Global Shale Oil and Gas Estimates Expand

• The Department of Energy's revised shale resource estimates shed new light on the global extent of shale gas and especially shale oil potential.
• While in the US shale gas preceded large-scale shale oil development, other countries may find fewer obstacles for the latter, and an eager market.

Recently revised estimates of global shale oil and gas resources from the Energy Information Administration (EIA) of the US Department of Energy represent a significant increase over the EIA's 2011 estimates.  Technically recoverable shale oil (tight oil) grew more than tenfold, due to the inclusion of formations outside the US, while estimated global shale gas resources rose by 10%. With these revisions, shale formations now constitute 10% of global crude oil resources and nearly a third of global natural gas resources, although the actual impact of these resources on production and markets is still likely to vary greatly from region to region and country to country.

This year's report reflects a greater focus on tight oil, incorporating insights from the significant development of US tight oil resources that has occurred since the previous report was published. Tight oil development is largely responsible for the 19% increase in US crude oil production from 2010 to 2012.  The smaller adjustment to shale gas is the net result of downward revisions for some countries assessed in 2011, such as Poland and Norway, together with the inclusion of resources in additional shale formations and countries, including Russia, Indonesia and Thailand.

The EIA and the consulting firm that prepared the report were careful to differentiate the technically recoverable resources (TRRs) identified in this data from the more restrictive categories of economically recoverable resources and proved reserves. In other words, these figures represent the quantities of oil and gas that could be recovered if prices justified development and infrastructure was available to carry them to market, not the amounts that producers currently plan to develop.  At the same time, these estimates constitute only a small fraction--at little as 5-25%--of the oil and gas thought to be present in the assessed shale deposits.  Further improvements in technology could substantially increase future TRRs. 

It's interesting to note that although the US leads the world in production of both tight oil and shale gas, it ranks second and fourth, respectively, in global resources of these fuels.  The report also indicates that estimated US tight oil resources of 58 billion barrels (bbl) are more than double current proved oil reserves, which represent just under 7 years of current production.  That's significant, because a sizable fraction of the 139 billion bbls of US conventional unproved TRR--non-shale crude oil not currently included in proved reserves--sits in onshore and offshore areas currently off-limits to drilling. So shale provides a pathway for US oil production to sustain higher output than in the recent past, without having to overcome barriers such as those impeding development offshore California or in the Arctic National Wildlife Refuge. 

Or consider Russia, for which the report cites proved reserves equivalent to 21 years of production and slightly exceeding tight oil TRRs.  Russia possesses many of the factors conducive to shale development, including a large drilling fleet and an oil industry accustomed to drilling large numbers of wells, along with oil-transportation infrastructure. It remains to be seen whether Rosneft and other producers will choose to develop the Bazhenov shale and other deposits rapidly, to increase total output and exports, or more gradually, to offset declines in mature fields and maintain current production rates.

The EIA also reported 32 billion bbls of tight oil TRR in China.  Conventional reserves are comparable to those of the US, supporting current production less than half America's.  Without tight oil, China's economic expansion and the rapid growth of its vehicle fleet put it on track to displace the US as the world's largest oil importer within a few years.  China-based companies are seeking oil in Africa, South America and North America, so it's hard to envision them leaving their own shale resources undeveloped. 

The situation is more complicated for shale-rich OPEC members like Libya and Venezuela.  For example, aside from its current political instability, Libya has nearly 90 years of conventional oil reserves at its current OPEC quota of around 1.5 million bbl/day, before considering the 26 billion bbls of tight oil identified by the EIA.

On balance, the latest EIA shale resource assessment presents a wider and more realistic view of shale outside the US than in 2011. That includes tempering some of the previous report's enthusiasm for shale gas prospects in places like Poland, where few wells had been drilled until recently. The new element is the report's portrayal of the tight oil resource base as broad and deep, centered mainly on countries likely to be motivated to develop it. The shale gas revolution may be slow to spread globally, due to much-discussed differences in the conditions for development, compared to those in the US.  By contrast the development of shale oil, or tight oil, faces fewer obstacles and an eager market.

A slightly different version of this posting was previously published on the website of Pacific Energy Development Corporation.

Energy Crisis Prices Persist

Watching oil prices is a hard habit to break, once formed. They're always moving up and down, sometimes for obvious reasons and sometimes not. It has probably escaped most observers' notice that the magnitude of this year's price moves has exceeded the total nominal price of oil that prevailed not many years ago, yet without the sort of apocalyptic events that one might expect such volatility would require. Perhaps that's because we seem to be stuck in the middle of an ongoing, slow-boil oil crisis from which the financial crisis and the demand contraction that accompanied the global recession only provided a brief respite. In fact, when you glance at the oil price trend in real dollars over the last 40 years, it's apparent that prices are back at the level associated with the peak of the oil crisis of the late 1970s and early 1980s:


One reason I've been paying extra attention to oil prices lately is that I've been observing the impact of the coordinated release from the US Strategic Petroleum Reserve (SPR) and strategic reserves of other members of the International Energy Agency. So far, my initial assessment that it would have little lasting effect seems to have been validated, though I'll reserve judgment until the oil is actually delivered during August, when we might see the market respond to the increase in commercial oil inventories that should result. Robert Rapier had an excellent posting yesterday on the folly of this decision. My view is, if anything, less flattering. Not only was this choice unwise, but it also appears to have been ineffective, which in the current economic climate is an even more damning assessment.

The modest response to this move tells us something about the fundamentals of the market. In the past, an SPR release on this scale would have crushed prices--not just for a few days, but for months at least. Consider the release that accompanied the start of the first Gulf War in 1991. Only about half of the nearly 34 million bbls authorized was eventually sold, but the price of oil dropped by 33% overnight and took 13 years to recover to the peak it had reached during the lead-up to Desert Storm. By comparison, the announced release of 30 million bbls from the US SPR--the sale of which was fully-subscribed--and another 30 million bbls from other IEA members managed to depress the price of oil by only around 5% for a week or so. As of this morning Brent crude, the global marker, is $4/bbl higher than it was on June 22nd. And as of this Monday's survey, the average pump price of unleaded regular in the US was also higher than before the President announced the release.

The market's tepid reaction to the SPR release suggests that oil prices have been driven up by more than just speculators. Speculation may be playing a role, but it's more like the head on a glass of beer. Beneath that froth lies the robust demand growth in the developing world, which has pushed global oil consumption to a record level of 89 million bbl/day this year. On the supply side, some point to incipient Peak Oil, but characterizing the crisis we're in doesn't require a grand theory. In addition to the curtailment of production from places like Libya and Yemen, and OPEC's desire to keep a lid on output to preserve their revenues, there's a fundamental mismatch between the companies that have the capital and the desire to invest in new production, and the willingness of some governments to grant access to the resources, whether in the Middle East or the US. All of this is compounded by the inherent time lags in resource development, which can range from 5-10 years, depending on the technology and permits required.

As different as the causes and symptoms of this crisis are from those of the 1970s, the broad outline of solutions remains quite similar: Reduce demand, increase supplies, and diversify our sources of energy. We have more and better options than in 1979, but still no miracle cures.

The Results of Energy Policy

The combination of an energy event yesterday in Washington, DC that I was unable to attend and a comment I received on Monday's posting got me thinking about energy policy in the context of the new year and the start of the new Congressional session today. National energy policy has been debated throughout my adult life, whether the policy of the time was clearly articulated and effectively executed or not. The most important question is not what the policy says, but what it does and whether that aligns with what the nation really needs its energy industry to deliver. In my view our current energy policy is on the wrong track, and the new Congress and the spirit of bi-partisan cooperation that emerged in the recent lame duck session provide an excellent opportunity to revise it along more effective lines.

I would summarize our current energy policy as being focused on promoting greater efficiency and the development and deployment of new energy technologies, in order to reduce our dependence on imported energy from unstable or unreliable sources, and to reduce our emissions of greenhouse gases, more than 80% of which are associated with our production and consumption of energy. That sounds fine, but in practice the effect of that policy appears to be replacing low-cost energy with higher-cost energy, while attempting to maximize the employment associated with producing clean energy, rather than minimizing its cost.

