Savings vs. Withdrawals
Many politicians are calling for changes to the Administration’s policy of continuing to fill the nation’s Strategic Petroleum Reserve (SPR), aimed at reaching a level of 700 million barrels by next year. Some are suggesting that oil be released from the reserve to put downward pressure on prices, while others, including Senator Kerry, are asking for a suspension of additions to the reserve. These two alternatives have very different ramifications.

First, in terms of the efficacy of SPR sales in dampening the market, the New York Times correctly cited the poor results achieved in past experiments of this type. There is little chance of better results today, given the very high utilization rate of US refineries. (96% based on the most recent data.) This means there are essentially no refineries that lack crude oil from which to make gasoline. The best-case result of a release might thus be to back out some deliveries of high-sulfur crude, replacing it with “sweeter” SPR crude, and improving refinery yields slightly. This would provide scant relief at the gas pump, which is the real issue for consumers, since they can’t burn crude oil in their cars.

More fundamentally, there’s a real problem with releasing SPR oil now. As most market commentators have noted--echoed in my blog yesterday--we are not in a crisis of disrupted oil supply, for which the SPR is intended. The chance of such a crisis is higher than normal now, as the current risk premium on oil attests. It is not prudent to release SPR oil unless and until we are in a real crisis, in which case we will need every drop and 659 million barrels will seem like a very modest emergency stock. This total is equivalent to only about 150 days’ shipments at the maximum SPR output rate.

Turning to the idea of halting additions to the reserve, my reaction in February (see posts of 2/17 and 2/18) was that it would make no real difference, since the SPR fill comprises only a tiny fraction of global demand. With oil prices over $40 today, I see things differently. The volume may still be miniscule, but a change in this policy could stimulate a change in market psychology, and that could be significant.

Rather than being based on detailed assessments of the chance of a disruption of shipments from Saudi Arabia or other key Middle East suppliers, a portion of the current risk premium on oil comes from traders assuming that the government’s actions in the market validate their own views of those risks. In other words, if the government is “going long”, so should I, because they have access to secret information that I don’t.

Taking a breather on additions until prices return to a more normal level would force market players to reassess their positions, and this might have a disproportionate impact on the market. That could be very helpful, and the foregone additions would make little difference in the country’s preparedness for a real crisis. It would also show that the Administration can be flexible in its responses, rather than simply continuing on a path that has become counterproductive.

By the way, there's an email chain letter circulating, trying to organize today as "Stick It To Them Day", a national gasoline boycott. This sort of thing would only harm the tens of thousands of independent businesspeople who own and operate most of the gas stations in the country, without sending any kind of signal to the global markets, unless people actually stop driving their cars, too.

Focus on Prices
It's hard to pick up a newspaper or turn on the TV news without seeing something about oil prices or gasoline prices. The NY Times Sunday edition had no less than three major articles, including this on the front page and a nice analysis of Saudi motivations in the Week in Review section. I liked the title of yesterday's Financial Times Online piece, "A new spike in prices raises fears for the world economy. But this is not the next great oil shock at least, not yet."

The FT goes into some detail on the causes of the current tight market, relating to higher-than-expected demand growth in the US and China, as well as concerns about Middle East security. Although it is a fine article, as far as it goes, I think it's also fair to say that what we are seeing today could be a dress rehearsal for a more serious situation down the road, relating to serious systemic supply constraints that I've discussed at length elsewhere in my blog. (See the posting of February 12, in particular.) Because whatever cause or set of causes to which the current conditions are attributed, I have yet to run across anyone suggesting that prices are high because the oil is simply not there.

True, production capacity has been stretched near the limit, with all the spare capacity in places that seem shaky for other reasons, but there is a clear sense that the overall global supply can grow from here to meet market demand, even if it takes a year or two to do it. That might not always be true, for reasons of access, inadequate investment, or actual geology.

As I said last week, I am fairly optimistic that the current prices will fall over the next four to five months, probably back to $30 or so. And it's not that hard to imagine that in a couple of years we could be back to $25 or less. Just look at the history of oil prices. In fact, I saw a quote over the weekend that made me much more confident in that view, with T. Boone Pickens proclaiming that "oil prices will never again fall below $30 a barrel." Statements like this, no matter how credible the source, are invariably wrong, and I love to bet against them.

But whether prices fall back soon or not is less important than the realization that there is a reasonable risk of a similar future crisis from which prices will not fall back, until we have made the enormous investments necessary to drastically reduce our dependence on oil. For that reason, it might just make sense to start now to adjust our habits accordingly.

By the way, my postings may be a bit spotty this week, as I'll be traveling on business.

The LNG Disaster Movie

The front page of last Friday's Wall St. Journal and the first page of the NY Times Business section both featured articles on the obstacles companies face in attempting to build LNG import terminals around the country. The Times article included a nice graphic showing where the proposed terminals would be, and what their current status is. Seven have already been cancelled in the face of public opposition.

I find two things remarkable about all this. The first is that these projects would face such overwhelming opposition at a time of genuine energy insecurity, and with crude oil at record high nominal prices. Domestic natural gas commands a price equivalent to the high crude price, and since this doesn't seem to be stimulating much new production, the only alternative is to increase imports.

If you've been reading my blog for a while, you know I don't consider LNG to be quite the panacea that some claim, but it is certainly part of the answer--a big part as long as we insist on steadily increasing our gas demand while holding discovered US gas reserves off the market for environmental reasons. (See my blog of March 11.)

The other remarkable feature of this situation is the degree of fear being instilled by those opposed to the LNG terminals. Although I don't fault communities for wanting a say in the kind of industrial facilities that will be in close proximity to them, those discussions should still be based on fact and not wild ravings. The Wall Street Journal cited one LNG opponent who claimed that the destructive potential of an LNG tanker was equivalent to 55 Hiroshima bombs (see analysis below). This reflects an irrational fear, bolstered by junk science. It's hard to argue with, but we cannot base the nation's energy policies on paranoia.

Many have picked up on the explosion at the LNG plant in Skikda, Algeria (see my blog of January 21) as evidence of the risks of handling LNG, but even if that were a fair comparison--and there are good reasons why it is not--it is actually a pretty good illustration that the risks are similar to those associated with many kinds of industrial facilities and not orders of magnitude greater, as activists assert.

Having recently seen prosaic and trusted objects turned into deadly weapons, it is natural to worry a bit more about LNG than we might have a few years ago. Every LNG tanker--along with every crude oil or gasoline tanker, tank truck, or rail car--has the potential for destructive misuse. Yet we have not grounded all airplanes for fear they will be turned into cruise missiles, nor can we shun every link in the energy chain on which we all rely. While we can minimize risk, we cannot eliminate it. And if you don't want the LNG terminal in your neighborhood, for reasons that seem perfectly valid to you, just exactly whose neighborhood are you proposing as an alternative? Or are you and your neighbors prepared to take your houses off the gas grid and heat them with something else?

Finally, for anyone interested in the atomic bomb comparison, a few facts:
1. A fully loaded LNG tanker of 120,000 cubic meters capacity holds about 50,000 tons of methane.
2. The yield of the Hiroshima bomb was equivalent to 21,000 tons of TNT.
3. Conservatively assuming that TNT and methane have the same energy content gives you a ratio of 2.5, not 55, but we are not done yet.
4. An atomic bomb releases its energy (from the conversion of matter into energy, via our old friend e=mc^2) in 1/1000th of a second. This makes for a stupendous flash and explosion, with a surface temperature comparable to that of the sun. This is why every H-bomb has an A-bomb trigger.
5. A chemical explosion of methane requires a narrow range of air/fuel mix (5-15%) that could not be achieved all at once for the entire volume of an LNG tanker. In the real world, it would take many seconds and probably minutes to consume all the available fuel.
6. The difference between points 4 and 5 above is analogous to the difference between going from 60-0 mph by hitting a brick wall, compared to a panic stop using the brakes. The same energy is released, but in very different ways.
7. If it were easy to liberate nuclear weapon yields from large quantities of fuel, people would be doing this routinely. The closest we get is something like this. And note that there is an enormous distinction between achieving A-bomb-like overpressures in a very limited radius with a fuel/air device vs. the kind of wide-scale effects of an actual nuclear explosion.

A Quicker Return on Hybrids?
Wednesday's Wall St. Journal Marketplace section (sorry, no link) carried a very good summary of current trends in auto technology, looking at a variety of different paths to greater efficiency and lower emissions. Their comment on the cost of hybrids echoed my own remarks of May 3, to the effect that it will take years for consumers to recover the higher costs of hybrid drive systems in fuel savings.

