Artificial Carbon Cycle

Part of the research for my writing and consulting involves watching for trends or common themes, and one that I've been picking up from diverse sources reflects a growing skepticism about "clean coal" and the processes for capturing and sequestering carbon (CCS) that are central to it. To get a flavor for this, Google on "clean coal" and "oxymoron". Some of these concerns are grounded in the science of thermodynamics, while the balance seem to reflect the long-standing attitude of environmentalists toward the coal industry, which would be the primary beneficiary of a practical CCS scheme. It's worth taking a few minutes examining why CCS is unlikely to be easy, but why, if it can be done cost-effectively on an industrial scale, it would be so beneficial.

It helps to think about CCS in the context of the earth's carbon cycle, in which carbon is exchanged through natural processes among the land, ocean, atmosphere, and living things. The principal issue in anthropogenic climate change is that our activities have upset the balance of this natural cycle, overloading it through the rapid release of vast quantities of stored carbon that had accumulated over geological time in fossil fuels. The goal of climate policy is to reduce the magnitude of that overload and eventually eliminate it by using carbon-intensive energy sources much more efficiently, while working to replace them with carbon-neutral or carbon-free energy. That's why biofuels, wind and solar power are regarded as essential elements of climate change mitigation, though it turns out that current biofuels are not remotely carbon-neutral. The idea behind CCS is to complement the main climate change mitigation strategies by creating an artificial version of the carbon cycle, in which the carbon released from the combustion of fossil fuels is collected and returned to long-term storage, before it can enter the natural carbon cycle.

That sounds simple enough, but to understand why it's so hard to do, consider the amount of coal necessary to produce one kilowatt-hour of electricity. In 2007 the US burned a little more than a billion tons of coal to generate just over 2 trillion kWh of electricity, for an average of 1.0 lb./kWh. Because most of the energy from coal derives from its carbon content, the main chemical reaction involved is very simple: C + O2 → CO2. So unlike the sulfate (SOx) or nitrate (NOx) pollution we have managed for decades, CO2 is neither the result of a fuel impurity nor an inadvertent byproduct of combustion, but rather its primary outcome, along with heat. On average, every lb. of coal yielding a kWh of electricity also emits 2 lb. of CO2 to the atmosphere. In other words, the mass of CO2 leaving coal-fired power plants is double the mass of coal that went in. That's a lot of gas to separate, compress, transport, and dispose of in geological or other storage.

Now consider the energy balance of such a system. Before adding CCS at the back end, you had to mine the coal, ship it to the power plant and burn it, producing heat that was used to make steam to turn a turbine that generated power. The typical thermal efficiency of such a facility is 35-45%, depending on coal quality, plant design and operation. But CCS is inherently energy-intensive, reducing the overall efficiency and the energy return on energy invested (EROEI) for the entire coal-to-power process. If separating the CO2 from the flue gas, compressing it, and putting it back into the ground at some remote location consumes up to a third of the energy generated from the coal, as some estimates suggest, then our artificial carbon cycle doesn't look very impressive, as a net energy source. After referring to the First and Second Laws of Thermodynamics, you might even wonder whether we could produce enough net energy from such a loop to be worthwhile, at all.

I had a hard time finding the EROEI of the standard coal-fired power lifecycle. It appears to fall in the range of 5:1 to 9:1, which compares favorably with conventional oil production and refining, and with the best renewable energy sources. If CCS reduced those returns by one-third, then while the energy balance would remain positive in a physics sense, the economics of some applications might become marginal, because CCS would consume a large helping of the energy surplus that coal-fired power normally creates. Another way to look at that is that the portion of the energy surplus thus consumed was attributable to the non-monetized externality of putting a greenhouse gas into the atmosphere, and thus not sustainable, anyway.

As daunting as all this sounds, there may be some clever ways to overcome the toughest impediments to getting started rounding up the carbon from coal power and stashing it back in the earth. In a new study, a team from MIT has proposed "partial capture": removing only enough CO2 from the flue gas to cut the emissions from a coal-fired power plant to the level of one running on natural gas, about a 35% reduction. This would allow CCS to be introduced incrementally, at a much lower investment cost and a less severe efficiency penalty than full CCS. And as I discussed in another posting, using captured CO2 to enhance the output from productive oil fields creates a positive value for it that offsets at least some of the cost of collecting and transporting it. Work at a Canadian oil field that does this suggests that the stored CO2 can be effectively monitored underground. Even more intriguingly, naturally-occurring mineral deposits called peridodites can act as CO2 sponges. These might be used to increase the efficiency of direct CCS, or to establish indirect CCS--a coal-scale emissions offset that would remove CO2 from the atmosphere without requiring a CO2 pipeline from the emissions source.

Easy or difficult, our motivation for pursuing CCS, instead of abandoning coal as incompatible with alleviating climate change, is based on the reality that we still derive roughly half of our electricity from coal and only about 1% from wind, solar and geothermal power. That means that our annual additions of renewable generating capacity are not yet covering the roughly 1.5% per year growth in US electricity demand we've experienced over the last 5 years, let alone taking market share away from coal or any other carbon-based fuel. Could we advance efficiency and renewables rapidly enough to displace a sizable fraction of our coal use within 10-20 years? Perhaps, though I'd feel a lot more confident about meeting the aggressive emissions-reductions targets the US is likely to take on within the next year or two, if we could tackle coal's emissions directly with CCS.

I'd like to wish my US readers a Happy Thanksgiving. Postings will resume on December 1.

Sales Mix and Fuel Economy

When Detroit's CEOs return to Washington, DC in early December for further Congressional hearings on a rescue package, the industry's prospects for meeting tougher fuel economy standards are likely exert significant influence on the granting of federal assistance. When I was writing last Monday's posting on "Detroit, Bailouts and Fuel Economy", the CAFE database of the National Highway Traffic Safety Administration, which administers the Corporate Average Fuel Economy standard, was undergoing maintenance. That meant I couldn't calculate the impact of this year's shift in the sales mix of the Big 3 on their fleet fuel economy. The numbers indicate that simply selling fewer SUVs and more of their existing car models, without any major changes in technology, is already yielding significant fuel savings. In addition, the figures for the leading Japanese brands indicate what might be possible for GM, Ford and Chrysler, simply by offering fewer V-8 and V-6 engines and selling more four-cylinder cars. That's a good thing, because the latest survey from R.L. Polk & Company suggests that hybrids will still make up less than 6% of US new car sales in 2012.

NHTSA tracks fuel economy for every automaker in three categories: domestic passenger cars, imported passenger cars, and light trucks. The latter includes most SUVs. These data, in combination with the year-to-date auto sales figures through October, facilitate some quick spreadsheet analysis revealing the key factors differentiating the fuel economy performance of the big US carmakers from their competitors, such as Toyota and Honda. For example, for the 2007 model year, the US companies averaged a combined 24.9 miles per gallon, while the US models of these two Japanese firms averaged 30.2 mpg. That gap is attributable to two components, neither of which comes as a surprise. The Japanese passenger cars averaged 5 mpg better than their US counterparts, helped considerably by their imported hybrid models. The passenger cars made in these firms' US factories averaged just under 3 mpg better than their US peers.

The other big influence comes from the relative sales mixes of these companies. Of the combined 2007 sales of GM, Ford and Chrysler, nearly 65% were "light trucks", comprised of SUVs and pick-up trucks. Such vehicles only made up 42% of the sales of Toyota and Honda. That's particularly significant for fuel economy, because the Big 3's light trucks turned in fuel economy ratings averaging 7 mpg lower than their passenger cars, while the light trucks of Toyota and Honda were 10 mpg worse than their cars.

With gas prices that surged past $4 per gallon this summer, 2008 has produced some modest but encouraging shifts in fuel economy. SUV sales are down much more than those of passenger cars, for both US and Japanese makes, while the cars and SUVs sold tended to be from the more economical models within their respective categories. This has improved the average fuel economy of the Big 3 by 0.4 mpg, year-to-date, with 75% of that improvement coming from the shift between passenger cars and light trucks, which fell to 63% of Detroit's mix. Toyota and Honda saw an even bigger fractional change in light trucks, with the drop to 38% of sales helping to boost their combined average by more than one full mile per gallon.

