Taxes vs. Projects

Earnings season is upon us, and the oil companies' 2005 results will certainly energize their critics. The top three US firms, ExxonMobil, Chevron, and ConocoPhillips, collectively earned almost $64 billion last year, up from the prior year's combined $47 billion. These remarkable figures will reinforce calls for some form of windfall tax and reduce the likelihood of derailing the "inventory tax" already under consideration. If the industry is going to make a compelling case for retaining all its profits to reinvest for the future, it must do so soon.

Returning to the windfall profit taxes of the 1970s--or some updated variant--would be a costly error, but it's harder to make that case when companies spend billions buying back their own shares. The inescapable fact is that expanding these companies' alternative energy portfolios, while simultaneously replacing their current oil and gas production, will require investments on a vast scale. A billion dollars currently buys one deepwater production platform, and the world will need scores of them in the next decade. Refineries, oil sands and gas-to-liquids plants are even pricier. The best argument against new taxes is a full slate of conventional and alternative energy projects, coupled to straightforward explanations of how they support future demand.

While I'm struck by the way this industry has been singled out for opprobrium for turning a healthy profit--in contrast to other sectors with less risk and much lower capital needs--I am convinced that a good part of this resentment flows from the inadequacy of the industry's public education efforts over the years. How many people understand what it takes to get a gallon of gasoline to the corner service station, let alone truly appreciate the difficulty of replacing even 10% of our present fossil fuel supply with renewable energy? Now, perhaps that's a failing of our schools, but it's also a huge missed opportunity for an industry that has such frequent contact with its customers.

Whether we like these companies or not, it's in the interest of everyone who drives a car, flies, or heats a home with oil or gas, that they earn a return sufficient to induce investors to keep their money there, instead of putting it all into stocks like Google. That might seem an incredible notion today, but it was a serious problem for the industry only a few years ago, when oil prices were lower. Recreating that situation now with taxes, rather than low oil prices, would guarantee a return to the underinvestment that has contributed to today's energy problems.

Why We Trade (Futures and Derivatives)

My posting two weeks ago on energy trading elicited several comments, including one requesting my views on how risk management benefits those with actual supply or demand, as opposed to a purely speculative interest in the market. This is a question I used to field on a regular basis, when I was in the market. The top managements of companies that produce, refine and distribute oil and gas are often suspicious of these trader types--including their own trading staffs, at times--so I had to have a ready answer for this. As the market became more sophisticated with the introduction of all sorts of derivatives, the answer got a little more complex, too.

There are at least two fundamental reasons for "hedging" commodity price risk using futures, options and derivatives . I have always felt the second was more important (and valuable) than the first, though they can wind up overlapping for smaller firms:

During the time a barrel of oil is produced, transported, refined, and distributed to the point of sale, market prices can change significantly. This creates a whole chain of realized or unrealized profits and losses along the way, depending on whether the transactions involved are between business units of one company or between unrelated companies. Being able to fix, or "lock in" all or a portion of the revenue as soon as the oil is produced or acquired makes the resulting cash flows, which may be large enough to affect the firm's bottom line, much more reliable and predictable. The key is making sure that the financial instrument used for hedging has a close enough correlation to the actual commodity being hedged, to match paper profits or losses to their physical-world counterparts. In other words, as an old boss of mine used to say, "What you lose in the grapes you make up in the bananas."

There's an argument in finance that the transaction costs of this kind of activity are simply a drain on shareholders. Equity investors should be astute enough either to manage these risks for themselves, or ignore them, because they are part of the risk they want to hold. Anyone who has seen the price of a company's stock drop 10% or more because it missed a quarterly earnings-per-share estimate by 5 cents will be pretty skeptical of this advice. And note that a routine program of executing market transactions to smooth commodity cash flows is philosophically (and legally) very different from doing extraordinary, off-market transactions to shift profits or losses from one period to another, or manufacture them out of thin air.

The deeper argument for hedging is that it enables companies to do deals they wouldn't do otherwise, because they couldn't stomach the resulting risk. Doing riskier deals and laying off some of that risk is thus a non-zero-sum activity, because it provides economic value from activities that wouldn't have happened without a hedge. An example might be in order:

If you live in the Northeast and use heating oil, you've probably at least been tempted to buy your oil at a fixed price for the entire winter season, or the whole year. But when you look at the way heating oil prices fluctuate, as a function of crude oil prices, refining margins, and other supply and demand factors, you can appreciate that your local heating oil company--probably a fairly small business, compared to the major oil or refining companies--couldn't possibly absorb all that volatility without running a big risk of going bankrupt every year. Instead, they--or their supplier--hedge that risk using some combination of futures, options and derivatives to create a fixed price contract, which they can then extend to you, for some fixed markup.

All of this hedging depends on a liquid market--one in which transactions of the necessary size can be done whenever needed--with enough counterparties willing to go the other way. If the only players in that market were your competitors in the same segment of the industry, e.g. other heating oil suppliers, isn't it likely that most of them would want to go the same direction on any given day, because you're all looking at the same business drivers? That's where speculators come in. This is no different than the stock market; when you sell shares, you need there to be someone willing to buy them at a mutually-agreeable price, and not just because his situation mirrors yours perfectly.

Multiply this across the whole market, and you get a pretty complex place filled with producers, refiners, marketers, end-users and lots and lots of speculators from Wall St. firms and hedge funds. Each needs the others, if the market is going to serve their collective needs. And as long as the markets aren't manipulated or "cornered", society as a whole benefits from economic activity at every level of the market, at least some of which wouldn't have happened otherwise.

Nuclear Power Paranoia

The UK is considering expanded nuclear power as a way to help meet its commitment to reduce greenhouse gas emissions under the Kyoto Treaty. This idea is controversial, but even a few leading figures in the environmental movement have come around to this view. Unfortunately, there are others who, rather than engaging in this important debate with facts, find it more expedient to attempt to scare the British public to death. An advertisement by Greenpeace, running on UK television, shows how far they'll go to sink the nuclear option.

In the last decade or so, many environmental groups have moderated their previous extreme rhetoric and, in the process, gained much greater acceptance as legitimate participants in national and international debates over energy and environmental policy. I consider this a positive development, because it helps environmental issues that merit serious consideration to be seen as part of the mainstream. By running this ad--reminiscent of the famous/infamous "daisy" ad in the 1964 US election--Greenpeace sets back the larger cause of environmentalism by casting it as a form of irrational alarmism.

