Market Psychology

It's an understatement to say that this is the strangest oil market that anyone could have imagined a few years ago. It is poised on the verge of the psychologically important, but otherwise essentially meaningless $100/barrel mark, and every retreat toward $90 is greeted with a sigh of relief--never mind that $90/barrel is an extraordinarily high price in the absence of a major supply disruption. And that's what worries me most about approaching $100 on the basis of perceptions of a tight supply/demand balance this winter and a bit of speculative momentum. In the event of a truly serious supply problem, the launch pad from which prices would rocket upward would be higher than at any point in history, after adjusting for inflation.

There are many different ways to look at the price of oil. Economists tend to see it as the level at which supply and demand are balanced, moment by moment, but that can't really be true, except in a "long run" that we never seem to reach. As a result of government price controls, fuel taxes, and the buffering effect of refining margins, few of the world's consumers are exposed directly to the price of oil. And even where they are, as in the US, fuel demand is affected more by the value we derive from its use, and by structural limitations of lifestyles that can't be altered quickly, if at all. That has been made abundantly clear over a four-year period in which the retail price of gasoline in the US has doubled.

Others look at patterns of global demand growth and shifts in production capabilities, particularly the flattening of non-OPEC output, and conclude that today's price has largely been set by OPEC, through a combination of its capacity decisions and the periodic revisions to its output quotas. The recent rhetoric coming out of OPEC can be interpreted either as an effort to shift blame for this, or the response of a group of producers who are honestly as surprised as anyone else by the current price level. Perhaps it's some of both. Delegates at the OPEC summit in Saudi Arabia are suggesting that prices could reach $150/barrel and apparently discussing whether an alternative mechanism for pricing oil is required. And while they seem to have conveniently forgotten that much of the path leading to this position was determined by their own investment and capacity decisions over the past decade, they aren't wrong to worry about what could happen in a real squeeze, if mere tightness has brought us this far. In his column in yesterday's Washington Post, Robert Samuelson provided as clear a description of these circumstances and their implications as I have seen in a long time.

Then there's the view that the price is built up from a combination of supply and demand fundamentals plus a consensus on geopolitical risks. This has more credibility, particularly for those who follow the market's day-by-day gyrations, many of which do not reflect any actual change in production and consumption, but are responding to the news-driven perceptions and expectations of various players. But even if part of today's price reflects the potential of a collapse in Iraqi output, conflict with Iran, or sabotage elsewhere, the actual manifestation of such an event would take us much higher.

Whichever theory best explains the current situation, though, the consequences of an unexpected event removing two million barrels per day from an already tightly balanced market look equally disastrous, and that's what ought to concern us most, since $95 West Texas Intermediate--yielding average crude oil acquisition prices between $85-90/barrel--hasn't brought the global economy to a halt. As a speaker at this fall's Herold Pacesetter Conference noted, the price increase that would be required to "crush demand" by a couple of million barrels per day would not be just a few dollars; it might be truly astronomical.

Smarter Ethanol

I've been writing about fuel ethanol since I started this blog in 2004, and I've been following it for just shy of 25 years. If there was ever a time for a critical reexamination of our national ethanol policy, it is now. Despite a broad array of federal and state agricultural and blending price supports, ethanol derived from grains is approaching a stall point, even as the Congress debates a nearly five-fold expansion of the federal Renewable Fuel Standard (RFS,) which mandates biofuel use in gasoline. At the same time, the means of producing ethanol from inedible plant material are on the verge of commercial-scale production. As questions about the sustainability of corn-based ethanol grow, it's becoming clear that we need a wiser ethanol strategy.

Ethanol production has grown enormously over the last five years. At the current production rate of around 6.6 billion gallons per year, cumulative production for 2007 should have eclipsed last year's 4.8 billion gallon record during the last two weeks. This impressive expansion has been driven by several key factors, including the phase-out of MTBE for oxygenate blending and the continued provision of the 51 cent-per-gallon blenders credit, along with an import barrier in the form of a 54 cent-per-gallon tariff.

While ethanol displaces some imported oil, most cars in the US cannot tolerate fuel blends containing more than 10% ethanol. Once it attains that share of total gasoline sales, ethanol will have reached a natural limit, at least until flexible fuel vehicles capable of burning 85% blends (E-85) become the norm, rather than a niche. That limit works out to around 14.5 billion gallons per year, after adjusting for ethanol's lower energy content, and it applies equally to ethanol derived from cellulose or corn. Note that this is much lower than the proposed 36 billion gallon RFS, which would require E-85 to capture about 13% of the gasoline market.

That means that new ethanol plants aren't being cancelled because the market is saturated, but because the economics of producing corn ethanol, even after the blenders' credit and tariff protection, are becoming marginal. High corn prices account for much of this, but high energy prices are contributing, as well, and this could get worse. The typical 6:1 ratio of oil price to gas price has increased to nearly 12:1 as crude marched past $90/bbl, and that can't last. If oil prices remain high, gas prices must eventually follow, as more gas is substituted for oil wherever possible. Because ethanol production is so energy-intensive, returning only 1.3 BTUs for every BTU invested, higher natural gas prices will make corn ethanol even more expensive to produce. Now factor in the long-term impact of the inevitable higher prices for water and the logistical challenges associated with getting larger volumes of ethanol to market. In this light, the proposed RFS, or at least the 15 billion gallons carved out for corn ethanol, looks unrealistic and unwise.

A quarter century of subsidies has not made ethanol from corn economically viable. Within a few years, corn ethanol will face new competition from ethanol derived from non-food plants and requiring significantly less energy, water, and other inputs in its production. These facts create a strong case for shifting the focus of the ethanol portion of US energy policy--and agricultural policy. Considering all the above factors, I believe a wiser ethanol policy would consist of the following:

1. Freezing the federal RFS at the current level of 7.5 billion gallons per year.


2. Phasing out all subsidies for ethanol derived from food sources within five years.


3. Phasing out the tariff on imported ethanol within two years.


4. Shifting the point of subsidy from the blender to the ethanol plant, to ensure that future subsidies go to US producers, rather than offshore.


5. Increasing the subsidy on cellulosic ethanol to $1.00/gallon until 2010, falling by 10 cents per gallon per year thereafter.

Such a program would focus federal incentives where they will do the most good, promoting the commercialization of cellulosic ethanol, which offers much larger energy and emissions-reduction benefits than corn ethanol and entails fewer concerns about sustainability. Since cellulosic ethanol is expected to be cheaper to produce, once it achieves economies of scale, it should not require permanent subsidies or tariff protection, as corn ethanol has. The result would be a very tough market for current ethanol producers, but it would ensure that the ethanol we use as an oil substitute is produced as efficiently as possible, without merely substituting LNG imports for oil imports. Whether or not something like this could ever be enacted by the US Congress, this is where the debate should focus, rather than on arguing about expanding an inefficient program by a factor of five.

SPR Temptations

Today's Wall Street Journal includes an op-ed advocating the sale of oil from the US Strategic Petroleum Reserve, based on a clever twist on the usual argument about the need to drive down global oil prices. Rather than worrying about the economic burden on low-income Americans, the author sees an opportunity for the federal government to earn an arbitrage profit on the SPR inventory, possibly creating an attractive way to plug the budget gap that will be created by reforming the Alternative Minimum Tax. The problem is not with the author's math, which seems generally correct, but with his assumptions about the nature of the futures market and how it would respond to such a scheme. Nor is his idea of depleting the SPR and ceding its function entirely to the market prudent, given the kind of world we in which we live. This is a classic half-baked idea: it contains the seeds of something interesting, but in its present form it would likely prove disastrous.

Mr. Henderson's idea depends on the shape of the "forward curve", the relationship between the futures market's price for oil delivered promptly, compared with the price for delivery in subsequent months. The market is currently in steep "backwardation," with yesterday's contract for delivery in December 2007 closing at a price $8.59/barrel higher than that for delivery one year later. Mr. Henderson looks at all that oil in the SPR and sees a chance to sell now and buy back later, earning the "front-to-back spread" on every barrel. If you look at the open interest and the daily volume in the Dec'08 contract, you might conclude that a million barrels per day (MBD) would disappear into that vast pool with scarcely a ripple. But with relatively few of those futures contracts ultimately resulting in a physical delivery, an extra MBD or two would change the entire market, not just via arbitrage, but by altering the expectations that set its current shape. In fact, a large portion of the arbitrage opportunity would probably disappear the moment the government announced its decision to sell SPR oil, and before the first SPR barrel was sold. The front-to-back spread would shrink quickly, and the total profit captured by the government might only be a few tens of millions of dollars.

