Naive forecasting: The fiasco of coal gasification

Naive forecasting: The fiasco of coal gasification

OMEGA Int. J. of Mgmt Sci., Vol. 13, No. 5, pp. 435~,41, 1985 0305-0483/85 $3.00+0.00 Copyright © 1985 Pergamon Press Ltd Printed in Great Britain. ...

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OMEGA Int. J. of Mgmt Sci., Vol. 13, No. 5, pp. 435~,41, 1985

0305-0483/85 $3.00+0.00 Copyright © 1985 Pergamon Press Ltd

Printed in Great Britain. All rights reserved

Naive Forecasting: The Fiasco of Coal Gasification 1 WILLIAM

S PEIRCE

Case Western Reserve University, Ohio, USA (Received January 1985; in revised form March 1985) The decision by the U.S. government to subsidize the development of coal gasification was based on a naive forecast that neglected the influence of price on both conventional sources of supply and consumer demand. Even before substantial construction costs were incurred on the Great Plains plant, a surplus of natural gas had developed. The poHticai process, however, did not include the sort of critical review that often accompanies the financing decision in the private sector and that would surely have prevented this error.

AFTER a decade of active discussion and the formation of the U.S. Synthetic Fuels Corporation, the program to produce gas of pipeline quality from coal is nearly dormant in the United States. The only active project is the Great Plains coal gasification plant in Beulah, North Dakota, sponsored by American Natural Resources Co., MidCon Corp., Tenneco Inc., Transco Energy Co., and Pacific Lighting Corp. As it neared completion during 1984, the future of even that project was clouded by a dispute regarding whether the consumers of its output or taxpayers in general should subsidize the product. Regardless of the source of the subsidy, it appears that the cost of the syngas from the Great Plains plant will exceed $10 per thousand cubic feet (MCF), compared with an average price at the wellhead of $2.42/MCF for natural gas in 1982. This is a particularly sorry denouement for syngas in view of the glowing accounts of its potential that have circulated in recent years. The situation has changed for several reasons in addition to the question of the price at which the gas can be sold. If the only problem were that of predicting the OPEC price for crude oil--to which all other energy prices are still closely

t A n earlier version of this paper was presented at the meeting of The Institute o f M a n a g e m e n t Sciences, College on the M a n a g e m e n t of Technological Change, 7 November 1983, Orlando, Florida. 435

tied--then syngas would take an inconspicuous place amidst a large collection of erroneous forecasts by politicians, economists, businessmen, and OPEC itself. There is more to the story than OPEC, however, so it will be useful to see how things came to such a sad pass. THE FUTURE OF GAS FROM THE PERSPECTIVE OF THE EARLY 1970'S It is not enough to point to surplus gasproducing capacity today and conclude that the syngas plant was a mistake. The policy on which it was based was formulated at an earlier time. To judge the correctness of an earlier decision one must consider it in the light of the information at hand when it was made. Figure 1 shows the forecast of natural gas production and demand made by the staff of the Federal Power Commission, as published in 1972. Note the downturn in conventional domestic production after 1975 and the continued rapid growth in what is labeled "forecast demand". The growing gap between the two is partly filled by a patchwork of "imports and supplements" including imports from Canada and Mexico, LNG imports, gas from Alaska, and gas from coal. There still remains a large and growing gap labeled "unsatisfied demand". Although this particular forecast comes from the FPC, it was not removed from the main-

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Peirce--Naive Forecasting: The Fiasco of Coal Gasification 50 Forecast

demand

40

30

20 Actuol

consumption

10

I Convenhonal

I-I 1970

~966

Source

U S

Federal

; 1975 Power

I 1980 Commission,

I 1985

FPC S - 2 1 8 ,

supply / ~

I 1990

February1972,

p.3

Fig. 1. The 1972 forecast for natural gas and actual consumption.

stream. The 'forecast demand' and the production data were close to those of the American Gas Association. The reality from which these curves were extrapolated included two key facts: consumption of natural gas had been growing rapidly and reserves of natural gas were declining. Any extrapolation would, therefore, show a gap of "unsatisfied demand", which would also suggest such measures as coal gasification to fill the gap. As the dashed line in Fig. 1 indicates, the results did not correspond with the forecast. The adjustment was mainly on the consumption side, which is not too surprising because gas that isn't there can't be burned. What is more surprising from the perspective of a decade ago is the replacement of the natural gas shortages that had been encountered during the 1970's by the surplus that has recently been reported. If consumption were pushing against a supply constraint, obviously, there could be no surplus in the market to depress prices. It is not the purpose of this paper to belittle the forecast of a decade ago. Anyone who forecasts makes mistakes. The purpose of this paper, rather, is to examine the consequences of

the forecast for policy-making. After all, even a totally naive extrapolation of consumption and production trends can sound the useful alarm that "something has to give". It is only the question of what is to be done with the alarm that I am examining here. POLICY BASED ON S T Y L I Z E D FORECAST

