Memes vs. Facts
Supposedly, just before the stock market crash of 1929, Bernard Baruch, one of the great financiers of Wall St., got a stock tip from the lad who shined his shoes (upon which he went to his office and instructed his broker to sell everything.)  In similar fashion, the oil-depletion meme now seems to be popping up everywhere.  Today, after logging out of Hotmail, MSN confronted me with this headline, "Is Saudi Arabia Running Out of Oil?"  The article is worth a look, but without rehashing the whole Hubbert argument, which I've discussed at some length in previous blogs, I must say I just want to yell at these people to ask the right question!

Whether you believe the current estimate of Saudi oil reserves of 260 billion barrels, the late 1980s estimate of 170 billion barrels--before most of OPEC revised their reserves upwards to game the quota system--or even the pre-nationalization estimate of 137 billion barrels, there is still a lot of oil left in the Kingdom.  Now, Matthew Simmons may well be right in assessing that the handful of giant fields that account for today's Saudi production are either in decline or nearing it, but that leaves a large number of identified, untapped oil fields for the future.  ExxonMobil and ChevronTexaco could probably confirm this, since they found most of them when they were joint owners of Aramco. 

So if there is plenty of oil left in Saudi Arabia, what is the right question to be asking?  I suggest it is this, "What is the project-by-project buildup behind their assertion that they can sustain production of 10 million barrels per day and grow it to 15, well into the future?"  If Saudi Arabia really wants to be the world's gas station for the next 50 years, rather than have us convert to renewable energy or develop all the oil sands, ultra-heavy oil, and other conventional alternatives, then it behooves them to be more open about their long-term production plans.  Specifically, year-by-year, when and how will they develop additional fields to take up the slack and grow production, as the super-giants like Ghawar slow down?  How much capital will this take, and where will it come from?  Do they have the technical expertise required, and if not, where do they plan to get it?  What assumptions are they making about the prices that underpin those cash flows? 

What this boils down to is providing the kind of information that the publicly-traded oil majors have to furnish in their SEC filings and analyst meetings.  In the past, that would have been unthinkable, and it's a bit hard to imagine now, but the world has changed.  Saudi Arabia is being asked to come to grips with an entirely new security environment, an internal and external challenge of terrorism, and the incompatibility of Saudi education with the modern world.  Why not throw in the lessons of Enron and Shell, in the bargain?  I won't hold my breath, but it's pretty clear that their failure to be forthcoming about this information merely fuels the uncertainty and suspicion that they are hiding something. 

Doing Well While Doing Good
A few days ago, I suggested that companies should approach climate change as a business risk, rather than an "issue".  I should have added that it is also a business opportunity, as exemplified by this program announced by the government yesterday.  Transferring technology and investing in projects to capture methane in developing countries is also an idea that makes sense regardless of where you stand on global warming.

Landfills in this country have been capturing methane for years, either to displace purchased natural gas or for onsite power generation.  The other, less publicized benefit is in reducing greenhouse gas emissions; this is the driving force behind the Methane to Markets Partnership.  Methane has 21 times the greenhouse impact of carbon dioxide, the greenhouse gas that gets the most attention.  If instead of allowing methane from landfills and agricultural sources to escape into the atmosphere, you capture it and simply burn it, you will reduce the greenhouse emissions to 5% of what they would have been.  If you take the next step and turn it into electricity, backing out another fuel in the process, you have effectively eliminated the emissions associated with the source you are managing, while producing something that can be sold at a profit.

Perhaps it is just human nature that we are more effective and enthusiastic when doing things for which we are rewarded than things someone requires us to do.  We are not going to make much headway on climate change if the only answer is draconian government mandates.  Harnessing the power of business and markets will go much further, in the long run.

Where To Spend It All
The major oil companies have begun releasing their earnings figures for the second quarter.  Earnings are expected to be up from the same time last year, and the first to report confirm this.  The Financial Times tallies the total from the top five companies at $17 billion dollars.  With oil and gas prices near record levels, and with most of the companies having merged and trimmed to lean fighting weight, how could they not now be rolling in cash?  Where will they spend it all?

