Gas-to-Liquids Impact

Yesterday's New York Times featured a story on the growing global industry to convert natural gas into synthetic diesel fuel, but it stopped well short of considering the implications of this expansion. Neither did it convey a clear idea of what is driving this development, beyond the economics of high oil prices. The actual story is more complicated. Although gas-to-liquids (GTL) has many positives, there is at least one significant drawback worth considering.

The historical perspective in the article was generally correct. The science behind this process has been around for many decades, helping to fuel Hitler's armies in World War II. Interest was revived in the 1970s, with plants built not just in Apartheid-era South Africa but also in New Zealand. Until very recently, however, GTL products have been much more expensive than conventional refined products from crude oil. The first large new GTL plant, a Shell facility in Malaysia, was helped by sales of valuable waxes and other byproducts, but the global markets for these products are too small to drive broader GTL expansion.

The prize here is twofold: harvesting the locked-up value of natural gas fields that are too far from markets to justify building pipelines, and producing diesel fuel that burns more cleanly than conventional diesel, especially with regard to particulate pollution. The Times cites a study by Cambridge Energy Research Associates (CERA) suggesting that GTL will contribute almost a million barrels per day of synthetic liquid fuels by 2010 and up to 2 million by 2020. As the cost per barrel of building GTL capacity falls, these numbers will continue to ramp up, tapping trillions of cubic feet of "stranded" gas. And there's the rub. At some level, GTL competes with the other technique for bringing stranded gas to market, LNG, or liquefied natural gas.

Today there's plenty of gas to fuel both processes, and the criteria for choosing one or the other are different enough that both can coexist. However, GTL has important advantages over LNG. Its output ships in conventional product tankers, rather than the expensive floating thermos bottles required by LNG, and it doesn't need costly and NIMBY-prone receiving infrastructure. If the capital costs of GTL fall faster than those for LNG, the former could eventually squeeze out the latter.

That would complicate plans to cover a growing fraction of US natural gas demand with imported gas, largely in the form of LNG. If the source gas isn’t available, because it’s been turned into diesel, then power plants will have to burn other fuels. While that could spur demand for additional renewable electricity from wind and solar, these are intermittent sources, so at some point there’s no substitute for a fossil-fuel fired plant, unless it’s a nuclear reactor. To put this in perspective, the 150,000 barrel per day Exxon project cited in the article will consume 1.8 billion cubic feet per day of gas, about the same quantity used last year by all the gas-fired power plants in the Northeast (New England plus NY, NJ and PA.)

As a consequence of these downstream tradeoffs, the net long-term environmental benefits of GTL are ambiguous. GTL fuel certainly burns cleaner than regular diesel, and that’s important because of the growing demand for diesel fuel, particularly in Europe. But the energy consumed in making GTL diesel dissipates much of the greenhouse gas benefit available from using natural gas directly, and the choice of GTL over LNG could result in more emissions from coal use.

Even if none of this product ever turns up at a service station in the US, it will still have a positive impact on fuel prices. The quantities of GTL under development may be small, relative to global oil consumption of 84 million barrels per day, but they represent an important component of incremental supply, where a million barrels per day one way or the other could be the difference between $35 oil and $50 oil. And by helping cover Europe’s growing diesel deficit, it will ensure that the US can continue to rely on a source of gasoline imports that we’d be hard-pressed to do without.

On balance, then, GTL is an important new source of clean liquid fuels, contributing to the global oil supply, but it complicates the prospect for wider use of natural gas in countries reliant on imports of LNG, including the US. As a result, its total environmental impact is mixed.

Hot Hybrids?

As I combed through email over the holidays, I ran across an interesting article from MIT's Technology Review about the potential to tap waste energy in cars using "thermoelectrics", which convert heat directly to electricity. The article focused on the possibility of using these materials to capture heat, e.g. from the car's exhaust, to run accessories or power steering. It now occurs to me that the best use of this technology might be as an adjunct to hybrid systems, boosting the stored electricity available to drive the car. That could make hybrids more efficient and attractive in the long run, giving fuel cells an even tougher competitor to beat.

The "holy grail" of energy efficiency is converting most of the chemical energy of our fuels into useful power, and much less of it into waste heat to the environment. The internal combustion engines that power our cars do a terrible job of this. The theoretical maximum efficiency of a heat engine is around 40%. Most car engines are lucky to deliver half of that, in the real world. In other words, for every gallon of gas you buy, you are only benefiting from the energy content of about one-and-a-half pints. What if you could turn that into 3-4 pints?

Two of the most popular energy efficiency technologies today, the hybrid car and the combined cycle gas turbine, are aimed directly at capturing energy otherwise lost as heat. This is done directly in the case of the CCGT, by using the hot turbine exhaust to generate steam to run another turbine, and indirectly in the case of a hybrid car, which recycles some of the energy lost in braking. Marrying a hybrid car drivetrain with thermoelectric material designed to turn engine heat into extra power might effectively give you a "combined-cycle car" with thermal efficiency approaching that of a fuel cell but without the latter's need for hydrogen infrastructure.

The biggest challenge in making this practical--aside from whatever is involved in perfecting the thermoelectric material--is maximizing the temperature at which the engine runs. If that sounds paradoxical or even dangerous, remember that the laws of thermodynamics dictate that the useful energy you can extract from something is related to its temperature. A CCGT is only as efficient as it is, because the turbine exhaust comes out at a couple thousand degrees F. By comparison, your radiator, the main heat sink for your car, keeps the engine block at 150-200 degrees, which is pretty low-level as heat sources go. This might be where ceramic engine blocks--an idea that has been floating around for decades--might shine, by operating at temperatures high enough to provide a nice heat source for thermoelectrics.

Now, I have to admit this whole idea is pretty speculative. But even if what I described never ends up in a car you can buy, it illustrates the diversity of ways to skin the vehicle efficiency cat. It is still premature to proclaim fuel cells, conventional or plug-in hybrids, or anything else the clear winner in this race.

Real Gasoline Prices

Last year, when the hurricanes helped push gasoline prices to their highest nominal levels in US history, many analysts suggested that we needed to look at this in terms of real dollars, which was only marginally higher than the previous record of the early 1980s. But it occurred to me that however accurate that might be as economics, it doesn't really reflect the way consumers think about prices. Many of us carry around a set of internal references about what things should cost, based on some period in which we focused on them. That would mean that there isn't any absolute sense of high and low prices, even within the same economic stratum, and that could have interesting policy implications.

The older I get, the more I notice myself comparing the prices of things to what they were when I was younger--a habit for which I used to chide my parents. On this basis, a carton of milk shouldn't cost $3, and a perfectly ordinary house has no business selling for more than a million. Gasoline is the most visible price in our economy, but have we really absorbed the way it has gone up and down over the years, relative to other things we buy?

For example, I can remember service stations posting prices of $0.359/gallon in the late 1960s and early 1970s (though it would occasionally drop below 30 cents during "price wars.") How do today's prices compare? Using the Consumer Price Index as a measure, that translates to about $1.90 in 2005 dollars. By the time I bought my first car in 1974, gas had jumped to about $.50/gallon, but that still equates to $2.00 now. In fact, when you look at historical gasoline prices converted to 2005 dollars, you see that from the end of World War II until the Iranian Revolution in 1979, gasoline averaged about $2.00/gallon. From then until 1985, it was around $2.50, hitting a high of $2.92 in 1981. And then from the oil price collapse in 1986 until 2004, it averaged $1.50/gal--coinciding with the rise of the SUV trend.

As a result, today's price of roughly $2.40 looks either in-line or out-of-line, as a function of which period you paid more attention to. And by extension, a $1.00/gal gasoline tax hike to spur efficiency would make the fuel seem twice as expensive to some of us, but only a bit pricier than usual for others. So if prices continue to drop from here, that could open up policy headroom for new gas taxes, while simultaneously reducing the effectiveness of a higher tax, depending on the individual perspectives of consumers.

Is Energy Trading a Dirty Word?

Sunday's New York Times business section led off with an article describing the state of energy trading, just over four years after Enron filed for bankruptcy. While the article was largely a human-interest piece on ex-Enron traders who have moved on to found their own trading operations, it also raised a number of interesting issues about the role and impact of energy trading. Here are some further thoughts on these topics, based on my own experience trading energy commodities from the mid-1980s to mid-1990s.

