Surprise Courtship
Today's Financial Times reported that Total of France (formerly TotalFinaElf) has the backing of Russia's government in acquiring a 25% stake in Sibneft, which is in the process of unwinding its merger with Yukos. This comes as something of a surprise on this side of the pond, considering that ExxonMobil and ChevronTexaco were widely seen as the leading bidders, with moral support from the US government.

Total is hardly a household name in America, having exited its modest refining and marketing presence here some time ago. In fact, its production levels and sales and profitability (at current dollar/euro exchange rates) put it in a dead heat for size with ChevronTexaco, behind ExxonMobil, BP, and Royal Dutch/Shell.

Total is also well-positioned to take advantage of the current geopolitical situation, in which some governments may be looking for an alternative to American or British companies. In bidding for Sibneft, Total looks to benefit from the closer relationship that was forged between France and Russia in the leadup to the Iraq War. Although the French government no longer hold its "golden share" in Total, the company still enjoys a unique level of government support and sympathy, as the sole standard bearer in this key industry.

Besides being the largest refiner and marketer in Europe at the moment, they have clear aspirations to become more global, complete with a new logo meant to symbolize global activity and multiple forms of energy. I suspect we'll see more moves like the Sibneft stake in the future.

Wrong Place, Wrong Time
This week's Economist provides an interesting update on a project I had lost track of. Going back to the mid-1990s, the state oil company of Vietnam had planned to build a refinery--the country's first--in the middle of their long coastline at Dung Quat. Despite the departure of all its foreign partners, PetroVietnam apparently won't give up on this idea, and now seems to want to build not one, but two refineries. The Economist correctly points out the dismal prospects of such a facility ever generating a return on its multi-billion dollar cost.

State enterprises have no monopoly on poorly-chosen projects. Several other refineries in the region were built by international companies to excellent designs, but only made sense under the rosiest of forecasts. This was an easy trap to fall into in the boom years of the 1990s, and I bear my own small share of the guilt. But during my time in the energy business in Asia-Pacific, I saw many examples of the pernicious nationalism that the Dung Quat project exemplifies.

Nearly every country in the region at one time or another has wanted a flagship petroleum project. For countries without a lot of oil or gas, that typically meant a refinery. These projects were explicitly tied to national prestige, as well as optimistic demand forecasts. Of course since refineries take a long time to design, fund, and build, your economics have to rely on forecasted demand. However, you cannot ignore forecasts of alternative supply, as too many such projects appeared to do.

Against a backdrop of globalization, refining capacity surpluses in other regions, and a developing surplus of refined products in Asia-Pacific, could the outcome of these projects been other than disappointing? We are talking about the destruction of billions of dollars of shareholder value for the industry, and the creation of large non-performing loans on the books of developing countries. The stigma of having to import your fuel needs from Singapore or Korea can't be worse than that.

This is the reality the PetroVietnam planners--and their World Bank investors--need to face. Isn't this what gives large-scale economic development such a bad name?

Missed Signals
Every day brings new headlines concerning Shell's booking of oil reserves. This is the typical pattern for scandals of this type. While I've made the odd comment along the way, here, there have generally been enough other topics to talk about, and the FT, WSJ, and NYT are generally doing just fine covering the story. When I thought about it this morning, though, I finally realized what had bothered me most about the revelations concerning Shell's top management. It wasn't just that Shell had a solid reputation in the industry. My discomfort stems from what I do for a living.

For the last seven years I have been involved in scenario planning, initially within a major oil company and now as an independent strategy consultant. In the world of scenario planning, Shell was the great groundbreaker, developer of many of the techniques still used, and most visible and vocal corporate practitioner of the technique. Just go to their website and look at all the information and articles devoted to the subject, as well as current and past scenario output.

The disconnect is not that Shell didn't have some previously worked out scenario dealing with a corporate scandal--they might--but that an organization that so rigorously analyzes the major social, political, and economic trends and forces shaping the world in which they do business should have failed to internalize the learnings from that work at the highest levels in the company.

In particular, consider their concept of TINA, "There Is No Alternative." As I understand it from reading their publicly available material, TINA would include the increased need for transparency, something Shell has embraced in the context of corruption. But somehow that didn't translate into elevating transparency with shareholders into a deeply-held value at the top. The principles are the same.

My purpose is not to pillory Shell. Rather, this should be another loud wake-up call to business across the board, as if Enron, WorldCom, Parmalat, et al weren't adequate clarions. Simply put, it's what so many managers derisively refer to as the "soft stuff", the things that constantly get trumped by the expediency of meeting this quarter's numbers. Getting the soft stuff wrong can cost you far more than any deficiency in your basic operations.

Having processes, programs and standards in place is not sufficient, if the leadership does not live by the principles behind them, and apply those principles equally to areas that were not their original focus. All the scenario planning in the world is pointless, if the human beings who commission it and participate in it are unwilling to accept what it tells them about the changing external world.

Clean Air
Last Wednesday (4/14) I commented on an article in the NY Times Magazine concerning the New Source Review policy of the Environmental Protection Agency. Yesterday's NY Times carried an editorial by David Brooks that also mentions New Source Review, as part of an overall report card on the Bush administration's environmental record. Brooks's basic conclusion is that things have improved pretty dramatically in the last couple of decades, but there are still some important gaps, notably on climate change. My view is pretty close to his.

To see why, you have to turn the clock back to the first Earth Day in 1970 and then fast forward to the present. It makes for an interesting movie. Watch the US population grow from 203 million to 293 million, and the number of vehicles on the road climb from 111 million to 235 million, each driving 19% more than their 1970 predecessors. Gross Domestic Product zooms from $3.8 trillion to 10.2 trillion, in year 2000 dollars. Against this background, a major focus on improving the environment delivers air that is cleaner in many places, and water that is generally purer. The dire predictions about the environment from the 1970s fail to materialize, because of hard work, tough policies and a large amount of investment. This brings us to to where we are today.

If we want to extend this improvement trend, should we continue the same policies as in the past--the ones that got us the benefits we can see--or do we need to try something different? Most environmentalists would probably say stick with what we know, but make it tougher. But this flies in the face of some awkward facts.

Consider vehicle tailpipe pollution. Modern cars emit only a small fraction of the pollution of a 1970 model, thanks to changes in fuel quality and engine technology, and the addition of catalytic converters. But the benefits of these advances are partially offset by the dramatic increase in total miles traveled, a trend that seems set to continue. Short of eliminating fossil fuels or replacing the internal combustion engine--either of which will take decades--we are approaching the point of rapidly diminishing returns.

What this suggests to me is that we should celebrate our achievement of the last two decades, scrutinize its history for what worked well and what didn't, and formulate new policies based on that learning and on the recognition that the problems we face have evolved and our old levers to move them have become less effective, as a direct result of their past success. Is it possible even to float such an idea, let alone get it enacted, in light of the quasi-religious zeal exhibited by both extremes of the argument? It would be close to heresy, and you know what they do to heretics.

Gas Taxes
In my April 9 posting I referred to remarks by the Chairman of Ford Motor Co. concerning higher gasoline taxes. This Sunday's New York Times business section carried a longer analysis of the issue, placing it in a useful historical and international context.

It was particularly interesting to see the comments by spokesmen for the Sierra Club and Union of Concerned Scientists, both of whom dismissed the auto industry's apparent endorsement of higher taxes as frivolous. This strikes me as ungracious. When your opponent concedes one of your major arguments, for whatever real or imagined reason, shouldn't you give him a little credit for it? In addition, the rebuttal by Mr. Friedman of the UCS is a little like the old one about trees falling in the forest; if we "save consumers money by raising fuel economy standards" on cars they don't actually buy, who benefits?

The article also cited Mr. Friedman's concern about the impact of higher gas taxes on the poor without mentioning the numerous solutions to this proposed in the past, such as income tax credits for fuel taxes paid, up to some income threshold. But this is a minor cavil.

At the heart of the question of higher fuel taxes is a serious objective, reducing our consumption of petroleum and its products. But behind that objective is a lot of fuzzy thinking and no consensus at all. Why do we want to reduce petroleum consumption? To protect the environment? To avert climate change? To increase national security? To reduce our trade deficit? Is oil just another input to the economy, or is it somehow different and special?

The current presidential campaign is as nasty as any I can recall, and at an earlier stage. It is probably not the ideal setting for trying to resolve some of the questions I've raised in the paragraph above, but at a minimum we should be comparing the substance of the two candidates energy plans, rather than debating the merits of a proposal that everyone agrees neither man is likely to implement.

