Wednesday, July 30, 2008

Offsets and Behavior

It took a while for US petroleum product demand to respond to high oil prices, but once gasoline neared $4 per gallon in a slowing economy that no longer afforded consumers the opportunity to translate home equity appreciation into purchasing power, it set up the first absolute decline in gasoline use since 1991. But would this response have been so dramatic, if the majority of consumers had already locked in their fuel costs, or hedged them financially? That question has interesting parallels with regard to climate change, for which emissions offsets can provide individuals with a cost-effective temporary alternative to more difficult or expensive changes.

Having just received a renewal notice from my emissions-offset provider, it seemed like a good time to recap my family's fuel consumption for the past year, in order to calculate how much CO2 our two cars emitted. I won't pretend the Styles household is typical in its gasoline consumption. Since neither adult commutes to work, we drive less than the national average. That's just as well, since our cars' fuel economy is nothing special: the station wagon and the sports sedan both get around the national average fuel economy of roughly 22 mpg. Together they consumed 705 gallons of gasoline in the last 12 months.

Tallying our fuel use also provided an opportunity to assess the actual impact of higher fuel prices on our family budget. At an average price increase since last July of 63 cents per gallon, we spent $450 more on gasoline than in the previous year. Although that result fell short of my perceptions, it still represents money we could have spent on other goods and services, or saved. Yet I also knew I couldn't view it isolation, without considering the impact of the natural hedge provided by the oil company stock I retain as a result of my previous employment. Although its performance has been disappointing since oil began its retreat from $145 per barrel, over the last four years it has more than offset the approximately $2 per gallon increase in fuel prices we've experienced. But that isn't just a benefit of being an ex-oil company executive; anyone could have created such a hedge, if they had a spare few thousand dollars to invest.

Four years ago the average US price for regular gasoline stood at $1.90 per gallon. This week it's $3.95. Although its rise has hardly been smooth, that works out to roughly an extra 50 cents per gallon each year, compounded. For a typical car consuming 500 gallons per year, that equates to a cumulative fuel-expense increase of $2,500 over the entire period. As it turns out, $2,900 invested in a fund tracking the Amex Oil Index (XOI), a basket of oil equities, on August 1, 2004 would have grown to $5,750 by now, enough to cover the entire increase in gasoline prices and still pay a 3% return on the principal, though not without significant risk and volatility. Since oil equities are hardly a perfect proxy for fuel prices, a bolder investor might have achieved the same hedge by investing directly in a commodity fund. Alternatively, anyone lacking the capital or the inclination to tie it up this way could have locked in his or her gas purchases using a service such as MyGallons.com. (I haven't tried it and can't vouch for it in any way; caveat emptor.) And never forget that hedges can lose money; if you hedge but the price falls, you will be worse off than if you had done nothing.

Even without our natural hedge, I doubt that we'd seriously be considering trading in our pair of 4-year-old cars on new, more efficient models, in order to save that $450 per year. We don't drive enough to justify taking the resulting hit on depreciation, even if we doubled our fuel economy. Nor does our desire to reduce our greenhouse emissions alter that calculation by much. The gasoline we've burned since last July produced 7 tons of CO2. Based on the rates charged by TerraPass, we can offset that for $83.30, getting us effectively to zero emissions, rather than the reduction of 1/3 to 1/2 we might expect from newer, thriftier cars--and at a much lower cost.

Now, I've heard all the arguments about "buying indulgences" instead of making real changes in our lifestyles. Although my family has effectively negated the personal impact of higher oil prices and our vehicles' CO2 emissions, the world as a whole might be better off if we had bought a pair of hybrids, instead. However, that argument contains two fallacies, one arising from the inappropriate application of a pollution mindset to greenhouse gases, and the other reflecting the limited supply of highly fuel-efficient cars and the benefit of allocating them first to the highest-intensity users. As long as my offset provider is really investing in projects that truly reduce emissions--emissions that are equivalent in impact regardless of where on the planet they occur, and that wouldn't be cut otherwise--then for less than $100 per year we have the climate equivalent of two EVs running on wind power, minus their cachet. And we aren't competing for a hybrid with someone who drives 20,000 miles per year.

That isn't an excuse for perpetual indulgence, of course. When we do buy new cars, they will be much more efficient: diesels or hybrids, at least. And if the US hasn't enacted economy-wide cap & trade or carbon taxation by then, we'd pay to offset the remaining emissions. Similar calculations by millions of Americans may help to explain the fuel economy inertia of the US vehicle fleet, and why it will only improve incrementally within the next five years, no matter how efficient the new-car fleet becomes.

Monday, July 28, 2008

NIMBY vs. TANSTAAFL

It is encouraging that our reaction to the current energy crisis has reached the stage at which we are beginning to see concrete plans for addressing it systematically, rather than via the grab-bag approach employed in last year's energy bill. The same applies to the related, but not quite parallel problem of climate change. But whether voters ultimately gravitate towards the Pickens Plan or to Mr. Gore's more dramatic goal of eliminating fossil fuels, such approaches are likely to run afoul of the same factors that have hampered the ability of the US conventional energy sector to keep pace with demand. Real progress in this area will require us to confront the collision between our desire for abundant energy and our distaste for the means of providing it.

The current debate over offshore drilling exemplifies many of the same obstacles that renewable energy sources will face, as we attempt to scale them up to a level that can compete with oil, gas and coal. Too many advocates of alternative energy cite our inability to drill our way out of this energy crisis--kicking a dead dog, if there ever was one--without realizing that the sensibility that opposes oil exploration off our coasts or in Alaska is not so different from the one raising lawsuits against the transmission of concentrated solar power from the desert to coastal markets.

Whether we are talking about oil wells, refineries, wind farms, or uranium mines, most Americans would prefer them to be far enough away from us that we can't see, hear or smell them. Until recently, it has been just barely possible to satisfy both our demand for energy and our state of denial about its origins, because the energy sources we have relied on are so concentrated. One mid-sized offshore oil platform contributes as much net energy production as the entire US ethanol program did in 2006. But as we shift toward renewable energy, it will become increasingly difficult to shield our sources of energy from our view. Generating the electricity necessary to displace natural gas from the power sector into transportation, as Mr. Pickens suggests, would require between 90,000 and 200,000 wind turbines, using current technology. In order the make that a reality, the viewscapes of millions more Americans must include either wind turbines or the new transmission lines necessary to bring their output to market.

