More Geo-Greens
On Monday I took issue with Tom Friedman's suggestion of a "geo-green" strategy for pressuring Middle East petro-states by reducing oil demand and thus driving down oil prices. Now I find that far from being alone in his views, there's a whole geo-green clique out there, including some neo-conservative heavyweights and keen environmentalists. While I stand by my previous posting on how hard it would be to move the oil demand needle appreciably, it's worth looking at the upside potential.

Start with some history. The last time there was a big push on oil conservation, the result was pretty impressive. After World War II oil demand grew steadily--doubling during the 1960s--until the first oil shock in 1973-74 caused it to stall. It resumed its growth path in the mid-70s, but from 1979, following the Iranian Revolution, to 1989 global oil demand was essentially flat. Along the way, the energy intensity of the US economy dropped sharply, even though the economy continued to grow. Even today, we use fewer BTUs, and certainly fewer barrels of oil, for each million dollars of GDP.

Could a similar drive to efficiency motivated by politics and patriotism, rather than just high energy prices or taxes, slow down or reverse recent trends in energy demand? It's entirely possible, but if we want this to have the maximum benefit, we are looking at the wrong target audience. Although getting Americans to drive more efficient cars and use energy more sparingly would have an impact, we have not been responsible for most of the recent surge in demand. The challenge and opportunity comes from the rapidly growing economies of Asia, and from China, in particular.

Between 2000 and 2004, China's oil demand grew by 2 million barrels per day (MBD), compared to an increase of about 1.3 MBD for the whole industrialized world. As its richest provinces reach the "take-off point" at which the demand for personal mobility soars, this trend will only accelerate. The time for cooperation on conservation is ripe, since China appears at least as concerned about its energy security as we are about ours (see my posting of 1/21/05.)

Getting China and India to develop along a more efficient path is the real prize, and it ought to be a money-spinner, since putting in the best and most efficient technology at the start should be much cheaper than retrofitting them here. In the process, this would do a lot to reduce the rapid growth of greenhouse gas emissions from developing economies, and it may turn out that the Clean Development Mechanism of the Kyoto Treaty is a handy way to transfer these technologies at a profit.

In essence, being geo-green could be quite beneficial and sensible, as long as our concept of "geo" encompasses the entire globalizing world.

The Other "Bad Boy"
President Hugo Chavez seems determined to chart a course for Venezuela that brings it increasingly into opposition to the US and our friends in Latin America. He is even finding common cause with Iran, to which I devoted the last couple of postings. Several US oil companies with interests in Venezuela are experiencing contractual difficulties, leading to speculation that Mr. Chavez intends to strengthen energy ties with China and other markets at the expense of the country's historically close ties to the US market. How realistic is this?

Although President Chavez's Bolivarian Revolutionary politics may motivate him to move in this direction, energy economics will make this a costly and difficult proposition. Venezuelan oil is typically much heavier and more viscous than oil from the Middle East, West Africa, or other major exporting regions. This makes it more difficult to extract, requiring large, capital-intensive facilities similar to those involved in extracting Canadian oilsands. Following the crippling 2002-3 strike by employees of the state oil company, PDVSA, a growing share of Venezuela's production has come from these internationally-financed joint venture facilities.

The poor quality of Venezuela's oil also makes it more expensive and less attractive to refine, yielding less gasoline and high-quality diesel per barrel than that of its competitors, without significant prior investment in upgrading facilities. The last time I looked, few refineries in China were set up to run Venezuelan crude oil profitably.

The largest concentration of refineries configured to run Venezuelan crude is in the US Gulf Coast. In fact, a large portion of the Venezuelan crude sent to this country goes to supply PDVSA's subsidiary, Citgo, which has one of the largest service station chains in the US. Diverting exports away from the US would cost Venezuela several times: in lower netbacks on crude sales due to higher freight costs to more distant markets, in larger discounts versus competing oil grades, and in reduced profitability at its US subsidiary, which would have to line up other supplies.

Rather than expecting a move by Mr. Chavez to nationalize US investments or cut off crude supplies to us, I continue to believe that the largest element of political risk involved for US investors in Venezuela's oil industry lies in the prospect that our own government would take action to precipitate a crisis with Venezuela, in response to Mr. Chavez's growing activism in Latin America. Only companies with broad and deep portfolios should be taking on these risks today.

Is "Geo-Green" The Answer?
Despite my usual soft spot for Tom Friedman and his normally insightful and bold commentary on geopolitics, his editorial in Sunday's New York Times oversimplified a bit too far with its "Geo-Green" energy strategy. Although he neatly describes the paucity of options for dissuading Iran's leaders from pursuing nuclear weapons (see Friday's posting) his prescription for reforming Iran and the rest of the Middle East by driving the price of oil back down to $18 per barrel rests on a shaky foundation.

Based on past oil market behavior, getting oil prices back to this level any time soon would probably require a combination of reduced global demand or increased global production on the order of 4 million barrels per day (MBD). Half of this volume represents a return to OPEC's recent "normal" quota of 25 MBD from its current, essentially flat-out quota of 27 MBD, while the other half mirrors the magnitude of demand drop that sent oil markets into free fall in the 1997 Asian Economic Crisis.

Although some new production will come on stream this year, most of the difference would have to come from the demand side, where Mr. Friedman's "geo-green" options of conservation and substitution via renewables and nuclear power reside. Since most petroleum is used for mobility, while most electricity is used for stationary purposes, the impact of renewables and nuclear on oil demand is fairly indirect and long-term. This leaves us with conservation, which is normally spurred by high prices--at least initially--rather than the low prices Mr. Friedman hopes to achieve. This is something of a paradox, unless he is willing to consider hefty new taxes on petroleum products to raise consumer prices without changing producer prices.

Even if I've overstated what it would take to drive oil prices down, there are other factors to consider. Although a low oil price world would benefit the US economy, along with some of the poorest nations on the planet, it would reduce the incentives to find more oil and to develop the technologies that must ultimately supplant oil. Along these lines, I suspect the likeliest precursor to another period of low oil prices will be the market itself. Petroleum is still a volatile and somewhat cyclical commodity, and the market has a history of confounding expectations. Unfortunately for Mr. Friedman's thesis, the last period of $18 oil prices in the late 1990s didn't exactly unleash a tide of liberalization in the Middle East.

Persian Puzzle
With hindsight, Iran's nuclear program appears to be more sophisticated and dangerous than anything going on in Iraq after UNSCOM dismantled Saddam's last attempt to get the Bomb in the mid-1990s. The country we invaded turned out to be a Potemkin village full of walking booby traps, and our presence there has eroded the leverage available to us in dealing with the threat posed by Iran. The approach suggested in yesterday's New York Times editorial is probably as good as any still available to us. It advocates relying on collaborative diplomacy with sizeable carrots and sticks. Unfortunately, this ignores the energy dimension, which remains Iran's trump.

Three years ago the global energy supply could and did lose production equal to Iran's without creating a severe price spike. When Venezuela's oil workers went out on strike, eliminating 2.3 million barrels per day of oil exports, other producers quickly filled the gap. Prices went up for a few months, and then came back down. Since then, though, the combination of rapid demand growth, persistent production problems in several countries, and a conservative approach to new oil investments has eliminated that cushion. Iran's leaders know this.

Although it is just possible that the US and EU could put aside our present differences in order to present a common front to Iran, it is hard to imagine that Iran would sit still for the imposition of joint sanctions without playing the oil card. The existence of this option reduces the likelihood that Iran would take the threat of sanctions seriously enough to abandon its nuclear efforts. In effect, Iran already holds something nearly as good as a nuclear deterrent: the ability to throw a world oil market that is balanced on a knife edge--at twice its historical average price--into chaos.

