Events have conspired to remind us how heavily dependent we are on a steady supply of energy.

In California, as all the world knows by now, shortages of electricity have sent prices skyrocketing, causing factory closures and periodic blackouts, and—thanks to a regulatory scheme described as “lunacy” by Treasury Secretary Paul O’Neill—have brought the state’s utilities to financial ruin. According to Curt Hébert, appointed by President Bush to chair the Federal Energy Regulatory Commission, New York State is next in line for a similar disaster.

In the Northeast and other parts of the country, shortages of natural gas caused prices to quadruple at the peak of the heating season. To make matters worse, the many electric generating plants that rely on natural gas for fuel—coal having been declared environmentally unacceptable, and nuclear power having been declared either unsafe or too costly—have seen their costs spike and in some instances have simply shut down and sold their remaining gas in the lucrative open market.

Meanwhile, a newly potent international cartel has driven the price of oil to approximately three times the level that prevailed just a short time ago, introducing American motorists to $2-a-gallon gasoline and causing so serious a drain on consumer purchasing power that the Federal Reserve Board, in cutting interest rates sooner and more steeply than anyone had predicted, cited high oil prices as one of the reasons for the current economic slowdown.

This triple whammy has accomplished two things: one good, one bad. On the plus side, it has reminded Americans that in the long run there can be no benign neglect of energy policy. The American economy runs on energy, which is one reason that it is so efficient. By substituting energy for muscle power, we have managed to increase the productivity of our agriculture and our factories, to move goods over huge distances at low cost, to power the Internet revolution, and to improve the quality of everyday life. (How many Americans now remember suffering through a heat wave without air conditioning?) Thanks to an abundant supply of electrical energy, we now have a thriving economy in states once made virtually uninhabitable by weather unconducive to year-round work.

The other, less salutary “lesson” that is emerging from our current difficulties is that when energy markets do not work, government intervention is needed to correct the failure. To this, the proper answer is that if intervention is indeed called for, it should be aimed at rooting out whatever is causing the markets to fail to do their job of balancing supply and demand, not at creating a new permanent role for the government. Politicians, of course, find it difficult to resist the temptation to overstay their usefulness. In California, they are expanding their regulatory role and, worse still, have used the current crisis to engineer a partial takeover of the private sector. In New York, the governor is proposing to cap electricity prices, while in the nation’s capital politicians are proposing to manipulate tax regimes and to use the strategic petroleum reserve to maintain prices at some “acceptable” level.

But prices are the symptom, not the cause, of the disease that has discomfited us. Having diagnosed the wrong ailment, policymakers are proceeding to prescribe the wrong medicine, and to take us in precisely the wrong direction.



What has happened in California is clear to all who would see. The state’s economy has boomed, led by “new economy” industries that, however sleek and high-tech, consume at least as much energy as old-economy steel mills and refineries. Meanwhile, California’s environmentally sensitive planners have refused to allow any new generating plants to be built in the past twenty years. The problem was compounded last year by low reservoir levels in Oregon and Washington, reducing the available supply of hydropower on which California depends, especially in the summer.

What else would a growing demand imposed on a fixed supply do, if not send prices up? To protect themselves from the ire of consumers, however, the state’s politicians had set ceilings on the retail prices that utilities could charge for electricity. In the meantime, they set no ceilings on what those utilities would have to pay to buy electricity in wholesale markets in the first place—this could amount to five times more than they were permitted to bill their customers for—and they obliged the utilities to buy all the power that retail customers might want.

Unlike the rise in wholesale gasoline prices, seen immediately at the pumps by consumers and thus causing them to reconsider their driving plans, the rise in electricity prices was noticed only by the utilities. As they bought dear and sold cheap, sinking deeper and deeper into debt, Californians, shielded from reality by price controls, continued consuming as if nothing had changed. A better prescription for disaster cannot be imagined.

The same sort of regulatory nightmare contributed to the soaring heating bills of natural-gas customers. The demand for gas has been stimulated by restrictions placed on the use of coal to generate electricity—restrictions that, according to the analyst George Schreiber, add somewhere between one-third and one-half to the cost of a coal plant. But the increase in demand has also come at a time when exploring for new gas supplies has itself been inhibited in part by restrictions on drilling offshore and in the Arctic. Increasing demand, a relatively fixed supply: once again, a rise in prices was inevitable.