The key to Mr. Henderson's strategy is how large a difference in supply or demand is necessary to flip the market from backwardation to "contango," in which oil for later delivery is worth more than prompt supply, and what would happen next. As the first SPR deliveries eased the current competition for prompt barrels, the market would more towards oversupply, and the basis of his whole proposition would be stood on its head. As long as the government continued to sell, the market would shift towards contango, and Mr. Henderson's front-to-back play would turn negative, with the Dec'08 repurchase costing more than the revenue from Dec'07 sales. The moment the SPR sale stopped, the market would revert to its former shape, though not quite as far, because participants would expect the government to intervene again.

The result of this scheme would be a game driven by expectations of future government intent, and that seems like a very undesirable sort of meddling in a complex market that underpins so much economic activity, globally. Nor is it clear that driving down the global price of oil by this means--the author's larger goal--would create more than a short-lived price holiday, during which demand growth here and in developing countries might accelerate. That would compress the gap between demand and actual global production capacity still further, rendering the market more volatile once the SPR ran out, and leaving us no way to replace the lost inventory without driving prices even higher.

I have long regarded the SPR as an outmoded holdover from a highly-regulated era. Its existence deters companies from holding larger inventories, and it offers minimal protection west of the Rocky Mountains. But simply abolishing the SPR without providing a practical alternative would be irresponsible, given the geopolitical risks we face; an unregulated market won't perform this function without a mandate or carefully-targeted incentives. The goal of any prudent proposal to privatize these stocks must be to position them closer to where they would be needed in an emergency, and to put them in more responsive, market-savvy hands, rather than using them all up in an unsustainable binge.

Brave New World

While lobbyists and other Congress-watchers await the reconciliation of the conflicting energy bills passed earlier this year in the US House and Senate, a piece of legislation with the prosaic title of "America's Climate Security Act" (S.2191) has begun the long process of committee review and revision. If passed by both houses in its present form--an unlikely proposition--it would trump many of the hotly-debated energy bill provisions, such as the renewable electricity standard, biofuels mandates, and higher fuel economy. The greenhouse gas "cap and trade" restrictions of "Lieberman-Warner", as the bill is also known, would mandate reducing US emissions by roughly 70% from current levels by mid-century. On a scale well beyond that of the cap-and-trade system introduced by the EU in pursuit of its commitments under the Kyoto Protocol, Lieberman-Warner would reorganize large segments of the US economy, along with those of some countries with which we trade. We stand at the threshold of a new world.

I don't have space here to provide a line by line analysis of the bill. If you're interested, the full text is available at http://www.thomas.gov/, entering S.2191 in the search box. (I apologize for many past broken links to thomas.gov, before I discovered that it doesn't retain search criteria.) For now, I'll cover the bill's key provisions and expand on them in later postings, as appropriate.

Since critics of emissions trading frequently cite the shortcomings of the EU Emissions Trading Scheme (ETS), it's important to state up front that Lieberman-Warner diverges from the former in scope, intent, and execution, sharing little more than the basic notion of a cap on covered emissions and the issuance of tradable allowances to enable those facing high costs of reduction to benefit from cheaper excess reductions by others. Most significantly, unlike the EU's focus on large industries and utilities, this bill covers the majority of US greenhouse gas emissions, whether from stationary sources or motor vehicles. The ETS also relied heavily on "grandfathering," furnishing free allowances for most of a firm's current emissions. That created a windfall for some companies and undermined the after-market for these permits, which has been highly volatile.

Lieberman-Warner limits grandfathering to 20% of emissions and then gradually phases it out entirely. In particular, oil companies would receive no free allowances, from day one. (More on this in a moment.) Instead, most allowances would be auctioned, with the proceeds allocated to fund a variety of activities, including alternative energy, carbon sequestration, and low-income energy cost relief. These benefits would be augmented by handing out some of the allowances themselves to states and a variety of other organizations. While this would ensure broad participation in the emissions market, it also appears vulnerable to criticisms of patronage.

One of the key arguments against US participation in efforts to reduce GHG emissions has been that it would result in the offshoring of our emitting industries, with Americans simply importing products and effectively exporting the associated emissions. Lieberman-Warner tackles this directly by requiring importers to purchase allowances for the intrinsic emissions of most products--effectively a GHG-equalizing tariff. We would presumably discover later whether that is permissible under the WTO.

So what would this mean for energy consumers? By requiring producers of fuel and electricity to obtain allowances or offsets for their direct emissions and for the downstream emissions of their products, and by severely limiting grandfathered emissions--to zero for petroleum products--it would drive up the price of fuel and electricity, as surely as if the price of oil, gas or coal had gone up. In other words, because Lieberman-Warner covers petroleum products at the wholesale, rather than retail level, it spares consumers the need to get involved in emissions trading, but does not spare them from the financial consequences. Now, an economist would point out that market conditions will determine whether 100% of the cost of allowances would be passed on, or something less. I think it's prudent, given the tightness of these markets today, to assume 100%. If an emissions allowance costs $10/ton of CO20-equivalent, then we should expect gasoline prices to rise by 10 cents per gallon, and coal-fired electricity by about 1 cent per kWh (less, initially, due to 20% grandfathering.)

This isn't the first such bill to be introduced in the Congress, and its prospects are uncertain. Lieberman-Warner is a bit more aggressive than the antecedent "Lieberman-McCain" (S.280), while somewhat less so--and decidedly more market-friendly--than "Sanders-Boxer" (S.309.) None of the previous cap-and-trade bills passed, but then none enjoyed centrist, bi-partisan support going into an election year in which climate change could emerge as a major campaign issue. For planning purposes, anyone potentially affected by this legislation--and that is effectively everyone except small businesses--ought to assume that something similar will be enacted within the next 2-3 years. And if a Democrat or Senator McCain wins the Presidency next year, it would stand a good chance of being signed into law. In the meantime, we can choose between taking voluntarily steps in this direction, or enjoying the final years of the no-cost emissions era.

An Elephant in Perspective

Enthusiasm about Brazil's new giant oilfield, Tupi, has sharply boosted the stock price of Petrobras, which owns 65% of the offshore block in which the field is located. If the estimates of its total reserves prove accurate, in the range of 5-8 billion barrels of oil equivalent, then it would be one of the largest finds in recent years. While this one discovery might not change our perspective on the long-term capability of global oil supplies to keep up with demand, or our proximity to a peak in global production, it has all sorts of interesting implications. As such, it probably deserves even wider coverage than it is getting.

Using the skewed math of the industry's critics, Tupi's reserves amount to only a three-month supply of oil for a world that consumes 85 million barrels per day. A drop in the bucket, right? But of course the world's supply of oil is made up of the output of thousands of oilfields, most much smaller than Tupi and only a relative handful larger. And it's those few, large fields, which can sustain a high output for decades, that are the bedrock upon which our entire oil edifice rests. Tupi's prospective reserves would put it in that top league and, together with possible extensions and adjacent fields, make Brazil a much bigger factor in oil markets. It also raises questions about how many more such "elephants" are waiting to be discovered, as technology extends our reach into ever deeper waters offshore.

As things stand now, Brazil is a modest net importer of oil, on the order of 200,000 barrels per day (bpd,) but with a steadily rising production profile. Even without Tupi, it has another million bpd of new production coming onstream in the next several years. That should vault it past Venezuela's stagnating output and make Brazil the largest oil producer in South America and a key oil exporter. Add Tupi into the mix, and Brazil begins to look like the next Norway, or at least another Mexico: an important new factor in non-OPEC supply.

Guessing at Tupi's ultimate production is beyond my technical skills. Alaska's Prudhoe Bay and associated smaller fields, which contained about twice as much oil, peaked at 2 million bpd and produced over one million for 19 straight years. Well into decline, it still accounts for more than 10% of US oil production. Viewed in that light, one oil field--it it's big enough--can affect the fortunes of an entire country. Together with Brazil's potential to become a much bigger exporter of ethanol from sugar cane, the country's net contribution to global liquid fuels markets over the next decade or two might be on a par with that of Canada's oil sands, with a corresponding influence on world oil prices.