What are the results so far? Well, the significant reduction in US oil imports that we've experienced recently is attributable mainly to the weak economy and high unemployment, rather than to improvements in vehicle fuel economy or domestic biofuel production. And the reduction of greenhouse gas emissions that has occurred in the last several years has mainly resulted not from policy-related measures to expand wind power or replace incandescent lights with compact fluorescents, but from two events with little connection to energy policy: the recession--particularly the slowdown in US manufacturing--and the unexpected growth of natural gas production from shale resources. That might not be a fair gauge of what current policies could achieve in the future, but it's clear that an energy policy that depended on economic weakness for its success would be contrary to our national interest.

For decades the de facto energy policy of the US promoted cheap and abundant energy to sustain economic growth. We live in more complex times, but focusing most of our current energy efforts on solutions that are still small-scale and high-cost seems unlikely to do much for the economic recovery. If we were really serious about fueling the recovery, we'd be at least as interested in promoting abundant, low-cost energy at a scale suitable for the needs of a $14 trillion economy, and for which employment gains in the energy industry didn't come at the expense of productivity. A study on the trade-offs between resource access and new taxes on the oil & gas industry that was prepared in conjunction with the release yesterday of API's "State of American Energy" report provides a case in point.

An international energy consultancy analyzed the potential production and employment gains associated with expanded access to the domestic resources that are currently off limits in places like the eastern Gulf of Mexico, the Atlantic and Pacific coasts, and the Arctic National Wildlife Refuge. They also looked at the federal revenue and employment impact of higher taxes on the US oil & gas industry, along the lines of a series of proposals from the administration and Congress in the last two years. They found that access to off-limits oil and gas could yield up to an extra 2.8 million barrels per day of oil and gas liquids and 6.6 billion cubic feet per day of gas by 2025, with direct and indirect gains in employment of more than 500,000 workers. By contrast, increasing taxes on the industry would not only reduce production and employment, as domestic opportunities become less attractive than those elsewhere, but also reduce total federal revenues from taxes, royalties and leasing, following a brief uptick in the initial period after their introduction. Although I'm not sanguine about the chances for increasing access when the administration has just reversed its earlier expansion, that would at least be more consistent with an effective energy policy than raising taxes on the production of energy.

We have a long, bi-partisan tradition of well-intended but ineffective energy policy, and the current policy continues that trend, even if its shortcomings differ significantly from those of past policies. The good news is that we have many more options and choices than we did when the US energy policy debate began in earnest in the 1970s. What we need now is a policy that recognizes that most of these sources, old and new, are important for our present and future energy security, but that what we chiefly require is abundant low-cost energy to fuel an economic revival strong enough to help shrink our enormous federal, state and local fiscal deficits and resulting massive debts, which also have solid bi-partisan pedigrees. It should also put us on a path to lower emissions from whatever sources can deliver them on a meaningful scale and at a cost that we can afford.

Setting Energy Goals

With the failure over the weekend of BP's "top kill" effort, the odds that the oil will continue flowing until relief wells can be completed--in months, rather than days--have gone up considerably. In addition to the accumulating economic and environmental consequences, that also means that media attention on the oil spill and the questions it raises about US energy policy will remain front and center for at least that long. In the absence of any formal effort to guide the discussion, we're likely to end up with the usual array of random energy musings and rants, built around an understandable, if unrealistic message of ending our reliance on oil now. That would be a shame, because this sad situation gives us a unique opportunity to refine our thinking about our energy future when much of the country is focused on it.

One comment that I've heard frequently in the last few weeks is that this spill serves as a reminder that oil companies are drilling in depths of a mile or more of water, far offshore, because the easy oil is mostly gone. There's more than a grain of truth in that view, though the full picture turns out to be rather more complicated. While it's certainly true that the mature oil regions of the US have been drilled like a pincushion for 150 years, and that many of the large, important undeveloped oil resources we know about are on the Outer Continental Shelf, there's still a lot of oil in other places, both onshore and in the nearer offshore, in shallower water, that we've chosen not to exploit. Access has driven development at least as much as geology in the last decade or two. In the US, we've made an implicit decision to focus oil and gas development on the Gulf Coast, not because it had the most resources--though it has plenty--or because it was less-densely populated , but presumably because it had already been developed so extensively. In effect, this approach sacrificed the Gulf Coast--whether that sacrifice was ever envisioned in quite the terms we're seeing today--to give us the oil we needed while preserving the beaches and viewscapes of our other coasts.

There's also an international dimension to this issue of access. At the same time the US offshore oil industry has been constrained in a box with only one open end pointed toward ever deeper water, the publicly-traded international oil companies have been progressively squeezed out of world-class oil opportunities elsewhere, as a result of full or partial nationalization and through competition with national oil companies that are guided not by market forces, but by geopolitical ones. As a result of these parallel trends, the major oil companies have focused their efforts where they retained both access and some key advantages over many of their state-owned competitors, usually in the form of technology or management of complex projects. In other words, they've been pushed to the frontiers, such as the deepwater Gulf of Mexico.

While many lament the powerlessness of the US government to plug the leaking well, and some like Admiral Allen ponder whether the government should acquire that capability for itself--a topic for a future posting--we shouldn't ignore that even without banning deepwater drilling the federal government has the power to shift the industry toward less-risky opportunities by expanding its access to onshore and near-offshore resources that are more attractive and less difficult, but have been restricted for years.

Another common response to the spill relates to the incentives for moving away from oil. If we just had more incentives for biofuels and for electric vehicles, goes this thinking, we could quickly wean ourselves off oil and not only do away with the need to import it, but also to drill for it in such challenging locations close to home. While many of my recent postings have been aimed at showing why this can't happen quickly, I want to disassociate myself from what Tom Friedman calls the "petro-determinist" approach. I'm not here to tell you that breaking our addiction to oil is impossible; if I thought that I wouldn't have spent much of my career working on or promoting alternatives to oil. At the same time, with the current euphoria for cleantech and green jobs, someone needs to remind us that if breaking our oil addiction requires a 12-step program, we are only on about step 2. More importantly, it matters how we get there: Not all paths are equally valuable, and we don't have good enough information to determine which ones will work best in replacing a hydrocarbon-based energy system that evolved over the better part of a century.

Consider vehicle electrification, which depends on batteries. If the goal is putting the largest number of mainly-electric vehicles on the road in the shortest time, then we might be on the right track, handing out extremely generous tax credits for consumers to buy fully- or partially-electric vehicles, along with billions of dollars in manufacturing tax credits, grants, loans and loan guarantees for the factories to build those cars and the batteries they require, in addition to installing the recharging infrastructure they'll need. But if our goal is to reduce oil consumption and the emissions that accompany it, then this approach could be counterproductive, particularly if growing concerns about the availability and sourcing of the crucial raw materials necessary to build today's state-of-the-art electric vehicle batteries are correct. Simply put, the batteries in a Prius-style hybrid that never plugs in save many more annual gallons of oil per kWh of onboard storage than the batteries in a plug-in hybrid (PHEV) or full EV. That's true for two reasons that are a function of physics, rather than economics: a) fuel economy is subject to diminishing returns, in which moving from 25 mpg to 50 mpg saves twice as much total fuel as going from 50 mpg to 100 mpg and b) PHEVs and EVs require a lot more battery capacity per car than conventional hybrids.

What both of these examples share in common is that focusing on specific paths instead of outcomes can be counterproductive and multiply risk, instead of reducing it. An oil policy that started with the recognition that we must produce significant quantities of oil domestically during a lengthy transition to alternative and renewable energy sources, and that asked where the best-placed resources were to provide that supply with the least risk, might arrive at a different answer than one that resulted from a series of isolated decisions to place a growing sequence of oil resources off-limits. Likewise, a fuel economy and emissions-reduction strategy centered on annual fuel savings, rather than rewarding consumers and carmakers for concentrating the largest number of batteries into each vehicle, would better leverage vehicle-electrification technology to reduce our reliance on oil. That's particularly relevant when batteries look like a short-to-medium term constraint and their raw materials might impose longer-term limits until we have better battery technology based on cheap and plentiful raw materials.