Unfortunately, the diplomatic stalemate described above raises the odds of an eventual military confrontation. The consequences of a crisis over Iran's nuclear program are unpredictable and potentially disastrous, but in spite of that, the crisis seems all but inevitable.

Climate Fiction?
Two weeks ago I posted some comments concerning Michael Crichton's latest novel, "State of Fear" (see posting of January 11.) One of the scientific papers cited by Dr. Crichton in support of his novel's arguments against climate change and the global response to it was by Dr. Gregory Benford, a physicist who is also a noted author of thrillers and award-winning science fiction. Now he and one of his collaborators have weighed in with an editorial in the San Diego Union, rebutting Dr. Crichton's interpretation of their peer-reviewed paper in Science, the journal of the American Association for the Advancement of Science.

The editorial by Drs. Benford and Hoffert is worth reading for its contribution to the controversy over the Crichton novel, but the source article struck me as much more interesting. If you are willing to tolerate a fair number of chemical equations (or like me, actually enjoy them), you will find it a fascinating overview of the relationship between energy and climate today, and as it might be in the decades ahead.

Dr. Benford and his collaborators discuss the evidence for a man-made greenhouse effect and the magnitude of the challenge it poses. They also show just how difficult it will be to avert its consequences. Along the way, they provide an excellent survey of the long-term prospects for renewable energy, including land- and space-based solar power, for nuclear power, and for truly clean fossil fuel use. Nor do they think small, covering every option I've ever heard of that could meet our energy needs, while stabilizing global warming. This includes strategies as exotic as using nuclear fusion to breed fuel for lots of new fission reactors.

Their conclusions are simultaneously sobering and optimistic, focusing on the need for major research and development efforts in a number of areas to make sure that we can actually produce greenhouse-free energy on a massive scale in the future, rather than merely having many interesting but unproven ideas in the laboratory or on paper. To this I would add something that they only hint at: we will also need an awful lot of fossil fuels to get us to the point of such a transition without putting the global economy into a nosedive that would hit developing countries hardest.

Unfortunately, the latter sounds a lot like what the opponents of climate change are saying, too. The trick--and the opportunity--is to tie the first proposition to the second. We could, for example, link drilling in the Arctic National Wildlife Refuge (ANWR) with doubling the research budget for renewable energy and nuclear fusion, funded by a surtax on ANWR oil. This kind of thing would have every vested interest on both sides howling, but it might just offer a workable pathway between irresponsible myopia toward the future and an impractical disregard for the needs of the present.

Windfalls
Well, it was bound to happen. I'm actually surprised it took this long, considering the sustained strength of energy prices and energy company earnings. Critics in the UK have started calling for a windfall profits tax, at least on domestic natural gas production, citing the level of oil company earnings exemplified by Lord Browne's comment in the Sunday Times that BP's profits for last quarter and last year would be "staggering."

We've been down this path before, and having started in oil trading just as the old system of price controls and oil windfall profits taxes in the US was being wound down, I saw first-hand how poorly such regulations work, and the kind of gross inefficiencies and distortions they promote. (Some other time we can get into "old oil" vs. "new oil" and how that was exploited by unscrupulous middlemen.) However, I must say with equal vigor that the industry is currently doing itself no favors in this regard by its conservative approach to capital investments.

It would be easier to quiet this chorus, which will only grow louder should prices rise again this year--or at least not moderate noticeably--if energy firms were seen to be reinvesting most of the cash flow thrown off by high prices. They need to increase their reserves and expand their production bases to keep pace with the growth in current and anticipated demand. Share buybacks and special dividends do little to dispel the notion that the industry is effectively taxing the entire economy and ought to be taxed in turn.

If capital spending doesn't soon pick up in line with market expectations of sustained high prices and demand, the oil companies are going to be in a major PR battle over where the money should go, instead. Wake up and smell the coffee, folks.

More Orphans
Last spring I wrote about the problems GM was having as the leases on its electric car, the EV-1, were running out and it was taking back the cars to scrap them (see posting of 3/29/04.) EV-1 lessees were not happy with this, preferring in many cases to keep the cars longer. Ford has encountered similar problems with its electric Ranger EV pickups, but it appears to have resolved matters more positively, now allowing lessees to purchase the vehicles.

The actual number of vehicles involved is tiny, only a few thousand, but this decision has much larger implications. All the big carmakers have advanced vehicle programs underway, involving hybrids, fuel cells, hydrogen internal combustion engines, or other technologies. Not all will pan out, but in order to avoid having that become a self-fulfilling prophesy, the auto companies must create a high level of trust that anyone who buys one of these cars will be treated fairly down the road, even if it turns out to be an "orphan."

It's also important to recognize that the bar for this is now much higher than in the past. Someone buying a 1959 Edsel would at least have been able to find mechanics who could fix it when it broke down; that might not be the case if BMW decided to stop servicing the hydrogen 745h, for example. Few consumers will buy a car they don't think will be supported, and the carmakers will only be able to recoup their enormous investments in their advanced technology vehicle programs if they turn out mass-market models at some point.

This creates a host of practical problems and could make the rollout of a totally new technology car even more expensive than it already is, by requiring a larger parts inventory than "just in time" programs would suggest, but it is all part of the price of entry and an investment in future success.

Beneficial Globalization
For the last several years globalization, shorthand for an incredibly complex and loosely-connected set of trends and actions, has taken a lot of hits for promoting environmental and damage and threats to endangered species, among other complaints. But here's a wonderful example of several key components of globalization--global finance and the application of global standards to local projects--being used to protect those same interests.

The proposed trans-Siberian pipeline project is of major importance to Russia and to energy consumers on both sides of the Pacific Rim. However, it will not be built without international financing, most likely from Japan, and that financing is much less likely to materialize if the local Russian authorities insist on locating the pipeline's terminus in the middle of a pristine tourist destination and wildlife habitat. They might not see it that way, yet, but I would put money on their having to revise their plans before the first Yen, Euro, or dollar is transferred.

What I find encouraging about this story is the apparent attitude of the environmental groups involved. The Japanese branch of Friends of the Earth--no friends of oil development in general--appear to understand that the project as a whole will likely go ahead and are focused on the terminal site decision. The executive director of Pacific Environment sums it up nicely in his quote, "The pipeline will be a test case of whether or not Russia can meet the top level environmental standards that the public expects from oil and gas projects around the world."

The potential of globalization to distribute human rights and environmental protection--as well as prosperity--much more widely makes it more of a blessing than a curse. I have a lot more sympathy for those who focus their criticism on specific facets or manifestations of globalization than for those who claim to be against it as a whole.

The Other Face of China
The energy world has been preoccupied with China's rapid growth in oil demand and the impact this has had on markets for the last year or two. This phenomenon is not unique to oil, with the prices of many commodities having shot up dramatically on the back of Chinese demand. But this week we had two reminders of another face of China, the political one often obscured behind its economic dynamism.

First, as a New York Times editorial yesterday pointed out, one of the main architects of China's recent growth died without fanfare, under house arrest. Nor did China's current leaders want Zhao Ziyang to be remembered with a state funeral, giving in on this only under pressure, because he chose the wrong side of the Tiananmen Square protests in 1989. So even as the world rushes to invest there, China is still waiting for its Gorbachev.

Another sign of China's less commercial face turned up in a Defense Department planning document describing the country's diplomatic and military efforts to shore up its energy supply lines, as part of a significant naval buildup. Now, this sort of thing is subject to multiple interpretations. One of my favorite books last year, The Pentagon's New Map, makes a strong case that China is likelier to be a great partner for the US in extending and solidifying globalization's benefits in Asia, rather than an adversary with which to start a new Cold War. Are their current actions just an expression of understandable insecurities, or do they portend a future conflict? I'd rather stay on the optimistic side of the fence, for now.

