Bureau of Business Research College and Graduate School of Business, University of Texas at Austin June 1993

The Prospects for Natural Gas Substitution, Revisited

Technological changes in the finding and re­covery of oil and natural gas, along with the intro­duction of new legislation that encourages use of alternate fuels, have improved the prospects for natural gas as a substitute for other fossil fuels. In an earlier article, 1 we evaluated the outlook for substi­tution under the Bush Administration's "National Energy Strategy" (NES)2 and concluded that, even if fully implemented, the NES would "do little to encourage substitution of natural gas for other fossil fuels and even less to encourage the domestic production of natural gas" because projected im­ports would exceed projected substitution.

But in the three years since the assumptions underlying those projections were made, a number of the relevant circumstances have changed dramat­ically. This article reappraises the prospects for natural gas substitution in light of these changes.

The New Circumstances

Although technological progress in the finding and recovery of oil and natural gas has been con­tinuous in recent decades, the implications of some major advances have been fully appreciated only in the last few years. These advances include: three­dimensional seismography and associated comput­erized analysis and imaging; new drill bits that . sharply reduce the time and cost of drilling to a giv­en depth; perfected horizontal drilling techniques; and designs for offshore platforms that enable eco­nomical drilling in waters of 1,000 meters (0.63 of a mile) or more in depth.3 The result is greater discov­ery efficiency (more discoveries for a given number of exploratory wells), lower development and ex­traction costs, and a greatly expanded economic oil and gas resource base for the nation.

The NES projections, based on 1990 data,

assumed a "low cost" U.S. resource base of 80 million barrels of oil and 770 trillion cubic feet of natural gas.4 (The oil resource base is relevant to future gas supplies because a substantial fraction of gas is discovered in association with oil.) These fig­ures now seem far too conservative. The latest au­thoritative estimates, assuming the use of advanced technology, are at least 142 billion barrels of oil (at $20/bbl in 1992 purchasing power)5 and 875 trillion cubic feet of natural gas (at $3 .5/mcf in 1990 pur­chasing power).6 Some estimates of the natural gas economic resource base go as high as 1,400 trillion cubic feet, about 70 years' supply at current rates of consumption.7 A larger effective resource base im­plies a lower real price of gas at any given level of production in the future, hence a greater potential for long-term substitution for other fossil fuels.

Other relevant developments include new legisla­tion and regulations, at both federal and state levels, that will increase the prospective demand for natural gas as a substitute fuel. These laws and regulations encourage adoption of alternative fuels, including compressed natural gas, in auto and fleet vehicles; promote integrated resource planning in electricity resource regulation, which opens new opportunities for both energy conservation and fuels substitution; increase participation in electric power markets by small cogenerators; and facilitate the competitive transportation and marketing of natural gas.

Projections in the Annual Energy Outlook 1992

In Annual Energy Outlook 1992, 8 the Energy Information Administration, which prepared the projections underlying NES, takes the above new circumstances into account both in its "reference case" and in four hypothetical cases involving high and low economic growth rates and high and low oil prices. Because the reference case makes inter­mediate assumptions about future economic growth

ltl I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I IJtr and oil prices, we will use it as the most reasonable predictor of future demand for natural gas and alternative sources of energy in light of develop­ments since the publication of NES. We will com­pare its projections for the year 2010 with those of the NES for the same year, so as to gain some sense of the expected effects of recent changes in the per­ceived resource base and regulatory environment. The relevant data are summarized in tables 1 and 2.

As for the individual sources of energy, we note that in comparison with the rates of growth pro­jected in the NES base case, the rates of growth of both oil and coal in the NES policy scenario and the Outlook 1992 reference case are much lower, and the reductions are relatively greater than the rates of decline in total energy consumption. In contrast, the rates of growth of the "other" category actually increase relative to the NES base case in the other

Table 1 Actual and Predicted Primary Energy Consumption by Source

United States, 1990-2010 {Quads/yr.)