Breaking this tension between NIMBY and TANSTAAFL--the popular acronym about free lunches that restates the Laws of Thermodynamics--will require a willingness to set clear national priorities and make the compromises necessary to turn them into practical reality. Does our desire to become energy independent, or at least reduce our reliance on unstable oil suppliers and the financial drain that accompanies it, exceed our preference for keeping big, ugly infrastructure out of sight and out of mind? Does our concern about the potential consequences of climate change trump the ability of small, vocal minorities to block essentially any project that doesn't fit their vision? Or has this energy crisis finally become painful enough to force us to grapple pragmatically with the consequences of solving it?

Thursday, July 24, 2008

Leveraging the SPR

Election-year politics and prudent energy policy do not mix well. The combination is even worse when the election cycle coincides with a genuine energy crisis, and both parties seek to curry favor through short-sighted proposals aimed at producing votes, rather than BTUs or kilowatt-hours. We saw this earlier in the year with suggestions by Senator Clinton and Senator McCain to suspend the federal tax on motor fuels for the summer, and we are seeing it again in calls by the Speaker of the House and others to release oil from the Strategic Petroleum Reserve to drive down fuel prices.

It's remarkable how quickly the debate over the Strategic Petroleum Reserve (SPR) has shifted from halting additions to it, to draining it. The former was eminently sensible, in light of the cost of the program and the possibility that diverting small quantities of light, sweet crude into storage was having a disproportionate impact on the price of all oil. The balance of risks strongly favored suspending additions to the SPR; quite the contrary is true for using SPR oil to create a brief, convenient slump in the oil market, while diverting attention from the more serious discussion of increasing supply and reducing demand--both sides of which would be harmed by a non-emergency release from the SPR.

Make no mistake: the current SPR is a relic of the energy crisis of the 1970s that merits serious re-thinking about its fundamental purpose and the best way to achieve it in a very different economic and geopolitical environment. It is also possible to conceive of ways in which oil in the SPR could be used to speed up the contribution of production from new oil fields, once they are identified and under development, via SPR vs. reservoir exchanges. However, such considerations are quite different from simply dumping SPR oil into the market--volumes that under the policy passed by this Congress could not be replaced as long as oil remains expensive--for no purpose other than to provide some relief at the gas pump, where prices are already likely to fall by another 25-35 cents per gallon, based on the past week's drop in the crude oil and gasoline futures markets.

The problems with releasing SPR oil now are straightforward. Inventory is not production. The proposed draw-down is not sustainable, while the production that new drilling could add would contribute to our energy supplies for a generation. Moreover, oil prices are a classic stock-and-flow system, reflecting the current balance between actual supply and actual demand, and the difference between actual inventory and desired inventory. Although the flow of SPR oil into the market would create a temporary glut and drive down the price of oil for prompt delivery, the subsequent lower inventory levels--even for an emergency back-up such as the SPR--could result in even higher prices after the release program ended than before it began. At the same time, this signal--not just from lower current prices but also from the demonstrated willingness of the government to use the SPR to manipulate the market--would deter new energy projects, including those for alternative fuels that are more attractive when oil prices are high, while impeding our transition to more efficient vehicles.

The world has changed in many ways since the SPR was first opened, and some of those changes make it even more essential for the US to have quick access to large volumes of oil in extremis. Among other things, our net oil imports have doubled since President Ford signed the SPR into law in 1975. Although oil prices remain high, supply still meets demand. Yet it is far too easy to envision plausible scenarios in which that would not be the case, involving terrorism, expanded conflict in the Middle East, or the effects of Peak Oil. In any of those cases, we might find that the SPR's current 160 days of supply at its 4.4 million barrel per day maximum delivery rate are not nearly as ample as they seem.

Aside from expediency, the theory behind releasing SPR oil now is based on a flawed narrative involving a bubble in oil prices. If the evidence were clear that supply and demand would balance at a much lower oil price, and that speculators were responsible for a large fraction of the current oil price, then I could support using a brief release from the SPR to crush speculation. The reality appears much different. Oil prices have fallen since this debate started, largely because of the extraordinary reduction in demand that high prices and a weak economy have triggered--and not because the market sees a realistic prospect of a SPR release this year. Oil is trading today below $125 per barrel for delivery in September 2008, as well as for delivery in December of 2010, 2011 and 2012. That could change tomorrow, due to some event, but it suggests that the impact of speculation is more like the foam in a glass of beer than a steadily-inflating bubble. The interests of the nation would be better served by a Congressional commission on re-engineering the SPR for the 21st century, than by Congressional legislation to fritter away this $88 billion asset in the pursuit of short-term goals.

Wednesday, July 23, 2008

Setting Oil Prices

As the Congress moves ahead with legislation aimed at reducing the contribution of speculation to high oil prices, it's worth taking a moment to reflect on how oil was priced before the influence of the futures markets became so pervasive, or before they even existed. A quick review reveals that any nostalgia for this earlier, simpler era is largely misplaced. Today's oil markets, for all their faults, are models of transparency and efficiency by comparison. Let's hope that our government can discover the right formula for curbing their excesses, without destroying the liquidity and highly-visible price discovery that they provide to producers and consumers, alike.

I've devoted a fair amount of space to the question of oil market speculation. I don't see the signs of a housing or Dot-Com-style bubble, but I also don't dismiss the effect of demand from long-biased asset-class investors on the market. As we often hear from skeptics of the influence of speculation, buyers and sellers must indeed be evenly matched, but higher demand for long futures can only be met by bidding up the price. That tends to drive up the price of the physical commodity bought by refiners, because of the mechanisms by which physical oil is priced. However much this has contributed to pushing oil beyond the $70-$80 per barrel that some industry experts suggest more reasonably fits the market fundamentals, a return to the way oil prices were formerly determined would not guarantee lower prices.