If the Gulf Coast spill represents another crisis too important to waste, then it's also one that is too important to relegate to unfocused wishes for an oil-free world within the next few years. The best "use" of the spill is to convene a concrete national conversation on how to provide the US with energy that is as affordable and environmentally-acceptable as we can realistically make it in the in the short, medium and long-term. That will require examining all the trade-offs involved, as well as how the balance between conventional energy and renewables and other alternatives is likely to shift in the years ahead. If that did nothing else but get us clearly focused on outcomes, rather than picking our favorite pathways, then it might constitute a positive outcome from an otherwise miserable episode in our nation's energy history.

FYI, tomorrow (June 2) at 1:00 PM EDT I'll be on a webinar panel hosted by The Energy Collective to discuss the implications of the oil spill for the future of energy. If you're interested, please sign up using this link.

A Self-Fulfilling Bet on Biofuels?

An article in today's Financial Times (registration required) raises a worrying possibility concerning the plans of the US and other oil-consuming countries to rely on biofuels for an increasing fraction of future fuel needs. What if oil-producing countries took those plans seriously and reduced their investment in new oil capacity, on the assumption that it wouldn't be needed? In some respects, that's exactly what we have in mind. However, if biofuels then failed to materialize in sufficient quantities to fill the gap between oil supply and total fuel demand, or proved to be economically or environmentally unsustainable, then we might inadvertently create precisely the sort of crisis these efforts were intended to avert. It would be easy to dismiss this argument as OPEC-inspired propaganda, if global oil production didn't require enormous ongoing investments to counteract the natural decline rates of producing fields, and if producing-country governments weren't already under internal pressure to spend their oil profits on programs other than reinvesting in future production.

The good news here is that biofuels have reached a scale at which they actually matter in the global oil supply and demand balance. That wasn't the case during the oil crises of the 1970s, and they were still only a marginal factor when oil prices last peaked in 2008. The latest publicly-available issue of the International Energy Agency's Oil Market Report indicates that biofuels now contribute the equivalent of 400,000 barrels per day (bpd) of oil, before including US and Brazilian ethanol volumes that together equate to another 650,000, bringing the global total to just over a million bpd. That might not sound like a large share of a total market of 85 million bpd, but it's enough to influence the global price of oil, which is set at the margin. Doubling or tripling biofuel output would certainly cost oil producers money, if they ignored this factor in their capacity planning.

So far, this is only a problem for oil producers. It becomes a problem for the rest of us when the biofuel plans and targets of consuming countries are based on unproven technology that may not be able to deliver in time, or possibly at all. Unfortunately, that's the position in which we find ourselves. Consider the Renewable Fuel Standard (RFS) enacted by the Congress in 2007 and refined in new regulations issued by the Environmental Protection Agency. Out of the 36 billion gallon per year target for 2022, only around 16 billion gallons is accounted for by corn-based ethanol and first-generation biodiesel--both of which have been amply proven, however much they depend on generous subsidies to remain competitive. 20 billion gallons per year must come from cellulosic ethanol and other advanced biofuels, none of which are in truly commercial production today, in spite of the hype that has been generated by a handful of "demonstration facilities."

One indication of just how unrealistic these targets might be is that EPA was forced to reduce the cellulosic biofuel target it will enforce for 2010 from 100 million gallons to 6.5 million gal.--the equivalent of just over 400 barrels per day of oil--due to lack of supply. And while the agency attributes that shortfall to delays in starting up new facilities using a variety of new technologies, a careful reading of their analysis suggests the problem might be more serious than that. Two firms account for nearly a third of the 694 million gallons of cellulosic biofuel capacity they expect will be in operation by 2014, Cello Energy and Range Fuels. Unfortunately, last year Cello was ordered by a federal court to pay $10 million for defrauding investors concerning its technology claims. Meanwhile blogger Robert Rapier has documented the problems that Range Fuels has experienced in scaling up its process for producing ethanol from gasified biomass. Until both of these firms have demonstrated they can actually do what they claim, at full scale, it's not prudent to bet the ranch on their production forecasts.

Problems such as this are probably just the tip of the iceberg when it comes to scaling up a myriad of new processes for producing motor fuels from non-food biomass, not because it's impossible or because the firms involved don't have sufficient smarts--though one or both of those factors will turn out to apply in at least a few cases--but because it is intrinsically hard. Scientists have been working on cellulosic biofuels and biomass-to-liquids processes for decades, yet the sum total of all that work, up until this point, has only yielded enough fuel production to cover the annual consumption of about 13,000 average American cars. That doesn't mean that companies and investors are foolish to pursue these technologies, or that ExxonMobil is wrong about the potential they apparently see in algae-based fuels, another hot biofuels sector. What it does mean, however, is that when dealing with technologies that can't be made to appear on command and are subject to a number of serious, unresolved technical and logistical challenges, neither consumers nor our governments should base their plans for the future on the assumption they will mostly succeed on schedule.

How realistic is it that the oil-producing countries that control access to the vast majority of the world's oil reserves would be so convinced by our rhetoric concerning biofuels replacing oil, that they will cut back their investments in new capacity? Part of the answer lies in the narrative of Peak Oil that generated headlines when oil prices were spiking a couple of years ago, involving the high decline rates of mature oil fields and the relatively low investment rates of many producing countries. When the government of Venezuela must borrow money from China despite $80 oil, that's one signpost that they might not have enough to reinvest in exploration and production. We can argue about the likely date of a peak in global oil output, but anything that provides governments an excuse to spend less sustaining their oil industries brings that date closer--and that's equally true for a US administration that appears so confident of the success of its biofuels and fuel economy programs that it can allow the timing of the next offshore oil leasing cycle to slip further and further.

Oil is still the lifeblood of our industrial civilization, but it's also a business requiring enormous investments premised on the likelihood of future demand. That doesn't mean we must remain helpless hostages to foreign oil suppliers; fuel efficiency and biofuels are both sensible--even necessary--strategies for us to pursue. But we have an even larger stake in ensuring that the biofuel goals and plans we communicate, not just among ourselves but simultaneously to our oil suppliers, are based on reality. If both we and they are betting on supplies of advanced biofuels that could well fall significantly short of our expectations, then it is we who will suffer the consequences at the gas pump.

2010 and Beyond

The start of my seventh year of blogging on energy and its related environmental concerns coincides with the start of a new decade, unless you're of the traditional school that believes the twenty-teens don't really begin until next January 1. Over the holidays I was struck by the number of retrospectives focused on the amply eventful, but profoundly disappointing decade that was ending. Having spent several years reassuring my readers that we weren't reliving the 1970s, in retrospect I'm not so sure. Yet as bad as the '70s were on so many levels, they gave birth to the '80s, which brought revitalization and tremendous technological developments, and culminated in the end of a Cold War that most of us had considered perpetual. There's cause for guarded optimism about the decade ahead, particularly for energy, which is still in the early stages of a massive transformation. The 'Teens will test the capacity of current energy systems to support a return to rapid economic growth and of new energy technologies to go from niche to mainstream.

I could fill the rest of this posting with grandiose predictions about the next ten years, but instead I want to focus on two stories that could provide early clues about energy in the crucial 2010-2020 period. The first almost escaped notice in the energy retrospectives I read last week. Many of them, including one in the Wall St. Journal, attributed the recovery of oil prices in 2009 mainly to the stabilization of the financial system, yet scarcely mentioned the essential role of OPEC's self-restraint. According to the figures in the latest public version of the International Energy Agency's Oil Market Report, between May 2008 and February 2009 OPEC reduced its output by more than 10%, taking well over 3 million barrels per day (MBD) off the market in response to a 3% drop in global oil demand. Despite the usual cheating on its official quotas, its members have avoided the competition for shares of a shrinking market that crashed oil prices from the $30s to $11/bbl in the mid-1980s and set up a decade of low oil prices.

