A Balanced Tax?

As gas prices retreat from the highs triggered by the two hurricanes, I expect to hear more suggestions along the lines of yesterday's New York Times editorial. It proposed a new gasoline tax that would keep prices at close to current levels, even after the underlying commodity price drops sufficiently to return gas to $2 or less, whenever that might be. While I give the Times credit for recognizing the regressive nature of gas taxes, even at the modest current level of 18 cents per gallon (Federal,) their reasoning includes two very shaky bits of economics, as well as a practical impediment that appears insurmountable, today.

First, consider the potential for this kind of tax to distort the economy. You can't tax gasoline without taxing diesel fuel, unless you want to promote a dramatic shift towards diesel cars, such as Europe is experiencing. And once you tax diesel, affecting short- and long-haul trucking costs, you're tweaking the entire supply chain for just about everything used in our homes, offices and factories. However, unless you were to tax jet fuel at a comparable level--thereby kicking the nearly-dead dog of US airlines even harder--you will also induce some odd shifts from trucking to air freight, and stretch our creaky passenger air transport system even further.

Ultimately, it makes little sense to tax one kind of energy and not all kinds, in proportion to their import sensitivity, impact on the environment, or some other consistent, logical basis. That, by the way, is precisely what a carbon tax does, and it would make more sense than a simple gas tax, though there are even better alternatives available, including emissions trading systems.

The Times also asserts that gas taxes create incentives for companies to invest in alternative energy. In fact, the opposite is true, because a high gas tax would reduce gasoline demand, putting downward pressure on its wholesale (pre-tax) price, and thereby on the price of crude oil. Thus, higher gas taxes would drive crude oil prices lower, reducing the attractiveness of any form of alternative energy that competes with oil on any level.

The final implausibility is that a tax like this could be approved without a revolutionary change in US politics. Despite growing concern among conservative members of Congress about energy security and the connection between energy and the War on Terror, it's hard to imagine the present Congress or administration passing a brand new tax. On a more basic level, the American public doesn't like expensive gasoline. One would have to be truly oblivious to have missed the vivid display of that dislike over the last several months. Our complex energy problems are not amenable to simple solutions, particularly ones lacking a wide base of public support.

Looking East

BP made news recently with a set of announcements concerning some big investments in India and China. They will apparently invest several billion dollars building a new refinery in India and refining and marketing assets in China, both in conjunction with large local partners. While this seems to answer those who have criticized the major oil companies for reinvesting too little in the business and returning too much of their profits to shareholders, the profit mechanisms for these new ventures are by no means certain, if past experience in the region is any indication.

Most of the large oil companies began to look for opportunities in China and India in the early 1990s, after a decade of highly profitable growth in the smaller, but rapidly growing countries of Asia, including Thailand, Malaysia, Singapore, and the Philippines. Exxon and Shell were early leaders in this race, forging substantial relationships with large state companies such as Sinopec and the Indian Oil Company (IOC). Turning these beachheads into thriving businesses has proved harder, however, and a decade has passed with only gradual evolution in the areas most critical for the creation of profitable, free-market based businesses. A handful of local companies still enjoy quasi-monopolies, and governance and partner relations still cause serious concern among investors.

Clearly, both of these countries will need significant foreign investment to develop their petroleum sectors to support both economic growth and increasing mobility. But it would be a mistake to assume that means they will develop along Western lines, or in ways that will contribute meaningfully to the bottom line of those companies investing there. This is particularly true in China, where the oil sector is still viewed as a "pillar industry."

In effect, the majors are in a quandary. They must reinvest the tremendous cash flows they are throwing off currently, or else risk being marginalized in the decade ahead by the state oil companies that control most of the world's oil and gas reserves. As many analysts have observed, the best upstream oil opportunities are off-limits, locked up either by resource nationalism or environmental restrictions. The majors also need to show the markets that they can extend their record of profitable growth, in order to keep share prices advancing and thus total return to shareholders high, and where better to do this than the most populous, fastest growing countries on earth?

But having operated in this area for so long, they can't be under any illusions about the risks they are taking on, and that one of the likeliest outcomes is a wave of new refinery construction that will alleviate current global tightness in refining capacity, destroying refining margins in the process and undermining the profitability of the entire global downstream sector. That might sound good from a consumer perspective, but it could leave the big oil companies strapped for cash at just the point they'd need to be spending big money bringing alternative energy projects on line, if conventional oil supplies can't keep up with demand.

Are We Ready?

For more than 20 years, it's been nearly an article of faith that no new nuclear power plant would be built in this country. Last year, a consortium of US power generators banded together as NuStart, to resurrect the US nuclear power industry from its post-Three Mile Island, post-Chernobyl purgatory. The group recently announced the selection of two sites for which to pursue approvals for constructing a new reactor, one in Alabama and the other in Mississippi. Whether these plants will actually be built depends on a lot more than the incentives and protections included in the Energy Policy Act of 2005. Has the cumulative impact of the Northeast Blackout of 2003, high energy prices, and the two hurricanes changed the socio-political landscape sufficiently for this to be more than a pipe dream?

Clearly, the justification for nuclear power has been altered by circumstances and events. Importantly, there's a real case to be made for nuclear as a response to climate change, including its possible use to generate hydrogen for fuel cell cars. Looking beyond the US, a couple dozen new plants are either under construction or in prospect around the world. Step back from the logic, though, and you have to wonder why Entergy and its NuStart partners think that the US public's mood has changed enough to give nuclear its second wind. Favorable poll results might help, though other recent polls suggest nuclear is still less popular than other energy options. When you consider the experience of other energy mega-projects, it's hard not to be skeptical.

Now, a nuclear power plant and a Liquefied Natural Gas terminal are different propositions in almost every way, except for the issue of perceived risk. If anything, our need for imported natural gas is more critical than for the CO2-free electricity nuclear plants generate. Gas prices have quadrupled, entire domestic industries are being offshored due to a lack of affordable gas, and we face a winter that might just see gas curtailed--cut off--for some commercial and industrial users. And yet, where is the groundswell of support for LNG? It's entirely possible that Congress and the Federal Energy Regulatory Commission will end up having to cram LNG down the throats of some coastal towns, for the good of the nation. That won't be pretty, but can you imagine the politics of that if the facilities involved were nuclear power plants, instead of ports for bringing in our cleanest, fastest-growing fuel?

So even though I believe nuclear power should be part of our energy mix for the foreseeable future, I'll be a lot less skeptical on the day when the leaders of the communities that have been fighting LNG tooth and nail stand up and say, "We really don't like this stuff, because a whole lot of folks have scared us about its dangers, but we know we need it to keep our houses warm, our employers competitive, and the country strong. Go ahead and build your LNG terminal."

Tackling Demand

With the US energy industry beginning what promises to be a long recovery from the Katrina/Rita double-whammy, it's worth reminding ourselves that, although supply problems have been a persistent feature of the oil market for the last couple years, it's largely the growth in demand that has landed us with $60 oil and a stretched global refining system. As Daniel Yergin of Cambridge Energy Research Associates has pointed out in recent op-eds, the current energy crisis is primarily a demand shock, not a supply shock such as we experienced in the 1970s. So while it's to important to address our overall supply of energy, the demand side of the equation is equally crucial.

There are lots of ways to reduce demand, most having to do with improving efficiency, but an increasing number of advocates are focusing on gasoline taxes. As I discovered last May, the decline in fuel economy attributable to the popularity of SUVs only explains part of the growth in US gasoline consumption. The steady increase in annual vehicle miles driven contributes significantly, as well. Shifting the way we use our cars turns out to be just as important as the kind of cars we drive, and the current diplomatic flap over the non-payment of the "congestion tax" by US embassy employees in London highlights a more focused alternative to higher gas taxes.

Many European cities have been plagued by terrible traffic for years. When I lived in London in the early 90s, a 10 mile commute could take 90 minutes, and things have gotten worse since then. Several cities in the EU have introduced congestion taxes, with drivers paying an extra charge for entering the downtown. Though hardly popular, these fees have helped improved traffic conditions in the City of London (the "square mile") and elsewhere. And while not primarily intended to reduce fuel consumption, congestion charges generate fuel savings not just for those who switch to mass transit, but also for those who spend less time stuck in gridlock. New technology may help with this, as well.

Before we hike the gasoline tax in this country (even if it's to fund Social Security private accounts, as recently proposed in the NY Times,) I'd like to know we've given more targeted measures such as tolls and congestion fees a fair try. This kind of approach also provides a useful perspective, in which our current fuel problems are revealed as only one aspect of the larger problem of overburdened infrastructure.

Energy Policy vs. Energy Plans

Some interesting comments on yesterday's posting got me thinking about what optimism and pessimism mean in the context of increasing the contribution of renewables and other alternative energy in a reasonable amount of time. More to the point, what kind of energy mix could we expect to fall back on, if we should find ourselves missing a significant chunk of our oil imports, either as a result of a geopolitical event, or due to the impact of depletion on global supply?

