Wednesday, November 26, 2008

Artificial Carbon Cycle

Part of the research for my writing and consulting involves watching for trends or common themes, and one that I've been picking up from diverse sources reflects a growing skepticism about "clean coal" and the processes for capturing and sequestering carbon (CCS) that are central to it. To get a flavor for this, Google on "clean coal" and "oxymoron". Some of these concerns are grounded in the science of thermodynamics, while the balance seem to reflect the long-standing attitude of environmentalists toward the coal industry, which would be the primary beneficiary of a practical CCS scheme. It's worth taking a few minutes examining why CCS is unlikely to be easy, but why, if it can be done cost-effectively on an industrial scale, it would be so beneficial.

It helps to think about CCS in the context of the earth's carbon cycle, in which carbon is exchanged through natural processes among the land, ocean, atmosphere, and living things. The principal issue in anthropogenic climate change is that our activities have upset the balance of this natural cycle, overloading it through the rapid release of vast quantities of stored carbon that had accumulated over geological time in fossil fuels. The goal of climate policy is to reduce the magnitude of that overload and eventually eliminate it by using carbon-intensive energy sources much more efficiently, while working to replace them with carbon-neutral or carbon-free energy. That's why biofuels, wind and solar power are regarded as essential elements of climate change mitigation, though it turns out that current biofuels are not remotely carbon-neutral. The idea behind CCS is to complement the main climate change mitigation strategies by creating an artificial version of the carbon cycle, in which the carbon released from the combustion of fossil fuels is collected and returned to long-term storage, before it can enter the natural carbon cycle.

That sounds simple enough, but to understand why it's so hard to do, consider the amount of coal necessary to produce one kilowatt-hour of electricity. In 2007 the US burned a little more than a billion tons of coal to generate just over 2 trillion kWh of electricity, for an average of 1.0 lb./kWh. Because most of the energy from coal derives from its carbon content, the main chemical reaction involved is very simple: C + O2 → CO2. So unlike the sulfate (SOx) or nitrate (NOx) pollution we have managed for decades, CO2 is neither the result of a fuel impurity nor an inadvertent byproduct of combustion, but rather its primary outcome, along with heat. On average, every lb. of coal yielding a kWh of electricity also emits 2 lb. of CO2 to the atmosphere. In other words, the mass of CO2 leaving coal-fired power plants is double the mass of coal that went in. That's a lot of gas to separate, compress, transport, and dispose of in geological or other storage.

Now consider the energy balance of such a system. Before adding CCS at the back end, you had to mine the coal, ship it to the power plant and burn it, producing heat that was used to make steam to turn a turbine that generated power. The typical thermal efficiency of such a facility is 35-45%, depending on coal quality, plant design and operation. But CCS is inherently energy-intensive, reducing the overall efficiency and the energy return on energy invested (EROEI) for the entire coal-to-power process. If separating the CO2 from the flue gas, compressing it, and putting it back into the ground at some remote location consumes up to a third of the energy generated from the coal, as some estimates suggest, then our artificial carbon cycle doesn't look very impressive, as a net energy source. After referring to the First and Second Laws of Thermodynamics, you might even wonder whether we could produce enough net energy from such a loop to be worthwhile, at all.

I had a hard time finding the EROEI of the standard coal-fired power lifecycle. It appears to fall in the range of 5:1 to 9:1, which compares favorably with conventional oil production and refining, and with the best renewable energy sources. If CCS reduced those returns by one-third, then while the energy balance would remain positive in a physics sense, the economics of some applications might become marginal, because CCS would consume a large helping of the energy surplus that coal-fired power normally creates. Another way to look at that is that the portion of the energy surplus thus consumed was attributable to the non-monetized externality of putting a greenhouse gas into the atmosphere, and thus not sustainable, anyway.

As daunting as all this sounds, there may be some clever ways to overcome the toughest impediments to getting started rounding up the carbon from coal power and stashing it back in the earth. In a new study, a team from MIT has proposed "partial capture": removing only enough CO2 from the flue gas to cut the emissions from a coal-fired power plant to the level of one running on natural gas, about a 35% reduction. This would allow CCS to be introduced incrementally, at a much lower investment cost and a less severe efficiency penalty than full CCS. And as I discussed in another posting, using captured CO2 to enhance the output from productive oil fields creates a positive value for it that offsets at least some of the cost of collecting and transporting it. Work at a Canadian oil field that does this suggests that the stored CO2 can be effectively monitored underground. Even more intriguingly, naturally-occurring mineral deposits called peridodites can act as CO2 sponges. These might be used to increase the efficiency of direct CCS, or to establish indirect CCS--a coal-scale emissions offset that would remove CO2 from the atmosphere without requiring a CO2 pipeline from the emissions source.

