Will the Keystone XL Decision Be Based on Incorrect Assumptions?

• Some of the facts about the Keystone XL pipeline project that President Obama cited in an interview last month turned out to be wrong. That's significant, if he is the ultimate decision-maker on this question.
• Whatever his assessment of the pros and cons of the project, the politics of Keystone are trumping the facts, indicating the decision is likely to be deferred as long as possible. 

When President Obama commented on the merits of the Keystone XL pipeline project in an interview in the New York Times last month, the Washington Post suggested that his remarks “give opponents reason for hope.” Although he confirmed that the White House’s main objective criterion for making this decision was still the pipeline’s greenhouse gas impact, the President also speculated about the project’s job-creation potential and the ultimate destination of the crude oil it would carry. This appeared to endorse arguments raised by opponents of the project. These issues deserve more than the dismissive treatment they received in the interview.

With regard to the number of direct construction jobs that the northern leg of the Keystone XL Pipeline (KXL) might create, I don’t know whether the right number is the 2,000 the President cited or the tens of thousands estimated in an earlier State Department study. However, fact checking by both PolitiFact and AP concluded he was wrong.

In any case, this administration lacks credibility on counting such jobs. Consider the White House's metric of “jobs created or saved” for assessing the impact of the 2009 stimulus, or the routine touting of projects with “green jobs” potential, not just in terms of their direct employment gains, but also their indirect job creation estimated via generous multiplier effects. Either indirect jobs are always relevant, in which case KXL would create far more jobs across the economy than the President seems willing to admit, or they also aren’t relevant to justifying clean energy and other, more favored infrastructure projects.

The more interesting issue Mr. Obama brought up relates to the disposition of the oil-sands crude that the KXL would ultimately carry from Alberta to the Gulf Coast. For starters, this isn’t relevant for whatever volume of North Dakota production the pipeline might also carry, since current rules prohibit its export to anywhere except Canada. Of the pipeline’s planned capacity of 830,000 barrels per day, some would be used to ship US crude to US destinations, some would carry Canadian  oil destined for US refineries in the mid-continent, while an unspecified remainder would arrive at the Gulf Coast.  However large the latter figure might be, it’s doubtful that much of it would ever leave these shores. To understand why, you need to consider the quantity of US oil imports of similar quality currently coming into the Gulf.

Overall, Gulf Coast crude oil imports have fallen by around a third since 2007, but they still amount to around 4 million barrels per day – 5x the total capacity of the KXL. Unsurprisingly, much of the crude imported into the Gulf is either sour or heavy, since the refineries in the region have invested billions of dollars in the hardware required to process such crudes, which are typically cheaper than lighter, sweeter grades. A quick glance at the countries of origin of the import mix confirms this, with suppliers such as Mexico, Saudi Arabia, Venezuela, and Iraq dominating recent imports. Imports from Algeria, Angola, and Nigeria have been slashed by surging production of light, sweet crude in Texas and other states.

In the interview, President Obama said, “So what we also know is, is that that oil is going to be piped down to the Gulf to be sold on the world oil markets, so it does not bring down gas prices here in the United States.” For him to be right about that, we must believe that the current importers of around 2.7 million barrels per day of generally similar crude from South America and the Middle East would ignore the arrival in their market of new supplies from Canada and continue to buy from existing suppliers, and that those other suppliers would be able to continue to charge the same prices as before, despite significant new competition. Although I wouldn’t argue that oil sands crude would never be exported from the Gulf, imagining that most of it would simply sail right by the closest and largest global refining center equipped to handle this type of crude oil reflects a remarkably superficial view of how oil markets actually work.

The Keystone XL decision process clearly encompasses both factual and political considerations.  On the facts alone and the criteria set by the administration, the pipeline would eventually have to be approved, since even in the worst realistic case its impact on global greenhouse gases would be minimal--on the order of 0.4% of global emissions--while it offers clear benefits including reliability of supply. The protracted delays in approving this project provide all the evidence needed to confirm that political considerations outweigh the facts. Deciding now in favor of either side offers limited political benefits but carries huge risks; continuing to leave the issue in suspense has paid dividends at little apparent political cost.

A different version of this posting was previously published on Energy Trends Insider. 

The Summer Oil Slump

Instead of US consumers facing $5 gasoline this summer, as some analysts had predicted, we now find prices slipping well below $4 per gallon as oil prices respond to weakening demand, a stronger dollar, and steady supply growth.  Yet as welcome as this is, it's largely the result of a mountain of bad news: Not only does financial turmoil threaten the very existence of the European Monetary Union and its currency, the Euro, but economic growth in the large emerging economies is also slowing, at least partly in response to the weakness in the developed countries that constitute their primary export markets.  The engine of global growth for the next year or two just isn't obvious.  That's the backdrop for this week's OPEC meeting in Vienna.

