Signs?
This morning's papers are full of the news that the Russian government has agreed to sell its 7.6% share in Lukoil, Russia's second-largest oil company and its most active outside the former Soviet Union, in a public auction.  At the same time, Mr. Putin has apparently met with the chairman of ConocoPhillips, which is keenly eyeing the Lukoil stake.   While such a deal might not be as material for Exxon or BP, it would be a nice plum for Conoco.

All of this is preliminary, and it is too soon to say whether this constitutes the positive, post-Yukos signal that the market needs.  Regardless of the fate of Yukos, minority holdings in Russian firms will still be risky, until the legal system has been cleaned up and modernized.  Still, with a sizeable portion of the non-OPEC world's unexploited oil reserves, Russia's strategic importance is simply too great to pass up.  Russian oil made the fortunes of an earlier generation of oil companies in the late 19th and early 20th centuries, and it clearly has the potential to turn this trick again.   Stay tuned. 

Sustainable Development
Bolivia has just held a referendum on how its hydrocarbon resources should be managed.  The five-point ballot covered the future role of the state and whether gas and oil should be exported, and how.  The referendum passed with a large majority, based on returns so far.  This was the issue that brought down the last government, amidst violent protests, and President Mesa may see the result as a vote of confidence in his government.

On the surface, the issue might seem almost ridiculous.  Bolivia, a poor, landlocked country, has few other things to sell to the world besides the natural gas reserves developed over the last few years with significant foreign investment.  Keeping the gas "for Bolivians" or renationalizing it would cut off both inward investment and hard currency revenues that the country badly needs. 

Aside from the issues unique to Bolivia, relating to the loss of its access to the sea in a 19th century war with Chile, the situation is consistent with resource management issues throughout the developing world.  In Indonesia, Nigeria, and other oil-rich countries we see local populations, which enjoy less benefit from the exploitation of these resources than they expect, reacting in ways that imperil the viability of massive projects.  Ultimately, for a resource contract to endure over the time required for the investors to earn an attractive return, there must be equity in benefits not only for the host government, but for the host population. 

I don't mean to suggest that the whole burden of ensuring this should fall to the international companies that find and develop these resources.  Rather, this is a primary responsibility of the governments in question, and it creates a responsibility for the companies to see that the countries fulfill their duties to their people.  Sustainable development, with its "triple bottom line" of economic, social, and environmental indicators may not be quite as prominent as it was a few years ago, but it is one way to devise measurable goals and milestones to which all parties can be held accountable.  Such an approach might have even headed off the renewed fervor in Bolivia for nationalization, which will benefit no one.

What Comes After Yukos?
The Yukos drama seems to be entering its endgame, with the Russian government announcing it will seize the company's largest asset and sell it to settle the year 2000 tax claim.  The operation in question is bigger than all but a handful of the international oil companies, at least in terms of reserves and production, and would be a gem in anyone's portfolio.  Will it go for top dollar or something closer to its original acquisition cost of $150 million?  Will international companies be allowed to bid?  What on earth does this mean for foreign investment in Russia's other companies?  There aren't any good answers yet, but the risk factor for investments in Russia should go way up, until we see whether this is a first move toward restructuring the whole post-breakup economy, or simply the resolution of a vendetta against Mr. Khodorkovsky. 

Oil has been a primary engine of Russian economic growth for the last several years, and I don't see how the government could imagine it could live without it.  Unless Mr. Putin is completely confident that there is already enough capital and expertise inside the country to sustain the recent expansion of Russian oil production, he will need to send a very big positive signal to foreign investors, and very soon.   

A Contrary Wind
Niall Ferguson isn't known for commentary on energy policy, but rather as a historian who has written perceptive and well-received books. His op-ed on wind power was published in Britain's Daily Telegraph paper last Friday. As he admits, it might easily be written off as a NIMBY-ism, but the issues he raises are ones that the proponents of wind power can't afford to ignore. They fall into three main categories:

First, that wind power is still expensive, compared with conventional power, and must rely on heavy government subsidies, though this was also true for other forms of power generation in their early days, notably the nuclear power industry.

Secondly, he complains that they are unreliable, and as such cannot replace other forms of power generation in supporting a stable electric grid. Wind is by its nature intermittent, and one of the biggest challenges wind developers face is either integrating it smoothly with the grid, or providing sufficient energy storage to smooth its peaks and valleys for remote, off-grid applications. This can run up the total cost of a wind project significantly. None of these problems is insurmountable, but they do add complexity that conventional power plants avoid.

Mr. Ferguson goes on to suggest that, because of these shortcomings, wind power's contribution to reducing greenhouse gas emissions will be much less than has been suggested and far less than the unpopular nuclear power plants that are being phased out in Britain and elsewhere. Others have made the same connection (see my blog of May 13, 2004), but I think in practice it's not a fair criticism. No developer is sitting down to choose between putting in a wind farm or building a nuclear power plant. The real-world choice is between wind power and fossil fuels, and on that basis, it reduces emissions.

Finally, the argument comes back to aesthetics, and in the long run I think this poses the most serious threat to really large-scale wind power development. Are there enough first class wind resources (see my blog of May 6, 2004 for a better explanation) in places close enough to where the demand is, but where few will object to their visual signature? The wind industry faces an uphill battle on this, and it would be wise to tackle it head on, with a well-designed public relations campaign. Not all of wind's critics are as articulate as Professor Ferguson, but they share his concerns.

By the way, without much fanfare, today is the 35th anniversary of Neil Armstrong's "small step for man". Coverage on the NASA website and on Space.com.

Future Competitors?
The Financial Times recently covered the ongoing changes in the Chinese oil industry, with PetroChina acquiring a licence for offshore exploration in the South China Sea.  Everyone seems to be talking about the rapid growth of China's oil consumption, but I haven't heard much about the implications for the international energy industry.  It's easy to forget that the main global competitors today, the Supermajors and their smaller kin, grew to dominance through a combination of successful oil exploration and large, growing downstream markets in their home countries.  The growth of China could well create one or two new global competitors for the same reasons.
 
A few years ago the conventional wisdom saw the biggest threat to the incumbant major oil companies coming from the national oil companies of the producing countries, both OPEC and non-OPEC.  In an era in which PDVSA, the Venezuelan state oil company, had bought Citgo in the US, and Kuwait had purchased the European refining and marketing assets of Gulf, that seemed a realistic development.  But the OPEC state oil companies haven't transitioned into true global competitors, for a variety of reasons including the domestic needs of their shareholder governments.  The Chinese companies could go down a similar path, but that doesn't seem consistent with other trends in China.  Instead, isn't it likelier that they'll learn as much as possible from their foreign joint venture partners and translate that knowledge into the competence to compete in a wider arena?
 
Today's international oil companies have tremendous advantages in technology, market access, brand identity, and capital, but in the globalizing economy none of these is permanent.  Legacies can be eroded, and new competitors become remarkably effective in less time than previously, if not exactly in "internet time."  If we try to imagine the top 10 international oil companies in 2020, who is willing to bet that a third of the list won't be Chinese or Russian?

Which Gas?
Whenever gasoline prices go up, there's a tendency to shop for cheaper brands and buy lower octane, to ease the pain. The NY Times last week published an article intended to help guide consumers in this quest. Most of it was pretty sensible, but I differ with them in a couple of areas, and this seems like a good topic for today, heading into a nice summer weekend.

First, octane. Octane is a measure of how slowly a gasoline burns. If it burns too fast in the cylinder, the engine pre-detonates, or "knocks". The Times recommended buying the lowest octane gas on which your car doesn't knock, and that's the tried and true rule. They also acknowledged that some cars can sense and compensate for lower octane, allowing a car designed for premium to run on regular. But I ask you, if you've spent upwards of $40,000 on a high-performance car, is it really worth saving $100/year (do the math) and missing some of the oomph you paid for?

Now, if that doesn't apply to you, then not only you but the rest of us are all better off if you buy lower octane. It turns out that the molecules that raise octane require more refining, consume more oil, and have a greater potential to harm the environment. If you're as old as I am, you might remember a TV ad for "Super Shell with Platformate." Well, all gasoline contains Platformate, and that's the stuff we're talking about here: aromatic hydrocarbons.

As to additives, I admit that this has gotten quite confusing and that even the cheapest gas contains a minimum level of detergent, set by the EPA. But particularly if your car has multi-port fuel injection, you can still benefit from paying for brand-name gas with a better additive package. As to the little cans and bottles of additive, which the Times seems to like, think about this. At the rate the best gasolines are additized, you are getting the equivalent of a bottle of top-grade additives with each 10 gallon fillup, at a price that I'll bet is less than what you'd pay for most of the do-it-yourself varieties, which may or may not be as good.

