Our Energy Omelet

Today's Washington Post cast some serious doubts on the environmental sustainability of producing ethanol from Brazilian sugar cane, demonstrating yet again that when it comes to energy, the temporary resemblance of any option to a silver bullet usually only reflects our poor understanding of its consequences. The cost in this case is the potential deforestation of the Cerrado, Brazil's non-rainforest plateau. While Brazilian cane ethanol clearly has a role to play in the world's future energy balance, this prospect should remind us that meeting the world's daily energy demand entails breaking eggs on a vast scale. Despite the growing sophistication of the public and our leaders on energy matters, the discussion is still not being framed in terms of the hard trade-offs involved.

Since ethanol has become the cornerstone of US energy policy, let's look at the size of the problem relative to the ethanol volumes we hear bandied about in the news and on the floor of Congress. The US currently produces about 6 billion gallons of ethanol, mostly from corn. The administration and Senate want to expand this volume six-fold. It's not clear that we can do that without a large contribution from cellulosic ethanol technology that is not yet commercial, but let's assume it could all come from corn. At a yield of about 2.7 gallons per bushel, this would consume 13 billion bushels annually, roughly equal to at least one estimate for the entire 2007 corn crop, planted on 90 million acres, or about 20% of total US cropland. So if it were all planted in corn for ethanol, our current agricultural land would yield something less than 200 billion gallons per year. That's a big number, but put it in perspective. The US uses 100 quadrillion BTUs per year of energy. That equates to 1.25 trillion gallons of ethanol on volume alone. Replacing the actual net BTUs from fossil fuels would require roughly 3.5 trillion gallons of ethanol, based on its current energy yield of 1.3:1 (energy return on energy invested.)

Of course, this is an absurd comparison, because we're not going to grow corn to make ethanol to feed power plants, home furnaces, or factories. The point here is to emphasize just how large the implied equivalent agricultural footprint of our energy consumption is. If we want an appreciable fraction of those needs to be met with biofuels, even if the actual crops involved are not corn, but Brazilian cane or US switchgrass--both of which are much more efficient net energy producers than corn--it's still a big footprint. And make no mistake, as long as oil prices remain high and federal incentives are in place, the market will deliver it, even if it has to overcome an import tariff to do it.

For all of our new-found environmental concern relating to climate change, I have yet to hear any politician debate how the total environmental impact of greatly increased biofuels output--including all land, water, and air impacts--compares to the environmental footprint of getting the same quantity of energy from natural gas drilling in protected areas, from large offshore wind farms, or new nuclear power plants, among our other choices. None of those options are silver bullets, either, but they could all be part of the mix, along with biofuels. Unless we talk about it in these terms, how can we be sure that the mix of broken eggs we're implicitly choosing is really the one we want? We ought to discuss this now, rather than after the Cerrado has all been planted in cane to power our cars.

Resting Bull?

Over the weekend I was struck by the apparent paradox of a stock market correction inspired by concerns about debt somehow affecting the market values of oil companies, which have some of the cleanest balance sheets around. Today's Wall Street Journal may be close to the mark, in assessing the prospects for future earnings growth of these shares, but ultimately the fortunes of these firms are tied to the supply & demand balance for the commodity, and that still looks quite robust. Is this just a case of market jitters in one sector affecting all, or does the market see something that's not readily apparent in the energy sector?

Considering that nothing occurred last week to ease the tight oil market fundamentals noted by the International Energy Agency (IEA) two weeks ago, the dramatic drop in oil equities on Thursday and Friday--starting from levels close to the all-time highs that many of these stocks set the previous week--seemed unlikely to be connected to growing worries about the quality of the nation's home mortgage debt. Leverage doesn't factor into the value of these companies, which have been retiring debt and repurchasing shares by the billions. But there's clearly more at work here than a flight from equities and into T-bills.

In an article tellingly titled "Energy, Once Hot, Now Not", the Wall Street Journal boils down energy equity analysis to two simple drivers of future earnings: volumes and margins. Observing that the major oil companies seem incapable of generating significant year-over-year production growth at this point, the whole issue reduces to the future of margins. The article notes that production costs have been going up, though that's hardly a new story, having been equally true when these stocks were making new highs. Almost as an afterthought, the Journal mentions demand. Last week's correction makes more sense, if it's viewed in the context of changing expectations for demand, which has been a key driver of the whole energy complex for the last few years.

Perhaps this is the scenario that put investors off last week: Continued weakness in the US housing market and spiking adjustable rate mortgages put pressure on middle class consumers, who respond by economizing on fuel and consuming fewer goods with a big energy component. That undermines US refining margins and crude oil prices, which in turn puts the earnings of US oil & gas companies in jeopardy, making their recent share values unsustainable. So they drop.

Now, does that scenario ignore the strong economic growth outside the US, and especially in China? At a minimum, it may overestimate the spillover effect, considering that China's continued expansion may now be more tied to exports to a resurgent Europe than to making further inroads here. And could struggling US consumers have to keep their old cars longer, even if they are gas guzzlers? That would make oil demand more inelastic, after months of $3 gasoline have squeezed a lot of discretionary driving out of the system. Gauging future demand is a tricky proposition, particularly when you factor in the impact of new energy legislation and efforts to address climate change.

On balance then, deciding whether last week's correction in oil equities was justified requires working through a fairly complicated assessment. Are the US debt problems that spooked the market big enough to slow the growth of global oil demand and allow the production increases cited by the IEA to overwhelm OPEC's market discipline, and thus to end the bull market in oil prices that has been in place since 2003? Betting against demand hasn't worked out very well, so far, but every trend eventually turns.

Doubling Oil-use Efficiency

Few energy technologies have generated higher expectations for reducing our oil consumption and greenhouse gas emissions than the plug-in hybrid car (PHEV). This week, Toyota announced that it was delivering two modified Prius hybrids to the University of California, to enable the latter to test how plug-in hybrids work in the real world. While my own enthusiasm about PHEVs is tempered by the time lag inherent in altering the overall performance of the US fleet of 240 million vehicles, this is still a big deal. The PHEV represents the first practical bridge between electricity and transportation energy since the failure of the EV-1 all-electric car a few years ago.

The long-term significance of a switch to PHEVs would go beyond their recently-confirmed emissions reductions from making better use of off-peak electric generating capacity and backing out a bit of foreign oil, or channeling some zero-emission wind energy into transportation. The core benefit of the PHEV, from a global energy perspective, derives from shifting the energy conversion step away from inefficient onboard internal combustion engines (ICEs) to central and distributed power plants that offer end-to-end efficiency improvements over ICEs of between 1.5x and 3.5x, depending on the specific power generation technology involved. Nor does the vehicle notice whether its source of electrons comes from coal, natural gas, wind, solar or nuclear power. Electricity is wonderfully fungible.

Aside from the obvious attraction of using a fleet of PHEVs as rolling battery storage to facilitate wider exploitation of intermittent renewable energy sources such as wind, you could also imagine a more prosaic, but equally impactful scenario in which oil refineries made less gasoline and more kerosene, which would be burned in combined cycle gas turbine power plants--many of which were built with this fuel-switching capability in mind, at least as a backup. In the process, refinery yields would rise and their energy consumption and emissions fall. As counter-intuitive as this might sound, it could more than double the effectiveness of our single largest source of primary energy, based on the enormous efficiency advantage of CCGTs over ICEs, even when electric transmission losses are factored in. So not only would PHEVs reduce the quantity of oil used in transportation, they would allow us to make much better use of the energy content of each barrel we did consume.

