just as global oil demand is rising fast.

The article by Dr. Christopher Chima, revisits the energy-GDP debate and provides an analysis of the energy-GDP rela-tionship in the U.S. from 1949-2003. He shows that economic activity influences energy consumption in the United States, and the direction of causality could run from GDP to energy. He suggests that energy conservation policies in the U.S. will not deter economic growth or yield negative welfare effects.

Finally, Vito Stagliano, a Former Deputy Assistant Sec-retary of Energy for Policy and Former Visiting Scholar at

Dialogue 6

Conference Proceedings on CD Rom23rd North American Conference

Mexico City, Mexico - - October 19-21, 2003The Proceedings on CD Rom from the 23rd Annual North American Conference of the USAEE/IAEE held in Mexico City, Mexico are now available from USAEE Headquarters. Entitled Integrating the Energy Markets in North America: Issues & Problems, Terms & Conditions, the price is $100.00 for members and $150.00 for nonmembers (includes postage). Payment must be made in U.S. dollars with checks drawn on U.S. banks. Please complete the form below and mail together with your check to: Order Department, USAEE Headquarters, 28790 Chagrin Blvd., Suite 350 Cleveland, OH 44122, USA.Name _______________________________________________________________________________________________ Address _____________________________________________________________________________________________City, State, Mail Code and Country _______________________________________________________________________

Please send me ____ copies @ $100.00 each (member rate) $150.00 each (nonmember rate). Total enclosed $_________ Check must be in U.S. dollars and drawn on a U.S. bank, payable to USAEE.

25th USAEE/IAEE NORTH AMERICAN CONFERENCE

STUDENT SCHOLARSHIPS AVAILABLE

USAEE is offering a limited number of student scholar-ships to the 25th USAEE/IAEE North American Conference. Any student applying to receive scholarship funds should:

1) Submit a letter stating that you are a full-time student and are not employed full-time. The letter should briefly describe your ener-gy interests and tell what you hope to accomplish by attending the conference. The letter should also provide the name and contact information for your main faculty supervisor or your department chair, and should include a copy of your student identification card.

2) Submit a brief letter from a faculty member, preferably your main faculty supervisor, indicating your research interests, the nature of your academic program, and your academic progress. The faculty member should state whether he or she recommends that you be awarded the scholarship funds.

USAEE scholarship funds will be used only to cover conference registration fees for the 25th USAEE/IAEE North American Conference. All travel (air/ground, etc.) and hotel accommodations, meal costs in addition to conference-pro-vided meals, etc. will be the responsibility of each individual recipient of scholarship funds.

Completed applications should be submitted electronically to USAEE Headquarters office no later than August 31, 2005. Email to usaee@usaee.org

Students who do not wish to apply for scholarship funds may also attend the conference at the reduced student registra-tion fee. Please respond to item #1 above to qualify for this special reduced registration rate. Please note that USAEE reserves the right to verify student status in accepting reduced registration fees.

If you have any further questions regarding USAEE’s scholarship program, please do not hesitate to contact David Williams, USAEE Executive Director at 216-464-2785 or via e-mail at: usaee@usaee.org

Dialogue DisclaimerUSAEE is a 501(c)(6) corporation and neither takes any position

on any political issue nor endorses any candidates, parties, or public policy proposals. USAEE officers, staff, and members may not repre-sent that any policy position is supported by the USAEE nor claim to represent the USAEE in advocating any political objective. However, issues involving energy policy inherently involve questions of energy economics. Economic analysis of energy topics provides critical input to energy policy decisions. USAEE encourages its members to con-sider and explore the policy implications of their work as a means of maximizing the value of their work. USAEE is therefore pleased to offer its members a neutral and wholly non-partisan forum in its con-ferences and web-sites for its members to analyze such policy impli-cations and to engage in dialogue about them, including advocacy by members of certain policies or positions, provided that such members do so with full respect of USAEE’s need to maintain its own strict political neutrality. Any policy endorsed or advocated in any USAEE conference, document, publication, or web-site posting should there-fore be understood to be the position of its individual author or authors, and not that of the USAEE nor its members as a group. Authors are requested to include in an speech or writing advocating a policy posi-tion a statement that it represents the author’s own views and not nec-essarily those of the USAEE or any other members. Any member who willfully violates the USAEE’s political neutrality may be censured or removed from membership.

Do You Want to Start Your Own USAEE Chapter?The requirements for starting a USAEE Chapter are

straightforward – You must have a viable group of at least 20 individuals all of whom must join the USAEE and have orga-nized to the point of adopting a set of bylaws and a group of elected officers. Sample bylaws can be requested and obtained by calling USAEE Headquarters at 216-464-2785. USAEE dues are $65.00 per person, per year for a subscription to The USAEE Dialogue, The Energy Journal and IAEE Newsletter. Student membership is $35.00. USAEE bills members directly for their membership in the Association. Chapter membership must be open to all individuals whose work or interest is in the field of energy economics. If you have any further questions regarding the establishment of a USAEE Chapter, please do not hesitate to contact David Williams at USAEE Headquarters, phone: 216-464-2785; email: usaee@usaee.org A complete Chapter start-up kit can be mailed to you.

7 Dialogue

The Geopolitics Of Oil: The Impact Of Russia, China And India

By Leonard L. Coburn*

Oil prices have exceeded $40 per barrel since January 2004 and appear to be maintaining their strength. Why have oil prices been so high and stayed so high for so long? What is the future price outlook?

Oil market price behavior is in response to a high level of uncertainty in the market, more so than usual. Demand has been robust, existing crude supplies have been responsive, but new crude supplies have not been forthcoming fast enough to replace declining existing supplies. Crucially, spare capacity to meet any supply contingency is virtually non-existent. Much of the existing crude spare capacity is heavy and sour that can-not be processed easily by existing refineries. There seem to be many hot spots in producing countries that could tighten the market almost instantaneously. As a result, traders have been pushing the price up because of the acute tightness in the mar-ket. In looking at the demand and supply factors contributing to this tightness and uncertainty, the story needs to focus on China and India on the demand side and on Russia and OPEC on the supply side.

Oil Markets

The oil market outlook is really one of basic economics – supply, demand and uncertainty. How markets deal with these issues is the fundamental question. Right now oil markets are not dealing with the problems well.

On the demand side, oil demand is being driven by the economic recovery in the U.S., by robust Chinese economic performance and soaring energy demand, and to some extent by India’s economic performance and growing energy needs. Last year saw the largest increase in oil demand in almost 30 years (since 1976) or about 2.6 million barrels per day. The U.S. and China accounted for one half of this increase. For this year compared to 2004, estimates from various sources indicate that the U.S. and China again will account for about 50 percent of the increase in oil consumption. If you add other Asia economies including India, then these areas will account for about 60 to 70 percent of the increase in consumption for 2005 over 2004. This strong growth is projected to continue for both China and India. For example, China is now the second largest oil consumer in the world, surpassing Japan in 2003. China alone accounted for 40 percent of world oil demand growth over the last four years. Estimates are that around 2020 China’s oil consumption will double to about 13 million bpd, with imports in the 10 million bpd range, or about what U.S. imports are today. Part of the underlying uncertainty roiling oil markets is the surprise factor – most oil analysts did not foresee the big jump in China’s oil demand in 2004. Certainly, analysts thought that Chinese oil demand would continue growing at

the pace it was growing since the mid-1990s, but the almost 1 million bpd jump in 2004 was unexpected. The question is whether China’s economic growth will be sustained and if it is, what will happen to China’s thirst for energy.

On the supply side, the analysis has to look at non-OPEC supply and OPEC supply. For non-OPEC, if you take out the growth in supply by countries of the Former Soviet Union (FSU), non-OPEC supply has been essentially flat since 2000. Virtually all of the growth has come from Russia and the Caspian region. Russia’s oil production growth has been spectacular over the last 5 years. From a low point in production of about 6 million bpd in 1998, Russia now produces more than 9 million bpd. Most of the increase has been exported since domestic demand has been flat. It has been Russia’s production and export growth and to some extent the growth in the Caspian (mostly Kazakhstan) that has supplied the growth in demand. For example, for the change in non-OPEC supply between 2003 and 2004, the FSU was re-sponsible for 97 percent of this net change if you factor in both the gains and losses of other non-OPEC suppliers. Of course, other countries increased their production including African and Latin American countries. But so much of the new supplies are coming from the FSU. For 2005, estimates range from 46 to 83 percent of FSU supplies contributing to non-OPEC supplies. The range is so wide because of uncertainty in the oil supply growth in Russia. The remainder comes primarily from Africa and Latin America. Interestingly, before the run-up in oil prices that started in 2004, the chief worry in the oil markets was too much supply because of the big supply increases in Russia. Un-fortunately, Russia oil production increases are slowing, while Caspian production continues to grow. In Russia, supplies are growing but at a rate that is about half of the previous five years. Russia bears watching closely since it appears that its growth in production may have peaked in 2004. As overall FSU produc-tion growth slows, and unless Africa and Latin America fill the gap, there will be a shift to OPEC.

The call on OPEC crude is the difference between what the world demands and what non-OPEC producers supply. Until 2003, the call on OPEC was relatively stable. Russia and other FSU producers took higher oil market share than before. The worry was that there was too much oil rather than not enough. Saudi Oil Minister Naimi remembering the disastrous OPEC meeting in Jakarta in November 1997 when OPEC added 1 million bpd to oil markets just when Asian demand plummeted and prices crashed to $10 per barrel in 1998 has vowed never to let that happen again. So at the December 10, 2004, OPEC meeting, OPEC left its quota at 27 million bpd, but agreed to cut production by 1 million bpd or 3.5% effective January 1, 2005, to ensure that oil prices would not fall much below $40 per barrel. OPEC thought that inventories were building too rapidly and that world oil markets were heading towards being over-supplied. In January, OPEC again left the quota at 27 mil-lion bpd but abandoned its price range of $22-$28 per barrel. OPEC’s worry of over-supplied markets vanished at the March meeting, a time when OPEC usually worries about lower de-mand in the second quarter.

The shift in market share from OPEC to non-OPEC is slowing, and more and more OPEC is being looked to fill the

* Leonard Coburn is President, Coburn International Energy Consul-tants, LLC. Mr. Coburn was the Director, Russian and Eurasian Affairs, U.S. Department of Energy from 1996 to 2004 and the Di-rector, Oil Policy, U.S. Department of Energy from 1993 to 1996.

Dialogue 8 9 Dialogue

supply gap. The question here is whether OPEC can meet the supply. In 2005, OPEC has reversed course and increased its quota. At the March 16, 2005, meeting in Isfahan, Iran, OPEC-10 (without Iraq) increased its quota to 27.5 million bpd, a boost of 500,000 bpd. But in reality, OPEC-10 already was producing slightly more than that, perhaps 27.7 million bpd. So OPEC merely was legitimizing what it was already doing. OPEC also signaled that it could increase production perhaps another 500,000 bpd later this spring. In fact, Minister Naimi of Saudi Arabia has said that Saudi Arabia is willing to supply markets in order to build inventories to avoid any problems later this year. But in looking at OPEC production, it is apparent that it is only Saudi Arabia and perhaps the UAE and to some degree Kuwait that have sufficient spare capacity to make these large production increases. For Saudi, most of this production is rel-atively heavy, sour crude oil. OPEC traditionally kept several million barrels of spare capacity available in order to meet any large disruption in supplies – as it did with the 1990 invasion by Iraq of Kuwait when production from both Iraq and Kuwait were lost. Today, OPEC’s spare capacity is thought to be about 1 to 1.5 million barrels per day, too small to meet any major oil disruption. As a result, the normal cushion that traders and the market rely upon is almost gone. This lack of spare capacity in a rising market, with hot spots in Iraq, Nigeria and Venezuela and choke points such as the Bosporus or Straits of Hormuz that can reduce supplies dramatically has placed upward pres-sure on oil prices. The bottom line is that market volatility and uncertainty are being caused by these multiple factors – strong demand, limited supply availability and growth, very limited spare capacity, and general nervousness in some major produc-tion centers.

What can be done to alleviate the current market condi-tions? Let’s focus on three major oil market players, Russia, China, and India, because understanding what is going on with them will explain a great deal about oil market behavior for the near term. First, let’s consider Russia, since this is where most of the new production has been coming from.

Russia

Russian oil and gas reserves hold the greatest promise for future production and investment, outside of the Middle East. Today, Russia is challenging Saudi Arabia as the world’s largest oil producer by producing a little over 9 million barrels per day. It is now the second largest oil exporting country. It has a large reserve base of about 60 to 69 billion barrels. As a side note, this figure comes from private company estimates, because offi-cial state reserve numbers are still secret based on a 1930’s law. Several Russian oil companies have done their own reserve es-timates and put Russian oil reserves in the 90-120 billion barrel range – approaching the reserves of Iraq, the second largest oil reserve holder behind Saudi Arabia.

