Thursday, September 30, 2004

The New Frontier, Again
Yesterday's announcement that ConocoPhillips was acquiring an approximately 8% interest--which could grow to up to 20%--in Russia's Lukoil is another signpost of the growing importance of Russia in the portfolios of the international energy majors. Despite a healthy dollop of political risk in several flavors, Russia represents one of the best opportunities for new reserves and production outside the Middle East, and on a scale that is material even to the world's largest oil and gas firms. As the Financial Times article notes, Conoco's Lukoil stake will have implications for the development of Iraq's enormous reserves, as well.

The timing of this announcement is noteworthy, coming as it does in the midst of the unresolved government assault on Yukos and the challenges facing BP's TNK stake. I'm sure the Putin government placed a lot of emphasis on this deal, as a way to restore some of the confidence that has been shaken recently. While it may not assuage all fears, this transaction, along with ChevronTexaco's recent announced linkage with Gazprom, affirms the central importance of Russian reserves over the next 10-20 years. With yesterday's stars fading, including a more rapid than expected decline in the UK North Sea, significant new production will be needed to meet growing demand.

In many respects this is "back to the future", since Russia was one of the first major oil producers a century ago, creating wealth on a vast scale, including that of the Nobels. Although the wealth is likely to be shared differently this time, Russian oil is no less attractive now than it was then.

Wednesday, September 29, 2004

Alternatives or Ultra-Efficiency?
The October 4 issue of Fortune features this article by Amory Lovins, the alternative energy guru I mentioned in my blog of March 26, 2004. It seems quite timely, with oil prices hitting new highs, to consider a radically different approach to meeting our energy needs. And no one would ever accuse Amory of thinking inside the box.

It's important to stimulate our thinking with viewpoints such as his, even if they seem outlandish or impractical at first blush. We need to understand that there are other energy choices out there besides the status quo, and make informed decisions about them, rather than choosing by default. In the process, I'd suggest that readers focus on Mr. Lovins's concepts, rather than his numbers, because I'm not sure the latter are entirely credible.

For example, his suggestion that an investment of $180 billion over 10 years could essentially wean the US off not only imported oil, but all oil, sounds at least an order of magnitude too low. ExxonMobil alone is on track to spend roughly that amount just to sustain its current business over the same period. I also don't see how Mr. Lovins's figures could include the cost of keeping current infrastructure available during a transition, while bringing on a whole new fuels economy in parallel. Perhaps I haven't understood his arguments.

Setting aside such criticisms, though, I find much here that is intriguing, clever, and worthy of further discussion and debate. If someone doesn't dream big and imagine a different future, then it is a foregone conclusion that we are heading for a world that won't differ much from today's.

Tuesday, September 28, 2004

The "Half Century"
I want to get back to writing about alternative energy, but there's so much going on in the world of oil and gas that I don't want to ignore, either. And who can ignore $50 oil? A milestone, certainly, but is it a herald, too?

I'm hard-pressed to respond much differently than I did in my posting of March 5 of this year, concerning the apparent end of cheap oil. We need to keep asking if we are seeing a true structural change in the market, or simply an unlikely convergence of bullish factors. Thus far, I believe the evidence still favors the latter view, at least on the supply side of the equation. But that doesn't mean I think oil will be cheap anytime soon. Earlier this year, it looked plausible that oil would be back close to $30 by the time the election rolled around. Sustaining that view now would require the perspective of the White Queen from Alice in Wonderland, who could "believe as many as six impossible things before breakfast."

Just to recap the list of important producing countries and regions currently experiencing problems, we now have Iraq, Nigeria, the Gulf of Mexico, Russia and Venezuela (though they would claim they don't belong on this list.) And then there's Indonesia, which has become a net oil importer. I'm sure I'm forgetting someone. In any case, the aggregate effect of a number of individually manageable problems has consumed the global capacity cushion and created a market in which the fundamentals seem as scary as the news.

I'm pleased to see that the DOE is loaning out some oil from the Strategic Petroleum Reserve. Given the storm-related disruptions in the Gulf of Mexico, this is highly appropriate, as would be suspending additions to the reserve until all of that production is back on line. This matters less for the volumes involved than the signal it would send.

