Is North America the New Middle East for Oil?

With the President of the United States currently playing the role of pessimist-in-chief with regard to US energy independence, it's refreshing to see that goal raised as a serious possibility by someone whose experience and position give him deeper insights on the subject. A few years ago Ed Morse was running the oil trading operation for Hess, and now he's at Citigroup. His op-ed in today's Wall St. Journal offers an upbeat analysis of the ongoing resurgence in US and Canadian production and the potential for North America to move within striking distance of true oil independence. He doesn't appear to be predicting $2.50 per gallon gasoline any time soon, but he does remind us that permanently higher oil prices needn't be inevitable, although he is also very clear about the obstacles that could impede these developments.

How often have politicians and pundits reminded us that we can't drill our way to energy independence? I've said that myself numerous times in the eight years I've been blogging here. So before exploring the implications of producing significantly more oil than we do today, it's worth asking why some experts are starting to question what has been a bedrock assumption about the US energy situation since our conventional oil production peaked in 1970--not coincidentally just before the first oil crisis in 1973-74.

If the tired talking point about the US having just 2% of the world's oil reserves were truly reflective of reality, rather than a technicality based on the way the SEC requires oil companies to account for their chief assets, people like Ed Morse wouldn't give energy independence a moment's thought. The number to focus on is not the 21 billion barrels of proved reserves on companies' books, but the nearly 200 billion barrels of discovered and undiscovered "technically recoverable oil resources" onshore and offshore, in the lower-48 and Alaska. That figure represents more than 95 years of production at current rates.

That estimate is also mostly based on assessments from the 1980s done with technology that bears the same relationship to current exploration techniques as an old Ma Bell rotary phone does to an iPhone. It's technology that is shifting expectations about what is actually possible. Consider the Bakken shale formation in the Dakotas. The conventional Williston Basin oil fields were discovered in the early 1950s and mostly played out by the late 1980s. The billions of barrels of resources in the adjacent Bakken shale, which might produce a million barrels per day by the end of this decade, simply couldn't have been produced at commercially useful rates with the technology that was available until the last decade. The hot question now is where the next Bakkens will be found.

Then there's deepwater drilling, which suffered a big setback with the Deepwater Horizon accident and spill but is still contributing 1.2 million barrels per day and could reach 1.9 million next year. What moves Mr. Morse's speculation from wishfulness into the realm of practical possibility is the potential of applying technologies like those to exploit conventional and unconventional reservoirs to which industry has not had access since their development, if ever.

Another talking point that we've heard like a drumbeat over the last several months is that even if the US could produce more oil, it would make little difference to oil prices in a global market of 90 million barrels per day. We simply don't control the price of oil; OPEC does. That has been true for essentially the entire time I've worked in energy. But here's where it's handy to have the background in oil trading that I share with Mr. Morse. Traders have to think about how prices are really set, and they understand that it's the interaction of the last few million barrels per day of supply, demand and spare capacity that really count, along with inventories. An extra million or two barrels per day--a quantity of which North America is certainly capable--can make a huge difference in oil prices. We saw that in 2009, when a drop of about 3 million barrels per day of demand sent prices from $140 to $40 within a few months, and we saw something similar involving both supply and demand during the Asian Economic Crisis of 1997-98. (See chart below.)


Nor is OPEC monolithic; it's made up of a group of producers with very different levels of reserves and production, and differing domestic requirements for the revenue they earn from selling their oil. That means that, contrary to yet another talking point, OPEC does not have unlimited capacity to back down production, in order to keep prices high when others increase output. And even when it can maintain enough cohesion to tighten quotas and restrict its own output, the production in question merely shifts to "spare capacity", the expansion of which reduces oil market volatility. Imagine how different the market's response to the current confrontation over Iran's nuclear program might look if other producers had a multiple of Iran's exports in reserve.

Just because something is possible with a decade or so of determined effort doesn't make it inevitable. While I share Mr. Morse's optimism about the benefits of boosting North American oil production on a scale that would dwarf the modest recent upturn, which has received so much attention from politicians who had nothing to do with it, I'm also skeptical that it could proceed to quite that extent in today's climate. Aside from people who are genuinely concerned about the possible environmental impact of more oil development, there are also those who would regard such a turn of events as contrary to their own interests and their perception of the nation's. How would we convince consumers to pay the premium for new cars achieving an average of 54.5 mpg in 2025 if gasoline remained between $3 and $4 per gallon, instead of trending toward $6--let alone shifting them into electric vehicles that the government and carmakers have invested billions in developing? And how would we stimulate production of advanced biofuels if the future price of crude oil were seen as being capped at or below $100 per barrel, except during geopolitical crises?

I believe all such questions have answers that don't depend on us constraining access to our resources at the cost of remaining more vulnerable to overseas suppliers and weakening both our trade deficit and our currency. I'd rather have the extra domestic oil and then worry about how to spend some of the resulting windfall of federal and state taxes, bid bonuses and royalties on achieving our other policy objectives, such as promoting efficiency and reducing emissions. Nor is relying on OPEC to keep prices high the best or most effective way to encourage us to use oil more frugally.

I don't know if North America is the next Middle East, although it's worth recalling that we were the world's biggest oil supplier before the first well was drilled in Saudi Arabia, and DOE estimates suggest we have as much oil left as we've produced to date since 1859. However, I do know that I would much rather give OPEC's leaders sleepless nights worrying how they'll keep oil prices high in the face of a wave of new production from the US, Canada and possibly Mexico, in preference to giving US consumers sleepless nights about how they'll pay for the gasoline they need for their commutes and the fuel to heat their homes, if prices stay this high or higher from here on out.

The Brazil Spill

Late yesterday I saw a headline reporting that Chevron was being assessed more than $10 billion for a spill from its drilling activities offshore Brazil last month. The story was later revised to clarify that the amount in question was associated with a civil lawsuit being filed by a Brazilian prosecutor, rather than an actual fine by the government petroleum or environmental agencies. Either way, the sum involved goes beyond surprising. Given the quantity of oil that actually leaked from an appraisal well at Chevron's Frade platform, it is grossly disproportionate to any objective gauge of the scale of the spill and the effectiveness of the response, which stopped the leak within a few days and reduced the surface oil slick to around one barrel within a couple of weeks, without any oil reaching shore. For a nation that aspires to sit at the top table globally, including a permanent seat on the UN Security Council, the reaction to this event raises questions about due process and rule of law. It could also backfire badly, in light of the substantial foreign investment Brazil is seeking in order to develop the enormous "pre-salt" oil deposits off its coastline.

