Energy Lessons of 2008

A year ago, I looked back on 2007 and ahead to 2008, a year that has defied the predictions of most observers. Although I can't claim to have foreseen the possibility that oil would break $140 and $40--from opposite directions--in the same year, I worried about energy market volatility and cautioned that risk cuts both ways. That seems equally appropriate advice today, when markets are focused on the downside, and "confirmation bias" is such a powerful force. But while we shouldn't expect a repeat of the wild ride of the year now ending, the experience has provided some expensive lessons about energy markets. The following is a non-exhaustive list of those that struck me:

1. Demand matters as much as supply in determining prices. The difference between oil at $145 per barrel and $40 is only a couple of percent of global demand, or more precisely a swing between steady growth of 1-2% per year and a shrinkage of similar magnitude.


2. Speculation can amplify prices and market volatility, but it can't override a dramatic shift in the underlying fundamentals of supply or demand. Leverage increases not only the magnitude of speculative gains and losses, but apparently also the speed of the shift from one state to the other.


3. When prices have been rising steadily, commodity price hedging can look like a sustainable revenue source--almost a perpetual motion machine--until the trend breaks. Then we see that the main benefit of hedging is to smooth out cash flows and enable firms to take on risks they couldn't bear otherwise. Used improperly, it's just an elaborate form of speculation, and as risky at Las Vegas.


4. Fundamental price imbalances between commodities that are substitutes for each other, however imperfect, don't persist indefinitely. For much of the year, natural gas traded for less than half the energy-equivalent price of oil. As of Friday, this relationship had closed to about an 11% discount for gas vs. oil.


5. High oil prices don't automatically make alternative energy sources competitive. For the last several years many alternatives faced higher construction costs, as they competed for some of the same inputs (materials and workers) as new oil and gas projects, while alternatives with low "net energy" or Energy Return on Energy Invested (EROEI) saw their operating costs rise in tandem with oil and gas prices.


6. In particular, investors in corn ethanol production found they were making two bets: one on the difference in price between food and fuel and another on the difference between petroleum products, with which ethanol competes, and natural gas, of which it consumes large amounts, directly and indirectly. (See #4 above.)


7. Government incentives and mandates can help to create a market for alternative energy, but they cannot guarantee its profitability, particularly when capacity is added faster than mandated targets rise, or than existing infrastructure can accommodate. The recent Chapter 11 filings of VeraSun and several other ethanol producers are evidence of this.


8. The cost of capital turns out to be as important as the cost of oil for the expansion of all forms of energy, conventional and alternative alike.

I'm sure I've missed some important learnings in this quick tabulation. Next week I'll look at what the coming year might bring, or at least what bears watching. In the meantime, I wish my readers a happy, healthy, and more prosperous New Year. Let's hope the economic consensus is as wrong about the length and severity of the contraction we're in, as it was about the prospects for a soft landing from the bursting housing bubble.

December Surprise

A month ago an old friend--in fact a former boss and mentor--hinted that the recent collapse of oil prices might lead to revisions of the oil & gas reserves that companies carry on their books. I recalled his suggestion a week ago, when the Wall Street Journal published an article on the subject of potential reserve revisions, indicating that "big chunks" of reserves might have be to declared "uneconomic", harming company valuations and potentially their ability to raise capital. This came into even sharper focus last Friday, when the January 2009 crude oil futures contract on the New York Mercantile Exchange (NYMEX) plunged sharply on its last day of trading, ending at $33.87 per barrel--the lowest oil price since February 10, 2004. I can only imagine how intently the reserves accounting groups of oil and gas companies must be scrutinizing the performance of the February contract, wondering how badly it might swoon by December 31, when the price for determining year-end "proved reserves" is established. The comparable price from which the 2007 year-end reserves were calculated was $95.98 per barrel, the highest ever. The subsequent slide puts reserves booked as long ago as 2004 at risk.

My friend knows more about oil & gas reserves and their reporting, from personal experience, than I ever will. It's an arcane subject. Despite the general designation of "reserves accounting", this task is normally carried out not by accountants, but by engineers under the supervision of a very senior and highly-experienced petroleum engineer or geoscientist. Tallying up how much oil and gas a company's leases are likely to produce involves consideration of a large array of technical and economic factors, including the market value of the future production these fields could yield. I'm sure there are other differences between the current SEC regulations, under which these figures are disclosed as part of a company's annual financial statements, and the standard industry approach set by the Society of Petroleum Engineers. The most important for the purposes of this posting is that under the SPE guidelines, the economic viability of the potential production from an oil deposit is assessed against the prevailing prices over the last 12 months, while also taking the firm's forecast of future prices into account. The SEC requires reserves to meet its standards for "proved" status at the price in effect as of the assessment, in this case at year-end.

