Another Default Option for Gas

Not many people are paying attention to the US's other big energy problem, in natural gas. It hasn't intruded much on our lives this winter, because of prudent inventory management and a remarkably warm start to the season in the Northeast. That's why the price of natural gas is currently $7/million BTUs on the New York Mercantile Exchange, instead of up to $14, as it was last winter. But this year-ago comparison masks two important facts: $7 is still more than three times the average gas price in the 1990s, and US net dry gas production has been declining steadily and is currently 6% below its recent peak in 2001. The reasons for this are complicated, but the consequences are straightforward: our reliance on imports will grow and the economic incentives to turn coal into synthetic gas will increase. Although the latter looks beneficial from an energy security standpoint, the environmental impact could be severe. We need to think seriously about whether we prefer that to the environmental risks of opening up the country's untapped gas potential.

The history of turning coal into gas goes back a long way, even longer than that of turning it into liquid fuels. The gas lights that electric lights displaced a century ago typically burned a fuel produced by the local "gas works", which literally cooked coal to make synthetic gas, or "town gas." There are a number of updated processes for doing essentially the same thing, including the gasification processes frequently mentioned as a way to burn coal more cleanly and efficiently in power plants. MIT's Technology Review recently highlighted another new process, the goal of which seems to be the production of gas that competes into non-power markets, including chemicals and fertilizer. From a purely financial perspective, I can see the desirability of doing this, and it might just result in fewer facilities being "offshored."

The problem is that we'd effectively be replacing our cleanest fossil fuel with our dirtiest. If every such instance had as convenient a way to dispose of CO2 as the plant cited in the MIT article--thus freeing up natural gas for other uses where that's not possible--this would be a good thing. But if this idea takes off, it could quickly outstrip the market for CO2 in enhanced oil recovery, and the extra CO2 will simply be emitted to the atmosphere, compounding the challenge of reducing our greenhouse gas emissions.

Some analysts suggest that US natural gas production has peaked for geological reasons, just as our oil production peaked in the early 1970s. Although a growing share of our gas supply now comes from "unconventional" sources such as coal bed methane and "tight" gas, the US still has a lot of natural gas left. Political constraints on drilling matter as much as geology, here, and while I don't necessarily question the value judgments behind them, I do wonder if these constraints were imposed with a full understanding that the alternative to that foregone supply might not be coming from a wind farm or a landfill, but from yet another new opportunity for coal producers.

A Long Enough Lever

The oil price drop of the last several months has been quietly proving one of the central tenets of the "Geo-Green" or "green hawk" groups that have emerged since 9/11. They suggest that by tipping the scales of the global oil supply/demand balance in the right direction, we can cause significant problems for energy-exporting, geopolitically-challenging states such as Iran and Venezuela, while improving our domestic economy. It's ironic that the current lesson hasn't been provided by a huge bow-shock of alternative energy, but largely through the normal functioning of the market. What's the difference between $77 oil and $55 oil? Apparently, it's the million barrels per day of slack that the Saudis have been endeavoring to take out of the market gradually, since last summer--a combination of higher supply and lower demand. But although this proof of concept may come courtesy of OPEC's over-production, that doesn't mean it is the only way to achieve a similar softening of prices.

15 billion additional gallons of ethanol per year would be roughly the equivalent of that million barrels per day of excess oil. Add that to current ethanol production, and it gives us a bogey of 20 billion gallons, well within the President Bush's announced 35 billion gallon target for 2017. Unfortunately, it's probably beyond the reach of current-generation corn ethanol to deliver that quantity at an environmental or food-supply price we could tolerate. In addition, given an ethanol "fossil energy balance" of 1.3:1, we'd need the equivalent of 770,000 barrels per day of energy from coal or natural gas to produce it. If that all came from gas, it would consume an extra 4.5 billion cubic feet per day (BCFD), or about 9% of current US net dry gas production. Since we are already struggling to cover our existing demand for natural gas, coming up with this volume would drive US natural gas prices back to their historical highs of last winter.

We could also get the equivalent in reduced demand from greater energy efficiency. A million barrels per day equates to a bit more than 8% of current gasoline demand, on a yield-and-energy-adjusted basis. That would require making all the vehicles on the road 8% more efficient, driving them 8% less, or any combination of the two adding up to 8%. Since the trend on vehicle miles driven has gone steadily upward year after year, for decades, efficiency will have to carry the load. Unfortunately, it takes 15 years to turn over the car fleet, so trying to influence oil prices via this route will take a long time, certainly more than a decade.

The other way to achieve the same result is to boost domestic oil production. While we are constantly reminded that we only have 3% of the world's proved oil reserves, the government's estimates of the undiscovered resources in areas currently off-limits to drilling appear ample to crank out an extra million barrels per day for a decade or two, before the natural decline of the entire production base swamped it. In addition to the political barriers to drilling in wilderness or offshore, though, this approach would run afoul of the time lags and project delays inherent in this kind of development. As tempting as this strategy might sound to some, it's not a quick fix, either.

But what if we combined all three of these approaches, allocating a third of the target to each? An extra 5 billion gallons per year of ethanol is almost a lock at this point. A 2.7 % reduction in gasoline use is far less ambitious than the President's "20-10" target and could be rolled out as a useful milestone along the way to that. And an extra 250,000 barrels per day of oil could probably be achieved by widening the recent expansion of Gulf Coast drilling leases a bit more. And the nice thing about divvying up the larger goal is that you get there that much faster, by multi-tasking.

The point of all this is simply to demonstrate that relying on any one strategy to get our energy security under control is destined to disappoint us. A combination of complementary approaches, including the important contribution that domestic oil and gas can still make, looks much more promising. Even if the three specific examples cited above aren't the components that we'd ultimately settle on, we need to start somewhere, and we can't ignore the role of energy consumers in determining demand.

Atlantic Convergence on Nuclear

One of the most interesting energy developments of the last 12 months, at least from a big-picture perspective, is the convergence of the US and EU on two big energy issues: energy security and climate change. That was certainly reflected in the discussions at last week's World Economic Forum, the annual meeting of the great and the good in Davos, Switzerland. And as the New York Times reported, nuclear power is increasingly getting another look for its contribution on both fronts, on both sides of the Atlantic. In particular, it is hard to imagine making a meaningful dent in the climate change problem if both nuclear and renewable energy lose market share to fossil fuels over the next 25 years, as status-quo projections suggest. But that is exactly what will happen, at least for nuclear power, if the developed world doesn't begin planning and building the next generation of reactors, shortly.

Nuclear power remains the largest-scale energy technology at our disposal that emits essentially no greenhouse gas emissions, even after factoring in those associated with their construction. Despite that, I'm skeptical that nuclear can offer a comprehensive solution to our energy needs in a climate-constrained world, because of the time, cost and political obstacles standing in the way of building the thousands of reactors that would require. But with global energy consumption on a path to grow by 50% in 20 years, the cost of having nuclear power go backwards seems even higher. Because of the long hiatus in nuclear plant construction outside of Japan, France and China, most of the nuclear plants in the US and Europe will reach the end of their operating lives during the same decades-long timeframe that we will be trying to decarbonize our energy sources. How many of these plants will be replaced or refurbished, particularly if Germany follows through on its plan to decommission its remaining nukes by 2022?

Although nuclear power currently contributes only about 6% of the world's total energy supply, about the same as hydroelectric dams, it accounts for 16% of electricity generation (19% in the US) and competes directly as base-load supply with coal, which fuels 40% of the world's electricity and produces a comparable share of all energy-related CO2 emissions. While critics of nuclear power point to the potential of energy efficiency to make nuclear irrelevant, we should ask whether that efficiency were better deployed to reduce emissions from our most carbon-intensive energy sources, rather than one of the least.

No one can ignore the significant challenges associated with continued use of nuclear power. Aside from high capital costs, these include waste management and the risks of terrorism and proliferation. Nuclear fuel supply presents its own challenges, and I've been tardy in following up the leads in this area provided by a reader. But wouldn't it be ironic if the countries best equipped to deal with all of these issues ceded the strategic use of this technology to other countries for which they are most problematic? That's the path we're on, unless the growing trans-Atlantic alignment on energy security and climate shifts our priorities.

Measuring Earthshine

Although emissions of greenhouse gases, especially those from industry and transportation, grab most of the headlines relating to climate change, they are not the only factor determining how much our planet is warming. One of the other key issues is the rate at which solar radiation is reflected back into space, by clouds, snow, or surface features. The technical term for this is "albedo", and it is central to the concerns about reforestation that I highlighted last Wednesday. It turns out that the albedo of the earth has not been constant over the last several decades. Because of the complex interactions involved, this could be a consequence of climate change, a factor compounding it, or both. In any case, measuring albedo as accurately as possible ought to be a high priority, if we're going to sharpen our predictions about the future course of global climate change. Surprisingly, a satellite built to do just that is sitting in a warehouse, with no launch date scheduled.

