Long-Term Policies Needed to Address Energy Use and Price Volatility

Published by the Government Accountability Office on 1990-09-05.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                       United States General Accounting Ofhe     / y &c 1 y 0          “,_
For Release            Long-term  Policies Needed to Address
on Delivery            Energy Use.and Price Volatility
Expected at
10:00 a.m. EDT
September 5, 1990

                       Statement   of
                       Victor   S. Rezendes, Director,  Energy       Issues
                       Resources,   Community,  and Economic
                       Development    Division
                       Before the
                       Committee on Government      Operations
                       House of Representatives

    O/RCED- 90 - 105                                                  GAO Form 160 (121871
 Mr. Chairman and Members of the Committee:

      We appreciate  the opportunity     to be here today to assist the
 Committee in examining issues relating      to the oil price increases
 that have taken place following     Iraq's  invasion of Kuwait.

       As you are aware, Mr. Chairman, along with the gasoline price
 spike after the -on     Valdes oil spill  and the home heating fuel
 price increases last winter,   this makes the third sharp increase in
 the price of petroleum products that we have experienced in the
 past 18 months.   Although the United States is in a better position
 to deal with these price increases than in the 1970s because of
 increased energy efficiency   and the existence of the Strategic
 Petroleum Reserve (SPR), concerns remain about

      -- recent    trends   showing increasing      oil   consumption,

      --   increased   reliance   on imports     from the Persian     Gulf,   and

      --   the SPR's role    in reducing   the impact      of these   incidents.

         The nation needs to act immediately to address these trends
  over the long term.     There is an urgent need for this country to
  develop a national    energy strategy that would reduce our dependence
.on oil and our vulnerability      to sudden price increases.   We believe
  that such a strategy    is sorely needed and long overdue.    A fresh
  look at policies   for drawing down oil from the SPR is also needed
  to ensure that it is being used as effectively      as it can be to
  offset the severe economic impacts of petroleum price increases.
  Finally,   we need to reemphasize the need for energy efficiency      as a
 way to reduce oil consumption.          ,

      EVENTS DF,            THJj$
CCNT-    VQ&,&,TY        OF ENERGYPm

      The recent price volatility    of crude oil and gasoline is not
an isolated   event.   This is the third sharp increase  in consumer
prices of one or more petroleum products in the past 18 months.        I
would like to briefly    discuss, each of these events, beginning with
the current situation.

        Prices Reacted to th8
  aai Invasion of Kuwait

       Since Iraqi military      forces invaded Kuwait, the United States
has experienced sharp increases in crude oil and gasoline prices.
World reaction     to the invasion--particularly    the embargo on trade
with both countries       imposed by the United Nations Security Council
--has interrupted      crude oil imports by the United States and other
countries.     Collectively,     in 1989, Iraq and Kuwait produced an
average of 4.6 million       barrels of oil per day. This represented
about 7.8 percent of worldwide oil production.          In 1989, the United
States imported about 600,000 barrels of oil per day from Iraq and
Kuwait, or about 8.4 percent of net U.S. oil imports.

       The actual disruption    of supplies will not take place until
after the tankers that were already en route to the United States
have delivered    their cargoes--in   30 to 35 days.     However, increased
demand, perceptions     of shortages,   and expectations   of higher prices
resulted   almost immediately in increased prices for oil and
petroleum products.      Between August 1 and August 23 the price for
oil futures on the New York Mercantile       Exchange increased from $21
per barrel to almost $32 per barrel before falling         to about $27 on
August 27.

      In terms of the amount of oil disrupted, this disruption is
larger than the oil shocks of the 1970s. The 1973-74 and 1979
disruptions    amounted to 1.6 and 3.7 million        barrels per day (MMBD)
 (or about 3 and 6 percent of world oil production),          respectively.
The impact on crude prices,       thus far, however, has not been as
great as the impacts from the disruptions          in the 1970s. As a
result of the 1973-74 disruption,         crude prices went from
approximately    $10 a barrel    (in 1989 dollars)     to $30 a barrel.     The
1979 disruption    had a similar'impact,       and crude prices increased
from about $26 to the equivalent         of about $50 a barrel.

