Still in the Market
In case anyone seriously thought that China Inc. would retreat to lick its wounds after CNOOC's withdrawal from the bidding for Unocal, another Chinese state oil company, CNPC, has just agreed to acquire PetroKazakhstan for $4 billion. In the process, it outbid the Indian state oil company, ONGC. While Unocal offered plenty of strategic fit for state-owned CNOOC, this deal has none of the drawbacks that would have accompanied buying the California-based Unocal:

• No North American production to complicate matters
• No US regulatory approvals required
• No need to trade Asian gas production already committed Thailand for something else that could have reached China
• No pariah regimes to deal with (e.g. Burma)

Instead, we see a sensible, if somewhat pricey acquisition of a clever Canadian company with production in a country in China's strategic back yard (as well as Russia's), linked by a soon-to-be-completed oil pipeline to China.

More importantly, this is the face of China with which the international major oil companies are going to have to contend in the years to come: a tough competitor with a growing appetite and a willingness to pay over the mark for strategic assets in the countries open to foreign development of oil and gas reserves, and perhaps in some that aren't. Energy company strategists should banished any complacency over the relative ease with which Chevron outmaneuvered CNOOC from their thinking.

Peak Oil Cover Story
With the public's focus on energy matters understandably elevated for the last couple of years, two previously esoteric subjects have received a remarkable amount of attention in the press. I suspect that increased coverage of liquefied natural gas (LNG) owes as much to a carefully managed public relations campaign as to the slew of proposals to build terminals to import liquefied gas to meet our growing domestic demand. I'm less sure about the other big emerging issue, "peak oil". There's no obvious lobby for the "peak oil" issue, unless it is those who support various alternative energy technologies or greater conservation. This weekend, the adherents of "peak oil" achieved a coup of sorts: a cover article in the New York Times Magazine. It also provided another high-profile venue for the widely-disseminated views of Matthew Simmons on Saudi Arabia's productive capacity.

I've talked about peak oil in a number of previous postings, looking at both its technical and sociological aspects. Many of the articles that prompted these postings focused squarely on a geological peak in oil production, the point at which global production cannot be increased further, but rather begins to decline. The fact that this point cannot be predicted with any certainty--having previously been specified for dates that have come and gone--makes it all the more fascinating. While the Times article does a good job of covering this same ground, it includes some very interesting new insights and some nuances that bring it closer to my own views.

First, the author correctly assesses that the point at which growing production cannot keep up with expanding demand is more important and world-altering than the technical peak, which may occur years or even decades later. That point, rather than the peak itself, is the market discontinuity that could make every alternative energy technology ever dreamt of economical.

The article's discussion of the Saudi situation is also balanced and informative. While some of the commentary from past and present Saudi officials might seem self-serving, their focus on the importance of looking at demand, rather than future Saudi supply, seems apt. The clear message is that although the world can probably rely on the Kingdom to maintain its current production for years, we should not assume more than modest increases for the future. Even if the Ghawar field, which produces half of all Saudi oil, does not go into precipitous decline, tapping the vast remaining Saudi reserves will be qualitatively different from their past efforts.

You can think about this by analogy to the US. We've produced oil since the 1860s, and our cumulative production exceeds that of Saudi Arabia, though our "original oil in place" was somewhat less than theirs. But imagine how our oil industry would look if all of our most productive fields, including not just the East Texas field, but also the North Slope, West Texas, offshore Louisiana, etc., had been produced between 1860 and 1920, rather than the pattern of major new producing areas coming onstream every couple of decades. This is what the Saudis face. They will have to go from an industry that has drilled only a few thousand wells in its entire history, to one that will have to drill thousands or tens of thousands within a few decades, just to maintain current production. Whether they can access the industrial, financial and professional capacity to achieve this is exactly the right question to be asking.

The good news, from my perspective, is that the recent optimistic production forecast by Cambridge Energy Research Associates does not rely on massive increases in Saudi production to attain global production of 100 million barrels per day by 2010. But maintaining that production level and growing it further to meet new demand from China and India could prove a bridge too far, so we had better use the time this buys to ramp up alternatives, even if the price of oil were to retreat from its current level for a few years.

Belated Anniversary
As I catch up on the email and articles that accumulated during my vacation, one op-ed in the New York Times caught my eye, because I was looking for something marking the second anniversary of the Great Northeast Blackout. The author laments the scant progress since then in securing our power grids against a deliberate attack. Considering the paralysis resulting from an accidental overload in the Midwest, it's sobering to consider what a dedicated terrorist might achieve on purpose. And while putting guards on key substations and other energy nodes might be a good stop-gap, I don't see much commentary about the role of distributed power, and renewable distributed power in particular, in helping to reduce our vulnerability in this area.

If you start from the premise that we are grappling with smart, capable opponents, at least at the leadership level, it makes sense to be worried about our energy infrastructure. Rather than trying to block every conceivable vulnerability, and focusing most of our efforts on those that have already been exploited, we might be better served by establishing a "red team", i.e. a bunch of guys who can think like the terrorists, and letting them plan their worst. To such a team, our energy infrastructure would look irresistible, with its pervasive impact and abundant choke points.

In addition, a great deal has been written recently about the virtues of reducing our dependence on imported oil as a way of hobbling Al Qaeda and its supporters in the Middle East. This seems like a pretty indirect and slow-motion response, as I've suggested previously. Putting up solar panels, small wind turbines, and other highly-distributed means of generating electricity may work on a much smaller scale, but it has the virtue of being immediately effective, at least locally.

Although I always worry about the risk of of subsidizing an energy dead end, such as grain ethanol, it strikes me that providing more support for small-scale renewable power and the network protocols to accommodate it within the grid would be at least as useful as many of the other ways we have responded to the terrorist threat. It also aligns nicely with the need to reduce greenhouse gas emissions and manage our growing energy imports.

Capturing the Scale
The other day a friend suggested I have a look at an article on alternative energy in the current National Geographic. No one is going to confuse the Geographic with a cutting-edge science journal, but in this case I thought they did a great job of surveying the energy future and giving the general audience a sense of what might be in store, and how it relates to the fossil fuels that have gotten us this far. Most importantly, the article does a wonderful job of capturing the mind-boggling scale of the problem, with the Geographic's typical lovely photographs and clever charts, though most of these are only available in the print edition.

When I talk with people about alternatives to oil, gas and coal, and the subject turns to the obstacles that must be overcome, I almost always mention scale. In particular, I talk about how hard it is for anyone not familiar with the numbers involved to appreciate just how big the fossil fuel economy is, and how large a problem it is to consider supplanting it with something else, or a combination of somethings. Pictures of people standing next to a giant wind turbine blade, or the excellent chart showing how much of New York City would have to be devoted to energy generation, in the absence of fossil fuels, convey that message better than any Powerpoint chart can.

While I could fill up this posting with minor quibbles about omitted details or emphasis that could have been adjusted, I'd have no qualms about handing this article to anyone who wanted to know more about the subject and could only devote 20 minutes to it. Of course those reading this blog can guess that I'd probably mutter also a few words about things being much more complex than the Geographic's portrayal, and the picture on biofuels being not nearly so clear-cut. My biggest disappointment in the article, though, was purely a function of my own expectations: I was hoping for something as comprehensive and visually striking as the Geographic's special supplement on energy in February 1981, which I still have on my shelf.

Summer Re-runs
With the heat and humidity reaching their typical August extremes for the Northeast, it's time to retreat to the balmy California coast for a week or so. As usual, I've set up some links to past postings that I think are still relevant, particularly for newer readers of this blog. Energy Outlook will resume its normal new posting schedule on August 18, 2005.

The new Energy Bill includes provisions to streamline the approval of facilities to import liquefied natural gas (LNG). Why was this necessary, and what if LNG remains blocked?
Where the LNG Will Go (February 18, 2005)

The Energy Bill excluded drilling in the Arctic National Wildlife Refuge, but that doesn't mean the idea is dead. Is looking for a big-ticket trade-off more sensible than diehard opposition, and are its opponents and advocates even looking at ANWR in the right way? (two postings)
Trading ANWR (March 21, 2005)
Geo-Greens Against ANWR (March 22, 2005)

Nuclear power will also benefit from the Energy Bill via increased funding for R&D. Could nuclear power turn out to be the key to a Hydrogen economy?
How Much Hydrogen? (February 4, 2005)

Finally, as you start on that long driving vacation, is it worth paying up for premium gasoline, with gas prices so high?
Which Grade? (April 14, 2005)

Climate Change and Hubris
Dr. James Schlesinger is someone I've always respected. He has the sort of stern, towering intellect that says little but means much. The prospect of having to debate someone of this caliber in person would doubtless turn my nerves to jelly. However, yesterday's Wall Street Journal included a commentary by Dr. Schlesinger entitled, "The Theology of Global Warming" (subscription required; summary here) and I feel obliged to comment about one aspect of this document. While the op-ed seems largely aimed as a warning about the risk of hubris in the projections of the scientific establishment concerning dramatic climate change, I find warnings of hubris just as appropriate for those who cannot accept that man's activities have become a major driver of the global environment, even at the scale of the climate.