A Muted Response

Yesterday afternoon I was interviewed by a reporter researching a story on why the response to high oil prices hasn't been more pronounced, especially on Capitol Hill. To the degree that Congress reacts when consumers complain, however, the current muted response is understandable. While the crude oil price has risen by 29% since Labor Day, the average pump price of unleaded regular has only gone up by 8%, so far. Nor is $3.00/gallon startling, any more, no matter how much it stretches the average person's budget. That kind of price fatigue is unlikely to last, though, if refining margins recover sufficiently to push gasoline to $3.50.

There are many reasons why the current oil price shouldn't be as worrying as the price spikes of the 1970s, and you've heard most of them before. The US uses only half as much energy per dollar of real GDP as it did then, and oil's share of those BTUs is 10% lower, today. At the same time, as I pointed out to the reporter, the price of crude oil is a pretty abstract concept to most people, compared to the price of gasoline or heating oil. I don't know how many other folks have actually bought or sold a barrel of petroleum, but I would guess it's fewer than 1 in 1,000, even counting those who receive royalty payments on their mineral rights.

Contrast that with gasoline. When we fill up at the self-service pump, we can hear it and smell it going into our cars, and most of us experience this at least once a week. How many times a day do Americans see a gas price on a pole-sign? I'd bet more people know the price of a gallon of gasoline than know the price of a loaf of bread. It doesn't get more concrete than that. So when the average retail gasoline price broke $3.00/gallon for the first time after Hurricane Katrina, the public's shock and outrage were palpable, and political consequences followed promptly. And when it breached $3 last summer and again this spring, it was hard for many people to understand, because it was being driven more by tight refining capacity than rising oil prices. With oil company profits soaring on higher refining margins, that didn't seem fair, even if it was a natural consequence of supply and demand.

The current situation is different. This spring, when gasoline peaked at $3.22/gallon, crude oil accounted for less than half of its cost; today, that ratio is over 70%. Oil company profits are being squeezed, as a larger share of the higher oil revenue is going to producers in Venezuela, West Africa and Russia. These shifts may not evoke much sympathy for Big Oil, but they undermine claims that the companies are gouging consumers.

The public's apathy about high oil prices can't last. If oil remains above $90 for very long, sooner or later gasoline prices will spike higher, as heating oil prices are starting to do now. It could happen because demand strengthens, or after some accident or other event shuts down a key refinery or pipeline. Then gasoline will push toward the next major price threshold, the complaints will sharpen, and a torrent of angry emails to Congress will follow, with unpredictable consequences in an election year.

Don't Panic

A few weeks ago we were facing the prospect of $100 oil by Christmas. Now it appears we might get there this week. As we wrestle with appropriate responses, it's important to remember that we didn't get into this pickle overnight. It has been coming on since at least 2003, when oil prices began the steady climb that has brought them to this level. On a deeper level, however, we've been headed for this juncture since 1991, the last year in which US oil production increased and our imports of crude oil and petroleum products fell. And just as it took more than a decade to reach this point, it's going to take longer to work our way out of it than anyone might wish.

The graph below shows how US demand for liquid fuels has been met, going back to 1975. The steady decline of US oil production since the mid-1980s is clearly visible, as is the steady rise in demand and the resulting growth of imports, which increased in every year from 1992 to 2005, dipping slightly in 2006--though not because of any drop in the demand for refined products.

Data from US Department of Energy, Energy Information Agency website

The thin yellow slice between oil production and imports reflects the impact of biofuels on an energy-equivalent basis. It's mostly ethanol, and even at last year's record production of 4.86 billion gallons, it barely registers at this scale. Expanding the current ethanol mandate from 7.5 billion gallons per year in 2012 to 36 billion gallons, as the President and the Senate have proposed, would reduce our oil imports--at the expense of higher imports of natural gas--but won't close the enormous gap we've created over the last 15 years. Nor is it clear how much further corn ethanol output can expand in the near term, or when next-generation cellulosic ethanol will be available at a competitive cost.

I'm not suggesting this is purely a US problem. Oil trades in a global market, and the rapid economic expansion in Asia has been a big contributor to global demand growth. However, we are still by far the world's largest oil importer, taking more than Japan, China and Germany combined. Trends here have a disproportionate effect on the whole market, not least through the influence of US oil futures on the price of physical oil.

If we look at the next few years, the only strategy that could make a meaningful dent in the problem is conservation, and in that timeframe it wouldn't come from improvements in fuel efficiency, but from changes in our daily consumption patterns. And that's why this problem appears so intractable. The short-term elasticity, or price response, of petroleum products isn't just low because of structural limitations around commuting to work and taking the kids to their activities, but because even at $3.00/gallon the economic benefits we derive from motor fuels far exceed their cost. The trick will be finding ways to bring down petroleum consumption without destroying the economic value its use has created. Achieving that is going to require more efficient cars and more effective biofuels than what we have today, and neither of these will arrive in time to affect the price of oil in 2007 or 2008.

Fuel Cell Test Drive - Part II

In a posting at the start of this year, I described the competition among various advanced technology vehicle options as a race that still had many laps to go. Moreover, it's a race in which the finish line keeps moving, as the technology of conventional cars improves--nudged along by a stricter CAFE standard, or by consumers placing a higher priority on fuel economy and emissions. Yesterday I described my experience test driving a hydrogen-powered Chevrolet. The Equinox Fuel Cell affirms that it's possible to build a fuel cell vehicle (FCV) that consumers might want to buy, although its future retail price remains highly speculative. Today I want to tackle the larger and more complex question of whether anyone should build such a car.

As I mentioned yesterday, the GM team that came to Washington to brief the media on the Chevrolet Equinox Fuel Cell didn't just bring a half-dozen or so of the cars; they also brought detailed presentations on their advanced vehicle strategy and the experts to answer our questions. They painted a picture of the progressive electrification of personal mobility, ranging from the kind of hybrid systems featured in some of their new SUVs to cars that are powered entirely by electricity, generated either onboard or externally: by a fuel cell, as on the Equinox FC, or by an internal combustion engine and the electric grid, as in the much-anticipated Chevrolet Volt plug-in hybrid (PHEV) car. That view of electric drive as the next big step in transportation is consistent with what I saw in Texaco's long-term scenarios, going back a decade.

Good strategy isn't just about having a sound and compelling vision; you must be able to implement it. As I discussed last month, the implementation of a successful fuel cell car must overcome a number of parallel obstacles dealing with hydrogen generation, storage and distribution, while also driving the cost of both the vehicle and its fuel down to a level at which the system becomes competitive with other options, or the status quo. GM's plans cover all of these bases, though I wonder whether they can achieve the simultaneous convergence of all of the factors necessary to go from a 100-car demo to full production. Let's look at the elements:

• Production - GM anticipates capitalizing on spare hydrogen production capacity from existing industrial operations--refineries, fertilizer plants, industrial gas facilities--to supply the H2 for the first large increment of fuel cell cars. That means relying on H2 made mostly from natural gas, at least initially, with its associated costs and emissions. In this regard, the "zero emissions/zero petroleum" label on the Equinox I drove only accounted for the vehicle's inputs and outputs, not a "well-to-wheels" lifecycle energy and emissions profile. While GM's figures on total US hydrogen production looked accurate, all of that output is currently spoken for, making cleaner gasoline, ultra-low-sulfur diesel, and other products. GM and its partners are apparently still working on an estimate of how much incremental H2 might be available from these sources. The energy and environmental benefits are likely to vary regionally and locally, depending on the source of H2, though all should be an improvement over the internal combustion engine (ICE).
  
