X-Prize Implications
You might well ask why a blog devoted to energy issues would even mention something like the winning of the X-Prize, a $10 million dollar award put up by the X-Prize Foundation for the first privately built and run spacecraft to fly to an altitude of 100 kilometers above the earth twice within a set period. What could this possibly have to do with energy, even in the most far out sense? The answer relates to a technology that might be the best long-term alternative to fossil fuels or nuclear power: space-based solar power.

Solar power developers routinely confront two major hurdles. The first is overcoming the intermittent nature of their energy source, with its diurnal and weather-based fluctuations. The second is, to put it bluntly, the NIMBY factor. But there is an unspoken third hurdle that underlies both of the others, in the atmospheric attenuation of sunlight.

Because surface-based solar collectors sit under a blanket of atmosphere, with shifting sun angles, cloud cover and night, the amount of energy hitting a sqare meter of solar collector is roughly 1/10th of what is available in space. That necessitates building collectors that are much larger, or trying to improve the efficiency of the collector, to turn more of the energy it does receive into electricity. It also forces developers to provide for some form of backup power, either from the grid, or from batteries or other storage. A solar collector sitting in orbit can be positioned to receive essentially 100% of the available solar radiation, 24/7.

I don’t mean to trivialize the task of building orbital solar power satellites and transmitting power to the surface of the earth. NASA and private industry have spent a lot of time and effort understanding what this would entail, and creating design studies and computer models. But in the studies in which I was involved a few years ago, one of the central issues was always the cost of getting a kilogram of material into orbit. If you had a space launch capability that could routinely put large payloads in orbit at low cost (several orders of magnitude lower than today’s cost), then a solar power satellite might start to make commercial sense.

Of course, the Space Shuttle, as we have learned so painfully, cannot function as a low-cost, reliable space truck. Nor will its successor, which will probably be merely a personnel shuttle to serve the Space Station. That is why Spaceship One is so important. Even though it is only a sub-orbital craft—incapable of entering orbit around the earth—it represents a major milestone on the path toward a privately-financed, low-cost, routine launch capability, and thus towards the day when a solar power satellite can be considered on its own economic and technical merits.

Knocking on OPEC's Door
In its Week in Review section, the New York Times expressed concern about dwindling non-OPEC oil reserves and the need for greater access to OPEC's reserves to boost future production. I think this is an issue that deserves a wider audience than industry experts and market analysts; its implications will drive economic and foreign policy decisions for decades to come. Still, in the process of highlighting the problem, the author has focused a bit too heavily on increased OPEC influence without considering the potential downside for these countries.

At this point, many of the large oil importing countries also have important domestic oil industries. This is true of the US, the EU, China, and to a lesser extent India. But as the domestic reserves of the developed countries wind down, their view of oil naturally becomes sharper and more objective. If a $1/barrel increase in the price of oil only puts money in the hands of foreigners, and a $1/barrel decrease harms no domestic constituencies, then the incentive to reduce consumption or find substitutes, in order to gain leverage over suppliers, grows.

If you look at OPEC this way, then the scenario in which it produces 100% of the world's oil without any foreign investment and with no non-OPEC competition is actually their worst nightmare, for the long run. Such a world has every incentive to switch away from oil, and none to keep paying distant and fractious suppliers. The graphic in the Times article nicely illustrates just how long the oil reserves of Persian Gulf producers might last, as well as what they stand to leave in the ground, if the world switched to a substitute in the next 20 years.

Consider Sheikh Yamani's oft-quoted epigram about the stone age not ending for lack of stones, and the oil age not ending for lack of oil. It suggests that the wiser heads in OPEC understand this issue, though I doubt they've made the connection to the surest way to avoid this trap: giving their customers a vested interest in their continued oil production by allowing them to invest in reserves and production. OPEC's best scenario is the one in which their oil is used first, not last--or possibly never.

So when we talk about our growing vulnerability to OPEC, let's not neglect to mention OPEC's growing dependence on us, and the leverage that may confer.