Monday, September 27, 2004

California Dreaming?
Friday's papers carried the news that California's Air Resources Board had approved rules to reduce the emissions of greenhouse gases from cars sold in the state by 2016. While this doesn't come as a surprise, it will have serious implications for the global auto industry and be hotly contested. As I've indicated previously (see my posting of 6/14/04) I think that state-by-state responses are the wrong way to respond to climate change, but I suppose they are a logical consequence of the administration's unwillingness to move ahead nationally on this issue.

It is also perplexing that the state would have set an easier standard for SUVs than cars, since the potential savings in the former is so much greater. Reductions in SUV emissions should also be easier to achieve, since they offer more scope for weight reduction, smaller engines and improvements in four- and all-wheel-drive transmissions, as well as higher technology approaches such as hybridization. Some of these changes might also begin to address these vehicles' disproportionate collision hazard, which has forced some passenger car makers to invest in costly countermeasures.

Right, wrong or indifferent, the auto industry will have to develop plans to meet this challenge, even as they gear up to fight it. California constitutes 10% of the US car market, and though carmakers have been producing separate California and 49-state models for years, changes in California affect the entire industry. In addition, a number of other states have taken to following California's regulatory framework, and this influence has spread abroad, too, to places like Korea.

The best outcome would be a set of EPA guidelines that gave states some leeway within a defined range of greenhouse gas reductions but provided the auto industry with clarity and reduced uncertainty about the targets it must meet. The worst outcome would mirror the current situation on the fuel side, where a Balkan complexity of state regulations has made a hash of the highly efficient and resilient gasoline distribution system.

Friday, September 24, 2004

Lord Browne Speaks
I've devoted a lot of space this week to concerns about future oil supply and some possible solutions. My regular readers know that I've formed the view that we face a prolonged period of tight oil supply in the future, though I'm skeptical that what we are now experiencing is it. I think it's worth capping the week with a very clear and articulate argument for the view that things will be OK. Who better than Lord Browne, Chairman of BP--arguably the world's most successful oil company at the moment--to provide it in this article from the Financial Times (subscription may be required).

In particular, his discussion of the situation in the key OPEC producers is well-reasoned, encompassing both their domestic needs and their wherewithal to build capacity when they perceive the need. He also makes some insightful comments about the distinction in roles between the international oil majors, such as BP, and the national oil companies of the countries from which much of the world's incremental oil supply must come.

His shareholder focus is also apparent and appropriate, urging caution about rushing into potentially unprofitable projects around the world. And he shows real passion in defending the industry's record of investment, stating categorically that the needed infrastructure is in fact being built. Finally, he ascribes the current high prices to a surge in demand, more than a shortfall in capacity.

None of this can be dismissed out of hand, but I think even Lord Browne would agree that his responsibilities and perspective are fundamentally different from those of someone charged with looking after the public's interests. He has given us a highly credible description of the successful status quo scenario for energy. We just can't forget that there are other, less comforting scenarios, which, even if less likely, have serious potential consequences for our economy and security.

Thursday, September 23, 2004

Unconventional Oil
Yesterday I looked at the debate concerning a possible early peak in conventional oil production. Today I'd like to cover one of the wild cards that might avert a peak. With the world’s spare oil capacity currently perilously close to zero, and with prospects of creating a safety margin anytime soon looking dim, “unconventional” oil is becoming increasingly important.

This term covers of ground, especially for those who recall the abortive and costly US experiment with oil shale in the 1970s. Generally speaking, it describes oil that either does not flow out of the ground readily through conventional drilling, or oil that requires significant processing after production. The two main forms of unconventional oil in wide production today and with good prospects for expansion, oil sands and ultra-heavy oil, fit one or the other of these criteria.

The reason these resources are so important now is that large deposits have already been identified, essentially eliminating the exploration risk associated with expanding conventional oil production. Bringing them onstream is a matter of deciding to invest in the industrial plants to handle their unique characteristics. While this sounds trivial, keep in mind that these are massive investments, running in the billions of dollars for each facility.

