SOME HARD TRUTHS ABOUT ENERGY

Peter T Treadway, PhD
Historical Analytics LLC
www.thedismaloptimist.com
pttreadway -at- hotmail.com
305 761 4718
852 9409 1186
305 489 7807
March 6, 2011

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“Once you throw down your stick, you will be bullied by a dog.”

Old Chinese Proverb

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“From the Halls of Montezuma,

To the shores of Tripoli;

We fight our country’s battles

In the air, on land, and sea”

From the Official Hymn of the United States Marine Corp

As the markets tremble at the massive changes now sweeping the energy-rich Arab world, once again we are reminded that the supply of energy is not something to be taken for granted. Clearly, a continued march upward of oil prices above $100 per barrel threatens an already tepid US economic recovery.

The US (and the rest of the world) needs an energy policy. But what should it be? In my opinion as a free market economist, current policies are a disaster. Note I do not pretend to be an energy expert. But basic economic principles underlie all economic activity.

Allow me to make some basic points:

1. Energy independence, a.k.a., energy autarky, is an impossible and undesirable dream. Every American President since Richard Nixon has loudly proclaimed that America should become “energy independent.”  However appealing this may be to the American public, energy independence hasn’t happened. For example, US petroleum imports increased steadily from 1981, slowed down only by the Great Recession beginning in 2007. Over the same period, US petroleum production has been slowly declining.

For an economist, independence and autarky amount to the same thing. Autarky means total self-sufficiency and it carries a pejorative connotation in economic texts. Since the days of Adam Smith and David Ricardo economists have held that free trade results in a higher standard of living and superior allocation of resources as opposed to autarchy.

Barring some miraculous discovery of new energy sources, total energy costs would rise dramatically if America (and most other nations) substituted much higher cost domestic sources of energy for imports to achieve energy independence.  Our ever higher standard of living and human progress in general has been driven by cheap and available energy. Dramatically increase the cost and reduce the availability of energy and the American and world economy fall into a serious recession.

2. A major objective of US (and all importing nations) foreign policy should be to secure reliable energy supplies. Is this an imperialist notion? Maybe. But I would argue that securing reliable energy supplies ought to be one of the major objectives of European, Chinese, Japanese or Indian foreign policies. All these areas are major petroleum importers. Sudden moves up to and beyond one hundred fifty dollars plus per barrel of oil will take no prisoners – they will kill all the world’s major and minor economies.

Petroleum is not a perfectly homogeneous commodity. For example, Italian refineries need high quality “sweet” Libyan oil vs. “sour” Saudi oil. But that said petroleum is homogeneous enough and its supply basically goes into one interchangeable  global pool.  And China, America, India, Europe, Japan all have the same overriding need for access to this pool.

The proponents of non-traditional alternative energy sources argue that the prices of oil and its byproduct gasoline are understated because among other things they do not include the price of supporting a global military presence to ensure the reliability of the oil. There is some truth in this for the US although the entire cost of the US military cannot be ascribed to oil security. It is less true for other countries which from the viewpoint of global oil security “underinvest” in military and “free ride” off the US. (Of course until recently when its fiscal situation began to reach the precarious state, the US may have preferred this state of affairs, especially in the case of China.)

I would argue that the US should at least get its money’s worth on its military expenditures. The US might start by trying to know what it is doing. Looked at this way, the invasions of Iraq and Afghanistan under the Bush Administration were serious errors. US military resources have been tragically squandered in this effort which in retrospect could be considered an overreaction to 9/11.  Afghanistan has no oil. It is highly debatable whether the US invasion of Iraq helped make Iraq and the Persian Gulf more or less secure as a source of oil for the global pool.  Saddam Hussein, while clearly not one of history’s “good guys”, was a secular Sunni ruling over a nation that is over 50 percent Shi’ite. Iran is Shi’ite. Saddam’s secular Sunni Iraq was counter balance for Iran. Today’s Shi’ite controlled Iraq will not be a counter balance for Iran. Iran now has much more flexibility in any attempt to undermine US influence in the Shi’ite minority kingdoms of the Persian Gulf (Bahrain, the home of the US Fifth Fleet, has a Sunni King but a Shi’ite majority). The Persian Gulf is where the oil is.