• Energy trading profits - The market for the last couple of years has been an ideal environment for traders. Volatility is the most important ingredient fueling the profitability of speculative trading, i.e. trading not directly related to managing the risk on an underlying business exposure. While many blame higher volatility on traders, I'd argue that the volatility arises from the well-documented combination of physical supply problems and geopolitical risk. In general, trading profits are a response to, rather than a cause of, volatility.
• Trader compensation - Given the huge profits available from trading around the world's trillion dollar a year energy flows, it shouldn't be surprising that some enterprising young folks--and trading is predominately a young man's game--are raking in incomes that put corporate executives to shame. But there are few things in life, other than owning your own business, in which personal contribution to profits is so easily measured, and in which rewarding good performance pays such large dividends for the firm. It's also worth noting that these salaries will fluctuate greatly, since it's unusual for even the best traders to keep winning big, year after year after year. The game changes rapidly; the deals that made you money last year get arbitraged away, and you have to keep innovating ahead of that curve to be successful.
• The role of hedge funds - Many of the same folks who blame trading for running up prices and volatility focus their ire on hedge funds. While these operations have brought billions of dollars of speculative money into energy trading, that isn't necessarily bad. From personal experience, I can tell you that markets involving only those with real stakes--companies with oil in transit, factory inputs to hedge, etc.--tend to be dull and illiquid. The oil company or utility trader needs a willing counterparty, and as often as not he won't find another oil company or utility that wants to take the opposite direction at the right time. That's where purely financial traders come in, and hedge funds are only the latest in a long line of non-fundamental players who have served that purpose. While they may occasionally drive the market, they have no intrinsic advantages over the companies that produce, refine and distribute the actual molecules and electrons.
• Recovering from Enron - Most of the people at Enron were smart, innovative, hard-working and honest. It's appropriate that the "scarlet letter" many of them received seems to be fading. I hope for their sakes that the trading operations in which they now work have a higher degree of transparency and checks and balances than Enron did, because the most important ingredient in sustained trading success isn't brains, but a solid reputation.

Politicians who think that regulating trading will bring down energy prices would be better advised to focus on the fundamentals that drive the markets. Stimulating more oil and gas production, facilitating gas imports, and fostering energy efficiency and cost-effective alternative energy will do a lot more for consumers than cracking down on speculation. Coincidentally, these actions will also make trading less profitable in the long run, by reducing market volatility.

Upping the Ante

Iran is back in the news, having broken the UN seals at Natanz and indicated its intention to restart its nuclear enrichment facility. As a result, the EU3 (Britain, France and Germany) seem prepared to refer the matter to the Security Council. I’ve discussed this issue at great length in previous postings and remain convinced of two things:

• Iran’s motives have little to do with producing electricity, and
• A major confrontation with Iran at this time would play havoc with energy markets.

There’s not much more to add at the moment, from my perspective. However, in the last few days we’ve heard some interesting commentary from Iranians, and it’s worth taking a look at these, if you haven’t already read them:

From the Wall St. Journal:
An indication that Iran’s theocratic hard line may not be as monolithic as it seems (subscription required.)

From the NY Times:
Ideas for averting a crisis

Anyone thinking that Iran's regime is innocuous and harmless should check out http://www.abfiran.org/english/memorial.php

Under Duress

At the same time that the singer Harry Belafonte was leading a UN visit to Venezuela and proclaiming how many in the US support President Chavez's socialist revolution, the country's oil minister was tidying up the details of the recent "renegotiation" of contracts covering energy projects with Shell, BP, Total and Chevron, among others. The changes make these deals significantly less attractive for the oil majors, and much more so for Venezuela. They amount to a partial nationalization, on threat of total expulsion if the companies hadn't agreed.

For example, the Hamaca heavy oil project, with which I am familiar from my time at Texaco, was established with 30% ownership by one of the arms of PdVSA, the state oil company. The previous government of Venezuela was happy to have foreigners invest in the oil sector, because they brought significant expertise in dealing with the challenging types of crude oil that make up most of Venezuela's reserves, and represented an important new revenue source, via the taxes and royalties they would pay. The contract revision has hiked state ownership to 51%, giving PdVSA--the main vehicle for funding the government largesse that maintains the President's popularity--control of these assets and their future development.

It is worth noting that the international projects covered by this forced renegotiation have been a godsend for Mr. Chavez. Not only are they big money-spinners, but they were the primary means of preventing the total collapse of Venezuela's oil production following the crippling industry strike of 2002-3. Rather than gratitude, the emotion this seems to have spawned is envy.

Did the affected companies have any real alternative, other than conceding? Could they have collectively refused to deal and taken their cases to the WTO or the World Court? Perhaps, but given the current profitability of Big Oil, they don't exactly make the most sympathetic group of plaintiffs. Venezuela would argue that it was merely seeking its legitimate share of the value of its own resources, an argument that would probably find favor in international circles.

Nor would the companies' shareholders be likely to reward them for walking away from billions of dollars of investment and hundreds of thousands of barrels per day of production, even to stand on a principle with important implications throughout their international portfolios. Without access to enough similar, large-scale opportunities in other OPEC countries or Russia, the managements of these firms had little choice but to agree, however distasteful and unethical they might regard the circumstances.

There's an old rule about blackmail, though, and it leads to the following prediction. If President Chavez was able to justify breaking these contracts and re-writing them in order to claim a larger share of the present high prices, he will have even more incentive to "renegotiate" again in the future, when oil prices fall and his absolute revenues decline. The companies involved need to consider at what point they would call Mr. Chavez's bluff about the ability of local staff to keep these plants--which include very sophisticated refineries, in addition to the drilling rigs one normally thinks of--going indefinitely. Otherwise, they will again find themselves having to compete to buy the output of facilities they designed, funded, built and lost.

Floor Price Pitfalls

A friend asked my opinion of a proposal in yesterday's Wall Street Journal to create an artificial floor price for oil by imposing a floating tariff, setting a minimum US oil price of $35/barrel. In his op-ed (subscription required) Mr. Marc Summerlin laid out a persuasive case for the benefits of such a tax. It would promote conservation and the development of alternative energy, while capturing revenue that might otherwise have gone to OPEC. Unfortunately, this idea has been around in various forms for decades, and it has many undesirable consequences beyond the energy markets.

The underlying concept has merit. In the absence of sufficiently liquid and affordable means for private firms to hedge against lower oil prices that would cripple alternative energy projects, the government could guarantee a floor price for oil, ensuring that alternative energy would be more competitive. The mechanism Mr. Summerlin suggests is a variable tariff that would kick in to keep the price of oil in the US above $35. If global conditions drove the price to $50 or $100, the full impact of those increases would be passed on to buyers. But a drop below $35 would be absorbed by the federal government in a dollar-for-dollar rise in the tariff.

A tariff on imported oil is another alternative to higher fuel taxes within the US. Both raise fuel prices and deter consumption, but they have very different effects on the economy and on the competitiveness of US products in the global marketplace. While a gas tax is imposed at the retail level, affecting consumers at the gas pump and raising the cost of all goods with a road-transport component, the proposed tariff would act at the producer level, driving up the cost of oil for refiners--thus raising the cost of gasoline, diesel and jet fuel--as well as for any businesses using oil or its derivatives in their manufacturing processes. That would make their products more expensive in the world market, relative to those of countries that don't impose such tariffs. As high as European fuel taxes are, they don't penalize their industries this way.

Another problem arises from the effect on domestically produced oil. Whenever the world price would fall below the level set by the tariff, US producers would begin to benefit from the artificially high price here. Unless taxed away in a manner matching the tariff, the US oil industry would receive a windfall. If this sounds familiar, that's because we tried something similar to this during the oil crises of the 1970s. The result was bureaucracy and market manipulation that rivaled anything seen with Enron. I started trading oil after the era of "Old Oil", "New Oil" and import certificates had ended, but I knew traders who lived in very nice houses and drove very impressive cars, as a result of exploiting those rules.

I also suspect Mr. Summerlin hasn't thought through the impact on the very futures market he's trying to help guide. The New York Mercantile Exchange's contract for West Texas Intermediate crude oil acts as the world marker price for oil, with a sizeable fraction of the physical crude delivered globally priced at a differential above or below it. The proposed tariff would terminate that role and truncate the market. Most of the volume would shift to the unconstrained London Brent contract, and the liquidity and influence of the US market on world prices would diminish.

It's possible that a narrower alternative to the tariff might achieve most of what the author intended. We could directly subsidize alternative energy projects for which the price of oil is a key factor. We might guarantee that oil sands projects, biofuels plants, and similar ventures always saw an effective oil price of $35 or more, without subjecting the whole economy to the distortions a tariff would create. Unfortunately, we tried that before, too, when the federal Synfuels Corporation guaranteed the market price for shale oil. The result was a set of billion-dollar boondoggles, none of which delivered meaningful benefits to the country. Similar mechanisms have perpetuated inefficient grain ethanol, at a high cost to taxpayers and with negligible energy benefits.

My regular readers know I have distinctly mixed feelings about higher fuel taxes, but I wouldn't hesitate to recommend them over either a tariff on imported oil or a price guarantee for alternative energy. Fuel taxes could raise at least as much revenue as a tariff and give a real boost to alternative energy and energy efficiency, while protecting the competitiveness of US exports and keeping the government out of the iffy business of picking technology winners and losers. The proposed tariff is just too similar to the failed energy policies of the 1970s.