There is nothing inherently evil about rising prices. The American economy is the powerhouse it is because changes in prices direct resources to uses that are responsive to consumer needs. What distinguishes the prices of electricity and natural gas from those that fluctuate in response to patterns of supply and demand is that they are the result not of markets but of men. In a free market, rising prices can be expected to spur producers to increase supply, and consumers to curtail demand. But neither of those reactions was possible in California, where not only have environmental restrictions prevented the construction of plants to provide more electricity—and, during the recent shortage, caused several already-built plants to lie idle—but consumers have been shielded from the price signals that might induce them to conserve. In short, it is not that markets are unable to bring demand and supply into better balance; it is that they have not been permitted to do so.

The California fiasco threatens the financial viability of the state’s utilities, its power providers, and, to judge by the involvement of the Federal Reserve, the health of some of the banks that have lent money to those companies. The shortage of electricity at prices the state will allow customers to pay will also deter companies from settling there, depressing the local economy, with, according to Alan Greenspan, important ripple effects for the national economy. All this is bad enough. But the situation in the oil markets is more troubling still—in fact, much more troubling, with profound implications for the overall health of the American economy as well as for our ability to pursue an independent foreign policy in the Middle East



In the oil markets, the strong arm of a producer cartel has replaced the invisible hand of Adam Smith as the determinant of prices that we pay to keep the wheels of commerce turning. What this means is that Spencer Abraham, the new Secretary of Energy, may well turn out to have as important a role to play as Greenspan, George W. Bush, and Colin Powell. For not only has Abraham assumed the chore of running a hugely inefficient bureaucracy that he once, while serving in the Senate, sought to eliminate, but he will also have to take the lead in wresting total power over the price of oil from a handful of Arab sheiks and a Venezuelan leftist.

The facts are once again uncomplicated. America accounts for about 25 percent of the world’s oil consumption but produces only about 10 percent of the world’s oil. And worse is to come: the United States possesses less than 3 percent of the world’s untapped oil reserves, the great bulk of which lie under the sands or in some cases the soil of the 12 members of the Organization of Petroleum Exporting Countries (OPEC): Algeria, Gabon, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. These nations, when they act together, can importantly affect the economic well-being of every society that relies on oil to power its factories, run its cars and trucks, and heat its homes. And because in many countries the price of natural gas is tied by edict or by market forces to the price of oil, OPEC’s policies have a major impact on the price of that fuel as well.

Since the end of the Arab oil boycott of the mid-1970’s and until recently, the consuming nations have benefited from the inability of the often quarrelsome producing nations to cooperate in a price-fixing conspiracy. But then the price of oil fell to $10 per barrel—a figure that, although still higher than what would prevail in a freely competitive market, was evidently too low to permit the producing nations to fund their arms purchases, their subsidization of anti-Israel terrorists and other groups, the massive subsidies doled out to their disenfranchised middle classes to prevent discontent from boiling over into outright revolution, and payments to princes and other potentates whose taste for the good life exceeds what their talents would command in a global workplace. Suddenly, the Arab kings felt poor and became debt-ridden, and the stage was set for renewed cooperation.

Enter Luis Téllez, then the energy minister of Mexico, an oil-rich state but not a member of OPEC. Until now, Venezuela and Saudi Arabia, two of America’s major suppliers, had been reluctant to raise prices by cutting production, fearing that Mexico would fill the gap by opening its own taps wider. But Téllez assured them that this would not happen, brokering a deal that would eventually lead to OPEC-wide action and to the tripling of prices we live with today.

The role of Venezuela in the current crisis is also noteworthy. Its new president, Hugo Chávez, came to power in 1999 trumpeting his fondness for Fidel Castro and Saddam Hussein and calling for a redistribution of income from the developed nations to the developing ones. As for the predilections of his oil minister, one Alí Rodríguez Araque, these are adequately captured in the New York Times description of him as “on the far left fringe of Mr. Chávez’s coalition.” But it is not ideology alone that has kept Venezuela solidly in the camp of OPEC members who want to keep production low and prices high. Venezuela’s failure to invest in exploration and development, or in modern technology, means that its state-owned oil company is physically incapable of producing more oil. Adhering to an OPEC production quota therefore costs it nothing.

