Friday, September 28, 2007

Every Molecule and Electron

Yesterday's panel discussion on alternative and renewable energy at the annual J.S. Herold Pacesetters Energy Conference covered a wide range of technologies and issues, reflecting the diversity of this growing sector. (The presentations are available on Herold's website.) In my introductory remarks, I cited the importance of energy security and climate change as key drivers of alternative energy, but a couple of comments from one of the panelists really put it all in perspective. Dr. Don Paul, the Chief Technology Officer of Chevron, emphasized that we will need the contribution of every technology--"every molecule," as he put it--to meet growing global demand. That's true, even after factoring in predictable improvements in efficiency.

Dr. Paul also a threw out a mind-boggling figure that describes the scale of the challenge better than any other I've heard: one trillion gallons per year. That's the quantity of energy we currently get from petroleum (it's actually 1.3 trillion) which supplies about a third of total global primary energy, the energy we turn into electricity and fuels to do useful work. That isn't intended to make the hundreds of millions or low billions of gallons of biofuels appear trivial, but it serves as a useful reminder of just how remote the prospect of replacing petroleum entirely is, today.

It also illustrates how the traditional units of measurement in different energy segments get in the way of appreciating the big picture. Oil people talk about barrels per day, in the thousands or millions, while the US gas industry refers to millions or billions of cubic feet per day--or trillions per year. And then there's the rest of the world, including the LNG trade, which talks about millions of tons per year and billions of cubic meters. Along come ethanol and biodiesel, and for some odd reason their producers chose the same unit as American consumers: gallons. Perhaps that explains part of ethanol's appeal, along with its farm origins.

In my geeky, idealistic youth I was a fanatic about metric conversion, and the Systeme Internationale or "SI", in particular. Kilograms, meters and Joules seemed much more sensible than pounds, feet and BTUs. The life-cycle of that movement in this country roughly paralleled that of leisure suits, and I am skeptical either could be revived any time soon. But wouldn't it be nice if energy people could agree on a few common units, one for molecules and another for electrons? If we're going to need every last one of each--and I fervently believe we will--then we at least ought to be able to add them up easily. Don't hold your breath, though. It probably won't happen until some other form of energy has pushed oil and gas off center stage, and then the industry will have to learn to speak in someone else's units.

Disclosure: Chevron Corp. is a client and I own Chevron stock.

Thursday, September 27, 2007

Dark Clouds

Two of yesterday afternoon’s panels at the Herold Pacesetters Conference really epitomized why I love to attend sessions like this. They dealt with geopolitical risks to energy supplies and the “megatrends” facing the entire energy industry and the wider world. In the interest of time, since I’ve ducked out of another session to write this posting, I’m just going to list some of the insights and sound-bites that caught my attention from these panels:

  • The panel on geopolitical risks included a presentation on an interesting tool for quantifying those risks objectively, and I plan to come back to that in a later posting. But another presenter provided some useful advice about not getting so focused on understanding the risks that we fail to plan our responses to common outcomes that could arise from a number of different events. If the market is short a million barrels per day, how important is it that it happened because of country X’s policies or because of a natural disaster, compared to making sure we can handle such a shortfall from any cause?
  • Cliff Kupchan of the Eurasia Group provided some insights into the upcoming transfer of power in Russia, suggesting that President Putin may surrender the Presidency, but that wherever he ends up may become the new center of power. This has implications well beyond energy.
  • Mr. Kupchan also discussed Iran. He sees two competing clocks ticking down in that country, the nuclear clock and the reform clock. Whether we end up with an application of “kinetic policy”—a euphemism for military force—may depend on which clock is running faster.
  • In the panel on megatrends we heard about resource depletion and the prospects for Peak Oil, which hinges not just on the oil in the ground but on the capacity to produce it. If the international oil companies can’t access those resources, and OPEC lacks the internal funding or motivation to build capacity, we could end up with a peak, regardless of the remaining reserve levels.
  • One indicator of the progress towards such a state is the steepening curve for per barrel capital costs in the oil industry. This suggests diminishing volumetric returns ahead, and the prospect of really severe price increases to destroy the demand that can’t be met. That could be especially painful for the US, since so many consumers around the world are buffered from oil price changes by controlled markets and high taxes.
  • There was also a brief discussion of a recent prediction that oil prices could be about to peak and return to $45/barrel, though that view didn’t get much credence on the panel or with the audience.

If this all sounds like doom and gloom, that’s the nature of the way we tend to look at risks. If there are bright spots in this outlook, they may have to come from non-conventional hydrocarbons and alternative energy, the subject of my panel this morning, which I’ll cover in tomorrow’s posting.

Wednesday, September 26, 2007

Two Industries

In the first day of the John S. Herold Pacesetters Conference, most of which was focused on the exploration and production portion of the global oil and gas industry, I heard many interesting comments and themes, but I was struck by a contrast between the typical external picture of an industry beset by political and environmental challenges, and the companies on display here, which are working on real growth opportunities and generating real value for their shareholders and the economy as a whole. Anyone expecting this industry to fade quietly and get out of the way of emerging energy sources such as wind, solar and biofuels, is bound to be disappointed. Yet the industry would be equally wrong to ignore the future competition those new sources represent.

In some respects, this contrast arises from something one of yesterday’s panelists observed, that there isn’t one oil & gas industry, but really two. On the one hand, we see the eight or so world-scale companies that are household names across large portions of the globe, while on the other, a constellation of smaller companies that belie the stereotype of an industry that values financial engineering as much as the physical kind. While no one should be surprised to see such companies at an investment conference touting their companies’ stories, the underlying facts are impressive: these smaller companies are generating real production and reserves with the drill-bit-- rather than just buying each other--generating healthy profits along the way.

But as yesterday’s lunch speaker made clear, even the smaller companies don’t necessarily fly under the political radar. The CEO of Chesapeake Energy, one of the largest independent producers of natural gas in the US, shared a remarkable set of correspondence with the audience, in which the Governor of Connecticut accused his company of manipulating the gas market, to the detriment of consumers, by constraining production. She has asked for a Congressional investigation of this practice, and in the current environment she will probably get one.

You don’t have to take Mr. McClendon’s word concerning the inaccuracies contained in Ms. Rell’s allegations; they are easily discernable in the price and inventory storage data maintained by the Energy Information Agency of the Department of Energy. It certainly leaves open the question of how much due diligence the Governor’s office conducted before leveling these charges. More fundamentally, however, it’s not clear why any state government might think it appropriate to criticize a decision by a private company in another state to cut production that has become unprofitable because of falling prices. If natural gas producers can be taken to task for this, can ethanol producers faced with falling margins be far behind?

Finally, I heard some interesting thoughts about what the shape of the current futures markets for oil and natural gas is telling us. When you ignore the fluctuations at the front end of the market and focus on the further-out contracts, the pricing of low $70’s for crude oil and $8 for natural gas are in line with the prices implied by the incremental oil and LNG projects now under development. While that doesn’t preclude the possibility of a collapse back to $50 or $60 oil and $5 natural gas, it does suggest that such drops wouldn’t be permanent—unless producers are forced to produce flat out regardless of price.