There are many excellent accounts of the history of oil and its pricing, and I can't possibly do justice to this subject in a brief blog posting. If you haven't read the book for which Daniel Yergin won the Pulitzer Prize in 1992, that would be a good place to start. Prior to the first oil crisis, the price of oil was effectively set by the Texas Railroad Commission, which published the monthly quota for production in the state. Together with import restrictions, this constrained supply enough to keep US oil prices between $2 and $4 per barrel. Once the Railroad Commission quota hit 100% in 1971, as a result of growing demand and the peaking of Texas oil output, its influence on prices ended. Oil from the Middle East and other big exporters in that period was sold mainly via long-term contracts, at prices that changed infrequently and that sometimes included "net-back" provisions, explicitly tying the price received by the producer to the revenue realized by refiners in key markets.

All of this changed in the 1970s, after OPEC consolidated its control and began raising the price. It ended net-back discounts and nationalized the holdings of the international oil companies. Between 1972 and 1978, the average price US refiners paid for imported crude oil quadrupled in dollars of the day. The US government intervened in the market by setting the price of "old" and "new" oil--trying to hold down prices while leaving incentives for new domestic production--and limiting imports. These distinctions were exploited by clever traders, and integrated refiners were forced to supply small, independent refiners, even if their own facilities were under-utilized. It was a mess. From 1978-81, in the aftermath of the Iranian Revolution, oil prices increased by another 150%. Over the next few years, OPEC's ability to set prices was eroded by a 10% reduction in global oil consumption and a tsunami of new non-OPEC output from the North Sea, the North Slope and elsewhere. In the ensuing battle for market share, the price of oil fell from its peak of around $40/bbl. to $13, requiring the 1990 Iraqi invasion of Kuwait finally to push it back above $20.

When I traded oil in the late 1980s, most of the US production I dealt with was bought and sold on the basis of the oil companies' posted prices, which solicited offers to sell them lease-level crude output. Alaskan North Slope crude was one of the few domestic grades I handled that was sometimes pegged to the price of West Texas Intermediate crude on the New York Mercantile Exchange (NYMEX.) The prices of the relatively few international cargoes I bought were typically negotiated for each cargo, without reference to other markets. Although I never bought Saudi oil, it was priced by Aramco on two formulas, one for "eastern" and one for "western" destinations. Transparency in that period depended on the ability of reporting services such as Platts to ferret out the details of the transactions that occurred each day. The fewer the transactions, the less reliable these reports were, especially for domestic grades outside the week or so prior to monthly pipeline scheduling, when most deals took place.

History is rarely a perfect guide, but in this case I think it offers some useful lessons concerning how oil might be priced, if the futures markets became less liquid or less influential. Although prices might not be as volatile, day to day, they would be no less prone to manipulation, or to sudden price spikes in response to changes in supply or demand. The pre-NYMEX oil market only yielded low prices when supply was abundant, a characteristic that has been absent since oil prices took off in 2003. Today's problems of transparency, involving the identity and motivation of market participants, pale in comparison to the former challenges of discerning precisely what the day's price was, in the absence of an open, visible exchange platform. I dislike clich├ęs, but as the father of a small child the image of throwing out the baby with the bathwater resonates strongly, here.

Monday, July 21, 2008

Changing Our Energy Diet

Over the weekend I participated in a panel discussion on space-based solar power (SSP) at a space-development conference, for the second time in as many months. My presentation focused on what it would take for a new source such as SSP to find a place in our energy diet, which will be changing at the same time that the technology for producing power in space and sending it to markets here on earth develops. The audience of entrepreneurs and space professionals was quite engaged by the idea that SSP couldn't just be a space project; it had to be a viable energy project, too. These same challenges apply to any new energy technology with a long development period, including some that are much more established than SSP. But with politicians, pundits, and experts of all stripes telling us we must rapidly shed our addiction to fossil fuels, the inertia of our present energy diet remains the under-appreciated elephant in the room.

I began my brief remarks with a simple pie-chart showing US energy consumption for 2007, based on data from the Energy Information Agency of the US Department of Energy. As replicated below, it showed the breakdown of our primary energy supply--the raw energy going into power plants, factories, and oil refineries for further processing into fuels, electricity and materials, along with the contribution from nuclear power plants and those energy sources that produce electricity directly, such as hydroelectric dams, solar panels and wind turbines. Despite the recent, breathtakingly-fast growth of wind and solar, and the tremendous success of the nuclear industry at squeezing more output from its 104 existing reactors, the low-emission portion of our energy diet only accounts for 15% of our primary energy needs, and less than a third of our electricity demand, with 93% of that coming from mature hydropower and nuclear sources.

US Primary Energy Supply



As in a diet, not all calories are equal or interchangeable. The 39% of this diet supplied by oil cannot be replaced by renewable sources of electricity without a lengthy and dramatic change in our vehicle fleets, because oil accounts for less than 2% of our electricity generation, and there's very little of it left to displace from the power sector. Nuclear power and natural gas already accomplished that task over the last several decades. The much bigger challenge now is to shift the roughly 97% of transportation energy currently derived from oil to other sources--either electricity in the view of Al Gore, Dr. Andrew Grove and others, or natural gas, as suggested by T. Boone Pickens. But as we make that shift, we can't leave the portions of our economy that will still depend on oil high and dry. We must continue to provide enormous quantities of petroleum, even as we work aggressively to shrink its share of our diet and expand the portion supplied by sources that don't emit greenhouse gases or contribute to our trade deficit. It is fundamental to the nature of oil production that if you don't keep drilling, its supply quickly dwindles.

