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COPYRIGHT 2004 C.D. Howe Research Institute
In this issue ...
Where do Canada's energy resources fit into the global outlook for energy? The escalation in the prices of oil and gas--beyond expecations--will force a vigorous response in the markets for fossil fuels and alternative energy sources.
For the first time in decades, Canadians are worried about energy resources. Heating bills are rising and the price of natural gas has doubled in a relatively short time. Meanwhile, the cost of fuel for vehicles has climbed to levels last reached 20 years ago and monthly bills for electricity have become a painful reminder that energy is decidedly more expensive. Most striking of all was the electrical blackout of August 2003. With that, Canadians discovered that the cascading effects of the power failure quickly translated into a lack of fuel for cars and trucks, the closure of oil refineries and industries, the sudden shutdown of public transit, and a reliance on backup generators at hospitals. Although the impact on employment was short-lived, the implications of a longer power outage became obvious.
The public expects the government to ensure electricity supplies at stable prices and when the price of primary energy--mainly hydro--was relatively stable for long periods, the system worked reasonably well. However, the diversification of fuel sources and the rise of energy prices have introduced problems for capital investment in power generation. The lead time between the commitment to develop a new source of energy and its operation can be as long as 10 years. If prices climb in the interval, who is going to bear the risk? Can public utilities transfer some of it to market suppliers? Will suppliers undertake new ventures amid unpredictability? One of the key issues for decision makers is to close the gap between short-term market pricing and the long-term burden of investment risk.
This Commentary discusses where Canada's resources fit into the global outlook and what this means for the nation and its public policies. Global prices for oil and gas are likely to increase more than expected--a central theme in this analysis. That outlook raises the issue of what role the government has in trying to encourage consumers to adapt. The first task of market participants and policymakers is to recognize that global market forces are driving energy prices higher. The appropriate response will have to be a combination of policies. Governments will have to allow the market to perform its function of curbing demand, while encouraging supply and facilitating production and trade in energy resources. The private sector must find ways to make relatively large long-term investments that take into account a much greater degree of unpredictability and risk.
The high degree of uncertainty about the rate of increase in energy prices will require a greater use of indexation in the negotiation of long-term contracts to develop new sources of energy, whether domestic oil and gas fields, imports and exports, or newer forms of energy like wind and hydrogen. The long lead times and the high cost of new energy sources will force elected officials to steel themselves to make hard decisions, allowing market participants to transfer higher energy prices to users, rather than sheltering them. Apart from electric utilities, markets for energy supplies are largely in the private sector, and the relationship between short-term and long-term prices is determined by the interaction of many forces in the market place.
The various markets for primary energy--oil, gas, coal, hydro, nuclear and others--have all experienced inconsistent government intervention in the past 30 years, which has made long-term planning next to impossible. For example, California and Ontario have reversed themselves on privatization of power generation and offered mixed signals on pricing policy for electricity. The National Energy Program in the 1980s disrupted the oil industry in Alberta for years. Misguided intervention discourages investments which are urgently needed.
Investors in energy resources, including governments, must have clear ideas on what global market forces will do to prices, to the levels of risk, and to the prospects of meeting growth targets. This requires an overview of all the energy markets because they are closely interrelated. Canada's energy resources cannot be looked at in isolation.
Although Canada is generally assumed to be well endowed with primary energy resources, the long-term outlook is not reassuring. There are only a few large, undeveloped hydroelectric power sites, and they are far from the main population centres. Conventional oil and gas reserves are declining and their replacement requires heavy investment in higher-risk resources in the Alberta tar sands, the Mackenzie Delta and the offshore fields on the East Coast, as well as on the West Coast if opposition to testing and drilling in that area is overcome.
Most thermal coal is imported but it is currently on the priority list for elimination. Some observers argue that nuclear energy should be abandoned in spite of the strong business case for its expansion. Many are hopeful that new forms of renewable energy, such as wind power, solar power and fuel cells, will replace fossil fuels and nuclear power. While there are promising developments in newer forms of energy, it will be a long time before they replace large-scale conventional forms of energy. Figure 1 shows the distribution of primary energy sources in Canada in 2001.
