OPEC's War on US Producers

The comments of Saudi Arabia's oil minister at the annual CERAWeek conference in Houston this week provided some sobering insights into the strategy that the Kingdom, along with other members of OPEC, has been pursuing for the last year and a half. Perhaps the ongoing oil price collapse is not just the result of market forces, but of a conscious decision to attempt to force certain non-OPEC producers out of the market.

Notwithstanding Mr. Al-Naimi's assertion that, "We have not declared war on shale or on production from any given country or company," the actions taken by Saudi Arabia and OPEC in late 2014 and subsequently have had that effect. When he talks about expensive oil, the producers of which must "find a way to lower their costs, borrow cash or liquidate," it's fairly obvious what he is referring to: non-OPEC oil, especially US shale production, as well as conventional production in places like the North Sea, which now faces extinction. If these statements and the actions that go with them had been made in another industry, such as steel, semiconductors or cars, they would likely be labeled as anti-competitive and predatory.

We tend to think of the OPEC cartel as a group of producers that periodically cuts back output to push up the price of oil. As I've explained previously, that reputation was largely established in a few episodes in which OPEC was able to create consensus among its diverse member countries to reduce output quotas and have them adhere to the cuts, more or less.

However, cartels and monopolies have another mode of operation: flooding the market with cheap product to drive out competitors. It may be only coincidental, but shortly after OPEC concluded in November 2014 that it was abandoning its long-established strategy of cutting production to support prices, Saudi Arabia appears to have increased its output by roughly 1 million barrels per day, as shown in a recent chart in the Financial Times. This added to a glut that has rendered a large fraction of non-OPEC oil production uneconomic, as evidenced by the fourth-quarter losses reported by many publicly traded oil companies.

That matters not just to the shareholders--of which I am one--and employees of these companies, but to the global economy and anyone who uses energy, anywhere. OPEC cannot produce more than around 37% of the oil the world uses every day. The proportion that non-OPEC producers can supply will start shrinking within a few years, as natural decline rates take hold and the effects of the $380 billion in cuts to future exploration and production projects that these companies have been forced to make propagate through the system.

Cutting through the jargon, that means that because oil companies can't invest enough today, future oil production will be less than required, and prices cannot be sustained at today's low level indefinitely without a corresponding collapse in demand. Nor could biofuels and electric vehicles, which made up 0.7% of US new-car sales last year, ramp up quickly enough to fill the looming gap.

Consider what's at stake, in terms of the financial, employment and energy security gains the US has made since 2007, when shale energy was just emerging. That year, the US trade deficit in goods and services stood at over $700 billion. Energy accounted for 40% of it (see chart below), the result of relentless growth in US oil imports since the mid-1980s. Rising US petroleum consumption and falling production added to the pressure on oil markets in the early 2000s as China's growth surged. By the time oil prices spiked to nearly $150 per barrel in 2008, oil and imported petroleum products made up almost two-thirds of the US trade deficit.

Today, oil's share of a somewhat smaller trade imbalance is just over 10%. Since 2008 the US bill for net oil imports--after subtracting exports of refined products and, more recently, crude oil--has been cut by $300 billion per year. That measures only the direct displacement of millions of barrels per day of imported oil by US shale, or "tight oil" and the downward pressure on global petroleum prices exerted by that displacement. It misses the trade benefit from improved US competitiveness due to cheaper energy inputs, especially natural gas.

Compared with 2007, higher US natural gas production, a portion of which is linked to oil production, is saving American businesses and consumers around $100 billion per year, despite consumption increasing by about 20%--in the process replacing  more than a fifth of coal-fired power generation and reducing CO2 emissions. $25 billion of those savings come from lower natural gas imports, which were also on an upward trend before shale hit its stride.

 

The employment impact of the shale revolution has also been significant, particularly in the crucial period following the financial crisis and recession. From 2007 to the end of 2012, US oil and gas employment grew by 162,000 jobs, ignoring the "multiplier effect." The latter impact is evident at the state level, where US states with active shale development appear to have lost fewer jobs and added more than a million new jobs from 2008-14, while "non-shale" states struggled to get back to pre-recession employment. That effect was also visible at the county level in states like Pennsylvania, where counties with drilling gained more jobs than those without, and Ohio, where "shale counties" reduced unemployment at a faster pace than the average for the state, or the US as a whole.

 

If the shale revolution had never gotten off the ground, US oil production would be almost 5 million barrels per day lower today, and these improvements in our trade deficit and unemployment would not have happened. The price of oil would assuredly not be in the low $30s, but much likelier at $100 or more, extending the situation that prevailed from 2011's "Arab Spring" until late 2014. If OPEC succeeds in bankrupting a large part of the US shale industry, we might not revert to the energy situation of the mid-2000s overnight, but some of the most positive trends of the last few years would turn sharply negative.

