Trading Lessons
It's easy to imagine that the global crude oil price increase of the last eighteen months or so has created fat times for oil traders, and indeed a number have made vast sums by being on the right side of this market. But as this recent story from the Financial Times (subscription may be required) reminds us, oil trading is far more complex than simply betting on the absolute price of oil. The changes in supply and demand underlying the higher oil price have also distorted many of the traditional relationships among various grades of oil and petroleum products. A little further explanation is in order, to understand how the trading profits and losses from this kind of transaction might overwhelm those of the overall market runup.

Trading in oil commodities has become as sophisticated as that in equities or bonds. While the futures and options on the New York Mercantile Exchange (NYMEX) and London's International Petroleum Exchange (IPE) are the most visible manifestations of this trade, oil traders--including those at energy companies, banks and hedge funds--have been using a variety of derivatives for more than fifteen years, in order to address price relationships not directly covered by the futures markets.

For example, an airline interested in protecting itself from spikes in jet fuel prices has several alternatives for managing this risk. They might simply look for a fixed price contract, putting all of the risk onto their supplier. Alternatively, they could choose to manage only one facet of their risk, such as the differential between jet fuel and diesel fuel, the production of which refiners can maximize at the expense of jet, particularly for winterization. (Ordinary diesel fuel has a tendency to gel at very low temperatures, and the addition of kerosene, the main component of jet fuel, combats this tendency.) In this case, they'd buy a derivative, or swap, covering that difference only, for a specified time period. If the actual price relationship were wider than what was agreed, they'd collect enough to cover the difference, and if it ended up narrower, they'd pay out the difference but still have the benefit of what they had "locked in."

Such "differential swaps" are extremely common and cover every imaginable difference in grades of crude oil and refined products. Each is customized to the situation. Although I'm not aware of any industry statistics on this, I wouldn't be surprised if the dollar volume of such swaps approached the magnitude of all bets on absolute price. But as the FT suggests, these swaps can generate surprising outcomes that are difficult to manage further. If I sold a swap of a million barrels volume on a differential that historically varied between 10 and 50 cents per barrel, I might gauge my exposure to be between $100,000 and $500,000. But if this relationship blew out to $2/barrel, I might be on the hook for four times what I expected, when the contract expired and was settled. These are the kinds of losses that some traders may be facing today.

In my experience, even many professional derivative traders lack sufficient experience with the physical commodities that underlie these "paper products", and so have only a superficial understanding of the production, refining, and distribution complexities involved. Most of the time, this doesn't matter, but when the market is changing fundamentally, as it may be currently, its capacity to create expensive surprises grows dramatically. Individual investors should think long and hard before dabbling in such instruments, as an alternative to more staid investments.

Memorial Day
No posting today.

Little to Big?
The development of fuel cells built around thin polymer membranes has generated interest in a wide range of applications for cars, homes, and portable devices. One of the unresolved questions, however, is whether experience in one area of fuel cell application, such as small electronics, benefits work in another, such as automotive fuel cells. This story from Technology Review highlights a case in point: a small fuel cell extracting its hydrogen from a novel fuel, sodium borohydride. If this technology proves out, will it resolve the hydrogen production, storage and distribution challenges that stand in the way of practical hydrogen fuel cell cars?

Fuel cells generate electricity through an electrochemical reaction of hydrogen and oxygen to make water. Supplying that hydrogen has been a problem, particularly where size is a factor and pressurized storage of hydrogen gas is inconvenient or unsafe. As the article indicates, many developers have focused on methanol, a simple alcohol that can be broken down relatively easily to give up its hydrogen content . Unfortunately, methanol--also known as wood alcohol--is both flammable and poisonous. In fact, it is more toxic to humans than gasoline, and there are unresolved questions about its biodegradability outside ideal laboratory conditions.

Millennium Cell, the company featured in the article, has proposed an alternative to methanol for small fuel cells, in the form of a relatively common inorganic chemical, sodium borohydride, which is made from sodium and borax. The borohydride reacts with water to produce sodium borate and hydrogen. The spent borate can then be stored and recycled to make more borohydride. I can see this working for small devices where energy density is more important than cost and efficiency, but there are two basic problems in trying to scale this idea up to cars.

As the company's own materials admit, current processes for making borohydride are expensive and inefficient. Advanced processes would have to be evaluated on the same kind of "well-to-wheels" basis as other ways to fuel a car. The more basic problem, though, seems to be weight. The great paradox of hydrogen for transportation is that the lightest element in the universe always seems to require heavy storage systems, either mechanical or chemical, to contain it. The amount of hydrogen by weight in this sodium borohydride system is around 4%, compared to about 7% for metal hydride storage. Imagine a gasoline tank for your car weighing 500 lb. empty, and you start to get the idea. With a higher proportion of vehicle weight devoted to hydrogen storage, your overall efficiency and payload will be lower.

This combination of high cost--or low energy efficiency--and high total weight compared to the amount of hydrogen stored look like compelling reasons why this approach might not be suitable at larger scales. As a result, I'm skeptical that liquid chemical solutions like borohydrate will turn out to be the answer for transportation. But for those of us worried about longer laptop and cellphone life, sodium borohydride fuel cells might well offer practical alternatives to methanol fuel cells and batteries. The market will sort that out.

Heroes and Goats
There's an old saying that today's hero is tomorrow's goat. Along those lines, BP appears intent on forfeiting whatever brownie points it may have garnered by so forthrightly accepting responsibility for the explosion at their Texas City, TX refinery. It seems that BP, through its PR/advertising agents, has been demanding what amounts to editorial control over news and commentary mentioning the company, from any media that carry their ads. According to Advertising Age (free registration required) BP's policy required that its ads be pulled from any outlet with adverse editorial commentary about BP. Apparently, this approach is nothing new in the advertising business, but for a company that has worked hard and spent a lot of money to spruce up its public image it is certainly counterproductive--aside from looking petty and mean-spirited.

Moreover, between voracious cable news channels, news websites, and the blogosphere, this is just the kind of tasty morsel guaranteed to get wider distribution than any negative editorial content might. Whoever in BP or its agency imagined that a policy like this wouldn't be "outed" in short order should consider a less mentally-challenging career. The oil industry doesn't inspire much trust on a good day; blunders like this just undermine its image further. In their editorial commentary on the matter yesterday, AdAge.com used the word "shame" to berate BP and other companies trying this tactic. The wagging finger is deserved, but no more so than a shaking head: what could BP have been thinking?

