When Is Risk Management Not?
I don't know how much I can add to what's being said about the problems of China Aviation Oil, a Singapore-based petroleum products trading company that has run up derivatives losses on jet fuel of around a half billion dollars in the last several months. The situation is being called everything from the result of a rogue trader to a warning about the governance of Chinese corporations. At a minimum, it serves as another cautionary tale on the need for absolute discipline in the area of price risk management.

We used to call this stuff hedging, until the proliferation of new tools such as options and derivatives--and the math and software to analyze and manage them--made the old term imprecise and unsophisticated-sounding. But for a firm with exposure to price risk on real physical barrels, the basic principles never really changed: understand the risk, match the "basis" (the relationship between what is being hedged and the commodity/location for which a futures/options/derivative contract is available) as closely as possible, see where you are at the end of every day, and never lose track of the connection between the value of your physical commodity and your profit/loss on the hedge.

What is not clear from the coverage I've seen is this final, all-important question about the value of the physical oil. If CAO was able to capture all of the upside on its physical jet fuel transactions that it gave away on the derivatives contracts it entered into, then what we have here is an accounting problem and a large opportunity cost. But if, as the articles hint, CAO was essentially buying and selling product at market prices, while taking a speculative bet on the price of jet fuel and rolling their losses forward in hopes of a market dip, then you have the worst possible nightmare for the person with ultimate responsibility for this activity: high-stakes casino gambling masquerading as risk management.

Derivatives make an easy scapegoat for losses like these, but I suspect the traders involved could have run up nearly as much red ink doing the same thing in the futures markets, or perhaps more, since they'd have been limited to the commodities and locations for which liquid futures exchanges exist, thus taking on not only price risk but large basis risk, as well.

Whenever an event like this occurs, it gives a black eye to trading and risk management, but it shouldn't deter anyone from using these extremely useful tools, as long as they have clear policies and controls in place, along with the kind of accounting that makes it difficult to obscure losses that are being rolled forward.

Iran and the NPT
The other major energy-related news item of the last couple of weeks is the negotiations with Iran over its nuclear fuel reprocessing capability, and the implications for nuclear weapons production. Even ignoring the fiery rhetoric coming out of Iran, the European-sponsored agreement announced this week is pretty clearly just a stopgap. Will the time thus bought be spent usefully, or are we merely postponing further unpleasant revelations?

The current deal can be viewed either as a pragmatic compromise facilitated by an effective "good cop/bad cop" act on the part of the EU and US, or as cynical appeasement by European governments eager for more trade with the mullahs and no appetite for confrontation. Whatever the motivation or the subsequent judgment of history, few experts seem to think this agreement will prevent Iran from joining the nuclear weapons club at a time of its choosing. The real benefit may be one I haven't seen articulated: buying time now is worthwhile, because full-blown sanctions on Iran are unthinkable in a world of $50 oil.

Iran currently exports 2.5 million barrels per day of oil, most of which goes to Europe and Asia. This quantity is greater than the most optimistic assessment of the world's remaining spare production capacity, so cutting it off would create a situation analogous to the 1973 and '79 oil crises. I am certain that the Iranian negotiators understand this completely--inasmuch as their own Islamic Revolution precipitated the 1979 crisis--and are taking full advantage of the bargaining power this gives them.

So is there a way out of this situation that won't result in Iran becoming a nuclear power, and in the process blowing the entire nuclear non-proliferation regime to kingdom come? The Wall Street Journal's suggestion of funding the Iranian opposition seems likelier to cost the latter their credibility and ruin any chances of turfing the mullahs out of power. This is a problem that cries out for some fresh thinking.

The Long Future of Oil
It's fashionable to talk about the coming Hydrogen Economy, and though I may often sound like a skeptic, I think that many of the elements of a hydrogen-based energy network could be in place in twenty years or so. However, an article about the petroleum potential of the deep Arctic waters got me musing about the long-term future of oil, which may be much longer than some expect.

If you extrapolate current oil production trends, by 2040 most of the conventional production in the US, Canada, and North Sea will be tapped out, and virtually every current producing country outside the Middle East will be in decline. Even if hydrogen (presumably generated by some non-fossil fuel source, such as renewables or nuclear) were to make major inroads into oil demand by this time, there would still be a need for significant quantities of oil, to supply those parts of the world that couldn't afford to make a transition to hydrogen, and for aviation, petrochemicals and other non-road demand sectors.

Saudi Arabia (assuming it still exists as a country 35 years from now; after all, it is only about twice that old now) should still be a major producer in 2040, as would Iraq and Iran. But would the world want to rely entirely on Middle Eastern oil, and could the Middle East by then cover even a diminished global appetite for oil? Where else might the oil come from?

That's where the potential described in the article on the Arctic comes in. By 2040, a substantial proportion of the world's oil--even if oil were well on its way to becoming obsolete--would have to come from unconventional sources, such as oil sands or heavy oil (see my posting of September 23.) In addition, resources that have yet to be identified, in ultra-deep waters (beyond the continental shelves?) or ultra-remote areas, such as the Arctic and Antarctic, would have to contribute materially to supply. That would raise all sorts of interesting questions about who owns the rights to those resources. Nor can one discount the possibility that in 35 years biotechnology and/or nanotechnology could either unlock the huge amounts of presently unrecoverable oil in abandoned reservoirs, or generate synthetic oil in large quantities.

Note that I haven't said anything about the price required for this to play out, or about the possibility of a truly superior energy technology, such as nuclear fusion. Barring such a development, and depending on the future attitude toward climate change and the long-term decarbonization of energy (which some claim is starting to reverse), oil could still be an important commodity well into the next century, and that implies some pretty exotic oil technology, rivaling anything the Hydrogen Economy has up its sleeve.

Turning Back the Clock?
Someone who had slept through the last fifteen years and woke up now to read the headlines out of Russia might be forgiven for thinking the USSR was still in place. The disputed election in Ukraine and President Putin's recent announcement concerning a new generation of ICBMs provide an interesting context to the unfolding Yukos endgame. Despite this, I still think we should avoid reading too much into these events, or at least their implications for the energy industry. The Financial Times appears to share this view. (subscription required.)

About all one can say with certainty is that if we thought Russia would emerge as a democratic, market-oriented counterweight to OPEC, that now looks naive. Oil and gas have been the engines of recent Russian economic success, and are fueling its inevitable reassertion of power and influence on the world stage. Russia may never again be as important as it was during the Cold War, but neither does it seem likely to be as marginal as it was in the 1990s, when pundits frequently compared it to the Netherlands.

It is also worth recalling that the late Soviet Union was an important and fairly reliable supplier of energy to the West, even during periods of high political tension and saber rattling. So even as it clamps down on freedom of the press and meddles in the affairs of its near neighbors, Vladimir Putin's Russia will remain an important trading partner, particularly for the EU. It also contains some of the best prospects for dramatic new oil and gas finds outside the Persian Gulf, and accessing some of them will require international capital and technology.

The deeper question is not where Russia is headed, but how comfortable we are with this. Are we as enthusiastic about Russian oil and gas as an alternative to greater reliance on autocratic Middle Eastern countries, now that Russia is reverting to being an autocratic Eurasian country? If not, then we had better gear up our other alternatives quickly, including demand management, more renewables and some options that have been unpalatable for environmental reasons, such as new nuclear power plants and drilling in the Arctic National Wildlife Refuge and offshore Florida and California.

Another Wrinkle on Hydrogen
Most of the planning for a future hydrogen economy revolves around the replacement of oil-based transportation fuels with hydrogen generated by cleaner energy sources. This would then be consumed in fuel cells--either vehicular or stationary--thus providing further efficiency gains due to the higher energy recovery of these devices compared to internal combustion engines. But a new development in hydrogen production, utilizing high-temperature nuclear reactors and ceramic separation technology, might provide a way to use hydrogen to leverage existing natural gas supplies.

Large quantities of hydrogen are already produced from natural gas within oil refineries and chemical plants. This hydrogen never appears in the market, because it is consumed in the production of reformulated gasoline, low-sulfur diesel, or ammonia-based fertilizer. The total quantity of natural gas involved is roughly a billion cubic feet per day in the US alone, or about 1.5% of our total consumption.

Hydrogen generated by a few centrally-located nuclear reactors in Texas, Louisiana and New Jersey, could supply a large portion of the demand for "process hydrogen" and free up a commensurate amount of natural gas for use in homes or in power generation, backing out dirtier fuels. This strategy would only work for hydrogen produced from an emissions-free source, such as nuclear, because of the large energy losses involved in making the hydrogen.