My purpose in writing about this incident isn't to defend Chevron. I don't have enough of the details of what happened, and my well-known conflict of interest as a former employee and Chevron shareholder would undermine my credibility on that front in any case. From my perspective the noteworthy aspects of this spill are its magnitude and the Brazilian government's hasty and exaggerated reaction to it. In terms of its energy implications, it almost doesn't matter what company was involved, except that it's highly unlikely that a similar spill by Petrobras, the partially-privatized national oil company of Brazil, would have elicited the same response.

Start with the magnitude of the leak. No oil spill is a good spill, but the estimated 2,600 barrels that leaked into open waters about 120 miles offshore was at least two orders of magnitude (100 times) smaller than the kind of worst-case tanker spill that oil companies routinely plan and train to be able to handle. Suggestions by the Brazilian government that a global oil company and its drilling contractor, Transocean, weren't prepared to handle a spill of less than 3,000 barrels--more than one year after the Deepwater Horizon accident--belong in the realm of politics, rather than serious analysis.

In fact, any comparisons to the disaster that killed eleven men and leaked 4.9 million barrels of oil into the Gulf of Mexico over 89 days, fouling beaches and harming birds and marine life in four states must pale. The total cost to BP and its partners in the Macondo well isn't yet known, but between the $20 billion escrow fund for Gulf Coast cleanup and claims, along with the federal fines they face, the bill could come to $40 billion, or 4 times what a Brazilian prosecutor is apparently seeking for a spill roughly 2000 times smaller, that never threatened Brazil's coastline. The Frade leak is also modest in comparison to spills from tankers and other ocean-going vessels. Comparable or larger spills averaged more than 3 per year in the last decade, according to the International Tanker Owners Pollution Federation.

Another interesting feature of the spill is that it didn't result from an uncontrolled well blowout, as BP's did, but from subsea oil seeps that developed during the process of drilling into the complex geology of Brazil's technically challenging pre-salt oil deposits. Although these particular seeps were apparently directly related to the well Chevron was drilling, similar seeps are a common feature of many oil-rich offshore regions. NASA has estimated that the Gulf of Mexico experiences similar, naturally occurring seeps on the order of 500,000 barrels per year.

So if the Frade spill was relatively small and contained in short order, why should anyone other than Chevron's management and shareholders care if Brazil slaps them with large fines or a multi-billion-dollar lawsuit, in an apparent attempt to make an example of them and enforce what amounts to a zero-tolerance policy toward oil spills from its offshore projects? I'd argue that we all have something at stake here, indirectly. Brazil's pre-salt reserves offshore represent some of the largest recent oil discoveries and are expected to contribute 2 million barrels per day or more to global oil supplies by 2020. With output in Latin America's two other largest producers, Venezuela and Mexico, falling due to mismanagement of their otherwise ample resources, Brazil's output could be a key factor in oil prices in this decade and beyond.

Brazil is poised to become a major oil exporter, but Petrobras can't take on the scale and risk of this opportunity on their own, without foreign partners. It's not that they lack the technology; Petrobras is a leader in deepwater development. However, if they have to go it alone because the government's response to this event scares off its potential partners, they will be forced to reduce the size of their program, and oil prices will end up higher than they would have otherwise. While I'm entirely sympathetic to the sentiment behind a "zero-tolerance" attitude towards oil spills, whether from oil platforms, tankers or pipelines, I'm afraid it belongs in the same category as a zero-tolerance toward plane crashes: a standard to aspire to, but not one on which national development policies with global consequences can realistically be based.

The Commission Finds...

I've been skimming through the report of the presidential commission on the Deepwater Horizon accident. Lacking time to read every word, I'm finding it on the whole a moderate document. By that I mean that it will not satisfy either those who expected the commission to repudiate deepwater drilling entirely or those that harbored faint hopes that it might issue a blueprint for a rapid return to drilling incorporating the key learnings of the disaster. Instead, as a number of observers have pointed out, its findings point to a complex web of contributing factors--in the process implicating the entire industry--and its recommendations suggest a thicket of new regulations and added fees for oil & gas exploration in US waters.

Anyone awaiting gleaming insights and Ah-ha! moments such as those that exemplified the Rogers Commission's investigation of the space shuttle Challenger accident was bound to be disappointed. With no commissioner having direct knowledge of the theory and practice of offshore drilling in the way that the Rogers Commission included some of the leading lights of the US aerospace community at the time, there was no one to lead it to such results, only paid technical staff to carry out the guidance of a team led by professional politicians. That's not as bad as it sounds. Given the breakdown of what little trust existed for the oil & gas industry, a commission made up largely of experienced oil executives, petroleum engineers and geologists would have lacked credibility with governmental decision makers and the public. However, the composition of the commission surely presaged the outcome of its work.

In the foreword to the document, which is probably all that many will ever read, I was reassured to see a broad recognition of the importance of petroleum to the US economy, the challenges involved in moving away from it, and the necessity of exploiting the resources of the Gulf of Mexico. The commission also pointed out that our conscious decision to focus offshore drilling in the Gulf and not elsewhere carries risks--a surprising admission considering that one of the commission chairs played a significant role in the establishment of that policy. However, I was disappointed at the sweeping indictment of the practices of the entire industry.

The commission was neither tasked nor staffed to investigate the entire US offshore drilling community. Such an undertaking would have required either years or a much larger effort. The parallel to the implication that because most of the industry uses the same contractors, then most of the industry must operate in a similarly risky manner would be as if the Rogers Commission had found that because most rockets and many aircraft were built with components from the same suppliers, most rockets and aircraft must be as risky as the shuttle proved to be. That logic is shaky, at best.

My own experience in the industry doesn't qualify me to pass judgment on the overall quality of the commission's investigation or the full implications of its technical and procedural recommendations. However, in my quick perusal of the document several points jumped out at me that seemed to reflect a limited perspective. I'll highlight two examples.

First, with regard to the risk of fatalities on offshore facilities, the report concludes that "From 2004 to 2009, fatalities in the offshore oil and gas industry were more than four times higher per person-hours worked in US waters than in European waters, even though many of the same companies work in both venues." This was backed up by a chart on page 228 comparing these statistics from several sources. Yet while every fatality is one too many, and no one should be complacent about them, I was astonished that it didn't seem to have occurred to the commission's staff to compare these accident statistics to the US industrial safety statistics, either overall or in similar industrial settings. In a brief Google search I turned up the "Census of Fatal Occupational Injuries Summary, 2009" from the Bureau of Labor Statistics of the US Dept. of Labor. Converting the average US fatal work injury rate of 3.3 per 100,000 full-time equivalent workers for 2009 (the year before Deepwater Horizon) to a comparable rate of 1.6 per 100 million manhours, it appears that offshore work is roughly three times as hazardous as the average of all work. When you consider that the latter reflects the contribution of tens of millions of service and government workers in categories for which highway accidents and homicides account for the largest share of risk, I'm not sure how much lower I'd expect the fatality rate to be for a group of people working long hours aboard facilities jammed with rotating equipment and heavy objects. The subject at least deserves a more thorough look than it was given here.