In the process, OPEC's spare production capacity has expanded from less than 2 MBD to roughly 6 MBD. That's quite a buffer against a big price spike as the economy recovers, though it's also the reason oil isn't drastically cheaper than it is today. While we can't know precisely what would have happened if, for example, Saudi Arabia had tried to squeeze the output of its new, Texas-sized Khurais field into the market on top of its existing sales, it's a good bet that oil wouldn't be trading anywhere near its current $81/bbl. The reason this is relevant for the decade ahead is that OPEC could be forced to accommodate even bigger increases from the production agreements recently signed in Iraq, along with more reliable output from Nigeria, if that country's ceasefire with rebels in the Niger Delta leads to a lasting resolution of the problems there. With many of the world's best onshore oil prospects currently off-limits for anyone else to develop, OPEC's members and their continued cohesion hold one of the main keys to oil prices in this decade.

Meanwhile the growth of renewable energy faces a number of important tests as it expands beyond the scale at which it can be tucked safely out of sight and out of mind. We've already seen large solar projects in California's Mojave Desert--one of the most reliably sunny spots on the planet--canceled or relocated to accommodate concerns about wilderness preservation, and now I read that the long-suffering developers of the Cape Wind project off Cape Cod are at risk of having the project's location declared a Historic Site by the National Park Service. With all due respect to the local tribes that apparently consider Nantucket Sound to be sacred, it's worth recalling some of the other history of the region that ought to bear on such a finding. In its heyday Nantucket Island was the center of the global whaling industry, made possible by a fleet of tall-masted sailing ships that used wind power to harvest a key energy resource of the time, from the slaughter of whales for their oil. It's hard to think of a better way to recognize that history--and in a more environmentally-sound 21st century way--than by putting up offshore wind turbines to harness the wind for direct energy production.

And while the permitting for America's first offshore wind farm drags on interminably, the UK government is expected to announce the results of its Third Round of offshore wind bids this week. The new installations would add 25,000 MW of new capacity to a base of offshore UK wind farms in operation or under construction that is already about four times larger than that contemplated for Nantucket Sound.

Oil prices and the expansion of renewables are only two of many factors that will determine the shape of the world's energy economy in 2020, though they rank high on my list of things to watch as the decade begins. Tight oil supplies and high prices would do a lot to promote energy efficiency and new vehicle technologies, while lower, more stable prices might result in a return to the complacency we saw in the late 1980s and '90s. And although renewable power sources are hardly the only means for reducing greenhouse gas emissions and rendering our steadily-growing energy use more sustainable, much depends on the capability of wind, solar and geothermal power to continue their recent impressive expansion. That's true whether you are banking on cleantech and "green jobs" to turn around the US economy or merely interested in the size of the potential opportunity for our suddenly-ample natural gas supplies. I look forward to sharing my observations about these and other trends in the months and years ahead.

Striking a Bargain

For several years I have been intrigued by the possibility of a "grand compromise" on energy and the environment, so I was pleased to see this idea resurface in Steven Pearlstein's column in today's Washington Post. Starting with the proposition that Democrats and Republicans each hold only half the recipe for a serious response to our vulnerability to high oil prices and the risks of climate change, he frames our political choice as one "between compromise or stalemate." The evidence for this has been in the headlines throughout the past month. The recent failure of the Lieberman-Warner-Boxer cap & trade bill and the current debate on opening up more areas for oil and gas drilling demonstrate the inseparability of our energy and environmental challenges. It is time to recognize this as an opportunity, rather than an obstacle.

Wednesday's posting looked at how expanded drilling fits into our larger energy and environmental challenges and concluded that it can make positive contributions on both fronts, though it is hardly the entire solution. The feedback I received suggests that many people would be receptive to more drilling, if it weren't seen as a means for enabling a return to cheap oil and wasteful behavior. Expanding supply without addressing demand merely postpones tough choices, while ambitious planning for "energy independence" that constrains demand and boosts alternatives but leaves US oil production on a glide path to oblivion is doomed to failure. And as Mr. Pearlstein notes, a package combining "well-regulated drilling" with reductions in greenhouse gas emissions could benefit everyone.

The formula for a winning compromise isn't obvious. It could involve expanded drilling with royalties dedicated to funding alternative energy R&D, or it could go as far as linking economy-wide emissions cap & trade with carefully-monitored access to the Arctic National Wildlife Refuge and all federal waters beyond the 3-mile state limits. The best place to define it would be in a bi-partisan conference of the House and Senate. An election year might not seem well-suited for pursuing such sweeping legislation, but as I learned in my years of trading oil commodities, you can't always wait for the timing to be ideal. When conditions provide the right combination of motivated parties and market drivers, that's the time to strike. This could be just such a moment for sweeping energy/environmental legislation.

Oil Panic Attack

After having mostly yawned our way through the first half of oil's amazing six-year ride, we now watch its movements as intently as any futures trader, and our level of concern seems to be building towards a national anxiety attack. Since 2002 we've seen the price of West Texas Intermediate Crude Oil rise from the mid-$20's to the mid-$70s, then retrace to $51 in early 2007, before beginning its remorseless climb past $100 and every other logical stopping point. Some industry analysts are predicting $200 per barrel oil, and warnings of $6, $10, or even $12 gasoline are treated seriously, bolstered yesterday by a new suggestion from the normally-conservative International Energy Agency that we may be approaching a global production plateau. My crystal ball isn't working any better than anyone else's, and thankfully I'm not paid to forecast oil prices. If we want to understand where we're headed, though, we should examine where we've been.

Until fairly recently, oil was regarded as a cyclical commodity, though its cycles didn't necessarily coincide with those of the global economy. It's also an industry that values experience, so its management includes many who have seen several of oil's up and down sequences. That means the senior members of the tribe can recall from personal experience--even if it was early in their careers--the collapse of oil prices in the mid-1980s after the lagged responses to the first energy crisis took hold. Then came the even more devastating drop in 1998/99, in tandem with the Asian Economic Crisis, when WTI bottomed out at just over $10/bbl, pushing the price of most grades of oil into single digits. Many projects that were planned in the late 1980s, when oil finally reached $20/bbl again, started up in a down market that destroyed billions of dollars of net present value. At the same time that oil companies were learning these painful lessons, the OPEC countries that hold most of the world's known oil reserves were attending a similar school, particularly with regard to the perils of over-capacity. The oil price collapse of the late 90s that squeezed the stock prices and investment budgets of the international oil companies created large external deficits for OPEC's members.

Next consider the unexpectedly large expansion of demand. Between 1998 and 2006, global oil demand grew by 10 million barrels per day. At the same time, the natural decline of mature oil fields would have required the industry to replace somewhere between 1.5 and 3 times that much output, just to stay even, in a period when an increasing proportion of the best opportunities were not available to the companies with the biggest incentive to grow production, and the big producing countries were starting to learn that selling more oil may be a less effective way to make more money than selling less, or at least holding output steady in the face of rising demand.

As a result of these factors, when prices began to rise again, breaking through $30 in 2000, oil companies and producing countries had good reasons to be skeptical that the fundamental relationship between supply and demand was on the verge of a permanent shift. That resulted in a crucial delay in funding new projects--crucial because of the time lags involved in the planning, permitting, procurement and construction stages of such projects. In the interim, most of the world's spare production capacity was tapped, and the industry seems unlikely to catch up, short of a global recession that would halt demand growth in its tracks.

Throw in a few other key factors, such as the dollar's decline, an increase in commodity speculation, and the artificially-low petroleum product prices in a number of developing economies, and we have all the necessary ingredients for the quintupling of oil prices that we have experienced in the last six years--doubling in just the last year. Getting out of the deep hole we have dug will require a combination of higher fuel efficiency, increased non-efficiency conservation, more drilling, greatly expanded non-food biofuels and synfuels output, and the partial electrification of personal transport. With the exception of conservation, none of these solutions will make a dent in the problem in this decade.

No one can predict with certainty where oil prices will go from here. It could be to $200, or back below $100. The market is flirting with contango, suggesting it is reasonably well-supplied for now. Despite this week's 5 million barrel drop in US crude oil inventories, days' supply of crude and gasoline are at a fairly healthy 22 days each. Yet the momentum of this market seems unshakable. In the meantime, I suggest prudent conservation and the avoidance of panic. $200 oil would not mean $12 gasoline. In fact, unless refining margins suddenly came back to life, it might not even get us to a $6 national average retail price for unleaded regular. That's not very reassuring, going into the Memorial Day weekend that signals the start of the peak driving season. Our enjoyment of the summer could depend on our level of stoicism.