Before we become too enthusiastic about the prospect of a period of cheaper oil, we should first put "cheap" in context.  Even ignoring West Texas Intermediate (WTI), the doldrums of which I've discussed at length, the world's most representative current crude oil price, for UK Brent, has fallen consistently below $100 per barrel for the first time since the beginning of the Arab Spring in 2011.  Yet even if it fell another $10/bbl, to about where WTI is currently trading, it would still exceed its annual average for every year save 2008 and 2011.  So while oil might be less of a drag on the economy at $90/bbl than at $120, that's still short of the kind of drop that would be necessary for it to provide a substantial positive stimulus, particularly when much of the drop reflects buyers around the world tightening their belts. 

The US is in a somewhat better position, thanks to surging production of "tight oil" in North Dakota and onshore Texas. This has more than made up for the inevitable slide in output from the deepwater Gulf of Mexico, two years after Deepwater Horizon and the ensuing drilling moratorium. With much of the new production trapped on the wrong side of some temporary pipeline bottlenecks, parts of the country are benefiting from oil prices that are $10-15/bbl below world prices, although short-term gains are a poor reason to perpetuate those bottlenecks, rather than resolving them and allowing North American production to reach its full potential.

Then there's the issue of speculation, which some politicians blamed for the recent spike in oil prices.  To whatever extent that was true--and I remain skeptical that the impact was nearly as large as claimed--we could be about to see what happens when the dominant direction of speculation flips from "long" to "short"--bullish to bearish--as noted in today's Wall St. Journal.  Since the main effect of speculation is to increase volatility, we could see oil prices temporarily drop even further than today's weak fundamentals would suggest they should.

All of this will be on the minds of the OPEC ministers meeting in Vienna Thursday, along with the usual dynamics between OPEC's price doves and hawks.  The pressures on the latter have intensified as Iran copes with tighter sanctions on its exports and Venezuela's ailing caudillo faces a serious election challenge.  OPEC meetings are rarely as dramatic as last June's session, but the global context ensures a keenly interested audience for this one.  Given the impact of gas prices on US voters, both presidential campaigns should be watching events in Vienna as closely as any traders.  $3.00 per gallon by November isn't beyond the realm of possibility.  It would only require a sustained dip below $80/bbl.

More Long-Term Pressure on Oil Prices

A pair of items in today's Financial Times could signal a longer run of high oil prices, even if Europe were to slip into recession and economic growth elsewhere slow. The first article (registration required) reported that Saudi Arabia has raised its target oil price to $100 per barrel, up from the $75 level that King Abdullah had previously endorsed as "fair." Meanwhile, Venezuela has announced that it would withdraw from a World Bank body for arbitrating contractual disputes, preferring them to be resolved within its own judicial system. That can't be welcome news for companies that had been considering new investments in the country's oil and gas sector. Taken together, these stories suggest both less future supply and a greater likelihood that OPEC would respond to any significant weakness in oil prices by restricting output.

With markets currently tense over the prospect that Iran might make good on its threat to close the Strait of Hormuz, the prospect of Saudi Arabia boosting output if necessary to keep prices from going much beyond $100/bbl must seem welcome, at least in the short term. But as the FT explains, the choice of that figure, rather than a lower one, reflects the fiscal realities of a broad group of Middle East producers. The Saudis, Iran, Iraq, and the UAE all require oil prices north of $80/bbl in order to balance national budgetary requirements. Considering that the cost of producing much of this oil is likely still in either the single digits or low double-digits, that is an extraordinary commentary on just how much these countries depend on oil revenues to fund the social expenditures that maintain their respective domestic status quos. So while Saudi oil minister al-Naimi may have intended his comment to convey a comforting price ceiling, it probably said as much about his government's view of where the floor should be. With UK Brent crude currently trading at roughly the same $111/bbl level that set a full-year price record last year, I'm not sure how many of us would find that reassuring.

The decision by Venezuela's dictator to exit the World Bank arbitration mechanism shouldn't have come as a surprise, with an estimated $40 billion in international claims outstanding for his past actions in nationalizing assets and arbitrarily altering contractual terms in a variety of industries. The recent ruling by the International Chamber of Commerce in favor of an ExxonMobil claim might just have been the final trigger. Yet despite the obvious expediency of such an exit, it seems grossly counterproductive in the context of a producing country that depends increasingly on foreign investment to stem a long-term decline in output. Since President Chavez punished his nation's oil industry by firing its most capable managers and engineers following a strike in 2002-3, Venezuelan oil production has fallen by at least 15%, and it only avoided a larger drop due to the contribution of the big Orinoco production and upgrading projects built by foreign firms such as ExxonMobil, Chevron, ConocoPhillips and Total--some of which are now seeking compensation for expropriation of assets and other grievances.