Easy or difficult, our motivation for pursuing CCS, instead of abandoning coal as incompatible with alleviating climate change, is based on the reality that we still derive roughly half of our electricity from coal and only about 1% from wind, solar and geothermal power. That means that our annual additions of renewable generating capacity are not yet covering the roughly 1.5% per year growth in US electricity demand we've experienced over the last 5 years, let alone taking market share away from coal or any other carbon-based fuel. Could we advance efficiency and renewables rapidly enough to displace a sizable fraction of our coal use within 10-20 years? Perhaps, though I'd feel a lot more confident about meeting the aggressive emissions-reductions targets the US is likely to take on within the next year or two, if we could tackle coal's emissions directly with CCS.

I'd like to wish my US readers a Happy Thanksgiving. Postings will resume on December 1.

Monday, November 24, 2008

Sales Mix and Fuel Economy

When Detroit's CEOs return to Washington, DC in early December for further Congressional hearings on a rescue package, the industry's prospects for meeting tougher fuel economy standards are likely exert significant influence on the granting of federal assistance. When I was writing last Monday's posting on "Detroit, Bailouts and Fuel Economy", the CAFE database of the National Highway Traffic Safety Administration, which administers the Corporate Average Fuel Economy standard, was undergoing maintenance. That meant I couldn't calculate the impact of this year's shift in the sales mix of the Big 3 on their fleet fuel economy. The numbers indicate that simply selling fewer SUVs and more of their existing car models, without any major changes in technology, is already yielding significant fuel savings. In addition, the figures for the leading Japanese brands indicate what might be possible for GM, Ford and Chrysler, simply by offering fewer V-8 and V-6 engines and selling more four-cylinder cars. That's a good thing, because the latest survey from R.L. Polk & Company suggests that hybrids will still make up less than 6% of US new car sales in 2012.

NHTSA tracks fuel economy for every automaker in three categories: domestic passenger cars, imported passenger cars, and light trucks. The latter includes most SUVs. These data, in combination with the year-to-date auto sales figures through October, facilitate some quick spreadsheet analysis revealing the key factors differentiating the fuel economy performance of the big US carmakers from their competitors, such as Toyota and Honda. For example, for the 2007 model year, the US companies averaged a combined 24.9 miles per gallon, while the US models of these two Japanese firms averaged 30.2 mpg. That gap is attributable to two components, neither of which comes as a surprise. The Japanese passenger cars averaged 5 mpg better than their US counterparts, helped considerably by their imported hybrid models. The passenger cars made in these firms' US factories averaged just under 3 mpg better than their US peers.

The other big influence comes from the relative sales mixes of these companies. Of the combined 2007 sales of GM, Ford and Chrysler, nearly 65% were "light trucks", comprised of SUVs and pick-up trucks. Such vehicles only made up 42% of the sales of Toyota and Honda. That's particularly significant for fuel economy, because the Big 3's light trucks turned in fuel economy ratings averaging 7 mpg lower than their passenger cars, while the light trucks of Toyota and Honda were 10 mpg worse than their cars.

With gas prices that surged past $4 per gallon this summer, 2008 has produced some modest but encouraging shifts in fuel economy. SUV sales are down much more than those of passenger cars, for both US and Japanese makes, while the cars and SUVs sold tended to be from the more economical models within their respective categories. This has improved the average fuel economy of the Big 3 by 0.4 mpg, year-to-date, with 75% of that improvement coming from the shift between passenger cars and light trucks, which fell to 63% of Detroit's mix. Toyota and Honda saw an even bigger fractional change in light trucks, with the drop to 38% of sales helping to boost their combined average by more than one full mile per gallon.

Why do these figures matter in the context of a bailout of Detroit? Last year the Congress passed, and President Bush signed, the Energy Independence and Security Act of 2007, which among its many provisions included an increase in the federally-mandated new-car fleet average to 35 mpg by 2020, including both passenger cars and light trucks. Given the emphasis during the recently-concluded election campaign on both energy independence and greenhouse gas emissions, Congress appears concerned that a bailout of Detroit should not be viewed as providing any leeway on fuel economy. So it's important to understand whether achieving 35 mpg would require a technological revolution that might be beyond the resources of the cash-strapped domestic industry. Encouragingly, the figures above suggest otherwise. If the Big 3 merely matched the 2008 passenger-car performance of the top Japanese brands (35.5 mpg) while reducing their light truck sales proportion to 25%--the level that prevailed in the US car fleet prior to 1990--they would be three-fourths of the way toward achieving their 2020 CAFE target.

As helpful as advanced-technology cars like the upcoming Chevrolet Volt would be for speeding up that transition, simply by shedding the least-efficient SUVs and offering peppy four-cylinder engines as the standard across most of their product lines, Detroit could deliver greatly-improved fuel economy, of the kind the Congress and new administration are seeking. Just as important, considering the priority that US consumers have placed on vehicle performance in the last decade, European-style turbo-diesels, better gasoline-engine technology, and hybridized drivetrains can deliver these gains at an mpg-vs-power trade-off that car buyers should find much more palatable than the one we were forced to accept in the early 1980s, the last time high oil prices focused US policy-makers on automotive fuel economy to this degree.