On balance this blog has been moderately in favor of nuclear power, largely on the basis of its potential as a low greenhouse-gas-emitting, base-load complement to renewable electricity sources such as wind and solar. At the same time, I recognize that it comes with drawbacks, including high project risks, proliferation issues and an unresolved, politicized waste problem, particularly here in the US. As the TerraPass blog in which I ran across the Greenpeace ad points out, there are legitimate safety concerns about nuclear power, but 9/11-style attacks with airplanes don't rank high on the list.

In short, I can see how reasonable people might differ over the pros and cons of this technology. What I can't grasp is the sanctimonious paranoia--or cynicism--that would motivate someone to engage in this kind of scare tactic. It doesn't advance the debate, and in the end I don't think it will aid the anti-nuclear power argument. It might even backfire.

Scale of Independence

In case you haven't run across their ads for it, Chevron is hosting an interesting discussion forum on energy issues at WillYouJoinUs.com. Recent topics have included improved conservation and stretching out our oil and gas supplies. The current subject is energy independence vs. interdependence; I posted the following comments on that issue there, and I thought they might be of interest to the readers of this blog:

"The last year in which the US was 100% self-sufficient in energy was 1957. Today, we use 100 quadrillion BTUs of energy in all forms, per year, while our production has plateaued at 70 quads. Balancing that equation, either by adding new supply or putting in enough efficiency to reduce our consumption to equal our own production, would require a change equivalent to all the energy we currently get from coal and nuclear power, combined. Factoring in that the magnitude of our energy deficit has doubled in the last decade, the likelihood of achieving independence any time soon is negligible.

If we raise the bar to require going off oil entirely (40 quads/year) the goal recedes even farther. Nor is there any single technology or set of technologies available today that can close these gaps within less than two decades, based on the most aggressive turnover of vehicles and capital stock that can be realistically imagined.

So this isn't a philosophical debate between the virtues of independence and those of interdependence; we have no choice. We must make a virtue of necessity and focus our efforts on the margins, where market prices are set. Reducing our energy consumption by 5% and shifting 5 quads per year (about 2.5 million barrels per day) from oil to natural gas would have a profound impact on energy markets, particularly if it were part of a larger strategy to replace further increments with large-scale renewables, such as biofuels.

Achieving even this modest level of change will require a combination of commitment, persistence and sacrifice that we haven’t experienced in decades. But, unlike independence, it could actually be done and would pay huge dividends by exerting leverage on our remaining energy imports."

Even though the discussion site is sponsored by a corporation as part of a PR campaign, I think the subject is important and the ideas diverse enough to encourage all my readers to visit WillYouJoinUs and post your own thoughts. While you're at it, you may also want to read this excellent article on energy security in this week's Economist.

By the way, an abbreviated version of my posting of January 10 was printed in the Letters section of yesterday’s Wall St. Journal (subscription required.)

Breaking Coal's Constraints

I just read an interesting commentary on coal over at EnergyCentral.com. We tend to think of coal as an essentially boundless resource in the US, limited more by its environmental impact, mine-safety concerns and capital constraints than by any physical restrictions on the resource. That may not be the case. The author suggests that factors in the rail industry, including the impact of the tremendous consolidation that's taken place in the last decade or so, are putting a cap on the amount of coal that can be shipped to power plants in the foreseeable future. Although that could have serious implications for our energy supply, this outcome seems far from certain, given the available alternatives.

For years, coal has suffered from a sharply divided image. Despite its leading role in electricity generation, providing an inexpensive domestic fuel for base-load power generation, coal's environmental profile has cast serious doubts over its future. The combination of local pollution, in the form of acid rain precursors and heavy metals, and its high greenhouse gas emissions put it at odds with the environmental trends of the last 25 years, including the widely-noted "decarbonization" of energy. The development of advanced clean coal technology, including Integrated Gasification Combined Cycle (IGCC) with its potential for sequestering carbon dioxide emissions and keeping them out of the atmosphere, has elicited surprisingly positive comments from ardent environmentalists. Wouldn't it be ironic if logistics, rather than environmental concerns, prevented coal from making its full contribution to energy security?

Fortunately, I think there are several reasonable, though not necessarily cheap, ways around this. If rail capacity can't or won't keep up, slurry pipelines might provide a good alternative. The technology to pulverize coal and create a coal-water slurry is off-the-shelf, and a lot of work has been done on additives to keep the coal in suspension while in transit. The slurry can either be burned directly, or the coal can be de-slurried and dried before use. The biggest problem with this approach is the high cost of power to run the pumps, which must move as much water as coal.

Another solution would be to treat stranded coal in the same manner contemplated for natural gas: onsite gasifiers could feed gas-to-liquids plants, producing liquid synthetic fuels that could then be shipped by product pipeline or rail tankcar. Even the latter would help alleviate rail capacity constraints, because of the higher value and higher energy density of GTL diesel vs. coal. The same train could carry many more BTUs of energy as diesel than as coal, and the value of the fuel could accommodate higher freight tariffs.

Finally, building power plants in proximity to coal supplies, rather than near their demand load--Mohammed going to the mountain, as it were--is a time-tested strategy, although new long-distance power transmission lines aren't necessarily more popular than rail expansions, and line losses put a limit on how far you can send the power economically.

Ultimately, if technology can successfully overcome the environmental and other constraints on wider use of coal, I don't see why it can't provide practical ways either to circumvent existing rail capacity limitations, or provide sufficient inducement to remove those constraints through additional rail investments. This might drive the cost of coal a bit higher, but there's little on the horizon that will make its main competitors, natural gas and oil, drastically cheaper any time soon, and, at the present stage of development, wind and solar power compete more with natural gas than with coal.

Car Sharing

I've long been intrigued by the car sharing clubs that have sprung up in Germany and elsewhere around the EU. An article in the Wall St. Journal last week (subscription required) described how the clever use of wireless technology and the text-messaging feature of Europe's GSM cellphone standard has made these services more convenient and secure. Even though this approach, in which you rent cars in increments of hours instead of days, seems incompatible with the way most Americans view their cars, there are fledgling car-sharing organizations in some US cities (e.g., NY, Seattle and San Francisco.) Aside from its convenience, this system could also save a fair amount of gasoline.

