Subtracting Wedges

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

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

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

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

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

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

Global Gas

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

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

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

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

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

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

Local vs. Global Solutions

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

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

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

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

Access to Resources

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

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

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

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

Deferred Again

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

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

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

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

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

Fat vs. Skinny Branches

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

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

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

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

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

Hybrids Down to Earth

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

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

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

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

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

The Next Oil Crisis

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

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

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

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

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

Too High or Too Low?

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

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

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

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

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

If Not There...?

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

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

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

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

Congress Examines Peak Oil

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

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

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

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

How Did Natural Gas Get to $15?

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

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

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

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

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

Revolving Tür

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

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

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

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

Voluntary Mechanisms

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

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

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

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

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

Is Oil Blocking Iraq's Exits?

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

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

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

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

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

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

From Little Green Plants to Big Gray Plants

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

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

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

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

A Nuclear Venezuela?

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

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

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

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

Electrons vs. Molecules

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

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

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

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

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

Protons vs. Electrons

My posting last Friday on hydrogen cars for China generated a thought-provoking comment suggesting that advances in battery technology would foreclose the opportunity that hydrogen fuel cells are chasing, at least in automobiles. When you consider developments such as next-generation Lithium-ion batteries that promise to cost less, recharge faster, and last longer than current hybrid car batteries, the threat to fuel cells could be considerable. After all, fuel cells and hydrogen are only one path with the potential to improve vehicle efficiency, reduce oil dependence, and lower greenhouse gas emissions. Hydrogen has no monopoly on these outcomes.

When the first hybrid cars appeared in the late 1990s, they raised the bar against which hydrogen fuel cells would have to compete, in three important areas:

• They provided energy efficiency improvements nearly as large as those promised by fuel cells.
• They reduced greenhouse gas emissions by almost as much as fuel cells, when the emissions associated with producing, storing and transporting hydrogen from natural gas--the primary current source--were included.
• They delivered these benefits at a substantially lower cost than fuel cells, even based on optimistic forecasts of fuel cell manufacturing cost reductions.

The prospect of plug-in hybrids raises the bar even higher, bearing in mind that neither plug hybrids nor fuel cell cars are yet in mass production. Plug-in hybrids would leverage the fuel consumption and emissions of an internal combustion engine by recharging with grid-based electricity, rather than just recycling braking energy, as conventional hybrids such as the Prius do. With improved batteries, the all-electric range of plug hybrids could be significant, and their cost premium over conventional hybrids modest.

As promising as this technology sounds, it's premature to write off the hydrogen fuel cell, because a device with no moving parts ought to have an inherent advantage over even a highly-advanced internal combustion engine. However, better batteries and the rapidly accumulating real-world experience generated by hundreds of thousands of production hybrid cars could keep pushing fuel cells over the horizon for some time.

Deeper Disincentives

Washington, DC, November 10, 2037 - Yesterday's Senate Energy Committee hearing on the exorbitant profits of the biodiesel industry was marked by controversy and a series of heated exchanges between senators and industry executives. Several senators accused the industry of collusion and price-fixing, while the biodiesel CEOs assured the panel that the recent doubling of biodiesel prices--and the resulting earnings bonanza for the industry--was entirely attributable to the summer drought and a persistent blight affecting canola and other oilseed crops. Suggestions that the provisions of the Energy Act of 2022 be waived temporarily to allow diesel cars and buses to fuel up with petroleum diesel brought Senator Jones to her feet. "My constituents have a right to purchase biodiesel at an affordable price, since it is the only environmentally safe fuel for their cars. Your high prices and excessive profits are a betrayal of the public trust granted to you."

This might seem like a highly fanciful scenario, but I think it illustrates an important argument concerning proposed Congressional action to tax the oil industry on its "windfall." As Ben Stein's Sunday NY Times column explained, and as I suggested in last Thursday's posting, this is bad policy with respect to the oil industry, but it also sends worrying signals to the alternative fuels industry that many hope will ultimately supplant a large portion of our currently petroleum dependence.