Space isn't the only place from which we can measure the earth's albedo. It has been done from right here on earth for decades by taking advantage of a phenomenon first discovered by Leonardo da Vinci. Scientists simply measure the amount of reflected "earthshine" illuminating the moon. From these readings, confirmed by instruments on existing satellites, we know that the albedo of the earth is roughly 0.30. That means that it reflects 30% of incident solar radiation back into space, compared to about 12% for the moon. Unfortunately, these measurements are apparently only accurate to within 2%. That doesn't harm their usefulness for discerning trends, such as the recent changes in albedo that have been reported. However, since the amount of extra "radiative forcing" responsible for climate change appears to be around 2 Watts/square meter over the last century--equivalent to 1% of the average solar radiation reaching the earth's surface--improving the accuracy of albedo measurement looks like a very useful thing to do.

NASA's DSCOVR satellite has already been built, but it has never been launched, and the whole mission appears to have fallen into a budgetary black hole. Reviving it would entail a bit more than just lining up a launch vehicle--supposedly France and Ukraine have offered that for free--but in light of the growing national interest in understanding and responding to climate change, perhaps we can drum up enough support to get it into its planned Lagrange Point 1 orbit before it's sold for scrap.

Cheap Gas Blues

Retail gasoline prices dropped another 8 cents last week, bringing the national average price down to $2.16/gallon. It seems strange to consider the prospect that gasoline might be getting too cheap, after seeing $3.00/gallon last summer, when consumers feared that lower prices might never return. Detroit seems worried about this, though, as the Big 3 ponder investments in expensive fuel efficiency technology and the President moots tougher Corporate Average Fuel Economy (CAFE) standards for passenger cars. As I pointed out in my comments yesterday on the State of the Union address, higher CAFEs won't ensure that more efficient cars will sell; all they will do is put them on dealers' lots. Detroit has just paid a heavy price for having mostly big SUVs on those lots when gas prices soared; how eager will they be to risk the reverse situation? This is a legitimate concern, even if crude prices don't drop any further.

The media and the public have generally linked recent high gasoline prices to the tremendous run-up in crude oil prices that occurred in the first half of 2006, capping a three-year trend. This was the stuff of newspaper headlines and graphics on the evening news for week after week in much of the past year. But that story missed another big influence, which was particularly noticeable following the hurricanes of the previous summer: the role of tight refining capacity and high refining margins in amplifying the impact of the oil price spike at the pump. The easing of this factor has also played a role, as high gasoline prices have unraveled.

The refining industry has historically been its own worst enemy when it comes to margins. Periods of good margins have typically prompted large new capacity investments, which expand refined product supply and dampen prices. Even without those large investments, refineries are subject to the phenomenon of "capacity creep", in which most facilities generally add about 1% of effective capacity annually, as a result of the continuous effort of engineers and managers to improve efficiency and remove bottlenecks. In a good year for refiners, demand for their products grows by more than this amount and margins stay healthy. In a normal year, the two factors keep pace. In a bad stretch, capacity can outgrow demand for several years in a row, and margins get stuck in the doldrums.

Looking at the difference between the traded prices of gasoline and crude oil on the New York Mercantile Exchange (the so-called "gas crack spread") as a proxy for US refining margins (ignoring the impact of diesel fuel and other products, as well as regional differences and seasonal variations in yield) we see that from 1991 through 2006 wholesale gasoline sold for $6.30/bbl over sweet crude, on average. That's a margin of 15 cents/gallon. However, during 2005-2006, that average was $9.76/bbl, or 23 cents/gal. But from March 1-August 7, 2006, when crude oil rose by $15/bbl to reach its peak of $78.42/bbl, the NYMEX gas crack--which in many years would have been squeezed between rising crude prices and resistant product prices--blew out to average almost 38 cents/gal. In other words, last spring and summer, increased refining margins accounted for nearly as much of the gasoline price increase as higher crude oil prices did. Right now, the gas crack spread is back to a more normal level of about 15 cents/gal.

Now throw biofuels into the mix. Whether or not expanded biofuels mandates are the answer to reducing our dependence on imported crude oil, they will likely have the unintended consequence of reducing gasoline prices by depressing refining margins. We've seen this effect before, in the early 1990s, when new environmental regulations forced refiners to incorporate up to 10% MTBE or ethanol in their gasoline blends in some regions, swelling the "gasoline pool" accordingly. The current growth in US ethanol production is adding the gasoline equivalent of a new medium-size oil refinery every year, and that pace would increase if the President's expanded biofuels mandate is enacted. Could this influx of non-oil-based gasoline blending component set up the refining industry for another period like 1992-94, when the NYMEX gas crack averaged under 10 cents/gal.? If so, it could usher in a sustained period of sub-$2.00/gal. gasoline for most of the country, even if crude oil remained above $50/bbl. The more biofuels enter the pool, the more pressure on gasoline prices, and market forces alone won't close this feedback loop.

This sounds like a classic case of good news/bad news. Many people would happily vote for more biofuels if they thought this would keep the fuel for their cars cheap. But cheap gas won't produce a groundswell of demand for highly fuel-efficient automobiles, such as hybrids that cost thousands of dollars more per vehicle. That means that our overall fuel consumption will continue to grow, even as we're trying to get the oil component of it under control, compounding our challenges in managing emissions and reducing imports. So before the federal government adopts a 35 billion gallon/year biofuel target, it should consider how to manage the accompanying unintended consequences.

Union on Energy

Although much of the world was watching last night's State of the Union Address to hear what the President would say about Iraq, the leadup to the speech included a remarkable amount of speculation and pre-positioning about its energy and environmental focus. Yesterday's Wall Street Journal included op-eds from a technology expert and an energy expert, taking opposite sides of the independence argument, a day after a technology icon highlighted our consistent failure to attain the energy independence goals set by past administrations. And all of this was taking place against the backdrop of our growing national concern about climate change, creating the realistic prospect that the US might finally enact legislation to reduce greenhouse gas emissions. What we heard last night was a set of proposals for expanding the current biofuels mandate, modestly increasing fuel economy standards, and doubling the Strategic Petroleum Reserve, accompanied by a one-sentence nod to climate change. While I suspect that there might indeed be a bi-partisan consensus available to enact legislation along the lines the President described, we need to ask whether these measures and the priorities implicit in them are sufficiently aligned with our real problems.

Between the new Congress and the Administration, energy independence and climate change are competing for primacy over energy policy, and it's crucial we make the right choice about which should come first. Focusing on climate change as the primary issue would automatically address our energy security, by getting the growth of demand under control--targeting emissions reductions through greater energy efficiency--and by making alternative energy of all types more competitive with traditional fuels. Of course, this runs afoul of two key legs of the energy independence platform, by putting coal-generated electricity and corn-based ethanol on a more level and less advantageous playing field, relative to other options. The President's target of 35 billion gallons per year of biofuels creates a big bet that cellulosic ethanol technology will mature and decline in cost in time to prevent a catastrophic collision between our fuel and food needs. However favorable the odds might seem to some, this is still a bet, not a certainty.

By putting energy independence ahead of climate change, we run the risk of investing too heavily in technologies that, while gradually reducing our dependence on unstable suppliers of foreign oil, will deliver little in the way of verifiable reductions in our overall greenhouse gas emissions, which are equivalent across all sources. Merely shifting them from tailpipes to smoke stacks will not avert the consequences of climate change, unless it creates a net energy efficiency gain and an actual--as opposed to theoretical--opportunity to sequester the carbon emitted by large central sources. At a minimum, a shift to more ethanol and plug-in hybrids would require expanded production or imports of natural gas, to limit the degree to which coal must take up the slack for the additional electricity generation and process heat required.

Stricter Corporate Average Fuel Economy standards may seem a motherhood and apple pie solution, but with gasoline prices falling, it's not at all apparent that consumers will line up to buy the more efficient vehicles that carmakers must offer. Without a higher gasoline tax, or a comprehensive carbon-cap system that raises gasoline prices, gasoline demand will continue to increase, as a growing population of consumers drives more and heavier vehicles farther each year.

As to increasing the SPR, there are good reasons to consider this, but not on the basis of simply expanding the current reserve, which can only pump out at a rate equivalent to 40% of our imports, and which provides no coverage for the Northeast or West Coast. Instead, as I've suggested periodically, we should be providing refiners with appropriate targets and incentives to hold larger stocks in their own facilities and nearby, where they would be less vulnerable to disruption by terrorists or hurricanes, and capable of serving parts of the country that cannot be reached by pipeline from South Louisiana or East Texas. See Monday's posting for more thoughts on an updated SPR.

