The New Car
The New York Times gets my vote for best title of an article dealing with high oil prices, “Laissez-Faire My Gas Guzzler, Already”. The article also nicely illustrates the difference between the short-term and long-term price elasticity of demand for petroleum products. It describes anecdotally why, even with higher gas prices pinching drivers' wallets, it’s hard for them to change their fuel consumption much. It also discusses some of the uncertainties that weigh in these longer-term responses, such as the purchase of a new car.

I have some skin in this game—beyond mere punditry—since I’m seriously considering replacing my seven-year-old car this fall. One of the first things I’ve discovered is that my technology choices are much wider than I’d have suspected, even given my interest in the industry. It’s not just a choice of hybrid or no hybrid.

In fact, there’s already a bewildering array of possibilities out there, without contemplating anything as exotic as fuel cells. Before I even get to styling and fun, which will be key decision attributes, I must evaluate the following powertrain choices:

- Conventional gasoline engine, normally aspirated (i.e. regular fuel injection)
- Conventional gasoline with turbocharging (or supercharging)
- Gasoline rotary engine (e.g. Mazda RX-8)
- Gasoline hybrid (e.g. Ford Escape Hybrid or Toyota Prius)
- Gasoline “mild hybrid” (several new pickup trucks coming out this fall)
- Advanced gasoline engine (e.g. GM’s new V-6 with variable valve timing)
- Advanced diesel engine (e.g. VW’s turbodiesel Passat with direct injection)
- Flexible fuel engine (capable of running on gasoline or 85% ethanol)

There are also several transmission choices that weren’t available seven years ago, including six-speed transmissions in either standard or automatic, plus the intriguing Continuously Variable Transmission, appearing on a few selected models. In addition, many makes now offer all-wheel drive as an option on multiple models; this was one of the key selling points of the Audi I bought in 1997, when they and Subaru had a near monopoly on AWD.

The above choices of engines, fuels and transmissions gets me into a pretty wide range of uncertainties that will affect my operating costs and future resale value:

- Will fuel prices remain high or return to historical levels (in nominal dollars)?
- In particular, will a car chosen today for better fuel economy retain value better or worse than one chosen on other grounds?
- Will a new technology, such as VVT or CVT, expose me to higher repair costs and lower reliability over the time I own the car?
- Does the rotary engine have enough experience behind it to be as reliable as a piston engine?
- Is it wiser to lease, rather than purchase, a car with a new and less proven powertrain?

Finally, these choices force me to get real about my concerns about climate change, local pollution and energy security. I will keep you, my readers, posted along the way with any noteworthy conclusions or discoveries.

Still Trading
For some time I've suggested that there was a high risk of throwing out the baby with the bathwater in the aftermath of the Enron debacle, at least as far as energy trading was concerned. It seems that at least a few companies saw it the same way. Last week's Economist profiled Constellation Energy, formerly Baltimore Gas & Electric, which has been busily expanding its energy trading so that it now accounts for the largest slice of the firm's revenue and profits.

As the article indicates, the enormous uncertainties in the primary energy markets, particularly natural gas, combined with continued deregulation at the wholesale electricity level create both a need and compelling argument for sophisticated risk management products that can only be offered by energy traders with a deep "book"--one that can make up for gaps in market liquidity.

I still wonder if the stock market truly understands how to value a company that has much of its flows made up of this kind of activity. While accounting rules have been tightened post-Enron, do P/E ratios for such firms reflect the unique risks and rewards inherent in energy trading?

Alternative Energy Giant
Seeing alternative energy as still largely the purview of small, aggressive start-ups may be an artifact of the late dot-com boom, or a consequence of its marginal contribution to the international energy majors, which still earn essentially all their profits from oil and gas. But there is another mammoth enterprise that seems quite interested in the potential of alternative energy. Over the last couple of years, General Electric has made an impressive series of acquisitions in this sector, including the purchase of Enron Wind in 2002, its acquisition earlier this year of AstroPower, and its recent purchase of ChevronTexaco's gasification technology. GE also recently opened a research facility in Germany devoted to alternative energy.

The combination of these businesses creates a very respectable alternative energy portfolio, in the hands of a company with both deep pockets and a track record of moving new technology into the market. I hesitate to say "synergies", but there may be genuine cross-benefits between these businesses and GE's other lines.

Even before these acquisitions, GE was an important player in this space. Although it may seem quite mainstream now, the successful domination of the power generation business by aero-derivative gas turbines, starting in the 1980s, is one of the most dramatic energy shifts of recent times, and GE was one of the prime movers and major beneficiaries of this change. So here is a company that has already had a hand in a major energy transition, investing in an array of technologies that could be as important in the next decade as the gas turbine was in the last.

In particular, the combination of gasification, which turns coal or other environmentally less desirable fuels into a clean synthetic gas, with GE's gas turbine expertise could be a big winner in a market that is hungry for clean electricity but facing the prospect of high natural gas prices for years to come. Gasification also has another nice feature, with concerns about climate change growing, at least in Europe. The carbon dioxide that comes out of the process is much more concentrated than the flue gas from a conventional coal plant or gas turbine, lending itself to easier handling should CO2 disposal become attractive.

All of this is both good news and bad news for other alternative energy developers, given GE's past strategy of "1, 2 or out." They bring momentum and credibility to this market, but they are also a heck of a competitor.

By the way, the blog will be on holiday until Wednesay, September 8.

SUV Confrontation
According to this story in the Financial Times, SUV sales are up 14% and the government is considering measures to limit their popularity and reduce their impact on fuel consumption and urban congestion. While this sounds like a plausible headline for the US, in fact the story is from Europe, where SUV sales are apparently up to a half-million units per year, or about 5% of the total market. That doesn't sound like much compared to the US, but considering gasoline that costs roughly $5 per gallon, and city streets that are often barely wide enough for a normal car, it's something that European governments don't think they can ignore.

The first showdown may occur in Sweden, where the parliament is contemplating an SUV tax of SKr 60,000 (about $8,500,) while France is looking at a tax of up to 3200 Euros ($4,000.) Carmakers such as Volvo are complaining this would cut into sales and production of some of their most popular and profitable vehicles. I'm sure Detroit would share this concern.

But while the US car industry has been successful at fending off stricter or rationalized Corporate Average Fuel Economy standards (e.g., reducing the difference between car and light truck standards,) Europe's priorities are different. Urban congestion is a very serious problem in centers like London and Paris, and climate change is a major policy driver at both the EU and national government levels. Some industries are already required to trade carbon emissions credits.

For European governments looking at ways to reduce oil consumption and its environmental consequences, SUV taxes might be more popular than further increases in taxes on gasoline or engine displacement, since the SUV constituency is still fairly small. It's harder to see what implications such measures might have for the US market, where the SUV trend is starting to plateau and morph into a new wave of "crossover" and other station-wagon-like vehicles.

Where Will Our Gasoline Come From?
An article in today’s Wall St. Journal highlights an important issue that has received little attention, even in this year of unusually high crude oil and gasoline prices. As the article’s title suggests, “US Relies on Europe For Gasoline”. In additional to all the crude oil this country imports, we also bought over two million barrels per day of petroleum products from foreign refiners last year, with a quarter of that consisting of finished gasoline, and a similar fraction requiring further processing or blending. This dependence will only grow in the years ahead, if US gasoline demand continues to ratchet up.

There are good reasons for our loss of gasoline self-sufficiency. First, as domestic crude oil supplies dry up, US refineries lose some of their competitive advantage against imports. More importantly, the domestic refining industry has been saddled with two decades of high investment to meet increasingly strict environmental regulations, both on the properties of the fuel and on refinery emissions.

Although necessary to stay in business, these investments have yielded very poor financial returns for oil companies, since consumers have not seen the changes as something for which they were willing to paying more. Nor have the government’s regulations provided for any profit-recovery on mandated investment, leaving that to the market. Other regulations make building new refineries in this country virtually unthinkable. The net result has been refinery closures and little investment in new capacity to keep up with demand.

As the Journal points out, this problem has been manageable so far, because Europe is in the midst of a sea-change from gasoline to diesel for its new cars, nudged along by tax and emissions policies that favor the latter. For European refiners, the opportunity to export to the US has provided a dual benefit; not only are they able to sell a high-margin product for which demand in Europe is falling, but they can forego the expensive refinery retooling that would otherwise be required to convert more oil to diesel and less to gasoline. But as the article suggests, there are strong indications that foreign suppliers, especially those in Latin America, are not enthusiastic to invest in refinery upgrades to meet more stringent US gasoline specifications, when other export markets--such as a rapidly growing China--may be just as attractive without additonal investment.