Answering that question requires wading through a host of big uncertainties, and it really calls for a scenario approach, rather than straight-line reasoning. That's more than I can take on in one day's posting, but I feel safe suggesting that we will need a much more aggressive energy plan than the one implicit in the current forecasts from the Energy Information Agency of the Department of Energy. Their 2005-25 reference case would have us using 1/3 more oil by 2025, while importing 60% more of it. At the same time, they don't see the energy contribution of renewables growing by enough even to cover what will be lost in the decline of domestic oil production, or to prevent renewable energy falling as a share of total consumption by 2025. This is not a slam on the DOE, because that's probably a reasonable status quo forecast. However, it doesn't constitute an acceptable national plan for energy. I'd also argue that it's out of synch with worldwide trends driven by climate change and two globalizing "billionaires."

If the DOE's view represents a floor for alternative energy, where is the ceiling? While there might not be any laws of physics preventing wind and solar power from ultimately providing most of our energy, several issues will limit their contribution over the next 20 years. The cost of energy storage is a big factor in this calculation, and we must assess how long it would take a breakthrough in this area to go from laboratory to low-cost, mass production. I'm not an expert on technology development cycles, but 10-15 years doesn't sound too long. If that's the case, then even with a continuation of the steady cost reduction trends for both wind and solar, their intermittent nature will impede their penetratation of the power market. Nor does that address our need for non-oil transportation fuels, which by 2025 might include a modest component of hydrogen. Despite this "pessimism", I expect both wind and solar to grow dramatically in the next decade, with results that should be noticeable at the scale of our national energy statistics.

The divergence betweeen the status quo future and what's realistically possible highlights an important distinction between the Energy Policy Act of 2005 and a true national energy plan. Plans include goals, as well as the means for achieving them. What we need are explicit, quantified national goals, and these would have to include things like the following:

• To reduce our use of oil as a fraction of the total energy we consume, e.g. from 40% down to 35% by 2025.
• To increase the contribution of non-hydroelectric renewable energy from less than 1% today to 5% by 2015 and 15% by 2025.
• To shift our energy imports from being 85% oil-based to 50% gas-based, including LNG and synthetic liquid fuels produced from gas.

Now, these still might not seem like aggressive goals to a real optimist, but achieving them in the real world would be an enormous stretch, even with ample R&D funding, government incentives, and an increase in the gasoline tax. Whether or not we'd hit these targets on time, this is what it would take for "alternatives to be in place," as I suggested yesterday. I'm also reminded of the portion of JFK's quote about going to the moon that we rarely include,

"...and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win, and the others, too."

The Contrarian View

One of the consultants I used to work with liked to remind workshop attendees of a psychological phenomenon called "availability bias." As he described it, this explained the difficulty most of us face in trying to imagine a world much different from the one we observe today. When the price of oil had dropped into single digits in the late 1990s, few industry leaders could envision it returning to $25/barrel, even though it had been there only eighteen months previously. Now, with oil at $60+, who sees it reverting to $25? Apparently, at least a few people do, and here's a good example, from a blog that takes a view diametrically opposed to the adherents of Peak Oil and other scarcity scenarios.

The argument it makes is sound economics: higher prices should spur innovation and more production, while dampening demand, thus eventually restoring prices to pre-crisis levels. This proposition has history on its side, as the author notes. Things might just turn out that way again this time. However, I think it's important to understand why this argument won't always be true, because of a close relative of our old friend, compound interest. The demand for oil grows the same way that interest compounds in a passbook savings account. The rate of growth may change from year to year, but each year it is applied to the entire previous year's quantity, which includes an increment over the year before, and so on.

That's how oil demand grew from 63 million barrels per day (MBD) in 1980 to 84 MBD today. If consumption continued to grow at 2% per year, then we'd be at 93 MBD in 2010, 113 in 2020, and 138 MBD in 2030. Considering the potential of China and India, it's not hard to imagine this kind of growth for the next 25 years, at least in the abstract. But the result, compared with holding demand steady at current levels, would be incremental consumption over this period of 235 billion barrels. In effect, we'd burn an extra Saudi Arabia. By 2050, growth alone would have consumed almost a trillion additional barrels, which is roughly equal to current global proved oil reserves.

As long the quantity of recoverable oil in the earth's crust is finite, whether it's one trillion barrels or 17 trillion, we can't play this compound growth game forever. At some point, higher prices won't yield more oil, anywhere. If we don't have our alternatives in place at that point--not on the drawing board, but tested, built and ready to go--the dislocations are going to be severe. The only question left is when this will happen, and the reality is that no one can tell you until we are there, not M. King Hubbert, not Matt Simmons, and certainly not me.

Two Double-A Cells at a Time

I received several comments on last week's post relating to energy density, mostly disputing my suggestion that low-density sources such as wind and solar could ever cover more than a fifth or so of our energy needs. That's really an argument for another day, though. The focus now, particularly for solar power, should be on how to provide 2% of our primary energy supply, not 10 times that. Company strategists should still be looking for applications that are less price sensitive, not trying to penetrate the mainstream market with a technology that's not ready. This article from Technology Review gives some useful hints.

When you evaluate the hierarchy of energy costs, grid-based power--even at the retail end--is pretty low, at least on average. Backup power is more expensive, but with an iron focus on high reliability, that's hardly the place for intermittent energy sources to attack. Battery power is further up the pyramid, and disposable batteries are close to the top, in terms of cost per kilowatt-hour of electricity delivered. Flexible solar cells, such as the ones described in the article, could be incorporated in device design in such a way as to reduce the required capacity of rechargeable batteries or eliminate disposable batteries entirely in some applications. In fact, the cost of solar is not the obstacle here, as it is in the residential market, since it is already at or below the cost of power from disposable batteries. The real issue is incorporating it into devices in a seamless way, without adding too much bulk or funky attachments.

If you want a picture of how alternative energy is likely to develop, don't watch the heart of the market, where petroleum products and large, central power plants have had a century to hone their competitiveness. Watch the margins, and watch trendsetters. A solar iPod, anyone?

Petroleum Bomb

I'm at a conference, so today's posting will be brief. Former Secretary of State George Schultz and former CIA Director James Woolsey have put out a clearly-articulated op-ed on the need to reduce our dependence on oil from the Middle East. It's worth reading, particularly since it anchors one end of the Geo-Green alliance that I've mentioned in a number of previous postings. Unfortunately, the crucial element missing from this article is the time required for the strategies these gentlemen propose to have a meaningful impact on world oil markets. There are no quick fixes to these problems.

Relying on the penetration of efficient cars into the vehicle fleet, and the development of new technology for producing biofuels more efficiently than crop-based processes can deliver, the proposed transition would take more than a decade to put a real dent in our oil demand, particularly if it did not include measures to reverse the existing trend in increasing vehicle miles driven. Europe's shift to diesel, discussed here last week, provides a baseline for comparison; it took more than a decade for diesel cars to reach 50% of new car sales, and with the slow fleet turnover rate, it will be some time before they account for half of all cars in the EU.

I am not saying that Messrs. Shultz and Woolsey's idea shouldn't be tried, but in practice this strategy would not achieve its desired geopolitical impact until well into the next decade or beyond.

The Hurricane Scenario

A train ride to D.C. provided an opportunity to catch up on my large backlog of articles, including this one from the New York Times (which alas is now in their paid archives) on the impact of hurricanes on offshore oil production in the Gulf of Mexico. As it happens, the article was written a few weeks before Katrina and Rita swept through the oil patch. The hurricane damage it described was from last year’s Ivan, which caused disruption to oil and gas operations that had not been entirely repaired a year later, but the comments apply to the current storms, as well. After several months, it’s possible to consider the long-term effects of all these storms, including the influence of what I’d call “the hurricane scenario” on future global oil production.

Once a hydrocarbon reservoir has been discovered and its size estimated, the economics of producing the oil or gas it contains must be carefully evaluated. This process has become much more sophisticated over the years, incorporating market and expert assessments of future energy prices and all the risks that could affect a project's economic viability. This kind of detailed analysis is crucial when a billion dollars or more of investment and many hundreds of millions of Net Present Value are at stake.

The Gulf Coast hurricanes of 2004 and 2005, and the prospect of a pattern of such storms for years to come, will explicitly shift the risk assessment for the large platforms required to exploit oil and gas in the deep waters of the Gulf. Developers will have to consider scenarios in which each platform would experience a Class 4 or 5 hurricane every couple of years for the next 10-20 years. This will change the economics of oil platforms in important ways, by increasing the cost and complexity of these projects, as well as elevating the risk of substantial delays in project startup--one of the top influences on project NPV.