Finally, when you pull your car into that cheap off-brand station, you might want to consider who would stand behind them, if you were to get a tank of bad gas--a rare occurrence these days, but not an impossibility. Personally, I think you'd stand a better chance of getting a Shell, Chevron, Exxon or the like to pay for the repair of your expensive engine than you would with "Ed's Gas." (No offense, Ed.)

Happy motoring!

Data Power
It was several years ago that I first ran across the idea of using power lines to transmit data, including high speed internet access. After a long period of dormancy, it looks like this idea is starting to catch on, in different ways.

This article in MIT's Technology Review proposes utilities as potential competitors to DSL and cable providers. The NY Times recently looked at the potential for data over power lines to solve the problem of the "last mile", or even the last few feet, particularly when cleverly matched to wireless networks.

The advantages of this approach seem obvious, at least in terms of the ubiquity of the infrastructure. If "BPL" turns out to be as reliable as other broadband connections, it will open up large market segments that are currently unserved by DSL or cable, as well as providing some healthy competition to current operators who may presently feel free to collect monopoly rents from their subscribers. (My own cable provider increased its ongoing rates to $45/mo. vs. their $29.95 intial come-on.)

Less obviously, could offering this additional service provide utilities with the revenue and incentives to upgrade their own infrastructure, a need highlighted by last year's Northeast blackout?

Drilling What's Left
Last week the NY Times featured an editorial by former Secretary of the Interior Bruce Babbitt, in which he decried potential oil drilling in a sensitive portion of the National Petroleum Reserve-Alaska. Note that this is not the Arctic National Wildlife Refuge, but rather an area set aside by Congress for future oil exploration. I can't dispute Secretary Babbit's assertions about the ecological importance of the lake in question, or the area in general. I haven't the competence, nor is that the point. Rather, I am struck by the urgency of approaching the country's energy needs in a way that is realistic and recognizes the inevitability of trade-offs.

The lower-48 states are the most heavily explored and exploited oil province in the world, having produced nearly as much oil in the last 140 years as the Saudis claim to have left today. That has real implications for future domestic oil production, which peaked in the early 1970s and has been declining ever since, from roughly 10 million barrels per day then to about 6 million now, including Alaska. Although less heavily explored, Alaska is also experiencing declining production. The North Slope oil that made such a difference in the aftermath of the 1970s oil shocks reached a peak of 2 million barrels per day in the late 1980s, and is now less than half that. Without new discoveries, it will continue to drop.

There is additional oil to be found, but it will be in places that are more challenging (e.g. in deep water offshore), more remote, or previously off-limits to drilling. While at best this oil can extend the long plateau of US production, foregoing it entirely will lead directly to the rapid offshoring of the entire industry. I don't know if the National Petroleum Reserve-Alaska can provide the backfill needed to maintain Alaskan production at the current level, but without it, or oil from the Arctic National Wildlife Refuge, it is predetermined that Alaskan production will fall. That means more imports, without even considering the steady growth in demand.

While I can understand that there are some areas that are just so beautiful or so important to the natural world that we shouldn't drill there, I have a harder time seeing how we can continue to carve out chunks of Alaska as big as other states, set them off-limits, and yet continue to demand increasing quantities of oil and other energy to fuel our lifestyles. Something has to give, and this should be obvious to everyone, policy-makers and voters alike.

Bullish or Bearish on Hydrogen
Several colleagues have suggested that I've become awfully pessimistic about the potential of the "Hydrogen Economy", especially for someone who had been such an optimist a couple of years ago. After reflecting on a talk I gave yesterday, I realized that I sound pessimistic even to myself. But I need to draw an important distinction: if we are talking about the grand vision of a world of transport and stationary energy fueled by hydrogen that is generated by some clean source, then I am truly less sanguine now that this will arrive soon. However, I am not at all pessimistic about things like this.

I'd lay odds that, long before the average person owns a hydrogen car or lives in a fuel cell-powered home, small fuel cells running on hydrogen or methanol will routinely power our personal electronics. After all, a fuel cell is really just a fancy battery with an open loop, meaning that you can keep adding the ingredients for the electrochemical reaction that produces power. And because chemicals such as methanol store more energy per gram than current batteries, you'll be able to run your iPod or PDA/phone a lot longer unplugged than with even the best lithium ion battery.

Granted this is not what most people think of when they imagine the Hydrogen Economy, but the essence of that is using hydrogen as an energy carrier without combustion, and that's what these tiny fuel cells do. There's nothing wrong with starting small.

Digging Up Dirt
If you haven't already read it, I recommend Paul Volcker's Wall Street Journal editorial from last week describing his approach to investigating the allegations concerning the UN Iraq Oil-for-Food program. Kofi Annan could not have tapped anyone with a stronger reputation for integrity and independence; now we will see if the results surprise him or his critics.

As I've suggested before, if the allegations about the subversion of the Oil-for-Food program are proved out by the facts, then its program administrators would bear as much blame for the failure to avert war in Iraq as the intelligence community in its failure to accurately assess weapons of mass destruction. The future credibility of the UN is on the line, and I can only advise them to be utterly forthright and transparent in this investigation.

End of An Era?
Based on reports in the Financial Times and elsewhere, it is looking increasingly likely that Royal Dutch/Shell will accede to investor pressure and radically alter its governance structure. This would effectively end the world's oldest unconsummated joint venture and result in Shell looking--and acting?--more like its largest competitors, Exxon and BP. It would also stifle some of the wild scenarios currently circulating, such as the one in which Total takes a controlling interest in Royal Dutch and leverages this into a takeover of its much larger European peer.

While it may be past time for such a change, I doubt that a standard, US-style corporate governance structure would have prevented the recent management problems relating to the overbooking of reserves and their tardy disclosure. One has only to look at this week's indictment of Ken Lay, the former chairman of Enron, to deflate that notion. Rather, Shell's current weakness presents investors with an an ideal opportunity to push through a pet peeve. Only time will tell if the result better positions the company to deal with the challenges that lie ahead for the industry.

Election Issue
One of the points John Kerry raised in the speech announcing his running mate related to this country’s dependence on Middle East oil. His plea for a new focus on energy independence highlighted our high energy use but low reserves, in contrast to the Middle East, with 65% of the world's oil. If this becomes a persistent theme, it should make for an interesting national debate on energy, something I think is long overdue.

When I looked at the campaign websites of Senators Kerry and Edwards a few months ago (see my blog of February 27, I found some interesting comments about energy. Both seemed to be arguing for a diversification away from oil as soon as possible, for various reasons. In contrast, the energy strategy of the Administration rests on two pillars: bolstering supplies of our current energy sources, and investing in a long-term future alternative, hydrogen.

It will be interesting to see how these two approaches differ in their details, as the campaign heats up with the conventions and eventual debates. It will be equally interesting to see if the Democrats can maintain their focus on the issues, without resorting to trying to connect current energy policy to scandals and innuendo.

How Much Is Enough?
Today is another travel day, so this will be short. A week ago the Financial Times carried an article suggesting that the global oil industry--both publicly traded and state owned--has not been investing enough in new oil and gas production projects to maintain and grow current production. In fact, I see this as a much likelier and more plausible near-term threat to the ability of oil supplies to keep pace with demand than the speculative geology of the adherents of King Hubbert.

I am a big fan of markets, but I lay much of the blame for this phenomenon on a widespread misunderstanding of the market. If you look at the oil futures more than a year out, they are telling you that prices will revert to "normal", and well they may. If they do, big investments in new production will not enjoy the benefit of today's high prices. But the futures markets do not predict future prices; they merely reflect what buyers and sellers can agree on today, and that is not the same thing at all. Another day I'll talk about "market backwardation" and the role it plays in amplifying these false signals.

Finessing Kyoto
I recently wrote about state-level attempts to regulate the greenhouse gas emissions linked to climate change. (See my blog of June 14) In an editorial in the New York Times over the weekend, the former US chief negotiator proposed a new approach to addressing these emissions, even if the US can't bring itself to endorse the Kyoto Treaty.

As Mr. Eizenstat and his co-author point out, the Kyoto Treaty only covers the years 2008-12, while climate change is expected to be a major concern for the next century. The Kyoto reductions are only the tip of the iceberg in terms of emissions of CO2 and other greenhouse gases; something further will be needed in the longer-term. Without some sort of global consensus, this could take the form of a patchwork of competing and conflicting regional, national, and subnational programs. Mr. Eizenstat suggests an intriguing alternative that would put greenhouse gases in the same context as trade issues.