• Storage - The Equinox Fuel Cell has three high-pressure H2 tanks. H2 at 10,000 psi is dense enough to give the car a 150-mile range, and it is manageable enough to allow the car to be refueled in 5-7 minutes, a bit longer than your typical gasoline fill-up, but far quicker than recharging any existing electric vehicle. Compressed H2 entails some trade-offs, however. While not subject to the venting concerns and boil-off losses that have plagued liquid H2--BMW's chosen mode--it is still not dense enough to provide as much range as gasoline, even after the 2X efficiency improvement from the fuel cell. And while the tanks are carbon-fiber-wrapped and the safety systems include sensors that close all the H2 valves in a collision, I will never be thrilled with a storage system that bottles up that much mechanical energy, even if it were compressed air, rather than H2. In the long run, metal hydrides or carbon nanotubes may provide a welcome upgrade, but I can appreciate that compressed H2 is what was doable now.
  
• Distribution - GM has mapped out how many refueling facilities would be necessary in each of their target markets. For example, in L.A. they foresee 30 local stations, supplemented by another 10 along the routes to Santa Barbara, Palm Springs, etc., handling up to 40,000 FCVs. The logistics of that seem a little snug to me, but that aspect has presumably been vetted by GM's fuel partners, including Shell. The economics of the required investment, cited at up to $3 million/station, look daunting, however. Absent government subsidies, the margin on retail H2 would have to be commensurately high, approaching $2/kg, to ensure positive returns on these facilities. Will GM's fuel partners have the stamina to put down in excess of $100 million against what could easily prove to be a negative NPV? But how many cars can GM sell, without pre-positioning enough stations to refuel them conveniently?

Many experts have written off hydrogen as a bad idea. As I mentioned in last Thursday's webinar (here, in case you missed it) I believe that view ignores the substantial well-to-wheels efficiency and emissions benefits that hydrogen fuel cells offer, and which the GM team highlighted in their presentation. It also presumes that we already know what will induce consumers to trade in their reliable-but-inefficient conventional cars. I give GM a lot of credit for getting the FCV to the point at which they can put it in the hands of real consumers, as Toyota is currently doing with a similar demonstration fleet of Priuses modified into plug-ins. Such market tests are essential to establish the viability of these concepts, though in neither case is consumer acceptance the only hurdle on the path to commercial viability. Manufacturers must still cut the cost of these cars to a level justified by their energy and emissions savings, and complex infrastructure issues--technical and economic--must be solved. For now, the race proceeds, but the finish line remains distant.

Fuel Cell Test Drive - Part I

Last Friday, along with several members of the press and a few other bloggers, I had an opportunity to drive GM's latest hydrogen vehicle, the Chevrolet Equinox Fuel Cell. This took place as part of GM's Project Driveway rollout, which will put 100 fuel cell cars in the hands of selected consumers (apply here.) The session in D.C. included an extensive briefing by GM's fuel cell team on the corporation's advanced technology vehicle strategy, the safety and design aspects of the Equinox FC, and its associated hydrogen refueling infrastructure. I couldn't possibly do justice to all this in a single posting, so today I'll focus on the fun part--driving a fuel cell car--and return to the larger strategic and policy implications tomorrow.

(Photos courtesy of GM.)

Even though I've been following the development of advanced technology vehicles pretty closely for ten years, as part of my broader focus on alternative energy and its environmental implications, I must admit that I was surprised at how normal the Equinox FC seemed. Nothing about it suggests a limited-production prototype. In appearance, trim and handling it looks and feels like a real car, rather than a test-bed for a highly efficient but very costly new propulsion system. Other than the animated fuel cell schematic on the dash and a power output gauge where you'd expect to find a tachometer--and the absence of a tailpipe--you'd be forgiven for not noticing that it isn't just another well-appointed example of the car-based SUVs that have become increasingly popular in the last few years.

How did it drive? Well, anyone who has never driven an electric car or a hybrid--which the Equinox FC is, too--might think that the equivalent 125 horsepower of the Equinox's 93 kW fuel cell stack wouldn't be adequate to deliver acceptable acceleration. After experiencing the EV-1 a decade ago, I knew to expect the electric motor's kick, with its instant torque. The car performed well on our loop around downtown Washington, DC, including a short hop onto I-395 towards Crystal City. It wasn't as eerily quiet as the EV-1; between the air compressor and H2 injectors, I might have guessed the car was powered by a big, refined V-6.

Naturally, there were a few other reminders that this wasn't a regular car. Because the Equinox FC employs regenerative braking, like other hybrids its brakes feel a bit stiff and unresponsive. Hybrid owners tell me they get used to this very quickly. Even when compressed at 10,000 psi, H2 takes up more room than its equivalent in gasoline or diesel. The hump in the cargo area behind the back seat--which would certainly complicate loading the car up for a family trip--isn't the only reminder of this fact. Even at an effective 43 miles per gallon, the maximum H2 capacity of 4.2 kg on board is only enough for about 150 miles, and H2 refueling stations are as rare as hen's teeth. (More on that subject tomorrow.)

I don't test drive cars very often, and the Equinox--fuel cell or otherwise--is quite different from my normal ride. I've never owned an SUV or mini-van, and the standard Equinox and its competitors weren't on my short list the last time I went car-shopping. So while my test drive didn't impart a desperate urge to own an Equinox FC, that's more of a knock on a car class that doesn't hold much appeal for me, than on this particular vehicle. At the same time, I think GM made a wise choice of the Equinox as a fuel cell platform, leveraging the standard model's 5-star crash rating to allay some of the safety concerns that hydrogen still raises, and put this technology in a package that most Americans would find similar enough to the cars they own to make them immediately comfortable.

So, on balance, count me as favorably impressed with the Equinox Fuel Cell. What's under the hood may be rocket science, but the car itself isn't. While that might disappoint some of us alternative energy "gear-heads", it's a useful reminder that no advanced technology vehicle will ever become a mass-market success, unless it incorporates the best marketing--as well as engineering--thinking. Tomorrow's posting will look at the energy and environmental implications of mass-producing a fuel cell vehicle such as this one.

Expecting Uncharacteristic Patience

The politics of climate change are awful. I'm not referring to the domestic or international politics surrounding the Kyoto Protocol, but to the inherent problem of responding to a complex global phenomenon that spans many election cycles, with a long, indirect feedback loop. Even if there were no remaining controversy over the contribution of anthropogenic greenhouse gas emissions, altering the warming trend will involve deep and permanent cuts in our emissions, with no guarantee of how soon we would see any change in the indicators that worry us. That is a risky proposition for any elected leader to espouse. It relies on an uncharacteristic degree of patience on the part of the electorate. Considering the long-term implications of this problem, we might need some alternative strategies for combating climate change that wouldn't take a decade to implement and another to produce noticeable results.

A necessary component of scenario planning is following implications to their logical conclusions, no matter how controversial. With regard to climate change, we are all now scenario planners. On that basis, climate intervention along the lines contemplated in a recent New York Times op-ed by a Carnegie Institution scientist, begins to look like a nearly inevitable outcome of the current trends and the political framework for addressing them. That doesn't mean we can ignore our growing emissions or wait for technology to transform them painlessly. There's a strong case for working hard to make the problem more manageable, rather than letting it grow out of control until we can put mirrors in orbit or simulate the heat-reflecting effects of a volcanic eruption. As Dr. Caldeira suggests, we will need a reasonable allocation of effort, with the emphasis on reducing emissions.

Reducing emissions rapidly enough to avoid the need for direct climate intervention is going to be hard. Consider the California wildfires that dislocated hundreds of thousands of residents and captured national attention last week. Few reports missed the opportunity to highlight the possible role of climate change in stimulating or amplifying the fires. At the same time, however, the controllable factors contributing to the damage are very clear, particularly to this former Los Angeleno. In the last 20 years, exurban development has encroached much farther into terrain that has always been prone to such fires. In fact, the life-cycle of the indigenous vegetation, the chaparral, has been shaped over millennia by periodic fires. If we can't overcome the obstacles impeding appropriate zoning, building standards and insurance practices to minimize our exposure by limiting development in such areas, how readily will we undertake the costly conversion to a low-emissions energy economy to enjoy the deferred rewards of a more benevolent future climate?