Why do these figures matter in the context of a bailout of Detroit? Last year the Congress passed, and President Bush signed, the Energy Independence and Security Act of 2007, which among its many provisions included an increase in the federally-mandated new-car fleet average to 35 mpg by 2020, including both passenger cars and light trucks. Given the emphasis during the recently-concluded election campaign on both energy independence and greenhouse gas emissions, Congress appears concerned that a bailout of Detroit should not be viewed as providing any leeway on fuel economy. So it's important to understand whether achieving 35 mpg would require a technological revolution that might be beyond the resources of the cash-strapped domestic industry. Encouragingly, the figures above suggest otherwise. If the Big 3 merely matched the 2008 passenger-car performance of the top Japanese brands (35.5 mpg) while reducing their light truck sales proportion to 25%--the level that prevailed in the US car fleet prior to 1990--they would be three-fourths of the way toward achieving their 2020 CAFE target.

As helpful as advanced-technology cars like the upcoming Chevrolet Volt would be for speeding up that transition, simply by shedding the least-efficient SUVs and offering peppy four-cylinder engines as the standard across most of their product lines, Detroit could deliver greatly-improved fuel economy, of the kind the Congress and new administration are seeking. Just as important, considering the priority that US consumers have placed on vehicle performance in the last decade, European-style turbo-diesels, better gasoline-engine technology, and hybridized drivetrains can deliver these gains at an mpg-vs-power trade-off that car buyers should find much more palatable than the one we were forced to accept in the early 1980s, the last time high oil prices focused US policy-makers on automotive fuel economy to this degree.

I don't want to make this change sound easier than it is likely to be. Reducing SUV sales by the necessary extent would require re-tooling on a massive scale, sending ripples through the North American auto supply chain that might be nearly as dramatic as the bankruptcy of one or more of the Big 3. Consumers are leading this shift today, and they must be willing--or encouraged by new policies--to stay the course. The fall of gasoline prices back below $2 per gallon, if it persists for more than the next few months, will work against that. If a rescue or restructuring is to succeed, it must result in a new mix of products that are globally competitive and not just more fuel-efficient, but also profitable to make and market. That argues against embedding expensive, unproven technology in millions of cars, until Detroit is strong enough to stand behind the warranties that will be crucial to selling them.

Buy Low?

Yesterday I received a question from a reader inquiring whether the price of oil has fallen to a level at which the US should consider resuming additions to the Strategic Petroleum Reserve. I hadn't looked at this issue since oil was much more expensive, when I supported efforts to halt additions to the SPR, but not to sell oil from the reserve to manipulate prices. Upon reflection my answer is no, at least for now. Oil at 50 bucks looks very cheap, relative to where it has been this year, and also to where it's likely to be again, once the global economy gets back on its feet. However, I see three primary impediments:

1. Under the law passed by Congress and signed by the President this May, filling of the SPR cannot resume before the end of 2008, or until the President certifies to the Congress that "the weighted average price of petroleum in the United States for the most recent 90-day period is $75 or less per barrel." By my reckoning, the three-month average price of West Texas Intermediate crude oil on the New York Mercantile Exchange is still somewhat above that level. As rapidly as it has fallen, it could meet that criterion in December, but with very little time for the current administration to act on it. If we use reported refiner acquisition costs, a more accurate gauge of what the nation pays for oil, the latest figure available is the $104/bbl indicated for September 2008. With August even higher, no crude could be bought without the help of the much lower assessment expected for November, which probably won't be published until January.


2. Even if that condition could be satisfied, I doubt that the administration--outgoing or incoming--or the Congress would regard buying more oil for a reserve that already holds a 160-day supply at its maximum drawdown rate of 4.4 million barrels per day as urgent, compared to the needs of addressing the financial crisis and recession. As slack as the oil market is, I'm not even sure it would help US producers. More importantly, none of the potential threats to our oil imports look so pressing that we should make adding oil to the SPR a top priority, at least for the next few months.


3. For me the most compelling reason to hold off on this buying opportunity is my hope that the new administration would not feel bound by the current administration's determination of the need for a 1-billion-barrel SPR in its current form, without further study. As I've commented periodically, the basic architecture of the SPR was designed three decades ago, in a very different world. It is in urgent need of a top-to-bottom review, to assess how it aligns with our strategic need to ensure continuity of fuel supplies to the US economy in all 50 states and to the US military wherever it operates, under various scenarios of supply disruption. Until that assessment has been carried out, we shouldn't rush to add more oil to the existing SPR.

Delayed Reactions

The analysis in the current edition of the Department of Energy's "This Week in Petroleum" highlights an unexpected finding from the department's Short Term Energy Outlook: a forecast of a pronounced uptick in US oil production for next year, by 8% compared to this year. The commentary emphasizes that this reflects more than just a rebound from production that was temporarily shut in by this year's hurricanes. What struck me, however, was how neatly the graph accompanying the analysis illustrated the delayed impact of changes in market conditions on our oil output. As the incoming US administration contemplates its policy stance towards the domestic oil and gas industry, it's worth thinking about how they might benefit from these lagged effects during the next four years, but pay for them in a possible second term, particularly if US energy policy turns more negative to oil next year.

When I studied macroeconomics in graduate school 25 years ago, it was generally understood that changes in fiscal policy--tax cuts and spending increases--involved a time-lag of about two years before they produced the desired results, while the effects of monetary policy--changes in interest rates and the money supply--lagged by about one year. (We haven't heard much about such lags during the current crisis, and even if they have shortened, they prevent any stimulus from yielding the instantaneous result the media seem to expect.) Energy has its own inherent time-lags. For large oil projects, such as offshore production, the delay from "green light" to first production is typically 5-7 years. That compounds the volatility of the oil markets, because by the time new supplies come on the market, the conditions that prompted them may have changed dramatically, as we are now witnessing.




The above chart is a modified version of the one in the EIA's weekly report. I've deleted the Alaskan and Lower-48 production volumes in the original graph and substituted the annual average WTI price, while retaining the annual year-on-year percent change in production. With that price overlay, the effects of the oil price collapse of the late-1990s, precipitated by the Asian Financial Crisis, are evident in both a short-term drop in US oil output and an echo roughly six years later. Although much of the drop in 2005 was attributable to Hurricanes Katrina and Rita, the decline in 2004 reflects a dearth of new production, due to projects that were delayed or cancelled when oil company revenues collapsed in 1998 and 1999. But that relationship also works in both directions. It is hardly coincidental that we should anticipate an oil production rise in 2009, five years after prices began their steady upward march in 2004. That trend might continue for a few years, when projects initiated when oil was $60, $80 or $100 come onstream. However, if we expect oil prices next year to be no higher than they are now, despite the rapid escalation in production costs over the last few years, then we might reasonably expect a dip in production, over and above normal decline rates, beginning around 2013 or 2014.

There's certainly a lot more to US oil production than a simple cause-and-effect relationship with oil prices. Government policies play an important role, as well, and it's reassuring to hear the House Majority Leader, Representative Hoyer (D-MD) indicate that the Congress would not seek to reinstate the recently-expired federal offshore drilling moratorium. Nevertheless, it's worth keeping in mind that oil supplies are ultimately price-elastic, just as oil demand has proved to be. If the lagged response to flagging oil prices coincides with policy decisions that reinforce their effect--for example, if the new administration follows through on President-designate Obama's campaign promise to impose a windfall profits tax on the largest US oil companies--we could be facing a substantial future drop in output that could negate much of our efforts to wean the US off of imported oil. We need to keep in mind that every million barrels per day of domestic oil production is the equivalent of roughly 20 billion gallons per year of ethanol, and is worth $20 billion to our trade deficit, even at today's diminished prices.

A Taxing Opportunity

While watching the scenery from Amtrak's Acela on my way back from a meeting in New York yesterday, I made my first sighting of $1.99 per gallon gasoline, posted on the polesign of a station in Delaware. With wholesale gasoline trading on the New York Mercantile Exchange for $1.138 per gallon at yesterday's close--nearly $7 per barrel below the closing price for light sweet crude oil--most of the country could shortly be paying less than $2/gal. for unleaded regular, for the first time in more than three years. An op-ed in yesterday's Washington Post started me thinking about gasoline taxes, again, and I agree that the current gas price collapse provides a uniquely opportune time for a symbolic increase in the federal gasoline tax, which has not been raised since 1993.

Raising taxes in a recession isn't terribly sound economics in general, but gasoline in 2008 presents an unusual case. As I noted in Monday's posting, the decline in prices from their summer peak to last week's $2.22/gal. average puts roughly $260 billion per year back in the pockets of US consumers, at a time when that ought to be quite helpful. However, it's equally clear that low gasoline prices will complicate the task of selling more efficient cars to an American public that is already buying fewer cars than at any time since the recession of the early 1990s. Moreover, with gasoline demand running at least 3% below last year's at this time, and with prices now a dollar per gallon lower than they were a year ago, and below their annual averages for 2005, 2006 and 2007, state and municipal tax revenues from sales taxes on gasoline will also fall well below expectations. That puts further pressure on state and local budgets already stressed by falling home values and rising unemployment, and it could force cuts in infrastructure projects that many economists suggest we need more of, just now, not less.