Gasoline Prices    SaLked After
the Alaskan Oil    SniJJ,,

       The second event occurred in March 1989, when sharp price
increases   occurred after the tanker Exxon VW             ran aground in
Alaskan waters.     After the Exxon Vala         grounded, transport      of
Alaskan North Slope crude oil was reduced from March 24 through
April 6 by about 13 million      barrels.      That is equivalent    to 18
hours of U.S. consumption.       However, the uncertainty       over Alaskan
supplies --about one-fourth     of U.S. production--translated         into
immediate short-term     increases in U.S. spot market prices for
crude oil of about $1 a barrel.          Spot market prices for gasoline
increased by 12 cents a gallon in New York and 50 cents a gallon on
the West Coast.     Nationwide,   retail    gasoline prices increased about
10 cents a gallon.      By August 1989, the price of crude oil and
gasoline dropped back to pre-crisis         levels.

Fuel Prices   Skvrocketed   Last Winter

      The third event occurred when the nation experienced sharp
increases in heating oil and propane prices last winter.             During
December 1989, the United States experienced severe cold weather,
the coldest in at least 60 years according to the Energy
Information    Administration  (EIA).      Many areas of the country,     and
the northeastern     states in particular,     were hit hard by the sharp
price increases for home heating oil and propane.           Nationally,    the
 average retail    price of No. 2 distillate    increased 29 percent
 between November 1989 and January 1990. Propane prices exhibited
 even more volatility.     Wholesale prices at Mont Belvieu, Texas, and
 Conway, Kansas --two major propane supply points through which a
 majority  of the U.S. domestic supply is marketed and distributed--
 increased 211 percent and 305 percent,      respectively,  between
 December 1, 1989, and January 2, 1990. In February 1990, the price
 of propane and heating oil fell back to the December 1 level.

       The current disruption   is affecting  not only prices for
petroleum products but the economy as a whole.. To illustrate       the
effect   of the increased gasoline prices,    for example, a survey
conducted by the American Automobile Association      showed that
between August 1 and August 10, average gasoline prices rose almost
18 cents per gallon.      Based on EIA's information  on gasoline
consumption, this means that consumers paid about $63 million       more
per day for gasoline on August 10 than on July 31.

        Increased oil prices also affect the costs of many other
 products.     Petroleum products provide much of the energy used in
 both industry     and agriculture.      Related petrochemical    products are
'used in paints,     plastics,    and synthetic    fibers.  Further,   if the
 higher fuel prices continue,        they could drive up the prices for
 many other products because nearly 90 percent of all consumer goods
  in the United States are transported          by truck.

        Some economic impacts are already being felt.      Within days,
several airlines     had announced fare increases or surcharges to
offset higher fuel costs.        As reported in the Wall Street Journgb,
a 1 cent per gallon increase in the price of jet fuel adds $160
million    to the industry's    annual expenses.   Because of weak demand,
however, the industry       may not be able to recover its increased
costs by increasing   fares, and some analysts       have forecast    deficits
of $1 billion  for the industry  this year.

       If the energy price increase is sustained,            it will present a
challenge to macroeconomic policy.             It is possible that the result
will be a deterioration         in economic performance in all of the major
directions--higher      inflation,-higher        unemployment, and lower
output.     According to various estimates,          a $5 increase in the price
of a barrel of oil could result in about a .5 to 1.0 percent
reduction     in the gross national       product,   in real terms.