What is the likely outcome of this situation? Clearly US gasoline prices, particularly in regions such as the East Coast that are highly dependent on imports, must rise relative to crude oil. And these higher margins must persist long enough to offer US or foreign refiners the prospect of attractive returns from investment in new capacity, which will take further years to build. So even if crude oil returns to $20 or $25 per barrel, we may not see gasoline prices as low as those of 2001 and early 2002 for a long time to come.

Safety vs. Security
Sunday's New York Times carried an article about John Young, the ex-architect who has dedicated himself to identifying our country's vulnerable infrastructure. His website, for which I decline to provide a link, amounts to a one-stop-shopping site for information about natural gas pipelines and pump stations, nuclear power plants, and even the security preparations for the Republican convention in New York. Mr. Young thus personifies a central dilemma of our time: how do you balance the public's right to know about things that impinge on their safety and security with the need to hide them from malefactors who would seek to destroy them?

When I first heard of Mr. Young several months ago, I thought he was providing a useful service by highlighting security deficiencies that needed to be addressed. On further reflection, and particularly in light of his zeal at exposing surveillance cameras and other security systems, I have to say that he goes too far. It is one thing to give people the information they need in order to avoid damaging pipelines in the course of construction projects, but it is quite another to broadcast every conceivable vulnerability, along with the preparations by public agencies to counter them. This irresponsibly increases, rather than lowers, our risk.

How might this balance better be struck? One way might be to create a secure intranet for contractors, providing them with access only to the local infrastructure maps they might need in their work. While such a system might still be subject to hacking or subversion, it would at least not do the terrorists' work for them.

Like many people, I'm uncomfortable about any attempt to restrain free speech, even in wartime, since once restrained it may be hard to retrieve later. But there is also a time-honored principle that free speech does not include the right to shout "fire" in a crowded theater, and Mr. Young seems to be doing that as loudly as he can. I suppose its a kind of tribute to our free society that his website is still up and running; let's just hope it's not a fatal tribute.

One Step at a Time
If renewable electricity is going to become a meaningful energy source in this country, it will have to do so by providing viable alternatives to conventional power projects on an industrial scale, not just "one roof at a time." That means that large customers and utilities will have to eschew traditional, reliable choices and take a chance on something greener. As a former L.A. resident, the cancellation by the city's Department of Water and Power of their stake in a major coal plant expansion in Utah caught my eye. Anyone who doesn't believe Mayor Hahn is taking a big risk with this hasn't been paying attention to California politics, with the recall of Governor Davis at least party attributable to his inept management of the state's electricity crisis.

Now, it's fine and good to say that the city will find greener alternatives to the foregone coal project, but time will tell what that really means, since there were no specifics provided. Do they intend to spend the saved $200 million on wind and solar projects, or, when the city's appetite for power grows again, will they just build or buy into more gas-fired turbines, exacerbating the need for new sources of natural gas? In any case, the DWP is about as large as municipal utilities get, and this decision should be seen as an important milestone and potential golden opportunity for developers of renewable electricity.

Future Oil Prices
Continuing on from yesterday's theme on oil prices and last week's comments on market backwardation, I see that the Economist (subscription required) has joined the growing consensus that oil prices are likely to remain high for some time. Their best argument comes in the form of a chart comparing the recent history of the "prompt" NYMEX WTI contract (for delivery in the next month) with that of the contracts for delivery 24 months later. It shows clearly that, despite big moves in the prompt prices, the price for two years out held steady in the mid-$20 range until the beginning of this year. Subsequently, something has convinced the market that we aren't on the verge of another slide toward "normal" prices.

The Economist article lists many reasons why high oil prices might not be temporary--including a few dubious items such as Asian speculation in oil futures as a play against the dollar. (I'm a simple type who believes that when traders want to bet against a currency, they have much better ways to do it than fooling around with a commodity that is influenced by practically everything on the planet.) If they are right, it is important for more than the obvious reasons; the level of oil prices three to five years from now is also a key signal about the sustainability of the industry.

Barring a global recession or a major slowdown in Asia, lower prices later this decade would indicate that conventional oil production can continue to expand to meet growing global demand, perhaps with a bit of help from oil sands and gas-to-liquids, but without reliance on more exotic alternatives. Prices would only fall back into the normal range if the events of the past few years have not pushed us into an entirely new regime of scarcity and constraint, or broken the industry's ability to respond to shifts in demand.

So when the longer-term futures prices join the spot-price party and backwardation shrinks, I think we should pay attention. While the futures markets don't predict the future, they provide useful insights into current thinking on it. At the moment, the market expects that prices will stay high beyond the typical response cycle the industry has exhibited in the past. That suggests the international oil majors should not only be redoubling their efforts to invest in the relatively few truly material resource opportunities out there (e.g. Russia and the Middle East), but they should also seriously reconsider some aspects of the last decade's main strategy of ruthless cost-cutting. Perhaps those "marginal" fields they've been busily divesting are not quite so marginal, and further consolidation--which reduces the industry's aggregate capital budget--might not be in the majors' or anyone else's best interest.

Today's Wall Street Journal raises this issue of oil industry underinvestment on their front page. Wouldn't it be ironic if the thing that finally drove the world away from oil and towards alternatives weren't climate change or OPEC, but the unwillingness of the oil industry to invest enough money in its core business to keep up with demand? That would have been unthinkable to the generation of oil executives who built the companies that are today's market leaders.

Those Hedge Funds Are At It Again!
Along with the routinely enumerated causes for the sharp escalation of oil prices in the last year, the role played by hedge funds is coming under increasing scrutiny and criticism. According to the Financial Times, the Japanese government is calling for "international discussions" on this aspect of high oil prices, though it isn't clear exactly what that means or what it might accomplish. Despite this, and in the face of the obviously serious potential consequences for the economy of sustained high oil prices, I would suggest that the concerns about hedge fund activity are overblown, at least for now.

Many of my readers have access to better statistics of hedge fund open interest on the New York Mercantile Exchange and other international oil commodity markets than I do, so I'll confine my comments to the issues, not the numbers. It does appear that hedge funds have taken a strong interest in oil futures and options, particularly as other markets have slowed. It also appears that their analytical tools drive them to increase their open positions in oil as prices go higher, adding to both the overall level of the market and to volatility, the main measure of market variability. In the short run, this creates a sort of self-fulfilling prophesy: previous futures positions appreciate as prices rise, and the value of long options grows with increasing market volatility.

But there are several ways in which the market for physical oil is buffered from these gyrations. First, although the daily trading volumes for the NYMEX West Texas Intermediate Crude (WTI) contract and the London Brent Crude futures contract are enormous relative to the actual volumes of these two grades of oil, they are not as representative of the market as a whole as some might think. While many contracts for physical crude oil are pegged to WTI or Brent, a great deal of the world's oil is too dissimilar from these light, sweet grades to be traded solely based on the futures markets. Nor is all of the world's crude actually delivered to the physical settlement locations of these futures contracts, such as the US Gulf Coast.

As a result of these factors, oil of substantially different quality, or for delivery to other locations, usually trades on the basis of a "differential" to WTI or Brent, that is, with an agreed amount added to or subtracted from the quoted daily or monthly price for the "marker" grade. For example, a cargo of heavy, high-sulfur oil delivered to the US West Coast might trade at $5.00 per barrel below WTI.

When the price of the marker crude becomes distorted by local conditions, such as unusually high or low inventories of oil in the US Midcontinent, or by excessive speculation, the differentials for the physical delivery of other grades--always in flux, anyway--will widen or shrink to take this into account to some degree. Imagine, for instance, that speculators have driven WTI up by $2.00 per barrel at the same time that increasing physical invetories of oil would suggest a drop of $2.00 might be more appropriate. The discount for that notional West Coast heavy sour cargo would probably widen from $5.00 per barrel to $6.00 or more, reflecting lower demand for it elsewhere due to higher inventories.

In addition to such cargo-specific factors, a large quantity of oil is traded on long-term contracts at prices that are not directly influenced by the futures markets. The combination of these factors means that the cost of much of the oil that is delivered to refiners around the world is at least partially protected from speculative swings in the price of the futures markets.

There's a cautionary note here for hedge funds and their investors, too. As with other markets, oil markets that get too far out of line with the underlying realities of the commodity have a tendency to correct with a vengeance. The hedge funds would not be the first to try to "corner the market" in oil, though they might be the deepest pockets to try it. The history of the industry is littered with commodity traders who built up a fabulous position but got their heads handed to them when the market finally corrected. Perhaps the funds are too sophisticated to get caught this way, but I wouldn't bet on it, which is exactly what they seem to be doing.

Missed Blog
Today ended up being entirely consumed by travel, unexpectedly, so no new posting. New commentary tomorrow.