When the price of oil was relatively stable, there wasn't much difference between these two perspectives, and thus between reserves determined under SEC or SPE guidelines. Even in the last several years, as prices rose dramatically from their roughly $20-25 per barrel range of the previous two decades, the 12-month averages were typically not drastically different from year-end prices, as for example the $66.25/bbl average for 2006, compared to $61.05/bbl on 12/29/06. However, if prices remain where they are today, we could see a $60/bbl difference between these two metrics for 2008, and a year-on-year decline of over $50/bbl. That would require any reserves that were booked at a price above $40 or so--not just this year, but going back as much as four years--to be reevaluated. (Natural gas has fallen, too, though by much less than crude oil.)

This situation is complicated by a bigger underlying question: what is the value of oil likely to be in the future, rather than at a moment in time or over some past interval? Reserves are future production, after all--in some cases extending over 20 or 30 years, or even longer. The market for prompt delivery might be glutted, and the outlook for the next year might appear pretty bleak, but without reading too much into the present steep "contango" in oil prices, there is every reason to believe that when global economic growth resumes, the fundamental conditions that pushed oil prices beyond $100/bbl will reassert themselves.

Before investors panic at the prospect of publicly-traded oil companies writing down hundreds of millions or billions of barrels of "proved reserves" for accounting disclosure purposes next year, they need to consider where the volumes in question will have gone. Were they merely shifted from the "proved" to "probable" category--thus not affecting the amount of oil that would ultimately be produced--by a temporary oil glut arising from a global recession, or did their existence depend on an oil-price bubble that is unlikely to reflate? And even if these conditions do prove to be temporary, there's a good chance that a number of oil and gas projects, including some fairly large ones, will have been deferred in the meantime, if not canceled entirely. That affects reserves in the most fundamental way possible, as well as altering the future global production profile. Since my own portfolio includes oil & gas equities, I face the same uncertainties in this regard as anyone else, as both an investor and a consumer. At the very least, this situation highlights the urgent need for a major revision of the SEC regulations covering the reporting of reserves, along the lines the Commission has already proposed, to put reserve estimates on a more meaningful and less volatile basis.

Energy Outlook will be on holiday break until next week. Merry Christmas, Happy Hanukkah, and Seasons Greetings, as appropriate!

Open Fuel Standard

One of the energy-related email lists to which I'm subscribed recently alerted me to an interesting piece of pending legislation in the US Congress, the "Open Fuel Standard Act of 2008", S.3303. The bill would require automakers to increase the proportion of their cars that are able to run on non-petroleum fuels to 50% by 2012 and 80% by 2015. Its title might be intended to conjure up analogies to high tech software standards, and its supporters may cite national security considerations, but its main purpose is to plug a gaping hole left by previous Congressional energy legislation. And while it mentions other fuels such as methanol and biodiesel, it is first and foremost about ensuring the future market share of ethanol.

The main focus of the "OFS Act" is Flexible Fuel Vehicles, cars that are factory-equipped to consume fuel containing high proportions of alcohol, which might otherwise damage their fuel systems and other components. Most of the 240 million cars in the US are only certified for alcohol blends of up to 10%. The few million FFVs already on the road were produced under a provision of the Corporate Average Fuel Economy regulations that allowed carmakers to offset them against low-mpg conventional cars, such as large SUVs. Considering that most FFVs burn gasoline most of the time, instead of the alternative fuels they were credited with enabling, this actually reduced the real-world fuel economy of the US new car fleet and increased US petroleum imports, a fact that was recognized and rectified when Congress passed the Energy Independence and Security Act of 2007. That bill established the new, higher national Renewable Fuel Standard (RFS), while progressively phasing out the CAFE benefit from FFVs by 2020. In the process, it set carmakers and fuel suppliers on a collision course, with the wreck now likely to happen several years sooner than it otherwise would have, because gasoline demand is falling.

Until this year, US gasoline demand was growing by about 1% per year. Starting from its 2006 volume of 141.8 billion gallons per year (GPY), the gasoline pool could have been expected to accommodate the quantities of ethanol required under the new RFS until at least 2014 without exceeding the maximum 10% blending rate (E10) for standard cars or requiring significant sales of E85, the 85% ethanol/15% gasoline blend that is the closest thing to pure ethanol that seems to be compatible with our fuels distribution system. But instead of growing by 2% since 2006, US gasoline demand in 2008 has dropped by around 3.5%. A similar decline next year would shrink gasoline sales to about 132 billion GPY and cause the RFS to bump into the E10 ceiling in 2012. That would require either selling E85 to large numbers of FFVs, or delaying the ethanol ramp-up until the fleet's flex-fuel capabilities caught up. Even bumping up the E10 limit to 11 or 12%, which is currently under consideration, would only buy us another year or two.

The Flexible Fuel Vehicle Club of America--who knew?--claims there are 7 million FFVs today. If every last one of them used nothing but E85, they would consume about 5 billion gallons per year. But that would require something like 7,000 retail locations selling at least 60,000 gallons per month of the fuel, instead of the current 1,600 stations selling a few thousand gallons per month each, totaling perhaps 150 million gallons per year. It would also probably require a much bigger discount for E85 vs. regular gasoline than the $0.17/gal reported by AAA currently. (Their calculation suggests E85 costs motorists $0.30/gal more than gasoline at today's prices, after adjusting for mileage effects.)

