What the Congressional Hearing on VW Missed

I made time in my schedule to watch yesterday's Congressional hearing on the VW scandal on C-SPAN. It left me with very much the same sense tweeted by Amy Harder of the Wall Street Journal, though perhaps for different reasons:

Similarly to the Deepwater Horizon hearing, some of the Members of the House Energy and Commerce Committee used the occasion to demonstrate that their outrage over this event equaled or exceeded that of their constituents back home. This is par for the course. But just as when confronted with the highly technical issues of a well blowout in the deep water of the Gulf of Mexico, the committee's members would also have benefited from more technical advice prior to and during the hearing.

In particular, I thought they missed key opportunities to follow up on answers given by the CEO of Volskwagen's US subsidiary, Michael Horn. One example followed Mr. Horn's response to a question about the timeline for attempting to fix the company's non-complying diesel cars from model years 2009-2015.

He explained that the affected models included three generations of engine and emissions treatment technology. The oldest, which he described as "Gen-1" would be the hardest to fix and was clearly not amenable to merely updating the engine management software to remove the "defeat device" code. However, he also indicated that the newest generation might be fixed in exactly that way. That's because they already incorporate the Selective Catalytic Reduction and urea technology used in bigger, more expensive models. The question left hanging in the air but never asked was why VW would have abandoned the exhaust-gas-recirculation (EGR) technology that had been matched to the 2-liter diesel engine since 2009, if it was convinced the cheaper technology was doing the job.

Several members of the committee pointed out to both Mr. Horn and Christopher Grundler, the EPA official responsible for emissions compliance, that although the EPA had indicated these cars were safe to drive and would not be pulled off the road, they would be emitting unacceptable levels of NOx until they were recalled and repaired.  Mr. Horn had already indicated that might take up to two years, which seemed quite realistic.

Despite Mr. Grundler's expertise, everyone seemed to treat these emissions as an unalterable circumstance, ignoring the fact that NOx is a traded commodity in the US. In fact, the markets for NOx and SOx emissions credits--overseen by the EPA--have been so effective that they provided the intellectual spark for the whole idea of CO2 cap-and-trade. In light of that, I was surprised that no one suggested that VW, either voluntarily or at the direction of the EPA, should immediately purchase NOx credits equivalent to the excess emissions of the affected cars until they have been brought into compliance.

Of course that wouldn't be a perfect substitute for tailpipe compliance. Unlike CO2, NOx acts locally, rather than globally. However, as I understand it the NOx markets function regionally, and I would be surprised if there wasn't a reasonable overlap between the geographic concentrations of VW diesel car sales and the focus of the NOx markets in the Northeast, Midwest and California. Buying large blocks of  NOx credits would push  up the price for these instruments and prompt more emissions reductions from power plants and other participants in these markets, leaving the air cleaner.

I am sure many of those watching the hearings shook their heads when Mr. Horn expressed his belief that the responsibility for circumventing the cars' emission controls likely rested with a few software engineers, rather than a corporate decision. Representative Chris Collins (R-NY) channeled a lot of frustration when he rejected that idea on the basis that if VW had found software to fix diesel emissions it would have rushed to patent the idea. I'm less certain of that in this age of widespread technology outsourcing. For VW's diesels, much of the key hardware came from vendors, and I would expect the same to be true for software. I was hoping someone would ask whether the "defeat device" software itself had been sourced from a vendor.

Either way, it was clear that Mr. Horn was struggling with the disconnect between his own beliefs about the situation and the facts that had emerged. I experienced something similar when my former employer, Texaco Inc., was embroiled in a scandal over diversity in the 1990s. The newspaper accounts I read of blatant discrimination in closed-door meetings were at odds with everything I knew about a company for which I had worked for two decades. Mr. Horn expressed similar feelings, but I doubt they provided much consolation to those whom VW's actions have harmed.

In that vein, there was a lot of speculation about damages and remedies at yesterday's hearing.  It was clear that most of the committee shared the view of one member, who advised VW to be "aggressively compliant" in responding to its customers and dealers. However, suggestions that the company offer "loaners" to all 500,000 affected customers seemed detached from reality, as did the notion that VW should voluntarily refund the full purchase price of these cars. A quick calculation puts the price tag on that idea in the $10-20 billion range, before paying any of the fines and penalties that seem inevitable in this case. I don't know what compensation I'd want if I had bought a diesel VW, instead of a gasoline model, but I don't think I'd be counting on getting my purchase price back.

Yesterday's hearing had its share of posturing, but on balance I thought it contributed to our understanding of the scandal and the next steps in the process. The panel treated Mr. Horn with remarkable civility, under the circumstances. That is likely attributable to his having been among the first to admit that the company had "screwed up." Perhaps his most telling remark yesterday was that they would have to figure out how to manage a company of 600,000 people differently, after this. "This company has to bloody learn," was how he put it. I imagine we'll be hearing a lot more in the weeks and months ahead about exactly what those lessons are, and how much they will cost.

Energy and the New Congress: Beyond Keystone

• The Keystone XL pipeline is likely to get another opportunity for approval once the new Congress is sworn in next January.
• However, it will not be the most important part of a new Congressional energy agenda, and it might not even be the most urgent.

Voters in the US mid-term election earlier this month might be forgiven for assuming that its result assures quick approval of the Keystone XL pipeline (KXL), notwithstanding the drama over a Keystone bill in the "lame duck "session last week. The pipeline has been under review by the Executive Branch for six years, yet despite its symbolic importance to both sides of the debate, and an apparent majority in both houses of the newly elected Congress favoring its construction, its future remains uncertain. Nor is KXL necessarily the most urgent or important energy issue that the new Congress is expected to take up.

It's worth recalling that the Senators who just lost their seats  were elected in the aftermath of the oil-price shock of 2007-8, amid great concern about increasing US dependence on imported oil and natural gas. They took office in 2009 with a President whose main energy policies focused on addressing global warming, with energy security inescapably linked to climate change. Largely as a result of the shale revolution, the new class of Senators will begin their jobs in an entirely different energy environment. That will have a bearing on both the priorities and approach of the new Congressional leadership.