But as I read the article, something hit me that should have been obvious before. If the buyer finances the purchase, the hybrid premium is not incurred up front, but spread out over the financing term, and offset by whatever residual value premium the used hybrid might fetch when you sell it.

For example, if a hybrid costs $3500 more than a comparable non-hybrid, but is still worth $1500 more after four years, then at 6% the extra cost of owning the hybrid is about $650/year (after factoring in the present value of the trade-in). This is still more than the current $300 to $400 of fuel savings you'd enjoy (at current gas prices), but we haven't gotten to the tax break for buying a hybrid. Although this benefit is being phased out, you can currently deduct $2000 of the purchase price of a hybrid from your Form 1040. In the 25% tax bracket, that nets you $500, or most of the cost of the first year's hybrid premium.

Add it all up, and at least for someone who borrows to buy the hybrid and is in a typical tax bracket, the extra cost of a hybrid car might not be more than a few hundred dollars over the time you own it. And if, on top of this, you think hybrids are a cool technology and good for the environment, that might look like a pretty good deal.

It's Alive
The media and internet have lately been brimming with commentary on the many ways in which the eastward expansion of the European Union may alter the nature of the existing body's economy and policies. The Economist has proposed an angle I haven't seen anyone else suggest: a possible revival of interest in nuclear power.

With a few notable exceptions, such as France, China, and until recently Japan, obtaining permits anywhere for a new nuclear power plant looked about as feasible teaching your horse to sing. But as the old saw tells us, the horse might just learn to sing, and that could happen if the Economist is correct in its assessment.

Certainly the EU will be inheriting a number of nuclear plants built with former Soviet technology. These can either be upgraded or decomissioned. But the latter choice entails replacing the lost electric generation, and that means more greenhouse gas emissions. Although the US isn't very interested in the Kyoto Treaty, it is still a Big Deal in Europe.

The EU has set some aggressive targets for adding renewable energy, but there is probably a limit to how many windmills you can put up without even the relatively good reception they've gotten so far turning sour. Nuclear remains the one large-scale alternative with no emissions of carbon dioxide or other greenhouse gases.

As the Economist suggests, price will be as big a big hurdle as anti-nuclear concerns, so the challenge to industry is to come up with safe, economical reactors that can be built relatively quickly. Standardization will be a big help, since the lack of it was one of the chief contributing factors in driving the costs of nuclear out of reach in the US, along with post-Three Mile Island concerns. In a future posting I'll talk about some of the radically new reactor designs being proposed.

The Taps Open
Last Wednesday I suggested that the only thing likely to bring prices down in the short run was a change in OPEC policy, driven by the Saudis. I concluded by saying that the price of oil in the near future will be largely what the Saudis desire it to be. They now seem to want it to be lower.

Saudi Arabia is in a unique position in the oil world. Not only do they wield enormous power as one of the largest exporters of oil, but their reserves give them a long-term perspective that few others can share or even afford. With 260 billion barrels of oil reserves, roughly a quarter of the known reserves on earth, they realize they are not playing a short-term game, and are also aware that consuming countries, while unable to do without their product today, have many more options than they did even a decade ago, given enough time and incentive to switch.

$40 per barrel seems to be the threshold at which the Saudis become concerned about upending the global economy and threatening the value of their long-term reserves. If the indicated 1.5 million barrel per day increase in OPEC quotas is approved at OPEC's June 3 meeting and actually translates into a comparable growth trend in oil inventories--instead of providing cover for quota cheating already occurring--then it should be sufficient to push prices closer to $30/barrel by the fall.

This stock build will only happen if non-OPEC production remains stable or grows somewhat, especially in Russia. Today's Wall St. Journal contains a good discussion on this topic.

At roughly $30 per barrel, the pressure on consumers should ease, despite the other factors that have contributed to high gasoline prices, including product specifications and refinery constraints. A drop of $8 or $9 per barrel of crude oil would not only eventually take 20 cents per gallon out of the cost of gasoline, but it would also change market psychology that encourages distributors to hold more inventory than they need, because they believe it will be worth more tomorrow. That could be good for another 5 to 10 cents per gallon.

All of this would help consumers, and it couldn't hurt incumbent politicians, either.

Is It Just the Curse?
Tom Friedman's Sunday New York Times editorial was entitled "The Curse of Oil." Along with a clever comparison involving robots, he focused on the differences in productivity and creativity between countries lacking natural resources, including Japan, Korea, and Taiwan, when compared to Saudi Arabia and other Arab countries that have abundant oil reserves.

Much has been written about the so-called "resource curse", particularly in relation to oil-rich West Africa. A sudden infusion of oil wealth can certainly work against the development of a healthy domestic economy and sound, transparent institutions. But although there is likely an element of this at play in the Arab world, I am not sure it is as important a factor as some others.

The comparison breaks down in other ways, as well. Mr. Frieman, himself, cites the more positive examples of Jordan, Morocco, Tunisia, Bahrain, Dubai, and Qatar, without noting that the first three have essentially no oil, while the latter three are (or were, in the case of Bahrain) blessed with a great deal of oil for their size. For that matter, Egypt probably didn't start the 20th century with a worse hand than Japan, in terms of resources, education, and institutions, though you'd never know it from a comparison of the two countries' situation today.

Finally, how does one explain the experience of the United States, which is the antithesis of the Resource Curse theory? Even in terms of oil--ignoring the profusion of other resources with which this country was endowed--we had as much under our land when Col. Drake drilled his first well in 1857 as did either Saudi Arabia or the entire former Soviet Union, and we have produced more of it to date than any other country.

At the end of the day, it's just too pat to say that the Arabs have poor economies because they have oil. Bernard Lewis and other scholars have more thoughtful explanations for the apparent discrepancies, as do Mr. Friedman's past columns.

Cheaper, Smaller Solar
The two main knocks on solar power today are that it is still expensive, on either a per kilowatt of capacity or per kilowatt-hour of delivered electricity basis, and that to get the cost down for the power you need, you have to cover large areas with solar cells of lower efficiency.

Technology Review recently reported on a new approach that would reduce both cost and the area entailed, by cheaply increasing the cell's efficiency. We already know how to make multi-bandgap solar cells that capture up to 36% of the light energy that shines on them, but these tend to be reserved for applications such as NASA's Spirit and Opportunity space probes, where the collection area available is at a premium and for use where the sun shines more faintly. But they are also quite expensive.

Being able to apply the same approach at even higher efficiencies, but at much lower cost, would improve solar's cost-competitiveness relative to other technologies and allow it to compete for applications that are currently impractical, due to size constraints. And in larger-scale installations, such as for distributed power, the same effect would reduce the environmental and aesthetic impact of the project.

As the article points out, more work is required, but this could be a big deal in a few years.

When Is the Crunch?
Paul Krugman's New York Times editorial today is titled "The Oil Crunch." His theme is the impact of growing oil demand from China and industrializing Asia competing with the growing US appetite for gasoline, against a backdrop of tighter supply in the future. His inevitable conclusion is higher oil prices, perhaps starting now, perhaps later.

In one key respect, his thesis echoes mine: the physical peak of oil production is not the key future event of concern; rather it is the point at which prices go only up, not down, because supply cannot keep up with demand. And his final assertion, that we can "neither drill nor conquer our way out of the problem" is ultimately correct. Where I think we part company is over the crucial issue of timing.

The reason this is so important is that it dictates the kind of response or adaptation that is possible. If the crunch is imminent or already here, then our responses are constrained to efficiency improvements and the increased exploitation of other hydrocarbons, such as gas and coal, plus a continued rapid growth of renewables. But let's be clear about the near-term potential of the latter. If we rapidly doubled the total amount of wind and solar power in use today, we would still cover only about 2% of the world's total primary energy demand.

On the other hand, if we face a decade or more of volatility with as much downward as upward price movement, or even a reversion to the mean oil price of the last decade or so, then many more options become available, including the start of a transition to hydrogen. This is probably the scenario most oil analysts believe, since oil company stock valuations currently reflect an underlying oil price below $30/barrel.

The other missing factor is the location of reserves. While it may be true that no major oil fields have been discovered since 1976 (though this depends heavily on your definition of "major", since a number of fields containing 500 million to 1 billion barrels have been found in that period, plus several over 1 billion), this ignores the number of large, known oil fields not presently being tapped, most of which are in OPEC countries. That implies a long-term increase in OPEC's market power.

And even though geology is not necessarily destiny, it can still provide useful hints about what to expect here. The current mean estimate of the total original conventional oil endowment, the amount of oil that was in the ground before we started drilling, and that can be accessed with current technology, is about 3 trillion barrels. To date, we have produced under 1 trillion barrels of this. That suggests that we still have a ways to go before we reach the midpoint of production, at which the adherents of King Hubbert's theories say production will start to fall.

