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Monday, June 30, 2008
The Anti-Manhattan Project
Sometimes it's good to pause and reflect, rather than blurting out one's first reaction to a news item such as this. If I had written a posting about this story on Friday, it would have probably turned into a rant against bureaucracy, when in truth the folks at BLM are just doing their jobs within the charter they've been given--and with considerable encouragement from mainstream environmental groups that are concerned about the impact of large-scale development on the desert southwest, a region for which I have a particular fondness. But that does not make this decision any less myopic, viewed in the larger context of the necessity to construct large-scale clean-energy alternatives, in order to make the transition away from our multiply-unsustainable reliance on fossil fuels. In particular, utility-scale solar thermal power represents an especially promising pathway for delivering predictable quantities of electrical power into existing power grids, as an alternative to coal-fired power plants. The states included in the ban possess the country's most promising solar resources.
Over the last several years, as energy prices mounted, pundits and politicians regularly issued calls for a new Manhattan or Apollo Project approach to solve our energy problems. I'm not convinced, however, that we need another massive, centrally-directed research effort. R&D must certainly play a role, as evidenced by the DOE's recent feasibility scenario for expanding wind power to supply 20% of US electricity. Technology has been developing at an impressive rate for a variety of options, with help from growing infusions of capital from the private sector, and these efforts should be supported. But without consistent policy at the federal level, and in the absence of a fast track to implementation, to enable projects based on these technologies to be built by the gigawatt, we will be left with the current set of unappealing trade-offs between economic growth, energy imports, and global environmental impact for many years longer than necessary.
Instead of a new Manhattan Project for energy, I wonder if we should revive the old position of "energy czar" and endow it with enough authority to coordinate and streamline the federal response to our conjoined energy-and-environment crisis. The reorganization of the national intelligence community along these lines may have delivered mixed results so far, but while energy is as complex as intelligence, it is surely less ambiguous and subjective. Even a czar who could merely remind agencies such as the BLM that our problems are too urgent to take a two-year time-out would serve a useful purpose.
Friday, June 27, 2008
The Baby and the Bath
There's no shortage of conflicting opinions on this topic. A number of academics and financial experts have dismissed the possibility that speculation in oil futures could have much influence on the price of the physical commodity, pointing instead to the very real contribution of rapid demand growth in the developing world, slower production growth, particularly among non-OPEC producers, and the disappearance of global spare production capacity. Others have highlighted the recent and substantial flow of funds into the market from a new class of commodity investors, including pension funds and other institutions. They spot a cause-and-effect relationship in the accompanying rise in oil prices and find worrying parallels to the high-tech and housing bubbles. For my own part, I worry about the systematic linkages between the impact of this additional demand on futures prices and the mechanisms by which the price of oil purchased by refineries is set. But while I see a connection between speculation and higher fuel prices, I am skeptical of attempts to quantify it.
My background gives me a unique vantage point on this debate. After my graduate training in business and economics, I acquired a hands-on education in markets during a decade spent trading energy commodities for Texaco, Inc. This included a two-year stint trading international petroleum products from London, involving extensive dealings with our futures trading group and external floor broker. When I returned to Los Angeles, I was responsible for managing the commodity risk profile of the company's West Coast refining and marketing operations. Although this experience wasn't recent, I have no conflicts of interest in this area that would constrain my objectivity about the various proposals for regulating oil market speculation.
Some of the recent suggestions for regulating energy futures and derivatives trading might do more good than harm. This includes raising margin requirements, which might decrease liquidity, but also ought to reduce volatility by deterring investors from putting on enormous positions in hopes of turning small per-unit margins into huge aggregate gains, a strategy that hedge funds have employed in many markets. Shrinking volatility would be bad for traders, who thrive on it, but good for the economy. Closing the so-called "Enron Loophole" probably falls into a similar category of positive benefit vs. cost.
Other ideas seem likely to do much more harm to non-financial firms seeking to manage their business risks. For example, one of Senator Obama's recent anti-speculation proposals would force all energy commodities to trade on regulated exchanges. If this shut down the over-the-counter "swap" transactions that are used to bridge the price gaps between the small selection of crude and products traded on the NYMEX and the actual grades that companies buy and sell, it would make it much harder for businesses to hedge their risks. Airlines come to mind, here. Because there is no futures contract for jet fuel, an airline hedging its fuel supplies by buying crude oil or heating oil futures/options often also executes a swap covering the difference in price between jet and crude or jet and diesel. Otherwise, it runs the risk that when it purchase its jet fuel later, the hedge will have only appreciated by a fraction of the increase in the price of the physical product, or worse yet, might have lost money, while jet fuel prices continued to climb due to local or global scarcity. But as important as this transaction has become to airlines, it seems unlikely to generate the scale and liquidity required to merit launching an exchange-traded futures contract to cover it.
An even worse notion making the rounds on Capitol Hill would require anyone buying a futures contract to take physical delivery of the oil or product. As sensible as this might sound to the public, it would be catastrophic for the market and for the vast majority of participants, large and small, who use these markets to manage the enormous price risks associated with real-world energy activities. Even the small minority of players who rely on the NYMEX for physical supply in the New York Harbor would suffer, as liquidity for these contracts dried up. Consumers used to buying heating oil at a fixed-price for the season or year would probably lose this option, as all but the largest suppliers would be unable to offer this service.