Just Another Scandal?
We must be growing inured to scandals. After revelations concerning Enron, WorldCom, Parmalat, and even staid companies like Shell, where does the scandal concerning the corruption of the UN's Iraq Oil for Food office fit? As William Safire notes in today's New York Times, a number of high profile individuals are implicated, including several very close to Secretary General Kofi Annan. At the same time, President Putin of Russia seems intent on hamstringing the proposed independent investigation. This suggests that Putin sees more potential for damage in what such an examination might uncover than in the appearance of guilt created by his stonewalling.

Pressing Russia and other foot-draggers will risk international relationships that are only starting to recover from their pre-Iraq War. And what will we learn? That some unscrupulous people lined their pockets at the expense of poor people in Iraq? That sort of thing happens every day, right?

I believe there are compelling reasons for exposing the full extent of malfeasance in administering the Oil for Food fund, and the most important concerns the future, rather than the past. Politicians and talking heads across the spectrum are calling for the US to turn over responsibility for civil administration in Iraq to the UN. If the UN takes on this role, we must aggressively manage the risks this will entail, and one of the largest of these is for corruption on a vast scale.

The Oil for Food program, which marketed Iraq's oil exports under sanctions, must have created tremendous temptations. After all, it involved billions of dollars of oil, relief supplies, and authorized replacement parts flowing through a system cluttered with bureaucrats and middlemen. But if that program had inherent incentives to cheat, just imagine the opportunities for corruption involved in running the entire country and administering not only oil, but contracts for reconstruction, education and infrastructure development, to name a few.

Before taking on such a task, the UN must empty its closet of all the baggage associated with Oil for Food. Anyone who took part in corrupting that program must be either dismissed or banned from future participation in Iraq. The UN leadership must signal strongly that such behavior will not be tolerated, and this must be clear not only inside the UN but also to every organization with which it would have dealings. Doing this will require new rules on transactions.

When you look at the kind of deals in which the Oil for Food program engaged, it is easy see how things went astray. While the international oil markets include many pure traders, along with producers and true end-users, the number of Oil for Food contracts in the hands of middlemen is a red flag. Among these middlemen were companies facing indictments in the US for past misdeeds. From this standpoint, Oil for Food seemed better structured to administer "baksheesh" than relief aid. Any UN Iraq mandate must be founded on transparency and a bias for dealing directly with suppliers and end-users, eliminating entirely any "brother-in-law" deals.

Finally I think it is important to remember the larger cost of the subversion of the Oil for Food program. It was set up to alleviate the impact on Iraq's population of the UN sanctions that enforced the ban on Iraq's post-Gulf War rearmament. Not only did corruption take food from the mouths of Iraqis, but it also gave Saddam Hussein the funds to invest in arms, palaces, and the personal largesse that kept him in power. In short, this corruption seriously undermined the effect of the sanctions and weakened the best alternative to war. Anyone doubting this should look at the recent, muich more positive outcome in Libya.

If the international community wishes the UN to be the vehicle for stabilizing Iraq, then it must be willing to purge the UN bureaucracy of those responsible for the Oil for Food debacle, as a prerequisite to assuming responsibility for nation-building and reconstruction in that country. Failing to do so will reduce the UN's credibility and guarantee a less effective, and likely unsuccessful effort. None of us can afford that.

Biofuels and Oil Reserves
Two articles from this week's Economist caught my attention. The first discusses the application of biotech to fuels and related products, such as plastics. Although I've been critical of the current US ethanol policy, there is tremendous potential in tapping the energy content of agricultural waste. New enzymes and "bio-refineries" are making this possible, but as the article points out, the economics still hinge on the price of oil.

The second article poses some useful questions for the current debate on how oil companies book their oil and gas reserves. This measure serves two important purposes, one of which is important primarily to a company's investors, the other of broader interest.

First, reserves are a measure of the firm's potential for future value creation through the exploitation of assets it already controls, as well as providing insights into the relative competitive efficiency of its operations for finding and producing oil and gas. Both are of critical importance to stock prices.

The second purpose of the reserves data is more basic, as a snapshot of the company's ability to sustain its current production volumes of oil and gas. This has implications not only for shareholders, but for those concerned with the ability of the industry to cope with growing energy demand, shifting geopolitics, and industry restructuring. For instance, in the aftermath of the industry consolidation of the 1990s and early '00s, are the collective reserves of the merged companies greater or lesser than the sum of the parts that went into them? If claims of synergies are to be taken as more than ephemeral cost savings, they should manifest in an increased capability to convert probable reserves to proved reserves and reserves to dollars.

The standards that support a uniform view across all companies in the industry need to take both of these perspectives into account, as well as the issues of changing technology and markets identified by the Economist. I doubt this concern will fade as Shell gets its house in order.

Oil's Impact on the Economy
The latest Consumer Price Index (CPI) figures for the US indicated an increase for March of 0.5%, with core inflation excluding food and fuel of 0.4%. Even though the current high gasoline prices are not part of the core inflation rate, it looks like we are beginning to see the result of sustained high prices for the oil and natural gas inputs used by businesses in the goods they sell to consumers. Is this a real threat to the economic recovery?

The price of crude oil has been high for over a year, and natural gas has been well above its historical average since the end of 2002. This hasn't prevented the economy from growing so far, even though that growth hasn't generated many jobs, for a variety of reasons. In fact the Wall St. Journal's reporting of DuPont's recent announcement of 3,500 layoffs cited the high cost of natural gas as a contributing factor, since it is a major input in its basic chemicals business.

If the impact of higher energy prices is starting to show up in higher consumer prices for non-fuel goods, though, then this will influence policy decisions, such as the actions of the Fed's Open Market Committee, which sets interest rates. This week the stock market fell in anticipation of an increase in interest rates by the Fed next month. In effect, there is a delayed feedback loop by which high oil and gas prices increase inflation, which raises interest rates, which slows the economy.

None of this should be surprising. Crude oil and gasoline prices today are at about the level they were, in inflation-adjusted dollars, after the first Oil Shock in 1973-74. (See my posting of March 25 in archives.) The US economy is very different today than it was then, and the amount of energy required for each dollar of gross domestic product is lower. So barring a radical jump in oil prices from here, it's hard to imagine the same kind of economic malaise resulting from the current price levels. But that doesn't mean there's no impact.

Much will depend on how consumers will respond. If, for example, we were to change our driving habits, consolidating trips, carpooling, and shifting more travel to cars with better fuel economy, demand would start to moderate and that would ease prices fairly quickly. This would take some of the pressure off companies that produce goods for sale.

If, on the other hand, we ingore the gasoline price signal and continue the remarkable growth trend in miles traveled each year, and instead cut back our purchases of goods with a large energy component, then the economy will slow first, which will eventually result in lower fuel prices.

So even though it is natural to see the entire problem as being well beyond anything we can individually control, the reality is that the sum of all our actions as individuals will have a lot to do with how bad high energy prices end up being for the economy. So blame OPEC if it makes you feel better, but don't ignore what you are doing about it, yourself.

Smoke Screen
I've been remiss in waiting this long to mention Bruce Barcott's interesting article on the Bush Administration's environmental policy in the NY Times Magazine of April 4, 2004. In "Changing All the Rules" (which has now gone into the NYT archives), he describes the impact of changes in "new source review" rules for the electric power industry. Under this provision, power plants can perform necessary maintenance, but any upgrades or expansions trigger a requirement to meet current emissions rules and install the best available emission control technology. Mr. Barcott's article focuses on past violations of this standard and the new administration's efforts to make it less onerous for industry.

I'm not in a position to verify all the information in the article, but at least one fact that underpins his argument that environmental regulations have not stifled the expansion of generating capacity to meet demand, requires further clarification. The "fact" in question relates to the California power crisis of 2000-01. The author states, "We now know that California's energy shock was largely caused by market manipulation (by Enron, among other companies) and regulatory breakdown, not by a drought in supply." This is not a fact, but rather an assertion. An examination of the facts would reveal that two other major factors contributed to California's problems, in addition to those he cites.

First, the Pacific Northwest, from which California imported a significant portion of its incremental power, was experiencing a water drought that curtailed hydroelectric generation. More germane to the issues in the article is the trend leading up to the period of "deregulation", in which the state's power reserve was steadily eroded by the rapid growth of demand in the 1990s and the difficulties utilities faced in getting new plants permitted and constructed. From an industry perspective, the balance between environmental protection and the provision of energy critical to economic growth and personal comfort had swung too far in one direction.