Tuesday, September 25, 2007

Global Energy Overview

I’m back in Connecticut this week, attending the annual Pacesetters Energy Conference of John S. Herold, Inc., which sponsors this blog. The conference brings together the oil & gas and investment communities, focusing on the major trends in the energy industry and their financial consequences. This year it is taking place against a backdrop of relevant events nearby, as the UN meets in New York and the President convenes an international conference on climate change in D.C. The UN session includes the visit of Iran’s President Ahmadinejad, the walking personification of political risk. It’s going to be an interesting week.

The opening panel of the conference provided some interesting statistics on the publicly-traded energy companies that Herold tracks. The industry spent $400 billion in “upstream” capital investments last year, apparently constituting the seventh consecutive increase and exceeding the total cash flow of the sector for the first time since the 1990s—when that cash flow was much lower. But because of limited access to resources around the world—a theme I’ve touched on many times—aggregate oil reserves have increased only modestly, and much of that has come from the Canadian oil sands. And the combination of weaker natural gas prices and rising costs are putting pressure on the industry’s profit margins—not something you expect to hear with oil at $80/barrel.

These are serious issues, to be sure, but in his videotaped message at the start of the conference Ron Mobed, the President and COO of IHS Energy, which recently acquired Herold, mentioned the “environmental and climate change concerns that are currently the biggest drivers of change in operating practices in the industry today.” Given the magnitude of the other challenges, such as political risk and access to resources, I thought this statement was remarkable.

Thursday morning I will be moderating a panel discussion on alternative energy, with participation from a major oil company, an ethanol technology startup, a large consultancy, a coal processor, and the US Department of Agriculture. Alternative energy is going to play an increasingly important role in connecting the energy industry to climate change. Not only is it a principal avenue for reducing emissions, both globally and for the industry’s own operations, but it could prove essential for making the product slate of energy companies compatible with a world of constrained carbon emissions and effectively constrained hydrocarbon production.

My postings for the remainder of the week will include some of the key insights from the conference, along with my comments on any noteworthy developments from NY and DC.

Monday, September 24, 2007

Tapping the Rest

I started writing this posting several weeks ago, with the idea of presenting some straightforward projections on the quantity of potential domestic oil production that the US has chosen to place off-limits to drilling. But while there are accepted estimates of the quantity of resources under the ground in the offshore and onshore areas that oil companies can't access, translating those figures into expected production--the number that really counts--turns out to be pretty difficult. So there's a lot of uncertainty surrounding how much oil we're forgoing and how quickly it could come onstream, if all drilling moratoria were dropped tomorrow. That makes the entire subject much harder to broach when the Congress, at least, has shifted from a paradigm in which increasing production was a key element of our energy and national security, to a stance that regards it as a futile distraction from the urgent task of promoting efficiency and alternatives.

Let's start with the resource estimates. Last year the Minerals Management Service of the US Department of the Interior issued a mean estimate of 85 billion barrels of "undiscovered, technically recoverable" oil under the federal waters of the Outer Continental Shelf, including the portions of the Gulf Coast currently open for drilling. Of that, they indicated at least 66 billion barrels of oil "resource" at a 95% confidence level--in other words a 95% chance that the quantity was at least that big. That compares to total current proved US oil reserves of just under 22 billion barrels, a figure that hasn't changed much in over a decade, despite annual production of around 2 billion barrels per year.

But resources are not reserves, which are based on how much of the oil or gas in the ground can likely be extracted economically with existing technology and at current prices. That means we can't look at the MMS estimate and conclude that we could produce as much from these undiscovered resources as we do from our current reserves. As the technical experts at the API pointed out to me when I asked them for help interpreting this, trying to arrive at a reasonable production profile for the portion of these resources that are off-limits is complicated not just by access, but by permitting requirements, proximity to existing infrastructure, and the availability of drilling rigs and experienced personnel. In addition, there would be a delay of at least 5-7 years in bringing new production on line from the time access was granted, nor could we develop it all at once.

The recent energy study by the National Petroleum Council also considered this issue. The study's supply team examined a variety of estimates and concluded that roughly 40 billion barrels of oil were currently off-limits to drilling in the US, including--as best I can tell--the resource estimate for the Arctic National Wildlife Refuge (ANWR). They also reported estimates that the offshore portion of roughly 18 billion barrels could generate additional oil production of one million barrels per day by 2025 and displace roughly 2.8 billion barrels of imports in the interim, with corresponding benefits for our trade balance and royalty revenues. (Please note that I participated in a different aspect of the NPC study as a paid consultant. While the data in this paragraph are taken from the published study, the opinions expressed in this posting are mine and do not represent those of the Council or its membership.)

Without heroic assumptions, it appears that our conscious choices about the undesirability of oil drilling outside the presently-permitted portions of the Gulf of Mexico, as well as on various onshore federal lands, are holding back domestic oil production in the range of 1-2 million barrels per day, or an extra 20-40% of current production. That is the equivalent, adjusted for energy content, of 22-44 billion gallons per year (BGY) of ethanol, a range that includes within it the entire expanded renewable fuels mandate passed by the Senate a few months ago. It is also a multiple of most estimates of the maximum quantity of corn ethanol the nation can produce.

I have heard some people suggest that our policy of restricting access to these resources is wise, because they will be worth more in the future, after conventional oil production has peaked. Even if that were true, I think it is very likely that if these volumes are not developed within the next decade, they never will be, because our industrial capability to extract them will atrophy and attitudes against drilling will harden further. While that might be welcome news to some, it should not be to anyone who is genuinely concerned about US energy security.

I'm not arguing that we can drill our way to energy independence. Given our low current oil production, relative to demand, that remains impossible under any scenario I can envision. But neither can we farm our way to energy independence, or conserve our way there any time soon. I believe politicians are ignoring the potential benefits available from adding more conventional oil production into our future energy diet. The combination of an extra million barrels per day of oil, 36 BGY of various biofuels, and a 35 mpg fuel economy standard might not quite achieve true energy independence, but together they would make a sizable dent in our oil imports. And this approach would produce substantially fewer greenhouse gas emissions than adding a comparable quantity of coal-to-liquids, oil sands, or shale oil production.

Friday, September 21, 2007

The Oil-Dollar Price Loop

Positive-feedback loops have become a familiar concept, thanks in part to the science of climate change. A warmer atmosphere melts icecaps and glaciers, which in turn reflect less sunlight back into space, causing the atmosphere to warm further, and repeat. Such relationships exist in many systems, and an article in yesterday's Wall Street Journal started me wondering if we are experiencing such a loop involving oil prices and the value of the US dollar. If so, the practical limit on the dollar price of oil could be much higher than we might otherwise expect.