 

Now, in fairness, I'm not suggesting that this situation can be explained as simply as the kind of old-fashioned price war that used to crop up periodically between gas stations on opposite corners of an intersection. The motivations of the key players are too opaque, and cause-and-effect certainly includes geopolitical considerations in the Middle East, along with the ripple effects of the shale technology revolution. It might even be possible, as some suggest, that OPEC has simply lost control of the oil market amidst increased complexity.  

 

However, to the extent that the "decimation" of the US oil and gas exploration and production sector now underway is the result of a deliberate strategy by OPEC or some of its members, that is not something that the US should treat with indifference.

This is an issue that should be receiving much more attention at the highest levels of government. The reasons it hasn't may include consumers' understandable enjoyment of the lowest gasoline prices in a decade, along with the belief in some quarters that oil is "yesterday's energy." We will eventually learn whether these views were shortsighted or premature.

A Late Christmas Gift for Renewable Energy

The US Senate's "fiscal cliff" package wasn't exactly eight maids a-milking--the traditional gift for the eighth day of Christmas--though it did apparently resolve the impending "milk cliff".  Of greater relevance, the "tax extender" portion of the American Taxpayer Relief Act of 2012 passed by both the Senate and House of Representatives represented a gift to renewable energy producers and developers worth around $18 billion.  Two-thirds of that is attributable to the extension and modification of the Production Tax Credit (PTC) for wind and other renewable electricity projects. Renewable energy technologies have gained another year of generous support from US taxpayers.  What remains to be seen is whether this win represents a last hurrah for the current US approach to renewable energy subsidies as lawmakers focus on shrinking an increasingly unsustainable federal budget deficit.

Based on the analysis of the bill provided in the Wall St. Journal, other energy-related beneficiaries  included producers of cellulosic and algae-based biofuels, blenders of conventional biodiesel and other alternative fuels, purchasers of 2- and 3-wheeled electric vehicles, as well as various energy efficiency investments including efficient homes and appliances.  Renewables should also benefit from other provisions of the bill, including a one-year extension of 50% bonus depreciation on project investments and a two-year extension of the 20% R&D tax credit. 

Of course the problem with all of this is that it sets up additional cliffs at the end of 2013 and 2014, and thus perpetuates the expiration-anxiety roller-coaster that has confounded both manufacturers and investors in these technologies. Part of the blame for that rests with the process by which the Congress drafts and enacts such legislation.  However, it's also a function of the unwillingness of current beneficiaries to shift their lobbying efforts to support realistic and predictable phaseouts of these subsidies, in light of renewables' improving competitiveness with conventional energy and the magnitude of future US fiscal problems.  Considering that the current PTC for wind power is worth the equivalent of about 90% of today's futures price for natural gas, a proposal by the wind trade association for a six-year phaseout ending at 60% strikes me as too much like St. Augustine's plea for chastity.

The high-pressure negotiations to avert the fiscal cliff provided a poor venue for producing genuine tax reform, while giving supporters of the status quo a golden opportunity to attach measures such as these "extenders" that couldn't be amended before the expiration of the current Congress.  The non-partisan Congressional Budget Office estimated that this bill actually increased federal spending by a net $330 billion over 10 years and added nearly $4 trillion to the deficit, compared to going over the cliff.  It's not clear that the even higher-stakes debt-ceiling debate slated for early in the new Congress will be any more conducive to solving these challenges. But whether then or later in the session, it's going to become harder to avoid some form of tax reform and spending discipline that considers all energy subsidies in the context of their direct costs and indirect revenues. I'll be surprised if the current subsidies for renewables can escape again without major adjustments to reduce their high effective cost per unit of energy produced and increase their long-term bang for the buck. 

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.

The Unlevel Playing Field for Energy

An editorial in last weekend's Wall St. Journal led me to a recent analysis by the US Energy Information Agency (EIA) summarizing the costs of the federal government's various "subsidies" for energy from different sources.  This is both useful and timely, since discussions of specific subsidies such as the expiring wind production tax credit inevitably lead to questions about how incentives for renewable energy compare to those for oil, gas, nuclear, and other more traditional sources.  As the Journal noted, the EIA stopped short of comparing these incentives on the basis of the relative productivity of different energy sources, but even without that it's still apparent that the category of new renewable electricity--excluding hydropower--received 21% of the federal energy benefits for 2010, while accounting for less than 3% of domestic energy production that year, when oil and gas, which provided 49% of US energy production, received less than 8% of these benefits.  Whether on an absolute or relative basis, renewables receive much more generous federal support than oil and gas.