Canadian policymakers must closely examine their underlying assumptions about the availability and price of the various forms of primary energy. If coal is displaced and nuclear power minimized, there will inevitably be a much greater reliance on other fossil fuels. It is not clear that Canada will be able to meet its own requirements for oil and natural gas and still maintain its exports to the United States. The likelihood of an American energy shortfall is growing at the same time that China is sharply increasing its demand for oil, gas, and nuclear reactors. Among suppliers, Russia and some former Soviet republics are becoming important net exporters, somewhat offsetting the moderation in export growth from the OPEC countries, which will remain the main source of oil. All these factors impinge on Canada, and the key considerations include:
* A high and rising price of oil will encourage the search for conventional crude in the Arctic and at deep offshore sites;
* Further development of the oil sands in Alberta will become increasingly feasible as rising prices more than offset rising costs;
* Canada will have difficulty maintaining its oil and gas exports to the United States for the next few years, until substantially more production comes on stream from the oil sands and Mackenzie Delta gas fields; * Proceeding with the Mackenzie Valley pipeline, subject to resolution of Aboriginal claims, will become more urgent with the declining supply of conventional gas; * Negotiation of an economic route for an Alaskan pipeline to the lower 48 states will become a high priority as conventional gas reserves in the U.S. decline; * Coastal facilities for the trans-shipment of Liquefied Natural Gas (LNG) to both Canadian and U.S. markets will receive a higher priority; * Conservation policies for electricity and fuel consumption will attract increasing public support and enable governments to set goals; * Contracts to supply natural gas and LNG for new electric power generation plants will require long-term agreements, indexed to global fuel prices, to attract the necessary investment by suppliers, and * Rising prices for all forms of energy will reduce the quantities demanded at these higher prices. This will be the most effective form of conservation.
The Price Isn't Right
Knowledgeable investors swiftly discern the influence of any change in the global supply of oil on the price, and their reactions move markets forcefully. In recent months, markets have reacted quickly as investors responded to several changes in OPEC's announced intentions for its agreed ceiling on aggregate output. The mere declaration of a planned change in supply of 1 million barrels per day (bpd) on a global base of about 80 million bpd, is often enough to cause a sharp adjustment in the price of oil in world markets. However, over a longer time span, a significant rise in price produces little response in the supply in North America. In fact, conventional oil output in Canada and the U.S. is declining. Whether global supplies are rising is in doubt.
In terms of demand, long-term projections are based largely on forecasts of economic growth, with little attention paid to price. Despite recent developments which have seen the world price of oil approach $50 per barrel, in June the U.S. Department of Energy confirmed its estimate that the price will rise from $22.68 per barrel in 2002 to $27 per barrel in 2025, in 2002 dollars. That would make the price of oil $23.37 in 2004, measured in 2002 U.S. dollars. (Unless otherwise stipulated, all prices are in U.S. dollars). On that basic price assumption, global oil exploration companies are misguided in their strenuous search for oil at the current price in 2004 dollars. Any success in finding oil would prove to be uneconomic.
In a longer perspective, $50 per barrel is not an unprecedentedly high price compared to the 1979-to-1985 period, when prices spiked to the range of $50-to-$100 per barrel, measured in 2004 dollars. From 1985 through the 1990s, the price was mostly In the $20-to-$35 range in 2004 dollars. In the last three years, the price has been rising. Will it fall back to 1990s levels? That seems highly unlikely. While global output of oil is near capacity, the demand for oil is suddenly burgeoning In China and South Asia. The prospect is for rising prices until they eventually affect consumer behaviour.
In the short run, a fuel price Increase may not cause much change in consumer demand, which tends to be inelastic for a relatively brief period. But consumer behaviour changes significantly over time. If one contrasts the frugal use of electrical power in a Japanese home compared to one in North America, the difference is striking. Figure 2 provides a microcosm of the difference in consumer response to the price of gasoline in the United States and Britain from 1990 to 2003.
[FIGURE 2 OMITTED]
The Global Energy Outlook
Global forecasts--or, as they are often called, "scenarios"--of the demand for, and supply of, energy are usually based on a set of assumptions about rates of economic growth, as well as on calculations of past relationships between economic growth and demand for energy. Two official forecasts are widely used, both of which examine in depth the widely varying rates of growth in different countries and regions. These are the annual World Energy Outlook, published by the International Energy Agency (IEA 2003), and the annual International Energy Outlook, published by the Energy Information Agency (EIA 2003 and 2004) of the U.S. Department of Energy.
The IEA, which represents 26 of the 30 member countries of the Organisation for Economic Co-operation and Development (OECD), defines its "Reference Scenario" in terms of a set of assumptions about macroeconomic and demographic conditions as well as energy prices and supply costs. The economic growth assumptions are based on data from the OECD, the World Bank and the International Monetary Fund. The EIA builds its global outlook on a similar methodology, with moderately different assumptions about economic growth rates in the developed and less developed regions of the world. Table 1 sets out the comparison.
Both forecasts aim to show that economic growth largely determines the demand for energy. The IEA calculations suggest that over several decades, a 1-percent increase in gross domestic product (GDP) has been associated with a 0.64-percent increase in energy consumption. The comparable increase in the EIA analysis is 0.61 percent. In the developed industrial economies, energy intensity (the use of primary energy per unit of GDP) tends to decline for several reasons. For one thing, technological change brings greater efficiency in fuel consumption, in electricity generation and transmission, in reduced wastage at the extraction level, in home insulation, and in industrial production. For another, the shift from heavy industry to light, and...
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