It's hard to turn on the TV or open a newspaper without being confronted with the evidence of an impending global climate crisis. By its nature, climate change is going to be unevenly distributed and mainly discernible from underlying random climate variation by statistical means that lack intuitive appeal. It is in the nature and market dynamics of the media, however, to select the most extreme and telegenic evidence, reinforcing our impression of accelerating climate change--noticeable from year to year, rather than just from decade to decade. In the process, this may inadvertently create a parallel expectation for a quickly discernible impact from any response we undertake. As a friend recently observed to me, we have been conditioned to seek solutions on the timescale of a "CSI" episode. Given the inertia of the systems involved, both natural and industrial, that expectation is likely to result in disappointment, which could either foster cynicism or spur calls for more extreme action.

That's why I think that if the current climate trends persist as we expect, there will be increasing pressure on governments to intervene in the climate directly, at the same time they attempt to remodel the ways in which our civilization produces and consumes energy and makes all those other products we need or crave. Unless we're lucky enough to see the implementation of emissions cuts coincide with a random dip in the temperature trend, our patience will only last so long, particularly if we experience more extreme fires, droughts and hurricanes in the interim.

Replacing Human Reserves

If I had a quarter for every time someone at my former company said, "People are our most important resource," I could retire now. And when confronted with the unsavory nature of many of the governments with which oil companies must routinely deal, how many of us have replied, "You have to go where the resources are"? An article in Monday's Wall Street Journal section on the environment describes the human resource challenges of the oil industry in a way that puts those two clichés into an entirely different context, in terms of how potential employees view the future prospects for alternative energy and a transition away from oil. This issue ought to prompt oil companies that have resisted investments in renewables and other new energy technologies to rethink their "cleantech" strategy.

Oil and gas companies are enjoying a run of extraordinary profitability. The mounting attacks from the Congress on "windfall profits" are as good an indication as any that these are truly boom times for oil firms. But many of these same companies contain within them a sort of demographic I.E.D., as the big bulge of employees in their 40s and 50s moves ever closer to retirement. Replacing those reserves might be even more important than replacing the hydrocarbon reserves they consume annually, if these companies are to continue serving the energy needs of their customers, and the financial needs of their shareholders. As the Journal describes, the ability to hire enough first-class talent to tackle the technological, environmental and economic challenges ahead may depend less on corporate salary and benefit policies than on the public's perception of the business in which these companies engage.

In the late 1990s, my former employer, Texaco, rolled out a new advertising campaign called, "A World of Energy." It was built on the premise that we were transforming from an oil company into a broader "energy company." BP has endeavored to convey the same message in its "Beyond Petroleum" rebranding. Such efforts have been criticized as being either cynical or entirely aspirational, rather than reflecting a serious portfolio realignment. I've seen BP advertising touting their revenues from non-traditional energy, but noted that they include natural gas--generally not regarded as a form of alternative energy--to make the numbers sufficiently impressive. However, they might doing this for reasons having little to do with boosting sales or the current bottom line.

Now, you could view the efforts of companies like BP, Shell, Chevron and ConocoPhillips to branch out into wind, solar and biofuels as the early stages of diversification into the types of energy that must someday replace oil & gas, or you may regard these steps as having a large PR component. Both views are probably correct, today. But I would argue that these companies are also beginning to react to the feedback from their college recruiting efforts. Several former colleagues that still do this have told me that new engineering graduates mainly want to hear what the company is doing in renewables or new energy technology, rather than deepwater drilling or enhanced recovery. The thinner the new energy story, the less likely you are to attract the top graduates.

One of the largest oil companies in the world, ExxonMobil, has stated that it won't invest in alternative energy project until it is profitable to do so. If you're the biggest and most profitable publicly-traded firm in the sector, you can probably follow that strategy without drying up your sources of new technical talent, or having your experienced scientists and engineers lured away by cleantech startups. Or perhaps Exxon's partnership with Stanford University sends the necessary signal to new graduates interested in cleantech, but desiring the stability and benefits that Exxon can offer. While these attributes may carry Exxon through this looming HR challenge, there's no other company in the industry that can be assured of winning the same bet. Rapidly growing renewable energy companies could alter the market for the industry's human resources faster and more profoundly than they affect the market for its products. That's an implication that many of these firms haven't anticipated.


Don't forget today's webinar on "Fuels for Now and the Future", hosted by Cleantech Collective. For more information and to register for the webcast, which is scheduled for 2:00 PM EDT, please follow this link.

Blaming OPEC

Lately, it seems that everyone has an opinion on why oil prices have reached the threshold of $100/barrel, including several of the candidates in last night's Democratic Presidential Debate. This morning's Wall Street Journal offers some theories from an interesting source, two ministers of an organization that features prominently in many analysts' explanations of the current market tightness: OPEC. Apparently, OPEC's members are vexed at being blamed for high oil prices, which they attribute to three factors: the weak dollar, market speculation, and refining bottlenecks. Considering the source, it's worth spending a few minutes examining these arguments to see whether they have merit.

Let's start with the easiest to dismiss, the refining sector. You don't even have to think through the logic of this argument, which inverts the usual understanding of how temporary shortages in refining capacity normally exert downward pressure on the prices of specific grades of crude oil, as volumes are backed out of the system and crude inventory grows. All that's necessary is a look at refining margins, which measure the difference between the revenue refiners receive for the products they sell and the cost of their raw material. These margins are dramatically lower than they were in the spring and early summer, when crude oil was trading in the mid-to-low $60s. This tells a clear story. Refining capacity--in the US, at least--is not tight, and this factor has not contributed to oil's $15 sprint in the last four months.

Next consider speculation. I don't think this can be dismissed quite so easily, at least as a general contributor to oil prices over the last four years. As I've noted before, the growth in demand for oil futures and options within the broader financial portfolios of hedge funds and other investors must put upward pressure on futures prices, and thus on the enormous volumes of physical oil that are sold at prices pegged to the futures. Still, there's some evidence that the speculative flow has reversed in the last few months, as the ripples from the sub-prime crisis have dried up credit and forced some firms to liquidate positions. In other words, it's much easier to see how speculation contributed to oil's rise from $40 to $70 than from $70 to $90.

That brings us to the dollar, and as the recipients of roughly $2.8 billion dollars per day at current prices, OPEC ought to know as much about that subject as anyone. A chart of oil prices for the last two years expressed in both dollars and Euros reflects remarkable differences, but doesn't quite tell the story that the OPEC ministers might wish.



Between June 1 and October 18 the dollar price of oil on the New York Mercantile Exchange increased by 37%, while in the same period, the price in Euros had risen by almost 30%. There is clearly a lot more at work here than the weakness of the dollar, at least over the last four months.

So while each of these factors has contributed to the escalation of oil prices since 2003, they don't explain why we suddenly find ourselves staring at the prospect of $100/barrel by Christmas. Instead, I think we have to examine the long-term fundamental trends of the industry, which are currently colliding. Demand continues to grow, driven by strong global economic growth, including many places where consumers are insulated from the true market price of petroleum products. Non-OPEC production can't keep up with this growth, because of the combination of production decline rates, drilling bans, and the lagged effects of the near collapse of the industry in the late 1990s. And that's where OPEC comes into the story.

As the world's main oil exporters and the holders of 69% of global proved oil reserves, at the latest count, OPEC has not planned properly for the growth of their long-term market. This isn't a question of the dwindling increments of existing capacity they are holding back by mutual agreement, but of their failure to reinvest in their core business and expand capacity ahead of demand. There are many reasons for this, including domestic financial pressures in many member countries, the impact of sanctions on Iran, and the war in Iraq. They have generally kept out the international companies that possess the motivation, capital and capability to develop OPEC's unexploited reserves, while failing to do the job themselves--with a few notable exceptions, such as the current expansion program in Saudi Arabia.

Whether this underinvestment in new capacity is due to resource nationalism, the inefficiency of state oil companies, or a deliberate effort to keep the market tight, OPEC must bear at least half the responsibility for $90+ oil. The other half, as one of the candidates implied last night, lies with US consumers (along with their counterparts in China and elsewhere) who have increased our demand steadily, with little thought of where the next gallon was coming from. Unless we do something to alter that trend, OPEC will continue to win and we will continue to lose from this ongoing collision.