The Russian situation is not all negative; otherwise the turnaround in Russian production would not have occurred. The so-called Russian production miracle is all due to reinvigo-rating its old fields in West Siberia and the Volga-Urals with investment by Russian oil companies. During the Soviet era, high production was maintained by pumping out the easy to ob-

tain oil, wrecking field pressure and ignoring maintenance. By the time the Soviet Union fell apart in 1991, production already was declining rapidly due to poor field maintenance and lack of investment. When the oil industry was privatized in the mid 90s, Russian companies thought their best years were behind them. Banks whose major concern was cash flow mostly con-trolled the newly privatized Russian oil companies. Their first thought was to milk the oil companies. By 1998, production was still falling.

Two significant events occurred to change Russian oil in-dustry dynamics. First, the Russian economy crashed in 1998 and the ruble was devalued. Overnight, Russian oil companies realized that the cost side of the equation changed since they were paying their costs in deflated rubles providing them a sig-nificant cost advantage and helping to boost cash flow. Second, by 1999, oil prices started to increase due to OPEC agreements to constrain production. Oil revenues in dollars started to pour into the coffers of the Russian oil companies. The banks con-trolling the oil companies went back to the drawing boards. They realized that by enhancing corporate governance and bringing in western managers they could vastly improve the way the companies were operated. These managers also un-derstood how modern field management could turn around oil production. They hired western service companies and using modern technology the Russian companies increased their pro-duction quickly. As oil prices started rising from 1999 onward, larger profits could be obtained through enhanced production rather than just milking the companies dry. Yukos led the way with double digit percentage production increases and account-ing for more than half of all Russian production increases. Other Russian companies, such as TNK and Lukoil, followed Yukos’ lead. They, too, brought in either western managers or western technology or both and the rest of the story is obvious – overall Russian production doubled in as little as five years.

The transition from President Yeltsin to President Putin also brought economic stability and some reforms of the econ-omy. Russia became a more desirable place to do business and to invest in. During Putin’s first administration, capital flight reversed, foreign direct investment grew and Russia’s economy experienced real growth leading to President Putin’s call for a doubling of GDP in ten years. It is my contention that the initial successes of the economy and especially the oil industry led to the present problems of slowing investment and slowing oil production because the continuation of the reforms that were necessary to maintain investment, especially in high cost oil producing areas, were not carried out. This situation also re-flects the power struggle within Russia between reformers and hard liners (siloviki).

On the negative side, I would include incomplete economic reforms, unstable contract sanctity and rule of law, and infra-structure bottlenecks. Economic reform really started moving ahead in a positive way after President Putin came to power in 2000. Before then economic policy under President Yeltsin was mercurial, just like Yeltsin. More recently, I would have to add President Putin’s re-nationalization that is reversing privatiza-tion in the oil industry.

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While the Russian oil companies were privatized, the privatization process was done in such a corrupt way that the reverberations are still being felt today. The privatizations led to the ascendancy of the oligarchs. The Russian economy and especially the oil industry resembled the American rob-ber baron era – corrupt with a few individuals dominating the industry. Rule of law and contract sanctity virtually did not exist. Taxation was not based on profits – most of it was based on excise taxes that changed dramatically from year to year. The mineral leasing process was antiquated. Other elements of the economy were in a shambles. Some investment in the oil industry did take place, but mostly on a relatively small scale through joint ventures. It was clear to the Russian oil companies that they lacked the capital and technology to develop many of their oil deposits. But at the same time there was a desire to control their own resources since many viewed yielding control over Russia’s oil and gas resources as losing their patrimony. The experience with joint ventures was short-lived as many western companies eventually bailed out due to the unfavorable tax system.

Larger investments sought protection from the uncertain investment environment by using production sharing agree-ments (PSAs) – agreements that set out all the terms of de-velopment, cost recovery, profit and taxation – and protect the investor from constant changes in taxation and other economic policies. Three projects have gone forward under PSAs, with agreements signed before legislation was put in place. But when it came to passing legislation that would legitimize more PSAs, the effort ultimately failed. Legislation passed in 1995, but the implementing rules and regulations never were promul-gated. The legislation itself was quite flawed and no new PSA projects went forward. By the time Putin came to power and some reforms went forward in taxation, contract sanctity and rule of law, many Russians argued that PSAs were unnecessary. By 2003, Russian oil companies were fat and happy due to high oil prices. They pressured the Duma to pass legislation that es-sentially killed PSA project development. Yukos and Mikhail Khodorkovsky was the primary leader in killing PSAs. So that avenue for investment has been closed.

President Putin did bring some economic stability and reform to the Russian investment environment. Most impor-tantly, the tax system was partially reformed by moving away from excise-based taxation to profit-based taxation. But the reforms are not complete and today we see a mixture of profit and excise taxation, with excise taxes primarily placed on crude and product exports. For the oil industry, this mixed tax system does not provide the incentives necessary for high-cost, long-term investments in new regions such as East Siberia or the offshore continental shelf. An analysis by a Russian company showed that the return on investments in East Siberia, for ex-ample, were only in the single digit range, clearly insufficient for these types of risky investments. While additional reforms have been promised, they have not been done since the Russian government has focused on short-term revenue maximization. To back up this short-term approach, a recent study of Russian taxation indicates that for each additional barrel of crude oil

exported when the price of Urals crude exceeds $25 per bar-rel, the marginal tax rate is 90 percent. Russia last changed its crude export taxation effective August 1, 2004, in order to take advantage of higher crude oil prices. [United Financial Group, Deutsche Bank, “Russian Oil & Gas Taxes: All For One (Or One For All)?” April 28, 2005.] This is one of the reasons I contend that recent successes in the oil industry and the as-cendency of hard liners have stalled new investment in riskier areas where new production will have to come from in order to sustain the Russian production miracle.

This is not to say that some new investments have not been made. We are seeing another round of investment activity most-ly through minority shareholder status in larger companies. But again opportunities are limited because of the limited number of worthwhile private companies.

Some companies have had success in investing in Rus-sia. In 2003, BP worked out a joint arrangement with TNK, Russia’s third largest oil company, to set up TNK-BP, a 50-50 venture – risking over $7 billion in capital investment. Late last year, ConocoPhillips bought 7.6 percent of Lukoil, now Russia’s largest oil company. ConocoPhillips plans eventually to buy as much as 20 percent of Lukoil.

But there is much more on the negative side. The invest-ment environment has suffered from the Yukos affair. In 2003, Yukos’ president Mikhail Khodorkovsky feeling safe due to the success of his company challenged President Putin politi-cally by openly supporting the political opposition in upcom-ing Duma elections. Moreover, speculation was rampant that Khodorkovsky wanted to succeed Putin as president in the 2008 elections – it was a foregone conclusion that Putin would win in the march 2004 presidential elections. Khodorskovsky made a serious error of judgment that led to his downfall and to the downfall of Yukos. In 2000, shortly after Putin was elected president he called many of the oligarchs to a Kremlin meet-ing at which it was reported that he would leave them alone if they stuck to business, paid their taxes and left politics to him, Putin. Khodorkovsky’s political challenge in 2003 violated this agreement. Consequently, Russian prosecutors used the vaga-ries of the tax code to attack Yukos for tax fraud. The demands made year-by-year eventually totaled $28 billion in back taxes. The attack also extended to Mikhail Khodorkovsky, Yukos president, who was arrested in October 2003 for tax fraud and remains in jail. His trial ended in April 2005. A decision on his guilt or innocence has been postponed until May, after Russia hosts world leaders on May 9, 2005, celebrating the 60th an-niversary of the end of World War II. I would be shocked if he was not found guilty and given the maximum sentence of 10 years of hard labor. This attack placed a pall over the entire investment environment, since other companies are fearful that the tax laws will be used against them in a pernicious and will-ful way. In fact, this has happened, although not on the scale of the Yukos attack. In April 2005, TNK-BP was slapped with a $1 billion tax bill. [The timing of the TNK-BP tax bill was quite suspicious since many investors in and observers of the Russian oil and gas industry were in London for a conference on investing in the Russian oil and gas sector and the announce-

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ment came just as Russian oil company officials were exclaim-ing the stability of the Russian investment environment.] Even German Gref, Russia’s Minister for Economic Development and Trade, acknowledged that the tax laws are sufficiently vague that they can be used by the state prosecutor to attack any company working in Russia. The Yukos scandal has gone so far as to lead to the dismemberment of the company. Its largest operating subsidiary, Yuganskneftgas, responsible for more than 1 million bpd of production, has been auctioned off in order to pay the back taxes. The auction was conducted in typical Russian fashion – opaquely, with the winner ultimately a state owned company – Rosneft. Thus, the re-nationalization of Russian energy assets has begun.

Contract sanctity and rule of law are under a serious cloud. The Russian government has moved to revoke the licenses of ExxonMobil and ChevronTexaco legally awarded to them in the Sakhalin 3 project, almost 10 years after the companies won them in a legal process and after more than 60 million dollars spent in exploration expenses. The government is standing firm in re-tendering the licenses.

In another area where reform is desperately needed, min-eral leasing, some reforms have been proposed, but they are off-set by the announcement of the Ministry of Natural Resources that in the future, only companies with 51 percent or more Rus-sian ownership will be allowed to bid on strategic oil and gas leases. This puts in jeopardy arrangements such as TNK-BP, a 50-50 joint venture, and is a clear signal to future arrangements that the Kremlin will not tolerate majority foreign ownership. Moreover, analysis of the proposals to change the mineral leas-ing law point to enhanced power by the bureaucracy to inter-vene in the process in an arbitrary and capricious way.

BP’s Chief Executive, Lord John Browne, recently sum-marized the situation in Russia quite succinctly:

It is important that the rules governing development, the role of government, the role of the state companies and the roles and responsibilities of international investors should be clear and secure. So should the fiscal regime. For many potential investors and for many commentators and observers, Russia remains a dark and hostile place, a source of risk rather than of opportunity.

Russia has severe bottlenecks in its infrastructure that is preventing more oil from being exported and will continue to hurt Russian oil exports in the future unless addressed. Surpris-ingly, Russia has only one deepwater port – Murmansk located on the Barents Sea – and that port is used for only limited amounts of oil exports. All of Russia’s major oil export ports are constrained by water depth and other tanker limitations. The major ports are located either on the Black Sea or the Baltic Sea. In the Black Sea, all tankers must use the Turkish Straits (the Bosporus and Dardanelles). Even though these waterways are protected by international treaties and can be used freely by Russian tankers, tankers larger than 150,000 dwt – supertankers – cannot transit the Straits. The same is true in the Baltic Sea. The only place supertankers can load is in Murmansk. Thus Russia cannot economically supply distant oil markets in the U.S. or elsewhere.

To be economical, oil is transported to Russian ports by pipeline. Transneft a government controlled company, controls all pipelines. Unlike the U.S. where pipeline companies set their own operating policies, in Russia, it is Transneft with government consent that sets operating policies. Because of capacity constraints and export bottlenecks, only about one third of each company’s oil production can be exported through the pipeline system. It is Transneft that sets this policy and pro-vides allocations to each company, telling the company where it can export its oil and not always to the port that the company prefers. It is Transneft that decides where to expand, despite the views of Russian and western companies. For example, it decided to expand its pipeline system into the Baltic area to a terminal called Primorsk, a region limited by shallow water and ice. Supertankers capable of reaching distant markets such as the U.S. cannot operate there. When confronted with Rus-sian oil companies desirous of building a pipeline to the north of Russia where supertankers could operate, Transneft exerted its influence and stopped the project and took it over. With Kremlin backing, Transneft decided to build a pipeline to the Far East, rather than the north. Why? Not because of better economics, since the pipeline to the Far East will be three times as costly as the pipeline to the north. But because it is in Transneft’s interest to show its ability to control the decision making process. Plus there were some rather juicy subsidy of-fers by the Japanese government and export assistance agencies that wanted to see the pipeline built to the Far East. Both Rus-sian and western companies are seeking ways to avoid using Transneft, either by developing projects on the periphery of Russia (Sakhalin Island) where Transneft does not operate, or by building their own transportation systems.

Russia has been able to export as much oil as it has by us-ing other more expensive means, mainly rail and barges. But there are limits on the ability to use these alternatives, espe-cially in the current high tax environment. Russia imposed an export tax on crude oil pegged to current prices. In conjunction with other taxes, the marginal tax rate equals 90 percent as oil prices exceed $25 per barrel. With rail and barge costing more three times pipeline transportation, netbacks on crude can turn negative when taxes are so high.