Practical Remedies

The price of oil has set consecutive record highs this week, with no end in sight. This energy crisis that has crept up on us over the last four years, doubling the historical average price of oil, doubling it again, and in the widely-reported view of Goldman Sachs heading for a third doubling, is now provoking a sense of panic. You can see this in the flurry of proposals for providing short-term relief from retail gasoline prices that have increased by nearly 60% in the last 18 months. But while most of these ideas would likely be either ineffective or counter-productive, there are a few options that could make a difference this year, without having to wait for infrastructure to be built, fleets to turn over, or new production to come on line.

In order to see what might work, we need to start with a clear understanding of what has driven prices well beyond most experts' expectations, including mine. Rising prices have failed to halt the steady growth of global demand, because many of the countries in which demand is increasing fastest insulate their consumers from the global energy market. Nor has $100+ oil stimulated a flood of new production, because too much of the world's resource base is locked up by nationalist or environmentally-inspired barriers. To make matters much worse, important suppliers such as Nigeria are under-producing due to unrest, while Mexico and Russia are allowing their output to slip because of domestic politics. Instead of giving in to our frustration at these seemingly intractable problems, we can still have a positive impact on them, if we focus our efforts intelligently.

The controversy over food vs. fuel is an example of how tangled this mess has become. Governors and Senators worried about food prices have asked for relief from the aggressive Renewable Fuel Standard put in place by last year's Energy Bill. As sensible as that may seem for addressing consumer-level inflation and an unfolding global food crisis, it could push oil even higher. The market expects a couple of billion gallons of additional ethanol this year, the equivalent of about 100,000 barrels per day of oil. Curtailing that would hardly help high oil prices. So what could we do?

Start with ethanol. For all its many faults, it is an effective oil extender, because most of the energy that goes into making it comes from natural gas, not oil. The most immediately helpful action Congress could take on this front is not a reduction in the ethanol mandate, but a temporary suspension of the $0.54 per gallon ethanol import tariff. That might even address both fuel and food costs, by allowing in more Brazilian ethanol and shutting down the least efficient US ethanol plants. As I've noted previously, dropping the tariff would effectively mean subsidizing foreign ethanol producers, because of the way our ethanol blenders' credit is doled out, but this would cost only a fraction of the lost revenue associated with a summer fuel tax holiday. The volumes involved are small, in oil terms, but with oil prices determined at the margin, every little bit helps.

There might also be more practical and productive uses of America's international influence than prosecuting OPEC for anti-competitive behavior. Instead of pleading with or pressuring Gulf oil producers to increase output, we might talk to them about ending retail subsidies and letting their domestic fuel prices rise to market levels. That would slow down some of the fastest demand growth rates in the world, which are starting to erode oil exports from the Middle East. And if we treated the problems in the Niger Delta with the same urgency we apply to other geopolitical crises, we might be able to mediate a solution that would bring most of the half-million barrels of Nigerian production shut in by rebel action back online. Recent signals from the rebels have suggested that possibility. That would have a salutary effect on the oil market, which has a terminal case of the jitters these days.

Then there's the Strategic Petroleum Reserve. With oil at $120/bbl., it has become an absolute "no-brainer" to stop filling it. Even better, this is one of the few measures that could be accomplished virtually overnight, and it is entirely within the President's power to do so. The switch by the government from buyer to seller--putting the barrels acquired under its most recent royalty-swap contracts back into the market--might not knock $10/bbl. off the oil price, but in combination with a requirement to suspend SPR additions until oil is back under $100/barrel--or better yet, $80--it could help cool off speculation.

Assuming these remedies would actually have the desired effect, we still face an important dilemma with regard to energy prices. As important as fuel price relief seems in an economy already battered by the housing slump and accompanying credit crisis, our goal can't be reducing gasoline and diesel fuel prices to a level that stimulates demand that can't be met without lighting a new fire under crude oil. Furthermore, with a new administration likely to institute climate change policies that will increase energy prices, either directly or indirectly, the chief objection to high oil prices within policy circles is not that they are too high, but that the revenue is going to the wrong people: producing countries and oil companies, rather than the US Treasury. Consumers see this matter quite differently, and until we resolve that divergence of aims, our actions are likely to be as disjointed as our politics on this matter are schizophrenic.

Going It Alone

The quest for US energy independence might just be the biggest and most persistent bad idea in the last several decades of energy policy. I've been railing about this subject since I started this blog more than four years ago, and I have acquired a deep understanding of what it means to swim against a strong tide. A few years ago, pointing out the impracticality of energy independence was treated as a mild eccentricity; since then it has become a form of political incorrectness verging on heresy. I'm glad to have some company in this effort, from the author of a comprehensive examination of the subject, "Gusher of Lies," by Robert Bryce. It provides a useful counterpoint to a seemingly endless stream of books and articles extolling the virtues and relative ease of shaking off our oil habit and thumbing our noses at the global energy market. But while I agree wholeheartedly with the main thrust of Mr. Bryce's book, I feel obliged to mention a few quibbles.

The subtitle of "Gusher of Lies" provides a good sense of the author's perspective on America's energy problems. "The Dangerous Delusions of 'Energy Independence'" sets it at odds with many of the statements about energy that we've heard from candidates in the current election cycle. Among the strongest chapters in the book are those placing our desire for energy independence in the context of the long energy history of this country, and explaining why many common assumptions about the mechanisms for attaining independence--and its ultimate outcome--are either mistaken or unwarranted. That's particularly true concerning the Middle East, which would continue to hold most of the world's oil endowment--and thus remain of paramount strategic importance to the global energy economy--regardless of the level of US energy imports.

As I've pointed out here periodically, energy independence is unattainable for the US at an acceptable price through any strategy, technology, or combination of them currently available to us, nor is it especially desirable in a world that is increasingly interdependent for basic commodities, manufactured goods, financing, and to a growing degree, for services and intellectual capital. Mr. Bryce shares this perspective, and he demonstrates it in many pages of facts and figures, scrupulously referenced in 50 pages of footnotes. Among the many sacred cows he takes on, he scorns corn ethanol and expresses skepticism about the chances of large-scale reliance on cellulosic biofuels. Nor is he enamored of coal-to-liquids or wind power, which he regards as "the electricity sector's equivalent of ethanol." Whether you accept his arguments or not, they provide a useful opportunity to ponder the likelihood that a transition away from oil-based transportation fuels and their valuable byproducts will be arduous, protracted and expensive, while failing to deliver the utopia that many expect.

"Gusher of Lies" does a good job explaining why the vast scale of our energy consumption and the trends of history, economics and geology work against the prospect of reducing by very much our reliance on other countries for primary energy. Unfortunately, the author's apparent neutrality on the subject of climate change creates a bias for the status quo that leads him to underestimate the incentives for greatly expanding our use of renewable energy forms such as wind power. And while he describes in some detail the geopolitical shifts that are marginalizing the formerly-dominant publicly-traded oil & gas companies, I didn't sense much concern about the way that bilateral arrangements between national oil companies of producing and consuming countries are undermining the vitality of the global free market for energy on which he urges us to rely for our energy security. As a result, he misses an obvious role for productive involvement by the federal government in bolstering the efforts of publicly-traded companies to gain access to global resources locked up behind nationalistic barriers.

Two other quibbles:

• Although the principal messages of "Gusher of Lies" aren't tied to any particular political ideology, Mr. Bryce's digressions on the evils of neo-conservatism and the errors of certain well-known media pundits became tiresome and distracting, undermining his main focus.


• The last section offering potential solutions to our energy challenges that avoid the independence trap seemed a little light. That's a shame, because several of his suggestions, such as simplifying the current nightmare of conflicting gasoline formulations and creating a "superbattery prize" look beneficial and relatively uncontroversial, and could be accomplished with the stroke of a pen.

