Deploying Extra Power for Japan

Just over two weeks after the earthquake near Sendai in northeastern Japan, which I'm increasingly seeing referred to as the "Great Tohoku Earthquake", the impact of the resulting disruption to various supply chains is being felt around the world. From car factories in Europe that rely on Japanese electronic components to producers of flat-panel displays and solar cells, several industries are feeling the pinch. This appears to be due more to the reduction in Japan's electricity-generation capacity than from actual damage to factories in the zone most affected by the disaster. With more power plants than just the troubled Fukushima Daiichi nuclear complex affected, the scale and potential duration of electricity shortages could result in a significant increase in the demand for smaller-scale generation, both conventional and renewable.

As reported in today's Wall St. Journal, the electricity shortfall resulting from the quake and tsunami is severe and affects both consumers and businesses. The Japanese government is exploring a number of emergency measures to mitigate the problem, including increasing electricity prices, instituting Daylight Savings Time, and calling on customers to conserve power. At the same time, the government appears to understand that Japan's scope for large-scale energy-efficiency improvements is limited. With an energy intensity in BTUs per dollar of GDP already 37% lower than that of the US, only the UK among large developed countries is more efficient. Efficiency and conservation will be helpful, but they can't cover the massive shortfall Japan faces now.

One of the most detailed analyses of the impact of the quake and tsunami on Japan's electricity sector that I've seen so far suggests that as much as 15,000 MW of generating capacity in the Tokyo/Tohoku region is offline and likely to remain so for durations ranging from a few months to several years--or permanently, in the case of most of the reactors at Fukushima Daiichi. This is something like 20% of the pre-quake generating capacity of the two main utilities serving the region, not counting the pumped-hydro storage capacity used for meeting peak demand. As a result, that part of Japan is experiencing an electricity deficit that will likely grow as the summer peak demand months approach, and that could persist even after the least-damaged facilities return to service. Nor can surplus power from southern Japan provide much assistance, because the northern and southern systems are relatively isolated from each other, with limited interconnections, and run on different frequencies--60 cycles for the south and 50 cycles for the north. Back-up and distributed generation appears to be the only real alternative to a protracted economic slowdown caused by insufficient electricity for Japan's businesses and industries.

We've seen this pattern before, if from different and less-catastrophic causes. In the early 1990s the Philippine grid was chronically unreliable, and many businesses bought or leased diesel generators to fill the gap, including barge-mounted units that could be brought in quickly and moved around coastlines and rivers as demand shifted. More recently, diesel demand in China increased substantially in the lead-up to the 2008 Summer Olympics, as the central government idled large, dirty power plants in order to reduce air pollution, and a number of factories chose to generate their own power, rather than shutting down.

For Japanese factories and other businesses facing the same dilemma, cost is unlikely to be the major factor in deciding whether or not to become more energy self-sufficient. Factory managers can often justify paying a lot more for power if their only other option is to slow production or shut down. They have several choices available, including some renewable power options, and I expect to see a surge in solar power installations. However, that's probably a better medium-term rather than short-term option, not just because the entire world didn't install enough solar panels last year to make up for the lost output of the Japanese nuclear plants, but because while solar can help with supply, it can't provide the reliability that is crucial right now. That makes diesel generation the leading contender to backstop Japan's idled power plants in the short term.

I can't speak to the availability of diesel generators, although I can easily envision suppliers and leasing agents scrambling to meet frantic Japanese orders. However, if enough generators are available to cover even 3,000 MW of the shortfall, running just half the time, they would require around 65,000 barrels per day of incremental diesel fuel, or roughly the entire diesel output of a medium-sized refinery. Whether that represented an increase in overall Japanese diesel consumption requiring additional imports would depend on the extent of the other economic consequences of the Tohoku disaster, and on when Japan's refineries return to normal operations.

So the use of diesel generators to make up for damaged or otherwise unavailable generating capacity in Japan could provide another modest boost to global oil demand, which already appears to have exceeded the record level set prior to the recession and financial crisis. And since much of that increased demand is for diesel, rather than gasoline, the impact of Japanese generation needs could affect diesel prices disproportionally. As a result, consumers around the world could see diesel prices rise, as the ripples from the events in Japan spread.