        At least in the short term, policies    that would reduce the
inflation     hazards also increase the risks of output losses and
higher unemployment.      Because we are already in a slow growth
economy, some economists predict that the effects         of increased
energy prices will push the economy into a recession.           If a
downturn occurs and gathers momentum through increasing           pessimism
about future economic conditions,      the overall   costs to the economy
could far exceed the direct consequences of the oil price increase.
The Federal Reserve should, however, be able to mitigate            this sort
of outcome by easing monetary policy at the appropriate           time.
Other targeted policies,      such as energy assistance to lower income
families    affected  by higher energy prices,   may also need to be


       Fortunately,    Mr. Chairman, the United States is better
prepared to respond to the disruption       of oil supplies from Iraq and
Kuwait than we were to the events in the 1970s. Over the past
decade, we have taken a number of steps to improve our energy
security,    including   decreasing our oil consumption and building   the
SPR. In addition,       according to EIA data, there is about 5 MMBDof
excess production      capacity in the world oil market.    This spare
                                      5                      -.           *.
capacity,     if brought on-line,   could help compensate for   the oil
supplies    that are disrupted.

       Unfortunately,      however, many of the gains that we have made
over the past decade are beginning to erode.          For example, oil
consumption in the United States and in other Organization           for
Economic Cooperation and Development (OECD) countries         has generally
been increasing       throughout the latter   part of the 1980s. Further,
the rate of increase has been higher in the United States than the
OECD average.       After falling    to an average of below 34 MMBDin 1983
following    the disruptions      of the 19708, OECD oil consumption
increased to more than 37 MMBDin 1989 (a 11-percent increase).
U.S. oil consumption has increased by almost 14 percent during the
same period-- from about 15.2 MMBDin 1983 to 17.3 MMBD in 1989.

      If  oil prices return to their pre-disruption   levels,   the
global trend toward increased oil consumption is expected to
continue at least throughout the rest of this decade, especially       in
the economies of the Far East that are growing rapidly.       For
instance,    the Department of Energy (DOE) projects  that worldwide
oil consumption is expected to increase by approximately      1 to 2
percent per year in the early 1990s. If oil prices remain higher,
the expected increased consumption should decline.       Regardless of
the rate of increase,    however, petroleum will continue to provide
about 40 percent of the United States t total energy consumption for
some years to come.


      If demand for oil by the United States and other petroleum
importers continues to rise, it will increase their dependence on
the Organization   of Petroleum Exporting Countries  (OPEC),
especially  on the countries   in the Persian Gulf. In 1989, OPEC
supplied 73 percent of the oil imported by OECD countries,    the
 highest percentage in 5 years.   The Persian Gulf nations alone
 accounted for 45 percent of total OECD oil imports.    The United
 States' dependence on OPEC and the Persian Gulf nations has
 increased even more dramatically  than has OECD's in general.     In
 1989, OPEC supplied nearly 60 percent of the total oil imported by
 the United States, as compared to just 42 percent 5 years earlier.
 Moreover, U.S. dependence on the Persian Gulf oil more than tripled
 from just 7 percent of total dil imports in 1985 to 26 percent in
 1989. Thus, the oil produced by Persian Gulf nations accounted for
 about 11 percent of the total U.S. consumption in 1989, compared to
 only 2 percent in 1985.

       The Persian Gulf holds both the largest proven oil reserves
 and the highest surplus production     capacity in the world.     About 63
 percent of the world's proven reserves are located in five Persian
 Gulf countries:     Saudi Arabia, Kuwait, Iran, Iraq, and the United
 Arab Emirates.    In contrast,   the United States, the worldls largest
 consumer of oil, has only about 3 percent (27 billion      barrels)   of
 the world's proven reserves.

        Excess production   capacity is also heavily concentrated   in
  Persian Gulf countries.     According to EIA statistics,   about 76
  percent of the world's excess production      capacity of 5.0 MMBDis
  located in Persian Gulf countries     (with about 26 percent in Iraq
. and Kuwait).     Less than 10 percent of this capacity is located
  outside of OPEC. Excess production      capacity outside of OPEC is
  expected to decline from 500,000 barrels per day to 200,000 barrels
  per day between 1990 and 1995.