Recently, Canada has made a bid for recognition as having the world’s second largest oil reserves, after Saudi Arabia. With all due respect to my Canadian colleagues, this is a bit disingenuous, since the largest share of those reserves would not qualify as such under the SEC’s definition. The Oil and Gas Journal reports Canadian reserves of 180 billion barrels, while World Oil indicates only 5.5 billion. Oil sands—which were formerly known as “tar sands”, and the extraction of which is more like mining than oil drilling—account for the difference. Oil sands production already comprises about a third of Canada’s oil production and has staved off a decline in that country's overall production and exports. A number of firms are considering adding oil sands capacity, including Suncor, one of the main producers.

The other leading form of unconventional oil being produced today comes from the Orinoco Belt of Venezuela. It is extremely heavy, with a density greater than that of water, and is both difficult to extract and requires a good deal of expensive pre-refining before the resulting synthetic oil can be shipped off to a refinery for processing into gasoline and other products. But like Canada’s oil sands, the quantities available are enormous. Several plants, including the Petrozuata and Hamaca facilities, have been built in recent years, with more in prospect. Their combined production will soon rival Venezuela’s conventional oil production.

The biggest problems with both of these forms of oil are the capital required to produce them and the time required to construct the necessary mining and processing hardware. As a result, I’ve always been skeptical that they are quite the silver bullet that some suggest. For example, the Canadian industry will spend between $30 and $50 billion between now and 2012 to add under a million barrels per day of new synthetic oil capacity. You'd have to multiply this by a factor of three or four to make a dent in the global oil production profile.

At least until the recent price spikes it hasn’t been clear that the industry could attract this kind of incremental capital and provide attractive returns over the lives of these investments. But if the pessimists are right about the challenges the Saudis face in just maintaining their current production capacity, we had all better hope that there are lots and lots of new oil sands and heavy oil projects coming down the pike.

Wednesday, September 22, 2004

Peaking Interest
Well, the peak-oil issue has finally made it to the front page of the Wall Street Journal. Yesterday's article presented both sides of the issue, focusing on Colin Campbell as a leading exponent of the "peak is imminent" faction, and Michael Lynch as the chief naysayer, backed up by statements from ExxonMobil. The Journal did a fine job of presenting enough of each side's argument that their audience can do some evaluating of its own, rather than having to rely on the writer's conclusions.

The theory of peak oil is built on the observation that when you have produced half of the oil that was there before you started pumping it, then production will reach a plateau and then begin to fall. This has been characteristic at the oilfield level, at the national level (particularly in the case of the US), and should be true for the globe as a whole, or so the argument goes. The article correctly differentiates this from the fallacy that we are "running out of oil." The succession of Mr. Campbell's previous incorrect estimates of a peak in production (e.g. in 1995) gets chalked up to inaccuracies in estimating the total amount of oil, not to failures of the underlying theory.

Mr. Lynch's counterargument is a bit more complicated, and possibly less appealing but likelier to be right for that very reason. He suggests that ultimate production is a function of geology, economics, and geopolitics. Thus any projection of future production based on historical levels will be skewed by changes in price, prevailing contractual terms, and access to resources. He also has some specific concerns about the data used by Campbell and others. As you might guess, he does not see a peak occurring anytime soon.

One of the interesting contrasts highlighted by the article is the extreme range of estimates for how much oil is actually still available. Mr. Campbell assumes that there is about as much left as we have pumped to date (roughly 900 billion barrels), while ExxonMobil sees up to 14 trillion barrels of recoverable oil, including non-conventional oil such as tar sands (my blog topic for tomorrow.)

As I've indicated previously (see my posting of May 7, 2004) I think that both sides in this debate are on to something. While much less skeptical about how much oil can ultimtely be extracted than Dr. Campbell, I think that many mainstream analysts underestimate the difficulties of getting timely access to resources and queuing up the financial and engineering means to harvest them, far enough in advance of the need. My retort to industry colleagues skeptical of this is simply this: show me the field-by-field production profile that in aggregate yields a steadily rising supply curve, and I will banish all thoughts of an impending gap between supply and demand. No takers, yet.

Tuesday, September 21, 2004

It's Here?
The other interesting news from last week was the reaction to Tony Blair's stern warnings about imminent effects of climate change. In the UK, leading London papers carried editorials calling for drastic responses, ranging from increased use of renewable energy, a new wave of nuclear power plant construction, and even investigating the feasibility of using oceanic phytoplankton as a giant "carbon sink". The reaction on this side of the pond was indifference.

