Are Renewables Set to Displace Natural Gas?

• Bloomberg's renewable energy affiliate forecasts that wind and solar power will make major inroads into the market share of natural gas within a decade. 
• This might be a useful scenario to consider, but it is still likelier that coal, not gas, faces the biggest risk from the growth of renewables. 

A recent story on Bloomberg News, "What If Big Oil's Bet on Gas Is Wrong?", challenges the conventional wisdom that demand for natural gas will grow as it displaces coal and facilitates the growth of renewable energy sources like wind and solar power. Instead, the forecast highlighted in the article envisions gas's global share of electricity dropping from 23% to 16% by 2040 as renewables shoot past it. So much for gas as the "bridge to the future" if that proves accurate.

Several points in the story leave room for doubt. For starters, this projection from Bloomberg New Energy Finance (BNEF), the renewables-focused analytical arm of Bloomberg, would leave coal with a larger share of power generation than gas in 2040, when it has renewables reaching 50%. That might make sense in the European context on which their forecast seems to be based, but it flies against the US experience of coal losing 18 points of electricity market share since 2007 (from 48.5% to 30.4%), with two-thirds of that drop picked up by gas and one-third by expanding renewables. (See chart below.)

It's also worth noting that the US Energy Information Administration projected in February that natural gas would continue to gain market share, even in the absence of the EPA's Clean Power Plan, which is being withdrawn.

Natural gas prices have had a lot to do with the diverging outcomes experienced in Europe and the US, so far. As the shale boom ramped up, average US natural gas spot prices fell from nearly $9 per million BTUs (MMBTU) in 2008 to $3 or less since 2014.  Meanwhile, Europe remains tied to long-term pipeline supplies from Russia and LNG imports from North Africa and elsewhere. Wholesale gas price indexes in Europe reached $7-8 per MMBTU earlier this year.

But it's not clear that the factors that have kept gas expensive in Europe and protected coal, even as nuclear power was being phased out in Germany, will persist. The US now exports more liquefied natural gas (LNG) than it imports. US LNG exports to Europe may not push out much Russian gas, but along with expanding global LNG capacity they are forcing Gazprom, Russia's main gas producer and exporter, to become more competitive.

Then there's the issue of flexibility versus intermittency. Wind and solar power power are not flexible; without batteries or other storage they are at the mercy of daily, seasonal or random variation of sunlight and breezes, and in need of back-up from truly flexible sources. Large-scale hydroelectric capacity, which makes up 75% of today's global renewable generation and is capable of supplying either 24x7 "baseload" electricity or ramping up and down as needed, has provided much of the back-up for wind and solar in Europe, but is unlikely to grow rapidly in the future.

That means the bulk of the growth in renewables that BNEF sees from now to 2040 must come from extrapolating intermittent wind and solar power from their relatively modest combined 4.5% of the global electricity mix in 2015 to a share larger than coal still holds in the US. The costs of wind and solar technologies have fallen rapidly and are expected to continue to drop, while the integration of these sources into regional power grids at scales up to 20-30% has gone better than many expected. However, without cheap electricity storage on an unprecedented scale, their further market penetration seems likely to encounter increasing headwinds as their share increases.

BNEF may be relying on the same aggressive forecast of falling battery prices that underpinned its recent projection that electric vehicles (EVs) will account for more than half of all new cars by 2040. As the Financial Times noted this week, battery improvements depend on chemistry, not semiconductor electronics. Assuming their costs can continue to fall like those for solar cells looks questionable. Nor is cost--partly a function of temporary government incentives--the only aspect of performance that will determine how well EVs compete with steadily improving conventional cars and hybrids.

I also compared the BNEF gas forecast to the International Energy Agency's most recent World Energy Outlook, incorporating the national commitments in the Paris climate agreement. The IEA projected that renewables would reach 37% of global power generation by 2040, or roughly half the increase BNEF anticipates. The IEA also saw global gas demand growing by 50%, passing coal by 2040. That's a very different outcome than the one BNEF expects.

Despite my misgivings about its assumptions and conclusions, the BNEF forecast is a useful scenario for investors and energy companies to consider. With oil prices stuck in low gear and future oil demand highly uncertain, thanks to environmental regulation and electric and autonomous vehicle technologies, many large resource companies have increased their focus on natural gas. Some, like Shell and Total, invested to produce more gas than oil, predicated on gas's expected role as the lowest-emitting fossil fuel in a decarbonizing world. If that bet turned out to be wrong, many billions of dollars of asset value would be at risk.

However, it's hard to view that as the likeliest scenario. Consider a simple reality check: As renewable electricity generation grows to mainstream scale, it must displace something. Is that likelier to be relatively inflexible coal generation, with its high emissions of both greenhouse gases and local pollutants, or flexible, lower-emitting natural gas power generation that offers integration synergies with renewables? The US experience so far says that baseload facilities--coal and nuclear--are challenged much more by gas and renewables, than gas-fired power is by renewables plus coal.

The bottom line is that the world gets 80% of the energy we use from oil, gas and coal. Today's renewable energy technology isn't up to replacing all of these at the same time, without a much heavier lift from batteries than the latter seem capable of absent a real breakthrough. If the energy transition now underway is indeed being driven by emissions and cleaner air, then it's coal, not gas, that faces the biggest obstacles.

The White House 2014 Budget Energy Proposals: Stuck in A Timewarp

• The President's budget proposal would increase taxes on energy in ways that would harm US competitiveness and consumers.
• Presenting the Energy Security Trust as a zero-sum game undermines its potential effectiveness and bi-partisan appeal.