Energy Autarky
In the course of catching up on last week's energy articles, I found this excellent discussion of the future US natural gas situation by Neela Bannerjee in last Friday's N.Y. Times. In particular, I found its treatment of LNG rather more balanced than some of the breathless articles that both the Times and Wall Street Journal have run over the last several months. In any case, the concerns it raises about potential future US dependence on unstable foreign suppliers of natural gas--along the lines of our current dependence on certain oil exporters--are worth some thought.

While I suggest that Ms. Bannerjee gives too little credence to the potential to increase domestic gas supplies (if we include Alaska and northern Canada in that definition), she correctly identifies the key challenge of investing sufficient capital to create an international gas infrastructure that can deliver enough gas to keep up with our needs. And once built, this expensive infrastructure of gas wells, liquefaction plants, and tanker loading facilities is indeed hostage to the good intentions of its hosts, whether they be Australian or Libyan.

Still, although I have my own reservations about relying on LNG imports to plug the current gap in North American gas supplies, I am a lot less worried about these particular issues. The international gas industry is at a much earlier stage in its development than the oil industry. An enormous amount of gas remains to be discovered as non-associated gas, or gas that is not produced in conjunction with oil. This is an important distinction, because much of the gas that is currently being produced was found by accident while seeking oil. Until the development of practical large-scale LNG systems in the 1960s and 70s, there was little incentive for energy companies to look for non-associated gas outside North America or Russia.

The implication of this is that as this market develops, it is quite possible that the current dominance of Russian and Middle Eastern gas reserves could be balanced by the discovery of significant reserves in a number of other countries. This is especially true if some of the more extreme theories about the geological origin of natural gas turn out to be correct.

Fundamentally, the concerns raised in the Times boil down to the same debate about energy independence that has been raging on and off for the last 30 years. It hinges on whether realistic alternatives to fossil fuels can be developed on a large enough scale to power our economy and applies equally to gas as to oil. In some respects, the situation is even worse for gas, since for the last two decades it has grown not just in its own right, but as the primary economically and environmentally attractive alternative to oil.

Barring the kind of wholesale development of nuclear power suggested in this satiric piece in the Sunday NY Times, I'm skeptical that wind or terrestrial solar power can be scaled up sufficiently to prevent us from burning through much of North America's natural gas endowment and becoming dependent on imported gas, even if it is used to provide the primary energy for a future hydrogen-based economy. But in a fully-globalized world with less conflict than today's, that wouldn't be the worst outcome imaginable.

A Whole New Perspective on Life
Although I've mentioned a number of books in the course of my blogging, this is the first time I've felt compelled to review one here. The book in question might at first seem slightly off-topic, but I believe that anyone contemplating the future of the global energy industry needs to consider the ideas it contains. "The Pentagon's New Map," by Thomas Barnett, creates a coherent, comprehensive model of the world in which we now live, and in which we are likely to find ourselves for some time.

Barnett's worldview is the equivalent of a Grand Unified Theory for geopolitics in the 21st century, and he achieves this by looking ahead at least as much as he looks back. He takes into account the effects of globalization, regional demographics, energy and capital flows, jihadist movements, the War on Terror, the Iraq War, and almost everything else, with the possible exception of environmentalism, and distills them into a map and a set of dynamics and strategies that explain where we are heading. His concept of the "Core" (the countries in which globalization works) and the "non-integrating Gap" (those countries that are poorly connected and whose leaders may want them to stay that way) is brilliant in its simplicity.

Even better, Dr. Barnett lays out a positive scenario for the future that doesn't require pretending that the last several years never happened. As a professional scenario planner, I think that's a big deal. Ever since 9/11, I've really struggled to see a happier future we can actually reach from where we are. Barnett presents realistic, if difficult pathways toward a better world, as Pollyannish as that may sound.

I won't say that this book will change the life of everyone who reads it, though it has certainly shifted and uplifted my own outlook. While much of it deals with the military, it is by no means exclusively a military book. If, like me, you feel that our leaders have done a poor job of explaining our course to us and to the world, then you should find this book of particular interest. Highly recommended.

Yesterday’s Wall Street Journal carried a guest editorial by Riad Ajami, proposing that the time was right for grand alliances between the state oil companies of the OPEC countries, which own the bulk of the world’s crude oil reserves, and the Supermajors of the international energy industry, which have access to the world’s most important downstream markets and much of the infrastructure linking the two. He suggested a linkup between ExxonMobil and Saudi Aramco, as an example. This is not exactly a new idea. However, it suffers from a fatal flaw: alliances work best when the interests of the parties are well-aligned, and the interests of the majors and OPEC may be contrary, at least in the short term.

Oil producers worry most about their ability to access downstream markets when oil is seen as abundant, and prices are soft. In such a buyers’ market, refiners can be choosy and drive a hard bargain with suppliers, who need to dispose of their production somewhere, or see it shut in. In contrast, refiners and marketers worry most about access to oil when markets are tight and even lower quality oil—heavy or high in sulfur—commands premium prices. Then, they risk having their expensive facilities underutilized, at a point in the cycle at which maximum throughput and efficiency are key. But at that point suppliers have a host of buyers competing for their output. Thus, the appetite for producers to enter into this kind of arrangement peaks precisely when that of the refiner/marketers hits its nadir, and vice versa.

Another problem relates to the main engine of earnings for the international majors. Except in rare years, they earn the lion’s share of their profits from discovering and exploiting oil and gas reservoirs. They do best when they can capture part of the economic rent associated with the resource, and that implies the need to own it, or at least have attractive, long-term access to it. The refining and marketing parts of these companies have typically been regarded as either an economic hedge or a legacy means of disposing of crude, or in industry parlance, “making it go away.” So in their most important line of business, the majors act as customers, service providers, and even competitors to the state oil companies. This is not exactly complementary, in the way you’d want for a natural alliance.

There’s also some history here. The last time this idea was tried was in the late 1980s, when Texaco formed a downstream alliance with Saudi Aramco for its US refining and marketing assets east of the Mississippi River. The stated rationale was exactly as described by Mr. Ajami. An additional alliance and a merger later, Shell now sits in Texaco’s chair in this alliance, called Motiva Enterprises. Without speaking out of school, it should be instructive that in the nearly 20 years since this alliance was formed, the industry hasn’t rushed to copy it.

As I’ve suggested in previous blogs, I believe the real opportunity here is not matching resources to downstream markets, but rather matching the majors’ technology and capital to OPEC’s underexploited resources. That could result in alliances, too, but they might look a bit different than the proposed ExxonAramco. On the other hand, an OPEC country, flush with cash generated by sustained $45 oil, might find one of these companies an attractive acquisition target. That has also happened before.

The Meaning of "No"
President Hugo Chavez may find much to relate to in Nietzsche's remark, "That which does not destroy me makes me stronger." Despite some expressions of concern about voting irregularities, the Carter Center and other international observers have endorsed the "no" outcome of Sunday's referendum on Chavez's rule. As I suggested last week, this may reduce one kind of political risk for oil investors, but it will surely create new ones.

Last Friday's NY Times carried this article describing Chavez's plans for an integrated energy network in South America. In itself, this may be a good idea that would promote broader economic development throughout the continent, even as it increased Mr. Chavez's political leverage and influence. But the plan also reflects a desire to reorient Venezuela's oil marketing efforts away from its reliance on the US market. While that may be good politics in Latin America, it poses big challenges for North America.

The great energy success story in the wake of the oil crises of the 1970s was the diversification of US energy imports away from the Middle East, and Venezuela played a key role in that. Along the way PDVSA, the Venezuelan state oil company, acquired a US refining and marketing company, CITGO, and international oil companies made significant investments in Venezuelan oil projects. Barring a new international crisis, it wouldn't make sense for Venezuela to cut off its oil shipments to this country, but even a gradual move away from the US and towards new partners in Latin America would leave a void.

With domestic production continuing to decline and West Africa, the other big success story of the 1980s and 90s, suffering from crippling unrest and corruption, the likely outcome of such a shift is either growing US reliance on Middle East oil, or a more intense effort to strengthen energy ties with Russia, which has significant untapped potential. If so, the results of Sunday's election will reverberate around the globe for years to come.

By the way, tomorrow is a travel day for me, so there won't be a new blog. Postings will resume on Thursday.

One Year Later
I'll never forgot the date of the Northeast blackout of 2003, because my daughter was born in the middle of it. However, I have to wonder if others' memories are shorter, particularly those of the legislators, regulators, and utilities that all seemed so gung ho to rectify the problems that led to the largest power disruption in the country's history. That view is corroborated by articles such as this one in the Financial Times.

It's relatively easy to imagine a future power grid that is much more resistant to outages such as last year's. It could be the intelligent grid that some have likened to the Internet, with widespread two-way metering and seamless integration of a myriad of small generators, enabled by high speed computing. It might just be a more robust version of today's grid, with extra capacity added to key choke points and a larger generating surplus, or a mixture of the two. The hard part is actually getting there from where we are now.