I don't want to make this change sound easier than it is likely to be. Reducing SUV sales by the necessary extent would require re-tooling on a massive scale, sending ripples through the North American auto supply chain that might be nearly as dramatic as the bankruptcy of one or more of the Big 3. Consumers are leading this shift today, and they must be willing--or encouraged by new policies--to stay the course. The fall of gasoline prices back below $2 per gallon, if it persists for more than the next few months, will work against that. If a rescue or restructuring is to succeed, it must result in a new mix of products that are globally competitive and not just more fuel-efficient, but also profitable to make and market. That argues against embedding expensive, unproven technology in millions of cars, until Detroit is strong enough to stand behind the warranties that will be crucial to selling them.

Friday, November 21, 2008

Buy Low?

Yesterday I received a question from a reader inquiring whether the price of oil has fallen to a level at which the US should consider resuming additions to the Strategic Petroleum Reserve. I hadn't looked at this issue since oil was much more expensive, when I supported efforts to halt additions to the SPR, but not to sell oil from the reserve to manipulate prices. Upon reflection my answer is no, at least for now. Oil at 50 bucks looks very cheap, relative to where it has been this year, and also to where it's likely to be again, once the global economy gets back on its feet. However, I see three primary impediments:

  1. Under the law passed by Congress and signed by the President this May, filling of the SPR cannot resume before the end of 2008, or until the President certifies to the Congress that "the weighted average price of petroleum in the United States for the most recent 90-day period is $75 or less per barrel." By my reckoning, the three-month average price of West Texas Intermediate crude oil on the New York Mercantile Exchange is still somewhat above that level. As rapidly as it has fallen, it could meet that criterion in December, but with very little time for the current administration to act on it. If we use reported refiner acquisition costs, a more accurate gauge of what the nation pays for oil, the latest figure available is the $104/bbl indicated for September 2008. With August even higher, no crude could be bought without the help of the much lower assessment expected for November, which probably won't be published until January.

  2. Even if that condition could be satisfied, I doubt that the administration--outgoing or incoming--or the Congress would regard buying more oil for a reserve that already holds a 160-day supply at its maximum drawdown rate of 4.4 million barrels per day as urgent, compared to the needs of addressing the financial crisis and recession. As slack as the oil market is, I'm not even sure it would help US producers. More importantly, none of the potential threats to our oil imports look so pressing that we should make adding oil to the SPR a top priority, at least for the next few months.

  3. For me the most compelling reason to hold off on this buying opportunity is my hope that the new administration would not feel bound by the current administration's determination of the need for a 1-billion-barrel SPR in its current form, without further study. As I've commented periodically, the basic architecture of the SPR was designed three decades ago, in a very different world. It is in urgent need of a top-to-bottom review, to assess how it aligns with our strategic need to ensure continuity of fuel supplies to the US economy in all 50 states and to the US military wherever it operates, under various scenarios of supply disruption. Until that assessment has been carried out, we shouldn't rush to add more oil to the existing SPR.

Thursday, November 20, 2008

Delayed Reactions

The analysis in the current edition of the Department of Energy's "This Week in Petroleum" highlights an unexpected finding from the department's Short Term Energy Outlook: a forecast of a pronounced uptick in US oil production for next year, by 8% compared to this year. The commentary emphasizes that this reflects more than just a rebound from production that was temporarily shut in by this year's hurricanes. What struck me, however, was how neatly the graph accompanying the analysis illustrated the delayed impact of changes in market conditions on our oil output. As the incoming US administration contemplates its policy stance towards the domestic oil and gas industry, it's worth thinking about how they might benefit from these lagged effects during the next four years, but pay for them in a possible second term, particularly if US energy policy turns more negative to oil next year.

When I studied macroeconomics in graduate school 25 years ago, it was generally understood that changes in fiscal policy--tax cuts and spending increases--involved a time-lag of about two years before they produced the desired results, while the effects of monetary policy--changes in interest rates and the money supply--lagged by about one year. (We haven't heard much about such lags during the current crisis, and even if they have shortened, they prevent any stimulus from yielding the instantaneous result the media seem to expect.) Energy has its own inherent time-lags. For large oil projects, such as offshore production, the delay from "green light" to first production is typically 5-7 years. That compounds the volatility of the oil markets, because by the time new supplies come on the market, the conditions that prompted them may have changed dramatically, as we are now witnessing.

