Thursday, November 20, 2008

Energy Security in the 21st Century

As the shock of $150/barrel oil and $4/gallon gasoline rippled throughout the economy, driving up food and commodity prices and slamming the brakes on growth, the issue of American reliance on foreign oil once again came to the forefront. UNLV’s Institute of Security Studies convened an Energy Security Roundtable – Reducing U.S. Dependence on Foreign Oil: Lessons From Abroad. The moderator was Major General (Ret.) Scott B. Smith, Executive Director of ISS, with distinguished panelists Dr. Jack Caravelli, Dr. Oliver Hemmers, Professor Phil Hutchinson, Professor Tatsuo Masuda and Dr. Dennis Pirages.

Caravelli quoted statistics revealing that while the US imported just 25-30% of its oil in the 1970’s that figure is now more than 2/3 - and the Department of Energy (DOE) estimates that the US will consume a third more energy in 2020 than today. This has become a national security issue as much of the world’s easily and cheaply extracted oil is controlled by unsavory regimes. Pirages expressed his support for the late Dr. M. King Hubbert’s Peak Oil Theory, which states essentially that worldwide oil production will reach its peak and begin to decline right about now. Even for those who don’t subscribe to this particular theory there is no doubt that the reserve of cheaply accessible oil is dwindling.

Price volatility is also a problem as evidenced by the recent extreme swings (from about $80/barrel up to nearly $150 and now back down below $60 in less than a year). As Pirages noted, this was the 3rd such swing in the last 35 years. Both Pirages and Caravelli observed that the consequences of low oil prices can be just as damaging as those of high prices. Low prices stifle development of alternative energy sources in oil-consuming countries and can severely harm the developing economies of oil producers. As Pirages put it, “Rising prices lead to hysteria; falling prices lead to apathy.”

But, if we are to reduce our dependence on oil, what is the solution? As Pirages said, “There is no magic bullet.” Each substitute for oil has drawbacks and tradeoffs associated with it. While the US has tremendous reserves of coal, it is a “very dirty fuel,” in Hutchinson’s words. He stated that burning coal emits toxics, irritants and CO2 and a coal plant produces more radioactivity than a nuclear plant. However, he noted that liquefaction can remove most of the carbon and toxins from coal and produce a fuel suitable for motor vehicles. Viable carbon sequestration, where the emissions of CO2 are captured and pumped underground, is still some years away.

Natural gas is another solution favored by some. It burns cleaner than gasoline but presents many of the same supply and environmental problems as oil. In many cases natural gas is found and must be extracted with oil. Pirages predicted that we will reach peak gas production approximately 10 years after peak oil.

A few nations around the world, notably France, have turned to nuclear. Some people consider it to be the most environmentally-friendly of all energy sources. But the US does not currently have a long-term solution to the problem of nuclear waste and there is a very vocal and activist segment strongly opposed to anything nuclear. It can take 15 years or longer to build a nuclear plant. In addition, since the US hasn’t built a new nuclear facility in more than 30 years, Hemmers revealed there has been a serious brain-drain in the industry.

So what of the renewables such as wind, solar, geothermal, hydrogen, biofuels? All of these are expensive and have other drawbacks as well. Developers of wind, solar and geothermal encounter distribution problems since these sources generally must be located far from the areas that need the energy. Hemmers asserted that there is not enough steel in the entire world to build all the wind turbines that would be needed to convert the US to wind power.

Solar requires huge amounts of land. According to my own back of the envelope calculations, solar panels consume about 600-800 times the land area that is needed for a coal or natural gas plant producing the same amount of power.

Hydrogen may not even be renewable. It can be extracted from natural gas, but the byproduct is methane, a greenhouse gas just like CO2. Hemmers conveyed optimism for long-term research using solar energy to extract hydrogen from water – if, that is, the funding remains in place. He expressed the frustration that long-term funding from DOE is not dependable – that the department has a tendency to cut support after a few years to projects that need many years to produce results. This impacts research in many areas, including biofuels.

Biofuels could be the long-term solution to the problem of fueling vehicles, but that day may be far in the future. Corn ethanol is the most common biofuel in the US but its use may have already reached its peak. Smith noted that it takes 30% of the US’s corn crop to produce 3% of its fuel. The market distortions caused by heavy corn ethanol subsidies produced a worldwide food crisis recently. Other biofuels may hold more promise. Hemmers is researching algae as a biofuel. It absorbs CO2 and grows faster and produces more energy per weight than other sources. Still, this option will require many more years of research to come to fruition.

Some have advanced battery-powered cars as a means of reducing our reliance on gasoline as a motor fuel. But battery technology is expensive and batteries do not produce energy; they merely store energy that has been produced elsewhere. Hemmers pointed out that if the US were to convert all of its automobiles to electric we would need the equivalent of 300 new nuclear power plants to generate the additional electricity required to power our cars.

Other nations have dealt with similar energy problems. Masuda, from Japan, and Hutchinson of the United Kingdom explained their nations’ experiences.