The advantages of such an approach would include the creation of a large hydrogen supply base prior to the introduction of hydrogen-fueled cars, thus helping to break some of the chicken-and-egg dependency of a hydrogen-based transportation system. It could also help to mitigate the growing gap between natural gas supplies and potential demand.

Ultimately, the feasibility of this scheme would hinge on whether it would be easier to build high-temperature nuclear reactors for hydrogen production, or to overcome the obstacles to creating a network of LNG receiving terminals, as well as on the relative economics involved.

Thanksgiving Vacation
This will be the last new posting until Monday, November 28. My family and I will be celebrating Thanksgiving with friends in the Southwest.

Today I ran across an article that describes a new technique for storing hydrogen at roughly room temperature and normal pressure. Practical storage is the sine qua non of a potential hydrogen economy, so anything that shows promise in this area is good news for hydrogen in general. In particular, I'm no fan of high-pressure storage on vehicles, no matter how well-designed the container. Nature abhors a vacuum, and to a gas at 10,000 psi, everything around it is a vacuum. In a future blog I will go into more detail on the other promising alternatives of the moment, including metal hydrides and nanotubes.

Before signing off the for the week, here are links to some past blogs that you might find interesting, if you didn't see them the first time around. (you'll have to scroll down in the linked monthly archive to the date indicated):

The oil markets have done their job:
Have We Really Forgotten? (August 9)

Climate change as a business risk:
What Can We Agree On? (July 27)

Hybrids may be a US and Japanese phenomenon:
Where Are the European Hybrid Cars? (June 28)

Has our air gotten cleaner or dirtier?
Clean Air (April 21)

This also seems like a good time to solicit your ideas about pertinent topics for the future. As this blog nears its first anniversary, what have I neglected to discuss, or what I have spent too much time covering? You can provide this feedback either by clicking on the "comments" link below this posting, or by email mailto:gsws@optonline.net.

Have an enjoyable Thanksgiving!

Oil Ecology - Continued
Yesterday’s blog covered one aspect of the changing global “ecology” of oil, the relationship between the majors and independents. Another important change concerns the evolving role of national oil companies, particularly those in large consuming countries, as they seek to diversify their supplies and bolster energy security. The majors have dealt with these companies for decades, often as partners but increasingly as competitors for projects. However, in the last few years new issues have given the national oil companies a potential edge in gaining access to undeveloped resources.

Human rights, sustainable development, and global environmental issues have all emerged as risks to manage, but also as factors that may determine with which countries the global oil companies can do business. All of these issues are squarely in the radar screens of socially conscious investors, who represent a sizable force in the markets, and exercise growing influence on company policies. As this article from the Financial Times points out, China and India, both of which have significant concerns about energy security, have a very different approach to of the issues cited above. This gives them access to resources that are untouchable by the majors.

Consider the impact of shareholder initiatives and lawsuits in constraining the US majors from investing in countries such as Burma. The Chinese National Oil Company and ONGC of India face no such scrutiny. So while US companies have ultimately sold their stakes in pariah states, or come in for withering criticism and pressure, CNPC and ONGC have crafted major investment strategies focused on them.

I am not suggesting that the international oil companies should be free to pursue opportunities without regard to political, social and environmental issues. These concerns are becoming much more important to global capital, and scorning them will have long-term, detrimental effects on shareholder value. Rather, the majors and their investors need to take cognizance of how the emergence of a class of players without the same constraints changes the competitive landscape and limits some opportunities.

A Changing Oil Ecology
Most of us grew up with a pretty clear perception of the difference between the small, independent oil companies and the giant, multi-national oil majors: the former took risks the latter didn't want to take on. While that may still be true in some instances, a decade or more of evolution and selection--natural and otherwise--have changed both the size and nature of the various niches in the industry's ecology. As this article on the UK North Sea from the Economist (subscription may be required) illustrates nicely, small companies are increasingly focusing where the rewards are too small for the majors, while the majors seek opportunities more material to their scale, often with higher risk.

This shift is the natural consequence of a period of mergers and fierce cost competition, and it has implications for global energy supply, as well as for the firms that provide it. The majors must constantly assess the relationship between sustaining and growing their production, and the need to deliver high returns to their shareholders. The extremely tight oil markets we are experiencing now are at least partly the result of this deference to capital markets, rather than to oil markets.

But there are other implications for the smaller companies. They are having to become as international as their larger brethren, and in the process must manage a whole range of political risks and cultural sensitivities--along with issues such as sustainable development and climate change--that would have been rare in the earlier heyday of the independents. They have also benefited from the maturation of producing technologies that were previously the exclusive province of the majors, such as 3-d seismic and enhanced recovery.

Several years ago, majors were busily snapping up the small-fry, and there were real questions about the future role of independents in the industry. Perhaps there should now be some questions about the majors. Many of the more mature fields--some with quite a bit of oil left to produce--are in the hands of independents, while the largest and best opportunities remain the exclusive province of national oil companies such as Saudi Aramco.

Finding and developing enough oil each year to maintain their reserves will become an increasingly difficult challenge for the majors, as demonstrated by recent figures from Wood Mackenzie (subscription required) showing that the exploration efforts of the 10 largest oil companies failed to recover their costs over the last three years. In the meantime, the future looks bright for those independents that specialize in making lemonade out of the majors' lemons.

Yucca Mountain vs. Buying Time
The proposed long-term nuclear waste storage site at Yucca Mountain, Nevada has been delayed by a combination of technical problems and localized opposition affecting both the site itself and the transportation of waste from hundreds of reactors and other locations to the site. (See my blog of August 12.) With the distortions of election-year rhetoric behind us, it's worth pondering the questions posed in a fascinating article in MIT's Technology Review, which suggests that delay might actually be the best strategy for dealing with our nuclear waste.

Waiting is always an alternative in any project, but it's often the least preferred, particularly when net-present-value economics are driving the decision, and the value of distant cash-flows is thus heavily discounted. NPV doesn't account for the value of information gained by waiting, nor does it consider the possibility that a much more valuable option may emerge after a few years. The best way of approaching this sort of decision is using the techniques of "real options", which explicitly value all possible future outcomes.

As I read the MIT article, it seemed to me that the author was describing a real-options approach to nuclear waste. Future "branchings" include not just the proposed facility in Nevada, but also the potential of new waste-disposal alternatives, better technology for reprocessing waste, and ways to improve the safety of sites such as Yucca. Including their potential in the calculation just might alter our choice today. Another key consideration is that deferring a permanent decision by 50 or 100 years will reduce the radioactivity--and thus both the hazards and storage challenges--of current waste.

The article didn't delve very far into any mitigating or offsetting concerns related to delay, beyond having to secure 60 temporary storage sites in lieu of one permanent site. However, delay adds to the scale of the subsequent problem, as existing reactors continue to generate waste. It also provides many more opportunities over time for disastrous security problems, including some that we simply cannot imagine today, because they would arise from new technology and techniques that develop in the interim.

Finally, and perhaps most insidiously, the absence of a permanent nuclear waste storage option would weigh heavily on any debate about the viability of new-generation nuclear plants as a high-capacity, zero-greenhouse-gas emission energy option. Without a plan for waste, new nukes are dead on arrival.

So when is delay not merely procrastination? Only if it is the result of considering all the benefits and costs of waiting and determining that time is truly on our side, something that has appeared counter-intuitive until now.

Doing the NIMBY Shuffle
In the past 11 months that I've been blogging, I've devoted much space to the problem of reconciling our energy needs with the desires of communities to have all energy infrastructure built somewhere else. Receiving terminals for Liquefied Natural Gas (LNG) get particular attention, because--barring the opening of off-limits areas to drilling--they provide the best chance for expanded use of the most environmentally sound fuel available globally in large quantities. I can now take perverse pleasure in reporting that such a facility has been proposed for my back yard.

The Broadwater Energy LNG facility would consist of a floating storage and regasification plant in Long Island Sound, with a capacity of 1 billion cubic feet per day of gas (about 1.5% of US demand), roughly equidistant from Long Island and the Connecticut coastline. This project has already come in for criticism from both the New York and Connecticut sides of the Sound.

Broadwater is only one of many LNG plants that have been proposed and opposed around the country. The sites generally provide either access to existing gas pipeline infrastructure, or, as in the case of Broadwater, proximity to large gas markets. The Northeast was short of gas last winter, with significant amounts of LNG imported through the existing Cabot facility near Boston. But as the market grows, even more gas will be needed and sources of additional pipeline gas are scarce, even if more pipelines could be built.