This needn't conflict with the necessity to put a price on our emissions of greenhouse gases, effectively taxing fuels on their inherent carbon content. My preference has been for cap & trade, but a simple carbon tax would do much the same thing. Every $10 per ton imposed on CO2 emissions would raise gasoline prices by roughly 10 cents per gallon, anyway, so I'd resist calls for the "big honking tax on gasoline" that Mr. Sloan's op-ed suggests. But with gas prices dropping by more than a dime per week since September, a 10 cent gas tax hike would scarcely be noticed, leaving that $260 billion effective stimulus I mentioned earlier untouched. It could also be shared with the states, with half of the roughly $14 billion per year it would raise going to fund federal infrastructure projects, and the other half allocated to backstop state-financed road and bridge work.

Ten cents a gallon might not sound like much, though the 4.3 cent increase in 1993 cost another first-year President a good deal of political capital. By itself, it wouldn't change the way Americans drive or buy cars. Nor would it be sufficient to nudge consumers towards diesel cars, when diesel fuel has carried an average premium of $0.50/gal. over unleaded regular this year, and currently sells for $0.73/gal. more. However, it would indicate the willingness of the government to intervene in gasoline pricing, when appropriate, in a manner that doesn't impede the market's ability to balance supply and demand, as price controls or a floor price mechanism would. And unlike raising income taxes when salaries and consumer spending are falling, a period of falling gasoline prices is precisely the right moment to raise the federal motor fuel tax, even if just by a little.

Detroit, Bailouts and Fuel Economy

As Congress meets today to take up the subject of rescuing the Big 3 US automakers from possible bankruptcy, I'm concerned that this issue has been conflated with energy and environmental policy, rather than being viewed as an expedient palliative. While the mix of cars made and sold in this country will certainly have a large and growing influence on the quantity of petroleum and other fuels consumed by our car fleet in the years ahead, and on its emissions, it requires several leaps of faith to travel from that indisputable fact to the proposition that only by preserving at least GM and Ford in roughly their present form can we ensure that consumers will be able to purchase highly-efficient cars made in the USA. There are other arguments for bailing out Detroit, but if it is done on the premise that US carmakers can immediately retool to make all hybrids and plug-in hybrids, everyone involved is bound to end up severely disappointed.

It has become conventional wisdom that these companies have been done in by high fuel prices, or more precisely by product strategies that assumed that gasoline would remain cheap in perpetuity. Yet while the profits of the Big 3 were indeed leveraged to the sales of large SUVs that on average deliver at least one-third worse fuel economy than their passenger car lines, Ford's stock price has been declining steadily since early 1999, when oil prices were under $15 per barrel and gasoline sold for just under $1 per gallon. GM's market value peaked in early 2000, when gasoline was around $1.50. It had already fallen by half by May 2004, when weekly average US gasoline prices breached $2.00/gal. for the first time.

Although it would be quite helpful for the parallel causes of reducing US oil imports and greenhouse gases for the Big 3 to pivot and begin producing large numbers of hybrids and plug-ins, it is by no means obvious that such a strategy--launched in the midst of what is shaping up to be the worst global and US recession in decades--constitutes a recipe for a quick return to profitability. GM's Volt plug-in hybrid (or range-extended electric vehicle, for purists) is a case in point. With a sticker price expected to be in the low $30,000 range, net of a $7,500 federal tax credit, and delivering fuel savings, the value of which has been cut in half by the precipitous decline of oil and gasoline prices, this car might make energy and environmental sense for the nation, but it looks like a tough sell to consumers in a weak economy, at least in numbers large enough to matter.

For as much attention as the Volt has garnered, it might be even more instructive to note that GM's new "Cruze" non-hybrid economy car will also not launch in the US before 2010, at the earliest. That serves as a useful reminder that it still takes several years to plan, design, and re-tool for a new model. Even converting plants to produce more of existing light-vehicle models, or to build the more efficient cars these companies already sell in Europe and elsewhere, could not be done overnight. The return on such an investment remains uncertain, as well, with the demise of lending to less-than-prime applicants contributing to car sales that have fallen to their lowest level in years. The combined passenger car sales of GM, Ford and Chrysler are off by 12% year-to-date, or more than a quarter-million cars in total. That's much better than the 25% decline in "light truck" sales compare to last year, but it confirms that there is more to Detroit's problems than just the demise of the SUV fad.

The most sobering analysis of the situation that I've read so far was a commentary in the Weekend Wall Street Journal by a professor at NYU's Stern School of Business. It points out that over the last ten years, GM and Ford collectively invested $485 billion dollars without closing the competitive gap versus Japanese carmakers, including those producing vehicles in this country. (I would add that attributing the relative success of Toyota, Honda and others to prescience about the benefits of hybrid cars represents a misleading distortion of a much more complex situation.) Along the way, their combined market capitalization fell by over $110 billion. The author decries the destruction not only of shareholder value, but national investment capital. That doesn't mean that allowing the Big 3 to fail is the wisest course, but it should at least temper our expectations that a bailout measured in the tens of billions of dollars would do more than stave off a drastic restructuring of Detroit for a brief interval.

I don't have a magic solution for saving the domestic car industry, and I doubt that anyone else does, either. By comparison, the recipe for boosting fuel economy and lowering CO2 emissions from our vehicle fleet is much simpler. Among other things, it involves higher fuel prices, whether by taxes or courtesy of OPEC, though at last week's average of $2.22/gal., gas prices were providing an implicit $260 billion per year economic stimulus, relative to the average for June and July. New incentives for consumers to buy efficient cars could also play an important role, and while the TARP bill included large tax credits for plug-in hybrids, the credits for conventional hybrids--which address the biggest increment of fuel savings--are phasing out. And we can't forget that buyers of more efficient cars need readily-available financing. That requires not just replenishing the capital of banks and other lenders, but restoring confidence that loans will be repaid. At least two of those three measures would benefit Detroit, but like a bailout, they would still fall well short of a guaranteed recovery from the hole into which the industry has fallen.

Unlimited Clean Fossil Fuel?

If I told you that there was a potentially limitless source of fossil fuel, you would naturally want to know what the catch was. In the case of methane hydrates, a form of natural gas that has been bound up in ice crystals in the Arctic and deep ocean beds, that catch has been so large that I seem never even to have mentioned the subject in nearly five years of blogging. Hydrates are in the news this week in a very significant way, however, though the quantity in question is still quite small, compared to their ultimate potential. The US Geological Survey released a report estimating that 85 trillion cubic feet (TCF) of technically recoverable gas hydrates are accessible on the Alaskan North Slope. If produced over 20 years and combined with the conventional gas supply from the North Slope, which has been waiting for a pipeline south for many years, this deposit could supply up to a third of total US natural gas consumption. But that barely scratches the surface of the overall potential of gas hydrates.

The reason this announcement is so significant lies in the words "technically recoverable." Geologists have known about gas hydrates for a long time, and estimates of global hydrate deposits have been refined to a range of between 100,000 and a million TCF, with the best estimate of US hydrate deposits currently at 200,000 TCF. To put that in perspective, one TCF of natural gas represents about 1% of US annual total energy consumption and contains the same energy as 180 million barrels of oil or 10 billion gallons of ethanol. In other words, that 200,000 TCF estimate is the equivalent of a 2,000-year energy supply for the US, at current consumption levels, of a fuel with half the greenhouse gas emissions of coal. If we could learn enough from tapping the identified deposit on the North Slope, we might be able to exploit the much larger, less accessible deposits elsewhere--and it should tell you something that the North Slope of Alaska looks easy in this regard.

A natural gas source of that magnitude would align nicely with an energy strategy such as the Pickens Plan, employing natural gas for transportation fuel and generating electricity from wind and other renewables. It is one possible path towards much greater energy self-reliance and much lower emissions. For that matter, hydrates and other unconventional gas could ultimately provide enough fuel to displace all coal from power generation, until it can be replaced by enhanced geothermal systems, nuclear fusion, space solar power, or some other reliable and essentially limitless source of emissions-free electric power.

To put this in its proper perspective, if it were easy, we'd already be doing it. Nor are hydrates free of risks, the biggest of which could make our climate problems much worse, very quickly. That's because methane is a powerful greenhouse gas, 21 times more than CO2, and methane hydrates are only stable under certain conditions of temperature and pressure. A sudden release of a large quantity of methane from hydrates could accelerate the greenhouse effect, as may have happened in the geological past. But while any plan to mine hydrates must include rigorous safeguards against such an outcome, that risk must also be weighed against the risk that gas hydrates will naturally begin to vent their methane, if we remain on the current global emissions trend line and polar and ocean temperatures continue to increase.