Even the basic principle of limiting futures market activity to entities that produce or consume oil or its products is fundamentally flawed. On any given day, the producers and end-users wouldn't be active enough to make a real, liquid market. I experienced this first hand trading refined products on the West Coast. Top management preferred us to deal mainly with other oil companies, but when our own output fell short, the other refiners weren't always in the mood to sell. Without being able to buy from risk-taking independent traders who had previously taken a bet on the market, we would have run out of product on many occasions, and consumers would ultimately have been harmed.
Speculation plays an important role in lubricating the wheels of commerce, although it may also be contributing to higher oil prices, as investors increasingly turn to these markets as an inflation hedge or as another long-term asset class. My advice to Congress is to err on the side of caution in regulating energy commodity trading, and to specify very precisely which activities they want to rein in, rather than designing indirect and intricate rules that would ultimately entangle many participants that are essential to the efficient functioning of these markets. If Congress disrupted the entire energy market, just to constrain speculation by pension funds and other portfolio investors, the resulting chaos would hardly benefit consumers.
Wednesday, June 25, 2008
Perception vs. Reality
In the course of an hour-long conversation, Mr. Johnson filled in some of the gaps in my knowledge on the efforts to make internal combustion engines more energy efficient, while reducing their environmental impact, in terms of both local and global emissions. I've written periodically about the rapid penetration of the European car market by high-performance diesel engines, and I was interested in Bosch's perspective on their potential market here. The company sees its new technology enabling diesels to capture 15% of the US new-car market by 2015. That forecast, however, predates the recent dramatic shift in the price of diesel fuel relative to gasoline. Although even at these prices, diesel still delivers better miles per dollar, seeing ultra low sulfur diesel average more than 50 cents per gallon above unleaded regular, year-to-date, must reduce some of the attraction for consumers that were accustomed to diesel selling at a discount to gas.
In addition, it appears that the arrival of this wave of advanced diesels, including new models from VW and BMW later this year, won't necessarily create the vast market that US biodiesel producers have been waiting for. Mr. Johnson stressed that while these vehicles should run well on blends containing 5% biodiesel (B5), higher proportions of first-generation biodiesel (FAME) would interfere with the engine and exhaust technology that enables these cars to meet tailpipe standards in all 50 states. Biodiesel derived from biomass-to-liquids technology, on the other hand, ought to be fully compatible.
During the course of our chat, I got a sense of the seismic shift underway in the global car business. As auto companies see their customers demanding higher efficiency and lower emissions, the suppliers on which they rely for many of the systems that go into their cars are gearing up to facilitate this. Bosch is branching out into lithium-ion batteries and other aspects of vehicle electrification, while also working on further improvements to the efficiency of diesel engines, partly in response to aggressive European targets for greenhouse gas emissions from vehicles, which look especially challenging for the German car manufacturers. Diesel's efficiency advantage over conventional gasoline engines could increase from about 30% to roughly 40%. Nor are these the only fuel economy tricks in Bosch's kit-bag--hardly surprising for a company that spends 10% of revenue on R&D. I learned about a cheap software/hardware patch to modify the way conventional cars recharge their batteries, saving around 2% of fuel. There's also stop/start technology, sometimes referred to as a "mild hybrid", and gasoline direct injection, which offers diesel-like fuel economy gains.
As promising as all this technology is, I can't help wondering whether consumers will regard it as passé in a world increasingly focused on not just using less oil, but getting off oil entirely. Plug-in hybrids, electric vehicles and fuel cells all seem to offer zero-oil/zero-emission options, even if their ultimate energy sources render them a good deal less green than they appear, at least for now. When I put this to him, Mr. Johnson seemed confident that reality would beat perception, particularly when consumers compared the actual costs and benefits. Bosch is pushing for a level playing field--"technology neutrality" in their parlance. The arithmetic of fuel economy, in which the first big increment of savings is worth more than all the rest, generally favors the lower-cost improvements that companies such as Bosch offer, at least for car owners who drive less than the national average. Of course, cars in this country have never just been about economics. Putting high-performance diesels in packages as sleek as the Audi R8 could go a long way to erase their image deficit. And as a potential buyer--though not this year--I find the ultra-cool Mini Clubman D (55 miles per US gallon but not slated for the US market, alas) as appealing as any current hybrid.
Monday, June 23, 2008
I see two visions competing for share of mind with regard to energy: one paints a future world in which clean energy is plentiful and cheap enough to support sustained global economic growth, while in the other the urgency of dealing with climate change forces us to kill off the hydrocarbon economy quickly and build a low-emissions energy future on its ashes. As convinced as I am that our energy plans must address climate change, I do not find the latter view very motivating or convincing. Nor do I think it would be terribly appealing to anyone who is dismayed by the relatively modest economic slowdown now playing out as a result of high energy prices and the fallout from the subprime crisis--a pale shadow of what a true oil crash would look like.
How close are alternatives to being able to replace fossil fuels? The progress that has been made in the last 30 years is certainly encouraging. For example, the cost of producing electricity from wind was once a large multiple of the cost of conventional power. That gap has shrunk so much that a 2 cent-per-kilowatt renewable electricity tax credit--which is still in jeopardy--appears to be the difference between profit and loss. But in order for renewables to make serious inroads into the market shares of power produced from coal and natural gas, wind and solar power must first reach a scale at which their annual capacity additions can cover the average annual growth of electricity demand. In the US, that figure has varied between 1-2%, which amounts to roughly an additional 60 billion kWh of net generation each year. That means that, at an average capacity factor of 30%, we would need to add 29,000 MW of wind, solar and other renewable electrical capacity per year. According to the American Wind Energy Association, installed US wind power capacity grew by 5,244 MW last year, and should grow by at least that much this year. Grid-connected solar is still much smaller, though growing somewhat faster than wind.