Before digging further into the EIA's analysis, I should point out an important distinction between the federal expenses and incentives covered in the report and the externalities that are frequently conflated with them.  It is certainly true that many of these energy technologies involve significant impacts that aren't reflected in their market prices, and that the production and especially the consumption of fossil fuels create serious environmental and security externalities. However, to whatever extent federal subsidies address externalities they do so indirectly, at best, and in many cases inefficiently.  The focus of this posting, just like the EIA report's, is on the federal government's cash outlays and "tax expenditures"--deductions, credits, etc.--that have a direct bearing on the federal deficit and debt burden that are the subject of intense debate in this election cycle.

The tables in the report's executive summary reveal several key facts.  Between 2007 and 2010 federal energy subsidies in constant dollars more than doubled to $37.2 B, with most of the increase going to renewables and energy efficiency, except for a sizable bump in low-income energy assistance payments.   $14.8 B of the increase originated with the 2009 stimulus bill, none of which was directed at oil and gas, but which appropriated nearly $8 B to conservation and efficiency.  Overall, renewables received $14.7 B, split 55/45 between electricity and biofuels, while nuclear received $2.5 B and oil and gas $2.8 B.  The latter figure is lower than you'll see elsewhere, because among other incentives that the EIA chose to exclude from its analysis was the Section 199 deduction for manufacturers, which is budgeted at around $1 B/yr for oil and gas firms.  The logic behind that exclusion seems sound, because US manufacturers of biofuels, wind turbines, solar panels and other renewable energy equipment qualify for the same tax credit, and at a higher rate than oil companies.

I was also struck by the fact that oil and gas received just $70 million out of the more than $4 B spent on R&D. If there's one category in which federal expenditures on renewables should be expected to dwarf those for conventional energy, this is it, and they did so by a factor of more than 20 times.  (Coal R&D received more than $0.6 B, presumably for clean coal technologies.)

It's also the case that while the growth of renewable energy output from 2000-10 was dramatic, the relatively smaller net changes in oil and gas output in that period masked the substantial replacement of depleting resources that would have otherwise resulted in a large drop in output, especially for natural gas.  This is precisely the aspect of the mature oil and gas industry at which these federal incentives are aimed, to enable US projects to compete with the international opportunities to which many of these companies have access.

The authors of the report suggested caution in comparing the allocations of incentives to the energy produced by each technology, because some of these incentives were paid for projects still under construction and in some cases represented the front-loading of what would otherwise have been a 10-year stream of tax credits.  Fair enough.  Yet even with the conservative assumption that the entire $4.9 B of non-R&D subsidies for wind power in 2010 came in the form of cash grants in lieu of the 30% investment tax credit for new wind turbines that would produce for 20 years at a 30% capacity factor, that still equates to a subsidy of more than 16% of the average present wholesale value of all the electricity those turbines will produce, using prevailing industrial sector electricity prices as a proxy for wholesale prices.  By comparison, the $2.7 B of oil and gas tax incentives for 2010 represented just 1% of the wholesale value of US production of these fuels, before refining.

A serious debate about the appropriate level of US energy subsidies should begin with the facts, rather than with misperceptions. It should also focus first on the goals of such incentives, before jumping to the details of this tax credit vs. that one.  What do we want these measures to achieve?  If it's simply the promotion of energy production, then the current incentive system looks too heavily skewed in favor of renewables.  If it's jobs, then we should be realistic about how many can be added by such a capital-intensive sector.  If it's the promotion of both energy security and innovation, then at least parts of the current system look directionally right, though I'd argue that we'd benefit from spending more on renewable energy R&D and less on the deployment of mature-but-expensive technologies like wind.  However, if emissions and climate change are our primary concerns, then these incentives are not a terribly effective way to address them.  My own expectation is that regardless of whether the wind tax credit is extended for another year, most of the tax incentives that the EIA assessed here will eventually be swept away by tax reform focused on reducing corporate tax rates to improve US competitiveness, while eliminating loopholes to make the changes revenue-neutral.

New Budget Reflects Inefficient Energy Priorities

An editorial in today's New York Times praising the energy priorities included in the President's latest budget is little more than a rubber stamp of a set of policies in serious need of rethinking. The goals the Times espouses, of "reducing America’s dependence on foreign oil and giving American workers a fighting chance in the global competition for clean-energy jobs", are perfectly fine; however, what's entirely absent is any critical assessment of whether the expensive programs they chose to highlight will contribute meaningfully to accomplishing them.