Now, this all sounds pretty esoteric, and you might think it’s only important from the perspective of higher insurance rates for oil companies. But it would also shift the economic breakeven point of deepwater oil and gas projects toward the larger end of the size distribution of fields. In other words, some fields that today are just big enough to support development under last year’s criteria would become too small to be economical, even at high energy prices. That would truncate the long-term production potential of the deepwater Gulf, which is the most promising and prolific area in the US oil & gas industry and may contain up to 70 billion barrels of oil equivalent. That means lower future US oil production, higher imports, and more pressure for both conservation and the exploitation of non-conventional resources (see yesterday’s posting.) Not good news for energy consumers.

It’s going to take months to sort out all of the impacts of these storms. In the hierarchy of consequences, the fallout I’ve described above will probably be much less noticeable than the cost of heating our homes this winter. Despite this, it will subtly reshape our options for solving our energy and environmental challenges, in ways we can't predict today.

Where the Lunch Bill Gets Paid

One of the repeated themes of this blog is the tradeoffs inherent in our decisions about energy consumption and supply policies--tradeoffs we have all too often ignored, until events such as the recent hurricanes bring these truths home. The global energy system is extraordinarily complex, with direct and indirect inter-connections that are often subtle enough to elude the most experienced analysts. Another article from Sunday's New York Times nicely illustrates the "no free lunch" aspect of these connections, in this case with regard to the environmental impact of oil sands production in Canada.

In the years ahead, resources such as these unconventional oil deposits in northern Alberta Province will become increasingly important in meeting North American and global oil demand. It's worth spending a few moments considering how oil sands recovery, which had previously been regarded as a marginal or uneconomical proposition, moved up the ladder of the energy industry's corporate capital allocation processes. This story has deep connections in US environmental and land use policy, in energy efficiency policy, and in the personal responsibility of individual consumers of energy.

When you look at where oil companies are currently producing oil, and where they expect to produce it in the future, some trends are clear. There has been a marked shift away from drilling in the US--other than the deepwater Gulf of Mexico--and toward opening up "frontier" areas such as the Caspian Sea region and parts of West Africa. At the same time, companies have had to go after more technically challenging opportunities such as deposits in ever deeper ocean depths, and oils that require significant processing and upgrading before they can be marketed. These include Venezuela's Orinoco Belt and Canada's oil sands, a.k.a. "tar sands."

Much of this shift would have happened in any case, because some of these opportunities were highly attractive, but part of the shift has occurred because domestic opportunities with lower technical and political risks (at least in the sense that one thinks of that term in the developing world) were foreclosed. I believe it is valid to draw a direct linkage between our decision to sequester vast oil and gas resources in Alaska and the offshore lower-48 and the increased attractiveness of mining oil sands in Canada, with everything that entails for the environment there. We have, in fact, made a value judgment trading the Canadian wilderness for our own, and for our coastal viewscapes and property values.

At the same time, consumer preferences for larger vehicles--facilitated by the well-known "SUV Loophole" in the federal Corporate Average Fuel Economy standards--have increased global demand for oil at a higher rate than would have otherwise been the case, accelerating the industry's push into the frontiers described above. Again, we've made an implicit tradeoff between our own personal consumption habits and the environmental and developmental impacts of drilling in more remote, less developed places.

All of these tradeoffs might be defensible, but they've been made blindly, without the debate that should have accompanied them. My purpose in bringing this up isn't to assess blame. Rather, as we consider the legislation that is bound to come up as a result of high energy prices and the deficiencies highlighted by the recent hurricanes, these tradeoffs should be explicitly considered. If we choose to continue the offshore drilling bans in Florida, California and elsewhere without taking concrete steps to reduce demand--by an amount proportional to the production these areas could contribute--then we must ask from where the difference will be made up. Alaska? Saudi Arabia? The North Pole? Or will we just continue to shrug our shoulders and assume that the fuel we need will materialize from somewhere far away, out of sight and out of mind?

This isn't just about responsibility, either. If you believe, as I do, that we are at the beginning of a lengthy transition to an energy world that is much less dependent on fossil fuels, then there are real decisions to be made about which areas should and should not be drilled--ever. But those choices need to made in a way that recognizes the vast quantities of hydrocarbons that will be consumed before we reach that destination, and our own role in determining the magnitude of that demand.

Highly Focused Wind

Wind power is one of the most competitive alternative energy technologies, but it suffers from two important drawbacks: The air currents powering wind turbines are much less reliable than the rivers tapped by hydroelectric dams. They are also sufficiently diffuse to require a large number of turbines, dispersed across a wide area, to generate as much electricity as a coal- or gas-fired power plant. Cyclones and hurricanes clearly pack a lot of power, but they are unpredictable and uncontrollable. Now someone has come up with a novel way of overcoming both of these limitations at once: artificial tornadoes.

Tell me this doesn't sound like something out of a 1950s sci-fi movie: you use solar power and steam to spin up your own storm, contained within a high circular wall and driving a set of turbines hard enough to generate 200 megawatts of power. An extension of the solar chimney concept, the whole thing sounds a bit nutty, but not nutty enough to keep it from being picked up by a prestigious international journal like The Economist.

Granted, this idea is a long way from becoming a practical reality. It's got at least as many public relations problems as the flying windmills I mentioned earlier this year. Despite that, though, it represents precisely the kind of thinking we need more of just now. Meeting our long-term future energy needs while reducing our dependence on fossil fuels leads us inexorably down one of two broad avenues: creating our own highly concentrated energy sources using nuclear fission or fusion, and finding ways to tap the densest energy flows in our environment, including ocean currents, high-velocity winds, dry-rock geothermal energy, or sunlight above the earth's atmosphere. We are swimming in energy; tapping it effectively is the trick.

That doesn't mean that low-density sources such as photovoltaics and conventional wind turbines won't be important contributors along the way, but they simply can't displace the 86% of global primary energy supplied by coal, oil and natural gas, without some serious help from something a lot more concentrated. Are pocket storms the answer? Unlikely. But could something come out of this initiative that, when combined with other concepts, unlocks a new, practical high-energy-density source? I wouldn't discount the possibility.

Bubble, Bubble?

I must lead a sheltered life, since the first suggestion I've seen that anyone thinks oil prices and the stock prices of oil companies might be in a speculative bubble is this commentary from yesterday's New York Times thoroughly refuting the notion. Perhaps the experience of the late 1990s, combined with the current real estate boom, has us looking for bubbles everywhere, but I can think of few sectors in which this idea has less grounding in reality.

Mr. Stein hits most of the key issues, including the large cash flows and earnings of oil companies, their modest price/earnings ratios relative to the rest of the S&P 500, and the fundamental supply/demand issues facing the global industry. Anyone expecting an oil price collapse on the order of the mid-1980s will to have to be very patient, particularly since it would likely rely on a slowing global economy that would damage the entire stock market, not just the oil and gas stocks. Another point worth raising is the valuation mechanisms employed by equity analysts, who are so influential with the large funds and investors that drive much of the movement in these stocks.

Most analysts use models of oil & gas companies that are heavily weighted to assumptions about the future value of the commodities. These often differ from the market assessments reflected in the futures exchange. For example, the current analyst consensus is apparently for oil to fall below $60/barrel after 2007, reverting to something like $40. That's not unreasonable. However, Friday's closing price for crude in 2011 on the NYMEX was over $57. The disconnect on natural gas is also large. The consensus for 2007 seems to be around $7.50 per million BTUs, while the 2007 contracts traded on the exchange averaged $9.36.

Now, I've often argued that futures prices are poor predictors of future reality. But when you depart from them, you need to have a pretty good rationale for why you think things will turn out differently than the market expects. A market value for an equity that ignores the market-traded price of the commodity underlying that equity has a technical name: an arbitrage opportunity (though not a riskless one.)

When you put all this together, I believe you can make at least as strong an argument that the prices of oil and gas equities are undervalued, as that they are overvalued. That says they are probably about right, and in no way "bubbled up." I should mention that I still have a significant portion of my portfolio in oil stocks, including that of my former employer. That means I might be biased in my view of this. But neither am I liquidating those positions out of fear of an imminent collapse in value. My money and my mouth are in tune, here.

Shooting the Messenger

Congress is rushing to respond to some of the energy shortcomings exposed by the hurricanes. Here's a good article at Econbrowser on HR 3893, which attempts to address the refining capacity shortfall by promoting new refinery construction. It also proposes to harmonize gasoline standards to a much smaller set of options for states. That alone would go a long way to streamlining our inventory problems and restoring some of the industry's flexibility of response. Unfortunately, this bill also acquired a scorpion's tail: a provision that narrowly defines "gouging" in the retail fuel context, and does so in a way that defies both common sense and basic economics. The bill may be voted on in the House today.

I wrote about gouging recently, but I want to get down to specifics as they pertain to this legislation. House Bill 3893 defines "gouging" under the slightly Orwellian rubric of "Gasoline Price Reform", based on the following:

...any finding that the price of gasoline available for sale to the public in September, 2005, or thereafter in a market area located in an area designated as a State or National disaster area because of Hurricane Katrina, or in any other area where price-gouging complaints have been filed because of Hurricane Katrina...exceeded the average price of such gasoline in that area of the month of August, 2005, unless the Commission finds substantial evidence that the increase is substantially attributable to additional costs in connection with the production, transportation, delivery, and sale of gasoline in that area or to national or international market trends.