Over the last several years I've discussed many reasons why oil prices have increased so dramatically, compared to their level prior to 2004. It's a long list, including the shift in power from commercial oil companies to national oil companies, and from non-OPEC producers to OPEC, geopolitical tensions, the growth of Asia, inventory, speculation, and even the lagged impact of the late 1990s oil price collapse. At first glance, though, because oil is normally traded in dollars, the value of the dollar itself might not seem to belong on that list. In a world awash in oil, it probably wouldn't. However, a dollar that is shrinking relative to other major currencies has at least two effects on oil, in a market that is already tight.

First, it reduces the income of producers, who sell in dollars. That leaves them less cash to reinvest in new production. At the same time, it makes oil cheaper in the currencies of other consuming countries, relieving the pressure on them to consume less and helping them to out-compete us for the world's available oil exports. Each of these factors alone would tend to drive up the dollar price of oil; with the oil market being driven by supply constraints (OPEC quotas) and rising demand, both effects operate. More importantly, they appear to work in a self-reinforcing fashion, linked back through their impact on the dollar.

So imagine a closed loop, and follow it around a cycle:
  1. The value of the dollar drops.

  2. Non-US demand rises and supply tightens, as discussed above.

  3. The dollar price of oil increases.

  4. The US trade deficit worsens, and foreigners hold more dollars than they need to buy US goods or assets.

  5. Return to step 1.
Events such as this week's interest rate cut by the Fed also feed this cycle, by weakening the dollar while propping up our economy and thus our oil demand. Of course, none of this happens instantaneously or in isolation. Many other things influence oil prices, exchange rates, and the other components of this highly-simplified feedback loop.

There's also a natural point at which these loops start to de-couple, and we could be nearing it. The growth of China and other large developing countries may be driving global oil demand, but we still import a quarter of all the oil that's exported around the world. Once the price gets high enough to dampen US oil demand and imports--or when the underlying factors weakening the dollar have the same effect--then this loop starts to run down. But at what oil price does that occur? I expected it long before we reached $80 per barrel, and there are signs that demand is slowing. Total petroleum products supplied in the US, one measure of demand, was down by about 0.5% for the last six weeks, compared to the same period last year, and total crude oil and petroleum product imports were down by a larger fraction. Time will tell whether this is a trend, or a random fluctuation. Meanwhile, I'll be watching exchange rates more closely than I used to.

Thursday, September 20, 2007

Oil's Pogo Problem

Yesterday I participated in another in a series of blogger conference calls hosted by the American Petroleum Institute (API.) This one covered a study commissioned by API and conducted by Dr. Robert J. Shapiro, a former Undersecretary of Commerce for Economic Affairs, examining the ownership of US oil and gas companies. The study's findings dispel the notion that the oil industry is owned by a few insiders, rather than by a broad cross-section of the public via our mutual funds, pension funds, and direct equity investment. In fact, the owners of these companies look a lot like those in other industries. While that might not surprise many of my readers, it highlights a significant disconnect in some pending energy legislation. Anyone familiar with the late Walt Kelly's cartoon possum, referred to in this posting's title, knows where this is headed.

The study looked at the ownership of oil & gas company shares, among management, individuals, and various institutional investors. Although these owners don't make the day-to-day decisions that guide these companies, they are entitled to all of the firm's earnings, whether paid out as dividends or reinvested. Out of every dollar of oil company pre-tax profit, roughly 35 cents cents goes to Uncle Sam and another 7 or 8 cents to the appropriate state tax authority. Of the remainder, Dr. Shapiro's study suggests that approximately 57 cents ends up in someone's IRA, 401-K, life insurance policy, or pension fund, leaving under a penny for "corporate insiders." That seems very much at odds with public perceptions about oil companies.

In the podcast interview that accompanied API's press release on the study, John Felmy, API's chief economist, made an astute observation. Referring to recent legislation increasing taxes on the industry, he said, "They seem to be predicated on the notion that people believe that no one owns the oil companies, and somehow if you take money from an oil company, no one gets hurt." The data paint a very different picture; the people who own those large profits we want our representatives to tax away are mainly the same ones who elected them: us. When I asked him about this, Dr. Shapiro was careful to make a distinction between the composition of the electorate and of the owners of financial assets. The latter group is skewed toward the upper half of income, compared to the whole population, though the electorate probably is to some extent, as well. However you slice it, though, raising taxes on oil companies means taxing the nest eggs of America's middle class.

In that light, the only practical difference between raising federal revenue by taxing the oil & gas industry, in preference to some other broad or narrow target of corporate income taxes, lies in reducing the amount available to invest in producing more energy, rather than materially shifting the pockets from which the funds will ultimately come. Surely that is counterproductive to the cause of reducing our reliance on imported energy, even if some of those profits would otherwise be spent on share repurchases or mergers. When we argue that we want to tax oil companies, because we have more confidence in the government to invest in alternative energy, we are really saying we want to tax our own savings and those of our parents, friends and neighbors to fund energy R&D. When you look at it that way, that's just not a very enlightened policy, compared to a tax on energy consumption or carbon, either of which would do far more to reduce demand, improve efficiency, and reduce greenhouse gas emissions.

Wednesday, September 19, 2007

Nuclear Freakonomics

Several weeks ago a reader of this blog commented to me on the contrast between the periodic calls for a new Manhattan Project to tackle our energy problems and the results of the actual Manhattan Project sixty years ago, which have matured to provide large quantities of economical base-load electricity in the US and many other countries. Several recent articles have addressed the revived prospects for nuclear energy, including one in last week's Economist and another in last Sunday's New York Times Magazine. In the latter, the authors of "Freakonomics" examine America's sudden shift away from nuclear power and the consequences that has had for our greenhouse gas emissions. I couldn't resist quantifying their observations.

What if the Three Mile Island accident had never occurred, or if it hadn't coincided with the release "The China Syndrome", which amplified the public's perception of the event? Would nuclear power plants have still encountered the project delays that drove up their construction costs, contributing to the roughly 20-year hiatus in new plant activity? Any answers to these questions would be purely speculative, but if the industry had continued expanding at its previous rate, then instead of the current 104 reactors, we might easily have 200, contributing 40% of our total electricity supplies. Coal-fired power plants would supply only 32% of our power needs, instead of 50%, and we'd emit roughly 650 million tons less CO2 per year. That's over 10% of our current CO2 emissions.

Or what if the US Congress had voted in 1997 to ratify the Kyoto Protocol on greenhouse gas emissions, and the country had embarked on a major expansion of nuclear power to meet our commitments under the treaty? The first new reactors would have started up a few years ago, and we'd be on a path to meet our target of reducing our emissions below 1990 levels by 2012--or at least come a lot closer to that than now seems likely.

While these scenarios ignore real-world complications such as nuclear waste and proliferation, they underline an important point. Choices have consequences, and our decision a generation ago to leave nuclear power in limbo has added billions of tons of CO2 to the atmosphere since we made it, while constraining our options for addressing the challenges we face. The decisions we make now could have similar consequences, because while renewable energy technologies such as wind and solar power can add important quantities of low-emissions electricity in the decade ahead, they cannot match nuclear's baseload characteristics and 90% onstream capacity factor. As impressive as the addition of 2,454 MW of new US wind power capacity last year was, the resulting increase in net power generation is still less than that from one new nuclear reactor.