Start with the reauthorization of Treasury cash grants for renewable energy projects. A quick review of the Treasury's own tracking spreadsheet shows that 77% of the $10.4 billion awarded since 2009 under this program went to projects employing wind turbines, a mostly mature technology, half the value of which goes to offshore manufacturers, based on the American Wind Energy Association's own assessment. If the goal is putting Americans to work producing wind power hardware, this is a grossly inefficient way to do it. Moreover, this temporary program was instituted to fill the gap created when the market for "tax equity"--private transactions that exchange current cash for future tax credits--dried up during the financial crisis. Tax equity investors have recently been returning to the market, but they can't readily compete with free money from the Treasury Department. In other words, at this late date the Treasury cash grants are a solution to a problem that their continuation would help perpetuate.

Then there's the matter of the wind production tax credit, which I looked at in some detail recently. While I agree that it's neither fair nor appropriate to drop the industry off a cliff by allowing this benefit to expire all at once, it is high time that the 20-year-old tax credit for wind power be reduced to account for the maturity of onshore wind technology, and then gradually phased out on a firm schedule. The Times makes no mention of any of this.

It's also important to understand that whatever the technologies covered by these two programs may contribute to reducing greenhouse gas emissions, they don't save a barrel of imported oil, because the US generates less than 1% of our electricity from oil, and much of that in island or other remote locations that can't easily get reliable electricity through other means. That makes it doubly ironic that the only "subsidies" the Times opposes are the current tax benefits for oil and gas companies, arguably the only program mentioned in their editorial that actually does help reduce US imports of foreign oil.

The President's 2013 budget, which has little chance of adoption as proposed, includes a number of other energy provisions. Some of them are very worthy, including increased support for energy R&D that is too risky or long-term for industry to undertake on its own. However, it also includes an extension of the loan guarantee program that gave us Solyndra--a program that should not be renewed without much stronger oversight than the DOE has provided to date, beyond just hiring a "chief risk officer". It also mentions "enhancements to the existing electric vehicle tax incentive", a $7,500 per vehicle credit that benefits mostly higher-income taxpayers and does little to reduce either emissions or oil imports. What I don't see in these proposals is any recognition that many of the programs they seek to extend or expand have either outlived their usefulness or fallen short of delivering the benefits on which they were originally justified, and that every dollar spent inefficiently in this manner adds to our $1.3 trillion deficit, the necessary narrowing of which keeps getting pushed ever further into the future. The administration's latest energy priorities would have us spending as though it were still 2006.

Energy Implications of a Federal Default

Much of the attention concerning a possible failure to increase the US debt ceiling by month-end has focused on the government's ability to borrow, and on how individuals might be affected, whether as recipients of social security, pay or pensions from various branches of the federal government, or as consumers seeking car loans or mortgages. I haven't seen a lot of discussion about the potential impact on energy, other than some speculation about higher oil prices. As I started to consider how different categories of energy might be affected, it occurred to me that a list, or a set of lists was the best way to tackle this. It's not intended to be comprehensive, and I would welcome your input on what I've overlooked.

The first category of energy impacts concerns companies or individuals who are awaiting a check or wire transfer from the government, for which funds might not be available in the absence of a prompt deal to extend the debt ceiling. These include:

• Projects that have qualified for Treasury renewable energy cash grants, but have not yet received the funds, or that hope to qualify shortly. Since this program started in 2009, the Treasury has disbursed $7.8 billion to project owners and developers.
  
• Companies that sell energy to the federal government and its various branches. This includes start-ups selling renewable aviation and diesel fuels to the Department of Defense, as well as firms selling the government the large quantities of electricity and conventional fuels it uses. (I will be attending a joint Army/Air Force energy forum tomorrow.
  
• Companies with contracts related to various energy efficiency programs initiated under the stimulus or previous legislation, including weatherization.
  
• Individuals who receive federal energy assistance.

The next category includes companies that aren't expecting cash, but are relying on loan guarantees from the federal government to help them secure more attractive financing--or in the case of some risky projects and technologies, any financing at all--either from commercial lenders or directly from the Federal Financing Bank.

• Beneficiaries of the Department of Energy's loan guarantee program that have not yet secured loans are a good example of this category. Note than many of the projects listed on the Loan Program Office's site have only obtained conditional approvals, indicating that their financing has not yet closed. They would be vulnerable either to a protracted default or one that undermined confidence in the government's "full faith and credit" to such an extent that a federal loan guarantee wouldn't aid in lining up lenders.

The next category covers the large number of entities that benefit from energy-related tax credits and deductions. Although they aren't directly vulnerable to a default, they are exposed to the risk that their particular tax benefits might be canceled or reduced as part of an agreement between the Congress and White House to extend the debt limit.