Then there's recommendation G2, which is the catch-all funding mechanism for all the extra regulatory work required to carry out the commission's other recommendations. I don't disagree that the agencies that monitor and issue permits for offshore drilling should be staffed with enough professionals of suitable experience and training to provide effective oversight and to minimize bottlenecks and delays in the permitting and oversight process. However, the idea that the industry should pay for this with added fees--based on a half-baked analogy to the telecommunications industry--ignores the enormous funding mechanism that's already in place in the form of the lease bonuses, rents and royalties collected by the government from these companies. In the previous fiscal year the agency formerly known as the MMS reported $2.3 billion in revenue from activity on the Outer Continental Shelf, after collecting $9.1 billion the year before. If the federal government has been spending these funds for other purposes, rather than allocating a sufficient portion to protect its investment, there's no guarantee that additional monies collected from the industry would be spent more wisely.

Ultimately, the questions of what happened on the Deepwater Horizon and who bears the blame are likely to be resolved in a court of law. It may be just as well that the commission didn't wait for all the evidence to be in to issue its findings. But they also can't be viewed in isolation. We live in a world in which OPEC seems to be quite content to sit on its ample spare production capacity and watch oil prices ratchet back up towards $100 per barrel and potentially higher, as the global economy recovers. The oil buried under the Gulf represents one our best hedges against OPEC's understandable satisfaction with the status quo. Yes, we need better response capabilities for future spills--some of which is already in the works--and yes, the industry must increase its focus on offshore safety and accident prevention. At the same time, we also need the industry to resume drilling absolutely as quickly as feasible under the new guidelines. The apparent lack of urgency on the part of the commission and administration to make that happen seems divorced from the broader context.

Big Energy Stories of 2010

Many of the main energy trends of 2010 were predictable at the year's start, including the growing reliance of renewable energy on government assistance in the aftermath of the financial crisis, the debate over US greenhouse gas legislation, the emphasis on green jobs and competition with China, the delayed arrival of cellulosic biofuels, and the anticipation surrounding the product launches of the first mass-market electric vehicles. As interesting as all this was, the year in energy was dominated by two transformative events: the Deepwater Horizon accident and the multi-million barrel leak that ensued, and the less spectacular but no less profound awakening to the possibilities of the shale gas revolution.

The Deepwater Horizon disaster has been the subject of such extensive coverage and investigation that there's little I can add concerning the facts, other than to note that we have not heard the last word on just how much oil actually leaked into the Gulf of Mexico. The consequences of our response to the spill will be with us for a long time, both in terms of reduced offshore drilling activity and the decline in US oil output that must inevitably follow. The impact will reach far beyond the tens of thousands of workers whose livelihoods are directly or indirectly linked to the US offshore industry. Early in 2010 it looked like the industry would finally be offered access to areas that had been off-limits for decades, and by year-end not only has drilling in the central and western Gulf come to a near standstill, but the prospect of leases in the eastern Gulf and the mid-Atlantic coast has been foreclosed, perhaps permanently.

The psychological impact of the event could extend even farther than its physical and economic fallout. Whatever misgivings many people had about offshore drilling before the accident, the industry had built up trust through an impressive string of technical achievements--pushing the boundaries of resource accessibility from depths of a few hundred feet into nearly two miles of inhospitable ocean--and a solid reputation for safety. In the space of one day and the following weeks, that trust was shattered. Coming on the heels of a financial crisis that destroyed the trust of millions of Americans in the nation's largest financial institutions and markets likely amplified the effect. As fickle as we Americans sometimes seem, I wouldn't bet that this trust can be restored quickly, or to the same degree.

The shale gas revolution is a completely different kind of story, though it, too, has arguably been tainted by Deepwater Horizon. As it unlocks a resource that has converted the US natural gas supply outlook from one of scarcity and growing import dependence to expected abundance for decades, the gas industry can't assume it will receive the benefit of the doubt concerning the environmental impact of the drilling techniques that have made this turnabout possible.


Perhaps one reason the impact of cheap natural gas hasn't sunk in yet is that the main market price for gas, the futures price at the Henry Hub in Louisiana, doesn't have much relevance for the average consumer. Residential gas customers don't buy their gas in the million-BTU (MMBTU) lots in which the futures contract is denominated; we buy gas in therms--one tenth of an MMBTU--and by the time we see it on our bills all sorts of handling and distribution fees and mark-ups have been added on. But when you compare the price of traded gas in barrels of oil equivalent (BOE) to the price of West Texas Intermediate crude, the remarkable divergence of the last two years becomes obvious, as shown in the chart above. Between 2000 and 2006 gas and oil tracked each other closely, allowing for the greater seasonal volatility of the former. There were even periods when a barrel-equivalent of gas was worth more than a barrel of oil. Yet while oil and gas prices fell precipitously when the recession and financial crisis burst the various asset bubbles, they have diverged sharply since then, with oil advancing back up to today's $91/bbl and gas settling into the $20-25/bbl range in which we were accustomed to see oil prices a decade ago. Adjust that for inflation and you're looking at an average natural gas price for 2010 equivalent to $20/bbl in 2000.

That might help explain why the developers of renewable electricity sources such as wind have struggled so much this year, despite receiving $3.9 billion in direct cash grants from the US Treasury. They're not competing with $90 oil; the US generated less than 1% of its electricity from petroleum this year, through September. Instead, they're competing with gas at an effective price of $25/bbl or less. But if this is a new obstacle for some renewables, it surely represents a huge opportunity for the country as a whole, as we struggle to find our way out of the fiscal and competitive pit we've dug. Cheap energy has always been a key to growth, and right now, gas is the only energy source offering that without requiring an enormous up-front investment. It's no panacea, and it can't take on every burden without being spread so thin that its price advantage would disappear. But I'd much rather be looking at the possibilities this presents than at the constraints that high-priced oil and natural gas imposed only a couple of years ago.

That's probably as good a note as any on which to end the year. New postings will resume the week of January 3, 2011. In the meantime, I wish my readers a happy holiday season.