The latter point encapsulates much of my discomfort with Mr. Barcott's approach. He raises issues meriting serious concern, and his observation about major changes in environmental policy being driven by bureaucratic fiat, rather than by Congressional action, is essentially correct, though hardly unique to this administration. However, his overall argument is undermined by the breathless tone of conspiracy that comes across in much of the piece.

While it is tempting to see the insertion of so many people with energy industry connections into the EPA and Dept. of Energy as simply putting the fox in the henhouse, there is another perspective on this. What I recall from my two decades in the oil industry was the relentlessly adversarial approach taken for most of that time by environmental regulators who had little appreciation or concern about the benefits the industry provided, seeing it only as a massive polluter.

When the Bush Administration took office, there was a sense in the parts of the industry with which I was involved of finally having someone in Washington who understood the complexity of the country's energy systems and who might be willing to listen to the input of those who actually run the machines that deliver power and fuel to a country that cannot do without them. Quite possibly this was taken too far, and the balance has swung in the opposite direction from the last twenty years. An article that presented both sides of the story would have been fairer but probably far less gripping and politically useful in an election year.

Desires vs. Markets
A couple of recent articles have speculated about the role that the demographics of Saudi Arabia will play in keeping the price of oil high in the years ahead, including this one in the Financial Times (subscription required.)

There's little doubt that the Saudis, in particular, and the Arab world in general, face a demographic crisis, and that much of the political unrest we see in that region is driven by a large and growing youth population. With a median age below 20 and high unemployment, the Saudis will need sustained high oil revenues to meet the demands on their social services.

However, desires alone don't drive markets. Clearly the US desires much lower oil prices, but our wishes don't make it so. The question is what other conditions need to exist in order to facilitate keeping prices high, since not even the Saudis can set the price of oil arbitrarily high just to suit their own needs, without disrupting the market. I see at least three other necessary conditions:

First, demand for oil would have to remain strong. This may seem like a foregone conclusion today. After all, the US economy is recovering, American driving patterns appear impervious to higher gasoline prices, and China is going great guns. But any number of things could dampen demand in the years ahead, such as another Asian economic slowdown, or unexpectedly rapid market penetration of fuel saving hybrid cars or clean diesel engines.

Second, the Saudis would have to convince the rest of OPEC that it is in their interest to adhere closely to quotas and avoid cheating, i.e. overproduction by individual members. That, too, seems like a slam dunk, in light of the recent success of this strategy. But once Iraq stabilizes, any new government there will have an enormous incentive to expand production, and they have the potential to blow huge holes in OPEC's dam, given enough time. Libya may be in the same position much sooner, as I indicated last week. However, these countries will have to compete for investment with opportunities in other countries.

This brings us to the third key factor; to sustain high oil prices, the growth of non-OPEC oil production would have to slow or stall. That, too, seems like a reasonable bet, with North Sea production plateauing and US production well past its peak, but it does not reckon with the potential of Russia, West Africa, and the countries in the Caspian region to add enough production in the next 3-5 years to ruin OPEC's calculations. But this, too, depends on the strength of demand, availability of capital, and OPEC policy.

So although understanding the impact of demographics can give important insights into Saudi oil policy, no issue, in isolation, will dictate the global price of oil. This complex and dynamic market has stymied numerous past attempts at prediction and control. As I've indicated in recent blogs, I think the willingness of the Saudis and other Middle Eastern producers to invite in foreign capital and capabilities will have at least as much influence on the future supply and price of oil as the Arab demographic bubble, unless it results in a full-blown revolution in the Kingdom.

The Other Gas for Cars
Yesterday's NY Times carried an article on celebrities converting their SUVs to run on compressed natural gas (CNG), as a way of reducing the environmental and energy security guilt associated with driving big, heavy cars. It raised several interesting questions about the advantages of natural gas powered vehicles that are available now, compared with hydrogen fuel cell cars that may still be ten years away. These are the kind of questions we should be asking, since any fuel conversion will entail major changes in our infrastructure and primary energy choices.

Other questions that should also be on the table include the following:

Although the Times cites natural gas as a domestically-produced fuel, most analysts including the government's Energy Information Agency anticipate that any growth in US natural gas demand will have to be met through increased imports, because US gas production has stagnated in recent years. This will require construction of a number of LNG (liquefied natural gas) import terminals, a new pipeline from Alaska or Canada, or both. Are incremental gas imports best used for transportation, or as the cleanest fuel for electricity generation?

Compressed natural gas cars are currently cheaper to fuel than their gasoline counterparts, largely because natural gas carries no transportation taxes. If more than a small fraction of the cars on the road converted to natural gas, some alternative means would have to be found for collecting taxes for highway repair and the other items funded by the state and federal fuel taxes. If natural gas for road use were taxed at the same rate as gasoline or diesel, much of its advantage would disappear. Should CNG receive this kind of subsidy because of its environmental benefits?

There's also a practical question about the number of miles an owner would have to travel annually in order to defray the investment in conversion to CNG, even if the fuel retains its road tax exemption. The Times indicated a conversion cost of $10,000, which seems high. Even at $5,000, I suspect that only fleets of high use vehicles, such as taxis, delivery vehicles would find this advantageous, and in fact, it is mostly these kinds of vehicles that have already made this switch.

I'll leave the safety concerns for others to highlight, except to say that I don't personally fancy the idea of driving around with a high-pressure tank in the back of my car, even if it is wrapped in Kevlar and has been dropped off the Empire State Building in tests. I spent enough time in refineries to have a very healthy respect for the amount of mechanical energy stored in a gas at 2000 psi or higher pressure.

At the same time I don't want to dismiss this idea out of hand. It has some merit and may make sense for some consumers, even if it does nothing more than assuage their consciences. And if our government saw enough benefit in this idea to be willing to open up some of the gas fields currently off limits (see my posting of March 11 in archives), then we might actually see domestic natural gas prices come down enough that this could be a real winner.

A New Tradeoff?
Ever since taking the helm at Ford Motor Co., William Clay Ford has been a controversial figure. He has spoken publicly about a strong environmental agenda, although some have criticised Ford for failing to follow through. This week, he threw his support behind the idea of higher fuel taxes couples with incentives for high-efficiency vehicles such as hybrids.

The tradeoff between taxes on consumers and fleet mandates at the manufacturer level is one that was settled in the US two decades ago. Europe has chosen to rely on high fuel taxes and taxes on engine displacement as a way of keeping cars efficient and moderating their oil imports. That approach was rejected here in favor of the CAFE standards I discussed earlier in the week (see Monday's posting.) Perhaps the time has come to reopen this debate.

The advantage of taxes is that they allow the market--consumers--to select the makeup of the car fleet and avoid the kind of loopholes and gaming that mandates such as CAFE are prone to. However, with consumers already complaining about gasoline prices that have skyrocketed due to market factors, how would they welcome a $.50/gallon tax increase on top of this?

Even if Mr. Ford's remarks are somewhat self-serving, since Ford has invested in hybrid technology and is launching the hybrid version of its small Escape SUV this year, this is still a national conversation worth having.

First Fruits
With Iraq's instability showing no signs of abating, it could be a long time before international oil companies see an atmosphere conducive to pursuing new exploration and production opportunities there, beyond pre-existing deals such as Lukoil's. The less heralded return of Libya to the international fold looks like it will bear fruit much sooner.

The Financial Times recently estimated that the oil sector in Libya would need up to $30 billion over the next 10 years as the country seeks to expand production capacity from 1.6 million barrels per day (MBD) to 3.0 MBD. Shell has already announced a gas exploration agreement with the Libyan government.

The terms required to lure more companies back will need to be attractive, and these opportunities will have to compete with others elsewhere. But they start with two key advantages: proximity to the large markets in Mediterranean Europe and the prospect of crude oil qualities matching those of Libya's current production, which is lighter and sweeter (lower in sulfur) than most Middle Eastern oil.

On balance, although Iraq has much greater long-term potential, the re-opening of Libya could have a bigger impact on the market in the medium term.

Trading Carbon Credits
Even though the Kyoto Treaty on climate change lacks the required number of signatory countries to go into effect, the European Union is moving ahead with measures to reduce emissions of carbon dioxide and other "greenhouse gases" (GHGs). At the same time, some EU leaders are expressing concerns about the competitive handicap these limits may create. The latest Economist includes an update on where emissions trading, which can reduce the cost of compliance, fits in the EU's plans.