• Refiners and others blending ethanol into gasoline and collecting the Volumetric Ethanol Excise Tax Credit.
  
• Producers of biodiesel and cellulosic biofuels and small ethanol producers, all of which receive tax credits for producing renewable fuels.
  
• Oil and gas companies benefiting from the various tax credits and deductions that have been in the administration's cross-hairs since it took office.
  
• US manufacturers, including oil and gas companies, power generators, ethanol producers, and a wide array of non-energy recipients of the Sec. 199 deduction for manufacturing their products in the US.
  
• Purchasers of electric vehicles eligible for the tax credit of up to $7,500 per car for EVs and qualifying plug-in hybrids, or up to $4,000 for natural gas vehicles and other alternative fuels.
  
• Car manufacturers and dealers depending on these tax credits to help sell their vehicles.

Then there's the effect on the vast majority of us who aren't in line for an energy-related grant, loan guarantee, or tax credit, but could see the ripple effects of all of these concerns in our energy bills, along with the more basic question of how a default might affect the price of oil and other mainstream energy sources. That subject deserves a posting of its own, but my quick take on this is that while a default could certainly drive up oil prices by means of a weaker dollar, that could be offset by the reduced oil demand that would follow the slowing of the US and global economies in the aftermath of a default. Up, then down, perhaps? I will join you in hoping we don't have to find out the hard way.

The Energy Transition Is Already Underway

Lately I've been struck by the number of new groups and proposals calling for America to begin the transition to cleaner energy. We even heard this call from the Oval Office several weeks ago. Yet while there's clearly much more to be done to wean ourselves from our reliance on oil and other high-carbon fuels, I'm baffled by the suggestion that this process didn't actually begin long ago--not just in the last year and a half--with policies and R&D initiatives put in place by at least the previous two administrations. Perhaps it's fashionable to ignore our progress to date, because acknowledging it serves as a reminder that the process will require decades to complete, and that the end-point might not resemble the one we imagined when we began.

Let's start by recognizing that a massive energy transition is already well under way on many fronts, including the development of advanced biofuels, nearly-mature wind power, highly fuel-efficient vehicles, electric vehicles, solar power that's not just a science fair project, and a range of other technologies and policies for reducing oil consumption and greenhouse gas emissions. These didn't just appear spontaneously; most required literally decades of effort to get to this point. So if we're already headed down this path, rather than arguing about starting out should we rather be asking how much we can do now to accelerate this shift?

Take fuel economy, which seems simple, because we all understand miles per gallon, or think we do. But how many people realize that the incremental fuel savings from higher mpg shrink as mpg increases? The chart below shows the annual fuel consumption for a car driving 12,000 miles per year, about the national average, versus fuel economy in mpg. The improvement in Corporate Average Fuel Economy of new cars between 1978 and 2008, from about 20 mpg to 27 mpg, has already saved a very substantial 160 gal/yr per car, while the increase to 34 mpg by 2016, the new CAFE target, will save another 90 gal/yr. However, advancing from there to 44 mpg, roughly equivalent to the 2012 EU target of 130 grams of CO2 per kilometer, would save only an extra 80 gal/yr. That's no reason not to move ahead with more efficient cars, but we must recognize that we've already captured the steep part of a curve that is now flattening out, as the cost/benefit of each successively-harder increment diminishes, unless they burn no oil at all. That's where biofuels and EVs come in.
The Renewable Fuels Standard established by Congress in 2007 calls for a quantity of advanced and cellulosic biofuels by 2022 that exceeds what we currently get from corn ethanol. The problem is that at this point, after many years of hard work developing these technologies, there is not a single commercial-scale cellulosic biofuel facility design that has been built, tested and certified for profitable replication on the scale required, despite a special production tax credit of $1.01/gal. Nor do I conclude that's for lack of the government, private investors and big companies like ExxonMobil, Chevron, Shell, and BP throwing plenty of R&D dollars at the challenge. Within a few years we might be at the point at which billions of extra dollars for advanced biofuels would result in hundreds of such facilities actually being built, but then plenty of experts thought we would already be at that point by now, including the EPA, which had to ratchet back its cellulosic ethanol quota for this year from a level equal to the annual output of one corn ethanol plant to the quantity that a corn ethanol plant produces every three weeks or so.