Just as international trade includes groupings such as NAFTA and bilateral arrangements, as well as supranational organizations like the WTO, the mechanisms to address climate change might include the global Framework Convention on Climate Change, as well as useful regional and nation-to-nation agreements. It is easier to imagine the US working within this kind of framework than in a purely Kyoto-centric system, particularly if the current administration is reelected.

But as the editorial rightly points out, there are threshholds below with independent approaches are not as helpful. US companies should be covered by rules that are consistent from coast to coast, rather than having to make their way through fifty different regimes.

This approach also requires some realism. The US is not going to meet its targets under the Kyoto Treaty, even if it were ratified by the Senate tomorrow. We are on a path to exceed that target by as much as a third, and trying to hit it even by the end of the 2012 first monitoring period would bring the economy to its knees. But that does not mean that we cannot be planning how we will get onto a path to greenhouse emissions stabilization and eventual reduction, in line with the other major industrial countries, even if that takes another decade.

Happy Independence Day!
...albeit a day late. No blog today, instead, a link to a remarkable new view of another planet, in this case, Saturn's moon Titan.

Is The Incremental Oil Too Sour?
An article in last Saturday's NY Times reminded me of an issue I've meant to cover for some time, namely the impact of changes in the sulfur content of oil as production shifts around the world. The Times focused on the impact on China, suggesting that rapidly growing demand and strains on its economy have lowered the quality of the crude oil China can afford to buy, with consequences for the level of sulfur emissions into the air. But this is only one aspect of a bigger picture.

While the rest of the world watches Saudi Arabia to see if it really can increase its oil production to meet the needs of the market, there has been little discussion about what kind of oil this will be. Oil quality varies tremendously from field to field and region to region. Saudi oil is typically light, indicating good yields of gasoline and diesel fuel with minimal processing, but sour, reflecting high sulfur content. Without additional processing, this sulfur will end up in the fuel products, and ultimately in the atmosphere. As a result, Saudi oil trades at a discount to West Texas Intermediate and North Sea Brent, the main marker crudes, which are light and sweet.

(These sweet vs. sour labels go back to the days before laboratory analysis was readily available in the field, and the standard way to gauge the sulfur content of oil was to taste it!)

Not only is the incremental oil from Saudi Arabia going to be sour, but many of the fields that are in decline in mature areas such as the US and North Sea have historically produced lighter, sweeter crudes. As a result, the average crude oil in the world will become increasingly sour, both in the near term as Saudi Arabia ramps up to fill the current gap, and in the longer term as more of the global production burden falls on the enormous reserves throughout the Middle East.

Although the developed countries can compensate for changing crude oil sulfur levels through investment in refinery hardware, this is harder for the developing world, where investments in environmental quality often take a back seat to building basic capacity. For example, if China has $1 billion to invest in refineries, will they spend it on desulfurization hardware to improve the environmental characteristics of fuels, or will they use it to expand refinery capacity, so they can meet the growing demand for fuels without higher imports of finished products? If the latter, then air quality will suffer.

Sulfur is only one aspect of changing crude oil quality. In the years ahead, refiners must find the capital for hardware to process crudes that are both higher in sulfur and contain fewer of the direct precursors of gasoline, while producing a slate of products meeting ever more restrictive quality requirements. Such investments have historically performed poorly, and more will be made only if refining margins—the difference between the price of crude and the value of its products—remain attractive, as they are this year. Otherwise, existing capacity will be strained further, and consumers will suffer, as we are seeing today.

The Island of California
My friends at the Global Business Network used to display an old map depicting California as an island, as a way of indicating how mental maps can affect planning. This morning's New York Times featured an analysis by Hal Varian, a professor at my B-school alma mater, that explains why California might as well be an island, insofar as its gasoline market is concerned.

Gasoline prices in California are generally higher and more volatile than in the rest of the country. Geography plays a role, since the distance to the main refining centers of the Gulf Coast has made pipeline supplies from there impractical. Regulations have reinforced this isolation, going back to the 1980s, when Southern California enacted its first rules creating gasoline specifications that were stricter than in the rest of the country. This disparity has been exacerbated by the extremely severe California Air Resources Board (CARB) specifications, which make gasoline in the state the toughest to produce in the world.

Professor Varian discusses some recent proposals for state government to play a role in the market and rightly dismisses these as likely to create further distortions. Having already suffered an electricity crisis largely caused by "misderegulation", the Golden State doesn't need another state sponsored energy meltdown.

The proposal he favors is not a new one. When local supply is inadequate to meet demand, refiners and traders would be allowed to import gasoline that meets US specifications--but not California's--by paying a sizable tax to equalize its cost to that of manufacturing CARB gasoline. While this might well alleviate some temporary price excursions, it still fails to address the long-term challenge of a market in which refiners have had little incentive--and many disincentives--to build enough local capacity to create a reserve margin.

In many ways, this situation resembles the conditions that existed just prior to the electricity crisis. Demand was outstripping capacity, which had stagnated for years due to problems of permitting and environmental regulations and litigation. The result was a market with no reserve capacity and highly inelastic demand, mirroring Dr. Varian description of the current gasoline market. The only effective way to redress this would be to encourage the construction of additional refining capacity, something that seems almost inconceivable in a state that has long appeared to have an implicit strategy to force refiners out of state.

So perhaps the only fixes are short-term fixes, until the system breaks completely, and voters demand a long-term solution. If so, then Dr. Varian's proposal is as good as any and better than most.

Yukos
The whole industry is watching events in Russia with great interest, as the Yukos drama plays out. Now the court has upheld the tax ruling, and Yukos is on the hook for $3.4 billion. With Russia seen as holding the main near term alternative to Middle East oil, the signals this case sends could be critical in attracting or repelling foreign investors.

I think we have to be cautions about reading too much into the fate of one company, however. There are many interpretations of this situation, which is complicated by national politics, personal ambition, and the desire of many Russians to see the injustices of the Yeltsin era rectified. Recall how Yukos and its peers were created, during a spasm of corrupt, winner-take-all privatization. So while Putin's actions look like a naked grab for power, they may also include an element of trust-busting, of the kind we saw in this country 100 years ago.

If the government forces Yukos into bankruptcy or dismemberment, our focus should be on what other steps Putin takes to reassure international investors and preserve the oil sector as the attractive engine of growth it has been in the last several years. That, more than the fate of Yukos itself, will indicate whether Russia wants its oil industry to be globalized or isolated.

The Picture of Dorian Gray
Today I’d like to talk about two companies. The first went through a lengthy period of reorganization and reinvention. It not only changed itself, but is on the way to transforming its entire industry. A darling of Wall Street, its competitors must take cognizance of its actions and direction, and many are scratching their heads at the implications of the changes they see. At the same time, it rewards its rank and file handsomely and is a generous contributor to the community.

The second company stands in stark contrast. It is the poster child for chicanery and corruption. Its top management benefited lavishly at the expense of stockholders and has been convicted or indicted for a wide range of felonies. Their hubris took down the entire company, leaving a wide swath of impoverished employees and shareholders in its wake.

Both companies are Enron, as perceived at different points in time. More intriguingly, the picture that emerges from an interview with Ken Lay published in the New York Times over the weekend, is that both may have been accurate. In any case, if the way the former Chairman of Enron managed his vast holding of Enron stock is any indication, he believed in the first, more attractive picture until the end. Contrast Ken Lay, borrowing money to preserve his stake in Enron, with Sam Wachsal, selling out in the face of insider knowledge of adverse news.

These days the media works overtime to create the impression that we live in a binary world. Our invasion of Iraq was first a quagmire, then a glowing victory of American arms, and now a debacle. Enron was the pacesetting firm in its industry; Enron is the devil.

F. Scott Fitzgerald once said, "The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function." We might do well to apply this skill in many areas, but I see particular value in looking at Enron this way. This company created remarkably innovative financial products that addressed entire categories of previously unidentified consumer and business needs, but it also engineered conflicts of interest for its finance officials that were dazzling in their scope and degree of deception.

At the same time it was working to turn the bland world of commodity energy sales into a customized, consumer-centric market, its traders were busily concocting intricate schemes to manipulate the California electricity markets, referring to their customers in the most callous language imaginable. (See my post of June 3, 2004.)

However naïve it may sound, I think it is possible—not certain, but possible—that Ken Lay genuinely believed in the transformation Enron was embarked on and was taken in as much as anyone by the fast footwork of a group of unethical finance executives. This doesn’t say much about his business acumen, but it might be enough to keep him out of jail. Meanwhile, I continue to believe that the wreck of Enron contains valuable nuggets of business innovation that will be mined by future entrepreneurs, when the market is again ready for them. I also look forward to a more complete history of Enron in the 1990s, once today's scandal fever dies down.