Each and every major western project has run into serious problems operating in Russia. Thus, President Putin’s words welcoming foreign investment in the energy sector are totally undermined by the Kremlin’s actions.

Russia’s production growth is slowing in 2005. Production peaked in September 2004, and month-on-month production has declined or is flat. The International Energy Agency sees production growth at only half the level it was in the past five years and in April 2005, lowered its supply growth projections after six months of slowing production growth. Recall, that Yukos led this production growth with year on year production increases exceeding 10 percent over the last five years. With Yukos being dismembered, the rest of the Russian industry has not kept pace. It seems that the attack on the investment environment is finally having an effect. Even one of Russia’s top energy officials admits that “the period of easy to recover

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oil is finishing.” (Sergei Oganesyan, Director of the Federal Energy Agency within the Ministry of Industry and Energy, in “Russia’s oil boom ends as Putin control hurts investment”, Moscow Times, March 15, 2005.)

With oil production slowing, and even with high oil prices, Russia’s economic growth is slowing. Putin’s goal of doubling GDP in ten years is in serious doubt. Perhaps Putin is waking up to the problem. On March 24th, he held a meeting with busi-ness leaders where he said that the Kremlin was now willing to shorten the statute of limitations on privatization deals from 10 years to 3 years. This is significant, since Putin and the tax authorities have been looking back to the Yeltsin era privatiza-tions and attacking them as unlawful. The attack on Yukos and the large tax bills associated with this attack are based on the unlawfulness of these privatizations. Putin acknowledged that the lack of security of property rights was undermining invest-ment. Deputy Prime Minister Zhukov said after the March 24th meeting that Putin’s important statement on privatizations means that “in Russia, property rights will be protected.” Many observers cheered Putin’s and the government’s statements. Even more to the point, President Putin in his State of the Na-tion speech on April 25, 2005, made even more dramatic state-ments about the problems with the investment environment. He reiterated his goal of shortening the statue of limitations on privatization deals from 10 years to 3 years. Importantly he directly addressed the problems in the tax system by saying, “Tax agencies have no right to terrorize business by gong back to the same problems again and again. We need to find ways for repaying back taxes that preserve the state’s interests while not ruining the economy pr driving business into a corner.” He also indicated that stamping out bureaucratic corruption was a priority. He said that the state bureaucracy was “an isolated and sometimes arrogant caste which sees the civil service as a variety of business.” But Putin has said similar things before and nothing changed. Are these hollow words or will they have real meaning? Only concrete actions will indicate whether real change will occur.

Why is any company willing to invest and operate in Rus-sia? One answer comes from Vagit Alexperov, the President of Lukoil, who said recently, “You are doomed to invest in Russia”, meaning that is where the large available deposits are located. It takes patience, fortitude and a very long view to invest and stay in Russia. The potential is large, but so are the headaches. But because today the negatives outweigh the posi-tives, future production gains will be limited, tightening sup-plies and shifting more of the production burden to OPEC.

China

China has been undergoing an economic boom. Its eco-nomic growth rate has averaged 8 percent from 1997 through 2002. In 2003 and 2004, its GDP growth was over 9 percent. Its energy growth has been phenomenal, normally averaging about 8 percent; however, last year it was 16.7 percent. China sur-passed 900,000 bpd oil growth last year. The only other coun-try to experience this kind of growth in absolute volume was the U.S. in the 1970s. This strong demand has been responsible for the overheated oil market we have been experiencing. China is

now the second largest primary energy consumer and third larg-est primary energy producer. Remember that China has huge coal reserves and that coal is the largest component in its energy production and consumption.

Most oil market analysts did not foresee the large increase in China’s oil consumption for 2004. Part of the reason is that about 20 percent of its 2004 oil demand went to electric power generation, where there are acute shortages.

Part of the moderation in China’s oil demand that many are predicting for this year will be due to less use in electric power generation. Some of the numbers coming out of China for first several months of this year seem to indicate a slowing of diesel demand for power generation. Most analysts are predicting about 8 percent growth in China’s oil demand for this year and next, or about 550,000 bpd. If these predictions are too low, we could be in for another price surge this year and perhaps another surprise.

China became a net oil importer in 1993. It now has as one of its goals the reduction of its vulnerability to oil disrup-tions. It has pursued a multi-pronged strategy to enhance its oil security. First, it is increasing its storage of strategic stocks so that it will have 30 days of imports on hand. Second, it is diversifying its oil supplies, and trying to limit its dependence on the Middle East, where it now gets about 2/3 of its supply. Third, its three state-owned oil companies have sought over-seas equity investments. Today, about 15 percent of its imports come from these equity investments. The question is whether this strategy will pay off and enhance China’s energy security. If the example of other national oil companies is examined, for example, Japan, equity investments have not paid off. But so far, China’s experience seems to be better than Japan’s and may be a winning strategy.

In pursuing supply diversity, China’s companies have had some success in spreading out their supply sources. The oil companies have made deals in many countries such as Kazakh-stan, Venezuela, Sudan, Iraq, Iran, Canada, West Africa, Latin America and they are seeking deals in Russia. Several years ago, Yukos proposed a pipeline from West Siberia to Daqing in China. The Russian government blocked this proposal. Instead it has agreed to build a pipeline to the Russia Far East, with the possibility of building a spur line off of this pipeline to China. In the meantime, China is receiving oil from Russia via rail. The Russian rail ministry has agreed to expand and upgrade its rail system into China in order to ship more oil. With the shrinking of Yukos, its contracts have been picked up by Lukoil and Rosneft. It also was reported recently that China helped Rosneft with its purchase of the Yukos subsidiary Yugansk by supplying the funding to pay for Rosneft’s purchase. China said that it would be repaid in oil in the future –essentially buy-ing oil forward.

China also is seeking ways to limit the amount of oil that goes through the Malacca Straits, a narrow waterway between Indonesia and Malaysia. China fears that without naval power to protect this waterway (and others) it is very vulnerable to oil disruptions. It has been exploring using other corridors or straits in Indonesia or building a pipeline through Myanmar to

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China or using other transportation routes in South Asia. As China’s economic growth continues apace – one ana-

lyst foresees China’s GDP quadrupling between now and 2020, while its energy demands only doubles – others see China as having the greatest impact on world energy over the next two decades. In this view, only slower economic growth can slow China’s energy use.

While so far China and the U.S. have not competed directly for increasingly scarce oil resources, it is possible to see that happening in the future. Moreover, the three Chinese oil com-panies, while partially privatized, are not driven by the same economics as a completely private company. While we have to worry about shareholders and oil analysts and regulators, these companies do not. If they want to pay a premium for an oil contract, they can. In several instances they have paid premi-ums, driving up the cost to find and produce oil. Will China’s investment drive come into conflict with U.S. goals? Possibly as China is willing to work with regimes in Iran and Sudan that the U.S. wants to isolate. China continues to increase oil investment in Iran, which is off limits to the U.S. China also is helping Iran with its nuclear ambitions. If the nuclear issue ever winds up in the U.N., China and the U.S. could be on op-posite sides of the issue. In Sudan, where China has large oil investments, it already has exerted its influence in the U.N. over the Darfur situation. One analyst thinks the potential is there for the U.S. and China to come to blows over energy.

Getting back to the challenge posed by China and its national oil companies, one analyst characterized their invest-ments as “security inspired, politically driven foreign invest-ment” as opposed to commercially driven foreign investment. When faced with competition from Chinese companies, they often make uneconomic bids, use Chinese state bilateral loans and financing, and use Chinese economic clout in other areas to help with their pursuit of oil (or gas) resources. “The con-sequences of the Chinese strategy are to reduce investment opportunities for commercial entities and ultimately reduce the flexibility of the global crude trading market.” (Frank Verastro, Center for Strategic and International Studies, Testimony before Senate Committee on Energy and Natural Resources, February 3, 2005.)

India

While India is farther behind China in its economic de-velopment and growth, there are some similarities with China. Interestingly, in 1980, China and India were at about the same place in per capita GDP. But since then, China’s GDP growth averaged 9.5 percent, while India’s averaged 5.7 percent. Chi-na’s real per capita GDP rose faster than any other economy, while India’s was ninth fastest. This led to substantial growth in both energy and oil demand for China. For India, its energy and oil consumption also grew, but not as fast. While today’s Chinese oil consumption is about 6 million bpd, India’s is about 2.5 million bpd. Where China’s oil consumption will more than double by to about 13 million bpd by 2020, India’s is projected to increase to 4.5 million bpd. However, when India and China oil demand growth are combined, they make up about 25 per-cent of the growth between now and 2020. For China, imports

now make up about 40 percent of supply with projections grow-ing to 74 percent of supply by 2030. For India, imports already account for 70 percent of supplies and likely will reach 90 percent by 2030. Because of this high dependence on foreign supplies (most of India’s imports come from the Middle East), energy security has replaced food security as one of India’s top priorities.

To meet this concern, India has embarked on a three-pronged approach. First, India’s oil companies, both state-owned and private, are seeking equity deals around the world as a way to tie up long term supplies and to reduce the cost of importing oil. Second, India is seeking more investment, both foreign and domestic, in its oil and gas fields to increase its own supplies. Third, India is seeking to enhance environmental and efficiency standards as a way to decrease demand.

In its pursuit of equity investments, the Oil and Natural Gas Company (ONGC), one of India’s state-owned companies, bought a share of the Russian Sakhalin 1 project operated by ExxonMobil. It also has offered to buy 15 percent of Yugansk, the Russian oil company Yukos owned and was recently auc-tioned off to Rosneft. ONGC has been competing with China’s three state-owned companies for oil supplies. For example, last fall the Chinese outbid ONGC’s effort to buy a portion of an Angolan offshore block from Shell as the Chinese com-pany used a $2 billion aid package for Angola as a sweetener. ONGC could not meet China’s higher price. We are likely to see more instances where the Chinese will outbid India’s com-panies, since India appears to be more price conscious than the Chinese. Plus the Chinese cash coffers are larger than India’s and are willing to throw in sweeteners that the Indians either are incapable or unwilling to use. Moreover, India also is sensitive to sanctions imposed by the U.N. on countries. The chairman of ONGC has said that if there are U.N. sanctions on a country they won’t touch it. But if there are only U.S. sanctions then the country is fair game. This is clearly the situation with Iran, where India is working closely with Iran to develop a pipeline to carry gas from Iran to India. A similar situation is occur-ring with Myanmar where India is working on a gas pipeline. Interestingly, the jury is still out in India on whether equity investments help solve India’s energy security concerns. There are some important Indian government officials who think that seeking equity deals may be a good investment strategy, but not necessarily a good energy security strategy.

On the domestic investment front, ONGC, Reliance and other Indian companies are actively pursuing new oil and gas development. Probably a Scottish company, Cairn Energy, made the biggest news when it found a 1 billion barrel oil field last year. India would like to draw in larger companies to ex-plore for and develop its resources. To date, India’s reputation as a bureaucratic nightmare for foreign energy companies has kept the big companies out.

There is no doubt that India’s future energy plans bear careful watching since its oil appetite is large and is growing. As has already occurred, there will be conflicts with China. The question is whether there are future possibilities for cooperation between India and China in seeking out and developing oil sup-

(continued pn page 16)

13 Dialogue

Will We Run Out of Crude?

By Lewis L Smith* In physical terms, the answer is “No”. In economic terms,

the answer is “Yes”. But nobody really knows when, notwith-standing the current outpouring of fearless forecasts of an early peak for world crude-oil production.

The great majority of the prognosticators lack crucial in-formation with regard to specific oil fields. As a result, they must base their forecasts on national data and indirect tech-niques of estimation. This is perilous in an industry where cur-rent statistics are not very precise, precise statistics are not very current, much information is a matter of “national security” and death can come swiftly to the inquisitive, as certain consulting firms already know. Worse yet, there exist conflicting versions of certain important time series, such as the monthly produc-tion of crude oil by Saudi Arabia. Indeed the tendency of most producing countries to lie about their own oil industries — even to the OPEC Secretariat — is an open secret.

Of those with information “from the mouth of the bore-hole”, very few are talking, and even fewer know anything about fields outside their own country. Last but not least, many of the analysts, commentators, forecasters and publicists who discuss this issue have “axes to grind”, since they are agents, bankers, contractors, consultants or employees of enterprises which produce and/or market crude oil.

To make a reliable forecast of the “peak oil year” for the whole world, one must have the following information for all of the major oil fields — pumping history, injection history [ad-ditives, gas, water] and current information with regard to some 15 physical parameters which describe each field’s present condition. Moreover, one must chose the correct decline curve for the years past the peak, forecast the success of exploration, development and production-enhancement activities already under way, forecast the potential impact of those not yet started and forecast the impact of new technologies not yet available commercially. [The choice of a decline curve is especially criti-cal, as the different curves have different shapes, and sometimes fields “switch curves” in the middle of a decline.]