PHEVs still have a lot of hurdles to overcome, not the least being the basic economic challenge associated with the diminishing dollar value of fuel economy increments beyond those that conventional hybrids already deliver. However, if they survive the rigors of development and consumer acceptance, they can deliver the kind of step-change improvement in fuel-conversion efficiency that was formerly associated only with hydrogen fuel cells--which have so far failed to overcome a much more complex set of barriers. This is one area in which energy security and the need for reducing greenhouse gas emissions aligns nicely.

LNG Inkblot

Yesterday my wife returned from the gym and suggested I turn on the TV. "An LNG facility in Dallas exploded. I saw it on the news," she said. The terms "LNG" and "Dallas" struck me as mutually exclusive, but I did as she suggested and saw the burning wreckage on CNN, which mentioned natural gas and cylinders. A quick Google search turned up dozens of reports from local Texas television stations and newspapers running leads such as "Liquefied natural gas tanks explode; send debris onto highway." Of course a day later we know that the accident involved acetylene tanks at a facility that has no connection to LNG. Aside from the fact that the technology involved was in use for decades before anyone even dreamed of liquefying natural gas for commercial purposes, what does the confusion over this event tell us?

For starters, it provides a sort of Rorschach test for the public's perception of LNG. If there are explosions and fire at a facility that has something to do with gas, then it must involve LNG, because LNG is inherently so hazardous. A variety of news organizations didn't bother to check their facts or even refer to their common sense before reporting yesterday's explosions as an LNG accident, which automatically made it national news. I learned a long time ago that it's unreasonable to expect reporters to recognize the visual profile of different industrial sites, but how long would it have taken them to ascertain that LNG facilities are normally found near deepwater ports where LNG tankers--which are pretty large vessels--can dock, not 300 miles inland? Or to do as I did, and search the Dallas area phone directories for industrial gas companies, discovering that there were none that handled LNG? If they had to guess at what was going on, exploding propane tanks would have made a much better working hypothesis than LNG, aside from being more commonplace.

Without inflating a media error into a conspiracy, it does seem remarkable that the initial explanation for yesterday's incident should involve a fuel that most Americans--reporters included--have never encountered outside the press, which has given equal time to the hysterical arguments of LNG opponents who can't differentiate between a chemical fuel and an atomic bomb. To say that LNG has a serious image problem in this country is an understatement, but the consequences of that are affecting consumers' gas bills. The proposed LNG facilities with the best chances of surviving the permitting process are those planned for the Gulf Coast, which is awash with gas, rather than near markets a thousand pipeline miles away, on the wrong side of costly distribution bottlenecks. As long as LNG provokes the kind of response we saw on display yesterday, that's unlikely to change.

More Than Talk?

In his column in today's Washington Post, Robert Samuelson expresses skepticism that the current rhetoric about reducing greenhouse gas emissions will deliver much in the way of actual cuts, characterizing a broad collection of policy initiatives as "Prius Politics." While I share some of his skepticism about climate goals that lack both enabling and enforcement mechanisms, he's no more than half-right, here, and that half looks like a necessary prerequisite for tougher measures that would actually begin to deliver the proposed reductions. I also think he underestimates the impact on actual emissions, even without a gas tax or cap & trade.

Mr. Samuelson sees a divergence between the rhetoric of dramatic greenhouse gas emissions reduction targets and the inexorable forces of population and economic growth that have been driving emissions steadily upward around the world. This isn't just a question of China's enormous pool of potential consumers, who are starting to acquire the energy-intensive middle class trappings we take for granted. It's also a function of Americans choosing homes that are 60% larger than in 1970, despite declining average household size. Even with reductions in the marginal energy input per dollar of GDP, economic growth and increasing wealth will translate into higher emissions, unless we take concrete steps to reduce the latter.

However, Mr. Samuelson appears to discount the creation of a national consensus on climate change as a necessary precondition for enacting the legislation and regulations that will actually cut emissions. Attitudes toward this issue have come a long way in the last two years, but it still isn't a high priority for most Americans, who worry more about Iraq, terrorism and the economy. That's why, as he notes in his column, the Congress has focused on more indirect measures such as CAFE and cap & trade, rather than carbon or gas taxes that might be political suicide for the party in power. The scope for leaders to get far ahead of the public on this or any other issue is more limited than it was a generation ago.

That doesn't mean that emerging green attitudes lack consequences for real emissions. As the Wall Street Journal reports today, planned coal-fired power plants are being deferred or cancelled, because of environmental concerns. Every cancelled coal plant reduces future emissions in two ways: directly, from a stream of flue gas that will never exist, and indirectly, as constraints on baseload electricity generation--which wind turbines can't produce, and for which new nuclear plants are at least a decade off--will push power prices higher and deter the growth in electricity consumption. Meanwhile, concerns about emissions are becoming sufficiently mainstream for GE and other issuers to begin offering green credit cards, which will provide emissions offsets, rather than airline miles or cash back.

It's good to be reminded that high hopes and bold talk alone won't solve the climate problem, even though changing attitudes are already starting to have consequences for projects and sectors that emit greenhouse gases. But neither is this a problem that lends itself to quick solutions, imposed without broad support from the electorate. Such an approach would likely unravel the fist time the economy slowed, or energy prices spiked to new highs. In the long run, that could be a lot worse for the climate than a few years of toothless targets.

The Big Picture

Last week the National Petroleum Council released its much-anticipated report on the future of energy. I missed the opportunity to highlight the presentation and webcast press conference on the report on Wednesday, because I was on a consulting engagement. Nor was I comfortable commenting on articles that appeared before the report was officially released, since I was a member and co-author on one the of the sub-teams of the study's Supply task group, dealing with renewable power. Now that it's out, there's enough material in the report to occupy all of my postings for weeks. Instead, I'll make some general observations now, and then periodically examine key subject areas in more depth. In the meantime, I encourage my readers to peruse as much of the study as their other priorities permit. You might also wish to check out the podcast or transcript of the API's blogger teleconference on the NPC Study.

Let's start with the title, "Facing Hard Truths About Energy." Although it's accurate enough, I wonder about the wisdom of bracing the audience that way. So what are these "hard truths"? Well, one of them is that for the next couple of decades, most of our energy will continue to come from oil, gas and coal, while unconventional hydrocarbons and alternative energy ramp up. Another hard truth is that the energy situation in which the US now finds itself is at least partly self-imposed, as the cumulative result of policies that have constrained domestic energy production without constraining the growth of energy demand. The study's recommendations about adjusting such policies might seem self-serving, coming from the industry that stands to profit from expanded access to domestic oil and gas reserves, but we should consider who stands to gain more: the companies that will make a margin producing and selling these volumes, or the economy that will benefit from their value-added, tax revenues and export displacement?

For that matter, it's worth pointing out that, although this study was conducted under the aegis of an oil & gas advisory body chartered by the Secretary of Energy, it was created with input from a pretty wide range of other sectors and groups, including Congressional staffs, executive branch departments, environmental and other NGOs, non-energy companies, and universities. This is a global and national view from those who do energy for a living, but they didn't just talk amongst themselves. That doesn't mean that all the non-industry folks will agree with every word of the report, but it was interesting to hear one of the executives at the press conference reflect on how views were exchanged and consensus created, altering some pre-existing perspectives along the way.

The report has been criticized for reflecting too much of the conventional wisdom of the oil and gas industry on subjects such as Peak Oil. And anyone expecting a clarion call for a crash program on renewable energy is bound to be disappointed. (The study's treatment of renewables is a topic for another day.) But having spent my entire working life in and around this industry, I can assure you that this is a far cry from its business-as-usual view. When the folks who make billions in profits producing the energy we use tell us that it's time for us to become much more efficient, we should pay close attention, especially when they go on to say, "The world is not running out of energy resources, but there are accumulating risks to continuing expansion of oil and natural gas production from the conventional sources relied upon historically. These risks create significant challenges to meeting projected total energy demand." Translation: banking on the return of cheap energy is a bad bet.