2010 projections

Source 1990 actual NES base Percentage NES Percentage Outlook 1992 Percentage consumption case change scenario case change reference case change

Oil 33.8 44.8 +32.5 38.0 +12.4 39.6 +17.2 Coal 19.1 33.3 +74.3 27.8 +45.5 25.2 +31.9 Nat. gas 19.4 23.0 +18.6 22.8 +17.5 23.4 +20.6 Other* 12.8 17.0 +32.8 22.2 +73.4 17.9 +39.8 Total 85.1 118.l +38.8 110.8 +30.4 106.1 +24.8

* Nuclear, hydropower, wind, solar, biomass.

Sources: National Energy Strategy, Technical Annex 2, pp. 11, 22; Annual Energy Outlook 1992, p. 5.

Table 1 shows the quantities of primary energy consumed in the United States in 1990, as well as the amounts projected by the NES for the year 2010 (a "base case" and the NES "scenario") and in the Outlook 1992 reference case. It also provides the percentage changes from actual 1990 consumption. Consider first the projected totals. In 1990 the United States consumed 85.1 quadrillion Btus ("quads") of primary energy. In the NES base case, the projected total for 2010 was 118.1 quads, an increase of 38.8 percent. The NES policy scenario projection was lower, 110.8 quads, but still a 30.4 percent increase. The Outlook 1992 projection for 2010 is lower still: 106.1 quads, an increase from 1990of24.8 percent. So the latest projection implies even greater conservation of energy than the NES policy scenario.

two projections, as does the growth of natural gas in the Outlook 1992 projection. Even in the NES policy scenario, the decline in the rate of growth of natural gas is less than that of total energy consump­tion. Both the NES policy scenario and the Outlook 1992 projections imply substitution of natural gas and "other" sources for oil and coal.

A Quantitative Estimate of Natural Gas Substitution

The data in table 2 confirm that implication, and, more precisely, they show the actual amounts of substitution by each major source of energy. (A minus sign signifies substitution for, a plus sign substitution of, the particular energy source.) In the NES policy scenario the projections imply the

Table 2 Energy Source Substitution Effects to 201 O Relative to NES Base Case,

NES Policy Scenario, and Outlook 1992 Reference Case {Quads/yr.)

NES policy scenario Outlook 1992

Source NES base case Adjusted Substitution Adjusted Substitution

Oil 44.8 Coal 33.3 Natural gas 23.0 Other* 17.0 Total 118.1

* Nuclear, hydropower, wind , solar, biomass. ** May not add exactly due to rounding.

40.5 29.6 24.3 23.7

118.1

Source: Calculated by the authors from data in table 1.

-4.3 44.1 -0.7 -3.7 28.1 -5.2 +1.3 26.1 +3.1 +6.7 19.9 +2.9

0.0 118.1** 0.0**

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tlll 11111 l I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I IDr substitution of 6.7 quads of "other" sources and 1.3 quads of natural gas for 3.7 quads of coal and 4.3 quads of oil. In the more recent Outlook 1992 projection for the same year (2010) the implied substitution is 2.9 quads of "other" sources and 3.1 quads of natural gas for 5.2 quads of coal and 0.7 quads of oil. Thus when the Outlook 1992 projec­tion is compared with the NES policy scenario, the substitution of natural gas for other sources of energy is larger by 1.8 quads (3.1 - 1.3). This is an increase of 138 percent in the substitution of natural gas for other energy sources. (The additional substi­tution is shown in the figure.) At the same time, there is more substitution for coal and less for oil, while there is less substitution for "other" sources.

All of this, including the dampened prospects for greater use of the "other" category of primary energy sources, which includes nuclear power,9 is consistent with the larger oil and gas resource base and lower recovery costs now perceived. It is also consistent with the perceived fact that the greatest potential for natural gas distribution is to be found in the generation of electricity, where coal is the dominant fuel but with environmental liabilities and where nuclear power has its only commercial use.

Natural Gas Consumption in the United States (Quad Btus) Actual 1990 and Projection to 2010

Quad Btua

28

26

24

22

20

Outlool<92• (adj. for comervation)

NES scenario• ~ • · - - .... (adj. for comervatlon) •• • - • • •

.?~--,.,, r--------­.'/ .'/

,'/ .. / .. / ·' /

NES"tuecuo" .. / •' ,, . ,, ,· ,, .... ,, ,,

18 ..._ ___ ,___ __ ___.... ___ -+------<

1990 1995 2000 2005 2010

*Adjustment for conservation is done by the authors.