The energy agenda for the two years of the 114th Congress will most likely include not just the status of KXL, but also restrictions on US crude oil exports, reform or repeal of the Renewable Fuel Standard (RFS), the extension of renewable energy tax credits for solar power (expiring at the end of 2016) and wind power (already expired),  regulation of greenhouse gases by the Environmental Protection Agency under the Clean Air Act of 1990, expanded oil and gas drilling on federal lands and waters, and a stalled piece of energy efficiency legislation that might be the least controversial energy bill, on its merits, that either chamber has considered in years. Support for nuclear power and the disposition of nuclear waste could get another look, too.

Tax incentives for both renewable and conventional energy may also be swept up in efforts to reform the US corporate and individual tax systems, a high priority for some incoming committee chairmen. The least likely measures to be considered, however, are comprehensive energy legislation along the lines of the Energy Independence and Security Act of 2007 or climate legislation similar to the Waxman-Markey bill of 2009 that subsequently died in the Senate.

It is also possible that the 113th Congress could clear some of its backlog of energy measures before handing off to the new Congress in January. The dynamics of the lame duck session will be different from the pre-election period, and the outgoing leadership could be motivated to strike deals on measures such as the restoration of the wind power tax credit (PTC) within a larger package of expiring tax measures called the "extenders bill."

Aside from KXL, perhaps the most pressing energy matter for the new Congress is to address is the question of US oil exports, which are restricted under 1970s-era laws and regulations. The urgency of debating oil exports is twofold: One company has already indicated its intention to export condensate, which is treated as crude oil under current regulations, without government approval. And with oil prices having fallen by 20-25% since summer, oil exports and related shipping regulations could provide a crucial relief valve as US producers of light tight oil (LTO) from shale deposits seek to reduce their costs and find higher-priced markets.  Senator Lisa Murkowski (R-AK) is slated to chair the Senate Energy & Natural Resources Committee, and this is one of her big issues.

However, the cooperation Sen. Murkowski will receive from the other party in getting export legislation to the Senate floor could depend on the result of December's runoff in Louisiana.  If Mary Landrieu, current chair of Energy & Natural Resources, falls to Representative Bill Cassidy (R-LA), her replacement as ranking member for the minority on that committee is expected to be Maria Cantwell (D-WA). Senator Cantwell appears to be more skeptical about oil exports, as well as on other issues the oil and gas industry might hope would advance next year. 

For that matter, while gaining approval of KXL and reining in the EPA are clearly part of the incoming Republican agenda for energy, other issues cut across party lines in ways that make their outcomes less easily predictable. For example, proponents of reforming or repealing the RFS may have as much difficulty getting traction in the 114th Congress as in the 113th. Geography, rather than party affiliation, seems like a better predictor of whether new Senators like Joni Ernst (R-IA) or Mike Rounds (R-SD) would support or oppose changing the rules for biofuels. That could apply to the wind tax credit, too.  Even an oil export bill might similarly split both parties.

That brings us back to Keystone XL. The election result put both chambers of Congress on the same page on this issue for the first time and has apparently increased support for KXL to the crucial 60-vote threshold. That would be sufficient to obtain "cloture" and prevent a filibuster, though not to overturn a presidential veto.

Before Senator Landrieu's bill came up short last week, the President's real position on KXL began to emerge from the opacity he maintained through two elections. Nor does the fallout from his recent actions on other issues bode well for striking a deal with the new Congress on Keystone, short of it being attached to some essential piece of legislation like the budget or defense authorizations. Other parts of the likely Congressional energy agenda could fall into the same gap, and I'm less optimistic than I was after November 4th about opportunities for cooperation on energy between the White House and a unified Congress. 

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

Will Falling Prices Shift Oil Industry's Focus to Cost Reduction?

• Lower oil prices may have less impact on US oil production from shale than competitors in Saudi Arabia and elsewhere appear to assume.
• The cost of  producing tight oil is not static, and US producers have various options for cost reduction, including optimizing their logistics. The newly elected Congress can help.

Oil prices have dropped by more than 20% since July, based on futures contracts for UK Brent crude. Some expect prices to rebound relatively quickly, apparently including at least one large oil services company. However, indications that the official policy of Saudi Arabia may have shifted away from its customary role of "swing producer" raise the possibility of an extended period of lower prices. This is new territory for the relatively young US shale industry.

From the end of 2010 to the first half of this year, as the rapid development of light tight oil (LTO) from shale deposits was adding more than 2.9 million barrels per day (bpd) to US output, the benchmark price of West Texas Intermediate crude oil (WTI) averaged $96/bbl. The global oil price, represented by UK Brent, averaged $110/bbl for the same period. Having now fallen to the $80s, if prices were to stay here or lower for long, we should expect to learn a great deal about the actual cost structure of new and existing LTO production in the Bakken, Eagle Ford, Permian Basin and other shale plays.

Based on my experience of several oil-price declines from the inside during my time at Texaco, Inc., I'm skeptical that many LTO producers would be inclined to trim output from currently producing wells, other than as a last resort. From late 1997 to the end of '98, WTI prices fell by almost half, from around $20/bbl to under $11--equivalent to roughly $15 today.  Prices for heavier grades of oil fell to single digits. After months of that, revenues from some oil fields no longer covered variable costs, and upstream management took the decision to shut in high-cost production. Once prices revived, they discovered that some of that capacity had been lost essentially permanently.

I suspect there would be even greater uncertainty and hesitation today about shutting in producing shale wells for any significant period, especially in light of the limited experience with such wells. The bigger question is whether the drilling of new wells would slow or stop, resulting in a gradual slide in output as existing wells decline.

Then and presumably now, however, the first option in a situation like this is generally to cut costs, rather than output. I saw this in the mid-1980s, when oil prices fell by nearly 60% and took more than a decade to recover fully, then again in the late '90s, and during periodic, smaller market corrections. Suppliers were squeezed, big projects deferred, and employees saw travel, raises and benefits curtailed. Similar actions now could make a difference in keeping new shale drilling going.

Even for relatively efficient operators, it can be surprising how much expense can be reduced without affecting near-term productivity, and many of those savings would persist if prices recovered. LTO producers might ultimately become more profitable after weathering a period of weak prices.

A heightened focus on costs would also likely extend beyond producing company budgets and supplier agreements. One of the biggest non-production costs for LTO is transportation, whether paid directly by the producer or deducted by the purchaser from the market price.  Because of its rapid growth and the constraints of existing infrastructure, a high proportion of LTO output must currently be shipped by rail--up to one million bpd in the second quarter of 2014.