Not An Alternative Fuel Vehicle
Frequent readers may recall a posting last month discussing my search for a new car. (See September 9 posting.) The search is over and I'm driving the new car, an Acura TL. While not as exotic as some of the choices I was considering, it incorporates a number of beneficial advances over my seven-year old Audi.

Although I mentioned many new technologies that I needed to test, such as continuously variable transmissions, mild hybrids, and advanced diesels, most of them were eliminated for entirely mundane reasons. For example, the VW Passat Turbodiesel was unavailable because of the model year changeover; all the '04s had been sold, and the '05s would not arrive for some time, coming after the '05 gasoline versions. Others dropped out of the running due to price (Mercedes E320 CDI) or poor reliability reports. And the early favorite, the Mazda RX-8, was only available with rear-wheel drive, which isn't very practical in snow and ice (traction-control hype notwithstanding.)

Although the only newish powertrain technology my new Acura sports is Variable Valve Timing, which gives it class-leading power with acceptable fuel economy, the car has many other nifty features. Built-in satellite radio and a Bluetooth-enabled mobile phone handsfree link may not sound earthshaking, but they reflect an attitude towards technology that I find very appealing. And of course, don't dismiss styling and fun as selling points.

Although this discussion may sound quite tedious to someone who isn't shopping for a car, I think there's an important point to be made. I began my car search with as keen and positive an attitude about new powertrain technology as you are likely to find, yet I still ended up with a "normal car." At this point, the alternatives either weren't available (months-long waiting lists for new Toyota Priuses) or didn't constitute an attractive package for me. Had there been an Acura hybrid, I'd have paid up to get one, but the closest to that is the favorably reviewed Honda Accord Hybrid, which is not due until December. So even if I'm not representative of the average buyer, carmakers still have a ways to go to deliver the kinds of advanced technology cars that consumers will consider seriously.

I still plan to test-drive a Passat diesel once they come in--solely in order to report on it here--because it's such an interesting combination of styling, features, and fuel economy at a reasonable price point.

The New Frontier, Again
Yesterday's announcement that ConocoPhillips was acquiring an approximately 8% interest--which could grow to up to 20%--in Russia's Lukoil is another signpost of the growing importance of Russia in the portfolios of the international energy majors. Despite a healthy dollop of political risk in several flavors, Russia represents one of the best opportunities for new reserves and production outside the Middle East, and on a scale that is material even to the world's largest oil and gas firms. As the Financial Times article notes, Conoco's Lukoil stake will have implications for the development of Iraq's enormous reserves, as well.

The timing of this announcement is noteworthy, coming as it does in the midst of the unresolved government assault on Yukos and the challenges facing BP's TNK stake. I'm sure the Putin government placed a lot of emphasis on this deal, as a way to restore some of the confidence that has been shaken recently. While it may not assuage all fears, this transaction, along with ChevronTexaco's recent announced linkage with Gazprom, affirms the central importance of Russian reserves over the next 10-20 years. With yesterday's stars fading, including a more rapid than expected decline in the UK North Sea, significant new production will be needed to meet growing demand.

In many respects this is "back to the future", since Russia was one of the first major oil producers a century ago, creating wealth on a vast scale, including that of the Nobels. Although the wealth is likely to be shared differently this time, Russian oil is no less attractive now than it was then.

Alternatives or Ultra-Efficiency?
The October 4 issue of Fortune features this article by Amory Lovins, the alternative energy guru I mentioned in my blog of March 26, 2004. It seems quite timely, with oil prices hitting new highs, to consider a radically different approach to meeting our energy needs. And no one would ever accuse Amory of thinking inside the box.

It's important to stimulate our thinking with viewpoints such as his, even if they seem outlandish or impractical at first blush. We need to understand that there are other energy choices out there besides the status quo, and make informed decisions about them, rather than choosing by default. In the process, I'd suggest that readers focus on Mr. Lovins's concepts, rather than his numbers, because I'm not sure the latter are entirely credible.