In this type of trading, parties that can achieve reductions in emissions at relatively low cost are able to sell their excess reductions to others facing higher costs. This is classical economics at its purest, and it produces benefits not only for the participants, but for society as a whole, as the total cost of achieving the same reductions is driven down to its most efficient level.

The application of trading to environmental issues was first demonstrated in the US, with the establishment of a market for acid rain and smog-causing sulfur emissions. This program has not suited everyone, with some Northeastern states downwind of plants that purchased credits in lieu of reducing their own emissions complaining and passing laws to limit trading. Still, it has arguably reduced overall power plant pollution, while keeping electric rates lower than if all generators had been required to reduce their own emissions.

Emissions trading is ideally suited to addressing the concerns of climate change, because it is truly a global issue. A ton of CO2 emitted in Brazil is exactly equivalent in its impact on the climate to a ton emitted in Boston. The regional and "downwind" issues that have bedeviled sulfur and nitrogen oxide trading are simply irrelevant to GHGs.

The larger EU emissions market now under discussion is a follow-on step to a number of national programs, starting with the UK's, which has been in effect since 2002. As the Economist points out, it is ironic that Europe is now proceeding to implement emissions trading, while it is off to a slower start in the land of its birth.

Here, without a firm cap on output driven by government policy, trading has so far been limited to a modest number of forward-looking companies that see it as an attractive hedge against potentially much higher costs of cutting their GHG emissions in the future. The importance and value of emissions trading is likely to grow significantly, should a Democratic administration take office next January.

And a follow-up from a colleague concerning yesterday's posting:
NPR carried this story concerning opposition to a promising gas discovery in New Mexico.

How Many Back Yards?
A colleague forwarded a report indicating that two proposed LNG import terminal projects have been cancelled or suspended, one in Maine and one in Northern California, due to strong local opposition.

There was a time when these projects would have been welcomed as valuable sources of jobs and local tax revenue. Today, even as we bemoan the offshoring of manufacturing jobs, it is clear that much of the country has adopted a distinctly post-industrial mindset toward any facilities that exude smoke and steam. That includes the infrastructure facilities upon which our lifestyles depend.

In contrast to the rather depleted state of our petroleum endowment, we still have sizable untapped resources of natural gas in North America. However, it is strictly verboten to drill into this gas if it happens to lie in places we value for their pristine appearance. The result is a growing reliance on imported natural gas.

That is a legitimate, values-based choice as far as it goes. Paradoxically, though, it is also apparently verboten to build facilities for importing gas from overseas. Having outsourced the production of the gas, do we now wish to outsource its importation, as well, perhaps to Mexico or Canada?

The inherent conflict between our insatiable appetite for things that consume energy and our recently-acquired sensibilities towards our surroundings is a slow-motion train wreck that has already begun. Americans usually prefer to solve our problems after they have reached crisis proportions, but in this case we need to be aware of how long it will take to respond, once we realize we have not built enough pipelines or LNG terminals, or drilled enough gas wells to keep the heat and lights on at a price we like.

Both Wrong?
In their lead editorial today, the New York Times castigates both the President and his challenger, Senator Kerry, for arguing about short-term fuel prices and ways to address them, rather than promoting a national debate on the underlying issues of energy use and how it might affect our national security. The Times would have done well to quit after making this excellent point, rather than weighing in for specific solutions, themselves.

Their preferred answer appears to be to tighten the Corporate Average Fuel Economy (CAFE) standards that were imposed in the 1970s, and about which I've written in the past (see my posting of 2/20/04.) A major drawback of CAFE is that it ignores consumer preferences, imposing instead a limitation on the average fuel economy of each manufacturer. Ignoring the loophole that has allowed ever larger SUVs to bypass the intent of the CAFE standards, it is not at all clear that large numbers of consumers will opt for smaller, thriftier vehicles, or willingly pay the higher prices necessary to pay for technology that could reduce fuel consumption.

The Times also chooses to ignore the vital role the market played in mitigating the supply crises of the 1970s, and the way in which the sources of this country's imported oil have diversified in that period, even as demand grew and domestic production declined. We are less reliant on OPEC today than we were in 1975, according to the government's own statistics on imports. The recent growth of production in Russia and the Caspian Sea region offers opportunities to maintain a diversified supply for at least the next decade or so, even though the preponderance of reserves in the Middle East must eventually shift that balance.

While markets have their limitations, and though their results are not always popular--as with current gasoline prices--they do some things much better than command-and-control approaches can. Surely this, too, must be part of the debate the Times presumably endorses.

SPR in the Crosshairs
I'm traveling on business, so no new blog Friday. Meanwhile, if you have been following the debate over whether we should still be adding oil to the Strategic Petroleum Reserve with oil and gasoline prices as high as they are, and if you have not previously read my posting of February 17 on this subject, you'll find it in archives. It is as relevant to what the presidential candidates are saying on this topic as it was to the Senate debate six weeks ago.

Iraq's Oil Patrimony
We are approaching the first anniversary of the fall of Baghdad. If you can believe the polls or the evidence of recent anti-war demonstrations, much of the world still believes the US went to war in Iraq to seize control of its oil resources. I never shared that view and could nominate several other countries whose actions in the UN Security Council suggested that they were influenced to a much higher degree by oil than was the US. Now, as we anticipate a handover to an Iraqi government in June, there is growing and legitimate concern about how Iraq's oil will be managed. There is a great opportunity here to benefit both the Iraqi people and the world.

Regular readers have seen my past comments on global oil depletion and a possible imminent peak in production. If we are facing a peak, it has to shift closer without open access to Iraq's 112 billion barrels of proved reserves, which could reasonably be expected to support production of at least 5 million barrels per day, compared to the current 2.5.

Achieving that won't just require access for US companies, or for companies in countries that joined our coalition. Rehabilitating Iraq's dilapidated oil industry and increasing production sustainably is such a big task that it will take expertise and investment from many sources. In the process, companies should find attractive opportunities, perhaps more attractive than some current and prospective projects they are pursuing elsewhere in the world. I can think of some countries that should be worried about that, with Venezuela topping the list.

However desirable it might seem to some, Iraq could never accomplish such an expansion on its own, without international help. Recall that the existing infrastructure was a shambles before Coalition troops crossed the border, and the repairs funded by the US are geared primarily to addressing acute and chronic problems, not building new capacity. And because the new Iraqi government will need oil export revenues to finance rebuilding their country, that money will not be available for reinvestment in the oil industry in the short or medium term. Finally, Iraq has missed out on at least a decade's worth of technical development in a very high-tech industry. They will need help just to get back to where they were, let alone move ahead.

Security, government & governance, and terms of access must all be settled as a prerequisite, and this will be a major undertaking in itself. The new government will also have to figure out how best to feed oil money into the system, to avoid perpetuating the Resource Curse seen in so many other oil-rich, institution-poor countries. Their success in this undertaking is very much in the self-interest of every energy consumer in the world. If they fail, we just might have no choice but to give up our SUVs.

The Dismal Segment
Just as economics is the "dismal science", petroleum refining is the dismal segment of the oil business. I started my career as a refinery process engineer, and it took me years to outgrow the pessimism that my two years there instilled in me. After all, if you are a refinery executive, on your best day the facility is running flawlessly, making some money and churning out product, but it's all downhill from there. It's the rare plant manager who hasn't been awakened at 3:00 AM by a phone call informing him of a serious problem or accident, and refinery accidents tend to be spectacularly attention-getting.

Business Week recently carried an excellent article on the current state of the US refining business and its contribution to high gasoline prices. The short version of the story is that refining capacity has been overextended through a combination of high demand, complex and conflicting regional gasoline specifications, and the impact of environmental regulations on the facilities themselves. It sounds bleak, but it is also generating healthy profits in a part of the business that until a few years ago was a perpetual "dog."

In the past, the normal cycle for the refining industry was that any period of high margins would be followed by heavy investment in new capacity. Rather than new refineries, of which I believe only one has been built in the US since 1971, this usually meant adding or expanding "cracking units", expensive hardware that turns low value byproducts into high value gasoline and diesel fuel. After each wave of capacity addition, gasoline production would increase and--surprise--prices and margins would drop, just as you'd expect in a competitive business. I doubt there were many US refineries that achieved better than a 5 or 6% return on average capital employed in the 1990s, when you could earn that much investing in T-bills.