After spending some time going through the White House's proposed budget for 2014-23, several conclusions were inescapable.  First, this administration still hasn't thought through the implications of the energy revolution that's currently unfolding in the US, as a result of the technology to develop our enormous shale oil and gas resources, which grew even larger this week. Not satisfied to see tax revenues and royalties from oil and gas expand as production grows, they miss no opportunity to seek to slice more from the current pie. This failure of imagination extends to the proposed Energy Security Trust Fund, which sounded intriguing when President Obama mentioned it in this year's State of the Union speech, but now appears to be mainly an accounting gimmick based on a zero-sum mentality.  Meanwhile, the budget's proposals for renewable energy and advanced technology vehicles seem largely divorced from our experience of the last several years.

Let's start with the tax changes and quickly dismiss them, because they're mostly a rehash of provisions in the administration's last four budgets and stand no better chance of Congressional approval this side of comprehensive tax reform.  Once again, we see proposals to eliminate about $4 B per year worth of tax treatment for the oil and gas industry, including provisions like the Section 199 deduction enjoyed by all US manufacturers.  Now add proposed changes in the treatment of foreign taxes, which would subject this highly international industry to double taxation on its activities outside the US, under the misappropriated label of "reform."  (True reform would move toward the territorial system used by most advanced economies.) Finally, the President's budget would eliminate both the widely used last-in, first-out (LIFO) and lower-of-cost-or-market (LCM) methods of cost accounting for inventories.  I don't know how much of the $87 B of higher revenue over ten years ascribed to that shift would come from the oil and gas industry, but it would certainly be in the billions, if this weren't all dead on arrival.

That brings me to the Energy Security Trust Fund, described in the State of the Union as a way to employ revenue from oil and gas development to fund R&D on reducing our dependence on oil.  That looked clever, if applied to incremental resource opportunities.  More production would fund more research, in an almost virtuous cycle.  Yet that's not how the idea would be implemented in this budget.  Instead of opening up new areas for drilling, and earmarking the royalties that would generate, the $2 B for the Trust would come mainly from diverting royalties from leases already in the budget, and from further "reform": higher royalties on US production and higher rentals and shorter lease terms to provide "incentives to diligently develop leases."  The latter echoes the "idle leases" canard we've heard since 2008, reflecting a continued misunderstanding of how the industry actually works, along with the real-world factors that often impede faster lease development, such as permitting delays and lawsuits.

So at least this part of the President's "all of the above" energy agenda is reduced to measures that, rather than "encouraging responsible domestic energy production", would make the US a much less attractive place to invest in developing oil and gas resources, and likely reverse our recent successes.  Yet if the new budget treats conventional energy as a slush fund to be raided, renewables and efficiency are treated to what would amount to a reprise of the 2009 stimulus.  I tallied $39.8 B through 2023 for programs such as alternative fuel vehicles, advanced technology vehicle manufacturing, advanced energy equipment manufacturing, bioenergy crop assistance, home energy efficiency retrofit credits, efficient buildings, and the Energy Security Trust Fund.  44% of the total would go to a single measure: making the production tax credit (PTC) for wind and other renewable energy permanent, instead of phasing it out, as even the American Wind Energy Association has suggested.  That's a bad idea for two reasons. 

First, it ignores a growing body of analysis pointing to the need for significant innovation in wind, solar and other renewable energy technologies, rather than continuing to pay project developers indefinitely to deploy the current technologies.  It also exposes a basic logical flaw in the argument for more subsidies: Renewables cannot simultaneously be approaching the point of becoming competitive with conventional energy, as they must if they are to capture significant shares of the energy market--wind accounted for 3.5% of US net electricity generation last year, and solar just 0.1%--while still needing permanent subsidies at rates orders of magnitude higher, on an energy-equivalent basis, than the tax breaks for oil & gas that the administration seeks to end.

After four years in office, it's reasonable to expect an administration to have learned what works and what doesn't. The President and his officials seldom miss an opportunity to brag about the enviable record of oil and gas production growth that has occurred since 2008, yet continue to propose and enact policies that, had they been in place in the previous decade--when the seeds of this growth were actually planted in an environment of rapidly rising energy prices--might well have nipped that growth in the bud. Nor do they seem to have learned much from the track record of business failures that has dogged their efforts in the renewable energy and advanced vehicles space--a record that extends well beyond the over-used example of Solyndra.  Taxing oil and gas much harder won't lead to more US production, nor will handing investors additional billions in taxpayer funds make renewables and electric vehicles competitive, without significant further improvements in the technologies.

Secretary Chu Advised on "Prudent Development" of Oil and Gas

A news item concerning last week's release of the National Petroleum Council's "Prudent Development" report referred to a recommendation supporting a national tax on carbon. That caught my attention. Given the NPC's makeup, a consensus on such a controversial issue would be surprising. The actual text of the report proved somewhat less dramatic on the climate policy front, but no less worthwhile for its comprehensive assessment of the abundance of North American hydrocarbon resources, as well as the development approach "necessary for public trust, protection of health, safety and the environment, and access to resources." The report doesn't just focus on macro concerns about climate change and other environmental issues, but also on timely details such as the methane emissions, water and land-use impacts involved in shale gas production and other resource development.

