As some of you may have noticed, energy prices dropped a whopping 5.6 percent in July, the steepest decline since April 1986. Gasoline prices dropped an even more stunning 11 percent. Energy gluts and declining profit margins are causing investors to freeze or even cancel energy infrastructure projects that looked so promising but a few months ago.
Forgive us if we gloat, but we told you so. There is not and never was an energy “crisis.” Supplies were not and are not running dry. Markets were not and are not broken. Regulations have not strangled the industry.
What happened then? First, the economy slowed down. Second, political and ideological gridlock prevented politicians and regulators from doing much harm while the markets did that supply and demand voodoo that they do so well.
Now for the details.
On the electricity front, the western power crisis was sparked primarily by a massive increase in natural gas prices. That increase, in turn, was triggered by a drought (which reduced the output from dams and thus increased the demand on gas‐fired generators), unseasonable weather (increasing home cooling and then home heating demand), historically low levels of natural gas inventories (50 percent below the five‐year average in February 2001), and bottlenecks in the pipeline system that kept gas suppliers from meeting local demand.
This summer, natural‐gas prices have returned almost to pre‐crisis levels which have, in turn, reduced electricity prices almost to pre‐crisis levels. One reason that supplies are ample is because natural gas inventories are now higher than usual. In fact, the scarcity last winter was somewhat due to the competition between summertime demand — buyers looking to stockpile natural gas to replenish inventories — and then‐and‐now wintertime demand. Summertime demand “won.”
Another reason that natural gas supplies are robust is because North American production is up … even without access to additional federal lands. U.S. domestic production has increased about 4 percent over a year ago while Canadian production is up 8 percent, which may not sound like a lot to you but those are big numbers in the energy industry.
A secondary cause of the power crisis was the large number of gas‐fired generators that were down for repairs last winter. As much as a third of the state’s generating capacity was offline at any given time during the worst of the crisis. The maintenance backlog from last summer is now over and a large amount of generating capacity has returned to the market.
Most newspaper stories tell us that an important reason for the spectacular electricity price drop is a spectacular drop in demand. True: Electricity use in the areas served by the California Independent System Operator is 4.4 percent lower through July 2001 than the first 7 months of 2000. These newspaper stories then go on to tell us that one of the main reasons for the drop in demand has been unseasonably cool weather. False: If you examine the number of “cooling degree days” in California (the difference between the average daily temperature and 65 degrees) and weight those figures by population, you’ll find that temperatures through July 2001 where most Californians live are actually 14 percent warmer than last year.
The drop in electricity demand is actually something of a mystery. Some of it is almost certainly due to the retail electricity price increases imposed in California this summer, but some of it is also probably due to the crisis mentality that has gripped the state. Once Californians accepted that the scarcity was real and that it could get even worse, conservation kicked in beyond what prices alone might have delivered. And some of it can be attributed to the slowing economy and the slumping dot.com sector in particular. No one knows, however, exactly how much each of these events contributed to the drop in demand.
The gasoline story is, however, a lot simpler. The widespread warnings of $3 a gallon gasoline were about what might happen if a key refinery or two blew up or if a key pipeline or two ruptured unexpectedly. Such things are indeed possible (in fact, a fire on August 14 at a Citgo refinery in Lemont, Illinois has increased Midwestern gasoline prices by 26 cents per gallon in the last two weeks), but they don’t happen all the time. And they didn’t happen in large part this summer. Unfortunately, most people missed the qualifications in the midst of the panic and braced themselves for a storm that was never sited in the first place.
When gasoline prices went up this spring, people bought less gasoline. And while it’s true that no new refinery has been built in the United States in about 30 years, there’s still room to increase production from existing refineries when profit opportunities present themselves … as they did (for a change) this summer. Moreover, foreign refineries for the first time in memory found it profitable to produce significant amounts of America gasoline for export. And what do you know; prices have been dropping steadily since Memorial Day.
The moral of the story is that markets aren’t “broke” when prices spike. They’re working fine; they’re just not delivering news that consumers or politicians are wild about hearing. But no matter how unpleasant price spikes are in the short term, they’re absolutely necessary to remedy the underlying economic problems. For those of you who either forgot your introductory economics or have simply spent too much time reading the op‐ed pages (a practice which can dull the mind), here’s how it generally works. On the supply side, high prices — > high profits — > increased investment — > increased supply — > declining prices. On the demand side, high prices — > reduced demand — > declining prices.
While it’s no surprise that liberals find such market success stories a constant revelation, the real surprise is that the ostensibly “hard‐right” Bush administration had such little faith in a free‐market system it’s constantly praising. When the President’s chief economics advisor, Larry Lindsey, was asked by the Washington Post a day after the administration’s energy plan was released whether Cato was right to argue that markets alone could and would alleviate energy shortages without any additional federal intervention, Mr. Lindsey said “I don’t think so.”
Well, think again Mr. Lindsey. Price hikes may come and go, but the invisible hand never takes a vacation.