Turning to liquid fuels, although demand growth in the US has stalled for the time being, due to high prices and lower economic growth, covering 1% annual growth in liquid fuels also looks challenging. Although US corn ethanol volume increased by 1.7 billion gallons last year and was on a pace to add at least that much new output this year, prior to the Midwest flooding, after adjusting for its lower energy content this amounts to 0.8% of US gasoline demand and only 0.3% of our total petroleum demand. Covering the 1% annual growth that would be consistent with stronger economic growth and lower energy prices would require the energy equivalent of an incremental 5.5 billion gallons per year of ethanol each year, without accounting for the significant quantities of oil and natural gas consumed in producing this fuel.
Conservation and efficiency can and should help to decrease the height of these goalposts, and we see that in the apparent shrinkage of US gasoline demand, as consumers adjust to the reality of $4 fuel. But whether needed to cover normal historical growth in energy demand, or merely as an important milestone along the path toward actually eroding the market shares of oil and coal, it will take wind, solar and biofuels several more years of sustained high growth rates to attain that scale. And that will still be the case, even if changes in consumer preferences speed up the planned improvement in US new-car fuel economy and bring more plug-in and all-electric vehicles and efficient homes and appliances into the market. For a system this large, massive change cannot happen overnight.
All of this makes for an uncomfortable transition period, during which we will remain frustratingly reliant on sources of energy that we know emit unsustainable quantities of greenhouse gases into the atmosphere, while leaving us vulnerable to unstable foreign suppliers. Although I am optimistic about the potential of alternative energy sources and improved efficiency to alleviate both of these problems in the longer term, I remain pragmatic about how much can be done right now. However viscerally satisfying the prospect might seem to many people, we cannot yet turn our backs on the fossil fuels that supply 85% of our energy needs today. Doing so prematurely would align us with the path of perpetual energy scarcity, rather than long-term clean energy abundance, just as much as if we abandoned the alternative energy technologies that are only now starting to produce on a scale that really matters. It's a shame The Economist didn't tackle the subject of managing our expectations during the energy transition they described so ably.
Friday, June 20, 2008
Striking a Bargain
Wednesday's posting looked at how expanded drilling fits into our larger energy and environmental challenges and concluded that it can make positive contributions on both fronts, though it is hardly the entire solution. The feedback I received suggests that many people would be receptive to more drilling, if it weren't seen as a means for enabling a return to cheap oil and wasteful behavior. Expanding supply without addressing demand merely postpones tough choices, while ambitious planning for "energy independence" that constrains demand and boosts alternatives but leaves US oil production on a glide path to oblivion is doomed to failure. And as Mr. Pearlstein notes, a package combining "well-regulated drilling" with reductions in greenhouse gas emissions could benefit everyone.
The formula for a winning compromise isn't obvious. It could involve expanded drilling with royalties dedicated to funding alternative energy R&D, or it could go as far as linking economy-wide emissions cap & trade with carefully-monitored access to the Arctic National Wildlife Refuge and all federal waters beyond the 3-mile state limits. The best place to define it would be in a bi-partisan conference of the House and Senate. An election year might not seem well-suited for pursuing such sweeping legislation, but as I learned in my years of trading oil commodities, you can't always wait for the timing to be ideal. When conditions provide the right combination of motivated parties and market drivers, that's the time to strike. This could be just such a moment for sweeping energy/environmental legislation.
Wednesday, June 18, 2008
Mutually Inclusive Solutions
Start with the rampant misunderstandings about the way oil production works. How often have we heard that the US consumes a quarter of world oil but has less than 3% of global reserves? That's true, but it is equally true--and much more relevant--that the US produces 10% of the world's oil output (including natural gas liquids) and has produced a cumulative 200 billion barrels from "proved reserves" that never exceeded 40 billion barrels. Nor do assertions that the remaining US oil resources would only amount to a few years of consumption correspond to the way oil is actually extracted. Oil fields produce over an interval determined by geology and technology, not wishful thinking. New fields brought on line this year will operate for anywhere from 10-40 years, and our current output is the aggregation of hundreds of thousands of wells in thousands of oil fields, with half of total production and 2/3rds of our reserves coming from the top 100 fields, a fifth of which were discovered since 1990.
In order to make sensible plans, we must also factor in the relative contribution of new increments of supply from the various possible sources. For example, after accounting for the oil, natural gas and electricity that go into its production, an extra billion gallons per year of corn ethanol yields the net energy equivalent of only 14,000 barrels per day of oil--the amount we get from a single, highly-productive deepwater oil well. A 3.5 MW wind turbine delivers, on average, as much electricity as could be generated by 230,000 cubic feet per day of natural gas. It takes 300 such turbines to produce as much energy as the least productive of the top 100 US gas fields. Replacing the energy content of current US net imports of petroleum and natural gas would require the equivalent of an extra 837 billion gallons per year of ethanol and 55,000 large wind turbines. Cut these figures in half to account for the potential contribution of conservation and energy efficiency, and they are still overwhelming, without a substantial contribution from additional conventional energy supplies.
