Taxing Carbon?

After an absence of a decade, the carbon tax is back under discussion in the Congress--even if it might be a bit of a Trojan Horse this time around. However, much has changed since 1993's "BTU Tax" fight. Climate change was just emerging as an issue, then, and the price of gasoline stood at $1.10/gallon--the equivalent of about $1.45 in current dollars. Cheap fuel was our right. But with increasing numbers of Americans coming to accept that climate change is a big, looming problem, and the days of cheap gas apparently over, the response this time might just be "Why not?" instead of "Why?"

As my regular readers know, I believe cap & trade is the preferred mechanism for establishing a price on carbon dioxide and other greenhouse gases emitted to the atmosphere. However, I recognize that some very smart people have concluded that a carbon tax would be more effective and efficient, with its lower administrative requirements. Taxing emissions isn't such a bad idea, especially if you view this as a kind of tariff on legacy energy sources that were developed in a world in which carbon emissions didn't matter. After all, until the establishment of the income tax in 1913, the federal government got much of its revenue from tariffs. The biggest problem with this idea is not that it's a tax, per se, but that someone will have to determine its level. Set it too low, and the planet keeps warming for decades; too high, and the economy goes into a slump and even more industry goes to China, which is one-fourth as energy-efficient--and hence emissions-efficient--on average as we are.

This is where cap & trade shines, at least in principle. Markets do price discovery better than anything else ever invented. If you doubt that, look at eBay. Greenhouse gas emissions may not be Aunt Martha's antique china, but I defy anyone to calculate the correct level of carbon tax to reduce emissions by the desired amount without triggering a recession. (It wouldn't do that if it were truly revenue-neutral, but the chances of that seem even lower than the odds of a carbon tax passing in the first place.) Our models of the economy are good, but are they that good?

I also doubt we could gauge the right carbon tax level by observing the European cap & trade system, which implements an idea we talked them into during the negotiations for the Kyoto Protocol. The basis of comparison is weak, because the EU emissions trading system is too limited, and the European and US economies have significant sectoral differences. Nor can you look to European consumers for hints on how their US counterparts might respond to a carbon tax, since consumers in the EU haven't seen anything remotely resembling free market prices for transportation for decades, with the exception of discount air fares, and are already taxed to the hilt.

Whether Representative Dingell's proposal reflects a change of heart on this issue, or merely a prompt to his colleagues to acknowledge the costs of addressing climate change, there is much to recommend a carbon tax: it would be simple, transparent, predictable and relatively easy to assess. Its application would reveal the relative greenhouse gas contributions of our various energy sources, including corn ethanol, which would attract a higher tax than many might assume, when all its fossil fuel inputs are properly tallied. But I still see the determination of an efficient level for the tax as the fatal flaw in this idea. Perhaps a hybrid approach, with businesses subject to cap-and-trade and consumers paying a carbon tax based on the average emissions market level for the previous period, could overcome this shortcoming. In any case, the upcoming debate between advocates of these two mechanisms should be quite interesting to watch.

Climate Change, Water, Food and Fuel

Few of the reports I've seen about the current heat wave and drought in the West explicitly mention a connection to climate change. After all, climate is what we expect, weather is what we get, and the two often seem disconnected from each other. But in this case, they are linked in at least the following way: current conditions out West exemplify what climate scientists have been telling us to expect more frequently, as the earth warms. It's hard to look at the situation and not see numerous feedback loops with significant potential consequences for the growing population of the Sunbelt, and for the entire economy. Sustained dry conditions in the Western US could jeopardize food supplies and amplify the mechanisms of global warming.

Having spent much of my life in California, I'm conscious of the way that water and development have always been tied together in the West. Los Angeles only grew to its present scale because of the contracts and infrastructure that bring water from the eastern Sierra Nevada and the Colorado River to SoCal. In the semi-arid southwest, residential and agricultural demand for water have historically been in tension with conservation interests, and the balance among them has gradually shifted towards the latter in the last few decades. If climate change yields a significantly drier pattern in the West than what has prevailed for the last fifty years, then the entire system will be stressed. Given the migration rate into the region, with metro areas like Las Vegas and Phoenix growing at multiples of the national rate, it's hard to see residential water use ending up as the lowest priority use of scarce water. Homeowners and businesses can outbid farmers, and the agricultural bounty of places like the central valley of California, which depends heavily on irrigation, could be at risk.


But just as climate change can influence these conditions, the reverse is also true, via the basic mechanisms of climate change. The drier the West becomes, the less vegetation it can support. That reduces the region's natural uptake of CO2, which helps to mitigate the impact of man-made emissions. But it also creates the conditions for putting large quantities of stored carbon back into the air, via the wildfires that become more frequent and extensive during a severe drought. That could ultimately force us to make even deeper cuts in the greenhouse gases emissions from transportation and industry, in order to stabilize the concentration of these gases in the atmosphere. The climate neither knows nor cares whether a ton of CO2 came from a car's exhaust, from a coal power plant, or from a forest fire. The global effect is exactly the same.

Now throw biofuels into the mix. While they represent an important strategy for reducing our use of the fossil fuels that contribute to climate change, their cultivation under drought conditions adds to the competition for water among food crops, natural systems, and the increasing demand from development. In this context, food vs. fuel becomes a subset of a larger fight over water, fed by climate change but affecting climate change in turn. Compared to this, the geopolitics of oil are simple.

No Relief

Yesterday the International Energy Agency (IEA) set off alarm bells in the energy markets with a report suggesting that oil supplies would be tight for the next five years. The market reacted predictably, with Brent Crude--a better benchmark for now than West Texas Intermediate--briefly breaking through $76/barrel. Even more worrying is the notion that OPEC's spare capacity will be reduced to a bare minimum by 2012. But what the market--and any consumers who noticed it--saw as more bad energy news must certainly be regarded as welcome in some quarters. Another five years of high oil prices should furnish ample incentives to redouble our efforts on renewable energy and conservation.

I haven't seen the full report yet, because the IEA's website hasn't been updated in several days. From the media coverage it seems clear that the main driver continues to be demand, on the back of strong economic growth. Some will point to the IEA's forecast as the harbinger of Peak Oil, validating concerns that we are approaching the point at which global oil output must stall. But even the rough numbers in the press belie that conclusion. The IEA expects global oil production to rise by a healthy 10 million barrels per day (MBD) over the period in question. If demand weren't expected to grow at 2% per year, that would be adequate to provide significant price relief--which it still could, if the global economy slows. But even with unconventional oil included, the growth in non-OPEC production is slowing, and that means that OPEC will be in an even stronger position in the future than they are today. If this forecast is right, they could abandon their quotas and semi-annual meetings with little fear that prices would cool.

The biggest beneficiaries of yesterday's report are probably alternative energy developers. For anyone looking for a guaranteed oil price floor, this is as good as you're likely to get. The chances of oil prices receding below $40/barrel just dropped appreciably. If anything, alternative energy could become one of the key determinants of oil prices, as indicated by the IEA's apparent concern that biofuels growth will slow after 2009. For all of its faults from an energy and food-competition perspective, ethanol is still a good oil substitute, and an extra 20 billion gallons per year (equivalent to 1 MBD of oil) over the next five years could make a difference in global energy prices.

The other wild card in this outlook is conservation and efficiency. The IEA translates a global economic growth forecast of 4.5% per year into oil demand growth at a little less than half that rate. Could the combination of demand elasticity--consumers changing their lifestyles in response to sustained high prices--and stronger measures to combat climate change alter the BTU/$GDP relationship by enough to trim a million barrels per day from that five-year demand forecast? It would have to depend on factors that don't require turning over our immense capital stock--car fleets, buildings and energy infrastructure. The IEA's report should help erase any doubts standing in the way of such actions.

Wind Bottleneck

The front page of today's Wall Street Journal features an article on an important strategic shift in the growing wind energy industry. A large backlog of wind turbine orders is apparently leaving some developers with a choice between long project delays or acquisition by larger companies that have turbines to spare--or a large enough project portfolio to shift turbines around to more attractive opportunities. Although some of the causes of this situation look like a microcosm of the same global hardware crunch that has oil companies delaying drilling projects for lack of appropriate rigs, the biggest are quite specific to the expanding renewable energy market. If wind power is to grow as fast as environmentalists and alternative energy investors hope, then these bottlenecks must be eliminated.