For those not familiar with the NPC, the organization is charged with advising the Secretary of Energy on matters relating to oil and gas, though in practice it looks at a much broader array of energy issues. In 2007 I helped with the renewable energy analysis in the group's previous study, entitled "Hard Truths." The current study is one of two requested of the NPC by Secretary Chu; the other will look at future transportation fuels and is due out in the first half of next year. What makes these reports unusual is that they incorporate the views of academics, government officials, non-governmental organizations, and the legal and financial sectors, along with those of the energy industry. In the current study, just under half the participants represented oil and gas companies, while the Emissions and Carbon Regulation Subgroup included members from the National Resources Defense Council and US EPA, and the Environment and Regulatory Subgroup was chaired by someone from the Environmental Defense Fund. I think we'd all benefit from more such "strange bedfellows" collaborations.

The report's specific recommendation on carbon pricing as a mechanism for addressing greenhouse gas emissions appears in the Executive Summary and originates in an entire chapter on "Carbon and Other Emissions in the End-Use Sectors." Although it's much more generic than the Fuelfix article indicated, it's still noteworthy. It deals with the need to internalize emissions costs into fuel and technology choices, with a carbon tax mentioned as just one option among a range of measures for establishing an explicit or implicit price on carbon. It states,

"As Congress, the Administration, and relevant agencies consider energy policies, they should recognize that the most effective and efficient method to further reduce GHG emissions would be a mechanism for putting a price on carbon emissions that is national, economy-wide, market-based, visible, predictable, transparent, applicable to all sources of emissions, and part of an effective global framework."

It goes on to address non-market mechanisms such as performance standards and clean energy standards, and how a policy on carbon should be phased in. While individual oil and gas companies have supported cap and trade or a carbon tax either individually or within multi-industry groups, I can't recall such a broad cross-section of this industry going along with the idea of carbon pricing, even in this non-specific manner.

The timing of this is interesting. It's hard to envision a comprehensive climate bill passing the Congress between now and the November 2012 election, or even being introduced on anything other than a symbolic basis. The pork-laden monstrosity of the Waxman-Markey bill succeeded only in making cap and trade toxic, and I can't imagine a worse environment for introducing any kind of new tax--a price on carbon is clearly a tax--even if the concept behind cap and trade has a solid bipartisan pedigree. Short of the miraculous materialization of a carbon tax as a compromise revenue solution from the deficit-fighting Supercommittee, carbon pricing in the US looks dead until 2013 and possibly well beyond. I'm also starting to see more comments along the lines of this one from the blog of the Information Technology and Innovation Foundation suggesting that policies promoting innovation might be a lot more important in addressing climate change than any level of carbon pricing that could realistically be implemented here.

So whether you regard this recommendation by the NPC as an attempt to restart a stalled debate on carbon pricing, or merely a tardy entry in a formerly crowded field, I think it also signals that the energy industry isn't oblivious to the fact that its emissions--including the lion's share associated with end-user consumption of their products--must eventually be dealt with. Chances are, that will await a return to economic health and stability, when US consumers, voters and taxpayers might be expected to prove more willing to incur the sacrifices this will entail. The report also includes a good perspective on the considerable North American resource upside that could be unleashed with different policies than the ones now in place, and that might just hasten the arrival of more favorable economic conditions for carbon policy.

A Geothermal Bankruptcy

I just caught up with last week's bankruptcy filing by Raser Technologies, Inc., a small developer of geothermal power plants. Burdened with excessive debt, Raser is filing for Chapter 11 protection to restructure its liabilities and continue operating under new ownership. In the process the current shareholders will see their much-diminished equity wiped out. This outcome is further evidence of just how challenging it is for small, poorly capitalized companies to exploit what is arguably the best, most reliable renewable energy technology in the world, other than hydropower.

Raser's bankruptcy hardly comes as a surprise. The company has been highly leveraged for a long time, and investors were losing patience with the firm. Last year its stock price fell below the minimum listing requirements of the New York Stock Exchange, and it moved to the over-the-counter market, effectively becoming a "penny stock." In the year prior to delisting, Raser had lost more than 80% of its market capitalization, or about $100 million. With only one operating asset generating cash--a 10 MW plant in Utah built with the help of a $33 million renewable energy grant from the US Treasury--and a number of projects under development consuming cash, Raser was losing the race to bootstrap its way into profitability.

Why is it so hard for start-ups to succeed in this space? It's not an accident that the world's largest geothermal operators are mainly big, well-capitalized firms like Chevron, Calpine, or the Green Power spinoff from Italian utility Enel. (Disclosure: I am a Chevron shareholder.) Geothermal developers face some fundamental challenges that require financial flexibility to manage. First is the capital cost of the assets, compared to other power generation technologies. The last figures I saw suggested that the cost of new geothermal capacity per installed megawatt was up to twice that of a wind farm and 4x that of a natural gas turbine. One reason the cost is so high is that it includes a lot more than the above-ground generating hardware.

Geothermal reservoirs must first be discovered, assessed, and drilled. That's why I've long thought that this technology is a natural for oil and gas companies, since it involves many of the same core skills. Geothermal exploration introduces not just additional cost, compared to wind power development, but also a daunting array of risks, including the possibility that the resource won't turn out to be as large as expected, or that its geology won't permit commercially attractive flow rates of steam and/or hot water. In the worst case, this results in the equivalent of a "dry hole", but even if it merely reduces the amount of power a given well can generate, that has a significant impact on project economics that depend on producing power predictably and reliably for decades. In effect, geothermal has all the up-front risks of oil and gas exploration without the quick payoff of a successful oil or gas well.