The above chart is a modified version of the one in the EIA's weekly report. I've deleted the Alaskan and Lower-48 production volumes in the original graph and substituted the annual average WTI price, while retaining the annual year-on-year percent change in production. With that price overlay, the effects of the oil price collapse of the late-1990s, precipitated by the Asian Financial Crisis, are evident in both a short-term drop in US oil output and an echo roughly six years later. Although much of the drop in 2005 was attributable to Hurricanes Katrina and Rita, the decline in 2004 reflects a dearth of new production, due to projects that were delayed or cancelled when oil company revenues collapsed in 1998 and 1999. But that relationship also works in both directions. It is hardly coincidental that we should anticipate an oil production rise in 2009, five years after prices began their steady upward march in 2004. That trend might continue for a few years, when projects initiated when oil was $60, $80 or $100 come onstream. However, if we expect oil prices next year to be no higher than they are now, despite the rapid escalation in production costs over the last few years, then we might reasonably expect a dip in production, over and above normal decline rates, beginning around 2013 or 2014.

There's certainly a lot more to US oil production than a simple cause-and-effect relationship with oil prices. Government policies play an important role, as well, and it's reassuring to hear the House Majority Leader, Representative Hoyer (D-MD) indicate that the Congress would not seek to reinstate the recently-expired federal offshore drilling moratorium. Nevertheless, it's worth keeping in mind that oil supplies are ultimately price-elastic, just as oil demand has proved to be. If the lagged response to flagging oil prices coincides with policy decisions that reinforce their effect--for example, if the new administration follows through on President-designate Obama's campaign promise to impose a windfall profits tax on the largest US oil companies--we could be facing a substantial future drop in output that could negate much of our efforts to wean the US off of imported oil. We need to keep in mind that every million barrels per day of domestic oil production is the equivalent of roughly 20 billion gallons per year of ethanol, and is worth $20 billion to our trade deficit, even at today's diminished prices.

Wednesday, November 19, 2008

A Taxing Opportunity

While watching the scenery from Amtrak's Acela on my way back from a meeting in New York yesterday, I made my first sighting of $1.99 per gallon gasoline, posted on the polesign of a station in Delaware. With wholesale gasoline trading on the New York Mercantile Exchange for $1.138 per gallon at yesterday's close--nearly $7 per barrel below the closing price for light sweet crude oil--most of the country could shortly be paying less than $2/gal. for unleaded regular, for the first time in more than three years. An op-ed in yesterday's Washington Post started me thinking about gasoline taxes, again, and I agree that the current gas price collapse provides a uniquely opportune time for a symbolic increase in the federal gasoline tax, which has not been raised since 1993.

Raising taxes in a recession isn't terribly sound economics in general, but gasoline in 2008 presents an unusual case. As I noted in Monday's posting, the decline in prices from their summer peak to last week's $2.22/gal. average puts roughly $260 billion per year back in the pockets of US consumers, at a time when that ought to be quite helpful. However, it's equally clear that low gasoline prices will complicate the task of selling more efficient cars to an American public that is already buying fewer cars than at any time since the recession of the early 1990s. Moreover, with gasoline demand running at least 3% below last year's at this time, and with prices now a dollar per gallon lower than they were a year ago, and below their annual averages for 2005, 2006 and 2007, state and municipal tax revenues from sales taxes on gasoline will also fall well below expectations. That puts further pressure on state and local budgets already stressed by falling home values and rising unemployment, and it could force cuts in infrastructure projects that many economists suggest we need more of, just now, not less.

This needn't conflict with the necessity to put a price on our emissions of greenhouse gases, effectively taxing fuels on their inherent carbon content. My preference has been for cap & trade, but a simple carbon tax would do much the same thing. Every $10 per ton imposed on CO2 emissions would raise gasoline prices by roughly 10 cents per gallon, anyway, so I'd resist calls for the "big honking tax on gasoline" that Mr. Sloan's op-ed suggests. But with gas prices dropping by more than a dime per week since September, a 10 cent gas tax hike would scarcely be noticed, leaving that $260 billion effective stimulus I mentioned earlier untouched. It could also be shared with the states, with half of the roughly $14 billion per year it would raise going to fund federal infrastructure projects, and the other half allocated to backstop state-financed road and bridge work.

Ten cents a gallon might not sound like much, though the 4.3 cent increase in 1993 cost another first-year President a good deal of political capital. By itself, it wouldn't change the way Americans drive or buy cars. Nor would it be sufficient to nudge consumers towards diesel cars, when diesel fuel has carried an average premium of $0.50/gal. over unleaded regular this year, and currently sells for $0.73/gal. more. However, it would indicate the willingness of the government to intervene in gasoline pricing, when appropriate, in a manner that doesn't impede the market's ability to balance supply and demand, as price controls or a floor price mechanism would. And unlike raising income taxes when salaries and consumer spending are falling, a period of falling gasoline prices is precisely the right moment to raise the federal motor fuel tax, even if just by a little.