Sporadic support for wind and other renewables by the US government is the main underlying cause of the situation described in the Journal. Because wind power is still not fully competitive without subsidies, government policy remains a key driver of growth. Wind turbine manufacturing capacity has grown faster in countries where the market for its output wasn't riding the roller-coaster of biennial wind subsidy expiration. That's why a European firm such as Iberdrola can leverage their call on Gamesa's turbine output into an entree to the US wind market. This may be just another example of the increasing globalization of the energy sector, but with the EU providing dependable incentives, it also provides a new twist on the old industrial policy debate of the 1980s.

I've always been squeamish about governments choosing winners and losers among industries and technologies. The market seems to do this better, on average. But if we're going to place such a big bet on renewable energy as a means for reducing greenhouse gas emissions and enhancing our energy security, then we are implicitly betting on the technologies that deliver that energy and on the companies that make the hardware with which to do it. If we like wind electricity well enough to promote its generation through production tax credits and state renewable portfolio standards, then wouldn't it make sense at least to make that support stable enough to foster the growth of the domestic wind turbine industry? The alternative will leave us no less reliant on foreign suppliers of turbines than we are on foreign suppliers of oil.

Suing OPEC

Today's Wall Street Journal looks at an aspect of the pending energy legislation in Congress that I hadn't really focused on, the so-called "NOPEC" provision that would allow the Organization of Petroleum Exporting Countries (OPEC) to be sued in US court for anti-competitive behavior. The article cites a similar measure in 2000, though the idea is much older than that, going back at least to the time of the first energy crisis in 1973-74. While the reasons for today's high oil prices are complex, as I discussed Monday, there's little doubt that OPEC is acting to restrain supply and drive up prices, as they have on many previous occasions. Taking the cartel to court over this issue is not the worst idea I've ever heard, though it could prove severely counterproductive for a nation as reliant on oil imports as we are. I think it all comes down to how it is pursued.

Including its newest member, Angola, OPEC produced 41.7% of the world's petroleum in 2006. And while Canada and Mexico both deliver more oil to the US than any single OPEC country, the cartel collectively supplied just under half our oil imports last year. With global oil demand having grown more rapidly than non-OPEC production for the last several years, OPEC has regained sufficient market leverage to exert significant control over prices. They may not exactly set the price, but they meet periodically in Vienna to discuss restraining supply to defend their target price range. If the CEOs of BP, Chevron, ConocoPhillips, Shell and ExxonMobil were to meet in Houston to agree on output quotas, they would quickly find themselves in a federal courtroom defending their actions.

While the idea of suing OPEC might sound sensible and even self-evident, it could be quite difficult to mount a successful anti-trust action against them. As the Journal points out, the cartel's members are not companies, but sovereign nations with the same "sovereign immunity" afforded to all governments. Furthermore, they could point to the precedent of the Texas Railroad Commission, which had effectively set world oil prices before OPEC even existed, by setting quotas to prevent unrestrained production that might damage the state's oil fields. Perhaps US prosecutors could finesse OPEC's sovereign defense by going after the national oil companies that carry out OPEC's policies, in order to get a conviction, but at that point our problems would only be starting.

If OPEC's members owned no assets in the US, an anti-trust conviction might provide a satisfying, symbolic victory. However, the Venezuelan state oil company, PdVSA, owns 100% of Citgo. Saudi Refining Inc., a subsidiary of Saudi Aramco, owns 50% of a refining & marketing joint venture with Shell. These two entities alone have billions of dollars worth of assets in the US, without counting the diversified US investments and deposits of many other OPEC countries. Because these countries own a variety of things that a US court could attach or seize in an anti-trust judgment against OPEC, the result could quickly devolve into a very risky game. It is hard to imagine us seizing OPEC's assets here without triggering at least a corresponding seizure of US property or investments in OPEC countries, or an actual OPEC embargo against the US. That would put our current notions of energy independence to the test, exposing just how aspirational they are. Nor is it obvious that the final outcome would actually alter the collusive behavior that prompted the action.

There might be a better alternative. If we are serious about holding OPEC to account for openly conspiring to restrict production and set global oil prices, we should do so in the appropriate multi-lateral body, whether the World Trade Organization or the World Court. Whatever misgivings Americans may have about the institutions of global governance, a finding in an international venue would be the only kind that could be enforced against OPEC across the globe, effectively deterring reprisals by holding every OPEC member's global holdings hostage to their good behavior.

I'm sure it's tempting to believe that previous administrations and Congresses shied away from these steps because they were beholden to oil interests or secretly winking at OPEC's behavior, because it somehow served opaque US interests. While Monday's posting might have convinced you otherwise, I tend to follow Occam's Razor in questions such as this. The simplest reason why we have never gone after OPEC for anti-trust violations is that our elected leaders have always understood that the consequences of winning would not be worth the hollow satisfaction it might provide.

Taking the Climate Pledge

An op-ed in last Sunday's New York Times reminded me that the big climate change concert, Live Earth, is coming up this Saturday. It's hard not to be impressed by an event taking place simultaneously on every continent save Antarctica, and featuring a mix of the world's biggest pop stars and regional talent. Even more ambitious, however, is its organizers' stated goal of ensuring that Live Earth "inspires behavioral changes long after 7/7/07." This all comes together in the "Live Earth Pledge" that attendees and listeners will be asked to sign, committing themselves to action against climate change. Unsurprisingly, its seven points embody an aggressive view of the problem and its solutions. While some are laudable, others deserve more debate and don't reduce easily to a single line sign-off.

Here is the Pledge, point by point, with a bit of analysis:

1. To demand that my country join an international treaty within the next 2 years that cuts global warming pollution by 90% in developed countries and by more than half worldwide in time for the next generation to inherit a healthy earth--The Pledge starts off with a bang, here. It suggests that the focus of international action has shifted beyond the Kyoto Protocol to a follow-on treaty, the scope and allocated responsibilities of which aren't yet known. So far, so good. Next, it proposes targets that implicitly accept the need to stabilize atmospheric CO2 concentrations somewhere between 450 and 550 ppm, while coming down squarely on the side of the developing world in putting most of the burden on "legacy emitters": the US, EU, and other OECD countries. Acceding to China's argument that historical and per-capita metrics matter more than current aggregate emissions may be high-minded, but frankly it won't get us where we must go. We need a mechanism that also recognizes that the easiest emissions to cut are ones that haven't yet occurred--from China's exponential growth, for example--rather than imposing truly draconian cuts on established economies. Even if you accept the idea that we can reduce a lot of emissions without causing major economic harm here, cutting by 90% goes far beyond that into hardship and dislocation territory, unless it happens through technology and infrastructure turnover. It's hard to see those gradual trends satisfying the "next generation" timetable, as fuzzy as that is.
2. To take personal action to help solve the climate crisis by reducing my own CO2 pollution as much as I can and offsetting the rest to become "carbon neutral;"--This is my favorite plank, since behavioral change has the biggest potential for bypassing the long lead times for technology and fleet turnover. It also explicitly endorses tradable emissions offsets, making our emission reduction efforts more efficient by focusing them on the cheapest cuts, wherever they are found. The biggest problem with pushing this idea down to the personal level, however, is that it's not progressive: more than half of energy consumers probably can't afford to pay extra--even a little extra--to offset their CO2 emissions.
3. To fight for a moratorium on the construction of any new generating facility that burns coal without the capacity to safely trap and store the CO2--Since the technology for carbon sequestration isn't fully proven for large-scale application, I'd be happier if this had said, "without a sequestration-ready design and escrowing the funds to implement it as soon as it is available." Absent such a caveat, this part of the Pledge really says, "No new coal power plants; we will rely on renewable energy from here on out." That's quite a bet.
4. To work for a dramatic increase in the energy efficiency of my home, workplace, school, place of worship, and means of transportation;--This is a useful recognition that our individual influence extends to all sorts of affiliations we enjoy. The aim is clearly to leverage the enthusiasm of Pledge signers into realms that might not have even noticed the Live Earth event.
5. To fight for laws and policies that expand the use of renewable energy sources and reduce dependence on oil and coal;--In a surprisingly short time, this has approached the status of motherhood and apple pie. I agree with the goal, but I continue to believe the transition will take much longer, and require the consumption of many billions more barrels of oil and tons of coal than most Pledge signers will guess.
6. To plant new trees and to join with others in preserving and protecting forests; and--This really is motherhood and apple pie.
7. To buy from businesses and support leaders who share my commitment to solving the climate crisis and building a sustainable, just, and prosperous world for the 21st century.--This last plank may be the cleverest and most effective of the bunch. As individuals our influence on governments is limited. The goal of transforming our own lives to make them carbon-neutral must compete with numerous other priorities: basic needs of food, clothing, energy and shelter; paying for new-but-indispensable services like cellphones, broadband and 200 channel TV; and all the other costs of modern middle class life. But harnessing our aggregate power as consumers is quite another matter. At little or no cost to ourselves, we can reshape the priorities of the companies we patronize, redirecting hundreds of billions of dollars of business expenses and capital investments toward "greener" suppliers and projects. Curiously, this rests on an assumption that many of those who would sign the Pledge instinctively could never admit: that business often responds more quickly to the choices of customers than governments to the choices of voters.