My long-time readers know that it wouldn't break my heart if the ethanol build-up came to a screeching halt. Ethanol is an inferior fuel in many respects, with an energy density a third lower than gasoline, translating into reduced vehicle range and fuel economy. This is confirmed by the government's own fuel economy ratings. Its environmental attributes are a distinctly mixed bag, and that extends to lifecycle greenhouse gas emissions that may be no better than gasoline's, when global land-use changes are included. Nor does it seem likely that ethanol from non-food sources, including cellulosic plant matter and waste, will be available in large quantities for some time, embedding fuel-vs-food competition into the economy for years to come. Its main selling point is that it is mostly home-grown--never mind the greater efficiency and environmental benefits of sugar-based ethanol from Brazil and the Caribbean. Because of its importance to US agriculture, it is highly unlikely that any US government, Democratic or Republican, would choose to back away from it without compelling evidence of harm--or unless it started to pile up at ethanol plants because there weren't enough FFVs to consume it.

So if Congress remains committed to increasing ethanol use and to denying carmakers the CAFE credits they formerly earned for selling cars that could burn E85, they must pass the Open Fuel Standard act or something like it, far enough in advance of the impending train wreck in 2012 or 2013, to get sufficient FFVs on the road to absorb the surplus ethanol beyond E10. Given the Big Three's other problems, it's hard to imagine the $100 or so in extra expense per car becoming the straw that breaks Detroit's back, but I wouldn't be surprised if they asked for a tax credit to cover the cost.

Oil Shock II

As OPEC's members and friends meet in Algeria to agree on deeper cuts in oil output, the effectiveness of their actions will depend greatly on the nature of the demand slump to which they are responding. If it proves to be merely a dip in the long-term growth trend, similar to the one associated with the Asian Financial Crisis of the late 1990s, then their current decline in revenue will likely be short-lived. If, on the other hand, the response in consuming countries is similar to that following the energy crisis of the 1970s and early 1980s, then OPEC and indeed all oil producers face protracted problems. In that case, they might have to hope that the chief economist of the International Energy Agency is correct in his new assessment that the credit crisis will hasten an expected peak in global oil production, perhaps sending oil prices beyond their summer 2008 highs within a few years.

Although the narrative concerning the present financial crisis and global recession is bound up in the collapse of the US housing market and the vast global debt bubble that fueled it--a bubble that had to burst sooner or later--it seems remarkably coincidental that it would begin to deflate just as oil prices raced past their previous inflation-adjusted peak of around $90 per barrel. Because that price rise took place over several years and was driven as much by demand as by supply constraints, the resulting oil shock wasn't as sharp or obvious as the one triggered by the Arab Oil Embargo of 1973 or the Iranian Revolution of 1979. But between 2003 and 2007, the US net oil import bill rose from around $100 billion per year to $300 billion, based on refiner acquisition costs. It crested at an annualized rate of $500 B per year in July. This added significantly to the US trade deficit, and the resulting sustained double-digit inflation in consumer energy costs helped push the annualized consumer-price inflation rate past 5% this summer. With the energy spike having folded, the November 2008 annualized CPI rate has fallen to 1.1%.

If in retrospect these indicators describe a true oil price shock, then what might OPEC and other oil producers expect in the years ahead? Well, in the aftermath of the last oil crisis, from 1979-83 global oil demand fell by 10%, the current equivalent of over 8 million barrels per day (MBD), based on last year's global consumption of 85.8 MBD. It didn't reach its 1979 level again until 1989. The effect on OPEC was devastating. With demand lower and non-OPEC output expanding steadily, OPEC's oil was squeezed out, losing a third of its former market share. Oil prices remained low for another fifteen years, contributing to the growth of the exurbs and the SUV fad.

History rarely repeats exactly, and it would be simplistic to think that we're likely to replicate the oil price environment of the mid-to-late 1980s. There's no tidal wave of non-OPEC conventional oil coming from places like the North Slope and North Sea, which looked technically challenging at the time but seem relatively easy, compared to today's opportunities. Biofuels have added the equivalent of around 0.5 MBD in the last several years, and Canadian oilsands a similar amount, but production in most non-OPEC countries is peaking or in decline, notably in Mexico and Russia. And as the IEA's Dr. Birol notes, tight credit and low prices will slow additions to supply from all sources, while natural decline erodes today's base production. That makes demand the crucial factor, particularly the behavioral elements of demand. Although rarely discussed in these terms, vehicle fuel economy faces diminishing returns. Boosting US fleet average miles per gallon from 13 to 25 under the original CAFE standard in the 1970s and '80s saved three times more fuel per mile than the mandated increase to 35 mpg will--in fact more than moving the entire fleet to 100 mpg plug-in hybrids would. Vehicle miles traveled have recently declined in the US. Along with the appetite of Asian consumers for their first cars, this will have as much impact as fuel economy on total oil consumption, and thus on prices.