When we assess nuclear power as an option for dealing with our energy security and emissions concerns, we ought to consider what a new fleet of reactors would enable, in terms of reducing our reliance on coal--with its implied dependence on future carbon sequestration--and providing large quantities of reliable off-peak power for the plug-in hybrids and all-electric cars that look like our lowest net-environmental-impact alternatives for displacing gasoline in the medium term. Are those benefits significant enough to warrant a more pragmatic approach to nuclear power and its byproducts? I believe so, and there are at least a few environmentalists who share that view. On balance, the risks of nuclear power look more manageable than the uncertainties of climate change or an unstable Middle East.

Tuesday, September 18, 2007

Zero Net Energy

An article in today's San Francisco Chronicle provides another example of California taking the lead on connecting energy and environmental policies. The state's Public Utilities Commission wants to require developers to build homes so energy efficient that they will require no net energy from the grid by 2020. This is consistent with the state's goal of drastically reducing greenhouse gas emissions, and it would also shrink the infrastructure burden associated with adding six million additional residents between now and then. Timing is sometimes as important as substance, however. It would be hard to imagine a worse time to impose such a potentially expensive new requirement on the housing sector.

As my regular readers know, I'm hardly unbiased about California, having spent three-fifths of my life there, including my entire education. Californians have long believed that they are about 10 years ahead of the rest of the country, and that what you see there today, you will see everywhere else eventually. It's probably more accurate to say that California represents a useful testing ground for new ideas, giving the rest of us a preview of some of their consequences, intended and unintended. Not all of these experiments have turned out well, as evidenced by the state's botched electricity deregulation a few years ago, and the impact of unregulated immigration on a massive scale.

The concept of zero-net-energy housing has much to recommend it. The technology to do this is certainly available, at least for homes in an area with as benevolent a climate as California's. It also makes a lot of sense to incorporate features such as solar roofs, extra insulation, and efficient appliances into original construction, and thus into the mortgageable purchase price of a home. A decade ago, my Texaco colleagues and I suggested that this was the most logical way to implement distributed generation technologies such as home fuel cells, including long-term supply contracts for the natural gas these devices would use. But whether it's fuel cells or solar panels, they are easier to incorporate into a house when it is built than as a retro-fit, and the economics work better, too.

Unfortunately, timing matters. You would have to be living under a rock to have missed the implications of the sub-prime mortgage crisis for home construction in California, one of the worst-affected states. Putting a major new requirement such as energy self-sufficiency onto developers at this juncture looks like a recipe for failure. The engine of easy credit and bootstrapped home equity from strong, steady appreciation has stalled and gone into reverse in California, where home sales are down and property values are declining. No one knows how long this situation will last, but it could take the California housing bubble years to deflate and return to normal growth.

I don't fault the PUC for wishing to align California's large housing sector with the state's overall emissions and efficiency targets. Floating this proposal now seems a bit tone-deaf, though. Hopefully, the California Energy Commission and the legislature will take a bigger-picture view and shelve this idea until conditions become more propitious. That shouldn't affect existing incentive programs for solarization and efficiency, nor would it preclude developers from packaging these systems as selling features. After all, there's nothing wrong with this idea, other than making it mandatory. In the meantime, California should seek big emissions reductions in less distressed sectors, since all such cuts are equivalent in their impact on climate change.

Monday, September 17, 2007

Common Interests

An op-ed in today's Washington Post got me thinking about the ways that the US and China would benefit from greater cooperation on energy. As energy security increasingly becomes a global, rather than merely national concern, there are big incentives for the world's two largest oil consumers to work together. Mr. Mallaby is right that both countries share a common interest in ensuring stable, affordable oil supplies for our economies, though he neglects to mention the opportunities created by the very different stages of development reflected in each. Applying US technology to China's energy challenges could help address our own.

On the supply side, while China produces significant quantities of oil--about as much as Iran or Mexico--its oil industry is not as mature as America's. China's large territory has not been explored to nearly the same degree as ours, nor has the latest technology for finding oil and gas been applied to the same extent. That means that there is still some upside in China's own production, even as the country seeks to secure supplies abroad. And while the rapid growth of its oil imports, relative to production, makes the idea of Chinese energy independence as elusive as it has been here, every extra barrel they produce is one for which they will not have to compete in the global market, driving prices up.

More importantly, the relative size of China's current installed base of energy-using devices--cars, appliances, etc.--is still modest relative to its ultimate potential. Efficiency technologies introduced now would have dramatic effects on future consumption, because the key factor is still growth, rather than turnover. 2007 car sales, estimated at 9 million units, will contribute between a quarter and a fifth of all the cars that will be on their roads next year. US car sales haven't had that kind of leverage on the characteristics of the total fleet since at least the 1950s, with current sales running at less than 7% of existing vehicles. If every new car in the US and China were a hybrid starting tomorrow, within five years China's fleet would be mostly hybrids, while ours would still have a large majority of less efficient vehicles.

The debate over US fuel economy regulations remains brisk, because auto makers face large investments to improve a vehicle attribute that has been a low priority for consumers until quite recently. However, if those investments could be spread across both the highly-competitive though slow-growing US car market, and the rapidly-growing Chinese market, the cost/benefit balance would shift. GM's plug-in hybrid (PHEV) technology, eagerly anticipated here, might be just the thing for China's big cities, particularly if, as some claim, the architecture GM has chosen reduces vehicle cost below that of conventional hybrids, and perhaps eventually below traditional cars. Buick is already the top brand in China, and PHEVs could cement that lead.

In that context, negotiating with China to align our respective CAFE standards might be a good way to reduce global oil demand, create opportunities for US companies, and attack climate change, all at the same time. Trade deals with China aren't exactly the flavor of the month, right now, so it's not obvious that expanding the issue this way would improve the political prospects of tougher CAFE standards in the Congress. But reframing it to address a broader definition of energy security, recognizing the common interests of consuming countries when OPEC's hold on oil markets seems unassailable, might look like very savvy leadership.

Friday, September 14, 2007

Nearing the Old High?

Whenever the price of crude oil breaks its previous record in nominal prices, we see comparisons to the all-time high of the early 1980s, adjusted for inflation. When it passed $80 the other day, I saw several such comparisons. Only one problem: they differed by more than a dollar per barrel among them. That's more than a rounding error, considering that price data are given to the penny, and the GDP deflator commonly used for such calculations goes out three figures beyond the decimal point--five when you realize it's quoted as a percentage. What could be causing these disparities, and what is the true, inflation-adjusted oil price high? That turns out to be a decidedly non-trivial question, and there's really no single correct answer. The best I can come up with is around $91/barrel, which is much lower than recent estimates over $100/barrel that probably rely on the consumer price index.

