Schlesinger, Energy and Iran Jude Wanniski March, 1979

Executive Summary: Revolution and the shutdown of oil production in Iran invites widespread speculation on whether 1979 will see a replay of the 1973-74 "energy crisis." Sooner or later, Iranian oil will flow again into world markets, as the new government develops a thirst for petrocash. The more serious energy problem, which is temporarily obscured by Iran, is the energy policy of the Carter administration, particularly the shortsighted economic solutions of Department of Energy Secretary James R. Schlesinger. Three major Schlesinger errors -- on natural gas regulation, Mexican energy relationships, and crude-oil pricing -- are cumulatively several times more destructive to the future of domestic energy supplies than the impact of Iran. A positive note: the U.S. people, politicians, and press corps are now more schooled and sophisticated on energy issues than they were in 1973-74, thus less likely to push for hysterical policy actions that would precipitate a genuine crisis atmosphere.

Schlesinger, Energy and Iran

There is in the petroleum industry a bitterly amusing joke told about Energy Secretary James R. Schlesinger, who has a Harvard PhD. in Economics and at one time taught the subject at the University of Virginia. Two of his students went into business upon graduation, the story goes, buying up firewood in the Virginia farm country and trucking it to the District of Columbia, where there are many fireplaces and a big demand for firewood. The students found they had to pay $60 per cord for the wood, and they could sell all they could manage at $55-per cord. As their business boomed, the lads found themselves working feverishly, nights and weekends, to meet demand. They were thus perplexed when their bank reported their working capital had been depleted and their truck repossessed. They went anxiously to Professor Schlesinger and asked where they had gone wrong. Dr. Schlesinger puffed on his pipe-a long moment before replying, "You should have bought a bigger truck."

The story accurately reflects Schlesinger's approach to national energy policy, which rests on the bizarre notion that economic benefits can be obtained by requiring energy producers to sell product below marginal costs (replacement costs). With political, economic and financial analysts now all pondering the situation in Iran — the most visible source of U.S. energy difficulties, scarcely any attention is being devoted to the more serious difficulties that have been arranged behind Professor Schlesinger's cloud of pipe smoke. After all, the Iranian difficulties are already in the process of being sorted out. Iranian oil will again be flowing into world markets, sooner rather than later, as the new government discovers myriad uses for petrocash. The damage being done to the U.S. economy by Carter Administration energy policies are less visible and less dramatic, but accumulations occur at a steady pace in a way that will have lasting negative impact. In a way, the most serious effect of the Iranian turbulence is the ready excuse it gives to U.S. policy-makers to obscure their own errors, which are now conveniently swept under this Persian rug.

The enormous damage that the Natural Gas Policy Act of 1978 will do during its existence is already demonstrable. The Carter veto of the Mexican gas deal, on Schlesinger's advice, played into the hands of those in Mexico who want to develop the nation's energy abundance at a leisurely pace. And Schlesinger, and others in the administration, are now using Iran as an excuse to continue indefinitely domestic crude-oil price controls instead of ending them or phasing them out, in accordance with the 1975 energy act, beginning June 1. Each of these errors will do more cumulative damage to the U.S. economy than the temporary disruption of Iranian oil supply. Together, they have colossal effects on the future of energy supplies to the U.S. economy and somehow must be reversed.

Taking the last error first: There is now only negligible chance that President Carter will do anything at all to begin lifting crude-oil price controls after May 31, the date on which the legislated requirement of such controls expires and is replaced with discretionary authority. The petroleum industry, at least the segment that wants decontrol, has been pinning its hopes for action on President Carter's Bonn commitment. In Bonn last summer, the President pledged to Western European heads of state that he would permit U.S. petroleum prices to rise to world levels by 1980. Of the roughly 8 million barrels a day of domestic crude production, about 3 million B/D are held down by price controls at $5.25 per barrel. The other production is priced at different tiers. Those domestic refiners who are given "entitlements" to this low-price crude are, understandably, not anxious to see an end to these subsidies. The industry thus remains politically divided on the question.