Requiring disputes to be resolved within a court system that has been stacked with Chavez loyalists hardly seems like the recipe for reducing political risk and reassuring companies that have already seen past investments turn sour. While companies that have too much at stake to leave will try to make the best of this, others would be well-advised to steer clear. However this turns out for the industry, the likely outcome for Venezuela is lower production in the future and even greater support for hawkish price policies within OPEC, to prop up the oil revenues upon which Chavez's redistribution policies depend.

Of course none of this guarantees high oil prices in perpetuity. After all, OPEC was unable to prevent prices collapsing to below $40/bbl in late 2008, though it did restrain output enough to get them back to around $80 within a year. However, both stories should remind us that in a world in which oil prices are set to suit producers better than consumers, our primary focus should be on actions and policies that enhance our energy security. That means substituting plentiful natural gas for oil and its products where we can, promoting conservation and efficiency, pursuing cost-effective renewables, and ensuring that we have access to as much oil from domestic and trusted international sources as possible. Rejecting the Keystone XL Pipeline, instead of committing to find a way to make it work while addressing reasonable concerns about it, would be nothing less than a gift to OPEC.

Disclosure: My portfolio includes investment in Chevron, which is mentioned above and owns projects and facilities that could be affected by these events.

The New Oil Cycle

As of yesterday's close on the New York Mercantile Exchange, the price of crude oil has fallen 50% from its July high-water mark. The membership of OPEC must be experiencing an uncomfortable sense of déjà vu, recalling a similar drop between August 1997 and December 1998, when West Texas Intermediate (WTI) bottomed out at $10.72 per barrel, and the OPEC average price fell into single digits. The cost of production is much higher today than in the 1990s, so $10 oil is hardly in prospect, but even an extended period below $50 per barrel would cause severe pain to the oil industry and to anyone investing in alternative energy that competes with oil. However, while a return to $140 oil probably lies on the other side of a global recession, other structural changes could shorten the down-cycle, or at least put a relatively high floor under it, once the customary market overshoot has passed.

Previous oil-price cycles hold some useful insights into the likely bottom of the current cycle, but important differences are also apparent. The 1997-98 collapse was caused by a conjunction of events with strong parallels to today's situation. A wave of new oil projects collided with a sudden drop in global demand triggered by the Asian Financial Crisis. Producers faced a choice between cutting output and bearing unsustainable losses on every barrel sold, but their obvious response was complicated by two serious problems. Operators of mature oil fields employing secondary and tertiary recovery methods knew that once shut in, production might not return to previous levels, later. My former employer, Texaco, saw that happen at its century-old Kern River Field in California. Meanwhile, OPEC's members worried about a long-term loss of market share, similar to what occurred when demand for OPEC's crude fell by 44% between 1979 and 1985, requiring two decades to recover. It took an unprecedented coordination of production cuts between OPEC and Mexico, Russia and Norway--countries that might have otherwise capitalized on OPEC's unilateral cuts--to stabilize the market and nudge prices back into the $20s by mid-1999.

What's different today? Well, for starters, OPEC already has a working relationship with Russia, and the latter's output has stalled, while Norway and Mexico are both in decline. Meanwhile, OPEC has expanded to include Angola, formerly an important source of non-OPEC production growth. If OPEC cuts now, it's hard to see who would step in to steal their market share. The cartel has also enjoyed a better-than-normal degree of cohesion recently--always easier when you are producing essentially flat-out. Key producers such as Venezuela and Iran have seen first-hand the benefits of cutting a little to boost revenue a lot, and their economies depend on prices remaining near $100 per barrel.

Another important change since the late 1990s is the dramatic growth of Canadian oil sands output. The current production of 1.3 million barrels per day now constitutes a large fraction of the world's high-cost marginal supply. More than half of it comes from mining operations that could be slowed or temporarily halted with minimal impact on future output or ultimate reserve recovery. In other words, a drop in crude oil prices below the variable cost of producing synthetic crude from oil sands could be at least partly self-correcting, and fairly quickly.

Biofuels might end up in a similar position. With corn prices back down to around $4 per bushel and ethanol selling for an average of $2.22 per gallon at racks on Wednesday, the "crush spread", or gross margin for producers is around $0.80/gal, similar to where it has been for much of the year. But although ethanol had for most of the year been priced well under Gulf Coast gasoline, the sudden collapse of gas prices has inverted that relationship. With wholesale gasoline--specifically the RBOB mix designed for blending with ethanol--trading on the NYMEX at under $1.70/gal, and the ethanol blenders' credit falling from $0.51/gal to $0.45/gal on January 1, the incentive for refiners to blend more ethanol into gasoline than legally mandated is evaporating.