As if the foregoing were not enough, there are three “jok-ers” in the “oil deck”. The first consists of the enormous fields of stranded natural gas throughout the world. Those of Quatar and Oman come to mind immediately. For over a decade, it has been commercially feasible to produce middle distillates from this gas, and the relevant technologies are slowly spreading throughout the world.

The second is the mine-mouth conversion of coal into gas. The relevant technologies are also commercial and spreading

slowly. The third consists of the natural gas molecules trapped in the enormous fields of methane hydrates known to lie be-neath the arctic tundra and the sea floors. It is already techni-cally possible to extract methane from tundra hydrates, and various enterprises are working on the remaining problems. Needless to say, some of the gas from these two sources will eventually be used to produce middle distillates.

So the future supply of diesel, kerosene, nafta and certain other “petroleum products” does not depend solely on the fu-ture supply of crude oil. We will have middle distillates at least for the foreseeable future, though not always at the right price. What is highly uncertain is the evolution of their supply and their availability at specific locations and during specific time periods.

Given the above, the safest thing to say is that world crude-oil production will peak, sometime between eight o’clock to-morrow morning and thirty years from now. However, despite so much uncertainty, we can still make a strong case for drasti-cally reducing the world’s dependence on oil and doing so as quickly as possible.

In the first place, there are the long lead times and long delays which characterize the planning, permitting, construc-tion and startup of so many energy projects, whether based on petroleum or on alternate sources of energy. Sad to say, a great many energy projects are not brought in on time, up to specs and under budget! Classic examples are the tar-sands projects in Canada and the plant in Carthage, Illinois, for the gasification of turkey offal. After 15 years of testing of the latter process in a pilot plant and one year of commercial-scale operations, it still stinks ! So if crude-oil production is going to peak within the lifetimes of our children, we had better “get off our duffs” and get moving, because time is running out faster than we think. The relevant time is not just the “time to peak”, but the time we need to prepare for this peak. And this latter time will be longer than we think.

Secondly there are the environmental impacts of fossil-fuel combustion, even when all current regulations are complied with, which is often not true. Good examples are the 17,000 high-pollution industrial establishments in the USA which have been grandfathered, for reasons which we leave to the collec-tive wisdom of our readers to figure out. Moreover, despite the ostriches in high places who incessantly repeat the mantra of “junk science” like a stuck record, every day brings new evi-dence of global warming. In truth, this is a difficult problem, fraught with more uncertainty than risk, especially as regards who should do what to whom, when, where, why and for how much. So it is certainly reasonable for knowledgeable people of good will and intelligence to disagree on such matters. But those who deny the very existence of the problem are, as the Bard says, “fools or knaves”.

Thirdly there are the hidden costs of petroleum fuels to the economies which consume them, costs which are widely ex-cluded from their market prices. In Puerto Rico, we have iden-tified some six different kinds [and there are probably more]. Although unable as yet to make meaningful “best estimates”

* Lewis L. Smith is an energy advisor to the Commonwealth of Puerto Rico [USA], a semi retired energy economist, a former director of the PR’s Office of Energy [now the Energy Affairs Administration] and a “Middle East watcher” since 1961. Has written many papers on energy subjects, and for five years was a member of the “Oil Policy Committee” of PR’s Economic Development Administration, including the period of successful negotiations with Saudi Arabia for a major refinery project. (continued on page 16)

Dialogue 14 15 Dialogue

Hubbert, Hotelling and Risk:The Three Causes Behind Peak Oil

By Doug Reynolds*

Some say we are near the worldwide peak in oil produc-tion. Others say oil demand has simply outpaced oil supplies but in a year or so if high prices persist, new supplies will come on line and demand destruction will begin. Then prices will go down again. Still more blame OPEC for all the current high prices. One problem with Saudi Arabia and other OPEC mem-bers is that they are not investing enough in oil development possibly due to their market power. For example see Adelman (1993).

What I believe is happening is the consequence of three unique aspects of non-renewable energy supplies. One is the Hubbert curve. In particular, we can study the information and depletion effect to see why the Hubbert curve works, and when the peak will occur, but the Hubbert curve is not the only thing happening. The second is the risk averse nature of oil suppliers. This has to do with how institutions affect oil production, and there hasn’t been much attention paid to this factor. The third is the Hotelling principle. The Hotelling principle suggests that some oil producers may conserve oil now to get a better price in the future. Waiting to produce, or at least not expanding production, will increase the present value of oil. All three are coming together at the same time to create a peak in oil produc-tion just as demand for oil is rising fast. This means that there is likely to be an oil price shock or even a super shock. I explain each of these factors in this paper.

First consider the Hubbert curve. The Hubbert curve is caused by the information and depletion effect. See Hubbert (1962), Reynolds (2002) and Bardi (2005). In the beginning phases of exploration, oil explorers are looking for oil without any knowledge about where it is. Even so they manage to find some. But as they successfully find more oil, they gather more information about where the oil tends to be located. This helps them find still more oil. Eventually the greater oil discoveries providing greater information and creating even more discover-ies, bootstraps the industry to continually increase oil output. See Norgaard (1990) for the Mayflower Problem.

Unfortunately, there comes a point when there is no longer much oil left to find. The law of diminishing returns sets in which is the depletion effect. At that point, oil discovery, and consequently oil production, reaches a peak and then declines. The problem with the Hubbert curve is you never know if you have really reached a peak or not. Information is always in-complete. Since information is incomplete then we don’t know how much oil we are likely to find.

Interestingly in the beginning phases of exploration, the increase of information dominates any depletion effect and so society sees greater and greater oil production. It’s just that in the end the effect of depletion must dominate the information

effect, and production eventually goes down. In fact it may be that Barnett and Morse (1963) are observing a pure information effect of increasing information causing increases in oil produc-tion. They speculate that is was pure technology that caused oil production to always increase, up until 1963 anyway, even while costs were always decreasing. But it was more likely greater information, and not technology alone, that allowed costs of production to decrease and production to increase. That means that we can easily be fooled into believing that since we have been finding plenty of oil then we will continue to find more oil and that since costs of discovery have been going down then they will always go down. We can even be fooled into believ-ing that new information about finding new oil fields, which in-creases discoveries even as it decreases costs, is really because of new technologies that are making new discovery possible when in fact it may not be new technology at all that is creating discoveries but rather new information. Once the peak occurs, it is a big surprise. But we do get a hint of when peak oil will occur by tracking discoveries. In fact it should not have been a surprise for the U.S. lower 48 that its regional peak oil date was coming due to the meticulous data on discovery which foretold of the peak. But then no one believed Hubbert even with the evidence. Rather everyone believed Barnett and Morse.

The worldwide peak however can also be predicted by tracking the rate of oil discoveries. See for example Campbell (1997). Since world wide discovery rates are decreasing, then future oil production will soon be decreasing too. However, some analysts believe that discovery will start rising again if only Saudi Arabia and OPEC would just invest more in oil ex-ploration and development. And that’s when my second point comes in—institutions and risk.

The next factor in oil production has to do with institu-tions. For example each OPEC country is part of what many people believe to be a cartel. However, OPEC has many char-acteristics that suggest it isn’t a cartel at all: it has no method to enforce agreements, these is no profit sharing, and high cost oil producers are allowed to produce their oil reducing cartel profits. Smith’s (2005) idea of a bureaucratic syndicate may be one explanation for how OPEC works, but seeing as there were no quota agreements on outputs from 1973 to 1981, there can’t have been a cartel-like syndicate during that time. An alternative explanation for OPEC is that each OPEC member is risk averse. In fact non-OPEC countries like Mexico and Egypt may also be risk averse which is why Maugeri (2004) can show convincing evidence that the Hubbert Curve does not fit all countries’ oil production patterns very well. Egypt, which has a government run monopoly which controls all oil production within the country, cannot be compared to the U.S., which has a competitive market. The difference in institutions is why Egypt does not follow a Hubbert curve while the U.S. does. A lack of a Hubbert curve trend is an indication of Egypt’s non-com-petitive market, rather than an indication that the Hubbert curve does not work. But this also means that Egypt’s oil production output is less than it could otherwise attain. In other words, institutions reduce output. Any oil producing country that has a government-owned oil monopoly within its borders will be risk

* Doug Reynolds is an associate professor of oil and energy econom-ics at the University of Alaska Fairbanks, and author of Scarcity and Growth Considering Oil and Energy, and Alaska and North Slope Natural Gas. He can be contacted at ffdbr@uaf.edu.

Dialogue 14 15 Dialogue

averse to exploration and production, causing its production to be lower than what a Hubbert curve would suggest. With lower levels of risk taking there is less investment in new oil produc-tion and so consequently less oil production. See Reynolds (2002) for a fuller explanation of risk averse behavior.

This means that OPEC, far from being a cartel, is just a set of risk averse oil companies engaging in tit-for-tat and tempo-rary oil production reductions. See for example Geroski, Ulph, and Ulph (1987). Each member is afraid to make changes in output and to invest in new projects not because of any agree-ments with other OPEC members but because all members are simply risk averse to chance. This lack of aggressiveness char-acterizes oil monopolies that have exclusive operations within oil producing countries.

Thus, just as the world is getting closer to its peak in oil production, many of the largest oil producers are risk averse to increasing their own individual outputs. And now that we are in an era of high priced oil, these institutions are not likely to change. This means a peak in oil production for the world will not happen when we reach the 50% cumulative produc-tion point, as a simple Hubbert curve and the Association of the Study of Peak Oil (ASPO) would suggest, it will happen sooner. In other words, ASPO may be correct in their predic-tions of peak oil not so much because of the Hubbert curve alone, but because of the risk averse nature of so many oil producers. Peak oil can happen at the 40% cumulative mark or the 30% mark. Luckily by having the peak earlier, it causes oil production to more slowly decline later which is to say oil will be available, albeit in smaller quantities, for the next generation and the transition from oil to oil alternatives will be more gradual than it otherwise would be. On the other hand it also indicates an earlier peak in oil production. Therefore even if the USGS says that the world has 3 trillion, or even 6 trillion, barrels of ultimately recoverable reserves of oil, it does not mean that we will not reach the peak in oil production soon since we are only at 1 trillion barrels of cumulative production today. Risk aversion will cause peak oil to happen earlier!

One other interesting point though is that Russia and other former Soviet countries are starting to put their oil into gov-ernment-controlled companies. This may only accelerate the world peak in production as Russia and others move toward a single government-owned oil and gas monopoly and then be-come risk averse to expanding their output.

The last point is the Hotelling principle. The question is, even though the Hotelling principle seems not to matter, see for example Watkins (1992), it could matter if the cost of the next best backstop technology of oil is expensive. Solow (1974) in his famous speech said the backstop price should be not much more expensive than what oil already costs today. However, Reynolds shows convincing evidence that most alternatives to oil are much less useful than oil in a number of physical dimensions. If in fact oil has no great substitute—and for over one hundred years no substantial alternative has emerged as a transportation fuel even in our own high tech economy—then oil could reach a back stop price in the $300 to $1,000 per barrel range. If that is the case, Saudi Arabia and Russia are currently

“giving away” their oil. That is, oil is currently undervalued. Soon Saudi Arabia and Russia will decide based on the Hotel-ling principle that they should wait to produce their oil, or at least not increase production, until prices indeed climb close to the long run value. But in order to conserve their oil, Russia and Saudi Arabia will have to reduce, or not increase, outputs. This will create a shock and push forward the peak oil date even further before the 50% cumulative production point. Therefore at any moment the peak in oil can occur.

Most analysts look to oil sands in Canada, heavy oil in Venezuela, or the possibility of a new hydrogen economy as the way of the future and believe that these technologies will save the day, by keeping oil prices well below the $100 per barrel mark. But I have heard all these claims in the 1970s, and they never came true. When oil prices finally fell in 1986, everyone said it happened because of new technology. Yet the real cause was substituting coal and natural gas for electricity production: not exactly a big technological revolution. Unfortunately this time around it will be harder to make the switch to coal when we need a transportation fuel alternative. An extra million bar-rels a day from oil sands or heavy oil won’t amount to much when we need an extra 2 or 3 million barrels a day of new oil supplies every year just to keep our current consumption con-stant as peak oil occurs. Probably natural gas itself will be the best alternative fuel.

It has been over thirty years since the U.S. reached its peak in oil production. Since then U.S. oil production has decline steadily to about half its 1970 production rate with only Alaska and the deep water Gulf of Mexico providing any barrier to the flood waters of decline. All the high tech oil production tech-nology in the world has not stopped that decline nor stopped demand from increasing.