Finally, don't underestimate the significance of the way the study addresses climate change. Whatever the personal views of some of the NPC's members, this is a picture of an industry that fully expects to have to treat emissions reduction and carbon sequestration as essential parts of the larger energy portfolio, from here on out. For many of the companies involved in the study, that idea would have been unimaginable only a few years ago. The key measure of success for the study will be in how it informs the debate around energy and environment in the Congress and the Administration. For that, it comes a bit late but not, let us hope, too late, as the House takes up the issue in the weeks ahead.

Ethanol: Oil & Energy

As an article in Slate last week made clear, the controversy over ethanol isn't likely to abate any time soon, in light of the expanding opposition to the ripple effects created by our growing use of this fuel. If you've been reading this blog for a while, you know that I'm an ethanol skeptic of long-standing, going back farther than most. However, it's important to understand that ethanol is not simply a product of agricultural interests run amok. It can deliver very substantial energy benefits, as long as we keep its limitations clearly in sight. Unfortunately, our ethanol strategy has not been developed with a clear understanding of those limitations, and that has handicapped our entire national energy policy.

The author of the Slate piece cites many of the concerns about ethanol that I've covered here since I started this blog in 2004. These issues have received increasing attention in the media in the last year. Ethanol's competition with global food markets, contribution to inflation, and indirect environmental consequences are all serious issues that should give policy makers pause on their way to quintupling the existing ethanol mandate. The most basic question, however, is whether ethanol is even good energy policy. The arguments over this point are complex and long-winded, involving the net energy balance of ethanol--how much energy goes into making it versus how much it delivers to the gas pump--and its lower energy density compared to hydrocarbons derived from petroleum. Fortunately, much of this complexity can be reduced to a simple statement that should guide policy in this area: ethanol is a poor energy source but a good oil substitute.

I've devoted a lot of space here to the energy balance of ethanol. Although that balance was solidly negative when I began looking at it in my Masters' project in the early 1980s, recent studies demonstrate that improved farming techniques and updated ethanol plant design have pushed it into the black. A 2002 paper from Argonne National Laboratory is fairly typical in showing the net balance at about 1.3 BTUs of energy out for each 1 BTU of inputs. But while ethanol advocates persist in their apples-to-oranges comparison to the 20% or so of petroleum energy lost along the gasoline value chain, the proper basis of comparison to oil is on the latter's 4:1 or 5:1 total energy return, on a BTU out-versus-in basis. That means that in order to replace the energy content--not the volume--of all the oil we import, we'd need to produce on the order of 700 billion gallons per year of ethanol, or roughly 20 times as much as the ethanol mandate included in the recent Senate energy bill. Whatever you think the upper bound of ethanol production might be, it's a lot less than 700 billion gallons.

That limitation doesn't mean that ethanol is ineffective oil policy. In fact, displacing oil is where ethanol shines. The same Argonne Labs study showed that ethanol's return on its liquid fuels inputs--the diesel fuel to run farm equipment, deliver the corn to ethanol plants and ethanol to blending terminals--is over 6:1. Thus every billion gallons per year of ethanol production backs out almost 600 million gallons of oil. At 15 billion gallons per year of ethanol, which is both the amount that can be easily absorbed into the existing petroleum products distribution system and the consensus limit on US corn ethanol production without a breakthrough, ethanol could displace almost 600,000 barrels per day of oil imports, or about 5% of the total.

The missing link between these two perspectives--and the key to an effective national ethanol strategy--lies in the non-oil energy that goes into making ethanol. Want to quintuple the amount of ethanol we produce? Then we need to quintuple the non-oil energy that goes into it, most of which comes from natural gas, in the form of ammonia-based nitrogen fertilizer (produced from gas) and the fuel to run ethanol facilities and distill the raw ethanol. Ramping up ethanol production to 36 billion gallons per year will require the equivalent of an additional 2 trillion cubic feet of natural gas, or a 50% increase in current US natural gas imports, mostly in the form of LNG. In other words, if you want to make ethanol our alternative fuel of choice, then you are implicitly signing up for LNG in a big way. US energy policy either needs to recognize that, or clear away the obstacles that stand in the way of producing that gas from US sources that have been placed off-limits.

I disagree with Mr. Gross, when he suggests that we shouldn't worry too much about the consequences of higher future ethanol use, because it probably won't all materialize. If the Congress sets an ethanol goal of 35 or 36 billion gallons per year, and puts in place the incentives and subsidies to support that, then I think there's a good chance we'll attain it. But the Congress should also recognize that because ethanol is a poor energy source, it can only fulfill its oil displacement potential, if they ensure an adequate supply of natural gas for the whole country. Otherwise, we will have to add another category to the growing list of ethanol's consequences: the offshoring of US industries that lost their natural gas supply to ethanol, along with higher natural gas prices for consumers and businesses. At the end of the day, ethanol is really a way to turn natural gas into transportation fuel, with some help from photosynthesis. US energy policy must factor in that linkage.

The SUV Advantage

Thanks to some glitches in hotel broadband access, yesterday's intended posting became this morning's, and today's is now this afternoon's.

A colleague sent me a link to a story in the New Yorker advancing an interesting explanation of the apparent contradiction between Americans' support for improved fuel economy standards and our ongoing love affair with large, inefficient vehicles. It immediately resonated with something I had recently read in The Economist, on the topic of "ultimatum games." At the core of both of these ideas is the innate competitiveness of humans. Recognizing this might be the necessary first step towards diverting this competition onto a more generally beneficial path, at least in the way our vehicle choices affect national energy consumption.

The New Yorker looks at our desire for bigger and more powerful cars and concludes that it is a manifestation of the same underlying causes that led individual hockey players to eschew helmets until they became mandatory: the pursuit of a personal competitive edge. If you go back to the beginning of the SUV trend in the 1980s, it's easy to see how this could develop. The drivers of early SUVs were afforded a privileged position above the general sightline of traffic, and the resulting impressions of greater safety and dominance would be a natural, and probably self-reinforcing reaction. But as increasing numbers of SUVs entered the fleet, this advantage quickly eroded. If the car in front of you was an SUV, you were effectively back to where you had been in a sedan. The only solution would be a bigger, more powerful SUV.

Does this explain the size, weight and horsepower "arms race" that ensued over the next 15-20 years? Perhaps. It certainly wouldn't have been possible without improvements in the basic technology of the internal combustion engine, which, as I've noted before, were diverted into the horsepower necessary to deliver higher performance in increasingly heavy cars, rather than into fuel economy that looked unimportant with US retail gasoline prices averaging $1.20/gallon from 1990-2002.

And the results of the "ultimatum game", which The Economist describes as a preference for "relative rather than absolute prosperity" might help explain why, even after realizing that big car dominance had been largely nullified by the proliferation of ever bigger cars, new car buyers didn't quickly shift back to smaller, more efficient cars, when fuel prices started going up four years ago. Lags in future gas price expectations may have reinforced this reluctance.

But does knowing we are competitive make us less so? Or is our best option to try to alter the basis on which we compete? What would it take to elevate efficiency and low environmental impact above our perception that in cars, larger is automatically safer, and brisk acceleration is more reflective of the winners we aspire to be? Can we imagine a world in which we try to "out-green" each other, instead?