Where Are The European Hybrids?
I'm sure some of my regular readers are beginning to wonder if my blog is nothing more than a shill for hybrid cars, since I've written about them so often. In my defense, today's posting was triggered by a question from a friend, asking if hybrids are so great for fuel economy, then why aren't there lots of them in Europe, where gas is so expensive? This is an excellent question, since European driving patterns would benefit much more from hybridization than those in the US, where long highway trips make up a larger share of total vehicle miles. I didn't have a good answer, but set out to find one.

One factor is simply awareness. Several European manufacturers with hybrids in either prototype or planning don't market in the US at all. Fiat and Renault both appear to working on hybrids, but neither has been a factor here for many years.

More importantly, many European carmakers are placing their bets on other technology. For some, like BMW, that means an internal combustion engine running on hydrogen; my long-time readers know I think this is a dead end. Most, including VW, have focused their fuel economy improvements on updated diesel engines for passenger cars.

Diesels boost mileage at a much lower cost premium than hybrids, but in the past this came with a big penalty in noise and performance. Direct injection, "common rail" and turbocharging changed all that. Having driven a couple of modern diesel rental cars in Germany, I can tell you that there is no comparison to the diesel cars of yore--they drive and handle as well as other cars. The European trend toward diesel has been underway for so long, driven by lower fuel taxes than on gasoline, that soon half the cars on the road in Europe will be diesel powered.

This has a big impact on the attractiveness of hybrids there. If the representative car in Europe is a midsize diesel sedan getting more than 30 miles per gallon, how much better is a hybrid that gets somewhat higher mileage but costs significantly more up front and requires the more expensive gasoline? Rough calculations show that if gasoline costs 20% more than diesel and the hybrid costs $2,000 more up front, then it would take at least six years to pay out the investment. In Germany most people don't own the same car that long, because of the high cost of complying with annual safety and maintenance inspections.

As a result of all this, and contrary to what one might think, hybrids will probably be a bigger hit in the US than in Europe, until the cost differential between hybrids and diesels shrinks a lot.

Another Unwelcome Straw
Just when the oil markets start to settle down, and prices head back in the direction of $30, we get this. I guess if you're a Norwegian oilworker, you might think now is an optimal time to achieve your goals through a strike. For the rest of us, the timing couldn't be worse.

So far, the strike has taken 300-500,000 barrels/day of Norwegian crude off line. But if it expands, the entire sector is threatened, exceeding 3 million barrels per day, essentially all of it produced from offshore platforms in the North Sea. Although the US typically only receives about 150,000 barrels/day of Norwegian oil, this strike could have a disproportionate impact on US consumers for several reasons:
- Most of Norway's production is very high quality, low in sulfur and containing a high proportion of gasoline and diesel, and requires less intensive refining.
- With US refineries running essentially flat out, all our incremental gasoline supplies must be imported. To the degree that the suppliers of these imports are running Norwegian oil, the strike will further handicap them in delivering cargoes to the US.
- Although Saudi Arabia has pledged an increase of 2.5 million barrels per day, it will take a month or two for this extra production to gear up, and another month or two for it to reach market. In contrast, oil from the North Sea reaches European refineries in a few days and the US in about two weeks. That means there will be a lag before other supplies can make up for the lost Norwegian oil.

The net result will keep crude oil prices high, longer, and put further pressure on the US gasoline market. Hardly good news in the peak summer driving months.

Addendum: I saw on Saturday that the Norwegian government stepped in to end the strike and prevent it from affecting the rest of the country's oil fields. The market dodged a bullet, here.

Dirty Bombs
An updated argument against nuclear power relates to our renewed fears of the proliferation of weapons of mass destruction. In the case of Iran, for example, it's very hard to distinguish a peaceful program from a weapons program. But along with concerns that more nuclear power now means more fissionable material available later for nuclear weapons, a number of commentators worry about the accumulation of radioactive material that could find its way into a "dirty bomb". This article in MIT's Technology Review puts that threat into proper perspective and is well worth your time.

All I would add is that, when it comes to setting our security priorities, we need to be very clear that actual nuclear weapons must be at the top of the list, with first call on funding. We should be much more aggressive in securing Russia's cooperation in decomissioning their old bombs and reactors, and getting the fissionable material under airtight security. When Russia was eager for help in this area in the 1990s, our response, though well-intentioned, was far too modest.

Omens
Analysts expect OPEC production to reach its highest level in 25 years, as Saudi Arabia steps up output and the others do what they can, in an attempt to meet the current, unexpectedly high demand from consuming countries. Anyone looking for a plausible scenario of future oil markets should look around now, since this is, in effect, a dress rehearsal.

There's been a lot of commentary, including in this weblog, about geological and other constraints on oil production, and a general conclusion that today's conditions are not symptomatic of such a situation, but rather a coincidence of war, instability, infrastructure delays, and high demand. But today's oil market does share many features of the extrapolated status quo energy world:

- Declining production in key non-OPEC producers such as the US and North Sea
- Capital management and reinvestment issues in high cost OPEC suppliers (e.g. Venezuela)
- Steadily increasing reliance on OPEC production growth to cover essentially all incremental demand
- Increasing reliance on a couple of key non-OPEC producers, such as Russia, to balance growing OPEC market power

I don't know anyone who thinks that the US can find enough domestic oil to prevent our dependence on imports from going up steadily. After all, North America is the most mature, heavily explored and exploited oil province in the world, and we are well down the right hand tail of the bell curve in our prospects for new oil discoveries. But I don't agree with the impression created by the New York Times this Sunday that the quantity of oil in those parts of the US that are currently off-limits to drilling is too small matter in this equation. As a former oil trader, I believe it matters enormously whether we produce only 4 million barrels per day ten years from now, or 5 million.

The current price excursion hinges largely on a global difference of 1-2 million barrels/day, just as the 1998 price collapse did. A combination of offshore California, offshore Florida, Rockies, and Arctic National Wildlife Refuge production could get us that extra million barrels/day, for a decade or so, even accounting for depletion elsewhere. The key is what we'd do with the time this would buy. Would we get serious about reducing our consumption and bringing on alternatives, or would we pursue the same old combination of feckless policy and arguments about whose backyard takes the hit? If the latter, then to paraphrase an old Cold War dictum, it's time to stop worrying and learn to love OPEC.

Early Signs of Life?
Contrary to perceptions that only Halliburton subsidiaries and other US companies with close ties to the US administration are being considered for major oil projects in Iraq, Arabian Oil Company, Ltd. of Japan is apparently in talks with Iraq's South Oil Company for a large infrastructure project to upgrade the country's southern export facilities. The project would be a key component of plans to increase production from new and existing oilfields.

Clearly such an undertaking is contingent on resolving the horrible security situation in the country, both in terms of ensuring the safety of personnel and ending the perpetual sabotage targeted against the oil infrastructure. These are large caveats, in light of the daily news out of Iraq, but the prize is enormous, and Japan has long taken a strategic--if not always entirely economical--interest in Middle East oil production.

The transition government, which will attain sovereignty later this month, estimates that the deliberate destruction of oil facilities has cost Iraq $1 billion, as well as creating significant environmental damage. Those engaged in these acts know precisely what they are doing, and it is telling that their attacks have focused on causing temporary disruption, rather than permanent destruction of Iraq's oil assets.

The upside of a stable Iraq includes the chance of founding a second "central bank of oil", as Saudi Arabia has been called recently. As reliance on Middle Eastern oil grows in the future, it will be important from the perspective of consuming countries to spread out Saudi Arabia's current role as sole supplier of last resort. A healthy Iraq--however hard that might be to imagine today--would reassure markets for more than just the obvious security reasons.

Conservation
I suspect that some of my colleagues have gotten the idea that I don't place much importance on energy conservation. Although many speak of conservation as a source of energy--and a cheap one at that--I think that designation muddles the already confused distinction between supply and demand. Conservation lives in the world of consumer behavior and industrial demand, while true sources depend on technology, geology, and other engineering disciplines.

The New York Times presented a somewhat pessimistic view of conservation in this Sunday's Week in Review section, in an article entitled, "Suddenly, It's Hip To Conserve Energy." While acknowledging the contribution of energy-saving appliances and other legacies from our last energy crisis, the author suggests that as soon as prices fall again, the shine will go off hybrid cars and other new means of saving energy.

That may be true, but I think it gives too little credit to the lasting impact of such advances. If you think of conservation as occurring in cycles, with successive waves of energy-saving investment following each sustained spike in energy price, and then falling back to lower levels as prices revert to normal, the base efficiency of the economy will still improve dramatically over time.