Opponents of Broadwater need to understand very clearly that there is no magic solution if we want natural gas to be there when we want it. We will either need more gas from this country, or more imported gas. Without LNG or new pipelines, we will eventually face the choice between turning off power plants or cutting off gas deliveries to homes and businesses. That's a truly dismal prospect, and it is completely unnecessary, if we can finally stop approaching projects like Broadwater from a purely self-centered, parochial perspective.

That doesn't mean Broadwater should get a free pass on safety and the environment, but it is clear that no LNG facility imaginable could ever satisfy all the opposition we're seeing. Now, you can choose to believe in a world in which projects like this aren't needed because we will all wake up and become much more frugal with energy, but the consequences of that fantasy will inevitably be higher consumption of dirtier fuels--with more greenhouse gas emissions--because we insisted on impossible standards and avoided the real-world tradeoffs required to ensure an adequate supply of natural gas.

Where Next for Oil Prices?
We've been living with oil at or near $50 long enough now that it has seeped into the collective consciousness and colored our views of the future. Psychologists refer to this phenomenon as an "availability bias." But as the end of the year approaches, expectations for oil prices for next year are beginning to diverge. The Energy Information Agency of the US Department of Energy has just issued a forecast of oil prices (based on West Texas Intermediate crude) in the mid- to high-$40s per barrel for next year, while the chief economist of Total has suggested it could fall back into the $30s.

The problem with forecasting prices now is that the range of possible outcomes has grown so large. With the world's excess oil capacity having been eroded to a whisker by a combination of booming demand and an array of supply problems and disruptions, the only safe prediction would seem to be for high volatility. Further disruptions could send prices soaring to record levels, while the gradual restoration of production in the Gulf of Mexico (post-hurricane repairs), Nigeria (easing unrest), Venezuela (continued recovery from the national strike) and Iraq (post-elections) should ease supply pressures. Add to this uncertainty about a Chinese economy that should start to slow in the wake of interest rate hikes by the central government. Taken together, this means we could see oil as high as $60 or $70 next year, or as low as the mid- to low-$30s. This range is so wide as to be meaningless for forecasting purposes.

As always, I have more confidence in scenarios than forecasts. Thus, one scenario might be the result of easing local tensions and promotion of supply from existing and new projects, coupled with healthy global economic growth. This would support Total's forecast, leading to gradually easing prices that might end the year near $30, much as we began 2003. Or we could see a repeat of 2004, with one supply disruption after another and unexpectedly robust growth in demand for petroleum products. Such a scenario would see prices more like the EIA forecast, with short-lived spikes into true record territory.

Fundamentally, it boils down to whether the trend is toward clearing up the numerous problems that have hampered supply, or drawing them out and adding new problems. My bet right now would be on the former, but I would have said the same for most of this year.

Veterans' Day (Armistice Day/Remembrance Day)
Since this is one of the few occasions when I get to observe November 11 as a holiday, I'll keep today's blog brief.

Yesterday I read that the Cape Wind project off Nantucket (see my blog of March 17 and a related posting on May 6) has passed a significant milestone, with the issuance of an apparently positive environmental impact report by the Army Corps of Engineers. The report will remain in draft form during a 60-day period for public comment.

No one should expect this to be the last word on the subject, as numerous opponents--including some influential public figures--are lined up to block the project. And perhaps, as opponents insist, it should be blocked, for aesthetic reasons; perhaps this is a case of wind power being good, but not good everywhere. However, if that is so, then exactly which other backyard (or viewscape) should defer to the public's need for more energy to run our lifestyles? Opposition without meaningful alternatives looks an awful lot like cynical self-interest.

Is a "Mild Hybrid" an Oxymoron?
Much of the buzz about hybrid cars has come from one hot model, the Toyota Prius, now in its second, improved version and selling like hotcakes. Ford is introducing a hybrid Escape (small SUV), and Honda has several hybrid models, but no one can say these cars are really mass market yet. The introduction of a "mild hybrid" pickup truck could change that, but is it worth the extra cost and complexity?

Environmentalists and those concerned about energy security get excited about hybrids because of their potential to improve fuel economy dramatically. In the case of the Prius, this improvement amounts to at least 50% better fuel economy than a comparable Camry (admittedly a somewhat bigger car.) But with sales of 50,000 Priuses per year, how much impact can you have on the fuel economy of a 200 million car fleet?

This is where the "mild hybrid" comes in. Unlike the full hybrids, such as the Prius, it does not have a separate electric drivetrain. Rather, it saves up some of the energy of braking in a 42 Volt battery and uses it to run accessories and to enable shutting off the engine at stoplights and restarting it instantly when the driver depresses the accelerator. The net result, at least in the case of the Chevrolet Silverado hybrid pickup, is a gas savings of about 10%, on a model that has sold about 500,000 units per year (in non-hybrid form), at a cost premium about half that of the true hybrids.

The question then is whether the "mild hybrid" technology, which is simpler and less expensive than full hybridization, and can thus enter the vehicle fleet more quickly and in much larger numbers than the Prius, is a useful adjunct to full hybrids or will undermine the whole concept by disappointing owners with its modest benefits. Only consumers can answer, as they determine whether modest fuel savings plus the cachet of a hybrid are worth the extra cost. GM won't be the only carmaker watching the outcome.

Oil for Food Won't Disappear
A couple of weeks ago the Wall Street Journal ran an editorial on the investigation of the UN's Iraq Oil for Food program that I thought neatly summed up the current state of affairs. I didn't cite it then, because it also contained a strongly partisan component that I didn't fit with my decision not to endorse a presidential candidate. With the election over, that is no longer a concern.

After filtering out a bit of hyperbole and the comments about Mr. Annan--which verge on the personal--I believe the Journal correctly assesses the scale and importance of this scandal. As I've indicated before, I believe there is a strong case that the corruption in the Oil for Food program--and the influence that went along with it--goes beyond a simple financial scandal, because of the way it undermined the effectiveness of the international sanctions against Iraq, thus contributing to the incredibly messy scenario in which we now find ourselves.

If the war in Iraq had truly ended when President Bush declared major hostilities over, without the ensuing guerrilla campaign, the Oil for Food scandal might have been swept under the carpet in the interest of getting the new Iraq off to a good start. But given the protracted conflict in which we are locked, I doubt that the US Congress will let up on this issue or allow the Volcker investigation to lose traction, until all the facts come out.

As the casualty list mounts in the days to come, I hope the architects of this chicanery lose some sleep at the prospect of embarrassing revelations to come.

Who Gets the Gas?
Russian energy has grown in importance in the last few years, particularly in light of the country's tremendous performance in increasing its oil production, and its potential to do more. But Russian gas, backed by enormous reserves, should have a larger long term impact on the market than its oil. One country that stands to benefit from this is Japan, which desires to diversify its energy supplies and currently relies heavily on natural gas from Indonesia. But now China, with its rapid growth and insatiable appetite for raw materials, may snatch (subscription required) a plum that Japan had been counting on: the new gas reserves on Sakhalin Island, north of Japan.

ExxonMobil recently indicated that it was considering other options for its Sakhalin-1 project, which had previously been slated for a new pipeline to Japan. An LNG project or a pipeline to northern China may look at least as attractive, financially and strategically. But are there even better options no one seems to be considering?

The inevitable shift of the Asian gas industry toward Russia will create opportunities for a clever and sensible rebalancing of existing Asian gas markets. In this instance, might it make sense for Sakhalin gas to be committed to China contractually, but delivered to Japan in exchange for LNG already contracted to the latter? After all, Sakhalin sits just to the north of Hokkaido, the northernmost of Japan's major islands, while the rapidly growing cities of southern China are closer to Indonesian LNG plants than to Russian gas. Such exchanges are commonplace in the world of oil, but much less so for natural gas, with its longer contractual terms and higher infrastructure costs.

As natural gas grows in importance as a primary fuel for the region's economies, the development of a functioning gas spot market and a network of long-term logistical exchanges should follow as a natural outgrowth and an indication that gas has matured and outgrown its junior-partner status relative to oil.

Ah, Those Subsidies
Periodically I'll run across an article on renewable energy, whether solar, or wind, or something more exotic, in which the author will downplay the importance of government subsidies in making them more competitive with traditional energy by citing the "hidden subsidies" that fossil fuels enjoy. They then go on to assert that if fossil fuels had to carry the full burden of those hidden subsidies, renewables would either compete now, or be on the verge of being fully competitive. This kind of thinking holds back the development of renewable energy, rather than advancing it.

Let's start by considering what might be included in such subsidies. Given current events, some sort of security subsidy seems like an obvious and important component. A lot of oil comes from a part of the world where the US has to maintain a big military presence to ensure continued access, the Middle East. By comparison, renewables are mostly homegrown, so they impose no such burden.

