Looking Back/Looking Ahead

A few months ago, a regular reader suggested I rename my blog to convey a more oil-focused message. I resisted, because from the start my intention has been to cover the full spectrum of energy, including conventional- and non-conventional alternative to oil and gas. I still see it that way, but I suspect that the aftermath of Katrina and Rita will probably keep this blog a bit "oilier" for a while, driven by my desire to stay relevant.

At the same time, my original manifesto from January 2004 still seems appropriate, to "provide a useful, if eclectic guide to navigating the gulf (between breathless reporting of new energy and the continuation of the status quo), based on my experience of over 20 years in the energy business and on scenario-based possibility thinking."

Here are a few of the subjects I hope to cover in the weeks ahead:

• Reducing energy infrastructure concentration
• Prospects for a revival of oil shale
• The growing importance of private equity in funding energy investments
• Implications of Europe's shift to diesel
• Energy investment priorities and waste

I appreciate the steady growth in readership and your comments on many of the subjects on which I post. I'd welcome any suggestions of topics where you think my perspective might be useful.

Climate Sensitivity

Today's Financial Times reports that operators of offshore oil and gas platforms in the Gulf of Mexico may see dramatic increases in their insurance costs, in the aftermath of the two hurricanes. This won't surprise anyone, but it's worth spending a moment thinking about the signal it sends. Part of the expected increase is surely an effort to recover via premiums some of the substantial payouts that the insurers will be making over the next few months, reaching into the billions of dollars. But I believe we see the reflection of a heightened sense of risk here, as well.

While others have the luxury to engage in theoretical debates about whether or not climate change is occurring, and what its consequences might be, insurance companies sit on the front lines of this issue and seem to be taking it more seriously than many other sectors. Recent predictions that Atlantic hurricanes will be more intense, either as a result of climate change or as a function of something like a twenty-year cycle in ocean temperatures, elevate the risk being insured against and justify higher premiums.

As I've suggested previously, this is precisely the right way to approach climate change: as a business risk to be managed in the same way we manage other risks, systematically and comprehensively. Scientists and environmentalists may focus on melting glaciers and shifts in the distribution of animal species, as indicators of climate change, but insurance companies provide the "canary in the coalmine" for the economy, and for business in general.

Building the Next Refinery

Hurricanes Katrina and Rita have exposed many problems with our energy infrastructure, not the least of these being the concentration of our refining capacity in a region likely to be hit by more large hurricanes in the future. It took more than two decades of environmental regulations, permitting policies, industry consolidation, and corporate strategies to create this situation. This cannot be rectified overnight, and I'm not even sure we should try, given the high cost and the desirability of reducing our reliance on oil in the decades ahead. In the meantime, though, we can try to address the underlying capacity problem in a way that would mitigate the national impact of a future Class 4 or 5 storm in the Gulf Coast.

A few weeks ago I described how we got to this point, with so many refineries, pipelines, terminals, and production platforms lining the Gulf Coast. It wasn’t always this way, either. Thirty years ago, the refining industry looked very different, with a larger number of smaller refineries dispersed around the country, mostly located in proximity to oil fields, markets, or both. The 1970s energy crisis changed all that, helped along by the depletion of mature oil deposits in states like Kansas, Oklahoma and Pennsylvania.

When oil rose from $2/barrel to $10, then $30, efficiency trumped proximity. The big refineries got bigger, while many of the smaller ones became uneconomical and failed to attract the investments required to keep pace with increasingly stringent environmental regulations. After a couple of decades of this, just under half of the country’s refinery capacity is clustered into only five areas: Chicago, L.A., Philadelphia, San Francisco, and Houston/Beaumont/Port Arthur.

Even if we were to eliminate all the obstacles to building new refineries in this country, we are not going to reverse that concentration. US oil production is in steady decline, only partially offset by increasing oil sands production in Canada, so any new refinery would have to rely on a mostly offshore crude oil diet. The alternative is having someone else refine the oil and then importing the products. That might reduce some of our vulnerability to energy disruptions from weather and earthquakes, but it brings a host of other concerns. Besides, this is the strategy we’ve chosen by default.

Post-Katrina, there's been a lot of talk about building more refineries. The President mentioned it in a speech Monday. There's even a proposal for a mega-refinery at Cushing, OK (thanks to Mel at Engine of the Future for the info.) The location offers some advantages, at least for crude oil supply. Cushing is already the major oil pipeline hub in the Mid-continent, as well as the delivery point for the NYMEX WTI futures contract that gets so much attention. When Enbridge's Spearhead pipeline is completed, it will be able to receive the full range of Canadian crude, including the heaviest synthetic crude and bitumen. And it's hundreds of miles from the coast, so that any hurricane would have dissipated quite a bit before reaching Cushing. Unfortunately, it's in the heart of Tornado Alley.

If we're thinking about where to locate another refinery, we'd better think about how we're going to induce someone to invest in building it, unless we're suggesting the government go into the refining business--something that other countries' governments have wisely spent the last 20 years getting out of. The problem is that the companies that own refineries have little incentive to build another one, even ignoring the scale of investment required.

Oil refining is extremely capital-intensive. The last new refinery in which I was involved was the 135,000 barrel per day Star Refinery in Thailand. It cost $1.7 billion 1995 dollars. Until the last few years, however, refining has been a low-margin, low-return business. I don't see the major oil companies queuing up to build more in the US, even if the permits were handed to them on a platter. They've sold off dozens of refineries, largely because equity analysts kept telling shareholders what a crummy business segment this was, and that the majors should invest only in exploration and production of oil and gas, and a bit in marketing the products. Their boards of directors listened, and as a result, the largest refiner in the US today is not Exxon or Shell, but Valero, an independent that has bought and merged itself into the number one spot.

How keen would Valero be to build a new refinery? Perhaps more than most, but I suspect they'd start to hear concerns from their shareholder base. It's one thing to buy up existing capacity and say that you'll run it more efficiently. It's quite another to build expensive new capacity that by its mere existence will reduce the operating margin of every other plant in the markets it serves. In a way, the refining business is like the restaurant business, where the person who builds a brand new restaurant, with a beautiful new kitchen, typically goes broke. By the time the third owner has bought it, at pennies on the dollar for the kitchen hardware, he has a chance to make a profit.

I'm not sure a producing country would want to come in on this, either. Saudi Arabia already owns an interest in Shell's refining system in Texas and the Southeast, via a joint venture. Their appetite for more is doubtful. Citgo, another large refiner, is owned by the Venezuelan government, which recently expressed an interest in selling. If you look at the other sources of the oil imported into the US, there aren't many obvious choices for large investments in refining, other than possibly Russia. Lukoil has already bought some service stations in the Northeast and is selling under their own brand, so it's just possible they might want to build a refinery. How well would that go over in Washington?