Don't let these minor shortcomings deter you from reading "Gusher of Lies." The higher oil prices go--and oil company profits with them--the greater the temptation to seek miracle cures for our energy problems. Mr. Bryce reminds us that as important as energy is, it does not stand apart from a national economy that is deeply connected to the rest of the world, any more than it can be divorced from the laws of thermodynamics. Nor should his informed skepticism be mistaken for cynicism or a sense of futility. His realistic portrayal of our energy situation is timely and important, dismissing widespread notions of quick-and-easy solutions and making a strong case that the current yearning for energy self-sufficiency, while understandable, is both unattainable and inconsistent with the basis of much of our post-World War II success. You can read the first chapter here.

Degrees of Freedom

The more I think about Tuesday's Congressional hearing on oil, the more convinced I am that much of the frustration of both sides arises from finding themselves in a problem with essentially zero degrees of freedom in the near term. In engineering parlance, that suggests an object that can't move or rotate in any dimension. All of the solutions to the linked problems of energy security, high energy prices, and climate change would take time to implement, with significant inertia to overcome, and none of them could take effect fast enough to provide relief for truckers burdened with $4 diesel fuel, or commuters struggling to pay for gasoline that exceeds $3.50 in some regions. The only short-term fix available to Congress might even make the situation worse, in both the short- and long-term. That leaves the ball in our court, as consumers.

Consider the available options for reducing fuel prices. Contrary to Congressman Larson's assertion, based on complaints from the Connecticut Independent Petroleum Association, that supply and demand is broken, those forces are precisely what determine the street price of gas and diesel. When marketers see their sales spiking and inventories drawing down, they raise prices, and when sales slow and inventories rise, they lower them. Any dealer that is priced too far above his local competitors will see throughput fall, and anyone who prices too low will run out. As I used to remind our marketing managers when I traded gasoline for Texaco's West Coast operations in the 1980s, if you're going to run out, you might as well run out at a high price. Increasing supply seems to be the quickest way to force prices down, since the whole system responds to changes in inventory that result from shifts in supply and demand--the latter being harder to influence directly.

How could we increase supply? Well, Congress was suggesting more renewable fuels. In fact, the 2007 Energy Bill increased the annual Renewable Fuel Standard target for 2008 from 5.4 billion gallons to 9 billion gallons. That compares to 6.8 billion gallons of ethanol actually blended into gasoline in 2007. Even if enough new ethanol plants start up this year to supply the additional 2.2 billion gallons required, the logistics of getting it to blending terminals will be challenging. And while ethanol is cheaper than gasoline today, offering the potential of some price relief, it is not clear that will remain the case. Higher demand for corn pushes up the cost of ethanol's inputs, against a crop expected to be smaller than last year's. That will either squeeze output or raise ethanol prices.

Nor would granting the industry's request for access to more offshore tracts help this year. There's much to be said for the argument that Chevron's Vice Chairman made to the Select Committee on Energy Independence and Global Warming, that it's hard to convince foreign countries to give companies access to their resources, when our own government won't do the same. However, the interval from leasing to first production is at least six or seven years, and probably longer. So when the industry execs were asking for access, it was for the supply we'll need in the 2015-2030 time frame, not 2008 or 2009. Expanding refinery capacity might bring relief sooner, but most of the current spike in gasoline prices is attributable to higher crude oil prices, not unusually high refining margins. And in any case, of the refinery expansions alluded to on Tuesday, such as at Port Arthur, TX , few of them will come on line this year.

As for reducing demand by means of increased fuel economy, that won't manifest quickly, either. The 2007 Energy Bill set a target for increasing the fuel economy of new cars to 35 miles per gallon by 2020, but with the economy slowing and new car sales down significantly from last year, it will take longer than expected to turn over the existing fleet. If every new vehicle sold this year were a hybrid, it would raise the fuel economy of our 230 million cars and light trucks by up to 4%. But despite their rapid growth, hybrids made up only about 2% of the US car market in 2007. And while SUV sales are down--often displaced by "crossovers" that are only marginally thriftier--and small car sales up, the resulting net reduction in fuel consumption could be lost in the rounding, this year.

The only lever left for policy makers to influence current fuel prices was only hinted at in Tuesday's hearing, for good reason. One of the committee members pointed out that federal and state taxes account for 13% of today's gas price at the pump. Those taxes range from $0.26 per gallon in Alaska to more than $0.64 in California, but the one constant is the $0.184/gal. federal gasoline tax. Congress could cut that tax or eliminate it--with serious consequences for the federal highway budget--but the resulting relief would be short-lived. Because it would tend to increase demand without affecting supply, a temporary reduction in the gas tax would eventually be overwhelmed by the rebound of total fuel prices, in order to balance supply and demand. Consumers would see a few months of relief, but the Treasury would be out several billion dollars without achieving any lasting benefit.

Unfortunately, unless I've missed some non-obvious factor, that leaves government and industry with no quick way to alleviate the fuel price increases that have already swamped last year's highs, well before their typical seasonal peak around Memorial Day. That leaves only one party to this situation with the power to change that balance: consumers. If we all drove just 12 miles less per week, fuel demand would fall by 5%, the equivalent of almost half a million barrels per day, or all the ethanol produced last year. The impact of that on gas prices would be much more dramatic than waiting for someone else to fix the problem.

The Road Not Taken

This week marks the fifth anniversary of the start of the Iraq War. With the outcome of November's US presidential election hinging at least in part on the judgment to go to war in 2003, and in light of the release of a new book by a Nobel-winning economist assessing the cost of the war, it seems appropriate to spend a moment reflecting on the road not taken, at least in terms of its energy aspects. Although we will never know what would have ultimately happened, had the US decided not to invade Iraq, we can make some educated guesses about the level of oil prices in such a world. Just as the war itself cannot properly be characterized as a war for oil--though it has certainly been about oil--today's oil price of $110 per barrel reflects the results of that decision, though it has not been directly caused by it.

In gauging the impact of the Iraq War on oil prices, we need to evaluate two broad areas: the relative importance of Iraqi under-production, compared to all the other factors that have contributed to oil's dramatic rise from the mid-$20s per barrel, and the nature of Iraq's status quo ante, with regard to oil. Let's start with the latter, since after five years of war, most commentators have forgotten about the way that Saddam Hussein's behavior regularly roiled the market.

In the aftermath of the 1991 Gulf War and leading up to our invasion in 2003, Iraq was under UN sanctions that inhibited its oil trade, among other things. Foreign firms could not enter into new development deals with the Iraqi government, and the country's oil exports were capped and managed under the Oil for Food Program, which was later revealed to have been rife with corruption and used by Saddam as an ATM to fund his pet projects. Between 1992 and 2003, Iraq suspended its oil exports several times--most recently in 2002--and threatened to do so on many other occasions, temporarily driving oil prices higher. If the war had never happened and the sanctions regime remained in place today, the combination of UN restrictions and Saddam's pattern of using oil exports as a geopolitical tool would be contributing to market instability, not lower prices.

I would argue that the likelier scenario was not a continuation of the pre-war status quo, but the gradual disintegration of the sanctions regime--a process already apparent in 2002--as oil companies from Security Council countries such as France and Russia pressed for commercial access to Iraq's enormous untapped oil reserves. Still, it takes time to bring new oil fields on line, even when exploration risk is very low and geology quite favorable, as it is in Iraq. Had sanctions collapsed entirely in 2004 or 2005, we still would not have any contribution from such projects at this point, and Iraq's exports would be about what they averaged between 1999 (when the dollar-cap on Oil for Food exports was eliminated) and 2002: 1.9 million barrels per day (bpd.) It's also likely, however, that these exports would have been interrupted by Iraqi politics and periodic military confrontations with the US, such as Operation Desert Fox in late 1998. In other words, other than the cumulative loss of perhaps a billion barrels of oil exports from 2003-2006, Iraq's current exports absent the Iraq War would probably be about the same as they are today.