Rail offers flexibility and can reach many destinations, but it is expensive.  For example, if it costs over $10/bbl to ship Bakken crude to the Gulf Coast by rail, that means that with WTI at $78/bbl the producer might realize less than $70/bbl at the wellhead.  Pipelines are often cheaper to use, though not in all cases. The current tariff on the existing Keystone Pipeline for taking oil from the Canadian border to Cushing, OK, the storage hub for WTI, works out to around $4/bbl. If oil prices stayed low for a while, that might increase interest in the proposed Bakken Marketlink Project. It would connect the Bakken shale operations to the Keystone XL pipeline, the prospects for which look decidedly better after the outcome of Tuesday's mid-term election.

Another aspect of transportation costs that could come under a different kind of pressure relates to federal restrictions on shipping oil and petroleum products by vessel between US ports. Under the "Jones Act", only US-flagged, -owned and -crewed ships can perform such deliveries, even though the rates for such shipments are normally significantly higher than on foreign-flag tankers in comparable service. This is a significant factor in current petroleum trade patterns, in which refined products from Gulf Coast refineries are often shipped halfway around the world, while blenders and marketers on the east and west coasts must import gasoline and other products from outside North America.

And as long as US crude oil exports are prohibited, with a few exceptions, the combination of the Jones Act and the export ban effectively keep LTO bottled up on the Gulf Coast--depressing its price--or force it onto rail. Amending the Jones Act to exempt LTO, or the issuance of a waiver to that effect from the Executive Branch, could increase producers' margins while expanding the supply options for US refineries on the other coasts. I wouldn't be surprised to see this taken up by the new Congress early next year.

 Based on the current behavior of oil markets, the global impact of the US shale oil boom has been greater than many expected and seems very much in the national interest of the US--and of US consumers--to keep it going. It remains to be seen whether measures such as new pipeline infrastructure and reform of shipping regulations, together with more traditional forms of expense reduction, could boost producers' returns on LTO sufficiently to sustain drilling at roughly current rates while oil prices are weak. 

Even if both drilling and tight oil production slowed for a while, this price correction won't spell the end of the shale boom. As the Heard on the Street column in the Wall Street Journal put it recently, "Once someone has cracked it, it can't be unlearned. Barring a prolonged period of very low prices, the US oil industry isn't about to disintegrate." Rather than an existential crisis, the current weakness in oil markets looks like a test of adaptability for this new but important energy sector.

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

Is An Ethanol Compromise on the Horizon?

• The RFS ethanol mandate increasingly benefits farmers and ethanol producers at the expense of motorists, small-engine users, food producers and restaurants.
• Repeal of the RFS looks unlikely, but equitable reforms addressing the needs of all affected groups are possible, if Congress is willing to compromise.

Earlier this month, National Journal hosted an event on the “Biofuels Mandate: Defend, Reform, or Repeal” from Washington, DC. I encourage you to skim through the replay. The session highlighted a wide range of views concerning the US Renewable Fuels Standard (RFS), including those of the corn ethanol and advanced biofuels industries, poultry growers, chain restaurants, environmentalists, and small engine manufacturers. Although these broke down pretty sharply along pro- and anti-RFS lines, I thought I detected hints of the kind of compromise that might resolve this issue. I’d like to focus on the elements of such a deal, rather than rehashing the positions of all of the participants, with one necessary exception.

The most disappointing contributions to the discussion occurred during the interview with Representative Steve King (R, IA) by National Journal’s Amy Harder. If we accept Mr. King’s perspective, we should embrace the RFS as being as relevant today as when it was conceived, with no changes required. That flies in the face of the serious market distortions now manifesting in the “blend wall” at 10% ethanol content in gasoline.

Among other things, Mr. King claimed that a 2008 reduction of $0.06 per gallon in the now-expired ethanol blenders tax credit brought the expansion of the corn ethanol industry to a standstill. The industry’s own statistics tell a very different story, with US ethanol production capacity having grown by a further 86% since that point.

Rep. King also characterized “food vs. fuel” concerns as a bumper sticker issue, with no basis in fact. That issue might be controversial, but it is far too substantive to dismiss so cavalierly. The latest evidence of that is a vote by the European Parliament to cap the contribution of conventional biofuel — ethanol and biodiesel derived from food crops — at 6% of transportation energy out of a 2020 target of 10%, based on concerns about sustainability and competition with food. It seemed fairly clear that the Congressman views the RFS more as a farm support measure than an energy program.

The only one of Mr. King’s comments that seemed to find traction with the other pro-RFS panelists was his odd suggestion that without a mandate for biofuels, the only federal mandate in place would be one for petroleum-based fuels. Certainly, gasoline and diesel have advantages in terms of infrastructure, energy density and the legacy fleet, but he appeared to have something else in mind. From the way others picked up on this, perhaps it was his earlier reference to the tax benefits that conventional fuel producers have long enjoyed. This is the first and easiest element on which to compromise.

If ethanol producers and advanced biofuels developers are convinced that fossil fuels get a better deal from the federal government than the one they have under the RFS and the $1.01 per gallon producer tax credit for second-generation biofuels, it would be a simple matter to replace these programs with the same incentives received by oil and gas producers and petroleum refiners. After all, the biofuel industry already benefits from the Section 199 tax deduction that accounts for a third of budgeted federal tax benefits for the oil industry, and it shouldn’t be hard to devise an accelerated depreciation benefit analogous to “percentage depletion” and the expensing of intangible drilling expenses. Combined, the value of these tax benefits is about 1.3¢ per equivalent gallon of oil or natural gas produced this year.

Other concerns came across clearly. Despite the endorsement of 15% ethanol blends by the Environmental Protection Agency, blending more than 10% ethanol in gasoline creates serious risks for the US’s 500 million existing gasoline engines, large and small. The scale of corn diversion necessary to go beyond 10% is also distorting the US agricultural economy and food value chain, all the way to the restaurants in our communities. However, those engaged in developing new biofuels that don’t rely on edible crops, or that are fully compatible with existing infrastructure and engines, are legitimately worried that the repeal of the entire mandate would strand the significant investments in new technology that have already been made, and possibly smother their industry just as it nears its first commercial-scale deployments. All these points of view struck me as eminently reconcilable within a reformed RFS that recognizes that most of the assumptions of the 2007 mandate are no longer valid.