For example, his suggestion that an investment of $180 billion over 10 years could essentially wean the US off not only imported oil, but all oil, sounds at least an order of magnitude too low. ExxonMobil alone is on track to spend roughly that amount just to sustain its current business over the same period. I also don't see how Mr. Lovins's figures could include the cost of keeping current infrastructure available during a transition, while bringing on a whole new fuels economy in parallel. Perhaps I haven't understood his arguments.

Setting aside such criticisms, though, I find much here that is intriguing, clever, and worthy of further discussion and debate. If someone doesn't dream big and imagine a different future, then it is a foregone conclusion that we are heading for a world that won't differ much from today's.

The "Half Century"
I want to get back to writing about alternative energy, but there's so much going on in the world of oil and gas that I don't want to ignore, either. And who can ignore $50 oil? A milestone, certainly, but is it a herald, too?

I'm hard-pressed to respond much differently than I did in my posting of March 5 of this year, concerning the apparent end of cheap oil. We need to keep asking if we are seeing a true structural change in the market, or simply an unlikely convergence of bullish factors. Thus far, I believe the evidence still favors the latter view, at least on the supply side of the equation. But that doesn't mean I think oil will be cheap anytime soon. Earlier this year, it looked plausible that oil would be back close to $30 by the time the election rolled around. Sustaining that view now would require the perspective of the White Queen from Alice in Wonderland, who could "believe as many as six impossible things before breakfast."

Just to recap the list of important producing countries and regions currently experiencing problems, we now have Iraq, Nigeria, the Gulf of Mexico, Russia and Venezuela (though they would claim they don't belong on this list.) And then there's Indonesia, which has become a net oil importer. I'm sure I'm forgetting someone. In any case, the aggregate effect of a number of individually manageable problems has consumed the global capacity cushion and created a market in which the fundamentals seem as scary as the news.

I'm pleased to see that the DOE is loaning out some oil from the Strategic Petroleum Reserve. Given the storm-related disruptions in the Gulf of Mexico, this is highly appropriate, as would be suspending additions to the reserve until all of that production is back on line. This matters less for the volumes involved than the signal it would send.

California Dreaming?
Friday's papers carried the news that California's Air Resources Board had approved rules to reduce the emissions of greenhouse gases from cars sold in the state by 2016. While this doesn't come as a surprise, it will have serious implications for the global auto industry and be hotly contested. As I've indicated previously (see my posting of 6/14/04) I think that state-by-state responses are the wrong way to respond to climate change, but I suppose they are a logical consequence of the administration's unwillingness to move ahead nationally on this issue.

It is also perplexing that the state would have set an easier standard for SUVs than cars, since the potential savings in the former is so much greater. Reductions in SUV emissions should also be easier to achieve, since they offer more scope for weight reduction, smaller engines and improvements in four- and all-wheel-drive transmissions, as well as higher technology approaches such as hybridization. Some of these changes might also begin to address these vehicles' disproportionate collision hazard, which has forced some passenger car makers to invest in costly countermeasures.

Right, wrong or indifferent, the auto industry will have to develop plans to meet this challenge, even as they gear up to fight it. California constitutes 10% of the US car market, and though carmakers have been producing separate California and 49-state models for years, changes in California affect the entire industry. In addition, a number of other states have taken to following California's regulatory framework, and this influence has spread abroad, too, to places like Korea.

The best outcome would be a set of EPA guidelines that gave states some leeway within a defined range of greenhouse gas reductions but provided the auto industry with clarity and reduced uncertainty about the targets it must meet. The worst outcome would mirror the current situation on the fuel side, where a Balkan complexity of state regulations has made a hash of the highly efficient and resilient gasoline distribution system.

Lord Browne Speaks
I've devoted a lot of space this week to concerns about future oil supply and some possible solutions. My regular readers know that I've formed the view that we face a prolonged period of tight oil supply in the future, though I'm skeptical that what we are now experiencing is it. I think it's worth capping the week with a very clear and articulate argument for the view that things will be OK. Who better than Lord Browne, Chairman of BP--arguably the world's most successful oil company at the moment--to provide it in this article from the Financial Times (subscription may be required).