It's also worth recalling that history provides numerous examples--some quite recent--of countries that built huge fleets but failed to create a great navy, something that requires generations and a lot more than just ships and men. The very name of the "People's Liberation Army Navy" might offer a reassuring hint along these lines.

The takeway is that for all our current focus on trade and investment, we can't lose sight of the fact that China is a country, not just an economy, and a big, complicated one at that. It is likely to be at least as important in this century as Japan was in the last, but let us hope more along the lines of Japan in the second half of the Twentieth Century, rather than in the first.

Executive Options
The FT reports that BP will alter its executive compensation plan to eliminate options and focus on stock grants (presumably restricted for some vesting period, or until retirement.) Although this is seen as improving the alignment of interests between management and shareholders, the article is silent on what may be the most important reason that some firms have seen options lead to behavior very much out of synch with shareholder value.

It's easy to forget how options derive their value. Many commentators, and even some option recipients, focus on the value of the shares into which the options are converted when the target or "strike" price is exceeded. Instead, as demonstrated by Messrs. Black and Scholes, the value of options comes from the amount of time remaining before expiration and the volatility of the underlying asset, in this case the stock price. The longer to expiration and the more volatile the stock price, the more valuable the option. This is very different from the benefit accruing to the stock itself, which must see prices rise steadily to generate attractive returns for its holder.

As attractive as options have been as a low-cost--at least initially--way to reward top employees and give them a "piece of the action", they actually reward the creation of stock cycles of seesawing prices; the wider the swings, the better. While this has not been a problem at BP and other major oil companies, it is prudent for them to move toward rewards that motivate the behavior they really want. After all, people are remarkably adept at figuring out how to maximize their benefits under any given compensation system, no matter how poorly it lines up with the goals you are trying to achieve.

All Those Flares
A headline in the Financial Times today caught my eye: Shell Faces Penalties Over Flare Deadline, with the first paragraph going into the environmental damage caused by flaring. When you evaluate the situation carefully, though, there is both more and less here than meets the eye, besides additional bad publicity for Shell.

The basic issue is simple. The production of most oil is accompanied by varied quantities of natural gas. Historically, much of this was "flared", or burned off at the wellhead in what amounts to a giant candle. I recall hearing astronaut accounts of flares in Saudi Arabia being visible from orbit. It's easy to forget that for decades natural gas was considered a valueless byproduct, and flaring was the best and cheapest way to dispose of it.

You see very little oilfield flaring in developed countries, not just because pollution standards are stricter, but because the gas is closer to markets in which its value more than offsets the costs of gathering it up and sending it through a pipeline to heat homes and run factories and power plants. It can also be compressed and reinjected into the oilfield, to keep well pressures up and enhance production. The problem for Shell and other producers in Nigeria is that there is no handy domestic market to consume and pay for the gas, and the cost of reinjection doesn't always have sufficient offsetting benefits.

In the 1990s the Nigerian government passed regulations requiring all producers to cease flaring by 2008. This seems fairly proactive from an environmental standpoint, but the greenhouse gas properties of methane, the main constituent of natural gas, make this less obvious. Since methane is 21 times more potent in its global warming potential than carbon dioxide, the greenhouse gas that gets the most attention, burning it and turning it into CO2--thus cutting its impact on climate change by a 95%--is not necessarily the worst thing one can do with it.

What Nigeria gets out of all this is a chance to earn royalties on some additional production of gas that might not otherwise be counted, and some brownie points from the EU and non-governmental organizations that are most concerned with climate change. In the process, the oil companies incur some additional production costs, and they are effectively forced to aggregate all this gas and do something useful with it in the market, either as LNG or using gas-to-liquids technology to convert it to clean diesel fuel. Along the way, they will generate some greenhouse gas offsets they can either trade or apply to their emissions elsewhere. None of this is bad, unless you think a difference of a percentage point or two in project economic returns, and ultimately in shareholder value, is awful.

While putting an end to flaring seems like a no-brainer, it is much more complicated and somewhat less beneficial than one's intuition might suggest.

Europe's Gas Dilemma
Natural gas is the fuel of choice for power generation, at least when it is available and its price is in rough parity--on an energy equivalent basis--with oil and other fuels. Europe, in particular, will see steady growth in gas consumption in the power sector as nuclear power stalls everywhere but France and as EU adherence to the Kyoto Treaty's greenhouse gas emissions targets makes coal unattractive. Fortunately, Europe sits at the doorstep of the world's largest gas exporter, with far and away the largest natural gas reserves on the planet: Russia. But therein lies the dilemma, as increasing reliance on Russian natural gas coincides with an assertive and increasingly autocratic Russian government.

Europe (EU-25) already imports 6.7 trillion cubic feet (TCF) of natural gas per year net of exports, with 4 TCF of it coming from Russia. This will only increase as North Sea oil--and its associated gas--dwindles and the continent's mature gas fields, such as the enormous Dutch Groningen field, deplete. Algeria, already a major supplier to Europe, can do more, but on a smaller scale and chiefly for countries fronting the Mediterranean. This leaves the Middle East as the only real alternative, with its attendant challenges.

How worried should Europeans, and especially Germans (as noted recently in the Financial Times) be about relying on Russia for the lion's share of their future natural gas needs? From a purely economic perspective, this seems as much of an opportunity as a challenge, since it would leave Russia with lots of Euros for either investment or consumer goods imports. But politically it could create a subtle form of veto that some might argue has already been exercised to give Russia a free hand in Chechnya.

In the long run, the situation gives Europe as much of an incentive as the US for the creation of a thriving global market for liquefied natural gas (LNG), and for the construction of the infrastructure necessary to import it. This might not displace Russian gas supplies, but it would help keep prices in balance with world levels and give traditional suppliers some healthy competition.

The Hidden Variable
Whenever you contemplate dramatically improving the gas mileage of cars in America, whether through new technology such as hybrids or by closing the loophole that led to the dominance of SUVs, you must confront two seemingly immovable obstacles: the size of the domestic vehicle fleet (236 million) and its very slow rate of turnover. The former will only increase, but what about the latter? This is the key to future transportation energy savings, in my view.

Conventional wisdom is that Americans will continue to turn cars over every 8 years, on average, or even longer (measured in terms of mean age of household vehicles). Only a few decades ago, that figure was closer to five years. Along the way, several things happened: cars got more expensive (though not by much as a fraction of average income--see below), families wanted to own more cars at the same time, and--with time out for bad behavior in the 1970s and early 80s--cars got progressively better and more reliable.

For years I've been asking what it would take to get us to turn our cars over more frequently, which would incidentally allow more efficient vehicle technologies to have a bigger impact much quicker. There are several possible answers, some of which have already come up short, such as leasing. My favorite is still technology-related coolness, which may explain part of the appeal of the Toyota Prius. But the sample size is too small so far to suggest whether this is changing how long people hold onto a car.

The best contender is probably a return to pizazz, as suggested in this Wall Street Journal guest editorial. I'm old enough to remember a time when the arrival of the new car models in the fall was a really big deal, whether you were in the market for one or not. Based on the steady increase in annual miles driven, cars command an even more central role in our daily lives now than back then, but they have relinquished much of their hold on our imaginations, perhaps partly for that very reason--familiarity breeds contempt.

If you are passionately concerned with reducing the amount of oil Americans use to run their cars, then paradoxically you should be thinking like a real marketer about how to get Americans much more excited about new cars. Could really bold styling, combined with more efficient technology, push that average turnover figure down to six or even five years again? That's what it would take to move America's miles per gallon into the same range as Europe's in our lifetimes. (Some other time we'll talk about what happens to the old cars, which don't all disappear into the crusher the way they used to.)

