Timely Sequestration

Carbon Capture and Sequestration (CCS) technology has come from literally nowhere a decade ago to the position of being widely regarded as the key enabling technology for making our continued use of coal compatible with the need to respond to climate change. Coal power plants are among the largest global sources of greenhouse gas emissions, and sequestration has the potential to bottle up these gases for decades or centuries, making it possible to keep using our cheapest, most carbon-intensive energy source. But what if sequestration arrives too late to help? That's not a reflection of pessimism about the technology itself, but a recognition of the way a number of different trends and time lags could affect its deployment.

Last week the Wall Street Journal published an overview of progress on sequestration, including pilot and demonstration-scale projects around the world. I'm encouraged that developers are combining CCS with a variety of coal-power technologies, rather than just the integrated gasification combined cycle (IGCC) technology that has looked like the best match. But when you allow enough time for all these tests to be built, run and evaluated, and the results factored into the next generation of the technology, it could take another full decade for CCS to be ready for wide-scale implementation with new coal power plants. That could be too late for two reasons.

First, we are in the midst of a global wave of new coal power plant construction, precipitated by the rapid growth of China and India, combined with the relatively sudden increase in the price of oil and natural gas over the last four years. As the recent MIT study on the future of coal makes clear, retrofitting CCS to an existing facility--rather than integrating it into the plant design from inception--could be more than just expensive. It might not be practical at all. So if the bulk of the world's coal power plant fleet will have already been built by the time CCS is ready for prime time, the game could already be over.

It requires a bit of imagination to suppose that the expansion in coal-based power generation might slow or even stop. After all, if China keeps growing as it has been, it could presumably keep adding coal power plants indefinitely. But the world in which these plants are queued up into the future doesn't stand still. The cost of competing alternative energy technologies will continue to fall, driven partly by the same Chinese expertise in low-cost manufacturing that is fueling the expansion of coal. Cheap wind and solar power could erode coal's share of new generation, even in developing countries. At the same time, these countries might come around to the idea of mandatory controls on carbon emissions. They are certainly no farther away from this than we were a decade ago. Together, these factors could dry up the market for new coal plants, just as CCS is coming on stream. That's not good news for the companies investing in this technology, nor for owners of coal resources.

I can think of two ways to prevent CCS from becoming irrelevant. The most obvious one is to increase the pace of technology development and especially demonstration-scale activity. If CCS were ready in five years, rather than ten, that would make a big difference. The other solution is riskier and a lot more expensive. We could impose new regulations requiring all new coal-fired power plants to be constructed "sequestration ready", that is, with a design that explicitly allows for CCS to be bolted on as soon as it is available. In addition, we could require plant operators to set aside enough money up front to build the necessary infrastructure for shipping compressed CO2 to an appropriate underground disposal site, which might be a long distance away. This cost could be at least partially offset by giving these plants a temporary waiver from inclusion in the carbon tax or cap-and-trade mechanism that the US eventually implements.

I can hear all the objections this would raise, including that it would make coal power plants immediately uncompetitive and put more strain on natural gas supplies. But unless we do something fairly soon, CCS may end up as the silver bullet that never gets fired, and that could make it much harder to reduce global greenhouse gas emissions in the long run.

Timing Is Everything

Two news items about oil caught my attention this week, and both of them illustrate the pitfalls of poor timing. If the windfall profits tax bill introduced by Senator Casey and seven of his freshman Democratic colleagues had been proposed at the front end of the current industry cycle, it would have at least been chasing a genuine price-spike windfall, rather than the profits from increasingly expensive new projects. And had the report that Iraq's oil reserves may be double their officially-reported 115 billion barrels--with the increment mostly in the Sunni western part of the country--come out a year or two ago, it might have helped Iraq's feuding factions find common ground. Instead, these two items merely contribute to a bleak picture of the future facing the major oil companies.

Because Iraq is still immersed in sectarian and terrorist violence, with no end in sight, it's going to be a long time before any of the country's newly-discovered oil gets to market. For that matter, any increase in production above pre-war levels would require a dramatic realignment of OPEC quotas, or Iraq's departure from the cartel. But if the new oil is anything like the old oil, distributed in a small number of large deposits with straightforward geology and low development and production costs, then Iraq's long-term future potential isn't 4-6 million barrels per day, as many have thought: it's another Saudi Arabia capable of similar volumes to what the Kingdom puts out. That needs to be factored into considerations of Peak Oil timing and the future oil price with which alternative energy projects must compete. It also serves as a reminder of just how much of the world's future energy supplies belongs to state oil companies in the Middle East.

As to a windfall profits tax on oil companies, this is never a good a idea, but at no time worse than when the industry is facing a serious profit squeeze--caught between rising global construction costs and more assertive national oil companies, both upstream and downstream. Our energy companies need to develop enormous quantities of new oil to replace reserves they are consuming, while investing in new refinery capacity to keep product supplies growing; all of that is going to cost hundreds of billions of dollars. Siphoning off a large slice of that money to fund new poverty programs is a good way to derail those projects and keep the prices we pay for petroleum products high indefinitely.

Taxing oil companies makes for great populist sound-bites, but it is directly contrary to any realistic notion of enhancing our energy security, when the state oil companies are getting bigger and more powerful.

A Superfluous Subsidy

While listening to the podcast of a recent conference call with the President of the American Petroleum Institute, a question from one of the participating bloggers provoked one of those slap-your-forehead moments for me. Robert Rapier, who writes the R-Squared Energy Blog, asked why ethanol still needed a subsidy, since its use is now mandatory under the new Renewable Fuels Standard (RFS) regulation in the US. It bothers me that when I was dissecting the RFS the other day, this never occurred to me. Mr. Rapier's question seems highly appropriate, since ethanol is now required under not one, but two federal fuel regulations, along with various state and local rules. It's hard to avoid the conclusion that, with ethanol production booming, it doesn't require three support mechanisms, and so the subsidy should go.

