Tuesday, August 09, 2005

Manufacturing an Energy Crisis

Under the guise of encouraging "more affordable and reliable sources of energy," the President signed the energy bill into law yesterday. In this CNN story, George W. Bush is quoted as saying, "This bill is not going to solve our energy challenges overnight." He's right. It's not going to solve any energy challenges at all.

Not every point in the energy bill is bad, as I explained in Good Energy Bill, Bad Energy Bill; however, the premise that "if the government doesn't force short-sighted consumers and suppliers into finding alternative sources of energy we will have an 'energy crisis'" is flawed. To base national policy on an assumption contrary to economics is dangerous.

A brief financial explanation of the current energy situation: let's just assume that the supply of oil is diminishing rapidly (we'll ignore that OPEC attempts to limit supply to raise the price of oil and ignore that we have untapped oil resources in the U.S. as well). What would we expect to observe? We know from basic economics that when the price of one good (oil) increases, the price of its substitutes (alternative sources of energy) also increases because the demand for the substitute increases as the quantity of oil demanded decreases. If I'm a good financial analyst and I genuinely believe that the price of oil is going to rise as its supply decreases, I'm going to perform an analysis of the present value of the future cash flows I can expect from the sale of alternative sources of energy. (In non-financial terms, I'm seeing if the amount I will get in the future is worth the investment today). For any large project, a financial analysis examines the expected future cash flows (the amount I am going to get over the years, discounted for time), any margin of error in the forecasts for future prices (risk level), and the cost of the project. If I am fairly confident that my expected future cash flows exceed my cost, I approve the project. Government doesn't need to be involved at all -- greedy entrepreneurs and financial analysts like myself are always looking for profit opportunities and will find those alternative sources of energy on their own - if the need arises. They are already taking into account that the profit may not be immediate. That is why they use present value analysis of future cash flows. Most of the population can be short-sighted if they so choose, but there will always be those who want to invest for the long term if there are profits to be made.

Another rule in economics is that a profit maximizing firm will produce until its marginal revenue equals its marginal cost. This means that the firm should not stop production if there are gains to be made from producing one additional unit. Government does not need to tell the firm when it is no longer in its interest to continue production. Likewise, government does not need to tell the consumer of oil when it is in his interest to stop consumption. To stop consumption of oil well before the marginal utility of oil consumption equals the marginal cost is to throw away the gains from continuing consumption of oil.

Through the energy bill, the government is immediately imposing huge costs but is not and cannot provide any real benefits. No long-run strategy needs to be adopted by the government - long-run strategies are already being adopted by profit-seeking entrepreneurs.

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