Natural Gas and The Gulf Hiatus

With so much attention focused on the boom in natural gas from new shale resources, we shouldn't lose sight of the importance of domestic offshore gas, mainly from the Gulf of Mexico. Although it has been declining for the last decade, offshore production still accounts for about 13% of US gas output. Before the Deepwater Horizon disaster the Department of Energy expected that proportion to increase again to as much as 18% of a larger total. However, if drilling in the Gulf doesn't resume--and fairly soon--not only could that portion of our supply deplete rapidly, but its shrinkage would erase much of the incremental contribution from shale gas, a scenario depicted in the chart below. If that occurred, ambitious plans to capitalize on shale gas to displace coal or imported oil would be nullified, and gas prices would shortly revert to their previous upward trajectory.

Despite the official end of the deepwater drilling moratorium and the recent release of new guidelines to aid the industry in filing for deepwater permits, it doesn't look like drilling has resumed or is likely to do so any time soon. Meanwhile, deepwater drilling outside the US seems to be recovering rapidly. It's almost irrelevant whether the ongoing US offshore hiatus is the result of the complexity of new rules and regulations, inadequate staffing of the reorganized Bureau of Ocean Energy Management, Regulation and Enforcement, or what some believe is a tacit, unofficial moratorium on the part of the administration. Together with the recent withdrawal of plans to lease portions of the Eastern Gulf of Mexico, where significant gas resources had already been discovered, the hiatus threatens to return the US to our previous situation of increasing reliance on LNG imports, in spite of growing shale gas output.

Aside from the gas volumes and the significant number of industry and related jobs involved, there's also a fair amount of government revenue at stake in the form of forgone royalties and bid bonuses. Salazar's announcement indicated new offshore leasing wouldn't resume until late next year, at the earliest. That wipes out at least $500 million of expected bonuses--the figure for 2008 was $6.9 B--and the aggregate production decline resulting from no new drilling would lead to a steadily increasing loss of annual royalties, as existing fields deplete and aren't replaced. Between extended environmental studies, delayed permits, and areas re-designated as off-limits that were expected to be available within the 2007-12 cycle, our offshore energy supplies are looking precarious, and that will eventually influence the price we pay for energy--for both gas and imported oil. Recent polling suggests the majority of Americans understand that.

As I've noted before, no one expects things to revert to the way they were before this summer's massive oil spill. However, if we erect too many obstacles in the way of exploiting the abundant hydrocarbon resources of the Gulf of Mexico--even for natural gas, which although subject to the risk of blowouts presents little or no risk of spills like the one from the Macondo well--the costs will not just be financial; they will extend to our environment and energy security.

What Won't Change After the Election?

Tomorrow's US mid-term election dominates today's headlines, with most analysts expecting a dramatic shift in control, at least in the House of Representatives. However, from an energy perspective, many aspects of the situation in which we will find ourselves after the ballots are counted will remain largely predetermined for the next two years, going into the 2012 election. As candidates debate differing perspectives on energy it's worth recalling the tremendous inertia of our energy systems. The seeds of significant change have already been planted and are promoting a gradual transformation, but the results will be more evident when we look back at the end of the decade than while it is underway.

One given is that for at least the next two years, fossil fuels will continue to supply well over 90% of US transportation energy and more than 2/3rds of US electricity generation, with nuclear and conventional hydropower accounting for more than 80% of the low-emitting remainder. Even though wind and solar power are still growing rapidly, though the former has slowed down appreciably compared to last year, they are still too small to make a significant difference in our consumption or emissions, and that will remain the case in 2012. Advocates of wind power and other renewables lament the lack of comprehensive energy legislation or a more focused national renewable electricity standard, but weak fundamentals have at least as much to do with the slowing rate of wind installations. US electricity demand has recovered somewhat from its low point last year, but it remains around 2% below its high of 2007. That has made utilities more reluctant to add generation of any kind, particularly in light of the strong emphasis on efficiency measures in the policies enacted in the last several years, starting with the Energy Independence and Security Act of 2007 and reinforced by last year's stimulus.

Another given is that oil will continue to dominate our concerns about energy security. The economic slowdown reduced net US imports of crude oil and petroleum products by 20%, compared to 2007, but even at this level imports are still a third larger than domestic production of crude oil and natural gas liquids--a disparity that is set to grow for two reasons. First, the greatly reduced rate of drilling in the Gulf of Mexico following the Deepwater Horizon disaster and the moratorium that was imposed in response is already starting to reverse the gains in US oil output that we saw in the last several years. Mature offshore fields are declining, while new projects will be slower to come online. Not even the remarkable success of onshore drilling in the Bakken formation of the Dakotas and Montana, which has moved North Dakota up to number four among oil producing states--past perennial heavyweights like Louisiana and Oklahoma--is likely to compensate for slower growth from the Gulf.

Nor are biofuels likely to add enough production in the next two years to avoid an increase in our oil imports, as ethanol approaches the limits of corn ethanol output and faces the expiration of the tax credit it has enjoyed since 1978. And while the proliferation of hybrids, electric vehicles and other efficient car models is a step in the right direction, their numbers are too small for now to counteract any increase in miles traveled. Even a modest amount of demand growth from a recovering economy will set US oil and refined product imports climbing again, with a corresponding impact on world oil prices and our trade deficit.

There's little doubt that the incoming 112th Congress will have a different approach to energy and its related environmental issues than the outgoing 111th has had. That could prove significant for many aspects of US energy policy, including climate policy. At the same time, the new members of the House and Senate are likely to find, as past Congresses have, that our energy challenges are less responsive to intervention than they assumed. I wouldn't be surprised if the biggest impact on energy in the next two years comes not from energy legislation, but from the indirect effect of whatever steps are taken to address our larger economic problems.

After the Drilling Moratorium Is Lifted

As I was thinking about the offshore drilling moratoria--both the official one that's scheduled to end in a few weeks and the unofficial one that might drag on for months or years--it occurred to me that the Deepwater Horizon accident couldn't have happened at a worse time, in terms of our grasping its impact on our energy economy. There's never a good time for a tragedy on that scale, but the fact that it occurred during a period in which slack global oil demand and temporarily abundant OPEC spare production capacity have insulated oil markets from its effects has created a misleading impression of its inconsequentiality to our oil supplies. If you doubt that, imagine how the oil market--and the stock market--might have reacted if the accident and our response to it had begun on April 20, 2008, when oil futures traded at $117 per barrel, on their way to $145 a couple months later. Unless drilling resumes fairly soon on something close to the previous scale, or unless expectations of an uptick in global oil demand next year prove premature, we could all be in for a taste of those masked consequences within a year or two.