The prospect for EVs looks more immediate--though still on a relatively small scale--with GM and Nissan launching flagship models later this year. However, as I noted in a recent webinar, every million EVs running entirely on electricity would save 31,000 barrels per day of gasoline, or about 0.3% of our current usage, and that's assuming they would replace cars getting today's average mpg, rather than Prius-type non-plug-in hybrids, as seems likelier to me. It's going to take a whale of a lot of EVs to make a real difference, and it's not yet obvious that offering more than the current $7,500 in consumer tax credits to buy them, or handing out more than the billions that have already been given to car companies--including some that have never built a mass-produced car--is going to put a lot more of these vehicles on the road in the next few years than would happen under existing policies that are still playing out.

However attractive energy visions such as the President's might be, even to me, there are practical limits to additional activism at a point when so many wheels have already been set in motion. I do understand that the nation is riveted by the oil spill, and that transforming this interest into support for a broader energy agenda could be a once-in-a-generation opportunity. At the same time, I worry about an approach that relies on expanding already-unsustainable financial incentives for clean energy deployment at a time when the deficit has taken on the aspect of a black hole threatening to devour our future, energy and otherwise. To see the energy transition really take off, we must reach the point at which the alternatives are unambiguously better/faster/cheaper than oil, or can at least match its cost and convenience in its primary transportation energy uses, and are not merely better for the environment--as important as that is. We're not there yet, but we've clearly already begun the journey.

Energy Outlook will be on holiday the rest of this week and through the July 4th weekend.

Deficits and Energy

After reading several articles about the administration's proposed 2011 fiscal-year budget, I decided to look through the figures myself. My primary interest was in finding indications of what might lie in store for energy-related taxes and incentives. However, once I noticed how the projected deficits accumulate and examined the assumptions behind them, it struck me that the larger concern for energy and everything else is whether this budget represents a reasonable and sustainable picture of our future national finances. The expected 10-year deficit for the 2009-2018 period appears to have grown by $1.5 trillion relative to last year's budget. And that's after counting roughly $2 T in newly-proposed spending reductions and tax increases, including higher taxes on the energy industry. Against that backdrop the extra few billion dollars for renewables and other favored energy technologies nearly get lost in the rounding.

As a veteran strategic planner, I started by examining the economic assumptions for the budget. While everyone hopes for a strong rebound that would boost tax revenues by moving millions of the un- and under-employed back onto the tax rolls, it seems overly optimistic to assume that on top of an expected 2.7% growth rate in real GDP for this year, real GDP growth would then average 4% per year from 2011-2015 (calendar years.) The last time we had a five-year growth spurt like that was in the late 1990s--thanks to the Tech Bubble--and prior to that in the late 1980s. Yet despite such strong projected growth and the addition of roughly $2 T in "savings" and new taxes, the Treasury would still need to borrow an additional $14 T over the next decade. Even less realistically, perhaps, given such robust growth and massive borrowing, the budget also assumes that consumer-price inflation will not rise above 2.1% for the next decade, while nominal interest rates go up only gradually, never averaging more than 5.3% for 10-year Treasuries.

All this suggests that the current budget might be merely a placeholder awaiting the recommendations of the proposed deficit-reduction commission, while generating a set of figures that just manages to keep the total federal debt level--Table S.14, not the same as the "debt held by the public" shown in summary table S-1--below around 106% of GDP. Of course, this hinges on achieving those higher tax revenues, some from growth and some from higher taxes, including the termination of the Bush tax cuts for "upper-income" Americans. Even if the Congress passed all the required tax legislation, which is not inconceivable since for the biggest portion they'd be voting for a tax cut for everyone except "upper-income" taxpayers, the chances of things turning out even this well seem low. If growth doesn't reach the projected levels and stay there for years, tax revenues will fall short, deficits will grow, and at some point interest rates will rise, requiring even bigger deficits to cover the cost of debt service that under this budget exceeds $800 billion a year by 2020.

Then there are the tax increases, starting with energy. The big difference vs. last year is the absence of $646 billion from cap & trade. Even if cap & trade is eventually enacted, it now seems likely that most of its proceeds would be rebated to taxpayers or spent on new energy programs, so it doesn't look like a way to close the budget gap. The proposed budget has roughly $3.6 billion per year in increased revenue from eliminating what the oil industry regards as appropriate tax benefits and the administration calls tax loopholes. Either way the budget would increase the cost of producing oil and gas in the US by around $0.60 per barrel of oil equivalent (BOE) after tax. While that won't break the industry, it also won't make US exploration and production any more attractive or competitive. In case you're wondering why we should care about that in light of our new emphasis on green energy, it turns out that the entire energy contribution of the record 10,000 MW of wind turbines installed in the US last year equates to about 100,000 BOE per day, the equivalent of one good-sized Gulf of Mexico oil platform or roughly 0.2% of our total energy consumption. We need more renewables and more conventional energy.