How quickly these factors could establish a hard floor under oil prices is anyone's guess, and I wouldn't be surprised to see WTI go well below $70/bbl before it corrects. This year's highs might have been helped along by a froth of speculation, but they were also what was required to destroy enough demand to bring a commodity with a low price-elasticity of demand back into balance with supplies that were straining at their near-term limits. That interpretation is also consistent with the dramatic fall in prices accompanying the current collapse of demand. But we can't forget that even if demand in the US and EU continue to shrink, thanks to conservation, efficiency, and alternative energy, the potential demand in Asia remains sufficient to outstrip global oil production capacity, once strong global economic growth resumes. Consumers should enjoy the relief from sub-$3.00 per gallon while it lasts, but they should not assume it will persist beyond the recession.

A Stall Point for Oil?

It's been a long time since the oil markets offered much good news, particularly on the supply side. Since the end of 2002, a litany of strikes, war, social unrest, sanctions, and other factors have contributed to oil's volatile climb from the mid-$20s to yesterday's settlement at $102.45 per barrel. Now we are treated to the possibility of armed conflict between three South American nations that between them account for about 5% of global oil production and exports. With demand in Asia compounding these pressures, it's ironic that the best news the market might get for a while should come in the form of consumption data for the world's largest oil importer, reflecting the price elasticity of demand and the impact of higher biofuels output.

The Energy Information Agency's figures for petroleum supply and demand in December 2007 are coming in, now, and the resulting annual totals represent milestones in several categories. Importantly, they show that as a result of the combination of higher oil and refined product prices and a slowing economy, and after factoring in the contribution of biofuels under the previous Renewable Fuel Standard, the growth of US oil consumption seems to have reached a stall point. And while in the past I might have been tempted to add, "for now," it isn't easy to envision the circumstances under which that growth would return to previous levels, even in a recovering economy.

With the addition of December's 9.25 million barrels per day (bpd) of finished gasoline supplied to the US market, our 2007 average consumption of 9.29 million bpd was only 0.4% higher than 2006. And when the larger quantity of ethanol blended into gasoline last year is factored in, the quantity of petroleum-based gasoline supplied actually declined by about 0.6%. In addition, total crude oil and petroleum product consumption in 2007 was essentially unchanged versus 2006, at 20.7 million bpd, before factoring in the 96,000 bpd year-on-year increase in ethanol use. Our net imports of crude oil and petroleum products were down, as well.

With our total oil demand essentially flat for four years, the US may have reached its petroleum high-water mark, from which consumption will gradually decline. Even if the benefit of more efficient vehicles is partially offset by a growing population and continued increases in annual miles driven, alternative fuels have finally reached a scale at which they are beginning to erode oil's market share in transportation, where it has been unchallenged for a century. Of course, halting US oil demand growth doesn't eliminate our 12 million bpd of net crude oil and refined product imports.

Skeptics would be right to remind us that we've been here before, and it didn't last. Between 1978 and 1983, total US oil consumption fell by almost 20%, before resuming its steady growth and breaking the old record in 1998. However, much has changed since then. Better technology and the urgency of addressing climate change have altered the energy landscape so much that it's even possible to extrapolate from static US oil demand to a future peak in global oil demand, a twist on the notion of Peak Oil that has nothing to do with the ongoing debate about how many barrels we can coax out of the earth. Reaching that point will require much hard work, including ensuring that when our economy recovers from its current woes, it is more energy efficient and makes better use of all the domestic energy sources at our disposal.

And One Cent

Oil futures finally closed above $100 per barrel yesterday, yet the context could not have been more different from the first time the market flirted with this level, last November. Then, the global economy was still perceived as growing strongly, albeit overhung with housing and debt troubles, and the US stock market was 7% higher. Now, the world economy is losing momentum, and the push above $100/barrel seems less like a bold move into uncharted territory and more like the late-race effort of a tired marathon runner.

Reading the market has never been easy, and it is even more challenging when the trends and underlying fundamentals shift out of alignment. Although the oil market's $4.50/barrel move yesterday was apparently prompted by several superficially bullish news items, upon further reflection at least two of those look bearish. OPEC's contemplation of a cut in production, which helped push prices higher, must be seen as a purely defensive measure, a tactic to forestall a precipitous drop in oil prices when winter's higher demand abates and economic growth continues to weaken. OPEC learned some bitter lessons in this regard in the late 1990s.

Another event that fueled the market's jitters yesterday was the unfortunate accident at AlON USA's Big Spring, TX oil refinery. But with due deference to the injured workers and their families, it requires a deep-seated bias to view this event as anything but negative for oil, and mildly positive for refining margins. The shutdown of a 70,000 barrel per day refinery, representing less than 0.5% of US refining capacity, will put more oil into a market in which inventories have been growing steadily since the first week of January. Big Spring runs high-sulfur crude oil, so the differential between West Texas Intermediate and West Texas Sour should widen. That seems a poor reason for WTI to spike, unless the market is being driven by investor psychology and technical indicators, not fundamentals.