Solar Power and Offsets

A friend recently mentioned that she was interested in adding solar panels to her house, as her contribution to reducing greenhouse gas emissions. An article in yesterday's San Francisco Chronicle suggests that many Californians share the same motivation for solarizing their homes. Residential solar power is growing rapidly in the US and elsewhere, and that's all to the good. But while the large investment this entails might make sense as a way to save money on residential electricity rates, it turns out to be a pretty expensive source of emission reductions.

The Chronicle cites the cost of a typical 2 kW home photovoltaic system at about $19,000--or $15,000 after state and federal tax benefits. In sunny California, such a system would generate roughly 4500 kW-hrs of electricity per year, which would be worth around $650/year, based on the minimum rate in PG&E's current schedule. The resulting simple investment payout is pretty long, but if you assume a 20 year life and factor in future inflation in electricity costs, the effect on your property value, and the benefits of financing, you might earn a long-term return of more than 10% on your investment.

From an emissions perspective, those 4500 kW-hrs of solar electricity would save about 2700 pounds of CO2 per year, based on California's average rate of 0.61 lb/kWh. So over a 20-year lifetime, a 2 kW home system will save a total of 28 tons of CO2. The value of those avoided emissions is currently around $300 in the retail offsets market in the US and under $1000 in the official EU emissions trading system. As it happens, my friend doesn't live in California, but in a somewhat less sunny state that relies heavily on coal for its power. In her case, the avoided 20-year emissions would be closer to 75 tons. At current offset costs, however, they would still only be worth about 10% of the total price of her photovoltaic system. Unless she's paying a lot more for electricity than I think, she would be better off staying on the grid, buying offsets for 100% of her consumption and spending the rather large difference in cost on something else.

Whether my friend ultimately follows my advice is entirely her choice. But because of the role of federal incentives for solar power, I feel more than a friendly interest in her decision. We're not just talking about one solar roof, after all, but potentially millions. In light of the figures above, incentives for residential solar power start to look questionable as climate policy, at least compared with the kinds of projects behind the emissions offsets being traded in the marketplace. In other words, while residential solar power offers important benefits in reducing peak electricity demand and greenhouse gas emissions, the government appears to be paying individuals a large premium for those reductions, compared with investing in wind turbines, landfill methane converters, reforestation, and other means of cutting or capturing CO2 emissions. And the more the government spends on each ton of reductions, the fewer emissions it can reduce.

An Old Idea Made New

A friend sent me a link to a story about some companies using a twist on a very old technology to reduce their office air conditioning bills. Several facilities have installed large vats of water that they freeze every night and then use the melting ice to cool the air during the day--apparently including the former White Plains, NY headquarters of Texaco, now owned by Morgan Stanley. The article goes on to suggest that the system actually improves cooling efficiency, besides shifting the cooling load to nighttime hours when power is cheaper. If this proves attractive enough, it could have important implications for the way we use energy.

Air conditioning is a major component of electricity demand, and one of the largest segments that fluctuates with the seasons. Its use is still growing, worldwide. Higher incomes and increasing urbanization are responsible, and the result is not just higher energy consumption, but a reshaping of power generation capacity to meet the daily and annual cyclicality of demand created by people's natural desire to stay cool. If ice cooling became popular, it would help to even out at least the daily peaks and valleys, while reducing the absolute magnitude of the summer/winter difference. That would allow a country's electrical needs to be met with less--and potentially less polluting--capacity.

This idea might even dampen one of the feedback mechanisms of climate change. A warmer climate requires more air conditioning, using more power, which in turn generates more of the emissions that contribute to climate change. Even if ice cooling could cut peak electricity demand by only 10%, that could be significant.

While installing giant ice vats might not be feasible for everyone, the economics should compare favorably with battery storage, or schemes to generate hydrogen at night and run it through fuel cells to meet peak demand. Ultimately, this is about storing power, efficiently, which is one of the keys to making the best use of intermittent sources of renewable energy, such as wind power.

Rethinking Nuclear

Periodically, I've noted the growing interest in nuclear power as a source of low-greenhouse-gas energy, and the way this issue is splitting environmentalists. Designs for generating electricity safely and reliably using nuclear fission have improved steadily since the last big wave of nuclear construction peaked, at least in the US--Japan and France built dozens of plants after we stopped. But while the technology has advanced, I wonder whether our mindset about it remains stuck in the model that prevailed in the 1980s, when large, centralized power plants were the norm everywhere. Is it time to rethink the application of nuclear energy to maximize its leverage on reducing greenhouse gas emissions?

What if nuclear power hadn't been discovered before World War II, and instead had emerged from the laboratory only a few years ago? How might we consider exploiting an energy source with its properties today, without the baggage of the last sixty-plus years? Is it pre-determined that the only way to tap the energy of the atom is in 1,000 MW increments? The record of the US nuclear naval propulsion program suggests otherwise. Consider the difference between coal-fired power plants and those burning natural gas. There are important economies of scale in the transportation and handling of coal, and in the sizing of boilers, that create a strong bias towards large plants. In contrast, gas-fired power comes in a wide variety of sizes, from under 100 kW to hundreds of MW, at least in part because the fuel infrastructure is so simple. So is nuclear power more like coal or gas in this regard? It's probably somewhere in between, after you factor in the need to contain the radioactive fuel.

I can think of lots of ways to use a medium-sized source of intense heat that doesn't need to be re-fueled continuously, and making power is only a sub-set of those applications. Combined-heat-and-power (CHP) at facilities that need large quantities of process heat and currently burn huge amounts of fossil fuels might be a better, more efficient candidate. Oil sands production shares those characteristics, and there was a brief flirtation with this idea several years ago. And I recently ran across the website of a company that wants to use nuclear energy in an even more novel way, for coal-to-liquids. CTL requires both process heat and large quantities of hydrogen to upgrade solid coal to liquid hydrocarbons, and using nuclear power, rather than coal or natural gas for these purposes would shrink the net emissions of CTL fuels down to roughly the same range as petroleum products.

Realistically, we can't ignore the legacy of the Cold War or nuclear accidents, nor the prospect of further weapons proliferation or WMD terrorism. But that doesn't mean we shouldn't examine where a "clean sheet" approach to nuclear energy might take us, particularly if it involved smaller scales, quicker implementation, and fuel cycles that are less vulnerable to accidents or proliferation. That might not be sufficient to convince critics to turn in their "No Nukes" signs, but it would go a long way towards convincing the public that nuclear energy is a viable element of our low-carbon energy future.

Sunny Greenland

Sunday's Washington Post was jammed with information on climate change, starting with a front-page article summarizing the policy challenges for the US government. It also included an interesting set of charts on the sources of our emissions, the shift in global emissions from developed to developing countries, and some options for managing them. Since I see this sort of thing all the time, I was more intrigued by the special travel section of the Post. "Climate is transforming many of the world's most striking tourist destinations," it said. "If you want to see them, better go soon." Climate change may be creating new opportunities for tourism, but in the case of Greenland and other presently chilly locales, it could also open up new frontiers.

One of the conclusions you should take away from the Post's coverage is that even after the US enacts tough restrictions on future emissions--no easy task--and convinces other large emitters to follow suit, a significant amount of further warming is almost inevitable. Stabilizing emissions at twice their pre-industrial level would not return the climate to its pre-industrial conditions, or even to where it was 20 or 30 years ago. Because of the long residence times of the various greenhouse gases in the atmosphere, significant change is baked in, perhaps as much as 3 degrees Celsius by the end of the century, and that is going to transform the landscape. Some of those changes will present enormous difficulties for rich and poor populations alike, but some of them may create new opportunities, particularly in places like Greenland.