There is a notion at the heart of the criticism of the oil industry's recent high profits that should make us all nervous, although you'll never see it articulated in precisely this way, that in this country, only the government is entitled to earn more than a few cents per gallon on the sale of motor fuels to the public. Companies in this industry are viewed as performing a public service in a near monopoly, and thus should earn utility-like returns. You'll note that there's nothing in this idea that is specific to oil.

Now, as long as the ire of the public and its elected representatives is focused on oil companies, who deal with unpleasant foreign governments and operate on a scale beyond the comprehension of the average person, this may seem like a reasonable proposition. Fuel for your car is a necessity, not a luxury, after all. Why should someone be allowed to make huge profits at the expense of consumers on products they'd make anyway?

It's even harder to see how this could ever apply to the alternative fuels industry, because at present it is so small--and thus benign. It functions either as a cottage industry or as a semi-philanthropic or highly prospective sideline of big energy firms. But if alternative energy is ever really going to matter, relative to our challenges of energy security, trade imbalances, and climate change, it must eventually operate on a scale comparable to today's oil business. That means producing and selling not just millions, but billions, and ultimately hundreds of billions of gallons per year of fuel.

Now, perhaps the people who currently invest in startup companies in this area would be satisfied merely to break even, because they are motivated by impulses other than the allure of profits. But the alternative fuels industry, whether it is built on biofuels, coal liquefaction, oil shale processing or other technologies, will require enormous capital--probably hundreds of billions of dollars--to attain even a tenth of the scale of the present oil industry. You don't invest that kind of money to earn what you could make on a T-bill or a market index fund. And you won't invest it, if you are convinced that the first time you make a big profit, the government will swoop in and seize part of it, because you are selling the public something they can't do without.

While most of the executives of today's alternative fuels companies would probably think that growing large enough to get on the radar screen of a congressional committee would be a remarkable indication of success, I'd be surprised if the more thoughtful among them aren't squirming already, just a bit, because they recognize the magnitude of the profits they will need to make--in proportion to the tremendous risks they are undertaking--to grow as rapidly as they and we would like.

Hydrogen for China's Cars?

I see in the San Francisco Chronicle that Governor Schwarzenegger included a pitch for renewable energy and hydrogen cars on his recent trade trip to China. He raised some interesting points about energy and the environment, though there are practical limitations on how quickly all this could happen. But as I read this article, it reminded me of the "technology leapfrogging" argument we've frequently heard in information technology and telecoms, and that some have attempted to apply to energy technology. Simply put, could China deploy technologies such as hydrogen fuel cell cars faster than the US, because they are not competing with as much legacy infrastructure? You can't dismiss this argument out of hand.

There are currently at least four major obstacles to the implementation of a hydrogen-based transportation system:

• Hydrogen requires significant energy inputs in its production, typically exceeding the energy content of the hydrogen by at least 50%. To be competitive, hydrogen would have to be produced from an energy source that is plentiful and low-cost.
• Distributing hydrogen requires new infrastructure, if it is produced centrally. Because of its tendency to make normal steel brittle, and to escape through all but the tightest seals, hydrogen pipelines would be significantly more expensive than for natural gas.
• Present methods for storing hydrogen either at high pressure or in liquefied form are very energy-intensive. Liquid hydrogen has a tendency to boil away, and the safety aspects of carrying any gas at 10,000 psi are worrying.
• Modifying internal combustion engines to run on hydrogen is an inefficient dead end. Hydrogen cars will need cheap, efficient fuel cells, or there won't be many hydrogen cars.

For China to implement hydrogen cars faster than the US, it stands to reason that they would need an edge in overcoming one or more of these obstacles. None of the above problems really plays to China's natural advantage in low-cost manufacturing. If anything, China is at a disadvantage, because it has smaller indigenous sources of energy than the US, and is rapidly growing dependent on expensive imports, to the chagrin of the whole oil-importing world. This puts them in a poor position to waste energy by converting oil and natural gas into hydrogen. And renewable electricity from wind and solar power would be in as much demand for displacing dirty coal plants, as for making clean hydrogen.