Wind to Spare
Here's a report at Discovery.com of a study suggesting that earth's available wind resources are more than adequate to supply all of our future electricity needs, with plenty left over. While reassuring, I'm not sure this fact will surprise anyone. Although our energy use has grown large enough to have a noticeable impact on the planet's environmental systems--this is what man-made climate change is all about--we are still pikers relative to the natural forces of sun, wind, or the heat welling up from the earth's core. Unfortunately, even for a well-developed technology such as wind power, tapping it depends on a lot more than simple availability of the energy flow. The comment from an environmentalist suggesting that the biggest impediment that wind power faces is the "fossil fuel habit" of utilities is thus a remarkable trivialization of what's entailed.

At the moment, wind is the most promising of the alternative energy technologies for electric power generation. In fact, it's almost at the point of being competitive with conventional alternatives without subsidies. This still leaves three significant obstacles to deployment on a wide enough scale to be considered a replacement for large, central power plants:

• Intermittent power. Even the best wind resources, those that blow reliably year round, still exhibit significant variations. That means that a standalone wind power grid would have to be built with a much higher nameplate capacity than necessary to meet demand, and will require either backup power or power storage. The combination of these factors quickly renders wind uncompetitive. This says that wind cannot grow its share in any distribution grid beyond the capacity of the grid to accommodate its intermittent supply.
• Environmental opposition. We've already seen a number of instances of organized opposition to major wind projects, by groups that might otherwise have been thought to favor clean energy. The Cape Wind project near Nantucket is only one example of this. Until environmental groups decide whether wind is a sufficient improvement over fossil or nuclear power to be willing to concur with its implementation in all but the most environmentally sensitive areas--and by this I don't mean those with the highest real estate values--then wind will remain a niche power source and fail to reach even the practical limits set by grid acceptance.
• Investment capital. Building all these wind farms will require lots of capital, but then so will generating the same electricity by conventional means. In order to succeed, wind needs to offer the same kind of returns as other options, or else be limited to that pool of investors willing to accept lower returns in recognition of its environmental benefits. Most of the environmentally-focused investors I've met expect returns comparable to other investments.

Knowing there's enough wind, with enough of it in the right places, is an important consideration in promoting the further expansion of wind power. Unfortunately, it's one of those classic necessary, but not sufficient conditions.

Modern Alchemy
I've recently been reading Neal Stephenson's Quicksilver, which is partly concerned with the 17th century popularity of the pseudo-science of alchemy. The goal of alchemy was turning a base material such as lead into something else that was prized (e.g. gold.) The closest thing to this today may just be the gasification process, which has been highlighted recently as part of the clean coal "integrated gasification combined cycle" power plant (IGCC) concept. The New York Times covered this in some detail in Sunday's business section, but without really explaining how gasification works. I'm surprised to find that in nearly 18 months of blogging, I've never covered that explanation, either.

As the name suggests, gasification turns a solid or liquid carbon-based fuel into a gas that can either be used as a chemical feed or burned. That is particularly useful in a power plant, because gasification eliminates most of the impurities that would otherwise become exhaust gas pollutants, by converting them into forms that can easily be separated from the resulting "synthesis gas" (syngas). Let's look at how this works in the case of coal.

Instead of being fed into a combustion chamber, pulverized coal is mixed with water to form a slurry, which is then injected into a reactor along with pure oxygen, in proportions less than those required for complete combustion. (This is why the process is often referred to as "partial oxidation".) The output of this reactor is the syngas stream, containing hydrogen, carbon monoxide, and hydrogen sulfide gas. The latter is easily stripped out and safely converted to elemental sulfur, which can be used in fertilizer production. The ash and metals content of the coal drops out of the reactor as solid slag, rather than the particles found in a typical coal power plant's exhaust stack.

We're used to thinking of carbon monoxide as a poison, but it turns out to be a handy industrial product. It can either be burned with the hydrogen in a combined-cycle gas turbine--the "CC" in IGCC--or it can be used in a variety of chemical reactions. The most interesting of these from an energy perspective is the so-called "water-gas shift reaction", in which the CO is reacted with steam over a catalyst to produce hydrogen, resulting in both pure hydrogen and nearly-pure carbon dioxide, ideal for use in the food industry or for sequestration. The latter is what makes gasification so appealing relative to climate change. And unlike traditional processes for making hydrogen from fossil fuels, it's not a problem if the feed has a low hydrogen content to start with. That means that in addition to coal, you can utilize feeds such as petroleum coke or various wastes without generating lots of pollution.

If I sound like a shill for this approach, it's no accident. I had a lot of contact with it at Texaco, where one version of this process was invented--the same technology used at the Tampa Electric plant cited in the Times article and that was ultimately sold to GE. I worked briefly on a coal gasification pilot plant in Germany and a liquids gasification hydrogen plant at Texaco's Los Angeles refinery. I was always impressed by the elegance and great versatility of the process, but without its applicability to greenhouse gas emissions control, it would probably have remained an interesting, but always just-a-bit-too-expensive alternative energy process. Given growing concerns about climate change and the need for alternatives to oil and natural gas, though, it may finally find its ideal milieu.

The chief drawback is cost. As you might guess, it's a lot cheaper to grind up coal and shove it into a furnace than to do all this pre-processing. That's especially true if you aren't too concerned about what's going to come out the exhaust stack, in terms of sulfur dioxide, nitrogen oxides, particulates and heavy metals, let alone greenhouse gases. It still costs about 10-15% more to build an IGCC power plant than a conventional coal power plant with full emission controls, and so it takes a while for the IGCC's higher thermal efficiency and environmental benefits to pay for the difference. As optimistic as I am about this process, I remain skeptical that this initial cost premium will ever disappear entirely, as the Times suggests. But as we move towards a world in which we will have to pay to emit carbon dioxide to the atmosphere, the payoff for that premium will become increasingly attractive. We should see this is Europe within the next few years. Look for gasification to play an increasing role there, as the impact of the EU's emissions trading system begins to shift the direction of the energy economy.