An abbreviated version of this posting was published in the Wall St. Journal's Letters section on January 24.

Getting in on the Right Floor

After China's CNOOC failed in its effort to acquire Unocal, being initially outbid and later outmaneuvered by Chevron, it was clearly time to rethink its strategy. Buying an international oil company that was larger than itself, and taking on all the operational challenges and risks that went with it, was not just a step too far for a company that still had one foot in the world of state oil monopolies and regulated markets, it was also a poor match for China's needs. Now it has made a major acquisition in Africa, buying into a project led by France's Total. This looks like a much better move.

China's rapid economic growth has turned it from a net oil exporter into a major importer in the course of about a decade. Energy security in the Chinese context will come from reliable, geographically diverse supplies of oil and gas to fuel further growth. Unocal could have provided some of that, but it came not just at a high price per barrel, but with counterproductive political complications . Its 45% stake in the Akpo project in Nigeria will serve it better, if on a smaller scale. As CNOOC and its sister companies attempt to grow internationally, their best bet is buying into precisely this kind of project, involving the development of a previously-discovered resource.

This approach offers several advantages for CNOOC. It will still have to reconcile different cultures and management styles, but this will be on the project venture level, where CNOOC already has considerable experience working with Western companies. It is also not taking on exploration risk, which was the bane of Japan's attempt to do the same thing twenty-five years ago. Nor will it have to operate the project, relying instead on--and learning from--a major oil company with significant experience both in Africa and in deep water. Through further acquisitions like this at attractive prices (this deal is estimated to work out to under $5/barrel) CNOOC can assemble an attractive international portfolio and grow itself into a meaningful supplier of China's import needs, as well as becoming a serious player in the global market.

From the standpoint of the international majors, this strategy creates more of a mixed blessing than a successful acquisition of Unocal would have. In the near term, it provides them a cash-rich partner with whom to share development risk on the multi-billion-dollar projects they must pursue, in order to replace their depleting reserves. In the long run, however, it puts CNOOC squarely into the market from which they derive the bulk of their cash flow, and it will drive up contract terms with host countries. And CNOOC is only the thin edge of the wedge of state and former-state oil companies that are looking to break out of their national cages.

LNG Catch 22

The floating LNG regasification facility proposed for Long Island Sound has hit another snag. An article in Sunday's New York Times described the curious permitting snafu that has developed on the way to review by the Federal Energy Regulatory Commission, relating to the project's safety plans. Apparently, the details of the Broadwater project have fallen under a post-9/11 infrastructure security regulation that effectively bars them from public scrutiny. In the absence of specifics, opponents are seizing on the classification of the plans to argue that the project is too risky for the busy waters of Long Island Sound, or its heavily populated shorelines. Welcome to the Twilight Zone.

Living only a couple of miles from Long Island Sound, I am more than a little interested in how this comes out. My first instinct is that Broadwater would be a tremendous boon for the region, providing direct access to international supplies of clean natural gas at prices much lower than those I see on my monthly gas bill. But, as I said before, the project shouldn't get a free ride on safety or environmental impact, just because it's a good business proposition.

As a resident, I share the frustration of those seeking to understand how Broadwater might affect the area, particularly in a worst-case scenario. Under our system we have come to expect full public scrutiny of such proposals as part of our Constitutional rights, honed by legislation such as the Freedom of Information Act. But we also shouldn't lose sight of the responsibility of the government and of businesses acting under government license to safeguard information, the release of which might be harmful in wartime. The Broadwater project must find a way to navigate the gap between those poles, if it is to go forward.

However, it is a long, unjustified leap from the dilemma described above to the flawed logic that uses the security around the project's plans as de facto evidence that it is inherently unsafe. Connecticut Attorney General Richard Blumenthal was quoted in the Times saying, "It is powerful evidence of the susceptibility to terrorist attack and proves that the public interest is greatly endangered." A filing by Suffolk County, NY went even further, citing FERC's comment that destruction of an LNG terminal by saboteurs would negatively impact public health and safety as proving, "that the Broadwater project can not be found safe or in the public interest." Franz Kafka would recognize a kindred spirit, there.

Every energy facility in the country is vulnerable to terrorism, with serious potential consequences, nor are energy facilities unique in this regard. If that fact were sufficient argument against building more, then we'd better consider a ban on the sales of new gas and electric appliances.

It may just be that wartime prudence prevents our knowing enough about Broadwater's design and safety systems to make us all comfortable. If so, then we must choose between blocking the project--thus obliging us to address the future energy balance of the greater NY region in some other way--or trusting in the judgment of those with the clearance to scrutinize these plans. The latter may seem a quaint notion in 2006, but to me the other choice looks worse. If we fail to find a sensible way through this procedural quandary, our energy future will be jeopardized as much as by any attack Al Qaeda could mount.

More Russian Risk

In recent conversations with family and friends I've been lamenting the conversion of the news media to an entertainment business model, robbing us of a more complete picture of what's going on in the world. Again this week, their "flash mob" approach to the tragedy in West Virginia overshadowed larger events across the globe. From an energy perspective, the story we should have been paying closer attention to was the natural gas dispute--now resolved--between Russia and Ukraine, because it has important implications for our future energy supplies.

Last week I discussed why Russia's willingness to threaten to cut off supplies over a disagreement on pricing should concern the EU, which relies on Russia for much of its gas imports. But the issue goes deeper and could have an influence on long-term global oil supplies, as well. Russia offers one of the best prospects outside of OPEC for bringing new oil supplies to market over the next decade or two. But ever since President Putin began to roll back the privatization of energy resources, foreign investors have seen the trends on "above-ground risk"--having to do with legal systems, politic stability and corruption--go the wrong way. The dismantling of Yukos was a giant red flag for anyone contemplating investment in Russia. The Russia/Ukraine gas standoff compounds these concerns.

One of the basic principles of the energy business is that getting oil or gas out of the ground is pointless if you can't sell it to someone. In Russia, that means being able to export to a buyer in Europe or Asia, because the internal Russian market is saturated with cheap government oil and gas. President Putin's threat to cut off gas exports to Ukraine raises the specter that he might actually follow through in a future dispute with some other country. If the oil or gas in question were coming from a multi-billion dollar private project, such as one of those on Sakhalin Island, the consequences for the project's economics would be dire.

To the extent this sort of power-play deters investment in the Russian oil and gas sector, the whole industrial world is worse off, because it makes us even more reliant on the Middle East. Apparently the global role Mr. Putin is looking to fill is not that of "reliable energy supplier." Companies will have to figure out just what his aspiration is, before putting more money into the Russian energy sector.

The Price of Coal

After every serious coal mining accident, commentators like to remind us that while coal may be cheaper than other forms of energy in terms of dollars, it exacts a high human price. The fate of the miners wasn't even being reported correctly when an op-ed in that vein appeared in the New York Times. To the extent the authors' criticisms are accurate, it's important to remember that we all share responsibility for the steady rise in coal consumption.

As the article reminds us, coal is our most plentiful domestic energy resource, and part of its value proposition derives directly from the higher cost of cleaner alternatives. I'm sure I seem like a broken record on this topic, but the combination of short-sighted bans on offshore gas drilling, restrictions on vast tracts of federal land, and inadequate infrastructure investment is rendering our most attractive fuel uncompetitive against coal.

At the same time, electricity consumption has been growing at 2%/year for the last decade, and with gas around $10 per million BTUs, coal will win the battle for new generating capacity. As optimistic as I am about alternative energy sources such as wind, solar and biomass, for the next decade they cannot grow fast enough to displace fossil fuels. The choice for new base-load electricity generation is between coal and gas--and just possibly nuclear.

Nor can we ignore the economic contribution coal makes in the areas in which it is found, particularly in the eastern US. However unappealing mining jobs may seem to those of us in the post-industrial portions of America, they remain attractive in communities that often have few other alternatives, a point made frequently during interviews in the last 24 hours.

Safety is a crucial concern in coal mining, and the safety record of the Sago mine is hardly exemplary. But although the national trend in mining deaths has been steadily downward, working underground is inherently risky. In the case of some of these old mines, total safety can only be achieved by shutting them down, because their economics are marginal even at today's higher coal prices.

Unfortunately, the bill for our energy "free lunch" gets paid periodically in towns like Sago, WV. Americans have chosen a highly energy-intensive lifestyle, while erecting obstacles in the way of the safest and cleanest energy resources we possess. It may be crass to point this out, but these miners died in part so that others can enjoy beaches with views unsullied by drilling platforms or wind turbines, and wilderness areas without derricks and pipelines. If that makes you uncomfortable--and it should--then we have ample means of correcting the situation by changing how we use energy and by demanding sensible and consistent energy and environmental policies.