As a result of the domestic controls, the disparity between total costs of imported crude and domestic crude continues to grow. In 1978, U.S. producers were paid $28.5 billion for delivery of 8,680,000 B/D on average while foreign producers were paid $45 billion for 8,275,000 B/D on average. The administration views the dollar differential as a current gain to consumers that would, with decontrol, become a "windfall" to producers. Producers see the difference as gross pre-tax cash flow (of which between 50 percent and 60 percent is captured by federal, state and local governments in increased tax revenues), a cash flow necessary to find and develop the domestic crude now being depleted. Independent producers, who drill 90 percent of the "wildcat" wells in the U.S., estimate that a phased decontrol between May 31, 1979 and Oct.31, 1981, when the President's discretionary authority expires, would result in an additional 400,000 B/D of domestic crude production in 1981 — with 1 billion bbl. added to reserves. The cash flow increment from this increased domestic supply, rolled over into further exploration, would add 2 million B/D by 1985 and add 5 billion bbl. to reserves. 

There is probably nobody in the Carter administration who understands the benefits that would flow to the economy from decontrol than Alfred Kahn, director of the Council on Wage and Price Stability. In the January-February issue of Regulation magazine, Kahn argues for decontrol:

On the question of energy prices and food prices, I agree that the solution is not mandatory price control or any kind of price control. To the extent that prices would be set below some sort of equilibrium point, we would simply be concealing from consumers what the real marginal costs of those supplies are — and that way lies disaster.... There are millions of things that can be done. But the thing that should not be done is to try to use rigid controls to hold down the price of oil when the incremental cost to the U.S. economy is $14 a barrel.

On February 8, however, Alfred Kahn met with President Carter, discussed Iran, inflation and the national Teamster contract and emerged with a Harvard, as opposed to Chicago, viewpoint. Instead of controls leading to disaster, now decontrol "would be seriously inflationary" and this is "simply not the time for deregulation of oil." Kahn perhaps believes there's no chance anyway of getting oil decontrol, so why not subordinate that idea to his central objective these days, getting the Teamsters to hew to the 7 per cent wage guidelines. In the same issue of Regulation by the way, Professor Kahn insists that while holding the price of energy below its marginal cost will produce "shortages," it is feasible to hold the price of Teamsters below market demand and not see a decline in the supply of Teamsters. The law of supply and demand works for things, not people, which suggests that Kahn is only halfway to the Schlesinger view of the marketplace.

In addition to the President's attempt to hold prices down by holding wages down (even as domestic and international monetary policies force prices up), there is a White House political calculation in crude-oil pricing. Carter political strategists have more or less written off Texas and Louisiana in 1980, both Carter states in 1976, especially after the Texas gubernatorial victory of William Clements. (Clements, incidentally, served as Undersecretary to Schlesinger when Schlesinger was Defense Secretary in the Ford Administration, and came to know and despise him.) To offset these electoral losses, Carter will have to pick up states he lost in 1976, states that are consumers of oil and gas. Schlesinger will "keep the price of their firewood down." The Carter politicos seem to ignore the opinion polls that indicate the public by wide margins (65 percent) favor energy price decontrol as a means of encouraging domestic energy exploration and production. The man in the street, who did not study at Harvard, knows supply is more important than price when homes must be heated and industries fueled. The President's decision to play along with Schlesinger will cost the U.S. in 1981 400,000 B/D in lost production every day of the year. The Iranian shortfall, by contrast will come to roughly 500,000 B/D in the U.S. during the period of interruption.