There are no energy panaceas, and methane hydrates don't constitute one, either, because of their technical challenges and possible drawbacks. However, as a long-term hydrocarbon supply for energy and petrochemicals, they offer significant advantages over many forms of unconventional oil, and they could be extremely useful in a post-Peak Oil, low-emissions energy economy, as conventional oil & gas supplies deplete. I'm encouraged that the USGS sees the North Slope hydrate deposit as falling within our current technical capabilities, potentially unlocking the equivalent of 15 billion barrels of oil or roughly 900 billion gallons of ethanol.

A Growing Imbalance

This spring I reviewed Robert Bryce's book, "Gusher of Lies," a thorough debunking of the notion that America could or should become energy independent any time soon. In a provocative article in Slate, he has connected the dots between our steadily rising ethanol mandates and the current weirdness in the US petroleum products market, in which wholesale gasoline continues to sell for less than light sweet crude oil, while diesel fuel/heating oil commands large premiums over both. In the process, he explains the short-to-medium-term constraints on attempting to reduce crude oil imports by increasing ethanol production. Although these impediments could be overcome in the long run, doing so would require enormous additional investments in the fuels sector, because it would render obsolete the configuration of virtually every current US oil refinery.

Reading Robert's article triggered two related thoughts. The first was that our present ethanol policy, embodied in the Renewable Fuel Standard (RFS) and the decades-old system of ethanol blending credits and import tariffs, reflects an outdated set of assumptions about the nature of the US motor fuels market. These subsidies and mandates arose during a period in which US gasoline demand was growing steadily at 1-3% per year, US refineries were producing as much gasoline as they could, and US imports of finished gasoline and gasoline bending components were growing steadily. None of these factors has survived this summer's price spike and the ensuing financial and economic crisis. Nor are they likely to recover to their former levels when the economy does, because of the growing emphasis on conservation, fuel economy and alternative transportation fuels and vehicle types.

I've commented periodically on the shifting global balance between gasoline and diesel fuel, but without factoring in the influence of US ethanol output--which has more than doubled in the last two years alone--on this relationship. The Slate article identifies the problems created by pushing increasing quantities of ethanol into a stagnating gasoline market, with upstream consequences for refinery operations and the production of other necessary products such as diesel, heating oil and jet fuel, for which long-term demand looks more robust than for gasoline, both domestically and internationally. With US ethanol output currently running at a level equivalent to 7% of US gasoline demand, it compounds the global weakness of gasoline, at the same time ethanol producers are adversely affected by gasoline's slump.

Markets eventually adjust to such disruptions, and I see several paths by which the US refining industry could accommodate a national energy policy aimed at steadily expanding our use of biofuels from 10 billion gallons per year today to 36 billion gallons by 2022, and perhaps to the 60 billion gallons per year envisioned by the President-elect for 2030. But getting there won't be easy or cheap, and that's a big problem for a segment of the energy industry that, with the exception of a brief surge of profitability several years ago, has generally returned no more than the cost of capital.

To see why this would be so expensive and challenging, you need to know a bit about what happens inside a refinery. All oil refineries separate crude oil into its natural fractions of LPG, gasoline, jet fuel, diesel, and heavier oils. The heart of most US refineries, however, is the Fluid Catalytic Cracking Unit, or "cat cracker", a massive device for breaking down and reassembling the molecules found in "vacuum gas oil" and "coker gas oil"--some of those heavier oils I mentioned a moment ago. The result is high-octane gasoline for blending, along with the precursors for making "alkylate", a key constituent of California-type reformulated gasoline. These units also make some low-quality diesel that is typically either processed further or sold into the bunker fuel market.

A refinery with a big cat cracker is fundamentally a gasoline machine, and there's very little you can do to change that, short of shutting the unit down and replacing it with a big, expensive "hydrocracker", which uses hydrogen generated mainly from natural gas to turn those same heavy gas oils into jet fuel and diesel. The other possible end of the ethanol road for US refiners would involve a huge ramp-up in synthetic diesel production, from gas-to-liquids and/or biomass-to-liquids, followed by a wave of refinery closings to end the growing global gasoline surplus. Either route involves hundreds of billions of dollars of investment, in aggregate, and the usual problems in obtaining the necessary permits and environmental offsets.

The energy industry has often attracted unintended consequences, and this one looks like a dandy: We create incentives and mandates for ethanol to substitute for gasoline (and thus imported oil) and end up driving up not just the price of food from which we make ethanol--notwithstanding claims to the contrary in the latest PR and lobbying campaign from the ethanol industry--but also the price of diesel fuel and heating oil, while having much less net impact on oil imports than we imagined. Biofuels will be a fact of life from now on, and along with CNG and electrified vehicles, they are probably a necessity, with oil production looking unlikely to keep up with long-run demand. The oil industry is already getting on this bandwagon. However, the dislocations this creates would be a lot easier to justify, if the biofuels involved were at least produced from feedstocks and processes that didn't consume food and nearly as much energy as the fossil fuels they are intended to displace.

The Shifting Senate

Although overshadowed by the presidential contest, there was much speculation going into last Tuesday's election about whether Democrats could capture a filibuster-proof majority of 60 seats in the US Senate. This would have had profound implications, not only for the ability of an incoming Democratic president to push his agenda through Congress, but for Congress to pass a number of measures that the leadership likely considers unfinished business. That includes major legislation on energy and climate change. Although three contests remain unresolved at this point, leaving this possibility tantalizingly open, a review of the voting on a couple of key bills suggests that even if they all went the Democrats' way, that outcome might be less useful than it appears, because several of the Republicans who retired or have been turfed out were moderates who voted with the majority on the measures in question.

Today's topic might seem overly focused on "inside-the-Beltway" concerns, but I think it could have serious consequences outside Washington, DC. Consider two key pieces of energy-related legislation that came before the Congress this year. The Boxer-Warner-Lieberman Bill, S.3036, would have enacted an increasingly-restrictive cap on greenhouse gas emissions, enforced through a national emissions-trading system ratcheting up energy prices and the prices of energy-intensive goods, in order to reduce US emissions of CO2 and other GHGs. After extensive debate, the bill failed on a "cloture vote", which would have brought it to the floor of the Senate for an up-or-down vote, which it might well have passed. The vote was 48-36, but should probably be counted as 54-36, due to some key absences. That would still have fallen short of the 60 votes required to end debate. Adding the six Senate seats the Democrats have already picked up in this election might lead one to see cap-and-trade as a shoe-in in the next Congress. That math doesn't quite work, however. Of those Senators who voted against cloture, only two lost their seats, while four of the six seats that changed hands were already in the "aye" column. Even if the unresolved races in Alaska, Georgia and Minnesota all send Democrats to Washington, they would still come up one vote short, unless another Senator who voted no or did note vote could be brought around.

The prospect of a windfall profits tax on oil companies looks equally shaky at this point, for similar reasons. Consider the voting on the "Consumer First Energy Bill of 2008", S.3044, which in addition to a 25% tax on "windfall" profits of the major integrated oil companies--over and above the taxes they already pay--would have allowed OPEC to be sued for anti-trust violations in US courts and imposed restrictions on energy commodity speculation. This bill also failed its cloture vote, by 51-43. When we adjust for the seats that have already changed hands, that improves to 55-39. Yet if Senators Stevens (R-AK) and Chambliss (R-GA) fall, it would only extend to 57-36, still short of the magic 60 votes.

So even if the new Senate tallies 58 Democrats and only 40 Republicans, not counting the two Independents who have historically voted with the Democratic caucus, enacting major energy legislation will likely require serious consideration of the views of the minority. While that will disappoint partisans and those desiring the strictest possible climate change legislation, the practical necessity of a bi-partisan approach to energy could pay dividends over the long haul, by preventing the majority from passing measures that could be overturned the next time the balance of power in the Congress shifts. Like the Cold War, solving our energy and climate problems is not the work of one Congress or one Administration, but will require a cumulative effort spanning decades. That should align with the necessity of avoiding further shocks to the economy, as well.

Next Tuesday I will be speaking on the climate change implications of the election at a breakfast panel in Manhattan hosted by my sponsor, IHS Herold. The topic of the session is "Investment Insights in Alternative Energy." If you are interested in attending, please email Bianca Smothers.