Who Is Right?
Today's Financial Times (subscription may be required) reports that the President of OPEC has suggested that underinvestment in refineries, especially in the US, is a contributing factor in high crude oil prices. Producing countries trot this argument out periodically, but this time it contains a novel element: a proposal to link investment in oil exploration and production opportunities to investment in refining capacity. Is this a cynical smokescreen to mask OPEC's own underinvestment in new oil production capacity, or is there a some truth to their argument?

To answer this, you need to understand the relationship between the markets for petroleum products and for crude oil. There are three distinct markets that bear on this issue: for crude oil, wholesale products, and retail products (i.e. pump prices.) Each of these segments is related to, but distinct from the others. So while the wholesale price of petroleum products is strongly influenced by the price of crude oil, and vice versa, the difference--which determines the margin enjoyed by the refinery--varies constantly over a fairly wide range, from a dollar per barrel negative to $8/barrel positive, or more. Marketing margins, the difference between the wholesale and ex-tax retail prices, are much less volatile and don't influence crude oil demand very much.

So how do the markets for crude oil and wholesale gasoline, for example, interact? Higher crude prices put upward pressure on gasoline prices by squeezing refining margins and forcing refiners to charge customers more. Similarly, higher demand for gasoline pulls crude prices up, by expanding margins, depleting crude inventories and giving refiners an incentive to compete for more crude oil to run. Once refineries are running at full capacity, though, more demand just raises refining margins, without increasing the quantity of crude being run. In fact at that point the influence of product markets over crude markets diminishes, although the premium paid for high quality crude oils--which can make a larger proportion of gasoline and diesel with less processing--will typically continue to widen. (This explains why a higher price for West Texas Intermediate crude oil doesn't automatically mean a correspondingly higher price for Saudi crude. )

Things work similarly on the way down. As product demand slows, refinery margins compress, refiners reduce runs, and crude oil inventories grow, putting downward pressure on crude prices. The same thing happens when product demand is high but crude producers supply more than the market needs: crude inventories grow and crude prices drop. (This is the best of all worlds for a refiner.)

Now consider OPEC's assertion that inadequate refinery capacity is causing crude prices to go up. If anything, the opposite should be true, because crude oil inventories would grow, provided that supply was not limited. Fully-utilized refining capacity is a brake on the demand for crude oil, not an accelerator. In light of the mechanisms above, we see that the problem that limited refining capacity creates for OPEC is really competition between the producers of heavy, sour crude oil (e.g., the Middle East) and producers of the more desirable light, sweet oils (e.g. West Africa and North Africa.) There has always been friction between OPEC's members, and this is another source.

Is it possible that in trying to link oil exploration opportunities to refinery investment, OPEC is actually seeking to ensure equal market access for all its producers, regardless of the quality of their oil, rather than providing relief to the world's economies and consumers?

Russian Riddles
In a 1939 radio broadcast Winston Churchill said, "I cannot forecast to you the action of Russia. It is a riddle wrapped in a mystery inside an enigma." Those words seem just as apt today. The mega-merger of the Russian state oil company, Rosneft, and the world's largest natural gas enterprise, Gazprom, now appears to be off. Instead, as the Financial Times notes, they will remain separate entities, but after a series of market transactions, each will have a majority stake held by the government and minority stakes held by investors, including foreigners. While it's interesting to speculate what signals this may send about factional politics within the Kremlin, there are larger issues at stake.

Gazprom controls the largest natural gas reserves on earth, exceeding those contained in North, Central and South America, combined. It also supplies most of Europe's natural gas imports. Rosneft, after a less-than-transparent purchase of Yukos's largest producing subsidiary, is now the preeminent oil producer in Russia. The key question for these two companies, and for the energy consumers of the world, is whether the arrangements following the failed merger will provide these companies with sufficient access to capital and technical services--both Russian and international--to tap their reserves efficiently and continue to grow production. This is particularly critical for Rosneft, since it is stepping into the shoes of the Yukos, which had been most successful at rejuvenating Russia's fading oil production and contributing to the growth of non-OPEC oil production.

As a consequence, the outcome of President Putin's forced restructuring of the Russian energy industry will play a major role in determining the balance of market power between OPEC and non-OPEC in the years immediately ahead, and thus have an inordinate influence on the global price of oil.

Practicing for Climate Change
It's rare that I agree with every word in a New York Times editorial, but today's is a pleasant exception. Their message to President Bush concerning climate change is spot on. The Times correctly assesses the growing concern--it's too early to call it a consensus--of business leaders and key Republican officeholders that strong action must replace voluntary programs in this area. They are also right to seize on GE's Ecomagination strategy as a sign that business sees not just constraints, but also opportunities in efforts to limit climate change.

A growing number of businesses have moved beyond seeing climate change as an "environmental issue" and now treat it as a key risk factor that they must manage. Critics who regard voluntary efforts, such as participation in the Pew Center on Global Climate Change or the Department of Energy's 1605b program, as some form of corporate social responsibility are missing the point. It's all about gaining future advantage. The companies that have signed on for these initiatives and voluntary emissions reduction targets see the likelihood of mandatory restraints and are practicing and learning now, to steal a march on their less alert competitors later.

Anyone who wonders what a mandatory greenhouse gas regime might look like need only look across the Atlantic to see one in action. Ironically, when emissions trading was first suggested during the Kyoto negotiations as a constructive, market-based approach to achieve desired cuts in emissions, it was the American delegation that sold skeptical Europeans on the idea. Who would have guessed that the EU would put our idea into effect before we do?

With Social Security reform in trouble, the President must be looking for another area in which to create his legacy. Climate change would be a great choice, and a coalition of CEOs, prominent Republicans, and evangelical leaders can provide him with the political cover he would need for such a reversal of course. In the long run, business would thank him, as would our children and grandchildren.

Blaming the SUVs

SUVs and their owners get the blame for all sorts of ills, including higher traffic fatality rates and parking lot congestion. They are even lampooned in Dilbert. And with gas prices sky high, at least in nominal dollars, SUVs take the brunt of concerns about our growing dependence on imported oil. The data needed to assess the validity of this complaint are readily available. They demonstrate that SUVs have a sizeable impact on US oil consumption, and by extension, on fuel prices. While that result might not surprise anyone, the same data reveal another, even bigger culprit, posing a major challenge for efforts to reduce oil consumption.