We could probably live with our current world population intact on one tenth or even one one-hundredth of the oil we currently use, but that would imply a $300 to $1,000 price for oil. In the meantime it will take a good twenty or forty years, depending on how high prices go, to reduce our oil use enough to put in place the kinds of infrastructure, such as trains, fuel efficient cars, and denser cities, that can make our society more oil efficient. It is not so much running out of oil that is the problem as much as it is that the peak in oil production, caused by the Hubbert curve, by risk averse oil producers, and by some major oil producers willing to reduce outputs to increase their oil value, will cause a dramatic price shock and extremely dif-ficult economic transition. But at least the silver lining in peak oil will be a slow post peak decline in supplies, which will make the transition more bearable. That means Maugeri is right in that the oil age is far from over, but he is wrong in thinking that peak oil will not happen soon. Indeed, we should applaud Saudi Arabia, Russia, and OPEC for their conservation of oil, even if it is an unintended consequence of their actions. They are actually helping make a smoother transition. That means the U.S. should actually encourage Saudi Arabia to decrease their output, not to increase it.

I believe the information effect of the Hubbert curve that has caused oil supplies to increase has fooled us into thinking

Dialogue 16

our technology is more powerful than scarcity. But now that the peak in production is upon us, it is time to realistically as-sess our technology, see its shortcomings, and begin the painful transition to a high price oil world. Energy economists need to be in the lead on this and warn our economy and political lead-ers that the three problems of the Hubbert curve, the risk averse oil producers, and the Hotelling principle will at any time cause peak oil and an oil price shock.

References1. Adelman, M. A. (1993). The Economics of Petroleum Supply:

Papers by M.A. Adelman 1962 - 1993, The MIT Press, Cambridge MA.2. Bardi, Ugo (2005). “The mineral economy: a model for the

shape of oil production curves,” Energy Policy, Volume 33, Issue 1 , January 2

3. Barnett, Harold J. & Chandler Morse.(1963). Scarcity and Growth; The Economics of Natural Resource Availability. Johns Hopkins University Press for Resources for The Future, Baltimore.

4. Campbell, C. J., (1997). The Coming Oil Crisis, Multi-Science Publishing Company & Petroconsultants S.A,.

5. Geroski, P.A., A.M. Ulph, and D.T. Ulph (1987). “A Model of the Crude Oil Market in which Market Conduct Varies,” The Economic Journal, Vol. 97 pp. 77-86.

6. Hotelling, Harold (1931). “The Economics of Exhaustible Resources,” Journal of Political Economy, Volume 39, Number 2, April, 1931. pp. 137 - 175.

7. Hubbert, M.K. (1962). Energy Resources, A Report to the Committee on Natural Resources: National Academy of Sciences, National Research council, Publication 1000-D, Washington, D.C., pp. 54, 61, 67.

8. Maugeri, Leonardo. (2004). “Oil: Never Cry Wolf—Why The Petroleum Age Is Far From Over.” Science, vol. 304, no. 21, May: pp. 1114 - 1115.

9. Norgaard, R.B. (1990). “Economic Indicators of Resource Scarcity: A Critical Essay,” Journal of Environmental Economics and Management, Volume 19, Number 1, July, pp. 19 - 25.

10. Reynolds, Douglas B., (2002). Scarcity and Growth Considering Oil and Energy: An Alternative Neo-Classical View. Sole Author academic monograph, The Edwin Mellen Press, 240 pages.

11. Smith, James L. (2005). “Inscrutable OPEC? Behavioral tests of the Cartel Hypothesis,” The Energy Journal, volume 26 Number 1, pp51-82.

12. Solow, Robert, (1974). “The Economics of Resources or the Resources of Economics,” American Economics Review 64:1-14.

13. Watkins, C. J. (1992). “The Hotelling Principle: Autobahn or Cul de Sac?” The Energy journal, Volume 13, Number 1, pp. 1 - 24.

Will We Run Out of Crude? (continued from page 13)

of their magnitudes, we are very sure that the cost of just the two principal ones exceeds three cents per kilowatt-hour at the bus bar.

But the fourth and most important reason of all, is the fol-lowing. More than 36% of the world’s production of crude oil comes from — and more than 61% of its “proven” reserves are found in — a region which we may call “the Oil Belt”. [For natural gas, the figures are 12% and 46% respectively. If you add in the signatories of the Shanghai accord, the figures jump to 37% and 85%.]

This region extends from Algeria to Iran and includes the Middle East and the Sudan. It is a region full of “time bombs”. Some of them have exploded already — the Palestinian inti-fada, the Iraqi insurrection and our forgotten but ongoing war with the network of terrorist networks. Others are latent — the water problem [now a regional crisis], unemployment, poverty, high birth rates, widespread disdain for Western life styles and values, remembrance of past Islamic glories, theological dis-putes et cetera.

Whenever one of these “bombs” goes off, the price of oil goes up and doesn’t always come back down to where it was be-fore. And it usually goes up quickly and comes down slowly, as it takes less than two minutes for news to spread around the world, and less than ten seconds for oil traders to act on it. So why do so many oil-importing countries insist on depending on a region which is characterized by repeated blowups and by price gouging for its principal product ? In the case, of the USA for example, it would have been a lot cheaper in both lives and money to raise gasoline-economy requirements for motor vehicles, subsidize hybrid vehicles, adopt peak-load pricing for electricity consum-ers, push energy conservation hard et cetera than to invade Iraq. To top matters off, this deed has set us well back in that most crucial war of all, the one which the network of networks is wag-ing against the West. Again we leave it to the collective wisdom of our readers to devine the various agendas at play.

Clearly many alternate sources of energy are not yet com-petitive at current market prices, if installed in large central generating stations. And given the worldwide struggle for new factories, it is seldom feasible to end the hidden subsides to pe-troleum fuels which permeate almost every human society.

But most alternate sources and thousands of energy con-servation measures are certainly feasible on a decentralized [“distributed”] basis. And a little ingenuity will find ways to compensate the alternate sources for the unfair market advan-tages which petroleum fuels currently enjoy almost everywhere. [Some of the same ingenuity used in devising “tax breaks” for oil companies, for example.]

In any case, the present situation is patently absurd. For example, we estimate that the highest “equilibrium price” ever recorded for the family of crudes known as “West Texas Inter-mediate” was $28 per barrel. [King Edward’s sardine barrel of 42 gallons, no less !] At $50 a barrel, oil-consuming countries are paying a premium of $22 per barrel or almost 79% . You can do an awful lot with $22 per barrel, if you just set your mind to it.

The Geopolitics Of Oil (continued from page 12)

plies. If so, then the combination would be formidable com-petitors in the world oil market.

Conclusion

In today’s oil market the only certainty is uncertainty. On the demand side, much of the uncertainty focuses on China and to some extent India regarding whether they can sustain their robust growth. On non-OPEC supply, the uncertainty focuses on Russia and whether it will be able to sustain its phenomenal production expansion or whether the slowdown that has oc-curred will be the harbinger for the future. OPEC’s reaction to the oil market also will lend to increased volatility.

17 Dialogue

Energy–GDP Relationship in the U.S.A.,1949 - 2003By Christopher M. Chima*

Introduction

There is a general belief and agreement that energy avail-ability and consumption play a key role in the process of eco-nomic growth. Energy use has been associated with population growth and the expansion of urban centers. Energy use is a key to industrialization and the development of industrial and in-frastructural facilities. Roads and transportation networks are among the most energy intensive of these facilities.

The gross domestic product (GDP) is a measure of the total market value, expressed in dollars, of all final goods and services produced within a nation in one year. It takes some form of energy to produce things of value. There is a close re-lationship between the GDP and energy consumption and this relationship is usually a good indicator of the level of economic development of a nation. The GDP per capita, which is the GDP divided by the population, is often used as a measure of the standard of living of a country. Therefore, it is essential to understand the relationship between energy consumption and economic growth. Energy is essential to the economic health and quality of life in every nation of the world. In fact, energy is the lifeblood of every economy.

A major and unsettled issue that arises in energy econom-ics is the nature of this observed relationship between energy consumption and economic growth. While some ambiguity has remained regarding the direction of causation -- whether from energy to GDP or from GDP to energy – the importance of the energy-GDP interaction has been well recognized. Energy use is a necessary input to economic growth and is also a function of growth.

Energy has been defined as both a consumer good and an intermediate good (Pierce, 1986). As a consumer good, at the early stages of economic growth, it is possible that consumers will demand and consume more energy as soon as they can ac-quire the means to do so. It is also possible that the income elas-ticity of energy demand could become low. As an intermediate good, the demand for energy is a derived demand.

The traditional argument is not that energy is merely con-sumption good, but that it is an essential input into technologi-cal advancement. The substitution of machines and other forms of capital for human labor is an integral part of the process of economic development that requires energy inputs.

Thus, one can view the consumption of large amounts of energy as either a cause or a symptom of economic growth. It is important though to note that the amount of energy con-sumed depends in part on its availability and price. In an era of expensive energy, it will become a priority for policymakers, managers, and researchers to devise ways to economize and use energy wisely and efficiently.

The energy sector has drawn a tremendous amount of at-tention from academicians, researchers, economists, and poli-cymakers, especially since the oil shocks of the 1970’s. The one remarkable effect of this oil shock is the attention it has drawn to the relationship between energy consumption and economic growth, and the consequent impact of rising oil prices on the economies of rich and poor countries alike. Prior to the oil shocks, the world economy had been built and flourished under the presumption of cheap and abundant oil.

During the 1970’s, there was a great deal of concern, espe-cially among the developed countries as to whether conserva-tion in energy use would adversely affect economic growth. Thus grew concern amongst policymakers in the industrialized economies regarding the acceptability of energy conservation policies. This concern led to the work of John and Arthur Kraft (1978), in which some light was shed on this issue and provided some answers. They conducted an empirical test, using data for the United States from 1947 to 1974, the purpose of which was to determine the causal relationship between energy consump-tion and the gross national product (GNP).

There was a widely held view then that there was a con-stant and unchanging relationship between energy consumption and gross national product. The implied corollary was that energy conservation was an unacceptable policy since it would adversely affect economic activity. Kraft and Kraft concluded from their study that causality was unidirectional, only running from GNP to energy for the post war period, and there was no causality running from energy to GNP. Thus, they concluded that energy conservation is an attractive policy that will not adversely affect economic activity.

The data used in this study was obtained from two main sources. The data for the real gross domestic product came from the U.S. Department of Commerce, Bureau of Economic Analysis, NIPA Tables. The GDP is expressed in billions of dollars, and the year 2000 chained index was chosen. Energy consumption data was obtained from the U.S. Department of Energy, Energy Information Administration (EIA). Total en-ergy consumption per year was used in this study and there was no decomposition into various forms of energy. Energy units are expressed in quadrillion BTUs per year.

The Real GDP, 1949 – 2003

The real GDP for the U.S.A. is depicted in Figure 1. It shows that the real GDP has grown steadily from a little over $1.6 trillion in 1949, to over $10.4 trillion in 2003. This repre-sents a cumulative growth of about 550% over the stated time period.

Energy – GDP Relationship in the U.S.A, 1949 - 2003

Figure 2, is a depiction of the total energy consumption in quadrillion Btu’s, for the time period stated. Total energy consumption increased from 31.98 to 98.16 quadrillion Btu’s, a cumulative increase of about 207% between 1949 and 2003. The data shows a relatively steady increase in energy consumption from 1949 to 1974. However, the data pattern shows some fluctuations or aberrations in energy consumption between 1974 and 1986, and thereafter, the pattern returned to

* Christopher M. Chima is with the Department of Economics, Cali-fornia State University Dominguez Hills. An expanded version of this paper is available from the author upon request.

See footnotes at end of text.

Dialogue 18 19 Dialogue

relationship was established.This adjustment period (1974 – 1985) corresponds to the

period of fluctuations observed in the energy consumption data, but not seen in the real GDP data. This indicates that energy prices have a strong influence on the relationship between ener-gy and GDP. Figure 3 also shows that over the time period from 1949 t0 2003, the graph tends more toward the energy axis, implying that real GDP growth is pulling energy consumption growth in the United States. .

In Figure 3, the relationship between energy consumption and GDP appears to be well pronounced and better defined. The observed aberration between 1974 and 1985 is clear. More importantly, this plot shows that since1974, the United States has been using less energy in producing each dollar of income (diminishing energy intensity).

Figure 3, the tends more toward the real GDP axis and away from the EC axis following each shock or adjustment period, thus, implying that real GDP pulls the level of energy consumption. It can also be observed that towards the top, the graph is tending to become more vertical; indicating higher lev-els of economic activity (GDP) with same or smaller amounts of energy. This means better energy use efficiency.

