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

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

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

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

But on the other hand:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Have an enjoyable Thanksgiving!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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