Explaining why this isn't nearly as simple as it looks requires a bit of background on the different grades of oil, how the market works now versus how it worked in the early 1980s, and what we mean by inflation adjustment. This isn't intended as an economic dissertation, however, so I'm going to paint it in broad strokes:

Start with oil, itself. There are probably more different types, or grades, of it than there are rock bands with funny names. The grade the media generally refer to is West Texas Intermediate (WTI), a generic mix of light, sweet domestic crude oil streams (plus a few specified import grades) with sulfur content below 0.42% and API gravity (a measure of density) between 37 and 42 degrees. While it has been the primary benchmark crude oil type for the US and the world for a very long time, it's not particularly representative of what most refineries actually run, though it was more representative 25 years ago.

Now consider the market. Today, the WTI price usually refers to the settlement price for the front-month futures contract on the New York Mercantile Exchange. Unfortunately for anyone trying to compare current and historical oil prices, the NYMEX only started trading crude oil in 1983, a couple of years after the price had peaked. To compare WTI before 1983, you must look at "first purchaser" wellhead prices. The best publicly-available proxy for those that I could find is "posted prices", which are not actual transaction prices, but price schedules published by companies soliciting offers to sell them oil. To complicate matters further, actual transactions typically occur at a premium to postings, referred to as "P-plus". For example, "XYZ agrees to buy 10,000 barrels per day of WTI at Cushing, OK for the month of June 1987 for P-plus 50 cents." As quaint as that sounds in an era of real-time electronic trading, I understand that a fair amount of crude is still transacted on a P-plus basis, for various reasons.

Next consider what we mean by inflation. How relevant is the commonly-used consumer price index to the wholesale price of a primary industrial commodity? Not very, even if oil isn't just any commodity. I'm a lot more comfortable using the GDP deflator, which is a very broad measure of the impact of inflation on nominal prices across the entire economy. It might be equally legitimate to argue for using some other index, such as nominal GDP per capita or relative share of GDP.

The highest posted price for WTI during the first energy crisis was $39.50/barrel from April-July 1980. (While there's better data available for imported crude oil in the same period, trying to equate that to current WTI requires all kinds of additional assumptions, and I'd prefer to avoid those.) Applying the ratio of GDP deflators to the posted price yields $87.92 in 1Q2007 dollars. If we assume that actual transactions in the peak month of 1980 were probably done at P-plus $1.00--about as much as the market would take before competitive forces pushed the postings up--then we get to $90.14. But that's still a wellhead price, so we'd need to add something for gathering, handling and transportation to arrive at a figure that equates to NYMEX WTI at Cushing, OK. Call it a buck, and we're at $91 and change.

If I've done my sums properly, we're closer to the all-time high oil price than some analysts are suggesting. The puzzle, of course, is how prices can be this high for this long without putting the economy into a deep recession, such as we saw in the previous energy crisis. Part of the answer is found by translating that July 1980 oil price based on its relative share of the 1980s GDP, compared to today's, rather than using the deflator. On that basis, oil at $80 still has a long way to go to match its equivalent of $187/barrel in 1980.

Update, 11/7/07: The Washington Post described similar difficulties in coming up with an inflation-adjusted all-time high, reporting different results from three groups, the IEA, CERA, and the Energy Information Agency of the US DOE. The EIA's figure comes closest to mine at $93.48. They applied the same GDP deflator, though they used a different starting point, the average monthly refiner acquisition price in Jan. 1981. CERA used WTI postings, as I did, but inflated at the CPI to arrive at $99.04.

Thursday, September 13, 2007

What About Iraq's Oil?

Congressional hearings are often as interesting for what is not said as for what is. After watching hours of C-SPAN's coverage of the House and Senate hearings on Iraq this week, I only heard the subject of oil come up a few times, and only in the context of how oil revenue was being shared between the central government and provinces. If you didn't know that this war was being fought in the heart of the world's largest concentration of oil and gas, you'd never have guessed it. Perhaps it has become impolite to mention the importance of Iraq's oil, when so many critics have convinced themselves that the whole war was about oil in the first place. Or maybe it's just assumed to be understood as part of the shorthand reference to "vital interests in the region." Either way, the result of the war in Iraq will have a significant influence on global oil markets, and part of my interest in the hearings was in trying to glean whatever I could about the likely outcome.

In his column in today's Washington Post, David Ignatius asks how this war will end, echoing a question that General Petraeus apparently asked in 2003. It's still the right question today, of course, and not just because of the Americans and Iraqis who are being killed or maimed. At the risk of seeming insensitive to those much greater costs, oil remains the lifeblood of global civilization, at least for now, and we can't ignore the pressure that the Iraq War has exerted on oil markets since it began. That pressure has short and long-term components.

At least part of today's $80/barrel price is the result of production lost to sabotage and corruption, and the Iraqi industry's inability to restore production to pre-war levels, along with the risk the war represents to the broader producing region across the Middle East. But in the long run, it is the delay in developing Iraq's enormous untapped reserves that matters most. Few countries have the potential to double or triple their current production, and as long as global oil demand continues to grow, incremental output from the few places with both the resources and the willingness to provide access to them is essential. That won't happen without the appropriate national and provincial legal framework--even if oil revenue is being shared equitably on an ad hoc basis, as Ambassador Crocker indicated--and certainly not until the violence has subsided to the point at which international geoscientists and engineers can work there safely. Hunt Oil's recently-announced agreement in the Kurdish north of Iraq is a special case, rather than a signpost, even if it stands up to scrutiny.

Many analogies have been drawn between the Vietnam War and Iraq, but the one that seems most relevant lately has both positive and ominous overtones. When General Creighton Abrams replaced William Westmoreland as commander of US forces in Vietnam in 1968, he altered the failed strategy of his predecessor and replaced unwarranted optimism with pragmatism. Unfortunately, although his new strategy largely succeeded on the ground, it came too late to redeem the war in the eyes of the media, public and politicians back home. Too much American blood and treasure had been spent learning what didn't work. In many ways General Petraeus looks like the General Abrams of this war, at a point when the country's patience has worn similarly thin.

The possible outcomes in Iraq, however, look very different from any Vietnam comparison, for energy if for nothing else. If Iraq collapses after we leave, and its 1.6 million barrel per day oil exports cease, $80 oil will look cheap. If it stabilizes, reconciles its "ethnosectarian" groupings, and starts to develop new oil fields, prices could start dropping, and no one can say for sure where they'd land. And if Iraq became a satellite of an expansionist Iran, all bets would be off, and the current "risk premium" on oil could expand even further. Whatever this Administration, the Congress and all the presidential candidates imagine about the ultimate end of the Iraq War, they cannot lose sight of its enormous energy implications.

Wednesday, September 12, 2007

The Flip Side

Yesterday's New York Times examined an aspect of global warming that doesn't get much attention: adaptation. Planning for adaptation is taboo in some circles, because it implies that it might be better to learn to live with climate change than to take steps to avert it. Mr. Tierney's article about the views of the controversial Danish environmental economist Bjorn Lomborg raises some interesting points for consideration, while contributing to the sense of futility attached to much of the adaptation discussion. That's a pity, because I view adaptation as an essential component of a rational global strategy to deal with climate change.