Natural gas policy in the United States during the 1970's was essentially one of pessimism about resources, restriction of uses and allocation of supplies by governmental directive, and attempt to prevent economic rents from being transferred from consumers to producers. Not only were reserves decreasing year by year, the conventional wisdom held that there was very little gas left to discover and that demand was inelastic. Under those conditions, there was little point in allowing prices to rise to market clearing levels. 2 Rather, the wellhead price would be kept low and the limited amount of natural gas would be reserved primarily for household use. Even the household sector was subdivided into the favoured group of households with existing natural gas connections and the unfavored groups (mainly, newly built hous2For a particularly vigorous enumeration of the reasons ing) against which connection bans were orwhy greater government control would accomplish more than setting the price free, see Wilson JW (Chief, dered. The decision to reserve gas for houseDivision of Economic Studies, Federal Power Commis- holds was justified by the fact that it is a fuel sion), Statement before the US Senate, Committee on the Judiciary, Subcommittee on Antitrust and Mon- that is convenient and clean for the household to use and competes directly with fuel oil deopoly, Washington, June 27, 1973.

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rived from imports. The larger energy plan had OPPOSITION TO THE STYLIZED power plants and large industrial users switchFORECAST AND POLICY ing to domestic coal. Needless to say, the dominant 'official' foreThe final piece of natural gas policy called for blending in high cost supplements. These in- cast met with substantial opposition. Econocluded Alaskan gas via a planned pipeline, mists within the Federal Energy Administration liquified natural gas (LNG) transported in cryo- and the successor Department of Energy, as well genic tankers from producing countries, Cana- as outside, raised questions about the absence of dian and Mexican gas at prices set by nego- price in the discussion of supply and demand. tiations between governments, gas from deep Just reasoning from general microprinciples, wells and tight formations, and syngas pro- many economists argued that supply would be duced from coal. The basic idea was to continue equal to demand at s o m e price, so the relevant selling the gas to households at the average cost questions concerned the elasticities of supply of the controlled old gas and the high cost and of demand and the time period required for supplements. A refinement in the Natural Gas adjustment.4 Even among those who saw little hope of Policy Act of 1978 called for "incremental pricing", which would have imposed the cost of increasing reserves, raising prices had some high-priced increments to the natural gas supply appeal. As the decade of the 1970's wore on, directly on industrial consumers. Marginal cost more conservationists began to advocate higher pricing, in contrast, sets the price to all at the prices as a device to encourage investments in cost of the marginal (highest cost) unit that saving energy. While this position was most enters supply. The market has largely overruled closely associated with the comparison of addincremental pricing because of the provision ing nuclear capacity vs spending more for conthat the price of gas to industrial users is limited servation and renewable energy sources, it by the price of competing fuels. Nevertheless, carried over also to other fuels and especially to the existence of that provision of the NGPA those based on coal because of the environserves to illustrate the political goal of reserving mental problems associated with mining. Nevertheless, the 'market price' solution met a great the low cost gas for households. Since prices were kept as low as possible, deal of opposition. The strongest probably came consumers would have little incentive to con- directly from politicians who were reluctant to serve gas. This was not a disadvantage in the permit the fuel bills of constituents to rise. Even within the industry, however, the interstylized view because the elasticity of demand with respect to price was considered to be low ests were hardly monolithic. Those who proanyway. The implication, however, was that the duced gas from old wells certainly wanted conhigh-priced supplements for conventional cheap trois to end so they could raise prices to market gas would find a ready market regardless of clearing levels. However, wells deeper than price because consumer prices would be largely 15,000 feet were not subject to price controls, determined by the low, controlled cost of con- and producers of deep gas fought decontrol, ventional gas. Such a view was especially per- knowing that the low prices for consumers, that suasive for synthetic natural gas because fore- resulted from averaging in the controlled gas, casts of costs in the range of $0.50-1.00 (1971 encouraged consumption. Furthermore, decontrolling prices would spur dollars) per MCF seemed cheap relative to other the search for conventional gas, further reducfuels anyway.3 ing demand for the expensive deep gas. Distributors, also, were reluctant to see the total decontrol that might price their product out of many 3 See, for example, US Federal Power Commission, Bureau markets, leaving them with only low volumes of Natural Gas, "Natural Gas Supply and Demand 1971-1990, "Staff Report No. 2 (Washington, D.C.: over which to spread heavy fixed costs. FPC S-218, Feb. 1972), p. 89; and "SNG Production That the official forecast and the official polby 1980 to Supply 10% of All US Gas," Oil Gas J. 15, November 1971, p. 133. icy also aroused great opposition should come 4For a solid economic analysis from this period, see as no surprise in view of the stakes involved. MacAvoy PW and Pindyck RS, The Economics of the Standard guesses about the economic rents that Natural Gas Shortage (1960-1980) North-Holland, could be transferred from consumers to proAmsterdam, 1975.

