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Issues in Focus

The Economic Decline in East Asia

Recent Developments

Although this Annual Energy Outlook 1999 (AEO99) focuses on the determinants of growth for the United States in a midterm (20-year) setting, it is also important to consider how near-term events may play out over the long run. The recent economic crisis in East Asia illustrates the need to reconcile volatility in the short run with the long-run determinants of growth for the world and the U.S. economy. The economic crisis in East Asia began in the summer of 1997 and continued to deepen throughout 1998. Currency markets in Southeast Asia became extremely volatile, with Thailand, Malaysia, and Indonesia experiencing sharp depreciations first, followed by the Philippines and South Korea. Between the end of May 1997 and September 1998, the U.S. dollar rose by 67 percent against the Thai baht, nearly 53 percent against the Malaysian ringgit, and more than 61 percent against the South Korean won. For most of the East Asian countries, however, the exchange rate fluctuations occurred between August 1997 and the end of March 1998, with currency values relatively stable during the summer of 1998 (although at much higher levels against the dollar than in January 1997). Indonesia's currency did continue to show volatility, as the country tried to accommodate increased financing needs for both economic investment and social costs.

The Asian economies affected by the crisis share many characteristics: relatively rapid economic growth over the past 3 to 6 years; high domestic savings rates; economic expansion sustained by exports rather than domestic demand growth; high current account deficits; high inflows of foreign capital before the currencies became volatile; and relatively lax financial regulations. Early in 1997 their currencies were pegged to the U.S. dollar, and they became overvalued when the countries experienced large current account trade deficits. In addition, credit was allocated in their financial sectors on non-business criteria, and excessive investments were made in real estate, leading to inefficient uses of the available capital. When the exchange rates rose loans could not be repaid, foreign portfolio capital fled, and Asian firms found it difficult to finance needed imports of essential intermediate products.

Current events have exposed significant vulner. abilities in Asian and other developing economies, raising questions about the timing and extent of short- and long-term recovery. Developing economies need to devote much of their economic resources to improving infrastructure (education, transportation, and communication as well as energy resources) and tend to rely on international capital flows to finance much of their investment. But international capital flows, especially portfolio investment, are volatile and may have substantial impacts on short-term growth. Whether long-run growth is also affected depends on the reasons for the financial instability, the underlying economic characteristics of the country (such as the skill of the labor force), the domestic savings rate, the prospects for traded goods in global competition, and the infrastructure that supports the economy.

In Thailand, Indonesia, and South Korea, the International Monetary Fund (IMF) has agreed to supply capital in exchange for agreement to a set of fiscal and monetary policies designed to reduce volatility in financial markets. The policies are aimed at decreasing government expenditures, removing some government controls over the financial sector, allowing insolvent financial institutions and businesses to fail, and allowing more foreign ownership to encourage foreign direct investment. The short-run impacts of such policies are likely to be higher inflation, lower imports, and reductions in sectors of the economy that are sensitive to interest rates (such as construction and investment). One result is projected lower economic growth for the next several years.

The Asian recession is proving to be more severe than anticipated last year when AEO98 was being prepared. At that time, most analysts thought that the Asian crisis would follow the course of the Mexi can crisis of 1994, when the Mexican economy saw a severe drop in GDP growth in 1995 (6.2 percent), followed by positive growth (5.2 percent) in 1996.

A number of factors have contributed to a deeper recession in Asia than originally expected. First, with import demand plunging in many Asian countries, intraregional trade, which fueled growth in the early 1990s, has collapsed. The Japanese economyweak at the beginning of the Asian crisis-has not yet recovered. In contrast, during Mexico's rapid

economic recovery after its 1994 currency crisis, its main trading partner, the United States, was experiencing strong economic growth. Second, high interest rates and weak currencies have made it difficult for Asian countries to obtain financing for essential intermediate inputs. Without the necessary inputs, many export products cannot be produced. Finally, with the collapse of many Asian countries and the absence of a Japanese recovery, world export demand has not been sufficient to offset the drop in intra-Asian trade. Domestic demand in the Asian countries must recover before the intraregional trade can resume its impetus for growth. High interest rates, prescribed by the IMF, were expected to cut wasteful spending while attracting more capital to the East Asia region. In fact, however, investors have been unwilling to channel their money to countries where there is a risk of further currency devaluations. Tighter credit has substanItially reduced domestic demand in the affected countries, but the region's exchange rates are still volatile.