Tom Friedman's column in Sunday's New York Times drew a parallel between Mr. Gore's ten-year goal for ending our use of fossil fuels and President Kennedy's commitment to reach the moon in a decade. Unfortunately, this analogy breaks down once it gets past the R&D stage. I regard our accomplishment of landing two men on the moon 39 years ago yesterday as the pinnacle of the 20th century. It was a remarkable feat, requiring billions of dollars and hundreds of thousands of scientists, engineers, and support staff of every description, yet it ultimately only put 12 Americans on the lunar surface. We're talking about displacing 85% of the current energy diet of a nation of 300 million people that accounts for between a fifth and a quarter of global GDP. Doing that within a decade wouldn't just be moonshot-impressive; it would require a flat-out miracle.

Friday, July 18, 2008

Farewell to $4?

The price of oil on the New York Mercantile Exchange has dropped $15 per barrel in less than a week, bringing us the first closing price under $130 since June 5. It is premature to suggest that this marks the start of a major correction back to sub-$100 territory, but it's noteworthy that this appears to be happening largely due to the weakening of demand, particularly in the US, where gasoline sales are now down around 3% compared to the same time last year--even more if we adjust for the additional ethanol being blended in under this year's higher Renewable Fuel Standard target. If the oil price stabilized here and refining margins remained weak, the national average retail price of gasoline would shortly drop back below $4.00/gallon. Although that wouldn't mean we'd never again experience prices that high, it would be very interesting to see how a return to the mid-to-high $3 per gallon range would affect consumer psychology.

At the very least, this week's drop should deflate some of the recent oil market hysteria, which was making $200 oil and $6 or $7 gasoline seem like an immediate inevitability, on the strength of little more than self-fulfilling prophesies and jitters about a possible conflict with Iran--something that has had the market on edge since oil was under $50. But while that other mainstay of expensive oil, demand growth in the developing economies, continues apace, the market cannot for long ignore a 3% aggregate drop in petroleum demand from a country that still accounts for nearly a quarter of the world's oil imports. Small fractions of large numbers can have a big impact.

Refiners remain caught in the middle, as they have been for most of the last year. With demand responding to high prices and the soft US economy, refiners are making very little money turning oil into gasoline. Weak demand has forced them to absorb a large chunk of the recent increase in oil prices. Nor does it seem likely they will be able to hang onto more of the margin as oil prices drop, because US gasoline inventories are building at the rate of roughly 2 million barrels per week, despite refiners shifting their operations to produce record quantities of diesel, partly at the expense of gasoline output. Refiners have room to increase crude runs, but at these margins, they are probably better off maximizing distillate and purchasing any gasoline shortfall abroad. But while these conditions have benefited consumers in the short run, they could set the stage for higher product prices in the longer term, by making the economics of refinery expansions less attractive.

After Hurricanes Katrina and Rita, there was a spate of concern about the nation's refining system. No new refineries had been built since the 1970s, and too many were concentrated along the Gulf Coast. All that talk came to nothing, but the exceptional margins that existing refineries were earning for several years kicked off some significant refinery expansions, including the Motiva and Marathon projects in the Gulf Coast that will effectively add the equivalent of a brand new refinery inside the boundaries of two existing facilities--a model currently under consideration by some nuclear plant operators.

Now, this might seem like an odd time to build more refining capacity, with demand falling and over a third of the country convinced that we'll get most of our energy from renewable sources within a few years, according to a new API/Harris Interactive survey. But even if we don't end up using more oil in the future, the kind of oil US refineries can process matters greatly in the global market. Although some analysts are skeptical that Saudi Arabia can deliver on the sustained output increases they have promised, one of the main reasons the market has largely yawned at the prospect of another 2 million barrels per day of Saudi crude is that much of the incremental oil will be of low quality--just the kind that these refinery projects are designed to handle. If refining margins don't recover soon, projects like this could be slowed down or deferred, and additional heavy, sour crude oil production will have less impact on the global price of oil--and that would affect us all at the gas pump.

In the meantime, no one should become complacent, even if average gasoline prices soon fall below $4 for a while--though probably not in California. Global supply and demand remain pretty tightly balanced, and we're now never more than one or two events away from a big spike in oil prices or refining margins. While we might soon spend a bit less at the gas pump, we'd be better off pocketing any savings, rather than turning them into a rebound in fuel demand.

Wednesday, July 16, 2008

Deferring Climate Action

Depending on one's perspective on climate change, last week's events provided either a series of predictable disappointments or a temporary breather, before our expected plunge into a world of constrained emissions. The statement on climate change from the G8 Summit in Hokkaido, Japan, and the subsequent "Major Economies Meeting" reflected only incremental progress since 2005's Gleneagles G-8 meeting and last year's Bali Climate Conference. And although the announcement that the EPA would effectively defer regulating greenhouse gas emissions under the Clean Air Act until the next administration was overshadowed by allegations that Vice President Cheney had interfered with Congressional testimony on the health risks of climate change, the former should not have shocked anyone. On the heels of the latest failure of US cap & trade legislation, it was not in the cards for 2008 to be more than a transition year for action on climate change, and that view has been borne out.

Lacking the time or space to comment on all of the implications of these actions, I'd like to focus on the principal complaint I've seen concerning the G8's contribution, to the effect that their stated target of cutting global greenhouse gas emissions in half by 2050 falls far short of what would be necessary to stabilize the climate. I would suggest that at this point setting any global emissions target and then starting to work towards it is more important than the absolute level of the goal. Stabilizing atmospheric concentrations of CO2 and other greenhouse gases at their current level would apparently require reductions on the order of 80%, but whatever target we set now for 2050 is unlikely to be the last word, and even more unlikely to be achieved with precision. We will ultimately either undershoot, because global emissions are now growing so rapidly that it will take longer and cost more to halt and reverse this trend than we hope, or we will overshoot, because the world will change so much in the next 42 years that a 50% reduction will prove to have been ridiculously timid.