No one expects drilling to resume as though Deepwater Horizon had never occurred, and the industry has its work cut out for it to restore trust in its capacity to develop this energy in a safe and environmentally acceptable manner. New regulations, more consistent enforcement, and initiatives such as the new Marine Well Containment System, to which several of the major oil companies have committed, should help. But until the government and public are satisfied that all of the key lessons from the Deepwater Horizon disaster have been identified and put into practice, the industry will remain on probation. It's somewhat ironic that while we are still grappling with all this, the Parliament of the European Union--widely regarded as being more environmentally sensitive than the US--just voted against a proposed drilling ban. In the meantime, the effects of delayed development will begin to compound, in the absence of any near-term alternative that can fill the gap at the scale required, other than increased oil imports.

In a posting in May I described the potential impact of a protracted halt in US offshore drilling, particularly from the deeper waters of the Gulf of Mexico, and explained why neither expanded biofuels production nor the deployment of electric vehicles (EVs) or highly fuel-efficient hybrids can substitute for domestic oil production. We require these alternatives in any case, but it will be quite a few years before they could plug the resulting gap in our energy supplies. Replacing the equivalent of each 50,000 barrel-per-day oil field that's not developed in the next year or two would require 20 additional ethanol plants, 1.6 million EVs, or a like quantity of foreign crude oil or imported gasoline, diesel, jet fuel, lubricants and other products. And as I noted at the time, delay amplifies the effects of the decline of existing fields, so that the hole out of which we must dig ourselves grows larger with every month that new exploration and production are deferred.

What makes this particularly worrying now is that it has become evident in the last few months that the scheduled lapse of Interior Secretary Salazar's deepwater moratorium at the end of November will almost certainly not restore drilling even in the Gulf of Mexico to anything close to its former level for some time. The impact on technically non-moratorium shallow water drilling from the reorganization of the former Minerals Management Service into the new Bureau of Ocean Energy Management, Regulation and Enforcement, under new management and with a new, stricter set of regulations to enforce, makes that clear. It's also evident that offshore drilling in the Arctic, which is needed to backfill declining output from the Alaskan North Slope, could be delayed even longer.

For the moment, this might not seem like a big deal, when weighed against the universally-shared objective of reducing the risk of another major oil spill as much as humanly possible. With US petroleum demand still depressed by the aftermath of the recession and financial crisis, and with domestic oil production having recovered to levels not seen since before Hurricane Katrina--thanks in large part to the success of deepwater drilling--our net petroleum imports are actually 2 million barrels per day (bpd) lower than they were in 2007. That has helped set up a global oil market in which OPEC has had to keep a tight lid on its output to prevent prices from falling. However, if the analysis in this week's Economist is correct concerning the significant growth of demand from the developing world this year and next, along with an impending peak in non-OPEC oil production, then OPEC's problem will become much easier to manage and prices will begin to head back upward.

The resulting scenario isn't very appealing, unless you're convinced that higher oil prices are a good thing and perhaps the only thing that will get us to address our energy security and emissions challenges head on--though that ignores the lessons from a couple of years ago concerning how the competitive breakeven price of many alternative energy technologies tends to recede as oil prices rise. The deepwater drilling moratorium has nothing to do with the upward trend of oil prices in the last few weeks, and it probably won't be the actual trigger for higher prices next year. However, if oil prices do resume their pre-recession trajectory, the accumulating lagged effects of the moratorium and its aftermath could reinforce the impact on our wobbly recovery and gaping deficits in very unpleasant ways. By the time we wake up to this, it will be too late for second-guessing whether the US government has moved swiftly enough to get this key industry back to work.

BP Shrinks by $16 Billion

I've been going though BP's second-quarter earnings press release and results to get a better sense of the impact of the Gulf Coast oil spill on the company's finances. It's a measure of the scale of a "Supermajor" like BP and the robustness of its underlying cash flows that it could continue to invest more than $6 billion (B) in capital projects and acquisitions in the quarter and even pay down a bit of debt, while recording a charge of $32.2 B against earnings related to the Deepwater Horizon disaster and ensuing oil leak. To put that figure in perspective, it's more than the market capitalization of Exelon Corporation, the largest owner and operator of nuclear power plants in the US. Yet among all of the remarkable and morbidly-fascinating numbers presented here, the one that stood out for me was the net decrease of shareholder equity by $16 B since the end of 2009. Anyone seeking to explain the decision of BP's board to change CEOs should start there.

The media have tended to focus on the impact on BP's market capitalization, which is a more immediate, though also much more volatile measure of shareholder value. As of today, it's down by about $70 B compared to its pre-disaster level. If it remained there and the market believed that the $32 B that BP has just recognized was likely to be the full extent of the impact on the company, a flurry of takeover bids would follow shortly. However, when you read BP's description of how they arrived at that amount, it's clear that there's relatively little upside--mainly from its partners in the Macondo field, if they eventually pay the $1.4 B of costs that BP believes they owe--and a great deal of downside. While including the entire $20 B escrow account set up to cover claims, BP has apparently not reserved extra amounts for the outcome of future lawsuits beyond litigation costs, or for the additional fines and penalties that would follow if it were found to have been grossly negligent.

All of these costs must be balanced somehow. BP's other businesses have continued to generate roughly $7 B per quarter, but the key to finding the money to pay all the claims and damages from the Deepwater Horizon disaster rests with the company's decision to sell up to $30 B of assets, with the first $7 B already sold to Apache, and in its coerced but convenient decision to suspend dividend payments for the balance of 2010. The latter was never really necessary to secure the $20 B escrow account, which BP indicates "will be assured by the setting aside of US assets with a value of $20 billion." No matter what, BP will be smaller in the future as a result of this event, but its management has effectively trimmed the shrinkage by investing some of the shareholders' money--their expected dividends--in projects and activities that might otherwise have been curtailed or sold.

Another figure in BP's results that is attracting some attention is the $10 B tax credit it is recording in conjunction with that $32 B charge. It's simple accounting--the spill-related charges are being incurred pre-tax and will reduce the income upon which BP pays taxes--but this may not sit well with Gulf Coast residents and US taxpayers who have been assured by BP that they will be kept whole. This is as meaningful a source of cash as an asset sale, though it could deliver yet another blow to BP's reputation.

Mr. Dudley has assumed the reins of a company that is still undergoing a near-death experience. Time will tell whether BP's accountants have included a sufficient "haircut" in the second-quarter results to allow him to begin rebuilding the firm's fortunes and restoring the lost shareholder value that was patiently accumulated over many years but destroyed in the course of just a few weeks. I've already seen a fair amount of speculation concerning whether his Gulf Coast roots and American accent will help mollify angry stakeholders, government officials, and Members of Congress, and it's hard to see how he could fare worse in this regard than his predecessor. However, it's going to take a lot more than that to enable BP to retain its access to valuable government contracts and exploration leases, including the extremely thorny decision about whether, when and how to bring up the subject of returning to unlucky Macondo to drill some proper wells and produce a field that some experts seem to think could hold up to a billion barrels of oil, less the several million that flowed into the Gulf.