Monday, November 17, 2008

Detroit, Bailouts and Fuel Economy

As Congress meets today to take up the subject of rescuing the Big 3 US automakers from possible bankruptcy, I'm concerned that this issue has been conflated with energy and environmental policy, rather than being viewed as an expedient palliative. While the mix of cars made and sold in this country will certainly have a large and growing influence on the quantity of petroleum and other fuels consumed by our car fleet in the years ahead, and on its emissions, it requires several leaps of faith to travel from that indisputable fact to the proposition that only by preserving at least GM and Ford in roughly their present form can we ensure that consumers will be able to purchase highly-efficient cars made in the USA. There are other arguments for bailing out Detroit, but if it is done on the premise that US carmakers can immediately retool to make all hybrids and plug-in hybrids, everyone involved is bound to end up severely disappointed.

It has become conventional wisdom that these companies have been done in by high fuel prices, or more precisely by product strategies that assumed that gasoline would remain cheap in perpetuity. Yet while the profits of the Big 3 were indeed leveraged to the sales of large SUVs that on average deliver at least one-third worse fuel economy than their passenger car lines, Ford's stock price has been declining steadily since early 1999, when oil prices were under $15 per barrel and gasoline sold for just under $1 per gallon. GM's market value peaked in early 2000, when gasoline was around $1.50. It had already fallen by half by May 2004, when weekly average US gasoline prices breached $2.00/gal. for the first time.

Although it would be quite helpful for the parallel causes of reducing US oil imports and greenhouse gases for the Big 3 to pivot and begin producing large numbers of hybrids and plug-ins, it is by no means obvious that such a strategy--launched in the midst of what is shaping up to be the worst global and US recession in decades--constitutes a recipe for a quick return to profitability. GM's Volt plug-in hybrid (or range-extended electric vehicle, for purists) is a case in point. With a sticker price expected to be in the low $30,000 range, net of a $7,500 federal tax credit, and delivering fuel savings, the value of which has been cut in half by the precipitous decline of oil and gasoline prices, this car might make energy and environmental sense for the nation, but it looks like a tough sell to consumers in a weak economy, at least in numbers large enough to matter.

For as much attention as the Volt has garnered, it might be even more instructive to note that GM's new "Cruze" non-hybrid economy car will also not launch in the US before 2010, at the earliest. That serves as a useful reminder that it still takes several years to plan, design, and re-tool for a new model. Even converting plants to produce more of existing light-vehicle models, or to build the more efficient cars these companies already sell in Europe and elsewhere, could not be done overnight. The return on such an investment remains uncertain, as well, with the demise of lending to less-than-prime applicants contributing to car sales that have fallen to their lowest level in years. The combined passenger car sales of GM, Ford and Chrysler are off by 12% year-to-date, or more than a quarter-million cars in total. That's much better than the 25% decline in "light truck" sales compare to last year, but it confirms that there is more to Detroit's problems than just the demise of the SUV fad.

The most sobering analysis of the situation that I've read so far was a commentary in the Weekend Wall Street Journal by a professor at NYU's Stern School of Business. It points out that over the last ten years, GM and Ford collectively invested $485 billion dollars without closing the competitive gap versus Japanese carmakers, including those producing vehicles in this country. (I would add that attributing the relative success of Toyota, Honda and others to prescience about the benefits of hybrid cars represents a misleading distortion of a much more complex situation.) Along the way, their combined market capitalization fell by over $110 billion. The author decries the destruction not only of shareholder value, but national investment capital. That doesn't mean that allowing the Big 3 to fail is the wisest course, but it should at least temper our expectations that a bailout measured in the tens of billions of dollars would do more than stave off a drastic restructuring of Detroit for a brief interval.

I don't have a magic solution for saving the domestic car industry, and I doubt that anyone else does, either. By comparison, the recipe for boosting fuel economy and lowering CO2 emissions from our vehicle fleet is much simpler. Among other things, it involves higher fuel prices, whether by taxes or courtesy of OPEC, though at last week's average of $2.22/gal., gas prices were providing an implicit $260 billion per year economic stimulus, relative to the average for June and July. New incentives for consumers to buy efficient cars could also play an important role, and while the TARP bill included large tax credits for plug-in hybrids, the credits for conventional hybrids--which address the biggest increment of fuel savings--are phasing out. And we can't forget that buyers of more efficient cars need readily-available financing. That requires not just replenishing the capital of banks and other lenders, but restoring confidence that loans will be repaid. At least two of those three measures would benefit Detroit, but like a bailout, they would still fall well short of a guaranteed recovery from the hole into which the industry has fallen.

Friday, November 14, 2008

Unlimited Clean Fossil Fuel?

If I told you that there was a potentially limitless source of fossil fuel, you would naturally want to know what the catch was. In the case of methane hydrates, a form of natural gas that has been bound up in ice crystals in the Arctic and deep ocean beds, that catch has been so large that I seem never even to have mentioned the subject in nearly five years of blogging. Hydrates are in the news this week in a very significant way, however, though the quantity in question is still quite small, compared to their ultimate potential. The US Geological Survey released a report estimating that 85 trillion cubic feet (TCF) of technically recoverable gas hydrates are accessible on the Alaskan North Slope. If produced over 20 years and combined with the conventional gas supply from the North Slope, which has been waiting for a pipeline south for many years, this deposit could supply up to a third of total US natural gas consumption. But that barely scratches the surface of the overall potential of gas hydrates.