The same is not true of Kuwait, the country that American troops risked their lives to save from Saddam Hussein while the Kuwaiti royal family fled to London and its casinos. Possessing about 10 percent of the world’s oil reserves, Kuwait produces only 3 percent of the world’s oil. It is thus one of the OPEC countries that could turn on the taps immediately and, if it so chose, increase its production capability even further. Since it costs so little to find, develop, and produce oil from new fields in Kuwait—perhaps as low as $2.50 a barrel—the country was making a handsome profit even at the old, “depressed” price of $10. Yet, when the price recently fell below $30, it was Kuwait’s oil minister who led the charge for further curtailments of output. Habits of greed die hard.

Saudi Arabia is not far behind in the “hawk” category—but in this case for reasons only partly related to greed. In fact, Sheik Ahmed Zaki Yamani, the former oil minister and “a man whose name is synonymous with black gold,” in the words of the London Observer, has warned his countrymen that a further cut in output might well end up harming the economies of oil producers themselves. Not only would a recession in the West reduce the value of the billions the Saudis have invested in Western economies, it would also encourage exploration of non-OPEC sources of oil, development of alternative fuels, and conservation. Nevertheless, the Saudi royal family does not live by bread alone. As Yamani says, “When you deal with oil you have to take so many other things into consideration.”

One of those things is the Israel-Arab conflict. Saudi leaders have made no secret of their displeasure with what they see as an American tilt toward Israel in its negotiations with the PLO; holding back the supply of oil is one way of sending a message. And the Saudis (and Kuwaitis) may also be taking a hard line in part to appease their own fundamentalist and pro-Palestinian constituencies, a restive and perennially threatening element in those societies.



But motives matter little. What does matter is that so long as American prosperity is held hostage to Arab oil producers, aided and abetted by an anticapitalist populist in Venezuela and a fellow-traveling government in Mexico, we will not have a free hand in setting our own foreign or economic policy. And the consequences of not having a free hand are ominous indeed, not least for George W. Bush if he ends up presiding over a major recession after eight years of Clinton prosperity—which may be one reason he announced that his first foreign port of call would be Mexico.

One way to assess the impact of OPEC collusion on the American economy is to consider the difference made by a rise in the price of oil from $10 per barrel to what seems to be OPEC’s new target price of $30. Since we import about 9 million barrels per day, the recent increase is transferring almost $65 billion per year from the pockets of American consumers to the various Arab kingdoms and other producing nations. (It has also transferred an approximately equal sum to domestic producers, but that is a matter of internal distribution that does not affect overall economic activity to anything like the same degree.) No one knows how large a tax cut Bush will wring from Congress, but even if he were to get everything he wanted, over the next ten years the oil producers will have claimed 50 cents out of every dollar he aims to return to the nation’s taxpayers.

Nor, unlike in the mid-1970’s, do the producers have any intention of being so generous in recycling their newly inflated profits. More recently, the money has been invested not in Western economies but at home—in infrastructure, job-creation schemes, and the repayment of debts. Although some petrodollars are filtering into the Western banking system, the proportion is nowhere near so large as during earlier oil-price booms.

Clinton’s Energy Secretary, Bill Richardson, spent his final days in office shuttling from Arab capital to Arab capital begging various ministers and sheiks not to cut back production, at least not before the West got through the winter and built up inventories in the spring. But looking for gratitude in Kuwait is as fruitful as looking for oil under the White House lawn, and asking the Saudi regime to put economic sense above the PLO line is as rewarding as asking the more extreme environmentalists to ease our national shortage by withdrawing their opposition to new drilling or new power plants. No, for a way out of our predicament we will have to look not to OPEC but to ourselves.