        Iraq's invasion of Kuwait again raised the issue of whether
 the SPR should be used to offset the current supply disruption's
 effect* on the economy. The SPR, authorized   by the Energy Policy
and Conservation Act (Public Law 94-163, Dec. 22, 1975), as
amended, represents the nation's     first line of defense in an oil
supply disruption.     The Secretary is authorized   to draw down the
SPR after the President determines that it is required by a "severe
energy supply interruption.@11     This is defined in the authorizing
legislation   as a national  energy supply shortage that

              is, or is likely to be, of significant    scope and duration,
              and of an emergency nature:

              may cause major adverse   impact on national   safety   or the
              national economy: and

              results,  or is likely to result,   from an interruption  in
              the supply of imported petroleum    products,  or from sabotage
              or an act of God.

       AS of August 1990, approximately 590 million barrels of oil
are contained in the SPR. The oil can be drawn down and
distributed   at a maximum rate of 3.5 MMBDfor 90 days.    After that
time, the rate will decrease as the caverns holding the SPR oil
empty. At the maximum rate, the bulk of the oil in the SPR would
be drawn down within 200 days.

      In 1984, the Secretary of Energy announced a policy of early
and rapid drawdown of the SPR during a major oil disruption.     This
replaced DOE's previous position   that the SPR would be used only as
a last resort.    The Secretary of Energy subsequently testified
before the Environment,   Energy, and Natural Resources subcommittee
of this Committee that early and rapid drawdown of the SPR will

1The legislation       also authorizes    the use of the SPR if needed to
meetbthe United       States' obligations    under the International Energy
                                        8                    "
      "greater  and more immediate protection against possible              price
      impacts than any other single action that the federal
      government can take."

      The desirability     of drawing down the SPR early was further
emphasized in the February 2, 1990, report on an interagency           study
on the future size of the SPR. One of the factors considered was
the uncertainty      about using the SPR early when a supply disruption
might increase in severity        after much of the SPR had been drawn
down. The report noted that several studies indicate            that V1across
a large range of probabilities         of how events might play out . . .
early use of the SPR in a major interruption         represents    a
consistently    efficient   strategy."

       As you are aware, Mr. Chairman, the President decided not to
authorize    drawing down the SPR to offset the impact of the supply
disruption     resulting    from Iraq's invasion of Kuwait. The reported
basis for this decision was that (1) an actual shortage in supplies
of crude oil had not developed and (2) the increases in price were
not sufficient      to justify   use of the SPR.

        It is difficult   for us to evaluate the         President's    decision
without knowing all of the facts upon which              the decision was
based, such as the likelihood      that hostilities           would lead to
further    disruptions.    However, the decision         does raise some long-
term policy issues regarding the severity           of     disruption   that would
trigger    the SPR's use.

       Since 1975, when the Energy Policy and Conservation Act was
passed, the world oil market has changed and prices have
potentially     become more volatile.   The price of oil,  for example,
is now generally      based on the spot market price at the time of
delivery    in the United States, rather than at the time of loading.
Further,    since the prices set by these markets reflect     buyers' and
sellers'    perceptions   of shortages and other market changes, as well
as actual supply and demand, even small supply interruptions              may
trigger  price increases such as we have seen recently.

        As the administration's     February 1990 report noted, early use
of the SPR can help offset the effects           of oil crises that are
 fueled by panic-driven       demand. However, in a 1985 report,         we noted
that many experts were skeptical          about the government's ability       to
use the SPR early because of the difficulty            of collecting   and
intewreting      the information    needed and the tendency to delay
decision making to keep options open as long as possible.2                A
suggestion to overcome these problems was the adoption of
procedures that would result        in the automatic release of oil from
the SPR when a chosen market indicator,           such as the world oil
price,    shows an oil disruption     to be serious.      ,One procedure
suggested to accomplish this was the sale, by competitive              bidding,
of options to buy oil from the SPR at an administratively              set
"strike    price II during a predetermined     future time period.       The
strike    price would be a composite price of oil on the world market
that, in the government's view, is high enough to warrant the
release of oil from the SPR. The purchase of these options would
be a way for the oil companies to self-insure            against sudden
increases in the price of oil.          If the market price would rise
above the strike price, the holders of options could exercise their
options to purchase oil from the SPR at the strike price.