Clearly some of this windfall will be go into financing: higher dividends, stock repurchases, and debt reduction.  BP's Chairman, Lord Browne, is quoted as saying, "Now is the turn of the shareholder." But even after satisfying investors and polishing balance sheets, there will be lots left over, adding to the accumulation from the last year of strong results.  There are really only two options that are likely to be considered, higher reinvestment and acquisitions. 

The former looks like an obvious choice, given global concerns about oil demand outpacing supply for the next few years, or longer.  But are there enough attractive opportunities in which to invest?  The best lie behind walls of state control or high risk, as in Saudi Arabia and Russia.  Absent enough star prospects, will companies really want to dig far down their lists of opportunities to invest in the kind of projects they've been busily divesting in the last five years?

That leaves M&A, which may look like a better deal.  After all, the stock prices of these companies currently reflect oil valuations far below current market levels.  If you believe in efficient markets, further consolidation at these prices would not be arbitrage, but folly.  However, as concern grows that oil production is approaching some sort of limit, whether imposed by geology, access to resources, or geopolitics, the industry starts to look like a zero-sum game.

How much more consolidation will regulators tolerate?  As long as buyers are happy to dispose of enough refining and marketing assets to keep the retail gasoline market looking competitive, there seem to be few impediments to higher concentration of exploration and production, particularly when the bulk of these activities falls outside the US or EU.  So does this portend the further rolling up of the second- and third-tier companies, or are we on the brink of the Super-Super Major?  Materiality will probably the decisive factor.

What Can We Agree On?
Regular readers know that I am fairly well persuaded that climate change is real, even if I'm still skeptical about some of the predictions concerning its outcomes.  But I also recognize that in the business world today there is nothing like consensus about the science behind climate change, or global warming, at least not in this country.  That's why I think articles like this one from Sunday's NY Times business section are so important.  It frames climate change as a business risk, not as a scientific debate, and I think that is precisely the right attitude for business to have, for several reasons.

First, as I used to tell the top management of my old company, nothing that an energy company can say about climate change (at least on the side of the skeptics) will be credible with the public.  Energy companies have too much of a vested interest, and I doubt that many non-energy companies would have much more credibility on the subject.  It's better to be seen as part of the solution than part of the problem.

Some might see that advice as unprincipled or cynical, but look at it this way: if the proponents, who seem to have a much larger fraction of mainstream scientists behind them, are right and things turn out badly, being on the wrong side of the issue might be catastrophic--and I'm not just talking about a few dollars of shareholder value here.  On the other hand, the risk of doing too much, too soon, is real, but it is like buying an insurance policy that might later turn out to have been unnecessary.

The other reason for adopting a risk framework, rather than treating it as an issue, relates to how companies solve problems.  It's natural to feel overwhelmed and out of one's depth when facing what could be the largest global environmental issue in the history of civilization.  It's important that governments and scientists view climate change that way, but that approach isn't conducive to sound business thinking.  On the other hand, dealing with it as a business risk, as Mr. Hakim's article argues that Ford, GM and other auto makers must, changes it into something that business is used to managing with the sophisticated tools at its disposal.

If we can all agree that climate change is a legitimate business risk, without having to line up on one side or the other of science that we may never be certain of in our lifetimes, then we are going to do a much better job of protecting shareholders' equity.  If you want to find companies that have made that leap, against the conventional wisdom, go talk to utilities, particularly those with a lot of coal-fired power generation. 

Finessing NIMBY
For a variety of reasons, the US supply of natural gas is not able to keep pace with demand.  This pushes us towards imports, with the largest potential for incremental imports coming from liquefied natural gas, or LNG.  But that requires large regasification facilities, which have generated a great deal of local opposition, as I've discussed in previous blogs.  Last Friday's Wall Street Journal highlights a different approach, based on an LNG tanker that regasifies its own cargo while still offshore, feeding it into a pipeline for delivery onshore.  This "Energy Bridge" could bypass much of the current opposition to LNG imports.