So what should the average person make of all this? It is certainly confusing and potentially worrying. Right now, based on all the evidence and arguments, I think one should be equally skeptical of those saying that the end of oil is just around the corner and of those saying that the status quo (with growth) can be maintained indefinitely. That says that as a society we should be buying options on large-scale alternatives, but only exercising those that are "in the money" or close to being economical, today.

And what would the prospect of a revolution or catastrophic terrorism in Saudi Arabia do to all of this careful reasoning? I think you can guess, and that's part of what has the oil market unsettled at the moment.

Where It's Windy
Sunday's New York Times covered a wind energy project that may prove as controversial as the proposed wind farm off Cape Cod has. The Long Island Power Authority plans to install up to 40 windmills a few miles off Jones Beach, a popular beachfront close to New York City. They would generate a total of 100-140 Megawatts.

The project is already generating the full range of expected responses from the community, including support from those who see wind power as an attractive alternative to burning fossil fuels, and opposition from those who feel the installation will ruin the view and deter beachgoers. One comment in the article raised a basic issue that is worth more discussion, since I have not seen explained well elsewhere.

The article cites a manager of a fishing company that sees itself threatened saying, "There's enough places on land where they can do this." Are there? I think we've forgotten something our great-grandparents knew innately; you can't put up a windmill just anywhere. There is a big difference between the random, intermittent winds we all experience and the reliable wind patterns that wind generators require. This is further complicated by the fact that it isn't the winds at the surface that matter, but those at the height of the generator hubs, 300 feet up in the air. Pilots understand this distinction pretty well.

Imagine prospecting for oil or some mineral, but with the added wrinkle that the resource is invisible and the amount available varies according to the season and the time of day. There are maps that identify the best wind resources in the country and grade them according to intensity and reliability. This information is essential in deciding where to site a wind installation. In fact, the wind map for Long Island shows "good" wind availability beginning offshore of Long Beach Island and continuing east along the southern shoreline.

The issue of tradeoffs has become a recurrent theme in my blog, and that's where we end up on this project. What do we value, and what are we willing to trade off to preserve it? One critic of this project was quoted saying, "Why, instead, isn't every government building using solar energy and every official driving a more fuel-efficient car?" This statement is framed as a tradeoff, but it comes across as a diversion. Perhaps we should be doing all of that and the Jones Beach wind project, in order to avoid having to build another gas- or coal-fired power plant to run our growing armada of appliances and gizmos. Or are we content to build the power plant and deal with a little more smog and acid rain, in order to keep a beach view? These are the tradeoffs we have to face up to, until we see the sales of air conditioners, electronics, and household conveniences fall, because consumers are no longer willing to pay the hidden costs of the power they consume.

What Will Bring Down Fuel Prices?
Last night's News Hour on PBS featured a segment on high gasoline prices and the public's reaction to them, ranging from outrage to bland acceptance, and including the standard level of denial that trading in a sedan or minivan getting 20 miles per gallon for a Suburban that gets 12 might be part of the problem. There was an intelligent discussion of the contributing factors, with crude oil prices leading the pack.

Other than a fall in crude prices, what could bring gasoline prices back to more normal levels in the near future? Lower demand? Not if SUV sales continue at their current, record rate, and not if the economy stays on a recovery path. A relaxation of the confusing welter of conflicting regional gasoline specifications? While the EPA is considering temporary waivers that would ease localized market distortions, this would will do little to reduce the current record average price. What about an easing of refinery bottlenecks? That would take a couple of years, and with the refining segment finally earning healthy profits, for once the industry seems disinclined to destroy them by investing in a wave of expansions. This takes us back to crude prices.

The list of culprits responsible for current high oil prices is long and varied: OPEC production policy, growing demand in China, the popularity of SUVs, instability in the Middle East, and a global economic recovery, particularly in the US. Other factors include fuel-switching due to tight natural gas supplies here, and continuing production problems in Venezuela in the wake of last year's disastrous petroleum industry strike. It is not that hard to account for the oil prices you have, but predicting future prices is a much tougher proposition.

What could cause the crude price to fall, and thus provide some relief on gasoline? Within three to five years, many things could and probably will drive prices back down to a more normal range, say between $20 and $25/barrel. But in the short run, assuming the demand factors I mentioned in the opening paragraph don't change, there is only one thing that will bring prices down: a visible growth trend in oil inventories.

If you were only going to look at one factor to try to assess whether the price of oil will rise or fall over a very short period, the level of crude oil inventories--excluding the government's Strategic petroleum Reserve--is your best bet. These inventories consist of oil that has already been produced or imported and is being held in tanks at refineries or somewhere in the distribution network. If crude inventories go up for a month and are above the level for the same time last year, the chances are good that the price of West Texas Intermediate, the marker crude traded on the NYMEX futures market, will fall.

According to the reports published by the Energy Information Agency of the Department of Energy, US crude oil stocks are currently just under 300 million barrels, up about 10% since the beginning of the year. This still puts them well below the average of the last five years. Inventories would have to increase a lot faster, say by an additional 10-15 million barrels over the next month, in order to signal a drop in prices. That looks unlikely, barring a change in OPEC policy that would make available the oil necessary to raise inventories.

At the moment, OPEC enjoys a remarkable degree of market control. Global conditions are ideal for them to be able to control prices through tight control of production by their member countries. OPEC's stated rationale is that failing to cut production now would lead to a rapid buildup of stocks and a price collapse that would be harmful to both producers and consumers in the longer run. On the surface, this is not as silly as it sounds. The price collapse in 1998 connected with the Asian Economic Crisis was a major factor in the wave of industry consolidation that followed, and has kept non-OPEC oil production on a slower growth path.

But in this case, OPEC's concern is fatuous and self-serving. All other indicators point upward, which was hardly the case in 1998. Demand is growing all over the world; non-OPEC oil production is stalled for the moment, as the North Sea reaches its peak of production, and as Russian production hits the limits of existing infrastructure. Nor is Iraq in a position to flood the market. And natural gas, which has lured demand away from oil for the last decade, has plateaued for now. From a structural standpoint, the risk of a price collapse right now is very low.

OPEC ministers point to the high level of speculation in the market, principally by hedge funds, as further rationale for their need to manage prices. But prices for delivery of physical crude have not weakened much relative to the futures prices, as one would expect in a speculation-driven market. This says that it is not just "paper barrels" that are in short supply, but real ones.

After going through all these factors, I can only see one logical answer to the question I posed above. The only thing likely to cause crude prices to fall any time soon is a change in OPEC policy. If you want to know what the price of oil will be over the course of the summer and into the fall, you need to ask the question in Riyadh and the other OPEC capitals. For now, at least, the price of oil will be largely what the Saudis decide it should be.

Nuclear Frees Up Oil
Tokyo Electric Power Co (TEPCO) recently announced it will restart two more nuclear plants in the next couple of weeks, as it recovers from last year's scandal concerning safety and maintenance data. This should take a small amount of pressure off oil prices.

Few countries still burn large quantities of fuel oil to generate power, but Japan is a notable exception. In fact, several Japanese utilities burn unrefined, low sulfur crude oil--primarily from Indonesia--directly in their power plants. The shutdown of so much of Japan's nuclear capacity last year increased demand for imports of crude oil and liquefied natural gas (LNG), contributing to the increase in global oil prices.

Each 2,000 MW nuclear complex brought back on line saves an amount of oil equivalent to the throughput of a small refinery, roughly 60,000 barrels/day. So restarting two more nukes, with two more to go, puts about as much oil back into the market as would be produced by a major offshore oil platform. This is modestly good news to help offset higher demand and OPEC's announced production constraints.

On a housekeeping note, you may have noticed some new text below each posting in this blog. Clicking on "comment" will bring up a form allowing you to post your reaction to my daily blog, as well as allowing you to see any previous comments on that posting. I've wanted to make the blog interactive from the start, and thanks to a friend alerting me to Haloscan, I was able to add that feature. I look forward to hearing from you!

Fast Lane for Hybrids
This recent article from the San Francisco Chronicle does an excellent job of cataloging the motivations of those who buy hybrid cars, which are becoming especially popular in the Bay Area.

It also highlights the apparent economic inconsistencies that some of these buyers display. Hybrids such as Toyota's Prius and Honda's Insight claim fuel economy in excess of 50 miles per gallon. But even at current high gasoline prices, this will only generate about $300-400 dollars per year of savings, when compared to comparable vehicles, such as the standard Honda Accord. (EPA ratings of 24 city/34 highway). This is not enough to compensate for the $3500 difference in the prices of the two cars, even after factoring in the Federal tax incentives that are being phased out.