The US has drained its military, thereby throwing down its stick as in the Chinese proverb above. Now for the US apparently even organizing a no-fly zone over Libya is a military challenge akin to climbing Mt. Everest. And Somali pirates? Why are they getting away with kidnapping oil tankers? The dogs are bullying the US.

The revolutions sweeping the Arab world are the equivalent of the revolutions that swept Europe in 1848. They are major events that will change the structure of the Arab world for the next generation. Perhaps if the US had left Saddam Hussein in place, he’d be tossed out today anyway and things would be worse. Perhaps the US should only watch. But if the oil kingdoms of the Persian Gulf are allowed to fall and oil prices rocket upward, the entire world could be sent into recession or worse. Now is the time for the US to be prepared to act decisively and exercise leadership. It will have to act in concert with the other major nations of the world who have the same foreign policy objective of secure oil as the US. Given its fiscal weakness, the US will have to combine diplomacy with its diminished but still considerable military muscle.

3. The free market—not the government – should be making the choice among various energy sources. The market has every incentive to find new and least cost energy alternatives. The markets are constantly experimenting.  New ideas are tried and discarded if viewed as failures. At the dawn of the twentieth century, the gasoline powered car competed with the electric and steam powered cars. Thomas Edison put his time and money on the electric car.  Henry Ford and his gasoline car won. Without subsidies.

It is not so with government programs. Take ethanol. There is now virtual unanimous agreement that corn-based ethanol is a failure on economic and ecological grounds. Corn-based ethanol is dependent on massive government subsidies and has driven up the price of corn in a world worried about food inflation.  Is it too much of a stretch to argue that food riots in Tunisia are linked to the American ethanol program? In any case ethanol goes on. Government programs always acquire their own rent- seeking vested interests who try to perpetuate these programs no matter what. Bankrupcy – the great Darwinian grim reaper in the private sector – does not exist in the ideologically driven, vested interest-supported world of government boondoggles.

The Obama Adminstration’s policy seems to be one of discouraging domestic production of proven sources of energy like oil, natural gas, coal and nuclear and offering massive subsidies to less efficient so-called “green” energy alternatives like wind, solar, ethanol and other biomass alternatives.  As far as I can tell, ideology – not economics or physics – is driving this policy. Authors whose conclusions are based on economics and physics seem to conclude that these green alternatives are inferior with regard to energy density, power density, cost and scale. I would cite Robert Bryce, Peter Huber, George Gilder and Vaclav Smil in this regard. George Gilder by the way has been outspoken in his condemnation of the US venture capital community which has enthusiastically bought into the green energy/government subsidy program.

The socialist British Labour government in 1945 assumed control of the “commanding heights” of the economy, only to nationalize what turned out to be the industries that were most important in the past and ignoring the new industries of the future. Only in the 1980s were Mrs Thatcher and her privatization programs able to rid the UK government of these government run albatrosses that held down British economic growth for the entire post war period. The Obama Administration has tried to seize from the markets the commanding heights of US energy policy. Will the US in the years to come be stuck with the various alternative energy boondoggles?

A counter argument may be made that China and many other countries are throwing massive subsidies at green energy. I wrote in a recent The Dismal Optimist how China’s state directed investment system is misallocating resources. My answer: the US does not have to emulate China’s mistakes.

4.  Domestic conventional sources of energy offer great promise. There is no question that domestically produced energy is more secure than that derived from foreign sources. To acknowledge the undesirability of energy autarchy does not imply opposition to the development of non-subsidized domestic energy sources.  And the US has plenty of untapped sources that need rational regulations, not subsidies. Offshore deepwater drilling and opening up Alaska could dramatically increase US petroleum production.  The US has abundant supplies of coal. And nuclear – which has been hindered by  government regulations and irrational  public fears since the Three Mile Island incident in 1979(where nobody died and the containment system worked perfectly)—is ready for further expansion as new technology has rendered nuclear safer and more efficient. The irrational response to Three Mile Island by the way has led to a greater reliance on coal which of course is a major carbon emitter as opposed to nuclear which does not emit carbon.