In particular, his discussion of the situation in the key OPEC producers is well-reasoned, encompassing both their domestic needs and their wherewithal to build capacity when they perceive the need. He also makes some insightful comments about the distinction in roles between the international oil majors, such as BP, and the national oil companies of the countries from which much of the world's incremental oil supply must come.

His shareholder focus is also apparent and appropriate, urging caution about rushing into potentially unprofitable projects around the world. And he shows real passion in defending the industry's record of investment, stating categorically that the needed infrastructure is in fact being built. Finally, he ascribes the current high prices to a surge in demand, more than a shortfall in capacity.

None of this can be dismissed out of hand, but I think even Lord Browne would agree that his responsibilities and perspective are fundamentally different from those of someone charged with looking after the public's interests. He has given us a highly credible description of the successful status quo scenario for energy. We just can't forget that there are other, less comforting scenarios, which, even if less likely, have serious potential consequences for our economy and security.

Unconventional Oil
Yesterday I looked at the debate concerning a possible early peak in conventional oil production. Today I'd like to cover one of the wild cards that might avert a peak. With the world’s spare oil capacity currently perilously close to zero, and with prospects of creating a safety margin anytime soon looking dim, “unconventional” oil is becoming increasingly important.

This term covers of ground, especially for those who recall the abortive and costly US experiment with oil shale in the 1970s. Generally speaking, it describes oil that either does not flow out of the ground readily through conventional drilling, or oil that requires significant processing after production. The two main forms of unconventional oil in wide production today and with good prospects for expansion, oil sands and ultra-heavy oil, fit one or the other of these criteria.

The reason these resources are so important now is that large deposits have already been identified, essentially eliminating the exploration risk associated with expanding conventional oil production. Bringing them onstream is a matter of deciding to invest in the industrial plants to handle their unique characteristics. While this sounds trivial, keep in mind that these are massive investments, running in the billions of dollars for each facility.

Recently, Canada has made a bid for recognition as having the world’s second largest oil reserves, after Saudi Arabia. With all due respect to my Canadian colleagues, this is a bit disingenuous, since the largest share of those reserves would not qualify as such under the SEC’s definition. The Oil and Gas Journal reports Canadian reserves of 180 billion barrels, while World Oil indicates only 5.5 billion. Oil sands—which were formerly known as “tar sands”, and the extraction of which is more like mining than oil drilling—account for the difference. Oil sands production already comprises about a third of Canada’s oil production and has staved off a decline in that country's overall production and exports. A number of firms are considering adding oil sands capacity, including Suncor, one of the main producers.

The other leading form of unconventional oil being produced today comes from the Orinoco Belt of Venezuela. It is extremely heavy, with a density greater than that of water, and is both difficult to extract and requires a good deal of expensive pre-refining before the resulting synthetic oil can be shipped off to a refinery for processing into gasoline and other products. But like Canada’s oil sands, the quantities available are enormous. Several plants, including the Petrozuata and Hamaca facilities, have been built in recent years, with more in prospect. Their combined production will soon rival Venezuela’s conventional oil production.

The biggest problems with both of these forms of oil are the capital required to produce them and the time required to construct the necessary mining and processing hardware. As a result, I’ve always been skeptical that they are quite the silver bullet that some suggest. For example, the Canadian industry will spend between $30 and $50 billion between now and 2012 to add under a million barrels per day of new synthetic oil capacity. You'd have to multiply this by a factor of three or four to make a dent in the global oil production profile.

At least until the recent price spikes it hasn’t been clear that the industry could attract this kind of incremental capital and provide attractive returns over the lives of these investments. But if the pessimists are right about the challenges the Saudis face in just maintaining their current production capacity, we had all better hope that there are lots and lots of new oil sands and heavy oil projects coming down the pike.