The question before us is not the one that President Nixon once asked: how can we become independent of foreign sources of oil? To that question, the short answer is that we cannot. We now import more than half of our oil, and will soon be importing an even larger percentage. This is not because we are wastrels, but because our highly efficient economy relies on energy to fuel its highly productive agriculture and its increasingly productive industry. But if independence is not in our future, what might be in our future, if we act wisely, is oil priced at more competitive levels.

On the supply side of things, the first objective must be to increase the development of whatever energy resources are available to us. This does not mean gutting the environment to keep our sport-utility vehicles rolling, but it does mean a more realistic assessment of the benefits of increased domestic production measured against its environmental costs. Although it might have made sense to ban some offshore drilling and Arctic exploration when oil stood at $10 per new barrel, the calculation surely shifts when potential output is valued at three times that level. Energy is not a priceless resource; but neither is the environment.

The same reasoning applies to the electric power industry. California, New York, and other industrialized states will have to chose between some—not all—environmental amenities and an adequate supply of electricity at prices that consumers deem acceptable. How they choose should be up to them, but one option—cheap electricity and no new plants—is not available.

As for the demand side, one objective would be to make certain that consumers of energy are charged all of the costs their consumption imposes on society. If OPEC-induced price run-ups threaten us with dire economic consequences—some studies reckon that every $5 increase in the price of oil knocks 0.3 percentage points off GDP—then the costs of such upheavals should be reflected in the prices paid by energy users, including by means of additional taxes if necessary. Such taxes need not go to swell the Treasury’s coffers: they can be recycled in the form of efficiency-enhancing lower marginal income-tax rates. Lest I be accused here of sounding like Al Gore, let me add that there is a difference between, on the one hand, forcing consumers to pay all of the costs that their use of energy imposes on others and, on the other hand, raising taxes simply to curtail energy use to some level that a politician deems acceptable. Cost-based taxes might also make energy more expensive, of course, but that would encourage consumers to conserve by investing in insulation or in more efficient appliances, or by driving less.

Finally, we must take steps to weaken the OPEC cartel. In part, the market is already doing just that, as oil companies, seemingly assured that prices are unlikely to fall below the range of $14 to $16, are stepping up their investments in domestic production. But this will not be enough, and that is where politics comes in.



Mexico, to begin there, sorely needs us to buy its goods, and also to turn a blind eye to the tide of illegal immigration coming across our common border. Assuredly we do not want to lose the benefits of Mexico’s cheaper goods. But we might suggest to the Mexicans that a situation in which we are expected to buy their sneakers, television sets, and other products while they threaten our prosperity by withholding oil is not acceptable, and that any decision we might take to retaliate by curtailing purchases from Mexico will hurt them a lot more than it will hurt us. In a similar vein, we might suggest to Kuwait that it can continue to live under American protection only so long as it pumps sufficient oil to keep prices at reasonable levels; faced with the choice of producing more or becoming a province of Iraq, even the Kuwaitis might be expected to recognize where their self-interest lies.1

Another arrow in our cartel-busting quiver is our antitrust laws. These have never been applied to OPEC, despite good legal precedent, because the State Department has always interposed its large institutional body. That could change if Colin Powell willed it so. Although new legislation might be necessary, surely few congressmen would vote for OPEC’s interests over those of American consumers.

The informing principle behind all these suggestions is that they are designed not to interfere with markets but to make them work better: by getting the price signals right, by removing uneconomic restrictions on supply, and by introducing more competition. What I do not propose are subsidies to this or that favored technology; special tax breaks to encourage consumers to behave this way or that; rationing or price controls; or merely punitive taxes on energy use. Although none of the measures I outline would, alas, eliminate the problem created by God when He put oil in such inhospitable places, some combination of them would go a long way toward increasing our international freedom of action and reducing the risk and impact of periodic shocks. If we do nothing, those shocks are only likely to become much more intense, and much more sustained.



1 As for Iran (Iraq remaining obviously beyond the pale), it has large untapped reserves, and, thanks to a twenty-year gap in significant investment, is producing far below its potential. Perhaps—and one can say no more than that—an opening to Iran might lend support to its reformers, such as they are, and perhaps, too, some program could be worked out to tie increased Western investment in exploration and production to a commitment by the Iranians to sell the newly found oil at reasonable prices.


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