Five Myths About the "Carbon Asset Bubble"

• The idea that efforts to mitigate climate change expose fossil fuel assets to the risk of a bubble-like collapse has attracted some high-profile supporters.
• However, the notion of a "carbon bubble" depends on questionable assumptions concerning our current knowledge of climate change, the rate of adoption of renewable energy technology, and how such assets are valued.

In their recent Wall St. Journal op-ed, Al Gore and one of his business partners characterized the current market for investments in oil, gas and coal as an asset bubble. They also offered investors some advice for quantifying and managing the risks associated with such a bubble. This is a timely topic, because I have been seeing references to this concept with increasing frequency in venues such as the Financial Times, as well as in the growing literature around sustainability investing.

Although bubbles are best seen in retrospect, investors should always be alert to the potential, particularly after our experience just a few years ago. In this case, however, I see good reasons to believe that the case for a “carbon asset bubble” has been overstated and applied too broadly. The following five myths represent particular vulnerabilities for this notion:

1. The Quantity of Carbon That Can Be Burned Is Known Precisely
Mr. Gore is careful to differentiate uncertainties from risks, which he distinguishes for their amenability to quantification. For quantifying the climate risk to carbon-heavy assets, he refers to the widely cited 2°C threshold for irreversible damage from climate change, and to the resulting “carbon budget” determined by the International Energy Agency (IEA). As Mr. Gore interprets it, “at least two-thirds of fossil fuel reserves will not be monetized if we are to stay below 2° of warming.” That would have serious consequences for investors in oil, gas and coal.

The IEA’s calculation of a carbon budget depends on a factor called “climate sensitivity.” This figure estimates the total temperature change resulting from a doubling of atmospheric CO2 concentrations. The discussion of climate sensitivity in the recently released Fifth Assessment Review of the Intergovernmental Panel on Climate Change (IPCC) sheds more light on this parameter, which turns out not to be known with certainty. Their Summary for Policymakers includes an expanded range of climate sensitivity estimates, compared to the IPCC’s 2007 assessment, of 1.5°-4.5°C with a likelihood defined as 66-100% probability. It also states, “No best estimate for equilibrium climate sensitivity can now be given because of a lack of agreement on values across assessed lines of evidence and studies.”

The draft technical report that forms the basis for the Summary for Policy Makers provides more detail on this. It further assesses a probability of 1% or less that the climate sensitivity could be less than 1°C. That shouldn’t be surprising, since temperatures have already apparently risen by 0.8°C above pre-industrial levels. At the same time, the report indicates that recent observations of the climate — as distinct from the output of complex climate models — are consistent with “the lower part of the likely range.”

In other words, while continued increases in atmospheric CO2 resulting from increasing emissions are widely expected to result in warmer temperatures in the future, the extent of the warming from a given increase in CO2 can’t be determined precisely before the fact. For now, at least, the CO2 level necessary to reach a 2°C increase would be consistent with calculated carbon budgets both larger and smaller than the IEA’s estimate. That means that the basis of Mr. Gore’s suggested “material-risk factor” — as distinct from an uncertainty — is itself uncertain.

2. The Transition to Low-Carbon Energy Is Occurring Fast Enough to Threaten Today’s Investments in Fossil Fuels
There is no doubt that renewable energy sources such as wind and solar power are growing at impressive rates. From 2010 though 2012 global solar installations grew by an average of 58% per year, while wind installations increased by 20% per year. Yet it’s also true that they make up a small fraction of today’s energy production, and that the risks for investors of extrapolating high growth rates indefinitely proved to be very significant in the past.

For further clarity on this, consider the IEA’s latest World Energy Outlook, the agency’s analysis of global energy trends, which was just released on November 12. The IEA projects global energy consumption to grow by 33% from 2011 to 2035 in its primary scenario, which reflects expanded environmental policies and incentives over those now in place. In that scenario, the global market share of fossil fuels is expected to fall from 82% to 76%, but with total fossil fuel consumption still growing by 24% over the period. Only in their “450″ scenario, based on similar assumptions to its carbon budget, would fossil fuel consumption fall by 2035, and then only by 11%.

Moreover, in its April 2013 report on “Tracking Clean Energy Progress,” the IEA warned, “The drive to clean up the world’s energy system has stalled.” This concern was based on their observation that from 1990 to 2010 the average carbon dioxide emitted to provide a given unit of energy in the global economy had “barely moved.” That’s hardly a finding to be celebrated, but it serves as an important reminder that while some renewable energy sources are growing rapidly, fossil fuel consumption is also growing, especially in the developing world — and from a much larger base.

The transition to lower-carbon energy sources is inevitable. However, it will take longer than many suppose, and it cannot be accomplished effectively with the technologies available today. That’s a view shared by observers with better environmental credentials than mine.

3. All Fossil Fuels Are Equally Vulnerable to a Bubble
As Mr. Gore correctly notes, “Not all carbon-intensive assets are created equal.” Unfortunately, that’s a distinction that some other supporters of the carbon asset bubble meme don’t seem to make, particularly with regard to oil and natural gas. The vulnerability of an investment in fossil fuel reserves or hardware to competition from renewable energy and decarbonization doesn’t just depend on the carbon intensity of the fuel type — its emissions per equivalent barrel or BTU — but also on its functions and unique attributes.