Note: In 1970 a middle-income family earned just under $10,000 and a new car averaged $3,500, or 36% of a year's income. In 2000 a middle-income family earned about $50,700 and an average new car cost a bit over $20,000, or 40% of a year's income.

Let's Keep It Clean
As I was going through some of my postings from last year, I ran across one from the early days of the UN Oil-for-Food scandal publicity. (See posting of 4/19/04.) My concern then was for a potential handover of Iraq to UN administration, but the parallels to the current tsunami relief effort are obvious. In particular, excerpting some of what I said then:

I believe there are compelling reasons for exposing the full extent of malfeasance in administering the Oil for Food fund, and the most important of these concerns the future, rather than the past. As the UN takes the lead role...we must aggressively manage the risks this will entail, and one of the largest is for corruption on a vast scale.

Although the current effort may be a better fit with routine UN activities than Oil for Food was, anyone who has done business in South Asia understands the temptations that those administering aid on this scale will face. Resolving the Oil-for-Food scandal promptly and publicly punishing those at fault--along with establishing strict new standards for contracting--will go a long way toward keeping the aid administrators out of trouble.

While I am not suggesting replacing the Secretary-General unless he is directly implicated, there are plenty of others who should clearly go, or at least be removed from any position involving contracting or funding. It would be a great shame if two or three years from now we learned about a "tsunami relief scandal", further compounding a tragedy of already staggering proportions.

Transparency of Reserves
Yesterday I discussed the prospect of a peak in oil production. The scarcity of good data on global oilfield performance has fueled much of the uncertainty in this area, and nowhere is this truer than for Saudi Arabia's enormous reserves, which underpin both the present and future of global petroleum supply. Many have suggested that the Kingdom and its OPEC brethren stand to benefit from greater transparency (see my posting of 7/30/04), in effect reassuring their global customers of their longevity. This week's Economist (subscription may be required) suggests that the Saudis' historic reticence has begun to dissolve. That is welcome news, indeed.

This prompted me to do a little Googling, which turned up recent presentations on Saudi oilfield management practices, along with some pretty interesting scenarios for future production growth, relying to various degrees on undeveloped and unproved, but "probable and possible" reserves. Reading between the lines suggests that anyone expecting Saudi Aramco to double its production is dreaming, while the most vocal skeptics of Aramco's ability to sustain its current production well into the future, such as Matthew Simmons, are probably wrong, as well.

So the good news is that Saudi Arabia appears to have both the reserves and the expertise to crank out 10 million barrels per day as far as the eye can see. The bad news is that they don't seem to contemplate contributing more than another 2-5 million barrels per day (MBD) toward the roughly 20 MBD of incremental production required to meet projected global oil demand a decade from now. (And this ignores all the new production needed just to replace the natural decline in current production over that timeframe.)

There are two implications to draw from this. The first is that the Saudis might be extremely conservative about their production potential, to avoid depressing future prices. If so, can we count on this? The second and more definite implication is that it is going to take a lot of money and hard work to dig up the rest of that incremental production elsewhere. We will need Russia, Iraq, Iran, Libya, and the Caspian, plus a bunch of places hardly anyone has heard of to make up the difference. Or just a lot of synfuels and alternative energy.

Given the lead time required for either path, the major oil companies had better be thinking very hard about their project selection criteria and future production profiles.

The End Is Near...Or Is It?
I was surprised to see an article in MIT's Technology Review suggesting that global oil production may have already started to decline. On further reading, it is mostly a rehash of the same Hubbert Curve arguments about which I wrote extensively last year. (See, for example, my post of 9/22/04.)

Global oil production and demand are already at about 82 million barrels per day (MBD), up from roughly 75 million a day a few years ago. The entire industry, both supply and demand sides, seem to be working under the assumption that this will grow to roughly 100 MBD within a decade. So if we were actually to start falling off from 82 MBD, instead of tracking towards 100, that would suggest one hell of a disconnect on the part of a very large number of analysts, both inside and outside the industry.

My regular readers know that I have a healthy skepticism that production can keep up with growing demand indefinitely, but not because of the geology-based concerns of Deffeyes and Hubbert's other disciples, but simply because it's not clear that the industry (both OPEC and publicly-traded companies) has invested in enough projects to make that happen, while simultaneously compensating for the inherent natural decline of the fields already in production. (I'd be happy to be proved wrong on this, by the way, so if any of you has a field-by-field, country-by-country buildup of real projects that gets to 100 MBD, I'd love to see it.)

That is a far cry from saying that the peak is here, as this MIT article flirts with. For that matter, if production were actually going down globally, rather than up, would the price of oil really be retreating from its $50 highs of last year, or would it instead be well on its way to $75 or $100? From this I conclude that we have time, not for complacency, but to come up with the right set of alternatives with which to fill the gap when production of conventional oil can truly no longer keep expanding.

State of Fear?
A friend was kind enough to bring this review of Michael Crichton's latest novel to my attention. "State of Fear" deals with climate change and, in particular, with the global management of the issue by governments and non-governmental organizations (NGOs). Although the reviewer, a scientist, has some interesting comments about the assumptions upon which Mr. Crichton's story rests, there's a more important point to make than whether this book has its facts straight.

First, I must admit that I haven't yet read "State of Fear." While I have enjoyed many of Mr. Crichton's previous works, he's not on my "buy on sight" list. He enjoys a wide and loyal readership and a reputation for solidly researched ideas. (Interestingly enough, many in the science fiction community--to which a layman might be forgiven for thinking he belongs--regard him as fundamentally anti-science.) As a result, a Michael Crichton book critical of climate change science carries a bit more weight than the average thriller.

What concerns me is that if an author with Mr. Crichton's scientific background (a Harvard M.D.) and all the time and money in the world for researching his novel can get key facts about climate change wrong, as Dr. Schmidt asserts, then what chance do the rest of us stand of grasping the complexities of this issue? This is not an elitist argument that only a few scientists can really understand climate change, but rather that most of the public lacks the context for how science like this really works, because our education system does such a poor job of teaching the sciences, particularly the history of science.

That's a big problem, because if the central hypothesis of climate change is correct, then man-made influences are contributing to drive the climate away from the range that has allowed humanity to reach its present extent and state of development. More importantly, all this is happening at a rate that is too gradual to be readily observable by the average person. Taking action to stave off the worst potential consequences requires not just consensus but faith that the science here is working as it should and in a way we can all trust.

It might make for a good thriller premise to imagine that scientists and NGOs have conspired to concoct "climate change" for their own purposes, but this is at odds with any objective assessment of the current state of climate theory. Ultimately, Mr. Crichton's book may prove helpful if it stimulates the public's interest in this issue and prompts some tough questions, but not if it undermines our faith in the scientific method itself.

Which Is More Reliable?
This is entirely frivolous and a week out of date, but I just saw this item and had to share it. PG&E, the San Francisco-based utility, is offering a free wake-up call service, in case your power is out.

Think about that. Implicit in this service is the idea that land-line phones, which we all love to hate, are inherently more reliable than electric power delivery. I recall this vividly from the great northeast blackout of 2003. My home was one of millions without power, yet I was able to pick up the phone and call our local hospital to figure out when to take my wife--who was in labor--in for delivery.

I'm not posting this to knock the power grid or utilities. Rather, in spite of all the hype about other ways to deliver telephony, including voice-over-IP, cable and cellular--on which an increasing number of people now rely exclusively--none has yet attained the reliability of Mr. Bell's twisted copper wires. If you want to get excited about a vision of the future, just contemplate the possibility of phones that work everywhere, all the time, seamlessly switching between cells, local wireless nodes and satellites--all without any of us having to give a second thought to reception issues. That day can't arrive too soon.