One of my consistent themes in this blog for the last several years--probably sparked by vivid memories of growing up in that inauspicious decade--is that we are not reliving the 1970s. Despite superficial similarities in the alignment of an unpopular war, an unpopular president, and an apparent energy crisis, we have better options than we did then, at least for energy. Ethanol and the SPR are the last holdovers from the first energy crisis, before the advent of hybrid cars and fuel cells--or even personal computers--and pre-dating our recognition of global warming. Rather than picking technologies, it's time to create the necessary targets for emissions and efficiency, instead. The President's goal of reducing gasoline consumption by 20% within 10 years is a step in the right direction, even if it's not directly focused on climate change. It is specific, measurable, and attainable--though probably just barely. What's required now is an overarching goal to arrest the growth of greenhouse gas emissions over the same period, and reduce them in absolute terms in the following decade.

ExxonMobil on Climate Change

Last week two other bloggers and I had the opportunity to interview ExxonMobil’s VP of Public Affairs, Mr. Kenneth P. Cohen, on the subject of climate change and a range of other energy topics. Mr. Cohen is responsible for communications and government relations, and he heads ExxonMobil’s political action committee and its foundation. The call, which took place on Wednesday, was arranged by one of the company’s PR agencies; the other participants were Carter Wood from the National Association of Manufacturers and Tim Haab from the Environmental Economics blog. I found the experience very interesting, not just for the relative novelty of being treated as a real journalist, but for what the content and setting of the conversation indicated about the changing attitude of mainstream American business towards climate change.

ExxonMobil (NYSE: XOM) has long been a lightning rod for skepticism about the science of climate change--and for those opposed to that skepticism--at least partly because of the company’s past support for organizations that questioned the growing consensus on climate change as a serious environmental problem. In our call, Mr. Cohen emphasized the company’s desire to define its position on climate change directly, rather than having it defined by others as a result of such relationships. He clarified that other organizations do not speak for ExxonMobil and rejected the notion that being against the provisions of the Kyoto Protocol makes ExxonMobil anti-climate change. He went on to say, “Unfortunately, for some individuals and groups, opposition to the Kyoto Protocol was equated with a failure to take the issue of climate change as a serious matter. We believe climate change is a serious issue and steps should be taken to reduce emissions in effective and meaningful ways.”

Speaking with bloggers—even as non-hostile a group as the three that participated in the call—appears to be just one aspect of a larger re-positioning effort, which includes a recent speech in Boston by Rex Tillerson, the company’s new CEO. While some may speculate about the timing and reasons for such a shift, I’m more interested in what it could mean for the energy industry and for creating a more effective response to the issue, especially in the US. A change in ExxonMobil’s stance on climate change could be an important bellwether for the large number of US corporations that haven’t been ready to follow DuPont, GE and others in urging the government to “take prompt action to establish a coordinated, economy-wide market-driven approach to climate protection.”

Although environmentalists and policy makers tend to focus on the public posture of corporations in such matters, it’s probably more instructive to look at how they are spending their money. ExxonMobil has an impressive track record of investing in large projects that make excellent profits for their shareholders, and it is in this area that we should look for tangible indications of a shift on climate change. I explored two aspects of this with Mr. Cohen, the first relating to how the risks of climate change were factored into capital project reviews. I was somewhat surprised to hear that project proposals within ExxonMobil now incorporate explicit or implicit costs of carbon emissions, but Mr. Cohen reminded me that ExxonMobil already deals with the EU’s cap-and-trade mechanism and other “current and pending environmental controls.” When I inquired how the inclusion of these risks might change Exxon’s portfolio over time, Mr. Cohen’s response reflected Exxon’s consistent view that oil and gas will remain the dominant energy sources for decades to come. He suggested that any portfolio shifts were likelier in the power sector (assuming technology breakthroughs) than in the upstream oil and gas part of Exxon’s business, which must “go where the resource is.”

This goes to the heart of how ExxonMobil apparently sees the business impact of this issue, in terms of future regulatory compliance by its core business, which is “mitigating greenhouse gas emissions through efficiency and best practices,” rather than as a new profit opportunity at this point. That will resonate with many other corporations. When I asked Mr. Cohen whether the company’s lack of alternative energy investments would handicap its effort to reposition itself on climate change, he was very clear. “ExxonMobil doesn’t invest in businesses requiring subsidies. We will invest when they can stand on their own feet.” He emphasized the potential contribution of the company’s technology efforts, such as its partnerships with Toyota and Caterpillar to improve the efficiency of internal combustion engines.

Along with the $225 million Global Climate & Energy Project at Stanford University, which ExxonMobil took the lead in launching, these are serious efforts to address both energy demand and greenhouse gas emissions, but they are in a different category from what BP and Shell are doing, devoting capital and personnel to building new businesses and gaining first-hand knowledge, not only of the technology, but of its interface with customers. In effect, ExxonMobil is foregoing the options some of its competitors are buying and plowing the money into what it does best. That’s a legitimate answer to the classic innovator's dilemma: if you can’t grow the disruptive business inside the big, established, successful business, let someone else do it outside, and then buy in when they've demonstrated its viability. It remains to be seen whether the key leaps in this area will occur within big energy companies or outside entrepreneurs. Is Exxon just sticking to its knitting, in line with its rigorous capital discipline, or is it making a conscious bet on the superiority of an external innovation model for alternative energy?

Although some might have wished for a sea change that would put ExxonMobil at the forefront of business response to climate change, bringing billions of dollars per year of capital to bear on the problem, I doubt their investors will be disappointed to see a more conservative approach. This is clearly a company that believes in markets and the signals they send. They appear to have received the signal that the cost of carbon emitted to the atmosphere won’t be zero in the future, and they are investing in technology to address that. Even if they don’t see the market telling them that the viability of the oil and gas business is in jeopardy from this issue, or that renewable energy and other alternatives are creating profitable new opportunities, it will be very helpful to those companies and policy makers who do see this to have Exxon on-side in articulating the risks of climate change and playing a constructive role in the public debate on the feasibility and cost-effectiveness of the various options available for dealing with it.

I’d like to thank Mr. Cohen for making himself available, and the folks at APCO for arranging it. I anticipate doing more of this sort of thing this year. I’d also encourage you to read Mr. Haab’s postings on last week’s interview, which cover other aspects of the discussion. (I haven’t seen Mr. Wood’s comments yet.)

Integrating China's SPR

Last week the Wall Street Journal reported on a meeting between the head of the International Energy Agency (IEA) and a vice chairman of China's National Development and Reform Commission (NDRC), discussing how the country's new strategic petroleum reserve might be coordinated with those of the developed countries. They also apparently talked about the speculation, figurative and literal, that has surrounded China's strategy for filling its SPR tanks. I hope the conversation included some of the lessons that the IEA's member countries, including the US, have learned about this strategic tool. It would be even better if it were clear that China is not merely replicating an outdated approach from the 1970s, but designing an oil backup mechanism that is truly suited for the realities of the early 21st century.

In this country, since the early 1980s we have seen our SPR grow from its original 250 million barrels to its current level of 689 million, on its way to a targeted 1 billion barrels. During the same period, however, commercial crude oil inventories have declined by 6%. When viewed in terms of days' supply, the latter trend is even more pronounced, falling from an average of 30 days in 1982 to 22 days in 2006. While some of this decrease is probably attributable to changes in inventory strategies relating to accounting rules and supply-chain management, the existence of a large government-held inventory has likely contributed to this trend, even if only by reducing the risk of being caught short in an emergency, and thus relieving companies of the need to hold extra inventory in their own tanks. The experience of previous releases of SPR oil to alleviate market tightness, rather than actual supply disruptions, has further reduced the perceived speculative benefit of holding inventory.

Based on my own observations, I'd offer our Chinese colleagues the following advice on the subject, keeping in mind that their political-economic system is quite different from ours:

• The closer SPR oil is to the refineries that would use it, the more valuable it is. The first line of defense is a refinery's own storage, and as China's refineries expand to meet growing demand, they should be provided with adequate tankage to accommodate inventory beyond that strictly required for operational efficiency.
• An SPR that combines centralized and dispersed storage is less vulnerable to terrorism and natural disasters than one entirely comprised of large central repositories.
• Make sure that accounting systems do not penalize refineries for holding additional inventory. Consider offering incentives for maintaining an onsite strategic reserve, equal to some set number of days' operation.
• When planning the scenarios under which SPR oil might be released, be sure to include disruptions in domestic supply, including major pipeline breakdowns or oilfield disasters. Over the life of an SPR, these are at least as likely as a disruption of imports. That means ensuring that the infrastructure is in place to distribute oil to any facilities vulnerable to this risk.
• Avoid the temptation to influence the market, internally or externally, through reserve releases or altered timing of reserve additions. This will be especially tempting in a country in which the prices of petroleum products do not always reflect world levels. It is one thing to subsidize consumption financially; it is quite another to use emergency stocks for this purpose.
• Consider diversifying China's SPR to include some level of emergency products inventory. Crude oil is useless in an emergency that knocks out a large number of refineries, as the US learned after Hurricanes Katrina and Rita.

