Wednesday, June 18, 2008

The Demand for Drilling

Not since the years of Jimmy Carter has the United States faced a greater energy crisis. While there are no shortages at the pump or plans to ration supplies, our nation’s neglect of energy infrastructure combined with a collective “not in my backyard” mentality has sentenced us to dependence on unstable and hostile regimes around the world. With supply and demand in such fragile balance, any political instability, terrorist attack, or shift in diplomatic relations could quickly send oil prices soaring further crippling our economy. We need more domestic drilling and we need it now.

In an attempt to bailout the credit crisis, the Federal Reserve has lowered its fed funds target interest rate to two percent. This has fueled a surge in inflation, debased our currency, and further precipitated the rise in the cost of oil. Opposition to domestic drilling by environmentalists has channeled government policy into “alternative energy” and led to the promotion and subsidization of corn based ethanol. As a result, commodity farm prices have soared as farmers shift production to corn while reducing acreage of wheat or soybeans. Ethanol has done little to solve our energy problems, but has further fueled core inflation in essential products such as food and energy. Combined with the tightening of credit following the mortgage and housing implosion, the increase in core inflation hits middle class consumers particularly hard and results in a significantly lower quality of living.

While alternative energy is the future, it will take years of additional research and development before any revolutionary technologies become available at affordable costs to consumers. Additionally, the high network and infrastructure barriers facing automobile producers create an uncertain environment and encourage innovation based on petroleum derived fuels. Honda’s new FCX Clarity fuel cell vehicle is a promising new technology, but the structural barriers facing innovative and revolutionary change discourage the allocation of capital to research and development. Mass production and distribution of hydrogen fuel cell vehicles is decades away and face significant barriers to widespread adoption. Despite much hype there are only 38 hydrogen fuel stations in California, with many of these owned and operated by the state, universities, or automobile manufacturers. Without significant infrastructure investment, consumers will be hesitant to buy such vehicles, but it is unlikely that current gas station owners will invest in hydrogen distribution without strong consumer demand. Ethanol fuel, known as E85, is a perfect example. Even with mass production and distribution of flex fuel vehicles, a very small percentage of gas stations sell E85 fuel. The substantial barriers imposed by the network externalities of alternative fuel technologies will create a significant impediment to mass adoption.

Despite optimistic projections by environmentalist groups, the ability of alternative energy to provide for our needs is limited without significant improvements in efficiency and conservation. These developments will take many decades before they are refined into commercially viable alternatives suggesting that further exploration and development of petroleum resources is required. Virtually all sources of domestic production have been off limits for more than 20 years. Congress has thwarted President Bush’s efforts to increase domestic drilling and develop a comprehensive energy policy, greatly contributing to the energy crisis that exists today. Until we develop the vast proven reserves in Alaska, the outer continental shelf, and shale formations in the West, we will continue to depend on others for critical energy needs. The lead time for diversifying our energy portfolio and constructing new facilities is significant, making us even more vulnerable to unstable foreign regimes and subject to growing competition for scarce resources. The time for action is upon us. Any further delays could lead us back to the dark ages – literally!