So for those who claim to be buying these cars for economic reasons, something else must be at work, too. Among the other reasons cited in the article were environmental concern and the way these cars have attained critical mass in the local market. At one Toyota dealership mentioned in the article, hybrids account for over 20% of total sales. Other factors include a sort of techno-cool image related to higher incomes (and perhaps to the proximity of Silicon Valley.)

It's interesting that a new vehicle type that wasn't technically possible a few years ago is taking off now, with relatively little fanfare. Some experts have even suggested that while public attention is focused on the potential of fuel cell cars in the future, hybrids are the revolution that is here today.

The article provides hints at the kind of things that might make hybrids take off in a much bigger way, including the potential for carpool lane treatment. Having driven in rush hour in the Bay Area many times, the latter could be a powerful motivator, even though it's not yet law. Among issues not mentioned are possible future increases in federally mandated corporate average fuel economy standards and state-by-state legislation under consideration to limit greenhouse gas emission. If the mainstream projections of J.D. Power are for 1 million hybrids in 10 years, what is the upside case, were these other issue to become more prominent?

The beauty of hybrids is that they are completely compatible with current infrastructure, including both fueling and repair networks. With low barriers and solid benefits, we could be at the very early stages of a classic s-curve takeoff.

Second Chance for Cold Fusion?
Fifteen years ago a pair of scientists from Utah conducted the classic demonstration of how not to announce a scientific breakthrough. Cold fusion, after a few moments of startling promise, looked like another in a long line of impossible energy devices. But MIT's Technology Review now reports that physicists are taking another look at it, and the Department of Energy is considering exploring it further.

Cold fusion is only one avenue that might deliver an energy surprise. Researchers and inventors with varying amounts of scientific training are pursuing a wide array of exotic energy technologies. Zero point energy is another contender, based on a quirk of physics called the Casimir Effect. Most of these ideas have in common the potential for essentially limitless clean energy. For more information on a variety of "wild card" issues, including energy wild cards, take a look at the Arlington Institute.

I approach such things as a skeptic. In physics, as in most of life, there's no free lunch, and many of these ideas appear to require one, in order to work. Having said that, though, I also absorbed enough history of science along the way in engineering school to appreciate how much of it was discovered by people who were regarded as crackpots before they started generating reproducible results.

I find area of wild card energy intriguing, because if enough people are pursuing enough different paths, the odds of one of them eventually discovering something useful improve. Even a tiny chance of that seems worth a bit of society's time and money. With a cheap, plentiful and clean source of primary energy, an awful lot of other things that look impractical today would make sense, such as a quick transition to a hydrogen economy and a large-scale attack on climate change. Don't hold your breath, and don't sell your oil company stock, but it is certainly entertaining to think about the possibilities, occasionally.

Does Size Matter for Oil Companies?
This question has vexed the industry for years, though the equity markets have clearly cast their vote in the affirmative. Most of the mega-mergers in the industry were greeted favorably by the markets, particularly ExxonMobil and BP-Amoco-Arco-Castrol (now just BP, Beyond Petroleum). But the recent problems at Shell have focused attention on some of the challenges brought about by operating at this scale, as highlighted in this provocative article in the Financial Times.

One of the biggest concerns is over the ability of the so-called Supermajors to replace their oil reserves economically, to underpin production and revenue growth into the future. Every year, these enterprises need to replace the enormous quantities of oil they produce, amounting to 1.5 billion equivalent barrels of oil and natural gas for Exxon alone. But in principle these mammoth companies have at least as many resources as their pre-merger predecessors, in terms of the capital budgets and technical staffs required to find this oil. So on the surface, size should be neutral in this calculation. However, I think size plays a negative role in two important ways.

First and most directly, much of the initial financial benefit of these mergers has come through staff reductions. (Full disclosure: I left Texaco immediately after its merger with Chevron.) Although these reductions are intended to come from overlapping headquarters and support staffs, some technical staff invariably leave for personal reasons including undesirable relocation, diminished promotion opportunities, and lucrative separation packages.

As a result, these mergers invariably trim vital capabilities, along with the intended overlaps. In a shrinking industry, separated workers often find employment in other industries, leaving fewer highly-skilled technical personnel to chase the next oil discoveries. While some of this attrition may be offset by new graduates and improved technology, including information technology, I'm skeptical that you can really replace the value of a 20 or 30 year veteran geoscientist or petroleum engineer this way.

The second problem is a direct result of the size of the merged companies' asset portfolios. These are so large that the threshold of what is material to them changes. If they can only work on x new opportunities a year, then they must be the largest x opportunities. But as the FT article reminds us, there is growing evidence that the largest opportunities have already been found, and in many cases sit within the inaccessible portfolios of state oil companies such as Saudi Aramco.

So would an Exxon be content to chase 1000 smaller opportunities, rather than the 100 larger ones they are structured for and financially biased towards? Not if they want to keep their finding and development costs in the top quartile, an important indicator to market analysts. It is much harder to hold these metrics down if the denominators shrink.

Even though I've chosen to illustrate these issues in the case of a merged Supermajor, I believe they also apply to Shell, which chose not to grow via merger. Instead, they have had to take many of the same steps through internal reorganization that others achieved through their mergers, in order to remain competitive.

Where does all this lead? Probably not to oil shortages, but at least to some significant challenges for the industry in the years ahead. At a time when the global demand for petroleum is advancing steadily, the most successful incumbents in the industry, driven by the financial expectations of the equity markets and by technical factors, have compromised their ability to expand their oil production to keep pace with demand. At the same time, social, political and demographic pressures on national oil companies will make it harder for them to finance and execute the further development of their own vast reserves, without capital and assistance from the international industry.

The solution to this conundrum is breathtakingly simple: allowing the major oil companies to access the reserves of the national oil companies. The trick will be to find a way to do this that does not threaten the proud independence of the latter, while still proving sufficiently lucrative for the former. The whole history of the industry since 1972 is against it, but there are promising signs in places like Venezuela and Libya. I think we'll hear a lot more about this in the future.

Is Sea Level Rising?
Yesterday's blog was about a movie portraying climate change happening in weeks. Of course that scenario is a wild exaggeration, beyond even the most hysterical of expert's claims. An article from this week's Economist looks in the other direction, citing a fascinating study of water wells in Israel over the last 2000 years. The conclusion is that, at least in the Mediterranean, sea level has been very stable until the last century or so, and then rising since, coinciding with the runup in atmospheric carbon dioxide associated with industrialization.

I won't argue that this is anything more than another data point in a very complex picture. And I don't want to beat the climate horse to death, since I have devoted a fair amount of space in my blog to this topic. However, it occurred to me that I've never stated why I think this issue is important and worth doing something about. It's time I remedied that.

The view of climate change that most of us get from the popular media has the world warming gradually, by a few degrees Celsius over the next century. If that were all there was to it, I would resign myself to needing a few more Hawaiian shirts. Even the concerns about how this could alter regional and local weather patterns and expand the ranges of infectious diseases are all within the realm of things we could cope with, at some cost. (Clearly these effects would cause greater hardships in developing countries, and I don't mean to be callous about it.)

In a gradually warming world, adaptation is a perfectly reasonable strategy. After all, the planet was warmer than it is now several times in the past, without life vanishing. What has me worried, though, is a much more dangerous possible path of climate change.

To a large degree, the earth's climate is self-correcting. If you shine more sunlight on it, extra water evaporates, some of that drops out as snow at the poles, which expand and get whiter, reflecting more sunlight, and we come back into some kind of balance. (Any physicists or climatologists out there are cringing at this simplistic view of the mechanisms involved.)

Anyway, all of this functions like a sort of buffer. But like the chemical buffer systems you might have played with in your high school chemistry class, that allowed you to add acid or base without changing the overall acidity of the solution very much, this effect only works over some range. You can overwhelm it, at which point you no longer get nice, gradual changes. And that in a nutshell is what worries me about climate change: after some unknown--and possibly unknowable in advance--amount of warming, we might move out of the smooth buffering zone and into a zone of unpredictable, non-linear responses.

There has been a fair amount of talk about disruptions of the North Atlantic current as a possible mechanism for sudden and unpredictable climate change. This is one example of how a non-linear response to climate change could happen. If it occurred, it would be bigger than any natural disaster or combination of disasters that we have dealt with since the dawn of civilization. It has the potential to change our world faster and more dramatically than our ability to adapt could handle. The implications for governments and businesses would be profound.