Energy in the Aftermath of the Sendai Quake

Investors and companies around the world are scrambling to assess the impact of the Sendai earthquake and tsunami on supply chains and markets, both within Japan and globally, between the direct damage from the event and the disruption to critical infrastructure in its aftermath. An item I spotted in this morning's Wall St. Journal provided an early clue concerning the potential ripple effects in global energy markets, as Chevron sold a cargo of Indonesian crude to a power customer south of Tokyo. However, it remains to be seen whether demand destruction or the impairment of supply capabilities will dominate over the short, medium and longer-term recovery periods.

The impact on the Japanese power grid extends beyond the shutdown of 9,702 MW of nuclear power capacity, including 2,812 MW at Fukushima Daiichi that will not resume operations for many years, if ever. Some fossil fuel power plants have also shut down, and more than a fourth of the country's refining capacity is down, cutting off a significant supply of power plant fuel oil, along with a wide range of other petroleum products. That helps explain the interest in light, sweet Indonesian crude that can be burned directly in power plants as a replacement for low-sulfur fuel oil. Significant quantities of Indonesian Minas crude formerly came to the US west coast for a similar purpose, when we still had a lot of oil-fired power generation, although the crude was normally processed to remove the valuable light products from the fuel oil before sale to utilities. (My first job in the industry was at a refinery that did just that as part of a contract Texaco had with a southern California utility.)

Burning crude oil for power is a practical stop-gap, and as long as so many of Japan's refineries remain shut for damage assessment and repair, it shouldn't have much impact on the global crude market, since the crude those refineries would have otherwise run is now surplus. That explains the $5 per barrel drop in crude prices this week. However, if demand recovers faster than Japanese refinery capacity returns to operation, much of that extra crude oil will need to be processed in refineries elsewhere around the Asia-Pacific region, to provide the refined product imports that Japan will need.

It's much harder to assess the medium-term situation, because it will be some time before the full extent of the damage to industry, power generation and transportation is known. If more demand was destroyed than the capacity to supply it, then Japan could actually end up with surplus energy capacity until demand recovers, and that would be a bearish factor in global energy markets. If more energy supply than demand was destroyed, as seems possible given the largely agrarian nature of the part of Japan that suffered the worst consequences of the quake and tsunami, then Japan could be importing additional supplies of energy from regional sources for a long time.

I've had several people ask me about the potential of these events to increase Japan's demand for renewable energy, and I think that's a likely outcome. As of the end of 2009 Japan already had the world's third-largest installed solar power capacity at 2,600 MW, to which another 1,000 MW or so was apparently added last year. For Japanese businesses suffering from rolling brownouts, solar power is one of their few options other than diesel generators for becoming more self-sufficient fairly quickly. However, at the scale of the grid, intermittent solar isn't a great substitute for 24/7 nuclear power. With Japan's average solar insolation, it would take about 5,000 MW of solar panels to replace the annual output of a just one of the Fukushima Daiichi reactors (#2, 3 or 4) at an installed cost in the neighborhood of more than $20 billion. That might give a welcome shot in the arm to photovoltaic manufacturers that are still expanding rapidly but have been overly-dependent on faltering European solar incentives. I don't know enough about the Japanese grid to know how easily they could adjust to such a shift from centralized, baseload power to distributed, cyclical generation.

The long-term outcome seems impossible to gauge at this point, and I hesitate to even speculate while the engineers are still working to cool down the damaged nuclear plants. (The American Nuclear Society has a useful site with updates and background on the Japanese reactors.) Much depends on how well Japan's nuclear industry will be seen to have responded to these incidents. Unless these facilities are either rebuilt or replaced with new, next-generation nuclear plants, then Japan's imports of LNG, coal and other fuels could increase significantly, until and unless renewables ramped up enough to make up the difference. Japan is already the world's largest importer of LNG, and it is perfectly situated to absorb the output of the new LNG plants planned for Australia. That could boost global LNG prices for years to come.

Disclosure: My portfolio includes investment in Chevron, which is mentioned above and owns projects and facilities that could be affected by these events.