I also question Dr. Schlesinger's characterization of the strong conviction of many scientists dealing with this issue as "theology". It does not require faith to see the available data as supporting the hypothesis that dangerous warming is occurring and that man-made sources play a role in the process. At the same time, I recognize that some, including scientists, politicians and bureaucrats, have attempted to apply these views with quasi-religious fervor. All parties should note that with the powers available to us in areas ranging from the atom to the gene, the old dictum about mixing religion and politics may be just as apt with regard to combinations of science and politics. Dissent serves a purpose, as long as it does not stand in the way of necessary action.

None of this changes my view that climate change remains one of largest risks facing both government and business. A risk is just that: something that might happen, with significant consequences if it did. Prudent people manage risks; fools ignore them. Dr. Schlesinger--no fool--is on record in previous statements agreeing that, despite his skepticism about anthropogenic causes of climate change, action should still be taken. I would add that new knowledge can always be incorporated later, but we cannot afford to wait for perfect information.

Globalization's Arrow
One of the things that fascinates me about globalization is the parallels between its current manifestation and the first wave of globalization in the late 19th and early 20th centuries. Both were driven by financial liberalization and information revolutions, resulting in dramatic increases in global trade and capital flows. Last Thursday's Wall Street Journal (subscription required) cites a recent lecture by Niall Ferguson, historian and bestselling author, spelling out this comparison in great detail. The article leaves open the same question I've been asking for six or seven years: what could cause the direction of today's globalization to reverse, as it did at the onset of World War I?

One similarity between Globalization I (1880-1914) and Globalization II that has only been true recently is rising commodity prices, including energy. Free and expanding global trade in energy has not only been a key feature of the last thirty years, but is the foundation upon which the energy security of this country rests. This mechanism becomes more critical with each passing year, as the gap between our energy demand and our indigenous supply expands. But as long as the market remains tight and prices continue rising, the temptations to circumvent it will grow.

While some continue to look for signs of the type of "Guns of August" event that halted Globalization I in its tracks, the real vulnerability could be less drastic than war. For a while, the anti-Globalization movement looked like a candidate, though it seems to have peaked a couple of years ago. A response to rapid climate change could have the same effect, depending on how it played out. Or it could come from a competing approach to trade.

The recent tussle over Unocal illustrates two competing visions of world trade, and despite the pro-free-trade rhetoric from CNOOC and the seemingly-protectionist backlash in the US, we shouldn't mistake the difference between a system solidly based on private ownership of the oil and gas companies that invest in the production of global energy resources and sell into the free market, and a system of state-controlled enterprises managing resources earmarked for a state-subsidized internal market. If the next era of the energy industry turns out to be a race between these two systems, the risks for the entire globalization system will increase.

Those of us who've grown up during this sustained period of accelerating global trade and prosperity probably find it hard to imagine that this might not continue unabated. Yet I'm sure that someone living in 1910 would have felt a similar confidence, only to be proved disastrously wrong within a few years. Ironically, recent arrivals to prosperity, including China itself, stand to lose much more than the rich, developed countries if globalization goes into retreat.

Global Warming and Bigger Storms
Even though the existence of global warming and its causes seem less controversial than they once were, the potential consequences of warming are still hotly debated. One of the outcomes that's been predicted for years is that continued warming will produce more frequent and more intense hurricanes and typhoons. However, this has generally been seen as a possible future event. Now a study from an MIT hurricane specialist indicates that we are already seeing this effect. Dr. Emanuel has apparently found that hurricanes in the North Atlantic doubled in total power since 1970, while North Pacific typhoons were 75% stronger. In a year with four named storms before early July and the earliest category 4 storm on record, that doesn't seem far-fetched.

Still, the study has drawn criticism from other climate scientists and must be regarded as preliminary. Dr. Emanuel's paper has appeared in Nature and will be subjected to the normal peer review. Even if some of the paper's findings are ultimately undermined, it's still sobering to contemplate that climate change might turn out to be something that my generation will experience directly. We could end up cursing our own inaction, rather than only worrying about what our descendents will say about us. That could turn out to be a good development, in a perverse way. Climate change, as an issue, has suffered from much of the same "Apres nous, le Deluge" attitude as Social Security reform and other seemingly intractable long-term problems that aren't yet full-blown crises.

Consider the insurance industry, though. It already pays more attention to climate change concerns than most other financial sectors. If a direct link were conclusively established between warming, the emissions that cause it, and the increasing insurance liabilities associated with more intense hurricanes, then the political winds around this issue might just start to shift in favor of prompt action. I'm sure this isn't the last we've heard on this subject.

Unintended Consequences and Diminishing Returns
I've previously highlighted Southern California's success at cleaning up its air. Yesterday's New York Times included a fascinating and lengthy article on the subject. It goes into some detail on how L.A.'s historic problem with ozone pollution was brought under control, while describing a new, growing problem with roots in a classic unintended consequence. However, there are a couple of points worth adding, relating to useful lessons and possible future consequences.

Somehow, the impact of pollution abatement on gasoline prices in Southern California escaped mention, even though it was a clear harbinger of subsequent price spikes elsewhere. Starting in the 1980s, the specifications for gasoline sold in the South Coast Air Quality Basin became much more restrictive than in the rest of California or in other states. This effectively turned Southern California into a remote island. Fortunately, the island was normally self-sufficient, with a large concentration of oil refineries.

Whenever a local refinery problem restricted gasoline supplies, though, obtaining replacement supplies elsewhere entailed extra cost and time lags for blending and shipping the so-called "L.A. Spec" gas. As a result, pump prices jumped by 5-15 cents per gallon--on a much lower base than today's--depending on the magnitude and duration of the outage. I experienced this firsthand a number of times, as Texaco's lead products trader for the West Coast in the mid-to-late 1980s. In fact, this was the beginning of the Balkanization of gasoline specifications that has contributed to supply disruptions and price excursions in other locations, including the price spikes in the Midwest a few years ago. The whole country could be facing this on a larger scale next year, as companies like Valero voluntarily phase out the use of MTBE, as a consequence of the failure of the Energy Bill to provide litigation protection for the industry.

Even though Angelenos have willingly paid this premium for cleaner air, control of auto emissions in the region is approaching a point of diminishing returns. Short of eliminating these emissions altogether--something that is still years or decades away--pollution from cars may be overshadowed by the particulate emissions of the diesel engines associated with L.A.'s burgeoning foreign trade. As imports from China and the rest of Asia have grown, more and more ships, trains and trucks have converged on the freight nexus of Southern California's ports. The article makes clear that addressing this source of pollution will be tricky, for many reasons.

Regulators will face particular challenges in reducing the sulfur of the fuel that ships burn. Bunker fuel, as it is called, is the final residue of the oil refining process. It contains very complex hydrocarbon molecules and impurities and is the most expensive fraction of the barrel to clean up further. In fact, hundreds of thousands of barrels per day of this material have vanished from the market in the last 30 years, as refiners turned it into more valuable products like gasoline and diesel, using various conversion processes. Faced with a choice between removing most of the sulfur from this fuel, or turning it into gasoline, some refiners will opt for the latter, even if this means massive investments. So whether it's cleaned up or transformed into something else, the fuel that shipping companies will buy in the future will become more expensive. That extra cost will eventually find its way into the price of the goods we import.

Finally, even after thirty years, I'll never forget the first time I drove to L.A. from Northern California. The smog was so bad that you could taste it, and after a couple of days my car had acquired a layer of shiny, metallic-looking dust. I subsequently spent 10 years in L.A., off and on, and by the time I left in the early 90s, there were many more clear days than smoggy ones. That was a tremendous achievement, involving the efforts of state and local regulators, citizens, and industry--even if the latter sometimes had to be dragged kicking and screaming. But as the Times article suggests, replicating this success with a different pollutant will require new thinking and novel strategies for dealing with another set of stakeholders. The risks of getting this wrong could be even larger than they were with ozone.

Specifying the Path vs. Choosing the Outcome
I'm struck by an unlikely analogy between the space program and alternative energy development. Consider the current plight of the US space shuttle. In spite of some intrepid inflight repairs, and assuming a safe landing by Discovery, the program will be hung up again with technical problems while engineers try to reconfigure the fuel tank insulation. Compare this to Russia's venerable Soyuz, whose managers brashly offered to throw together enough ships to rescue Discovery's crew, should that become necessary. The single-use Soyuz fleet has flown for 40 years--with some upgrades--and has had an exemplary safety record since the early 1970s.