The infrastructure step is the only place I see any real possibilities, and the challenge there is that it's unclear where in the supply chain hydrogen should be produced: centrally, locally, or onboard the vehicle. Until you have that figured out, based on production technology and storage advances, you can't invest in mass infrastructure. Meanwhile, Chinese sales of cars using gasoline are growing at rates that we haven't seen here in 50 years, putting tremendous pressure on existing petroleum products infrastructure. They simply can't wait to figure out the hydrogen path, before investing to fuel today's cars.

The most intriguing possibility may actually be the one implicit in Governor Schwarzenegger's trip. If you haven't lived in California, it would be easy to miss the degree to which the state has become an important Pacific Rim country, with strong trans-Pacific trade ties and a GDP larger than that of South Korea, Thailand, Taiwan, Singapore and Hong Kong, combined. A Sino-Californian hydrogen alliance could fill most of the capability gaps I identified above, while providing two enormous early-adopter markets eager for new, clean tech. Perhaps Arnold is onto something.

Clawing Back the Windfall?

No one who watched last week's Senate hearing on the oil industry will be surprised by the latest development. On Tuesday, the Senate Finance Committee voted to incorporate what amounts to a temporary tax on oil company profits in a bill designed to provide tax breaks for hurricane reconstruction. While this may go a small way towards satisfying irate motorists, the mechanism involved will make our already stretched energy infrastructure even more vulnerable to disruption.

The proposed change would affect the way that oil companies account for the value of their inventories for tax purposes. Most companies use the Last-In/First-Out (LIFO) method of inventory accounting. Under this system, the cost of goods sold is determined by the most recent purchases, not by cheaper product already in inventory. If the Senate version of this bill passes, any oil company with more than $1 billion in sales would have to recognize 75% of the increased inventory value between year-end 2004 and year-end 2005. If that were done based on yesterday's closing price on the NY Mercantile Exchange, it would amount to about $10.00/barrel of additional taxable earnings for every barrel of inventory held by these companies. In aggregate, the Senate expects this to generate approximately $5 billion in extra taxes from the affected companies.

The arguments against this are different from those against a simple surtax on oil company profits, which would act as a general deterrent to investment in the industry. In some respects, this kind of back-door tax is even worse, because it increases the existing disincentives for holding commercial oil inventories, while taxing income that hasn't yet occurred and may never, if prices fall again. Lower inventories will increase oil market volatility and translate directly into reduced flexibility in operations.

The less inventory a refinery carries, the less it is able to respond to sudden changes in the market or events that affect crude oil supplies, such as hurricanes or terrorist incidents. Hammering oil companies for the unrealized appreciation of their inventories--not unlike taxing you for the market appreciation of your house, even if you have no plans to sell it--sends a negative and unhelpful signal to an industry that has already seen its inventories decline from the equivalent of 27 days of average refinery throughput in 1990 to only 19 days in 2004.

There could also be other, unintended consequences. LIFO accounting creates all sorts of quirks. It's entirely possible that some of the companies subject to this provision have been hanging onto inventory they might otherwise not want, to avoid realizing the earnings associated with selling it. For example, a company might have a "LIFO layer" going back to when oil was $10/barrel. Liquidating it at $60 would generate cash but also a big tax liability. However, if the Senate is going to impose that liability even if the inventory isn't sold, then the incentive to hang onto those barrels vanishes. The result of this across the whole industry might create a quantum drop in inventory.

An even more convoluted version of this scenario would entail drawing down inventories drastically at the end of December, then stocking up in early January at prevailing market prices. That would create a massive new high-cost LIFO layer, effectively trading unavoidable high taxes today for lower taxes later.

I fully understand the pressures under which our elected representatives are operating in this area. But sometimes leadership means recognizing and explaining the counter-productivity of a popular measure. The oil companies won't win any "most admired" contests these days, but it is in everyone's interest that they be allowed to function in a manner consistent with providing reliable supplies of energy, even if that means that they occasionally earn extraordinary profits when prices are high. Clawing back these profits by selectively fiddling with established accounting methods is a deeply bad idea.