Consider 1966, removed from us by the same interval as the world of 2050, and the sorts of predictions that were then current regarding the 21st century--predictions rooted firmly in the dominant technologies and institutions of the day. By now all air travel should take place in sumptuous luxury aboard supersonic aircraft. Rather than lumbering along with gasoline engines, our cars should zoom down the roads on nuclear batteries and occasionally even fly. Recessions and credit crises should be a relic of the past, as gigantic mainframe computers guide the economy with total accuracy. And don't forget the colony on the moon. For good or ill, we didn't get those outcomes. Instead, we got ubiquitous real-time information and communications via wireless PCs, cellphones and the Internet, and the beginnings of unprecedented medical and materials revolutions based on DNA-level biotech and nanotechnology. In addition, the world's population has grown by about a half billion fewer people than once expected, making some of our current problems less severe than they would have been. I see little reason to conclude that the next four decades will be any less surprising and prediction-thwarting than the last four. That doesn't mean we should punt on climate change and wait for a miracle, but it does suggest that focusing our first steps firmly on the next 10-20 years makes more sense than bogging down in arguments about a longer-term future we can't forecast.

Few things about climate change are certain, including the level of our emissions in 2050. However, at this point we do know that the roadmap set forth in Bali last December, and resting on the findings of the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, continues to guide the negotiations on a new global climate agreement. Although the shape of the ultimate compromise between the developed and developing economies--the sine qua non of a meaningful successor to the Kyoto Protocol--remains unclear, the key parties at least seem to be willing to tackle it. And we know that on January 20, 2009, a new US administration will take office with climate change as a top priority from day one.

Monday, July 14, 2008

Energy Resilience

In an important op-ed in yesterday's Washington Post the former CEO of Intel, Andrew Grove, issued a rebuttal to all the slogans we've been hearing lately promoting energy independence. Without ever mentioning it by name, he also offered a practical alternative to the recently-proposed Pickens Plan. In the process, he has introduced a phrase that might catch on as more precise and pragmatic than either energy independence or energy security: "energy resilience." This notion relies on extending the dominance of electricity into transportation, and on producing this energy carrier from many different primary energy sources, including fossil fuels, various renewable flows, and nuclear energy. An energy economy entirely mediated by electricity would be much less vulnerable to disruptions or price spikes in any one commodity, such as oil.

When confronted with the overwhelming challenges preventing the US from achieving true energy independence in the foreseeable future, many of the advocates of this goal respond that we ought not be overly literal in interpreting it. Independence is a matter of degree, and what they really intend is that we become more energy independent, despite the arrow having pointed steadily in the opposite direction since the early 1980s. If that isn't merely rhetoric, then perhaps they'd be willing to trade in this imprecise slogan for one that represents an equally desirable, yet more achievable goal. Energy resilience could be just what a nation reeling from the inflationary impact of the quadrupling of oil prices in five years is seeking: an economy with the ability to absorb an oil (or natural gas or coal) price shock and keep on growing.

So what might a transition to a more resilient energy economy entail, with electricity powering most transportation, in addition to its other roles? As Dr. Grove notes, shifting our transportation systems to electricity wouldn't be easy, because it will require much new infrastructure and the turnover of most of our vehicle fleet. Powering half of the energy needs of the current US fleet of cars and light trucks would require an additional 40 1,000 MW nuclear power plants or 125,000 MW of additional wind and solar capacity--a seven-fold expansion from current levels--or some combination. In the early years of this transition, we might also consume more natural gas for power generation, not less, because natural gas turbines provide much of the existing base of spare overnight electrical generating capacity that would be used to recharge the first wave of electric cars. In addition, we'll need to upgrade our electrical infrastructure to accommodate more generation from intermittent and cyclical sources, and more sharing between regional grids.

Then there are the cars themselves. Here I think Dr. Grove may be overly optimistic in his estimate of a decade to make this shift. It has taken conventional hybrids, which don't plug into the grid, 9 years to capture 3% of the US car market, though until recently their sales depended more on government incentives and green cachet than on fuel economics. The first original-equipment plug-in hybrid models should reach the market within one to two years, depending on whether Toyota or GM launches first, and until then electric cars such as the Tesla and Aptera will occupy a small niche. Replacing half the 240 million cars and light trucks now on the road by 2020 with plug-ins hybrids and pure EVs would require them to attain a 50% market share within about five years and essentially 100% a few years after that. Dr. Grove suggests retrofitting existing cars to shorten the transition, though I wonder how attractive consumers will find such options. Nor will plug-ins and EVs be the only efficient models vying for market share.

During such a transition our demand for liquid fuels would fall gradually at first, and then more dramatically, while demand for natural gas for power generation would probably rise initially and then level out, depending on how climate change legislation affects the output of our existing coal-fired power plants. Increasing domestic oil and gas production and expanding biofuels output have an important role to play in reducing our net energy imports in the early years of a transition to a strategy of energy resilience. In any case, US oil demand would continue at reduced levels for many years to come, as the long tail of our vehicle fleet turned over, and liquid fuels continued to underpin long-distance travel.

The approach suggested by Dr. Grove has many advantages, and the most important is avoiding the trap of becoming overly reliant on any one source of primary energy, imported or domestic, in the future. In this respect, his idea has an edge over the plan put forward by T. Boone Pickens, though the latter might be simpler to execute. Energy resilience also has thermodynamic efficiency on its side. Because fossil fuels can be used to generate electricity at least twice as efficiently as burning them in internal combustion engines, a US vehicle fleet made up mostly of electric cars would require much less primary energy than the current one, without reducing annual vehicle miles traveled. That would have very beneficial implications for the long-term price of energy, and it would greatly reduce our energy imports. That still might not get us to energy independence, but the combined price and volume effects would shrink our oil import bill to much more manageable proportions.

Friday, July 11, 2008

Airlines vs. Speculators

Yesterday a friend sent me a copy of an email letter she had received from an airline on which she is a frequent flyer. It made an urgent plea for public support to rein in oil market speculation, which it blamed for between $30 and $60 per barrel of the current oil price, which has been ruinous for the airline industry. Millions of Americans received the same letter--apparently I haven't flown enough, lately, to merit one--with a link to the "Stop Speculation Now" campaign website. Congress and the Commodity Futures Trading Commission have been grappling with this issue, and new energy futures market regulations should be forthcoming shortly. However, I hope that the chiefs of America's airlines are not banking on a speedy return to sub-$100 oil, and the $1.00 or more per gallon this would subtract from their jet fuel bills. Even if all speculation were eliminated tomorrow, the combination of a weak supply response and the low price elasticity of demand for oil make it unlikely that prices would quickly revert to last fall's $80-$95 per barrel price range.