What appears to be happening now, contrary to the recurring suspicions of collusion mentioned in the article, is the end result of environmental and permitting regulators having achieved their implicit goal of limiting refinery expansions. In the process, they have saved the refinery owners from themselves in a way they could never have done on their own, by breaking the cycle of unprofitable capacity additions.

So when you pull into the gas station and grumble at the high prices, in addition to cursing OPEC, you might make a mental note that you are at last paying a premium for the cleaner gasoline that has helped to improve air quality in many of our metropolitan areas. If you live in Southern California and are old enough to remember Second-Stage Smog Alerts (23 of them in 1978 and not one since 1988), you know exactly what I mean.

High Tech Power Grid
Aside from providing a sharp non-US perspective on things, the Economist puts out a good series of periodic reports on various industries and issues. Their latest Technology Quarterly includes an article on "The Energy Internet", describing the potential shape of the power grid of the future.

Before the Enron collapse and the botched California electricity deregulation, the hot buzzword was "distributed power", in which we would gradually shift away from large central power plants and high-voltage lines, and toward a new model relying on small generators, either owned by end-users or sitting very close to them. These generators would use a variety of technologies, including microturbines, wind turbines, diesel generators, and eventually fuel cells. Ultimately, these small devices would not only meet the immediate needs of their owners, but would sell power back into the grid. The result could eventually resemble the internet, with power flowing in and out from a myriad of small nodes.

Along with summarizing the current state of the power grid, the Economist article provides an update on the development of distributed power. Advances have continued, including the development of "microgrids" and new storage options, but we are apparently still some years away from anything resembling an energy internet, however desirable it might be for reducing the risk of blackouts and the volatility of markets.

But although the author correctly identifies politics and regulations as factors retarding progress in this trend, he does not mention the ambivalence of many utilities about losing control over who is allowed to put power into the grid. These companies should consider distributed power in light of their experience in the 1980s and 90s with cogeneration.

Starting in the late 1970s, large industrial facilities began installing their own medium-size power generation, typically using aircraft-derived gas turbines that efficiently provide both electricity and steam for industrial processes. Utilities often resisted buying the cogenerators' excess power, until they were forced to do so by state and federal regulators. But rather than being the threat they feared, cogeneration turned out to be a blessing for utilities, allowing them to defer major investments in new power plants that would likely have earned low returns in the market conditions that prevailed prior to 2000.

In fairness, the cogeneration story may not be 100% positive. The steady stream of cogeneration projects may have lulled utilities and regulators in California into believing that capacity investment could be deferred indefinitely, thus contributing to their problems during deregulation. Despite this, I think the story shows that distributed power could result in unexpected benefits for utilities, and that further analysis is warranted. Perhaps someday the inserts in our monthly utility bills will encourage us to generate our own electricity, rather than buying theirs.

Orphan Cars
In the 1980s and early 1990s, consumers had to worry about buying computers that would turn into "orphans" when their makers went bust or were absorbed into another company. Now it's orphan cars, all-electric vehicles that their manufacturers insist on taking back, once their initial leases are up. This seems like terrible PR on the part of GM and Ford, but it's not hard to envision the conversations between company lawyers and accountants that might have led to these decisions.

A key fact missing from the Times article is that most of these first-generation cars were delivered with conventional lead-acid batteries--dozens of them. Imagine pulling into Sears to buy 26 DieHards in one go. This was one reason the auto firms' chose to offer battery cars only on lease. You also have to wonder what other parts might now be wearing out, with which the average mechanic would have no prior experience. Let's see, my EV-1 breaks down after warranty, and I take it to the corner mechanic, who accidentally comes in contact with a high voltage circuit... The lawyers must have been in a cold sweat at this prospect.

A few years ago I had the pleasure of driving one of these cars. It was a brand new GM EV-1, and I got to take it around the streets of Phoenix, AZ for a few minutes. I was amazed not only by how quiet it was, but by its terrific acceleration. It was great fun leaving a BMW in the dust at a green light, with its owner wondering what on earth I was driving.

However, it was also clear that the car I drove would never be mass marketed. Its range was under 100 miles, and achieving that required either an overnight charge at home, or about an hour and a half at a public, high voltage recharging station, of which there were relatively few. On top of this, it was a 2-seater with limited storage space. Fun, different, but not very practical.

Rather than lament its passing, I'd rather cheer for the few thousand enthusiasts who got to drive the car of their dreams--and consciences--for three or four years, and the car companies that learned a tremendous amount about the practicalities of electric drive. That knowledge is already paying dividends in the new hybrid cars--part electric and part gasoline-powered--and will certainly benefit future electric-based vehicles such as those powered by fuel cells.

At the same time, environmentally-oriented EV owners should remember that the power to recharge these cars must be generated somewhere. For Southern California, where most of these vehicles were leased, the EV-1's "virtual tailpipe" was probably connected to a coal-fired power plant in Four Corners, AZ.

Frontier Outpost
This week the Wall St. Journal Online carried an interview with Amory Lovins, the guru and founder of the Rocky Mountain Institute, an alternative energy think tank. His views on the future of the oil industry and other parts of the mainstream energy landscape are interesting and iconoclastic. They are worth noting as much because of who else is listening to them as for their insights. Mr. Lovins has the attention of global energy and auto firms, among others, a fact that becomes even more surprising when you realize how critical he is of their orthodoxies.

In the interview, along with some good observations about China's growing energy demand, Mr. Lovins compares the oil and airline industries as "a great industry but a bad business." This seems a stretch, considering the highly profitable super-majors dominating the oil and gas scene today. While it is true that these firms and their smaller brethren have not consistently recovered their cost of capital or outperformed the market over time, they are a million miles from the sad state of commercial aviation. As of a few years ago, the latter had delivered a cumulative loss since its inception , and it's hard to see that the post-9/11 world would have improved that score.

Still, Mr. Lovins shines in creating a compelling vision of a future world of clean and efficient energy and transportation, even if I'm skeptical that we can get there in the manner he describes. You need visionaries pushing the frontiers, and he certainly qualifies as one.

Record Gasoline Prices?
A recent article on gasoline prices included a surprising historical graph (you'll have to scroll down a bit to find it.) Gasoline prices have gone up dramatically this year, in line with higher crude oil prices and the replacement of MTBE by ethanol in several states. Here in Connecticut I pay over $2.00/gallon for self-service. Recently I've been thinking I have never paid more, other than on trips to Europe or Asia, but the graph showed I was wrong.

As low as inflation has been for the last few years, it's easy to forget how big the difference can be between nominal prices--prices in today's dollars--and real prices, adjusted for inflation. Nominal gasoline prices after the first oil crisis in 1973-74 averaged $.53/gallon for leaded regular, while those after the Iranian Revolution rose to $1.25/gallon for unleaded. When you adjust for inflation and bring them into 2003 dollars, these figures translate to $1.69/gal and $2.49, respectively.

This is not to say that gasoline isn't unusually expensive at the moment, but even for someone who follows these issues regularly and traded energy commodities for more than 10 years, it's instructive to see that we're still well short of the real record. And if the times we live in are less turbulent than the oil crisis years of the 1970s, it's not by much.

Smart Cars
Anyone who has traveled to Europe in the last several years has probably noticed the tiny Smart cars driving--and easily parking--in the Continent's most congested cities. They come in eye-catching colors and are even smaller than the popular Mini Cooper seen over here in increasing numbers. Last Friday the Smart hit the front page of the NY Times's "Escape" section, which described how enthusiasts are trying to acquire the car in advance of its 2005 rollout in the US.

Many times when I was trying to find a parking space in Manhattan or elsewhere I have wished I were driving one of these little cars, which were designed to fit three to the same parking space as a single Mercedes S-Class. But there were other times on Interstate 95, while being tailgated by an 18-wheeler going 65 and trying to go 75 right through my back seat, that I was glad I wasn't driving one. Clearly the Smart won't appeal to everyone, for every situation.

But I think that is the whole point. Here is a car that can meet a need for practical, economical transportation to the train station or generally around town, even if it's not the car you'd choose to drive from New York to D.C. Also noteworthy is that this car gets 60 miles per gallon without any of the fancy and costly technology of the hybrid cars or future fuel cell vehicles that I and others extoll.