Superficially, this resembles a classic tortoise-and-hare competition. Fundamentally, though, these two vehicles reflect the answers to two very different questions. Soyuz responds to a simple query: Can you build an inexpensive, reliable craft to carry humans to earth orbit and return them home? The Shuttle, on the other hand--for reasons related as much to Cold War strategic needs as to the scientific and technical goals that NASA was established to pursue--addresses a much more exacting specification, along the lines of: Can you build a reusable spacecraft to carry crew and large quantities of cargo and instruments to low earth orbit, loiter in orbit for extended periods, and return to earth and land like an airplane? The result is an infinitely more complex machine that has proven much more expensive and much less reliable than originally expected.

Now think about the US approach to our energy goals. The Energy Bill that awaits President Bush's signature includes funding for incentives and research that are fairly narrowly specified. There's money for coal gasification, for increased ethanol production, for incentives to induce consumers to buy hybrid cars, and so on. This money will get spent, and it will produce many of the intended results. But how will those results compare with the what we'd get if instead of specifying the path, it simply stated the desired outcome?

Instead of incentives for hybrid cars, for example, we could have had incentives based on graduated increments of gas mileage above the Corporate Average Fuel Economy standards. This could even have been made revenue-neutral by taxing cars getting equivalent increments of gas mileage below the CAFEs, all without changing CAFE. The result would reward efficient hybrids like the Toyota Prius or Ford Escape Hybrid, as well as efficient conventional cars like the Chevy Aveo or VW Jetta diesel, while treating hybrids like the Lexus RX400h as what they are, lifestyle choices that don't reduce fuel economy in a meaningful way. And with this kind of approach, we wouldn't have needed a separate category of incentives for fuel cell cars, as we will now have. Rather, the reward for an ultra-efficient car could have been set ultra-high, and any technology that would get us there would qualify. And that is my point in a nutshell.

The same issue came up in a conversation with a close friend in D.C. concerning coal gasification. She rightly pointed out that the answer to cleaner coal is not necessarily gasification--though I think it probably is. Rather, the answer is to specify what we mean by "clean coal" and to fund and reward anything that delivers on that. Imagine the entrepreneurial energy that would be unleashed if a portion of the money earmarked for specific line items in the Energy Bill were diverted to fund the energy equivalent of the X-Prize. It may not be good politics, but it would be very sound economics.

Chevron 1, CNOOC 0
CNOOC has apparently withdrawn its offer for Unocal, as of this morning. Given the support Chevron was garnering, including that of the proxy advisor, this was probably inevitable. Chalk it up to a successful PR campaign on Chevron's part, and to some tyro mistakes by CNOOC's management (and the Chinese leadership in Beijing.)

The most important lesson that should be drawn from this situation is to recognize that it was only the first round in a trend that is likely to continue. The underlying forces behind CNOOC's bid, including China's growing energy appetite, its limited resources relative to its population, and its still not-quite-market mentality favoring control of resources through direct ownership, suggest that we will face similar issues in the future. It would be helpful if that could happen in the context of some frank bi-lateral discussions concerning the "rules of the road" for future transactions in the energy space (or other areas we deem strategic.)

It's one thing to treat the first example as a one-off, resulting in some very mixed messages, but we'd better be prepared with a clearer and more consistent posture next time.

Changing of the Guard
The attention focused on the death of King Fahd and the ascendance of Crown Prince Abdullah, the de facto ruler since Fahd's stroke in 1996, reflects both the ongoing importance of Saudi oil and the durability of the dynasty founded against the odds by ibn Saud. Whatever your views on the role the Kingdom has played in events ranging from OPEC and the 1973 Embargo, the Middle East peace process, the expulsion of the Soviets from Afghanistan, the Gulf War, and the War on Terror, we all have a stake in a smooth transition. There's little reason to think it will be otherwise, since the much more interesting transition from the aging sons of ibn Saud to his grandsons' generation remains years off. In light of this, it's worth spending a moment thinking about the future energy role of Saudi Arabia.

Despite widespread assumptions that the Saudis, who have the world's largest reserves of crude oil, must bear the lion's share of future production increases, there's little indication of this from Saudi Aramco, the state oil company. In fact, the company has suggested (FT subscription may be required) that they will only be able to increase capacity to 12.5 million barrels per day by 2009, and to 15 MBD eventually. That could be as much as 4 or 5 MBD less than the world will need, unless other producers can make up the slack. (The CERA study I referred to the other day provides some reassurance in that regard.)

Pronouncements like this only serve to bolster the arguments of those who believe the Saudis have consistently exaggerated their reserves and hidden signs of imminent decline in the country's largest oilfields. I see a simpler explanation. Saudi Arabia suffers from the same problems as many other countries that rely on oil exports for their income, such as Venezuela and Algeria. A growing population with high, unmet expectations has forced the government to siphon off much of its oil earnings to pay for social programs and job creation, instead of developing more oil. The current price spike has been a two-edged sword, enabling them to stave off social unrest, but also allowing them to postpone urgently needed reform. At some point, though, even these inflated revenues won't be adequate, and the Kingdom will have to consider allowing in foreign investors, as an alternative to domestic chaos.

The flip side of this argument includes various scenarios for the overthrow of the Saudi royal family and revolution of some sort, whether democratic or Islamist. These predictions have been around for longer than I've been in the industry, and they've usually underestimated the tenaciousness of the al Saud clan, as well as their savvy political sense. But if something like this did occur, our Iraqi experience suggests we'd be unable to intervene effectively. We would have to ride out the storm, which would blow oil prices through any ceiling we can imagine, especially if it started with prices as high as they are now.

At the same time, though, the combination of less ambitious future production expectations and the advent of new energy technologies such as hybrid cars and gas-to-liquids plants suggests that the importance of Saudi Arabia's oil to the global economy may not grow as much as conventional wisdom would suggest. The longer the Kingdom resists opening its doors to foreign investment, the likelier this view will prove to be correct.

Watching the Fundamentals
Not many years ago, you could gauge the price and direction of oil and petroleum products in the US just by looking at the levels and trends of reported inventories. Anyone doubting that this no longer works, and that the US fuels market is strongly connected with the global market, need only look at the current market fundamentals as reflected in the inventories.

The Energy Information Agency of the Department of Energy released their latest weekly report on oil and oil products last Friday, showing production, imports, refinery utilization and inventories. The results are consistent with the recent pattern, with US crude oil inventories slipping but still at the top of their seasonally-adjusted historical-average range. Gasoline stocks exhibit a similar picture, both nationally and regionally, except for some tightness in the Rocky Mountains region. Distillate stocks (diesel and heating oil) are climbing toward the top of their seasonally adjusted range, as you'd expect. Anyone who'd spent the last several years on a desert island and was shown these inventory trends might reasonably think that crude oil was at about $25 and falling, with gasoline no more than a buck and a half at the pump.

So how can you have these kinds of market fundamentals and still be stuck at $60+ West Texas Intermediate crude and $3.00 gasoline? The details are complex, but I think two factors stand out. First, the fraction of crude oil we must import continues to rise, accounting for more than 10 million barrels per day (MBD) of the nearly 16 MBD run in US refineries. Imports of refined products also now make up about 10% of the 20+ MBD of gasoline, diesel and other petroleum products sold in the US. As long as the factors supporting the international prices of these commodities persist--high demand, tight refining capacity, and almost no spare crude production capacity--prices can't slip much here, no matter how high our inventories get.

Then look at the way that sustained demand growth shifts the relationship of historical data, when you compare inventory levels in terms of the number of days of demand they represent. With US demand rising 1 or 2% each year, after a few years a high absolute inventory figure can look average, or even low, in terms of days' usage. For example, US gasoline inventory reports for July 2005 averaged 212 million barrels, 6 million barrels higher than for the same month five years ago. However, the 2000 figure represented 24 days' demand, compared to 2005's 22.3 days. Effective inventory is 7% lower, despite totaling more barrels, because we are driving more.

All in all, then, while tracking of the EIA's raw statistics has suggested for some time that prices ought to be heading lower, I wouldn't bet on it until we see demand in China or the US slowing , or some sizable chunks of new production coming on line. We may have to wait until next year for either of these to have an impact.

Longer Days
In my discussion of the pending Energy Bill on Wednesday, I neglected to mention a provision that may actually have a greater impact on Americans than all the others combined: the extension of Daylight Savings Time (DST) by a month, starting next year. While its supporters argue this will reduce electricity demand by 1%, recent experience suggests that the net energy savings may be more modest and chiefly come in the form of load-shifting that would benefit areas where peak generating capacity is tight. But aside from its debatable energy benefits, the larger impact of extended DST may be symbolic, and I worry about the message being sent.