The best example of this might be a recent transaction involving the sale of a leading coal company’s mines. What’s behind this wasn’t just new EPA regulations making it much harder to build new coal-fired power plants in the US, but some fundamental, structural challenges facing coal. Power generation now accounts for 93% of US coal consumption, as non-power commercial and industrial demand has declined. This leaves coal producers increasingly reliant on a utility market that has many other--and cleaner--options for generating electricity. That’s particularly true as the production of natural gas, with lower lifecycle greenhouse gas emissions per Megawatt-hour of generation, ramps up, both domestically and globally. Coal accounts for about half of the global fossil fuel reserves that Mr. Gore and others presume to be caught up in an asset bubble.

Compare that to oil, which at 29% of global fossil fuel reserves, adjusted for energy content, still has no full-scale, mass-market alternative in its primary market of transportation energy. Despite a decade-long expansion, biofuels account for just over 3% of US liquid fuels consumption, on an energy-equivalent basis. They’re also encountering significant logistical challenges and concerns about the degree to which their production competes with food. This has contributed to efforts in the EU to limit the share of crop-based biofuels to around 6% of transportation energy. Biofuels have additional potential to displace petroleum use, particularly as technologies for converting cellulosic biomass become commercial, but barring a prompt technology breakthrough they appear incapable of substituting for more than a fraction of global oil demand in the next two decades.

Electric vehicles offer more oil-substitution potential in the long run, though they are growing from an even smaller base than wind and solar energy. Their growth will also impose new burdens on the power grid and expand the challenge of displacing the highest-emitting electricity generation with low-carbon sources.

Meanwhile, natural gas, at 20% of global fossil fuel reserves, offers the largest-scale, economic-without-subsidies substitute for either coal or oil. In any case, it has the lowest priority for substitution by renewables on an emissions basis, and so should be least susceptible to a notional carbon bubble.

4. A Large Change in Future Fossil Fuel Demand Would Have a Large Impact on Share Prices
Although Mr. Gore’s article includes a good deal of investor-savvy terminology, it is entirely lacking in two of the most important factors in the valuation of any company engaged in discovering and producing hydrocarbons: discounted cash flow (DCF) and production decline rates. Unlike tech companies such as Facebook or even Tesla, the primary investor value proposition for which depends on rapid growth and far-future profitability, most oil and gas companies are typically valued based on risked DCF models in which near-term production and profits count much more than distant ones.

At a conservative discount rate of 5%, the unrisked cash flow from ten years hence counts only 61% as much as next year’s, while cash flow 20 years hence counts only 38% as much. Announced changes in near-term cash flow due to unexpected fluctuations in production or margins would normally be expected to have a much bigger impact on share prices than an uncertain change in demand a decade or more in the future.

This is compounded by the decline curves typical of many large hydrocarbon projects. If the first 3-5 years of a project account for more than half its undiscounted cash flows, it won’t be very sensitive to long-term uncertainties, nor would a company made up of the aggregation of many projects with this characteristic. This is even truer of shale gas and tight oil projects, which yield faster returns and decline more rapidly.

I can’t speak for Wall Street's oil and gas analysts, but I’d be surprised based on past experience in the industry if the risk of a 10% or greater drop in global demand for oil or gas in the 2030s would have much of an effect on their price targets for companies — certainly not enough to qualify as a bubble.

5. Fossil Fuel Share Prices Don’t Already Account for Climate Risks
The assertion of a carbon bubble in fossil fuel assets ultimately depends on investor ignorance of climate-response risks, presumably because companies haven’t quantified those risks for them. To the extent the latter condition is true, it represents an opportunity for companies seeking to capitalize on the boom in sustainability-based investing.

However, you needn’t be an adherent of the Efficient Markets Hypothesis for which Eugene Fama was named as a recipient of this year’s Nobel Prize in Economics to realize that thanks to the Internet, average investors have access to most of the same information on this subject as Mr. Gore and his partners. Institutional investors, who make up the bulk of the shareholding for at least the larger energy firms, and the analysts who follow these companies have the resources to access even more information.

Nor is the idea of a carbon bubble exactly new. Mr. Gore didn't create it, and I’ve been following it for a couple of years, as it took over from waning interest in Peak Oil. It’s not an obscure risk, either, in the sense that sub-prime mortgages and credit default swaps were in the lead-up to the failure of Lehman Brothers in 2008. It’s becoming more mainstream every day, although the burden of proof that this risk is mispriced rests with those advocating this view.

Before concluding, a word of disclosure is in order. As you may gather from my bio, I spent many years working with and around fossil fuels, though my ongoing involvement in energy is much broader than that. As a result of that experience, my portfolio includes investments in companies with significant fossil fuel holdings. I strive for objectivity, but I can’t claim to be disinterested. However, neither can Mr. Gore. As a major investor in renewable energy and other technologies through the firm cited in the article and other roles, he has as much at stake in promoting the idea of a carbon bubble — and on a very different scale — as I might have in dispelling it.