For example, a Toyota Prius purchased today will continue to save gas for ten or more years, even if the original owner trades it in the moment prices fall below $2.00/gallon. In the same way, a new energy efficient boiler or HVAC plant at an industrial facility will save energy for decades, long after the economic drivers behind the project have disappeared. This legacy effect, along with the growth of the service and knowledge sectors of the economy, is one of the main reasons we use much less energy per dollar of GDP today than in the 1970s.

I also believe the article also focuses too much on oil, and the likelihood that its price will fall in the near future, returning us to the height of the fad for large SUVs. A higher proportion of energy conservation in the US will probably be driven by the high price of natural gas, which is unlikely to drop anytime soon, as I've discussed in previous postings. High natural gas prices will provide strong incentives for conservation for many years, so we should expect those graphs of BTUs/dollar of GDP to continue their downward slope, with attendant benefits for greenhouse gas emissions and our balance of trade.

Rather than seeing conservation as unimportant, I think it's a vital component of the long-term energy picture, but one that is essentially a foregone conclusion while energy prices remain volatile and "cheap and reliable energy" becomes a contradiction in terms, due to geopolitical disruptions and inadequate investment in new infrastructure.

A New Era
Periodically I feel the need to include something in this blog that has no immediate implications for energy. Monday's planned launch of SpaceShip One is such an item. If successful, it will inaugurate a new era in humanity's conquest of space, beginning to move it out of the realm of things that governments do at great expense and toward something that private enterprise can do to make a buck.

Without in any way diminishing the achievements of two generations of astronauts and NASA employees, as well as Russian and other international space programs, this transition will mark the real beginning of our move out into the solar system, making accessible quantities of energy and resources far beyond anything we can imagine on earth. Solar power is much concentrated in space, without the atmosphere to absorb the sun's light, and a typical asteroid contains enough iron to meet the world's needs for a year.

None of this will be easy or cheap, but it has to start somewhere. Even though SpaceShipOne won't achieve orbital flight, it should reach an altitude of 100 kilometers, passing the threshold of space and qualifying for the first hurdle of the "X Prize".


I wish them luck, and I'll be eagerly tuned in to watch their progress.

Hybrid Fever
There were two good articles on the prospects for hybrid cars in the last week. In the Sunday Style section, the New York Times covered some of the sociology of hybrids, for example the desire to be the first on your block with something new. The Financial Times looked at the introduction of the first hybrid SUV, the Ford Escape Hybrid, and focused on the benefits of stressing performance, rather than just fuel economy, to American consumers.

It's worth thinking about performance and what that really means to the average driver. Although carmakers have stressed horsepower as the key measure of a car’s performance, this indicator of maximum engine output isn’t that useful in assessing what most people are really interested in, namely good acceleration. That has more to do with torque, and electric motors are wonderful at providing lots of torque without the time lags associated with internal combustion engines. So hybrids can effectively deliver six-cylinder performance, but with four-cylinder economy, or better.

As the FT points out, this advantage erodes in sustained high-speed driving, where horsepower matters more, especially when towing. It will be interesting to see whether hybrids—as presently configured—meet the needs of the average motorist, or only of those seeking excellent gas mileage and low environmental impacts. Personally, I'm waiting for a hybrid sports sedan that gets 30 mpg and does 0-60 in under 7 seconds.

Cuban Oil?
The Economist reports on wildcat drilling for oil off the coast of Cuba, in a deepwater zone of the Gulf of Mexico, just around the Yucatan from some of Mexico's most productive wells. Two foreign (and obviously non-US) companies are involved in the exploration. The implications of finding oil in Cuban waters are fascinating.

First, it would provide a major wealth injection into the moribund Cuban economy, and thus extend the longevity of the Castro government. All too often elsewhere, this has led to a rise in corruption, but the Cuban situation is sufficiently different from, say, West Africa, that such an outcome isn't a certainty. In any case, a major oil find would likely make the current US policy of isolation futile, leading the way to future engagement.

Second, if the oil resources were comparable to those on the other side of the Yucatan Peninsula, they could provide oil in excess of Cuba's needs, creating another oil exporter on America's doorstep. This would be a further incentive for normalization, however unpopular that might be with the exile community.

In addition, success in deepwater offshore Cuba could suggest attractive prospects elsewhere in the Gulf, beyond the recent deepwater developments and discoveries. That would be good news for US energy security, irrespective of the impact on Cuba.

Now it only remains to wait for the results of the drilling. If successful, oil could be flowing in four or five years, enough time to work out all the possibilities that my noodling above barely begins to cover.

More Hubbert Admirers
Until recently, only geologists and petroleum engineers had heard of the Hubbert Curve. Now, while not exactly a household phrase, it is fast becoming a familiar concept. This article in the Washington Post (free sign-up required) does a good job of explaining it and considering some of its implications, without getting hung up on precise predictions of when it might occur.

A few of the authors' facts are a bit shaky, such as the assertion that no really large oil fields have been found in the last 30 years. At least one was found in that timeframe in the Caspian region. Does finding fewer of these "elephants" than we used to necessarily mean we're running out oil, or were they just the easiest to find, because of their size?

Nevertheless, the article raises the right concerns, with the right degree of urgency. Even if you are skeptical about an imminent Hubbert Peak, as I am, the more important message is that we cannot assume that oil production will continue to grow smoothly or endlessly to meet increasing demand. Geopolitics and oil industry economics can create a similar situation, and seeing that as credible doesn't require an act of faith, because it doesn't hinge on an event that can't be known until we have past it.

So whether you buy the arguments of Hubbert or not, it is still important to consider what might fill the gap if oil production stopped growing, but economies didn't. There are no easy answers, and we can't even rely on the markets to signal when we should begin investing in alternatives. That's why this whole subject falls into the realm of risk management, for both countries and companies. We still have time to do this properly, since it's pretty clear that the current market glitch is NOT a Hubbert-like event, even though it gives us a small taste of what one might be like.

Opting In to CO2 Limits
The body responsible for reducing air pollution in California recently decided to extend their boundaries by proposing regulations on emissions of carbon dioxide (CO2) from automobiles in the state. Now, according to the New York Times, several other states appear set to follow suit, including New York and Connecticut. While this approach might appear to some as laudable pragmatism in the face of a federal administration that disdains action on climate change, I believe it to be misguided and ultimately counterproductive.

There are two major problems with this kind of back-door response to climate change. The first results from a basic fact of life: CO2 is not a pollutant. A pollutant is something that contaminates the environment. CO2, to the contrary, is an essential component of our environment, linking animals and plants in the well-known “carbon cycle.” This is not mere semantics, because thinking of CO2 as a pollutant constrains us to approach it in the same way that we have approached past pollution problems.

Consider the sulfur and nitrogen oxides emitted by cars and power plants. These gases can only be reduced at the source, and three decades of environmental regulation have made great strides in managing these emissions, even though problems still remain. For CO2 and the other greenhouse gases, however, reduction at the tailpipe or smokestack is only one of several possible strategies for reducing the emissions that contribute to climate change, particularly if one is concerned about keeping the cost of emissions reductions low.

For example, there are vast quantities of emissions from agriculture that could be reduced or eliminated cheaply. The effect would be the same, because all CO2 emissions are equivalent, everywhere on the globe. While the greenhouse gas emissions from the transportation sector can’t be ignored, focusing exclusively on this sector would result in unnecessary distortions and economic penalties.

The other problem with addressing CO2 emissions this way relates to the charters of the agencies involved. The California Air Resources Board has worked aggressively to reduce air pollution, particularly in Los Angeles and the San Francisco Bay Area. Their efforts have paid off, even if they have created unintended consequences, including forcing Californians to pay more for fuel than residents of most other states. The majority of Californians is probably willing to pay that premium, because the results are visible: air pollution in the L.A. basin has improved significantly in the last 20 years, in spite of a major increase in both population and vehicle miles driven. But that support will only reach so far.

Fundamentally, the only way to achieve the goals that CARB and the other states have set forth is to improve vehicle fuel economy. Setting aside the argument over whether this parameter is under federal or state jurisdiction, we cannot ignore the fact that the decline in fuel economy over the last decade is largely the result of a change in consumer preferences. Californians, like other Americans, have demanded larger vehicles and, along the way, have insisted that these SUVs not require 10 minutes to accelerate to freeway speeds.

To improve fuel economy dramatically, you can make the car smaller and lighter, reduce the power of its engine, or add expensive technology to reduce energy consumption, as in hybrids. All of these solutions are possible today, but all impose costs that collide with the desires of the majority of current consumers. As a result, I believe this approach creates a hidden trap for the regulators.