Anyone over 40 probably remembers the last time this step was taken. Daylight Savings Time was extended by President Nixon in the wake of the Arab Oil Embargo of 1973-74. Other responses to that emergency included the 55 mile per hour speed limit and the establishment of the Strategic Petroleum Reserve. But we're not really in an "energy crisis" now, but rather a market-driven adjustment to capacity constraints. What kind of signal does extended daylight saving time send, compared to the signals already being sent by higher energy prices?

More importantly, I'm concerned about the subtext of the message. "We're in a fix and the best we can do is reach back to a thirty year old emergency measure" doesn't really cut it for me. As I've suggested many times in this blog and in conversation with friends and colleagues, the most striking difference between the energy crises of the 1970s and the situation in which we find ourselves today is the wealth of options we now have: our sources of oil are more diverse, we have hybrid cars that can get more than 50 miles per gallon, natural gas is becoming a diversified global business--thanks to technology and cost improvements in LNG--and renewable energy, especially wind power, is ready for prime time. None of this was true in 1973 or 1979.

If adding a few more hours of evening daylight--and morning darkness--in March and November alerts Americans that we should be more efficient in our use of energy, that's great. But if it shifts our focus away from the real solutions that are now available to us and tells us that we are back in the same box as the 1970s, then it will merely be a counterproductive annoyance.

The Sierra Club and Ford
Hats off to the Sierra Club and Ford for finding a way to work together. While other environmentally-focused non-governmental organizations (NGOs) may feel that the Sierra Club has taken leave of its senses in helping Ford to promote a hybrid SUV, the Mercury Mariner, I think this represents a positive step towards addressing climate change and energy security in a context that will be palatable to most Americans.

It is certainly true, as a spokesperson from a more radical NGO--the Rainforest Action Network--implied, that even greater fuel economy and emissions reductions could be achieved if everyone just bought existing sub-compacts like the Ford Focus. However, the only way to make that happen would be by legislative edict. It hasn't even been possible to line up a majority of Congress to tighten the longstanding Corporate Average Fuel Economy standards for cars and light trucks, so don't expect a "mini-car mandate" any time soon.

As Amory Lovins of the Rocky Mountain Institute indicated in an interview in the Wall Street Journal's special section on the Car of the Future on Monday, the answer must lie in using technology to improve the performance of the cars people actually want to buy and drive. His suggested approach relies not only on hybrid engines, but also extensive use of carbon fiber materials to reduce the weight of cars without sacrificing safety. He makes a good argument that these interim measures would actually lower the hurdles that fuel cells must overcome for commercialization, and hasten a production fuel cell car.

Whatever the ultimate technology solution, which should be accompanied by effective policies to encourage Americans to reduce the number of miles they drive, it is important to get more cars like the Mariner on the road. If an endorsement from the Sierra Club helps that along, that's great.

The Missing Framework
As the pending Energy Bill gets closer to the final House/Senate conference version that will presumably be enacted, it is shedding provisions like an old jalopy racing down a bumpy road. This shouldn't come as a surprise, being in the nature of our democratic processes, but it is still a disappointment for many. I see it somewhat differently. The way individual proposals such as requirements for a set percentage of renewable energy or the goal of reducing oil consumption by a million barrels per day have gone in and out of the mix merely reflects a lack of consensus on the underlying problems we face. Energy security is an inadequate lens through which to view national energy policy, and the result has been a grab-bag of programs, rather than a coherent plan.

Consider the basic issues that need to be addressed:

1. Despite a reduction in the energy input required for incremental GDP growth, an expanding US economy still relies on steady increases in both electricity and liquid fuels supply.
2. Without fundamental changes in our energy mix, this results in a lock-step increase in greenhouse gas emissions.
3. Improvements in the fuel economy of the US car fleet have stalled as a result of consumer preferences for larger, heavier vehicles with more horsepower and more power-consuming accessories.
4. Demand for petroleum products continues to grow, at the same time that domestic oil production is in steady decline.
5. Domestic natural gas suffers from underinvestment in infrastructure, environmental ring-fencing of resources, and knee-jerk opposition to import facilities.
6. Any expansion of nuclear power hinges on a permanent solution to nuclear waste that has been delayed for decades by largely political concerns.
7. The growth of wind power has been impeded by inconsistent subsidies and local opposition.
8. Our largest alternative energy program, fuel ethanol, objectively contributes little to the overall energy balance of the country and may actually have been not only a financial drain, but an energy drain, as well.
9. The resulting increased reliance on coal shifts more of the burden to our least-efficient, most environmentally-challenging fuel.

At the highest level, then, we see a picture of a multi-trillion dollar energy system on an unguided, unsustainable path. However, without a clear definition of the problem and a clear set of goals and objectives--with accompanying timetables and investment plans--the likelihood of a change in direction is low, and any improvements are likely to occur only around the edges. Focusing on fuzzy notions of energy security doesn't help matters, particularly when relatively benign proposals to inventory the country's remaining unexploited oil and gas resources prove more controversial than an increased emphasis on nuclear power.

Even though a comprehensive approach to climate change has been a bitter pill for this country to swallow, it has the compelling advantage of providing a consistent, all-encompassing way of viewing our energy system and guiding its future development. The introduction of emissions trading in Europe--doubly ironic, considering our market orientation and the idea's US provenance--shows that limiting greenhouse gas emissions need not require the iron fist of command-and-control regulation, or a centrally-planned energy economy with bureaucrats choosing technology winners and losers. Even better, emissions caps based on rigorous analysis of all energy pathways would weed out ineffective measures and enhance energy security as a byproduct. Thus the most effective energy bill I can imagine would not carry that title at all, but rather the designation of Comprehensive Climate Change Legislation.

Diverting the Wind
Another article in last Sunday's New York Times got me thinking about the compatibility of renewable energy in the communities that host it. The article in question described local opposition to a proposed wind power development in upstate New York, with a past and possible future gubernatorial candidate offering financial support for the fight against wind. I would have normally ended up simply labeling this as NIMBY-ism, but for some reason I started considering what it would take satisfy the concerns of all parties in a situation like this.

Unfortunately, not all areas have equivalent wind resources. Developers need to go where the wind is suitable, blowing reliably and strongly at the elevation of the turbine blades. In some respects, this is analogous to lease-level oil prospecting, in which the mineral rights to underground energy deposits are the prize. But even in the heyday of the US oil industry, not everyone sitting on an oil reservoir wanted to see a derrick in his back yard, any more than everyone living near a prime wind resource wants to see 130 foot blades whirling away 250 feet above the ground.

Perhaps the resolution lies in deconstructing the outcomes of a wind power development and thinking about how to repackage them. After all, the output of a wind turbine is essentially an electricity flow and a rate of avoided emissions. Both can be quantified for a given location. From a public perspective, the same result could be achieved in other ways, via energy conservation projects, rooftop solar panels, or conventional power plants matched up with the requisite emissions credits. And given the growing sophistication of the financial services industry at developing tools and products to manage these kind of non-financial factors, there might even be a business opportunity here, to offer to communities that can't stomach wind power.

Imagine a town that objects to a proposed wind farm. Rather than spending money on PR and lobbying, what if they could find a banker or other provider willing to create a package giving comparable power and environmental benefits at a lower cost than the wind project? It might provide the community with a meaningful basis of negotiating with the developer, rather than just presenting petitions and arguments. Turning this into a financial instrument to be bought and sold avoids having it become an easy out, i.e. allowing opponents to say they will come up with the tradeoffs some other way, but then continuing the status quo. This sort of disciplined recognition of trade-offs is notably absent from the opposition to the Cape Wind project off Nantucket.

Now, I don't want my regular readers thinking I was under the influence when I had this idea. I am still opposed to most manifestations of the NIMBY instinct. In the long run, we will need lots of wind farms and solar arrays and conservation, as well as many new conventional (or nuclear) power plants, if we are going to meet our future electricity needs. But we're a long way from having used up all the good wind prospects, and not every town should be forced to take a wind farm, if they don't want it. Even if the notion above is a bit too wacky to work, I still think that market mechanisms offer the best prospect for growing the generating base while still accommodating those who insist on not living in the shadow of a wind turbine. It at least seems a more promising avenue than turning anti-renewable-power NIMBY-ism into a political campaign strategy.

