How to Break Up Opec; C. Henkel and B. Poole, Jr.

Carlos Henkel and Robert Poole, Jr. HOW TO BREAK UP OPEC Myths and Realities of Gas Deregulation DEREGULATION of the price of nat ural gas has been this year's hottest energy issue. Despite a campaign pledge to abolish federal price con trols, President Carter subsequently urged Congress to extend the con troIs to the unregulated intrastate market. He also called deregulation a ~~rip-off" of consumers, and urged Congress not to be swayed by oil and gas industry lobbyists. Yet the facts about natural gas are so much at variance with the impression one gets from politicians and television commentators as to be almost unbelievable. The fact is that there are vast quantities of gas Carlos Henkel received an M.S. in radiochemistry from the University of Buenos Aires, and currently works as a radiochemist and scientific translator. Robert Poole, Jr., holds an M.S. in mechanical en gineering from MIT. He edits Reason Magazine and does consulting on public policy issues.

available in the United States enough to break the back of the OPEC cartel-if only regulations did not prevent its being produced. And deregulation will very likely end up costing consumers less than any of the alternatives now being considered. Congress-and the TV commentators-continue to discuss the issue as if these facts were not available. Yet, as we hope to show in this article, all the necessary infor mation is, and has been, readily available. Regulations and their Consequences Natural gas availability first took on the air of a ucrisis" during the deplorable shortages of the winter of 1976-77. We say deplorable for sev eral reasons: not only the human misery that resulted from a lack of 579 580 THE FREEMAN October heat, but also the loss of jobs, pro duction, and income (which means a decrease in the standard of living for all of us). Most of all, it's deplorable because it wasn't really necessary.

In 1974 the Federal Power Com mission (FPC) warned that, other things being equal, the United States was in danger of running out of natural gas. 1 Gordon K. Zareski, chief of planning and development at the FPC's Bureau of Natural Gas, has pointed out that while drilling almost doubled in four years, from 22.6 million feet in 1971 to 41.9 million feet in 1975, additions to reserves remained below annual consumption every year. Part of the problem is that deeper wells must now be drilled to obtain gas. Wells three miles deep are now common in Texas and Oklahoma. It costs $3 million to drill a 20,000-foot well in West Texas. Offshore wells, though averaging only $1 million to drill, take five to six years to get into production. Fewer large gas fields are being found these days, and pro duction peaked at 23 trillion cubic feet (tef) in 1974, falling to about 19 tcf in 1977. The key measure in any discus sion of gas supplies is ~~reserves."

Proved reserves are estimates of what is available from developed reservoirs, assuming present prices and current technology. Several con clusions follow directly from this definition. First of all, reserves are, by defini tion, dependent on the price at which gas can be sold. This is easy enough to see. Amounts of gas in deposits currently being exploited can be sent to the pipelines at cur rent prices. But what about gas de posits that are harder to get at, or those reasonably assumed to exist but not yet being exploited? Obvi ously, to deliver this gas to the pipeline will cost more than deliver ing gas already in production. And if the cost exceeds the price the gov ernment allows the producer to charge, then that excess cost must either be absorbed by the producer (and his stockholders)-or, more likely, that gas will simply not be produced, at current prices. Second, if ~~current prices" are al lowed to increase, then ~~proved re serves" immediately increase. Why?

Because those gas deposits too ex pensive to exploit before can now be produced at a profit. No matter what your opinion of producers might be, a second-grader could tell you there is no profit in selling lemonade at 5¢ a glass if it costs you 7¢ to make it. Third, development of new technology is expensive. Without adequate incentives, a producer may spend some funds on developing new technology, in the hope that in the long run a better or cheaper produc tion method will result. But when everyone from the President to the corner girlwatcher is shoutin~ 1978 HOW TO BREAK UP OPEC 581 ~~crisis" then ~~in the long run" is not good enough. The development of new technology should receive high priority when price and tax incen tives are being discussed. No other incentive will generate the capital investments required, because new capital is not going to flow to sub sidize enterprises that must sell below their cost. If new capital did this, our country would be out of capital in a very short time.