Ethanol Bust

The world doesn't stop when you're on vacation, and I will be playing catch-up for some time, between the implications of the US election, a report from the International Energy Agency on chronic under-investment in new oil and gas capacity, and several other noteworthy developments. Although it doesn't quite rank with a new US president, the Chapter 11 filing by ethanol giant VeraSun seems like a good place to start, because it represents an important warning sign for a sector that was already badly strained by rapid expansion and weak margins, even before the financial crisis and accompanying precipitous drop in commodity prices put it on the ropes. The corn ethanol industry owes its existence to government policy, but policy alone can't shore up its inherent shortcomings, or give it the resilience to withstand the kind of shock that is currently propagating throughout the economy.

In many ways VeraSun exemplifies the US corn ethanol sector under the present system of federal renewable fuel mandates and price subsidies. In 2006 VeraSun operated two ethanol plants with combined capacity of 230 million gallons per year (MGY) of ethanol. After an aggressive program of new construction and its 2007 acquisition of US BioEnergy Corp., its capacity stands at 1,420 MGY from 16 plants, with another still under construction. That's 250% compound growth over two years. During the same interval, the price of corn spiked from $3 per bushel to $7 this summer, and then fell back below $4, while gasoline prices went from the low $2s to over $4 per gallon, recently returning to the mid-$2s. The combination of rapid growth and falling, volatile margins explains the company's current status.

Any number of companies have operated successfully during Chapter 11 and emerged to restored profitability. VeraSun has at least gotten off to a good start, lining up the financing that will be necessary to enable its facilities to continue buying feedstock and paying their bills. However, the larger question is whether the underlying factors that put VeraSun into bankruptcy will change sufficiently to allow them eventually to emerge, or if this measure can only keep them on life support until a better-capitalized firm can take over its assets. The prospects are decidedly mixed.

As long as the economy remains weak, fuel demand is unlikely to pick up, and so the price of the commodity for which ethanol is intended to substitute, gasoline, could remain around current levels. Pipeline gasoline from Gulf Coast refiners now sells for under $1.50/gal. Ethanol is currently over-supplied, relative to the mandated blending requirement, and unless a number of plants now under construction are delayed or halted, that situation could persist for several years. In addition, the blenders' credit is due to drop from $0.51/gal. to $0.45/gal. in January. None of this bodes well for the return of healthy "crush spreads", the margins ethanol plants earn from turning corn into fuel.

At the same time, ethanol remains a cornerstone of federal energy policy, and that role could expand in the new administration. During the campaign, Senator Obama spoke many times of the need to increase biofuel production, in order to reduce our reliance on imported oil. While much of that increase is intended to come from advanced technologies that turn non-food biomass into fuel, most of those processes are still either experimental or extremely expensive, relative to $60 oil. It remains to be seen how they can contribute the expected 21 billion gallons per year by 2022, or whether conventional ethanol will have to expand beyond its contemplated 15 billion gallon maximum to achieve the overall 36 billion gallon biofuels target.

So we have the paradox of a product that we've decided is essential for energy security and environmental reasons--as well as for the continued viability of the US agricultural sector--but that might not be profitable to produce in the desired quantities, at current prices. The government has already raised the possibility of federal assistance for ethanol producers that made bad bets on corn futures. If VeraSun were unable to continue operations during bankruptcy--and its is only the biggest of several recent ethanol bankruptcies--an ethanol shortage could develop, forcing the government to intervene. While it has the authority to issue waivers to oil refiners and gasoline blenders to sell fuel with less than the mandated quantity of ethanol, that was intended as a temporary measure. Perhaps I'm the only one to see a possible parallel to banks that are considered "too big to fail", or to the way the Federal Reserve has engaged in matchmaking to put failing banks into stronger hands, but I see the possibility of much larger ethanol subsidies ahead. At the very least, the combination of $60 oil and tight credit has called the architecture of the government's future renewable fuel policy into question.

Understanding Southwest's Hedging

I don't normally pay much attention to the quarterly earnings reports of companies outside the energy sector, so I initially missed the confusion over the impact of fuel hedging on the third quarter results of Southwest Airlines. An article in yesterday's Washington Post brought this to light again, along with the effect of falling oil prices on the fuel hedging efforts of a diverse group of companies, including Coca Cola, Royal Caribbean Cruise Lines, and local heating oil distributors. The reporting on this subject illustrates two important points: commodities hedging is no free lunch, and understanding its full consequences requires more that a superficial look at the bottom line.

This morning I pored over Southwest's quarterly earnings press release to see what had happened. I was suspicious of the headlines suggesting that hedging had pushed Southwest into the red, because the average futures price of West Texas Intermediate crude oil for the quarter was $118 per barrel--hence ExxonMobil's record-breaking earnings--still well above the level at which Southwest was generally understood to have hedged its jet fuel. After some scrutiny, and to my considerable surprise, I concluded that both the Post and the Wall Street Journal in their earlier story on Southwest's earnings appeared to have misinterpreted some key aspects of the hedging results. Discerning that wasn't easy, since Southwest saw fit to report their earnings on both a GAAP (Generally Accepted Accounting Principles) and non-GAAP basis, and the intricacy of their "Reconciliation of Impact from Fuel Contracts" table forced me to jump-start some brain cells that have been dormant since my B-school financial accounting course.

Evaluating the benefit or cost of a hedge must include the result of the physical transactions it was intended to cover. In the case of Southwest, it appears that its unhedged fuel cost for the quarter--what it actually paid its fuel suppliers--was $1.387 billion. The hedges and related derivative contracts that settled in the quarter offset that by $448 million, reducing Southwest's effective fuel bill to $939 million. The problem that the Journal and Post focused on was related to future hedges, not those that unwound between July and September. Marking the company's total hedge portfolio to market resulted in an additional pre-tax cost of $247 million, reported as a special item. Factoring this in turned the company's modest operating profit of $69 million into a $120 million net loss, after tax. But it's not correct to say that hedging hurt Southwest. Had it not hedged at all, its after tax loss for the quarter would have been approximately $189 million, assuming it could have operated in the same manner. That seems unlikely, given the behavior of competitors with less active hedging programs.

But while the confusion over Southwest's earnings seems to arise from the requirement to recognize the reduced value of the future hedges still on its books as a loss to current income, this doesn't justify calls to set aside mark-to-market accounting. That special item should prompt investors to read the explanation Southwest has provided concerning its overall hedge portfolio, because it signals the prospect of further hedge-related losses in the future:

"In addition to our fourth quarter 2008 derivative position, we have derivative contracts for over 75 percent of our estimated 2009 fuel consumption at an average crude-equivalent price of approximately $73 per barrel; approximately 50 percent of our estimated 2010 fuel consumption at an average crude-equivalent price of approximately $90 per barrel; approximately 40 percent of our estimated 2011 fuel consumption at an average crude- equivalent price of approximately $93 per barrel; over 35 percent of our estimated 2012 fuel consumption at an average crude-equivalent price of approximately $90 per barrel; and have begun building a modest position for 2013."

That means that if oil prices remain between $60 and $70/bbl, then the effective cost Southwest will pay for jet fuel in future quarters could end up higher than that of competitors who didn't hedge or who hedged lower percentages of their expected fuel consumption than Southwest. Of course, that's not certain, either, because the price of oil might again rise above the level of their hedges.

The key to a successful hedging strategy is that companies shouldn't view it as a magician's hat out of which to pull larger profits, quarter after quarter. The benefit comes from reducing the volatility of earnings and enabling firms to continue operating more normally, when others have had to cut back drastically. Although this strategy could rebound on Southwest, if oil prices remain low for an extended period, falling prices may not hurt them as much as rising prices have hurt their less-hedged competitors, some of whom are now in a very poor position to capitalize on lower fuel costs.

Note: Energy Outlook will be on vacation next week, with postings resuming the week of November 10.

Iran's Oil Shield Slips

Between the US election and the gyrations of the financial markets, some important implications of the declining price of oil haven't received the attention they deserve. A case in point is the effect on Iran's geopolitical posture, particularly with regard to its nuclear program. Many articles have considered the impact of lower oil prices on that country's economy and its influence in the greater Middle East. However, as global demand for oil slows and its price sinks toward $60 per barrel, the effectiveness of Iran's implied threat to suspend oil exports in response to aggressive sanctions or a military strike on its nuclear facilities also erodes. This should create an opportunity for some very assertive diplomacy by the next administration, backed by a much more credible recourse to force. Given the progress of the visible parts of its nuclear program, this could be our last chance to prevent Iran from developing nuclear weapons.