Geothermal power provides clean energy production for the power grid on a nearly 24/7 basis, something that neither wind nor solar power can match without energy storage capabilities that remain prohibitively expensive today, in most cases. However, it is both capital-intensive and risky to develop. The handful of publicly traded geothermal companies left after Raser's Chapter 11 filing, including firms such as Ormat Technologies and Magma Energy Corp., are doing yeoman work. However, it's hard to envision geothermal energy achieving its full potential without much greater participation from much larger, better-capitalized firms that could pursue such opportunities on a completely different scale.

Deficits and Energy

After reading several articles about the administration's proposed 2011 fiscal-year budget, I decided to look through the figures myself. My primary interest was in finding indications of what might lie in store for energy-related taxes and incentives. However, once I noticed how the projected deficits accumulate and examined the assumptions behind them, it struck me that the larger concern for energy and everything else is whether this budget represents a reasonable and sustainable picture of our future national finances. The expected 10-year deficit for the 2009-2018 period appears to have grown by $1.5 trillion relative to last year's budget. And that's after counting roughly $2 T in newly-proposed spending reductions and tax increases, including higher taxes on the energy industry. Against that backdrop the extra few billion dollars for renewables and other favored energy technologies nearly get lost in the rounding.

As a veteran strategic planner, I started by examining the economic assumptions for the budget. While everyone hopes for a strong rebound that would boost tax revenues by moving millions of the un- and under-employed back onto the tax rolls, it seems overly optimistic to assume that on top of an expected 2.7% growth rate in real GDP for this year, real GDP growth would then average 4% per year from 2011-2015 (calendar years.) The last time we had a five-year growth spurt like that was in the late 1990s--thanks to the Tech Bubble--and prior to that in the late 1980s. Yet despite such strong projected growth and the addition of roughly $2 T in "savings" and new taxes, the Treasury would still need to borrow an additional $14 T over the next decade. Even less realistically, perhaps, given such robust growth and massive borrowing, the budget also assumes that consumer-price inflation will not rise above 2.1% for the next decade, while nominal interest rates go up only gradually, never averaging more than 5.3% for 10-year Treasuries.

All this suggests that the current budget might be merely a placeholder awaiting the recommendations of the proposed deficit-reduction commission, while generating a set of figures that just manages to keep the total federal debt level--Table S.14, not the same as the "debt held by the public" shown in summary table S-1--below around 106% of GDP. Of course, this hinges on achieving those higher tax revenues, some from growth and some from higher taxes, including the termination of the Bush tax cuts for "upper-income" Americans. Even if the Congress passed all the required tax legislation, which is not inconceivable since for the biggest portion they'd be voting for a tax cut for everyone except "upper-income" taxpayers, the chances of things turning out even this well seem low. If growth doesn't reach the projected levels and stay there for years, tax revenues will fall short, deficits will grow, and at some point interest rates will rise, requiring even bigger deficits to cover the cost of debt service that under this budget exceeds $800 billion a year by 2020.

Then there are the tax increases, starting with energy. The big difference vs. last year is the absence of $646 billion from cap & trade. Even if cap & trade is eventually enacted, it now seems likely that most of its proceeds would be rebated to taxpayers or spent on new energy programs, so it doesn't look like a way to close the budget gap. The proposed budget has roughly $3.6 billion per year in increased revenue from eliminating what the oil industry regards as appropriate tax benefits and the administration calls tax loopholes. Either way the budget would increase the cost of producing oil and gas in the US by around $0.60 per barrel of oil equivalent (BOE) after tax. While that won't break the industry, it also won't make US exploration and production any more attractive or competitive. In case you're wondering why we should care about that in light of our new emphasis on green energy, it turns out that the entire energy contribution of the record 10,000 MW of wind turbines installed in the US last year equates to about 100,000 BOE per day, the equivalent of one good-sized Gulf of Mexico oil platform or roughly 0.2% of our total energy consumption. We need more renewables and more conventional energy.

The budget also includes roughly three-quarters of a billion over 10 years in new fees on "non-producing oil and gas leases." Grounded in the mistaken notion of "idle leases," this was ill-advised last year and remains so, not just because oil companies don't bid on leases to take them off the market and keep them idle--they already pay rentals on any leases that aren't producing, which revert to the government after 10 years--but because adding these fees will merely reduce the up-front bonuses companies would be willing to bid to get them in the first place. As a result, the net revenue from this item ought to be zero.

Of course in terms of total revenue all of this pales in comparison to what the administration expects to collect from upper-income Americans, who seem unlikely to get any more sympathy than the oil companies. (Ironically this segment probably includes the bulk of the potential early buyers for the advanced technology vehicles that the government is lending or granting carmakers billions to produce.) The budget includes about $700 billion of additional revenue over 10 years from reversion to the pre-2001 tax rates for this group, along with some less obvious increases involving phaseouts of itemized deductions and exemptions and the treatment of deductions for those in the new 39.6% federal bracket as though they were incurred in the 28% tax bracket. Together these features would impose effective marginal tax rates much higher than that notional 40% on the folks at the bottom of the new bracket, creating a heck of a disincentive on earning a little more once you're near that threshold. But aside from making additional work or investment unrewarding for those unlucky enough to qualify narrowly for this bracket, this approach increases our collective reliance on this group to fund our government. These folks were already paying 86.3% of the federal income tax before these increases, and that share would go up under this budget. I wouldn't call that either reform or a sound basis for responsible democracy.