The budget also includes roughly three-quarters of a billion over 10 years in new fees on "non-producing oil and gas leases." Grounded in the mistaken notion of "idle leases," this was ill-advised last year and remains so, not just because oil companies don't bid on leases to take them off the market and keep them idle--they already pay rentals on any leases that aren't producing, which revert to the government after 10 years--but because adding these fees will merely reduce the up-front bonuses companies would be willing to bid to get them in the first place. As a result, the net revenue from this item ought to be zero.

Of course in terms of total revenue all of this pales in comparison to what the administration expects to collect from upper-income Americans, who seem unlikely to get any more sympathy than the oil companies. (Ironically this segment probably includes the bulk of the potential early buyers for the advanced technology vehicles that the government is lending or granting carmakers billions to produce.) The budget includes about $700 billion of additional revenue over 10 years from reversion to the pre-2001 tax rates for this group, along with some less obvious increases involving phaseouts of itemized deductions and exemptions and the treatment of deductions for those in the new 39.6% federal bracket as though they were incurred in the 28% tax bracket. Together these features would impose effective marginal tax rates much higher than that notional 40% on the folks at the bottom of the new bracket, creating a heck of a disincentive on earning a little more once you're near that threshold. But aside from making additional work or investment unrewarding for those unlucky enough to qualify narrowly for this bracket, this approach increases our collective reliance on this group to fund our government. These folks were already paying 86.3% of the federal income tax before these increases, and that share would go up under this budget. I wouldn't call that either reform or a sound basis for responsible democracy.

What we're left with, then, is a federal budget that even under a rosy set of assumptions expands the cumulative deficit and total US indebtedness into a range that greatly multiplies the large-scale uncertainties we face, while making minimal cuts to spending and increasing taxes only on unpopular corporations and upper-income Americans. Unfortunately, this scenario doesn't look conducive to generating the enormous private investments in new energy technology and infrastructure that will be necessary and that the government can't afford to make, particularly as mounting debt constrains its freedom of action. We seem to be stuck in a zone in which the only real solutions are unpopular, while most of the ideas that are popular wouldn't be real solutions.

Oil Prices and the Recovery

As oil prices continue their upward trend, I'm noticing more articles and getting more comments from readers questioning whether $80-plus oil could squelch the nascent economic recovery--or for those who believe the recession isn't over, deepen it again. It's not an unreasonable question, particularly when we compare current retail fuel prices to their level of a year ago: the "gasoline stimulus" that I was tracking for much of last year. A quick glance at the chart below reveals that instead of paying a dollar or more per gallon less than twelve months earlier, as we were for much of 2009, the average US retail price for unleaded regular is now roughly a buck higher than it was the same time last year. That can't be favorable news for consumers or for businesses depending on a resurgence in consumer demand for other goods and services. But is it enough to stall economic growth?


Although I still check oil prices on a regular basis--at least every couple of days, instead of every few minutes when I was trading the stuff--sometimes I notice price trends the same way most of my readers do: by driving by neighborhood gas stations and watching the most visible price in America change day to day. The recent steady, counter-seasonal rise against the backdrop of generally slack demand and comfortably high inventories, and in the absence of any significant global supply disruptions has had me a bit perplexed. And it's really all down to oil prices, since refining margins remain fairly weak and are only as strong as they are as a result of several refineries being shut down entirely and most others running at historically low rates of throughput.

Nor does this seem to be an instance of what I've called the oil-dollar price loop. Since December 11, 2009 crude prices are up by 18%, despite the US dollar strengthening by 3% against the Euro and 5% against the Japanese Yen over the same interval, amid a general surge of commodity prices.

Most analysts seem to attribute higher oil and commodity prices to higher demand from countries like China, as the global economy responds to the impact of various stimulus packages and the stabilization of the banking system. China's growth has been particularly impressive, but even if this is boosting its demand for oil imports by 25%, as one source suggested, that hardly seems likely to swamp the substantial spare capacity that OPEC has accumulated in the last year and a half. As I noted last week, OPEC has successfully held over 3 million barrels per day off the market and maintained global oil prices at a level that wouldn't be possible based only on renewed economic growth in China and its anticipation by the market elsewhere. OPEC has attracted remarkably little flak for this policy, which a year ago probably prevented oil prices from going into free fall. That would have harmed all producers, and eventually consumers, too, by drying up future supplies.

So what's the financial impact of OPEC's self-restraint on US consumers and our economy? Even if you ignore the year-earlier comparison, current retail gas prices are around 30 cents per gallon above their average for last year. For a household driving 25,000 miles per year in typical cars, that's worth at least $25 per month. Across the entire 138 billion gallon-per-year gasoline market, that aggregates to around $40 billion/year. Applying the underlying $13/bbl oil price rise since mid-December to our net oil imports of roughly 10 million bbl/day, that figure increases to just under $50 billion/year.