Unnecessary Reserve?

I was pleased to read this op-ed in yesterday's New York Times advocating the abolition of the Strategic Petroleum Reserve (SPR). I've been writing about this topic for the last two years. In general, I agree with the authors' assertion that the existence of the SPR has deterred companies from holding their own inventories, at a high cost to taxpayers and a similar cost to markets. However, I find the authors' alternative of simply letting the market handle this function inadequate. That's because the market participants they would rely on have conflicting interests--and some clear disincentives--in fulfilling this function.

Let's start with the basic question about whether any reserve is necessary, and if so, whether the amount currently in the SPR (685 million barrels)--or its recently authorized expansion to 1 billion barrels--is appropriate. As we've seen very clearly in the last few months in particular, and for the past two decades in general, the oil markets are good at reallocating supplies to make up for shortfalls due to weather, war, strikes, or accidents. This comes at a price, though. Unlike the market for airline seats, the price of the last barrel sets the price for all barrels, except where state intervention buffers this effect. The bigger the disruption and the shorter the timeframe over which adjustments must be made, the larger the magnitude of the price impact across the entire economy. In the event of a major disruption from a key supplier, such as the Saudis, the price shock could be crippling.

How much difference would 1 billion barrels make in a worst-case-scenario? As currently configured, the SPR could supply 4.4 million barrels per day (MBD)--roughly 40% of our total oil imports--for nearly eight months. Viewed in the context of a market in which a global shift in the supply/demand balance of about 2 MBD has been sufficient to double prices, 4 MBD looks very significant and adequate to all but the most extreme disruptions.

Could the same volume held in private hands have an even larger impact? Absolutely. The two biggest limitations on the SPR are the cap on its delivery rate and its inability to affect supplies in parts of the country not connected by pipeline to the Gulf Coast. Putting the SPR oil in commercial tankage near refineries all across the country might reduce its ability to respond to a local disaster, such as a Gulf Coast hurricane, but would greatly enhance its effectiveness in a national crisis by reducing the delivery time-lag and increasing the rate at which oil could be pumped out.

Unfortunately, there are two serious drawbacks to this approach, and neither was identified in the op-ed. First, oil companies currently have significant incentives to keep inventories as low as possible, consistent with smooth day-to-day operations. Accounting rules penalize them for holding high inventories, and it is expensive to manage the price-risk exposure that long-term inventory creates. Just as importantly, while oil companies like security of supply, they don't (and shouldn't) share the government's interest in mitigating price spikes. High prices bolster profits, as we've seen, and increase returns to shareholders. As the op-ed suggests, companies will only hold extra inventories if they see a clear way to profit from them.

And that's why I think the Cato Institute has provided a good opening salvo but not the whole answer. The SPR is an outdated response to the problems of the 1970s, and it carries over the regulatory mindset of that period. Its basic purpose, though, is at least as valid today, from a national perspective. The conversation should focus on the best means of executing that purpose, at the lowest cost and least disruption to the market. In my view, that means shifting the SPR oil to commercial ownership, but under carefully-crafted guidelines and with incentives that would reward companies for holding these barrels, while ensuring they would be used when needed. Tackling this would make a great energy goal for 2006.

Bubble-itis

The media have been saturated with the customary cusp-of-the-year analysis and projections, and so far little of it seems particularly surprising or insightful. I ran across one small item in the New York Times that I thought merited further consideration, though. In Sunday's Week in Review Section, one segment of their "What in the World We'll Do in 2006" report featured this discussion of whether alternative energy was turning into the new stock market bubble. The author never quite comes out and says that it is, but he sets up his criteria for a bubble and asserts that alternative energy meets them all.

In much the way that the Depression focused economists on the dangers of deflation, the Tech Wreck gave rise to a whole industry of bubble-mavens, and there are certainly areas of concern, such as housing markets across the developed world. But either in terms of their share of market capitalization to the total stock market, or of their contribution to the global $3 or $4 trillion energy market, alternative energy stocks aren't even on the scale of the bubbles in glass of soda, let alone something policy makers, economists or investors should worry about.

The increased attractiveness of alternative energy stocks is clearly attributable to the dramatic increases in the prices of oil and natural gas, and the growing environmental challenges facing coal. To the degree these energy sources face long-term problems, alternative energy seems on secure footing. The sector includes some very promising technologies, in addition to the obvious wind and solar power segments. Gasification and sequestration, next-generation biofuels, advanced batteries, and stationary fuel cells will likely all be applied at material scales within the next decade. That means selling real products to real buyers, and generating real BTUs and kilowatts. In this light, analogies to the Tech Bubble begin to look silly.

Investors still need to be savvy about where to invest in this sector. Many of the new technologies under development today will turn out to be impractical or uneconomical. Many of the companies involved will not be viable. This is exactly what you'd expect in a market segment that, though it has been around for quite a while, has only recently entered the limelight. Talk of bubbles at this stage is particularly unhelpful, because it undersells the promise of the sector while distracting investors from the crucial details of specific technologies and company structures and capabilities on which they should be focused.

And while a substantial drop in energy prices might create a short-term flight from alternative energy, reinforcing the idea that it was all hype, the long-term trends ensure that this sector has plenty of room to grow, for a long time to come.

Subtracting Wedges

Since I started following the climate change issue in the mid-1990s, I’ve given a lot of thought to what might significantly change the US approach to the problem. Major signposts, such as weather/climate events, and dramatic scientific findings top the list. But perhaps a new way of looking at the situation could make a big difference, too. A novel conceptual framework from a Princeton engineering professor might just fit the bill, as described recently in The Economist (subscription required.)

Dr. Socolow’s idea is deceptively simple: rather than trying to tackle the whole problem at once, break it down into little pieces and focus on those. In the source article from last December's issue of Environment, he breaks down the emissions “triangle”--the difference between the status-quo greenhouse gas emissions trendline and the total reduction required to stabilize atmospheric GHG concentrations--into smaller, more manageable segments. These segments can be "filled" by improvements in five different areas:

• Energy conservation
• Renewable energy
• "Enhanced natural sinks" (forest- and land-management)
• Nuclear energy
• Fossil carbon management (sequestration of CO2 and other greenhouse gases)

Even though all these areas have been widely discussed in the context of mitigating climate change, this framework isn’t as trivial or obvious as it might seem. After all, the fatal flaw of the Kyoto Treaty is that it applies modest reductions against the entire slate of global greenhouse gas emissions, simultaneously going too far for some and not far enough for others--or to make a real dent in the problem. One of the primary arguments against US participation in the Kyoto Treaty is that major developing countries, and in particular China and India, aren’t bound by Kyoto’s reduction targets and would gain competitive advantage vs. our economy.

If the successor treaty to Kyoto for the post-2012 period were made up of nested agreements focusing on individual slices of the problem, we might have a process in which all countries would willingly participate in some segments--and thus contribute towards bringing global emissions down to a sustainable level. For example, the EU might choose to pursue all segments, while the US could opt in for sequestration and nuclear power, but out for other areas. China and India might find renewables and reforestation attractive, while opting out of higher-cost sequestration.

This sounds potentially chaotic, but it aligns nicely with the pragmatic approach being pursued in the G-8 and elsewhere, of focusing on areas of agreement, rather than seeking unattainable universal agreement. It also puts the emphasis on truly solving the problem, rather than on satisfying preconceived notions of what a solution must look like.

Global Gas

Ever since the hurricanes disabled a sizable fraction of US energy production from the Gulf Coast, I've been worried about the availability of natural gas this winter. So far, unseasonably warm weather has kept prices from spiking, indicating that supply remains adequate. Ironically, it's Europe that appears to be struggling with gas availability, rather than the US.

Natural gas futures prices in the UK are more than double their level of a year ago, actually exceeding US natural gas prices as of yesterday ($16/million BTU vs. $11.50 here.) With North Sea production declining and the UK economy growing, Britain is becoming a net importer of energy. At the same time, Continental Europe could get squeezed by the ongoing gas pricing dispute between Russia and Ukraine, with the former threatening to cut pipeline deliveries in the main line supplying Germany and the rest of Europe. This highlights the EU's critical dependence on Russian gas, as I've noted previously.

The reason for pointing this out isn't to make us feel better about the high prices we're paying for natural gas. Rather, it's to remind us that we are competing in an increasingly global natural gas market, not only with India and China, which are hungry for energy in any form, but with Europe, which has a particular preference for natural gas due to its low greenhouse gas emissions, relative to coal and oil. The focus of this competition will be liquefied natural gas, or LNG, the form in which gas can be shipped all over the world from its origin.