All in all, the conversation between Monsieur Mandil and NDRC Vice Chairman Chen is good news. China's economic growth, and the accompanying rapid growth in its oil imports, puts it on the same side of the supplier-consumer relationship as the EU, Japan and the USA. At a time when OPEC is expanding both its membership and its future production potential--based on its dominant reserves position--it is entirely appropriate that the largest factor in recent world demand growth begin to coordinate energy policies with the IEA, and perhaps even join it at some point.

How Low?

Oil is putting on a lively demonstration of what happens when the psychology of a market shifts; the reaction is pretty dramatic. The media are full of stories speculating on how low oil prices can go--and how long it will take sticky retail gasoline prices to catch up--and analysts are poring over data looking for the retrospective tipping point last year. I've been generally bearish for a while, in light of early indications of slowing demand and the prospect that 2007 would see more new producing capacity come on stream than new demand to consume it. That doesn't mean we're headed back to historical averages, however, and it's important to put the factors contributing to the price decline into perspective. We've been here before, but the specific configuration of influences looks rather different.

The last time we saw oil go into a deep slide was in the late 1990s, when the key factors were the sudden collapse of demand in Asia, as a result of an expanding economic crisis, and the to coincidental arrival of a large wave of new capacity that had been developed largely to meet the rapid growth of Asian demand. In effect, producers zigged when they should have zagged, and some grades of oil saw single digit prices before the trend reversed. That's not what's happening here. We've had a long bull market driven by steady demand growth, tight capacity, and political risk, none of which is unraveling all at once. Instead, a gradual easing of all three of these is being exaggerated by an unexpectedly warm Northern Hemisphere winter, drying up heating oil demand.

As an article in today's Wall Street Journal points out, another new factor is the growth in biofuels production, which some see expanding to the point of being able to absorb all of oil's incremental demand growth within a few years. The Journal cites some misleading figures for the degree of displacement involved, however, suggesting that current global biofuel production of 10 billion gallons per year, roughly 650,000 barrels per day, equates to a supply of almost 2 million barrels per day (MBD) of Saudi crude. The problem with this math, which assumes a 1/3 yield of gasoline and diesel in a "topping" refinery, is that it ignores the other 2/3 of the barrel, at least some of which also ends up as gasoline and diesel via the secondary feedstock market that fills up the spare cracking capacity of many refineries. It also ignores the lower energy content of ethanol versus gasoline, as well as the oil input to ethanol production.

By the time you factor these in, that 650,000 bbl/day of biofuel looks more like 1 MBD worth of oil on a gasoline/diesel-equivalent basis, and less than 200,000 bbl/day on its total energy contribution. Much of this was already in place in 2005, further reducing its contribution to the sudden shift of the oil market. Looking ahead, the potential incremental biofuels growth between now and 2011 is roughly the equivalent of between 0.3-1.7 MBD, depending on whether you are looking at energy replacement or motor fuels displacement, not the extra 3 MBD the Journal cites. This is hardly insignificant, and it will certainly affect prices, but it's not going to crater the oil market by itself.

The other thing to watch on the biofuels front is its reaction to changing oil prices. I have little doubt that the expected capacity will be built, largely because it looks cheap at roughly $1 invested per gallon per year of corn ethanol capacity. But with petroleum product prices falling and corn prices rising, I wouldn't expect all those plants to run full, even with the $0.51/gallon tax credit. In effect, as biofuels grow out of the niche market they've occupied until recently, they become more like other hydrocarbon liquids and are subject to similar forces of market self-correction as petroleum products, in spite of their environmental benefits.

If I learned anything from more than a decade as an oil trader, it is the tendency of markets to overshoot, in both directions. We are in for a very interesting ride with oil this year, particularly since none of the risk factors I described (1/2/07) a few weeks ago has disappeared. 2007 could even see both $40/bbl and $70/bbl, depending on how these risks play out.

Floor Price, Round Two

A year ago, the Wall Street Journal carried an op-ed proposing that the US set a floor price for oil by means of a floating oil import tariff, as a way to reduce our reliance on the Middle East and to provide greater certainty for investors in alternative energy projects. My response to that idea later appeared in the letters section of the Journal. A week ago, in a column (Times Select required) addressing President Bush’s Iraq “surge” strategy, Tom Friedman of the New York Times proposed essentially the same concept, differing mainly in the price level involved, $45/barrel instead of $35. With all due respect to Mr. Friedman, whom I genuinely admire, this idea is just as ill-advised as it was a year ago, and in the meantime I’ve thought of a few more reasons why.

In addition to its inherent drawback of reducing the competitiveness of US manufacturers that sell into the global market, implementing such a tariff would be trickier than it might appear. If Mr. Friedman is talking about a $45 floor price for the West Texas Intermediate Crude (WTI) traded on the New York Mercantile Exchange, then what should be the floor prices of the various types of oil we actually import? Policy makers would have essentially three choices: they could impose the same floor price on all imported crude oil, set the tariff based on the price of WTI and apply it equally to all imported crudes, or vary it based on the quality of each individual crude type. Each option poses serious problems.

The first option just isn’t viable; setting an identical floor price for heavy sour crude from Venezuela and for light sweet crude from Nigeria would eliminate the incentive refiners require to invest in the costly hardware necessary to process the former. But applying a uniform tariff based on the difference of the legislated floor price and the price of domestic WTI wouldn’t work either, because once the tariff was triggered, the price of WTI would no longer be set by the market, but by the price of the imports that contribute to its supply, which in turn would be set by the tariff. This circular logic could only be avoided by basing the tariff on some foreign crude market. The only one sufficiently transparent and liquid to serve this purpose is the Brent contract on the ICE exchange in London. Thus if Brent were trading for $40/bbl, the tariff on all crude imported into the US would be set at $5/bbl, and WTI would be at $45. That could work, but applying that same $5 tariff to low quality heavy crudes would inflate their cost by a higher percentage and distort the crude selection process for refiners.

The ideal choice would be a tariff mechanism that explicitly recognized the inherent differences in quality, product yield, and market value of different crude oils, and preferably did so dynamically, rather than statically. Even something as simple as the sort of “gravity and sulfur bank” system used by domestic pipeline systems would be better than a flat tariff across all crude types. However, it would still be a poor substitute for the way a free market sets these differentials, because the value of each grade of crude oil is different for each refinery in which it might be run, and this shifts minute-by-minute as the value of the products that can be made from the oil changes. It’s just not the sort of thing that lends itself to a simple calculation and a scale that can be set once and for all, or even once a year. I’m not saying any of this is insurmountable, given our modern infotech capabilities, but it would introduce unwelcome complications into a process, the smooth functioning of which we all implicitly depend on when we pull up to the gas pump. It would also create a heck of an incentive for traders to try to outfox the system.

And all of this ignores the larger question of how to go about choosing a suitable price level at which to establish a floor. Should it change, year by year into the future, and should the trend go up or down? Up would make sense if we wanted to accelerate the process of weaning the US off of imported oil, but down has its own logic, as alternative energy technologies gradually matured and required less protection. And let’s be clear, protectionism is precisely what we’re talking about here.

What does $45/bbl mean at the gas pump? Well, depending on your state’s gasoline taxes and the level of refining margins at any point in time, this could translate into anywhere from $1.70 to $2.15 per gallon for unleaded regular. Given the national sense of relief that was apparent when prices fell back from $3.00/gallon to $2.25 this fall, it’s unlikely that a $45/bbl oil price floor would do much to promote conservation, though it might indeed foster more alternative energy by assuring investors that the projects they are supporting won’t be exposed to the risk of a future oil price collapse to the old norm of $25/bbl or less. (Domestic oil producers wouldn’t see much incentive for increasing their production, because any windfall they accrued from this measure would likely be taxed away, as demonstrated by the current royalty waiver flap.)

In contrast to a wide range of other options, including the much more politically challenging one of raising the federal tax on gasoline and diesel fuel, the floor price oil tariff is a deceptively simple-sounding, but actually quite complex bad idea. As a form of price controls, it is fraught with unintended consequences, many of which couldn’t be predicted in advance-- though I will suggest that increasing US emissions of greenhouse gases is a likely outcome. While I share Mr. Friedman’s concern that falling oil prices could slow down the development of necessary alternatives to oil, this is just the wrong way to support them.