Doing so will require greatly reduced uncertainty about the future regulatory framework, along with the prospect of returns that are attractive enough to lure capital away from other investment opportunities. That means Congress needs to enact an energy bill to replace the one that has been stalled for the last year, despite broad consensus that better energy policy is urgently required. It also means that local regulators must make electrical reliability a higher priority and create incentives for the grid operators and utilities to upgrade their systems.

That can only happen with strong public support and a willingness to set aside parochial concerns such as the interstate rivalry that bedeviled the new connector between Long Island and Connecticut, as well as a better process for addressing local concerns about infrastructure projects, rather than the current labyrinth of legal challenges that most such projects now face.

When you consider all the necessary preconditions, it's no wonder that little progress has been made since last August. This summer nature has been kind, with milder temperatures in the Northeast. But the combination of economic growth, which will drive up power demand, with more typical weather patterns will surely test the system again.

Backwardation
It's generally agreed that the current high oil prices are the result of an accumulation of factors, none of which by itself would be sufficient to drive prices up very far, or for very long. When combined, however, they have taken us to sustained record nominal prices and real prices that are high enough to constitute a significant drag on the global economy. This thoughtful article in today's New York Times reminds us that, while this is true, the magnitude of the outcome is also a function of decades of underinvestment in infrastructure that erased the former surplus capacity, which acted as the buffer against such glitches.

The article also touches on the role that the market feature called "backwardation" has played in this drama. Backwardation is a condition of commodities markets in which the price of the commodity falls off into the future months, the further you get from the nearest, or "prompt" month being traded. In equilibrium, the level of backwardation, that is, the difference in prices between successive months, should be just enough to cover the cost of holding the commodity in storage for a month, plus time value of money.

In practice, that difference varies a good deal, and is the subject of much speculative trading, as players bet on its widening or narrowing. Sometimes the difference goes negative, producing "contango", the opposite of backwardation.

But when you get beyond a year or two in the future, the shape of the futures market curve should flatten, because the alternate supply is not oil in a tank, but oil in the ground, the carrying costs of which are very low. This is at the heart of Mr. Norris's argument. When today's price for the commodity several years from now is very much lower than the price for current delivery, because the market believes that prices will fall back after the current crisis is resolved, it sends a negative signal to producers: investing to get more oil out of the ground will not yield an attractive return. This same feature has played Hobb with the value of oil company equities, which haven't benefited nearly as much as they should have from the runup in oil and gas prices in the last year. That's yet another negative signal for investors.

The good news is that the future price is rising, even though it is still well below the prompt price, signaling a belief that today's problems may persist for a while. That should finally result in an uptick in capital spending, which is the only way that world oil production is going to keep pace with the growth in demand; it has to look like an attractive proposition for investors.

Nuclear Waste
Yesterday I ran across this press release from the Kerry campaign, concerning storage of nuclear waste at the designated federal waste site at Yucca Mountain, Nevada. It certainly raises some very serious concerns about this location and about the storage of nuclear waste, in general. However, there are some logical questions that we should be asking about some of these objections, such as:

- Will it be possible to find any storage site so remote that no population is ever at risk, should the storage eventually leak? The fact that Yucca Mountain is within the government's nuclear weapon test site suggests to me that it is probably about as unpopulated as one could find anywhere these days. The alternative would probably be so remote that it would draw criticism for the damage that new infrastructure would do to pristine ecosystems.

- Is it possible to locate any site that is truly seismically inert? A little knowledge of plate tectonics and the geology of the continent suggests that could be a very high hurdle. Instead, we should be asking whether any of the six faults identified near the Yucca site has a history of generating earthquakes large enough to threaten the proposed containment systems.

- Can any disposal method avoid road or rail transportation of nuclear waste and radioactive material from the 100+ currently operating and decomissioned nuclear plants around the country, and from other industrial sources of radioactive waste? Whether the waste goes to Nevada or to the moon it has to travel there somehow. This criticism is not really specific to the Yucca Mountain project, but rather reflects an aspect of any long-term solution to nuclear waste that must be scrutinized carefully.

At the end of the day, it could be that Yucca Mountain isn't the right spot to bury the accumulated waste of sixty years of commercial nuclear power and nuclear weapons production. And with the current threat of terrorism, maybe we need to sharpen our pencils a bit more on how we'd move waste from where it was generated to where it will be buried. But I have to admit to a large degree of skepticism about a laundry list of more-or-less relevant concerns about a proposed waste site in a critical "swing state", released during a political campaign.

We still need to be able to store or otherwise neutralize nuclear waste with a high level of security and integrity for a minimum of several thousand years, based on the half-lives of its most dangerous components. That's no mean undertaking, and the choice of how and where to do this should be made with great care and deliberation. But is it realistic to think that, after at least two decades of working on this problem, we are ever going to find a disposal option that does not meet with opposition from some local community and/or group of well-intentioned experts? With all due respect to the citizens and voters of Nevada, if not there, then where?

We also need to keep firmly in mind that every day we generate additional tons of waste, and that in most cases the present storage location for that waste is a much poorer choice from both a security and integrity perspective than any long-term storage site we could contemplate. Is this a classic case of the perfect getting in the way of the good?

Fuels for Wartime
With so much attention focused on the attractiveness of alternative fuels for industry and consumers, the energy needs of the military are easy to ignore. But with increasingly sophisticated combat hardware deployed in multiple theaters of war, this is an issue in which the Pentagon is keenly interested. As this article on possible battlefield applications of gas-to-liquids technology indicates, it is also an area with no shortage of R&D money.

As we have seen in Iraq, the high fuel consumption of modern tanks, infantry fighting vehicles, and attack and transport helicopters requires a large, expensive and vulnerable fuel supply chain. The military and its civilian partners are pursuing both the application of advanced technology to reduce fuel consumption, including hybridization and fuel cells, as well as efforts such as the Syntroleum approach to produce fuel closer to where it is needed.

While it is possible that one or the other avenue will produce useful spinoffs for domestic applications, the history of military procurement cycles suggests that it is equally likely that technology will flow in the opposite direction.

Nevertheless, military applications of advanced vehicle technology and alternative fuels represent an important early market for both. Because the cost of fuel delivered to the battlefield is so much higher than for any other application you can think of, short of spaceflight, this market will be less price-sensitive and more focused on performance. This could give developers a chance to move down the experience curve with fewer of the usual commercial pressures, and that might mean a greater variety of viable alternatives showing up in the marketplace in a few years. Ultimately, that could be very positive for improving energy security and possibly even lowering energy costs.

Betting on Hugo
The long-anticipated Venezuelan referendum on the rule of Hugo Chavez will take place this Sunday. Despite Mr. Chavez's anti-US rhetoric, the energy industry appears to be betting on his winning a reprieve, as this article from the Financial Times notes. This puts them in the uncomfortable position of favoring someone who will most likely end up as a classic South American Generalissimo/President-for-Life, even if he got there democratically. It all comes down to risk management.

As the FT points out, the goal for companies with billions of dollars of past investments at risk, and billions in future opportunities at stake, is political stability, regardless of its flavor. In this case, I suggest that this attitude is not merely cynical, but ill-advised. Whatever positive remarks Mr. Chavez may have made concerning his commitment to continue supplying oil to the US, his current policies set him on a collision course with US diplomacy, and possibly even the War on Terrorism, in the future.

Venezuela needs the energy companies at least as much as they need its resources. In the wake of the massive oil industry strike in 2002 and the subsequent draconian restructuring of the state oil company, PDVSA, the country requires foreign technical expertise to keep its oil flowing. This is not the Middle East, where you drill a hole and watch the oil happily flow out for decades. The bulk of Venezuelan petroleum is heavy, and, as such, it takes much more ongoing maintenance and management to keep production going, as demonstrated by the unreported quantity of pre-strike output that is still offline.

The Chavistas also need capital investment from the international energy companies. With the lion's share of oil revenues committed to social programs--which coincidentally greatly bolster Mr. Chavez's support at the polls--rather than being reinvested, oil production will eventually grind to a halt without steady infusions of foreign money. I'm sure the companies are reassured by this dependency.

But I wouldn't bet that a confrontation won't originate on our side, particularly if the Bush administration is reelected. A Venezuela that supports the Colombian rebels and cozies up to Cuba is probably only a few steps away from an "Axis of Evil" designation. Instability comes in many varieties, and anyone considering new investments in Venezuela should bear that in mind.