Having followed the climate issue for some time and developed scenarios focused on what would get the attention of the US public on this issue, I'm surprised that we can endure a succession of three major hurricanes hitting Florida and the Gulf Coast within a month without our politicians even hinting at a link to climate change--despite a contentious presidential campaign in which John Kerry is trying to position himself as the candidate of the environment.

And while I certainly understand the distinction between weather and the climate, this event, suggesting a possible increase in the frequency and magnitude of Atlantic hurricanes, is precisely the kind of consequence that climate researchers have predicted. Could it just be coincidence or bad luck? Perhaps, but it takes a true skeptic not to see the pieces of the puzzle beginning to fall into place.

If anyone here is paying attention, I suspect it is the insurance industry, as Mr. Blair suggested. The combined damage from the three storms may amount to $20 billion or more, and insurers and their reinsurance backers will be hit for a large chunk of that. Don't be surprised to see them raise a red flag on climate change in the near future.

Monday, September 20, 2004

Chess, Anyone?
The most interesting news I saw over the weekend was the report that Yukos, the embattled Russian oil giant, has revised its estimated oil reserves upward by a factor of five, to 93.7 billion barrels. Note that this compares to published reserves, as of 1/1/03, of 60 billion barrels, not for Yukos but for all of Russia. Even allowing for the inclusion of some gas, this is a stunning announcement. If accurate, it has major implications.

Most importantly, as some have suspected, it would indicate that Russia has significant untapped and previously unreported oil reserves that put it in the same league as the larger Middle Eastern producers, such as Iraq, if not with Saudi Arabia itself. At the same time, this would throw pessimistic estimates of when Russian oil production is likely to peak into a cocked hat. And it would make Russia that much more attractive an investment play for the international oil majors, many of which are struggling to increase production by more than a percent or two.

However, such an announcement cannot be divorced from its context, the confusing confrontation between Yukos and the Russian government. Is this intended as a signal to the government that the consequences for the Russian economy of the threatened dismemberment of Yukos are far beyond the Kremlin's calculations? That Yukos, as presently constituted, is better equipped to boost Russia's oil production--and thus its export earnings--than any possible successor to its assets? At the very least it is an interesting way of raising the stakes in what is already a very high stakes game. While it must be taken with a healthy dose of skepticism, given the timing, it certainly qualifies as an amazing development.

Friday, September 17, 2004

Bad Timing
Last week's Economist carried one of their excellent periodic industry sector reports, this one focused on the global automotive industry. As the lead article and subsequent details demonstrate, the industry is shaky and probably undercapitalized for dealing with the challenges it faces. Thus the problems generated by the prospect of sustained high fuel prices could not come at a worse time for carmakers, especially Ford and GM, which still rely heavily on profits from the sale of large SUVs.

I also suspect it is no accident that Toyota should be so well-positioned, financially, geographically, and technologically, to prosper under these conditions. They are making big bets on efficiency and the environment, in the form of hybrids now and fuel cells later, and on capturing the early loyalty of a new generation of carbuyers, through the introduction of the Scion brand aimed at the Millennials (the so-called "echo boomers"), which at least in the US will ultimately rival the Baby Boom generation in size and influence. If these bets pay off, Toyota could challenge GM for top rank, having already narrowly passed Ford.

It's even more intriguing, though, to ponder some of the other possibilities raised by the Economist. We've already seen one car designed and fabricated in the decentralized and highly outsourced fashion they suggest: Mercedes' Smart. Is this the wave of the future, and if so, how would this change the industrial landscape of the US and other developed countries?

Thursday, September 16, 2004

Independence vs. Interdependence
Yesterday's Wall St. Journal included this commentary concerning Senator Kerry's repeated references to "energy independence." In the next few weeks I plan to revisit my earlier analysis of the Senator's energy proposals (see my blog of 2/27/04) but I think it's worth touching on this aspect now. As Mr. Tucker indicates in this article, it is just not reasonable to imagine that we will be able to do without oil from the Middle East anytime soon.