The reason this announcement is so significant lies in the words "technically recoverable." Geologists have known about gas hydrates for a long time, and estimates of global hydrate deposits have been refined to a range of between 100,000 and a million TCF, with the best estimate of US hydrate deposits currently at 200,000 TCF. To put that in perspective, one TCF of natural gas represents about 1% of US annual total energy consumption and contains the same energy as 180 million barrels of oil or 10 billion gallons of ethanol. In other words, that 200,000 TCF estimate is the equivalent of a 2,000-year energy supply for the US, at current consumption levels, of a fuel with half the greenhouse gas emissions of coal. If we could learn enough from tapping the identified deposit on the North Slope, we might be able to exploit the much larger, less accessible deposits elsewhere--and it should tell you something that the North Slope of Alaska looks easy in this regard.

A natural gas source of that magnitude would align nicely with an energy strategy such as the Pickens Plan, employing natural gas for transportation fuel and generating electricity from wind and other renewables. It is one possible path towards much greater energy self-reliance and much lower emissions. For that matter, hydrates and other unconventional gas could ultimately provide enough fuel to displace all coal from power generation, until it can be replaced by enhanced geothermal systems, nuclear fusion, space solar power, or some other reliable and essentially limitless source of emissions-free electric power.

To put this in its proper perspective, if it were easy, we'd already be doing it. Nor are hydrates free of risks, the biggest of which could make our climate problems much worse, very quickly. That's because methane is a powerful greenhouse gas, 21 times more than CO2, and methane hydrates are only stable under certain conditions of temperature and pressure. A sudden release of a large quantity of methane from hydrates could accelerate the greenhouse effect, as may have happened in the geological past. But while any plan to mine hydrates must include rigorous safeguards against such an outcome, that risk must also be weighed against the risk that gas hydrates will naturally begin to vent their methane, if we remain on the current global emissions trend line and polar and ocean temperatures continue to increase.

There are no energy panaceas, and methane hydrates don't constitute one, either, because of their technical challenges and possible drawbacks. However, as a long-term hydrocarbon supply for energy and petrochemicals, they offer significant advantages over many forms of unconventional oil, and they could be extremely useful in a post-Peak Oil, low-emissions energy economy, as conventional oil & gas supplies deplete. I'm encouraged that the USGS sees the North Slope hydrate deposit as falling within our current technical capabilities, potentially unlocking the equivalent of 15 billion barrels of oil or roughly 900 billion gallons of ethanol.

Thursday, November 13, 2008

A Growing Imbalance

This spring I reviewed Robert Bryce's book, "Gusher of Lies," a thorough debunking of the notion that America could or should become energy independent any time soon. In a provocative article in Slate, he has connected the dots between our steadily rising ethanol mandates and the current weirdness in the US petroleum products market, in which wholesale gasoline continues to sell for less than light sweet crude oil, while diesel fuel/heating oil commands large premiums over both. In the process, he explains the short-to-medium-term constraints on attempting to reduce crude oil imports by increasing ethanol production. Although these impediments could be overcome in the long run, doing so would require enormous additional investments in the fuels sector, because it would render obsolete the configuration of virtually every current US oil refinery.

Reading Robert's article triggered two related thoughts. The first was that our present ethanol policy, embodied in the Renewable Fuel Standard (RFS) and the decades-old system of ethanol blending credits and import tariffs, reflects an outdated set of assumptions about the nature of the US motor fuels market. These subsidies and mandates arose during a period in which US gasoline demand was growing steadily at 1-3% per year, US refineries were producing as much gasoline as they could, and US imports of finished gasoline and gasoline bending components were growing steadily. None of these factors has survived this summer's price spike and the ensuing financial and economic crisis. Nor are they likely to recover to their former levels when the economy does, because of the growing emphasis on conservation, fuel economy and alternative transportation fuels and vehicle types.

I've commented periodically on the shifting global balance between gasoline and diesel fuel, but without factoring in the influence of US ethanol output--which has more than doubled in the last two years alone--on this relationship. The Slate article identifies the problems created by pushing increasing quantities of ethanol into a stagnating gasoline market, with upstream consequences for refinery operations and the production of other necessary products such as diesel, heating oil and jet fuel, for which long-term demand looks more robust than for gasoline, both domestically and internationally. With US ethanol output currently running at a level equivalent to 7% of US gasoline demand, it compounds the global weakness of gasoline, at the same time ethanol producers are adversely affected by gasoline's slump.