Turning the Table
A few weeks ago I wrote about the changing "ecology" of the oil industry (see postings of 11/17/04 and 11/18/04), as the traditional relationships between the international majors and national oil companies shift. Today's headline concerning the possible acquisition of Unocal by China National Offshore Oil Co. (CNOOC) provides a concrete example of this trend.

Unocal has had an interesting history. It began as a regional west coast integrated producer/refiner/marketer and gradually acquired global interests. In the 1990s it changed direction dramatically, selling its US refining and marketing assets to Tosco, although it retained its valuable (and unusually acquired) patents for reformulated gasoline (RFG). It also shifted its focus to emphasize the international upstream, which was seen as being more profitable and less bound up by regulations. Unocal has come in for a lot of criticism and legal challenges for its operations in Burma.

There would be multiple ironies involved if CNOOC were to acquire Unocal, not the least being how well Unocal's strategy of disentangling itself from refining and marketing in the US has lowered the regulatory barriers to acquisition by a non-US company.

On further reflection, it is inconceivable that a foreign government should collect royalties on most of the gasoline designed to reduce air pollution in this country. As an absolute prerequisite of any transaction between Unocal and CNOOC, the FTC should require that the RFG patents be transferred to the Department of Energy, with the royalties used to fund renewable energy research. Granting them in the first place was questionable and contrary to the public interest, but they have survived legal challenges and probably cannot be revoked. That does not mean they should end up in the hands of one of our country's greatest potential commercial rivals.

Another Look Ahead
Business Week recently published their 2005 Industry Outlook. There's not much to quibble with in their view of the energy industry, though it does focus heavily on the issues that produced the conditions we saw in 2004, rather than trying to anticipate any surprises in the new year.

In particular, I'm struck by their confidence in OPEC's ability to manage the supply side of the market, citing calls to cut production to avert an inventory bubble. It's worth recalling that OPEC's current discipline only dates back to the recovery from the 1998-99 price collapse, which required cooperation from Russia, Mexico and Norway to drag prices back above $10 per barrel. This was preceded by a decade of cheating, reminding us that there will be tremendous incentives for individual OPEC countries to cheat on any future quota reductions, particularly as prices continue to ease and their lofty 2004 revenues shrink.

There's also scant mention of any shift in consumer demand, despite evidence that sales of the largest SUVs are off dramatically, and sales of hybrids are growing as fast as Toyota can churn them out. Granted, it would take years for this to have any appreciable impact on aggregate demand, but it could be an important signal for long-term investors.

Otherwise, most of the big issues and their implications for corporate earnings are well represented in the article, with the exception of climate change. It's well worth a read.

Tsunamis and Risk
The catastrophic tsunami in South Asia is a prime example of a low-probability/high-impact event, as described in this excellent guest editorial in yesterday's Wall Street Journal (subscription required.) Mr. Posner also includes rapid climate change among the risks that share these characteristics. He goes on to discuss the challenges of addressing such threats before they occur, including the problem of getting them above the noise threshold of politicians.

There may be a more fundamental barrier, as well. There have been some interesting efforts to understand how and why people gauge risks improperly , including those of more common threats, such as smoking, car accidents, and environmental carcinogens. While the root-cause may be psychological, or even evolutionary, it still ought to be something that we can overcome, just as an individual with dysfunctional neuroses can overcome them with proper treatment. Without being alarmist, it should be sobering to contemplate potential disasters for which no global relief effort may be possible after the fact, because all regions were affected or the most capable responders were overwhelmed at home.

One of the biggest arguments I have with climate change skeptics is their insistence on an unrealistically high level of certainty concerning the likelihood of global warming and its consequences. When you consider the extreme effects that are possible, dwarfing what we've just seen in the Boxing Day Tsunami, they justify a sizeable effort to delay, mitigate, or perhaps even prevent them entirely, even if the cost of doing so is significant.

Another Competitor for Detroit
It was inevitable. With China on the verge of passing Germany as the number 3 carmaker globally, could anyone believe they would not be tempted by the world's largest auto market? An old name in groundbreaking imports, Malcolm Bricklin, will be importing a new name, Chery, to the US starting in two years.

Detroit has had to worry about competition from Japan, Europe and Korea for decades, but the prospect of competing with China--in some cases with car companies enjoying joint ventures with the world's top carmakers--may seem more daunting, given China's successes in low-cost production in other sectors. Does the answer lie in technology, and in moving the basis of competition onto platform a that Chinese companies won't be able to match for years?

Perhaps this is part of Toyota's motivation for its move into hybrids. After all, they have seen China coming for longer than we have, since so much Japanese investment has flowed into China and the rest of Asia for so long.

The Challenges of Oil
And so another year begins. I spotted two interesting articles in the New York Times over the weekend, which together illustrate some of the key challenges facing the world as we continue to seek new sources of petroleum. The first, from Sunday's front page, highlights the challenge of access for the international majors seeking to offset production declines in the mature parts of their portfolios. Libya is probably the best prospect available, given the restrictions in the Middle East and the concerns about rule of law in Russia. But as the article suggests, it won't be easy, and the removal of international sanctions hasn't created the yellow brick road, exactly.

The second article, from Saturday's business section, focuses on the impact of oil revenues on the countries producing it. Norway is often held up as an example of how this can be done without causing massive corruption on the one hand, or "Dutch Disease"--the enervation of the non-oil domestic economy--on the other. The temptation to use Norway's sequestered oil funds, which are growing rapidly at current oil prices, on projects other than the intended bolstering of social security must be enormous.

For someone who tries to think about the long-run implications of issues, reducing the leverage of dodgy states such as Libya and the economic distortions associated with oil wealth are powerful non-environmental arguments for increasing our use of renewable energy.

Happy New Year!

How High?
Although the price of West Texas Intermediate crude oil (WTI) may be the most frequently reported indicator of the oil market, it is not necessarily the best measure. Most oil trades at a discount to WTI, because of quality, location, or timing. But for looking at big trends and market shifts, the WTI market, and specifically the WTI futures contract on the New York Mercantile Exchange, has the advantage of being highly transparent and liquid. And what a story it tells for 2004!

WTI started the year $9 lower than it is today, at a level that many thought was already quite steep, reflecting problems in Iraq and other producing countries. In fact, the average for 2004 will be more than $10 per barrel higher than for 2003, which itself was nearly $5 higher than for 2002. Even ignoring the $55 peak in October of this year, oil is up about $15 in the last two years, putting it about that much above the long-term average price in nominal dollars. So is this an anomaly, or a trend that we should expect to persist?

Here are some of the issues that support the idea of persistent higher-than-normal prices:

• Demand has grown faster than expected, largely driven by China and other Asian markets.
• Many key producers continue to experience shortfalls due to weather, labor unrest, politics, and a host of other factors.
• Mature areas such as the North Sea and North Slope are in decline.
• The reserve base of the major oil companies looks less secure than in the past, partly for accounting reasons, but more importantly due to constraints on access.
• OPEC is enjoying huge revenues, most of which are needed to alleviate domestic social problems.

But on the other hand:

• The global economy is expected to slow somewhat next year.
• Inventories in consuming countries are growing, indicating slower demand.
• New production will be coming onstream in West Africa and Russia.
• Many speculators have reduced their exposure to oil.
• The market has a long history of reverting to the average, despite countless projections for continued increases.

When I tally up all of these factors, I see enough constraints to keep prices above the long-term average for the next year or two, but not enough to keep it at quite today's level, barring another crisis. OPEC's discipline in cutting production to prevent an inventory bubble will get a real test if this winter continues to be mild. So when I look at the NYMEX futures market's price for delivery in December 2005 of $41, I don't see a forecast of stability, but rather a market that is probably just playing it safe and might rather wish to bet that the price will be either $30-35, or over $50, depending on world events.