Nor has the Iraq War been the only factor applying pressure on oil prices since 2003. You've heard the litany many times: the growth of Asia and especially China, turmoil in Nigeria, resource nationalism, tensions with Iran, Hurricane Katrina, and so on. Is there any reason to think these wouldn't have been just as significant--except for the risk of conflict with Iran --had the Iraq War never occurred? If anything, global economic growth, and oil consumption with it, might have been even higher, if the US hadn't embarked on a major war financed largely by foreign debt. The largest direct contribution of the Iraq War to oil prices probably occurred in 2003-2004, when Iraq's curtailed output helped drive OPEC's spare capacity below 1 million bpd, and sent prices soaring past $50/bbl for the first time. That impact has largely abated, as Iraq's oil exports have gradually been restored.

On balance, then, the effect of the Iraq War on current oil prices has been largely indirect. I believe it is attributable more to mismanagement of the war, and particularly to our choices about how to finance it, than with the 2003 decision to invade. The alternative scenario is less a function of how much oil Iraq might now be producing than of the relative health of a US economy that was only engaged in one foreign war, not two. Spending hundreds of billions of dollars on a war, without raising taxes to support it, has expanded our fiscal and external financing deficits, weakening the US dollar and feeding speculation in commodities--a lesson we should have learned from the Vietnam War. Had the dollar maintained its 2003 pre-war level against the Euro of about $1.08, oil might today be closer to $75/bbl than $110.

Bursting Bubbles

The possibility of an oil price bubble has been discussed since at least 2005, when oil was trading in the $50s and $60s per barrel. At the time, it wasn't hard to justify that level and dismiss the notion of a bubble, based on the fundamentals of supply and demand. Lately the term has resurfaced, and I'm not at all sure that the arguments against it outweigh the evidence of large-scale speculation, including the apparent divergence between oil futures prices and the price of oil equities. To whatever extent oil futures and options appear to be an attractive hedge against resurgent inflation, a speculative bubble in oil would reinforce inflation and economic weakness, until events converge to burst the bubble, causing further disarray.

It's usually hard to discern a speculative bubble until after it has popped. In retrospect, the housing bubble seems blindingly obvious, now, along with the 1990s Dot-Com bubble. But why is it any likelier that today's roaring oil prices are evidence of such a bubble, when they clearly were not, a few years and $50 per barrel ago? After all, the US economy may be slowing, and US oil consumption with it, but global consumption is still growing, thanks to booming demand in China, India and the Middle East. Global oil demand has risen by 2.4 million barrels per day (MBD) since 2005, and suppliers have struggled to keep pace. The International Energy Agency recently estimated that OPEC has only about 2.4 MBD of spare capacity in reserve, barely another year's growth. Add the ongoing instability in Nigeria and the Middle East, sprinkle in a dash of Chavez, and you have the recipe for a tight oil market. The problem with this logic is that a very similar recipe added up to much lower prices in recent years.

In the absence of speculative pressures, oil prices are generally determined by a few main factors, though evaluating them is far from simple. Inventories and spare capacity are widely regarded as the key differentiators between a strong oil market and a weak one. Commercial oil inventories in the OECD countries are certainly on the low side, though still within their five-year historical range, except in Asia. Although US oil inventories fell unexpectedly last week and are about 6% below their level of a year ago, they are still smack in the middle of their historical range, based on data from the Energy Information Agency (see their chart below) and have generally been rising since the start of the year. On balance, this picture doesn't look more bullish than in March 2005, when oil was $55/bbl.


Now consider oil equities. Since last December 31, the front-month crude oil contract on the New York Mercantile Exchange has risen by 13%, while the Amex Oil Index (XOI), a composite of 13 large international oil companies, including ExxonMobil, Shell, BP, Chevron and ConocoPhillips, has declined by 9%--only 1% less than the drop experienced by the entire S&P 500 index. While it's true that these oil companies are exposed to rising costs and slumping US sales, it's hard to fathom that they wouldn't see any net benefit in their cash flows from a $10 spike in oil prices, relative to the broader market. Part of the explanation may lie in the fact that speculators don't need oil equities for exposure to the commodity; they can get that directly on the NYMEX and via the over-the-counter swaps market. The NYMEX/AMEX disconnect might not constitute proof of a bubble, but it's consistent with one.

Finally, we have the behavior of OPEC. It's certainly convenient for them to blame speculators for the current high prices, which earn them record revenues while producing nearly flat out. And they do bear a good deal of responsibility for higher prices, not because they've been squeezing the taps, lately--far from it--but because as the holders of 69% of the world's proved oil reserves, they've failed to invest in enough new capacity to ensure the market is well-supplied. However, despite strong elements of self-interest in their recent decision to maintain current production levels, the cartel seems to be on the defensive, rather than in the driver's seat. Perhaps they smell a bubble, too.

If the current oil market does incorporate a speculative bubble, it's worth recalling that many of the brokers and hedge-fund traders involved are too young to remember the collapse of previous commodity bubbles, such as the Silver Thursday demise of the Hunt brothers' scheme--also spurred by fears of inflation--to corner that market. And few would have experienced the sudden collapse of oil prices when Operation Desert Shield became Desert Storm on January 17, 1991. I traded petroleum products for Texaco in London at the time, and I can assure you that the last thing anyone expected was for the price of West Texas Intermediate to drop by one-third overnight, once the bombing started. Any speculator thinking he had ample time to unravel positions when the market turned got a very rude shock, indeed. As conservative as my company's trading rules and my own approach were, I lost several million dollars on a single cargo of jet fuel.

Time will tell whether $108 oil is the result of a bubble or fully justified by fundamental factors. If it turns out to be the former, the damage could be considerable. Because of the tremendous leverage of oil futures on the physical oil market, each dollar per barrel of speculative froth adds 2.4 cents to every gallon of gas and $4.4 billion per year to the US petroleum import tab, sending ripples throughout the economy. In aggregate this outstrips the speculative gains available to investors on the NYMEX and feeds the vicious cycle of dollar weakness and inflation. While that argument won't--and perhaps shouldn't--deter a single oil speculator, a careful review of the outcomes of past bubbles just might.

Disclosure: My portfolio includes at least one of the components of the Amex Oil Index.

The Missing Ingredient

Yesterday the House of Representative passed compromise energy legislation, an amended version of the previous HR.6 that the Senate passed earlier in the year, by a margin of 235-181. The bill now goes to the Senate for a final vote, which could take place this weekend. In her remarks closing the debate, Speaker Pelosi referred to the bill as a "shot heard 'round the world for energy independence for America." I wish it were so. While the bill contains many useful elements, including the 35 mpg fuel economy provision on which I've commented recently, on balance its thousand or so pages seem unlikely to worry the Middle East oil producers at whom this rhetoric is aimed. Because it fails to promote additional oil and gas production, it could actually reduce domestic energy production in the near term, worsening our reliance on imports. If anything, with its focus on the technology and production of renewable energy, the Energy Bill should raise more eyebrows on Wall Street and in Silicon Valley than in Caracas, Riyadh, or Tehran.

The renewable energy sources covered by HR.6 are going to be extremely important for the energy future of this country. Cellulosic ethanol, wind, solar and geothermal power constitute important new resources that also provide significant benefits for tackling our greenhouse gas emissions. We need them to become competitive and expand rapidly, in order to meet the challenges posed by climate change. However, they won’t supplant oil and gas or make the US independent of its foreign energy suppliers within the timeframe considered by this legislation. What is needed, then, is a transition from the current, fossil-heavy energy mix to a future diet built mainly around renewable energy and nuclear power. By excluding the most obvious source of new energy production available to us, this bill will make that transition more arduous and expensive than it has to be. Anyone expecting this bill to drive down the price of gasoline or heating oil within the next several years is bound to be disappointed.

Given the kitchen-sink nature of the "Energy Independence and Security Act of 2007", including the tougher CAFE standard, an expanded renewable fuel standard, a controversial 15% national renewable electricity standard, and assorted other subsidies and a few earmarks, it's hard to understand the absence of truly meaningful supply provisions. CAFE, ethanol and renewable electricity do not add up to energy independence, not by a long shot, though the demand-side measures in the bill should begin to slow the rate at which our energy dependence is growing.