For the last year, I have discussed the potential impact of speculation on oil prices. Investment in oil futures, options and derivatives as a new asset class has affected the market in ways that traditional speculation by financial players--a key ingredient of market liquidity--didn't. Even if these investors never take delivery of a single barrel of oil, they constitute a new segment of demand for oil futures and exert upward pressure on the market. I have also described at length the mechanism by which the resulting higher futures prices affect the prices that refineries pay for the physical barrels of oil they process, and why in that margin-based business, resistance to higher prices is likelier to come from end users, rather than refiners. But none of this alters the main facts governing the price of oil: The growth of global demand over the last five years has consumed most of the existing spare production capacity, and restrictions on access to resources--within OPEC and the US--combined with the time-lags inherent in bringing new supplies online have left the market balanced on a knife edge, setting up the conditions without which asset-class investments in oil futures would just be another complicated way to lose money, which may still be the ultimate result for many.

In a recent Wall Street Journal op-ed, Martin Feldstein, a former chairman of the Council of Economic Advisers, provided an exceptionally clear explanation of how small changes in supply and demand can translate into large price movements for commodities with very low short-term price elasticity, or sensitivity, of demand. Yesterday I discussed the recent demand response in the US. It took $4 per gallon pricing to halt the steady year-on-year rise of US gasoline consumption, a trend that was unbroken since 1991. And in the absence of serious refining problems, the only two paths to $4 gasoline were $130 oil or the imposition of a $1.00 per gallon surtax when oil was still under $100/bbl. Constraining the futures market now might provide some temporary relief, but it won't resolve the underlying problems that brought us to this point.

I don't blame the CEOs of the airlines for grasping at this straw. The signatories to the letter include my former boss at Texaco, Glenn Tilton, who understands the oil and airline businesses better than most. These executives know that a commercial aviation industry built on cheap fuel will emerge from a long period of sustained high oil prices as transformed as if it had been re-regulated, and that the mass access to cheap and convenient air travel that we have taken for granted could disappear. Their effort here may even pay off, but as I noted recently, the exact form of any new regulations on energy trading matters greatly, if the cure is not to be worse than the disease.

Thursday, July 10, 2008

Driving Less

The signs that Americans are driving less are everywhere. From headlines such as, "Gas Prices Spur Drivers to Cut Use to Five-Year Low", to increasing ridership on mass-transit systems and TV news segments on the growing numbers of folks bicycling to work, we see $4 gasoline doing what $3 fuel didn't: deliver a meaningful conservation response. But before we pat ourselves on the back for the DOE report that gasoline demand has fallen by 3% compared to last year, we should review a somewhat longer stretch of our recent history of fuel consumption and vehicle miles traveled. It suggests that the current decline, abetted by a weak economy, barely scratches the surface of our per-capita fuel consumption increase since 1995.

Conventional wisdom blames the SUV fad for most of the increase in US oil consumption in the last decade or so. But while rising sales of large SUVs in that period certainly helped to stall the positive trend of passenger car fuel economy, the bigger culprit has been the heretofore steady growth in vehicle miles traveled (VMT.) Between 1995 and 2005 this statistic grew by 23%, slightly more than the 21% increase in gasoline and diesel fuel consumption, and ahead of the 19% expansion of our car and light truck fleet. By comparison, during this period the US population grew by about 13%. In other words, Americans have been driving more cars, and on average driving them farther each year, than in 1995, accounting for more of the accompanying increase in fuel consumption than SUVs. This year's 2% decline in VMT compared to last year's record figure only erases part of the roughly 10% per capita growth of average annual miles driven since 1995. If we unraveled the rest of that growth, we could reduce US gasoline consumption by another 8% without any contribution from the higher fuel economy of the new cars consumers are now choosing. That equates to more than twice as much oil as our use of ethanol will save this year.

I don't pretend that conservation on that scale would be easy or costless. Some portion of the increase in VMT is structural, in the form of workers traveling longer distances from communities beyond the traditional suburbs. Much of the rest is associated with some sort of economic activity, including delivering goods and taking children to daycare or activities. The main advantage of this kind of conservation is that, at least in principle, it can occur much more rapidly than the efficiency gains from the gradual turnover of the vehicle fleet to smaller cars and a larger number of hybrids and alternative fuel vehicles.

It remains to be seen whether the fuel savings we are now observing will persist and expand, level out, or rebound. The first appearances of $2 gasoline in 2004 and $3 gasoline in 2005 delivered milder shocks to a healthier economy, slowing the growth of gasoline demand but not reversing it in the way that sustained $4 fuel has. That result could be put to the test, if oil prices continue to slide from their $145 high last week, or once the economy finally starts to improve. In the meantime, the scope for further behavior-based conservation remains significant.

Tuesday, July 08, 2008

A Man, A Plan

T. Boone Pickens, well-known oilman and corporate raider, has a plan for reducing America's reliance in imported oil by more than one-third within a decade or so. When I opened the morning paper, I found a full-page ad heralding the Pickens Plan and directing my attention to http://www.pickensplan.org/ for the details. The idea behind the plan is simple and appealing: ramp up wind power to displace natural gas from power generation, and then use the natural gas to fuel vehicles, backing out gasoline and diesel fuel. The net result of this shift would reduce US expenditures on imported petroleum by perhaps $250 billion per year at current prices. Although the plan appears feasible, its implementation would face serious obstacles. More importantly, its key provisions appear to conflict with other solutions that offer bigger efficiency improvements and greenhouse gas reductions. Perhaps its largest benefit is in laying out a clear set of choices for discussion, in contrast to the wonkish complexity of most energy policy proposals.