And just to put to rest another myth, who is it that defines what amount of proved reserves exist? The producers, trying to force higher prices, as most people believe? No, these estimates are prepared by the American Gas Association, which is an organization of distributors, not producers.They are people who pay the wellhead price, not those who charge it. The AGA Qommittee on Natural Gas Reserves is made up of eight representatives of pipeline and distribution companies, three from major oil companies, and represen tatives of the Department of the Interior, the Bureau of Mines, the FPC, and the Federal Energy Ad ministration. How Controls Disrupt The present structure of price con trols produced its most serious effects-thus far-in the winter of 1976-77. But the area most in jeopardy now appears to be California. In that state 55% of all nonvehicular energy requirements are met by clean-burning natural gas.

Distribution systems for fuels other than natural gas are com pletely inadequate. Even if alter nate fuels such as coal or oil could be distributed instead, pollution in the Los Angeles basin would become unbearable. 2 Already a shortage of natural gas exists in California, and is getting worse. FPC figures showed a 22% supply shortage for the winter of 1976-77; the figures were 18% in 1975 and 14% in 1974. Thus, unless expensive liquified natural gas (LNG) is imported (at approxi mately $3.50 per thousand cubic feet compared with $0.70 for the average pipeline gas price) the alternatives are: either demand is left unsatis fied and the economy suffers (loss of jobs and income) or the demand is filled by alternate fuels like oil and the environment suffers. The price of the shortage has al ready been substantial in Califor nia. A study by SRI International shows that since 1971 over 76,000 California jobs have been lost be cause of reduced gas supplies. The same study estimates that by 1981 the loss will have risen to 800,000 jobs, just due to gas shortages.

The outlook for California indus try is more of the same. Joseph R. Reusch, president of Pacific Light ing Corporation (parent of Southern California Gas Company), warns 582 THE FREEMAN October that gas curtailments will acceler ate. At Kaiser Steel's huge Fontana mill Pacific Lighting will curtail gas boiler fuel on about 200 days this year. The alternative is low-sulfur fuel oil, which is about 1.67 times as expensive, per BTU, as natural gas. Lockheed Aircraft Corporation's six plants suffered gas curtailments only a few days in 1974 and 1975, but reached fairly heavy cutbacks in 1976, and 60% cutbacks in 1977 with no gas at all in 1978. According to Harry Winston, head of Lock heed's energy program, the com pany is turning to diesel fuel, two and a half times as expensive as natural gas. Diesel fuel will become short, too, because of limited West Coast refining capacity. ((By 1980 we'll be running tight on overall product demand," predicts Edward J. Cahill, economist with Standard Oil of California.

Agriculture Affected So much for industry. What about agriculture? At one end, the fer tilizer industry is concerned about receiving enough gas feedstocks at a price that .will permit staying com petitive. At the other end, canneries are being cut off and are having to convert to diesel oil, at about $500,000 per plant, according to Tri-Valley Growers, Inc. Executive vice president Harvey A. Proctor of Pacific Lighting pre dicts cuts to firm customers by the winter of 1978-79 and warns that many of Southern California Gas Company's 12 million users will lose their jobs if a solution is not found. He points out that, attempting to remedy some of the shortage prob lems, Pacific Lighting negotiated to buy the rights to 4.2 trillion cubic feet of gas from ARCO, in return for $327 million to finance additional development of Alaska's North Slope. The plan was first approved, then vetoed, by the California Pub lic Utilities Commission.

Meanwhile, production continues to drop. Edward Najaiko, vice presi dent of EI Paso Company, whose pipeline delivers a lot of gas to California, says, ((In the past few years we've been using twice as much gas as has been found." De spite the addition of the Prudhoe Bay deposits in 1970, U.S. natural gas reserves went from 292.9 trillion cubic feet in 1967 to 228.2 tcfby the end of 1975, a decrease of 22%. An nual production decreased from 22.6 tcf in 1973 to 19.4 tcf in 1977.3 Yearly consumption is about 19 tcf. Short-Term Prospects What, then, is the outlook? How much gas do we have left? Surely some agreement can be found in this area? Actually, not. As we noted before, it all depends on what gas price you are talking about. Let's look at some of the reported figures and estimates.