In Whose Interest?
I've already devoted more space to the CNOOC/Unocal/Chevron tussle than I intended, but I can't fail to point out an excellent article on the subject in yesterday's New York Times. In addition to including my favorite quote of the week, characterizing China as "Walmart with an army", it includes concrete proof of something I said earlier this month, concerning the adverse impact of CNOOC's offer on its outside shareholders, who make up 30% of the company's total equity. A fund manager at William Blair & Company, which recently sold its stake in CNOOC, was cited by the Times saying, "If China is going to sell shares in a company like Cnooc to outside shareholders, it should not be run for the benefit of Chinese economic policy." Yet that is precisely what seems to be occurring, and why what should otherwise be regarded as a normal commercial transaction, along the lines of BP's acquisition of ARCO in 2000, has rightly drawn so much opposition.

Frankly, at this point the only parties clamoring for Unocal's board to accept CNOOC's offer are Unocal shareholders, whose enthusiasm for a higher price may be understandable but is too narrowly-based to outweigh larger concerns of national interest and policy. Now that the underlying forces behind this situation are evident, I hope that our lawmakers will consider measures that go beyond an ad hoc response to a single deal, but rather lay out the terms under which Chinese companies would be allowed to buy US companies in any sector of strategic importance. The first principle of such an approach should be reciprocity: CNOOC should not be allowed to buy Unocal until China's laws would permit ExxonMobil to buy Sinopec, or some other large Chinese energy company. That day is probably still a long way off.

Oil and the Yuan
Beware of getting what you ask for. For months the US government has been pressuring China to revalue its currency, to help bring the huge and growing trade imbalance between the two countries under control. Now China has acted, releasing the Yuan from its dollar peg. Even though the initial change is only a 2% increase in the value of the Chinese currency relative to the dollar, the new policy apparently allows Beijing to adjust this rate each day, so over the course of a few months, we could be looking at a significant change. At least in the short run, the new policy is likely to put further pressure on oil prices and may even worsen the overall US trade deficit.

The problem is that under globalization, the financial world is tremendously interconnected and replete with feedback loops of different sensitivity and speed. The obvious goal on the part of the US is to make Chinese goods more expensive in dollar terms, reducing demand for them and reversing the trade deficit. However, this could take a long time, because as the Times article suggests, US retailers of Chinese goods may resist raising prices immediately. And as long as the Chinese government is content to hold the even larger number of dollars it will be receiving, investing them in T-bills or equities, the normal feedback mechanisms of the currency markets will not come into play.

But while we are waiting for demand for Chinese goods to slow, something else will happen almost immediately: the price of oil for Chinese companies and consumers will fall, since oil is denominated in dollars. Cheaper oil will mean faster demand growth, and at the scale we are talking about in China, a small change can result in large volumes, as we've seen in the last few years. This could be enough to forestall or overwhelm the slowing in Chinese oil demand that most analysts were expecting this year. And that means that oil prices will stay higher, longer than otherwise.

Since steeper oil prices translate into a bigger bill for our oil imports, our overall trade deficit will grow until another lagging feedback loop, US drivers' response to higher gas prices, kicks in. As a result, the net short-term result of the Chinese revaluation is likely to be contrary to what was expected. That doesn't mean that it isn't the right thing for everyone in the long run, but it certainly reinforces the idea that there are no quick fixes for our current economic problems.

Understanding Natural Gas
I just ran across an excellent article on natural gas that I think is worth sharing with my readers. Gas played a crucial role in the resolution of the 1970s energy crises, and is widely expected to play an equally important role in reducing emissions from the electricity sector. However, as the article explains clearly, the ability of domestic gas resources to fulfill that role is in serious question, as a result of persistent underinvestment in infrastructure and governmental policies towards gas drilling in undeveloped areas. Despite the relationship between increased use of renewable energy and natural gas conservation that I pointed out recently, renewables cannot be expected to substitute for natural gas and coal and nuclear (depending on one's politics.)

While covering a lot of important ground, the article misses a few key points that are worth mentioning, to complete the picture:

• Whatever one's views about "peak oil", global gas supplies are nowhere near a geological peak. In fact, gas has really been exploited heavily in only a few selected areas, such as the US and Northwest Europe. The key problems in increasing global natural gas supplies are unrelated to geology, but are rather a function of investment, logistics, markets and regulation.
• An important reason for the current plateau in domestic gas supply is the inexorable decline in oil production here. This is a natural consequence of the depletion of US oil reserves, and it reduces "associated gas"--gas produced in conjunction with oil--in lock-step.
• Remaining gas reserves in the US are huge, not only in the off-limits areas described in the article, but also in Alaska. The "gas cap"--associated gas--of the North Slope field is enormous, and gas production equal to about 10% of total US supply has been reinjected into the reservoir, at least partly for lack of a market. Together with other Alaskan and remote Canadian gas it could fill much of the anticipated supply gap, if sufficient pipeline capacity were built. This is what is at stake in the Congressional debate about a trans-Alaska gas pipeline.
• LNG cannot restore the US to an era of cheap gas, even if an unlimited number of import terminals were approved and built. Imports will play an increasingly important role in meeting demand, but current landed LNG prices, while below today's high levels, are still at least double the historic US natural gas price. The full economic consequences of permanently expensive gas have yet to manifest fully, in terms of the offshoring of gas-dependent petrochemical and other industries from the US to regions with cheaper supply.

For various reasons, natural gas has always been treated as less glamorous than oil and now operates in the shadow of cleaner, sexier alternate energy technologies. However, it provides just under a quarter of the total energy we use, on a par with coal but with less than half the greenhouse gas emissions. It would be a disaster for this contribution to slip, but that is precisely where we are headed without a major reappraisal of our national priorities. The gas provisions of the current Energy Bill are a small but positive step in that direction.

Staying Power
A couple of weeks I ago I looked at some lessons learned from the energy crises of the 1970s. These included the undesirability of direct government intervention in markets, the value of supply diversification, and the nature of the market's response to high energy prices. But one of the lessons I neglected to mention deals with the importance of planning for an unexpected future, when investing in alternative energy projects. This is nicely illustrated by a recent article from MIT's Technology Review on the history of the Dakota Gasification Company.

Dakota started as an energy crisis project to turn coal into synthetic methane. As the article explains, it was built assuming the future price of natural gas in the US would be $9 or $10 per thousand cubic feet. Although it has approached or exceeded that level recently, the company had to survive almost two decades in which it was between $1 and $3. The original buyers of the gas canceled their contracts, the investment was written off, and Dakota essentially went bust. The reason it has survived and now looks like a model for the future is not just high energy prices, but an unexpected benefit from one of the plant's byproducts, carbon dioxide, which was also starting to look like a liability in a world increasingly focused on climate change.

In a classic lemons-to-lemonade story, Dakota is now selling CO2 to a Canadian oil company that will use it to enhance oil recovery from a declining field, and in the process lock up the CO2 geologically, preventing it from entering the atmosphere for millennia or longer. This is only possible because in gasification, unlike conventional coal combustion, the inevitable CO2 exhaust is concentrated enough to be handled in this way and create side-benefits.

Without realizing it, the original investors in this 1970s coal-to-gas plant also purchased an option on future sales of carbon dioxide. And that is precisely the lesson worth remembering for anyone investing in ethanol plants, wind farms, and new generations of alternate energy: the future might not be quite as green, or the price of energy quite as high as you expect. Prepare for volatility, and think about the other options your project can create at little or no cost today, but that might be the difference between success and failure in an unpredictable future. A project that is prepared to capitalize on a wide range of outcomes is a much better investment than one that requires a specific result to be profitable. And that's a lesson that's not just limited to the energy industry.

The G-8 and Climate Change
The G-8 summit in Scotland was overshadowed by the London bombings and dominated by aid for Africa. Climate change, intended by its British hosts to be a major focus, got shorter shrift. However, this relatively upbeat report from the Economist highlights some encouraging news from the meeting. Whatever the geopolitical pressure on America, or the scorn heaped on George W. Bush, the position of the US on the Kyoto Treaty is now largely moot. It's getting very late to have much impact on US emissions in the 2008-12 timeframe included in the treaty, and the attention must begin to shift to the post-2012 world, and to what needs to be a much more ambitious and comprehensive global approach on climate change, if it is to matter.

The EU has certainly embarked on serious measures to reduce the emissions of its member states, in line with their targets under Kyoto, but even if they succeed, their efforts cannot compensate for the growth in emissions in three countries: the US, China and India. Nor can any successor to Kyoto, addressing the post-2012 period, be successful without including them. A Kyoto II agreeable only to the EU and the smaller countries is unimaginable for two reasons. It would be practically irrelevant to halting the increase in atmospheric greenhouse gas concentrations, as the EU's share of global energy usage and GDP shrinks, and it will be unacceptable to EU members, for reasons of economic competitiveness, real or perceived.