The essentials of the Pickens Plan involve boosting US wind power to 20% of our electric generation mix, equal to the net generation currently derived from natural gas. This element of the plan draws on the DOE's recently released feasibility scenario for 20% wind, about which I blogged in May. That would free up the nearly 7 trillion cubic feet per year of natural gas supplied to the electricity sector for direct use in transportation. The energy content of that gas is equivalent to 4 million barrels per day of gasoline, 44% of our 2007 consumption. This would also save the 200,000 barrels per day of ethanol currently blended into that gasoline, for use elsewhere. Ignoring the impact of these drastic changes on refinery yields, the net result would displace at least 34% of our net 12 million barrel per day petroleum imports. Thus, as one would expect from someone with Mr. Pickens's background and resources, the math behind his plan works.

Of course, achieving all this would require more than just determination. If you accept that the necessary technical and logistical hurdles identified in the DOE's 20% wind scenario can be overcome promptly, including increasing the average on-line capacity factor of wind farms by 50% and installing enough new high-voltage transmission lines to move all this wind power from the central-US "wind corridor" to its ultimate markets, then the current wind power sector must grow by a factor of 18 within 10 years, and 44% of our vehicle fleet--over a hundred million cars and SUVs--must be built or converted to run on natural gas within the same interval, along with an enormous expansion of natural gas refueling infrastructure. In the process, existing natural gas-fired turbine generating capacity worth on the order of $400 billion would essentially be abandoned--generators that, by the way, account for much of the idle overnight capacity that would otherwise be available to recharge plug-in hybrids and electric cars. This gets to the crux of the hard choices inherent in the Pickens Plan.

Our national energy mix is better thought of as an "energy diet." In a diet, not all calories are alike, and the same is true for BTUs and kilowatt-hours. The power derived from natural gas provides much of the mid- and peak-load capacity in many US power markets. This is dispatchable, on-demand power that can shift rapidly to meet changes in the load. Without expensive energy storage, wind power is intermittent and unreliable--the opposite of dispatchability. Although some of this problem can be overcome by a sort of portfolio effect from widely-dispersed wind farms, the drastic shift suggested by Mr. Pickens would abandon the natural synergies between wind and gas-fired power, including the interesting option of compressed-air power storage.

The impact of the Pickens Plan on US greenhouse gas emissions must also be evaluated carefully. Mr. Pickens is certainly correct that natural gas vehicles emit fewer local pollutants and less CO2 than conventional cars, but for a change on this scale, we must consider the bigger picture. If wind power can grow to 20% of net generation and somehow overcome its intermittency problem, what is the best use of those green electrons? Is it in displacing one of our lower-emitting sources of electricity, in order to replace a fuel emitting 20 lb. of CO2 per gallon with one that emits 14 lb. of CO2 per energy-equivalent gallon? Or should we use that zero-emission electricity to back out coal-fired power producing 2 lb. of CO2 per kWh, contributing in aggregate over one-third of total US emissions? A similar argument can be made, based on the relative energy-conversion efficiencies of gas turbines vs. internal combustion engines.

Because of its scale, the Pickens Plan would affect other efforts to make the US vehicle fleet more efficient. Although the market is certainly large enough to accommodate both natural gas cars and plug-in hybrids, idling our natural gas turbine generating capacity and tying wind power to the demand that gas currently satisfies would make the adoption of electrified vehicles more challenging. It is also hard to imagine conducting two fleet turnovers on the scale required to have a meaningful impact, simultaneously. In other words, at least at first blush, adopting Mr. Pickens's approach might result in electric vehicles being pushed off for another decade or more.

Now, a cynic might suspect that the Pickens Plan has as much to do with promoting Mr. Pickens's investments in wind power as it does with addressing our national energy crisis. I prefer to give him the benefit of the doubt on this, and credit him with introducing an idea that merits further analysis and consideration. Discussing a proposal as concrete as this one might help frame our energy problems in a clearer context and prompt more action. Nor do I think the Pickens Plan must be considered as an all-or-nothing proposition. Natural gas could be an attractive vehicle fuel, if it didn't merely shift oil imports into LNG imports, or cannibalize a key part of our low-emission electricity portfolio. This prospect should increase our incentive to produce more gas in North America. At the same time, wind power should and will compete with gas power, but at the margin, not in its entirety, and all of this must take full account of the need to reduce US greenhouse gas emissions, a process that would be aided by putting a price tag on those emissions. On the whole, we should be grateful to Mr. Pickens for providing us with an interesting, non-partisan "straw man" proposal, to help us grapple with these complex issues.

Monday, July 07, 2008

Oil Prices and Inventory

Oil prices set another record last week, closing above $145 per barrel for the first time, on the strength of heightened fears of an attack by Israel or the US on Iran, combined with a dip in US commercial oil inventories below 300 million barrels, their lowest level since the end of January and at the bottom of their seasonal historical average range. But although lower inventories are generally a bullish signal for the market, we shouldn't forget that the relationship between prices and inventories runs in both directions. Current and expected future prices, along with actual supply and demand, play a significant role in guiding companies in setting their desired inventory levels. Determining whether a drop in inventories reflects tight supplies or expected future weakness depends on a broader array of indicators, including how seriously the oil industry takes forecasts of oil prices reaching $170-200 per barrel later this year.

The Department of Energy defines "crude oil stocks" as including "domestic and Customs-cleared foreign crude oil stocks held at refineries, in pipelines, in lease tanks, and in transit to refineries" and excludes the oil held in the nation's Strategic Petroleum Reserve (SPR). Some of this oil is required to ensure the uninterrupted operation of US refineries and pipelines, while the rest ebbs and flows with shifts in supply and demand and changing expectations for future prices. Although last week's figure looks low compared to average US commercial oil inventories since 2005 of 323 million barrels (MB), it is still 15 MB higher than the average during 2003-2004, and well above the 264 MB seen in January 2004. If nothing else, that suggests that current inventories remain safely above the minimum level required to keep the US pipeline and refinery network operating smoothly. That is consistent with the calculated 19.5 equivalent days of refinery supply at current consumption, compared to a low of about 17 days in September 2004.