As you might expect from a group of organizers that includes former-VP Gore, the Live Earth Pledge has an enormous amount of thought behind it, reflecting his viewpoint that climate change represents an immediate global crisis requiring immediate global action. As my regular readers know, I share a somewhat more nuanced version of that view, expressed as a need for urgent, prudent management of an enormous risk. But did I "click here"? Even though I can accept four of the seven commitments more or less as they are, and two more with a few mental reservations, I can't get past #1. The realistic timeline for a 50% cut is probably more like 30 or 40 years than 20, which suggests we'll probably overshoot 550 ppm and have to pull back harder, later, with better technology. I also see the stated allocation of responsibilities for emissions reductions as a deal breaker, regardless of which party wins the White House next year. I don't know how we'll resolve the legacy emissions issue with China and India to get a truly global deal, but ceding this up front is bad policy and a lousy negotiating strategy.

Sharing the Forecourt

A comment in an article on Brazilian ethanol in today's Financial Times got me thinking about how ethanol will move into the US retail marketplace, as it outgrows its current role as a gasoline blending component. The FT cited Ricardo Leiman of Noble Group, who remarked, "There is a conflict of interest between [fossil fuel] distributors and the newcomers." That's certainly the conventional wisdom, with E-85 pumps at major oil company stations as rare as hen's teeth. But I wonder if that gives sufficient credit to the marketing segments of these large enterprises, which have pursued profits in many other areas not directly related to the output of their own refineries. It also ignores the structure of the retail gasoline market, which could be quite hospitable to ethanol, once it reaches critical mass.

First, consider the composition of the retail motor fuels business in the US. Of the 169,000 retail fuel facilities across the nation, fewer than 10% are actually owned and operated by integrated oil companies such as ExxonMobil, Shell, ConocoPhillips or Chevron. The rest are run by retailers with varying degrees of independence. Some own their own facility, while others lease it from the company. Many receive their supplies through a distributor, rather than directly from the company. As a result, even if all of the major oil companies decided that E-85, biodiesel or some other alternative fuel represented an unacceptable threat to the petroleum products they produce, the number of stations at which they could enforce a ban on E-85 is only a small fraction of the total. For the vast majority of service stations, the question of whether to add a pump to sell E-85 or biodiesel isn't determined by corporate policy, but by the economics for the station owner.

Gasoline retailing is not a high-margin business. That's why there are so many convenience stores and co-branded food outlets, both of which offer much higher unit margins than for fuel. Total potential E-85 sales in a given area would be a function of the local flexible fuel vehicle (FFV) population and the number of other E-85 outlets in the same market. FFVs currently make up only 2% of the US car population, and until their numbers grow substantially, E-85 will be a low-volume business for most retailers. That combination of low margins on low volumes limits the return on the investment required to convert a station to sell E-85, offset by any available government incentives. And unless the owner is willing to add an additional tank, he must sacrifice the revenue on another grade of fuel to make this switch. The primary obstacles for introducing E-85 at most retail sites are strictly financial, and only time and the growth of the FFV fleet will overcome them.

Viewed from this perspective, the major oil companies are in a much better position than individual retailers to introduce E-85 selectively into a new market. Not only do they have the financial resources to absorb the costs of conversion, but they also possess sophisticated software that would allow them to determine the best sites to convert, and how to phase alternative fuel into the market, in synch with the expanding FFV fleet. Nor do I think the marketing groups of these companies will resist this, if it provides an opportunity to enhance both profitability and brand image.

Many people forget that the integrated oil companies are no longer the monolithic, command-and-control organizations they once were. Their marketing divisions are independent profit centers charged with earning an attractive return on their employed capital. Many of the executives responsible for these units have more in common with the people running other retail businesses than with their colleagues who run the refining or exploration and production segments. When I tried to get Texaco's marketing department interested in installing electric vehicle recharging facilities at service stations in Southern California in the late 1990s, their main worry was how they could make money on them, not their effect on gasoline sales. What counts is traffic, and if E-85 will bring them traffic, they will buy in. The best way to make sure that E-85 spreads quickly is to ensure that the major oil companies can take advantage of the same incentives for E-85 as independent retailers. Alternative fuel advocates should view major oil company marketing groups as natural partners, rather than potential opponents.

Energy Outlook will observe the US Independence Day holiday tomorrow and resume new postings on July 5.

Why Is Oil So Pricey?

For the last several months, almost everyone has been asking why gasoline prices are so high. The standard answers often fail to satisfy, and far too many people see signs of a conspiracy. I've devoted a fair amount of space to this issue, but I've largely ignored the more important, fundamental question of why oil prices are so high. Oil prices remain the largest single component of retail gasoline prices, accounting for about 54% of the pump price, and most of those who follow oil are focused on the factors that could move its price up or down, rather than looking at its absolute price level. Why should oil be trading at $70 today, instead of $30 or $40? This question ought to be of great interest to the public and to government officials, and especially to those developing or investing in alternative energy.

Reviewing the long history of oil prices provides some interesting insights. Prior to 1973, oil prices were quite stable, which meant they were trending downward in real terms. From 1985 to 2002, nominal oil prices averaged $21/barrel, and with the exception of a few spikes, such as the Gulf War, real oil prices were generally falling. The overall pattern reflects sharp upward discontinuities, followed by a gradual decay in prices until the next spike. This history includes periods with all sorts of economic, geopolitical, and market conditions. To understand why the oil price is so high, we need to ask what is different today, compared to previous, similar periods when it was lower. Consider some of the factors that are usually trotted out to explain high current oil prices:

Asia's growth - India and China are growing rapidly, straining global oil supplies and pushing prices higher. But is this growth unprecedented? Since 1997 China's oil demand has grown at an average rate of 7% per year, based on US Department of Energy data. Over the last five years, that has added roughly 500,000 barrels per day (bpd) to global oil consumption. But that increment is still only 0.6% of total global consumption of 84 million bpd. From 1960-1970 oil demand in the OECD--essentially the US, Western Europe and Japan--grew by over 8% per year, driving total global demand up by around 6% per year for a decade, during which total consumption more than doubled. Over that entire period, when prices weren't influenced by OPEC, but guided by the Texas Railroad Commission, they were steady in nominal terms and falling when converted to 2005 dollars.

Falling spare capacity - Many analysts suggest that the decade's global economic growth has outpaced the ability of oil producers to expand spare capacity, and the resulting narrowed gap between supply and demand has pushed prices higher. There's no question that global oil capacity has been strained, particularly in 2004 and 2005. It's hard to gauge spare capacity reliably, but it was clear that Saudi Arabia, the world's swing producer, had to dig deeper into less desirable, heavier grades of oil to meet the call on its output. But one of the best proxies for the interaction between supply and demand, inventory, tells a different story. Total OECD oil inventories--which include strategic reserves--have grown by 10% since 2002, with US commercial crude oil inventories currently 9% above their 10-year average. By itself, this fact doesn't suggest that crude is overpriced, but it certainly doesn't justify today's price level, either.