While I am enthusiastic about alternative energy, including wind and solar power, and intrigued by the potential of a hydrogen-based economy, I would hope that anyone governing this country--or aspiring to that responsibility--would understand the enormous costs and time required for any such transition and the need to ensure that our current energy supplies remain adequate in the meantime.

Any sensible energy policy should be built around several key principles, including the fact that gasoline will remain our primary transportation fuel for at least the next decade and probably longer, that natural gas is the cleanest and best fuel for power generation, as well as for a number of other stationary applications, and that continued economic growth will require increased supplies of oil and gas, from both domestic and foreign sources. It should also recognize the growing importance of alternatives and the need to help them compete against traditional sources, at least initially. It should include the following kinds of measures:
- Incentives for the development and deployment of alternative energy, particularly in areas in which reaching economies of scale is important.
- Revised corporate fuel economy standards that create a level playing field for cars, SUVs and light trucks, and advanced technology vehicles.
- More rational offshore drilling restrictions that recognize the difference between drilling for oil, with its potential for spills in sensitive areas, and drilling for "non-associated" natural gas, for which those risks are negligible.
- Regulations and incentives to modernize and upgrade our electric power infrastructure to make it more reliable and resilient and less vulnerable to sabotage.
- A fast-track permitting process for LNG import facilities that fairly balances local concerns with pressing regional and national energy needs.
- An impartial, fact-based cost-benefit analysis of oil development in the Arctic National Wildlife Refuge, including environmental costs. This should include preliminary, non-invasive exploration at government expense to assess the true scale of the resources that we are presently choosing to forego.
- Removal of current disincentives for industry to hold higher inventories of oil and refined petroleum products, as a way of partially privatizing the function of the Strategic Petroleum Reserve.

I don't think this is merely the standard oil industry laundry list, and I would also suggest that as part of the energy security debate, many of us may need to reconsider old prejudices. Isn't it just possible that some things that look good for Big Oil might also benefit everyone?

Wednesday, September 15, 2004

A New Giant
On the heels of yesterday's discussion about opening up OPEC's reserves to foreign investment comes the announcement that Rosneft, the Russian state oil company, and Gazprom, the largest gas enterprise in the world, will combine to form the world's largest publicly-traded energy firm (measured by reserves.) Today's Wall Street Journal also speculates that the new entity could serve as a receptacle for assets seized from Yukos. In any case, this is a momentous development, if actually carried out, and it could provide a useful model for other countries.

At the same time, this news poses challenges for the existing international oil and gas companies. Although examples such as BP's investment in Russia's TNK abound, the international majors need more than just passive--and hopefully profitable--minority investments. Their business models depend on access, so any such investments must be made in the expectation that access to resources will follow, and on a scale to justify the portfolio and governance risks endemic to minority stakes in countries with poorly-developed legal protections for investors.

As enticing as the new Gazpromneft may be from a market perspective, it is harder to discern how an investment by an Exxon or Shell in this new entity will translate into profitable equity oil and gas production and bookable reserves. Without those, the oil majors may end up evolving into service companies that no longer enjoy the resource rent that has fueled their earnings for the last century.

Tuesday, September 14, 2004

Total Speaks Out
The Financial Times reports that Total's CEO, Thierry Desmarest, has publicly called for OPEC countries to open up access to their oil reserves for international development, in order for oil production to keep pace with global demand. Regular readers of my blog will recognize an issue I've been harping on for a while, but M. Desmarest goes beyond this to highlight a critical crossroads for the industry. I hope that the head of every oil company reads his comments, particularly those running the national oil companies in OPEC countries.

When considered carefully, his remarks point out the disconnect between the current business model of the international oil and gas industry and what is required for future oil production to keep up with growing demand, ignoring concerns about geological limits to oil production. He is saying that the international oil majors can be quite successful and profitable operating as they are, relying largely on developing their own exploration discoveries and bringing them to market, but that this will not close the gap that is now apparent between future production capacity and potential future demand.