That might sound counter-intuitive at first, if you assume car-sharing would mainly induce the car-less to car-share, instead of taking mass transit. But it should make it even more attractive for those who are fed up with the hassle and cost of owning cars in urban areas like Manhattan to give them up, on the assurance that they can micro-rent one any time for an errand or appointment. Even if these two customer categories canceled each other out, the scheme might still improve overall fuel economy, by reducing the number of SUVs on the road. After all, if you could get an SUV any time you really needed one for hauling capacity or traction, then you wouldn't need to drive one all the time.

Car sharing is also a good avenue through which to ramp up sales of fuel-efficient hybrid vehicles. Since hybrids typically achieve their best mileage in urban driving, they are ideal for lowering the costs of urban car-sharing. It also keeps the consumer risk associated with this kind of new technology to a minimum. Maintenance, battery life, and resale issues that might deter an individual buyer can be managed much more easily within a commercial fleet.

Improving the technology behind car-sharing, as described in the article, should do more than just make it more efficient and secure. It should make it more appealing, as well. I love the thought of being able to wave a smart card or cellphone at some random car on the street, hop in, and drive away. It wouldn't work for my suburban lifestyle, but if I lived in New York City, I'd sign up in a heartbeat.

High Tension

Speculation about a confrontation over Iran's nuclear program continues, as Iran moves its money out of European banks and the oil market exhibits a fine case of jitters. Yesterday's New York Times hinted strongly at one possible military scenario, while explaining its many undesirable consequences. In the same section, David Brooks's op-ed (subscription required) described the growing domestic political rifts over the various options available to us. The only parties heartened by all this must be President Ahmadinejad and the mullahs.

In David Sanger's article, various US officials--most off the record--described a possible air strike on Iran's nuclear facilities. It would have more in common with 2003's "Shock and Awe" air campaign in Iraq than with Israel's 1981 raid on Osirak. But unlike Iraq, Iran would not absorb such an attack without responding in ways that could quickly involve the entire region, throwing energy markets and stock markets into chaos. Iran's recent rhetoric suggests they see this as their trump card.

Meanwhile it's clear that Iran has gone to school on Saddam's methods for sowing division within the international community. As long as they can string out talks with Russia about external processing for their nuclear fuel, the likelihood of Russia or China participating in any meaningful international sanctions will remain low. Iran is stalling, and that is their best strategy at the moment; it may be ours, as well.

In the absence of a military option with acceptable costs, and without a broad consensus--in either Congress or the UN--on sanctions that would punish the Iranian government without backfiring elsewhere, both sides will keep posturing, until everyone's patience is exhausted. The ultimate outcome depends mostly on the true nature of the Iranians' goals and the strength of their determination to achieve them. Perhaps their intended model is Pakistan, which has suffered little lasting damage from joining the nuclear club. But will they risk ending up like North Korea, armed but isolated, or Iraq, which bluffed once too often?

The New Sputnik

Tom Friedman of the New York Times is widely regarded as one of our most astute observers of global trends, a view I share. In today's op-ed (subscription required) he suggests that Iran's nuclear threat, climate change, and the shrinking of Detroit's auto industry are all aspects of a multi-faceted wake-up call to America--the Sputnik of our era--and all share energy as a common denominator. I agree. Our response to these challenges will largely determine our future success and prosperity as a nation. Unfortunately, I'm skeptical about his prescription that all this can be addressed by a gasoline tax fixing the price of the fuel between $3.50 and $4.00 per gallon, regardless of fluctuations in global oil prices.

Toyota has received a lot of media coverage recently for its past success and the prospect that it could overtake GM as the world's largest auto maker this year. Some commentators have cited Toyota as the best American carmaker, with US auto plants every bit as good as those in Yokohama or elsewhere. This year Toyota will roll out its newest Camry, the best-selling car in America, and one of its versions will be a hybrid estimated to get 43 miles per gallon. If Toyota thought US buyers wanted them, they have the technology and wherewithal to make every Camry a hybrid within a few years. I know Ford takes this possibility seriously, but I'm not sure that GM or Daimler-Chrysler do.

However tempting they might be as a way to nudge us in this direction, gasoline taxes can't substitute for informed consumers who value energy efficiency at least as highly as they do power windows and cupholders. It's worth reminding ourselves that decades of extremely high fuel taxes have not freed Europe, where gasoline currently sells for $5-6 dollars per gallon, from dependence on Middle East oil.

Advanced technology and alternative energy sources, including biofuels, wind, solar and clean coal, hold great potential for shrinking our need for oil in the future. But we will burn a lot more barrels of oil and a lot more cubic feet of natural gas before those alternatives can grow enough to become entrees, rather than mere appetizers in our 100 quadrillion BTU per year energy menu. Getting to that point will require all of our discovered-but-off-limits natural gas reserves and the Alaskan gas pipeline and LNG and Canadian tar sands and--in my view--ANWR's oil, in addition to clearing away the NIMBY obstacles that block many of these as much as they do the wider development of wind and solar power.

Meanwhile I hope Mr. Friedman will continue to remind us that many of our worries--high oil prices, Islamic extremism, increasingly unpredictable weather, and our trade deficit--are truly connected. We have more control over these factors than we give ourselves credit for, not at the ballot box, but in the choices we make as consumers every day.

Gas-to-Liquids Impact

Yesterday's New York Times featured a story on the growing global industry to convert natural gas into synthetic diesel fuel, but it stopped well short of considering the implications of this expansion. Neither did it convey a clear idea of what is driving this development, beyond the economics of high oil prices. The actual story is more complicated. Although gas-to-liquids (GTL) has many positives, there is at least one significant drawback worth considering.

The historical perspective in the article was generally correct. The science behind this process has been around for many decades, helping to fuel Hitler's armies in World War II. Interest was revived in the 1970s, with plants built not just in Apartheid-era South Africa but also in New Zealand. Until very recently, however, GTL products have been much more expensive than conventional refined products from crude oil. The first large new GTL plant, a Shell facility in Malaysia, was helped by sales of valuable waxes and other byproducts, but the global markets for these products are too small to drive broader GTL expansion.