So if the recent G-8 has set the stage for new climate change talks engaging all parties on a basis that they are willing to discuss, its work in this area could be looked back on as being of greater significance than its well-intended efforts concerning Africa.

Hybrid Purpose
Few advanced energy technologies generate more interest and excitement than hybrid cars. However, not all hybrid cars save huge amounts of fuel, as explained in this article in Sunday's New York Times. Nor did the Times mention the new "mild hybrid" pickup trucks, such as the Chevy Silverado, that are barely hybrids at all and get little better mileage than their conventional twins. With the federal and various state governments offering tax credits for consumers who buy hybrid cars, should these be restricted to hybrids that deliver substantial fuel savings, or are all hybrids worthy?

In some respects, this is a problem we've created for ourselves, by targeting government support at a specific technology, rather than offering credits based on actual fuel economy--which is presumably the end goal at issue. (We will face the same problem when fuel cell cars hit the road.) But since we're in this pickle, I'd opt for generosity, for two reasons. First, hybrids are a critical tool for retarding the further deterioration of fuel economy in the US. As the Times article noted, the long-term consumer trend has diverted most of the advances in engine technology in the last 20 years and yoked them to hauling heavier and heavier cars with ever greater acceleration. So the context for the Lexus RX-400h luxury hybrid SUV is not just its conventional version, but competing SUV's such as Volvo's XC90, which has just launched its first V-8 engine to meet customer demands for more power. A peppier hybrid six-cylinder is still likely to use less fuel than a V-8 with comparable performance, and is thus a step in the right direction.

In addition, every new hybrid put on the road advances the technology and moves manufacturers down the learning curve. This will result in better and cheaper hybrids in the future. It's important to remember that hybrids are still at about 250,000 cumulative units sold, while conventional cars are well over a billion.

This is an issue that should be resolved sooner rather than later, because within a few years there will be dozens of hybrid models available, with even greater confusion about the benefits provided.

Sticking Point Over MTBE
Once again, final reconciliation of House and Senate versions of comprehensive energy legislation may hinge on whether agreement can be reached concerning protection from litigation arising from the use of the gasoline additive methyl tertiary butyl ether, or MTBE. At first glance, this provision seems to be yet another handout for big business. However, careful consideration of the history of MTBE use and the likely future path of fuels development suggests that some level of industry protection is justified and appropriate.

Widespread use of MTBE, which is soluble in water and can produce strong odors at very low concentrations, began in response to regional air quality regulations and the Federal Clean Air Act of 1990. These rules introduced “reformulated gasoline”, designed to produce the fewest pollutants from cars lacking the latest smog-reduction equipment. In urban areas with high levels of air pollution, this fuel was required to include chemical compounds containing oxygen, in order to reduce carbon monoxide emissions.

To meet this oxygen specification, oil companies had two choices, both of which were approved by the federal government and by most of the state governments involved: ethyl alcohol (ethanol) and MTBE. MTBE was less expensive, even after factoring in the tax subsidies for ethanol. More importantly, gasoline with MTBE could be shipped through efficient networks of regional petroleum product pipelines, while gasoline containing ethanol could not. The choice of MTBE helped consumers by reducing costs and shoring up the reliability and flexibility of the gasoline distribution system.

Thus the companies that used MTBE in their reformulated gasoline did so at the behest of, and with the full approval of the relevant regulatory bodies. It hardly seems fair now to saddle these companies with the entire burden of universal shortsightedness about the consequences.

Beyond this issue of fairness, turning MTBE into the next asbestos or tobacco litigation bonanza could have adverse longer-term consequences for the environment. The effort to improve the environmental qualities of automotive fuels is an ongoing process, with regulations already on the books to reduce the sulfur content of gasoline and diesel fuel. Looking farther ahead, we will not know the full consequences of using alternative fuels such as methanol or hydrogen on the same scale as gasoline, until we are actually doing so many years down the road. Exposing the motor fuels industry to a wave of product liability lawsuits at the same time we need it to invest in the next phase of gasoline reformulation or the creation and marketing of even more exotic fuels is counterproductive and shortsighted.

The main objection to MTBE tort relief comes from state and local authorities whose jurisdictions face costly cleanups of water supplies that are contaminated with MTBE, at a time when public funds are tight. They need someone to foot the bill and don't want to see the deepest pockets in sight let off the hook. In the final analysis, though, the public benefits derived from the reduction in air pollution attributable to reformulated gasoline outweigh the costs of MTBE cleanup. The air quality regulations of the 1980s and 1990s achieved many of their goals, although with a classic unintended consequence, in the form of MTBE pollution. Shouldn't the ultimate responsibility for the fallout from MTBE rest with--or at least be shared by--the governments and agencies that established the clean fuels mandates and approved MTBE for widespread use, and that can also claim the credit for the improvements it brought? On this basis, giving the energy industry relief from MTBE litigation is a reasonable proposition.

How Strategic Is Unocal's Oil?
CNOOC's bid for Unocal is slated to go before CFIUS, the Committee on Foreign Investment in the United States, where the various concerns about its national security implications will presumably be debated at length. So far, I've focused my comments on the energy and business implications of this transaction, the basis of which leaves me skeptical about CNOOC's motives. However, there's been plenty of commentary both here and elsewhere about the geopolitical aspects. An idea just occurred to me that just might help to crystallize the basic issues at stake, by putting them into quantifiable terms.

The dilemma is that, from a trade standpoint, the laws and regulations of the United States treat oil no differently than any other commodity. If anything, in the post-deregulation era since the early 1980s, the domestic oil industry has received notably less overt protection than steel, textiles, and any number of other products of lesser importance to the functioning of our national economy than oil. We have allowed our indigenous oil supply to wither, as natural depletion reduces the productive potential of resource basins that have been exploited for decades, while we place other known deposits of oil off-limits to drilling for environmental and other public policy reasons. When combined with an unrestrained appetite for increased oil consumption, the inevitable result has been to roughly double the share of imported oil in our energy mix in the last 20 years.

But even as we continue to treat this strategic commodity more or less in accordance with the principles of free-market economics, we are deeply concerned about the possible acquisition of a mid-sized US oil company--the best assets of which lie in Asia--by an Asian company, and in particular a semi-privatized Chinese state enterprise. In the absence of a comprehensive energy policy governing all kinds of investment, it certainly looks like we are talking out of both sides of our mouth.

Is there a way to quantify the national security value of Unocal's production or reserves? I can think of several, but here are two fairly simple approaches. First, look at Unocal's domestic oil production. According to Unocal's 2004 Annual Report, this amounts to 70, 000 barrels per day (bpd), ignoring natural gas that couldn't easily be exported. Let's assume that the long-term price is now $40/bbl and that it costs Unocal $20/bbl to produce this oil. Having to replace that production with imports, in the unlikely event that CNOOC chose (and was allowed) to export it, would increase the US trade deficit by $500 million per year, for a net present value of $3.7 billion at 6% interest over 10 years.

A simpler approach is to consider control as a proxy for the national security value. Comparing the two competing bids for Unocal, the CNOOC offer is higher by about $1.7 billion. This could be thought of as the premium for foreign control, over and above the fair market value established by Chevron's bid, assuming no other US company would have paid more.

Looking at the combination of these two approaches suggests that the value of keeping Unocal in US hands is somewhere between $1.7 and $3.7 billion. The best way to resolve a situation that risks igniting a trade war with one of our largest trading partners might simply be to offer Chevron tax credits or other considerations in the range of $2 billion, to enable them to outbid CNOOC without destroying value for Chevron's shareholders (including me.)

Now, you can argue that this would constitute a form of highly selective corporate welfare, or violate WTO rules, or that $2 billion could be better spent on funding alternative energy research. All of these might be true, but framing the problem this way at least concentrates our thinking about what it's worth to keep Unocal in American hands. After all, simply blocking CNOOC's bid by fiat, on shaky political grounds, seems certain to cost this country much more than $2 billion in the long run.

Voiding the Warranty
Looking forward to my 30th high school class reunion this summer reminds me of a time when my car's engine was simple enough to work on with a crescent wrench and a pair of pliers, instead of looking like a prop from the latest Star Wars movie. I have fond memories of fiddling with my first automobile, a very used '65 V-8 Mustang. I mention this by way of establishing that my heart is with the folks who want to tinker with the way their Toyota Priuses use electricity, including the addition of a plug to recharge them from the grid. This sort of urge is what made this country great. And without innovators like this, providing a little external, unfunded R&D for Detroit and Yokohama, the evolution of cars would be slower than it is. But I must admit that I'm a little offended by the idea of someone charging $10,000 to add a plug and exchange the advanced nickel metal-hydride batteries of the Prius for a bunch of low-tech lead-acid batteries, just for the privilege of driving a few miles in pure electric mode.