Additional substitution effect

Sources: Natwnal EMrgy Strategy, Technical Annex. 2, pp. 11, 12; and AMUal EMrgy Outlook 1992, p. 65.

As a result of recent technological and institutional changes, the prospects for the substitution of natural gas for other sources of energy, especially for coal, look considerably brighter.

- Stephen L. McDonald, Ph.D. Professor of Economics and Senior Fellow

and Mina Mohammadioun, Ph.D. Head, Natural Resources Program Bureau of Business Research

Notes l. Stephen McDonald and Mina Mohamrnadioun, "Natural Gas Substitution Under the 'National Energy Strategy,' " Texas Business Review, February 1992. 2. National Energy Strategy: Powerful Ideas for America (Washington, D.C.: Department of Energy, 1991). 3. American Gas Association, Changes in Natural Gas Recovery Technology and Their Implications, September 1990, pp. 11-23. 4. National Energy Strategy, Technical Annex 2: Integrated Analysis Supporting the NES (Washington, D.C.: Department of Energy, 1991), pp. 8-9. 5. An Assessment of the Oil Resource Base of the United States (Austin, TX and Bartlesville, OK: Bureau of Economic Geology, University of Texas at Austin and National Institute for Petroleum and Energy Research, October 1992), p. 1. 6. The Potential for Natural Gas in the United States (Washington, D.C.: National Petroleum Council, December 1992), p. 5. 7. Robert J. Finley, "A Positive Assessment of the U.S. Natural Gas Resource Base" in The Role of Natural Gas in Environmental Policy, edited by Stephen McDonald and Mina Mohammadioun, Bureau of Business Research, forthcoming. 8. Annual Energy Outlook I992 (Washington D.C.: Energy Information Administration, Department of Energy, 1992). 9. Within the "other" category, the substitution effect for nuclear power is + 1.1 in the NES policy scenario and + 1.2 in the Outlook 1992 reference case. For renewables, the corresponding figures are +5 .6 and +l.6.

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Total nonagricultural employment Total employment Unemployment (thousands) (thousands) rate

Percentage Percentage Area Mar. 1993 Mar.1992 change Mar. 1993 Mar. 1992 change Mar. 1993

Abilene 50.7 49.3 2.8 49.0 48.2 1.7 6.1 Amarillo 80.4 80.3 0.1 92.2 92.8 -0.6 4.9 Austin 420.3 403.2 4.2 457.1 444.6 2.8 4.3 Beaumont-Port Arthur 149.6 149.6 0.0 157.7 159.7 -1.3 10.2 Brazoria 68.2 68.6 -0.6 82.7 84.6 -2.2 7.4 Brownsville-Harlingen 84.3 80.4 4.9 100.4 97.0 3.5 10.4 Bryan-College Station 61.4 58.8 4.4 65.8 64.l 2.7 3.2 Corpus Christi 137.9 136.4 I.I 152.8 154.4 -1.0 8.1 Dallas 1,408.9 1,377.8 2.3 1,368.3 1,363.8 0.3 5.9 El Paso 221.3 214.2 3.3 234.8 231.0 1.6 9.1 Fort Worth-Arlington 598.9 581.2 3.0 694.2 686.8 l.l 5.9 Galveston-Texas City 83.8 79.2 5.8 110.8 105.9 4.6 7.4 Houston 1,630.0 1,621.4 0.5 1,635.I 1,650.l -0.9 6.8 Killeen-Temple 82.0 75.9 8.0 97.6 92.5 5.5 6.4 Laredo 51.l 48.6 5.1 53.5 51.4 4.1 8.1 Longview-Marshall 69.4 70.2 -I.I 72.6 73.9 -1.8 8.9 Lubbock 99.2 98.0 1.2 108.3 109.6 -1.2 6.5 McAllen-Edinburg-Mission 110.7 105.7 4.7 140.8 137.9 2.1 14.6 Midland 45.4 45.9 -l.l 44.9 46.0 -2.4 6.8 Odessa 44.7 45.2 -1.l 48.3 49.8 -3.0 9.2 San Angelo 39.3 38.3 2.6 43.2 43.0 0.5 5.5 San Antonio 563.3 539.2 4.5 598.4 584.0 2.5 5.3 Sherman-Denison 36.7 36.4 0.8 43.0 43.0 0.0 6.3 Texarkana 47.0 46.7 0.6 NA NA NA NA Tyler 64.9 63 .8 1.7 71.l 70.6 0.7 8.0 Victoria 32.3 30.8 4.9 37.7 36.7 2.7 5.3 Waco 84.3 82.9 l.7 87.9 87.9 0.0 5.6 Wichita Falls 50.2 49.3 1.8 50.6 50.7 -0.2 7.8 Total Texas 7,382.5 7,187.3 2.7 8,097.6 8,057.1 0.5 6.7 Total United States 108,320.0 107,359.0 0.9 117,406.0 116,106.0 l.l 7.3