Peirce--Naive Forecasting: The Fiasco of Coal Gasification

438

Decreasing certainty L

Known

Increasing cost

Speculative

Reserves Today's COSt

Fig. 2. Reserves, resources and resource base.

ducers in the event of decontrol of gas prices and uses were in the order of $35 billion per y e a r - - a n amount worth fighting about. The most important consideration for the long-run welfare of the country, however, should have been a hard-headed appraisal of reserves and resources. RESERVES A N D RESOURCES The depiction of reserves and resources that is standard in mineral economics is indicated in Fig. 2. The little box in the upper left hand corner is the working inventory of proved reserves held by the producing companies. This is the figure that is generally reported to the public. Proved reserves of natural gas peaked out in 1967 at 292.9 trillion cubic feet (TCF) and then declined steadily (except for the addition of Alaskan reserves in 1970) to about 200 TCF in 1978. They have remained close to that level since. With current production in the vicinity of

5 This statement made by John O'Leary, administrator of the Federal Energy Administration, in 1977 is quoted in Bupp IC and Schuller F, "Natural Gas: How to Slice a Shrinking Pie," Chap. 3. In Robert Stobaugh and Daniel Yergin, eds., Energy Future: Report of the Energy Project at the Harvard Business School p. 77 (Edited by Stobaugh R and Yergin D) Ballantine, New York.

20 TCF, reserves of 200 T C F are equivalent to a 10 year supply. Ratios of reserves to output in the mineral industries are often in the range of 10 to 20 years, so the ratio for natural gas was not especially alarming, although the steady decline from 1967 to 1978 was. Of more significance are the guesses about the dimensions of the bigger box. These are inherently uncertain, of course. If you don't look you don't know whether anything is there, but what is the incentive to look? Once newly discovered gas was freed of the rigid price controls, the search did, indeed, discover new reserves at about the same pace as old reserves were depleted, but will this process continue for 15 years or hundreds of years? The mood of the 1970's was generally pessimistic: " W h a t more do you get out of raising the price of natural g a s . . , every indication we have is that you get very little. ''5 Indeed, when Robert Stobaugh and Daniel Yergin published their bestselling review of energy problems entitled Energy Future in 1979, they subtitled the natural gas chapter (by Bupp and Schuller) " H o w to Slice a Shrinking Pie". But whether the pie really had to shrink--and correspondingly whether high cost synthetic gas was a good idea to try---depended on the vague and speculative boundaries of the poorly identified "resources" box. While it is important to bear in mind that

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are a function of price, it is even more important to realize that r e s o u r c e s are a function of. geological theory. As gas prices have risen, it has become profitable to drill deeper, search for smaller fields, and exploit more difficult locations. It may even become profitable to build the Alaskan gas pipeline someday. Such activities move the boundaries of the small box. The only way to guess at the dimensions of the big box, however, is to theorize about the geological origins of natural gas and the occurrence of particular geological formations. Appraisals of the resource base for natural gas have become very controversial during the past decade. If one looks only at "conventional" sources (including extending the boundaries of existing fields and exploring similar formations, and also the gas between 15,000 and 30,000 feet, in Alaska, or under deep water) the potential recoverable gas is guessed by the Potential Gas Committee of the American Association of Petroleum Geologists to be around 1000 TCF. With production running around 20 TCF per year, that indicates about 50 years of potential resources, in addition to the 10 years of proved reserves. 6 Taken at face value, this would indicate exhaustion in the year 2040. Interestingly enough, the estimates of ultimately recoverable gas by the Potential Gas Committee have not changed much since 1964. What these estimates leave out, however, are the less conventional possibilities: gas deeper than 30,000 feet, geopressured aquifers, coal seams, Devonian shales, tight gas sands, or other sources that cannot be economically proreserves