Have We Really Forgotten?
Returning from a week's vacation, I see that concerns about high oil prices remain staples for both the media and politicians. Today's Wall St. Journal included articles on oil's impact on the economy, and on the presidential candidates' positions on energy policy. But it strikes me as odd that we haven't heard anyone--so far as I've noticed--point out the blindingly obvious but genuinely noteworthy fact that current high oil prices are actually a strong signal that the markets are working, doing their job as intended and doing it well.

The last time we had sustained oil prices at this level in nominal terms--though not in real dollars--our worries were more immediate than a possible slowdown in economic growth. We had gas lines, gas rationing of a sort (odd-even license plate restrictions), and bizarre wholesale- and producer-level activity that actually reduced efficiency and held up supplies. All of this was the result of non-market based policy responses to an "energy crisis." As tempting as it might be to fiddle with things now in an attempt to push down energy prices in the short run, we should remember that there are worse outcomes than buying the energy we need at high prices.

Any meaningful long-term changes in our energy situation will require years to implement and still longer to take effect. That doesn't mean such changes aren't worth undertaking--quite the contrary--but the debate about them shouldn't be colored by short-term concerns, which are driven at least in part by short-term problems (Yukos, Nigeria, etc.,) and for which only smoothly-functioning energy markets can compensate.

It is also worth recognzing that those most affected by high oil prices are not consumers in the developed countries, such as the US, but the billions in the developing world living on a dollar or two a day. High oil prices represent a serious drain on hard currency for their nations, many of which have little alternative but increased external borrowing.

Blog on Vacation
There won't be any new postings to this blog until next Monday, August 9. Before signing off the for the week, I'll provide links to some past blogs that seem particularly timely, again.

I'm also thinking about pertinent topics to write on in the weeks ahead, beyond what is suggested by my reading of the news. One area I've wanted to discuss for a while is the more conventional forms of alternative energy, such as tar sands (now usually referred to as oil sands), ultra-heavy oil, and shale, along with coal liquefaction and gasification. But I'm also interested in hearing from you concering subjects of interest. You can provide this feedback either by clicking on the "comments" link below this posting, or by email mailto:gsws@optonline.net.

Now for the links to "classic postings" (you'll have to scroll down in the linked monthly archive to the date indicated):

LNG Security (January 20, 2004)
Democratic Energy Policies (February 27, 2004)
Nuclear Genie (March 12, 2004)
Iraq's Oil Patrimony (April 1, 2004)

In addition, I recommend this week's very intersting NY Times Magazine cover story, contrasting Vagit Alekperov, the founder and head of Lukoil, with Mikhail Khodorkovsky, the embattled Yukos boss.

Memes vs. Facts
Supposedly, just before the stock market crash of 1929, Bernard Baruch, one of the great financiers of Wall St., got a stock tip from the lad who shined his shoes (upon which he went to his office and instructed his broker to sell everything.)  In similar fashion, the oil-depletion meme now seems to be popping up everywhere.  Today, after logging out of Hotmail, MSN confronted me with this headline, "Is Saudi Arabia Running Out of Oil?"  The article is worth a look, but without rehashing the whole Hubbert argument, which I've discussed at some length in previous blogs, I must say I just want to yell at these people to ask the right question!

Whether you believe the current estimate of Saudi oil reserves of 260 billion barrels, the late 1980s estimate of 170 billion barrels--before most of OPEC revised their reserves upwards to game the quota system--or even the pre-nationalization estimate of 137 billion barrels, there is still a lot of oil left in the Kingdom.  Now, Matthew Simmons may well be right in assessing that the handful of giant fields that account for today's Saudi production are either in decline or nearing it, but that leaves a large number of identified, untapped oil fields for the future.  ExxonMobil and ChevronTexaco could probably confirm this, since they found most of them when they were joint owners of Aramco. 

So if there is plenty of oil left in Saudi Arabia, what is the right question to be asking?  I suggest it is this, "What is the project-by-project buildup behind their assertion that they can sustain production of 10 million barrels per day and grow it to 15, well into the future?"  If Saudi Arabia really wants to be the world's gas station for the next 50 years, rather than have us convert to renewable energy or develop all the oil sands, ultra-heavy oil, and other conventional alternatives, then it behooves them to be more open about their long-term production plans.  Specifically, year-by-year, when and how will they develop additional fields to take up the slack and grow production, as the super-giants like Ghawar slow down?  How much capital will this take, and where will it come from?  Do they have the technical expertise required, and if not, where do they plan to get it?  What assumptions are they making about the prices that underpin those cash flows? 

What this boils down to is providing the kind of information that the publicly-traded oil majors have to furnish in their SEC filings and analyst meetings.  In the past, that would have been unthinkable, and it's a bit hard to imagine now, but the world has changed.  Saudi Arabia is being asked to come to grips with an entirely new security environment, an internal and external challenge of terrorism, and the incompatibility of Saudi education with the modern world.  Why not throw in the lessons of Enron and Shell, in the bargain?  I won't hold my breath, but it's pretty clear that their failure to be forthcoming about this information merely fuels the uncertainty and suspicion that they are hiding something. 

Doing Well While Doing Good
A few days ago, I suggested that companies should approach climate change as a business risk, rather than an "issue".  I should have added that it is also a business opportunity, as exemplified by this program announced by the government yesterday.  Transferring technology and investing in projects to capture methane in developing countries is also an idea that makes sense regardless of where you stand on global warming.

Landfills in this country have been capturing methane for years, either to displace purchased natural gas or for onsite power generation.  The other, less publicized benefit is in reducing greenhouse gas emissions; this is the driving force behind the Methane to Markets Partnership.  Methane has 21 times the greenhouse impact of carbon dioxide, the greenhouse gas that gets the most attention.  If instead of allowing methane from landfills and agricultural sources to escape into the atmosphere, you capture it and simply burn it, you will reduce the greenhouse emissions to 5% of what they would have been.  If you take the next step and turn it into electricity, backing out another fuel in the process, you have effectively eliminated the emissions associated with the source you are managing, while producing something that can be sold at a profit.

Perhaps it is just human nature that we are more effective and enthusiastic when doing things for which we are rewarded than things someone requires us to do.  We are not going to make much headway on climate change if the only answer is draconian government mandates.  Harnessing the power of business and markets will go much further, in the long run.

Where To Spend It All
The major oil companies have begun releasing their earnings figures for the second quarter.  Earnings are expected to be up from the same time last year, and the first to report confirm this.  The Financial Times tallies the total from the top five companies at $17 billion dollars.  With oil and gas prices near record levels, and with most of the companies having merged and trimmed to lean fighting weight, how could they not now be rolling in cash?  Where will they spend it all?

Clearly some of this windfall will be go into financing: higher dividends, stock repurchases, and debt reduction.  BP's Chairman, Lord Browne, is quoted as saying, "Now is the turn of the shareholder." But even after satisfying investors and polishing balance sheets, there will be lots left over, adding to the accumulation from the last year of strong results.  There are really only two options that are likely to be considered, higher reinvestment and acquisitions. 

The former looks like an obvious choice, given global concerns about oil demand outpacing supply for the next few years, or longer.  But are there enough attractive opportunities in which to invest?  The best lie behind walls of state control or high risk, as in Saudi Arabia and Russia.  Absent enough star prospects, will companies really want to dig far down their lists of opportunities to invest in the kind of projects they've been busily divesting in the last five years?

That leaves M&A, which may look like a better deal.  After all, the stock prices of these companies currently reflect oil valuations far below current market levels.  If you believe in efficient markets, further consolidation at these prices would not be arbitrage, but folly.  However, as concern grows that oil production is approaching some sort of limit, whether imposed by geology, access to resources, or geopolitics, the industry starts to look like a zero-sum game.

How much more consolidation will regulators tolerate?  As long as buyers are happy to dispose of enough refining and marketing assets to keep the retail gasoline market looking competitive, there seem to be few impediments to higher concentration of exploration and production, particularly when the bulk of these activities falls outside the US or EU.  So does this portend the further rolling up of the second- and third-tier companies, or are we on the brink of the Super-Super Major?  Materiality will probably the decisive factor.

What Can We Agree On?
Regular readers know that I am fairly well persuaded that climate change is real, even if I'm still skeptical about some of the predictions concerning its outcomes.  But I also recognize that in the business world today there is nothing like consensus about the science behind climate change, or global warming, at least not in this country.  That's why I think articles like this one from Sunday's NY Times business section are so important.  It frames climate change as a business risk, not as a scientific debate, and I think that is precisely the right attitude for business to have, for several reasons.

First, as I used to tell the top management of my old company, nothing that an energy company can say about climate change (at least on the side of the skeptics) will be credible with the public.  Energy companies have too much of a vested interest, and I doubt that many non-energy companies would have much more credibility on the subject.  It's better to be seen as part of the solution than part of the problem.