Does Blogging Make a Difference?

A few months ago I mentioned signing up for TerraPass, a voluntary mechanism for offsetting automobile greenhouse gas emissions by funding projects to reduce emissions in other sectors. Now it appears that TerraPass, or more specifically their blog, may have helped defeat a ballot initiative in California. Proposition 80 would have re-regulated the market in such a way as to restrict customer choice in electric providers. Having grown up in California, and considering the market mayhem that occurred there in 2001-2, I'm somewhat surprised that this initiative didn't win, let alone that it went down to resounding defeat, by a margin of 66% against 34%. It's just possible that bloggers played a role in that defeat, as TerraPass suggests.

Why would TerraPass care about the structure of California's utility market, and why, for that matter, should anyone else? It comes down to promoting innovation and the ability of alternative energy, including "green" alternative energy, to compete in the market on an equal footing with traditional energy suppliers. If you block their access to the market--in this case to retail electricity customers--alternative energy firms won't be able to demonstrate the kind of value that attracts investors. No investors, no alternative energy. Furthermore, stifling these activities in California, where many of them have been incubated in the past, could have consequences far beyond the state's borders.

This is crucial for TerraPass and anyone else who cares about reducing greenhouse gas emissions, because alternative energy projects, including wind and solar power, are a major source of the emissions offsets on which TerraPass's business is based. They are also an important, though at this point small, source of greenhouse-gas-free energy for the economy as a whole.

I think there are a couple of takeaways from this event. First, having a market that's open to innovation appeals to a broad range of constituencies. It appears that California's voters didn't buy into the victimization model that's been foisted on them by folks peddling highly distorted versions of the lessons from the California Energy Crisis. Perhaps they understand better than their state's lawmakers that it was a poorly-designed, badly-executed deregulation that caused the problem, rather than deregulation, per se. Secondly, the non-traditional voices that are having a greater impact on politics in general turn out to be influential on energy policy issues, too. That's good news for those of use blogging away in the energy space, trying to cut through a mass of confusion and partisan propaganda.

Market Pricing

I keep seeing further reactions to last week's Senate hearing on the oil industry. While some commentators seem satisfied by explanations of hurricane-induced gasoline shortfalls and comparisons to profit margins in other industries, others continue to pursue oil company profits as if they were the next Enron scandal. While stipulating that the industry has done a dismal job of explaining how it works--not just at times of exceptional profits but throughout the boom-and-bust cycles that have typified most of its century-plus existence--I find the economic ignorance on display by journalists and elected officials simply breathtaking. In the process, the public is being misled into a conspiracy-theory mindset, hardly a tough sell in 2005 America.

For example, Friday's Washington Post business section included an article entitled, "Oil's Bigwigs Enjoy a Rigged Market." It's author, Mr. Pearlstein, offered some "simple truths", including his observation that the oil market is rigged by Middle East producers and thus doesn't justify being called a market. Perhaps he paid too much attention to Exxon Chairman Lee Raymond's muddled explanation of how oil prices are set, which should have mentioned that the Saudis and other producers do not set their prices in a vacuum, but instead pay a great deal of attention to oil markets around the world, and particularly to the futures markets in London, New York and Singapore. While it's true that the major oil companies don't set the price of the commodity, neither does OPEC, when all its members are producing flat out in a global market with essentially no spare capacity. Who sets the price, then? Buyers do, including those in Shanghai and Mumbai, by bidding it up.

Monday's Post featured an op-ed by William Raspberry, "An Oily Flavor." He correctly observed that the five industry execs couldn't adequately explain why record profits and record prices happened to coincide with the hurricane aftermath, and thus weren't the direct result of gouging consumers. (Try my posting of last Thursday for an explanation.) Where Mr. Raspberry and the CEOs went awry was in linking prices with costs. Street prices for gasoline may have gone up because suppliers raised their prices to dealers, but the prices charged by suppliers went up because a market with a voracious appetite was suddenly short about a quarter of its normal supplies, not because the cost of making gasoline had suddenly shot up. The laws of economics may not function with quite the remorseless rigor of those of physics, but in a situation like that there's only one way prices can go: up, with a vengeance. If companies had "sacrificed" by keeping prices low, as Mr. Raspberry and Senator Boxer suggested they should have, then half the gas stations in the country would have run out, and the ensuing hearings would have focused on oil company incompetence and shareholder injury, not profits.