This approach has several advantages, including the avoidance of expensive onshore regasification facilities.  LNG terminals with this kind of equipment cost around a half billion dollars, while a simplified terminal with an offshore receiving point and some onshore storage tanks should cost a great deal less.  This strategy also puts the portion of the process that opponents see as most hazardous well away from the facility's neighbors.  And by reducing the onshore fixed costs, it might allow more receiving facilities to be built, enabling a more flexible supply network with tankers calling where their cargoes are in greatest demand, not just at a few locations, as now. 

Despite its advantages, the economics may not be quite as attractive as the intial impression suggests, due to the structure of the LNG business.  Because of the scale of investment required, LNG projects are developed only when the entire value chain is economical and the output of a new plant can be committed on long-term contracts.  A traditional chain consists of the liquefaction plant, a fleet of tankers, and several regasification facilities (often owned by the customer, not the producer.)  A value chain built around the EP Energy Bridge technology would require the same front end, a less expensive back end, but a larger and costlier tanker fleet. 

It is an old maxim of the shipping business that ships make money when they are moving, not when they are sitting still.  When a ship is idle in port, because of delays in loading or unloading, the ship owner collects demurrage from the cargo owner.  The longer the ship sits in port, the more demurrage you run up, and the more tankers you will need to deliver the contracted annual quantity.  Thus the economics of the Energy Bridge approach are a function of how much more these special tankers cost to build and operate than conventional LNG tankers, and how much time is added to each voyage to allow for regasification at the delivery point.   Furthermore, if these ships are not dedicated to fulfilling a long-term contract, but are casting about for spot cargoes, the situation looks much worse, and the return to the owner (or the lessee) will be much lower.   

On balance, it's a nifty idea that could help fill in some crucial gaps in our natural gas supply, but I doubt it will entirely displace the need for at either more LNG terminals with their own regasification capability, or a major new gas pipeline from Alaska or northern Canada.

Signs?
This morning's papers are full of the news that the Russian government has agreed to sell its 7.6% share in Lukoil, Russia's second-largest oil company and its most active outside the former Soviet Union, in a public auction.  At the same time, Mr. Putin has apparently met with the chairman of ConocoPhillips, which is keenly eyeing the Lukoil stake.   While such a deal might not be as material for Exxon or BP, it would be a nice plum for Conoco.

All of this is preliminary, and it is too soon to say whether this constitutes the positive, post-Yukos signal that the market needs.  Regardless of the fate of Yukos, minority holdings in Russian firms will still be risky, until the legal system has been cleaned up and modernized.  Still, with a sizeable portion of the non-OPEC world's unexploited oil reserves, Russia's strategic importance is simply too great to pass up.  Russian oil made the fortunes of an earlier generation of oil companies in the late 19th and early 20th centuries, and it clearly has the potential to turn this trick again.   Stay tuned. 

Sustainable Development
Bolivia has just held a referendum on how its hydrocarbon resources should be managed.  The five-point ballot covered the future role of the state and whether gas and oil should be exported, and how.  The referendum passed with a large majority, based on returns so far.  This was the issue that brought down the last government, amidst violent protests, and President Mesa may see the result as a vote of confidence in his government.

On the surface, the issue might seem almost ridiculous.  Bolivia, a poor, landlocked country, has few other things to sell to the world besides the natural gas reserves developed over the last few years with significant foreign investment.  Keeping the gas "for Bolivians" or renationalizing it would cut off both inward investment and hard currency revenues that the country badly needs. 

Aside from the issues unique to Bolivia, relating to the loss of its access to the sea in a 19th century war with Chile, the situation is consistent with resource management issues throughout the developing world.  In Indonesia, Nigeria, and other oil-rich countries we see local populations, which enjoy less benefit from the exploitation of these resources than they expect, reacting in ways that imperil the viability of massive projects.  Ultimately, for a resource contract to endure over the time required for the investors to earn an attractive return, there must be equity in benefits not only for the host government, but for the host population. 

I don't mean to suggest that the whole burden of ensuring this should fall to the international companies that find and develop these resources.  Rather, this is a primary responsibility of the governments in question, and it creates a responsibility for the companies to see that the countries fulfill their duties to their people.  Sustainable development, with its "triple bottom line" of economic, social, and environmental indicators may not be quite as prominent as it was a few years ago, but it is one way to devise measurable goals and milestones to which all parties can be held accountable.  Such an approach might have even headed off the renewed fervor in Bolivia for nationalization, which will benefit no one.