Some might see that advice as unprincipled or cynical, but look at it this way: if the proponents, who seem to have a much larger fraction of mainstream scientists behind them, are right and things turn out badly, being on the wrong side of the issue might be catastrophic--and I'm not just talking about a few dollars of shareholder value here.  On the other hand, the risk of doing too much, too soon, is real, but it is like buying an insurance policy that might later turn out to have been unnecessary.

The other reason for adopting a risk framework, rather than treating it as an issue, relates to how companies solve problems.  It's natural to feel overwhelmed and out of one's depth when facing what could be the largest global environmental issue in the history of civilization.  It's important that governments and scientists view climate change that way, but that approach isn't conducive to sound business thinking.  On the other hand, dealing with it as a business risk, as Mr. Hakim's article argues that Ford, GM and other auto makers must, changes it into something that business is used to managing with the sophisticated tools at its disposal.

If we can all agree that climate change is a legitimate business risk, without having to line up on one side or the other of science that we may never be certain of in our lifetimes, then we are going to do a much better job of protecting shareholders' equity.  If you want to find companies that have made that leap, against the conventional wisdom, go talk to utilities, particularly those with a lot of coal-fired power generation. 

Finessing NIMBY
For a variety of reasons, the US supply of natural gas is not able to keep pace with demand.  This pushes us towards imports, with the largest potential for incremental imports coming from liquefied natural gas, or LNG.  But that requires large regasification facilities, which have generated a great deal of local opposition, as I've discussed in previous blogs.  Last Friday's Wall Street Journal highlights a different approach, based on an LNG tanker that regasifies its own cargo while still offshore, feeding it into a pipeline for delivery onshore.  This "Energy Bridge" could bypass much of the current opposition to LNG imports.

This approach has several advantages, including the avoidance of expensive onshore regasification facilities.  LNG terminals with this kind of equipment cost around a half billion dollars, while a simplified terminal with an offshore receiving point and some onshore storage tanks should cost a great deal less.  This strategy also puts the portion of the process that opponents see as most hazardous well away from the facility's neighbors.  And by reducing the onshore fixed costs, it might allow more receiving facilities to be built, enabling a more flexible supply network with tankers calling where their cargoes are in greatest demand, not just at a few locations, as now. 

Despite its advantages, the economics may not be quite as attractive as the intial impression suggests, due to the structure of the LNG business.  Because of the scale of investment required, LNG projects are developed only when the entire value chain is economical and the output of a new plant can be committed on long-term contracts.  A traditional chain consists of the liquefaction plant, a fleet of tankers, and several regasification facilities (often owned by the customer, not the producer.)  A value chain built around the EP Energy Bridge technology would require the same front end, a less expensive back end, but a larger and costlier tanker fleet. 

It is an old maxim of the shipping business that ships make money when they are moving, not when they are sitting still.  When a ship is idle in port, because of delays in loading or unloading, the ship owner collects demurrage from the cargo owner.  The longer the ship sits in port, the more demurrage you run up, and the more tankers you will need to deliver the contracted annual quantity.  Thus the economics of the Energy Bridge approach are a function of how much more these special tankers cost to build and operate than conventional LNG tankers, and how much time is added to each voyage to allow for regasification at the delivery point.   Furthermore, if these ships are not dedicated to fulfilling a long-term contract, but are casting about for spot cargoes, the situation looks much worse, and the return to the owner (or the lessee) will be much lower.   

On balance, it's a nifty idea that could help fill in some crucial gaps in our natural gas supply, but I doubt it will entirely displace the need for at either more LNG terminals with their own regasification capability, or a major new gas pipeline from Alaska or northern Canada.

Signs?
This morning's papers are full of the news that the Russian government has agreed to sell its 7.6% share in Lukoil, Russia's second-largest oil company and its most active outside the former Soviet Union, in a public auction.  At the same time, Mr. Putin has apparently met with the chairman of ConocoPhillips, which is keenly eyeing the Lukoil stake.   While such a deal might not be as material for Exxon or BP, it would be a nice plum for Conoco.

All of this is preliminary, and it is too soon to say whether this constitutes the positive, post-Yukos signal that the market needs.  Regardless of the fate of Yukos, minority holdings in Russian firms will still be risky, until the legal system has been cleaned up and modernized.  Still, with a sizeable portion of the non-OPEC world's unexploited oil reserves, Russia's strategic importance is simply too great to pass up.  Russian oil made the fortunes of an earlier generation of oil companies in the late 19th and early 20th centuries, and it clearly has the potential to turn this trick again.   Stay tuned. 

Sustainable Development
Bolivia has just held a referendum on how its hydrocarbon resources should be managed.  The five-point ballot covered the future role of the state and whether gas and oil should be exported, and how.  The referendum passed with a large majority, based on returns so far.  This was the issue that brought down the last government, amidst violent protests, and President Mesa may see the result as a vote of confidence in his government.

On the surface, the issue might seem almost ridiculous.  Bolivia, a poor, landlocked country, has few other things to sell to the world besides the natural gas reserves developed over the last few years with significant foreign investment.  Keeping the gas "for Bolivians" or renationalizing it would cut off both inward investment and hard currency revenues that the country badly needs. 

Aside from the issues unique to Bolivia, relating to the loss of its access to the sea in a 19th century war with Chile, the situation is consistent with resource management issues throughout the developing world.  In Indonesia, Nigeria, and other oil-rich countries we see local populations, which enjoy less benefit from the exploitation of these resources than they expect, reacting in ways that imperil the viability of massive projects.  Ultimately, for a resource contract to endure over the time required for the investors to earn an attractive return, there must be equity in benefits not only for the host government, but for the host population. 

I don't mean to suggest that the whole burden of ensuring this should fall to the international companies that find and develop these resources.  Rather, this is a primary responsibility of the governments in question, and it creates a responsibility for the companies to see that the countries fulfill their duties to their people.  Sustainable development, with its "triple bottom line" of economic, social, and environmental indicators may not be quite as prominent as it was a few years ago, but it is one way to devise measurable goals and milestones to which all parties can be held accountable.  Such an approach might have even headed off the renewed fervor in Bolivia for nationalization, which will benefit no one.

What Comes After Yukos?
The Yukos drama seems to be entering its endgame, with the Russian government announcing it will seize the company's largest asset and sell it to settle the year 2000 tax claim.  The operation in question is bigger than all but a handful of the international oil companies, at least in terms of reserves and production, and would be a gem in anyone's portfolio.  Will it go for top dollar or something closer to its original acquisition cost of $150 million?  Will international companies be allowed to bid?  What on earth does this mean for foreign investment in Russia's other companies?  There aren't any good answers yet, but the risk factor for investments in Russia should go way up, until we see whether this is a first move toward restructuring the whole post-breakup economy, or simply the resolution of a vendetta against Mr. Khodorkovsky. 

Oil has been a primary engine of Russian economic growth for the last several years, and I don't see how the government could imagine it could live without it.  Unless Mr. Putin is completely confident that there is already enough capital and expertise inside the country to sustain the recent expansion of Russian oil production, he will need to send a very big positive signal to foreign investors, and very soon.   

A Contrary Wind
Niall Ferguson isn't known for commentary on energy policy, but rather as a historian who has written perceptive and well-received books. His op-ed on wind power was published in Britain's Daily Telegraph paper last Friday. As he admits, it might easily be written off as a NIMBY-ism, but the issues he raises are ones that the proponents of wind power can't afford to ignore. They fall into three main categories:

First, that wind power is still expensive, compared with conventional power, and must rely on heavy government subsidies, though this was also true for other forms of power generation in their early days, notably the nuclear power industry.

Secondly, he complains that they are unreliable, and as such cannot replace other forms of power generation in supporting a stable electric grid. Wind is by its nature intermittent, and one of the biggest challenges wind developers face is either integrating it smoothly with the grid, or providing sufficient energy storage to smooth its peaks and valleys for remote, off-grid applications. This can run up the total cost of a wind project significantly. None of these problems is insurmountable, but they do add complexity that conventional power plants avoid.

Mr. Ferguson goes on to suggest that, because of these shortcomings, wind power's contribution to reducing greenhouse gas emissions will be much less than has been suggested and far less than the unpopular nuclear power plants that are being phased out in Britain and elsewhere. Others have made the same connection (see my blog of May 13, 2004), but I think in practice it's not a fair criticism. No developer is sitting down to choose between putting in a wind farm or building a nuclear power plant. The real-world choice is between wind power and fossil fuels, and on that basis, it reduces emissions.

Finally, the argument comes back to aesthetics, and in the long run I think this poses the most serious threat to really large-scale wind power development. Are there enough first class wind resources (see my blog of May 6, 2004 for a better explanation) in places close enough to where the demand is, but where few will object to their visual signature? The wind industry faces an uphill battle on this, and it would be wise to tackle it head on, with a well-designed public relations campaign. Not all of wind's critics are as articulate as Professor Ferguson, but they share his concerns.