High geopolitical and other risks - Al Qaeda, war in Iraq, unrest in West Africa, climate change, hurricanes: the last six years have been a compendium of nearly every bad thing that can happen to affect the price of oil, and the idea of a high "risk premium" on oil is widely accepted. But how high should it be? What did previous events like this do to the price of oil? Consider the case of the Gulf War, when Iraq invaded Kuwait and threatened Saudi Arabia. From the time Saddam's forces crossed into Kuwait in August 1990 until the coalition air campaign began in January 1991, the price of West Texas Intermediate crude on the NYMEX rose by about 50% from the average of the preceding 12 months. (Once the shooting started, the price plummeted back to the low $20s.) On a comparable percentage basis, the Iraq War, which has had a smaller impact on actual oil production than the Gulf War, might thus account for about $15/barrel of the current price. It's hard to imagine all the other risks doubling that figure.

That brings us at last to the question of whether speculation might account for the remainder of the doubling of oil prices that has occurred since 2002. This is certainly a relatively new factor in the oil markets, compared to the 148-year history of the commodity. The number of players in the futures, options and oil derivatives market, compared to even a decade ago, has exploded. "Open interest" on the New York Mercantile Exchange, a measure of the scale of trading, has more than doubled since 1999, when it stood at 638 million barrels of crude oil. As of Friday's session, aggregate open interest across all crude oil contracts going out to 2012 was just under 1.5 billion barrels. But does that mean that speculators are manipulating the price of oil, as some have alleged? I think there's a different explanation that looks at the nature of these markets, rather than the intentions of their participants.

Oil futures have a basic similarity to equities. Both reflect the underlying value of the thing to which they are linked--barrels of oil in one case, the fortunes of a company in the other--but both also have an independent existence. Oil commodity futures are in demand as financial instruments in a different way than when they were used primarily as a way for refiners and distributors to manage the risk on their physical market activities. As that demand grows--as more individuals, companies, and hedge funds want to participate in the oil market, without a link to any physical supply or demand for the commodity--then the price of these instruments ought to rise, in tandem. But with the price of most physical oil pegged to a futures market, whether for WTI or European Brent crude, that demand can influence the physical market, as well, without changing the real supply or demand by one barrel.

Anyone who has traded oil knows that the physical market needn't move in lock step with the futures market. Differentials for physical oil versus futures wax and wane, depending on a variety of factors, and if the only thing going on were long-term inflation of oil futures by financial demand, you'd expect the discounts for real grades of oil to widen versus the futures to compensate. But those differentials aren't set in a vacuum, without reference to previous prices. You don't wipe out the entire price history of the commodity and arrive at the price from scratch every day.

How much of an influence could the expansion of market participation have? I honestly don't know, but the shortcomings of the other explanations that I discussed above at least suggest that we're missing something important. Frankly, I find this a much more interesting question than many of those that are being asked about gasoline prices in the Congress and elsewhere. Rather than wondering if the market is being manipulated by oil companies or hedge funds, we ought to be analyzing the broader impact of the enormous increase of investor interest in oil price instruments on the cost of real oil to the economy. If anyone has run across a study looking at that, I'd love to see it.

What We Don't Know

Our energy problems would be sufficiently challenging, if a majority of Americans weren't laboring under a set of unhelpful misconceptions about the structure and functioning of the energy industry. If that sounds like a paranoid statement, check out the poll that was just conducted on behalf of the API, the trade association representing most US oil and gas companies, gauging the country's "Energy IQ." Before looking at the results, you might want to take the quiz yourself. While the answers shouldn't surprise many of my readers, I hope you will be as dismayed as I am at the general lack of knowledge about this key sector, with crucial policy decisions imminent. We will only make good decisions about energy, personally and nationally, if we know the facts.

Consider the distorted view of energy that the typical responses reflect. If the poll is representative, most people apparently see the US as being much more reliant on a handful of unstable foreign governments than we actually are, but at the same time, they greatly inflate the importance of US companies in a global industry increasingly dominated by large, national players--as was just demonstrated in Venezuela, where the top US firms just lost billions of dollars of assets to Sr. Chavez's Bolivarian Revolution. Without diminishing the importance of energy security, the fact that most Americans mistakenly think we get more oil from the Middle East than from our NAFTA partners, combined with a belief that alternative energy will soon supply a large fraction of our needs, might explain the current appeal of the unrealistic notion of energy independence, despite its elusiveness for three decades. Reality is more complicated, and as the head of the API suggested during Wednesday's blogger conference call on the survey, "There is room for all fuel sources to be part of the energy equation."

Without excusing anyone for not being better informed, I think I understand how we got to this point. If oil companies were ever widely trusted, it was in the period when they were personified by polite, uniformed service station attendants who cleaned your windows and checked your oil, while your tank filled with 30 ¢ gas. Throughout my adult life, oil companies have been viewed with disdain or hostility, depending on the current price at the pump. Their credibility has suffered from a historical lack of responsiveness and transparency and from the identification of their products and processes with pollution, compounded by the misdeeds of firms like Enron. When the people who arguably know the most about a subject are among the least likely to be believed, the resulting void looks like the Internet: a sprinkling of fact surrounded by opinion, rumor, and deliberate misinformation.

There might be some avoidance of cognitive dissonance here, as well. If oil companies are just doing their job as large businesses, in the same way as the companies that produce our food, deliver our packages, or make our iPods, then maybe they're not to blame for the high prices at the gas pump. Perhaps we bear some of that responsibility, either through the aggregation of all our consumption choices, or through our support for policies restricting access to natural resources and the construction of energy infrastructure. That insight could either empower or paralyze us.

The point of all this is not to hold a pity party for the oil industry, which is doing quite well and will likely continue to prosper in spite of--and sometimes because of--the regulations we throw their way. Many of the misconceptions highlighted by the API's poll are not harmless, however, and the interests at stake are not just the industry's, but the country's. We face complex problems, and our attempted solutions will be more successful if they are grounded in reality, not distortion. It will be interesting to see whether blogs like this one can help to close that gap over time, by sharing informed but independent perspectives on energy.

The Real CAFE Debate

Reform of US vehicle fuel economy standards has passed two out of three hurdles. The President proposed a 4% per year improvement in Corporate Average Fuel Economy targets in his State of the Union address, and last week the Senate passed a bill that would increase the CAFE standard to 35 miles per gallon by 2022. The last piece of the puzzle must come from the House of Representatives, which may defer consideration of CAFE until it takes up greenhouse gas limits later this year. In the interim, it's worth looking at two aspects of the CAFE system to get a better sense for what implementation of stricter standards might actually mean.

Last weekend, at a cocktail party at a friend's home, I chatted with some auto industry folks about the energy bill that had just passed. They were genuinely concerned about the ability of the US industry to deliver 35 mpg across the entire fleet, and I didn't get the impression this was just a question of whether they could do it and still make money--though that's not a trivial consideration, either. But this is not just a matter of technical feasibility. As I pointed out in a posting earlier this year, the European brands of two of the Big Three already meet the proposed target, with Ford's 2005 models averaging 36.3 mpg and GM's Opel and Vauxhall models coming in at 35.2 (after converting from grams of CO2 per km to mpg.) When you look at how they do it, two factors are obvious: size and fuel choice. Europeans drive smaller cars, with smaller engines, and more than half of new cars burn diesel fuel, which provides about a 30% boost in fuel economy versus a comparable gas engine.

Dropping a diesel into a big SUV would only take you from 17 mpg to 23. Hybridization of the gas model gets you to roughly the same point. Increasing overall fleet fuel economy by 10 mpg will certainly require Detroit to produce more models with more efficient power trains, but it will also require US consumers to shift their preferences towards smaller, lighter vehicles, probably sacrificing some performance in the process. Unless gas prices keep rising, I have my doubts about how rapidly that shift will take place. After all, if everyone wanted a Toyota Camry Hybrid, we could meet the new target next year.