The other major category of subsidy usually cited is environmental. The use of fossil fuels emits oxides of sulfur and nitrogen into the atmosphere, along with a bit of heavy metals and gobs of carbon dioxide. In addition to the high cost of mitigating these at the source, which is paid directly by the producer or user, this pollution imposes costs on society via effects such as smog, acid rain, and their consequences.

All of this can be estimated and quantified, and a number of academic studies have done so. The resulting value of the "hidden subsidies" for fossil fuels ranges from fractions of a cent to roughly 12 cents per gallon. (This figure could be even higher, depending on how much of the annual defense budget you want to attribute to oil security.) Even if you quibble with some of the methodologies in question, it's pretty obvious that the figure isn't zero, and that economic decisions about our energy systems ought to take this into account.

But if we're going to look at the full economic cost of using fossil fuels, we should also consider the offsetting penalties built into the current system. Most of these penalties come in the form of taxes, and they are significant.

Consider the taxes on road fuels. In the US these include both federal and state excise taxes, and state sales taxes. In theory the revenue from these taxes is meant to fund highways and roads, though in reality it often disappears into general funds. Federal tax collections from road fuels totaled $32.4 billion in 2001. States collect anywhere from 8 cents to 26 cents per gallon (yielding another $30.3 billion in 2001), plus sales taxes, which go up with rising fuel prices. So even in the US, with much lower fuel taxes than Europe, we're in roughly the same ballpark as some aggressive estimates of the hidden subsidies.

So what is the point of all this? I assure you it's not just another argument for the status quo, although I suppose some might see it that way. After all, gasoline is cheaper than bottled water, and it will be a while before any practical alternative can make the same claim. My point is that the whole argument about hidden subsidies is a red herring, because the case is highly debatable, at best.

If we decide that it is worthwhile to subsidize alternative and renewable energy, then we should just get on with it, rather than rationalizing that the competitive bar is kept higher than it might otherwise be, because of some sneaky subsidy for fossil fuels. You're not going to displace fossil fuels on economics alone, no matter how many "externalities" you include; what is needed is something that is at least as practical and convenient, but that also supports our other, non-economic values.

Next Steps
With the election behind us, the world must now accept a US government with a renewed (or in many respects, initial) mandate and recognize that there is no more "waiting for John Kerry." We should use that to our advantage, as an opportunity to refresh moribund relationships, and an obvious place to start is with the US-EU partnership, as Tony Blair suggested yesterday. I see no better way to begin such a rapprochement than for the US to re-engage the Kyoto process on climate change.

Global warming may lack the urgency of Iraq or the economic impact of trade relations, but it is something that Europe takes very seriously, at both the EU and national levels. In addition, much of the EU's current policy in this area relies on market-based approaches originally advanced by the US, and for which major American corporations are now gearing up.

The Administration's previous dismissal of Kyoto burned political capital in Brussels, Paris and Berlin that might have proved valuable later in the UN Security Council, possibly even forestalling conflict in Iraq. This is water under the bridge, but rejoining the global conversation on climate change now in a serious way would signal a welcome new direction for US foreign policy.

Nor would that necessarily require ratifying the present Kyoto Treaty, which is probably not politically feasible under any president, Republican or Democratic. Kyoto is, after all, only a starting point on a long journey, and discussions on its successor will be even more important and challenging, since they will need to bring in both the US and the large, rapidly growing economies of the developing world, in order to be meaningful.

At this point you may be wondering what I'm smoking, and I admit I'm suggesting a fairly optimistic scenario. But there is a long history of US presidents doing surprising things when they feel comfortable with their base of support, as George W. Bush now must. If he's looking for an olive branch to hold out to Europe, climate change would be a great choice.

Waiting for An Outcome
Election Day +1
Well, in spite of an impressive showing by President Bush in winning the first absolute majority in the popular vote since his father's election in 1988, it is not yet clear (as of 9:00 AM EST) who will win the Electoral College. With most of the country focused on the cliffhangers in Ohio and farther west, smaller news items are likely to get missed today. I spotted one in the Wall Street Journal that shouldn't be overlooked, because of its potential to affect oil prices.

On page 2 the Journal reports (subscription required) that Saudi Arabia has ordered enough new drilling rigs to increase their total by 70% and move towards a target of doubling the number of active rigs, to 60. This is solid evidence to support the Saudi's assertion that they intend to increase both oil production and sustainable production capacity by a meaningful amount. Whether these rigs are used to tap previously undeveloped fields or to rejuvenate the legacy supergiant fields, the result should help reverse the negative trends about which a number of outside observers have speculated.

While it might take a couple of years for the full impact of this move to begin to show in actual output, it constitutes an important earnest of intent, after a great deal of rhetoric that the market has frankly discounted. Many other things will affect oil prices and prices at the pump over the next two years, but this is at least one welcome piece of news offering some eventual relief.

Election Day and the Future of Oil Companies
In yesterday's blog, I posted a comparison of President Bush's and Senator Kerry's proposals for energy. I'm not sure how many voters will focus on energy as a pivotal issue in this election, given the prominence of Iraq, terrorism, and the economy. But I'm sure the major oil companies will be watching with great interest.

Last week's Economist looked (subscription or fee required) at the profits and reinvestment rates of the world's largest publicly traded oil firms and joined the chorus suggesting they are not reinvesting enough in finding and developing new oil reserves. The author also saw the prospect that these companies will be precluded from pursuing the best oil opportunities, which are in the Persian Gulf, and will instead accelerate their shift towards becoming "energy companies", focused largely on natural gas. So while several years ago some of these firms talked aspirationally about the larger energy picture--including my old company, Texaco--this may now become a necessity, as prodigious upstream earnings must either be plowed back into new resource opportunities or returned to shareholders.

A win by Bush today (or in the protracted, post-election day process we may be facing) may give the industry at least the hope of a shot at some of the off-limits oil reserves in the US, particularly in Alaska. A Kerry win would put paid to that notion and add additional impetus for the shift overseas and into gas. Although that would bode ill for any prospect of mitigating a precipitous decline in US oil production over the next 10 years, it would merely reinforce the position of gas as the key fuel of the future, at least the next two decades.

Energy Policies - Head to Head
Friday I indicated that I would devote today's blog to a review of John Kerry's energy proposals. On further reflection, it made more sense to do a head-to-head comparison between President Bush and Senator Kerry on key energy initiatives. The result shows a remarkable degree of overlap in some areas, and strong divergence in others.

In a nutshell, beyond both men supporting various measures to increase the use of renewable energy, ethanol and biodiesel; to expand research into hydrogen and its associated technology; and to reward consumers for buying more fuel-efficient cars. President Bush emphasizes expanded production of conventional energy (oil, gas and nuclear) in the US--including the Alaska National Wildlife Refuge, which Senator Kerry explicitly rules out--while the Senator promotes higher targets for automobile fuel efficiency (without directly saying he would reform the CAFE system or remove the SUV loophole) and a clear target for the country to get 20% of its energy from renewable sources by 2020.

I was a bit surprised, though, when I studied the energy portions of the Kerry/Edwards official website. Much of the impressive background detail that I found on the Kerry website back in February was gone. In its place is a lot of negative discussion of the President's energy policies, including this highly partisan "head-to-head comparison", along with bold claims about "energy independence", a mythical notion if there ever was one. I find the shift disturbing, because I thought the earlier material was refreshing, well thought out, and generally conveyed a more positive and practical program. The end result is closer to the superficiality I saw when I examined Senator Edwards' energy proposals during the primaries.

My own side-by-side policy comparison of the two candidates' energy proposals appears below. Despite the overlaps, I think it demonstrates a clear choice of emphasis between the two men, with the President leaning toward supply-side solutions, and the challenger to demand-side measures. If you've read my previous postings on energy security, you know I believe that serious work is needed on both sides of the balance, in order to prevent our current energy position from deteriorating further. Some other commentators have found both campaigns' proposals inadequate.

I should also point out that in the table below, an overlap does not mean identical programs or funding levels, merely an area in which both candidates have articulated something meaningful. (Also please pardon the formatting; I was unable to insert the table I created in Excel.)