When I see cars like the Mini and the Smart, I can't help wondering if they represent the next big trend in the auto world. Everyone focuses on SUVs now, fans and opponents alike. After all, they have been the hot trend for a decade. But the recent proliferation of extremely large, high-end SUVs such as the Lincoln Navigator or Cadillac Escalade, reminds me of the 1991 Buick Roadmaster station wagon, simultaneously the apex and last hurrah of the American station wagons that created the niche SUVs would later fill. Are we nearing that kind of tipping point, and is the Smart a sign of its arrival?

OPEC Waffles
Last month OPEC ministers decided to reduce oil production in the second quarter, even though the market is currently at historic highs. Their rationale centered on avoiding a glut in the in the upcoming post-winter heating, pre-summer driving season. Dissent now seems to be dividing the ranks before the cuts go into effect, as unnamed members wake up to the political damage that sustained high prices is causing them, and more importantly, to the risk that their actions will slow the economic recovery and reduce demand for the next couple of years.

It's about time. Over the last decade the market has swung back and forth between periods when OPEC could control prices and others in which a lack of OPEC cohesion or tranches of new non-OPEC production left them powerless to prevent a price slide. But as time passes, this game becomes riskier. Alternatives are creating new choices for industry and consumers, and each successive price spike takes a small notch out of future oil demand. These alternatives include not only wind and solar power, but more conventional fuels such as LNG.

As always, OPEC's leaders must find a way to balance the desires of members such as Algeria and Indonesia, whose limited production and reserves drives them to maximize short term revenue, with those such as the Saudis and Kuwaitis, whose reserves will last decades and who must lose sleep over the prospect of losing the market to coal, gas or renewables. But neither can they forget 1998, when the slide in prices due to falling Asian demand became a collapse. Let us hope they realize that this kind of scenario is highly unlikely today, as China booms and the US gets back on a growth track.

The FT quoted the Algerian representative fretting about a possible $7 drop in prices. $30 oil would take about 17 cents out of the gasoline price, and that would be good news indeed for consumers.

Numerators and Denominators
An article in yesterday's New York Times, quoted opponents of oil and gas drilling in Montana's Front Range saying, "How can someone take an area of this magnificence and sell it down the river for a few minutes of natural gas supply?" This perennial anti-development mantra may vary in proportion with the amount of hydrocarbons in question, but it is based on a serious fallacy.

In some ways, the terminology and shorthand of the oil industry helps give rise to this kind of misunderstanding. When experts talk about reservoirs and pumps and express reserve life in terms of reserves-over-production (R/P), a layman could easily conclude that engineers simply dial in how rapidly they want to produce the oil in a given field.

Actual production rates are a function of geological conditions, available technology, and the characteristics of the oil in question, which can vary considerably. There is an optimal rate of production for each well, and exceeding it can damage the reservoir and reduce overall recovery. As a result, production is spread out over many years, with volumes reaching an early peak and then declining. US oil and natural gas production is made up of the contributions from tens of thousands of producing wells, each with its own unique lifespan measured in years or decades, rather than the fanciful minutes or hours indicated.

The "only a few minutes/days/months of supply" fallacy is a wonderful tool for opposing oil or gas development, since through careful choice of numerator and denominator, the value of essentially any oil or gas project--no matter how large, can be made to appear trivial when compared to the environmental consequences that might ensue.

We hear this argument frequently in the case of the Arctic National Wildlife Refuge, which is deemed by opponents to hold only "six months of our national demand". Voters might view it differently if told that it has the potential to supply a fifth of total US oil production for 20 years, based on reserve estimates by the US Geological Survey.

Every oil or gas project such as the Front Range or ANWR has genuine pros and cons, some of them quite complex. But I don't think the debate is enhanced by cynically or ignorantly resorting to the kind of trivialization I have described above. We live in a country with an enormous and insatiable appetite for energy. Without the output of thousands of oil and gas fields--all of which were originally in some other, possibly pristine state--none of us would be able to heat our homes or get to work in the morning.

Making Lemonade
A recent article on the prospect for further tightening of the global market for metallurgical coke, the carbon source for steel production, triggered an odd train of thought. At the same time that this higher quality, coal-derived coke for steel production is becoming pricier, the world is being glutted with lower quality coke derived from petroleum, much of it produced in the US and Venezuela. Simultaneously, the price of natural gas has risen to historical highs in the US. The combination of these two factors creates an opportunity.

Petroleum coke (petcoke) is the byproduct of upgrading heavy oil into lighter oil, as done in a number of projects in Venezuela, or turning the heavy, tarry residue of petroleum refining into more valuable, lighter products, such as diesel fuel. Petcoke is similar in appearance and consistency to coal, and about as desirable from an environmental perspective. By virtue of being the absolute "bottom of the barrel", it concentrates the sulfur and metals from the source oil to much higher levels. As more upgrading capacity comes on line, more coke is produced and prices of this "fuel grade" coke fall.

But petcoke is an ideal source of carbon for the gasification process, in which low value, high carbon materials such as coal, coke, or residual fuel are converted into a so-called synthesis gas, resembling very low-grade natural gas. One of the main attractions of gasification is that contaminants such as sulfur and metals emerge in forms that are much easier to handle and remediate than if the same fuel were burned in a conventional power plant.

Although the resulting synthesis gas is not a direct substitute for the natural gas we burn in our homes, it can displace natural gas used in gas turbines for electricity generation.

Three or four years ago, this kind of "integrated gasification combined cycle", or IGCC, with its high investment cost, was nearly competitive with conventional coal power plants, but quite a bit more expensive than gas turbines running on natural gas. But with gas prices having doubled and tripled, and with cheap petroleum coke widely available as a feedstock, these economics should be reevaluated.

Perhaps we can kill two birds with one stone: helping to alleviate a very tight natural gas market in the US, while reducing the mounting piles of petroleum coke produced by the increasing number of heavy oil upgrading projects around the world.

Reaping the Wind
It seems appropriate to follow a discussion of solar energy with one on wind power, since they share many characteristics, as well as a common source: the sun. Both are intermittent in nature, producing energy only when the sun shines or the wind blows. This means neither can produce reliable power without some means of storing power for use in the dark or calm, or a backup generator. And both are low intensity, in the sense that they require a much larger footprint for producing a quantity of power equivalent to a natural gas or coal-fired central power plant.

But whereas solar power is still a niche product, wind power has moved well into the mainstream. The US added 1700 MW of wind generation last year, moving into second place behind Germany in total installed wind turbines.

Wind has also become a significant source of revenue for family farms in states like Minnesota. Even with the Federal subsidy for new wind power installations in abeyance, due to the stalled energy bill, wind will continue to grow in importance, partly due to state renewable power mandates.

As positive as all this sounds, a collision is occurring between the drive for more renewable electricity and concerns for preserving the environment. The poster child for this dilemma is the proposed wind power installation off Cape Cod. It has divided the environmental community in two, between those who see the benefits of a non-polluting energy source and those who say "not in my viewscape."

The fundamental issue here is the same as the one underlying my posting of March 11 concerning the natural gas that is kept off limits by restrictions on offshore drilling. Everyone wants their appliances and cars, but few indeed want the energy needed to run them to come from anywhere they can see or easily imagine.

We are nearing the end of the time when such views can prevail without exacting a high price in dependability. Last summer's northeast blackout, which added extra anxiety to the birth of my daughter that day, was a signal of how tenuously we are stretching the infrastructure upon which we rely. We may get another signal this summer, in the form of a gasoline price spike related to the Balkanization of state regulations governing gasoline specifications--a topic for another day.

None of this will change until we start, as a country, to connect actions and consequences: mentally linking the flip of a light switch to the spinning of a turbine somewhere, the turning of an ignition key to the drilling of an offshore oil well. The energy industry has made this pretty seamless for a long time, but the seams are beginning to show.

Solar Moves Mainstream
Last week General Electric announced it was buying the assets of the bankrupt solar power manufacturer, AstroPower. This follows GE's success in the wind power business.

In addition to giving GE an entree to a small but rapidly growing market, it may also be a signal that the global solar photovoltaic (PV) industry is approaching a critical threshold. As the scale of manufacturing increases, solar panels should enjoy similar "experience curve" effects as other technologies--though not necessarily as dramatic as Moore's Law for computer chips. Costs will continue to fall, and as they do, solar will expand out of its current niche applications, such as powering remote devices not connected to the power grid.

While the dream of clean solar power replacing large central power plants may never be realized, due to environmental objections to covering the landscape with the vast area of solar collectors that would entail, economical PV could create new markets that are additive, rather than competitive with traditional power. Besides expanding the growing range of options for homeowners and businesses seeking to reduce their dependence on the electric grid, it may find an even larger opportunity in the developing world, where people making only a few hundred dollars a year buy the most expensive form of power on the planet: disposable batteries.

