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.

Cost of Carbon

One of the main points of debate in the argument over climate change concerns the cost of complying with the Kyoto Treaty or other mechanisms to reduce greenhouse gas emissions. Today's New York Times includes an editorial suggesting that the cost could be much lower than previously estimated, as low as $1.00 per ton of carbon dioxide equivalent reductions. However, the basis for this estimate is extremely weak, even though it originates in a recent study by the US Environmental Protection Agency.

Last month the EPA issued the results of their analysis of a variety of proposed clean air programs, including the Administration's Clear Skies initiative and several competing House and Senate bills. Their findings for the bill cited in the Times editorial, Senator Carper's S.843, are the source of the $1/ton estimate, although when you read the analysis, you will discover this note: "Due to modeling limitations, some provisions of the Clean Air Planning Act (Carper, S843) are not directly modeled. These provisions include the carbon offset provision." So the range of carbon credit prices reported are not apparently the result of detailed modeling. That's reassuring, because they don't even reflect the price of such offsets in today's market, let alone that of 2010, 2015, and 2020, as they purport.

For example, comparable credits currently trade in the EU at a level equivalent to about $25/ton. Prices on the Chicago Climate Exchange, which is strictly voluntary and not backed by the kind of mandatory national emissions cap envisioned in Senator Carper's bill, are already over $2/ton, and would certainly go higher if S.843 became law.

While large volumes of low-cost emissions offsets are available in the agricultural sector, the magnitude of reductions necessary over the next half-century will require industrial reductions on a larger scale, either from new energy technology that fundamentally emits less, such as fuel cells running on hydrogen from renewable sources, or by the capture and sequestration of carbon dioxide from combustion products. Neither of these methods will be cheap, compared to current power generation. Optimistic estimates of these costs are closer to $50/ton than to $1.

I'm not pointing out this discrepancy because I'm against dealing with climate change, or oppose emissions trading. In fact, I regard climate change as one of the most important issues of the 21st century, and I believe emissions trading is the only practical way in which to manage it, unless we enter a true climate crisis. However, selling this program to the American people on the basis that it would be virtually cost-free is misleading and probably counterproductive for an effort that will depend on a broad, sustained commitment over a very long haul.

Answers, Part II

Following on from Wednesday's posting, and turning to the more complicated question of our current energy problems, I'll toss out one new idea, aimed at bringing the growth in oil consumption in the transportation sector under control. While it's focused on cars, I recognize that trucking and airlines use a lot of fuel, too, and may require their own measures. Given my reticence about higher gasoline taxes, and the failure of past efforts to legislate improvements in fuel economy, I suggest we tackle the problem from a novel direction: horsepower.

When you review the evolution of cars over the last 15 years, our appetite for more power and speed has been the real villain of the piece, rather than the shift to SUVs, per se. Engine technology improved significantly during this period, but most of the potential fuel economy benefits of these advances were sacrificed in a race to boost horsepower, even for economy cars. For example, a 140 hp engine is now standard on the new Honda Civic , compared to the 67 hp powerplant of a 1980 model. Although horsepower isn't the only factor influencing fuel consumption, its importance expands when you consider indirect effects, such as enabling larger and heavier vehicles. Can you imagine a Lincoln Navigator powered by a 140 hp engine?

So why not tax excess horsepower, to encourage us to make do with less, and put downward pressure on many of the factors that have hurt fuel economy over the last 20 years? For example, we could start with a new-car tax of $1/hp for every horsepower over 100. This would apply on every car, without distinction to size, weight or class. This tax would increase by $1/hp/year, until it reached, say, $10/hp. In the case of my 270 hp Acura TL, for example, I'd pay an extra $170 if I were buying it now under this scheme, but if I bought the same new car with the same engine ten years from now, the tab would have risen to $1700. To make sure it bites properly, this tax should be collected at the time of purchase and not be financeable, so it couldn't be buried in the lease payments.

Compared to increasing our gas taxes, or imposing a tax on engine displacement, as some European countries do, this approach has the following advantages:

• It promotes efficient hybrid cars by exempting the horsepower from a hybrid's electric motors. At the same time, though, it doesn't reward "performance hybrids", which still need large gasoline engines.
• It also does not reward supercharging and turbocharging approaches that make small engines perform like big ones. That might be controversial, because turbos have been seen as being economical. They are, but only in relative terms, against the alternative of needing a bigger engine to get more power.
• It is much less regressive than fuel taxes, because it would be collected only on new car purchases, not used cars, and could be avoided entirely by purchasing appropriately economical vehicles.
• It helps offset the higher initial cost of diesel engines, which generate less horsepower for equivalent levels of performance (torque) vs. gasoline engines.