From 1962-72 Japanese economic growth averaged 10.3%. As it is a hydrocarbon resource poor nation, this growth was fueled by imported oil. The oil embargo of 1973 was crushing but it motivated the nation’s political leaders to devise a strategy to deal with energy security.

Japan’s approach consisted of “three dashes” as Masuda called them. The first was crisis management in response to the immediate emergency of the oil shock. Secondly, the government embarked on an enormous campaign of innovation to increase energy efficiency and conservation. The third was a movement to develop alternative sources of energy and they decided that nuclear power would be a large part of that.

Hutchinson described the UK’s approach as “a wonderful example of how not to do it.” Their policy consisted of “faith, hope and charity – faith in wind turbines,” despite there not being much wind in Britain; “hope that that the Russians don’t turn off the gas tap; and look to the French for charity should both of those happen.”

The UK currently relies on a very diverse mix of fuel sources – notably coal, oil, gas and nuclear – but are moving away from all of these sources. The current administration raised taxes on North Sea exploration, which forced oil producers to look elsewhere, further away. They will lose 20% of their current nuclear capacity in the next decade and there is no commitment to build any additional nukes. Even if there were, the UK does not have the engineers and scientists they would need. In order to reduce CO2 emissions they have decided to shut down coal plants and not replace them. Hutchinson predicted that the UK will begin suffering from the effects of a severe energy shortage within the next several years, at which point they will return to building coal plants.

The United States is faced with a potentially huge problem and limited experience to draw from. Pirages advocated a paradigm shift. He expressed his dismay at the lack of investment in alternative energy on the part of the private sector and the belief that the public sector must become more involved. He advocated for a program of stabilizing gas prices by instituting a floating tax that would adjust up and down to maintain pump prices at a certain minimum level and using the proceeds to fund development of renewable sources.

If the government does become more involved, which agency should administer such a campaign? According to Caravelli, the Department of Homeland Security is a behemoth that may not be able to handle another huge undertaking and the DOE has a limited track record of success in bringing projects to bear.

What is the answer? Energy independence is probably not a realistic, or even a desirable, goal. Caravelli declared “fossils will be with us for probably all of our lifetimes.” Masuda stated that purchasing oil from foreign countries allows us to maintain some level of influence with them. Renewable sources come with a variety of hurdles. The answer is: there is no easy answer, and I wouldn’t trust anyone who says otherwise.

Arthur Laffer at the NDA

I arrived at the Bellagio for the Nevada Development Authority’s annual luncheon not knowing exactly where the event was being held. After wandering around the lobby for a few minutes looking for a sign I noticed a man in a suit and a woman in a dress who appeared to know where they were going. I followed them and, lo and behold, ended up in the right place. The featured speaker was economist Dr. Arthur Laffer, an adviser to Ronald Reagan also known as the father of supply-side economics. He offered his thoughts on taxes, the economy and the current financial crisis.

Laffer proffered his theory that the origin of the current crisis had its roots in a blunder in monetary policy. The demand for money is based upon two factors: the level of transactions (people hold higher or lower levels of cash based upon their expected future purchases) and interest rates. He explained that real income peaked in 2003. From ’03-’07 the demand for money collapsed. The Federal Reserve reduced the rate of growth in the money supply (the “best thing” they could have done, according to Laffer) and interest rates increased during this period.

But, in mid-’07, the situation changed. The transaction demand for money expanded rapidly but the Fed continued to fight inflation. The Fed committed “an enormous mistake” by not allowing the supply of money to increase to meet demand. This caused a panic, which resulted in a collapse of the credit markets.

He listed a series of government responses to and revenue effects of the crisis that total to nearly $3 trillion – among them the $170B stimulus; $75B now as much as $150B for AIG; $300B additions to housing and farm bills; $200B for Fannie Mae and Freddie Mac; $700B financial system bailout; $300B proposed additional stimulus; and $300B revenue shortfall. Although its proponents are well-intentioned, government stimulus is folly, he explained, because “the income effects always net to zero of any government policy.” Worse, the overall effect is a net loss because of transaction costs, or “the toll for the troll”, as he described it. In other words, a package that provides $100B in stimulus actually costs $130B. His prescription for what government should do to mend our current economic woes: “do nothing.”

Laffer is most famous, and most controversial, for his views on tax policy. He invented the Laffer curve, which shows that at a certain (undefined) level increased tax rates result in decreased tax revenues.

He explained that in 1981 when the highest marginal income tax rate was 70% the top 1% of earners supplied 17.5% of the income tax revenue (or 1.5% of GDP). In 2007, with the highest rate at 36%, this same group accounted for 40% of income tax revenue (3.2% of GDP). One reason he submitted for this phenomenon is that those at the highest income levels can change the “timing, location and volume of their income.” He offered himself as one example. For what he does to generate income (lectures, TV appearances, writing) he can not only choose to work as much or as little as he desires, he can also live anywhere he wants. He chooses to live in a state, Tennessee, with no income tax, thus avoiding the income tax collectors of his boyhood home of California.

Laffer is a very controversial economist. Whatever one thinks of his work, however, he is a highly intelligent and talented person and a very entertaining speaker.