It should also be noted in Figure 3, that after the adjustment period ended around 1985, a new linear relationship between energy consumption and GDP developed, but with a different slope. The curve had shifted to the left, closer to the GDP axis and away from the EC axis. This is a significant shift, implying the adjustment to the high-energy price era. Such shifts occur through energy conservation, improvement in energy use ef-ficiency, and technological innovation.

This analysis shows that economic activity influences energy consumption in the United States, and the direction of causality could run from GDP to energy. However, it must be noted that it is energy consumption, hence the price of energy plus other factors that influence energy consumption, which de-termines the slope of the graph. This slope reflects energy use efficiency, which is influenced by the price of energy.

Therefore, we can deduce from the analysis of the histori-cal data for the United States that energy conservation policies will not deter economic growth or yield negative welfare ef-fects

Conclusions

The causal relationship between energy consumption and gross domestic product is a subject of intense debate. The de-bate about the precise role of energy in economic development

Figure 3. U.S. Energy Consumption v. Real GDP (1949-2003)Figure 3. U.S. Energy Consumption v. Real GDP (1949 - 2003)

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a fairly steady rise. This period of fluctuations corresponds to the advent of the Arab oil embargo and a period of unstable oil markets and of rising oil prices. Therefore, this period of fluc-tuations can be considered an adjustment period, and it carries an obvious conclusion that energy prices affect the quantity of energy consumed.

U.S. Total Energy Consumptions, 1949-2003

As already noted in the literature1, there is a general agree-ment that a relationship exists between energy consumption and gross domestic product, however, the nature and direction of the relationship is unsettled. Different models and techniques have been applied to this cause without a general consensus.

Figure 3, depicts the total energy consumption versus real GDP, from 1949 – 2003 for the United States. In Figure 3, real GDP is treated as the dependent variable, the variable to be de-termined, and plotted on the y-axis, while energy consumption (EC) is treated as the independent variable that influences the dependent variable and plotted on the x-axis.

Figure 3 shows a smooth linear relationship between en-ergy consumption and real GDP from 1949 until 1974. Then, an adjustment period followed. Between 1976 and 1980, an-other linear trend developed, though short, but to the left of the previous trend, indicating an adjustment. Then, 1981 to 1985 was a period of further fluctuations, with no clear or set pattern. Again, it can be seen that beyond 1985/86, a new linear trend or

Figure 1. U.S. Real Gross Domestic Product (1949 - 2003)

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Figure 2. U.S. Total Energy Consumption (1949 -2003)

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Dialogue 18 19 Dialogue

is still contentious. However, the debate is important because if energy consumption causes economic growth, then a reduction in energy availability could create some serious welfare impli-cations for many countries. Policymakers face many challenges in trying to make the right policy choices. In the era of rising energy prices severe economic consequences could result. The results from this study show that in the face of rising energy prices, energy conservation policies have not adversely affected economic activity, and are therefore desirable policies.

Footnotes1 Akarca, A. T. and Long, T.V. 1980. Notes and Comments on the

Relationship between Energy and GDP. A Reexamination.” Journal of Energy and Development (Spring): 326-331.

Asafu-Adjaye, J. 2000. “The Relationship between Energy Consumption, Energy Prices and Economic Growth. Time Series Evidence From Asian Developing Countries.” Energy Economics 22 (6): 615-625.

Darmstadter, J.: Dunkerley, J.: and Alterman, J. 1977. How Industrial Societies Use Energy. A Comparative Analysis. Published for Resources for the Future by the Johns Hopkins University Press.

Ebohon, O. J. 1996. “Energy, Economic Growth and causality in Developing Countries. A Case Study of Tanzania and Nigeria.” Energy Policy 24 (3): 447-453.

Elias, J. and Grabik, W. 1980. “A Comparison of Energy Consumption in Eastern and Western Europe.” Energy Economics (October): 237-242.

Ferguson, R.; Wilkinson, W. and Hill, R. 2000. “Electricity Use and Economic Development.” Energy Policy 28 (2000); 923-934.

Granger, C. W. J. 1969. “Investigating Causal Relationships by Econometric Models and Cross-Spectral Methods.” Econometrica 37 (3): 424-439.

http://www.bea.gov/bea/dn/nipaweb/table. National Income and Product Accounts Table

http://www.eia.doe.gov/emeu/aer/txt. Table 1.1 Energy Overview, 1949 - 2003

Jones, D. W. 1991. “How Urbanization Affects Energy-Use in Developing Countries.” Energy Policy (September): 621-630.

Judson, R. A.; Schmalensee, R. and Stoker, T. 1999. “Economic Development and the Structure of the Demand for Commercial Energy.” The Energy Journal 20 (2): pg.29.

Kraft, J. and Kraft, A. 1978. “On the Relationship between Energy and GDP.” Journal of Energy and Development (Spring): 401-403.

Masih, A. M. M. and Mansih R. 1996. “Energy Consumption, Real Income and Temporal Causality: Results from a Multi-Country Study Based on Cointegration and Error-Correction Modeling Techniques.” Energy Economics 18 (3): 165-183.

Medlock, K. B. and Soligo, R. 2001. “Economic Development and End-Use Energy Demand.” The Energy Journal 22 (2): pg.77.

Morimoto, R. and Hope, C. 2004. “The Impact of Electricity Supply on Economic Growth in Sri Lanka.” Energy Economics 26 (1): 77-85.

Murtishaw, S. and Schipper, L. 2001. “Disaggregated Analysis of U.S. Energy Consumption in the 1990’s : Evidence of the Effects of the Internet and Rapid Economic Growth.” Energy Policy 29 (2001): 1335-1356.

Oh, W. and Lee, K. 2004. “Causal Relationship between Energy Consumption and GDP Revisited: The Case of Korea 1970- 1999.” Energy Economics 26 (1): 51-59.

Oh, W. and Lee, K. 2004. “Energy consumption and economic growth in Korea: testing causality relation.” Journal of Policy Modeling 26 (8, 9): 973

Paul, S. and Bhattacharya, R. N. 2004. “Causality between energy consumption and economic growth in India: a note on conflicting results.” Energy Economics 26 (6): 977

Pierce, W. S. 1986.b “Economics of the Energy Industries.” Belmont, Calif.: Wardsworth Publishing Co. 43-54.

Sims, C. A. 1972. Money, Income, and Causality.” American Economic Review (September): 540-552.

Soytas, U. and Sari, R. 2003. “Energy Consumption and GDP: Causality Relationships in G-7 Countries and Emerging Markets.” Energy Economics 25 (1): 33-37

Tabti, M. T. and Mandi, W. 1985. “Energy Indicators.” OPEC Review 9 (Winter): 417-455.

Yang, H. Y. 2000. “A note on the causal relationship between energy and GDO in Taiwan.: Energy Economics 22 (3): 309-317

Yu, E. S. and Hwang, B. 1984. The Relationship between Energy and GDP: Further Results.” Energy Economics (July): 186-190.

Yu, E. S. and Choi, J. 1985. The causal Relationship between Energy and GDP: Am International Comparison>” Journal of Energy and Development (Spring): 249-271.

ANNOUNCEMENT8th Annual USAEE/IAEE/ASSA MeetingBoston, Mass., USA January 6 - 8, 2006

Current Issues in Energy Economics and Energy Modeling

Presiding: Fred Joutz, George Washington University

Youngho Chang, National University of Singapore – Mod-eling Pricing Behavior with Vesting Contracts in a Deregulated Electricity Market

Young Yoo and Bill Meroney, Federal Energy Regulatory Commission – A Regression Model of Gas/Electricity Price Relationship and Its Application for Detecting Potentially Anomalous Electricity Prices

Margaret Taylor and Greg Nemet, University of California, Berkeley –The Interaction Between Policy and Innovation In Renewable Energy Technologies

Graham A. Davis, Colorado School of Mines – The Re-source Curse: Assessing the Empirical Evidence

Abstracts are posted at http://www.iaee.org/documents/2005/assa-abstracts.pdf

We still need some discussants. If you are interested in being a discussant contact Carol Dahl – cdahl@mines.edu right away as program will be finalized very soon. Date, time, and location will be posted in September.

The meeting is part of the Allied Social Science Associa-tion meetings (ASSA) .

For program information and pre- registration forms on the larger meeting (usually available in September) go to http://www.vanderbilt.edu/AEA/anmt.htm.

Dialogue 20 21 Dialogue

The U.S. Electric Power Industry: Policy Forest and Jurisdictional TreesBy Vito Stagliano*

Summary

The U.S. electric power industry is in a state of policy paralysis. Many factors have contributed to the stillbirth of re-form of this vital economic sector, among them schizophrenic public perceptions of what constitutes a “market” for power; how “competition” is fostered or avoided; what purpose should be served by “restructuring,” and what actually constitutes “de-regulation.” The policy debate has in some respects reverted to 1933, when the New Dealers were forced into a reassessment of the very nature of electric utilities in the wake of the collapse of the monopoly structures that had haphazardly emerged in the initial 50 years of the electric industry1.

It should be noted that investor-owned monopoly utilities have never been the sole or even preferred public policy option for delivery of electric service to consumers. The power sector has long comprised a multiplicity of organizational structures, including Federal utilities, municipal utilities, rural and urban cooperatives, and even the exceptional, publicly owned and State-supervised utility structure of Nebraska, where inves-tor-owned utilities have never been permitted. This diversity of structural options attests to the century-long debate that has taken place in the United States and abroad on how and by whom electric service should be provided, and consequently to the inherently evolutionary nature of the industry itself.

The limited change that was introduced barely a decade ago in the power generation component of the U.S. power sec-tor, in the form of allowing non-utility, independent generators to build power plants and sell the output at wholesale, hardly merits the “restructuring” terminology that has been applied to it in the intervening years. And yet, a great deal of opposition has emerged in many regions of the nation to the very concept of generators that are not public utilities. Among the reasons for what can only be described as nostalgia for the traditional, staid and previously local2 utility monopoly, is a lack of clarity about the public policy objectives of the Energy Policy Act of 1992 (Epact), the meaning and consequences of events such as the fateful collapse of the California market in 2001, and a re-assertion of ancient rivalries between Federal and State regula-tory authorities whose jurisdictional domains over the industry were thought to have been set in stone by the combined Federal Power Act (FPA) and the Public Utility Holding Company Act (PUHCA) of 1935.

The current impasse in the process of sector reform can be attributed, in part, to a utility structure that is predisposed to seek protection at State level when confronted by political change, and cost-of-service regulation to avoid economic risk-taking. Rate regulation provides financial security to monopo-

lies generally, and to electric utilities in particular, because it is typically more forgiving of managerial and operational miss-judgments than is a competitive business model. In rate regula-tion, the financial risk is borne by the consumers rather than by the monopoly and, consequently, the consequential incentives that usually drive unregulated businesses are either ab-sent or unclear. The Context

The 1992 enactment of Epact held the promise of evolu-tionary change in the structure of the power generation sector, allowing, for the first time since the industry was re-organized under PUHCA, an alternative to utility construction and opera-tion of power plants. The alternative thus created, at its most fundamental sought to shift the economic burden and risk of power-plant financing from ratepayers to shareholders, thereby directly addressing the notoriously costly exposure to the previ-ous two decades of utilities’ misjudgments on supply forecasts, choice of technology and near pathological inability to control and contain plant construction costs3. Yet, nothing in the record of Epact deliberations would lead one to believe that the Con-gress intended to either “restructure” or to “deregulate” electric utilities. Rather, the aim of Epact’s electricity provisions was to introduce a degree of technology, economic and regula-tory choice in the power generation component of utilities that would otherwise remain vertically integrated.

With Epact, Congress signaled its displeasure with the performance of traditional utilities, but was careful to narrow the message to the part of the utility business – wholesale generation - whose regulation was and remains clearly within Federal jurisdiction of both electric sales for resale and inter-state commerce. The “deregulation” of retail power markets, which ensued in the wake of Epact, beginning with California and subsequently in New England and in a total of 17 States and the District of Columbia4, was and remains entirely the initia-tive of the States, and exclusively within their jurisdiction. That the record of retail deregulation has been mixed, at best, attests to the difficulty of finding value in the change of a system that even when “deregulated,” appears to require no less regulatory oversight than in its previous state.