On the other side, proponents of expanded drilling access need to be clear about the uncertainties and time lags involved. No one can predict the exact quantity of economic oil reserves--even at the current $130/bbl--into which the current estimate of up to 85 billion barrels of untapped US oil would translate. Members of Congress are already complaining that companies aren't drilling all the prospects that have been opened up to them in the eastern Gulf of Mexico, no doubt reflecting the availability of drilling rigs and personnel, and the relative rankings of all of the undrilled inventories of the lease holders. Nor does an exploration program yield immediate production. If a new field is adjacent to existing infrastructure, it might be brought onstream in three or four years. But that's not relevant to the portions of the offshore that are currently off limits. If new pipelines are required, that raises the bar for what will be economic, and it could extend the time from discovery to first production by years. With regard to the areas currently under drilling bans, we are thus debating our energy mix in the middle of the next decade, not today, and it's not obvious how the futures market would react to a green light for expanded drilling. Near-term price relief at the pump could be essentially zero, unless a perceived wave of new US supplies in 2012-2016 was sufficient to dry up the speculation that has compounded the very real tightness in the current global supply/demand balance.
As for the repeated assertions that more drilling won't amount to a hill of beans, we should apply some critical thinking and common sense to forecasts suggesting that even large increments of future production, as from the Alaskan National Wildlife Refuge, would hardly cause a ripple in world oil markets. I wonder how many of the economists responsible for these estimates have ever traded a barrel of oil. With enough supplies from all new sources, including oil, gas, and biofuels, we could shift the market dynamic that has tilted so strong in OPEC's favor and bring oil prices down, even if only to create policy headroom for a cap & trade system or carbon tax to address climate change.
Nor are the environmental trade-offs in this discussion as simple as many advocates would have the public believe. The latest science casts doubts on the greenhouse gas benefits of biofuels versus conventional fuels, and conventional oil emits less CO2 from well to tailpipe than the large-scale default options of extracting hydrocarbons from oil sands, oil shale, or coal. Producing more oil in the US, where industry practices are more strictly regulated than in developing countries, would not create an environmental catastrophe--perhaps quite the opposite.
I'm encouraged that this subject is finally getting the attention it merits and requires, even if the quality of the debate still leaves something to be desired. If we accept that there are no simple and obvious solutions to the fix we're in, then we should be willing to engage in a rational debate without resorting to unflattering characterizations of opposing viewpoints--or of the people holding them. At the same time, nothing should be off the table simply because it offends someone's sensibilities or beliefs. The potential contribution of expanded US oil drilling should not be dismissed out of hand or without carefully considering the combination of alternatives that would be required to make up for its continued exclusion, or without a serious assessment of whether replacing all oil use is even our highest priority, when power generation accounts for 20% more of our greenhouse gas emissions than transportation. Energy security can no longer be divorced from climate policy, and it's going to take real creativity and cooperation founded on mutual respect to tackle both of these problems simultaneously, as we must.
Monday, June 16, 2008
Crush Spreads and the Price of Gasoline
Over the weekend I heard one reporter compare the flooding in Iowa to the aftermath of Hurricane Katrina, and it struck me that the impact on ethanol might be analogous to Katrina's on oil and gas production and refining output, though on a proportionally smaller scale. As a direct consequence of the floods, a significant fraction of Iowa's ethanol plants have been shut down. The impact on transportation systems has apparently been even more severe, with barge traffic stranded and a number of rail lines cut--thus restricting the means by which ethanol plants receive much of their feedstock and ship their product to market. These are short-term effects, similar to what happens when a refinery or pipeline problem disrupts gasoline deliveries. However, with total US ethanol inventories running at about 20 days of consumption prior to the flooding, a protracted outage could leave refiners and gasoline blenders short of ethanol for most of the summer, coinciding with peak gasoline demand.
The impact on ethanol production over the next year could also be significant, depending on how much of the corn crop has been lost. Compared to last year's 13 billion bushels, this year's corn crop was already predicted to be over a billion bushels smaller, even before the floods. With ethanol consumption mandated to increase from 6.8 billion gallons in 2007 to 9 billion gallons this year, ethanol's share of the smaller crop could rise dramatically, putting additional pressure on the price of corn and other agricultural products. That outcome is hardly pre-determined, though.
As I noted in a recent webcast (subscription required) on the US ethanol industry in which I participated with John S. Herold, Inc., ethanol output is driven by both economics and regulations. From a peak of nearly $3.00 per gallon, the "crush spread"--an indicator of ethanol plant margins derived from subtracting corn prices from ethanol rack prices--have recently fallen well below $1.00/gal. Based on Friday's CBOT July 2008 corn futures settlement at $7.07/bushel and ethanol at $2.799/gal., a crush spread of $0.28/gal. does not look sustainable. Ethanol prices must rise promptly, or ethanol output will fall, as higher-cost facilities are forced to shut down--or new plants delayed or canceled--pushing ethanol prices up later.
The knock-on effect on gasoline prices is harder to gauge, because of the uncertainties involved. In the best case, ethanol production might recover quickly and crush spreads rise by just enough to get ethanol plants back up to the 8.7 billion gal/year rate at which they were operating in March. Because gasoline contains no more than 10% ethanol, and with ethanol currently selling ex-distillery for as much as $0.50 per gallon less than the spot price of gasoline in the Gulf Coast before factoring in the $0.51/gal ethanol blenders' credit, the pump price of gasoline might go up by no more than a few pennies per gallon, or possibly not at all. But with several million acres of this year's crop already lost to the flooding, and the entire ethanol supply chain affected, including processing and distribution, that scenario seems wildly optimistic.