What Comes After Yukos?
The Yukos drama seems to be entering its endgame, with the Russian government announcing it will seize the company's largest asset and sell it to settle the year 2000 tax claim.  The operation in question is bigger than all but a handful of the international oil companies, at least in terms of reserves and production, and would be a gem in anyone's portfolio.  Will it go for top dollar or something closer to its original acquisition cost of $150 million?  Will international companies be allowed to bid?  What on earth does this mean for foreign investment in Russia's other companies?  There aren't any good answers yet, but the risk factor for investments in Russia should go way up, until we see whether this is a first move toward restructuring the whole post-breakup economy, or simply the resolution of a vendetta against Mr. Khodorkovsky. 

Oil has been a primary engine of Russian economic growth for the last several years, and I don't see how the government could imagine it could live without it.  Unless Mr. Putin is completely confident that there is already enough capital and expertise inside the country to sustain the recent expansion of Russian oil production, he will need to send a very big positive signal to foreign investors, and very soon.   

A Contrary Wind
Niall Ferguson isn't known for commentary on energy policy, but rather as a historian who has written perceptive and well-received books. His op-ed on wind power was published in Britain's Daily Telegraph paper last Friday. As he admits, it might easily be written off as a NIMBY-ism, but the issues he raises are ones that the proponents of wind power can't afford to ignore. They fall into three main categories:

First, that wind power is still expensive, compared with conventional power, and must rely on heavy government subsidies, though this was also true for other forms of power generation in their early days, notably the nuclear power industry.

Secondly, he complains that they are unreliable, and as such cannot replace other forms of power generation in supporting a stable electric grid. Wind is by its nature intermittent, and one of the biggest challenges wind developers face is either integrating it smoothly with the grid, or providing sufficient energy storage to smooth its peaks and valleys for remote, off-grid applications. This can run up the total cost of a wind project significantly. None of these problems is insurmountable, but they do add complexity that conventional power plants avoid.

Mr. Ferguson goes on to suggest that, because of these shortcomings, wind power's contribution to reducing greenhouse gas emissions will be much less than has been suggested and far less than the unpopular nuclear power plants that are being phased out in Britain and elsewhere. Others have made the same connection (see my blog of May 13, 2004), but I think in practice it's not a fair criticism. No developer is sitting down to choose between putting in a wind farm or building a nuclear power plant. The real-world choice is between wind power and fossil fuels, and on that basis, it reduces emissions.

Finally, the argument comes back to aesthetics, and in the long run I think this poses the most serious threat to really large-scale wind power development. Are there enough first class wind resources (see my blog of May 6, 2004 for a better explanation) in places close enough to where the demand is, but where few will object to their visual signature? The wind industry faces an uphill battle on this, and it would be wise to tackle it head on, with a well-designed public relations campaign. Not all of wind's critics are as articulate as Professor Ferguson, but they share his concerns.

By the way, without much fanfare, today is the 35th anniversary of Neil Armstrong's "small step for man". Coverage on the NASA website and on Space.com.

Future Competitors?
The Financial Times recently covered the ongoing changes in the Chinese oil industry, with PetroChina acquiring a licence for offshore exploration in the South China Sea.  Everyone seems to be talking about the rapid growth of China's oil consumption, but I haven't heard much about the implications for the international energy industry.  It's easy to forget that the main global competitors today, the Supermajors and their smaller kin, grew to dominance through a combination of successful oil exploration and large, growing downstream markets in their home countries.  The growth of China could well create one or two new global competitors for the same reasons.
 
A few years ago the conventional wisdom saw the biggest threat to the incumbant major oil companies coming from the national oil companies of the producing countries, both OPEC and non-OPEC.  In an era in which PDVSA, the Venezuelan state oil company, had bought Citgo in the US, and Kuwait had purchased the European refining and marketing assets of Gulf, that seemed a realistic development.  But the OPEC state oil companies haven't transitioned into true global competitors, for a variety of reasons including the domestic needs of their shareholder governments.  The Chinese companies could go down a similar path, but that doesn't seem consistent with other trends in China.  Instead, isn't it likelier that they'll learn as much as possible from their foreign joint venture partners and translate that knowledge into the competence to compete in a wider arena?
 