Peaking Interest
Well, the peak-oil issue has finally made it to the front page of the Wall Street Journal. Yesterday's article presented both sides of the issue, focusing on Colin Campbell as a leading exponent of the "peak is imminent" faction, and Michael Lynch as the chief naysayer, backed up by statements from ExxonMobil. The Journal did a fine job of presenting enough of each side's argument that their audience can do some evaluating of its own, rather than having to rely on the writer's conclusions.

The theory of peak oil is built on the observation that when you have produced half of the oil that was there before you started pumping it, then production will reach a plateau and then begin to fall. This has been characteristic at the oilfield level, at the national level (particularly in the case of the US), and should be true for the globe as a whole, or so the argument goes. The article correctly differentiates this from the fallacy that we are "running out of oil." The succession of Mr. Campbell's previous incorrect estimates of a peak in production (e.g. in 1995) gets chalked up to inaccuracies in estimating the total amount of oil, not to failures of the underlying theory.

Mr. Lynch's counterargument is a bit more complicated, and possibly less appealing but likelier to be right for that very reason. He suggests that ultimate production is a function of geology, economics, and geopolitics. Thus any projection of future production based on historical levels will be skewed by changes in price, prevailing contractual terms, and access to resources. He also has some specific concerns about the data used by Campbell and others. As you might guess, he does not see a peak occurring anytime soon.

One of the interesting contrasts highlighted by the article is the extreme range of estimates for how much oil is actually still available. Mr. Campbell assumes that there is about as much left as we have pumped to date (roughly 900 billion barrels), while ExxonMobil sees up to 14 trillion barrels of recoverable oil, including non-conventional oil such as tar sands (my blog topic for tomorrow.)

As I've indicated previously (see my posting of May 7, 2004) I think that both sides in this debate are on to something. While much less skeptical about how much oil can ultimtely be extracted than Dr. Campbell, I think that many mainstream analysts underestimate the difficulties of getting timely access to resources and queuing up the financial and engineering means to harvest them, far enough in advance of the need. My retort to industry colleagues skeptical of this is simply this: show me the field-by-field production profile that in aggregate yields a steadily rising supply curve, and I will banish all thoughts of an impending gap between supply and demand. No takers, yet.

It's Here?
The other interesting news from last week was the reaction to Tony Blair's stern warnings about imminent effects of climate change. In the UK, leading London papers carried editorials calling for drastic responses, ranging from increased use of renewable energy, a new wave of nuclear power plant construction, and even investigating the feasibility of using oceanic phytoplankton as a giant "carbon sink". The reaction on this side of the pond was indifference.

Having followed the climate issue for some time and developed scenarios focused on what would get the attention of the US public on this issue, I'm surprised that we can endure a succession of three major hurricanes hitting Florida and the Gulf Coast within a month without our politicians even hinting at a link to climate change--despite a contentious presidential campaign in which John Kerry is trying to position himself as the candidate of the environment.

And while I certainly understand the distinction between weather and the climate, this event, suggesting a possible increase in the frequency and magnitude of Atlantic hurricanes, is precisely the kind of consequence that climate researchers have predicted. Could it just be coincidence or bad luck? Perhaps, but it takes a true skeptic not to see the pieces of the puzzle beginning to fall into place.

If anyone here is paying attention, I suspect it is the insurance industry, as Mr. Blair suggested. The combined damage from the three storms may amount to $20 billion or more, and insurers and their reinsurance backers will be hit for a large chunk of that. Don't be surprised to see them raise a red flag on climate change in the near future.

Chess, Anyone?
The most interesting news I saw over the weekend was the report that Yukos, the embattled Russian oil giant, has revised its estimated oil reserves upward by a factor of five, to 93.7 billion barrels. Note that this compares to published reserves, as of 1/1/03, of 60 billion barrels, not for Yukos but for all of Russia. Even allowing for the inclusion of some gas, this is a stunning announcement. If accurate, it has major implications.