As I described last week, the new national RFS sets an annual quantity of alternative fuel--which today means principally ethanol--that must be blended into gasoline, starting with 4 billion gallons in 2006 and rising each year. Anyone caught short must buy credits from another blender who used more ethanol than required. At the same time, however, most of the present ethanol supply is used to satisfy the oxygenate specification under EPA and state reformulated gasoline (RFG) regulations. So ethanol producers have a guaranteed market on two levels: the amount required for RFG and an overlapping and steadily increasing quantity set by the RFS. And that is now in addition to the 51 cent per gallon Volumetric Ethanol Excise Tax Credit, which effectively subsidizes production of fuel ethanol by enabling refiners and blenders to pay more for it than it is worth as a gasoline extender. How many other businesses would like to have the government pay them to make something, and then force their customers to buy it?

The US ethanol market would eventually look very different without the subsidy. Let's start with some numbers. Eyeballing the chart for the May ethanol contract on the Chicago Board of Trade exchange, ethanol was going for about $2.20/gallon (delivered in storage in Chicago) when the comparable wholesale gasoline futures contract for May was trading for an average of $1.92/gallon in New York. Considering that rail freight can add another 10-15 cents/gal. to the price of ethanol delivered to the blending location, incorporating 10% into gasoline raises its cost by about 4 cents/gallon, offset slightly by ethanol's higher octane rating. In today's market, the difference is covered by a 5 cent contribution from the excise tax credit.

Absent the subsidy, several things would have to happen. First, since the demand for ethanol required to meet oxygenated fuel specifications would not change, ethanol sellers into that segment should be able to hold their prices, while refiners would see their net cost of producing marketable gasoline rise. Eventually, the ethanol price for this segment would settle out at a level equivalent to the gasoline price plus the market value of the new, traded Renewable Identification Number attribute created by the RFS. Most of the resulting increase in gasoline cost would eventually be passed on to consumers.

Once the ethanol supply exceeds the quantity necessary to back out any remaining MTBE from the oxygenate requirement--somewhere around 6 billions gallons of ethanol per year--the price of any production in excess of the national RFS quota would fall toward parity with gasoline, plus a small premium for its octane value. Some of the surplus might end up in E-85, which at least for now commands a premium price, but the resulting price pressure would eventually trigger a shakeout among ethanol suppliers. Large, efficient (newer) ethanol producers would win, and some small producers with higher costs would go out of business, or have to idle their facilities until the expanding RFS quota broadened the mandated market enough to include them.

To complicate the picture further, if the subsidy were lifted, it would be hard to justify maintaining the 54 cent tariff on imported ethanol. If that were repealed, marginal US suppliers would find themselves under even more pressure, and they would lose share to imports that might come in at a low enough price to compete into gasoline on blending value alone.

But if small ethanol operators could ultimately lose from the end of the subsidy, who would win? Not the oil companies, which stand to see their blending costs increase, perhaps by more than they can recover in the marketplace. Although some foreign ethanol producers might benefit, the biggest winners would be the US economy and taxpayers. We'd get all the ethanol necessary for environmental and energy security purposes at the most efficient price, and at an immediate federal budget savings of $2.5 billion/year, and growing. At that point, the only remaining argument for continuing the subsidy would be to protect the least efficient domestic producers from competition, at a very high effective cost per gallon.

Repairing Road Taxes

The President set a goal to reduce gasoline consumption by 20% within 10 years, and the EPA has rolled out a national Renewable Fuel Standard regulation to make it happen. But for those in charge of planning for the construction and maintenance of the country's highway system, that goal needs to be parsed differently: the President's plan is to reduce receipts of the road taxes collected at the gas pump by more than 20% within 10 years. Since Americans continue to drive more miles each year, and our population of drivers continues to grow, this is a recipe for disaster. Today's Wall Street Journal looks at some of the ways that states are exploring to adjust to this situation, but I wonder if the agencies involved have thought this matter through to its logical conclusion. Collecting GPS-based mileage fees at gas stations won't work, either, if future generations of cars fuel up rarely, if at all.

While I retain my doubts that the President's target can be reached within ten years, the momentum is certainly shifting, as stricter Corporate Average Fuel Economy legislation looks highly probable within the current Congressional session, and as sales of alternative fuels that are either exempt from road taxes, or for which foregone tax collections are backfilled from the general fund, grow. As a result of these factors, US gasoline sales are likely to reach an inflection point within the next decade and start to decline. Unless the road-tax collection system is radically overhauled, highway tax receipts will go down in tandem with petroleum-based gasoline.

Anyone looking at successor tax systems must think carefully and clearly about the nature of future cars and their energy sources. If plug-in hybrid cars become practical and affordable, they will get most of their energy from recharging at home, using off-peak electricity, which is free of any road taxes. And plug-hybrids are just another step on the path to a practical all-electric car. Nor do those touting the energy security and environmental benefits of these cars seem apt to welcome taxes on the electricity they would use. Cars running on natural gas, which are already available, enjoy the same natural tax exclusion. I haven't seen anyone suggest that hydrogen for cars be taxed, either. The inescapable conclusion is that any future road tax system must be based on miles traveled, rather than fuel consumed, and that the collection mechanism will have to be divorced from liquid fuel sales.

The trick, of course, is how to get from the current system to something like that. If anything, I think the Journal underestimates the privacy concerns that GPS-based tax collection would raise. The cost of retro-fitting 243 million cars isn't trivial, either. It would be much simpler to shift the tax collection point to the annual vehicle registration process. Many states already require annual vehicle inspections, and the odometer readings from these could easily be translated into a mileage-based tax levy. Anyone preferring to "pay as they go" could volunteer for GPS-based taxation. The alternative to mileage-based taxes is to ratchet up the per-gallon tax on gasoline, to compensate for any future volume loss, but in the long run, that's a dead end.