Hybrid Reality
Catching up on my reading from Christmas week I ran across this article in the New York Times, reporting some disappointing results from GM's hybrid buses. As the official from the American Public Transit Association indicated, hybrids offer more benefits than just fuel economy, including acceleration and reduced emissions. Still, it is apparent that the actual fuel savings achieved, just like those on conventional vehicles, vary widely with driving patterns. In particular, hybrids provide the greatest benefit when they are used in urban, stop-and-go traffic, and much less on the open road. This is something that anyone considering buying a Toyota Prius or Honda hybrid should remember, too.

The other interesting element in this story is the strategy behind GM's entry into the hybrid bus segment, based on the assumption that these vehicles' heavy use patterns makes them ideal for hybridization. I've heard the same rationale for targeting buses and trucks for early fuel cell applications. But targeting the right subset of this segment will be critical, to maximize the benefits of hybrids or fuel cells. Developers must also consider all the attributes that customers care about, not just fuel economy. GM's experience with hybrid buses shouldn't be seen as a setback, but rather as a learning opportunity.

Tsunami Aftermath
The scale and breadth of the human tragedy from this disaster simply boggle the mind. Although small consolation to those grieving lost relatives, it appears that the region's energy infrastructure escaped major damage, including the major oil and liquefied natural gas production facilities on Sumatra, near the epicenter of the quake that triggered the tsunamis. Nor have I seen any reports of damage to the refineries in the region, including Thailand's substantial refining industry on its southern coast. Both in economic and practical terms, these facilities will be critical in supporting the reconstruction that must begin shortly.

Now I can only wonder about the fate of the many fine people I met over the years, both in my travels in Southeast Asia and here.

Energy Independence?
Yesterday's Wall Street Journal carried a guest editorial (subscription required) by Robert MacFarlane, former national security advisor to President Reagan, on the theme of energy independence. Citing Amory Lovins' latest book, "Winning the Oil Endgame," (see my posting of September 29) he indicated that not only greater energy security, but actual energy independence could be achieved within 35 years. Is this possible or even desirable?

The idea of energy independence grew out of the two oil shocks of the 1970s. Technology has advanced sufficiently since then for us at least to paint a picture of what an energy-independent US might look like, and the changes this would require. Dr. Lovins' view is as good an attempt at that as any, though it is not the only possible version of independence. But having the technology and making it happen are two different things. We have the technology to return to the moon, even if that meant using the same methods as the first time, but does that mean we will go anytime soon? If $50 oil doesn't galvanize an effort for a radical change in our approach to energy, then we are probably looking at the entire problem the wrong way.

Further, even if Dr. Lovins' figures are correct in terms of the amount of investment required to replace key portions of our energy and automotive infrastructure, is this the best use of that capital? The market alone will not deliver such a change on anything like the timetable suggested by Mr. MacFarlane. Although this may well be one of those areas in which the market doesn't send the right signals far enough in advance, going against it requires some caution. Pushing ahead to have these conversions in place by 2040 requires choosing technology winners and losers now or in the near future. Our track record in that area is not very good.

Finally, we need a genuine consensus on the criteria for making these choices. For example, is it only a question of energy independence, which might be met entirely with coal, or rather of clean energy independence? If the latter, is clean limited to local pollutants, or does it include greenhouse gases? No consensus on these issues exists today, and these distinctions have major practical implications for the path we would choose. The debate highlights the need for a real energy policy for the country, and for a different way to go about arriving at one.

I've never thought that energy independence was the right goal, as appealing as it might sound, any more than we should be textile-independent or knowledge-independent. Energy independence is a 20th century notion that translates poorly into an increasingly globalized 21st century. Instead, being smarter about energy--whether foreign or domestic--has a higher chance of leading us down the right path and improving not just our energy security, but our entire economic well-being. That means reexamining and reengineering our entire energy ruleset, for starters, and giving businesses the right incentives and tools to provide reliable, safe and clean energy, with less disruptive price volatility.

The Changing Future of Energy
As we approach the end of the year, it's appropriate to think about how our picture of the energy future has changed in the last twelve months. Here are some thoughts, in no particular order:

• OPEC still matters, if only as a constraint on Saudi Arabia, which left to its own devices might choose to produce at much higher levels. Nor is there any visible sign that the Kingdom intends to offer the international oil companies access to its undeveloped reserves, despite a growing chorus in the industry that this will be necessary to meet future demand.
• Thanks to the insurgency's calculated attacks on contractors and the generally poor security environment, development of Iraq's hundred billion plus barrels of oil may be delayed for years. More new oil will probably flow out of Libya than Iraq in the next five years.
• The future of the most promising non-OPEC producer, Russia, is now under a cloud. At this point we don't even know the identity of the winner of the auction for Yukos's largest subsidiary.
• Although nearly everyone now realizes the necessity for importing large quantities of LNG into the US to prevent a serious shortfall of natural gas supply, most of the proposed import terminal locations face uphill--if not entirely futile--battles for approval.
• Hybrid cars have gone from a novelty driven by Toyota to a mainstream trend that all the carmakers are rushing to follow.
• Climate change looms as yet another EU/US political crisis, thanks to our apparent unwillingness even to engage in a reasonable conversation on the subject.
• While fuel cell vehicles may look even further off than they did a year ago, small fuel cells are going to start turning up in consumer devices, raising at least awareness of the technology.

The biggest surprise for me in 2004 is that we could see $50/barrel oil and end the year with oil and natural gas prices roughly double their long-term averages (in nominal dollars) without seeing any consequences more serious than a lot of complaining. Are energy issues simply trumped by security concerns in the post-9/11 world, or are we really that confident that the market will deliver the energy supplies we need?

My blogging is going to be a lot more sporadic over the next week, as the holidays approach, but I'll be on the alert for any news the really demands comment.

A Friendlier Venue
It's not terribly surprising that Yukos was able to find a court in Texas willing to involve itself in the battle over its dismemberment, even though a couple of years ago Yukos convinced another Texas court that it didn't have enough activities in the state to be sued there.

At this stage, it appears that the goal of Yukos's management-in-exile has shifted from preventing the sale of their largest subsidiary--which appears to be a foregone conclusion--to making it as politically costly as possible for President Putin. Taken together with Russia's heavy-handed, unsuccessful meddling in Ukraine's recent election, this has produced the worst patch in US/Russia relations since the collapse of the USSR.

At the end of the day, though, too much of Russia's financial future is bound up in trade--especially mutually-beneficial energy trade--with the EU and US for the rift to be allowed to worsen and become permanent. The outcome is uncertain, but pragmatism should still win out over pride to keep Russia at least nominally in the Western camp, rather than striking out entirely on its own, again.

The Real "New World Order"
I see that Unocal has settled the case against it relating to human rights in Burma. Unocal was charged with complicity with the government of Burma in various human rights violations related to the construction of a gas pipeline in that country. Although its not clear how much precedent an out-of-court settlement creates for this kind of application of the Alien Tort Claims Act of 1789, the implications for businesses, either US-based or with significant US operations, seem pretty clear.

For some time various non-governmental organizations (NGOs) have pushed for the application of US standards in labor practices, safety, and environmental protection on companies operating outside the US. One case doesn't make a trend, but prudent managers and investors should expect wider and more frequent use of this approach in the future. The rise of global "civil society", in the form of influential NGOs with both media and legal savvy, is one of the major developments of the last decade or so.