Today's international oil companies have tremendous advantages in technology, market access, brand identity, and capital, but in the globalizing economy none of these is permanent.  Legacies can be eroded, and new competitors become remarkably effective in less time than previously, if not exactly in "internet time."  If we try to imagine the top 10 international oil companies in 2020, who is willing to bet that a third of the list won't be Chinese or Russian?

Which Gas?
Whenever gasoline prices go up, there's a tendency to shop for cheaper brands and buy lower octane, to ease the pain. The NY Times last week published an article intended to help guide consumers in this quest. Most of it was pretty sensible, but I differ with them in a couple of areas, and this seems like a good topic for today, heading into a nice summer weekend.

First, octane. Octane is a measure of how slowly a gasoline burns. If it burns too fast in the cylinder, the engine pre-detonates, or "knocks". The Times recommended buying the lowest octane gas on which your car doesn't knock, and that's the tried and true rule. They also acknowledged that some cars can sense and compensate for lower octane, allowing a car designed for premium to run on regular. But I ask you, if you've spent upwards of $40,000 on a high-performance car, is it really worth saving $100/year (do the math) and missing some of the oomph you paid for?

Now, if that doesn't apply to you, then not only you but the rest of us are all better off if you buy lower octane. It turns out that the molecules that raise octane require more refining, consume more oil, and have a greater potential to harm the environment. If you're as old as I am, you might remember a TV ad for "Super Shell with Platformate." Well, all gasoline contains Platformate, and that's the stuff we're talking about here: aromatic hydrocarbons.

As to additives, I admit that this has gotten quite confusing and that even the cheapest gas contains a minimum level of detergent, set by the EPA. But particularly if your car has multi-port fuel injection, you can still benefit from paying for brand-name gas with a better additive package. As to the little cans and bottles of additive, which the Times seems to like, think about this. At the rate the best gasolines are additized, you are getting the equivalent of a bottle of top-grade additives with each 10 gallon fillup, at a price that I'll bet is less than what you'd pay for most of the do-it-yourself varieties, which may or may not be as good.

Finally, when you pull your car into that cheap off-brand station, you might want to consider who would stand behind them, if you were to get a tank of bad gas--a rare occurrence these days, but not an impossibility. Personally, I think you'd stand a better chance of getting a Shell, Chevron, Exxon or the like to pay for the repair of your expensive engine than you would with "Ed's Gas." (No offense, Ed.)

Happy motoring!

Data Power
It was several years ago that I first ran across the idea of using power lines to transmit data, including high speed internet access. After a long period of dormancy, it looks like this idea is starting to catch on, in different ways.

This article in MIT's Technology Review proposes utilities as potential competitors to DSL and cable providers. The NY Times recently looked at the potential for data over power lines to solve the problem of the "last mile", or even the last few feet, particularly when cleverly matched to wireless networks.

The advantages of this approach seem obvious, at least in terms of the ubiquity of the infrastructure. If "BPL" turns out to be as reliable as other broadband connections, it will open up large market segments that are currently unserved by DSL or cable, as well as providing some healthy competition to current operators who may presently feel free to collect monopoly rents from their subscribers. (My own cable provider increased its ongoing rates to $45/mo. vs. their $29.95 intial come-on.)

Less obviously, could offering this additional service provide utilities with the revenue and incentives to upgrade their own infrastructure, a need highlighted by last year's Northeast blackout?

Drilling What's Left
Last week the NY Times featured an editorial by former Secretary of the Interior Bruce Babbitt, in which he decried potential oil drilling in a sensitive portion of the National Petroleum Reserve-Alaska. Note that this is not the Arctic National Wildlife Refuge, but rather an area set aside by Congress for future oil exploration. I can't dispute Secretary Babbit's assertions about the ecological importance of the lake in question, or the area in general. I haven't the competence, nor is that the point. Rather, I am struck by the urgency of approaching the country's energy needs in a way that is realistic and recognizes the inevitability of trade-offs.