Note: Data are not seasonally adjusted. Figures for 1992 have undergone a major revision; previously published 1992 figures should no longer be used. Revised figures are available upon request. All 1993 figures are subject to revision. NA: Not available.

Sources: Texas Employment Commisson and U.S. Department of Labor, Bureau of Labor Statistics.

Maquiladoras (continued) NAFf A has focused attention on the economic

performance of the maquiladora industry in the context of trade liberalization. Those maquiladoras that produce products with a large content of North American components will benefit from the elimi­nation of duties and the increased access to the Mexican market afforded by NAFfA. At the same time, the duty refund program will impose higher nontariff restrictions on maquiladoras that use a large percentage of foreign components and ma­chinery (those from outside the free trade region). Most affected will be Japanese maquiladoras that assemble television sets from components mainly imported from Japan.

The effect on Texas will be mainly positive. Mexico is already the state's largest, as well as the nation's third largest, trading partner, and an ex­panded trading relationship will have a profound impact on Texas. The agreement will favor the maquiladora industry as a whole by gradually eliminating tariffs on components of North

American origin and by facilitating access to the Mexican market. A healthier maquiladora industry will mean more jobs for Texas through backward and forward linkages. Furthermore, the emphasis on international trade as a result of N AFf A will highlight the need to improve the environment, infrastructure, and customs services on both sides of the border.

- Elsie L. Echeverri-Carroll, Ph.D. Head, Economic Development Program Bureau of Business Research

Note 1. GSP makes certain duty concessions to developing nation ex­porters of eligible products. Under this system, the entire value of the product returned to the United States can be imported free of duty when the local content increases to at least 35 percent. HST item 9802.00.60 permits the reimport of "fabricated" (but in effect unfinished) metal products into the United States for further proces­sing; 9802.00.80 permits only the "assembly" of finished goods for reexport to the United States for final consumption. In 1990 pro­ducts worth $73. l billion were imported under item 9802.00.80, while products worth only $1.3 billion were imported under item 9802.00.60.

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Maquiladoras: An Industry in Transition

The number of maquiladora or in-bond plants in Mexico grew from 454 in 1975 to more than 2,000 by October 1992. Accordingly, the number of ma­quiladora jobs increased from 67,214 to over 502,000 in the same period. In 1991, these plants earned over $4.1 billion in foreign exchange, sup­planting tourism as Mexico's second largest earner of foreign exchange after its oil export sector. How­ever, this manufacturing growth is not confined to Mexico. Manufacturing jobs are being added on the Texas side, too. It has been estimated that maquila­doras contribute one in five new jobs created in El Paso. In 1987, when most of the state experienced a 1.2 percent decline in jobs, the mix of industries along the border allowed this area a 1.1 percent increase in employment.

The maquiladora industry is heavily concentrated along the U.S.-Mexico border, with the largest num­ber of plants in Ciudad Juarez, across the border from El Paso. When Juarez launched into the ma­quiladora business in 1969, eleven plants and 255 maquiladora workers were located in the city. By October 1992, Juarez registered a total of 266 plants with over 128,000 workers, 12.8 and 25.5 percent, respectively, of the totals of all in-bond plants. A major factor in this success is that Juarez and El Paso are the largest metropolitan areas on the Texas-Mexico border and contiguous to one an­other. Rapid growth of the industry is occurring in other such cities on the Texas border, including Reynosa (McAllen), Matamoros (Brownsville), and Nuevo Laredo (Laredo), and some maquiladora activity is developing in such nonmetropolitan city pairs as Ciudad Acuna (Del Rio) and Piedras Negras (Eagle Pass).