Most importantly, as some have suspected, it would indicate that Russia has significant untapped and previously unreported oil reserves that put it in the same league as the larger Middle Eastern producers, such as Iraq, if not with Saudi Arabia itself. At the same time, this would throw pessimistic estimates of when Russian oil production is likely to peak into a cocked hat. And it would make Russia that much more attractive an investment play for the international oil majors, many of which are struggling to increase production by more than a percent or two.

However, such an announcement cannot be divorced from its context, the confusing confrontation between Yukos and the Russian government. Is this intended as a signal to the government that the consequences for the Russian economy of the threatened dismemberment of Yukos are far beyond the Kremlin's calculations? That Yukos, as presently constituted, is better equipped to boost Russia's oil production--and thus its export earnings--than any possible successor to its assets? At the very least it is an interesting way of raising the stakes in what is already a very high stakes game. While it must be taken with a healthy dose of skepticism, given the timing, it certainly qualifies as an amazing development.

Bad Timing
Last week's Economist carried one of their excellent periodic industry sector reports, this one focused on the global automotive industry. As the lead article and subsequent details demonstrate, the industry is shaky and probably undercapitalized for dealing with the challenges it faces. Thus the problems generated by the prospect of sustained high fuel prices could not come at a worse time for carmakers, especially Ford and GM, which still rely heavily on profits from the sale of large SUVs.

I also suspect it is no accident that Toyota should be so well-positioned, financially, geographically, and technologically, to prosper under these conditions. They are making big bets on efficiency and the environment, in the form of hybrids now and fuel cells later, and on capturing the early loyalty of a new generation of carbuyers, through the introduction of the Scion brand aimed at the Millennials (the so-called "echo boomers"), which at least in the US will ultimately rival the Baby Boom generation in size and influence. If these bets pay off, Toyota could challenge GM for top rank, having already narrowly passed Ford.

It's even more intriguing, though, to ponder some of the other possibilities raised by the Economist. We've already seen one car designed and fabricated in the decentralized and highly outsourced fashion they suggest: Mercedes' Smart. Is this the wave of the future, and if so, how would this change the industrial landscape of the US and other developed countries?

Independence vs. Interdependence
Yesterday's Wall St. Journal included this commentary concerning Senator Kerry's repeated references to "energy independence." In the next few weeks I plan to revisit my earlier analysis of the Senator's energy proposals (see my blog of 2/27/04) but I think it's worth touching on this aspect now. As Mr. Tucker indicates in this article, it is just not reasonable to imagine that we will be able to do without oil from the Middle East anytime soon.

While I am enthusiastic about alternative energy, including wind and solar power, and intrigued by the potential of a hydrogen-based economy, I would hope that anyone governing this country--or aspiring to that responsibility--would understand the enormous costs and time required for any such transition and the need to ensure that our current energy supplies remain adequate in the meantime.

Any sensible energy policy should be built around several key principles, including the fact that gasoline will remain our primary transportation fuel for at least the next decade and probably longer, that natural gas is the cleanest and best fuel for power generation, as well as for a number of other stationary applications, and that continued economic growth will require increased supplies of oil and gas, from both domestic and foreign sources. It should also recognize the growing importance of alternatives and the need to help them compete against traditional sources, at least initially. It should include the following kinds of measures:
- Incentives for the development and deployment of alternative energy, particularly in areas in which reaching economies of scale is important.
- Revised corporate fuel economy standards that create a level playing field for cars, SUVs and light trucks, and advanced technology vehicles.
- More rational offshore drilling restrictions that recognize the difference between drilling for oil, with its potential for spills in sensitive areas, and drilling for "non-associated" natural gas, for which those risks are negligible.
- Regulations and incentives to modernize and upgrade our electric power infrastructure to make it more reliable and resilient and less vulnerable to sabotage.
- A fast-track permitting process for LNG import facilities that fairly balances local concerns with pressing regional and national energy needs.
- An impartial, fact-based cost-benefit analysis of oil development in the Arctic National Wildlife Refuge, including environmental costs. This should include preliminary, non-invasive exploration at government expense to assess the true scale of the resources that we are presently choosing to forego.
- Removal of current disincentives for industry to hold higher inventories of oil and refined petroleum products, as a way of partially privatizing the function of the Strategic Petroleum Reserve.