With the equity markets weak and the debt markets in a funk, there is a lot of money floating around looking for a big return, somewhere. At the same time that forecasts of 2008 oil demand are still being revised downward, investors are piling into oil futures in search of a fast buck, creating a recipe for higher volatility. It's hard to see $100+ oil being sustained, barring some event that actually takes a big slice of production off the market, rather than merely increasing anxiety about such a prospect, a la Venezuela.

As I've noted before, the price of oil is a peculiar indicator. Until it passes through the value chain and emerges as higher prices for petroleum products and the goods and services that require oil as an input, it remains a highly theoretical barometer for most people. Weak refining margins have buffered consumers from the full retail effects of the recent excursions into the high $90s, and with US gasoline inventories well above their seasonal norms, marketers will have a hard time passing on yesterday's uptick, except in the area directly served by the Big Spring refinery. The larger question is whether yesterday's $100 close will affect the behavior of consumers or investors, and if so, how? Perhaps having breached the magic mark, we will tuck it away in the backs of our minds until oil hits the next psychologically-significant milestone, as we seem to have done with $3.00 per gallon gasoline.

Barrel Rattling

The chance that Venezuelan President Chavez will follow through on his threat to cut off oil exports to the US, in retaliation for a freeze on Venezuelan financial assets secured by ExxonMobil, seems minimal. As today's Wall Street Journal notes, he probably gains more through the impact of the threat on oil markets than he could from its actual execution. Still, Mr. Chavez has earned his reputation for being mercurial and unpredictable. With high energy prices already contributing to the weakness of the US economy, how much damage could such an oil cut-off inflict?

As of November, US crude oil imports from Venezuela in 2007 were averaging 1.1 million barrels per day, or about 11% of all our oil imports, with most of it coming into the US Gulf Coast, followed by the East Coast and an occasional cargo to the West Coast. By contrast, that volume amounts to roughly half of Venezuela's total oil exports, corresponding to roughly 20% of the country's GDP at current exchange rates. While the global crude oil market would surely readjust to compensate for a Venezuelan oil embargo against the US, the financial consequences of the temporary chaos following such a move could be proportionally worse for the perpetrator than the victim.

At the same time, we shouldn't underestimate the fallout in domestic energy markets, and for the economy as a whole. Even in a globalized market for crude oil, it would take a while to work around such a significant shift. US refiners would have to scramble to purchase cargoes of oil from more distant suppliers, driving up the cost of shipping and bidding up the price of the nearest substitute grades of oil. Coming at a time when the output from West Africa has been reduced by problems in Nigeria, it could take a couple of months to arrange suitable alternatives. In the interim, commercial crude oil inventories, which have recently recovered to more comfortable levels, would fall dramatically, unless bolstered by releases from the Strategic Petroleum Reserve.

Nor would refiners be the only ones affected. Although oil futures seem to be pricing in some small probability of such an outcome, the actual event would drive prices up by a lot more than a dollar or two. A $10 per barrel spike, about the least I can imagine for such a disruption, would quickly translate into another $0.25/gallon or so at the retail level, pushing us close to a record high for gasoline. That would pinch the average household's budget to the tune of another $20/month, further squeezing a variety of merchants or adding to credit-card debt.

Mitigating against that eventuality is the reality of what such a cut-off would mean for Venezuela. Citgo, the US refining and marketing subsidiary of PdVSA, the Venezuelan state oil company, controls about 5% of US refining capacity. Its facilities would presumably be hit as hard as any others by an embargo. Meanwhile, just as US refiners would drive up the price of non-Venezuelan oil in their search for substitutes, PdVSA would have to discount its oil twice, to keep it flowing. That's because the cost of shipping it to Europe or Asia would be much higher than for the short voyage from Maracaibo to Houston, and because few refineries elsewhere are configured to extract maximum value from the heavy sour crudes that make up much of Venezuela's output.

While I'm skeptical that President Chavez's remarks about suspending exports to the US mean much outside the context of his ongoing dispute with ExxonMobil over the nationalization of their assets in his country, stranger things have happened. Given the general antipathy of his government for ours, I continue to believe that we would be wise to plan for this outcome occurring sooner or later, and wean ourselves from a supplier so bent on creating the perception of unreliability. A gradual divorce would hurt both countries a lot less than a sudden breach.

Another Castro, With Oil?