Although a spot market in LNG is starting to emerge, it is still very much a long-term contract business. That's understandable when you look at the cost of a gas liquefaction plant and its associated infrastructure, running into the multiple billions of dollars. Companies don't make these investments without having a large chunk of the future production contracted. This has important implications for the US, as we expand our infrastructure for receiving LNG, against a great deal of local opposition.

Delays in approving US LNG projects, due to lawsuits and local permitting problems, preclude the companies involved from signing contracts for the gas to supply these facilities, until the uncertainties are resolved. As a result, they may miss out entirely on the output of a new LNG production plant in the Middle East, Nigeria, Australia or Indonesia, because others are prepared to commit when we aren't. Since these contracts typically run for 20 years, which may be close to the life of the underlying gas reserves, there are typically no second chances. Missing out on the "base-load" output of new plants forces us to compete for unreliable "spot" market supplies, typically at higher prices.

With US natural gas production stagnating at least partly as a matter of choice--with substantial gas reserves placed off-limits for development--and with gas demand continuing to grow, we have no choice but to play the LNG game. But if this isn't to become another source of energy volatility for our economy, we must learn to play it astutely, and that means resolving our infrastructure schizophrenia, so US companies can compete effectively for new, long-term gas supplies in a market with many other players.

Local vs. Global Solutions

Climate change is a global issue. The consequences of greenhouse gas emissions manifest on a greatly-delayed basis around the world, rather than in direct changes to local conditions. Accordingly, it's not the kind of problem that lends itself easily to state-by-state measures, or even clusters of states acting together. But that is exactly what is happening, because the federal government has opted out of the international Kyoto process. A group of northeastern states, most of them participants in the regional acid-rain program, banded together to set their own emissions targets, and predictably one of these states has bailed out at the last minute.

The decision by Governor Romney of Massachusetts to withdraw from the seven state plan may be politically motivated--what isn't, these days--but it reflects the difficulty of trying to tackle global warming on your own, when your neighbors aren't subject to the same rules. Any governor has a responsibility to weigh environmental vs. economic impact in a situation such as this, and with interstate commerce and relocation--not to say offshoring--of offices and factories so common, this is a tough call even with regard to the local pollutants that cause smog.

But it's not a perfect world, and the same rationale can be used to justify inaction at any level, including internationally. The aggregate economy of the seven states in question is larger than all but a small handful of countries, so scale can't be the issue here. I suspect that most of Governor Romney's concerns could by alleviated by including access to emissions trading outside the Northeast, not as a fallback, but as a primary mechanism to keep costs down. Emissions trading works best when it can tap into the widest possible pool of available offsets, rather than a narrow trading pool of industries with very similar (and high) costs of achieving reductions.

Ultimately the message here should be that significant portions of the country want to tackle the problem directly, rather than waiting for R&D to produce lower-emission power plants and cars. That signal, combined with the inefficiency of a Balkanized approach similar to that for reformulated gasoline, should provide the impetus for stronger federal measures on climate change.

Access to Resources

Two stories in last week's news provide perfect counterpoints of the challenge facing the international oil industry with regard to gaining access to explore and produce oil and gas resources around the world. Both illustrate the degree to which these firms, despite their enormous cash flows and commensurate influence, are subject to the changing moods of host governments. The Bolivian election seems to be closing the door in that country, while changes in Kuwait's posture towards international participation in its oil sector seem much more positive.

As this op-ed from the New York Times suggests, it would be easy to over-react to the election of an avowed socialist as President of Bolivia. Evo Morales could never match the threat to US interests that Venezuela's President Chavez poses, but the rise of a similar anti-capitalist democratic sentiment in a resource-rich country such as Nigeria could be disastrous. Bolivia is a good example of the shortcomings of the current globalization system. It is in everyone's interest that these failings be addressed in a way that makes free markets beneficial for as many as possible, and not just for elites.

Kuwait is a very different story. As this excellent article from Friday's NY Times explains, Kuwait's desire to expand its production and optimize the income from its petroleum before alternatives cap the market can only be facilitated through foreign investment and expertise. Opening up Kuwait's undeveloped fields to international companies, even on terms that won't allow the latter to book the associated reserves, would represent an important breakthrough with positive implications for future oil supply and moderating prices for the next decade.

As much as the oil companies tout their impressive technology for locating and extracting oil in hard-to-reach places, their ability to navigate local responses to globalization could have a bigger impact on future energy supplies.

Deferred Again

The Congressional opponents of drilling for oil in the Arctic National Wildlife Refuge (ANWR) won another battle this week in their long war of attrition against the majority that thinks drilling should proceed. I don't have anything new to say on the underlying issue and continue to believe that time is running out on the opportunity to trade a concession on ANWR for major improvements in energy efficiency or a national cap on CO2 emissions. I'll confine my comments today to the process by which ANWR came up for its most recent vote.

The major objection seems to be that the provision to allow drilling was attached to a vital defense spending bill in a "procedural trick." But isn't defeating it by a minority threat of a Senate filibuster, rather than an up-or-down floor vote, just as much of a "trick"--at least from the perspective of an average citizen?

It's also fascinating that so many Senators took umbrage at linking ANWR to a defense bill, given the mileage that Democratic candidates have gotten connecting America's unconstrained appetite for energy to our global defense posture and expenditures. I've never entirely bought that argument, but I have to admit that with troops deployed in the heart of the Middle East, it is hardly a non-sequitur to talk about increasing domestic oil production in the same breath.

Where I agree wholeheartedly with some of the opponents is that ANWR is big enough and important enough to deserve a fair hearing on its merits--and I would add, shorn of all the posturing and pandering that has attended it over the years. Those who see ANWR merely as a gift to the oil companies have been drinking too much of their own Kool-Aid, and anyone who was high-fiving and crowing at this outcome ought to gain some sobriety contemplating his or her future remorse, should the result eventually go the other way with nothing to show for a two-decade holding action.

Well, I suppose that's an awfully cynical note to attach to my holiday greetings. Nevertheless, I'd like to wish all my readers a Merry Christmas or Happy Hanukkah, and a happy Boxing Day (which I've celebrated ever since my stint in the UK.) Postings will resume on 12/27.

Fat vs. Skinny Branches

No sooner had I posted yesterday's blog on the economics of hybrid cars than I ran across an article on an entirely new hybrid technology, developed by no less than the Environmental Protection Agency. Hybrids are a long way from being a mature technology, so it shouldn't bother anyone that this entirely mechanical system might go into production to compete with the hybrid-electrics currently on the market. The only risk I see in this development resembles that of the Betamax vs. VHS video format wars of the 1980s: the best technology might not win out.

When comparing different technologies, it's useful to think about the further options they create. The whole advanced energy technology field looks like a giant decision tree, loaded with branches, many with multiple sub-branches. An advance at one level of the tree can create new branches or terminate old ones. Nor are all branches equally "thick", in the sense of how many other branches they affect. Viewed this way, the hybrid-electric technology behind the Toyota Prius, Ford Escape, et al constitutes a particularly thick branch, and that makes the technology pretty robust.

For example, the power electronics and battery systems developed for this type of hybrid will also benefit work on fuel cell cars, and vice versa. Battery advances will not only improve the performance of today's hybrid models, but will also facilitate bringing to market "plug-in" hybrids with substantial electric-only range. For that matter, the growing real-world experience with hybrids would be applicable to a new generation of all-electric cars, if a cost or performance breakthrough in batteries occurs. So you can see how these various branches of hybrids, batteries, and fuel cells twist around each other and support each other. In other words, hybrid-electrics represent the thin end of a wedge that could allow electricity to substitute directly for gasoline, an option we don't have today.

By comparison, the hydraulic hybrid vehicle system being developed by the EPA represents a lone, skinny branch. It would have to rely on an initial cost advantage to capture market share, either from hybrid-electrics or from conventional cars. Now, don't get me wrong; the fuel economy improvements touted for this technology are substantial and would have a real impact on US oil demand if widely adopted. However, when you compare the two technologies in the way I suggested above, hydraulic hybridization starts to look like a dead end or potential "orphan" in the future. That could result in a consumer backlash against all hybrids and other new technology cars.

Furthermore, if the adoption of mechanical hybrids ended up slowing down or aborting the broader trend of electrification of cars, the short-term fuel economy gains would not be worth the loss of long-term, non-hydrocarbon transportation energy options. And I'm not sure you can rely on the market to sort this out, since the playing field isn't exactly level in this case. Someone may actually have to make a tough call, based on a careful assessment of the complex issues involved.

Hybrids Down to Earth

Lately I keep running into articles and commentaries (subscription required) suggesting that hybrid cars are a disappointment and simply not worth their price premium over conventional cars. Most of these critiques miss some fundamental aspect of the hybrid value proposition, but taken together they provide a useful reminder that hybrids will achieve full success--wide popularity that translates into a large market share--only if they can satisfy large numbers of consumers.