While I could single out many other comments for similar treatment, the basic problem is that we live in a market economy in which only a small fraction of the population actually seems to understand markets or be comfortable with their adverse outcomes. And those few who do are either incapable of explaining market behavior in simple English, or are afraid that providing such an explanation would result in a populist backlash and further regulation.

If I told you that the price of oil is set in the same way as the price of a share of stock or a bushel of corn, would it make more sense than what you heard last Wednesday? Buyers buy because they have a need or think the price is going up. Sellers sell because they have more than they need or think the price is going down. Some have a bit more information about future supply or demand than others--or think they do--and some have a longer-term perspective than others. The level at which as many buyers are willing to buy as sellers are to sell is the price, for that moment. You can add as much complexity to that story as you wish, for oil, stocks or corn. You can talk about OPEC, its efforts to restrict current and future supply, and how effective it has been at different times. You can talk about the futures markets and the various forces that drive them, along with the leverage they generate when most other transactions around the world are settled based on their closing prices--something that was not true when I traded oil in the 1980s and early 90s. In other words, you can make this picture as detailed as you like, without changing its essence.

The point is that however complicated these markets are, they aren't incomprehensible, particularly to someone with a reasonable education. The failure here is not of oil markets, but of our past efforts to explain them simply and understandably. We pay for that failure every time the conversation about pricing becomes so confused and convoluted that it looks like someone is hiding something, as so many seem to have concluded from last week's panel in D.C.

Complacency and Conservation

For Americans my age and older, "energy conservation" conjures up images of President Carter appearing on TV in a sweater, as noted in this business op-ed from Sunday's New York Times. However awkward those efforts might have been, then, serious conservation behavior is appropriate again, at least for the next several months. We are in a brief, seasonal trough between two different energy crises, and it would be natural to become a bit complacent. But rather than easing up on our conservation efforts, this is just the time to put them into high gear, to avert the worst of the energy problems that winter could bring.

When the hurricanes clobbered the gulf coast this summer, they hit the refining industry as it was preparing for the end of the peak driving season and the onset of the annual transition to maximum heating oil production. In order to mitigate the resulting gasoline shortfall, refineries continued to flog gasoline production much later into the year than normal, at the expense of diesel fuel and heating oil. This is why diesel prices have fallen much less than gasoline prices have in recent weeks, and inventories of diesel and heating oil are unusually low going into winter.

In parallel with the heating oil shortfall, the hurricanes shut in about 10% of US natural gas production. 4 billion cubic feet per day of gas remains offline at this point, but inventories in storage are at about seasonal norms, due to the reduction in industrial demand resulting from high prices and hurricane damage. But that shouldn't promote over-confidence; gas inventories would have to be exceptionally high to compensate for both high winter demand and production that remains 7% below average.

All this suggests that while gasoline prices have retreated to their lowest levels since before Hurricane Katrina hit, we face an even tougher problem with heating fuels in the months ahead. And as unglamorous as it may sound, the only factor that can make a difference at this point is conservation. There's no extra production that can be brought online. There's no flood of imports waiting to save the day, as there was for gasoline. A little belt tightening now could pay big dividends when the weather gets cold.

The kind of conservation I have in mind has nothing to do with driving less, unless you own a diesel car. It's as simple as turning off unnecessary lights, waiting to run the dishwasher until it's full, and turning off the power strip--not just the pc--when you're done with it. Saving electricity saves natural gas, because 42% of the gas we use goes to generate electricity. And saving gas now frees up more to go into storage, for use in January and February.

Not only would immediate conservation ensure that there'll be more gas when we really need it, but it would also cut our gas and power bills, as part of the normal market "feedback loop." We normally focus on the other part of this cycle, in which high prices reduce demand, which in turn reduces prices, but you can jump into this loop anywhere. Voluntary conservation works just as well as the price-motivated kind, even though it's harder to explain to economists.