And that brings me to the aspect of CAFE that I haven't heard discussed at all, enforcement. What happens if carmakers miss these new mpg targets? Under the current system, they pay fines, and the record of fine collection makes interesting reading. When you compare the fines assessed with the fuel economy of the vehicles sold by each firm, you see that falling short by one or two mpg hasn't been very expensive; averaged across a company's entire sales, it works out to under $100 per vehicle. Even for Ferrari, which is routinely 40% below target, the cost is around $700 per car. If the new targets are implemented under the existing system of penalties, then there's little need for additional "offramps" to shelter manufacturers. However, if the penalties are strengthened, US carmakers could find themselves caught between the vise jaws of consumer inertia and regulatory pressure, despite having designed cars that would meet the target. I can understand why the Big Three might be uncomfortable about a national debate on fuel economy that avoids talking about the carrots and sticks that might nudge consumers towards the car choices that constitute an essential ingredient of meeting these goals.

Mandate To Nowhere?

Of all the provisions of the Senate energy bill that were debated over the last several weeks, the greatly expanded mandate for renewable fuels was probably the least controversial. It increases the amount of renewable fuel--chiefly ethanol--that fuel marketers must sell annually from the previous target of 7.5 billion gallons by 2012 to 36 billion gallons by 2022, or the equivalent of about 1.6 million barrels of oil per day. It's easy to understand the appeal of this from an energy security perspective, with ethanol providing modest climate change benefits, as well. And with 21 billion of the 36 billion gallons slated to come from cellulosic ethanol, rather than from corn ethanol that competes with food, it sounds like a blueprint for a better energy future for the country. But are we placing too large a bet on the relatively unproven technology of producing ethanol from converted crop waste and non-food energy crops? An article in Slate raises some worrying questions about this strategy. After reading it, I came up with a few concerns of my own.

The author's critique of cellulosic ethanol focuses on the resources and the rapid pace of development that would be necessary to produce the volumes mandated by the Senate. He also questions the net energy benefits of cellulosic ethanol, based on a forthcoming study from the University of Colorado. Finally, he expresses doubts about whether the total impact of ethanol will be worth its cost. The article is worth reading, and all of these issues ought to be addressed rigorously before the House of Representatives takes up this proposal in a few weeks.

Like many people, I've generally accepted most of the claims about the potential of cellulosic ethanol to provide a useful petroleum substitute that will be bigger, better, and ultimately cheaper than that the corn-based variety, about which I have had serious concerns for 25 years. Chalk it up to the natural American enthusiasm for new technology. But after reading the Slate piece, I started thinking about the implications of a biofuels mandate this large. If gasoline demand continues growing at 1%/year, 36 billion gallons would cover about 21% of the total gasoline consumed in that year, after adjusting for ethanol's lower energy content. That compares to about 3% last year. And if conservation and the new CAFE standards actually manage to slow the growth in demand, the proportion would be even higher. That makes this a high-stakes gamble, indeed.

How reasonable is it to expect the current ethanol industry, the oil industry, or a new set of players--including a number of high-tech types--to grow a 21 billion gallon per year cellulosic ethanol business from zero in the next 15 years? I'm less skeptical on this point than Slate. Even if cellulosic ethanol plants cost twice as much to build as the traditional kind, the total cumulative investment involved would be on the order of $40 billion. If there's one thing American business can do, it's raise money. Of course, I don't hear many people talking about just what would attract that money: profits. The only way you're going to build this many ethanol plants is if someone thinks there are big profits to be made, either on the wholesale price of ethanol or from government subsidies. If one of my clients asked me, I'd tell them to focus on price, because investing that kind of money on the prospect of indefinite federal largess looks pretty risky. Bottom line, don't expect cellulosic ethanol to be much cheaper than gasoline, or it won't happen.

So if the economics work, and if the plants get built, what else could go wrong? Ignoring the basic technology risk, there are a couple of potentially serious constraints that could bite. First, consider logistics. The supply chain for cellulosic ethanol looks much more logistics-intensive than for gasoline. Producers will have to haul large quantities of low-grade plant matter to their facilities and then ship large quantities of ethanol out by rail and truck, because it can't share pipeline space with oil products. The feedstock alone would comprise about 200 million tons per year of additional haulage. Developers will also face the old dilemma of locating near their raw materials or their markets. Whether that will be dictated by transportation limitations or the economies of manufacturing scale remains to be seen.

Then we have the problem of consumption, which hardly sounds like a problem at all, until you realize that 98% of the cars on the road today can't handle ethanol in concentrations over 10% of gasoline without modifications. The new 15 billion gallon corn ethanol mandate is sufficient to bring every gallon of gasoline sold today up to that fraction. Effectively, cellulosic ethanol producers would either have to displace corn ethanol from standard gasoline or create a large enough market for E-85 to absorb it. That means growing the current fleet of 5 million flexible fuel vehicles (FFVs) to around 44 million within 15 years. Doing that will require that 20% of all cars sold from here on out be FFVs, to the tune of 3 million per year.

And if that weren't enough to get the Congress just a little bit worried about the risks of forcing that much ethanol into the system, we come to the key vulnerability of the whole plan. An FFV is just that: flexible. No one can ensure that every FFV will fill up with E-85 every time, even if the fuel were readily available across the country, as the Senate bill requires. Sooner or later, drivers will figure out that unless E-85 is consistently 25% cheaper than gasoline, they will get more miles per dollar on the latter. But that discount can only exist if wholesale ethanol is cheaper than wholesale gasoline everywhere, or if the subsidy is large enough. And if wholesale ethanol is always cheaper than gasoline, the economics of rapid ethanol capacity expansion start to look shaky. The net result of this feedback loop is that the lower the FFV E-85 usage rate is, the more FFVs we will need, in order to burn 21 billion gallons/year.

Cellulosic ethanol could still turn out to be a wonderful boon, overcoming all of these obstacles and going beyond to truly begin to wean the US off imported oil. But what we're asking of this untested technology is analogous to the growth of the automobile and its fuel infrastructure in the first third of the 20th century, telescoped down to 15 years. After a little reflection, I find that I'm less comfortable with the idea of this transformation happening by fiat, without a demonstration of competitive superiority in the marketplace.

Aligned Interests

I know it seems counter-intuitive to suggest that the interests of big oil companies and American consumers and voters might be aligned, particularly in light of the strained mutual dependence manifested at the gas pump these days. However, there is at least one aspect of the ongoing Congressional energy debate in which we all should be rooting for the oil company lobbyists to be successful, as they were--at least temporarily--last week. The issue in question relates to the imposition of a new severance tax on domestic oil and gas production from the federal waters of the Gulf of Mexico, in order to fund alternative fuels incentives and projects. This amounts to a larger-scale recycling of California's failed Proposition 87 . You don't have to like Big Oil or be skeptical of alternative energy to see the flaws in this approach.

The logic behind the proposal seems compelling. Oil companies are making record profits, some of which accrue from Gulf Coast leases on which they were granted relief from federal royalties, when oil prices were under $20 per barrel in the late 1990s. At the same time, Congress would like to encourage the production of alternative fuels and the adoption of more efficient technology. Where better to find the money for that than from funds to which the government would have been entitled, absent royalty relief? Getting oil companies to pay for alternative energy sounds like a smart and popular notion. Unfortunately, the consequences of that simple logic turn out to be counterproductive, at least if the overall goal of the legislation is to reduce America's dependence on imported energy.

US oil production peaked in 1970 and has been in steady decline since the late 1980s. Geology had a lot to do with that, but it is not a coincidence that real-dollar oil prices had started falling in the early 1980s, a trend that only reversed in the last few years. For a free-market producer like the US, oil production is intimately related to its expected profits. Compounding this problem, US natural gas production has apparently reached a plateau. The more of both commodities we must import, the higher their domestic prices will go. The more oil and gas we can produce here, the less we will import, and the less we will compete for supplies with the rapidly growing economies of Asia.

In the meantime, we are reaching a national consensus on the importance of reducing our oil consumption by conserving, by improving vehicle efficiency, and by expanding our production of alternatives, at least those with the potential to become competitive without large, permanent subsidies. But that does not mean that it makes sense to pit alternative energy against domestic oil, particularly when in the process we stand to reduce oil and gas production by more than the net energy contribution of our current alternative fuels efforts. And that's the crux of the problem, here. By making the largest remaining accessible oil and gas resources in the US less attractive, a severance tax could actually shrink our overall energy supplies, particularly if the alternative energy and efficiency projects do not contribute as much or as quickly as the foregone oil and gas production. That would increase our oil and gas imports.