The politics of all of these alternatives to the current system look challenging, but the cost of starving our highway budgets, in terms of safety and economic impact, would be high. Unless we're willing to assume that gasoline sales will continue to grow forever, someone is going to have to make a tough choice on a new approach to collecting road taxes.

Benchmark At Sea?

Since reading the Wall Street Journal's analysis of the growing disconnection between the industry's West Texas Intermediate (WTI) crude oil benchmark and the actual crudes that refineries purchase and process, I've been pondering this latest version of a fairly old problem. Although current concerns about supply, demand and capacity in the Mid-Continent have made hedging with WTI more problematic than usual, anyone engaged in this sort of risk management--or speculation--must surely understand that the "basis risk" has always been subject to unpredictable swings from local factors, as well as the larger shifts of the global oil market. At the same time, market professionals have been concerned for two decades about the potential for WTI to become irrelevant in a world of disproportionately heavy and sour future oil production.

Although all of my oil trading experience was in the dark ages before the Internet, when orders were placed by phone, rather than on a screen, some aspects of the business haven't changed. As the Journal rightly points out, the physical oil at the heart of WTI trading still represents a shrinking and increasingly unrepresentative sample of global crude oil grades, many of which are heavier and higher in sulfur and other impurities, rendering them harder to refine and thus less valuable. That never stopped crude sellers from pegging their prices to WTI, including the heavier, somewhat more sour Californian and Alaskan crudes I traded in the late 1980s and early 1990s. In hedging San Joaquin Valley Heavy crude with WTI, the basis risk--reflecting the correlation between the price of thing being hedged and the instrument with which it was hedged--could be nearly as large as the total market risk.

The circumstances described in the article are an extreme case of this phenomenon, in which a temporary glut of crude oil in Cushing, OK, the delivery point for the WTI contract, has detached the WTI price from the world price, as represented by the price of Brent Crude from the North Sea. Historically selling at a discount to WTI, Brent is now roughly $2.50/barrel higher, reflecting conditions in the larger market outside Oklahoma. But in assessing whether this is a temporary problem or a long-term shift, it's important to realize that WTI at Cushing, OK isn't quite as stranded or inflexible as the Journal indicates. A quick review of the terms for WTI on the NY Mercantile Exchange shows that a variety of crude oil types can be delivered in satisfaction of the contract, including other sweet crudes from the US, Colombia, Nigeria, Norway and the UK. The contract also provides for an "alternative delivery procedure," which could include other locations besides Cushing. If there's one thing physical oil traders know how to do, it is negotiating location differentials.

Nor is the arbitrage between storage and future delivery quite the permanent feature the author suggests. It only works when the market is in "contango", with future prices higher than current prices, typical of an oversupplied market. But over the long haul, the market is more often in "backwardation", with future prices falling off from current levels. Speculators playing this "front-to-back arb" are exposed to a sudden shift from one state of the market toward the other, and anyone thinking contango is a perpetual motion machine is in for a rude surprise.

So at least part of the problem described by the Journal looks like a transient and a normal part of market risk--another good reason for those who know little about oil fundamentals to forgo dabbling in oil futures. However, this doesn't alter the underlying problem that most of the oil that will be produced in the future will look a lot less like WTI than most of the oil that's already been produced. Explorationists have had a remarkable run for the last 20 years, finding more sweet crude than anyone expected in places like West Africa, the North Sea, and the deep waters of the Gulf of Mexico. But the odds against continuing that streak get worse each year, with the preponderance of global reserves lying in the Middle East, where oil is typically heavier and higher in sulfur and than WTI. The need for a sour crude benchmark similar to what WTI and Brent provide for sweet crudes has existed for a long time, and it will continue to grow.

But here we run into a Catch-22. Launching a new futures contract isn't easy, especially when many of the parties that could provide the liquidity necessary to lure major oil companies and other conservative players into a new market have vested interests in seeing a "sour contract" fail, as NYMEX's previous attempt in the 1980s did. If your firm is making good money writing over-the-counter swaps for illiquid and much less transparently-priced commodities, why would you want to help put this activity out of business by encouraging a transparent, liquid and flexible exchange-traded sour crude contract with low transaction fees? The only thing I see changing this calculus is if the problems at Cushing grow large enough to make the basis risk unmanageable for both sides of the transaction, eroding the profits of market makers, as well as hedgers. The Journal seems to be saying we're at that point, but I've heard that before.

What does this mean to the average person? For starters, it reduces the importance we should place on that part of the media's energy coverage--not that there was much benefit in following day-to-day changes in the WTI price, before. At the same time, investors in the energy sector may want to broaden the indicators they follow, to include more of grades that refineries actually run. That will require a little more legwork. If the new Middle East Sour contracts on the ICE and the Dubai Mercantile Exchange actually take off, that task will be easier.

Half Measures

Friday I wrote about the prospects for achieving significant emissions reductions in time for the 50th anniversary of Earth Day in 2020. After watching the 38th Earth Day pass almost without notice, I'm a little more pessimistic. My local paper, the Washington Post, hardly mentioned the event. Included in their limited coverage were some blog excerpts from a pair of entertainment personalities who seem to think the solution to our environmental problems might be found in steps such as rationing toilet paper. Even the Post's list of ten things we can do to help the global and local environment, while entirely sensible, was hardly consistent with the scale of impending catastrophe that is conveyed elsewhere in the media. If climate change is as serious as the scientists are telling us, it won't be solved with a few well-intended and painless half measures.