The latest year for which all the necessary statistics are available is 2003. In that year, 87 million vehicles were classified as 'light trucks', including SUVs, pickup trucks, and all sorts of commercial vehicles. They drove 11,400 miles each, on average, and they averaged 21 miles per gallon, compared to 28 for passenger cars. The total number of light trucks in service in 1985, at the beginning of the SUV trend, seems like a reasonable proxy for all the non-SUV types of light truck today. If we assume that all the light trucks sold after 1985 were SUVs (or pickups used as SUVs,) that gives us a total of 50 million SUVs in 2003. With SUV sales running at half of all US car sales of 14.8 million per year, this seems like the right ballpark.

If the SUV fad had never happened, or if SUVs didn't fall under a special category of the Corporate Average Fuel Economy regulations allowing them to get considerably worse fuel economy than 'passenger cars', their owners would likely have bought cars getting about the same gas mileage as the average for the rest of the car fleet. Based on all these assumption, SUVs consume at least 440,000 barrels per day more fuel than if they were 'passenger cars'. That works out to 6.8 billion gallons per year, or about 5% of total gasoline demand.

What does that volume mean for prices? Well, this volume is about a quarter of the recent global demand increase that is generally held responsible for pushing oil prices from $30 to $50/barrel. In terms of gasoline, it's the difference between US refineries running at maximum capacity or at more comfortable levels. Or it's half of all the gasoline the US imports. No one can calculate the impact of this precisely, but when markets are as tight as they are now, that extra 5% of demand could easily account for 15-20 cents per gallon of today's prices.

Before we lay all the blame on SUV owners, though, it's worth considering another fact that emerges from the same data. Compared to 1985, Americans now drive 2,000 miles more per year, on average--passenger cars and SUVs alike. The impact of this change is more than twice as big as that of SUVs: 1 million barrels per day of extra fuel consumption at a fleet average of 25 miles per gallon. In other words, changes in our behavior have increased gasoline demand in the US by 1.5 million barrels per day, and 2/3 of that has nothing to do with the switch to SUVs.

Here's one last statistic to ponder: if the late 1980s had brought us a fad for cars getting 50 miles per gallon, instead of for SUVs getting 21, we would today use a million fewer barrels per day gasoline than we do. That would be just enough to make up for all of our increased driving. This illustrates the essence of today's fuel-economy debate: over time, the choices of millions of individual consumers--not just the kind of cars they buy, but how they use them--add up to big volumes of oil, with serious economic, environmental and security implications.

Bulletin: Standing Up
Early in my career, I realized I never wanted to be a refinery plant manager, even though that was the pinnacle of the career path on which I began. One of the main reasons for this, aside from the 24/7 intrusions into one's personal time--before cellphones, when that concept still meant something--was the understanding that on a refinery's best day its excellent performance is taken for granted, and on its worst day, it is on TV, burning. Two months ago, such an incident occurred at BP's Texas City, TX refinery. At the time I commented on BP's high-profile crisis management, including a flying visit and press conference by Lord Browne, the CEO. This afternoon BP released a truly remarkable statement accepting responsibility for the accident and accompanying loss of life.

It seems to have become the norm that when something bad happens, or someone is caught doing something they shouldn't be doing, they will issue a denial, whether of the facts, or their involvement, or of any responsibility. It is refreshing and encouraging to see a major corporation, in an industry not generally noted for forthright communications with the public, accept full responsibility not only for an explosion at one of their facilities, but for the accompanying injuries and loss of life. Nor are they hiding behind the contractors by whom most of the injured workers were actually employed. Their lawyers must have had fits when it was first suggested that they go public with this. In fact, that reaction would be understandable, because it is nearly inconceivable in our society that this will not "be used in evidence against them in a court of law."

I hope that doesn't happen, because it would warn off everyone else who might be tempted to tell the unvarnished truth in situations like this. Imagine, for instance, how different the last couple of years would have been for Martha Stewart,had she simply admitted that she screwed up. Instead, she's wearing a tracking anklet, while Lord Browne will be collecting deserved kudos for being a stand-up guy.

Oil for Influence?
When I first wrote about the scandal concerning the UN's Iraq Oil for Food program a year ago, I focused on the need for a speedy investigation, in order to bolster the credibility of the UN and its Security Council to deal with future crises. With Iran now threatening to resume nuclear fuel separation, and Britain's government indicating it might refer the matter to the Security Council, the urgency for a complete picture of what happened during Oil for Food has grown.

Unfortunately, facts and allegations continue to emerge in dribbles, including the latest reports from the US Senate's investigation, suggesting that a high official in the Russian government under Vladimir Putin benefited personally from Saddam's largesse. If this and other allegations concerning officials in other Security Council governments (e.g. France) prove true, then the scope of this scandal expands beyond the merely financial and into the realm of having foreclosed the remaining peaceful options in the leadup to the Iraq War. This must not be allowed to happen in the case of Iran, where the stakes are even higher.

While any corruption within the UN should certainly be uncovered and rooted out, the focus of our attention ought not to rest solely on UN officials or the ultimate accountability of the Secretary General. Compared with the integrity of the Security Council members and possible conflicts of interest in matters of war and peace, the actual administration of Oil for Food is a sideshow. Today's hearings will delve further into these matters and hopefully shed more light on both US and international involvement in subverting the aims of the Oil for Food Program.

Apollo for Fuel Cells
This weekend the leaders of Toyota and GM announced they would join forces to bring fuel cell cars closer to reality, as part of a more comprehensive technology alliance. Rumors in advance of the meeting in Japan suggested the alliance would be called "Project Apollo". Both firms have been investing heavily on fuel cell R&D as a pathway to a true zero-emission vehicle, after the market failure of battery-powered cars such as GM's EV-1 a few years ago. Not only is this a signal that neither company has given up on the prospect of fuel cell cars, but it also rebuffs those who think that hybrid cars eliminate the need for fuel cells.