One of the speeches I caught on C-SPAN's coverage of the House debate provided a clue as to why such a massive omnibus energy bill would rule out expanding US oil and gas production, which account for almost half of our present 71% level of energy independence. Representative Hinchey (D-Ithaca, NY), recited as part of the bill's justification the well-worn "3-25 Fallacy": Although it is accurate that the US consumes 25% of the world's oil, while possessing only 3% of global proved oil reserves, this ignores the fact that we have produced 1 out of 5 barrels of petroleum ever extracted and still contribute 10% of global production, ranking third behind Saudi Arabia and Russia, but ahead of Iran and Venezuela combined. And while our output is declining because of the mature nature of most of our oil fields, this is also occurring because we have chosen to leave many billions of additional barrels--barrels that would really get OPEC's attention--untouched.

Speaker Pelosi described the effect of the energy bill as being, "as immediate to them as the price at the pump they face when they fill up their tanks." Given the long phase-in of renewables and higher fuel economy standards, that is surely an exaggeration. As urgent as the problems of energy and the environment are, there is still time to get this right, and that ought not to be dictated by the legislative or electoral calendar. The question facing the Senate and, should they pass it, the President, is whether the many positive aspects of this bill are sufficient to outweigh its negatives, including its notable failure to increase domestic conventional energy production by opening up new areas for drilling or making it easier to add new refining capacity. No legislation is ever perfect, and we urgently need stronger energy policy. Nevertheless, a bill constructed on the premise of moving us towards energy independence--however unattainable that goal may be--should include more robust supply provisions than doubling our already problematic output of corn ethanol. While the country's former energy policy has been too oil-centric for years, this new policy is not oil-centric enough, when petroleum still accounts for 98% of the energy we use for transportation. If opening up additional offshore tracts and federal lands to drilling is a bridge too far for this Congress, then at least they ought to ensure that the 2007 Energy Bill is oil-neutral.

A Muted Response

Yesterday afternoon I was interviewed by a reporter researching a story on why the response to high oil prices hasn't been more pronounced, especially on Capitol Hill. To the degree that Congress reacts when consumers complain, however, the current muted response is understandable. While the crude oil price has risen by 29% since Labor Day, the average pump price of unleaded regular has only gone up by 8%, so far. Nor is $3.00/gallon startling, any more, no matter how much it stretches the average person's budget. That kind of price fatigue is unlikely to last, though, if refining margins recover sufficiently to push gasoline to $3.50.

There are many reasons why the current oil price shouldn't be as worrying as the price spikes of the 1970s, and you've heard most of them before. The US uses only half as much energy per dollar of real GDP as it did then, and oil's share of those BTUs is 10% lower, today. At the same time, as I pointed out to the reporter, the price of crude oil is a pretty abstract concept to most people, compared to the price of gasoline or heating oil. I don't know how many other folks have actually bought or sold a barrel of petroleum, but I would guess it's fewer than 1 in 1,000, even counting those who receive royalty payments on their mineral rights.

Contrast that with gasoline. When we fill up at the self-service pump, we can hear it and smell it going into our cars, and most of us experience this at least once a week. How many times a day do Americans see a gas price on a pole-sign? I'd bet more people know the price of a gallon of gasoline than know the price of a loaf of bread. It doesn't get more concrete than that. So when the average retail gasoline price broke $3.00/gallon for the first time after Hurricane Katrina, the public's shock and outrage were palpable, and political consequences followed promptly. And when it breached $3 last summer and again this spring, it was hard for many people to understand, because it was being driven more by tight refining capacity than rising oil prices. With oil company profits soaring on higher refining margins, that didn't seem fair, even if it was a natural consequence of supply and demand.

The current situation is different. This spring, when gasoline peaked at $3.22/gallon, crude oil accounted for less than half of its cost; today, that ratio is over 70%. Oil company profits are being squeezed, as a larger share of the higher oil revenue is going to producers in Venezuela, West Africa and Russia. These shifts may not evoke much sympathy for Big Oil, but they undermine claims that the companies are gouging consumers.

The public's apathy about high oil prices can't last. If oil remains above $90 for very long, sooner or later gasoline prices will spike higher, as heating oil prices are starting to do now. It could happen because demand strengthens, or after some accident or other event shuts down a key refinery or pipeline. Then gasoline will push toward the next major price threshold, the complaints will sharpen, and a torrent of angry emails to Congress will follow, with unpredictable consequences in an election year.

Blaming OPEC

Lately, it seems that everyone has an opinion on why oil prices have reached the threshold of $100/barrel, including several of the candidates in last night's Democratic Presidential Debate. This morning's Wall Street Journal offers some theories from an interesting source, two ministers of an organization that features prominently in many analysts' explanations of the current market tightness: OPEC. Apparently, OPEC's members are vexed at being blamed for high oil prices, which they attribute to three factors: the weak dollar, market speculation, and refining bottlenecks. Considering the source, it's worth spending a few minutes examining these arguments to see whether they have merit.

Let's start with the easiest to dismiss, the refining sector. You don't even have to think through the logic of this argument, which inverts the usual understanding of how temporary shortages in refining capacity normally exert downward pressure on the prices of specific grades of crude oil, as volumes are backed out of the system and crude inventory grows. All that's necessary is a look at refining margins, which measure the difference between the revenue refiners receive for the products they sell and the cost of their raw material. These margins are dramatically lower than they were in the spring and early summer, when crude oil was trading in the mid-to-low $60s. This tells a clear story. Refining capacity--in the US, at least--is not tight, and this factor has not contributed to oil's $15 sprint in the last four months.

Next consider speculation. I don't think this can be dismissed quite so easily, at least as a general contributor to oil prices over the last four years. As I've noted before, the growth in demand for oil futures and options within the broader financial portfolios of hedge funds and other investors must put upward pressure on futures prices, and thus on the enormous volumes of physical oil that are sold at prices pegged to the futures. Still, there's some evidence that the speculative flow has reversed in the last few months, as the ripples from the sub-prime crisis have dried up credit and forced some firms to liquidate positions. In other words, it's much easier to see how speculation contributed to oil's rise from $40 to $70 than from $70 to $90.

That brings us to the dollar, and as the recipients of roughly $2.8 billion dollars per day at current prices, OPEC ought to know as much about that subject as anyone. A chart of oil prices for the last two years expressed in both dollars and Euros reflects remarkable differences, but doesn't quite tell the story that the OPEC ministers might wish.



Between June 1 and October 18 the dollar price of oil on the New York Mercantile Exchange increased by 37%, while in the same period, the price in Euros had risen by almost 30%. There is clearly a lot more at work here than the weakness of the dollar, at least over the last four months.

So while each of these factors has contributed to the escalation of oil prices since 2003, they don't explain why we suddenly find ourselves staring at the prospect of $100/barrel by Christmas. Instead, I think we have to examine the long-term fundamental trends of the industry, which are currently colliding. Demand continues to grow, driven by strong global economic growth, including many places where consumers are insulated from the true market price of petroleum products. Non-OPEC production can't keep up with this growth, because of the combination of production decline rates, drilling bans, and the lagged effects of the near collapse of the industry in the late 1990s. And that's where OPEC comes into the story.

As the world's main oil exporters and the holders of 69% of global proved oil reserves, at the latest count, OPEC has not planned properly for the growth of their long-term market. This isn't a question of the dwindling increments of existing capacity they are holding back by mutual agreement, but of their failure to reinvest in their core business and expand capacity ahead of demand. There are many reasons for this, including domestic financial pressures in many member countries, the impact of sanctions on Iran, and the war in Iraq. They have generally kept out the international companies that possess the motivation, capital and capability to develop OPEC's unexploited reserves, while failing to do the job themselves--with a few notable exceptions, such as the current expansion program in Saudi Arabia.

Whether this underinvestment in new capacity is due to resource nationalism, the inefficiency of state oil companies, or a deliberate effort to keep the market tight, OPEC must bear at least half the responsibility for $90+ oil. The other half, as one of the candidates implied last night, lies with US consumers (along with their counterparts in China and elsewhere) who have increased our demand steadily, with little thought of where the next gallon was coming from. Unless we do something to alter that trend, OPEC will continue to win and we will continue to lose from this ongoing collision.