The second item on the Post's list, for example, related the following "fact" about energy-saving light bulbs: "If every American home (114 million of them, at latest count) replaced one standard bulb with an energy-efficient one, it would save enough electricity to light 2.5 million homes for a year." Actually, some reasonable assumptions yield a much more impressive comparison, along the lines of lighting 12 million homes, based on the national average of 940 kW-hrs of electricity for lighting per year. However, these savings pale to insignificance at the national level, where they represent only 0.3% of the electricity we use. That doesn't mean efficient light bulbs are a bad idea, though a recent story about the hazards of cleaning up the mercury from broken ones gives pause for thought. But instead of simply jumping on board the compact fluorescent bandwagon, why didn't the Post think to admonish us about the impact of all those households buying plasma TVs, with their average 180 watts of extra power use versus the cathode-ray TVs they are replacing? At 8 hours per day of average usage, that would amount to 1.5% of annual electricity generation, or five times as much power as one efficient light bulb per household would save. That also equates to an additional dozen or so power plants, most likely burning coal or natural gas.

Compare this to the announcement yesterday of New York Mayor Michael Bloomberg's ambitious plan for a 30% reduction in NYC's emissions footprint, based on the city's recently-completed greenhouse gas inventory. Including such measures as congestion fees and expansion of the already extensive mass transit system, the mayor's plan at least conveys the right sense of proportion.

We've heard a lot of criticism that Americans weren't asked to make any sacrifices after 9/11. So far, though, requests for sacrifices to avert a global "climate crisis" are thin on the ground, despite the fact that this problem results largely from the aggregation of billions of choices by individuals. The Congress is considering a national cap-and-trade system for greenhouse gas emissions, and California has already enacted such a program, with a target of reducing emissions by 25% by 2020. While I generally favor this approach, I recognize that it will lead to profound and potentially costly changes in our economy. So if we're seeking voluntary measures to help mitigate climate change, shouldn't we ask people to do something that might actually matter, or even reduce the scope of regulations that will be necessary to address the problem?

Earth Day + 50

This Sunday marks the 38th annual observance of Earth Day since its beginning in 1970. Rather than focus on this year's event, I started thinking about what the fiftieth anniversary of Earth Day in 2020 might look like. The focus today is on the tough challenges ahead. But considering the rate at which global interest in climate change is coalescing, much as concern for air and water pollution did in the 1960s and 70s, we ought to see great progress in reducing emissions by then. Or will we? We're pushing against an energy system with enormous inertia, and that still hasn't stopped growing. How different might the environmental impact of our energy systems be on Earth Day plus Fifty?

Consider some extrapolations. If renewable energy were able to capture 50% of the projected annual increases in US electricity generation between now and 2020--which seems attainable, based on recent experience--then by the end of the next decade renewables including hydropower would have expanded from 9% of the mix to roughly 16%. That's impressive growth, though it would still put renewables behind nuclear power, which starts at 20% and is expected to decline slightly. Fossil fuel-based power would account for 65%, down from 71% now. However, even if renewables captured 100% of the growth in electricity generation between now and 2020, giving them a 25% share of the electricity market, the resulting mix would still emit as much greenhouse gas as today's.

Turning to fuels, US ethanol consumption has quadrupled in the last decade. If it could sustain that kind of growth--assuming it doesn't run into limitations on corn supply or other inputs and that current incentives are retained or expanded--ethanol would contribute 25 billion gallons per year of motor fuel in 2020. With gasoline consumption continuing to expand at 1%/year, there would be enough ethanol to allow every gallon of gas to contain 10% ethanol, while enabling E-85 to grow to 8% of the market, a bit less than the current share for premium or mid-grade unleaded. But even if most of the extra ethanol came from cellulosic sources, with minimal greenhouse gas emissions, our vehicles would emit more carbon dioxide in 2020 than they do today, because we'd be using at least as much "base" gasoline as we do now.

These examples suggest that, from a climate change perspective, it won't be sufficient just to make our energy mix greener, if it's still growing. And while the figures above must look pretty conservative to environmentalists and alternative energy boosters, I would wager they look quite optimistic to experienced industry professionals. I'm sure you could get the marketing departments of major oil companies pretty excited by telling them that there's a new product that could deliver sales volumes almost as large as premium unleaded in a decade, without stealing any of their current sales. But I'm not sure you could convince them that they can get there from here, or that there'd be a profit in it for them.

That doesn't mean I'm pessimistic about the next decade. The best bet for achieving real progress by Earth Day 2020 might be neither economic or regulatory, but demographic. By the fiftieth anniversary of the first Earth Day, the oldest Baby Boomers will be in their mid-70s, while the youngest of us, along with the oldest Gen-X'ers, will be eligible for early retirement. Today's college students will be in their early 30s, and the oldest cohorts of the Millennial Generation will be hitting their mid-career stride, approaching their peak earning years. If their collective attitude towards the environment is as different from that of the Boomers as ours was from our parents', and if that translates into different consumption and investment patterns, then by 2020 they should be having a dramatic impact on the way that America uses energy. That might just be enough to rein in the growth of emissions.

New Ethanol Risks

A new study from a Stanford University scientist suggests that burning large quantities of ethanol might actually promote more smog, even as it reduces greenhouse gas emissions. I have a healthy respect for unintended consequences, and the only surprising aspect of this result is that it should pop up now, after so many decades of blending ethanol into gasoline. Coming as this does in the midst of a growing debate about the tradeoffs between ethanol and food supplies--a topic that has apparently caught the attention of Venezuelan President Hugo Chavez--it complicates the picture for our de-facto primary alternative energy strategy.

Engineers have known for a long time that ethanol increases evaporative emissions from gasoline, thus boosting the local concentration of ozone precursors in the air we breathe. That was one of the factors that led refiners to favor MTBE over ethanol, until the unintended consequences of the former, in terms of groundwater contamination and odor, became clear. The Stanford study sheds new light on what happens to ethanol molecules in the atmosphere. If this finding is confirmed by other researchers, it is likely to create additional obstacles for E-85, besides infrastructure. It might also generate more interest in a process for turning corn and other biomass into clean-burning propane, which until ethanol's recent popularity was our most successful "alternative fuel."