It is likelier that there simply won't be enough ethanol this year to meet the target of 9 billion gallons of combined production and imports set by the Energy Independence and Security Act of 2007. That goal looked like a stretch even before the floods, and the probable shortfall raises the odds that the EPA and states must ultimately agree to at least a portion of the ethanol blending waivers already requested by various states and municipalities, and preferably do so before the predictable ethanol supply crunch becomes a crisis. But even that won't be a panacea. With ethanol currently accounting for roughly 6% of the US gasoline pool, any shortfall must be made up by additional petroleum-based gasoline, which would come either from higher refinery runs--driving up crude imports and prices--or higher gasoline imports, in competition with demand from developing Asia. It seems ironic that an alternative energy program intended to make US energy supplies more secure might have the opposite effect, at least in the short run.
In a posting earlier this year concerning the food vs. fuel controversy, I suggested that our growing reliance on biofuels was introducing new linkages between two very complex, linked systems--food and energy. The results of these new interactions may surprise us, and one such surprise appears to be unfolding right now. That doesn't mean we shouldn't expand our use of biofuels, though there are ample reasons for caution with regard to food-based biofuels. But it does suggest that before we increase our reliance on these sources from 6% to the 20% or more contemplated by last year's Energy Bill, we need to learn much more about how this will work in the real world of floods, droughts, blights and all the other things that can impede the production of fuel from agricultural inputs.
Friday, June 13, 2008
Speculation And Crude Oil Differentials
The growth of the futures exchanges over the last two decades has fundamentally changed oil trading. Most oil is now bought and sold on price formulas pegged to the futures prices, or to published market reports strongly influenced by the futures. What traders are agreeing to when they do a deal is not a fixed price, but a fixed differential above or below a particular futures contract during a set period, usually aligned with the time when the shipment will be loaded or delivered. So while these differentials fluctuate due to a variety of factors, the price that refiners pay for crude oil remains directly tied to the futures price. That means that anything that drives up the futures market, whether a disruption in supply, higher demand, or speculation by a new class of commodity investors, has a direct impact on what we all pay for the products that refineries make.
As the FT correctly notes, various factors have contributed to make light sweet crudes more valuable and heavy sour crudes less valuable, relative to each other. By itself, though, this does not prove that speculation hasn't driven all of these prices higher than they otherwise would be, because refiners focus mainly on the price relationships among different grades of crude oil, and between crudes and the wholesale prices of the products they yield. Refining is a margin business. Higher absolute prices tend to weaken demand and make it harder to pass on increases in their costs, but refiners have no more control over the market price of oil at $130/bbl than they did at $50/bbl or even $20, so they focus on what they can control: in the short run that means finding the cheapest grades of crude that will yield the products they need to meet their sales commitments, and in the long term it involves investing to enable them to run even cheaper, lower-quality crudes, if increasingly intrusive regulators will allow it.
Source: Energy Information Agency
When we compare the acquisition prices reported by US refiners to the Energy Information Agency for the actual mix of imported and domestic crudes they bought through April 2008, we see that although the discounts to WTI have widened in the last year, they are not unprecedented. As a result, refiners are paying well over $100/bbl for even the least attractive crude oil grades.
Source: Energy Information Agency
On balance then, what does all this tell us about the influence of speculation on oil prices? In the view of the Financial Times and others, speculation is unlikely to be the major driver of high oil prices, since the prices for the physical crudes that refiners process have increased more or less in lock-step with the futures prices we observe, rather than disconnecting in the manner that might logically be expected, if the oil futures were experiencing a speculative bubble. However, I would argue that this hypothesis depends on an understanding of the oil markets that is at odds with the actual structure of the market. The manner in which physical oil is traded with reference to the futures price, combined with the reinforcing-loop relationship between crude oil and refined product prices, makes a disconnect between these markets improbable, even if the futures were caught up in a speculative bubble. That's not good news, because it suggests that we might not know whether we're in a bubble until it collapsed, either under its own weight, or through regulatory intervention.
Wednesday, June 11, 2008
Throw Out The Kitchen Sink
Although the current bill, the America-First Energy Act of 2008 (S.3044) contains an interesting proposal on commodity trading margin limits that might reduce some of the speculation that many believe is contributing to high oil prices, it also includes a windfall profits tax on oil, at the rate of 25% on "the excess of the adjusted taxable income of the applicable taxpayer for the taxable year over the reasonably inflated average profit for such taxable year." The latter curious notion is defined as, "an amount equal to the average of the adjusted taxable income of such taxpayer for taxable years beginning during the 2002-2006 taxable year period (determined without regard to the taxable year with the highest adjusted taxable income in such period) plus 10 percent of such average" but reduced by excess of "qualified investments of such applicable taxpayer for such taxable year" over an average from 2002-2006. Those "qualified investments" refer to wind, solar, biomass and a variety of other renewable energy technologies. This entire provision would only apply to any "major integrated oil company." In other words, any profits of ExxonMobil, Chevron, ConocoPhillips, or the US divisions of Shell and BP not reinvested in alternative energy would be subject to a 25% surtax, after paying income taxes at the full corporate rate.
Now, whether or not you believe that the profits of oil companies should be taxed at more than the effective 40% rate to which they are already subject, or that these companies should invest more in renewable energy, it should be painfully obvious that even if such a bill received a majority of votes in the Senate and House, it would promptly be vetoed by the President. Whatever other valuable provisions this bill may contain have been made hostage to a measure that would further handicap US oil companies that already operate at a disadvantage in the intense global competition for new resources now underway. The inclusion of this Poison Pill for partisan political purposes exemplifies the unseriousness of our present approach to energy policy.