Planting Green Seeds

Finding ways to help China become more energy efficient and reduce its pollution and greenhouse gas emissions is one of the top energy and environmental priorities in the world. It represents the ultimate win-win opportunity. Success on both fronts would reduce the impact of China's growth on global energy markets and on atmospheric CO2, while improving China's economy and its air quality. GM has just announced a significant step in this direction, with the establishment of a new R&D center near Shanghai, as part of a $250 million investment in the country. The potential Chinese market for hybrid and electric cars and alternative fuels is enormous, though it is not clear whether this will improve GM's profitability in China, rather than merely solidifying their position there.

Shifting China's growing personal transportation sector onto a more sustainable basis as rapidly as possible would benefit everyone. If the technologies involved in the new GM R&D center could be introduced quickly enough, China could end up with one of the world's most efficient vehicle fleets, capitalizing on conditions that form the counterpoint of our situation. Instead of being handicapped by the inertia of an installed base of 250 million vehicles, China is at a sufficiently early stage of growth that its first 100 million cars could still be dominated by hybrids and other advanced technologies. In the process, experience curve effects would flow back to developed countries, reducing the manufacturing costs and improving the reliability of all such cars, everywhere. But as fast as China's car output is growing, this window will begin to close within a few years.

The resulting energy savings from such a shift, relative to the status quo alternative, could amount to several billion barrels of oil over the next 20 years, or a daily volume comparable to the entire US ethanol program in 2007. It would also reduce China's CO2 emissions by at least 1%, or much more if the outcome of this effort were something novel, such as a cheap, bare-bones electric car designed to appeal to the entry-level buyer who currently rides a bicycle.

Pundits such as Tom Friedman of the New York Times have been pointing to the challenge of greening China as a great opportunity for which US industry is well equipped and from which it could benefit enormously. While I see the same opportunity, I'm less convinced of the prospect of translating those benefits to the bottom lines of US companies. "Cleantech" is certainly the new darling of venture capital and other investors--as noted in the Wall Street Journal's special section on Monday--but if it follows a path similar to "high tech", it could turn out that the profits accrue more to the implementation than to the owners of the technology itself: to the equivalent of cellphone service providers, rather than handset makers. Why would cleantech not end up every bit as competitive globally as PCs and other devices have become?

Local factors will come into play, as well. In China you are only as good as your partner. GM has fared well in this regard so far, but there is no guarantee that Shanghai Automotive Industry Corp. or Liuzhoue Wuling Motors Ltd. won't emerge in a decade as major global competitors, armed with GM's latest technology. Depending on GM's fortunes elsewhere, it's not beyond the pale that GM's car business could ultimately go the way of IBM's PC business, which was bought out by its partner, Lenovo.

Improving China's automotive technology will have all sorts of consequences, some self-evidently positive, others less so; some foreseeable, others either unintended or entirely unknown. Despite all that, GM looks wise to steal a march on its competitors in this regard, because the alternative is not just leaving things as they are. The world can't accommodate a half-billion Chinese driving conventional SUVs, and GM's global competitors can't be more than a quarter-step behind them in pouring their best resources into the world's fastest-growing large market for cars.

Renewable Reality Check

Last week's issue of Business Week included a fascinating article documenting the frustrations of a manager charged with implementing green energy and sustainability strategies within his company. It also includes a scathing critique of the efficacy of Renewable Energy Credits (RECs,) a form of emissions offsets. Anyone thinking that "going green" will be simple and quickly profitable, even after the low-hanging fruit of highly-attractive projects is exhausted, ought to read this article. But they would also be wrong to conclude that emissions offsets do nothing to benefit the environment, because they allow companies purchasing them to continue to emit and pollute. In fact, it is precisely because of the way they shift the burden of those reductions that RECs help to maximize our response to climate change and local pollution, while minimizing its cost.

RECs are not quite the same thing as the greenhouse gas emissions credits officially traded in countries that have ratified the Kyoto Treaty, or on a voluntary basis here. RECs are specific to electricity produced from new renewable sources--wind, solar, small hydro, etc.--and as with many other derivative instruments, they represent the separation and repackaging of an attribute of a project's operations, risks, or cash flows: in this case the "renewable attribute." The key to this practice is that once a REC has been separated from the Megawatt-hour of renewable electricity that gave rise to it and then sold, the underlying power can no longer be sold as "green." In other words, while its REC can be traded or re-sold, the renewable attribute of a given MWh can't be counted more than once.

What seems to worry Mr. Schendler, the ski-resort sustainability manager in the article, is that the current price of a REC is too low to encourage the construction of more renewable power projects. As a result, he may be paying for something that would have been built anyway. This issue, known as "additionality" was a major concern in the design of the Kyoto emissions trading system, in which a project can't generate emissions credits unless it wouldn't have been built otherwise. For example, in the case of Kyoto's Clean Development Mechanism (CDM,) that effectively means that a developed country facing high costs of reducing its emissions can invest to build a project in a developing country that avoids a like quantity of emissions much more cheaply. Such projects generate emissions credits that can be traded. No CDM, no project; no project, no credits.

US RECs are generated in a very different environment, and not just because we didn't ratify Kyoto. First, the federal government and states provide various cash and tax incentives for the production of renewable power. In addition, 23 state governments have established Renewable Portfolio Standards (RPSs) that require utilities to buy a set fraction of their power from renewable sources--with a federal RPS currently percolating through the energy bill negotiations in Congress. Throw in tradable RECs, and it becomes hard to say why a particular green energy project got built, other than that its net financial returns looked attractive to the developer.

When you consider the rapid build-out of renewable energy capacity in the last couple of years, it shouldn't surprise anyone that the supply of such power might exceed its demand in the market, with the result that RECs end up being pretty cheap. It's still a zero-sum game, however. Because Aspen Skiing Co. paid for RECs to render its power consumption green, some other business or cluster of consumers somewhere else in the system can't make the same claim about theirs. True additionality will return with a vengeance, once federal climate change regulations, or the national Renewable Portfolio Standard now under consideration in the Congress, create a tidal wave of demand for offsets. In the meantime, uniqueness ought to be an adequate standard for RECs within US electricity markets, providing an attractive means for businesses to manage emissions they can't afford to reduce directly.

Breaking The Record

Six weeks ago I crunched some numbers and arrived at an inflation-adjusted all-time high oil price of roughly $91/barrel. I also explained why that was lower than the $101 figure that has appeared in numerous publications. With the market currently trading above yesterday's record closing price in nominal dollars of $90.46, we are within a gnat's eyelash of setting a new real-dollar record for oil prices. An article in today's Wall Street Journal provides a good analysis of the factors that brought us here from $80 only a few weeks ago, while one on Canadian royalties offers useful hints about where things might go from here. Although I remain skeptical that we are encountering geologically-driven Peak Oil, the current market is beginning to exhibit the practical effects of a peak, in which production can no longer keep up with demand. If that's so, then it's impossible to say just how high prices might go before destroying enough demand to right the balance.

In a peak, producers lose the ability to bring on enough new output to meet growing demand. I don't think it matters much to consumers of oil whether that occurs because there aren't enough large new oilfields to tap, or because resource nationalism and geopolitics have made those fields inaccessible or unaffordable. The announced increase in royalties for the Alberta oil sands provides an example of this in a country that has attracted billions in foreign capital, because it looked safer than places like Venezuela or Russia, which have lots of oil but don't honor their contracts. Boosting the oil sands royalty rate to as much as 60% of revenue (combined federal and provincial take) might not bring new development to a halt, but in combination with global project-cost inflation and the steady rise of local costs in Canadian dollars that have risen dramatically against the US dollars in which the oil is sold, it makes the whole proposition a lot less profitable. Thus, at the stroke of a pen, hundreds of thousands of barrels per day of future production have probably just vanished.

That highlights an important difference between the current oil price excursion and past spikes that ended in a flood of new production. Production in the OECD countries is barely replacing the natural decline of mature reservoirs. The non-OECD output that has enabled the expansion of demand in the last several years has come mainly from projects that were planned under more attractive fiscal terms, in host countries that have since cooled towards international oil investment, at least from the western oil companies. Producing countries may be entitled to a fair share of the rent on their own resources, but they are also quite capable of killing the golden goose. Meanwhile, spare OPEC production capacity that might have been adequate a decade ago is now too small to dampen the volatility of an 85-86 million barrel per day market.