It goes on to set penalties of "not more than $11,000 per person per day in which a violation occurs."

This economic mischief will be visited largely upon a group of independent businesspeople, many of whom did the right and responsible thing by raising prices to avoid running through their entire supply of fuel in a day, when no replacement was in sight for an unknown number of days. In effect, if you are a retailer in Louisiana, Mississippi, Alabama or Florida, and you hiked your prices before the distributor or major oil company that supplies you raised its rack price, then you could easily be found guilty of gouging and fined $11,000/day, under the provisions of this legislation.

Let's put that in perspective. The average gas station in this country pumps a bit under 100,000 gallons per month. (Less than that if you exclude the big company-operated stations from the average.) That works out to about 3300 gallons per day, on which the typical station operator would normally make a couple hundred bucks, after paying rent, wages, and other costs. $11,000 is a lot of money to someone running a gas station. A week's worth of this kind of penalty could put many of them out of business, or at least into debt.

Before you say, "It serves them right," consider what this means going forward. This provision is obviously intended to frighten gas station owners into holding prices flat in future disasters. That's a problem, because raising gas prices after this kind of disaster is the economy's way of saying, "Something big has just happened, and you need to think twice about how badly you need this fuel." How will ambulance services, fire companies, and other responders such as doctors keep their vehicles fueled, if all the inventory in the area has disappeared in a brief spasm of hoarding? That's precisely why prices need to be allowed to go up, to ration fuel to those who need it most.

The dearth of gas lines and serious supply disruptions in the wake of Katrina and Rita--despite the temporary loss of a large part of our refining and distribution infrastructure--is clear evidence that this system works better than state controls, including the pernicious retroactive price controls included in this bill.

Addendum: HR 3893 passed the House of Representatives today on a vote of 212-210, with no Democrats voting in favor. It goes on to the Senate.

Europe's Shift to Diesel Fuel

As we ponder how to improve our fuel economy in light of $3.00 gasoline, the first thing that comes to mind for many is the hybrid, with a powertrain combining electrical and gasoline-driven components. I'm a big fan of this technology, even though I don't own a hybrid car myself. But I think it's worth thinking about the very different choice that Europeans have made, going back more than a decade, and how that decision is changing the global supply and distribution of petroleum products. The technology in question is the diesel engine, running on either petroleum diesel, biodiesel, or increasingly a blend of the two.

The US experimented with diesels during the oil crisis of the 1970s, and by most accounts the result was a failure. Not only were the diesel cars of that era noisy, smelly and balky, but they were also unreliable. Since then, and unbeknownst to most of us on this side of the Atlantic, terrific diesel cars began arriving in Europe, equipped with smooth and responsive turbocharging and other innovations, and almost indistinguishable from gasoline cars in their driving performance. I've driven a couple, and I loved them. These vehicles get much better fuel economy than their gasoline cousins, up to 35% better in models such as the Ford Mondeo or GM's Opel Vectra.

Europe's shift toward diesel began more than a decade ago, helped along by government policies that taxed diesel fuel at a lower rate than gasoline. That provided a double benefit for consumers, on a cost/kilometer basis. Diesels were also helped indirectly by the taxes on engine capacity that took effect in the UK and elsewhere. Today, this transition is in full swing, with diesels accounting for more than half of all new car sales in the EU.

The less well-publicized aspect of this change is its impact on the refining industry and international trade. As early as the late 1980s/early 90s, when I traded gasoline, diesel and jet fuel out of Texaco's London office, the reduction in the growth of European gasoline demand was starting to hurt refining margins. That's because the choice between making gasoline or diesel fuel is built into the design of a refinery's very expensive hardware.

All refineries do essentially two things. First, they separate crude oil into its component fractions of propane, butane, gasoline, kerosene, diesel, various "gasoils", and heavy fuel oil or asphalt. Then, after separation, some of these fractions are processed further to convert them into other products or improve their quality. The workhorse for much of this in most refineries, particularly in the US, Europe and Japan, is the fluid catalytic cracking unit, or "cat cracker", an expensive piece of hardware using updated versions of a 60-year old technology to turn diesel and gasoil into gasoline. These devices make a lot of high-octane gasoline, but their flexibility to shift operations between gasoline and diesel is somewhat limited.

The competing "conversion" technology is hydrocracking. It's more expensive--both in capital and operating costs--and requires a reliable supply of hydrogen, but it provides a lot more flexibility between gasoline and diesel output. Unfortunately, all but the largest refineries had to choose between one technology or the other. In the market of the 1960s and 70s, when many of these facilities were built or expanded, and with demand for gasoline going through the roof, cat cracking was the obvious way to go.

Today, many of Europe's refineries sit there with big cat crackers in a market that's increasingly demanding more diesel, of a higher quality, than this process can easily produce. They can't all build hydrocrackers at once, though some are suggesting they will have to do this eventually. One of the things they can do is run a bit more crude oil, of types that makes more diesel out of the front-end separation process, and sell their excess gasoline into another market that needs it. Where might such a market be found? Right here on the other side of the Atlantic, where environmental and permitting restrictions have limited the ability of refiners to expand to meet US demand.

The problem for both sides of the pond is that this game can't go on this way forever. At some point, if the trend towards diesel in the EU continues, European refineries will need to reconfigure to make a lot more of it and a lot less gasoline from the same quantity of crude oil. That looks likely, because "dieselization" is one of the EU's main strategies for meeting its greenhouse gas targets under the Kyoto treaty. Diesel's greater fuel economy translates directly into lower CO2 emissons. Changing the manufacturing base is going to be expensive and largely irreversible, and it will have a ripple effect in the US, as a reliable source of gasoline imports becomes less reliable over time. That might be another justification for building more refineries here.

What would happen, though, if the US followed the same path as Europe? It hasn't happened so far, because most European diesel cars couldn't meet the US regulations on car exhaust, especially for particulate matter. But technology will likely close that gap, and consumers will then have a non-hybrid option for getting 40 miles per gallon in a mid-size car. It wouldn't even bother US refiners for a long time, because we have all those gasoline imports to back out before they'd have to change their operations very much.

This might be a pretty good thing for US carmakers, too. While they may lag Toyota on hybrid technology, their European branches sell loads of nifty diesel cars. In fact, they may be betting on this technology as a way of getting the profitable SUV segment up to a respectable fuel economy standard before it is forced out of existence.

Nuclear Waste, Or Is It?

Late last year I commented on the delays affecting approval of the proposed nuclear waste storage facility at Yucca Mountain, Nevada. After originally ascribing the problem to politics, I came around to the idea that waiting wasn't the worst thing we could do. Now I've read this article by a regular reader and commenter on this blog who has an even better idea than indefinitely prolonged temporary storage: recycling the nuclear waste back into fuel. With nuclear power looking more attractive than it has for decades, due to its energy security and greenhouse gas benefits, viewing this "mountain of waste" as a useful resource rather than a disposal problem seems like a timely shift of perspective.

Based on nuclear industry expertise, Mr. Somsel's article speaks for itself. There isn't much I'd add, other than in two specific areas. First, a change like this would require significant public relations and public education. How many Americans remember enough high school chemistry to understand that the elements (isotopes) with the shortest half-lives are the most radioactive and thus most hazardous? At the same time, long half-life elements such as uranium and plutonium present both the biggest long-term storage challenge, and the greatest potential for recycling into valuable fuel.

The other issue relates to nuclear weapons proliferation. Mr. Somsel rightly identifies this as a primary reason that the long-term storage strategy was chosen over recycling in the past. As much as anything, this has been a gesture of consistency in our approach to nascent civilian nuclear programs around the world. But as the current diplomatic wrangling with Iran and North Korea suggests, the global non-proliferation model is in flux. Denying ourselves the ability to reuse spent fuel won't be sufficient to keep bomb-quality material out of the wrong hands. Making smart use of this material, on the other hand, could be part of the solution to taming our insatiable appetite for imported energy and contribute to global stability.

Market Imperfections

This post started out as a response to a comment, but after I'd written several paragraphs, I realized it should stand on its own. A reader indicated some concern about a statement I made in yesterday's posting, relating to government incentives for promoting greater energy efficiency. He responded, "There's a Libertarian hiding in my Republican body who cannot accept managed economics." I can appreciate that sentiment. However, I think we have to draw a distinction between managing markets and managing economics. After all, more than half our laws and tax policies, whether introduced by Republican administrations or lawmakers or Democratic ones, are aimed squarely at the latter.

You can't spend 10 years trading commodities without becoming a believer in the power of markets. But you also get a sense for their limitations, for when and where markets don't work well enough or with enough foresight. That's not socialism; it's pragmatism. Now, I think there's tremendous scope for applying market solutions to problems that would have previously been attacked with purely policy measures. Greenhouse gas emissions trading is a great example of that. But without some kind of policy fix, be it higher fuel taxes, stronger CAFE standards, or incentives for efficiency investments, the US energy market will simply deliver more SUVs, higher consumption, and higher imports.