Although the oil price shock of the last several years can't be blamed for the full extent of the mess we're in, it is at least a plausible candidate for the trigger that caused the debt bubble to pop now, rather than a few years from now. That has important implications, because current conditions may be setting the stage for another, possibly sharper oil shock shortly after the economy begins to recover. Although we face a drastically altered set of energy concerns going into 2009, energy policies that promote both conservation and increased supply look just as essential as they did a year ago.

Steel on the Ground

2009 is shaping up as the Year of the Stimulus. The consensus for a massive fiscal stimulus of the US economy, in the form of direct government spending and targeted tax breaks, grows daily. The biggest remaining questions focus on how much and how quickly. Estimates of the magnitude under consideration range from $400 billion to over a trillion, spread out over two years. Some would even like to see a stimulus bill ready for President Obama's signature on Inauguration Day. As urgent as the need to kick-start the economy appears, however, there are good reasons to spend at least as much time considering what to stimulate and how to go about it. That's particularly true of the energy economy, where the results of a stimulus will be felt for the next forty years.

An essay in Sunday's Washington Post highlighted some of the pitfalls of past government spending on infrastructure. Despite the best of intentions, our elected and appointed officials don't appear to have any keener insights into the future than corporate executives. It's inevitable that some of the stimulus will end up funding inefficient and ineffective projects, and in the interest of avoiding an economic implosion and a deflationary spiral of job cuts, demand reduction, price cuts, output reduction, and more job cuts, that might not be the worst outcome. But we need to ensure that the lion's share of the stimulus is focused on things that really need doing and that the private sector, even in the best of times, has difficulties undertaking. My top candidate for this is a major upgrade of our electricity infrastructure.

It's going to be very tempting for the federal government to invest directly in energy technology deployment--not just R&D--and even in private firms. The $350 million loan sought by Tesla Motors, the Silicon Valley electric car start-up that has just sold its 100th $100,000 electric sports car, comes to mind. We need clear guidelines that avoid putting tax dollars into companies that operate in markets that are already distorted by federal mandates and subsidies, such as those supporting biofuels production. But while I would not wish the government to invest in wind and solar power developers or their projects, the infrastructure necessary to make those projects more effective and competitive is a different story.

The case for increased federal investment in our power grids is similar to that for the Interstate Highway system in the 1950s, as another great enabler of economic transformation. Ever since the northeast blackout of 2003, we've known that the grid must become more resilient and reliable, and utilities and the grid operators have been working hard on that. But it also needs to be able to accommodate a much larger number of generators, ranging from rooftop solar arrays to widely dispersed utility-scale solar power installations and wind farms. Moreover, we need more long-distance transmission, particularly from the ten or so states that are home to roughly 80% of US wind power potential. Our best solar resources are similarly concentrated. If we're serious about reducing greenhouse gases from the electricity sector, which contributes a third of US emissions, this will require a better-integrated, higher-capacity, faster-reacting electrical grid to ensure that we make the most of distributed and intermittent renewable energy sources. It is also the sine qua non of the eventual mass electrification of our transportation systems, which account for another 28% of our GHGs and two-thirds of our petroleum consumption.

Unfortunately, we must also be realistic about how much can actually be accomplished, or in stimulus terms, spent on this task within the next two years. Although we might like to imagine a massive, Works Progress Administration-like marshaling of the nation's unemployed to undertake great tasks, those Depression-era efforts faced nothing like the modern regulatory requirements for permits and environmental impact reports. I've been associated with a fair number of large projects in my day, and the practical obstacles for quickly revamping the power grid boggle my mind. For starters, it would require setting aside all of the existing regional, state and local permitting processes and handing someone--a "grid czar"?--sweeping powers even greater than the power to designate "National Interest Electricity Corridors" that was given to the Federal Energy Regulatory Commission under the Energy Policy Act of 2005. Even if permits were no problem and plans already in place, I wonder how much actual "steel on the ground" we'd see by the end of 2010, beyond "last-mile" investments, such as smart electricity meters. Perhaps the best we can hope for in this timeframe would be to fund the planning and design process and get all of the environmental impact studies done. That might stimulate a lot of engineering and consulting firms, but it wouldn't necessarily put many construction folks to work. I can't help wondering how many other aspects of a federal stimulus beyond energy will be subject to similar constraints.