The lower-48 states are the most heavily explored and exploited oil province in the world, having produced nearly as much oil in the last 140 years as the Saudis claim to have left today. That has real implications for future domestic oil production, which peaked in the early 1970s and has been declining ever since, from roughly 10 million barrels per day then to about 6 million now, including Alaska. Although less heavily explored, Alaska is also experiencing declining production. The North Slope oil that made such a difference in the aftermath of the 1970s oil shocks reached a peak of 2 million barrels per day in the late 1980s, and is now less than half that. Without new discoveries, it will continue to drop.

There is additional oil to be found, but it will be in places that are more challenging (e.g. in deep water offshore), more remote, or previously off-limits to drilling. While at best this oil can extend the long plateau of US production, foregoing it entirely will lead directly to the rapid offshoring of the entire industry. I don't know if the National Petroleum Reserve-Alaska can provide the backfill needed to maintain Alaskan production at the current level, but without it, or oil from the Arctic National Wildlife Refuge, it is predetermined that Alaskan production will fall. That means more imports, without even considering the steady growth in demand.

While I can understand that there are some areas that are just so beautiful or so important to the natural world that we shouldn't drill there, I have a harder time seeing how we can continue to carve out chunks of Alaska as big as other states, set them off-limits, and yet continue to demand increasing quantities of oil and other energy to fuel our lifestyles. Something has to give, and this should be obvious to everyone, policy-makers and voters alike.

Bullish or Bearish on Hydrogen
Several colleagues have suggested that I've become awfully pessimistic about the potential of the "Hydrogen Economy", especially for someone who had been such an optimist a couple of years ago. After reflecting on a talk I gave yesterday, I realized that I sound pessimistic even to myself. But I need to draw an important distinction: if we are talking about the grand vision of a world of transport and stationary energy fueled by hydrogen that is generated by some clean source, then I am truly less sanguine now that this will arrive soon. However, I am not at all pessimistic about things like this.

I'd lay odds that, long before the average person owns a hydrogen car or lives in a fuel cell-powered home, small fuel cells running on hydrogen or methanol will routinely power our personal electronics. After all, a fuel cell is really just a fancy battery with an open loop, meaning that you can keep adding the ingredients for the electrochemical reaction that produces power. And because chemicals such as methanol store more energy per gram than current batteries, you'll be able to run your iPod or PDA/phone a lot longer unplugged than with even the best lithium ion battery.

Granted this is not what most people think of when they imagine the Hydrogen Economy, but the essence of that is using hydrogen as an energy carrier without combustion, and that's what these tiny fuel cells do. There's nothing wrong with starting small.

Digging Up Dirt
If you haven't already read it, I recommend Paul Volcker's Wall Street Journal editorial from last week describing his approach to investigating the allegations concerning the UN Iraq Oil-for-Food program. Kofi Annan could not have tapped anyone with a stronger reputation for integrity and independence; now we will see if the results surprise him or his critics.

As I've suggested before, if the allegations about the subversion of the Oil-for-Food program are proved out by the facts, then its program administrators would bear as much blame for the failure to avert war in Iraq as the intelligence community in its failure to accurately assess weapons of mass destruction. The future credibility of the UN is on the line, and I can only advise them to be utterly forthright and transparent in this investigation.

End of An Era?
Based on reports in the Financial Times and elsewhere, it is looking increasingly likely that Royal Dutch/Shell will accede to investor pressure and radically alter its governance structure. This would effectively end the world's oldest unconsummated joint venture and result in Shell looking--and acting?--more like its largest competitors, Exxon and BP. It would also stifle some of the wild scenarios currently circulating, such as the one in which Total takes a controlling interest in Royal Dutch and leverages this into a takeover of its much larger European peer.

While it may be past time for such a change, I doubt that a standard, US-style corporate governance structure would have prevented the recent management problems relating to the overbooking of reserves and their tardy disclosure. One has only to look at this week's indictment of Ken Lay, the former chairman of Enron, to deflate that notion. Rather, Shell's current weakness presents investors with an an ideal opportunity to push through a pet peeve. Only time will tell if the result better positions the company to deal with the challenges that lie ahead for the industry.