1978 HOW TO BREAK UP OPEC 583 In 1977 a study was performed by some 70 people at the Energy Re search and Development Adminis tration (ERDA). The study, titled MOPPS (Market Oriented Program Planning Study), provided three es timates of natural gas reserves, based on a number of assumptions. 4 According to the most pessimistic estimate, the potential reserves at $3.25 per thousand cubic feet* are double those at Congress's proposed $1.75 ceiling. And this includes only conventional sources of natural gas. The most optimistic estimates in clude unconventional sources (more on those, below), and estimate over 600 tef at prices below $3.25. If we consider that the closest competitive substitute for natural gas is No. 2 fuel oil at an equivalent of $3.00, the good people at ERDA have just told us that deregulation of gas prices could break up the OPEC cartel. It is that simple. It also appears that nobody in high places was listening~r that this information is being deliberately ignored.

When the MOPPS study speaks of deregulation, it is not bringing up a new issue. Economists have been urging that gas prices be decon trolled for at least the past decade. In the February 14, 1977 issue ofBusi ness Week Anthony J. Parisi rec ommended immediate deregulation *Gas prices subsequently quoted are at the rate per thousand cubic feet. of the price of new gas supplies. 5 Parisi pointed out that free market prices have not been allowed to in terstate pipeline companies for over 23 years. Intrastate prices and supplies, meanwhile, were allowed to follow the laws of supply and demand. As a result, the average price of gas within Texas is $1.80 about four times the average price of all interstate gas, and only 10% below the world oil price, on a BTU-equivalent basis. < Across State· Lines Due to interstate price controls, reserves committed to big interstate pipelines have dropped drastically: in recent years they have secured only about 15% of all new gas sold, coming mostly from offshore fields in federal waters .. (And these are dedicated by law to the interstate market.) Parisi points out that de regulation would permit interstate buyers to compete with intrastate buyers for new gas sources. As a consequence, a greater percentage of gas coming on stream each year would go to customers in distant states. Also, many as yet uneconom ical offshore gas fields would become economically viable and more virgin sites would be drilled. And, as gas bills increased, demand would di minish, especially industrial de mand. Currently, industry pays less than homeowners and thus uses gas in lower priority applications.

584 THE FREEMAN October Charles L. Blackburn, executive vice president in charge of explora tion at Shell, states, ((There are lots of prospects in the Gulf that every body knows have gas. These fields could be exploited and developed." James Murphy, president of Va-quero Petroleum in Houston, thinks that liberating just new gas prices would add two billion cubic feet to the current Gulf area production of nearly 10 billion cubic feet per day. This would not solve the shortage, since freeing only new gas would affect only 10% of the gas in current interstate commerce. ((The other 90% will continue to sell at long term contract prices of less than $0.30 per thousand cubic feet equiv alent to crude oil at $1.80 a barrel," says A. V. Jones, Jr., president of the Independent Petroleum Associa tion of America. How Much Gas Is Really There? The U.S. Geological Survey (USGS) estimates gas reserves as follows: 228.2 trillion cubic feet in proved reserves, 201.6 tcfin inferred reserves (including Alaska and offshore deposits), and anywhere from 322 to 655 tcf as undiscovered but recoverable reserves. These fig ures are less than 50% of what USGS estimated as recently as 1974. Julian Martin of the Texas Independent Producers and Royalty Owners (wildcatters) estimates un discovered reserves at approximately 700 tcf, and considers this a conservative estimate, since others have mentioned anywhere from 350 to 4000 tcf.6 But all these estimates apply only to conventional sources of natural gas. Besides these, there are at least four ((unconventional" sources of gas-mostly methane-that could eliminate any gas shortage for hun dreds of years. All four sources would be exploitable-at less cost than LNG or exotic coal-to-gas con versions-if price controls on gas were removed.

The first such source is the huge ((geopressurized zone" of the Gulf coast. The USGS estimates that geothermal hot salt water under Texas and Louisiana contains 24,000 tcf of methane. 7 In this re gion large aquifers at 8,000 to 25,000 feet depth, at a temperature of 150°C. and high pressures, con tain up to 45 cubic feet of gas per barrel of water. s Estimates of the total amount of methane gas in on shore aquifers vary. Bill Rise of Louisiana State University esti mates 3000 tcf; the USGS, as men tioned, says 24,000 tcf; and Paul H. Jones of LSU projects 49,500 tcf (about a 2600-year supply!). And simi lar amounts are expected in offshore deposits. Production costs would be high, and because of subsidence, only about five percent of the water in the aquifers could be removed. Thus, using the most conservative 1978 HOW TO BREAK UP OPEC 585 estimates of onshore and offshore gas supply, this would mean 300 tcf of recoverable gas-more than doubling current proved reserves.