Hire the Best

The apparent selection of Steven Chu, the Director of the Lawrence Berkeley National Laboratory to be the new Secretary of Energy looks like a good choice. Since he is already employed by the Department of Energy, he understands the organization he would lead. The lab he currently heads does important work on renewable energy and efficiency, which President-Elect Obama emphasized throughout his campaign. Bringing in a Nobel Prize winner in Physics to run DOE exemplifies the principle of hiring outstanding individuals with deep, relevant experience to manage complex problems. Let us hope that the outgoing and incoming administrations can agree on someone equally qualified to oversee the restructuring of the US auto industry, should Congress ultimately pass a version of the emergency assistance legislation on which the US Senate could not agree last night.

Dr. Chu, who is also a professor at UC Berkeley and the former chair of the Physics Department at Cal's cross-bay rival, Stanford, seems well-qualified to manage an organization that must balance the application of chemistry, physics and biology to a wide variety of existing and emerging energy sources with the legacy of the Big Physics project of a previous generation: the nation's aging nuclear weapons complex. A quick review of the Lawrence Berkeley website turned up some fascinating work, including the Helios Project, which aims to produce new carbon-neutral fuels through accelerated artificial photosynthesis. Although there were some other fine people in the running, and only time will tell how well this pick will turn out, Dr. Chu certainly brings an appropriate mix of technical knowledge and administrative experience to running this large and complex agency. Overseeing a federal bailout and restructuring of the "Big Three" US carmakers--an eventuality that looks less likely today than it did yesterday--would require an equally apt selection.

If a Detroit bailout does come to pass, one of the most critical decisions will be the choice of a federal trustee to guide the restructuring of the industry. Rumors that the former head of the 9/11 Victim Compensation Fund was the front-runner have given way to a more familiar name, that of former Federal Reserve Chairman Paul Volcker. His experience, including with the Chrysler bailout in the 1970s, certainly qualifies him for the post of federal "car czar." But as much as I admire him for his role in extinguishing the US price inflation of the 1970s and early 1980s, and for his handling of the investigation into the UN Iraq "Oil for Food" scandal, I wonder if an even more experienced car hand might be called for. The person I have in mind would be a long-shot, not least for being a Frenchman and a current competitor of the Big Three. Yet I can't think of anyone who better epitomizes the global auto industry with which Detroit has failed to keep pace than Carlos Ghosn, with his proven track record of turning around two car companies, Renault and Nissan, both of which he now heads. If we really want to make Detroit competitive again, I see no one better qualified to direct that initiative.

The drawbacks are obvious: cultural, political, and practical. All of those could be turned into advantages, particularly since Mr. Ghosn has become a keen advocate of electric cars, which would play well in the new DC atmosphere. In any case, I doubt that he would find the presumably-obligatory compensation limit of $1 a year an impediment, weighed against the historic challenge of restoring GM, Ford and Chrysler to global leadership, or at least global parity. I admit it's highly unlikely to happen, but perhaps we could just get him on loan, as a favor from President Sarkozy, with whom both President Bush and President-Elect Obama seem to have an excellent relationship.

The Contango Warning

President-Elect Obama is expected to name his energy and environmental team shortly. Whoever is nominated as the next Secretary of Energy will be swamped with an array of competing priorities, including modernizing the nation's electrical grid, managing the nuclear weapons infrastructure, and above all guiding the shift to a greener energy diet that will reduce our greenhouse gas emissions, and perhaps also our dependence on imported energy. With regard to the latter outcome, however, the incoming Secretary should pay careful heed to the signal that the oil market is sending about the importance of boosting declining US petroleum production. While the media focuses on a front-month futures contract price for West Texas Intermediate crude oil in the low $40s per barrel, traders have been paying north of $60 per barrel for delivery in 2010 and $80 for oil in 2016. That suggests that the relief we are seeing at the pump today is only temporary, while the global economy is gripped by a recession and credit crunch. Our oil worries will return soon enough, once the economy recovers.

Aside from the remarkably rapid drop in the price of crude oil for prompt delivery, the current market conditions are unusual because of the steep rise, or "contango", of the prices in successive futures contract months. At yesterday's settlement on the New York Mercantile Exchange, oil for delivery in February carried a $2.59/bbl premium over January, and March was another $2.20/bbl higher. Oil for delivery in December 2009 was a whopping $13.81/bbl higher than the January '09 futures. The fact that sufficient oil is not being bought today and put into storage for future delivery to close the arbitrage opportunity this situation creates is a clear indication of just how tight commercial credit has become, recently. As it is, US oil inventories have climbed by 26 million barrels since the end of September, rising from close to the bottom of their seasonally-adjusted range to near the top.

Although the oil market isn't any more prescient about future oil prices than the stock market is about future corporate earnings, it still reflects the current consensus on the future--and not just of those with an opinion, like me, but of those willing to bet serious money on it. In that light, the extreme contango of the current market reflects many factors, chief among them the extraordinary weakness of current demand that has caused prompt prices to collapse, combined with the seemingly-inevitable collision between limited global supplies and the long-term demand from the large developing economies of Asia. Even if US oil demand never returns to its high-water mark of 20.8 million barrels per day in 2005--a level 6% above our monthly average for 2008, to date--the potential demand from China and India is more than sufficient to drive prices back to OPEC's desired floor price of $75 or more. Throw in a bit of political risk from our old friends Iran, Venezuela and Russia, and it's the current price that looks like the outlier, not today's long-dated futures prices between $60-$80/bbl.