Moratorium Follies

This week Secretary of Interior Salazar reissued the administration's deepwater drilling moratorium, with a few new twists and a notional six month limit. This happened in spite of loud protests from the states most affected by the spill, some of their representatives in Washington, and even some skepticism from the heads of the President's own drilling commission. The old ban is still in court, and the new one probably will be soon, but this is really all moot, because whether the Salazar moratorium is technically in force or not, the legal battle over it has created a moratorium limbo that few companies would be willing to test, given the costs involved. One irony of all this is that in addition to the obvious indirect winners in OPEC, there's at least one direct winner in this hemisphere: Brazil, which will be quite happy to export to us their deepwater oil that we're inadvertently helping them to develop quicker and cheaper.

When I read the Interior Department press release on the new moratorium, which was presumably crafted to satisfy the federal judge's objections to the original deepwater drilling ban, several points stand out, aside from the redefinition of the ban to cover not water depth, but the kind of rigs that are required to drill in deep water. In the Secretary's statement that he "remains open to modifying the new deepwater drilling suspensions based on new information", he appears to offer greater flexibility and the prospect of case-by-case exemptions or an early termination. Yet when you read the first item on the list of reforms for which the moratorium is intended to buy time, dealing with "companies demonstrating that they have the ability to respond effectively to a potential spill in the Gulf," the implication seems clear. If an unprecedented response to the Macondo spill using the state-of-the-art technology and techniques has been inadequate to meet the government's implied standard--as seems self-evident--then this is a classic Catch 22. If drilling can only resume when the industry can prove it could contain a blowout like this and any oil spilled within a few days, then we could be waiting a very long time, while technology catches up to that new, higher bar.

When you parse through this document and examine the evidence that's been made available so far concerning the causes of the Deepwater Horizon disaster and spill, it's hard to avoid the conclusion that the main driver behind the moratorium is not technological, or even necessarily environmental, given the extremely low risks of a similar event occurring from a properly managed rig equipped with a properly-maintained blowout preventer. It seems due at least to "an abundance of caution"--that lovely phrase we have heard several times this week--if not ultimately from hard-nosed political considerations. If I were a President whose party was facing a tough mid-term election, I'd be tempted to eliminate any possible risk of another blowout between now and November 2, too.

The problem with that approach is that the administration won't pay the short-term price for that abundance of caution. That burden falls on the economy of the region, which has already been affected by the spill, on the domestic drilling industry--a vital national asset, not just a bunch of corporations--and its employees, and eventually on the entire US, as our domestic energy supply will again begin to dwindle. According to a new study, the economic impact of the moratorium already extends well beyond the region, because offshore oil workers, who typically work two weeks on and two weeks off, live all over the country, apparently in more than two-thirds of Congressional districts. Yet while unemployed oil workers might at least be covered by the $100 million fund that BP set aside for that purpose at the administration's request, the local businesses that employ many of them need help with more than just meeting payroll, if they are to survive until the end of the moratorium, whenever that might be. That's not BP's responsibility; it's the direct responsibility of the government that has taken a calculated decision to impose a blanket moratorium on the entire industry, rather than on individual bad actors.

Meanwhile, aside from OPEC, an indirect beneficiary of the moratorium that understands very well that when you stop drilling your existing production begins to fall away, there is at least one direct beneficiary that is about to take advantage of the opportunity the ban has created. Brazil has discovered enormous offshore oil reserves in the deep waters of the Santos Basin and elsewhere along its lengthy coastline. As I've noted before, it's the exploitation of these resources, rather than its effective but comparatively-small cane ethanol program, that has made Brazil energy independent and is turning it into one of the most important new oil exporters in the world, including to the US. Until recently, the companies exploring for oil off the coast of Brazil faced the same problems that Gulf Coast drillers did, of high rig rental costs and a long queue for hiring them. Our response to Deepwater Horizon is mitigating both issues. So while it might be promoting safer drilling in the Gulf, one of the unintended consequences of the suspension of drilling here is that it will simultaneously create a greater need for the US to import oil, while ensuring that countries like Brazil will have more of it to sell us, sooner than otherwise and at a bigger profit.

I expect to post over the course of the summer on ideas for what it would take to get our government and the rest of the country comfortable with resuming drilling, although some indications suggest that most of our fellow citizens are already there. This is complicated by an opportunistic PR campaign from environmental groups suggesting that this is the moment to get the US off oil entirely, rather than figuring out how to drill more safely. However desirable that might sound, for many reasons, at this point it's about as feasible as suggesting to a hospital patient that this is the moment for him to try living without blood. For good and ill, oil is still the lifeblood of our economy. We should absolutely work on reducing our dependence on it, but we're going to burn many billions of barrels of oil getting there, and that will require continued drilling in the US--unless we're happier than I think to go back to our former pattern of importing more and more of it from other countries. Stay tuned.

Expand the Presidential Commission on Deepwater Horizon

Amid the other news this week, including the President's address to the nation on the Gulf Coast oil disaster and his meeting with BP officials yesterday, the announcement on Monday of the five remaining members of the Presidential Commission to assess the "environmental and safety precautions...to ensure an accident like this never happens again" seems to have sunk without a trace. I don't recall seeing it mentioned in either the Washington Post or Wall St. Journal. I ran across it in the New Orleans Times-Picayune online last night. Yet it's clear that the staffing of such a commission has an enormous influence on its approach and ultimate findings, and on both counts I am seriously concerned. From my review of their published bios, I cannot discern that any named member possesses any direct training or experience with the technology and practices of offshore drilling, a field that in its own way is every bit as complex as aviation, terrorism, or other past subjects of similar commissions.

The gold standard for Presidential commissions investigating accidents of national importance was set by the Rogers Commission on the explosion of the Space Shuttle Challenger shortly after its launch on January 28, 1986. The commission--not just its technical staff--was packed to the rafters with figures of national prominence and deep expertise in aviation and space technology and operations. Headed by former Secretary of State William P. Rogers, it included Neil Armstrong, the first astronaut on the moon, Dr. Sally Ride, first American woman in space, Gen. Chuck Yeager, first pilot to fly faster than the speed of sound, Gen. Donald Kutyna, an expert on spacecraft launches and accidents, and Joseph Sutter, the "father" of the Boeing 747, along with an aeronautical engineering professor, an aircraft designer, a solar physicist, and several other leading experts on aerospace matters. Last but never least was Richard P. Feynman, Nobel Prize-winning physicist, quintessential iconoclast, and perhaps the smartest and most inquisitive human being ever to walk the earth, with the possible exception of Albert Einstein. It was, of course, Dr. Feynman whose famous ice-water experiment with the solid rocket boosters' O-ring material uncovered the root cause of the disaster.