6 Oil Gas J., 9 April 1979, p. 82. 7Gold T, for example, argues that much methane is primordial rather than organic (Oil Gas J., 5 February 1979, p. 30; Boston Globe, 27 July 1980, p. D3; New York Times, 29 November 1981, Sec. 3, p. 1). If the argument is correct, exploration for gas need not be restricted to the sedimentary formations that contain fossil fuels. 8 "Assessment of Onshore Geopressured-Geothermal Resources in the Northern Gulf of Mexico Basin~" In Assessment of Geothermal Resources of the United States--1975. (Edited by White DF and Williams DL) pp. 125-146. US Geological Survey Circular 726, 1975), Washington. 9 Indeed, the politicians followed the time-honored practice of firing the bearers of good news. See Easterbrook G, "Washington Fiddles while Huge Gas Deposits Spurned," The Washington Monthly, October 1980, pp. 20-30. 1°See, for example, US Energy Information Administration, Annual Energy Outlook, 1982, p. 76.

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duced with current technology. Theories of the origins of natural gas that break the rigid connection between oilbearing sedimentary formations and accessibile natural gas open up a whole new array of areas in which search can proceed. 7 Some of the estimates for geopressured aquifers, alone, would extend the availability of natural gas hundreds of years. POLITICAL RESPONSE TO IMPROVING RESERVE AND RESOURCE PROSPECTS Obviously, national policy cannot be based upon the most optimistic available speculations. Nevertheless, the estimates of the Potential Gas Committee did suggest that production could be maintained for decades. Furthermore, speculations regarding the availability of vast resources of geopressured methane had acquired some intellectual respectability by 1975 with the publication of the study by Papadopulos, Wallace, Wesselman, and Taylor of the U.S. Geological Survey.8 In short, it was obvious that conventional gas reserves would last a comfortable length of time permitting orderly investigation of some of the more spectacular possibilities that had been suggested. The political response was to ignore and downgrade the good news about resources in the interest of maintaining support for the existing energy policy.9 The economists and conservationists fortunately prevailed in substantial measure on the pricing issue, which brought consumption down to sustainable levels. Nevertheless, the overriding theme remained one of the scarcity and impending exhaustion of natural gas. Once prices began their sharp climb, consumption decreased, exploration increased, and the forecast of a significant role for synthetics receded into the distant future. 1° Nevertheless, the assumptions from the earlier era still shaped policy. Despite escalating costs, it was assumed that expensive syngas and deep gas could be sold when averaged in with cheap, old gas because the policy assumed that conventional gas would remain scarce. Furthermore, it was assumed that the mixed gas would need to compete only with No. 2 fuel oil for home heating. If gas remained plentiful, however, it would have to compete with residual oil for general industrial uses. The difference is

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Peirce--Naive Forecasting: The Fiasco of Coal Gasification

significant: No. 2 oil sold to residential customers for about $8.60 per million BTU in 1982 while power plants bought residual oil for $4.75 per million BTU. The assumption about scarcity influences both the relevant fuel and the market in which gas must compete. LESSONS F R O M THE EXPERIENCE A case can be made for government subsidy for one full scale plant as a way of accumulating the knowledge and experience that will be necessary if supplies run short. The implication of subsidizing a plant to gain operating experience, however, is that the subsidy will be continued until syngas becomes profitable. If the plant is abandoned, the 'know-how' of its operation (and even of its design) will fade rapidly. As Rosegger points out, "learning by doing" has as its counterpart "forgetting by not doing". 11 The implication of this is that, even for demonstration purposes, a syngas plant is useless unless additional plants will be profitable to build before the demonstration plant has reached the end of its economic life. Unlike a plant for producing synthetic liquid fuel, a syngas plant cannot even be justified as a contribution to national security. Aside from the movements by pipeline from Mexico and Canada, imports of natural gas are negligible. Since 11Rosegger G (1980) The Economics of Production and Innovation: An Industrial Perspective, p. 38. Pergamon Press, Oxford. t2 The progress of the plant has been chronicled in a series of articles in the Wall Street Journal, including Paul B, "Future of Synthetic Gas from Coal Grows Cloudy as Court Ruling, Lack of Financing Stall a Plant," 10 December 1980, p. 48; and Ingrassia L, "Synfuels Project in North Dakota Troubled as Oil-Price Fall May Make it Uneconomic," 1 April 1983, p. 13. ~3Managerial Evaluations of Technological Innovations and Other Capital Projects. Chap. 4. In Evaluating Technological Innovations (1980) (Edited by Gold B, Rosegger G and Boylan MG Jr) D.C. Heath, Lexington, Massachusetts. 14See Normanton EL (1966), Accountability and Audit of Governments: A Comparative Study, pp. 160-165 Praeger, New York; and Kaufman H (1976), Are Government Organizations Immortal? Brookings, Washington. ~SGold B provides an example in Wartime Economic Planning in Agriculture (New York: Columbia University Press, 1949), p. 542; the testimony of General Hawkins in the suit of CBS by General Westmoreland (February 1985) provides another. Tullock G analyzes the mechanism in great detail in The Politics of Bureaucracy (Washington: Public Affairs Press, 1965). Peirce W provides some more recent references in Bureaucratic Failure and Public Expenditure (New York: Academic Press, 1981), Chap. 2.