Consider Dr. Lomborg's ideas about rising sea level and coastal development. Citing the example of the minimal impact of past sea-level increases on rich countries like the US, he suggests we would do better to increase global wealth and limit coastal development, rather than investing heavily to reduce greenhouse gas emissions, in order to slow the rise in sea level from global warming. While there's some merit to this argument, I don't see it in the same either/or terms he does.

If an increase of a foot or two in sea level were the worst potential outcome of climate change, then it probably wouldn't be worth expending enormous efforts preventing it, instead of planning to adapt to a world with a bit less shoreline. But that presumes we can predict those results accurately, instead of facing enormous uncertainties, due to intricate feedback mechanisms involving ice, water and cloud cover. Sea level could go up by inches or meters, along with a wide range of other global warming impacts affecting agriculture, biodiversity, and human health.

However, if we took some of Dr. Lomborg's ideas as being additive, rather than alternative to the measures necessary to mitigate climate change, then we might have something useful. Reducing our emissions sufficiently to avert the worst consequences of global warming will be quite challenging. We are likely to see further warming and some adverse consequences, despite our best efforts. In that case, taking reasonable steps to prepare for a world that includes some of those outcomes--such as higher sea levels--looks smart, rather than defeatist.

So let's imagine that the Congress passed strong measures to reduce US emissions along the lines currently being debated, and that the President signed them into law. That would suggest not only a scientific consensus on climate change, but a political consensus that it represents a high-priority problem for us and the world. Might it then also make sense to begin a frank conversation about how prudent it is for millions of Americans to migrate to a state with a mean elevation above present sea level of only 100 feet? Census estimates show the population of Florida growing from 18 million today to 29 million by 2030. Even if you dismiss the computer animations that show Florida going underwater within a century or so, putting that many extra people, their homes and other property at future risk from climate change doesn't make much sense, particularly if the US government ends up as the insurer of last resort for most of these folks. The alternative might require seawalls on an unimaginable scale.

The politics of this look terrible, of course. Florida has been a key state in the last couple presidential elections, and both parties see it as pivotal to their future chances. Which candidate would be first in line to suggest that Florida shouldn't grow so rapidly? Perhaps adaptation isn't the easy way out, after all. But easy or not, this is only one example of how we cannot argue that climate change is an enormous problem demanding urgent action, while simultaneously promoting actions that will compound the impact of its foreseeable consequences. In that sense, mitigation and adaptation are two sides of the same coin.

Tuesday, September 11, 2007

Practical Energy Security

Since 9/11/01 many of us have accepted the notion that energy security matters, and that it is risky for the US to rely on unstable countries and regions for large portions of our energy supplies. However, most of our preferred responses to that situation seem to be long-term in nature. Nor have we asked the large domestic oil & gas industry for help in shoring up our energy security in the meantime; if anything, we appear more interested in penalizing it for the profits created by high energy prices. But while stricter vehicle fuel economy standards and renewable fuel and electricity standards will take years to affect our dependence on OPEC, there's something that the oil industry could do quickly that would improve our energy security in the meantime, and it has to do with inventories.

US policies on strategic petroleum inventories--epitomized by the Strategic Petroleum Reserve--were set decades ago when the country had ample refining capacity and was not a consistent net importer of petroleum products. Storing up emergency supplies of crude oil seemed sufficient to our anticipated needs. Now, US refineries run close to capacity, and we import on average 1.5 million barrels per day of gasoline, diesel and jet fuel--imports we may not be able to rely on in a crisis. That makes product inventories the critical cushion between a disruption and widespread runouts, as we saw after Hurricane Katrina. But even after adding in the uncounted ethanol inventories I mentioned last week (9/5), US gasoline inventories from 2002 to the present have consistently averaged lower than they did in 2001, in terms of the number of days of supply they represent. That hardly seems prudent for a nation facing the possibility of another major terrorist attack, particularly if it involved our energy infrastructure.

Why have commercial gasoline inventories failed to keep up with growing demand? It has everything to do with the way inventories are treated for accounting and tax purposes. As long as companies see petroleum product inventories tying up capital, attracting taxes, and dragging down their return on capital employed statistics, they have no incentive to increase them beyond the bare minimum necessary for normal operations, let alone building a permanent buffer against a future supply shock or terrorist attack; quite the contrary.

So how could we remedy the situation? I see three possible solutions:
  1. We could create a federal strategic gasoline reserve, along the lines of the crude oil SPR.

  2. We could do what many European countries and other members of the International Energy Agency's emergency stocks program do: impose minimum compulsory stocks levels on the industry, set at a level to ensure some arbitrary number of days' supply on hand, typically between 60 and 90 days.

  3. We could eliminate the disincentives for companies to hold extra inventory. That would require the government to create special rules for inventory accounting and taxes, to render them neutral to the bottom line.

Of these options, the third makes the most sense to me. For all their perceived utility in a crisis, government-held strategic reserves create significant disincentives for holding commercial inventories, as I've discussed previously for the existing SPR. And the logistics of a federal gasoline SPR in a market made up of dozens of gasoline grades and environmentally-mandated formulations look extremely daunting. The second and third options share the virtue of maintaining dispersed inventories close to the point of demand, where it would be most useful in extremis. But requiring large compulsory stocks merely shifts a national strategic burden onto the backs of private companies, from which it would ultimately be passed to consumers. The third option would address the need for higher inventories at the least cost to consumers and taxpayers.

But let's be clear: the industry isn't asking for help on this, and as best I can tell they aren't remotely interested in pursuing it, at a time when there has been so much outcry over the industry-friendly provisions of the Energy Policy Act of 2005. The current Congress isn't motivated to do anything that might be interpreted as corporate welfare for a highly profitable industry. However, if we're serious about our desire to make the US more secure, including in energy terms, it's time to set aside our prejudices against this industry and begin to harness its capabilities, at least in this small way. The alternative is muddling along with the bare minimum of gasoline inventories, until some event exposes the folly of such a policy in the post-9/11 world, or until a recession punctures demand.

Monday, September 10, 2007

Ethanol Diversification

The lead story of today's Wall Street Journal concerns the efforts of international commodity firms, including US companies such as ADM, Cargill and Bunge, to break into the Brazilian sugar cane ethanol market. On one level, this reflects the growing globalization of the ethanol business, as more countries look for alternatives to petroleum products. Deeper strategic issues are at work, as well, involving the need for these companies to reduce their dependence on high-cost supplies of corn ethanol, in anticipation of new competition from cellulosic ethanol within a few years. Brazil's potential as a low-cost supplier of ethanol has been recognized for along time; what's new is the apparent international bidding war to participate in this bounty.