The chief complaints seems to focus on a basic cost/benefit analysis of gasoline savings. Taking the most popular hybrid, the Toyota Prius, as an example, the car costs $3,280 more than a base-model 4-cylinder Camry. I've seen others compare it to the Corolla, but it's really closer to the former, based on passenger room and cargo space. The Camry is rated at 28 miles per gallon, versus the Prius at 55. With gasoline now at $2.26 per gallon on average in the US, and assuming the national average usage of 12,000 miles per year, the non-discounted payout for the implied hybrid premium is 7 years, or about the average time most folks keep a car that they buy, instead of leasing.

But I don't think this tells the full story, for two reasons. First, if you think about a hybrid's value in terms of consumer utility, only part of this relates to fuel savings. At least for environmentally-minded consumers, some of the utility derives from the Prius's lower emissions of greenhouse gases and tailpipe pollutants. The value of the former can be quantified by looking at the alternative of buying emissions offsets from TerraPass at $50 per year. This shortens the hybrid's payout period by at least a few months. Finally, if the buyer is of the "Geo-Green" persuasion, he would also derive some utility from the knowledge that he is doing his bit to reduce our dependence on imported oil, including oil from the Middle East. I don't know how to put a value on that.

The other problem is that you need to make an assumption about how much of the initial premium will persist in the car's resale value. Resale values from Kelly Blue Book give us early estimates of this, recognizing that the market for used hybrids is pretty thin. Comparing a 2001 base Camry to a 2001 Prius with the same mileage, the Prius is worth $5,000 more, based on KBB's "private party value." That suggests that the added cost of buying a hybrid might not be more than the time value of money on the up-front premium. It may even be negative, if hybrids consistently retain more of their initial value than their conventional counterparts.

Finally, we need to recognize that hybrids are still pretty new, and part of their high cost relates to the relatively low volume built so far. Eventually, hybridization should effectively become an option on most models, rather than creating a separate and distinct models. In that way, it will end up being priced like more traditional options, such as automatic transmissions and air conditioning, which have declined substantially as a fraction of total car purchase price since they were first offered. At that point, the tradeoffs involved in buying a hybrid should be simpler and more transparent.

The Next Oil Crisis

Yesterday I suggested that we are seeing signs of the fundamentals for oil starting to weaken, setting up the possibility that oil could finish next year quite a bit lower than this year, possibly under $40/barrel. Now let's turn to the flip side. Other than the usual production problems, contract disputes and strikes that have amplified the oil-price roller-coaster ride for the last couple of years, there are two geopolitical situations that contain the seeds of a genuine oil-supply crisis. I've been talking about both for a while: Venezuela and Iran. As much as I've been on President Chavez's case, my gut feeling is that we will find a modus vivendi with him; I'm much less sanguine about Iran, and less sure than I was previously that time is on our side, there.

While I disagree with Charles Krauthammer well over 50% of the time, I believe his Wall St. Journal op-ed on Iran (subscription required) is 100% right. The country's duly-elected president is a rabid nut-case, though unfortunately not without like-minded support in the region. And based on what the IAEA has reported, the chances of his having access to nuclear weapons within his term of office are uncomfortably high. President Ahmadinejad is literally a Wild Card.

Furthermore, I have little faith that the international diplomatic processes now underway will succeed in denying Iran the means of developing nuclear weapons. Given the nuclear technology that has circulated in black-market channels and the state of Iran's missile programs, the only missing ingredient is weapons-grade Uranium or Plutonium, and that is precisely what Iran's present nuclear program appears designed to deliver. The relationships Iran has cultivated with Russia and China virtually guarantee they will be allowed to complete their work.

Although the other regional and global ramifications of that development are highly uncertain, the implications for oil markets are clear. Whether as a response to serious international sanctions--which I consider unlikely to be imposed--or to a pre-emptive strike against Iran's weapons complexes, the likelihood of Iran's oil being withdrawn from the market at some point is very high. That would send oil prices to record highs. Ironically, the real-dollar highs that would be broken would be those from the last Iranian oil crisis, back in 1979.

So what's the probability of this happening in the next twelve months? Without any scientific basis I'd say at least 25%. If it happens, it could provide just the kind of crash-program impetus that supporters of alternative energy have been looking for. At the same time, it makes the shares of oil-company stocks a pretty interesting option play, even at their current high prices.

Too High or Too Low?

One of the deep truths about oil prices is that they are impossible to predict even a year out, and that they have a historical tendency to change direction dramatically, as markets over-correct to changing circumstances. Last week's OPEC meeting ended with unchanged quotas and the hope that the cartel could keep the price propped up over $50 indefinitely. The gradual abatement of at least two of the three main factors underlying current high prices--low inventories in the wake of the Gulf Coast hurricanes, a global production capacity cushion near zero, and soaring global demand--may make it harder for OPEC to pull that off than most of us would guess today. However, even as the first real glimmer of the fundamentals that would take prices lower begin to appear, there are a lot of other folks besides OPEC rooting for prices to stay high.

First, the companies that have benefited with record earnings and cash flows may be reluctant to see prices drop, though as the Economist recently suggested, it is price uncertainty, rather than absolute price levels, that weighs heaviest on oil companies' future production planning calculations. Most of these companies would still do very well at $35-40/barrel, and their growth prospects would benefit greatly if oil settled into a more stable range of $35-45, rather than the $20-70 we've seen over the last four years.

Environmentalists and those concerned about energy security, though, are pulling for higher prices for other reasons. In the absence of a consensus to raise US gasoline taxes to European levels, the only mechanism that is likely to constrain the growth of demand while providing enough incentive to develop alternative fuels is high market prices, even if the main beneficiaries are the multinational oil companies and OPEC, rather than US taxpayers. And I can understand this concern, as the retreat of gasoline prices to the low $2's has restored much of the apparent energy compacency of the American public.

I can't help wondering if this lies behind some of the opposition to drilling in the Arctic National Wildlife Refuge (ANWR), which the current Congress is doing its darnedest to approve. After all, couldn't finding another North Slope and injecting a million-plus barrels per day into America's oilstream postpone the advent of renewables and synfuels for another decade? No one should worry on this account. As strongly as I've supported ANWR, for what I believe are very good reasons, its peak output in the mid-2010s would only provide some valuable negotiating leverage in international markets. It would take a lot more than ANWR to change the global supply/demand balance enough to hold back the coming wave of alternatives, including oilsands, gas-to-liquids, and renewables.

If you must oppose ANWR, please do so out of concern for what you fear it will do in Alaska, not out of some game-theoretical calculation about its effect on alternative energy programs. The recent CERA presentation to Congress on peak oil made it clear that meeting future energy demand growth will call for a bit of everything, including some things they didn't mention, such as wind, solar and other renewables. Improvements in technology are lowering the cost threshold of many of these alternatives, so that they won't need $70 oil to be competitive, and their very success will act to depress future oil prices. We need to advance to the point at which we are pursuing alternative energy in spite of oil prices, not because of them.

If Not There...?

Highlighting the destructive and counter-productive nature of the NIMBY-ism that is so prevalent today has been a consistent theme of this blog since its inception. Nowhere are these contradictions more evident than for wind power projects, which while producing some of the cleanest energy in our entire national portfolio, nevertheless have been opposed by a variety of groups including prominent environmentalists. The Cape Wind project off Nantucket is the leading example of this, as demonstrated by today's New York Times op-ed by Robert F. Kennedy, Jr., one of the project's most vocal opponents.

Developing wind power is like exploiting oil or gas reservoirs in the sense that you have to go where the resource is, not where you wish it were. That means that wind developers do not have an infinite choice of suitable locations. In a country of 300 million people, and especially in the heavily populated Northeast, the chances of finding a prime wind location that won't affect someone--whether in terms of livelihood or aesthetics--are low. Mr. Kennedy suggests that Cape Wind go elsewhere, but his suggested alternative of deep water further offshore contradicts his own earlier argument about the high cost of offshore wind compared to land-based developments.

I think Mr. Kennedy also overplays the term "wilderness" in this context. The area in question may indeed be a national treasure, as he suggests, but it fails any common sense definition of wilderness, based on the real estate, commercial and transportation interests he cites as being at risk. Having recently passed through Santa Barbara, CA, which can make equal claims to natural beauty, I also have to question his estimates of lost tourism. It certainly wasn't apparent that Santa Barbara's economy has suffered from the offshore oil platforms that dot its coast, and wind turbines are arguably more attractive than oil rigs.

In any case, I continue to believe that in the current environment of high energy prices and concerns about pollution and climate change, the only reasonable basis for shutting down a project such as Cape Wind would be for its opponents to assemble a package of equivalent clean energy or efficiency projects, so that the net result of stopping Cape Wind isn't simply burning more coal in someone else's back yard. Mr. Kennedy should understand as well as anyone the importance of securing clean, domestic energy sources, given the recent involvement of his brother's company, Citizens Energy Corporation, with Venezuelan President Huge Chavez's "energy charity" to New England.