Using the USGS estimates leads to a figure of 2400 tcf of recoverable gas-a 126-year supply, at present rates of use. Methane in Coal Beds According to the National Re search Council Forum on Potential Resources of Natural Gas, methane in coal beds would be the cheapest and easiest new source to exploit. All coal deposits contain trapped methane. This gas is hazardous to coal mining, and is currently being vented to the atmosphere, because gas prices are too low to make it economical to recover. The average methane content is 247 cubic feet per metric ton of coal. Thus, known U.S. coal deposits contain at least some 300 tef of methane. Another source is gas in Htight sands." Tight sands are layers of clay, chalk, and sandstone in shale that sometimes contain gas. The USGS estimates that there are some 600 tcf trapped in the Fort Union and Mesaverde reservoirs in the Rock ies, and similar amounts else where. Recovery requires extensive fracturing of the shale. Nuclear fracturing has been tried, without too much success, but hydraulic fracturing looks promising. If gas prices were to rise to only $2.00 per thousand cubic feet, the Rocky Mountain basin could be producing almost a trillion cubic feet per year within seven years, according to Lloyd E. Elkins of Amoco.

A fourth unconventional source is gas in Devonian shale. Found in the eastern and midwestern United States, shale contains from 22 to 33.5 cubic feet of trapped gas per metric ton. The USGS estimates that approximately 494 tcf of gas could be found in this type of shale. Such gas has already been produced locally in eastern Kentucky. The wellhead cost for shale gas is ap proximately $2.00, according to Wil liam Morse of Columbia Gas Transmission Corporation. Together, these four sources could provide an additional 3794 tcf-17 times more than existing proved re serves and equal to the highest es timates of remaining undiscovered gas from conventional sources. The 3794 tcf is equivalent to a 200-year supply, at present consumption rates. This gas w ill be produced if prices are allowed to rise to between $2.00 and $3.00. It cannot be pro duced at today's controlled prices or even at the proposed new ceiling of $1.93.

What About Your Gas Bill? About 30% of all gas used goes to residential customers. The rest goes to industry, as we have seen, at lower rates. How is the gas price to 586 THE FREEMAN October the consumer arrived at? The Wall Street Journal recently provided an illuminating case study.9 In Brook lyn, New York only 20% of the bill goes for the gas itself; the other 80% goes· to pay for pipeline costs. This immediately tells us that the well head price of gas-the only factor in the deregulation controversy-will have comparatively little effect on your gas bill. Today's average well head price is $0.45. What does Brooklyn Union Gas charge its resi dential customers? $3.38 for heating and cooking, or $5.78 for cooking only. In 1973, when the wellhead price was $0.25, the company charged $1.72 for heating and cook ing gas, and $3.42 for cooking only. Clearly, most of the four-year in crease was not due to the increase in the wellhead price. To what then?

Pipeline costs. Pipeline amortization plusoperat ing costs plus profit are estimated long in advance per cubic foot car ried. In 1973 the pipeline was full; it was halfempty in 1977 and the price doubled. To anticipate your next question:. pipelines are not allowed to pay higher wellhead prices to keep the lines full and thus keep costs down-that's what the price controls prevent. A 1975 study by Arthur Young & Company showed that without new· supplies from de regulation, by 1980 Brooklyn Union Gas would have to sell its gas at $4.45. If the pipeline were kept full with a wellhead price even as high as $2.50-a 5.5-fold increase-the price to consumers would be $3.98. At a wellhead price of $1.50, gas would retail at $3.31 with a full line. This is actually cheaper than today's $3.38 with a halfempty line and a wellhead price of $0.45! For other locations the actual figures would vary, but the point remains the same: the price to the consumer de pends primarily on pipeline costs, and is less when the pipeline can be kept full by abundant supplies of (more expensive) gas.