Several key facts support his argument. First, as we've known for years, OPEC has a disproportionate share of the world's oil reserves, and these tend to be more easily produced than non-OPEC's. In addition, the price collapse accompanying the Asian Financial Crisis of the late 1990s taught oil companies that it is much riskier to overestimate future demand than to underestimate it. The latter also turns out to be enormously more profitable, as we are seeing now. M. Desmarest has omitted a third contributing factor, industry consolidation.

Part of the process of delivering merger synergies entails high-grading the exploration and production portfolios of the merging firms. That means that some upstream projects are cancelled, postponed, or sold off to companies with fewer resources. The result of the seven recent top-tier mergers that come quickly to mind must be lower aggregate oil production in the future than would have been the case without the mergers, unless you believe the survivors are going to be that much more efficient at executing the remaining projects, or at finding new ones.

So the crossroads looks like this: one branch takes the oil majors down a road of strong financial performance on a base of stable (+/-) production volumes, but risks sustained oil prices that justify lots of alternatives, while the other branch involves a number of initially less profitable ventures with OPEC countries, but keeps the industry healthy and capable of supplying all the transportation fuel the world wants for many years to come. It's a fascinating choice, especially when you start probing the criteria for making such a choice.

I think M. Desmarest is also sending a subtle message to Russia. Because their oil tends to be cost more to extract than OPEC's, they face a window of opportunity that may close when and if OPEC realizes it could produce a lot more oil, a lot faster, with outside help. Does Mr. Putin hear this clock ticking?

Monday, September 13, 2004

Joining the Club--But Why?
I have to admit to being perplexed by the controversy over Iran's nuclear ambitions. In particular, I'm baffled by the degree to which the international community seems to accept that Iran might want to possess a complete nuclear fuel cycle (i.e. the ability to produce their own reactor fuel and reprocess the spent fuel) for some motivation other than wanting nuclear weapons. After all, as a report I cited in an earlier blog (March 12, 2004) put it, the difference between a country with a civilian nuclear fuel cycle and one with nuclear weapons is largely one of intent.

If you consider the main reasons that a country might choose to have nuclear power plants and nuclear fuel processing, most of them can be ruled out in the case of Iran. First, although Iran's consumption of primary energy grew by 75% between 1992 and 2002, to 5.9 quadrillion BTUs/year (compared to US consumption of 97.6 "quads"), it produces 10.4 quads/year of oil and natural gas and has reserves of over 800 trillion cubic feet of the latter, nearly five times as much as the US and second only to Russia. That works out to about an 80-year supply of their current energy use. Iran is hardly short of primary energy.

A slightly more sophisticated version of the energy shortage argument turns on preserving oil and gas for export to earn hard currency, by shifting domestic power generation to nuclear. This doesn't really hold water, either, since with vast untapped gas reserves it should be much more cost effective to generate additional export income by investing the cost of the nuclear program in LNG export facilities.

I think we can also rule out environmental concerns as a driver. Even though Iran is a signatory to the Kyoto Treaty on greenhouse gases, and nuclear power plants are one solution to generating emissions-free electricity, Iran's economy is critically dependent on the world's appetite for hydrocarbon fuels--with their accompanying emissions--and nuclear power plants won't change that.

Perhaps I'm missing something, but the only other rationale I can see besides the obvious one has to do with national prestige. That played a big role in Iran's previous nuclear ambitions, under the Shah, but in today's world this is a particularly expensive and dangerous way to try to impress one's neighbors. If this is the driver, we should actively encourage the mullahs to find another arena for competition.

So if we were to call a spade a spade, here, what would be the outcome? The US has had economic sanctions in place against Iran since the mid-1980s, and they have been effective mostly against US companies whose foreign competitors weren't under such constraints. Little impact on Iran is apparent. Any action to restrain Iran would have to be multilateral and strongly enforced.

Could the world do without Iran's oil and gas just now, if international sanctions were imposed? I think this takes us to the crux of the issue. With Iraq's production frequently interrupted by sabotage, and with global oil demand bumping up against supply limits, Iran is in the driver's seat. Invading or embargoing Iran would be a short path to $100 oil, and there are plenty of folks around who remember 1978-9, the last time Iran's oil went off the market.

This is about as cynical as I get, but it seems to me that Iran is very clearly on a path to getting nuclear weapons and will receive a "get out of jail free" card from the world because of its critical importance as an oil supplier. What am I missing?