A recent Washington Post op-ed by two former US Senators, one from each party, described the threat posed by a nuclear-armed Iran, along with a set of principles for addressing this challenge vigorously and promptly. Several years ago I took a detailed look at the rationale for Iran to build an entire nuclear fuel cycle for civilian purposes and found it wanting. The world's second-largest natural gas reserves provide it with a much more cost-effective means of generating additional power for its economy, without exposing the country to international sanctions or potential attack. Notwithstanding the findings of a controversial US National Intelligence Estimate last year, the simplest explanation for Iran's tenacity in pursuing uranium enrichment is the option that creates for building nuclear weapons. Nor has the International Atomic Energy Agency been able to gather enough information within Iran to rule out this scenario. This interpretation also aligns nicely with Iran's extensive work on ballistic missiles, which without the extreme accuracy of US missiles looks like a very expensive way to deliver conventional explosives.

Until recently, Iran has held all the cards. With the US focused on wars in Iraq and Afghanistan, Iran successfully played off Russia and China against other UN Security Council members that sought tougher sanctions to back up their diplomatic efforts to halt the nuclear program. And as oil prices went from high to astronomical, the consequences of a disruption in Iranian oil exports became increasingly unbearable and unthinkable for the US and the world economy. While still potentially quite disruptive and hardly to be invited lightly, that prospect looks much less dire today.

Iran exports a bit more than 2 million barrels per day (bpd) of oil. For most of the last four years, that quantity exceeded the sum of global spare oil production capacity, rendering Iran's contribution indispensable. That is no longer the case. Just last week OPEC announced production cuts that could cover all but 900,000 bpd of Iran's exports, with further cuts in prospect. Any shortfall beyond that could be made up from the US Strategic Petroleum Reserve, which could supply the difference for up to two years, if necessary. Oil prices would rise, though prompt releases from the SPR would limit the magnitude of any spike. In other words, if the Iranian government has assumed that the dreadful prospect of an Iranian oil embargo was sufficient to deter any measures strong enough to force them to give up their nuclear program, or to disable it on the ground, they should reconsider. Their ace-in-the hole looks more like a 10 or a Jack, today.

These altered circumstances should not be construed as providing a green light for air strikes on Iran's nuclear facilities. That option should remain a last resort, due to its many adverse consequences beyond oil. At the same time, because this and a number of less-violent steps suddenly look feasible, it might induce Iran to negotiate, prompted by the realization that it has more valuable things at stake than a uranium-enrichment program, including the health of an economy that is critically dependent on oil revenue and on imports of petroleum products that its own refineries cannot produce in sufficient quantity to satisfy domestic demand without rationing. While not exactly a silver lining of the present global crisis, this constitutes an opportunity that Western governments cannot afford to ignore, because its consequences will endure long after the present financial and economic problems have been resolved.

Slowing Growth and Lower Emissions

Even before the global economy began to stumble, 2009 was set to be a milestone year for climate change policy. A new US administration will take office with a decidedly more pro-active attitude toward addressing climate change, and international negotiations are expected to culminate in a new agreement to replace the Kyoto Protocol, which expires in 2012. But while efforts to address climate change have always had to contend with their possible impact on the economy, we are receiving a vivid reminder that this relationship also works in reverse: a slowing economy will emit fewer greenhouse gases than if growth continued at previous rates, and the financial burden of emergency fiscal stimulus and capital injections will hamper governments' ability to dedicate large sums to addressing climate change.

This morning I was looking at the most recent oil market estimates from the International Energy Agency in Paris. In January the IEA had expected global oil demand for 2008 to average 1.7 million barrels per day (MBD) higher than in 2007, or +2%, exceeding the 1.5% growth in 2007 that had helped to push oil prices from the $50s into the $90s per barrel. As of October 10, however, their estimate for 2008 has fallen to 86.5 MBD, a scant 0.5% increase over last year. Nor do they expect growth to pick up much next year. Their current 2009 forecast is for an average of 87.2 MBD, down from 87.7 MBD in July, and growth will almost certainly fall further--perhaps below zero. We see the tangible echoes of these expectations in falling oil prices and in the 1.5 MBD production cut announced by OPEC on Friday.

Each million barrels per day of global oil demand equates to about 160 million metric tons of greenhouse gas emissions per year. The consequences of high oil prices and slowing economic growth have thus reduced 2008 emissions by around 200 million tons of CO2, and the OPEC cuts should take a comparable slice out of next year's emissions, with the total slashed by even more, when consumption of other fossil fuels is taken into account. Of course, this represents only about 0.5% of global GHG emissions, and it falls far short of the kind of reductions that climate experts have called for.

What can we conclude from this simple observation? First, it shouldn't surprise anyone that the relationship between economic growth and energy consumption--and hence emissions--should work in both directions. But simply cutting growth can't be a desirable way to tackle climate change, not least because the reduction in growth necessary to achieve the desired emissions levels would be catastrophic for both developed and developing countries. Nor are countries in deep recession likely to spend as much on environmental protection, notwithstanding all the recent euphoria about "green jobs." And if the pessimists are right, merely slowing our emissions growth won't even buy us time for improving our responses, because we've already passed the sustainable level of atmospheric CO2 concentration. If that's true, then no realistically-achievable climate treaty is going to solve the problem before it gets much worse.

Because I still view climate change in terms of risks and trade-offs, however, I see one bright spot in the current economic difficulties. With their governments and trans-national institutions such as the G-8, IMF and World Bank scrambling to forestall a global financial and economic collapse, the negotiators following the Bali Roadmap towards a new climate agreement to be announced in Copenhagen next December must focus on approaches that deliver the largest emissions reductions at the least cost, with the least damage to an already fragile economy. That seems likely to produce the most sustainable result, in any case, and thus the response that is best suited to endure the financial instability that the further progress of climate change, itself, could still deliver, on top of the boom-bust cycles of markets.

A Slower Green Shift?

The global financial crisis could not have arrived at a worse time for alternative energy. When I read the comments of many of my fellow bloggers concerning the implications of a recession for the near-term implementation of green energy, advanced technology vehicles, and action on climate change, the spectrum runs from denial to despair. This is understandable, considering how bright the green future looked when oil was on the threshold of $150 per barrel. The world has changed a couple of times this year, and the latest lurch does not very bode well for "cleantech", unless you are in the lemons-into-lemonade mold of The New York Times's Tom Friedman, who sees a "green buildup" as the basis for reviving the economy. With the media issuing moment-by-moment comparisons to the Great Depression and every other economic setback in the history of capitalism, it's easy to lose sight of the likelihood that however bad the next year or two might be, compared to the boom period that has just ended, the economy will recover, and with it, the driving forces that support the shift to cleaner, more efficient sources and uses of energy.

That could be small consolation for companies that have bet their future on a successful green product launch during the next two years. GM's Volt plug-in hybrid car comes immediately to mind. Even if GM survives long enough to complete its investment in mass-producing this "range-extended electric vehicle", the stars are lining up to impede its rapid market penetration. GM hasn't announced its sticker price, yet, but if it is close to the $40,000 figure that GM's Vice Chairman Bob Lutz mentioned earlier this year, then even after the federal tax credit of up to $7,500 for the first 250,000 plug-in hybrids, it would be a stretch for most consumers during a downturn in which car loan terms become stricter. Moreover, sub-$3 per gallon gas prices would stretch the car's fuel savings payout compared to a non-plug-in Prius into decades, rather than just years. The success of the 2010 Volt might depend on the looming recession being an average one, of less than a year's duration, rather than the deep and prolonged downturn that the media and the stock market appear to expect.

The timing of Honda's new Insight hybrid model looks somewhat better. Using a simpler hybrid system than either the Volt or the Prius, it is aimed at more price-conscious consumers. If, as expected, the Insight retails for under $20,000, it would deliver 40+ mpg hybrid performance at price that competes with such non-hybrids as the Ford Focus, or with VW's similarly-efficient Jetta TDI diesel, after tax credits. More radically, a slowing economy might be just what is required to sell not just new cars, but an entirely new model for selling mobility, such as the electric-vehicle-based approach of Better Place--assuming that it can be financed on the scale necessary to have an impact.

Savvy consumers and businesses should recognize that cheaper gas is much more likely to be short-lived this time than it was after the first energy crisis. While OPEC might struggle to cut production enough to defend a $60 or $70/bbl price in the short term, the current credit crunch is already sowing the seeds for slower production growth in the future, as smaller oil companies will be forced to scale back their exploration and production activities, and as national oil companies in Venezuela, Iran and elsewhere are forced to remit even more of their revenues to fund non-energy government programs, rather than their oil & gas capital budgets. That could set the stage for an even bigger oil price spike within a few years. Still, if you are worried about your job, or are struggling to keep up with your mortgage and home-equity loan payments, buying the greenest car on the planet might not be your highest priority for the near future.