Election Issue
One of the points John Kerry raised in the speech announcing his running mate related to this country’s dependence on Middle East oil. His plea for a new focus on energy independence highlighted our high energy use but low reserves, in contrast to the Middle East, with 65% of the world's oil. If this becomes a persistent theme, it should make for an interesting national debate on energy, something I think is long overdue.

When I looked at the campaign websites of Senators Kerry and Edwards a few months ago (see my blog of February 27, I found some interesting comments about energy. Both seemed to be arguing for a diversification away from oil as soon as possible, for various reasons. In contrast, the energy strategy of the Administration rests on two pillars: bolstering supplies of our current energy sources, and investing in a long-term future alternative, hydrogen.

It will be interesting to see how these two approaches differ in their details, as the campaign heats up with the conventions and eventual debates. It will be equally interesting to see if the Democrats can maintain their focus on the issues, without resorting to trying to connect current energy policy to scandals and innuendo.

How Much Is Enough?
Today is another travel day, so this will be short. A week ago the Financial Times carried an article suggesting that the global oil industry--both publicly traded and state owned--has not been investing enough in new oil and gas production projects to maintain and grow current production. In fact, I see this as a much likelier and more plausible near-term threat to the ability of oil supplies to keep pace with demand than the speculative geology of the adherents of King Hubbert.

I am a big fan of markets, but I lay much of the blame for this phenomenon on a widespread misunderstanding of the market. If you look at the oil futures more than a year out, they are telling you that prices will revert to "normal", and well they may. If they do, big investments in new production will not enjoy the benefit of today's high prices. But the futures markets do not predict future prices; they merely reflect what buyers and sellers can agree on today, and that is not the same thing at all. Another day I'll talk about "market backwardation" and the role it plays in amplifying these false signals.

Finessing Kyoto
I recently wrote about state-level attempts to regulate the greenhouse gas emissions linked to climate change. (See my blog of June 14) In an editorial in the New York Times over the weekend, the former US chief negotiator proposed a new approach to addressing these emissions, even if the US can't bring itself to endorse the Kyoto Treaty.

As Mr. Eizenstat and his co-author point out, the Kyoto Treaty only covers the years 2008-12, while climate change is expected to be a major concern for the next century. The Kyoto reductions are only the tip of the iceberg in terms of emissions of CO2 and other greenhouse gases; something further will be needed in the longer-term. Without some sort of global consensus, this could take the form of a patchwork of competing and conflicting regional, national, and subnational programs. Mr. Eizenstat suggests an intriguing alternative that would put greenhouse gases in the same context as trade issues.

Just as international trade includes groupings such as NAFTA and bilateral arrangements, as well as supranational organizations like the WTO, the mechanisms to address climate change might include the global Framework Convention on Climate Change, as well as useful regional and nation-to-nation agreements. It is easier to imagine the US working within this kind of framework than in a purely Kyoto-centric system, particularly if the current administration is reelected.

But as the editorial rightly points out, there are threshholds below with independent approaches are not as helpful. US companies should be covered by rules that are consistent from coast to coast, rather than having to make their way through fifty different regimes.

This approach also requires some realism. The US is not going to meet its targets under the Kyoto Treaty, even if it were ratified by the Senate tomorrow. We are on a path to exceed that target by as much as a third, and trying to hit it even by the end of the 2012 first monitoring period would bring the economy to its knees. But that does not mean that we cannot be planning how we will get onto a path to greenhouse emissions stabilization and eventual reduction, in line with the other major industrial countries, even if that takes another decade.

Happy Independence Day!
...albeit a day late. No blog today, instead, a link to a remarkable new view of another planet, in this case, Saturn's moon Titan.

Is The Incremental Oil Too Sour?
An article in last Saturday's NY Times reminded me of an issue I've meant to cover for some time, namely the impact of changes in the sulfur content of oil as production shifts around the world. The Times focused on the impact on China, suggesting that rapidly growing demand and strains on its economy have lowered the quality of the crude oil China can afford to buy, with consequences for the level of sulfur emissions into the air. But this is only one aspect of a bigger picture.