Issue_______________________________Bush__Kerry
Increase oil exploration, including ANWR-------X
Alaska natural gas pipeline-------------------------X----------X
Promote LNG-----------------------------------------X
Facilitate new refinery construction---------------X
Nuclear power----------------------------------------X
Electricity reliability---------------------------------X
Energy-efficient homes------------------------------X----------X
Energy-efficient communities----------------------X
Fuel economy incentives (hybrids)----------------X----------X
Car fuel economy targets----------------------------------------X
Clean Coal technology------------------------------X-----------X
Clean Coal retrofit funding-------------------------------------X
Ethanol/biodiesel------------------------------------X-----------X
Hydrogen R&D---------------------------------------X-----------X
Renewable energy tax credits----------------------X-----------X
20% renewable energy goal-------------------------------------X

Energy Policies - George W. Bush
Some time ago, I promised another look at the candidates' energy policies, and time is running short to do this before next Tuesday. I reviewed Senator Kerry's and Senator Edwards' energy planks during the primaries (see my posting of February 27), and I'll take another run through the Kerry proposals on Monday. Meanwhile, here's a quick look at what George W. Bush's campaign website suggests would happen in a second Bush Administration.

The Bush energy agenda really boils down to three basic initiatives: removing obstacles to increasing domestic energy production, especially oil and gas; investing in infrastructure and technology; and fostering conservation and renewables. The first aspect is the most controversial, by far.

The basic premise of Bush's supply-side proposals is that there is still untapped oil and gas in hard to reach or environmentally sensitive areas, that the nation needs these resources, and that the energy industry can extract them with less environmental impact than previously possible. All three statements are true, though it's important to understand the distinction between what is possible for oil and for gas.

Without rehashing all of the facts I've covered in previous blogs, the US is far down the depletion curve in terms of its original oil endowment. We've produced something like 80 or 90% of what was there to start with (in terms of recoverable oil), and the goal of further development should be seen in terms of managing the rate of overall decline, rather than any possibility of becoming self-sufficient again. Having said that, I think it makes a big difference strategically if we are able to continue producing 5-6 million barrels a day for the next 20 years, or will instead see this fall to 3-4 million without the Arctic National Wildlife Refuge and other currently off-limits resources.

Gas is another story. The big drive for LNG imports, which the President supports, is necessitated by the stagnation of domestic gas supplies, due at least in part to access restrictions in sensitive areas. Promoting more use of gas is good for the environment and for US jobs, but the gas has to come from somewhere. Unless we want to see the steady advance of gas--with all its environmental benefits--stall and give way to dirtier fuels, we will need all of what Bush suggests: more domestic gas, a gas pipeline from Alaska, and LNG imports (which means finding a better way to balance local concerns with national and regional energy needs in deciding where to site LNG terminals.)

In terms of infrastructure, the national power grid, which is really a collection of regional grids, needs new both infrastructure and new ideas. A new electricity policy is overdue, though the specifics matter, and I haven't examined the details of what the Administration is proposing.

Environmental groups roundly criticized George W. Bush for inadequate measures on conservation and alternative energy, but his support for continued tax benefits for buying hybrid cars, plus the proposed extension of the wind power tax credit, would put real dollars in places where they will have a direct impact on advancing alternatives. My biggest quibble concerns his support for ethanol and biodiesel, most of which has neutral or negative consequences for energy security and provides little more than farm supports in a different guise. This money could be much more effective supporting other forms of renewable energy.

Finally, though Bush's hydrogen proposals have been seen as a distraction from saving more energy in the near term, it is vitally important to fund basic research and development on this now, if we expect to see any kind of progress towards a hydrogen economy within the next generation. Hydrogen is something that is most certainly not just "off the shelf". Still, there's little discussion--at least on the campaign website--of where all this "pollution-free" hydrogen will come from. As you all know by now, hydrogen is an energy carrier, like electricity, and not an energy source, like oil.

All in all, this list is sort of a "status quo on steroids". I'd like to see more emphasis on demand-management, particularly on closing the SUV loophole and broadening incentives not just for hybrid cars, but for efficient vehicles of any technology. On the supply side, I wish I saw an alternative to what Bush is proposing that wouldn't result in the US being even more reliant on foreign oil suppliers and on high-carbon fuels like coal in the future. I don't. The reality is we'll need more domestic energy and more imported energy, even as we become more efficient.

What disappoints me most is that an administration with such a solid energy background and access to the best talent in the energy industry couldn't have come up with a really A+ energy program, rather than a laundry list. We need a balance of vision, in the form of a grand strategy for reducing the country's reliance on unstable suppliers, and practicality in laying out attainable short-, medium-, and long-term steps to get us there. And the most potentially serious shortcoming is the administration's failure to connect energy to climate change, which could prove to be as large a global challenge as the War on Terror.

Quite A Contrast
Most of the stories one hears about the oil industry in Africa tend to focus on corruption and the "resource curse", strikes and threats of violence against foreign companies, or environmental damage. By contrast, this story from the Financial Times concerning "black empowerment" in South Africa is almost heartwarming.

Since the end of the Apartheid era, the South African government has worked to involve black entrepreneurs in the downstream oil products business, often at the individual service station level, but as the article describes, sometimes at much larger scale, in the billions of Rand (@ ZAR 6.15 to the dollar). The result is a substantial economic stake in the the country's fuels business by the previously disenfranchised majority population, as well as employment opportunities and transfers of business practices and relationships.

Some might see this as a soft form of asset appropriation or nationalization, but I think it bodes well for the future of the country, especially when compared with the graft that is routine in places like Nigeria. It is also a much better outcome than companies like Mobil, which formerly owned the Engen assets that are going into the joint venture with Sasol referenced in the article, might have expected in a post-Apartheid South Africa. While the country still has a ways to go in deregulating the oil industry, its energy industry is probably on the best path of any sub-Saharan African nation.

Plowing It Back
With the international oil majors in the midst of releasing earnings that should set new records, based on sustained high oil prices, those who follow the industry are increasingly asking how much of this cash windfall will be reinvested to find and develop new oilfields. Share buybacks and healthy dividends are fine and good if the only goal is elevating stock prices, but the current market tightness poses a challenge that the industry must either meet or else run the risk of damaging the market's future potential and stimulating the rise of alternatives.

Another recent Financial Times editorial, though, points out that OPEC has been even more remiss in reinvestment than the majors have, for reasons that make perfect sense to the producing countries, if not to the global economy. Much of this comes down to metrics.

The indicators by which you evaluate your success have a lot to do with shaping your future direction, and for the last decade most of the private oil sector has focused on reducing expense , lowering finding and development costs, and improving upstream margins. Those are excellent metrics from a shareholder perspective, since they reward companies for developing only the most profitable projects, but not for a global economy that needs expanding reserves and production to meet future demand.

Similarly, for the OPEC countries the metric that matters most is the remittance from their national oil companies to their national treasuries, or, in some cases, to the pockets of corrupt officials. Investing in extra capacity has not been seen as a good way to maximize this metric, in a market that yields higher prices--and thus higher OPEC revenues--when supplies are tight.

Today's producers, driven by these two sets of metrics, could never have created the industry we see. Rather, we are living off the largesse of a previous era, when the industry's performance metrics supported growth in capacity and infrastructure, even if that didn't always maximize short-term profitability. The vintage of the key producing oilfields around the world (when they were discovered and first developed) reflects this, and has become the prime evidence for those suggesting a geologically driven peak in production is near.

Could it be that the relative age of these big discoveries reflects a recent marketplace of diminished rewards for the behavior that found those fields in the first place, rather than signifying a diminished universe of opportunities? Perhaps the key component of a peak in production--or at least a supply crunch--lies not in the earth's crust, but in the incentives driving corporate executives and national oil company chiefs.

Low-Profile Power
Hydrogen has been getting lots of coverage lately, but the other "H", hydroelectric power, quietly supplies about 4% of this country's total energy consumption and about 7% of our electricity. In fact, the primary publicity hydropower gets these days tends to be bad, relating to the environmental impact of dams, impediments to fish spawning, and some of the same age-related problems as much of our other infrastructure. And as with most other forms of renewable energy, it turns out that when deployed on a sufficiently large scale, it creates as many adversaries as supporters. Perhaps the answer lies in smaller scales: mini- and micro-hydropower.

The idea of mini-hydro, or "run-of-the-river" hydro, as it is sometimes called, is that the energy of the current is tapped without having to build a dam to pen in water and force it through large turbines. A mini-hydro turbine functions more like an underwater windmill. It may also be a better fit than conventional hydroelectric power in developing countries, requiring as it does less upfront investment and less infrastructure, such as construction roads that can permanently alter settlement and land-use patterns.

The whole subject of hydropower merits more discussion in the future, since it still represents the largest fraction--by far--of renewable power in this country and elsewhere. With the world looking for more power but lower greenhouse gas emissions, hydropower is an obvious part of the solution, and mini- and micro-hydropower may be the forms that will be most broadly acceptable, given today's concerns about dams.