You can see that building another refinery isn't going to be easy, unless the government is prepared to offer large inducements, including tax holidays, investment tax credits, and low-interest loans. It certainly won't happen quickly, either, and I haven't even mentioned the various interests that would line up to oppose such a development. While we do need more refining capacity, the 1-2% per year "capacity creep" that we've been able to rely on until recently might just be enough to get us by, if combined with sensible policies to reward companies for holding larger inventories, closer to markets. At the same time that we try to buffer the nation's petroleum product supply system from future shocks, though, we need to learn the lessons of over-concentration of infrastructure and plan for alternative energy on a more dispersed, less vulnerable basis. That's a subject for a future blog.

Spending the Windfall

Yesterday, I cited a recent survey showing that most Americans support taxing the extraordinary profits that oil companies are experiencing as a result of weather- and demand-related increases in the price of oil. The dollars involved are significant: in the second quarter the top five US oil companies earned after-tax profits at an annual rate of $60 billion, compared with $36 billion in 2003. When you add in the rest of the industry, including the US earnings of non-US companies like BP and Shell, the total could reach $90-100 billion. Given the cost of rebuilding after two major hurricanes and the constraints imposed by large budget deficits and an expensive war, the temptation to tax an unpopular industry may prove greater than politicians can resist. However, the industry's actions may play as big a role in determining the outcome of this debate as will those of the Congress.

When you consider the survey results, the message seems pretty clear. Consumers think that not enough is being done to reduce our vulnerability to foreign suppliers of oil and develop practical alternatives to it. The industry has contributed to both the perception and reality of this in several ways:

• The international oil industry, including the US majors, was slow to step up investment in exploration and production as disruptions such as the Iraq War and Venezuelan strike, combined with increasing demand from China, eroded the global capacity cushion.
• Investments in truly alternative energy--wind, solar, biofuels, and hydrogen--have represented only a small fraction of major company R&D budgets. Instead, companies rely heavily on external research (including the government labs) for new technology in this area, and on economics to drive the deployment of alternatives.
• With a couple of notable exceptions, investments in this area are not highlighted in corporate advertising campaigns, with agencies focusing instead on generic, feel-good messages. Consumers, especially younger ones, see through this and extrapolate to assume that nothing substantive is behind them.

While all of the above represent justifiable strategic choices, they also increase the risk of a government response to limit profits. Make no mistake, a windfall profits tax would be a disaster, even if it were structured to provide dollar-for-dollar credits for all new E&P and alternative energy investment. Unfortunately, when you start digging into the mechanics of such a tax, you inevitably end up resurrecting some of the worst elements of the old, pre-deregulation inefficiencies. I started in the industry at the end of the last period of controls, in the 1970s, and I saw first-hand the distortions they created.

A large part of our current problem is the result of a decade of under-investment in energy by the equity markets--anyone who worked in a company making real products during the Dot-Com Boom knows exactly what I mean--and that's significant because energy projects typically have lead times of five to ten years. The projects that should be coming onstream right now would have been started at a time when the market only wanted to hear about "clicks vs. bricks", not barrels per day. A windfall profits tax would make energy company stocks look similarly unattractive today.

At the same time, though, I can understand the temptation that the industry profit pool presents to lawmakers faced with enormous bills, huge deficits, and an electorate with an aversion to higher income taxes on the only group with enough money to close the gap: the middle class. My best advice to my industry colleagues, if they want to head off this trend, is to crank up your capital budgets for traditional and new energy projects, even at the risk of driving down future profits through oversupply. Just as important is making sure that these actions are highly visible; consumers want to know about the billions you're spending to increase supply. The alternative is to lose a large chunk of your profits to an inefficient tax, and lose control of your own destiny in the process.

Quantifying Rita

For the second time in a month, the Gulf Coast oil and gas industry is tallying up the damage from a major hurricane. Although Rita's last-minute eastward shift spared the region and the country its maximum energy impact, it's going to be some time before the full extent of the damage is known, particularly to the offshore platforms and pipelines. In the meantime, as after Katrina, initial estimates of the effect on petroleum product supply are a combination of guesswork and basic arithmetic. Even if none of the region's refineries suffered serious damage, as seems to be the case, gas prices will have to rise again to balance the short-term supply deficit.

The Texas/Louisiana border region hit hardest by Rita includes the Shell and Valero refineries at Port Arthur, TX, the Exxon facility at Beaumont, TX, and three large plants at Lake Charles, LA. The combined capacity of these refineries totals 1.7 million barrels per day, just under 10% of US capacity for turning oil into gasoline, jet fuel and other products. If we assume that these facilities will be down for two weeks, on average, and that the entire 4 MBD Texas coast refining complex is down for a week, assessing damage and restarting process units, then we are looking at a supply shortfall of 40 million barrels. About half that would be gasoline. It will be difficult to make this up in the short term, because the refineries still running last week were operating at 96% of capacity.

In effect, then, we've lost nearly half the nation's gasoline production for the next week, and another sixth for a week or two beyond that, on top of the 5% still down after Katrina--with proportional effects on the other products. As I mentioned last week, one of the surprises after Katrina was that gasoline inventories never dropped below the 190 million barrel mark, despite the lost production, and even recovered to pre-Katrina levels. That was due to a combination of extra imports and reduced demand.

We're facing a comparable challenge for the next couple weeks, and demand will have to fall by at least as much as after Katrina to keep from drawing down inventories to the point that runouts become widespread. Unfortunately, the only way that will happen is through price increases, even though the weekend traders on the New York Mercantile Exchange don't seem to have figured that out. Gasoline dropped below $2.00 on the exchange, a fall of nearly 10 cents/gal. That seems highly optimistic to me; perhaps, as one analyst described it, the market just breathed a sigh of relief that things weren't much worse.

It took an increase of $0.45/gal. at the pump to balance demand after Katrina, from a starting point about $0.25/gal. lower than where we were right before Rita hit. That says we could see a national average of $3.30/gal. and regional averages $0.10-.20/gal above that, before prices start to come back down. Averages being what they are, I wouldn't be surprised if stations in a few locations come close to $4.00, before the Katrina/Rita wave has passed through the system. Consumers will howl, and politicians will act outraged in response, but remember that the alternative to high prices is low prices but no gas.