Roger Cohen’s column in yesterday’s New York Times called attention to Venezuela’s impending constitutional referendum, which is expected to cement Hugo Chavez’s aspirations as President-for-Life, giving him effective control of the few levers of government that he had not yet consolidated. The following is excerpted from a posting I wrote in August 2006, examining some of the implications for Venezuela and the US:

As Fidel Castro fades from view and Venezuelan President Chavez accretes ever more power to himself, the speculation about Sr. Chavez’s ability to assume the mantle of Castro's revolutionary leadership grows. That would be worrying enough, geopolitically, if Venezuela weren't also our fourth largest oil supplier. Oil is the only thing that makes Chavez's "Bolivarian Revolution" economically feasible, though it's worth recalling that Chavez's own actions had previously put Venezuela's future oil revenues into a death spiral, by breaking the 3-month strike of the national oil company, PdVSA, and firing 18,000 managers and workers. By a quirk of fate or good luck, this was just about when oil began its long march to $75/barrel, with the US invasion of Iraq. So even though Venezuela's oil production has never entirely recovered from the strike, its oil revenue has risen dramatically.

According to the Oxford Institute for Energy Studies, Venezuela's oil export revenues in 2000 were $27 billion, but their net from that was only about $11.3 billion, after accounting for tax and royalty rates that were intended to make the country's challenging oil reserves more attractive to international investors. At current (2006) prices, gross revenue on today's lower volumes should be roughly $50 billion, but their net take has probably tripled, after factoring in the recent changes in terms. That's quite a track record, but where does it go from here? While oil may yet hit $100, that won't necessarily add another $25/barrel to the price of the heavy oil Venezuela specializes in. We are into diminishing returns, here. Venezuela has only a few more levers to pull on oil revenues:

• Completing the recent partial nationalizations. However, if companies like Chevron actually do know more about running these complex facilities than PdVSA's downsized staff, production would fall again.


• Expanding production via more international investment, presumably with a different group of companies, since the political risk models of the folks who've already been semi-nationalized must be flashing all sorts of warnings. Unfortunately, those same companies are the ones that best understand the intricacies of Venezuela's Orinoco Belt geology and the necessary upgrading technology. There's also a significant time lag involved in bringing new upgraders on-line.


• Cutting off oil exports to the US. They'd have to hope that the resulting rise in world oil prices would more than offset the much higher freight costs to Venezuela's alternate markets in Asia or Europe, and that this could be done without triggering a direct response from us. This looks like a fool's bet.

So, unless the adherents of the Peak Oil theory are correct and global production will never again outpace demand growth, Mr. Chavez could just be looking at the high-water mark of his oil revenues, at the same time that he has committed himself to foreign activities and transactions that will tie up an increasing share of them, on top of an ambitious domestic social agenda. There's no better antidote to good luck than hubris, and an extra $20 billion or so of oil money only goes so far in a region with an aggregate GDP of $2-4 trillion.

The Chavez Way (Re-run)

I see that President Chavez has moved another step closer to reshaping Venezuela into a Cuba with oil, by gaining preliminary approval for his constitutional "reforms", which include the removal of term limits on his rule. As preoccupied as we are with events in the Middle East and Afghanistan, we can't afford to ignore this self-declared foe of America's interests. I looked at some of the implications of his policies in this posting from last April:

The Chavez Way
It might be tempting to view the creeping nationalization of Venezuela's oil industry as an appropriate re-assertion of indigenous ownership of natural resources, taking them back from a greedy international oil industry dominated by rich European and American companies. President Chavez's energy minister, Sr. Ramirez, explains these actions (NY Times archives) by saying, "...this country and this government do not allow themselves to be blackmailed. We don't want companies that do not adjust themselves to our laws in our country." Unfortunately, this is a classically inverted piece of propaganda, in which the blackmailers claim to have been blackmailed, and the thieves complain they are the victims of theft. Herr Goebbels would recognize the emulation, conscious or not.

I don't need to recite my earlier comments about the degree to which Sr. Chavez's present power and growing political influence are largely the result of sophisticated oil processing hardware built and paid for by the same multi-national companies that have become his scapegoats. You can read those elsewhere, if you like. Instead, I think it's more important to contemplate the implications of the latest round of oil asset seizures for the global energy market.

Venezuela may not be Saudi Arabia, but in energy terms it is in the same league, in terms of its direct impact on the US energy situation. We rely on Venezuela for 11% of our oil imports, along with additional supplies of gasoline and distillate. The country has between a quarter and half of the western hemisphere's oil reserves, depending on how you count Canadian oil sands, and excluding Venezuela's undeveloped ultra-heavy Orinoco deposits. At the same time, a wholly-owned subsidiary of the Venezuelan state oil company supplies 10% of the US gasoline market. How many Americans realize that 14,000 Citgo stations provide are the local face of an increasingly hostile foreign government?