This artificial dilemma can be solved easily. If the $29 billion worth of alternative energy incentives and projects targeted by the Congress have merit, then we should fund them from a source that doesn't treat domestic energy production as a zero-sum game. For example, over the 10 years in question, a surtax of less than 2 cents per gallon of gasoline would do the trick, while providing a small incremental incentive for conservation. But wherever we find the money, it doesn't make sense to take it from companies that invested billions of dollars of their shareholders' capital to increase US oil output, at a time when that looked very risky.

Peak Preparation

Following on from Friday's posting on the uncertainty about how close we are to a peak in global oil production, I want to focus on a question I think is actually more important: However close we are to a peak--whether it is already here, or 5, 10, or even 20 years away--are we doing enough to prepare for the possibility of one? The short answer is no, but that doesn't mean we aren't doing anything. In fact, many of our strategies for addressing climate change and energy security also provide some insurance against the consequences of Peak Oil or its forerunner, a sustained period in which liquid fuel supply doesn't grow as fast as potential demand, and the oil-market discontinuity that would trigger.

On a basic level, oil is important for two main reasons. It is the source of most of our transportation fuels and many useful petrochemicals and lubricants, and it also accounts for 35% of the world's primary energy production. Preparing for a gap between oil supply and demand requires addressing both of these aspects of oil's value to the economy, and in that regard it dovetails neatly with the concerns about global warming and energy security that are prompting big changes in our energy policies.

For example, while improved energy efficiency is a primary strategy for countering climate change and reducing oil imports, it looks equally important in preparing for a future oil shortfall and price spike. Peak Oil worries could lend urgency to the debate over CAFE and appliance energy standards. At the same time, efforts to expand biofuels production and bridge electricity into transportation via plug-in hybrids and electric vehicles, though driven by emissions and energy security calculations, are also excellent prescriptions for mitigating Peak Oil's impact and even delaying its onset.

There are a few areas in which this one-size-fits-all logic fails. The conversion of solid and gaseous hydrocarbons into liquid fuels--CTL and GTL--looks quite useful from a Peak Oil perspective. Viewed through a climate change lens, however, it looks like an expensive diversion or downright counterproductive. And while natural gas has oddly fallen from favor with those most concerned about climate change, despite its relatively low CO2 emissions, improving our access to gas (imported and domestic) looks like another key leg of the energy security/Peak Oil axis. If Peak Oil is a significant risk, we would certainly not want to face it in the midst of an emerging natural gas crisis.

For me, all of this boils down to effective large-scale risk management. For the next decade Peak Oil remains a big uncertainty, not a given, but prudent planning must take it into account. Where it reinforces other concerns, it may prompt accelerated timetables. Where it conflicts, as on some aspects of climate change, we need a candid debate about which problem looms larger, and which consequences would be most damaging or costly. At a minimum, we should improve our monitoring capabilities, including the means of auditing global production and reserves data for all liquid fuels, not just the conventional oil on which most Peak Oil predictions are focused.

How Near Is the End?

Although Peak Oil has faded somewhat as a "front page" issue this year, after a couple of years in the limelight, yesterday I received a question suggesting that a peak was either imminent or already upon us. That prompted a quick review of global oil production data to see whether there had been any changes that might support that view. I'm generally agnostic on the whole idea of an imminent geologically-driven peak in production, as distinct from one that might occur as a result of OPEC policy or problems queuing up the necessary drilling kit, personnel and investments to keep production rising ahead of demand. As complex as this issue is, however, there is one statistic that I think provides a pretty good barometer for the proximity of a peak; based on that measure, at least, we're not there yet.

Without going through the whole Peak Oil argument again, technical and otherwise, I want to focus on one aspect of peak oil that ought to be fairly non-controversial, among both peak adherents and peak skeptics. The global distributions of oil reserves and current production are remarkably different, as a function of the upside-down economics of the oil industry, in which the low-cost producers constrain their output and the high-cost producers go flat out. OPEC countries (excluding the newest member, Angola) hold 60% of the world's proved reserves but account for only 40% of production. Fundamentally, if there is a geologically-based peak in oil production waiting for us, OPEC is much farther from it than the rest of us, so it must manifest first in non-OPEC production.

So what do the numbers tell us? Has non-OPEC production stalled or gone into decline, as many expect? After looking at the most recent data available from the Energy Information Agency (EIA) of the US Department of Energy, the International Energy Agency (IEA), and the just-released BP Statistical Review, the clear answer seems to be no. Between 2004 and 2006 non-OPEC production grew by an average of 0.5%/year, and the IEA expects growth >1% this year, in a predictably lagged response to four years of sustained oil high prices. I don't see how that would be possible if we were as close to a global peak as pessimists believe.

There are two important caveats about the above figures, and if I didn't mention them, I know my readers would keep me honest. If you subtract from non-OPEC production the contribution of Canadian oil sands projects and the rising output of Angola, the residual trend looks like a plateau, at least over the last three years. But it no longer makes sense to look at non-OPEC supply without including oil sands--which are now a fact of life--just as we routinely include natural gas liquids. For that matter, anyone looking at peak oil ought to be counting the growing contribution of biofuels and any CTL or GTL that comes along, because what matters to the market is total liquid fuel supply, not just conventional oil. As to the change in Angola's status, it highlights OPEC's recent cleverness and reinforces the significantshift in market power that is underway.

The net result of all this leaves us just as uncertain as we were before about the timing of a future peak in "oil" production, but increasingly vulnerable to OPEC's production decisions. While much of that vulnerability is the inescapable result of the maturity of the producing basins in North America and Europe, some of it is self-imposed, and we ought to be doing some serious soul-searching about the consequences of that choice. Improved fuel economy and more biofuels will help, but we could dig our way out of this hole faster with some help from the oil we've chosen to place off-limits to development.

In the Meantime

For all the discussion on Capitol Hill about energy legislation--the subject of my last two postings--I have yet to hear a disclaimer that the impact of these proceedings on actual energy supply, demand, or prices in the next five years will be minimal. And yet, when you consider the time lags associated with the activities covered by these policies, whether relating to the expansion of alternative energy production, improvements in fuel economy, or even the easing of some restrictions on offshore oil and gas drilling, that must be true. It's not obvious that the public has figured that out, yet, but if they are expecting help from Congress at the gas pump any time soon, they are probably going to be disappointed. Unless they are warned in advance, that could have political consequences.

Consider the proposed new fuel economy standards. The bill by Senators Feinstein and Durbin, the "Ten-in-Ten Fuel Economy Act", would increase the CAFE standard for new cars to 35 mpg by 2020 and close the "SUV loophole" treating SUVs differently from passenger cars by 2013. The bill doesn't prescribe how this target would be phased in, but even if new car fuel economy were increased by 1 mpg/year starting next year, by 2012 the total improvement in the entire US car fleet of 243 million vehicles would only be about 3%. That's the equivalent of roughly 300,000 barrels per day (bpd) out of a gasoline market that exceeds 9.3 million bpd.

Now add in the biofuel mandates in Senator Dorgan's bill, S-875, the "SAFE Energy Act of 2007." Looking at its effect between now and 2012, we see the quantity of ethanol in the gasoline pool increasing from 4.7 billion gallons to 13.2 billion gallons per year. Ignoring concerns about the potential impact on food prices, and after adjusting for ethanol's lower energy content, that incremental supply works out to just under 400,000 bpd, or about 4% of current consumption.

Together, these two measures, which appear to offer the largest near-term fuel price impact of any of the provisions under consideration, would displace about 7% of our current gasoline consumption within five years, through a combination of efficiency gains and alternative supply. If everything else stood still, that would almost certainly be enough to exert significant downward pressure on gasoline prices--barring any new taxes that might be imposed in the interim. But how likely is it that everything will stand still? The recent price spike only slowed gasoline demand growth to about 1% per year. That means that over five years, the underlying growth in the car population and in total miles driven could erode all but 1-2% of the benefit of the new energy policies. That would reduce the impact on fuel prices to a level indistinguishable from the background noise.