Abrupt, non-linear climate change would therefore be very bad, but no one can predict whether or when it will happen. I see this situation as very similar to the question of whether I should insure my home against fire. I know it's highly unlikely, and I can look at statistical averages to estimate how much I should pay for insurance. But for the individual, statistically-derived expected values aren't very useful. If it happens and I'm not insured, it will affect my family in ways that are unacceptable.

In my mind, the Kyoto Treaty and similar measures, which would clearly impose costs on our economy, act as an insurance policy against something we simply can't afford to deal with, were it to occur. Even if all we can do is delay it or keep the change in the range of gradual shifts, that would be worth a lot. And if it never happens, well, we've paid for an insurance policy that we are happy not to have to collect on.

A Major Motion Picture?
Do movies influence public opinion? The best recent example I can think of is "Wag the Dog", which became part of the vernacular during the Clinton administration. I'm sure a movie critic could think of others. As I mentioned in my blog of March 2, 2004, this Memorial Day weekend features the release of an action film about the effects of sudden--really sudden--climate change. Some fear it could have a similar impact, while others hope that it will.

Sunday's New York Times reported that NASA had issued a memo to employees asking them not to comment publicly on the science behind "The Day After Tomorrow". Climate change is always politically sensitive, but this year it has the potential to become an election issue.

As a public agency, it may be appropriate for NASA to eschew a role that could turn political, though as one of several federal agencies receiving funding to work on this issue, it also has some responsibility to improve the public's knowledge on the subject. To NASA's management, this must look like a good way to get into a crossfire. At the same time, the article indicates that some supporters of urgent action to combat climate change worry that this film could trivialize the subject, rather than galvanizing the public.

In reality, I suspect neither side has much to worry about. After all, "Deep Impact", a fairly serious movie about a comet hitting the earth--backed up by solid research--didn't energize support for programs such as NASA's Spacewatch any more than did its silly competitor, "Armageddon."

At any rate "The Day After Tomorrow" looks like a lot of fun and has a good pedigree in the action film world, coming from the director of "Independence Day". Will it stir up the debate on global warming and the potential for sudden climate change? Only time and audience polling will tell.

Surprise Courtship
Today's Financial Times reported that Total of France (formerly TotalFinaElf) has the backing of Russia's government in acquiring a 25% stake in Sibneft, which is in the process of unwinding its merger with Yukos. This comes as something of a surprise on this side of the pond, considering that ExxonMobil and ChevronTexaco were widely seen as the leading bidders, with moral support from the US government.

Total is hardly a household name in America, having exited its modest refining and marketing presence here some time ago. In fact, its production levels and sales and profitability (at current dollar/euro exchange rates) put it in a dead heat for size with ChevronTexaco, behind ExxonMobil, BP, and Royal Dutch/Shell.

Total is also well-positioned to take advantage of the current geopolitical situation, in which some governments may be looking for an alternative to American or British companies. In bidding for Sibneft, Total looks to benefit from the closer relationship that was forged between France and Russia in the leadup to the Iraq War. Although the French government no longer hold its "golden share" in Total, the company still enjoys a unique level of government support and sympathy, as the sole standard bearer in this key industry.

Besides being the largest refiner and marketer in Europe at the moment, they have clear aspirations to become more global, complete with a new logo meant to symbolize global activity and multiple forms of energy. I suspect we'll see more moves like the Sibneft stake in the future.

Wrong Place, Wrong Time
This week's Economist provides an interesting update on a project I had lost track of. Going back to the mid-1990s, the state oil company of Vietnam had planned to build a refinery--the country's first--in the middle of their long coastline at Dung Quat. Despite the departure of all its foreign partners, PetroVietnam apparently won't give up on this idea, and now seems to want to build not one, but two refineries. The Economist correctly points out the dismal prospects of such a facility ever generating a return on its multi-billion dollar cost.

State enterprises have no monopoly on poorly-chosen projects. Several other refineries in the region were built by international companies to excellent designs, but only made sense under the rosiest of forecasts. This was an easy trap to fall into in the boom years of the 1990s, and I bear my own small share of the guilt. But during my time in the energy business in Asia-Pacific, I saw many examples of the pernicious nationalism that the Dung Quat project exemplifies.

Nearly every country in the region at one time or another has wanted a flagship petroleum project. For countries without a lot of oil or gas, that typically meant a refinery. These projects were explicitly tied to national prestige, as well as optimistic demand forecasts. Of course since refineries take a long time to design, fund, and build, your economics have to rely on forecasted demand. However, you cannot ignore forecasts of alternative supply, as too many such projects appeared to do.

Against a backdrop of globalization, refining capacity surpluses in other regions, and a developing surplus of refined products in Asia-Pacific, could the outcome of these projects been other than disappointing? We are talking about the destruction of billions of dollars of shareholder value for the industry, and the creation of large non-performing loans on the books of developing countries. The stigma of having to import your fuel needs from Singapore or Korea can't be worse than that.

This is the reality the PetroVietnam planners--and their World Bank investors--need to face. Isn't this what gives large-scale economic development such a bad name?

Missed Signals
Every day brings new headlines concerning Shell's booking of oil reserves. This is the typical pattern for scandals of this type. While I've made the odd comment along the way, here, there have generally been enough other topics to talk about, and the FT, WSJ, and NYT are generally doing just fine covering the story. When I thought about it this morning, though, I finally realized what had bothered me most about the revelations concerning Shell's top management. It wasn't just that Shell had a solid reputation in the industry. My discomfort stems from what I do for a living.

For the last seven years I have been involved in scenario planning, initially within a major oil company and now as an independent strategy consultant. In the world of scenario planning, Shell was the great groundbreaker, developer of many of the techniques still used, and most visible and vocal corporate practitioner of the technique. Just go to their website and look at all the information and articles devoted to the subject, as well as current and past scenario output.

The disconnect is not that Shell didn't have some previously worked out scenario dealing with a corporate scandal--they might--but that an organization that so rigorously analyzes the major social, political, and economic trends and forces shaping the world in which they do business should have failed to internalize the learnings from that work at the highest levels in the company.

In particular, consider their concept of TINA, "There Is No Alternative." As I understand it from reading their publicly available material, TINA would include the increased need for transparency, something Shell has embraced in the context of corruption. But somehow that didn't translate into elevating transparency with shareholders into a deeply-held value at the top. The principles are the same.

My purpose is not to pillory Shell. Rather, this should be another loud wake-up call to business across the board, as if Enron, WorldCom, Parmalat, et al weren't adequate clarions. Simply put, it's what so many managers derisively refer to as the "soft stuff", the things that constantly get trumped by the expediency of meeting this quarter's numbers. Getting the soft stuff wrong can cost you far more than any deficiency in your basic operations.

Having processes, programs and standards in place is not sufficient, if the leadership does not live by the principles behind them, and apply those principles equally to areas that were not their original focus. All the scenario planning in the world is pointless, if the human beings who commission it and participate in it are unwilling to accept what it tells them about the changing external world.

Clean Air
Last Wednesday (4/14) I commented on an article in the NY Times Magazine concerning the New Source Review policy of the Environmental Protection Agency. Yesterday's NY Times carried an editorial by David Brooks that also mentions New Source Review, as part of an overall report card on the Bush administration's environmental record. Brooks's basic conclusion is that things have improved pretty dramatically in the last couple of decades, but there are still some important gaps, notably on climate change. My view is pretty close to his.

To see why, you have to turn the clock back to the first Earth Day in 1970 and then fast forward to the present. It makes for an interesting movie. Watch the US population grow from 203 million to 293 million, and the number of vehicles on the road climb from 111 million to 235 million, each driving 19% more than their 1970 predecessors. Gross Domestic Product zooms from $3.8 trillion to 10.2 trillion, in year 2000 dollars. Against this background, a major focus on improving the environment delivers air that is cleaner in many places, and water that is generally purer. The dire predictions about the environment from the 1970s fail to materialize, because of hard work, tough policies and a large amount of investment. This brings us to to where we are today.

If we want to extend this improvement trend, should we continue the same policies as in the past--the ones that got us the benefits we can see--or do we need to try something different? Most environmentalists would probably say stick with what we know, but make it tougher. But this flies in the face of some awkward facts.

Consider vehicle tailpipe pollution. Modern cars emit only a small fraction of the pollution of a 1970 model, thanks to changes in fuel quality and engine technology, and the addition of catalytic converters. But the benefits of these advances are partially offset by the dramatic increase in total miles traveled, a trend that seems set to continue. Short of eliminating fossil fuels or replacing the internal combustion engine--either of which will take decades--we are approaching the point of rapidly diminishing returns.