Storm Symptoms

It's oddly seductive to watch the gradual progress of another major hurricane moving across the Gulf Coast, on its way to a landfall in America's energy heartland. CNBC's coverage yesterday afternoon was dominated by discussions of "Worst Case Scenarios." Rather than speculating further on the possible impacts Rita, I think it's important to remind ourselves that although Katrina did significant damage to the oil and gas production and refining system, as may Rita, these are short-term effects. While they draw attention to some serious issues, the vulnerability of our energy infrastructure to weather-related disruptions is only a symptom of a larger set of fundamental problems. These include:

• The unintended consequences of a loophole in the federal Corporate Average Fuel Economy (CAFE) standards have transformed the US automobile fleet with a wave of SUVs, stalling fuel economy improvements and amplifying the demand increases associated with more cars driving further every year.
• In recent years gasoline demand has outstripped the ability of US refineries to supply, even when operating near 100% of nameplate capacity. This puts more stress on lean inventories and increases our imports of refined products, making fuel prices more volatile.
• We have handcuffed our cleanest and most efficient fossil fuel, natural gas, with poorly-considered land-use restrictions and bans on offshore drilling. These rules ignore the significant downstream environmental benefits of using gas and push us towards higher use of coal and imported oil.
• At the same time, we've erected numerous roadblocks in the way of importing gas in the form of LNG. The combination of these two factors has pushed natural gas prices to all-time highs (nearly six times the historical average,) and put power supplies, winter heating, and entire segments of the fertilizer and petrochemical industries at risk.
• Finally, our current energy mix and the way it is growing contribute to increases in the atmospheric greenhouse gases that are changing the climate in unpredictable ways, with consequences that are extremely unlikely to be beneficial.

At a minimum, Rita has shut down most of the Gulf Coast energy facilities that escaped harm from Katrina. Even without serious damage, the markets will be in turmoil for weeks, and the prices of gasoline, heating oil, and natural gas are going to go up even further. This is drawing attention to an energy sector that for years has been taken for granted and treated as an inconvenient necessity. Now that energy has everyone's attention, it is time to start talking about the dangerous contradictions embedded in our lifestyles and attitudes. We cannot continue to increase our use of energy without also expanding the infrastructure for producing and processing it. Nor can we expect the industry to maintain adequate inventories to handle disruptions such as Katrina and Rita, while imposing tax and accounting penalties on it for holding those inventories. For years, people like me have been predicting that something will have to give. Two hurricanes have brought that day into the present.

Waiting for Rita

Shortly after Hurricane Katrina hit the eastern Gulf Coast, I commented that a storm track further west could have done even greater damage to the country's energy infrastructure. Unfortunately, we're about to find out if I was right, with Class 5 Hurricane Rita headed directly for Texas.

Not only is the Texas coastline home to a large number of offshore oil and gas platforms, but it is has 23% of US oil refining capacity, more than twice as much as the Louisiana/Mississippi coast. In addition, the refining complex around Houston is the origin and largest supply point for the Colonial Pipeline that carries petroleum products to the Southeast, Mid-Atlantic, and Northeast regions. A hurricane hitting this concentration could create an even bigger oil, natural gas, and petroleum product supply problem than Katrina did.

The market is reacting in predictable fashion. Crude oil is headed back towards $70/barrel, and unleaded gasoline futures, after having dipped below $2.00/gallon recently, seem headed back to record territory, as well. Factor in the facilities that remain offline after Katrina, and we could be in for a real jolt to prices. Aside from the potential damage to the offshore and onshore oil and gas production facilities, any protracted refinery shutdowns in the area could send retail gasoline prices over $4.00/gallon. The only bright spot in the picture is the modest recovery of gasoline inventories since Katrina hit.

In the short term, there's nothing we can do but wait and see, and hope that Rita will shed some wind speed and make landfall away from population and industry. Let's also hope that whatever the industry learned from Katrina about protecting facilities from storm damage has been rapidly disseminated through the internal and external "best practice" networks.

Getting There from Here

I'm embarrassed to admit that it took an article in MIT's Technology Review to introduce me to a name in the "peak oil" world that I should have already known, James Howard Kunstler. His book, "The Long Emergency: Surviving the End of the Oil Age, Climate Change and Other Converging Catastrophes of the Twenty-First Century", has apparently gathered quite a following for its pessimistic portrayal of our energy future, among other looming problems. TR's skeptical review suggests that his predictions can be boiled down to an assertion that the alternative energy future is a sham, and that we can't get there from here. Without getting into detailed arguments about a book I haven't read, these points function as a rejoinder to my argument last week about the new choices that weren't available in the last energy crisis.

Mr. Kunstler's concerns seem to fall into two main categories, starting with the superiority of oil as a fuel and the absence of anything else combining its low cost, high energy density, and ready availability, to serve as a replacement when the global oil supply reaches its inevitable peak. The second area deals with the availability of energy sources and technologies that could bridge us into an alternative energy future from the "cheap oil" world we inherited.

Let's think about the first point. Oil is a truly remarkable substance, and the geological circumstances that dispersed enough of it in deposits close to the surface, where it could be tapped using 19th century technology--imagine giant post-hole diggers--played a major role in the creation of our mobile, industrialized world. But when you consider how much we've learned about the universe since the first oil well was drilled in 1859, it's nearly inconceivable that we can't find ways to live--and even prosper--without it, eventually.

Without being a Pollyanna, the diversity of possible energy sources that could fill that bill, at least for the next century or two, makes me confident that there is a good energy future ahead. In terms of sheer magnitude, the ultimate potential of things like orbital solar power, dry-rock geothermal power and nuclear fusion (hot or cold) dwarfs what we currently receive from all hydrocarbons combined, to the point of raising concerns about the environmental impact of waste heat on the scales that would be possible. Energy is out there in abundance, if we can figure out how to tap it.

That takes us back to the problem of getting there from here, which is certainly non-trivial. Again, work is underway on enough different paths to provide reassurance that the world won't end on the day that oil demand permanently exceeds the supply. Some of these paths involve new chemical fuels, including hydrogen, that work in tandem with various kinds of fuel cells or advanced engines. Others involve electricity, either in combination with new battery technology, or in conjunction with hydrogen. And in the shorter term, there are proven methods of extracting natural and synthetic petroleum from other hydrocarbons that are much more plentiful than oil. The key to all of this will be marshaling the necessary capital and technical resources far enough in advance of the need.

None of what I’ve described above will be easy. That does not mean, however, that we can’t get there. Rather, it’s an argument for getting off our butts, banishing complacency, and making it happen by voting for it, investing in it, and encouraging our children to choose careers in science and engineering so they can contribute to it.

While you can make a very strong case that it took oil to get our industrial civilization off the ground--literally--it does not follow that the gradual disappearance of oil, whenever that might start, will lead to the end of life as we know it. We have the ingenuity, motivation, and resources to overcome this challenge, however just-in-time and nerve-wracking the result may be. Betting against that is tantamount to writing off the last 150 years of human development, and attributing it solely to a geological accident.

Can Fuel Taxes Be Too High?

It's fascinating watching the debates over fuel taxes on both sides of the Atlantic. The US has among the lowest fuel taxes in the industrialized world, but, yielding to public pressure to lower gas prices, many state legislatures are considering suspending portions of their fuel tax collections. Europe, on the other hand, with both the highest gasoline prices and fuel tax rates (no coincidence there) in the world, is attempting to hold firm in the face of growing public protests from truckers and farmers. Who is right? In my estimation, neither.