I don't think this is merely the standard oil industry laundry list, and I would also suggest that as part of the energy security debate, many of us may need to reconsider old prejudices. Isn't it just possible that some things that look good for Big Oil might also benefit everyone?

A New Giant
On the heels of yesterday's discussion about opening up OPEC's reserves to foreign investment comes the announcement that Rosneft, the Russian state oil company, and Gazprom, the largest gas enterprise in the world, will combine to form the world's largest publicly-traded energy firm (measured by reserves.) Today's Wall Street Journal also speculates that the new entity could serve as a receptacle for assets seized from Yukos. In any case, this is a momentous development, if actually carried out, and it could provide a useful model for other countries.

At the same time, this news poses challenges for the existing international oil and gas companies. Although examples such as BP's investment in Russia's TNK abound, the international majors need more than just passive--and hopefully profitable--minority investments. Their business models depend on access, so any such investments must be made in the expectation that access to resources will follow, and on a scale to justify the portfolio and governance risks endemic to minority stakes in countries with poorly-developed legal protections for investors.

As enticing as the new Gazpromneft may be from a market perspective, it is harder to discern how an investment by an Exxon or Shell in this new entity will translate into profitable equity oil and gas production and bookable reserves. Without those, the oil majors may end up evolving into service companies that no longer enjoy the resource rent that has fueled their earnings for the last century.

Total Speaks Out
The Financial Times reports that Total's CEO, Thierry Desmarest, has publicly called for OPEC countries to open up access to their oil reserves for international development, in order for oil production to keep pace with global demand. Regular readers of my blog will recognize an issue I've been harping on for a while, but M. Desmarest goes beyond this to highlight a critical crossroads for the industry. I hope that the head of every oil company reads his comments, particularly those running the national oil companies in OPEC countries.

When considered carefully, his remarks point out the disconnect between the current business model of the international oil and gas industry and what is required for future oil production to keep up with growing demand, ignoring concerns about geological limits to oil production. He is saying that the international oil majors can be quite successful and profitable operating as they are, relying largely on developing their own exploration discoveries and bringing them to market, but that this will not close the gap that is now apparent between future production capacity and potential future demand.

Several key facts support his argument. First, as we've known for years, OPEC has a disproportionate share of the world's oil reserves, and these tend to be more easily produced than non-OPEC's. In addition, the price collapse accompanying the Asian Financial Crisis of the late 1990s taught oil companies that it is much riskier to overestimate future demand than to underestimate it. The latter also turns out to be enormously more profitable, as we are seeing now. M. Desmarest has omitted a third contributing factor, industry consolidation.

Part of the process of delivering merger synergies entails high-grading the exploration and production portfolios of the merging firms. That means that some upstream projects are cancelled, postponed, or sold off to companies with fewer resources. The result of the seven recent top-tier mergers that come quickly to mind must be lower aggregate oil production in the future than would have been the case without the mergers, unless you believe the survivors are going to be that much more efficient at executing the remaining projects, or at finding new ones.

So the crossroads looks like this: one branch takes the oil majors down a road of strong financial performance on a base of stable (+/-) production volumes, but risks sustained oil prices that justify lots of alternatives, while the other branch involves a number of initially less profitable ventures with OPEC countries, but keeps the industry healthy and capable of supplying all the transportation fuel the world wants for many years to come. It's a fascinating choice, especially when you start probing the criteria for making such a choice.

I think M. Desmarest is also sending a subtle message to Russia. Because their oil tends to be cost more to extract than OPEC's, they face a window of opportunity that may close when and if OPEC realizes it could produce a lot more oil, a lot faster, with outside help. Does Mr. Putin hear this clock ticking?