That, after all, is the world we've lived in for the last 25 years, since Reagan deregulated energy prices. Free markets did a great job of bringing down oil prices in the 1980s, and creating a much more diverse base of supply for our growing oil imports. But markets can't insulate us from the consequences of a global supply shortfall, or a localized weather catastrophe, any more than they can pre-price (or preempt) the effects of a truly discontinuous event, such as a peak in global oil production or a permanent gap between actual supply and theoretical demand. There are just some areas in which markets need a bit of a nudge from time to time; that's a classic role of government, going back to the Founders.

Having said that, I've also written about the importance of those nudges focusing on the results we want, and not on the means to achieve them. That means providing incentives for better fuel economy, not for hybrid cars (or some other specific technology.) I don't see this as a replay of the 1980s debate over industrial policy, focused on picking winners or losers. Rather, it's a question of embedding a bias for efficiency into our economy--not at the expense of everything else, but more than our short-term-focused markets would provide. There are a lot of us who think that this will pay financial and geopolitical dividends in the long run, too.

Prioritizing Environmental Concerns

It's looking increasingly likely that the impact of Hurricanes Katrina and Rita on our energy infrastructure will persist long enough to force us to address some of the inherent inconsistencies in our approaches to energy and the environment. As yesterday's New York Times suggests, this will put drilling in Alaska's wilderness areas back into play. Until now, the interests favoring exploitation of the Arctic National Wildlife Refuge (ANWR) have been blocked by those advocating preservation. An honest assessment of our future energy needs will likely eliminate that veto. What will remain at issue is the framework under which exploration and production should eventually proceed.

While the Times article focused primarily on the National Petroleum Reserve (NPR), rather than ANWR, both regions have the potential to arrest the decline of Alaskan oil production, which accounts for roughly a fifth of total US production today, having contributed as much as a quarter in its prime. As the impact of lost production from damaged Gulf Coast facilities shows, even one million barrels per day out of a total US consumption of 20 million is truly material and consequential. ANWR and the NPR would support overall Alaskan output for decades, rather than constituting--as some have spuriously argued--a "few months of supply" for the US. Their contribution could be a critical factor in world oil pricing, if global supplies remain tight or actually begin to decline.

For years, opponents of drilling have argued that conservation could easily save quantities of energy comparable to what ANWR or the NPR would contribute. Given the available technology and companies whose entire businesses revolve around providing, installing, and managing such efficiency measures, this is a powerful argument. However, it sets up a false dichotomy. With US oil production declining steadily, and our demand for oil (and other forms of energy) rising, the need for both new sources of supply and serious improvements in energy efficiency has become acute.

The hurricanes have made efficiency fashionable again, across the political spectrum. But while high gasoline prices today and the promise of exceptionally high winter heating costs ahead create a short-term incentive for efficiency, the kind of investments necessary to change our energy usage significantly require longer payouts. Markets alone may not be sufficient to drive such investments, without some kind of government assistance. Linking efficiency incentives with new production in a comprehensive approach to our energy problems is not only logical but necessary, if we are to have an impact in both the short and long term. New oil supplies from Alaska and elsewhere will take years to reach the market, while efficiency measures can contribute much sooner, as well as reducing the magnitude of future demand that must be supplied--and reducing emissions of all kinds in the bargain.

Opening up these pristine areas without some kind of quid pro quo would be a shame, but that's the likely outcome if environmentalists don't become more pragmatic about their priorities. The choice is not between drilling in Alaska or not; rather, it is between the gradual erosion of the support base for opposing drilling--as a result of an emerging energy crisis--versus seizing the opportunity for a historic compromise that would benefit the entire country. It's up to the environmental community to craft the shape of such a compromise, but time is running out, as the value of the hand they hold shrinks with every upward move of crude prices.

Looking Back/Looking Ahead

A few months ago, a regular reader suggested I rename my blog to convey a more oil-focused message. I resisted, because from the start my intention has been to cover the full spectrum of energy, including conventional- and non-conventional alternative to oil and gas. I still see it that way, but I suspect that the aftermath of Katrina and Rita will probably keep this blog a bit "oilier" for a while, driven by my desire to stay relevant.

At the same time, my original manifesto from January 2004 still seems appropriate, to "provide a useful, if eclectic guide to navigating the gulf (between breathless reporting of new energy and the continuation of the status quo), based on my experience of over 20 years in the energy business and on scenario-based possibility thinking."

Here are a few of the subjects I hope to cover in the weeks ahead:

• Reducing energy infrastructure concentration
• Prospects for a revival of oil shale
• The growing importance of private equity in funding energy investments
• Implications of Europe's shift to diesel
• Energy investment priorities and waste

I appreciate the steady growth in readership and your comments on many of the subjects on which I post. I'd welcome any suggestions of topics where you think my perspective might be useful.

Climate Sensitivity

Today's Financial Times reports that operators of offshore oil and gas platforms in the Gulf of Mexico may see dramatic increases in their insurance costs, in the aftermath of the two hurricanes. This won't surprise anyone, but it's worth spending a moment thinking about the signal it sends. Part of the expected increase is surely an effort to recover via premiums some of the substantial payouts that the insurers will be making over the next few months, reaching into the billions of dollars. But I believe we see the reflection of a heightened sense of risk here, as well.

While others have the luxury to engage in theoretical debates about whether or not climate change is occurring, and what its consequences might be, insurance companies sit on the front lines of this issue and seem to be taking it more seriously than many other sectors. Recent predictions that Atlantic hurricanes will be more intense, either as a result of climate change or as a function of something like a twenty-year cycle in ocean temperatures, elevate the risk being insured against and justify higher premiums.

As I've suggested previously, this is precisely the right way to approach climate change: as a business risk to be managed in the same way we manage other risks, systematically and comprehensively. Scientists and environmentalists may focus on melting glaciers and shifts in the distribution of animal species, as indicators of climate change, but insurance companies provide the "canary in the coalmine" for the economy, and for business in general.

Building the Next Refinery

Hurricanes Katrina and Rita have exposed many problems with our energy infrastructure, not the least of these being the concentration of our refining capacity in a region likely to be hit by more large hurricanes in the future. It took more than two decades of environmental regulations, permitting policies, industry consolidation, and corporate strategies to create this situation. This cannot be rectified overnight, and I'm not even sure we should try, given the high cost and the desirability of reducing our reliance on oil in the decades ahead. In the meantime, though, we can try to address the underlying capacity problem in a way that would mitigate the national impact of a future Class 4 or 5 storm in the Gulf Coast.

A few weeks ago I described how we got to this point, with so many refineries, pipelines, terminals, and production platforms lining the Gulf Coast. It wasn’t always this way, either. Thirty years ago, the refining industry looked very different, with a larger number of smaller refineries dispersed around the country, mostly located in proximity to oil fields, markets, or both. The 1970s energy crisis changed all that, helped along by the depletion of mature oil deposits in states like Kansas, Oklahoma and Pennsylvania.

When oil rose from $2/barrel to $10, then $30, efficiency trumped proximity. The big refineries got bigger, while many of the smaller ones became uneconomical and failed to attract the investments required to keep pace with increasingly stringent environmental regulations. After a couple of decades of this, just under half of the country’s refinery capacity is clustered into only five areas: Chicago, L.A., Philadelphia, San Francisco, and Houston/Beaumont/Port Arthur.

Even if we were to eliminate all the obstacles to building new refineries in this country, we are not going to reverse that concentration. US oil production is in steady decline, only partially offset by increasing oil sands production in Canada, so any new refinery would have to rely on a mostly offshore crude oil diet. The alternative is having someone else refine the oil and then importing the products. That might reduce some of our vulnerability to energy disruptions from weather and earthquakes, but it brings a host of other concerns. Besides, this is the strategy we’ve chosen by default.

Post-Katrina, there's been a lot of talk about building more refineries. The President mentioned it in a speech Monday. There's even a proposal for a mega-refinery at Cushing, OK (thanks to Mel at Engine of the Future for the info.) The location offers some advantages, at least for crude oil supply. Cushing is already the major oil pipeline hub in the Mid-continent, as well as the delivery point for the NYMEX WTI futures contract that gets so much attention. When Enbridge's Spearhead pipeline is completed, it will be able to receive the full range of Canadian crude, including the heaviest synthetic crude and bitumen. And it's hundreds of miles from the coast, so that any hurricane would have dissipated quite a bit before reaching Cushing. Unfortunately, it's in the heart of Tornado Alley.

If we're thinking about where to locate another refinery, we'd better think about how we're going to induce someone to invest in building it, unless we're suggesting the government go into the refining business--something that other countries' governments have wisely spent the last 20 years getting out of. The problem is that the companies that own refineries have little incentive to build another one, even ignoring the scale of investment required.