Congress Examines Peak Oil

One of the topics to which I've devoted considerable space in this blog in the last two years is that of an imminent peak in oil production. This idea has emerged from a technical argument in the journals of the industry to become a topic of considerable interest to the general public, particularly to those concerned about our future supplies of energy. The percolation of this notion has finally reached the top, with a recent Congressional hearing devoted to the subject.

On December 7 (unintentional irony?) the Energy and Air Quality subcommittee of the House Committee on Energy and Commerce heard testimony from two panels, including a presentation by a senior representative of Cambridge Energy Research Associates (CERA). As I've mentioned previously, CERA's detailed analysis of oil projects under development or in planning stages indicates that production will continue to grow to meet--or exceed--demand. That means no peak within the project planning horizon of the energy industry, going out 15 to 20 years. However, I don't anticipate that these figures--even if they prove entirely accurate--will dispel concerns about Peak Oil. The Peak Oil meme is uniquely suited for the times in which we live, which one of the New York Times' regular op-ed contributors recently referred to as an Age of Skepticism.

The combination of the Iraq War, the Enron scandal, and Shell's reserve accounting snafu last year sets the stage for deep skepticism about any analysis suggesting that running short of oil needn't concern us for a generation. After all, it's been a fundamental assumption since the 1970s that oil was finite and would run out, possibly within the lifetime of the Baby Boomers. But it's also worth noting that some of the production streams deferring a peak in oil production are pretty unconventional, at least by 1970s standards. Without the contribution from oil sands and heavy oil, ultra-deepwater drilling, and the liquids associated with higher global natural gas production, we would be in deep trouble very soon.

Personally, I remain skeptical about the Peak Oil theory, worrying less about the Hubbert Curve than about the "above-ground risk" issues to which CERA alluded. These encompass all of the things--strikes, hurricanes, coups, terrorist attacks, and changes in contractual terms--that happen in the real world to keep oil in the ground from being delivered to customers. Add to this the inevitable and worrying enhancement of OPEC's market power implicit in CERA's projections, and we ought to have all the incentive anyone would need to diversify our energy sources to include more natural gas, renewable energy, and nuclear power.

How Did Natural Gas Get to $15?

The futures contract for natural gas for delivery in January 2006 is currently over $15 per million BTUs. The same contract traded under $8 this time last year, and that was high compared to historical averages of $2-3/MMBTU. Its current price equates to $90/barrel crude oil and suggests that our natural gas supplies are even tighter than for crude oil, since the two commodities were trading at a rough energy-equivalent parity until recently. While this is partly a function of icy cold weather in the Northeast and the extended recovery from this year's hurricanes, the causes go much deeper.

The switch by industry and utilities from oil to natural gas played a key role in resolving the energy crises of the 1970s and early 1980s. US gas demand has grown steadily ever since. Natural gas now accounts for 18% of total US electricity generation--50% more than in 1991--and has dominated new electric generating capacity construction for more than a decade, as a result of the tremendous improvements in combined cycle gas turbines and the impact of environmental regulations restricting power plant emissions. This will be an even more important factor in the future, because of the low greenhouse gas emissions of natural gas-fired power plants.

Unfortunately, investment in gas resource development and pipeline infrastructure has been more sporadic, and this wasn't helped by industry forecasts as recently as 1999 that anticipated ample future supplies to meet the expected rapid growth in demand. When power plant developers chose gas-fired technologies over coal or other alternatives, they did so with reasonable assurances that the gas would be there for them at an affordable price. Calpine was one of the companies that placed big, strategic bets on this proposition, and those bets are now coming due.

So over the course of a few years, we've gone from an expected surplus to a serious shortfall, and that didn't just happen because of some hurricanes in the Gulf Coast. The decline of US oil production and the oil industry's understandable shift to looking overseas for larger production opportunities is an important factor. Reduced domestic oil production decreased the potential for "associated gas", i.e. natural gas produced from crude oil reservoirs. Combine that with more rapid decline rates from mature gas fields and the drilling bans and other restrictions I've been railing against since I started this blog, and we have the perfect setup for a gas crunch. The twin storms of 2005 merely hastened its arrival by a year or two.

The only mitigating factor today is that the key gas-consuming industries in the Gulf Coast were as badly affected by the hurricanes as the gas production itself, with the result that the levels of gas in storage for winter have been about normal for this time of year. That stored gas won't last long, though, if industrial demand returns to normal while supplies remain shut in. I doubt we'll experience residential supply interruptions, but companies that rely on gas may face actual interruption of deliveries, not just high prices. After a few months of that, I suspect those proposed LNG import terminals won't look nearly so scary.

Revolving Tür

Another item from the last week that caught my attention was the announcement that the recently-former German Chancellor Gerhard Schroeder had accepted a management position with a subsidiary of the Russian state natural gas company, Gazprom. Russia is one of Germany's largest energy suppliers, so to put this in perspective for a US audience, it would be tantamount to George W. Bush accepting a position with Saudi Aramco in February 2009. Can you imagine the political fallout that would create?

To spice things up a bit more, only a few months ago Herr Schroeder was instrumental in pushing through a new gas pipeline route from Russia to Germany that will traverse the Baltic Sea and bypass Poland and the former Baltic republics of the USSR, vexing them all. In his new capacity, Herr Schroeder will apparently supervise the division of Gazprom responsible for building this pipeline. Rumors to this effect were vigorously denied when they surfaced back in October. In the US, this kind of revolving-door hiring of someone directly involved in a controversial contract would generate all kinds of investigations and Congressional outcry. The German reaction so far seems focused on creating a code of conduct for ex-officials.

Absent the appearance of impropriety, Schroeder's appointment might have been seen as a clever move from both the German and Russian perspectives. It provides Gazprom with a bit of international leadership credibility in advance of a partial privatization--if that ever really materializes--and it helps cement a very important trade relationship for Germany. But can an event like this really be viewed in such a narrow context, particularly given the lingering frictions between Germany and France, and the new EU members that were Soviet satellites as recently as 1990? Surely this presents the new German coalition government with an unwelcome intra-EU political challenge, as well as a distraction from their efforts to institute meaningful economic reforms.

However the situation turns out, including the possibility that he may yield to critics and withdraw from this new post, you have to hand it to Gerhard Schroeder. He didn't hesitate to oppose the US over Iraq for personal political gain--aiding his reelection but alienating his country's most important ally in the process--and he isn't shy about seeking personal gain out of office in a move laden with conflicts of interest.

Voluntary Mechanisms

There are several topics from my week's absence that I could comment on, including the pending difficulties of Calpine and the prospects for a change in OPEC quotas at today's meeting, but the item with the longest-term implications may be the inconclusive climate change talks that wrapped up on Saturday in Montreal. Although they agreed to begin discussions on what should follow the Kyoto Treaty after it expires in 2012, the major blocs remain divided on whether the response to climate change should be based on voluntary or mandatory targets. It is hard to divorce these competing approaches from underlying views on the urgency of action.

The UN Framework Convention on Climate Change and the specific Kyoto Treaty that grew out of it require periodic global meetings on the issues, of which the Montreal meeting was only the latest. One of Montreal's most visible goals was to lay the groundwork for an agreement subsequent to the 2008-2012 "measurement period" of the current Kyoto Treaty--the so-called "son of Kyoto." Now, it might seem premature to ring alarm bells about a process that wouldn't even take effect for another 7 years. However, given the difficulties in the Kyoto negotiations, which ultimately missed including the US or large developing countries such as China and India, it is imperative that any successor treaty have all the parties on board, or risk total irrelevance in the real world. That means finding a way to bridge the gap between voluntary emissions reductions--which the US favors--and the mandatory reductions agreed to by the Kyoto signatories such as the EU, Russia and Canada.

The other impetus for early agreement on a successor to Kyoto stems from a growing recognition that the Kyoto Treaty itself falls far short of the dramatic reductions that would be required if climate change were proceeding along anything like a worst-case path. Nor is it clear that the reductions agreed to by the countries that signed on to Kyoto will actually be achieved. "Son of Kyoto" must make broader and deeper cuts for the long-term, or we should forget about the UN climate process and focus on adapting to a warmer world, with unpredictable local consequences.

This sounds bleak, but there've been lots of positive indications recently, including the G-8 Gleneagles agreement and a similar Asia-Pacific approach, focusing on areas of agreement, rather than differences. Technology is the key to this approach, based on a recognition that the greenhouse gas emissions reductions necessary to stabilize the atmospheric concentration of these gases cannot be achieved with current vehicle and power plant technology and global economic growth.