By the way, without much fanfare, today is the 35th anniversary of Neil Armstrong's "small step for man". Coverage on the NASA website and on Space.com.

Future Competitors?
The Financial Times recently covered the ongoing changes in the Chinese oil industry, with PetroChina acquiring a licence for offshore exploration in the South China Sea.  Everyone seems to be talking about the rapid growth of China's oil consumption, but I haven't heard much about the implications for the international energy industry.  It's easy to forget that the main global competitors today, the Supermajors and their smaller kin, grew to dominance through a combination of successful oil exploration and large, growing downstream markets in their home countries.  The growth of China could well create one or two new global competitors for the same reasons.
 
A few years ago the conventional wisdom saw the biggest threat to the incumbant major oil companies coming from the national oil companies of the producing countries, both OPEC and non-OPEC.  In an era in which PDVSA, the Venezuelan state oil company, had bought Citgo in the US, and Kuwait had purchased the European refining and marketing assets of Gulf, that seemed a realistic development.  But the OPEC state oil companies haven't transitioned into true global competitors, for a variety of reasons including the domestic needs of their shareholder governments.  The Chinese companies could go down a similar path, but that doesn't seem consistent with other trends in China.  Instead, isn't it likelier that they'll learn as much as possible from their foreign joint venture partners and translate that knowledge into the competence to compete in a wider arena?
 
Today's international oil companies have tremendous advantages in technology, market access, brand identity, and capital, but in the globalizing economy none of these is permanent.  Legacies can be eroded, and new competitors become remarkably effective in less time than previously, if not exactly in "internet time."  If we try to imagine the top 10 international oil companies in 2020, who is willing to bet that a third of the list won't be Chinese or Russian?

Which Gas?
Whenever gasoline prices go up, there's a tendency to shop for cheaper brands and buy lower octane, to ease the pain. The NY Times last week published an article intended to help guide consumers in this quest. Most of it was pretty sensible, but I differ with them in a couple of areas, and this seems like a good topic for today, heading into a nice summer weekend.

First, octane. Octane is a measure of how slowly a gasoline burns. If it burns too fast in the cylinder, the engine pre-detonates, or "knocks". The Times recommended buying the lowest octane gas on which your car doesn't knock, and that's the tried and true rule. They also acknowledged that some cars can sense and compensate for lower octane, allowing a car designed for premium to run on regular. But I ask you, if you've spent upwards of $40,000 on a high-performance car, is it really worth saving $100/year (do the math) and missing some of the oomph you paid for?

Now, if that doesn't apply to you, then not only you but the rest of us are all better off if you buy lower octane. It turns out that the molecules that raise octane require more refining, consume more oil, and have a greater potential to harm the environment. If you're as old as I am, you might remember a TV ad for "Super Shell with Platformate." Well, all gasoline contains Platformate, and that's the stuff we're talking about here: aromatic hydrocarbons.

As to additives, I admit that this has gotten quite confusing and that even the cheapest gas contains a minimum level of detergent, set by the EPA. But particularly if your car has multi-port fuel injection, you can still benefit from paying for brand-name gas with a better additive package. As to the little cans and bottles of additive, which the Times seems to like, think about this. At the rate the best gasolines are additized, you are getting the equivalent of a bottle of top-grade additives with each 10 gallon fillup, at a price that I'll bet is less than what you'd pay for most of the do-it-yourself varieties, which may or may not be as good.

Finally, when you pull your car into that cheap off-brand station, you might want to consider who would stand behind them, if you were to get a tank of bad gas--a rare occurrence these days, but not an impossibility. Personally, I think you'd stand a better chance of getting a Shell, Chevron, Exxon or the like to pay for the repair of your expensive engine than you would with "Ed's Gas." (No offense, Ed.)

Happy motoring!

Data Power
It was several years ago that I first ran across the idea of using power lines to transmit data, including high speed internet access. After a long period of dormancy, it looks like this idea is starting to catch on, in different ways.

This article in MIT's Technology Review proposes utilities as potential competitors to DSL and cable providers. The NY Times recently looked at the potential for data over power lines to solve the problem of the "last mile", or even the last few feet, particularly when cleverly matched to wireless networks.

The advantages of this approach seem obvious, at least in terms of the ubiquity of the infrastructure. If "BPL" turns out to be as reliable as other broadband connections, it will open up large market segments that are currently unserved by DSL or cable, as well as providing some healthy competition to current operators who may presently feel free to collect monopoly rents from their subscribers. (My own cable provider increased its ongoing rates to $45/mo. vs. their $29.95 intial come-on.)

Less obviously, could offering this additional service provide utilities with the revenue and incentives to upgrade their own infrastructure, a need highlighted by last year's Northeast blackout?

Drilling What's Left
Last week the NY Times featured an editorial by former Secretary of the Interior Bruce Babbitt, in which he decried potential oil drilling in a sensitive portion of the National Petroleum Reserve-Alaska. Note that this is not the Arctic National Wildlife Refuge, but rather an area set aside by Congress for future oil exploration. I can't dispute Secretary Babbit's assertions about the ecological importance of the lake in question, or the area in general. I haven't the competence, nor is that the point. Rather, I am struck by the urgency of approaching the country's energy needs in a way that is realistic and recognizes the inevitability of trade-offs.

The lower-48 states are the most heavily explored and exploited oil province in the world, having produced nearly as much oil in the last 140 years as the Saudis claim to have left today. That has real implications for future domestic oil production, which peaked in the early 1970s and has been declining ever since, from roughly 10 million barrels per day then to about 6 million now, including Alaska. Although less heavily explored, Alaska is also experiencing declining production. The North Slope oil that made such a difference in the aftermath of the 1970s oil shocks reached a peak of 2 million barrels per day in the late 1980s, and is now less than half that. Without new discoveries, it will continue to drop.

There is additional oil to be found, but it will be in places that are more challenging (e.g. in deep water offshore), more remote, or previously off-limits to drilling. While at best this oil can extend the long plateau of US production, foregoing it entirely will lead directly to the rapid offshoring of the entire industry. I don't know if the National Petroleum Reserve-Alaska can provide the backfill needed to maintain Alaskan production at the current level, but without it, or oil from the Arctic National Wildlife Refuge, it is predetermined that Alaskan production will fall. That means more imports, without even considering the steady growth in demand.

While I can understand that there are some areas that are just so beautiful or so important to the natural world that we shouldn't drill there, I have a harder time seeing how we can continue to carve out chunks of Alaska as big as other states, set them off-limits, and yet continue to demand increasing quantities of oil and other energy to fuel our lifestyles. Something has to give, and this should be obvious to everyone, policy-makers and voters alike.

Bullish or Bearish on Hydrogen
Several colleagues have suggested that I've become awfully pessimistic about the potential of the "Hydrogen Economy", especially for someone who had been such an optimist a couple of years ago. After reflecting on a talk I gave yesterday, I realized that I sound pessimistic even to myself. But I need to draw an important distinction: if we are talking about the grand vision of a world of transport and stationary energy fueled by hydrogen that is generated by some clean source, then I am truly less sanguine now that this will arrive soon. However, I am not at all pessimistic about things like this.

I'd lay odds that, long before the average person owns a hydrogen car or lives in a fuel cell-powered home, small fuel cells running on hydrogen or methanol will routinely power our personal electronics. After all, a fuel cell is really just a fancy battery with an open loop, meaning that you can keep adding the ingredients for the electrochemical reaction that produces power. And because chemicals such as methanol store more energy per gram than current batteries, you'll be able to run your iPod or PDA/phone a lot longer unplugged than with even the best lithium ion battery.

Granted this is not what most people think of when they imagine the Hydrogen Economy, but the essence of that is using hydrogen as an energy carrier without combustion, and that's what these tiny fuel cells do. There's nothing wrong with starting small.

Digging Up Dirt
If you haven't already read it, I recommend Paul Volcker's Wall Street Journal editorial from last week describing his approach to investigating the allegations concerning the UN Iraq Oil-for-Food program. Kofi Annan could not have tapped anyone with a stronger reputation for integrity and independence; now we will see if the results surprise him or his critics.

As I've suggested before, if the allegations about the subversion of the Oil-for-Food program are proved out by the facts, then its program administrators would bear as much blame for the failure to avert war in Iraq as the intelligence community in its failure to accurately assess weapons of mass destruction. The future credibility of the UN is on the line, and I can only advise them to be utterly forthright and transparent in this investigation.