Oil refining is extremely capital-intensive. The last new refinery in which I was involved was the 135,000 barrel per day Star Refinery in Thailand. It cost $1.7 billion 1995 dollars. Until the last few years, however, refining has been a low-margin, low-return business. I don't see the major oil companies queuing up to build more in the US, even if the permits were handed to them on a platter. They've sold off dozens of refineries, largely because equity analysts kept telling shareholders what a crummy business segment this was, and that the majors should invest only in exploration and production of oil and gas, and a bit in marketing the products. Their boards of directors listened, and as a result, the largest refiner in the US today is not Exxon or Shell, but Valero, an independent that has bought and merged itself into the number one spot.

How keen would Valero be to build a new refinery? Perhaps more than most, but I suspect they'd start to hear concerns from their shareholder base. It's one thing to buy up existing capacity and say that you'll run it more efficiently. It's quite another to build expensive new capacity that by its mere existence will reduce the operating margin of every other plant in the markets it serves. In a way, the refining business is like the restaurant business, where the person who builds a brand new restaurant, with a beautiful new kitchen, typically goes broke. By the time the third owner has bought it, at pennies on the dollar for the kitchen hardware, he has a chance to make a profit.

I'm not sure a producing country would want to come in on this, either. Saudi Arabia already owns an interest in Shell's refining system in Texas and the Southeast, via a joint venture. Their appetite for more is doubtful. Citgo, another large refiner, is owned by the Venezuelan government, which recently expressed an interest in selling. If you look at the other sources of the oil imported into the US, there aren't many obvious choices for large investments in refining, other than possibly Russia. Lukoil has already bought some service stations in the Northeast and is selling under their own brand, so it's just possible they might want to build a refinery. How well would that go over in Washington?

You can see that building another refinery isn't going to be easy, unless the government is prepared to offer large inducements, including tax holidays, investment tax credits, and low-interest loans. It certainly won't happen quickly, either, and I haven't even mentioned the various interests that would line up to oppose such a development. While we do need more refining capacity, the 1-2% per year "capacity creep" that we've been able to rely on until recently might just be enough to get us by, if combined with sensible policies to reward companies for holding larger inventories, closer to markets. At the same time that we try to buffer the nation's petroleum product supply system from future shocks, though, we need to learn the lessons of over-concentration of infrastructure and plan for alternative energy on a more dispersed, less vulnerable basis. That's a subject for a future blog.

Spending the Windfall

Yesterday, I cited a recent survey showing that most Americans support taxing the extraordinary profits that oil companies are experiencing as a result of weather- and demand-related increases in the price of oil. The dollars involved are significant: in the second quarter the top five US oil companies earned after-tax profits at an annual rate of $60 billion, compared with $36 billion in 2003. When you add in the rest of the industry, including the US earnings of non-US companies like BP and Shell, the total could reach $90-100 billion. Given the cost of rebuilding after two major hurricanes and the constraints imposed by large budget deficits and an expensive war, the temptation to tax an unpopular industry may prove greater than politicians can resist. However, the industry's actions may play as big a role in determining the outcome of this debate as will those of the Congress.

When you consider the survey results, the message seems pretty clear. Consumers think that not enough is being done to reduce our vulnerability to foreign suppliers of oil and develop practical alternatives to it. The industry has contributed to both the perception and reality of this in several ways:

• The international oil industry, including the US majors, was slow to step up investment in exploration and production as disruptions such as the Iraq War and Venezuelan strike, combined with increasing demand from China, eroded the global capacity cushion.
• Investments in truly alternative energy--wind, solar, biofuels, and hydrogen--have represented only a small fraction of major company R&D budgets. Instead, companies rely heavily on external research (including the government labs) for new technology in this area, and on economics to drive the deployment of alternatives.
• With a couple of notable exceptions, investments in this area are not highlighted in corporate advertising campaigns, with agencies focusing instead on generic, feel-good messages. Consumers, especially younger ones, see through this and extrapolate to assume that nothing substantive is behind them.

While all of the above represent justifiable strategic choices, they also increase the risk of a government response to limit profits. Make no mistake, a windfall profits tax would be a disaster, even if it were structured to provide dollar-for-dollar credits for all new E&P and alternative energy investment. Unfortunately, when you start digging into the mechanics of such a tax, you inevitably end up resurrecting some of the worst elements of the old, pre-deregulation inefficiencies. I started in the industry at the end of the last period of controls, in the 1970s, and I saw first-hand the distortions they created.

A large part of our current problem is the result of a decade of under-investment in energy by the equity markets--anyone who worked in a company making real products during the Dot-Com Boom knows exactly what I mean--and that's significant because energy projects typically have lead times of five to ten years. The projects that should be coming onstream right now would have been started at a time when the market only wanted to hear about "clicks vs. bricks", not barrels per day. A windfall profits tax would make energy company stocks look similarly unattractive today.

At the same time, though, I can understand the temptation that the industry profit pool presents to lawmakers faced with enormous bills, huge deficits, and an electorate with an aversion to higher income taxes on the only group with enough money to close the gap: the middle class. My best advice to my industry colleagues, if they want to head off this trend, is to crank up your capital budgets for traditional and new energy projects, even at the risk of driving down future profits through oversupply. Just as important is making sure that these actions are highly visible; consumers want to know about the billions you're spending to increase supply. The alternative is to lose a large chunk of your profits to an inefficient tax, and lose control of your own destiny in the process.

Quantifying Rita

For the second time in a month, the Gulf Coast oil and gas industry is tallying up the damage from a major hurricane. Although Rita's last-minute eastward shift spared the region and the country its maximum energy impact, it's going to be some time before the full extent of the damage is known, particularly to the offshore platforms and pipelines. In the meantime, as after Katrina, initial estimates of the effect on petroleum product supply are a combination of guesswork and basic arithmetic. Even if none of the region's refineries suffered serious damage, as seems to be the case, gas prices will have to rise again to balance the short-term supply deficit.

The Texas/Louisiana border region hit hardest by Rita includes the Shell and Valero refineries at Port Arthur, TX, the Exxon facility at Beaumont, TX, and three large plants at Lake Charles, LA. The combined capacity of these refineries totals 1.7 million barrels per day, just under 10% of US capacity for turning oil into gasoline, jet fuel and other products. If we assume that these facilities will be down for two weeks, on average, and that the entire 4 MBD Texas coast refining complex is down for a week, assessing damage and restarting process units, then we are looking at a supply shortfall of 40 million barrels. About half that would be gasoline. It will be difficult to make this up in the short term, because the refineries still running last week were operating at 96% of capacity.

In effect, then, we've lost nearly half the nation's gasoline production for the next week, and another sixth for a week or two beyond that, on top of the 5% still down after Katrina--with proportional effects on the other products. As I mentioned last week, one of the surprises after Katrina was that gasoline inventories never dropped below the 190 million barrel mark, despite the lost production, and even recovered to pre-Katrina levels. That was due to a combination of extra imports and reduced demand.

We're facing a comparable challenge for the next couple weeks, and demand will have to fall by at least as much as after Katrina to keep from drawing down inventories to the point that runouts become widespread. Unfortunately, the only way that will happen is through price increases, even though the weekend traders on the New York Mercantile Exchange don't seem to have figured that out. Gasoline dropped below $2.00 on the exchange, a fall of nearly 10 cents/gal. That seems highly optimistic to me; perhaps, as one analyst described it, the market just breathed a sigh of relief that things weren't much worse.

It took an increase of $0.45/gal. at the pump to balance demand after Katrina, from a starting point about $0.25/gal. lower than where we were right before Rita hit. That says we could see a national average of $3.30/gal. and regional averages $0.10-.20/gal above that, before prices start to come back down. Averages being what they are, I wouldn't be surprised if stations in a few locations come close to $4.00, before the Katrina/Rita wave has passed through the system. Consumers will howl, and politicians will act outraged in response, but remember that the alternative to high prices is low prices but no gas.

Storm Symptoms

It's oddly seductive to watch the gradual progress of another major hurricane moving across the Gulf Coast, on its way to a landfall in America's energy heartland. CNBC's coverage yesterday afternoon was dominated by discussions of "Worst Case Scenarios." Rather than speculating further on the possible impacts Rita, I think it's important to remind ourselves that although Katrina did significant damage to the oil and gas production and refining system, as may Rita, these are short-term effects. While they draw attention to some serious issues, the vulnerability of our energy infrastructure to weather-related disruptions is only a symptom of a larger set of fundamental problems. These include:

• The unintended consequences of a loophole in the federal Corporate Average Fuel Economy (CAFE) standards have transformed the US automobile fleet with a wave of SUVs, stalling fuel economy improvements and amplifying the demand increases associated with more cars driving further every year.
• In recent years gasoline demand has outstripped the ability of US refineries to supply, even when operating near 100% of nameplate capacity. This puts more stress on lean inventories and increases our imports of refined products, making fuel prices more volatile.
• We have handcuffed our cleanest and most efficient fossil fuel, natural gas, with poorly-considered land-use restrictions and bans on offshore drilling. These rules ignore the significant downstream environmental benefits of using gas and push us towards higher use of coal and imported oil.
• At the same time, we've erected numerous roadblocks in the way of importing gas in the form of LNG. The combination of these two factors has pushed natural gas prices to all-time highs (nearly six times the historical average,) and put power supplies, winter heating, and entire segments of the fertilizer and petrochemical industries at risk.
• Finally, our current energy mix and the way it is growing contribute to increases in the atmospheric greenhouse gases that are changing the climate in unpredictable ways, with consequences that are extremely unlikely to be beneficial.