If you can look around your home or office without finding easy ways to save 10% of your electricity use, I'd be surprised. The aggregation of 200 million consumers doing that could bring natural gas prices down by several dollars per million BTUs, now, and shave a comparable amount off the winter peaks, later. What are you waiting for?

Optimizing Nuclear Power

Conventional wisdom is increasingly coming around to the idea that nuclear power will be an important contributor to meeting our needs for low-greenhouse-gas energy. While there are still groups that oppose nukes for both environmental and economic reasons, they are being undermined by market conditions and voices of dissent from within. When I look at the potential of nuclear power, though, I can't help wondering if we're looking at it in the right way. Are large, central nuclear power plants, with their issues of lengthy permitting, daunting project timelines, and large-scale waste management problems, the best way to use the power of the atom? An article from Technology Review suggests another approach, and I'm equally intrigued by the possibility of using nuclear to leverage conventional fuels.

The CEO of Total made news recently by suggesting that nuclear power could be the key to unlocking Canada's oil sands reserves. The more I've thought about this, the more sense it makes, as a specific and useful, non-traditional application of nuclear energy.

The basic problem with oil sands--or tar sands, as they were called before their PR makeover--is that it takes a lot of energy to free the liquids from the minerals that have trapped them, and to upgrade this heavy, sludgy material into something resembling the crude oil we pump out of the ground. The principal sources of that energy are Canadian natural gas, which would otherwise come to the US market to heat homes or produce electricity, and the solid residue from oil sands upgrading, which can be turned into synthetic gas. In either case, the combustion of these fuels generates greenhouse gases. When added to the emissions from burning the products made from the synthetic crude in our cars and homes, they make the environmental impact of the total oil sands cycle look pretty similar to mining and burning coal.

Generating the heat for oil sands extraction and processing from nuclear fission, rather than from methane combustion, would improve both the energy efficiency and climate change consequences of oil sands, putting them on a par with conventional crude oil. It would have the added benefit of removing a key constraint on the total volume of oil sands that can be recovered, which is currently restricted by natural gas availability. The net result would be to increase both Canadian oil sands production and natural gas exports.

What this really comes down to is asking what nuclear power can do better than other energy sources, and applying it there preferentially. That might not eliminate all opposition to nuclear power, but it would certainly make the benefits clear.

Vertical Integration

Yesterday's Senate hearing provided some fascinating insights, not only on the energy industry but in how our government processes work. Other than two Senators who used the occasion to attempt to embarrass the executives into supporting a specific proposal, or badger them into appearing to support something detrimental to the industry, most of the questions were thoughtful, appropriate, and stimulating--even if they didn't cover all the issues I highlighted in yesterday's posting. I'd like to focus on a question from Senator Gordon Smith of Oregon. He asked about the impact of vertical integration on high prices and industry profitability. I'm not sure he got a clear answer, or at least one that would adequately explain to the public what vertical integration in the energy industry really means today, which is quite different from what it used to mean.

When I filled up my first car at Shell stations in the mid-1970s, the gasoline I put into it almost certainly came from a Shell refinery, processing crude oil produced from Shell's oil wells and transported in a Shell tanker or pipeline. That's what we normally think of when we talk about "integrated oil companies." But however true that picture was then, it no longer reflects the way the industry actually operates. Today, while these companies still participate in the most important elements of the industry's "value chain"--the connected business segments that hand off the commodity to the next segment in line, and finally sell it to consumers--that participation is increasingly through relationships other than direct ownership of the commodity at every stage.

First, let's look at crude oil. After the wave of nationalizations in the 1970s, much of the oil previously "owned" by the international companies became the property of state enterprises such as Saudi Aramco, Petroleos de Venezuela, Pertamina, and others. The major oil companies had to rebuild their portfolios, typically on terms that involved higher royalties, taxes, and sometimes even profit caps. As production from their US oil reserves declined over the last three decades, while demand increased, most of them became increasingly reliant on third party suppliers of crude oil. Exxon, for example, produces less than half the oil they refine globally, and that doesn't factor in any production sold to third parties, due to location or quality.