As recently as last Friday I wrote about the importance of allowing prices here to rise when demand is constrained, in order to restore balance. Lowering fuel taxes here would either increase demand, if the savings are passed through to consumers, or boost the profits of oil refiners and marketers, if they are not. Europe is another story, however.

Gasoline prices there were already high enough to promote efficiency, even before the crude price run-up of the last 18 months. Volume-based fuel taxes in the EU are only part of a broader tax strategy to reduce demand, including high taxes on vehicles and specific taxes on engine size. This links to the EU's policies on managing traffic congestion and protecting the environment, particularly with regard to climate change. These taxes have been effective, resulting in smaller, lighter cars than here, more use of diesels, and higher mass transit utilization, although total kilometers driven has been rising. They also bring in enormous revenues. In fact, as of a couple of years ago, the government of Germany made as much money from fuel taxes as Saudi Arabia did producing crude oil.

Now, none of these circumstances suspend the laws of supply and demand, and price increases are as necessary in Europe as they are here to restrain demand in the wake of an event that reduced the global supply of oil and petroleum products. But that doesn't mean that European governments need to profit at the expense of their consumers, who have fewer options than Americans for further efficiency gains. European parliaments should fix their tax receipts at pre-Katrina levels and allow fuel prices to rise and fall cent-for-cent with the world market, rather than compounding taxes on the increases at rates that include Value Added Taxes as high as 18%.

The end result is a scenario that few would have believed only two years ago: the US with gasoline prices at a level we've always associated with Europe, and Europe with gasoline prices that are running at twice that level ($1.83/liter = $6.92/gal.) Through this combination of market response and taxation, we have embarked together on a wrenching experiment testing what economists call the "price elasticity of demand," i.e. how much will demand fall for each unit of increased price? While painful to millions, you have to believe this is going to create great opportunities for alternative energy all over the globe.

Slow Road to Showdown

Last week's session of the UN General Assembly did more than tie up traffic well into New York City's northern suburbs. In his first speech before the world body, Iran's new President, Mr. Ahmadinejad signaled a more distressing kind of gridlock in the negotiations to resolve the potential international crisis over Iran's nuclear ambitions. His repeated assertion of Iran's right to develop a full civilian nuclear fuel cycle has implications for energy markets, as well as geopolitics. Iran seems to believe it holds the winning hand in this high-stakes game. That could prove as big a miscalculation as Saddam's complex WMD bluff, or might well be an accurate assessment of the situation.

As I've described elsewhere in some detail, arguments by Iran's leaders concerning the desirability of nuclear power as a backstop to the eventual end of its oil reserves simply doesn't stand up to scrutiny. Even if Iran's oil reserves were shrinking--which they are not--it also possesses the world's second largest reserves of natural gas, rendering any Iranian civilian nuclear facilities both uneconomical and unnecessary.

The most interesting element here is the subtle way in which Iran is deploying its greatest leverage, the "oil card." Rather than threatening an embargo, which still remains a last resort, Iran seems to be lining up support from China and India--large and growing customers of and investors in Iran's energy sector--and Russia--a key supplier of nuclear technology--to outmaneuver US and European efforts to hold Iran accountable for discrepancies under the Nuclear Nonproliferation Treaty. Iran must be calculating that, with oil prices over $60/barrel and supply even more precarious after Katrina, diplomacy is the only avenue against which it must defend, and one in which it has important allies.

So Iran plays for time, presumably hoping to produce a nuclear fait accompli; the EU plays for time, seeking to avoid a confrontation; and the US plays for time, trying to regain room for maneuver, up to and including military action in the event that US forces can be extracted from daily combat in Iraq. This kind of geopolitical instability has produced some very unpleasant surprises in the past, and any kind of big surprise in Iran would throw the oil markets into a tizzy.

The most hopeful note in this affair comes from an unlikely quarter. Even as President Ahmadinejad was exclaiming his hard line at the UN, North Korea was in the process of agreeing to decommission its nuclear weapons program, much as Libya did a couple of years ago. Who would have guessed that Tripoli and Pyongyang might show Teheran the way forward?

The Numbers Are In

I finally had a chance last night to look at the latest weekly statistics from the Energy Information Agency of the DOE, and they tell a remarkable story about the energy impact of Katrina and the effectiveness of prices at stimulating gasoline production and moderating demand. This involves more numbers than you will normally see in this blog, but I would like to point out a few things that I found noteworthy:

• US crude oil production stands at 4.3 million barrels per day (MBD), down from 5.4 pre-Katrina. You have to go back to the 1940s to find an oil production rate this low.
• As a result, crude oil inventories fell by 7 million barrels, despite some withdrawals from the SPR. Despite this, crude oil stocks are still above the top of their normal, seasonal range.
• Although refinery utilization was down by a full 10%, refiners have deftly adjusted yields and made the most of the EPA's specification waiver to get gasoline production back up to almost 8.5 MBD, only about 300,000 bbl/day below where it was before the storm hit. That compares to initial estimates, including mine, of sustained losses of 800,000 bbl/day.
• Average US retail gasoline prices are back below $3.00/gallon, from a high of $3.06.

The real story here is what happened to gasoline demand. For all the resulting acrimony and political posturing, the price increases did their work. Demand fell by 8% from where it was before the hurricane, and by more than 6% from the same period last year. That's more than twice what you'd expect just from reduced driving in the region most affected by storm damage. As a result, with gasoline imports over a million barrels per day, total US gasoline inventory actually went up slightly to 194 million barrels, the equivalent of 22 days of demand. While still at the bottom of the normal seasonal range, that is excellent news and bodes well for things to continue improving, as long as demand doesn't go back up. (What all this means for heating oil later this year is still not clear, with production down and inventories falling at a time of the year when they should be growing steadily.)

Now, it's easy to read too much into these figures, given the historical variation in the week-to-week data, but things look better than I would have expected this soon after the disaster, particularly with 5 major refineries still down for the count. Anyone who remains skeptical about the power of prices to adjust demand to match supply should study the EIA's figures and charts carefully. I can think of a few politicians who should be assigned this as homework.

Here We Go Again?

For someone who grew up in the 1970s, I have little nostalgia for that decade. Aside from comprising the sartorial nadir of western civilization, those years were marked by such wonderful things as Watergate, the Arab Oil Embargo, the Iranian Hostage Crisis, Three Mile Island, inflation, stagflation, gas lines, and "malaise". Isn't it strange to wake up after a terrible natural disaster and discover that some of the problems we'd thought were safely relegated to the past are rising up again, like zombies? As if the reappearance of gas lines and government intervention in the retail gasoline market (price caps and tax holidays) weren't bad enough, it now seems that some enterprising thieves have rediscovered the art of siphoning gas from your car, and that locking gas caps are making a comeback.