What will be required to develop all these markets? Topping the list are manufacturing excellence, marketing expertise, and financial creativity. GE appears to have all of these skills in abundance, but it has no monopoly on them. Smaller players should see GE's entry to this market as legitimizing in the eyes of investors and potential customers. That can only benefit the industry as a whole.

Oil Reserves vs. Strategy
The Wall St. Journal has done an excellent job of covering the reserves problems at Shell without resorting to sensationalism. On Friday's front page they stepped above the questions of who knew what--and when--to raise a more profound question about the company's strategy.

The overstatement of Shell's reserves as far back as the mid-1990s distorted key indicators such as reserve replacement rates--their success at finding new oil reserves to replace what was pumped in a given year--and finding and development costs--how much they paid for each new barrel in the ground. As a result of these distortions, was Shell lulled into believing that it could deliver the results investors demanded via organic growth alone, when their competitors had concluded they must replace reserves through significant mergers and acquisitions?

This is a critical question, because by now the best opportunities of this kind have been snapped up by others. Amoco, Texaco and Mobil are gone, and only Marathon, ENI, and ConocoPhillips--itself the result of several mergers--remain in this size category. In order to be material to a company of Shell's size, growing reserves through M&A would now likely require buying multiple smaller firms, against a background of significantly higher oil prices than obtained when the transactions creating ExxonMobil, BP-Amoco-Arco (pronounced "BP"), and ChevronTexaco took place.

It may be that Shell's existing asset portfolio can deliver the desired growth, and that most of the reserves recently un-booked can be restored with time and prudent investment. If not, the shareholders of Royal Dutch and Shell Trading & Transport will have grounds for second-guessing management's decision to go it alone.

In response to my earlier comments on this situation, one colleague responded as follows:
"Reassessment is a painful and long process. They could've said that they were not in compliance when they first knew, but they probably could not have estimated the amount of the change without a rigorous survey of all the reserves.

Texaco had a similar problem in the 1990’s as management found out it may not be anywhere near its production growth targets. Even the analysts, in that case, knew that the forecasts were off. But it was only after a rigorous survey that took the better part of a year that a better picture emerged."

Finally, on the non-energy front, I am trying to digest the implications of the Socialist's come-from-behind win in yesterday's election in Spain. I don't understand all the complexities of Spanish politics, but it appears on the surface that the terrorists succeeded in scaring voters into a more isolationist view. Should we now expect a similarly aimed attack here in early November?

Nuclear Genie
Nuclear proliferation has been in the news a lot lately, between concerns about North Korea's weapons program and the even more worrying revelations about Dr. Khan's Pakistani nuclear Home Depot. Wednesday's NY Times featured N. Kristof's bleak editorial on a potential Nuclear 9/11 ,and last week's Economist carried their depressing, good news/bad news assessment of the situation. As they commented, "...the only real difference between a civilian nuclear fuel-cycle and a military nuclear fuel-cycle is one of intent."

What does this mean for the future of nuclear power? Roughly 450 nuclear power plants in 33 countries currently supply 6.5% of the world's primary energy (8% for the US alone.) They represent an enormous capital investment and an important base load of electricity. Barring the advent of economical nuclear fusion (see my posting of 2/13/04) or some new energy source with similar characteristics, they won't go away soon on economic grounds.

But that's the problem. Traditional economics does a very poor job of evaluating low risks of truly catastrophic outcomes. Previous conventional wisdom saw the nuclear industry's long-lived waste products as its biggest problem and assumed that proliferation was essentially under control. Surely that assumption must now be revisited.

We also need to be clear about the precise nature of our concern. Public speculation about terrorist use of a radiological device, or "dirty bomb", has created the impression that radioactive material is so ubiquitous that controlling it is beyond anyone's ability. But to paraphrase a friend's favorite Mark Twain quote, the difference between a nuclear bomb and a "dirty bomb" is the difference between lightning and a lightning bug. While a radiological explosion in an urban area would be a deadly disaster with serious aftereffects, a nuclear explosion, with its much larger effects of blast, heat, and radioactive fallout, would be a nightmare orders of magnitude worse.

That means that the real issue is not controlling all radioactive material, but rather fissionables, the uranium used to fuel reactors and the plutonium byproduct they produce. Is it possible to create a foolproof, ironclad global system that would deny any country not already in possession of both nuclear fuel and fuel processing technology access to either or both, while also severely restricting the activities of countries already in the club? President Bush has proposed one approach, while the International Atomic Energy Agency has its own plan. While it's not clear that either approach goes nearly far enough, neither is it clear that the will exists to go even that far.

Fundamentally, we must either find a way to control this trade, or it must be stopped entirely, with the massive economic consequences that would entail. Any other alternative risks creating a world order infinitely more dangerous than the nuclear roulette of the Cold War.

Unintended Environmental Damage
This fascinating article by a former Greenpeace activist details some of the unintentional fallout of concerted opposition to genetically modified crops around the world. Although Mr. Moore's focus is on biotechnology, it could just as well have been on energy.

Consider the bans on offshore oil and gas drilling imposed in areas such as California and Florida. Although targeted mainly at preventing drilling-related oil spills, such as the one that blighted Santa Barbara's beaches in 1969, they make no distinction between drilling for oil and drilling for gas, which incurs little or no risk of spills. As a result, billions of cubic feet of natural gas that US consumers and industry desperately need today are not being produced.

In the case of Florida alone, the resources in question appear sufficient to supply all of that state's gas needs for the next twenty-plus years. We know what these bans are intended to prevent, but what are their unintended consequences for the environment?

Well, for one thing, with natural gas prices extremely high today, the incentive to produce electricity from coal goes up dramatically. Coal plants are run harder, gas turbines less so, and this means more acid rain precursors and greenhouse gases are emitted into the air. Similarly, home heating oil looks more attractive relative to gas, and although it is not as dirty as coal, it is certainly not as clean as gas. So again, air pollution increases, because of policies that keep known reserves of gas locked underwater.

Finally, demand for gas imports goes up, too. Since new supplies from Canada and Alaska will require major new pipelines (with their own environmental impacts, which may prevent them from being built), the incentive to import liquefied natural gas (LNG)increases. We are currently seeing a media blitz on the virtues of LNG, which is indeed a clean fuel in and of itself.

Of course, when we evaluate the benefits of LNG, we don't typically factor in the energy that was used to liquefy it, a process that consumes 10-20% of the original gas, with accompanying emissions of greenhouse gases. Once it is in a tanker on the water, it requires a terminal near its final market in which to receive and regasify it. A number of companies are currently discovering the complexities of siting such facilities near anyone or anything.

So we begin with a set of values that declare natural gas to be cleaner and thus the fuel of choice, but then other values make it next to impossible actually to produce a good chunk of the gas that's right here in the US. The consequences are more pollution from burning other fuels and, in effect, "outsourcing" the negatives that concern us to some other country that will produce gas for us, turn it into LNG and put in on a tanker.

So in a manner not so different from the opponents cited by Mr. Moore, a number of prominent people who appear smart enough to understand the big picture relating to natural gas supply and demand have deliberately chosen not to, for reasons of ideology or political gain, resulting in a substantial increase in air pollution and worsening of the US balance of trade. They are entitled to their views, but they should not continue to masquerade as friends of the environment.

Proven Oil Reserves?
The ongoing shakeup at Royal Dutch/Shell over the recent restatement of their oil reserves is beginning to acquire the whiff of scandal, with coverage shifting from the business section to the front page, and with headlines verging on the sensational: "Oil Giant's Officials Knew of Gaps in Reserves in '02".

Whatever the ultimate outcome of current investigations at Shell, the end result will restore the company to conformance with SEC standards for the booking of oil reserves, which are meant to indicate an oil company's future production potential. Instead of viewing this situation through the lens of Enron/Worldcom/Parmalat paranoia, one could actually see it as an example of the system working, albeit a bit slowly. In any case, it offers an important caveat for international oil investors.

As the energy business becomes increasingly global, and as the number of players from outside the traditional circle of US and European majors--where standards such as the SEC's hold sway--expands, it is useful to remember that not every foreign company's reserve estimation processes would withstand such scrutiny. Before piling into shares of Russian and Chinese oil companies, for example, or partially-privatized entities such as India's ONGC, investors should make sure they truly understand what they are getting for the price.