On one level, companies operating abroad will need to do so to the higher of US or local standards. But, as in the Unocal case, the greater peril may come from the actions of local partners, including governments, that are not under the control of the US entity, but for whose actions the US firm may be held responsible. Fair or not, this raises the stakes significantly when considering whether an opportunity in a country with a less-than-perfect government, or less-than-ideal commercial partners, may be attractive enough to offset the financial and reputational risks involved. It also suggests that companies need to build up positive "soft power" in form of relationships with NGOs and multi-lateral agencies.

The Big Sucking Sound
The finances of the big national oil companies aren't usually very transparent. If the picture of Pemex, Mexico's state oil company, in the current Business Week article (site registration may be required) is representative of its counterparts in other key producing countries, there could be serious trouble ahead. These companies have monopolies over the most productive oil resources on the planet, along with the lion's share of the world's untapped oil reserves. If they cannot generate the capital to develop these reserves in a timely manner, then the world's oil pipeline has a great big slug of air coming our way, somewhere in the 5-10 year timeframe.

Pemex's balance sheet is shaky because of a phenomenon we also see in the Middle East and Venezuela: it is easier for these governments to dole out oil industry profits for social welfare and infrastructure projects than to tax their citizens. But even in countries blessed with huge oil endowments, some level of reinvestment is essential to keep oil reservoirs healthy and to sustain future production. The worst example is in Iraq, where the fall of the Ba'ath regime exposed a decade of starvation diets for both the oilfields and oil infrastructure, with Oil-for-Food money skimmed off to build palaces and missiles.

A growing industry chorus is calling for the producing countries to provide commercial access to their resources to the international oil companies, which have the best technology for managing them. But a side benefit might be improved governance that would treat reinvestment as a priority and withhold these funds from remittances to the state. This would benefit all parties in the long run, by improving the stewardship of these resources.

Not Quite Ready for Prime Time
Developers of fuel cell vehicles (FCVs) face some basic challenges in preparing their prototypes to handle the extremes of winter, as highlighted in this recent article in the Automobile section of the Sunday New York Times. The primary concern is that the membranes in a polymer-type fuel cell can be damaged if the water in the cell freezes, and carmakers are having to find some clever workarounds. By itself, though, no one should see this as an insurmountable obstacle to fuel cell vehicle adoption, unless the overall performance of these cars remains inferior to that of internal combustion powered cars.

You'd have to be in your nineties to remember when early piston-engine automobiles suffered from similar problems. Modern radiator anti-freeze only dates back to the 1930s, and prior to that, motorists either had to keep their cars above freezing or use methanol in the radiator, which created other problems. People continued to buy early cars in spite of limitations that we would now find totally unacceptable, because cars represented such an improvement, and because owning one was considered cool (or hep or whatever the term would have been.)

Unfortunately for FCV developers, the competition isn't horses and trolleys, but engine technology that has been refined continuously for a century to a high degree of reliability and performance. Hybrids raise the competitive bar even higher, by delivering fuel economy that approaches that of an FCV, with technology that is less radical and--at least today--perceived as more reliable.

Aside from all the other impediments to rapid commercialization of FCVs, such as infrastructure availability, hydrogen supply, and the high cost of fuel cell stacks (all of which are very big issues), I still think the key will be consumer acceptance. Will there will be enough early adopters prepared to take a step or two backwards on convenience and reliability to get the next "great leap forward"? You can bet carmakers are paying extremely close attention to the profiles and demographics of the folks buying hybrids today.

Deliberately Obtuse?
Today's lead editorial in the Wall St. Journal (subscription required) is entitled "Kyoto Capitalists". It criticizes firms such as Cinergy (see my blog of December 7, by scrolling down this page) for committing to reduce greenhouse gas emissions, on the grounds that these reductions are motivated by a thirst for profits, and that they will be too small to prevent global warming in any case. Along the way, the Journal displays a fundamental misunderstanding of the chemistry behind greenhouse gas emissions. While I often find the Journal's views compelling and well-reasoned, their arguments here seem mostly mean-spirited and wrong-headed.

Let's start with the profit motive. In fact, the whole impetus behind market-based emissions reduction tools, such as cap-and-trade and the Clean Development Mechanism built into the Kyoto Treaty is that more reductions will be achieved if they benefit the parties making them. This used to be called "doing well while doing good." So of course companies like Cinergy want to make reductions in the most profitable way possible. The Journal's assessment that these profits will come out of the hide of consumers and taxpayers is no more or less true than for any other type of profit. The real issue is whether the economic activity associated with greenhouse gas reductions is a zero-sum game or an increasing-pie game, and I see no inherent reason why it must be the former and not the latter.

Another charge the Journal levels at these companies is that they are seeking to get paid for greenhouse gas reductions that will happen anyway, as a consequence of meeting stricter rules on emissions of sulfur and nitrogen compounds. This may be true to a small extent, but it misses the basic distinction between sulfate and nitrate pollution and the emission of CO2 and other greenhouse gases. The former results from either fuel impurities (sulfur) or the amount of nitrogen present when combustion takes place. This pollution can be managed with a variety of strategies, including fuel treatment, stack gas scrubbing, lean burning, and oxygen-firing. But CO2 emissions are not pollution; they are the principal product of combustion, along with water vapor. Reducing them significantly means either using much less fuel in the first place, or separating CO2 from exhaust gases and storing it underground. Either approach requires not just a little scrubbing and tweaking, but a major redesign of process hardware, at enormous cost. The alternative is buying reductions from other sectors of the economy that can make them more cheaply, and that is the whole point of cap-and-trade.

Ultimately, the Journal's sarcasm reflects their skepticism that climate change is real. While this is still a legitimate viewpoint, it is increasingly out of step with mounting evidence to the contrary. But even if one remains skeptical, the potential consequences of global warming are serious enough that they justify buying some insurance, and I believe that is precisely what the companies in question are wisely doing. Whether their actions will matter in the event of major climate change is really beside the point. Action must begin somewhere, if it is to happen at all. For the rest of the developed world, like it or not, that start is the Kyoto Treaty and its modest emissions reductions, as a downpayment on broader and deeper cuts later.

The Future of Oil Companies
A couple of weeks ago I wrote about some of the changes taking place in the international oil industry, describing them as a of realignment of ecological niches. (See postings of Nov. 17 & 18.) Yesterday's Financial Times included a truly insightful article that probed these issues in much greater detail, using the opening of new exploration and production opportunities in Libya as a case in point. Anyone interested in the oil industry, whether as an investor, supplier, or employee, should give some thought to the issues the authors raise. The outcome will determine the nature and profitability of the major oil companies for the next ten to twenty years.

If you look at the oil business in purely economic terms, there are three principal sources of value associated with petroleum. (The analysis is similar, but slightly different for natural gas.) First, there is the value created by finding oil, taking it from the earth and bringing it to market. This corresponds to the "upstream" portion of the industry. The second portion covers the "midstream" and "downstream", in which the oil is transported, refined, and the resulting products sold. Finally, there's the value created through the use of the products, including transportation and the petrochemicals.

Despite massive investments in refineries and highly visible service station networks, most of the economic value of the international oil majors, for most of their history, has come from the Upstream, through their ability to capture part of the economic "rent" on oil production. What makes the issues raised in the FT article so challenging is that they threaten to dry up the companies' access not only to new oil and gas reserves, but more fundamentally to the gusher of above-average returns--the "rent"--derived from them.

To understand how this works, compare an oil field in the North Sea to one in Kuwait. In the former case, the company producing the oil paid for an exploration concession, invested in finding and developing the oil, and now enjoys the full value of the production stream, less operating costs, taxes and royalties. In Kuwait, on the other hand, the state oil company may hire one of the majors or service companies to perform work on a field, but only pays them a fee for the work. The state oil company keeps essentially 100% of the uplift between the cost of production and the market price. The worst-case scenario for the majors is a world in which all the future production opportunities look like Kuwait, and none look like the North Sea.

