STATEMENT OF JAMES SCHLESINGER

BEFORE THE

COMMITTEE ON AGRICULTURE, NUTRITION & FORESTRY

UNITED STATES SENATE

20 July 2000

Mr. Chairman, Members of the Committee:

I thank the Committee for its invitation to appear before you today to discuss the nature of current energy policy and its implications. In the time available, needless to say, I can only touch on a few highlights.

I start with the nature of energy policy, which is frequently misunderstood. The phrase "energy policy" is all too frequently used as a kind of incantation--or free floating talisman which will miraculously, if one happens on the right energy policy, somehow preclude any distress about energy supply or price. By contrast, the reality of energy policy is far less benign and not lacking in pain. One needs to define one or two objectives, map out a program that presumably will achieve those objectives--and then accept the consequences, which means accepting the higher costs in other areas for pursuing those objectives. Thus, those other areas become secondary to the main objectives.

The oil embargo of 1973 drove home to this country its dependency on foreign sources of energy supply. After the start of the embargo, national energy policy came to be focused primarily on reducing the nation's vulnerability to oil supply cutoffs. This started with President Nixon's Project Independence and continued through the Carter years. Other objectives, including environmental objectives, remained important but were frequently sacrificed to the main objective. Elements of those programs were fuel switching, conservation, and developing alternate (preferably domestic) sources of supply. By the early eighties, dependency on foreign sources of supply had been substantially reduced--though that outcome depended to a large extent on the fortuitous start up of production in Alaska and the reduction in demand induced by OPEC's higher prices.

During the Reagan years, government intervention in pursuit of reduced vulnerability to supply cutoffs was generally abandoned. Our energy policy became one of reliance on the market--with the Strategic Petroleum Reserves serving as a hedge against supply cutoffs. That willingness to accept dependency on overall market forces became increasingly justified by the events of the 1990s. Specifically, the collapse of the Soviet Union largely removed a major threat to the security of the oil tap in the Middle East; the defeat of Saddam Hussein in the Gulf War substantially eliminated the possibility of a hostile local potentate achieving control over those Middle Eastern oil supplies. Thus, events substantially reduced the national security motivation for interference with market forces.

On the economic side, the collapse of OPEC after 1985 was also reducing the economic threat. In the 70s, an arrogant OPEC appeared to be both a permanent and dominating monopoly. Since the 80s, OPEC has been substantially tamed, most dramatically so compared to the 1970s, by recognition that their market power can rapidly be undermined by too high prices.

National energy policy today accepts the primacy of market forces. (Indeed, we make that acceptance more than a necessity but a virtue as well. Our foreign policy emphasizes, if it does not trumpet, the need for other nations to embrace the benefits of free markets.) Yet, reliance on market forces has its consequences. Prices will fluctuate--in accordance with supply and demand. Consumers love free markets when prices are stable or declining, but they grow resentful when prices rise.

In addition to a general reliance of market forces, environmental goals have become an increasingly critical element in national energy policy. Included amongst such elements are greater specificity regarding the quality and type of fuels to be burned--which reduces flexibility and thus the ability of the market to respond to local imbalances. There are also restrictions on the areas that can be drilled, significant monetary costs in avoiding environmental damage in those places that are drilled, and barriers to the use of nuclear power. Indeed, it has been said, with some justification, that the most important legislation on national energy policy is the Clean Air Act and Amendments. It should also be noted that the Kyoto Protocol, if it is ever seriously pursued, would have an even more dramatic effect on national energy policy.

Both the dependency on market forces and the impact of environmental regulation have been dramatically illustrated by the recent difficulties in energy markets--and by the additional difficulties that we may anticipate in the months ahead. The shrinkage of Asian economies and Asian oil demand after the financial collapse in 1997, followed by OPEC's "error" in raising production led to burgeoning inventories of oil and a collapse of oil prices to around $10 a barrel. Low oil prices resulted in a shrinkage of investment activities by oil companies, which increased world dependence on OPEC sources of supply with the revival of demand. By March of 1999, the OPEC nations had been so badly burned by low oil prices that to the surprise of many they achieved the cohesion necessary to cut production and subsequently inventories. Over time that has led to a tripling of crude oil prices. Shrinking crude oil inventories and weak margins led to reduced refinery operations. Since the spring of this year, oil supplies have increased and refineries have been operating at 95-96 percent of capacity. Gasoline inventories are slowly being rebuilt to normal levels. But in the interim, limited inventories associated with high demand have resulted in higher gasoline prices. The disruption of the market has been intensified by the legal deadline to start Phase II for Reformulated Gasoline (RFG) on June 1^st. Inventories of Reformulated Gasoline have been especially low. Prices have risen to equate available supply against high demand. Such developments underscore the necessity for careful coordination of environmental and energy policies.

In parts of the Midwest, the problems posed by RFG have been reinforced by state preference for using ethanol as an oxygenate. This has meant that it was not possible to move additional supplies into the affected areas because the rest of the country used MTBE as an oxygenate--thereby limiting additional supplies from the outside. Pipeline breakdowns also added to the problem. Happily these special problems in the Midwest are now being alleviated. Nonetheless, the overall gasoline supply situation remains tight--and will do so for the balance of the summer driving season.

OPEC and its somewhat erratic behavior impose instability on the international supply of oil. Nonetheless, we can readily draw on that supply. By contrast in the case of electric power and natural gas supplies, we are dependent on domestic infrastructure (for which there is no alternative to government regulation) and largely on domestic supplies. Consequently, those energy markets are subject to disruptions, which seem likely to intensify in the future. Such markets consequently appear particularly appropriate elements for national energy policy.

To the extent that we impose specific supply rules that reduce market flexibility and to the extent that there may be inadequate infrastructure or production capacity, one should not be surprised that that will result in temporary supply dislocations in the marketplace. What has occurred of late results from our national decision to rely primarily on market forces--which from time to time inevitably will inflict pain on energy users.

Thank you for your attention. I shall be happy to take any questions that the Members of the Committee may have.