The prize here is twofold: harvesting the locked-up value of natural gas fields that are too far from markets to justify building pipelines, and producing diesel fuel that burns more cleanly than conventional diesel, especially with regard to particulate pollution. The Times cites a study by Cambridge Energy Research Associates (CERA) suggesting that GTL will contribute almost a million barrels per day of synthetic liquid fuels by 2010 and up to 2 million by 2020. As the cost per barrel of building GTL capacity falls, these numbers will continue to ramp up, tapping trillions of cubic feet of "stranded" gas. And there's the rub. At some level, GTL competes with the other technique for bringing stranded gas to market, LNG, or liquefied natural gas.

Today there's plenty of gas to fuel both processes, and the criteria for choosing one or the other are different enough that both can coexist. However, GTL has important advantages over LNG. Its output ships in conventional product tankers, rather than the expensive floating thermos bottles required by LNG, and it doesn't need costly and NIMBY-prone receiving infrastructure. If the capital costs of GTL fall faster than those for LNG, the former could eventually squeeze out the latter.

That would complicate plans to cover a growing fraction of US natural gas demand with imported gas, largely in the form of LNG. If the source gas isn’t available, because it’s been turned into diesel, then power plants will have to burn other fuels. While that could spur demand for additional renewable electricity from wind and solar, these are intermittent sources, so at some point there’s no substitute for a fossil-fuel fired plant, unless it’s a nuclear reactor. To put this in perspective, the 150,000 barrel per day Exxon project cited in the article will consume 1.8 billion cubic feet per day of gas, about the same quantity used last year by all the gas-fired power plants in the Northeast (New England plus NY, NJ and PA.)

As a consequence of these downstream tradeoffs, the net long-term environmental benefits of GTL are ambiguous. GTL fuel certainly burns cleaner than regular diesel, and that’s important because of the growing demand for diesel fuel, particularly in Europe. But the energy consumed in making GTL diesel dissipates much of the greenhouse gas benefit available from using natural gas directly, and the choice of GTL over LNG could result in more emissions from coal use.

Even if none of this product ever turns up at a service station in the US, it will still have a positive impact on fuel prices. The quantities of GTL under development may be small, relative to global oil consumption of 84 million barrels per day, but they represent an important component of incremental supply, where a million barrels per day one way or the other could be the difference between $35 oil and $50 oil. And by helping cover Europe’s growing diesel deficit, it will ensure that the US can continue to rely on a source of gasoline imports that we’d be hard-pressed to do without.

On balance, then, GTL is an important new source of clean liquid fuels, contributing to the global oil supply, but it complicates the prospect for wider use of natural gas in countries reliant on imports of LNG, including the US. As a result, its total environmental impact is mixed.

Hot Hybrids?

As I combed through email over the holidays, I ran across an interesting article from MIT's Technology Review about the potential to tap waste energy in cars using "thermoelectrics", which convert heat directly to electricity. The article focused on the possibility of using these materials to capture heat, e.g. from the car's exhaust, to run accessories or power steering. It now occurs to me that the best use of this technology might be as an adjunct to hybrid systems, boosting the stored electricity available to drive the car. That could make hybrids more efficient and attractive in the long run, giving fuel cells an even tougher competitor to beat.

The "holy grail" of energy efficiency is converting most of the chemical energy of our fuels into useful power, and much less of it into waste heat to the environment. The internal combustion engines that power our cars do a terrible job of this. The theoretical maximum efficiency of a heat engine is around 40%. Most car engines are lucky to deliver half of that, in the real world. In other words, for every gallon of gas you buy, you are only benefiting from the energy content of about one-and-a-half pints. What if you could turn that into 3-4 pints?

Two of the most popular energy efficiency technologies today, the hybrid car and the combined cycle gas turbine, are aimed directly at capturing energy otherwise lost as heat. This is done directly in the case of the CCGT, by using the hot turbine exhaust to generate steam to run another turbine, and indirectly in the case of a hybrid car, which recycles some of the energy lost in braking. Marrying a hybrid car drivetrain with thermoelectric material designed to turn engine heat into extra power might effectively give you a "combined-cycle car" with thermal efficiency approaching that of a fuel cell but without the latter's need for hydrogen infrastructure.

The biggest challenge in making this practical--aside from whatever is involved in perfecting the thermoelectric material--is maximizing the temperature at which the engine runs. If that sounds paradoxical or even dangerous, remember that the laws of thermodynamics dictate that the useful energy you can extract from something is related to its temperature. A CCGT is only as efficient as it is, because the turbine exhaust comes out at a couple thousand degrees F. By comparison, your radiator, the main heat sink for your car, keeps the engine block at 150-200 degrees, which is pretty low-level as heat sources go. This might be where ceramic engine blocks--an idea that has been floating around for decades--might shine, by operating at temperatures high enough to provide a nice heat source for thermoelectrics.

Now, I have to admit this whole idea is pretty speculative. But even if what I described never ends up in a car you can buy, it illustrates the diversity of ways to skin the vehicle efficiency cat. It is still premature to proclaim fuel cells, conventional or plug-in hybrids, or anything else the clear winner in this race.

Real Gasoline Prices

Last year, when the hurricanes helped push gasoline prices to their highest nominal levels in US history, many analysts suggested that we needed to look at this in terms of real dollars, which was only marginally higher than the previous record of the early 1980s. But it occurred to me that however accurate that might be as economics, it doesn't really reflect the way consumers think about prices. Many of us carry around a set of internal references about what things should cost, based on some period in which we focused on them. That would mean that there isn't any absolute sense of high and low prices, even within the same economic stratum, and that could have interesting policy implications.

The older I get, the more I notice myself comparing the prices of things to what they were when I was younger--a habit for which I used to chide my parents. On this basis, a carton of milk shouldn't cost $3, and a perfectly ordinary house has no business selling for more than a million. Gasoline is the most visible price in our economy, but have we really absorbed the way it has gone up and down over the years, relative to other things we buy?

