All Commentary
Thursday, May 1, 1980

The Economics of Energy

David P. Hunt is vice president of The East Ohio Gas Company, part of The Consolidated Natural Gas System.

This article is reprinted from the Winter, 1980 issue of Strategy, a news journal of Case Western Reserve University’s School of Management alumni.

Two years ago much of the United States experienced a natural gas shortage of emergency proportions; today, there is a surplus of natural gas. What happened to turn a shortage into a surplus so quickly? What similarities are there between the natural gas shortage and today’s gasoline shortages?

There has been little change in basic natural resources in the last two years to explain the shift from shortage to surplus. New discoveries of natural gas still fall short of annual production. The ratio of proven reserves to production is still declining as the carrying cost of this 10-year inventory rises. But the much publicized decline in annual production has halted and seems poised to turn upward. Geologists now estimate that at today’s prices the U.S. probably has another 50 year’s reserves that could be economically produced if wells are drilled. World-wide potential gas reserves are now at least 200 times the world’s annual consumption. And these figures don’t count gas from coal, gas from shale, or gas from other technologically feasible alternatives that can supplement conventional natural gas supplies.

The reason for the natural gas shortage was not a lack of natural resources but the lack of an economic policy permitting the development of these resources. Why was the U.S. the only country in the world to experience a natural gas shortage?

Federal ceiling prices on natural gas production sold across state lines were first established in 1954. For almost 15 years the ceiling prices remained nearly constant while inflation eroded the number of new wells that could be drilled with the revenue stream from past drilling investments. By 1968 interstate price ceilings were too low to attract new capital investment for drilling ventures, and over half of the independent producers in the U.S. had gone out of business. Natural gas distributors in consuming states such as Ohio, which obtains 90 per cent of its gas from out of state, found that they were no longer able to contract for new interstate supplies to meet growing market demands stimulated by low prices relative to alternate fuels. What followed was the destruction of market equilibrium that could have been predicted by any economist.

While consumers can change their energy consumption patterns significantly in the long run, the demand for energy, and each specific form of energy, is rather inelastic in the short run. Consumers can switch fuels or reduce consumption only if they make the capital investment to replace or modify their existing appliances, buildings, industrial processing equipment or vehicles. There are also three to five years lead times between investment decisions and the development of energy resources. In the severe natural gas shortage of the winter of 1977, supply fell short of demand by only 3 per cent and yet the impact was felt by almost everyone. Likewise, the recent gasoline shortage is the result of a very small supply/demand imbalance relative to the total market.

The Market at Work

The natural gas shortage would have been far more severe and still exist today were it not for the fact that market forces eventually provide the incentive to circumvent government controls. For example, blocked from interstate sources of gas in 1969, The East Ohio Gas Company turned to two other sources not subject to federal regulation: Ohio intrastate resources and the world market.

Company management recognized the need for a short-term supply to fill in the gap until gas could be obtained from the world market or until U.S. policy would again en courage gas production for interstate sales. For that vital interim supply, the Company turned to the previously marginally economic Ohio gas fields. The unregulated price paid to small independent Ohio producers was doubled, then tripled, and within several years Ohio production tripled also. The share of market met with Ohio gas increased from 5 per cent to 15 per cent in three years.

As vital as the Ohio gas has been in minimizing shortages, it must still be kept in perspective. It is not the long-term solution to Ohio’s energy problems. All of the gas be lieved to be in Ohio could meet the needs of Ohio consumers for only two years.

For a longer-term solution, East Ohio Gas, as part of the Consolidated Natural Gas System, signed a 25-year contract in 1970 to bring liquefied natural gas by tanker from Algeria. After years of government red tape and $2 billion of construction, LNG deliveries began in 1978. LNG will increase supplies by 15 per cent and satisfy market growth for the next ten years.

In the meantime, federal policy on natural gas has become more realistic. Interstate price ceilings have been increased in real dollar terms beginning in 1975 and the Natural Gas Policy Act of 1978 established interim price ceilings leading to complete decontrol by 1985. The stage is now set for free market forces to do what federal regulation has been unable to do: to balance supply and demand at the lowest reasonable price.

Despite an eightfold increase in the wellhead prices of new sources of gas in the last ten years, natural gas is still the bargain energy. Natural gas distributors have moderated much of this increase by blending the new supplies with lower cost supplies under older contracts. For the customers of The East Ohio Gas Company, rates have just doubled in the last ten years—a pace only slightly exceeding the general inflation rate. Natural gas is still only two-thirds the cost of home heating oil or coal and one-fourth the cost of electricity.

Higher prices have already begun to dampen demand and increase drilling. Conservation, primarily in response to increased cost, has reduced residential use per customer by 15 per cent since October 1973, and gas well completions are on the rise again—proof again that energy shortages are more the result of economic policy than the availability of natural resources.