The carbon bubble is an interesting hypothesis, even if I don’t yet find the arguments made in support of it convincing. Despite that, I see nothing wrong with investors wanting to track their carbon exposure, consider shadow carbon prices, or ensure they are properly diversified. However, the biggest risk I see that might eventually warrant considering divestment of fossil-fuel-related assets isn’t based on the merits of this analysis, but on the possibility of creating a self-fulfilling prophesy by means of drumming up social pressure on institutional investors. You might very well think that applies to this Wall St. Journal op-ed. I couldn’t possibly comment.

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

Global Shale Oil and Gas Estimates Expand

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

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

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

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

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

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

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

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

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

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

Will California Be the Next Big Shale Oil Play?

I've spent the last couple of weeks contemplating California's Monterey shale, which has been widely discussed recently as the country's next Bakken-style oil play, or even bigger.   The Bakken shale has turned North Dakota into the second-biggest oil-producing state in the US, at the same time that development of the Eagle Ford shale has been shoring up Texas's claim to the number one spot.  So far, The Golden State has largely missed out on the shale revolution, despite having shale oil resources estimated to exceed the rest of the US combined. The scale of the opportunity makes it an intriguing subject, but I find it particularly interesting, because the Monterey is deeply intertwined with the long history of the California oil industry, in which I spent the first half of my career. 

The Monterey shale is hardly a new prospect.  One of the first documents my search turned up was a 1905 USGS report on its fossil content, noting its oil potential.  First production from this shale apparently occurred a decade earlier.  Moreover, it appears that the Monterey formation, which underlies many of the state's conventional oil fields, is actually the "source rock" for those fields: the zone from which the hydrocarbons trapped in their reservoirs originated.  So the estimated 400 billion barrels or so of original oil in place in the Monterey have presumably already yielded a substantial share of the roughly 29 billion barrels of oil that California's oil fields have produced to date.

Development of this play doesn't just lag shale projects elsewhere because of California's well-known environmental sensitivity.  The geology of this deposit also differs significantly from that of the Bakken and other east-of-Rockies shale plays, partly due to its relative youth, as well as the effects of the Golden State's seismic activity.  Its oil-bearing strata are thick and often jumbled up by past earthquakes. One expert characterized this as signifying that the Monterey wasn't a "resource play" but a "structural play."  So unlike the Bakken or Eagle Ford, individual wells carry higher risks of failing to yield commercially useful output.  It also makes it less likely that steady efforts in the Monterey will result in an easily replicable recipe for unlocking the entire deposit. 

That brings us to fracking, which is surely as controversial in California as anywhere, even though, as in many other locations, it's been done safely and with little fanfare for decades.  The state recently announced preliminary fracking regulations, but this may have less impact on development of the Monterey shale than one might suppose.  That's because this formation seems to be less amenable to fracking, or at least to the combination of horizontal wells and multi-stage fracking that's been a game-changer elsewhere. Other techniques, such as acid injection, may prove more useful.

However it is eventually unlocked, the Monterey shale offers significant benefits to California.  Start with the fact that the state's oil production has been in steady decline since the mid-1980s. Together with the depletion of Alaska's North Slope field, that has meant that the US West Coast, which was once a net exporter of oil, now imports increasing quantities of oil--half of it from OPEC--to meet local demand.  That trend has continued even as the import dependence of the rest of the country has fallen substantially due to higher production and receding demand.  The Monterey could slash California's imports, while adding billions of dollars a year to the local economy and to the shaky state budget, along with lots of good jobs.

It could even provide environmental benefits. Restoring oil self-sufficiency would reduce the risk of spills from the tankers bringing in imports, while refilling existing infrastructure.  And if the Monterey yields oil similar in quality to the light, sweet crude now being produced from the Bakken and Eagle Ford shales, it could actually cut both greenhouse gas emissions and local pollution by reducing the refining intensity required to turn the state's current diet of heavier crudes into ultra-low sulfur gasoline and diesel fuel. 

I suspect from my research in the last few weeks that anyone betting on an imminent explosion of oil output from the Monterey shale is likely to be disappointed.  The process seems likely to be slower than elsewhere, though with a bigger potential payoff.  But that doesn't make it irrelevant to a state that has set its sights on being at the forefront of the transformation to cleaner energy sources.  California still consumes 1.8 million barrels per day of petroleum products, and it will burn many more billions of barrels on its way to its chosen future of electric vehicles running on wind and solar power, and trucks and buses burning compressed or liquefied natural gas. Developing the Monterey shale won't solve all of California's energy challenges and might create a few new ones, yet it could prove another timely contribution from a local oil industry that has been a major driver of the state's economy for well over a century. 

Are Oil and Gas Renewable?

A long-time reader of this blog sent me a link to a New York Times article highlighting the diverse scientific pursuits of Jesse Ausubel of Rockefeller University, among which is the exploration of the "deep carbon cycle". Although much is known about the behavior of carbon in the first seven miles or so of the earth's crust into which we routinely mine and drill for resources, relatively little is known about the flows of carbon-based compounds in the other 99.6% of earth's total volume. Increasing our knowledge in this area could have momentous implications for our long-term energy supplies, while expanding our understanding of the processes affecting climate change. It's also just plain fascinating.