E-85 proponents might be skeptical of the study's results, because of their coincidental timing--just when ethanol is taking off--or the connection between Stanford and ExxonMobil. However, the statement from Senator Feinstein's office suggests that officials are taking it seriously. Whatever the final outcome, this is a useful reminder that every large-scale energy alternative has consequences that must be weighed carefully against those of the status quo, to ensure that we get the most benefit from our investment of time and treasure, and to avoid costly dead ends.

By the way, Energy Outlook got a nice plug from the Wall Street Journal's blogroll on Tuesday. I'd like to welcome any new readers that found this site as a result.

Prospects for an OGEC (re-run)

Last week's meeting of the Gas Exporting Countries Forum in Qatar spurred all sorts of speculation about a future gas version of OPEC. I wrote about this possibility last fall, and my view hasn't really changed:

An interesting article in the Financial Times (subscription required) raises--and then partially demolishes--the idea that producers of natural gas might band together in a cartel similar to OPEC, in order to control the future supply and price of international gas. Concerns about Russia's intentions seem to be the main driver, here, and at least for Europe these are quite legitimate. But while the FT accurately skewers the notion of an OGEC from the perspective of the current international gas business, dominated as it is by long-term contracts for pipeline gas and LNG, I wonder if they lack the necessary imagination to see how it could be made to work in the future.

I'm no expert on the history of OPEC, but when it was formed in 1960, the international oil industry looked quite different from today's. Global trade in oil was dominated by the major oil companies--the so-called Seven Sisters of BP, Chevron, Esso (Exxon), Gulf, Mobil, Royal Dutch/Shell and Texaco. In their glory days, these companies controlled proprietary value chains from wellhead to gas station, not unlike today's LNG value chains. The founders of OPEC foresaw a different world, in which nations owned not only the resource in the ground, but also the means of getting it to market and capturing much of its value added. In this regard, they were more accurate forecasters of the future than the corporations whose assets they subsequently nationalized, and which 30 years later had merged down to four survivors in order to compete with the big national oil companies.

Several of the factors the FT cites as hurdles to forming an alliance of gas-producing countries seem either temporary or superficial. Although most LNG is tied up on long-term contracts, many of which are pegged to oil prices, the number of "spot" cargoes is on the rise, as producers de-bottleneck their facilities to squeeze out extra volumes, outside their contractual commitments, and as contract-holders learn to optimize the value of their offtake by taking advantage of arbitrage opportunities. At the same time, having to attract project investors may be less constraining than suggested. The majors have been frozen out of many of the best remaining oil prospects, and they are turning to LNG to create bookable reserves to fill the gap. As long as gas resource owners offer access, and on terms at least as generous as those available for oil, the integrated international companies will sign up.

The biggest impediment to the effectiveness of a future OGEC may be more fundamental. Oil still enjoys a near monopoly on the transportation fuel market, and biofuels and synfuels will be a long time breaking it. Gas has no comparable lock on its future markets. Current gas consumers and their suppliers are locked in an embrace that is tantamount to Mutual Assured Destruction, but when, for example, power plant developers doubt the future affordability or availability of gas, they build coal, wind, nuclear, or some other capacity instead, and the associated potential gas demand disappears. Gas left in the ground due to greed is nearly worthless. This difference may not rule out an eventual OGEC, but it implies that it should at least be more user friendly than OPEC has proved.

Energy Two-Step

A recent article on hydrogen cars in MIT's Technology Review got me thinking about the big challenges we face in energy: not only must we reduce the greenhouse gas emissions of our present energy systems, but we must also begin to plan for an energy economy that relies much less on petroleum products. To most people, that probably sounds like one problem, but I believe it is really two, with potentially very different solutions. The reason for that is that the replacements for oil's primary uses in transportation are simply not ready for prime time. That means we're looking at a two-stage transition in energy systems, with work on both proceeding simultaneously. This includes some options that will require great patience, such as hydrogen. We need to be prepared to fund both near-term and long-term efforts, without worrying that work on one competes with the other.

Everything that Technology Review says about BMW's hydrogen-powered 7-series sedan is accurate today, and not just because I've been saying it here going back to 2004. Producing a hydrogen car now, as the solution to our present energy and climate change problems, will not improve matters. Not only is burning H2 in an internal combustion engine inherently just about the least efficient thing you can do with the energy that went into making the H2, as Mr. Talbot rightly points out, but the entire H2 infrastructure of production, storage and distribution is at least a decade away, maybe two or three.

If we're serious about tackling climate change any time soon, as the evidence suggests we must, then we need options that are available now. Even hybrid cars, for all their efficiency benefits, are at least one full "implementation lag" (about 15 years) away from achieving their maximum impact. We need more efficient mass-market cars starting right away, together with changes in consumer behavior, as I suggested last week. CAFE standards and tax credits can help with the former, but I don't know how to promote the latter other than by increasing the price of petroleum products, either through new taxes or the application of a cap-and-trade system for its greenhouse gas emissions.

But all of that still only buys us the time towards making more radical changes in the long haul. That's because even if we can reverse our steady upward trend in oil consumption, the billions in the developing world are on a big energy consumption uptrend from near zero per capita. Together, we will be driving inexorably toward the point at which oil production, conventional and unconventional together, won't be able to keep up with demand. Whether oil reaches a peak or an "undulating plateau" only matters in determining the full magnitude of the problem that's waiting for us, sometime between now and mid-century.