*****

The problems Schlesinger has created with Mexico are at least as severe in terms of impact on future U.S. energy supply. Mexico has vast oil and gas reserves, oil reserves at least as great as Saudi Arabia's. It is in U.S. interests to have Mexico produce and market their reserves at an ambitious pace in the 1980s, but the problem is that many Mexicans want development to proceed at a leisurely pace, fearing the squandering of oil revenues. Clearly the U.S. should have encouraged the gas deal Mexico last year struck with five private U.S. firms, committing gas that is otherwise flaring in its giant northern gas field to the firms at $2.60 per thousand cubic feet (Mcf). Because he was in the process of pushing his energy bill through Congress, a bill that permits U.S. gas producers no more than a maximum of roughly $2.10, Schlesinger talked the President into vetoing the Mexican deal. His public excuse was that Canada was selling gas into the United States at $2.16 per Mcf, and if Mexico got $2.60 the Canadians would want more. This, too, was nonsense, for the Canadians at $2.16 were charging all the traffic would bear in the markets near their gas. At $2.60 per Mcf., the Mexican gas is the equivalent of $14.04 per barrel of crude, roughly the world price. Meanwhile, Northeastern utilities are forced to pay the equivalent of $18 per barrel of synthetic gas and $25 per barrel of imported liquified gas in order to meet peak gas demands.

Even congressional liberals were baffled by Schlesinger's Mexico strategy. Senator Javits of New York in January told Schlesinger at a meeting of the Joint Economic Committee that he was "materially poisoning the atmosphere with Mexico." Senator Kennedy of Massachusetts accused Schlesinger at the same JEC meeting of tailoring prices to justify construction of a multi-billion dollar gas pipeline from Alaska to the Midwest, at taxpayer expense. Schlesinger told Javits he would rather use American (Alaskan) gas than Canadian or Mexican gas, and that Mexico was not planning to boost production beyond 2.2 million B/D in the next few years anyway. He told Kennedy that the Alaska pipeline would be a "bargain in the long run" even if there is no more gas in Alaska — a natural spinoff of his bigger-firewood truck theory.

President Carter's visit to Mexico in mid-February may have taken the edge off the hostility Schlesinger generated South of the Border, but that's all it could do. In effect, Schlesinger strengthened the hands of the most conservative elements in Mexico vis-a-vis energy policy. The correct economic course for Mexico is to develop its resources ambitiously, and to use oil revenues to offset domestic taxation on the people of Mexico so that they might become competitive in industrial markets. Instead, Mexico is being pushed toward government-directed industrial use of its oil and gas. The inefficiency of this route will impede Mexico's development even as the U.S. economy loses prospective energy supplies in the 1980s. Schlesinger could not have done worse if he planned to.

*****

Schlesinger's supreme achievement as DOE Secretary thusfar is his muscling of the Natural Gas Policy Act through Congress in October of 1978. At the time, we argued that the 100-point drop in the Dow Jones Industrials in the week following the narrow passage of the act on Oct. 24 in significant part reflected the market's awareness of the destructiveness of the Act to future U.S. energy supplies. Once again, Schlesinger acted to attempt solution of an immediate problem at the expense of the future. The one thing the act got him that he really wanted was control of the intrastate gas market at a time when surplus gas had built up in that market. The surplus had developed in large part because of an earlier short-run Schlesinger "fix," pushing northern industrial users of natural gas to coal conversion. There too, the market did not respond according to his vision, as industrial users pushed out of gas went into imported oil. Now, even with government control of the intrastate gas market, the surplus of gas or "bubble" persists, and Schlesinger is now in the position of pleading with industrial users to switch back to gas to no avail. A big reason is the incremental pricing provision of the 1978 Act, which loads marginal costs of new gas onto industrial users relative to residential users. This, too, pushes industrial users -away from gas toward imported oil. "Schlesinger," says an executive of a middle-sized oil company, "is cursed with cleverness."

If gas is to be found for use in the 1980s, the search must be underway today. And it will not be the big companies that search for it. The 10,000 independents are the people who do 90 percent of the exploratory drilling, and as a result of the Act's regulatory burdens, the independents are pulling away from exploration just as they had said they would have to. The pricing provisions of the 1978 Act are so complex, and the penalties for violation of them are severe enough that wildcatters may not know for years whether wells drilled today are legal or will turn into legal liabilities.