At a minimum, Rita has shut down most of the Gulf Coast energy facilities that escaped harm from Katrina. Even without serious damage, the markets will be in turmoil for weeks, and the prices of gasoline, heating oil, and natural gas are going to go up even further. This is drawing attention to an energy sector that for years has been taken for granted and treated as an inconvenient necessity. Now that energy has everyone's attention, it is time to start talking about the dangerous contradictions embedded in our lifestyles and attitudes. We cannot continue to increase our use of energy without also expanding the infrastructure for producing and processing it. Nor can we expect the industry to maintain adequate inventories to handle disruptions such as Katrina and Rita, while imposing tax and accounting penalties on it for holding those inventories. For years, people like me have been predicting that something will have to give. Two hurricanes have brought that day into the present.

Waiting for Rita

Shortly after Hurricane Katrina hit the eastern Gulf Coast, I commented that a storm track further west could have done even greater damage to the country's energy infrastructure. Unfortunately, we're about to find out if I was right, with Class 5 Hurricane Rita headed directly for Texas.

Not only is the Texas coastline home to a large number of offshore oil and gas platforms, but it is has 23% of US oil refining capacity, more than twice as much as the Louisiana/Mississippi coast. In addition, the refining complex around Houston is the origin and largest supply point for the Colonial Pipeline that carries petroleum products to the Southeast, Mid-Atlantic, and Northeast regions. A hurricane hitting this concentration could create an even bigger oil, natural gas, and petroleum product supply problem than Katrina did.

The market is reacting in predictable fashion. Crude oil is headed back towards $70/barrel, and unleaded gasoline futures, after having dipped below $2.00/gallon recently, seem headed back to record territory, as well. Factor in the facilities that remain offline after Katrina, and we could be in for a real jolt to prices. Aside from the potential damage to the offshore and onshore oil and gas production facilities, any protracted refinery shutdowns in the area could send retail gasoline prices over $4.00/gallon. The only bright spot in the picture is the modest recovery of gasoline inventories since Katrina hit.

In the short term, there's nothing we can do but wait and see, and hope that Rita will shed some wind speed and make landfall away from population and industry. Let's also hope that whatever the industry learned from Katrina about protecting facilities from storm damage has been rapidly disseminated through the internal and external "best practice" networks.

Getting There from Here

I'm embarrassed to admit that it took an article in MIT's Technology Review to introduce me to a name in the "peak oil" world that I should have already known, James Howard Kunstler. His book, "The Long Emergency: Surviving the End of the Oil Age, Climate Change and Other Converging Catastrophes of the Twenty-First Century", has apparently gathered quite a following for its pessimistic portrayal of our energy future, among other looming problems. TR's skeptical review suggests that his predictions can be boiled down to an assertion that the alternative energy future is a sham, and that we can't get there from here. Without getting into detailed arguments about a book I haven't read, these points function as a rejoinder to my argument last week about the new choices that weren't available in the last energy crisis.

Mr. Kunstler's concerns seem to fall into two main categories, starting with the superiority of oil as a fuel and the absence of anything else combining its low cost, high energy density, and ready availability, to serve as a replacement when the global oil supply reaches its inevitable peak. The second area deals with the availability of energy sources and technologies that could bridge us into an alternative energy future from the "cheap oil" world we inherited.

Let's think about the first point. Oil is a truly remarkable substance, and the geological circumstances that dispersed enough of it in deposits close to the surface, where it could be tapped using 19th century technology--imagine giant post-hole diggers--played a major role in the creation of our mobile, industrialized world. But when you consider how much we've learned about the universe since the first oil well was drilled in 1859, it's nearly inconceivable that we can't find ways to live--and even prosper--without it, eventually.

Without being a Pollyanna, the diversity of possible energy sources that could fill that bill, at least for the next century or two, makes me confident that there is a good energy future ahead. In terms of sheer magnitude, the ultimate potential of things like orbital solar power, dry-rock geothermal power and nuclear fusion (hot or cold) dwarfs what we currently receive from all hydrocarbons combined, to the point of raising concerns about the environmental impact of waste heat on the scales that would be possible. Energy is out there in abundance, if we can figure out how to tap it.

That takes us back to the problem of getting there from here, which is certainly non-trivial. Again, work is underway on enough different paths to provide reassurance that the world won't end on the day that oil demand permanently exceeds the supply. Some of these paths involve new chemical fuels, including hydrogen, that work in tandem with various kinds of fuel cells or advanced engines. Others involve electricity, either in combination with new battery technology, or in conjunction with hydrogen. And in the shorter term, there are proven methods of extracting natural and synthetic petroleum from other hydrocarbons that are much more plentiful than oil. The key to all of this will be marshaling the necessary capital and technical resources far enough in advance of the need.

None of what I’ve described above will be easy. That does not mean, however, that we can’t get there. Rather, it’s an argument for getting off our butts, banishing complacency, and making it happen by voting for it, investing in it, and encouraging our children to choose careers in science and engineering so they can contribute to it.

While you can make a very strong case that it took oil to get our industrial civilization off the ground--literally--it does not follow that the gradual disappearance of oil, whenever that might start, will lead to the end of life as we know it. We have the ingenuity, motivation, and resources to overcome this challenge, however just-in-time and nerve-wracking the result may be. Betting against that is tantamount to writing off the last 150 years of human development, and attributing it solely to a geological accident.

Can Fuel Taxes Be Too High?

It's fascinating watching the debates over fuel taxes on both sides of the Atlantic. The US has among the lowest fuel taxes in the industrialized world, but, yielding to public pressure to lower gas prices, many state legislatures are considering suspending portions of their fuel tax collections. Europe, on the other hand, with both the highest gasoline prices and fuel tax rates (no coincidence there) in the world, is attempting to hold firm in the face of growing public protests from truckers and farmers. Who is right? In my estimation, neither.

As recently as last Friday I wrote about the importance of allowing prices here to rise when demand is constrained, in order to restore balance. Lowering fuel taxes here would either increase demand, if the savings are passed through to consumers, or boost the profits of oil refiners and marketers, if they are not. Europe is another story, however.

Gasoline prices there were already high enough to promote efficiency, even before the crude price run-up of the last 18 months. Volume-based fuel taxes in the EU are only part of a broader tax strategy to reduce demand, including high taxes on vehicles and specific taxes on engine size. This links to the EU's policies on managing traffic congestion and protecting the environment, particularly with regard to climate change. These taxes have been effective, resulting in smaller, lighter cars than here, more use of diesels, and higher mass transit utilization, although total kilometers driven has been rising. They also bring in enormous revenues. In fact, as of a couple of years ago, the government of Germany made as much money from fuel taxes as Saudi Arabia did producing crude oil.

Now, none of these circumstances suspend the laws of supply and demand, and price increases are as necessary in Europe as they are here to restrain demand in the wake of an event that reduced the global supply of oil and petroleum products. But that doesn't mean that European governments need to profit at the expense of their consumers, who have fewer options than Americans for further efficiency gains. European parliaments should fix their tax receipts at pre-Katrina levels and allow fuel prices to rise and fall cent-for-cent with the world market, rather than compounding taxes on the increases at rates that include Value Added Taxes as high as 18%.

The end result is a scenario that few would have believed only two years ago: the US with gasoline prices at a level we've always associated with Europe, and Europe with gasoline prices that are running at twice that level ($1.83/liter = $6.92/gal.) Through this combination of market response and taxation, we have embarked together on a wrenching experiment testing what economists call the "price elasticity of demand," i.e. how much will demand fall for each unit of increased price? While painful to millions, you have to believe this is going to create great opportunities for alternative energy all over the globe.

Slow Road to Showdown

Last week's session of the UN General Assembly did more than tie up traffic well into New York City's northern suburbs. In his first speech before the world body, Iran's new President, Mr. Ahmadinejad signaled a more distressing kind of gridlock in the negotiations to resolve the potential international crisis over Iran's nuclear ambitions. His repeated assertion of Iran's right to develop a full civilian nuclear fuel cycle has implications for energy markets, as well as geopolitics. Iran seems to believe it holds the winning hand in this high-stakes game. That could prove as big a miscalculation as Saddam's complex WMD bluff, or might well be an accurate assessment of the situation.