Whether the sharp currency devaluations in East Asia will lead to lower growth rates over the next 25 years will depend in large part on the policies enacted in response to short-run developments. If the financial reforms enacted make financial transactions more transparent, then market conditions will judge the efficacy of new investments. Making investment decisions more market-driven could lead to potentially higher long-run economic growth, especially given the relatively high education levels and savings rates of the labor force.

Impacts on the World Oil Market

Over the past 2 years, crude oil prices have dropped by more than 40 percent, reflecting a significant world oil surplus. Abundant supply and weak worldwide demand, especially among the struggling economies of the Pacific Rim, have combined to produce the lowest world oil prices since the early 1970s.

The timing and magnitude of an expected rebound in demand for oil and in world oil prices are the source of much uncertainty in AEO99. The reference case forecast assumes that real prices for oil rise at an annual rate of almost 6 percent from 1999 to 2007. After 2007, the reference case oil prices are

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The Organization of Petroleum Exporting Countries (OPEC) has agreed on production cutbacks of about 2.6 million barrels a day in 1998 to counter the slow growth in world oil demand and the drop in oil prices. There is much skepticism, however, as to whether member nations will strictly adhere to such quotas. Prior excursions into quota-setting have resulted in temporary impacts on world oil prices, but cutbacks have been difficult to maintain and verify over the long term. Many OPEC countries are almost totally dependent on oil export revenues for their national income, and production cutbacks are especially painful. An additional factor of critical importance to OPEC supply potential is the reemergence of Iraq as an oil exporter. The United Nations Security Council has agreed to allow Iraq to export oil (for humanitarian reasons) at a rate of 1.6 million barrels a day. When Iraqi export sanctions are eventually lifted (assumed to be after 2000 in the reference case), Iraq could easily expand its production capacity to more than 3 million barrels a day by 2005. In addition, several non-Persian Gulf OPEC members (Algeria, Nigeria, and Venezuela) have active plans to expand their production capacities over the next half-dozen years.

Non-OPEC production potential continues to grow despite the low price environment. North Sea production is expected to peak by the middle of the next decade at levels that are at least 1 million

Issues in Focus

barrels a day greater than current output. Other countries within the Organization for Economic Cooperation and Development (OECD) that are expected to register production increases within the next decade include Australia, Canada, and Mexico. In Latin America, Argentina, Brazil, and Colombia are showing accelerated growth in oil production due in part to privatization efforts. Deepwater projects off the coast of western Africa and in the South China Sea are not expected to be delayed and will start producing significant volumes early in the next century. Because subsea oil platforms have to be scheduled so far in advance, most of the worldwide deepwater projects are proceeding on schedule even at today's prices.

The bleak economic outlook for several Southeast Asian economies has significantly dampened the growth in oil demand for the region, which in recent years has accounted for about one-half of the growth in Asia's oil demand. In 1998 demand is expected to decline, and the timing of its recovery has become increasingly uncertain. Other regions whose nearterm GDP growth is less optimistic than that assumed in AEO98 include China, the Former Soviet Union, and Japan. Even with lower oil prices, near-term oil demand is expected to increase at only about half the rate of the past 5 years (Figure 9).