For example, I can remember service stations posting prices of $0.359/gallon in the late 1960s and early 1970s (though it would occasionally drop below 30 cents during "price wars.") How do today's prices compare? Using the Consumer Price Index as a measure, that translates to about $1.90 in 2005 dollars. By the time I bought my first car in 1974, gas had jumped to about $.50/gallon, but that still equates to $2.00 now. In fact, when you look at historical gasoline prices converted to 2005 dollars, you see that from the end of World War II until the Iranian Revolution in 1979, gasoline averaged about $2.00/gallon. From then until 1985, it was around $2.50, hitting a high of $2.92 in 1981. And then from the oil price collapse in 1986 until 2004, it averaged $1.50/gal--coinciding with the rise of the SUV trend.

As a result, today's price of roughly $2.40 looks either in-line or out-of-line, as a function of which period you paid more attention to. And by extension, a $1.00/gal gasoline tax hike to spur efficiency would make the fuel seem twice as expensive to some of us, but only a bit pricier than usual for others. So if prices continue to drop from here, that could open up policy headroom for new gas taxes, while simultaneously reducing the effectiveness of a higher tax, depending on the individual perspectives of consumers.

Is Energy Trading a Dirty Word?

Sunday's New York Times business section led off with an article describing the state of energy trading, just over four years after Enron filed for bankruptcy. While the article was largely a human-interest piece on ex-Enron traders who have moved on to found their own trading operations, it also raised a number of interesting issues about the role and impact of energy trading. Here are some further thoughts on these topics, based on my own experience trading energy commodities from the mid-1980s to mid-1990s.

• Energy trading profits - The market for the last couple of years has been an ideal environment for traders. Volatility is the most important ingredient fueling the profitability of speculative trading, i.e. trading not directly related to managing the risk on an underlying business exposure. While many blame higher volatility on traders, I'd argue that the volatility arises from the well-documented combination of physical supply problems and geopolitical risk. In general, trading profits are a response to, rather than a cause of, volatility.
• Trader compensation - Given the huge profits available from trading around the world's trillion dollar a year energy flows, it shouldn't be surprising that some enterprising young folks--and trading is predominately a young man's game--are raking in incomes that put corporate executives to shame. But there are few things in life, other than owning your own business, in which personal contribution to profits is so easily measured, and in which rewarding good performance pays such large dividends for the firm. It's also worth noting that these salaries will fluctuate greatly, since it's unusual for even the best traders to keep winning big, year after year after year. The game changes rapidly; the deals that made you money last year get arbitraged away, and you have to keep innovating ahead of that curve to be successful.
• The role of hedge funds - Many of the same folks who blame trading for running up prices and volatility focus their ire on hedge funds. While these operations have brought billions of dollars of speculative money into energy trading, that isn't necessarily bad. From personal experience, I can tell you that markets involving only those with real stakes--companies with oil in transit, factory inputs to hedge, etc.--tend to be dull and illiquid. The oil company or utility trader needs a willing counterparty, and as often as not he won't find another oil company or utility that wants to take the opposite direction at the right time. That's where purely financial traders come in, and hedge funds are only the latest in a long line of non-fundamental players who have served that purpose. While they may occasionally drive the market, they have no intrinsic advantages over the companies that produce, refine and distribute the actual molecules and electrons.
• Recovering from Enron - Most of the people at Enron were smart, innovative, hard-working and honest. It's appropriate that the "scarlet letter" many of them received seems to be fading. I hope for their sakes that the trading operations in which they now work have a higher degree of transparency and checks and balances than Enron did, because the most important ingredient in sustained trading success isn't brains, but a solid reputation.

Politicians who think that regulating trading will bring down energy prices would be better advised to focus on the fundamentals that drive the markets. Stimulating more oil and gas production, facilitating gas imports, and fostering energy efficiency and cost-effective alternative energy will do a lot more for consumers than cracking down on speculation. Coincidentally, these actions will also make trading less profitable in the long run, by reducing market volatility.

Upping the Ante

Iran is back in the news, having broken the UN seals at Natanz and indicated its intention to restart its nuclear enrichment facility. As a result, the EU3 (Britain, France and Germany) seem prepared to refer the matter to the Security Council. I’ve discussed this issue at great length in previous postings and remain convinced of two things:

• Iran’s motives have little to do with producing electricity, and
• A major confrontation with Iran at this time would play havoc with energy markets.

There’s not much more to add at the moment, from my perspective. However, in the last few days we’ve heard some interesting commentary from Iranians, and it’s worth taking a look at these, if you haven’t already read them:

From the Wall St. Journal:
An indication that Iran’s theocratic hard line may not be as monolithic as it seems (subscription required.)

From the NY Times:
Ideas for averting a crisis

Anyone thinking that Iran's regime is innocuous and harmless should check out http://www.abfiran.org/english/memorial.php

Under Duress

At the same time that the singer Harry Belafonte was leading a UN visit to Venezuela and proclaiming how many in the US support President Chavez's socialist revolution, the country's oil minister was tidying up the details of the recent "renegotiation" of contracts covering energy projects with Shell, BP, Total and Chevron, among others. The changes make these deals significantly less attractive for the oil majors, and much more so for Venezuela. They amount to a partial nationalization, on threat of total expulsion if the companies hadn't agreed.

For example, the Hamaca heavy oil project, with which I am familiar from my time at Texaco, was established with 30% ownership by one of the arms of PdVSA, the state oil company. The previous government of Venezuela was happy to have foreigners invest in the oil sector, because they brought significant expertise in dealing with the challenging types of crude oil that make up most of Venezuela's reserves, and represented an important new revenue source, via the taxes and royalties they would pay. The contract revision has hiked state ownership to 51%, giving PdVSA--the main vehicle for funding the government largesse that maintains the President's popularity--control of these assets and their future development.

It is worth noting that the international projects covered by this forced renegotiation have been a godsend for Mr. Chavez. Not only are they big money-spinners, but they were the primary means of preventing the total collapse of Venezuela's oil production following the crippling industry strike of 2002-3. Rather than gratitude, the emotion this seems to have spawned is envy.

Did the affected companies have any real alternative, other than conceding? Could they have collectively refused to deal and taken their cases to the WTO or the World Court? Perhaps, but given the current profitability of Big Oil, they don't exactly make the most sympathetic group of plaintiffs. Venezuela would argue that it was merely seeking its legitimate share of the value of its own resources, an argument that would probably find favor in international circles.