While the rest of the world watches Saudi Arabia to see if it really can increase its oil production to meet the needs of the market, there has been little discussion about what kind of oil this will be. Oil quality varies tremendously from field to field and region to region. Saudi oil is typically light, indicating good yields of gasoline and diesel fuel with minimal processing, but sour, reflecting high sulfur content. Without additional processing, this sulfur will end up in the fuel products, and ultimately in the atmosphere. As a result, Saudi oil trades at a discount to West Texas Intermediate and North Sea Brent, the main marker crudes, which are light and sweet.

(These sweet vs. sour labels go back to the days before laboratory analysis was readily available in the field, and the standard way to gauge the sulfur content of oil was to taste it!)

Not only is the incremental oil from Saudi Arabia going to be sour, but many of the fields that are in decline in mature areas such as the US and North Sea have historically produced lighter, sweeter crudes. As a result, the average crude oil in the world will become increasingly sour, both in the near term as Saudi Arabia ramps up to fill the current gap, and in the longer term as more of the global production burden falls on the enormous reserves throughout the Middle East.

Although the developed countries can compensate for changing crude oil sulfur levels through investment in refinery hardware, this is harder for the developing world, where investments in environmental quality often take a back seat to building basic capacity. For example, if China has $1 billion to invest in refineries, will they spend it on desulfurization hardware to improve the environmental characteristics of fuels, or will they use it to expand refinery capacity, so they can meet the growing demand for fuels without higher imports of finished products? If the latter, then air quality will suffer.

Sulfur is only one aspect of changing crude oil quality. In the years ahead, refiners must find the capital for hardware to process crudes that are both higher in sulfur and contain fewer of the direct precursors of gasoline, while producing a slate of products meeting ever more restrictive quality requirements. Such investments have historically performed poorly, and more will be made only if refining margins—the difference between the price of crude and the value of its products—remain attractive, as they are this year. Otherwise, existing capacity will be strained further, and consumers will suffer, as we are seeing today.

The Island of California
My friends at the Global Business Network used to display an old map depicting California as an island, as a way of indicating how mental maps can affect planning. This morning's New York Times featured an analysis by Hal Varian, a professor at my B-school alma mater, that explains why California might as well be an island, insofar as its gasoline market is concerned.

Gasoline prices in California are generally higher and more volatile than in the rest of the country. Geography plays a role, since the distance to the main refining centers of the Gulf Coast has made pipeline supplies from there impractical. Regulations have reinforced this isolation, going back to the 1980s, when Southern California enacted its first rules creating gasoline specifications that were stricter than in the rest of the country. This disparity has been exacerbated by the extremely severe California Air Resources Board (CARB) specifications, which make gasoline in the state the toughest to produce in the world.

Professor Varian discusses some recent proposals for state government to play a role in the market and rightly dismisses these as likely to create further distortions. Having already suffered an electricity crisis largely caused by "misderegulation", the Golden State doesn't need another state sponsored energy meltdown.

The proposal he favors is not a new one. When local supply is inadequate to meet demand, refiners and traders would be allowed to import gasoline that meets US specifications--but not California's--by paying a sizable tax to equalize its cost to that of manufacturing CARB gasoline. While this might well alleviate some temporary price excursions, it still fails to address the long-term challenge of a market in which refiners have had little incentive--and many disincentives--to build enough local capacity to create a reserve margin.

In many ways, this situation resembles the conditions that existed just prior to the electricity crisis. Demand was outstripping capacity, which had stagnated for years due to problems of permitting and environmental regulations and litigation. The result was a market with no reserve capacity and highly inelastic demand, mirroring Dr. Varian description of the current gasoline market. The only effective way to redress this would be to encourage the construction of additional refining capacity, something that seems almost inconceivable in a state that has long appeared to have an implicit strategy to force refiners out of state.

So perhaps the only fixes are short-term fixes, until the system breaks completely, and voters demand a long-term solution. If so, then Dr. Varian's proposal is as good as any and better than most.