There's no question that some of the early enthusiasm and optimism concerning fuel cells has abated, as developers grapple with the complexities of refueling infrastructure and standards, manufacturing economics, and the fundamental question of hydrogen supply. I remember telling my former company's top management in the late 1990s that fuel cell cars could be a reality by 2004. (I also told them that successful hybrids might delay fuel cells for a while.) Despite sustained progress in building prototype vehicles and refueling stations, practical fuel cell cars look nearly as far off now as they did then.

In light of these delays and the intervening success of hybrid cars, it's not surprising that some have concluded that hybrids can deliver comparable fuel savings with off-the-shelf technology and without requiring any new infrastructure, rendering fuel cell cars unnecessary and uneconomical. More aggressive hybrid advocates suggest that modified hybrids able to recharge from the power grid during off-peak hours would be as efficient and environmentally beneficial as fuel cells, from a total system ("well-to-wheels") perspective. Toyota, the world's largest and most successful manufacturer of hybrid cars, does not seem to agree with this prognosis. Rather, they are pursuing a consistent strategy of technology leadership, with hybrids as one component and fuel cells as another. Similarities in electric-drive and power-management systems ensure that these programs are at least partly synergistic.

Any shift toward hydrogen will be long and gradual, and hybrid cars are at least a key transition technology, particularly in a high oil price environment. The larger question of competing visions for a post-petroleum transportation future, between fuel cell cars running on renewable-source hydrogen versus hybrid cars running on biofuels, cannot be answered today and must be approached by creating viable options for each. Final judgment on a Toyota/GM Apollo Project must await details on commitments of capital and human resources, as well as a timetable for results, but it certainly looks like an important step toward creating a production fuel cell car that could be sold by both companies. When you consider that they jointly account for a quarter of the global auto market, this starts to look like a strategy to set the industry standards, as well.

Hybrid Comparisons
When I started car-shopping last year, I signed up for a couple of the internet buying services, including Autobytel.com. Since then, they've been sending me periodic content. Most of it gets deleted unread, since I've already bought my new car. However, they just emailed me an interesting road-test comparison of the three main hybrid cars that buyers can choose from today, the Toyota Prius, Honda Accord Hybrid, and Ford Escape Hybrid. If you're currently thinking about a hybrid, this article might help you to refine your thinking, because it does a nice job of showing where each car shines and where it is weaker than its competition. All three appear to be pretty good cars, aside from being economical. That's a significant milestone for hybrids, by itself.

I was surprised to see the Accord Hybrid, which has gotten great press and a laudatory New York Times op-ed by a semi-famous author, come in third. Of the three, this is the one that has given me twinges of buyer's remorse, since I bought a non-hybrid from Honda's Acura division. The reported 25 mpg that Autobytel experienced has cured that, because the car I chose cost only a little bit more, is only a couple of miles per gallon less economical, but blows the Accord away on styling. Don't get me wrong; Honda is on the right track in hybridizing mainstream cars. This one just doesn't deliver quite the combination of style, performance and economy that I wanted.

As expected, the Toyota Prius come out on top of this comparison. Toyota is beating Detroit financially, even after you adjust for their advantage in the pension department, and the Prius is just another facet of this dominance. It remains the hybrid for which buyers queue up and pay up, because Toyota has managed to imbue an economy car with iPod-like coolness. As much as I respect what they're doing, though, I look forward to reading a similar comparison a few years from now and seeing the Prius unseated by an American hybrid, because that would indicate that Detroit has finally figured out how to make a "must-have" car that doesn't force you to sacrifice fuel economy or the environment.

Holding Back The Tide
Much of the discussion of climate change in the popular media focuses on the potential for stronger and more frequent hurricanes, melting icecaps, and loss of habitat for endangered species. This recent op-ed from the New York Times reminds us of the human face of some of these issues. As sea level rises, even by a foot, a small amount of habitable land, including islands and coastal areas, will be permanently lost. While tiny as a percent of the earth's landmass, these losses could evict millions from their homes. The consequences of this for global society and the economy would be significant.

What makes this problem all the more frustrating is that even drastic, immediate action against climate change, including severe cuts in emission-producing activities and the reforestation of large tracts of land, would probably not avert at least some of these outcomes, because of the inertia of the climate system and the persistent effect of higher greenhouse gas concentrations in the atmosphere and of warmer seawater.

The UN High Commission on Refugees (UNHCR) estimated that there were 20 million refugees globally in 2002. Although the recent South Asian tsunami added to that number, the authors of the Times op-ed suggest it could multiply to 200 million by 2080, due to rising sea levels. That does not include additional dislocations from persistent changes in rainfall patterns and agricultural productivity. This is a daunting figure and would completely overwhelm the existing and already-stressed mechanisms for dealing with refugees and immigration.

Estimates are only educated guesses, and I'm well aware of the distortions that flawed assumptions can generate, particularly over a span of time such as the one cited above. But if even a fraction of these people are displaced from their homes, it will create a human migration that would rival anything we've experienced previously. While the op-ed suggests preparing to receive them, noting the demographic benefits they might bring with them, we need to consider other solutions that might be less disruptive for all concerned. Adaptation will be the key, including the construction of dikes, levees and seawalls on a massive scale. Island populations could be transported to uninhabited islands that are less threatened, and provided with development assistance to recreate their infrastructure, which might have to include seawater desalinization, if fresh water isn't available.

This may sound daunting, but the technology is available today, and the cost to us of helping people to adapt where they are would likely be less than asking the US to absorb 50 million immigrants, on top of the millions who will come here from other places and for other reasons in the same timeframe. And it might just be more amenable to the populations affected. If you give people the choice between saving their homes and having to move to a strange place, I'm betting most would choose the former.

Adaptation doesn't get us off the hook for addressing the causes of climate change, as some of its opponents fear. Rather, it's a complementary and necessary strategy for both the developing world and the developed world. But unless we also attack the root causes of climate change, we just might be presented with a planet to which the entire global population of 8 or 9 billion (by then) of us cannot adapt.

Friedman Half Right
Tom Friedman's column in today's New York Times deals with nuclear proliferation in Iran and North Korea. Rather than blaming US policy towards these countries, he suggests that Europe, with respect to Iran, and China, vis-a-vis North Korea, possess sufficient leverage to eliminate these proliferation threats unilaterally. He proposes a very simple solution in each case, and one of them is right on target. Unfortunately, the other ignores a key energy issue and would likely provoke a response for which the whole world would pay dearly.