national security is not an issue, production of gas from coal can be justified only if it is profitable. This leads to the question of how the supply and demand for natural gas appeared at the time when the decision was made to proceed with the syngas plant. Although the sponsoring companies had spent a substantial amount (at least $40 million of their own and $25 million from DOE) by 1980, it was not until Reagan's approval of the project on 5 August 1981 that the heavy construction expenditures (exceeding $2.7 billion) actually began. 12 Ironically, the project would have died had a conservative President not infused new life into it when the opposition had caused it to founder with procedural delays. By the time it was salvaged, however, the markets had already turned from shortage to surplus and reserves had stabilized. What, if anything went wrong? It is obvious that governments have no special skill at forecasting prices, quantities, and rates of return. As Bela Gold has warned, however, such variables are inherently difficult or impossible to forecast with a degree of accuracy useful for deciding on major technological innovations, t3 A more strategic approach ("Our business is to sell gas, how can we ensure supplies?") is probably appropriate. When a firm in the private sector has pursued a major project through the planning and engineering stages for several years, it is likely to include many people strongly committed to it. If the firm has to turn to the capital markets to finance such a project, the market serves as a valuable check that the confidence of the advocates is not misplaced. In the political sphere it is not at all clear that such a check exists. It would seem, rather, that political commitment to a project increases with expenditure on it because the recipients of benefits become more obvious and articulate as the project proceeds. This accounts for the extreme difficulty in nipping off a bad public project once it is underway. 14 It is clear that the public process failed to accord sufficient weight to happenings outside the main scenario: gas was expected to become increasingly scarce, yet supply and demand were not supposed to be much influenced by price. Information that contradicted the preconceptions was not permitted to influence them. This has been identified as an inherent weakness of hierarchical organization.15

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As a final twist in this already convoluted tale, the tax laws may well turn this losing project into a winner for the companies involved! The exact results depend on the prices at which the gas will be sold during the next two decades, but one estimate is that the partners will receive an annual return of 20~ on their equity, even though the project loses money during its first eight years. 17 This results from the investment credit and rapid depreciation of the project during the early years, which in turn reduce the tax that the parent companies must pay. Whether the companies profit or not, however, society does not profit by using $2.75 billion of scarce capital to build a plant that produces gas for $10.00 per MCF when the =6The budget of the Department of Energy for fiscal year 1974 included only $1.1 million for geopressured gas market price is less than half of that. A tax and geothermal energy. The 1980 appropriation was system that creates a private reward for such $36 million. In comparison, the total cost of the Great waste may be a substantial part of the problem. Plains gasification plant was estimated at $2.76 billion.

As long as government policy kept retail price low, but made access to reserves questionable and permitted pipelines to average in the cost of syngas, any one pipeline faced with scarcity seemed to be better off relying on syngas. It was not a superior solution for the federal government, however, which had the option of permitting price to rise enough to suppress demand and encourage exploration for conventional supplies. The federal government could also have moved more aggressively to test the off-beat geological theories and to clear the legal clouds that have inhibited development of geopressured methane. 16

=7US General Accounting Office, "Economics of the Great Plains Coal Gasification Project" (Washington: GAO/RCED-83-210, August 24, 1983), Appendix I, p. 6.

Professor W S Peirce, Department of Economics, Case Western Reserve University, Cleveland, Ohio 44106, USA.

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