Candidates & Energy: McCain Revisited

Before delving into the details of Senator McCain's energy plans, it's worth noting how remarkable it is that our final choice should be between two candidates who view our energy and environmental challenges so similarly, even if their preferred solutions differ markedly, both in execution and in their underlying philosophy. It was not at all a forgone conclusion that the ultimate Republican nominee for President would consider climate change as a problem rivaling energy security, or that he would regard action on the former as a means of addressing the latter. Several of Senator McCain's challengers in the primaries appeared to view climate change as either a hoax or a nuisance issue. In essence, Senator McCain's proposals would create a transition plan for moving the US economy towards using much less imported oil, improving overall energy efficiency and reducing emissions. This would be achieved by ramping up domestic energy production, encouraging new energy and efficiency technology, and putting a market price on greenhouse gas emissions.

If you asked me for the single-sentence summary of the McCain energy plan, it would be nearly identical to one for the Obama Plan: "Make the US more energy independent and reduce greenhouse gas emissions through an emissions cap and trade system and other measures." The energy and climate sections of Senator McCain's campaign website mirror these priorities. Although it has gained considerable detail since I reviewed it in January, it remains less specific than Senator Obama's site. That no longer appears to be an omission, but rather a reflection of a profound philosophical difference in their approaches.

Where Senator Obama's energy plan relies heavily on mandates or incentives for specific technology pathways--electrified vehicles, for example--Senator McCain's emphasizes outcomes and offers incentives based on making progress towards them. For example, his Clean Car Challenge provides consumers with incentives for purchasing advanced technology vehicles based on the reduction of CO2 emissions they achieve, with zero-emission vehicles (tank-to-wheel) qualifying for a $5,000 tax credit. In addition to a tax credit for R&D, he proposes an X-Prize-like $300 million payoff for a quantum leap in vehicle battery technology. He would also end both the subsidy for domestic corn ethanol and the tariff on imported ethanol, forcing US ethanol producers to compete with other fuels, and particularly with more energy-efficient cane ethanol from Brazil and the Caribbean.

This emphasis on outcomes also applies to Senator McCain's approach to vehicle efficiency. Rather than calling for further increases in the recently-enacted 35 mpg Corporate Average Fuel Economy target for 2022, he has proposed strengthening CAFE enforcement by increasing the fines for missing the targets already in place--something that has received scandalously-little attention. This currently amounts to $55 per car for each mile-per-gallon below the standard. In 2006, for example, Daimler Chrysler paid $30 million in fines on 196,000 imported Mercedes Benzes, or $154/car. If CAFE is to be an effective tool for promoting fuel efficiency, rather than just measuring it, it must have sharper teeth than that.

Senator McCain's approach to climate change builds on the first cap & trade bill that he co-authored with Senator Lieberman in 2003 and reintroduced in the Senate in 2005 and 2007. His current version of this proposal would reduce US greenhouse gas emissions by 60%, compared to 1990 emissions, with milestone targets along the way. The first of these would see US emissions return to 2005 levels by 2012. That would make for a relatively soft transition, since 2006 emissions were below 2005's, and a slowing economy is liable to reduce them further. The gradual phase-in of auctioning for emissions permits would also ease the transition into this otherwise radical means of transforming the US energy economy. However, as I noted in my analysis of Senator Obama's plans, cap & trade would still function much like a tax on the entire economy, with potentially serious consequences during a major economic downturn. The odds of enacting and implementing such a system in the next two years have clearly diminished within the last month, no matter how high a priority either candidate deems climate change to be.

The most notable departure from Senator McCain's focus on outcomes, rather than specifying technology, involves nuclear power. He has described nuclear energy as a centerpiece of his energy security and climate change program and proposed building 45 new nuclear reactors in the US by 2030, with a target for eventually building 100 new plants--presumably to counteract the eventual retirement of most of the existing fleet of 104 reactors, some of which date to the early 1970s, with the newest having been completed in 1996. This is a very ambitious goal, and it represents one of the biggest differences between the energy plans of the two candidates. Senator McCain's confidence in nuclear power appears to rely as much on the decades-long experience of the US Navy with nuclear propulsion as on the current power reactor fleet that supplied 19% of all US electricity generated last year. Senator Obama has frequently expressed concerns about the safety, security, waste disposal and proliferation risks of nuclear power, and although he supports it in principle, it is not obvious that any of the nuclear plants for which permit applications have already been submitted would proceed in an Obama administration.

As helpful as more nuclear power plants would be for reducing the emissions that accompany our current reliance on coal-fired power plants, along with enabling truly zero-emission electric vehicles--as opposed to those that merely shift their emissions to a central power plant--nuclear is no quick fix. Considering that the only US nuclear power plant already under construction--following a 20-year hiatus--is not expected to start up until 2013, the 2030 timeline for achieving the 45-reactor goal looks just barely long enough. Perhaps that explains Senator McCain's emphasis on drilling for oil and gas in portions of the US currently off-limits to exploration, as a transition strategy to buy time for renewables and nuclear power to ramp up.

His support for expanded drilling covers the estimated 18 billion barrels of undiscovered potential oil resources and 77 trillion cubic feet of natural gas that were restricted by the recently-expired federal drilling ban, but it apparently does not extend to lifting the ban on drilling in the Arctic National Wildlife Refuge (ANWR.) While the mantra of "Drill Here, Drill Now" may seem overly simplistic, inclusion of conventional energy recognizes two key facts of our energy security challenge: The US still possesses enough remaining hydrocarbons to make a serious dent in our oil imports--though not to displace them entirely--and those hydrocarbons represent a concentrated and efficient energy source (in the energy return on energy invested in producing them, EROEI,) on a scale that renewable energy will not attain for years to come.

Although many of the elements of Senator McCain's plan look sensible, I still struggle with the notion of energy independence that underpins much of his--and Senator Obama's--energy strategies. Although Senator McCain has recently refined his goal of "strategic independence" to encompass backing out Middle Eastern and Venezuelan oil, we might get greater benefits from a more positive strategy of working with our natural hemispheric allies, such as helping Mexico revitalize its flagging energy industry and partnering with Brazil to develop its vast new oil finds, while we expand our own sources and use energy more efficiently. That would enhance energy security in a manner more consistent with the Senator's general espousal of free trade principles.

With regard to energy and the environment, voters face a difficult--and thus extremely fortunate--choice between two candidates who treat the energy crisis and climate change with the seriousness that these closely-connected issues deserve. The proposals of either one would move us much closer to a coherent and practical national energy policy, something that we have not had for far too long. At the same time, the differences in their approaches are significant and merit careful consideration. While Senator Obama's plans may depend too heavily on help from a federal government that could be over-extended by a number of other pressing concerns, Senator McCain's may rely too much on free market solutions that would be a tough sell in light of perceptions concerning the causes of the current financial crisis. And if elected, either one would find himself facing a powerful Congressional majority with its own ideas for solving these problems. The one certainty is that I will not lack for suitable topics on which to blog in 2009.

The New Oil Cycle

As of yesterday's close on the New York Mercantile Exchange, the price of crude oil has fallen 50% from its July high-water mark. The membership of OPEC must be experiencing an uncomfortable sense of déjà vu, recalling a similar drop between August 1997 and December 1998, when West Texas Intermediate (WTI) bottomed out at $10.72 per barrel, and the OPEC average price fell into single digits. The cost of production is much higher today than in the 1990s, so $10 oil is hardly in prospect, but even an extended period below $50 per barrel would cause severe pain to the oil industry and to anyone investing in alternative energy that competes with oil. However, while a return to $140 oil probably lies on the other side of a global recession, other structural changes could shorten the down-cycle, or at least put a relatively high floor under it, once the customary market overshoot has passed.

Previous oil-price cycles hold some useful insights into the likely bottom of the current cycle, but important differences are also apparent. The 1997-98 collapse was caused by a conjunction of events with strong parallels to today's situation. A wave of new oil projects collided with a sudden drop in global demand triggered by the Asian Financial Crisis. Producers faced a choice between cutting output and bearing unsustainable losses on every barrel sold, but their obvious response was complicated by two serious problems. Operators of mature oil fields employing secondary and tertiary recovery methods knew that once shut in, production might not return to previous levels, later. My former employer, Texaco, saw that happen at its century-old Kern River Field in California. Meanwhile, OPEC's members worried about a long-term loss of market share, similar to what occurred when demand for OPEC's crude fell by 44% between 1979 and 1985, requiring two decades to recover. It took an unprecedented coordination of production cuts between OPEC and Mexico, Russia and Norway--countries that might have otherwise capitalized on OPEC's unilateral cuts--to stabilize the market and nudge prices back into the $20s by mid-1999.