The real solutions to our energy problems must be genuinely bi-partisan and endure from one administration to the next, much as our Cold War strategies did. This bill in its current form violates that principle. If its provisions are as sensible and beneficial for the American public as its sponsors apparently believe, then they should be willing to disentangle them and offer them up for separate votes, on their merits. That may not be the way things are usually done, but then perhaps this is the kind of change that voters consistently say they are seeking in this election cycle.
Note: My personal portfolio includes shares of one or more of the companies mentioned above.
Tuesday, June 10, 2008
The Price of Alternative Fuels
The article addressed the impact of high oil prices on US airlines, and its tone was appropriately sober. It mentioned the possibility of some relief on fuel prices from alternatives to oil-based jet fuel, citing the recent example of Virgin's "biojet" experiments and an initiative by Airbus to pursue alternative fuels derived from algae and other plants. The authors correctly cited the technical challenges involved in producing biofuels with the necessary combination of energy density and resistance to low temperatures, but then suggested that the cost of such biofuels might be "cheap enough for airlines to turn a profit." We've heard similarly attractive claims about a variety of alternative fuels, including cellulosic ethanol and liquid fuels from coal, and unfortunately they're all mistaken, or at least highly premature, based on the way the marketplace is likely to respond.
Imagine that you are running an airline with a sufficiently strong balance sheet to enter the alternative fuels business and make enough jet fuel substitute to supply your entire fleet, based on a process that is ready for full-scale production. Let's assume that this synthetic fuel matches all the specifications of ordinary Jet A, and it costs $2.00/gal. to produce, including all fixed and variable costs and a return on the investment meeting the firm's cost of capital. But should the facility transfer the biofuel to the airline operations division at cost, or at a market-based price? After all, if it meets all of the normal specs, you could sell it to one of your competitors at the jet fuel price, perhaps with a small discount because it is a new, less-tested product. There is more than just cost accounting at stake here, because this decision involves a real opportunity cost, and if operations received the fuel at cost, they might not focus as hard on efficiency as the airline's competitors.
We might convince ourselves that the airline's management would come up with a transfer price that gave their flight operations an advantage over their competitors, but not so low that this benefit would be squandered through inefficiency. But what happens in the likelier case that the airline can't afford to get into the fuel business, and must rely on someone else to build, own and operate the facility making the biofuel, selling it to them on an arms-length basis? Why would a third party sell to Airline X at $2, when Airline Y would pay more, perhaps even twice as much? The company producing the biofuels would naturally want to make as much profit for its investors or shareholders as possible, and in fact would have a fiduciary responsibility to seek the highest price for their output. The same would be true for alternative fuel manufacturers serving other market segments, such as motor vehicle fuel. While the cost of making alternative fuels will affect the survival and profitability of the producer, it won't determine the product's price in a market as competitive as the global transportation fuels market.
Of course that doesn't mean that the price of petroleum products would remain unaffected by the expanding output of biofuels and other alternatives. Even though ethanol still accounts for less than 6% of US gasoline sales, the price of gasoline is lower by an unknown amount than it would have been without this extra increment of supply. Bulk ethanol currently sells for less per gallon than gasoline, comparing the Chicago ethanol futures and New York gasoline futures prices. But that comparison changes when ethanol competes directly with gasoline at the service station. In May E85 at the pump averaged about 12% higher than unleaded regular, on an energy-equivalent basis. With the exception of those locations where it is priced at least 25% below gasoline, the price relief that ethanol is providing consumers occurs mainly as a result of swelling the overall gasoline pool by roughly 8 billion gallons per year.
Last year the US consumed just under 25 billion gallons of jet fuel, in a global market roughly three times that size, and essentially all of it came from crude oil. It's anyone's guess how much synthetic jet fuel from all sources would be required to drive down the price for that entire market by enough to make a difference in the economics of operating passenger jets, but it would certainly take more than a few facilities on the scale of current ethanol and biodiesel plants to do the trick. The minimum would probably be at least several billion gallons per year, on a par with the current US biodiesel capacity, or the entire output of one medium-sized oil refinery. As high a priority as it might be for airlines to find cost-effective alternatives to jet fuel produced from crude oil, I have to wonder how many of the current incumbents will survive long enough to see flightworthy biofuel arriving in sufficient quantities to help them.
Monday, June 09, 2008
After a long stretch in which the price of gasoline consistently lagged the rate of consumer price inflation, it is now leading the CPI higher along with food-price inflation, which also includes a significant energy-related component. In June 2006 the average retail price of gasoline was $2.85/gal. If it had only increased as fast as overall CPI inflation--ignoring its impact on same--we would now be paying $3.04/gal. That's about what the price would be if gasoline had inflated steadily with the CPI since 1981, when it averaged $1.38/gal. We're just beginning to see the adjustments consumers must make to accommodate this sudden shift in gasoline's share of household expenses, in the absence of ready cash from home-equity loans. If these conditions persist, we will eventually learn what they mean for the value of real estate in outer suburbs that benefited from the rise of long-distance commuting.