Nor would the companies' shareholders be likely to reward them for walking away from billions of dollars of investment and hundreds of thousands of barrels per day of production, even to stand on a principle with important implications throughout their international portfolios. Without access to enough similar, large-scale opportunities in other OPEC countries or Russia, the managements of these firms had little choice but to agree, however distasteful and unethical they might regard the circumstances.

There's an old rule about blackmail, though, and it leads to the following prediction. If President Chavez was able to justify breaking these contracts and re-writing them in order to claim a larger share of the present high prices, he will have even more incentive to "renegotiate" again in the future, when oil prices fall and his absolute revenues decline. The companies involved need to consider at what point they would call Mr. Chavez's bluff about the ability of local staff to keep these plants--which include very sophisticated refineries, in addition to the drilling rigs one normally thinks of--going indefinitely. Otherwise, they will again find themselves having to compete to buy the output of facilities they designed, funded, built and lost.

Floor Price Pitfalls

A friend asked my opinion of a proposal in yesterday's Wall Street Journal to create an artificial floor price for oil by imposing a floating tariff, setting a minimum US oil price of $35/barrel. In his op-ed (subscription required) Mr. Marc Summerlin laid out a persuasive case for the benefits of such a tax. It would promote conservation and the development of alternative energy, while capturing revenue that might otherwise have gone to OPEC. Unfortunately, this idea has been around in various forms for decades, and it has many undesirable consequences beyond the energy markets.

The underlying concept has merit. In the absence of sufficiently liquid and affordable means for private firms to hedge against lower oil prices that would cripple alternative energy projects, the government could guarantee a floor price for oil, ensuring that alternative energy would be more competitive. The mechanism Mr. Summerlin suggests is a variable tariff that would kick in to keep the price of oil in the US above $35. If global conditions drove the price to $50 or $100, the full impact of those increases would be passed on to buyers. But a drop below $35 would be absorbed by the federal government in a dollar-for-dollar rise in the tariff.

A tariff on imported oil is another alternative to higher fuel taxes within the US. Both raise fuel prices and deter consumption, but they have very different effects on the economy and on the competitiveness of US products in the global marketplace. While a gas tax is imposed at the retail level, affecting consumers at the gas pump and raising the cost of all goods with a road-transport component, the proposed tariff would act at the producer level, driving up the cost of oil for refiners--thus raising the cost of gasoline, diesel and jet fuel--as well as for any businesses using oil or its derivatives in their manufacturing processes. That would make their products more expensive in the world market, relative to those of countries that don't impose such tariffs. As high as European fuel taxes are, they don't penalize their industries this way.

Another problem arises from the effect on domestically produced oil. Whenever the world price would fall below the level set by the tariff, US producers would begin to benefit from the artificially high price here. Unless taxed away in a manner matching the tariff, the US oil industry would receive a windfall. If this sounds familiar, that's because we tried something similar to this during the oil crises of the 1970s. The result was bureaucracy and market manipulation that rivaled anything seen with Enron. I started trading oil after the era of "Old Oil", "New Oil" and import certificates had ended, but I knew traders who lived in very nice houses and drove very impressive cars, as a result of exploiting those rules.

I also suspect Mr. Summerlin hasn't thought through the impact on the very futures market he's trying to help guide. The New York Mercantile Exchange's contract for West Texas Intermediate crude oil acts as the world marker price for oil, with a sizeable fraction of the physical crude delivered globally priced at a differential above or below it. The proposed tariff would terminate that role and truncate the market. Most of the volume would shift to the unconstrained London Brent contract, and the liquidity and influence of the US market on world prices would diminish.

It's possible that a narrower alternative to the tariff might achieve most of what the author intended. We could directly subsidize alternative energy projects for which the price of oil is a key factor. We might guarantee that oil sands projects, biofuels plants, and similar ventures always saw an effective oil price of $35 or more, without subjecting the whole economy to the distortions a tariff would create. Unfortunately, we tried that before, too, when the federal Synfuels Corporation guaranteed the market price for shale oil. The result was a set of billion-dollar boondoggles, none of which delivered meaningful benefits to the country. Similar mechanisms have perpetuated inefficient grain ethanol, at a high cost to taxpayers and with negligible energy benefits.

My regular readers know I have distinctly mixed feelings about higher fuel taxes, but I wouldn't hesitate to recommend them over either a tariff on imported oil or a price guarantee for alternative energy. Fuel taxes could raise at least as much revenue as a tariff and give a real boost to alternative energy and energy efficiency, while protecting the competitiveness of US exports and keeping the government out of the iffy business of picking technology winners and losers. The proposed tariff is just too similar to the failed energy policies of the 1970s.

An abbreviated version of this posting was published in the Wall St. Journal's Letters section on January 24.

Getting in on the Right Floor

After China's CNOOC failed in its effort to acquire Unocal, being initially outbid and later outmaneuvered by Chevron, it was clearly time to rethink its strategy. Buying an international oil company that was larger than itself, and taking on all the operational challenges and risks that went with it, was not just a step too far for a company that still had one foot in the world of state oil monopolies and regulated markets, it was also a poor match for China's needs. Now it has made a major acquisition in Africa, buying into a project led by France's Total. This looks like a much better move.

China's rapid economic growth has turned it from a net oil exporter into a major importer in the course of about a decade. Energy security in the Chinese context will come from reliable, geographically diverse supplies of oil and gas to fuel further growth. Unocal could have provided some of that, but it came not just at a high price per barrel, but with counterproductive political complications . Its 45% stake in the Akpo project in Nigeria will serve it better, if on a smaller scale. As CNOOC and its sister companies attempt to grow internationally, their best bet is buying into precisely this kind of project, involving the development of a previously-discovered resource.

This approach offers several advantages for CNOOC. It will still have to reconcile different cultures and management styles, but this will be on the project venture level, where CNOOC already has considerable experience working with Western companies. It is also not taking on exploration risk, which was the bane of Japan's attempt to do the same thing twenty-five years ago. Nor will it have to operate the project, relying instead on--and learning from--a major oil company with significant experience both in Africa and in deep water. Through further acquisitions like this at attractive prices (this deal is estimated to work out to under $5/barrel) CNOOC can assemble an attractive international portfolio and grow itself into a meaningful supplier of China's import needs, as well as becoming a serious player in the global market.