Each of the fine individuals President Obama has named to the Deepwater Horizon Commission brings valuable experience and an important perspective, including that of a professional environmentalist, biological oceanographer, an accomplished physicist and manager of science, and a pair of lawyers with past experience in various aspects of the Exxon Valdez spill and cleanup. I have no objection to any of them individually. However, collectively they are not a patch on the Rogers Commission.

The obvious solution to this problem is that the President should immediately expand the commission to include at least two additional members, and preferably four, with deep expertise and experience in oil & gas drilling, geoscience, and offshore industry operations. It is absolutely essential that the commission includes people who understand not just the ocean environment, but also subsea geology, drilling technology, and relevant oil & gas industry practices, first-hand. They should of course have no connections to BP or to any other company that stands to lose or gain from the commission's findings. While that might narrow the field somewhat, it would not rule out the faculties of the leading petroleum engineering and geosciences university departments, or a wide swath of recently-retired experts in these fields. The US is blessed with abundant expertise in this area, and it would be a crime to exclude it from this vital study.

Despite a nearly universal desire to accelerate our shift away from petroleum in the wake of this disaster, we are nowhere near being able to turn our backs on either the energy or convenience we get from oil. As I've shown in a series of postings since the accident occurred, offshore drilling is a crucial component of US domestic energy supplies, and no current alternative energy source operates at either the scale necessary to replace it, or in sufficiently direct substitution for the transportation energy of which oil is our principal provider. The less oil we produce domestically, the more we will have to import.

In this context it is of the highest importance that the commission be given the best chance possible to interpret the findings of the technical investigations of what went wrong on the Deepwater Horizon rig, and to determine how to structure an approach to offshore drilling that reduces the risks posed by human error and technical failures to the maximum degree possible. Every member of the commission has important contributions to make in this regard, but without the match between relevant experience and the nature of the problem exemplified by the Rogers Commission, the Deepwater Horizon Commission will be operating at least partly in the dark.

I don't often urge my readers to take action on the subject of one of my blogs, but in this case, if you share my concerns about the omission of critical experience from the staffing of this commission, you should contact the White House and your Representatives in Congress to express that view.

The Panic Button

I suppose it was inevitable that we would arrive at the moment in the ongoing oil spill crisis at which the baby would be thrown out with the bath. That moment came at about 7 minutes into President Obama's press conference on the spill yesterday. After announcing the suspension of offshore drilling in Alaska, the cancellation of planned lease sales for the Gulf of Mexico and Virginia, and the extension for six months of his administration's moratorium on new drilling permits for deepwater wells, he ordered a halt to 33 exploration wells currently being drilled in the Gulf, excluding the two relief wells for the leaking Macondo prospect. Everything up until that point could be considered as reasonable, prudent, and expected responses by an administration faced with an unprecedented and still-unfolding environmental and economic disaster. But while stopping work on the 33 projects already underway might look like prudence to some, it could ultimately have economic consequences rivaling those of the spill.

The President's order is based on the recommendations of the 30-day investigation of offshore drilling carried out at his request by the Department of Interior. The report recommended a number of new standards for equipment and procedures for use in deepwater drilling, and it follows that it will require some time to implement all of these changes, both on the part of the drilling industry and in the government agencies charged with regulating and inspecting these activities. Absent from this report and from the President's order is any path for companies with rigs already drilling wells in deep water to quickly demonstrate that they are already sufficiently in compliance with these recommendations--which I must add have been issued without the final results of the various investigations into the actual causes of the accident, and thus must make significant assumptions concerning the relative importance of equipment failure, procedures, and human error.

I understand that the President has an obligation to protect the residents, businesses and environment of the Gulf Coast region from further harm. Another blowout or leak could turn disaster into total catastrophe. Yet the safe drilling record of the other firms operating in the Gulf does not give us any reason to expect that allowing the projects in question to continue would constitute such an unwarranted risk. It's also worth recalling that all of the drilling projects now required to suspend operations have already passed the emergency inspections the President ordered in the immediate aftermath of the Deepwater Horizon explosion and sinking. These inspections were completed on May 9.

What does this order mean on a practical level? A number of companies that paid for leases conveying the right to explore for and develop hydrocarbons in the Outer Continental Shelf, and that subsequently invested significant effort and expense in planning and obtaining permits for the exploration of these leases--instead of other leases offshore Angola, Brazil, or elsewhere--and that signed contracts with drill-ship operators and many other suppliers must now abrogate those contracts, declare force majeure, or pay off their suppliers and abandon these wells as if they were all dry holes. It is simply not realistic to imagine that any of these companies can afford to leave these rigs and crews in place for six months, waiting for the government to either show them a way forward or deliver another moratorium extension. Instead, the companies will scramble to redeploy this equipment and some of these workers to projects outside US waters, while arguing urgently with the government--and probably in court--that they should either be allowed to complete these projects or awarded substantial damages.

Please don't imagine that I'm inviting you to a pity party for the oil industry. While some of the firms involved, particularly those with minority, non-operating stakes in these projects, are smaller players, most are big international firms with global operations and multi-billion dollar capital budgets. This move will be a financial setback for them, but they will recover and shift their efforts elsewhere, to the extent they can. When the moratoria end--if they do under the current administration--they will step back into the Gulf of Mexico OCS, but probably much more tentatively, as appropriate for the significantly higher "above-ground risk" involved--essentially a measure of the relative reliability or capriciousness of the legal and regulatory system in which they're dealing. They will not be the big losers from this decision. That honor is reserved for many of the individuals and businesses along the Gulf Coast that have added jobs and made investments to serve this growing market. In other words, the President's decision will compound the economic damage to a Gulf Coast already reeling from the impact of the spill.

We should take some consolation that the President didn't shut down the 591 deepwater wells that are already producing oil and gas in the Gulf. The mere fact that this was reported suggests it had probably been under serious consideration. As I've noted on numerous occasions in the last several weeks, the oil and gas we produce from the Outer Continental Shelf is a crucial source of domestic energy and vital to our energy security. However, that importance also extends to our offshore drilling capacity, which was put at risk by this decision.