Meeting that challenge will require more than just becoming smarter about how we use oil. We will need to develop future vehicles that don't burn gasoline, diesel, or even biofuels. From what we can see today, that will come down to a race between hydrogen fuel cells and batteries, powering an all-electric vehicle. Hybrids and plug-in hybrids are the bridge to this, and the critical foundation is a vast new capacity for low-greenhouse-gas electricity or hydrogen. These energy carriers would be generated by a mix of renewable energy from wind and solar, coal with carbon sequestration, and advanced nuclear power. Reaching that point will require dramatic performance and cost improvements for most of these technologies. Only then will we be able to begin the transition from away from oil entirely, for most of its current uses.

Like a lot of baby boomers, I grew up thinking we'd have flying cars by now. It's natural to overestimate the potential for prompt change, while underestimating the cumulative effects of long-term trends and new technologies. The energy and transportation systems of 2020 are already taking shape, with a growing emphasis on efficiency. But the world of 2050 is very much up for grabs, and that's good, because from everything we can tell, we will need it to look very different.

Global Geo-Green

Sunday's New York Times Magazine carried a long article on energy and the environment by Tom Friedman. The article reprises a lot of themes that Mr. Friedman has covered in the last several years, including the economic benefits of creating markets for greener products, the issue of "funding both sides of the War on Terror", and the challenges and opportunities that China poses for energy and the environment. What's new here is a more complete picture of how this could all be made to work not just for America's benefit, but for that of the whole world: a "Geo-Green" strategy for the planet, not just the USA. I could argue with some of the details, but on the whole this is Friedman doing what he does best: stimulating and provoking us with concrete, human examples of the ideas he is reporting.

One of the big advances this piece demonstrates over many of Mr. Friedman's earlier NY Times columns on this same broad topic is a recognition of the scale of the challenge, perhaps influenced by Dr. Socolow of Princeton, whose greenhouse gas "wedge" strategy he endorses, or perhaps because of his frequent exposure to China. For the first time, you don't get the sense that he thinks these problems can be solved easily or quickly, if only we agreed on the right strategy, as his columns have often implied.

The article is also full of quotable catch-phrases and remarks from various trend-setters, such as on the military's need to "eat its tail"--reducing its energy supply chain--or the requirement for alternative energy to meet the "China price." My favorite is from GE's Jeffrey Immelt on how the market forces big energy players "to take a 15-minute market signal and make a 40-year decision."

There are still a few blind spots. For example, in advocating the benefits of lower oil prices in advancing democracy in "petroauthoritarian" states, Mr. Friedman still ignores one of the most obvious ways we could jump-start this process, by opening up some of the areas under drilling bans. Perhaps he's paid too much attention to those who parrot the "25% of consumption, 3% of reserves" mantra. Nor does he directly address the paradox of the impact on oil demand of the lower oil prices he intends to create. Despite these quibbles, it's a thought-provoking article, and I recommend it.

Another Layer

This week the EPA issued its new rules for a nationwide Renewable Fuel Standard (RFS). It provides the details of how we will move toward President Bush's goal of reducing gasoline consumption by 20% within 10 years, on the way to 35 billion gallons per year of alternative fuels. The program adds another layer of complexity for refiners already stretched by balkanized gasoline specifications and a variety of recently enacted or pending state regulations restricting greenhouse gas emissions from their facilities. While this looks like a step towards a unified national approach to addressing our energy and environmental challenges, it is unlikely to be as effective as it should be, because it is based on a muddle of environmental, energy security, and agricultural drivers. Even more bizarrely, the EPA expects this program to reduce consumers' fuel costs, though that has never been the case for any previous fuel regulation.

The RFS program mandates a minimum level of renewable fuel blending by refiners and marketers each year, starting at a baseline of 4 billions gallons in 2006 and rising each year until it reaches the 7.5 billion gallons targeted by the Energy Policy Act of 2005. Because the ethanol blender credit and import tariff remain in place, the new rules are likely to produce a further windfall for US farmers and domestic ethanol producers, along with the railroads that transport the fuel to market. The program exempts small refiners from meeting these requirements until 2010, and they could enjoy a similar, if temporary windfall. Oddly, the RFS also exempts Alaska and Hawaii entirely--unless they opt in--thus denying efficient international ethanol producers such as Brazil a natural outlet that wouldn't compete with US producers.

The program contains a mechanism designed to give refiners some flexibility in meeting their quotas, though this adds a layer of bureaucracy to its implementation. It creates a new tradable energy attribute, the Renewable Identification Number (RIN), similar to the existing "renewable energy certificate" or "Green-e" attribute for renewable-source electricity. Refiners will have the option of blending in renewable fuel (chiefly ethanol or biodiesel) or buying an equivalent quantity of RINs from another party that has generated them in excess of its RFS quota.

Although the EPA has estimated both the energy security and greenhouse gas reduction benefits from this program, the RFS comes across as another instance of our failure to decide what our real goal is, reducing greenhouse gas emissions or backing out imported oil. Instead of providing targets with incentives for meeting them, we're again prescribing the means, regardless of their efficacy in solving the underlying problem. Any cap-and-trade system for greenhouse gas emissions, which is surely in the offing, will now have to mesh with the RFS system, unless Congress wisely decides to scrap the former when introducing the latter. In the end, consumers will pay more, but not by enough to promote meaningful conservation.

TXU and Coal's Future

I rarely pay attention to newspaper ads, but a full-page ad in yesterday's Wall St. Journal caught my eye. It featured a photo of a young girl with her face covered with grime. The tag line below the photo read, "Face It. Coal Is Filthy." It included a statistic comparing greenhouse gas emissions from a coal power plant to "cutting down 161 million trees." Only when I followed the link below the ad did I learn that the Clean Sky Coalition that sponsored the ad is, in fact, the Texas Clean Sky Coalition, and that the ad, along with its smaller companions scattered throughout the Marketplace section, is really another salvo in the battle over TXU and its power plant construction plans. Could this tactic mushroom into a broader anti-coal strategy, covering any new coal-fired power plant, anywhere? If so, the TXU takeover (2/26/07) could prove to be even more pivotal for coal than it first appeared.