As I've described elsewhere in some detail, arguments by Iran's leaders concerning the desirability of nuclear power as a backstop to the eventual end of its oil reserves simply doesn't stand up to scrutiny. Even if Iran's oil reserves were shrinking--which they are not--it also possesses the world's second largest reserves of natural gas, rendering any Iranian civilian nuclear facilities both uneconomical and unnecessary.

The most interesting element here is the subtle way in which Iran is deploying its greatest leverage, the "oil card." Rather than threatening an embargo, which still remains a last resort, Iran seems to be lining up support from China and India--large and growing customers of and investors in Iran's energy sector--and Russia--a key supplier of nuclear technology--to outmaneuver US and European efforts to hold Iran accountable for discrepancies under the Nuclear Nonproliferation Treaty. Iran must be calculating that, with oil prices over $60/barrel and supply even more precarious after Katrina, diplomacy is the only avenue against which it must defend, and one in which it has important allies.

So Iran plays for time, presumably hoping to produce a nuclear fait accompli; the EU plays for time, seeking to avoid a confrontation; and the US plays for time, trying to regain room for maneuver, up to and including military action in the event that US forces can be extracted from daily combat in Iraq. This kind of geopolitical instability has produced some very unpleasant surprises in the past, and any kind of big surprise in Iran would throw the oil markets into a tizzy.

The most hopeful note in this affair comes from an unlikely quarter. Even as President Ahmadinejad was exclaiming his hard line at the UN, North Korea was in the process of agreeing to decommission its nuclear weapons program, much as Libya did a couple of years ago. Who would have guessed that Tripoli and Pyongyang might show Teheran the way forward?

The Numbers Are In

I finally had a chance last night to look at the latest weekly statistics from the Energy Information Agency of the DOE, and they tell a remarkable story about the energy impact of Katrina and the effectiveness of prices at stimulating gasoline production and moderating demand. This involves more numbers than you will normally see in this blog, but I would like to point out a few things that I found noteworthy:

• US crude oil production stands at 4.3 million barrels per day (MBD), down from 5.4 pre-Katrina. You have to go back to the 1940s to find an oil production rate this low.
• As a result, crude oil inventories fell by 7 million barrels, despite some withdrawals from the SPR. Despite this, crude oil stocks are still above the top of their normal, seasonal range.
• Although refinery utilization was down by a full 10%, refiners have deftly adjusted yields and made the most of the EPA's specification waiver to get gasoline production back up to almost 8.5 MBD, only about 300,000 bbl/day below where it was before the storm hit. That compares to initial estimates, including mine, of sustained losses of 800,000 bbl/day.
• Average US retail gasoline prices are back below $3.00/gallon, from a high of $3.06.

The real story here is what happened to gasoline demand. For all the resulting acrimony and political posturing, the price increases did their work. Demand fell by 8% from where it was before the hurricane, and by more than 6% from the same period last year. That's more than twice what you'd expect just from reduced driving in the region most affected by storm damage. As a result, with gasoline imports over a million barrels per day, total US gasoline inventory actually went up slightly to 194 million barrels, the equivalent of 22 days of demand. While still at the bottom of the normal seasonal range, that is excellent news and bodes well for things to continue improving, as long as demand doesn't go back up. (What all this means for heating oil later this year is still not clear, with production down and inventories falling at a time of the year when they should be growing steadily.)

Now, it's easy to read too much into these figures, given the historical variation in the week-to-week data, but things look better than I would have expected this soon after the disaster, particularly with 5 major refineries still down for the count. Anyone who remains skeptical about the power of prices to adjust demand to match supply should study the EIA's figures and charts carefully. I can think of a few politicians who should be assigned this as homework.

Here We Go Again?

For someone who grew up in the 1970s, I have little nostalgia for that decade. Aside from comprising the sartorial nadir of western civilization, those years were marked by such wonderful things as Watergate, the Arab Oil Embargo, the Iranian Hostage Crisis, Three Mile Island, inflation, stagflation, gas lines, and "malaise". Isn't it strange to wake up after a terrible natural disaster and discover that some of the problems we'd thought were safely relegated to the past are rising up again, like zombies? As if the reappearance of gas lines and government intervention in the retail gasoline market (price caps and tax holidays) weren't bad enough, it now seems that some enterprising thieves have rediscovered the art of siphoning gas from your car, and that locking gas caps are making a comeback.

Worse yet, from an energy perspective, it must seem to many as if, in the short term, we have few options that we didn't have in 1979. We can drive less, carpool, make sure our tires are properly inflated, switch to a lower-octane grade, and turn off our engines at long stoplights. Not very comforting, with gas over $3.00/gal.

But before we succumb to the post-Katrina malaise, it's worth remembering that in the mid-to-long term, we have some strikingly different choices than we did 25 years ago. Consider:

• Hybrid cars are a reality. If we can convince Detroit and Yokohama that fuel economy will be a primary driver of consumer preferences for the next decade, they will offer us a wide range of cars and SUVs that are comfortable, safe, and get 35-50 miles per gallon.
• Alternative fuel technologies have become economical or nearly so at current oil prices. This includes the production of liquid transportation fuels--our biggest need and the largest hurdle in the 1970s--from natural gas, coal, crops and crop waste.
• Hydrogen fuel cells have moved out of the laboratory and into prototype cars and production buses. Despite infrastructure obstacles, fuel cells hold out the promise of using existing energy sources much more efficiently in the future.
• Clever exploitation of the Internet is constantly providing new means for substituting the movement of information for the movement of people and goods. This is one reason that the ratio of energy inputs to GDP output continues to fall.

As I've suggested before in this blog, we have learned an awful lot in the last couple decades, even if it doesn't always seem that way. Thinking that we are back in the 1970s is only going to lead to the unnecessary repetition of failed strategies for solving our energy problems. We need to treat the Oughts (has anyone heard of a better name for this decade?) as unique and approach our current problems with the benefit of historical insight, but led by a fresh perspective.

Misplaced Outrage

At the same time the country is absorbed with efforts to assign responsibility for the tragically confused post-Katrina rescue effort, another "blame game" is playing out: why are gasoline prices so high? Despite the evidence supporting a simple answer having to do with the nearly instantaneous loss of 10% of the country's oil refining capacity, and the need for higher prices to balance a market that was suddenly facing a shortfall of a magnitude not seen in several decades, the noises coming out of various state governments seem to be emanating from a parallel universe.

I'm going to use the example of my own state, Connecticut, but I'm sure you can find similar discussions going on in nearly every other state. According to my local paper, the Attorney General of Connecticut, Richard Blumenthal (D), is apparently surprised by the speed and magnitude of the price response. He sees it as evidence of at least a lack of competition, if not actual collusion. He regards high oil company profits as further evidence of this. In response, he is calling for an investigation into the operation of the New York Mercantile Exchange, where crude oil, gasoline and heating oil futures trade, and calling for an excess profits tax on oil companies.

Anyone looking for a partisan slant to this line of thinking will be disappointed. State Representative Lawrence Miller, R-Stratford, provided the quote of the week, "I've heard a lot about looting since the hurricane. But I think the real looters up here are called the Mercantile Exchange of New York. Hearing about $4 a gallon is unreasonable and unacceptable."

Now, when I think about these comments, I am torn over whether to ascribe them to ignorance or profound cynicism. Is it really possible that these gentlemen understand so little about how markets work, and about how petroleum products reach consumers, that they can ignore the evidence of photos of drowned refineries and pursue rabbit trails of conspiracy, at public expense? But, as I've suggested before, it is easier and more expedient to feed public outrage over high prices than to explain that this is actually how markets work.

We need to keep clearly in mind that we have two basic choices for how we want the gasoline market to function:

1. Allow the market to move in response to changes in supply and demand, with price as the mechanism by which balance is achieved, or
2. Impose constraints or actual rationing, involving price caps, odd-even days, gallon limits on fill-ups, etc.

We have experienced two major crises that offer excellent examples of how each of these approaches works. Choice Number 1 has operated throughout the Katrina Crisis. Despite starting with very low inventories, the gasoline supply system has rebalanced at a higher price, and gas lines only appeared in communities that suffered a direct loss of physical supply. These quickly abated, when pipeline deliveries resumed. Choice Number 2 was tried from 1973-1981, and it resulted in widespread gas lines, enormous productivity losses, grotesque distribution inefficiencies, and a nearly universal desire to deregulate markets.

In fact, it was the installation of Choice Number 1 in 1981 that set the stage for two decades of gasoline prices that consistently lagged the national inflation rate, until surging global oil demand and a series of supply disruptions, including wars and strikes, set prices on their current upward path, starting in 2002.

The biggest problem with the market option, of course, is that someone makes money on it. That puts us in mind of gouging and profiteering, rather than thinking about the Herculean efforts performed behind the scenes to make the outcome as seamless as possible for consumers. Our officials should spend more time thinking about how to mitigate the impact of high prices on those least able to bear them, and less on how to tamper with the means of ensuring reliable supply. That's not as glamorous, or as ambition-advancing, but it would serve their constituents' interests much better.