After an event like this spill, no one should expect things to continue exactly as they were. However, the New York Times is right to call the President's response "partly a political exercise aimed at showing that his administration is on top of the unfolding disaster in the Gulf of Mexico." Instead of singling out the companies that were directly involved in the Deepwater Horizon accident for this time-out to prevent further spills, he has chosen to punish the entire industry and all its stakeholders in the region, including the most safety-conscious and diligent operators with unblemished records. Halting all of BP's projects, or even all projects involving Transocean, could have been defended as a sensible precaution. Freezing everything looks like the act of an administration that is so out of its depth in this situation that its fundamental instinct is to eliminate any possibility of another problem from this source on its watch. Unfortunately, American energy consumers will be paying for years for this extreme level of risk aversion.

Disclosure: My portfolio includes investments in Chevron, which appears to be the operator of several of the projects affected by this order.

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.

How Fast a Transition from Oil?

The Gulf Coast oil spill remains the top energy story this week, eclipsing a $10 drop in oil prices that should soon ripple through to gas pumps near you. With BP's latest effort to contain the spill having run afoul of a slush buildup composed of methane hydrate crystals, the deepwater well continues to leak at an undetermined rate. The longer the spill continues, the greater the chances for severe environmental consequences, and the likelier that it will become a perception-altering milestone event as some environmentalists have already suggested. However, even if the spill were to galvanize public opinion in a manner similar to the 1969 Santa Barbara oil spill, what options do we have that could realistically reduce our reliance on oil produced from offshore platforms?

Last week I focused on the energy contribution of the oil we produce offshore in US waters, particularly in the deep water of the Outer Continental Shelf (OCS) of the Gulf of Mexico. It constitutes 30% of domestic crude oil production, or about 10% of our total oil consumption, and contrary to the wildly-inaccurate assertion on a widely-read environmental blog last week, essentially none of it is exported. (Anyone who doesn't know the difference between crude oil and petroleum products has no business commenting on that aspect of energy policy.) Today I'd like to go into a little more detail on the alternatives to offshore drilling that I alluded to last Wednesday.

Gasoline, jet fuel and diesel accounted for 75% of the petroleum we consumed last year. Other than the heating oil included in the diesel tally, these are the fuels that power most transportation of people and goods. Many initiatives are under way to develop non-petroleum fuels for cars, trucks and even jet aircraft, though at this point they are all in relatively early stages of development or deployment. On paper, at least, electricity looks like the best option for replacing gasoline, by means of plug-in electric vehicles like the Chevrolet Volt and Nissan Leaf. Since less than 1% of US oil consumption is used to generate electricity, switching cars from gasoline to electric power represents a nearly total displacement of oil. It would also facilitate the direct use of renewable electricity sources to eliminate greenhouse gas emissions. This prospect has many people excited, and I've heard it mentioned frequently in reactions to the Gulf spill. Yet this is hardly a slam-dunk, for numerous reasons, topped by scale and the unproven consumer acceptance of mass-market EVs.

In one of their periodic special sections on energy, today's Wall St. Journal included an article on the development of EV recharging networks in the US. It cited a study by Pike Research forecasting 610,000 EVs by 2015. That would be a great start, though it would fall short of President Obama's goal to put a million plug-in vehicles on the road by then. Even assuming that the million-EV mark were reached that soon, and that they were driven as much as other cars and replaced vehicles averaging 25 mpg, the quantity of gasoline they would displace amounts to just 31,000 bbl/day--less than the quantity of oil the leaking Macondo field would have been producing in a couple of years, had Deepwater Horizon's exploration well been completed uneventfully. Substituting for all of the oil currently produced from offshore drilling--or for the decline in US oil production that would occur by 2020 if we stopped drilling offshore--would require up to 50 million EVs, making up roughly 40% of all the cars likely to be sold in the US this decade. I suppose that might barely be possible on a crash basis, with a World War II-style mobilization of the resources required to achieve it, but it doesn't look very likely to me. I would be impressed if the US had 10 million EVs by 2020, implying annual production of well over a million units within just a couple of years, though that would reduce our current oil demand by under 2%.

So if EVs can only take us a small part of the way to replacing our oil consumption in the near future, what about advanced biofuels? There are many promising avenues, including biofuels produced from agricultural or forestry waste or dedicated energy crops, biofuels from algae, and bio-hydrocarbons from plant sugars. All are in their infancy. The EPA recently had to reduce its mandate for advanced biofuels delivered in 2010 from 100 million gallons to just 6.5 million gallons--424 barrels per day--because no truly commercial-scale facilities will come on-stream this year. We might get a few billion gallons per year from these sources by 2020, if numerous technical and economic hurdles can be overcome, but that would displace at most a couple of hundred thousand bbl/day of oil.

Natural gas looks like another good alternative transportation fuel. T. Boone Pickens has put forward his plan to shift long-distance trucking onto compressed or liquefied gas. There's no shortage of gas available for this purpose, thanks to the much larger supplies made possible by shale gas drilling. It starts from a very low level, however, with current natural gas used in transportation equivalent to less than 1,500 bbl/day of diesel fuel. It also competes with other uses of gas, such as generating more electricity to reduce our consumption of coal. Or, looking at it another way, there might be plenty of gas to do both, but not at today's price.

That leaves what looks like the best option for reducing our oil consumption, other than simply deciding to drive less, as some folks have apparently already done. Because the US car fleet is so large and is driven so far, increasing its fuel efficiency by just 3 miles per gallon could save nearly a million bbls/day of gasoline. That's more than the entire contribution of corn ethanol, our most significant alternative transportation fuel. In fact, the latest demand forecasts of the Energy Information Agency are already based on that kind of improvement, reflecting new regulations requiring new-car fuel economy to increase to 35 mpg before 2020. Still, only a small fraction of our fleet of 240 million cars turns over every year, so it will take a long time before average fleet fuel economy even begins to approach these levels.

Whether your preferred alternative to offshore drilling requires replacing millions of vehicles with hybrids, EVs, natural gas-powered vehicles, or highly-efficient small conventional cars like the new Ford Fiesta, or depends on a vast new infrastructure of alternative fuel production and distribution, none of these solutions can work overnight. In the meantime, every barrel of oil we consume but don't produce here must be imported, some of it from countries that don't like us very much--as we're frequently reminded--and all of it with serious implications for our national financial and trade balances. (And don't forget the inevitable oil spills from all those extra tankers.) If we don't want OPEC to be the biggest beneficiary of a new environmental mindset after the Gulf Coast spill, then we face some very tough choices, including whether we'd prefer to open up major new areas for onshore drilling, instead of some of the offshore prospects that were slated to be leased in the next few years, or to continue drilling offshore under updated procedures and with strengthened environmental protections, at the same time we pursue all of our options for reducing our overall reliance on oil.