What we're left with, then, is a federal budget that even under a rosy set of assumptions expands the cumulative deficit and total US indebtedness into a range that greatly multiplies the large-scale uncertainties we face, while making minimal cuts to spending and increasing taxes only on unpopular corporations and upper-income Americans. Unfortunately, this scenario doesn't look conducive to generating the enormous private investments in new energy technology and infrastructure that will be necessary and that the government can't afford to make, particularly as mounting debt constrains its freedom of action. We seem to be stuck in a zone in which the only real solutions are unpopular, while most of the ideas that are popular wouldn't be real solutions.

Petro Profits

This energy crisis has given rise to a new American ritual: every quarter, after ExxonMobil's earnings are announced, the media breaks them down into dollars per hour, minute and second, and then cues to reaction shots of consumers expressing outrage that any company should benefit so much from their pain at the gas pump. Although I'm not suggesting we should all feel warm and cozy about oil company profits, we might be better served to focus our fulminating on the dog that doesn't bark. If the largest US oil company produces only 3% of the world's oil and still made nearly $12 billion last quarter, what did the national oil companies that own most of the world's oil make, and who paid for that?

Considering the average price of oil in the 2nd quarter, no one should be surprised that Exxon had stellar results, in spite of earning 54% less on refining and marketing and a third less on chemicals than they did last year at the same time. Allocated over the 26 billion gallons of petroleum products they sold around the world in the quarter, these profits equate to an average of 45¢ per gallon, with 87% coming from finding and producing the oil that went into making those products. It's not unreasonable for consumers paying roughly $4 per gallon to grouse about that, though it does say something about our current national mood that the media chooses to highlight that reaction, rather than someone seeing the results enjoyed by Exxon's shareholders and wanting a piece of the action, no matter how small. But whatever the US oil companies, including Chevron, ConocoPhillips, Marathon, and numerous others make, at least most of their profits get recycled into the US economy, in the form of new investments and the savings and spending of the millions of us who collect their dividends, directly or indirectly. The same can't be said for the profits of Saudi Aramco, the National Iranian Oil Co. (NIOC), Kuwait Petroleum Co., PdVSA, Rosneft, and so on.

Consider NIOC, the second-largest producer among national oil companies, at 4.15 million barrels per day, about 60% of which is exported. Iran is a relatively low-cost producer, though probably not as low as Saudi Arabia. If their total costs per barrel averaged more than $15 per barrel, I'd be surprised. So at an average price for Iranian Heavy for 2Q08 of $113.85/bbl., that works out to a quarterly gross profit just on exports in the neighborhood of $22 billion, excluding NIOC's earnings from domestic sales, refining and its substantial production of natural gas. Those might add another $10 billion to the total. Lop off a billion or so for overhead, and NIOC is probably reporting to its sole shareholder second-quarter results north of $30 billion. That'll buy a few centrifuges.

So go ahead and grumble about big US oil companies making record profits, while we pay near-record prices at the pump. But don't forget that we import 12 million barrels per day of oil and petroleum products, for which each and every quarter we must send roughly $135 billion outside the country, at current prices. Mr. Pickens is right to bemoan this enormous and unsustainable transfer of wealth. In that context, a smart national energy policy would not bog down in trying to choose among expanded drilling, conservation, and renewable energy, as though these were mutually exclusive options; it would pursue all of them, vigorously, and without vilifying companies for wanting to produce more energy here in the US.

Ending Oil's Monopoly

In yesterday's Financial Times (subscription required for full text) Daniel Yergin suggested that the current oil price spike is creating a historical "break point" for petroleum that will result in the loss of oil's dominance in the global transportation fuels market. The commentary by Mr. Yergin, the Chairman of Cambridge Energy Research Associates articulated a shift that has become increasingly apparent to careful observers of the industry. His conclusion that oil will "share the transport market with other sources as never before" is almost certainly correct, even if oil prices were to revert to $60 per barrel next week. There is an important corollary to Mr. Yergin's analysis that he didn't explore in his FT op-ed: At the same time that gasoline and diesel will have to share the market with other fuels, the primary sources of transportation energy will also become much more diverse, as well. That has important implications for both national energy policy and corporate strategies.

Consider the supply chain for petroleum products. Oil is extracted from underground reservoirs and transported to refineries that separate it into its familiar product categories, while transforming low value portions of the barrel into high-quality fuels and removing sulfur and other impurities along the way. A modern refinery is a complex, expensive set of hardware, but its functions would still be recognizable to an oilman from the 1930s. Even ethanol has retained this model, with corn going in one end of an ethanol plant and ethanol and its byproducts coming out the other end. The new transportation energy market that Mr. Yergin hints at will shatter this model. Oil and its products--and corn and its fuel products--will play an important role for decades to come, but they will compete with synthetic diesel and jet fuel from natural gas, coal and biomass; biodiesel, ethanol and other alcohols from a wide variety of feedstocks and technologies; and electricity and hydrogen from a multitude of conventional and renewable sources, both centralized and distributed.

This new model will break three effective monopolies: of spark-ignition and compression-ignition internal combustion engines, of gasoline and diesel fuel as the dominant energy carriers for delivering transportation energy--and note that ethanol has so far only piggy-backed on gasoline's monopoly, rather than breaking it--and of petroleum as the source of primary energy for most forms of transportation. While the market shares of all three of these monopolies are in the high 90%'s today, the signposts of change are all around us. Biotechnology promises to break down the cellulosic material that gives plants their rigid structure and turn it into ethanol and other fuels, but it could eventually give us plants that excrete market-ready fuels. Better batteries will give consumers the choice between plugging in and filling up, but they could also facilitate the much wider adoption of renewable electricity from intermittent sources such as wind and solar power. And fuel cells running on hydrogen might yet provide a practical and more efficient way to turn chemical energy into useful work onboard the vehicle, powering electric motors that will become increasingly ubiquitous on all ground vehicles.