That certainly supports the case for the next Secretary of Energy to push hard for the fuel-saving technology and alternative fuels that can reduce our dependence on expensive sources of foreign oil, but it might be less clear why maintaining domestic oil production and increasing it to the maximum extent possible matters just as much. We can't escape the mathematical certainty that imports must cover the difference between demand and domestic production. Those domestic supplies, which still represent 13 times as much gross energy content as our current 10 billion gallons per year of ethanol production, and contribute more than 30 times as much net energy to our economy, remain essential. Even a modest further drop in US oil production could negate the energy security gains from efficiency and additional biofuels.

There's also a lot of money at stake for the country, not just for oil companies. A new study from ICF International, commissioned by the American Petroleum Institute, confirmed the findings of the 2007 National Petroleum Council study in which I participated, to the effect that allowing drilling on the off-limits portions of the Outer Continental Shelf, onshore federal lands, and the Arctic National Wildlife Refuge could increase US oil production by 2 million barrels per day in 2030, above the expected baseline. That would displace tens of billions of dollars per year of imported oil--even at today's low prices--while cumulatively generating hundreds of billions in state and federal royalties and corporate income tax revenue that would be very helpful in covering the enormous debts being run up combating the financial crisis and recession.

As I noted frequently during the summer's debate over offshore drilling, there's no question of drilling our way to energy independence. We urgently need to expand and diversify our energy supplies and become much more efficient in how we use energy, but that doesn't mean we can turn our backs on oil, just yet. The new Energy Secretary will have to work hard to ensure that the oil replaced by the aggressive adoption of renewable energy and efficiency technology doesn't end up being our own.

Electric Cars vs. Oil in Hawaii

Ever since last week's announcement of a deal to roll out Project Better Place's model for recharging electric cars in Hawaii, I've been curious about how it would work out, if the supplies of new renewable electricity needed to wean the Islands' million or so cars and light trucks off of oil were not forthcoming, or at least didn't materialize as quickly as the company and state hope. If I've done my sums right this morning, it appears that electrifying Hawaii's passenger cars would still save large quantities of oil and reduce greenhouse gas emissions significantly, even if every kilowatt-hour (kWh) to run them was generated from the state's oil-fired power plants.

Since the late 1990s, I've been convinced that in the long run, the majority of cars would be some form of electric vehicle (EV), whether in the form of hybrids, with power generated onboard from engines or fuel cells, or battery EVs tapping external sources of power. The rate at which this transformation takes place, however, remains highly uncertain, with conventional, Prius-type hybrids still accounting for less than 3% of the US car market, and battery EVs other than golf carts as rare as hen's teeth. I've followed the plans of Better Place with great interest, since their mobility-based business model could provide a key ingredient for accelerating the electrification of personal transportation, even while the high cost of batteries makes EVs more expensive to purchase than their gasoline-based competitors.

As Better Place founder Shai Agassi noted in an interview published in Sunday's Washington Post, Hawaii looks ideally suited to be an early adopter of this technology. With no indigenous production, all of Hawaii's oil, including that from which its gasoline needs are refined, must be imported. In that context, the benefits of the Better Place plan look obvious, until you realize that powering a million cars on renewable electricity would require on the order of 3 billion kWh of electricity per year, the equivalent output of more than 400 wind turbines of 2.5 MW each. Ignoring issues of transmission and intermittency, that's about 16 times the state's currently-installed wind power base. Year-to-date through August, 75% of the state's electric power was generated from oil, and less than 7% from various renewables. So at least for now, if this model is going to work in Hawaii, it has to make sense assuming that most of the incremental power for electric cars would be generated from oil.

That sounds counter-intuitive, until you consider the relative efficiencies of centralized power generation versus the gasoline engine under the hood of your car, combined with the inherent efficiencies of electric drive. Comparing the fuel consumed by Hawaii's oil-fired power plants to the power they generated, I found that each gallon of fuel oil yielded roughly 15 kWh of electricity. If the typical electric cars that will be sold in Hawaii travel 3-4 miles per kWh, that equates to an average effective fuel consumption of around 47 miles per gallon, after allowing for 10% transmission losses. That's 43% lower than the 26.8 mpg of the 2008 model year average for the US new-car fleet, and it would reduce greenhouse gas emissions by roughly the same proportion. Although that's no better than the fuel economy of a Toyota Prius, that comparison would improve, as renewable power gradually displaced oil-fired power.

So at least from an oil-consumption and importation perspective, this idea appears to make sense in Hawaii. I can't speak to its economics, or to how practical it is today for regions such as California's Bay Area, where in recent years increasing numbers of workers have been driving in from communities such as Modesto, Tracy and Stockton--commutes that would have seemed unthinkable 25 years ago--in order to beat the high cost of housing near the coast. I wish Better Place well, and I would certainly appreciate having the choice of an attractive, economical electric car, when it comes time to replace my current sedan in a few years.