Figure 9. Oil demand projections for developing
Asia in AEO98 and AEO99, 1990-2020
(million barrels per day)

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Because only a relatively small portion of U.S. exports goes to those countries where current economic disruptions are greatest, current Asian events are not expected to have as lasting an effect on the U.S. economy as on the world oil market. Nonetheless, compared with AEO98, slower growth in exports is expected from 1997 through 2010 in the AEO99 reference case. The expected reduction in export demand is expected to reduce real GDP growth by as much as a tenth of a percentage point. The relatively lower growth in exports in the first 10 years of the forecast results in slower growth in domestic U.S. manufacturing relative to last year's expectations. Manufactured goods are affected more by export and import trends in the economy than are either services or wholesale and retail trade. As exports recover, so does the growth rate of manufactured output.

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Responding to Growth in Demand for Natural Gas

In the AEO99 reference case projections, natural gas consumption in 2020 is nearly 50 percent higher than the 1997 level of 22.0 trillion cubic feet. In order to satisfy the demand projected for 2020, a number of changes will be needed in the U.S. natural gas industry, including a significant increase in production and considerable expansion of infrastructure. Onshore and offshore production are projected to increase by 57 and 14 percent,

respectively, and pipeline capacity to increase by 32 percent over 1997 levels. Although today's market differs from the markets that existed in past periods of significant growth, increases well above those projected in AEO99 have been realized in the past, and the industry's past performance gives reason for confidence that the projected increases can be accommodated.

Interregional pipeline capacity increased by 6.9 trillion cubic feet (21 percent) over the 7-year period from 1990 (the first year ELA began compiling capacity data) to 1997. The driving force behind the expansion was not to meet an overall increase in demand per se-the 1997 market of 22.0 trillion cubic feet is roughly equivalent in size to the 1972 historical peak of 22.1 trillion cubic feet-but instead to provide new access corridors as supply and demand centers shifted in a changing market. Similarly, the need for additional pipeline capacity projected in AEO99 primarily reflects the demand for greater customer access to new and expanding supply sources and for supplemental capacity into areas of growing demand where peak period utilization is approaching maximum available capacity.

As an example, proposed additional capacity from Canada will bring significantly greater volumes of gas to the midwestern marketplace. At the same time, several existing pipelines already have the capacity to move large volumes of gas from the South Central region to the same area. As capacity expansion projects proceed over the next several years, there is a strong potential for surplus supply to develop in the Chicago area. As a result, pipelines exiting the South Central region that compete with Canadian gas could become underutilized. To alleviate the situation, and to address the growing demand for natural gas in the Northeast, a number of projects have been proposed that would tap into the expanding Chicago hub and redirect some of its supplies eastward.

Much of the new capacity that has been added since 1990 or is to be completed by 2000 consists of longhaul pipelines from growing supply areas. By 2000, much of the projected new capacity will be able to link with nearby major long-haul pipelines already in operation, so that the primary short-term requirements will be for feeder lines to tap into the existing pipelines or compression and looping along

Issues in Focus

existing routes where capacity needs to be augmented. Compression and looping are much less expensive than laying pipe along new routes and usually require less lead time.

Much of the expansion projected in AEO99 before 2001 already is either under construction or planned, and more than half the pipeline expansion expected by 2020 is likely to occur between now and 2000. A number of projects have been proposed (although not all of them will actually be built), and substantial investment has been made in pipeline expansion. The added capacity will provide access to new and expanding production areas, such as Canada and the deep offshore, and will accommodate shifts in demand patterns, such as new demand for natural gas to replace electricity generation capacity lost as a result of nuclear retirements.

Government policy supports an optimistic outlook for the post-2000 pipeline expansion forecast. FERC policy allows the pipelines to assume more risk rather than requiring firm contracts to be in place before approving an expansion, and the Council on Environmental Quality has recently allocated funding to promote interagency cooperation in the review of pipeline permits, with the primary intention of speeding up the process. The FERC has responded positively to issues raised by the pipeline industry regarding its method of determining allowed rates of return by evaluating possible changes in the method it uses to calculate returns. Pipelines have claimed that they face considerable risk because of increased competition and the threat of capacity turnback, and that the 12- to 13-percent average rate of return for pipelines in 1996 was far lower than the 20-percent rate earned by most public companies [17].