A decade ago, this scenario was just that, one possible future outcome of a number of competing trends and uncertainties. Now, thanks to the combination of concerns about climate change and energy security, and the practical problems of $130 oil, some version of it seems more plausible than the unchallenged continuation of those three "natural monopolies" for another generation. Whatever its other faults, the "farm bill" just passed by the Congress over the President's veto takes a step in that direction, by reducing the subsidy for corn ethanol, the so-called Blenders' Credit, from $0.51 per gallon to $0.45 and using the savings to fund a $1.01/gal. direct subsidy for producers of cellulosic biofuel.

As Mr. Yergin points out, oil "is not going to fade away soon." It will take time to turn over car fleets and move new fuel processes out of the laboratory, through demonstration-scale testing, and into full commercial production. But as frustrating as the wait for these new technologies and fuels may seem, while Americans pay $4 at the pump and Europeans pay the equivalent of $8 per gallon, this energy crisis--unlike the one of the 1970s and early 1980s--might just put in place the means of averting all foreseeable future energy crises centered on oil, by reducing the status of oil producers to that of merely one transportation energy source among many.

Big Oil and Renewable Energy

After watching nearly three hours of yesterday's Congressional hearing on gas prices, I'm torn between my desire to emphasize the few positive aspects of the meeting or the serious contradictions it revealed. Let's start with the latter and try to end on a more uplifting note. The most obvious disconnect relates to the implicit and probably erroneous assumption by the chairman and many members of the House Select Committee on Energy Independence and Global Warming that lower fuel prices are actually consistent with either of the principal aims of the committee's charter. But while high gasoline prices provided the subtext, most of the discussion-- including Chairman Markey's Puritan-style shaming of ExxonMobil for its lack of investment in alternative energy--revolved around the tension between the need to continue providing conventional energy, while renewable energy ramps up. That was exemplified by Rep. Walden's important question, "How do we do both?"

In his remarks, Rep. Markey (D-MA) issued a challenge to oil companies to invest 10% of their profits in renewable energy, with the veiled threat that if they didn't, then losing $18 billion per year in tax benefits might not be the worst outcome they face. Absent from this exhortation, however, was any recognition that some forms of renewable energy are not as beneficial as others, either in terms of reducing greenhouse gas emissions or in making a substantially positive net contribution to the country's energy balance. The committee seemed to be saying that biofuels are the obvious answer, and that any oil company not investing large sums in them is cheating consumers. While that might provide useful soundbites for some House Members' reelection campaigns this fall, this line of argument has largely been superseded by events.

Although the net impact of renewable energy remains modest, compared to the energy we derive from fossil fuels, the recent dramatic growth of biofuels has positioned them as a key element of current and future liquid fuel volumes, which no industry supply and demand forecast can afford to ignore. With one exception, the companies whose executives testified yesterday are already significant participants in this sector, with investments in biofuel production, next-generation biofuel R&D, and, as a result of fuel specifications and renewable fuel mandates, as some of the largest blenders of biofuels in the world. It remains to be seen, however, whether any of these companies will ultimately come out on top in the renewable energy marketplace, which is dominated by a host of new entrants. This is a classic case of the Innovator's Dilemma, with the major oil companies' renewable energy businesses having to compete for financial and human resources and management attention with the giant upstream and refining segments that are still the engines of oil company economic value, and will be for years to come.

When asked their highest priorities for addressing today's high energy prices and our reliance on imported oil--a situation that Chevron's Vice Chairman, Peter Robertson, characterized as "unsustainable"--all of the execs cited the urgent need for gaining access to oil and gas resources that the Congress and various states have placed off limits. (Disclosure: I own Chevron stock.) The execs stopped just short of saying that, if the Congress is serious about bringing down energy prices, it could have the largest impact by opening up the 85% of the outer continental shelf waters that are presently off-limits for drilling, rather than hammering on oil companies to invest in renewables. That is certainly born out by the size of the potential offshore opportunity, which could easily add another 1-2 million barrels per day to slipping US oil production, and by the enormous differences in physical and financial scale between conventional and renewable energy projects. ExxonMobil isn't wrong to suggest it can make more impact by sticking to its knitting in this regard, though I continue to believe they will eventually regret not taking a position in renewables now--a defensible strategic choice that has been a PR disaster for them.

The financial realities of this were explained in greater detail by Mr. Robertson in a blogger teleconference (podcast and transcript available shortly) following the hearing, arranged by API, in which he cited 40 global oil and gas projects in which Chevron is engaged globally, each greater than a billion dollars, Chevron's share, and each expected to provide substantial, profitable production. At the current scale of renewables, there are still relatively few billion-dollar projects of the kind that companies of this size must pursue, in order to have a measurable impact on their results and on shareholder value. It is still uncertain whether the billions that companies such as Shell, Chevron, ConocoPhillips and BP are investing in renewables will yield results on that scale.

