RELATIONSHIP BETWEEN SUPPLY/DEMAND AND PRICING FOR ALTERNATE FUELS IN TEXAS: A STUDY IN ELASTICITIES by Russell G. Thompson, R. J. Lievano, Robert R. Hill, James A. Calloway, and John C. Stone This study was supported by the Texas Governor's Energy Advisory Council, Lieutenant Governor William P. Hobby, Chairman of the Council. Dr. Thompson was the Principal Investigator for the study. ACKNOWLEDGMENTS The Houston NSF (RANN) industry models developed at the University of Houston under the direction of Russell G. Thompson were used to estimate the response of industry to price and to assist in estimating the market-clearing prices mutually acceptable to producers and consumers. Dr. James A. Calloway and Mr. John C. Stone were primarily responsible for developing the Houston NSF (RANN) models for use in this study. Drs. Herbert W. Grubb and Milton L. Holloway of the Texas Governor's Office of Information Services assisted the authors repeatedly throughout the period of the study. Dr. H. Peyton Young of City University of New York assisted the authors in his incisive review of the final draft and in his helpful suggestions for completing the final report. Drs. H. Hollis Oxspring and Lynn LaMotte assisted the authors in the statistical analysis of the study. LIST OF FIGURES Figure 1-Residential Electricity Use in Texas, 1970-2000. Figure 2-Residential and Commercial Natural Gas Use in Texas, 1970-2000. Figure 4-Projected Texas Crude Supplies at $4.00 and $7.85 per Barrel. LIST OF TABLES Table 1-Fuel Use Distribution-Selected Industry Categories. Table 2-1985 Fossil Fuel Consumption Forecasts. 1. Executive Summary. 2. Results of Previous Studies. TABLE OF CONTENTS 3. Results of University of Houston Studies. A. Energy Demand Studies. B. Supply Models. C. Pricing Analysis. D. Summary and Conclusions. TECHNICAL APPENDICES Technical Appendix A-Electricity Demand. Technical Appendix B-Gasoline Demand. Technical Appendix C-Description of Industry Models. 1. EXECUTIVE SUMMARY-ENERGY SUPPLY, DEMAND AND PRICE ANALYSIS The primary objectives of the energy supply, demand and price analysis studies made at the University of Houston for the Texas Governor's Energy Advisory Council were to determine (1) how profit-maximizing producers of oil and gas will increase production in response to higher oil and gas prices, (2) how cost conscious users of oil and gas will decrease use in response to higher oil and gas prices, and (3) how these producer and user responses will affect the marketclearing prices of oil and gas in Texas and in the nation. Responses of producers to price were developed to show the effects of higher oil and gas prices on the exploration and development of new reserves and the production of oil and gas from presently known and newly developed reserves. Responses of users to price were developed to show the effects of higher oil and gas prices on the use of important petroleum products and their derivatives in both industrial production and final consumption. The market-clearing prices represent the minimum oil and gas prices needed to guarantee U.S. self-sufficiency in oil and gas in 1985. The Houston NSF (RANN) models, "National Economic Models of Industrial Water Use and Waste Treatment," Russell G. Thompson, Principal Investigator, were used to estimate the industrial demands for crude oil and natural gas. These models show how cost conscious managers will modify their methods of production, their use of fuel, water, and feedstock inputs, and their discharges of wastes to the air, water, and land in response to higher fuel prices, limited availabilities of clean fuels, and increasingly restrictive waste discharge standards. The Joint Association Survey and Petroleum Facts & Figures published by the American Petroleum Institute and the Annual Reports of the Texas Railroad Commission represent important primary sources of data used in developing the supply models for crude oil and natural gas. Statistical estimates were made of the economic demands for gasoline in motor vehicle use and electricity in residential use in Texas. Twenty-six years of annual observations for the period 1946 through 1972 were analyzed in estimating the motor vehicle demand for gasoline in Texas. Five years of annual observations for 20 electric utilities servicing 96% of Texas use were analyzed in estimating the residential demand for electricity in Texas. Results of other studies were used to complete the estimates of the economic demands for important fuel and products of the heavy fuel and water-using industries. Results of the modeling studies were as follows: Supply Production of Crude oil and natural gas in Teras.--A 90% increase in price of crude oil from $4.00 to $7.85 ner barrel, and a 140% increase in price of natural gas from $0.25 to $0.60 per 1000 cubic feet in 1972 dollars, result in a 77% increase in crude oil production in 1985 and a 76% increase in natural gas production in 1985. These price increases were assumed to be made simultaneously in 1972 and held constant through 1985. A three-year exploration and development lag was assumed; suggested limits of industry representatives on yearly availability of drilling equipment were included in the model. Demand 1. Residential Electricity Use in Texas.-A 10% increase in the price of electricity results in a 1% decrease in the use of electricity in a one-year period and a 6.5% decrease in the use of electricity in a six-year period: a 10% increase in disposable income per capita results in a 3% increase in the use of electricity in a one-year period and an 18% increase in the use of electricity in a six-year period; and a 10% increase in the temperature above 65° F. results in a 1% increase in the use of electricity. 