      Our report noted that there were a number of technical
obstacles that would have to be overcome before such a program
could be implemented.     The obstacles included determining  the
appropriate   strike price at which the oil would be sold, the
period during which the options could be exercised,     the portion of
the SPR that would be sold this way, and the administrative       process
for selling  the options.

         .     of the Denartment of Enerav's Plan t Sell Oil From the
Str$ea=      Petroleum Reserve (GAO/RCED-85-80, Junz 5, 1985).
        The time is also ripe for consideration       of other steps to
address our energy dependency over the long term.               We support the
initiative     to develop a national    energy strategy     and believe that
such a strategy      is sorely needed and long overdue.          The need is
evidenced by the trends toward increased energy consumption in the
United States      and the related concerns for the reliability          of
energy supplies and environmental        protection.    Timely completion of
the strategy     is important because the electric      utility     industry,
the automotive industry,       and others in the energy sector will be
making decisions       about what technologies    and energy sources to

      We also believe actions are needed to encourage improvements
in energy efficiency    to reduce U.S. dependence on oil and its
vulnerability   to potential   oil supply disruptions.    Significant
gains in energy efficiency,     largely  attributable  to new
technologies,   have been achieved in the United States since 1972,
but continued progress is not certain.

       A June 1990 study by the Office of Technology Assessment (OTA)
reports that without the energy savings achieved between 1972 and
1985, the U.S. economy would have needed 20 percent more energy in
1985 to produce its output.    However, OTA also reported that the
1%year trend of gains in energy efficiency     was broken between 1985
and 1988 when energy use increased by 8 percent.

        DOE's conservation   research and development (R&D) program has
contributed    to the technology base that brought about improvements
in national    energy efficiency    in the 1970s and early 1980s. The
program's R&D successes include advances in fluorescent       lights,
windows, and industrial      processes that are enhancing energy
efficiency.      However, funding for the program has declined
significantly       in the past decade, reflecting     a change in federal
policies      regarding R&D. The program sustained a %-percent           funding
cut between 1980 and 1982, from $346 million           to $152 million.3      In
real terms, funding since 1982 has remained at about 50 percent or
less of the level in 1980 even though the Congress has generally
appropriated       about twice the amounts requested by the
administration        in recent years.    In January 1990, the Secretary of
Energy said the Department will give increased priority             to DOE's
conservation       program.    However, the fiscal   year 1991 budget request
would reduce funding for the conservation           R&D program by about 9
percent compared to the 1990 appropriation.            Congress has not yet
passed the 1991 appropriations         for this program.

      We have recommended changes to DOE's planning process for
conservation  R&D program that we believe would provide executive
branch and congressional  decision makers with better information
upon which to base future funding recommendations and decisions.


      In conclusion,  the nation's    ability  to protect  itself  from
and mitigate   the impact of rapid increases in energy prices remains
a matter of major concern.     Although the country is better prepared
to deal with energy crises than it was in the .1970s--because of the
increase in energy efficiency      and the existence of strategic
reserves to replace lost supplies--concerns        remain about the

     --   recent   trends   showing increasing      oil   consumption,

     --   increased    reliance   on imports     from the Persian     Gulf,   and

     --   SPR's role    in reducing   the impact     of these    incidents.

3Amounts are expressed       in 1982 constant      dollars;   years   cited   are
fiscal years.
A national energy strategy that     specifically   addresses   these
concerns is sorely needed.

     This concludes my statement.        I would be pleased    to respond to
any questions you may have.