From the standpoint of the international majors, this strategy creates more of a mixed blessing than a successful acquisition of Unocal would have. In the near term, it provides them a cash-rich partner with whom to share development risk on the multi-billion-dollar projects they must pursue, in order to replace their depleting reserves. In the long run, however, it puts CNOOC squarely into the market from which they derive the bulk of their cash flow, and it will drive up contract terms with host countries. And CNOOC is only the thin edge of the wedge of state and former-state oil companies that are looking to break out of their national cages.

LNG Catch 22

The floating LNG regasification facility proposed for Long Island Sound has hit another snag. An article in Sunday's New York Times described the curious permitting snafu that has developed on the way to review by the Federal Energy Regulatory Commission, relating to the project's safety plans. Apparently, the details of the Broadwater project have fallen under a post-9/11 infrastructure security regulation that effectively bars them from public scrutiny. In the absence of specifics, opponents are seizing on the classification of the plans to argue that the project is too risky for the busy waters of Long Island Sound, or its heavily populated shorelines. Welcome to the Twilight Zone.

Living only a couple of miles from Long Island Sound, I am more than a little interested in how this comes out. My first instinct is that Broadwater would be a tremendous boon for the region, providing direct access to international supplies of clean natural gas at prices much lower than those I see on my monthly gas bill. But, as I said before, the project shouldn't get a free ride on safety or environmental impact, just because it's a good business proposition.

As a resident, I share the frustration of those seeking to understand how Broadwater might affect the area, particularly in a worst-case scenario. Under our system we have come to expect full public scrutiny of such proposals as part of our Constitutional rights, honed by legislation such as the Freedom of Information Act. But we also shouldn't lose sight of the responsibility of the government and of businesses acting under government license to safeguard information, the release of which might be harmful in wartime. The Broadwater project must find a way to navigate the gap between those poles, if it is to go forward.

However, it is a long, unjustified leap from the dilemma described above to the flawed logic that uses the security around the project's plans as de facto evidence that it is inherently unsafe. Connecticut Attorney General Richard Blumenthal was quoted in the Times saying, "It is powerful evidence of the susceptibility to terrorist attack and proves that the public interest is greatly endangered." A filing by Suffolk County, NY went even further, citing FERC's comment that destruction of an LNG terminal by saboteurs would negatively impact public health and safety as proving, "that the Broadwater project can not be found safe or in the public interest." Franz Kafka would recognize a kindred spirit, there.

Every energy facility in the country is vulnerable to terrorism, with serious potential consequences, nor are energy facilities unique in this regard. If that fact were sufficient argument against building more, then we'd better consider a ban on the sales of new gas and electric appliances.

It may just be that wartime prudence prevents our knowing enough about Broadwater's design and safety systems to make us all comfortable. If so, then we must choose between blocking the project--thus obliging us to address the future energy balance of the greater NY region in some other way--or trusting in the judgment of those with the clearance to scrutinize these plans. The latter may seem a quaint notion in 2006, but to me the other choice looks worse. If we fail to find a sensible way through this procedural quandary, our energy future will be jeopardized as much as by any attack Al Qaeda could mount.

More Russian Risk

In recent conversations with family and friends I've been lamenting the conversion of the news media to an entertainment business model, robbing us of a more complete picture of what's going on in the world. Again this week, their "flash mob" approach to the tragedy in West Virginia overshadowed larger events across the globe. From an energy perspective, the story we should have been paying closer attention to was the natural gas dispute--now resolved--between Russia and Ukraine, because it has important implications for our future energy supplies.

Last week I discussed why Russia's willingness to threaten to cut off supplies over a disagreement on pricing should concern the EU, which relies on Russia for much of its gas imports. But the issue goes deeper and could have an influence on long-term global oil supplies, as well. Russia offers one of the best prospects outside of OPEC for bringing new oil supplies to market over the next decade or two. But ever since President Putin began to roll back the privatization of energy resources, foreign investors have seen the trends on "above-ground risk"--having to do with legal systems, politic stability and corruption--go the wrong way. The dismantling of Yukos was a giant red flag for anyone contemplating investment in Russia. The Russia/Ukraine gas standoff compounds these concerns.

One of the basic principles of the energy business is that getting oil or gas out of the ground is pointless if you can't sell it to someone. In Russia, that means being able to export to a buyer in Europe or Asia, because the internal Russian market is saturated with cheap government oil and gas. President Putin's threat to cut off gas exports to Ukraine raises the specter that he might actually follow through in a future dispute with some other country. If the oil or gas in question were coming from a multi-billion dollar private project, such as one of those on Sakhalin Island, the consequences for the project's economics would be dire.

To the extent this sort of power-play deters investment in the Russian oil and gas sector, the whole industrial world is worse off, because it makes us even more reliant on the Middle East. Apparently the global role Mr. Putin is looking to fill is not that of "reliable energy supplier." Companies will have to figure out just what his aspiration is, before putting more money into the Russian energy sector.

The Price of Coal

After every serious coal mining accident, commentators like to remind us that while coal may be cheaper than other forms of energy in terms of dollars, it exacts a high human price. The fate of the miners wasn't even being reported correctly when an op-ed in that vein appeared in the New York Times. To the extent the authors' criticisms are accurate, it's important to remember that we all share responsibility for the steady rise in coal consumption.

As the article reminds us, coal is our most plentiful domestic energy resource, and part of its value proposition derives directly from the higher cost of cleaner alternatives. I'm sure I seem like a broken record on this topic, but the combination of short-sighted bans on offshore gas drilling, restrictions on vast tracts of federal land, and inadequate infrastructure investment is rendering our most attractive fuel uncompetitive against coal.

At the same time, electricity consumption has been growing at 2%/year for the last decade, and with gas around $10 per million BTUs, coal will win the battle for new generating capacity. As optimistic as I am about alternative energy sources such as wind, solar and biomass, for the next decade they cannot grow fast enough to displace fossil fuels. The choice for new base-load electricity generation is between coal and gas--and just possibly nuclear.