As unwelcome as this additional drag on the recovery might be, at current levels it seems unlikely to further derail our $14 trillion economy, even if it contributes several billion dollars a month to our trade deficit and, along with high unemployment, depresses consumer confidence. However, near-$3 gas is one thing; widespread expectations of a return to $4 per gallon would be quite another. While higher oil prices mainly due to OPEC restraint aren't yet a cause for panic, this trend certainly bears watching.

Deficits, Dollars, and the Price of Energy

The latest revision to the forecasted federal deficit has implications beyond the sustainability of current government spending. Reading a pair of high-profile, skeptical assessments of Peak Oil in the context of a $9 trillion deficit projection for the next decade, it occurred to me that the most serious risk of higher oil prices in the near future might not be flagging production or surging demand but the further depreciation of the US dollar. The quickest route back to $4 gasoline could run through Washington, DC, rather than Riyadh or Beijing, and that might not be as helpful for renewable energy as its advocates might guess.

The main worry I've heard expressed about the size of the federal deficit has focused on the risk of inflation. However, high deficits carry another risk that could have a much more direct effect on energy prices, which in turn could help re-ignite inflation. The problem is acute because it goes well beyond the one-time impact of federal stimulus efforts, which have apparently ballooned this year's deficit to $1.6 trillion. Fundamentally, there is a persistent and growing gap between government revenue and expenses, exacerbated by high unemployment and lower income--and thus lower tax collection--particularly from the top quintile of earners who have consistently been paying 86% of the federal income tax. Unless that gap can be brought back into line with recent history, the government will soon face a difficult choice. Financing a steady stream of trillion-dollar annual deficits will require either interest rates high enough to attract investment from all over the world--and thus high enough to stifle a nascent recovery--or the monetization of the debt by means of the Federal Reserve printing even more money than recently. The latter course, which seems likely to be more politically palatable, despite Dr. Bernanke's reappointment, would inevitably weaken the dollar and lead in fairly short order to higher energy prices.

We got a taste of this effect in 2007, when oil prices and the dollar moved in opposite directions in an oil-dollar price loop that looked more than merely coincidental. A weaker dollar encourages producers to raise prices, or to consider pricing their output in a stronger, more stable currency. Meanwhile, non-US consumers experience stable or falling energy prices that encourage demand growth, which eventually leads to higher prices in all currencies. Either way, US consumers would see higher prices for petroleum products, though it's not clear how much further demand could fall in the near term, with US oil consumption already running 10% below 2007's, on a comparable year-to-date basis.

The dollar has already weakened by about 10% against the Euro and 5% vs. the Japanese Yen since March, as the resolution of the financial crisis and early signs of a global recovery have eased the fears that prompted a classic flight to dollar safety. This shift merely returns the exchange rate to roughly its level of pre-crisis 2008. Oil prices have risen by around 40% over the same interval, though how much of that is due to a weaker dollar is far from clear. However, from today's $70/bbl level, another 25% drop in the value of the dollar could return us to the threshold of $100 oil.

Higher oil prices due to a weaker dollar would not necessarily be beneficial for biofuels and other alternatives to oil, either. If we learned anything from the oil price spike of 2006-'08, it was that higher oil prices don't automatically make alternative energy more competitive. If only oil prices were moving, it might be helpful, but the only way to achieve that is through taxation, not inflation or currency depreciation. Just as oil functions in a global market, so too the components of the main alternative energy technologies have become global, with wind turbines and solar panels sourced globally and in high demand in many regions. So too for the steel and other basic materials for constructing such installations, as well as the grains and oilseeds turned into ethanol and biodiesel. A weaker dollar wouldn't just mean higher oil prices, but higher prices at least for all of the new energy sources to which we are turning in our effort to address climate change and bolster our energy security.

At an average price for 2008 of $93/bbl, oil made up just 15% of the value of the goods and services we imported last year, and a weaker dollar would see the prices of a host of other things--cars, electronics, call-center assistance, for example--go up, as well, fueling inflation and further depressing our standard of living. That scenario is hardly inevitable. A sea change on the part of the American public could convince the Congress and administration that we are finally prepared to pay for the government we have been demanding, or to see government services fall to a level commensurate with the level of taxation we appear willing to bear. Or the Fed could start raising interest rates to defend the dollar, in spite of the consequences for economic growth and unemployment. I'm pretty sure which choice I'd vote for.