Another issue that the industry will face in meeting the production forecast is supply availability. Uncertainty in estimates of the Nation's natural gas resources, both onshore and offshore, has always been an issue in projecting production [18]. Despite the fact that offshore production levels in the AEO99 forecast do not exceed current levels until 2003suggesting that offshore production will not be a problem-there are a number of potential problems related to the recovery of natural gas from offshore

areas.

Issues in Focus

One issue is a potential shortage of offshore rigs and skilled personnel. Although the short-term situation has changed with the recent downturn in oil prices, every available offshore rig was in use throughout 1997, and the construction of new rigs has been limited by uncertainty surrounding their demand for the longer term. The lead time for construction of new rigs is 2 to 3 years, and costs range from $115 million for a 350-foot jack up to $325 million for a deepwater semisubmersible [19]. Training is needed to develop a work force for offshore production, and because of its cyclical history many people are reluctant to enter this work force.

An additional issue is the need for infrastructure expansion. Infrastructure to move natural gas from offshore drilling platforms to the shore will need to expand as production grows, and gathering systems for offshore production, the costs of which are not known with certainty, need to be developed. Despite the problems these issues may present, however, continuing developments in offshore technology have improved the prospects for offshore gas production. Although there have been some spending cutbacks as a result of current low oil prices, investments are being made in all these areas, and technology advances are cutting lead times and improving the economics of smaller fields.

Because of expected growth in natural gas demand, several studies are being undertaken to assess what steps the natural gas industry needs to take to be able to respond. Former Secretary of Energy Federico Peña commissioned the National Petroleum Council (NPC) to undertake a study of what is needed for the industry to be able to respond to demand increases. In addition, the Natural Gas Supply Association (NGSA) is working on a report that will analyze whether the industry can meet increased demand projections without increasing wellhead prices, and the Interstate Natural Gas Association of America (INGAA) is working on a study to determine what needs to be done for the pipeline industry to meet the needs of a market of 30 trillion cubic feet by 2010 (2 trillion cubic feet above the AEO99 forecast). The key uncertainties in satisfying a market of that size are where the demand will occur and whether there is enough pipeline capacity to move the gas into growing demand centers.

The INGAA study addresses the question of whether the pipeline industry can provide the expanded infrastructure needed to get the gas to market. One of the problems with rapid expansions is the lead time necessary for a pipeline project. Barring unforeseen delays, capacity expansion requires a lead time of 2.5 to 3 years. If an environmental impact statement is required, it can add another 3 months to the completion time [20].

The pipeline capacity expansion currently underway reflects the industry's anticipation of an expanding market. Positive steps are also being taken in other parts of the industry. Again, despite recent cutbacks resulting from low oil prices, investments still are being made in exploration and production, and they are expected to continue, largely independent of lower oil prices, as higher gas prices provide a positive incentive for investment. In fact, spending on natural gas projects increased in the first quarter of 1998 and was unchanged in the second quarter [21].

The rising levels of demand and prices for natural gas projected in AEO99 will provide additional economic incentives for the investments in infrastruc ture, rigs, drilling, and manpower development needed to meet the necessary increases in gas production. As a result, it is expected that the natural gas industry will be in a position to meet the challenge of satisfying the demand increases projected.

Renewable Portfolio Standards

Federal legislation proposed by Senator Jeffords, Senator Bumpers, and Congressman Schaefer include renewable portfolio standard (RPS) provisions that are similar to those included in State restructuring plans. Each of the Federal bills proposes a renewable credit system as described in "Legislation and Regulations” (see page 15). The key differences in the respective RPS provisions are the required renewable share and the renewable technologies that would receive credits. The share required by 2020 varies from 4 percent in H.R. 655 (Schaefer) to 20 percent in S. 687 (Jeffords). Each of the bills allows all nonhydroelectric renewable resources to receive credits. S. 237 (Bumpers) also provides partial credits to large hydroelectric facilities, greater than 80 megawatts.

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