The starting point for reform of the RFS should be a 10% cap on ethanol from all sources in mass-market gasoline — excluding E85 — combined with measures to give ethanol from non-food sources priority within that cap over ethanol produced from corn or other food crops. The advanced biofuel targets of the RFS should also be scaled back significantly to reflect the reality that the 2007 targets were wildly optimistic. Ideally, they should be adjusted each year based on the previous year’s actual output. In return, the current producer tax credit for cellulosic and other second-generation biofuels could be extended beyond its scheduled expiration at the end of this year, and then phased out over a reasonable, predictable period, perhaps tied to cumulative output.

Finally, since few on the panel seemed impressed by the EPA’s exercise to date of its statutory power to adjust the RFS to fit changing circumstances, that authority should be transferred to another agency, along with clearer guidelines on when adjustments would become mandatory.

I’d be the first to admit that the reforms I’ve outlined above fall well short of the outright repeal of the RFS that many, including myself, would prefer. That’s the essence of compromise. Having just experienced a government shutdown and debt ceiling crisis brought on by the clash of two intransigent positions, this might be preferable to an impasse that leaves an unsustainable status quo untouched. And if the assessment of Representative Welch (D-VT) concerning the appetite of the Congress to take up this matter is accurate, something along these lines might just be achievable.

Reform of the RFS would leave in place for a while longer the outlines of a mechanism that one of the session's panelists accurately described as a Rube Goldberg construction. Short of a guarantee to bail out everyone who invested in biofuels production or research on the basis of the RFS that Congress put in place in 2007, should they fail in a post-repeal market, I’m not sure there’s another course that would be sufficiently equitable to all parties involved.

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

Energy and the Federal Budget Sequester

Barring a last-second deal to avert it, the federal government's budget will be cut on Friday by $85 billion for the current fiscal year, which ends in September.  These cuts will be applied across the board to every cabinet department and agency of the federal government, though at different rates for defense and non-defense activities, and with some functions exempted by the legislation that set the sequester in place.  Energy is no exception, and some of the cuts there may seem surprising, given the President's emphasis on promoting new energy sources.  It's worth putting all this into perspective.

Much of the discussion I'm hearing about sequestration, including efforts to replace it with a mix of smaller, more-surgical spending cuts and new tax revenue, seems to miss the bigger picture.  Sequestration was devised by the White House and agreed to by Congress as an intentionally repulsive fallback to the $1.2 trillion of detailed spending reductions that were to have been negotiated in exchange for raising the federal debt ceiling by what ended up being $2.1 trillion--already spent in the meantime.  There were certainly political reasons why that deal focused on spending cuts, rather than a mix of cuts and new revenue.  However, after reviewing the White House's own data on federal revenues and expenditures for the last five years, it would be hard to avoid the conclusion that the US government has a serious spending problem, irrespective of any revenue concerns. 

Specifically, the Office of Management and Budget (OMB) expects combined federal revenue for fiscal year 2013 to come in at $2.9 trillion, or 13% higher than the previous all-time, pre-recession peak in 2007.  Yet 2013 expenditures of $3.8 trillion would be 40% higher than the 2007 level--a trillion dollars more, in fact.  Some of that increase reflects carry-overs from the 2009 stimulus bill, most of which was spent in 2010-12. Even after factoring out expenditures related to the higher unemployment resulting from our weaker economy, federal spending has grown rapidly.

What does sequestration mean for federal energy programs?  Before the cuts were postponed for two months, OMB identified annual reductions totaling $2.4 billion from non-exempted programs within the Department of Energy.  That included cuts of about 8% to the department's science budget, the Office of Energy Efficiency and Renewable Energy (EERE), ARPA-E, the Strategic Petroleum Reserve, innovative technology loan guarantees, and other activities.  Around a billion would be cut from the DOE's nuclear weapons and defense-related work.  Yet when applied to the DOE's 2013 budget request, it appears the department would still receive about a billion dollars more after sequestration than it spent in 2008.

DOE isn't the only place that energy spending would be cut.  I was surprised when I was alerted by a friend in the renewable energy practice of the Akin Gump law firm that Treasury renewable energy grants in lieu of future tax credits would also be subject to sequestration. The federal low-income heating energy subsidy (LIHEAP) would be cut, too, along with the budget for the Bureau of Ocean Energy Management, which administers offshore oil, gas and renewable energy leases. Together they amount to just over $3 billion in reductions from the roughly $44 billion appropriated for energy-related activities this year.

Across-the-board cuts should never be management's first choice for reducing expenses, because they hack away at necessary and useful functions along with the wasteful ones.  However, these cuts are occurring because the administration and Congress couldn't agree on setting priorities for where to cut. After seeing the reactions to the threat of cuts from almost every interest group in America, are we in any position to blame them?  When everything is a priority, nothing is a priority. That's what the sequester reflects, nor is it without precedent.

Because of where I live, some of my relatives, friends and neighbors will feel the direct impact of sequestration.  They have my sympathy. I'm sure it would be little consolation to them to know that  I spent several stretches of my own corporate career under various across-the-board budget cuts, pay freezes, and similar programs that frustrated me, too, because I saw so much muscle cut along with the fat. Parts of the private sector have been through their own versions of sequestration numerous times, some quite recently.  It's never ideal, but sometimes it's the only workable option to rein in spending.

With respect to energy the numbers above suggest that, if given some flexibility in how to allocate cuts on this scale, the government should be able to fund all the core functions of the Department of Energy in promoting energy security and helping to develop new technology, while preserving its key organizational capabilities.  That might not be true of the department's recent efforts in industrial policy. It remains to be seen whether the Congress and White House can agree on providing that kind of flexibility in the execution of a sequestration policy that now looks virtually certain to go into effect this weekend.

Does the Gas Tax Belong in the Fiscal Cliff Fix?

Recently I've seen several articles along the lines of this one from CNN, suggesting that an increase in the federal gasoline tax might be included in negotiations to avert the impending US "fiscal cliff".  While the gap between the gas tax, which was last raised in 1993, and highway repair costs grows each year, that's not just because past Congresses and administrations have been reluctant to hike it again.  As I've discussed in previous posts, gas tax revenue is declining for structural reasons related to curtailed driving, rising fuel economy and alternative fuel vehicles.  Simply adding another 10-15 ¢ per gallon to the current 18.4 ¢ tax wouldn't solve the long-term problem, although it would raise enough revenue to allow us to continue to ignore these growing challenges for a few years.  For that and other reasons, changing the gas tax deserves closer scrutiny than the waning hours of a preoccupied lame-duck Congress can provide.