Markets eventually adjust to such disruptions, and I see several paths by which the US refining industry could accommodate a national energy policy aimed at steadily expanding our use of biofuels from 10 billion gallons per year today to 36 billion gallons by 2022, and perhaps to the 60 billion gallons per year envisioned by the President-elect for 2030. But getting there won't be easy or cheap, and that's a big problem for a segment of the energy industry that, with the exception of a brief surge of profitability several years ago, has generally returned no more than the cost of capital.

To see why this would be so expensive and challenging, you need to know a bit about what happens inside a refinery. All oil refineries separate crude oil into its natural fractions of LPG, gasoline, jet fuel, diesel, and heavier oils. The heart of most US refineries, however, is the Fluid Catalytic Cracking Unit, or "cat cracker", a massive device for breaking down and reassembling the molecules found in "vacuum gas oil" and "coker gas oil"--some of those heavier oils I mentioned a moment ago. The result is high-octane gasoline for blending, along with the precursors for making "alkylate", a key constituent of California-type reformulated gasoline. These units also make some low-quality diesel that is typically either processed further or sold into the bunker fuel market.

A refinery with a big cat cracker is fundamentally a gasoline machine, and there's very little you can do to change that, short of shutting the unit down and replacing it with a big, expensive "hydrocracker", which uses hydrogen generated mainly from natural gas to turn those same heavy gas oils into jet fuel and diesel. The other possible end of the ethanol road for US refiners would involve a huge ramp-up in synthetic diesel production, from gas-to-liquids and/or biomass-to-liquids, followed by a wave of refinery closings to end the growing global gasoline surplus. Either route involves hundreds of billions of dollars of investment, in aggregate, and the usual problems in obtaining the necessary permits and environmental offsets.

The energy industry has often attracted unintended consequences, and this one looks like a dandy: We create incentives and mandates for ethanol to substitute for gasoline (and thus imported oil) and end up driving up not just the price of food from which we make ethanol--notwithstanding claims to the contrary in the latest PR and lobbying campaign from the ethanol industry--but also the price of diesel fuel and heating oil, while having much less net impact on oil imports than we imagined. Biofuels will be a fact of life from now on, and along with CNG and electrified vehicles, they are probably a necessity, with oil production looking unlikely to keep up with long-run demand. The oil industry is already getting on this bandwagon. However, the dislocations this creates would be a lot easier to justify, if the biofuels involved were at least produced from feedstocks and processes that didn't consume food and nearly as much energy as the fossil fuels they are intended to displace.

Tuesday, November 11, 2008

The Shifting Senate

Although overshadowed by the presidential contest, there was much speculation going into last Tuesday's election about whether Democrats could capture a filibuster-proof majority of 60 seats in the US Senate. This would have had profound implications, not only for the ability of an incoming Democratic president to push his agenda through Congress, but for Congress to pass a number of measures that the leadership likely considers unfinished business. That includes major legislation on energy and climate change. Although three contests remain unresolved at this point, leaving this possibility tantalizingly open, a review of the voting on a couple of key bills suggests that even if they all went the Democrats' way, that outcome might be less useful than it appears, because several of the Republicans who retired or have been turfed out were moderates who voted with the majority on the measures in question.

Today's topic might seem overly focused on "inside-the-Beltway" concerns, but I think it could have serious consequences outside Washington, DC. Consider two key pieces of energy-related legislation that came before the Congress this year. The Boxer-Warner-Lieberman Bill, S.3036, would have enacted an increasingly-restrictive cap on greenhouse gas emissions, enforced through a national emissions-trading system ratcheting up energy prices and the prices of energy-intensive goods, in order to reduce US emissions of CO2 and other GHGs. After extensive debate, the bill failed on a "cloture vote", which would have brought it to the floor of the Senate for an up-or-down vote, which it might well have passed. The vote was 48-36, but should probably be counted as 54-36, due to some key absences. That would still have fallen short of the 60 votes required to end debate. Adding the six Senate seats the Democrats have already picked up in this election might lead one to see cap-and-trade as a shoe-in in the next Congress. That math doesn't quite work, however. Of those Senators who voted against cloture, only two lost their seats, while four of the six seats that changed hands were already in the "aye" column. Even if the unresolved races in Alaska, Georgia and Minnesota all send Democrats to Washington, they would still come up one vote short, unless another Senator who voted no or did note vote could be brought around.

The prospect of a windfall profits tax on oil companies looks equally shaky at this point, for similar reasons. Consider the voting on the "Consumer First Energy Bill of 2008", S.3044, which in addition to a 25% tax on "windfall" profits of the major integrated oil companies--over and above the taxes they already pay--would have allowed OPEC to be sued for anti-trust violations in US courts and imposed restrictions on energy commodity speculation. This bill also failed its cloture vote, by 51-43. When we adjust for the seats that have already changed hands, that improves to 55-39. Yet if Senators Stevens (R-AK) and Chambliss (R-GA) fall, it would only extend to 57-36, still short of the magic 60 votes.