What this suggests to me is that we should celebrate our achievement of the last two decades, scrutinize its history for what worked well and what didn't, and formulate new policies based on that learning and on the recognition that the problems we face have evolved and our old levers to move them have become less effective, as a direct result of their past success. Is it possible even to float such an idea, let alone get it enacted, in light of the quasi-religious zeal exhibited by both extremes of the argument? It would be close to heresy, and you know what they do to heretics.

Gas Taxes
In my April 9 posting I referred to remarks by the Chairman of Ford Motor Co. concerning higher gasoline taxes. This Sunday's New York Times business section carried a longer analysis of the issue, placing it in a useful historical and international context.

It was particularly interesting to see the comments by spokesmen for the Sierra Club and Union of Concerned Scientists, both of whom dismissed the auto industry's apparent endorsement of higher taxes as frivolous. This strikes me as ungracious. When your opponent concedes one of your major arguments, for whatever real or imagined reason, shouldn't you give him a little credit for it? In addition, the rebuttal by Mr. Friedman of the UCS is a little like the old one about trees falling in the forest; if we "save consumers money by raising fuel economy standards" on cars they don't actually buy, who benefits?

The article also cited Mr. Friedman's concern about the impact of higher gas taxes on the poor without mentioning the numerous solutions to this proposed in the past, such as income tax credits for fuel taxes paid, up to some income threshold. But this is a minor cavil.

At the heart of the question of higher fuel taxes is a serious objective, reducing our consumption of petroleum and its products. But behind that objective is a lot of fuzzy thinking and no consensus at all. Why do we want to reduce petroleum consumption? To protect the environment? To avert climate change? To increase national security? To reduce our trade deficit? Is oil just another input to the economy, or is it somehow different and special?

The current presidential campaign is as nasty as any I can recall, and at an earlier stage. It is probably not the ideal setting for trying to resolve some of the questions I've raised in the paragraph above, but at a minimum we should be comparing the substance of the two candidates energy plans, rather than debating the merits of a proposal that everyone agrees neither man is likely to implement.

Just Another Scandal?
We must be growing inured to scandals. After revelations concerning Enron, WorldCom, Parmalat, and even staid companies like Shell, where does the scandal concerning the corruption of the UN's Iraq Oil for Food office fit? As William Safire notes in today's New York Times, a number of high profile individuals are implicated, including several very close to Secretary General Kofi Annan. At the same time, President Putin of Russia seems intent on hamstringing the proposed independent investigation. This suggests that Putin sees more potential for damage in what such an examination might uncover than in the appearance of guilt created by his stonewalling.

Pressing Russia and other foot-draggers will risk international relationships that are only starting to recover from their pre-Iraq War. And what will we learn? That some unscrupulous people lined their pockets at the expense of poor people in Iraq? That sort of thing happens every day, right?

I believe there are compelling reasons for exposing the full extent of malfeasance in administering the Oil for Food fund, and the most important concerns the future, rather than the past. Politicians and talking heads across the spectrum are calling for the US to turn over responsibility for civil administration in Iraq to the UN. If the UN takes on this role, we must aggressively manage the risks this will entail, and one of the largest of these is for corruption on a vast scale.

The Oil for Food program, which marketed Iraq's oil exports under sanctions, must have created tremendous temptations. After all, it involved billions of dollars of oil, relief supplies, and authorized replacement parts flowing through a system cluttered with bureaucrats and middlemen. But if that program had inherent incentives to cheat, just imagine the opportunities for corruption involved in running the entire country and administering not only oil, but contracts for reconstruction, education and infrastructure development, to name a few.

Before taking on such a task, the UN must empty its closet of all the baggage associated with Oil for Food. Anyone who took part in corrupting that program must be either dismissed or banned from future participation in Iraq. The UN leadership must signal strongly that such behavior will not be tolerated, and this must be clear not only inside the UN but also to every organization with which it would have dealings. Doing this will require new rules on transactions.

When you look at the kind of deals in which the Oil for Food program engaged, it is easy see how things went astray. While the international oil markets include many pure traders, along with producers and true end-users, the number of Oil for Food contracts in the hands of middlemen is a red flag. Among these middlemen were companies facing indictments in the US for past misdeeds. From this standpoint, Oil for Food seemed better structured to administer "baksheesh" than relief aid. Any UN Iraq mandate must be founded on transparency and a bias for dealing directly with suppliers and end-users, eliminating entirely any "brother-in-law" deals.

Finally I think it is important to remember the larger cost of the subversion of the Oil for Food program. It was set up to alleviate the impact on Iraq's population of the UN sanctions that enforced the ban on Iraq's post-Gulf War rearmament. Not only did corruption take food from the mouths of Iraqis, but it also gave Saddam Hussein the funds to invest in arms, palaces, and the personal largesse that kept him in power. In short, this corruption seriously undermined the effect of the sanctions and weakened the best alternative to war. Anyone doubting this should look at the recent, muich more positive outcome in Libya.

If the international community wishes the UN to be the vehicle for stabilizing Iraq, then it must be willing to purge the UN bureaucracy of those responsible for the Oil for Food debacle, as a prerequisite to assuming responsibility for nation-building and reconstruction in that country. Failing to do so will reduce the UN's credibility and guarantee a less effective, and likely unsuccessful effort. None of us can afford that.

Biofuels and Oil Reserves
Two articles from this week's Economist caught my attention. The first discusses the application of biotech to fuels and related products, such as plastics. Although I've been critical of the current US ethanol policy, there is tremendous potential in tapping the energy content of agricultural waste. New enzymes and "bio-refineries" are making this possible, but as the article points out, the economics still hinge on the price of oil.

The second article poses some useful questions for the current debate on how oil companies book their oil and gas reserves. This measure serves two important purposes, one of which is important primarily to a company's investors, the other of broader interest.

First, reserves are a measure of the firm's potential for future value creation through the exploitation of assets it already controls, as well as providing insights into the relative competitive efficiency of its operations for finding and producing oil and gas. Both are of critical importance to stock prices.

The second purpose of the reserves data is more basic, as a snapshot of the company's ability to sustain its current production volumes of oil and gas. This has implications not only for shareholders, but for those concerned with the ability of the industry to cope with growing energy demand, shifting geopolitics, and industry restructuring. For instance, in the aftermath of the industry consolidation of the 1990s and early '00s, are the collective reserves of the merged companies greater or lesser than the sum of the parts that went into them? If claims of synergies are to be taken as more than ephemeral cost savings, they should manifest in an increased capability to convert probable reserves to proved reserves and reserves to dollars.

The standards that support a uniform view across all companies in the industry need to take both of these perspectives into account, as well as the issues of changing technology and markets identified by the Economist. I doubt this concern will fade as Shell gets its house in order.

Oil's Impact on the Economy
The latest Consumer Price Index (CPI) figures for the US indicated an increase for March of 0.5%, with core inflation excluding food and fuel of 0.4%. Even though the current high gasoline prices are not part of the core inflation rate, it looks like we are beginning to see the result of sustained high prices for the oil and natural gas inputs used by businesses in the goods they sell to consumers. Is this a real threat to the economic recovery?

The price of crude oil has been high for over a year, and natural gas has been well above its historical average since the end of 2002. This hasn't prevented the economy from growing so far, even though that growth hasn't generated many jobs, for a variety of reasons. In fact the Wall St. Journal's reporting of DuPont's recent announcement of 3,500 layoffs cited the high cost of natural gas as a contributing factor, since it is a major input in its basic chemicals business.

If the impact of higher energy prices is starting to show up in higher consumer prices for non-fuel goods, though, then this will influence policy decisions, such as the actions of the Fed's Open Market Committee, which sets interest rates. This week the stock market fell in anticipation of an increase in interest rates by the Fed next month. In effect, there is a delayed feedback loop by which high oil and gas prices increase inflation, which raises interest rates, which slows the economy.

None of this should be surprising. Crude oil and gasoline prices today are at about the level they were, in inflation-adjusted dollars, after the first Oil Shock in 1973-74. (See my posting of March 25 in archives.) The US economy is very different today than it was then, and the amount of energy required for each dollar of gross domestic product is lower. So barring a radical jump in oil prices from here, it's hard to imagine the same kind of economic malaise resulting from the current price levels. But that doesn't mean there's no impact.

Much will depend on how consumers will respond. If, for example, we were to change our driving habits, consolidating trips, carpooling, and shifting more travel to cars with better fuel economy, demand would start to moderate and that would ease prices fairly quickly. This would take some of the pressure off companies that produce goods for sale.