I'm sure Toyota isn't kidding when they say this modification would void the warranty on these cars. Given the uncertain future maintenance needs of even a totally stock hybrid car, this risk should not be taken lightly. Notwithstanding the extra cost, swapping out the batteries and power controller (hardware and/or software) seems very likely to shorten the lifespan of of this very sophisticated and hardly inexpensive car.

Nor do the potential fuel savings justify this kind of investment, since $10,000 worth of gasoline at today's prices would take a factory Prius more than 150,000 miles. While it's true that a "plug hybrid" that was driven mostly short distances could stretch its gasoline usage to a truly remarkable degree--100 miles per gallon or more--the electricity it would use instead would be neither free nor non-polluting. The degree to which this would truly benefit the environment depends on the composition of the local grid power, which in many areas is fueled by coal.

Plug capability could make lots of sense for the next generation of hybrid cars, and I would encourage all of the carmakers to pursue this technology vigorously. But modifying an existing car that is already a paragon of fuel economy, greenhouse gas emissions reductions, and practically pollution-free driving makes little sense. It's a nice concept as an engineering prototype, but bad news for environmentally-focused consumers at this point.

Solar Potential
What would it take for solar power to move out of the niches to which it's been confined and start to compete directly as a primary source of energy? Cost is one of the biggest factors, and several new technologies for solar collectors offer the prospect of significant reductions, as described in this article from the San Francisco Chronicle. But the cost of collectors is not the only obstacle solar must overcome. Like wind, solar power is an intermittent source, and this must be factored into how and where it can be used. Even with the potential for lower unit costs described in the article, solar has a ways to go to compete on a level playing field with electricity derived from fossil fuels.

It's also not clear which is the most relevant cost on which to focus. The above article compares only capacity costs (though this is never clearly stated) that relate to the expense of building and installing a power plant or solar array. These costs are measured in dollars per kilowatt (kW) of capacity. This is a poor basis for an apples-to-apples comparison, however. The market tends to look at the price of flowing electricity at various points in the distribution system, measured in cents per kilowatt-hour. Consumers ultimately pay the retail price, while generators and traders deal with various levels of wholesale pricing. Solar is hard to compare on a flow basis, since its costs are essentially all capacity-related, with a negligible ongoing cost. Its pricing on a delivered unit of electricity basis depends on many assumptions, particularly with regard to financing.

For example, a 2 kilowatt solar rooftop array for consumers would cost $2,000, based on the most optimistic figures ($1,000/kW) from the article and ignoring costs of installation, DC/AC conversion, and other factors that would increase the real-world installed cost significantly. This also ignores any tax credits that might be available. In a favorable location such as Southern California, such a system would collect on average 5.5 peak sun hours per day, generating about 3200 kW-hours over the course of the year, after wiring and inverter losses and sun-angle factors. If the cost of the solar panels is amortized over ten years at 6%, this translates to an effective cost of electricity of 8.5 cents per kW-hr.

This figure would be competitive with retail power costs in most of the country, but not with wholesale costs or the prices many large businesses pay. In other words, while a roughly five-fold cost reduction versus the current technology would position solar power nicely in the market for home power--a sizeable market to be sure--it still misses most of the business/industrial market, even ignoring the substantial added costs of turning its intermittent output into a continuous, reliable power source by adding storage (batteries or ultracapacitors) or generating hydrogen for use in fuel cells.

When fully-deployed, mass-market rooftop solar power would have a major impact on utility planning for peak generating capacity needs, without affecting baseload power demand much. Paradoxically, then, this puts rooftop solar in competition, not with coal-fired or nuclear power plants, but with gas-turbine plants that are already among the most efficient and environmentally-benign energy assets out there. In effect, cheap solar panels are really a way to reduce natural gas consumption in the electricity sector, freeing it up for other uses (or reducing future import requirements.) I wonder if this is what most solar advocates have in mind?

Energy and the War on Terrorism
In the wake of the London terrorist bombings a spate of op-eds such as this one from the Detroit Free Press are suggesting that energy independence is the key strategy for winning the war on terrorism. The author cites Tom Friedman's Geo-Green editorials and endorses hydrogen as the ultimate answer, in spite of substantial remaining uncertainties about sources, storage and delivery methods. I truly wish it were that simple. I rarely make firm predictions, but I feel safe stating that the War on Terrorism will be over before the US achieves energy independence. As daunting as it seems, dealing with Islamo-fascism and the Al Qaeda death-cult will probably turn out to be the easier of the two tasks, besides being more urgent.

In addition, recent events have undermined the suggested linkage between Middle Eastern oil and the wellspring of terrorism. Trickled-down oil money--and the degree to which it was either sanctioned or ignored by our Middle Eastern allies--may have been a vital ingredient in launching Al Qaeda, but the London bombings, like the Madrid attacks before them, are indicative of more of a "retail model" of terrorism. It draws on grassroots support from a minority of radicalized Moslems in Europe and elsewhere. You don't need oil billions to fund this kind of terrorism, and this fact makes it look somewhat naive to think that putting downward pressure on oil prices will somehow lower the "terrorism index."

Rather than chasing the the chimera of energy independence, there are a host of things we can and should pursue to make our need for imported energy more manageable within a few years, rather than decades. We need to promote energy efficiency, stimulate new energy technologies, and lower the barriers for implementing many projects that require only permits, not R&D. But switching to a hydrogen economy, along with the transformation in primary energy this would require--hydrogen is only an energy carrier, not an energy source--hardly constitutes a quick solution. It could easily take 20 to 30 years, and if the terrorists aren't all in early graves by then, we will have much bigger problems to contend with than a conventional attack on London's mass transit system or the other tactics we have seen so far.

Refueling Safely
One of the positions I held during my 20 years at Texaco involved extensive dealings with the company's Asian refining and marketing affiliates. Self-service gasoline stations were just coming into vogue in Japan, and my department arranged numerous tours for Japanese marketing executives eager to see how self-service worked here. Their biggest concern always ended up being safety: how can so many people refuel their own cars without setting them--and the stations--on fire? At the time, this argument seemed like a smokescreen for a general reluctance to change. Now here's a rare-but-real example, captured on video, of what these guys were worried about: a car in an Oregon service station bursting into flames during a routine fill-up.

The article from the Oregon newsite is undoubtedly correct in blaming static electricity for this mishap. Such incidents occur sporadically, averaging about 1 per month in the whole country, but with wide variability in the data. The data also show that most of these accidents happen in the winter months, though this is probably skewed by the heavy weighting of population in states with high summer humidity. A hot summer day in Oregon would be as good a candidate as a cold winter day in Michigan for the dry conditions needed to generate enough static charge to ignite gasoline vapors.

The good news is that such fires are exceedingly rare, literally about a one-in-a-billion chance event (once per month out of about 4 refuelings each for 236 million registered vehicles.) They are also easy to prevent. Touching the body of your car after you exit the vehicle and before you open the gas cap or handle the fuel nozzle should be sufficient to ground you and prevent any static discharge. This is a good habit to develop, year-round. And while the owner of the Ferrari in Oregon wasn't injured, I don't envy his efforts at convincing his insurance company to cover the repairs.

Mr. Fu's Letter
First and foremost, my sympathy and solidarity goes out to any readers in London, and to those with family and friends there. I rode those trains and buses for two years and can only imagine the shock and literal terror of today's events.

The potential acquisition of Unocal by CNOOC constitutes a sort of Rorschach inkblot for US feelings about China and its growing economic and political muscle. Yesterday's Wall Street Journal carried a lengthy op-ed by CNOOC's chairman, Mr. Fu. This well-written document doubtless reflects the input of CNOOC's team of American advisors, in an obvious attempt to shift public sentiment. The letter touches many of the hot buttons identified by Congress and others skeptical of the merits of this deal: US oil imports and energy security, jobs, CNOOC's track record in international partnerships, and its market orientation. It makes a compelling case. The only thing that I find notably absent is the "industrial logic" of the merger, the concrete value-added for CNOOC's shareholders (Unocal's would simply get cash.)

In laying out his arguments, Mr. Fu allays some of the obvious concerns about the disposition of Unocal's oil and gas: US production to remain here (and grow) and Asian production largely committed to other markets, such as Thailand, or managed by the host country, as in Indonesia. But if all of Unocal's production stays where it is, what does CNOOC--and China--get out of the deal? If all the employees are expected to stay, how will any cost savings be generated, no matter how short-term they might prove to be? Where are the synergies, in all senses of that word, of a deal that entails a substantial premium over Unocal's current market value? In other words, where is the new economic value for CNOOC's shareholders that would compensate them for paying an above-market price for these assets?