That doesn't mean that changes in energy policy are unnecessary or futile. After all, most of the measures under discussion are designed to have their biggest effect after 2017. What it does mean, though, is that for at least the next few years gasoline prices will continue to be influenced primarily by the same things that have affected them in the past. That's why factors such as the expansion of US refinery capacity and the diversity of our sources of crude oil and refined product imports remain highly relevant, even as our efforts to reduce their importance in the future make these issues much more complicated. Rather than creating high expectations that can't be met in the near term, we ought to acknowledge the complexity and potential volatility of the transition period ahead.

Security vs. Emissions, Round I

It's probably premature to describe yesterday's Senate votes on energy as another turning point for coal in this country. Two separate amendments promoting coal-to-liquids (CTL) were voted down by healthy margins, as described in today's Washington Post. That doesn't automatically derail the industry's interest in producing liquid fuels from coal, but it seems to ensure that the final energy legislation coming out of Congress this year will include neither federal funding for CTL, nor a privileged place for its output within the liquid alternative fuels mandate of 35 or 36 billion gallons per year. While the US clearly can't ignore the energy bounty of the coal under our land, it looks increasingly likely that concerns about climate change will constrain coal's future contribution to sectors in which most of its CO2 emissions can be prevented from entering the atmosphere. That represents a real energy milestone.

In arriving at yesterday's decisions, it might appear that the Congress is expressing skepticism about the potential for Carbon Capture and Storage (CCS) technology to put CTL on an equal emissions footing with petroleum products. I don't think that's the case, because Senator Dorgan's SAFE Energy Act of 2007 (S-875), which is the centerpiece of the Senate's current debate on energy policy, spells out the importance of CCS in its charge to the Secretary of Energy to undertake R&D for CCS. If anything, the importance of CCS as an enabling technology for coal (and shale) has been elevated, at the same time that CTL has been recognized as a less attractive path towards low-emissions energy than biofuels or electricity.

I don't mean to rehash yesterday's posting, which addressed some of these same issues. Nor do I think that these votes rule out CTL entirely, because it could still emerge on a purely commercial basis. But I think it's worth noting that on its first opportunity to choose between the two main priorities that have emerged for national energy policy, enhancing energy security and reducing greenhouse gas emissions, the Congress has set the latter higher than the former. That could create a precedent that will carry beyond the current Congress and into the next Administration, regardless of who wins in November 2008, Democrat, Republican, or independent.

Do No Harm

The Senate and House of Representatives are both feverishly working on new federal energy legislation, and it's a reasonable bet that a bill will end up on the President's desk within a few months. However, it is still anyone's guess as to precisely what provisions will survive or be added along the way, as the process converges toward an eventual conference to iron out differences between the two bodies' differing energy visions. As the final legislation takes shape, however, we can only hope that our elected representatives will see the wisdom of adopting the credo of at least doing no harm. The potential for wasteful and counterproductive energy policy is enormous, particularly in two areas: the functioning of the petroleum products market and the promotion of alternative fuels.

The API ran a full page ad in today's Washington Post with a tag line of, "It's 2007, not 1977." That echoes a theme I've expounded here for several years. Many of the measures introduced to deal with the energy crisis of the 1970s were either ineffective or downright harmful. We should have learned from that experience, and from the much more successful market-oriented approaches of the subsequent decades. While fuel prices may be high again, we have seen none of the incredibly disruptive gas lines and runouts that plagued us then. In particular, the "anti-gouging" provisions espoused by some in Congress look like standby price controls, aimed at the point in time when the ability of the market to rebalance supply and demand is most essential, as we saw after the hurricanes of 2005. This idea clearly fails the "do no harm" test.

Turning to alternative fuels, it's rare that I agree with the editors of The New York Times on energy policies, but their editorial of May 30th on the impact of coal liquefaction on energy security and climate change was spot on. "A policy designed to solve one problem should not make the other worse," they said, citing the high greenhouse gas emissions associated with coal-to-liquids (CTL) plants. A recent posting on the Clean Car Congress site provides useful supporting data from a Carnegie-Mellon study comparing CTL, conventional fuels, and plug-in hybrids.

So in this regard, it is one thing to codify a greatly increased biofuels mandate that relies on production from unproven cellulosic ethanol technology to meet its long-term goals, but quite another to turn the understandable ambitions of coal-state legislators into a national policy that would double down our bet on the equally unproven technology of carbon capture and sequestration (CCS.) Even if cellulosic ethanol didn't take off as expected, we would still end up with liquid fuels that--however costly at the pump and the supermarket--could reduce both our oil imports and our greenhouse gas emissions by modest amounts. However, if we went ahead with CTL, but CCS proved either ineffective or uneconomical, we'd end up with a synthetic fuels industry that would roughly double our greenhouse gas emissions per gallon of gasoline or diesel. That would make a farce of any national effort to reduce those emissions via cap-and-trade or some other mechanism.

If we are indeed headed for a "grand compromise" on energy that would incorporate meaningful elements of energy efficiency and conventional and alternative energy supply, then those crafting a compromise must hold firm in excluding provisions that would sabotage either the ability of the fuel marketplace to respond to sudden shocks, or our first steps toward reducing our enormous greenhouse gas emissions. In the give-and-take world of Capitol Hill that won't be easy.

Global Energy Decarbonization

Last week I had the opportunity to hear Professor Jeffrey Sachs address a small “new energy” gathering hosted by Merrill Lynch in Manhattan. Dr. Sachs, who heads the Earth Institute at Columbia University, spoke about reducing greenhouse gas emissions, and I was impressed by his authoritative command of a subject that’s at least somewhat removed from his primary expertise in global development. But then, climate change could prove to be the ultimate global development issue, in terms of its potential impact and of the opportunities its solutions could create.

Dr. Sachs began by briefly reviewing the evidence for anthropogenic global warming and projections of its future progress. He made a strong case for the need to reduce humanity’s emissions of greenhouse gases--especially carbon dioxide--expeditiously, and for why that won’t happen without a serious and intentional global effort. The bulk of his remarks focused on the policy and technological tools required to stabilize atmospheric CO2 emissions between 450 and 560 parts per million (ppm), and preferably at the lower end of that range.

On the technology front, Professor Sachs expressed doubts that renewable energy and improved efficiency by themselves will deliver the energy sector emissions reductions that will be necessary in the next several decades. Based on his work with these countries, he sees the growth of China and India continuing to be fueled largely by coal, and for that reason regards carbon capture and sequestration (CCS) as “the indispensable technology” for achieving meaningful CO2 reductions from fossil fuels. When I expressed my concern, prompted by the recent MIT Future of Coal study, that the challenge of retrofitting CCS to existing power plants has been underestimated, he cited modeling work at the Earth Institute showing that even if applied only to new construction, CCS could reduce CO2 emissions from the power sector to very low levels by 2050, provided old plants were retired after 40 years.

The most interesting discussion, from my perspective, centered on the policy recipe for inducing sufficient emission reductions across the global economy. Dr. Sachs was optimistic about the prospect of achieving a follow-on agreement to the Kyoto Protocol among all of the large emitters, including China and the US, by 2009 or 2010. At the same time, he seemed quite skeptical about the practical aspects of a cap-and-trade mechanism, but stopped short of endorsing a simple carbon tax, because of the enormous financial transfers that would entail. He seemed to prefer a more flexible approach, tailored to each country’s situation and incorporating a mix of carbon pricing, mandates and performance standards for specific industries. (Something like that could be very compatible with the “stabilization wedge” approach proposed by Robert Socolow of Princeton.)

I thought the most reassuring element of the whole conversation wasn’t in the technical or policy details, but in Dr. Sachs’s conclusion that greenhouse gases can indeed be stabilized at a cost that won’t wreck the global economy, perhaps less than 1% of global GDP. When I hear that from climate scientists or politicians, I take it with a grain of salt. But coming from someone who has devoted his career to advancing the cause of economic growth and the extension of its benefits to the world’s poor, it gives me more confidence that taking action to retard climate change--in spite of the residual uncertainties--represents the right cost and risk trade-off.