While that may be an unlikely outcome, the threat of the cost of production sharing contracts and concessions being bid up by new competitors to levels that leave little room for upstream profitability by the majors is not. Nor is it hard to imagine more and more of these deals being done preferentially between state oil companies, leaving little role for the majors.

None of this is new. Some companies have seen these possibilities for at least a decade. What is not apparent, however, is the kind of transformed oil company value proposition that would be required to carve out an advantaged and highly profitable niche in such a world. To find that, as the article suggests, the companies must have a very clear idea of what they bring to the table, and with today's global markets for capital, it can't just be money.

What can the likes of ExxonMobil, BP, Shell, ChevronTexaco and their smaller brethren offer that a Sinopec or Petrobras--or an alliance between a hedge fund and a service provider--can't compete with? The answer to that question will end up being the majors' dominant business model for the next couple of decades, unless they want to treat their upstream businesses as depleting cash cows from which to fund other activities.

Very Stationary Sources
Vehicles get an awful lot of the attention when it comes to improving energy efficiency and reducing emissions of local pollutants and greenhouse gases. This is natural, since their inputs and outputs are part of our daily experience of life. But as this interesting article from last week's Economist points out, energy efficient buildings represent a tremendous opportunity to cut energy use and pollution, as well as providing many other benefits.

The statistics are impressive. According to the article, buildings in the US account for roughly a third of total energy use and greenhouse gas emissions, and nearly two thirds of electricity consumption. The most efficient buildings appear to be 1/3 to half again more efficient than the average. Multiplied across the entire economy, the potential savings could be comparable to increasing the market share of hybrid cars to half of new car sales in 10 years.

The key strategies for achieving these savings include the use of new building materials, better insulation, more use of natural light, and some degree of onsite power generation from wind, solar, or fuel cells. Less obvious but just as dramatic is the benefit of computer modeling during design to understand how a building interacts with its surroundings, and to optimize these relationships.

The most encouraging thing here is that this seems to be an architectural movement driven by economics, rather than aesthetics, and should thus be more sustainable. Even if oil and gas prices reverted to their historical averages--something that looks like a dim prospect anytime soon, especially for gas--there are big dollars driving these innovations. To my tastes, a side benefit is that these buildings aren't just high tech, but they look it, too. You can regard them as anything from odd to cool, but boring they're not.

A Cheaper Alternative to Fuel Cells?
For the past several years I've been intrigued by the potential of fuel cells for home power generation and incidental water heating. There are already several prototypes on the market, such as those from Plug Power. But now there's a lower-tech version of the same idea: a natural gas-fired home generator that can run a circulating hot water heating system and put out 1200 watts of electricity. It's powered by a Stirling engine, which until recently has been a novelty device, but was always seen on the verge of a big breakthrough.

The WhisperGen, built in New Zealand, is on initial home trials in the UK, at a cost of 1350 pounds sterling ($2600 at current exchange rates.) It could give home fuel cells serious competition on two fronts. First, it is billed as a boiler that also generates electricity, rather than as a generator that incidentally produces some hot water, so consumers may regard it as more similar to existing home heating systems. Secondly, although the Stirling engine is not exactly a familiar item, it is still less exotic--and perhaps more reliable-sounding--than a fuel cell.

At the end of the day, I suspect that a little competition in this area will turn out to be healthy for both technologies, since at this point the success of both relies on changing consumers' perceptions about producing electricity in the home, rather than relying exclusively on the power grid.

Reducing Uncertainty
Risk and uncertainty are the bane of market value, when they can't be managed effectively. With respect to climate change, some companies seem to be coming around to the idea that setting limits on emissions and relying on market mechanisms to implement them is preferable to the risk of a patchwork of state-by-state regulation of greenhouse gas emissions--perhaps similar to our balkanized gasoline specifications--or of a more onerous national program that might follow a future crisis. The publication of a report on greenhouse emissions by Cinergy, a midwestern utility, affirms this view.

Their report may not come as a surprise, since Cinergy was already a member of the Pew Center on Climate Change, an industry group that supports proactive measures to address global warming. But it is sobering, given the assessment that complying with proposed reductions could cost Cinergy up to $2 billion over 10 years, because of its reliance on coal-fired power generation. That suggests that Cinergy's executives believe it is better for their shareholders to define the risk, even if managing it costs real money, rather than leaving it as a gaping uncertainty overshadowing the firm's value.

In this light, the Administration's position on the Kyoto Treaty--reiterated at the Conference of the Parties (COP-10) in Argentina--can only be viewed as counterproductive. It may actually be damaging US business interests, at least in terms of their market value, well in excess of the estimated cost of compliance.

Apollo for Energy
In his Sunday New York Times column, Tom Friedman made a strong case for an Apollo Program for energy, to make the US independent of foreign oil suppliers. Aside from the geopolitical benefits that would accrue, such an effort would presumably create lots of jobs in this country, and perhaps whole new industries. Is this feasible and practical, or is it an unattainable dream?

Just to set a baseline, the cost of the Apollo Program, adjusted for inflation, was roughly $170 billion, including all R&D and procurement. By comparison, Canada will spend about C$25 million to add one million barrels per day of synthetic oil production over the next decade (see my blog of September 23). The US today imports ten times that much oil. This suggests that Apollo is probably the right cost ballpark, though it does not tell us which path to pursue.

There are two broad, distinct strategies for getting there, each with very different paths and implications, and requiring different combinations of research, infrastructure, demonstration facilities, and incentives. The first would involve the production of substitute fuels that are compatible with our existing transportation energy system. That might include biofuels, such as alcohol or biodiesel, or synthetic oil from other hydrocarbon sources, such as coal, oil shale, or natural gas. This option would be mostly a matter of improving current processes, then embarking on a massive construction spree.

The other major alternative entails creating an entirely new energy system, along the lines envisioned for a hydrogen-based economy. This would require much more upfront R&D, construction of new, parallel infrastructure and, in the case of hydrogen or a similar energy carrier, a major increase in primary energy production. That could take the form of a vast expansion of renewable energy, new nuclear plants, or even new coal-fired power plants.

Without delving any further, the cost of the latter approach would clearly be much larger, and the transition period longer than for a synthetic hydrocarbon fuels program, because it would require so much new hardware. The timing and total cost are also much more uncertain, because they hinge on breakthroughs or major technology improvements that haven't yet occurred.

Choosing between these different strategies also takes us beyond the realm of energy security and into global environmental and industrial policy. For example, how important is it that the result be "carbon neutral", to avoid contributing to further greenhouse gas emissions? Are we just trying to back out oil imports, or do we want to transform the whole US energy economy? The more ambitious our goal, the longer it will take and the riskier the path will be.

The good news is that in either case the cost of oil imports should start to come down long before the final result was in place. The market would begin to discount the price of oil as soon as the tangible proof of our commitment--people and investment dollars--was in place. And oil producers with long-lived reserves, such as the Saudis, would likely react by bringing lots of production on quickly and flooding the market, to try to make our alternatives uneconomical. That alone would go a long way toward achieving Mr. Friedman's goals.

Unfortunately, although I think it's truly possible to mount an Apollo-like effort for energy, I just don't see the will to do it. If an election held against the backdrop of $50 oil wasn't sufficient to focus our attention on this issue, what would be? I also question whether such an approach would produce the best answer, since it would require making some irreversible choices early on. A less ambitious but still significant increase in energy R&D--both public and private--plus some X-Prize-like incentives for key technology milestones might not give us energy independence in ten years, but it could provide a range of great new options in surprising areas and lay the groundwork for a viable, sustainable energy future.

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.