So far, consumers have gone along with CARB and other air quality regulators , because most of the burden of compliance has fallen on carmakers and oil refiners, and the results have been apparent in their communities. Regulating automobile attributes that consumers truly care about, in order to mitigate a long-term problem without any visible local manifestation, could undermine that support. Once car buyers in California and elsewhere realize that these new rules will constrain their choices in terms of size, weight and horsepower, they may decide that CARB has overstepped its bounds. The reaction could cost CARB not only its ability to manage CO2, but also some of its mandate to tackle "normal" pollution.

If you have been reading my blog for a while, you know that I think climate change is a serious issue that merits action, and that my opposition to this approach is not obfuscation. We need a genuine national debate on this issue, and any response must have broad voter support, because it will impose costs across our entire economy, and beyond. For that reason, and the others I’ve outlined above, I believe that treating CO2 as a pollutant and letting local agencies charged with keeping the air clean regulate it will backfire. It is also undemocratic.

What Should We Do with the SPR? (Rerun)
Last week's Barron's carried an editorial suggesting the sale of the Strategic Petroleum Reserve to private investors, arguing that this would remove another layer of government interference in the market. That approach is a somewhat more radical than my own modest suggestion of February 18:

Following on from yesterday's posting about the Strategic Petroleum Reserve, rather than asking about the timing of adding oil to the existing SPR, Senators Levin and Collins might instead have asked whether the SPR itself is the most efficient way to provide the desired protection from supply disruption.

The tricky aspect of such a strategic reserve is that it sends two signals: the intended one to suppliers about our ability to do without them in extremis, and an unintentional signal to the market affecting the overall psychology of holding inventory. In the last twenty years commercial crude oil stocks--in absolute terms and particularly when measured in days' supply--have declined significantly. While this might be coincidental, the mere existence of the SPR has reduced the risk of holding lower commercial inventories.

In addition, President Clinton's decision in the fall of 2000 to release crude oil from the SPR to try to hold down home heating oil prices sent a particularly confusing signal, since it directly undermined the incentive for companies to build inventories during low demand for use in periods of higher seasonal demand and prices.

The basic issue is providing an adequate backstop in case of actual disruption of supply, not trying to run the SPR for a profit or using it as a political tool to influence prices. This can certainly be done by a combination of government-owned storage and iron discipline on when to release stocks, as with the current SPR, but it could also be achieved or augmented by making commercial inventories less onerous for companies to hold.

Refiners are conservative people by nature. They are rewarded for running their facilities safely and profitably, and they work hard to avoid anything that interferes with that. Left to their own devices, they would hold lots of inventory, because it increases their flexibility and reduces the risk of running short of crucial inputs. But their accountants have been telling them for years that holding more inventory than absolutely necessary has dire tax and working capital consequences, and reduces the rates of return on their huge capital base. If companies were given incentives that eliminated these detriments, refinery managers would happily increase their inventories.

The other benefit of a scheme like this would be to circumvent the limits on how quickly the reserve could be drawn down when needed. The current limit on the SPR is 4.3 million barrels/day (MBD). At this rate, it would take almost six months to draw down the entire 700 million barrels on hand today. Holding equivalent volumes in hundreds of facilities, instead of a handful, would avoid this bottleneck.

Of course no one foreign supplier sells the US this much oil today, so one could argue that the likelihood of needing to draw down more than 4.3 MBD is low. But the loss of Saudi Arabia--not so hard to imagine in today's world--would take much more oil out of the world market and create major disruptions as traders tried to rebalance supply and demand.

But a side benefit of moving to a commercialized, incentivized structure would address precisely the concern of the two Senators. Decisions on when to add to inventory would be made by managers who are actively in the market, routinely making such decisions, rather than by government bureaucrats. Could such a system be gamed, a la Enron? Perhaps, but the incentives could be structured to minimize such behavior.

In many respects, though useful and better than blind faith, the SPR is an anachronistic holdover of a period of extreme regulation--remember the wage & price controls of the 1970s? Given the waves of deregulation that have swept industry after industry, it might be timely to look at this relic in a new light.

The Next North Sea?
Another posting from January, discussing the impact of declining oil production in the US and other mature non-OPEC regions:

US energy policy seems to lack a fundamental vision for what our federal energy funding should be buying us. I suggest that the goal should be to expand our energy options to keep our reliance on hydrocarbons from the Middle East from growing much further than it has. When we experienced our first energy crisis in the 1970s, this goal seemed clear. We lost sight of it when new non-OPEC supplies, from places like Alaska, the North Sea, the Gulf of Mexico and West Africa bailed us out. But we should have always seen that the bailout was only temporary.

Now the North Slope is deep in decline, producing less than half what it did in 1988. The North Sea is entering decline, and Gulf of Mexico production is only propped up by new technology allowing access to deeper water depths. Today it is Russia and the Caspian Sea region that appear as the bright hopes for keeping OPEC at bay for the next 20 years or so. But sooner or later the geological fact of the heavy concentration of oil reserves in the Middle East will become destiny, and there won't be another North Sea or Caspian waiting in the wings.

So let's not waste the next two decades that Russia and the Caspian can give us. It will take that long to make the transition to ways to produce and use energy that will make us less dependent, whether it's hydrogen, renewables (not alcohol--see Monday's post) or something more exotic.

But we can't just rely on foreign producers to limit the power of OPEC; we need to slow the decline of our own production, to preserve some leverage in the oil markets. It won't be easy. We have to begin with the inescapable truth that the US--at least the "lower 48"--is the most heavily explored and produced petroleum region in the world. Since Col. Drake's first well in PA in 1857, we have produced 80-90% of the oil that current technology can exploit. That amounts to about 200 billion barrels of oil, putting the US in a very exclusive club indeed; we were the world's Saudi Arabia before oil was ever found in the Kingdom.

While those days are past, it is hardly pointless--as some suggest--to try to find more oil here and to bring on production from areas currently off limits (e.g. offshore Florida.) Despite great improvements in oilfield technology, we still need new volumes to offset the severe decline from oilfields that have been producing for 20 or 30 years. Lifting environmental and land use restrictions on access to such reserves could also be linked directly to more funding for alternatives to oil, or to higher efficiency standards for cars.

The biggest challenge to slowing the decline of US oil production is that the oil industry sees much more attractive opportunities elsewhere, and has shed thousands of excellent jobs in the US in pursuit of a major geographical realignment of focus. Just watch the excitement Libya will generate once we drop sanctions.

Can we make investment in smaller, riskier US oil opportunities attractive, again? Tax breaks, accelerated depreciation, environmental offsets, and a host of other low-cost options could help enormously, but all would require a revised "sniff test" concerning "corporate welfare." That won't be easy in the current political climate, but the results could be extremely helpful while we wait for the Hydrogen Economy.

Saudi Shortfall?
This rerun is from from Feb. 25, but much of it seems quite relevant in light of recent events:

The subject of oil depletion keeps cropping up. Yesterday an article in the New York Times confirmed what I had heard from colleagues in the upstream oil business a few years ago: production from the largest Saudi oilfields is declining, perhaps irreversibly.

We should not overreact. Saudi Arabia is not running out of oil, nor is the world, notwithstanding the arguments of the disciples of King Hubbert. But there is a very serious issue here, with implications for the economies of all oil-importing countries. For decades we have relied on Saudi Arabia as the "swing producer" within OPEC, able to make up for shortfalls elsewhere, such as when most of Venezuela's production was shut in at the end of 2002. The future of that role is now in doubt.

No one questions the Saudis' enormous reserves. They still rank #1, with 260 billion barrels of proved reserves, roughly a quarter of the world's total. Nor do they lack the necessary technical expertise to find and develop the new oil reservoirs needed to make up for the depletion of their venerable supergiant fields. But they do have the same problem as many smaller producing countries: the social demands of their growing population are competing away the internal funds necessary to revitalize their oil industry. In this light, the Kingdom's persistence in keeping out all foreign investment in the oil sector is a luxury that neither they nor we can afford.

The message the US and other G7 countries need to send the Saudis, consistently and with emphasis is, "Our oil companies have the capital you need, and together we have the expertise. Open up your oil sector, or we will do whatever we must to wean ourselves off the need for your oil. If you maintain your current posture, your oil reserves will end up locked under the sand, worthless to you or your descendants."

Without access to Saudi and Iraqi reserves, which can be developed quickly and relatively cheaply, the international oil majors will spend their investment dollars on increasingly remote and technically more challenging opportunities elsewhere, drilling in ever deeper water and finding ways to make smaller and smaller fields economical.

The same dollars that would unlock millions of barrels per day of Saudi oil will yield half or a quarter as much oil elsewhere and with longer lead times, creating the possibility that the majors will not be able both to meet growing demand and compensate for the decline of mature fields. That would lead to the kind of supply/demand collision I've referred to before, and to much higher oil prices as far as the eye can see.