Yesterday I attended another excellent event held by Resources for the Future in Washington, DC.  This one was devoted to "The Future of Fuel."  The panel discussion began with a presentation of the current energy forecast of the Energy Information Agency (EIA) highlighting the shifting energy mix the agency expects between now and 2035.  Although the slide deck didn't include the chart below, taken from EIA's 2012 Annual Energy Outlook, I couldn't help thinking of it in the context of both yesterday's meeting and the question of future fuel tax revenues. 

The EIA forecasts US gasoline demand to decline by about 8% from current levels by 2035 as cars meeting the new federal fuel economy standard enter the fleet, along with small but growing numbers of vehicles running on electricity and other non-petroleum fuels. An 8% drop in gasoline sales--and thus gas tax revenues--doesn't sound large until you realize that the current gas tax system was predicated on consistently rising gasoline sales as a means of expanding revenues. That's crucial, because highway construction and maintenance costs rise each year, too.  If gasoline sales were still growing at the 1% annual rate typical when the gas tax was last increased, gas tax revenues would be at least 37% higher by 2035 than the level the EIA would now project.

Stepping back from the details, the government faces a fundamental disconnect between its need to raise sufficient funds from the gas tax to cover the cost of maintaining the nation's road network and explicit federal policies aimed at reducing our consumption of the fuels being taxed.  Another one-time bump in the gas tax, whether of 5¢, 10¢ or 15¢ per gallon, will again be overtaken by the combined forces of inflation and declining volumes.  Fortunately, this problem is well-understood and a number of solutions are under consideration.  Inconveniently, many of them involve basic and controversial changes in how the road tax would be collected, such as shifting to a mileage-based tax assessed via annual inspections or real-time GPS monitoring. 

No one should expect or desire the 112th Congress to resolve these issues between now and the end of its term in January, particularly when the money at stake represents such a tiny fraction of either the fiscal cliff's package of tax increases and spending cuts or of the entire federal deficit.  I'm also not sure that reforming the gas tax belongs within the larger federal tax reform effort that should be undertaken next year, because the issues involved are so different from those associated with revamping the business, income, and payroll taxes.  Even a temporary fuel surtax would likely encounter strong opposition, due to its regressive nature and coincidence with gasoline prices that, despite recent declines, remain at or near seasonal record highs.  Unlike the rest of the fiscal cliff, this might just be one can that would benefit from being kicked down the road, at least past the current crisis.

Last Hurrah for the Wind Power Tax Credit?

Ahead of Thursday's meeting of the Senate Finance Committee, a bipartisan deal has apparently omitted the expiring production tax credit (PTC) for wind power from a package of "tax extenders"--various expiring federal tax provisions, including the annual "patch" for the Alternative Minimum Tax.  This development might surprise some of the industry's supporters, but the politics of wind have changed since I last examined this issue in February.  A measure that once enjoyed solid bi-partisan support is now caught between two presidential campaigns that hold diametrically opposed views on its fate. 

A quick review of the PTC seems in order.  This tax credit, which covers a variety of technologies but with wind as the main beneficiary, dates back to 1992--interrupted by several past expirations but then revived in essentially its present form. That's significant, because during the same 20 years in which the PTC has been escalating annually with inflation--from 1.5 ¢ per kilowatt-hour (kWh) to the present level of 2.2 ¢/kWh--the cost of wind turbines and their output has fallen significantly. In the same period, US installed wind capacity grew from 1,680 MW to nearly 49,000 MW as of the first quarter of 2012.  So in effect, we're subsidizing today's relatively mature onshore wind technology by a larger proportion than we did when it was in its infancy. That makes no sense, especially in the current environment.

The US wind industry has received substantial government support in recent years.  When the long-standing tax credit against corporate profits proved to be much less beneficial during the financial crisis, the administration gave wind developers a better option within the stimulus: a 30% investment tax credit that could be claimed as up-front cash grants, instead of having to wait until power was generated and sold over the normal 10 year period of the PTC.  From 2009-11 the wind industry received a cumulative $7.7 B, in addition to ongoing tax credits on older projects, manufacturing tax credits for new wind turbine factories, and loan guarantees for selected wind farms.  And even with new turbine installations in 2012 running well below their record rate of 10,000 MW in 2009, the wind projects that qualify for the PTC this year could receive a total of $4.5 B over the next decade. 

Many people seem to want to equate the tax breaks that wind and other renewable energy technologies receive with the controversial tax benefits for the oil and gas industry, without realizing how unfavorable that comparison truly is for renewables.  Subsidies for technologies such as wind are much higher per unit of energy produced, consistent with their intended purpose of bridging the competitive gap vs. conventional energy.  Yet since the total output of new renewables is still relatively small, the disparity in total subsidies is much larger than it appears.  One way to illustrate that is that if the oil and natural gas produced in the US received tax credits at the same rate per equivalent kWh as wind power, then the annual oil and gas tax preferences that the Congress and President Obama have been sparring over for the last three years wouldn't be $4.8 B per year, but around $100 B per year. 

As the Reuters article makes clear, there will be other opportunities for the PTC to be reinserted in the extenders bill or other legislation.  However, by persistently arguing for extending the existing credit without modification, the wind industry and its supporters may be misreading the public's appetite for such generous subsidies in a period of protracted economic weakness, notwithstanding the recent Iowa poll.  Despite its rapid recent growth wind still contributes less than 4% of the nation's electricity and just 1% of our total energy consumption, and the green jobs angle is wearing thin. Last year's expiration of the ethanol blenders credit set a precedent for ending another large, generous subsidy before its beneficiaries agreed they were done with it. If congressional Republicans line up behind their party's standard bearer on this issue, the wind industry will have missed its opportunity for a graduated, multi-year phaseout of the PTC, instead of stepping off a cliff in 2013.

Extend or Reform?

As the US Congress returns from its election recess to take up its "lame duck" session, one of many crucial pending items it will likely take up is the so-called "extenders" package: key tax provisions that are due to expire at the end of the year, unless extended by legislative action. From an energy perspective, this includes both the expiring ethanol blenders credit and the Treasury renewable energy grants issued in lieu of the investment tax credit (ITC) for renewables. Both incentives face a much more uncertain reception when the new Congress is sworn in next January, so the lame duck might just be their last gasp.