Last week I ran across an academic paper arguing that the energy balance of ethanol was irrelevant. Aside from the errors in the author's conclusions about oil displacement, his suggestion of framing the balance in economic, rather than energy terms has merit. He argued that the market values different forms of energy differently. While that is certainly correct, it underlines the challenges facing a fuel requiring energy inputs that nearly equal its ultimate delivered energy content; corn ethanol can never be as cheap as ethanol from sources requiring fewer costly inputs. That's the essence of the appeal of ethanol derived from sugar cane grown in the tropics, instead of corn from the northern temperate zone. It's also the promise represented by cellulosic ethanol, which will be produced from agricultural waste and non-food crops requiring minimal fertilizer.

So if the bulk of your company's energy portfolio is tied up in something that, in spite of federal and state subsidies and a mandatory renewable fuel standard, looks like the high-cost supply in the long term, what do you do? You seek to diversify, of course. It's a little early to buy into cellulosic ethanol, because there are so many competing technologies and no industrial -scale facilities, yet. But cane ethanol is here, now, and it's been industrial-scale in Brazil for decades. The biggest risk is paying too much for the assets.

At the same time, US corn growers ought to be watching these moves closely. They should regard cane ethanol as a tough competitor, even if they succeed at preserving both the domestic ethanol blenders' credit and the tariff on imported ethanol. While pending Congressional energy legislation may expand their future market significantly, rising corn prices and the advent of cellulosic ethanol are putting the big ethanol firms under a lot of pressure to diversify and reduce costs, at the same time that the competition between food and fuel uses of corn is becoming more apparent. A future drop in oil prices would compound these problems.

The Journal does a good job on most of these issues, but their effort to put Brazilian ethanol in perspective is off by a wide margin. They compare its 9.5 billion gallon per year (BGY) potential output to crude oil from the Alaskan North Slope (ANS.) That doesn't even work using current ANS production, on the back end of its long, steady decline. 9.5 BGY equates to about 435,000 barrels per day (bdp) of oil, after adjusting for ethanol's lower volumetric energy content. That's nothing to sneeze at, but if the Journal's readers construed it as comparing favorably to the North Slope in its prime, they'd be sadly mistaken. ANS production peaked at over 2 million barrels per day in 1988 and yielded more than 1 million bpd for 26 consecutive years, starting in 1978. It still delivers roughly 800,000 bpd, or about 15% of total US crude oil production.

Even if Brazilian ethanol isn't quite another North Slope or North Sea, energy-wise, it will be an important part of a global energy market in which renewable fuels from many sources play an increasingly important role. And as the market for ethanol and other biofuels globalizes, the domestic market will shift, too. The ethanol commodity firms appear to see that, and the corn-belt states and their farmers should, too. The ethanol business is about to change, and not all the changes will be positive for corn.

Friday, September 07, 2007

Black Taxis and Global Dimming

When I recall the two years I spent working in central London in the late 1980s, my memories frequently involve traveling in one of the city's ubiquitous "black taxis" or wonderful old Routemaster buses. All of these conveyances were powered by diesel engines that contributed greatly to the incredible levels of soot I encountered. Now I see that one of the largest London taxi operators is switching to a 30% biodiesel blend that should provide a welcome reduction in particulates and other emissions. In a bizarre twist, however, reducing this pollution might have negative consequences for the entire planet.

If you don't live in a city in which particulate matter pollution (PM) is prevalent, you can't fully appreciate the benefits of reducing it. I'll never forget how shocked I was the first time the cleaners came around our Knightsbridge trading room, which overlooked a very busy street, to wipe off the phones, computer screens and keyboards. How quaint, I thought, until I saw how quickly the accumulated soot turned their rags black. For the next two years, I worried more about the state of my lungs than I ever had in L.A.

Improvements in diesel fuel quality and the retirement of the Routemaster buses, with their smoky old engines, have already made a noticeable difference in London's air pollution since then. But fuel desulfurization is a game of diminishing returns; today's ultra-low sulfur diesel fuel has already lost 98% of the particle-promoting sulfur that it contained in the late 1980s, and by 2009 new regulations will cut UK diesel sulfur levels by a further factor of five, getting as close to zero as practical. This is where biodiesel comes in. It provides environmental benefits beyond a simple dilution effect: biodiesel blends burn more cleanly than you would expect from just looking at the proportions of fuel involved. Among other things it reduces diesel soot. So this looks like a sensible way to make a highly-congested major city's public transportation even healthier and more attractive.

But when we zoom out from the local level, we find that these same particles that were fouling the air in London and other cities have also been affecting the global climate. This week's episode of PBS's NOVA science program focused on a key aspect of this, "Global Dimming." It describes how the small particles created when we burn fossil fuels, especially those high in sulfur, reflect sunlight both directly and through the formation of more reflective clouds. Scientists have known about this effect for years, but as NOVA explains, its full impact on attenuating sunlight globally has only recently been confirmed by the scientific community and by satellite measurements. Not only has this global dimming apparently altered rainfall patterns in some parts of the world, but it may well be offsetting a sizable fraction of the warming effect associated with carbon dioxide and other greenhouse gases.

In other words, a form of pollution that we've generally assumed to be mostly localized turns out to have been having global consequences, both adverse and beneficial, for decades. Moreover, its elimination, while certainly improving local air quality and mitigating downwind dimming, may accelerate global warming, perhaps dangerously so. If the interactions between these phenomena are validated, then we may need to rethink our approach to a wide range of energy and environmental issues. That's more than I can tackle in one blog posting.

Meanwhile, what about efforts to clean up London's taxis? Should they go on hold, while we sort out all the ramifications of global warming vs. particulate-related cooling? At least in this case probably not, because biodiesel addresses both problems; while it reduces particulate pollution, it also reduces greenhouse gas emissions. On the face of it, that sounds better than squeezing ever harder on the sulfur content of petroleum products, which reduces particulates but also increases greenhouse gas emissions from the energy and hydrogen consumed in the process. We will likely hear a lot more about these conflicting effects in the future. Stay tuned.

Thursday, September 06, 2007

Sage Advice on Climate

Yesterday's Washington Post op-ed on climate change by former Secretary of State George P. Shultz is notable for its approach to reconciling the competing interests of developed and developing countries with regard to greenhouse gas emissions, past, present and future. This is one of the thorniest problems in the diplomacy of climate change, and quite possibly the biggest roadblock impeding an accord to replace the Kyoto Protocol. Secretary Shultz describing the key principles and learnings from the Montreal Protocol for dealing with ozone-depleting chemicals, and suggests that they ought to be applied to climate change. He also offers practical advice to the negotiators. From source and substance, these ideas deserve wide attention.

In the last few years, the simple picture of the US as the world's largest emitter of greenhouse gases (GHGs) has been complicated by the emergence of large emitters in the developing world, notably China, which by some estimates has already surpassed our current output of the main gases contributing to global warming. GHGs from big developing countries are growing at a much faster rate than in the US or EU, as these countries build infrastructure and pass through more energy-intensive economic stages, while relying on carbon-intensive primary energy endowments. Of course the comparison looks quite different in per-capita terms, with China and India lagging US emissions/person by a wide margin. Throw in the wide disparity in historical emissions and you have all the ingredients for a classic deadlock of competing perceptions.