End of An Era?
Based on reports in the Financial Times and elsewhere, it is looking increasingly likely that Royal Dutch/Shell will accede to investor pressure and radically alter its governance structure. This would effectively end the world's oldest unconsummated joint venture and result in Shell looking--and acting?--more like its largest competitors, Exxon and BP. It would also stifle some of the wild scenarios currently circulating, such as the one in which Total takes a controlling interest in Royal Dutch and leverages this into a takeover of its much larger European peer.

While it may be past time for such a change, I doubt that a standard, US-style corporate governance structure would have prevented the recent management problems relating to the overbooking of reserves and their tardy disclosure. One has only to look at this week's indictment of Ken Lay, the former chairman of Enron, to deflate that notion. Rather, Shell's current weakness presents investors with an an ideal opportunity to push through a pet peeve. Only time will tell if the result better positions the company to deal with the challenges that lie ahead for the industry.

Election Issue
One of the points John Kerry raised in the speech announcing his running mate related to this country’s dependence on Middle East oil. His plea for a new focus on energy independence highlighted our high energy use but low reserves, in contrast to the Middle East, with 65% of the world's oil. If this becomes a persistent theme, it should make for an interesting national debate on energy, something I think is long overdue.

When I looked at the campaign websites of Senators Kerry and Edwards a few months ago (see my blog of February 27, I found some interesting comments about energy. Both seemed to be arguing for a diversification away from oil as soon as possible, for various reasons. In contrast, the energy strategy of the Administration rests on two pillars: bolstering supplies of our current energy sources, and investing in a long-term future alternative, hydrogen.

It will be interesting to see how these two approaches differ in their details, as the campaign heats up with the conventions and eventual debates. It will be equally interesting to see if the Democrats can maintain their focus on the issues, without resorting to trying to connect current energy policy to scandals and innuendo.

How Much Is Enough?
Today is another travel day, so this will be short. A week ago the Financial Times carried an article suggesting that the global oil industry--both publicly traded and state owned--has not been investing enough in new oil and gas production projects to maintain and grow current production. In fact, I see this as a much likelier and more plausible near-term threat to the ability of oil supplies to keep pace with demand than the speculative geology of the adherents of King Hubbert.

I am a big fan of markets, but I lay much of the blame for this phenomenon on a widespread misunderstanding of the market. If you look at the oil futures more than a year out, they are telling you that prices will revert to "normal", and well they may. If they do, big investments in new production will not enjoy the benefit of today's high prices. But the futures markets do not predict future prices; they merely reflect what buyers and sellers can agree on today, and that is not the same thing at all. Another day I'll talk about "market backwardation" and the role it plays in amplifying these false signals.

Finessing Kyoto
I recently wrote about state-level attempts to regulate the greenhouse gas emissions linked to climate change. (See my blog of June 14) In an editorial in the New York Times over the weekend, the former US chief negotiator proposed a new approach to addressing these emissions, even if the US can't bring itself to endorse the Kyoto Treaty.

As Mr. Eizenstat and his co-author point out, the Kyoto Treaty only covers the years 2008-12, while climate change is expected to be a major concern for the next century. The Kyoto reductions are only the tip of the iceberg in terms of emissions of CO2 and other greenhouse gases; something further will be needed in the longer-term. Without some sort of global consensus, this could take the form of a patchwork of competing and conflicting regional, national, and subnational programs. Mr. Eizenstat suggests an intriguing alternative that would put greenhouse gases in the same context as trade issues.

Just as international trade includes groupings such as NAFTA and bilateral arrangements, as well as supranational organizations like the WTO, the mechanisms to address climate change might include the global Framework Convention on Climate Change, as well as useful regional and nation-to-nation agreements. It is easier to imagine the US working within this kind of framework than in a purely Kyoto-centric system, particularly if the current administration is reelected.

But as the editorial rightly points out, there are threshholds below with independent approaches are not as helpful. US companies should be covered by rules that are consistent from coast to coast, rather than having to make their way through fifty different regimes.

This approach also requires some realism. The US is not going to meet its targets under the Kyoto Treaty, even if it were ratified by the Senate tomorrow. We are on a path to exceed that target by as much as a third, and trying to hit it even by the end of the 2012 first monitoring period would bring the economy to its knees. But that does not mean that we cannot be planning how we will get onto a path to greenhouse emissions stabilization and eventual reduction, in line with the other major industrial countries, even if that takes another decade.

Happy Independence Day!
...albeit a day late. No blog today, instead, a link to a remarkable new view of another planet, in this case, Saturn's moon Titan.

Is The Incremental Oil Too Sour?
An article in last Saturday's NY Times reminded me of an issue I've meant to cover for some time, namely the impact of changes in the sulfur content of oil as production shifts around the world. The Times focused on the impact on China, suggesting that rapidly growing demand and strains on its economy have lowered the quality of the crude oil China can afford to buy, with consequences for the level of sulfur emissions into the air. But this is only one aspect of a bigger picture.

While the rest of the world watches Saudi Arabia to see if it really can increase its oil production to meet the needs of the market, there has been little discussion about what kind of oil this will be. Oil quality varies tremendously from field to field and region to region. Saudi oil is typically light, indicating good yields of gasoline and diesel fuel with minimal processing, but sour, reflecting high sulfur content. Without additional processing, this sulfur will end up in the fuel products, and ultimately in the atmosphere. As a result, Saudi oil trades at a discount to West Texas Intermediate and North Sea Brent, the main marker crudes, which are light and sweet.

(These sweet vs. sour labels go back to the days before laboratory analysis was readily available in the field, and the standard way to gauge the sulfur content of oil was to taste it!)

Not only is the incremental oil from Saudi Arabia going to be sour, but many of the fields that are in decline in mature areas such as the US and North Sea have historically produced lighter, sweeter crudes. As a result, the average crude oil in the world will become increasingly sour, both in the near term as Saudi Arabia ramps up to fill the current gap, and in the longer term as more of the global production burden falls on the enormous reserves throughout the Middle East.

Although the developed countries can compensate for changing crude oil sulfur levels through investment in refinery hardware, this is harder for the developing world, where investments in environmental quality often take a back seat to building basic capacity. For example, if China has $1 billion to invest in refineries, will they spend it on desulfurization hardware to improve the environmental characteristics of fuels, or will they use it to expand refinery capacity, so they can meet the growing demand for fuels without higher imports of finished products? If the latter, then air quality will suffer.

Sulfur is only one aspect of changing crude oil quality. In the years ahead, refiners must find the capital for hardware to process crudes that are both higher in sulfur and contain fewer of the direct precursors of gasoline, while producing a slate of products meeting ever more restrictive quality requirements. Such investments have historically performed poorly, and more will be made only if refining margins—the difference between the price of crude and the value of its products—remain attractive, as they are this year. Otherwise, existing capacity will be strained further, and consumers will suffer, as we are seeing today.

The Island of California
My friends at the Global Business Network used to display an old map depicting California as an island, as a way of indicating how mental maps can affect planning. This morning's New York Times featured an analysis by Hal Varian, a professor at my B-school alma mater, that explains why California might as well be an island, insofar as its gasoline market is concerned.

Gasoline prices in California are generally higher and more volatile than in the rest of the country. Geography plays a role, since the distance to the main refining centers of the Gulf Coast has made pipeline supplies from there impractical. Regulations have reinforced this isolation, going back to the 1980s, when Southern California enacted its first rules creating gasoline specifications that were stricter than in the rest of the country. This disparity has been exacerbated by the extremely severe California Air Resources Board (CARB) specifications, which make gasoline in the state the toughest to produce in the world.

Professor Varian discusses some recent proposals for state government to play a role in the market and rightly dismisses these as likely to create further distortions. Having already suffered an electricity crisis largely caused by "misderegulation", the Golden State doesn't need another state sponsored energy meltdown.

The proposal he favors is not a new one. When local supply is inadequate to meet demand, refiners and traders would be allowed to import gasoline that meets US specifications--but not California's--by paying a sizable tax to equalize its cost to that of manufacturing CARB gasoline. While this might well alleviate some temporary price excursions, it still fails to address the long-term challenge of a market in which refiners have had little incentive--and many disincentives--to build enough local capacity to create a reserve margin.

In many ways, this situation resembles the conditions that existed just prior to the electricity crisis. Demand was outstripping capacity, which had stagnated for years due to problems of permitting and environmental regulations and litigation. The result was a market with no reserve capacity and highly inelastic demand, mirroring Dr. Varian description of the current gasoline market. The only effective way to redress this would be to encourage the construction of additional refining capacity, something that seems almost inconceivable in a state that has long appeared to have an implicit strategy to force refiners out of state.

So perhaps the only fixes are short-term fixes, until the system breaks completely, and voters demand a long-term solution. If so, then Dr. Varian's proposal is as good as any and better than most.