While it would clearly take years for the full fuel economy effect to be felt across the entire fleet, enacting such a tax would send a clear signal to carmakers and consumers that their priorities need to shift. I'm also aware that this tax violates my own dictum about focusing on desired outcomes, rather than on the means to them. However, it's still at least a step or two closer to that than a gas tax. It might also be more politically palatable than closing the SUV loophole in the CAFE standards, because it would preserve the critical right of consumer choice, while providing some serious incentives to move in the desired direction.

Answers, Part I

The other day one of my readers challenged me to go beyond pointing out problems and recommend some solutions. In particular, he wanted me to suggest how to reduce the threat posed by Venezuela’s President Chavez, and to identify some ways in which the US could limit its energy problems over the next five years. Tall orders, both. I'll tackle the first part of this today, and follow up on Friday.

Venezuela represents a serious problem for the US, as I suggested in Monday’s posting. Here’s a country that has historically run neck-and-neck with Saudi Arabia for second place in the list of our most important oil suppliers, after Canada. American and other western companies made large investments in Venezuela’s upstream oil sector, after the government liberalized its rules in the 1990s, and these ventures currently account for 45-50% of the country’s oil production. But in the last several years, the Venezuelan government has turned decidedly anti-American, and President Chavez’s policies and rhetoric have grown increasingly inimical to American interests in the hemisphere. Doubtless his attitude towards us wasn’t helped by our perceived complicity in the failed attempt to oust him, or by our support for his political opponents in last year's referendum on his rule. (I'm not counting Pat Robertson's recent assassination rant, here.)

Direct confrontation at this point would likely only serve to bolster Sr. Chavez’s image and appeal within his country and with the less affluent throughout South America. Instead, it seems timely to apply Zhou En Lai's clever inversion of Von Klausewitz--that diplomacy is the continuation of war by other means--and to pursue aggressive efforts to restore the flagging image of the US in Latin America. (There were some alarming statistics about these trends in this week’s Economist.)

After all, even with its fortunes buoyed by high oil prices, Venezuela's entire GDP is about the size of that of Louisiana, pre-Katrina. If President Chavez can offer his neighbors a better deal on trade and development than we can, then there’s something fundamentally wrong with the way we are looking at the problem. I’m not sure which specific measures would work best, whether a host of new bi-lateral trade deals, a generous Latin American development fund, or something else entirely, but we must surely have economic and political levers available to us that Sr. Chavez can’t hope to match.

By reducing Chavez's influence in the region, we would effectively isolate him and make him look more like the tinpot dictator that he is. That seems more fruitful than confronting him and building him up as the people's hero, who can poke his finger in the eye of the US and make us like it, because of his oil.

A Multi-Polar World

As I read this article from Sunday's New York Times on the growing environmental impact of China, I was reminded of how physicists describe the spatial distortion caused by a large mass, and the complicated interactions several large masses create between them. China is a large mass, if there ever was one, and it is joining a world currently dominated by two other large masses, the US and the EU. We haven't even begun to experience the full impact of this change, particularly when it comes to energy and the environment.

Nor is this just a function of the relative population sizes--the "China Big" effect. Rather, the development of China has been so rapid, and sufficiently distorted by state central planning, that the energy and environmental consequences of that growth have only recently become apparent against the backdrop of basic economic drivers such as employment and exports. If present trends continue, pollution from China could overwhelm the environmental efforts of all other countries. Not only is China on a path to exceed US emissions of greenhouse gases, but its emissions of "local pollutants"--the oxides of sulfur and nitrogen that have historically produced smog and acid rain in places like L.A. and the Northeast--may also have global impact. The Times suggests this is already the case for particulate pollution, as a result of burning coal without modern pollution control equipment.

This paints a very bleak picture of the decades ahead, but it's not pre-determined. All of these problems create tremendous opportunities, and that's not just a cliche in this case. The greatest leverage available for reducing future emissions is to ensure that new cars, factories, and other sources of pollution incorporate the best available technology. More of those will be added in China than anywhere else. That means if you're going to spend a dollar to reduce emissions, you can get a lot more reductions for your buck in China, than here.

I'm not suggesting letting domestic polluters off the hook. But I do think that global problems call for different approaches than we've applied to local and national problems in the past. We need to be smart about how and where we invest in reducing emissions, if we want to have the maximum impact, both on climate change and on air quality. We also need to think seriously--without fear-mongering and demagoguery--about the resulting tradeoffs between jobs, economic growth, and global pollution. Saving the environment may require building state of the art factories in China that will cost jobs here. Can our political system cope with this kind of challenge?

By the way, I'll be traveling on business for the next several days, so postings may become more erratic.