I also noticed a surprising omission in yesterday's proceedings. While both the committee and the witnesses mentioned the enormous potential of Canada's oil sands for reducing US dependence on unstable overseas suppliers, the prospect that imports of oil sands syncrude might be blocked by US environmental regulations was only referenced obliquely by Mr. Simon of ExxonMobil. As I noted recently, this issue could have severe supply repercussions in the Midwest, where much of the Canadian oil we import is consumed, as well as for the overall US oil import mix. I'd call that a key missed opportunity on the part of the companies.

So with the committee telling the oil companies to help consumers by investing in renewables, and the oil execs asking Congress to help consumers by lifting restrictions on off-limits oil and gas resources, what was constructive? Well, there was a very encouraging discussion about energy efficiency and its vital contribution to reducing emissions and saving money. This is surely common ground on which the industry and government could cooperate more. The companies also heard some sage advice from Rep. Candice Miller (R-MI) that, regardless of the economic justification of their profits and prices, they face significant consumer and regulatory backlash if they aren't seen to "do the right thing with these profits." I think they ignore that at their peril and ours, because the likely regulatory response would harm the industry and be counterproductive for the entire country. Perhaps most revealingly, though, and in sharp contrast to a similar hearing involving the CEOs of these companies several years ago--and to an entirely out-of-context clip from yesterday's event that aired on last night's NBC Evening News--there was little disagreement about the fundamental drivers of high oil prices, and the degree to which the US is integrated into global energy markets. In that respect, at least, our national conversation about energy has progressed in useful ways since 2005.

The Tax Debate

It's not unusual for politics to focus more on perceptions than reality, but there are few areas in which those perceptions are more divorced from fact than on the subject of taxes, and that is particularly true in this election cycle. Various candidates propose tax cuts, the repeal of tax cuts, a "fair tax", and other options affecting taxation, but few of them begin by describing the magnitude of current taxation, its allocation between individuals and corporations, and the relative tax rates paid by these different segments. The resulting distortions are especially glaring when it comes to the taxes paid by the energy industry.

The debate over whether to tax the oil industry to fund subsidies for alternative energy and energy efficiency is a small aspect of the larger discussion over the appropriate level of taxation on businesses and individuals. The argument to withdraw certain tax benefits from the highly-profitable US oil industry is founded on the perception that the oil industry is under-taxed, violating Americans' sense of fairness. While it is indisputable that the domestic oil and gas industry has been making money hand over fist, the perception that it pays less tax than other industries is not only false but entirely contradicted by the government's own data in this regard.

The income tax on individuals raises about $1 Trillion annually, three times the amount collected from taxing corporate income. According to the Energy Information Agency of the Department of Energy, in 2006 the 29 companies included in its Financial Reporting System paid $90 billion in income tax--or 25% of all US corporate income tax receipts--on pre-tax income after adjustments of $222 billion. That yielded an effective tax rate of 40.7% before counting the $8 billion in production and other taxes they paid. This group of companies, which includes ExxonMobil, Chevron, ConocoPhillips, Valero, Tesoro and the US operations of BP and Shell, had combined revenues of $1.4 Trillion and accounted for about half of US oil and gas production and 80% of refining. By comparison, the effective tax rate on all US manufacturing companies was 22%. In other words, the oil and gas industry is already taxed about twice as heavily as all US industry.

It shouldn't surprise us that our perceptions about the tax burden on the energy industry are wrong, because commonly-heard assertions about the relative income taxation of individuals turn out to be equally flawed. In contrast to our sense that this burden falls mainly on middle-class Americans, the most recent data from the Congressional Budget Office show that the 2nd, 3rd and 4th quintiles of households by income, roughly corresponding to lower-middle, middle, and upper-middle income Americans, together earned 41.6% of all income and paid 16.6% of federal personal income tax liabilities in 2005, while the top 20% earned 55.1% of income and paid 86.3% of the personal income tax. The lowest quintile actually received a net credit. Nor is it true that this allocation has become less fair over time. Since 1980, the share of the income tax collected from the middle class has fallen by half, from 35%, and the load carried by the top quintile has increased by a third.

Now, it's possible to evaluate these figures and conclude that oil companies and wealthy individuals should pay out an even higher fraction of their incomes in taxes. The US still has a substantial budget deficit, and the likelihood of reducing expenditures by enough to close that gap seems low, when entitlements, defense spending and interest on the national debt account for most of the federal budget. But we need to understand that raising those taxes will have consequences, too. Energy companies already pay double the effective tax rate of all manufacturers, and raising their taxes will make them less competitive with other sectors of the economy, and with foreign firms, at a time when we claim to place a high premium on energy security.

We must also be realistic about how close alternatives and efficiency really are to being able to displace our oil imports. Domestic oil and gas still account for 45% of US energy production--eight times the contribution of the rapidly-growing non-hydroelectric renewable energy sector. Doubling our ethanol output over the next decade will only replace 3% of our net petroleum imports. In that light, penalizing our largest domestic energy sources to support our smallest, and basing the argument on a fundamental misunderstanding of how the country's tax burden is apportioned, seems unlikely to advance the cause of energy independence.

Oil's Geothermal Opportunity

Reading a recent article about the expansion of California's geothermal power capacity at the Geysers, northeast of San Francisco, I was again struck by how little geothermal energy resembles higher-profile, intermittent renewable sources such as wind and solar power, and how similar it is to the development and lifecycle management of large oil fields. That extends to dealing with a problem that wind and solar never face: although the wind will blow and the sun shine long after the last human is around to observe them, the type of geothermal reservoirs that we have successfully tapped gradually deplete, as their stored energy is carried away and their natural pressure declines--not unlike an oil or gas field. When you consider all the similarities, it is remarkable that more oil companies have not embraced this technology as the nearest alternative to their core business of finding hydrocarbons underground and bringing them to the surface.