The "Hail Mary" Pass
A week or so ago the BBC evening news (on PBS) included a report on the possibility of sudden, rapid climate change as a result of accumulating carbon dioxide and other greenhouse gases in the atmosphere. The prospect of the climate changing within a decade or two--which has apparently happened in the geological past--reminded me of a novel strategy I heard about a few years ago, one that might be able to counter such a development. It's called "ocean sequestration".

I've mentioned carbon sequestration before. Most of the work in this area currently focuses on recovering carbon dioxide from smokestacks, compressing it, and pumping it into disused oil or gas wells or other underground sinks. The technique looks very promising, but it is essentially industrial in nature, requiring substantial investment, infrastructure and expense, making it hard to deploy quickly or on a large scale.

Ocean sequestration differs in several important ways. First, it would tie up carbon using biological processes, by stimulating plankton growth and effectively capturing the carbon in the pelagic food chain and its solid wastes. As a result, it does not require large amounts of capital or infrastructure. Second, it removes CO2 directly from the atmosphere, rather than from a smokestack, and appears to be easily scalable, making it possible to tackle the much larger sequestration goals that sudden climate change would require.

It's important to recognize that all of the world's other efforts to deal with climate change, such as they Kyoto Treaty, focus on slowing the rate of increase in greenhouse gas concentrations in the atmosphere, not on reducing them in absolute terms. However, if we were in a runaway greenhouse effect, we would need a technique that could cut the absolute quantity of CO2 in the atmosphere, in order to restore equilibrium.

Although ocean sequestration is still in early stages of research, it has come in for serious criticism for its possible impact on ocean ecosystems. The jury is still out on these concerns, and it could turn out that they are negative enough to prevent ocean sequestration from becoming a standard approach for managing greenhouse gas emissions. But if faced with a choice between a rapidly changing climate--with its unpredictable effects not only on ecosystems but on human survivability--I'd like to think that we had at least one "Hail Mary" pass like this waiting in our playbook, just in case.

Overwhelmed by Barrels
I was late getting to yesterday's Wall Street Journal, or this item would have been Thursday's blog topic. The editorial page featured this item (subscription required) by Professor Steve Hanke of Johns Hopkins University concerning the impact on oil markets of the Administration's decision to continue filling the Strategic Petroleum Reserve (SPR). He asserts that this policy has added $10.00 per barrel to the price of oil. After following this topic for months, I must say that this is easily the most blatantly exaggerated assessment I've seen of the impact of the SPR fill, hinging on a fundamental misunderstanding of how the oil markets work.

You may recall that in previous blogs I had initially defended the SPR addition policy (see posting of February 17), which takes about 130,000 barrels per day out of a 15 million barrel per day physical market in the US. More recently, I concluded that suspending additions would be a good idea (see posting of May 19), but for very different reasons than Dr. Hanke claims.

The problems with his analysis start with the role that inventories play in the oil markets. While changes in inventory certainly influence prices, this does not happen in the way Dr. Hanke suggests, in terms of "the economics of storage", but rather by what those changes imply about trends in the supply and demand for oil. The notion that SPR additions "crowd out" commercial stocks in any physical sense is absurd. A more defensible conclusion would be that a larger SPR reduces the incentive for holding commercial stocks, but this only works over the long run, not on a week-to-week basis.

Dr. Hanke goes on to suggest that crude oil prices for current delivery, or "spot" prices, should normally be lower than prices for future delivery, or "futures". In fact, this state of the market, called "contango", occurs sporadically and normally only as the result of a current oversupply of physical oil.

In fact, Dr. Hanke's justification for his claim of a $10.00 per barrel SPR premium seems to rest entirely on the evidence of the market's response to the first President Bush's announcement of an SPR release coinciding with the onset of the Gulf War. As someone who was trading oil products in London that day, I can tell you that the conversation in the market had little to do with changes in inventory and everything to do with the prospect that a volume of oil greater than that produced by Kuwait would turn up in the market if the SPR were tapped, and that the risks of a wider regional war had diminished. (I freely admit that the price drop caught me and many other traders by surprise.)

Ultimately, it appears that Professor Hanke has made the classic mistake of an academic analyzing market data and arriving at a logical but erroneous conclusion, entirely divorced from market realities and, in this case, possibly clouded by politics. The only subject on which we seem to agree is the desirability of modernizing the entire concept of strategic oil storage.

Fear of the Bear
Yesterday the Washington Post published an editorial highlighting the growing influence of Russia on energy markets. It has surpassed Saudi Arabia as the world's largest oil producer and is well-positioned by geology and geography to be the world's number one natural gas supplier. At a time when Russia's commitment to democracy and markets is less clear than a few years ago, it's reasonable for this realization to cause some concern.

I'm not sure that I can dispel these worries entirely, but I'd like to point out a few mitigating facts. First, Russian oil represents this generation's chance--analogous to the North Sea and North Slope 25 years ago--to forestall the total dominance of the oil markets by the Middle East. It may be the last such opportunity, as geology increasingly becomes destiny in terms of the disproportionate share of the world's oil endowment held by the countries around the Persian Gulf. Kremlin politics could still truncate this opportunity, by scaring off the international investors that will be needed for it to reach its full potential in oil.

Russia's share of global natural gas reserves is even more impressive than in oil, legitimately earning it the title of the Saudi Arabia of gas. But it is important to understand that global natural gas development is at a very different point than for oil. Gas exploitation is a full generation behind oil exploitation, and the kind of end-game in which Russia's dominant gas reserve position becomes the trump card is many decades away. The challenge for today's gas developers is not a scarcity of world-scale gas reservoirs; rather it is connecting those reserves--in places like Australia, Indonesia, Alaska and Russia--to long-term customer commitments and the capital required to build LNG plants and ships or multi-thousand mile pipelines. This game is in its early days.

Ultimately I think it's wrong, or at least overly pessimistic, to view Russia as a potential OPEC-like monopolist in gas. Though its economy has a lot of catching up to do, it is hardly a mono-resource developing country. Its oil and gas reserves create a terrific opportunity to align and integrate with the rest of the developed world, including the rapidly developing economies of Asia, rather than holding them hostage to scarcity later. A large part of our diplomacy with Mr. Putin should focus on helping him to see the benefits of such a relationship.

What Might Have Been
Several weeks ago, the New York Times printed an article comparing US and French energy policies and energy efficiency over the last several decades. The article was subsequently picked up by the International Herald Tribune, from which this reprint was taken. While interesting in its own right, I think it also provides a fascinating glimpse of a world that might have been, had energy efficiency remained a core value of this country after the resolution of the oil crises of the 1970s.

In fact, such a world is not entirely fanciful, since many commentators have recently suggested that the US should have imposed high gasoline taxes in the aftermath of 9/11, in order to wean the country off imported oil and to reduce the ultimate funding source for many terrorist groups.

Using France as a proxy for a more energy-efficient USA, we can draw some interesting conclusions. For example, from 1971 to 2001, oil's share of total energy in France dropped from roughly 2/3 to just over 1/3, with nuclear power taking up most of the slack. Over the same period, oil reliance in the US dropped from about 48% to 40%. Had the US followed the French pattern, even if the energy alternatives chosen were different, we would today use about 5 million barrels per day less oil than we do, and our oil imports about would be roughly half of the current 10 million barrels per day.

The intervening 30 years would have looked very different. Among other things, the SUV trend would probably never have happened, with all that implies for US carmakers, and we would be driving smaller, less powerful cars. We might even be living in smaller homes, watching smaller TVs, and so on. On a larger scale, the geopolitical implications might have been dramatic, too, including a different relationship with the Middle East.

There's a catch, of course. Over the last 30 years, a side-by-side comparison of the French and US economies (using OECD data) shows that ours grew by an additional 20% of GDP, creating more jobs and more wealth in the process. While there are many reasons for this, setting an artifically high value on energy versus its real-world cost in this period no doubt contributed to the difference in performance.

No one doubts that the US could become much more energy efficient if we chose--or had to--but we should keep in mind that we would also be choosing a different economy, with different outcomes, some better and some worse.

Tiny Turbines
Several years ago, microturbines were the hot new trend in small-scale, local power generation, either for backup power or off-grid applications. They were stealing a march on fuel cells, by being readily available now and by requiring only ordinary and widely-available fuels. These devices are essentially jet engines that have been shrunk to fit in a box the size of a small refrigerator. Now there is news of a new generation of even smaller turbines, built from a silicon chip, and aimed at powering small electronic devices.