This issue is important for the US and our participation in a global climate-change agreement for several reasons. While some Americans see an inherent equity in allowing developing countries the same chance to develop that we had, others, including economists, politicians and policy makers, recognize that an agreement that constrains the emissions of the G8 or OECD countries without capping those from China, India, Brazil, etc. will merely postpone the consequences of climate change by a few years, at best. And with a significant proportion of China's emissions attributable to products exported to the US, the problem crosses into the realm of trade, industrial and labor policies. Perhaps as importantly, the unwillingness of these countries to approach climate change on the basis of the absolute cuts in emissions required of the developed world creates convenient cover for a wide range of other objections.

That's why I think Mr. Shultz's message is important and timely. Here is a key figure of an administration with impeccable conservative credentials pointing out the need for an agreement covering essentially all of the world's man-made greenhouse gas emissions, and suggesting that it must be structured in a way that takes into account the widely varying national priorities and capabilities of the parties.

I don't get the impression he thinks this will be easy. The appropriate handling of intellectual property alone could would require intensive and far-reaching negotiations, as Mr. Shultz of all people certainly realizes. But he does seem to imply that any approach to a global agreement on greenhouse gases that ignores these principles will be difficult or impossible. That doesn't mean abandoning our concerns about the competitive advantages that would accrue from a treaty that doesn't treat every country exactly the same, but it does mean negotiating in good faith, with enough leeway to build the kind of compromises necessary to bring China, India and other developing countries into the process as full participants. Mr. Shultz's advice might also provide a useful basis for a pragmatic environmental platform for the eventual Republican Presidential nominee.

Wednesday, September 05, 2007

The Missing Inventory

While I was on vacation, a potentially important energy threshold was reached without much media attention, outside of Robert Rapier's energy blog. As gasoline prices declined steadily for the last month, except in the Midwest, gasoline inventories were dropping, too. Last week, for the first time since at least 1991, they fell to a level equivalent to twenty days' supply at current consumption rates. That ought to signal that gas prices will soon head back up, even though we're now past the traditional end of the peak driving season. However, a key factor is missing from these figures. Ethanol may only amount to 3.5% of our gasoline consumption, but its volume is growing large enough to affect our view of traditional industry statistics.

The energy industry produces a bewildering variety of data, but analysts pay particular attention to crude oil and refined product inventories, because they reflect the outcomes of the interaction of all current supply and demand factors. When inventories fall, prices generally rise, and vice versa. We certainly saw that earlier this year, when gasoline inventories dropped by 15% from the end of January to end-April, and retail gasoline prices rose by 35% in response. Something unusual has been affecting these inventories throughout the entire 2007 driving season. Total US gasoline inventories have remained below their seasonal-average range since March. While this is partly due to refining problems in the Midwest, inventories have been quite low on the East Coast and Gulf Coast, too. Something else is at work.

The chart below, taken from last week's edition of the DOE's This Week in Petroleum, expresses these inventories in terms of the equivalent number of days of gasoline consumption. This provides an even more focused view of inventories, because it takes the current level of demand into account. It shows that days' supply normally ranges between 21.5 and 25 days, with a strong seasonal pattern. When the EIA reports that this measure has fallen to 20 days for the first time since they've been monitoring it, we should take notice and possibly worry. In fact, the curve for this year's data is consistently 0.5-1 day below that for 2006. Besides refining problems, what else could explain this shift? I think ethanol provides at least part of the answer.

Consider how the growth of ethanol blending has changed the gasoline business, driven by a combination of gasoline reformulation, the phaseout of MTBE, and the introduction of a national renewable fuel standard. Since gasoline containing ethanol can't be transported in pipelines, refiners must produce a pre-ethanol blend for shipment, to which ethanol is added at distribution terminals close to the point of sale. In just the last two years, the share of total gasoline inventories made up of this "RBOB" pre-blend has increased from 10.7% to 20.2%, reflecting the rapid increase in ethanol production. But while RBOB is counted in gasoline inventory, the ethanol required to turn it into merchantable gasoline isn't. That means that EIA inventory data is missing at least 2% of the volume that will end up in total gasoline sales, the equivalent of 4 million barrels, or nearly a half-day's supply at the national level. A quick look at ethanol inventories, which stood at nearly 9 million barrels in April, validates this logic.

In other words, when we add in the ethanol held in storage for blending into gasoline that's also in storage, we find a volume sufficient to eliminate most of the days'-supply gap between the 2006 and 2007 data. Before we relax too much, however, we should recognize that even 21 days of gasoline inventory represents a pretty slim cushion, relative to typical historical levels. And if most of that uncounted ethanol is sitting in rail cars or in places where it far exceeds the 10% limit for blending into gasoline, rather than E-85, then it wouldn't do much good in a pinch--such as after another big Gulf Coast hurricane. But what seems pretty clear is that, as our reliance on ethanol grows, our use of inventory and other industry benchmarks must adjust to the reality of a non-petroleum blending component significant enough to distort the old patterns.

Tuesday, September 04, 2007

The Energy Diet

An article I read over the long weekend got me thinking about how we talk about energy supply and demand, particularly when we're looking at alternatives to current sources and usage patterns. In an editorial in the July issue of Chemical Engineering Progress, the journal of the American Institute of Chemical Engineers, the editor referred to efforts to "find the right 'energy diet'." I'm sure I've seen that phrase a million times before, but for some reason this time it struck me as particularly apt for addressing the energy and environmental problems we face today.

Generally, I've tried to frame competing energy alternatives in terms of how they might fit into our future energy mix. That often prompts questions about which current component of the mix would give up market share to the newcomer, as oil effectively yielded to nuclear power in the 1970s and 80s. But as accurate as it is, the terminology of "energy mix" lacks something in the context of our concerns about climate change and energy security. In particular, it is neutral about the size of the total energy pie, when its size ought to be as much of an issue as its makeup. "Energy diet" connotes something quite different: not only the notion of balance among the various components, but the idea that there might be an optimal quantity of energy for an entity of a given size.

If we talked more about a national or global energy diet, it would be harder to dodge the need for conservation and efficiency, to address the large quantities of energy we now waste. It could also remind us that not all calories--BTUs or kW-hours--are equal, in a world that is increasingly worried about greenhouse gas emissions. High-carbon energy sources such as coal might come to be seen as analogous to cholesterol-promoting foods or trans-fats. Renewables such as wind, solar and biofuels then start to look like fruits and vegetables: healthy components of a balanced diet, but not enough to live on, by themselves.

I don't want to belabor this point, except to say that the way we frame these issues is important. Terminology matters, whether it's the aide of a Congressional leader referring to coal power plants "destroying the air", or proposals to subsidize renewable energy sources by penalizing fossil fuels in the name of "energy independence." All-or-nothing tactics seem unlikely to deliver an energy mix that promotes economic growth while minimizing greenhouse and other emissions. Debating the national energy diet--how much of which kinds of energy we should consume--just might.