The travel section described how Greenland was settled by Vikings during a previous warming phase, the "Medieval Warm Period" (MWP) and then partly abandoned after the onset of the "Little Ice Age." There is much debate about whether the MWP was warmer or cooler than current conditions. Either way, it looks like we're going to see a much warmer Greenland in our lifetimes, opening up tremendous swaths of new territory for development. It will no longer be a matter of mere trivia that an island three times larger than Texas is a territory of tiny Denmark, and thus a big chunk of the European Union lies only a few hours flying time from New York. Whatever mineral wealth has been locked up under its permafrost may soon become accessible. And while environmentalists may bridle at that prospect, companies and investors will see the chance for profits. On a more basic level, people dislocated by political, religious and even climate events may see an opportunity for a new start in a new land.

Don't mistake this for the "cup half full" thinking of those who would like to see more global warming. But just as we can't ignore the impending negative consequences of further warming in the form of droughts, shoreline erosion, and shrinking biodiversity, we shouldn't close our eyes to the possibility that some very thinly populated areas, including Alaska, might become more attractive. Siberia has about 3 people per square kilometer; China has 136. As the former thaws, it's hard to imagine that cross-border migration pressure wouldn't increase. As demonstrated by the current US debate over immigration, it will be much easier to address the challenges caused by such shifts while they are still small. Likewise for issues of resource access and navigation rights. I'm not optimistic that these will attract much attention, as long as we are focused on bigger geopolitical problems, so we will probably end up dealing with them ad hoc, as with so many other issues.

Prius in the Sky

A lot has changed since I last commented on the competing air travel visions of Airbus and Boeing two years ago. The former has stumbled, with its flagship A380 plagued by delays and manufacturing problems. Meanwhile Boeing rolled out the avatar of its new vision this week to much fanfare. Paralleling this change in fortunes, the implications of these two technologies now look different, as well. In 2005 I was concerned about the potential of thousands of A380s to put billions of new travelers in the air, consuming enormous incremental quantities of jet fuel in the process. But with the world increasingly worried about climate change and the means of managing it economically, Boeing's Dreamliner looks like the aircraft equivalent of Toyota's Prius hybrid car: the first real demonstration of a set of technologies that could dramatically reduce both fuel consumption and greenhouse gas emissions in the aviation sector, at least compared to their status quo trends.

A recent Economist article looked at this in some detail. It cited figures from the UK's Stern Report on climate change indicating that emissions from air travel, though only around 3% of the total today, are growing at a faster rate than those from other sectors. Saving 20% of fuel and emissions with the 787's better engines and lighter construction may not sound as dramatic as the doubling of fuel economy in hybrid cars, but aircraft don't offer similar opportunities to recapture braking energy, which is where hybrids derive most of their gains.

Economic growth is intertwined with mobility, and as long as the global economy keeps growing, more and more people will be flying. While planes like the 787 represent a hardware solution for minimizing the energy and environmental impacts of that growth, a broader range of strategies will be needed. Travel booking websites like Expedia already connect green consumers with the means of offsetting the emissions from their air travel, but airlines could provide this service on all their tickets at a lower cost; in the not-too-distant future, they may be required to do so.

Taxing Carbon?

After an absence of a decade, the carbon tax is back under discussion in the Congress--even if it might be a bit of a Trojan Horse this time around. However, much has changed since 1993's "BTU Tax" fight. Climate change was just emerging as an issue, then, and the price of gasoline stood at $1.10/gallon--the equivalent of about $1.45 in current dollars. Cheap fuel was our right. But with increasing numbers of Americans coming to accept that climate change is a big, looming problem, and the days of cheap gas apparently over, the response this time might just be "Why not?" instead of "Why?"

As my regular readers know, I believe cap & trade is the preferred mechanism for establishing a price on carbon dioxide and other greenhouse gases emitted to the atmosphere. However, I recognize that some very smart people have concluded that a carbon tax would be more effective and efficient, with its lower administrative requirements. Taxing emissions isn't such a bad idea, especially if you view this as a kind of tariff on legacy energy sources that were developed in a world in which carbon emissions didn't matter. After all, until the establishment of the income tax in 1913, the federal government got much of its revenue from tariffs. The biggest problem with this idea is not that it's a tax, per se, but that someone will have to determine its level. Set it too low, and the planet keeps warming for decades; too high, and the economy goes into a slump and even more industry goes to China, which is one-fourth as energy-efficient--and hence emissions-efficient--on average as we are.

This is where cap & trade shines, at least in principle. Markets do price discovery better than anything else ever invented. If you doubt that, look at eBay. Greenhouse gas emissions may not be Aunt Martha's antique china, but I defy anyone to calculate the correct level of carbon tax to reduce emissions by the desired amount without triggering a recession. (It wouldn't do that if it were truly revenue-neutral, but the chances of that seem even lower than the odds of a carbon tax passing in the first place.) Our models of the economy are good, but are they that good?

I also doubt we could gauge the right carbon tax level by observing the European cap & trade system, which implements an idea we talked them into during the negotiations for the Kyoto Protocol. The basis of comparison is weak, because the EU emissions trading system is too limited, and the European and US economies have significant sectoral differences. Nor can you look to European consumers for hints on how their US counterparts might respond to a carbon tax, since consumers in the EU haven't seen anything remotely resembling free market prices for transportation for decades, with the exception of discount air fares, and are already taxed to the hilt.

Whether Representative Dingell's proposal reflects a change of heart on this issue, or merely a prompt to his colleagues to acknowledge the costs of addressing climate change, there is much to recommend a carbon tax: it would be simple, transparent, predictable and relatively easy to assess. Its application would reveal the relative greenhouse gas contributions of our various energy sources, including corn ethanol, which would attract a higher tax than many might assume, when all its fossil fuel inputs are properly tallied. But I still see the determination of an efficient level for the tax as the fatal flaw in this idea. Perhaps a hybrid approach, with businesses subject to cap-and-trade and consumers paying a carbon tax based on the average emissions market level for the previous period, could overcome this shortcoming. In any case, the upcoming debate between advocates of these two mechanisms should be quite interesting to watch.

Climate Change, Water, Food and Fuel

Few of the reports I've seen about the current heat wave and drought in the West explicitly mention a connection to climate change. After all, climate is what we expect, weather is what we get, and the two often seem disconnected from each other. But in this case, they are linked in at least the following way: current conditions out West exemplify what climate scientists have been telling us to expect more frequently, as the earth warms. It's hard to look at the situation and not see numerous feedback loops with significant potential consequences for the growing population of the Sunbelt, and for the entire economy. Sustained dry conditions in the Western US could jeopardize food supplies and amplify the mechanisms of global warming.

Having spent much of my life in California, I'm conscious of the way that water and development have always been tied together in the West. Los Angeles only grew to its present scale because of the contracts and infrastructure that bring water from the eastern Sierra Nevada and the Colorado River to SoCal. In the semi-arid southwest, residential and agricultural demand for water have historically been in tension with conservation interests, and the balance among them has gradually shifted towards the latter in the last few decades. If climate change yields a significantly drier pattern in the West than what has prevailed for the last fifty years, then the entire system will be stressed. Given the migration rate into the region, with metro areas like Las Vegas and Phoenix growing at multiples of the national rate, it's hard to see residential water use ending up as the lowest priority use of scarce water. Homeowners and businesses can outbid farmers, and the agricultural bounty of places like the central valley of California, which depends heavily on irrigation, could be at risk.


But just as climate change can influence these conditions, the reverse is also true, via the basic mechanisms of climate change. The drier the West becomes, the less vegetation it can support. That reduces the region's natural uptake of CO2, which helps to mitigate the impact of man-made emissions. But it also creates the conditions for putting large quantities of stored carbon back into the air, via the wildfires that become more frequent and extensive during a severe drought. That could ultimately force us to make even deeper cuts in the greenhouse gases emissions from transportation and industry, in order to stabilize the concentration of these gases in the atmosphere. The climate neither knows nor cares whether a ton of CO2 came from a car's exhaust, from a coal power plant, or from a forest fire. The global effect is exactly the same.