It's too early to properly assess this technology and its potential for real-world practicality and reliability, but the implications are fascinating to consider. As with the small fuel cells that will shortly be available to run your cellphone, the goal of these micro-micro turbines (nanoturbines?) is to bypass the power density limitations of batteries by tapping the excellent energy storage of hydrocarbon fuels. Either approach could offer dramatically improved usefulness from handheld devices and laptop computers.

As promising as that seems, I am even more intrigued by the suggestion that clusters of these tiny turbines could potentially power entire homes. It wouldn't be good news for companies like Capstone or Plug Power , if building many little turbines out of silicon turned out to be cheaper than building a single home-sized microturbine or fuel cell.

I don't know if this development will pan out, but I see it as further evidence that we are on the leading edge of a wave of change in energy technology, the likes of which we haven't seen since steam, batteries and internal combustion were all competing to be the dominant power source for automobiles at the beginning of the 20th century. In the next few years we will find out whether it is cheaper to continue to build power plants as industrial-scale construction projects, or to create the same amount of electric generating capacity by mass producing small energy devices. I'd bet on the latter, particularly If the techniques involved are similar to those that have brought down the cost of computing power.

The Hockey Stick
One of the most compelling pieces of evidence for human influence in climate change is a famous chart showing variations in temperature over the last 1000 years. In this graph, the variation in temperatures over the last century clearly breaks out of the long-term pattern, resulting in the so-called "hockey stick" shape. That breakout coincides with the dramatic increases in fossil fuel use in the Industrial Era. So A+B = clear evidence of anthropogenic climate change. But it now appears that the analytical technique used to create the 1000 year temperature chart in question may have been flawed. If so, while not exactly destroying the notion of global warming, it would force us to rethink the distinction between natural and man-made warming.

If you've been following my blog for a while, you know I take climate change very seriously. My nose is attuned to the smell of anti-climate change propaganda, but this article from MIT's Technology Review doesn't come across that way. Rather, this is how science--and the scientific method--works. Someone analyzes a bunch of data, reaches a conclusion, and then others try to replicate that result and discover any flaws in the methodology. That process seems to be well represented here, with peer-reviewed articles, responses by the original researcher, and so on. It could take years to play out.

We know that there have been warming and cooling trends in the past, both from historical records and from the observable evidence of the geological past. The key question is where the current warming trend (which is real) fits in the context of previous ones. The hockey stick graph suggests it is unprecedented, but if that turns out to be invalid, then we must at least reconsider the relationship between human drivers of warming and natural ones. That could have profound implications for climate change policy, perhaps even pushing us toward an adaptation strategy and away from emissions management. Stay tuned.

Where Do Batteries Fit?
I ran across an article (subscription may be required) a while ago that has had me thinking about the future role of batteries in adapting renewable energy sources for power generation. Last Tuesday I talked about overcoming the intermittent nature of solar power by putting the solar collectors in orbit where the sun shines all the time. Another way, of course, is to store the energy generated when the sun shines or the wind blows, for later use.

There are already applications for which this is attractive, in places not currently connected to the electric power grid. Elsewhere, developers must contend with the cost and efficiency of storing electricity. A wind generator that nearly competes with electricity generated from a natural gas-fired turbine doesn't look nearly as cost-effective if you must pay for batteries to store some of its output before delivery.

The efficiency problem is less obvious. Storing electricity in a battery and retrieving it later is not a free ride. Some of the energy will be lost as heat, at too low a level to recover cost-effectively. That's just the Second Law of Thermodynamics in action, but it has implications for sizing a wind farm or solar collector array, if the power is going to be stored rather than delivered right away. And as battery arrays get bigger, managing the heat byproduct becomes a more important issue.

It's also important to think about how this stored power will be used. If the goal is to enable solar collectors to deliver power day and night, batteries may be a good choice, but so might reversible fuel cells. And if eliminating short-term fluctuations in wind is the issue, or covering brief periods of peak demand, then other technologies better suited to discharging large amounts of power in a short time, such as ultracapacitors, may be more appropriate.

In any case, what we are beginning to see is the shattering of the old paradigm that electricity must be generated as needed, or used as generated. Perhaps, like rainfall, it can be stored cost-effectively for delayed distribution.

Just Shy of the Complete Picture
Gregg Easterbrook writes insightfully about energy. His latest piece at New Republic looks at the presidential candidates' energy policies. It is also an excellent overview of the current energy security debate in this country. While I recommend this article highly, I can't resist picking a nit or two, and mentioning something that goes well beyond nits. Since it's such a long article, I'll keep my comments brief.

First, either Mr. Easterbrook doesn't quite grasp how the oil markets work, or he has oversimplified for effect. Oil is sourced as it is because of a variety of factors, mainly centered on quality, price, and availability. Rather than saying, "I think I should have oil from Saudi Arabia", a refiner would say, "I need oil with the following characteristics, delivered in this timeframe, and costing no more than this discount off of West Texas Intermediate (WTI)." That makes backing out Persian Gulf oil a good more complicated than simply cutting our overall oil demand by a corresponding amount, because it involves refinery configurations that are expensive to change. But this is a nit compared to my other concern.

If I've said it once, I've said it here a hundred times: improving energy security can't be accomplished solely by reducing demand. Without a major initiative to open up off-limits US oil reserves (e.g. ANWR, or offshore California), by the time Mr. Easterbrook's 1/3 improvement in miles per gallon works its way through the system, US domestic oil production will have declined by an amount similar to the efficiency savings, and we will be importing just as much or more, including more from the Persian Gulf. Of course, if we don't improve vehicle efficiency, our future imports will be even higher.

And one last nit: while I'm pleased that he mentioned the real-world technology of integrated gasification and combined cycle combustion for coal, I think he is selling short its competitiveness in a market where natural gas is $6 or more per million BTUs, as far as the eye can see. (See my blog of March 18.)

So read the article, but consider that we might actually need the energy policies that both candidates are proposing, not just one or the other's.

Hydrogen Pessimism
An article from the British magazine Nature reports on a study that may dampen the enthusiasm of some advocates of a hydrogen economy. The authors' research looked at the difficulties in generating hydrogen without producing large quantities of the very greenhouse gases that the use of hydrogen is intended to eliminate. Their calculations suggest mind-boggling numbers of windmills or new nuclear plants (a million or a thousand, respectively) would be needed to produce enough greenhouse-free hydrogen to run the US transportation system. There is sound logic here, but also a glaring blind spot.

Few of us really think about the scale of global fossil fuel use, and how it relates to sunlight. The world uses 3.4 billion gallons of oil every day, to put in more familiar units of measurement. Each gallon started as sunlight and plants, compressed and processed by heat and pressure underground. In the space of a couple of centuries, we will consume an energy larder that took millions of years to create. It stands to reason, based on this kind of concentration, that replacing fossil fuels would require harvesting today's sunlight (either directly with solar collectors, or indirectly by harnessing wind that is driven by sunlight) on a truly awesome scale.

So far, then, the authors' dose of reality holds up pretty well. But I believe they have fallen into the same trap as those who focus only on the pristine tailpipe emissions of a hydrogen vehicle, without considering the source of hydrogen. The only way to compare energy systems is to examine the effect on the entire system using a measure such as the "well-to-wheels" efficiency. This is where the hydrogen opportunity--even hydrogen created from fossil fuels--shines.

Because of the much greater thermodynamic efficiency of a fuel cell compared to an internal combustion engine (or any other heat engine), a hydrogen fuel cell based transportation fleet has the potential to cut greenhouse gas emissions by roughly half. Add to this the compounding effects of other efficiency improvements (carpooling incentives, better mass transit), and the potential reduction in greenhouse gas emissions is even more impressive.

So while we may not get to zero emissions this century, reducing current emissions by half or more would be a tremendous improvement. (The Kyoto Treaty targets a reduction of about 8% vs. a 1990 baseline.) Just to be clear, though, I'm not saying this will be cheap, easy, or quick. But putting up impossible targets and impractical pathways and saying that proves that hydrogen isn't worth the effort is obtuse and misleading.

False Dichotomy
Having lived and worked in London for a couple of years, I probably pay more attention to news stories from the UK than the average person. As this story from the New York Times indicates, there is an interesting debate underway in Britain concerning renewable power and nuclear power. It highlights two major energy issues, one European, the other more specific to the UK.

The first deals with the challenge of a commitment, backed by a public sense of urgency, to address climate change by reducing greenhouse gas emissions. But this bumps up against another commitment, to reduce or eliminate nuclear power in key parts of Europe. At the moment all the large-scale alternatives, such as coal or natural gas, would increase greenhouse gas emissions. The EU and its member countries need to determine which priority is higher: climate change or de-nuclearization.