Whatever the contribution of speculation to high oil prices--the number one cocktail-party-and-dinner question I am asked, these days--or the role of the weakening dollar, we mustn't forget that oil wouldn't be an attractive investment for commodity speculators and dollar-hedgers without the ongoing collision between global constraints on expanding its output and the rapid growth of demand from the economies of Asia and the Middle East. It would be counterproductive at this point for our government to implement policies that resulted in further increases in demand or reduced supply. Gas tax relief at the pump or a windfall profits tax on oil companies might mollify consumers and voters, but they would ultimately make markets even tighter. So would any quick reversal of the apparent trend by consumers to keep less fuel in their gas tanks.
It might seem odd to look for good news in this situation, but compared to the late 1970s, things could be worse. Gasoline inventories are still at reasonable levels in terms of the number of days of supply they represent. As a result, the only gas lines we've seen were the result of consumers capitalizing on a lag in price increases at stations serving the New Jersey Turnpike. As painful as rationing supply by price has become in this case, it works better than price controls or odd-even refueling restrictions. That's worth remembering in this election year.
Friday, June 06, 2008
I've heard many statements and suggestions from both parties with regard to energy over the past year. While some of them clearly reflected objective analysis and sincere beliefs, others were easily discernible as calculated efforts to bolster a candidate's standing with the voters of his or her party, and possessed only a tenuous connection to what is realistic or even possible. As the campaign shifts into general election mode, it is time to stop discounting these assertions for partisan content and subject them to serious scrutiny. When it comes to energy, in particular, a dose of healthy skepticism is in order.
Take the drumbeat from both parties for energy independence, as an example. Even if we assume that this phrase is intended in a relative, rather than absolute sense--as in more energy independence--the chance of a dramatic shift within the next four years on this metric is slight. The scale of our energy imports is too great and the net contribution of our preferred options too small at this point to make much of a dent in the net 12 million barrels of petroleum and 12 billion cubic feet of natural gas we import every day. Even if every new car sold in America delivered an actual city/highway average of 30 miles per gallon starting tomorrow, in four years this would only improve the average fuel economy of our total fleet by 2 mpg, which might reduce imports by one million barrels per day, if it wasn't partially offset by a rebound in vehicle miles traveled. Doubling our ethanol output --an increasingly dicey proposition, given concerns about food vs. fuel competition--would displace the equivalent of another 300,000 barrels per day of oil. Doubling our current wind power capacity might save the equivalent of 1 billion cubic feet per day of natural gas.
After adding up all these contributions and even assuming that some form of cap and trade or carbon tax will eventually be enacted, it remains an absolute certainty that the 2012 presidential election will take place in the context of very large US energy imports. The next president would be wise to eschew the temptation of quick fixes and instead focus his efforts on promoting energy efficiency and ensuring that the nation has diverse and reliable supplies of conventional energy, as we undertake the long transition to a more sustainable energy mix. If he instead creates the expectation of an energy revolution, how satisfied would the public be with the steady accumulation of incremental progress that is probably the best we can hope for in the near term?
Thursday, June 05, 2008
Unlocking Demand Elasticity
I've been hearing about the problems in India from a friend and former colleague who grew up in India and spends part of the year there. Thus far, the government's "administered price" program has forced refiners, including the private and state-run oil companies, to absorb the impact of higher crude oil prices. The Journal estimates this cost at $5 billion for the current fiscal year. Although the government was ultimately going into debt over this policy, because it finances the refining companies' deficits with government bonds, raising prices to world levels appeared to be political suicide. Apparently American consumers aren't the only ones who feel entitled to cheap fuel. The consequences of this logjam were starting to mount, according to my friend. Companies were rationing dealers to the previous year's volumes, and several companies, including Reliance Petroleum and Essar, closed thousands of service stations, many of them new. The latest reduction of subsidies has pushed the gas price to the equivalent of over $4.00 per gallon, and the protests have begun.
Malaysia is in some respects an even more interesting situation, because unlike India, it is a net exporter of oil. Although its oil consumption is modest, in global terms, the government's decision to move retail prices closer to world levels could be influential with other producers, including Middle Eastern countries that have kept their domestic prices very low, and that have experienced an explosion of demand in recent years--in aggregate rivaling the growth of petroleum demand in China. A few years ago, Malaysia exported nearly twice as much oil as it does now, and the growth of domestic demand threatens to turn the country into a net importer within a few years, a shift that Indonesia has already experienced. There's a lesson here for those who think that energy independence and cheap energy are inherently synonymous, a lesson that the UK has already learned.
If we're looking for US diplomacy to have an impact on the price American consumers pay for gasoline, the elimination of market-distorting fuel subsidies around the world looks like a better target than exhorting oil producers to increase their output to drive prices down. It would also be more consistent with US policy in other areas, in contrast to our schizophrenic approach to oil drilling.
Tuesday, June 03, 2008
Questioning Cap & Trade
Long-time readers of this blog know that I have supported cap & trade since before starting Energy Outlook at the beginning of 2004, dating back to my corporate career at Texaco, Inc., where I served on the company's Climate Change Council. I didn't arrive at that view in a single step. Besides undergoing something of a conversion experience on the risks of climate change itself, I spent a lot of time contemplating the various ways to manage these emissions, based on my engineering and financial background and commercial experience. The path by which the Congress is attempting to arrive at cap & trade skips at least one key step, even once you accept that the science is settled--which some still regard a debatable proposition. In particular, where is the vital public discussion on how best to reduce emissions, and why cap & trade rises above the other options?