The re-direction of Venezuela's oil wealth has immediate consequences, raising the stakes in an already frothy, risk-driven oil market. It also has two less-direct, longer-term outgrowths. First, although I remain skeptical about the prospect of an imminent peak in global oil production, the peak in non-OPEC production is in sight, as mature basins in North America and the North Sea run down. The world will increasingly need to draw on the oil resources of OPEC countries, and access to that oil on commercial terms is key. Venezuela's actions remind other producers of the temptation, especially at times of high prices, of enjoying 100% of the proceeds of investments made in their countries by Exxon, Shell, et al, rather than having to share them. We have been down this path before, and its benefits are largely short term, as countries such as Libya and Kuwait have begun to realize. A return to the large-scale nationalizations we saw in the 1970s would guarantee the premature arrival of Peak Oil.

The other geo-political concern is not specific to energy. Surging oil income gives a disproportionate heft to the distorted economics of President Chavez's Bolivarian Revolution and make it more attractive and influential throughout Latin America. What he portrays as a fairer system is nothing more than the re-distribution of billions of dollars in resource rent. However, that may not be immediately obvious to the millions in poverty for whom his philosophy appears superficially more attractive than the international system of globalized trade, as we saw in Bolivia's recent elections. While much of our attention is focused on dealing with radical Islamic adversaries, we cannot ignore the dangers of an emerging petro-fascism to our south. Mr. Chavez has ways to hurt us of which Al Qaeda can only dream.

Joining the Party Up North

Marathon's announced acquisition of Western Oil Sands Inc., a Canadian firm with a significant stake in the Alberta oil sands play, extends a sequence in which most of the large integrated oil companies have expanded their portfolios to include these unconventional hydrocarbons. With the notable exception of BP, the majors have all either been there from the start, decades ago, or bought their way in, as access to other opportunities around the world dried up. Marathon's move could signal a further shift, however, in which the next tier of the industry also looks north; this might not be limited to integrated firms or independent producers, either.

A decade ago, Venezuela's Orinoco Belt looked like the place that everyone had to participate, for many of the same reasons that Canada's oil sands now look attractive: enormous potential reserves with minimal exploration risk, a friendly government, and a big technology component that fits the international firms nicely. Like the Orinoco, oil sands exploitation involves big, upfront investments that pay healthy returns as long as oil prices are high. Unlike Venezuela, however, it's hard to imagine a scenario in which Canada would unilaterally change the terms of access or nationalize these resources. Political risk was always the Achilles' heel of the Orinoco, and the only risk in Canada that comes close to the same importance is climate change policy, given the high greenhouse gas emissions of oil sands extraction.

When you consider the characteristics of these projects, there is little that would prevent a company with no current upstream exposure or expertise from getting involved. Much of the capital of these facilities is tied up in the refinery-like processing hardware that turns the gooey bitumen into a synthetic crude suitable for pipeline transportation and handling in a conventional oil refinery. To the extent that upstream expertise is required, Canadian partners can provide it. So might an oil sands investment appeal to one of the big independent refiners, Valero or Tesoro?

On the face of it, the idea of a pure-play refiner integrating upstream might seem unlikely. These companies largely built their portfolios from the divestitures of majors that saw little benefit in integration. Part of their appeal to investors is their lack of exposure to the above-ground risks that bedevil the majors in places like Nigeria, Russia, and Venezuela. But in a scenario in which crude oil became not only expensive but hard to get, integration could again pay big dividends, and independent refiners could find themselves under-running their multi-billion dollar assets. One needn't even believe in imminent Peak Oil to imagine such a scenario. Unwillingness on the part of OPEC to boost oil output, the continued growth of Asian demand, and a wave of new refinery construction in the Middle East and Far East could combine to leave US refiners scrambling for feedstock. Companies with their own equity crude to run or trade would have a real edge, as we saw in the early 1980s. Having a lock on a supply of pipeline crude from Canada might be worth a lot in such an environment.

Please note that this idea is entirely speculative; I have no reason to believe that either Valero or Tesoro is pondering such an investment. But if I were in charge of strategy for either firm, this option would now be high on my list for consideration.

Replacing Venezuela

When Venezuela takes control today of the Orinoco oil fields largely developed at the expense of American oil companies, it is sending a clear signal that it is time for us to diversify our supplies. This event doesn't come as a surprise, but as yet another milestone on the path that President Chavez began when he turned the country's formerly independent national oil company, PdVSA, into an instrument of state policy. This coerced transfer of ownership ends a long period in which Venezuela was an important bulwark of US energy security. While we will continue to receive Venezuelan oil for years, because of its proximity to and suitability for US Gulf Coast refineries, we can no longer count on them to be there in a pinch, or to honor contractual commitments made in good faith. But where do we find another Venezuela, in resource terms?

A recent op-ed in the Wall St. Journal explained that the essence of energy security lies not in self-sufficiency--which hasn't been practical since the 1950s--but in a diverse supply base. Some might look to ethanol to fill the gap, but even at its expected production rate of 6 billion gallons this year, ethanol provides less volume than the oil we import from Algeria and contributes the energy equivalent of just one medium-sized offshore oil platform. For the near term, only more oil--or the conservation that has yet to materialize--can replace lost oil. As important as it has been in bolstering our diversity of supply for the last several decades, it is fortunate that Venezuela only supplies about 10% of our crude oil imports, making its gradual shift toward supplying its Latin American neighbors and China in preference to us a challenge, but not a crisis.