In any case, this news heralds the importance of developing and deploying meaningful alternatives to oil. This must include renewable forms, such as wind and solar and the hydrogen-based technologies that would allow them to displace petroleum products, as well as fossil-based alternatives, such as gas-to-liquids and coal gasification. These actions can't replace Saudi oil anytime soon, but they would speak louder than all the diplomats we can send to Riyadh.

Summer Reruns
The blog (or rather the blogger) will be on vacation for the next week. Barring some major story on which I feel I just have to comment, I will be providing a selection of writings from the last five months. (The hundredth posting in this blog was yesterday.) So if you've been reading from the start, or you can't stand the idea of something that wasn't written in the last day, you may want to tune out until next Thursday.

Here is the first vintage blog, from January 8:

Access to Oil
It appears that several US companies will be getting contracts to develop new and existing oil fields as a result of the war in Iraq. The surprise is that the contracts will be with Libya, not Iraq.

Although Libya's reserves are much smaller than Iraq's, they are larger than those of either Nigeria or Mexico, and they are in close proximity to the major markets of Italy, France and the rest of the Mediterranean. Libya currently produces about 1.4 million barrels of oil per day, but this level has stagnated for some time, despite identified new oilfields. US investment and expertise can make a real difference--without any of the risks and bottlenecks we face in Iraq--once sanctions are lifted. That should happen soon, given Libya's new stance on WMD and its cooperation in the War on Terrorism.

This may not seem like a big deal, but it has to be viewed in the context of the steadily increasing global demand for oil, which is expected to increase by 40% over the next 20 years. One of the strategic goals of the war in Iraq was almost certainly the elimination of political barriers to developing key oil resources that will be needed to meet future demand, without relying solely on Saudi Arabia and the other Gulf states. The opening of Libya is a pleasant and probably unexpected consequence, though the big prize of open international access to Iraq's 100 billion barrels of reserves remains to be realized.

Trader Tapes
The tv in the gym where I work out was tuned to CNN yesterday morning, when they reported on the taped conversations between Enron's electricity traders and others during the California Electricity Crisis of 2001. Some of the comments captured on tape were startling, others merely vulgar.

Many companies routinely tape record all conversations on traders' telephone lines, in case of subsequent disputes over the wording of transactions, so the traders are fully aware they are being recorded. That makes these remarks even more surprising and symptomatic of a toxic corporate culture.

As you know if you've been reading my blog for a while, I spent about ten years of my career in energy trading, handling both physical petroleum commodities and petroleum futures and options. For part of that time, I supervised a small trading operation. I can only say that if any traders that worked for me had ever uttered the kind of things these tapes captured, they would have been disciplined or worse.

When I began trading in the mid-1980s (before taping), my supervisors always impressed upon me that I was a public spokesman for my company, and that I should never say anything that I wouldn't want to read on the front page of the paper. That seemed eminently sensible, and it stuck with me. Now it's true that traders tend to be a boisterous lot, and the humor can sometimes get a bit raw, but the remarks I heard this morning went beyond anyone's idea of a joke. Once again, the arrogant behavior of Enron employees is tarring a whole swath of the industry, like a hazardous waste site that has not been fully remediated.

Perhaps there are traders out there today gloating in similar fashion over the high prices of gasoline and crude oil, but most of the people I dealt with during my time in that part of the business were ethical and honorable, and the few that weren't suffered for their poor reputations. Things may have changed, but I don't think they've changed that much.

By the way, the blog (or rather the blogger) will be on vacation for the next week. In the interim, I will be providing a selection of writings from the last five months. (The hundredth posting in this blog went up yesterday.)

Whither the Kingdom?
The attacks in Saudi Arabia over the weekend have the markets jittery, though perhaps not for the right reason. Traders fear that stepped up attacks on oil infrastructure, both human and physical, will impede the ability of Saudi Arabia to deliver the oil that the market is counting on. The Economist has an excellent article covering this prospect and its potential impact in some detail. As bad as this may seem, it is a short-run concern, compared to what these incidents may be signaling for the longer term.

More worrisome than the number of attacks against foreigners this year is that the perpetrators seem able to penetrate targets that have at least some level of security and then escape from the scene, despite a rapid response from police and other security forces. If this is an indication that the security apparatus of the Kingdom has been infiltrated or compromised through sympathy for Al Qaida within its ranks, then we could be in for a much rougher time ahead.

The longevity of the Saudi monarchy has been questioned for decades, but the House of Saud has clung to power through an astute balance of religious legitimacy, social benevolence and technocratic orientation, all backed by the use of force, when necessary. The post-9/11 world is putting pressure on the monarchy's ties to Wah'habi Islam, and the country's demographic bubble is eroding the welfare state. If the military and police were to prove unreliable, then the outcome could be precisely the kind of upheaval that some analysts have predicted for years.

The evidence so far doesn't support such a conclusion, but the Kingdom isn't exactly the most open society on the planet, either. This situation bears careful scrutiny in the months ahead.

Cost or Cleanliness?
The market penetration of alternative energy sources depends on the difference in price between the alternatives and conventional fuels, such as oil and gas. This is a pretty standard assumption, but the New York Times recently suggested otherwise. This assertion rests on two foundations: first, that the cost of alternatives has become much more competitive in recent years, allowing other considerations to play a major role in project decisions, and secondly, that environmental concerns have increased to become the paramount driver of such projects.

I think there is merit in both of these arguments, particularly where wind power in concerned, but I also think the article is too cavalier about the influence of historically high natural gas prices over the last several years.

During the 1980s and 1990s, natural gas became the fuel of choice for power generation, because it was both clean and relatively cheap. For most of this period, gas averaged between $1.50-$2.00 per million BTU at the wellhead. But since 2000, the price of natural gas has been considerably higher, often a multiple of the historical average. This changes the economics of generating electricity with natural gas. So for any alternative energy projects considered since 2000, the main competitor has been costlier, and more importantly, the general perception is that gas will not become cheap again, anytime soon. The main beneficiary of this change has probably been coal, as I suggested last week, but it had to help wind power, too.

The other factor in this equation is the difference between the wholesale and retail cost of electricity, which plays out differently for wind and for solar power. Because wind is a medium-scale technology, unsuitable for small applications, it competes with wholesale power on the grid. That means prices in the range of 3-5 cents per kilowatt-hour, typically.

Solar competes in a different arena. Because it is scalable from the size of your calculator to an entire factory roof, it is an alternative to retail power from the local distribution company, which costs upwards of 10 cents per kW-hr. Solar still costs a multiple of this, but brings other benefits in terms of reliability, at least when the sun shines.

When these issues are taken into consideration, it is much less clear that the cost of conventional energy no longer matters in the development of alternatives, as the Times suggests. Too many other things have changed to be able to assert this confidently, without a deeper understanding of the motivations of consumers and energy project developers.

Memorial Day
No blog today.

Could This Work?
Recently a friend emailed me one of those articles that provokes a really negative initial reaction but later percolates into your thoughts and triggers unexpected changes. The article in question proposes a radical solution to the urban problems of increasing traffic congestion and hazardous intersections. Rather than indicating a need for greater regulation of speed, lanes, and turns, it proposes creating a kind of traffic free market, in which cars and pedestrians must rely on seeing each other to navigate through the chaos. Thus traffic control would be an emergent phenomenon, not a result of laws and lights.

My first reaction was total rejection. Are they crazy? Have they driven in New York, with half the drivers distracted by cellphones and the other half trying to jam as many fares into each hour as humanly possible? When it comes to driving, I'm definitely a "stay within the lines" kind of guy, paying more attention to posted speed limits than apparently any other driver in the Northeast, so this kind of suggestion was guaranteed to raise my hackles.

Later, as I was driving back from a meeting I gave it more thought and concluded that this notion just might be bizarre and counter-intuitive enough to work. Clearly it has some serious research behind it; no one would suggest something like this without doing a lot of homework, because my first reaction would be the norm.

So why is it relevant to the theme of this blog? Well, consider the amount of fuel wasted by cars idling at traffic signals, or stuck in stop-and-go traffic, with endless cycles of acceleration and braking. I don't have good figures on it, but it is probably not trivial. In fact, it is one of the main reasons that hybrid cars are more efficient than conventional autos. By turning off the engine at stoplights and recycling some of the energy lost in braking, hybrids use less fuel than other cars and typically get better fuel economy in city driving than on the highway, where these effects are less important.

Even the so-called "mild hybrids" that will soon appear in the market, lacking the battery storage of conventional hybrids but also starting and stopping the engine seamlessly at intersections, rely on the fundamental assumption that traffic will look like it always has. But what if it doesn't?