In fact the private sector and technology have produced a “near-miracle” in energy production. I refer to natural gas. For many years natural gas was in short supply thanks to price controls which were only finally lifted in the first Bush Administration . (Government price controls on natural gas – another dumb government action forcing a greater reliance on coal.) Today new horizontal drilling and fracking technology are producing a quantum increase in the supply of domestically produced natural gas and a decline in its price. This has occurred not only in the US but in other areas such as Western Europe as well. STRATFOR chief George Friedman has forecast that the Russian natural gas stranglehold on Western Europe will be broken because of the new supplies of natural gas being brought forward in Western Europe by the new technology. None of this has happened with major government subsidies. It has happened in spite of governments’ attitudes.

5. So called-green energy alternatives are not necessarily easier on the environment. The public and the politicians somehow have this naïve attitude that alternative energy sources like sun, wind and biomass are “free” and involve no damage to the environment. Wrong. The damage list is a long one.

For example, wind and solar for are intermittent sources of energy. Both require substantial investments in conventional energy facilities (including carbon emitting coal facilities of course) which must be inefficiently turned on and off when “the wind don’t blow and the sun don’t shine.” Moreover both wind and solar facilities have to be located way out in the boondocks and require massive investments in environmentally dubious power transmission lines. They take up enormous swaths of land. Wind turbines are major birdkillers and make a low grade humming noise that drive their unfortunate human neighbors batty. No wonder the usually well heeled and typically liberal NIMBY (Not In My Backyard) crowd is against wind turbines being built near them.

One particularly sad example of green power gone bad is Indonesia. This story is best told by quoting directly from Robert Bryce’s Power, the Myths of “Green” Energy and the Real Fuels of the Future:

In Indonesia “the misguided quest to produce more biofuels has led to rapid deforestation. Since 1996, some 9.4 million acres of Indonesian forest have been destroyed to make way for palm oil plantations. And much of that palm oil was aimed at producing biodiesel for export for the European market. The lowland tropical forests in Sumatra and Borneo have been decimated by the quest for palm oil…as the forests have declined, so, too, have the numbers of rare endemic species such as tigers and orangutans.”(p175)

The fact is that all energy sources involved some type of environmental risk. But, intuitively difficult as this may be to grasp for some, more efficient conventional sources of energy and power may do less environmental damage than inefficient green alternatives.

6. Don’t worry about peak oil. Peak oil, according to Wikipedia, is “the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline.” Actually this definition has been tweaked to give it a geopolitical twist whereby the maximum rate of global extraction is partly a function of the fact that new petroleum reserves tend to reside in politically hostile and/or unstable countries. The peak oil concept derives from the work of M. King Hubbert who first put forth the concept in the 1950s.

Among experts there’s substantial controversy over how accurate this model is.  No matter. Reportedly there are “peak oil groupies” who spend their days worrying about the world running out of petroleum. Peak oil has become one more excuse for massive government subsidies for alternative green energy projects.

I’m not qualified to pass on the technical aspects of this except to say that in the past somehow technology and new discoveries have always shifted this peak outwards towards the future. As an economist, I’m not surprised. I remain convinced that, absent irrational constraints, a functioning free market in energy unencumbered by irrational constraints will solve any problem of petroleum supply constraints. Solutions include shifting to other economically viable energy sources. We’ve seen how technology has suddenly dramatically increased the supply of natural gas. We would see this with nuclear if rational regulations prevailed. And there is plenty of coal. The universe is filled with energy. We’re not going to run out. Higher prices for oil are a price signal for further oil exploration and technology improvements in petroleum extraction and for other energy sources. The decline in oil production in the United States is as much a function of political rather than geological constraints.

7. Increasing energy efficiency results in the use of more energy. This counter-intuitive notion was first advanced by British economist Stanley Jevons, one of the founders of neoclassical economics. In 1866 Jevons wrote:

“It is wholly a confusion of ideas to suppose that the economical use of fuel is equivalent to a diminished consumption. The very contrary is the truth.”

This idea is called the Jevons Paradox. Basically this is saying that efficiency makes energy is cheaper and when something is cheaper we use more of it.  Our economy and our prosperity depend on energy. More energy yields more prosperity, more energy efficiency yields cheaper energy, cheaper energy yields more demand for energy.

Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong

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