Now throw biofuels into the mix. While they represent an important strategy for reducing our use of the fossil fuels that contribute to climate change, their cultivation under drought conditions adds to the competition for water among food crops, natural systems, and the increasing demand from development. In this context, food vs. fuel becomes a subset of a larger fight over water, fed by climate change but affecting climate change in turn. Compared to this, the geopolitics of oil are simple.

No Relief

Yesterday the International Energy Agency (IEA) set off alarm bells in the energy markets with a report suggesting that oil supplies would be tight for the next five years. The market reacted predictably, with Brent Crude--a better benchmark for now than West Texas Intermediate--briefly breaking through $76/barrel. Even more worrying is the notion that OPEC's spare capacity will be reduced to a bare minimum by 2012. But what the market--and any consumers who noticed it--saw as more bad energy news must certainly be regarded as welcome in some quarters. Another five years of high oil prices should furnish ample incentives to redouble our efforts on renewable energy and conservation.

I haven't seen the full report yet, because the IEA's website hasn't been updated in several days. From the media coverage it seems clear that the main driver continues to be demand, on the back of strong economic growth. Some will point to the IEA's forecast as the harbinger of Peak Oil, validating concerns that we are approaching the point at which global oil output must stall. But even the rough numbers in the press belie that conclusion. The IEA expects global oil production to rise by a healthy 10 million barrels per day (MBD) over the period in question. If demand weren't expected to grow at 2% per year, that would be adequate to provide significant price relief--which it still could, if the global economy slows. But even with unconventional oil included, the growth in non-OPEC production is slowing, and that means that OPEC will be in an even stronger position in the future than they are today. If this forecast is right, they could abandon their quotas and semi-annual meetings with little fear that prices would cool.

The biggest beneficiaries of yesterday's report are probably alternative energy developers. For anyone looking for a guaranteed oil price floor, this is as good as you're likely to get. The chances of oil prices receding below $40/barrel just dropped appreciably. If anything, alternative energy could become one of the key determinants of oil prices, as indicated by the IEA's apparent concern that biofuels growth will slow after 2009. For all of its faults from an energy and food-competition perspective, ethanol is still a good oil substitute, and an extra 20 billion gallons per year (equivalent to 1 MBD of oil) over the next five years could make a difference in global energy prices.

The other wild card in this outlook is conservation and efficiency. The IEA translates a global economic growth forecast of 4.5% per year into oil demand growth at a little less than half that rate. Could the combination of demand elasticity--consumers changing their lifestyles in response to sustained high prices--and stronger measures to combat climate change alter the BTU/$GDP relationship by enough to trim a million barrels per day from that five-year demand forecast? It would have to depend on factors that don't require turning over our immense capital stock--car fleets, buildings and energy infrastructure. The IEA's report should help erase any doubts standing in the way of such actions.

Wind Bottleneck

The front page of today's Wall Street Journal features an article on an important strategic shift in the growing wind energy industry. A large backlog of wind turbine orders is apparently leaving some developers with a choice between long project delays or acquisition by larger companies that have turbines to spare--or a large enough project portfolio to shift turbines around to more attractive opportunities. Although some of the causes of this situation look like a microcosm of the same global hardware crunch that has oil companies delaying drilling projects for lack of appropriate rigs, the biggest are quite specific to the expanding renewable energy market. If wind power is to grow as fast as environmentalists and alternative energy investors hope, then these bottlenecks must be eliminated.

Sporadic support for wind and other renewables by the US government is the main underlying cause of the situation described in the Journal. Because wind power is still not fully competitive without subsidies, government policy remains a key driver of growth. Wind turbine manufacturing capacity has grown faster in countries where the market for its output wasn't riding the roller-coaster of biennial wind subsidy expiration. That's why a European firm such as Iberdrola can leverage their call on Gamesa's turbine output into an entree to the US wind market. This may be just another example of the increasing globalization of the energy sector, but with the EU providing dependable incentives, it also provides a new twist on the old industrial policy debate of the 1980s.

I've always been squeamish about governments choosing winners and losers among industries and technologies. The market seems to do this better, on average. But if we're going to place such a big bet on renewable energy as a means for reducing greenhouse gas emissions and enhancing our energy security, then we are implicitly betting on the technologies that deliver that energy and on the companies that make the hardware with which to do it. If we like wind electricity well enough to promote its generation through production tax credits and state renewable portfolio standards, then wouldn't it make sense at least to make that support stable enough to foster the growth of the domestic wind turbine industry? The alternative will leave us no less reliant on foreign suppliers of turbines than we are on foreign suppliers of oil.

Suing OPEC

Today's Wall Street Journal looks at an aspect of the pending energy legislation in Congress that I hadn't really focused on, the so-called "NOPEC" provision that would allow the Organization of Petroleum Exporting Countries (OPEC) to be sued in US court for anti-competitive behavior. The article cites a similar measure in 2000, though the idea is much older than that, going back at least to the time of the first energy crisis in 1973-74. While the reasons for today's high oil prices are complex, as I discussed Monday, there's little doubt that OPEC is acting to restrain supply and drive up prices, as they have on many previous occasions. Taking the cartel to court over this issue is not the worst idea I've ever heard, though it could prove severely counterproductive for a nation as reliant on oil imports as we are. I think it all comes down to how it is pursued.

Including its newest member, Angola, OPEC produced 41.7% of the world's petroleum in 2006. And while Canada and Mexico both deliver more oil to the US than any single OPEC country, the cartel collectively supplied just under half our oil imports last year. With global oil demand having grown more rapidly than non-OPEC production for the last several years, OPEC has regained sufficient market leverage to exert significant control over prices. They may not exactly set the price, but they meet periodically in Vienna to discuss restraining supply to defend their target price range. If the CEOs of BP, Chevron, ConocoPhillips, Shell and ExxonMobil were to meet in Houston to agree on output quotas, they would quickly find themselves in a federal courtroom defending their actions.

While the idea of suing OPEC might sound sensible and even self-evident, it could be quite difficult to mount a successful anti-trust action against them. As the Journal points out, the cartel's members are not companies, but sovereign nations with the same "sovereign immunity" afforded to all governments. Furthermore, they could point to the precedent of the Texas Railroad Commission, which had effectively set world oil prices before OPEC even existed, by setting quotas to prevent unrestrained production that might damage the state's oil fields. Perhaps US prosecutors could finesse OPEC's sovereign defense by going after the national oil companies that carry out OPEC's policies, in order to get a conviction, but at that point our problems would only be starting.

If OPEC's members owned no assets in the US, an anti-trust conviction might provide a satisfying, symbolic victory. However, the Venezuelan state oil company, PdVSA, owns 100% of Citgo. Saudi Refining Inc., a subsidiary of Saudi Aramco, owns 50% of a refining & marketing joint venture with Shell. These two entities alone have billions of dollars worth of assets in the US, without counting the diversified US investments and deposits of many other OPEC countries. Because these countries own a variety of things that a US court could attach or seize in an anti-trust judgment against OPEC, the result could quickly devolve into a very risky game. It is hard to imagine us seizing OPEC's assets here without triggering at least a corresponding seizure of US property or investments in OPEC countries, or an actual OPEC embargo against the US. That would put our current notions of energy independence to the test, exposing just how aspirational they are. Nor is it obvious that the final outcome would actually alter the collusive behavior that prompted the action.