Conclusions What can we conclude from all this? We realize that for many peo ple this information must be some what confusing, because of its tech nical nature and the many· figures involved. But the subject is inher ently complex because of its nature, and thus must be presented in a fairly technical manner in order to be understood. Many of our elected officials take advantage of this com plexity, counting on their listeners being too naive to understand what's really going on. Thus, the cries of ((profiteering" and ((ripoffs" tend to be taken at face value, rather than being dismissed as ob fuscation of the real issues. It is worth keeping in mind, also, that even if some of the figures in this article were not completely accu rate, even if some were off by 100%, 1978 HOW TO BREAK UP OPEC 587 Competition Serves Consumers PRIVATE enterprisers are constantly trying to find new materia.ls and new uses for known resources, always looking ahead to see which ones will be available and how efficiently they can be utilized. Pick up any trade journal and note the articles on how to cut costs, utilize waste materials, be more efficient. Because the government told them to? No. The hope of profits acts as a powerful compulsion to be efficient, to improve, to conserve. The following examples show how private enterprisers eliminate waste and utilize natural resources to meet the needs of the consuming public.

Until natural gas was known to be useful as a fuel, petroleum producers burned it to get rid of it. Until ways were found of storing and transporting gas with safety, it had only local use. Competition forced the search for further uses and wider markets, and profits rewarded those who best served consumers. As ways were found to handle gas beyond local markets, consumers elsewhere gained a wider choice of fuel, and other fuels were thereby conserved. RUTH SHALLCROSS MAYNARD "Who Conserves Our Resources?" the basic conclusions would still be the same. Some of these conclusions are as follows. First, we have, if not a crisis, certainly a gas shortage. FPC data tell us that reserves were decreasing even while drilling almost doubled. In fact, we'll have a five-year gas shortage even if we get deregula tion. An MIT computer study found that there will be a five-year lead time to eliminate the shortage, once prices are set free. 10 Kevin Lloyd of MIT's Energy Lab reports that if the price were to rise immediately to $2.00 we would see only a five per cent production increase the first year. By 1980 the shortage would be reduced to 5-10% of demand, from the current 25-30%. At the $2.00 price level, all demand, old and new, would be filled by 1982.

The severe effects of the shortage in winter 1976-77 were very expen sive: up to 1.5 million jobs lost, and a 32% increase in oil imports over 588 THE FREEMAN 1976. These effects could have been prevented by allowing gas prices to reach free-market levels. On an energy content (BTU) basis, unregu lated intrastate prices are only 10% below oil prices on the world market. And the MOPPS study showed that reserves of conventional sources of natural gas would double if the price were to reach $3.25. The analysis in that study took place in 1974. But nothing has been done. Those who projected the effects of deregulation found that it would solve the problem in a matter of a few years. If interstate gas were to rise above $2.00, it would be able to compete with intrastate gas. This would help to keep pipelines full, leading to lower retail prices to con sumers, other things being equal. Even a very dramatic increase in the wellhead price of natural gas would not affect domestic gas bills proportionally: this is because only about 20% of the bill is due to the cost of the gas, with the bulk of it accounted for by pipeline costs.

From these findings we cannot escape the conclusion that we could literally break up the OPEC oil car tel if we developed our unconven tional gas resources and expanded conventional ones. If intrastate gas at $2.00 is only 10% below intemational oil prices on a BTU basis, then OPEC has a very limited fu ture. At $2.50 or $3.00 the United States would be awash in natural gas, and the price of oil, as a less desirable fuel, would be forced down. We believe it is in the interest of all of us to reduce our dependence on foreign sources of energy, when this can be done at such a relatively minor cost. @ -FOOTNOTES1"1974 Report Warned of Possible Gas Crisis," Robert Gillette, Los Angeles Times, Feb. 7, 1977. 2"The Natural Gas Shortage," Business Week, Sept. 27,1976. 3"Misconceptions About the Gas Shortage," Alan Reynolds, First Chicago World Report, April 1977, plus telephone update. 4"Jimmy Carter on the Run," Wall Street Journal, June 14, 1977.

5<tNeeded More than Ever: Realistic Gas Pricing," Anthony J. Parisi, Business Week, Feb. 14, 1977. 6"Drillers Say Natural Gas Abounds-Deep Down," Nicholas C. Chriss, Los Angeles Times, Feb. 3, 1977. 7"Fizz from a Dead Well," Bill Crider, As~ sociated Press, June 20, 1977. S"Natural Gas: U.S. Has It, If the Price Is Right," Thomas H. Maugh, II, Science, Feb. 13, 1976. 9"Cheap Gas for Brooklyn," Wall Street Journal, June 21, 1977. 10"Five Year Gas Shortage Seen Even With Price Increase," Los Angeles Times, Feb. 3, 1977.