With resource owners such as Russia enjoying the negotiating power that high oil prices bring, many of the companies being displaced from Venezuela are looking to Canada's oil sands, where Statoil has just acquired a $2 billion stake. There aren't many other opportunities at this scale that aren't controlled by national companies. Although technically quite different from Venezuela's heavy oil reserves, the oil sands require the kind of process-intensive techniques at which the international oil majors excel. A dependable legal system makes them even more attractive. Oil sands production is growing fast enough eventually to offset any lost supplies from Venezuela, though at an environmental cost that includes large quantities of greenhouse gas emissions.

The situation in Venezuela illustrates some important lessons about the role of publicly-traded oil companies and the challenges they face. Although earning disconcertingly large profits at the moment, these firms face daunting risks and deteriorating terms in the countries where most of their future production lies. Russia's recent "renegotiation" with Shell over the Sakhalin LNG project looks little different from what Sr. Chavez has just done to ExxonMobil, Chevron and ConocoPhillips. At the same time, the direct country-to-country ties that are emerging as a threat to the prevailing commercial model of oil development carry their own risks. If the web of petroleum links between the US and Venezuela were at the government-to-government level, rather than between large international oil companies and PdVSA, would we now be looking at a complete cutoff of supply, rather than a partial nationalization?

Given all the geopolitical risks and environmental challenges that are piling up around the world, we need large, financially-sound US-based energy companies that can find and develop oil and gas under a variety of geological and political conditions, in a large number of countries. Whether we like it or not, these companies will provide the main sources of our energy security for years to come, until alternative energy eventually grows large enough to displace them from this function.

Trade Missions

In the last week two powerful executives have taken important trips to meet with officials in nations that could supply the US with additional energy. These missions couldn't be more different in their public profile, but together they tell us a lot about the likely sources of our energy security over the next decade. President Bush is in Brazil, meeting with President Lula da Silva on the topic of ethanol production, and the CEO of ExxonMobil, Rex Tillerson, just returned from a visit to Libya, where he discussed that country's under-developed oil reserves with Muammar Qaddafi. Some might contrast these trips as the dawn of a new world of energy and a last hurrah of the old one, but I'd prefer to view them both as important aspects of the real world of energy in which we will live for the next couple of decades.

Despite problems of logistics and energy return, ethanol demand is growing, because of its environmental and energy security benefits. However, barring a prompt cost breakthrough on cellulosic ethanol technology, the US will be unable to meet the President's aggressive alternative fuel targets without help from imports. Brazil, which can produce large quantities of additional ethanol at lower costs than the US, represents the leading edge of the global trade that will be necessary to satisfy future biofuels demand in the US and other developed countries. Doing so won't be easy, because the US goal of 35 billion gallons per year by 2017 represent more than 3 times the worldwide production of fuel ethanol in 2006. That means that global ethanol output would have to sustain growth of 12% per year for 10 years, just to satisfy the US.

Creating a framework for high volumes of ethanol trade looks equally challenging, in part because of the distortions created by the US ethanol subsidy and the accompanying--and much misunderstood--tariff on imported ethanol. Today's Wall Street Journal described the lengths that producers and traders will go to, to avoid the 54 cent tariff, effectively capturing a 51 cent subsidy intended for American farmers, rather than their Latin American counterparts.

So where does Mr. Tillerson's visit fit in? Well, even at 35 billion gallons, ethanol would still only equate to a bit more than 2% of global oil production by 2017, or less than 10% of projected US oil consumption. The security of the remainder will have to be ensured in the same way that it has been for the last two-plus decades: by creating as diverse and reliable a base of suppliers as possible. Venezuela was a bulwark of that diversification throughout the 1980s and '90s, but it is now moving sharply into the "unreliable" category, with international companies of all stripes facing high political risk there. Libya can't replace Venezuela for us, even if Col. Qaddafi has turned over a new leaf, but boosting its output by a million barrels per day or more would shore up supplies to southern Europe, thus freeing up production from West Africa for Atlantic Basin customers. And for now Libya looks like a better bet than Iraq, where tens of billions of barrels of untapped oil are certain to remain in the ground until the civil war ends.

As important as President Bush's ethanol mission to Brazil is, applying the influence and leverage of the US government to opening up access to the oil reserves held by the national oil companies is even more urgent. In our understandable enthusiasm for alternative energy, we can't lose sight of the total energy mix, which will be dominated by fossil fuels for some time, yet. Balancing these complementary sources is a key element of national energy policy.