Cheap Gas

As rapidly as it has fallen, the average pump price of unleaded regular gasoline in the US still has a ways to go, to end up lower on Barack Obama's Inaugural Day next January 20 than its inflation-adjusted level of $1.60 per gallon when Bill Clinton took office in 1993. However, it does seem likely to beat the adjusted $1.82 per gallon in effect when George W. Bush took the oath of office. The fall from its $4.11 peak in July is a classic good news/bad news story, with evidence of the latter showing up in several forms this week.

I can't recall when I've spent more time examining the data for US car sales, or for that matter when they have received more media attention. The November figures were simply awful, and not just for the Detroit Three that are pleading for life-support in Washington, DC. The sales of Toyota and Honda fell by slightly more than Ford's, compared to November 2007, with Nissan off by as much as GM. But contrary to the view that the summer's high gas prices were burned indelibly into the minds of consumers, "light trucks", the category that includes SUVs, recovered some of their lost market share for the month, accounting for 51.9% of all light vehicles sold, in contrast to their year-to-date market share of 48.5%. That might not be entirely attributable to low gas prices, though it struck me as significant that Honda's only model to post a sales gain for the month was their Pilot mid-sized SUV (EPA 18 mpg), while Toyota's popular Prius hybrid (EPA 46 mpg) fell by 48%, year-on-year. One month does not a trend make, but it's clear that sub-$2 gasoline negates essentially any financial benefit from expensive fuel-saving technology.

An interesting analysis of gasoline prices from the American Petroleum Institute puts today's prices in perspective. Despite the precipitous drop of the last several months, the average price for 2008 should still tie the previous annual, inflation-adjusted high of $3.277/gal. for 1981. That makes today's $1.81/gal. even more remarkable. While it looks typical or even high compared to most of the years from 1982-2002, it appears quite low in the longer historical context. The question facing consumers and policy-makers alike is whether future gas prices are more likely to resemble the first two-thirds of 2008 or the last third, once the economy recovers. Setting aside concerns about Peak Oil, which has receded from attention, lately, the period coinciding with the lower gas prices on API's chart featured a weak OPEC and steady non-OPEC oil production growth of around 1% per year. That looks unsustainable, even without the likely impact of $40 per barrel oil on new deepwater drilling and oil sands projects.

Nor is it clear how much more biofuels can contribute, at least in the next several years. US ethanol output already stands at roughly 10 billion gallons per year, the energy equivalent of about 400,000 barrels per day of crude oil. That's priced into today's oil balance. Getting beyond 15 billion gallons will require a large contribution from cellulosic ethanol technologies that are still at the demonstration scale, with the largest currently-operating facility producing only 1.4 million gallons per year--less than 100 barrels per day.

So if $1.80/gal. gasoline looks unsustainably cheap, what should we be planning for? Eyeballing the API's 1918-2007 gasoline price chart suggests the long-term average is pretty close to 1949's inflation-adjusted $2.43/gal. Coincidentally, that's consistent with the level implied by OPEC's notional "fair price" for oil of $75 per barrel. That's a problem, because $2.50 gas won't do much for the sales of the hybrid, plug-in hybrid, and all-electric cars that Congress and others are insisting the Detroit Three agree to build more of, in order to qualify for a federal bailout. Even a $50/ton carbon tax or cap & trade permit price for CO2 only gets us to $3.00. Without a lot more help than that, gas prices alone are not likely to deliver the anticipated contribution of fuel economy towards improved US energy security and reduced greenhouse gas emissions. That might just require convincing Americans that more efficient cars are justified by values, rather than mere value.

The Road to Copenhagen

The road to Copenhagen goes through Poland. If you know what that geographically-dubious statement refers to, then you must follow the news relating to climate change pretty closely. This week and next, the UN Framework Convention on Climate Change (UNFCCC) is holding its fourteenth Conference of the Parties (COP-14) in Poznan, Poland. Along with conducting the ongoing business of the UNFCCC, the main goal of the meeting is to table a first draft of the replacement for the Kyoto Protocol, which expires in 2012. A new agreement is meant to be finalized in a year's time, at COP-15 in Copenhagen, Denmark. While this is all consistent with the "road map" agreed at last year's conference in Bali, the current conference is taking place in a remarkably different context, with financial uncertainties that were never contemplated in Bali.