Worse yet, from an energy perspective, it must seem to many as if, in the short term, we have few options that we didn't have in 1979. We can drive less, carpool, make sure our tires are properly inflated, switch to a lower-octane grade, and turn off our engines at long stoplights. Not very comforting, with gas over $3.00/gal.

But before we succumb to the post-Katrina malaise, it's worth remembering that in the mid-to-long term, we have some strikingly different choices than we did 25 years ago. Consider:

• Hybrid cars are a reality. If we can convince Detroit and Yokohama that fuel economy will be a primary driver of consumer preferences for the next decade, they will offer us a wide range of cars and SUVs that are comfortable, safe, and get 35-50 miles per gallon.
• Alternative fuel technologies have become economical or nearly so at current oil prices. This includes the production of liquid transportation fuels--our biggest need and the largest hurdle in the 1970s--from natural gas, coal, crops and crop waste.
• Hydrogen fuel cells have moved out of the laboratory and into prototype cars and production buses. Despite infrastructure obstacles, fuel cells hold out the promise of using existing energy sources much more efficiently in the future.
• Clever exploitation of the Internet is constantly providing new means for substituting the movement of information for the movement of people and goods. This is one reason that the ratio of energy inputs to GDP output continues to fall.

As I've suggested before in this blog, we have learned an awful lot in the last couple decades, even if it doesn't always seem that way. Thinking that we are back in the 1970s is only going to lead to the unnecessary repetition of failed strategies for solving our energy problems. We need to treat the Oughts (has anyone heard of a better name for this decade?) as unique and approach our current problems with the benefit of historical insight, but led by a fresh perspective.

Misplaced Outrage

At the same time the country is absorbed with efforts to assign responsibility for the tragically confused post-Katrina rescue effort, another "blame game" is playing out: why are gasoline prices so high? Despite the evidence supporting a simple answer having to do with the nearly instantaneous loss of 10% of the country's oil refining capacity, and the need for higher prices to balance a market that was suddenly facing a shortfall of a magnitude not seen in several decades, the noises coming out of various state governments seem to be emanating from a parallel universe.

I'm going to use the example of my own state, Connecticut, but I'm sure you can find similar discussions going on in nearly every other state. According to my local paper, the Attorney General of Connecticut, Richard Blumenthal (D), is apparently surprised by the speed and magnitude of the price response. He sees it as evidence of at least a lack of competition, if not actual collusion. He regards high oil company profits as further evidence of this. In response, he is calling for an investigation into the operation of the New York Mercantile Exchange, where crude oil, gasoline and heating oil futures trade, and calling for an excess profits tax on oil companies.

Anyone looking for a partisan slant to this line of thinking will be disappointed. State Representative Lawrence Miller, R-Stratford, provided the quote of the week, "I've heard a lot about looting since the hurricane. But I think the real looters up here are called the Mercantile Exchange of New York. Hearing about $4 a gallon is unreasonable and unacceptable."

Now, when I think about these comments, I am torn over whether to ascribe them to ignorance or profound cynicism. Is it really possible that these gentlemen understand so little about how markets work, and about how petroleum products reach consumers, that they can ignore the evidence of photos of drowned refineries and pursue rabbit trails of conspiracy, at public expense? But, as I've suggested before, it is easier and more expedient to feed public outrage over high prices than to explain that this is actually how markets work.

We need to keep clearly in mind that we have two basic choices for how we want the gasoline market to function:

1. Allow the market to move in response to changes in supply and demand, with price as the mechanism by which balance is achieved, or
2. Impose constraints or actual rationing, involving price caps, odd-even days, gallon limits on fill-ups, etc.

We have experienced two major crises that offer excellent examples of how each of these approaches works. Choice Number 1 has operated throughout the Katrina Crisis. Despite starting with very low inventories, the gasoline supply system has rebalanced at a higher price, and gas lines only appeared in communities that suffered a direct loss of physical supply. These quickly abated, when pipeline deliveries resumed. Choice Number 2 was tried from 1973-1981, and it resulted in widespread gas lines, enormous productivity losses, grotesque distribution inefficiencies, and a nearly universal desire to deregulate markets.

In fact, it was the installation of Choice Number 1 in 1981 that set the stage for two decades of gasoline prices that consistently lagged the national inflation rate, until surging global oil demand and a series of supply disruptions, including wars and strikes, set prices on their current upward path, starting in 2002.

The biggest problem with the market option, of course, is that someone makes money on it. That puts us in mind of gouging and profiteering, rather than thinking about the Herculean efforts performed behind the scenes to make the outcome as seamless as possible for consumers. Our officials should spend more time thinking about how to mitigate the impact of high prices on those least able to bear them, and less on how to tamper with the means of ensuring reliable supply. That's not as glamorous, or as ambition-advancing, but it would serve their constituents' interests much better.

It's Up to Me

Last week I had the opportunity to speak on energy matters to a local community group. Although the topic of my talk focused on uncertainties about future supply, I wanted to include some thoughts on the impact of Hurricane Katrina. My last bullet point, "What Can You Do?" prompted someone to ask whether that really should have been "What Can We Do?" My negative response clearly wasn't what he expected, but it was very much what I intended: While collective action must certainly play a role, it is up to each of us to manage our own use of energy. This country's enormous, surging demand for energy is simply the aggregation of the individual choices of 270 million consumers, and we are indeed the intended recipients of the countless little price signals we've been getting, including some rather urgent ones in recent weeks.

It seems that Ben Stein agrees. While probably best known these days as a quiz show host, Mr. Stein is a smart, savvy guy, and as a former official in the Nixon/Ford White House during the first energy crisis, he saw firsthand our efforts to deal with these problems before. His thoughts about the benefits of energy investments and the desirability of personal energy responsibility are timely, including his suggestion to cut your next car's engine size by two cylinders.

It makes you think twice about things we see have become accustomed to seeing. For example, on my way to the meeting where I was to speak, I was passed by someone driving his Mercedes Gelandewagen (EPA 13 city, 14 highway) like a Porsche, hardly what the EPA expects when it tests gas mileage on a vehicle weighing nearly 7,000 lbs. Now, he was certainly within his rights--speed limits and public safety notwithstanding--and if he can afford a G, he can handle $3.50 gasoline. That does not, however, make his behavior any less selfish or irresponsible at a time when we've lost 10% of our gasoline production. (I'm feeling better about my purchase of an Acura last year, having just netted 31 MPG over the weekend in mixed interstate and back-road driving.)