Bad Trees

Ever since a friend sent me a link to this BBC story reporting on the potential adverse consequences of planting trees to mitigate climate change, I've been in a funk. Not only is tree-planting one of the simplest carbon-sequestration strategies available, but it is one in which I was personally involved, when Texaco was first investigating CO2 management. Now it appears that reforestation in the temperate zone could actually make things worse, by trapping additional heat near the earth's surface. If true, this is another example of just how complex the planet's climate is, and how intricately-related its various feedback mechanisms. A month after reading the article, however, the logic of this model-based finding seems less compelling, and its reconciliation with the historical climate record more problematic. Although one of the co-authors of the study published an unequivocal op-ed on this subject in yesterday's New York Times, I still think we need to know a bit more, before we abandon reforestation as a CO2 abatement strategy.

The whole problem starts with how much of the energy that we receive from the sun is retained in the land, oceans and atmosphere, and how much is reflected back into space. De-forestation in the tropics is bad for multiple reasons. It reduces the amount of CO2 being incorporated into plant growth and releases large quantities of stored CO2 into the air, when the logged trees are burned, or when they decay on the ground. It can also lead to reduced cloud cover. Both of these effects increase the earth's retention of solar radiation, apparently by more than the shift in vegetation from forest to food crops or cattle forage enhances the Earth's reflectivity, or albedo. So re-planting the tropical forests, or at least preserving current forests, seems unambiguously beneficial.

But according to research at the Carnegie Institution and the Lawrence Livermore National Laboratory, this is not the case when the forests being re-grown are in the middle and high latitudes, the zones in which the US, Canada and much of Europe fall. There, the addition of warmth-absorbing dark tree cover, especially where highly-reflective snow would otherwise cover the ground for much of the winter, could neutralize or even overwhelm the carbon sequestration benefit. Bottom-line: planting trees in the US to soak up CO2 might do more harm than good.

There are a lot of US businesses, including some very large utilities, that must be very disappointed to hear that, because before this study, tree-planting looked like a cheap and effective means of offsetting industrial emissions that would otherwise be very expensive to reduce directly. At the same time, these findings will be welcomed by those environmentalists who believe that tree-planting and other means of offsetting emissions are simply no substitute for cutting emissions directly, which by extension entails large reductions in humanity's energy consumption and general footprint on the earth. The lead researcher of the study in question appears to share that view. While I'm not suggesting that the findings of the Carnegie/LLNL study were skewed by this, it would be naive to think that climate change skeptics have a monopoly on influence from non-scientific factors.

Even though the general trend of global climate change now appears clear, with supporting evidence accumulating practically every day, it does not mean we must accept every new finding in this area without question, any more than we do in the areas of health or cosmology. Before I buy into the conclusion that reforestation outside the tropics is of no use in combating climate change, I would like to see the model in question validated against the historical and paleo-climate data. If the effect of northern-latitude reforestation is large enough to contribute a couple of degrees of warming by the end of the century, as cited by the BBC, then its influence ought to be discernible in the record of previous eras in which North America was much more heavily forested than today, but the northern hemisphere climate was much cooler, as in the Little Ice Age of the 16th-19th centuries, when the Thames routinely froze over.

Unless the model can account for the forestation effect in earlier periods that lacked today's man-made climate influences, it would be premature to base policy decisions on its future predictions about the efficacy of planting trees now. Until then, I'm at least in complete agreement with Dr. Caldeira that no one should use these findings as an excuse to cut down even more trees.

On-Target Advice

Even though I've moved away from the greater New York area, I still try to keep up with the New York Times, not because it's a better paper than the Wall Street Journal or the Washington Post--it's not--but because it's still influential with American elites. While the quality of the Times' reporting on energy has improved dramatically over the last several years, its editorial record in this area generally hasn't, and I've devoted a fair amount of space on this blog to refuting various assertions and recommendations they've made. Now and again, though, they get it right, and today's editorial on "Energy Time" is a fine example, with three practical "guideposts" for Congress, as it considers new energy legislation. All three points constitute sound advice, but each could have been made even more helpful, if the Times were more willing to challenge their own preconceptions and biases about energy.

The first piece of advice to Congress is to keep energy legislation simpler, implying the inclusion of less pork and fewer pet projects. They hold up pending legislation from Senators Reid and Bingaman on reducing oil imports and greenhouse gas emissions as a positive example. But they should have also reminded the Congress that legislation alone won't solve these problems, without also convincing the American people of the urgency involved, and of the personal responsibility each of us bears for our energy use and emissions. Technology investments will take years to bear fruit; behavioral changes can begin now.

The second suggestion deals with the avoidance of partisanship, while paradoxically endorsing the new leadership's push to eliminate tax benefits for the oil companies that must surely play a major role in any serious effort to improve our energy security. A truly bi-partisan approach would harness both the Democrats' clear understanding of the need to reduce demand growth and the Republicans' long-standing focus on supply. In this regard, bi-partisan = supply + demand.

The editor's final admonition is a reminder that getting serious about energy will cost a great deal of money, using coal-to-liquids as an example. He should have added that most of that money will have to come from investors, rather than from government, because even without our trade and fiscal deficits, the government has neither the wherewithal nor the mandate to build and own large-scale energy infrastructure. That means investors must see the prospect of attractive returns, relative to their alternatives. The government's role here is in providing national energy objectives, a consistent tax and regulatory framework, wise incentives, seed capital, and long-range R&D--things the private sector either can't or won't do--and then unleashing the enormous power of American capitalism to deliver.

I give the New York Times a lot of credit for understanding the importance of energy, and for seeing the relationship between solving our energy problems and dealing with climate change, even if they don't always get the details right. They've started an energy blog on their Times Select subscriber service, and it's telling that the blogger they hired is a journalist who covers energy, rather than someone with deep energy experience, either in industry or government. The missing ingredient at the Times is the ability not just to report on the industry, but to see the world from the industry's perspective, without necessarily having to agree with it.

The Ripple Effect

The newly-elected center-right President of Mexico is facing a crisis over the price of corn. Tortillas are a staple of the Mexican diet, especially for the poor, and the price of corn tortillas in Mexico is soaring. Politicians blame speculators, but when you assess the factors driving the North American corn market in which such speculation is occurring, the largest seems to be the growing US demand for corn-based ethanol. Several months ago I wrote a posting describing the growing food/fuel arbitrage being created by our increasing reliance on biofuels. I have to admit I was thinking mostly of the impact on US consumers, through increases in the cost of anything that had corn as an ingredient, whether in the form of animal feed or high-fructose corn syrup. When I considered the developing world, it was in terms of the opportunities the biofuel market might create. It didn't occur to me that Americans weren't the most vulnerable consumers in this equation.

While the corn varieties used for ethanol and tortillas are different--and becoming more different all the time, as biotech devises new corn varieties that are genetically optimized for ethanol production--they meet in the farmer's decision of which variety to plant: corn for people or corn for cars. The near-to-medium-term challenge for biofuels is not whether there's enough cropland for ethanol and biodiesel crops to replace all the oil we're importing, but the degree to which inflation in consumers' food budgets might offset the economic and geopolitical benefits of increased energy security. In the US, food accounts for about 10% of disposable income, down from 15% in the 1960s and 12% in the 1980s. That compares to about 3.5% of disposable income spent for gasoline, at the current price of $2.31/gallon. This 3:1 ratio favoring food is doubtless much higher in countries like Mexico.

In many respects, ethanol has constituted this country's primary alternative energy strategy for the last twenty-five years. It currently contributes roughly 3% to total gasoline volumes across the country. But while this has had a modest impact on energy prices, it is enough to drive up corn prices across an entire continent, and that effect is only getting started. Like all agricultural subsidies, the ethanol subsidy distorts markets at home and abroad, and that impact is now being felt disproportionately in poor communities. While that ethical dimension probably isn't sufficient to deter further expansion of ethanol, it ought to provide an extra incentive to accelerate the development of biofuels that can be produced from plants that don't compete for cropland, and from crop waste. In the meantime, we can add Mexican peasants to the list of those affected by our energy policies.

Oil from Coal?

Energy independence is becoming the biggest energy issue in American politics. If it hasn't eclipsed climate change in importance, that's only because many see the two issues as strongly connected. Over the last three years, I have written a variety of postings pointing out just how big and challenging a goal energy independence is--not to take the wind out of the sails of those pushing for it, but to promote realistic expectations about how long it would take to achieve, even if we started right away. My analysis has typically focused on the complexities of replacing oil with biofuels, or on shifting our power generation to wind and solar power, to produce or displace the energy to fuel cars. Along the way, I've neglected another obvious choice for closing the oil import gap: converting coal into synthetic oil.