Mr. Ausubel was already well-known in energy circles for his assessment of the progressive decarbonization of our energy consumption since the start of the industrial revolution and continuing into the future. Some colleagues at Texaco introduced me to his work on that subject in the mid-1990s. However, until I read the Times article I was unaware of his involvement with the Deep Carbon Observatory, an international project of the Carnegie Institution to investigate the organic and inorganic carbon cycles deep in the earth. Although this involves such esoteric questions as the disposition of the carbon content of the "planetesimals" that accreted to form the earth billions of years ago, it also has much more practical aspects, such as the origins of oil and gas. That includes both the fuels we consume and the methane and other hydrocarbons released into the environment without human intervention.

Most experts in the oil and gas industry accept the traditional Western view of these substances as fossil fuels, the remains of ancient forests and dinosaurs that have been processed into their present form by exposure to high pressures and temperatures over the course of millions of years. Although most hydrocarbons weren't formed in the reservoirs where they are found today, it's generally assumed that they were generated from organic material in sedimentary rock elsewhere and migrated until they reached the various geological structures that trapped and stored them for subsequent discovery and exploitation. The shale gas that has been the subject of so much activity and debate in the last few years is a special case, for which the source and trap are one in the same: organic-rich rock with such low porosity that the gas can't escape without assistance.

However, there's another, more controversial theory of the origins of at least some oil and gas, suggesting that they were formed by chemical or biological activity much deeper in the earth, and then migrated long distances before being trapped. If correct, that would mean that not only aren't these fuels truly fossils--and thus essentially static and finite--but that they might actually be continuously regenerated by natural processes in much shorter time spans. A number of academics appear to hold this view, and it was a common theory of petroleum origin among Soviet scientists. Much of this is explored in a lengthy white paper on the Deep Carbon Observatory site, including the shortcomings of current analytical techniques in determining definitively whether a given sample of methane originated from organic material in sedimentary rock or from some other source.

Finding gas or oil in deposits much deeper than those we already know about, or in places that aren't consistent with our present understanding of petroleum geology, would represent an even bigger potential energy revolution than the one begun by the recent development of the means of unlocking shale gas resources. It would also shift our perspective on the nature and required speed of the energy transition on which we've embarked. If oil and gas weren't finite--at least in human terms--it might alter the urgency of deploying some of the alternative energy technologies now in our repertoire. At the same time, it would have enormous implications for climate change, by greatly increasing the ultimate quantity of carbon we could eventually emit to the atmosphere.

From my reading of the material on the Deep Carbon Observatory site, it would be extraordinarily premature either to celebrate or panic--depending on one's perspective--over this prospect. The possibility of extracting useful quantities of hydrocarbons from unknown reservoirs in the deep earth remains speculative and might never come to pass. As a presenter from Shell put it in a slide deck from a conference on the subject, "Shell is not interested in drilling exploration wells into Earth's mantle in search of petroleum fluids." But despite understandable skepticism about the underlying theory of deep carbon and the failure of previous efforts to prove it, I don't see how it can be disproved without a much more detailed picture of the earth's interior than we are likely to possess for a long time.

The likelier near-term outcomes of the work of the DCO's multi-disciplinary researchers from industry, government and academia are both more benign and far less polarizing than the cornucopia of hydrocarbons it might someday uncover. Better techniques and instruments for analyzing the carbon and hydrogen isotopes in methane and other hydrocarbons could have wider application in many fields, including pharmaceuticals, while a better understanding of the physics and chemistry of the deep carbon cycle could lead to lower-cost and more widely acceptable means of sequestering the CO2 emissions from our use of "fossil fuels", regardless of their origin. I look forward to hearing about the progress of these efforts.

What Does Tiber Tell Us?

Like many bloggers this week, I've been thinking about the implications of BP's big, new oil find in the Gulf of Mexico. Some analysts suggest that the Tiber field might contain as much as 3-4 billion barrels of oil, though much of it might never be recovered. The Wall St. Journal's Environmental Capital blog suggests that such discoveries serve as a kind of Rorschach test, with the various interpretations of it telling us more about the observer than the thing being observed. Fair enough. Without venturing into grandiose conclusions about whether the Tiber-1 deep water well refutes--or in some convoluted fashion confirms--the central hypothesis of the Peak Oil theory, this discovery provides a handy opportunity to remind my readers of a few principles and themes about oil exploration and production that I've been discussing here for the last six years:

1. There's still life in the old dog. While the US has been drilled like a pincushion for 150 years, we have still not found every barrel of oil that nature provided us. Don't be misled by proved reserves data that seem to show that we have less than 12 years of oil left at current production rates. In point of fact, the US has produced a cumulative 200 billion barrels of oil from reserves that never exceeded 40 billion barrels. Not only do we continue to find new resources in the manner of Tiber-1, but we continually learn how to extract more oil from the reservoirs we've already found, revising their reserves steadily upward over time.
2. A discovery like Tiber doesn't mean we've merely added two weeks worth of production to reserves. US oil production, like global production, is comprised of the contributions from thousands of oil fields and hundreds of thousands of oil wells, with the most productive 20% or so accounting for roughly 87% of output. If initial guesses of recoverable oil are right, then the Tiber field could yield on the order of 100,000 bbl/day of oil for 20 years--2% of US production for a generation. If we turn up our noses at that, then we surely ought to think twice about wind power. In 2008 all the wind turbines in the US generated 52 billion kilowatt-hours, backing out natural gas power generation equivalent to just 245,000 bbl/day of oil, or 5% of US oil output.
3. We've heard a lot from skeptics about how inconsequential the oil in areas that have been off limits to drilling would be, whether we're talking about offshore California, the eastern Gulf of Mexico, or the Arctic National Wildlife Refuge. Yet without actually exploring these areas using the kind of technology that found the Lower Tertiary trend of which Tiber appears to be a part, in a place that just a few years ago would have seemed both inaccessible and highly improbable, we can't know what's really there, waiting to be discovered. In that light, the official estimate of 18 billion barrels of "undiscovered, technically recoverable" oil in these areas must be regarded as an extremely conservative lower bound, based on totally obsolete 1970s technology.
4. Although finding more oil may look problematic from a greenhouse gas perspective, oil is not our worst fuel, and it remains the hardest to displace, because of its unique combination of energy density and portability. I share the vision of many for a future made up of electrified cars and low- or no-emission power plants, but we're going to burn many billions of barrels of oil getting there. For reasons including national security, national pride, and our balance of trade, it matters whose oil it will be, as we make the long transition to a more sustainable energy economy. If we ignore that principle, we're likely to end up even more reliant on unstable foreign suppliers, before we arrive at the elusive promised land of energy independence.

"Over a Barrel" - Part I

I finally caught up with last Friday's broadcast of an ABC News special entitled, "Over a Barrel: The Truth About Oil." The subtitle gives a strong hint at the tone of the piece, though Charles Gibson and his crew did a reasonable job of lining up some talking heads who could offer a balanced perspective, along with the more predictable exponents of suspicion and conspiracy. My former employer, Chevron, also provided access to several facilities and got some good exposure in the process. Rather than dissecting the entire program and its arguments, I thought it might be more useful to take essentially the same starting point and create my own quick summary of the basic facts about oil that informed Americans ought to know, referring to the show when appropriate. That's a tall task, since the subject is clearly too complex to cover in much detail in a single posting. As it is, I'll break it up into two segments, with today's focused on oil and a subsequent posting looking at gasoline, other products, and the impact of climate change.

1. Oil is finite, but production matters more than reserves, at least when it comes to influencing prices. Nor are reserves an especially good predictor of future production, since they reflect a static view at a given level of price and technology, both of which constantly evolve. That explains the apparent paradox that since 1859 the US has produced just shy of 200 billion barrels from reserves that never exceeded 40 billion barrels. So when you hear, as Mr. Gibson reminded us, that the US consumes 23% of the world's oil but possesses under 3% of proved reserves, you should also consider that we produced 10% of global petroleum output in 2008. And that 23% of demand doesn't look quite so disproportionate, when you recall that the US makes up roughly 24% of the world economy.

2. Contrary to widely-held perceptions, overall net US energy independence, considering all the different forms of energy we produce and consume, import and export, currently stands at 74%. That's less than it once was, but not so bad compared to some of our economic competitors around the world. While China is about 90% independent (but falling,) the EU is at around 50%, and Japan is only 16% energy independent. When we talk about energy independence, though, we tend to focus on oil, because it is so important for the economy and accounts for 84% of US energy imports--a vulnerability that had been growing at an alarming rate in the last 15 years.

3. While we certainly cannot drill our way back to energy independence--a condition we have not enjoyed since the 1950s--the US still has substantial untapped oil and gas resources that are not counted in current reserves, along with many other forms of under-utilized energy that are beginning to reach a useful scale. Although I don't see us becoming truly energy independent again, or even needing to, the only potentially insurmountable obstacles to restoring a more comfortable and sustainable level of energy security are of our own making. That potential 2 million barrels per day (MBD) of additional production that T. Boone Pickens described in his interview, which awaits only unimpeded access and capital, would make a serious dent in our net petroleum imports of roughly 10 MBD, down from 12 MBD in 2007 as a result of the recession.

4. Oil still supplies vastly more energy than biofuels, wind, and solar power, and that comparison cannot change very quickly, no matter how fast these alternatives grow--and they are growing rapidly indeed. That's because of the enormous scale of our oil use and the sheer quantity of energy in each barrel. Last year the US consumed roughly 300 billion gallons of gasoline, diesel and other petroleum products. That figure includes 9.6 billion gallons of ethanol and 320 million gallons of biodiesel. After adjusting for ethanol's much lower energy content, biofuels thus met just 2% of our petroleum needs, equivalent to 400,000 barrels per day. That's not inconsequential, any more than the output of new US offshore oilfields would be. Biofuels won't close the oil import gap anytime soon, however, because the targeted 36 billion gallons of ethanol and biodiesel expected to be produced under the national Renewable Fuel Standard in 2022 works out to only about 1.5 MBD on an oil-equivalent basis. (For comparison purposes, the 29,440 MW of wind turbines currently in place in the US generate the equivalent of roughly 0.3 MBD of oil, assuming it displaces natural gas in gas turbine power plants.)