Conflicting Signals - Revised

Several news stories caught my attention this week. They all relate to things I've covered at length in past blogs, and together they send conflicting signals about our energy future:

Item: In conjunction with the release of its annual statistical review for energy, BP has dismissed the prospect of an imminent peak in oil output due to production constraints. They see sufficient reserves to support another 40 years at current consumption levels. I'm not sure how that view maps into a variety of forecasts that show oil demand growing by 30-50% over the next 20 years. The difference between consuming 85 million barrels per day (MBD) for forty years versus growing to 120 MBD in twenty years and sustaining that level for another twenty is about 370 billion barrels, or roughly the current proved oil reserves of Saudi Arabia plus Iraq. (This corrects the math error in the earlier version of this posting; I don't believe it changes the point I was trying to make.)

Item: Chevron is reported to have deferred drilling on the giant Jack discovery in the Gulf of Mexico until next year, because there aren't enough deepwater rigs available. (Perhaps this is what Senator Kerry was referring to yesterday, when he said that the Congress didn't need to open up more of the Gulf for drilling, because oil companies weren't drilling the areas that were already open.) Jack made headlines last fall, because it pointed to the potential of up to 15 billion barrels of unexploited reserves in the deepwater Gulf, in the "lower Tertiary" layer. While Jack's reserves might still incrementally support the BP view that there's plenty of oil left, the question of practical importance is not how much oil is still in the ground, but whether and how quickly we can extract it. Turning reserves into production is not as simple as it used to be, with the necessary access, hardware, and personnel all in short supply.

Item: The Congress is debating increasing fuel economy standards either to 35 mpg for all light-duty vehicles or to 36 for passenger cars and 30 for SUVs, depending on which version of the legislation you're looking at. There are two main ways to achieve these higher averages, either by raising the fuel economy of most vehicles by 50%, or by concentrating on converting about 15% of the new car fleet to ultra-efficient technologies, such as 100 mpg plug-in hybrids (PHEVs.) (See below.)

Item: The timing of PHEVs was dealt a blow this week, when Toyota backed away from using lithium-ion batteries in its 2008 model Prius hybrid, apparently because of the "flaming laptop" problem. Li-ion batteries, which can be cycled many times without degrading and are much lighter than competing batteries, are widely regarded as essential to providing adequate range to make PHEVs practical at an acceptable penalty in bulk and weight. This is probably not insurmountable, but if PHEVs are delayed, then auto makers may be forced to start down the harder path of making all their new models much more efficient.

So while there may be plenty of oil left in the world, the pace of global economic growth and the nature of the accessible resources are stretching the industry's capacity to expand production fast enough to meet demand. And although the US is finally approaching consensus on the need to improve automobile efficiency, there is still no single off-the-shelf technology that will achieve it painlessly, without significant tradeoffs in vehicle cost, performance, and/or weight.

A Wave of Wind

A long train ride provided the opportunity to review the new report from the Department of Energy on the state of wind power in the US. For those who like numbers the ones in this document are fascinating. Significantly, they show that for the second year in a row, wind power capacity additions were second only to those for natural gas-fired turbines and ahead of coal, even when adjusted for “capacity factor”, the proportion of nameplate capacity actually utilized, on average. Furthermore, in at least a few states wind power is now contributing shares of total electricity sales that are comparable to the national shares from conventional sources such as hydropower and nuclear energy. At least regionally, wind is becoming mainstream, rather than niche.

The DOE report reflects the reality that practical wind power is not a national phenomenon, partly because of differences in state renewable energy policies, but also because wind resources are unevenly distributed. Twenty states account for almost 99% of all US wind power capacity, both incrementally for 2006 and cumulatively since the 1980s. Within that group, just six states account for 76% of 2006 additions and 72% of total capacity, with Texas, California, Minnesota and Washington making both lists.

In four relatively sparsely-populated states, New Mexico, Iowa, North Dakota, and Wyoming, wind made up over 5% of total electricity supply last year. That isn’t quite up to Danish levels of 21%, but it approaches the shares in Spain and Germany, the world leaders in installed wind capacity, and it greatly exceeds the US and global averages of just under 1% of total power from wind.

The data make it clear that consistent federal policy is the key to sustaining this kind of growth, and in particular avoiding the previous situation in which the Production Tax Credit for renewable power was at risk of expiring nearly every year, and periodically did. The Energy Policy Act of 2005 provided a two year extension of the PTC, and the Tax Relief and Health Care Act of 2006 tacked on an extra year, through the end of 2008. A permanent extension of the PTC, even one that included a gradual phaseout of the benefit, would put wind on an equal footing with conventional power and support the growth of domestic wind turbine manufacturing. The proliferation of state Renewable Portfolio Standards (RPSs) and the prospect of a national RPS from pending energy legislation are also helping to expand the market for wind.

The report provides some useful information on the structure of the US wind industry, which is dominated by independent power producers, including many small developers focused entirely on wind power, but which has recently seen significant consolidation and acquisitions by large, non-utility players such as oil companies and investment banks.

Some of the most interesting data concern the power price garnered by wind generators. Although this had been falling steadily throughout the decade, it appears to have turned up slightly last year. The DOE attributes this to rising turbine costs, but it must surely also reflect the higher price of the fuel for wind’s chief competitor, gas turbines, as well as the induced demand from state RPSs. However, we shouldn’t conclude from this uptick that wind is likely to be any less competitive in the future. That will depend on improvements in transmission capacity and load management, as well as the expansion of the turbine manufacturing base. It also begs the larger question of what should happen to the specific subsidies for wind under a national climate change policy that puts a price on carbon emissions from wind’s conventional competitors.

Cellulosic Spindletop

Thus far, much of the interest in cellulosic ethanol has focused on the development of enzymes to promote fermentation, rather than on the provision of the crop waste or non-food crops that would be converted into fuel. An article in Monday's San Francisco Chronicle focused on the activity at the "upstream" end of this future value chain. Even if the comparison to a "Spindletop" of cellulose is hyperbole at this point, it's intriguing to consider the risks that these developers are taking on, as they push to develop and plant new energy crops in advance of the full commercialization of the process they are intended to feed.

When I first ran across the research into methods of turning cellulose into ethanol a few years ago, the Department of Energy folks who were promoting it were targeting "corn stover", the waste from corn ethanol production, as their likely initial feedstock. That still probably makes sense, since this material will already have been harvested and collected in the course of producing the feed for current-generation ethanol plants. It's not hard to imagine first and second generation facilities operating side by side, until the cellulosic process becomes cheap enough to displace the grain-based version--if ever. However, others are looking beyond corn stover to switch grass and the miscanthus hybrid mentioned in the Chronicle. The allure of this tall, rapidly growing "superweed" is understandable, although those pioneering this energy crop will have to manage two key issues.

First, they must find alternative outlets for their production, in case of delays in making cellulosic ethanol processing fully operational. That probably means lining up biopower plants to consume their biomass. This sector, which involves firing or co-firing smallish thermal power plants with wood and other biomass, has been a modest success, despite receiving much less publicity than wind or solar power. The key hurdle involved would be proximity, given the economics of transporting low-density fuels long distances.

The other issue concerns real or perceived hazard to other crops. Even if the ultimate variety of miscanthus chosen for energy cropping doesn't involve genetic modification, there's a long history in this country of foreign plants that have gotten out of control or failed to work out as intended. In California brittle, messy Eucalyptus trees were introduced from Australia as wind breaks. I'm particularly attuned to this example, since one of these ill-considered trees dropped a 9-ton limb on our house when I was growing up. The southern experience of kudzu is probably even more relevant to miscanthus.

Whatever the ultimate feedstock limit on biofuel production, it's clear that that limit will be much higher if it is based on a wide variety of hardy, low-input energy crops, rather than on a few food crops. Once the cellulosic ethanol process has been fully demonstrated at an industrial scale and the cost of its enzymes falls sufficiently to make it competitive with corn ethanol, its ultimate success will depend on the availability of high-quality, low-cost biomass. Outside the corn belt, that will mean dedicated energy crops such as miscanthus and switchgrass, if their commercial risks can be managed successfully. Perhaps the players in the different segments of this nascent value chain should start considering vertical integration or alliances.