The recent tributes to President Ford brought back vivid memories of the energy crisis of the 1970s. How many times since then have we heard that America is the "Saudi Arabia of coal?" It's true enough. We produce 18% of the world's coal, and only China produces more (twice as much, in fact.) Our coal reserves are sufficient to sustain these production levels for another 236 years, based on current rates of recovery. In addition to this vast raw material, we have the technology to turn coal into synthetic gasoline and diesel fuel. It's not a cheap process, but it is proven.

Coal can be gasified to produce a synthesis gas (carbon monoxide and hydrogen,) which is reacted using a catalyst to create liquid hydrocarbons. The Germans used a version of this technology in World War II, as has South Africa since the Apartheid era. Other counties are working on it today. The biggest hurdle to doing that here was always economic, rather than technical; oil at its typical price of $25/barrel yielded gasoline at about $1.25/gallon at the pump, including tax, and coal-to-liquids (CTL) simply couldn't compete. At $50-60/barrel, though, cost isn't nearly as big an impediment, and were it not for our concern about climate change, or our growing appetite for coal in the power generation sector, because of the high price of natural gas, CTL would look like a slam-dunk energy independence pathway.

In fact, it still could be, if we had a cheap way to sequester all the CO2 produced as a byproduct of turning coal into liquid fuels. Synthetic gasoline or diesel produced from coal releases no more greenhouse gas when combusted than fuels derived from petroleum, and there's a pretty solid argument that advanced diesel engines running on ultra-clean CTL diesel offer nearly as big an efficiency improvement (and thus greenhouse gas reduction) as gasoline hybrids, for a lower up-front cost premium over conventional cars. Throw plug-in hybrids into the mix, and coal can contribute in two ways: providing the liquid fuel for the onboard engine and fueling the power generation behind the plug.

To many Americans that scenario might sound a lot more realistic and achievable than trying to ramp up biofuels and other renewable energy sources from their current very small base (3% of total US energy use.) The problem is that our current oil shortfall is roughly 13 million barrels per day, including imported petroleum products. Coincidentally, that figure is just a shade larger, on a BTU-equivalent basis, than the entire US output of coal. In other words, even if the CTL conversion were 100% efficient, which it isn't, this approach to energy independence would require us to double our current production of coal, with all of the environmental, land-use, and human consequences that would entail. In any case, it would take many years, and the price tag for the capital equipment involved would be at least a half Trillion dollars, just for the CTL side, ignoring the additional mining and transportation infrastructure required.

Now, I'm not suggesting that CTL or any other technology must be capable of replacing every drop of imported petroleum, before it could be considered a good candidate for improving our energy security. But if the only other energy source already operating at a similar scale to oil or natural gas--accounting for 23% of US energy consumption and half our net electricity generation--couldn't realistically fill the entire US oil supply gap anytime soon, then neither could any combination of renewables or other sources. If we're serious about reducing our reliance on imported oil, then not only should we invest aggressively in technologies like CTL, but we must also tackle our inefficiency and shore up our flagging domestic oil production. That means drilling in places we'd rather not drill, because they are scenic or sensitive. Unless we work on all three fronts simultaneously, the odds are that ten years from now we'll find ourselves at least as reliant on the Middle East as we are today, and wondering why energy independence remains as elusive as it was when Gerald Ford was President.

Carousel of Progress?

I'm always intrigued by what car shows tell us about the future of motoring and transportation energy. Setting aside the flashy concept cars that attract the true car buffs, this year's Detroit Auto Show, currently underway in the Motor City (what will they call it when Detroit's share of the US market falls below 50%?) offers some interesting glimpses of the cars of tomorrow. GM scored a major PR coup with its Chevrolet Volt, a sleek prototype plug-in hybrid car. But no, it's not scheduled for production, yet, and thus doesn't fill the gap I identified in last Friday's posting. Other carmakers are demonstrating new technology, as well, but much of it seems aimed at a more seamlessly integrating cars into the information age, rather than making them more efficient and less polluting. And from all indications the weight and horsepower "arms race" of recent years continues unabated.

When brands like Lexus and Audi start touting hybrids, the technology isn't just about fuel efficiency any more. The Audi Q7 hybrid SUV pairs a gasoline direct-injection V8 engine and a battery-electric motor to push its 5300 lb. curb weight from 0-60 miles per hour in under 7 seconds, but still delivers less than 20 mpg in the bargain. And at the same time that Toyota was showing off its FT-HS hybrid sports car concept, it was also rolling out its distinctly non-hybrid 2007 Tundra CrewMax truck (14-20 mpg, depending on equipment,) which is designed to compete with Detroit's biggest pickups. It expects to sell 200,000 of these per year, about twice the number of Priuses it sold last year.

In order to reduce our oil imports and our greenhouse gas emissions by enough to matter in geopolitical or climate change terms, one necessary precursor will be a mainstream car show in which a majority of the vehicles displayed are powered by hybrids, advanced diesels, or fuel cells--and not merely as concepts or prototypes, but representing the next year's production models. Detroit 2007 falls well short of meeting that criterion, but it's a start. Probably the best news there from an energy perspective is the growing number and popularity of "crossover" models, which are car-based SUV/station wagon surrogates. By attracting enough buyers to make a serious dent in the sales of big SUVs, the resulting 3-5 mpg per vehicle fuel economy improvement could have a bigger impact on our overall energy consumption than all the hybrids and other advanced vehicles--or ultra-minis like the long-awaited Smart Fortwo--at least over the next five years.

Fuel Decarbonization

Once again, the states are taking the initiative in shaping an aggressive climate change policy, and California leads the way. Governor Schwarzenegger's latest announcement in this area is a proposal to force oil refiners to reduce--either directly or virtually--the carbon content of the fuels they produce, thus attacking the problem of greenhouse gas emissions at a major source. This approach, which echoes the recent breakdown of auto/oil cooperation on emissions reduction in Europe, puts more of the burden of reducing CO2 from transportation on fuel suppliers, rather than carmakers. This has one very important benefit and several serious drawbacks, though some of the latter may be mitigated by the manner in which California's Air Resources Board (CARB) chooses to implement this change.

The Governor's plan, described in his annual State of the State speech yesterday, would require refiners and blenders to reduce the carbon content of gasoline through greater use of ethanol or the production of other alternative fuels, such as hydrogen. It would go well beyond existing federal and state ethanol mandates by scrutinizing the "well-to-wheels" carbon content of the alternatives used to reduce or offset petroleum carbon. This could create a significant advantage for cellulosic ethanol over corn-based ethanol in the longer term, and for hydrogen from renewable, rather than fossil fuel sources. It is less clear how this proposal will mesh with the state's recently enacted carbon cap-and-trade system, which targets reducing California's greenhouse gas emissions by 25% by 2020.

Although many oil and gas companies have begun to address the greenhouse gas (GHG) emissions resulting from their own activities, through measures ranging from energy efficiency projects to large-scale tree planting, most have assumed that the responsibility for mitigating the carbon content of the fuels they sell would rest with automakers or consumers. I have always doubted that assumption, because capital-intensive industries such as oil tend to have less political clout than labor-intensive ones such as car manufacturing, and because consumer interests often trump business interests. The Governator and his advisors have read the tea leaves, and they see the benefits of putting more of this burden on the oil industry.

The clear advantage of this approach is that, once implemented, it will reduce the GHG emissions of every car on the road in California, without waiting for technologies such as hybridization to become mass-market, and for the existing vehicle fleet to turn over. In other words, this step would make at least a modest dent in automotive CO2 emissions within a few years, rather than requiring a generation before the full effect was felt. For the growing number of people who have become convinced that climate change is a serious problem, this is a compelling argument. It has the added benefit of simultaneously addressing growing concerns about US energy security and our vulnerability to unreliable oil suppliers.

The disadvantages of this measure start with the underlying premise that GHG emissions are best addressed at the source. This is a holdover from decades of dealing with pollutants such as carbon monoxide and oxides of sulfur and nitrogen, which could only be dealt with in this way, and which have largely been removed from automobile exhaust through fuel reformulation and improved catalytic converters and engine controls. GHG emissions are fundamentally different, and all CO2 emissions are equivalent, as are all CO2 reductions, anywhere on the planet. This creates the opportunity to make the cheapest cuts first, globally, achieving the greatest impact for the least cost. Refinery-based fuel limits distort that principle and reduce the benefits of an economy-wide cap-and-trade system. If refiners and blenders are at least allowed to fold the new 10% decarbonization standard into their emissions caps, and then choose the optimum mix of direct cuts and trading to achieve the required reduction, then this shortcoming would be partially negated.