The refining business has changed significantly, too. We heard a great deal yesterday about the lack of new refinery construction in the US, but little about the vast restructuring of the industry in the 1980s and 1990s, when many small refineries were shut down, and many others were sold by the majors to independents such as Valero, today's number one US refiner. This change has put most of the majors in the position of buying refined products from either independent US refiners or offshore facilities, in order to supply their domestic markets. Chevron's refineries cover only half the company's global marketing requirements.

Transportation has changed, too. Few of the companies own their own tanker fleets, and even when they do, they must supplement with chartered tankers owned by others. And while the majors still own important pipeline interests, companies such as Kinder Morgan and Berkshire Hathaway own large chunks of this critical infrastructure.

Finally, in retail marketing most of the name-brand gas stations you see are owned or operated by local businesses. Many of them don't even receive their products directly from the company, but through a distributor, who is responsible for delivery and probably maintains his own inventory.

The actual industry structure has evolved to one of "virtual integration", rather than true vertical integration, and I think this helps to explain some perplexing aspects of the current industry profitability. One of the Senators observed that it seemed odd that high crude oil prices would push up profits, when they simultaneously raise the company's cost of doing business. But when you examine this disaggregated business model, you can see how this could happen:

• High oil prices boost earnings for the Upstream, where oil is discovered and produced, on the production it owns outright, and to a lesser degree on oil for which it shares profits with foreign state oil companies.
• The refining segment pays more for its inputs, but when demand exceeds the ability to supply, refining margins go up. As a result, refining segment earnings rise, in some cases dramatically. So even for companies that experienced refinery damage or shutdowns in the aftermath of the hurricanes, the margins at their remaining facilities offset the value of lost throughput.
• Marketing sees higher costs for both third-party and company supplies--which are normally transferred at market prices--but it passes these on to dealers and distributors, and so is probably little affected.
• Retailers at the end of the chain see their costs go up, and may end up getting squeezed between their suppliers and customers. Even if they can pass along 100% of the increases, their profits may drop, since higher prices reduce the volumes they sell.

That's how a "virtually integrated" oil company can make money from each segment, even if it doesn't control 100% of its supply throughout the chain. All of these segments are run as profit centers, or as totally independent businesses, and optimize their own activities more or less without regard to the others. It's a model that has worked very well in an era of plentiful hydrocarbons and ample refining capacity. Whether it can sustain its performance in a period of scarcity and tight capacity remains to be seen.

Grilling the Chiefs

The heads of the largest US oil and gas companies, including the US subsidiary of Shell, will testify before the US Senate today (9:30 AM, C-SPAN3.) Energy markets have given the economy an E-ticket ride for the last year-and-a-half, and these conditions have produced remarkable profits at Exxon, Chevron, ConocoPhillips, etc. Under the circumstances, no one should be surprised to see energy CEOs hauled before Congress, but other than attempting to shame them for making lots of money while the rest of the country struggles to pay its fuel bills, what can we really learn?

The premise of the hearing appears to have been set by Senator Domenici, the chair of the Energy Committee, who said, “Oil companies have failed to tell us and show us what they are doing with these profits that justify them.” Fair enough, though I'm not aware of any restriction that companies may earn only those profits they can "justify"; it would certainly be news to Yahoo and Google, and to a number of large banks. The Congress could be kept pretty busy interviewing executives of companies earning more than, say, a 5% net margin on sales. (The big oils are currently making about 7-10%.)

If this is going to be more than an opportunity for Senators to show their constituencies that they are seriously concerned about our energy woes, they will need to ask more insightful questions than, "What are you doing with all the money?" Here are a few suggestions, by category:

Upstream:

• Are there any significant domestic reserves of oil and natural gas that would be economical to produce, but to which you do not have access? Where are they, and what prevents your bringing them to market?
• How can the Congress and the Government assist the industry in obtaining access to world-class energy reserves in countries that currently limit their access to monopoly state oil and gas enterprises?
• Many of your companies currently return as much cash to stockholders as you invest in finding and developing new oil and gas fields. Please explain all of the factors governing these decisions, including the influence of institutional investors and equity analysts.