"Live longer. Live better. No new filthy coal plants." Strong, direct language aimed not at regulators or voters, but at investors. Environmental groups have become very savvy at determining where the leverage lies in a given situation, and here it's with TXU's stockholders. Although competing offers for the company now look unlikely, preserving the environmentally friendly bid of KKR and its partners has become an environmental cause celebre. Whatever influence this has on the transaction at hand, it's not hard to imagine it having a wider appeal.

Coal looks vulnerable, too. Consider how different the prospects for coal would be, absent concerns about global warming. The combination of high oil and gas prices and growing calls for energy independence seem tailor-made for a big increase in coal consumption and fantastic growth for coal companies. That could still happen, given the opposition to the other primary base-load electricity technology, nuclear power, and emerging concerns about the limitations of biofuels. If it does, though, it will be an uphill battle.

The clever part of the Clean Sky Coalition's campaign is its conflation of greenhouse emissions with familiar forms of pollution. It's clever, because even if the Supreme Court didn't specifically label CO2 as a pollutant, it certainly put it in the same bucket with SOx, NOx and particulates. If you didn't already know that CO2 was colorless and odorless, you just might think that it was responsible for those blackened faces--and lungs?--besides warming the planet. How many people already think that the ozone hole and global warming are caused by the same things? Lumping CO2 together with the causes of local air pollution could create some very tough new obstacles for coal. Between the long-term challenges highlighted in the recent MIT report (3/15/07) on the future of coal and the "Face It" campaign, the environment for coal producers and coal-based utilities looks increasingly daunting.

Whose Responsibility?

Today's Wall Street Journal reports that ConocoPhillips has become the first US integrated oil company to call for a cap on greenhouse gas emissions. This is a noteworthy development, because until now, only European oil firms such as BP and Shell had endorsed aggressive action to control climate change. The article supplies several good reasons why an oil producer and refiner might support a measure that would ultimately require it to reduce its own emissions, but it leaves open the question of who will be responsible for the much larger pool of emissions resulting from the use of petroleum products. With oil and auto firms pointing at each other in this regard, it's easy to ignore the role consumers must play. Unless we are willing to pay more for fuels or voluntarily conserve, emissions reductions from the transportation sector will be elusive.

Based on detailed well-to-wheels emissions analysis by the Argonne National Laboratory of the Department of Energy, the entire process of producing oil, refining it, and delivering gasoline to service stations consumes about 20% of the energy content of the original crude oil. Greenhouse gas emissions are directly correlated to energy use, so for every gallon of gasoline we buy, the supplier emitted up to 5 lb. of CO2-equivalent, compared to the 20 lb. that will be emitted when we burn it in our cars. However, because much of the energy used in the refining process comes from natural gas or electricity, rather than the oil itself, actual "upstream" emissions are generally lower than that 5 lb. estimate. Even if an oil company can reduce its emissions by 25%, that only cuts the total emissions from the gasoline value chain by 3-5%. In order for transportation emissions to come down materially, someone needs to take responsibility for that downstream 20 lb. of CO2 per gallon.

As I discussed yesterday, carmakers can contribute by producing more efficient cars, and that will almost certainly happen. But unless consumers buy them in large numbers, the net result will be that the manufacturers will pay fines, but emissions will remain unchanged or grow. Oil companies can also contribute by blending up to 10% ethanol into the fuel they sell. If that ethanol is derived from corn, this will only reduce vehicle emissions by about 2%. So unless consumers buy more efficient cars and/or drive less, we're looking at a maximum reduction of about 7% of the total emissions from the oil well to the tailpipe. That's not enough to reach a target like California's, which would require a cut of 25% by 2020.

Unless lawmakers are willing to let consumers shoulder a large part of the burden, as the ones using most of the energy that creates these emissions, then the producers of energy must ultimately slash their own emissions and offset ours. At $20/ton of CO2 credits, that would equate to another 5 cents per gallon in added cost for a 25% reduction in emissions. One way or another, consumers will pay more at the pump, because the cost of producing and distributing motor fuel will go up significantly under an emissions cap.

Attainable Goals?

The Supreme Court decision on greenhouse gases that I discussed in yesterday's posting dealt with regulating emissions from cars. The Wall Street Journal published an interesting virtual debate on the attainability of such emissions reductions, pitting Robert Lutz, head of product development for GM and an auto industry icon, against the Union of Concerned Scientists (UCS.) The UCS has come up with a mini-van design that they claim would meet all of the requirements of the California emissions standards that carmakers are suing to block, and would do so with existing technology--without hybridization--while costing only an additional $300 per vehicle. Is it possible to build a car that, as UCS claims, requires essentially no compromises on the part of US consumers, or would stricter federal and state fuel economy standards require us to buy cars that won't meet our expectations of space or performance? Mr. Lutz appears skeptical, and so am I.

The UCS mini-van design is clever, taking advantage of available features such as cylinder deactivation, variable valve timing, direct fuel injection, and turbocharging. I have no doubt that it could be built. Where they stretch credibility, however, is in suggesting that you can do all of this for hardly any extra cost. Anyone who has ever bought a car with a choice of engines, transmissions or other options should be deeply suspicious of that claim. If a stereo upgrade can run you $300, it's hard to see turning a plain vanilla 6-cylinder into the "engine of the future" for anything less than a couple grand.

In addition, two of their strategies for reducing vehicle emissions look highly problematic. First, they want to make every car a flexible fuel vehicle, capitalizing on the emission reductions attributable to ethanol. Even if those benefits were unambiguous, the logistics involved in delivering E-85 to every gas station in California alone are daunting. As to the low rolling-resistance tires used in their design, I wonder how well these would perform in the climate in which I live. "Rolling resistance" is another name for friction, which is largely responsible for keeping your car from skidding off the road. There's some optimal level of friction, especially when driving on snow and ice; a couple of brushes with black ice have given me religion on this. Perhaps UCS is relying on the electronic stability control that the government has just mandated for all 2011 models, but I'll need to see more global warming before I trade in my all-season tires on a low-friction set.