The other issue deals with the way that alternatives such as wind are being pitted against nuclear power in an either-or sort of public debate. I believe this is a false and misleading choice, because the two energy sources are so different. Wind, regardless of scale is an intermittent energy source that does best supplementing a power grid that has a lot of other incremental capacity that can be ramped up or down, as wind power fluctuates. Nuclear, by contrast, is an ideal base-load source that can run all the time, and that needs to in order to defray its large investment costs.

Nuclear plants--at least the current technology--come in 1000 Megawatt increments with large price tags and require up to a decade to build, while wind turbines are easily scalable in increments of up to 5 Megawatts and can be manufactured and installed in a matter of months. Each has environmental consequences, though neither emits greenhouse gases.

Considering all these differences, it seems clear that wind and nuclear are actually complementary technologies, rather than competitive. If the UK is serious about meeting its climate change commitments in the future, it will almost certainly need to make wide use of both of these options.

Happy Columbus Day
Hindsight or Not?
Every now and again I feel compelled to comment on a wider topic. Assessing the quality of past decisions has become a major political issue this year, and it has relevance in many other applications, including energy projects. The release of the final report of the weapons inspections in Iraq and the political reaction on both sides makes this discussion especially timely.

I don't recall the source of the following taxonomy of decisions and outcomes (I leave it to you to Google for it.) It goes something like this:
1. A decision that was made well and turned out well.
2. A decision that was made poorly and turned out poorly.
3. A decision that was made poorly but turned out well.
4. A decision that was made well but turned out poorly.

It's clear that type 1 is a good decision and type 2 a bad one. The outcome of type 3 is the result of other factors, often summed up as luck. But it's #4 that gives us the greatest difficulty. We're often tempted to call it a bad decision, instead of a bad outcome. But that's not really right, unless we believe that all factors can be fully anticipated, and that decision science should have eliminated all bad decisions by now.

And so we come to the reaction to Mr. Duelfer's conclusion that Iraq had no weapons of mass destruction at the time the Administration decided to go to war. How should the finding of an 18-month inspection process that had unfettered access in a prostrate country bear on the quality of the decision to go to war in 2003? In my view, and given the taxonomy above, not at all. (It's highly relevant, though, to how we assess US intelligence at the time, but that's another issue.)

This argument doesn't get the Administration off the hook for either the quality of their decision or the outcome, but it frames our assessment of the decision in terms of the information in the their possession at the time, along with the context in which it was made. At this point, it is possible to look at the evidence and legitimately differ on how well that decision itself was made.

With regard to the outcome, while it's tempting to compare it to the road not taken, an exact alternate outcome is inherently unknowable and can only be guessed at through a sort of reverse scenario process. For instance, is the world in which sanctions remained tightly in place--in spite of growing international criticisms about the cost to Iraqi civilians--and in which Saddam was contained in perpetuity, more or less credible than the world in which the consensus in the Security Council collapsed following an ambiguous completion of the UN inspections headed by Dr. Blix, leading to the end of sanctions and containtment?

So where does this leave us? Voters who see the decision to invade Iraq as a Type 2 (bad decision/bad outcome) would probably vote for Senator Kerry. Those who see it as, at worst, a Type 4 (good decision/bad outcome), are likely inclined to give President Bush another four years. Unfortunately, the whole debate distracts us from questions that I find more urgent and important today: which candidate has the better and more credible plan for turning the current situation in Iraq into something good, and which candidate is better equipped to make robust decisions with the imperfect information he is likely to have in future aspects of the war on terrorism? I don't think we've heard enough about either of these areas, from either candidate.

Oil Prices and the Election
A friend forwarded a copy of this week's other interesting energy editorial, Robert Samuelson's Washington Post piece on oil prices and the election. (Free site registration required.) In it, Mr. Samuelson weighs in on the depletion debate--at least by reference to the recent PFC Energy study--and finds both candidates' energy policies lacking, characterizing them as fantasies.

Before I quibble with a couple of his suggestions, I want to applaud him for being one of the very few commentators to recognize the obvious: that we need a energy policy that deals effectively with both supply and demand. Unfortunately, the Administration's policy has been largely supply-driven, while Senator Kerry's looks chiefly at demand management (via efficiency, rather than taxes,) as did the Clinton Administration's policies.

Now to my quibbles: Mr. Samuelson apparently sees the Strategic Petroleum Reserve as a way to help manage the market. Fill it when prices are low; stop when they go up. In my view, an SPR is worth filling most of the time, regardless of price (with rare exceptions such as now, with surplus global production capacity exhausted.) Better yet, it should be privatized by giving companies incentives to hold the inventory for us, and to manage the accompanying price risks using the standard tools of risk management.

And while proposing a high gas tax to encourage better fuel economy (see my blog yesterday for more on gas taxes), he misses the opportunity to suggest rationalizing the Corporate Average Fuel Economy (CAFE) standards by eliminating the SUV loophole, or eliminating CAFEs entirely as relics of a bygone era of government control. In practice, a more modest combination of these moves might achieve similar results, by giving carmakers the rights signals to produce lighter, more efficient vehicles and giving consumers the right signals to buy them. This would eliminate the carmakers' standard lament that when they build economical cars, no one wants them.

Even with these cavils, though, the article is an excellent commentary that I sincerely hope both campaigns are reading and digesting. Might there be a debate question or two in it?

The Cost of Taxes
Let me start today by saying that Tom Friedman is my hero. In his columns in the New York Times and his appearances on PBS's News Hour and elsewhere, he has never flinched from the articulate description of the world's ills, as he sees them, no matter whose sacred cows are involved. Today is one of those rare occasions when I may agree in principle with his commentary, but must disagree strongly with its recommendations.

Mr. Friedman rightly points out that the resource curse of abundant oil has helped to create the conditions that have fostered a violently anti-Western, nihilistic strain of Islamic radicalism in the Arab world, along with the complacent or complicit attitude of many Arab governments towards it. But blaming our appetite for oil and suggesting that curbing it would stimulate genuine economic and social development puts too much of the responsibility for a century of stagnation on us and too little on them.

It's also important to understand the full implications of a sudden, large increase in gasoline taxes in this country. Europe has had taxes of the kind Mr. Friedman suggests for decades, and they have indeed resulted in a more efficient car fleet and better public transport. However, none of this was achieved overnight, but rather as a result of deliberate and remarkably persistent public policy. It is facile to suggest we should have done the same thing here; we didn't and must start from where we are.

Without a decade in which to transform the car fleet into a more efficient one, Americans would have only two choices: drive less or consume less of other products to pay for gasoline. Either choice exacts a price on the economy. In the former case, whatever economic benefit was attached to the incremental driving, whether it be shopping, an evening out, or some kind of work-related activity, is lost. In the latter, the overall demand for goods and services falls. We've seen some of this already, since gasoline prices have risen by more than $0.50/gallon over the last year.

Now, such a tax phased in over many years would probably be good policy and allow time for the necessary adjustments, but it would fall short of achieving what Mr. Friedman and others seek. Considering the cost to the economy of a suddenly higher gas tax, we need to ask if we are willing to change our lifestyles and make real sacrifices to achieve the impact such a move would have on the war on terrorism. Perhaps that's the real question Tom Friedman is asking us today.

The New Environmental World Order
Russia's announcement last week that, pending a vote in the Duma, it would ratify the Kyoto Treaty on climate change clears the final hurdle to putting the treaty into effect. I don't think that the reports of this event have really captured its full significance. Once the Russian ratification is official, the Kyoto Treaty will become international law and theoretically binding on its signatories. This may ultimately extend to anyone wanting to do business with the signatory countries, as well. Without exaggeration, we will be living in a new world, even if the US chooses to continue to ignore it.

The news of Russia's agreement is already affecting the markets for carbon emissions credits. One of the key uncertainties holding down the value of such credits has been removed, or at least drastically decreased. Other large uncertainties remain, however.

Unfortunately, the treaty that will go into effect is not as good as it should have been, largely because the Bush Administration chose to disengage from the process nearly four years ago. Ironically, some of the best features in the Treaty, such as the Clean Development Mechanism allowing a project that reduces emissions in one country to count toward the emissions quota of another country investing in the project, were principally the result of past US negotations and leverage. But as noted by critics on both sides of the argument, the existing Kyoto Treaty is flawed by exclusion of the countries whose emissions will grow the most in the next decade, and barely makes a dent in the scale of the actual problem.

If John Kerry is elected in November, look for an early effort to reengage in the Kyoto process. It's less clear how a returning Bush Administration would address the new reality of a Kyoto Treaty that our major trading partners will regard as law.