What all this means is that the safety valve, if there is one, must be found on the demand side. Any adjustments are unlikely to be evenly distributed, however. The continued growth of the large emerging economies is tied to oil, and many of their consumers are artificially insulated from its true price by government intervention. The price that European consumers pay is already dominated by taxes, so changes in oil prices result in smaller percentage increases in fuel prices there than in the US, which has so far been sheltered by weaker refining margins, at least for gasoline, though heating oil is now starting to spike. Nor are measures such as the 35 mpg CAFE standard I discussed Wednesday going to have any impact in the short run.

On balance, then, the mechanisms by which high oil prices might tend to self-correct look weaker than the factors driving them higher. It worries me that this seems to be as true at $90 as it was at $50, a couple of years ago. For some time now, my trading instincts have been telling me that we ought to be approaching a big correction in prices. However, it's getting harder to construct scenarios that would produce that outcome, and the ones that do pivot on economic events that would be even less pleasant than high oil prices have been.

Recharging the Electric Car

An article in yesterday's Wall St. Journal prompted some thoughts about the relative merits of entirely-electric cars (EVs,) compared with hybrids employing varying degrees of electric boost. It's interesting that Honda and GM, both of which have marketed all-electric cars in the past, should arrive at such different conclusions on the subject. Honda now apparently finds pure EVs superior to hybrids and plug-in hybrids (PHEVs,) while GM, which invested close to a billion in today's dollars in its EV-1 in the 1990s, is not convinced. Although some of the factors that led to the failure of the EV-1 might no longer apply, others look daunting, except perhaps to environmental regulators, who would naturally find zero-local-pollution EVs preferable to hybrids.

When you consider the experience of GM's EV-1, a few things stand out--after setting aside the unfounded allegations that it was killed by a conspiracy. As the testimonials from its former lessees attest, the EV-1 was a terrific car, as long as your driving needs didn't exceed about 75 miles, or you didn't need to transport more than one additional passenger. The latter was a design issue, constrained by the size of the original lead-acid battery pack and the body shape GM selected. But while the range was largely a function of the available battery technology, it also reflected the challenge of quickly recharging a partially-drained battery, even with a small number of high-voltage recharging facilities that GM and its partners installed around Southern California. How many of us would have really wanted a car that couldn't go more than 100 miles without stopping for a charge that might take an hour?

Batteries have improved a lot since the first EV-1 left the factory. If the lithium batteries around which GM is planning its Chevrolet Volt PHEV are able to deliver 40 miles of gasoline-free driving, surely a larger array of the same batteries could take an all-electric version of the same car 200 miles or more. That's the basis of the Tesla, which claims a range of 245 miles for its sleek electric roadster, running on thousands of laptop batteries.

Paradoxically, that range is both good news and bad news. Because it easily exceeds what most of us require for our daily commutes or errands, it effectively severs the chicken-and-egg infrastructure dependency that I believe really killed the EV-1: you can't sell EVs without recharging facilities but can't justify the recharging facilities without lots of EVs already on the road. A 200+ mile range eliminates the need for most recharging away from home, workplace or other predictable sources of electrical outlets and reduces the inconvenience associated with the lengthy intervals required for low-voltage recharging. In the process, though, it also eliminates most of the incentive to build a fast-recharging infrastructure to meet the needs of longer-distance travel.

It's arguable that this isn't a real impediment. When I first started looking at these issues in the mid-1990s, I saw compelling data that suggested that American motoring habits were evolving towards each household owning a mini-fleet of specialized vehicles: the commute or train car, the kid-hauler, the weekend sports car, etc. That meant that a car like the EV-1, which couldn't fill all of these roles but excelled at one, had great potential. Unfortunately, that view turned out to be wrong, or at least premature. This is still a key question today. Would millions of consumers be happy to own a car that they couldn't sensibly drive from Boston to Washington, DC, let alone from Washington to Minneapolis?

If the answer is yes, then a pure electric car looks pretty good, and the added complication and expense associated with a plug-in hybrid might not be justified, provided the cost per Watt-hour of batteries keeps falling. Personally, though, I think the flexibility of a PHEV able to run on gasoline, E-85 or electricity will appeal to more folks than a simpler battery car. I also doubt that the target market for the six-figure Tesla will tell us much about that trade-off. But isn't it nice that technology is finally providing multiple choices for our future transportation needs? EVs and the various hybrids may compete for market share, but they could also coexist nicely, all furthering the gradual electrification of automobiles.

CAFE and Energy Independence

As the readership of this blog has grown, I find myself receiving more inquiries from small PR firms seeking my aid in promoting some issue, product, or cause. Last week, I was contacted by an agency working with the Pew Center on Global Climate Change on their campaign in support of the 35 mile per gallon Corporate Average Fuel Economy (CAFE) standard under consideration in the Congress. After an exchange of emails with the PR contact, I learned that the message for conservatives is intended to emphasize CAFE's impact on energy independence. Instead of harping on the practical impossibility of that goal, I'd rather look at how a tougher CAFE standard could align with other measures and arrest the steady deterioration of our energy independence that has taken place over the last two decades.

I haven't changed my view that CAFE is a relatively weak policy by itself--a target and a tracking mechanism without the teeth to drive the change it will measure. The original CAFE standards probably get too much credit for the improvement in fuel economy that followed the oil price spikes of the 1970s. And while they kept fuel economy on the radar screens of the auto companies after oil prices collapsed in the mid-1980s, their loophole for light trucks--designed to protect small businesses--subsequently midwifed the explosive growth of SUVs. So if we regard CAFE as an important and consequential metric, but not the prime driver of automotive fuel efficiency, it forces us to think about the larger environment in which it plays out. CAFE won't be out there by itself.

Today that environment includes two primary drivers of change. The first is energy security, manifested by the high and volatile prices we pay for fuel. The quantity of energy we import affects those prices directly, through our competition with other consuming countries for the limited exports from oil producing countries, and indirectly, by expanding our trade deficit and weakening the dollar. But while "energy independence" has been part of the campaign rhetoric of most of the presidential candidates, I've yet to hear one quantify it. The chart below highlights the decline in US self-sufficiency, in terms of the share of our total primary energy consumption that we produce ourselves. Remarkably, at 71% our current level of energy independence is much lower than when independence first became an aspirational target in the mid-1970s. Nor has renewable energy made a noticeable dent in the problem, so far.

Energy Independence, %

(source data from http://www.eia.doe.gov/emeu/aer/txt/ptb0101.html)

Although the decline in US oil production contributed to this deterioration, we actually produce more primary energy today than we did in 1984, when we were 90% energy independent. The cumulative effect of demand growth has been the big story, here, and CAFE speaks directly to that trend.

The other major driver of change is global warming. Whether the current fires, drought, Arctic melting, or any other phenomenon is directly attributable to man-made climate change, it is noteworthy that the question is now asked in every case. I will cover the Lieberman-Warner climate change bill, which was introduced last week, in more detail later. Even if it turns out not to be the last word on a cap & trade system, it is becoming hard to imagine a future in which the Congress does not pass meaningful legislation limiting US greenhouse gas emissions. The details are important, but the fundamental fact of assigning a monetary cost to CO2 emissions represents a step-change in the economics of energy and transportation.

Taken together, that means that a 35 mpg CAFE standard would be implemented against the backdrop of high oil prices with no end in sight (eerily reminding me of 1982) and escalating costs for the CO2 that is an inevitable byproduct of burning gasoline, at the rate of 20 pounds for every gallon. Achieving 35 mpg will doubtless reduce those emissions and break the trend of our growing energy dependence. However, it must be the consequences of those high oil prices and of monetizing CO2 that ultimately convince consumers to buy the cars that will make 35 mpg attainable. And if that mechanism isn't as clear-cut as the high carbon tax that many economists would prefer, it at least has the virtue of being possible in the current political environment.

The Hydrogen Bet

Preparing my slides for use in the upcoming webinar on future transportation fuels (see below) forced me to confront the difficulties of presenting a positive case for hydrogen without glossing over the numerous caveats that go along with it. As I Googled for data, I ran across an interesting debate that reflects the same conundrum. Although I don't feel compelled to choose a side in this particular debate, which has been blogged by Treehugger, it got me thinking about the introduction of fuel cell vehicles (FCVs) and whether they would be able to ramp up gradually, the way that hybrids have. My conclusion is that in 2015, when Dr. Romm and Mr. Blencoe must settle their bet, there's likely to be no ambiguity about who has won.