What's different today? Well, for starters, OPEC already has a working relationship with Russia, and the latter's output has stalled, while Norway and Mexico are both in decline. Meanwhile, OPEC has expanded to include Angola, formerly an important source of non-OPEC production growth. If OPEC cuts now, it's hard to see who would step in to steal their market share. The cartel has also enjoyed a better-than-normal degree of cohesion recently--always easier when you are producing essentially flat-out. Key producers such as Venezuela and Iran have seen first-hand the benefits of cutting a little to boost revenue a lot, and their economies depend on prices remaining near $100 per barrel.

Another important change since the late 1990s is the dramatic growth of Canadian oil sands output. The current production of 1.3 million barrels per day now constitutes a large fraction of the world's high-cost marginal supply. More than half of it comes from mining operations that could be slowed or temporarily halted with minimal impact on future output or ultimate reserve recovery. In other words, a drop in crude oil prices below the variable cost of producing synthetic crude from oil sands could be at least partly self-correcting, and fairly quickly.

Biofuels might end up in a similar position. With corn prices back down to around $4 per bushel and ethanol selling for an average of $2.22 per gallon at racks on Wednesday, the "crush spread", or gross margin for producers is around $0.80/gal, similar to where it has been for much of the year. But although ethanol had for most of the year been priced well under Gulf Coast gasoline, the sudden collapse of gas prices has inverted that relationship. With wholesale gasoline--specifically the RBOB mix designed for blending with ethanol--trading on the NYMEX at under $1.70/gal, and the ethanol blenders' credit falling from $0.51/gal to $0.45/gal on January 1, the incentive for refiners to blend more ethanol into gasoline than legally mandated is evaporating.

How quickly these factors could establish a hard floor under oil prices is anyone's guess, and I wouldn't be surprised to see WTI go well below $70/bbl before it corrects. This year's highs might have been helped along by a froth of speculation, but they were also what was required to destroy enough demand to bring a commodity with a low price-elasticity of demand back into balance with supplies that were straining at their near-term limits. That interpretation is also consistent with the dramatic fall in prices accompanying the current collapse of demand. But we can't forget that even if demand in the US and EU continue to shrink, thanks to conservation, efficiency, and alternative energy, the potential demand in Asia remains sufficient to outstrip global oil production capacity, once strong global economic growth resumes. Consumers should enjoy the relief from sub-$3.00 per gallon while it lasts, but they should not assume it will persist beyond the recession.

Candidates & Energy: Obama Revisited

The US Presidential election is now under three weeks away, after the longest campaign in living memory. Unsurprisingly, after several years of escalating oil prices, energy features prominently in the programs of both candidates, as does a response to growing concerns about climate change. Senator McCain and Senator Obama have spoken extensively on these issues, and both campaigns' websites feature lengthy discussions on US energy challenges and the possible solutions to them. Unfortunately, their ideas must be weighed in the context of a weakening economy and a federal budget deficit that may ultimately approach a trillion dollars per year. With their attention focused on the financial crisis and the shifting electoral map, it is not clear how much thought either campaign has devoted to reassessing their energy and climate programs in light of the changed circumstances in which the next administration will find itself. After flipping a coin, I will begin with Senator Obama and follow up with a review of Senator McCain's energy proposals within a week.

It seems appropriate at the start to remind my readers of this blog's determined non-partisan stance. My focus is on the candidates' energy policies and anything relevant to those, without making any endorsement. My goal is to provide my readers with insights on the energy aspects of these two candidates' proposals, including their pitfalls, based on my own perspective and experience. However important, energy is only one issue among the many upon which they should base their choice.

Senator Obama has a detailed, coherent energy plan, and his team has clearly spent a lot of time assembling and refining the energy proposals outlined on the campaign's website. Compared to the version I examined in January, during the primaries, the Senator's energy and climate framework has evolved and become more realistic. Although energy independence is still a major theme of Senator Obama's energy platform, his independence goal has become more specific and less ambitious. It is currently stated in terms of reducing our oil imports by an amount comparable to what the US receives today from the Middle East and Venezuela. That equates to around 3.3 million barrels per day, or roughly one-third of net US oil imports in 2007. As I noted recently, such a reduction just might be feasible, but not without a significant effort to ensure that US oil production does not continue to decline. Instead, Senator Obama appears to consider the US tapped out for oil, and apparently expects his energy independence goals to be met without more help from that quarter.

That assessment pervades his approach to the oil & gas industry, though recently he has described natural gas in more favorable terms. It is also consistent with his periodic citations of the "3% of reserves vs. 25% of consumption" soundbite, which drastically understates the remaining resource potential of the US. This may explain his 2006 vote against a modest expansion of the allowed drilling area in the Gulf of Mexico, and his restrained support for expanded access to oil & gas during this summer's Congressional debate on various drilling proposals.

If anything, he seems to regard the domestic oil industry not as a potential source of new supply, but as a source of new tax revenue. His short-term energy program leads off with one-time energy rebates--$1,000 per family or $500 per individual taxpayer--funded by a windfall profits tax on oil companies. He hasn't put a price tag on this, but assuming all taxpayers would be eligible, it would require on the order of $20 billion dollars per year in new taxes over the next five years. Although there are legitimate differences of opinion on the justification for such a tax, its consequences for future US oil output are unambiguous: what you tax more, you get less of. The most positive elements of the Senator's oil strategy feature some interesting ideas for extracting more oil from existing reservoirs through CO2 injection--simultaneously sequestering it. He also supports building a natural gas pipeline from Alaska to the lower-48.

With regard to climate change, Senator Obama shares my preference for an emissions cap with credit trading over a carbon tax. His version would be stricter than the one embodied in the Boxer-Lieberman-Warner Bill defeated earlier this year, with deeper cuts and auctioning of all credits. Although the latter reflects the view that partial auctioning in the EU's limited cap & trade system resulted in a windfall for emitting industries, it also increases the revenues that would be collected to well over $100 billion per year, based on current emissions and the likely cost of credits. The Congressional wrangling over how to spend the smaller windfall from Boxer-Lieberman-Warner was nearly enough to turn me against a policy I have promoted for nearly a decade. We also can't lose sight of the fact that, like a tax, cap-and-trade would raise energy costs for consumers and businesses. That may be a necessary evil, but it is still a fact that has received precious little attention in this campaign. If the price of emissions credits settles at the current European level, we would see gasoline go up by about $0.35/gal, and electricity prices rise by up to 3 cents per kilowatt-hour.

Nor would cap & trade supersede the existing system of selective incentives and tax credits. Initially, at least, it would be additive to these, and apparently also to Senator Obama's $150 billion plan to promote alternative energy technologies over the next 10 years, along with a new low-carbon fuel standard and a greatly-expanded federal biofuels mandate--from 36 billion gallons per year (BGY) by 2022 to 60 BGY by 2030. I still regard the 36 BGY target with its 21 BGY of cellulosic and other advanced biofuel as a stretch, since the first commercial-scale cellulosic biofuel plant has yet to start up. 60 billion gallons is beyond ambitious.

Not every element of Senator Obama's energy plan represents a departure from current policy. His proposal for a 4% per year improvement in Corporate Average Fuel Economy for vehicles is broadly consistent with the 35 mile-per-gallon fleet CAFE target for 2022 adopted in the Energy Independence and Security Act of 2007, and his proposed tax credit of up to $7,000 per car for plug-in hybrids and electric vehicles closely resembles the incentives included in the $700 billion rescue bill recently signed into law. And with regard to "clean coal", his approach seems similar to the Department of Energy's restructuring of its Futuregen program, earlier this year.

There is much to like about Senator Obama's positive vision of cleaner energy, focused on making America more self-sufficient. At the same time, it would impose the biggest and most intrusive changes on US energy markets since at least 1980, entailing the collection and redistribution of many hundreds of billions of dollars--not temporarily, as contemplated for the current federal intervention in financial markets, but on an effectively perpetual basis. The benefits of cutting our energy imports and greenhouse gas emissions to a more sustainable level would be significant, though if we are serious about reducing our reliance on unstable foreign oil suppliers, it is counter-productive to pit solar, wind and biofuels against domestic oil & gas, which today contribute roughly 30 times as much net energy to the US economy, and could do more. We may indeed be entering a new era of big government; however, while parts of the Senator's energy plan would stimulate new industries and new jobs, other portions would act as a drag on existing businesses, and on consumers. This may ultimately be necessary, in order to tackle climate change, but undertaking it during a recession would complicate efforts to revive the whole economy, not just its new green parts.