If, as the article suggests, the new traffic pattern is one of somewhat slower progress between intersections, but less impeded flow through them and minimal complete stops, the whole idea of a hybrid or mild hybrid car would have to be reexamined. Clearly these reforms face an uphill battle in developed countries with established traffic patterns, but their major impact could be in the developing world. What if China continues on this path and others follow? A lot of assumptions about the shape of the future automobile might have to change as a result. Food for thought on a long weekend.

The Fuel No One Loves
"It was the best of times, it was the worst of times." That's how Dickens began "A Tale of Two Cities", and it may aptly characterize this year for the coal industry. With increasing global attention on environmental concerns, including air pollution and climate change, coal is truly the fuel no one loves, but upon which we have come to depend heavily. This love/hate relationship could be put in sharp focus this year, spurred by two external events: record high energy prices and the release of a Hollywood blockbuster focused on the coal world's worst case scenario, sudden climate change.

After the oil crises of the 1970s, consumption of coal increased steadily but then plateaued as natural gas became the fuel of choice for new power plants, due to its much cleaner combustion. Consumption of coal is up this year, and prices in the international market are at 20-year highs. The reasons are similar to those behind the high oil prices: strong economic growth in China and the US, coupled with tight natural gas supply in the US. This looks to be an extremely profitable year for coal companies.

Factor in the dim prospects for increasing US natural gas production and the strident opposition to the siting of facilities to import it in its liquefied form, and you have a recipe for excellent growth prospects for coal. The fly in the ointment is its environmental performance.

Enforcement of New Source Review is now an election issue (see my blog of April 21), but with the price of natural gas expected to remain extremely high (two to three times its historical average) for years to come, coal-fired power generators can afford the cost of cleaning up their sulfate and particulate pollution. New generation "clean coal" plants, employing gasification and other technologies, will have almost none of these emissions. The one thing coal plants cannot currently address is their enormous emissions of carbon dioxide, the principal greenhouse gas implicated in climate change. So far, at least in China and the US, this has not been a fatal weakness. Heightened public awareness of the climate change issue could change that.

As I indicated when the film was first announced, I don't know if "The Day After Tomorrow" will be that trigger, or if it will take some large-scale weather event to shift public perception. Nor are coal-burning utilities oblivious to this. A number of them have been pursuing carbon trading and carbon offsets for several years, as a way to mitigate the impact of their coal consumption. I give these companies credit for recognizing climate change as a major risk management issue for their industry, whatever their personal beliefs about the underlying science might be.

So we are back to the paradox I started with: coal is either our salvation from a looming energy crisis, or the main villain in the climate change story. This year it could be seen as both.

Questionable Timing
I have a lot of respect for Gregg Easterbrook's opinions on energy matters. He writes well, and what he writes usually seems well-reasoned and well-researched. But I'm a little perplexed at the timing of his New York Times editorial advocating the imposition of a 50 cent per gallon gasoline tax. It also stands in odd juxtaposition to a highly sensible suggestion on the same editorial page concerning ways in which Saudi Arabia and the US could calm the current oil price frenzy.

Although much of Mr. Easterbrook's speculation about a world shaped by a 50 cent gas tax sounds plausible, it also provides a good example of "should'a, would'a, could'a" thinking. We will never know if a higher gas tax would have truly kept SUVs smaller or scarcer. And while higher taxes probably would have reduced crude oil imports, it seems quite a stretch to suggest that they would have diminished the geopolitical importance of the Middle East. No tax can change the fact that half of the world's oil reserves reside there.

Perhaps it would have been more instructive to discuss how the revenues from those higher gasoline taxes in Europe have been used, along with their impact on European consumers, factoring in differences in geography and mass transit options.

In any case, it appears we'll get our opportunity to see what sustained $2.00/gallon gasoline does to consumer behavior and to the economy, and we won't have to pass untenable legislation to do so. Later, if we all decide we like it this way, we can ask our Congressional representatives to add new taxes to keep gas prices from falling, as they eventually will. Something tells me that when that happens, we'll prefer keep the savings in our own pockets.

Detroit's Gamble
When I suggested a few years ago that Detroit was taking a big risk by remaining so focused on increasingly larger SUVs, while Japanese carmakers were pioneering hybrids and more flexible conventional vehicle types, people regarded me with amusement. At the time, I wasn't even thinking about high gas prices, but rather that all trends eventually end, and ones related to fad and fashion often end more abruptly and expensively than others. I saw hybrids as a contender for the Next Big Thing.

Now we are starting to get a sense of the possible exposure this strategy has created for Detroit, as described in this Business Week article. It doesn't have to result in a decade of pain like the 1980s, when Detroit offered few of the good small cars that the public demanded and the Japanese had perfected. However, I suspect that the only thing that will prevent such an outcome is some fairly nimble thinking by GM, Ford, and Chrysler, along with a willingness to lead the way in undercutting their own cash cows.

That is never an easy decision, especially when it appears so risky, but the alternative could see a further dramatic erosion of market share of the Big Three in their home market, since it is not only Toyota, Honda, and Nissan they must worry about, but also the newly respectable Hyundai and Kia. If gas prices are this high a year from now, Detroit will need a solid alternative to its largest SUVs.

Saudi Rebels?
It's hard to know what to make of the announcement by Saudi Arabia that it would increase oil production by half a million barrels per day in June, without prior OPEC concurrence. Does this signal a split in OPEC, just when its cohesion has been seemingly most effective at raising prices? Or is it mere theater for our benefit?

The Saudis have been signaling for at least the last month that they see the current price levels as being unsustainably high, in terms of their impact on the global economy and on future demand for oil. At the same time, they have blamed high prices on a number of issues other than the volume of crude being produced by OPEC: tight refinery capacity, conflicting US gasoline specifications, and speculation by hedge funds and others.

The key to all of this is inventories. Even if the extra crude that the Saudis will begin selling in June does not immediately turn into petroleum products, because refineries are full, it will prop up the very lean crude oil inventories that have contributed to the run up in prices. Once the market flattens or actually turns down, the incentive to bet on higher future prices diminishes and speculation should return to normal levels. Speculators that miss that shift will find themselves giving back most of their recent gains.

As others have noted, none of this is likely to make driving any cheaper this summer, but it should ease some concerns about how costly heating oil might be next winter.

One Less
Traveling today, so just a quick thought. When you are tallying up the countries that will contribute to meet growing demand for oil in the future, you need to scratch one from the list. Indonesia, one of the founding members of OPEC, has become a net importer of oil. Although its production might get back on a positive trend with additional investment, it's likely that economic and population growth will keep it from again becoming a significant net exporter.

Is the System Broken?
I missed this article from the New York Times last week, describing testimony before the Senate on the influence of environmental regulations on the current high gasoline cost. From the description in the article, the non-industry participants reflected their ignorance of how the industry actually functions to deliver fuel to customers, and the industry representatives did a poor job of explaining the facts.

Let's start with the basics. Contrary to popular opinion, when you pull into an Exxon station, there's a high likelihood the gasoline you are buying on a given day was not refined by Exxon. This would be equally true of any other brand you could name. The reason is that the industry has been optimized over the years though a system of "exchanges" that reduce the cost to the companies and, more importantly, to consumers.

If companies could only market in those areas in which they could guarantee 100% supply from their own facilities, the retail gasoline market would look a lot more like the market for milk: most consumers would only have one or two brands from which to choose, and they would pay prices that were inflated by virtue of those companies having to maintain higher inventories, in order to be able to keep their stations supplied, and by less competition.

Instead, the industry evolved into a system in which each company supplies other companies in the markets served by its refineries, and in turn receives supplies in markets in which it has no refineries in close proximity. In addition, they buy product from third party refineries that produce more gasoline than their own marketing outlets require, or that have no service stations at all.

When a company ran short of product in a given market, either because of a refinery problem, or because sales were higher than anticipated, they would borrow or buy supplies from other companies that have temporary surpluses. The increasing complexity of environmental regulations governing local gasoline specifications across the country confounds this response and ensures that local supply disruptions that previously would have been covered by other companies instead result in outages or price increases.

For example, if Company A has a refinery problem that reduces its gasoline production, it calls Company B to ask to borrow some for a short time. But all of Company B's excess above immediate requirements has been blended for the specifications of other markets, for delivery by pipeline. This product cannot legally be sold in the market in which Company A is short. Result: Company A raises prices to slow sales and avoid running out entirely.

What we are witnessing is the undoing--as an unintended consequence of regulations designed to improve local air quality--of a highly flexible mechanism that for decades promoted both more market competition and higher reliability of supply. Although it is not clear how much impact this is having on prices at the moment, there's an excellent chance that we will see some truly startling price spikes this summer, as the system gets stretched further by higher seasonal demand.