There are two reasons why higher prices might lead companies to hold lower inventories. The most basic has to do with the carrying cost of owning high-priced oil. If a 200,000 barrel per day refinery had 4.4 MB of oil on hand when the price of West Texas Intermediate crude oil was $100/bbl, then the spike to $140 has increased its carrying cost for that inventory by the equivalent of $0.19 per barrel of output, assuming a corporate cost of capital of 8%. At $140/bbl, reducing plant inventory by 10% would cut the total carrying cost by 6 cents per barrel. While that might appear trivial on the scale of the profits oil companies are making, it would look very significant indeed to refineries that have experienced a gross margin between gasoline and crude oil of only about $8.00 per barrel so far this year. For a refinery manager seeking to contain costs, running a bit closer to minimum operating inventories looks like a good option, particularly when gasoline demand is dropping.

The other reason to reduce inventories has to do with expectations of future prices. While the market seems to be locked into a "shortage psychology", bolstered by pessimistic production estimates and forecasts of ever higher demand in Asia, the industry itself seems skeptical that current prices will last, despite futures markets trading at $142/bbl all the way out to 2016. If companies were planning their investments based on a return to $100/bbl or less, it would be hard for refinery managers to justify deliberately adding to inventory at today's price. And although the risk of a new war in the Middle East might alter that calculation, it must contend with the near-certainty that the government would release oil from the SPR to counter any actual disruption of supplies that would follow such an event. Moreover, rumblings in the Congress to release SPR oil to deflate a perceived speculative bubble in oil act as an additional deterrent to holding any more inventory than absolutely necessary.

For the present, then, falling crude oil inventories constitute another ambiguous component of the mixed bag of fundamental signals the market must interpret, including comfortably stable US gasoline stocks and falling gasoline demand, recovering diesel and heating oil stocks, weak refining margins and rising biofuels production. In the absence of a clear indication that supply will soon exceed demand, every mildly bullish indicator will push the market toward fulfilling the views of the growing cadre of analysts engaged in an apparent arms race of escalating forecasts, egged on by the media attention this attracts. But despite scare stories of $7 gasoline--which at current refining margins would require light sweet crude oil to reach at least $250/bbl--no one knows where oil prices will be in six months. Six months ago, crude oil was trading under $90. Can anyone look at the fundamentals and determine conclusively that it couldn't be back there this winter, rather than continuing on to $200? This reality makes even tactical planning for companies that are big energy consumers an extremely challenging undertaking.

Wednesday, July 02, 2008

The Ethanol Tariff and Subsidy Reform

Brazilian ethanol producers have long sought a level playing field on which to compete with their US counterparts, and this week they are launching a campaign to publicize their message that ethanol derived from sugar cane could be imported from Brazil at a lower cost than ethanol can be produced from corn in the US, if only the import tariff were reduced or eliminated. Legislation to reduce the tariff has been introduced in both the House and Senate. But while the modest step of cutting the tariff to match the domestic ethanol subsidy makes sense, eliminating it entirely would require substantial changes in the mechanism by which the federal government supports the use of domestic ethanol, to prevent taxpayer dollars directly subsidizing Brazilian cane growers and distillers. It is hard to imagine legislators wanting to open such a can of worms this year.

With the exception of imports under the Caribbean Basin Initiative, all ethanol imported into the US is subject to an import tariff and "secondary duty" worth about $0.60 per gallon. Although its original purpose may have been to protect domestic producers from foreign competition, it serves an important practical function, because of the way the US subsidizes domestic ethanol. Along with direct support to corn farmers and loan guarantees and other benefits for ethanol distillers, the government provides a credit of $0.51/gal. to companies that blend ethanol into gasoline, as a reduction to the fuel tax they would otherwise owe--though no longer at the expense of funding for road maintenance. The Farm Bill recently enacted over President Bush's veto reduced this "blenders' credit" to $0.45/gal, starting next year, but it will still amount to over $3 billion per year, based on 2007 volumes, which are slated to double by 2012.

Due to surging US ethanol production in 2007, imports from Brazil fell last year, compared to 2006. However, in the wake of the flooding that has devastated crops and paralyzed rail and barge transport in a large section of the Midwest, more imports might be necessary in order to meet the mandated volume of 9 billion gallons of ethanol for this year, under the Renewable Fuel Standard provisions of the Energy Independence and Security Act of 2007. If the tariff were repealed without changing the way the blenders' credit is paid, and if Brazilian imports merely matched their 2006 level, taxpayers could end up subsidizing Brazilian ethanol producers to the tune of $220 million this year.

I see two possible ways to avoid this outcome, while still taking advantage of lower-cost, higher-efficiency Brazilian ethanol: First, the law governing the ethanol credit could be modified to restrict its application to volumes produced in the US. Even if that passed muster under World Trade Organization rules, it would require the creation of a two-tier ethanol subsidy system and the means of monitoring it. In the process, it would increase the incentives for ethanol smuggling. That might sound like a relic of Prohibition, but given their established involvement in evading gasoline taxes, organized crime might find it a lucrative new line of business.

The other, more drastic alternative would be to shift the point of subsidy payment from the blender to the ethanol producer. This would impose its own regulatory and accounting burden and create other opportunities for abuse. However, it would also raise a more awkward question for ethanol producers. The original choice to subsidize blenders was hardly accidental; it was designed to encourage greater use of a domestic fuel during the previous energy crisis, and it has certainly achieved that goal. But with refiners and other blenders of gasoline now required by law to blend specified quantities of ethanol into gasoline, and with wholesale ethanol now generally selling for less at the distillery gate than wholesale gasoline, the justification for providing blenders with additional financial incentives to use this fuel has been greatly diminished.

Considering all these factors, ending the tariff and duty applied to imports of ethanol from Brazil and elsewhere would hardly be the simple matter suggested by the supporters of this idea. It would force a choice between extending ethanol subsidies to foreign producers--imagine that coming up in a presidential debate--and confronting the larger question of continuing ethanol subsidies at a time when our ethanol use is widely perceived to contribute to higher food prices. Unless the logistical problems caused by the Midwest flooding result in a severe enough shortage of domestic ethanol to drive up gasoline prices, I would be surprised if this idea got any traction this year.