For the ethanol credit, that is as it should be; if 32 years of federal subsidies haven't made corn ethanol competitive with gasoline--particularly when its use is now mandatory--then nothing will. The situation for the renewable energy grants is more complicated. This is a relatively new benefit that, as I've noted in previous postings, was instituted as part of last year's American Recovery and Reinvestment Act--a.k.a. the stimulus--to substitute for a class of market transactions ("tax equity") that renewable energy developers could no longer access as a result of the financial crisis. Bridging that gap became all but essential for smaller companies without enough taxable earnings to take full advantage of the tax credit on their own, or lacking adequate working capital to afford to wait until their next tax filing to recoup the applicable ITC portion of the cost of a project.

If that situation still obtained, justifying the extension of the grants for another year or two would be easy. In the meantime, however, much has changed. Although not yet functioning at the same pace as before the financial crisis, the tax equity market is recovering. Banks and insurance companies have announced a growing number of tax equity deals in the last few months. This market might revive even faster if it weren't competing with essentially free money from the Treasury.

The other aspect of the situation that has changed is the growing dominance of large players in renewable energy project development, particularly for wind. Contrary to the perception that the Treasury grants mainly benefited small companies, more than half of the $5.4 billion in grants awarded to date went to just three companies, all of them large and profitable enough to have waited until tax time to collect their ITC benefits--though I don't doubt that getting cash up front improved the economics of their projects. For example, EDP Renovaveis, through its Horizon Wind Energy subsidiary, collected around $565 million in grants in the first half of 2010, after receiving "in excess of 685 million dollars" in 2009. Meanwhile, between its 3Q2010 earnings presentation and its 2009 full-year presentation Iberdrola Renovables claimed approximately $983 million in US renewable energy grants. NextEra Energy (the renamed parent company of Florida Power & Light) booked $556 million in grants in the first 9 months of 2010, on top of $100 million last year. All of this was entirely appropriate under the provisions of the stimulus, but it doesn't quite fit the picture of an emergency measure intended to help small, struggling firms.

Some have argued that in any case the grants are merely a matter of timing for the government: paying eligible developers cash now, or paying them the same amount later, via reduced taxes. That would only be true if every project that was eligible for a grant could (or should) proceed without one. Sparing wind farms, solar installations and other projects from the discipline of rigorous review by private investors risks allowing weaker projects to proceed, when they should either be rethought or cancelled. That was an unavoidable risk in early 2009, when the renewable energy industry was in peril of imploding, but overlooking it seems less justifiable today.

The Treasury renewable energy grants were instituted as an extreme step at an unprecedented time. It's hard to imagine that anyone intended them to become a permanent entitlement to replace the existing renewable energy tax credits, which were simultaneously extended through the end of 2012 for wind power and 2013 for most other technologies. However, if this program is to be extended for now, it ought to be reformed to exclude beneficiaries for which it constitutes merely a convenience, rather than a necessity. That would mean either capping the maximum payout for any recipient at something less than $100 million, or imposing a corporate income threshold. I'll be watching this issue with great interest between now and the end of the year.

By Executive Order

I recently ran across a mention in the New York Times of a new study suggesting a variety of energy and climate measures the administration could undertake on their own, without requiring new legislation passed by Congress. I've been thinking about this during some long stretches of driving this week. At first glance, the group's ideas merit consideration, and they might indeed be sufficient to meet the near-term emissions reduction goals the US endorsed at last year's Copenhagen climate conference. However, as tempting as such an approach might be in a year of legislative gridlock on energy, its pitfalls probably outweigh its benefits.

I haven't had time to scrutinize the report of the Presidential Climate Action Project item by item, since I'm on vacation. It caught my eye mainly because of the involvement of former Senator and presidential candidate Gary Hart. So my reactions don't really constitute analysis, but are more along the line of ruminations on a first impression that I might examine in more depth later.

At the very least, the idea that the administration could take major steps--beyond what it has already done--to reduce emissions and shift our economy away from its reliance on fossil fuels represents a potentially significant new scenario for the energy/climate environment, particularly if the mid-term elections reduce or eliminate the current Democratic majority in both houses of Congress. It could provide a new policy twist that many of the companies and organizations that have invested so much time in working with Congress on these matters haven't incorporated in their planning.

The problem with such an approach arises from the same source as its appeal: the lack of a sufficient bi-partisan consensus in Congress to enact these changes legislatively. Without a consensus spanning both parties and all factions, any action the President takes on his own could be reversed within a few years. We're not going to lick climate change or our energy problems in the span of any one administration; these problems look much more like the Cold War and require a similarly enduring bi-partisan coalition to deal with them. Major energy policy swings every 4 or 8 years would make this approach much more costly and much less effective, because of the planning and investment horizons involved. The evidence of that is already on display, as this administration reverses many of the energy policies of its predecessors.

Such an outcome is even likelier if these policies become overly identified with a president whose popularity has been waning and who is by no means assured of a second term, barring an unexpectedly robust revival of the US economy. Congress might be even less popular at the moment, but it remains the venue in which a long-term, bi-partisan energy and climate strategy must be hammered out. If a comprehensive energy bill with limits on carbon isn't possible today, important elements of a least common denominator approach to energy security and lower emissions could likely still be enacted. That could include more effort on energy efficiency and a low-carbon electricity standard encompassing both nuclear power and with the currently favored list of renewables. Future administrations and congresses could build on these steps later. A modest compromise along these lines wouldn't please everyone, but it seems preferable to an approach that depends on one party controlling the White House in perpetuity.

Preparing for the Next Big Spill

In the last few weeks numerous industry experts and outside observers have pointed out that the technology for dealing with major oil spills has advanced much more slowly than the technology for finding and producing oil under increasingly marginal conditions. That's an important insight, because if all the leaking oil were being safely and efficiently collected and processed, our main focus would be on the circumstances of the tragic accident that destroyed the Deepwater Horizon and killed 11 workers, rather than on the slow-motion disaster looming off the Gulf Coast. As it debates raising the oil spill fee collected on all the oil the US produces or imports, the Congress should consider setting aside a portion of any incremental revenue to fund research on improved oil spill remediation methods and technology, rather than just accumulating more money to spend in the future on today's relatively ineffective technology, should another large spill occur.