In the February 12, 1979 Fortune, the horrors of the Act are detailed in an article "A Bad Start on Gas Deregulation."

How (the government) will separate the abuses, from the simple mistakes is the question troubling gas producers, One Texan said he was thinking of making someone already in prison an officer of his company so that he can sign the filings. "That way, the government won't have to spend money to put him in jail, and I can try to find oil and gas rather than marker wells."

The result has been a steady decline in exploration. Hughes Tool Co. issues a weekly report on the number of rotary drilling rigs active in the United States. The week Schlesinger's energy bill passed last October there were 2,385 rigs active. Traditionally, the number of rigs active increases in November and December of each year as wildcatters push unutilized cash into the calendar year for tax purposes. Not last year. The number of rigs active has been steadily declining since October, and by the first week of February the number was down to 2,094. For the first time in the memory of the oldest oilmen there were inactive rigs stacked in Oklahoma during a November month.

*****

As far as we can tell, Secretary Schlesinger had nothing to do with the shutdown of the Iranian oilfields. But he shows every sign of using Iran into the future to explain away the accumulating problems caused by his present and past domestic policies. Iran is even blamed for the weakness of the U.S. dollar in foreign exchange markets, although it is inconceivable how the dollar could be weak against the yen and Deutschemark when Iranian oil as a percent of total U.S. consumption is 4.3 percent, but 16.3 percent of Japan's consumption and 11 percent of Germany's. Schlesinger will now press gasoline rationing and mandatory allocations if, by April 1, prospects of renewed flows of Iranian crude are not in sight.

Even with this worst-case scenario, no Iranian oil in 1979, world and U.S. markets could adjust short of rationing if prices and allocations were permitted to move freely. In such a market, industry experts believe OPEC would take up perhaps 3,000,000 B/D of the Iranian shortfall of 5,000,000 B/D, that non-OPEC producers would close some more of the gap, and that higher prices would take down world demand from the other side of the equation. The United States could shift marginally toward more natural gas and less imported oil. It could increase Elk Hills production. And it could halt injection of 400,000 B/D into the strategic petroleum reserves — a program that has been proceeding with scandalous inefficiency under the direction of Secretary Schlesinger; no technical provision has thusfar been made to draw injected oil out of the reserves, for example.

The chances of this worst-case scenario developing are minimal, however. When the smoke clears in Tehran, the new government will be exporting oil again, both to service its $8 billion in foreign debt and to buoy the economy after months of disruption and destruction. The new government, though, will play hardball in negotiating down the size of the foreign debt, attempting to peel away those loans that went into the Shah's personal treasury. Ayatollah Khomeini's designated prime minister, Mehdi Bazargan, has already announced (Feb. 17) that Iran intends to resume oil exports "to all parts of the world" as soon as possible. And even if this government cannot maintain control, almost any conceivable successor will likely develop a similar thirst for oil revenues.

* * * * *

How can there be grounds for optimism in financial markets as the energy problem is pondered, especially given the fact that James Schlesinger continues to freely stalk the streets and corridors of Washington? The biggest difference between 1979 and 1973-74, when panic was in the air over the OPEC embargo, is the experience of the American citizenry. It has been through it once before, and the people, the politicians and especially the press corps have been reasonably schooled on energy issues. There is now a striking measure of calm and sophistication in the mass media reportage of these issues, contrasting with the hysterical conspiracy theories of 1973-74. President Carter and Treasury Secretary Blumenthal seem to have their wits about them as well, viewing the situation with less alarm than the energy boss. Perhaps Schlesinger can be contained, after all. Even if he is, though, the energy supply problems of his creation will take years to unravel, a job not likely to be tackled by the man who gave Schlesinger his position.