There might be a better alternative. If we are serious about holding OPEC to account for openly conspiring to restrict production and set global oil prices, we should do so in the appropriate multi-lateral body, whether the World Trade Organization or the World Court. Whatever misgivings Americans may have about the institutions of global governance, a finding in an international venue would be the only kind that could be enforced against OPEC across the globe, effectively deterring reprisals by holding every OPEC member's global holdings hostage to their good behavior.

I'm sure it's tempting to believe that previous administrations and Congresses shied away from these steps because they were beholden to oil interests or secretly winking at OPEC's behavior, because it somehow served opaque US interests. While Monday's posting might have convinced you otherwise, I tend to follow Occam's Razor in questions such as this. The simplest reason why we have never gone after OPEC for anti-trust violations is that our elected leaders have always understood that the consequences of winning would not be worth the hollow satisfaction it might provide.

Taking the Climate Pledge

An op-ed in last Sunday's New York Times reminded me that the big climate change concert, Live Earth, is coming up this Saturday. It's hard not to be impressed by an event taking place simultaneously on every continent save Antarctica, and featuring a mix of the world's biggest pop stars and regional talent. Even more ambitious, however, is its organizers' stated goal of ensuring that Live Earth "inspires behavioral changes long after 7/7/07." This all comes together in the "Live Earth Pledge" that attendees and listeners will be asked to sign, committing themselves to action against climate change. Unsurprisingly, its seven points embody an aggressive view of the problem and its solutions. While some are laudable, others deserve more debate and don't reduce easily to a single line sign-off.

Here is the Pledge, point by point, with a bit of analysis:

1. To demand that my country join an international treaty within the next 2 years that cuts global warming pollution by 90% in developed countries and by more than half worldwide in time for the next generation to inherit a healthy earth--The Pledge starts off with a bang, here. It suggests that the focus of international action has shifted beyond the Kyoto Protocol to a follow-on treaty, the scope and allocated responsibilities of which aren't yet known. So far, so good. Next, it proposes targets that implicitly accept the need to stabilize atmospheric CO2 concentrations somewhere between 450 and 550 ppm, while coming down squarely on the side of the developing world in putting most of the burden on "legacy emitters": the US, EU, and other OECD countries. Acceding to China's argument that historical and per-capita metrics matter more than current aggregate emissions may be high-minded, but frankly it won't get us where we must go. We need a mechanism that also recognizes that the easiest emissions to cut are ones that haven't yet occurred--from China's exponential growth, for example--rather than imposing truly draconian cuts on established economies. Even if you accept the idea that we can reduce a lot of emissions without causing major economic harm here, cutting by 90% goes far beyond that into hardship and dislocation territory, unless it happens through technology and infrastructure turnover. It's hard to see those gradual trends satisfying the "next generation" timetable, as fuzzy as that is.
2. To take personal action to help solve the climate crisis by reducing my own CO2 pollution as much as I can and offsetting the rest to become "carbon neutral;"--This is my favorite plank, since behavioral change has the biggest potential for bypassing the long lead times for technology and fleet turnover. It also explicitly endorses tradable emissions offsets, making our emission reduction efforts more efficient by focusing them on the cheapest cuts, wherever they are found. The biggest problem with pushing this idea down to the personal level, however, is that it's not progressive: more than half of energy consumers probably can't afford to pay extra--even a little extra--to offset their CO2 emissions.
3. To fight for a moratorium on the construction of any new generating facility that burns coal without the capacity to safely trap and store the CO2--Since the technology for carbon sequestration isn't fully proven for large-scale application, I'd be happier if this had said, "without a sequestration-ready design and escrowing the funds to implement it as soon as it is available." Absent such a caveat, this part of the Pledge really says, "No new coal power plants; we will rely on renewable energy from here on out." That's quite a bet.
4. To work for a dramatic increase in the energy efficiency of my home, workplace, school, place of worship, and means of transportation;--This is a useful recognition that our individual influence extends to all sorts of affiliations we enjoy. The aim is clearly to leverage the enthusiasm of Pledge signers into realms that might not have even noticed the Live Earth event.
5. To fight for laws and policies that expand the use of renewable energy sources and reduce dependence on oil and coal;--In a surprisingly short time, this has approached the status of motherhood and apple pie. I agree with the goal, but I continue to believe the transition will take much longer, and require the consumption of many billions more barrels of oil and tons of coal than most Pledge signers will guess.
6. To plant new trees and to join with others in preserving and protecting forests; and--This really is motherhood and apple pie.
7. To buy from businesses and support leaders who share my commitment to solving the climate crisis and building a sustainable, just, and prosperous world for the 21st century.--This last plank may be the cleverest and most effective of the bunch. As individuals our influence on governments is limited. The goal of transforming our own lives to make them carbon-neutral must compete with numerous other priorities: basic needs of food, clothing, energy and shelter; paying for new-but-indispensable services like cellphones, broadband and 200 channel TV; and all the other costs of modern middle class life. But harnessing our aggregate power as consumers is quite another matter. At little or no cost to ourselves, we can reshape the priorities of the companies we patronize, redirecting hundreds of billions of dollars of business expenses and capital investments toward "greener" suppliers and projects. Curiously, this rests on an assumption that many of those who would sign the Pledge instinctively could never admit: that business often responds more quickly to the choices of customers than governments to the choices of voters.

As you might expect from a group of organizers that includes former-VP Gore, the Live Earth Pledge has an enormous amount of thought behind it, reflecting his viewpoint that climate change represents an immediate global crisis requiring immediate global action. As my regular readers know, I share a somewhat more nuanced version of that view, expressed as a need for urgent, prudent management of an enormous risk. But did I "click here"? Even though I can accept four of the seven commitments more or less as they are, and two more with a few mental reservations, I can't get past #1. The realistic timeline for a 50% cut is probably more like 30 or 40 years than 20, which suggests we'll probably overshoot 550 ppm and have to pull back harder, later, with better technology. I also see the stated allocation of responsibilities for emissions reductions as a deal breaker, regardless of which party wins the White House next year. I don't know how we'll resolve the legacy emissions issue with China and India to get a truly global deal, but ceding this up front is bad policy and a lousy negotiating strategy.

Sharing the Forecourt

A comment in an article on Brazilian ethanol in today's Financial Times got me thinking about how ethanol will move into the US retail marketplace, as it outgrows its current role as a gasoline blending component. The FT cited Ricardo Leiman of Noble Group, who remarked, "There is a conflict of interest between [fossil fuel] distributors and the newcomers." That's certainly the conventional wisdom, with E-85 pumps at major oil company stations as rare as hen's teeth. But I wonder if that gives sufficient credit to the marketing segments of these large enterprises, which have pursued profits in many other areas not directly related to the output of their own refineries. It also ignores the structure of the retail gasoline market, which could be quite hospitable to ethanol, once it reaches critical mass.

First, consider the composition of the retail motor fuels business in the US. Of the 169,000 retail fuel facilities across the nation, fewer than 10% are actually owned and operated by integrated oil companies such as ExxonMobil, Shell, ConocoPhillips or Chevron. The rest are run by retailers with varying degrees of independence. Some own their own facility, while others lease it from the company. Many receive their supplies through a distributor, rather than directly from the company. As a result, even if all of the major oil companies decided that E-85, biodiesel or some other alternative fuel represented an unacceptable threat to the petroleum products they produce, the number of stations at which they could enforce a ban on E-85 is only a small fraction of the total. For the vast majority of service stations, the question of whether to add a pump to sell E-85 or biodiesel isn't determined by corporate policy, but by the economics for the station owner.