First, Mr. Friedman is correct in pointing out North Korea's near-total dependence on China for key aspects of its economy, particularly fuel and electricity. A serious threat by Beijing to cut these off, even for a short time, would bring the Hermit Kingdom to its knees--and to the bargaining table. Any desperation attack Mr. Kim might be tempted to launch in response would quickly grind to a halt for lack of petroleum products. I think it's safe to assume that the aim of the Administration's much-criticized six-country strategy for dealing with North Korea is to encourage China to use its leverage in just this way. It's not clear what else will prevent a nuclear arms race in North Asia.

If only the situation with regard to Iran were so simple. While Iran depends heavily on trade with Europe, the EU and the rest of the world also rely on Iranian oil. We'd better assume that the mullahs understand that as well as we do. They certainly remember the impact on global oil prices the last time their production was pulled from the market, resulting in the highest oil prices in over a century. As I pointed out in an article just published by Geopolitics of Energy, the journal of the Canadian Energy Research Institute, current oil market conditions have raised Iran's market leverage to a 25-year high. Iran's oil exports of 2.5 million barrels per day exceed the current supply capacity cushion of all other producers. A retaliatory boycott by Iran could send prices even higher than the $81/barrel level we saw in 1980 (expressed in 2005$.)

(Here's another angle to consider: Which country bordering Iraq gains the most from the persistent Iraqi insurgency that is killing hundreds of Shi'ites a week and tying down 140,000 American troops, effectively preventing them from getting involved in any other problems in the region?)

While some credible tough talk from Europe would certainly get Iran's attention in a way that no US diplomacy or threat can achieve, it must be part of a comprehensive international approach that ought to be transferred from the relatively toothless International Atomic Energy Agency to the UN Security Council as soon as possible. While that might still result in endless wrangling, it would at least bring together all the major players in a venue that Iran could not dismiss out of hand.

To Tax or Not To Tax
Today's Wall Street Journal website includes an op-ed concerning a proposal in Oregon to change the way vehicles are taxed for their use of public roads. Road taxes are currently collected principally in the form of the state and local taxes we pay on gasoline and diesel fuel. These vary from state to state, and, as Oregon has realized, from vehicle to vehicle as a function of fuel economy. Gas-thrifty cars such as hybrids pay much less in the way of road taxes than thirstier big sedans and SUVs, and a hydrogen fuel cell car would pay none at all. How can the federal and state governments reconcile their desires to use these taxes to promote fuel efficiency, while still raising the funds needed for road construction and repair?

Here are just a few of the competing issues:

• Heavier vehicles wear out roads faster and should pay more.
• Ultra-fuel-efficient cars need incentives to compensate for their higher purchase prices.
• Geo-Greens assert that all of us should pay European levels of fuel taxes to discourage consumption and reduce greenhouse gas emissions.
• Low-income drivers pay a disproportionate share of their earnings in fuel taxes.
• States need to raise more general revenue funds to cover growing budget deficits

These are legitimate policy concerns, but it's hard to see how they can all be managed without a major change in the way we assess fuel taxes. Oregon's idea of using technology--in this case global positioning systems--to tailor the tax to the user's circumstances is attractive, notwithstanding the Journal's legitimate concerns about the accompanying loss of privacy. In changing the system, however, we should avoid adding to the complexity of the income tax system or creating an auditing nightmare. These criteria point in the direction of a pay-as-you-go approach, similar to that which Oregon is considering or the one already in effect in Singapore. What these systems give up in simplicity they can make up in fairness, by assessing taxes based on miles driven in a given state, rather than at the point of fuel sale, which may be out-of-state.

This is a complex issue and unlikely to be resolved soon, but it's important to realize that we have many new tools available for implementing creative solutions, including not just GPS, but also technologies such as ExxonMobil's Speedpass for communicating with the gas pump. But before we get to implementation, we need a stronger consensus on the fundamental purposes for which we collect these taxes. Achieving that will take longer than figuring out how to put the result into effect.

New Strategy Launch
Last September, I commented on General Electric's creation of an impressive portfolio of alternative energy assets, including wind power and the key technology for coal gasification. Now we see the fruition of this strategy, with the launch of GE's new "Ecomagination" campaign. Today's Wall Street Journal (and presumably other national papers) included a multi-page advertising supplement highlighting the environmental benefits GE can bring to bear. Accompanying articles cited GE's commitment to reduce its own greenhouse gas emissions by 1%, compared to expected growth in these emissions by over 45%.

This approach does several important things for GE. First, it capitalizes on the recent implementation of the Kyoto Treaty on climate change, following Russia's triggering ratification last November. This has brought a number of measures into force in countries that have signed the treaty, including mandatory emissions trading in Europe and industry/government accords in Canada and elsewhere. Positioning GE with the right solutions will enable it to capitalize on these new markets, especially in Europe.

Another important aspect of GE's alternative energy strategy is defensive. The rise in US natural gas prices over the last several years threatens GE's sales of gas turbines and other hardware for gas-fired power plants. Electric utilities and generators will respond by shifting back toward coal for new power plants, particularly if the new plants can meet air quality restrictions and lay the groundwork for eventual handling of carbon dioxide emissions. GE's gasification technology--acquired from ChevronTexaco--does both of these things. It also turns the dirtiest coal into clean gas that can be burned most efficiently in gas turbines. So not only does GE sell gasification technology, but by doing so it protects its valuable market for turbines.

"Ecomagination" takes a risk, though. As BP can attest from its "Beyond Petroleum" campaign of several years ago, making a large corporation greener may perversely attract more green critics, by raising expectations that will be difficult to meet. Despite this, I would say GE's move is well-timed and, if executed with GE's customary skill, should pay off handsomely for shareholders.

By the way, Energy Outlook was mentioned in my town's newspaper yesterday, as part of a story on local bloggers.