Nor can we ignore the economic contribution coal makes in the areas in which it is found, particularly in the eastern US. However unappealing mining jobs may seem to those of us in the post-industrial portions of America, they remain attractive in communities that often have few other alternatives, a point made frequently during interviews in the last 24 hours.

Safety is a crucial concern in coal mining, and the safety record of the Sago mine is hardly exemplary. But although the national trend in mining deaths has been steadily downward, working underground is inherently risky. In the case of some of these old mines, total safety can only be achieved by shutting them down, because their economics are marginal even at today's higher coal prices.

Unfortunately, the bill for our energy "free lunch" gets paid periodically in towns like Sago, WV. Americans have chosen a highly energy-intensive lifestyle, while erecting obstacles in the way of the safest and cleanest energy resources we possess. It may be crass to point this out, but these miners died in part so that others can enjoy beaches with views unsullied by drilling platforms or wind turbines, and wilderness areas without derricks and pipelines. If that makes you uncomfortable--and it should--then we have ample means of correcting the situation by changing how we use energy and by demanding sensible and consistent energy and environmental policies.

Unnecessary Reserve?

I was pleased to read this op-ed in yesterday's New York Times advocating the abolition of the Strategic Petroleum Reserve (SPR). I've been writing about this topic for the last two years. In general, I agree with the authors' assertion that the existence of the SPR has deterred companies from holding their own inventories, at a high cost to taxpayers and a similar cost to markets. However, I find the authors' alternative of simply letting the market handle this function inadequate. That's because the market participants they would rely on have conflicting interests--and some clear disincentives--in fulfilling this function.

Let's start with the basic question about whether any reserve is necessary, and if so, whether the amount currently in the SPR (685 million barrels)--or its recently authorized expansion to 1 billion barrels--is appropriate. As we've seen very clearly in the last few months in particular, and for the past two decades in general, the oil markets are good at reallocating supplies to make up for shortfalls due to weather, war, strikes, or accidents. This comes at a price, though. Unlike the market for airline seats, the price of the last barrel sets the price for all barrels, except where state intervention buffers this effect. The bigger the disruption and the shorter the timeframe over which adjustments must be made, the larger the magnitude of the price impact across the entire economy. In the event of a major disruption from a key supplier, such as the Saudis, the price shock could be crippling.

How much difference would 1 billion barrels make in a worst-case-scenario? As currently configured, the SPR could supply 4.4 million barrels per day (MBD)--roughly 40% of our total oil imports--for nearly eight months. Viewed in the context of a market in which a global shift in the supply/demand balance of about 2 MBD has been sufficient to double prices, 4 MBD looks very significant and adequate to all but the most extreme disruptions.

Could the same volume held in private hands have an even larger impact? Absolutely. The two biggest limitations on the SPR are the cap on its delivery rate and its inability to affect supplies in parts of the country not connected by pipeline to the Gulf Coast. Putting the SPR oil in commercial tankage near refineries all across the country might reduce its ability to respond to a local disaster, such as a Gulf Coast hurricane, but would greatly enhance its effectiveness in a national crisis by reducing the delivery time-lag and increasing the rate at which oil could be pumped out.

Unfortunately, there are two serious drawbacks to this approach, and neither was identified in the op-ed. First, oil companies currently have significant incentives to keep inventories as low as possible, consistent with smooth day-to-day operations. Accounting rules penalize them for holding high inventories, and it is expensive to manage the price-risk exposure that long-term inventory creates. Just as importantly, while oil companies like security of supply, they don't (and shouldn't) share the government's interest in mitigating price spikes. High prices bolster profits, as we've seen, and increase returns to shareholders. As the op-ed suggests, companies will only hold extra inventories if they see a clear way to profit from them.

And that's why I think the Cato Institute has provided a good opening salvo but not the whole answer. The SPR is an outdated response to the problems of the 1970s, and it carries over the regulatory mindset of that period. Its basic purpose, though, is at least as valid today, from a national perspective. The conversation should focus on the best means of executing that purpose, at the lowest cost and least disruption to the market. In my view, that means shifting the SPR oil to commercial ownership, but under carefully-crafted guidelines and with incentives that would reward companies for holding these barrels, while ensuring they would be used when needed. Tackling this would make a great energy goal for 2006.

Bubble-itis

The media have been saturated with the customary cusp-of-the-year analysis and projections, and so far little of it seems particularly surprising or insightful. I ran across one small item in the New York Times that I thought merited further consideration, though. In Sunday's Week in Review Section, one segment of their "What in the World We'll Do in 2006" report featured this discussion of whether alternative energy was turning into the new stock market bubble. The author never quite comes out and says that it is, but he sets up his criteria for a bubble and asserts that alternative energy meets them all.

In much the way that the Depression focused economists on the dangers of deflation, the Tech Wreck gave rise to a whole industry of bubble-mavens, and there are certainly areas of concern, such as housing markets across the developed world. But either in terms of their share of market capitalization to the total stock market, or of their contribution to the global $3 or $4 trillion energy market, alternative energy stocks aren't even on the scale of the bubbles in glass of soda, let alone something policy makers, economists or investors should worry about.

The increased attractiveness of alternative energy stocks is clearly attributable to the dramatic increases in the prices of oil and natural gas, and the growing environmental challenges facing coal. To the degree these energy sources face long-term problems, alternative energy seems on secure footing. The sector includes some very promising technologies, in addition to the obvious wind and solar power segments. Gasification and sequestration, next-generation biofuels, advanced batteries, and stationary fuel cells will likely all be applied at material scales within the next decade. That means selling real products to real buyers, and generating real BTUs and kilowatts. In this light, analogies to the Tech Bubble begin to look silly.

Investors still need to be savvy about where to invest in this sector. Many of the new technologies under development today will turn out to be impractical or uneconomical. Many of the companies involved will not be viable. This is exactly what you'd expect in a market segment that, though it has been around for quite a while, has only recently entered the limelight. Talk of bubbles at this stage is particularly unhelpful, because it undersells the promise of the sector while distracting investors from the crucial details of specific technologies and company structures and capabilities on which they should be focused.

And while a substantial drop in energy prices might create a short-term flight from alternative energy, reinforcing the idea that it was all hype, the long-term trends ensure that this sector has plenty of room to grow, for a long time to come.