5. In the absence of any realistic means of becoming 100% energy independent, energy security should be the main focus of government oil policies. Happily, this outcome is not nearly as unattainable as self-sufficiency, though it can seem awfully elusive at times. The principal source of our energy security today, aside from our very large production of non-oil energy sources, derives from our diverse mix of suppliers. Crude oil imports are dominated by Canada and Mexico, which together contributed 32% last year, compared to 24% from the Persian Gulf. Meanwhile, over half of our substantial net imports of petroleum products came from Canada, the EU and the US Virgin Islands. The US Strategic Petroleum Reserve, which presently contains 724 million barrels of oil, constitutes an important emergency back-stop in case of a disruption in these supplies, though it is long overdue for a fundamental re-think.

6. The oil market is global, and prices are not set by oil companies or even mainly by traders on the New York Mercantile Exchange, though the latter play their part. The price level for oil is mostly determined by the interaction between global demand and the two key components of supply: OPEC and non-OPEC production. When non-OPEC output is growing faster than demand, prices tend to fall, while any increment of new demand or shortfalls in non-OPEC output that boosts OPEC's market share tends to raise prices. If you want to understand why oil has rebounded above $60 with the global economy still in recession, look no farther than the roughly 3 million barrels per day of oil that OPEC has managed to keep off the market, in an uncharacteristic display of cohesion and discipline.

Although I've omitted numerous other important aspects of the situation, we would have a more fruitful national dialogue on energy if our leaders and the electorate just understood these six points. Reasonable people differ as to how best to respond to these facts, as demonstrated by a long succession of US administrations that have pursued a variety of energy approaches, seeming consistent only in their lack of a coherent strategy with respect to oil, or at least in their inability to find one that could be sustained from one administration to the next. And before my readers inundate me with comments reminding me that any comprehensive discussion of oil must now incorporate climate change, I intend to cover that when I address the petroleum products side of this story, since most of oil's emissions result from consumption, not production.

China's Oil Strategy

I was intrigued by a couple of items I ran across in the morning papers concerning China's pursuit of new oil sources. The Chinese National Petroleum Corp. is apparently in talks with the Venezuelan state oil company, PdVSA, and Total for a heavy oil producing and upgrading concession in the Orinoco heavy oil zone, as well as discussing a partnership with Shell to bid on new oil projects in Iraq. China may still lag the US in oil imports, but it is catching up fast, and the efforts of state-controlled CNPC suggest that China has a strong sense of the importance of future oil supplies in supporting the country's economic growth. Perhaps we should take a page out of their book.

I'm not suggesting that the US consider setting up state-owned oil companies or pursuing the kind of government-to-government deals that would take large quantities of oil off the global market for years to come. Not only is that unnecessary for us but counterproductive, as well, considering the inflexibility it locks in. At the same time, it seems clear that China regards oil as a key strategic resource--a pillar industry--and that ensuring access to it remains essential for economic and national security, even in a world increasingly focused on renewable energy. Although our environmental priorities are quite different from those of China, our economic priorities have more in common. Oil represents energy diversification for China, while it is a mainstay of our own energy economy; however, both countries will consume many billions of barrels more oil before either of us reaches the point at which some combination of energy efficiency and alternative energy renders it passé.

The common thread here is access. In the case of China, it is to oil reserves around the world, as its oil industry outgrows its domestic roots. For the US, the task is more complicated. Falling oil prices have created a great opportunity to reverse the tide of resource nationalism that accompanied the rapid rise of oil prices from the $20s to nearly $150 per barrel. Countries that built their budgets on soaring oil revenues are straining, and some astute diplomacy by our government could help open some doors that had swung shut in recent years. But just as we are keen to set the right example on climate change policy, going into December's talks in Copenhagen, it is bootless to plead for access to other countries' oil fields when we restrict access to our own untapped resources so tightly.

A new report by the Department of the Interior indicates a mean estimate of "undiscovered technically recoverable resources" under the US Outer Continental Shelf of 86 billion barrels of oil and a similar quantity of natural gas, including significant quantities off the Pacific coast. To put that in perspective, the cumulative volume of the federal Renewable Fuel Standard between now and 2022--including large quantities of cellulosic ethanol that is still at least as speculative as the undiscovered oil resources highlighted by the Interior Dept.--sums to 308 billion gallons of ethanol, the energy equivalent of a little over 4 billion barrels of oil. In other words, there's potentially 40 times more energy in the oil and gas that remains to be found in our own waters than in all the ethanol and biodiesel we're required to burn over the next 14 years.