Catching the Next Wave
The latest issue of The Economist includes a special report on oil. Their lead editorial (subscription may be required) discusses the problems of high oil prices for all parties involved, and it's well worth reading. What caught my interest, though, was its opening anecdote citing Winston Churchill's momentous decision as First Lord of the Admiralty to convert the Edwardian-era Royal Navy from coal to oil. That was hugely risky, since Britain had no indigenous oil at the time, but it paid off as a key strategic advantage in World War I. This story illustrates nicely how energy, which we seem to be conditioned to consider a problem, can be turned into a great opportunity, as I suggested yesterday concerning climate change.

Politicians like to remind us that the US is the world's largest consumer of energy, despite having tiny reserves of remaining oil. Out of the world's annual energy budget of 412 quadrillion BTUs (quads), we consume 100 quads per year. At the same time, when you consider not just oil, but also natural gas, coal, nuclear, and renewables, we produce about 70 quads, equal to the entire energy consumption of Western Europe.

Now, you can conclude from this that if we were as efficient as Europe, we would be self-sufficient in energy, and all the current problems would abate. There's some truth to that, but it's an over-simplification in our market-driven, globalizing world. What is clear, though, is that at the scale at which this country uses and produces energy, we ought to be the world leaders in this area. We certainly were in the past, when America's tremendous natural endowments of coal and oil helped turn an agrarian country into the world's industrial giant within two generations. There's no reason it couldn't be true in the future, if we can marshal the vision and patience to invest now in the forms of energy that would create a comparable advantage for the next several decades. And while climate change might compound the problem, it also multiplies the potential opportunities.

In the late 19th Century, oil was clearly the next wave in energy, and catching it early paid dividends for at least 50 years. Agreeing on what the next wave might be is more difficult today, because energy is much more complex. There's no single obvious choice. But rather than looking at renewable energy, which is one of the obvious contenders, and seeing a road to potential self-sufficiency, shouldn't we regard wind, solar, and biofuels as the seeds of the great global energy empires of the next half-century? And while an objective assessment might suggest we are behind in some of these areas, compared to our global competitors, the US was behind at the turn of the 20th Century, too. That didn't hold us back then, nor should it now.

Scenarios for Peak Oil
The idea that oil production is approaching a geologically-determined peak gains more credibility and supporters, the longer high oil prices persist. I've commented on this periodically, usually to point out the inherent uncertainty of such an event, and the disservice that simple forecasts of a particular peak year can do. Thanks to a lead from a friend, I followed a posting at GreaterDemocracy.org to a recent report on this subject by Science Applications International (SAIC.) SAIC was commissioned by the Department of Energy to look at the likelihood and potential impact of a peak in oil production, and to evaluate strategies to mitigate those effects. The result is a highly-readable document that adopts just the right tone of concern and reasoned recommendations. Their ultimate conclusion happens to align neatly with mine, in seeing peak oil primarily as a risk management issue.

Although I could quibble with some of SAIC's assumptions and the relative simplicity of their scenario formulations, the assumptions are clearly stated and the scenarios quite understandable even for those not familiar with this tool. I would have also liked to see more country data on the production side, since the global production profile is really the aggregation of all the country profiles, which in turn aggregate all the individual oilfield profiles within their boundaries. Nevertheless, this report is a must for anyone interested in the topic. Don't be put off by the length, at 91 pages, since it has a good executive summary and is quite skimmable.

Where I differ from many of those looking at this issue is in the importance I place on non-geological issues, such as geopolitics, access, and industry investment patterns. These could create something resembling a geological peak, but sooner and with less uncertainty--or at least without the inherent unknowability of the geological scenarios. As I was reading the SAIC report, an idea occurred to me that I hadn't considered before: Could an OPEC policy aimed at increasing prices by restricting access to reserves result in a premature, but nonetheless permanent peak in oil production, either deliberately or inadvertently?

Here's how this would work: Based on the most recent estimates from the Oil and Gas Journal, OPEC holds roughly 70% of total world oil reserves of nearly 1.3 trillion barrels. These eleven countries have an average reserve life (R/P) of 81 years, compared with under 20 years for the non-OPEC producers. Non-OPEC production will peak before OPEC's, as mature basins such as the North Slope, North Sea, and US onshore and continental shelf production decline. This can be offset for a while by increases from the US deep-water Gulf of Mexico, Russia, Caspian and non-OPEC West Africa, but they will reach their limits, too. (Many analysts have commented on this in the context of the ongoing consolidation of the international major oil companies, in their race to replace reserves.)

If OPEC continues to constrain production through a combination of internal under-investment and restrictions on the development of OPEC reserves by the international oil companies, then increases in OPEC production could easily be inadequate to offset declines in non-OPEC countries. Total global production would then reach a temporary peak and begin to decline. This peak would become permanent if OPEC were to delay its own development program long enough that the combination of project timelags and steepening non-OPEC decline rates made it impossible ever to catch up with falling non-OPEC production. Such a peak might occur a decade earlier than if access to reserves was determined by free-market economics, instead of OPEC politics.

There are two questions you have to ask about such a scenario. First, would OPEC see an artificial peak in global oil production as being in its best interests, in the short, medium and long term, considering the kind of responses it might stimulate? Since OPEC is hardly monolithic, I wouldn't be surprised if at least a couple of its members thought so, but not all of them. That suggests this scenario likely happens by accident, if at all.

Second, how soon could it happen, given that we know a lot more about the performance of non-OPEC oilfields than we do about OPEC's? I would say not in the next couple of years, in spite of the mounting number of pessimists who might disagree. There's still some life left in the non-OPEC dog, especially if Russia gets its act together. But as long as demand continues to grow as it has recently, the day when OPEC will hold the whip hand gets closer.

Finally, from a risk management perspective--in line with SAIC's thinking--time is wasting. This issue should be debated not just on blogs and in the media, but on the floor of Congress. We need to get past the talking stage and well into planning and creating options. Merely doing that would send important signals to OPEC that their inadequate reinvestment in capacity could truly cost them their market and leave much of their oil in the ground forever.

The Wind and the Sands
Our Canadian neighbors have supplied important quantities of oil and gas to the US for many years. Much of Canada's oil production is from fields in Alberta that have been producing for decades. This production is declining, but overall Canadian production is growing as a result of exploiting non-conventional hydrocarbons from "oil sands", formerly called "tar sands." (See my posting of 9/23/04.) In fact, some estimates of Canada's oil reserves now count all these oil sands deposits, which increase the total from a mere 5 billion barrels to 179 billion, exceeding all others except Saudi Arabia. There's just one problem with this addition, and it is the Kyoto Protocol on Climate Change.