So to paraphrase Mr. Stein, if each of us assumes that energy will be more expensive and less reliable in the future, and if we all act and invest accordingly, then at worst things won't turn out to be that bad, and the benefits in other areas will far outweigh any regrets associated with our energy frugality. Status quo behavior, on the other hand, assuming that it is up to government, car companies, and the oil companies to solve the problem, will virtually guarantee that things will only get worse from here.

Shining a Light in the Corner

For most of the time that I have been involved in the energy business, with the exception of the last few years and a couple of brief windows that closed quite rapidly, the refining segment of the industry has been the least glamorous, least appreciated, and least career-advancing part of the industry to be associated with. I've described this situation before, but of course now, in the aftermath of an almost-worst-case event for the US Gulf Coast oil and gas industry, we appreciate rather more the work that refineries do and how delicately balanced the whole system is. The best summation of the pivotal nature of these unappealing beasts is from the Saudi Oil Minister, in Sunday's New York Times. "We cannot keep producing oil with no refineries. There is a limit."

The Times article, along with several other recent ones elsewhere, does a good job of explaining the current situation and how things got this way. I've posted comments on other people's blogs, trying to shed whatever light I can on remaining misunderstandings about this part of the petroleum "value chain." At the same time, I've been scratching my head about suggestions for a "strategic refining reserve" and ways to induce the industry to expand capacity. That won't be easy.

Part of the reason we're in the pickle we're in--in addition to all the points others have raised about poor historic returns and the costs and difficulties associated with permitting and environmental regulations--is that the industry finally escaped its vicious cycle of overbuilding every time the margins looked healthy. In fact, the industry had quite a bit of help in this regard from the government, which broke the back of the earlier independent refining sector (i.e., pre-Valero) with a series of environmental regulations that added enormously to the capital cost of the business without changing the products in a way that anyone seemed willing to pay even a penny more for. Only the majors and the largest independents could play that game for long, and even the majors tired of it, selling off dozens of refineries in the 1980s and 1990s, and even demolishing a few along the way.

Now, many of those regulations were necessary and beneficial. We can all see the consequences, though: an industry that couldn't withstand even a much smaller disaster than Katrina without severe disruptions, but that's finally making a healthy profit, for which it is widely reviled. Just as importantly, since Katrina a number of folks have been going through the numbers--which were always available on the DOE's Energy Information Agency website--and have suddenly realized that the US doesn't just import vast quantities of crude oil. We also import between one and two million barrels per day of refined products that we lack the capacity to produce for ourselves. These quantities will only grow, until we get our consumption of transportation fuels under control, or find a good alternative.

These imports have consequences for the country as a whole, and for environmental regulators, in particular. So far, whenever we've wanted to tighten the specifications on the gasoline and diesel fuel sold in this country, to reduce their impact on the environment, the burden has fallen entirely on a domestic industry with no alternative but to comply. What else were the oil companies going to do, dismantle their refineries and move them to China?

Now, however, we've grown reliant on imports, and Katrina makes us even more so, for the coming months. If we want to reduce sulfur, aromatics, or some other component or impurity further, will our foreign suppliers rush to comply? Will they invest in extra capacity to supply us, when other markets are growing at least as rapidly, but are less finicky about quality? And which will be the first company to build a new refinery in the US--with permits rushed through a worried Congress, perhaps--in the certain knowledge that the moment it starts up will be the beginning of a long slide back to returns you wouldn't accept on a bank cd?

Of course, the alternative is to nationalize them all and turn the whole downstream part of the oil industry into a utility, which is how we seem to expect it to behave most of the time, anyway. Somehow I can't imagine that outcome delivering anything like the kind of reliability and efficiency that the profit motive has done for over a century. If you are skeptical about that, there are plenty of examples to look at in other countries.

In an odd way, Katrina has done the same thing for oil refining that the 2003 Northeast Blackout did for electric power distribution. It has shined a light into a dark corner of the energy industry and scared the daylights out of anyone who bothered to look. What is waiting in the other dark corners, as a result of two decades of the expanding disconnection between our appetite for more energy and our low regard for the means of producing it?

Final Accountability

The UN's independent inquiry into the Oil-for-Food scandal, headed by former Fed Chairman Paul Volcker, issued its final report this week. This puts an end to an episode in international governance that goes beyond mere embarrassment. Its consequences have never been fully appreciated, and in my view, both the Volcker Report and Secretary-General Annan's appropriately contrite response still fall short in that regard, even though they support the need for UN reform.

Accountability is a word that has recently reentered our vocabulary in the context of the confused response to Hurricane Katrina. Politicians, pundits, and average citizens across the spectrum are calling for a thorough investigation that will hold those responsible for the poor execution of rescue and relief efforts accountable. Admission of responsibility for actions or inaction, without acceptance of responsibility for the consequences, does not meet the test of real accountability. And that is precisely my problem with Oil-for-Food.

The Iraq War was a war of choice for America and the allies that joined us. Whether you agree with that choice or not, it is hard in retrospect to argue that Iraq was an immediate danger to world peace or an immediate threat to this country. But just as this is now clear, it is equally clear that the circumstances that put this choice on the table were created by the perceived failure of international sanctions and the mechanisms by which they were enforced to deprive Iraqi of the means for acquiring weapons that threatened their neighbors, up to and including the unrealized potential--call it a too-clever bluff--of WMD.

In evaluating the failures of the UN's administration of Oil-for-Food, it's important to keep in mind the role that the program played within the international sanctions regime. Oil-for-Food was the key to the sustainability of sanctions, with its intended purpose of minimizing the impact on Iraqi civilians. The corruption of Oil-for-Food and the misallocation of the supplies it acquired created a machine that Saddam used to turn oil, food and medicine into cash for arms and palaces, while keeping his people in misery--misery that was highly visible to the international community and that was visibly eroding the resolve within the Security Council to maintain and enforce sanctions. (Mr. Volcker's finding that Oil-for-Food succeeded in maintaining "the international effort to deprive Saddam Hussein of weapons of mass destruction" ignores the rate at which support for sanctions was decaying in 2000-2002.)

I am not calling for Kofi Annan's head on a platter. Rather, I am disappointed and vexed that the UN has still failed to admit that its actions set the stage for a war that Oil-for-Food was established to prevent, and that has contributed to the tightening of global oil supplies. Anything short of this escapes true accountability and reduces the likelihood that the UN will be given such responsibility in the future.

Not Just Oil

Right now the primary energy focus of the post-Katrina recovery is on the refineries that produce 10% of our gasoline, diesel/heating oil, and other petroleum products. At the same time, companies are scrambling to find enough crude oil to supply these facilities, once they restart, since a sizeable fraction of Gulf of Mexico crude oil production--a quarter of all domestic oil production--will be offline for some time. But a growing number of analysts are beginning to realize the implications of Katrina for natural gas markets, as described by today's Financial Times (subscription required.) We are in for a serious crunch, and the extraordinarily high gas prices on the futures market underline this view.