Former-President Clinton may have said it best in Montreal, when he indicated that while firm targets were essential to the creation of a viable carbon-trading market, those standing outside firm targets could still focus on the things--e.g. technologies--that would have to be done to achieve reductions. "Disagreements (over specifics) shouldn't be a reason to do nothing." The ultimate shape of any consensus on this issue will probably be influenced by a combination of real-world experience putting Kyoto into action during 2008-12, and on the visible environmental indicators of actual climate change.

Is Oil Blocking Iraq's Exits?

Considering the degree to which the US-led invasion of Iraq was linked by so many of its critics to petroleum, it is remarkable that the commodity has hardly been mentioned in the debate over an exit strategy. If anything, concerns about linkage would be much more appropriate now than they were in 2003. Whatever factors one believes took us into Iraq, leaving prematurely could have grave consequences for the global petroleum supply and demand balance, with potential price spikes at least as large as those associated with the summer's hurricanes.

Far from providing an opportunity for the US to seize the country's 100 billion barrels of oil reserves and operate them as our own "filling station", as some had speculated, war was the second-worst thing that could have happened to the Iraqi oil industry, behind the continuation of the slow death it was suffering under sanctions and the UN Oil-for-Food program. The best oil scenario would have required a declaration that Iraq was free of WMD, followed by normalized relations and the termination of sanctions. That's the scenario that a number of French, Russian, and other non-US companies were banking on before the war, as they busily negotiated contingent deals to develop Iraq's reserves.

In the two-and-a-half years following the invasion, Iraqi production has fluctuated in the unequal competition between terrorists and engineers. It is still producing just under 2 million barrels per day, a bit less than before the war, but that 2 MBD is a lot more valuable and much less optional now than it was then. When the US invaded Iraq in March 2003, the price of oil stood at $30, and supplies were starting to recover from the lengthy oil industry strike in Venezuela. Now, after a couple of years of feverish demand growth in Asia and a long series of production glitches, including Katrina and Rita, any serious disruption of Iraq's output would send prices back over $70, and possibly well beyond.

What does this have to do with US troop withdrawals, since most of the oil-field, pipeline and refinery security is in Iraqi hands? It's all a question of conditions after the US leaves. Conspiracy theories notwithstanding, the oil industry thrives on political stability, particularly when investments in the billions of dollars are involved. Only a stable, secure Iraq, ruled by laws and not fatwas, will provide an environment suitable for the investments needed to maintain and expand production. And in the event of a full-blown civil war--a very real possibility after a precipitous US pullout--damage or disruption to the oil facilities would be a virtual certainty, especially in the northern oil fields around Kirkuk that are claimed by the Kurds and the Sunnis.

I firmly believe that oil was not our primary motivatation for going into Iraq, nor should it be the main consideration in determining the timetable for a US military "redeployment." However, ignoring the security of Iraqi oil production and the role it plays in a very nervous global market could be extremely expensive, in both economic and political terms.

FYI, Energy Outlook will be on vacation until Friday, December 9.

From Little Green Plants to Big Gray Plants

Here's a good article from Technology Review on some of the new processes that could make biofuels much more economically and environmentally attractive than today's crop ethanol and biodiesel. The new techniques have a lot more in common with petrochemical plants than with the sort of "twee" whisky distillery-style operations that have characterized biofuels thus far. In order to contribute on a scale big enough to matter from a global energy perspective, bio starts to look pretty industrial.

Even so, industrial-scale biofuels should still offer beneficial geographic diversity of supply, compared to the petroleum products manufacturing and distribution system. After all, the relatively large bulk and low energy density of biomass, consisting of crop waste and energy crops, dictate a shorter supply chain than for coal and oil, which pack enough energy per ton to justify shipping them halfway around the world. As a result, it's hard to imagine biofuels facilities growing quite as large or concentrated as today's world-scale oil refinieries.

But larger scale is also probably the only way that biofuels can succeed in the long run, by gaining sufficient economies of scale to forego the motor fuels tax exemptions that keep boutique biofuels in the running today. Such benefits should always be regarded as an entry mechanism, and never as a sustainable source of profits, despite the experience of the US ethanol business. If biofuels are truly successful in displacing gasoline and diesel, governments will have to close these loopholes or find other ways to compensate for the lost revenues. That's probably still a decade or so away, but well within the operational--and financial--lifetime of any biofuels facility being planned today.

So although some of the current appeal of ethanol and biodiesel derives from the idea that they are produced in small, local facilities operating in harmony with nature, we're going to have to set aside some of this romanticism to gain the full energy and environmental benefits these fuels can offer.

A Nuclear Venezuela?

Two of the factors that contributed to America's rise as a world power were its abundant natural resources and the lack of a serious rival in its own hemisphere. Venezuela's current regime calls both of these attributes into question. It provides a temporarily successful alternative economic philosophy to sway its neighbors, and exploits its status as a key oil supplier to the US to hold our displeasure in check. In his latest effort to put a burr under our saddle, President Hugo Chavez's has expressed his ambition to bring nuclear power to Venezuela. It's hard to ignore the coincidence with the current international effort to bring Iran's nuclear program under control, but despite superficial similarities, this is probably more worrying in its generalities than its specifics.

While the economics of nuclear power in Iran appear unattractive, as I've described at some length, Venezuela is in a different position. It, too, has significant reserves of natural gas, but their proximity to growing markets makes them potentially more valuable than Iran's. And with an abundance of extremely heavy, low-quality oil, Venezuela might just be able to exploit nuclear power to leverage its hydrocarbon resources for export, in much the way that Iran has professed that it seeks to--spuriously, I believe.

So while it is entirely possible that Venezuela's desire for nuclear power stems from legitimate aspirations, it also neatly illustrates the challenges we face in preventing a wide variety of unreliable regimes from acquiring technology and materials that can be diverted into weapons, either directly by these regimes or indirectly through leakage into black-market channels such as those of A.Q. Khan's former nuclear hardware-and-knowhow network.

The seemingly inevitable final result of all this will be a nuclear detonation, somwhere, at some time in the future. The social, economic, and human consequences of that prospect ought to provide a tremendous incentive for the development of nuclear power that isn't only environmentally safer, but that inherently circumvents proliferation concerns. A fuel cycle based on Thorium, rather than Uranium, is one possibility, as one of my readers suggested a few months ago. Absent such a development, we're liable to find ourselves forced to choose between increasingly unsustainable double standards between the nuclear "haves" and "have nots", or a draconian international non-proliferation enforcement mechanism--an IAEA with real "black helicopters."

Electrons vs. Molecules

Following on from a couple of comments to yesterday's posting concerning batteries competing with fuel cells, the basic issue is how to deploy non-petroleum energy sources for transportation. Over 90% of all energy for transportation, including planes, trains and automobiles, currently comes from oil. Hydrogen fuel cells and rechargeable batteries are only two possible alternatives for enabling primary energy sources such as natural gas, wind and solar power, or coal, to compete directly with petroleum products.

There are other alternative routes requiring greater changes in our current transportation systems, including converting to electric cars that pick up power from the roadway or from microwave transmission. (Sadly, the Bluetooth short-range wireless protocol has co-opted one of the best frequencies for the latter.) I think designers have generally assumed that a fuel cell constitutes a more modest and palatable change, because it simply replaces the internal combustion engine, while leaving the car it powers recognizably a car, able to use the same roads as today. Hybrids better that proposition by avoiding the need for entirely new fueling infrastructure. Pure battery cars fall somewhere in between; electricity is ubiquitous but not necessarily at the voltage and amperes required to recharge a battery car quickly enough to suit motorists. (That was the downfall of the Southern California experiment with GM's EV-1.)

So when we think about how to make hydrogen for fuel cells, we need to consider how else that energy source could be used. Nuclear power produces no greenhouse gas emissions, but is its best use making hydrogen for cars or backing down coal-fired power plants? The hydrogen for the first fuel cell cars will mostly come from natural gas, but is that gas better employed that way or should it be burned directly in internal combustion engines, as we see in more and more city bus and taxi fleets? These questions can be answered, but only by looking at entire energy systems, rather than the little slices in which we're typically most interested. This is referred to as "well-to-wheels" analysis, and it considers every step in the chain, from the energy invested to extract the primary energy source, be it coal, oil, gas or uranium, to its final use in a vehicle or other energy-using device. It can be done on the basis of both energy efficiency and greenhouse gas emissions.

Finally, it's important to remember that engineering analysis doesn't always exert the greatest influence on such decisions. Consumer choices, politics, relative returns on investment, and a number of other factors will largely determine the final selection of the successor to our current gasoline-driven systems, if in fact any one successor emerges. It's equally possible that we could see a diverse mix of future transportation systems relying on different technologies and energy sources, but sharing the roads together.

With that I'll wish my US readers a Happy Thanksgiving. New postings will resume on Monday, November 28.