When Russia ratified the Kyoto Treaty last November, it went into force and activated Canada's Kyoto commitment to reduce its emissions of carbon dioxide and the other covered greenhouse gases by 6%, compared to 1990. All things being equal, this would effectively rule out the development of most of the oil sands reserves, because of the way they are produced.

The hydrocarbons in Canada's oil sands are tied up in the source minerals in such a way that you can't simply drill into an underground deposit and produce it as you would conventional petroleum. Instead, the oil sands must either be mined for surface processing, or processed "in situ", in the ground. Heat is used to drive the oil out of the sand, and generating that heat consumes either natural gas or the residue of previously extracted oil sands liquids. Both methods emit carbon dioxide, the main greenhouse gas implicated in climate change. Once the liquid is extracted from the sands, it is similar to a very heavy crude oil, requiring further processing to create a "synthetic crude" that can be shipped in pipelines and sold alongside Canada's conventional oil production. This extra processing generates additional greenhouse gases, excluding the emissions that will occur later, when the oil is refined and the resulting petroleum products consumed.

So aside from the large investment costs that I've discussed in past blogs, oil sands development imposes a significant cost on Canada's national greenhouse gas emissions "budget." In order to neutralize the impact and remove this barrier to large-scale oil sands production, the companies that own the rights to develop this resource will have to acquire offsetting emissions reductions. One way to do this is by investing in projects such as this wind farm.

You can choose to regard the greenhouse gas emissions associated with oil sands production as an enormous problem for the global environment. The alternative is to recognize the tremendous opportunity this creates for renewable energy developers around the world, mirroring the kind of positive industry/environmental partnership I talked about yesterday.

Turning No Into A Qualified Yes
Today's Wall Street Journal (subscription required) includes an excellent editorial explaining some of the reasons why natural gas has become so expensive in this country, when it seemed so cheap and plentiful only a few years ago. The Journal paints a picture of a conflicting welter of environmental arguments that have shifted the perception of gas from the fuel of choice to a hazardous despoiler, but cannot even get solidly behind one of cleanest energy technologies on the planet, wind power. Building on this, I would like to offer a radical proposal for the environmental community that would enhance its standing and make it a greater force for positive change.

Although many commentators have criticized the Administration's proposed energy legislation as a patchwork of corporate welfare and environmental rollbacks, the main alternative is just a partisan reprioritization of the same basic programs, with a few obvious exceptions such as on drilling in ANWR. What is really needed is a national environmental consensus on energy. This would require a national convention of all environmental groups, large and small, to hammer out a comprehensive energy strategy for the country, for today and into the future.

The meeting would have to start with some basic facts, foremost among them the national energy appetite of 100 quadrillion BTUs (quads) per year, only 6% of which comes from renewable energy, with nearly half of that from hydroelectric dams. In fact, solar and wind power, though growing rapidly, together accounted for less than a quarter of one quad in 2003. That means that any practical energy plan must rely heavily on some mix of oil, coal, gas and nuclear power to cover the bulk of the country's energy needs for at least the next decade, at the same time it promotes more renewables.

Designing such a plan would require tough tradeoffs, such as weighing the total impact of offshore natural gas drilling and LNG imports against more coal-fired power plants or nuclear plants. It might also logically include removing arbitrary barriers to wind development, if wind is to grow fast enough to contribute meaningfully at the scale we must consider. It also means that the impact of efficiency measures must be fed in gradually over time, in line with real-world adoption rates, rather than in huge blocks as a way to veto unpopular energy modes.

Now for the kicker: the price of admission to this convention should be an agreement to abide by the majority vote of the assembly and a pledge to terminate all lawsuits and protests against any projects or energy types supported by the convention, along with eliminating support for any groups that refuse to abide by the convention's findings. With stakes so high, it's not hard to imagine a meeting like this taking a year or more to reach consensus.

This idea may be a fantasy, but I think it's an attractive one. If environmentalists want industry to do the right things, they must speak consistently and recognize the long-term nature of investments in this area. If gas is better than coal, for example, then gas must be available in sufficient quantities to displace coal, even if that means drilling off the coast of Florida and bringing LNG into Long Beach harbor. Simply saying "no" to everything is no longer good enough, because we have exhausted all the options that don't require some kind of tradeoff--if they ever really existed. Some carefully-considered yeses, now, would lay the groundwork for enduring partnerships with industry that would benefit both consumers and the environment.

More Small Fusion?
When it comes to long-term energy solutions, nuclear fusion remains the holy grail. And while mammoth projects like the International Thermonuclear Experimental Reactor provide the best prospects for fusion, the idea of achieving it on a scale small enough to power a house, car or clothes dryer is still exciting. A couple of weeks ago I posted concerning “sonofusion”, a technique that some researchers claimed was achieving fusion through the collapse of bubbles. That process remains controversial. Now there is a new small-scale fusion development, based on colliding molecules of heavy hydrogen inside crystals.

Accelerating and crashing deuterium ions with electric fields in a crystal makes more intuitive sense than collapsing bubbles with sound waves to achieve the temperature and pressure required for fusion. Intuition hardly constitutes a basis for proof, though, and Dr. Putterman and his colleagues at UCLA will be busy for some time defending their findings, particularly the emission of statistically-significant quantities of neutrons, a classic fingerprint of nuclear reactions.

I find it reassuring that no one is claiming that this process, even if proven, will produce useful quantities of energy anytime soon, if ever. I’m more intrigued by some of the non-energy applications cited, such as medical devices or spacecraft propulsion. There might also be other, serendipitous applications for a small source of neutrons and x-rays that could indirectly contribute to meeting our energy needs, such as in creating a smaller, safer nuclear fission power plant.

It’s encouraging to see this kind of research continuing, but it won't solve our problems today. A breakthrough in a lab might translate into a world-changing energy source within a couple of decades. Meanwhile, we must continue to wrestle with the mundane problems of fuel efficiency, intermittent renewable power, NIMBY-provoking infrastructure projects, and the provision of enough oil, gas and coal to get us through the next big energy transformation.