Looking to Europe, it's readily apparent from the cars that GM and Ford sell there that it is possible to produce attractive, safe and affordable vehicles that get much better gas mileage than the average cars sold here, even without resorting to the extra technology that UCS suggests. However, those aren't the cars most Americans want, even with gasoline again approaching $3.00/gallon nationally. Europe also provides some useful lessons on the limits of fuel economy. Despite much higher gasoline prices, along with taxes on engine displacement and other regulations favoring smaller cars, European manufacturers are struggling (2/2/07) to meet the 45 mile per gallon goal the EU has set for 2012. The carmakers that are closest to achieving this level, Fiat and Renault, sell cars that are least like those that Americans buy. The German auto firms facing the toughest challenge sell cars that are household names here. If there were an easy fix for getting big cars to 45 mpg, these folks already have an incentive to find it. Ultimately, something has to give: size, fuel economy, or price.

Somewhere between Mr. Lutz's concerns and UCS's claims there is a set of options and tradeoffs that will achieve meaningful improvements in fuel economy, even without hybridization or sleight-of-hand fuel switching. Detroit and the imports are going to have to learn how to do this, because stricter fuel economy standards are practically a given, with or without climate change, because of growing concerns about energy security and the impact of high energy prices. However, it's unrealistic to think that this can be done in a way that keeps both carmakers and US consumers whole. The former will see their costs rise, or the latter their range of choices shrink--or both. Telling us we can have it all, as the UCS seems to be doing, is a great way to leave the debate stuck where it's been for the last decade or more. Someone is going to have to sacrifice, and determining who and how much is precisely what we elect our leaders to do.

Tectonic Shift on CO2

It's ironic that such a major development on an issue to which I am so attuned would occur while I was on vacation. Somehow, the Supreme Court's landmark decision on regulating greenhouse gases escaped my notice, in the small amount of news I read or watched between stops on our driving vacation out west. But without exaggeration, the Court's ruling in Massachusetts v. Environmental Protection Agency was as important as any in recent years, with the possible exception of the resolution of the 2000 election. By a narrow majority, the justices affirmed that greenhouse gases, including the carbon dioxide given off by every car and fossil fuel power plant--as well as every animal--on the planet, are pollutants. In the process, they have made it much harder for the federal government to continue its current approach to climate change on the basis of incentives and voluntary measures.

I recall my Public Policy professor in business school making quite a point about the number of votes behind a Supreme Court decision, in evaluating the precedent it sets. 5-4 decisions usually set weak precedents, because the shift of a single vote, either through a distinction in circumstances or the retirement of a justice, can undo it the next time a relevant case comes before the court. But in today's political context, that 5-4 looks more like a 7-2 in its likely durability. Had this decision been rendered in 2005, when the Administration and Congress agreed on climate change--and before Hurricane Katrina and "An Inconvenient Truth" raised the public's concern--my main message would have been one of caution. In 2007, however, the stars are lining up for a stronger response on climate change, and the Supreme Court has added its authority to the side of prompt action.

The court's ruling doesn't change my concern that defining CO2 as a pollutant will lead us down the wrong path, but that no longer matters. What counts now is the impact of this decision on US climate policy, and by extension, the global response to climate change. A world in which the US and EU are generally aligned on reducing emissions will look very different from the period that is now drawing to a close. Even developing countries should take notice of the Court's finding, because it implies they will ultimately have to fall into line, as well.

Although this decision may pave the way for action by the states, particularly in forcing the EPA's hand in allowing California and other states to regulate CO2 from automobile tailpipes, the ruling appears much less prescriptive than, say, Brown v. Board of Education or Roe v. Wade. It still remains for the Congress and the White House, whether this one or the next, to map out the actual means of limiting emissions. The biggest long-term impact of this ruling may be in foreclosing many of the legal challenges that will surely follow any such legislation or administrative rule-making.

For the last decade it has looked increasingly likely that the cost of carbon emitted to the atmosphere would not be zero for much longer. Since the 2006 election, that likelihood has increased to a high probability, and with Mass. v. EPA it now looks like a certainty. Based on the views expressed by most of the major candidates for President, by 2009 all three legs of the federal government will agree on the need for urgent action. It now falls to the current Administration to decide whether to work with the Congress to draft climate change legislation that addresses the President's legitimate concerns about international competition and the domestic economy, or to defer action for another two years, setting the stage for tougher regulations, later.

Post-Vacation

Only two news items penetrated my vacation mindset this week. The more immediate one was Iran's release of the UK military personnel they were holding hostage, which ought to reduce oil price risk at least a little. I don't see the resolution of this crisis as quite as much of a victory for Iran as the pundits are proclaiming. However deftly Ahmadinejad and the mullahs may have outmaneuvered the UK, the reminders of an earlier hostage crisis will not enhance international confidence in the regime. It remains to be seen whether the dynamics of the nuclear controversy have changed.

The other item that caught my attention was a report on US auto sales, indicating that Detroit has lost more market share to Toyota and other imports, at least partly on the back of the growth of the Prius and other hybrids. At a 200,000 unit/year clip, the Prius looks successful as a car model, not just a technology platform or loss-leader. We're not far from the day when US auto firms sell less than half the cars in America, and the shift looks to have more to do with strategic mistakes than lingering concerns about quality. The Chrysler 300 rental car we just drove from Arizona to Southern California was as nice as any import in its class, and it averaged 27 mpg on the highway. But Detroit needs a dozen such hits, if it's going to recapture any lost ground, and it's not clear that GM has the vision to leverage its coming Chevrolet Volt plug-in hybrid in the same way that Toyota has done with the Prius.