While it is disconcerting to find that an established firm like Shell overstated reserves, a similar revelation about a company just coming into the world market would be disastrous for anyone who had bought into it. I suspect a lot of hard questions will be asked in the next weeks and months, in places that are less accustomed to that kind of transparency.

Venezuelan Politics
This short but insightful article from the Financial Times covers another electoral process that Americans should be watching with great interest this year: the effort by the opposition parties in Venezuela to recall President Hugo Chavez. Venezuela is the US's second largest foreign oil supplier--ignoring our NAFTA partners--and only a little over a year ago provided a vivid reminder of the impact of political instability on oil markets. A similar crisis today would send oil prices to the stratosphere.

Last week, it appeared that the efforts of the opposition to hold a national referendum on President Chavez had failed. The FT points out the hazards facing the opposition if they abandon their goal of a democratic solution to the current problem. President Chavez is popular with the poorer segments of the country and has a firm grip on the military.

Of equal concern is how he might react to any pressure the US might seek to apply, if the electoral process were derailed. Chavez is famous for his volatility and anti-American rhetoric, even as he relies on US and other international oil firms to grow his country's sagging oil production. Those companies will need to manage this relationship with particular care and sensitivity, while prudently managing their risks.

Image vs. Environment
The NY Times carried an amusing post-Academy Awards article over the weekend, contrasting the stars who drove Hummers to the Oscars against those who drove more economical and environmentally benign hybrid cars. The Toyota Prius and the Hummer represent completely opposite views of what car-buyers want, and the challenge for Detroit, Yokohama, and Stuttgart is how to weave these strands back together.

The Hummer is all about potential, and it epitomizes the dominant theme in auto design over the last ten-plus years: building cars with the potential to go faster, accelerate quicker, and carry more payload, further offroad, than the miserable cars foisted on us in the 1980s. The consumer who buys such a car wants to be going 70 mph by the end of the offramp, even if he knows he will have to jam on the brakes to avoid crashing into gridlock. She wants to be able to take the whole family and a week's gear to a base camp in the wilderness, even as she realizes her car will rarely carry more than her briefcase to the office. It is the triumph of image over practicality and economy.

The Prius represents something very different. It's a reminder that car technology has not stood still for 20 years, and that if we hadn't been so focused on adding speed, throw-weight and endless power gizmos to cars over the years, we would today have a car fleet averaging well over 30 miles per gallon and delivering reasonable comfort, safety and reliability, with all that entails for the environment and energy security.

But even if a new administration were to ramp up the minimum Corporate Average Fuel Economy (CAFE) standards--and close the SUV loophole in those standards--most consumers will still want it all: performance plus safety, economy plus spaciousness. How else do we explain the Hummer buyer who is dismayed to discover it gets less than 12 miles per gallon? Perhaps the new generation of hybrid SUVs currently under design will start to address this.

Cheap Oil?
A friend forwarded a recent article in Business Week that suggests the era of cheap oil is over, due to a combination of increased demand and greater OPEC cohesion. The industry has a rich history of seeing the future as a continuation of the present: when prices crashed in the late 1990s, due largely to the Asian economic crisis, it was hard for even seasoned oil executives to imagine a return to prices over $20/barrel any time soon. I believe the technical term for this is "availability bias."

We are clearly in an alignment that favors the producers at the moment. The US economy is recovering--whatever the politicians may say--and China is booming. At the same time, exports from Iraq have been sporadic and well below expectations for this stage of the occupation. Venezuelan production is probably less than officially stated, due to lingering aftereffects of last year's strike and production shut-in.

So in the short term, prices look very firm and have some upside. And in the long term, as I've discussed several times in this blog, there is the prospect of supply being unable to keep up with demand, due to the combination of depletion of mature basins and problems in bringing on new fields rapidly enough. But that leaves the all-important medium term, from a year to five years out. And the lesson of the 90s is that a swing of less than 5% from short to long can drop the market by multiple dollars.

In less than five years Iraq could start to have a real impact in the market, with existing production and infrastructure rehabilitated and new fields starting to come on. There are a number of other projects around the world that will be reaching the market in that period, including major projects in West Africa, the Caspian, and possibly Iran. And that ignores any demand-side impact a new US Administration might have. Combine these factors, and a couple of years from now we could just as easily be looking at $18-20 oil and wondering if OPEC can hold it together. And a few years after that, we could be back to scarcity.

The real lesson here is understanding the difference between true structural changes and temporary market conditions. And the kind of structural changes I'm talking about would be at the level of economical alternatives, new regulations, geological or capital constraints, or major new discoveries. However tempting it is to proclaim that things have changed for good and we are now looking at permanently high/low prices (take your pick), the incredible complexity of the factors involved has a way of overtaking such predictions in a remarkably short time.

China Big
The People's Republic of China recently passed a significant milestone: it now imports more crude oil than any country other than the US, at roughly 5.5 million barrels per day. This is remarkable to me, since I can recall when China routinely exported crude oil and refined products, because its domestic market was so small.

Last week's Economist described the impact of growing demand from China across a wide range of commodities, including metals, plastics, and energy. In essence, China's appetite for imported raw materials, whether driven by export industries or growing consumer demand, has become a force to be reckoned with in the same way as the US's.

This is a new thing in the world, and it is the opposite of what people typically meant a decade ago when they uttered the phrase in today's title. Back then, "China Big" was the standard justification for entering into any kind of deal with a local Chinese partner, since the market was bound to be so enormous later. A number of companies destroyed a great deal of shareholder value following that logic, and others will have to be very patient about their returns. But that's all beside the point.

China has graduated into a very exclusive club. At least in sectors like energy and mining, they have attained the size at which global firms simply can't afford not to be engaged with them in some way. An inevitable consequence is that we will see Chinese firms grow to truly global scope (and maybe scale), on the back of this.

The question is whether they will be content to follow the Japanese model of buying small shares of other people's projects, as in their recent purchase in the liquefied natural gas arena, or will prefer originating their own projects and truly competing with the majors globally. The answer to that question may say a great deal about the composition of the global energy industry of the 2010s.

Fire or Ice?
Two recent articles in the New York Times highlight growing concerns about the possible consequences of climate change, generally referred to as global warming. In the first, investors are becoming more assertive in asking energy companies to quantify their exposure to future regulation of greenhouse gases, which are associated with the observed warming trend of the last century or so. A number of firms, including mid-sized US upstream-only companies, are facing shareholder resolutions along these lines.

The second article compares the upcoming action film, "The Day After Tomorrow", by the director of "Independence Day", with an extreme climate change scenario commissioned by the Pentagon. The scenario was developed by Peter Schwartz, the founder of the Global Business Network, a leading scenario planning group. However one might assess the likelihood of such a scenario occurring, involving drastic cooling of Northwest Europe and the Northeast US as a result of interference with the North Atlantic warming current, such an event would certainly have major security implications.

Given the criticisms by both of the Democratic frontrunners of the Bush Administration's handling of global warming and the Kyoto Treaty, and with a blockbuster movie that could elevate the public's awareness, climate change could become a hot issue this year. If so, let us hope that this stimulates a meaningful national debate on the subject, rather than a rush for a quick fix. After all, even the most ardent supporters of Kyoto would agree that it was only intended as a first step in dealing with a problem that could be with us for the next century, or longer.

In Whose Orbit?
Interesting to see US Secretary of Defense Donald Rumsfeld visiting Kazakstan the other day and making security overtures to the Kazak government. Since the collapse of the Soviet Union, the countries around the Caspian Sea have been seen by some as a sort second Middle East. While the area's proved reserves of oil are still not on the scale of even Kuwait, by itself, it has upside potential and is an increasingly important supplier.

The Secretary's visit is notable for what it signals about the changing nature of US interest and involvement in a region that until recently was under the more-or-less exclusive influence of Russia, their "Near Abroad." Once Western companies began to establish themselves--ChevronTexaco set up operations in Kazakstan in 1993--closer governmental ties were bound to follow.

Russia is likely to view this relationship as unwelcome, and it is important to note that our interests and those of the Russians don't align well in the Caspian. Russia wants a big share of the infrastructure for getting Caspian oil to market, while the US prefers multiple routes involving smaller neighboring countries, such as Georgia, with its new pro-US government. This greatly oversimplifies the complexities of Caspian pipeline issues, about which books could be (and probably are being) written.

All in all, this is an area to watch, particularly as Russia becomes more self-confident and assertive in the wake of the likely landslide re-election of President Putin next month.