The bigger problem is timing. Depending on how long a period over which this new rule is phased in, it could significantly distort the markets for ethanol and for gasoline. Californians already pay the highest gasoline prices in the nation, because California's reformulated fuel standards are already the most stringent in the nation. If the 10% carbon cut comes in too rapidly, it could cause a larger dislocation than the recent phaseout of MTBE and require more ethanol than the state can produce, putting California in competition with other regions that are aggressively promoting alcohol fuels and likely requiring foreign ethanol imports, which incur a high tariff. Every time California has ratcheted up its gasoline standards ahead of the rest of the country, California consumers have paid a high premium at the pump. It would be interesting to assess how much of the desired emissions benefit could be achieved by simply raising the state gasoline tax, without mandating a further change in fuel formulation.

California's initiative on greenhouse gas reduction can't be viewed in isolation, because of the size, influence and economic importance of the Golden State. Six years of federal caution on this issue have created a growing gap between the public's perception of the climate change problem and of the appropriateness of the government's response. California and like-minded states are filling that gap with interesting but potentially conflicting measures. Sooner or later, the federal government must step into this arena to harmonize these actions and create a consistent national approach to this truly global problem, or else risk losing control of a key sector of interstate commerce and economic leverage.

Step by Step

The Bolivarian Revolution of Hugo Chavez has taken a few more big steps in its transformation of Venezuela from a democracy into a sort of Cuba with oil. President Chavez yesterday announced the nationalization of the country's telecommunications and utility industries, and reiterated his earlier decision that the foreign oil projects in the Orinoco Belt should become state property. At the same time, he apparently asked for the authority to make the country's central bank subject to his orders, and to issue laws by decree. These are clear signals of Sr. Chavez's intention to create a fully autocratic, cult-of-personality style socialist dictatorship, in a country that supplies 11% of the crude oil that the US imports. This constitutes yet another warning that we should prepare for the eventuality of a complete breakdown in ties between our two countries.

Ever since the 2002 coup that temporarily unseated him, President Chavez has become increasingly anti-American and anti-capitalist, and more unpredictable. His recent re-election has emboldened him to consolidate power and continue re-shaping the Venezuelan economy to conform with his version of socialism. In effect, the Venezuelan people voted for this, and it would be a matter merely of interest, rather than concern to us, if it didn't infringe on the property rights of US corporations--as it does in the current nationalizations--or threaten our energy security. Since we can apply little meaningful pressure on Sr. Chavez without harming our own interests further, the most prudent step we can take is to ensure that we have plans in place to minimize the impact of a disruption of Venezuelan oil supplies that could happen at any time, on a whim.

Aside from the volume involved, currently running at about 1.4 million barrels per day, there are two other aspects of Venezuelan oil that would make its replacement in extremis challenging. Because of the country's proximity to the US Gulf Coast, Venezuelan crude oil tankers have a short voyage, compared with those coming from the Persian Gulf. Any cutoff of supply would entail a time lag of more than a month between the time the last tanker from Maracaibo docked here, and when the first replacement tanker from the Middle East could arrive. That means that the Strategic Petroleum Reserve (SPR) should be primed to begin supplying emergency oil on short notice, to minimize the shock to the market. Affected companies should have exchange agreements with the SPR in place and up to date, along with any inter-company exchanges necessary to parlay the SPR oil into more suitable grades.

The latter point is important, because most Venezuelan crude oil is heavy and high in sulfur, normally selling at a substantial discount to West Texas Intermediate. Refineries optimized for a diet of this crude cannot easily switch to more expensive light, sweet crudes without serious penalties of cost and product yield. Companies with supply agreements with Venezuela should begin immediately to shop for suitable replacement crudes, and begin to reduce their reliance on Venezuela. The net result of such a switch would likely increase our dependence on the Middle East, and on Saudi Arabia in particular--as the likeliest supplier of similar oil. While that might create additional vulnerabilities in the long run, it is preferable to continuing to rely on such an unpredictable supplier.

Although he certainly has his supporters at home and abroad, Sr. Chavez is doing incalculable harm to his country's economy. The foreign investors he is alienating have poured substantial sums into his country, and much of this occurred before high oil prices provided their current bonanza. The Orinoco projects, in particular, constituted the main bulwark against a collapse of Venezuelan oil production after the disastrous 2003 oil strike, and they are a major source of the funds Sr. Chavez taps for his social and foreign aid programs. Nationalization will cut off further investment, by increasing the country's political risk to unacceptable levels, and accelerate the decline of Venezuelan oil production, which is not being sustained by appropriate levels of reinvestment. Losing his steady outlet in the US would compound these problems by reducing net revenues on Venezuela's exports to alternate markets in Asia. As undesirable as all this sounds, for both Venezuela and the United States, it is beginning to look like an unavoidable outgrowth of President Chavez's strident nationalism.

Update 1/11/07: Now the other shoe drops; Chavez will abolish the limit on his term of office to become the archetypal Latin American President-for-Life.

Loading the Dice

A lengthy comment posted by a reader over the weekend reminded me of the extreme range of our energy policy options. While growing concerns about energy security and climate change are generating strong interest in energy-saving technology, higher CAFE standards, and government incentives to promote alternative fuels, some people believe that our problems are so severe that only mandates will answer. Businesses and consumers must be forced to switch to renewable energy sources and employ the latest efficiency measures, or suffer penalties. In light of our modest response to the last three years of high energy prices, I can appreciate the frustration that gives rise to such notions. However, in the absence of World War II-style consensus and resolve, this sort of approach is unthinkable. Nor would it be desirable, because of the gross inefficiencies that central planning invariably causes. The challenge for the administration and the new Congress is to find an effective approach somewhere between the poles of laissez-faire reliance on the market and command-and-control mandates, to accelerate the decarbonization of energy and the decoupling of energy consumption and economic growth.

This is a bitter pill for those, like me, with a strong market orientation. When it comes to rationing a shortage of supply or choosing which new technology should be adopted, the market has a much better track record than government intervention. But the market alone isn't going to provide the clear, consistent signals we need to reduce our dependence on imported oil, and on fossil fuels in general, in time to avert an economic or climatic disaster down the road. The lead times are too long, and the market too fickle. Anyone doubting the latter has only to look at the behavior of the long end of the oil futures market last year.

During 2006 the futures price of West Texas Intermediate crude for prompt delivery ranged from a low of $56/barrel to a high of $77. That was an entirely understandable reflection of current fundamentals and risks. But during that same period, the price for delivery in December 2012 bounced around from under $60 to over $70, closing at $62 last week. This behavior probably had more to do with trading strategies for inter-period price differentials than with any underlying change in supply and demand or risk. Companies planning alternative energy projects that rely on oil prices being over $60 in four or five years must be getting a little nervous. Are we on the verge of another catastrophic oil price decline, such as we saw in the mid-1980s or late 1990s? Or is this just the short-term over-reaction of a market driven by speculation? In any case, the "true" future oil price hasn't changed; what has changed is the market's view of it, and those are not the same things at all.

If the country can agree that we have two big energy-related problems, the solutions to which require a reduction in our national energy intensity, especially for oil, and that the market alone won't get us there, then we need an approach that works with the market, amplifying its weak signals and providing alternative energy investors with greater confidence in their outcomes than a volatile, unpredictable commodity market can. We have a broad menu of choices available to do just that, ranging from carbon cap-and-trade, carbon taxes, investment tax credits for R&D and infrastructure construction, consumer tax credits for efficient cars, appliances or light bulbs, increased gasoline taxes, electricity taxes, and a host of other ideas that are circulating around Washington.

As intrusive as many of these proposals may seem to market purists, they are still a far cry from the kind of mandates my reader suggested. But those who can't bring themselves to consider any of the policy tools listed above should understand clearly that inaction--total reliance on the market to tell us when and whether to change--stands a good chance of leading us into a world in which the time for working with the market will have passed, and only draconian measures will be effective--or popular.

The Race Is Far From Over

As I was catching up on the backlog of energy-related articles that accumulated over the holidays, I noticed an interesting trend. Although there are still many possible ways that we can solve the problem of providing clean and affordable energy for transportation, a growing number of experts and pundits seems to be zeroing in on the plug-in hybrid car as our best option, despite the fact that it has yet to appear in a production model for consumers. Although I remain enthusiastic about this technology's potential, we need to remember that that's all it is today: potential. Anyone suggesting that we should cease funding research into hydrogen fuel cells or any other option, based on the promise of the plug-in hybrid, is making a premature judgment that can't be validated by modeling and prototypes, but only by head-to-head competition in the marketplace.