Friday, September 10, 2004

Rumors Quashed?
The Financial Times reports that Total's CEO, M. Desmarest, has denied speculation that his firm is interested in a takeover of Royal Dutch/Shell. Whether this is just the usual rumor control around the edges of something proceeding stealthily, or a genuine recognition that the conditions aren't right for this kind of merger, his remarks are welcome. An increasing number of analysts are recognizing that the global oil industry faces a serious capacity crunch. At this point, the oil majors need to invest in new exploration and production projects, not in each other.

The consequences of previous under-investment weigh heavily on fuel prices today, though they have done wonders for oil company equity prices. The stock of my old firm, ChevronTexaco, is up 15% vs. the S&P 500 in the last six months, and up nearly 30% since the start of the year. But even though recent investment constraints look smart for shareholders in the short run, they diminish the companies' long-term growth prospects and expose the global economy to risks that must affect shareholders' overall wealth to a greater degree.

Unfortunately, if the industry dramatically ramps up investment now, this could create a future oversupply that would undermine the returns on those projects for a few years. This is the perennial paradox of the industry, and part of the cost of doing business. Ultimately, if oil supply fails to keep up with demand, the incentive for alternatives will be much greater, and yesterday's prudence will look like tomorrow's myopia.

Thursday, September 09, 2004

The New Car
The New York Times gets my vote for best title of an article dealing with high oil prices, “Laissez-Faire My Gas Guzzler, Already”. The article also nicely illustrates the difference between the short-term and long-term price elasticity of demand for petroleum products. It describes anecdotally why, even with higher gas prices pinching drivers' wallets, it’s hard for them to change their fuel consumption much. It also discusses some of the uncertainties that weigh in these longer-term responses, such as the purchase of a new car.

I have some skin in this game—beyond mere punditry—since I’m seriously considering replacing my seven-year-old car this fall. One of the first things I’ve discovered is that my technology choices are much wider than I’d have suspected, even given my interest in the industry. It’s not just a choice of hybrid or no hybrid.

In fact, there’s already a bewildering array of possibilities out there, without contemplating anything as exotic as fuel cells. Before I even get to styling and fun, which will be key decision attributes, I must evaluate the following powertrain choices:

- Conventional gasoline engine, normally aspirated (i.e. regular fuel injection)
- Conventional gasoline with turbocharging (or supercharging)
- Gasoline rotary engine (e.g. Mazda RX-8)
- Gasoline hybrid (e.g. Ford Escape Hybrid or Toyota Prius)
- Gasoline “mild hybrid” (several new pickup trucks coming out this fall)
- Advanced gasoline engine (e.g. GM’s new V-6 with variable valve timing)
- Advanced diesel engine (e.g. VW’s turbodiesel Passat with direct injection)
- Flexible fuel engine (capable of running on gasoline or 85% ethanol)

There are also several transmission choices that weren’t available seven years ago, including six-speed transmissions in either standard or automatic, plus the intriguing Continuously Variable Transmission, appearing on a few selected models. In addition, many makes now offer all-wheel drive as an option on multiple models; this was one of the key selling points of the Audi I bought in 1997, when they and Subaru had a near monopoly on AWD.

The above choices of engines, fuels and transmissions gets me into a pretty wide range of uncertainties that will affect my operating costs and future resale value:

- Will fuel prices remain high or return to historical levels (in nominal dollars)?
- In particular, will a car chosen today for better fuel economy retain value better or worse than one chosen on other grounds?
- Will a new technology, such as VVT or CVT, expose me to higher repair costs and lower reliability over the time I own the car?
- Does the rotary engine have enough experience behind it to be as reliable as a piston engine?
- Is it wiser to lease, rather than purchase, a car with a new and less proven powertrain?

Finally, these choices force me to get real about my concerns about climate change, local pollution and energy security. I will keep you, my readers, posted along the way with any noteworthy conclusions or discoveries.

Wednesday, September 08, 2004

Still Trading
For some time I've suggested that there was a high risk of throwing out the baby with the bathwater in the aftermath of the Enron debacle, at least as far as energy trading was concerned. It seems that at least a few companies saw it the same way. Last week's Economist profiled Constellation Energy, formerly Baltimore Gas & Electric, which has been busily expanding its energy trading so that it now accounts for the largest slice of the firm's revenue and profits.