Two changes, in particular, will affect the effort to develop a new set of international commitments on the emissions contributing to climate change, and for addressing the consequences of further warming. The election of a US President with a very different approach to climate change alters the negotiating dynamic, even though he has not yet taken office. The official US delegation is accompanied by a Congressional delegation headed by Senator John Kerry (D-MA.) Although Sen. Kerry does not officially represent the President-Elect, he certainly brings a point of view much closer to that of the incoming US administration than to the outgoing one, reflecting a shift back toward greater harmony with the positions of the EU members, Japan and other countries that adopted the Kyoto targets. Considering the views on climate change of Senator McCain, however, this change since Bali is not nearly as surprising as the one that ultimately may overwhelm it: the evolution of a US housing slump and already-nascent recession into a global financial and economic crisis.

We don't know what lies ahead, but we can make some reasonable guesses. Unemployment will continue to increase in the US and EU, and even if the recession in Asia proves less severe than the one in the late 1990s, as a recent article in the Economist suggested, China and India will face the prospect of millions of people falling back into poverty, after having risen close to middle class status. That will make it harder for their governments to devote resources to reducing CO2 or to be seen to sacrifice future economic growth to slow emissions. Nor will it be easy for Western governments to agree to terms on delayed targets and generous technology transfers benefiting countries that many of their citizens worry are competing for their jobs.

It was always going to be tricky for the delegates following the Bali road map to design an agreement that would reconcile the divergent emissions histories and economic growth rates of the developed and developing countries in a way that left all parties feeling fairly-treated, while still making meaningful progress on stabilizing and ultimately reducing global greenhouse gas emissions. Attempting this against the backdrop of a major global recession complicates matters greatly, going beyond the question of whether economic priorities will trump environmental challenges for the next few years. Depending on the ultimate duration of the current crisis and the manner in which it is resolved, the future mechanisms of our international system might look quite different, and the scope for a global response to climate change could alter significantly. Simply put, the delegates to Poznan cannot assume that the world in which a Copenhagen Protocol would be implemented will resemble the one in which the process for negotiating its terms was outlined a year ago.

The Right Price

So OPEC has kicked the can down the road another two weeks, deferring further production cuts until at least their December 17th meeting in Algeria, when they can better assess the impact of the cuts they've already made--code for observing how badly its members have cheated on their earlier quota reductions. As usual, the cartel's control over prices is much stronger when demand is surging and production capacity strained, than when markets develop considerable slack. This is a much-rehearsed dance, and the market has apparently already discounted it, with the price of light, sweet crude poised to test the $50 mark again this week. The more interesting commentary out of Cairo concerned OPEC's desired price, which is apparently $75 per barrel: well above today's level but far below summer's peak. Wishing won't make it so, but there has been much discussion lately about the "right" price for the most liquid of energy commodities.

I can't help observing the irony that $50 oil, the prospect of which seemed nearly inconceivable to seasoned industry experts only a few years ago, now looks too cheap, not just to OPEC, but also to producers of unconventional oil, developers and supporters of alternative energy, and those concerned about climate change. When you dig a little deeper, however, the insight here seems to be that the absolute price matters less than its volatility, at least from a planning perspective. It's hard for producers of all kinds of energy to plan their business, if the monthly average price of their output--or the key commodity affecting it--can spike up by 150% and then drop by 60%, all within the course of two years. Oil remains a cyclical business, as anyone who's been around it for a while understands, but this is ridiculous.

That $75 per barrel figure from OPEC is interesting for many reasons. It probably represents the minimum level needed to balance the considerable budgetary expansions taken on by its most aggressive spenders, such as Venezuela and Iran, along with pseudo-member Russia. But it also looks like the level that is required to keep additions of new unconventional oil capacity, such as Canadian oil sands, on track. With typical refining margins, instead of the bizarrely-inverted pricing we've seen recently, it would translate into an average gasoline pump price in the US of around $2.50/gal. And because US ethanol distillers are producing well beyond the volumes required to satisfy the federal Renewable Fuel Standard, that would yield an ethanol price after subsidies in the neighborhood of $2/gal., enough to give ethanol producers a 75 cent per gallon "crush spread" over corn at $3.50 per bushel. That's a lot better than the 40 cents or so implied by the current ethanol and corn futures prices.

If the drop to $50 were short-lived, most of those energy producers would experience little lasting impact, other than ethanol firms that have been pushed to the brink by the combination of overly-rapid expansion, tightening credit, and slumping prices. But looking ahead, no one can say with any certainty whether oil will remain here, test $40/bbl, or zoom past $100 again next summer. In this regard the futures market, which last week reflected prices above $70/bbl. beyond 2010, has been a very poor barometer. Nor have the forecasts of government departments or international agencies fared any better at anticipating the volatility that is so disruptive to economies and to the plans of energy companies and oil-exporting countries.

Consumers are in the best position of anyone affected by these developments. If you drive an average car an average amount, your fuel bills ought to be about $90 per month lower than they were in July, which is the equivalent of a $120 per month raise for anyone in the 33% combined federal income and social security tax bracket. Save it or spend it, but don't count on it lasting longer than a year. That means buying your next car with the prudent assumption that at some point in its life, you will be paying $4 or more per gallon, once again.

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.

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.

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.

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.

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.

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.

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.