I have no doubt that the assessment of the factors contributing to the Deepwater Horizon accident and the ensuing spill in the Gulf will lead to new regulations on offshore drilling. With some luck, those will contribute to reducing the risk of a recurrence, though regulations can never eliminate the possibility of someone making a bad decision, with tragic consequences. But even if President Obama imposes an extended moratorium on deepwater drilling, there will eventually be another big spill, somewhere--if not from a deepwater well, then from one of the many additional supertanker cargoes the US would require when domestic oil production resumes the long slide that deepwater drilling had arrested and was beginning to reverse. Either way, it's not too early to start thinking about the next spill, while this one is still fresh in our minds.

There's no shortage of ideas for dealing with the oil slick off the Gulf Coast. Online innovation sites are gathering suggestions, and the former head of Shell's US operations, John Hofmeister, has one of his own concerning the use of supertankers to skim and collect the oil. Even actor Kevin Costner has a technology to offer. Decades of offshore drilling without a major accident like this, but with plenty of spills from oil tankers, other vessels, and ports, pipelines, and other facilities, have not prepared the industry to handle the current leak, the rate of which can't even be measured precisely. But even for the spills they were designed to address, the present array of booms, skimmers, and chemical dispersants, plus bags and shovels for what eventually reaches the shore, seems decidedly low-tech. It's hard to conceive of anyone finding the current approaches truly adequate to the task.

Pending legislation in Congress would raise the ceiling on payments out of the Oil Spill Liability Trust Fund from $1 billion to $5 billion per incident, to be funded by increasing the per-barrel fee assessed on oil produced in or imported into the US from $0.08/bbl to $0.34/bbl. (This is the same bill that would extend unemployment benefits and a dog's breakfast of expiring tax benefits, including a retroactive extension of the $1.00/gallon biodiesel production tax credit back to 1/1/10, when it expired.) It's not clear how this would apply to the current situation, particularly since the Constitution seemly unambiguous in its prohibition on ex post facto laws. In any case, the House Ways and Means Committee estimates that the higher fee would raise an extra billion dollars a year for future oil spills. It wouldn't take very much of that to fund the R&D necessary to bring oil-spill containment and remediation technology into the 21st century, through a combination of targeted tax credits and direct funding of good ideas.

Even though this fee is levied on oil companies, we should understand clearly that consumers will eventually pay most of this increase at the gas pump, to the tune of about a half-cent per gallon. US refiners, who are experiencing low margins, are in no position to absorb it, and the market will pass it on to us. If it's going to come out of our pockets, then shouldn't at least some of it go to making sure that future oil spill response efforts have much better tools to work with? I'll bet the folks in Louisiana wish that some of the $1.5 billion currently sitting in the Oil Spill Liability Trust Fund had been invested that way over the last 20 years.

FYI, next Wednesay, June 2, at 1:00 PM EDT I'll be on a webinar panel convened 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.

Finding Facts or Fault

I devoted several hours yesterday to watching Senate hearings on the Gulf Coast oil spill. The Energy and Natural Resources Committee hosted two panels, one a technical panel featuring a former official of the Minerals Management Service--the agency that Interior Secretary Salazar has announced he intends to split in two--and a Professor of Petroleum Engineering from Texas A&M. The second, juicier panel was composed of senior executives from the three main companies involved in the spill, BP, Transocean and Halliburton. Despite the importance of these hearings in putting a face on this disaster and giving our elected representatives an opportunity to demonstrate their concern, I thought the panels served a useful educational purpose. And somewhat to my surprise, they also turned up at least one apparently new fact that might prove crucial in understanding what went wrong 5,000 feet below the Gulf of Mexico on April 20th.

I can't claim to be a great connoisseur of Congressional hearings. They offer some of the same morbid fascination as a car wreck: you know you shouldn't be watching, but you can't take your eyes off it. True to form, a few of the Senators treated the session as an opportunity to show their outrage and alignment with their constituents' concerns. Most, however, followed the tone set by the Chairman, Senator Bingaman (D-NM), in asking thoughtful, probing questions--though I couldn't help chuckling when one Senator seemed to imply that she had participated in the 1986 Space Shuttle Challenger hearings in that same room--alluding to their famous "O-ring" revelation--even though she would have just been elected to her state's legislature that year. Despite the obvious frustration of the committee members when the three executives deflected their efforts to pin the blame for the accident on each of them in turn, the discussion remained civil and the comments and questions mostly substantive.

I found two lines of questioning especially intriguing. The first related to the cause of the accident itself--as distinct from the subsequent leak--and whether it might have had something to do with the well having been cleared of drilling mud prior to setting the final concrete plug in the well. As I understand it, drilling mud is used to balance the pressure in the well between the higher reservoir pressures deep underground and the much lower pressure at the surface. Once the heavy mud was removed and replaced with lighter seawater, the barriers installed in the well (steel casing, cement, the first plug, and ultimately the blowout preventer, or BOP) would have had to withstand the full pressure in the reservoir, which Dr. F.E. Beck from the first panel estimated at 14,000 psi. Since this was apparently the last action performed by the drilling crew prior to the explosion, the sequence and timing of this step makes it an obvious candidate for one of the root causes leading to the explosion on the topsides of the Deepwater Horizon rig. Senator Sessions (R-AL), in particular, tried in vain to get any of the three witnesses to concur that it was contrary to normal practice for the mud to be displaced prior to the setting of the final cap.

The other fascinating exchange occurred later in the hearing, at about 1:24 into C-SPAN's archive video, when the ranking member, Senator Murkowski (R-AK), questioned Transocean's CEO, Mr. Newman, about reports that Deepwater Horizon's BOP had been modified. According to Mr. Newman, one of the five "ram" preventers on the BOP stack was converted "from a conventional well-bore-sealing ram preventer to a BOP test-ram", to "allow for more efficient testing of the BOP." He went on to explain the economic benefits of such a modification, which apparently has been done on other rigs, in reducing the cost and delays associated with testing the BOP. Unfortunately, although Senator Murkowski followed up with a question about whether any modified BOPs had experienced incidents, she didn't ask whether that modification had reduced the capability of the BOP to respond to a catastrophic failure of well control.

Perhaps I've misunderstood Mr. Newman's remarks, and the modification would have had no impact at all on the operation of the BOP. Or it's possible that one extra ram might have made no difference at all, in conjunction with the cascade of other failures necessary to produce a blowout of this magnitude. However, this certainly seems like a topic that should be examined in much greater depth during the full incident investigation that must follow.