For some time, I have expressed concern that we are headed for a train wreck with regard to natural gas. Gas is our cleanest fossil fuel, and its consumption has grown rapidly as the preferred fuel for generating electricity most efficiently, with low emissions of all types, including greenhouse gases. Unfortunately, our supply of conventional natural gas has hit a stall point, for several reasons:

• The natural decline rates of mature offshore gas fields have exceeded expectations. In other words, existing wells in these fields are slowing down faster than new wells can be drilled, and the new wells lose productivity faster than in the past.
• Vast quantities of previously discovered gas have been placed off-limits by land-use restrictions and by offshore drilling bans that fail to differentiate between oil and non-associated gas deposits (i.e., gas not found in oil fields.)
• Imports from Canada face competition from growing Canadian demand, including demand for the gas required to fuel oil sands extraction projects in Northern Alberta.
• Imports of LNG have topped out at existing facilities, and construction of new import terminals has been impeded by permitting problems and blatant NIMBY-ism.

These trends were all in place before the hurricane hit. Now, with roughly 20% of US natural gas production out of action during the period in which gas must be injected into storage for use during the winter heating season, all remaining slack in the system has been eliminated, and we will face hard choices within a few months. Nor are there any policy decisions--including easing some of the post-9/11 shipping restrictions that have limited LNG imports at Cabot's Everett, MA facility--that could change this picture materially in time for the cold weather.

Instead, we are likely to see an acceleration of the existing response mechanisms, with domestic demand destruction filling in for expanded supply. That means shifting more power generation onto coal-fired plants, with the accompanying increases in emissions. We will also see beleaguered industrial users, particularly fertilizer and petrochemical producers that were already losing the competitive battle against imports from countries with cheaper gas, selling their long-term supplies back into the market and shutting down capacity. That will result in lost jobs and lost GDP.

Some of this would have been unavoidable, but much of it must be attributed not to Katrina--which merely exposed the flaws--but to years of bad policy decisions that have hobbled the fuel that was our primary safety valve during the previous energy crisis. Prompt action to rectify these policy faults, some of which were partially addressed in the recent Energy Bill, could put us in a much better position for the winter of 2006-2007. Meanwhile, it is not too early for us all to start cutting back on our natural gas consumption by reducing electricity use and keeping heater thermostats a couple of degrees lower than normal. That way, a few more cubic feet might find their way into storage, for use when we will really need them in January and February.

Banning "Gouging" from Our Vocabulary

Bravo for the Wall St. Journal's editorial today (subscription required) concerning gasoline price gouging. It's pretty gutsy, even for the flagship media outlet of capitalism, to praise a practice that carries so many negative associations, not just in the recent past, but throughout the history of this country. And yet, it's a useful reminder that we have chosen freely to live in a market economy, and price is the tool through which the market regulates the necessary balance between supply and demand.

The impulse behind the general condemnation of gouging is noble: no one should profit from the misfortune of his neighbors. The problem is that, no matter how heartfelt and compassionate the basis of this dictum may be, when it comes to the sale of a commodity like gasoline, it is unwise and counterproductive. Anti-gouging laws and prosecutions of those suspected of the practice send a signal to the market that the government is willing to restrain prices artificially at a time when supply is scarce, thus contributing to a mentality of hoarding and negating the feedback mechanism that reduces demand.

Think about this from the standpoint of competition, which is generally the test of how well a market is functioning. At latest count, there were roughly 170,000 service stations in the US, 90% or so of which are owned by individuals or small businesses, not by oil companies. Never a high margin activity, gasoline retailers must typically supplement with sales of convenience items with much higher margins, in order for a station to turn an acceptable profit for the owner. Despite frequent allegations of collusion and price-fixing, this is a highly competitive business. How many other stores post the prices of their products where you can see them while driving by? Any station pricing significantly higher than its neighbors would see its sales dry up in a day. By the same token, undercutting its neighbors' prices by a large increment would drive up sales, but at the expense of already skinny profits.

Of course, allegations of gouging are normally only raised in the context of unusual circumstances, such as in the aftermath of a disaster. Competition plays less of a role in situations like this, and it's easy to see how a station owner might be able to set prices very high and still expect to sell his product. In fact, in a disaster in which the means for producing and distributing petroleum products has been severely disrupted, that is precisely what he should do, to prevent all the product being sold quickly and then none being available at any price, until the next delivery, which might not come for days.

Why is running out so bad? Consider drivers who need to fill up on their way to work. If the most convenient station has no fuel, they will have to drive to the next one. If that station is out, too, many of these folks will just head to work and hope to fill up later, but some won't have enough gas to do that, and will be faced with the choice of driving around until they find a station that has fuel, or of missing work that day. The value of the time lost in this activity, and the work lost if they are unsuccessful, outweighs the incremental cost of filling up at a higher price. For work, you can substitute any other activity of social or economic importance, and the argument still applies. Runouts are bad for the economy and bad for society.

So far, in the case of Katrina, higher prices seem to have had their intended effect. As of yesterday's report from the Energy Information Agency of the Department of Energy, the average price of regular gasoline had risen to $3.06/gallon, with some regions as high as $3.29. By definition, that means that while some stations fall below these averages, others are above, and some well above. But as stressful as that has been for consumers, only a few stations have reported running out.

Returning to our compassionate impulses and public morality, doesn't it make more sense to put these into practice by finding ways to reduce the impact of market forces on those least able to bear them? A gas-tax rebate for low income consumers makes for better policy than interfering with the market's ability to balance supply and demand. I believe that most of our legislators and public officials, up to and including the President, understand this. After all, it's only the application of things you'd learn in the first week or two of any Economics course. Unfortunately, they find it more politically expedient to condemn gouging and promise hearings and prosecutions, rather than reminding the public that paying more for a scarce commodity is fully consistent with the principles on which this country was founded, even if it might be painful in practice.

"People Are Our Most Important Resource"
For years oil companies have included words like the above quote in their annual reports and other communications, but this cliche has never been more apt than now. One of the biggest challenges facing the companies attempting to repair and restart their refineries, pipelines, and oil and gas production facilities will be gathering up their workforces, which have been scattered throughout the South and Southeastern US. This article from the Houston Chronicle describes the problem in more detail. Based on reports of displaced refinery workers who are seeking jobs near the shelters in which they are living, this process could take some time. If so, finding or replacing missing employees could turn out to be the key factor in resuming normal operations.

Current indications suggest that about half the idled refineries, representing 5% of US capacity, will restart within days, while the other half could be laid up for weeks or months. If the latter all require major repairs, locally-available resources would be strained in the best of times. It's important to realize that over the last couple of decades, oil companies have responded to the same competitive pressures as other industries, outsourcing many functions--including most non-routine facility maintenance and repair--and trimming operating staffs to a point of lean efficiency. But that also means that if the hurricane created more than a few vacancies in key operating positions on vital units within a refinery, managers will be hardpressed to undertake the complicated procedures required for a safe startup.