So even if the new Senate tallies 58 Democrats and only 40 Republicans, not counting the two Independents who have historically voted with the Democratic caucus, enacting major energy legislation will likely require serious consideration of the views of the minority. While that will disappoint partisans and those desiring the strictest possible climate change legislation, the practical necessity of a bi-partisan approach to energy could pay dividends over the long haul, by preventing the majority from passing measures that could be overturned the next time the balance of power in the Congress shifts. Like the Cold War, solving our energy and climate problems is not the work of one Congress or one Administration, but will require a cumulative effort spanning decades. That should align with the necessity of avoiding further shocks to the economy, as well.

Next Tuesday I will be speaking on the climate change implications of the election at a breakfast panel in Manhattan hosted by my sponsor, IHS Herold. The topic of the session is "Investment Insights in Alternative Energy." If you are interested in attending, please email Bianca Smothers.

Monday, November 10, 2008

Ethanol Bust

The world doesn't stop when you're on vacation, and I will be playing catch-up for some time, between the implications of the US election, a report from the International Energy Agency on chronic under-investment in new oil and gas capacity, and several other noteworthy developments. Although it doesn't quite rank with a new US president, the Chapter 11 filing by ethanol giant VeraSun seems like a good place to start, because it represents an important warning sign for a sector that was already badly strained by rapid expansion and weak margins, even before the financial crisis and accompanying precipitous drop in commodity prices put it on the ropes. The corn ethanol industry owes its existence to government policy, but policy alone can't shore up its inherent shortcomings, or give it the resilience to withstand the kind of shock that is currently propagating throughout the economy.

In many ways VeraSun exemplifies the US corn ethanol sector under the present system of federal renewable fuel mandates and price subsidies. In 2006 VeraSun operated two ethanol plants with combined capacity of 230 million gallons per year (MGY) of ethanol. After an aggressive program of new construction and its 2007 acquisition of US BioEnergy Corp., its capacity stands at 1,420 MGY from 16 plants, with another still under construction. That's 250% compound growth over two years. During the same interval, the price of corn spiked from $3 per bushel to $7 this summer, and then fell back below $4, while gasoline prices went from the low $2s to over $4 per gallon, recently returning to the mid-$2s. The combination of rapid growth and falling, volatile margins explains the company's current status.

Any number of companies have operated successfully during Chapter 11 and emerged to restored profitability. VeraSun has at least gotten off to a good start, lining up the financing that will be necessary to enable its facilities to continue buying feedstock and paying their bills. However, the larger question is whether the underlying factors that put VeraSun into bankruptcy will change sufficiently to allow them eventually to emerge, or if this measure can only keep them on life support until a better-capitalized firm can take over its assets. The prospects are decidedly mixed.

As long as the economy remains weak, fuel demand is unlikely to pick up, and so the price of the commodity for which ethanol is intended to substitute, gasoline, could remain around current levels. Pipeline gasoline from Gulf Coast refiners now sells for under $1.50/gal. Ethanol is currently over-supplied, relative to the mandated blending requirement, and unless a number of plants now under construction are delayed or halted, that situation could persist for several years. In addition, the blenders' credit is due to drop from $0.51/gal. to $0.45/gal. in January. None of this bodes well for the return of healthy "crush spreads", the margins ethanol plants earn from turning corn into fuel.

At the same time, ethanol remains a cornerstone of federal energy policy, and that role could expand in the new administration. During the campaign, Senator Obama spoke many times of the need to increase biofuel production, in order to reduce our reliance on imported oil. While much of that increase is intended to come from advanced technologies that turn non-food biomass into fuel, most of those processes are still either experimental or extremely expensive, relative to $60 oil. It remains to be seen how they can contribute the expected 21 billion gallons per year by 2022, or whether conventional ethanol will have to expand beyond its contemplated 15 billion gallon maximum to achieve the overall 36 billion gallon biofuels target.

So we have the paradox of a product that we've decided is essential for energy security and environmental reasons--as well as for the continued viability of the US agricultural sector--but that might not be profitable to produce in the desired quantities, at current prices. The government has already raised the possibility of federal assistance for ethanol producers that made bad bets on corn futures. If VeraSun were unable to continue operations during bankruptcy--and its is only the biggest of several recent ethanol bankruptcies--an ethanol shortage could develop, forcing the government to intervene. While it has the authority to issue waivers to oil refiners and gasoline blenders to sell fuel with less than the mandated quantity of ethanol, that was intended as a temporary measure. Perhaps I'm the only one to see a possible parallel to banks that are considered "too big to fail", or to the way the Federal Reserve has engaged in matchmaking to put failing banks into stronger hands, but I see the possibility of much larger ethanol subsidies ahead. At the very least, the combination of $60 oil and tight credit has called the architecture of the government's future renewable fuel policy into question.