It was furthermore not the intent of the Federal Energy Regulatory Commission (FERC) to “restructure” the power sector when, in 1996, it issued its landmark Orders 888/889, which, in line with the Epact statutory mandate, created the standard, subsequently upheld by the courts, of non-discrimi-natory open access to the transmission system. Access to the grid – the interstate highway for electrons - is, of course, the condition precedent to the participation of non-utility genera-tors in the power sector. Such access, fair and equitable and non-discriminating, is essential to the creation of a viable busi-ness model for non-utility suppliers regardless of what other elements of the power sector structure are changed or restruc-tured or deregulated. Experience has shown that competitive generation is unlikely to be institutionalized in the U.S. power system, until and unless, transmission owners provide service on terms and conditions that are both equal and enforceable for all market participants.

Orders 888/889, per se, created neither wholesale power “markets” nor a competitive generation sector. Rather the Or-

* Vito Stagliano is former Deputy Assistant Secretary of Energy for Policy, former visiting scholar at Resources for the Future; author of “A Policy of Discontent: The Making of a National Energy Strategy,” and co-author of “A Shock to the System: Restructuring America’s Electricity Industry.”

See footnotes at end of text.

Dialogue 20 21 Dialogue

ders established the regulatory framework that enabled such markets and competitive processes to come into being. Epact and the Orders, together, assisted the power generation sec-tor to evolve from the highly constrained model created by the Public Utilities Regulatory Policy Act (PURPA) of 1978. PURPA allowed independent generators to build power plants of particular sizes and technology, and allowed them to sell the output of those plants solely and exclusively to the utilities to which they were interconnected. Epact essentially eliminated all of the conditions imposed by PURPA, while still allowing PURPA facilities to continue to be constructed.

It is important to note that the first electric energy market to become operational in the United States was not created by Federal mandate or regulation, but was, rather established by a legislative act of the State of California. The California initial market, in all of its innovation and flaws, set in motion “restruc-turing” forces of far greater power than any till then unleashed by the FERC. The mid-Atlantic region followed suit with the design of the PJM Interconnection Independent System Opera-tor (ISO), the first regional (multi state) transmission organi-zation capable of transforming itself into, thus far, the most durable and sophisticated market structure in North America. New England, New York and Texas followed, and then, much later, the Midwest ISO.

In 2005, nearly 50% of American consumers are served – well, for the most part - by structures that did not exist a decade earlier. These structures - so-called ISOs and regional transmission organizations (RTOs) – seek to fulfill the FERC’s fundamental objective of non - discriminatory open access to the transmission grid. More importantly for consumers, ISOS/RTOs administer competitive wholesale markets for electric energy, which have proven to be the only effective alternative to regulated cost of service rates. The effects of competition at wholesale have been both remarkable and ambiguous, when viewed in the context of the experience with States’ experiments with retail markets and related restructuring efforts, which have, not incidentally, frequently been linked to economically counter-productive but politically expedient imposition of ex-tended freezing of retail rates5.

Energy Information Administration data show that aver-age national electricity rates were 7.1 cents per kilowatthour in 1993 and 7.4 (constant) cents per kilowatthour in 2004. These rate ranges represent the remarkable part of the achievement because their long-term stability, and notwithstanding recurrent short term price volatilities in the wholesale part of the market, stands in marked contrast to the increases experienced in the same period in the price of the essential fuels that are used to produce power: coal prices have nearly doubled, natural gas prices have more than trebled and oil prices have risen from less than $20/barrel to over $50. The contested part of the achievement – and concurrently the confusion-causing part of the public discourse – is the extent to which “restructuring,” or “deregulation,” or “competition” accounts for the noted effect on rates.

Regions such as the South, which have experienced neither restructuring nor deregulation nor meaningful competition at wholesale, will argue that the generally reasonable electric service rates their citizens enjoy are due to adherence to the monopoly utility model, and related prudent state regulation of

these monopolies. Pacific north-westerners will argue that they would have continued to enjoy the reasonably priced (albeit Federally subsidized) electricity generated by Federal hydro-power, had they not been “victimized” by the unmitigated flaws and eventual collapse of the California market6. Northeastern-ers tend to believe that they have benefited from the restructur-ing7 of their utilities, to some extent by moving to a complex form of retail competition, and more generally because of their well functioning but still evolving wholesale markets. Texans believe they have derived measurable economic benefits from their restructuring efforts, but continue to debate the relative merits of a market structure that, despite their efforts to find State-specific alternatives, is moving inexorably towards the model perfected by the PJM Interconnection. As to the Mid-west—its long road to a functional ISO and market structure and its limited retail level “deregulation” remain, in essence, economic promises to be fulfilled, based on costs that have already been fully incurred.

The South and the West have led what can only be described as a rebellion against any further restructuring of the power sec-tor, which, in their view, was spearheaded by the FERC and, if allowed to persist, would have resulted in unacceptable incursions on the State’s jurisdictional prerogatives. Perhaps understandably in light of recent history, perceptions, in these two regions, often outweigh facts in regard to regulation of the power industry. It can be argued that, as a practical matter, the FERC has shown rather exceptional deference to the insistence of the two regions to retain a monopoly model that has not only prevented the emergence of a competitive wholesale market, but has in the process protected behavior on the part of local utilities that has repeatedly been found to be discriminatory in regard to access to the transmission grid, and to procurement of incremental supply. The South has no power markets whatso-ever, but enjoys an extraordinary surplus8 of generation capacity that was spurred and built on the promise of Epact, and in spite of the protectionist State regulation of the industry. The excess capacity represents a de facto wholesale market structure whose downward pressure on prices allows these non- restructured states to keep retail rates low and reasonable.

The West has not yet recovered from its California/Enron post-traumatic market syndrome. With the exception of Mon-tana, most states in the region have indefinitely postponed restructuring/deregulatory initiatives as well long-gestating ef-forts to create regional transmission organizations and centrally administered markets. The West-wide wholesale bilateral mar-ket for power, by contrast, which recovered within weeks of the California market collapse, remains a major contributor to the highly competitive electric energy prices that the region’s con-sumers could see reflected in their monthly service bills, were it not for the miss-judgments of many of their utilities in reaction to the California market volatility and eventual collapse. That is to say that too many utilities in the West negotiated multiple high-cost, long term supply contracts at the height of the mar-ket’s dysfunction, unable consequently to take advantage of the market’s correction, and were subsequently forced into seeking -- from their State regulators, or from their members in the case of public power entities -- significant increases in retail rates to finance the blunders. As in the South, the wholesale power market of the West worked, and works effectively, in spite of

Dialogue 22

the behavior of market participants - utilities in the main – who seem unable to master market fundamentals.

Utilities and State regulatory officials in states that have resisted industry reform in any guise frequently resuscitate the long-buried California market to justify the continuation of the vertically-integrated monopoly model, as if there were no other option available in the rather wide spectrum of electric system structural organization. The evidence suggests, rather, in the wide policy space between California and Armageddon, that a number of structural models have been developed in the U.S. and abroad that concurrently – and by design – make the system economically more efficient, enhance reliability, and ac-tually serve the best interests of consumers. It is consequently not necessary for policymakers to believe that the only options available to them are either the experimental, short-lived and un-replicated California market model OR a 19th century fran-chised monopoly model.

To ensure that consumers benefit from competition, it is not necessary to actually restructure or de-regulate the power sector. It is however necessary to insist that all market partici-pants, native utilities, especially abide by competitive rules of behavior. Competition can be broad or narrow in scope. It can be limited to a State-run procurement process for new genera-tion capacity, or an auction to procure supply for retail load. Competitive functions can be established within or outside the scope of an ISO/RTO, but they cannot be established on a foun-dation of embedded institutional self-dealing.

When utilities’ earnings are based on return on equity for capital expenditures, an insurmountable bias ensues for utilities to build their own plants and roll the investment into their rate base, rather than procure the same capacity on the open market, and simply pay the market price. Functions subject to competi-tion can range across the entire utility business—restructured or not –and can include daily or weekly procurement processes for energy or capacity or both; market-based settlement of imbalance charges; competitively procured reserves to satisfy reliability requirements, and procurement of ancillary services. Even metering and billing can be competitively procured, as can any number of operational and maintenance functions cur-rently embedded within the typically over-staffed bureaucra-cies of monopoly structures.

History teaches that there is no true economic alternative to competition in the procurement of goods and services, indeed that even the most efficient monopoly can be made more cost effective for the consumers it serves, by exposing any aspect of its functions and behavior to forces in the marketplace. It follows therefore that the clearer, least ambiguous policy objec-tive for the achievement of the superior electric power sector of the future should be the institutionalization, in regulation as in business practice - of the concept of competition. The con-cept, it can be argued, can be institutionalized by any number of means, including a process of “restructuring” or “deregula-tion,” or regulation by other means, such as the requirement by States that all market players, but especially native utilities, procure and deliver all goods and services according to un-equivocal competitive rules and practices, with no exceptions, no caveats and no codicils.

History can also teach nothing, if the public discourse premises that all structural models have equal merit. Various

structural models deliver performance relative to expectations, but it matters a great deal if the expectations are set by consum-ers or by regulators acting on consumers’ behest, or by Wall Street, or by utilities themselves. As a practical matter, consum-ers do not yet directly participate in the various market struc-tures that serve them, and do not therefore directly affect prices. In reality, proxies perform the consumers’ demand function. These are utilities acting as load serving entities, aggregators, or retail service providers that secure supplies on behalf of end-use customers. Customers remain unable to obtain service tai-lored to their needs. Proxies can be appropriate market players, but only to the extent that they facilitate the development of dif-ferentiated products that meet the different needs of consumers. They are less than useful when they enter the market to deliver rate-frozen bundled services, or when they act as mere collector of utilities’ stranded costs. Notwithstanding the enormous effort that has already been invested to reform the power sector, cur-rent conditions illustrate the limitations of the “restructuring” that has occurred thus far and the relative immaturity of the market structures that have actually been created.

Neither restructuring nor de-regulation are ends in them-selves, and should not therefore be treated as end states. They are, rather, means to the end of delivering superior service to consumers. Competitive procurement practices are also means to value creation for consumers, as are regimes that objectively set the order of economic merit for the dispatch of energy from all generating units available to any given local system. Mar-kets are also means to the same end, and their evolution and perfectibility contribute to the discovery of prices that can be used as a frame of reference for judgment of all other forms and structures that regulators might consider.

In sum, the present state of the power sector – neither pro-verbial fish nor fowl – represents an unsatisfactory policy state, most importantly because the key players in the marketplace engage in a game with variable rules on the basis of unequal handicaps. Native utilities can be, concurrently, native monop-olies and unregulated market participants; they can own and operate their proprietary transmission systems and unilaterally determine the conditions under which they will provide service to others; they can procure goods and services competitively or not, and they can typically avoid managing the volatility of the fuels they use, by simply passing those costs to their customers. Independent producers of power neither have nor can obtain rate protection for their costs of production, do not own or oper-ate transmission systems, and can only participate in processes and markets administered by others. The playing field, in sum, is rather crevassed and stony, and hardly the field on which to plant the seeds for the next phase of the reform of a sector of the economy without which modern life is virtually unthinkable.

Footnotes1 Thomas Edison’s “age of electricity” was launched when he

energized the Pearl Street Generation Station in lower Manhattan in 1882. Samuel Insull subsequently consolidated the industry, accepting regulation as preferable to what he called “debilitating competition.” New York and Wisconsin were the first States to regulate the electric industry, beginning in 1907. Federal regulation did not begin until 1920 when the Federal Power Commission was established.

(continued on page 27)

23 Dialogue

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Dialogue 24

BEG-Center for Energy EconomicsOn June 1, the Bureau of Economic Geology at the Uni-

versity of Texas, Austin welcomed the new “BEG Center for Energy Economics” (BEG-CEE) to its growing list of research programs. The BEG-CEE, formerly the Institute for Energy, Law, and Enterprise at the University of Houston, is managed and directed by Dr. Michelle M. Foss. Dr. Foss’ associates that transferred to the Bureau include researchers Dr. Gürcan Gülen, Ruzanna Makaryan and Dmitry Volkov and support staff Aisha Hanif and Natalie Silva. Although the group will remain in Houston, they will be supported by and interact with the Bureau in many research projects.

Since 1991, Dr. Foss and her team have built an interdis-ciplinary, university-based Center of Excellence that provides research, training and outreach on energy economics and markets; policy and regulatory frameworks for commercial investment; and training and capacity building for energy sec-tor reform and related institutional development. The Center’s mission is to educate stakeholders on energy economics and commercial frameworks using comparative research to facili-tate energy sector development.

The Center concentrates on the policy and regulatory frameworks that facilitate sustainable, commercial investment in energy resource and infrastructure development, and optimal strategies for investment, trade, and problem solving – the in-gredients for successful, “bankable” energy investments. The Center is externally funded through corporate and government partnerships, research grants and contracts and revenues from training programs and publications. The Center network of several hundred experts consists of senior professionals from corporate and government donors and sponsors; senior associ-ates and international advisory boards; professional staff and international research fellows; current and former graduate student research assistants; and visiting scholars.