After a disaster of this magnitude, refiners will likely have to employ the same approach as the affected electric utilities: bringing in employees and contractors from unaffected facilities all over the country, in order to fill the gaps. This adds complexity to an already arduous task, and likely adds further delays. As a result, deft management of existing inventories and expected imports remains critical. This burden falls on another group of key people.

Because the impact of refined product imports from Europe and elsewhere won't be felt for at least another week, the task of rebalancing the crippled products distribution system and minimizing localized outages rests with the oil company supply and distribution groups, which will need all their resourcefulness to respond to unpredictable changes in delivery schedules. I vividly recall dealing with this on a much smaller scale, when a single refinery or pipeline shut down unexpectedly, and I can only imagine the hours these folks have put in since Katrina hit. If you live east of the Mississippi and your region hasn't experienced runouts, it is probably the result of some very fancy footwork by a small number of stressed-out oil company traders and pipeline schedulers in Houston. Lets hope they can continue their magic until the cavalry arrives.

Happy Labor Day!

Yergin on Katrina
Today's Wall St. Journal includes an excellent op-ed by Daniel Yergin on the impact and implications of Katrina. Unfortunately, it only seems to be available to subscribers. Besides providing a good summary of how Katrina has affected the nation's energy system, he has some good suggestions about changing the way we think of energy security, shifting to a more comprehensive, supply-chain assurance approach and away from a focus on potential disruptions to crude oil supply.

Those Unintended Consequences
For as long as I can remember, I've delighted in trying to think things through to their logical conclusions, even if those conclusions aren't readily apparent. John Tierney of the New York Times had a go at this game earlier this week, in an op-ed focused on the unintended consequences of granting special privileges to hybrid cars. The particular perk he had in mind was the use of carpool lanes by designated highly-efficient hybrids. He makes a good case that this will result in more pollution, congestion, and oil consumption overall, exactly the opposite of the intended outcome.

Without a careful analysis of the number of vehicles involved, city by city, I can't confirm that Mr. Tierney's conclusion is correct, though it's likelier to be right if this benefit is extended for more than a year or two. I also need to give some further thought to the alternative he proposes. In any case, he has uncovered a thorny problem at the heart of almost every alternative fuel and alternative transportation technology: the dilemma posed by the need to make the alternative--which typically starts out requiring some form of subsidy or incentive--attractive enough to catch on without creating a self-perpetuating constituency for preserving the incentive, long after it becomes unnecessary or counterproductive.

The classic example of this is the road tax on fuels. Alternative fuels are usually introduced with either no road tax or a reduced tax, to make them competitive with gasoline. Gasoline containing ethanol has received a tax break for decades, and you won't hear any advocate of natural gas or hydrogen suggest that they be fully taxed when used in cars. Of course, as the number of cars using these low-tax or tax-free fuels climbs, tax revenues will fall, and the impact will fall hardest on states and municipalities lacking the means to make up these revenues elsewhere. LPG, which has been used in cars for years, is still not fully-taxed in all states.

Now, I have no problem with subsidizing the fuels and car technologies that we want to promote, but doesn't it make sense to rethink the mechanisms that these incentives distort, in order to minimize any long-term disruptions? If we want a future in which fuel consumption declines or disappears altogether, then taxing cars or miles driven, rather than fuel, is a better way to pay for the infrastructure they use. (I'm sure we can find other things to do with the fuel tax revenue.)

The bottom line is that government bodies need to think through the consequences of their actions concerning alternative fuels and transportation, because of the persistence of the changes involved. Anyone proposing carpool-lane access for hybrids--or a tax holiday for alternate fuels--should be required to present a clear plan for what will happen when a sizeable fraction of the cars on the road qualify. In the process, they just might come up with a better way to achieve the goal they are pursuing, instead of narrowly focusing on one particular means of reaching it. In the meantime, the discussion about incentives for hybrids may become moot, if Katrina turns out to be the final tipping point for hybrid car sales.

As Prices Head Higher
It's been fascinating watching the price of the most visible commodity in the world. In yesterday's session on the New York Mercantile Exchange light, sweet crude oil settled slightly lower, suggesting that for now the market has dialed in the impact of a lengthy shutdown of much of the Gulf Coast's oil production, along with the Administration's willingness to at least lend oil from the Strategic Petroleum Reserve (SPR) to refiners having trouble getting access to their normal supplies.

Gasoline, which poses more immediate supply problems, exceeded $2.90/gallon for part of the session but closed below $2.60. If you want to know where your local street price is headed, a good first approximation is to take that price, add in federal and state taxes, and another $.15-.20 for dealer margin. Where I am in Connecticut, that works out to about $3.30, vs. $3.059 yesterday afternoon at my local Shell station. But remember that local factors are going to create a wide variance around these figures, especially in states with no other supply than that from the affected refineries and pipelines.

Trying to predict where prices will go from here is tricky. Within a few days, we'll have a better sense of how long the key petroleum product pipelines and refineries will be down, and the market will be getting a sense of what's available to import, from where, and how long it will take to arrive. That should get us another price adjustment, probably up. In the meantime, the biggest factor of all, demand, will set the market direction. As I indicated the other day, with gasoline inventories already tight when Katrina hit, and refineries already running flat out, the only ways to make up for any lost production are with imports and reduced demand, and the latter will predominate until the former can come into play. How much will demand have to fall to balance the system in the meantime?

If you figure that demand in the three states most affected has fallen by a large fraction, say 2/3, then on a ratio of affected population to the whole, that should reduce US gasoline demand by about 3%. Since we've lost 10% of gasoline production for the time being, we need to cut another 7%. That amounts to 25 million gallons/day, or about the quantity used by 19 million cars. How do we cut that much? With prices approaching $3.00/gallon before Katrina, I have to believe it's going to take something much higher than that, $4 or $5, given how hard it is for consumers to adjust their usage patterns.

Finally, I'm disturbed by comments about price gouging. Sure, the guy in Georgia who jumped his price to $6 in one day deserves the trouble he will get, but we need to be very clear, here: This is not some scheme by Big Oil to squeeze money out of our pockets; this is a national crisis. If gasoline prices don't rise enough to slash demand by the quantities suggested above, then instead of a few outages--confined to locations that have lost their main supply source for a few weeks--we will have nationwide outages due to hoarding behavior. From my perspective, the higher prices go, the lower the risk of gas lines all over the country, with the accompanying penalty in lost productivity. I understand this will mean real economic hardship for those least able to bear it. Perhaps we need to be talking about an income tax rebate for the poorest Americans, rather than capping gasoline prices, as has been done in Hawaii.