Once again, I should emphasize that this is not an either-or proposition. For all the faults and limitations of our present biofuel strategy--and they are numerous--the potential of non-food-based biofuels looks significant and too good to pass up. However, the same is also true for the opportunity represented by our own undiscovered potential oil and gas resources, which at least one study suggests could contribute over a trillion dollars in new royalties and taxes to the Treasury, if developed. Whether or not China would be as reticent as we have been about such a resource off their shores, we must recognize that the global oil game is changing in response to new players, and that it is a game we cannot yet afford to opt out of, because renewable energy is not yet ready to fill the gap that would be left, nor will it be for at least another decade or two.

Energy Omission

When President Obama spoke about energy in last night's address to a joint session of Congress, his focus was on renewable energy. There was no mention of last year's hot-button issue of drilling for more oil off the coast of the US, and I doubt that this struck many listeners as odd. After a 72% drop from last July's peak oil price and the onset of a global recession and financial crisis, offshore drilling must seem like yesterday's news. The world is now awash in oil for which the expected demand has receded, and many Americans are convinced that the passage of an economic stimulus package that included $77 billion for energy--mostly renewables and efficiency--has put us on a path to achieving energy independence. But while the conditions that gave rise to last summer's mantra of "Drill, Baby, Drill" have altered beyond recognition, the continued development of the nation's oil endowment turns out to be as important to our economic future as the infrastructure investments that were included in the stimulus, or the wind, solar power and biofuels that the President cited in his remarks. That's because renewable electricity doesn't displace oil; our output of biofuels is still relatively small; and before the high-mileage vehicles we've been promised are on the road in large enough numbers to matter, natural decline will have pared the output of the oil fields upon which we rely today by at least a third--more than the energy contribution of all these new programs combined.

Start with non-hydroelectric renewable power--wind, solar, geothermal, and the other means of tapping natural, perpetual energy flows. They are essential contributors to the lower-emission energy economy we must have in the future, and they enhance our energy security, but aside from supplying only a small fraction of our current energy needs, they have next to no effect on oil demand, at least in the US. Last year only 1.1% of the electricity we used was generated from oil, so there's not much left to displace from the power sector. That work was done in the 1970s and '80s by nuclear power and natural gas turbines. Instead, intermittent or cyclical renewables such as wind and solar power will largely displace natural gas, while geothermal can take the place of some baseload coal power.

Biofuels are a different story. Liquid biofuels compete directly with oil, and the Congress has committed us to using an increasing volume of them every year through at least 2022. However, even ignoring the substantial quantities of fossil energy required to produce them, their contribution is still on a small scale, compared to current US petroleum consumption. For example, last year's record output of approximately 9.2 billion gallons of ethanol, the energy equivalent of 6.1 billion gallons of gasoline, made up only 4.4% of our 2008 gasoline consumption on a BTU basis. By comparison, the nation's oil wells produced roughly 76 billion gallons last year, despite significant disruptions from Hurricane Ike. And because of its lower energy content, every gallon of ethanol blended into gasoline increases our overall fuel demand. In a recent study, the Oak Ridge Laboratory of the Department of Energy found that cars running on a blend containing 20% ethanol--a level currently under consideration for reasons I could devote an entire posting to explaining--required an average of 7.7% more fuel to travel the same distance as on a gallon of petroleum gasoline.

That brings us to improved fuel economy and vehicle electrification, which together probably constitute our best hope for reducing oil consumption by large quantities in the long run. Unfortunately, the median age of US cars has been rising for the last decade, even before the car industry suffered an 18% drop in sales last year. So while the total fleet of 235 million cars and light trucks is likely to grow more slowly than in the past, it will also turn over at a lower rate than previously. Even if the fuel economy of new cars improved by 1 mpg per year--four times the recent rate--the whole fleet might still only be about 10% more efficient than today's within eight years. Do that and double ethanol output over the same interval, and we'll still need a lot of oil to fuel our transportation sector.

Where will that oil come from? Well, few Americans want to increase our reliance on the Middle East, which holds roughly 60% of the world's oil reserves. And our safe, reliable suppliers close to home are going to be challenged just to continue to supply what they already do. Canadian output depends heavily on oil sands production, which is highly capital-intensive and does not compete well at current prices. Production in Mexico is falling off a cliff, with the sharp decline of the super-giant Cantarell field. These two countries together accounted for 33% of our net oil imports in 2007. It's not all bad news; Brazil has discovered vast new oil deposits--in deep water offshore--and plans to ramp up production in the next few years. However, the global oil industry needs to bring on between 3 and 5 million barrels per day of new production every year, just to keep pace with the inexorable depletion of existing fields. When investment slows, decline wins out, and last week the CEO of Total, the French oil super-major, indicated that this effect could cap global output at 89 million barrels per day, providing scant headroom once the global recession ends.