When you consider the barriers standing in the way of mass-market hydrogen cars, they really all need to be solved at once, or if not at once, then at least in a package that allows enough of these cars to get on the road quickly enough that their sales can rapidly climb to the 500,000 to 1 million level that manufacturers such GM and Ballard indicate would be necessary to reduce the cost of the fuel cell stack assembly and power electronics into the same range as an internal combustion engine powertrain. The Blencoe/Romm bet hinges on whether FCVs can reach 1% of new car sales by 2015. Allowing for a bit of growth between now and then, that works out to roughly 200,000 units. That level of sales couldn't be achieved without sufficient infrastructure for hydrogen production and distribution, in the form of magnesium hydride or simply compressed H2--infrastructure that is entirely new and incompatible with our current fuels distribution systems.

The best scenario for overcoming this critical interdependence involves a focused regional rollout. Southern California comes to mind as a likely venue. But with about 13 million cars in the entire L.A. Basin, and total car sales in California running at 2 million per year, FCVs would quickly have to attain a 20% local market share within five years from launch. (It has taken hybrids 10 years to capture roughly 5% of this key regional market.) The necessary infrastructure would have to roll out even faster, to prevent a refueling bottleneck from developing, and to assure consumers that they won't be buying orphan cars. If you've ever tried to get anything permitted in California, let alone built, you begin to grasp the magnitude of that challenge, and I haven't even mentioned the problem of producing enough hydrogen to supply a half million or so FCVs, and whether it would come from natural gas, as most of the H2 used in the fertilizer and chemical industries does, or be produced by electrolysis in a state that experienced serious electricity shortfalls only a few years ago.

My readers know I'm generally cautious about projections that depend on many things going just right, especially when fleet turnover and infrastructure are involved. But let's grant, for the sake of argument, that all the necessary preconditions could be met in Southern California between now and 2010, perhaps as a result of new legislation. But then things get tricky. Hydrogen cars will have to compete in a competitive landscape in which many new car models will be available as hybrids, high-efficiency European-style diesels, or in some cases as plug-in hybrids (PHEVs.) Dr. Romm is not alone in regarding the PHEV as a potential fuel cell killer, because it offers similar efficiency while requiring minimal new infrastructure.

The appropriate analogy here isn't to the 1980s' battle between VHS and Betamax, or even the current competition between Blu-ray and HD-DVD. In the case of FCVs vs. PHEVs, it's as if you didn't just need a new DVD player to play a Blu-ray disc, but also a different TV and an entirely re-wired home, while HD-DVD required only one new box. In order for Blu-ray to win under those circumstances, I think it would have to do a lot more than just display incredibly sharp images on your TV. Even 3-D might not be enough. (Note: I don't own a high-def DVD player and have no dog in that fight--this is just an analogy.) For the fuel cell car to win, it must be demonstrably so superior to anything else, including the PHEV, that consumers will yearn for it as though it were the latest iPod/iPhone with wheels, and energy companies must abandon caution--and their economic models--and race to build the infrastructure in advance of the demand, just to be in on the ground floor of the Next Big Thing.

Please understand that my heart is with Mr. Blencoe, here. An FCV running on clean hydrogen is a much more elegant concept than the PHEV, which for all its clever engineering seems a bit kludgy by comparison. But while I've never been as pessimistic about hydrogen's prospects as Dr. Romm, I'm afraid he has the surer side of this bet. 2015 is not much time, to complete all the necessary development, prototyping, certification, permitting and retooling necessary to sell 200,000 fuel cell cars per year.



On November 1, 2007 I'll be participating in a webcast discussion on "Fuels for Now and the Future" with Scott Sklar of The Stella Group, Ltd., hosted by Cleantech Collective. For more information and to register for the webcast, please follow this link.

Regulating Speculation

The front page of the Sunday Washington Post featured an article on the perils of speculation on under-regulated energy futures exchanges. The Post cites the cost to consumers from speculators driving up the cost of these commodities and makes a case for expanding both the powers and budget of the Commodities Futures Trading Commission (CFTC), the federal body established to regulate such transactions. However, the article also describes how further regulation might drive this trade off the regulated exchanges and deeper into the unregulated and much less transparent over-the-counter markets (OTCs.) While all of this is interesting, it reflects the typical shortfalls of coverage that treats futures markets as black boxes. The reality is more complex and less nefarious--and the likely solution much simpler--than the Post suggests.

Futures markets offer important benefits for all participants, particularly for those seeking to manage the price risks of the physical oil positions intrinsic to their operations. That includes oil, gas and electricity producers, refiners and large consumers. The fixed-price heating oil contracts that have become so popular with consumers would not exist without thriving futures markets. Purely financial participants play an essential role in these markets, providing liquidity and taking offsetting positions that the physical players might eschew on any given day. Pegging the price of physical transactions to the settlement prices of these exchanges became popular starting in the late 1980s, because their liquidity and transparency was impossible to match for all but a few high-volume physical trades. The other main benefit for exchange participants is the virtual elimination of counter-party risk, the risk that when the time comes to collect the oil or money owed at the settlement of the transaction, the other party won't be able to make good.

The OTCs serve a different, but complementary role, facilitating transactions that are too specialized or thinly-traded for the established futures exchanges to take on. These can be very lucrative deals for market makers, because transparency is low and transaction costs are often very high. The frontier between the exchanges and OTCs is dynamic, with the former periodically offering new products that encroach on the turf of the latter--sour crude, fuel oil, etc. Anything that made the futures markets less useful or more expensive for their participants would drive trade toward the OTCs, and that's the chief risk of over-regulating these exchanges.

Several months ago I wrote a lengthy posting concluding that it was plausible that speculation had contributed to the dramatic increase in oil prices over the last four years. I took a lot of flak for that suggestion, which I still find eminently defensible on fundamental economic grounds. Notwithstanding expanding global demand for oil and the sharply increased marginal cost of bringing new supplies to market, along with a wide array of "above-ground" risks, financial speculation in oil by non-industry players represents a growing source of demand in the virtual markets that set the price for much of the physical trade in oil and petroleum products. But commodity markets, either regulated formal exchanges or unregulated OTCs, are not responsible for this phenomenon. They are merely the conduit for the impulses of an increasingly securitized financial economy that bets on every aspect of life, down to the weather. The pitfalls of some of these complex bets often don't become apparent until after they go bad, as we are witnessing on a large scale today.

Now factor in the legitimate national interest of the US government and the public it serves to minimize the impact of financial speculation on the final cost of petroleum products and the other forms of energy upon which the real economy depends. There is no corresponding national interest in allowing speculators to profit from these commodities, beyond a practical interest in allowing enough liquidity to ensure that these markets work smoothly for of all participants, especially those with physical exposure to hedge. If speculation in oil commodities drove their price up by $10/barrel, that would cost businesses and consumers $70 billion/year and increase the US trade deficit by about $40 billion. On that basis, I believe there is a solid argument for new regulation. The trick is ensuring that the treatment doesn't kill the patient.

That's where I think the Post and various members of Congress pursuing tighter scrutiny of commodity exchanges are on the wrong track. The issue here is not the exchanges, or even the OTCs, but rather the investors using them. The challenge for an external party trying to piece together all of the market positions taken across various futures exchanges and OTC markets by a party such as Amaranth, the new poster-child for commodities excesses, looks truly daunting, even for auditors examing them after the fact. The most sensible alternative to such a regulatory nightmare would be to require investors themselves to disclose aggregate positions exceeding some threshold to federal regulators, just as the SEC requires the disclosure of any stake over 5% in the equity of a traded company.

While journalists and the public may regard such speculators as undisciplined cowboys, every one of them has internal controls that require daily or real-time "mark-to-market" trading reports, tallying the entity's current exposure to each commodity. Reporting that exposure to the CFTC whenever it exceeded 10 million barrels of oil or the equivalent in gas or other energy commodities could be accomplished with minimal new bureaucracy or accounting burden, and without distorting the relationship among the physical, futures and OTC markets. That would provide the over-the-shoulder scrutiny that the Post and others advocate, but at a much lower cost to the economy.