If, on the other hand, we ingore the gasoline price signal and continue the remarkable growth trend in miles traveled each year, and instead cut back our purchases of goods with a large energy component, then the economy will slow first, which will eventually result in lower fuel prices.

So even though it is natural to see the entire problem as being well beyond anything we can individually control, the reality is that the sum of all our actions as individuals will have a lot to do with how bad high energy prices end up being for the economy. So blame OPEC if it makes you feel better, but don't ignore what you are doing about it, yourself.

Smoke Screen
I've been remiss in waiting this long to mention Bruce Barcott's interesting article on the Bush Administration's environmental policy in the NY Times Magazine of April 4, 2004. In "Changing All the Rules" (which has now gone into the NYT archives), he describes the impact of changes in "new source review" rules for the electric power industry. Under this provision, power plants can perform necessary maintenance, but any upgrades or expansions trigger a requirement to meet current emissions rules and install the best available emission control technology. Mr. Barcott's article focuses on past violations of this standard and the new administration's efforts to make it less onerous for industry.

I'm not in a position to verify all the information in the article, but at least one fact that underpins his argument that environmental regulations have not stifled the expansion of generating capacity to meet demand, requires further clarification. The "fact" in question relates to the California power crisis of 2000-01. The author states, "We now know that California's energy shock was largely caused by market manipulation (by Enron, among other companies) and regulatory breakdown, not by a drought in supply." This is not a fact, but rather an assertion. An examination of the facts would reveal that two other major factors contributed to California's problems, in addition to those he cites.

First, the Pacific Northwest, from which California imported a significant portion of its incremental power, was experiencing a water drought that curtailed hydroelectric generation. More germane to the issues in the article is the trend leading up to the period of "deregulation", in which the state's power reserve was steadily eroded by the rapid growth of demand in the 1990s and the difficulties utilities faced in getting new plants permitted and constructed. From an industry perspective, the balance between environmental protection and the provision of energy critical to economic growth and personal comfort had swung too far in one direction.

The latter point encapsulates much of my discomfort with Mr. Barcott's approach. He raises issues meriting serious concern, and his observation about major changes in environmental policy being driven by bureaucratic fiat, rather than by Congressional action, is essentially correct, though hardly unique to this administration. However, his overall argument is undermined by the breathless tone of conspiracy that comes across in much of the piece.

While it is tempting to see the insertion of so many people with energy industry connections into the EPA and Dept. of Energy as simply putting the fox in the henhouse, there is another perspective on this. What I recall from my two decades in the oil industry was the relentlessly adversarial approach taken for most of that time by environmental regulators who had little appreciation or concern about the benefits the industry provided, seeing it only as a massive polluter.

When the Bush Administration took office, there was a sense in the parts of the industry with which I was involved of finally having someone in Washington who understood the complexity of the country's energy systems and who might be willing to listen to the input of those who actually run the machines that deliver power and fuel to a country that cannot do without them. Quite possibly this was taken too far, and the balance has swung in the opposite direction from the last twenty years. An article that presented both sides of the story would have been fairer but probably far less gripping and politically useful in an election year.

Desires vs. Markets
A couple of recent articles have speculated about the role that the demographics of Saudi Arabia will play in keeping the price of oil high in the years ahead, including this one in the Financial Times (subscription required.)

There's little doubt that the Saudis, in particular, and the Arab world in general, face a demographic crisis, and that much of the political unrest we see in that region is driven by a large and growing youth population. With a median age below 20 and high unemployment, the Saudis will need sustained high oil revenues to meet the demands on their social services.

However, desires alone don't drive markets. Clearly the US desires much lower oil prices, but our wishes don't make it so. The question is what other conditions need to exist in order to facilitate keeping prices high, since not even the Saudis can set the price of oil arbitrarily high just to suit their own needs, without disrupting the market. I see at least three other necessary conditions:

First, demand for oil would have to remain strong. This may seem like a foregone conclusion today. After all, the US economy is recovering, American driving patterns appear impervious to higher gasoline prices, and China is going great guns. But any number of things could dampen demand in the years ahead, such as another Asian economic slowdown, or unexpectedly rapid market penetration of fuel saving hybrid cars or clean diesel engines.

Second, the Saudis would have to convince the rest of OPEC that it is in their interest to adhere closely to quotas and avoid cheating, i.e. overproduction by individual members. That, too, seems like a slam dunk, in light of the recent success of this strategy. But once Iraq stabilizes, any new government there will have an enormous incentive to expand production, and they have the potential to blow huge holes in OPEC's dam, given enough time. Libya may be in the same position much sooner, as I indicated last week. However, these countries will have to compete for investment with opportunities in other countries.

This brings us to the third key factor; to sustain high oil prices, the growth of non-OPEC oil production would have to slow or stall. That, too, seems like a reasonable bet, with North Sea production plateauing and US production well past its peak, but it does not reckon with the potential of Russia, West Africa, and the countries in the Caspian region to add enough production in the next 3-5 years to ruin OPEC's calculations. But this, too, depends on the strength of demand, availability of capital, and OPEC policy.

So although understanding the impact of demographics can give important insights into Saudi oil policy, no issue, in isolation, will dictate the global price of oil. This complex and dynamic market has stymied numerous past attempts at prediction and control. As I've indicated in recent blogs, I think the willingness of the Saudis and other Middle Eastern producers to invite in foreign capital and capabilities will have at least as much influence on the future supply and price of oil as the Arab demographic bubble, unless it results in a full-blown revolution in the Kingdom.

The Other Gas for Cars
Yesterday's NY Times carried an article on celebrities converting their SUVs to run on compressed natural gas (CNG), as a way of reducing the environmental and energy security guilt associated with driving big, heavy cars. It raised several interesting questions about the advantages of natural gas powered vehicles that are available now, compared with hydrogen fuel cell cars that may still be ten years away. These are the kind of questions we should be asking, since any fuel conversion will entail major changes in our infrastructure and primary energy choices.

Other questions that should also be on the table include the following:

Although the Times cites natural gas as a domestically-produced fuel, most analysts including the government's Energy Information Agency anticipate that any growth in US natural gas demand will have to be met through increased imports, because US gas production has stagnated in recent years. This will require construction of a number of LNG (liquefied natural gas) import terminals, a new pipeline from Alaska or Canada, or both. Are incremental gas imports best used for transportation, or as the cleanest fuel for electricity generation?

Compressed natural gas cars are currently cheaper to fuel than their gasoline counterparts, largely because natural gas carries no transportation taxes. If more than a small fraction of the cars on the road converted to natural gas, some alternative means would have to be found for collecting taxes for highway repair and the other items funded by the state and federal fuel taxes. If natural gas for road use were taxed at the same rate as gasoline or diesel, much of its advantage would disappear. Should CNG receive this kind of subsidy because of its environmental benefits?

There's also a practical question about the number of miles an owner would have to travel annually in order to defray the investment in conversion to CNG, even if the fuel retains its road tax exemption. The Times indicated a conversion cost of $10,000, which seems high. Even at $5,000, I suspect that only fleets of high use vehicles, such as taxis, delivery vehicles would find this advantageous, and in fact, it is mostly these kinds of vehicles that have already made this switch.

I'll leave the safety concerns for others to highlight, except to say that I don't personally fancy the idea of driving around with a high-pressure tank in the back of my car, even if it is wrapped in Kevlar and has been dropped off the Empire State Building in tests. I spent enough time in refineries to have a very healthy respect for the amount of mechanical energy stored in a gas at 2000 psi or higher pressure.

At the same time I don't want to dismiss this idea out of hand. It has some merit and may make sense for some consumers, even if it does nothing more than assuage their consciences. And if our government saw enough benefit in this idea to be willing to open up some of the gas fields currently off limits (see my posting of March 11 in archives), then we might actually see domestic natural gas prices come down enough that this could be a real winner.

A New Tradeoff?
Ever since taking the helm at Ford Motor Co., William Clay Ford has been a controversial figure. He has spoken publicly about a strong environmental agenda, although some have criticised Ford for failing to follow through. This week, he threw his support behind the idea of higher fuel taxes couples with incentives for high-efficiency vehicles such as hybrids.

The tradeoff between taxes on consumers and fleet mandates at the manufacturer level is one that was settled in the US two decades ago. Europe has chosen to rely on high fuel taxes and taxes on engine displacement as a way of keeping cars efficient and moderating their oil imports. That approach was rejected here in favor of the CAFE standards I discussed earlier in the week (see Monday's posting.) Perhaps the time has come to reopen this debate.

The advantage of taxes is that they allow the market--consumers--to select the makeup of the car fleet and avoid the kind of loopholes and gaming that mandates such as CAFE are prone to. However, with consumers already complaining about gasoline prices that have skyrocketed due to market factors, how would they welcome a $.50/gallon tax increase on top of this?