Although I grew up less than 200 miles from the Geysers, I was surprised to see that in 2006 the field supplied almost 5% of California's electricity--more than wind and solar power combined--and it did so around the clock, operating in either baseload or load-following modes that wind and solar can't emulate without expensive energy storage. At the same time, despite significant investment in recent years, the area now produces about a quarter less power than it did at its peak a generation ago, because of the loss of steam pressure in the main reservoirs in contact with the hot rocks. A major project to recharge the water supply of the field recently restored about 10% of its generating capacity, and the new drilling and additional turbines described in the San Jose Mercury News article will increase that further, though with a finite, depleting life.

Geothermal is a natural fit for oil companies, because it capitalizes on existing oil and gas skills such as 3-D seismic interpretation, horizontal and directional drilling, reservoir management, and the extensive experience some companies have gained in reservoir heat management, which is a key aspect of enhanced oil recovery, ultra-heavy oil production, and in-situ oilsands development. The business model of a geothermal field, with its large up-front investment and gradually declining output--boosted at later stages by enhanced recovery projects--looks nearly identical to the established oil and gas model, with two exceptions, both of which make oil companies nervous. The market for the electrons it produces is quite different from those for oil and gas, and its economics are subject to the vagaries of government incentives, such as the renewable energy Production Tax Credit.

Of the large international oil companies, only Chevron (in which I own stock) seems to have a significant focus on geothermal energy, and much of that was inherited with its acquisition of Texaco, my former employer, and later Unocal. According to their corporate website, Chevron operates geothermal plants in Indonesia and Thailand generating a combined 1273 MW of power. As big as that is in geothermal terms, it only equates to about 5% of the company's daily production of natural gas. That proportion isn't limited by the size of the available geothermal resources, even in the US, but by the historically lower profitability of geothermal power, compared to upstream oil and gas projects. As access to new hydrocarbon reserves becomes increasingly constrained by geopolitics and other factors, and as legislation puts a higher premium on low-emissions energy sources, the relative attractiveness of geothermal opportunities should increase for all of these firms.

Replacing Human Reserves

If I had a quarter for every time someone at my former company said, "People are our most important resource," I could retire now. And when confronted with the unsavory nature of many of the governments with which oil companies must routinely deal, how many of us have replied, "You have to go where the resources are"? An article in Monday's Wall Street Journal section on the environment describes the human resource challenges of the oil industry in a way that puts those two clichés into an entirely different context, in terms of how potential employees view the future prospects for alternative energy and a transition away from oil. This issue ought to prompt oil companies that have resisted investments in renewables and other new energy technologies to rethink their "cleantech" strategy.

Oil and gas companies are enjoying a run of extraordinary profitability. The mounting attacks from the Congress on "windfall profits" are as good an indication as any that these are truly boom times for oil firms. But many of these same companies contain within them a sort of demographic I.E.D., as the big bulge of employees in their 40s and 50s moves ever closer to retirement. Replacing those reserves might be even more important than replacing the hydrocarbon reserves they consume annually, if these companies are to continue serving the energy needs of their customers, and the financial needs of their shareholders. As the Journal describes, the ability to hire enough first-class talent to tackle the technological, environmental and economic challenges ahead may depend less on corporate salary and benefit policies than on the public's perception of the business in which these companies engage.

In the late 1990s, my former employer, Texaco, rolled out a new advertising campaign called, "A World of Energy." It was built on the premise that we were transforming from an oil company into a broader "energy company." BP has endeavored to convey the same message in its "Beyond Petroleum" rebranding. Such efforts have been criticized as being either cynical or entirely aspirational, rather than reflecting a serious portfolio realignment. I've seen BP advertising touting their revenues from non-traditional energy, but noted that they include natural gas--generally not regarded as a form of alternative energy--to make the numbers sufficiently impressive. However, they might doing this for reasons having little to do with boosting sales or the current bottom line.

Now, you could view the efforts of companies like BP, Shell, Chevron and ConocoPhillips to branch out into wind, solar and biofuels as the early stages of diversification into the types of energy that must someday replace oil & gas, or you may regard these steps as having a large PR component. Both views are probably correct, today. But I would argue that these companies are also beginning to react to the feedback from their college recruiting efforts. Several former colleagues that still do this have told me that new engineering graduates mainly want to hear what the company is doing in renewables or new energy technology, rather than deepwater drilling or enhanced recovery. The thinner the new energy story, the less likely you are to attract the top graduates.

One of the largest oil companies in the world, ExxonMobil, has stated that it won't invest in alternative energy project until it is profitable to do so. If you're the biggest and most profitable publicly-traded firm in the sector, you can probably follow that strategy without drying up your sources of new technical talent, or having your experienced scientists and engineers lured away by cleantech startups. Or perhaps Exxon's partnership with Stanford University sends the necessary signal to new graduates interested in cleantech, but desiring the stability and benefits that Exxon can offer. While these attributes may carry Exxon through this looming HR challenge, there's no other company in the industry that can be assured of winning the same bet. Rapidly growing renewable energy companies could alter the market for the industry's human resources faster and more profoundly than they affect the market for its products. That's an implication that many of these firms haven't anticipated.


Don't forget today's webinar on "Fuels for Now and the Future", hosted by Cleantech Collective. For more information and to register for the webcast, which is scheduled for 2:00 PM EDT, please follow this link.