Natural Gas:

• Four years ago, natural gas was touted as a cheap, plentiful and environmentally sound fuel. Why has supply failed to keep up with the growth in demand, resulting in the quadrupling of natural gas prices?
• How much natural gas is available internationally, and what investment and permits would be required in order to import an additional 5 billion cubic feet per day of gas into the US? How soon could this natural gas be available, and what impact would it have on domestic natural gas prices?

Refining & Marketing:

• Please explain to consumers how the products refined from crude oil reach local gas stations, including the use of location exchanges and "time trades", and describe your involvement in this "value chain."
• Major oil companies have sold or shut down a number of US refineries in the last 10 years. Please explain the factors involved in these decisions, and comment on the relative attractiveness of building new, "grass roots" refining capacity now.
• Several Senators and Congressmen have proposed the development of "strategic product reserves", in which gasoline and heating oil could be stockpiled for use in the event of a supply disruption or natural disaster, such as the recent hurricanes. How would these stockpiles affect existing mechanisms for meeting seasonal fluctuations in demand? What prevents the industry from holding large enough commercial inventories to meet emergency needs?

Alternative Energy:

• Please describe the economics and technological readiness of alternative energy technologies, including both unconventional hydrocarbons and renewable resources, with particular emphasis on those capable of producing liquid fuels that could be distributed through existing infrastructure.
• How much investment would be required, and how quickly could facilities be brought on-stream to produce one million barrels per day from these sources? 10 million barrels per day?

You'll note that none of these questions addresses efficiency or any other demand-side concerns. Frankly, I'm not sure the companies that supply these fuels have any deeper insights into how and why we use their products than the rest of us do, and they could spend the next month just answering the above in sufficient detail. Meanwhile, I'll be watching today with high interest--if low expectations--to hear something that might surprise me, from either side of the discussion.

Inching Towards ANWR

The pending budget legislation in Congress includes a provision allowing drilling the Arctic National Wildlife Refuge. If the bill passes with this provision intact, it should not be seen as a victory for oil companies, but rather as the failure of an unrealistically obstinate strategy by its environmental opponents. By assuming that it was possible to prevent ANWR from ever being drilled, they will have foregone any opportunity to obtain important concessions in other areas, and thus failed in the larger sense of environmental stewardship. While there might be a parallel universe in which ANWR's oil stays in the ground forever, it is certainly not the world of $60 oil in which we live.

I also question the cited 2004 study from the Energy Information Agency, suggesting that oil from ANWR would only save a penny a gallon in 2025. Anyone with experience dealing in commodity markets would find that conclusion naive. Recall that a mere delay in BP's Thunder Horse project after hurricane Dennis passed through the Gulf of Mexico sent oil markets $1/barrel higher. And Thunder Horse will produce only a quarter of the oil that ANWR is expected to yield, in terms of both peak production rate and total reserves. ANWR could comprise as much as a quarter of total US production when it starts up, if current decline rates for mature US oil fields continue. It might produce as much oil as Texas does today (onshore.)

If the world of 2025 is anything like today, with a very slim cushion between total oil demand and maximum global production capacity, that extra million barrels per day of supply from ANWR could depress oil prices by as much as $5.00/barrel, or $0.12/gallon. That's because the price for the entire global market is set by the last several million barrels per day of supply and demand, which determine whether inventories are growing or shrinking. So even though ANWR's potential production would probably only represent 1% of total global oil supply at that point, its influence as the "marginal barrel" would be greatly disproportionate.

No matter how much one believes in protecting pristine wilderness, or in the potential of alternative energy and improved energy efficiency to moderate our oil consumption in the next 20 years, it simply doesn't make sense to think that we would permanently forego the oil equivalent of another Texas on our own soil, given the current economic and geopolitical environment. Those who imagined that scenario was realistic need to reexamine their assumptions.