Even if Mr. Ford's remarks are somewhat self-serving, since Ford has invested in hybrid technology and is launching the hybrid version of its small Escape SUV this year, this is still a national conversation worth having.

First Fruits
With Iraq's instability showing no signs of abating, it could be a long time before international oil companies see an atmosphere conducive to pursuing new exploration and production opportunities there, beyond pre-existing deals such as Lukoil's. The less heralded return of Libya to the international fold looks like it will bear fruit much sooner.

The Financial Times recently estimated that the oil sector in Libya would need up to $30 billion over the next 10 years as the country seeks to expand production capacity from 1.6 million barrels per day (MBD) to 3.0 MBD. Shell has already announced a gas exploration agreement with the Libyan government.

The terms required to lure more companies back will need to be attractive, and these opportunities will have to compete with others elsewhere. But they start with two key advantages: proximity to the large markets in Mediterranean Europe and the prospect of crude oil qualities matching those of Libya's current production, which is lighter and sweeter (lower in sulfur) than most Middle Eastern oil.

On balance, although Iraq has much greater long-term potential, the re-opening of Libya could have a bigger impact on the market in the medium term.

Trading Carbon Credits
Even though the Kyoto Treaty on climate change lacks the required number of signatory countries to go into effect, the European Union is moving ahead with measures to reduce emissions of carbon dioxide and other "greenhouse gases" (GHGs). At the same time, some EU leaders are expressing concerns about the competitive handicap these limits may create. The latest Economist includes an update on where emissions trading, which can reduce the cost of compliance, fits in the EU's plans.

In this type of trading, parties that can achieve reductions in emissions at relatively low cost are able to sell their excess reductions to others facing higher costs. This is classical economics at its purest, and it produces benefits not only for the participants, but for society as a whole, as the total cost of achieving the same reductions is driven down to its most efficient level.

The application of trading to environmental issues was first demonstrated in the US, with the establishment of a market for acid rain and smog-causing sulfur emissions. This program has not suited everyone, with some Northeastern states downwind of plants that purchased credits in lieu of reducing their own emissions complaining and passing laws to limit trading. Still, it has arguably reduced overall power plant pollution, while keeping electric rates lower than if all generators had been required to reduce their own emissions.

Emissions trading is ideally suited to addressing the concerns of climate change, because it is truly a global issue. A ton of CO2 emitted in Brazil is exactly equivalent in its impact on the climate to a ton emitted in Boston. The regional and "downwind" issues that have bedeviled sulfur and nitrogen oxide trading are simply irrelevant to GHGs.

The larger EU emissions market now under discussion is a follow-on step to a number of national programs, starting with the UK's, which has been in effect since 2002. As the Economist points out, it is ironic that Europe is now proceeding to implement emissions trading, while it is off to a slower start in the land of its birth.

Here, without a firm cap on output driven by government policy, trading has so far been limited to a modest number of forward-looking companies that see it as an attractive hedge against potentially much higher costs of cutting their GHG emissions in the future. The importance and value of emissions trading is likely to grow significantly, should a Democratic administration take office next January.

And a follow-up from a colleague concerning yesterday's posting:
NPR carried this story concerning opposition to a promising gas discovery in New Mexico.

How Many Back Yards?
A colleague forwarded a report indicating that two proposed LNG import terminal projects have been cancelled or suspended, one in Maine and one in Northern California, due to strong local opposition.

There was a time when these projects would have been welcomed as valuable sources of jobs and local tax revenue. Today, even as we bemoan the offshoring of manufacturing jobs, it is clear that much of the country has adopted a distinctly post-industrial mindset toward any facilities that exude smoke and steam. That includes the infrastructure facilities upon which our lifestyles depend.

In contrast to the rather depleted state of our petroleum endowment, we still have sizable untapped resources of natural gas in North America. However, it is strictly verboten to drill into this gas if it happens to lie in places we value for their pristine appearance. The result is a growing reliance on imported natural gas.

That is a legitimate, values-based choice as far as it goes. Paradoxically, though, it is also apparently verboten to build facilities for importing gas from overseas. Having outsourced the production of the gas, do we now wish to outsource its importation, as well, perhaps to Mexico or Canada?

The inherent conflict between our insatiable appetite for things that consume energy and our recently-acquired sensibilities towards our surroundings is a slow-motion train wreck that has already begun. Americans usually prefer to solve our problems after they have reached crisis proportions, but in this case we need to be aware of how long it will take to respond, once we realize we have not built enough pipelines or LNG terminals, or drilled enough gas wells to keep the heat and lights on at a price we like.

Both Wrong?
In their lead editorial today, the New York Times castigates both the President and his challenger, Senator Kerry, for arguing about short-term fuel prices and ways to address them, rather than promoting a national debate on the underlying issues of energy use and how it might affect our national security. The Times would have done well to quit after making this excellent point, rather than weighing in for specific solutions, themselves.

Their preferred answer appears to be to tighten the Corporate Average Fuel Economy (CAFE) standards that were imposed in the 1970s, and about which I've written in the past (see my posting of 2/20/04.) A major drawback of CAFE is that it ignores consumer preferences, imposing instead a limitation on the average fuel economy of each manufacturer. Ignoring the loophole that has allowed ever larger SUVs to bypass the intent of the CAFE standards, it is not at all clear that large numbers of consumers will opt for smaller, thriftier vehicles, or willingly pay the higher prices necessary to pay for technology that could reduce fuel consumption.

The Times also chooses to ignore the vital role the market played in mitigating the supply crises of the 1970s, and the way in which the sources of this country's imported oil have diversified in that period, even as demand grew and domestic production declined. We are less reliant on OPEC today than we were in 1975, according to the government's own statistics on imports. The recent growth of production in Russia and the Caspian Sea region offers opportunities to maintain a diversified supply for at least the next decade or so, even though the preponderance of reserves in the Middle East must eventually shift that balance.

While markets have their limitations, and though their results are not always popular--as with current gasoline prices--they do some things much better than command-and-control approaches can. Surely this, too, must be part of the debate the Times presumably endorses.

SPR in the Crosshairs
I'm traveling on business, so no new blog Friday. Meanwhile, if you have been following the debate over whether we should still be adding oil to the Strategic Petroleum Reserve with oil and gasoline prices as high as they are, and if you have not previously read my posting of February 17 on this subject, you'll find it in archives. It is as relevant to what the presidential candidates are saying on this topic as it was to the Senate debate six weeks ago.

Iraq's Oil Patrimony
We are approaching the first anniversary of the fall of Baghdad. If you can believe the polls or the evidence of recent anti-war demonstrations, much of the world still believes the US went to war in Iraq to seize control of its oil resources. I never shared that view and could nominate several other countries whose actions in the UN Security Council suggested that they were influenced to a much higher degree by oil than was the US. Now, as we anticipate a handover to an Iraqi government in June, there is growing and legitimate concern about how Iraq's oil will be managed. There is a great opportunity here to benefit both the Iraqi people and the world.

Regular readers have seen my past comments on global oil depletion and a possible imminent peak in production. If we are facing a peak, it has to shift closer without open access to Iraq's 112 billion barrels of proved reserves, which could reasonably be expected to support production of at least 5 million barrels per day, compared to the current 2.5.

Achieving that won't just require access for US companies, or for companies in countries that joined our coalition. Rehabilitating Iraq's dilapidated oil industry and increasing production sustainably is such a big task that it will take expertise and investment from many sources. In the process, companies should find attractive opportunities, perhaps more attractive than some current and prospective projects they are pursuing elsewhere in the world. I can think of some countries that should be worried about that, with Venezuela topping the list.

However desirable it might seem to some, Iraq could never accomplish such an expansion on its own, without international help. Recall that the existing infrastructure was a shambles before Coalition troops crossed the border, and the repairs funded by the US are geared primarily to addressing acute and chronic problems, not building new capacity. And because the new Iraqi government will need oil export revenues to finance rebuilding their country, that money will not be available for reinvestment in the oil industry in the short or medium term. Finally, Iraq has missed out on at least a decade's worth of technical development in a very high-tech industry. They will need help just to get back to where they were, let alone move ahead.

Security, government & governance, and terms of access must all be settled as a prerequisite, and this will be a major undertaking in itself. The new government will also have to figure out how best to feed oil money into the system, to avoid perpetuating the Resource Curse seen in so many other oil-rich, institution-poor countries. Their success in this undertaking is very much in the self-interest of every energy consumer in the world. If they fail, we just might have no choice but to give up our SUVs.