Now, on one level, the answer to this question is really between CNOOC, its shareholders and its banker(s). But it does raise questions about the degree to which a transaction like this can truly be all things to all people, and whether all of the promises implicit in this can be met over time. By comparison, the logic of Chevron's offer is self-evident, and I can speak to it from personal experience, as a former Texaco employee. Chevron stands to benefit by the absorption of Unocal's assets and activities into its own businesses, particularly Chevron's own longstanding but growing presence in Asia. Layoffs and operational efficiencies will generate cost savings, and it's a good bet that within two years of the transaction, half of Unocal's original workforce will be gone. Such a package contains pros and cons for Unocal's stakeholders, but it's a pretty clear picture. The CNOOC bid remains a good deal fuzzier, nor has Mr. Fu's letter clarified things.

I don't feel I need to add to the list of geopolitical concerns being raised by others. There is clearly more at stake in this transaction than a simple business merger. But I'm not sure those other issues are as central to the business proposition as this question of exactly how CNOOC expects to benefit without doing anything that someone would object to, whether rightly or wrongly. I'll be listening carefully for the answer in the weeks ahead.


FYI, in the in the interest of full disclosure I should mention that I own Chevron stock and options.

Killing the Goose, or Just Plucking It?
A recurring theme in my blog over the last year and a half has been the challenges facing energy companies in getting access to the reserves of oil and gas necessary to replace their current production and expand for the future. This article from yesterday's New York Times nicely illustrates the problem, which has grown in tandem with higher oil prices. But it also provides a few hints about the potential downside for countries looking to turn the screws a little tighter on companies that are already committed to expensive projects--and reliant on the market capitalization these booked reserves generates. Neither side should forget that oil is a long-term business, and that feasts have been known to turn into famines.

The current combination of high demand, industry consolidation and limited access to new opportunities certainly gives resource-rich host countries extra leverage in negotiating--or renegotiating--contract terms with the international energy companies. For the remaining large players, Exxon, BP, Shell, Chevron, and Total, only very large oil and gas projects are big enough to materially affect their bottom lines and reserve statistics. Only a handful of countries offer such opportunities--setting aside places like Saudi Arabia and Mexico that are essentially closed to foreign investment. At the same time, Chinese and Indian firms, with rapidly growing home country demand, are keen to sign up deals at terms that would make the majors blanch.

Right now, if you are one of these big, resource-rich countries (e.g. Russia, Venezuela, Kazakhstan, etc.) the downside of demanding all sorts of extra benefits and extracting the last dollar in taxes and royalties on your contracts must look negligible, compared to the upside. This is particularly true, if you subscribe to concerns about a potential imminent peak in global oil production and see no limits on the economic growth prospects of Asia. However, in spite of all of these arguments, there might just be a case for reasonableness and honoring previous contractual agreements.

The Economist recently cited a report by Cambridge Energy Research Associates (CERA), a bunch of very smart folks, who tallied up all known global oil projects that are already committed and concluded that oil production could grow by as much as 16 million barrels per day by 2010. This neatly answers a question I've been asking since the start of my blog, about the project-by-project buildup that gets to 100 million barrels per day of production. And although I've not seen the data, CERA is a reliable enough source that I would accept it within the context of its assumptions.

What does this mean for producers and for prices? A potential glut, or if not a glut, at least a return to a more comfortable supply/demand balance with a sizeable cushion in reserve. It would take five years of demand growth over 4% to eat up this kind of additional production, while five years of 2% growth would leave 7 million barrels to spare. Prices would fall, competition for new projects would ease, and companies would have long memories about how they had been dealt with when oil was tight.

Now, if you're Russia, with arguably some of the best conventional oil prospects left outside the Middle East, that may be little cause for concern. On the other hand, if you are Venezuela, with its state-run oil industry in tatters after the post-strike layoffs and the diversion of its cash flow to social programs, relying on investments by international companies just to maintain current production, you might want to think twice before changing the terms of existing deals. And if you are Bolivia, with a little bit of natural gas and a populace apparently dead-set on taxation that approaches expropriation, you could just end up out of the game completely, for good.

Overall, companies need to recognize that they are dealing with sovereign entities with more complex needs and new alternatives, while countries should see that companies need reliable contracts and consistent terms, along with a good share of the occasional upside that offsets the lean times that have traditionally followed. Excessive greed on either side can have disastrous results, later.

Decarbonization Model
Despite President Bush's statements about the lack of quid pro quos on climate change vs. Iraq, global warming will be an important topic at the G8 summit getting underway at Gleneagles, Scotland. Two related stories out of the UK caught my eye this weekend. The first item described the UK's provisions for importing LNG, as it becomes a net gas importer for the first time in more than a decade. The second announced the construction of a new kind of power plant in Scotland, in which natural gas will be converted to hydrogen and fed into a gas turbine, with the resulting carbon dioxide piped into an underground reservoir. Building this kind of power plant in the knowledge that Britain will have to import a growing share of its gas needs says a great deal about the country's commitment to reducing greenhouse gas emissions.

Natural gas is already one of the cleanest fuels for power generation, in terms of both traditional pollutants such as oxides of sulfur and nitrogen, as well as carbon dioxide emissions. Converting gas to hydrogen consumes about a third of its energy content, turning it into heat that will be difficult to recover and use. As a result, while the hydrogen-fired gas turbine will produce emissions-free electricity, it won't win any prizes for efficiency. That means that it will consume more natural gas to produce the same amount of electricity as a conventional gas-turbine plant. There's nothing inherently wrong with that, but it's a remarkable choice in a country that is at the end of its long run of energy self-sufficiency, as production from the North Sea oil and gas fields declines. (Norway built a similar plant a few years ago, but it remains a large gas exporter.)

The energy situations of the UK and US are clearly different on a number of fronts besides just scale. But as the leaders of the industrial West discuss these issues this week, President Bush should be aware of the degree to which Prime Minister Blair is "putting his money where his mouth is" on climate change.

Happy Independence Day

The Wrong Lessons?
Last night over dinner with friends we discussed some of the differences between the oil crises of the 1970s and our current situation. Given editorials such as this one from Wednesday's Wall Street Journal, it's apparent that the lessons from that earlier period need to be assessed and updated to account for the changes of the last several decades.

Some of the key learnings from the 1970s have held up well:

• Direct government intervention in energy markets to affect prices is counterproductive, in both the short- and long-term.
• Diversification of supply is a top priority for enhancing energy security, balanced against proximity and reliability of major suppliers.
• The price-elasticity of demand for oil products is not zero, but the response takes time, as consumers and industry readjust their practices to accommodate higher energy prices.

But, as exemplified by the WSJ editorial, much of the conventional wisdom about alternative energy needs to be revised. It is fair to say that government investments in alternative energy technology (e.g., wind and solar power) or production (e.g., shale oil) played little or no role in ending the energy problems of the 1970s. Decontrol and the free-market stimulus to new production, along with a good deal of fuel-switching to natural gas, effectively neutralized OPEC's market leverage by the mid-1980s. But that does not mean that the alternative energy provisions of the pending Energy Bill in Congress should be likened to the Synthetic Fuels Corp. and other Oil Crisis dead ends.

We find ourselves in very different circumstances from those of 1979. Alternative energy technologies that were clearly not ready for "prime time" then are today moving into the market, some with subsidies but others on their own merits. Wind power is almost competitive with gas-fired power plants, on an incremental basis, and Canada already produces 40% of its oil from oil sands deposits. While continued taxpayer investment in major new systems such as hydrogen is still necessary, other alternative energy sources would benefit more from legislation to streamline the permit approval process. This is particularly true for LNG and wind power.

At the same time, conventional oil supplies offer no silver bullets. At their peaks, the North Slope and North Sea contributed over 8 million barrels per day to non-OPEC oil production. The Caspian Sea region and the Arctic National Wildlife Refuge might provide a bit more than half that much in new production.

Finally, the Strategic Petroleum Reserve, a cornerstone of 1970s energy policy needs to be totally rethought. It still serves as an insurance policy against a catastrophic disruption in oil imports, and the Administration has been right to resist calls to release SPR oil to moderate prices. However, commercial stocks have fallen as a function of increases in SPR levels, because the present structure of the SPR creates a disincentive for holding commercial inventories of oil. Providing positive incentives to increase the latter would do more to dampen price volatility, while positioning oil precisely where it would be needed in the event of a supply shortfall.

Simply put, while the current energy market bears some similarities to the oil crises of the 1970s, dealing with it effectively requires critical reassessment of what we think we learned from our previous experience with high oil prices. Much has changed in the intervening thirty years, and we have new tools available to us.