2. Gasoline Use in Motor Vehicles in Texas.-A 10% increase in price results in a 2% decrease in use in a one-year period and a 10% decrease in use in a sevenyear period. A 10% increase in income results in a 1.5% increase in use in a oneyear period and a 9% increase in use in a seven-year period. 3. Industrial Use of Crude Oil in the United States (results of previous study).— With a 400% increase in the price of crude oil from $3 to $15 per barrel, crude oil use in a petroleum refining/chemical/electric power complex decreases 26%. coal use increases 75%, and production costs increase 135% 18% of this 26% decrease occurs with an increase in price from $3 to $5 per barrel. With the implementation of restrictive environmental waste discharge policies, crude oil use increases less than 5% for all prices greater than $8.40 per barrel; production costs increase 8%. Self-Sufficiency in Energy and Market-Clearing Prices National self-sufficiency prices of crude oil and natural gas were estimated gas supplies at $7 per barrel from Alaska and the Outer Continental Shelf will be available for domestic use; interstate limitations or natural gas prices at the wellhead will be removed; coal will be available for use as needed at an average price of $0.55 per million Btu's; and domestic production of crude oil and natural gas will be used to satisfy domestic needs. With these assumptions, 1985 self-sufficiency prices of crude oil and natural gas were $7.85 per barrel and $0.60 per thousand cubic feet in 1972 dollars. Imports of crude oil from foreign sources were not needed to satisfy domestic requireemnts. All prices were measured in 1972 dollars. Existing petroleum refining capacity is sufficient to produce 1985 forecasts of requirements for fuels and petroleum derivatives; natural gas feedstocks are substituted for petroleum refinery byproduct feedstocks in the production of petrochemicals. 1985 fuel use in industry and electric power generation was 21% petroleum products, 37.2% natural gas, and 41.8% coal. More specifically, fuel use in electric power generation was 76% coal and 24% natural gas; and fuel use in petroleum refining was 85% crude oil, 11% coal and 4% natural gas. United States self-sufficiency in oil and gas production is achievable by 1985 at prices similar to those being paid today IF decisions are made immediately to insure a normal return on investments in oil and gas production and IF all profits above normal profits from these insured prices are invested in exploration and development and in the research and development of new energy technologies. 2. RESULTS OF PREVIOUS STUDIES Residential and Commercial Demands In previous studies, analysts have estimated total energy demands in residential and commercial use and energy demands for electricity and different fuel sources (natural gas, fuel oil, coal) in residential and commercial use. Certain studies have been primarily methodological. Balestra's 1967 study (2) of the demand for natural ags in residential and commercial use provides an illustrative example. His methodological study indicates that the deamnd for natural gas in residential and commercial use is relatively insensitive to price; however, the residential and commercial use of natural gas in new facilities may decrease 7% with 10% increase in price. Levy (14) in 1973 used Balestra's methodology to estimate the regional demand for electricity in residential use in New England. Levy used price/quantity data of 67 New England electric utilities for 1969 in estimating the electricity demand. He found residential electricity use would decrease 11% with each 10% increase in price. Baughman and Joskow (3) in 1974 estimated residential and commercial demand for different fuels in house heating, water heating, clothes drying, and cooking uses. Their results show the importance of fuel prices in the selection of appliances in residential and commercial energy use. In addition, Baughman and Joskow estimated fuel choice equations for the relative use of gas and electricity and the relative use of oil and electricity both for the nation and for five regions of the nation. The economic use of energy in residential and commercial use was found to decrease less than 2% with a 10% increase in fuel price in a one-year period and to decrease 5% with a 10% increase in fuel price in a period of more than one year. Significant differences in regional responses to price were indicated. Tyrell (17) in 1973 estimated the residential and commercial demand for electricity on a national and regional basis. His estimates indicate that, in the long run, electricity demand in this sector is relatively sensitive to price, with a 10% increase in the price of electricity influencing a 13% decrease in consumption. The Federal Energy Administration, in the November 1974 Project Independence Report (9), estimated total energy consumption, electricity demand, and market shares for natural gas, oil products, and coal in the residential and commercial sector. The use of energy in this sector was estimated to decrease 2.3% with a 10% increase in the average price of energy and to increase 6.4% with a 10% increase in per-capita income. A 10% increase in the price of electricity is estimated to reduce consumption by 4.2%, while a 10% increase in the price of competing energy sources would influence a 2.8% increase in electricity consumption. The demand for electricity is estimated to increase 19% for a 10% increase in per-capita income. The FEA's estimates did not differentiate between |