Consider the Wall Street Journal's lead editorial on May 27. The Journal's editors referred to the pending Climate Security Act of 2008 as "the most extensive government reorganization of the American economy since the 1930s." They aren't necessarily wrong about that. They went on to describe the pitfalls of cap & trade as a "hidden tax" on the economy, and presented some of the obstacles to achieving the bill's emission-reduction goals. Unfortunately, their entire argument appeared to assume that the alternative to cap & trade was to do nothing, or to remain on the current path of voluntary abatement. But if climate change is the threat that most scientists believe, that is surely not possible.
There are two primary options for reducing emissions, with important variations on each. One option would simply extend the kind of environmental mandates that have been used for traditional air and water pollutants to greenhouse gases. This could be done by sector, by industry, or by technology, and it could be as simple as telling every emitter of CO2 and other GHGs--including consumers and the government itself--to begin reducing their emissions by 2.5% per year starting in 2010, subject to verification of compliance and stiff fines. That would deliver roughly the same emissions reductions by mid-century as the Boxer-Lieberman-Warner bill, and it would be much simpler than cap & trade. This approach would be complementary with and reinforce the effect of current incentives for new, less-emitting technologies, such as biofuels and renewable power.
The other main option is to establish a price for emitted greenhouse gases, and then to let the marketplace adjust to the monetization of this formerly free externality. Most economists and business leaders prefer this over mandates, because it would foster greater innovation and allow the most efficient companies and sectors to profit and grow, while gradually reducing the size and importance of the less-efficient. The economy would be transformed in the direction of higher GDP, instead of just lower output. Cap & trade represents an even more market-oriented subset of this approach, because rather than setting the level of a carbon tax and hoping that it reduces emissions by at least the desired amount, it specifies the increment of reduction required and allows the market to set the CO2 price and drive it towards the lowest marginal cost. So rather than seeing cap & trade as a top-down, bureaucratic drag on the economy, it might better be viewed as the means for achieving the necessary cuts in greenhouse gas emissions at the least burden on the rest of the economy.
In the process of selling cap & trade, we should avoid promising the public that it could be implemented at little or no cost to them, even if it generates long-term savings and growth. Yesterday I had a long conversation with Deron Lovaas of the Natural Resources Defense Council on this issue. His organization's analysis suggests that by 2020 consumers would actually spend less on energy than they do now, as higher efficiency vehicles and devices proliferated, and domestic energy production increased. While I certainly see the potential for that, I also definitely expect higher fuel prices short-term, as a result of the higher operating costs that cap & trade would impose on refiners and on oil, gas and power producers. Until vehicle fleets and capital stock have time to turn over, that will raise consumer outlays on energy. Mr. Lovaas also highlighted another aspect of the legislation that would promote carbon capture and sequestration, which when used as part of enhanced oil recovery could bring oil prices down by reducing imports. By its nature this, too, would take time to bear fruit. All of these effects reflect the complexity of the economy with which we would be interfering, and we should expect unforeseen consequences, both good and bad.
It is unlikely that the bill currently being debated in the Senate this week will become law this year. This is the opening salvo--or really just the most recent round--in a longer process that should also feature prominently in this year's presidential campaign, particularly since the remaining major-party candidates all support some version of cap & trade. As we attempt to build a national consensus for this measure, we can't afford to leave the public in the dark concerning the rationale behind the crucial choice between mandates and market-based solutions, and the pros and cons of cap & trade versus a carbon tax.
Monday, June 02, 2008
Since my prior involvement with it in the late 1990s, the context for the development of SSP has changed radically. Energy prices have risen to levels that were virtually unimaginable in 2000, and concerns about climate change have evolved from a scientific investigation and environmental cause célèbre to a major policy issue. Less obviously but more dramatically, a transforming military engaged in two wars sees the potential of SSP to provide a better alternative for battlefield power than delivering generator fuel to forward bases by helicopter--a reality described vividly to the audience by Colonel Paul Damphousse of the National Space Security Office, who recently returned from a second tour in Iraq piloting Marine CH-53 transport helos.
But if the need for SSP seems greater today than it did a decade ago, the obstacles to making it a reality are no less daunting. The nation's Space Shuttle fleet has suffered another loss and is on the verge of retirement, and its planned replacement is years from deployment. The private-sector space ventures that were well-represented at ISDC hold significant promise, but they already have attractive markets for telecom satellites and "space tourism." Advances in photovoltaic conversion efficiency have reduced the size requirement for a solar power satellite, but the same technology makes ground-based solar more competitive. Perhaps the biggest challenge would come from the public's perception of the risks of beaming power from space to the earth in the form of microwaves. Would this be regarded as a benign cousin of ubiquitous radio transmissions, or morph NIMBY into Not In My Sky?
Whatever the practical considerations today, it was tremendously stimulating to be with a group of people who were looking ahead with optimism to a time when SSP and other space technologies would make a larger contribution to life on earth. I was particularly intrigued by an idea from a start-up called Heliosat Corporation to use SSP to develop America's abundant shale oil resources. This plan has apparently captured the interest of the Greater Houston Partnership, and of some of its oil and gas membership. Whatever the technical and economic merits of this application, the model of using relatively small amounts of power from space to leverage a larger ground-based energy source, or to supply a unique market, looks like the right focus for the immediately-foreseeable future. Whether the first demonstration project is beaming power to a Marine Expeditionary Unit in the field or to a remote oil project, no one will invest the kind of money necessary for SSP to make a serious dent in our global energy needs without first seeing the concept turned into tangible reality.