As the article indicates, the enormous uncertainties in the primary energy markets, particularly natural gas, combined with continued deregulation at the wholesale electricity level create both a need and compelling argument for sophisticated risk management products that can only be offered by energy traders with a deep "book"--one that can make up for gaps in market liquidity.

I still wonder if the stock market truly understands how to value a company that has much of its flows made up of this kind of activity. While accounting rules have been tightened post-Enron, do P/E ratios for such firms reflect the unique risks and rewards inherent in energy trading?

Thursday, September 02, 2004

Alternative Energy Giant
Seeing alternative energy as still largely the purview of small, aggressive start-ups may be an artifact of the late dot-com boom, or a consequence of its marginal contribution to the international energy majors, which still earn essentially all their profits from oil and gas. But there is another mammoth enterprise that seems quite interested in the potential of alternative energy. Over the last couple of years, General Electric has made an impressive series of acquisitions in this sector, including the purchase of Enron Wind in 2002, its acquisition earlier this year of AstroPower, and its recent purchase of ChevronTexaco's gasification technology. GE also recently opened a research facility in Germany devoted to alternative energy.

The combination of these businesses creates a very respectable alternative energy portfolio, in the hands of a company with both deep pockets and a track record of moving new technology into the market. I hesitate to say "synergies", but there may be genuine cross-benefits between these businesses and GE's other lines.

Even before these acquisitions, GE was an important player in this space. Although it may seem quite mainstream now, the successful domination of the power generation business by aero-derivative gas turbines, starting in the 1980s, is one of the most dramatic energy shifts of recent times, and GE was one of the prime movers and major beneficiaries of this change. So here is a company that has already had a hand in a major energy transition, investing in an array of technologies that could be as important in the next decade as the gas turbine was in the last.

In particular, the combination of gasification, which turns coal or other environmentally less desirable fuels into a clean synthetic gas, with GE's gas turbine expertise could be a big winner in a market that is hungry for clean electricity but facing the prospect of high natural gas prices for years to come. Gasification also has another nice feature, with concerns about climate change growing, at least in Europe. The carbon dioxide that comes out of the process is much more concentrated than the flue gas from a conventional coal plant or gas turbine, lending itself to easier handling should CO2 disposal become attractive.

All of this is both good news and bad news for other alternative energy developers, given GE's past strategy of "1, 2 or out." They bring momentum and credibility to this market, but they are also a heck of a competitor.

By the way, the blog will be on holiday until Wednesay, September 8.

Wednesday, September 01, 2004

SUV Confrontation
According to this story in the Financial Times, SUV sales are up 14% and the government is considering measures to limit their popularity and reduce their impact on fuel consumption and urban congestion. While this sounds like a plausible headline for the US, in fact the story is from Europe, where SUV sales are apparently up to a half-million units per year, or about 5% of the total market. That doesn't sound like much compared to the US, but considering gasoline that costs roughly $5 per gallon, and city streets that are often barely wide enough for a normal car, it's something that European governments don't think they can ignore.

The first showdown may occur in Sweden, where the parliament is contemplating an SUV tax of SKr 60,000 (about $8,500,) while France is looking at a tax of up to 3200 Euros ($4,000.) Carmakers such as Volvo are complaining this would cut into sales and production of some of their most popular and profitable vehicles. I'm sure Detroit would share this concern.

But while the US car industry has been successful at fending off stricter or rationalized Corporate Average Fuel Economy standards (e.g., reducing the difference between car and light truck standards,) Europe's priorities are different. Urban congestion is a very serious problem in centers like London and Paris, and climate change is a major policy driver at both the EU and national government levels. Some industries are already required to trade carbon emissions credits.

For European governments looking at ways to reduce oil consumption and its environmental consequences, SUV taxes might be more popular than further increases in taxes on gasoline or engine displacement, since the SUV constituency is still fairly small. It's harder to see what implications such measures might have for the US market, where the SUV trend is starting to plateau and morph into a new wave of "crossover" and other station-wagon-like vehicles.