Gasoline retailing is not a high-margin business. That's why there are so many convenience stores and co-branded food outlets, both of which offer much higher unit margins than for fuel. Total potential E-85 sales in a given area would be a function of the local flexible fuel vehicle (FFV) population and the number of other E-85 outlets in the same market. FFVs currently make up only 2% of the US car population, and until their numbers grow substantially, E-85 will be a low-volume business for most retailers. That combination of low margins on low volumes limits the return on the investment required to convert a station to sell E-85, offset by any available government incentives. And unless the owner is willing to add an additional tank, he must sacrifice the revenue on another grade of fuel to make this switch. The primary obstacles for introducing E-85 at most retail sites are strictly financial, and only time and the growth of the FFV fleet will overcome them.

Viewed from this perspective, the major oil companies are in a much better position than individual retailers to introduce E-85 selectively into a new market. Not only do they have the financial resources to absorb the costs of conversion, but they also possess sophisticated software that would allow them to determine the best sites to convert, and how to phase alternative fuel into the market, in synch with the expanding FFV fleet. Nor do I think the marketing groups of these companies will resist this, if it provides an opportunity to enhance both profitability and brand image.

Many people forget that the integrated oil companies are no longer the monolithic, command-and-control organizations they once were. Their marketing divisions are independent profit centers charged with earning an attractive return on their employed capital. Many of the executives responsible for these units have more in common with the people running other retail businesses than with their colleagues who run the refining or exploration and production segments. When I tried to get Texaco's marketing department interested in installing electric vehicle recharging facilities at service stations in Southern California in the late 1990s, their main worry was how they could make money on them, not their effect on gasoline sales. What counts is traffic, and if E-85 will bring them traffic, they will buy in. The best way to make sure that E-85 spreads quickly is to ensure that the major oil companies can take advantage of the same incentives for E-85 as independent retailers. Alternative fuel advocates should view major oil company marketing groups as natural partners, rather than potential opponents.

Energy Outlook will observe the US Independence Day holiday tomorrow and resume new postings on July 5.

Why Is Oil So Pricey?

For the last several months, almost everyone has been asking why gasoline prices are so high. The standard answers often fail to satisfy, and far too many people see signs of a conspiracy. I've devoted a fair amount of space to this issue, but I've largely ignored the more important, fundamental question of why oil prices are so high. Oil prices remain the largest single component of retail gasoline prices, accounting for about 54% of the pump price, and most of those who follow oil are focused on the factors that could move its price up or down, rather than looking at its absolute price level. Why should oil be trading at $70 today, instead of $30 or $40? This question ought to be of great interest to the public and to government officials, and especially to those developing or investing in alternative energy.

Reviewing the long history of oil prices provides some interesting insights. Prior to 1973, oil prices were quite stable, which meant they were trending downward in real terms. From 1985 to 2002, nominal oil prices averaged $21/barrel, and with the exception of a few spikes, such as the Gulf War, real oil prices were generally falling. The overall pattern reflects sharp upward discontinuities, followed by a gradual decay in prices until the next spike. This history includes periods with all sorts of economic, geopolitical, and market conditions. To understand why the oil price is so high, we need to ask what is different today, compared to previous, similar periods when it was lower. Consider some of the factors that are usually trotted out to explain high current oil prices:

Asia's growth - India and China are growing rapidly, straining global oil supplies and pushing prices higher. But is this growth unprecedented? Since 1997 China's oil demand has grown at an average rate of 7% per year, based on US Department of Energy data. Over the last five years, that has added roughly 500,000 barrels per day (bpd) to global oil consumption. But that increment is still only 0.6% of total global consumption of 84 million bpd. From 1960-1970 oil demand in the OECD--essentially the US, Western Europe and Japan--grew by over 8% per year, driving total global demand up by around 6% per year for a decade, during which total consumption more than doubled. Over that entire period, when prices weren't influenced by OPEC, but guided by the Texas Railroad Commission, they were steady in nominal terms and falling when converted to 2005 dollars.

Falling spare capacity - Many analysts suggest that the decade's global economic growth has outpaced the ability of oil producers to expand spare capacity, and the resulting narrowed gap between supply and demand has pushed prices higher. There's no question that global oil capacity has been strained, particularly in 2004 and 2005. It's hard to gauge spare capacity reliably, but it was clear that Saudi Arabia, the world's swing producer, had to dig deeper into less desirable, heavier grades of oil to meet the call on its output. But one of the best proxies for the interaction between supply and demand, inventory, tells a different story. Total OECD oil inventories--which include strategic reserves--have grown by 10% since 2002, with US commercial crude oil inventories currently 9% above their 10-year average. By itself, this fact doesn't suggest that crude is overpriced, but it certainly doesn't justify today's price level, either.

High geopolitical and other risks - Al Qaeda, war in Iraq, unrest in West Africa, climate change, hurricanes: the last six years have been a compendium of nearly every bad thing that can happen to affect the price of oil, and the idea of a high "risk premium" on oil is widely accepted. But how high should it be? What did previous events like this do to the price of oil? Consider the case of the Gulf War, when Iraq invaded Kuwait and threatened Saudi Arabia. From the time Saddam's forces crossed into Kuwait in August 1990 until the coalition air campaign began in January 1991, the price of West Texas Intermediate crude on the NYMEX rose by about 50% from the average of the preceding 12 months. (Once the shooting started, the price plummeted back to the low $20s.) On a comparable percentage basis, the Iraq War, which has had a smaller impact on actual oil production than the Gulf War, might thus account for about $15/barrel of the current price. It's hard to imagine all the other risks doubling that figure.

That brings us at last to the question of whether speculation might account for the remainder of the doubling of oil prices that has occurred since 2002. This is certainly a relatively new factor in the oil markets, compared to the 148-year history of the commodity. The number of players in the futures, options and oil derivatives market, compared to even a decade ago, has exploded. "Open interest" on the New York Mercantile Exchange, a measure of the scale of trading, has more than doubled since 1999, when it stood at 638 million barrels of crude oil. As of Friday's session, aggregate open interest across all crude oil contracts going out to 2012 was just under 1.5 billion barrels. But does that mean that speculators are manipulating the price of oil, as some have alleged? I think there's a different explanation that looks at the nature of these markets, rather than the intentions of their participants.

Oil futures have a basic similarity to equities. Both reflect the underlying value of the thing to which they are linked--barrels of oil in one case, the fortunes of a company in the other--but both also have an independent existence. Oil commodity futures are in demand as financial instruments in a different way than when they were used primarily as a way for refiners and distributors to manage the risk on their physical market activities. As that demand grows--as more individuals, companies, and hedge funds want to participate in the oil market, without a link to any physical supply or demand for the commodity--then the price of these instruments ought to rise, in tandem. But with the price of most physical oil pegged to a futures market, whether for WTI or European Brent crude, that demand can influence the physical market, as well, without changing the real supply or demand by one barrel.

Anyone who has traded oil knows that the physical market needn't move in lock step with the futures market. Differentials for physical oil versus futures wax and wane, depending on a variety of factors, and if the only thing going on were long-term inflation of oil futures by financial demand, you'd expect the discounts for real grades of oil to widen versus the futures to compensate. But those differentials aren't set in a vacuum, without reference to previous prices. You don't wipe out the entire price history of the commodity and arrive at the price from scratch every day.

How much of an influence could the expansion of market participation have? I honestly don't know, but the shortcomings of the other explanations that I discussed above at least suggest that we're missing something important. Frankly, I find this a much more interesting question than many of those that are being asked about gasoline prices in the Congress and elsewhere. Rather than wondering if the market is being manipulated by oil companies or hedge funds, we ought to be analyzing the broader impact of the enormous increase of investor interest in oil price instruments on the cost of real oil to the economy. If anyone has run across a study looking at that, I'd love to see it.