Joining the Club--But Why?
I have to admit to being perplexed by the controversy over Iran's nuclear ambitions. In particular, I'm baffled by the degree to which the international community seems to accept that Iran might want to possess a complete nuclear fuel cycle (i.e. the ability to produce their own reactor fuel and reprocess the spent fuel) for some motivation other than wanting nuclear weapons. After all, as a report I cited in an earlier blog (March 12, 2004) put it, the difference between a country with a civilian nuclear fuel cycle and one with nuclear weapons is largely one of intent.

If you consider the main reasons that a country might choose to have nuclear power plants and nuclear fuel processing, most of them can be ruled out in the case of Iran. First, although Iran's consumption of primary energy grew by 75% between 1992 and 2002, to 5.9 quadrillion BTUs/year (compared to US consumption of 97.6 "quads"), it produces 10.4 quads/year of oil and natural gas and has reserves of over 800 trillion cubic feet of the latter, nearly five times as much as the US and second only to Russia. That works out to about an 80-year supply of their current energy use. Iran is hardly short of primary energy.

A slightly more sophisticated version of the energy shortage argument turns on preserving oil and gas for export to earn hard currency, by shifting domestic power generation to nuclear. This doesn't really hold water, either, since with vast untapped gas reserves it should be much more cost effective to generate additional export income by investing the cost of the nuclear program in LNG export facilities.

I think we can also rule out environmental concerns as a driver. Even though Iran is a signatory to the Kyoto Treaty on greenhouse gases, and nuclear power plants are one solution to generating emissions-free electricity, Iran's economy is critically dependent on the world's appetite for hydrocarbon fuels--with their accompanying emissions--and nuclear power plants won't change that.

Perhaps I'm missing something, but the only other rationale I can see besides the obvious one has to do with national prestige. That played a big role in Iran's previous nuclear ambitions, under the Shah, but in today's world this is a particularly expensive and dangerous way to try to impress one's neighbors. If this is the driver, we should actively encourage the mullahs to find another arena for competition.

So if we were to call a spade a spade, here, what would be the outcome? The US has had economic sanctions in place against Iran since the mid-1980s, and they have been effective mostly against US companies whose foreign competitors weren't under such constraints. Little impact on Iran is apparent. Any action to restrain Iran would have to be multilateral and strongly enforced.

Could the world do without Iran's oil and gas just now, if international sanctions were imposed? I think this takes us to the crux of the issue. With Iraq's production frequently interrupted by sabotage, and with global oil demand bumping up against supply limits, Iran is in the driver's seat. Invading or embargoing Iran would be a short path to $100 oil, and there are plenty of folks around who remember 1978-9, the last time Iran's oil went off the market.

This is about as cynical as I get, but it seems to me that Iran is very clearly on a path to getting nuclear weapons and will receive a "get out of jail free" card from the world because of its critical importance as an oil supplier. What am I missing?

Rumors Quashed?
The Financial Times reports that Total's CEO, M. Desmarest, has denied speculation that his firm is interested in a takeover of Royal Dutch/Shell. Whether this is just the usual rumor control around the edges of something proceeding stealthily, or a genuine recognition that the conditions aren't right for this kind of merger, his remarks are welcome. An increasing number of analysts are recognizing that the global oil industry faces a serious capacity crunch. At this point, the oil majors need to invest in new exploration and production projects, not in each other.

The consequences of previous under-investment weigh heavily on fuel prices today, though they have done wonders for oil company equity prices. The stock of my old firm, ChevronTexaco, is up 15% vs. the S&P 500 in the last six months, and up nearly 30% since the start of the year. But even though recent investment constraints look smart for shareholders in the short run, they diminish the companies' long-term growth prospects and expose the global economy to risks that must affect shareholders' overall wealth to a greater degree.

Unfortunately, if the industry dramatically ramps up investment now, this could create a future oversupply that would undermine the returns on those projects for a few years. This is the perennial paradox of the industry, and part of the cost of doing business. Ultimately, if oil supply fails to keep up with demand, the incentive for alternatives will be much greater, and yesterday's prudence will look like tomorrow's myopia.

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.