As frustrated as many of us get with the status quo for transportation in general and cars in particular, we are blessed with a profusion of alternatives for the future, including advanced internal combustion engines, hybrids, and plug-in hybrids running variously on gasoline, diesel, hydrogen, or biofuels; fuel cell vehicles using stored hydrogen or hydrogen produced onboard from other fuels; and advanced electric vehicles with no onboard energy source other than batteries. Each of these options faces an array of obstacles on the way to attaining the scale necessary to make a difference in overall greenhouse gas emissions, oil imports, or any other criteria. These obstacles fall into three basic categories: changes to the vehicle that increase its complexity and cost, changes to the energy distribution network requiring either modifications or parallel infrastructure, and changes to underlying energy production sources (e.g., oil refineries, power plants, etc.) An option involving only one or two of these areas will have a faster, easier pathway, in general, than one affecting all three.

Compare the plug-in hybrid car to the fuel cell car in this regard. Both entail expensive and complex changes to the basic automobile, though at this point the hybrid looks cheaper to implement. While the fuel cell requires an entirely new distribution network for hydrogen, and major plant and equipment to produce hydrogen on an industrial scale, the plug-in hybrid can piggyback on existing electrical distribution infrastructure, with only modest modifications--ignoring the much trickier vehicle-to-grid, or V2G, version. But as I pointed out on Monday, mass adoption of this technology will require either a large expansion of the fuel supply for surplus off-peak electrical generating capacity--natural gas--or the construction of enormous new capacity based on renewable or nuclear power, or coal-fired capacity with carbon sequestration. This is a tall order, beating the fuel cell on complexity, but not necessarily on scale.

In the meantime, simpler technologies such as conventional hybrids will be moving down their cost curves and gaining market share and momentum. In the process, they will capture the most valuable increment of fuel efficiency, going from 20 mpg to 40 mpg. That will make it harder for either plug-in hybrids or fuel cell cars to compete, once they're ready for the mass market, because going from 40 mpg to 100 mpg is only worth a few hundred dollars a year to the average motorist, while the first 20 mpg improvement is worth over $1000, at current fuel prices.

It's tempting to view this technology competition as a NASCAR or Indy-style car race, in which all the cars are on the same track, heading for the same finish line. A better analogy, though, might be a steeplechase with each horse on a unique course, with different hurdles and distances. Like horses, these technologies also interact with each other in complex ways. For example, improved batteries that make plug-in hybrids more practical also lower the hurdle for fuel cells, by allowing developers to reduce the size of the costly fuel cell stack. While it may indeed prove easier to sell 100 million plug-in hybrid vehicles than 100 million fuel cell cars--and that's the scale we're really talking about--it's not clear that we know that, yet. Nor can we say whether either of these options can actually beat the European-style diesels or conventional hybrids that have a substantial head start on them. This race still has a few more furlongs to run, before we can declare a winner.

Redirecting the Incentives

As the front page of today's Washington Post reminds us, one of the top priorities of the new Democratic majority in Congress will be the realignment of federal energy incentives, shifting them away from the oil and gas industry and toward alternative energy. On the face of it, this action aligns nicely with the need to address growing concerns about climate change and US energy security. Renewables are mostly home-grown, and they generally reduce emissions of greenhouse gases, relative to conventional fuels. Furthermore, many alternative energy technologies are at stages of development that still require government incentives to be competitive, while the oil and gas industry is reaping record profits, thanks to sustained high oil prices. Closing the royalty loophole and reversing a manufacturing tax break for oil companies makes eminent sense, viewed from the current vantage point. However, it ignores both the context that gave rise to the waiver, and the relative medium-term contribution of these energy sources to energy security.

The royalty waiver in question relates to contracts signed with oil companies in 1998-99. Instead of phasing out the waiver of royalty payments, when oil prices rise above some threshold, these contracts waived them altogether. The Congressional leadership estimates lost revenue at $9-11 billion over time. But with current oil prices still over $55/barrel, it's easy to forget that the average price of West Texas Intermediate crude oil in 1998 was only $14.40/barrel, and the average for the two years was $16.85. Price forecasts at the time were consistently low, with small probabilities assigned to any scenarios above the $20-25/barrel historical price band--which itself seemed quite a stretch. The risked contribution of any royalty-free prices above $30 to the economics of oil projects that were in the planning stages in the late 1990s would have been small, but still important in approving expensive new deep-water drilling platforms at a time when the industry's future seemed in doubt. The projects that were approved in that period were thus predicated in some small but crucial way on the royalty relief that is so controversial today. Many of them have come on stream in the last couple of years, providing a much-needed boost in domestic production. I don't know how many of these platforms would have been deferred or canceled without full royalty relief, but it's not zero.

The other consideration here is the future value of the lost royalties. If the estimates cited above are based on the assumption that prices will remain near current levels, then they could prove as disappointing as the estimates of future federal budget surpluses made during the height of the Dot-Com Boom. In order to believe that oil prices will not revert to levels closer to their long-term historical range sometime during the next five years, you have to be convinced that there will be no economic slowdown in the US or Asia within that timeframe, that most new production projects will be delayed or disrupted by geopolitical factors, or that global oil production is very close to a Hubbert Peak--if not already past it. From my own experience of 27 years in this industry, having repeatedly seen prices spike when least expected, or dive when the conventional wisdom was certain they would remain high forever, that's a shaky bet.

On balance then, we need to weigh the benefit of some uncertain number of billions of dollars in extra revenue from revising the terms of the contracts in question, against the risk of undermining confidence in the industry that still accounts for 46% of our domestic energy production. There's no question that transferring these incentives to alternative energy efforts will spur significant new development in wind, solar and biofuels. But if repealing the lower tax rate and closing the royalty loophole make US oil and gas projects less attractive, then our imports of these commodities will increase further. Even at the current high growth rates for renewable energy sources, their low base of 3% of total US energy is too small from which to compensate for a higher decline rate in domestic oil and gas production. The medium-term result of this exchange would be a net reduction in energy security.

Ultimately, if these measures are enacted, the industry will have contributed significantly to their justification. Perhaps because the big oil companies were burned by poor returns on investments made prior to the late 1990s price collapse--when everything seemed rosy, until suddenly it wasn't--they were slow to boost reinvestment when prices began to climb in 2003. They have returned as much or more money to shareholders via stock buybacks and dividends as they plowed back into the business. That may have been smart economics, laying the groundwork for solid profits, but it has also set up a populist backlash that could go well beyond the modest measures under consideration this week. As a result, the only ones left smiling will be developers of alternative energy, who are about to get their turn at the federal spigot.

Balance of Risks

The year ahead looks every bit as unpredictable for energy markets as the year just ended. The three-year old bull market for oil has paused in an unstable equilibrium, waiting either to be driven higher by a new string of bad news or lower by weakening demand or new production. At the same time, alternative energy is gathering momentum and could begin having a modest effect on the price we pay at the gasoline pump. As always, oil prices will be set by the complex interaction of supply and demand fundamentals, geopolitical risks, and market psychology. Predicting the outcome is a crapshoot, no matter how sophisticated one's models. Here are some of the key inputs to watch in the months ahead:

• West Africa rivals the Middle East in supplying high-quality oil to the countries of the Atlantic Basin. Angola's admission to OPEC and the risk of widening unrest in Nigeria could choke off the growth of this valuable contributor to supply diversification, at a time when other key suppliers are also looking less reliable.
• Iraq and Iran together account for roughly 10% of the world's oil exports. The US occupation of the former is approaching a strategic and political crisis point, and we are on a collision course with the latter over its nuclear program. The odds of a significant disruption in supply from this region look about even with those of going another year without one.
• At its present rate of growth, the US ethanol industry will add the gasoline equivalent of a new "grassroots" oil refinery every year for the next several years. When the supply of ethanol exceeds the needs of mandated fuel oxygenate--to replace MTBE--it will enter the gasoline pool at its blending value. That will put downward pressure on both ethanol prices and refining margins. Refiners could end up pushing "E85" as a way to keep this excess in a premium niche, rather than depressing traditional gasoline.
• Many economists are worried about the effect of continued trade and fiscal imbalances on the economy as a whole, and on the dollar in particular. A significant fall in the value of the dollar would ripple through the entire oil industry. The impact would be compounded, if major oil producers responded by going off the "dollar standard" for oil. We could see oil prices rise for US consumers, but fall globally.
• Large volumes of new oil production are expected to come onto the market within the next two years, including major new projects in Saudi Arabia and the output of expanded oil sands extraction in Canada. If the sum of these turns out to be larger than the incremental demand growth from Asia and the US over the same period, oil prices will weaken further.

This list is far from exhaustive, ignoring Russia's slide back into totalitarianism, the ramifications of the deflating housing bubble, the possibility of another Hurricane Katrina, and the uncertainties associated with the incoming Congress. Considering that the price for the entire 85 million barrel per day market is set by the last couple of million barrels per day of supply or demand, we are currently blessed or cursed with a large array of factors that could move the market up or down by that magnitude. We could find out fairly soon whether the present $55-65/barrel range has permanently replaced $25-35, which prevailed as recently as 2003.