The Center focuses its interdisciplinary research on the economic fundamentals of the energy value chains and linkages to commercial frameworks; the role of government (at all lev-els) and policy and regulatory models for commercial energy development; business/government interactions; and strategic responses to more competitive energy markets. The Center’s proven model for all of its research derives from working with corporate and government partners to help set priorities with balance assured through the Center’s network of advisors, se-nior associates and faculty. Center researchers use conceptual models to define problems and to support quantitative models for solutions. Case studies contribute thorough treatment and monitoring. Ongoing evaluations of market fundamentals are maintained via outlooks and scenarios, with a focus on validat-ing basic assumptions.

The main ongoing efforts of the Center include the follow-ing.Ø Energy Sector Governance grant from the U.S. Agency

for International Development. Through this grant, the Center has established a partner entity, Resource Center for Energy Economics and Regulation at the University of

Ghana, which so far produced several reports and educa-tional seminars, and an energy database. Ø Grant from the Association Liaison Office of Univer-

sity Cooperation in Development to help develop energy economics research and teaching capacity at Bangladesh University of Engineering & Technology. A new energy course has been developed and offered; a professional workshop was held; and several research projects have been initiated.Ø Annual international capacity-building program “New Era

in Oil, Gas & Power Value Creation,” which serves as the Center’s main tool in the international efforts of capacity building and public education in energy economics and regulation. In five years, the Center has trained over 100 participants (in Houston and in-country sessions) from 24 countries.Ø A research and public education consortium on “Commer-

cial Frameworks for LNG in North America.” The Center has established an independent, objective and widely ac-cessible knowledge and education base on the role of LNG in North American energy security. This research and public education effort on LNG is supported by a number of public and private organizations. The U.S. Department of Energy - Office of Fossil Energy provides a federal in-terface to the federal and state agencies that play lead roles in ensuring public safety and security associated with LNG facilities. The Center’s LNG research consortium also is a part of our overall research and public education efforts on natural gas and the role of natural gas in the U.S. and world energy mix, as well as our ongoing, overall research and education on the energy value chains, energy markets and energy policy and commercial frameworks.Ø Various publications, such as the “Guide to Electric Power

in Texas” which provides both background on our state’s electric power industry and history and the points of debate on how best to provide free choices and a different set of options so that the benefits of competition can be intro-duced and flourish.The Center expects to continue its international work in

Africa, South Asia and Latin America through additional grants and sponsored projects. Associated with its international ef-forts, the Center will organize an International Development Assistance conference in fall 2006. On the home front, new ar-eas of research for the BEG-CEE include CO2 value chain eco-nomics through the Gulf Coast Carbon Center and commercial frameworks for newer generation technologies such as IGCC while continuing to monitor electricity restructuring, especially in Texas. The Center will also support degree programs at the Jackson School of Geosciences, the university’s Energy and Mineral Resources program and the university’s newly formed Center for International Energy and Environmental policy, a joint program of the Jackson School, the College of Engineer-ing and the LBJ School of Public Affairs.

For more information on BEG-CEE, please visit www.beg.utexas.edu/energyecon or call 281-313-9763.

25 Dialogue

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Dialogue 26

In today’s economy you need to keep up-to-date on energy policy and developments. To be ahead of the others, you need timely, relevant material on current energy thought and comment, on data, trends and key policy issues. You need a network of professional individuals that specialize in the field of energy economics so that you may have access to their valuable ideas, opinions and services. Membership in the IAEE does just this, keeps you abreast of current energy related issues and broadens your professional outlook.The IAEE currently meets the professional needs of over 3100 energy economists in many areas: private industry, non-profit and trade organizations, consulting, government and academe. Below is a listing of the publications and services the Association offers its membership.• Professional Journal: The Energy Journal is the Association’s distinguished quarterly publication published by the Energy Economics Education Foundation, the IAEE’s educational affiliate. The journal contains articles on a wide range of energy economic issues, as well as book reviews, notes and special notices to members. Topics regularly addressed include the following:

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27 Dialogue

The U.S. Electric Power Industry (continued from page 22)

2 The “local” nature of electric utilities has ceased to be meaningful, given the consolidation of the industry into multi-state utilities such as Southern Company, Entergy, PacifiCorp, Xcel, Exelon AEP and others, and the additional presence of unregulated affiliates of the same utilities in multiple regional markets beyond their initial franchised territory.

3 As documented in Brennan et al in: “A Shock to the System: Restructuring America’s Electricity Industry,” published by RFF in 1996: Between 1974 and 1980 alone, U.S. utilities filed rate cases seeking increases in excess of $4.0 billion (a very substantial sum at the time) in the first phase of recovery of cost-over-runs for plant construction and for imprudent management of energy input costs.

4 EIA: Annual Energy Outlook 20055 For example: The State of Illinois imposed a rate freeze of ten

years as part of enactment of utility restructuring legislation in 1996. 6 Because California relies for about 20% of its electrical needs

on imports from the Pacific Northwest, the high volatility experienced in its market in 2000/2001 had repercussions in the entire region; affecting wholesale prices in the Pacific Northwest quite as much as prices were affected in California itself.

7 The restructuring process in the Northeast was most radical in its requirement that native utilities divest some or all of their generation assets and become, in effect, load serving entities/distribution utilities.

New Members of USAEE

Welcome!! The following individuals joined USAEE from 3/1/05 to 6/30/05Jean AgrasR W BeckMasood AhmadDominion Resources, Inc.Sulayman Al-QudsiMOFCamilo Hyoma ArayaBradley BallardLower Colorado River AuthorityCharles R. BamfordRockwood AssociatesHussaini A. BasakaAlbert Garaudy & Assoc. EngineersRonald W. BehrnsVermont Public Service DepartmentGeoffrey BlanfordAmy BoweZiff Brothers InvestmentsDerik BroekhoffWorld Resources InstituteKelani ChanJohns Hopkins SAISNorvic ChicchonConnie ClonchMidAmerican Energy Holdings CoMichael CohenUS Department of Energy/EIABahman DaryanianPA Consulting GroupTravis DunbarAmit DuttaGranherne/KBR

Jennifer GardyneDeloitteEugene M. Geddes IIIFdn. For Res. On Economics & Envir.Joshua GiordanoEnergisticsIndur GoklanyTim GrantDOE Nat’l. Energy Tech. Lab.Charles HarderCenterPoint EnergyAndrew HigierEnerl Inc.Paulina JaramilloCarnegie Mellon UniversityKajal KapurPrincipal, Kajal B. KapurMark KarlISO New EnglandTimothy LaneJoshua LinnDaniel D. MahoneyCambridge Energy Research Assoc.Marwan H. MasriCalifornia Energy CommissionJulie McLaughlinJohn MorrisEconomists IncorporatedGail MoseyNRELKen NicholsTransCanada

Albert OlagbemiroYris OlayaChris J. OverendUS CongressGian PorroNelson RicardoAlan RistownLindsay RothfelderStephen SewalkEdward StevensonSolar Integrated TechnologiesHiroaki SuenagaUniversity of California-DavisJ. Michael TrainorUSAID Caucasus/AzerbaijanRahul T. VaswaniAlliance to Save EnergyDaniel WilliamsUS Gov’t. Accountability OfficeJeffrey WilliamsUniversity of California – DavisDonna WilsonUniversity of GeorgiaPaul WinnShell International E&PBo YangExelon CorpNancy YongeYonge & AssociatesYoung S. YooKenneth ZimmermanOregon PUC

!!! Congratulations 2005 USAEE Award Winners !!!Awards committee chair Adam Sieminski and his commit-

tee members Kevin Forbes, Herman Franssen, Shirley Neff and Sam Van Vactor are pleased to announce the following 2005 USAEE Award winners:USAEE Adelman-Frankel Award

Awarded to an organization or individual for unique and innovating contributions to the field of energy economics.

Energy Modeling Forum, Stanford UniversityUSAEE Senior Fellow Award

Awarded to individuals who have exemplified distin-guished service in the field of energy economics and/or the USAEE.

Leonard CoburnCoburn Int’l Energy Consultants LLCRobert EbelCenter for Strategic & International StudiesArlon TussingUniversity of AlaskaThese award recipients will receive their awards and rec-

ognition at the 25th Annual North American Conference of the USAEE/IAEE, September 18-21, in Denver, CO.

Dialogue 28

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Energy Conference at The Hilton at Santa Fe, New Mexico, USA. Contact: Amanda Ormond, Conference Director Email: swrec2005@yahoo.com URL: www.SWREC.org

1-5 August 2005, PV Industry Week at Carbondale, CO. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

1-5 August 2005, Micro-Hydro Power at Carbondale, CO. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

6-7 August 2005, Solar Water Pumping at Carbondale, CO. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

8-19 August 2005, Wind Power at Carbondale, CO. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

14-17 August 2005, Energy 2005 -- The Solutions Network at Long Beach, California. Contact: JoAnn Stirling Email: joann@fsec.ucf.edu URL: http://www.energy2004.ee.doe.gov

14-17 August 2005, Energy 2005-The Solutions Network at Long Beach Convention Center, Long Beach, CA. Contact: Maddie Harwood, Senior Conference Planner, Sage Systems Technologies, 10440 Balls Ford Road, Suite 200, Manassas, VA, 20109-2602, USA. Phone: 1(800)608-7141 or (540)937-1739. Fax: (540)937-7848 Email: energy2005@doeevents.com URL: www.energy2005.ee.doe.gov

August 22, 2005 - September 2, 2005, PV Design and Installation at Carbondale, CO. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

28-30 August 2005, 7th IAEE European Energy Conference, European Energy Markets in Transition, Bergen, Norway. Contact: Kellis Akselsen, Conference Secretary. Phone: +47-55-959500. Fax: +47-55-959439 Email: kellis.akselsen@snf.no URL: www.snf.no

18-21 September 2005, 25th USAEE/IAEE North American Conference: Fueling the Future: Prices, Productivity, Policies, and Prophesies at Omni Interlocken Resort, Denver, Colorado, USA. Contact: David Williams, Executive Director, United States Association for Energy Economics, 28790 Chagrin Blvd., Suite 350, Cleveland, Ohio, 44122, USA. Phone: 216-464-2785. Fax: 216-464-

2768 Email: usaee@usaee.org URL: www.iaee.org/conferences22-23 September 2005, Nuclear Fuel Strategies at Washington,

DC. Contact: Ronald Berg, Conference Manager, Platts, 24 Hartwell Avenue, Lexington, MA, 02421, USA. Phone: +1-781-860-6100 Email: registration@platts.com URL: www.events.platts.com

4-6 October 2005, Plant Management Institute at Philadelphia, PA USA. Contact: Marianna Senteno, Executive Assistant, Sterling Energy International, Inc., 26893 Calle Hermosa, Capistrano Beach, Ca, 92624, USA. Phone: 949-248-2917. Fax: 949-248-2539 Email: MariannaS@Sterling-Energy.com URL: www.Sterling-Energy.com/training.htm

5-7 October 2005, 25th Annual Bonbright Center Electric & Natural Gas Conference at PineIsle Resort & Golf Club, Atlanta GA USA. Contact: Albert L. Danielsen/Donna Wilson, Executive Director/Administrator, University of Georgia, Executive Education, 118 Spruce Valley Road, Athens, GA, 30605, USA. Phone: 706 425-3053. Fax: 706 546-6517 Email: bonbright@terry.uga.edu URL: http://www.terry.uga.edu/bonbright

6-9 October 2005, Solar Power 2005 at Washington, DC. Contact: Julia Judd, Exec. Director, SEPA Email: jjudd@solarelectricpower.org URL: http://www.solarpowerconference.com

10-15 October 2005, PV Design and Installation at Guemes Island, WA. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

11-12 October 2005, Empire Energy & Environmental Expo at Saratoga Springs, NY. Contact: Ed Parker, Marketing Director, EBA/NYS, Inc, 126 State Street, 3rd Floor, Albany, NY, 12207, USA. Phone: 518-432-6400 x227. Fax: 518-432-1383 Email: ed@eba-nys.org

17-23 October 2005, Renewable Energy for the Developing World at Nicaragua. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

17-21 October 2005, Micro-Hydro Power at Guemes Island, WA. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org

24-29 October 2005, Wind Power at Guemes Island, WA. Contact: sei@solarenergy.org, Solar Energy International, PO Box 715, Carbondale, CO, 81623, USA. Phone: (970) 963-8855. Fax: (970) 963-8866 Email: sei@solarenergy.org URL: http://www.solarenergy.org