I didn't have time to catch the afternoon hearings, in which the same executives were grilled by the Senate Environment and Public Works Committee, or the House hearings this morning. I'll be interested to see if any other new insights emerge, though a couple of things seem clear. First, and with due respect to the Senators and their staffs who clearly worked hard to get up the steep learning curve on this subject, they are simply not equipped to conduct an engineering investigation into an accident of the technical complexity involved in deepwater drilling. Moreover, the format and adversarial approach aren't well-suited to eliciting the necessary level of candor and cooperation from witnesses who've essentially been told they are auditioning for the role of chief villain in the piece. If anything, that understandable tendency to prioritize blame-apportionment over impartial fact-finding seems to have been amplified by the financial crisis and recession. But while it's easy to write such hearings off as political theater, they can still serve a useful purpose, because that same lack of technical knowledge on the part of these committees constrains the dialog to a level that the average American actually has a chance of understanding. That makes it all the more essential that the Congress should refrain from leaping to premature conclusions that could turn out to be wrong, but very hard to correct later with the public.

Big Oil and Renewable Energy

After watching nearly three hours of yesterday's Congressional hearing on gas prices, I'm torn between my desire to emphasize the few positive aspects of the meeting or the serious contradictions it revealed. Let's start with the latter and try to end on a more uplifting note. The most obvious disconnect relates to the implicit and probably erroneous assumption by the chairman and many members of the House Select Committee on Energy Independence and Global Warming that lower fuel prices are actually consistent with either of the principal aims of the committee's charter. But while high gasoline prices provided the subtext, most of the discussion-- including Chairman Markey's Puritan-style shaming of ExxonMobil for its lack of investment in alternative energy--revolved around the tension between the need to continue providing conventional energy, while renewable energy ramps up. That was exemplified by Rep. Walden's important question, "How do we do both?"

In his remarks, Rep. Markey (D-MA) issued a challenge to oil companies to invest 10% of their profits in renewable energy, with the veiled threat that if they didn't, then losing $18 billion per year in tax benefits might not be the worst outcome they face. Absent from this exhortation, however, was any recognition that some forms of renewable energy are not as beneficial as others, either in terms of reducing greenhouse gas emissions or in making a substantially positive net contribution to the country's energy balance. The committee seemed to be saying that biofuels are the obvious answer, and that any oil company not investing large sums in them is cheating consumers. While that might provide useful soundbites for some House Members' reelection campaigns this fall, this line of argument has largely been superseded by events.

Although the net impact of renewable energy remains modest, compared to the energy we derive from fossil fuels, the recent dramatic growth of biofuels has positioned them as a key element of current and future liquid fuel volumes, which no industry supply and demand forecast can afford to ignore. With one exception, the companies whose executives testified yesterday are already significant participants in this sector, with investments in biofuel production, next-generation biofuel R&D, and, as a result of fuel specifications and renewable fuel mandates, as some of the largest blenders of biofuels in the world. It remains to be seen, however, whether any of these companies will ultimately come out on top in the renewable energy marketplace, which is dominated by a host of new entrants. This is a classic case of the Innovator's Dilemma, with the major oil companies' renewable energy businesses having to compete for financial and human resources and management attention with the giant upstream and refining segments that are still the engines of oil company economic value, and will be for years to come.

When asked their highest priorities for addressing today's high energy prices and our reliance on imported oil--a situation that Chevron's Vice Chairman, Peter Robertson, characterized as "unsustainable"--all of the execs cited the urgent need for gaining access to oil and gas resources that the Congress and various states have placed off limits. (Disclosure: I own Chevron stock.) The execs stopped just short of saying that, if the Congress is serious about bringing down energy prices, it could have the largest impact by opening up the 85% of the outer continental shelf waters that are presently off-limits for drilling, rather than hammering on oil companies to invest in renewables. That is certainly born out by the size of the potential offshore opportunity, which could easily add another 1-2 million barrels per day to slipping US oil production, and by the enormous differences in physical and financial scale between conventional and renewable energy projects. ExxonMobil isn't wrong to suggest it can make more impact by sticking to its knitting in this regard, though I continue to believe they will eventually regret not taking a position in renewables now--a defensible strategic choice that has been a PR disaster for them.

The financial realities of this were explained in greater detail by Mr. Robertson in a blogger teleconference (podcast and transcript available shortly) following the hearing, arranged by API, in which he cited 40 global oil and gas projects in which Chevron is engaged globally, each greater than a billion dollars, Chevron's share, and each expected to provide substantial, profitable production. At the current scale of renewables, there are still relatively few billion-dollar projects of the kind that companies of this size must pursue, in order to have a measurable impact on their results and on shareholder value. It is still uncertain whether the billions that companies such as Shell, Chevron, ConocoPhillips and BP are investing in renewables will yield results on that scale.

I also noticed a surprising omission in yesterday's proceedings. While both the committee and the witnesses mentioned the enormous potential of Canada's oil sands for reducing US dependence on unstable overseas suppliers, the prospect that imports of oil sands syncrude might be blocked by US environmental regulations was only referenced obliquely by Mr. Simon of ExxonMobil. As I noted recently, this issue could have severe supply repercussions in the Midwest, where much of the Canadian oil we import is consumed, as well as for the overall US oil import mix. I'd call that a key missed opportunity on the part of the companies.

So with the committee telling the oil companies to help consumers by investing in renewables, and the oil execs asking Congress to help consumers by lifting restrictions on off-limits oil and gas resources, what was constructive? Well, there was a very encouraging discussion about energy efficiency and its vital contribution to reducing emissions and saving money. This is surely common ground on which the industry and government could cooperate more. The companies also heard some sage advice from Rep. Candice Miller (R-MI) that, regardless of the economic justification of their profits and prices, they face significant consumer and regulatory backlash if they aren't seen to "do the right thing with these profits." I think they ignore that at their peril and ours, because the likely regulatory response would harm the industry and be counterproductive for the entire country. Perhaps most revealingly, though, and in sharp contrast to a similar hearing involving the CEOs of these companies several years ago--and to an entirely out-of-context clip from yesterday's event that aired on last night's NBC Evening News--there was little disagreement about the fundamental drivers of high oil prices, and the degree to which the US is integrated into global energy markets. In that respect, at least, our national conversation about energy has progressed in useful ways since 2005.