There's no doubt that the US oil sector is the world's most mature, having produced a cumulative 200 billion barrels since Col. Drake's first well in 1859. But that doesn't mean that there aren't significant quantities of oil left to extract, both in the large untapped deposits onshore and offshore, and in oil fields abandoned under earlier extraction methods. Even if pessimistic estimates that accessing the former would only add 200,000 bbl/day of new oil are correct--defying logic, experience, and any reasonable assessment of likely reserves-to-production ratios--the increment would still contribute as much net energy as our entire recent ethanol expansion, while creating many jobs when they're most needed. And instead of requiring subsidies, tax incentives, and federal grants to get this effort going, it could begin with a signature and ultimately contribute many billions of dollars in royalties and income tax toward paying down the crippling debt we are taking on to ease the recession.

Although offshore drilling seems unlikely to become a cause célèbre again, until oil prices spike on the other side of the recession, it has an important role to play in a balanced energy strategy for the country. Domestic oil and renewable energy aren't mutually exclusive; bridging our oil supplies will be essential for a smooth transition to the cleaner and greener energy and transportation mix we all want. Nor have low gas prices sapped the public's interest in proceeding with development. A new poll indicates that 61% of those who voted in last November's election still support more drilling. The administration should take note, and clear the way for responsible access to the billions of barrels of oil that were kept off limits for decades.

December Surprise

A month ago an old friend--in fact a former boss and mentor--hinted that the recent collapse of oil prices might lead to revisions of the oil & gas reserves that companies carry on their books. I recalled his suggestion a week ago, when the Wall Street Journal published an article on the subject of potential reserve revisions, indicating that "big chunks" of reserves might have be to declared "uneconomic", harming company valuations and potentially their ability to raise capital. This came into even sharper focus last Friday, when the January 2009 crude oil futures contract on the New York Mercantile Exchange (NYMEX) plunged sharply on its last day of trading, ending at $33.87 per barrel--the lowest oil price since February 10, 2004. I can only imagine how intently the reserves accounting groups of oil and gas companies must be scrutinizing the performance of the February contract, wondering how badly it might swoon by December 31, when the price for determining year-end "proved reserves" is established. The comparable price from which the 2007 year-end reserves were calculated was $95.98 per barrel, the highest ever. The subsequent slide puts reserves booked as long ago as 2004 at risk.

My friend knows more about oil & gas reserves and their reporting, from personal experience, than I ever will. It's an arcane subject. Despite the general designation of "reserves accounting", this task is normally carried out not by accountants, but by engineers under the supervision of a very senior and highly-experienced petroleum engineer or geoscientist. Tallying up how much oil and gas a company's leases are likely to produce involves consideration of a large array of technical and economic factors, including the market value of the future production these fields could yield. I'm sure there are other differences between the current SEC regulations, under which these figures are disclosed as part of a company's annual financial statements, and the standard industry approach set by the Society of Petroleum Engineers. The most important for the purposes of this posting is that under the SPE guidelines, the economic viability of the potential production from an oil deposit is assessed against the prevailing prices over the last 12 months, while also taking the firm's forecast of future prices into account. The SEC requires reserves to meet its standards for "proved" status at the price in effect as of the assessment, in this case at year-end.

When the price of oil was relatively stable, there wasn't much difference between these two perspectives, and thus between reserves determined under SEC or SPE guidelines. Even in the last several years, as prices rose dramatically from their roughly $20-25 per barrel range of the previous two decades, the 12-month averages were typically not drastically different from year-end prices, as for example the $66.25/bbl average for 2006, compared to $61.05/bbl on 12/29/06. However, if prices remain where they are today, we could see a $60/bbl difference between these two metrics for 2008, and a year-on-year decline of over $50/bbl. That would require any reserves that were booked at a price above $40 or so--not just this year, but going back as much as four years--to be reevaluated. (Natural gas has fallen, too, though by much less than crude oil.)

This situation is complicated by a bigger underlying question: what is the value of oil likely to be in the future, rather than at a moment in time or over some past interval? Reserves are future production, after all--in some cases extending over 20 or 30 years, or even longer. The market for prompt delivery might be glutted, and the outlook for the next year might appear pretty bleak, but without reading too much into the present steep "contango" in oil prices, there is every reason to believe that when global economic growth resumes, the fundamental conditions that pushed oil prices beyond $100/bbl will reassert themselves.

Before investors panic at the prospect of publicly-traded oil companies writing down hundreds of millions or billions of barrels of "proved reserves" for accounting disclosure purposes next year, they need to consider where the volumes in question will have gone. Were they merely shifted from the "proved" to "probable" category--thus not affecting the amount of oil that would ultimately be produced--by a temporary oil glut arising from a global recession, or did their existence depend on an oil-price bubble that is unlikely to reflate? And even if these conditions do prove to be temporary, there's a good chance that a number of oil and gas projects, including some fairly large ones, will have been deferred in the meantime, if not canceled entirely. That affects reserves in the most fundamental way possible, as well as altering the future global production profile. Since my own portfolio includes oil & gas equities, I face the same uncertainties in this regard as anyone else, as both an investor and a consumer. At the very least, this situation highlights the urgent need for a major revision of the SEC regulations covering the reporting of reserves, along the lines the Commission has already proposed, to put reserve estimates on a more meaningful and less volatile basis.

Energy Outlook will be on holiday break until next week. Merry Christmas, Happy Hanukkah, and Seasons Greetings, as appropriate!