For more than a decade, the growth of the U.S. economy and low Mexican wages have been the major factors contributing to the success of the maquiladora industry. Estimates indicate, for instance, that an increase of one unit in U.S. indus­trial production will increase maquiladora employ­ment 2.8 times. Therefore, the near-term transition of the U.S. economy to substantially slower real domestic economic activity can be expected to influence maquiladora growth adversely. Moreover, it is expected that the increased investment (both foreign and domestic) in Mexico likely to result from the North American Free Trade Agreement

(NAFfA) will be accompanied by increases in both Mexican wages and the demand for Mexican labor.

However, the implementation of NAFfA will also create incentives for the maquiladora industry that should compensate for the slowdown in the U.S. economy and the increase in Mexican wages. In the past, a major competitive advantage of maquiladora production has been the favorable tariff treatment provided by the U.S. government through the Generalized System of Preferences (GSP) program and HTS (Harmonized Tariff Schedule) provisions 9802.00.60 and 9802.00.80. 1

Currently, only U.S. components enjoy preferential treatment under HTS provisions; under NAFf A, maquiladoras can trade Mexican, Canadian, and foreign (i.e., Japanese) components duty-free, providing that their products comply with percent­ages on rules of origin.

The most important changes associated with NAFf A will affect nontariff provisions, in particu­lar, those that allow the importation of goods duty­free pending exportation to the importing country. This in-bond arrangement will be replaced in each partner country with a duty refund program. Under this new program, maquiladoras will pay duties on components imported into Mexico and again on these components in the United States if the assem­bled product does not meet rules of origin standards. To avoid double taxation, the lesser duty payment will be refunded. This means more red tape for the maquiladora, making this measure equivalent to a nontariff barrier. It is also equivalent to lending money to the country with the higher import tariff for the lag between the time that a product is im­ported and the time when the duty is refunded. The Japanese maquiladoras assembling TV sets may be among the most affected by this measure because of their reliance on a large percentage of foreign components.

Foreign investment in Mexico remains regulated by a 1973 law that primarily promotes domestic investment. However, the 1989 foreign investment decree introduced important changes designed to create an environment more open to foreign trade. Despite the 1989 decree, Mexico's restrictive 1973 foreign investment law remains in effect, and liberalization can be implemented only through executive decrees. Although NAFf A continues the possibility of 100 percent foreign ownership, some changes still have to be made to the 1973 law before liberalization of foreign investment can be effective. (continued on preceding page)

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Editor: Lois Glenn Shrout Assistant Editor: Sally Furgeson

Texas Business Review is published six times a year (February, April, June, August, October, and December) by the Bureau of Business Research, Graduate School of Business, University of Texas at Austin. Subscriptions to Texas Business Rev_iew are available free upon request, as are back issues.

The Bureau of Business Research serves as a primary source for economic and demographic data on the state of Texas. An integral part of UT Austin's Graduate School of Business, the Bureau is located on the sixth floor of the College of Business Administration building.

Announcements Although manufacturing employment in the

United States has been shrinking over the past five

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years, Texas has experienced the reverse: growth in manufacturing jobs. The Bureau's Manufacturing in Texas draws together articles that focus on such recent trends as high-tech manufacturing and the maquiladora industry in Texas, accompanied by statistical appendices. Ready for distribution in June, the collection may be purchased for $16.50 plus tax. To order, phone (512) 471-1616 or fax (512) 471-1063.

The second edition of the Natural Fibers Fact Book will be ready for release in June. This collec­tion offers statistical data on cotton, wool, mohair, oilseeds, and textiles, with particular emphasis on Texas production, quality, end use, and trade data. Tables and charts offer the most current data avail­able. The price is $15 plus tax. Also available by subscription is the Natural Fibers Electronic Newsletter. To order the book or get information about the newsletter, call (512) 471-1616 or fax (512) 471-1063.

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